Research in Accounting Regulation, Volume 14 (Research in Accounting Regulation)

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RESEARCH IN ACCOUNTING REGULATION

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RESEARCH IN ACCOUNTING REGULATION Series Editor: Gary J. Previts Volumes 1–14: Research in Accounting Regulation Supplement 1:

10th Anniversary Special

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RESEARCH IN ACCOUNTING REGULATION VOLUME 14

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

NANDANI CHANDAR School of Management, Rutgers University, USA

2000

JAI An Imprint of Elsevier Amsterdam – London – New York – Oxford – Paris – Shannon – Tokyo iii

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ELSEVIER SCIENCE Inc. 655 Avenue of the Americas New York, NY 10010, USA © 2000 Elsevier Science Inc. 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.nl), 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: (978) 7508400, fax: (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 2000 Library of Congress Cataloging in Publication Data A catalog record from the Library of Congress has been applied for. ISBN: 0-7623-0735-8 ISSN: 1052-0457 The paper used in this publication meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper). Printed in The Netherlands.

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CONTENTS EDITORIAL BOARD

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LIST OF CONTRIBUTORS

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INVITED REFEREES FOR VOLUME 14

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MAIN PAPERS GOING CONCERN AUDITOR REPORTS AT CORPORATE WEB SITES Michael Ettredge, Vernon J. Richardson, and Susan Scholz

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ASSESSING THE VALUE ADDED BY PEER AND QUALITY REVIEWS OF CPA FIRMS Arnold Schneider and Robert J. Ramsay

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THE RELEVANCE OF AUDIT COMMITTEES FOR COLLEGES AND UNIVERSITIES Zabihollah Rezaee, Robert C. Elmore and Joseph Z. Szendi

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ENVIRONMENTAL POLICY: CORPORATE COMMUNICATION OF EMISSION ALLOWANCES S. Douglas Beets and Paul L. Lejuez 61 CORPORATE DISCLOSURE OF THE DECISION TO CHANGE THE FISCAL YEAR-END Thomas L. Porter, Edward P. Swanson, Michael S. Wilkins and Lori Holder-Webb EARNINGS MANAGEMENT, THE PHARMACEUTICAL INDUSTRY AND HEALTH CARE REFORM: A TEST OF THE POLITICAL COST HYPOTHESIS Joseph Legoria v

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LIST OF CONTRIBUTORS

RESEARCH REPORTS ANALOGIES DRAWN BETWEEN MARKETING AND FINANCIAL REPORTING RESEARCH - POSSIBLE IMPLICATIONS FOR REPORTING COMPREHENSIVE INCOME Pamela A. Smith and Kim R. Robertson 135 A SELECTED ANNOTATED BIBLIOGRAPHY OF SEC ACCOUNTING RESEARCH J. Edward Ketz and Jimmy W. Martin

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AUDITORS AND THE POST-LITIGATION REFORM ACT ENVIRONMENT Ross D. Fuerman

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PERSPECTIVES REMARKS ON AICPA RECOGNITION OF FEDERAL ACCOUNTING STANDARDS ADVISORY BOARD Robert K. Elliott and Barry Melancon

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ACCOUNTING: CONTINUITY AND TRANSITION Shyam Sunder

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INVESTORS’ EXPECTATIONS AND THE CORPORATE INFORMATION DISCLOSURE GAP Asokan Anandarajan, Gary Kleinman and Dan Palmon

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QUO VADIS CPA? Gary John Previts

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THE TYRANNY OF THE ANALYSTS: VALUE DRIVING INFORMATION Larry M. Parker and Gary John Previts

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BOOK REVIEWS CORPORATE SOCIAL AWARENESS AND FINANCIAL OUTCOMES by Ahmed Riahi-Belkaoui Reviewed by Timothy J. Fogarty

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List of Contributors

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EARNINGS MEASUREMENT, DETERMINATION, MANAGEMENT, AND USEFULNESS: AN EMPIRICAL APPROACH by Ahmed Riahi-Belkaoui Reviewed by Bob R.C.J. Van den Brand

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THE ART AND SCIENCE OF BUSINESS VALUATION By Albert N. Link and Michael B. Bogei Reviewed by Haoling Tan

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VALUE ADDED REPORTING AND RESEARCH: STATE OF THE ART by Ahmed Riahi-Belkaoui Reviewed by Michael E. Doron

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MEXICO FOR THE GLOBAL INVESTOR: EMERGING MARKET THEORY AND PRACTICE by Timothy Heyman Reviewed by Rahmadi Murwanto

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LIST OF CONTRIBUTORS

List of Contributors

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EDITOR Gary John Previts Weatherhead School of Management Department of Accountancy Case Western Reserve University Associate Editor Thomas R. Robinson University of Miami, Florida

Assistant Editor Nandani Chandar Rutgers University

EDITORIAL BOARD Dennis R. Beresford University of Georgia

Paul A. Pacter International Accounting Standards Committee

Peter Bible General Motors Corporation

Larry M. Parker Case Western Reserve University

Jacob Birnberg University of Pittsburgh

Robert H. Parker University of Exeter, England

Michael P. Bohan Deloitte & Touche, LLC

James M. Patton University of Pittsburgh Federal Accounting Standards Advisory Board

Paul Brown New York University Graeme W. Dean University of Sydney, Australia

Robert Sack University of Virginia–Darden School

Timothy Fogarty Case Western Reserve University

E. Kent St. Pierre University of Delaware

William Holder University of Southern California David L. Landsittel, CPA Winnetka, Illinois

William J. L. Swirsky Canadian Institute of Chartered Accountants

Harry T. Magill Arizona State University

Sir David P. Tweedie Accounting Standards Board, U.K.

Donald L. Neebes Ernst & Young, LLP

Wanda Wallace College of William and Mary

Hiroshi F. Okano Osaka City University, Japan

Yuksel Koc Yalkin University of Ankara ix

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List of Contributors

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LIST OF CONTRIBUTORS

Asokan Anandarajan

New Jersey Institute of Technology

S. Douglas Beets

Wake Forest University

Michael E. Doran

Case Western Reserve University

Robert K. Elliott

American Institute of CPAs

Robert C. Elmore

Tennessee Technological University

Michael Ettredge

University of Kansas

Timothy J. Fogarty

Case Western Reserve University

Ross D. Fuerman

Frank Sawyer School of Management, Suffolk University

Lori Holder-Webb

Texas A&M University

J. Edward Ketz

Penn State University

Gary Kleinman

Fairleigh Dickinson University

Joseph Legoria

Mississippi State University

Paul L. Lejuez

Credit Suisse First Boston

Jimmy W. Martin

University of Montevallo

Barry Melancon

American Institute of CPAs,

Rahmadi Murwanto

Case Western Reserve University xi

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Dan Palmon

Rutgers - The State University of New Jersey

Larry Parker

Case Western Reserve University

Thomas L. Porter

Financial Accounting Standards Board

Gary John Previts

Case Western Reserve University

Robert J. Ramsay

University of Kentucky

Zabihollah Rezaee

Middle Tennessee State University

Vernon J. Richardson

University of Kansas

Kim R. Robertson

Trinity University

Arnold Schneider

Georgia Institute of Technology

Susan Scholz

University of Kansas

Pamela A. Smith

Northern Illinois University

Edward P. Swanson

Texas A&M University

Shyam Sunder

Yale University

Joseph Z. Szendi

Booz, Allen & Hamilton Inc.

Haoling Tan

Case Western Reserve University

Bob R.C.J. Van den Brand

Tilburg University

Michael S. Wilkins

Texas A&M University

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Research in Accounting Regulation, Volume 14 INVITED REFEREES Abdul Malik Al-Hogail Case Western Reserve University

Jimmy W. Martin University of Montevallo

Aaron Ames Ernst & Young, LLP

Mary Medley Colorado Society of CPAs

Kristen L. Andersen U.S. Securities and Exchange Commission

Albert Nagy John Carroll University

Lee Blazey, Jr. Case Western Reserve University Dale Buckmaster University of Delaware A. Rick Elam University of Mississippi

David Pearson Case Western Reserve University M. A. Pendergast Urbach, Kahn & Welin, PC Pamela Stuerke Case Western Reserve University

Reza Espahbodi Indiana University

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Going Concern Auditor Reports at Corporate Web Sites

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MAIN PAPERS

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MICHAEL ETTREDGE, VERNON J. RICHARDSON & SUSAN SCHOLZ

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GOING CONCERN AUDITOR REPORTS AT CORPORATE WEB SITES Michael Ettredge, Vernon J. Richardson and Susan Scholz

ABSTRACT Firms are required to include their auditor’s report in SEC Form 10-K ﬁlings, presumably because the report contains relevant information for investors and others. The report is particularly likely to be useful when it contains a ‘going concern’ modiﬁcation. However, current SEC regulations and AICPA standards do not require ﬁrms to provide auditors’ reports at their Web sites. This is true even if those sites include year-end accounting data, and even if the auditor’s report contains a ‘going concern’ modiﬁcation. This study ﬁnds evidence that companies receiving going concern modiﬁcations are less likely to publish those opinions at their Web sites than are matched (distressed) ﬁrms that did not receive such modiﬁcations. Yet the ‘going concern’ ﬁrms do provide extensive ﬁnancial accounting data at the Web sites, including summaries of year-end results. This ﬁnding should interest regulators and others who are concerned with the quality of ﬁnancial information provided at ﬁrms’ Web sites.

Research in Accounting Regulation, Volume 14, pages 3–21. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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MICHAEL ETTREDGE, VERNON J. RICHARDSON & SUSAN SCHOLZ

INTRODUCTION The Internet has become an important source of ﬁnancial information for investors. The SEC has generally encouraged the use of this new medium as a way to achieve wider dissemination of ﬁnancial data. Other than specifying that existing securities laws apply equally to information disseminated on the Internet, it has not imposed signiﬁcant new regulations on the information presented at corporate Web sites. Similarly, the AICPA has adopted a handsoff attitude towards the ﬁnancial content of corporate Web sites, and seems to be mainly concerned with clarifying that auditors should not be held responsible for the content of their clients’ sites. As might be expected given these attitudes, there is a great deal of variation in the information presented at corporate sites. Some have no ﬁnancial content, others provide current and historical annual reports, quarterly reports, and numerous other items of investor interest (Ettredge et al., 2000; Ashbaugh et al., 1999). Pertinent to this study, companies frequently provide accounting information, but not the audit report, by providing unaudited statements, such as quarterly reports, or by excerpting sections from audited statements (Ettredge et al., 1999). Omission of the audit report may conceal important information, especially if the report contains a going concern modiﬁcation. This modiﬁcation states that the auditor has substantial doubt that the entity will be able to continue as a going concern for the next year (AICPA, 1988b). Presumably the auditor is assigned the responsibility of evaluating and reporting on a company’s continued viability because the auditor’s inside information and expert ﬁnancial opinion is deemed useful to investors. This study compares the Web site accounting content of 100 companies that received going concern opinions to a matched sample of companies with unmodiﬁed reports. Our results indicate that the going concern opinion companies are less likely to present their audit report at their Web sites. However, most of them still provide accounting information of some sort, mainly unaudited quarterly reports that often include year-end results. The next section of this chapter provides background information on current regulations, the relevance of going concern modiﬁcations and ﬁnancial information at corporate Web sites. The third section develops hypotheses and explains the models used to test them. Section four explains the sample selection and shows descriptive statistics. Results are shown in the ﬁfth section, followed by the conclusion.

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BACKGROUND Rules Governing the Presentation of Audit Reports As long as the annual report to shareholders was the primary means of corporate communication with investors, the auditor’s report was disseminated automatically in conjunction with the ﬁnancial statements.1 However, corporate Web sites allow companies to easily adapt and excerpt information from traditional reports. Existing regulations, discussed below, do not address this new venue directly. The Securities and Exchange Commission (SEC) and the American Institute of Certiﬁed Public Accountants (AICPA) both promulgate regulations regarding the dissemination of auditor reports. SEC regulation S-X Section 210 requires that a report accompany the ﬁnancial statements provided in the Form 10-K ﬁling. The regulation also dedicates Article 2 to specifying qualiﬁcations for the auditor and the auditor report (see SEC Handbook Reg. § 210.2–01 to 210.2–05.) This attention suggests that the SEC perceives the report to be a useful component of the investor information set but does not mandate its distribution other than as a part of Form 10-K. The AICPA has dedicated several Statements of Auditing Standards (SASs) to the content of the auditors report (e.g. SAS No. 58 Reports on Audited Financial Statements (AICPA 1988a), SAS No. 59 The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern (AICPA 1988b)), but their guidance concerning the distribution of the audit report is mainly concerned with limiting and deﬁning the circumstances in which the report can be associated with ﬁnancial statement data. According to SAS 26 (AICPA 1979), ﬁnancial statements that have not been audited or reviewed should not include the name of the auditor and should be marked as unaudited (SAS 26.06.) Excerpted or condensed versions of ﬁnancial statements are addressed by SAS 42 (AICPA 1982). It states: Because condensed ﬁnancial statements do not constitute a fair presentation . . ., an auditor should not report on condensed ﬁnancial statements in the same manner as he reported on the complete ﬁnancial statements from which they are derived (SAS 42.04).

This has been interpreted to mean that a company that publishes incomplete ﬁnancial statements, for example, an income statement and balance sheet, but no footnotes, should not present the audit report, or even associate the auditor with the information presented (see AICPA Auditing Interpretations at AU § 9504.15-.18 (AICPA 1998)).

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If an auditor prepares a report speciﬁcally for condensed ﬁnancial statements, the report should note the type of opinion expressed in the original report (SAS 42.05). In general, the primary concern of this statement seems to be that incomplete ﬁnancial statements might be misleading (SAS 42.04), so the auditor should avoid association with them. In the case of a going concern report, however, this restriction may be counter-productive. In private discussions, a member of the AICPA technological staff indicated that he would consider the presentation of ﬁnancial statement excerpts unaccompanied by an associated going concern report to be ‘misleading.’ So, although there are no extant regulations speciﬁcally addressing this possibility, it appears that some representatives of the AICPA unofﬁcially prefer that the client present either full ﬁnancial statements,2 including the auditor’s report, or no ﬁnancial statement data, if the audit report contains important information such as a going concern modiﬁcation.

Signiﬁcance of Audit Report Modiﬁcations The issue of whether or not going concern reports are shown at corporate Web sites is important only if: (1) investors use corporate Web sites to gather ﬁnancial information and (2) the report adds relevant information. Web sites are not yet an acceptable method of initial corporate disclosure. The SEC and major stock exchanges still prescribe SEC ﬁlings and wire releases as the primary means of broad distribution to the public (NIRI 1998c, p.9). However, the National Investor Relations Institute (NIRI) advocates using multiple technologies to further disseminate information (NIRI 1998b, p.41), and the SEC has encouraged this use of Web sites, mainly by allowing the medium to evolve with few regulatory restrictions. The agency has emphasized that general anti-fraud provisions apply to the Internet venue, but otherwise has not provided much speciﬁc guidance (Prentice et al., 1999). Investor demand for on-line information is strong and growing. A BoozeAllen & Hamilton – Cyber Dialogue study concluded that investors perceive on-line ﬁnancial content to be equal to or better than traditional information services, such as brokerages (Cyber Dialogue, 1999). Corporate Web sites play an important role in providing this data. For example, a survey of 600 public companies that provide investor relations pages found that trafﬁc increased 38% in the fourth quarter of 1998, to an average of 30,000 hits per site (CCBN.com 1999).

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Thus, the use of corporate Web sites to present ﬁnancial information has become pervasive (NIRI, 1998a, p. 6.iii). Of course, there are other on-line sources of accounting information, such as the SEC’s EDGAR site. But ﬁnancial information users who ﬁnd sufﬁcient information for their purposes at a corporate Web site may not exert the additional effort to ﬁnd and use the information at EDGAR. Furthermore, there are impediments to using information from the EDGAR site. First, to locate information, users must have a basic understanding of SEC form codes. Second, EDGAR documents are simply electronic versions of raw SEC ﬁlings such as 10-K’s and 10-Q’s. They have none of the graphics or hyperlinks that make corporate Web sites accessible and user-friendly. So, although an audit report is publicly available through SEC ﬁlings, companies may believe that not posting the report at their own site will limit its dissemination, at least to certain investors who gather most of their investment information through Web sites. Or, they may simply see no reason to expend resources to advertise their auditor’s poor opinion of their viability. Evidence exists that managers sometimes engage in self-serving behavior when making voluntary disclosures via other media (e.g., Lewellen, Park & Ro, 1996, among others). The same is likely true of ﬁnancial disclosure at Web sites. This is of concern only if a going concern report contains important incremental information. Presumably, the going concern modiﬁcation is required by SAS 59 (AICPA 1988b) because auditors have access to clients’ internal data and are expert in ﬁnancial matters. Therefore, their opinion regarding the immediate prospects of the company is important incremental information for investors. Prior research supports this presumption. Hopwood et al. (1989, 1994) show that going concern reports are incrementally signiﬁcant in bankruptcy prediction models. Chen & Church (1996) present evidence that prior going concern opinions reduce the market ‘surprise’ associated with bankruptcy. On an individual level, Campbell & Mutchler (1988) provide evidence suggesting that investors increase their assessment of the probability of a ﬁrm’s failure if a going concern report is issued. Overall, existing evidence reinforces the relevance and information content of going concern reports.

