Knowledge that Transforms

The proliferation of control contests for large public corporations at 50% + premiums above market Illustrates the wide divergence between open-market stock prices and equity exchange values. This paper considers equity valuation in corporate control transactions-e.g., management buyouts and hostile takeovers-that engender potentially severe manager-stockholder conflicts. These conflicts generate a demand for independent assessments of equity values by investment bankers who specialize in these appraisals. The paper provides evidence from (1) a large sample of fairness opinions on management buyouts, and (2) a small sample of investment bankers' working papers which indicates that investment bankers' valuation techniques make extensive use of accounting data. This demand for accounting information in equity valuation is distinct from that previously recognized in the capital markets or contracting literatures.

Examines the motivation of managers to release forecasts of future earnings. Comparison of four potential motivating factors; Ownership structure and capital offerings; Analysts' forecast errors as indications of good news.

This paper compares the disclosures firms would seek to make voluntarily with mandated disclosures in a single period, multi-firm model, in which there are covariances between firms' cash flows. This comparison is important because, in those circumstances in which the two types of disclosure coincide, it is possible to economize on the process of setting mandatory disclosures. The principal factors which contribute to the existence or absence of a correspondence between mandatory and voluntary disclosures are (1) the nature of the externality associated with a firm's disclosure, (2) the relation between the risk preferences of the shareholders of the firms making the disclosures and outside investors, (3) how much relative weight is placed on existing shareholders and outside investors' preferences in the social welfare function determining the optimal mandatory disclosure policy, and (4) the covariance structure between firms' cash flows. T | nHIS paper compares the disclosure policies that firms select voluntarily with the policies an accounting standards board or other regulatory body would mandate to maximize social welfare. This comparison is important because of the considerable resources devoted to developing accounting standards and related disclosure requirements. When an accounting standards I wish to thank Mike Fishman, Steve Hansen, Bill Kinney, Bob Magee, and seminar participants at the University of Minnesota for helpful comments on a previous draft, and the Accounting Research Center at Northwestern University for financial support. I especially want to thank Jerry Feltham (a referee) and an anonymous referee. They contributed significantly by extending some results and, in several instances, proposing (and proving) important additional results. Manuscript received August 1987. Revisions received June 1988 and December 1988. Accepted July 1989. This content downloaded from 207.46.13.129 on Sat, 25 Jun 2016 06:03:27 UTC All use subject to http://about.jstor.org/terms 2 The Accounting Review, January 1990 board merely succeeds in mandating the disclosures which firms would adopt voluntarily, the resources used in setting the standards are wasted. By identifying a variety of situations in which mandatory and voluntary disclosures coincide, the paper provides some evidence for Beaver's (1977) proposal that promulgators of accounting standards should be obliged to provide explicit cost-benefit analyses to support the expansion of disclosure regulations. The claim that voluntary and mandatory disclosure requirements should be presumed to be the same, unless otherwise demonstrated, stands in contrast to much of the prevailing scholarly literature on the subject. Proponents of additional mandatory disclosures argue that information about firms' financial conditions constitutes a public good which will be under-provided without regulation. They also assert that firms will tend to suppress the disclosure of unfavorable information. I Opponents of regulation counter by arguing that managers have incentives to disclose information about the firms they run to differentiate themselves from more poorly run enterprises. This incentive, as well as the incentive of investors to obtain trading profits through costly search, are considered to provide sufficient motives for voluntary information production and disclosure so as to ensure a properly functioning securities' market.2 This paper does not directly contradict either of these views. The point made is that, in presenting these externality-based arguments for or against additional disclosures, one must differentiate between the various kinds of externalities that can arise. We consider two alternative types of externalities here, and financial. A disclosure by one firm is said to create a real externality for other firms if the disclosure alters those firms' cash flows. For example, the disclosure of a firm's trade secrets generates positive real externalities for its competitors. In contrast, a disclosure by one firm generates only financial externalities on other firms if the disclosure has the potential of altering the equilibrium prices of those firms without altering the actual distributions of their cash flows. Financial externalities arise when one firm's disclosures affect only investors' perceptions of the distributions of other firms' cash flows. For example, disclosures by one firm in an industry may alter investors' beliefs about the profitability of other firms in the same industry, and thereby change their market values (Foster 1981). Mandatory and voluntary disclosure policies do not always coincide when disclosures generate only financial externalities. Shareholders' attitudes toward risk, shareholders' relative weights in the social welfare function defining the optimal mandatory disclosure policy, and the covariance structure between firms' cash flows can all affect whether voluntary and mandatory disclosure policies coincide. However, there are a variety of circumstances in which these distinctly motivated disclosure policies do coincide when financial externalities alone exist. These disclosure issues are studied using a *snap-shot of an overlapping generations model (Samuelson 1958; Dye 1988) in which one generation of I See, for example, Beaver (1977,1981) or Gonedes and Dopuch(1974) forasummary of these efficiency arguments for and against regulated disclosures. 2 For example, Hirshleifer (1971), Demski (1974), and Wilson (1975) illustrate the possibility of excessive information production by private parties. This content downloaded from 207.46.13.129 on Sat, 25 Jun 2016 06:03:27 UTC All use subject to http://about.jstor.org/terms Dye-Mandatory Versus Voluntary Disclosures 3 shareholders is forced by life-cycle considerations to sell its firms to the next generation of shareholders before the firms' cash flows are realized. Because of this forced-sale assumption, the first generation of shareholders cannot directly share in the risk of the firms' cash flows with the second generation of shareholders. However, they indirectly share in this risk by participating in the stock market on which shares are transferred from one generation to the next. Disclosure policies matter here because disclosures affect the perceived riskiness of the securities when the exchange of shares takes place, and so disclosure policies affect risk-sharing between the two generations of shareholders. This paper builds upon Demski (1973, 1974) who showed that (1), in general, rankings of information systems may not be complete, and (2) the selection among financial reporting systems may have redistributive consequences. These papers indicate that progress in comparing financial reporting systems depends on identifying more restricted settings where such rankings are viable. The present paper pursues this line of inquiry and reveals the following: in many contexts where comparisons of information systems are most easily made-where only financial externalities are present-mandated disclosures are superfluous, because the optimal mandated disclosures simply coincide with firms' voluntary disclosure decisions. Where comparisons of information systems are most difficult-where real externalities are present-optimal mandatory and equilibrium voluntary disclosure tend to diverge. The paper proceeds as follows. Section I outlines the basic model. Section II provides the preliminary analysis, by studying the disclosures which representative market participants with common objectives make. Sections III and IV, respectively, study disclosures with financial and real externalities. Section V concludes the paper. I. Model Description for Disclosures with Financial Externalities The basic chronology of events corresponding to this model of disclosure requirements is summarized in the following time line: Entrepreneurs Entrepreneurs Security market Investors learn (indexed by choose disclosures opens; entrepreneurs realized values (i) =1. . .,n) own all policies (ri), and sell their firms of cash flows. firms. Firm i's cash produce information (at prices P) flows, denoted 2, (x,) according to the to investors. are distributed disclosure policies ( .ll ... * , I they select. ~-N(jA,). Priors on

