Knowledge that Transforms

[Under existing generally accepted accounting principles, no compensation expense is recorded for executive stock options (ESOs) if the exercise price on the date of grant is equal to (or greater than) the market price of the stock. Similarly, only negligible compensation expense tends to be recorded if the exercise price on the date of grant is less than the market price of the stock. The inadequacy of this method (see Boudreaux and Zeff 1976; Smith and Zimmerman 1976; and Weygandt 1977) has led the Financial Accounting Standards Board (FASB) to consider a proposal to measure compensation related to grants of ESOs at their fair values, with a lower bound constraint. A candidate model for the estimation of fair value (Swieringa 1987) is the Black and Scholes (B-S) (1973) pricing model with the Merton (1973) modification that allows for continuous-dividends. It would seem natural (and we infer that the FASB would opt) to use the continuous-dividend version of the B-S model for firms that pay cash dividends and the no-dividend version for firms that do not pay dividends. Note that if cash dividends are assumed to be zero (as would be the case for firms that do not pay dividends), the continuous-dividend version reduces to the original B-S formulation. Thus, we label the B-S continuous-dividend model (subject to the stipulation that the B-S estimate not be less than the number yielded by the FASB's minimum-value model) as the FASB proposal. This labeling applies whether the grant date or the vesting date is considered to be the measurement date (discussed below). To examine the income effect of changing the accounting method of ESOs, this study applies the FASB's proposal to a random sample of firms that granted stock options in order to assess the impact of the related compensation expense on operating income. A second objective is to compare ESO compensation estimates from the two models underlying the FASB proposal: (1) the B-S continuous-dividend model, and (2) the FASB's minimum-value procedure (discussed subsequently). In addition, the latest FASB proposal requires that stock option compensation be measured as of the vesting date, as opposed to the date of grant. Thus, a third objective is to provide evidence as to whether vestingdate estimates of ESO compensation are significantly different from ESO estimates generated on the grant date. The results indicate that, using a three percent materiality threshold, more non-dividend paying firms (about 30 percent) would have material income effects than dividend-paying firms (about eight percent). Furthermore, using alternative measures of service periods shorter than the lives of options, produces material ESO compensation expense for a high percentage of sample firms. Finally, applying the FASB proposal on the basis of the vesting date would result in a lower income effect than applying it on the basis of the date of grant. In general, material income effects are observed when the FASB's proposal is adopted irrespective of the valuation model used.]