HYPOTHESES AND MODEL DEVELOPMENT In this section we develop hypotheses regarding the presentation of going concern audit reports at corporate web sites. The primary (alternative) hypothesis is that auditor report content affects the presentation of auditor reports; speciﬁcally, that going concern opinions are less likely to be found at web sites, ceteris paribus. 7

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However, because auditor reports are so closely tied to ﬁnancial statements, and are subject to the dissemination rules and conventions discussed above, our hypotheses and tests also consider the demand for accounting information in general and alternatives to full ﬁnancial statements. Web Site Accounting Variables We consider three levels of accounting information presentation. Companies are categorized based on the presence or absence of speciﬁc accounting information items at each Web site. This information ranges from none to a complete annual report or 10-K. The individual accounting items considered (labeled Y1 to Y8), and the levels to which they belong, are deﬁned in the Appendix, and discussed below. The highest level, LEVEL2, includes companies that provide current, complete annual reports (or 10-K’s), including the auditor’s report, at the site. LEVEL2 directly addresses our primary hypothesis. We expect it to be negatively associated with going concern reports. The next level of accounting information, LEVEL1, includes companies that provide accounting-based ﬁnancial information but not the current auditor’s report. These companies may provide earnings announcements, excerpts from annual ﬁnancial statements, or old annual reports that have been superseded by reports not available on-site. The site may have a link to EDGAR for investors interested in SEC documents, but provide none directly. Or, the company might post quarterly reports. Fourth quarter reports, which generally include year-end results, are a particularly good substitute for an annual report. They usually consist of a brief balance sheet, income statement and management discussion, but they are unaudited. Thus, management can convey condensed versions of the basic ﬁnancial statements without explicitly omitting the audit opinion. All these presentation strategies allow a company to provide access to accounting items that are not associated with audit reports. Thus, we hypothesize that going concern reports will be positively associated with LEVEL1 if managers attempt to exploit this strategy. In general, going concern companies are likely to have incentives to present no accounting information at all, LEVEL0, because of their relatively poor ﬁnancial condition. Financial information users are thought to interpret the absence of voluntary disclosure as an indication of ‘bad news’ about a ﬁrm. This provides average-or-better performing ﬁrms with an adverse selection incentive to disclose (Lev & Penman, 1990, Lang & Lundholm, 1993, among others). As noted previously, presentation of ﬁnancial data at Web sites is not initial disclosure to the market as a whole. However, subsequent distribution

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of information via Web sites provides initial exposure of ﬁnancial data to some investors. The worst performing ﬁrms do not have an incentive to advertise this fact, particularly when doing so is costly. But accounting information need not be accompanied by the incremental information found in the auditor’s report, and the ﬁnancial condition of the matched companies should approximate that of the going concern companies. Therefore, both sub-samples should have similar incentives to present no onsite accounting information. In effect, we hypothesize no relationship between going concern reports and LEVEL0 in this context. However, we include a test involving LEVEL0 (described below) so that our analyses address the entire range of possible presentation conditions. Our hypotheses are (in alternate form): H1: presentation of LEVEL2 accounting information is negatively associated with going concern reports. H2: presentation of LEVEL1 accounting information is positively associated with going concern reports. H3: presentation of LEVEL0 accounting information is not associated with going concern reports.

Test and Control Variables Because of the wide range of potential interpretations of the various other types of report modiﬁcations, we compare the going concern companies to companies that received an unmodiﬁed opinion. These two types of reports provide the clearest distinction for our tests. The test variable, GC, is recorded as one (zero) if the company received a going concern (unmodiﬁed) auditor report in the most recent year. Companies provide accounting data at Web sites in response to the perceived demand of information users. Ettredge et al. (2000) present evidence that the information items presented at Web sites differ with the information clienteles associated with a company. Therefore, we use proxies for two major user groups to control for demand effects: RETAIL is the natural log of the number of shareholders; it is used to proxy for individual ‘retail’ investors. ANALYST is the proxy for analyst following. It is the natural log of one plus the number of analysts forecasting year end results, as reported by Zacks. ZSCORE, Altman’s measure of ﬁnancial distress, is used to capture any residual variation in ﬁnancial condition that was not controlled by the matching procedure. Likewise, we use SIZE, the natural log of net sales, to control for residual size differences. These variables are deﬁned in the Appendix. 9

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MICHAEL ETTREDGE, VERNON J. RICHARDSON & SUSAN SCHOLZ

Model Overview Several logistic regression models are used to test the hypotheses. They are summarized in the Appendix. In models 1–3, the levels (LEVEL0–2) are dependent variables regressed against the test variable, GC, and the control variables RETAIL, ANALYST, ZSCORE and SIZE. These models are intended to test the association between the various levels of accounting information presented and GC, while controlling for user demand and any unmatched differences in ﬁnancial condition and size. In Model 4, GC is regressed against dummy variables LEVEL1–2 (LEVEL0 is captured by the intercept) and the control variables ZSCORE and SIZE. This model is intended to test the association between GC and all of the information levels, while controlling for other factors expected to be associated with a going concern report: ﬁnancial condition and size. Finally, Model 5 regresses GC against all of the individual accounting information items found at the Web sites: earnings releases, quarterly reports, stale reports, EDGAR links, and current, complete ﬁnancial statements. Fourth quarter reports (with year-to-date results) are presented separately from reports for quarters 1–3. Each site could have none, one or several of these items. Only annual reports and annual report excerpts, and stale data and current reports are mutually exclusive. Results will provide additional information about the relationship between going concern reports and Web site presentation of speciﬁc items. Again, ZSCORE and SIZE are included as control variables.

SAMPLE SELECTION AND DESCRIPTIVE STATISTICS Sample Selection Inventories of Web site content occurred between September and November 1998. Because of the immediacy and timeliness of the Internet, we are concerned with the most recent accounting results that might possibly be posted at a Web site. Assuming a 90-day lapse between the end of a company’s ﬁscal year and the release of its annual ﬁnancial statements, the most recent ﬁscal year-end dates that could be found at Web sites would be from July 1997 to June 1998. Companies that received going concern reports during this period were obtained from a search of the Lexis/Nexis Disclosure database. To qualify for our sample, companies had to appear on the 1997 Compustat database and have an existing Web site. To identify our sample of going concern ﬁrms, we randomly selected going concern companies identiﬁed by the Lexis/Nexis search, veriﬁed their

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presence in Compustat and then searched the Web for a company maintained site. Web searches for 249 going concern companies were necessary to obtain 100 going concern–Web site observations. Each going concern observation was matched with a company that received unmodiﬁed reports on their most recent ﬁnancial statements.3 Matching was based on: (1) three digit SIC code; (2) whether the company reported positive or negative earnings; and (3) sales, to control for industry membership, proﬁtability and size respectively. Internet searches for 185 potential matches were necessary to locate the required 100 matching observations with Web sites. Overall, we found sites for 46% of our searches: 40% of the going concern report companies and 54% of the unmodiﬁed report matched sample. Pearson Chi-squared tests indicate the difference is not independent of report type (p = 0.004). Table 1, panel A shows the Web site frequencies for the two subsamples. Panel B shows the industry distribution of the ﬁnal sample. The highest concentrations are found in SIC 7300 (19%), SIC 2800 (16%) and SIC 3800 (12%). No other two-digit code contains more than 9% of the sample. Table 1. Sample Derivation Panel A: Web site Frequency Auditor report type

Number of Number of Web Web sites sought sites found

Percent

Going concern report companies Matched unmodiﬁed report companies

249 185

100 100

40 54

Total

434

200

46

Panel B: Industry Distribution of Sample SIC Codes

Sample %

1000–1900 2000–2999 3000–3999 4000–4999 5000–5999 6000–6999 7000–7999 8000–8999 9000–9999

4 18 33 8 6 3 24 4 0

Total

100

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Descriptive Statistics for Web site Variables Descriptive statistics of Web site contents are presented in Table 2. Chi-squared tests of accounting level variables show no signiﬁcant differences between the going concern and control samples for LEVEL0 and LEVEL1. However, there are signiﬁcantly fewer LEVEL2 companies in the going concern sample, providing preliminary evidence that report content may inﬂuence the presentation of audit reports and accounting information. However, only 26% of the unmodiﬁed sample provides audit reports, suggesting that reports are relatively uncommon overall.4 LEVEL1 companies (providing accounting information but no audit report) are most common, representing 52.5% of the sample (going concern 53%, unmodiﬁed 52%). The majority of the members of this group (70%) provided varieties of quarterly reports. Twenty-eight of the going concern companies in LEVEL1 provided fourth quarter statements which included brief year-end income statements and balance sheets. Presumably these results were unaudited, Table 2.

Descriptive Statistics of Web site Accounting Variables

Panel A: Levels of Accounting Information (Exclusive Categories) Report Type Going Concern Unmodiﬁed

Overall Percent

Chi-squared p-value 0.11 0.89 0.05

LEVEL0 LEVEL1 LEVEL2

32 53 15

22 52 26

27 52 21

Total sites

100

100

100

Panel B: Accounting Items (Non-Exclusive) Report Type Going Concern Unmodiﬁed None EDGAR link Earnings release Stale data Q1 – Q3 report Q4 report AR excerpts Full ﬁnancial statements

32 30 12 17 46 32 0 15

22 44 10 6 50 38 1 26

Overall Percent

Chi-squared p-value

27 37 11 12 48 35 1 21

0.11 0.04 0.65 0.01 0.57 0.37 n/a 0.05

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although they did not consistently say so. We identiﬁed only one company that provided an excerpted annual report.5 About a quarter of the sample (27%) had no accounting information at their sites. The frequencies of individual accounting items are shown in panel B. Because one company might provide several of these items, the columns do not sum to the total number of companies in the sample. Chi-squared tests indicate that the going concern sample has signiﬁcantly fewer EDGAR links (p = 0.04) and annual reports (p = 0.00), and more sites with stale data (p = 0.01). This last result suggests that ﬁrms stop posting certain accounting information items upon receiving a going concern report. For example, at least two of the stale data sites posted complete annual reports for the prior year (with unmodiﬁed reports), but did not post the current year’s annual report, which had received a going concern modiﬁcation. Descriptive Statistics for Control Variables Descriptive statistics are summarized in Table 3. Due to the nature of the sample and matching procedures, the overall sample is composed of relatively small companies and both going concern and unmodiﬁed report samples exhibit poor earnings performance. Differences between the sub-samples’ mean sales and net income are insigniﬁcant, as intended by the matching procedure. The going concern report sample has signiﬁcantly lower analyst following and worse Z-scores than the unmodiﬁed sample companies.

RESULTS Results of models 1–3 are presented in Table 4, panel A. These models use the different presentation levels as dependent variables regressed against the test variable, GC, and the control variables: ZSCORE, SIZE, ANALYST, RETAIL. All of the models are signiﬁcant at conventional levels. However, GC is signiﬁcant (p = 0.01) only with LEVEL2 as the dependent variable. The coefﬁcient is negative, as hypothesized. It is the only signiﬁcant variable in this model.6 The user demand control variables are signiﬁcant in other panel A models. LEVEL0 is negatively associated with RETAIL (p = 0.07) and ANALYST (p = 0.08) and LEVEL1 is positively associated with ANALYST (p = 0.03). These results suggest that, absent a going concern report, higher user demand increases the level of accounting information provided.7 Models 4 and 5 reinforce the results of the ﬁrst series of models. In Model 4, LEVEL2 is signiﬁcantly and negatively associated with GC (p = 0.04); but 13

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Table 3. Descriptive Statistics of Control Variables Report Type Going Concern n = 100

Unmodiﬁed n = 100

Sales (millions) Mean Median Std. Deviation

41.9 3.9 163.0

27.7 5.5 63.2

Net Income (millions) Mean Median Std. Deviation

–12.4 –5.4 29.6

–11.7 –4.0 29.1

Z-score Mean1 Median Std. Deviation

–5.7 –1.3 15.0

13.0 3.2 27.4

Analysts Mean1 Median Std. Deviation

0.2 0.0 0.6

1.0 0.0 1.8

Shareholders Mean Median Std. Deviation

1.4 0.6 2.1

1.1 0.6 1.4

Descriptive statistics are presented for untransformed variables. Statistical results are substantially the same for the transformed variables used in multivariate analysis. 1

T-test results indicate difference between groups is signiﬁcant (p < 0.01).

LEVEL1 is not. Model 5, which uses all the accounting items found at the sites as independent variables, reports a signiﬁcant, negative relationship between GC and full ﬁnancial statements (p = 0.04). It also indicates a positive relationship between GC and stale data (p = 0.01). In both models, the control variable ZSCORE is negative and signiﬁcant at the 0.01 level. Overall, these results support our primary hypothesis, that LEVEL2 Web site accounting information presentation (accounting documents including auditor reports) is negatively associated with companies receiving going concern reports. However, the hypothesis that going concern companies shift to the lower level of presentation, relative to unmodiﬁed report companies, is not strongly supported. The positive, marginally signiﬁcant coefﬁcient on the intercept in

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Table 4. Multivariate Results Panel A: Models 1–3 Dependent Variables: Independent Variables: GC LNRETAIL LNANALYST ZSCORE SIZE Constant Model Chi–square

LEVEL0

LEVEL1

0.4412 –0.6241 –0.7728 0.0044 –0.0198 –0.6674

*

0.3599 0.1807 0.7049 0.0046 0.1449 –0.6888

11.529

**

10.069

* *

LEVEL2

**

* *

–1.1183 *** 0.3995 –0.3365 –0.0125 –0.2313 –0.5552 11.081

**

Panel B: Models 4–5 Dependent variable: Independent variables Constant

GC

0.7069

GC

*

Independent variables Constant None

–0.1831 0.8682

EDGAR link Earnings release Stale reports Q1–Q3 report Q4 report AR excerpt

–0.3606 0.6512 1.6291 *** 0.7415 0.0419 –6.2875

Full ﬁnancial statements

–1.0334

LEVEL1

–0.2233

LEVEL2

–1.0270

ZSCORE

–0.1090 ***

ZSCORE

–0.1078 ***

SIZE

–0.1078

SIZE

–0.0980

Model Chi–square

**

60.132 ***

Model Chi–square

**

72.508 ***

*** indicates signiﬁcance at = 0.01 level ** indicates signiﬁcance at = 0.05 level * indicates signiﬁcance at = 0.10 level

Model 4 (which captures LEVEL0) is countered by the insigniﬁcant coefﬁcient on the GC variable in model 1, and the insigniﬁcant intercept and NONE variables in model 5. Similarly, the positive association between stale data and going concern reports in Model 5 suggests that companies that receive going concern reports reduce their level of presentation relative to prior years. But our tests do not provide clear evidence of this. 15

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CONCLUSION AND PERSPECTIVE FOR THE FUTURE In summary, the results of this study indicate that accounting documents that include audit reports are less likely to be disseminated at corporate Web sites when the report includes a going concern modiﬁcation. However, these sites (as well as unmodiﬁed report sites) often provide alternative accounting reports (i.e. fourth quarter reports) which contain unaudited versions of the basic accounting results. Together, these results indicate that companies effectively limit the dissemination of the information contained in a going concern report while continuing to provide accounting information via their Web sites. This practice conforms to current regulatory requirements. In fact, assuming that the companies choose not to present a complete set of ﬁnancial statements, they are prohibited from providing or mentioning their going concern opinions. This permits companies to omit an important component of investor information. Regulators should consider whether such omission is detrimental to investors. We conclude with an informed speculation on the future of Web-based disclosure of the auditor’s report. Information technology increasingly makes it affordable and feasible for ﬁrms to provide investors with continuously updated ﬁnancial information, such as ﬁnancial statements ‘on demand.’ The Internet provides a ready means for dissemination of such information. Many observers predict that, in future, continuous online reporting will be provided to investors via ﬁrms’ Web sites. See, for example, an article by Thompson Financial Investor Relations (2000). The AICPA’s (2000) development and distribution of XBRL (extended business reporting language) will facilitate this scenario. XBRL works by using XML (extensible markup language) to ‘tag’ each data item underlying the ﬁnancial statements using agreed-upon terms that both humans and machines can read (e.g., ). Major software ﬁrms will support XBRL, enabling automated extraction of ﬁnancial information from electronic ﬁnancial reports or underlying databases. The data extracted can be distributed via Web sites or otherwise. The International Accounting Standards Committee is participating in the XBRL project. This should facilitate automated translation of ﬁnancial statements from IASC standards to U.S. GAAP or vice versa. Firms’ legal liability poses a major obstacle to this envisioned future of continuous reporting (Richardson & Scholz, 1999). Firms likely will desire to reduce or share this liability with external auditors. Auditors will offer assurance that ﬁrms’ ﬁnancial reporting and other IT systems are reliable, e.g. the AICPA’s SysTrust product (1999). However, investors also are likely to desire timely assurance that ﬁrms’ updated ﬁnancial reports (or other ﬁnancial data)

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are reliable. Auditing will occur continuously throughout the ﬁscal year. The SEC’s recent move to mandate timely review of quarterly data by external auditors can be viewed as a precursor to this future scenario, although the quarterly reviews do not currently include an auditor’s opinion. In future, ﬁrms might provide investors with assurance that frequently updated ﬁnancial reports or data are reliable, by purchasing some form of timely audit assurance. Auditors would employ a form of auditing that produces audit results simultaneously with, or shortly after, an accounting event occurs. Continuous auditing likely would be implemented via a permanent computer network connection between the auditor and auditee (Kogan et al., 1999). XBRL will assist external auditors in extracting desired data from client databases. In the limit, an auditor will be capable of reprocessing or parallel processing the client’s entire population of business transactions. Updated ﬁnancial data from comparable ﬁrms, used in analytical review, might be obtained from their Web sites (or elsewhere on the Internet) using an intelligent software agent such as the FRAANK agent being developed by researchers at Rutgers and the University of Kansas. Firms’ use of XBRL format will enhance retrieval of data in this fashion. The content of the auditor’s report on ﬁnancial data will depend on the nature of the data for which assurance is desired. If investors continue to desire auditors to provide a going concern modiﬁcation when warranted, that auditor judgment might be made more often than once per year. The judgment could be based on analytical review using a ﬁrm’s current and historical data, and using updated data from comparable ﬁrms. Auditors might also continuously monitor qualitative data such as news items about the client, its competitors, and its industry (Jia & Vasarhelyi, 1999). No matter what exact forms auditors’ reports take in future, and regardless of the precise manner in which they are disseminated, the scenario described above suggests that accounting regulators will face interesting issues and problems.

