Research in Accounting Regulation, Vol. 16 (Research in Accounting Regulation) (Research in Accounting Regulation)

RESEARCH IN ACCOUNTING REGULATION RESEARCH IN ACCOUNTING REGULATION Series Editor: Gary J. Previts Recent volumes: Vo...

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RESEARCH IN ACCOUNTING REGULATION

RESEARCH IN ACCOUNTING REGULATION Series Editor: Gary J. Previts Recent volumes: Volumes 1–15: Research in Accounting Regulation Supplement 1: 10th Anniversary Special

RESEARCH IN ACCOUNTING REGULATION VOLUME 16

RESEARCH IN ACCOUNTING REGULATION EDITED BY GARY J. PREVITS Case Western Reserve University, Cleveland, USA

ASSOCIATE EDITOR THOMAS R. ROBINSON University of Miami, Coral Gables, USA

ASSISTANT EDITOR NANDINI CHANDAR Rutgers Business School, Newark and New Brunswick

BOOK REVIEW EDITOR LARRY M. PARKER Case Western Reserve University, Cleveland, USA

2003

JAI An imprint of Elsevier Science Amsterdam – Boston – London – New York – Oxford – Paris San Diego – San Francisco – Singapore – Sydney – Tokyo

ELSEVIER SCIENCE Ltd The Boulevard, Langford Lane Kidlington, Oxford OX5 1GB, UK © 2003 Elsevier Science Ltd. All rights reserved. This work is protected under copyright by Elsevier Science, and the following terms and conditions apply to its use: Photocopying Single photocopies of single chapters may be made for personal use as allowed by national copyright laws. Permission of the Publisher and payment of a fee is required for all other photocopying, including multiple or systematic copying, copying for advertising or promotional purposes, resale, and all forms of document delivery. Special rates are available for educational institutions that wish to make photocopies for non-proﬁt educational classroom use. Permissions may be sought directly from Elsevier Science Global Rights Department, PO Box 800, Oxford OX5 1DX, UK; phone: (+44) 1865 843830, fax: (+44) 1865 853333, e-mail: [email protected]. You may also contact Global Rights directly through Elsevier’s home page (http://www.elsevier.com), by selecting ‘Obtaining Permissions’. In the USA, users may clear permissions and make payments through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; phone: (+1) (978) 7508400, fax: (+1) (978) 7504744, and in the UK through the Copyright Licensing Agency Rapid Clearance Service (CLARCS), 90 Tottenham Court Road, London W1P 0LP, UK; phone: (+44) 207 631 5555; fax: (+44) 207 631 5500. Other countries may have a local reprographic rights agency for payments. Derivative Works Tables of contents may be reproduced for internal circulation, but permission of Elsevier Science is required for external resale or distribution of such material. Permission of the Publisher is required for all other derivative works, including compilations and translations. Electronic Storage or Usage Permission of the Publisher is required to store or use electronically any material contained in this work, including any chapter or part of a chapter. Except as outlined above, no part of this work may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the Publisher. Address permissions requests to: Elsevier Science Global Rights Department, at the mail, fax and e-mail addresses noted above. Notice No responsibility is assumed by the Publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent veriﬁcation of diagnoses and drug dosages should be made. First edition 2003 Library of Congress Cataloging in Publication Data A catalogue record from the British Library has been applied for. ISBN: 0-7623-1022-7 ISSN: 1052-0457 (Series) ∞ The paper used in this publication meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper). Printed in The Netherlands.

CONTENTS EDITORIAL BOARD

ix

LIST OF CONTRIBUTORS

xi

INVITED REFEREES

xv PART I: MAIN PAPERS

THE MARKET PERCEPTION OF CORPORATE CLAIMS Qiang Cheng, Peter Frischmann and Terry Warﬁeld

3

AN ANALYSIS OF THE ACCOUNTING PROFESSION’S OLIGARCHY: THE AUDITING STANDARDS BOARD John E. McEnroe and Marshall K. Pitman

29

THE ORIGINS OF THE SEC’S POSITION ON AUDITOR INDEPENDENCE AND MANAGEMENT RESPONSIBILITY FOR FINANCIAL REPORTS Nathan Felker

45

AUDITOR LIABILITY: A REVIEW OF RECENT CASES INVOLVING GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AND GENERALLY ACCEPTED AUDITING STANDARDS Scot P. Gormley, Thomas M. Porcano and Wayne Staton

61

PROFESSIONAL REGULATION AND LABOR MARKET OUTCOMES FOR ACCOUNTANTS: EVIDENCE FROM THE CURRENT POPULATION SURVEY, 1984–2000 James Schaefer and Michael Zimmer

87

v

vi

THE ECONOMIC THEORY OF REGULATION AND SUNSET REVIEWS OF PUBLIC ACCOUNTANCY LAWS: THE ROLE OF POLITICAL IDEOLOGY Gary Colbert and Dennis Murray

105

THE IMPACT OF STATEMENT OF FINANCIAL ACCOUNTING STANDARD NUMBER 123 ON EQUITY PRICES OF COMPUTER SOFTWARE COMPANIES Mark Myring, Rebecca Toppe Shortridge and Robert Bloom

121

GAAP: A REGULATORY TOOL TO MANAGE HEALTHCARE Mark Holtzman and Olga Averin

145

PART II: RESEARCH REPORTS IMPROVING AUDITOR INDEPENDENCE – THE PRINCIPLES VS. STANDARDS DEBATE: SOME EVIDENCE ABOUT THE EFFECTS OF TYPE AND PROVIDER OF NON-AUDIT SERVICES ON PROFESSIONAL INVESTOR’S JUDGMENTS Elaine G. Mauldin

159

THE ASSOCIATION BETWEEN AUDITOR INDUSTRY SPECIALIZATION AND EARNINGS MANAGEMENT Uma Velury

171

CONCURRING PARTNER REVIEW: DOES INVOLVEMENT IN AUDIT PLANNING AFFECT OBJECTIVITY? Arnold Schneider, Bryan K. Church and Robert J. Ramsay

185

LOCAL GOVERNMENT AUDIT PROCUREMENT REQUIREMENTS, AUDIT EFFORT, AND AUDIT FEES Laurence E. Johnson, Robert J. Freeman and Stephen P. Davies

197

AN EXPERIMENTAL EXAMINATION OF THE PEER REVIEW PROCESS Jeff L. Payne

209

vii

DEREGULATION OF THE PRIVATE CORPORATION AUDIT IN CANADA: JUSTIFICATION, LOBBYING AND OUTCOMES Morina Rennie, David Senkow, Richard Rennie and Jonathan Wong

227

SFAS 95 CASH FLOW INFORMATION AND SECURITIES VALUATION Sulaiman A. Alaraini, Joanne P. Healy and Ray G. Stephens

243

PART III: PERSPECTIVES A LONG FALL FROM GRACE David Mosso

259

REMARKS OF DONALD J. KIRK: INDEPENDENCE, AUDIT EFFECTIVENESS AND FRAUDULENT FINANCIAL REPORTING Donald J. Kirk

265

THE “INFORMATION RIGHT” AND THE CPA PROFESSION Gary J. Previts

275

PART IV: BOOK REVIEWS PRO FORMA BEFORE AND AFTER THE SEC’S WARNING: A QUANTIFICATION OF REPORTING VARIANCES FROM GAAP By Wanda Wallace Reviewed by Julia Grant

281

THE VALUEREPORTINGTM REVOLUTION: MOVING BEYOND THE EARNINGS GAME By Robert G. Eccles, Robert H. Herz, E. Mary Keegan, and David M. H. Phillips Reviewed by Kevin Carduff

285

viii

CREATING SHAREHOLDER VALUE By Alfred Rappaport Reviewed by Garen Markarian

289

EXPECTATIONS INVESTING By Alfred Rappaport and Michael J. Mauboussin Reviewed by Evelyn A. McDowell

293

UNDERSTANDING AUDITOR-CLIENT RELATIONSHIPS: A MULTI-FACETED ANALYSIS By Gary Kleinman and Dan Palmon Reviewed by Reed A. Roig

297

EDITOR Gary John Previts Weatherhead School of Management Department of Accountancy Case Western Reserve University

Assistant Editor Nandini Chandar Rutgers University

Associate Editor Thomas R. Robinson University of Miami, Florida

Book Review Editor Larry M. Parker Case Western Reserve University

EDITORIAL BOARD Andrew Bailey University of Illinois – Urbana-Champaign

William Holder University of Southern California

Dennis R. Beresford University of Georgia

Daniel Jensen The Ohio State University

Peter Bible General Motors Corporation

David L. Lansittel, CPA Winnetka, Illinois

Jacob Birnberg University of Pittsburgh

Donald L. Neebes Ernst & Young, LLP

Michael P. Bohan Consultant, Cleveland, Ohio

Hiroshi F. Okano Osaka City University, Japan

Paul Brown New York University

Paul A. Pacter Deloitte Touche Tohmatsu, Hong Kong

Graeme W. Dean University of Sydney, Australia

James M. Patton Federal Accounting Standards Advisory Board

J. R. Edwards Cardiff University

William J. L. Swirsky Canadian Institute of Chartered Accountants

Timothy Fogarty Case Western Reserve University ix

x

Sir David P. Tweedie International Accounting Standards Board Wanda Wallace College of William and Mary

Yuksel Koc Yalkin University of Ankara Head, Commission of Accounting Standards, Turkey

LIST OF CONTRIBUTORS Sulariman A. Alaraini

King Saud University, Saudi Arabia

Olga Averin

Frank G. Zarb School of Business, Hofstra University, USA

Robert Bloom

Department of Accountancy, John Carroll University, USA

Kevin Carduff

Department of Accountancy, Case Western Reserve University, USA

Qiang Cheng

School of Business, University of Washington, USA

Bryan K. Church

DuPree College of Management, Georgia Institute of Technology, USA

Gary Colbert

University of Colorado at Denver, USA

Stephen P. Davies

College of Natural Sciences, Colorado State University, USA

Nathan Felker

School of Law, Case Western Reserve University, USA

Robert J. Freeman

College of Business Administration, Texas Tech University, USA

Peter Frischmann

College of Business, Idaho State University, USA

Scot P. Gormley

Department of Accountancy, Miami University, USA

Julia Grant

Department of Accountancy, Case Western Reserve University, USA

xi

xii

Joanne P. Healy

Department of Accounting, Kent State University, USA

Mark Holtzman

Frank G. Zarb School of Business, Hofstra University, USA

Laurence E. Johnson

College of Business, Colorado State University, USA

Donald J. Kirk

Former Vice-Chairman, Public Oversight Board, New York, USA

Garen Markarian

Department of Accountancy, Case Western Reserve University, USA

Elaine G. Mauldin

College of Business, University of Missouri-Columbia, USA

Evelyn A. McDowell

Department of Accountancy, Case Western Reserve University, USA

John E. McEnroe

School of Accountancy and Management, Information Systems, DePaul University, USA

David Mosso

Federal Accounting Standards Board, Washington, DC, USA

Dennis Murray

University of Colorado at Denver, USA

Mark Myring

Department of Accounting, Ball State University, USA

Jeff L. Payne

School of Accounting, University of Oklahoma, USA

Marshall K. Pitman

Department of Accounting, The University of Texas at San Antonio, USA

Thomas M. Porcano

Department of Accountancy, Miami University, USA

xiii

Gary J. Previts

Department of Accountancy, Case Western Reserve University, USA

Robert J. Ramsay

Carol Martin Gatton College of Business & Economics, University of Kentucky, USA

Morina Rennie

Faculty of Administration, University of Regina, USA

Richard Rennie

Faculty of Administration, University of Regina, USA

Reed Roig

Department of Accountancy, Case Western Reserve University, USA

James Schaefer

School of Business Administration, University of Evansville, USA

Arnold Schneider

DuPree College of Management, Georgia Institute of Technology, USA

David Senkow

Faculty of Administration, University of Regina, USA

Rebecca Toppe Shortridge

Department of Accounting, Ball State University, USA

Wayne Staton

Department of Finance, Miami University, USA

Ray G. Stephens

Department of Accounting, Kent State University, USA

Uma Velury

Department of Accounting & Management Information Systems, University of Delaware, USA

Terry Warﬁeld

Graduate School of Business, University of Wisconsin, USA

Jonathan Wong

Vancouver, Canada

Michael Zimmer

School of Business Administration, University of Evansville, USA

This Page Intentionally Left Blank

INVITED REFEREES Aaron Ames Ernst & Young, LLP, Canada

Jimmy W. Martin University of Montevallo

Kristen L. Anderson Georgetown University

Yoshinao Matsumoto Kansai University

Lee Blazey Case Western Reserve University

Dwight W. Owsen Louisiana State University

Salvador Carmona Juan Carlos III University, Madrid

David Pearson Case Western Reserve University

Anthony Catanach Villanova University

Vaughan Radcliffe Case Western Reserve University

Edward Coffman Virginia Commonwealth University

Alan Richardson Queens University

John Cumming Miami University – Ohio

Arnold Schneider Georgia Institute of Technology

A. Rick Elam University of Mississippi

Joseph Schultz Arizona State University

Asim Erdilek Case Western Reserve University

Mark Segal University of South Alabama

Ross Fuerman Northeast University

Ray Stephens Ohio University

Jula E. S. Grant Case Western Reserve University

Paul Walker University of Virginia

Joseph Legoria Mississippi State University

Mark Wilder University of Mississippi

Garan Markarian Case Western Reserve University

Steve Young Salomon Smith Barney xv

This Page Intentionally Left Blank

PART I: MAIN PAPERS

This Page Intentionally Left Blank

THE MARKET PERCEPTION OF CORPORATE CLAIMS Qiang Cheng, Peter Frischmann and Terry Warﬁeld ABSTRACT This paper examines the economic substance of a broad range of securities by investigating their association with systematic risk and prices. The analysis is motivated by continuing security innovation and its impact on hybrid security reporting. Based on a sample of 2,617 ﬁrms that reported minority interests or preferred stock during 1993–1997, the results indicate that redeemable preferred securities (including trust preferred stock) are not viewed by the market as either debt or equity, suggesting dichotomous security classiﬁcation may lack representational faithfulness. Inconsistent with their treatment in the ﬁnancial statements, non-redeemable preferred stock and minority interests are viewed as debt-like and equity-like respectively. Additional analyses document that the systematic risk and pricing results vary based on ﬁrm size, performance, and bond rating.

1. INTRODUCTION In this paper, we examine the economic substance of a broad range of securities issued by corporations. Using complementary approaches, we study the market pricing of claims represented by debt, minority interests, redeemable preferred stock, and non-redeemable preferred stock.

Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 3–28 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160012

3

4

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

Prior research has provided evidence concerning the economic substance of some hybrid securities. Kimmel and Warﬁeld (1995, hereafter KW) examine the association between systematic risk measures and redeemable preferred stock (RPFD) and document that, despite mandatory redemption payments, RPFD does not have a debt-like impact on systematic risk. KW also provide evidence that the market perception of a hybrid security is conditioned on security attributes. Findings from KW indicate that the market’s perception of RPFD is not consistently similar to either debt or equity, thus questioning the dichotomous classiﬁcation of hybrid securities as either debt or equity. This paper extends the analysis in KW to examine the economic substance of a broader range of securities, including those reported as minority interests, those in the mezzanine between debt and equity (such as redeemable preferred stock and trust preferred stock), and those reported in equity as preferred stock. This analysis is motivated by continuing deliberation of hybrid security reporting by standard setting boards such as the IASB and the FASB, as well as accelerated innovation in new securities, which may be contributing to a growing mezzanine section in corporate balance sheets (Frischmann et al., 1999). Furthermore, there is little or no research that examines some of the more recent innovative securities or other ownership claims, such as minority interests and non-redeemable preferred stock, which also exhibit hybrid features.1 We examine two indicators of the economic substance of securities – their association with the issuing ﬁrm’s systematic risk and with equity price. The tests are conducted on a sample of 2,617 ﬁrms that reported minority interests or preferred stock during 1993–1997. We examine variation in systematic risk and price relationships, controlling for the amount of these alternative securities in the subject ﬁrms’ capital structures. If investors believe that certain features of these securities make them similar to debt, then the observed relation between the securities and systematic risk (prices) should be similar to that between debt and systematic risk (prices). Consistent with prior research, our results indicate that redeemable preferred securities (including the recent innovation in the form of trust preferred stock) are viewed by the market as neither debt nor equity. Thus, the current mezzanine reporting treatment of these securities appears to coincide with their market treatment. In contrast, the associations exhibited by both non-redeemable preferred stock and minority interests are more consistent with these claims being viewed as debt-like and equity-like respectively, which is inconsistent with their treatment in the ﬁnancial statements. These results, apparently driven by large ﬁrms (which are on average ﬁnancially stronger than small ﬁrms), further document the context-speciﬁcity of ﬁnancial instruments.

The Market Perception of Corporate Claims

5

These results have implications for assessing the usefulness of classiﬁcation as a means of reporting hybrid securities. The ﬁndings in this study indicate that the market perception of these alternative claims depends on the context. That is, the economic substance of these securities, as reﬂected in associations with systematic risk and prices, varies depending on ﬁrm characteristics, such as size and the economic context in which the securities are issued, including ﬁnancial performance and debt rating. For example, all preferred stock is currently classiﬁed as equity. However, relative to small ﬁrms, large ﬁrms are generally ﬁnancially stronger, have higher debt ratings, and are more likely to issue preferred securities without characteristics such as convertibility. Hence, the preferred securities of large ﬁrms exhibit more debt-like characteristics. Since the usefulness of classiﬁcation is reduced if the items within a category are not similar in their economic substance, the grouping of large and small ﬁrm preferred stock into the same dichotomous classiﬁcation may result in ﬁnancial reports that lack representational faithfulness to the economic substance of these securities, as measured by their effects on systematic risk and ﬁrm value. More generally, the evidence presented here questions the merits of the current dichotomous classiﬁcation framework within ﬁnancial statements as a means of conveying useful information about hybrid securities. Our results suggest that if a dichotomous framework is retained, the equity classiﬁcation should be comprised of only common stock and minority interests, which are clearly more residual relative to other claims. Given the diversity of attributes that could be reﬂected in the securities classiﬁed as liabilities within this framework, disclosure may be more important for communicating the features relevant to the economic substance of these securities.

2. BACKGROUND AND MOTIVATION The usefulness of ﬁnancial reporting depends in part on the representational faithfulness of the reporting treatment to the economic substance of the underlying phenomenon (FASB, 1980, SFAC 2, para. 63). The FASB has been working on a project to develop representationally faithful classiﬁcations of securities issued by ﬁrms. Classiﬁcations of securities issued by companies within the issuer’s ﬁnancial statements exhibit this characteristic (are useful) when the distinctions between classiﬁcations are meaningful and when the securities summarized within a particular classiﬁcation have similar economic substance. However, determining the most useful classiﬁcation framework is difﬁcult because ﬁnancial statements are used by a diverse set of stakeholders. For

6

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

example, equity investors, as residual claimants, are interested in any information about corporate claims, regardless of classiﬁcation, if that information is useful in predicting future cash ﬂows to equity. Creditors, on the other hand, may rely on classiﬁcations to assess their relative claims on ﬁrm assets and to enforce contractual terms of debt agreements. Hybrid securities, such as redeemable preferred stock (RPFD), are non-divisible securities having both debt and equity characteristics and recent decisions by the FASB with respect to hybrid security reporting reﬂect adherence to the current dichotomous classiﬁcation model based on the (revised) deﬁnitions of debt and equity. Under this proposed approach, securities will be classiﬁed according to how obligations associated with the securities can be settled. Thus, if an obligation can be settled by issuing additional equity shares, then the security claim could be reported in equity. Otherwise, when the claim must be settled through distribution of assets or by issuing debt claims to assets, the security will be reported in debt (FASB, 2000). Some prior research has used the current conceptual framework deﬁnitions by focusing on mandatory redemption features to argue that certain hybrid securities (e.g. RPFD) be classiﬁed as debt within the current dichotomous model (Nair et al., 1990). However, the economic substance of these hybrid securities is arguably a function of features that are not easily accommodated in the current model. For example, legal features of preferred stock preclude payments to holders of such securities when the payments threaten the solvency of the ﬁrm.2 In this regard, the evidence in KW indicates that redeemable preferred stock is not perceived by the market as either debt or equity. Furthermore, continuing security innovation in preferred stock has led to a growing mezzanine section in corporate balance sheets, thereby drawing attention to accounting standards for hybrid security reporting. For example, trust preferred stock (TPS), which was introduced in 1993, derives its popularity from receiving debt treatment for tax purposes while receiving non-debt treatment for ﬁnancial reporting (Frischmann et al., 1999). Non-equity treatment for TPS arises from mandatory redemption features similar to RPFD, that is, TPS may not be reported in equity but does not have to be reported in debt either.3 However, TPS reporting currently varies across different issues (Frischmann et al., 1999). For TPS issued during 1993–1996, 13% are reported as debt in the balance sheet, 58% are reported in the mezzanine section, and only 3% are reported as equity (the balance being reported on unclassiﬁed balance sheets). As for income statement classiﬁcation, TPS “dividends” are expensed as interest by 36% of all ﬁrms; 36% are reported as minority interest; and 7% are reported as dividends (the balance are unidentiﬁed). Thus, the reporting method varies within

The Market Perception of Corporate Claims

7

and across industries. These heterogeneous reporting practices impose difﬁculties for investors valuing a ﬁrm and illustrate the importance of developing accounting and reporting standards for hybrid securities. In contrast to the accounting for redeemable preferred stock and TPS, the reporting practices for minority interest and other preferred stock are more widely accepted. Minority interest generally is reported in the liability section of the balance sheet, while non-redeemable preferred stock is reported in equity. However, minority interest has all the characteristics of equity from the point view of investors, from the dividend payment to rights in liquidation. On the other hand, non-redeemable preferred stock is reported in equity, although it is clearly different from common equity. In fact, Smith (1986) and Clark (1993) argue that in general, capital structure theory views preferred stock as a liability, considered to be a senior security just like a secured bond. Furthermore, it is conceivable that the economic substance of a security is context-speciﬁc. Because of industry membership, ﬁrm size, and risk, securities may be used as substitutes in one instance but not another. For example, Engel et al. (1999) document the replacement of debt with trust preferred securities and Frischmann and Warﬁeld (1999) note that this activity is concentrated in ﬁnancially strong ﬁrms. The conﬂicting implications of the features of various corporate claims suggest that a simple characterization of preferred stock or other hybrid securities as either debt or equity based on the conceptual framework deﬁnitions is unlikely to result in useful classiﬁcation. If these conﬂicting debt and equity features are relevant to the economic substance and useful classiﬁcation of these securities, then questions arise concerning adherence to the dichotomous classiﬁcation for reporting hybrid securities. The tests described below provide evidence on the economic substance of these securities and other corporate claims (minority interest and non-redeemable preferred stock) based on an analysis of systematic risk and prices, conditional on the inclusion of these securities in the capital structure. While these tests may not be relied upon to deﬁnitively determine the appropriate classiﬁcation model for corporate claims, they provide important information regarding indicators of a security’s economic substance – its relation to systematic risk and price. To the extent that a security’s relation to these market measures differs from that of securities classiﬁed as either debt or equity, classiﬁcation within a dichotomous framework may result in misclassiﬁcation of securities when compared to their economic substance.4 The next section develops the theoretical framework for the empirical tests of the market perception of the economic substance of corporate claims.

8

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

3. RELATION BETWEEN SYSTEMATIC RISK, MARKET VALUE AND CORPORATE CLAIMS We use two different methods to examine the economic substance of corporate claims: a systematic risk analysis and a valuation analysis.5 For the systematic risk analysis we examine the following relationship: Systematic Risk = f(Operating Risk, Debt, Other Claims)

(1)

Prior research has used a systematic risk framework to address the economic substance of redeemable preferred stock (KW) and that of unfunded pension obligations (Dhaliwal, 1986). The rationale for this method is that ﬁnancial leverage (Debt) is a determinant of the systematic risk of the ﬁrm. In KW, this idea is extended to debt and equity having different effects on systemic risk of the ﬁrm. In the setting here, by decomposing the capital structure into debt and other corporate claims (e.g. preferred stock, minority interest), we can assess economic substance based on the association between the claim and systematic risk. Consistent with the theoretical relationship between leverage and systematic risk, positive and signiﬁcant coefﬁcients are expected for securities that increase ﬁnancial risk. Therefore, if a security affects the market assessment of systematic risk in a manner similar to debt, we expect the estimated coefﬁcients on the debt variable and the other corporate claims to be positive. Alternatively, an insigniﬁcant or non-positive coefﬁcient estimate for a non-debt claim is predicted if, conditional on the level of debt, the claim is perceived by the market to have both debt and equity features.6 Although the systematic risk analysis has an appealing theoretical foundation, it has two limitations. First, the risk measure (market beta) used in systematic risk analysis may not be a sufﬁcient measure for risk (Fama & French, 1992). Second, the data requirements for estimating the variables in the systematic risk model reduce the sample signiﬁcantly, possibly decreasing the generalizability of our results. In response to these limitations, we also use a valuation analysis based on the relationship between corporate claims and prices: Price = f(Assets, Debt, Other Claims)

(2)

Equation (2) is based on a valuation model that represents the market value of common equity of ﬁrm i at end of year t as a function of net assets – total assets minus all other ﬁnancial claims. Similar to prior research (Barth, 1991, 1994; Barth & McNichols, 1994; Barth et al., 1991), we disaggregate net asset value into assets, debt, and other claims (minority interest, preferred stock, trust and

The Market Perception of Corporate Claims

9

redeemable preferred stock) to examine their associations with the market value of equity. Because of potential measurement errors in accounting variables, omitted variables, and conservative accounting, the coefﬁcients on assets and the debt may not be one and minus one respectively. Thus, we limit our tests to comparisons of the coefﬁcient on debt to that on the other claims to see whether the ﬁnancial instrument exhibits a price association similar to debt.

4. SAMPLE AND DATA 4.1. Sample We collected data on ﬁrms with minority interest, trust preferred stock, or other preferred stock outstanding in the 1993–1996 time period. The sample used in this paper comes from two sources: (1) 2,510 ﬁrms with preferred stock or minority interest outstanding during 1993–1996 on the 1996 Compustat Industrial Annual File; and (2) 256 ﬁrms issuing preferred stock from October 1993 to June 1997. A second sample, the TPS sample, was identiﬁed separately to discern the amount of TPS.7 As 149 ﬁrms are shown in both sub-samples, the whole sample consists of 2,617 ﬁrms or 10,468 ﬁrm-year observations.8 Missing data on ﬁrm capital structures from Compustat and the restriction that the book value of net assets (the deﬂator used in valuation analysis) should be at least 1 million dollars, reduce the sample to 6,727 ﬁrm-year observations used for the valuation analysis. Elimination of ﬁrms for lack of enough data in CRSP and Compustat to calculate systematic risk and accounting beta reduces the ﬁnal sample to 1,770 ﬁrm-year observations, used for systematic risk analysis. The sample selection process is summarized in Table 1.

4.2. Variable Measurement Systematic Risk The systematic risk (Beta) measure for each ﬁrm-year was estimated with a one-factor market model using weekly returns on common stock and a market index (NYEX/AMEX weekly value-weighted market return).9 Operating Risk Similar to KW (1995) and Dhaliwal (1986), this paper uses accounting beta as the proxy for operating risk. Accounting beta for each ﬁrm was derived from the regression of accounting returns (accounting earnings before tax and

10

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

Table 1. Sample Selection Process. Number of Observations Firms with preferred stock or minority interests outstanding during 1993–1996 Plus: Firms issuing trust preferred securities from October 1993 to June 1997

2,510a 256

Total ﬁrms in sample Firm-year observations [2617 × 4] Less: With not enough ﬁnancial data or net assets less than 1 million

2,617b 10,468 (3,741)

Firm-year observations used in valuation model Less: Not enough data on CRSP to calculate weekly beta Less: Not enough data to calculate accounting beta

6,727 (2,488) (2,469)

Number of ﬁrm-year observations used in systematic risk analysis

1,770

a These

ﬁrms also have liabilities outstanding, with no missing value on (redeemable) preferred stock and minority interest, and no change in ﬁscal year-end during 1993–1996 time period. b The double counting of 149 ﬁrms who are members of both sub-samples is eliminated. Data from four ﬁscal year periods (1993–1996) are used in this study.

interest expenses divided by beginning-of-period total assets) of a ﬁrm on the value-weighted average of accounting returns of S&P 500 ﬁrms. Capital Structure Variables Because our objective in this paper is to investigate the economic substance of a whole range of ﬁnancial instruments, we decompose ﬁnancial leverage into different parts according to capital structure items in ﬁnancial statements. All capital structure variables, except for trust preferred stock, are measured based on data from the Compustat ﬁle as of the end of the ﬁscal year. Debt represents total liabilities (data item 181) minus minority interest (data item 38). Non-redeemable preferred stock is total preferred stock (data item 130), excluding redeemable preferred stock (data item 175). Due to its recent introduction, trust preferred stock is not a distinct item in the Compustat database and as mentioned earlier, we identiﬁed trust preferred stock from the Investment Dealer’s Digest and hand-collected data on these issues from company ﬁlings. Tax rate (tax expense/pretax income), ROA (income before extraordinary items/total assets), DA (debt/total assets), common shares outstanding, and market value (market price times number of outstanding shares) at the end of each year for each ﬁrm are also collected from the Compustat ﬁle. To reduce the impact of extreme values, all independent variables are winsorized at the 1 and 99% level in the following regression analysis.

The Market Perception of Corporate Claims

11

4.3. Descriptive Statistics Descriptive statistics for sample ﬁrms are presented in Table 2, which summarizes variables used in the analysis for the full sample and for sub-samples by ﬁrm size. The mean weekly beta for the whole sample is 0.996, close to 1. This indicates that the sample is representative of the overall population of ﬁrms with respect to systematic risk. Large ﬁrms have the lowest systematic risk (0.934), while the small ﬁrms have the highest beta (1.084). Overall, the debt-equity ratio (DEBT) is 1.760, while minority interest (MI) is 2.1% of the common equity (market value). The redeemable preferred stock (RPFD) and other preferred stock (PFD) are 1.2% and 3.4% of the common equity respectively. Trust preferred stock (TPS), likely because of its recent introduction and tendency to be issued by only large ﬁrms, represents only 0.1% of common equity. The mean market value is 4,523 million dollars for the systematic risk analysis sample, which is signiﬁcantly greater than the mean market value of the valuation sample (2,470 million dollars). This reﬂects the impact of restricting the systematic risk analysis sample to only those ﬁrms for which we have data to estimate both weekly systematic risk measures and accounting betas. Analysis by ﬁrm size shows small ﬁrms having the highest weekly beta, but medium ﬁrms having the highest accounting beta. Large ﬁrms have the lowest risk measures, but the highest debt-equity ratio. Less than half the sample ﬁrms have minority interest or preferred securities.10

5. EMPIRICAL RESULTS In this section we present the results of systematic risk and valuation analyses. Consistent with prior research, we add industry, size, and year dummy variables to the basic models. Using this expanded speciﬁcation, we also examine the relationships on sub-samples of the data partitioned by ﬁrm size and the type of corporate claims comprising the capital structure.11 The size partition is motivated both by ﬁndings that market pricing relationships vary by size (see e.g. Warﬁeld et al., 1995) and by the evidence in Table 2 that capital structure varies by ﬁrm size. For example, note (in Table 2) that the small ﬁrm sub-sample has no TPS and a relatively smaller amount of minority interests. Examination of sub-samples in which only certain non-debt securities have been issued is motivated by recent research indicating that preferred stock and other hybrids can be issued as substitutes for either debt or equity depending on economic incentives faced by the ﬁrm (Frischmann & Warﬁeld, 1999). Examining, in isolation, the market pricing of these alternative security claims relative to debt provides less ambiguous evidence on the economic substance of these securities.

12

Table 2. Descriptive Statistics. (Descriptive Statistics of Variables used in Systematic Risk Analysis and Valuation Analysisa,b ) Full Sample Mean

Large Firms

Medium Firms

Small Firms

Median

Mean

Std.

Median

Mean

Std.

Median

Mean

Std.

Median

Mean

Std.

Median

12,396 0.623 4.538 2.675 0.064 0.006 0.027 0.078

1,131 0.905 1.234 0.714 0.000 0.000 0.000 0.000

602 11,466 0.934 1.133 3.165 0.026 0.003 0.013 0.045

18,923 0.454 1.539 3.690 0.057 0.008 0.025 0.078

5,304 0.878 0.876 1.108 0.002 0.000 0.000 0.001

584 1,675 0.973 1.860 1.091 0.029 0.001 0.011 0.026

2,506 0.546 4.153 1.663 0.068 0.006 0.027 0.066

1,131 0.849 1.377 0.668 0.000 0.000 0.000 0.000

584 214 1.084 1.194 0.980 0.028 0.000 0.013 0.031

327 0.816 6.644 1.534 0.068 0.000 0.031 0.090

118 1.064 1.854 0.402 0.000 0.000 0.000 0.000

588 2,401 0.913 0.839 2.116 0.000 0.002 0.027 0.083

9,607 0.604 4.089 2.832 0.000 0.008 0.038 0.113

993 0.807 0.730 1.025 0.000 0.000 0.000 0.031

Valuation Model Variables N 6,727 MVALUE 2,470 AT 2.806 DEBT 2.086 MI 0.035 TPS 0.001 RPFD 0.013 PFD 0.027

8,344 4.756 4.417 0.111 0.005 0.060 0.087

223 1.338 0.691 0.000 0.000 0.000 0.000

2,303 6,823 3.729 3.072 0.036 0.003 0.010 0.032

13,181 5.987 5.648 0.088 0.008 0.035 0.081

2,529 1.860 1.198 0.002 0.000 0.000 0.000

2,216 357 2.994 2.243 0.042 0.000 0.014 0.024

508 4.991 4.610 0.124 0.001 0.059 0.080

212 1.438 0.763 0.000 0.000 0.000 0.000

2,208 49 1.654 0.899 0.026 0.000 0.016 0.024

66 1.922 1.432 0.116 0.000 0.078 0.098

25 0.795 0.277 0.000 0.000 0.000 0.000

1,813 1,673 4.084 3.208 0.000 0.003 0.041 0.077

7,043 5.895 5.486 0.000 0.007 0.102 0.144

182 1.937 1.171 0.000 0.000 0.000 0.009

a Descriptive statistics are based on all ﬁrms-years with preferred stock or minority interest outstanding, or issuing trust preferred securities during 1993–1996. Size classiﬁcation is based on the 33rd and 66th percentile of total assets. The PFD-Only sample includes ﬁrms with TPS, RPFD, or PFD, but not MI outstanding during 1993–1996. b N is the number of ﬁrm-year observations included in each sample. MVALUE is the market value of the common equity. BETA is the weekly beta, estimated with a one-factor market model using weekly returns on common stock and a market index (NYEX/AMEX value-weighted market return) for each ﬁrm-year. ABETA (accounting beta) for each ﬁrm is derived from the regression of the accounting returns of this ﬁrm on the value-weighted average of the accounting returns of S&P 500 ﬁrms. Accounting returns are calculated as accounting earnings before tax and interest expenses for one period divided by total assets at the beginning of that period (at least 10 observations are used). DEBT is total liabilities, excluding minority interests. MI is total minority interests excluding trust preferred stock for ﬁrms except utilities. TPS is the total amount of trust preferred stock. RPFD is the total amount of redeemable preferred stock excluding trust preferred stock for utilities. PFD is the total amount of preferred stock, excluding redeemable preferred stock. AT is total assets. All ﬁnancial structure variables are scaled by market value. DEBT and TPS are adjusted for the tax shield for systematic risk analysis just as they appear in regressions.

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

Std.

Systematic Risk Variables N 1,770 MVALUE 4,523 BETA 0.996 ABETA 1.393 DEBT 1.760 MI 0.021 TPS 0.001 RPFD 0.012 PFD 0.034

PFD-Only

The Market Perception of Corporate Claims

13

5.1. Systematic Risk Analysis The results for the systematic risk analysis are reported in Table 3.12 All regressions reﬂect estimations including industry, size, and year dummy variables (not tabled) to control for temporal and cross-sectional variation in the systematic risk relation Table 3. Systematic Risk Analysis. Betai,t = ␣1 OPi + ␣2 OPi +␣4 OPi

(1−T i,t )Debti,t MVi,t

(1−T i,t )TPSi,t MVi,t

+ ␣5 OPi

MI

+ ␣3 OPi MVi,ti,t RPFDi,t MVi,t

OP

Debt

MI

TPS

0.3590 (24.78) 0.2884 (19.55) 0.3401 (17.40) 0.3646 (13.85)

0.0100 (4.70) 0.0106 (4.24) 0.0065 (1.16) −0.0043 (−0.64)

−0.1612 (−1.84) −0.3436 (−4.22) −0.0267 (−0.21) 0.0047 (0.02)

0.2879 (0.60) −0.0889 (−0.16) 0.1385 (0.21)

Panel B: PFD-Only Sample All Firms 0.3820 (15.67) Large Firms 0.3304 (10.44) Medium Firms 0.3651 (16.02) Small Firms 0.3893 (7.75)

0.0071 (1.82) 0.0085 (2.16) −0.0070 (−1.34) 0.0079 (0.49)

Panel A: Full Sample All Firms Large Firms Medium Firms Small Firms

−0.3289 (−0.52) −0.5466 (−0.68) −0.5865 (−0.66)

+ ␣6 OPi

PFDi,t MVi,t

+ ␷i,t

PFD

N

Adj. R2

0.0200 (0.11) 0.4048 (1.90) 0.0754 (0.36) −0.1253 (−0.32)

0.1761 (2.35) 0.2051 (2.02) −0.0716 (−0.82) 0.2859 (1.93)

1755

0.76

612

0.87

591

0.80

552

0.67

0.1609 (0.89) 0.4199 (1.76) 0.1077 (0.46) 0.1293 (0.27)

0.1701 (1.79) 0.1981 (1.52) −0.0208 (−0.17) 0.1828 (1.13)

585

0.78

227

0.88

216

0.83

142

0.66

RPFD

Notes: The model used is an expanded model, containing ﬁnancial instruments speciﬁed in each row, with controls for industry, ﬁrm size (not for size subgroups), and year. We use dummy variables to control for industries (utilities, ﬁnancial companies, and other industries), ﬁrm size (large, medium, and small ﬁrm classiﬁed according to total assets at the ﬁscal end), and each year for the test period. The PFD-Only sample contains ﬁrms with no MI outstanding, but with TPS, RPFD, or PFD outstanding. White t-statistics in (·). N is the number of ﬁrm-year observations included in each sample. BETA is the weekly beta, estimated with a one-factor market model using weekly returns on common stock and a market index (NYEX/AMEX valueweighted market return) for each ﬁrm-year. OP is transformed accounting beta. Accounting beta is derived from the regression of the accounting returns of this ﬁrm on the value-weighted average of the accounting returns of S&P 500 ﬁrms. DEBT is total liabilities, excluding minority interests. MI is total minority interests excluding trust preferred stock for ﬁrms except utilities. TPS is the total amount of trust preferred stock. RPFD is the total amount of redeemable preferred stock excluding trust preferred stock for utilities. PFD is the total amount of preferred stock, excluding redeemable preferred stock. Independent variables are winsorized at the 1% and 99% levels to reduce the inﬂuence of extreme values. 15 observations are detected as outliners using the method described in Belsley et al. (1980) and are excluded from the full sample. Two-sided t-stat for 0.10, 0.05, 0.01 signiﬁcance level are 1.65, 1.96, 2.58 respectively.

14

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

likely to exist in this sample, given the security innovation in recent years and the heterogeneous nature of the sample. Including industry dummy variables controls to some extent for variation in operating risk that is not captured in the accounting beta variable.13 In general, the results indicate that minority interest is priced to be equity-like, non-redeemable preferred stock is viewed similar to debt, and other claims to lie somewhere between these two. For the full sample, as reported in panel A of Table 3, the coefﬁcient on debt is signiﬁcantly positive (p < 0.001). The coefﬁcient on MI is also signiﬁcantly different from zero, but with a negative sign, suggesting that it is equity-like. The coefﬁcients on TPS and RPFD are positive but insigniﬁcant. TPS and RPFD variables exhibit relations with systematic risk that are not consistent with their being priced as either debt or equity. These results on redeemable preferred stock are similar to the ﬁndings of KW. Surprisingly, given its reporting in ﬁnancial statements, the coefﬁcient on non-redeemable preferred stock is positive and signiﬁcant, suggesting that it is debt-like. As discussed earlier, because the overall sample is fairly heterogeneous in terms of size, which may be related to security choice, we also estimate the regression conditional on ﬁrm size. The results for these partitions are reported in panel A and indicate that the preferred stock and minority interest results for the full sample appear strongest in large ﬁrms and that the RPFD of large ﬁrms exhibits a relation more consistent with it being viewed by the market as a leverage increasing claim.14 Panel B reports results based on sub-samples with only preferred stock but no minority interest (PFD-Only), also conducted on ﬁrm size partitions. Overall, the coefﬁcient on debt is still positive and signiﬁcant as is the preferred stock estimate. Neither the TPS nor the RPFD coefﬁcients are signiﬁcantly different from zero. However, the analysis conditional on ﬁrm size indicates that the coefﬁcient estimates for RPFD exhibit a debt-like relation for large ﬁrms.

5.2. Valuation Analysis The valuation models were estimated on all ﬁrm-years with available data. The valuation test sample is not directly comparable to the sample used in the systematic risk analysis. The sample is much larger (N = 6,727), because this approach does not require systematic risk measures and accounting betas, which were estimated from a long time-series of data. In general, the results from the valuation model corroborate earlier ﬁndings based on systematic risk. The results for the full sample are shown in panel A of Table 4.15 As in the systematic risk analyses, we also control for intercept shifts for industry, size, and year.

The Market Perception of Corporate Claims

15

Table 4. Valuation Model Analysis. MVi,t = ␣1 ATi,t + ␣2 Debti,t + ␣3 MIi,t + ␣4 TPSi,t + ␣5 RPFDi,t + ␣6 PFDi,t + ␣7 NIi,t + ␣8 NI × Posi,t + ␣9 NA1i,t + ␷i,t AT

Debt

MI

TPS

RPFD

PFD

N

Adj R2

1.5846 (9.06) 1.0125 (4.94) 1.3495 (5.46) 2.3122 (10.75)

−1.6263 (−9.27) −1.0355 (−5.00) −1.3958 (−5.65) −2.3619 (−10.23)

−1.5042 (−4.16) −0.1855a (−0.32) −1.1085 (−2.08) −3.7519 (−6.56)

1.3199 (0.36) 5.2345a (1.35) −3.0426 (−0.40)

−0.7945a (−1.24) 2.8815a (2.07) −1.3633 (−1.45) −2.5611 (−3.11)

−1.7894 (−4.32) −1.6958a (−3.08) −2.0421 (−3.59) −1.6271 (−6.63)

6727

0.65

2303

0.74

2216

0.67

2208

0.62

Panel B: PFD-Only Sample All Firms 1.3205 (6.21) Large Firms 1.1877 (5.49) Medium Firms 1.2727 (3.65) Small Firms 1.3093 (3.41)

−1.3797 (−6.27) −1.2466 (−5.75) −1.3464 (−3.78) −1.2500 (−2.88)

−0.0271a (−0.04) 3.7603a (2.51) −0.3868 (−0.49) −0.4198 (−0.41)

−0.4187a (−0.88) −1.2399 (−2.28) −0.8341 (−1.28) 1.0903a (1.20)

1813

0.67

718

0.78

473

0.73

622

0.64

Panel A: Full Sample All Firms Large Firms Medium Firms Small Firms

−2.7144 (−1.41) −3.2592 (−1.57) −3.9270 (−0.66)

Notes: The model used is an expanded model, containing ﬁnancial instruments speciﬁed in each row, with control for industry, ﬁrm size (not for size sub-samples), and year. We use dummy variables to control for industries (utilities, ﬁnancial companies, and other industries), ﬁrm size (large, medium, and small ﬁrm classiﬁed according to total assets at the ﬁscal end), and each year for the test period. The PFD-Only sample contains ﬁrms with no MI outstanding, but with TPS, RPFD, or PFD outstanding. White t-statistics in (·). N is the number of ﬁrm-year observations included in each sample. MV is market value and AT is total assets. DEBT is total liabilities, excluding minority interests. MI is total minority interests excluding trust preferred stock for ﬁrms except utilities. TPS is the total amount of trust preferred stock. RPFD is the total amount of redeemable preferred stock excluding trust preferred stock for utilities. PFD is the total amount of preferred stock, excluding redeemable preferred stock. NI is net income and Pos is dummy variable, deﬁned as one if net income is positive. NA is book value of net assets. All ﬁnancial instrument measures are scaled by book value of common equity at ﬁscal year end. We winsorized the independent variables at 1%, 99% levels to reduce the inﬂuence of extreme values. Two-sided t-statistics for 0.10, 0.05, 0.01 signiﬁcance level are 1.65, 1.96, 2.58 respectively. a The

coefﬁcient is signiﬁcantly different from that on debt at 5% level.

Coefﬁcients on total assets and debt excluding minority interest are signiﬁcantly positive and signiﬁcantly negative respectively. Similar to prior studies, the absolute values of coefﬁcients are different from one because of omitted variables, potential measurement errors in the variables, and conservative accounting. The coefﬁcient on non-redeemable preferred stock is also signiﬁcantly negative, and the absolute value is greater than that of debt, although not signiﬁcantly. This suggests that, as in the systematic risk analysis, preferred stock is priced similar to

16

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

debt. In the full sample, the coefﬁcients on redeemable preferred stock (TPS and RPFD) are not signiﬁcantly different from zero, thereby not exhibiting relations similar to debt or equity (although RPFD appears equity-like compared to the debt coefﬁcient). The coefﬁcient on minority interest is less negative than that on debt (appearing equity-like), although not signiﬁcantly. These results are generally consistent with the systematic risk results reported above. As with the systematic risk analysis, we split the sample into three different sub-samples according to ﬁrm size. As expected, large ﬁrms have more minority interest than small ﬁrms and the size-partitioned results in panel A indicate that results on MI for large ﬁrms are stronger. The coefﬁcient on MI is signiﬁcantly less negative than that on debt for large ﬁrms, consistent with it being priced more like equity. As in our earlier analysis, the debt-like non-redeemable preferred stock relationships are strongest for the large ﬁrms. However, the difference between the coefﬁcient on non-redeemable preferred stock and that on debt goes from signiﬁcantly negative to marginally signiﬁcantly positive from the large ﬁrm subsample to the small ﬁrm sub-sample in panel A of Table 4. The reverse situation applies to minority interest. This suggests that non-redeemable preferred stock is debt-like for large ﬁrms, but equity-like for small ﬁrms, while minority interest is equity-like for large ﬁrms but debt-like for small ﬁrms. The results for the preferred stock sub-sample and associated size partitions are reported in panel B of Table 4. Consistent with the full sample, the coefﬁcients on the total assets and debt excluding minority interest are all signiﬁcantly positive and signiﬁcantly negative respectively. The results are similar to those reported for small ﬁrms in panel A. While on an overall basis, the coefﬁcient on the non-redeemable preferred stock variable is signiﬁcantly higher than the debt coefﬁcient, the size analysis indicates that this is primarily due to the small ﬁrm sub-sample. This lends support to the discussion above that non-redeemable preferred stock is equity-like for small ﬁrms. Similar to results for the full sample, but inconsistent with the systematic risk analysis, conditioned on ﬁrm size, the results indicate that the coefﬁcient estimates for RPFD exhibit an equity-like relation for large ﬁrms.16 In summary, the systematic risk and valuation analyses reveal the following results concerning the market pricing of alternative corporate claims. Conﬁrming prior research, debt obligations exhibit an association with systematic risk and equity prices consistent with their treatment in the ﬁnancial reporting framework. Also as in prior research, our results indicate that redeemable preferred securities (including the recent innovation in the form of TPS) are not viewed by the market as either debt or equity. Thus, the current reporting treatment of these securities (in the mezzanine) appears to be in line with their market associations.17 In contrast, the associations exhibited by both non-redeemable preferred stock

The Market Perception of Corporate Claims

17

and minority interest are more consistent with these claims being viewed as debt-like and equity-like respectively (leverage increasing (decreasing)), especially for large ﬁrms, which is inconsistent with their treatment in ﬁnancial statements.

5.3. Additional Analysis of Firm Characteristics The ﬁndings reported in the prior section indicate that the market perception of corporate claims varies according to ﬁrm size. For example, preferred stock is viewed like debt for large ﬁrms, but more similar to equity for small ﬁrms. There are two possible explanations for this phenomenon. First, as noted by Fama and French (1995) and Hayn (1995), smaller ﬁrms generally have lower accounting return and higher default risk. Debt holders of small ﬁrms are more likely to exercise their option to take over the ﬁrm than the debt-holders of large ﬁrms, so debt and preferred instruments are more equity-like for small ﬁrms (Warner, 1977a). Second, small ﬁrms tend to issue equity-like securities, and choose convertible preferred stock to attract investors, lower agency costs, and thereby reduce capital costs (Jensen & Meckling, 1976; Smith, 1986). To further examine the impact of ﬁrm characteristics on our results, we collected data on ﬁrms’ performance measures and convertible preferred stock. We chose ROA (income before extraordinary items/total assets), S&P senior debt rating, and the debt-to-asset ratio as measures of ﬁnancial performance.18 To reduce the industry effect on ROA, we created a relative ROA variable, REROA, the difference between a ﬁrm’s ROA and the industry mean ROA, divided by the industry mean ROA. Consistent with the above analysis, we classiﬁed ﬁrms into three industry groups: utilities, ﬁnancial companies, and other ﬁrms. We also collected the amount of convertible preferred stock for each ﬁrm-year, and calculated a convertible ratio (convertible preferred stock/total preferred stock), CNVPRE.19 One method to assess the impact of convertibility and ﬁrm performance on the market’s perception of preferred stock is to control for the convertibility of redeemable or non-redeemable preferred stock in the systematic risk and valuation analyses. However, Compustat data do not allow us to determine convertibility among various preferred stock issues (redeemable or not). Thus, to explore differential results on preferred stock conditional on size, we analyze: (1) the relation between the overall convertible ratio and ﬁrm performance, conditional on ﬁrm size; and (2) the market perception of convertible preferred stock, conditional on ﬁrm performance. The correlation among ﬁnancial performance measures, convertible ratio, and ﬁrm size (total assets) are reported in panel A of Table 5. Consistent with our

18

Table 5. Evidence on the Relation Between Firms’ Characteristics, Convertibility and Differential Pricing of Preferred Stock. Panel A: Spearman Correlation Coefﬁcientsa ROA 0.98981 −0.37984 −0.13597 −0.23427 0.3639

REROA −0.34408 −0.15021 −0.18738 0.35539

SP

0.34543 0.33728 −0.65418

DA

−0.1408 0.12198

CNVPRE

−0.32016

Full Sample

PFD-ONLY Sample

Panel B: Descriptive Statistics for the Performance Variables and Convertible Ratiob

ROA REROA SP DA CNVPRE

Full 2.5105 0.4738 9.5560 27.283 0.3842

Large 3.0540 0.7985 8.3112 27.9298 0.2951

Medium 3.8691 1.2380 10.4405 28.5907 0.3527

Small 0.5916 −0.6249 12.2857 25.4223 0.5836

Full 1.0161 −0.7555 9.8457 31.3132 0.3425

Large 2.0640 −0.0650 9.2833 31.9943 0.2137

Medium 3.0683 0.3880 10.2516 32.1543 0.2987

Small −3.3328 −3.3311 10.8378 29.1869 0.5433

Panel C: Systematic Risk Analysis of Convertible Preferred Stock Contingent on Firm Performance c (1 − T i,t )Debti,t MIi,t (1 − T i,t )TPSi,t NCPFDi,t + ␣3 OPi + ␣4 OPi + ␣5 OPi MVi,t MVi,t MVi,t MVi,t CPFDi,t +(␣6 + ␣7 ROA + ␣8 SP)OPi + ␷i,t MVi,t

Betai,t = ␣1 OPi + ␣2 OPi

OP 0.2993 (12.63)

Debt 0.0145 (5.74)

MI −0.1220 (−1.40)

TPS −0.4304 (−0.62)

NCPFD 0.1024 (1.20)

CPFD −0.1454 (−1.05)

CPFD × ROA 0.0019 (0.13)

CPFD × SP 0.0640 (2.33)

N 517

Adj. R2 0.84

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

REROA SP DA CNVPRE AT

Panel D: Valuation Analysis of Convertible Preferred Stock Contingent on Firm Performance c MVi,t = ␣1 ATi,t + ␣2 Debti,t + ␣3 MIi,t + ␣4 TPSi,t + ␣5 NCPFDi,t + (␣6 + ␣7 ROA + ␣8 SP)CPFDi,t + ␣7 NIi,t + ␣8 NI × Posi,t 1 +␣9 + ␷i,t NAi,t AT 1.6946 (8.66)

Debt −1.7266 (−8.28)

MI 1.2671* (2.20)

TPS 2.5910 (0.55)

NCPFD −1.2970 (−2.40)

CPFD CPFD × ROA 1.8257* 0.2200 (3.08) (5.10)

CPFD × SP −0.7076 (−5.16)

N 10,42

Adj. R2 0.70

The Market Perception of Corporate Claims

Table 5. (Continued )

a Panel A is based on the whole sample, with no restriction on

weekly beta and accounting beta. ROA is return on assets (income before extraordinary items/total assets, in percentage), SP is S&P senior debt rating, and DA is debt-assets ratio. To reduce the industry effect on ROA, we create a relative ROA variable, REROA, which is the difference between a ﬁrm’s ROA and its industry mean divided by industry mean of ROA. CNVPRE is preferred stock convertible ratio (convertible preferred stock/total preferred stock). All correlation coefﬁcients are signiﬁcant at the 0.0001 level. b Panel B is based on the ﬁrms used in systematic risk analysis. A similar, but more signiﬁcant pattern exists for the sample used in the valuation analysis. c CPFD is the total amount of convertible preferred stock and NCPFD is the total amount of non-convertible preferred stock. Other variables are deﬁned as in Tables 3 and 4. In Panels C and D, we use mean-adjusted ROA and SP debt rating (based on sample means) in the interaction with convertible preferred stock, so that the intercept on convertible preferred stock (␣6 ) can be interpreted as coefﬁcient on convertible preferred stock for an average ﬁrm. ∗ The coefﬁcient is signiﬁcantly different from that on debt at 5% level. White t-statistics are in (·).

19

20

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

conjecture, small ﬁrms are generally ﬁnancially weak, with lower ROA and relative ROA, and higher SP value (lower rated debt).20 Also consistent with our conjecture, small ﬁrms tend to issue convertible preferred stock. The Spearman correlation coefﬁcient between total assets and convertible ratio is −0.32016, signiﬁcant at 0.0001 level. Panel B of Table 5 highlights the difference in ﬁnancial performance measures and the convertible ratio across size-subgroups for the whole sample and the PFDOnly sample. There is no signiﬁcant difference between medium ﬁrms and large ﬁrms in ﬁnancial performance measures and convertible ratio. However, small ﬁrms have lower ﬁnancial performance and a higher convertible ratio, compared to medium-size ﬁrms and large ﬁrms. Compared to large ﬁrms, the mean ROA for small ﬁrms is lower by 2.462% (t = 3.562), or 20% of the mean ROA for the large ﬁrms, for the full sample. Small ﬁrms have a higher SP code (by 3.975, t = 9.198), and therefore a lower debt rating. The small ﬁrms also have a higher proportion of convertible preferred stock (with t = 7.25). These results are similar for the PFDOnly sample. Overall, small ﬁrms generally exhibit weaker ﬁnancial performance and a larger proportion of convertible preferred stock, which is consistent with the preferred stock being considered equity-like for small ﬁrms, but debt-like for large and medium-sized ﬁrms. To investigate the impact of conversion features and ﬁrm performance on the market’s perception of preferred stock, we replace redeemable and non-redeemable preferred stock with convertible preferred stock and nonconvertible preferred stock and we include interaction terms of convertible preferred stock with the return on assets and S&P debt ratings. These interaction terms are introduced to control for the effects of ﬁrm performance and other risk aspects on the market’s perception of convertible preferred stock. The results for the systematic risk (valuation) models are reported in panel C(D) of Table 5. After controlling for ﬁrm performance and other risk factors, convertible preferred stock is equity-like in both the systematic risk and valuation analyses. Moreover, the signiﬁcant coefﬁcient on the interaction of convertible preferred stock and return on assets suggests that the convertible preferred stock of more proﬁtable ﬁrms is priced more similar to equity. The signiﬁcant coefﬁcient on the interaction of convertible preferred stock and S&P debt ratings suggest that convertible preferred stock of riskier ﬁrms is more debt-like. That is, investors are more likely to convert convertible preferred stock of more proﬁtable ﬁrms to capture future growth opportunities and less likely to convert preferred stock of riskier ﬁrms in face of high default risk. The ﬁndings for non-convertible preferred indicate that, consistent with the earlier results, that these securities are priced more similar to debt.

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6. CONCLUSION We examine the economic substance of a broad range of securities, including those reported in minority interest, those in the mezzanine between debt and equity (such as redeemable preferred stock), and those reported in equity as preferred stock. While prior research has provided evidence concerning the economic substance of some hybrid securities (e.g. KW), evidence on the broader range of corporate claims is limited. Our analyses are motivated by continuing security innovation, which is contributing to a growing mezzanine section in corporate balance sheets. Evidence on how the market views various corporate claims should be useful to standard setting boards such as the IASB and the FASB in their deliberations. Indeed, there is no study that we are aware of that has examined some of the more recently developed securities (trust preferred stock) or other corporate claims, such as minority interest and preferred stock, which also exhibit hybrid features. We employ two indicators of the economic substance of securities – their impact on the issuing ﬁrm’s systematic risk and their association with equity prices. If investors believe that certain features of the securities make them similar to debt, then the observed relation between the securities and systematic risk (and prices) should be similar to that between debt and systematic risk (and prices). Our evidence suggests that, consistent with prior research, debt obligations exhibit an association with systematic risk and prices consistent with their treatment in the ﬁnancial reporting framework. Also consistent with prior research, our results indicate that redeemable preferred securities (including the recent innovation in the form of TPS) are not viewed by the market as either debt or equity. Thus, the current reporting treatment of these securities (in the mezzanine) appears consistent with their market treatment. In contrast, the associations exhibited by both non-redeemable preferred stock and minority interests are more consistent with these claims being viewed as debt-like and equity-like respectively (leverage increasing (decreasing)), which is inconsistent with their treatment in the ﬁnancial statements. However, the fact that these results appear to be driven by large ﬁrms suggests the substance of such instruments are context speciﬁc. The contextual nature of these ﬁndings questions the merits of the current dichotomous classiﬁcation framework within ﬁnancial statements as a means of conveying useful information about hybrid securities and provides evidence relevant to the FASB’s deliberation on hybrid security reporting. These results indicate that the FASB project has merits, but that care must be exercised in choosing the demarcation between various corporate claims.

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Speciﬁcally, the ﬁndings with respect to preferred stock and minority interest suggest that a less ambiguous line between liability and equity claims may be drawn based on a strict deﬁnition of equity. Consequently, the equity classiﬁcation would contain only common equity (including minority interest) and the equity elements of compound securities. All other claims (including preferred stock) would be classiﬁed as liabilities. Under this approach, at least the elements reported within equity would exhibit similar economic substance. Given the diversity of attributes that could be reﬂected in the securities classiﬁed as liabilities within this framework, disclosure is arguably the most effective means of communicating the features relevant to the economic substance of these securities.21

NOTES 1. Linsmeier et al. (1999) use a single valuation approach (based on the residual income model) to examine the market pricing of debt and equity classiﬁcations. However, they do not examine the economic substance of minority interests and some of the more recent security innovations. Their results for preferred stock are consistent with the ﬁndings in this paper. 2. While RPFD payments are an obligation of the ﬁrm under normal operating conditions, RPFD investors cannot force a delinquent ﬁrm into bankruptcy (FASB, 1990; Manning & Hanks, 1990). This is important because ﬁnancial theory suggests that a primary characteristic of debt is that creditors have the option of forcing a delinquent debtor into bankruptcy (Myers, 1977; Warner, 1977a, b). Prior research has examined the implications of bankruptcy costs for ﬁnancial instrument innovations such as hybrid and compound securities (John, 1993). 3. Frischmann et al. (1999) provide evidence that these popular securities represent nearly two-thirds of new preferred stock issuance in the 1993–1996 time period. Frischmann and Warﬁeld (1999) and Engel et al. (1999) provide evidence on the importance of tax and ﬁnancial reporting motivations for issuing TPS. 4. Hopkins (1996) ﬁnds that the ﬁnancial statement treatment of a security can affect how securities are treated by analysts in evaluating the company’s ﬁnancial position. These results suggest that classiﬁcation in ﬁnancial statements matters. Furthermore, in collecting our data, we observed inconsistent treatment of hybrid securities in ﬁnancial databases, which raises concerns about the lack of standards for the reporting of hybrid securities. At a minimum, when classiﬁcations lack representational faithfulness, users bear costs to adjust information reﬂected in ﬁnancial statements to make the information more comparable. 5. These approaches take the perspective of investors, which is justiﬁed given the preeminence of this set of users within the FASB’s conceptual framework. A more complete development of the models and speciﬁcations are presented in the Appendix. 6. Insigniﬁcant coefﬁcients for this test could also be caused by low variation in the distribution of the independent variable or high correlation in the measure of the security with another variable in the model. We address these issues by estimating the models on subsamples and by examining the distribution of the independent variables through the use of collinearity diagnostics.

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7. From Investment Dealer’s Digest, we obtained a listing of all new preferred security issues in the October 1993 to June 1997 period, amounting to 471 issues of 272 different ﬁrms. This period spanned the beginning of TPS issues (with Texaco being the ﬁrst in October 1993) up to the most recent year when new issue data, annual ﬁnancial statements, and Compustat data were available. Our 1997 data end in June, which is the latest ﬁscal year end in the 1996 Compustat ﬁle. Financial information and attributes of each preferred security issue were obtained from the company’s annual report, 10-K, or prospectus as it appeared on Laser Disclosure or on the SEC EDGAR database. Data availability, chieﬂy the inability to identify or obtain a copy of the parent company annual report or lack of detailed disclosure to verify the details of the preferred issue, reduced this sample to 417 issues of 256 ﬁrms. 8. Not all ﬁrms issuing preferred stock are included in the preferred stock-minority interest sample for three reasons: (1) Some ﬁrms issued preferred stock after the ﬁscal year end of 1996 and did not have preferred stock or minority interests before; (2) Some ﬁrms’ TPS are included in other liabilities, rather than in minority interests or redeemable preferred stock; (3) Some ﬁrms issuing preferred stock have no data in Compustat (and are not used in the tests). 9. KW argue that estimates based on daily returns are downward biased for some inactive stocks, hence weekly beta is used for the main analysis. Firm-years with less than 30 weekly returns were dropped from the tests. Daily beta (estimated from the daily return of each common stock and market return) are calculated for sensitivity analysis. Long-term beta is also extracted from Compustat for sensitivity analysis. Results for these alternative measures are similar to those reported below. 10. Correlation statistics (not reported) indicate that multicollinearity is not an issue, based on the diagnostic suggested by Belsley et al. (1980). 11. We estimated the models below on industry sub-samples and observe similar but weaker results than those reported in the tables. To control for potential serial correlation in residuals caused by including up to ﬁve years data of individual ﬁrms, we also estimated a cross-sectional regression based on composite observations for each ﬁrm by averaging variables over years. Year-by-year regressions were estimated and the resulting coefﬁcients were averaged over time. Both methods were implemented for the full sample and size partitions to check the sensitivity of results. The results based on both methods are qualitatively similar to those reported in the paper for both systematic risk and valuation analyses. 12. Fifteen observations are detected as outliers and excluded from the sample. The criterion is that the absolute value of the R-student measure is larger than three (Belsley et al., 1980). We also run the tests: (1) using truncated leverage ratios; and/or (2) with all ﬁnancial instrument variables scaled by the total assets. The results are qualitatively similar. 13. KW use a similar speciﬁcation. We repeated the systematic risk analysis by using the variability of earnings to proxy for operating risk, as in prior research (KW, 1995), and found similar results. 14. Similar results were obtained (not tabled) on a sample of ﬁrms with only minority interest. 15. For the full sample, coefﬁcients on net income, its interaction term with a positive income dummy, and the inverse of net assets are −3.05, 9.06, 2.34 respectively, and are all signiﬁcant. Consistent with theoretical predictions, similar coefﬁcients are observed for sub-samples. As these coefﬁcients are not of interest in this study, they are not reported in the table.

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16. In contrast to the systematic risk model, which excludes many smaller ﬁrms because of the lack of data, it is the small ﬁrms that are most inﬂuential in the valuation model. More ﬁrms in the PFD-Only sample are small ﬁrms because large ﬁrms are more likely to have minority interest. 17. The result on TPS could partly be driven by limited number of ﬁrms having trust preferred stock. While, the inconsistent results on redeemable preferred stock between the two analyses may reﬂect ﬁrm size differences between the two samples, results of the valuation analysis based on the systematic risk sample are qualitatively similar to those reported in Table 4. 18. We included the debt-to-asset ratio as a measure of ﬁrm performance as it is an indicator of the risk of a ﬁrm not meeting its maturing obligations. 19. Some ﬁrms issue ESOPs (Employee Stock Ownership plans), which are included in convertible preferred stock and current liabilities, but not in total preferred stock. This will bias the convertible ratio upward. To reduce the bias, we set the ratio to be one if the convertible preferred stock (including the ESOP) is greater than net preferred stock (not including the ESOP). 20. The S&P senior debt rating code is low for higher rated debt, and high for lower rated debt. For example, the code for AAA rated debt is 2, 17 for B rated debt, and 27 for D rated debt. 21. Kimmel and Warﬁeld (1993) make a similar recommendation in their analysis of potential approaches for reporting RPFD. Some decisions by the FASB within the liability and equity project are consistent with this approach. As mentioned earlier, based on current deliberations, TPS and other RPFD will be classiﬁed as debt while minority interests and the equity elements of compound securities will be reported in equity. 22. See Brealey and Myers (1984), chapter 17, for further discussion of this model. This formulation is similar to those in Hamada (1972) and Bowman (1979), with the approach here incorporating alternative claims (besides debt) with potentially different risks. 23. This regression does not include an intercept term because it is not theoretically motivated and the inclusion of an intercept potentially causes multicollinearity problems. The coefﬁcients on corporate claims in Eq. (2) are interpreted as the difference between 1 and the ratio of the beta of corporate claims to operating risk. An alternative regression format, theoretically and empirically identical to Eq. (2), is one replacing those interaction terms between operating risk and corporate claims with corporate claims alone. The coefﬁcients from this latter speciﬁcation are interpreted as the difference between operating risk and the beta of corporate claims. The results based on this speciﬁcation are qualitatively similar. 24. See, for example, Barth and McNichols (1994), Barth (1991, 1994), Barth et al. (1991), Collins et al. (1999). This model is consistent with Ohlson (1995) (see Eq. (7) on p. 670). 25. We chose the levels speciﬁcation because of two signiﬁcant shortcomings of the changes speciﬁcation. First, the misspeciﬁcation of a return regression is more severe as manifested by the low adjusted R-square (Lev, 1989) and may affect the coefﬁcients on independent variables (Kothari, 2000). Second, to implement the return regression, we need to take ﬁrst differences of corporate claims, which reduces the sample size unnecessarily. While the levels regression is subject to a scale effect (Brown, Lo & Lys, 1999; Easton, 1998), we use net assets as the deﬂator to control for this. The results are not sensitive to the use of alternative deﬂators, such as beginning-of-period net assets or net sales.

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ACKNOWLEDGMENTS Qiang Cheng gratefully acknowledges the ﬁnancial support of the Graduate School of University of Wisconsin and the Department of Accounting and Information Systems at the University of Wisconsin. P. Frischmann gratefully acknowledges the ﬁnancial support of the College of Business of Idaho State University and the Department of Accounting and Information Systems at the University of Wisconsin. T. Warﬁeld gratefully acknowledges the ﬁnancial support of the PricewaterhouseCoopers Foundation. We thank our anonymous referees, Joe Anthony, Mike Lacina, Tom Linsmeier, Peter Pope, Steve Ryan, workshop participants at Lancaster University, The London Business School, Tilburg University, the University of Wisconsin-Madison, and conference participants at the 1999 AAA Annual Meeting in San Diego for helpful comments on earlier versions of this paper.

REFERENCES Barth, M. E. (1991). Relative measurement errors among alternative pension asset and liability measures. The Accounting Review (July), 433–463. Barth, M. E. (1994). Fair value accounting: Evidence from investment securities and the market valuation of banks. The Accounting Review (January), 1–25. Barth, M. E., Beaver, W. H., & Stinson, C. H. (1991). Supplemental data and the structure of thrift share prices. The Accounting Review (January), 56–66. Barth, M. E., & McNichols, M. F. (1994). Estimation and market valuation of environmental liabilities relating to superfund sites. Journal of Accounting Research (Supplement), 177–209. Belsley, D. A., Kuh, E., & Welsch, R. E. (1980). Regression diagnostics. New York: John Wiley & Sons, Inc. Bowman, R. G. (1979). The theoretical relationship between systematic risk and ﬁnancial (accounting) variables. Journal of Finance (June), 617–629. Brealey, R., & Myers, S. (1984). Principles of Corporate Finance. New York: McGraw-Hill. Brown, S., Lo, K., & Lys, T. (1999). Use of R2 in accounting research: Measuring changes in value relevance over the last four decades. Journal of Accounting and Economics (December), 83–116. Clark, M. W. (1993). Entity theory, modern capital structure theory, and the distinction between debt and equity. Accounting Horizons (September), 14–31. Collins, D., Pincus, W., & Xie, H. (1999). Equity valuation and negative earnings: The role of book value of equity. The Accounting Review, 74(January), 29–61. Dhaliwal, D. S. (1986). Measurement of ﬁnancial leverage in the presence of unfunded pension obligations. The Accounting Review, 61(October), 651–661. Easton, P. D. (1998). Discussion of revalued ﬁnancial, tangible and intangible assets: Association with share prices and non-market-based value estimates. Journal of Accounting Research, 36(Supplement), 235–247.

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Engel, E., Erickson, M., & Maydew, E. (1999). Debt-equity hybrid securities. Journal of Accounting Research, 37(Autumn), 249–274. Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance (June), 427–465. Fama, E. F., & French, K. R. (1995). Size and book-to market factors in earnings and returns. The Journal of Finance (March), 131–155. FASB (1980). Statement of ﬁnancial accounting concepts No. 2. Qualitative Characteristics of Accounting Information. Stamford, CT: FASB. FASB (1990). Discussion memorandum. Distinguishing between liability and equity instruments and accounting for instruments with characteristics of both. Norwalk, CN. FASB (August). FASB (2000). Proposed statement of ﬁnancial accounting standards: Accounting for ﬁnancial instruments with characteristics of liabilities, equity, or both. Financial accounting series – No. 213-B (October 27). Frischmann, P., & Warﬁeld, T. D. (1999). Innovation in preferred stock: The impact of tax, ﬁnancial reporting, and industry factors (Working Paper). University of Wisconsin. Frischmann, P., Kimmel, P., & Warﬁeld, T. D. (1999). Innovation in preferred stock: Current developments and implications for ﬁnancial reporting. Accounting Horizons, 13(September), 201–218. Hamada, R. (1969). Portfolio analysis, market equilibrium and corporation ﬁnance. Journal of Finance (March), 13–31. Hamada, R. S. (1972). The effect of the ﬁrm’s capital structure on the systematic risk of common stocks. The Journal of Finance (May), 435–452. Hayn, C. (1995). The information content of losses. Journal of Accounting and Economics (September), 125–153. Hopkins, P. (1996). The effect of ﬁnancial statement classiﬁcation of hybrid securities on ﬁnancial analysts’ stock price adjustments. Journal of Accounting Research (Supplement), 33–50. Jensen, M. C., & Meckling, W. H. (1976). Theory of the ﬁrms: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 4(October), 305–360. John, K. (1993). Managing ﬁnancial distress and valuing distressed securities: A survey and a research agenda. Financial Management (Autumn), 60–78. Kimmel, P., & Warﬁeld, T. (1993). Variation in attributes of redeemable preferred stock: Implications for accounting standards. Accounting Horizons (June), 30–40. Kimmel, P., & Warﬁeld, T. (1995). The usefulness of hybrid security classiﬁcations: Evidence from redeemable preferred stock. The Accounting Review (January), 151–167. Kothari, S. P. (2000). Capital market research in accounting. Journal of Accounting and Economics (forthcoming). Lev, B. (1989). On the usefulness of earnings: Lessons and directions from two decades of empirical research. Journal of Accounting Research (Supplement), 153–201. Linsmeier, T., Shakespeare, C., & Sougiannis, T. (1999). Liability/equity classiﬁcations decisions and shareholder valuation (Working Paper). University of Illinois. Manning, B., & Hanks, J. J. (1990). Legal capital (3rd ed.). Westbury, NY: Foundation Press. Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics (November), 147–175. Nair, R. D., Rittenberg, L. E., & Weygandt, J. J. (1990). Accounting for redeemable preferred stock: Unresolved issues. Accounting Horizons, 4(2), 33–41. Ohlson, J. (1995). Earnings, book values and dividends in security valuation. Contemporary Accounting Research, 11(Spring), 661–687.

