Municipal bond rating changes can have significant consequences for both borrowers and investors. Multivariate discriminant analysis (MDA) was used to examine whether financial ratios could discriminate between cities that had their ratings upgraded or downgraded from an A rating. In addition, both the upgraded and the downgraded groups of cities were matched, using a paired sample design with a control group to examine the predictive ability of fiscal information. Fiscal variables do appear to be associated with rating revisions, in addition, it appears that rating revisions are more closely associated with operating working capital flow than the "total flow of resources" statement generated by current generally accepted accounting principles (GAAP).

Reviews the book "Financial Reporting for Non-Profit Organizations: A Research Study."

[Government auditing standards place strong emphasis on strengthening internal controls and ensuring compliance with laws and regulations.1 A high quality audit can provide assurance to the municipal bond market that the local government's internal controls and legal compliance are adequate to minimize opportunities for waste and fraud and to assure the continued inflow of federal financial assistance. Simunic and Stein (1987) suggest that in the capital markets, auditor reputation is made credible by the potential loss of quasi-rents on fixed investments from the failure to deliver the implied audit quality and the subsequent revelation of such failure. Although auditor moral hazard has received some attention in the academic literature, it is perceived to be particularly acute in the government environment. In this environment, the chances of client financial failure and consequent ex post revelation of lower-than-implied audit quality are minimal. Thus, there is a need for alternative mechanisms for enhancing the credibility of the audit. Both the General Accounting Office (GAO 1987) and the American Institute of Certified Public Accountants (AICPA 1987) view appropriate audit procurement practices as a mechanism for ensuring that the contracted audit quality is in fact delivered. To the extent that management quality is multidimensional, appropriate audit procurement could be viewed as one dimension of the overall quality of administration, or perhaps as part of a larger managerial control dimension. Nonetheless, the GAO and the AICPA suggest that appropriate procurement practices can independently contribute to the selection of a competent auditor in a market in which it is difficult to directly assess whether an auditor possesses the specialized knowledge necessary to provide a high quality government audit. The bond market remains the primary source of (financial) market discipline at the municipal level. In this market, default risk is priced using yield-to-maturity which is a continuous variable. Thus, cities do not have to actually fail for bondholders to suffer capital losses. While information about audit quality may be conveyed by other means (e.g., by size of audit firm), the procurement practices recommended by the GAO (1987) offer the opportunity for additional discrimination in the municipal bond market. Prior research suggests that two discrete levels of implied audit quality (Big Eight/non-Big Eight) are available in the market for audit services.2 However, given the greater risk of auditor moral hazard in the government environment, the traditional Big Eight/non-Big Eight dichotomy is not considered sufficient for differentiating the quality of government audits. The highly specialized knowledge and skills required for government audits results in wide variation in auditor qualifications from firm to firm, and even from office to office within a Big Eight firm. Moreover, the risk of obtaining a low quality audit is relatively high because such audits traditionally have not been easily detected, and only recently have auditors faced significant business risk from providing low quality government audits. Both the GAO and the AICPA have stressed the role of appropriate procurement practices (client monitoring) in mitigating the widespread problem of substandard government audits by CPAs. The purpose of this paper is to evaluate the hypothesis that client monitoring is priced in the seasoned municipal bond market above and beyond other independent measures of local administration quality and the Big Eight/non-Big Eight dichotomy. Our empirical results are generally consistent with the hypothesis, even though the results for a subsample of cities with a Big Eight auditor are also consistent with the auditor competition hypothesis tested by O'Keefe and Westort (1992) and Copley and Doucet (1993).]

Discusses governmental audit procurement practices and seasoned bond prices. Role of credible auditor reputation on capital markets; Insight into multidimensional quality management; Bond markets as sources of market discipline; Levels of implied audit quality; Factors affecting the variation of auditor qualifications.

In this study, we investigate whether investor perceptions of the financial reporting credibility of Big 5 audits are related to the auditor's economic dependence on the client as measured by nonaudit as well as total (audit and nonaudit) fees paid to the incumbent auditor. We use the client‐specific ex ante cost of equity capital as a proxy for investor perceptions of financial reporting credibility and examine auditor fees both as a proportion of the revenues of the audit firm and as a proportion of the revenues of the audit firm's practice office through which the audit was conducted. Our findings suggest that both nonaudit and total fees are perceived negatively by investors' that is, the higher the fees paid to the auditor, the greater the implied threat to auditor independence, and the lower the financial reporting credibility of a Big 5 audit. Furthermore, our findings appear to be largely unrelated to corporate governance: investors do not perceive the auditor as compensating for weak governance. Separately, recent anecdotal evidence suggests that declining revenues from nonaudit services' as a result of recent regulatory restrictions” are being offset by substantial increases in audit fees. Other things being equal, rising audit fees imply higher profit margins for audit services, indicating that the audit function may no longer be a loss leader. Thus, to the extent that investors perceive total fees negatively, recent regulatory initiatives to limit nonaudit fees may not have adequately addressed the perceived, if not the actual, threat to auditor independence posed by fees.

