Knowledge that Transforms

In evaluating the variance investigation decision made by a manager, information ex ante or ex post to the decision may have an impact. Although normative models generally consider only ex ante data, research on hindsight or outcome bias has shown that performance evaluations are often affected by decision outcomes. This outcome effect can be explained through the following cognitive links. First, the outcome of the investigation will have an impact on the perceived benefits of the investigation. Second, as posited by decision research on mental accounting, investigation expenditures matched with perceived benefits are framed as costs while those without perceived benefits are framed as losses. Third, evaluators with a cost frame provide higher performance ratings than those with a loss frame. A series of experiments with students and members of the Institute of Management Accountants demonstrates that managers making variance investigation decisions were evaluated more favorably when investigations revealed problems in the system. This is the well-known outcome effect. Further, the investigation outcome affected the perceived benefits from the investigation and, as predicted by mental accounting, expenditures with perceived benefits were framed as costs while those without perceived benefits were framed as losses. Finally, these frames affected performance evaluation as predicted. Thus, the outcome effect on performance evaluation can now be understood within a framework that includes the cognitive impact of mental accounting and framing. Surveys report that 85 percent of large U.S. manufacturing companies use standard costing systems (Cress and Pettijohn 1985; Gaumnitz and Kollaritsch 1988). Standard costing is particularly useful for managerial control purposes since variances from standards can be calculated for management use (Horngren and Foster 1987). At that point, managers must decide whether to collect more information regarding the performance reflected in the variances. Mathematical models have been formulated to analyze this variance investigation decision (e.g., see Kaplan 1969; Jacobs and Marshall 1984). Although these mathematical models provide normative or optimal prescriptions for the variance investigation decision, managers may not follow the recommendations of the models if their decisions are judged using criteria unrelated to the models (Magee 1976). Research on human information processing and decision making has shown that judgments are affected by outcomes (or hindsight) and mental accounting (a form of decision framing). If the managerial evaluations are affected by these phenomena, managerial actions will be effected by their potential impact. This study investigates the effects of outcomes and framing on the evaluations of managers responsible for the variance investigation decision. Specifically, it develops a cognitive mechanism for the impact of outcomes on such evaluations using prior results and ideas from judgment and decision making research. Although the impact of hindsight and outcomes has been demonstrated in prior work in accounting (Helleloid 1988; Brown and Solomon 1987), a satisfactory cognitive explanation for the effect remains elusive (but, see Brown and Solomon 1991). Thus, the contribution of the present study is in the development and testing of this cognitive mechanism.

Comments on the paper "Information Content of Accounting Announcements," by Alex Dontoh and Joshua Ronen. Similarities of all competitive, rational expectations models; Relation between price and volume; Effect of the anticipation of public announcements on the decision to acquire private information in advance of the announcement.

One of the most common decisions facing an internal auditor is choosing which line items to investigate. An extensive literature (Dworin and Grimlund 1984; Leslie et al. 1980; Menz& fricke 1984; Teitlebaum and Robinson 1975) deals with the statistical and decision-theoretic aspects of his choice. This paper expands on previous work by adding a strategic source of errors: dishonest employees. It addresses the question of how the presence of strategic errors affects the relationship between the auditor's testing strategy and item value. I show that incorporating strategic errors can lead to audit strategies similar to Physical Units and Dollar Units Sampling. I highlight the assumptions driving the results by contrasting a firm's (or internal auditor's) use of an optional test in four stylized models of accounts receivable. The first model examines the firm's behavior when faced with nonstrategic (statistical) billing errors. In this model the accounting system generates random errors that result in over- or underbilling customers. The firm can use a costly, imperfect test to remove errors before the bills are sent out. In this nonstrategic model the firm randomizes and tests an item if and only if the benefit is greater than the cost. Because the amount of billing error is unrelated to the item value, there is no clear link between the firm's testing decision and the value of the line item. The second billing model adds the possible existence of dishonest employees who can steal from line items. A dishonest employee makes two decisions. He decides whether to steal from the line item, and, if he steals, he chooses the amount of the theft. A dishonest employee would steal the entire item if he were certain that the firm would never test that item. The dishonest employee's behavior forces the firm to consider the value of the item in determining the region of untested items. Specifically, low value items are never tested. As in many strategic models, the interaction with dishonest employees may lead to randomization. In particular, the randomized testing strategy can look like Stratified Physical Units Attributes Sampling (Leslie et alt 1980). The firm sorts items into different groups and each item in a group has the same probability of being tested. The third model contains only the statistical errors of incorrectly adding or deleting a sales discount, a percentage of the item value. Since the testing gain is directly related to the value of the line item, the firm's strategy depends on an item's value. The firm always tests high value items, and never tests low value items. The fourth model adds potentially dishonest employees who can pros vide unearned sales discounts to their confederates. In this model the firm stratifies items into three groups. It never investigates small items, always investigates large items, and randomizes over intermediate value items with probabilities roughly proportionate to the value of the item. This procedure is similar to a common audit procedure, Dollar Unit Cell Width Sampling (Leslie et al. 1980).