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Smith, C. W., Jr. (1986). Investment banking and the capital acquisition process. Journal of Financial Economics, 1/2 (January/February), 3–29. Warﬁeld, T. D., Wild, J. J., & Wild, K. L. (1995). Managerial ownership, accounting choices and informativeness of earnings. Journal of Accounting and Economics, 20(July), 61–91. Warner, J. B. (1977a). Bankruptcy, absolute priority and the pricing of risky debt claims. Journal of Financial Economics, 4(May), 239–276. Warner, J. B. (1977b). Bankruptcy costs: Some evidence. Journal of Finance (May), 337–347.

APPENDIX Systematic Risk Analysis The systematic risk model used in this paper is based on Hamada (1969, 1972).22 If the correlation between the interest on debt, the dividend rate on preferred stock, and the market return is not negligible, it can be shown that: (1 − T)Debt PFD + (␤U − ␤PFD ) (1) MV MV where: ␤S is the systematic risk of the ﬁrm as measured by the beta of its common stock. Similarly, ␤D , ␤PFD are betas of the debt and the preferred stock of this ﬁrm. Debt, PFD, MV represent the debt, preferred stock and equity of the ﬁrm respectively. ␤U is the operating risk of the ﬁrm (the systematic risk of an unlevered ﬁrm). T represents the tax rate faced by the ﬁrm. Extending this equation to a situation with minority interest, TPS, and redeemable preferred stock, the following regression Eq. (for all ﬁrm-year observations) can be constructed as:23 ␤S = ␤U + (␤U − ␤D )

Betai,t = ␣1 OPi + ␣2 OPi + ␣4 OPi

(1 − T i,t )Debti,t MIi,t + ␣3 OPi MVi,t MVi,t

(1 − T i,t )TPSi,t RPFDi,t PFDi,t + ␣5 OPi + ␣6 OPi + ␷i,t MVi,t MVi,t MVi,t (2)

where: Beta = an estimate of the systematic risk of the ﬁrm’s common stock, ␤S ; OP = measure of operating risk, ␤U ; Debt = total debt; MI = minority interest; TPS = total trust preferred stock; RPFD = total redeemable preferred stock; PFD = total preferred stock (excluding redeemable preferred stock); MV = market value of common equity.

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Valuation Analysis The following valuation model is based on prior research and is used to examine the market pricing of book value components.24 We use this model as a second methodology for assessing the economic substance of alternative corporate claims. The valuation model is constructed as follows: MVi,t = ␣1 ATi,t + ␣2 Debti,t + ␣3 MIi,t + ␣4 TPSi,t + ␣5 RPFDi,t 1 + ␣6 PFDi,t + ␣7 NIi,t + ␣8 NI × Posi,t + ␣9 + ␷i,t NAi,t (3) where: AT is total assets; NI is net income; Pos is one if the net income is positive; NA is book value of common equity; other variables are deﬁned as in Eq. (2). All variables are scaled by book value of equity to reduce heteroscedasticity and to eliminate scale effects (Easton, 1998).25 If the coefﬁcient on one instrument is signiﬁcantly different from that of debt, we infer that the market perception of this instrument is different from that of debt.

AN ANALYSIS OF THE ACCOUNTING PROFESSION’S OLIGARCHY: THE AUDITING STANDARDS BOARD John E. McEnroe and Marshall K. Pitman ABSTRACT The Auditing Standards Board (ASB), a committee of the American Institute of Certiﬁed Public Accountants (AICPA) has been granted the authority to promulgate auditing standards in the United States. Unlike the members of the Financial Accounting Standards Board (FASB), ASB members are all AICPA volunteers and are not required to sever ties with their employers. In its present mode of operation, the ASB brings in revenue for the exclusive beneﬁt of members of the profession as well as creating a legal defense in the case of a lawsuit arising from an audit. Abbott (1988) refers to this as a jurisdictional claim. Over the past quarter of a century, there have been many critics of the ASB, but the accounting profession resisted making any signiﬁcant changes in either the Board’s composition or its operations. Given this background, this paper involves the following sections: a review of the auditing standardsetting process, criticisms and recommendations for a change in the ASB’s operations, beneﬁts to the profession of the current structure, and a call for a restructuring of the ASB in light of the recently signed Sarbanes-Oxley Act of 2002.

Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 29–44 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160024

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INTRODUCTION If a profession were allowed to select two privileges involving its operations, those chosen might very well be those same ones accorded to the accounting profession in the United States: a monopoly over its services, and the right to promulgate the speciﬁc procedures that deﬁne these services. The ﬁrst beneﬁt was conferred in 1933 and represents a monopoly regarding the audits of publicly traded companies. The second was bestowed in 1939 and is the ability to determine the ofﬁcial rules and procedures that constitute an audit. While the former prerogative brings in revenue for the exclusive beneﬁt of members of the profession, the latter is especially propitious, for it is capable of not only generating revenue, but also, creating a legal defense in the case of a lawsuit arising from an audit. Abbott (1988), in his acclaimed work, The System of Professions,1 refers to the above phenomenon as a jurisdictional claim, which is the claim before the public for the legitimate control of a particular work (p. 59). However, as will be discussed in this paper, Congressional critics and others claim that the accounting profession has not lived up to society’s needs in performing its public service, especially given the recent collapses of Enron and WorldCom. Accordingly, they have called for reforms in the manner in which auditing standards are promulgated. Yet the accounting profession, except for some minor modiﬁcations that will be addressed later, continues to resist the calls for any signiﬁcant modiﬁcation of its oligarchical agent, the Auditing Standards Board (ASB). Given this background, the focus of this paper involves an examination of the ASB, the ofﬁcial body that creates these rules that govern the audits of companies – publicly traded and non-public. Abbott’s work, in large part, is used to explain the accounting profession’s behavior towards the resistance of change in the auditing standard-setting process in the U.S. The paper consists of the following sections: a review of the auditing standard setting process, criticisms and recommendations for a change in operations, beneﬁts to the profession of the current structure, and a call for a restructuring of the ASB. The recent events involving Arthur Andersen LLP and its association with the Enron and WorldCom collapses, which have engendered calls for increased oversight and reforms in the accounting profession, help serve to make our research timely.

THE AUDITING STANDARD-SETTING PROCESS The accounting profession retained its authority over audit standard setting in the wake of the McKesson-Robbins fraud of the 1930s by prompt response to concerns for more effective processes, and despite a lengthy inquiry by the SEC into the issues of the event (Previts & Merino, 1998, pp. 294–296). In 1939,

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the Committee on Auditing Procedure (CAuP) was established by the American Institute of Accountants, predecessor to the American Institute of Certiﬁed Public Accountants (AICPA). The Auditing Standards Executive Committee (AudSEC) replaced the CAuP in 1972, and evolved into the present organization, the Auditing Standards Board (ASB) in 1978. At the present time, the ASB is a senior technical committee of the AICPA. The Board consists of 15 members, representing individuals from each of the four largest audit ﬁrms,2 another three from other national ﬁrms, and ﬁve from small and regional audit ﬁrms, a person from a local, state, or federal governmental unit (currently from a state auditor’s department), one accounting academic, and a vacant position created by the resignation of the Arthur Andersen representative. A critical point to note is that unlike the Financial Accounting Standards Board (FASB), ASB members are AICPA volunteers and are not required to sever ties with their employers (parent organizations). The stated objective of the ASB is, “To develop and communicate performance and reporting standards and practice guidance that enable the public auditing profession to provide high quality objective attestation services at a reasonable cost and in the best interests of the profession and the beneﬁciaries of those services, with the ultimate purpose of serving the public interest” (AICPA, 2002a). The importance and power of the ASB is immense, since these standards and procedures must be adhered to in conducting audits, and the ASB is the exclusive promulgator of these auditing rules, called Statements on Auditing Standards (SASs).3 The AICPA states that the evaluation of a SAS (as well as SSAE) is the result of a due process procedure (AICPA, 1992, p. 13). A proposed pronouncement is developed by a task force composed of members of the ASB and other individuals who possess technical expertise in the subject matter of the project, after which an exposure draft (ED) is placed on the ASB’s website for comment.4 Comments are then collected for at least a 60-day period (normally 90 days) and reviewed by the ASB. Other matters that are contained in the comment letters that the Board did not consider previously are then evaluated. The ASB then usually issues the ED as a ﬁnal standard. A member may cast either vote in one of these manners: assent, assent with qualiﬁcation and dissent. If a member casts an assent with qualiﬁcation or a dissent vote, the reason for the objection must be included in the SAS.

CRITICISMS AND RECOMMENDATIONS FOR CHANGE IN OPERATIONS OF THE ASB Although the ASB has not received either the same degree of attention in the media and the criticism by the ﬁnancial community that the FASB has engendered, the ASB’s operations have been scrutinized on occasion, especially over the past

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twenty-ﬁve years. This scrutiny has come from various parties, including one U.S. Senate and two U.S. House of Representatives investigations. Perhaps the most exhaustive study was conducted in 1976, by the late Senator Lee Metcalf (D-Montana) who chaired a U.S. Senate committee that examined the U.S. accounting profession and released a 1,700-page diatribe titled The Accounting Establishment (U.S. Senate, 1976). Table 1 list a summary of the major criticisms and recommendations of the Metcalf and other committees pertaining to the ASB: the Cohen Commission, (CAR, 1978); the Oliphant Committee (Oliphant, 1978); the Treadway Commission (Treadway, 1987); the General Accounting Ofﬁce (GAO, 1996); and the panel on Audit Effectiveness, 2000 (PAE, 2000). At about the same time, another government ofﬁcial, Representative John Moss (D-California), also investigated the accounting profession and recommended that the SEC prescribe the auditing standards that public accountants follow in certifying ﬁnancial statements that are ﬁled with the SEC (GAO, 1996, p. 112). These recommendations should not have taken the accounting profession by surprise, for Davidson and Anderson (1987, p. 126) state that by 1974 congressional critics of the accounting profession began to ask “whether independent auditors were living up to the expectations of the investing public.” In response to the criticisms of Metcalf and Moss, the AICPA formed a task force (the Cohen Commission) which issued a report The Commission on Auditors’ Responsibilities: Report, Conclusions and Recommendations (CAR, 1978). Representative John Dingell (D-Michigan), chairman of the Energy and Commerce Subcommittee on Oversights and Investigations, followed the lead of Metcalf and Moss by conducting hearings involving the accounting profession in the 1980s and 1990s, oftentimes focusing on well publicized audit failures. The committee was very outspoken. One member, Rep. Ronald Wyden (D-Oregon), on two occasions, warned SEC Chairman John Shad that the SEC was “. . . inviting Congress to step in and write a whole new set of rules” (Ingersoll, 1991, p. 50). Furthermore, he labeled Ernst & Whinney as “essentially a three time loser” for its involvement in three audit failures (p. 50). He also categorized the accounting profession’s Public Oversight Board as the “Private Oversight Board,” arguing that the self regulation of the public accounting profession is inherently ﬂawed, since, “This is an industry where the same people write the rules, interpret the rules, and enforce the rules” (p. 50). Chairman Dingell even once compared his committee’s investigation of the accounting profession to a quail hunt, using the metaphor to emphasize his perception of the magnitude of the profession’s deﬁciencies. “You’re talking to a quail shooter. I always use good dogs, and I never go into a ﬁeld where I don’t think there are quail” (Berton & Ingersoll, 1990, p. 47). In 1977, the AICPA appointed another group, the Oliphant Committee, to review the structure within the AICPA by which auditing standards are developed

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Table 1. Criticisms of the ASB by Various Committees. Source (Reference)

Primary Criticism(s)

Primary Recommendations(s)

Metcalf Committee, 1976 (U.S. Senate, 1976)

1. National ﬁrms dominate the establishment of auditing standards through membership on the AudSEC (predecessor to the ASB). 2. No mechanism for public participation in establishing auditing standards.

1. Federal government should establish auditing standards through the GAO, SEC, or by Federal Statute.

Cohen Commission, 1978 (CAR, 1978)

1. AudSEC too large, members work part time.

1. AudSEC should be reduced from 21 members to a smaller full time board compensated only by the AICPA.

Oliphant Committee, 1978 (Oliphant, 1978)

1. AudSEC too large, no representation from individuals outside the profession.

1. AudSEC be reconstituted as the ASB, allowing individuals with extensive audit training to serve on the Board, even if not a member of the AICPA.

Treadway Commission, 1987 (Treadway, 1987)

1. ASB promulgates auditing standards that are too narrow.

1. ASB be restructured to include knowledgeable person whose concern is with the use of auditing products. 2. ASB be composed of equal number of auditing practitioners and person not engaged in public accounting, selection based on expertise rather than constituencies.

2. No mechanism for public participation in establishing auditing standards.

General Accounting Ofﬁce, 1996 (GAO, 1996)

1. No mechanism for public participation in establishing auditing standards.

1. Appoint knowledgeable non public accounting practitioners to the ASB.

Panel on Audit Effectiveness (PAE, 2000)

1. No mechanism for public participation on AICPA various self regulating bodies.

1. Public Oversight Board (POB) should oversee the ASB, including approval of all appointments to the ASB. 2. Majority of ASB members be from audit ﬁrms that provide attest services to SEC clients.

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and to recommend any changes deemed necessary to improve the process. The committee’s ﬁndings, are titled the Report of the Special Committee of the AICPA to Study the Structure of the Auditing Standards Executive Committee (Oliphant, 1978). A decade later, the National Commission on Fraudulent Financial Reporting (the Treadway Commission) issued a document, Report of the National Commission on Fraudulent Financial Reporting, which criticized both the ASB and the process by which it develops auditing standards for promulgating standards which were deemed to be too narrow. A notable recommendation of the Commission was that the ASB be reconstituted to include an equal number of auditing practitioners and persons not employed in public accounting (outside members). The resistance to this proposal was viewed with disdain by the accounting profession, who apparently regarded the potential outside ASB members as interlopers. For example, Hugh Marsh, a member of the Commission, stated that this recommendation was the most controversial of all the recommendations involving the public accounting sector and that the chairman of the AICPA was speaking against it in public forums. He added that the resistance came entirely from the upper levels of the accounting professions and was one of the key issues in the response by the chairmen of the (then) Big Eight accounting ﬁrms to the exposure draft report (p. 37). Marsh countered, protesting the accounting profession’s phalanx by stating: “We of the Commission felt strongly that this participation by non-practicing members would enhance the credibility of the standard-setting process signiﬁcantly and take away some of the secrecy inherent in a standards setting group which is totally within the practicing profession” (Marsh, 1988, p. 36). The GAO released a report in 1996 that analyzed the extent to which recommendations made to the accounting profession by major study groups had been implemented (GAO, 1996). A large section of the report focused on those involving the ASB and the auditing standard setting process. It stated, in agreement with the SEC Chief Accountant, that if more knowledgeable non-public accounting practitioners were appointed to the ASB then the auditing standards would “better meet the public interest” (GAO, 1996, p. 123). Furthermore, in 1998 the chairman of the SEC requested the Public Oversight Board (POB) to appoint The Panel on Audit Effectiveness (PAE) to thoroughly examine the current audit model. In mid-2000, the PAE issued its document, titled Report and Recommendations (PAE, 2000). One recommendation was that the POB oversee the ASB and in that capacity would approve all appointments to the ASB. The ASB appointment oversight authority was granted to the POB in 2001, however the POB voted itself out of business in 2002 in response to SEC

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Commissioner Harvey Pitt’s recommendation (2002) to replace it with a new oversight Board. Pitt’s proposed Board, which was a result of the Enron collapse, would have been composed largely of individuals independent of the accounting profession. Lynn Turner, the former SEC chief accountant, stated that the proposed Board “falls way short.” Turner believes that all of the new Board members should be chosen from outside of the profession and also have the power to establish auditing standards (Smith & Schroeder, 2002, p. C15). In early 2002, Turner’s structure was endorsed by the GAO (2002a), who recommended that such a Board be formed. This recommendation to establish a new Board, whose functions would include the establishment of professional standards including auditing standards, was reafﬁrmed in a May 2002 letter to Senator Paul Sarbanes from David M. Walker, Comptroller General of the United States (GAO, 2002b, p. 77). On July 30, 2002, President George W. Bush signed the Sarbanes-Oxley Act of 2002 (P. L. No. 107–204) which involves corporate governance and oversight of the accounting profession. This legislation establishes a ﬁve member panel called the Public Company Accounting Oversight Board (PCAOB). Only two members may be CPAs and if the chairperson is a CPA, he or she may not have been a practicing CPA for at least ﬁve years prior to his or her appointment to the PCAOB (P. L. No. 107–204, Sec. 101). The PCAOB will, among other things, oversee the audits of companies that are subject to Securities Act of 1933 and 1934. At this point the SEC’s relationship with the ASB should be mentioned, especially since it will oversee the new PCAOB. Although the SEC has generally been supportive of the ASB, Lynn Turner, a former Chief Accountant, emphasized the SEC’s authority to write, modify, or supplement auditing standards in a comment letter to the ASB involving the ED of SAS No. 95, Generally Accepted Auditing Standards (AICPA, 2002b). In his letter, Turner suggested that this authority be disclosed in summary fashion in a footnote to SAS No. 95, and the ASB complied (Turner, 2001, pp. 1–2). Furthermore, an individual who is very knowledgeable regarding the auditing standard-setting process stated that the SEC often prods the ASB to place issues on its agenda. These actions underscore the SEC’s desire not to abrogate its authority in the establishment and oversight of auditing standards, and will, no doubt, continue to so through the PCAOB. Having reviewed several calls for a restructuring of the ASB, the question arises then, as to why the accounting profession has repeatedly assumed an immutable posture against change, especially in allowing outsiders to sit on the ASB.5 The answer is provided by analyzing the rewards accruing both to the profession and also to audit ﬁrms who have an employee serving on the ASB under the current structure.

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ADVANTAGES AWARDED TO THE PROFESSION AND MEMBER FIRMS BY THE ASB The primary beneﬁts accruing to the accounting profession from the ASB’s current structure discussed in this section are those associated with the establishment of audit rules (standards). The Metcalf Committee, offered the following observation regarding the auditing standard-setting process: “The accounting profession and ultimately the public, depend on auditing standards to establish the reliability of ﬁnancial statements, but the Auditing Standards Executive Committee operates autonomously on behalf of the AICPA. There are no provisions to guarantee public participation in the process” (p. 91). As Robson et al. (1994, p. 531) state, occupations seek to afﬁrm their professional status as resulting from a social contract between itself and the public. In the case of the accounting profession this results from its monopoly status in attesting ﬁnancial statements. As stated earlier, Abbott (1988, p. 60) refers to this as a “jurisdictional claim,” which is a claim before the public for the legitimate control for a particular kind of work. Abbott goes on to state that this assertion involves, ﬁrst and foremost, a right to perform the work as the profession desires. It also includes the right to exclude other workers (non-CPAs), to create the public deﬁnitions of the tasks involved, as well as professional deﬁnitions of the tasks to competing professions (p. 60). Furthermore, a profession may further its agenda by controlling its abstract knowledge system which in turn generates the practical techniques of its workers. Such a knowledge system has the power to redeﬁne its problems and tasks, defend them from interlopers, and seize new problems (p. 9). Applying Abbott’s framework to the ASB, the deﬁnition of the problems and tasks become the SASs, and the defense against interlopers is the resistance to the appointment of outsiders to the ASB. The above analysis partially explains the behavior of the accounting profession in resisting calls for restructuring of the ASB. However, besides these general beneﬁts, the speciﬁc beneﬁts accruing to the profession and/or individual ﬁrms from the current system should also be examined. These fall under the following categories: revenue production, ologarichal status of national ﬁrms, limitation of the legal liability for individual ﬁrms, and legitimizing the audit ﬁrm approach. Revenue Production The ASB’s ability to increase revenue for its members stems from its ability to prescribe the standards for attestation (i.e. SASs and SSAEs). The more

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complicated the promulgation of standards, the more revenue it generates for the large member ﬁrms that do audits. This overt strategy has also led to a protest by small practitioners, who feel that such esoteric SASs place a burden on their ability to compete in a system of increasingly complex rules. This schism was accelerated by the “conglomeration of industries” phenomenon cited by Abbott (1988, p. 25). Abbott states that when the accounting profession took a “divergent change” in the twentieth century, local accountants were replaced by “conglomerate accountants.” The end result was a few giant, transnational ﬁrms versus individuals and small partnerships doing a completely different type of local business. Martens and McEnroe (1998) provided empirical evidence of the revenue producing ability of the ASB, especially for the beneﬁt of large audit ﬁrms. They found that after the ASB issued the ED for SAS 72, it subsequently modiﬁed the ﬁnal SAS in order to protect the prices charged for comfort letters (p. 367).

Oligarchy Status of National Firms Over twenty-ﬁve years ago, the Metcalf Committee stated that the national ﬁrms dominated the auditing standard-setting process (U.S. Senate, 1976, p. 11) and chief ﬁnancial ofﬁcers believe this still to be the case (McEnroe, 2000, p. 30). The CFO’s also perceive that national audit ﬁrms maintain a greater advantage than other parties in achieving comment integration into the ﬁnal SAS (p. 30). Although studies by McEnroe (1993) and McEnroe and Martens (1998) found no evidence of an advantage of national ﬁrms having their comments integrated into a ﬁnal SAS versus other parties, the research of Kaplan and Pany (1992) found evidence that the large ﬁrms were more successful than others in lobbying before the ASB. McEnroe (1994, 2002) examined the voting behavior of members of the ASB involving the issuance of the expectation gap SASs (EGSASs), SAS Nos. 53–61, and post expectation gap SASs (PEGSASs), SAS Nos. 62–87. In the 1994 study, covering the EGSASs, he found that agency relationships existed in the voting patterns of certain ASB members and the ﬁrms that employ them. In addition, he found that there was often a strong correlation between an ASB member’s reason listed for an objection to a SAS and his/her parent organization’s position as expressed in a comment letter submitted to the ASB. In his 2002 study, covering the PEGSASs, he found that “agency” voting behavior is still evident. He also found that there is less participation, as measured by the submission of comment letters regarding a proposed SAS, on the part of organizations who have an employee serving on the ASB. Although the AICPA states that the development of a SAS is the result of a due process procedure, there is certain evidence to the contrary. For example, in the

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development of SAS 82, Considerations of Fraud in an Audit (AICPA, 1997), the AICPA apparently vetted the ED to the legal departments of the (then) Big Six audit ﬁrms before revealing it to the other parties for their input. In examining the comment letters responding to the ED, Martens and McEnroe (2001) found that three of the letters mentioned a meeting consisting of the National Accounting and Auditing Symposium where an AICPA representative reportedly declared that attorneys representing the (then) Big Six audit ﬁrms had already analyzed the proposed standard and had concluded that it would not increase auditors’ exposure to legal liability. As further evidence of a concentration of the national audit ﬁrms controlling the audit standard-setting process, consider the following. In an interview conducted by Carmichael and Craig (1994, p. 45) of ﬁve sitting ASB members, the following question was asked: Do members of the large ﬁrms dominate the process? The ASB member stated: “The large ﬁrms send their best talent, supported by the technical resources of their organizations. It is difﬁcult for local practitioners to be as prepared for discussions as the large ﬁrm representatives. The present members respect the views of all members. The large ﬁrms by no means vote as a block or seem to demonstrate common interests or points of view. The task-force chairs tend to be members from the large ﬁrms. I think local practitioners should have more opportunity to provide leadership by serving as task-force chairs.” When asked if ASB members were voting on their own versus on their ﬁrm’s behalf, the member stated that he “only noticed it one or two times” when an individual was voting his/her position rather than “what he or she thought was right for the profession” (p. 45). This observation contrasts with the evidence of lobbying behavior in the McEnroe studies (1994, 2002) which will be discussed in a subsequent section. Further evidence of an oligarchy is revealed by a couple of observations by Arens (1993, p. 44) who stated that, the Vice President of Auditing of the AICPA and the ASB Chair “almost completely control” the issues the ASB addresses and that these same individuals select all of the ASB members except the (then) Big Six. As Arens states, “This puts them in a position to signiﬁcantly inﬂuence auditing standards by who they select as members” (p. 44).

Limit the Exposure to Liability The ability to limit the liability of its members through the deﬁnition of the task is probably the second greatest privilege accruing to the ASB. A case in point is the issuance of SAS 82, Consideration of Fraud in a Financial Statement Audit.

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Martens and McEnroe (2001) analyzed the events leading up to and including the release of the SAS. The authors contended that although the stated purpose of the SAS was to clarify the auditors’ responsibilities in the area of fraud detection, the actual intent was an attempt by the AICPA to lower public expectations as to auditor’s responsibilities involving fraud detection. Indeed, an AICPA representative even characterized a series of panel presentations of ASB members and the Fraud Task Force as “road show” presentations (Landsittel & Bedard, 1997, p. 5). As further evidence of the professions ability and desire to limit the liability of auditor, consider the following observation of Arens: “It is obvious from being on the ASB that the driving force in setting auditing standards now is legal liability. Given that fourteen of the ASB members are practitioners, this is completely understandable. Many practitioners, including those on the ASB, believe that the extensive exposure to legal liability puts the existence of the profession at risk. Many members also believe that their life savings are jeopardized by the legal liability crisis. Given that environment, it is not surprising that potential legal liability is the driving force in any deliberation by the ASB. It may not be in the best long-term interest of the profession to have liability considerations dominate auditing standard-setting, but in the present environment, it is likely to remain the key factor” (1993, p. 43). This ability to limit the legal liability through the formation of a SAS awards the profession great power, for as Abbott (1998, p. 136) notes, if the public accepts an incumbent’s deﬁnitions of its problems, the incumbent requires an enormous power over opponents whose case depends on new deﬁnitions.

Legitimization of Audit Firm Approach Another beneﬁt to the ﬁrms (parent organizations) who have employees serving on the ASB is the possible adoption of their audit approach as a SAS. Kinney (1986, p. 77), a former member of the ASB, has stated that audit ﬁrms may beneﬁt from SASs in several ways, including a perception of increased quality of the audit, decreased training costs (given that SASs are taught in colleges and universities), reduced legal liability, and avoidance of government intervention in the regulation of auditing. However, Kinney argues that although the beneﬁts of new SASs apply to all auditors, they may vary across ﬁrms. As an example, an SAS that would increase the structure of an audit would be less costly for a ﬁrm that maintains a structured audit appraisal and more exposure for those that employ an unstructured approach. Thus, structured ﬁrms would likely support SASs that require increased audit actions versus unstructured ﬁrms who would not be expected to support them.

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Thus, Kinney states that different ﬁrms have different economic interests in the adoption of certain SASs, and that to satisfy those interests may require a major commitment of the ﬁrm’s employees’ time to the auditing standard-setting process; including besides ASB membership, AICPA task forces and sub-committees. He concluded that “the auditing standards environment provides a direct link between standard-setting behavior and economic self interest.” But the question arises to what extent do ASB members engage in lobbying for their ﬁrms’ agendas? In a study of ASB voting behavior on the expectation gap SASs, McEnroe found that if no letter involving an ED was on ﬁle by the parent organization, or if the parent was in favor of the ED, there was about a 95% probability that ASB member will cast an assent with qualiﬁcation or assent vote. If, however, the parent opposed the ED via a negative letter, the proability increased to 35% that he would dissent to the SAS (1994, p. 126). Similar results were found in the McEnroe (2002) study, involving the post expectation gap SASs. Another analysis combined the assent with qualiﬁcation and the dissent votes in a “total protest category.” In this exercise, it was thought that if the parent organization objected to the ED, although the ASB member might not cast a dissent vote, he might cast a qualiﬁcation to his assent. The results showed that if the parent organization was against the ED, there was a 50% chance that the ASB member would cast either an assent with qualiﬁcation or dissent vote. If there was no letter on ﬁle, however, opposing the ED, the probability of voting a pure assent vote was about 85%. Lastly, McEnroe listed 12 examples of parent organization’s positions that closely resembled the ASB member’s objection in the ﬁnal SAS for eight different ﬁrms (seven national ﬁrms). He concluded that his narrative analysis that the parent organization’s position is being voted on and recorded in the SAS through their ASB member’s objection (1994, p. 130). Subsequent research by McEnroe (2002) on the post expectation gap standards found such agency voting behavior to be the status quo. As a result, there is evidence that certain audit ﬁrms with ASB member/employees are using the ASB as a vehicle to further their interests.

CALL FOR REORGANIZATION OF THE ASB As previously mentioned, the PCAOB is the new body that will oversee and regulate accounting ﬁrms that audit public companies. Since the PCAOB will have no more than two CPAs, it is unlikely that they will directly establish auditing standards. Rather, it will probably subcontract that function to the ASB6 and “jawbone” the ASB when it deems appropriate to issue or strengthen certain standards. In

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addition, there will still be a need for auditing standards to be established for audits of non-public companies. Given these events and the deﬁciencies of the current auditing standard-setting process cited, it is our proposal that the ASB should be restructured. The authors believe that it is the opportune time for the ASB to establish its credibility and expertise in the audit standard-setting arena. Three issues need to be considered: funding, structure, and reporting. Currently, the ASB is funded solely by the AICPA. To improve the independence and authority of the ASB, an alternative funding source must be obtained. One possible funding source would be the PCAOB. Public accounting ﬁrms and audit partners who have ﬁlings with the SEC will now be required to register with the new board and pay annual registration fees. These registration fees, along with other fees for services such as peer reviews, would cover the full costs of the board; they could also be used to fund the ASB. As to the structure, several matters are recommended. First, it should be a full-time board structured in a similar manner to the FASB. Second, all members (with the exception of an academic member) would be required to sever their membership from their ﬁrms or employers and not be allowed to rejoin the organization when their tenures on the ASB end. Third, in accordance with the Treadway Commission’s recommendation, the ASB would be comprised of an equal number of former auditing practitioners and individuals not engaged in public accounting but are qualiﬁed and knowledgeable about auditing (outside or public members). Fourth, the ASB should consist of ten members. This size is within the range of 8 to 12 suggested by the Treadway Commission but is larger than the ﬁve members of the PCAOB. This size was chosen to be large enough to be representative of those who would use the ASB’s products, but small enough to be efﬁcient in its standard-setting function. The ﬁve former auditing practitioners would be selected as follows: one from the Big Four ﬁrms, one from the other national ﬁrms, two from the Practice Group B ﬁrms (regional and large local ﬁrms), and one from a small (less than 10 professionals) ﬁrm. The ﬁve public members would be selected as follows: one from academia, one from internal auditing, one from a governmental unit or agency, and two other individuals who are qualiﬁed and knowledgeable about auditing including those with a background in international auditing standard setting. The third issue regarding the new board is its reporting responsibility. Besides reporting to the PCAOB, the new ASB should also report annually to the public, the SEC, and Congress. The report might include the results of audit standard setting and the coordination with other standard-setting bodies. The auditing profession maintains a position of public trust. It has enjoyed a state sanctioned monopoly over its services since 1933. However, the increasing

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number of audit failures and the inevitable question of “where were the auditors” might erode conﬁdence in the profession to the extent that its monopoly status might be revoked. As a result, others (e.g. ﬁnancial service companies) might be allowed to perform audits. The proposed structure and funding should address the problem of agency voting and the focus on limiting the liability of auditors. Finally, such an ASB could promulgate the auditing standards that as the GAO stated might “better meet the public interests” (1996, p. 123). In summary, it is too early to speculate how active the PCAOB will be in the auditing standard-setting arena. In any event, the ASB ofﬁcial subjugation to the PCAOB is a loss of power and prestige to the accounting profession, and is, in part, a consequence in some measure of the deﬁciencies of the current system that are discussed earlier in this paper. Future research should be undertaken to document the outcome of this power-sharing scheme and the “true” power in auditing standard setting. In the meantime, the implementation of the ASB model as proposed in this paper may serve to restore both the public trust and conﬁdence in the profession.

NOTES 1. This work was the winner of the 1991 Distinguished Publication Award of the American Sociological Association. 2. Currently, the Chair of the ASB is from a Big Four ﬁrm. 3. Besides developing SASs, the ASB is responsible for: (1) Statements on Standards for Attestation Engagements (SSAEs); (2) being alert to new oportunities to serve th epublic; and (3) providing guidance in the implementation of its pronouncements (AICPA, 1992, p. 1). 4. A two-thirds majority approval by the ASB is necessary for the release of the ED, as well as the passage of the SAS. 5. However, in recent conversations with two individuals involved with the ASB, one individual revealed that as a concession as a result of the recent events, the ASB will probably appoint another academic member. The other individual stated that they believe that non-AICPA members are likely to be appointed to the ASB in the near future. 6. Sec. 3 of the Sarbanes-Oxley Act of 2002 states, “The Board shall, by rule, establish, including, to the extent it determines appropriate, through adoption of standards proposed by 1 or more professional groups of accountants designated pursuant to paragraph (3) (A) or advisory groups convened pursuant to paragraph (4), and amend or otherwise modify or alter, such auditing and related attestation standards, such quality control standards, and such ethics standards to be used by registered public accounting ﬁrms in the preparation and issuance of audit reports, as required by this Act or the rules of the Commission, or as may be necessary or appropriate in the public interest or for the protection of investors” (P. L. 107–204).

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McEnroe, J. (1994). An examination of voting behavior of the ASB. Journal of Accounting, Auditing, and Finance, 9(1), 117–147. McEnroe, J. (2000). The auditing standards board and the auditing standard-setting process. Internal Auditing (July/August), 25–31. McEnroe, J. (2002). An analysis of post expectation gap voting behavior by the ASB. Abacus (forthcoming). McEnroe, J., & Martens, S. (1998). An examination of the auditing standards promulgation process involving SAS No. 69. Journal of Accounting and Public Policy (17), 1–26. National Commission on Fraudulent Financial Reporting (Treadway Commission) (1987). Report of the National Commission on Fraudulent Financial Reporting. Oliphant, W. (1978). Report of the Special Committee of the AICPA to study the structure of the Auditing Standards Executive. New York: AICPA. Pitt, H. L. (2002). Public statement by SEC chairman: Regulation of the accounting profession (January 17). Washington, DC: SEC. P. L. 107–204, Sarbanes-Oxley Act of 2002. Previts, G. J., & Merino, B. D. (1998). A history of accountancy in the United States: The cultural signiﬁcance of accounting. Columbus: Ohio State University Press. Robson, K., Willmott, H., Copper, D., & Puxty, T. (1994). The ideology of professional regulation and the market for accounting labor: Three episodes in the recent history of the U.K. accounting profession. Accounting Organizations and Society (19), 527–533. Smith, R., & Schroeder, M. (2002). Pitt’s SEC Plan for self-regulation of accountants may have pitfalls. Wall Street Journal (January 18), C15. The Panel on Audit Effectiveness (PAE) (2000). Report and recommendations. Stamford, CT: Public Oversight Board. Turner, L. E. (2001). Comment letter No. 1 to the Auditing Standards Board (June 4). U.S. Senate (1976). The accounting establishment. A staff study prepared by the Subcommittee on Reports, Accounting and Management of the U.S. Senate Committee on Governmental Operations, 94th Congress, 2nd Session. Government Printing Ofﬁce, Washington, DC.

THE ORIGINS OF THE SEC’S POSITION ON AUDITOR INDEPENDENCE AND MANAGEMENT RESPONSIBILITY FOR FINANCIAL REPORTS Nathan Felker ABSTRACT Contemporary legislation recently enacted by Congress seeks to reinforce the responsibility for ﬁnancial statements with the ﬁnancial ofﬁcers and executives of SEC registrants. This paper reviews the development of SEC policy and case law regarding the established and traditional view of such responsibility as it affects auditors and ﬁnancial ofﬁcers and executives of these companies. The Cornucopia Gold Mines (1936) and Interstate Hosiery Mills (1939) actions reﬂect the origins of long standing views as to the role and responsibility of executives and auditors.

INTRODUCTION The notions of auditor independence and management responsibility for company ﬁnancial records have become fundamental principles in the SEC’s regulation of ﬁnancial disclosure by covered ﬁrms.1 The enforcement action against Cornucopia Gold Mines (1936) would establish, early in the SEC’s regulatory existence, its position on the necessity for independent outside auditors to review a disclosing Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 45–60 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160036

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company’s accounting work. Three years later, the Commission’s action against Interstate Hosiery Mills (1939) would afﬁx on a disclosing ﬁrm’s management the ultimate responsibility for the integrity of the company’s ﬁnancial statements, even if problems in those statements result from the work of the audit ﬁrm. The precedents developed in these actions would be cited repeatedly as the SEC considered similar matters in subsequent proceedings. Included below are detailed summaries of both enforcement actions, stating the basis of the SEC’s action, the relevant factual background, the SEC’s opinion and the ruling based on that opinion. Following each summary is a brief assessment of the opinion offered by the SEC as well as a citation history of the treatment given to these decisions by the SEC in subsequent actions and Commission pronouncements.

IN THE MATTER OF CORNUCOPIA GOLD MINES File No. 2-1200; 1 SEC 364 (March 28, 1936) Issue The action against Cornucopia Gold Mines was brought by the SEC under Section 8(d) of the 1933 Securities Act, regarding the effectiveness of Cornucopia’s registration statement. Speciﬁcally, the SEC alleged that Items 50, 54, & 55 of the registration statement ﬁled by Cornucopia, as well as the prospectus which contained the same information, were deﬁcient. The crux of the SEC’s argument was that the dual role of David Hill as both comptroller of Cornucopia as well as independent auditor for the company (as an employee of White and Currie) caused a failure of the independence requirement contained in the registration’s certiﬁcation statement. Factual Background Cornucopia Gold Mines, which was incorporated in 1930 in Washington State, ﬁled a registration statement under Form A-1 in November of 1934. The registration became effective on April 5, 1935. Cornucopia contracted with White and Currie, a local accounting ﬁrm to perform the audit of its books. According to the contract, White and Currie were to be paid $5,000 per year plus 1% of the annual metal sales. The contract included that, in addition to auditing services, White and Currie was to put in place an accounting system for Cornucopia and provide the company with ofﬁce space. Finally, under the arrangement, David Hill, an employee of White and Currie, was made the comptroller of Cornucopia in December 1934. David Hill’s entire salary was paid by White and Currie. The record further showed that David

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Hill had purchased 1,760 shares of Cornucopia prior to ﬁling of the Registration statement with the SEC. As comptroller, David Hill supervised employees doing accounting work as well as signed checks and mailings. In preparation of the registration statement, David Hill signed the statement as Comptroller of Cornucopia, however, he also performed the audit of the company’s Balance Sheet and Proﬁt & Loss statements on behalf of White and Currie. The auditing ﬁrm then issued a certiﬁcate, as required under Schedule A (26) of the 1993 Act, stating that the ﬁnancial statements had been audited by an independent certiﬁed accountant. SEC Proceedings and Opinion The SEC claimed that David Hill’s status as comptroller of Cornucopia as well as employee of White and Currie caused the auditor’s certiﬁcate, ﬁled in connection with Cornucopia’s registration statement, to be false and misleading, as White and Currie was in fact not independent. The SEC reasoned that David Hill could not have disassociated himself from his role as the chief ﬁnancial and accounting ofﬁcer as well as shareholder of Cornucopia in performing the independent audit. The audit would have required that he inspect the company’s books and accounting practices with objectivity and be willing to criticize or correct problems that were detected – problems that he himself would have taken part in creating. Consequently, White and Currie could not be considered independent since Hill’s audit work in connection with the issuance of the auditor’s certiﬁcate was performed on behalf of the auditing ﬁrm. The SEC found that White and Currie further failed to establish its status as an independent auditor due to its interest in 1% of Cornucopia’s annual sales. The contract was held to create a continuing pecuniary interest in the registrant. Although such an interest does not per se cause an auditor to lose its objectivity, the interest in this case was material and substantial enough to disqualify the auditor’s objectivity. The SEC stated that a claim of this sort would give the holder too close an association with the ﬁnancial performance of the company and cause too much personal concern with the management of Cornucopia to allow the holder to exercise the “objectivity which is the essence of an independent accountant.” The SEC rejected Cornucopia’s argument that even if certiﬁcation of the registration statement was not issued by an independent auditor, it is of no consequence since the certiﬁcate itself is not a material fact – it is merely a tag attached to the ﬁnancial statements signifying the propriety of the information within the statements. It was the SEC’s position that certiﬁcation by an independent auditor is material “for it gives meaning and reliability to ﬁnancial data and makes less likely misleading or untrue ﬁnancial statements.” The real function of the 1933 Act’s insistence on certiﬁcation by an independent auditor is

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the submission of the registrant’s accounting practices and policies to an impartial independent mind. This review provides a level of protection for investors against falsehoods and half-truths which could ﬁnd their way into ﬁnancial statements without such scrutiny. The history of ﬁnance demonstrates the need for this check against unsound accounting practices and support it provides for the truth of the ﬁnancial condition of the enterprise. The SEC found that Cornucopia’s answer to Item 50 in the registration statement was also deﬁcient in that it failed to list the interest in Cornucopia held by White and Currie. The language of Item 50 requiring that any expert or person (legal definition including corporations as well) employed by the registrant that is to receive an interest or payment from the registrant must be fully disclosed. In the opinion of the SEC, use of the term “employed” did not only include master and servant relationships but also independent contractors and, thus, included White and Currie. Therefore, White and Currie’s interest should have been included in Item 50. Ruling Therefore, the certiﬁcate’s assertion that the ﬁnancial statements had been reviewed by an independent public or certiﬁed accountant, and that the relationship between White and Currie and Cornucopia was that of the usual relationship of independent auditor to its accountant were untrue statements of material fact sufﬁcient to justify the issuance of a stop order denying effectiveness of Cornucopia’s registration statement under Section 8 of the 1933 Act. These deﬁciencies rendered the Balance Sheet and Statement of Proﬁt and Loss included in the Registration Statement to be similarly deﬁcient. Items 54 and 55 of Form A-1 require the ﬁling of a Balance Sheet and Proﬁt and Loss Statement. Schedule A requires that these Items be certiﬁed by an independent auditor. Since White and Currie and were not in fact independent, the statements submitted to the SEC did not comply with Schedule A and were, therefore, deﬁcient. In issuing its ﬁnal ruling, the SEC determined that it is not limited to review of the registration statement at the time of initiation of the proceedings and, therefore, allowed consideration of amendments ﬁled by Cornucopia subsequent to the effective date of the registration statement, which cured the deﬁciencies. In light of Cornucopia’s resolution of the deﬁcient registration statement, the SEC exercised its discretionary power and decided to dismiss the stop order proceedings in favor of Cornucopia.

Assessment of Auditor Independence There are a number of concepts dealing with auditor independence that resulted from the SEC’s opinion in Cornucopia (1936). The foremost is the importance

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of submitting ﬁnancial statements for review by independent auditors in order to provide assurance to investors of the reliability and veracity of the information. With this opinion, audit ﬁrms and disclosing companies were now expressly aware that the SEC considered the certiﬁcation of ﬁnancial statements a substantial element of the ﬁnancial disclosure and that audit ﬁrms should take notice of the signiﬁcance that is attached to their signing it. Accompanying this concept are two somewhat related issues. The ﬁrst is that an auditor who is both the outside reviewer of the company books, as well as the person in charge of preparing those books, cannot possibly give the sort of unbiased critical assessment that is required of an independent auditor. The second is where employees of the audit ﬁrm hold a pecuniary interest in the audit client which could cause them to become too concerned with the ﬁnancial performance and management of the company. While this does not per se defeat the independence of the auditing ﬁrm, an interest that is “substantial and material” can be deemed to cause the individual auditor(s) to lose their objectivity, “which is the essence of an independent accountant.” This opinion would serve as the basis for the degree of separation between the auditing ﬁrm and client necessary for the auditor to be considered “independent,” an issue that has become extremely relevant in recent times. These principles would be cited a number of times over the decades following the action against Cornucopia Gold Mines, typically in situations where the importance of independent review is coupled with one or both of the cases where the auditor has conﬂicting positions. Citation History – Review of Disclosure Documents by an Independent Auditor (In reverse chronological order) In the Matter of KPMG Peat Marwick LLP c/o Michael Carrol, Esq. Davis Polk & Wardell, 450 Lexington Ave., New York, New York 10017 (January 19, 2001), Admin. Proc. File No. 3-9500, SEC, Securities and Exchange Act of 1934 Release No. 43862; Accounting and Auditing Enforcement Release No. 1360, 2001 SEC LEXIS 98. Cited for precedent that an audit ﬁrm having a substantial pecuniary interest in an audit client defeats the independent nature of the auditor. The requirement that the ﬁnancial statements be audited and certiﬁed by independent auditors signiﬁes the real function of submitting the ﬁnancial statements to an impartial mind. The continuous ﬂow of reliable ﬁnancial data is critically important to the efﬁcient function of the securities markets.

In the Matter of Dixie Land and Timber Corporation (Section 8(d) of the Securities Act of 1933, as amended) (June 23, 1966), Admin. Proc. File No. 3-215; 2-2278, SEC, 1966 SEC LECIS 2371. Cited for notion that the lack of independence of the auditor causes the representations made to that fact as well as the ﬁnancial data in the registration statement to be false and misleading.

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Precision Microwave Corporation, Main Street, Mills, Massachusetts (January 11, 1963), File Nos. 2-18720 & 1-4583, SEC, 1963 SEC LEXIS 2451. In a matter involving auditor independence, quoted SEC’s opinion that certiﬁcation by an independent auditor signiﬁes the real function of which certiﬁcation should serve – submission of ﬁnancial data for review by an impartial mind.

In the Matter of Bollt and Shapiro, Theodore Bollt, and Bernard L. Shapiro, Proceeding Pursuant to Rule ii(e), Rules of Practice (January 28, 1959), SEC, Accounting Series Release (ASR) No. 82, 1959 SEC Lexis 1096, 38 SEC 815. Issuance of a certiﬁcation by an independent auditor reﬂects the importance to investors and the public that the information had been audited by an outside auditor and not management.

In the Matter of Touche, Niven, Bailey, & Smart, et al., Proceeding Pursuant to Rule ii(e), Rules of Practice. (March 25, 1957), File No. 4-77, SEC, Accounting Series Release (ASR) No. 78, 1957 SEC LEXIS 1014, 37 SEC 629. The insistence by the 1933 Act that the ﬁnancial statements be audited and certiﬁed by Independent auditors signiﬁes the real function of submitting the ﬁnancial statements to an impartial mind.

In the Matter of Associated Gas and Electric Company, Common Stock, $1 Par Value, and Class A Stock, $1 Par Value (August 4, 1942), No. 1610, File No. 1-1810, SEC, Securities and Exchange Act of 1934 Section 19(a)(2), 1942 SEC LEXIS 3051; 11 SEC 975. Cited for support that an auditor cannot be independent if a number of the auditors employees hold an interest in the audit client which is a substantial part of the client or the employees personal wealth.

In the Matter of Proceeding under Rule ii(e) of the Rules of Practice, to determine whether the privilege of Kenneth N. Logan to practice as an accountant before the Securities and Exchange Commission should be denied, temporarily or permanently. (January 8, 1942), SEC, 1942 SEC LEXIS 1942. Cited for the proposition that an interest in the audit client by employees of an audit ﬁrm that is so substantial with respect to the accountants net worth is sufﬁcient to defeat the independence of the audit ﬁrm.

In the Matter of Proceeding under Section 19(a)(2) of the Securities and Exchange Act of 1943, as amended, to determine whether the registration of A. Hollander & Son, Inc. Capital Stock $5 par value, should be suspended or withdrawn (February 6, 1941), File No. 1-627, SEC, Securities and Exchange Act of 1934, Release No. 2777, 1941 SEC LEXIS 1465; 8 SEC 586. An auditing ﬁrm is precluded from being considered independent (as part of the Certiﬁcation requirement) where it owns a pecuniary interest in the gross proceeds of the audit client.

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In the Matter of Rickard Ramore Gold Mines, Ltd. (June 16, 1937), File No. 2-2592, SEC, Securities Act of 1933, Release No. 1476, 1937 SEC LEXIS 986; 2 SEC 377. Cited as precedent in comparison of the ownership interest in the audit client with the level of independence required by an independent auditor.

In the Matter of American Terminals and Transit Company (September 29, 1936), File No. 2-1289, SEC, 1 SEC 701; 1936 SEC LEXIS 1759. Used to ﬁnd that the relationship of the auditor to the registrant did not fall short of the measure of independence established by the SEC in Cornucopia gold Mines.

Assessment of Other Concepts Developed in Cornucopia Gold Mines While not as signiﬁcant as the SEC’s opinion on auditor independence, there are a number of other positions that the action has been cited for. These include: (i) the materiality of the auditor’s certiﬁcate; (ii) the auditor’s certiﬁcate being subject to consideration for deﬁciency under §19(a)(2); (iii) the SEC’s discretionary power to consider, in its review, amendments ﬁled after initiation of the proceeding; (iv) the requirement for including under Item 50 of Form S-1 an attorney who issues an opinion on a ﬁrm in connection with a registration ﬁling and also owns stock in that ﬁrm; and (v) perhaps the most important of the ancillary issues, the materiality, substance and speciﬁc areas to be included in the auditor’s certiﬁcation. Citation History – Various Concepts In the Matter of Military Robot Corporation (April 15, 1986), File No. 3-6493, SEC, Securities Act of 1933, 1986 SEC LEXIS 2356; 48 SEC 473. Cited as support for proposition that the materiality of the Auditor’s Certiﬁcation of ﬁnancial data has long been recognized.

Qualiﬁcations and Reports of Accountants; Proposed Amendment of Rules Regarding Independence of Accountants (October 14, 1982), SEC, Securities Act of 1933 Release Nos. 33-6430; 34-19137; 35-22668; IC-12738; S7-947 17 CFR 210, 1982 SEC LEXIS 673. Cited as an example for SEC’s position that enforcement actions are used to assure the integrity of the concept of Auditor Independence.

In the Matter of Miami Window Corporation. (June 21, 1962), File No. 2-14766, SEC, Securities Act of 1933, Section 8(d), Release No. 4503, 1962 SEC LEXIS 644; 41 SEC 68.

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NATHAN FELKER Deﬁciencies in certiﬁcation are considerable under a Section 19(a)(2) review.

In the Matter of the Registration Statement of Kiwago Gold Mines Limited (No Personal Liability), 1102 Central Building, 45 Richmond Street, West, Toronto, Canada (March 31, 1948), File No. 2-6852, SEC, Securities Act of 1933, Section 8(d), Release No. 3278, 1948 SEC LEXIS 7; 27 SEC 934. Cited for discretionary power of SEC to consider amendments ﬁled after initiation of proceedings.

In the Matter of Mica Corporation of America (August 15, 1941), File No. 2–4675, SEC, Securities Act of 1933, Section 8(d), Release No. 2636, 1941 SEC LEXIS 225; 9 SEC 889. Cited for precedent that the attorney who issued an opinion on Mica Corporation also owned 100 shares of the company and should have therefore been listed in Item 50 of the Registration Statement.

Independence of Accountants; Indemniﬁcation by Registrant (March 14, 1941), SEC, Securities Act of 1933, Release No. 2498; Securities and Exchange Act of 1934, Release No. 2820; Accounting Series Release No. 22, 1941 SEC LEXIS 1413; 11 FR 10922. Cited for the review of auditor independence in a stop order proceeding.

In the Matter of National Electronic Signal Company (November 6, 1940), File No. 2-4381, SEC, Securities Act of 1933, Section 8(d), Release No. 2387, 1940 SEC LEXIS 358; 8 SEC 160. Cited as reference for Rule 651 of the 1933 Act requiring that the certiﬁcate be reasonably comprehensive as to the scope of the audit, clearly state the auditor’s opinion on the ﬁnancial statements, and indicate the accounting principles upon which they are based. The certiﬁcate in this case lacked these features and was, therefore, substantially deﬁcient.

In the Matter of Callahan Zinc-Lead Company (September 26, 1939), File No. 2-1039, SEC, Securities Act of 1933, Section 8(d), Release No. 2061, 1939 SEC LEXIS 565; 5 SEC 1009. Cited for discretionary power of SEC to consider amendments ﬁled after initiation of proceedings.

In the Matter of Queensboro Gold Mines, LTD. (November 17, 1937), File No. 2-2922, SEC, Securities Act of 1933, Release No. 1617, 1937 SEC LEXIS 893; 2 SEC 860. Cited for position that the full certiﬁcation is one of substance and not easily satisﬁed.

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In the Matter of Equity Corporation (August 24, 1937), File No. 2-684, SEC, Securities Act of 1933, Release No. 1535, 1937 SEC LEXIS 876; 2 SEC 675. Cited for discretionary power of SEC to consider amendments ﬁled after initiation of proceedings.

In the Matter of Condor Pictures, Inc. (May 11, 1937), File No. 2-2763, SEC, Securities Act of 1933, Release No. 1433, 1937 SEC LEXIS 971; 2 SEC 292. Review under a stop order proceeding is discretionary and the Commission is not limited to consideration of the registration statement at the time of ﬁling.

IN THE MATTER OF INTERSTATE HOSIERY MILLS, INC. File No. 1-300; 4 SEC 706 (March 18, 1939) Issue This matter was brought before the SEC for a determination under Section 19(a)(2) of the 1933 Act on whether the stock of Interstate Hosiery Mills, Inc. should be suspended or delisted from the New York Curb Exchange. The SEC charged that the ﬁnancial statements submitted to it by Interstate Hosiery Mills for 1934 through 1936 were false and misleading due to gross misstatements of ﬁnancial data as well as the failure of the auditor and Interstate’s management to properly supervise and review the audit process. Factual Background Homes & Davis was a certiﬁed public accounting ﬁrm organized in 1917. Beginning in 1929, Interstate Hosiery Mills employed Homes & Davis for audit services in relation to preparation of various ﬁnancial reports (annual, monthly, etc. . . .). Raymond Marien of Homes & Davis was responsible for reviewing and auditing Interstate’s books. In February 2, 1938, employees of Interstate discovered that Raymond Marien had forged two checks from Interstate’s bank account. Upon this discovery, Mr. Greenwald, VP for Interstate, made arrangements with Homes & Davis management to review the work done by Marien. After review of Marien’s work on Interstate’s books and ﬁnancial statements for 1937, it was determined that there were discrepancies between Interstate’s books and balance sheet in the cash and accounts receivable items. On February 12, Interstate management notiﬁed the SEC and the New York Curb Exchange of the problems with its ﬁnancial statements. In response, on February 15, the Exchange suspended trading of Interstate’s stock. After further review of Interstate’s ﬁnancial statements, it became evident that from 1934 through 1936, the ﬁnancial statements

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submitted to the SEC contained overstatements in operating proﬁts and, resultantly, in cash, accounts receivable, and inventory & surplus. There were no problems with the ﬁnancial statements ﬁled by Interstate prior to 1934. SEC Proceeding and Opinion The SEC determined that Marien had been acting on his own in misstating the ﬁnancial performance of interstate, therefore, the issues to be decided on were: (1) whether Homes & Davis had exercised due care in employing Marien and reviewing his work;2 and (2) whether the misstatements should have been discovered by Interstate’s management. In reviewing the circumstances of Marien’s employment by Homes & Davis, the SEC concluded that even though the auditing ﬁrm missed a forgery conviction in 1924, Marien came highly recommended and had more than adequate advanced education, earning two degrees from the University of Montreal. This was sufﬁcient to justify Homes & Davis hiring Marien in 1928. As for supervision by Homes & Davis, the audit ﬁrm’s management supervised Marien’s work from 1928 until 1931. These managers found Marien to be competent, accurate, and conscientious. In 1931, Homes & Davis quit its supervision of Marien, but still reviewed his reports. The SEC then turned its inquiry to Marien’s audit procedures and the efforts by his supervisor, Phillips, to review the work. It was revealed that Phillips review consisted of reading the draft reports and working papers, asking question on unusual items and making any necessary corrections. The ﬁgures included in the ﬁnancial statements were checked against the schedules, but the schedules themselves were not checked in detail. Phillips testiﬁed that his main role was to make sure that the audit had been performed, which he accomplished through review of the working papers and asking questions on the accuracy and consistency of reported information with the corporate records. With this level of review, there was nothing in the ﬁnancial statements that would notify Phillips of the falsiﬁed ﬁgures in the proﬁt and loss statement. In addition, Marien had also falsiﬁed data that may have indicated that there were problems with the proﬁt and loss statements. Ultimately, Phillips’ review did not involve recalculations of the data used to determine the ﬁnal statements but rather relied on Marien’s ability for accuracy. Expert witness testimony was solicited from other audit ﬁrms who testiﬁed that the review performed by Homes & Davis was not outside of the usual practice and that it is typical to not question ﬁgures that do not appear unreasonable or unclear. The expert witness audit ﬁrms also disclosed that the results of the audit are usually accepted without independently verifying the data. The SEC concluded that the review by Homes & Davis was not any less extensive than that ordinarily made by accounting ﬁrms. However, the SEC chastised the audit review process that was

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revealed through the witness testimony. As part of its criticism, the SEC stated that an audit review should not be a mere series of questions on basic procedures of the audit and nor should the reviewer accept responses to unusual items without supporting evidence from the working papers. The purpose of the audit review is to, ﬁrst, insure integration of the original working papers with the ﬁnancial statements and, second, to perform a searching analysis of the data yielded by the audit process. It was the SEC’s opinion that had the review been conducted with these principles in mind, it would have revealed the misstatements. The SEC concluded that the monthly reports that Marien was preparing were merely unaudited summaries of Interstate’s corporate ledger and that this sort of data preparation is not in any sense of the word an audit. Therefore, the auditor’s certiﬁcates furnished on these reports were false. It was also determined that Marien in fact had some participation in the bookkeeping of Interstate, which was against Homes & Davis’ rules and procedures. Not only did this defeat the audit ﬁrm’s independence, but also placed much of the responsibility for Marien’s fraudulent reports on Interstate’s management. Despite the fact that Homes & Davis failed to adequately review Marien’s work, it was with Interstate’s almost complete abdication of responsibility to conﬁrm the correctness of the information where the SEC found the ultimate blame to lie. Of all the parties involved, Interstate’s employees and management had the greater knowledge of the hosiery business and the record indicated that it would have been relatively easy for Interstate’s management to discover the problems through a routine comparison of the reports furnished by Homes & Davis against its own records. A check of Interstate’s operating schedules and cost sheets against Marien’s reports would have disclosed the huge discrepancies; however, it appeared that this was never done. The SEC found unpersuasive Interstate’s assertion that Homes & Davis’ reports were ﬁled too late for them to be of any beneﬁt in comparing with Interstate’s internal records because the information that the reports were based on was outdated by the time the report was released. Regardless of this, the comparison would still have yielded important information on the accuracy of the ﬁnancial data. This level of review did not only ﬂow from a duty to test the accuracy but also from the obligation of the management to “use all available means of assuring the correctness of its public ﬁnancial statements.” From this, the SEC concluded that the “fundamental and primary responsibility for the accuracy of information ﬁled with the Commission and disseminated among the investors rests upon management.” Interstate’s management had not discharged its duty by contracting with Homes & Davis to review the company’s accounting, and, in the opinion of the SEC, Interstate’s conduct associated with the preparation of the ﬁnancial statements submitted to investors, the New York Curb Exchange

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and the Commission was a “complete abdication of responsibility.” Since the SEC determined that Interstate’s management had been at fault, the Commission disregarded the company’s defense that the SEC may not under Section 19(a)(2) of the 1933 Act, suspend or withdraw a registrant’s securities due to violations of the Act that it was not party to. Ruling Although Interstate’s failure to adequately review and ensure the accuracy of its ﬁnancial reports would have justiﬁed the SEC in suspending the registration of Interstate’s stock, the SEC concluded that the actions taken by the company after discovering the problems with its ﬁnancial statements had mitigated its culpability. These actions included (i) immediately informing the SEC and the New York Curb Exchange of the problems; (ii) reauditing and amending the ﬁnancial statements; and (iii) requiring management to return the excess compensation given on the inﬂated earnings. Due to these mitigating factors as well as the New York Curb Exchange’s willingness to reinstate Interstate’s stock, which had already been suspended from trading for one year, the SEC ruled that Section 19(a)(2)’s function of protecting investors by bringing to their attention “the seriousness of the misstatements and the negligence of management” had already been served, and, therefore, suspension or withdrawal of Interstate’s stock registration was not necessary. Assessment of Auditor Independence The SEC’s opinion in Interstate Hosiery Mills developed the principle that the duty to verify information presented to investors in the form of ﬁnancial statements rests with management and cannot be passed-off to an independent auditor. Although the Interstate Hosiery Mills matter has only been cited three times, holding management responsible for materially false and misleading information contained in documents ﬁled with the SEC and disseminated to investors, even when actually caused or produced by the auditing ﬁrm, is a hallmark of the SEC’s regulatory framework. Through this opinion, the SEC warned management that in preparing for disclosure, the duty to ensure the accuracy of the ﬁrm’s information does not end when the company’s records are given to an outside auditor who then prepares the ﬁnal document. The ﬁnancial statements belong to the disclosing ﬁrm and, as such, management is ultimately responsible for their content. Citation History – Management Responsibility for Financial Statements Commission’s Guidelines on Independence of Certifying Accountants; Example Cases and Commission’s Conclusions, (July 19, 1972), SEC, Securities Act of 1933 Release No. 5270, Securities Act of 1934 Release No. 9662, Public Utility

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Holding Company Act of 1935 Release No. 17636; Investment Company Act of 1940 Release No. 7264, Accounting Series Release No. 126, 1972 SEC LEXIS 2107; 37 FR 14294. In the Matters of Babcock & Co., 136 South Main Street, Salt Lake City, Utah, Louis W. Babcock, Robert Stead (June 19, 1970), Admin. Proc. File Nos. 3-1512 & 8-11902, SEC, Securities and Exchange Act of 1934, Sections 15(b) and 15A, Release No. 8905, 1970 SEC LEXIS 406; 46 SEC 350. Circumstances under which independent public accountants may properly express an opinion, and the form of such an opinion with respect to summary earnings tables to be included in registration statements under the Securities Act of 1933 (June 27, 1947), SEC, Accounting Series Release No. 62, Securities Act of 1933 Release No. 3234, 1947 SEC LEXIS 1419; 15 FR 9104. The enforcement action and two SEC pronouncements above directly quoted the opinion in Interstate Hosiery Mills that a disclosing ﬁrm’s management bears the fundamental and primary responsibility for the accuracy of information ﬁled with the Commission and disseminated among investors. This duty is not discharged by employing an independent auditor to review the accounting work. Assessment of the Audit Process and Review Somewhat related to management responsibility for information contained in the ﬁnancial statements is the SEC’s expression of what it considered to be a sound audit review. Clearly troubled by the procedures being employed by audit ﬁrm supervisors and management, the SEC expressed that a cursory review of the work is insufﬁcient and that a proper inspection must make efforts to verify the data produced by the audit work as well as ensure the integration of the audit work into the ﬁnal statements. This opinion put audit ﬁrms on notice of what the SEC would expect in terms of supervisory level review in the performance of all future audits. Citation History – Supervisory or Management Level Review of Audit Work In the Matter of Proceeding under Rule ii(e) of the Rules of Practice, to determine whether the privilege of Barrow, Wade, Guthrie & Co., Henry H. Dalton and Everett L. Mangam to practice as accountant before the Securities and Exchange Commission should be denied, temporarily or permanently. (April 18, 1949), SEC, Accounting Series Release (ASR) No. 67, 1949 SEC LEXIS 1319. Cited to support long established position of SEC that an auditing ﬁrm should have upper level supervision and detailed review of the work done by employees performing the audit.

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In the Matter of Red Bank Oil Company (January 4, 1946), File No. 2–5754 &; File No. 1-342, SEC, Securities Act of 1933, Section 8(d), Release No. 3110, Securities and Exchange Act of 1934, Sections 19(a)(2), Release No. 3770, 1946 SEC LEXIS 162; 21 SEC 695. Cited as precedent for auditing ﬁrm’s failure to undertake management or supervisory level review necessary to conduct a sound audit program.

Assessment of other Concepts Covered in Interstate Hosiery Mills Although not original to Interstate Hosiery Mills, the SEC opinions on expert witness testimony and auditor independence have been cited fairly often in subsequent enforcement actions and SEC pronouncements. Citation History – Expert Witness Testimony In the Matter of Ernst & Young, Cleveland, Ohio; Clarence T. Isensee, John F. Maurer (May 31, 1978), Admin. Proc. File No. 3-2233, SEC, Accounting Series, Release No. 248, 1978 SEC LEXIS 1452; 46 SEC 1234. In the Matter of Ernst & Young, Clarence T. Isensee, John F. Maurer, Rule 2(e) of the Rules of Practice, (October 21, 1975), Admin. Proc. File No. 3-2233, SEC, 1975 SEC LEXIS 2561. In the Matter of Ernst & Young, Clarence T. Isensee, John F. Maurer, Rule 2(e) of the Rules of Practice, (October 21, 1975), Admin. Proc. File No. 3-2233, SEC, 1972 SEC LEXIS 4257. In the Matter of Haskins & Sells and Andrew Stewart, File No. 4-66, (Rules of Practice – Rule ii(e)). SEC (October 30, 1952), SEC, 1952 SEC LEXIS 1062. All cited Interstate as precedent for the notion that expert witness testimony by auditing or accounting ﬁrms may be helpful, yet it is the responsibility of the SEC to evaluate the merit of the service or practice in question.

Citation History – Auditor Independence: Dual Role as Auditor and Bookkeeper Qualiﬁcations and Reports of Accountants; Proposed Amendments of Rules Regarding Independence of Accountants; (October 14, 1982), SEC, Securities Act of 1933 Release Nos. 33-6430; 34-19137; 35-22668; IC-12738; S7-947 17 CFR Part 210, 1982 SEC LEXIS 673. Cited as support for the difference between the SEC and AICPA rules on independent auditors performing both auditing and bookkeeping services. The SEC’s position, stated in Interstate Hosiery Mills, is that independent auditors should not do bookkeeping for audit clients.

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In the Matter of Precision Microwave Corporation, Main Street, Mills, Massachusetts (May 22, 1964), File Nos. 2-18720 & 1-4583, SEC, Securities Act of 1933, Section 8(d), Release No. 4694, Securities and Exchange Act of 1934, Sections 19(a)(2), Release No. 7319, 1964 SEC LEXIS 506; 41 SEC 971. In a case involving an auditor who also served as comptroller of the audit client, Interstate cited for the notion that this sort of relationship is inconsistent with the objectivity required by independent auditors.

In the Matter of Christina Copper Mines, Inc., (May 1, 1952), File Nos. 2-8487, SEC, Securities Act of 1933, Section 8(d), Release No. 3439, 1952 SEC LEXIS 7; 33 SEC 397. In a case where an auditor helped maintain the audit client’s books and records, Interstate cited for the notion that this sort of relationship is inconsistent with the objectivity required by independent auditors.

Form of Accountants’ Certiﬁcate (February 20, 1940), SEC, Accounting Series Release No. 13, 1940 SEC LEXIS 1537; 11 FR 10916. Although not in issue in this matter, SEC referred to the independence of the auditor being jeopardized when employees of the Auditing Firm prepare the company ledger or perform accounting work which is treated as a substitute for management’s own accounting.

CONCLUDING COMMENTS Although citation of the precedents developed in Cornucopia and Interstate Hosiery has fallen off over the last several decades, it is perhaps the case that the more recent enforcement actions and SEC pronouncements that utilized Cornucopia and Interstate Hosiery have become the more recognized embodiments of the principles developed in these two hallmark cases. What is clear, however, is that the concepts of auditor independence and management bearing the ultimate responsibility for a company’s ﬁnancial statements are as important and fundamental today as they were when ﬁrst pronounced by the SEC, perhaps more so in light of the recent Enron and World Com debacles. It is no surprise, therefore, that when Congress proposed the Sarbanes-Oxley Act as a corrective measure in response to these signiﬁcant accounting failures (along with others experienced throughout the later part of 2001 and the ﬁrst half of 2002) it included provisions which would strongly reinforce the positions taken by the SEC nearly 70 years ago. The ﬁnal Act as passed by Congress and signed into law by President Bush at the end of July, 2002, requires that the CEO’s and CFO’s of all Covered Companies certify to the SEC the accuracy of the company’s ﬁnancial reports, while attaching enhanced criminal penalties for knowing or

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willful violations related to the reports. In terms of auditor independence, the Act imposes greater restrictions on the type of additional services that an audit ﬁrm can perform for a client “contemporaneously” with audit work, and creates the Public Company Accounting Oversight Board, organized as a non-proﬁt entity under the supervision of the SEC to oversee ﬁrms that audit public companies. With the Act applying to companies who ﬁle registration statements under the 1933 Act and periodic reports under the 1934 Act, the SEC will serve as the oversight and enforcement agent for the Act’s regulatory provisions. Thus, it may be that the Sarbanes-Oxley Act will further supplant use of the Cornucopia Gold Mines and Interstate Hosiery Mills opinions, yet it is certain that the importance of the principles developed in these actions will continue to play a central role in ensuring the stability of the U.S. capital markets.

NOTES 1. “Covered ﬁrms” used to refer to companies under the reporting requirements of the Securities Act of 1933 and the Securities and Exchange Act of 1934. 2. The Auditor was a proper party in this hearing to determine whether its certiﬁcates ﬁled with the statements were false.

AUDITOR LIABILITY: A REVIEW OF RECENT CASES INVOLVING GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AND GENERALLY ACCEPTED AUDITING STANDARDS Scot P. Gormley, Thomas M. Porcano and Wayne Staton ABSTRACT The Securities and Exchange Commission (SEC), the primary regulatory body that oversees the operations of the ﬁnancial markets, requires that publiclytraded companies be subject to an annual audit – a set of procedures designed to determine whether a ﬁrm’s ﬁnancial statements fairly comply with generally accepted accounting principles (GAAP). When performing audits, auditors use generally accepted auditing standards (GAAS) as guidelines in determining the amount of evidence to gather and to what degree the client’s accounting system may be relied upon. Since investors and their advisors rely on audited ﬁnancial statements to make investment decisions, auditors have a signiﬁcant impact on the ﬁnancial

Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 61–85 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160048

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community and capital markets. Accordingly, auditors must be diligent in the execution of their duties. However, notwithstanding the high level of care exercised by most auditors, sometimes misleading or erroneous information is released to the investing public, and this article focuses on recent case law dealing with the auditor liability that attaches in such situations.

LIABILITY UNDER THE SECURITIES EXCHANGE ACT OF 1934 A survey of recent case law shows that most of the cases involving plaintiffs’ claims against auditors are based on the Securities Exchange Act of 1934 (the 1934 Act) and the regulations prescribed thereunder. Section 10(b) of the 1934 Act provides that it is unlawful “to use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] . . . may prescribe.” Additionally, SEC Rule 10b-5 is the primary interpretive pronouncement that is cited in Section 10(b) claims. Similar to Section 10(b), Rule 10b-5 makes it unlawful for any person to do any of the following (either directly or indirectly): . . . employ any device, scheme, or artiﬁce to defraud, . . . make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or . . . engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Basic Requirements for Section 10(b) and Rule 10b-5 Claims Although Section 10(b) and Rule 10b-5 were designed to protect investors from fraudulent activity on the part of investees, the provisions are not meant to be means of investor insurance whereby investors would be entitled to reimbursement for every instance of stock value decline. Instead, through common law a four-element test has emerged that plaintiffs generally must meet in order to sustain securities fraud claims under Section 10(b) and Rule 10b-5. In the majority of the Circuit Courts, plaintiffs must establish that: (1) the defendant made false statements or omitted material facts; (2) the defendant acted with scienter; (3) the plaintiffs justiﬁably relied upon the defendant’s false statements; and (4) the false statements proximately caused the plaintiffs’ injury. Discussed below are the elements of the test that generate the most debate – scienter and causation.

