Knowledge that Transforms

ABSTRACT: The current study examines the outcomes of three fraud brainstorming procedures—nominal group, round robin, and open discussion—via a randomized between-participant field experiment involving 150 audit clients and 2,614 auditors who participated in natural, hierarchical audit teams. The results indicate that nominal group and round robin brainstorming resulted in equivalent numbers of unique fraud risks and comparable increases in planned audit hours, while open discussion brainstorming yielded the least number of unique ideas and the smallest increase in planned audit hours. Furthermore, nominal group and round robin brainstorming yielded more changes/additions to the nature and timing of substantive testing than open discussion brainstorming. Study findings offer theoretical and practical insight into fraud brainstorming.

ABSTRACT: We examine the value relevance of a comprehensive set of summary performance measures including sales, earnings, comprehensive income, and operating cash flows. We find that, while value relevance peaks for measures “above the line,” no single measure dominates around the world. Instead, a measure is more relevant when it captures, directly and quickly, information about firms’ cash flows. Specifically, for each performance measure by country, we estimate eight attributes commonly used to assess earnings quality. We find these attributes highly correlated—most of their variance is explained by only two principal factors. A factor capturing articulation with cash flows is positively associated with a measure’s value relevance; a factor reflecting the measure’s persistence, predictability, smoothness, and conservatism is negatively associated. Our results suggest that, when it comes to equity valuation, accounting researchers and standard-setters should focus not on what performance measure is “best” at a given point in time, but on the underlying attributes that investors find most relevant.

ABSTRACT: McVay (2006) concludes that managers opportunistically shift core expenses to special items to inflate current core earnings, resulting in a positive relation between unexpected core earnings and income-decreasing special items. However, she further notes that this relation disappears when contemporaneous accruals are dropped from the core earnings expectations model. McVay (2006) calls for research to improve the core earnings expectations model and to provide additional cross-sectional tests of classification shifting. Using a core earnings expectations model that is not dependent on accrual special items, we show that classification shifting is more likely in the fourth quarter than in interim quarters. We also find more evidence of classification shifting when the ability of managers to manipulate accruals appears to be constrained and in meeting a range of earnings benchmarks. Overall, our evidence provides broad support for McVay’s (2006) conclusion that managers engage in classification shifting. Our study also sheds new understanding of the conditions under which managers are more likely to employ classification shifting.

ABSTRACT: We derive sufficient conditions for ranking performance evaluation systems in multi-task agency models (using both optimal and linear contracts) in terms of a second-order stochastic dominance (SSD) condition on the likelihood ratios. The SSD condition can be replaced by a variance-covariance matrix of likelihood ratios (VCM) condition when the utility function is square-root, the performance measures are normally distributed, and for LEN models. We identify existing results derived under the LEN assumptions that rely on the VCM condition and, thus, also hold for optimal contracts.

ABSTRACT: Funds from Operations (FFO) is the prevailing performance measure in the Real Estate Investment Trust (REIT) industry. However, prior studies are inconclusive about the superiority of FFO over GAAP net income. Because depreciation is the largest reconciling item between FFO and net income, we examine the information content and value relevance of depreciation for both the REIT and non-REIT industries and report the following findings. First, accumulated depreciation is value-relevant for the REIT industry, whereas accumulated depreciation has little value relevance for comparably capital-intensive non-REIT industries. Second, accounting depreciation deviates from economic depreciation to a greater extent for REITs than for non-REIT industries. Third, accumulated depreciation has predictive ability for future revenues for REIT firms, but not for non-REIT firms. Finally, only the REIT industry displays all of these properties. In sum, evidence supports the REIT industry's assertion that GAAP depreciation consistently exceeds economic depreciation and that book value of assets is systematically understated.

ABSTRACT: This study reports the result of an experiment examining two aspects of the audit context that auditors likely do not suspect can influence audited account balances: the magnitude of an audit difference and the presence of a prior client concession. Negotiation theory shows that negotiators’ initial positions (e.g., clients’ unaudited balances) as well as feelings of reciprocity created by prior negotiations serve to create expectations for the current negotiation and, in turn, affect the outcomes of such negotiations. Our results show that the magnitude of an audit difference involving an estimate (i.e., difference between client’s account balance and the auditor’s independent estimate) as well as the presence of a prior client concession influence auditors’ negotiation expectations. Specifically, auditors proposed smaller adjustments when the magnitude of the audit difference was high and when the client conceded on an audit issue prior to resolving the difference in estimates. These manipulations similarly influence the negotiated outcome, and this influence is fully mediated by the auditor’s initial negotiation position.

ABSTRACT: Prior research finds that mandatory expensing induces underinvestment in research and development (R&D). The current study investigates whether capitalization can also create R&D investment problems. Abandoning a capitalized project requires asset impairment, a negative reporting effect that could damage managers' reputations. In an experiment utilizing M.B.A. student participants, I find that managers responsible for initiating an R&D project are more likely to overinvest when R&D is capitalized. I show that high self-monitors (those most likely to alter their behaviors to convey a positive image) are most likely to overinvest, suggesting that reputation concerns contribute to this behavior. A follow-up survey reveals that, when R&D is capitalized, experienced executives anticipate overinvestment and expect project abandonment to have a stronger negative impact on the responsible manager's reputation and future prospects at their firm. The results suggest that managers are held responsible for the external reporting consequences of their projects, such that mandating R&D capitalization may not reduce real earnings management.

ABSTRACT: In a setting in which corporate headquarters dictates total sales targets, we study how supervisors allocate sales targets to individual stores. Specifically, we analyze whether supervisors strategically use discretion in the target-setting process to address compensation contracting issues. We first examine whether supervisors use discretion to manage compensation risk. The results are consistent with the agency-theoretic prediction that supervisors provide easier targets to stores facing higher levels of store-specific risk. Next, we examine whether discretion is used to mitigate fairness concerns. The results suggest that, consistent with behavioral arguments, supervisors use discretion to deal with fairness issues, even if the area of the supervisor’s discretion is not the source of the fairness concerns. Finally, we analyze whether supervisors use discretion in the target-setting process to reduce their potential confrontation costs. Consistent with research in psychology, we find that supervisors provide easier targets to store managers with relatively higher hierarchical status.

ABSTRACT: Previous research in management accounting and economics has noted the potential for complementarities between the firm’s performance measurement system and its other organizational design choices. We add to this literature by studying how the informativeness and incentive properties of a performance metric can be influenced by one particular organizational design choice—the size of the firm’s inventory buffers. We model a manufacturing setting in which an agent manages a workstation that processes intermediate units. As intermediate units arrive, they are stored in an inventory buffer until the agent can process them. The buffer can hold a maximum number of intermediate units—its buffer size. The agent is compensated on the basis of his workstation’s throughput. We characterize the conditions under which reducing the inventory buffer enhances/degrades the informativeness of the performance metric and, hence, mitigates/exacerbates the agent’s incentive problem.

ABSTRACT: This study investigates whether individual top executives have incremental effects on their firms’ tax avoidance that cannot be explained by characteristics of the firm. To identify executive effects on firms’ effective tax rates, we construct a data set that tracks the movement of 908 executives across firms over time. Results indicate that individual executives play a significant role in determining the level of tax avoidance that firms undertake. The economic magnitude of the executive effects on tax avoidance is large. Moving between the top and bottom quartiles of executives results in approximately an 11 percent swing in GAAP effective tax rates; thus, executive effects appear to be an important determinant in firms’ tax avoidance.