The objective of this study is to evaluate the debt covenant hypothesis by using the details of lending agreements at the time of the FAS No. 19 Exposure Draft If adopted, FAS No. 19 would have eliminated the use of the full-cost method for firms involved in oil and gas exploration. Several studies found a significant difference between the abnormal returns of full-cost and successful-efforts firms in response to the release of the FAS No. 19 Exposure Draft (Collins and Dent 1979; Lev 1979; Lys 1984), and this has been hypothesized to result from possible effects on accounting-based covenants in debt contracts. However, empirical tests were indirect in that variables of financial leverage were used as proxies for debt covenant effects. According to the debt covenant hypothesis, firms choose accounting methods to maximize slack in debt covenant constraints. Mandatory changes in accounting methods might bring some firms closer to violating their debt covenants. Borrowing firms, however, can anticipate the possibility of such regulatory change and protect themselves, for example, by completely specifying the accounting methods that will be used to deter- mine covenant compliance, regardless of subsequent changes to generally accepted accounting principles. When outstanding debt contracts are so structured, the probability of default on accounting-based covenants could be unaffected by GAAP changes. Financial leverage variables fail to distinguish between firms with and without such protection. Using exhibits to SEC filings, I examined 83 debt contracts in effect in 1977 for each firm in a sample of 35 full-cost firms. I identified 13 firms that had at least one covenant that would have been affected by FAS No. 19. Portfolio tests indicated that these 13 firms drive the difference between the returns of full-cost and successful-efforts firms in the full sample. An alternate set of portfolios based on leverage as a proxy for debt covenant effects showed no relation to those based on actual debt contracts and also failed to explain the stock price response to the Exposure Draft release.

A multi-year adoption period now appears to be the norm for new accounting standards issued by the Financial Accounting Standards Board (FASB). For example, FAS No. 52, which pertained to foreign currency, was issued in December 1981 and became effective in 1983, a three-year adoption period. FAS No. 71, which concerned regulation, was issued in December 1982, but became effective in 1984. FAS No. 87 on pensions was issued in December 1985 and became effective in 1987, but a key provision of this statement--the recognition of a "minimum liability"--became effective only in 1989, thereby allowing a five-year adoption period. FAS No. 96 on income taxes was issued in December 1987, but amendments under FAS Nos. 100 and 103 extended its adoption to 1990 and then to 1992, a six-year adoption period (ultimately, FAS No. 109 substantially changed FAS No. 96 and its successors). Although several early statements (e.g., FAS Nos. 2 and 8) issued late in the calendar year allowed adoption over that year and the following one, practically all FASB statements issued in the 1970s became effective on a uniform date close to their issuance. Thus, it appears that the FASB changed its adoption policy in the 1980s. The Board's main justification for an extended adoption period Is to alleviate firms' implementation costs, particularly the costs of renegotiating agreements with lenders and suppliers (see, e.g., FAS No. 52, par. 147-48, and FAS No. 87 par. 259-60). Interestingly, no justification was offered for the extended adoption period of FAS No. 96 (Income Taxes), perhaps an indication that a three-year adoption period had become a norm. However, when a fourth year was added under FAS No. 100, the following rationale was given (FASB 1988, par. 8): The Board believes that the disadvantages to preparers from not having a deferral of the effective date outweigh the disadvantages to users from a one-year delay in the required adoption of Statement 96, including diversity in financial reporting from the continued application of Opinion 11 by some enterprises. Given the obvious costs imposed by an extended adoption period on financial statement users, because of reduced cross-company comparability, the FASB's policy warrants scrutiny. This is the objective of the current study which focuses on FAS No. 87 (FASB 1985a) and the related FAS No. 88 (FASB 1985b). Specifically, we consider various possible managerial motives for choosing the timing of adoption of FAS No. 87 within the allowed period, and classify these motives as involving either compliance costs (the FASB's express justification for an extended adoption period) or investor perceptions (managers' attempts to change investor expectations). We then identify the adoption timing motives that are consistent with the data derived from samples of early (1986) and late (1987) adopters. The FASB's case for extending adoption periods will obviously be supported if compliance costs figure predominantly in firms' adoption-timing decisions. Of the eight proxies for adoption-timing motives examined by us, only one--increasing reported earnings--consistently discriminates between early and late adopters. This holds for interyear (1986 vs. 1987) as well as intrayear adoptions (first three quarters of 1986 vs. fourth quarter). Of the compliance-cost motives examined, company size and the number of outstanding loans were associated with the adoption-timing decision in some cases. Overall, our analysis does not provide compelling support for the FASB's cost-reduction justification for a multiyear adoption period for FAS No. 87.