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Scienter As applied to Rule 10b-5, “scienter” refers to a mental state embracing intent to deceive, manipulate or defraud.1 For plaintiffs to establish a meritorious claim that defendants acted with scienter, the plaintiffs must show that the defendants’ conduct was so unreasonable that it lacked the care that ordinarily would be taken by a reasonable person in the defendant’s position.2 This type of conduct usually results in obvious fraud about which the defendant reasonably must have known.3 Additionally, the conduct must have been so grossly negligent as to be tantamount to actual intent to aid a client in perpetrating fraud.4 Causation Causation is present when it can be shown that an act was the cause of some event that happened later in time. To satisfy Section 10(b), plaintiffs must demonstrate both transaction causation and loss causation. Transaction causation. Transaction causation (also known as “but for” causation), is demonstrated when plaintiffs can show that, in making decisions to purchase a ﬁrm’s debt securities or equity securities, the plaintiffs relied on the ﬁrm’s erroneous ﬁnancial statements and would not have purchased the securities if the ﬁrm had disclosed its true ﬁnancial condition in its ﬁnancial statements.5 When material errors exist in ﬁnancial statements (and auditors nonetheless fail to issue qualiﬁed opinions) transaction causation automatically is established so long as the Supreme Court’s fraud-on-the-market theory applies.6 Under the fraud-on-the-market theory, there is a dual presumption that: (1) purchasers rely on an open, well-developed, and efﬁcient market for purchasing stock; and (2) most publicly available information is reﬂected in the market price of debt and equity securities. For purposes of Section 10(b) and Rule 10b-5 actions, it is presumed that investors rely on material public misrepresentations when making decisions to purchase debt or equity securities. Thus, although under Section 10(b) transaction causation generally is easier to establish than loss causation, in order for the presumption of transaction causation to attach, plaintiffs must establish that the fraud-on-the-market theory validly applies. As shown in Zucker v. Sasaki,7 mere “fraud by hindsight” is insufﬁcient to support Section 10(b) claims. Zucker involved Cygne Designs (Cygne), a designer and manufacturer of clothing that made ill-fated purchases of two other clothing manufacturers (FW&M and GJM). Prior to making the purchases, Cygne made public statements that the transactions would result in higher earnings and proﬁts for Cygne, and Cygne made a secondary common stock offering of 2.3 million shares to raise cash for the purchases. Ultimately, the acquisitions of FW&M and GJM resulted in substantial losses for Cygne; consequently, the ﬁrm’s stock prices plummeted.

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As a result, a plaintiff class of Cygne’s shareholders ﬁled a Section 10(b) complaint, asserting that Cygne and Ernst and Young (E&Y), Cygne’s independent auditor, had misled the investing public. Speciﬁcally, the plaintiffs claimed that, at the time that Cygne was considering purchasing FW&M, Cygne was aware that FW&M was in ﬁnancial distress and that the purchase price and capitalized goodwill amounts were unrealistic. Additionally, the plaintiffs claimed that E&Y had taken afﬁrmative steps to further Cygne’s fraud by: (1) failing to disclose the potentially adverse effects that the FW&M acquisition could have on Cygne’s earnings; and (2) intentionally choosing to treat Cygne’s later sale of an FW&M division as a subsequent event to avoid disclosing the negative ﬁnancial impact of the transaction. In its discussion, the District Court found the plaintiffs’ complaint to be insufﬁcient under Section 10(b). Noting that there was no indication that E&Y had attempted to deceive investors (the plaintiffs offered no facts to support an inference that E&Y had actual or constructive knowledge of the unreasonableness of the goodwill or its associated amortization period), the court determined that E&Y’s treatment of Cygne’s FW&M acquisition was appropriate. In its analysis, the court characterized the plaintiffs’ argument as “fraud by hindsight.”8 Second, consistent with the Second Circuit’s ruling in Denny v. Barber,9 the District Court disallowed the plaintiffs’ claim that E&Y intentionally had chosen to treat a ﬁscal year 1994 transaction as a subsequent event so as to avoid revealing the negative ﬁnancial impact of the transaction. This was the case because the 1994 auditor’s report was issued after the plaintiffs’ ﬁnal stock purchases. Therefore, the court reasoned that the plaintiffs could not possibly have relied on the allegedly false statements in making their stock purchases. Accordingly, the District Court found that the plaintiffs’ claims failed to meet the requirements of Section 10(b) because the plaintiffs could not rely on the presumption of reliance that accompanies the fraud-on-the-market theory. Loss causation. The second part of the causation requirement, loss causation, has a relatively high burden of proof in most courts. Historically, the Second,10 Fourth,11 Fifth,12 Sixth,13 Seventh,14 and Eleventh15 Circuits have required plaintiffs to allege facts demonstrating a causal connection between their loss and the material representation.16 For example, in a recent case, the Eleventh Circuit explicitly provided that the mere fact that a defendant’s representation led to artiﬁcial inﬂation of stock prices does not satisfy loss causation requirements.17 Accordingly, in most circuits plaintiffs must establish that their losses were proximately caused by material misrepresentations in a given ﬁrm’s ﬁnancial statements. However, although the application of the loss causation standard generally requires plaintiffs to establish causation, this is not a uniform rule in all the Circuits.

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Instead, the Eighth18 and Ninth19 Circuits depart from the majority view and assume that loss causation exists when plaintiffs assert the fraud-on-the-market theory. Accordingly, to establish viable Section 10(b) claims in Eighth and Ninth Circuits, plaintiffs merely need to demonstrate that material misstatements were disseminated to the investing public, and on the date of their purchases the plaintiffs paid artiﬁcially inﬂated prices for the securities because of the defendant’s fraudulent misrepresentations.20 Although the majority of the Circuits requires a more explicit demonstration of proximate causation than that required by the Eighth and Ninth Circuits, that is not to say that the appellate court majority requires plaintiffs to show that the defendants’ actions solely were responsible for the plaintiffs’ losses. Instead, the majority viewpoint acknowledges that many factors affect the market values of debt and equity securities and that it would be virtually impossible for plaintiffs to isolate and identify all such factors. Accordingly, in cases where plaintiffs can show that a defendant’s actions substantially contributed to the plaintiff’s loss, the appellate court majority will consider the loss causation requirement as being met.21 Determining plaintiffs’ damages. When determining the monetary damages that plaintiffs may seek from Section 10(b) and Rule 10b-5 actions, 15 U.S. C. section 78bb(a) provides that plaintiffs may recover actual damages, and courts generally apply an “out-of-pocket rule”22 to determine such damages. Under the out-of-pocket rule, plaintiffs’ damages are measured as the difference between the price paid and the actual fair market value of the securities in question absent the fraudulent misrepresentation that compelled the investors to purchase the stock.23 However, when determining the damages that may be recovered by plaintiffs, all factors other than the defendant’s actions that contributed to the plaintiff’s loss must be removed from consideration.24 Additionally, it should be noted that in the majority of the Circuits, proof of damages under the out-of-pocket rule does not establish loss causation; instead, loss causation must be established independently.25 Applying the causation requirements to cases involving accounting ﬁrms. The establishment of causation is fact speciﬁc; therefore, it is difﬁcult to deﬁne a common set of criteria that will establish causation for any particular group of defendants. However, common law does provide some guidance. For example, the Second Circuit has held that plaintiffs meet their burden of establishing both transaction causation and loss causation when the plaintiffs can show that an accounting ﬁrm helped to further a client’s fraud by willfully violating GAAP and GAAS by preparing false and misleading ﬁnancial statements opinions and by failing to update those opinions.26 Nonetheless, recent case law indicates

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that there is still a signiﬁcant burden that plaintiffs must meet in establishing causation. This was illustrated in two recent cases (Robbins v. Koger Properties27 and Ausa Life Insurance Co. v. Ernst & Young28 ) in which the plaintiffs failed to establish causation as required by Section 10(b) and Rule 10b-5. Robbins v. Koger Properties involved Koger Properties (KPI), a publicly-traded commercial real estate construction and management company and Koger Equity (KE), a company in which KPI had a 20% equity interest. In their complaint, the plaintiffs argued that they sustained losses in their investments in KPI’s stock due to KPI’s false and misleading accounting methods. Speciﬁcally, the plaintiffs alleged that KPI violated GAAP by improperly recognizing revenue and by improperly capitalizing several types of costs – thereby inﬂating earnings and creating the illusion that KPI’s operations generated sufﬁcient cash to sustain the company’s steadily-increasing quarterly dividend payments. The plaintiffs alleged that they had relied on the company’s increasing trend of dividend payments when assessing the value of KPI’s stock. That is, the investors assumed that KPI’s operating revenues were sufﬁcient to cover the dividend payments. Despite outward appearances, KPI’s ﬁnancial condition was dire. KPI did not use operating revenues to ﬁnance its dividend payments; instead, KPI ﬁnanced its dividend payments by liquidating non-inventory real estate.29 In late 1990, KPI management bowed to the inevitable and reduced quarterly dividends per share from $0.70 to $0.25. Consequently, KPI’s stock price dropped an average $10.05 per share, and its shareholders suffered signiﬁcant losses. In the surviving portion of the plaintiffs’ complaint,30 the plaintiffs asserted the fraud-on-the-market theory and charged Deloitte & Touche (D&T) with violations of Section 10(b) and SEC Rule 10b-5. The plaintiffs asserted that, despite D&T’s knowledge of many of KPI’s GAAP violations, D&T nonetheless gave unqualiﬁed audit opinions for the years at issue and thereby proximately caused the plaintiffs’ losses. For example, D&T was aware that KPI had capitalized interest payments in contravention of GAAP. D&T initially insisted that KPI record the payments as interest; however, D&T eventually abandoned this tactic. Additionally, for the years 1989–1990, D&T informed KPI that its practice of capitalizing “lease up” costs was proscribed by GAAP. However, KPI refused to correct its accounting methods with respect to these costs, and D&T nonetheless issued unqualiﬁed audit reports. Finally, the plaintiffs presented testimony of an expert witness who identiﬁed other instances in which D&T had tacitly approved of improperly capitalized indirect property costs by KPI.31 Taken as a whole, the plaintiffs argued that, by allowing KPI to continue its non-GAAP accounting methods, D&T misled

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investors into believing that KPI’s cash ﬂow was sufﬁcient to support its increasing dividend payment level. In District Court, a jury held D&T liable for damages of $10.05 per share (a total of $81,338,647). In making this determination, the jury apparently was inﬂuenced by an expert witness who opined that KPI would have been forced to cut its dividends at a much earlier date if D&T had insisted that one of KPI’s primary ﬁnancial statements, the statement of cash ﬂows, had been restated to reﬂect reality. D&T appealed to the Eleventh Circuit, arguing that the plaintiffs had failed to meet the loss causation threshold for Section 10(b) actions because the plaintiffs failed to show that D&T’s conduct was the actual cause of the plaintiffs’ losses. The Eleventh Circuit agreed – thereby reversing the District Court’s ruling and rendering judgment for D&T. The Eleventh Circuit found that the plaintiffs had presented sufﬁcient evidence that could lead a jury to conclude that D&T’s misrepresentations led to artiﬁciallyinﬂated stock prices (the plaintiffs showed they were led to purchase KPI stock based on their reliance on KPI’s erroneous ﬁnancial statements). However, the Eleventh Circuit ruled that such a showing was insufﬁcient to meet the loss causation requirement for a Section 10(b) claim. Additionally, the Eleventh Circuit found that the plaintiffs had failed to present any other evidence suggesting that their loss was due to D&T’s misrepresentations. As factors in the determination, the court noted that in 1991 KPI corrected improper operating revenue amounts that were recorded in earlier periods and in 1992 charged an adjustment for amounts that were previous overcapitalized. The court reasoned that since these events occurred well after the $10.05 per share average drop in stock prices, the plaintiffs could not have been harmed by the existing errors in the ﬁnancial statements. That is, the investing public was unaware of the errors; therefore, a drop in stock prices could not have been attributable to the errors. The court also noted that KPI’s board made the decision to reduce quarterly dividends based on concerns about future ﬁnancing to support sales of properties – not because of any accounting errors that resulted in overstated cash ﬂows. In a second recent causation case, Ausa Life Insurance Co. v. Ernst & Young,32 the District Court found that the plaintiffs had likely failed to establish transaction causation and deﬁnitely had failed to establish loss causation. The court also noted that there might be different reliance standards that should be applied for equity investors (stockholders) as compared to debt investors (note holders). In Ausa Life, a plaintiff group of insurance companies that purchased debt instruments from JWP (a regulated water utility) ﬁled claims against E&Y – JWP’s independent auditor. In their complaint, the plaintiffs charged that E&Y had issued clean audit opinions for JWP ﬁnancial statements which failed to disclose JWP’s

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true operating condition after JWP undertook an aggressive and ill-fated campaign of expansion through the purchase of diverse business interests. Ultimately, JWP was forced into bankruptcy. Accordingly, the value of the debt instruments (notes) held by the plaintiffs plummeted, and the plaintiffs suffered approximately $100 million in losses after selling their notes at heavy discounts. In the complaint against E&Y, the plaintiffs argued that when making their decisions to purchase the debt securities, they relied on JWP’s annual reports (which included unqualiﬁed audit opinions by E&Y) and on annual assurance letters prepared by E&Y and issued to debtholders. JWP’s ﬁnancial statements were misstated because they included a variety of GAAP violations. E&Y was aware of JWP’s GAAP violations, but E&Y nevertheless issued clean audit opinions for 1987–1990 – the main years at issue. In certain instances, there was apparent justiﬁcation for E&Y not requiring amounts to be restated. In other instances, E&Y erroneously concluded that JWP’s practices conformed to GAAP. In still other instances, E&Y was aware of GAAP violations and requested that JWP correct the erroneous accounting entries; however, in these cases JWP refused to make correcting entries, and E&Y nonetheless issued clean audit opinions. In its analysis, the District Court acknowledged that E&Y was aware of JWP’s misstatements. Furthermore, the court ruled that, although it would be virtually impossible to calculate the exact amount of the understatement caused by the GAAP violations, it was clear that the understatements were of a sufﬁcient magnitude to be considered signiﬁcant by reasonable investors. The court also found that the plaintiffs had relied on the ﬁnancial statements and assurance letters when making their decisions to purchase the debt securities. Accordingly, the reliance criterion of the Section 10(b) test was satisﬁed. However, the District Court did not make a deﬁnitive ruling on the transaction causation issue because the plaintiffs’ claims clearly failed the loss causation test.33 In ruling on the loss causation requirement, the District Court found that JWP’s bankruptcy and corresponding inability to meet obligations due to the plaintiff noteholders was primarily due to JWP’s failed business activities – the most notable of which was the purchase of Businessland, a computer retailer which faced severe ﬁnancial distress at the time at which JWP acquired it. Accordingly, the court found that JWP’s inability to pay amounts owed to the plaintiff noteholders was due to unforeseeable post-audit events and not due to any misstated amounts on JWP’s ﬁnancial statements. Additionally, the court noted that virtually all of JWP’s GAAP violations affected JWP’s accounting income but had a negligible effect on JWP’s cash ﬂow. Thus, the misstatements present in JWP’s ﬁnancial statements did not affect JWP’s ability to meet its obligations to the plaintiff debtholders.

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Statute of Limitations on Section 10(b) Claims In accord with the Supreme Court’s 1991 ruling in Lampf, Pleva, Lipkind & Petigrow v. Gilbertson,34 plaintiffs who seek recovery under Section 10(b) must commence their actions within one year after discovery of the facts constituting a defendant’s Section 10(b) violation and within three years after such defendant’s violation. In interpreting these requirements, the Second Circuit has ruled that a plaintiff’s constructive notice must also be included when determining if an action properly falls within the limitation period.35 In determining the point at which constructive notice attaches to defendants, the Second Circuit applies a reasonable person standard: when circumstances would cause investors of ordinary intelligence to suspect they have been defrauded, the investors have the duty to inquire about the nature of their investments. Failure to make such inquiries will result in the court imputing notice of the fraud to the investors. However, based on the distinctly different needs of equity investors and debt investors, some courts make a distinction between equity investors (individuals mainly concerned with the earnings prospects of companies) and debt investors (creditors primarily concerned with investee companies’ ability to meet contractual interest payments) with respect to the point at which constructive notice attaches. That is, equity investors may be considered to have a duty of inquiry (and thus have constructive notice of potential problems) at times during which the investee’s stock value drops. By contrast, constructive notice does not necessarily attach to debt investors in similar situations. For example, the ﬁling of a class-action lawsuit by corporate shareholders is not necessarily a triggering event that affects debtholders because debtholders may suffer no loss so long as the investee continues to make its periodic interest payments. Accordingly, in Ausa Life Insurance Co. v. Ernst & Young36 the District Court disallowed a defendant’s claim that the plaintiffs’ motion should be dismissed because it violated the statute of limitations. The court ruled in this manner because it considered the ﬁling of a number of class-action Section 10(b) lawsuits against a debtor corporation and its independent auditors insufﬁcient notice to trigger an inquiry duty on the part of the plaintiff debtholders.

Pleading Standards of Fed. R. Civ. P. 9(b) [Rule 9(b)] When analyzing the common law dealing with Section 10(b) and Rule 10b-5 actions, it becomes abundantly clear that procedural rules (especially the Federal Rules of Civil Procedure) often determine the ultimate disposition of individual

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cases. Of the cases surveyed, Rule 9(b) was the most dominant, as the following discussion illustrates. Because securities fraud claims under Section 10(b) require proof of scienter, the claims are subject to Rule 9(b)’s pleading requirements. Generally speaking, Rule 9(b) exists to provide defendants with fair notice of plaintiffs’ claims so the defendants may prepare an adequate defense, to protect defendants against harm to their reputation, and to reduce the potential number of strike suits that might be ﬁled against defendants.37 Rule 9(b) sets forth a two-pronged pleading standard which plaintiffs must satisfy in order to sustain a Section 10(b) securities complaint: (1) the complaint must be stated with “particularity”; and (2) allegations of scienter must be established in the complaint. A description of the detailed requirements follows. Particularity of the Complaint Rule 9(b)’s ﬁrst prong requires that “the circumstances constituting fraud or mistake shall be stated with particularity.” There has been some debate as to what constitutes “particularity,” but the Second Circuit has indicated that for plaintiffs to meet the particularity threshold, they must specify the allegedly fraudulent statements, identify the speaker, state where and when the statements were made, and explain why the statements were false or misleading.38 By contrast, there appears to be a lower threshold for meeting Rule 9(b) in the Seventh and Ninth Circuits. For example, in Cooper v. Pickett,39 the Ninth Circuit overturned the District Court’s earlier ruling that a plaintiff’s complaint failed to meet the Rule 9(b) particularity threshold. Cooper v. Pickett involved the Merisel corporation – a distributor of computer products and services. In late 1993, the trading value of Merisel’s stock was $14.50 per share. In February 1994, Merisel announced its purchase of a related business (Computerland). By March 24, 1994, the trading value of Merisel’s stock had risen to $22.50 per share, and this increase primarily was due to Merisel’s reported year-end results for 1993 combined with favorable securities analysts’ reports.40 Early in 1994, Merisel announced a planned secondary common stock offering to ﬁnance the debt associated with the Computerland acquisition. However, just prior to the planned date of the offering, Merisel announced that its proﬁts had fallen; subsequently, the company’s stock prices fell, and the company canceled the planned stock offering. Merisel’s trend of decreasing proﬁtability continued through the second quarter of 1994, and in June of 1994 the stock value declined from $17.50 per share to $8 per share. After the rapid decline of Merisel’s stock value, Merisel’s shareholders ﬁled a class action lawsuit alleging that certain Merisel corporate ofﬁcers, D&T (Merisel’s independent auditor), and certain securities analysts had colluded in a scheme to

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defraud Merisel’s shareholders. Speciﬁcally, the plaintiffs alleged that, for ﬁscal year 1993, Merisel had violated GAAP by recording sales revenue for shipments of merchandise that customers did not order as well as other merchandise for which customers had an unlimited right of return.41 Alleging that D&T deliberately or recklessly failed to follow GAAS in conducting the Merisel audits, the plaintiffs also directed Section 10(b) and Rule 10b-5 complaints against D&T because D&T issued unqualiﬁed audit opinions on Merisel’s ﬁnancial statements for 1993 and the ﬁrst quarter of 1994 even though D&T allegedly had reason to know of Merisel’s true business condition. In January of 1995, the defendants ﬁled a motion to dismiss the plaintiffs’ complaint. Finding that the plaintiffs’ claims constituted broad allegations that lacked the particularity required by Rule 9(b), the District Court granted the defendants’ motion and accordingly dismissed the plaintiffs’ claims with prejudice.42 On appeal, the Ninth Circuit – while mindful of the Supreme Court’s Central Bank liability limitation rules with respect to aiding and abetting securities fraud43 – found that Merisel might be liable if it released false information to the securities analysts that ultimately misled investors. The Ninth Circuit found that Central Bank did not apply because the allegedly false statements were made directly by Merisel and were intended to be communicated to the stock market. In this case, the Ninth Circuit distinguished between a conspiracy, under which defendants are not liable for Rule 10b-5 violations per Central Bank, and a scheme, in which defendants may be liable for Rule 10b-5 violations. Since in this case the defendants were alleged to have directly participated in a scheme to defraud investors, the Ninth Circuit ruled that Central Bank did not apply. As for particularity, the Ninth Circuit overruled the District Court and found that the plaintiffs’ complaint was sufﬁcient under Rule 9(b). In applying its GlenFed44 test, the Ninth Circuit noted that “Merisel’s ﬁnancial house . . . was built on a landﬁll.” With respect to the alleged GAAP violations, the Ninth Circuit found that the plaintiffs’ complaint had sufﬁcient particularity despite the plaintiffs’ inability to identify any single transaction that led to improper revenue recognition. In its ruling, the Ninth Circuit applied the following Seventh Circuit rule (see DiLeo v. Ernst & Young45 ): to show that fraud exists, details of speciﬁc fraudulent transactions need not be identiﬁed; instead, plaintiffs merely need to identify “who, what, where, when, and how”46 the alleged fraud was perpetrated. In the instant case, the plaintiffs identiﬁed speciﬁed customers who were overshipped merchandise, speciﬁc ﬁscal quarters of the alleged revenue overstatements, and speciﬁc overstatement amounts; thus, the plaintiffs were considered to have alleged the fraud with sufﬁcient particularity so that the defendants could prepare an adequate answer. Accordingly, the Ninth Circuit allowed the plaintiffs’ claim to stand against Merisel, the securities analysts, and D&T, but the court refrained

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from ruling on the evidence because discovery had not yet occurred when the case was dismissed by the District Court at the trial level. With respect to D&T, the Ninth Circuit noted that the plaintiffs met the particularity requirements because their complaints named speciﬁc customers who were alleged to have received shipments for which improper revenue recognition techniques were employed and for which D&T knowingly “certiﬁed” ﬁnancial statements including the false revenue ﬁgures.47

Establishing Knowledge and Intent Rule 9(b)’s second prong provides that “malice, intent, knowledge, and other condition of mind of a person may be averred generally.” Historically, this prong of the standard has been highly controversial. Through case law, a majority position (ﬁrst established by the Second Circuit) emerged for determining the adequacy of plaintiffs’ complaints. Under the majority position, plaintiffs were required to allege facts that would give rise to a strong inference of scienter. Plaintiffs could create such an inference either: (1) by alleging facts demonstrating a motive for committing fraud and a clear opportunity to do so;48 or (2) by identifying circumstances indicating conscious or reckless behavior by the defendant.49 However, the Ninth Circuit rejected the Second Circuit’s “strong inference” test and instead concluded that fraud may be averred generally. Accordingly, in the Second Circuit plaintiffs were not required to identify speciﬁc facts that gave rise to an inference of scienter.50 Thus, a split of opinion among the appellate courts existed for some time. In response to this split, and to alleviate abuses in private securities lawsuits (Congress was concerned about the abuse of the discovery process in imposing costs so burdensome that it was often more economical for victimized parties to settle),51 Congress enacted the Private Securities Litigation Reform Act of 1995 (the PSLRA)52 to develop uniform pleading standards.53 (President Clinton initially vetoed PSLRA, but Congress subsequently overrode his veto.) However, the PSLRA may have failed to achieve its purpose. For example, in a recent District Court case, In re Health Management, Securities Litigation,54 the plaintiffs unsuccessfully argued that the PSLRA abrogated the Second Circuit’s alternative motive and opportunity or recklessness test. In denying the plaintiffs’ argument, the Health Management court noted that in the PSLRA, Congress essentially adopted the Second Circuit’s “strong inference” pleading standard in that the PSLRA explicitly requires that scienter claims under Section 10(b) must plead with sufﬁcient particularity. However, the PSLRA does not clearly deﬁne what facts sufﬁce to establish a strong inference of fraudulent intent. Thus, such a determination is still within the purview of the courts.

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The belief that PSLRA produced more restrictive discovery rules led plaintiffs to ﬁle parallel actions in federal and state courts because of the less-restrictive discovery rules at the state level. Concern about such actions was a major factor behind the passage of the Securities Litigation Uniform Standards Act of 1998 (SLUSA). SLUSA effectively precludes litigation of major securities class actions in state courts. Since its enactment, there have been at least 40 cases involving SLUSA (although none deal with alleged GAAP violations). In those cases, the courts generally have upheld the preclusion of a state court action when the allegations involved securities fraud violations. However, two exceptions remain, and, therefore, do not preempt a state court from hearing the case. An exclusively derivative action brought by one or more shareholders on behalf of a corporation is not preempted, and the availability of state court class actions is preserved where state law already provides that corporate directors have ﬁduciary disclosure obligations to shareholders. These two exceptions are known as “Delaware carve-outs.”55 Accordingly, despite the uniformity that Congress sought to achieve by enacting the PSLRA, case law illustrates that an on-going debate surrounds the proper interpretation of the PSLRA’s pleading requirements. Some District Courts have held that plaintiffs need only show circumstantial evidence that a defendant acted consciously to satisfy the PSLRA’s pleading requirements.56 Some assert that the muddled legislative history of PSLRA, with conﬂicting expressions of legislative intent, has contributed to disagreement in interpreting and applying PSLRA.57 Other District Courts have adopted an approach akin to the Second Circuit’s “strong inference” test for pleading fraudulent intent.58 Additionally, current case law illustrates that the debate regarding the interpretation of the PSLRA continues. In In re Health Management, Securities Litigation,59 the District Court ruled that allegations of recklessness on the part of a defendant or a showing that such defendant had the motive and opportunity to perpetrate fraud were sufﬁcient to pled a strong inference of fraudulent intent as contemplated by the PSLRA.60 Accordingly, in In re Health Management, the District Court ruled that the PSLRA did not abrogate the Second Circuit’s pre-PSLRA pleading standard for fraudulent intent. However, despite the varying interpretations of the PSLRA, it remains clear that Section 9(b)’s two-pronged test is subjunctive. For example, the In re Health Management plaintiffs failed to establish motive and opportunity, but the District Court allowed the plaintiffs’ complaint to stand because it adequately pled recklessness (and therefore created an inference of scienter) on part of the auditor. In re Health Management involved a provider of health management services that was experiencing difﬁculty in collecting its accounts receivable. Due to its collection problems, Health Management (HM) had a high ratio of days’ sales

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outstanding (DSO) in accounts receivable – an indicator to potential investors and current shareholders that HM’s asset utilization was inefﬁcient. To remedy the situation, HM devised and implemented a strategy whereby it sought to decrease its DSO by purchasing complementary health care companies with low DSO levels. HM issued new common stock to ﬁnance many of the acquisitions. In its complaint, a plaintiff class of HM’s shareholders alleged that HM’s independent auditor, BDO Seidman (BDO), and several of HM’s corporate ofﬁcers participated in a fraudulent scheme solely designed to inﬂate the fair market value of HM’s stock. Since HM’s acquisitions of new companies were primarily funded through sales of common stock, the plaintiffs argued that HM had a clear motive for engaging in fraud. As for the speciﬁc components of the fraudulent scheme, the plaintiffs identiﬁed several GAAP violations, and as a result of these violations, HM’s net income was overstated by more than 116% for 1996. The investment community reacted favorably – thereby increasing the market value of HM’s stock. However, after HM’s GAAP violations later came to light, BDO withdrew its favorable audit opinion on HM’s 1995 ﬁnancial statements, and HM restated its ﬁnancial statements for 1995 and for the ﬁrst two quarters of 1996. Ultimately, the value of HM’s stock collapsed. In attempting to establish BDO’s complicity, the plaintiffs argued that BDO had a clear motive for participating in the fraudulent scheme because HM was one of BDO’s largest clients, and BDO’s independence was impaired because the wife of HM’s chief ﬁnancial ofﬁcer was a BDO employee during the audit period. Furthermore, in attempting to establish BDO’s recklessness, the plaintiffs argued that BDO either had actual or constructive knowledge of HM’s malfeasance because, given the magnitude and frequency of HM’s GAAP violations, BDO apparently turned a blind eye to the improper activities. When ruling on the elements set forth by the plaintiffs to establish motive, the District Court applied the Second Circuit’s “strong inference of scienter test.” In considering prong one of the test (establishing that a defendant had motive and opportunity for committing fraud), the District Court found that the mere receipt of a professional fee was not sufﬁcient to create an inference of scienter of the part of BDO.61 That is, despite the potential risk of complicity that existed as a result of impaired independence, the court found it unlikely that BDO would endanger its professional reputation and expose itself to legal liability merely to preserve the HM account that, although it might represent a signiﬁcant source of revenue for one of BDO’s ﬁeld ofﬁces, was likely to be a minute portion of BDO’s aggregate revenue. Accordingly, the District Court concluded that the plaintiffs had failed to satisfy the ﬁrst prong of the strong inference test. However, when considering the alternative prong of the strong inference test (establishing that a defendant acted consciously or recklessly) the District Court

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ruled that BDO’s recklessness could be inferred because there were severe GAAP and GAAS violations, and BDO was faced with multiple “red ﬂags” which should have notiﬁed any reasonable auditor of potential wrongdoing. For example, a securities analyst notiﬁed BDO that HM’s accounts receivable were artiﬁcially inﬂated, and BDO was also aware that the SEC had inquired about the accuracy of HM’s reported accounts receivable. Despite these warnings, BDO nevertheless refrained from investigating, and the District Court ruled that BDO’s actions were unreasonable. Accordingly, the District Court denied BDO’s Fed. R. Civ. P. 12(b)(6) motion to dismiss the plaintiffs’ claims because the plaintiffs’ claims against BDO met the Second Circuit’s “strong inference” standard for averring fraud. As the previous discussion illustrates, accountants are often held liable for Section 10(b) violations. However, accountants who merely fail to follow GAAP or GAAS or who attest to incorrect accounting numbers are not liable under Section 10(b).62 Thus, although violations of GAAS and negligence on the part of an auditor are factors that, in combination with other factors, may ultimately lead to an inference of scienter, and thus to a viable Section 10(b) securities fraud claim, GAAS violations and mere negligence, in themselves, are insufﬁcient to meet the Section 10(b) scienter threshold.63 Accordingly, in many cases plaintiffs are adequately able to plead scienter with respect to individual defendants (such as corporate ofﬁcers) but fail to meet the scienter threshold for pleadings against auditors. This situation was illustrated by the District Court’s recent ruling in In re Wellcare Management Group, Securities Litigation.64 In re Wellcare Management involved a holding company engaged in the managed health care business. In making a Section 10(b) claim against Wellcare, a plaintiff class alleged that Ullman (Wellcare’s President and Chief Executive Ofﬁcer) and Corsones (Wellcare’s Chief Financial Ofﬁcer and Vice President of Finance), the two corporate ofﬁcers who primarily oversaw Wellcare’s ﬁnancial operations, had engaged in a series of improper transactions and non-GAAP accounting practices with the intention of manipulating Wellcare’s ﬁnancial position so it would be perceived in an unrealistically favorable light by the investment community. As support for their allegations, the plaintiffs inferred that since Wellcare used a system of incentive compensation tied to corporate earnings, Ullman and Corsones had sufﬁcient motive to overstate Wellcare’s earnings. In March 1996, Barron’s magazine published an article exposing Wellcare’s fraudulent activities. The market responded to this article, and Wellcare’s stock prices fell by 12%. Subsequently, Wellcare was forced to restate its ﬁnancial statements for the ﬁscal years 1994 and 1995. The 1994 and 1995 restatements resulted in 50 and 75% decreases in Wellcare’s earnings per share (EPS), respectively. In addition to the claims against Ullman and Corsones, the plaintiffs also implicated D&T, Wellcare’s independent auditor. In their Section 10(b) complaint, the plaintiffs alleged that D&T either had actual knowledge of Wellcare’s GAAP

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violations or, alternatively, due to recklessness in the audit process, D&T should be imputed with constructive knowledge of the violations. Speciﬁcally, the plaintiffs alleged that: (1) D&T disregarded “red ﬂags” which should have altered any reasonable auditor to Wellcare’s GAAP violations; (2) D&T was aware that Wellcare had purchased a shell corporation in an effort to improve the appearance of Wellcare’s ﬁnancial statements; and (3) D&T was aware of the scheme in which Ullman conspired to reduce Wellcare’s expenses by channeling his loan proceeds to Wellcare through various health care providers – thus making it appear that Wellcare received deﬁcit payments when in fact it did not. With respect to the allegations against Wellcare’s corporate ofﬁcers, the District Court found the plaintiffs’ charges sufﬁcient to establish that Ullman and Corsones had opportunity and motive to commit fraud; thus, the plaintiffs adequately supported an inference of scienter. In its discussion, the District Court noted that although the receipt of incentive compensation, as an isolated factor, is an insufﬁcient basis upon which to predicate a sustainable allegation of fraud,65 the plaintiffs’ claims against Ullman and Corsones were sufﬁcient to establish motive and opportunity. This was the case despite the fact that the plaintiffs failed to allege expressly that Ullman and Corsones received direct beneﬁts from their allegedly fraudulent behavior.66 Additionally, in dicta, the court stated that even if the plaintiffs’ complaint had failed the motive and opportunity portion of the strong inference test, the complaint nonetheless would have satisﬁed the test’s alternative prong – that is, the prong dealing with recklessness. The District Court found that the allegations against the defendants sufﬁciently established negligence that was tantamount to intent. Accordingly, the District Court rejected Ullman and Corsones’ motion to dismiss the plaintiffs’ complaint. As shown by the preceding discussion, the District Court found the plaintiffs’ complaint against the individual defendants sufﬁcient to meet Section 10(b)’s scienter threshold. By contrast, the court reached a different conclusion with respect to the plaintiffs’ complaint against D&T. In its analysis, the court noted that the plaintiffs alleged that D&T had violated GAAS and that D&T knew or should have known that certain actions by Wellcare’s ofﬁcers would have the long-term effect of decreasing Wellcare’s reported income and stock price. However, the District Court also noted that the plaintiffs’ complaint made it clear that D&T concealed no speciﬁc information from the public. Additionally, the court noted that it was undisputed that D&T had no knowledge that the payments received by Wellcare (and fraudulently reported as deﬁcit payments from third-party doctors) actually came from bank loans guaranteed from Ullman. Furthermore, the court noted that when D&T later became aware

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of the phony deﬁcit payment scheme, D&T restated its audit opinion to reﬂect the knowledge. Taking the above factors into account, the District Court concluded that the plaintiffs’ complaint merely alleged violations of GAAS that amounted to claims of negligence in D&T’s performance of Wellcare’s audits. Since mere allegations of negligence are insufﬁcient to sustain Section 10(b) claims, the District Court granted D&T’s motion to dismiss the plaintiffs’ claims.

Fed. R. Civ. P. 11(b) [Rule 11(b)] In addition to Rule 9(b)’s procedural rules that apply to Section 10(b) and Rule 10b-5 claims, plaintiffs must also concern themselves with other standard procedural rules as well. For example, in a recent District Court decision (Trovato v. Coopers & Lybrand67 ), the court dismissed a complaint in which the plaintiffs made allegations that ran counter to facts obtained through the legal process of discovery. Trovato v. Coopers & Lybrand involved the accounting ﬁrm Coopers & Lybrand (C&L) and its audit of the Happiness company – a business involved in the marketing of children’s entertainment products. C&L audited Happiness’ 1995 ﬁnancial statements and issued a clean audit report that later was withdrawn. A group of plaintiffs ﬁled a Section 10(b) claim against C&L and certain individual directors of Happiness. In their claim, the plaintiffs alleged that Happiness overstated its 1995 ﬁnancial statements by recording ﬁctitious credit sales of approximately $6.3 million to two corporate customers – Wow Wee and Hoffman. Regarding C&L’s performance as independent auditor, the plaintiffs alleged that C&L was deﬁcient in its audit of amounts due from Wow Wee and Hoffman. Speciﬁcally, the plaintiffs argued that in gathering evidence about the receivable due from Wow Wee, C&L accepted a facsimile (fax) transmission as the sole conﬁrmation of the amount due. With respect to the receivable due from Hoffman, the plaintiffs argued that C&L accepted a false conﬁrmation. Additionally, the plaintiffs argued that although C&L audit workpapers identiﬁed alternate procedures to be used in auditing receivables, the workpapers failed to indicate that C&L actually applied any of these alternate procedures to the Wow Wee and Hoffman accounts. Furthermore, the plaintiffs charged C&L with failing to perform any procedures to test the underlying sales transactions from which the accounts receivable were generated. In response to the plaintiffs’ claims, C&L’s attorney notiﬁed the plaintiffs that the audit workpapers did in fact show that C&L had employed proper procedures in addition to conﬁrmation to the Wow Wee and Hoffman receivables. Upon

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receipt of the notice from C&L’s attorney, the plaintiffs amended their complaint but continued to assert that the sole procedure used by C&L to conﬁrm the Wow Wee receivables was the reliance on a faxed transmission. The plaintiffs took special exception to this practice and referenced an audit risk announcement issued by the AICPA that alerted auditors to the risks of accepting conﬁrmation via fax. According to the announcement, auditors should be wary of potentially falsiﬁed fax transmissions and, when the amount being conﬁrmed is material, should take steps to ascertain the origin of the transmission. The plaintiffs argued that, since C&L took no steps to verify the authenticity of the faxed transmission’s origin, C&L deliberately had violated AICPA guidance. Additionally, the plaintiffs noted that if C&L had examined invoices for sales made to Hoffman, C&L would have noticed that the invoices included a purchase order number that pertained to goods that Happiness was not scheduled to ship until six months after the date of the sale. In its analysis, the District Court scrutinized the plaintiffs’ petition and found that it violated the pleading requirements of Rule 11(b). That is, the plaintiffs’ complaint set forth allegations inconsistent with evidence obtained through discovery. Speciﬁcally, the court found that C&L’s workpapers clearly indicated that C&L used several techniques to gather evidence of the correctness of the accounts receivable at issue. The court found that the petition was not grounded in fact because, by virtue of their access to C&L’s workpapers and several clarifying communications from C&L’s legal counsel, the plaintiffs were aware of C&L’s performance of multiple techniques to test the accuracy of the Wow Wee and Hoffman receivables, but the plaintiffs’ complaint nonetheless ignored this knowledge. Accordingly, the court ruled in favor of C&L.

Right of Contribution under Section 11( f ) The right of contribution is a common-law doctrine that applies when two or more parties share a common liability, and one party pays more than his/her/its equitable share. Under contribution, the party who pays an inordinate share of the liability may sue to recover the overpayment from the jointly-liable party or parties. The contribution doctrine usually is associated with contract and tort law. However, the doctrine also has been codiﬁed in securities law. Section 11(f) of the 1933 Act provides the following: Every person who becomes liable to make any payment . . . may recover contribution as in cases of contract from any person who if sued separately, would have been liable to make the same payment, unless the person who has become liable was, and the other was not, guilty of fraudulent misrepresentation.68

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However, although the section provides a right of contribution, the PSLRA bars contribution from a covered person once a settlement is executed.69 In re Cendant Corporation Securities Litigation70 (hereinafter, Cendant) is a recent New Jersey District Court case involving the application of the contribution doctrine against an accounting ﬁrm. The case illustrates the intricate interaction between the 1933 Act and PSLRA. Cendant Cendant dealt with E&Y’s audit of HFS, a corporation whose upper management was involved in a pervasive pattern of fraud. As a result of the fraud and E&Y’s alleged inadequate audit, HFS’s operating income was inﬂated by approximately $500 million. This overstatement led to inﬂated stock prices and subsequent shareholders losses once HFS’s fraudulent activities were revealed. E&Y and Cendant (the surviving corporation in a stock-for-stock merger with HFS)71 entered into a joint settlement agreement that required monetary damages of approximately $3.2 billion be paid to the aggrieved class of shareholders. E&Y paid $335,000 and Cendant paid $2.85 billion. After the settlement agreement was approved by the court, Cendant sued E&Y under various theories. It asserted that E&Y, either through willful acts or negligence, contributed to a pattern of fraudulent activities that resulted in misstated ﬁnancial statements and inﬂated stock prices. The primary issue at the federal level was Cendant’s claim for contribution. Cendant conceded that it was not entitled to contribution under the PSLRA, but it argued that it was entitled to contribution independently of Section 11(f). E&Y asserted that it was not liable for contribution under Section 11(f). It argued that since both parties entered into settlement agreements, then neither one had become liable as required by the statute. Alternatively, E&Y also argued that a Section 11(f) analysis was moot because even if Cendant had become liable within the meaning of Section 11(f), the PSLRA contribution ban would eliminate Cendant’s right to contribution. Thus, the District Court considered two primary issues regarding contribution: (1) Can a settling party become liable under Section 11(f)? (2) If a party does become liable under Section 11(f), then does the PSLRA override the 1933 Act and impose a ban on contribution? The District Court concluded that a party may become liable under Section 11(f) even though the party had entered into a settlement agreement. The Court reasoned that since a settling party becomes liable under the settlement agreement, then there is no requirement that a judgment be rendered against the party in order for the statutorily-prescribed liability to attach. Accordingly, if it could be determined that Cendant had paid more than its equitable share of the

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settlement amount, then the Court could sustain Cendant’s Section 11(f) claim for contribution. With respect to the second issue, the District Court found that Cendant’s Section 11(f) claim for contribution was integrally related to securities transactions that initially gave rise to Section 10(b) claims by the settled class (the group of shareholders which originally ﬁled a class action lawsuit against Cendant and E&Y). This intertwining relationship meant that all claims arising from the Cendant fraud were governed by the PSLRA. Since the PSLRA explicitly bars contribution claims, the Court granted E&Y’s motion to dismiss.72 Cendant appealed the District Court decision to the Third Circuit.73 The two issues dealing with the federal level of the case were: (1) the plaintiff class objecting to the size of the settlement (they believed that it was too low); and (2) the ruling to bar contribution claims. The Third Circuit upheld the settlement amount and upheld the position that the PSLRA bars contribution claims.

CONCLUSION Auditor liability for GAAP and GAAS violations continues to be a highly-litigated area. Under the Securities Exchange Act of 1933, CPAs are potentially liable in instances where they have attempted to defraud users of a ﬁrm’s ﬁnancial statements. In order for a CPA to be liable, the plaintiff must establish that the defendant made false statements or omitted material facts and acted with scienter, that the plaintiff relied on the defendant’s false statements, and that these false statements caused the plaintiff’s injury. Scienter and causation are the elements that have caused the most debate, and much of the litigation centers on these elements. Additionally, issues dealing with statute of limitations, pleading standards, and other procedural items have affected the outcomes of the litigation. Accordingly, CPAs must be fully aware of the trends in recent litigation with respect to all of these areas. Such knowledge might help establish better audit procedures and if necessary might help in a subsequent defense of said procedures. This article has dealt with GAAP and GAAS violations (and related legislation) that have been adjudicated as such by the courts. It has not addressed situations where pre-trial settlements were reached and no wrongdoing was acknowledged. It also has not addressed the Enron-Arthur Andersen situation because at this time no GAAP or GAAS violations have been adjudicated by a court of law. (Government ofﬁcials are still trying to determine if such violations had occurred.) Clearly, if the number of pre-trial settlements (and the dollar amount involved) continues to increase, then this will impact future CPA liability and legislation.74 Also, the

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results of any Enron-related litigation (which could take many years) involving GAAP or GAAS violations will have a signiﬁcant impact on subsequent litigation and CPA liability.

NOTES 1. Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). 2. Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978). 3. See, e.g., Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978); see also, Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977). 4. See, e.g., In re Time Warner Securities Litigation, 9 F.3d 259, 268 (2d Cir. 1993); Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 120 (2d Cir. 1982); In re The Wellcare Management Group, Securities Litigation, 964 F. Supp. 632, 640 (N.D.N.Y. 1997). 5. See, e.g., Currie v. Cayman Resources Corp.: “Transaction causation, another way of describing reliance, is established when the misrepresentations or omissions cause the plaintiff ‘to engage in the transaction in question.’ ” 835 F.2d 780, 785 (11th Cir. 1988) (quoting Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir. 1974). 6. The Court established the fraud-on-the-market theory in Basic v. Levinson, 485 U.S. 224 (1988). 7. 963 F. Supp. 301 (S.D.N.Y 1997). 8. Zucker v. Sasaki, 963 F. Supp. 301, 305 (S.D.N.Y 1997); see also Acito v. IMCERA Group, 47 F.3d 47, 53 (2d Cir. 1995) (“defendants’ lack of clairvoyance simply does not constitute securities fraud”). 9. 576 F.2d 465, 468 (2d Cir. 1978). 10. First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 769 (2d Cir. 1994); In Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir. 1974). 11. Gasner v. Board of Supervisors, 103 F.3d 351 (4th Cir. 1996). 12. Huddleston v. Herman & MacLean, 640 F.2d 534, 548 (5th Cir. Unit A 1981), aff’d in part, rev’d in part on other grounds, 459 U.S. 375 (1983). 13. Murray v. Hospital Corp. of America, 873 F.2d 972 (6th Cir. 1989). 14. Bastian v. Petren Resources Corp., 892 F.2d 680, 683–85 (7th Cir. 1990). 15. Robbins v. Koger, 116 F.3d 1441 (11th Cir. 1997). 16. However, it should be noted that of the appellate courts involved in the debate, the Second Circuit has been the most inconsistent in its application of the loss causation criterion. That is, the Second Circuit ﬁrst required the explicit showing of loss causation in Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir. 1974), but has ﬂoundered on the issue over the years. In recent decisions, the Second Circuit has been more consistent in its consideration of loss causation (see Citibank, N.A. v. K-H Corp., 968 F.2d 1489, 1495 (2d Cir. 1991) (“a plaintiff must prove that the damage suffered was a foreseeable consequence of the misrepresentation.”); First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 769 (2d Cir. 1994) (same)), and thus the Second Circuit has joined the majority of the appellate courts. 17. Robbins v. Koger Properties, 116 F.3d 1441, 1448 (11th Cir. 1997). 18. In re Control Data Securities Litigation, 933 F.2d 616 (8th Cir. 1991). 19. Knapp v. Ernst & Whinney, 90 F.3d 1431 (1996).

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20. Knapp v. Ernst & Whinney, 90 F.3d 1431, 1438 (9th Cir. 1996); see also In re Control Data Corp. Securities Litigation, 933 F.2d 616, 619-20 (8th Cir. 1991). (“This is a ‘fraud on the market’ case . . . To the extent that the defendant’s misrepresentations artiﬁcially altered the price of the stock and defrauded the market, causation is presumed.”) 21. See Bruschi v. Brown, 876 F.2d 1526, 1531 (11th Cir. 1989); Wilson v. Comtech Telecommunications Corp., 648 F.2d 88, 92 (2d Cir. 1981). 22. See, e.g., Robbins v. Koger Properties, 116 F.3d 1441, 1447 (11th Cir. 1997); Huddleston v. Herman & MacLean, 640 F.2d 534, 556 (5th Cir. Unit A 1981), aff’d in part, rev’d in part on other grounds, 459 U.S. 375 (1983); Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir. 1974). 23. See, e.g., Huddleston v. Herman & MacLean, 640 F.2d 534, 556 (5th Cir. Unit A 1981), aff’d in part, rev’d in part on other grounds, 459 U.S. 375 (1983). 24. Robbins v. Koger Properties, 116 F.3d 1441, 1447 (11th Cir. 1997). 25. Bruschi v. Brown, 876 F.2d 1526, 1530-2 (11th Cir. 1989); Huddleston v. Herman & MacLean, 640 F.2d 534, 549–56 (5th Cir. Unit A 1981), aff’d in part, rev’d in part on other grounds, 459 U.S. 375 (1983). 26. See, e.g., Ross v. Patrusky, Mintz & Semel, 1997 U.S. Dist. LEXIS 5726, 50 (S.D.N.Y. 1997); Citibank N.A. v. K-H Corp., 968 F.2d 1489, 1496 (2d Cir. 1992). 27. 116 F.3d 1441 (11th Cir. 1997). 28. 991 F. Supp. 234 (S.D.N.Y. 1997). 29. The cash received from these liquidations were more properly characterized as gains rather than revenues. In accounting terminology, cash inﬂows directly attributable to the primary operating activities of a business entity are considered revenues; conversely, cash inﬂows from sources other than a business entity’s primary operations are considered gains. For equity investors, revenues are better indicators of a ﬁrm’s operating performance than are gains. 30. In the original complaint, the plaintiffs charged KPI and several individual defendants with violations of Section 10(b) and Rule 10b-5. Later, Deloitte and Touche (D&T), KPI’s independent auditor for 1998 through 1990, was added to the list of defendants. Subsequently, the complaints against KPI and the individual defendants were dismissed – thereby leaving D&T as the sole defendant. 31. In general, testimony of expert witnesses is an essential element of securities litigation. Usually each party’s expert witness testiﬁes in favor of said party. However, in situations where a party’s expert witness has given damaging testimony against said party, the testimony may not be recanted later in a self-serving purpose to defeat summary judgment motions by the opposing party. See, e.g., Danis v. USN Communications, 121 F. Supp. 2d 1183; 2000 U.S. Dist. LEXIS 16767. 32. 991 F. Supp. 234 (S.D.N.Y. 1997). 33. The plaintiffs’ failure to establish loss causation was fatal not only to their Section 10(b) claims, but also to their charges that E&Y was liable for common law fraud and negligent misrepresentation. 34. 501 U.S. 350 (1991). 35. See Menowitz v. Brown, 991 F.2d 36, 41 (2d Cir. 1993). (“ ‘discovery’ . . . includes constructive or inquiry notice, as well as actual notice.”) 36. 991 F. Supp. 234 (S.D.N.Y. 1997). 37. See O’Brien v. National Property Analysts Partners, 936 F.2d 674, 676 (2d Cir. 1991); In re Health Management, Securities Litigation, 970 F. Supp. 192, 207 (E.D.N.Y. 1997).

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38. See, e.g., Acito v. IMCERA Group, 47 F.3d 47, 51 (2d Cir. 1995); Mills v. Polar Molecular Corp., 12 F.3d 1170, 1175 (2d Cir. 1993); Goldman v. Belden, 754 F.2d 1059, 1069-70 (2d Cir. 1985). 39. 122 F.3d 1186 (9th Cir. 1997); see also DiLeo v. Ernst & Young, 901 F.2d 624 (7th Cir. 1990) (illustrating that, on Section 9(b) issues, the Seventh Circuit rules in a fashion similar to the Ninth Circuit). 40. Both Merisel’s announced earnings and the securities analysts’ reports indicated that the Computerland acquisition had a positive impact on Merisel’s earnings. 41. Under the modifying convention of conservatism that pervades accounting measurement, when two estimates of amounts to be paid or received equally are likely, accountants should adopt the less optimistic estimate. When applying the principle of conservatism to sales revenue, accountants generally should refrain from anticipating revenues and gains until collectibility is reasonably certain but should recognize losses and expenses immediately. In Merisel’s case, many of the improperly shipped goods and consignment goods were returned – a fact that Merisel allegedly concealed. 42. In reaching this conclusion, the District Court relied on Fed. R. Civ. P. 12(b)(6), which authorizes courts to dismiss complaints that fail to state claims upon which relief can be granted. 43. As per the Supreme Court’s holding in Central Bank, there is no Section 10(b) liability for aiding and abetting securities fraud unless the defendant in question personally commits a deceptive act. However, that is not to say that only persons who directly make fraudulent misrepresentations are subject to liability; instead, Rule 10b-5 may be imposed in cases where a party has knowledge of fraud and assists in its perpetration. See SEC v. First Jersey Securities, 101 F.3d 1450, 1471 (2d Cir. 1996) (quoting Azrielli v. Cohen Law Ofﬁces, 21 F.3d 512, 517 (2d Cir. 1994)). 44. In re GlenFed, Securities Litigation, 42 F.3d 1541 (9th Cir. 1994) (en banc). 45. 901 F.2d 624 (7th Cir. 1990). 46. 901 F.2d 624, 627-8 (7th Cir. 1990). 47. The Ninth Circuit remanded the case to District Court so that the substance and accuracy of the plaintiffs’ complaint could be determined. 48. In the Second Circuit, motive must be shown by identifying concrete beneﬁts that a defendant may have been expected to realize as a result of furthering a fraud perpetrated through a ﬁnancial statement misstatement or wrongful disclosure. “Opportunity” involves the defendant having the means through which to realize such concrete beneﬁts. See, e.g., Shields v. Citytrust Bancorp, 25 F.3d 1124, 1129-30 (2d Cir. 1994). 49. See San Leandro Emergency Med. Group Proﬁt Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 809 (2d Cir. 1996). However, it should be noted that in cases where plaintiffs solely rely on allegations of recklessness in asserting scienter, they must present a greater amount of evidence than is required when alleging motive to create an inference of scienter. See, e.g., Beck v. Manufacturers Hanover Trust Co., 820 F.2d 46, 50 (2d Cir. 1987). 50. See In re Glenfed, Securities Litigation, 42 F.3d 1541, 1546–47 (9th Cir. 1994). 51. Statement of Managers for the Private Securities Litigation Reform Act of 1995, H.R. Conference Report 104-369 (Nov. 28, 1995). 52. Pub. L. No. 104-67; codiﬁed at 15 U.S.C. Section 78u-4. (The PSLRA amended the Securities Exchange Acts of 1933 and 1934.) 53. Mednick and Peck (1994) noted that most cases involving CPA ﬁrms settled because plaintiffs’ attorneys have an inherent bias toward settlement. The CPA ﬁrms are included

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in class action suits because of their “deep pockets.” These deep pockets lead to large settlements (and this avoids all subsequent costs associated with a trial). They further suggest that the concept of proportionate liability be used to help reduce unreasonable and unfair liability claims and settlements. Mednick, R., & Peck, J. J. (1994). Proportionality: A muchneeded solution to the accountants’ legal liability. 28 Valparaiso Law Review, 867–918. 54. 970 F. Supp. 192 (E.D.N.Y. 1997). 55. Malone v. Brincat, 722 A.2d 5, 1998 Del. LEXIS 495. 56. See, e.g., In re Silicon Graphics, Securities Litigation, 1996 U.S. Dist. LEXIS 16989 (N.D. Cal. 1996); Friedberg v. Discreet Logic, 959 F. Supp. 42, 49 (D. Mass. 1997); Norwood v. Venture Corp. v. Converse, 959 F. Supp. 205, 208 (S.D.N.Y. 1997). 57. Helwig v. Vencor, 251 F.3d 540 (6th Cir. 2001). 58. See Page v. Derrickson, 1997 U.S. Dist. LEXIS 3673, 1997 WL 148558, at ∗ 10 (M.D. Fla. 1997); Fugman v. Aprogenex, 961 F. Supp. 1190, 1997 U.S. Dist. LEXIS 3299, at ∗ 11 (N.D. Ill. 1997); Shahzad v. H.J. Meyers & Co., 1997 U.S. Dist. LEXIS 1128 (S.D.N.Y. 1997); Rehm v. Eagle Finance Corp., 954 F. Supp. 1246, 1252-53 (N.D. Ill. 1997); Fischler v. Amsouth Bancorp., 1996 U.S. Dist. LEXIS 17670, 1996 WL 686565, at ∗ 2–3 (M.D. Fla. 1996); Sloane Overseas Fund, Ltd. v. Sapiens Int’l Corp., 941 F. Supp. 1369, 1377 (S.D.N.Y. 1996); Zeid v. Kimberley, 930 F. Supp. 431, 438 (N.D. Cal. 1996); Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., 927 F. Supp. 1297, 1310 (C.D. Cal. 1996). 59. 970 F. Supp. 192 (E.D.N.Y. 1997). 60. In re Health Management, Securities Litigation, 970 F. Supp. 192, 201 (E.D.N.Y. 1997). 61. See also In re Health Management, Securities Litigation, 970 F. Supp. 192 (E.D.N.Y. 1997) (in ﬁnding that plaintiffs’ claims failed to meet Fed. R. Civ. P. 9(b)’s pleading requirements, the court noted that the auditor’s mere receipt of audit fees was insufﬁcient to establish scienter); but cf. In re Leslie Fay Cos., Securities Litigation, 835 F. Supp. 167, 174 (S.D.N.Y. 1993) (receipt of professional auditing fee, combined with an “unlikely degree of mere carelessness” by the auditor creates an inference of motive for fraud). 62. In re Worlds of Wonder Securities Litigation, 35 F.3d 1407, 1426 (9th Cir. 1994), cert. denied, 116 S. Ct. 185 (1995)(quoting Malone v. Microdyne Corp., 26 F.3d 471, 476 (4th Cir. 1994)): [Scienter] requires more than a misapplication of accounting principles. The [plaintiff] must prove that the accounting practices were so deﬁcient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts. 35 F.3d at 1426 (quoting SEC v. Price Waterhouse, 797 F. Supp. at 1240).

In a recent case, the District Court for the Southern District of California followed the Worlds of Wonder rationale. Reiger v. Price Waterhouse Coopers, 117 F. Supp. 2d 1003; 2000 U.S. Dist. LEXIS 15185. 63. See, e.g., Decker v. Massey-Ferguson, 681 F.2d 111, 120 (2d Cir. 1982) (generalized statements of accounting violations do not state a fraud claim); Duncan v. Pencer, 1996 U.S. Dist. LEXIS 401, 1996 WL 19043 at ∗ 11 (S.D.N.Y., Jan. 18, 1996) (same). 64. 964 F. Supp. 632 (N.D.N.Y. 1997). 65. See Acito v. IMCERA Group, 47 F.3d 47, 54 (2d Cir. 1995); Shields v. Citytrust Bancorp, 25 F.3d 1124, 1130 (2d Cir. 1994).

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66. In most Second Circuit cases in which there has been found to be a strong inference of fraud based on defendants’ motives, the defendants generally have been shown to have actually received beneﬁts as the result of their allegedly fraudulent actions. See, e.g., Turkish v. Kasenetz, 27 F.3d 23, 24 (2d Cir. 1994) (through fraudulent actions and concealment of material facts, defendants induced sale of 25% interest in family business to an estate); Cohen v. Koenig, 25 F.3d 1168, 1174 (2d Cir. 1994) (motive was sufﬁcient alleged when plaintiffs’ complaint stated that buyers intentionally had misstated assets of corporation to obtain more favorable terms and to close sale). However, although the Wellcare plaintiffs made no explicit allegations that Ullman and Corsones directly beneﬁted from their fraudulent actions, the Wellcare court apparently considered the plaintiffs’ complaint as having implied that Ullman and Corsones received beneﬁts in the form of increased compensation as a result of their actions to fraudulently inﬂate Wellcare’s proﬁts. 67. 1998 U.S. Dist. LEXIS 52 (S.D.N.Y. 1998) (unreported). 68. 15 U.S.C. Section 77k(f)(1) (emphasis added). 69. The PSLRA deﬁnes a “covered person” as: (i) a defendant in any private action arising [under the Securities Exchange Act of 1934] . . . or; (ii) a defendant in any private action arising under section 77k of [section 11 of the Securities Act] . . . who is an outside director of the issuer of the securities that are the subject of the action. 15 U.S.C. Section 78u-4(f)(10)(C). 70. 2001 U.S. Dist. LEXIS 4638. 71. The surviving corporation was originally known as CUC, but its name was changed to Cendant after the merger. 72. The Court also ruled that Cendant could seek legal remedies at the state level for breach of contract, negligence, fraud, and breach of ﬁduciary duty. 73. 2001 U.S. App. LEXIS 19214. 74. Some recent settlements are: Waste Management ($220,000,000), Sunbeam ($110,000,000) and Colonial Realty ($90,000,000) – Arthur Andersen; YBM Management ($76,000,000) – Deloitte & Touche; Merry-Go-Round ($185,000,000) and Informix ($34,000,000) – Ernst & Young; Orange County ($75,000,000) – KPMG; and Bank of Credit and Commerce International ($95,000,000) – PricewaterhouseCoopers.

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PROFESSIONAL REGULATION AND LABOR MARKET OUTCOMES FOR ACCOUNTANTS: EVIDENCE FROM THE CURRENT POPULATION SURVEY, 1984–2000 James Schaefer and Michael Zimmer ABSTRACT This study examines state regulations in the accounting profession and their impact on earnings and employment choices of accountants. It is based on U.S. Current Population Surveys from 1984 to 2000. The results of this study demonstrate that provisions for quality review, limited liability and continuing class of accountants appear to have induced entry of accountants into professional services. In addition, quality review and limited liability provisions appear to be positively associated with self-employment. Moreover, increased entry into the professional services sector appears to have exerted some competitive pressure on earnings.

INTRODUCTION This study examines state regulations in the accounting profession and their impact on earnings and employment choices of accountants. It is based on combined cross Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 87–104 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S105204570216005X

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sections of accountants in the U.S. Current Population Surveys from 1984 to 2000. The period witnessed signiﬁcant changes for professional credentials in accounting. First, many states implemented programs for quality review of accountants’ practices. Second, ten states maintained a continuing class of licensure in addition to the Certiﬁed Public Accountant (CPA), permitting the continuing class to perform some services traditionally provided by CPAs. Third, some states instituted a limited liability form of CPA practice to address growth in malpractice litigation. These changes were implemented in various years on a state-by-state basis, and some states refrained altogether on one or more initiatives. Since our sample spans all years and states, we augmented the data with indicators that identify years and states in which quality review, limited liability, and continuing classes were implemented. We estimate a model of individual earnings that includes background variables describing human capital and other demographic factors. Inclusion of the regulatory variables isolates the impact of the mandated changes on accountants’ earnings after controlling for relevant background factors. Regulations are issued to help control the behavior of those serving the public. In a post-Enron era the accounting profession will have to function in an increasingly regulated environment. Consequently, there is a need for additional research concerning effects of regulation in the accounting profession. Regulation alters labor market outcomes in ways other than earnings. An additional purpose of this study is to examine effects of quality review, limited liability and continuing class on individuals’ choices of sector of employment. Our data include information on each individual’s industry and his or her choice of salaried employment versus self-employment. The industry choice of interest is accounting and auditing services, which includes public accounting, tax work, and consulting activity related to accounting. We model sector outcomes as a bivariate probit model in which the dependent variables capture combined choices regarding self-employment and the accounting services industry. Inclusion of the regulatory variables reveals whether the mandated changes exerted signiﬁcant effects on the sector choices of accountants.

BACKGROUND All states have accountancy statutes administered by state boards that set regulations for entry into the profession and govern the practice of public accounting. The American Institute of Certiﬁed Public Accountants (AICPA) advocates policies and administers codes of conduct. Substantial interaction takes place between state boards and the AICPA. First, collective action and coordination of policies of the state boards are facilitated by the National Association of State Boards of Accountancy (NASBA), to which state boards belong (Magill &

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Previts, 1991, p. 56). Second, many states join the AICPA in the Joint Ethics Enforcement Program, under which ethics investigations are carried out by the AICPA or state boards. This has expanded the power of the AICPA to regulate accountants, including those who are not CPAs or members of AICPA. While economists have conducted research concerning labor market outcomes of occupational licensing, to date there has been little work focusing on effects on earnings of regulation in the accounting profession. Friedman and Kuznets (1945) studied the institution of certiﬁed public accountancy, producing evidence that licensure through certiﬁcation has the effect of increasing earnings of practitioners. Schaefer and Zimmer (1995) examined effects of education and experience requirements and provisions for quality review. This paper extends that study by exploiting a larger sample over a longer period of time, and by examining effects of limited liability and continuing classes, which have not been studied in previous work. Since additional states adopted quality review programs and limited liability corporations after 1995, our data permit an updated analysis of both issues. Regarding effects of regulation on sector decisions, our study appears to be the ﬁrst to investigate whether quality review, continuing class, and limited liability have affected accountants’ choices regarding self-employment and employment in the accounting services industry. Labor economists have examined individuals’ choices of self-employment (see, for example, Carrington, McCue & Pierce, 1996). Our focus on accountants, along with the added dimension of industry choice, distinguishes this study from that literature.

THEORETICAL EFFECTS OF REGULATIONS Professional regulations in accounting are intended, in part, to protect the public from incompetent or dishonest practitioners. By placing restrictions on the profession and the manner in which it is practiced, regulation might contribute in conﬂicting ways to individuals’ decisions to work in the profession. In particular, regulations have potential to affect the sectors in which accountants decide to work and whether they choose to be self-employed. Since these choices naturally have implications regarding barriers to entry and the supply of labor to various sectors, regulations have potential to affect individual earnings. In addition, regulations in some instances can shift the demand for professional services, as they convey valuable information to consumers regarding the reputation of service providers. Quality Review Quality review is intended to evaluate a CPA ﬁrm’s audit procedures and to improve the quality of accounting and auditing practices. Accounting ﬁrms participating

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in quality review programs are evaluated on whether their policies and procedures are adequate to achieve standard elements of quality control. Due to the rigor of evaluation and costs associated with it, states that implement quality review programs might deter accountants from either working in or becoming self-employed in the accounting and auditing services sector. On the other hand, presence of quality review is likely to reduce the risk of malpractice exposure and increase the perceived value of services to potential clients. If the consequence is to increase the demand for services, practitioners’ earnings are likely to increase as a result, serving to attract individuals to the services sector. Previous research has examined the effect of peer review on the quality of audit services. Wallace and Campbell (1988) found evidence that quality review programs improve the quality of public accounting services. Francis et al. (1990) found no signiﬁcant fee differences for peer reviewed ﬁrms, and they conclude there is an economic disincentive to join the AICPA division for CPA ﬁrms where peer review would be required. However, Giroux et al. (1995) using audits of Texas independent school districts, found that peer reviewed audit ﬁrms provide higher quality audits, with fee premia related to more extensive audit procedures. Schaefer and Zimmer (1995) found no evidence that a quality review environment affects earnings in either direction. In the range of years covered by our sample, three states had a quality review program for the entire period of study, and 27 more states inaugurated new requirements. These changes provide an opportunity for further analysis of quality review.

Continuing Class Licensure in the form of a CPA establishes professional credibility, which should create a market advantage for those who are licensed. Ten states recognize a second class of licensed accountants (AICPA/NASBA, 1996, pp. 126–127). During the years in our sample, no additional states implemented the continuing class. The additional class has implications for competition in accounting services. By easing entry to the services sector, continuing class provisions might exert competitive pressure on practitioners’ earnings.

Limited Liability Form of Practice In the early days of the accounting profession in the United States, it was common for CPAs to practice as corporations. Corporate status allowed practitioners to protect their personal assets by limiting their liability (Miller, 1993, p. 134). By

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the turn of the century, partnerships had become a common form of practice. As the number of malpractice suits increased after 1980 and accountants sought to protect themselves from litigation, the AICPA moved to allow members to practice under any legal form of organization, effective January 1992. During the range of years in our sample, all states adopted limited liability corporate or limited liability partnership statutes. The effect of these changes was to provide increased protection from tort and general contract claims, as well as limited tax liability. In addition, as a general rule, members of a limited liability organization are not personally liable for its debts. The ability to form an LLC presents no obvious disadvantages to practitioners, and may reduce barriers to entry into self-employment and the accounting and auditing services sector. As in the case of the continuing class provision, the reduction in barriers to entry might put pressure on practitioners’ earnings.

DATA AND SAMPLE COMPOSITION The sample consists of individual records for accountants and auditors from annual March Current Population Surveys (CPS) of the U.S. Census. The CPS gathers data from nearly 60,000 households, selected on the basis of area of residence to be nationally representative. The CPS classiﬁes workers by industry and occupation, both in 3-digit codes, in a manner sufﬁciently detailed to isolate accountants and auditors (occupation code 023) and those employed in the accounting services industry (industry code 890). By searching annual CPS ﬁles for this code, we extracted between 700 and 900 accountants and auditors for each year. Following this procedure for all surveys from 1984 through 2000 resulted in a sample of 13,227 individual records dispersed across every major region and industry. The CPS questions individuals regarding their employment and earnings during the preceding year; thus the data span the period 1983 to 1999. Since the CPS does not subdivide occupation code 023, we cannot distinguish between such categories as management accountants, public accountants, and internal auditors. This limitation of the data prevents us from examining the effects of regulation on individuals’ decisions to engage in managerial rather than public accounting. We adhered to the range of occupation codes deﬁned as “executive, administrative and managerial occupations.” Among occupations excluded from the sample, with census codes in parentheses, are: bookkeepers, accounting and auditing clerks (337); payroll and timekeeping clerks (338); billing, posting and calculating machine operators (344); posting ofﬁce clerks (379), and secretaries and stenographers (313–315). Classiﬁcations are sufﬁciently detailed to exclude occupations peripheral to accounting and auditing. For example, occupations

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Table 1. State Regulatory Requirements: 1984–2000. Continuing Class of Accountants Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas

All Years All Years

All Years All Years

All Years

All Years

All Years All Years

All Years

Limited Liability Corporation

Quality Review Program

1993 1995 1992 1993 1995 1992 1995 1992 1993 1994 1997 1993 1994 1993 1992 1992 1994 1992 1995 1992 1995 1993 1992 1994 1994 1993 1993 1992 1991 1994 1993 1994 1993 1993 1994 1992 1993 1994 1993 1994 1993 1994 1993

1987

1989 1987 1989 All Years 1992 1996

All Years 1987 1986 All Years

1997 1992 1986 1986 1987 1988 1998 1987 1998 1992 1988 1985 All Years 1994 1988 1988 1987

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Table 1. (Continued ) Continuing Class of Accountants Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming

All Years

Limited Liability Corporation

Quality Review Program

1991 1995 1991 1994 1996 1993 1990

1994 1987 1987

1988

Notes:

Years indicates the effective date of the regulation (not the year it was passed). “All years” indicates that the regulation was in effect in that state for the entire period of study. Continuing Class of Accountant data were obtained from AICPA/NASBA (1996, pp. 126–127). Limited Liability Corporation data were obtained by reviewing the public accountancy statutes via LEXIS/NEXIS and state board websites. Quality Review Program data were obtained from Wallace and Campbell (1988, pp. 126–127), and by reviewing state public accountancy statutes via LEXIS/NEXIS.

excluded from the sample include underwriters (024) and other ﬁnancial ofﬁcers (025). Consequently, the sample encompasses professional accountants and auditors whose job responsibilities are not primarily clerical. Table 1 provides a chronology of implementation, by state, for each of the regulatory initiatives. Entries indicate the year in which each initiative was implemented. Blanks indicate that, as of 2000, the state had not taken up the initiative in question. We used the information in Table 1 to construct person-speciﬁc indicators for each regulation. An accountant in a state during any year in which a particular regulation was in effect is assigned a value of one; a value of zero was assigned if the regulation was not in effect. In this manner each sample observation is assigned a value for each of three regulatory dummy variables: quality review, limited liability, and continuing class.

