Knowledge that Transforms

[As examined in previous research (e.g., Gramlich 1991; Dhaliwal and Wang 1992), accounting accruals related to the alternative minimum tax (AMT) may either contain effects unrelated to the book income adjustment or be confounded by other changes in the 1986 Tax Reform Act. For example, total accruals in Gramlich (1991) arising from changes in accounts receivable and inventory have no effect on the book income adjustment because they affect taxable income and book income simultaneously.1 Also, the repeal of the investment tax credit and a slower capital recovery schedule in the 1986 Tax Reform Act may induce firms to reduce investment. This change may decrease depreciation (a component of accruals in Gramlich (1991)) and the depreciation timing difference (a component of accruals in Dhaliwal and Wang (1992)) in 1987 and may contribute to the observed results.2 Prior research also relied on pre-1987 data and certain assumptions to predict the likelihood that firms would be subject to the AMT in 1987 (see Gramlich (1991) and Dhaliwal and Wang (1992) for examples). Such an approach is warranted only under an assumption of no change in tax status for the sample firms. However, the overwhelming changes instituted by the 1986 Tax Reform Act make such an assumption questionable. Misclassification of firms can lead to results attributable to sample partition rather than the AMT. Furthermore, firms with low tax payments are classified as the AMT firms in these studies. Since low tax payments may be an indication of poor financial condition, the AMT sample is likely to contain firms with deteriorating financial condition which may lead to an overall decrease in accruals in 1987. This study improved three aspects of previous research designs to test the effect of the book income adjustment on financial reporting. First, the sample consisted of firms that were indeed subject to the AMT in 1987 to ensure that only the behavior of AMT firms were examined. Second, only accrued expenses and revenues that were not sensitive to other major changes in the 1986 tax law were assessed. Third, a time-series model controlling for changes in firms' financial condition was used to estimate the unexpected accruals. In general, the results indicated that firms that were subject to the AMT in 1987 exhibited unusual shifts in accounting accruals in 1986 and 1987. Unlike the institution of the AMT in 1987, the repeal of the book income adjustment in 1990 was independent of other major changes in tax law, providing a rather clean event to examine the effect of the book income adjustment on financial reporting. Evidence of accruals shifting for firms subject to the AMT in 1989 would lend further support to the conclusion that the AMT affects financial reporting practices. Accordingly, accruals of sample firms subject to the AMT in 1989 were examined. An unusual shift in accounting accruals was observed in 1989 but in a direction opposite to the 1987 sample.]

[The relation between audit opinions and auditor switching has received considerable attention in recent years. Chow and Rice (1982) report a positive association between a firm's propensity to switch auditors and the receipt of a qualified opinion in the year prior to the switch. 1 However, firms that switch auditors do not seem to receive "improved" opinions in the year following the switch (Chow and Rice 1982; Smith 1986). Despite this evidence, the Securities and Exchange Commission (e.g., Release No. 33-6594 [1985] and Financial Reporting Release No. 34 [1989]) and the popular financial press (e.g., Power 1984) continue to express concerns about opinion shopping. This study focuses on the auditor's opinion formulation process for switching and non-switching clients in the year prior to the switch. In particular, it examines the possibility that auditor switches are triggered not by the receipt of qualified opinions, but by auditors' use of conservative judgments for some clients. While conservatism refers to a number of accounting and auditing issues, the overall conservatism of the auditor is assumed to be reflected in a tendency to issue qualified opinions. An ordered probit model of the qualification decision is estimated with different threshold values for prospective switchers and non-switchers measuring different judgments applied to the two groups of clients. The results support the hypothesis that threshold values for switchers are significantly lower (more conservative) than those for non-switchers. Further analysis of switching patterns suggests that when qualified opinions are based on conservative standards, the switching rate is higher than when average standards are applied. The observed conservatism could be the auditor's reaction to negative private information gathered during the audit that makes continued association with the client uneconomical or undesirable. However, the evidence indicating that opinions do not improve after switches suggests that opinion shopping is generally futile. This condition may exist because private information is obtained during the audit process, and a client usually will not be able to shop for a less conservative auditor with a prior commitment of a favorable treatment. Recent concerns about opinion shopping and its effect on auditor independence may therefore not be justified.]