ACKNOWLEGEMENTS We are grateful for our research assistants Mike James, Marissa Haines, Suriporn Waradejwinyoo and Angela Bezdek. We also thank Eric Cohen of Cohen Computer Consulting for helpful comments. Financial support was provided by the Ernst & Young Center for Auditing Research and Advanced Technology at the University of Kansas and the Steve Berlin/CITGO grant. 17

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NOTES 1. The emphasis placed on the annual report by the SEC is demonstrated in ASR 279, which reads in part: “The annual report to security holders has long been recognized as the most effective means of communication between management and security holders.” (SEC Handbook, Codiﬁcation of Financial Reporting Policies §102.01.c.) 2. Full or complete ﬁnancial statements are deﬁned as a balance sheet, income statement, statement of cash ﬂows, statement of shareholders’ equity and footnotes. 3. Unmodiﬁed reports were identiﬁed from Compustat, AUOP code-1. 4. Since the unmodiﬁed report sample is in similar ﬁnancial condition to the going concern sample, signaling theory would predict that the unmodiﬁed group has an adverseselection incentive to present their auditor’s report, demonstrating that it is not a going concern opinion. Our ﬁnding that they usually do not provide the report suggests that the perceived information content of an unmodiﬁed report is low. 5. Complete ﬁnancial statements were presented at this site, but no audit report. The report was unmodiﬁed. 6. GC is also the only signiﬁcant variable (t = 1.8, one-tailed) in an OLS version of this model using a summary variable ranging from 0–3 as the dependent variable. However, the overall model is not signiﬁcant (F = 1.6). 7. The same model using both LEVEL0 and LEVEL1 companies as the dependent variable (not shown) is also signiﬁcant (p = 0.05). The only signiﬁcant variables are going concern (p = 0.01) and size (p = 0.08). Both coefﬁcients are positive, reinforcing the results of model 1.

REFERENCES American Institute of Certiﬁed Public Accountants (AICPA). (1979). Statement of Auditing Standards No. 26: Association with Financial Statements. New York, NY: AICPA. American Institute of Certiﬁed Public Accountants (AICPA). (1982). Statement of Auditing Standards No. 42: Reporting on Condensed Financial Statements and Selected Financial Data. New York, NY: AICPA. American Institute of Certiﬁed Public Accountants (AICPA). (1988a). Statement of Auditing Standards No. 58: Reports on Financial Statements. New York, NY: AICPA. American Institute of Certiﬁed Public Accountants (AICPA). (1988b). Statement of Auditing Standards No. 59: The Auditor’s Consideration of an Entities Ability to Continue as a Going Concern. New York, NY: AICPA. American Institute of Certiﬁed Public Accountants (AICPA). (1998). AICPA Professional Standards (Vol.1). New York. NY: AICPA. American Institute of Certiﬁed Public Accountants (AICPA). (1999). AICPA/CICA SysTrust Principles and Criteria for Systems Reliability, Version 1.0. Stamford: CT. American Institute of Certiﬁed Public Accountants (AICPA). (2000). XFRML for Financial Statements (February 4) http://www.xfrml.org. Ashbaugh, H., Johnstone, K. M., & Warﬁeld, T. (1999). Corporate reporting on the Internet. Accounting Horizons, (September), 241–258. Cyber Dialogue (1999). New Booz-Allen & Hamilton – Cyber Dialogue study investigates impact of online brokerage services on retail brokerage industry. Business Wire (April 26).

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Campbell J., & Mutchler, J. (1988). The ‘expectations gap’ and going-concern uncertainties. Accounting Horizons, 2, 42–49. CCBN.com. (1999). CCBN.com survey reveals skyrocketing popularity for investor relations web sites. Business Wire (April 5). Chen, C. W., & Church, B. K. (1996). Going concern opinions and the market’s reaction to bankruptcy ﬁlings. The Accounting Review, 71, 117–128. Ettredge, M., Richardson, V. .J., & Scholz, S. (2000). An Emerging Model of Web Site Design for Financial Disclosures: Targeting Information Clienteles. Communications of the Association for Computing Machinery (forthcoming). Ettredge, M., Richardson, V. J., & Scholz, S. (1999). The presentation of ﬁnancial information at corporate web sites. working paper, University of Kansas. Hopwood, W., McKeown, J., & Mutchler, J. (1989). A test of the incremental explanatory power of opinions qualiﬁed for consistency and uncertainty. The Accounting Review, (January), 28–48. Hopwood, W., McKeown, J., & Mutchler, J. (1994). A reexamination of auditor versus model accuracy within the context of the going-concern opinion decision. Contemporary Accounting Research, (Spring), 409–431. Jia, P., & Vasarhelyi, M. (1999). Qualitative Corporate Dashboards for Corporate Monitoring, IS Audit & Control Journal, V, 45–48. Kogan, A., Sudit, E., & Vasarhelyi, M. (1999). Continuous Online Auditing: A Program for Research, Journal of Information Systems, (Fall). Lang M., & Lundholm, R. (1993). Cross-sectional determinates of analysts ratings of corporate disclosures. Journal of Accounting Research, 32, (Autumn), 246–271. Lev, B., & Penman, S. H. (1990). Voluntary forecast disclosure, non-disclosure, and stock prices. Journal of Accounting Research, 28, (Spring), 49–76. Lewellen, W. G., Park, T., & Ro, B. T. (1996). Self-serving behavior in managers’ discretionary information disclosure decisions. Journal of Accounting and Economics, 21, (April), 227–251. National Investor Relations Institute (NIRI). (1998a). Online IR: IR Guide Number 6. Investor Relations (July). National Investor Relations Institute (NIRI). (1998b). Standards of Practice for Investor Relations. Vienna, VA: National Investor Relations Institute. National Investor Relations Institute (NIRI). (1998c). Symposium on Corporate Disclosure Impact of Technology and Role of Media (April) Vienna, VA: National Investor Relations Institute. Prentice, R. A., Richardson, V. J., & Scholz, S.(1999). Corporate web site disclosure and rule 10b–5: An empirical analysis. American Business Law Journal, (Summer). Richardson, V. J., & Scholz, S. (1999). Corporate Reporting and the Internet: Vision, Reality and Intervening Obstacles, Paciﬁc Accounting Review, 11(2). SEC Handbook: Rules and Forms for Financial Statements and Related Disclosures. Commerce Clearing House, Inc. Chicago, IL. Thompson Financial Investor Relations. (2000). IR in the New Millennium, Investor Relations (January).

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APPENDIX: MODELS AND VARIABLES Overview of LOGIT Models to be Estimated Model 1:

LEVEL0 = f(GC, Retail, Analysts, Zscore, Size)

Model 2:

LEVEL1 = f(GC, Retail, Analysts, Zscore, Size)

Model 3:

LEVEL2 = f(GC, Retail, Analysts, Zscore, Size)

Model 4:

GC

= g(LEVEL0, LEVEL1, LEVEL2, Zscore, Size)

Model 5:

GC

= h(Y1…Y8, Zscore, Size) Dependent Variables

LEVEL0

Equals one if there is no accounting information at site, otherwise zero. Y1 = None

LEVEL1

Equals one if the Web site provides accounting information but no current auditor’s report (at least one of the items Y2-Y7 is present), otherwise zero. Y2 Y3 Y4 Y5 Y6 Y7

LEVEL2

= = = = = =

Edgar link Earnings Release Stale data First – third quarterly reports Fourth quarter report (including year to date results) Annual report excerpts

Equals one if the Web site provides current complete ﬁnancial statements, (with auditor’s report), otherwise zero. Y8 = Complete ﬁnancial statements

GC

Equals one (zero) if the ﬁrm did (did not) receive an audit opinion modiﬁed for ‘going concern’ in the test year. (Source: Lexis/ Nexis and Compustat).

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Test and Control Variables GC

Equals one (zero) if the ﬁrm did (did not) receive an audit opinion modiﬁed for ‘going concern’ in the test year. (Source: Lexis/ Nexis and Compustat).

RETAIL

The natural logarithm of the number of common shareholders at year-end. (Source: Compustat) Variable Retail proxies for the extent of individual investor ownership of the corporation.

ANALYST

The natural logarithm of one plus the number of analysts estimating year-end earnings for the test year. Companies not covered by Zack’s are assumed to have no analyst following. (Source: Zack’s ) Variable Analysts proxies for the corporation’s analyst following.

ZSCORE

The Altman’s Z Score measure of ﬁnancial condition for the test year. (Source: Compustat) Variable Zscore proxies for the ﬁrm’s ﬁnancial condition.

SIZE

The natural logarithm of the ﬁrm’s sales for the test year. (Source: Compustat) Variable Size controls for residual (unmatched) differences in corporation size.

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ASSESSING THE VALUE ADDED BY PEER AND QUALITY REVIEWS OF CPA FIRMS Arnold Schneider and Robert J. Ramsay

ABSTRACT This study examines the value added by audit peer reviews and quality reviews to ﬁnancial statement users. A survey of 193 bank lending ofﬁcers indicates that peer/quality reviews do increase conﬁdence in audited ﬁnancial statements, but they do not directly affect lenders’ willingness to approve lines of credit, nor do they directly affect the size of the lines of credit approved. Surprisingly, lending ofﬁcers provided with audited ﬁnancial statements where no peer or quality review is mentioned were slightly more likely to approve a lower interest rate, indicating that bank lending ofﬁcers do not consider the results of peer or quality reviews unless they are speciﬁcally provided to them. Where peer or quality review information is provided, bank lending ofﬁcers express more conﬁdence in the ﬁnancial statements if the opinion of the review was clean, and the reviewer was reputable. They were willing to provide a signiﬁcantly lower interest rate if the audit ﬁrm had received a peer review rather than a quality review. This supports the AICPA’s decision to abandon quality reviews in favor of peer reviews for ﬁrms offering audit and attest services (Elsea & Stewart, 1995).

Research in Accounting Regulation, Volume 14, pages 23–38. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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The results suggest that CPAs should do more to make ﬁnancial statement users aware of the peer review process. Clients of ﬁrms that receive clean reviews may take advantage of the apparent value added by the review by making users of their ﬁnancial statements aware of such reviews.

INTRODUCTION In 1977, the American Institute of Certiﬁed Public Accountants (AICPA) began requiring that ﬁrms that belong to their Division for CPA Firms1 must undergo a peer review once every three years. Peer reviews examine the CPA ﬁrm’s quality control system and are conducted by other CPAs. In 1989, the AICPA began a more general program which requires that all AICPA members who are engaged in the practice of public accounting be afﬁliated with ﬁrms that are enrolled in the AICPA’s peer review program or in a quality review program sponsored by the AICPA or a state society of CPAs. The peer review and quality review programs are very similar with the main difference being that peer review reports are available in a public ﬁle, whereas quality review reports need not be made available to the public. In 1994, the AICPA approved the combination of the peer review program of its Private Companies Practice Section with its quality review program effective April 1995 (Elsea & Stewart, 1995). This combination, however, did not affect the AICPA’s peer review program for its SEC Practice Section. In October 1999, the AICPA Peer Review Board revised standards for ﬁrms that do not audit SEC registrants. Firms that perform audits and/or examinations of prospective information will undergo system reviews, which are essentially the same as the current peer review. Firms that perform only compilations that omit substantially all disclosures will have off-site report reviews. All ﬁrms not falling into these categories will have engagement reviews, which will also be off-site (AICPA, 2000).

VALUE ADDED BY PEER AND QUALITY REVIEWS Many past articles have espoused the value added by peer and quality reviews to the reviewed CPA ﬁrms, to the entire accounting profession, and to the public at-large (e.g. Evers & Pearson, 1989 and Huff & Kelley, 1989). Some articles provide anecdotal evidence of added-value (e.g. Macklin, 1989), while others provide indirect evidence by comparing reviewed versus non-reviewed ﬁrms or by analysis of reviewed ﬁrms over time. For instance, Mancuso (1991) notes that the incidence of SEC enforcement actions against ﬁrms not having undergone peer review was eleven times higher than for ﬁrms that had a peer review.

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He also notes that the General Accounting Ofﬁce found problems in 18% of ﬁrms that had been peer reviewed, while for other ﬁrms the incidence of problems was 59%. These lower enforcement actions or lower incidence of problems cannot be directly attributed to peer reviews since those ﬁrms that voluntarily subjected themselves to peer reviews may have been the ones with the best quality control systems. An example of an inter-temporal study is provided by Geary and Wessendarp (1989), who report that while 86% of ﬁrms that had their ﬁrst peer review received clean opinions, the percentage of ﬁrms that received clean opinions in subsequent peer reviews increased to 92%. Even if this comparison involves the same exact set of ﬁrms over time, one cannot necessarily attribute the improvement to the peer reviews. Some researchers have done surveys on perceptions about the added-value of peer and quality reviews. For instance, Felix & Prawitt (1993) found that 33% of their respondents felt that peer reviews resulted in positive changes in their practices. Karnes et al. (1991) report that 62% of their respondents believed that quality review requirements will improve the quality of work which small practitioners perform for clients. According to managing partners of CPA ﬁrms surveyed by McCabe et al. (1993, p. 114), “peer review has provided impetus to maintain the highest degree of compliance with professional pronouncements.” Elsea & Stewart (1995) also found that practitioners believed information and recommendations from quality/peer reviews helped improve their practices, but they also indicated that clients were unaware of reviews – partially because the participating practitioners didn’t promote that they had reviews. Despite these claims and evidence, not everyone is convinced about the value added by peer and quality reviews. For instance, The Alliance for Practicing CPAs contends that “mandatory quality reviews ‘unrealistically raise the conﬁdence level of the public’.” (Hock 1993, p. 31). Fogarty (1996, p. 256) discusses a “. . . decoupling between peer review as espoused and peer review as achieved . . .’.” and questions whether reviews actually enhance quality. To our knowledge, no study to date has provided a direct test, in a controlled setting, of the value added by peer and quality reviews. Our study ﬁlls this void by conducting a controlled experiment using an important group that relies on CPA ﬁrm quality – bankers. Bankers are a particularly relevant user group for this study since some banks require that their borrowers’ CPA ﬁrms participate in quality review (Hock, 1993). Speciﬁcally, the purpose of our study is to test whether peer and quality reviews affect lending decisions made by commercial bank lending ofﬁcers. We also examine the impact of six different variables on the value added by peer and quality reviews. The results of this study should have policy implications for the AICPA and state societies of CPAs. These organizations should be interested in knowing 25

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how an important user group such as bankers perceives the value added by peer and quality reviews. These reviews currently have guidelines concerning time frames, types of reviewers, and other matters. This research should help policymakers assess the adequacy of those guidelines relating to variables that are examined in this study. “The need for future research into the peer review process grows in tandem with the growing scope of review programs and the increasing allocations of resources to support quality control assessments” (Wallace, 1991, p. 65). In particular, one of the research questions Wallace suggests to be important is: “Have reviewees experienced a reputation effect from the peer review process?” (p. 66). Our study addresses this issue. The variables chosen and the research questions we tested reﬂect the exploratory nature of this study. Also, interpretation of our ﬁndings should be tempered because the study is exploratory.