The performance of audit tasks has been modeled as a function of the auditor's ability, knowledge and experiences (Libby 1993). Thus, an important aspect of assigning audit tasks is identifying the levels of knowledge and types of experience an auditor must have to achieve a sufficiently high level of performance (Abdolmohammadi and Wright 1987). An objective of the current study is to determine whether auditors' knowledge of basic accounting principles and error frequencies improves over the course of their early careers so as to enhance performance of a common analytical procedure, ratio analysis. Research in psychology suggests that two characteristics of a task (say, analytical procedures) could diminish the accuracy with which auditors learn error frequencies from experience and apply their knowledge to a task. First, auditors' memories of financial statement errors are encoded while they perform other information-processing activities. These competing task demands could use enough of an auditor's information-processing capacity to diminish both the accuracy with which memory traces of errors are encoded and the accuracy of their knowledge of error frequency (Naveh-Benjamin and Jonides 1986). Second, auditors must consider a variety of evidence when performing analytical procedures. In diagnostic tasks like ratio analysis, inordinate attention is given to evidence that is highly diagnostic of low-frequency events, causing an "inverse base rate effect" in which auditors consider such events as more likely (Medin and Edelson 1988). Assessing the extent to which either of these characteristics of the analytical procedures context prevents auditors from learning and applying error frequency knowledge is a second objective of this study. To test hypotheses about these objectives, an experiment is conducted in which experienced auditors, accounting students, and nonaccounting students learn the frequencies of financial statement errors through their experience in solving a series of problems using ratio analysis. Subjects are then tested for their accuracy in using frequency information by having them diagnose novel combinations of the same evidence. Other subjects perform similar tasks for an abstract medical diagnosis to provide a benchmark for comparison. The results indicate that differences in accounting knowledge influenced the subjects' performance of ratio analysis, and that neither potential source of inaccurate learning of event frequency knowledge holds in this setting. That is, subjects learned frequencies in the presence of competing task demands, and the inverse-base rate effect was not observed. These results suggest that experienced, but not novice, auditors use both their superior knowledge of accounting and of error frequencies learned through experience. Another implication is that the performance of novice auditors may be improved by increasing their knowledge of basic accounting principles and error frequencies.