ECONOMETRIC FRAMEWORK AND SPECIFICATION The ﬁrst item of interest is the allocation of individuals into self-employment versus wage and salary employment and the accounting services industry versus other industries. Suppose each accountant possesses a latent propensity to be selfemployed as opposed to seeking wage and salary employment. The individual becomes self-employed if the latent index, SE∗i , exceeds zero; otherwise he accepts

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wage and salary employment. We do not observe SE∗i . Instead we observe the individual’s response to the CPS question on self-employment: SEi = 1 SEi = 0

if SE∗i > 0 if SE∗i ≤ 0

(1)

A probit model postulates the probability that a randomly selected accountant is self-employed to be a function of explanatory variables and unknown parameters: P(SEi = 1) = (␣ Z i ) − ␯i

(2)

where the error term ␯i is assumed to possess a normal distribution with zero mean and unit variance and denotes the cumulative distribution function of a standard normal distribution. In the self-employment model, explanatory variables include the three regulatory dummy variables. In addition, consistent with Carrington, McCue and Pierce (1996), control variables include age, schooling attainment, and dummy variables for race, marital status, and work-limiting health disabilities. Subject to the assumption of a normal distribution in the error term, the vector of parameters ␣ can be estimated by maximum likelihood probit methods. A similar framework can be established for the industry of employment. Let AS∗i denote individual i’s latent propensity to choose the accounting services industry. We observe only ASi = 1 ASi = 0

if AS∗i > 0 if AS∗i ≤ 0.

(3)

The corresponding probit model is P(ASi = 1) = (␦ W i ) − ␩i

(4)

where the explanatory variables Wi include the three regulatory initiatives and ␦ represents a vector of parameters. The error term ␩i is assumed to possess a standard normal distribution. There is potential for correlation between the random error terms in Eqs (2) and (4). Correlation would be present if, for a given accountant, unmeasured factors that affect his or her propensity for self-employment tend to be associated with unmeasured factors that affect his or her decision to work in the accounting services industry. Consequently, we estimate Eqs (2) and (4) jointly as a bivariate probit model, which permits the error terms ␯ and ␩ to possess a correlation parameter ␳. Since there is no a priori basis for selecting variables for inclusion on the right hand side of (4), aside from the key regulatory variables, we include the same controls as Eq. (2), i.e. age, years of education, marital status, race, and health status.

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In the most common formulation of the earnings equation (Mincer, 1974), the logarithm of earnings is a linear combination of explanatory variables and a random disturbance term: ln E i = ␤ X i + ␧i

(5)

where Ei denotes earnings of worker i, Xi is a vector of explanatory variables measuring human capital as well as other background and demographic information, and ␤ is a vector of unknown parameters. The error term is assumed to possess a normal distribution with zero mean and constant variance. The assumption of constant variance is important in this study. If the error term is heteroscedastic, standard errors of the estimated coefﬁcients are biased and inferences about the critical regulation parameters are unreliable. To obtain correct standard errors, we use White’s (1978) generalized correction for heteroscedasticity. The vector Xi includes the three dichotomous indicators of state regulatory initiatives. In addition, the model has additional controls for schooling; potential work experience, deﬁned as age minus schooling minus four, and experience squared; a race dummy variable equal to one for whites and zero otherwise; a gender dummy variable equal to one for males and zero otherwise; a marital status dummy variable equal to one for marrieds and zero otherwise; a physical limitation dummy variable equal to one for individuals who report a health condition that limits their work, and zero otherwise; a residence dummy variable equal to one for individuals living in a metropolitan statistical area, and zero otherwise; and a series of industry variables to indicate the individual’s 3-digit industry of employment.1 The dependent variable is the natural log of weekly earnings, where earnings are measured in constant 1984 dollars.2 To isolate the regulatory effects from general factors that might be due to macro events in particular years or regions rather than to regulations per se, the model includes dummy variables for years and geographic regions.3

RESULTS OF ESTIMATION Table 2 presents descriptive statistics for selected variables in the model. Average weekly log earnings are 5.97, which corresponds to nearly $650 in 1984 dollars. The average accountant possesses more than 19 years of potential work experience and the schooling equivalent of nearly a college degree. While a majority of the sample consists of whites and marrieds, the distribution between genders is more even, with 49% males. For the regulatory variables, the sample means reveal that 41% of the accountants resided in a state and during a year in which quality review was mandated. For states recognizing continuing class, the proportion is 11%, and for states recognizing limited liability corporations, it is 37%.

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Table 2. Descriptive Statistics. Variable

Sample Mean

Log Earnings

Log of real weekly earnings, 1984 dollars

Earnings

Real weekly earnings, 1984 dollars

Experience

Potential work experience

19.30

12.197

Education

Highest grade attended

15.49

1.797

White

= 1 if white = 0 otherwise

0.878

0.328

Married

= 1 if married = 0 otherwise

0.642

0.480

Male

= 1 if male = 0 if female

0.485

0.500

Disabled

= 1 if health condition limits work = 0 otherwise

0.016

0.124

Reside MSA

= 1 if residence is metropolitan = 0 otherwise

0.451

0.498

Self-Employed

= 1 if self-employed = 0 otherwise

0.088

0.283

Quality Review

= 1 if quality review mandated in the state and during the year of observation = 0 otherwise

0.411

0.492

Continuing Class

= 1 if continuing class is recognized in the state and during the year of observation

0.112

0.316

Limited Liability

= 1 if limited liability corporations recognized in the state and during the year of observation = 0 otherwise

0.370

0.483

Sample Size

5.979

Sample Standard Deviation

648.16

0.675 591.40

13,227

Table 3 reports estimates of the bivariate probit model of sector choice. Estimates for the control variables reveal a proﬁle of individuals who choose self-employment and/or accounting services. They tend to be older and more educated. Both choices are more likely among marrieds and whites. Physical disability is not signiﬁcant in either case.

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Table 3. Bivariate Probit Estimates: Self Employment and Accounting Services.* Variable

Constant Age Education Disabled Married White Quality Review Limited Liability Continuing Class Error Term Correlation: N ∗ Figures

Equation (2) Self-Employed

Equation (4) Accounting Services

−5.596 (28.11) 0.031 (20.47) [<0.01] 0.146 (13.86) [<0.01] 0.145 (1.27) [0.20] 0.386 (9.56) [<0.01] 0.282 (4.73) [<0.01] 0.158 (4.67) [<0.01] 0.120 (3.50) [<0.01] 0.028 (0.52) [0.60] 0.742 (59.74) [<0.01] 1,158/13,227

−4.124 (27.56) 0.004 (3.62) [<0.01] 0.163 (19.42) [<0.01] 0.022 (0.22) [0.83] 0.101 (3.58) [<0.01] 0.473 (10.61) [<0.01] 0.076 (2.83) [<0.01] 0.115 (4.22) [<0.01] 0.101 (2.55) [0.01] 2,709/13,227

in parentheses are absolute t statistics. Figures in square brackets are the corresponding

p-values.

Effects of the regulatory variables are positive and signiﬁcant in all but one case. The sole exception is the effect of continuing class, which is not signiﬁcant in the self-employment equation. The estimates indicate that after controlling for background variables, quality review increases the likelihood of both self-employment and location in the professional services sector. The limited liability statute provides individuals with some safeguards against personal loss. Its effect appears to increase the ranks of both self-employed and accounting service professionals. The continuing class provision has the effect of reducing barriers to entry in the market for CPA services. It appears to increase the likelihood of working in the professional services sector. The estimated correlation between error terms is positive and signiﬁcant. Individuals who for unmeasured reasons are prone to self-employment possess unmeasured tendencies to work in the professional services sector. Table 4 presents regression estimates of Eq. (5), the earnings model. Results are presented for two partitions of the sample. The ﬁrst column reports estimates for the accounting and auditing services sector (industry code 890). This isolates individuals employed in public accounting or consulting services, the target population with greatest potential to be affected by the regulatory statutes described in previous sections. In this model we include a dummy variable for self-employment. Inspection of the data revealed that a large majority of the self-employed accountants in the original sample were concentrated in industry 890; of the 1,158 total self-employees, 879 (76%) were in accounting and auditing services. Column

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Table 4. Estimates of the Log Earnings Equation.* Variable Constant Experience Experience sq./100 Education White Married Male Disabled Reside MSA Self-Employed Quality Review Limited Liability Continuing Class Year Dummies Region Dummies Industry Dummies R Square N

Accounting and Auditing Services 3.908 (17.40) [<0.01] 0.043 (10.88) [<0.01] −0.089 (10.81) [<0.01] 0.080 (7.05) [<0.01] −0.073 (1.52) [0.13] 0.098 (3.06) [<0.01] 0.456 (15.02) [<0.01] −0.691 (3.91) [<0.01] 0.004 (0.12) [0.91] −0.020 (0.50) [0.62] 0.015 (0.51) [0.61] −0.264 (2.54) [0.01] −0.122 (3.12) [<0.01] Yes Yes N/A 0.218 2,709

All other Industries 3.779 (54.08) [<0.01] 0.041 (17.33) [<0.01] −0.071 (13.08) [<0.01] 0.089 (25.47) [<0.01] 0.034 (2.22) [0.03] 0.036 (3.18) [<0.01] 0.246 (20.49) [<0.01] −0.179 (3.71) [<0.01] 0.011 (0.89) [0.37] N/A −0.039 (3.08) [<0.01] −0.174 (4.30) [<0.01] −0.110 (6.42) [<0.01] Yes Yes Yes 0.236 10,239

∗ Figures

in parentheses are absolute t statistics. Figures in square brackets are the corresponding p-values. Dependent variable is the natural logarithm of weekly earnings in constant 1984 dollars. Estimated coefﬁcients of the year, region and industry dummy variables are presented in Table A1 of the Appendix.

two is restricted to individuals who were not self-employed and were working in industries other than accounting and auditing services. Estimates for the control variables in both models are consistent with results of numerous other studies of earnings. The coefﬁcients reveal a pattern of returns to potential work experience that increase at a diminishing rate over the life cycle. Returns to additional years of schooling are positive and signiﬁcant, and appear to be somewhat lower in the accounting services sector. Racial differences are insigniﬁcant in the service sector, while a marginal advantage for whites is evident in the broader non-services sector. Consistent with ﬁndings in other studies, there appear to be earnings advantages for marrieds and for males. Persons with physical limitations earn less, after controlling for other background factors. The disability effect is surprisingly large in the services sector. Residence in a metropolitan area is not signiﬁcant in either model. In the service sector, the self-employed effect is not signiﬁcant. Both models contain sets of dummy variables to control for the year and region of observation. Consequently, the regulatory coefﬁcients are net of year and

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region effects that affect earnings on an annual or regional basis. In addition, the larger sample partition of all other industries includes dummy variables for 3-digit industry sectors. Estimates of coefﬁcients for the additional controls are provided in Table A1 of the Appendix. With the background factors controlled, the regulatory coefﬁcients reveal several signiﬁcant effects on earnings. Focusing ﬁrst on the accounting and auditing services sector, the limited liability and continuing class coefﬁcients are signiﬁcantly negative. The effect of continuing class is to reduce earnings by slightly more than 10%. The limited liability effect is substantially larger. The quality review coefﬁcient is small in magnitude and not signiﬁcant. In the larger partition of all other industries, both the limited liability and continuing class coefﬁcients are again negative and signiﬁcant. The limited liability coefﬁcient is smaller than its counterpart in the accounting services sample, while the continuing class coefﬁcient is similar across samples. The R-square statistics indicate that the explanatory variables in both models explain nearly 24% of measured sample variation in weekly log earnings. The results in Table 4 suggest that programs of quality review do not exert an effect on earnings in the accounting services sector. While it might seem that compliance with quality review would entail costs in the form of resources and time that could hinder practitioners’ earnings, costs appear to be offset by outcomes favorable to earnings. It is likely, for example, that a systematic process of quality review increases earnings by improving the caliber of accounting services and perceptions of quality among prospective clients, thereby increasing the demand for professional services. Outside the service sector, it is not immediately clear why quality review should have an adverse effect on earnings, as the estimate in the second column indicates. The effect is not large in magnitude; based on the average weekly earnings for the entire sample, the quality review coefﬁcient (0.039) indicates a reduction in earnings in an amount less that $25 (1984 dollars) per week. A plausible explanation is that services of accountants in the professional services sector are, to some extent, substitutes for services provided outside the service sector. If quality review conveys an image of competence and quality to potential clients, the tendency might be for clients to purchase services such as tax work from the services sector rather than from other sectors. The shift in demand might have the consequence of placing competitive pressure on earnings for those in the other sectors. It is worth repeating that the effect, while statistically signiﬁcant, is small in magnitude. The continuing class provision exerts a negative impact on earnings, with similar magnitudes in both samples. In the services sector, the sanction given to an expanded class of practitioners increases the supply of individuals who render services equivalent to CPAs. The effect is to increase competition among

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practitioners and reduce earnings. This appears to exert an indirect effect in the nonservice sector. As practitioners enter accounting services, the array of available services expands, placing competitive pressure on earnings of those who provide similar services in other sectors. The coefﬁcient of limited liability is negative and signiﬁcant in both groups, indicating that statutory limits on professional liability have exerted a negative effect on earnings. At ﬁrst this seems counterintuitive, given the asset protection that limited liability provisions convey to practitioners. However, several factors attenuate the advantages of liability limitations. First, some states (notably California) require liability insurance coverage. Second, practitioners remain liable for their own malpractice, as well as that of any individuals under their supervision. Third, a blanket provision of limited liability does not give any individual a competitive advantage over others. Fourth, limited liability provisions do not create any new fee-generating services for accountants. On the contrary, they might make those services less attractive to potential customers, thereby weakening the demand. Finally, limited liability provisions have the potential to either increase the supply of labor (directly in the services sector and indirectly in other sectors) or to shift the choice of employment from the non-service sector to the service sector. The consequence is a negative effect on earnings. Evidence from the model of sector choice and the earnings model, taken together, suggests that self-regulation has effected several outcomes in the labor market for accounting practitioners. Initiatives of quality review, limited liability, and continuing class are associated with an increase in the allocation of individuals to the accounting services sector, while quality review and limited liability have increased the incidence of self-employment. At the same time, the labor market has adjusted to those sector choices by exerting competitive pressure on earnings; our estimates indicate an adjustment in excess of 10% due to the continuing class provision and no discernible penalty associated with quality review. The effect of limited liability provisions is to reduce earnings by approximately 16% in the nonservice sector and 23% in the service sector. The latter estimate seems larger than might be expected, although we have no research precedent to serve as a frame of reference. Whatever advantages have been conveyed to practitioners from these initiatives, the net effect on earnings appears to be modestly negative. Given the mobility of accounting professionals and the general portability of their expertise, it is not surprising that both sectors feel the impact of self-regulation. Our evidence indicates that market adjustments diminish earnings in both sectors, holding other factors constant. This result suggests a need for further study on the extent to which the two sectors are related and the manner in which policy changes in one can affect the other.

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CONCLUSION During the period 1984–2000 the accounting profession experienced substantial changes in its regulatory environment. Numerous states enacted new professional mandates, providing a useful backdrop for empirical research about the labor market consequences of the changes. Our evidence, based on a sample of individual accountants, suggests several noteworthy consequences. First, provisions for quality review, limited liability and continuing class appear to have induced entry of accountants into the professional services sector. Second, quality review and limited liability appear to be positively associated with self-employment. Finally, increased entry into professional services appears to have exerted some competitive pressure on earnings. Although real earnings have grown over time, they apparently would have attained higher levels if not for the effects of increased competition. Numerous other aspects of regulation in professional accounting offer potential for useful research. These include implementation of centralized state boards of accounting, allowances for CPA commissions and contingent fees (which are banned in some states), and experience requirements for CPA certiﬁcation. This study indicates that regulatory policies affect the labor market, both in terms of sectors in which accountants choose to work and their earnings. Future research can shed light on effects of other regulations and licensure requirements.

NOTES 1. The industry categories, with the range of three-digit census codes that encompass each category in parentheses, are: Agriculture (010–030); Mining (040–050); Construction (060); Manufacturing (100–391); Transportation Communications and Utilities (TCU: 400–472); Wholesale Trade (500–571); Retail Trade (580–691); Finance Insurance and Real Estate (FIRE: 700–712); Business and Repair Services (721–760); Personal Services (762–791); Entertainment and Recreation Services (800–810); Professional and Related Services (812–892); and Public Administration (900–931). Due to small numbers of observations in some categories, we formed a combined category by collapsing the following into a single group: Agriculture, Mining, Construction, Personal Services, Entertainment and Recreation Services.In 1992 the Census Bureau redesigned the question concerning years of schooling. The revised question elicited categories of educational attainment rather than years of schooling completed. In order to express education as years completed, we converted the categories to equivalent years completed. For example, “high school completed” is coded as 12 years. Details of the conversion are available from the authors on request. 2. The Census Bureau implemented a redesign of the Current Population Survey in 1994. Included in the redesign were reformulated questions about earnings. Cohany, Polivka and

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Rothgeb (1994, Table 7) estimate that the revised questions produce slightly higher estimated earnings. For full time workers, the difference is approximately 3%. 3. The regional categories, with member states in parentheses, are: South Central (Alabama, Arkansas, Kentucky, Louisiana, Mississippi, Oklahoma, Tennessee, Texas); North Central (Iowa, Illinois, Indiana, Kansas, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota, Wisconsin); South Atlantic (Delaware, District of Columbia, Florida, Georgia, Maryland, North Carolina, South Carolina, Virginia, and West Virginia); Mid Atlantic (New Jersey, New York, and Pennsylvania); New England (Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, and Vermont); Mountain (Arizona, Colorado, Idaho, Montana, Nevada, New Mexico, Utah, and Wyoming); and Paciﬁc (Alaska, California, Hawaii, Oregon, and Washington).

ACKNOWLEDGMENTS An earlier version of this paper was presented at the 1999 conference of the Midwest Economics Association. The authors wish to thank David Smith, Gary Previts, and two anonymous reviewers for their helpful comments.

REFERENCES American Institute of Certiﬁed Public Accountants and National Association of State Boards of Accountancy (1996). Digest of state accountancy laws and state board regulations (Updated ed.). New York: AICPA. American Institute of Certiﬁed Public Accountants (1997). Digest of state issues. Washington, DC: AICPA. Carrington, W., McCue, K., & Pierce, B. (1996). The role of employer/employee interactions in labor market cycles: Evidence from the self employed. Journal of Labor Economics (14), 571–602. Cohany, S., Polivka, A., & Rothgeb, J. (1994). Revisions in the current population survey effective January 1994. Employment and Earnings, 41, 13–37. Francis, J., Andrews, W., & Simon, D. (1990). Voluntary peer reviews, audit quality, and proposals for mandatory peer reviews. Journal of Accounting, Auditing & Finance, 5(3), 369–378. Friedman, M., & Kuznets, S. (1945). Income from independent professional practice. New York: National Bureau of Economic Research. Giroux, G., Deis, D., & Bryan, B. (1995). The effect of peer review on audit economies. In: G. J. Previts (Ed.), Research in Accounting Regulation (Vol. 9, pp. 63–82). Greenwich, CT: JAI Press. Magill, H. T., & Previts, G. J. (1991). CPA/professional responsibilities: An introduction. Cincinnati: South-Western Publishing Company. Miller, R. (1993). Alternative forms of organization: Guidelines for CPAs. In: K. S. Anderson (Ed.), Accountants’ Liability: The Need for Fairness (pp. 133–148). Washington, DC: National Legal Center for the Public Interest. Mincer, J. (1974). Schooling, experience and earnings. New York: Columbia University Press. Schaefer, J., & Zimmer, M. (1995). Occupational licensure in the accounting profession: Effects of public regulations on accountants’ earnings. Journal of Applied Business Research, 11(2), 9–16.

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Wallace, W., & Campbell, R. (1988). State boards of accountancy: Quality review and positive enforcement program. In: G. J. Previts (Ed.), Research in Accounting Regulation (Vol. 2, pp. 123–154.) Greenwich, CT: JA1 Press. White, H. (1978). A heteroscedacticity-consistent covariance matrix estimator and a direct test for heteroscedasticity. Econometrica (48), 149–170.

APPENDIX Table A1. Estimated Regression Coefﬁcients: Years, Regions and Industries.*

Years 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Regions South Central North Central New England Mid Atlantic South Atlantic Mountain Industries Manufacturing TCU W. Trade R. Trade

Accounting and Auditing Services (n = 2,709)

All Other Industries (n = 10,239)

0.130 (1.30) [0.19] 0.172 (1.78) [0.08] 0.170 (1.70) [0.09] 0.310 (3.15) [<0.01] 0.324 (3.31) [<0.01] 0.378 (3.88) [<0.01] 0.312 (3.25) [<0.01] 0.164 (1.48) [0.14] 0.279 (2.57) [0.01] 0.380 (2.90) [<0.01] 0.464 (2.84) [<0.01] 0.548 (2.43) [0.02] 0.565 (2.47) [0.01] 0.506 (2.69) [<0.01] 0.609 (3.26) [<0.01] 0.601 (3.18) [<0.01]

0.158 (4.37) [<0.01] 0.104 (2.92) [<0.01] 0.137 (3.78) [<0.01] 0.182 (4.92) [<0.01] 0.193 (5.18) [<0.01] 0.174 (4.69) [<0.01] 0.186 (5.04) [<0.01] 0.204 (5.21) [<0.01] 0.218 (5.48) [<0.01] 0.250 (5.26) [<0.01] 0.303 (5.11) [<0.01] 0.415 (4.97) [<0.01] 0.395 (4.68) [<0.01] 0.316 (4.68) [<0.01] 0.388 (5.84) [<0.01] 0.425 (6.45) [<0.01]

0.186 (1.45) [0.15] 0.074 (1.69) [0.09] 0.099 (2.13) [0.03] 0.105 (2.68) [<.01] −0.009 (0.20) [0.84] 0.024 (0.46) [0.64] n.a. n.a. n.a. n.a.

−0.012 (0.27) [0.79] 0.010 (0.62) [0.53] −0.039 (1.83) [0.07] 0.059 (3.55) [<0.01] 0.019 (1.18) [0.24] −0.062 (2.99) [<0.01] 0.169 (10.10) [<0.01] 0.181 (8.43) [<0.01] 0.064 (2.48) [0.01] −0.093 (3.48) [<0.01]

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Table A1. (Continued ) Accounting and Auditing Services (n = 2,709) FIRE Bus. Services Pub. Admin. Combined

n.a. n.a. n.a. n.a.

All Other Industries (n = 10,239) 0.123 −0.067 0.060 −0.142

(6.83) [<0.01] (2.23) [0.03] (3.52) [<0.01] (1.81) [0.07]

∗ Figures in parentheses are absolute t statistics. Figures in square brackets are the corresponding pvalues. Variable deﬁnitions for regions and industries are given in notes 1 and 2. Omitted categories for the dummy variables are: years, 1983; regions, Paciﬁc; and industries, Professional and Related Services. The 1984–2000 CPS surveys question individuals regarding their employment and earnings during the preceding years; thus the data span the period 1983 to 1999.

THE ECONOMIC THEORY OF REGULATION AND SUNSET REVIEWS OF PUBLIC ACCOUNTANCY LAWS: THE ROLE OF POLITICAL IDEOLOGY Gary Colbert and Dennis Murray ABSTRACT The economic theory of regulation (ETR) holds that various groups will attempt to inﬂuence the regulatory process to promote their self-interest, and that politicians respond most favorably to those groups that can assist them in their careers. Prior research has used ETR to explain the variation in accounting regulations across states. This paper extends that work by examining, in depth, a recently completed sunset review process in one state. Various parties, including government ofﬁcials, the State Board of Accountancy, the State Society of CPAs, and educators, were involved in this process. We conclude, as indicated by ETR, that the positions of these groups appear to be consistent with their respective self-interests. Also consistent with ETR, several factors suggest that the regulated profession (CPAs) has successfully captured the ﬁrst level regulators (the State Board). In addition, we conclude that the political ideology of the governor was an important determinant of the sunset review’s outcome.

Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 105–119 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160061

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1. INTRODUCTION The economic theory of regulation (ETR) seeks to explain the existence, strictness and pattern of regulation. Brieﬂy, ETR assumes that individuals and groups act in their self-interest when attempting to induce a government to use its powers for their beneﬁt (Becker, 1983; Peltzman, 1976; Stigler, 1971). In the setting of occupational licensing, the involved groups include the providers of a service, the consumers of the service and the providers’ competitors (Graddy, 1991). These groups attempt to inﬂuence regulators through lobbying efforts, political contributions and the offering of votes. Groups that can provide regulators with the most political support are the likely victors. Although consumers can potentially beneﬁt from some level of regulation, the providers of a service might be the primary beneﬁciaries of greater (i.e. stricter) regulation (Rottenberg, 1980). For example, unnecessary educational requirements and difﬁcult reciprocity provisions for practitioners from other jurisdictions can serve as entry barriers and can reduce consumers’ access to the service and raise fees. Accounting researchers have employed ETR to explain the variation in professional accountancy laws and regulations among the individual states. These studies have largely been cross-sectional analyses, using only a few independent variables as surrogates for the underlying constructs. Although the results have supported ETR, considerable unexplained variation remains. For example, Young (1991) reports pseudo R2 s ranging from 0.29 to 0.47. Colorado conducted a sunset review of its public accountancy law during the 2000 legislative session.1 Sunset reviews are periodic examinations by state ofﬁcials to assess the necessity, effectiveness and efﬁciency of various state functions, including regulatory boards and commissions. The outcome of a sunset review can range from a minor change in the existing law to outright elimination of the regulatory function. Colorado’s sunset review provided us the opportunity to examine, in depth and on a contemporaneous basis, the revision of a public accountancy law.2 Various parties, such as government ofﬁcials, the State Board of Accountancy, the State Society of CPAs, and educators, were involved in this process. We interviewed and/or observed all of these parties. This enabled us to directly examine their behaviors and to assess their motivations. We were also able to compare our observations to the implications of ETR. We ﬁnd that ETR and political ideology explain much of the participants’ behaviors. This paper is organized as follows. Section 2 reviews ETR. The following section describes the sunset review process and identiﬁes the various involved parties. Section 4 examines the consistency of ETR’s implications with our

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observations of the sunset review. The ﬁnal section offers a summary and conclusion.

2. ECONOMIC THEORY OF REGULATION Governmental intervention in the markets in the form of occupational licensing is usually justiﬁed because of two possible market failures: information asymmetry and externalities (Akerlof, 1970; Leland, 1979; Wolfson et al., 1980). Information asymmetry exists when a service provider is knowledgeable about his or her competence, but the consumer is unable to evaluate service quality. Audits would seem to reﬂect this situation; audit quality is difﬁcult to assess, even after the audit has been completed. Minimum quality standards in the form of licensing restrictions can potentially beneﬁt the public by ensuring that only individuals who meet the minimum standards are permitted to conduct audits. Externalities arise when the societal impact of a transaction exceeds the impact incurred by the transactors. In a recent audit related situation, U.S. taxpayers incurred a $500 billion cost as the result of the savings and loan crisis (United States General Accounting Ofﬁce, 1991). While faulty audits were not primarily responsible for these failures, they clearly played some role. These costs constitute an externality involving published ﬁnancial information. A purpose of accountancy regulations could be to consider the interests of various parties who bear the costs of audit related business failures. The notion that regulations are promulgated by legislatures to protect the public does not fully explain the observed variation in occupational regulations across jurisdictions (Graddy, 1991). Why, for example, are landscape architects regulated only in some states and why has the 150-hour requirement for a CPA license not been adopted in all states? ETR provides a more complete view of the regulatory process and the resultant regulations (Becker, 1983; Peltzman, 1976; Stigler, 1971). ETR rests on the frequently invoked assumption that individuals and groups act in their self-interest. ETR further recognizes that governments hold the power to selectively help or hinder different components of society (e.g. industries and occupations). Various competing groups seek to have the government use its powers for their own beneﬁt. In exchange, groups can offer regulators (i.e. politicians) votes and resources that can be used to enhance political careers. Those groups that have greater incentives and resources and more votes will likely succeed in securing favorable governmental action. Service providers typically have more to gain (per capita) from a given regulation than other groups, such as the consumers of their services. Moreover, the existence of professional organizations (such as State Societies of CPAs)

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reduces the organizational costs necessary for collective political action by the service providers. Accordingly, service providers are more likely to become active in the regulatory process and they are consequently more successful in inﬂuencing regulators. To the extent that the regulated occupation is successful, “predatory capture” exists (Becker, 1986; Peltzman, 1976). Several earlier studies have used ETR to examine the variability in accounting regulation among states (Roberts & Kurtenback, 1998; Young, 1988, 1991). They found that variables, such as the percentage of CPAs that belong to a state society (an inverse measure of the cost to organize political action), help explain variations in the strictness of public accountancy laws. Our study extends prior work by adopting a case-method approach and focusing on one regulatory event: Colorado’s sunset review of its public accountancy law. Although this approach is narrower than the previous cross-sectional studies, it enables a deeper and more thorough examination of the forces at work. The next section describes Colorado’s sunset review process.

3. COLORADO’S SUNSET REVIEW3 Colorado’s Department of Regulatory Agencies (DORA) is charged by statute with the regulation of most occupations and professions. This responsibility includes performing sunset reviews of applicable agencies, which are conducted according to established evaluation criteria. State agencies are typically reviewed every 5 to 15 years. Enabling legislation must be drafted and passed for the agency to continue its existence.

Initial Stages of the Sunset Review Process DORA conducted the initial review and prepared the sunset review report, which was disseminated to the legislature and the governor. This report identiﬁed the issues that would be the focus of subsequent legislative activity. Several parties provided input to DORA. They included the State Board of Accountancy, the State Society of CPAs, and educators.

State Board of Accountancy and State Society of CPAs The State Board of Accountancy and State Society of CPAs formed a joint task force to address the sunset review and to make recommendations to DORA prior

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to the drafting of its report. The joint task force included four members of the State Board, the State Board’s current and former Executive Directors, a state of Colorado assistant attorney general who is assigned to advise the State Board on legal matters, the State Society’s Executive Director, the State Society’s lobbyist, and six additional representatives of the State Society. The joint task force met three times to develop its recommendations. Representatives of each group consulted with their larger bodies in developing ﬁnal positions. Agreement was reached on several issues. A letter summarizing these issues and recommendations was sent to DORA under the signatures of the State Board’s Chair and the State Society’s President. A number of the task force’s recommendations addressed substantial equivalency to the Uniform Accountancy Act (AICPA/NASBA, 1998).4 One objective of the Uniform Accountancy Act (UAA) is to enable CPAs to more freely practice across jurisdictions. Certiﬁcation requirements can differ considerably across states. Obtaining a license in a foreign state can be a costly, time-consuming process. Under the UAA, if a state were to adopt the essential provisions of the UAA, it would be viewed as substantially equivalent. All CPAs from that state could then freely practice in other states viewed as substantially equivalent. The joint task force recommended two changes in Colorado’s experience requirement needed to achieve substantial equivalency with the UAA. The UAA allows a broad array of qualifying experience including any type of service or advice involving the use of accounting, attest, management advisory, ﬁnancial advisory, tax or consulting skills. The experience need not be obtained in a public accounting ﬁrm. Colorado’s existing requirement, in general, allowed only public accounting experience. Thus, the task force recommended that Colorado broaden the nature of its qualifying experience.5 Colorado’s existing law also included an education in lieu of experience alternative to the one year requirement of public accounting experience. In general terms, a candidate with the equivalent of a master’s degree in accounting can waive the experience requirement. The joint task force recommended that Colorado void this alternative. The joint task force also recommended that the State Board be granted an exemption to Colorado’s accountant/client privilege statute for the purpose of issuing a subpoena when investigating alleged misconduct by a licensee. Colorado’s existing law contained an accountant/client privilege provision, and in 1998 the Colorado Supreme Court ruled that existing law did not grant the SBA exemption from this provision. Consequently, a CPA suspected of misconduct could invoke accountant/client privilege, thereby thwarting an SBA investigation by withholding documents. The task force concluded that an

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exemption is necessary to enable the Board to effectively undertake disciplinary actions. Educators Three educators6 jointly authored a letter to DORA recommending that Colorado’s 150-hour requirement7 be repealed. Using a cost/beneﬁt framework, the educators asserted that the beneﬁts from the 150-hour requirement would be minimal, while the costs would be substantial. They concluded that the requirement would likely result in fewer CPAs, reduced availability of CPAs’ services and higher fees to the public. The educators also commented on the experience requirement. Citing the expansion of services offered by CPA ﬁrms, they agreed with the joint task force in recommending that the experience requirement be broadened. The educators also recommended retaining the education in lieu of experience option since it provides candidates with an alternative path to certiﬁcation. Sunset Review Report A DORA staff analyst, under the supervision of the Director of Sunrise/Sunset, conducted the sunset review of the State Board of Accountancy. The review took approximately six months to complete. The culmination of the review was a 74page report rendered to the Colorado State Legislature. The report contained several recommendations. First, DORA recommended that the Colorado Board of Accountancy be continued until 2005 when the next sunset review would be conducted. This recommendation was necessary to avoid the Board’s termination under the sunset review statute. Signiﬁcantly, DORA also recommended that the state eliminate the 150-hour educational requirement. Where regulation is deemed necessary, the state’s sunset review criteria require that DORA recommend the least restrictive form of regulation consistent with the public interest. In considering this criterion, DORA concluded that the 150-hour rule was an “overly restrictive entry barrier with no demonstrable public protection function.” Agreeing with the Board-Society task force, DORA also recommended amending Colorado’s accountant/client privilege statute, giving the Board subpoena power for purposes of investigating alleged misconduct by a licensee. DORA concluded that this change, if properly structured, would eliminate a signiﬁcant barrier to effective enforcement of Colorado’s accountancy statutes and regulations while preserving the privacy rights of consumers.

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The Legislative Process and the Governor The accountancy sunset legislation was assigned to the House Business Affairs Committee. Prior to the ﬁrst committee hearing, legislative staff drafted a bill based on DORA’s sunset review recommendations. The ﬁrst House Business Affairs Committee hearing followed a structured process. DORA’s Director of Sunrise/Sunset and the Policy Analyst who conducted the review briefed the committee on all of their recommendations. A CPA member of the State Board testiﬁed on behalf of the Board.8 The public was also invited to testify. Two practicing CPAs provided testimony; both were CPA ﬁrm partners. One was the current President of the State Society of CPAs and the other was a past President of the State Society. The Executive Director of the State Society also testiﬁed, as did one of the educators. The Board member, the other two CPAs and the Executive Director of the Society all testiﬁed in support of the concept of substantial equivalency and against repeal of the 150-hour rule. The educator testiﬁed in favor of repealing the 150-hour rule. Lastly, the Executive Director of DORA testiﬁed in support of the report’s recommendations. During testimony, committee members asked questions and offered their own comments on the 150-hour rule and accountant/client privilege. Following the testimony, the committee voted (12 for, 0 against) to continue the Board until 2005, (six for, six against) to eliminate the 150-hour educational requirement and (four for, eight against) to amend Colorado’s accountant/client privilege to enable the Board to conduct investigations and disciplinary actions. Amendments receiving a positive vote became part of the draft bill; those receiving a tie vote or a negative vote did not. In the interim preceding the second Business Affairs committee hearing, DORA staff met with the accountancy bill’s legislative sponsor. Also, during this interim the Governor took a public stance on the 150-hour rule. The Governor was quoted in one the Denver papers as saying, “Colorado CPAs aren’t suffering with only four years of college. It’s just a way to protect current CPAs. Its just a needless expense” (Rocky Mountain News, 2000). At the second hearing, the bill’s legislative sponsor offered two principal amendments. First he proposed that the Board have restricted subpoena power, allowing some intrusion on existing accountant/client privilege. He also proposed that the 150-hour requirement be repealed, as originally recommended in DORA’s report. Public testimony was heard from the current President of the State Board, the Executive Director of the State Society and DORA’s Director of Sunrise/Sunset. The President of the Sate Board and the Executive Director of the State Society testiﬁed in favor of the subpoena power amendment and against the repeal of the 150-hour rule. In response to their testimony, the bill’s legislative sponsor replied

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that the Governor was adamantly opposed to the 150-hour rule. DORA’s Director of Sunrise/Sunset spoke in favor of both amendments. The committee voted against (six for, seven against) the subpoena power amendment and in favor (13 for, 0 against) of the amendment repealing the 150-hour rule. Following House committee action, the bill passed the entire House on a 53–12 vote. Next the bill moved to the Senate Business Affairs Committee for further hearing. The State Society’s Executive Director and the current President of the State Board again testiﬁed against repeal of the 150-hour rule. The Committee took no action to modify the repeal of the 150-hour requirement as passed by the House, and passed the bill on a 6–3 vote. The Senate passed the bill by a 33–0 vote. The Governor subsequently signed the bill into law.

4. ETR AND SUNSET REVIEW ETR indicates that groups with high per capita net beneﬁts from regulation and groups with resources to expend will be inclined to participate more fully and forcefully in the regulatory process. These groups are likely to prevail when contentious issues arise. The next three sub-sections examine the incentives, motivations and behaviors of the various parties involved with Colorado’s sunset review.9 The ﬁnal sub-section assesses the ultimate results of the political process and identiﬁes various factors that appear to have signiﬁcantly affected the outcome.

State Board and State Society ETR would predict that those individuals and groups with large per capita beneﬁts and low organizing costs are more likely to participate in the regulatory process. The State Board and State Society were more active in the sunset review than any other party (other than government ofﬁcials). They devoted a large number of hours to developing the recommendations of their joint task force. They also testiﬁed at every opportunity in the legislative process, hired a lobbyist and made monetary contributions to politicians. These activities are consistent with ETR. Our second observation relates to the joint task force formed by the State Board and the State Society. A collaboration between the State Board (the ﬁrst level of regulators) and the State Society (the primary advocate for the regulatees) appears inconsistent with the public interest. Indeed, from a public interest perspective there should be a certain adversarial nature to the relationship between these groups. Instead, a very cordial, cooperative and accommodating relationship

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existed. Agreement was quickly reached on most issues. When agreement was not reached, neither group pursued the issue. This is consistent with a predatory capture model where the regulatees have captured the regulators. Such capture should, perhaps, be expected given the composition of the State Board. By law, the State Board is comprised of ﬁve CPAs and two public members. Thus, the collective actions of the CPA members can dictate Board positions. The primary recommendation of the joint task force was for Colorado to achieve substantial equivalency. Many existing Colorado CPAs would beneﬁt from the primary result of substantial equivalency: easier reciprocity. However, CPAs from outside of Colorado would also beneﬁt by more easily being able to practice in Colorado. This increased competition could potentially harm Colorado CPAs. Evidently, the task force felt that the present costs to Colorado CPAs of securing reciprocal licences in other jurisdictions exceeds their anticipated loss from the increased competition. The most signiﬁcant cost of substantial equivalency would be the implementation of the 150-hour requirement. This cost, which would be borne by new entrants10 and clients (in the form of higher fees), did not appear to concern the State Board or State Society. The joint task force also recommended that the State Board be granted subpoena power to conduct investigations of alleged misconduct by licensees. The Board has a public interest responsibility to conduct reasonable investigations into the professional conduct of licensees. Without appropriate subpoena power, the Board is prevented from discharging this responsibility. This recommendation appears consistent with the public interest. The recommendation also seems consistent with the self-interest of the more ethical and competent members of the profession. These members can beneﬁt from the policing of unethical and incompetent CPAs who might otherwise harm the profession’s reputation (Benham, 1980). Thus, on particular issues, the interest of at least one or more elements of the profession may be aligned with the public’s interest.

Educators The three participating educators represented only two of Colorado’s 14 institutions with accounting programs. Several factors explain the low participation by educators. First, strong differences of opinion existed regarding the most contentious issue: the 150-hour requirement. Without general agreement, the efﬁciencies of delegating to a few individuals the responsibility of participating in the sunset review process were not available. This raised the per capita cost considerably. Second, a formal association of the individual colleges and

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universities did not exist. This also made collective action more difﬁcult. Finally, many educators were uncertain about the enrollment impact the 150-hour requirement would have on their programs. Without a clear view of the enrollment effect, educators had a limited incentive to become engaged. The three educators who did provide input to DORA recommended repeal of the 150-hour requirement. One of the educators was from a four-year program that was unlikely to develop a master’s program. Thus, retention of the 120-hour requirement would enable that institution to fully service CPA candidates. The other two educators were from a program that offers an undergraduate accounting degree and a master’s program. The 150-hour requirement would likely reduce demand for the undergraduate program but perhaps increase demand for the master’s program. Thus, the net effect on enrollments is unclear. The three educators also expressed support for retaining the education in lieu of experience provision. Much of the demand in the master’s program referenced above is from students seeking certiﬁcation via the education in lieu of experience alternative rather than by public accounting experience. Eliminating the education in lieu of experience alternative would substantially reduce enrollment in that program. Thus, the educators appear to have taken positions that would promote their programs. DORA The personnel within DORA appeared to act with the utmost professionalism and seemed quite intent on fulﬁlling their legislative mandate to recommend the least restrictive form of regulation that is consistent with the public interest. DORA disagreed with the State Board and State Society regarding the 150-hour requirement. In its view, the 150-hour requirement was overly restrictive and anti-competitive. DORA, however, agreed with the State Board and State Society regarding the need to enhance the State Board’s subpoena power. DORA did not ally itself with any one party. It assessed each issue within the context of its legislative responsibility. Results of the Political Process The State Board and State Society strongly supported substantial equivalency, which implies retention of the 150-hour requirement and elimination of the education in lieu of experience option. In contrast, the educators favored repeal of the 150-hour requirement and retention of the education in lieu of experience option. ETR would predict that the parties with the greatest political strength are more likely to prevail.

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The State Society engaged the services of a lobbyist. During the legislative hearings, we observed that the State Society’s Executive Director was familiar with many committee members. We suspect that the lobbyist was successful in gaining the Executive Director access to those legislators. The State Society also has a Political Action Committee (PAC). The PAC made contributions of $26,900 during the 1998–2000 period. In contrast, the educators did not have the funds to hire a lobbyist; nor did they establish a PAC. ETR would suggest that the positions of the State Board and State Society would prevail. These groups were not, in fact, successful in inﬂuencing DORA. DORA’s initial report recommended eliminating the 150-hour requirement. Moreover, DORA’s representatives staunchly defended this position through out the legislative process. The State Board and State Society did appear to successfully inﬂuence some legislators. In the initial meeting of the House Business and Labor Affairs Committee, repeal of the 150-hour requirement failed on a 6–6 tie vote. However, after the Governor voiced strong opposition to the 150-hour requirement, this same committee subsequently voted unanimously to repeal the 150-hour requirement. That repeal was not seriously challenged during the remainder of the legislative process. Thus, a major implication of ETR (i.e. the group that can offer politicians the greatest political support will prevail) does not, at ﬁrst glance, hold in this instance. The position of the Governor was pivotal in determining the outcome of the 150-hour debate. A question arises as to the motivation of the Governor in opposing this requirement. Peltzman (1984) suggests that by maintaining positions consistent with a particular ideology, politicians can signal to a broad base of constituents their commitment to act in the constituents’ behalf. The Governor of Colorado is a conservative republican, whose basic philosophy toward higher education is “access and affordability.” The 150-hour requirement is inconsistent with access because some CPA candidates in remote areas of the state would not have ready access to 150-hour programs. The requirement is also inconsistent with affordability because CPA candidates would be required to bear a higher educational cost to enter the profession. The Governor possibly felt that his net political advantage was maximized by taking a position consistent with his basic educational philosophy of access and affordability. By so doing, he helps conﬁrm his basic ideology with the hope of satisfying a broad base of his constituents. Of course, this stance comes at the cost of potentially alienating the much smaller voting block of CPAs who favor the 150-hour requirement. The above explanation, while speculative, is consistent with ETR. A politician is acting to appease a block of voters. While ETR usually focuses on groups that are active in the political process related to the issue at hand, Peltzman (1984) suggests

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that politicians can communicate their commitment to constituents’ preferences by exhibiting a record consistent with a particular ideology. Thus, tests of ETR might be improved by including variables that reﬂect politicians’ ideologies.

5. SUMMARY AND CONCLUSIONS The three groups that formally participated in the sunset review (the State Board, the State Society and educators) all appeared to act in their own self-interest. No members of the public participated. This is not surprising given that the per capita effect of a change in the public accountancy law was likely to be quite small for members of the public. Without public input, we might suspect that the public interest would not be represented during the sunset review process. However, DORA assumed the responsibility of presenting the public interest case. This is consistent with its legislative obligation to recommend the least restrictive form of regulation that is consistent with the public interest. Given that the public’s view is often not expressed in occupational licensing situations, the existence of a governmental organization such as DORA can be helpful in presenting a balanced case to regulators. The most controversial issue that arose during the sunset review was the 150hour requirement. The State Board and State Society favored retention of that requirement, while the educators favored repeal. Given that the State Board and State Society had greater political strength than the educators, ETR would predict that the former groups would prevail. In actuality, the educators’ positions were adopted. This outcome, however, was not driven by their inﬂuence. Both DORA and the Governor adopted a philosophy of minimal regulatory intrusion. This served as the foundation for repealing the 150-hour requirement. Several factors suggest that the regulated profession (CPAs) has successfully captured the ﬁrst level regulators (the State Board). The mere existence of the joint task force of the State Board and State Society is a strong indication. The cooperative and accommodating nature of the task force’s proceedings is another indication. Further, in at least one legislative committee hearing, the State Board’s President and the State Society’s Executive Director testiﬁed jointly. A ﬁnal indication is the exchange of personnel. Two of the ﬁve CPA members of the State Board are past Presidents of the State Society. In our judgment, predatory capture could not be more starkly displayed. A fundamental policy issue relates to the composition and independence of the State Board. Colorado law requires ﬁve members to be CPAs and two members to be non-CPAs. Board members clearly need an understanding of accounting and auditing issues. CPAs are the most knowledgeable segment of society in these areas.

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Yet, the State Board is responsible for regulating the profession in the best interest of the public, not the best interest of the profession. One possible improvement would be to increase the number of non-CPA members, so that CPAs would not have such an overwhelming majority. Another possibility would be to include CPAs who are not in public practice. These individuals would be knowledgeable about issues facing the Board, yet not as directly affected by Board actions as CPAs in public practice. Colorado’s sunset review experience also has implications for studying and understanding variations in accounting regulations across states. We found that political ideology was the most important determinant of the sunset review’s outcome regarding the 150-hour requirement. Consequently, studies such as Roberts and Kurtenback (1998) and Young (1991), which seek to explain variations in licensing restrictiveness across states, might beneﬁt from including one or more variables reﬂecting the ideology (e.g. political party) of the politicians who ultimately make the regulatory decisions.

NOTES 1. The public accountancy laws of twenty-ﬁve states are subject to sunset reviews (AICPA/NASBA, 1994). 2. Colorado’s sunset review was chosen for study as a matter of convenience. Our campus is located less than one mile from the state capitol. This proximity enabled us to observe numerous events that occurred during the sunset review. The examination limits the external validity of the study. 3. Colbert and Murray (2001) provide a more complete description of Colorado’s sunset review process. 4. The Uniform Accountancy Act (UAA) is a model accountancy act developed by the American Institute of CPAs (AICPA) and the National Association of State Boards of Accountancy (NASBA). 5. Since Colorado’s experience requirement is stricter than the UAA, the State Board and State Society eventually concluded that the existing experience requirement is not an impediment to achieving substantial equivalency. Accordingly, this issue was not raised during the legislative process. 6. The educators included ourselves and a colleague from a four-year institution. 7. In 1998 the State Board adopted the 150-hour requirement by rule. The requirement was scheduled for implementation in 2002. 8. This State Board member is a past President of the State Society. 9. Interestingly, employers of CPAs’ services (e.g. audit clients) and users of ﬁnancial statements (e.g. bankers and mutual fund managers) did not participate in the sunset review. This is consistent with the prediction of ETR that the regulation of a profession has a much smaller per capita effect on consumers than professionals. This implies that professionals have greater incentive to incur the cost of participation than do consumers.

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10. Existing CPAs would be “grandfathered” (i.e. exempted from the new entry standards).

ACKNOWLEDGMENTS We are grateful to Colorado’s Department of Regulatory Agencies, the Colorado State Board of Accountancy and the Colorado Society of CPAs for their help and cooperation. We thank Woody Eckard, workshop participants at the University of Colorado at Boulder and two anonymous reviewers for comments on an earlier draft of this paper.

REFERENCES Akerlof, G. A. (1970). The market for “lemons”: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(August), 488–500. American Institute of Certiﬁed Public Accountants (AICPA) and the National Association of State Boards Accountancy (NASBA) (1994). Digest of State Accountancy Laws and Regulations. New York, NY: AICPA/NASBA. American Institute of Certiﬁed Public Accountants (AICPA) and the National Association of State Boards Accountancy (NASBA) (1998). Uniform Accountancy Act and Uniform Accountancy Act Rules. New York, NY: AICPA/NASBA. Becker, G. S. (1983). A theory of competition among pressure groups for political inﬂuence. Quarterly Journal of Economics, 98(August), 371–400. Becker, G. S. (1986). The public interest hypothesis revisited: A new test of Peltzman’s theory of regulation. Public Choice, 49, 223–234. Benham, L. (1980). The demand for occupational licensure. In: S. Rottenberg (Ed.), Occupational Licensure and Regulation. Washington, DC: American Enterprise Institute for Public Policy Research. Colbert, G. J., & Murray, D. (2001). Sunset review of public accountancy laws: The Colorado experience. Accounting Horizons, 15(June), 183–192. Graddy, E. (1991). Toward a general theory of occupational regulation. Social Science Quarterly, 72(4), 676–695. Leland, H. E. (1979). Quacks, lemons, and licensing: A theory of minimum quality standards. Journal of Political Economy, 87(6), 1238–1246. Peltzman, S. (1976). Towards a more general theory of regulation. Journal of Law and Economics, 19(August), 211–240. Peltzman, S. (1984). Constituent interest and congressional voting. Journal of Law and Economics, 27(April), 181–210. Roberts, R., & Kurtenback, J. (1998). State regulation and professional accounting reforms: An empirical test of regulatory capture theory. Journal of Accounting & Public Policy, 17(Autumn), 209–226. Rocky Mountain News (2000). CPA restriction may be vetoed (January 26), 10A.

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Rottenberg, S. (1980). Introduction. In: S. Rottenberg (Ed.), Occupational Licensure and Regulation. Washington, DC: American Enterprise Institute for Public Policy Research. Stigler, G. J. (1971). The theory of economic regulation. Bell Journal of Economics, 2(1), 3–10. United States General Accounting Ofﬁce (1991). Failed banks: Accounting and auditing reforms urgently needed. Washington, DC: GAO. Wolfson, A., Trebilock, M., & Tuohy, C. (1980). Regulating the professions: A theoretical framework. In: S. Rottenberg (Ed.), Occupational Licensure and Regulation. Washington, DC: American Enterprise Institute for Public Policy Research. Young, D. S. (1988). The economic theory of regulation: Evidence from the uniform CPA examination. The Accounting Review, 63(2), 283–291. Young, D. S. (1991). Interest group politics and the licensing of public accountants. The Accounting Review, 66(October), 809–817.

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THE IMPACT OF STATEMENT OF FINANCIAL ACCOUNTING STANDARD NUMBER 123 ON EQUITY PRICES OF COMPUTER SOFTWARE COMPANIES Mark Myring, Rebecca Toppe Shortridge and Robert Bloom ABSTRACT Stock options have become a signiﬁcant component of compensation for top executives. However, the appropriate method of accounting for stock options has been the subject of much debate. We document the history and current status of accounting for stock options including the issuance of Statement of Financial Accounting Standard No. 123, Accounting for Stock Based Compensation (SFAS 123). We then examine the stock market reaction to six events leading to the adoption of SFAS 123. The results from this test show that the market reacted negatively to the possibility that a standard would be adopted requiring stock options to be expensed. We also document that the magnitude of the market reaction is affected by debt contracting costs and political costs. These results suggest that the market reduces the value of ﬁrms who might violate their debt covenants and that ﬁrms with higher income are more subject to regulation by political entities. These results can add to the debate about accounting for stock options that has been revived in light of the Enron, WorldCom, and Tyco accounting scandals. Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 121–144 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160073

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INTRODUCTION Stock options represent an increasingly signiﬁcant component of executive compensation. Recent surveys show that CEOs receive 60% of their total compensation from stock options (Henry et al., 2002). Theoretically, the inclusion of stock options in executive compensation contracts motivates managers to take actions that increase the market value of the ﬁrm’s stock. Speciﬁcally, stock options tie compensation to stock price; when executives engage in actions which increase stock price, their compensation increases. Thus, stock options help to align the goals of management with the goals of the ﬁrm’s stockholders. Accounting standards regulating the treatment of stock options continue to be controversial.1 Prior to 1995, accounting for stock options was governed by APB Opinion No. 25, Accounting for Stock Issued to Employees (APB, 25). Under APB 25, compensation expense from stock options occurred only when options had intrinsic value, that is when the market price at the measurement date, usually the date of grant, exceeded the exercise price of the options. In October 1995, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation (SFAS, 123). The standard required the disclosure of the fair market value of stock options granted in executive compensation packages. The standard-setting process proceding the release of SFAS 123 was characterized by intense debate. The Exposure Draft, requiring ﬁrms to expense the fair value of stock options, was vigorously opposed by many, including companies using options in compensation packages, the Council of Institutional Investors (Harlan, 1993a), the Big Six accounting ﬁrms (Harlan, 1993b), and Treasury Secretary Lloyd Bentsen (Wall Street Journal, April 1993). Opponents argued that expensing the fair value of options would have a detrimental impact on ﬁrms that utilized stock options. If such ﬁrms retained stock options as a component of compensation, they would face lower income and thus an increased likelihood of violating debt covenants. Alternatively, if the use of stock options were abandoned, ﬁrms would lose a key means of motivating managers to maximize ﬁrm value. Opponents of the Exposure Draft even lobbied Congress to block its implementation (Wall Street Journal, June 1993). Faced with extreme political pressure, the FASB abandoned the proposal to expense employee stock options. Instead, it required ﬁrms merely to disclose the fair value of options granted in executive compensation contracts in the footnotes of ﬁnancial statements. Under SFAS 123, stock options possess a “fair value” which is usually computed using a sophisticated mathematical option model derived by Black and Scholes (1973).2 Essentially, the reporting requirements were altered

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only slightly as the Securities and Exchange Commission (SEC) required detailed disclosures of the fair value of stock options prior to SFAS 123.3 Recent corporate scandals have renewed the debate addressing the accounting treatment for stock options. Many feel that corporate executives inﬂate earnings to increase the value of their stock options. To address these concerns, Congress has introduced several bills concerning accounting for stock options. Federal Reserve Board Chairman, Alan Greenspan, has criticized the current standard (Frangos, 2002) while Harvey Pitt, the former Chairman of the Securities and Exchange Commission, believes shareholders should be able to vote on the appropriate accounting treatment for stock options (Burns, 2002). Further, Joseph Stiglitz, a Nobel Prize winning economist and professor of ﬁnance at Columbia University, strongly favors an expense-based treatment of stock options (Stiglitz, 2002). Many corporate executives have become involved in the stock option debate as well. Warren Buffet, CEO of Berkshire Hathaway, supports the expensing of stock options. In fact, when the controversy erupted in l993, Buffet said that those who believed options should be expensed might be outnumbered, “but not outreasoned” (Crystal, 2002). TIAA-CREF plans to ask the chairmen of over 1,700 companies to treat stock options as expenses (Lublin, 2002). In addition, the Conference Board, a high-proﬁle group of executives, favors expensing stock options (Brown & Lublin, 2002). Previous accounting research has examined the economic consequences of the standard-setting process on the ﬁrm (see, for example, Espahbodi, Strock & Tehranian, 1991, 1995; Lys, 1984; Schipper & Thompson, 1983; Sefcik & Thompson, 1986). Two studies which are directly related to SFAS 123, DeChow et al. (1996) and El-Gazzar and Finn (1998), yield conﬂicting results. DeChow et al. (1996) examined the stock price reaction surrounding the adoption of SFAS 123 for three types of ﬁrms: ﬁrms which lobbied against the standard, ﬁrms with high option usage, and ﬁrms in the biotech industry. For the sample of ﬁrms which lobbied against the standard, a signiﬁcant negative abnormal return was identiﬁed around the date the FASB agreed to pursue a standard requiring ﬁrms to expense the fair value of compensatory options.4 No abnormal returns were detected for any of the event dates for the sample of ﬁrms in the biotech industry or for the sample of ﬁrms with high option usage. In contrast, El-Gazzar and Finn (1998) found evidence of abnormal returns around the issuance of the Exposure Draft for high-risk and emerging ﬁrms. Firm characteristics explaining the magnitude of the market reaction were also examined. The number of options outstanding was associated with the magnitude of the return. Our study extends prior research in three ways. First, we examine the adoption of SFAS 123 using ﬁrms from the computer software industry. In particular, we

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examine whether events leading to the adoption of SFAS 123 impacted stock prices in the computer software industry. This industry is investigated because it, like many high-tech industries, relies extensively on stock options in employee compensation packages and intensely opposed expensing stock options. Second, we use the Watts and Zimmerman (1986) framework to examine if the magnitude of the market reaction is impacted by ﬁrm characteristics. Speciﬁcally, we examine whether the efﬁcient contracting, debt contracting, and political cost hypotheses explain variations in the market reaction to events leading to the adoption of SFAS 123. Finally, our study examines event dates that are not included in either of the two previous studies.5 The results of this study indicate that ﬁrms in the computer software industry experienced abnormal returns around certain events leading to the implementation of SFAS 123. Thus, the contentions of Watts and Zimmerman (1986) are supported. In addition, cross-ﬁrm variation in the magnitude of abnormal returns around event dates provides support for the debt contract and political cost hypotheses. This research is important because it documents the inﬂuence that the FASB’s standard-setting process has on companies. First, we review the political nature of the standard-setting process. Speciﬁcally, we document how ﬁrms expend time and resources in an attempt to inﬂuence the standard-setting process. In addition, we attempt to explain why ﬁrms choose to engage in such behavior. We also show that there is a relationship between the accounting standard-setting process and the market value of ﬁrms in the computer software industry, an industry that lobbied strongly against SFAS 123. Thus, we provide a rationale for their activity during the standard-setting process. Further, we document ﬁrm characteristics that impacted the reaction to events during the standard-setting process. Finally, this paper is important as it appears that stock option accounting may be revisited. In light of recent events and the current emphasis on the quality of earnings, would the implementation of a new standard requiring that options be expensed cause less upheaval than before? This appears to be the feeling of many investors. Recently, Standard & Poor’s announced that it would deduct the fair market value of stock options in calculations of operating proﬁts (Sender, 2002). What steps can the FASB take to reduce the negative impacts perceived by the market? These and other considerations can contribute to future deliberations on stock option accounting standards.

ACCOUNTING TREATMENT OF STOCK OPTIONS: A CONTINUING CONTROVERSY In theory, stock options represent an operating cost to the company, a form of compensation. Therefore, to be consistent with the conceptual framework of the

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FASB, the cost of this type of compensation should be reﬂected in the income statement and matched against the beneﬁts over the employee service period. As discussed in the introduction, prior to the issuance of SFAS 123, APB 25 prescribed the accounting treatment for transactions involving stock options. Under APB 25, compensation expense related to stock options was recognized only when such plans had intrinsic value. Since the exercise price was typically ﬁxed at the market price on the grant date, compensation expense was seldom recognized under option plans. Critics argued that this treatment is inappropriate as companies could be selling their stock to outside investors at prices higher than option exercise prices. Hence, an opportunity cost exists to the issuing ﬁrm, which APB 25 failed to recognize. Further, distributing shares to executives at less than the market price dilutes the investment of current owners. Because of the shortcomings of APB 25, the FASB added a project to its agenda to re-examine stock option accounting in 1984. Between 1985 and 1988, the FASB conducted research on various aspects of stock based compensation plans. Tentative conclusions, reported in the FASB’s Weekly Action Alert, implied that the FASB would require companies to expense the fair value of stock options. Expensing of stock options was criticized by many companies, especially high-tech companies in Silicon Valley, who argued that they would have to eliminate stock options if expensing were required under GAAP. During the board deliberations from 1985 to 1988, more than 200 letters were received that commented on, and usually objected to, the tentative conclusions reported in the Action Alert (SFAS, 123, par. 368). In June 1992, the Wall Street Journal (WSJ) reported that the FASB had begun a project to examine accounting for stock options (Carlson, 1992). Accounting for stock-based compensation was addressed at nineteen public board meetings and at two public task force meetings in 1992 and 1993. Again, tentative conclusions from these meetings were reported in the Action Alert. During this time period, the FASB received more than 450 comment letters, most of which objected to the tentative conclusions (SFAS, 123, par. 374). On June 30, 1993, the FASB issued an Exposure Draft on accounting for stock options that required ﬁrms to expense the fair value of the options. The FASB received 1,786 comment letters, including 1,000 form letters, most of which objected to the Exposure Draft (SFAS, 123, par. 376). Opponents argued that adoption of the Exposure Draft as the ﬁnal standard would cause the elimination of stock options from compensation packages. Under intense criticism from many parties, including Congress and the SEC, and apprehensive about the federal government assuming control of accounting standard setting, the FASB changed the proposed standard to allow ﬁrms to disclose, rather than expense, the fair value of stock options. On July 28, 1995, the FASB voted ﬁve to two to adopt SFAS 123 in its amended form (WSJ, July 1995).

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SFAS 123 gives ﬁrms two options; they may expense the fair value of options in the income statement or apply APB 25 with fair value information disclosed in the footnotes. While the FASB prefers that ﬁrms actually expense the fair value of options, this methodology is rarely used because of the signiﬁcant effect of this expense on net income. Thus, in practice, most ﬁrms continue to follow APB 25. To apply APB 25, the option price is typically set equal to or greater than the market price at the grant date, allowing ﬁrms to avoid reporting any income statement expense for options. Pro forma income and earnings per share are disclosed in the footnotes as if the fair market value of stock options had been expensed in the ﬁnancial statements. A typical presentation of stock option information appears in a footnote to Lands’ End’s 2002 Annual Report (see Fig. 1). As illustrated in the Lands’ End’s footnote, the inclusion of the fair value of stock options as a component of compensation expense signiﬁcantly impacts earnings. In fact, recent ﬁndings show that the net income of Standard & Poor’s 500 companies would decline 9% for the year 2000 if an expense were recorded for the fair value of stock options granted (Gleckman, 2002). The debate surrounding the accounting treatment of stock options has been rejuvenated in the current Sarbanes-Oxley environment. Enron, for example, was able to boost its income by not expensing stock options granted to former CEOs Kenneth Lay and Jeffrey Shilling. In fact, Lay received $123.4 million from exercising his options in 2000 (Barlas, 2002). Many argue that the inappropriate application of accounting standards by Enron and others was a result of upper management’s desire to increase share prices through misstatement of ﬁnancial information. This type of ﬁnancial statement fraud is harmful because it has been found to damage the perceived validity of disclosures (Nagy, 2001). In response to the renewed controversy, Congress, government ofﬁcials and business leaders have taken an active interest in the accounting treatment of stock options. Prior to the recent accounting scandals, Congress clearly sided with corporate America and the major accounting ﬁrms, which were overwhelmingly against expensing options. Currently, the opinion of those on Capitol Hill is mixed. Senator John McCain of Arizona has introduced a bill calling for options to be expensed (Gleckman, 2002). Senator Christopher Dodd of Connecticut and Senator Jon Corzine of New Jersey have also introduced a bill calling upon the SEC to provide recommendations to the FASB concerning the accounting rules for stock options (Barlas, 2002). Senator Carl Levin of Michigan introduced a bill that would enable companies to take a tax deduction or credit for stock options only to the extent that they recognize option expense in the income statement (Barlas, 2002). Corporations are also joining the movement to expense stock options. Craig Barrett, CEO of Intel, suggests that companies should expense the fair market value of stock options granted to top executives (Boslet, 2002). When Coca-Cola

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Fig. 1. Stock Option Data Provided by Lands’ End.

Company announced that it would expense options, Gary Fayard, chief ﬁnancial ofﬁcer, said: “There’s no doubt that stock options are compensation. If they weren’t, none of us would want them” (McKay, 2002). Meanwhile, there is continued support by some for the current treatment of stock options. Senator Lieberman believes that the current system of footnote disclosure for the effects of stock option plans is satisfactory (Gleckman, 2002). The Bush administration seems to support the status quo on option accounting

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(Frangos, 2002) and former Treasury Secretary Paul O’Neill argues that stock option costs should only be reﬂected in income when and if they are exercised (Gleckman, 2002). One reason critics are against expensing is that valuing options is highly subjective. Further, Bloomﬁeld (2002) theorizes that most corporations prefer to report stock options in footnotes as investors may not spend the resources to incorporate that information in investment decisions.

HYPOTHESES DEVELOPMENT The relationship between accounting standards and ﬁrm value has been the subject of many academic studies. Watts and Zimmerman (1986) were among the ﬁrst to investigate this important relationship. Their research identiﬁed three factors explaining the relationship between ﬁrm value and accounting standards: the efﬁcient contracting hypothesis, the debt contracting hypothesis, and the political cost hypothesis. We examine the relationship between ﬁrm value and accounting standards using this theoretical framework to identify important factors that inﬂuence standard setting for stock option accounting. Efﬁcient Contracting Hypothesis A change in accounting standards can lead to a wealth transfer to or away from stockholders. The hypothesized stock price effect of a change in accounting standards depends on whether the standard expands or restricts the available set of accounting procedures (Watts & Zimmerman, 1986). Restrictions of acceptable accounting procedures may limit ﬁrms’ optimal contracting choices causing stock prices to decline. Alternatively, expansion of the acceptable accounting procedures may expand ﬁrms’ optimal contracting technology causing stock prices to increase. The use of stock options is a part of many ﬁrms’ employment contracting alternatives as they motivate managers to focus on the long-term goals of a company. In addition, stock options do not consume cash or reduce earnings. The approval of the Exposure Draft preceding SFAS 123 would have likely decreased high-tech ﬁrms’ use of stock options. As an indication of this, prior to the issuance of the Exposure Draft, the WSJ reported the results of a survey of 500 start-up companies primarily in the high-tech industry (Berton, 1993). Ninety percent of those surveyed indicated that a requirement to expense option values would prompt them to stop issuing stock options to employees other than top executives or to eliminate the use of stock options entirely. If stock options were no longer used by high-tech ﬁrms as a result of SFAS 123, one method for structuring efﬁcient employment contracts would be removed.

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Debt Contract Hypothesis Much of the previous research on stock market reactions to accounting standards has focused on the debt contracting hypothesis. The debt contracting hypothesis relates to the use of covenants in debt contracts, which include accounting numbers. Stock prices are hypothesized to increase (decrease) if a newly introduced procedure reduces (increases) the probability of defaulting on existing debt (Watts & Zimmerman, 1986). The stock price reaction, however, is bounded by the cost of renegotiating debt contracts or repaying the debt. The Exposure Draft required ﬁrms to record expenses for the fair value of stock options at the grant date. For many ﬁrms, this would have resulted in an increase in expenses, which causes a decrease in net income, retained earnings, and stockholders’ equity. Thus, ﬁrms may come closer to violating their debt covenants. Tightening debt covenants is likely to result in increases in contracting costs and decreases in stock prices.

Political Cost Hypothesis The political cost hypothesis assumes politicians and bureaucrats have incentives to seek wealth transfers through the political process (Watts & Zimmerman, 1986). Such wealth transfers are easily justiﬁed from large, proﬁtable companies. Thus, political costs are more common for ﬁrms with high proﬁts or high market values. Managers of politically sensitive ﬁrms are expected to prefer accounting standards that reduce or defer reported proﬁts. Accounting researchers generally hypothesize that large ﬁrms are more politically sensitive than small ﬁrms are and, therefore, face different incentives in their choice of accounting procedures. Stock price effects of mandated accounting changes from the political process depend on whether the change reduces or expands the set of available procedures. A new accounting standard that requires ﬁrms to increase (decrease) reported income is hypothesized to reduce (increase) stock prices. The adoption of the Exposure Draft would have reduced net income for ﬁrms that utilize stock options. This reduction would cause a decrease in political costs, and thus, increase stock prices.

Net Stock Price Effect Stock price reactions to events leading to the implementation of SFAS 123 are a function of the proposed standard’s impact on efﬁcient contracting, debt covenants, and political costs. In general, announcements that increased the probability of

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mandatory expensing are hypothesized to increase the probability of default on debt contracts and reduce the use of options in employment contracts, both of which are hypothesized to cause decreases in stock prices. Alternatively, the approval of the Exposure Draft would have decreased earnings and, consequently, political costs for large and proﬁtable ﬁrms. According to the political cost hypothesis, a decrease in political costs is likely to result in increased prices. Therefore, the economic impact of the proposed standard is determined by the magnitude of the offsetting effects. Previous studies have documented a negative stock price reaction to the introduction of regulation limiting an income increasing accounting method (e.g. Espahbodi et al., 1991, 1995; Leftwich, 1981; Lys, 1984; Salatka, 1989). Thus, the ﬁrst hypothesis is as follows: H1. Stock prices of software ﬁrms utilizing stock options will decrease (increase) following events that increase (decrease) the probability that the FASB will require mandatory expensing of the fair value of stock options. Clearly, the stock price reaction to events leading to the adoption of SFAS 123 will differ across ﬁrms within the computer software industry. Firms utilizing options extensively in compensation contracts are likely to experience large stock compensation expenses, large reductions in net income and greater probability of violating debt covenants. Alternatively, such ﬁrms may choose to eliminate stock options from their compensation packages, thus reducing the efﬁciency of employment contracting. Therefore, the stock market reaction to events altering the probability of mandatory expensing is likely to be greater for ﬁrms that rely heavily on options. This leads to the second hypothesis: H2. The stock price reaction to announcements that decrease (increase) the probability that the FASB will require mandatory expensing of the fair value of stock options will be greater, in absolute terms, for software companies that use options extensively. As previously discussed, if SFAS 123 were adopted in Exposure Draft form, the probability of violating debt covenants would increase for many ﬁrms. For ﬁrms near their debt covenant constraints, the Exposure Draft is likely to induce managers to take costly actions to avoid restrictions on additional borrowing, to renegotiate restrictive covenants, and/or to avoid possible default (Espahbodi et al., 1991, 1995). Thus, the impact of the standard will be more pronounced for ﬁrms that are closer to their debt covenant restrictions. This leads to the third hypothesis: H3. The stock price reaction to announcements that decrease (increase) the probability that the FASB will require mandatory expensing of the fair value

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of stock options will be greater, in absolute terms, for software companies with extensive debt. Political costs may also affect the stock market reaction of new accounting pronouncements. The adoption of mandatory expensing decreases political costs in large and/or proﬁtable ﬁrms. Thus, events that increase the probability of adoption result in a stock price increase because of the reductions in political costs. This positive stock price effect will at least partially offset the negative stock price reaction associated with the debt contract and the efﬁcient contract hypothesis. Consequently, the larger and/or more proﬁtable the ﬁrm, the smaller the stock price reaction will be around events that increase the probability that the standard would be adopted in exposure draft form. Alternatively, events that decreased the probability of adoption would result in a stock price decrease. This negative stock price effect will offset the positive stock price reaction associated with the debt contract and the efﬁcient contract hypothesis. Thus, the larger and/or more proﬁtable the ﬁrm, the smaller the stock price reactions around events that decrease the probability that the standard is adopted. These theories are formalized in the following hypothesis: H4. The stock price reaction to announcements that decrease (increase) the probability that FASB will require mandatory expensing of the fair value of stock options will be greater, in absolute terms, for software companies with high political costs. The results of the above hypotheses may provide insight into why ﬁrms in the computer software industry strongly opposed a standard requiring the fair market value of stock options be expensed. The test of H1 will document the impact of the standard setting process on stock prices. If stock prices are affected by events leading to the adoption of SFAS 123, the motivation of companies that opposed this standard is clear: expensing stock options will result in lower stock prices. Because stock options are used extensively by computer software ﬁrms, it is in management’s interest to oppose this standard. Results of the ﬁnal three hypotheses will help explain why stock prices of different ﬁrms within the computer software industry reacted in different ways.

RESEARCH METHODOLOGY The ﬁrst hypothesis is tested by examining the market reaction around six events leading to the adoption of SFAS 123. Each event, summarized in Table 1, was

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Table 1. Relevant Events Leading to the Issuance of SFAS 123. Event No.

