Some corporate decisions increase stockholder wealth while reducing the wealth of bondholders. When wealth transfers are large enough, stock prices can rise from decisions that reduce firm value. Yet, rational bondholders understand that actions taken after issuance will tend to increase stockholder wealth, and they forecast the value effects of future decision when bonds are sold. In an efficient market, the bond price at issuance reflects an unbiased forecast of the effects of such future actions. Thus, on average, bondholders will not suffer losses, although the firm (and hence its stockholders) must bear the costs of nonoptimal decisions motivated by wealth transfers from debtholders. Therefore, effective control of this bondholder-stockholder conflict can increase firm value. Bond covenants that constrain activities such as asset sales or dividend payments are examples of voluntary contracts that can reduce the costs generated when stockholders of a levered firm follow a policy that deviates from maximization of the firm's value. The cost-reducing benefits of covenants accrue to the firm's owners through the higher price the bonds command when issued. Furthermore, if covenants lower the costs that bondholders incur in monitoring managers, these cost reductions also are passed to stockholders through higher bond prices at issuance. Therefore, in structuring an optimal debt contract, the firm's managers face a trade-off between increased proceeds from the debt issue and reduced flexibility with respect to future policy choices. The constraints imposed through covenants are frequently specified in terms of accounting numbers. Debt covenants that employ accounting numbers are conventionally divided into (1) affirmative covenants, which require firms to maintain specified levels of accounting-based ratios, and (2) negative covenants, which limit certain investment and financing activities unless specified accounting-based conditions are met. For example, negative covenants restrict the payment of dividends, the disposition of assets, the issuance of additional debt, and merger activity; affirmative covenants specify minimum working capital and net worth requirements. Although standard covenants in debt issues require that accounting numbers be consistent with generally accepted accounting principles (GAAP), they normally do not prohibit managers from switching between accepted methods. In some bank-loan agreements, firms are required only to provide unaudited, internally generated financial statements, but the contract also requires the firm to maintain substantially the same set of GAAP. If a change becomes necessary, the bank must be notified in writing prior to the change with the reasons detailed (see Zimmerman 1975). Since different accounting techniques imply different accounting numbers, firms have incentives to relax onerous constraints through the choice of accounting techniques. Academic accountants have devoted substantial effort to obtain empirical evidence on the importance of debt agreements in determining accounting policy. (Watts and Zimmerman 119861 and Christie [19901 provide reviews.) Initial studies adopted indirect methods to account for the effect of debt covenants on accounting decision by using the firm's debt-equity ratio as an explanatory variable in cross-sectional regressions. This ratio is a proxy for closeness to covenant constraints, as well as for the expected costs should a breach occur. Duke and Hunt (1990) and Press and Weintrop (1990) offer evidence to support the use of the debt-equity ratio as a proxy for the closeness to debt covenant constraints. Christie (1990) documents significant support for this debt hypothesis by aggregating cross- sectional studies of accounting choice, generally concluding that the larger the firm's debt-equity ratio, the more likely the firm's managers are to select accounting procedures that shift reported earnings to the current period from future periods. Researchers have generally interpreted support for this debt hypothesis as evidence that managers act opportunistically. However, Watts and Zimmerman (1990) question whether the documented association is misinterpreted by researchers. Rather than reflecting managerial opportunism, the evidence may reflect the association among firms' investment opportunity sets, financial policies, and their efficient set of accounting methods. Even in theory, it is difficult to distinguish between opportunism and contracting efficiency as determinants of accounting policy choice. Given positive contracting costs, there will be a positive efficient amount of opportunism. Distinguishing between opportunism and efficiency is difficult in empirical work also. For example, a significant relation between accounting policy choice and leverage could indicate that managers of firms with high leverage act opportunistically in selecting accounting techniques to reduce costs imposed by constraints in debt covenants. Alternately, it could indicate that corporations for which a particular set of accounting techniques is efficient also tend to be those firms for which high leverage is efficient. Firms examined in these cross-sectional studies are not necessarily close to their debt covenant constraints at the date examined. When firms are not close to debt covenant constraints, managerial opportunism is a less plausible explanation for the documented association between leverage and accounting choice. Yet, since it is costly for firms to switch back and forth between accounting procedures, firms that switch accounting methods to delay default are likely to continue to employ incomes increasing accounting procedures, even if default is no longer likely (see Sweeney 1992). A firm's current accounting policies thus should depend on its historical choices and the time series of variables hypothesized to influence accounting policy. Therefore, cross-sectional studies do not provide the most direct or most powerful tests of the relation between accounting choice and debt contracts. Recent studies overcome a number of limitations inherent in cross sectional analyses by examining accounting-based defaults in debt covenants. Careful examination of the default process, its causes and cures, provides evidence on important aspects of the lending process. In this article, 1 review this developing literature to provide a richer under-standing of the costs of leverage. These costs have important implications. For accountants, they offer potential explanations of a firm's accounting policy choice; for financial economists, they enrich our understanding of the firm's optimal capital structure.