OTHER PEER AND QUALITY REVIEW STUDIES Including the surveys mentioned above, little research has been done on peer or quality reviews. Wallace (1991) examined peer review ﬁles for members of the SEC Practice Section of the AICPA for 1980 through March 1986 to determine if a moral hazard problem exists in the peer review process. She found that the types of quality review reports issued were consistent with the number of ﬁndings listed by the reviewers and there was no difference between number of ﬁndings and type of reviewer (i.e. make-up of review team, etc.) or type of reviewee (i.e. large vs. small ﬁrm). She did ﬁnd that reviews with a larger number of ﬁndings tended to be ﬁled later (a problem the AICPA has moved to correct by requiring a 30-day ﬁling period) and reviews by or of larger ﬁrms tend to be ﬁled later. All in all, however, she does not ﬁnd support for a moral hazard problem in the peer review process. King et al. (1994) examined whether an allegation of lack of independence inﬂuenced peer reviewers’ assessments of audit work quality. They found that knowledge of the allegation negatively inﬂuenced peer reviewers’ evaluations of auditors’ procedures. Ehlen & Welker (1996) examined whether fairness of decision-making procedures relating to peer and quality reviews affected reviewees’ commitment to the AICPA or their trust in reviewers. The study found that procedural fairness was associated with both commitment to the AICPA and trust in the reviewer. Studies of the effects of peer review ﬁnd that there are no systematic audit fee differences among ﬁrms who are members of the AICPA’s Division for CPA Firms, and are thus subject to peer review, and those who are not

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(Francis, Andrews & Simon, 1990). However, the use of a peer review system does appear to have some inﬂuence on how employees perceive audit pronouncements (Specht & Waldron, 1992). This implies a relationship between peer review and the quality of a ﬁrm, which leads to better understanding of professional pronouncements. Colbert & Murray (1998) examined the relationship between auditor quality and auditor size for small CPA ﬁrms, using peer review ratings from the AICPA’s Private Companies Practices Section. They also investigated whether peer review ratings improved with successive reviews and whether the oversight organization (AICPA or state society) affected peer review ratings. Results showed that for ﬁrms that performed audits, reviews, and compilations (but not for ﬁrms that performed reviews and compilations only), auditor quality was positively associated with ﬁrm size, the number of previous reviews, and oversight by state societies.

EXPERIMENT Scenario The experiment involves a scenario where an applicant is applying for a commercial bank loan. The questionnaire describes the past relationship between the bank and the applicant, the size of the loan requested, ﬁnancial information about the applicant, collateral offered, and the audit opinion (which was unqualiﬁed) for the client’s most recent ﬁnancial statements. The information is constructed such that there is approximately a 50% probability that a loan ofﬁcer would approve the loan. This was validated through pre-testing the questionnaire. Dependent Variables The objective of peer reviews and quality reviews is to enhance CPA ﬁrms’ quality control systems. Enhanced quality control should provide more conﬁdence to lending ofﬁcers about the credibility of ﬁnancial statements that have unqualiﬁed audit opinions issued by auditors from these CPA ﬁrms. Therefore, for our ﬁrst dependent variable, participants were asked to indicate their conﬁdence that the ﬁnancial statements are presented fairly in conformity with generally accepted accounting principles (GAAP) on a scale of 0 to ten, with ten representing complete conﬁdence. Since ﬁnancial statement credibility also may affect loan decisions, we then elicited three dependent variables associated with lending. We asked the lending ofﬁcers to indicate the probability that they would grant the line of credit 27

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requested in the case ($300,000) on a scale of 0% to 100%, with 100% representing certainty that the line would be granted. They were also asked to indicate the maximum line of credit they would grant in the case (in dollars), and the minimum interest rate premium above prime they would require for such line.

Independent Variables We examine the effects of six different independent variables. The ﬁrst four pertain to characteristics of the review, the ﬁfth relates to the reviewing ﬁrm, and the last relates to the ﬁrm reviewed. Since there are no extant models, theory, or prior research studies to serve as a foundation for selecting variables that would affect value added by peer and quality reviews, we chose our six variables based on a review of the literature and pronouncements relating to peer and quality reviews. The variables and their levels, which are summarized in Table 1, are described in the following paragraphs. The ﬁrst variable, TYPE, distinguishes between peer review and quality review. The basic distinction is that the results of peer reviews must be publicly disclosed, while the results of quality reviews can be kept conﬁdential. CPA ﬁrms undergoing peer reviews, therefore, might be expected to have greater concern for quality control than ﬁrms that have quality reviews. Hence, lending ofﬁcers may attach greater value to peer reviews than to quality reviews. We pose the following research questions: Table 1. Independent Variables and Levels Variable TYPE (of review) SOURCE (of reviewers)

OPINION (result of review) WHEN (time since last review) REPUTATION (of reviewers) REVIEWEE (size of CPA ﬁrm)

Levels (i) (ii) (i) (ii) (iii) (i) (ii) (i) (ii) (i) (ii) (i) (ii) (iii)

Peer review; Quality review CART; Firm-on-ﬁrm; Association Unqualiﬁed (clean); Qualiﬁed 1 month ago; 2.5 years ago Very reputable; Not reputable Big Six ﬁrm; National ﬁrm; Local ﬁrm

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RQ1a: Will subjects have greater conﬁdence in reports prepared by auditors who have undergone a peer review than by auditors who have undergone a quality review? RQ1b: Will subjects be more likely to: (1) approve a speciﬁed line of credit, (2) approve a larger credit limit, and (3) require a lower interest rate for companies whose reports are prepared by auditors who have undergone a peer review than by auditors who have undergone a quality review? Our second variable, SOURCE, relates to the three possible sources from which the reviewed CPA ﬁrm can obtain the reviewers. One option is for the reviewed ﬁrm to obtain a randomly selected review team by the AICPA or their state society of CPAs (i.e. the administering entity). This is referred to as a committee appointed review team (CART). A second option is for the reviewed ﬁrm to appoint a reviewer ﬁrm that has been qualiﬁed by the administering entity. This is termed a ﬁrm-on-ﬁrm review. The third option is where a reviewed ﬁrm, which belongs to an association that has met the AICPA’s requirements to do reviews, may request that the association perform the review. This is referred to as an association review. Because the ﬁrm-on-ﬁrm review offers the reviewed ﬁrm the most control over the selection of reviewer, we expect that it will be perceived as being the least credible of the three options. As Wallace (1991, p. 60) states, “The back-scratching result has been asserted to be potentially problematic for ﬁrm-on-ﬁrm reviews.”2 Since the CART option offers the reviewed ﬁrm the least selection control, we expect that option to be most credible. The value added by CART reviews, therefore, should be the greatest of the three options, while the value added by the ﬁrm-on-ﬁrm reviews should be the least. Hence, we have the following research questions: RQ2a: Will subjects have greater conﬁdence in reports prepared by auditors who have undergone a review by a CART than by an association, and will the conﬁdence relating to an association review be greater than for a ﬁrm-on-ﬁrm review? RQ2b: Will subjects be more likely to: (1) approve a speciﬁed line of credit, (2) approve a larger credit limit, and (3) require a lower interest rate for companies whose reports are prepared by auditors who have undergone a review by a CART than by an association, and will subjects be more likely to: (1) approve a speciﬁed line of credit, (2) approve a larger credit limit, and (3) require a lower interest rate for companies whose reports are prepared by auditors who have undergone a review by an association than by a ﬁrm-on-ﬁrm? 29

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Our third variable, OPINION, pertains to the results of a review. We will test the effects of a clean (unqualiﬁed) opinion versus a qualiﬁed opinion for instances of failure to perform audit procedures sufﬁcient to support the reports issued. Our review of the literature as well as peer review letters issued by the AICPA indicated that this was a common reason for qualiﬁcation. While adverse opinions exist, they are extremely rare3, and thus we do not examine them. Since a clean opinion implies better CPA ﬁrm quality control than a qualiﬁed opinion, we would expect a clean opinion to add more perceived value to the peer or quality review than a qualiﬁed opinion. Therefore, our research questions are: RQ3a: Will subjects have greater conﬁdence in reports prepared by auditors who have received a clean review opinion than those who have received a qualiﬁed opinion? RQ3b: Will subjects be more likely to: (1) approve a speciﬁed line of credit, (2) approve a larger credit limit, and (3) require a lower interest rate for companies whose reports are prepared by auditors who have received a clean review opinion than those who have received a qualiﬁed opinion? As a fourth variable, we examine whether the length of time since the last review (WHEN) inﬂuences the value added by the review. The following recommendation made by the Public Oversight Board (1993, p. 18) suggests that this variable may have an impact: “The SEC should amend its rules to require SEC registrants to disclose whether their auditors have had a peer review, the date of the most recent peer review and its results” (emphasis added). Since ﬁrms are supposed to be reviewed every three years, we set one level close to that bound – 2.5 years. We set the other level to be very recent – one month. Since a recent review is likely to be perceived as more up-to-date information about the CPA ﬁrm’s quality control, we expect lending ofﬁcers to attach more value to information from a recent review than from an older review. Therefore, we pose the following research questions: RQ4a: Will subjects have greater conﬁdence in reports prepared by auditors who had reviews that took place one month ago than reviews that took place 2.5 years ago? RQ4b: Will subjects be more likely to: (1) approve a speciﬁed line of credit, (2) approve a larger credit limit, and (3) require a lower interest rate for companies whose reports are prepared by auditors who had reviews that took place one month ago than reviews that took place 2.5 years ago?

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Our ﬁfth variable involves the reputation (REPUTATION) of the reviewing ﬁrm. “Bankers around the country will very often acknowledge, conﬁdentially of course, that they maintain lists of CPAs whose work is not acceptable or is to be subjected to additional scrutiny” (Huff & Kelley, 1989, p. 34). Wallace notes that “the reputation notion has been recognized explicitly in the market for peer reviewers” (Wallace, 1991, p. 59). We describe the reviewers as either very reputable or as not reputable. We would expect lending ofﬁcers to attach more credibility, and therefore more perceived value, to reviewers who are more reputable.4 Our research questions are as follows: RQ5a: Will subjects have greater conﬁdence in reports prepared by auditors who had reviews performed by very reputable reviewers than reviews performed by reviewers who are not reputable? RQ5b: Will subjects be more likely to: (1) approve a speciﬁed line of credit, (2) approve a larger credit limit, and (3) require a lower interest rate for companies whose reports are prepared by auditors who had reviews performed by very reputable reviewers than reviews performed by reviewers who are not reputable? The sixth variable, REVIEWEE, relates to the CPA ﬁrm being reviewed. We wish to investigate whether the value added by reviews depends on the size of CPA ﬁrm being reviewed. We distinguish among a Big Six ﬁrm,5 a national ﬁrm, and a local ﬁrm.6 Peer review results have shown that smaller CPA ﬁrms have more serious problems with the quality of audits than larger ﬁrms (U.S. General Accounting Ofﬁce (1996, p. 92)). Therefore, reviews would add more value to smaller ﬁrms. On the other hand, quality reviews7 for larger ﬁrms are greater in scope than for small ﬁrms. Whereas reviews for ﬁrms with over 10 professionals encompass nine elements of quality control, quality review standards for ﬁrms with 10 or fewer professionals “would ordinarily restrict compliance tests to four elements” (Walters, 1989, p. 62). This suggests that reviews for small ﬁrms may be perceived as adding less value than reviews for larger ﬁrms. Hence, we have counter arguments relating to the effects of CPA ﬁrm size on the value added by reviews. We state our research questions as follows: RQ6a: Will subjects have different conﬁdence levels in reports prepared by Big Six ﬁrms versus national ﬁrms versus local ﬁrms? RQ6b: Will subjects differ in: (1) likelihood of approving a speciﬁed line of credit, (2) in the size of the credit limit, and (3) in the required interest rate for companies whose reports are prepared by Big Six ﬁrms versus national ﬁrms versus local ﬁrms? 31

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Design A full factorial design would entail 144 treatments (232223). To obtain ﬁve responses per cell would necessitate a total of 720 participants for a between subjects design. Since it would be extremely difﬁcult and costly to obtain this total, we employed a fractional factorial design using 41 different versions of the instrument (40 treatments as well as one control group). This allowed analysis of all main effects between subjects.

PARTICIPANTS We distributed 549 questionnaires to representatives of participating banks, who then distributed them to commercial bank lending ofﬁcers. The loan ofﬁcers mailed the completed questionnaires directly to the researchers. 232 (42%) questionnaires were received. Of these, 19 consisted of a control group where subjects were told that there was no quality review or peer review of the company’s auditors. There were 31 respondents who had at least one missing answer and eight respondents whose answers indicated that they did not understand one or more questions (there was no pattern to the latter phenomenon). A total of 193 complete versions are used in the following analysis. The case described a small company requesting a $300,000 line of credit. An unqualiﬁed audit report for the company was presented along with descriptions of the peer or quality review including the variables described earlier. We then asked them to rate their conﬁdence, on a 0–10 scale, that the ﬁnancial statements are presented fairly in conformity with GAAP. Subjects then read a description of the company including summary ﬁnancial information and ﬁnancial statements. After indicating: (1) the probability they would grant the line of credit, (2) a maximum line of credit, and (3) a minimum interest rate premium, they completed ﬁve demographic questions and a rating of the capital structure of the company. The demographic questions included years of experience, education level, size of bank, average loan size, and who normally approves loans at their bank.

RESULTS Table 2 provides descriptive statistics related to the dependent variables (2a) and demographic questions (2b). The mean probability of approving the $300,000 was very close to our target of 50%. The average respondent has 10 years experience, a bachelor’s degree, works in a bank with more than one

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Table 2a. Descriptive Statistics Mean, Median, Std. Dev., and Range of Variables for All Subjects

N

Mean

Median

Standard Deviation

CONFIDENCE PROBLINE MAXLINE

193 193 193

6.74 48.92 $242,381

8 50 $200,000

2.51 34.62 $92,263

RATE EXPERIENCE CAPITAL STRUCTURE

193 193 193

1.27% 9.7 6.95

1.25% 9 7

0.62% 6.95 1.46

Range 0–10 0–100 $75,000$600,000 0.0%–3.0% 0–31 2–10

CONFIDENCE =

Conﬁdence that ﬁnancial statements are presented fairly on scale of 0 (No Conﬁdence) to 10 (Complete Conﬁdence). PROBLINE = Probability of granting a line of credit at the requested amount on a scale of 0 (no chance) to 100 (certainly would grant the line). MAXLINE = maximum line of credit. RATE = minimum interest rate premium (above prime). EXPERIENCE = years served as a loan ofﬁcer. CAPITAL STRUCTURE = rating of capital structure of company requesting the loan (scale of 0 to 10, 0 = extremely weak, 10 = extremely strong).

Table 2b.

Personal Data

Education Level High School

Bachelor’s Degree

Master’s or higher

116

70

7

Bank Size (Assets) Less than $100,000,000 10

$100,000,000 to $500,000,000

$500,000,000 to $1,000,000,000

Greater than $1,000,000,000

25

16

142

Average Loan Size Approved Less than $100,000 8

$100,000 to $200,000

$200,000 to $400,000

Greater than $400,000

18

50

117

Note: Cells indicate number of subjects in those groups.

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billion dollars in assets, and approves loans whose average size is in excess of $400,000. Table 3 provides a comparison of the control group with the treatment groups, subdivided by type of opinion and reputation of the reviewer.8 Compared to no review, receiving an unqualiﬁed opinion from a reputable reviewer increased lenders’ conﬁdence, the probability of obtaining a line of credit, and the maximum line obtainable. Subjects in the control group were willing to give a slightly lower (31 basis points) interest rate than those in the unqualiﬁed opinion/reputable group. After controlling for the effects of demographic variables such as bank size, the difference in conﬁdence was statistically signiﬁcant (p < 0.01), and the difference in rate was marginally signiﬁcant (p < 0.10). The marginally signiﬁcant ﬁnding of a higher rate for the unqualiﬁed opinion/ reputable group than for the control group was contrary to our expectations. Any explanation for this anomaly would be pure speculation.9 A multivariate analysis of covariance (MANCOVA) was run on the treatment groups to determine the effect of the independent variables and the demographic variables on all four dependent variables. Only OPINION had a signiﬁcant effect (F = 3.68, p > 0.01). Univariate ANCOVAs summarized in Table 4 indicate that OPINION and REPUTATION had a signiﬁcant effect on subject’s conﬁdence in the audited ﬁnancial statements (CONFIDENCE).10 The type of review (TYPE) signiﬁcantly affected the interest rate above prime (RATE) (means: peer review 1.21%, quality review 1.51%). The size of the average loan (AVLOAN) granted by the subjects’ banks affected PROBLINE, the maximum line of credit they would grant (MAXLINE), and RATE.

