Knowledge that Transforms

[This research examines the information content of the bank earnings components entitled "Securities Transactions Gains and Losses" (STGL). STGL reflect the accounting gain or loss that arises when a bank sells an investment security at a price different from the book value. Institutional as well as anecdotal evidence suggests that investors may price STGL differently from the operating earnings component entitled "Income before Securities Transactions" (IBST). For example, prior to 1983, bank regulators viewed the IBST and STGL components as reflecting unique aspects of bank activities and, therefore, required that total bank earnings be disaggregated into IBST and STGL components (SEC 1983). In addition, because of investment market volatility and the discretionary nature of investment securities sales, STGL may convey limited information about current changes in bank value (Linden 1990). Indeed, with banks, security analysts often focus on IBST (Barth et al. 1990), and managers have been accused of selectively selling appreciated investment securities to increase reported levels of accounting earnings (Berton 1991; Wyatt 1991). Research by Barth et al. (1990) has assessed the relative ability of the IBST and STGL income components to explain cross-sectional variation in annual common stock prices. They predicted, for many of the reasons cited above, that the STGL earnings/security price multiple should be less than the multiple assigned to the IBST component. Their results confirm this prediction: IBST played an important role in explaining bank stock prices, but the earnings/security price multiple assigned to STGL did not differ significantly from zero. There are several reasons why STGL might not have exhibited information content in this research. First, as Barth et al. suggest, the incremental information content of the STGL component may have been diminished because STGL appear to be realized to smooth income. In this situation, STGL are likely to provide little incremental information about changes in bank equity values. Second, Barth et al. measure stock returns over a 12-month interval corresponding to the bank's fiscal year. When returns are measured over such a long period, the likelihood increases that information unrelated to earnings will also be reflected in equity prices, thereby (potentially) reducing the ability of earnings to explain security returns. Third, significant tax-related, cross-sectional differences may exist in the STGL earnings component/security price relationship, and these are "averaged away" when one overall earnings/security price coefficient is estimated. For example, Scholes et al. (1990) suggest that STGL may be realized to minimize taxes. Based on this tax-planning scenario (described in section I), security transaction losses (gains) for tax-paying (non-tax-paying) banks are predicted to be negatively (positively) related to bank equity values. The objective of this study is to assess whether the STGL earnings component is priced by investors in a manner consistent with this tax-planning rationale. Empirical tests measure the market reaction to IBST and STGL earnings information over the two-day interval consisting of the day before and day of the preliminary quarterly earnings release, and the results provide evidence that STGL are priced by investors in a manner consistent with the tax-planning hypothesis. However, these results appear to hold only in the first three quarters of the fiscal year. In the fourth quarter, there is no evidence that the STGL component is priced by bank investors. These fourth-quarter results are consistent with an increase in earnings-management activity related to STGL near the fiscal year-end]

[Much of the research in positive accounting theory deals with whether managers choose accounting methods that reduce or minimize certain costs faced by firms, such as the cost of violating bond covenant restrictions, political costs, and the tax cost associated with the use of the FIFO rather than the LIFO inventory method. However, this research ignores some more fundamental costs associated with the legal form under which the firm chooses to operate, a much larger issue that precedes the choice of accounting methods. This article examines this larger issue by focusing on the trade-off that exists between tax costs and transaction costs in the choice of organizational form. Scholes and Wolfson (1986, 1989) assert that an organization's form is chosen to minimize both tax costs and transaction costs. Under this theory, if the corporate form has a greater tax cost than that of an alternative form, the partnership, the corporate form would not be chosen unless the transaction costs of the partnership form exceed those of the corporate form. Fama and Jensen (1983b, 327) examine costs of alternative organizational forms and state that "the form of organization that survives in an activity is the one that delivers the product demanded by customers at the lowest price while covering costs." Although Fama and Jensen specifically excluded tax costs from their analysis, Scholes and Wolfson argue that both relative tax costs and relative transaction costs are important determinants of organizational form choice, and that changes in relative tax costs will result in changes in form. They also make the following predictions about the effect of the 1986 Tax Reform Act: corporations will be replaced as an organizational form by partnerships for new ventures financed with equity; many existing corporations will convert to partnership form; absent this conversion, many corporations will add debt to their capital structure. These predictions lead directly to two questions. First, how do tax laws affect the choice of business entity? Second, what happens when these tax laws change? These two general questions are