[Although health-care reform has emerged recently as an important national priority, there has been little research on the effect of possible deficiencies in both accounting and auditing standards in the development of problems in this area. This study examines earnings management in the health maintenance organization (HMO) sector of the prepaid health-care industry. HMOs are a principal component of the managed health-care concept currently being promoted as important in controlling escalating health-care costs. The study examines possible strategic behavior by HMO management in the accrual of "incurred but not reported expenses" (IBNRs). IBNRs are the costs of medical care provided to HMO enrollees during a given year but not yet reported to the HMO by the fiscal year-end. They consist primarily of five components: accrued inpatient hospitalization costs, accrued primary physician costs, accrued costs from medical specialists to whom HMO enrollees have been referred, accrued medical incentive pool payments, and other miscellaneous medical costs. Their accrual was first recommended by the Health Maintenance Organization Task Force of the American Institute of Certified Public Accountants in an issues paper later published as an exposure draft (AICPA 1985). It was eventually released as SOP 89-5 entitled Financial Accounting and Reporting by Providers of Prepaid Health Services in 1989 to be effective for fiscal years beginning on or after 15 June 1989 with earlier application encouraged. However, by the time SOP 89-5 was issued, a significant majority of HMOs was already in compliance with the SOP, at least so far as the accrual of IBNRs was concerned. The results of this study suggest that IBNRs may have been used as part of a strategic response by HMO management to events specific to the industry in the 1986-1989 period. These events included the outbreak of a premium war apparently waged to obtain market share at the expense of immediate profitability and the enactment in many states of minimum net worth regulations designed to prevent the resultant increase in financial failures among HMOs. The results suggest that the IBNRs were systematically understated by financially weaker HMOs (relative to their stronger counterparts) in order to minimize regulatory costs associated with the statutory minimum net worth requirements imposed by some states during this period. Furthermore, the results were also consistent with the political visibility hypothesis, which theorizes that highly profitable firms in politically sensitive sectors seek to reduce their visibility by adopting income-decreasing accounting methods and discretionary accruals. However, the findings were not consistent with the political visibility hypothesis if size is visualized as a proxy for political visibility.]

[This article provides evidence on the news content of managements' preliminary earnings estimates, which we define as projections of earnings conveyed in expectational language after the end of the reporting period but before the release of final earnings numbers. We examine stock price changes to assess whether a preponderance of these disclosures are interpreted as "good news" by investors, and the extent to which good news releases are disclosed earlier than bad news. Associated with preliminary earnings estimates are disclosure and timing issues. While previous theoretical work suggests managers have incentives to suppress or delay disclosure of adverse information (Verrecchia 1983; Dye 1985), studies examining the disclosure issue using management forecasts produced inconsistent results, and results on the timing of corporate earnings announcements are ambiguous. Although there is evidence on the information content of preliminary earnings estimates (Foster 1973), no study has used these data in investigating the relation between corporate disclosure and news content. Preliminary estimates are important because they embody aspects of disclosure choice similar to other voluntary disclosures such as forecasts, and the time lags between preliminary estimates and earnings releases are short, thereby assuring a strong timing aspect to their release. We document significant negative mean abnormal returns associated with the disclosure of preliminary estimates. The median is negative, but not significant at conventional levels. Tests on the timing issue indicate an ambiguous relation between disclosure timing and news content. Preliminary estimates of quarters 1-3 earnings are more likely to be bad news compared to estimates of quarter 4 and annual earnings, but within quarters there is no strong relation between news content and disclosure timing.]