Reviews the book "The Australian Accounting Standards Review Board: The Establishment of Its Participative Review Process," by Asheq Razaur Rahman.

[Some corporate decisions increase stockholder wealth while reducing the wealth of bondholders. When wealth transfers are large enough, stock prices can rise from decisions that reduce firm value. Yet, rational bondholders understand that actions taken after issuance will tend to increase stockholder wealth, and they forecast the value effects of future decision when bonds are sold. In an efficient market, the bond price at issuance reflects an unbiased forecast of the effects of such future actions. Thus, on average, bondholders will not suffer losses, although the firm (and hence its stockholders) must bear the costs of nonoptimal decisions motivated by wealth transfers from debtholders. Therefore, effective control of this bondholder-stockholder conflict can increase firm value. Bond covenants that constrain activities such as asset sales or dividend payments are examples of voluntary contracts that can reduce the costs generated when stockholders of a levered firm follow a policy that deviates from maximization of the firm's value. The cost-reducing benefits of covenants accrue to the firm's owners through the higher price the bonds command when issued. Furthermore, if covenants lower the costs that bondholders incur in monitoring managers, these cost reductions also are passed to stockholders through higher bond prices at issuance. Therefore, in structuring an optimal debt contract, the firm's managers face a trade-off between increased proceeds from the debt issue and reduced flexibility with respect to future policy choices. The constraints imposed through covenants are frequently specified in terms of accounting numbers. Debt covenants that employ accounting numbers are conventionally divided into (1) affirmative covenants, which require firms to maintain specified levels of accounting-based ratios, and (2) negative covenants, which limit certain investment and financing activities unless specified accounting-based conditions are met. For example, negative covenants restrict the payment of dividends, the disposition of assets, the issuance of additional debt, and merger activity; affirmative covenants specify minimum working capital and net worth requirements. Although standard covenants in debt issues require that accounting numbers be consistent with generally accepted accounting principles (GAAP), they normally do not prohibit managers from switching between accepted methods. In some bank-loan agreements, firms are required only to provide unaudited, internally generated financial statements, but the contract also requires the firm to maintain substantially the same set of GAAP. If a change becomes necessary, the bank must be notified in writing prior to the change with the reasons detailed (see Zimmerman 1975). Since different accounting techniques imply different accounting numbers, firms have incentives to relax onerous constraints through the choice of accounting techniques. Academic accountants have devoted substantial effort to obtain empirical evidence on the importance of debt agreements in determining accounting policy. (Watts and Zimmerman [1986] and Christie [1990] provide reviews.) Initial studies adopted indirect methods to account for the effect of debt covenants on accounting decision by using the firm's debt-equity ratio as an explanatory variable in cross-sectional regressions. This ratio is a proxy for closeness to covenant constraints, as well as for the expected costs should a breach occur. Duke and Hunt (1990) and Press and Weintrop (1990) offer evidence to support the use of the debt-equity ratio as a proxy for the closeness to debt covenant constraints. Christie (1990) documents significant support for this debt hypothesis by aggregating cross-sectional studies of accounting choice, generally concluding that the larger the firm's debt-equity ratio, the more likely the firm's managers are to select accounting procedures that shift reported earnings to the current period from future periods. Researchers have generally interpreted support for this debt hypothesis as evidence that managers act opportunistically. However, Watts and Zimmerman (1990) question whether the documented association is misinterpreted by researchers. Rather than reflecting managerial opportunism, the evidence may reflect the association among firms' investment opportunity sets, financial policies, and their efficient set of accounting methods. Even in theory, it is difficult to distinguish between opportunism and contracting efficiency as determinants of accounting policy choice. Given positive contracting costs, there will be a positive efficient amount of opportunism. Distinguishing between opportunism and efficiency is difficult in empirical work also. For example, a significant relation between accounting policy choice and leverage could indicate that managers of firms with high leverage act opportunistically in selecting accounting techniques to reduce costs imposed by constraints in debt covenants. Alternately, it could indicate that corporations for which a particular set of accounting techniques is efficient also tend to be those firms for which high leverage is efficient. Firms examined in these cross-sectional studies are not necessarily close to their debt covenant constraints at the date examined. When firms are not close to debt covenant constraints, managerial opportunism is a less plausible explanation for the documented association between leverage and accounting choice. Yet, since it is costly for firms to switch back and forth between accounting procedures, firms that switch accounting methods to delay default are likely to continue to employ income-increasing accounting procedures, even if default is no longer likely (see Sweeney 1992). A firm's current accounting policies thus should depend on its historical choices and the time series of variables hypothesized to influence accounting policy. Therefore, cross-sectional studies do not provide the most direct or most powerful tests of the relation between accounting choice and debt contracts. Recent studies overcome a number of limitations inherent in cross-sectional analyses by examining accounting-based defaults in debt covenants. Careful examination of the default process, its causes and cures, provides evidence on important aspects of the lending process. In this article, I review this developing literature to provide a richer understanding of the costs of leverage. These costs have important implications. For accountants, they offer potential explanations of a firm's accounting policy choice; for financial economists, they enrich our understanding of the firm's optimal capital structure.]

