Knowledge that Transforms

This study examines differences in auditors’ search behaviors associated with the preferences of audit management (reviewer preferences) and the nature of the required response (belief versus action) in the context of an accounts receivable collectibility review. I find that auditors facing reviewers who expressed concern about auditors spending time specifically looking for evidence inconsistent with explanations provided by the client (credence preference) examined fewer evidence items and followed a more client‐prompted search (i.e., a search for evidence that follows directly from the client’s explanation) than those facing reviewers who expressed concern about auditors’ ready acceptance of client explanations without adequate justification (skepticism preference) and those facing reviewers who expressed no specific concern (unknown preference). Further, auditors in the action conditions examined fewer evidence items and spent less time per evidence item than those in the judgment conditions. Additional analyses also indicate that auditors who were held accountable to a reviewer with an unknown preference generally responded as if the reviewer maintained a skepticism preference.

We analyze the stock market’s valuation of electric utility “stranded costs” (i.e., costs that might become unrecoverable under deregulation), and investigate whether stranded costs that have arisen as a result of voluntary firm business decisions are valued differently from those that are more directly linked to regulatory mandates. Further, we study whether investor valuations differ across jurisdictions. Finally, we examine the relation between investor valuation of stranded costs and the decision by utilities to make stranded cost‐related disclosures in their financial statements voluntarily. We find that investors anticipate that, on average, approximately 10% of total stranded costs will be borne by utility shareholders. Stranded costs arising from voluntary operating or investing decisions made by utilities are valued more negatively than those associated with mandatory power purchase contracts, consistent with investors assigning a higher recovery probability to the latter. Investor valuations of stranded costs associated with utility generating investments do not differ systematically across jurisdictions. We find that stranded costs are valued less negatively for voluntary disclosers not just in the year of disclosure but also in the preceding two years, implying that it is not disclosure per se that favorably influences valuation. Voluntary disclosers operate in jurisdictions that have more clearly established stranded cost recovery mechanisms, suggesting that both stranded cost disclosure and valuation are prompted by reduction in uncertainty about recoverability.

This study investigates whether the ability of book‐to‐market to predict returns derives from systematic errors in the market’s expectation of future earnings. We extend Beaver and Ryan (1996, 2000) by decomposing book‐to‐market into a more persistent (bias) component and a delayed recognition (lag) component. We find that both components are related to analyst expectations of future earnings, but the lag component is the dominant factor across all forecast horizons. Similarly, we find that the lag component explains most of the inverse relation between book‐to‐market and future returns. Given that lag is constructed by regressing book‐to‐market ratios on lagged price changes, our results are consistent with the lag component capturing systematic stock price reversals. We find that the components have unique relations with subsequent earnings forecast revisions, and controlling for these relations substantially mitigates the components’ ability to predict returns. Our component‐level analysis provides insight into how expected future earnings, summarized in book‐to‐market ratios help to explain this market anomaly.

This paper investigates the role of the stock of unionized labor in determining equity investment risk. I estimate a labor stock measure based on expected compensation costs, and use the ratio of labor stock to total assets as a risk proxy. At the median, the labor stock is comparable in magnitude to total assets. Regression estimates show the associations between labor‐based risk proxies and equity market risk measures are both economically and statistically significant. In addition, the labor‐based measures provide risk information over and above information contained in standard risk proxies such as financial and operating leverage.

We study a principal‐agent model in which there is an option to defer a capital project approval decision. A control (incentive) problem makes the option to wait valuable when it would not have been valuable otherwise. Deferring the project approval decision has both a cost and a benefit. The cost of waiting is that the agent’s uncertainty regarding future project cost realizations cannot be exploited. However, by delaying the first project’s approval decision, the principal can condition its approval on the agent’s cost report of the second project. Such conditioning can be valuable in the provision of incentives because of a diversification effect.

We examine how an auditor’s ability to terminate a multi‐period client relationship provides the auditor with a real option whose value depends on the nature of informational asymmetry between the incumbent and other potential auditors. In particular, we isolate conditions under which the auditor’s private and public sources of information behave as complements rather than substitutes. In such circumstances, increasing the likelihood of publicly provided information induces the auditor to expend more (rather than less)resources in private information gathering activities.

Existing research indicates that firms with high accruals are more likely to experience future earnings problems, but that investors' expectations, as reflected in stock prices, do not appear to anticipate these problems. In this paper, we directly examine the published opinions of two types of professional investor intermediaries to see if they provide investors with information concerning the future earnings problems experienced by firms with high accruals. First, we examine the earnings forecasts of sell‐side analysts. We show that analysts' earnings forecasts do not incorporate the predictable future earnings declines associated with high accruals. Second, we examine the behavior of independent auditors. We find no evidence that auditors signal the future earnings problems associated with high accruals through either their audit opinions or through auditor changes. Overall, our evidence indicates that analysts and auditors do not alert investors to the future earnings problems associated with high accruals, thus corroborating previous findings that investors do not appear to anticipate these problems.

In this paper, the principal rewards an agent’s farsighted effort both in the short and long term, with the short‐term reward based on a noisy, forward‐looking performance measure and the long‐term reward based on a potentially less noisy, trailing performance measure. The main result is that optimal contracting weights depend on the agent’s employment time horizon: the shorter the agent’s employment horizon the greater the emphasis on the forward‐looking performance measure and vice versa. This implies that contracting on forward‐looking performance measures can be valuable in mitigating any adverse long‐term effects of employees myopically focusing on short‐term trailing performance measures.

The AICPA Special Committee on Financial Reporting has urged disclosure of relevant forward‐looking information on risks and opportunities to supplement conventional financial statements. We conduct a laboratory market experiment to assess the effects of such disclosures on capital allocation decisions. We develop two sets of competing hypotheses regarding how capital markets react to supplemental disclosures. One set is based on the assumption of semi‐strong market efficiency, while the other posits that the bounded rationality of individual traders leads to inefficient market prices. We find that explicit disclosure of management’s best estimate of an uncertain quantity improves market efficiency, even though this disclosure is redundant with information in financial statements. Second, we find disclosure of an upper bound of management’s estimate has the potential to bias security prices upward, while informationally equivalent disclosure of both upper and lower bounds removes this bias. These results suggest that experimental market reactions to these supplemental disclosures are inconsistent with market efficiency. Supplemental analyses of individuals’ price predictions and trading behavior support our conclusion that inefficiencies are at least partially attributable to individual information processing biases.

Despite extensive research on the determinants of external audit fees, there is little empirical evidence on the effect of internal audit contribution on the external audit fee. Using a cross‐sectional regression model based on prior audit fee research, this study provides evidence that internal audit contribution is a significant determinant of the external audit fee. Further, a second model that provides evidence on the determinants of internal audit contribution is developed and tested. This second model indicates that internal audit contribution is influenced by internal audit quality and, conditional on the level of inherent risk, the availability of internal audit and the extent of coordination between internal and external auditors. These results are based on a unique data‐set comprised of publicly available data matched with survey responses from internal and external auditors affiliated with 70 non‐financial services Fortune 1000 firms. The sample includes all of the former “Big 6” international accounting firms and clients from twenty‐nine different industries.