Event Date

Description

1

2/19/1993

2

4/08/1993

3

6/30/1993

4

1/05/1994

5 6

3/28/1994 7/28/1995

First time WSJ documents investors criticized the FASB for the proposed standard. The FASB voted to require that the estimated value of stock options be recognized as an expense. Exposure Draft issued and a potential Bill to derail the proposed Standard is discussed in Congress. Letters from small companies opposing the proposed standard are received by the FASB. FASB studies a compromise on the Exposure Draft FASB votes 5–2 for the adoption of the revised standard.

Expected Reaction + – ? + – ?

identiﬁed from a search of the WSJ. These events represent important occurrences, which lead to the adoption of SFAS 123.6 Event 1 refers to the ﬁrst article in the WSJ (during our event window) in which the FASB received criticism involving SFAS 123 (Harlan, 1993a). This event decreased the probability of the standard being implemented in Exposure Draft form. Thus, the hypothesis predicts that the return around this event is positive. The second and third events involve actions taken by the FASB early in the standard setting process. Event 2 reports that the FASB made a preliminary conclusion requiring ﬁrms to expense the value of options (Berton, 1993). The predicted return on this date is negative. Event 3 reﬂects the issuance of the Exposure Draft preceding SFAS 123 (WSJ, June 1993). On the same day, the WSJ reported that Congressional opponents of the standard moved to block the FASB’s efforts (WSJ, June 1993). Thus, two confounding events occur on this date and the net effect on returns is indeterminate. Event 4 reports that the FASB received 500 letters from small businesses in opposition to the standard (Berton, 1994a). The predicted returns on this date are positive as it decreased the probability that the standard would be approved in its original form. The ﬁnal two events document the FASB’s move away from expensing options. Event 5 reﬂects a report that the FASB was considering a compromise in the treatment of options (Berton, 1994b). The compromise would have allowed companies to account for stock options using two different methods depending on the length of time that stock resulting from the exercise of options was held. Stock sold quickly would be considered compensation and charged against earnings. Alternatively, stock held for a mandated time period would be considered an

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equity stake in the company and not charged to expense. Event 5 is hypothesized to have a negative impact on stock returns because, even though it reduced the probability that the Exposure Draft would be adopted, it increased the probability that a compromise standard would be adopted that would change reporting requirements. The compromise standard still required ﬁrms to deduct the value of certain stock options. The ﬁnal event is the passage of the standard (WSJ, July 1994). We do not predict the sign on this event because even though the standard was implemented, ﬁrms were not required to deduct the cost of stock options. Market reaction to these events is estimated using the multivariate regression method proposed by Schipper and Thompson (1983) and used by Espahbodi et al. (1991, 1995), among other researchers. This methodology, explained in detail in the Appendix, is used to determine whether there is a signiﬁcant stock price reaction to the above events for the computer software industry. A signiﬁcant market reaction indicates that investors believed that the event had an impact on the contracting costs, debt costs or political costs of the organization. The ﬁnal three hypotheses examine whether the magnitude of the market reaction can be explained by ﬁrm-speciﬁc characteristics. The methodology used to test these hypotheses is a portfolio weighting procedure implemented by Sefcik and Thompson (1986) and Espahbodi et al. (1991, 1995). This methodology reveals the relative importance of different ﬁrm characteristics in explaining variability in the market reaction to events leading to the adoption of SFAS 123. In particular, we test whether variations in returns among ﬁrms in the computer software industry can be explained by the efﬁcient contracting, debt contracting, and political cost hypotheses. Details of this methodology are provided in the Appendix.

SAMPLE SELECTION AND VARIABLES The effect of the standard-setting process for SFAS 123 is examined using a sample of ﬁrms from the computer software industry. The use of stock options in compensation contracts is especially beneﬁcial for computer software ﬁrms (and other high-tech industries) because these companies typically have considerable levels of research and development expenditures. Financial statement measures of ﬁrm performance (e.g. EPS) in such industries are less informative than stock-based performance measures (e.g. stock prices) because of the long lag time between research and development efforts and the resulting ﬁnancial beneﬁts (Clinch, 1991). Thus, the use of ﬁnancial measures of ﬁrm performance as a basis for executive compensation may not align the actions of management with the goals of the stockholders. In contrast, research and development expenditures are reﬂected in stock prices relatively quickly (Sougiannis & Lev, 1996). Thus,

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the use of stock options in compensation contracts may help to align the goals of management and shareholders. Stock options are also common in high-tech industries because they do not consume cash. Hence, they provide a relatively painless method to compensate executives. Therefore, the sample used in this study consists of 35 ﬁrms in the computer software industry.7 H2 examines the relationship between the market reaction to the events preceding the release of SFAS 123 and the importance of stock options in employment contracting. We use two different proxies to measure the importance of stock options in employment contracting; the number of stock options used in compensation deﬂated by outstanding shares and option value deﬂated by total assets. Options deﬂated by outstanding shares is calculated as the simple average of the number of options used in executive compensation divided by the outstanding stock for the years 1993–1995. As shown in Table 2, on average, 4% of outstanding shares are granted as options. The value of options deﬂated by total assets is deﬁned as the average fair value of options used in executive compensation divided by total assets for the years 1993–1995. Table 2 shows that the mean value of options is approximately 4.5% of total assets while the median is only 1% of total assets. This indicates that a few ﬁrms have relatively high option values compared to their total assets. H3 examines the relationship between debt cost and the variation in the magnitude of returns around event dates. Consistent with previous research (e.g. Espahbodi et al., 1991, 1995; Leftwich, 1981; Salatka, 1989) the ratio of debt to total assets is used as a proxy for the tightness of debt covenants. The debt ratio is the simple average of the long-term debt of the ﬁrm divided by total assets for

Table 2. Descriptive Statistics of Firm Characteristics (1993–1995). Variable Options Number Options Value Debt Ratio Market Value EPS

Mean

Median

0.042 0.045 0.089 2462.2 0.607

0.035 0.012 0.016 263.5 0.470

Std. Dev. 0.368 0.066 0.122 6518.7 0.985

Option number = simple average of the number of options used in executive compensation deﬂated by outstanding stock for the years 1993–1995. Option Value = the simple average of the value of options used in executive compensation divided by total assets for the years 1993–1995. Debt ratio = the simple average of the long-term debt divided by total assets for the years 1993–1995. Market Value = the simple average of the ﬁrms’ market value of equity for the years 1993–1995. EPS = the simple average of the ﬁrms’ EPS for the years 1993–1995.

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the years 1993–1995. Table 2 shows that the average debt ratio of the sample ﬁrms is approximately 9%. H4 tests the political cost hypothesis. Market value of equity and EPS are used as proxies for political costs. Market value of equity is a common proxy for political costs as larger ﬁrms are generally scrutinized more than smaller ﬁrms. EPS is used as an alternative proxy as ﬁrms with large earnings are frequently seen as generating excess proﬁts. For example, in the early 1990s, the pharmaceutical industry was investigated by the Clinton administration because it earned “excess” proﬁts (Birnbaum & Waldholz, 1993). Market value of equity is the average of the market value of equity for the years 1993–1995. The mean market value of the sample ﬁrms is almost ten times the median, indicating that the sample contains a few large outliers. EPS is the simple average of the ﬁrm’s earnings per share for the years 1993–1995. For the sample ﬁrms, the average EPS is 0.607 while the median is 0.470.

RESULTS Table 3 provides the analysis of abnormal returns around the six event dates. The estimates presented in this table represent the average abnormal returns over a three-day event window around the events described in Table 1. The results indicate that signiﬁcant abnormal returns occurred around two dates, Event 4 and Event 5. The ﬁrst, Event 4, refers to an article in the WSJ discussing a letter-writing campaign by small companies in opposition to the proposed standard (Berton, 1994a). For this event, the average abnormal return is 0.0055 which is signiﬁcantly Table 3. Abnormal Returns around Events Leading to the Adoption of SFAS 123. Event 1 2 3 4 5 6

Date

Predicted Sign

2/19/93 4/8/93 6/30/93 1/5/94 3/28/94 7/28/95

+ − ? + − ?

Mean Abnormal Return −0.0032 0.0008 0.0035 0.0055 −0.0096 −0.0014

p-value 0.29 0.78 0.23 0.08 0.01 0.63

Events as described in Table 1. Portfolio abnormal returns and p-values for the 35 ﬁrms around each of the six events. These estimates are the coefﬁcients from a regression of weighted, portfolio returns and dummy variables corresponding to the six events. Each dummy variable equals 1 during the three day event period (t = −1, t = 0 and t = 1) and zero otherwise. Regression is estimated over the years 1993–1995 (757 days).

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different from zero at the 0.10 level. This implies that sample ﬁrms had, on average, a 0.55% greater return than ﬁrms outside the computer software industry that possess a similar level of risk. Thus, the market believed Event 4 reduced the probability that the Exposure Draft, requiring options to be expensed, would be adopted. Event 5, which discusses a proposed compromise (Berton, 1994b), is negative and signiﬁcant at the 0.05 level, as predicted. This suggests that the market interpreted this event as an indication that a revised standard would be implemented. These two results provide support for H1 and indicate that the market believed SFAS 123 impacted the ﬁnancial well-being of ﬁrms in the computer software industry. Table 4 presents the tests of H2–H4 using the Sefcik and Thompson (1986) methodology. Each column represents a regression of weighted portfolio returns on market returns and event dummy variables (see Appendix). The estimated value of the coefﬁcient is reported along with its p-value.

Table 4. Firm-speciﬁc Determinates of Abnormal Returns Magnitude. Event

Alternative Portfolios Option Number

1 2 3 4 5 6

0.003 (0.02) 0.051 (0.34) −0.167 (−1.11) −0.104 (−0.70) −0.065 (−0.43) −0.026 (−0.18)

Option Value 0.068 (0.871) −0.102 (−1.33) 0.040 (0.510) 0.076 (0.98) −0.068 (−0.87) 0.023 (0.30)

Debt Ratio

Market Value

EPS

0.068 (2.10)* −0.007 (−0.23) 0.002 (0.08) 0.021 (0.64) −0.06 (−1.86)** 0.043 (1.33)

1.26E−8 (1.04) −6.41E−9 (−0.53) 1.06E−8 (0.89) 2.056E−8 (1.69)* −1.87E−9 (−0.15) −1.10E−9 (−0.09)

0.004 (0.11) −0.002 (−0.41) −0.004 (−0.69) 0.057 (0.14) 0.008 (0.20) −0.001 (−0.16)

Results based on the portfolio weighting method developed by Sefcik and Thompson (1986). Each portfolio represents the results of OLS of individual weighted returns on six event dates (see Appendix). Option Number = simple average of the number of options used in executive compensation divided by outstanding stock for the years 1993–1995. Option Value = the simple average of the value of options used in executive compensation divided by total assets for the years 1993–1995. Debt Ratio = the simple average of the long-term debt divided by total assets for the years 1993–1995. Market Value = the simple average of the ﬁrm’s market value of equity for the years 1993–1995. EPS = the simple average of the ﬁrm’s primary EPS for the years 1993–1995. Events described in Table 1. ∗ Signiﬁcance at p < 0.10. ∗∗ Signiﬁcance at p < 0.05.

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The estimated coefﬁcients on the proxies for option utilization are not significant. This ﬁnding provides little support for H2, indicating that the magnitude of returns around event dates is not affected by the utilization of stock options. Thus, the results do not support the efﬁcient contracting hypothesis as it relates to employment. This may suggest that market participants did not believe that the passage of the Exposure Draft would reduce the use of stock options in executive compensation packages. It is possible that the lack of results may be attributed to the low degree of variability in the sample since the majority of ﬁrms in this industry rely on the use of stock options. H3 is tested using the debt ratio as a proxy for the likelihood a ﬁrm will violate its debt contracts. The results from Table 4 indicate that the debt ratio is a signiﬁcant predictor of returns on Event 1 and Event 5.8 In particular, the coefﬁcient on the debt ratio for Event 1 is positive and signiﬁcant, indicating that those ﬁrms with larger debt ratios had greater returns than those with smaller ratios. This is consistent with the debt contracting hypothesis. However, the results from H1 indicated that, overall, the market did not react to Event 1. Thus, the market reaction to ﬁrms with high and low debt apparently cancelled each other out. As previously discussed, the hypothesized sign on Event 5 is negative, and the abnormal returns are negative and signiﬁcant. The negative reaction is likely a result of the realization that the standard would proceed in a modiﬁed form rather than be abandoned. The coefﬁcient on the debt portfolio is negative and signiﬁcant for Event 5. This is consistent with H3 and implies that ﬁrms with higher debt have larger negative abnormal returns around an event increasing the probability that SFAS 123 would be issued. The more debt a ﬁrm has, the more negatively it is affected by this event. The strength of this result is a little surprising as software companies tend to have low levels of debt compared to other industries. However, software ﬁrms with debt are likely to be very sensitive to maintaining covenants to avoid losing debt ﬁnancing that is difﬁcult to obtain. Thus, any change in accounting rules that reduce reported income may have a substantial impact on a software company’s ability to maintain debt ﬁnancing. The political cost hypothesis is tested using two proxies: market value and EPS. Table 4 shows that market value is positively related to returns on event date 4. This appears to be inconsistent with the hypothesis that large ﬁrms have higher political costs and therefore, smaller stock price reaction. However, the event on this date focused on small ﬁrms. Speciﬁcally, the WSJ reported that the FASB received 500 letters from small ﬁrms (Berton, 1994a). Thus, a potential explanation for this reaction is that the market believed this event might delay implementation of the standard for small ﬁrms. If this were the case, small ﬁrms’ returns may increase marginally because there would be a delay in the implementation of the standard. However, large ﬁrms are typically not granted delays, and thus their returns would

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be affected by the increased probability of passage of the standard and the resulting reduction in political costs. The results of the EPS regressions are not signiﬁcant, indicating that EPS does not explain cross-ﬁrm variation in stock prices around event dates. In sum, there is some evidence to support H4, indicating that the political cost hypothesis played a limited role in explaining returns around event dates. One possible explanation for the weak results of the political cost hypothesis is discussed in Legoria (2000). He argues that using proxies for small and large ﬁrms may not be the ideal method to examine the political cost hypothesis as entire groups of ﬁrms may behave in similar ways regardless of their size. This seems likely in this setting as all of the ﬁrms in the computer software industry were opposed to the possibility of expensing options. Hence, it is likely that the small and large ﬁrms within this industry did not behave differently. Overall, the results of this analysis document a signiﬁcant stock market reaction to events leading to the release of SFAS 123. Thus, the standard-setting process itself affected stock prices of ﬁrms in the computer software industry. This ﬁnding may explain why software ﬁrms lobbied against SFAS 123. Speciﬁcally, executives may have chosen to expend resources and energy in the campaign against SFAS 123 because its passage would have had an adverse affect on the stock price of the ﬁrm. Such behavior may have been intensiﬁed in this industry because of the extensive use of stock options in compensation packages. Results from Table 4 provide evidence to support the debt covenant hypothesis and political cost hypothesis. Speciﬁcally, as debt increases, returns become more positive (negative) around Event 4 (Event 5), indicating that the level of debt is a driving factor in market responses. This result indicates that ﬁrms which are more reliant on debt are more sensitive to accounting treatments that reduce income. Further, there is some evidence to support the political cost hypothesis. Speciﬁcally, the results indicate that larger ﬁrms are scrutinized more if they report higher earnings levels. This result may be even more dramatic in the current environment as the quality of earnings appears to be important to the investment community in light of the recent difﬁculties of large corporations including Enron and WorldCom.

SUMMARY AND CONCLUSION This study examines the impact of the standard setting process resulting in the issuance of SFAS 123 on ﬁrms in the computer software industry. First, we document the political environment surrounding the issuance of SFAS 123. Speciﬁcally, we show that intense opposition in high-tech industries, including the computer software industry, led to executives expending time and resources

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to lobby against the standard. Next, we try to explain the motivations for this behavior. The seminal work of Watts and Zimmerman (1986) suggest that the standard-setting process can impact the value of the ﬁrm. We investigate this hypothesis as a potential explanation of ﬁrms’ choice to lobby against the expense treatment of stock options. Finally we investigate the relative strength of three causes of stock market reaction: the efﬁcient contracting hypothesis, the debt contracting hypothesis and the political cost hypothesis. The relation between ﬁrm value and signiﬁcant events in the standard-setting process is documented by examining the behavior of stock prices around these dates. Events increasing the probability of a standard requiring ﬁrms to expense stock options are hypothesized to generate negative abnormal returns for ﬁrms in the computer software industry. Alternatively, events decreasing the probability of the adoption of a standard requiring expensing stock options are hypothesized to produce positive stock returns for ﬁrms in the computer software industry. Results of this analysis identify a market reaction on two events leading to the adoption of SFAS 123. This indicates that ﬁrm value in the computer software industry was affected by the standard-setting process. This ﬁnding provides some insight into the choice to lobby against the standard. Speciﬁcally, executives may have lobbied against the standard as a means of maximizing the value of their ﬁrm and therefore, the options included in their compensation. We also examine ﬁrm-speciﬁc causes for variation in stock prices leading to the adoption of SFAS 123. Using the methodology proposed by Sefcik and Thompson (1986), we investigate whether stock price variation in the events leading to the adoption of SFAS 123 are explained by the debt covenant, efﬁcient contracting and political cost hypotheses. Results of these analyses show that proxies for political costs and debt covenants help to explain abnormal returns on event dates. The primary limitation of this analysis lies in the choice of event dates. Speciﬁcally, we assume that investors are unaware of events before they are reported in the WSJ. Because some WSJ articles report an aggregation of events that occurred over a relatively short period of time, informed investors may have reacted to information prior to the WSJ article date. This may be an explanation for the lack of signiﬁcance around certain events. This research is important as the stock option debate continues today. As discussed, there is no clear consensus on the appropriate accounting method for options. Currently, the International Accounting Standards Board is deliberating on the accounting treatment of stock options. Like the FASB, the IASB has received numerous letters against a standard requiring that options be expensed (Ascarelli, 2002). It also seems likely that pressures from Congress and the investment community will result in the FASB re-evaluating SFAS 123. Improving the accounting treatment for stock options may enhance the perceived validity

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of ﬁnancial statements. The results of this paper can contribute to discussions of stock option accounting and the economic impact of accounting standard setting.

NOTES 1. Street, Fordham and Waylan (1997) document the controversy surrounding stock options through an analysis of newspaper and business magazine articles between 1975–1993. 2. The fair value is a function of a number of variables, including the option price, option term, stock price, expected volatility of the stock price, dividend yield, and the ﬁrm’s risk-free interest rate. 3. The SEC requires publicly traded companies to disclose information regarding executive compensation, including the fair market value of stock options in their proxy statements. 4. An abnormal return occurs when a ﬁrm has a return greater (or less than) the market average after controlling for the ﬁrm’s risk. 5. DeChow et al. only examines three dates: two in 1993 and December 15, 1994, the date the FASB voted not to require mandatory expensing, El-Gazzar does not examine any events occurring after the issuance of the Exposure Draft on June 30, 1993. 6. Event dates were identiﬁed through a search of the WSJ using the Lexis/Nexis Database. Certain events were excluded due to data limitations, lack of relevance, and lack of signiﬁcance in preliminary statistical tests. Event dates prior to 1993 were excluded because of data limitations; speciﬁcally, the SEC did not require disclosure of the fair value of stock options used in executive compensation contracts prior to 1993. Post 1992 events were excluded due to lack of relevance to the standard setting process and weak statistical signiﬁcance in preliminary tests. Though some events reported in this paper do not represent massive changes in investors’ perceptions of FASB’s intentions, they do represent information aggregated over time which may not have been widely known until the article was published. 7. All sample ﬁrms meet the following criteria: (1) have a three digit SIC code of 737; (2) report complete data on the COMPUSTAT database; (3) have complete return data for the years 1993–1995 on the daily CRSP database; and (4) provide proxy statements on the EDGAR database. 8. Analysis of the debt ratio provides little evidence that this ﬁnding is the result of outlier observations.

ACKNOWLEDGMENTS We would like to thank H. Espahbodi for his insights on the application of the methodology used in this paper. We would also like to thank G. Previts (Ed.), the two anonymous reviewers, P. Alam, C. Brown, J. Duncan, C. Van Alst, L. Zucca and workshop participants at John Carroll University for their valuable comments.

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REFERENCES Accounting Principles Board (APB) (1972). Accounting for stock issued to employees. Opinion No. 25. New York: AICPA. Ascarelli, S. (2002). Tweedie strives to establish strict standards on options. Wall Street Journal (May 29). Barlas, S. (2002). Congress to take some action on stock options. Strategic Finance (June), 21–23. Berton, L. (1993). FASB moves to make ﬁrms deduct options. Wall Street Journal (April 8). Berton, L. (1994a). Accounting rule-making board’s proposal draws ﬁre. Wall Street Journal (January 5). Berton, L. (1994b). FASB to study compromise on options rule. Wall Street Journal (March 28). Birnbaum, J. H., & Waldholz, M. (1993). Harsh medicine: Attack on drug prices opens Clinton’s ﬁght for health-care plan. Wall Street Journal (February 16). Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81, 637–659. Bloomﬁeld, R. J. (2002). The “incomplete revelation hypothesis” and ﬁnancial reporting. Accounting Horizons (3), 233–243. Boslet, M. (2002). Intel chief executive proposes listing executive-stock options as expenses. Wall Street Journal (May 23). Brown, K., & Lublin, J. (2002). Conference Board backs stricter options rules. Wall Street Journal (September 17). Burns, J. (2002). SEC’s Pitt wants shareholders to be able to vote on options. Wall Street Journal (September 23). Carlson, E. (1992). Stock-option proposal worries high-tech ﬁrms. Wall Street Journal (June 26). Clinch, G. (1991). Employee Compensation and ﬁrms’ research and development activity. Journal of Accounting Research, 29(1), 59–79. Crystal, B. (2002). Bloomberg Television News (May 27). Dechow, P. M., Hutton, A. P., & Sloan, R. G. (1996). Economic consequences of accounting for stock-based compensation. Journal of Accounting Research, 34(Suppl.), 1–20. El-Gazzar, S. M., & Finn, P. M. (1998). Economic implications of proposed accounting for stock-based compensation. Atlantic Economic Journal, 26(3), 259–273. Espahbodi, H., Espahbodi, P., & Tehranian, H. (1995). Equity price reaction to the pronouncements related to accounting for income taxes. The Accounting Review, 70(4), 655–668. Espahbodi, H., Strock, E., & Tehranian, H. (1991). Impact on equity prices of pronouncements related to non-pension postretirement beneﬁts. Journal of Accounting and Economics, 14(4), 323–346. Financial Accounting Standards Board (FASB) (1995). Accounting for stock-based compensation. Statement of Financial Accounting Standards No. 123. Stamford, CT: FASB. Frangos, A. (2002). Perk patrol: The furor over stock options. Wall Street Journal (May 12). Gleckman, H. (2002). Options: It’s time for companies to come clean. Business Week (April 1), 35. Harlan, C. (1993a). Group opposes stock-option accounting plan. Wall Street Journal (January 14). Harlan, C. (1993b). Accounting ﬁrms, investors criticize proposal on executives’ stock options. The Wall Street Journal (February 19). Henry, D., Conlin, M., Byrnes, N., Mandel, M., Holmes, S., & Reed, S. (2002). Too much of a good incentive. Business Week (March 4), 38–39.

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Leftwich, R. (1981). Evidence of the impact of mandatory changes in accounting principles on corporate loan agreements. Journal of Accounting and Economics, 3(1), 3–36. Legoria, J. (2000). Earnings management, the pharmaceutical industry and health care reform: A test of the political cost hypothesis. Research in Accounting Regulation (14), 101– 131. Lublin, J. (2002). TIAA-CREF wants options seen as expenses. Wall Street Journal (July 24). Lys, T. (1984). Mandated accounting changes and debt covenants: The case of oil and gas accounting. Journal of Accounting and Economics, 6(1), 39–65. McKay, B. (2002). In a key change, Coke to treat stock options as compensation. Wall Street Journal (July 15). Nagy, A. (2001). Financial statement fraud: Capital market effects and management actions. Research in Accounting Regulation (15), 95–117. Salatka, W. (1989). The impact of SFAS No. 8 an equity prices of early and late adopting ﬁrms. Journal of Accounting and Economics, 11(1), 35–69. Schipper, K., & Thompson, R. (1983). The impact of merger-related regulations on the shareholders of acquiring ﬁrms. Journal of Accounting Research, 11(1), 184–221. Sefcik, S., & Thompson, R. (1986). An approach to statistical inference in cross-sectional models with security abnormal returns as dependent variable. Journal of Accounting Research, 14(2), 316–335. Sender, H. (2002). S&P to change its methodology for calculating operating proﬁt. Wall Street Journal (May 13). Sougiannis, T., & Lev, B. (1996). The capitalization, amortization, and value relevance of R&D. Journal of Accounting and Economics, 21, 107–138. Stiglitz, J. (2002). Accounting for options. Wall Street Journal (May 3). Street, D., Fordham, D., & Wayland, A. (1997). Stock options as a form of compensation for American executives: Impact on accounting rules of themes and arguments reported in newspapers and business magazines, 1975–1993. Critical Perspectives on Accounting, 8, 211–242. Wall Street Journal (1993). Bentsen opposes FASB on reporting stock options (April 7). Wall Street Journal (1993). Bill aims to derail accounting board’s options-rule review (June 30). Wall Street Journal (1995). FASB to issue ﬁnal rule on valuing stock options (July 28). Watts, R. L., & Zimmerman, J. L. (1986). Positive accounting theory. Englewood Cliffs, NJ: PrenticeHall, Inc.

APPENDIX MODELS AND VARIABLES Models and Variables Used in Tests of H1 The ﬁrst hypothesis is tested by examining the market reaction around six events leading to the adoption of SFAS 123 using the multivariate regression method proposed by Schipper and Thompson (1983). This methodology increases the efﬁciency of parameter estimates by incorporating contemporaneous correlation into the estimation process (Schipper & Thompson, 1983). Following Espahbodi et al. (1991, 1995), portfolio returns are weighted based on the estimated full

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covariance matrix of residuals. The model is as follows: R t = ␣j + ␤j R mt where:

E + ␥e D et + ␧t

(1)

e=1

R t = weighted portfolio of returns on day t, ␤j = risk coefﬁcient on the portfolio, R mt = return on the market, ␥e = the coefﬁcient measuring the impact of the event, D et = dummy variables that take the value of one during a three day event period and zero therwise, ␧t = error term. The model is estimated using seemingly unrelated regressions. Coefﬁcients are constrained to be equal, resulting in a single regression equation rather than an equation for each ﬁrm. H1 is supported if there is a signiﬁcant market reaction around events preceding the release of SFAS 123. Models and Variables Used in Tests of H2–H4 The methodology used follows the portfolio weighting procedure implemented by Sefcik and Thompson (1986) and Espahbodi et al. (1991, 1995). This weighting procedure accounts for collinearities among ﬁrm characteristics, which may cause inefﬁcient and potentially biased estimates of standard errors under traditional OLS regression. Therefore, this methodology provides an opportunity to evaluate the relative importance of different ﬁrm characteristics in explaining variability in the market reaction to events leading to the adoption of SFAS 123 while conforming with all statistical assumptions (Espahbodi et al., 1991, 1995; Sefcik & Thompson, 1986). The weighting procedure consists of three steps. The ﬁrst step, as described by Espahbodi et al. (1991, 1995), is to deﬁne a matrix C having a column of 1s and k − 1 columns of ﬁrm characteristics which will include the variable related to stock options. The matrix will be as follows: C = [1X 2 , . . ., X n ] Next the portfolio weights are developed: ⎢ ⎥ ⎢w ⎥ ⎢ 1 ⎥ ⎢w ⎥ ⎢ 2⎥ W = ⎢ . ⎥ = (C C)−1 C ⎣ .. ⎦ wn

(2)

(3)

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The portfolio returns for each set are then computed as follows: WR kt = W k R it

(4)

where: W = K × N matrix of portfolio weights W k = Kth row of portfolio weights that are only inﬂuenced by the kth ﬁrm characteristic C = N × K matrix deﬁned in Eq. (3) R kt = Weighted return of portfolio k on day t. R it = N × 1 vector of individual ﬁrm’s security returns on day t. Essentially, we apply a weighting procedure to the portfolio returns and run ﬁve different OLS regressions for each set of ﬁrm characteristics. After applying the weighting procedure, we derived ﬁve arrays of weighted returns (WRtk ), one for each proxy. These weighted returns are then used to estimate ﬁve separate OLS regressions for each array of returns using the following formula: WR tk = ␣k + ␤j R mt +

E ␥ke D et + ␧t

(5)

e=0

where: WR t ␤j R mt ␥ke D et

= = = = =

weighted portfolio of returns on day t, risk coefﬁcient on the portfolio, return on the market, the coefﬁcient measuring the impact of the event, dummy variables that take the value of one during a three day event period and zero otherwise, ␧t = error term.

A dummy variable for each three-day event period is the variable of interest. If the coefﬁcient on that variable is signiﬁcant, the ﬁrm characteristic was signiﬁcant in affecting the market return for that event.

GAAP: A REGULATORY TOOL TO MANAGE HEALTHCARE Mark Holtzman and Olga Averin ABSTRACT How effectively can government use accounting measures in a privatization scenario, where public duties are entrusted to non-government organizations? Texas Senate Bill 427 establishes minimal levels of charity care, using accounting measures, that Texas not-for-proﬁt hospitals must provide. We test how this legislation inﬂuenced: (1) not-for-proﬁt hospitals’ charity care spending; and (2) the distribution of charity care among not-for-proﬁt hospitals. We provide evidence suggesting that the legislation led to improved tracking of charity care but only nominally increased spending on charity care. Furthermore, we ﬁnd that the burden of charity care may have shifted from the hospitals which were spending the most on charity to those that were spending less, so that, in response to the legislation, some hospitals apparently reduced their charity care spending. Finally, we document anecdotal evidence indicating that, when creating and enforcing accountingbased standards, unfamiliarity with accounting techniques may encumber legislators’ efforts.

INTRODUCTION The broad distribution of healthcare has presented a difﬁcult challenge to policymakers. Possible solutions to this problem have included the socialization

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of medicine (as practiced in Europe and Canada), government subsidization of medical insurance (as currently practiced in the U.S.), and the universal healthcare system proposed for the U.S. in the early 1990s. In response to the latter proposal, many states experimented with smaller-scale solutions to this problem. One such solution, Texas Senate Bill No. 427, requires not-for-proﬁt hospitals to provide minimal levels of community service, including charity care provided to indigent patients. The Bill’s sponsors argued that the tax exemptions received by not-for-proﬁt hospitals should obligate them to provide beneﬁts to their respective communities. Such a program could improve the distribution of healthcare at no cost to the State. This Bill used accounting-based measures of charity care, which, we contend, may have undermined the legislators’ intent. How successfully could regulators use accounting measures to encourage not-for-proﬁt hospitals to increase their charity care? The question relates to a more general issue: how can accounting measures assist government in a privatization scenario, where public duties are entrusted to non-government organizations? It is possible that regulated entities could manipulate the measures used in order to meet the letter of the law without actually increasing the economic beneﬁts that they provide. In this case, did hospitals manipulate their charity care measures in order to meet legal requirements, without actually increasing their spending on charity care? Our study provides several insights into the beneﬁts and problems associated with accounting-based regulation. First, our observation of the legislative process indicates that State legislators and their staff were insufﬁciently familiar with accounting conventions to write them into legislation. While the results of our study indicate that hospitals met the letter of the law, reporting higher amounts of charity care in their regulatory reports, an alternative measure of charity care indicates that once the legislation took effect, most hospitals’ charity care spending did not increase at a statistically signiﬁcant level. Furthermore, we document additional unintended consequences of the legislation, namely that many not-for-proﬁt hospitals reduced their charity care to the state-prescribed minimum standards.

THE LEGISLATIVE PROCESS Senate Bill 427 Bill 427, signed into law on May 31, 1993, requires each not-for-proﬁt hospital in the State of Texas to provide charity care and other community beneﬁts of

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at least four percent of net patient revenue through 1995, and increased to ﬁve percent in subsequent years.1 Within 120 days of its ﬁscal year end, each hospital is required to ﬁle an annual report of its charitable activity, including a mission statement, information about how the community beneﬁts plan was developed and the actual amounts of charity care and community beneﬁts provided. The Bill required hospitals to report charity care at cost, calculated by multiplying the charity care “charge” (the billing rate to cash customers) by a “cost-to-charge” ratio.2 This cost-to-charge ratio, based upon Medicare cost reports, excluded many hospital costs, such as bad debt expense and charity care.

Senate Bill 1190 Signed into law on June 16, 1995, Bill 1190 amended these provisions, permitting cost-to-charge ratios to be “derived in accordance with generally accepted accounting principles for hospitals [and] shall be based on the most recently completed and audited prior ﬁscal year of the hospital or hospital system.” A review of the AICPA Audit and Accounting Guide to Health Care Organizations (June 1, 1996 ed.) and other authoritative literature reveals no reference to any GAAP standards for calculating hospital cost-to-charge ratios. When estimating the cost-to-charge ratio and the reported cost of charity care, this new deﬁnition afforded hospitals increased, and probably unintended, ﬂexibility. How did this happen? Subsequently, in 1997, one of the authors of this study attended a meeting in the Texas Capital on new legislation that would redeﬁne the cost-to-charge ratio and increase the required rate of charity care. Present were the Bill’s sponsor, Rep. Glenn Maxey (D-Austin), other legislative staff members, consumer lobbyists, and hospital lobbyists.3 At least 30 minutes was spent discussing the positive relationship between expense items to be included in the cost-to-charge ratio and reported charity care. Among this confusion, only the hospital lobbyists, all hospital ﬁnance ofﬁcials, appeared to fully understand these relationships. The hospital lobbyists contended that such expenses were part of the cost of running a hospital, and should therefore be included in the cost-to-charge ratio (inﬂating reported charity care) under GAAP. The consumer lobbyists appeared to be insufﬁciently versed in accounting or ﬁnance to counter such arguments. This meeting led us to conclude that legislators’ and lobbyists’ unfamiliarity with accounting was most likely a factor in the passage of Bill 1190 provisions that referred to non-existent GAAP standards, affording hospitals increased ﬂexibility when estimating the cost of charity care.

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HOSPITALS’ INABILITY TO FUND INCREASED LEVELS OF CHARITY CARE AND COMMUNITY BENEFITS When meeting new mandates to provide increased services free of charge, not-for-proﬁt hospitals would have little or no excess resources to draw on. Already heavily constrained by increased costs of providing healthcare, high malpractice rates and pressures by insurers to keep revenues down, decision makers may have no choice but to artiﬁcially increase reported charity care.4 This could be accomplished by writing off uncollectible debts to charity care, because a patient unable to pay hospital bills is likely to qualify for charity care anyway. However, the AICPA Audit and Accounting Guide for Providers of Health Care Services deﬁnes charity care as “healthcare services that are provided but are never expected to result in cash ﬂows (paragraph 10.03)” Therefore, such reclassiﬁcations would be inconsistent with GAAP.5 On the other hand, de-facto reclassiﬁcations from bad debt expense to charity care could be expected. Bill 427 encouraged not-for-proﬁt hospitals to revise their charity care policies, so that many ﬁnancially indigent patients who were, under older guidelines, billed and then later deemed as uncollectible accounts would, under the new guidelines, be classiﬁed as charity care cases. Such practices would artiﬁcially increase reported charity care without increasing the beneﬁts actually provided to indigent patients.

TESTING FOR INCREASES IN CHARITY CARE This study hypothesizes that not-for-proﬁt hospitals’ charity care expenditures are inﬂuenced by the Texas legislation taking effect in 1994. We construct two different measures of charity care beneﬁts. The ﬁrst, “reported charity care,” is a percentage of the hospital’s services offered as charity care. It is calculated by dividing charity care recorded at “charge” (the amount which patients would have been billed for the care provided) by gross patient service revenues.6 The second measure, “unreimbursed medical care,” is a percentage of the hospital’s services offered for which it received no compensation, including charity care and bad debts. It is calculated as the sum of charity care at charge and bad debt expense, divided by gross patient service revenues, and can be used to determine the actual economic beneﬁt provided to indigent patients, regardless of whether the hospital billed the patient. Accordingly, we test whether the legislation was associated with increases in: (1) reported charity care; and (2) unreimbursed medical care.

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Pooled regression models set the two different measures of charity care as alternative dependent variables, and organizational form as the independent variable. Since a hospital’s charity care level could also be a function of hospital size, population density (urban versus rural), the size of minority populations, age of the population, income level/distribution, education and employment rates, we add control variables for each of these factors to the regression model. Increases in charity care coinciding with the legislation’s effective date will be captured by a dummy shift variable (for year) multiplied by another dummy variable representing not-for-proﬁt hospitals.

SAMPLE SELECTION We collect data from the American Hospital Association/Texas Department of Health/Texas Hospital Association Annual Survey of Hospitals databases, for years 1990 through 1995, compiled by the Bureau of State Health Data and Policy Analysis, which is part of the Texas Department of Health. Information about Bill 427 compliance was obtained from the Annual Statement of Community Beneﬁts Standard databases for 1994 and 1995. Bill 427 requires these forms to be ﬁled with the Bureau of State Health Data and Policy Analysis. We reviewed the sample for missing or invalid data about charity care, bad debt expense or gross patient revenues. Hospitals with zero balances for any of these variables between 1991 and 1995 were omitted, resulting, as shown on Table 1, in samples of 115 not-for-proﬁt hospitals, 108 public hospitals, and 26 for-proﬁt hospitals.

RESULTS Table 1 provides results of the tests of changes in reported charity care and unreimbursed care after the legislation took effect. The not-for-proﬁt hospitals’ reported charity care increased from 2.7% of gross patient service revenues in 1993 to 3.4%. This difference is statistically signiﬁcant (p < 0.006), indicating that implementation of Bill 427 coincides with a substantial increase in reported charity care. Reported charity care increased among public hospitals, and decreased among for-proﬁt hospitals, but these changes were not statistically signiﬁcant. Not-for-proﬁt hospitals’ unreimbursed medical care also increased, from 6.8% of revenues in 1993, to 7.5% in 1994. This statistically signiﬁcant increase (p < 0.044) indicates that Bill 427 implementation coincided with an increase in not-for-proﬁt hospitals’ unreimbursed medical care.

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Table 1. t-Test of Increases in Reported Charity Care between 1993 and 1994. Variable

Reported Charity Care: Reported charity care divided by gross patient service revenues

Unreimbursed Care: Calculated as the sum of charity care reported at billed prices and bad debt expense, divided by gross patient service revenues

1993 Mean Std. Dev. n

1994 Mean Std. Dev. n

t-test Signiﬁcance (One-Tailed)

Not-for-proﬁt hospitals

2.7% 0.188 n = 115

3.4% 0.022 n = 115

t = 2.52 p < 0.006

Governmentowned public hospitals

4.4% 0.063 n = 108

4.8% 0.074 n = 106

t = 0.45 p < 0.327

For-proﬁt hospitals

1.1% 0.001 n = 26

0.9% 0.009 n = 27

t = −0.82 p < 0.208

All hospitals

3.3% 0.045 n = 249

3.7% 0.052 n = 248

t = 1.03 p < 0.153

Not-for-proﬁt hospitals

6.8% 0.028 n = 115

7.5% 0.030 n = 115

t = 1.70 p < 0.044

Governmentowned public hospitals

11.8% 0.088 n = 108

12.5% 0.100 n = 106

t = 0.55 p < 0.292

For-proﬁt hospitals

5.0% 0.035 n = 26

4.4% 0.024 n = 27

t = −0.71 p < 0.240

All hospitals

8.8% 0.067 n = 249

9.3% 0.075 n = 248

t = 0.78 p < 0.217

The regression results, shown in Table 2, take into account the confounding factors of population density, minority population, median age, median income, poverty level, education and unemployment rates. The coefﬁcients on the not-forproﬁt hospital variable amounted to 1.6% with respect to reported charity care and 2.7% with respect to unreimbursed medical care. These would be interpreted as follows: not-for-proﬁt hospitals provided, on average, 1.6% higher charity care, and 2.7% higher unreimbursed medical care than for-proﬁt hospitals prior to 1994.7 After the state legislation took effect, not-for-proﬁts’ charity care increased by an additional 0.9% of revenues (which is statistically signiﬁcant, p < 0.050).

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Table 2. Regression Results. Variable

Intercept Not-for-proﬁt hospital Not-for-proﬁt hospital × Post-1993 Public hospital Revenues Exempt hospital Population density Minority population Median age Median income Poverty rate High school graduation rate Unemployment rate Sample size Adjusted R2 F-Factor

Predicted Direction

Dependent variable: Reported Charity Care

Dependent variable: Unreimbursed Medical Care

Coefﬁcient

(Std. Error)

None Positive Positive

−0.05699* 0.01613*** 0.00919*

(0.032) (0.005) (0.005)

0.05274 0.02687*** 0.00620

(0.044) (0.007) (0.007)

Positive Positive Negative Positive Positive Positive Negative Positive Negative

0.04504*** 0.04141*** 0.00645 0.00001*** 0.05697*** 0.00075 −0.00028 −0.109 0.02603

(0.005) (0.005) (0.006) (0.000) (0.014) (0.001) (0.001) (0.045) (0.011)

0.08616*** 0.04157*** −0.01405* 0.00001 0.06257*** −0.00036 −0.00255 −0.182 0.03224

(0.007) (0.007) (0.008) (0.000) (0.020) (0.001) (0.002) (0.063) (0.016)

Positive

0.00711

(0.099)

0.00321

(0.139)

1245 19.5% 26.042***

Coefﬁcient

(Std. Error)

1245 21.3% 29.120***

All based on one-tailed t-tests except for intercept (two-tailed). Where: Reported charity care = Reported charity care divided by gross patient service revenues. Unreimbursed medical care = Unreimbursed medical care, calculated as the sum of charity care reported at billed prices and bad debt expense, divided by gross patient service revenues. Not-for-proﬁt hospital = Dummy variable equal to one for not-for-proﬁt hospital, otherwise zero. Post-1993 = Dummy variable equal to one in 1994 and 1995, otherwise zero. Public hospital = Dummy variable equal to one for government-owned public hospital, otherwise zero. Revenues = Reported gross patient service revenues. Exempt hospital = Dummy variable equal to one for not-for-proﬁt hospitals exempted from charity care requirements, otherwise zero. Exemptions to the requirements were provided for hospitals with a high proportion of Medicare/Medicaid services, charity care exceeding the value of tax-exempt beneﬁts received, or other technicalities. Population density = County population density. Minority population = County minority population, as a percentage of overall population. Median age = County median age. Median income = County median per capita income. Poverty rate = percentage of county population living below the poverty level. High school graduation rate = percentage of county population having graduated high school. Unemployment rate = County unemployment rate. ∗ Statistically signiﬁcant at less than the 0.05 level; ∗∗ Statistically signiﬁcant at less than the 0.01 level. ∗∗∗ Statistically signiﬁcant at less than the 0.001 level.

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Not-for-proﬁts’ unreimbursed care increased by 0.6% of revenues, but this result was not statistically signiﬁcant (p < 0.34). A number of alternative regression models were run, using alternative measures of different variables and additional dummy variables, with minimal changes in these results. Most of the control variables’ coefﬁcients are in the predicted direction. However, the percentage of county population living below poverty level is negatively associated with charity care and unreimbursed medical care, at statistically significant levels. Higher poverty levels are associated with lower levels of community beneﬁts. This relationship may indicate that the legislation held little beneﬁt for senior citizens and patients living below poverty level because they were already covered by government-sponsored programs like Medicare and Medicaid. Rather, the legislation more likely beneﬁted middle-income patients, possibly uninsured, who did not qualify for Medicare or Medicaid, but nevertheless couldn’t afford costly hospital procedures. This explanation may also explain why education is positively associated with community beneﬁts. Higher education rates were associated with higher community beneﬁts. Better educated patients may be more aggressive when pursuing medical care, and more savvy in taking advantage of hospitals’ charity care programs.

DISTRIBUTION OF CHARITY CARE AMONG NOT-FOR-PROFIT HOSPITALS Did the legislation encourage some hospitals – those which previously offered the highest levels of charity care – to reduce their charity care downwards to the legally-prescribed minimum? We divided the sample into eight subsamples, or “octiles,” according to the level of reported charity care in 1993.8 We expected observations in the lowest octiles (those hospitals providing the lowest amount of reported charity care) to increase their charity care, while observations in the highest octiles were expected to decrease their reported charity care to levels closer to the legal requirements. The lowest six octiles increased their reported charity care in 1994 by statistically signiﬁcant amounts (1-tailed p factors range from 0.001 to 0.035). On the other hand, the top octile decreased reported charity care (t = 1.55, p < 0.067). This weakly signiﬁcant result indicates that there were some unintended consequences to this legislation. With respect to unreimbursed medical care, the lowest seven octiles increased their mean charity care, although all of these increases were statistically insignificant. When considered alongside the statistical signiﬁcance for reported charity care, these results indicate that reductions in bad debts may have cushioned the effects of increased charity care costs. The hospitals in the eighth octile

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decreased unreimbursed care, from 10.4% to 8.9%, a statistically signiﬁcant decline (p < 0.011).

CONCLUSION In general, accounting permits an entity’s stakeholders to monitor its activities, and as such, can be useful not only in an investing environment, where stockholders read ﬁnancial statements to assess managers’ performance, but also in a public regulatory environment, where government ofﬁcials read specially-prepared reports to assess entities’ compliance with legal standards. This study examines the usefulness of accounting in such a regulatory environment, speciﬁcally where not-for-proﬁt hospitals report accounting-based measures of charity care and community beneﬁts. We ﬁnd that, as a result of accounting-based regulation by the State of Texas, not-for-proﬁt hospitals increased their reported charity care levels. Following the effective date of the legislation, not-for-proﬁt hospitals’ reported charity care and unreimbursed care levels signiﬁcantly increased, according to univariate t-tests. Regressions indicate statistically signiﬁcant increases in reported charity after controlling for hospital size, legislative exemptions, population density, minority population, median age, median income, poverty levels, education and unemployment rates. Controlling for all of these factors, increases in unreimbursed care by not-for-proﬁt hospitals were also higher than for other hospitals, but this difference was not statistically signiﬁcant. These results suggest that the legislation led to improved tracking of charity care but only nominally increased spending on charity care. Tests of the distribution of charity care and unreimbursed care indicate that those hospitals providing the lowest levels of charity care and unreimbursed care increased their care levels as the legislation took effect. However, the hospitals providing the highest reported charity and unreimbursed care actually decreased their care levels, suggesting that the Bill bore some unintended consequences. This study provides valuable new information about how to use (and misuse) accounting in a scenario where government entrusts non-government organizations to perform public duties. Such a public approach to accountability would be common in a “privatization” scenario, where government empowers non-governmental or quasi-governmental agents to execute certain tasks, such as law enforcement, public utility management, prison management, and public education. The lessons learned are quite simple – accounting measures need to be easily understood, tightly deﬁned, but difﬁcult to manipulate.

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NOTES 1. The Bill offers numerous exceptions for individual hospitals’ special circumstances. 2. For example, suppose that Hospital X incurs costs of $800,000 and recognizes gross patient billings of $1,000,000. Its cost-to-charge ratio would be 80%. If the billing price of charity care rendered amounts to $50,000, then the cost of such charity care would be $40,000 ($50,000×80%). 3. While Maxey’s legislation was tabled before any committee hearings, subsequent bills (Senate Bill 788, May 26, 1997; House Bill 2556, June 11, 1997; House Bill 2384, June 19, 1997; and House Bill 2397, June 19, 1997) did add certain technical clauses to the state’s charity care regulations. 4. Leone and Van Horn (1999) provide evidence that, even though they have no explicit proﬁt objective, not-for-proﬁt hospital managers may artiﬁcially manipulate their ﬁnancial statements. 5. The Principles and Practices Board of the Healthcare Financial Management Association (1993) argues that collection efforts do not disqualify accounts from charity care treatment (Statement of Position No. 15). However, their guidance is classiﬁed as level “e” in the GAAP heirarchy, while the AICPA (1996) guide is classiﬁed as level “b.” Furthermore, the Audit and Accounting Guide proposes a series of ﬁeld procedures auditing charity care, suggesting that direct reclassiﬁcations from bad debt sto charity care should be addressed during the audit process. 6. We could not use the data from charity care reports mandated under Bill 427: (1) because of the unavailability of comparable data prior to 1994; and (2) because Bill 1190 revised the calculation of charity care in 1996. 7. These percentages should be interpreted as a percentage of revenues, and not as a percentage of for-proﬁts’ beneﬁts levels. 8. Tests of the change in variance of commnuity beneﬁts between 1993 and 1994 result in F-factors of 0.058 and 0.185, respectively, both statistically insigniﬁcant.

ACKNOWLEDGMENTS We thank the Frank G. Zarb School of Business, Hofstra University for its ﬁnancial support. We appreciate the comments of the editor, Urton Andersen, Michael Granof, Steve Kachelmeier and two anonymous reviewers. Data is available from the Texas Department of health, Bureau of State Health Data and Policy Analysis, or from the corresponding author.

REFERENCES American Institute of Certiﬁed Public Accountants (1996). Audit and accounting guide: Health care organizations. Jersey City, NJ: AICPA.

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Healthcare Financial Management Association, Principles and Practices Board (1993). Statement number 16: Classifying, valuing, and analyzing accounts receivable related to patient services. Westchester, IL: Healthcare Financial Management Association. Leone, A., & Van Horn, R. L. (1999). Earnings management in not-for-proﬁt institutions: Evidence from hospitals. University of Rochester working paper.

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PART II: RESEARCH REPORTS

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IMPROVING AUDITOR INDEPENDENCE – THE PRINCIPLES VS. STANDARDS DEBATE: SOME EVIDENCE ABOUT THE EFFECTS OF TYPE AND PROVIDER OF NON-AUDIT SERVICES ON PROFESSIONAL INVESTORS’ JUDGMENTS Elaine G. Mauldin ABSTRACT In response to reported corporate irregularities, in 2002 Congress and the General Accounting Ofﬁce (GAO) addressed the issue of auditor independence in ways which continue to contrast the approaches identiﬁed as “principles vs. standards.” Non-audit services are included in the revisions because of concerns that auditor independence, in fact or appearance, could be impaired when the auditor also provides their client with non-audit services and that even a perceived lack of independence could cause investors to be less likely to invest in a company’s securities. This paper discusses differences in the revised regulations and reports the results of an experiment examining the impact of non-audit services on professional investors’

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judgments with implications for the regulations’ relative effectiveness. The results indicate that the participants’ stock recommendations did not vary between outsourced internal audit and mergers and acquisitions non-audit services. Both were considered to impair independence, supporting the GAO’s principles-based approach to auditor independence. Further, the participants issued about twice as many “sell” stock recommendations when the non-audit services were provided by an associated entity than by either the accounting ﬁrm itself or an unrelated ﬁrm, supporting the GAO’s standard for, and the SEC’s expected administrative treatment of, associated entities.

INTRODUCTION Recent major accounting scandals have led to widespread interest in reform aimed at improving audit quality including auditor independence, both in fact and appearance. The primary contentious auditor independence issue revolves around the provision of non-audit services to audit clients, including restrictions on the type of non-audit services performed for audit clients and the provision of non-audit services by an associated entity, such as a publicly traded afﬁliate of the audit ﬁrm. Though there has been general agreement that changes in the business environment warrant changes in auditor independence regulations, there is debate whether such changes should be principles-based, employing judgment about the facts and circumstances of a particular non-audit service, or standards-based, employing rules prohibiting speciﬁc types of non-audit services (ISB, 1997; SEC, 2001; Ward, 1998). The recently enacted Sarbanes-Oxley Act of 2002 (The Act), applicable to publicly traded companies, restricts speciﬁc types of non-audit services in a standards-based approach and leaves the associated entities issue to the discretion of the Securities and Exchange Commission (SEC). In contrast, the recently revised General Accounting Ofﬁce’s (GAO’s) standards, applicable to government and certain not-for-proﬁt entities, restricts non-audit services in a principles-based approach and also provides deﬁnitive guidance on associated entities (GAO, 2002). The purpose of this paper is to discuss these two different approaches to limiting non-audit services and to report the results of an experiment with implications on the efﬁcacy of each approach. In the experiment, 74 professional investors completed a stock analysis task for a hypothetical company. Two types and three providers of non-audit services were manipulated between subjects. The results show that type of non-audit services did not signiﬁcantly impact either stock recommendations or perceived independence judgments. Outsourced internal audit services, one of the prohibited

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services under The Act, was perceived to be no better or worse than the provision of a form of mergers and acquisitions services that is not prohibited. Both services were perceived to impair independence, supporting the GAO’s focus on principles, including the signiﬁcance, not the speciﬁc type, of non-audit services. The results also show signiﬁcantly more recommendations to sell the stock when non-audit services were provided by an associated entity than either directly by the ﬁrm or by an unrelated ﬁrm. These results support the GAO’s restrictions on associated entities as well as the SEC’s expected treatment of associated entities as evidenced by a recent independence impairment case against KPMG, LLP. The remainder of the paper is organized as follows. The next section reviews prior literature and develops research questions. Then, the experimental design is described and the results are presented. The last section provides concluding comments.

PRIOR LITERATURE AND RESEARCH QUESTIONS Non-audit service fees averaged 2.73 times audit fees in 2001 for companies in the Dow Jones Industrial Average (Investor Relations Business, 2002). The impact of non-audit services on auditor independence is the subject of a recurring debate. Proponents argue that non-audit services do not reduce auditor objectivity and that the performance of non-audit services can improve the quality of the audit (Antle et al., 1997). Opponents, on the other hand, argue that non-audit services do impair auditor independence because, for example, the auditor may end up auditing their own work or acting as management (SEC, 2001). Though a considerable body of prior behavioral research focuses on non-audit services, most of the studies were completed prior to the growth in non-audit fees and ﬁndings are mixed and inconclusive (Kleinman et al., 1998). Historically few non-audit services were prohibited. However, in the 1990s, the types of non-audit services rapidly expanded and is now quite diverse, including investment banking, strategic planning, and internal audit outsourcing (Sutton, 1997), spurring renewed interest in limitations on non-audit services. Recent accounting scandals increased the intensity of the debate and resulted in revised regulations by both Congress, for publicly traded companies, and the GAO, for government entities. These regulations illustrate two very different approaches to limiting types of non-audit services. The Act, passed by Congress, continues the SEC’s traditional standards-based approach where rules are developed prohibiting speciﬁc lists of non-audit services, under the assumption that certain types of non-audit services are worse than others. The Act simply modiﬁed the existing

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SEC prohibitions. For example, outsourced internal audit is now completely, instead of partially, prohibited. The GAO, on the other hand, adopted a principles-based approach in their January 2002 amendment to the Government Auditing Standards related to auditor independence and the July 2002 Answers to Independence Standard Questions. Rather than issue lists of non-audit services that are prohibited, the GAO’s standard for all types of non-audit services is based on two overarching principles. First, non-audit work cannot involve performance of management functions or result in the auditor making management decisions. Second, non-audit work cannot result in the auditor auditing their own work or involve situations where the amounts or services involved are signiﬁcant/material to the subject matter of the audit. This principles-based approach considers not only the type of non-audit service but also its signiﬁcance (GAO, 2002). The ﬁrst issue examined in the study is the type of non-audit services. The study compares professional investors’ stock recommendations in the presence of two different types of non-audit services to provide some evidence about the effectiveness of principles-based versus standards-based regulatory approaches. Professional investors are used as subjects because they are representative of a reasonable investor, the SEC’s major target group (SEC, 2001). Stock recommendations are the focus judgment because this is the ultimate judgment an analyst makes (Schipper, 1991). Further, the SEC argues that trust in ﬁnancial statements provides a framework for investor decisions to buy or sell common stock and supports liquidity and growth of investors participating in the capital markets (Sutton, 1997). Anecdotally, analysts report a tendency to sell or avoid a stock if they perceive an independence problem (ISB, 1997). Finally, contracting theory argues that perceived auditor independence is a necessary ingredient for trust in the ﬁnancial statements (Watts & Zimmerman, 1986). If non-audit services are perceived to impair independence and analysts reduce their trust in the ﬁnancial statements, they should issue more recommendations to sell the stock. The ﬁrst type of non-audit service examined is outsourced internal audit, a relatively new type that will be considered to impair independence under either the standards-based or principles-based approach. The second type is mergers and acquisitions consulting, a type of service commonly provided by audit ﬁrms that is not speciﬁcally prohibited in the standards-based approach but likely would be in the principles-based approach. The ﬁrst research question explores whether analysts distinguish between types of non-audit services. Research Question 1. Do professional investors’ stock recommendations vary across type of non-audit services?

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The second issue examined in the study is the treatment of associated entities. In their revised independence rules effective in 2001, the SEC expressed concern about changes in the organizational structure of accounting ﬁrms. For example, KPMG spun off their consulting business into a separate entity with partial public ownership (SEC, 2001). In another strategy, the non-audit portion of the accounting ﬁrm is sold to a public company. While the original accounting ﬁrm continues to issue reports for audit clients, it becomes in essence a shell that leases staff time and obtains support services from the public company (SEC, 2001). This example is illustrated by American Express subsidiaries purchasing a large group of CPA ﬁrms (Ward, 1998). In spite of their concern, the regulations stated that associated entities would be addressed on an individual basis because these afﬁliations are relatively new (SEC, 2001). The Act leaves the ruling on associated entities to the SEC’s discretion suggesting the issue is yet to be fully resolved. The SEC appears likely to effectively prohibit non-audit services provided by associated entities based on their cease-and-desist order, upheld in a U.S. appeals court, for impairment of independence from non-audit services provided by KPMG Baymark, an associated entity, to KPMG audit client, Porta (KPMG, LLP v. SEC 2002). The GAO standards state that an audit ﬁrm cannot do indirectly what it could not do directly. Speciﬁcally, if an audit ﬁrm or the audit ﬁrm’s senior leadership or partners has any direct ﬁnancial interest and/or control over its work in an associated entity, the audit ﬁrm’s independence would be impaired by non-audit services performed by the associated entity in the same manner it would be if it performed them directly. Although regulators are limiting non-audit services provided by associated entities, it is not clear that the introduction of an associated ﬁrm negatively impacts either perceived independence or the effectiveness of institutional incentives to remain independent. Perceived independence could potentially be improved because the external audit ﬁrm has diversiﬁed part of the risk of non-audit services to the outside owners and are participating in fewer rewards from those services. On the other hand, institutional incentives may be blunted with the introduction of an associated entity. First, the addition of public ownership may result in an increased orientation towards proﬁtability and client retention. Public ownership may be perceived to heighten pressure to meet earnings forecasts and the auditor might be perceived to be less able to “stand up” to an audit client providing the ﬁrm with consulting proﬁts. Second, if the associated entity were not subject to the independence guidelines that the audit ﬁrm is subject to, investors may perceive less effective oversight (Ward, 1998). Finally, trust in the audit ﬁrm’s reputation may not transfer to an associated entity. Because the direction of any impact of associated entities is unclear, this study simply poses the following research question:

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Research Question 2. Do professional investors’ stock recommendations vary across provider of non-audit services.

RESEARCH METHOD AND RESULTS The results are based on responses from 74 professional investors from a variety of organizations with mean experience in ﬁnancial analysis of 7.25 years. Participants were recruited through the AIMR national ofﬁce and its local chapters. AIMR is a global industry organization of investment professionals. The experiment was conducted in person in nine small group sessions in a conference room setting. Experimental materials consisted of a stock evaluation task that included general instructions with simplifying assumptions and companyspeciﬁc information for a hypothetical large company traded on the New York Stock Exchange. Company-speciﬁc information was based on typical reports used in ﬁnancial analysis. Participants were randomly assigned to one of six conditions resulting from the 3 × 2 between-subjects design. The ﬁrst factor manipulated the provider of non-audit services as either an accounting ﬁrm not related to the external auditor (Unrelated), the external auditor’s local ofﬁce (Traditional), or the external auditor’s associated, publicly traded, consulting ﬁrm (Associate). The second factor manipulated the type of non-audit services as either outsourced internal audit or mergers and acquisitions. Both independent variables were manipulated within the materials for the stock evaluation task. After turning in the completed stock evaluation task, participants were given and completed a post-experimental questionnaire including manipulation checks, demographics, and rating of auditor independence. Analysis of manipulation checks and demographics for participants included in the results indicated that participants paid attention to the study materials and that different types of experience were not unduly inﬂuencing the results. Research Question 1 (2) asks whether stock recommendations vary by provider (type) of non-audit services. Results are shown using two variables to explore these questions. The ﬁrst, Stock Recommendation, is a binary measure coded zero for “strong buy,” “buy,” or “hold” responses and one for “sell” or “strong sell” responses. The second, Weighted Recommendation, is a continuous measure of participants’ stock recommendation (on the full ﬁve point scale) multiplied by their conﬁdence in the recommendation (rated on an 11 point scale). Descriptive statistics for both dependent measures are reported in Panel A of Table 1. Both measures are lowest (fewer sell recommendations) for Unrelated and highest (more sell recommendations) for Associate. Both measures are lower for mergers and acquisitions than outsourced internal audit, but only for Unrelated and Traditional, not Associate.

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Table 1. Analysis of Stock Recommendation by Type and Provider of Non-Audit Services. Panel A: Descriptive Statistics: Mean, Standard Deviation (N) Provider Unrelated

Traditional

Associate

Overall

0.56 0.49 (14) 0.38 0.51 (14)

0.58 0.48 (13) 0.38 0.45 (15)

0.88 0.42 (10) 0.92 0.40 (6)

0.70 0.46 (37) 0.43 0.50 (35)

4.73 5.29 (14) 2.25 3.40 (14)

5.05 6.81 (13) 3.17 5.55 (15)

6.32 3.05 (10) 8.64 6.89 (6)

5.86 5.31 (37) 3.11 5.33 (35)

a

Stock Recommendation Outsourced Internal Audit

Mergers & Acquisitions

Weighted Recommendationb Outsourced Internal Audit

Mergers & Acquisitions

Panel B: ANCOVAc Stock Recommendation Source Type Provider Type × Provider Value Per Shared Likelihood Ratio Model F Adjusted R2

d.f.

Chi-Square

1 2 2 1 54

0.45 7.58* 0.53 9.30** 59.23

Weighted Recommendation F 0.33 3.57* 1.40 19.60** 5.54** 0.28

Panel C: Planned Contrasts

Associate vs. Traditional Associate vs. Unrelated Traditional vs. Unrelated a

Stock Recommendation

Weighted Recommendation

Two-tailed p-value

Two-tailed p-value

0.007 0.01 0.93

0.03 0.01 0.62

Percent of participants making a “sell” recommendation. Participants selected Strong Buy, Buy, Hold, Sell, or Strong Sell as a recommendation based on their analysis of the stock for current returns and safety. For the analysis reported above, the dependent variable was coded 0 for Strong Buy, Buy, or Hold, and 1 for Sell or Strong Sell. The above results are robust to alternative coding including all ﬁve categories individually or the three categories Buy, Hold, and Sell. b Stock Recommendation times the participants’ conﬁdence in the strength of their stock recommendation (0–10 scale; higher values indicate greater conﬁdence). c Stock Recommendation is categorical and the data was analyzed with maximum likelihood ancova using the CATMOD procedure in SAS. CATMOD treats the responses as generalized logits of the marginal probabilities of the dependent variable and results in a chi-square test. The Weighted Recommendation was analyzed with regular ANCOVA. d Participant’s estimate of the per share stock value. ∗ p < 0.05 (two-tailed); ∗∗ p < 0.01 (two-tailed).

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Panel B of Table 1 reports ANCOVA results for each measure. Since Stock Recommendation is a categorical dependent variable, maximum likelihood ANCOVA using the CATMOD (categorical data modeling) procedure in SAS was used. Participants’ estimate of the stock value per share is included as a covariate to represent quantitative considerations that are combined with qualitative considerations in analysts’ recommendation judgments (Francis & Soffer, 1997). For Stock Recommendation, the model ﬁt is acceptable since the likelihood-ratio goodness-of-ﬁt test is not signiﬁcant. The Weighted Recommendation model is signiﬁcant with an R2 of 0.28. The main effect for Provider is signiﬁcant in both Table 2. Analysis of Perceived Auditor Independencea by Type and Provider of Non-Audit Services. Panel A: Descriptive Statistics: Mean, Standard Deviation (N) Provider Unrelated Perceived Auditor Independence Outsourced Internal Audit

Mergers & Acquisitions

6.13 1.77 (15) 6.07 1.98 (15)

Traditional

Associate

Overall

2.69 1.70

3.10 2.47 (10)

4.16 2.50 (38)

3.53 1.85

3.00 1.41 (6)

4.50 2.25 (36)

(13)

(15)

Panel B: ANOVA Source Type Provider Type × Provider Error Model F Adj. R2 = 0.36

d.f. 1 2 2 68

SSE 0.84 79.92 1.82 246.07

F

p*

0.23 22.09 0.50

0.63 <0.0001 0.61

9.07

<0.0001

Panel C: Planned Contrasts Mean Difference Unrelated vs. Traditional Unrelated vs. Associate Traditional vs. Associate

2.96 3.04 0.08

p* <0.0001 <0.0001 0.92

a Participant’s assessed independence of the external auditor on a scale of 0–10. Higher values indicate greater perceived independence. ∗ Two-tailed.

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models (p < 0.05). The main effect for Type and the interaction of Type and Provider are insigniﬁcant in both models (p > 0.25). The covariate, Value Per Share, is signiﬁcant (p < 0.01) in both models. Panel C reports analysis of planned contrasts from the model in Panel B. Participants in the Associate condition are signiﬁcantly more likely to recommend sell than either Traditional (p ≤ 0.03) or Unrelated (p = 0.01). However, Traditional is not signiﬁcantly different than Unrelated (p ≥ 0.62). In summary, results using either dependent measure suggest that professional investors are more likely to issue sell recommendations when either non-audit service is provided by an associated entity. To check whether participants perceived impaired independence from the provision of non-audit services, the post-experimental ratings of auditor independence were also analyzed. As reported in Panel A of Table 2, for both types of non-audit services, professional investors’ mean perceptions of auditor independence for Unrelated were about double that for either Traditional or Associate. The ANOVA model, reported in Panel B, ﬁnds the main effect for Provider highly signiﬁcant (p < 0.0001). The main effect for Type and the interaction of Type and Provider is insigniﬁcant. Panel C reports planned contrasts that suggest that perceived independence is signiﬁcantly lower for both Traditional (p < 0.0001) and Associate (p < 0.0001) compared to Unrelated. Traditional and Associate are not signiﬁcantly different.

CONCLUSIONS In this study, professional investor participants rated perceived auditor independence around 50% less when the external auditor provided non-audit services either through their local ofﬁce or an associated entity than when the same services were provided by a ﬁrm unrelated to the external auditor, regardless of the type of non-audit service. These results suggest that the professional investor participants recognized the potential conﬂicts of interest inherent in non-audit services provided by the external auditor, but did not distinguish between types of services. Consistent with these independence perceptions, the results found no difference in stock recommendations between types of non-audit service. However, the stock recommendations by provider results are not always consistent with independence perceptions. Independence impairment did not manifest in greater sell stock recommendations for Traditional, though it did for Associate. Overall, these ﬁndings may suggest that though investors recognize potential for perceived independence problems, they may rely on the well-established trust in the institutional incentives

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of the traditional practice structure that is yet to be developed or transferred to the auditor’s associated entities. The study is subject to a number of limitations. Professional investors are generally sophisticated investors and may not be representative of all investors. The study only examines two types of non-audit services and ﬁndings may not extend to other types. Additionally, the study used one company that was ﬁnancially sound with declining proﬁtability. The impact of perceived independence questions may vary based on the ﬁnancial condition of the company. Finally, the experiment was performed prior to revelation of the recent major accounting scandals and these scandals may change investor perceptions. In conclusion, the study suggests that the principles-based approach to limiting non-audit services used by the GAO may be preferable to the standards-based approach used by Congress and the SEC because investors do not seem to distinguish between different types of non-audit services. Further, the results support the limits on non-audit services provided to audit clients through associated entities, explicitly in the GAO standards and implied through application of the SEC standards. The study also indicates that restrictions on non-audit services should not be considered a panacea for improving auditor independence. Even in the absence of non-audit services the professional investors rated auditor independence only 6.10 on an 11 point scale. The regulations or proposals do not address the issue of the economic importance of the audit to the partners in charge of the engagement. In debrieﬁng participants, this issue was identiﬁed as important to auditor independence. Further, other efforts to improve audit quality and oversight of auditors are important as well.

ACKNOWLEDGMENTS I gratefully acknowledge helpful comments received from Vairam Arunachalam, Timothy Fogarty, Jere Francis, James Hunton, Steven Kaplan, Linda McDaniel, Mark Peecher, Kenneth Reynolds, John Stowe, and participants at the AAA 2000 Annual Meeting.

REFERENCES Antle, R., Grifﬁn, P. A., Teece, D. J., & Williamson, O. E. (1997). An economic analysis of auditor independence for a multi-client, multi-service public accounting ﬁrm. In: AICPA (Ed.), Serving the Public Interest: A New Conceptual Framework for Auditor Independence (White Paper). New York, NY: Commerce Clearing House, Inc.

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Francis, J., & Soffer, L. (1997). The relative informativeness of analysts’ stock recommendations and earnings forecast revisions. Journal of Accounting Research, 35(Autumn), 193–211. General Accounting Ofﬁce (2002). Government auditing standards answers to independence standard questions. Report GAO-02–870G. Washington, DC: GAO. Independence Standards Board (ISB) (1997). Minutes of the public meeting (October 20). Investor Relations Business (2002). Many companies fail to address auditor independence (June 3), 1. New York. Kleinman, G., Palmon, D., & Anandarajan, A. (1998). Auditor independence: A synthesis of theory and empirical research. Research in Accounting Regulation, 12, 3–42. KPMG, LLP v. SEC, 289 F.3d 109, (U.S. App., 2002). Schipper, K. (1991). Commentary on analysts’ forecasts. Accounting Horizons, 5(December), 105–119. Securities and Exchange Commission (SEC) (2001). Revision of the commission’s auditor independence requirements, ﬁnal rule S7-13-00. www.sec.gov/rules/ﬁnal/33-7919.htm (February 5). Sutton, M. H. (1997). Auditor independence: The challenge of fact and appearance. Accounting Horizons, 11(March), 86–91. Ward, G. M. (1998). The Big Five battle: CPAs and non-CPAs square off on auditor independence. Financial Executive, 14(April), 32–36. Watts, R. L., & Zimmerman, J. L. (1986). Positive accounting theory. Englewood Cliffs, NJ: Prentice-Hall.

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THE ASSOCIATION BETWEEN AUDITOR INDUSTRY SPECIALIZATION AND EARNINGS MANAGEMENT Uma Velury ABSTRACT The purpose of this paper is to investigate if clients of industry-specialist auditors are less likely to manage earnings relative to clients of nonspecialist auditors. This paper focuses on two speciﬁc contexts: (1) when ﬁrms are highly leveraged; and (2) when the accrual generating ability of the ﬁrm is substantial. Using discretionary accruals as a proxy for earnings management, this study found that there is less earnings management for specialist clients, consistent with industry-specialists constraining earnings management when the accrual generating ability of the ﬁrm is substantial. Such an association was not apparent for highly leveraged ﬁrms, however. Prior research indicates that the quality of an audit is a function of the size of the auditor. The results of this paper indicate that quality of the audit is partly a function of auditor industry expertise as well. Such an association is, however, context-speciﬁc.

1. INTRODUCTION The recent spate of accounting scandals has raised the question of whether external audits are effective in constraining earnings management. One issue that might Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 171–184 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160103

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impact the effectiveness of audits in reducing the risk of earnings management concerns the degree of expertise auditors possess and bring to bear on the audit task. The purpose of this paper is to examine if industry-specialist auditors are more effective in constraining earnings management relative to non-specialist auditors. Audit ﬁrms with a greater amount of experience in an industry are generally described as industry-specialists in that industry (Gramling, Johnson & Khurana, 1999). Industry-speciﬁc experience arguably gives industry-specialists knowledge and expertise in identifying industry-speciﬁc issues and discovering ﬁrm-speciﬁc problems and mis-statements. The experience and expertise possessed by industryspecialists is likely to result in higher quality audits, and therefore, higher quality earnings. Recent research provides some evidence indicating that client ﬁrms of industryspecialist auditors report higher quality of earnings numbers compared to client ﬁrms of non-specialists (Gramling et al., 1999; Krishnan & Yang, 1999). The quality of earnings relates to the usefulness of accounting information to ﬁnancial statement users. The Financial Accounting Standards Board (1995) (FASB) in Statement of Financial Accounting Concepts (SFAC) No. 2 discusses qualities that make information useful. According to this statement, The qualities that distinguish “better” (more useful) information from “inferior” (less useful) information are primarily the qualities of relevance and reliability, with some other characteristics that those qualities imply (para. 15).