[Individuals failed to report between 70 and 79 billion in federal taxes due on legal income received in 1986. This amount is equivalent to approximately 20 percent of federal income taxes due and 40 percent of the federal deficit in that year. Including underreporting of organizations and of those who receive illegal income likely pushes the annual amount of taxes due, but not paid, above the $100 billion mark (Roth et al. 1989, 1). Thus, reporting income for tax purposes may be characterized by a high degree of inaccurate self-reporting with an immediate economic impact. This problem can be countered by auditing self-reported income. An audit scheme is the approach by which a taxing authority chooses the self-reports to be audited. This paper describes an experiment that examines the effect of three audit schemes on taxpayers' joint or related decisions about the level of labor to be supplied and the amount of income (if any) to underreport. The three audit schemes differ principally in the information used by the taxing authority to determine which self-reports of income to audit: (a) no information is used-reports are chosen strictly at random; (b) reported income is the basis for choosing the reports to be audited; (c) an estimate of true income is used in addition to reported income to select audit cases. Also examined is the impact of alternative tax rates and penalty levels on earned and underreported income. Traditional theoretical work shows that income taxes alter the amount of labor supplied (e.g., Flanagan et al. 1984, 143-5). However, predictions regarding the direction of the change in labor supply are ambiguous: the labor supplied may increase as the taxpayer tries to compensate for the income lost to taxes by working more (the income effect), or the amount of labor may drop as alternatives to work become more economically attractive (the substitution effect). Swenson (1988) experimentally examined labor supply in response to varying marginal tax rates, and the overall results are consistent with the substitution effect dominating the income effect. The taxpayer's labor response to the tax system may not be determined solely by the direct effect of tax rates. Once a tax system is imposed, those electing to underreport their actual earned income may also elect to increase their labor supply as a result of a diminished tax substitution effect in the presence of underreporting. If the reporting decision directly affects the labor supply decision, then any tax system parameter (e.g., penalty and audit) affecting the reporting decision will also impact the labor supply decision. Consistent with the reasoning above, Pencavel (1979) analytically portrays the taxpayer's response to the tax system (i.e., rates, penalty, and probability of audit) as a joint or related decision about labor supply and the income reported. In a similar vein, Atkinson and Stiglitz (1980, 27-8) refer to the impact of taxation (and evasion opportunities) on labor supply in terms of income, substitution, and "financial" effects. They explain that financial effects arise when "the same real activity can correspond to several different forms of payment, which are taxed at different rates." The most extreme example offered of the financial effect on labor supply is the underground or "hidden" economy. Taxpayers may restructure their activities or transactions so as to operate in an economic environment free of taxation. Recognition of the jointness of the labor and reporting decisions suggests that it is reasonable to incorporate both variable in empirical studies to test how the taxpayer responds to the tax environment. In another study, Collins et al. (1990) found evidence that a positive relationship exists between work effort and noncompliance opportunities. In general, subjects with a noncompliance opportunity worked harder than those without an underreporting opportunity. The effects of the tax environment (i.e., audit schemes, tax rates, and penalty levels) on income earned and underreporting of income are tested in a laboratory setting because well controlled real world setting counterparts are not available. The experimental design consists of three audit schemes and two levels of tax rate and penalty resulting in 12 between-subject conditions. The subject's task is a computerized letter decoding task. During the experiment, each subject participated in a practice work session and four five-minute actual work sessions. At the end of each work session, subjects self-reported the income earned and corresponding tax liability. One of the three audit schemes was followed to select reports to verify. The reports denoting whether audit selection had occurred were returned privately to the subjects before the beginning of the next work session. Subjects were compensated based on the actual income earned less the taxes self-reported and possible penalties (proportional to the tax deficiency) imposed as a result of the audit. The subjects' underreports of income and work effort are analyzed for each work session separately and across work sessions two through four together using a multivariate analysis of covariance (MANCOVA). The number of letters decoded by each subject in the practice work session is included as the covariate. This measure serves as a surrogate for ability. Subsequent analyses of covariance (ANCOVAs) and mean comparisons are performed for each dependent variable. Verification schemes that incorporate the preliminary information signal sent by the taxpayer are more successful overall in curbing underreporting than purely random audit models. Also, underreporting is generally greater when tax rates are high and penalty levels are rather low. Finally, underreporting and effort are positively related. Those subjects electing to underreport also produce significantly more income.]

[During 1987, the climate of international bank lending changed dramatically and prompted major restatements of the loan portfolios of the largest U.S. money-center and regional banks. The circumstances involved decisions by several countries in Latin America-notably Brazil-to suspend scheduled interest and principal payments on their foreign debt. The exposure of the U.S. banks became most visible on February 20, 1987, when Brazil declared a moratorium on interest payments on 67 billion of medium- and long-term bank debt and, five days later, froze payments on 10 billion of short-term credits and $5 billion of money market deposits. A chain of events began in March 1987 and produced the largest reported losses in U.S. banking history. This article examines how the stockholders' returns of 13 of the largest U.S. money-center and regional banks were affected by disclosures made during 1987 regarding decisions to place Brazilian loans on a nonaccrual basis and to increase loan loss reserves to recognize the higher probability of default and the lower present value of future interest and principal. The study adds to the recent literature on banks' earnings and asset relations (Barth et al. 1990; Beaver et al. 1989) and to the accumulated evidence on the role of banks' accounting decisions in response to the resulting substantial asset impairment caused by the 1987 Latin American debt situation (Elliott et al. 1989; Grammatikos and Saunders 1990; Johnson 1989; Musumeci and Sinkey 1990a, 1990b). Using a methodology that focuses on the unanticipated short-term effects of the announcements, we find that the stock market responded adversely to the banks' reclassification of loans to the nonaccrual basis and positively to subsequent announcements of additions to loan loss provisions. The latter reaction is viewed as consistent with banks' use of those adjustments as credible signals about their intentions and abilities to resolve the Latin American debt situation. We also find that changes in secondary market prices for Brazilian loans explain banks' stockholders returns during the period and that returns measured over short intervals varied according to the balance-sheet amount of foreign loans. Such results are consistent with the hypothesis that the stock market discriminates among banks on the basis of reported foreign loan data.]