DISCUSSION It appears that bank lending ofﬁcers gain conﬁdence in audit opinions from awareness of an unqualiﬁed peer/quality review received by the auditors from reputable reviewers. This may translate into greater ease of borrowing, but it does not translate into lower borrowing rates in this experiment. It may be that once a minimum level of credibility is achieved, further increases make little difference to the lenders’ risk assessments. Bankers also consider the reputation of the reviewer. In addition, they appear to grant lower interest rates in light of a peer review compared to a quality review. This last ﬁnding is consistent with the AICPA’s decision to eliminate quality reviews (Elsea & Stewart, 1995). Finally, the lack of signiﬁcance for the WHEN variable perhaps indicates that the three-year cycles are sufﬁcient timeliness for the peer reviews. This would support the AICPA’s current policy approach on frequency of peer reviews.11

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Table 3. Effect of Peer/Quality Reviews Descriptive Statistics for Dependent Variables Peer/Quality Review Clean Opinion

Qualiﬁed Opinion

No Peer/Quality Review

Reputable Reviewer

Not Reputable Reviewer

Reputable Reviewer

Not Reputable Reviewer

CONFIDENCE Mean Standard Dev. Median Range

7.16 (1.80) 8 3–9

8.33 (1.62) 9 2–10

6.36 (2.48) 7 0–10

5.89 (2.72) 7 2–10

6.03 (2.68) 7 1–10

PROBLINE Mean Standard Dev. Median Range

44.32% (42.23%) 45% 0%–100%

52.28% (32.0%) 60% 0%–95%

50.09% (33.80%) 57.5% 0%–98%

50.57% (34.29%) 50% 0%–100%

45.10% (35.76%) 50% 0%–100%

$241.413 ($85,723) $200,000 $100K–$500K

$259,543 ($115,710) $225,000 $100K–$600K

$239,571 ($78,613) $200,000 $100K–$500K

$234,905 ($86,562) $225,000 $75K–$500K

1.05% (0.66%) 1% 0%–2%

1.36% (0.61%) 1.5% 0.25%–3%

1.31% (0.59%) 1.25% 0%–3%

1.19% (0.57%) 1.25% 0%–2%

1.30% (0.68%) 1.5% 0%–3%

19

46

46

35

47

MAXLINE Mean $226,842 Standard Dev. ($83,437) Median $200,000 Range $100K–$450K RATE Mean Standard Dev. Median Range N CONFIDENCE PROBLINE MAXLINE RATE

= Conﬁdence that ﬁnancial statements are presented fairly on scale of 0 (No Conﬁdence) to 10 (Complete Conﬁdence). = Probability of granting a line of credit at the requested amount on a scale of 0 (no chance) to 100 (certainly would grant the line). = maximum line of credit. = minimum interest rate premium (above prime).

Note: The analysis at Table 4 controls for Bank Size and Average Loan, which are important covariates to facilitate discerning which differences are statistically signiﬁcant.

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Table 4. Univariate ANCOVA Results F VALUES CONFIDENCE REVIEWEE TYPE OPINION WHEN SOURCE REPUTATION EXPERIENCE EDUCATION BANKSIZE AVLOAN CONFIDENCE PROBLINE MAXLINE RATE REVIEWEE TYPE OPINION WHEN SOURCE REPUTATION EXPERIENCE EDUCATION BANKSIZE AVLOAN

0.83 0.70 11.24*** 0.96 0.06 4.78** 1.00 0.03 2.70 0.32

PROBLINE 0.74 0.16 0.65 1.61 2.30 0.41 0.46 1.90 0.34 5.44**

MAXLINE 0.20 0.13 1.26 2.54 1.89 0.09 0.15 1.00 0.54 3.98**

RATE 0.51 5.13** 0.92 0.13 0.77 0.41 0.07 0.74 7.28*** 5.08**

= Conﬁdence that ﬁnancial statements are presented fairly on scale of 0 (No Conﬁdence) to 10 (Complete Conﬁdence). = Probability of granting a line of credit at the requested amount on a scale of 0 (no chance) to 100 (certainly would grant the line). = maximum line of credit. = minimum interest rate premium (above prime). = 1 if Local ﬁrm, 2 if National ﬁrm, 3 if Big 6 ﬁrm. = 0 if Peer Review, 1 if Quality Review. = 0 if qualiﬁed report, 1 if unqualiﬁed. = 0 if review done 1 month ago, 1 if done 2.5 years ago. = 0 if done by CART, 1 if Firm-on-Firm, 2 if Association. = 0 if reviewer is not reputable, 1 if reviewer is very reputable. = years served as a loan ofﬁcer. = 0 if High School, 1 if Bachelor’s, 2 if Masters’ or higher. = 0 if assets of bank are less than $100,000,000, 1 if $100,000,000 to $500,000,000, 2 if $500,000,000 to $1,000,000,000, and 3 if greater than $1,000,000,000. = 0 if average loan approved is less than $100,000, 1 if $100,000 to $200,000, 2 if $200,000 to $400,000, 3 if greater than $400,000.

***p < 0.01, (two-tailed). **p < 0.05, (two-tailed).

Our ﬁndings suggest that it may be in audit clients’ interests for audit ﬁrms to begin promoting the results of their peer/quality reviews. This has not been done extensively in current practice, as found by Elsea & Stewart (1995). Moreover, in our discussions with bankers, we found that many bankers are unaware of the review process, so the profession probably can do a better job of informing potential third-party users of the beneﬁts of peer and quality reviews. We wish to emphasize that this study is an exploratory work to examine how a variety of factors might affect the way in which lending ofﬁcers react to

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peer/quality reviews. As such, the above ﬁndings are of a preliminary nature, and further research is necessary to corroborate our results.

NOTES 1. This Division consists of a Private Companies Practices Section and an SEC Practice Section. AICPA member ﬁrms that audit SEC clients are required to join the SEC Practice Section. However, not all SEC registrants are audited by AICPA member ﬁrms. 2. Yet, remember the lack of reviewer effect found in the 1980–86 ﬁlings. 3. Nast (1993) reports that as of July 1992, only 2% of all reviews have resulted in adverse opinions. In a phone conversation with a staff member of the SEC Practice Section, we learned that this rate was 1% for each of 1995 and 1996 and it was 2% for 1997. 4. It may be that some loan ofﬁcers in this study assumed that the auditor knowingly selected a reviewer with a poor reputation. Such an assumption might have different implications to the loan ofﬁcers. Although we have no reason to expect subjects to make such an assumption, its possibility remains a limitation of this study. 5. Since all Big Six ﬁrms were members of the AICPA Division for CPA ﬁrms, they would undergo peer reviews. Hence, we did not include any treatments that had both Big Six ﬁrms and quality reviews. 6. Since the time that our study was undertaken, the Big Six has become the Big Five. 7. The scope for peer reviews does not depend on the size of the reviewee. 8. Some relationships in Table 3 appear to be nonintuitive. For instance: (1) for a clean opinion, the rate for “Reputable” is higher than for “Not Reputable”; (2) for a clean opinion, the maximum credit line is higher for “Not Reputable” than for “Reputable”; and (3) for a qualiﬁed opinion, the conﬁdence for “Not Reputable” is higher than for “Reputable”. However, these differences are not statistically signiﬁcant and also they do not consider the effects of factors like average loans and bank sizes. Signiﬁcance tests are conducted in Table 4, where we control for these factors. 9. A within subjects study could be done to assess whether the results between subjects hold consistently within subjects. We did not go back to our subjects for additional data because many of them had moved to different positions and/or banks at the time we considered extending the study. 10. When an interaction between OPINION and REPUTATION is included in the model, none of the variables are signiﬁcant in the MANCOVA; however, OPINION, REPUTATION, and their interaction are all signiﬁcant in the ANOVA with CONFIDENCE as the dependent variable (p < 0.05, one-tailed). 11. We thank an anonymous reviewer for this insight.

REFERENCES AICPA (2000). Peer Review is Revised. The Practicing CPA, (January), 1–2. Colbert, G., & Murray, D. (1998). The Association Between Auditor Quality and Auditor Size: An Analysis of Small CPA Firms. Journal of Accounting, Auditing & Finance, (Spring), 135–150.

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Ehlen, C. R., & Welker, R. B. (1996). Procedural Fairness in the Peer and Quality Review Programs. Auditing: A Journal of Practice & Theory, (Spring), 38–52. Elsea, J. E., & Stewart, J. R. (1995). Perceptions of Peer and Quality Review. The CPA Journal, (June), 58–60. Evers, C. J., & Pearson. D. B. (1989). Lessons Learned from Peer Review. Journal of Accountancy, (April), 96–105. Francis, J. R., Andrews, W. T., & Simon, D. T. (1990). Voluntary Peer Reviews, Audit Quality, and Proposals for Mandatory Peer Reviews. Journal of Accounting, Auditing & Finance, (Summer), 369–378. Felix, W. L., & Prawitt, D. F. (1993). Self Regulation: An Assessment by SECPS Members. Journal of Accountancy, (July), 20–21. Fogarty, T. J. (1996). The Imagery and Reality of Peer Review in the U.S.: Insights from Institutional Theory. Accounting, Organizations and Society, (Feb.-April), 243–267. Geary, M., & Wessendarp, W. G. (1989). Mandatory Quality Review: Impact on CPA Firms and Practitioners in Ohio. Ohio: CPA Journal, (Summer), 5–9. Hock, S. (1993). Quality Review, in 2nd Phase, Gets Tuned for Speed, Cost. Accounting Today, (June 21), 2, 31. Huff, B. N., & Kelley, T. P. (1989). Quality Review and You. Journal of Accountancy, (February), 34–40. Karnes, A., King, J. B., & Walker, R. B. (1991). Quality Review and the Small Practitioner: Burden or Beneﬁt? CPA Journal, (June), 16, 18. King, J., Welker, R., & Keller, G. (1994). The Effects of Independence Allegation on Peer Review Evaluation of Audit Procedures. Behavioral Research in Accounting, 6, 72–91. Macklin, M. (1989). How Three Firms Beneﬁted from Peer Review. Journal of Accountancy, (June), 87–90. Mancuso, A. J. (1991). The Road to Quality. CPA Journal, (September), 94–95. McCabe, R. K., Luzi, A., & Brennan, T. (1993). Managing Partners’ Perceptions of Peer Review. Auditing: A Journal of Practice & Theory, (Fall), 108–115. Nast, W. (1993). Quality Review: What’s New? CPA Journal, (May), 16–24. Public Oversight Board (1993). A Special Report by the Public Oversight Board of the SEC Practice Section, AICPA (Stamford, CT: Public Oversight Board). Specht, L. B., & Waldron, D. G. (1992). Auditor Perceptions of Statements on Auditing Standards 53 and 54: A Study of Demographics and Perceptions of Efﬁcacy. Journal of Applied Business Research, 8, (Spring), 87–93. U.S. General Accounting Ofﬁce (1996). The Accounting Profession (Washington, DC: U. S. General Accounting Ofﬁce). Wallace, W. A. (1991). Peer Review Filings and Their Implications in Evaluating Self-Regulation. Auditing: A Journal of Practice & Theory, 10, (Spring), 53–68. Walters, R. (1989). Operation Highroad: Confused by Reviews? Outlook, (Fall), 62.

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THE RELEVANCE OF AUDIT COMMITTEES FOR COLLEGES AND UNIVERSITIES Zabihollah Rezaee, Robert C. Elmore and Joseph Z. Szendi

ABSTRACT The importance and number of audit committees have grown signiﬁcantly for proﬁt-oriented organizations during the last two decades. Corporate audit committees are viewed as playing an important role in insuring a responsible corporate governance and a reliable ﬁnancial reporting process. There is, however, little evidence regarding the relevance of audit committees for colleges and universities and their perceived functions and responsibilities. This study gathered survey opinions regarding the relevance and roles of university audit committees. The results indicate that: (1) audit committees are relevant for colleges and universities; (2) college audit committees are more likely to be responsive to top administrators than to governing boards; and (3) the perceived functions of university audit committees are similar to those of municipal governments and private corporations. The results should be useful to regulators, authoritative bodies, and colleges and universities in establishing new audit committees or redesigning existing committees.

Research in Accounting Regulation, Volume 14, pages 39–60. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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INTRODUCTION Increased corporate governance and accountability for entities appears to be a national trend. A number of reports (e.g. the Treadway Commission, 1987; the Cadbury Committee, 1992; the Public Oversight Board, 1993; the Kirk Panel, 1994; the Blue Ribbon Committee, 1999) state that audit committees play a prominent role in ensuring a responsible corporate governance and a reliable ﬁnancial reporting process. The Blue Ribbon Committee, in February 1999, issued a report that contains ten recommendations for strengthening the independence of the audit committee and making it more effective oversight function of the board of directors. Business ﬁrms have thus taken proper actions to improve the role, structure, functions, responsibilities, and public proﬁles of their audit committees (Rezaee & Farmer, 1995). The American Institute of Certiﬁed Public Accountants (AICPA) and the U.S. General Accounting Ofﬁce (GAO) have urged large public entities receiving federal assistance to establish audit committees to improve the quality of both internal and external audit functions and create greater accountability by those in the public sector (Nix & Nix, 1996). Prior research on audit committees (e.g. Knapp, 1987; Zahra & Pearce, 1989; Bradbury, 1990; Breasley, 1996; Daily, 1996; Rezaee, 1997; Scarbrough et al., 1998) has examined issues regarding the structure, composition, functions, and beneﬁts of audit committees for corporations. There is, however, no current research which gathers empirical evidence regarding: (1) the extent to which audit committees are used in audit oversight activities in colleges and universities (hereafter, C&U); and (2) the organizational governance and accountability functions of audit committees in higher education institutions. The primary purposes of this study are to: (1) determine the extent to which audit committees are used in C&U; (2) examine the current status and characteristics of college and university audit committees; (3) determine the relevance of audit committees for C&U; (4) describe the appropriate functions of audit committees, and (5) ascertain how college audit committees adjust to different demographic characteristics. Insights and views of the respondents (vice presidents of ﬁnance) on the proper role, structure, and attributes of audit committees should be useful to many C&U in establishing audit committees or improving the performance of existing audit committees.

BACKGROUND The use of audit committees in overseeing corporate governance and the ﬁnal reporting process has gained popularity in the past decade even though audit

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committees have a relatively long history. The Securities and Exchange Commission (SEC) ﬁrst recommended the establishment of audit committees in 1940 (Birkett, 1986). The report of the Public Oversight Board (POB) of the SEC Practice Section of the AICPA (AICPA, 1994, 13) states that “corporate governance in the United States is not working the way it should . . . more effective corporate governance depends vitally on strengthening the role of the board of directors.” The POB also underscores the importance of audit committees, because external auditors typically interact with the board of directors through audit committees. The Treadway Commission called for a re-examination regarding the structure, role, and functions of audit committees, including the suggestion that the SEC require companies under its jurisdiction to have an independent audit committee (Treadway, 1987). The Federal Deposit Insurance Corporation (FDIC) regulations (Section 363.5) require large ﬁnancial institutions to establish an independent audit committee of outside, non-executive board members (FDIC 1993). Both the Treadway Commission and the FDIC regulations recognize the value and importance of audit committees in enhancing the reliability of the ﬁnancial reporting process, promoting greater corporate accountability, and securing responsible corporate governance. The New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the National Association of Security Dealers (NASD) require listed companies to establish audit committees, with the majority of membership consisting of independent members of the board. The SEC has recently proposed rules to improve disclosure about the structure, functions, and role of corporate audit committees and to enhance the reliability and credibility of ﬁnancial statements of public companies (AICPA 1999a). In the United Kingdom, universities are required to establish audit committees in order to be in compliance with the Universities Funding Council (PCFC) (Deming & Williams, 1995). C&U in the United States, like their counterparts in the United Kingdom, are facing increased demands for accountability from both external and internal forces. They are confronted with an unprecedented need for evaluating their stewardship and effectiveness in response to declining resources, decreasing enrollments, increasing operating costs, and growing complexity (Azad, 1994). An effective audit committee would meet the need for stewardship and accountability. The legislators (e.g. the U.S. Department of Education) could even mandate the establishment of audit committees, since the majority of, if not all, C&U use some sort of local, state, and federal funding.

