Knowledge that Transforms

Abstract Implicit taxes reflect the extent (if any) to which tax-favored assets bear lower pretax returns than do tax-disfavored assets of similar risk. Prior research on implicit taxes has met with mixed results, particularly in equity securities, because of the difficulty in separating tax effects from effects caused by cross-sectional differences in risk. We avoid problems of risk by essentially comparing each security to itself before and after an unexpected change in the manner in which dividends are taxed to corporate investors. We find strong evidence of implicit taxes in preferred stocks. Extensive testing using the same event date indicates that no similar implicit tax effect exists in common stocks.

Abstract The performance goal for a unit is commonly created by consolidating the goals of its subunits. This paper shows that if it is difficult (easy) for the subunits to achieve their goals, it is almost always even more difficult (easier) for the unit to whole will almost certainly not meet a goal to cut its costs by a certain percentage if the degree of cost cutting is difficult to achieve at the individual subunit levels.

Abstract Prior research on auditors' memory for evidence encountered during working paper review suggests that auditors commit memory errors that could inhibit audit efficiency and effectiveness. The current study extends this line of research by examining whether two prominent features of the auditing environment. The current study extends this line of research by examination whether two prominent features of the auditing environment, audit risk and information importance, affect the accuracy of auditors' memory and auditors' memory and author's willingness to rely on memory. These issues were examined in an experiment in which auditors were required to review two working-paper areas (accounts) and, 24 hours later, recognize if information items had been present in the working papers and express how willing they would be to rely on their memory for each item. The results indicate that (1) the accuracy of auditors' memories is positively related to the level of audit risk of the area and the degree of importance of an information item within the area; (2) the auditors' willingness to rely on memory is negatively related to the degree of information importance but not related to the level of audit risk of the area; and (3) the auditors' likelihood of referring back to the working papers is negatively related to the accuracy of auditors' memories, and this negative relationship increase with the degree of information importance. Collectively, these results suggest that audit risk and information importance altered auditor's cognitive activities during the review process in a manner that contributes to the effectiveness (e.g., better memory for more consequential evidence) and efficiency (e.g., less verification more strongly remembered and less consequential evidence) of the audit.

Abstract This study provides evidence on the relevance and reliability of option pricing-based value estimates for bonds and their components, i.e., conversion, call, put and sinking fund features. Findings reveal component value estimates represent large fractions of bond par value, and a fundamental components approach to account for corporate debt results in key financial statement amounts significantly different from those presently recognized. Component value estimates and financial statement amounts vary significantly with component estimation order. Thus, bond value estimates potentially meet the FASE3's relevance criterion. However, estimate variation across component estimation orders and comparisons of estimates to available benchmarks indicate bond value estimates lack reliability.

Abstract This study evaluates the relation between security returns and funds-based earnings components. We document that proxies for market expectations of the components that are based on measures of historical serial- and cross-dependencies are substantially more accurate than random-walk proxies. Moreover, we detect significantly higher valuations of the operating cash flow component of earnings, relative to current accruals, when market expectations are represented using the dependency-based predictions. Such differential valuation is not detectable for random-walk representations. Contrary to results in Ali (1994), we find incremental information in unexpected cash flows over the whole spectrum (moderate and extreme) of unexpected cash flow realizations.

Abstract We provide evidence that the auto-regressive structure of seasonally differenced quarterly earnings is consistent with the requirements of the integral approach to interim reporting. In particular, we show that the auto-regressive coefficients for standardized seasonally differenced quarterly earnings are larger when the quarters employed in the auto-regressions belong to the same fiscal year than when they belong to different fiscal years. We then show that the signs and magnitudes of abnormal stock returns following earnings announcements are systematically related to these differences in the auto-regressive structure of seasonally differenced quarterly earnings. Specifically, stock returns act as if investors underestimate the larger auto-regressive coefficients between quarters in the same fiscal year. Thus, we corroborate and extend the Bernard and Thomas (1990) hypothesis that stock prices fail to reflect the extent to which quarterly earnings series differ from a seasonal random walk.

Abstract Economic theory stresses that opportunity costs are relevant to resource allocation decisions, while prior empirical accounting research finds that decision makers tend to ignore or underweight opportunity cost information. This study examines whether accounting knowledge is associated with a decision maker's tendency to ignore opportunity costs in business decisions. The experiment's results indicate that the number of opportunity costs ignored by subjects in a business resource allocation decision is greater for subjects with high-accounting knowledge than for subjects with low-accounting knowledge. The experiment also indicates that subjects with high- accounting knowledge ignore a greater number of opportunity costs when the decision is posed in a business context than when it is posed in a personal context.

Abstract Institutional investors have strong incentives to search for private predisciosure information about companies in their portfolios because of their fiduciary responsibilities and large resource bases. In addition, large institutional ownership may induce a high level of voluntary disclosure prior to earnings announcements. Greater private information acquisition and greater levels of voluntary disclosures prior to earnings releases suggest that the content of the earnings releases by firms with higher institutional ownership is partially preempted in predisciosure market prices. This paper tests the hypothesis that the market price response to the earnings announcements is smaller for securities with higher institutional holdings. The empirical tests provide evidence that the higher the institutional holdings, the lower the market reaction to earnings releases after controlling for security capitalization and the number of analysts following the firm.

Abstract We examine whether the application of fundamental analysis can yield significant abnormal returns. Using a collection of signals that reflect traditional rules of fundamental analysis related to contemporaneous changes in inventories, accounts receivables, gross margins, selling expenses, capital expenditures, effective tax rates, inventory methods, audit qualifications, and labor force sales productivity, we form portfolios that earn an average 12- month cumulative size-adjusted abnormal return of 13.2 percent. We find evidence that the fundamental signals provide information about future returns that is associated with future earnings news. Moreover, a significant portion of the abnormal returns is generated around subsequent earnings announcements. These findings are consistent with the underlying focus of fundamental analysis on the prediction of earnings. Significant abnormal returns to the fundamental strategy are not earned after the end of one year of return cumulation, indicating little support for the idea that the signals capture information about multiple-year-ahead earnings not immediately impounded in price or about long-term shifts in firm risk. Additional analysis on a holdout sample suggests that the strategy continues to generate abnormal returns in a period subsequent to the introduction of the fundamental signals in the literature, and contextual analyses indicate that the strategy performs better for certain types of firms (e.g., firms with prior bad news).

Abstract We construct a dynamic multi-agent moral hazard model to analyze the interactions among the firm owner, the manager and the auditor. Moral hazard may arise in hierarchical agency because a rational monitoring agent may accept a side payment from the monitored agent for misrepresenting information to the principal. This multi-agent moral hazard problem is the essence of the concern for auditor independence. We show that a "low-balling" compensation scheme and the auditor's legal liability constitute an efficient dynamic contracting mechanism for hierarchical agency. In particular, low balling serves as a substitute for legal liabilities for maintaining auditor independence. Low balling reduces the transaction costs associated with the audit engagement relative to the flat-fee structure and can actually improve auditor independence.