Knowledge that Transforms

[In auditing an account balance, an auditor must first assess the inherent risk that the balance is misrepresented. This paper identifies factors determining the accuracy of the auditor's inherent risk assessment in a hidden information audit setting, under the assumption that both players construct expectations through a process of rational inference known as rationalization. The accuracy of the auditor's risk assessment is shown to be influenced by the risk of unintentional errors, the players' incentives, the precision of the auditor's data, and regulatory bounds on detection risk.]

[This study examines empirically the prediction of long-term stock return volatility. We find: (1) when using historical volatility to predict five-year monthly volatility, returns should be measured either weekly or monthly, and the historical period should be approximately five years; (2) when constructing a forecast based solely on historical volatilities of comparable firms, comparable firms should be selected on the basis of industry and firm size; and (3) a shrinkage forecast formed by adjusting a historical forecast toward a comparable-firms forecast is more accurate than either a historical or a comparable-firms forecast. Our results suggest that errors in pricing employee stock options due to errors in predicting long-term volatility would rarely have a material effect on net income.]

[We reexamine the "uniformity vs. flexibility" debate by considering the consequences of varying the amount of discretion managers have in reporting current period expenses. We study the effects of altering GAAP on both the "internal agency problem" between current shareholders and their manager and the "external agency problem" between current and prospective shareholders. We show that the internal agency problem is ameliorated by expanding discretion, and we exhibit examples where expanding discretion is undesirable when the internal and external agency problems are present concurrently and the nonexpense-related components of earnings are measured with error. We establish that expanding discretion is welfare-enhancing if either the manager's contract is publicly observable or else the nonexpense-related components of earnings are measured without error. These results demonstrate the limitations of evaluating GAAP on a piecemeal, or issue-by-issue, basis.]

[This paper explores a possible explanation for the observed use of bonus pool arrangements. Under fairly general conditions, the use of a bonus pool arrangement results in a strict Pareto improvement by enabling an owner to exploit non-contractible information, that might otherwise not be used, to motivate agents. We characterize the optimal bonus pool arrangement and analyze the interdependencies which it induces between agents. Our results demonstrate the manner in which the use of non-contractible information via bonus pool schemes distorts the payoffs to agents relative to the case in which the non-contractible information is not used.]

[This paper investigates whether replacing a standard that employs a vague, verbal disclosure threshold with a standard that employs a more stringent, numerical threshold mitigates the aggressiveness of reporting decisions. Two experiments were performed in a tax setting. The results indicate that (1) when a verbal standard is in place, tax practitioners use the latitude inherent in a verbal standard to support aggressive reporting decisions, and (2) when a numerical standard is in place, tax practitioners use instead the latitude available in assessing evidential support to justify an aggressive reporting decision. This shift in incentive effect is pronounced enough to render reporting decisions made under the numerical standard as aggressive as reporting decisions made under the verbal standard. These results indicate that replacing verbal thresholds with numerical thresholds may not diminish the aggressiveness of reporting decisions.]

[This paper examines the impact of product mix heterogeneity (PMH) on manufacturing overhead costs (MOHC) in three plants of a textile firm. An approach for measuring PMH is adapted from the group technology literature of operations. Factor analysis of product engineering specifications identifies seven forms of PMH for woven fabrics. Regression analysis indicates that two of the seven forms of heterogeneity are costly: differences in processing efficiency and in customer-specified quality requirements. The new measures of PMH perform better in estimating MOHC than the traditional measure of PMH, the number of products produced. Finally, the paper provides evidence that experience producing a heterogeneous mix of products mitigates costs of PMH.]

[This study uses an experiment to investigate how structured audit approaches affect managers' human resource assignments in environments varying in complexity. Results indicate that consistent with a "knowledge-sharing" role of structured approaches, structured firm managers assigned less experienced auditors than did unstructured firm managers to perform and to supervise/review a set of judgment-oriented audit tasks. Increased environmental complexity resulted in the assignment of more experienced auditors in unstructured firms, but not in structured firms, which instead increased reliance on specialists. Finally, structured firm managers' staffing assignments were generally less variable than those of unstructured firm managers. Analysis using task-level structure measures suggests that task-level structure rather than a firm-level mediating variable is the operational construct.]

[This study uses data on 123 firms over an 11 year period to examine whether the accounting for employee stock options permits them to be used as part of an income management strategy. Using a pooled cross-sectional, time-series analysis, the value of options granted is found to be negatively related to the extent the firm is below its target level of income and positively related to the firm's use of income-increasing accounting methods. I also find weak evidence of a positive relation between the firm's relative use of income-increasing accounting methods and the probability of issuing unattached stock options rather than income-decreasing securities such as stock appreciation rights or tandem securities. However, the results from both tests are sensitive to the estimation method and are not consistent over time.]

[Many states removed their bans on direct univited solicitation during the 1980s, while others retained their restrictions. This period of contrast provides an opportunity to examine and provide insight into associations that exist among information dissemination, client-auditor alignment, and auditor independence. Although concerns have been voiced that recent changes in competitive conditions in the audit market are detrimental to audit quality, we present arguments and evidence to the contrary. Results of a logistic regression analysis suggest that, ceteris paribus, auditors in the market allowing solicitation are more likely than those in the market banning solicitation to issue a nonstandard report.]

[This study examines the equity price reaction to two generally income increasing standards on accounting for income taxes, namely the Statements on Financial Accounting Standards (SFAS) No. 96 and No. 109. It is hypothesized that significant positive abnormal returns should be observed around the Exposure Draft dates. It is also hypothesized that the equity price reaction to these standards should be related to the magnitude of their income effects and the economic consequences of a given income effect. The results are consistent with contracting and political cost hypotheses.]