Knowledge that Transforms

[Varian (1985) and Karpoff (1986) showed analytically that trading volume is positively related to the degree of differing beliefs. This study provides empirical evidence on the postulated relationship. The extent of disagreement or dispersion in financial analysts' forecasts of annual EPS for a firm is employed as the proxy for agents' differing beliefs about the firm's prospects. The revision in analysts' mean EPS forecasts, from one month to the next, is used to control for the volume effects of the net information signals emanating during the period. While some researchers have addressed the relation between the level of trading and earnings announcements (Beaver 1968; Morse 1981), and between trading volume and the magnitude of earnings forecast errors (Bamber 1986, 1987), the impact of discordant expectations on trading volume has been the subject of more recent empirical examination (Comiskey et al. 1987; Ziebart 1990; Lang and Litzenberger 1989). The hypothesis tested in this study posits that the fraction of outstanding common shares traded is a positive function of both forecast dispersion and mean forecast revision. While most previous studies of volume have concentrated on specific accounting disclosures, this study examines the trading associated with an almost continuous flow of information about the sampled firms that analysts implicitly use in their periodic revisions of earnings forecasts. Hence, tests of the model become possible at several times during the year, independent of formal accounting events/disclosures. Monthly observations in each of the four years 1978 to 1981 are used for the sample of 420 calendar-year firms; total number of observations is 16,747 over 48 months. Generalized least squares (GLS) estimation is applied to observations pooled over time and cross-sections and for each of the four years separately. Ordinary least squares (OLS) estimations are also performed and reported for comparative purposes and also to assess the stability of the models in monthly cross-sections. The results indicate a significant positive association between the dispersion in analysts' forecasts of annual EPS and the volume of trading. A relatively stable and positive association is found even after controlling for the volume effects of the magnitude of monthly revisions in the mean analysts' (annual) EPS forecast. The evidence corroborates the theoretical result that the degree of heterogeneity in beliefs is a determinant of the intensity of trading.]

[Evaluating the strength of audit evidence is a primary activity of auditors, but little is known of the factors that affect these evaluations. This article identifies and investigates two factors that affect auditors' evaluations of evidence strength. The first factor deals with underlying constructs of evidence, called strength dimensions in this study. Although the auditing literature suggests that evidence strength is determined by such underlying constructs (see, e.g., AAA ASOBAC 1973; AICPA 1980, 1988), prior research has focused on the surface characteristics of evidence. Hence, "source of evidence" has been studied (see, e.g., Joyce and Biddle 1981; Knechel and Messier 1990; Rebele et al. 1988) rather than the underlying strength dimension of "validity" (see AICPA 1980, AU 326). The present study focuses on the underlying dimensions to determine whether they provide a basis for understanding auditors' evaluations of evidence strength. The second factor concerns accounting firms' policies for auditing procedures. Firms' policies represent different methods of conducting efficient and effective audits (Cushing and Loebbecke 1986), and it is likely that these policies influence field auditors' judgments. Therefore, prior research on how accounting firms' degrees of structure affect auditors' judgments is extended to include the effects of specific policies. Auditors' evaluations of test-of-control strength were used to assess whether underlying dimensions of evidence strength and the specific policies of accounting firms affect auditors' judgments. Tests of controls (TCs) are auditing procedures that determine the effectiveness of an internal control; TC strength is the degree of assurance about a control's effectiveness provided by evidence generated by a TC. In this study, TC strength is defined and evaluated along the dimensions of validity, verifiability, and coverage. Auditors evaluated five TCs along the three strength dimensions to provide dimension-based rankings of TC strength. Other auditors participated in a laboratory experiment that involved control risk assessment. Correlations between the implied ranking of TC strength from the experiment and the dimension-based rankings are high, positive, and statistically significant, which suggests that auditors' judgments of evidence strength reflect the professional standards. Conversely, studies of audit adjustments have shown that evidence strength (measured as the ability to initially detect errors) does not strongly reflect the standards. The discrepant results suggest that characterizations of evidence strength may need to be studied further. To assess the effect of accounting firm policies on judgments, I develop predictions about the effects of policies that require reperformance and those that caution about the relative weakness of inquiry and observation. Because the predictions are largely confirmed by auditors' judgments in the laboratory experiment, accounting firms' policies are deemed to influence audit judgments. If generalizable, this finding suggests that results of research studies may be affected by the policies of accounting firms supplying subjects or data, to the extent that firms' policies differ. Researchers should therefore become familiar with firm-specific policies. For practitioners, this finding indicates that setting firm-wide policies may be effective in influencing field auditors' judgments.]