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RELATED RESEARCH Audit Committees in For-Proﬁt Entities A number of reports (Treadway Commission, 1987; COSO, 1992; FDIC, 1993; AICPA, 1994) have addressed the role of the board of directors and its representative audit committee in overseeing corporate governance and the ﬁnancial reporting process in for-proﬁt entities, thus emphasizing the important role of audit committees in the private sector. Prior research on audit committees has concentrated on two issues related to the role of audit committees for public companies, which are: (1) audit committees’ role in ensuring responsible corporate governance; and (2) functions of audit committees in enhancing quality of the ﬁnancial reporting process. Audit Committees and Corporate Governance Proper corporate governance requires the exercise of power over the direction of the corporate entity while focusing on ﬁnding ways to make the entity run better (Clarke, 1993). Corporate governance and accountability focus on the entity’s board of directors, organizational structure, management, and audit committee. The role of audit committees in the area of corporate governance and accountability is to assume oversight responsibility in providing reasonable assurance that the entity: (1) is in compliance with applicable laws and regulations; (2) maintains an effective internal control system; (3) is conducting its business professionally and ethically; and (4) is monitoring its ﬁnancial reports (Rezaee, 1997). The extent to which the audit committees assist the board in its oversight role is determined by the set of functions performed by the audit committee, its independence from the board, and how effectively these functions are performed. The POB (1993) has stated that “. . . in too many instances the audit committee members do not perform their duties adequately.” Cadbury Committee (1992) and Sommer (1991) found similar ﬁndings regarding the effectiveness of audit committees in fulﬁlling their responsibilities. Kalbers & Fogarty (1993) provide a comprehensive summary of studies relating to audit committee effectiveness. Vicknair et al. (1993) found the majority of companies (74% of NYSE companies) have at least one grey director on their audit committee, which may impair their independence. Menon & Williams (1994) and Daily (1996) investigated the effect of audit committee structure on monitoring by focusing on the committees’ composition, the frequency of their meetings, and other factors associated with their structure. Spangler & Braiotta

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(1990) provide some evidence of audit committee effectiveness by investigating how the leadership style of the chair of the audit committee could inﬂuence effectiveness. Audit Committees and Financial Reports Audit committees, by overseeing the ﬁnancial reporting process, internal control structure, and audit function, can play an important role in determining the type and quality of ﬁnancial information provided by companies. Audit committees can provide an invaluable communication link between auditors (both external and internal) and the board of directors, which can strengthen the audit function and auditors’ role in the ﬁnancial reporting process. A number of studies have examined the association between the presence of audit committees and various proxies used for the quality of ﬁnancial reporting. The SEC has stated that an effective audit committee provides the “greatest possible protection to investors” (Price Waterhouse, 1993). Wild (1996) found a signiﬁcant increase in an entity’s earnings response coefﬁcient subsequent to the formation of an audit committee. Beasley (1996) examined the effect of the audit committee on ﬁnancial statement fraud and found an inverse relationship between the percentage of outside directors and the likelihood of fraudulent ﬁnancial reporting. Wright (1996) found: (1) a direct relationship between the quality of an entity’s ﬁnancial reporting and the percentage of outside directors on the audit committee; and (2) an inverse relationship between the likelihood of being sanctioned by the SEC for a ﬁnancial reporting violation and the percentage of outside directors on the audit committee. McMullen (1996) provides some evidence that indicates a direct relationship between the existence of audit committees and ﬁnancial reporting quality measured in terms of lack of shareholder litigation alleging fraud, SEC enforcement actions, auditor turnover, illegal acts, and corrections of reported earnings. Knapp (1987) found that the audit committee can assist in preserving the independence of the external auditor by mitigating management pressure that might be placed on the auditor. Scarbrough et al. (1998) examined the relationship between audit committee composition and the committee’s involvement in the internal audit function and found that the audit committee composed solely of outside directors was more likely to have frequent meetings with the chief internal auditor and review the internal auditing program as well as results of internal auditing. An effective audit can assist the board of directors in fulﬁlling its oversight responsibility (Zahra & Pearce, 1989). Effective audit committees can limit the board of directors’ exposure to litigation by providing evidence of due care in the exercise of board obligations (Eichenseher & Shields, 1985). A potential 43

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beneﬁt to corporations of voluntarily formed audit committees is high image value (Bradbury, 1990). Internal auditors believe that an audit committee consisting of knowledgeable, effective, and active members can have a positive impact on their effectiveness (Kalbers, 1992). Audit committees also serve as a liaison between management and external auditors in resolving audit issues (Knapp, 1987). The SEC, NYSE, and NASD, in September 1998, sponsored a “blue ribbon” panel consisting of the various constituencies of the ﬁnancial community to make recommendations on strengthening the role of audit committees in overseeing the corporate ﬁnancial reporting process (SEC, 1998). The panel undertook an intensive study of the effectiveness of the audit committee in fulﬁlling its oversight responsibilities and made ten concrete recommendations for its improvement (Blue Ribbon Committee, 1999). These ten recommendations are classiﬁed into three groups. The ﬁrst group consists of two recommendations aimed at strengthening the independence of the audit committee, which essentially suggest that the NYSE and the NASD require that listed companies with a market capitalization above $200 million have an audit committee composed solely of independent directors, and members of the audit committee should be considered independent of their corporation. The second group of recommendations is aimed at making the audit committee more effective by suggesting that the audit committee: (1) be composed of a minimum of three directors who are ﬁnancially literate; (2) adopt a formal written charter that is approved by the full board of directors; and (3) disclose in the company’s proxy statement for its annual meeting of shareholders whether it has adopted a formal written charter and whether it has satisﬁed its responsibility during the reporting year. The last set of recommendations describes mechanisms for accountability among the audit committee, the outside auditors, and management by suggesting that: (1) the outside auditor is ultimately accountable to the board of directors and the audit committee; (2) the audit committee is responsible for ensuring its receipt from the outside auditor of a formal written statement delineating all relationships between the auditor and the company; (3) the outside auditor should discuss with the audit committee the auditor’s judgment about the quality, not just the acceptability, of the company’s accounting principles as applied in its ﬁnancial reporting; (4) the SEC should require all reporting companies to include a letter from the audit committee in the company’s annual report to shareholders; and (5) the SEC should require that a reporting company’s outside auditors conduct an interim ﬁnancial review prior to the company’s ﬁling of its Form 10-Q. Two of these recommendations pertain to independent auditors and suggest changes to generally accepted auditing standards (GAAS). Thus, the Auditing Standards Board has issued an exposure draft of a proposed statement on auditing

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standards (SAS) titled Amendments to Statement on Auditing Standards No. 61, Communication with Audit Committees and Statement on Auditing Standards No. 71, Interim Financial Information. The proposed SAS was issued in response to recommendations of the Blue Ribbon Committee and would require, among other things, that: (1) the auditor discuss certain information relating to the auditor’s judgments about the quality, not just the acceptability, of the company’s accounting principles with the audit committees of SEC clients; and (2) the accountant of an SEC client discuss with the audit committee matters described in SAS No. 61 prior to the ﬁling of the Form 10-Q (AICPA, 1999b). In summary, prior research, publications, and authoritative reports have demonstrated the following beneﬁts of audit committees for proﬁt-oriented organizations: (1) enhanced quality of ﬁnancial reporting; (2) improved external auditor independence; (3) increased quality of internal and external audits; (4) improved internal control structure; and (5) increased public conﬁdence in the credibility and impartiality of ﬁnancial reports. Governmental Audit Committees Governmental audit committees also have an important role. Audit committees in municipal governments have a perceived role of promoting “effectiveness and efﬁciency of city government” (Sharp & Bull, 1992, p. 64). Important attributes of an effective governmental audit committee are independence of members; written charters, objectives, and minutes documenting the scope of their charge; regularly scheduled meetings; and public disclosure (Gebhart & Reinstein, 1987). Audit committees are perceived as making positive contributions to communication between councilmen/directors and external and internal auditors, independence and review of internal auditors, independence and review of external auditors, review and advisement of ﬁnancial management, and improvement in implementation time of internal controls (Wagner, O’Keefe & Bostwick, 1987). Governmental audit committees’ areas of activity include selecting auditors, serving as a liaison between the audit staff and the auditee organization, reviewing audit reports, and assisting with audit planning and operation (Dittenhofer, 1988). In general, governmental audit committees spend more time dealing with external auditors than internal auditors (Montondon, 1992). Dealing with external auditors involves selecting external auditors, acting as a liaison with external auditors, and setting the scope of external audits. Activities involving internal auditors include receiving internal reports, identifying weaknesses, and overseeing the implementation of audit ﬁndings. Despite the fact that audit committee members with ﬁnancial backgrounds are perceived as the 45

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best members, the audit committees are typically municipal ofﬁcers and city council members (Montondon, 1992). In the United Kingdom, universities are required to organize and use audit committees. C&U in the United States are facing increased demands for stronger stewardship and accountability, which can be achieved through the use of effective audit committees. Furthermore, the AICPA and GAO have urged large public entities receiving federal assistance to establish audit committees. There is no empirical evidence regarding the use and effectiveness of audit committees in C&U in the United States. Our research seeks to determine the extent to which audit committees are currently used in C&U and to examine the role, functions, and responsibilities of institutions of higher education audit committees. The identiﬁcation of the set of functions commonly performed by colleges and university audit committees is important for several reasons. First, the set of functions performed by an audit committee provides some indication of the audit committee’s involvement and effectiveness in the audit oversight function, corporate governance, and the ﬁnancial reporting process. Second, insights into the set of functions commonly performed by audit committees would be of interest to those policymakers and regulatory agencies (e.g. U.S. GAO, FASB, and GASB) involved in establishing recommended practices for college and university audit committees. The recommendations of such standard-setting bodies can only be improved by a better understanding of the functions commonly performed by audit committees.

METHODOLOGY This study surveyed a large sample (1,000) of ﬁnancial administrators (vice presidents of ﬁnance) of C&U randomly selected from the 1996 membership rolls of the National Association of College and University Business Ofﬁcers (NACUBO). There was a choice of whether to send the questionnaire to chairpersons (or any member) of audit committees or to the vice president of ﬁnance at the surveyed C&U. There were two main practical reasons for not sending the questionnaire to chairpersons of audit committees. The ﬁrst was the difﬁculty of identifying chairs of audit committees in the surveyed C&U. The second reason was the difﬁculty of communicating with them, especially if they were lay members of audit committees of the surveyed C&U. Despite the potential for compromise, the questionnaires were therefore sent to vice presidents of ﬁnance, the principal reason being that they would have sufﬁcient knowledge of their institution’s governance, ﬁnancial reporting process, audit functions, and audit committees. To maximize the response rate, the questionnaire was

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accompanied by a cover letter stating the survey objectives, assuring conﬁdentiality of the responses, agreeing to share the ﬁndings, giving the approximate time needed to complete the questionnaire, and providing a pre-addressed postage-paid return envelope. After six weeks, a second mailing was sent to all C&U who did not return a questionnaire in which they revealed their identity. We compared the responses of both groups for differences and found no statistical differences between the two groups. It is impossible to determine how nonrespondents would have answered. However, as a test of nonresponse bias, late responses were compared to early responses, assuming that late responses are similar to nonresponses (Babbie, 1979; Solomon, 1990). Usable completed questionnaires were received from 290 vice presidents of ﬁnance resulting in a response rate of 29%. A two-page questionnaire was designed, pretested, revised, and then mailed to subjects. The questionnaire contained ﬁve sections.1 The ﬁrst section sought general factual information about the existence and characteristics of audit committees, such as size, length of tenure, and number of meetings. Section two asked questions regarding reasons and purposes for establishing audit committees. Section three asked subjects to express their perceptions regarding the roles and responsibilities of audit committee members. Section four asked for demographic and background information, which was used for classiﬁcation purposes. The ﬁnal section sought comments on the previous four sections. The Kruskal-Wallis nonparametric test was used to test for signiﬁcant differences between public and private C&U. Bartlett’s Box-F test was used to test for any violation of the heteroskedasticity assumption, and accordingly any questions violating this assumption were eliminated. Responses were tested for nonresponse bias using an accumulated ANOVA test and found to be free of nonresponse bias. Table 1 provides demographic information about the respondents. Over 60% of responding institutions were private schools, and the remainder were statesupported universities. Accordingly, classiﬁcation of public versus private provided the most signiﬁcant explanatory variable of the demographic data. The majority of universities were primarily non-commuting (54.3%). Ninety-nine percent of the respondents’ universities have been in operation more than 20 years. More than one-half (51.4%) have been in operation more than 100 years. Table 1 provides the characteristics of size in terms of students, faculty, and budget. The majority of respondents also reported having two to ﬁve colleges or schools (55.8%). More than 32% of the responding universities have an annual budget of $21 to $50 million, about 38% reported a total budget of more than $50 million, and approximately 30% indicated their annual operating budget is less than $20 million. 47

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Table 1. Characteristics of Respondents NUMBER OF RESPONSES

PERCENTAGE

A. State supported or private State supported Private

115 175

39.7 60.3

B. Commuting or noncommuting Commuting Noncommuting

122 145

45.7 54.3

C. Number of years in operation Less than 20 20–50 51–100 More than 100

2 62 76 149

1.0 21.4 26.2 51.4

D. Student Population Less than 2000 2001- 5000 5001–10000 10001–20000 20001–35000 Greater than 35000

120 72 43 26 19 10

41.4 24.8 14.8 9.0 6.6 3.4

E. Number of Faculty Less than 100 101- 300 301- 500 501–1000 1001–2000 2001–5000 Greater than 5000

163 94 27 27 23 10 3

35.9 32.8 9.4 9.4 8.0 3.5 1.0

F. Number of Colleges (Schools) 5 or less 6 to 10 11 to 20 Greater than 20

163 60 16 5

66.8 24.6 6.6 2.0

11 25 51 95 37 50 22

3.8 8.6 17.5 32.6 12.7 17.2 7.6

G. Total Budget in Millions Less than 5 5 to 10 11 to 20 21 to 50 51 to 100 101 to 500 Greater than 500

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RESULTS The results are presented in the following ﬁve sections: (1) the current status of college and university audit committees; (2) attributes of college and university audit committees; (3) relevance of audit committees for C&U; (4) functions of college and university audit committees; and (5) differences in audit committees between public and private institutions. The Current Status of College and University Audit Committees Table 2 provides information on the percentage of respondents having an audit committee and whether they believe C&U should have audit committees. Respondents generally were supportive of the concept of audit committees in C&U. Nearly 60% of the respondents (59.9%) have audit committees. This is encouraging when compared to surveys of municipal government. Nix & Nix (1997) found 17%; Montondon (1992), 18%; and Pelfrey & Peacock (1993), 34% of their governmental respondents have audit committees. There was a general agreement that audit committees have a role in C&U. Over 79% of the respondents agree that universities and colleges should have audit committees. These results are consistent with the recommendations of both the U.S. GAO and the AICPA that public entities such as state-supported universities should establish and use audit committees in their audit oversight function. Attributes of Audit Committees in Colleges and Universities Table 3 presents the responses to three questions pertaining to the attributes of audit committees. Question 1 of Table 3 provides the number of members on

Table 2. The Status of Audit Committees 1. Does your university or your board of regents system have an audit committee? PERCENTAGE YES NO 59.9 40.1 2. Do you think colleges and universities should have audit committees? PERCENTAGE YES NO 79.5 20.5

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the audit committee. Over 21% of respondents reported their audit committees consist of three members, while almost the same percentage indicated they have ﬁve members on their audit committees. Nearly 38% reported more than ﬁve members on their audit committees. The mean size of the college audit committees is 5.275 members. Our results are consistent with those of Gebhard & Reinstein (1987) and Rezaee (1997). Prior research (e.g. Gebhard & Reinstein, 1987; Dittenhofer, 1988; Chait & Haller, 1979) found that audit committees in municipal units typically consist of three members in small cities and ﬁve members in large cities. Other studies (e.g. Rezaee, 1997; Treadway report, 1987) have found three to ﬁve audit committee members for private corporations. The Blue Ribbon Committee (1999) suggests that the corporate audit committee be composed of a minimum of three ﬁnancially literate directors. Question 2 of Table 3 provides the number of years audit committee members serve. More than 30% reported their audit committee members serve three years on the committee, while about 34% indicated less than three years, and nearly 36% reported more than three years. These members serve a mean-length term of 3.280 years. This is consistent with studies involving municipal governments. For example, Wagner, O’Keefe & Bostwick (1988) found that municipal audit committees typically are appointed for two-year terms, while Gebhard & Reinstein (1987) found one to four years to be the norm. In establishing the terms of audit committee members, universities should assess and balance the need for both continuity and freshness (Coopers & Lybrand, 1994, p.4). Rapid turnover can negatively affect the effectiveness of the audit committee, while new members can bring a fresh perspective to the committee. Turnover in audit committees of C&U is greater than that of private corporations, with college and university members serving a mean-length term of 3.280 years, compared to seven years in private corporations (Rezaee, 1997). One may argue that the smaller size and shorter length term of audit committee members in C&U may result in a negative impact on their knowledge of the ﬁnancial system and a less important role in dealing with organizational governance and accountability. Table 3 also provides the number of times that audit committees meet with various parties. Audit committees were most likely to meet with internal auditors, meeting 3.088 times annually. They also met frequently with the vice president of ﬁnance, 2.920 times annually; the board of regents or governing board, 2.816 times annually; the president, 2.789 times annually; the provost and vice president of academic affairs, 2.452 times annually; and state legislators, twice a year. Audit committees also meet more than once a year with independent CPAs and accreditation bodies. These results indicate that the audit

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Table 3. Attributes of Audit Committees 1. Number of members on the college audit committees NUMBER OF MEMBERS 3 4 5 6 7 8 9 GREATER THAN NINE

PERCENTAGE 21.9 19.1 21.3 16.3 7.3 3.4 3.9 6.7 Mean Response = 5.275

2. Length of terms of audit committee members in years. YEARS SERVED 1 2 3 4 5 GREATER THAN FIVE

PERCENTAGE 15.9 17.8 30.7 12.1 5.1 18.5 Mean Response = 3.280

3. How many times did your audit committee meet in the last 12 months with: Internal Auditors Vice President of Finance Governing Board or Board of Regents President Provost and Vice President of Academic Affairs State legislators Independent CPA Accreditation bodies

NO. OF TIMES 3.088 2.920 2.816 2.789 2.452 2.000 1.620 1.500

committee tended to meet regularly with the favored option being three times per year with the stakeholders while there is certainly overlap at the same meeting. Relevance of Audit Committees for Colleges and Universities Respondents were asked to check the listed reasons and purposes for establishing the audit committee at their institution. The results are presented in Table 4. 51

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Table 4. Relevance of Audit Committees for Colleges and Universities 1. To improve corporate governance and accountability 2. To enhance reliability of ﬁnancial and nonﬁnancial reports 3. To meet the requirements of the board of regents 4. To comply with applicable rules and regulations 5. To meet the requirements of accreditation bodies