[Several analytical models of the year-end inventory purchasing decision of a LIFO firm have been developed (Cohen and Halperin 1980; Halperin 1979, 1981; Biddle and Martin 1985).1 This study finds empirical support for the prediction of these models that, since only LIFO firms reduce their tax burden by purchasing additional inventory (i.e., "extra" inventory) at year-end, LIFO firms are more likely to purchase extra inventory at year-end than FIFO firms. This research also provides evidence that high-tax LIFO firms are more likely to purchase extra inventory at year-end than low-tax LIFO firms. This behavior is predicted because a LIFO firm's tax savings from purchasing extra inventory at year-end are increasing in its marginal tax rate. Additional evidence of tax-motivated year-end inventory purchases is offered by tests which find that (1) consistently high-tax LIFO firms accelerated their year-end inventory acquisitions-and thus reduced their taxable income-to a significant degree in the years immediately preceding the reduction in tax rates mandated by the Tax Reform Act of 1986; and (2) differences in tax status are not related to differences in fourth quarter inventory purchasing behavior for FIFO firms. The results of this study indicate that taxes have a sizable effect on the inventory purchasing policy of LIFO firms. For example, (1) the estimated difference in the percentage of annual inventory purchases made in the fourth quarter between high-tax and low-tax LIFO firms is equivalent, on average, to 12.66 million of purchases (3.8 percent of ending inventory); and (2) the estimated decrease in inventory purchases made in the fourth quarter by LIFO firms that move from a high-tax status in one year to a low-tax status in the following year is equivalent, on average, to 28.89 million of purchases (12.1 percent of ending inventory). These large dollar amounts lend credence to the concern that year-end LIFO inventory purchases made for tax purposes may lead to inventory management inefficiencies (Jannis et al. 1980, 186).]

[This study develops an empirical model to examine the responsiveness of budgetary allocations to public demand for services and the resulting outcome-generating activities in the New York City Police Department (NYPD). The analysis combines nonfinancial measures of the results of operations with budgetary and financial measures. The model explicitly incorporates efficiency and effectiveness measures and reflects as well the interactive nature of outcome-generating activities in the NYPD. The setting investigated suggests that, as in for-profit managerial accounting, task complexity and budgetary slack may be important conditioning variables in performance assessment. The empirical analysis uses publicly available NYPD data. We find evidence that budgetary provisions are responsive to perceived social needs. In addition, task complexity is a pervasively important determinant of both budgetary allocations (a major cost-driver) and the effectiveness of the police department in achieving specific outcomes. The data also suggest that the department may rely extensively on budgetary slack to cope with rapid changes in demand. The nature of the outcome-generating activities of the organization is illustrated in the responsiveness of outputs and outcomes to increased inputs. These results illustrate both the feasibility and the potential usefulness of comprehensive performance evaluation in the not-for-profit sector. The next section of the paper provides background on the empirical research issues and a brief review of relevant academic research. The empirical model is developed in section II. Section III reports the results of the model estimation and hypothesis tests. We discuss the implications of the results in section IV.]

[Recent attention has focused on the design of cost systems that improve measurement of product costs. Much of this work has been classified under the general heading of Activity-Based Costing (ABC). There has been little systematic analysis, however, of why an ABC system with multiple cost pools, activity drivers and allocation bases generates more accurate product costs. The intuitive argument rests on the belief that multiple cost pools and multiple activity drivers better reflect the cause and effect relation between overhead resource consumption and products. Our analysis reveals the existence of trade-offs attributable to specification error, aggregation error, errors in measurement of overhead costs and errors in measurement of product-specific units of allocation bases. Our research provides some guidance for implementing ABC systems. There are two principal results of our analysis. First, partially improving specification of cost allocation bases and increasing the number of cost pools in a costing system can actually increase specification and aggregation errors. Second, reductions in specification and aggregation errors from more disaggregated and better specified costing systems may increase measurement errors and hence errors in product costs. We assume that firms do not know actual product costs, but rather implement new cost systems by identifying better cost drivers and increasing the number of cost pools under an implicit assumption that refinements in the cost system lead to improved accuracy of product cost numbers. This assumption is warranted in many cases. However, our results suggest that such incremental refinements in the cost system may actually cause product cost errors to increase. Therefore, a firm cannot assume that refining its cost system will always lead to more accurate product costs.]

