Knowledge that Transforms

Abstract This paper reports the results of an experiment that examines the influence of uncertainty about the probability that a future loss will occur ("ambiguity") on auditors and financial statement users' judgments about appropriate reference to contingent losses in audit reports. Application of Einhorn and Hogarth's (1985) ambiguity model suggests that, with respect to losses of tow (high) probability, both auditors and users will act as if an ambiguous probability of loss is higher (lower) than a precise probability of the same magnitude, thus demonstrating a conservative (unconservative) reaction to ambiguity. In addition, since auditors may jeopardize client relations when they unnecessarily make audit report reference to contingent losses, auditors may react less conservatively to ambiguity than do users. The results of the experiment support these predictions.

Abstract This study finds that, for a sample of 335 open-market repurchase announcements during 1978 to 1992, the market reaction to the announcement is significantly associated with the firm's sales growth and accounting profitability in prior periods. This result holds after controlling for two known correlates of the market response, the announced fraction to be repurchased and prior returns. This result is consistent with the market reinterpreting previously released accounting information when interpreting a subsequent repurchase announcement by the firm. Further, the association between the market response and prior accounting information is more pronounced for firms that are smaller in size or have fewer analysts following them. This suggests that the degree of reinterpretation of prior accounting information at the time of the repurchase announcement increases in the information asymmetry between managers and investors.

Abstract Firms expend costly resources on audit-based monitoring schemes to improve interdivisional coordination. This study investigates the premise that the effectiveness of and demand for audit-based monitoring may be sensitive to societal factors. Data from a between-subjects experiment involving 60 compensated groups of four (a total of 240 subjects) indicates an interaction between the experiment's two factors: (1) country (20 groups conducted in Canada, 20 in Hong Kong and 20 in the People's Republic of China (PRC)), and (2) the degree of anonymity in internal reporting. Specifically, we find that audit-based monitoring is less effective and less demanded in Hong Kong and the PRC than in Canada, but this difference arises only in a setting with a low degree of anonymity. The interaction with anonymity supports the attribution of results to differing cultural values.

Abstract Managers frequently encounter situations involving a trade-off between financial reporting and tax reporting incentives. This paper examines whether inside ownership concentration, a proxy for reduced capital market pressure, influences the balance of these two opposing external reporting incentives. The empirical tests use a sample of major asset divestitures to show that, for high tax- rate firms, managers of firms with lower levels of inside ownership concentration realize larger gains or smaller losses, on average. This work extends previous research by combining insights from the micro-economics tax incentives literature and financial reporting incentives literature, and by considering explicitly the effect of a firm-specific variable on the balance between these two incentives.

Abstract This paper presents an analytical model that explores the impact of auditors' legal liability on audit quality and investment. The model is particularly concerned with the impact of damage measures on investments. The threat of liability payments creates an incentive for the auditor to work hard: however, the potential liability payments can also provide an "insurance" for investors in the event the state of nature is bad. Indeed, if damages are measured based on actual investments, investors can increase the liability payments by over-investing. Thus, the potential transfer of wealth from auditors to investors can lead to an over- investment in risky assets, relative to a socially optimal level, even with a high-quality audit. A socially optimal level of investment can be induced by removing the association between actual investments and liability payments. In my model, a legal regime that can induce the socially optimal level of investment, while still motivating the auditors to exert the socially optimal effort level, consists of a strict liability rule with a damage measure that is independent of the actual investment.

Abstract This study investigates the separate and joint effects of prior knowledge and accountability on performance in the information search phase of a tax research task. An experiment is reported in which 63 tax professionals performed a computer-based tax research task. The results indicate that increases in effort duration, which are partly attributable to the accountability manipulation, improved search effectiveness regardless of the level of prior knowledge. In addition, after controlling for the effect of effort duration, accountability had an incremental positive effect on performance among the more knowledgeable professionals. These results suggest that effort can substitute for knowledge in performing information search tasks, but this substitution does not appear to be complete. The results also support the hypothesis that the effect of accountability on performance depends upon the level of knowledge, which suggests that certain aspects of effort and knowledge act as complements in improving performance.

Abstract This paper analyzes seven mandated disclosures contained in Management Discussion and Analysis (MD&A) to assess their information content. Generally, the results show that certain MD&A disclosures, particularly the discussions of future operations and planned capital expenditures, are associated with future (short-term) performance measures and investment decisions, after control- ling for information contained in financial-statement-based ratios. However, the associations with longer-term results are generally not significant. The study illustrates that, in conjunction with the financial statements, the MD&A disclosures, especially prospective disclosures, can assist in assessing firms' future (short-term) prospects.

Abstract This paper examines the relationship between the incidence of litigation events with potentially large damage awards and managers' accounting choices. We argue that the size of damage awards is a function of reported net income and net worth, and that this relationship provides management an incentive to manipulate accounting numbers. Our results indicate that managers of oil firms facing potentially large damage awards choose income decreasing non-working capital accruals relative to managers of other oil firms. Further, the results indicate that the management of these firms makes accounting choices that result in lower non-working capital accruals during the litigation period than in other years. These negative non-working capital accruals appear to result from the under-estimation of new reserves.

Abstract This study examines the trade-offs that an entrepreneur makes in an initial public stock offering (IPO) between the incremental costs and benefits of selecting a Big 6 audit firm. The benefit of hiring a Big 6 auditor is assumed to be reduced underpricing, consistent with Beatty (1989) and Balvers et al. (1988). The cost of hiring a Big 6 auditor is higher auditor compensation. Evidence drawn from a sample of lPOs during the early 1990's is consistent with a differentiated market for audit services where owners select the type of auditor that minimizes the sum of underpricing and auditor compensation costs.

Abstract This paper investigates the association between aspects of investors' disagreement around earnings announcements and investors' trading decisions. Theory suggests that trading volume arises because of investor disagreement, but disagreement is a multi-faceted construct. We find that three distinctly different aspects of disagreement each play an incremental role in explaining trading volume around earnings announcements, even after controlling for the magnitude of the contemporaneous price change. These aspects of disagreement are: dispersion in prior beliefs, change in dispersion, and belief jumbling . Dispersion in prior beliefs is the level of variation in expectations before the earnings announcement, change in dispersion is the difference in the level of dispersion in beliefs after vs. before the earnings announcement, and belief jumbling occurs when investors' beliefs change positions relative to each other around the earnings announcement. Our results indicate that each of these three aspects of disagreement is associated with investors' real economic (i.e., trading) decisions around earnings announcements.