45.2 32.9 21.6 16.8 8.6

The most important reason was seen as improving corporate governance and accountability (45.2%). Second and third, respectively, were: to enhance reliability of ﬁnancial and nonﬁnancial reports (32.8%) and to meet the requirements of the Board of Regents (21.6%). The least relevant purposes for establishing audit committees for C&U were to comply with applicable rules and regulations (16.8%) and to meet the requirements of accreditation bodies (8.6%). Functions of Audit Committees Respondents were asked to indicate the importance of the responsibilities of audit committees in C&U by ranking several questions pertaining to functions of audit committees on a ﬁve-point Likert scale ranging from ‘5 = very important’ to ‘1 = not important.’ The mean-response results are presented in Table 5. Considered most important are the following: participate in selecting external auditors and review their reports (4.015); ensure adequacy and effectiveness of internal controls (3.878); oversee ﬁnancial reporting (3.821); ensure responsible corporate governance (3.628); and monitor performance of internal auditors and review their reports (3.527). Results are consistent with the ﬁndings of Sharp & Bull (1992) and Rezaee (1997), in that the primary role of the audit committee in municipal governments and private sectors is to meet with external auditors and review the ﬁndings and issues. These results indicate the perceived function of the university and college audit committee is similar to the function of those in municipal government and in private corporations. College and university respondents considered the following as least important functions of audit committees: review compliance reports to regulatory agencies (3.198); preview university policies and use of resources (3.06); review code of professional ethics (2.804); review university budgets (2.625); and

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Table 5. Functions of Audit Committees MEAN RESPONSE 1. Participate in selecting external auditors and reviewing their reports 2. Ensure adequacy and effectiveness of internal controls 3. Oversee ﬁnancial reporting 4. Ensure responsible corporate governance 5. Monitor performance of internal auditors and review their reports 6. Review compliance reports to regulatory agencies 7. Review university policies and use of resources 8. Review code of professional ethics 9. Review university budgets 10. Review accreditation standards and compliance with them

4.015 3.878 3.821 3.628 3.527 3.198 3.010 2.804 2.625 2.487

review accreditation standards and compliance with them (2.487). These results are consistent with the idea that presidents, vice presidents, deans, and other top level administrators would have greater expertise in reviewing and complying with accreditation standards as well as reviewing the university budgeting process. However, it is surprising that, with the internal ﬁnancial problems and scandals involving C&U (e.g. Engle & Smith, 1990; Kibler, 1994), there is little concern about the role of audit committees in reviewing compliance with codes of professional ethics and in reviewing university budgets. Differences in Responses Between Public and Private Universities It can be argued there should be some variations in the formation, structure, and functions of audit committees at public universities compared to private institutions, primarily because of the differences in their administrative and ﬁnancial reporting environments. The Kruskal-Wallis nonparametric test was performed to examine differences in all responses between public and private universities. Results are presented in Table 6. Signiﬁcant differences were found in that audit committees of public C&U met more often with governing boards or boards of regents (3.7600 to 2.2674), the president (3.2500 to 2.5517), vice president of ﬁnance (3.4545 to 2.5762), the independent CPA (2.0000 to 1.4804), and internal auditors (3.6667 to 2.0400). 53

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Table 6. Differences Between Private and Public Universities Regarding the Frequencies of Audit Committee Meetings MEAN RESPONSES PUBLIC PRIVATE

1. Board of Regents 2. President 3. Provost and VP of Academic Affairs 4. VP of Finance 5. Independent CPA 6. Internal Auditors

CHI-SQUARE

n=115 3.7600 3.2500 2.8667

n=175 2.2674 2.5517 2.2222

19.9645** 6.1797* 0.5126

3.4545 2.0000 3.6667

2.5762 1.4804 2.0400

7.1195* 5.0739** 15.6158*

*Signiﬁcant at p = 0.01. **Signiﬁcant at p = 0.05.

The differences in responses pertaining to the importance of certain responsibilities of audit committees are summarized in Table 7. Private universities considered more important the overseeing of ﬁnancial reporting (4.1349 to 3.2206) and participating in selecting external auditors and reviewing their reports (4.2578 to 3.5441). Public C&U found the following more important: reviewing compliance reports to regulatory agencies (3.5714 to 2.9841); monitoring performance of internal auditors and reviewing their reports (4.1176 to 3.1770); and ensuring responsible corporate governance (3.8696 to 3.4841). Responses on the other questions were not statistically different, indicating there is a general agreement between private and public universities regarding the relevance, importance, and functions of audit committees for institutions of higher education. Subjects are invited to write in any comments regarding the relevance of audit committees for C&U. One respondent wrote, “our audit committee is newly formed and required by system of Board of Governor. However, no interest has been shown by administration or Board of Trustees to make the committee active.” Another respondent wrote, “Audit committee is composed of positions, not individuals, such as ﬁnance chair of Board of Regents, Chancellor, Vice Chancellor of Finance and Administration.” Comparisons with the U.K. Research Findings and Industrial Context As mentioned previously, the Polytechnics and Colleges Funding Council in the U.K. requires U.K. universities to establish audit committees and also sets forth detailed rules regarding established audit committees’ structure, composition

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Table 7.

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Differences Between Private and Public Universities Regarding Audit Committee Responsibilities MEAN RESPONSES PUBLIC PRIVATE

1. Oversee ﬁnancial reporting 2. Review university budgets 3. Review compliance reports to regulatory agencies 4. Review code of professional ethics 5. Participate in selecting external auditors and reviewing their reports 6. Monitor performance of internal auditors and review their reports 7. Ensure adequacy and effectiveness of internal controls 8. Ensure responsible corporate governance 9. Review university policies and use of resources 10. Review accreditation standards and compliance with them

CHI-SQUARE

n=115 3.2206 2.4203 3.5714

n=175 4.1349 2.7280 2.9841

25.6288** 1.3391 9.8109**

2.8261

2.7823

.0561

3.5441

4.2578

10.6928**

4.1176

3.1770

17.4479**

3.9275

3.8413

.6288

3.8696

3.4841

5.2928*

3.0725

2.9606

.3333

2.3676

2.5492

.7958

*Signiﬁcant at p=.01. **Signiﬁcant at p=.05.@HB:Comparisons with the UK Research Findings and Industrial Context

meetings, and functions (Dewing & Williams, 1995). We compare our results with those of the U.K. research on audit committees for C&U on comparable and related similar questions. There is more agreement than divergence between our results and those of the U.K. research in the following areas: (1) the reasons for establishment of audit committees; (2) size of audit committees; (3) number of meetings of audit committees; and (4) audit committee roles for C&U. Finally, it is interesting to make some summary comparisons of our results for C&U audit committees with those of Rezaee’s (1997) regarding audit committees for business ﬁrms. This comparison indicates that: (1) the numbers of audit committee members are slightly different, as college and university audit committees tend to be smaller than those in private corporations; (2) the relationships of audit committees with internal auditors and independent auditors 55

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are broadly similar; (3) the frequency of audit committee meetings with various parties is quite different in the sense that private sector audit committees meet more frequently with their constituencies than their counterparts at C&U; and (4) the speciﬁcation of duties is virtually identical regarding overseeing organizational governance, ﬁnancial reporting process, and audit functions.

CONCLUSION Issues related to oversight functions of audit committees in organizational governance and the ﬁnancial reporting process for the private sector have been extensively debated in the literature. This paper presents evidence regarding the relevance, role, functions, and proﬁle of audit committees for C&U. It represents the ﬁrst study to consider issues related to the formation, functions, and beneﬁts of college and university audit committees. The results of this study should be useful to regulators, authoritative bodies, and C&U as they attempt to establish a more responsible organizational governance, an effective audit oversight, and a more reliable reporting process. The results may also be relevant to policymakers who are considering mandatory audit committees for C&U. Our results indicate that college and university audit committees are less likely than corporate audit committees to meet with their various constituencies. College audit committees also seem to be less responsive to governing boards, while meeting more often with the university president and the vice president of ﬁnance. College and university audit committees tend to be smaller than those in private corporations. The function of the university and college audit committee is similar to the function of those in municipal government and private corporations. The perceived important functions of college audit committees are: (1) participation in selecting external auditors and reviewing their reports; (2) ensuring adequacy and effectiveness of internal controls; (3) overseeing ﬁnancial reporting; (4) ensuring responsible organizational governance; and (5) monitoring performance of internal auditors and reviewing their reports. The emerging corporate governance and accountability issues have boosted the role, responsibility, and public priorities of audit committees for proﬁtoriented organizations. Our study of the relevance of audit committees for C&U indicates that respondents generally were supportive of the concept of audit committees in C&U. Audit committees are of signiﬁcant importance in fulﬁlling the oversight responsibilities of governing boards pertaining to: (1) the reliability of the ﬁnancial reporting process; (2) sufﬁciency and effectiveness of internal control structure; and (3) increased quality of both external and internal

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audits. While the ﬁndings of this study are encouraging to C&U attempting to establish or promote their audit committees, there is concern that despite the internal ﬁnancial problems and scandals involving C&U (e.g., Engle & Smith, 1990; Kibler, 1994), there is little concern for the role of audit committees in reviewing compliance with codes of professional ethics and in reviewing university budgets. This study is subject to the normal limitations of any survey research. First, the apparently homogeneous subjects (college ﬁnancial administrators), because of their role in ﬁnancial administration, may have systematic biases in their perceptions as to why audit committees were formed and what their role is. While this does not negate interest in the survey results, the ability to generalize the ﬁndings beyond that population may be limited. Second, the results are dependent on reported responses. The signiﬁcant nature of college and university audit committees, coupled with the sensitive college and university environment, may have inhibited some respondents from answering truthfully. For example, do weak responses related to “review of codes of professional ethics’ reﬂect the role of the audit committee or the ﬁnancial administrators” interest in such codes? Third, there may have been a nonresponse bias present in the results. As mentioned previously, there was no signiﬁcant difference between late responses and early responses. It should also be noted that the 29% response rate in this study is typical for survey research of this type. Finally, we did not examine the association between audit committees’ composition in C&U and their effectiveness. Further research is urged to obtain opinions of a variety of groups on the issues pertaining to effectiveness and composition of audit committees. Moreover, it is the authors’ hope that this study stimulates additional interest in the emerging organizational governance and accountability for C&U as well as the relevance, importance, and functions of audit committees for institutions of higher education. Given the continuing focus on issues of corporate governance by both the accounting profession and policymakers, additional research into the determinants of audit committee formation, composition, and effectiveness in C&U is needed. We believe our survey serves as a useful springboard for these future studies.

NOTES 1. The initial questionnaire was pre-tested by 15 participants known to the authors and considered to be knowledgeable in ﬁnancial reporting and administration of C&U. Suggestions and comments of these participants were incorporated into the ﬁnal version of the questionnaire. A copy of this questionnaire is available from the authors.

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ENVIRONMENTAL POLICY: CORPORATE COMMUNICATION OF EMISSION ALLOWANCES S. Douglas Beets and Paul L. Lejuez

ABSTRACT As a result of the Clean Air Act Amendments of 1990 (CAAA), utility companies are annually issued emission allowances (EAs) by the federal government; each allowance allows a company to emit one ton of a certain pollutant, sulfur dioxide, into the atmosphere. Companies that reduce their pollution below a benchmark level do not need all of the allowances that they are given, so they may sell their excess EAs to other companies or investors, retain them for future purposes, or donate them to environmental organizations. If a company’s annual emission levels exceed the number of allowances they are given, that company must acquire an adequate amount of EAs commensurate with their pollution. These allowances, consequently, are marketable commodities, and their market prices and trading activity have increased materially since inception of the CAAA in 1995. Unfortunately, however, current accounting and disclosure requirements result in ﬁnancial statements that inadequately reﬂect company EA holdings, receipts, and trading activity. A study of the public utility companies affected by the ﬁrst phase of the CAAA revealed that several companies have EA holdings from prior years that have a market value of millions

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of dollars but are not represented on the ﬁnancial statements. Many of these companies have also had several transactions regarding EA sales, purchases, and donations, and the ﬁnancial statements fail to disclose these events. Because emissions trading is widely considered successful and may become a part of the business environment for any polluting organization, accounting and disclosure requirements regarding this phenomenon should be revised as many ﬁnancial statement users may consider information regarding EAs relevant and inﬂuential to their decisions.

INTRODUCTION Shareholders and potential investors have an interest in the ﬁnancial position and operating results of corporations. Accordingly, the ﬁnancial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP) must accurately convey information that would inﬂuence the decisions of interested parties. But what about relevant information that is not included in these statements, is not addressed by GAAP, but could affect the decisions of investors? As a result of the 1990 Clean Air Act, the federal government annually gives many companies in the electric utility industry millions of dollars of marketable assets that may be sold or used in the course of business. GAAP, however, does not require disclosure of these government-granted assets, and investors cannot determine the presence, purchase, sale, or use of these assets from an examination of the ﬁnancial statements of public utilities.

THE 1990 CLEAN AIR ACT In 1990, the Bush administration of the U.S. federal government proposed a market-oriented approach to limit sulfur dioxide (SO2), a primary cause of acid rain. The resulting legislation, the Clean Air Act Amendments of 1990 (CAAA), was passed by the U.S. Congress, signed by President Bush, and took effect on January 1, 1995. One of the goals of the CAAA is to set a nationwide annual cap on SO2 emissions, which are a by-product of burning fossil fuels (Fialka, 1997). A typical 500-megawatt coal-ﬁred utility station, for example, may annually produce 3.5 billion kilowatt hours of electricity and emit 5,000 tons of SO2, 10,000 tons of nitrogen oxide, and 500 tons of particulate matter into the atmosphere (Repetto et al. 1997), and one utility corporation may own several stations or plants. Under the CAAA, each electric utility involved is annually issued marketable emission allowances (EAs) according to a benchmark, which is the utility’s average annual mmBtu (a standard measure of heat) generated by consumption

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of fossil fuel from 1985 through 1987. Each EA has an indeﬁnite life and gives the holder the legal right to emit one ton of sulfur dioxide into the air. SO2 emissions of the affected utilities are monitored by the federal government, which annually requires these utility companies to remit an amount of EAs commensurate with their annual emissions (EPA, 2000). Companies that are able to reduce their pollution such that they receive more allowances than are needed for current emissions are allowed to save these EAs for future years, sell them to companies that exceeded their benchmark, sell them to investors, donate them to environmental groups, or retire them. Those companies that have emissions in excess of the government-given EAs must acquire enough allowances for their level of pollution; failure to accumulate sufﬁcient EAs commensurate with annual emissions results in heavy ﬁnes and a reduction of EAs to be received in the future (Ackerman & Moomaw, 1997). Phase I of the CAAA took effect in January 1995 and involved 110 utility companies that were considered the worst offenders in terms of emitting sulfur dioxide. During this phase, EA allocation was calculated at an emission rate of 2.5 pounds of SO2 multiplied by the benchmark mmBtu mentioned previously (EPA 2000). The second phase of the CAAA began on January 1, 2000 and involves practically all large utility plants in the United States. EA allocation is stingier under Phase II, as it is now calculated at an emission rate of 1.2 pounds of SO2 multiplied by the benchmark mmBtu. As a consequence, each Phase I power plant is now annually allocated less than half of the EAs received under Phase I. The ultimate goal of the program is to reduce total annual nationwide SO2 emissions from 18.9 million tons to less than 9 million tons (EPA 2000). The Chicago Board of Trade (CBOT) is playing a critical role in this program by providing a conveyance mechanism for the buying and selling of emission allowances. The CBOT facilitates the trading of allowances, helps establish a market price, and acts as a source where new power plants can obtain allowances. Since the inception of Phase I, the volume of EA trading has almost doubled every year. In 1994, less than one million EAs were traded between unrelated organizations, but the volume of trades exceeded nine million EAs and 1.6 billion dollars in 1998 (EPA, 2000; Golden, 1999). The Environmental Protection Agency (EPA) anticipates that allowance trading is likely to be more active during Phase II as more companies are involved (Fialka, 1997). The marketable nature of EAs, the increasing volume of trading activity, and the increasing value of the allowances has attracted investment companies to emissions trading; several brokerage organizations now arrange deals between buyers and sellers of EAs (Harder & Golden, 1998). One of these organizations, Cantor Fitzgerald, even has an internet site which displays the current market 63

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values of SO2 EAs, as well as other pollution allowances (www.cantor.com/ebs/ marketp.htm). Because the allowances are marketable commodities, many of the buyers of EAs are not electric utility companies. Some of the buyers are investors who speculate on the price; others are environmental organizations who buy EAs to retire them, thereby eliminating the emission of one ton of SO2 into the atmosphere for each allowance retired. Such groups receive EA donations, in many situations, from utility companies that enjoy tax beneﬁts from donating their government-granted EAs to non-proﬁt organizations (Kruger & Dean, 1997). Many currently consider the CAAA to be a successful legislative model for reducing pollution while allowing companies alternatives to comply with the law. Rather than traditional ‘command-and-control’ restrictions on pollution amounts, the CAAA provides ﬂexibility in achieving reductions in sulfur dioxide emissions. Some companies may choose to comply by investing in pollution abatement equipment that will result in unneeded EAs that can be sold. Alternatively, other companies may decide not to invest in such costly equipment but, instead, purchase EAs when needed. Ultimately, through this mechanism, the federal government has a ﬂexible means of reducing total nationwide emissions and the related acid rain. These beneﬁts are not only viewed favorably by the federal government but also by economists and brokers for linking the issue of pollution control to market forces (Ackerman & Moomaw, 1997). The effectiveness of the CAAA has resulted in adoption of similar programs by other governmental units (Rich, 1998) and may be considered a precursor of future environmental laws that will have a major impact on many companies (Ewer et al., 1992). In addition to EAs related to SO2, the federal government has also begun issuing pollution allowances regarding nitrogen oxide emissions. Several individual states are planning to build on the success of the national pollution trading program by applying similar standards to other emissions (Ackerman & Moomaw, 1997). Twelve northeastern states are using a version of the sulfur dioxide program in the hopes of achieving the same success in reducing ozone levels, and a group of thirty-seven states are currently considering a large-scale smog reduction plan as well (Fialka, 1997). An important consideration in state, regional, national, and international pollution abatement is the nature of pollution. Because pollution ﬂows with the wind or rivers regardless of borders, the emissions of one state or country often contaminate the air or water of other states or countries. U.S. air and water pollution, for example, affects air and water quality in Canada and vice versa. In some regions, pollution consequences are complex; e.g. air pollution from the Detroit, Michigan region of the U.S. can affect the air quality of the Toronto,

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Ontario region of Canada. Air pollution from the Toronto region, in turn, can affect air quality in the Buffalo, New York region of the U.S. As a consequence, pollution trading plans are being considered globally, as the U.S. and other countries are discussing international agreements of which emissions trading of greenhouse gases would be a key component. In 1997, an international treaty regarding global warming was signed in Kyoto, Japan which included a global greenhouse-gas emissions market modeled after the CAAA (Fischer et al., 1998; Fialka, 1997; Golden, 1998). The Clinton administration’s plan for controlling greenhouse gases ‘conﬁrms that a system of tradable emissions permits will ﬁgure prominently in any long-term effort to control pollutants’ (Passell, 1997).