investigated here through two more specific research questions. The first is, What are the incremental tax costs and transaction costs of alternative organizational forms (corporations and master limited partnerships) available to large, publicly traded firms? The second is, How will managers of existing corporations respond to a tax law change (the 1981 Economic Recovery Tax Act) that causes the tax cost of the corporate form to increase relative to that of the partnership form? The results of empirical tests of four hypotheses developed to investigate these research questions indicate that, for the period 1978-85, the corporate form resulted in a significantly greater average tax cost than the partnership form, and this incremental tax cost increased significantly after the 1981 Economic Recovery Tax Act (ERTA). Partnerships are found to have a significantly lower return on assets and sales than a matched sample of corporations. Responses of managers to increasing tax costs of the corporate form after 1981 are predicted to be (1) increasing long-term debt, (2) increasing non-dividend distributions, and (3) decreasing dividend payout ratios. Empirical results for both univariate and multivariate tests are consistent with these predictions. These results make a significant contribution to accounting research for two reasons. First, they demonstrate a relationship between changes in relative tax costs of alternative (competing) organizational forms and changes in such fundamental elements of capital structure as debt levels, non-dividend distributions, and dividend payout ratios. Previous research on the relationship between taxes and capital structure (e.g., Bradley et al. 1984; DeAngelo and Masulis 1980; MacKie-Mason 1990; Titman and Wessles 1988) has not considered the effect of the tax cost of alternative organizational forms. Second, the results provide empirical support for predictions by Scholes and Wolfson (1986, 1989) and Petruzzi (1988) regarding responses of corporations to increases in relative tax costs (i.e., Scholes and Wolfson predict increasing long-term debt; Petruzzi predicts increasing non-dividend distributions).]

[This study examines participative budgeting in the context of the psychology of risk. As Young (1985) and Waller (1988) report, there is some preliminary evidence that risk-averse workers create more budgetary slack than risk-neutral ones. They show that "truth inducing incentive schemes" (e.g., Soviet incentive schemes; see Weitzman 1976) reduce budgetary slack for risk-neutral subjects but not for risk-averse subjects. If this is true, it means that resource allocations within organizations are mediated by perceptions of risk. Young (1985) and Waller (1988) define risk preference as a dispositional variable, which presumes that it is a stable personal trait, a latent variable, traditionally inferred from observed behavior of risk propensity in such settings like lotteries. This study tests whether risk preferences are domain-specific; that is, latent risk preferences translate into differing manifest risk preferences according to the context. Domain-specific risk preference can be understood as a manifest psychological variable that may well be the result of the combination of latent risk propensity and the situation. Kahneman and Tversky's prospect theory (1979) suggests that manifest risk preferences depend upon whether the subject frames his or her task in the context of gain or loss prospects, where gains and losses are defined in relation to a neutral reference point. If risk preferences are domain-specific, then past studies' suggestion that incentive schemes should be designed in consideration of dispositional, or latent, risk preferences needs to be reexamined (Waller 1988; Kaplan 1982). The question before this study is: If subordinates are influenced by prior period performance in setting current period budgets for themselves, will that influence take the form predicted by prospect theory and thus lead to riskier preferences (tight budgets) when the subordinates perceive themselves in a losing situation? This is an important question considering Young's (1985) alluding to the possibility that inducing subordinates to less risk-averse behavior may be a way to favor tight budgetary standards and reduce slack. This prediction is consistent with prospect theory's implication that losers who are slow to adjust their reference point act in a more risk-seeking manner. Thus, the induction of losing prospects might be a way to minimize budgetary slack. An additional concern in this study is to jointly test domain-specific risk preferences and dispositions toward risk as influences over budgetary decisions. Whereas prospect theory explains risk preferences as domain-specific contingencies, other theories construe risk preferences as dispositional. It is likely that both domain-specific and dispositional factors influence budgetary decisions. This study deploys a conventional lottery procedure to elicit and test dispositions toward risk. An experiment simulating the public accountants' budgeting of billable hours was designed to test the hypothesis that subject preference for tight or safe budget behavior depends on the performance of coworkers and domain-specific risk preferences. The hypotheses were tested in an experiment employing 81 students. The results generally support the view that subordinates' risk preferences are influenced by a situation-dependent variable. The reversal of risk preferences around a neutral reference point is statistically significant for both dispositionally risk-averse and dispositionally risk-seeking subjects. The dispositional variable also contributes to the explanation of variations in subjects' manifest risk preferences. Thus the propensity to induce budgetary slack seems to be a joint function of situations and dispositions.]