Previous studies concerning experience effects in audit judgments have produced mixed results, possibly because they did not consider the knowledge necessary to complete the task and when it would normally be acquired. Further, many studies did not view the global judgment process as consisting of several components, e.g., cue selection. Task-specific knowledge may aid the performance of experienced auditors more in some components than in others. Not considering task-specific knowledge or viewing the judgment process as being comprised of components may have led to certain problems in generalizing the results of these studies to other auditing tasks. Those problems are addressed in the design of this study, which examines experience effects, specifically the role of task-specific knowledge, in the cue selection and cue weighting components of two audit tasks, analytical risk assessment and control risk assessment. Results indicate that task-specific knowledge aided the performance of experienced auditors in both the cue selection and cue weighting components only in analytical risk assessment.

Proposes and tests a probabilistic extension of the efficient market hypothesis toward the functional fixation hypothesis (FFH). Calendar time positioning of the swap announcement and swap quarter's earnings; Debt-equity swaps as a test of extended FFH (EFFH); Empirical methods.

Describes a multiperiod model of the market for audit services for a single client. Pricing phenomena of low-balling and price-cutting in the audit market; Reporting issue over which the auditor and client may disagree; Auditor's value of incumbency; Factors which may affect the client's pressure to the auditor.

This paper reviews and critiques the positive accounting literature following publication of Watts and Zimmerman (1978, 1979). The 1978 paper helped generate the positive accounting literature which offers an explanation of accounting practice, suggests the importance of contracting costs, and has led to the discovery of some previously unknown empirical regularities. The 1979 paper produced a methodological debate that has not been very productive. This paper attempts to remove some common misconceptions about methodology that surfaced in the debate. It also suggests ways to improve positive research in accounting choice. The most important of these improvements is tighter links between the theory and the empirical tests. A second suggested improvement is the development of models that recognize the endogeneity among the variables in the regressions. A third improvement is reduction in measurement errors in both the dependent and independent variables in the regressions.

