Knowledge that Transforms

Due to recent technological advancements such as online workpapers and email, audit firms have alternative methods of workpaper review that they did not have in the past. While audit workpaper preparers typically know they will be reviewed, and know the form their review will take, prior research has focused on comparing the judgments of auditors who expect to be reviewed with auditors who expect to remain anonymous. This study examines the effects on preparers of using two different methods of review: face-to-face and electronic review. The study also compares both review groups to a no-review control group. Consistent with the Heuristic-Systematic Model, we find that the method of review affects preparer effectiveness and efficiency. Specifically, preparers anticipating a face-to-face review are more concerned with audit effectiveness, produce higher quality judgments, are less efficient at their task, are less likely to be influenced by prior year workpapers, and feel more accountable than preparers in both the electronic review and no-review conditions. Interestingly, electronic review preparers generally do not differ from the no-review group. These results suggest that how a review will be conducted, and not merely the expectation that a review will occur, affects the decision-maker's judgments and perceptions.

This paper presents an experiment that examines the effect of pro forma earnings disclosures on the judgments of analysts (i.e., more sophisticated investors) and nonprofessional (i.e., less sophisticated) investors. In the experiment, participants developed stock price assessments after reviewing background financial information and a current earnings announcement for a company. The earnings announcement was manipulated to report only GAAP earnings in one condition and both pro forma and GAAP earnings in the other condition. Consistent with empirical evidence, the pro forma earnings in our experiment exceeded GAAP earnings. The results indicate that nonprofessional investors who received an earnings announcement that contained both pro forma and GAAP disclosures assessed a higher stock price than did nonprofessionals who received an announcement containing only GAAP disclosures. Financial analysts' stock price judgments were not affected by the pro forma disclosures. Followup analyses suggest that analysts and nonprofessional investors used different valuation models and information processing. Analysts used well-defined valuation models, based on either earnings-multiples or cash flows, while the nonprofessional investors were more likely to use simpler, heuristic-based valuation models. The pro forma disclosure did not cause nonprofessional investors to assess a higher earnings number for determining a stock price, but rather caused nonprofessionals to perceive the earnings announcement as more favorable, which in turn caused them to convert earnings or some other performance metric into a higher stock price. This effect appears to be due to unintentional cognitive effects, rather than nonprofessionals relying on pro forma earnings information because they perceived it to be informative.

We examine the relation between the cost of equity capital and seven attributes of earnings: accrual quality, persistence, predictability, smoothness, value relevance, timeliness, and conservatism. We characterize the first four attributes as accounting-based because they are typically measured using accounting information only. We characterize the last three attributes as market-based because proxies for these constructs are typically based on relations between market data and accounting data. Based on theoretical models predicting a positive association between information quality and cost of equity, we test for and find that firms with the least favorable values of each attribute, considered individually, generally experience larger costs of equity than firms with the most favorable values. The largest cost of equity effects are observed for the accounting-based attributes, in particular, accrual quality. These findings are robust to controls for innate determinants of the earnings attributes (firm size, cash flow and sales volatility, incidence of loss, operating cycle, intangibles use/intensity, and capital intensity), as well as to alternative proxies for the cost of equity capital.

From 1996 to 1998, listed companies in China were required to achieve a minimum return on equity (ROE) of 10 percent in each of the previous three years before they could apply for permission to issue additional shares. As a result of this rule, there was a heavy concentration of ROEs in the area just above 10 percent. We show that the Chinese regulators appear to have scrutinized firms using excess amounts of nonoperating income to reach the 10 percent hurdle. In addition, their ability to do so seems to have improved over time, which allows them to be better able to identify firms that subsequently performed better. However, many firms were still able to gain rights issue approval through excess nonoperating income. We show that these firms subsequently underperformed other approved firms that did not use the same practice, indicating that the Chinese regulators' objective of guiding capital resources toward the well-performing sectors is partially compromised by earnings management.

Prior research suggests that Big 4 auditors provide higher quality audits in the U.S. in order to protect the firm's brand name reputation and to avoid costly litigation. In this study, we examine whether the perceived higher quality of a Big 4 audit is related to auditor litigation exposure or to reputation concerns. Specifically, we utilize an estimable proxy for financial reporting credibility—the ex ante cost of equity capital—to examine whether Big 4 auditors are perceived as providing higher quality audits (relative to non-Big 4 auditors) in the U.S., and in the less litigious (but economically similar) environments in other Anglo-American countries during the 1990–99 period. We find that a Big 4 audit is associated with a lower ex ante cost of equity capital for auditees in the U.S. but not in Australia, Canada, or the U.K. Our findings suggest that it is litigation exposure rather than brand name reputation protection that drives perceived audit quality.