[Researchers generally agree that culture affects the behavior and attitudes of individuals within organizations (Hofstede 1980; Adler et al. 1986). Therefore, it may be assumed that an organizational system such as a participative budget-process will have different effects in different cultures. Recent research has indicated that a personality variable, internal-external locus of control, impacts the relationship between budgetary participation and both managers' performance and job satisfaction (Brownell 1981, 1982b). The locus of control construct categorizes individuals as (1) externals, those who believe that events are controlled by fate, luck, chance or powerful others, or (2) internals, those who believe that they have some control over events (Rotter 1966). This article examines whether cultural differences affect the previously identified interrelationship of individual locus of control and participation in the budgeting process as it impacts managerial performance and satisfaction. The prior research (Brownell 1982b) used middle-level managers in U.S. manufacturing organizations. In this study, Mexican managers were selected because Mexico provides an interesting cultural contrast to the U.S. on three dimensions identified by Hofstede (1980) which are considered relevant to participative budgeting issues. In contrast to the "Anglo" Cluster, the Latin Cluster of which Mexico is a unit differs on the dimensions of "uncertainty avoidance" and "power distance." An additional factor in the selection of Mexican managers was the magnitude of economic ties between Mexico and the U.S. The importance of this relationship continues to grow as more multinationals establish "maquilladoras" within the border region and as the Mexican government frees some of its constraints on foreign investment. The responses of 83 Mexican managers to survey instruments were analyzed using regression to test the interrelationship of locus of control and budgetary participation and their impact on managerial performance and job satisfaction. While the results of this study are generally consistent with previously reported findings for managerial performance, the impact of locus of control on managerial satisfaction was not significant, reflecting an ostensible difference in culture. In addition, the effect of locus of control on the performance of high-level managers was significantly stronger than its impact on the performance of lower-level managers. Finally, contrasting significantly to other Mexican managers, the performance of those Mexican managers employed in 100 percent foreign-owned firms was not discernibly affected by either budgetary participation or locus of control. This last result may be due to the cognitive dissimilarities relating to the cultural interface in these foreign-owned firms. This suggests that, within the Mexican culture, different conclusions are obtained depending on whether the firm is controlled by local or foreign interests.]

[Accounting histories have dated the advent of sophisticated cost management from the mid-1880s (Solomons 1952). The scientific management movement is credited with instituting and popularizing cost management techniques. However, it might be suspected that British entrepreneurs of the Industrial Revolution would have developed sophisticated costing techniques earlier, given their significant methodological advances in other economic areas. This article reports the findings from surviving business records of 25 sizeable British industrial firms (mostly in the iron and textile industries) from 1760 to 1850. Substantial evidence of a relatively mature cost management has been found in four major areas of activity: cost control techniques, accounting for overhead, costing for routine and special decision making, and standard costing. Speculations about the motivations for cost management and about specific factors influencing the iron and textile industries are considered. Because the accounting practices of these firms predated the genesis of "the costing renaissance" a century later, our understanding of cost management practices in the Industrial Revolution is augmented by the survey.]

[Research on analysts' earnings forecasts has produced two major results. First, security analysts provide more accurate forecasts than do time-series models (Brown et al. 1987) and, second, analysts' forecasts become more accurate and less dispersed as the forecast horizon decreases (Brown et al. 1985). This study examines the effect of an annual earnings announcement on the dispersion of analysts' one-year-ahead forecasts. It seems logical that forecasts should be less dispersed after the release of a value-relevant publicly observable signal. However, we find the opposite; i.e., that forecasts become more dispersed than would be expected in the absence of an earnings announcement. Security analysts' forecasts have often served as a proxy for the unobservable market expectation of earnings. Similarly, the dispersion of analysts' forecasts may proxy for the diversity of investor beliefs about future earnings. A number of studies have suggested that diversity of beliefs is important in security pricing as well as being a determinant of trading volume. Insight into the effects of earnings announcements on the heterogeneity of investors' beliefs will improve our understanding of how information gets impounded into prices and how information alters investors' portfolio decisions. The Bayesian belief revision model developed in this study suggests that the surprise content of the signal and the diversity of the perceived precision of the signal are important factors in determining whether the information event will cause a convergence or divergence of forecasts. Holthausen and Verrecchia (1990) reach similar conclusions when they examine the effect of information on consensus. In their model, a decrease in consensus (increase in diversity of beliefs) is possible if there is disagreement about the effect of the signal on the value of the firm. Bamber (1987) argues that the surprise content of the announcement and disagreement about the interpretation of the signal are related; i.e., "more surprising or informative announcements are likely to spawn a wide variety of interpretations...." Empirical results are consistent with the insights provided by our model. There is a greater divergence of forecasts when the earnings announcement contains a bigger surprise, where surprise is defined as the difference between reported earnings and analysts' predictions of those earnings. An alternative explanation for the empirical results is nonsynchronous updating of forecasts by analysts. By partitioning the sample on the length of time between the announcement date and the next IBES report, we are better able to identify which IBES report (the first or second after the announcement) contains updated forecasts. This partitioning provides a more accurate measure of changes in the dispersion of forecasts due to an earnings announcement.]