[This article considers audit sampling and the auditor's risks of incorrect conclusions in deciding whether an accounting population contains a material error amount. The proposed new sample evaluation procedure takes into account the correction of all errors observed in the sample and calculates a modified upper bound on the total error amount remaining in the unsampled population. This procedure is known as rectification. It is shown that rectification significantly reduces the risk of incorrect rejection when sample sizes of 150 and 300 are used. Since the size of the error amount observed in the sample is crucial to the extent of risk reduction, the first stage of this study investigated the magnitude of rectification for three dollar-unit sample selection methods commonly used in practice-systematic, random, and cell selection. Theoretical results for the expected error amount contained in systematic samples were obtained for 32 different study populations for three sample sizes (65, 150, and 300). Simulation was used to estimate the expected error amounts with random and cell selection for the same 32 study populations and three sample sizes. The results show that the average error amount subject to rectification with cell selection is very close to that with systematic selection for all three sample sizes. Random selection produced smaller expected error amounts than did systematic selection, especially for the larger sample sizes. In the second part of the study, the risks of incorrect rejection with and without rectification were compared. Factors considered in this comparison were sample size (65, 150, or 300) and sampling method (systematic, random, or cell). Use of rectification led to noticeable reductions in the risk of incorrect rejection for sample sizes other than 65. For a given application, auditors will need to determine whether the cost of the additional sampling is balanced by the savings from the reductions in the risk of incorrect rejection with rectification.]

[The accounting profession is witnessing an increase in both the number of lawsuits against auditors and the settlements associated with those suits. As an example, partners with Laventhol & Horwath cited litigation claims against their firm as a major factor in the nation's seventh largest accounting firm's decision to file for bankruptcy protection. Disclosures by Big Eight (now Six) firms show that between 1980 and 1984 nearly 180 million dollars were paid to settle audit-related litigation (Public Accounting Report 1985). An additional cost to firms associated with this litigation is reflected in the rise of malpractice insurance rates. For example, during 1984 the AICPA's professional liability insurance plan doubled its insurance premiums while at the same time increasing deductibles and decreasing coverage (Collins 1985). Auditing firms also suffer indirect costs as a result of increasing litigation. Prior research (St. Pierre and Anderson 1984; Palmrose 1988) examined audit litigation cases and provided descriptions of characteristics of auditors in those cases. Palmrose (1988) suggests that an increasing frequency of litigation against an auditing firm is viewed as a negative signal about the quality of auditing services provided by the firm, thereby impairing its reputation. Two conditions are likely to exist in order for a lawsuit to be filed against an auditor: (1) an allegation of audit failure, and (2) legal action provides a cost-effective alternative for potential plaintiffs. This study hypothesizes that the client's financial condition, asset structure, and sales growth affect the likelihood of erroneous financial statements being issued and that the auditor's ability to detect and willingness to disclose errors are related to the probability of an audit failure. This study also suggests that the greater the market value of the client and the higher the variability of the client's returns, the more likely the auditor of that client will be a target of litigation. A matched-pairs design is used to analyze a sample of companies involved in lawsuits against auditors and a sample of companies matched with the experimental sample on industry and time period. The results provide evidence of an association between pre-audit engagement characteristics of both the client and the auditor, and the subsequent filing of a lawsuit against the auditor. After controlling for industry effects, the ratios of accounts receivable and inventory to total assets, the client's variance of abnormal returns, financial condition, and market value are found to be significantly associated with lawsuits against auditors. A test of the model's predictive ability using various relative error costs and assuming various prior probabilities of auditor litigation results in concluding that model's ability to outperform a naive strategy is sensitive to the parameters selected. However, when realistic priors and error costs are assumed, the model is effective in identifying high-risk audit engagements.]