[Top executives' compensation contracts typically provide for annual incentive awards that link executives' cash compensation and reported earnings. This link has been confirmed empirically by Lambert and Larcker (1987), who document a positive association between the cash compensation of chief executive officers (CEOs) and their firms' contemporaneous earnings performance. The widespread use of earnings-based incentives has prompted concerns that executives may select real decisions and accounting procedures to maximize their earnings-based compensation, irrespective of the impact on the economic well-being of the firm (Kaplan and Atkinson 1989, 724; Watts and Zimmerman 1986, 204). These concerns presume that the earnings-based performance measures specified in compensation contracts are strictly adhered to in setting executive compensation. In practice, however, these plans are administered by compensation committees, who could adjust compensation to prevent executives from engaging in opportunistic behavior. Existing research provides mixed evidence as to whether compensation committees adjust earnings-based compensation. For example, Abdel-khalik (1985) finds evidence that CEO compensation is adjusted in response to accounting procedure changes. In contrast, Healy et al. (1987) find no evidence that CEO compensation is adjusted for the effects of accounting procedure changes on reported earnings. This study provides evidence suggesting that compensation committees do adjust earnings-based incentive compensation. It documents reliable and systematic evidence that CEOs' cash compensation is adjusted for restructuring charges. We investigate a sample of 182 restructuring charges taken by 91 Fortune 500 firms between 1982 and 1989. The short-term incentive plans of the sample firms do not include explicit provisions for restructuring charges to be excluded from the definition of earnings used to determine executives' incentive compensation. The empirical analysis, however, indicates that CEO cash compensation is shielded from restructuring charges relative to other components of earnings. The results also suggest that the degree to which executive compensation is adjusted for a restructuring charge depends on the characteristics of the restructuring. Our evidence is consistent with the hypothesis that compensation committees systematically override the provisions of incentive plans to avoid providing executives with incentives to behave opportunistically. Restructurings typically require a large charge to earnings but can have a positive impact on the economic well-being of a firm. By adjusting executive compensation for restructuring charges, the compensation committee ensures that executives are not deterred from undertaking value-enhancing restructurings.]

[Often overlooked in empirical analyses of the relation between audit quality and audit fees is the recognition that they are mutually determined by the interaction of the client's demand for, and the audit firm's supply of, audit quality. Failure to account for this endogeneity can lead to biased inferences concerning the audit quality/audit fee relation. We adopt a simultaneous equations estimation procedure (offered by Amemiya 1978) applicable to jointly determined endogenous variables when one of the variables (in our case the quality review outcome) is qualitative in nature.1 To illustrate the procedure, we use a dataset developed by the United States General Accounting Office (GAO 1987) in its study of the audit procurement practices of entities receiving federal financial assistance. Inferences using this procedure differ from those of single-stage analyses. The results suggest that within the context of the application examined, audit fees appear to be positively related to the supply of audit quality and inversely related to the demand for audit quality. These findings have implication for studies involving audit fees and studies examining the demand characteristics of auditing.]

[In 1983, Medicare changed its method of reimbursement for hospitals from an all-charges-paid basis to a flat-fee-per-diagnosis basis. Managing the cost of treatment became increasingly important. In an effort to influence physicians to reduce the amount of resources used, hospital controllers began providing cost information about patient treatment to physicians. Several questions were being asked at the time: (1) Although society affirmed that cost containment is necessary, should physicians ethically consider costs in making treatment decisions? (2) Would a group of professionals incorporate a new set of information provided by the accounting system into their decision-making process? (3) What design of management accounting system would best facilitate physician decision making around cost containment? This research examines the effects of providing cost reports, as a new information set, in this complex professional environment which is characterized by implicit contracts. An economic analysis explores the conditions necessary to align hospital and physician goals around cost management. An appropriate set of accounting information may help detect overtreatment. In addition, the reputation cost of being known as an overtreater may provide the necessary incentive for success in containing costs. A cross-sectional analysis of hospitals was undertaken to determine the response of physicians to this new information set. Differences in their practice patterns were analyzed in relation to the types of accounting information received. Average charges were used to measure practice patterns. The study population was partitioned according to the types of information provided and frequency of reporting. The results of the empirical analysis suggest hospitals providing physicians with their own case costs and some comparison information had significantly lower average charges, statistically, than those hospitals that did not. The comparison information may be reports of other individual physicians' case costs or on-the-average practice patterns within the hospital or within the state. This study contributes to current research in several ways. First, a theoretical framework has been developed that links incentives to manage costs with the type of accounting information provided in organizational environments characterized by a reliance upon implicit contracts. Second, from an accounting perspective, disaggregate information gathered by the accounting process and some sort of benchmark are necessary to induce this reputation effect that appears to influence behavior. Third, a linkage between total cost management and the use of accounting benchmark information in an implicit contracting environment is documented.]