The majority of empirical regulatory accounting studies on financial reporting have focused on the ex post evaluation of accounting choices (see Lev [1979] and Barth [1991] among others) after an accounting method is adopted. There has not been much research involving the evaluation of accounting methods ex ante because, it is argued, newly mandated accounting information is usually available only some time after the Financial Accounting Standards Board (FASB) has required its release. In December 1990, after lengthy and controversial deliberations, the FASB issued SFAS No. 106, Employers' Accounting for Postretirement Benefits other than Pensions (PRB) replacing the current "pay as you go" practice with a combination of present-value and accrual method. Few of the information items mandated by SFAS No. 106 has yet been disclosed earlier. Consequently, this research uses the data that were available during the time of the FASB's deliberations as an example of ex ante empirical research concerning the standard-setting process. This study uses the PRB cash payments to retirees as disclosed by firms in their footnotes to the financial statements under SFAS No. 81 (FASB 1984) to investigate whether investors underestimated the full effect of the PRB liability on firms' values. Such underestimation would occur if investors are not aware of the high rate of increase in health care costs or when future benefits' payments to current employees are partially ignored. Additionally, this study investigates whether an estimate of the present value of the PRB liability is value-relevant to investors. Finally, an analysis is made of the range and sensitivity of economic parameters (discount rate and health care cost trend rate) used by investors to estimate the PRB obligation. The results indicate that, during the period 1984-1986, investors, on average, valued each dollar of PRB cash payment in any year as a dollar; i.e., they underestimated the full consequences of firms' promise to continue making such payments in the future. During the period 1987-1990, in contrast, investors translated each dollar of PRB cash payment to an average of $13.75 PRB obligation. Further, estimating the present value of the PRB obligation with publicly available data shows that the present-value measure is value-relevant to investors in addition to the cash payments disclosed by firms.

Examines whether the provision of audit clients with nonaudit services result in knowledge spillovers and audit production efficiencies that could produce economic rents for the auditor. Demonstration of the comparability of the research sample with prior studies; Data set compiled from the participating firm's internal billing records.

Since the pioneering work of Hall and Jorgenson (1967), numerous studies (e.g., Bischoff 1971; Chirinko and Eisner 1982; and Coen 1971) have examined the effect of attempts by the tax authority to influence investment decisions through accelerated depreciation or investment tax credits (ITC). This body of research has been fraught with econometric estimation problems, and consequently has failed to provide a clear picture of the effect of tax policies on capital investment. In a review of the literature, Chirinko (1986, 151) concludes that "[w]hile investment may respond significantly to variations in tax parameters, it appears to this author that the supporting empirical evidence has yet to be generated." At the core of the difficulties in the econometric research paradigm Is the operationalization of the neoclassical investment function itself. Chirinko (1986) notes that numerous inherent difficulties are introduced, including (1) estimations of the purchase cost of a unit of capital, financial cost of capital net of inflation, rate of depreciation of the capital good, rate of income taxation, rate of investment credit, discounted value of depreciation allowances, net cost of debt finance, and the like; and (2) the inability to control for firms' expectations regarding output, and hence the marginal product of capital. These difficulties highlight the general limitations of econometrics in certain settings. This sentiment was echoed by Chirinko and Eisner (1983, 139) when they concluded that, in the neoclassical tax policy arena, "one can get almost any answer one wants by making sure that the chosen model has specifications appropriate to one's purpose." In response to the inconclusive econometric evidence regarding the effect of tax incentives on capital investment, we adopt an alternative approach in this study, using laboratory markets to overcome the limitations noted above, thereby providing a controlled empirical test of neoclassical predictions. Although the results of our experiments provide no evidence regarding the real-world dollar responses of investment to income tax accounting subsidies, some insight into the ability of theory to predict more general aspects of taxpayer investment behavior is provided. Specifically, the research question addressed is whether capital investment increases when depreciation or investment credits allowed by the tax system result in more rapid deductions than true economic depreciation. Although this question follows directly from neoclassical predictions, we relax the assumption of price taking to permit the more realistic consideration of market price adjustments. The results of our experiments do not support the neoclassical prediction that depreciable asset investment will increase In response to accelerated tax depreciation or to investment tax credits. Demand was unresponsive to tax incentives because the prices of depreciable assets were bid up. That is, tax benefits were captured to some extent by factor suppliers. From a theoretical perspective, the study's results provide a "piece of the puzzle" in light of conflicting or nonexistent econometric evidence. In section I, a description of the experimental setting and administration is provided. Theoretical predictions of investment price and quantity are then derived from our experimental operationalization of a production economy in section II. Finally, results and conclusions are presented in sections III and IV, respectively.

Reports on the time-series properties and predictive ability of variables in funds-flow statement. Descriptive evidence that documents the statistical patterns of the cash flow and working capital series for a sample of firms; Measurement of the predictive ability of variables in a funds-flow statement; Security return effects.