[This research examines and interprets the security market response around annual report release dates. Annual reports contain data beyond that reported in preliminary earnings announcements. While prior research has concentrated on the price response to annual report releases and the issue of information content with mixed results, this paper extends earlier work by employing both price and trading measures. The trading measures, which include number of transactions, size-stratified transactions, and mean transaction size, enable the analysis to address not only information content issues, but also social welfare issues in the sense of Lev and Ohlson (1982) and to coarsely identify what type of investor responds to the annual report by trading. Inferences as to the relative usefulness of annual reports to different investor groups are also made based on these trading measures. A number of studies address, often indirectly, annual report informativeness by examining the price response accompanying the report's release. Of these, studies by Wilson (1987) and Lobo and Song (1989) suggest a price response to the earlier of the annual report or 10-K. However, other studies, including Foster et al. (1986), Mynatt (1988), and Bernard and Stober (1989), fail to detect such a price response. The informativeness of annual reports from a price-based perspective remains an open question and from a trading-based perspective it is an unaddressed question. In this study, price response to the annual report is measured using both absolute value and squared unexpected returns. A market model approach is used to estimate unexpected returns. A simulation analysis is included to substantiate the ability of these two metrics to detect a price response. Unexpected volume and unexpected number of transactions, both in general and for size-stratified trading, are estimated via market model regressions. Unexpected mean transaction sizes are estimated from a temporal drift regression. No evidence of a price response and little evidence of a volume of shares response at annual report dates is found. Number of transactions, however, increases significantly around annual reports, peaking four to five trading days after the annual report release date. This trading response suggests that investors find annual reports informative. The simultaneous absence of an economically significant price response is interpreted as indicating that annual reports provide social welfare value in the sense proposed by Lev and Ohlson (1982). Most notably, the analysis of trading response stratified by transaction size suggests that the trading response occurs mostly within the smallest size strata (i.e., 100 and 200 share transactions, transactions of less than $30,000 in value). Consistent with this, mean transaction sizes during the annual report period are less than expected. This is contrary to mean transaction size behavior at earnings announcement dates (Cready 1988) and suggests that annual reports are of greater value to less wealthy individual investors relative to wealtheir individual and institutional investors. Such a finding is consistent with Hakansson (1977) in that it suggests that "small" investors rely on the public information system (i.e., the annual report) while "large" investors rely more on predisclosure information in making investment decisions.]

[Many accounting studies examine dichotomous choices (e.g., qualify/do not qualify an audit opinion or capitalize/do not capitalize a cost). These studies often involve small overall sample sizes, disparate response group sizes, and predictor variables that are skewed and collinear. These factors can cause distributional problems in test statistics for logit (or probit) regression models, which can lead to incorrect inferences. However, few empirical benchmarks exist for assessing the effect of these factors. The current paper determines how response group size and the number, distribution, and correlation of predictor variables affect empirical error rates and the minimum required sample size for using logit. Comparisons are made with the error rates obtained from an ordinary least squares (OLS) linear probability model, an alternative that has been suggested for small sample studies. Because accounting researchers choosing between logit and OLS may be concerned with more than the calibration of the models' test statistics, comparisons of the sensitivity of logit and OLS parameter estimates to the range of data sampled for the predictor variables and of the models' classificatory ability also are made. Both simulated and real accounting data are used. The results of Monte Carlo simulations show that logit test statistics are biased when the sample size is small. However, much of the bias is attributable to the skewness of the predictor variables, a problem that is characteristic of accounting research and that also affects OLS test statistics. In such settings, OLS may result in test statistics that are minimally better calibrated. The parameter estimates of the model, however, will be more sensitive to the sampling frame. Furthermore, experimentation with data on auditors' Statement No. 87 consistency judgments indicates that OLS also may result in higher Type I error rates when it is used for prediction or classification. These results are interpreted as indicating that, even for sample sizes as small as 50, logit rather than OLS still may be the preferable model for accounting choice studies.]