In this paper we examine the effect of filing form 10-K on EDGAR on the incidence of small and large trades. We find that the change to EDGAR filings results in significant increases in the volume of small, but not large trades, during the five-day window (−1, 3) around the filing date. While our data does not allow us to directly examine the trading profits and transactions costs of investors, we are able to examine whether the trading patterns reflect information available in the 10-K differently in the pre- and post-EDGAR period. Using stock return as a proxy for the information content of the 10-K, our results show that post-EDGAR small trades are more likely to reflect that information, i.e., more likely than in the pre-EDGAR period to be buys (sells) when returns in the five-day window after the trade are positive (negative). We also find that while the product of the net buys (sells) and the price change over the five-day window after the trade for small trades in the post-EDGAR period is still less than that for large trades, the difference between the two groups decreased significantly. Consequently, while we cannot directly examine the profitability of these transactions, the evidence presented is consistent with EDGAR improving the trading outcomes of small vis-a`-vis large investors.

Audit clients often employ a former partner of their present auditor as an officer or a director. This “revolving door” practice presents a potential threat to auditor independence. Using the Jones (1991) model to calculate abnormal accruals for firms in 1998 and 1999, we find that firms employing former partners as officers or directors report larger signed and unsigned abnormal accruals than other firms, after controlling for other factors that plausibly affect abnormal accruals. To ensure that the results are not driven by performance characteristics of the former partner firms, we construct a performance-matched control sample and obtain consistent results. We also observe a disproportionately higher (lower) proportion of former partner firms than expected just meeting (missing) analysts' earnings forecasts.

Prior research reveals that write-offs of long-lived assets are both large in magnitude and frequent in occurrence. Responding to calls for enhanced reporting of these items, the FASB issued SFAS No. 121, Accounting for the Impairment of Long-Lived Assets. However, its effect on the characteristics of reported write-offs remains unclear, as implementation requires inherently subjective estimates. Further, critics (including dissenting FASB board members and the SEC) question the standard's guidance. Motivated in part by this debate, this paper contrasts the characteristics of write-offs reported prior versus subsequent to the issuance of SFAS No. 121. Empirical results reveal that economic factors have a weaker association with write-offs reported after SFAS No. 121. This is consistent across macro, industry, and firm-specific variables. Results also indicate a higher association between write-offs and “big bath” reporting behavior after the standard's implementation, and that this “big bath” behavior more likely reflects opportunistic reporting by managers rather than the provision of their private information. These inferences are robust to a number of alternative specifications and variable definitions. Overall, the results suggest the reporting of write-offs under SFAS No. 121 has decreased in quality, consistent with criticisms of the standard.

Using unique data on brokerage-firm trading, I examine whether analysts' earnings forecasts and stock recommendations affect their brokerage firms' share of trading in the forecast stocks. I find that individual analyst's forecasts that differ from the consensus forecast generate significant brokerage-firm trading in the forecast stocks in the two weeks after the forecast release date, affirming that analysts' forecasts affect their brokers' commission revenue. However, I find no evidence that analysts' forecast errors—the difference between forecast earnings and actual earnings—increase brokerage-firm trading. This result suggests that analysts cannot generate trade for their employers simply by adding error to their forecasts. I find that buy recommendations generate relatively more trading, both buying and selling, through the analyst's brokerage firm. Collectively, these results suggest that analysts can generate higher trading commissions through their positive stock recommendations than by biasing their forecasts.

Prior research has examined audit pricing for publicly held firms and provided some evidence of a Big 8 premium in pricing. We investigate audit pricing among private firms, and provide evidence that private firms do not pay such a premium on average. The relatively greater degree of dispersion in auditor choice (between Big 5 and non-Big 5 auditors) in our large sample of privately held audit clients allows us to predict the auditor choice for each firm and to control for potential self-selection. We reject the null hypothesis that clients are randomly allocated across Big 5 and non-Big 5 auditors. Using standard OLS regressions, we document a Big 5 premium; however this premium vanishes once we control for self-selection bias. Moreover, we find that client firms choosing Big 5 auditors generally would have faced higher fees had they chosen non-Big 5 auditors, given their firm-specific characteristics. Our results are consistent with audit markets for private firms being segmented along cost-effective lines. Further, our results suggest that auditees in our setting do not, on average, view Big 5 auditors as superior in terms of the perceived quality of the services provided to a degree significant enough to warrant a fee premium.