The FASB then notes that the components of these primary qualities are predictive value, feedback value, timeliness, veriﬁability, neutrality, and representational faithfulness. Thus, according to the FASB, the earnings quality construct is multidimensional. Recent empirical research examining the relationship between audit quality and the quality of reported earnings has documented a positive association between audit quality and certain dimensions of earnings quality (Gramling et al., 1999; Krishnan & Yang, 1999). This study is an extension of the current literature that examines the impact of audit quality on earnings quality. Gramling et al. (1999) ﬁnd that the power of current earnings to predict future cash ﬂows is greater for companies that are clients of industry-specialist auditors compared to those that are clients of non-industry expert auditors. Krishnan and Yang (1999) ﬁnd that the Earnings Response Coefﬁcients (ERC) of clients of industry-specialist auditors are signiﬁcantly larger relative to earnings response coefﬁcients of clients of non-specialist auditors. Thus, Gramling et al. (1999) and Krishnan and Yang (1999) investigated speciﬁc dimensions of earnings quality, i.e. predictive value and feedback value of earnings, respectively. This study extends the stream of research that examines an additional dimension of earnings quality – neutrality. According to SFAC No. 2, neutrality is the

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absence in reported information of bias intended to attain a predetermined result or to induce a particular mode of behavior. If managers faithfully report earnings, making no attempt to manage them for other purposes, then the earnings number would be devoid of bias. Prior research has examined earnings management based on the magnitude of discretionary accruals (e.g. Becker, DeFond, Jiambalvo & Subramanyam, 1998). Larger (smaller) discretionary accruals suggest the presence of more (less) earnings management. In the present study, I examine whether client ﬁrms of industry-specialist auditors report smaller discretionary accruals as compared to client ﬁrms of non-specialist auditors. If client-ﬁrms of industryspecialist auditors report smaller discretionary accruals, then it is consistent with industry specialists constraining earnings management relative to non-specialist auditors. The question is investigated for two high-risk contexts in which ﬁrms are known to have incentives to manage earnings. First, in the context of leverage, it has been documented that when the ﬁrm is highly leveraged, management has incentives to manage earnings (Becker et al., 1998; Warﬁeld et al., 1995). Management of high leverage ﬁrms is likely to opt for income increasing strategies to avoid debt covenant violations. On the other hand, as the level of debt increases, management could manage earnings down to re-negotiate better credit terms with current lenders. Second, when the ﬁrm’s endogenous accrual generating ability is high, management is likely to manage earnings because existing investors are likely to have difﬁculty in separating the discretionary portion of accruals from non-discretionary accruals. If the audit quality of the industry-specialist is high, then ceteris paribus, client ﬁrms of industry specialists in these two contexts should report smaller discretionary accruals relative to client ﬁrms of non-specialists. The results of this paper indicate that ﬁrms that are able to generate substantial accruals and at the same time employ industry-specialist auditors, report smaller discretionary accruals as compared to similar ﬁrms that do not employ industry-specialist auditors. These results lend support to the notion that industry-specialist auditors perform superior audit services and thereby constrain earnings management. In the context of leverage, however, the results do not support the notion that industry-specialists constrain earnings management. In other words, industry-specialist client ﬁrms are just as likely to manage earnings as client ﬁrms of non-specialists when leverage is large. Thus, the effectiveness of audits performed by industry-specialists appears to be context-speciﬁc. These results imply that creditors should ensure that alternative monitoring mechanisms are in place (such as the presence of audit committees) when the ﬁrm is highly leveraged. This study contributes to the audit quality literature by providing evidence which

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suggests that the effectiveness of audits performed by industry-specialists might be context speciﬁc. The remainder of the paper is organized as follows. In the next section, the hypothesis is developed. Section 3 describes the research design and the measurement of variables. Finally, the results are discussed in Section 4 and a summary and conclusions are presented in Section 5.

2. HYPOTHESIS DEVELOPMENT Modern corporations are characterized by separations of ownership and control. Agency theory suggests that separation of ownership and control creates incentives to management to maximize their own personal wealth and not act in the shareholders’ interest. Shareholders use accounting numbers to monitor management’s performance. Management can manipulate such numbers, however. Auditing is one of the tools available to shareholders to ensure the fairness of the reported numbers. Auditors are external, presumptively independent, parties charged with verifying that the information provided to shareholders by managers is indeed reliable. Of course, an audit does not ensure that that all material misstatements have been discovered. The likelihood that all material misstatements will be detected depends on the quality of the audit – the higher the quality of the audit, the greater the chances of detecting material misstatements. The quality of an audit depends in part on whether the auditor is an industry specialist or not. Industry-specialist audit ﬁrms possess more experience and industry-speciﬁc knowledge than non-specialist audit ﬁrms. Such experience and knowledge arguably helps industry-specialist auditors identify industry-speciﬁc issues and problems. Audit ﬁrms are also likely to make investments in staff training and technologies in the industries in which they have extensive experience (Gramling et al., 1999). Beasley and Petroni (2001) note that superior industry knowledge and better audit technologies help industry specialists perform better audits. Industry-specialists have not only expertise, but incentives to perform high quality audits as well. Audit ﬁrms develop reputations for being industryspecialists in the industries in which they invest resources (Gramling et al., 1999). Accordingly, an audit ﬁrm risks losing its reputation if it performs a low-quality audit. This suggests an increased incentive on the part of industry-specialist auditors to perform high quality audits. Consistent with the notion that industry-specialist auditors perform superior quality audits relative to non-specialist auditors, empirical research has demonstrated that industry-specialist audit ﬁrms command higher fees (Craswell,

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Francis & Taylor, 1995; DeFond, Francis & Wong, 2000).1 The higher fees earned by industry-specialist auditors are presumably for the high-quality audits they perform. This fee structure gives industry-specialists a natural incentive to guard their reputations by providing higher quality audits. Because audit quality is not easily observable, researchers typically examine the quality of reported earnings to ascertain the quality of audits. It is generally presumed that high audit quality translates into high quality of earnings. Prior research has examined the effectiveness of audit quality of industry specialists relative to non-specialists by examining two speciﬁc dimensions of earnings quality. Gramling et al. (1999) examine the predictive value of earnings stream of client-ﬁrms of industry specialists relative to non-specialists. They ﬁnd that the earnings stream of client ﬁrms of industry specialists is superior to that of non-specialists. And Krishnan and Yang (1999) ﬁnd that the ERC of client ﬁrms of specialists is higher than that of non-specialists. This study examines a third dimension of earnings quality, which is neutrality. If earnings are devoid of bias then one can conclude that earnings are neutral and not managed. As noted by Gramling and Stone (2001), understanding the relationship between industry-specialists and earnings management is one possible approach to understanding the effects and effectiveness of audit ﬁrm expertise. Consistent with prior research this study uses magnitude of discretionary accruals, as a proxy for earnings management. Prior research has identiﬁed two contexts in which ﬁrms are likely to manage earnings. Several studies that used leverage as a proxy for proximity to debt covenant violations have found a positive association between ﬁrm leverage and discretionary accruals (e.g. Becker et al., 1998; Warﬁeld et al., 1995). As the ﬁrm gets closer to debt covenant violations, management is likely to strategically opt for income increasing discretionary accruals. Alternatively, management could opt for income decreasing discretionary accruals and negotiate better credit terms from creditors. If industry-specialists constrain earnings management, however, then client ﬁrms of industry specialists should report lower discretionary accruals compared to client-ﬁrms of non-specialists. Therefore, the following hypothesis is posited: H1A. Ceteris paribus, highly leveraged clients of industry-specialist auditors report relatively smaller discretionary accruals relative to high leveraged clients of non-specialist auditors. The second context examined in this paper is when the accrual generating ability of the ﬁrm is substantial. When a ﬁrm generates substantial accruals,

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management might choose to manage earnings because investors are likely to have trouble in differentiating the discretionary portion of accruals from the non-discretionary portion. Using the absolute value of total accruals to proxy for ﬁrms’ endogenous accrual generating ability, Becker et al. (1998) found a positive association between discretionary accruals and total accruals. When audited by industry-specialist auditors, however, such ﬁrms should report smaller discretionary accruals in comparison to ﬁrms that are not audited by industry-specialist auditors. Therefore, the following hypothesis is examined: H1B. Ceteris paribus, clients that have substantial endogenous accrual generating ability and are audited by industry specialists report relatively smaller discretionary accruals relative to similar clients of non-specialist auditors.

3. RESEARCH DESIGN Data and Sample Selection The sample consists of all publicly traded ﬁrms in non-regulated industries for the period 1994–1996. The sample period is restricted to these dates to avoid post merger affects of Big Six ﬁrms. Firms in regulated industries were excluded because close monitoring by regulatory agencies is likely to reduce the agency conﬂicts between managers and owners. To eliminate the confounding effects of Big Six/Non-Big Six membership, the sample was limited to Big Six client ﬁrms. The ﬁnal sample includes observations that met the following criteria: (1) Availability of ﬁnancial information on all variables of interest from the COMPUSTAT database; (2) Availability of information on institutional ownership from the Compact Disclosure database; (3) The ﬁrm’s two-digit industry had at least 10 observations in each sample year (similar to Hogan & Jeter, 1999; Krishnan & Yang, 1999). This resulted in 4,128 ﬁrm-year observations. To examine the monitoring role of industry specialists in different contexts, this study used a pooled cross-sectional model. The dependent variable of the model was abnormal accruals (DISAC) and the independent variable was a dichotomous variable to indicate whether the audit ﬁrm was industry specialist or not (SPL). To calculate discretionary accruals, an expectation model is used

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to generate expected total accruals for each ﬁrm. The difference between actual accruals and the expected accruals are considered to be discretionary accruals and larger (smaller) discretionary accruals suggesting more (less) earnings management. This study also controlled for the following variables, which have been found signiﬁcantly associated with discretionary accruals. These are ﬁrm-speciﬁc beta (BETA), ﬁrm size measured as log of market value of equity (SIZE), and variation of earnings measured as standard deviation of operating income (scaled by total assets) of current year and prior two years (EARNVAR). In addition, this study also controls for potential monitoring of institutional investors. The measurement of these variables is discussed in detail in Appendix A.

4. RESULTS Descriptive Statistics and Correlation Analysis Table B1 (see Appendix B) presents descriptive statistics for the variables of interest for the sample of ﬁrms audited by industry-specialist auditors and those audited by non-specialist auditors. Consistent with the main hypothesis of the paper, industry-specialist clients report relatively lower discretionary accruals compared to client ﬁrms of non-specialists. Table B1 also shows that ﬁrms audited by industry-specialist audit ﬁrms were signiﬁcantly larger in size, had greater institutional ownership, had larger cash ﬂows from operations and were more proﬁtable compared to the group of ﬁrms that were audited by non-specialist auditors. Table B2 (see Appendix B) presents Pearson correlation coefﬁcients between predictor variables. The correlation between ﬁrm size (measured as log of market value of equity) and institutional ownership (PIH) was positive and signiﬁcant (correlation coefﬁcient = 0.6270, p = 0.0001), allowing for some potential redundancy among these two variables in the model.

Association between Audit Quality and Discretionary Accruals Table 1 presents the OLS results of the impact of predictor variables on discretionary accruals. The third column presents the results of a control model that includes only control variables. The results suggest that ﬁrms that are highly leveraged and ﬁrms that generate high accruals are relatively more likely to manage earnings. Smaller ﬁrms and ﬁrms with high beta are also relatively more

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Table 1. Results of OLS Regression of Discretionary Accruals on Predictor Variables. |DISACit | = ␤0 + ␤1 TACCRit + ␤2 TACCRit × SPL + ␤3 DEBTit + ␤3 DEBTit × SPL + ␤4 EARNVARit + ␤6 BETAit + ␤7 PIHit + ␤8 SIZEt + ␧ Predictor Variable

Intercept TACCR TACCR × SPL DEBT DEBT × SPL EARNVAR BETA SIZE PIH Model Adjusted R2 N Average R-squared for three annual estimates

Predicted Sign

Control Model

Pooled Estimations

Mean of Annual Regression

? + – + – + + – –

0.0265*** 0.7932***

0.0188 0.0027* −0.0020** −0.0059

0.0269*** 0.8192*** −0.1098*** 0.0147*** −0.0116 0.0176 0.0023† −0.0019** −0.0048

0.0339*** 0.7590*** −0.1033*** 0.0180* −0.0157 0.0321 0.0002 −0.0019† −0.0037

0.57 4128

0.58 4128

0.01210**

0.52

|DISAC| = Absolute value of estimated discretionary accruals; SPL = dummy variable set equal to one if auditor is industry-specialist; else zero; TACCR = Absolute value of total accruals divided by total assets at the beginning of year; DEBT = Dichotomous variable indicating whether the ﬁrm is in the highest decile of leverage, by year and industry; EARNVAR = Standard deviation of earnings in the current and last two years; BETA = Firm speciﬁc beta; PIH = Number of shares held by institutions/total outstanding shares; SIZE = Log of market value of equity. † Signiﬁcant at 0.10 level (one-tail test). ∗ Signiﬁcant at 0.10 level (two-tail test). ∗∗ Signiﬁcant at 0.05 level (two-tail test). ∗∗∗ Signiﬁcant at 0.01 level (two-tail test).

likely to manage earnings. The proportion of institutional ownership in the ﬁrm does not translate into lower discretionary accruals.2 The fourth column of Table 1 presents the results of the full model which includes all the variables in the control model and also two interaction terms, TACCR×SPL and DEBT×SPL, to examine if industry-specialists constrain earnings management when ﬁrms report high accruals or are highly leveraged. The results indicate that client ﬁrms of industry specialists are less likely to manage earnings compared to similar client ﬁrms of non-specialists. High leveraged client

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ﬁrms of industry specialists audit ﬁrms are, however, just as likely to manage earnings as clients of non-specialist auditors. To reduce the effect of cross-sectional correlation in the regression error terms, annual regressions were also run for each of the sample years and t-statistics were calculated using the average of the respective parameter estimates and the pooled variance. The results are similar to those reported earlier. These results suggest that industry-specialists constrain earnings management in some contexts but not in others.

Additional Analysis Alternative Speciﬁcation of Industry Specialists In this study, I used a market share cutoff of twenty percentage points to deﬁne industry-specialists. To examine, if the results are sensitive to the market threshold used above, industry-specialist was also deﬁned using 15% and 25% threshold. The results are qualitatively the same.

5. CONCLUSIONS This study examines whether client-ﬁrms of industry specialist auditors are less likely to manage earnings compared to client ﬁrms of non-specialist auditors in two high-risk contexts. The contexts that were examined were when the ﬁrm generates substantial accruals and when the ﬁrm is highly leveraged. The results indicate that client-ﬁrms of industry specialists that generate high accruals report lower discretionary accruals compared to client-ﬁrms of non-specialists. Such an association was not found for highly leveraged ﬁrms. The results thus suggest that the quality of an audit is partly a function of the expertise of the auditor. Such an association, however, is apparently context-speciﬁc in nature. The recent wave of audit failures has created an increased awareness of the importance of audit quality in ﬁnancial markets. How then, are audit ﬁrms going to respond to the heightened scrutiny from the public? Is the quality of an audit likely to increase in general in the wake of recent events such as the failure of Enron, WorldCom, and so forth? Are auditors of client ﬁrms with independent boards, audit committees and sophisticated shareholders relatively more likely to further enhance the quality of audits they provide? These questions and many more regarding the relation between audit quality and auditor type await future research.

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NOTES 1. The Craswell et al. (1995) study examines the Australian audit market and DeFond et al. (2000) focus on the Hong Kong market. 2. The lack of signiﬁcance is likely due to the high correlation between PIH and ﬁrm size. When SIZE was excluded from the model, PIH was negatively and highly signiﬁcantly associated with discretionary accruals.

REFERENCES Beasley, M., & Petroni, K. (2001). Board independence and audit ﬁrm type. Auditing: A Journal of Practice and Theory (Spring), 97–114. Becker, C., DeFond, M. L., Jiambalvo, J., & Subramanyam, K. R. (1998). The effect of audit quality on earnings management. Contemporary Accounting Research, 15, 1–24. Craswell, A. T., & Taylor, S. L. (1991). The market structure of auditing in Australia: The role of industry specialization. Research in Accounting Regulation, 5, 55–77. Craswell, A. T., Francis, J. R., & Taylor, S. L. (1995). Auditor brand name reputations and industry specializations. Journal of Accounting and Economics, 20, 297–322. DeFond, M. L., Francis, J. R., & Wong, T. J. (2000). Auditor industry specialization and market segmentation: Evidence from Hong Kong. Auditing: A Journal of Practice and Theory, 19(Spring), 49–66. Dunn, K. A., Mayhew, B. W., & Morsﬁeld, S. G. (2000). Auditor industry specialization and client disclosure quality (Working paper). Baruch College and University of Wisconsin-Madison. FASB Statement of Concepts (1995). Statement of ﬁnancial accounting concepts No. 2 qualitative characteristics of accounting information (June), 1021–1055. Gramling, A. A., Johnson, V. E., & Khurnana, I. K. (1999). The association between audit ﬁrm industry experience and ﬁnancial reportin quality (Working paper). Wake Forest University, University of Illinois-Champaign, and University of Missouri-Columbia. Gramling, A. A., & Stone, D. N. (2001). Audit ﬁrm industry expertise: A review and synthesis of the archival literature. Journal of Accounting Literature, 20, 1–29. Hogan, C. E., & Jeter, D. C. (1999). Industry specialization by auditors. Auditing: A Journal of Practice and Theory, 18(Spring), 1–17. Krishnan, J., & Yang, J. S. (1999). Auditor industry specialization and the earnings response coefﬁcient (Working paper). Temple University. Warﬁeld, T. D., Wild, J. J., & Wild, K. L. (1995). Managerial ownership, accounting choices, and informativeness of earnings. Journal of Accounting and Economics, 20, 61–91.

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APPENDIX A MODEL AND VARIABLES Model Speciﬁcation To examine the monitoring role of industry specialists in different contexts, the following model was constructed: |DISACit | = ␤0 + ␤1 TACCRit + ␤2 TACCRit × SPLit + ␤3 DEBTit + ␤4 DEBTit × SPLit + ␤5 EARNVARit + ␤6 BETAit + ␤7 PIHit + ␤8 SIZEit + ␧it

(A.1)

where, for sample ﬁrm i at the end of year t: |DISAC| = Absolute value of estimated discretionary accruals; SPL = dummy variable set equal to one if auditor is industry-specialist, else zero; TACCR = Absolute value of total accruals of ﬁrm i divided by total assets at the beginning of year t; DEBT = Dichotomous variable indicating whether the ﬁrm is in the highest decile of leverage, by year and industry; EARNVAR = Standard deviation of earnings in the current and last two years; BETA = Firm speciﬁc beta; PIH = Number of shares held by institutions/total outstanding shares; SIZE = Log of market value of equity; ␧ = Error term.

Measurement of Variables Discretionary Accruals The following model was used to calculate the expected total accruals: TAijt /A ijt−1 = ␣jt (1/A ijt−1 ) + ␤1jt (REVijt /A ijt−1 ) +␤2jt (PPEijt /A ijt−1 ) + ␧ijt where, for sample ﬁrm i, in industry j, for year t:

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TAijt = total accruals, deﬁned as net income before extraordinary items less operating cash ﬂows; A ijt−1 = total assets at the end of year t − 1; REVijt = change in revenue from year t − 1 to year t; PPEijt = gross property plant and equipment; ␧ijt = error term. The coefﬁcient estimates generated by this model were then used to calculate the expected (normal) total accruals. Thus, expected accruals for ﬁrm i at the end of year t are: REVijt PPEijt TAijt 1 = a jt + b 1jt + b 2jt E A ijt−1 A ijt−1 A ijt−1 A ijt−1 where: E(TAijt /Ai,t −1 ) = expected total accruals scaled by total assets of year t − 1; and other variables are as previously deﬁned. Because normal accruals change over time due to changes in a ﬁrm’s economic conditions, the model attempts to control for the changes in economic conditions by including the effect on accruals associated with property, plant and equipment and changes in revenues. Separate calculations were performed for each group of ﬁrms with the same two-digit SIC code and ﬁscal year. Expected accruals were computed and then deducted from total accruals to calculate discretionary accruals. The difference between actual accruals and expected accruals is then attributed to discretionary accruals. Smaller values of discretionary accruals indicate less earnings management and suggest that earnings exhibit a greater degree of neutrality and are thus more useful. Industry-Specialist Auditors A dummy variable was used to denote if the auditor is an industry-specialist. Consistent with Dunn et al. (2000), an auditing ﬁrm was classiﬁed as industryspecialist if its market share was greater than or equal to 20% of total market share of its speciﬁc industry. Each industry was delineated by a two-digit Standard Industry Classiﬁcation (SIC) Code. Similar to prior studies (Craswell et al., 1995; Craswell & Taylor, 1991; Dunn et al., 2000; Gramling et al., 1999; Hogan & Jeter, 1999), auditor industry market share was deﬁned as the proportion of industry revenue audited by an individual accounting ﬁrm relative to the total industry revenue for all companies in that industry audited by all public accounting ﬁrms.

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Notationally, the market share (MS) of industry k audited by audit ﬁrm i is calculated as follows:

J ik j=1 REVijk MS ik = I J k ik i=1 j=1 REVijk

Jik where, j=1 REVijk is the revenue of company Jik clients in industry k audited

Ik Jik by audit ﬁrm i and i=1 j=1 REVijk is the revenue of Jik clients in industry k summed over all Ik audit ﬁrms with clients (Jik ) in industry k instead of “where, REVijk is the revenue of company j in industry k audited by audit ﬁrm i.” Measurement of Institutional Ownership The percentage of institutional holdings (PIH) was calculated as close to the beginning of the ﬁscal year as possible. Because institutional ownership data are ﬁled with the SEC at the end of each calendar quarter, institutional holdings were measured at the end of the calendar quarter preceding the beginning of the ﬁrm’s ﬁrst ﬁscal quarter. For instance, if a ﬁrm’s ﬁscal year began on August 1, 1995, the PIH as of June 30, 1995, was considered the PIH for the ﬁscal year August 1, 1995 through July 31, 1996.

APPENDIX B Table B1. Descriptive Statistics for Firms Audited by Specialist and Non-Specialist Auditors. Variable

Discretionary Accruals Total Accruals Cash Flow from Operations/Total Assets Long Term Debt/Total Assets Percentage of Institutional ownership Log of Market Value of Equity Operating Income (in ml. $) N Note: All p-values are for a two-tailed test. ∗ Signiﬁcant at 0.10 level. ∗∗ Signiﬁcant at 0.05 level. ∗∗∗ Signiﬁcant at 0.01 level.

Mean for NonSpecialist Group

Mean for Specialist Group

0.0911 0.0886 0.0434 0.1693 0.355 5.2712 144.00

0.0831 0.0901 0.0741 0.1989 0.4043 5.6896 266.91

2851

1277

Difference in Means 0.008** −0.001 −0.031*** −0.030*** −0.049*** −0.418*** −122.90***

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Table B2. Pearson Correlation Coefﬁcients. Variables SPL DEBT TACCR SIZE PIH EARNVAR BETA

SPL

DEBT

TACCR

1.00 −0.0216 1.00 (0.1652) 0.0063 0.0462 1.00 (0.6874) (0.0030) 0.0980 −0.0129 −0.1142 (0.0001) (0.4084) (0.0001) 0.0944 −0.0173 −0.1403 (0.0001) (0.2664) (0.0001) −0.0625 −0.0204 0.2905 (0.0001) (0.1892) (0.0001) −0.0419 0.0104 0.0378 (0.0071) (0.5045) (0.0153)

SIZE

PIH

EARNVAR

BETA

1.00 0.6270 (0.0001) −0.2595 (0.0001) 0.1924 (0.0001)

1.00 −0.2665 (0.0001) 0.1075 (0.0001)

1.00 0.0104 0.5045

1.00

Note: Parenthetical numbers are p-values. SPL = dummy variable set equal to one if auditor is industry-specialist; else zero; TACCR = Absolute value of total accruals divided by total assets at the beginning of year; DEBT = Dichotomous variable indicating whether the ﬁrm is in the highest decile of leverage, by year and industry; EARNVAR = Standard deviation of earnings in the current and last two years; BETA = Firm speciﬁc beta; PIH = Number of shares held by institutions/total outstanding shares; SIZE = Log of market value of equity.

CONCURRING PARTNER REVIEW: DOES INVOLVEMENT IN AUDIT PLANNING AFFECT OBJECTIVITY? Arnold Schneider, Bryan K. Church and Robert J. Ramsay ABSTRACT This study examines the effect of prior involvement in audit planning on concurring partners’ willingness to agree with an engagement team’s conclusion. Thirty-six audit partners from eight CPA ﬁrms in the U.S. participated in the study. Some of these partners played a role in audit planning for bad debt allowance, while others did not. Our results indicated that the degree of concurring partners’ agreement with an engagement team’s conclusion was unaffected by prior involvement in audit planning. We also obtained data that revealed general characteristics regarding the activities performed as part of concurring partner reviews.

INTRODUCTION Many CPA ﬁrms in the U.S. require concurring partner reviews (also called “second partner reviews”) for audit engagements. In fact, since 1978, the SEC Practice Section of the American Institute of Certiﬁed Public Accountants has had a requirement that member ﬁrms perform concurring partner reviews on

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all audits of Securities and Exchange Commission registrants (AICPA, 1986). These reviews entail independent analysis of the audit and its documentation by a partner who is not in charge of the engagement. Concurring partner reviews aim to reduce audit risk, i.e. the likelihood of issuing an inappropriate audit opinion. “The objective of the concurring partner review is review of: (a) signiﬁcant auditing, accounting, and ﬁnancial reporting matters that come to the attention of the concurring partner reviewer; and (b) the resolution of such matters prior to the issuance of the ﬁrm’s audit report” (Public Oversight Board, 1999, p. 8). A concurring partner is intended to provide an independent and fresh review of the audit evidence to ensure that the evidence supports the opinion to be issued. “By having a cold review, the CPA ﬁrm attempts to reduce any bias towards the client or towards certain audit procedures” (Guy et al., 1990, p. 808). Little is known about the review process, including the concurring partner’s role and the speciﬁc activities performed during the review. There is controversy regarding the concurring partner’s level of involvement in the audit engagement. Some argue (e.g. Mautz & Matusiak, 1988) that in order to ensure objectivity, the concurring partner should have no contact with the client and should not even serve in a consultative role during the course of the audit. Others argue that in order to “provide added assurance that the audit scope is appropriate for the detection of fraudulent ﬁnancial reporting,” the concurring partner should be involved in the planning stages of the audit in addition to the ﬁnal review stage (Treadway Commission, 1987). No previous research study has tested the merits of these arguments. Moreover, our preliminary discussions with several concurring partners from different CPA ﬁrms indicate a lack of agreement concerning the partner’s role in the review process (see also, Leuhlﬁng et al., 1995). The Public Oversight Board has identiﬁed the lack of objectivity in concurring partner review as a problem. “The Board is frankly puzzled as to why, if a truly thorough second partner review is conducted objectively, ﬁnancial statements reﬂect some of the accounting judgments it sees as a result of the QCIC’s activities” (Public Oversight Board, 1993, p. 48). The U.S. General Accounting Ofﬁce (1996, p. 86) has also commented about deﬁcient concurring partner reviews: “The most frequently cited factor contributing to a modiﬁed peer review opinion was inadequate concurring partner reviews . . . .” These types of concerns led the SEC to expand the responsibility of the concurring review partner, a decision that was upheld in 1998 by the Eighth Circuit Court of Appeals. As a result, in 1999 the SEC Practice Section strengthened concurring partner review requirements, including prohibiting the engagement partner from serving as concurring partner reviewer for at least two audits subsequent to service as engagement partner (Public Oversight Board, 1999, p. 8).

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The objective of this research is to investigate whether the objectivity of a concurring partner is affected by involvement in the audit prior to the ﬁnal review stage. Our study should aid standard setters and accounting ﬁrms in evaluating the beneﬁts and drawbacks of having concurring partners involved in audits prior to the ﬁnal review stage. As a secondary objective, we provide descriptive evidence on the nature of the review process itself (i.e. the activities performed during the review).

THEORY FOR CONCURRING PARTNER REVIEWS Based on a review of the literature and discussions with audit partners, there appear to be two important factors for the justiﬁcation of a concurring partner review. The ﬁrst is that the engagement team, including the partner, may develop a positive affect towards the client. Prior research (Zajonc, 1968, 1980) indicates that repeated exposure to a stimulus object leads to positive affect towards the object. In terms of auditing, an engagement partner’s ongoing association with a client may lead to a more favorable attitude towards the client, which in turn may inﬂuence the partner’s professional judgment. Dribbin and Brabender (1979) found that individuals who feel positively are more receptive to persuasive communications than those who feel negatively. Others suggest that positive affect can prompt a search for evidence to support a particular position and may lead to the biased interpretation of evidence (Kunda, 1990; Sternthal et al., 1978). To minimize the inﬂuence resulting from positive affect towards the client, concurring partners have less interaction with the client than engagement partners, although the degree of permissible interaction is open for debate. The second justiﬁcation for concurring partner reviews is that the engagement partner, having participated in decision making throughout the audit, may be reluctant to challenge or question those decisions in the ﬁnal review stage. Moreover, due to human nature, they likely will continue to believe that their decisions were correct. Mautz and Matusiak (1988, p. 62) believe that the concurring partner should not even have a consultation role in the audit – “a person so involved would be less likely to challenge decisions in which he or she participated than would a ‘cold’ reviewer.” Research in behavioral decision-making documents that prior involvement often impairs subsequent objectivity (for a review of the literature, see Brockner, 1992). In auditing, ﬁndings suggest that prior involvement in an audit task can affect subsequent judgments and decisions (e.g. Brody & Kaplan, 1996; Church, 1991; Church & Schneider, 1993). In testing whether a concurring partner’s involvement in the audit affects objectivity, the above justiﬁcations suggest that involvement can be operationalized by

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inducing a positive affect towards the client or by having the concurring partner participate in some decision-making aspect(s) of the audit. Our study focuses on the latter approach. Before elaborating on this more speciﬁcally in the context of our experimental design, we discuss the prior research on concurring partner reviews.

PRIOR LITERATURE ON CONCURRING PARTNER REVIEWS Little research has been conducted on concurring partner reviews. Mautz and Matusiak (1988) report that the staff of the Public Oversight Board studied policies and procedures of 18 CPA ﬁrms. They found differences among the ﬁrms regarding reviewer qualiﬁcations, scope of the review, and responsibility assigned to the reviewer. Leuhlﬁng et al. (1995) also found that signiﬁcant differences exist in the extent of concurring partner reviews across large CPA ﬁrms. Matsumura and Tucker (1995) developed an analytical model that provides an economic rationale for the value of concurring partner reviews. Using an experimental economics approach, Tucker and Matsumura (1997) found that reporting bias was reduced, but not eliminated, by adding concurring partner reviews and/or the availability of additional sampling information. Johnson et al. (1991) used a concurring partner review task to determine whether reviewers who were supplied misleading ﬁnancial information by a client would be able to detect and overcome the misleading information. The study found that, depending on industry experience or other expertise, some reviewers detected the misleading information, while others did not. In a subsequent study, Jamal et al. (1995) compared the mental representations of concurring partners who were able to successfully detect misleading ﬁnancial information with those who were not successful. Auditors who proposed a standard hypothesis to explain the inconsistencies in ﬁnancial data were able to successfully detect ﬁnancial statement fraud. Auditors who proposed multiple hypotheses typically failed to aggregate data (i.e. failed to recognize the pattern of relationships in the data) and were much less successful detecting the fraud. These two studies focused on auditors’ abilities to analyze ﬁnancial statement information. Yet, no previous study has examined whether involvement in the audit by concurring partners affects their objectivity.

RESEARCH METHOD Overview Our experimental design consisted of a treatment group and a control group. The treatment simulated involvement by the concurring partner in the audit prior

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to the ﬁnal review stage, while the control simulated detachment until the ﬁnal review stage. We contacted CPA ﬁrm personnel, who distributed questionnaires to partners with experience in performing concurring partner reviews. For each ﬁrm, we sent an equal number of treatment and control questionnaires.

Participants The research participants consisted of 36 audit partners – 19 in the control group and 17 in the treatment group. These participants were from eight CPA ﬁrms located in two U.S. cities. Five of these were Big Six (now Big Four) ﬁrms. The treatment and control groups each had two partners from non-Big Six ﬁrms. In addition, 32 of the participants had served as a concurring partner on 11 or more engagements.

Procedures Participants in the treatment group were asked, as a concurring partner, to review an audit plan approved by the engagement team relating to the bad debt allowance for a hypothetical client. We developed this audit plan after several iterations of pre-testing with CPA ﬁrm auditors. This audit plan was reasonable, but left room for some improvement. We provided the participants with a list of six procedures they could add to the audit plan. They could also add other modiﬁcations in an open-ended manner. The audit plan and additional procedures are shown in the Appendix. After we received these completed questionnaires, we developed customized second questionnaires for each respondent. The second questionnaires contained revised audit plans, based on the participant’s added audit procedures. We informed participants in the second questionnaires that the revised audit plan was implemented by the engagement team. The result of this implementation – the engagement team’s evaluation of the allowance account – was then presented. The evaluation indicated that the allowance for doubtful accounts balance was adequate. Afterwards, we asked participants to assess the likelihood (on a nine-point scale) that they, as concurring partners, would agree with the engagement team’s conclusion. Finally, the questionnaire contained a manipulation check and questions regarding their experience with concurring partner review. The control group was given only one questionnaire. It contained the audit plan that included all six possible added audit procedures. These participants were not asked to provide any input into developing the audit plan. The remaining

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information and instructions given to the control group were the same as for the treatment group.

RESULTS Manipulation Check First, we performed a manipulation check of our inducement of involvement in developing the audit plan. All participants were asked to rate their involvement with the audit plan. They responded on a nine-point scale, where 1 = no role at all and 9 = a major role. The average response of those in the treatment and control groups was 4.63 and 2.69, respectively.1 We compared the mean difference and found that the t-statistic of −2.56 was statistically signiﬁcant at p = 0.016, two-tailed test.2 Participants in the treatment group perceived a greater degree of involvement than those in the control group. Hence, the manipulation was successful. The data also indicate that participants in the treatment group were inclined to add procedures to the existing audit plan, which provides further evidence of their involvement. The mean and median additional procedures selected were four, with a range of two to seven. In general, participants supplemented the existing audit plan by sending positive conﬁrmations to a sample of small accounts, making inquiries about accounts pledged, discounted, and assigned, and analyzing actual write-offs to assess the reasonableness of the allowance accounts.

Main Analysis To determine whether objectivity is affected by involvement in the design of the audit plan, we examined participants’ willingness to agree with the engagement team’s conclusions. We tested whether the responses of the treatment group were more likely to indicate agreement than those of the control group. Participants’ responses were elicited using a nine-point scale, where 1 = certainly agree and 9 = certainly disagree. The data indicate that the mean response of those in the treatment and control groups was 4.69 and 3.89, respectively. We compared the mean difference and found that it was not statistically signiﬁcant (t = −1.08, p = 0.286, two-tailed test).3 Thus, participants in the treatment group were not more likely to agree with the engagement team’s conclusions, even though they perceived and had a greater degree of involvement in the audit plan. We performed additional analysis to determine whether our ﬁnding holds after eliminating unexpected, but potential confounds. First, we tested for differences

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in experience between the two groups of participants (treatment versus control). As part of the post-experiment questionnaire, participants indicated the percent of concurring partner reviews in which they perform certain activities (described in the next subsection). We compared responses between the two groups and did not ﬁnd any statistically signiﬁcant differences.4 Next, we considered the effect of having four participants from non-Big Six ﬁrms in our sample. In general, non-Big Six ﬁrms deal with smaller clients, which may affect the review process. We dropped the responses of these four participants and found similar results (t = −0.90, p = 0.376). Finally, we considered participants’ inclination to disagree with the engagement partner. As part of the post-experiment questionnaire, participants indicated the percent of concurring partner reviews in which they disagreed with the engagement partner. The response to this question was included as a covariate in the analysis. The results were unaffected: prior involvement did not affect participants’ willingness to agree (F = 1.423, p = 0.242) and the covariate was not statistically signiﬁcant (F = 2.087, p = 0.158). Hence, our ﬁnding appears to be robust. We suggest that participants in the treatment group were not more inclined to agree with the engagement team’s conclusions because they potentially felt accountable for the conclusions. Allowing concurring partners to take a consultation role may have created a sense of accountability, causing them to scrutinize the engagement team’s work more closely. In turn, they may have been more vigilant in their review of work performed by the engagement team. Tan (1995) provides evidence that accountability can lead to more vigilant processing of information. As a consequence, this effect may have offset any tendencies for participants in the treatment group to go along with the engagement team’s conclusions, which often reﬂect client preferences.

Supplementary Analysis To gain further insight into concurring partner reviews, we examined participants’ responses to the post-experiment questionnaire. The mean, median, and range for which certain activities are performed as part of concurring partner reviews are shown in Table 1. The mean and median statistics indicate that concurring partners review the audit plan on a majority of their assignments. On about half of their assignments, the review consists of an examination of the report and a summary of issues only. They review actual workpapers less frequently and they seldom meet with the client, review the report only, or disagree with the engagement team’s conclusions. Lastly, data on the range of responses suggest that behavior varies dramatically across concurring partners. For six of seven activities the range of responses is at least 0–75 and for four of the six, it is 0–100. In general, the disparity

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Table 1. Percent of Concurring Partner Assignments in Which Speciﬁc Activities are Performed. Activity

Mean

Median

Range

Meet with the client. Review the audit plan. Participate in planning. Review the report only. Review the report and a summary of issues only. Review some of the actual workpapers. Disagree with the engagement partner on a substantive issue.

10.42 60.43 23.71 10.00 45.71 33.14 11.86

10.00 90.00 10.00 0.00 50.00 20.00 10.00

0–75 0–100 0–100 0–90 0–100 0–100 0–40

across partners is consistent with Mautz and Matusiak (1988) and Leuhlﬁng et al. (1995).

CONCLUSION This study examines the effects of prior involvement in the audit plan on concurring partners’ willingness to agree with the engagement team’s conclusions. Our results suggest that such willingness is unaffected by prior involvement. In our setting, concurring partners are able to maintain their objectivity, even when they are involved in the design of the plan. This result suggests that permitting concurring partners to take a consultation role throughout the audit process does not detract from the effectiveness of the review. Allowing concurring partners to take a consultation role may even prove beneﬁcial. Potentially, it may increase the perceived accountability for work performed by others, for which the concurring partner provided input, and it may make the concurring partner more attentive during the review process. The importance of this issue should not be underestimated. In these troubling times, it is paramount that accounting ﬁrms take actions to enhance audit quality and maintain auditor independence. Future research may explicitly investigate whether conditions can be identiﬁed under which the audit process is improved through the concurring partner’s involvement in the design of the audit plan. A potential limitation of our study is that the client is hypothetical. As a consequence, it may be harder to determine whether prior involvement has a signiﬁcant effect on behavior. Yet the manipulation check indicates that we were able to induce, to some degree, involvement in the audit plan. Moreover, all participants in the treatment group modiﬁed the existing plan. Thus, our ﬁnding appears valid. Lastly, our data indicate large differences across participants in the activities performed as part of concurring partner reviews. Future research may attempt to

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identify similarities and differences across CPA ﬁrms and across clients (e.g. SEC vs. non-SEC clients), which was beyond the scope of the current study, and to develop a more complete understanding of the concurring partner review process.

NOTES 1. Notably, the mean response of participants in the control group suggests that they may have construed some involvement in the audit plan design. The mean response, however, may be attributable to the response scale. Participants responded on a nine-point scale with the midpoint labeled “some involvement.” Research suggests that when response scales offer an explicit midpoint, participants may have an increased tendency to respond toward the middle of the scale (Kalton & Schuman, 1982). Regardless, what is important here is that the control group’s perception was signiﬁcantly different from the treatment group’s perception. 2. A nonparametric, Mann-Whitney test yielded similar results (z = −2.28, p = 0.023). 3. A nonparametric, Mann-Whitney test produced similar results (z = −1.35, p = 0.177). 4. Further, all additional analyses were performed using nonparametric tests and inferences were unaffected.

REFERENCES AICPA, Division for CPA Firms SEC Practice Section (1986). SECPS manual. New York: AICPA. Brockner, J. (1992). The escalation of commitment to a failing course of action: Toward theoretical progress. Academy of Management Review (January), 39–61. Brody, R. G., & Kaplan, S. E. (1996). Escalation of commitment among internal auditors. Auditing: A Journal of Practice and Theory (Spring), 1–15. Church, B. K. (1991). An examination of the effect that commitment to a hypothesis has on auditors’ evaluation of conﬁrming and disconﬁrming evidence. Contemporary Accounting Research (Spring), 513–534. Church, B. K., & Schneider, A. (1993). Auditor objectivity: The effect of prior involvement in audit programme design. Accounting and Finance (November), 61–78. Dribbin, E., & Brabender, V. (1979). The effect of mood inducement upon audience receptiveness. Journal of Social Psychology (February), 135–136. General Accounting Ofﬁce (1996). The accounting profession. United States General Accounting Ofﬁce. Guy, D. M., Alderman, C. W., & Winters, A. J. (1990). Auditing. New York: Harcourt Brace Jovanovich. Jamal, K., Johnson, P. E., & Berryman, R. G. (1995). Detecting framing effects in ﬁnancial statements. Contemporary Accounting Research (Fall), 85–105. Johnson, P. E., Jamal, K., & Berryman, R. G. (1991). Effects of framing on auditor decisions. Organizational Behavior and Human Decision Processes (October), 75–105. Kalton, G. J., & Schuman, H. (1982). The effect of the question on survey responses: A review. Journal of the Royal Statistical Society, 145(1), 42–73.

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Kunda, Z. (1990). The case for motivated reasoning. Psychological Bulletin (November), 480–498. Leuhlﬁng, M. S., Copley, P. A., & Shockely, R. A. (1995). An examination of the relationship between audit-related risks and the second partner review. Journal of Accounting, Auditing & Finance (Winter), 43–70. Matsumura, E. M., & Tucker, R. R. (1995). Second partner review: An analytical model. Journal of Accounting, Auditing & Finance (Winter), 173–200. Mautz, R. K., & Matusiak, L. W. (1988). Concurring partner review revisited. Journal of Accountancy (March), 56–63. Public Oversight Board (1993). A special report by the Public Oversight Board of the SEC Practice Section, AICPA. Stamford, CT: Public Oversight Board. Public Oversight Board (1999). Annual Report 1999. Stamford, CT: Public Oversight Board. Sternthal, B., Dholakia, R., & Leavitt, C. (1978). The persuasive effect of source credibility: Tests of cognitive response. Journal of Consumer Research (March), 252–260. Tan, H.-T. (1995). Effects of expectations, prior involvement, and review awareness on memory for audit evidence and judgment. Journal of Accounting Research (Spring), 113–135. Treadway Commission (1987). Report of the National Commission on Fraudulent Financial Reporting. National Commission on Fraudulent Financial Reporting. Tucker, R. R., & Matsumura, E. M. (1997). Second partner review: An experimental economics investigation. Auditing: A Journal of Practice & Theory (Spring), 79–98. Zajonc, R. (1968). Attitudinal effects of mere exposure. Journal of Personality and Social Psychology, 9(2 pt2), 1–27. Zajonc, R. (1980). Feeling and thinking: Preferences need no inferences. American Psychologist, 36, 151–175.

APPENDIX AUDIT PLAN AND PROCEDURES PROVIDED TO TREATMENT GROUP AUDIT PLAN – Accounts Receivable During our review and walk-through of the revenue cycle we have noted a lack of separation of duties in the accounts receivable area. This weakness has been mentioned in our recommendations letters of the last three years. The lack of separation of duties is partially offset by the high level of involvement of senior management and the board of directors in reviewing accounting reports, comparisons to budget, and the aged accounts receivable trial balance. Nevertheless, we will rely primarily on substantive tests of the accounts receivable balance including analytical review procedures to achieve satisfaction that the receivables account is fairly presented. Speciﬁcally, we will mathematically test the client’s aged trial balance and reconcile it to the general ledger. Also, the aged trial balance will be analyzed for related party accounts and credit balances. We will send positive conﬁrmations as

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of year end to all large accounts. We will also have the client apply subsequent cash receipts to all balances outstanding at December 31. We will test the client’s application of cash receipts. Large accounts that do not pay or conﬁrm will be followed up by reviews of correspondence and by discussions with the accounting manager, who handles credit approval. Cut-off will be tested by tracing shipping documents obtained during the year-end inventory to accounting records, and by tracing year-end sales entries to shipping documents. Materiality Total materiality has been set at $230,000 (pre-tax), approximately 1% of total assets. Tolerable error related to the account balances is as follows: Account Cash Net Receivables Inventory Other Current Assets P, P&E Current Liabilities Long-Term Debt

Balance at 12/31/96*

Tolerable Error

$2,793,542 $5,247,018 $10,874,022 $219,418 $4,591,018 $4,609,233 $7,251,333

$10,000 $100,000 $100,000 $5,000 $50,000 $100,000 $50,000

∗ Unaudited.

From the following list, please check those that you feel should be added to the audit plan: — (1) Send positive conﬁrmations to a sample of small accounts. — (2) Compare the aged trial balance to underlying invoices. — (3) Analyze the aged trial balance for customers having numerous small accounts. — (4) Analyze the aged trial balance for patterns among natural groupings such as geographic regions. — (5) Make inquiries to determine receivables pledged, discounted, assigned, etc. — (6) Analyze actual write-offs for the past ﬁve years to ascertain reasonableness of the allowance account. If you feel any other modiﬁcations should be made to the audit plan, please list here:

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LOCAL GOVERNMENT AUDIT PROCUREMENT REQUIREMENTS, AUDIT EFFORT, AND AUDIT FEES Laurence E. Johnson, Robert J. Freeman and Stephen P. Davies ABSTRACT For several years, Florida local governments have been subject to laws intended to enhance audit quality. Hackenbrack et al. (2000) report that the ﬁscal 1992 audit fees of Florida local governments exceed those of local governments in surrounding states and conclude that Florida’s audit procurement requirements created an “audit market climate” that promotes audit quality. We extend Hackenbrack et al.’s research by comparing the audit effort (hours) and audit fees associated with selected Florida local governments with the audit effort and fees associated with a nationwide sample of local governments in states other than Florida for ﬁscal 1996. We ﬁnd that both audit hours and audit fees are higher in Florida vis-`a-vis those of other local governments. Our results provide further empirical support for the premise that Florida’s local government audit procurement laws represent sound public policy.

1. INTRODUCTION Do legal restrictions on competitive bidding in local government audit procurement enhance audit quality, as intended, or do such restrictions merely provide a windfall Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 197–207 © 2003 Published by Elsevier Science Ltd. ISSN: 1052-0457/PII: S1052045702160127

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for auditors in the form of higher fees? Although several state governments assume some role in local government audit procurement (e.g. NASACT, 1996), Florida is unique among the 50 states1 in that its local governments have long been subject to laws requiring that prospective auditors be evaluated on technical qualiﬁcations before fees are negotiated. From 1972 until 1993, the Florida public accountancy statute (Florida Statutes, Ch. 473.317, hereafter Ch. 473) prohibited cities and counties from obtaining audit fee estimates until prospective auditors “had been ranked by other means, including quality of work and prior experience” (State of Florida Ofﬁce of the Auditor General, 1995, p. 146). Florida’s Supreme Court invalidated Ch. 473 in July 1993 on free speech grounds. Signiﬁcantly, a Florida local-government audit procurement statute (Ch. 11, Section 45.3, hereafter Ch. 11) retains the thrust of Ch. 473, that is, precedence of technical ability over fees in auditor selection.2 “Non-charter” counties must follow the provisions of Ch. 11; “charter” counties and municipalities may do so. Hackenbrack et al. (2000) test the effect of Ch. 473, ﬁnding that the ﬁscal 1992 audit fees of Florida cities exceed the audit fees of municipalities in seven other southeastern states. They assert that Florida governments beneﬁt from “superior auditor performance” in that, comparatively, Florida’s government audit environment is characterized by a predominance of Big Six3 ﬁrms, among other factors. However, Hackenbrack et al.’s assertion of superior auditor performance in Florida is not fully persuasive. They ﬁnd no fee premia associated with Big Six auditors (counter to several prior studies) but observe a high concentration of Big Six ﬁrms in Florida. Moreover, prior researchers report a negative relationship between audit fees and the use of competitive bidding in government audit procurement. Thus, it is reasonable to question whether Hackenbrack et al.’s ﬁnding of fee premia associated with Florida is driven by the Big Six inﬂuence and/or absence of competitive bidding, and, as such, does not represent higher audit quality. We compare ﬁscal 1996 audit effort (audit hours) and audit fees of a sample of Florida counties and cities with fees and hours of counties and cities in other states. We ﬁnd that audit hours and fees are higher for audits of local governments in Florida than in other states. Our results suggest that Chs. 473 and 11, collectively, have promoted government audit quality in Florida, and thus represent sound public policy. The remainder of this paper is organized as follows: In the next section, we review the literature to identify issues related to audit quality and audit effort and develop the research hypothesis. The third section presents the research design, while the fourth section reports our data collection, analysis, and results. The paper concludes with a discussion of the study’s ﬁndings, implications, and limitations.

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2. PREVIOUS LITERATURE AND THE RESEARCH HYPOTHESIS Audit quality is unobservable (Copley & Doucet, 1993a), so researchers have employed various proxies for audit quality, including auditor size and audit fees. Auditor size, typically Big Six vs. non-Big Six, is dichotomous and therefore coarse. The validity of a simple Big Six/non-Big Six distinction as a deﬁnitive quality measure is questioned by Francis et al. (1999, p. 186) who suggest that the expertise of individual Big 6 ofﬁces may vary from one locale to another. Audit fees appear to be a better measure of audit quality since fees are continuous. However, their usefulness is limited for two reasons: First, fees are highly correlated with auditee size (Copley & Doucet, 1993a) but audit quality as measured by oversight-agency review is a decreasing function of size (Deis & Giroux, 1992; O’Keefe & Westort, 1992), confounding the clear interpretation of fees as a quality metric. Second, as previously noted, prior studies (e.g. Copley & Doucet, 1993a; Raman & Wilson, 1992; Rubin, 1988; Ward et al., 1994) ﬁnd a negative association between competitive bidding in audit procurement and fees. Thus, the comparative absence of such competition in Florida could be an alternative explanation for Hackenbrack et al.’s ﬁnding of elevated government audit fees in that state. Our study requires a generalizable surrogate for quality. Private sector audit quality research incorporating audit effort as the dependent variable has been conducted by Palmrose (1989). More compellingly, in the government arena, Deis and Giroux (1992) document a direct relationship between audit quality (as assessed in an oversight agency quality review) and audit effort (hours). Audit effort thus appears to be a reasonable proxy for audit quality for the purpose of this study. The Government Finance Ofﬁcers Association (GFOA) Audit Management Handbook (Gauthier, 1989, p. 81) suggests that procurement policies emphasizing auditors’ qualiﬁcations over fees encourage high quality auditors to enter the local government audit market. Similarly, Hackenbrack et al. (p. 2) argue that “the bidding restriction [imposed by Ch. 473] created a market climate [in Florida] in which required non-price competition impeded the entry of the lesser qualiﬁed auditors while the anticipated ﬁnancial rewards induced the entry of the more qualiﬁed auditors.” We contend that Chs. 473 and 11 were mutually reinforcing. Moreover, though Ch. 473 was invalidated in 1993, it is likely that its effects persisted for some time, at least for continuing auditors appointed while Ch. 473 was in effect. Thus, we state our research hypothesis (in alternate form) as follows: H1. Audit effort is higher, on average, for Florida local governments than is audit effort for local governments in other states.

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3. RESEARCH DESIGN We regress audit fees and audit hours separately against a common set of independent variables, following prior research (e.g. Deis & Giroux, 1996; Palmrose, 1989). The focus of the research is the categorical variable FLA, signifying a Florida jurisdiction, for which we predict positive coefﬁcients; the control variables in our model are derived primarily from prior studies. Table 1 summarizes the study’s independent variables, data sources, and regression model.

4. DATA COLLECTION, ANALYSIS, AND RESULTS We obtained our data primarily from the ﬁscal 1996 Comprehensive Annual Financial Reports (CAFRs) of selected U.S. cities and counties (populations ≥ 50,000) and via questionnaire. Our sampling frame consisted of 335 high-quality CAFRs of governments from around the U.S. maintained at Texas Tech University and 150 additional CAFRs obtained from governments selected randomly (100 cities and 50 counties) from Carroll’s Municipal/County Directory (1995). (See Table 1 for sources of the data.) We requested actual audit hours and estimated audit hours per the audit proposals.4 Florida governments not legally required to follow the procedures prescribed by Florida statute Ch. 11 were requested to indicate whether they voluntarily followed these procedures. We received 279 (57%) responses providing audit fees. One-hundred ﬁfty-four (31%) of the responses providing fee data also provide hours data (nine responses include only actual hours, 60 provide actual- and proposed hours, and 85 provide only proposed hours). For responses providing both actual and proposed hours, we use the actual value. Actual hours are highly correlated with proposed hours for responses reporting both, thus responses reporting only proposed hours are suitable for use in the study (Pearson correlation coefﬁcient = 0.992, p < 0.001). We estimate both models from the 154 responses providing audit hours and fee data.5 A t-test of total revenues indicates no difference (t = 1.10, p = 0.271) between non-responding governments and those that returned the questionnaire with fee data. However, total revenues of governments providing only fee data are smaller than governments providing both fees and hours (means = $254 million vs. $351 million, t = 2.01, p = 0.045). This is consistent with Copley and Doucet’s suggestion (1993b) that larger governments are more likely to monitor auditor performance. Table 2 presents descriptive statistics for the sample. The data represent ﬁve of the (then) Big Six audit ﬁrms, and numerous regional and local ﬁrms. The data also represent 53 counties and 101 cities from 31 states.6 The 20 Florida governments

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Table 1. Summary of the Regression Model. Independent Variable Auditee size Total revenuea Auditee complexity Number of component units Extent (%) to which the auditor drafted the ﬁnancial statements State audit agency requirements address scope and nature of audit work (categorical = 1 if yes) Risk Low bond rating (categorical = 1 if yes) Government sold bonds during year (categorical = 1 if yes) Audit delay (days) Other control Auditor size (categorical = 1 if auditor is Big Six) Auditor tenure (years) Audit procurement process includes competitive bidding (categorical = 1 if yes) December 31 (“busy season”) year end (categorical = 1 if yes) Research variable Florida government (categorical = 1 if yes)

Name

Source

Use in prior research

LTR

CAFRb

Ward et al. (1994)

CU DRAFT

CAFR Questionnaire

SAAR

NASACTd

Johnson (1998) Suggested by Gauthier (1989) None

LOBR NEWBONDS

Moody’sc Questionnaire

Rubin (1988) None

DELAY

CAFR

Johnson (1998)

B6

CAFR

Rubin (1988)

ATEN BID

Questionnaire Questionnaire

Rubin (1988) Rubin (1988)

DYE

CAFR

Rubin (1988)

FLA

CAFR

Hackenbrack et al. (2000)

Note: In summary, the model is estimated as: ln(hours), ln(fees) = b 0 + b 1 LTR + b 2 CU + b 3 DRAFT + b 4 SAAR + b 5 LOBR + b 6 NEWBONDS + b 7 DELAY + b 8 B6 + b 9 ATEN + b 10 BID + b 11 DYE + b 12 FLA + ␧ a Logarithmically transformed for analysis. b Obtained from review of Comprehensive Annual Financial Report (CAFR). c Derived from information in CAFR in instances where bonds were not rated by Moody’s (1995). This variable = 1 for governments having unrated bonds and debt per capita > $1,200, as suggested by Leonard (1996). d Obtained from Auditing in the States: A Summary (NASACT, 1996).

represent about 35% of Florida cities and counties with populations ≥ 50,000. Eight Florida governments were required to follow the auditor procurement procedures of Ch. 11 or did so voluntarily. Of the Florida observations not following Ch. 11, six indicate auditor tenure of three years or less (i.e. they appointed their

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Table 2. Descriptive Statistics and Univariate Tests for Untransformed Variables. Florida Governments (n = 20) Mean Continuous Variables Audit hours* 2,366 147 Audit fees ($ in thousands)* Total revenues ($ in 336 millions) Number of component units 4.5 Extent to which auditor 16.5 drafted ﬁnancial statements (%) Audit delay (days) 114 Auditor tenure (years) 6.1

sd

Min

1,454 97 304

673 50 48

4.3 32.6

35 6.1

Florida Governments (n = 20)

Categorical Variables State audit agency requirements address scope and nature of audit work Government has a low bond rating Government issued bonds during the year Big Six audit ﬁrm Auditor procurement process includes obtaining bids December ﬁscal year end ∗ Means

1 0.0

44 1

Other Governments (n = 134) Max

5,875 460 1,095 17 100.0

162 25

Mean

sd

Min

Max

1,542 1,323 160 10,105 82 73 12 494 345 463 23 2,556 3.6 27.8

119 5.9

3.5 37.9

0 0.0

33 31 5.7 1

21 100.0

270 40

Other Governments (n = 134)

Number

% of n

Number

% of n

20

100.0

42

31.3

2

10.0

15

11.2

10

50.0

32

23.9

12 12

60.0 60.0

59 126

44.0 94.0

0

0.0

40

29.8

are signiﬁcantly different at ␣ ≤ 0.10.

auditors after Ch. 473 was nulliﬁed). That is, 14 of the 20 Florida responses are from governments that were subject to the audit procurement requirements of either Ch. 473 or Ch. 11. It is reasonable, then, to expect the fee premia reported by Hackenbrack et al. (2000) during 1992 to persist into 1996.

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Table 3. Ordinary Least Squares Regression Estimates of Audit-Effort and Audit Fees Models. (Dependent Variables are the Natural Logs of Audit Hours and Audit Fees.) Variable (name)

Audit Hours

Audit Fees

Expected Sign

Coefﬁcient (Std. Error)

Expected Sign

Coefﬁcient (Std. Error)

Constant

?

−

LTR

+

CU

+

DRAFT

+

SAAR

+

LOBR

+

NEWBONDS

+

DELAY

+

B6

+

ATEN

?

BID

+

DYE

?

FLA

+

0.9778 (0.6686) 0.4339*** (0.0580) 0.0063 (0.0142) 0.0040*** (0.0012) −0.0033 (0.1086) −0.0825 (0.1465) 0.0213 (0.1091) 0.0048*** (0.0013) −0.0309 (0.0991) −0.0075 (0.0080) 0.1797 (0.1640) 0.0158 (0.1094) 0.5583*** (0.1667)

5.8154*** (0.5516) 0.4061*** (0.0478) 0.0034 (0.0117) 0.0032*** (0.0010) −0.0757 (0.0896) 0.1191 (0.1208) 0.1168* (0.0900) 0.0022** (0.0011) 0.2091*** (0.0817) −0.0103* (0.0066) −0.1307 (0.1353) 0.0887 (0.0903) 0.5928*** (0.1375)

Model F-statistic Prob (F-statistic) Adjusted R2

12.3284 <0.0001 0.4704

+ + + + + + + + + − + +

19.5215 <0.0001 0.5922

Note: All signiﬁcance tests are 1-tailed except those for coefﬁcients for which no sign is predicted; signiﬁcance tests for coefﬁcients for which no sign is predicted are 2-tailed. ∗ Signiﬁcant at ␣ ≤ 0.10. ∗∗ Signiﬁcant at ␣ ≤ 0.05. ∗∗∗ Signiﬁcant at ␣ ≤ 0.01.

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One-hundred forty-seven (95%) of the CAFRs include a GFOA Certiﬁcate of Achievement for Excellence in Financial Reporting, while none had other than an unqualiﬁed auditor’s opinion. Thus, our sample represents a uniformly high level of quality of ﬁnancial reporting, minimizing the likelihood that differences in ﬁnancial reporting quality between states will confound our results. The regression estimates for both audit hours and fees appear in Table 3. For hours, this table shows that the control variables LTR, DRAFT, and DELAY have signiﬁcant coefﬁcient estimates and the expected signs. The coefﬁcients for the remaining control variables, including B6, are not signiﬁcant. The FLA coefﬁcient is positive and signiﬁcant, supporting the research hypothesis. The model explains just under one-half of the observed variation in audit hours (adjusted R 2 = 0.470). For fees, the coefﬁcients for LTR, DRAFT, NEWBONDS, DELAY, and B6 are signiﬁcant at conventional levels and have the expected signs, while the coefﬁcient for ATEN is signiﬁcant but unexpectedly negative. The coefﬁcient for FLA is positive and signiﬁcant, supporting Hackenbrack et al.’s ﬁndings. The model’s adjusted R 2 = 0.592; the higher explanatory power of the fee model versus the hours model is consistent with Palmrose (1989) and Deis and Giroux (1996). Diagnostic procedures (Wilks-Shapiro tests, White’s test, and variance inﬂation factors, and Pearson correlation coefﬁcients, respectively) reveal no problems of non-normal residuals, heteroscedasticity, or collinearity in the regression estimates. Likewise, Cook’s D suggests that the regression estimates are not affected by outliers. Inspection of residual plots does not suggest an omitted-variables problem; Chow tests indicate that regression coefﬁcients do not differ between the Florida and other-states data for either model.

5. DISCUSSION We ﬁnd that audit hours received and audit fees paid by Florida local governments exceed those of other U.S. local governments, indicating that the “Florida effect” on fees reported by Hackenbrack et al. for 1992 persisted into 1996. Our results further imply that, collectively, Chs. 473 and 11 were successful in promoting the quality of local government audits in Florida, albeit at higher cost. Our ﬁndings suggest that other states would do well to consider adopting local government audit procurement laws similar to Florida’s (assuming free speech concerns can be addressed) to promote local government audit quality. The study yielded one other noteworthy ﬁnding. We observe that Big Six ﬁrms devote no more effort to their government clients than do other ﬁrms, counter

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to the widely-held view that Big Six ﬁrms provide categorically superior audit quality. Thus, it is possible that the observed equivalent effort between Big Six and other ﬁrms in the government sector is the norm. In this regard, Copley (1991, p. 263) suggests that “the (then) Big Eight ﬁrms are not the only [government] auditors providing a higher quality service.” This concept is tenable given that government audit providers likely have improved their specialized government auditing knowledge due (at least in part) to the complexities of government auditing imposed by the Single Audit Act of 1984 (Raman & Wilson, 1992). Accordingly, governments may ﬁnd beneﬁt in engaging non-Big Six auditors having governmental expertise rather than assuming the highest quality audits are always provided by Big Six ﬁrms, exclusive of their governmental expertise. That is, smaller, specialist auditors may provide high quality audits and cost savings. This study’s results must be considered in light of its limitations. First, audit effort may not fully capture audit quality, as noted by Palmrose (1989). Also, the CAFRs reviewed for this study do not represent a random sample of U.S. local governments, both because of the convenience nature of part of the sampling frame and because conscious effort was made to ensure that Florida local governments were well represented. Third, though the overall response rate (57%) was good, the number of responses which included a measure of audit hours was smaller (31%). Finally, it is possible that our ﬁndings are driven by some latent systematic difference between the Florida governments and those in the other states. These limitations should be borne in mind when generalizing the results of this study.

NOTES 1. A Lexus-based review of state laws addressing local government audit procurement procedures in all 50 states supports the uniqueness of the Florida laws in emphasizing technical competence in the procurement process. 2. Chapter 11 Section 45.3 was enacted in 1979 and remains in effect to the present. 3. During 1992, the time period represented by Hackenbrack et al.’s data, and 1996, the ﬁscal year for which we collected our data, the former Big Six represented the largest public accounting ﬁrms. Thus, for clarity, we refer to the Big Six throughout the paper. 4. Local government ﬁnance ofﬁcers we consulted during development of the questionnaire suggested that many respondents would be unable to provide actual audit hours. We were advised, though, that respondents generally would be more able to provide proposed audit hours and that proposed audit hours would be an acceptable surrogate for actual audit hours. 5. The response rate for Florida (other)governments providing hours data is 62% (29%). The response rate for Florida (other) governments providing fee data is 71% (55%). 6. Our sample draws from states around the U.S. and thus differs from Hackenbrack et al.’s sample, which is restricted to Florida and the immediately-surrounding states.

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ACKNOWLEDGMENTS We gratefully acknowledge the comments of two anonymous reviewers and those of the Editor of this journal in improving this paper. We also express our appreciation to Paul Copley, Randal Elder, Suzanne Lowensohn, Kinney Poynter, and Ted Sauerbeck for their helpful comments on earlier versions of the paper. We thank David Bean for pointing out the existence and nature of Chapter 11. We also thank George Hunt and Pamela Krohn for research assistance.

REFERENCES Carroll Publishing Company (1995). Carroll’s municipal/county directory. Washington DC: Carroll Publishing Company. Copley, P. (1991). The association between municipal disclosure practices and audit quality. Journal of Accounting and Public Policy, 10(Winter), 245–266. Copley, P., & Doucet, M. (1993a). The impact of competition on the quality of governmental audits. Auditing: A Journal of Practice & Theory, 12(Spring), 88–98. Copley, P., & Doucet, M. (1993b). Auditor tenure, Public Budgeting, ﬁxed fee contracts, and the supply of substandard single audits. Public Budgeting & Finance, 13(Fall), 23–35. Deis, D., Jr., & Giroux, G. (1992). Determinants of audit quality in the public sector. The Accounting Review, 67(July), 462–479. Deis, D., Jr., & Giroux, G. (1996). The effect of auditor changes on audit fees, audit hours, and audit quality. Journal of Accounting and Public Policy, 15(Spring), 55–76. Francis, J., Stokes, D., & Anderson, D. (1999). City markets as a unit of analysis in audit research and the re-examination of big 6 market shares. Abacus, 35, 185–206. Gauthier, S. (1989). Audit management handbook. Chicago: Government Finance Ofﬁcers Association. Hackenbrack, K., Jensen, K., & Payne, J. (2000). The effect of a bidding restriction on the audit services market. Journal of Accounting Research, 38(Autumn), 355–374. Johnson, L. (1998). Additional evidence on the determinants of local government audit delay. Journal of Public Budgeting, Accounting & Financial Management, 10(Fall), 375–397. Leonard, P. (1996). Debt management. In: J. Aronson & E. Schwartz (Eds), Management policies in local government ﬁnance (4th ed.). Washington, DC: International City/County Management Association. Moody’s Investors Service (1995). Moody’s municipal and government manual. National Association of State Auditors, Comptrollers and Treasurers (NASACT) (1996). Auditing in the States: A summary. Lexington, KY: NASACT. O’Keefe, T., & Westort, P. (1992). Conformance to GAAS reporting standards in municipal audits and the economics of auditing: The effects of audit ﬁrm size, CPA examination performance, and competition. Research in Accounting Regulation, 6, 39–77. Palmrose, Z. (1989). The relation of audit contract type to audit fees and hours. The Accounting Review, 64(July), 488–499. Raman, K., & Wilson, E. (1992). An empirical investigation of the market for “single audit” services. Journal of Accounting and Public Policy, 11(Fall), 271–295. Rubin, M. (1988). Municipal audit fee determinants. The Accounting Review, 63(April), 219–236.

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State of Florida Ofﬁce of the Auditor General (1995). Report No. 12574: Performance audit of the State of Florida local government ﬁnancial reporting system. State of Florida Statutes (1993). Chapter 473: Public Accountancy. State of Florida Statutes (1996). Title III, Legislative Branch; Chapter 11, Legislative organization, procedures, and stafﬁng. Ward, D., Elder, R., & Kattelus, S. (1994). Further evidence on the determinants of municipal audit fees. The Accounting Review, 69(April), 399–411.

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AN EXPERIMENTAL EXAMINATION OF THE PEER REVIEW PROCESS Jeff L. Payne ABSTRACT The recent ﬁnancial failure of several multi-billion dollar publicly traded companies has dramatically increased ﬁnancial statement users concerns about the quality of ﬁnancial reporting. In response, President Bush recently signed the Sarbanes-Oxley Act, which signiﬁcantly increases regulatory oversight of the ﬁnancial reporting and auditing processes. A section of the Act creates an inspection process for ﬁrms that provide audits to publicly traded companies. This research provides an examination of the timing of the current peer review and recently enacted inspection processes. The stated goal of these review processes is to increase the value of accounting services by improving quality. Utilizing the laboratory markets methodology, this paper examines the inﬂuence of a peer review type process on the provision of audit quality, speciﬁcally examining the periodicity of review process. The results indicate a timely review process increases audit quality.

INTRODUCTION On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act (U.S. House, 2002) in an attempt to restore investor conﬁdence in the ﬁnancial reports of publicly traded companies. The recent ﬁnancial failure of several large publicly traded companies (e.g. ENRON) was a stimulus for this legislation. This Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 209–225 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160139

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210

JEFF L. PAYNE

Act represents the most signiﬁcant change in regulations concerning ﬁnancial reporting since the laws adopted during the economic depression of the 1930s. A signiﬁcant part of the new law is the creation of a new inspection process for auditors of publicly traded companies. In Sec. 104. Inspections of Registered Public Accounting Firms, the Act directs the Public Company Accounting Oversight Board (established under Sec. 101. of the Act) to “conduct a continuing program of inspections to assess the degree of compliance of each registered public accounting ﬁrm and associated persons of that ﬁrm, with this Act, the rules of the Board, the rules of the Commission, or professional standards, in connection with its performance of audits, issuance of audit reports, and related matters involving issuers” (U.S. House, 2002). Inspections will be conducted annually for accounting ﬁrms that provide audit reports for more than 100 publicly traded companies, and at least once every three years for ﬁrms auditing fewer than 100 publicly traded companies. The Board has the option of performing special inspections at any time. An examination of the current peer review process, last amended in January 2001, provides an opportunity to gain initial insights into the effectiveness of the inspection process established by the Sarbanes-Oxley Act. Like the inspection process required by the Act, the current peer review report examines a ﬁrm’s system of quality controls for its accounting and auditing practice and provides reasonable assurance that the ﬁrm is in compliance with professional standards. Peer review is currently required for all ﬁrms that have partners or employees that are members of the AICPA and for all ﬁrms that audit companies required to ﬁle ﬁnancial statements with the Securities and Exchange Commission (SEC). Firms auditing publicly traded companies are required to join the SEC Practice Section, other ﬁrms can fulﬁll the peer review requirement by joining the AICPA peer review program. A peer review is required within one year of joining a peer review program with subsequent reviews performed every three years. Audit ﬁrms select their peer review team from the list of qualiﬁed ﬁrms maintained by the SECPS or the AICPA and pay negotiated fees for their services. The issue of peer review timing has been a recent topic of discussion by regulatory agencies and professional organizations. Chairman Pitt of the Securities and Exchange Commission stated that a more frequent peer review process should be implemented to improve the quality of auditing services (U.S. Securities and Exchange Commission, January 17, 2002). In their report issued in May, 2000 entitled “The Panel on Audit Effectiveness Report and Recommendations” (AICPA, 2000) the Panel indicates that “The peer review process is an integral part of ensuring ongoing quality of the audit process . . . and is a critical element in ‘closing the loop’ to provide assurance to the public that audit performance measures up to high standards and continues to improve.” One speciﬁc recommendation offered by the Panel and Lynn Turner, the Chief

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Accountant at the SEC, is to increase the timing of the peer review process. Turner suggests performing peer reviews on an annual basis (Turner, 2000). In this paper, I report the results of a laboratory market experiment designed to investigate audit quality and pricing under settings that manipulate the timing of the peer review process. This is the ﬁrst research to speciﬁcally examine the issue of peer review timing. The results of this study indicate that peer review timing has a signiﬁcant impact on auditor’s willingness to provide consistent high quality services. This suggests that the current peer review process and the forthcoming inspection process have the potential to address regulators’ concerns regarding the quality of the audit function but that the timeliness with which the quality information is provided is critical. If the information provided by the peer review or inspection process is not timely, customers will potentially not rely on the peer review or inspection report as a signal of audit quality. Additionally, audit providers might not have sufﬁcient incentives to motivate the provision of high quality audit services. The remainder of this paper is divided into four sections. The next section examines prior research investigating peer review and audit quality. Next, the laboratory market structure is discussed along with information about the market information structure and players’ strategies. Predicted market outcomes are then presented along with hypotheses for testing. The results are then discussed. The ﬁnal section provides a summary and conclusions derived from the experimental markets.

