[This paper demonstrates how a manager's concern for reputation can distort reports made to superiors about an investment project and hence, can affect a firm's capital budgeting decisions. In the first setting examined, a manager is assumed to know more than her superior about both her personal abilities and the prospects of a project under consideration. A manager's ability has two dimensions-ability to forecast a project's returns and productivity. A more talented manager has both better forecasting abilities and higher productivity than a less talented manager. It is shown that while a more talented manager always reports her assessment of a firm's project truthfully, a less talented manager's report depends on the magnitude of the difference in productivities between the more and less talented managers. When this productivity gap is large, the less talented manager conceals her lack of talent by claiming that the project's returns are low so as to discourage investment by the firm. Shifting blame to factors beyond her control protects the manager's reputation. Such managerial misreporting results in underinvestment by the firm. In contrast, where the productivity gap between a less talented manager and a more talented manager is small, a less talented manager guards her reputation by sometimes reporting favorable prospects and sometimes unfavorable prospects. This leads the firm either to over- or underinvest its resources, respectively. Thus, managerial misreporting occurs in equilibrium because a less talented manager tries to masquerade as a more talented manager, resulting in investment distortions. Whether a manager's concern for reputation exacerbates or mitigates the incentive problem depends on the manager's type. While the labor market forces align the incentives of a more talented manager with those of the firm, they also serve to misalign incentives for a less talented manager. In the second setting, this paper examines managerial investment distortion in the choice between short term and long term projects. Consider a scenario in which the outcome of a short term project is observed publicly earlier than that of a long term project. It is shown that managerial reputation incentives, coupled with superior two-dimensional private information, would cause a more talented manager to implement a short term or a long term project as dictated by the firm's interests, whereas a less talented manager with low productivity would choose a long term project. Through such choice, she is able to delay disseminating project outcome which is also informative about her type. A less talented manager who is relatively more productive would, however, implement a short term project sometimes and a long term project some other times. These investment distortions cannot be avoided either by restructuring the decision-making responsibilities or by the principal's committing to any implementation rules.]

Abstract Demonstrates how a manager's concern for reputation can distort reports made to superiors about an investment project and affect a firm's capital budgeting decisions. Managerial investment distortion in the choice between short term and long term projects; Underinvestment of the firm as a result of managerial misreporting; Participative budgeting issues.

[A major concern in the literature is that participation by subordinates may result in the generation of slack budgets (Antle and Eppen 1985). In one of the earliest studies, Williamson (1964) concluded that subordinate managers will try to influence the budget-setting process and obtain slack budgets. In conformance with Merchant (1985a), Lukka (1988), and Young (1985), budgetary slack is defined as the express incorporation of budget amounts that make it easier to attain. Managers may build slack into budgets by strategies that understate revenues and overstate costs (Schiff and Lewin 1970). Whether budgetary slack is a likely outcome in all participatively set budgets is a matter of conjecture. Lukka (1988) argued that a high degree of participation gives subordinate managers the opportunity to contribute directly to the creation of slack, and vice versa. However, the link between participation and slack is equivocal, since Cammann (1976), Merchant (1985a), and Onsi (1973) provide evidence that participation may lead to a reduction in slack, which can be attributed to the positive communication between managers so that subordinates feel less pressure to create slack. The literature proposes a link between participation and budgetary slack through two variables: superiors' budget emphasis in their evaluation of subordinate performance, and the degree of information asymmetry between superiors and subordinates. When participation, budget emphasis, and information asymmetry are high (low), slack will be high (low). For this study, samples of managers were drawn from manufacturing organizations in the Sydney, Australia, metropolitan area. Measures of budgetary slack and information asymmetry were developed. Support was found for low (high) slack when the predictors are high (low).]

Abstract A major concern in the literature is that participation by subordinates may result in the generation of slack budgets (Antle and Eppen 1985). In one of the earliest studies, Williamson (1964) concluded that subordinate managers will try to influence the budget-setting process and obtain slack budgets. In conformance with Merchant (1985a), Lukka (1988), and Young (1985), budgetary slack is defined as the express incorporation of budget amounts that make it easier to attain. Managers may build slack into budgets by strategies that understate revenues and overstate costs (Schiff and Lewin 1970). Whether budgetary slack is a likely outcome in all participatively set budgets is a matter of conjecture. Lukka (1988) argued that a high degree of participation gives subordinate managers the opportunity to contribute directly to the creation of slack, and vice versa. However, the link between participation and slack is equivocal, since Cammann (1976), Merchant (1985a), and Onsi (1973) provide evidence that participation may lead to a reduction in slack, which can be attributed to the positive communication between managers so that subordinates feel less pressure to create slack. The literature proposes a link between participation and budgetary slack through two variables: superiors' budget emphasis in their evaluation of subordinate performance, and the degree of information asymmetry between superiors and subordinates. When participation, budget emphasis, and information asymmetry are high (low), slack will be high (low). For this study, samples of managers were drawn from manufacturing organizations in the Sydney, Australia, metropolitan area. Measures of budgetary stack and information asymmetry were developed. Support was found for low (high) slack when the predictors are high (low).

