Knowledge that Transforms

This study examines the effects of management forecast precision (i.e., lack of uncertainty) on equity pricing and the assessment of earnings uncertainty. Kim and Verrecchia (1991) modeled the price reaction to the public release of information as a positive function of both the unexpected component of the information and the information's precision. We test these predictions with a sample of 868 management forecasts for 1983-1986 annual and interim earnings. The use of management forecasts rather than actual earnings to test the precision hypothesis has the distinct advantage that the level of forecast precision is not directly regulated and thus may vary across forecasts. Further, managers explicitly disclose their level of uncertainty. Both this study and Pownall et al. (1993) document that most forecasts are open-interval (minimums and maximums), closed-interval (ranges), or general impressions rather than point estimates. The method used to test the precision hypothesis removes restrictions on the traditional regression of unexpected returns on unexpected earnings. Specifically, the slope and intercept coefficients that map unexpected earnings into unexpected returns can vary in the cross-section as a function of forecast precision. Our results support a direct relation between forecast precision and the importance of management forecasts for security pricing. Holthausen and Verrecchia (1990) and Morse et al. (1991) modeled a decrease in investors' consensus as a positive function of the magnitude of signal surprise and the dispersion of the perceived precision of the signal. We examine these predictions with a sample of 221 point and closed-interval (range) forecasts. We calculate whether the range of outcomes disclosed by a manager exceeds the range of Institutional Brokers Estimate System (IBES) analyst forecasts. We find this variable and the magnitude of unexpected security returns (a proxy for signal surprise) to be positively associated with increases in the standard deviation of IBES analyst forecasts. Morse et al. (1991) found the hypothesized relation between signal surprise and increase in analyst forecast variance, but were unable to separate the precision effect from the signal surprise effect. Managers' explicit labeling of forecasts as more uncertain through range disclosure permits the direct calculation of management forecast precision relative to analyst forecast precision. Our tests involve joint hypotheses of the effects of forecast precision on security prices and the credibility of managers' disclosures of forecast precision. Ajinkya and Gift (1984) developed and tested the "expectations adjustment hypothesis" which posits sufficient incentives for credible, symmetric forecast disclosure. King et al. (1990) argued that expectations adjustment also suggests credible labeling of the precision of forecasts.

This paper examines the stock price effects of alternative types of management earnings forecasts. Beyond deciding whether to disclose forecasts, managers must decide whether to issue a point projection or a more qualitative estimate (e.g., a bounded range), and whether to project interim or annual earnings or both. Our empirical tests assess differences in the information content of management earnings forecasts that differ by form and horizon. Our tests provide a comprehensive investigation of the price effects of these alternative forecast disclosure types. While an extensive literature exists on the relation between management forecasts and stock prices, most previous studies examine only point and range forecasts of annual earnings (e.g.. Penman 1980; Ajinkya and Gift 1984; Waymire 1984; McNichols 1989; Pownall and Waymire 1989). Exceptions include Lev and Penman (1990), Patell (1976), and Baginski et al. (1993). Lev and Penman (1990) include lower and upper bound forecasts for part of their sample period, but do not examine these disclosure forms separately. Patell (1976) provides evidence on mean price changes associated with a pooled sample of annual minimum and maximum forecasts. Baginski et al. (1993) examine alternative forecast forms. Prior analyses of managers' disclosure incentives speculate that investors may condition their assessment of forecast information on disclosure form and horizon. For instance, King et al. (1990) suggest that forecast disclosures emerge as voluntary managerial actions to reduce costly information asymmetry in capital markets. Under the "expectations adjustment" hypothesis, managers have incentives to acquire and maintain a reputation for credible disclosure. Rational investors recognize that disclosure quality varies systematically by disclosure form and will discount qualitative projections or those issued with longer horizons. Policy debates on mandatory disclosure of qualitative information, such as the recent SEC debates over the content of "Management Discussion and Analysis" disclosures, and deliberations on forecast disclosure in the 1970s (see King et al. 1990), also suggest a need for evidence on the information content of qualitative prospective disclosures and alternative forms of forecasts. Our primary tests are based on a sample of 1,252 forecasts disclosed by 91 firms between July 1, 1979 and December 31, 1987. Several conclusions emerge from these tests. First, forecast disclosures remain highly informative even when including other disclosure types not analyzed in prior studies. Second, forecasts are less informative than earnings announcements for our full sample, a finding that is inconsistent with earlier results in Pownall and Waymire (1989). Third, differences across forecast forms are not significant at conventional levels. Fourth, interim forecasts are significantly more informative than annual projections. This result is driven largely by maximum forecasts, which are highly informative and more frequent in the interim forecast subsample. We document several additional regularities that may be of interest to researchers. First, point and range annual forecasts comprise less than 20 percent of our sample. This suggests that the incidence of voluntary management forecast disclosure is possibly far greater than suggested by previous studies. Second, range forecasts tend to be quite inaccurate ex post. Actual earnings per share (EPS) fell outside the forecasted bounds in more than 50 percent of our range forecasts. Third, forecasts that are more qualitative tend to be issued over longer horizons. Minimum forecasts are issued over the longest horizons for our sample, and interim point projections have the shortest horizons. Finally, extensions to our primary tests provide some evidence that maximum forecasts have significant negative price effects, and that for point forecasts, forecast revisions are highly informative.