LITERATURE REVIEW Existing empirical investigations of the peer review process produce conﬂicting results regarding its effectiveness. Peer review does not appear to increase audit fees (Francis et al., 1990; Giroux et al., 1995) or affect the amount or price of credit that loan ofﬁcers are willing to extend to potential borrowers (Schneider & Ramsay, 2000). However, several studies indicate that peer review does affect the quality of services provided by ﬁrms. Notably, research using several metrics for audit quality consistently indicate that peer reviewed ﬁrms provide higher quality auditing services (Deis & Giroux, 1992; Giroux et al., 1995; Krishnan & Schauer, 2000). Prior research also indicates that the peer review process inﬂuences ﬁnancial statement users’ decisions. Schneider and Ramsay (2000) ﬁnd that peer review increases loan ofﬁcers’ conﬁdence in an audit ﬁrm’s report and related company ﬁnancial statements. Alam et al. (2000) analyzed survey responses from four distinct groups, members of the AICPA peer review program, audit clients,

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JEFF L. PAYNE

bankers, and ﬁnancial analysts. These constituents agreed that peer review reduces the likelihood of audit failure and that peer review was a useful process for auditors to participate in. Prior research also provides some support for the idea that peer review allows ﬁnancial statement users to differentiate quality. File et al. (1992) ﬁnd that bankers and auditors reduce their reliance on audit ﬁrm size as a proxy for audit quality when peer review reports are available. Prior experimental markets research has investigated various forms of institutional settings to mitigate or lessen the provision of low quality audit services. These include various negligence liability rules (DeJong et al., 1985a; Dopuch et al., 1994, 1997; Gramling et al., 1998; King & Schwartz, 1998, 2000; Wallin, 1992), allowing ex post costly investigation of auditor quality by the client (DeJong et al., 1985b), reputation formation (King, 1996), and the use of voluntary self regulation in multi-person coalitions (Grant et al., 1996). This research, with the exception of Grant et al. (1996), fails to ﬁnd market settings where high quality producers receive sufﬁcient rewards to motivate and sustain high quality services. Grant et al. (1996) ﬁnd that a regime of voluntary self-regulation in a multiperson coalition can provide incentives for participants to provide high quality services. Lundholm (1999) shows that market conditions can exist where rational investors can trust a ﬁrm’s quality disclosures to be truthful. However, this result is predicated on the availability of an ex post report on the truthfulness of the ﬁrm’s disclosures. Therefore, for a ﬁrm’s quality representations to be trusted, a report, much like the current peer review, and the recently enacted ﬁrm inspection, process, is required to facilitate truthful communication between the ﬁrm and potential and existing clients. The peer review/inspection process represents an institutional remedy that potentially provides sufﬁcient information for clients to make informed decisions regarding auditor quality.

THE STUDY This study consists of eight multi-period laboratory markets contracting via a computerized sealed-offer auction.1 Actual market periods ranged from 13 to 18 with an average of 15.5 market days. Each market has four buyers (clients) and four sellers (auditors). The experimental parameters include an asset given to the client at the beginning of each experimental period that can have either a high or low value. The client’s objective is to purchase audit services to report on the value of the asset. Based on this report the client sells the asset to the experimenter. The client is paid more for an asset reported with a high value. Auditors can provide high or low quality audit services. High quality services are more likely to accurately

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report the true value of the asset. Auditors are required to truthfully report the asset value revealed from their audit. Clients incur three potential costs: (1) the audit fee; (2) the loss of value when a high valued asset is incorrectly reported as low; and (3) a penalty for misreporting when the low valued asset is reported as high. Auditors only cost is based on the quality of audit services they provide, with high quality services costing more. To assist the clients in determining the quality of an auditor’s services, auditors can elect to provide a peer review type report that indicates the quality of their audit services provided in past experimental periods. The peer review truthfully reports on the quality of audits provided. The timing of the peer review report is set at either one or three experimental periods. For a detailed discussion of the experimental conditions and participant incentives, see the Appendix.

PREDICTED MARKET OUTCOMES AND HYPOTHESES The experimental parameter of interest for this study is the inﬂuence of the timing of the peer review report on the price and quality of audit services provided. A peer review report is provided to the auditor in the next experimental market period after joining the peer review process. Reports indicate that the audit services provided in the last period (last three periods) were high or low quality. To receive a high quality peer review report, all audits performed during the review period must be high quality. In markets with a three period review period, the peer review report is only updated every third market period allowing the auditor to potentially provide low quality services at high quality prices for three periods without being detected. This indicates that players’ optimal strategies regarding the quality of audit services to contract for are affected by the timing of peer review. The following prediction is made (stated in alternative form): H1. The proportion of high quality audit services provided will increase as peer review timing decreases. There is a positive relationship between the required price for the auditor to provide consistent high quality services and the timing of the peer review (Klein & Lefﬂer, 1981; Shapiro, 1983). As the time between peer reviews increases, the client’s willingness to pay for audit quality will have to increase to support the provision of high quality audit services. However, as peer review timing increases, the client’s ability to determine audit quality is mitigated providing incentives for clients to not rely on the peer review report’s representation of audit quality. Therefore, as peer review timing increases clients may be less willing to pay prices sufﬁcient to encourage the provision of high quality services. The following hypothesis (stated

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JEFF L. PAYNE

Table 1. Analysis of Audit Quality. Effect Main effect Error Peer Review Timing 1 period 3 period

Degrees of Freedom 1 247 Average Quality* 0.625 0.231

Sum of Squares

F Ratio

p Value

9.63 51.52

46.20

0.001

Standard Deviation 0.486 0.423

∗ This

value represents the average quality provided by auditors in the experimental markets. High quality audits are valued at 1, low quality audits are valued at 0.

in alternative form) is not presented in directional form as alternative outcomes are available. H2. The price of the audit services provided will be affected by peer review timing.

RESULTS Hypotheses 1 and 2 are analyzed by examining each of the respective dependent variables of audit fees and audit quality using ANOVA to determine the effects of peer review timing (three periods or one period). The results are organized by dependent variable and will incorporate a discussion of the speciﬁc hypotheses affected.2

Audit Quality In support of H1, the audit quality provided was signiﬁcantly affected by the timing of peer review (p < 0.001) (see Table 1). The proportion of high quality audit services provided increased in markets with the 1-period peer review (0.625 vs. 0.231). It appears that the 1-period peer review process allowed clients to isolate high quality auditors which increased the provision of audit quality within those markets.

Market Prices Market prices were signiﬁcantly affected by the timing of peer review (p < 0.001) in support of H2 (see Table 2). Average prices appear to increase in markets where

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215

Table 2. Analysis of Market Prices. Effect

Degrees of Freedom

Main effect Error

Sum of Squares

F Ratio

p Value

28243.43 581237.47

12.00

0.001

1 247

Peer Review Timing 1 period 3 period

Average Price*

Standard Deviation

178.38 157.84

48.31 48.72

∗ Represents the average price paid by clients during the experimental market periods under investigation.

the one-period peer review is present (178.38 vs. 157.84). This result indicates that the more timely one period peer review provides quality discriminating information to clients that allow them to make more informed purchase decisions. Lower prices are paid for services in the markets with the three period peer review as potential clients are not able to discern the quality of services being offered. To supplement these reported results I also analyze the affect of peer review timing on the willingness of auditors to utilize the peer review process, auditors providing low quality services when reporting a “high” peer review report, the market surplus captured by the clients and auditors as well as the total market surplus generated in the market settings. These analyses are performed in a similar manner to the previously reported results using ANOVA. Review of Table 3 indicates that auditors are no more likely to use the peer review process in the markets with the one period review timing (0.750 vs. 0.686; p = 0.263). However, Table 4 reveals that auditors are less likely to provide low quality services when representing their services as high quality in the one period markets (0.056 vs. 0.314; p < 0.001). These results appear to indicate that while the more timely annual or one period peer review does not necessarily increase Table 3. Analysis of Peer Review Membership. Effect Main effect Error Peer Review Timing 1 period 3 period ∗ The

Degrees of Freedom 1 247 Peer Review Membership* 0.750 0.686

Sum of Squares 0.26 50.07

F Ratio

p Value

1.26

0.263

Standard Deviation 0.435 0.466

percentage of audit investigations that were offered with a peer review report.

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Table 4. Analysis of Auditor Quality Provision. Effect Main effect Error Peer Review Timing

Degrees of Freedom 1 104 Low Quality Percentage*

1 period 3 period

Sum of Squares

F Ratio

p Value

1.560 11.318

14.33

0.001

Standard Deviation

0.056 0.314

0.232 0.471

∗ This represents the percentage of audit investigations purchased with a high peer review report where

the auditor was providing low quality audit services.

auditor’s willingness to voluntarily participate in the peer review program, it does encourage auditors’ continual provision of high quality services after the peer review report is made available to potential clients. In the markets used in this study, excess supply was induced by allowing each auditor to contract with multiple clients. In settings with excess supply, competition will force auditors to price their services at prices slightly above their cost (Smith, 1982). This allows the market surplus to be captured by the clients. However, in settings with information asymmetry regarding audit quality, it is possible for auditors to record higher proﬁts than the competitive equilibrium if clients cannot perfectly determine the quality of audit services that are provided. As the market information environment improves and audit quality is known, increasing portions of the market surplus will be captured by the clients. Analysis of the market surplus indicates that the one period peer review process increases client proﬁtability (142.72 vs. 58.64; p < 0.025, Table 5) and total market surplus (158.59 vs. 89.50; p = 0.063, Table 6), while the auditors’ proﬁts are Table 5. Analysis of Client Surplus. Effect Main effect Error Peer Review Timing 1 period 3 period ∗ Client

Degrees of Freedom 1 247

Sum of Squares

F Ratio

p Value

439750.21 214205253.88

5.07

0.025

Client Surplus*

Standard Deviation

142.72 58.64

263.30 324.24

surplus represents the average proﬁts earned by clients during the market periods under investigation. This is calculated as the value of the asset received less the cost of the auditor’s investigation and any penalty for auditor misreporting.

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Table 6. Analysis of Market Surplus. Effect Main effect Error Peer Review Timing 1 period 3 period

Degrees of Freedom 1 247

Sum of Squares

F Ratio

p Value

296907.78 21094549.12

3.48

0.063

Market Surplus*

Standard Deviation

158.59 89.50

266.94 316.82

∗ Represents the average earnings of the auditors and clients during the market periods under investigation.

reduced (15.88 vs. 30.87; p < 0.01, Table 7) when compared to the three period markets. This is consistent with an improved ability of clients to assess audit quality in the one-period markets. Untabulated additional analyses of the transactions within each market period indicates that proﬁts were increased in the three period review market settings by auditors who were providing less costly low quality services while reporting a high quality peer review report. This allowed auditors to earn additional proﬁts until their low quality services were detected in subsequent periods. This is consistent with the results reported above that indicate increased levels of this behavior in the three period peer review markets. The inabilities of clients to accurate assess audit quality in the three period markets created a setting where auditors could not recover the cost of providing high quality services. Overall, the market statistics indicate that market surplus is increasing with the improved information environment created by the one period peer review. Clients are successful in capturing this additional surplus by using the more timely peer review information reported in the one period markets. Table 7. Analysis of Auditor Surplus. Effect Main effect Error Peer Review Timing 1 period 3 period

Degrees of Freedom 1 247

Sum of Squares

F Ratio

p Value

13981.69 513523.88

6.73

0.010

Auditor Surplus*

Standard Deviation

15.88 30.87

43.82 47.40

∗ Auditor surplus represents the average proﬁts earned by auditors during the market periods under investigation. This is calculated as the selling price of the auditor’s investigation less the cost of the investigation.

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SUMMARY AND CONCLUSIONS The results of this study indicate that the information provided by the peer review process is useful to clients in assessing the quality of audit services they are receiving. The information provided by the one-period peer review process led to a reduction in the information asymmetry regarding audit quality and increased the quality of audits provided in the market over the three-period peer review process currently utilized within the accounting profession. Additionally, the timing of the peer review signiﬁcantly affected auditor behavior. Markets with the three-period peer review incurred signiﬁcantly higher levels of auditors providing low quality services when presenting a high quality peer review report. These results indicate that the current peer review process and the ﬁrm inspection process detailed in the Sarbanes-Oxley Act (U.S. House, 2002) have the potential to address regulators’ concerns regarding the quality of the auditing process but that the timeliness of the review process is critical. The results of this study support the ability of the peer review/inspection process to provide quality differentiating information to clients of audit services that improves their ability to purchase high quality audit services. Several limitations are intrinsic in the research design used in this study. First, experimental laboratory markets are abstractions from the external market. Only the critical decision variables utilized in the markets are theoretically developed and utilized. This requires that potentially signiﬁcant variables be excluded. This reduces the ability to make inferences from the results obtained to settings outside the laboratory setting. However, the strength of laboratory markets is the ability to control for confounding variables that are not of interest to a particular study. Other market variables that might be considered for future research include: (1) incorporating a cost for participating in peer review process; and (2) including error in the peer review reporting process (i.e. peer review would not always perfectly signal audit quality). We also need a better understanding of how ﬁnancial statement users make use of peer review reports. Lastly, Lynn Turner, former Chief Accountant at the SEC, stated in a recent speech “as an engagement partner, I was always told in advance which of my audits were going to be peer reviewed. I think it would be beneﬁcial if the staff of the POB [Public Oversight Board] could review some audits on an unannounced basis” (Turner, 2000). A possible effect that is not investigated by this research is the inﬂuence of audit reporting on management effort. If management is conﬁdent that its diligent efforts will be accurately reported, this might increase managers’ incentives to exert more effort. This research provided probabilistic information about the value of the asset to clients to assist in their valuation of audit services. Future research

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should examine managers’ incentives to purchase audit services based on their private information about their own effort level.

NOTES 1. The experimental settings used for this study are a subset of the market periods conducted utilizing the same subjects. The experimental manipulation was controlled to ensure that all subjects were exposed to identical experimental settings in the ﬁrst phase of the experiment to minimize any inﬂuence their behaviors in that setting might have on the markets of interest to this study. The peer review report was not available in the initial market settings. These settings were performed to determine market behavior without the availability of an audit quality signal. These markets all collapsed to a low quality/low price level as predicted. For sake of parsimony, these results are not included in this analysis but are available upon request from the author. 2. The reported results are based on the last eight experimental periods in each market. This controls for experience effects in the early market periods (Schatzberg & Sevcik, 1994). 256 market period observations are possible (eight markets × eight periods × four assets to audit in each market period). In eight market periods the client chose not to purchase an audit. Review of the market data indicates that these non-purchases all occurred in settings where the client could not determine the quality of audits being offered by the auditor. Additional analysis indicates that results from use of all experimental periods are qualitatively similar. 3. Physical barriers were present in the computer laboratory to prevent participants from making visual contact with other players. Participants were instructed that verbal contact was prohibited and this was monitored by the administrator. Players were classiﬁed as buyers (clients) or sellers (auditors) and audits were termed investigations to control for effects of terminology on participants. 4. The ﬁrst peer review report is not available until after the initial audit had been provided under peer review. If auditors exit the peer review process in Step 2, no peer review report will be available for that market period. 5. During the experiment clients were provided with their expected proﬁts based on the quality of audits they may have received, high or low as the game progressed. Clients could see the expected impact of an auditor’s provision of high and low quality audits without being able to directly infer an auditor’s quality provision during the execution of the game. 6. This creates an expected number of experimental days of 15 per market given the one-sixth chance the market would end on any given day after day 12. 7. Based on the experimental parameters from Fig. 1 the valuation of low and high quality audit services are calculated based on the probability the asset is of high/low value 0.40/0.60, the ability of the auditor to detect the state of nature for high/low quality audit services 0.90/0.50, and the potential penalty for auditor misreporting. The calculations for high and low quality audit services follow: High quality: 0.4 × 0.9 × 600 + 0.4 × 0.1 × 300 + 0.6 × 0.9 × 300 + 0.6 × 0.1 × (600–900) = 372 Low quality: 0.4 × 0.5 × 600 + 0.4 × 0.5 × 300 + 0.6 × 0.5 × 300 + 0.6 × 0.5 × (600–900) = 180

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ACKNOWLEDGMENTS I am grateful for helpful comments from my dissertation committee, W. Robert Knechel (Chairperson), Karl Hackenbrack, John Lynch, and David E. R. Sappington for their comments and guidance. Additional helpful suggestions were provided by Mark Anderson, Andy Cuccia, Brian Mayhew, and two anonymous reviewers. I would also like to thank the workshop participants at the University of Alabama, University of Florida, Georgetown University, University of Illinois, Indiana University, University of Northern Iowa, and the University of South Carolina for comments on an earlier version of this paper. I gratefully acknowledge the ﬁnancial support provided for this research by the Deloitte & Touche Foundation.

REFERENCES AICPA, The Panel on Audit Effectiveness Report and Recommendations (2000). AICPA (August). Alam, P., Hoffman, R. C., & Meier, H. H. (2000). Perceptions of the peer review program of the accounting profession: Implications for management. Journal of Managerial Issues, 12(Winter), 427–445. Deis, D. R., Jr., & Giroux, G. A. (1992). Determinants of audit quality in the public sector. The Accounting Review, 67(July), 462–479. DeJong, D. V., Forsythe, R., & Uecker, W. C. (1985a). The methodology of laboratory markets and its implications for agency research in accounting and auditing. Journal of Accounting Research, 23(Autumn), 753–793. DeJong, D. V., Forsythe, R., Lundholm, R. J., & Uecker, W. C. (1985b). A laboratory audit of the moral hazard problem in an agency relationship. Journal of Accounting Research, 23(Supplement), 81–120. Dopuch, N., Ingberman, D. E., & King, R. R. (1997). An experimental investigation of multi-defendant bargaining in “joint and several” and proportionate liability regimes. Journal of Accounting & Economics, 23(July), 189–221. Dopuch, N., King, R. R., & Schatzberg, J. W. (1994). An experimental investigation of alternative damage-sharing liability regimes with an auditing perspective. Journal of Accounting Research, 32(Supplement), 103–131. File, R. G., Ward, B. H., & Gray, C. A. (1992). Peer review as a market signal: Effective self-regulation? Research in Accounting Regulation, 6, 179–193. Francis, J. R., Andrews, W. T., Jr., & D. T (1990). Voluntary peer reviews, audit quality, and proposals for mandatory peer reviews. Journal of Accounting Auditing and Finance, 5(Winter), 369–377. Giroux, G., Deis, D., & Bryan, B. (1995). The effect of peer review on audit economies. Research in Accounting Regulation, 9, 63–82. Gramling, A. A., Schatzberg, J. W., Bailey, A. D., Jr., & Zhang, H. (1998). The impact of legal liability regimes and differential client risk on client acceptance, audit pricing, and audit effort decisions. Journal of Accounting, Auditing & Finance, 13(Fall), 437–460.

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Grant, J., Bricker, R., & Shiptsova, R. (1996). Audit quality and professional self-regulation: A social dilemma perspective and laboratory investigation. Auditing: A Journal of Practice and Theory, 15(Spring), 142–156. Kachelmeier, S. (1991). A laboratory market investigation of the demand for strategic auditing. Auditing: A Journal of Practice and Theory, 11(Supplement), 25–48. King, R. R. (1996). Reputation formation for reliable reporting: An experimental investigation. The Accounting Review, 71(July), 375–397. King, R. R., & Schwartz, R. (1998). Planning assurance services. Auditing: A Journal of Practice and Theory, 17(Supplement), 9–36. King, R. R., & Schwartz, R. (2000). An experimental investigation of auditors’ liability: Implications for social welfare and exploration of deviations from theoretical predictions. The Accounting Review, 75(October), 429–451. Klein, B., & Lefﬂer, K. (1981). The role of market forces in assuring contractual performance. Journal of Political Economy, 89(August), 615–641. Krishnan, J., & Schauer, P. C. (2000). The differentiation of quality among auditors: Evidence from the not-for-proﬁt sector. Auditing: A Journal of Practice and Theory, 19(Fall), 9–25. Lundholm, R. (1999). Historical accounting and the endogenous credibility of current disclosures (Working paper). University of Michigan. Pitt, H. L. (2002). Public regulation of the accounting profession. Public Statement by SEC Chairman. U.S. Securities & Exchange Commission, January 17, SEC headquarters, Washington, DC. http://www.sec.gov/news/speech/spch535.htm Schneider, A., & Ramsay, R. J. (2000). Assessing the value added by peer and quality reviews of CPA ﬁrms. Research in Accounting Regulation, 14, 23–38. Schatzberg, J. W., & Sevcik, G. R. (1994). A multi-period model and experimental evidence on independence and ‘low balling’. Contemporary Accounting Research, 11(Summer), 137–150. Shapiro, C. (1983). Premiums for high quality products as returns to reputations. The Quarterly Journal of Economics, 98(November), 659–679. Smith, V. L. (1982). Microeconomic systems as an experimental science. The American Economic Review, 72(December), 923–955. Turner, L. E. (2000). Shifting paradigms in self-regulation. Speech by SEC staff. U.S. Securities and Exchange Commission, January 27. 27th Anniversary Securities Regulation Institute. http://www.sec.gov/news/speeches/spch340.htm U.S. House. 107th Congress, 2nd Session (2002). H. R. 3763, An Act to Protect Investors by Improving the Accuracy and Reliability of Corporate Disclosures Made Pursuant to the Securities Laws, and for Other Purposes. http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=107 cong bills&docid=f:h3763enr.txt.pdf Wallin, D. E. (1992). Legal recourse and the demand for auditing. The Accounting Review, 67(January), 121–148.

APPENDIX After arriving at the experimental location each player received the same set of written instructions. An instructional period was then completed where the game instructions were read aloud to players and a pre-experimental questionnaire

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Fig. 1. Experiment Parameters.

was completed to ensure the market structure was understood. After random assignment to computer workstations,3 which determined player classiﬁcation as a buyer (client) or seller (auditor), a training phase (no cash earned) was conducted that consisted of three experimental market periods using the same computerized trading mechanism as the experimental phase. The sequence of activities for the markets is as follows (see Fig. 1 for a description of the experimental parameters): Step 1. At the beginning of each market period, the client is endowed with an asset that can have a high or low value. The client can employ the services of an auditor to report on the value of the asset and is paid based on this reported value. Clients are not able to directly observe the value of the asset. In the experimental instructions, the clients are given information that the asset has a high (low) value 40% (60%) of the time. Step 2. Auditors elect to join/remain-in/exit the peer review process (denoted as the “analysis report” in the experimental sessions). To receive a high review report all audits conducted during the period(s) (one period or three periods) under review must be of the high quality type.

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Step 3. Auditors decide the quality of audit to provide (cost to provide audit services, High quality = 200 cents, Low quality = 100 cents). High quality audits are more likely to accurately report the value of the client’s asset. High (low) quality audits will correctly report the true value of the asset 90% (50%) of the time. Step 4. Auditors elect to provide peer review information (if available)4 to prospective clients. (i.e. if the peer review report indicates that the auditor provided low quality audit services in the prior period(s), the auditor can elect not to reveal this information with their offer to provide audit services in the current period). If disclosed, auditor’s must truthfully report the outcome of the peer review. Step 5. Auditors submit offers and peer review information (if available) that are visible to all clients. The auditor does not inform potential clients of the quality of audit they have selected to provide. Step 6. Clients choose a speciﬁc auditor by agreeing to pay the auditor’s fee. An auditor can be selected by more than one client. Step 7. For each contract between an auditor and client, the auditor issues a private report to their client(s) indicating a high or low asset value. The auditor is required to truthfully report the asset value observed to the client. Step 8. Auditors receive the peer review report after the audit(s) is (are) completed and the report on asset value has been issued to the client. The ﬁrst peer review is performed after the initial market period the auditor is in the peer review process. Subsequent peer reviews are every one (three) period(s) depending on the market setting. Step 9. Based on the auditors report the clients sell their asset to the experimenter for a high (600 cents)/low (300 cents) payoff. In the market settings the clients’ demand for quality was operationalized with a penalty charged to clients at the end of the game for all periods where assets were sold at the high asset value when the actual value of the asset was low. The penalty is calculated for each market period and affects the ﬁnal experimental earnings of the clients. The asset’s sale price is based on the auditor’s report, so the penalty is created by auditor reporting errors.5 This design is similar to Kachelmeier (1991) and recognizes that any loss from the receipt of low quality audit services often occurs many periods after the fact (i.e. when there is recognition that an audit failure has occurred). The ﬁnancial losses incurred by ﬁnancial statement users of ENRON are a recent example of this type of ex post ﬁnancial loss.

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Participants were students enrolled in graduate level accounting and MBA courses at a major state university. A total of 64 players participated in the eight markets (four buyers and four sellers to each market). Market settings for the one period and three period peer review were each replicated four times. The experimental sessions lasted approximately two and one-half hours. Payments averaged $24 per participant. In order to mitigate end game effects, players were informed at the end of market period 12 that at the end of each subsequent period the computer would roll a “die” with values 1 through 6. If the roll was a six, the game would end, otherwise the game would continue on to the next period. The outcome of the roll was displayed on each player’s computer at the end of each affected period.6 At the conclusion of the market settings, players were asked to complete a post-experimental questionnaire and were paid their cash earnings (privately) for all trading periods. Analysis of the post-experimental questionnaire responses indicated that participants did not have prior experience with this type of experimental setting and that they understood the instructions and how their decisions would affect their earnings. Comparison of participant groups by review timing settings indicates no signiﬁcant difference in participants understanding of the experimental process, level of information received about the experiment before participating, or their desire to perform well in the study.

Client Strategies The clients expected value is affected by the true value of the asset, the audit’s quality, the payoff received based on the auditor’s report, and the audit fee. Clients are also affected by the potential for auditor reporting errors inducing a demand for high quality audits. This is evidenced by the increased price clients are willing to pay for high quality audit services: clients are willing to pay at most 180 cents for low quality and 372 cents for high quality audits.7

Auditor Strategies Auditor’s attempt to maximize proﬁtability which is based on the audit fees received less the cost of audit services provided. Assuming competitive markets (established via use of excess supply in the experimental settings) auditors will set prices at levels greater than or equal to cost. Therefore, auditors will only sell high (low) quality services at prices greater than 200 (100) cents based on the experimental parameters.

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The previous discussion indicates that players’ optimal contracting strategies regarding the quality of audit services are affected by the client’s demand for audit quality and the ability to discern the quality of audits purchased. The experimental markets will examine the ability of a peer review type process to provide quality information to prospective clients to allow them to make more informed audit purchase decisions.

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DEREGULATION OF THE PRIVATE CORPORATION AUDIT IN CANADA: JUSTIFICATION, LOBBYING, AND OUTCOMES Morina Rennie, David Senkow, Richard Rennie and Jonathan Wong ABSTRACT We examine the deregulation of an audit requirement for a group of private Canadian companies. In particular, we study the circumstances surrounding this deregulation and the impact of the change in legislation on the subsequent purchase of audit services. The study was done through the examination of archival documents relating to the change to the legislation, together with a survey of Chief Financial Ofﬁcers of companies that were affected by this change in legislation. We found that the federal government justiﬁed the change as a response to a perceived threat to the viability of the federal incorporation legislation, and that the government pursued this course in spite of the lobbying efforts of representatives from the accounting profession. Approximately one-quarter of the companies whose audit requirement was deregulated, purchased lesser levels of assurance services or no assurance services after the change in legislation.

Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 227–241 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160140

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INTRODUCTION Government-mandated audit requirements are believed to result in a greater level of acquisition of audit services than would occur in a free market. This may be desirable because of the nature of audit services as a public good. Without government intervention, such services may be under produced due to disagreement among ﬁnancial statement users as to who ought to bear the cost of providing the service (Ng, 1979). Falk (1989, p. 117) notes that the imposition of audit costs on companies represents a tax on these companies for the public good. Deregulation of a government-mandated audit requirement provides a rare opportunity to study the shift from a mandatory audit regime to a market regime. A limited amount of research has been carried out relating to the mandatory audit. For example, Ng (1979), Benston (1985) and Wallace (1980, 1987) addressed regulation as part of the larger issue of the market for audit services. The regulation and deregulation of the ﬁnancial statement audit was addressed in several studies of the history of accounting (for example, see Murphy, 1979; Parker, 1986; Previts, 1985). Falk (1989) looked speciﬁcally at the issue of mandatory audits in relation to the 1934 initiation of an audit requirement for American public companies. The purpose of this research is to study the circumstances surrounding the deregulation of the mandatory audit for large Canadian private corporations. Of particular interest is the justiﬁcation for this change, the lobbying efforts that occurred, and the consequential assurance choices made by affected companies. This paper reports the results of the examination of archival documents surrounding the change in legislation and a survey of Chief Financial Ofﬁcers from companies affected by this change in regulation. This research contributes to the literature on the regulation of audit services by examining the issues surrounding deregulation and the immediate consequences of deregulation of such services. The remainder of the paper is organized as follows. The next section provides a brief historical background for the study. This is followed by sections on the method, justiﬁcation and criticism of the proposed deregulation, the impact of deregulation and the conclusion.

BACKGROUND The English Joint Stock Companies Act of 1844 appears to have been the ﬁrst instance of a mandatory audit provision in legislation. The subsequent 1862 Act did not contain this requirement (Stacey, 1954, p. 37). However, most companies at the time, in fact, had included an audit requirement in their articles of association

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(Previts, 1985, pp. 25–26). The issue arose again when it became compulsory for banks to have audits in 1879. Apparently, few banks had discontinued their audits during the period 1862 to 1879 in any case (Falk, 1989, p. 107). In 1900 another change to the English Companies Act made the ﬁnancial audit mandatory for limited liability companies (Murphy, 1979, p. 331). A 1967 revision to the Act abolished an earlier exemption from this requirement for private companies (p. 345). Mandatory audit legislation in the United States began with the 1934 Securities Act, following the stock market crash of 1929. Falk (1989, p. 111) reports that the inclusion of an audit requirement in the 1934 Act was a result of intense lobbying by members of the American accounting profession. In Canada, the ﬁrst federal legislation mandating a ﬁnancial statement audit and disclosure requirement came in 1917 (Murphy, 1993a, p. 440), although private companies were allowed to obtain exemption from this requirement. In 1970, the Canada Corporations Act abolished this exemption provision for economically signiﬁcant private companies (Iacobucci et al., 1977, pp. 388–389). In 1975, the Canada Business Corporations Act (CBCA) came into force, replacing the Canada Corporations Act. The mandatory ﬁnancial statement audit and disclosure provision for both public companies and economically signiﬁcant private corporations was incorporated in the new act. Private companies having gross revenues exceeding $10 million or assets exceeding $5 million were subject to this requirement. The rationale for this provision was the belief that subsidiaries of large conglomerates, although technically classiﬁed as private companies, have considerable economic impact in Canada. Due to the economic signiﬁcance of these companies to the Canadian economy, it was thought important to have a measure of public accountability through the required disclosure of audited ﬁnancial statements. Moreover, it was believed that these large private companies should not be allowed a competitive advantage in terms of information (non)disclosure over public companies in the same line of business (Iacobucci et al., 1977, p. 389). On June 14, 1994, the mandatory ﬁling of audited ﬁnancial statements for these large private corporations was removed from paragraph 160 of the Canada Business Corporations Act (CBCA) with the passing of Bill C-12. The revised provision allowed large private corporations to forego their audits with unanimous consent of the shareholders. This amendment is the subject of our research.

METHOD The 1994 discontinuance of the audit and public ﬁling requirement for large private Canadian corporations was studied through both archival research and a survey of companies affected by the amendment.

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The archival research included the examination of: transcripts from the House of Commons debate on the change in the CBCA legislation; the report and the minutes of the sub-committee studying the proposed changes; Bill C-12 (the legislation to amend the CBCA); written responses sent to government regarding the proposed changes; and the Library of Parliament summary of written submissions about the proposed change. This research enabled us to explore the issues surrounding this amendment and the lobbying activities that occurred. We searched a recent version of the CanCorp Plus corporate database for ﬁnancial statement information on the companies that responded to our survey to determine the impact of this legislation on the availability of ﬁnancial statement information on large private corporations. We also surveyed Chief Financial Ofﬁcers of corporations that were no longer required to have a ﬁnancial statement audit as a result of the change to the CBCA. We began with a listing of companies incorporated under the CBCA. The list was provided to us by Industry Canada (a federal government department). We then identiﬁed all companies from this list that were reported in the CanCorp Plus corporate database, were private companies, and had revenues greater than $10 million or assets exceeding $5 million. We sent a cover letter1 and questionnaire to the chief ﬁnancial ofﬁcers for each of the 896 corporations meeting these criteria. The questionnaire brieﬂy reviewed the change in the Act and asked respondents to indicate what the company’s response to the change had been (i.e. either to continue the audit or to discontinue the audit). Respondents were also asked to provide the most important reason for the company’s decision to continue (or discontinue) the audit. If they discontinued the audit, they were asked to indicate what was done with respect to their ﬁnancial statements (i.e. review engagement, compilation, no involvement of public accounting ﬁrm, or other (explain)).

DEREGULATION OF A MANDATORY AUDIT: JUSTIFICATION AND CRITICISM In Canada, companies are incorporated through either the federal incorporating act (the Canada Business Corporations Act) or one of the provincial/territorial incorporating acts. Incorporating federally is advantageous if one intends to operate in more than one province. Federal incorporation offers nationwide protection for the corporate name. Moreover, a federally incorporated company has the automatic right to be registered in any province. Provincially incorporated companies do not have this right. They must apply to each other province in which they intend to carry on business, and the right to register is granted at the discretion of the province (Georgas, 1986, pp. 3–4).

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An advantage of incorporating provincially, prior to 1994, was that one could avoid the ﬁnancial statement audit/disclosure requirement of the federal legislation. Provincial incorporating acts do not require the ﬁling of audited ﬁnancial statements by large private corporations. Although many of these acts had generally been patterned after the 1975 CBCA, provincial legislators tended not to incorporate this particular provision (Canadian Bar Association, 1994, p. 7). This discrepancy had been the cause of some concern for federal legislators. The Canada Business Corporations Act was amended through Bill C-12. This change was intended to be the ﬁrst of two stages of amendments to this act. Bill C-12 dealt with what the minister perceived to be technical matters, while a future bill to amend the Act would be more substantive (Commons Debates, May 4, 1994, p. 3902). One of these technical amendments was the removal (from paragraph 160) of the mandatory ﬁling of audited ﬁnancial statements for large private corporations.2 The revised provision allowed these companies to forego their annual ﬁnancial statement audit with unanimous consent of the shareholders. This change made Canada’s federal incorporation statute more lenient than the vast majority of OECD and G-7 countries in terms of mandatory audit and ﬁling requirements for private companies. The major exception in this regard is the United States for which the issue of large foreign-owned private corporations is not as important as in Canada and other countries (Sub-Committee on Bill C-12, 1994, p. 1:18). The Brieﬁng Book for Bill C-12, prepared for members of parliament, outlined the justiﬁcation for the CBCA amendment to remove the requirement for large private corporations to ﬁle audited ﬁnancial statements. The justiﬁcation given was that the legal community and private business believed section 160 made the CBCA an unattractive incorporation statute for private corporations. This provision for ﬁling audited ﬁnancial statements “hinders the competitiveness of large CBCA privately-held corporations by releasing valuable corporate proprietary information to their competitors” (Brieﬁng Book, 1994). This justiﬁcation mirrors the Canadian Bar Association’s brief to the Sub-committee on Bill C-12.3 The Bar Association noted that lawyers had been advising their clients to incorporate under a provincial incorporating act rather than under the CBCA because of this particular provision (Canadian Bar Association, 1994, p. 7). In the House of Commons debate on the amendment, the Minister of Industry indicated that, “Mandatory public disclosure of ﬁnancial statements of large private corporations is not required by the provinces, nor is it required by the laws of our major trading partner, the United States.” He also expressed concern that the audit/disclosure requirement “may discourage foreign businesses from

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establishing in Canada, certainly under federal jurisdiction” (Commons Debates, May 4, 1994, p. 3903). Lobbying in response to the proposed amendment did occur. Thirteen written submissions commenting on the proposal were received. These responses were summarized by the Research Branch of the Library of Parliament (Library of Parliament, 1994). Eight respondents supported the elimination of the requirement for large private corporations to ﬁle audited ﬁnancial statements, while four were opposed. One respondent commented only on other aspects of the Bill. The speciﬁc groups/individuals sending submissions and their positions are listed in Table 1. Three of the opponents to the change were accountants (The Canadian Institute of Chartered Accountants and two accounting ﬁrms). The other opponent was a law professor from the University of Toronto. Lobbying also occurred through less formal channels.4 One member of the Sub-Committee on Bill C-12 commented that they had been hearing from large private companies that were threatening to discontinue their incorporation under the CBCA and become incorporated under a provincial jurisdiction (Sub-Committee on Bill C-12, 1994, p. 1:21). Table 1. Lobbying Efforts for Bill C-12. Group or Individual sending Submission on Bill C-12

Position Taken on Clause Removing the Requirement for Large Private Companies to File Audited Financial Statements

Barreau du Quebec – Committee on Corporations and Bodies Corporate Canadian Bar Association – National Business Law Section Canadian Bar Association – Ontario, Business Law Sub-committee Canadian Manufacturers’ Association Conseil du Patronat du Quebec Fraser & Beatty (law ﬁrm) Gilbey Canada Inc.(subsidiary of foreign parent company) The Institute of Corporate Directors Canadian Institute of Chartered Accountants Coopers & Lybrand (assurance services ﬁrm) Ernst & Young (assurance services ﬁrm) Professor Jacob Ziegel (law professor) Association of Universities and Colleges of Canada

Supported Supported Supported Supported Supported Supported Supported Supported Did not support Did not support Did not support Did not support Did not address this clause

Source: Summary of Briefs and Representations on Bill C-12 Amendments to the Canada Business Corporations Act. Research Branch, Library of Parliament.

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The most vocal opponent of the amendment was the Canadian Institute of Chartered Accountants (CICA). In its position paper, the CICA suggested that the proposed amendment would have a detrimental effect on public accountability (because ﬁnancial statements would not be ﬁled) and on the quality of information in the ﬁnancial system (because the ﬁnancial statements may not be audited). The CICA predicted that, “many economically signiﬁcant, federally incorporated, private corporations will regard the elimination of the ﬁling requirement as an invitation from the federal government to eliminate the audit requirement” (CICA, 1992, p. 3).5 They indicated that members of large public accounting ﬁrms were predicting that foreign owners of subsidiary companies would immediately eliminate the audit of the Canadian ﬁnancial statements (p. 4). It should be noted that unanimous consent should be easier to obtain in cases where the company is a wholly owned subsidiary. The CICA also emphasized the importance of the audit in providing credible ﬁnancial information to the marketplace, to the business press, and to government agencies such as Statistics Canada and taxation authorities (p. 6). They pointed out that many stakeholders that beneﬁt from having access to audited ﬁnancial statements will not have sufﬁcient inﬂuence to achieve this in the absence of a legislated requirement (p. 5). The Sub-committee on Bill C-12 met on May 12 and May 31, 1994 to consider the proposed amendments to the CBCA. At the May 12 meeting, the Sub-committee agreed to deal with all the amendments in Bill C-12 in one day (including any representations from interested groups) (Sub-Committee on Bill C-12, 1994, p. 1:14). They also decided that they, as a committee, would not request any witnesses to appear (p. 1:15). However, they did consent to allow two “lobby groups” to appear at their next meeting (May 31, 1994) – the Canadian Bar Association (National Business Law Section) and the Canadian Institute of Chartered Accountants. Representatives of both groups summarized the points made in their written submissions and answered committee members’ questions. In this forum, the CICA cited the Kinney and Martin (1994) study to provide additional support for its contention that the quality of information could suffer in the absence of a mandated audit. Sub-committee members asked the CICA representatives a wide-ranging series of questions, including whether the CICA’s position on the issue might be self-serving.6 The CICA representatives, in response to the questioning, consistently argued that the interest of all stakeholders should be considered – not only those of shareholders and creditors who are able to demand audited ﬁnancial statements for their own use. They suggested more than once that, rather than lowering the audit/disclosure standard to the level of the provincial incorporating

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acts, the federal government should play a leadership role (Sub-Committee on Bill C-12, 1994). However, the CICA representatives’ ability to get these points across seemed to be hampered by suspicion on the part of committee members about the accountants’ motives and fear for the viability of the federal legislation. The other lobby group allowed to speak was the Canadian Bar Association. The representatives of this group successfully positioned themselves as independent parties who were not advocating any particular outcome and were there out of concern for the future of the federal legislation (Sub-Committee on Bill C-12, 1994, pp. 1:34, 1:35, 1:38).7 Following the presentations of the Canadian Institute of Chartered Accountants and the Canadian Bar Association, clause-by-clause study of the Bill’s 33 clauses occurred. This process took just 21 minutes during which time the proposed amendment to remove the requirement for large private corporations to ﬁle audited ﬁnancial statements was approved (Sub-Committee on Bill C-12, 1994). Bill C-12 was passed in the House of Commons two weeks later. A comparison of the circumstances surrounding this instance of deregulation to those surrounding the implementation of a mandated audit in the 1934 U.S. Securities Act reveals some similarities. In both cases, accountants lobbied for a mandatory audit (in 1934 to create a mandatory audit requirement and in 1994 to maintain one). In both cases, the audit issue was of little interest to the legislators. In the Canadian case, the revoking of the audit requirement was considered a mere technical issue. In the American situation, Falk (1989, p. 111) notes that Congress appeared not to be particularly concerned or interested in any requirement for audited ﬁnancial statements. He also notes (p. 107) that “no public cry demanding mandatory audit of ﬁnancial statements of publicly traded ﬁrms was documented during or preceding the pre-legislation debate in Congress. While the New York Stock Exchange and other exchanges strongly opposed the mandatory audit provision, no strong support was voiced by affected parties other than the accountants.” In the Canadian case there was also relatively little interest shown by ﬁnancial statement users in this change to the mandatory audit requirement (Sub-Committee on Bill C-12, 1994, pp. 1:24–1:25). The American Institute of CPAs hired a former judge to lobby on their behalf and apparently, he was the one who convinced the legislators to include a provision in the 1934 Securities Act for the mandatory audit of the ﬁnancial statements of all public companies (Falk, 1989, p. 112). The Canadian Chartered Accountants in years past had a strong inﬂuence in developing disclosure provisions of incorporation legislation (Murphy, 1993a, b). But the attempt to exercise their inﬂuence to retain a mandatory audit/disclosure requirement in 1994 was unsuccessful.

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CONSEQUENCE OF DEREGULATION To look at the immediate consequence of the deregulation in terms of audit retention or discontinuance, we sent out 896 questionnaires to chief ﬁnancial ofﬁcers of ﬁrms affected by the change. Two hundred and ﬁfty-one completed questionnaires were received.8 We asked respondents whether their ﬁrm was subject to other government regulations that required audited ﬁnancial statements. Forty-seven (18.7%) of the respondents indicated that they were. Because these companies were required still to have an audit by government regulation we removed them from the analysis. This left a sample of 204 companies. We found that of the 204 companies in this study, 149 (73.0%) reported that they had continued their ﬁnancial statement audit; 29 (14.2%) downgraded the level of assurance attained to a review engagement (from high to moderate assurance); seventeen (8.3%) purchased no assurance services from a public accounting ﬁrm (two of these had a compilation engagement); and ﬁve companies (2.5%) obtained some assurance on the ﬁnancial statements as part of the parent company’s audit. The Minister of Industry at the time of the change to the legislation believed that the marketplace would require economically signiﬁcant private corporations to provide audited ﬁnancial statements (CICA, 1992, p. 9). The signiﬁcant proportion of companies choosing to retain the audit lends some support to his conﬁdence in the market place. The proportion of companies choosing to continue the audit (73%) is consistent with earlier research that looks at the demand for auditing in other contexts. Chow (1982) studied the demand for audits during the year 1926 for a sample of public companies (this was prior to the mandatory audit for public companies). He found that 75% of these public companies had audits performed that year. Abdel-Khalik (1993) studied a sample of fully manager-owned private American corporations that were not required to have audits. He observed that 77% of these companies had their ﬁnancial statements audited. This proportion didn’t hold true for a group of small American manufacturing ﬁrms (all having fewer than 100 employees). Bareﬁeld, Gaver and O’Keefe (1993) found that only 10% of these companies purchased audit services. Our respondents were asked to provide the most important reason for their company’s decision. The explanations are reported in Tables 2 and 3. The most often cited explanations for audit continuance were lender and owner requirements for an audit. Other respondents wished to provide assurance/comfort about the credibility of ﬁnancial statements to users and/or management. Cost savings represented the single most important reason for reducing the level of assurance services purchased. Falk’s (1989, p. 117) observation that the

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Table 2. Explanation for Continuing Audit. Reasons Given

First reason Number

Lenders require audit Parent company requires audit Owners (general) require audit A desire to provide assurance/comfort about the credibility of the ﬁnancial statements to users and/or management To help obtain ﬁnancing Separation of owners/managers To enhance internal control/security Other services are provided by the auditing ﬁrm Other No reason given Total

Other %

53 40 5 25

35.6% 26.8% 3.4% 16.8%

5 4 2 3

4 2 2 0 10 8

2.7% 1.3% 1.3% 0.0% 6.7% 5.4%

2 1 1 3 6

149

100.0%

27

mandatory audit produces a public good that is paid for by “taxing” companies that are subject to such regulation is relevant here. The companies in this group clearly believe that their own private beneﬁt from an audit was less than the cost that they were bearing. Approximately one-quarter of our respondents chose to reduce the level of assurance services purchased. Most of these companies took advantage of the availability of a moderate level assurance engagement which would provide some level of comfort about the reliability of the ﬁnancial statements. This outcome supports the idea that the review engagement has value for private companies. Others moved directly from obtaining high assurance on their ﬁnancial statements to no assurance.9 This could be a concern from the perspective of the quality of information. Kinney and Martin (1994), in a synthesis of 13 previous research studies of auditor-related adjustments, found that, overall, pre-audited ﬁnancial statements tended to materially overstate results. Another outcome of this deregulation was the impact on the availability of ﬁnancial statement information about these economically signiﬁcant private companies. In order to assess this, we searched for ﬁnancial statement information on our sample of 204 companies in a current version of the CanCorp Plus corporate database. Although ﬁnancial statement information was available for the sample companies prior to 1994, we found that the database did not have ﬁnancial statement information on 202 of these companies after 1994. Of the two remaining companies, one had gone public so had current ﬁnancial statement

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Table 3. Explanation for Reducing Level of Assurance. Reasons Given

First Reason Number

Moderate level of assurance acquired Cost savings Owners don’t require Value of audit is less than cost Canadian operation is immaterial The audit is not useful Will use internal auditors instead Other

Other %

18 3 3 1 1 1 2

62.1% 10.3% 10.3% 3.4% 3.4% 3.4% 6.9%

29

100.0%

8

5 4 2 3 1 1 1

29.4% 23.5% 11.8% 17.6% 5.9% 5.9% 5.9%

3

17

100.0%

6

40.0% 0.0% 20.0% 20.0% 20.0%

0 1

100.0%

1

Audit discontinued but no information provided about new level of assurance Cost savings 1 25.0% Owners don’t require 1 25.0% Value of audit is less than cost 1 25.0% Other 1 25.0%

1

No assurance acquired Cost savings Value of audit is less than cost Will use internal auditors instead Canadian operation is immaterial Owners don’t require The audit is not useful No reason given

Some assurance acquired as part of parent company audit Cost savings 2 Owners don’t require 0 Will use internal auditors instead 1 Value of audit is less than cost 1 Other 1 5

4 Total discontinuing

55

100.0%

2

2 4

3

0

1 16

information available and the other had ﬁnancial statement information up until ﬁscal 1996 which had been obtained directly from the company. The federal legislators’ choice to deregulate audit/disclosure requirements made incorporating legislation in all Canadian jurisdictions more consistent with that of

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the United States. It seems that our geographic proximity continues to cause an evolution of the regulatory environment away from its European roots and towards that of the United States, in spite of the fact that there are important differences between the economic environments of the two countries.

CONCLUSION Over the last century and a half, governments have from time to time amended statutes to increase the scope of mandatory audit requirements, and have on some occasions reduced the scope of these requirements. The 1994 amendment to the Canada Business Corporations Act has provided an opportunity to study such a reduction in scope. The deregulation of the ﬁnancial statement audit occurred as a result of pressure from large private corporations and the legal profession to dispense with the requirement to ﬁle audited ﬁnancial statements. This change resulted in a “leveling of the playing ﬁeld” by bringing the federal legislation in line with provincial and American incorporation statutes. It could be argued that the leveling was achieved by moving to the lowest common denominator. A substantial majority of the companies responding to our survey did retain their ﬁnancial statement audit. The most prevalent explanations for this choice were that lenders and/or owners needed audited ﬁnancial statements. Shareholders and some lenders can wield sufﬁcient inﬂuence to demand audited ﬁnancial statements. Other stakeholders such as employees, labor unions, special interest groups, and members of the public seldom have this advantage. Unfortunately, because the ﬁnancial statements are no longer on public record, these other stakeholders no longer have ready access to ﬁnancial statement information for these economically signiﬁcant companies. The results of our study suggest that a number of large private corporations acquired a lower level of assurance or even no assurance on the reliability of their ﬁnancial statements as a result of the 1994 change to the Canada Business Corporations Act. This choice has undoubtedly increased the risk of misstatement for these companies’ ﬁnancial statements. The events of 2002 have led us to an increased awareness of the social cost that occurs when capital markets do not have credible ﬁnancial information. From the discontinuing companies’ perspective, their action (made possible by the change in the CBCA) has produced private costs savings. As a result, stakeholders of these companies no longer have access to audited ﬁnancial statements – a private cost saving in exchange for the loss of a public good.

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NOTES 1. The cover letter asked for their voluntary participation in this research, assured participants that their responses would be kept conﬁdential and indicated that they had the right not to participate if they so chose. 2. The treatment of this as a technical matter did attract some criticism both in the parliamentary debate and in the written responses to the proposed amendment. 3. The full title of this sub-committee is “The Sub-committee on Bill C-12: An Act to amend the Canada Business Corporations Act and to make consequential amendments to other Acts of the Standing Committee on Industry.” In this paper we will use the shorter title, The Sub-committee on Bill C-12. 4. It should be noted that these representations were not made at sub-committee hearings – only two groups, the Canadian Bar Association and the Canadian Institute of Chartered Accountants were formally heard by the sub-committee. 5. A signiﬁcant proportion of Canada’s largest companies are classiﬁed as private companies and compete directly with public companies who would still be required to disclose audited ﬁnancial statements. In the early 1990s, it was estimated that half of the Globe and Mail’s Report on Business’s top 300 corporations in Canada were wholly-owned subsidiaries of foreign parent companies, and were thus classiﬁed as private (Canadian Institute of Chartered Accountants, 1992, p. 5). 6. The ﬁrst question asked of the CICA representatives was this (translated from the original French): “As you must be aware, the members of this sub-committee have been for some time asked upon by your opponents to maintain, as is, clause 16 of Bill C-12. Their main argument is that according to them, chartered accountants are of no use and that the information given to the public is not a priority. In fact, what concerns them above all, is to maintain their jobs. What is your answer to the arguments of your opponents?” (Sub-Committee on Bill C-12, Minutes May 31, 1994, p. 1:21). Other questions addressed such issues as: the discrepancy between provincial companies acts and the federal act on the ﬁling requirement for private corporations (Sub-Committee on Bill C-12, Minutes May 31, 1994, pp. 1:22–1:24); the existence of threats by large private companies to change from federal to provincial incorporation and the resulting danger to the viability of the federal Act (pp. 1:21, 1:24); the fact that banks, institutional investors and investment houses did not come to the hearings to defend the need for audited ﬁnancial statements (p. 1:24); the contention that the public disclosure requirement puts large private federally incorporated companies at a competitive disadvantage relative to other companies(p. 1:21); and that ﬁnancial statements are not very important in any case (p. 1:27). 7. During the presentation and the ensuing question period, the CBA representatives argued that: shareholders and creditors can arrange to have audited ﬁnancial statements provided to them if they so choose; the public disclosure requirement of the CBCA represents a disincentive to incorporate under that Act; lawyers and other advisors commonly advise clients not to incorporate federally; and that private companies have expressed concern to them about the privacy of their information (Sub-Committee on Bill C-12, 1994). 8. This represents a response rate of 28% of the total mailing of 896 questionnaires and a response rate 32% of the 788 delivered. 108 of the 896 questionnaires mailed out were returned uncompleted/undelivered. Because fewer than 100% of those surveyed responded, the possibility of non-response bias exists. Although there is no satisfactory solution to this problem, we were able to determine that at reasonable levels of signiﬁcance, there was

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no difference between respondents and non-respondents in terms of company size (total assets) and capital structure (debt/asset ratio) (Total assets: t = 0.572, p > 0.10; Debt/asset ratio: t = 0.677, p > 0.10). We also compared the proportion of companies discontinuing the audit for early and late respondents and found no signiﬁcant difference between these groups (Chi-square = 0.258, 1 df, p > 0.10). 9. One cannot help but wonder if the sometimes onerous disclosure requirements of GAAP that are primarily for the beneﬁt of users of public companies’ ﬁnancial statements had some bearing on the decision of some companies to discontinue the audit.

ACKNOWLEDGMENTS The authors gratefully acknowledge the ﬁnancial support of the Canadian Academic Accounting Association. We also thank the Canadian Institute of Chartered Accountants and the Corporations Branch of Industry Canada for their assistance; Jennifer Senkow for her research assistance; and the editor and anonymous reviewers for their helpful comments.

REFERENCES Abdel-Khalik, A. R. (1993). Why do private companies demand auditing? A case for organizational loss of control. Journal of Accounting, Auditing & Finance, 8(1), 31–52. Bareﬁeld, R. M., Gaver, J. J., & O’Keefe, T. B. (1993). Additional evidence on the economics of attest: Extending results from the audit market to the market for compilations and reviews. Auditing: A Journal of Practice & Theory, 12(1), 74–87. Benston, G. J. (1985). The market for public accounting services: Demand, supply and regulation. Journal of Accounting and Public Policy, 4, 33–79. Brieﬁng Book – An Act to amend the Canada Business Corporations Act for CBCA. Section 160(1) (1994). Canadian Bar Association, National Business Law Section (1994). Commentary to the Sub-Committee on industry of the standing committee on Bill C-12: An Act to Amend the Canada Business Corporations Act and to make consequential amendments to other acts (May). Canadian Institute of Chartered Accountants (1992). Private corporations and public accountability: A position paper on the audit and ﬁling requirements for economically signiﬁcant federally incorporated private corporations (June). Chow, C. W. (1982). The demand for external auditing: Size, debt and ownership inﬂuences. The Accounting Review, 57(2), 272–291. Commons Debates (1994). Government of Canada (May 4). Falk, H. (1989). A comparison of regulation theories: The case for mandated auditing in the United States. Research in Accounting Regulation, 3, 103–123. Georgas, M. S. (1986). Federal Incorporation & Business Guide. Vancouver: International Self-Counsel Press Ltd. Iacobucci, F., Pilkington, M. L., & Prichard, J. R. (1977). Canadian business corporations. Agincourt, Ontario: Canada Law Book Limited.

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Kinney, W. R., & Martin, R. D. (1994). Does auditing reduce bias in ﬁnancial reporting? A review of audit-related adjustment studies. Auditing: A Journal of Practice & Theory, 13(1), 149–155. Library of Parliament, Research Branch (1994). Summary of briefs and representations on Bill C-12, amendments to the Canada Business Corporations Act. Prepared for the Sub-Committee on Bill C-12 of the House of Commons Standing Committee on Industry (May 19). Murphy, G. (1979). The evolution of corporate reporting practices in Canada. In: E. N. Coffman (Ed.), The Academy of Accounting Historians Working Paper, Series (Vol. 1, pp. 329–368). Birmingham, AL: The Academy of Accounting Historians. Murphy, G. (1993a). Financial statement disclosure and corporate law: The Canadian experience. In: G. Murphy (Ed.), A History of Canadian Accounting Thought and Practice (pp. 437–449). New York: Garland Publishing. Murphy, G. (1993b). A chronology of the development of corporate ﬁnancial reporting in Canada: 1850 to 1983. In: G. Murphy (Ed.), A History of Canadian Accounting Thought and Practice (pp. 519–550). New York: Garland Publishing. Ng, D. S. (1979). Supply and demand for auditing services and the nature of regulations in auditing. In: S. Davidson (Ed.), The Accounting Establishment in Perspective: Proceedings of the Arthur Young Professors’ Roundtable 1978. Virginia: The Council of Arthur Young Professors. Parker, R. H. (1986). The development of the accountancy profession in Britain to the early twentieth century. Birmingham, AL: The Academy of Accounting Historians. Previts, G. J. (1985). The scope of CPA services: A study of the development of the concept of independence and the profession’s role in society. New York: John Wiley & Sons. Stacey, N. A. H. (1954). English accountancy: A study in social and economic history. London: Gee and Company (Publishers) Limited. Sub-Committee on Bill C-12 (1994). Minutes of proceedings and evidence of the sub-committee on Bill C-12, an Act to amend the Canada Business Corporations Act and to made consequential amendments to other Acts, of the Standing Committee on Industry. Ottawa: Queen’s Printer for Canada. Wallace, W. A. (1980). The economic role of the audit in free and regulated markets. The Touche Ross Aid to Education Program, 1980. (Reprinted in Auditing Monographs, New York: Macmillan Publishing Co., 1985.) Wallace, W. A. (1987). The economic role of the audit in free and regulated markets: A review. Research in Accounting Regulation, 1, 7–34.

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SFAS 95 CASH FLOW INFORMATION AND SECURITIES VALUATION Sulaiman A. Alaraini, Joanne P. Healy and Ray G. Stephens ABSTRACT This paper examines the effect of the changing presentation of cash ﬂow information in SFAS No. 95 on securities valuation. The study shows that SFAS No. 95 provides beneﬁts to the securities market from improved relationships between cash ﬂow information and securities valuation. Results indicate that cash ﬂows have incremental information content for market values beyond earnings after SFAS No. 95 became effective in 1988. Additionally, bid-ask spreads before and after SFAS No. 95 are examined. Bid-ask spread is found to decrease signiﬁcantly between the period 1986–1987 and the period 1989–1990. Overall, our results suggest that SFAS No. 95 had an impact on the market microstructure, supporting regulators enactment of standards such as SFAS No. 95 intended to improve the quality and content of accounting information.

INTRODUCTION Earnings announcements reported in The Wall Street Journal (WSJ) usually consists of the accounting earnings and earnings per share amounts. Release of annual reports may occur either before or after the earnings announcement

Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 243–255 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160152

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in the WSJ. Annual reports include substantial amounts of information such as cash ﬂow related items in addition to earnings. Investors should have been able to estimate cash ﬂows from ﬁnancial statements prior to Statement of Financial Accounting Standard (SFAS) No. 95. Because estimates of cash ﬂows could have been different, the question is whether SFAS No. 95 provides additional value-relevant information to investors by reducing estimation differences. This study investigates whether information required by SFAS No. 95 improves the quality of accounting information. The value relevance of cash ﬂow information is the impact of SFAS No. 95 since the information required and the presentation format were so different from that required by previous accounting standards. Ketz and Largay (1987) noted that there was no precise deﬁnition of cash provided from operations under SFAS No. 95’s predecessor, Accounting Principles Board (APB) No. 19. Prior to the effective date of SFAS No. 95, ﬁrms were allowed much discretion over the format used to prepare their Statement of Changes in Financial Position (SCFP), the statement under APB Opinion No. 19. The two most commonly used bases for the SCFP were the cash basis and the working capital basis. Financial statements prepared using the cash basis showed the net change in cash for the accounting period and the cash sources (inﬂows) and uses (outﬂows) from activities which led to this change. Financial statements prepared using the working capital basis showed the increase or decrease in working capital for the accounting period and listed the activities which led to the net increase or decrease in working capital. Ketz and Largay (1987) found inconsistencies in how ﬁrms classiﬁed events as operating or non-operating on the SCFP such as classiﬁcation of interest, dividend revenue from marketable securities, gains or losses on the sale of plant and equipment, and the extinguishment of debt. These inconsistencies in reporting operating cash ﬂow would allow investors to make different interpretations when estimating a ﬁrm’s cash ﬂow. Two reasons are usually provided for SFAS No. 95 being issued to replace APB Opinion No. 19. First, there was the lack of clear objectives for the SCFP since ﬁrms were allowed a wide range of choices in format and deﬁnition of funds. Second, there was a growing recognition of the signiﬁcance of cash ﬂow information and SFAS No. 95 requires ﬁrms to prepare a statement of cash ﬂows (SCF).1 SFAS No. 95 deﬁnes three categories of activities (operating, investing, and ﬁnancing) to be presented on the SCF and provides deﬁnitive guidance for classifying cash inﬂows and outﬂows into these categories. The FASB issued SFAS No. 95 believing that the new standard would provide ﬁrms with better guidance on how to report cash ﬂow components. We examine the incremental information content of cash ﬂows focusing on the period following the requirement to follow SFAS No. 95 (after July 1988) and by comparing this subsequent period to a period prior to the effective date of SFAS No. 95.

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The beneﬁts of SFAS No. 95 are examined: (1) by empirically investigating the relationship between cash ﬂows and stock returns upon the release of annual reports before and after the effective date of SFAS No. 95; (2) by comparing results using estimated versus reported cash ﬂows; and (3) by examining the bid-ask spreads before and after the effective dates.2

HYPOTHESES The Effect of SFAS No. 95 on the Association between Unexpected Cash Flows and Stock Returns We should see a market reaction when the annual reports are released if cash ﬂows provide information to investors beyond earnings. The association between unexpected cash ﬂows and stock returns is examined by testing the following two null hypotheses: H1. Unexpected cash ﬂows (UCF) have no incremental information content beyond that of earnings prior to SFAS No. 95. H2. UCF have no incremental information content beyond that of earnings subsequent to SFAS No. 95.

A Comparison of the Information Content of SFAS No. 95 Operating Cash Flows with Estimates of Operating Cash from SCFP The effectiveness of revised standards for ﬁnancial reporting of cash ﬂows is whether there is an improvement in information content between investor estimates prior to SFAS No. 95 and reported cash ﬂows under SFAS No. 95. The effectiveness is examined by testing the following null hypothesis: H3. There is no signiﬁcant difference in the incremental information content of UCFs between the pre and post SFAS No. 95 periods. These hypotheses are tested using data from two periods: 1986–1987 (pre SFAS No. 95) and 1989–1990 (post SFAS No. 95).

The Impact of SFAS No. 95 Tested by Examining Bid-Ask Spreads Lev (1988) argues that the beneﬁts of disclosure requirements which are intended to reduce asymmetric information can be tested by examining a ﬁrm’s bid-ask

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spread. Lev argues that information asymmetry decreases should result in bidask spread decreases. As the amount or quality of information increases, bid-ask spreads should decrease. Security dealers provide a service in the market by matching buy and sell orders and by holding an inventory of stock. The difference between the dealer’s selling price (ask) and the buying price (bid) is known as the bid-ask spread and represents compensation to the dealer for services.3 A dealer will increase the bid-ask spread as information asymmetry increases in order to compensate for the losses from transactions with informed traders. Several studies have examined the impact of reduced information asymmetry on bid-ask spreads. Hagerman (1972, 1975) and Hagerman and Healy (1992) found no impact from regulation of the banking industry. Raman and Tripathy (1993), Greenstein and Sami (1994), and Boone (1998) found that bid-ask spreads are reduced when ﬁrms provide more detailed disclosures. Coller and Yohn’s (1997) results show that bid-ask spreads decline subsequent to management forecasts providing support for Lev’s argument. The results of previous studies suggest that more detailed accounting information may reduce information asymmetry and lead to decreases in bid-ask spreads. If SFAS No. 95 improves the quality or amount of information, we expect bid-ask spreads to decrease. This leads to the following null hypothesis: H4. There is no signiﬁcant difference in the bid-ask spreads between the pre and post SFAS No. 95 periods.

SAMPLE SELECTION, METHODOLOGY, AND VARIABLES Sample Selection The sample was selected as follows: (1) (2) (3) (4)

Firms were available on COMPUSTAT. Only 12/31 year end ﬁrms were used. Earnings announcement dates were available in the WSJ. Annual report ﬁling dates were available in Lexis/Nexis for 1986, 1987, 1989, and 1990. (5) The daily market returns for the period (−239, +60) were available in CRSP for the years 1986–1991.4 (6) Bid/ask quotes were listed on the Francis Emory Fitch Sheets for the last trading day of each quarter for years 1986, 1987, 1989, and 1990.5

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Only ﬁrms whose annual report date follows that of the earnings announcement are included in the sample.6 The ﬁnal sample consists of 132 ﬁrms or 528 ﬁrm years. The information required are obtained from COMPUSTAT, CRSP, and the Francis Emory Fitch Company. When reviewing the reporting pattern of the sample ﬁrms, we noted that some ﬁrms ﬁled the 10-K and annual reports at different dates. Also, some ﬁrms sent amendments pertaining to their ﬁnancial statements after they had ﬁled their 10-K form. Bernard and Stober (1989) examined the effect of ﬁling the 10-K and annual reports at different times on the incremental contribution of cash ﬂows and conclude that the results are not materially sensitive to the timing of ﬁling. Like Wilson (1987) and Bernard and Stober (1989), we use the ﬁling date of annual reports as the event date. Summary of Tests Performed Three tests were performed to assess the change in the incremental information content of cash ﬂows after SFAS No. 95. The ﬁrst assessment is made by regressing the cumulative abnormal returns (CAR) against the unexpected component of cash ﬂows (UCF) around the release of ﬁnancial statements. The second assessment is a comparison of the information provided in SFAS No. 95 with investor estimates based on APB No. 19 information. The two periods (before and after SFAS No. 95) are combined and an estimated measure of the amount of cash ﬂows is used. Third, empirical tests of the impact of SFAS No. 95 on bid-ask spreads was performed. Tests for Market Reactions to Cash Flows The effect of the release of annual reports on the market, after the announcement of earnings in the WSJ, is examined using the following model which is the same model used by Wilson (1987) and Bernard and Stober (1989) which is presented in Appendix A.

Tests for Beneﬁts of Disclosure by Examining Changes in Bid-ask Spreads Several early studies examined the determinants of bid-ask spreads. Demsetz (1968), Tinic (1972), Tinic and West (1972), Benston and Hagerman (1974), Stoll (1976), and Hamilton (1976, 1978) found price to be an important determinant of spread. Their results consistently show that as price increases, spread increases or relative spread decreases.

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Table 1. Selected Studies on the Incremental Information Content of Cash Flows. Study

E(CF) Proxy

Wilson (1986)

Pooled time-series cross-section estimation Same Same Random walk and time-series (holdout method) Random Walk Random Walk Random Walk Random Walk

Wilson (1987) Bernard and Stober (1989) Rayburn (1986) Bowen et al. (1987) Livnat and Zarowin (1990) Ali (1994) Cheng et al. (1997)

Testing Period 1982–1984 1982–1984 1977–1984 1963–1982 1973–1981 1974–1986 1974–1988 1988–1993

Volume has also been found to be a signiﬁcant explanatory variable (Benston & Hagerman, 1974). As trading volume increases, bid-ask spreads decrease because of the reduction in inventory holding costs (Demsetz, 1968).7 We test the hypothesis that SFAS No. 95 led to reductions in asymmetric information using the model presented in Appendix B.

Cash Flow Variables Used in the Study An estimated cash ﬂow variable is required for some of the tests performed in this study. A summary of some studies that have examined the market reaction to estimated cash ﬂows and accruals is presented in Table 1. There is no agreement among researchers on the proxies that should be used for estimated cash ﬂows. We use the estimation method used by Wilson (1987) and Bernard and Stober (1989) in developing measures of estimated operating cash ﬂows. Reported operating cash ﬂows for the post-SFAS No. 95 period is the operating cash ﬂow deﬁned by SFAS No. 95 (item No. 308 in COMPUSTAT). Estimated cash ﬂows for both periods are determined as working capital less change in receivables less change in inventory plus change in accounts payable plus tax payable.

EMPIRICAL RESULTS AND DISCUSSION The Incremental Information Content of Cash Flows to Earnings One measure of unexpected cash ﬂows (UCF), a measure based on estimated cash ﬂows, is available prior to SFAS No. 95 (the measure is also available subsequent

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Table 2. Results of Cross-Sectional OLS Regression: CARjt = aˆ 0 + aˆ 1 UCFjt + a˚ jt . aˆ 0

aˆ 1

Adj-R

Panel A: UCF Based Estimated Cash Flow, 1986, 1987, 1989, and 1990 All Years 0.007* −0.043* 0.0231 (2.549) (−3.083) 1986, 1987 0.008** −0.053* 0.045 (2.211) (−2.992) 1989, 1990 0.006 −0.033 0.011 (1.486) (−1.521) Panel B: Reported Cash Flow, 1989 and 1990 All Firms 0.004 (1.125)

0.083* (3.279)

0.050

F-Value 9.505* 8.950* 2.312

10.751*

Notes: t-statistics are in parentheses. UCF = [CF(year t) − CF(year t − 1)]/MV(year t − 1). The CARs are estimated over testing period: −4, +4. ∗ Signiﬁcant at the 1% level. ∗∗ Signiﬁcant at the 5% level.

to the effective date of SFAS No. 95). The ﬁrst question here is whether the only available measure, the estimate-based UCF, has information content when it was available. Panel A of Table 2 shows three tests of the estimate-based UCF. The ﬁrst test is whether the estimate-based UCF has information content over the entire test period, the pre- and post-SFAS No. 95 periods. The estimate-based UCF for all years is signiﬁcant, but the signiﬁcance appears to be due only to its signiﬁcance in the pre-SFAS No. 95 period. Thus, Hypothesis 1 is rejected in this study. This information content result is inconsistent with the ﬁndings of Bernard and Stober (1989), but consistent with the ﬁndings of Wilson (1987). A second measure of UCF, a measure based on reported cash ﬂows is available after the effective date of SFAS No. 95. The results of the test of information content of the reported-based UCF are reported in Panel B of Table 2. The reported-based UCF is signiﬁcant during the period after the effective date of SFAS No. 95. Thus, Hypothesis 2 is rejected. The rejections of both Hypotheses 1 and 2 indicated that UCF have information content in both periods, even though the basis of cash ﬂows used to prepare the UCF measures changes between the periods. One explanation for this ﬁnding is that investors ﬁnd reported cash ﬂow components to be more value-relevant in the sense that they can be used to predict future cash ﬂow. Note, however, that this ﬁnding does not mean that accounting earnings do not convey useful information to the market, since we do not test for the information content of earnings. Our sample includes only ﬁrms which

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previously announced earnings. Investors would have previously incorporated earnings information in stock prices. Since annual ﬁnancial statements are released approximately three months after annual earnings are announced, investors would have previously incorporated earnings information in stock prices at the time of the release of the ﬁnancial statements. Focusing on the period following the effective date of SFAS No. 95, the results on the relationship between unexpected cash ﬂows and market returns around the release of annual reports reveal that cash ﬂows have incremental information content beyond that of earnings.8 The coefﬁcient of unexpected cash ﬂows is positive and signiﬁcant at conventional levels when the change in the reported operating cash ﬂows is used.