[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 non-accounting 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.]

Reviews the book `Management Accountant's Guide to Fraud Discovery and Control,' by Davia et al.

[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.]

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.

Comments on the valuation of executive stock options (ESO) and the fair value proposal of the Financial Accounting and Standards Board. Stability of the added parameter; Compatibility of lambda and the numerical method with accounting policy; Analysis of the ESO estimation.

[Positive theory hypothesizes that accounting-based debt covenants are important factors in accounting choices. According to Watts and Zimmerman's (1990) survey, this hypothesis has generally been supported by earlier studies. That is, the closer the firm is to violating accounting covenants, the more likely managers would choose income-increasing methods. Recently, research attention has shifted to the event of covenant violation itself. For example, Beneish and Press (1993) estimate debtors' costs of violations. Further, DeFond and Jiambalvo (1991) and Sweeney (1992) examine debtors' manipulative behavior before covenant violations. These latter studies find that violations of accounting covenants are costly to debtors, who generally try to manipulate accounting numbers to avoid or defer technical defaults. The present study also focuses on the event of violation, but from the perspective of creditors. It explains two aspects of creditors' decision process following covenant violations. First, we find that creditors react to actual violations in two distinct ways: they could either waive the violations or could demand certain conditions such as early payment, increase of interest rate, reduction of borrowing base, and so forth. Second, we also model creditors' decisions either to waive or to call the debt using the option-pricing framework. We hypothesize that the determinants of waiver decisions include the firm's bankruptcy probability and leverage ratio. Moreover, maturity, size, and security of the debt issue involved should also be important factors in the waiver decisions. Empirically, we find that creditors are more likely to grant a waiver to the firm with a lower estimated probability of bankruptcy and a lower leverage ratio. Further, debt issues that are secured or smaller in size are more likely to have violations waived than unsecured or larger issues. The maturity variable, however, is not found a significant determinant of the waiver decisions. Using the factors identified in this study, managers can assess the probability of receiving a waiver and prepare necessary strategies to ensure the firm's survival. Auditors also can use those factors to assess the possibility of the client's receiving a waiver of covenant violation as part of their evaluation of the firm's ability to continue as a going concern. Moreover, since debtors prefer waivers to nonwaivers, the prospect of receiving a waiver is likely to influence managerial behavior, including the choice of accounting alternatives. Managers expecting a nonwaiver from creditors would have more incentive to select accounting methods to avoid covenant violations.]