To date, the discussion of the Lev and Thiagarajan 1993 fundamentals in the prior literature has been exclusively in the context of the stock market. Our study is the first to examine the value‐relevance of these fundamentals for default risk. By focusing on the market for new bond issues, we examine the value‐relevance of the fundamental score using expected rather than realized returns. Also, by focusing on the bond market we provide a different perspective than that brought by prior studies relying solely on stock prices. We find the fundamentals to be priced in the market for new bond issues as indicators of expected future earnings and to be value‐relevant in enabling the market to discern differences in bond credit quality over and above the published bond ratings.

Available evidence suggests that state and local government pension plans may be substantially underfunded. The capitalization of these unfunded obligations in borrowing costs is an important public policy issue, since noncapitalization may lead to the misallocation of credit and stimulate the provision of an inefficiently high level of current services. Prior research has relied largely on pension ratios as surrogates for unfunded liabilities and also appears to have made no attempt to distinguish between projected benefits and accumulated benefits. The Governmental Accounting Standards Board requires the disclosure of projected benefits and asserts that accumulated benefits severely understate the obligations of a governmental unit. The empirical evidence reported in this study suggests that, for state governments, unfunded projected liabilities provide no incremental information to the bond market over and above that already provided by unfunded accumulated liabilities. Résumé. Les données existantes laissent supposer que la capitalisation des régimes publics de pensions à l'échelle de l'État et à l'échelle locale pourrait être largement insuffisante. Le financement des obligations non capitalisées à même les coûts d'emprunt est une question de politique importante, puisque la non‐capitalisation risque d'entraîner une mauvaise répartition des crédits et la fourniture d'un niveau de services actuel trop élevé. Dans les travaux de recherche précédents, l'on s'est appuyé en grande partie sur les ratios de retraite comme substituts dans le cas des dettes non capitalisées et l'on semble également n'avoir d'aucune façon tenté d'établir une distinction entre les prestations projetées et les prestations constituées. Le Governmental Accounting Standards Board exige la présentation des prestations prévues et affirme que le chiffre des prestations constituées sous‐évalue de beaucoup les obligations gouvernementales. Les résultats concrets de la présente étude donnent à penser que pour les États, la communication des dettes prévues non capitalisées ne fournit au marché obligataire aucune information supplémentaire à la communication des dettes constituées non capitalisées.

Barry R. Marks, Krishnamurthy K. Raman, The Importance of Pension Data for Municipal and State Creditor Decisions: Replication and Extensions, Journal of Accounting Research, Vol. 23, No. 2 (Autumn, 1985), pp. 878-886

Considerable evidence exists that governmental accounting numbers are related empirically to bond risk and return measures. However, prior research does not preclude the possibility that accounting numbers merely reflect unobserved factors such as economic and political attributes impounded in bond measures. This study considers whether governmental annual financial reports convey new information directly to the bond market. Changes in bond prices during the period around the release date of governmental annual reports were examined to assess market responses to the reports. No significant evidence was obtained to suggest that municipal bond investors use the information in the annual report at the time of its release to adjust bond prices. In contrast, new bond issues and bond rating announcements were associated with significant market reactions. Thus, these results indicate that, while issuer-specific accounting information may be used by bond investors in conjunction with decisions involving new issues and rating evaluations, investors do not appear to impound the information directly into secondary market prices at the time the information is released.

[Considerable evidence exists that governmental accounting numbers are related empirically to bond risk and return measures. However, prior research does not preclude the possibility that accounting numbers merely reflect unobserved factors such as economic and political attributes impounded in bond measures. This study considers whether governmental annual financial reports convey new information directly to the bond market. Changes in bond prices during the period around the release date of governmental annual reports were examined to assess market responses to the reports. No significant evidence was obtained to suggest that municipal bond investors use the information in the annual report at the time of its release to adjust bond prices. In contrast, new bond issues and bond rating announcements were associated with significant market reactions. Thus, these results indicate that, while issuer-specific accounting information may be used by bond investors in conjunction with decisions involving new issues and rating evaluations, investors do not appear to impound the information directly into secondary market prices at the time the information is released.]