Comparing Pre-SFAS No. 95 and Post-SFAS No. 95 UCF Measures A comparison of the UCF measures pre-SFAS No. 95 (the estimate-based UCF) and post-SFAS No. 95 (the reported-based UCF) can be made using the results reported in Table 2. Hypothesis 3 speciﬁes that there is no change in the incremental information content due to SFAS No. 95. Hypothesis 3 is rejected for two reasons. First, the estimate-based UCF has a signiﬁcant negative coefﬁcient during the pre-SFAS No. 95 period while the reported-based UCF has a signiﬁcant positive coefﬁcient in the post-SFAS No. 95 period. Second, the estimate-based UCF is not signiﬁcant in the post-SFAS No. 95 period while the reported-based UCF is signiﬁcant. These two results indicate that UCF measures have information content and that the reported-based measure of SFAS No. 95 is preferred in the period when it became available. What we examine is whether the information content of information in the ﬁnancial statements other than earnings changes subsequent to SFAS No. 95. The results suggest that cash ﬂows have information content beyond that of earnings. Results also suggest that the cash ﬂows from operations under SFAS No. 95 provided value-relevant information to investors not provided previously from cash ﬂow related items under APB No. 19.9 This difference in results between SFAS No. 95 operating cash ﬂows and estimated cash ﬂows is important to accounting regulators. The SFAS No. 95 operating cash ﬂows are being valued by investors while the estimate of cash ﬂows used in this research is not.

Tests for Beneﬁts of Disclosure by Examining Changes in Bid-Ask Spreads Descriptive statistics and non-parametric tests for signiﬁcant differences in bidask spreads are presented in Table 3. Results show that the spreads signiﬁcantly

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Table 3. Descriptive Statistics: Means (Standard Deviations in Parentheses). (t-Tests for Differences in the Means) BID 1986, 1987

32.81 (21.72) 27.88 (18.88) 2.68*

1989, 1990 t-test ∗ Signiﬁcant

VOL 133,999.46 (196,823.20) 134,232.02 (215,641.76) −2.01**

SPREAD 0.266 (0.121) 0.231 (0.112) 4.59*

at the 1% level. at the 5% level.

∗∗ Signiﬁcant

Table 4. Results of Cross-Sectional OLS Regression: LREL = a´ 0 + ␤1 LPRICE + ␤2 YEAR + ␤3 VOL.

All 4 years

a´ 0

␤1

1.26* (−19.79)

−0.79* (−67.02)

␤2 −0.12* (−6.85)

␤3

Adj. R2

−0.08* (−14.88)

0.73

F-Value 1789.85*

Notes: t-values are in parentheses. LREL = (Ask−Bid)/{(Ask + Bid)/2}. LPRICE = natural logarithm of the bid price. LVOL = the natural logarithm of the trading volume. YEAR = 1 for years 1989 and 1990. Year = 0 for years 1986 and 1987. ∗ Signiﬁcant at the 1% level. ∗∗ Signiﬁcant at the 5% level.

decreased after SFAS became effective allowing us to reject null Hypothesis 4. Results also indicate that trading volume signiﬁcantly increased. Multivariate tests are presented in Table 4. The signs are as expected for all coefﬁcients. The coefﬁcient for the dummy variable representing the pre- and post-time periods, YEAR, is negative and signiﬁcant providing further support for the rejection of null Hypothesis 4 after controlling for price and volume. Bid-ask spreads decrease after SFAS No. 95 became effective. The results indicate that spreads decrease signiﬁcantly between the period 1986–1987 and the period 1989–1990, suggesting that SFAS No. 95 may have an impact on the market microstructure.

SUMMARY AND CONCLUSIONS The primary focus of this study is to examine whether SFAS No. 95 provides useful information to the securities market. A determination that SFAS No. 95 is

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useful to the securities market indicates the standard setting activity was effective when SFAS No. 95 replaced prior disclosures under APB Opinion No. 95. This study examines the difference in the incremental information content of cash ﬂows around the release of annual reports over the periods 1986–1987 (pre-SFAS No. 95) and 1989–1990 (post-SFAS No. 95). Evidence suggests that the change in operating cash ﬂows required by SFAS No. 95 does provide incremental information to the securities market beyond that provided by earnings announcements. An interesting ﬁnding is the difference in the results using estimated cash ﬂows and the results using reported cash ﬂows for the 1989–1990 period. When cash ﬂows are estimated similar to Wilson (1987) and Bernard and Stober (1989), an insigniﬁcant negative coefﬁcient is obtained. However, when we use reported cash ﬂows for the same period, the coefﬁcient is positive and signiﬁcant. This suggests that investors use reported operating cash ﬂows provided under SFAS No. 95 in preference to estimates required to be made under APB Opinion No. 19. Estimates of cash ﬂows derived from APB Opinion No. 19 required information did not have signiﬁcant information content prior to the effective date of SFAS No. 95. The results are strengthened by the ﬁndings about the effect of the statement of cash ﬂows on bid-ask spreads. The bid-ask spread decreased and trading volume increased in the period subsequent to the enactment of SFAS No. 95. When price and trading volume are controlled for, OLS regression results indicate that bidask spreads signiﬁcantly decreased subsequent to SFAS No. 95 strengthening the previous ﬁndings that SFAS No. 95 does provide useful information to the capital market. Overall, results of all tests indicate that SFAS No. 95 improves the quality and content of accounting information for valuing securities. The effectiveness of standard setters in changing accounting standards is important to the functioning of the capital markets. These overall results indicate that effective standard setting occurred for cash information, especially because a reported accounting measurement replaced the need for user estimates in the valuation of securities.

NOTES 1. Financial Accounting Standards Board (1987) Statement of Cash Flows, Statement of Financial Accounting Standards No. 95 (November). 2. The present study as well as those of Wilson (1987) and Bernard and Stober (1989) does not address the question of whether cash ﬂow is superior to earnings. Several studies have examined this issue (see for example, Dechow, 1994). A study by Cheng et al. (1997) examines the association between components of cash ﬂows and market returns only for the period after the issuance of SFAS No. 95. Charitou and Clubb (1999) examined the

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incremental information content of cash ﬂow variables and the incremental information content of accounting earnings and cash ﬂows over several time intervals using U.K. data. 3. The spread is set by security dealers to cover three types of costs: order transaction costs, inventory holding costs, and information costs (Stoll, 1976). Order transactions costs are the costs of executing the transaction. Inventory holding costs are the costs of holding a non-diversiﬁed portfolio of securities. This research does not test the effect of order transaction costs or inventory holding costs on bid-ask spreads, but focuses on the third type of cost, information costs. Information costs are the costs incurred by the dealers from trading with informed traders. 4. Because we purchased only the bid and ask prices for the NYSE from the Francis Emory Fitch Company, the sample is limited to NYSE ﬁrms. 5. This research is not intended to measure changes in the bid-ask spread upon the release of annual reports. The purpose is to test whether the average bid-ask spread declined subsequent to SFAS No. 95. The cost of purchasing data for each trading day in 1986, 1987, 1989, and 1990, prevented us from using all trading days in these four years. To control for confounding events, however, we selected the last trading day of the quarter in each of the four years. 6. Wilson (1987) and Bernard and Stober (1989) limit their sample ﬁrms to those whose annual report release date follows the earnings announcement in the WSJ by at least seven days. In this study, the only requirement is that the annual report date should not precede the earnings announcement date. 7. Callahan et al. (1997) provide a more comprehensive summary of studies on the determinants of bid-ask spreads. 8. Bernard and Stober (1989) examined the relationship between the cash ﬂows and abnormal returns over the period 1977–1984. A proxy for expected cash ﬂows similar to Wilson’s (e.g. a pooled time-series cross-sectional estimation method) was used by Bernard and Stober. Bernard and Stober’s results failed to support the hypothesis that cash ﬂows provide information content beyond earnings in periods other than the fourth quarters of 1981 and 1982. This was for a period prior to SFAS No. 95. 9. The results for Eq. (1) do not change substantially when the market model method is used to estimate the values of the CARs. 10. We also tested the periods (−1, 1) and (−10, 10) and found no difference in our results and therefore, report only (−4, 4) for comparisons to Wilson (1987) and Bernard and Stober (1989).

REFERENCES Ali, A. (1994). The incremental information content of earnings, working capital from operations, and cash ﬂows. Journal of Accounting Research (Spring), 61–74. Benston, G., & Hagerman, R. (1974). Determinants of bid-ask spread in the over-the-counter market. The Journal of Financial Economics, 3, 353–364. Bernard, V., & Stober, T. (1989). The nature and amount of information in cash ﬂows and accruals. The Accounting Review (October), 624–652. Boone, J. (1998). Oil and gas reserve value disclosures and bid-ask spreads. Journal of Accounting and Public Policy, 17, 55–83.

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Bowen, R., Burgstahler, D., & Daley, L. (1987). The incremental information content of accruals versus cash ﬂows. The Accounting Review (October), 723–747. Callahan, C. M., Lee, C. M. C., & Yohn, T. L. (1997). Accounting information and bid-ask spreads. Accounting Horizons (December), 50–60. Charitou, A., & Clubb, C. (1999). Earnings, cash ﬂows and security returns over long return intervals: Analysis and U.K. evidence. Journal of Business Finance & Accounting (April/May), 283–312. Cheng, C. S. A., Liu, C., & Schaefer, T. (1997). The value-relevance of SFAS No. 95 cash ﬂows from operations as assessed by security market effects. Accounting Horizons (September), 1–15. Coller, M., & Yohn, T. (1997). Management forecasts and information asymmetry: An examination of bid-ask spreads. Journal of Accounting Research (Autumn), 181–191. Dechow, P. (1994). Accounting earnings and cash ﬂows as measures of ﬁrm performance: The role of accounting accruals. Journal of Accounting and Economics (July), 3–42. Demsetz, H. (1968). The cost of transacting. Quarterly Journal of Economics, 82(1), 33–53. Financial Accounting Standards Board (1987). Statement of cash ﬂows. Statement of ﬁnancial accounting standards No. 95 (November). Greenstein, M., & Sami, H. (1994). The impact of the SEC’s segment disclosure requirement on bid-ask spreads. The Accounting Review (January), 179–199. Hagerman, R. L. (1972). The value of regulation F: An empirical test. Journal of Bank Research (Autumn), 178–185. Hagerman, R. L. (1975). A test of government regulation of accounting principles. The Accounting Review (October), 699–709. Hagerman, R. L., & Healy, J. P. (1992). The impact of SEC-required disclosure and insider-trading regulations on the bid-ask spreads in the over-the-counter market. Journal of Accounting and Public Policy (Fall), 233–243. Hamilton, J. (1976). Competition, scale economics, and transaction cost in the stock market. Journal of Financial and Quantitative Analysis, 11(5), 779–802. Hamilton, J. (1978). Marketplace organization and marketability: NASDAQ, the stock exchange, and the national market system. Journal of Finance, 33(2), 487–503. Ketz, J. E., & Largay, J. A., III (1987). Reporting income and cash ﬂows from operations. Accounting Horizons (June), 9–17. Lev, B. (1988). Toward a theory of equitable and efﬁcient accounting policy. The Accounting Review, 63, 1–22. Livnat, J., & Zarowin, P. (1990). The incremental information content of cash-ﬂow components. Journal of Accounting and Economics (May), pp. 25–46. Raman, K., & Tripathy, N. (1993). The effect of supplemental reserve-based accounting data on the market microstructure. Journal of Accounting and Public Policy (Summer), 113–133. Rayburn, J. (1986). The association of operating cash ﬂow and accruals with security returns. Journal of Accounting Research (Supplement), 112–133. Stoll, H. (1976). Dealer inventory behavior: An empirical investigation of NASDAQ stocks. Journal of Financial and Quantitative Analysis, 11(3), 359–380. Tinic, S. (1972). The economics of liquidity services. Quarterly Journal of Economics, 86(1), 79–93. Tinic, S., & West, R. (1972). Competition and the pricing of dealer service in the over-the-counter stock market. Journal of Financial and Quantitative Analysis, 7(3), 1707–1728. Wilson, P. (1986). The relative information content of accruals and cash ﬂows: Combined evidence at the earnings announcement and annual report release date. Journal of Accounting Research (Supplement), 165–200. Wilson, P. (1987). The incremental information content of the accrual and funds components of earnings after controlling for earnings. The Accounting Review (April), 293–321.

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APPENDIX A Model for Tests of Unexpected Cash Flows and Stock Returns CARjt = aˆ 0 + aˆ 1 UCFjt + a˚ jt

(A.1)

where: CARjt is the cumulative abnormal returns for ﬁrm j at time t. UCFjt is the unexpected cash ﬂows for ﬁrm j at time t, measured as the difference between cash ﬂows at time t minus cash ﬂows at time t − 1 scaled by the market value of the ﬁrm at time t − 1. a˚ jt is the error term. The dependent variable CAR in Eq. (A.1) is measured as follows: ARjt = R jt − R mt

(A.2)

where: ARjt is the abnormal return for ﬁrm j at day t. Rjt is the market return for ﬁrm j at day t. Rmt is the market return index at day t. j is the ﬁrm index. t is the day index. t = −4, 0, 4. The cumulative abnormal returns (CAR) over the testing periods: −4, +4 are used as the dependent variable in Eq. (1).10

APPENDIX B Model for Tests of Bid-Ask Spreads LREL = a´ + ␤1 LPRICE + ␤2 LVOL + a˚ where: LREL is the natural logarithm of (ask − bid)/[(ask + bid)/2] LPRICE is the natural logarithm of the bid price LVOL is the natural logarithm of trading volume

(B.1)

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PART III: PERSPECTIVES

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A LONG FALL FROM GRACE How Accountants Frittered Away Their Franchise

David Mosso ABSTRACT For over a century the accounting profession held a franchise for self regulation founded on a commitment to serving the public interest. Public interest is the thread that runs through and binds together the principles stated in the profession’s code of ethics. For all practical purposes, our profession was created by the business community in recognition that business self-interest and the public interest coincided in the need to restrain deceptive ﬁnancial reporting. By failing to successfully regulate itself, the accounting profession has failed to serve society’s objective and the public interest. This franchise has now been given over to the Public Company Accounting Oversight Board, a government agency in all but cosmetic details as a consequence of the passage of the Sarbanes-Oxley Bill of 2002. What comes next as to the processes of regulation affecting the accounting profession? The partisan bickering surrounding the creation of the new Public Company Accounting Oversight Board and the Board’s lawyerly composition are sad consequences of a profession that lost its way and in its wanderings lost its long-standing self-regulatory franchise. For over a century the accounting profession held a franchise for self-regulation founded on a commitment to serving the public interest. Public interest is the thread that runs through and binds together the principles stated in the profession’s

Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 259–264 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160164

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DAVID MOSSO

Fig. 1.

code of ethics. When the Sarbanes-Oxley legislation caught ﬁre in late July, the accounting profession stood by, frantic but helpless, as all but a fragment of its franchise for self-regulation was sucked into the vortex of public outrage. The franchise was dropped into the lap of the Public Company Accounting Oversight Board, a government agency in all but cosmetic details. How could that happen? It seemed sudden like an unexpected volcanic eruption. But, in fact, the eruption had been building up for decades. Here is a brief history of the accounting profession’s self-immolation. As a backdrop, recall that the CPA’s contribution to the ﬁnancial markets and to public conﬁdence rests on the effective functioning of what might be called the credibility triangle (Fig. 1). On one corner of that triangle is GAAP, or generally accepted accounting principles. On a second corner is GAAS, or generally accepted auditing standards. On the third corner is the audit OPINION. The audit opinion says essentially that the auditor used professional auditing procedures to examine the company’s ﬁnancial statements, which were based on professional accounting principles, and found that, in the auditor’s professional judgment, the statements are, or are not, a fair presentation. There is rot in the foundation of the credibility triangle, but more on that later. Establishing and enforcing professional standards is the very essence of any profession’s responsibility. The AICPA, the American Institute of Certiﬁed Public Accountants, assumed that responsibility many years ago. At one time, the AICPA established professional standards for all three corners of the credibility triangle: for GAAP, for GAAS, and for a group of professional standards that underpin the integrity of the audit opinion, namely, standards for ethical conduct, standards for maintaining auditor independence, and standards for quality control over a public

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261

Fig. 2.

accounting ﬁrm’s practice. The AICPA also had responsibility for enforcing the standards (Fig. 2). In 1973, under great pressure from the Congress because of perceived deﬁciencies in the accounting standard setting process, the AICPA surrendered a major piece of its self-regulatory franchise, the right to set accounting standards (Fig. 3). That function was transferred to the Financial Accounting Standards Board, a private sector not-for-proﬁt entity independent of the AICPA. Again in 1977, under pressure from the Securities and Exchange Commission, the AICPA surrendered another piece of its franchise, the standards for quality control, to a new semi-independent Public Oversight Board. That Board was to ride herd on quality control standards centered on peer reviews of one accounting ﬁrm by another ﬁrm. Then in 1997, after protracted negotiations with the Securities and Exchange Com-

Fig. 3.

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DAVID MOSSO

Fig. 4.

mission, the AICPA grudgingly acceded to the establishment of an Independence Standards Board to deal with consulting services and other auditor independence issues. All three of those more or less independent Boards were symptomatic of the AICPA’s inability to establish and police effective professional standards. Then came the latest eruption. Enron was thrown up by the ﬁrst belch of the volcano. WorldCom was next. The Sarbanes-Oxley Act surfed the lava ﬂow like Lucifer cavorting on the river Styx. When it was over, the AICPA was a hollow shell. It had lost control over all professional standards, the substance of the profession. Auditing, ethics, independence, and quality control standards and their enforcement are now vested in the Public Company Accounting Oversight Board. Accounting standards remain with the Financial Accounting Standards Board (Fig. 4). The AICPA retains an education role, including administering the CPA examination. Even there Sarbanes-Oxley gave it a slap in the face because the new Public Company Accounting Oversight Board will administer a merit scholarship program funded by penalties imposed on errant accountants! The AICPA also retains the one thing it was really good at – lobbying. The irony is that in opposing constraints on audit ﬁrms’ free-wheeling business practices, the AICPA’s lobbying successes created a bunch of cannibalistic creatures that turned around and ate their parent. The three more or less independent boards cited above were by no means the only small eruptions that preceded the grand ﬁnale embodied in the SarbanesOxley Act. There were countless AICPA special committees and studies along the way, almost always a result of external pressures stemming from accounting

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scandals. In retrospect, the reaction was always too little, too late. And as noted above, there was rot accumulating in the credibility triangle. In the auditing standards corner of the triangle, the biggest source of rot has always been the profession’s unwillingness to come to grips with ﬁnancial fraud. Every bankruptcy involving massive fraud leads the public to ask “Where were the auditors?” And invariably the auditors answer “Audits are not designed to detect fraud.” So they are not. But the public keeps asking “Why not?” And the auditors keep replying in many words, best summarized by a shrug. This dialog has been repeated going back at least to the Cities Service holding company scandal of the 1920s, the McKesson Robbins bankruptcy of the 1930s, the Equity Funding scandal of the 1960s, the Penn Central bankruptcy of the 1970s, the savings and loan ﬁasco of the 1980s, and on to the Enron, WorldCom, you-name-it scandals of the early twenty-ﬁrst century. Stripped of control over its core professional standards responsibilities, the AICPA ﬁnally seems to have got it. In a speech at the Yale Club in September, Barry Melancon, AICPA CEO, outlined six leadership goals for the post-SarbanesOxley era. Four of them involved fraud detection or prevention of some sort. Once upon a time, the AICPA could have taken the fraud issue and run with it. Now it must bow ﬁrst to the new government oversight board. The accounting standards corner of the credibility triangle also has one dominant source of rot. That is free-choice accounting standards, meaning that a variety of answers can be obtained and defended for any one transaction without being in violation of GAAP. An ancient and prosaic example is inventory valuation in which the well-known ﬁrst-in-ﬁrst-out versus last-in-ﬁrst-out methods produce widely different results. Examples involving ﬁnancial instruments, particularly derivative instruments and leases, are more hair-raising. The existence of free-choice standards ﬁrst became a public policy issue with the stock market crash of 1929. It took the accounting profession ten years after the crash to establish the Committee on Accounting Procedure. It took the profession twenty more years to concede that Committee’s failure, attributable to inability to signiﬁcantly reduce the body of free-choice standards. The Accounting Principles Board came next. It lasted almost ﬁfteen years, failing again largely because of its inability to signiﬁcantly reduce the body of free-choice standards. The Financial Accounting Standards Board took over in 1973. It acknowledged the problem of free-choice standards and undertook to develop a Conceptual Framework aimed directly at developing principles that would eliminate or narrow the choice of accounting methods. Nonetheless, the Board has, in its turn, failed to signiﬁcantly reduce the number of free-choice standards. The swampland of free-choice standards has had two consequences. First, it has subverted the accounting standard-setting process by changing it from a

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search for the best accounting measurement methods (oriented to security buying investors) to a search for lobbyist-infested legislative-style solutions similar to the tax code (oriented to security selling corporations). Second, it has put undue pressure, seemingly irresistible, on those auditors whose professional judgment is genuinely geared to the public interest as professional ethics mandates. Conversely, it has unduly reduced pressure on those auditors whose professional judgment is subordinated to self-interest. Thus, the predominance of free-choice accounting standards has contributed greatly, if indirectly, to erosion of the profession’s ethical, independence, and quality control standards. Adam Smith, the great philosopher of laissez faire markets, presaged the need for regulation of business with his remark “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public . . .” Regulation does not, however, have to imply government regulation; it can be voluntary self-regulation compatible with a free market philosophy. The very existence of the accounting profession is a prime example. For all practical purposes, the profession was created by the business community in recognition that business self-interest and the public interest coincided in the need to restrain deceptive ﬁnancial reporting. By failing to regulate itself, the accounting profession has failed to serve that business self-interest objective as well as the public interest. What comes next for the accounting profession? I will not predict, but I will conclude with two reminders. First, governments almost never give back regulatory prerogatives so at best we will henceforth have to live with an accounting profession operating on the edge of being a public utility. If future audit performance does not shape up, we can expect the government noose to tighten and the public utility model to encroach further. Second, the Financial Accounting Standards Board still retains its private sector status, but with the Sarbanes-Oxley Act it too took a step toward government dependence through a government-imposed “user fee” to cover any deﬁcit the Board may have from its private sector ﬁnancing. If free-choice accounting standards continue to offer loopholes for deceptive ﬁnancial reporting, accounting standards could go the way of auditing standards into the maw of the Public Company Accounting Oversight Board. Think about that and shudder. Accounting standards being set by ﬁve lawyers with politicians looking over their shoulder!

REMARKS OF DONALD J. KIRK: INDEPENDENCE, AUDIT EFFECTIVENESS AND FRAUDULENT FINANCIAL REPORTING RECIPIENT – THE BRADEN AWARD 2001–2002 WEATHERHEAD SCHOOL OF MANAGEMENT CASE WESTERN RESERVE UNIVERSITY

Donald J. Kirk ABSTRACT This presentation delivered by Donald J. Kirk on November 27, 2001 is one of the few public addresses made by a member of the Public Oversight Board prior to the disclosures and subsequent public debate which preceded action by the members of the Board to discontinue its operations. In his remarks Mr. Kirk addresses three issues which continue to be central to the debate and the concerns affecting the role of auditors in the contemporary capital market: (1) independence and scope of services of the auditing ﬁrms; (2) the recommendations of the Panel on Audit Effectiveness; and (3) fraudulent ﬁnancial reporting. It is indeed an honor to be recognized with the Braden award in my old hometown. Since I left, almost ﬁfty years ago, a great deal has happened –

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to this university, to this city, to this world, and on a much smaller scale, to the profession that I have devoted more than forty of those years. I have no intention of covering those forty years or all the roles I have played during that time as an auditor, standard setter, professor, overseer and audit committee member. There is enough happening currently involving my role as an overseer – as vice-chairman of the Public Oversight Board – to more than ﬁll the time allotted to me today. After a few words about the Public Oversight Board, I would like to comment on three subjects – ﬁrst, the independence and scope of services of the auditing ﬁrms; second, on some of the recommendations of the Panel on Audit Effectiveness; and lastly, on fraudulent ﬁnancial reporting. The change in administration in Washington is an interesting backdrop to, and integral ingredient in, the current considerations of these subjects, thus no remarks would be complete without some observations on that major event.

THE PUBLIC OVERSIGHT BOARD – WHAT IS IT? The Public Oversight Board, known as the POB, is a ﬁve member board with a ﬁve person, full-time professional staff, supplemented with signiﬁcant part-time assistance from highly qualiﬁed, retired professionals. The Board was established in 1977 as part of the self-regulatory program now carried out for approximately 1200 ﬁrms. About 800 of those ﬁrms audit the ﬁnancial statements of at least one SEC registered company and the other 400 ﬁrms voluntarily participate in the program. It is these 1200 ﬁrms that comprise the SEC Practice Section of the American Institute of CPAs (AICPA). The major self-regulatory elements of the Practice Section’s program are peer review and inquiry into alleged audit failures. While the scope of the POB’s activities has recently been expanded beyond the Practice Section (and I will say more later about the new charter that deﬁnes its role) the Board continues to be a monitor of and reporter on, but not a director or manager of, those self-regulatory programs. I am now the longest serving member of the present POB, having served since 1995. The chairman of the Board is Charles Bowsher, former Comptroller General of the United States. The other members are Norman Augustine, former Chief Executive Ofﬁcer of Lockheed Martin, Aulana Peters, former practicing attorney and SEC commissioner, and John Biggs, the present Chief Executive Ofﬁcer of TIAA-CREF. Our most recent past members are Melvin Laird, a former Secretary of Defense and Paul O’Neill, the present Secretary of the Treasury. The Board has had many other distinguished members in its twenty-ﬁve year history, but that membership has not kept it free from criticism, for when the auditing profession

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or one of the major ﬁrms is criticized, its overseers, rightly or wrongly, come in for some of the blame.

THE CHANGE IN ADMINISTRATION – WHAT DOES IT MEAN? It makes sense to note at this time an important change impacting the subjects of my remarks – the change in administration, or more precisely the change in leadership at the SEC. No other position has such a pervasive and continuing impact on ﬁnancial reporting and the auditing profession. However, at times members of Congress, especially the chairs of relevant committees in the House and Senate, have had signiﬁcant impact. At the present time John Dingell, a congressman with a continuing interest in those subjects, is in the minority party and, therefore cannot call for hearings, but he continues to be heard from via letters to the SEC and the POB and via requests to the Government Accounting Ofﬁce (GAO) for investigations. I experienced a signiﬁcant change in SEC leadership during my chairmanship of the Financial Accounting Standards Board – from an activist, Democratic chairman, Harold Williams, to a more laissez-faire Republican, John Shad. But, that change pales in comparison to the change from Chairman Arthur Levitt to Chairman Harvey Pitt. Chairman Levitt was active right to the end and during his last months was at war with the leadership of the AICPA and a majority of the large ﬁrms. Chairman Pitt arrived having been, as a practicing attorney, an advocate for some of the positions of the auditors in those war-like struggles with the SEC. The auditing profession’s hopes were very high that the relationship with the SEC would become more civil and less adversarial. With regard to the former – civility – the profession has not been disappointed. The olive branch that Chairman Pitt extended at the meeting of the AICPA’s governing Council in October was, I have read, greeted with a standing ovation. Is civility needed in the relationship? Absolutely. The relationship had become too adversarial; each side (there were several) resorted to pulling political strings and backroom bargaining. At the end of his tenure even Chairman Levitt recognized that the relationship needed patching. However, many eyes, including those of Congressman Dingell, are on Chairman Pitt to see if civility translates into softness, or as a headline to a Floyd Norris article in the New York Times one month ago, put the question: “Harvey Pitt’s SEC: From Guard Dog to Friendly Puppy?” As much as the new administration might like to change or undo what the old did, the press will shine light upon

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what the new administration proposes, and the defenders of what the old administration did will rally political support in an attempt to thwart or slow a new administration.

A LOOK-BACK AT THE LEVITT ADMINISTRATION Before commenting on the present situation, I should let you know how I feel about the prior administration at the SEC. Its leader, Arthur Levitt, is an intelligent, disciplined, motivated, persuasive (and charming) individual. He has disavowed ever being just a caretaker of whatever he undertakes. He has a strong sense of public service and the drive to push for what he thinks is right. I believe his instincts are good and the issues he identiﬁed and pursued were the right ones. His tactics were designed to achieve his ends. If you agreed with those ends, the tactics were viewed favorably, or at least admired for their audacity, but, if you did not agree with the ends, the tactics were viewed as heavy-handed or unfair. I give Arthur high marks, except in his last actions on auditor independence. Three structural changes, with which I am familiar, that Levitt brought about were signiﬁcant achievements – at the National Association of Securities Dealers (where I serve as a public governor), at the Financial Accounting Foundation (which oversees and funds the Financial Accounting Standards Board) and with the role of corporate audit committees. In all three cases he enhanced the role of independent overseers charged with protecting the public interest. He helped bring about a similar, but short-lived, structural change in the process for establishing independence standards for the auditing profession.

INDEPENDENCE AND THE SCOPE OF SERVICES OF AUDITING FIRMS The Public Oversight Board was an early and active player in urging the establishment of a non-governmental process for the establishment of the independence rules for auditors of public companies. The then Chief Accountant of the SEC, Mike Sutton, was supportive; Chairman Levitt endorsed the idea, and after negotiations with the AICPA, the Independence Standards Board (ISB) was formed – in a manner consistent with reconstitution of the National Association of Securities Dealers and of the Financial Accounting Foundation to include public members. The ISB, unfortunately, came under suspicion (on the part of the SEC) that it would be a pawn of the profession, in part because the ﬁrst submission to it was

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a white paper calling into question the dictates and process of the SEC and suggesting that the ﬁrms themselves become a main safeguard against independence violations. (The main orchestrator of the paper was Harvey Pitt and the profession’s focal point in its preparation was Bob Herdman, now Chief Accountant of the SEC.) This suspicion was compounded by the discovery of numerous independence violations by the two predecessor ﬁrms comprising PriceWaterhouse Coopers (PWC). I do not believe that Mike Sutton’s successor, Lynn Turner, ever bought into this non-governmental approach. Possibly, the PWC violations may have been what made him skeptical and distrustful. Also the rush of middle-size auditing ﬁrms to join up with publicly-owned entities and the intentions of several of the largest ﬁrms to dispose of the bulk of their consulting practices triggered negotiations with the SEC about the numerous independence issues related to these transactions. Frustration in dealing with those issues and with the ISB, sent the SEC down the track of addressing the age-old issue of scope of services and searching for the smoking gun that would justify severe restriction or prohibition of auditors’ providing non-audit related consulting services to their publicly-owned audit clients. I will not recite the well-known outcome of the SEC’s efforts, but sufﬁce it to say this period of political arm twisting and backroom negotiating was not the SEC’s (and, in some ways, not the profession’s) ﬁnest hour. (For an excellent analysis of the these events, I recommend a soon-to-be published article by Ralph S. Saul and Zoe-Vonna Palmrose entitled, “Not the Finest Hour: The SEC’s Rulemaking on Non-Audit Services.”) While I am sure the profession wants no further restrictions on or scrutiny of non-audit services, I believe this is one of those issues that just will not go away as long as major audit failures happen on engagements with signiﬁcant non-audit services. I do not mean to suggest there is a cause and effect between audit failures and non-audit services, but there is a perception that the additional income from such services might undermine the objectivity and integrity of the auditor. On the other hand, the record is also clear that many major audit failures happen when there is little or no such other services. With issuance of the independence rules by the SEC and the undercutting in those rules of a private sector ISB activity, it was just a matter of time before the funeral of the ISB. That funeral, which has taken place, was a very unfortunate outcome of this SEC initiative. The POB urged the formation of the ISB and protested against its burial. This is one instance wherein I would like to see a roll-back of the old administration’s actions. Another carry-over aspect of compliance with independence rules that the new administration has to deal with is the result of an agreement between the SEC and the largest ﬁrms. The POB was not a party to that agreement or consulted in its

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drafting. The agreement, a follow-on to the PWC independence violations, called for each of the largest ﬁrms to engage independent counsel to review independence compliance for a period of time ending on March 31, 2000. (Those reviews have been completed and ﬁled with the SEC. The SEC has not yet published a report on the results of those reviews.) The agreement also notes that new independence systems and procedures are to be in place for the year 2001 and calls for the ﬁrms to: “submit to review and oversight by the POB of the effectiveness of the design and implementation of these systems, procedures, and internal controls, and to testing by the peer reviewers or the POB of their effectiveness.” The POB (which, I say again, was not party to the agreement) is instructed to issue public written reports. For the last year the POB has been in inconclusive discussions with the ﬁrms about the scope of these reviews, the nature and content of the called-for reports and the conﬁdentiality of, and access to, the working papers supporting these reviews. As a result no work on the ﬁrms’ systems has commenced but substantial costs have been incurred by the personnel engaged by the POB to conduct these reviews as a result of these protracted discussions and the on-again off-again planning for these reviews. The ﬁrms are now looking to the SEC to clarify the agreement with the hoped-for result of reducing the scope of the reviews and the content of the POB’s report. The SEC wants this leftover business done quickly and at the staff level seems to want to accommodate the ﬁrms, but the Commission is in the spotlight and obviously will not want to be labeled, in the words of the New York Times, a “friendly puppy.” So far, the POB position has been that if the ﬁrms and SEC clarify or modify the agreement and explain the changes in a way that will withstand public scrutiny, the POB will do what is agreed to. Stay tuned; this should play out over the next several weeks.

THE RECOMMENDATIONS OF THE PANEL ON AUDIT EFFECTIVENESS Another initiative of the Levitt administration was its focus on management of earnings and fraudulent ﬁnancial reporting. As a result of Chairman Levitt’s prodding and his “Numbers Game” speech in September 1998, the POB formed the Panel on Audit Effectiveness, chaired by Shaun O’Malley. That Panel issued its landmark report in August of last year and the POB is devoting signiﬁcant time to monitoring the implementation of the excellent recommendations in that report. The POB will publicly report on the status of implementation as of the end of this year. Faithful implementation of these recommendations will go a long way to improving the effectiveness of auditing.

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THE POB’S NEW CHARTER Tangled up in all the ﬂurry of activity in the last years of the Levitt administration about scope of service were questions about the governance of the auditing profession and its self-regulatory programs. Formal consideration of governance became one of the charges given to (or assumed by) the O’Malley Panel. One of the eight chapters in the Panel’s report is entitled, “Governance of the Auditing Profession.” Keep in mind that the AICPA is a voluntary, professional organization that does not license CPAs and has a vast membership of which it is estimated that less than ten percent is involved in audits of public companies. This voluntary organization sets ethical, quality control and auditing standards. It is also the umbrella organization and employer of staff that supports the peer review and quality control inquiry committees of the SEC Practice Section. While the AICPA has over the years been very responsive to any well-founded criticisms of the manner in which it carries out its public-like responsibilities, the web of responsibilities of state boards of accountancy, state legislators and federal regulators in the governance of the auditing profession result in a system that no one with a clean sheet of paper would design. Thus, the criticism of this byzantine governance system recurs. The AICPA’s self-regulatory program is dependent upon the voluntary participation and cooperative behavior of its members. That is a signiﬁcant commitment on the part of AICPA members, particularly in view of the fact that the system is not protected, i.e., it is not subject to legislation that protects the conﬁdentiality of the process. Under the present circumstances the members require reasonable assurance that participation will not jeopardize their legal rights or unfairly damage their professional reputations by inadvertent or forced disclosure of the inner workings of the program. To avoid doing that, disciplinary actions are in large part delayed until lawsuits and SEC investigations are resolved, and the working papers related to peer reviews and quality control inquiries are destroyed as soon as practicable. While the O’Malley Panel stated it would support legislation that would protect the conﬁdentiality of the process, it concluded that achievement of such legislation was problematic. In view of that outlook, the Panel’s proposal, in part, was to mitigate the limitations of the current self-regulatory system “by building on the POB’s experience and reputation and giving it increased authority.” That increased authority was recommended to include oversight of the Auditing and Independence Standards Boards. That expanded role and suggested operational changes affecting the POB were recommended to be incorporated into a new charter that the Panel urged be agreed to by the POB, SEC, AICPA and the major ﬁrms. With the war raging

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among those other parties, the POB’s charter became a hostage to that war and the discussions leading up to its ﬁnalization dragged on for close to a year. After that long gestation period, it is fair to say that the result was like an elephant giving birth to a mouse. Yes, the span of the POB’s activities was broadened and the charter provisions do ensure that the POB will receive the necessary funding to do its expanded role, but as the charter makes clear, “the POB’s role is oversight and not management.” I do not mean to disparage this broadening of scope or suggest that “oversight, not management,” is some new limitation, for it is not. While the ISB has been buried and the role, if any, of the AICPA in establishing independence standards for auditors of publicly-owned companies is yet to be determined, the oversight by the POB of the Auditing Standards Board (ASB) will prove, I believe, to be a way of insuring that the public interest in those standards is not overlooked. A point I want to make is that the POB does not have command and control of the self-regulatory program; it cannot function without the cooperation of those it oversees. The POB recently explained the nature and limitations of its powers in a submission to the General Accounting Ofﬁce. The GAO became involved because of a request from Congressman Dingell on January 17, 2001 that the GAO’s 1996 report on the profession and its governance be updated in view of the O’Malley Panel recommendations. Congressman Dingell asked for a report on “the status of the profession’s response to the Panel’s recommendations, and the likelihood that the reforms, if implemented, will be effective.” While the GAO was in the early stages of its work in response to the January request, Congressman Dingell followed up in June with further requests of the GAO, asking for inquiry into “the adequacy and effectiveness of the SEC’s oversight of the profession’s governance system”; for inquiry into the “adequacy and effectiveness of the response of the governance system to the string of major accounting debacles”; and, for inquiry into “the adequacy and effectiveness of the response of the governance system . . . to ensure compliance with SEC and ﬁrm independence regulations.” If that were not enough, Congressman Dingell has recently written directly to the POB. This letter, I believe, contains the seeds of the next serious examination of the profession’s governance structure – certainly if the Democrats gain control of the House, but may be even without that. In that November 16th letter Congressman Dingell writes “to request that the POB conduct an oversight review or special investigation of Arthur Andersen LLP” as a result of its alleged audit failure at Enron and some past unfavorable ﬁndings concerning that ﬁrm. Congressman Dingell cites an article in the POB’s charter as the basis for his request. The pertinent part of the article referred to by the congressman reads as follows:

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. . . the POB is authorized: . . . To conduct oversight reviews and to undertake other projects and actions, after consulting with the EC (i.e., the Executive Committee of the SEC practice Section), on matters covered by the POB’s activities that the POB deems appropriate to protect the public interest.

In an earlier article in the charter there is a similar description of the POB’s “authority” but with an additional admonition to the POB that it should note “the factor of conﬁdentiality” in carrying out oversight reviews. Based on my earlier comments on the issues holding up the POB’s reviews of the ﬁrms’ independence systems, I am sure you can imagine the issues that this request raises about conﬁdentiality of and access to working papers. Wisdom suggests that I say no more about this subject in view of the fact that the POB will be discussing its response to Congressman Dingell at a regularly scheduled meeting next week. However, what is legitimate to talk about further is Congressman Dingell’s focus in that letter on alleged earnings management and the slide down the slippery slope to fraudulent ﬁnancial reporting. That too, was a major focus of the O’Malley Panel report.

EARNINGS MANAGEMENT AND FRAUDULENT FINANCIAL REPORTING One of the eight chapters in the Panel’s report is entitled, “Earnings Management and Fraud.” This chapter of the report and its recommendations probably have the greatest potential for enhancing the value of an audit and demonstrating to the public that the profession takes seriously its responsibility to provide reasonable assurance that ﬁnancial statements are free of material misstatements caused by fraud. Reducing the incidence of fraudulent ﬁnancial reporting is not a simple matter. It must be attacked from several directions. Recent actions and some now underway will be a big help. The bolstering of the role of audit committees is an important step. The requiring of auditors to report to audit committees about the quality of ﬁnancial reporting, not just its acceptability, should be an early warning system that a company may be on that slippery slope that leads to fraudulent reporting. Tightening up the materiality “loop-hole” by the SEC staff in a Staff Accounting Bulletin was a great step, but more needs to done in that area, as suggested by the O’Malley report, to eliminate the language in the auditing literature that allows two ways to make the materiality assessment. The requirement for auditors to show audit committees the schedule of adjustments proposed but not made, should be another step to smoke out problems before they become an embarrassment or result in fraudulent ﬁnancial reporting.

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The AICPA is considering how it can be a force in attacking the problem of fraudulent ﬁnancial reporting on a broad front. I commend the Institute for working on such an effort. But on a more narrow front the auditing profession has a challenge and an opportunity to enhance its own prevention and detection efforts. The Panel report contains sound suggestions for improving the training by ﬁrms of audit staff members in the detection of fraud, and sound suggestions for how the peer review and quality control inquiry activities can be enhanced to contribute to the lessening of ﬁnancial reporting fraud. However, the real opportunity for the profession is to set the stage for these other efforts by replacing Statement on Auditing Standards No. 82, Consideration of Fraud in a Financial Statement Audit, with a new auditing standard that is responsive to the recommendations of the O’Malley Panel. The Auditing Standards Board has opened up its process to the POB, has been attentive to our observations and is working diligently on a new proposed standard to replace SAS 82. When asked how the POB will judge whether the new standard is responsive to the O’Malley Panel recommendations, my short answer is as follows: If the ASB members (and the ﬁrms that the members represent) believe and so tell the profession and the public that the new standard does two things – ﬁrst, in the words of the Panel, it requires “an attitudinal shift in the auditor’s degree of skepticism”; and, second, again in the words of the Panel, it “effects a substantial change in auditors’ performance and thereby improve(s) the likelihood that auditors will detect fraudulent ﬁnancial reporting” – then, assuming the ﬁrms act accordingly, the profession will have succeeded and the public will beneﬁt.

THE “INFORMATION RIGHT” AND THE CPA PROFESSION Gary J. Previts ABSTRACT A profession is a skilled association of individuals who profess to serve the public interest above their own self-interest. In the market driven, versus mandate driven accountancy world of the 1980s and 1990s where competition was unleashed at the direction of an AICPA-FTC accord, the orientation was top line – expand the use of skill sets to meet market demands for the knowledge services related thereto. As the Y2K bubble burst and 2001–2002 events unfolded, much as the survivors of a shipwreck, individual CPAs, their leadership and practice units are picking through the philosophical ﬂotsam and jetsam strewn about their environment. Serving the public’s information right is identiﬁed as the proper orientation for our profession’s domain. In their writings over seventy years ago, Berle and Means identiﬁed the issue of agency [the separation of ownership and management] as a principal issue in corporate governance. The Modern Corporation and Private Property has inﬂuenced and directed public policy and academic research ever since. The premise of their issue relates to a constitutional phenomenon, the right of citizens to privately own productive property. An examination of this “right”, given the events following the December 2001 declaration of bankruptcy by Enron and the June 2002 revelations about WorldCom, would seem valuable in a capital market society seeking to reorient itself, and an accountancy “profession” labeled as being more an “industry” than the former. A profession is a skilled Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 275–277 © 2003 Published by Elsevier Science Ltd. ISSN: 1052-0457/PII: S1052045702160188

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association of individuals who profess to serve the public interest above their own self-interest. In the market driven, versus mandate driven accountancy world of the 1980s and 1990s where competition was unleashed at the direction of an AICPA-FTC accord, the orientation was top line – expand the use of skill sets to meet market demands for the knowledge services related thereto. As the giddy heights of the late 1990s markets were achieved, driven by what Federal Reserve Chairman Greenspan infamously termed “irrational exuberance” . . . there seemed to be no end to the scope of service expansion, up to and including the acquisition of major law ﬁrms by the globally expanding Big Five Professional Services ﬁrms [aka “the accounting industry”]. As the Y2K bubble burst and 2001–2002 events unfolded, much as the survivors of a shipwreck, individual CPAs, their leadership and practice units are picking through the philosophical ﬂotsam and jetsam strewn about their environment. The largest object aﬂoat is SOX [Sarbanes-Oxley], the Federal legislation of July 2002 which attempts to specify a new social contract for a foundering profession. It is a mandate to supplant the market driven mania of the score of years of an expansive view to CPA scope of service. Our language is developing new terms such as “cascade effect” – the likelihood that the restrictions on scope of service speciﬁed in SOX will extend to non-public corporate practice as well as to public company SEC registrations, and there is vigilance at the State Society of CPA level for signs of “sympathetic” state legislation or regulation that could establish similar mandates. In the midst of this change there appears to be no lack of insight from persons who are best known for their media appearances and criticism of those upon who’s watch these events have taken place. Critics abound, and their message is often direct and simple. “Return to what we were before all of the market driven changes occurred . . . and we will redeem our destiny.” But is that the answer? In most human experience the fact of the matter is that you cannot go back. Rather, fundamentals must be realigned, we must adapt. “Adapt what?” you may say? Adapt our role in society to the recognition that today we serve a nation of investors, individual and institutional, in a far more fundamentally important way than we previously recognized. For the role which accountants play in providing capital markets information goes further than functioning as the “go between” identiﬁed in Berle and Means model of separation of ownership and control. Indeed our role goes to the heart of the constitutional right to own private productive property. For of what value is the fundamental constitutional right to own private productive property if there is not a fully served “right” to the information about the uses of that property? What rational investor would put capital at risk

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without proper information about the performance of that capital? Serving the public’s information right is our profession’s domain, just as surely as society has preserved advocating individuals’ personal rights as the domain of the bar. Serving this right is both a social contract and an implied constitutional mandate. We serve the public interest today by preparing, assuring, assessing, analyzing and relating information to millions of 401(k) individual investors and institutional intermediaries who are relying on our skills to provide information fundamentals about performance and control imbedded throughout the corporate and investment communications process. The implications of our task, to serve this information right, are substantial. More details will begin to manifest themselves in the political processes which are now shaping themselves in the post-mid-term election period. A greater attention to and awareness of the implications of serving this information right now seems clear as well as important.

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PART IV: BOOK REVIEWS

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PRO FORMA BEFORE AND AFTER THE SEC’S WARNING: A QUANTIFICATION OF REPORTING VARIANCES FROM GAAP By Wanda Wallace, Published by FEI Research Foundation, 2002.

Reviewed by Julia Grant This study presents a detailed content analysis covering pro forma reporting from three different periods: October 2000–February 2001, prior to FEI-NIRI’s presentation of guidelines; September 2001 after those guidelines were released but before the SEC’s advisory about these reports; and December 2001– early 2002 following the SEC advisory to both reporting companies and investors on how pro forma disclosures should be discussed and interpreted. Wallace uses the Yahoo! Finance website to collect press releases for each period. The releases are then analyzed for inclusion of pro forma earnings disclosures. This study provides a rich set of information and related analysis that, similar to articles previously published in this journal and other outlets, points to the need for greater understanding, as well as a discussion of further regulation of this arena. As happens with content analysis, the author has generated a signiﬁcant amount of data. A detailed appendix is provided that includes speciﬁc non-GAAP terms used by 78 companies. These data indicate the complexity of the task in front of the user of this sort of ﬁnancial information. Wallace’s more detailed analyses presented in the text indicate the pressing need for such users to understand this information, even in the face of its complexity. Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 281–283 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S105204570216019X

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Wallace uses a sample taken on February 13, 2001 to document various references and deﬁnitions for the pro forma measure “EBITDA” (earnings before interest, taxes, depreciation, and amortization). She collects further data from October 2000 and presents comparisons of ﬁnancial analysis data for companies that disclosed EBITDA versus those that did not, and additional comparisons of the discloser companies against the entire Compustat database. She ﬁnds that these EBITDA companies are bigger but have lower net income compared to both groups. The net income of the EBITDA reporters “is a median loss, while the Compustat median is positive; the same . . . for the basic EPS . . .” (p. 9). The second time period sample, taken to address whether ﬁrms are following the FEI-NIRI best practices, ﬁnds that other terms for pro forma earnings (besides EBITDA) were becoming more common. Detailed information on the various terms that were used and the differing levels of disclosure within these information releases is provided, along with a determination of how many of these companies followed the FEI-NIRI guidelines. About half of the companies were following the guidelines that call for disclosures to enable reconciliation between a pro forma disclosure and GAAP. While it is encouraging that some were voluntarily complying with best practices, still about half were not. Again, the overall statistics are consistent with the reporting ﬁrms’ using non-GAAP measures to improve their ﬁnancial appearance. The third analysis sample, taken in a time period following the SEC warning, comes from the same source and again documents a number of different types of pro forma adjustments to GAAP measures. As with the ﬁrst time period, the ﬁnancial proﬁle comparisons of pro forma companies to others again demonstrate a lower set of EPS measures for the companies that report pro forma numbers. For this time period, Wallace also addresses the use of these terms within regulatory ﬁlings in such locations as ﬁnancial statement notes and management discussion and analysis pages. In this monograph Wallace addresses and documents the wide variations in nonGAAP terminology. She also suggests that some standardization of terms may be appropriate. This, of course, is what GAAP provides, a (large) set of standardized terms and procedures that allow for some degree of comprehension. An extension of the notion of common deﬁnitions to non-GAAP terminology may well be a useful step. And further steps are needed in order to address the larger issue of how market participants may or may not be able to use the information provided. It is important to remember that even if we can agree on the meaning of pro forma terms,1 this does not necessarily translate into full understanding of what they might represent. This important monograph points out some other questions that must be addressed, for example, “Why . . . do some companies see a need to normalize reported numbers?” (p. 46). Other such questions that may occur to the

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reader include speculation about why the ﬁnancial analysis community so readily and unquestioningly accepts non-GAAP and/or ill-deﬁned terms, or about what might be the effects of recent regulatory and legislative actions on these unregulated reporting practices.

NOTE 1. On October 8, 2002, The Wall Street Journal reported that the National Investor Relations Institute (NIRI) has created guidelines for use of pro forma earnings numbers. These include a recommendation that GAAP earnings always appear ﬁrst to ensure that information users are aware of the differences. However, these NIRI recommendations are voluntary, pointing to the need for continued research and analysis of these sorts of corporate disclosures.

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THE VALUEREPORTING™ REVOLUTION: MOVING BEYOND THE EARNINGS GAME By Robert G. Eccles, Robert H. Herz, E. Mary Keegan and David M. H. Phillips Published by New York • Chichester • Weinheim • Brisbane • Singapore • Toronto: John Wily & Sons, 2001, 349 pp., Hardback, $29.95.

Reviewed by Kevin Carduff ValueReporting (VR) is a compilation of the research and applications by PriceWaterhouseCooper (PWC) in implementing a more effective business reporting model – VR – with their clients. All four authors are afﬁliated with PWC. Eccles is a former Harvard professor and advisor to PWC, while the remaining three authors (Herz, Keegan & Phillips) are top-level employees in the ﬁrm. All have been intimately involved in the development of the ValueReporting model. This project began in 1997 and 1998 when PWC began surveying top CEOs in American corporations, institutional investors, and sell-side analysts. The project attempted to gauge whether the ﬁnancial reporting model developed over the years (especially since the Securities Acts of 1933 and 1934) was relevant to the fastmoving business world of today. Their data overwhelmingly concluded that it was not. From this, PWC began developing a new model of value reporting which would not only improve ﬁnancial reporting, but begin to include non-ﬁnancial information of the ﬁrm concerned with strategic plans, human resources, organization and technology. The theory of reporting non-ﬁnancial information to stakeholders emerged in the 1970s with the “social reporting” movement, mainly centered on Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 285–288 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160206

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environmental disclosures. However, this movement began to look for improved disclosures regarding human resource productivity, human rights violations and civic participation of major corporations. During this time, the term “stakeholder” began to emerge to replace the solitary “shareholder” model for corporate disclosure. Many believed corporations had obligations to others beyond parties with direct claims against the assets of the ﬁrm. These stakeholders had different claims for information from the ﬁrm, and many had needs for different types of information beyond the ﬁnancial statements. To determine the spectrum of information needs within the ﬁnancial markets, PWC constructed a research instrument, “ValueReporting Capital Market Survey,” to evaluate the disconnect between the views of senior management in the ﬁrm and the views of sell-side analysts and institutional investors. The ﬁrst ﬁrm to agree to implement this survey was Swiss Re, a leading insurance company in the world. After going through this process, and presenting their value-model to analysts, Swiss Re’s share price increased signiﬁcantly. This is presented as evidence ValueReporting can improve corporate performance. While the book is divided into six parts containing 15 chapters, the book can be characterized as having two sections: the authors’ assessment of the problems in the ﬁnancial markets and their battle plan for the “revolution.” The ﬁrst problem in the ﬁnancial markets identiﬁed is the failure of the ﬁnancial reporting model. They contend that a new business model must be designed which focuses upon the relationships between the key value-drivers within the ﬁrm. This business model would include all relevant ﬁnancial and non-ﬁnancial measures. A call for nonﬁnancial information is not new to corporate reporting. The Jenkins committee proposed the same idea in their report, Improving Business Reporting – A Customer Focus in 1994. The authors recognize the Jenkins committee’s contributions, but they contend their movement goes further than the Jenkins model. Another problem in the market is the lack of real value. The authors identify the tremendous amount of volatility in the stock market as a signiﬁcant problem. Long-term growth and earnings potential is stressed over the boom created by “ﬂash-in-the-pan” high tech stocks. The authors are amazed at the stock price, and volatility, of Yahoo while market stalwarts – General Motors and Proctor & Gamble – languish. They feel this phenomenon of the “New Economy” is a threat to the stability of the market. Given the dips in the stock market in 2002, the authors were correct in predicting the dangers presented by such high volatility. ValueReporting stresses a long-term focus on the market, and encourages accounting for intangible assets to create value for the ﬁrm. The authors identify the “earnings game” as the biggest problem in the ﬁnancial market, and one of the reasons to implement ValueReporting. Companies are focusing all of their energies on meeting arbitrary analyst earnings projections,

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rather than dedicating themselves to their core businesses and long-term revenue growth. Currently, markets will hammer a stock that “misses earnings” and, even worse, they might hammer a company who makes analyst earnings, but misses the mysterious “whisper number” on the Street. The book contends this arbitrary approach to ﬁrm valuation is undermining corporate performance. Analysts are setting random earnings performance marks, and companies are manipulating earnings to meet the market through various accounting conventions like write-downs, “big baths,” and accounting reserves. This approach focuses too much upon the analyst’s needs, and not the needs of the corporate stakeholders. The ﬁnal problem identiﬁed in the book is accounting standards. The authors feel that the development of accounting standards, primarily in America, is too slow to respond to the business world. In addition, the differences between standards in multiple countries creates confusion and comparability problems across nations and industries. The authors recognize the depth of the U.S. accounting standards; however, they feel that they are too complicated to translate across the globe and encourage the development of an international accounting standards framework which will establish a common ﬁnancial reporting language. In describing their VR battle plan, the authors begin by describing the “gaps” in the current ﬁnancial reporting model: information, reporting, quality, understanding, and perception. These gaps create confusion in the market and foster instability. They conducted a survey among corporate ofﬁcers, analysts and institutional investors to identify key value drivers. The survey returned thirty-seven criteria, which were ranked as high/medium/low impact. These criteria are the foundation of the PWC ValueReporting method. The authors also call for increased disclosure of “risk” in the MD&A. The types of risk to be detailed are market risk, credit risk, and operational risk. These disclosures would give investors a better sense of the market position of the ﬁrm. To demonstrate the impact of ValueReporting, the authors detail the work they have performed for the oil company, Royal Dutch Shell (Shell). In the 1990s, Shell was under public attack by special interest groups regarding environmental concerns and human rights violations. These special interest groups would make bold claims against Shell, and Shell had no method for correcting the misconceptions in the market stemming from the special interest group claims. Once Shell implemented a ValueReporting perspective, they were able to reduce false claims against the ﬁrm by providing non-ﬁnancial performance measures through their website and other forms of media to pre-empt any claims made by special interest groups. This proactive approach to disclosure provided credibility to upper management and helped prevent hits to their stock price due to the claims of special interest groups.

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Through the Shell example, the authors argue that ValueReporting is feasible and is the appropriate method for business reporting. They claim the ﬁrst companies to adopt this approach to corporate reporting will reap the beneﬁts of increased management credibility, more long-term investors, increased analyst following, improved access to new forms of capital and higher share value. They recognize the arguments management will make: “The market only cares about earnings”; “it’ll cost too much”; “our competitors will steal our competitive advantages”; “we’ll get sued”; etc. However, they claim with new technologies with the Internet and the eXtensible Business Reporting Language (XBRL), the question of changing reporting models is not one of feasibility, but of corporate willingness, and the time for change has come!!

Overall, this is a well written and compiled book. However, the reader must take this concern for improving the ﬁnancial markets with a “grain of salt,” and remember that this book was written by and for a consulting ﬁrm with a reporting model and change process to sell. PWC is touting ValueReporting as a business solution and one of their trademarked products. In addition, there are not many new concepts presented here that were not covered through the business reporting model advocated by the Jenkins committee in 1994. ValueReporting simply speciﬁes certain non-ﬁnancial disclosures, while the Jenkins committee described the concept broadly to allow companies to elect their own industry-speciﬁc disclosures. Given the corporate failures and market downturns of 2002, it is evident that the market is demanding more (and accurate) information from companies. However, until corporate boards begin to demand that management provide this level of corporate disclosure, I believe the ValueReporting will face the same resistance and challenges that Ed Jenkins received with business reporting.

CREATING SHAREHOLDER VALUE By Alfred Rappaport. Published by New York: Free Press, Revised edition, Dec. 1997, 205 pp., Hardback $35.00.

Reviewed by Garen Markarian This is the revised and updated version of the widely cited work that appeared sixteen years ago, Rappaport’s ideas on shareholder value and its applications have become commonplace with market participants. In this new edition, Rappaport eschews objections to the discounted cash ﬂow valuation model, and provides strong arguments in support of the cash ﬂow-based valuation mechanism. Professor Rappaport shuns familiar measures of performance such as return on investment, price to earnings ratio, and return on equity, as an alternative he makes a convincing case in support of “value drivers” such as operating proﬁt margin, sales growth rate, working capital investment, etc. The main theme throughout the book is that the deﬁnitive test of corporate strategy success is how much economic value it creates for shareholders. Chapter one presents the foundations of the shareholder value approach to managing public corporations. He convincingly argues that the duty of business is to create shareholder value in a lawful and ethical fashion. Chapter two discusses the limitations of using accounting numbers in company valuation. He discusses the inadequacies of accounting-based ratios such as earnings per share, return on investment, and return on equity, and indicates that such ratios do not measure changes in economic value because different companies use alternate accounting methods, that investment requirements are excluded, and that principal factors such as the time value of money and risk are disregarded. The main theme of the book, the shareholder value approach, is presented in Chapter three. Professor Rappaport outlines the procedure for estimating

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shareholder value and shareholder value added. He presents straightforward examples and charts that illustrate the association between value drivers, valuation components such as cash ﬂows, and corporate objectives. Chapter four links corporate strategy to the shareholder value creation process. Rappaport argues that creating a sustainable competitive advantage is analogous to creating shareholder value. The author provides charts and tables that outline how industry attractiveness and a ﬁrm’s competitive position, along with selecting from different strategic options, results in the maximum attainable shareholder value. The author also focuses on the prevailing evidence that value is driven by performance over long time horizons that range from ﬁfteen to twenty years, and not by short-term accounting numbers as many managers believe. Chapter ﬁve is an application of the concepts discussed in the preceding chapter. He presents three cases where he explicitly links strategy formulation to shareholder value creation. Professor Rappaport again illustrates with simple examples how alternative business opportunities and interdivisional synergies can be valued. The next chapter discusses the implications of the market’s expectations of a company’s performance. Professor Rappaport argues that even if a company achieves returns higher than the cost of capital in its investments, shareholders might still experience returns that are lower than the cost of capital. This reasoning is built on the premise that stock price performance not only depends on the successful implementation of investment plans by the corporation, but on the market’s expectation of the company’s performance. Chapter seven discusses different executive compensation methods, how pay can be linked to performance, what the appropriate benchmarks to use are, and how to compensate the operating managers. He also discusses performance measurement methods such as residual income and Economic Value Added. The following chapter discusses mergers and acquisition in light of the shareholder value creation framework. The author provides guidelines that reduces overpayment for desirable companies and reduces instances of buying undesirable companies. He tackles the fundamental question as to whether mergers create value for the acquiring company and provides simple rules of thumb in that regard. The chapter ends with two cases that illustrate the above points. Chapter nine discusses how a successful shareholder value creation program can be implemented in an organization. He asserts that the success of any program depends on the commitment of the executive managers and the acceptance of all organization members. The steps include assessing value drivers, deciding on timing, shareholder value education, and reinforcing common goals, common frameworks for analysis, and a common language. The next chapter provides a framework for shareholders to keep score on organizational performance, and highlights the importance of market expectations in sound investing. The author

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argues that only the investors who can correctly anticipate a company’s changing prospects before they are incorporated into a stock price can earn above average returns. Rappaport’s revised edition is an excellent discussion of many issues that managers face in their day to day activities. There is convincing exposition of ideas, and the theoretical framework is solid. However, I found a few sections that I wished Professor Rappaport had clariﬁed better. The section that presents methods to calculate the cost of capital that incorporate factors such as beta and the expected risk free rate is elusive, here the sound theoretical framework is lacking as there is still debate as to what constitutes risk and how the cost of equity capital is correctly measured. Also, in the section dealing with performance measurement, the performance measurement and compensation of middle management remains a thorny issue in governance circles. It is the operating division managers and not the CEOs who are more involved in day to day decisions that add shareholder value, yet the author does not give the required attention as to how to provide the correct incentives, and how to measure the performance of managers below the executive positions. The book is a quick and easy read, rich in ideas, but not as far reaching in applications and detail. It provides a solid framework for the user, but leaves much of the “detail” work to be done by users according to their own needs. The book does an excellent job in highlighting why and how shareholder value should be managed. It is especially helpful for practitioners who do not have a ﬁrm groundwork in the ﬁnancial aspects of doing business. I recommend this book be used as a supplementary textbook for undergraduate, graduate, and executive education.

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EXPECTATIONS INVESTING By Alfred Rappaport and Michael J. Mauboussin. Published by Harvard Business School Press Boston Massachusetts, 2001, 221 pp. Price $29.95. ISBN 1-57851-252-2.

Reviewed by Evelyn A. McDowell Offering their ideas to the vast array of investment strategies and stock valuation books, Rappaport and Mauboussin eloquently and simply advocate and describe their expectation investing approach. Expectation investing is the ability to correctly read market expectations and to anticipate revisions. Upon doing so, the authors claim, the reader will be able to attain long-term returns above market performance by using stock prices as a proxy for collective expectations. The book provides the reader with a step-by-step guide and detailed examples of the application of the expectation investing strategy, describing traditional ﬁnance jargon and formulas. The book consists of twelve chapters divided into three main parts. It begins with a discussion about the advantages of expectation investing and then expounds on the main aspects of that approach. In the ﬁrst part, Gathering the Tools, three chapters are used to describe the market valuation of stock, the market expectation infrastructure, and the process of competitive analysis. The second part, Implementing the Process, focuses on the how-to’s of expectation investing including estimating price implied expectations; identifying ﬁrm opportunities; looking for mismatches in expectations; and using stock prices to make buy, sell, hold decisions. Other supplemental techniques such as using real-options valuation and understanding how types of businesses and value factors help identify potential sources of expectation revisions are also the subjects of discussion in part two. The third and ﬁnal part, Reading Corporate Signals, explains how mergers

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and acquisitions, share buybacks, and incentive compensation give investors information about the ﬁrm performance expectations. On the surface, the author’s message of expectation investing appears simple and easy to follow; however, many of the steps are very difﬁcult and arduous to implement. Their message is simple; match your expectations with the current market expectations and exploit the differences. Unfortunately, this is not easily done. For example, in gathering the tools for expectation investing, the authors advise investors to “evaluate value drivers and ‘visualize’ the cause and effects of the expectation revision.” The authors list six value factors – volume, product price and mix, operating leverage, economies of scale, cost efﬁciencies, and investment efﬁciencies. These values are triggered by sales, operating costs, and investments and are key factors in sales growth rate, operating proﬁt margins, and incremental investment rates. To obtain the information for the value factors is difﬁcult enough, but the investor must translate the effects of the factors into market expectations – not an easy task. Another step, analyzing competitive strategy, requires similar analysis and far-reaching estimations. The authors strongly advocate traditional ﬁnance theory to value companies, favoring cash ﬂow over accounting earnings as proxy for true measure of shareholder value. To calculate shareholder value, they start with stock price and then estimate the market expectations for cash ﬂow, the cost of capital, and the forecast horizon. In addition, an important assumption of expectation investing that is prevalent throughout most of the calculations is that the market uses a long-term horizon, which is embedded in the current stock price. This assumption is important since many traditional valuation techniques use a much shorter-term horizon to base their calculation. Many of the examples used in illustrations are dated and point to potential ﬂaws in the methodology of expectation investing. Firms in their prime such as Enron, Gateway, and Amazon are used. The author’s approach did not anticipate the bankruptcy of Enron, the decline of Gateway Computers, and the difﬁculties of Amazon. Perhaps one would need a crystal ball to predict these failures; however, the use of these companies in the book’s illustrations and examples only weakens their arguments. The most interesting topics were covered in the last section, Reading Corporate Signals. In these last three chapters, the authors explain how to obtain information from the actions of corporations. Mergers and acquisitions, share buybacks, and incentive compensations are the topics of the chapters. Alfred Rappaport uses his earlier research with Mark Sirower on mergers and acquisitions to present a method to derive the value of the company’s risk if the combination is unable to capitalize on the created synergies. This tool is called shareholder value at risk (SVAR® ). Another tool used is the premium at risk, which is used by the seller to assess the risk

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inherent in the merger. These important tools help the investor read the expectation in the price of the merged company stocks. The authors give us a golden rule for share buybacks: a company should only repurchase its shares when expected value is below market value and when no better investment opportunities exits. Further, they also give us reasons why a company would use share buyback that may cause the investor to re-evaluate their expectations. Incentive compensation, the extent equity-linked compensation is used as incentives and not just compensations, is also attributed as possible reasons for expectations to change. This book is uniquely relevant to many individuals – academics with interests in ﬁnance as well as investors, analysts, traders, and portfolio managers. This book could also be used as a supplement in an MBA ﬁnance course on investment theory. Rappaport and Mauboussin’s book gives readers an interesting alternative investment strategy, and for that reason I recommend it.

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UNDERSTANDING AUDITOR-CLIENT RELATIONSHIPS: A MULTI-FACETED ANALYSIS By Gary Kleinman and Dan Palmon. Rutgers Series in Accounting Research, Markus Wiener Publishers, Princeton, NJ, 2001, 164 pp, USD 49.95.

Reviewed by Reed A. Roig The authors aim high with this project when they seek to develop a “truly comprehensive model of the auditor-client relationship,” with a focus on the issue of independence. Although they may fall short of their goal, they do not miss by much. I do not believe that they develop a “model” of the auditor-client relationship, but they do provide a solid overview of research in this area to date, a comprehensive discussion of the conﬂicts, pressures and issues in this relationship (at several levels of analysis), and a comprehensive framework on which future research in this area can be built. The foundation of their work is auditor independence, so it is ﬁtting that they begin with a discussion of its importance and meaning. The discussion is grounded in both the historical context of the development of the audit function and the recent prominence it has been given by the formation of the Independence Standards Board (now disbanded). They correctly highlight the critical importance of independence to the audit function and therefore to the credibility of ﬁnancial markets and costs of market transactions. However, as they succinctly deﬁne the issue: “How does a professional that is retained, paid, and subject to dismissal by its client, manage to report honestly to third parties about the honesty of its client? This is the crux of the auditor independence question . . .” (p. 17).

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They review various deﬁnitions of independence that have been proposed (behavioral, attitudinal, and character/value based), but reject each of these principally due to the lack of consideration of contextual factors. They suggest that they have developed a broader deﬁnition of “independence,” but this is a weak point in the book. This deﬁnition, if it is developed, is not clearly stated. Instead, they seem to deﬁne independence by what it “is not.” The key point they make is that independence cannot simply be examined by deﬁning the characteristics of the individual auditor in a vacuum, but the individual auditor in the context of a profession, a ﬁrm and a situation. Prior to describing their framework the authors provide a good summary of existing research on the independence issue. They review previous research modeling the auditor-client relationship and the independence issue using economic, resource dependence, and exchange theories. They also describe research on issues of “perceived independence” factors in the auditor-client relationship such as management advisory services, auditor ﬁnancial dependence on the client, competitiveness of the market for audit services, audit ﬁrm size, tenure of the relationship, client ﬁnancial condition, and nature of the conﬂict issue. The apparent strengths and limitations of each of these models in the eyes of the authors form the guideposts that lead to their comprehensive framework. The complexity of the framework is both its strength and its weakness. It is a behavioral framework, built principally from models developed initially in social psychology. It properly brings many factors to bear on the issue of independence in the auditor-client relationship, but this makes it less “elegant” and will certainly add to the difﬁculty in building empirical tests. The authors describe the framework on two levels: Micro Level (1) The individual (the “Partner-in-charge”): personality, values, motivations, career stage, and aspirations. (2) The Partner-in-Charge’s perception of his/her role and “role set” (those individuals or groups that are relevant to a particular role). The role set for the Partner-in-Charge would include, for example, the client, the SEC, other clients, the review partner, other ﬁrm partners, other audit ﬁrms, family, etc. (3) The interaction of the Partner-in-Charge with the ﬁrm and its control structures: selection and socialization, audit structure, administrative structure, culture (including ethical climate), and formal/informal control mechanisms. Macro Level (1) The relationship between the audit ﬁrm and the client as moderated by: (a) Environmental factors

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(i) Homogeneity (uniformity of expectations of the auditor’s/client’s role sets) (ii) Dynamism (volatility of the environment) (iii) Muniﬁcence (ability of the auditor to replace a lost client) (iv) Observability (how visible the auditor-client interactions are to their role sets) (b) Inter-personal factors (i) Stage of “group formation” (ii) History of interactions The micro and macro levels are not analyzed separately, but must be examined in tandem as the relationships established at the micro level moderate the macro level relationships. I believe the key points of the framework are: Although the issue of independence is focused on the individual Partner-inCharge, that individual is placed in a role located in a social context (audit ﬁrm and auditor-client relationship) which inﬂuences his/her actions. Referring to the Partner-in-Charge’s ordering of conﬂicting role set preferences, the authors suggest that “This issue is the heart of the auditor independence problem. How does one respond to the conﬂicting claims of clients, the profession, the employer, and, where relevant, one’s family?” (emphasis in original, p. 59). The essential importance of audit ﬁrm culture (ethical climate) as a means of control over the independence issues facing Partners-in-Charge. However, the authors also note that “Each auditor-client pairing . . . creates a new psychological and cultural entity that transcends the cultures and processes of each” (p. 107). This certainly suggests the potential of long-term auditor-client relationships to take on a life of their own (for good or bad) in spite of the ﬁrm or client culture. That “history matters.” The auditor-client relationship is not a one period model and past interactions will effect current and future interactions. Although written before the Enron/Andersen debacle became daily news, I found myself mentally “ﬁtting” David Duncan (the Partner-in-Charge), Andersen, and Enron into the framework as I read the book. What were David Duncan’s perceptions of his role set and how did he “prioritize” them? What was the culture (ethical climate) and control structure at Andersen that could have allowed this to happen? How did the history of the Andersen/Enron relationship impact the independence decision making over time? The answers to some of these questions have been hinted at as the Andersen trial played out and much of the framework generally seems to “ﬁt.” The Enron/Andersen failure raises new issues that may need to be added to the framework, but this is not surprising. Independence, like most

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core accounting/auditing principles, is not an issue that will ever be permanently resolved to everyone’s satisfaction. As noted above and by the authors, empirical testing of this framework will be difﬁcult. The authors suggest the necessity of on-site observation and longitudinal testing to gain a richer understanding of the context of the auditor-client relationship. Certainly empirical testing of this framework will beneﬁt from recent advances in multilevel testing such as hierarchical linear modeling. In conclusion, this book provides an excellent framework to examine the auditor-client relationship and its effect on auditor independence. Individuals who are simply interested in a deeper understanding of this relationship (due to current events) or are looking for new avenues of research will ﬁnd this helpful. The most important open question that it does not answer is – By what standard does one judge “independence?” The authors suggest that true independence may be impossible. Perhaps. It appears, though, that there is at least room for improvement.

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