Knowledge that Transforms

Based on stock price behavior around the release of annual reports in 1981 and 1982, Wilson [1987] concludes that for a given amount of earnings, the market reacts more favorably the larger (smaller) are cash flows (current accruals). The goals of this paper are to assess the generality of Wilson's finding and to assess alternative economic arguments that would manifest themselves as a "preference" for cash flows over current accruals. For the overall period, 1977-1984, there Ts no evidence of the simple relation observed by Wilson in his two-quarter test period. We then examine progressively more contextual models of the implications of cash flows and accruals. These models are also unsuccessful in explaining stock price behavior around the release of detailed financial statements. We conclude that either (1) the security price reactions to the release of cash flow and accrual data in financial statements are too highly contextual to be modeled parsimoniously, or (2) important uncertainties about the contents of detailed financial statements are resolved prior to their public release.

It is hypothesized that an Inverse relation exists between the reputation of the auditor of an Initial public offering and the initial return earned by an investor. Specifically, clients that hire more reputable CPA firms should exhibit lower initial returns than clients that choose to hire CPA firms with less reputation capital at stake. Two proxies for auditor reputation are used to test this hypothesis. The first reputation proxy uses indicator variables for auditor size. Results indicate that the widely used Big Eight/non-Big Eight classification may measure CPA firm reputation capital with error particularly for the smaller Big Eight end larger non-Big Eight firms. A second reputation proxy is developed by regressing compensation paid to the auditing firms on measures of marginal cost of performing the audit, The initial return to the IPO investors is regressed on the residual from the compensation regression to provide evidence of the reputation hypothesis. Results indicate that clients that pay a premium for their registration audit exhibit lower initial returns for their investors. Thus, the results of both tests provide support for the hypothesized inverse relation between auditor reputation and initial public offering initial return.

[The data processing systems that auditors examine and evaluate are modified frequently. Somehow they must decide what effect changes to a system may have on the controls needed to ensure the system is reliable and on the audit procedures used to determine whether controls are in place and working. This paper provides a model that allows auditors to structure their search space so they can identify those system locations where controls and audit procedures must be modified when system changes occur. The model shows that auditors need examine only those parts of a system where structural changes made at the system level induce structural changes at the subsystem level. A formalism is provided for tracing the propagation of change through the various levels of subsystems.]

[Prior work has examined models in which the reciprocal cost allocation method yields allocation rates that are equal to the marginal costs of operating service departments. We extend this work by analyzing more general production functions for service departments and by incorporating uncertainty. The results demonstrate that the allocation rates derived from the reciprocal cost allocation method are random variables that, in general, are not equal to the expected marginal costs of operating the service departments. In particular, the reciprocal cost allocation rates are biased estimates of these expected marginal costs if any of the service departments operate at a point on their production functions at which the marginal physical product is not equal to the average physical product of their inputs. We also analyze three econometric procedures that provide consistent estimates of the marginal costs. The simulation results indicate that the standard deviations of these estimators are considerably larger than those of the reciprocal cost allocation rates. Because the estimates of the marginal costs provided by the reciprocal cost allocation method have a greater degree of bias, but a lower standard deviation than the estimates provided by the other methods, none of the methods provide estimators that are unambiguously best. Factors that affect the magnitudes of the bias and relative efficiency of the reciprocal cost allocation rates are also discussed.]

[This study assesses the impact of the firm size effect on test statistics based on market-adjusted and market model abnormal returns. The performance of two alternative abnormal return methods that explicitly control for the effect of firm size on expected returns is also examined. These methods, the size control portfolio and size model approaches, are based upon a companion portfolio approach where companion portfolios are constructed on the basis of firm size. Simulation results indicate that when event dates are clustered in calendar time and the event affects either small or large firms, conventional t-statistics based on market-adjusted or market model abnormal returns are misspecified in that their empirical Type I error rates deviate significantly from those expected under a true null hypothesis. Significance tests based on empirical distributions mitigate these over-rejection tendencies but, in doing so, they sacrifice power. On the other hand, conventional t-statistics based on size control portfolio or size model abnormal returns are well-specified across a variety of event conditions. Accordingly, either size-based method can control for the firm size effect in event study contexts where such control is warranted. Since the size control portfolio approach is simpler to implement, it is the preferred alternative. The study also documents that abnormal performance is detected more often when large firms are affected than when small firms are affected.]

