Knowledge that Transforms

Accounting decisions often involve similar types of judgments regarding different clients, projects, or employees. These tasks may use similar information items and be performed within the same work session. While independent consideration of the information for each respective decision may be desired, psychology research on contrast effects suggests that the information from a previous decision may be retained and compared to the information provided for a current judgment. Such contrast effects are potentially critical to accounting judgments because they suggest that the information associated with a given decision task will be evaluated differently depending on the nature of the prior contextual information. Using a multi-client audit context, we find that auditors are susceptible to contrast effects such that their judgments on a current client are influenced by their exposure to similar judgment information on a prior client. We also extend prior psychology and accounting research by examining and finding that for a current client, the magnitude of the contrast effect from an initial judgment task cascades to influence indirectly related subsequent judgment tasks for which no information from the prior client is available for comparison. We also find auditors' documentations of evidence are systematically affected by the contrast and cascading of contrast effects. Thus, our results provide support for contrast effects and, most important, the cascading of contrast effects to subsequent decisions.

Auditors face the challenging tasks of attesting that the financial statements are free from material misstatement while simultaneously fostering a functional working relationship with the client. As the financial statements may be considered, in part, a product of negotiations between the auditor and client management (Antle and Nalebuff 1991), the negotiation strategy employed by the auditor may be useful in effectively fulfilling both tasks. To investigate the effect of auditor strategy on the resolution of proposed audit adjustments in a post Sarbanes-Oxley environment, we conduct experiments that examine both the client and auditor sides of the negotiation. We investigate a strategy of “concession” that draws upon the societal rule of reciprocation, which makes the waiving of inconsequential audit differences transparent. Specifically, with a concession approach, the auditor brings to the attention of the client all the audit differences (both significant and inconsequential) discovered during the audit and, subsequently, waives the inconsequential items. In contrast, a strategy of “no-concession” of inconsequential items (in which the auditor discloses to the client only the significant audit differences that must be booked) renders the client unaware of the waived inconsequential differences. Results from the client experiments indicate that, relative to a no-concession approach, participants representing client management (controllers/CFOs) are more willing to post significant income-decreasing adjustments (both objective and subjective) when exposed to a concession approach in the course of negotiating the final contents of the audited financial statements. A concession approach also results in greater client satisfaction and retention. Consistent with these findings, results from the auditor experiment suggest that auditors also perceive that altering their approach toward greater disclosure of waived inconsequential audit differences can improve client satisfaction and retention.

This paper develops a theoretical model to explain corporate divestment in the context of accounting-based valuation and provides empirical evidence to support the model's predictions. Building on Zhang's (2000) real-options-based equity value model, we develop a model to explain why firms with multiple business segments may have incentives in financial reporting to shift earnings from one segment to another to influence market valuation. Cross-segment earnings shifting, however, causes information asymmetry about segmental performance, which leads to market misvaluation. Divestment arises as a voluntary commitment by (some) firms to not engage in segmental earnings manipulation, with the aim of restoring valuation accuracy. Our theoretical analysis yields a number of testable implications. Consistent with our model's predictions, we find empirically that (1) divestment is preceded by an increased divergence in profitability between the divested and continuing segments of the divesting firm, (2) there are positive abnormal stock returns surrounding divestment announcements that are not dependent on increased expectations about future operating performance, (3) the magnitude of market revaluation increases with the profitability divergence between the divested and continuing segments, and (4) market revaluation is greater for more complex firms (in terms of having a larger number of segments and greater uncertainty facing investors).

In this study, we investigate underlying mechanisms for the effects of management guidance forms on investors' judgments. We do so by comparing effects of point and range guidance with those associated with a hybrid management guidance form that combines the attributes of both point and range guidance. With respect to investors' earnings reestimates made after actual earnings announcements, we find that both the number and type of benchmarks associated with the guidance forms matter. High-knowledge investors use both primary (explicitly stated) and secondary (implicitly stated) benchmarks, whereas low-knowledge investors attend only to primary benchmarks. We also find that investors have greater confidence in their earnings estimates when management guidance explicitly provides best estimates.