[Current reporting rules require inter-period tax allocation whereby the income tax expense reported in the income statement is determined on the basis of pretax book (accounting) income, adjusted for permanent differences between the period's taxable income and book income. The temporary differences accumulate on the balance sheet as a deferred tax liability and are assumed to reverse in future years, gradually reducing the liability. Opponents of interperiod tax allocation argue that reversal of these temporary differences is unlikely or will occur only in the remote future. Thus, support has developed for either partial allocation (e.g., allocating only short-term temporary differences) or no deferral at all. Regardless of such concerns, in 1987 the Financial Accounting Standards Board (FASB) reaffirmed the use of comprehensive interperiod tax allocation. In this study, we perform cross-sectional analyses relating unexpected stock returns around news disclosures about the Tax Reform Act of 1986 to pertinent firm characteristics in an attempt to assess whether the deferred tax liability is viewed as a liability. The main findings of the study are consistent with the hypothesis that investors view the deferred tax liability as a real liability. They appear to discount it according to the timing and likelihood of the liability's settlement. The remainder of the article is organized as follows. Section I describes the previous research on the informativeness of tax deferrals, outlines the hypotheses of this study, and details the procedures used to test them. Section II presents and discusses the results, and the final section provides concluding remarks.]

[Sequential processing of evidence is important to auditors because it characterizes the manner in which many audit judgments are made. For example, Gibbins (1984, 110) has stated that "as a normal routine, judgment proceeds incrementally rather than by gathering full information and integrating it all before choosing a response." One advantage of sequential processing is that it allows an auditor to keep a "running total" of the effects of prior information and therefore reduces memory load (Einhorn and Hogarth 1985). Although sequential processing of evidence promotes cognitive economy, recent findings in psychology seem to indicate that it can lead to non-normative responses, including order and framing effects (Einhorn and Hogarth 1985; Tversky and Kahneman 1981). Drawing on these general studies in psychology, previous auditing research has examined the impact of task variables (including temporal order and mode of processing) on judgments (Ashton and Ashton 1988; Butt and Campbell 1989; Tubbs et al. 1990). However, none of these studies examines how such differences in judgments are manifested in audit actions. This study extends previous research by examining whether these order effects (1) occur in alternate hypothesis frames and (2) translate into different choices of audit reports. It was hypothesized that sequential processing of evidence leads to a recency effect in auditors' going-concern judgments. This effect should lead auditors who evaluate contrary information followed by mitigating factors to issue relatively more unqualified opinions than those who evaluate the same evidence in a reverse order. An experiment was conducted involving 70 audit managers and partners working on a case adapted from an actual audit. The auditors were randomly assigned to one of four experimental conditions created by crossing two levels of hypothesis frame and two levels of evidence presentation order. The framing manipulation involved either a failure or a viability condition. Auditors assigned to the failure (viability) frame were asked to express their belief that the firm will fail (continue in existence) during the next financial statement period. Within each framing condition, the auditors evaluated four pieces of evidence presented in two different orders. In one sequence, two mitigating factors were followed by two pieces of contrary information, and these were reversed in the other condition. After evaluating all the evidence, subjects were asked to indicate the type of opinion (audit report) they would issue. The results support the existence of recency effects in both belief revisions and audit report choices. Auditors who evaluated contrary information followed by mitigating factors issued more unqualified (fewer modified) opinions than those who evaluated the same evidence in the reverse order. Further, as expected, hypothesis frame did not affect the existence of recency effects.]