[This paper provides an analysis of the association between the accounting gain produced by an equity-for-debt swap and executive compensation. Our results suggest that the executives of firms completing a swap transaction experience an increase in cash compensation (salary plus bonus). The increase is largest both in absolute magnitude and in statistical significance for firms whose compensation plans are more "accounting-oriented" (i.e., firms whose executives would be expected to experience the greatest increase in compensation under the hypothesis that firm's compensation plan is not adjusted for the accounting gain produced by the swap). We also find that, on average, the value of the executives' personal equity holdings decreases in the period surrounding the announcement of the swap. The magnitude of this decrease is, on average, comparable in size to the increase in their compensation. However, there is some weak evidence that executives of firms whose compensation plans are more "accounting-oriented" experience a statistically significant increase in their total wealth (i.e., the sum of excess compensation and the value of personal equity holdings) as a result of the swap transaction.]

[An area of concern to tax policymakers is the role of third-party preparers in income tax reporting. This research examines the degree of consistency in judgments of preparers subject to differing degrees of governmental regulation. Economic theory of regulation suggests that CPAs, who are subject to a higher degree of government regulation, would be expected to recommend and justify more pro-taxpayer positions in ambiguous areas of tax law than would unlicensed preparers. This hypothesis was tested by administering a set of tax cases with a high degree of uncertainty regarding the correct tax status to groups of CPA and non-CPA tax practitioners. CPAs were found to be consistently more pro-taxpayer than were non-CPAs.]

[This paper investigates an exogenous proxy for predisclosure information, analyst following, and empirically contrasts its earnings announcement price response performance with the endogenous firm size factor. The theoretical motivation for the comparison rests on the premise that the analyst community formulates its preference ranking of firms to follow on the basis of a multivariate information search cost-benefit framework (i.e., incentive considerations in addition to size). The empirical results, based on 2,466 annual earnings announcements over 1976-1982, are consistent with this hypothesis. Regression analyses corroborate the firm size effect found in prior studies as well as a univariate analyst following effect. In a multiple regression model, however, analyst following continues to be incrementally significant while firm size does not. Further analysis demonstrates that thinly followed large firms have significantly larger price reaction than widely followed small firms. Both are supportive of a "non-size-related" analyst following effect.]

[Based on stock price behavior around the release of annual reports in 1981 and 1982, Wilson [1987] concludes that for a given amount of earnings, the market reacts more favorably the larger (smaller) are cash flows (current accruals). The goals of this paper are to assess the generality of Wilson's finding and to assess alternative economic arguments that would manifest themselves as a "preference" for cash flows over current accruals. For the overall period, 1977-1984, there is no evidence of the simple relation observed by Wilson in his two-quarter test period. We then examine progressively more contextual models of the implications of cash flows and accruals. These models are also unsuccessful in explaining stock price behavior around the release of detailed financial statements. We conclude that either (1) the security price reactions to the release of cash flow and accrual data in financial statements are too highly contextual to be modeled parsimoniously, or (2) important uncertainties about the contents of detailed financial statements are resolved prior to their public release.]

[Does tax policy affect accounting choices? In this paper we examine how corporate tax affects management's accounting choices. Because (1) management compensation is typically linked to both accounting earnings and stock prices, (2) stock prices are related to cash flow distributions expected to be generated by the firm, (3) corporate-issued reports change cash flow assessments and, thus, affect compensation in a given period, and (4) changes in corporate tax rate changes the firm's cash flows, management will exploit its ability to "manage" reported accounting earnings in reaction to changes in tax rates, so as to maximize compensation. Assuming exogeneously determined generally accepted accounting principles, it is shown-using a stylized model-that increases in corporate tax rate induce choice of income-increasing accounting treatments. Empirical results applying logit analysis to a sample of compensation data are consistent with this implication of the model.]