[Accounting research that uses financial ratio data often assumes that sets of ratios have multivariate normal distributions. Multivariate distributional properties, multivariate outliers, and modified power transformations were examined to determine whether multivariate normality could be approximated for cross-sectional samples of financial ratios. The results were that the joint distribution of the financial ratios differed appreciably from multivariate normality and the financial ratio data contained multivariate outliers. Approximate multivariate normality was obtained by deleting multivariate outliers and applying modified power transformations to the ratios. Consequently, it would be possible to use multivariate outlier detection and transformation methods in accounting research to enhance statistical conclusion validity and to improve the effectiveness of decision models when multivariate methods that assume normality are used with financial ratios.]

[Negotiation is frequently advocated as a transfer-pricing mechanism in decentralized organizations to foster greater divisional autonomy and to improve firm profit performance. Empirical evidence reveals that many firms rely upon negotiation in determining transfer prices. A concern, however, is that negotiation may not always be efficient in terms of maximizing firmwide profits, or equitable with regard to divisional performance evaluation. Given external market opportunities and private information with respect to divisional cost and revenue functions, one division could conceivably make itself better off at the expense of another or the firm as a whole. This study used a bilateral bargaining methodology to examine negotiated transfer-pricing outcomes between a buying and selling division. The negotiation was nonzero sum; that is, market externalities existed. Each division had private profit information. One hundred and thirty-four subjects participated in face-to-face negotiations. Experimental manipulation included a mixed-incentive (company and divisional) scheme versus a divisional-incentive scheme; single-period versus multiperiod negotiations; and varying levels of market price uncertainty in the negotiations. It was hypothesized that divisional-incentive schemes would increase profit differences between divisions but would be more effective in terms of maximizing overall company profits. Absent learning effects, a negotiation history was expected to increase company profits as bargaining strategies evolved over time. Finally, divisional profit differences were hypothesized to increase in the face of uncertain market alternatives available to either the buying or selling division. The results indicate that divisional incentives did not produce greater divisional profit differences than mixed incentives. However, as hypothesized, uncertain outside market alternatives significantly increased divisional profit differences. Company profits increased significantly under divisional incentives and through time. Finally, single-period profits were significantly lower than final multiperiod profits. The results have potentially important implications for research on negotiated transfer pricing under decentralization. First, divisional profit-based incentives appear to motivate negotiators to achieve higher company profits regardless of outside market alternatives. Bargaining strategies evolved over time, leading to an increase in company profits. Negotiated transfer prices, however, do not always attain the desired objective of maximizing companies' profits or providing equitable divisional performance evaluation. This was particularly true in cases of short negotiation histories and in cases of uncertain market environments. Results of this study suggest that one way to mitigate these dysfunctional consequences is through the company's incentive system. Mixed (company and divisional) incentives in uncertain environments appear to lead to more integrative agreements, benefiting both the company and the division. Because these results are based upon analysis of experiments, caution must be exercised in generalizing the conclusions beyond this setting.]

[This study extends the existing research on the audit effectiveness of analytical procedures in a setting that used actual accounting data seeded with "material" simulated accounting errors. Five sample companies, whose revenues represented a wide range of time-series behavior, were selected to analyze the effects of eight commonly encountered accounting errors on 15 often-used analytical procedures (eight ratios and seven accounts). A "best case" scenario was induced by using, among other factors, single-industry companies, quarterly data, and more sophisticated expectation models than had been used in prior studies. The best predicting of six candidate models (four naive, a regression, and the Census X-11 time-series model) was used to generate quarterly predictions for comparison with actual data seeded with the largest of four empirically based materiality measures. Five investigation rules, including two simple percentage change rules and a statistical rule using three different alpha levels, were applied to prediction errors to determine whether error investigations were correctly signaled. The results of prediction model selection were dominated by X-11, followed by regression. Also, X-11 emerged as the "best" model more often for ratios than for accounts, while the reverse was true for the regression models. Overall, the analytical procedures examined did not signal (Type I and Type II error rates) very well when applied in isolation to quarterly data. However, when the quarterly signaling resulting were "annualized," and when an annual material error was seeded into an individual quarter's data, the results were much more encouraging. The lowest error rates were observed for instances where the primary substantive test would have been direct recomputation (i.e., interest and depreciation errors). The assertion of SAS No. 56 that income statement accounts should be more predictable than balance sheet accounts was contradicted, but the evidence is limited. The seeded quarterly material errors were generally swamped by prediction errors of the best-predicting expectation models. A significant correlation was observed between the ratio (prediction error/materiality) and the incidence of Type II signaling errors, indicating that this relationship might be used as a filter to determine when analytical procedures are likely to be effective audit tests.]