[Analyses of audit judgment have suggested or implied that frequency knowledge (i.e., knowledge of the base rates associated with error occurrences) acquired through experience is an important component of audit expertise. For example, auditors are assumed to use base-rate expectations about error occurrence (modified to reflect client-specific information) to allocate audit effort among financial statement accounts and to use likelihoods associated with alternative causes of errors that are identified by analytical review. This article reports two studies that examine both error-effect frequency knowledge, i.e., the frequency with which an individual financial statement account is affected by error, and error-cause frequency knowledge, i.e., the underlying reason for an error in a particular account. In the first study, auditors' knowledge of the frequencies with which errors affect financial statement accounts in five industries is compared with archival frequencies. In the second study, auditors' knowledge of both the causes and effects of errors in the manufacturing industry is compared with the archival frequencies of both error causes and their effects on financial statement accounts. The second study provides a within-auditor comparison of both types of error frequency knowledge and allows comparison with the empirical results on error causes (in manufacturing) reported in Libby (1985) and Libby and Frederick (1990). In both studies, the relation between error frequency knowlege and several measures of experience is examined. This article provides evidence on three research questions: (1) How many audits (in a particular industry) does an auditor experience? The answer to this question will help establish whether auditors learn error frequencies from direct, personal experience with financial statement errors or acquire their knowledge of error frequencies by other means. (2) What do auditors know about the relative frequencies actually associated with the population of financial statement errors discovered during the audit process? If error frequency knowledge is essential to audit expertise, then it is useful to understand the nature of that knowledge. Further, if expertise is to be measured, a valid empirical measure of knowledge must be developed. (3) Do more experienced auditors have more accurate error frequency knowledge than less experienced auditors? Discernible knowledge differences across experience levels would suggest that error frequency knowledge is gained through audit experience, consistent with the general psychological characterization of expertise. The results show, first, that even the most experienced auditors have limited direct experience with financial statement errors. Second, auditors seem to know only the most frequently occurring error effects and causes. Third, differences in auditors' knowledge of error effects across experience levels are not explained by differences in the length of either audit experience or industry-specific audit experience, or by the number of clients audited in an industry. Moreover, auditors with similar experience levels show large individual differences in knowledge of causes and effects. These results suggest that audit experience should be viewed as relating to specific audit tasks rather than as a singular, all-encompassing concept and that particular experience must be understood as it relates to a particular type of knowledge. Moreover, the results and the fact that financial statement errors are rare events raise questions about the value of normative and descriptive models that have been proposed as the basis for understanding audit judgment and expertise-models that assume knowledge of error frequencies.]

[The information furnished by management accounting systems aids top management in assessing the performance of lower levels and in setting proper incentives. These systems also provide information to lower levels which aids them in making operational decisions. Typically, detailed information is provided to lower levels in the organization, while only a summary of this information is furnished to top management. Therefore, in designing a management accounting system, a question arises as to the welfare effect of giving an employee access to detailed information, on which he can base his decisions, when such (detailed) information cannot be used in evaluating his performance. More generally, the question arises as to the welfare effects of increasing the informational asymmetry between upper and lower management by improving lower management's private pre-decision information system. Answering the above question can provide important insights into the proper design of firms' management accounting systems. We examine this issue using the principal-agent framework. In any given period, information reported in the managerial accounting system may be pre-decision or post-decision. When the system reports post-decision information and the contracts are complete, it is clear that the value of such information is non-negative. The value of pre-decision information is more difficult to assess. An agent who has access to better pre-decision information is able to use that information to make better decisions, given his objectives. However, the agent's objectives and the principal's objectives need not be the same. For example, the agent may use his better pre-decision information system to more successfully shirk on the job, making the principal strictly worse off. Thus, the principal is not necessarily better off by improving the agent's pre-decision information system. One way in which the principal can mitigate any negative effects of improving the agent's private pre-decision information system is to require the agent to communicate the private information. In this paper, we ignore the possibility of such communication. The reason for this is, as noted earlier, while large amounts of detailed information are provided to individuals at lower levels of the firm, only a small amount of that information is ever communicated to higher levels of the firm. Therefore, we view ignoring communication as an approximation. We examine a principal-agent model in which the principal can influence the extent to which the agent has superior private information on which the latter can base his action choice. We find sufficient conditions under which a strict Pareto improvement results from improving the agent's private pre-decision information system. This result arises because improving the agent's private pre-decision information system leads to improved coordination between the agent's information signal and action choice, which, in turn, results in an increase in the agent's average productivity. Although we do not find sufficient conditions under which a strict negative value might arise, we discuss some possible reasons and illustrate them with examples.]