A major concern in the literature is that participation by subordinates may result in the generation of slack budgets (Antle and Eppen 1985). In one of the earliest studies, Williamson (1964) concluded that subordinate managers will try to influence the budget-setting process and obtain slack budgets. In conformance with Merchant (1985a), Lukka (1988), and Young (1985), budgetary slack is defined as the express incorporation of budget amounts that make it easier to attain. Managers may build slack into budgets by strategies that understate revenues and overstate costs (Schiff and Lewin 1970). Whether budgetary slack is a likely outcome in all participatively set budgets is a matter of conjecture. Lukka (1988) argued that a high degree of participation gives subordinate managers the opportunity to contribute directly to the creation of slack, and vice versa. However, the link between participation and slack is equivocal, since Cammann (1976), Merchant (1985a), and Onsi (1973) provide evidence that participation may lead to a reduction in slack, which can be attributed to the positive communication between managers so that subordinates feel less pressure to create slack. The literature proposes a link between participation and budgetary slack through two variables: superiors' budget emphasis in their evaluation of subordinate performance, and the degree of information asymmetry between superiors and subordinates. When participation, budget emphasis, and information asymmetry are high (low), slack will be high (low). For this study, samples of managers were drawn from manufacturing organizations in the Sydney, Australia, metropolitan area. Measures of budgetary stack and information asymmetry were developed. Support was found for low (high) slack when the predictors are high (low).

Relates the efficiency of nonprofit organizations to the composition of their board of trustees. Derivations of technical and allocative efficiency of charities; Background and motivation of the board of trustees; Indications that nonprofit organizations are more efficient if their board of trustees have a larger proportion of outsider trustees.

In competitive product markets, product prices and thus firms' revenues incorporate the cost of equity capital. In a competitive capital market, the cost of equity capital (the expected return on equity) increases with the risk of firms' Investments. Because accounting earnings are calculated without deducting the cost of equity capital, they are expected to be an increasing function of firms' investment risks. This simple competitive equilibrium analysis predicts a positive relation between changes in investment risk and expected earnings. The presence of corporate debt complicates the analysis because leverage effects seem likely to affect the relation between changes in investment risk and expected earnings. Using annual earnings and return data from 1950 to 1988, we document a statistically significant positive association between changes in equities' relative risks and in earnings. However, on average, only a small proportion of changes in earnings can be attributed to changes in risk. A much larger proportion is attributable to changes in economic rents (windfall gains and losses). The observed positive association between changes in earnings and changes in equities' risks suggests that leverage effects do not fully offset the effect of changes in investment risks. This association is robust with respect to subperiod analysis, alternative specifications of the earnings change variable, alternative data-availability requirements, and the number of portfolios formed.

The Internal Revenue Service (IRS) relies increasingly on its ability to detect taxpayer noncompliance without engaging in a comprehensive individual audit. The IRS's compliance initiative, Compliance 2000, emphasizes the targeting of noncompliant taxpayers rather than relying on random audits to enforce the tax laws. For example, the IRS uses a model developed from the Taxpayer Compliance Measurement Program (TCMP) to help it choose which returns to audit. The treatment of losses from tax shelter partnerships presents a difficult compliance problem for the IRS. It is not evident from the face of either the partnership return or the partner's return whether the losses from the partnership can be legitimately deducted. A plausible audit strategy is for the IRS to develop models that can predict when an individual is improperly deducting a loss. The tax shelter disclosure rules in I.R.C. §6111 and §6112 provide information to the IRS that helps it detect taxpayers investing in abusive tax shelters. Previous work has modeled tax compliance as a game between a wealth-maximizing taxpayer and a tax enforcement agency trying to maximize government revenues, net of audit costs (Graetz et al. 1986; Reinganum and Wilde 1986; Beck and Jung 1989). In these papers, the IRS uses the taxpayer's declaration of income when it decides whether to audit that taxpayer. The purpose of this paper is to examine the effect of information that helps the IRS predict tax evasion on the strategic choices made by the taxpayer and the IRS. The information has a direct effect by giving the IRS information that can improve its audit decision. It also has an indirect effect by changing the taxpayer's incentives to engage in tax evasion, which in turn changes the IRS's incentives to audit taxpayers. The optimal level of information acquisition is also examined. The analysis yields four important results regarding the effect of information on tax compliance. First, it can induce an increase in tax evasion. Second, it has no effect on the expected level of gross government revenues. Third, it can increase expected audit costs. Fourth, the optimal level of investment in information acquisition does not vary monotonically with tax rates, penalty rates, audit costs, or the amount of loss deducted by the taxpayer.