We examine the association between cost of equity and internal control weakness (ICW) for firms that filed first-time Section 404 reports with the SEC. Using several proxies, we find higher implied cost of equity associated with ICW firms than for a control sample of firms that disclosed no ICW. However, the higher cost of equity associated with ICW disappears after controlling for primitive firm characteristics and for analyst forecast bias. Overall, we find that, on average, ICWs are not directly associated with higher cost of equity.

Cost accounting systems provide accurate costs only under stringent conditions. However, we know little about the nature, level, and bias of costing errors. This paper reports the results of a simulation study of two-stage cost allocation systems that provide the following main insights: (1) partial improvement in the costing system usually increases the overall accuracy of reported product costs except in specific cases identified in this paper where errors have an offsetting effect, most notably when there is aggregation error in the activity cost pools and measurement error in the resource drivers; (2) the impact of Stage II costing errors on overall accuracy is stronger than that of Stage I errors, so system refinements should focus on Stage II; and (3) the presence of aggregation and measurement errors usually results in relatively more products being under- than over-costed, with large amounts of over-costing for a few “big-ticket” (in dollar terms) products, and small amounts of under-costing for a larger number of less expensive products.

This study examines former Arthur Andersen clients and provides evidence on the factors involved in their selection of new auditors after Andersen's collapse. Using a unique dataset that identifies whether former Andersen clients followed their audit team to a new auditor, findings reveal companies with greater agency concerns were more likely to sever ties with their former auditor, whereas those with greater switching costs were more likely to follow their former auditor. We also investigate the effect of the forced auditor change on financial statement quality in an effort to provide insight into the mandatory auditor rotation debate. Using performance-adjusted discretionary accruals as a proxy for reporting quality, our results fail to reveal significant improvements for companies with extreme discretionary accruals that severed ties with Andersen, which is inconsistent with the notion that mandatory rotation improves financial reporting.

This paper investigates two competing hypotheses for the accrual anomaly: investment/growth and persistence. Both investment/growth and persistence information in accruals are likely to vary cross-sectionally, depending on a firm's business model, a fact that generates different cross-sectional implications for the accrual anomaly. I find that the magnitude of the accrual anomaly monotonically increases with the investment information contained in accruals, as measured by the co-variation between accruals and employee growth. In industries/firms in which accruals co-vary with employee growth, accruals show strong predictive power for future stock returns. In industries/firms in which accruals show little correlations with employee growth, the accrual anomaly is much weaker. In contrast, the evidence from the cross-sectional analysis is inconsistent with the persistence argument. From the earnings perspective, the evidence on one-year-ahead earnings growth is inconclusive, but the results on longer-term earnings growth support the investment argument but not the persistence argument. Collectively, I conclude that these results support the view that the accrual anomaly is attributable to the fundamental investment information contained in accruals.

It is a common practice for firms to conduct performance evaluations of their employees and yet to withhold this information from those employees. This paper argues that firms strategically withhold performance information to retain workers. In particular, if the worker enjoys high outside options and is tempted to quit, then the firm chooses not to reveal his performance information in order to keep him on the job. The firm's equilibrium strategy is to fire if performance is sufficiently low, reveal information if performance is sufficiently high, and withhold information otherwise. The pooling equilibrium is robust under a wide variety of settings, such as general cost functions, ability-contingent outside options, nonlinear contracts, nonverifiable output, and multiple stages of production.

We reexamine the relative importance of earnings and operating cash flows in equity valuation. In contrast to previous studies that use stock returns (Dechow 1994) or future operating cash flows (Barth et al. 2001), we use ex post intrinsic value of equity as the criterion for comparison. We determine ex post intrinsic value of equity by discounting future dividends over a three-year horizon and market price at the end of the horizon by industry cost of equity. The advantage of the ex post intrinsic value measure over stock returns is that it is not contaminated by the stock market's fixation on reported earnings (Sloan 1996). Also, unlike finite horizon future operating cash flows, ex post intrinsic values better reflect the magnitude, timing, and uncertainty of investors' future cash flows (SFAC No. 1, FASB 1978). Our results suggest that accrualbased earnings dominate operating cash flows as a summary indicator of ex post intrinsic value.