Abstract Reviews the book "Financial Reporting in Japan: Regulation, Practice and Environment," by T.E. Cooke and M. Kikuya.

[Current policy on how auditors should limit uncertainty about misstatements in auditee assertions is based on the audit risk model (AICPA 1992) that decomposes the components of audit risk as inherent risk (IR), control risk (CR), and detection risk (DR). The literature on the audit risk model has focused on a priori analyses of the model's assumptions and implications (see, e.g., Cushing and Loebbecke 1983; Kinney 1983, 1989, 1992; Leslie 1984), and auditors' risk assessments in experimental settings (see, e.g., Colbert 1988; Daniel 1988; Jiambalvo and Waller 1984; Libby et al. 1985). Absent are empirical studies that examine applications of the model in field settings. This article reports empirical evidence on auditors' IR and CR assessments in field settings by analyzing archival data drawn from the audit workpapers of KPMG Peat Marwick. As a part of audit planning, the firm requires its auditors to make and document IR and CR assessments for each assertion of each significant account.1 The assessments are made with respect to tolerable error, an algorithm-based measure of planning materiality at the assertion level.2 The data include approximately 5,000 risk assessments at the assertion level for trade accounts receivable, inventory, and trade accounts payable, on a total of 215 audit engagements. The data also indicate, for each assertion, whether a misstatement exceeding tolerable error was detected by the auditor. The data analysis considers four issues, the first of which is whether there is a statistical association between auditors' IR and CR assessments. A priori researchers (e.g., Cushing and Loebbecke 1983) argue that the audit risk model's multiplicative combination of IR and CR suggests independence between risk components, which contradicts auditors' conventional wisdom of dependence. The analysis in this study concludes that the dependence problem arises because (1) its event structure is ill-defined and (2) it fails to recognize that an auditor's assessments are conditional on his or her knowledge. A knowledge-based dependence may produce a statistical association between IR and CR. Contrary to expectation, the empirical evidence supports the conclusion of an insignificant association between IR and CR; however, in a predominance of cases, CR is assessed at the maximum probably for reasons of efficiency. The remaining issues pertain to the policy requirement of assertion-level risk assessments. Viewed generally over many audit engagements, current policy depends on the following premises: (1) the rate of misstatements varies over assertions, (2) auditors' risk assessments vary over assertions, and (3) the association between the rate of misstatements and auditors' risk assessments is positive (i.e., the assessments are accurate). The data analysis examines the empirical validity of each premise, and supports the first inasmuch as there are significant differences in the rate of detected misstatements over assertions for each account. However, auditors typically assess IR and CR at the same value for all assertions for an account, which is inconsistent with the second premise. When the data pertaining to all assertions for an account are included in the analysis, the association between IR and the rate of detected misstatements (after controlling for CR and DR) tends to be positive but low, which indicates modest support for the third premise. When the analysis includes only the "most important" assertion for each account, the association is considerably stronger. In general, auditors' risk assessments are consistent with a heuristic that deliberately assesses risk for an account's "most important" assertion but does so mechanically for other assertions. Taken as a whole, the results indicate a need either to reconsider the policy of multiple risk assessments for an account or to enhance auditors' ability to assess assertion-specific risk.]

Abstract Reviews the book "Doing Business in Russia and the Other Former Soviet Republics: Accounting and Joint Venture Issues," by Adolf J.H. Enthoven, Jaroslav V. Sokolov and Alexander M. Petrachkov.

Abstract Explains why some states in the United States have adopted relatively permissive licensing laws for public accountants. Use of hypotheses to test the power of interest groups, political systems and socioeconomic variables in explaining differences in licensing requirements; Role of the American Institute of Certified Public Accountants.

Abstract Reviews the methodology of models involving qualitative and limited-dependent variables and their application in accounting research. Logit and probit models and discriminant analysis; Tobit model and the truncated regression model; Models involving sample selection bias; Models involving self-selectivity; Prediction of the effects of mandated accounting changes.