[Tax law complexity and ambiguity may result in uncertainty about taxable income (Slemrod 1988) and are of concern to policy-making bodies such as the ABA, the AICPA, and the IRS (Sheppard and Evans 1990). Several studies have modeled the effects of uncertainty on taxpayer reporting and the role of tax practitioners in reducing uncertainty (Alm 1988; Shavell 1988; Beck and Jung 1989a, 1989b; Scotchmer 1989a, 1989b; and Scotchmer and Slemrod 1989). Empirical and experimental research, however, have not kept pace. This paper reports experimental tests of the effects of income uncertainty and other economic factors based on tax reporting models in Beck and Jung (1989a). Hypotheses were tested regarding the effects of changes in the uncertainty level, tax rate, penalty rate, and audit probability on reported taxable income. In addition, the explanatory power of the models was evaluated by comparing the taxable income reported by the subjects with model-based predictions. Subjects were endowed with a fictitious currency and were given a range of possible post-audit taxable incomes from which to report. A proportional tax was paid on reported income and, in the event of an audit, a monetary penalty was imposed when the actual taxable income was greater than the amount reported. Incentives were provided by making the subjects' post-experimental remuneration a function of the after-tax income retained from each experimental trial. Since previous theoretical research indicates that taxpayers' reporting decisions are sensitive to risk preferences, three seperate experiments were performed and the results were analyzed by repeated measures ANOVAs. In the first and second experiments, subjects' risk-taking attitudes were controlled by the Berg et al. (1986) mechanism. Risk-neutrality (risk-aversion) was induced in the first (second) experiment, while subjects' preferences in the third experiment were measured ex post, rather than controlled. Two measures of taxpayer reports were employed-the actual income reported by subjects and the corresponding reporting fractile. The experimental results provided support for risk-neutral predictions. First, risk-neutral subjects were found to report higher levels of income when penalty rates and audit probabilities increased. Second, the tax rate did not affect the reporting behavior of risk-neutral subjects. Third, income reports were affected by two interactions: audit probability with uncertainty and penalty rate with uncertainty. Specifically, a reduction in uncertainty led to higher (lower) levels of reported taxable income when penalty rates or audit probabilities were decreased (increased). In addition, the mean reporting fractile did not change with the uncertainty level and the deviation of mean observed reports from predicted levels was small. For the risk-averse model, the predicted tax rate effect was marginally significant for reports and insignificant for fractiles. Furthermore, only a small percentage of the variance was explained by the interaction of tax rate and uncertainty. Report fractiles, however, did increase significantly as predicted when uncertainty was elevated.]

[This study provides empirical evidence on the economic effects of Securities and Exchange Commission (SEC) mandated segment data. In 1970, the SEC required multisegment firms to report segment revenue and income in their 10-K reports. Previous studies have reported that SEC mandated segment data reduced the systematic risk and improved earnings prediction but had no impact on security prices. However, the security price studies suffered from methodological deficiencies. This study overcomes these deficiencies and reexamines the security price impact of SEC mandated segment data. It also extends the earnings prediction studies by examining the impact of segment data on divergence of beliefs of multiple financial analysts' earnings forecasts, an aspect of earnings prediction not studied by previous research. Disclosure of segment data is conceptualized as providing a more precise information signal about firm value to investors. Using theories developed in the information economics literature (Holthausen and Verrecchia 1990, and others), two hypotheses are derived. The first hypothesis predicts that price variability around the dates of release of 1970 10-K reports will be higher than price variability around the dates of release of 1969 10-K reports. The second hypothesis predicts that divergence of beliefs in May 1971 (after the release of SEC mandated segment data) will be lower than divergence of beliefs in May 1970 (before the release of such data). Based on theory and evidence in Bhushan (1989), two more hypotheses are derived. The magnitudes of increase in price variability and decrease in divergence of beliefs are hypothesized to be positively correlated with the number of segments. The Patell (1976) methodology is used to measure price variability, and multiple financial analysts' earnings forecasts reported in the Standard & Poor's Earnings Forecaster are used to measure divergence of beliefs. The sample is divided into a control group and an experimental group based on segment data disclosures prior to the SEC mandate. The empirical evidence shows that, for the experimental group, there is a significant increase in price variability and a significant decrease in divergence of beliefs. There are no such effects for the control group. The evidence also shows that, for the experimental group, the magnitudes of increase in price variability and decrease in divergence of beliefs are directly proportional to the number of segments. There are no such relationships for the control group.]