[The quality of bank portfolios has declined in recent times, and allegations have been made that auditors have failed to detect material overstatements of the value of bank loan portfolios (McCoy et al. 1990; Thomas and Ricks 1990), lawsuits have sought to hold auditors liable for the misleading financial statements (Bailey 1987; Finn 1984), and audit firms have been censured by the SEC for improper professional conduct in the audits of banks (Grisdela and Berton 1987). This research examines the evaluation of the bank loan portfolio, a critical and high-risk component of the audit of banks. The Allowance for Credit Losses "should be adequate to cover specifically identified loans, as well as loans and pools of loans for which losses are probable but not identifiable on a specific loan-by-loan basis" (AICPA 1986, 3). The focus of this research is the effect of participation in sequential audits on auditors' loan evaluation judgments. The sequential nature of audit judgments is an important consideration, but previous research has considered only the sequential nature of individual audit tasks (see, e.g., Ashton and Ashton 1988; Cushing and Loebbecke 1986; Gibbins 1984). To date, research has not focused on the fact that audits themselves are sequential; most audits are repeat engagements, and the same auditors participate in the audit year after year. A theoretical framework for the effect of personal involvement on judgment (Kiesler 1971; Staw 1976; Staw and Ross 1987) suggests that personal involvement fosters commitment and an escalation of commitment occurs when there is personal responsibility for a series of judgments. The current research extends previous studies by evaluating the effect of personal responsibility in a professional environment with experienced subjects performing a realistic task. The literature suggests that experience could significantly affect the tendency of subjects to escalate their commitment to a chosen course of action. Experience is expected to improve judgments when (1) the decision maker is exposed to a variety of exemplars so that information about relative frequencies is learned, (2) the task is sufficiently complex and is either semistructured or unstructured, and (3) feedback on decisions is available. These conditions are all present for loan riskiness evaluations by auditors. Previous research results also indicate that experience may improve judgments by mitigating the effect of cognitive heuristics on judgments (see, e.g., Libby et al. 1985; Shields et al. 1987). Mechanisms leading to these results include (1) improved probabilistic reasoning as a function of experience, (2) incentives to learn decision rules with accountability for judgments, and (3) sensitivity to evidence. Ashton and Ashton (1988, 1990) indicate that experienced auditors are particularly sensitive to evidence. Like many other audit decisions, loan evaluation involves sequential judgments. The research reported here seeks to determine (1) whether personal involvement in sequential audits leads to an escalation of commitment to previous loan evaluation decisions and (2) whether experience in the audit environment diminishes or eliminates any negative consequences of personal responsibility. Personal involvement is manipulated across two groups of independent auditors, and audit experience and loan evaluation judgments are elicited. It is hypothesized that the interaction between personal involvement and experience affects the loan evaluation judgment. When there is a high level of personal involvement, the loan evaluation judgments of inexperienced auditors are predicted to be more favorable than those of experienced auditors; when there is a low level of personal involvement, no differences between the judgments of experienced and inexperienced auditors are predicted. Based on experimentation with 41 auditors, the results indicate that a significant interaction does exist. Escalation behavior in loan evaluation judgments was evident in the evaluations of inexperienced auditors; experience mitigates the escalation effect.]