Recent audit studies by Brown and Solomon (1990, 1991) reveal that careful consideration of domain-specific knowledge can result in the experimental detection of configural relationships between information cues. These findings suggest that auditors' decisions may be more complex than indicated by some previous research, and that additional research is necessary to identify conditions in which auditors utilize configural processes. This study investigates the role of environmental risk factors on the configurality of audit decisions. That is, we test whether the systematic consideration of audit risk variables results in the Identification of higher order, interactive decision processes where linear relationships have previously been detected. The findings of Libby et al. (1985) and existing audit pronouncements are used to develop hypotheses regarding auditors' internal audit decisions. The hypotheses concern (1) the interactive effect of inherent risk and control strength on the extent to which auditors rely on internal audit functions to reduce planned audit work and (2) the extent to which these environmental factors affect consideration of three components of internal audit quality: objectivity, competence, and work performed. Audit managers from a Big Six accounting firm responded to a series of audit-planning cases concerning the receivables cycle of a medium-sized manufacturing firm. Inherent risk and strength of control architecture were manipulated as between-subject variables, while the objectivity, competence, and work of the internal auditors were manipulated within subjects. The results indicate that specific audit decisions are quite complex when elements of the risk environment are explicitly considered. Specifically, reliance on the internal audit function was based on a configural relationship between the levels of inherent risk and control strength. Auditors relied more on internal auditors when control architecture was strong rather than weak in conditions of high inherent risk. However, the effect of control architecture was mitigated when inherent risk was low. Also, complex relationships existed between environmental risk and task-specific components of internal audit quality. For example, auditors considered all three internal audit components when making reliance decisions in the high inherent risk and strong control strength condition, but not in certain other risk conditions. Implications of the experimental results are discussed.

In a thorough review of market-based research on the information content of accounting earnings, Lev (1989) concludes that the explanatory value of earnings for stock returns, and therefore the usefulness of earnings disclosures, tends to be embarrassingly low. A number of nonmutually exclusive explanations have been advanced for these disappointing results, including: (1) poor specification of the estimating equation, such as a failure to allow for cross-sectional variation in the regression parameters; (2) inappropriate choice of the assumed proxy for expected earnings; (3) the availability of more timely sources of the value-relevant information in earnings statements (Beaver et al. 1980); and (4) poor informational properties (quality) of reported earnings because of biases induced by accounting measurement practices or creative "abuses" of the earnings measurement process. Lev (1989) speculated that the last of these explanations was the most likely cause of the poor statistical performance consistently found in returns-earnings research. In contrast, the present study shows that a considerable improvement in statistical performance can be achieved by working with a more general specification of the returns-earnings relation. Lev's article has resulted in serious questioning of the contribution of market-based research, but we believe that the present study provides grounds for a more positive assessment. We use a panel regression approach to examine the association between annual stock price returns and reported earnings figures of industrial companies in the United Kingdom. We combine several recent advances in market-based accounting research design to produce a specification of the relation between earnings and price changes that subsumes the following key features: 1. Contemporaneous earnings yield is included in addition to the deflated first difference in earnings that is normally included in models of the returns-earnings relation. 2. Regression parameters are allowed to vary both cross-sectionally and over time. 3. Parameter values are allowed to vary across components of earnings to accommodate differences in the degree of persistence; in particular, we model the explanatory power resulting from attempts by accountants to distinguish extraordinary and exceptional items from the other components of earnings. We introduce these features in a general model in a way that allows us to assess the incremental explanatory power of each individually as well as the joint effects of two or more combined. Each methodological improvement contributes significantly to our ability to explain security price changes, and we show that the best fit is achieved by incorporating all three features in a single general model. In moving from the standard model, which regresses a measure of abnormal returns on earnings changes, to the most general model, the adjusted A-squared increases from 0.10 to 0.38.

Tests the effects of agency incentives and knowledge spillovers in joint engagements for audit and nonaudit services. Association of external parties and regulators joint nonaudit purchases with impaired auditor independence; Agency costs and the procurement of jointly produced services; Recognition by auditees of the potential for perceptions of independence impairment.

An auditor's reputation lends credibility to the earnings report that he audits. An unresolved issue is whether auditor size is correlated with auditor quality, where a high-quality auditor is defined as one who brings about more credible earnings reports. According to basic intuition and a modified Holthausen-Verrecchia (1988) model, investors' response to an earnings surprise will depend on the perceived credibility of the earnings report. In this study, we examine whether the earnings response coefficient (ERC) differs between Big Eight (B8) and non-Big Eight (NB8) audited firms. This provides a test of the joint hypotheses that auditor size is a proxy for auditor credibility and of the modified H-V model. Consistent with the joint hypotheses, we find that the ERCs of Big Eight clients are statistically significantly higher than for non-Big Eight clients. The result obtains in both a matched sample of firms paired according to industry membership, and a switch sample of firms grouped according to shifts from and to B8 and NB8 auditors. Furthermore, the result is robust with respect to the inclusion of other explanatory factors for ERG that have been suggested by previous studies: growth and persistence, risk, firm size, and predisclosure information environment.