[This study provides additional evidence on factors influencing inventory accounting policy choice. Following Lee and Hsieh (1985), Dopuch and Pincus (1988), and Lindahl (1989), we compare long-time FIFO users with long-time LIFO users to test variables that might be expected to influence inventory method choice. This study incorporates a tax savings variable in evaluating the LIFO/FIFO choice. We also survey financial executives to corroborate the results of secondary data analyses and to seek new insights about inventory method choice. The findings suggest that: (1) anticipated tax savings is the primary reason firms use LIFO and (2) other firms do not use LIFO because of numerous factors without a single dominant reason. Most of these factors diminish the potential tax savings from LIFO. They include LIFO layer liquidations, LIFO bookkeeping costs, declining production costs, and contradictory tax and financial reporting rules on accounting for inventory obsolescence. However, other factors include effects on debt covenants, concern about the complexity of LIFO, and the requirements of FIFO for government contracts. Two unexpected findings emerged. First, the multivariate model is quite accurate in predicting FIFO firms, but predicts less then half of those using LIFO. Second, the correspondence between the responses to the FIFO survey and the cross-sectional data is not as strong as might be expected, which suggests that determinants of inventory choice continue to be elusive.]

[The accounting rate of return (ARR) is "not only a central feature of any basic text on financial statement analysis but also figures commonly in the evaluation by investment analysts of the financial performance of firms" (Whittington 1988, 261). Notwithstanding the prominence given to this financial ratio (Foster 1986, 77-79), many writers have warned that the ARR lacks economic significance and can be a very misleading measure of profitability. Fisher and McGowan (1983, 90), for example, conclude that "there is no way in which one can look at accounting rates of return and infer anything about relative economic profitability." In the same vein, Rappaport (1986, 31) states flatly that the comparison of the ARR with the cost of capital is "clearly like comparing apples with oranges." The limitations of using ARRs to estimate the economic rate of return have been discussed over the last 25 years; for example, Harcourt (1965), Solomon (1966), Kay (1976), Fisher and McGowan (1983), Salamon (1985), Edwards et al. (1987), and Brief and Lawson (1991). This research has focused mainly on the question of whether the ARR is a good proxy for the economic return and the literature contains virtually no discussion of other ways in which the ARR might be used in financial analysis. An important exception is Peasnell (1982b) who presents a common analytical framework connecting conventional economic concepts of value and yield and accounting models of profit and return. However, even here, the main emphasis is on the relationship between accounting and economic rates of return. This emphasis is quite evident in Peasnell's concluding comment that "it is difficult to assign economic significance to accounting yields except either (1) as surrogate measures of IRR or (2) when they are defined in terms of entry- or exit-market prices" (379-80). A different slant on the economic significance of ARRs is presented here where the focus is on the use of the ARR in the valuation process, not in the determination of profitability. The purpose is to show that an expression for an accounting-based measure of discounted cash flows (DCF) can be derived in terms of the ARR. Thus, quite apart from the question of whether or not the ARR is an accurate estimate of the economic rate of return, this financial ratio has a key role to play in the valuation process. The results have both analytical and practical significance. On an analytical level, the derivations can be viewed as basic "bookkeeping relationships" that are associated with a double-entry system. On the more practical side, while the DCF techniques currently used in practice "are largely accounting-based valuation approaches" (DeAngelo 1990, 100), the use of accounting data in DCF valuations is very indirect. Present practice is to "use historical accounting relationships to forecast future earnings, from which future cash flows are estimated" and, in addition, to estimate terminal values "from projections of future earnings" (p. 100). However, instead of basing DCF valuations on cash flows which are derived from accounting data, a more direct method of analysis is to base the DCF valuations directly on accounting data. Understanding how accounting data can be used in DCF analysis leads to a greater appreciation of the general nature of accounting and provides a compelling reason to give the ARR a more prominent place in financial statement analysis.]