THE LACK OF EA DISCLOSURE IN FINANCIAL STATEMENTS The apparent success of the emissions trading program of the CAAA and its support by members of national and state governments suggest that the trading of pollution rights may not be a temporary legislative phenomenon, but an ongoing component of conducting business. The focus of the CAAA is the electric utility industry, but consideration is being given to expanding emissions trading to other pollutants which would affect a wide variety of industries (Fialka, 1997). Consequently, while the accounting and disclosure issues of pollution trading currently relate primarily to electric utilities, similar legislation at the state, federal, and international levels may soon affect many companies that pollute air, water, or land. Much of the motivation for the CAAA and emissions trading programs stems from public concern regarding environmental issues. Relatedly, many stockholders are demanding more disclosures regarding corporate environmental records (Mastrandonas & Strife, 1992), and research on investor preferences and behavior has shown that many investors express interest in corporate environmental matters and may be more likely to invest in environmentallyconsiderate companies (The Accountant, 1998; Deutsch, 1998; Investors Chronicle, 1998; Krumsiek, 1998). Kreuze et al. (1996) estimated that current investments that are selected on the basis of ethical, environmental, and political factors exceeds one trillion dollars. Some corporations have responded to investor and stockholder requests for company environmental information by publishing annual environmental reports on their corporate internet sites or in a printed form similar to annual ﬁnancial reports. Such environmental reports are voluntary, however, and the lack of 65

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widely-recognized reporting standards and the absence of required third-party veriﬁcation currently mitigate the validity and use of such reports (Beets & Souther, 1999). Regardless of what a company chooses to disclose in a voluntary environmental annual report, however, many companies fail to adequately report environmental concerns in their ﬁnancial statements (Kreuze et al., 1996). Disclosure of EAs and related transactions, for example, are not speciﬁcally required by GAAP or SEC disclosure requirements, although such allowances are considered by many to be valuable assets (Johnson & Ewer, 1992). Possibly because EAs are a relatively new phenomenon, the Financial Accounting Standards Board (FASB) has not addressed the topic of accounting for EAs and emissions trading. In part because of federal regulatory oversight, accounting rule-making for public utility companies is promulgated by the Federal Energy Regulatory Commission (FERC). In 1991, shortly after the CAAA was signed into law, the FERC decided that the accounting for EAs should be based solely on their historical cost to the company; and in a December 1991 meeting, the Securities and Exchange Commission (SEC) Staff and the Public Utilities Committee of the American Institute of Certiﬁed Public Accountants (AICPA) agreed with the conclusion of the FERC. Likewise, the Internal Revenue Service (IRS) has stated that the receipt of EAs from the federal government does not cause a company to realize gross income (Nelson, 1993). The FERC also speciﬁed that allowances obtained for speculative purposes must be accounted for differently from those obtained for compliance. Speculative EA purchases are treated as investments and also accounted for using historical cost (Burkhart, 1993). Current accounting for EAs, consequently, results in no change in the ﬁnancial statements when the federal government annually gives a company thousands of EAs, because the company incurred no cost in acquiring the allowances. Each of these EAs, however, has an approximate current market value in excess of $140, and many companies have been given thousands more EAs than are required for their annual emissions. As a result, many companies have banked thousands of allowances for future use, sale, or retirement, which have a market value of millions of dollars. Unfortunately, however, this information does not appear on corporate ﬁnancial statements because of the FERC’s decision that such allowances should be accounted for based on historical cost rather than current market value. The consequent result of these circumstances is that while EAs are considered assets, their ﬁnancial statement presentation and value may be confusing for users of those statements (Ewer et al., 1992).

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AN EXAMINATION OF EMISSIONS DATA OF PHASE I PUBLIC COMPANIES In an effort to understand the signiﬁcance and magnitude of EAs and emissions trading, data was collected from the internet sites of the SEC (www.sec.gov) and the EPA (www.epa.gov). The latter site provides emissions and EA information regarding each electric utility plant affected by Phase I of the CAAA. This information includes annual SO2 emissions, fuel utilization, and EAs granted by the federal government, required for emissions, and traded. Of the 110 organizations that own plants that are affected by Phase I, 62 are publiclyowned corporations, and the remainder are privately-owned corporations or governmental units. Table 1 shows the related 1997 EPA information in an aggregated form for the public companies. In constructing this table, the tons of SO2 emitted during 1997 from each company were divided by the fuel utilization, which is the mmBtu generated when fossil fuels are burned. This ratio of emissions/mmBtu, consequently, measures the extent of pollution created by a company associated with the fossil fuel consumed to create production; a utility corporation with a relatively small emissions/mmBtu ratio, for example, is able to consume fossil fuel while generating relatively little SO2. Conversely, those companies with a relatively large emissions/mmBtu ratio emitted proportionately larger amounts of SO2 considering the fossil fuel used. Table 1 was completed by sorting the public companies by this emissions/mmBtu ratio and aggregating those companies into quartiles. The ﬁrst quartile, therefore, is comprised of those companies that emit relatively large amounts of SO2 compared to the other Phase I public companies. Table 1 also displays, for each quartile, the average tons of SO2 emissions, fuel utilization, EA transfers, EAs granted, and EAs carried over to 1998. In addition to emissions/mmBtu, three other relevant ratios were calculated and included in Table 1: (1) emissions divided by EAs granted, which measures the 1997 SO2 emissions compared to the government-granted EAs related to 1997 production; (2) EA transfers divided by EAs granted, which measures the extent of 1997 EA transfers compared to the government-granted EAs related to 1997 production; and (3) EAs carried over to 1998 divided by EAs granted, which measures the extent of EAs held by a company at the beginning of 1998 compared to the government-granted EAs related to 1997 production. An analysis of the emissions/mmBtu ratio for the four quartiles indicates signiﬁcant differences among the public companies affected by Phase I of the CAAA (p-value < 0.001, Kruskal-Wallis). The companies in quartile 1 emitted SO2 at a rate more than six times larger than that of the companies in quartile 67

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Table 1.

1997 Emissions Information of Phase 1 Public Companies Sorted by Emissions/mmBtu

Phase 1 Units Fuel Utilization SO2 Emissions (mmBtu)

Transfers of EAs

Granted by Fed. Gov’t

EAs Carried over to 1998

emissions/ mmbtu

emissions/ EAs granted

EAs carried EA transfers/ over/ EAs granted EAs granted

(A)

(B)

(C)

(D)

(E)

(A/B)

(A/D)

(C/D)

(E/D)

1 2 3 4 mean p-value1

129,629 78,860 28,210 11,569 63,428 <0.001

101,212,368 97,252,444 51,894,158 39,474,232 73,321,981 0.004

1,468 –26,202 –12,508 –20,083 –14,268 0.511

129,245 119,074 50,036 30,350 83,530 <0.001

56,646 77,861 26,575 13,463 44,398 0.003

0.13% 0.08% 0.05% 0.02% 0.07% <0.001

106.59% 68.82% 54.40% 33.97% 66.65% <0.001

4.10% –19.78% –30.53% –64.49% –27.04% <0.001

48.24% 67.27% 67.44% 72.45% 63.65% 0.597

1

Kruskal-Wallis test

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Quartile

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4; i.e., considering the amount of fossil fuel burned by each plant, some plants emitted much more pollution than others. Similarly, the emissions/EAs granted ratio from Table 1 differs signiﬁcantly among quartiles (p-value < 0.001, Kruskal-Wallis). This ratio compares the annual SO2 emissions of each company to the EAs that the company was granted for the year. As mentioned previously, each Phase I company annually receives an amount of EAs associated with the amount of fossil fuel consumed (mmBtu) during a base period. The companies in quartile 1 had an average emissions/EAs granted ratio of around 107%, indicating that their pollution for the year exceeded the amount of EAs received; i.e, they had to acquire additional EAs beyond the annual amount given to them by the federal government. Those companies in quartile 4, however, had an average emissions/EAs granted ratio of approximately 34%, meaning that only about one third of the EAs received from the government were needed for their level of SO2 pollution. Notably, the average emissions/EAs granted ratio for all of the Phase I public companies was approximately 67%, signifying that, on average, each company received three EAs for every two that were needed for their current level of emissions. More than 80% of these companies received more EAs than they needed for their annual emissions. Average annual emissions for the Phase I public companies were 63,428 tons of SO2, but the federal government gave each of these companies an average of 83,530 EAs, which were worth approximately $100 each on December 31, 1997. This excess of more than 20,000 EAs for each company, consequently, was worth approximately two million dollars at the end of 1997. Transfers of EAs are also enumerated on Table 1. Decreases in the numbers of EAs held by a company, designated as negative numbers on Table 1, could be the result of EA sales or gifts of the allowances to other companies or environmental groups. Increases in a company’s EA holdings could be the result of purchases or gifts from other companies. The heaviest-polluting companies, which comprise quartile 1, were those that were acquiring EAs, each of them purchasing or being given an average of 1500 EAs during the year. Most companies in the other quartiles, however, were selling or giving away EAs. In fact, the average annual EA transfers for all of the Phase I public companies was a decrease of 14,268, worth approximately 1.4 million dollars for each company. These EA transfers were also included in one of the ratios shown in Table 1: EA transfers/EAs granted. This ratio differs signiﬁcantly among the four quartiles (p-value < 0.001, Kruskal-Wallis) and expresses the annual transfers of allowances as a percentage of the EAs granted to the company by the federal government during the year. This ratio indicates that these companies sold or gave away an average of 27% of the EAs given to them by the federal 69

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government. The heaviest-polluting group of companies, quartile 1, bought or were given an additional 4 percent of the amount of EAs granted by the government. Most companies in the other quartiles, on the other hand, sold or gave away EAs; those in quartile 2 transferred an average of about 20% of the EAs given to them during the year, and those in quartile 3 sold or gave away an average of around 30% of the annual EAs received. The least-polluting group of companies, quartile 4, sold or gave away an average of about 65% of the EAs given to them during the year. Table 1 also reveals the number of EAs that the companies in each quartile carried into 1998; i.e. the residual EAs that had been granted or received through gifts or purchases that had not been required by the government for past emissions. These EAs may have been received in 1997 or during a prior year since the inception of the CAAA in 1995. On average, each of the Phase I public companies carried more than 44,000 EAs into 1998 that were not required for prior emissions. Considering the market value of these EAs at that point in time, each company had a bank of EAs worth, on average, about 4.4 million dollars. A related ratio included in Table 1 is EAs carried over/EAs granted. This ratio indicates that, on average, each company retained, for future uses, an amount of EAs from current and prior periods that constitutes around 64% of the EAs granted during the year. The heaviest-polluting companies carried over an amount of EAs that was less than half of the total of EAs granted to them during the year, while the least-polluting companies, i.e. those in quartile 4, carried over an amount of EAs that was more than 70% of the EAs they had received. This ratio, however, did not differ signiﬁcantly among quartiles (p-value = 0.597, Kruskal-Wallis).

AN EXAMINATION OF FINANCIAL DATA OF PHASE I PUBLIC COMPANIES Table 2 was constructed by analyzing the 1997 ﬁnancial statements from the annual SEC ﬁling (10K) of each of the Phase I public companies. In an effort to be consistent with Table 1, the corporations were sorted by the emissions/ mmBtu ratio discussed previously and grouped into quartiles. Consequently, the quartiles from both tables contain the same corporations; e.g. the ﬁrst quartile from Table 1 contains the same corporations as the ﬁrst quartile from Table 2. The ﬁnancial information presented in Table 2 includes operating revenue; net income; book value of property, plant, and equipment (historical cost less accumulated depreciation); and the total cash outﬂows during 1995, 1996, and

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1997 related to property, plant, and equipment additions. Three relevant ratios were calculated from this data: net income divided by operating revenue, net income divided by total assets, and 1995–1997 cash outﬂows for property, plant, and equipment (PPE) divided by book value of property, plant and equipment. An analysis of the information in Table 2 reveals a consistent lack of significant differences among the quartiles when companies are sorted by their extent of emissions, i.e. emissions/mmBtu. The quartiles do not differ signiﬁcantly with regard to operating revenues, net income, book value of PPE, total assets, or the three-year cash outﬂows for PPE (all p-values ≥ 0.868, Kruskal-Wallis). Similarly, the two proﬁtability measures shown on Table 2 indicate no significant differences among the quartiles (both p-values ≥ 0.221, Kruskal-Wallis). A third ratio displayed on Table 2, however, does indicate signiﬁcant differences among the quartiles. The ratio, 1995–1997 cash outﬂows for PPE additions/PPE book value, differs signiﬁcantly among the quartiles when the Phase I public companies were sorted by the extent of their pollution (p-value = 0.036, Kruskal-Wallis). On average, this ratio was larger for the less-polluting companies and smaller for the heaviest-polluting companies. A possible explanation for this difference is that the less-polluting companies had invested in pollution abatement equipment which, after purchase and installation, materially reduced the company’s emissions.

DISCUSSION AND IMPLICATIONS Although ﬁnancial statements are often silent with regard to pollution, information regarding emissions and EAs may be of interest to investors and corporate stockholders, particularly those who are concerned about environmental issues. Several of the Phase I public companies, for example, emitted signiﬁcantly more SO2 than others when their levels of fuel utilization are considered. When grouped into quartiles by the extent of their emissions, the heaviest-polluting quartile of companies had an emissions/mmBtu ratio that was more than six times larger than that of the least-polluting quartile. The SO2 emissions of the heaviest-polluting quartile of companies were so high that they not only needed all of their annual government-granted EAs for subsequent remittance, but also had to acquire additional EAs for their annual emissions. Conversely, the emissions levels of the least-polluting quartile of companies were, in a relative sense, so low that only about one third of the EAs given to them by the government were required for that year’s level of pollution. Obviously, these circumstances result in several companies with EAs that are not needed for current levels of pollution and several other companies who 71

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Table 2.

1997 Financial Data of Phase 1 Public Companies Sorted by Emissions/mmBtu in thousands of dollars Operating Revenues

Net Income

Book Value of PPE

Total Assets

95–97 outﬂows for PPE adds.

net income/ operating revenu

net income/ total assets

95–97 outﬂows for PPE adds./ PPE book value

Quartile

(table 1)

(F)

(G)

(H)

(I)

(J)

(G/F)

(G/I)

(J/H)

1 2 3 4 mean p-value1

0.13% 0.08% 0.05% 0.02% 0.07% <0.001

1,591,846 1,703,027 1,859,051 1,739,268 1,720,851 0.896

114,943 180,018 160,903 –28,714 108,100 0.909

3,000,292 3,464,384 3,225,441 3,406,280 3,272,752 0.934

4,453,516 4,969,238 5,064,243 5,776,197 5,054,366 0.983

474,238 548,107 550,962 711,599 569,289 0.868

7.30% 10.85% 8.06% 3.36% 7.45% 0.221

3.16% 3.90% 3.29% 2.36% 3.19% 0.886

15.98% 16.71% 19.43% 22.70% 18.63% 0.036

1

Kruskal-Wallis test

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emissions/ mmbtu

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need to acquire additional EAs because their emission levels are high. As a consequence of their relatively low levels of pollution, the companies with excess EAs have options that may be ﬁnancially, socially, and environmentally attractive: they may sell, retire, donate, or save the allowances; i.e. the excess EAs are a form of reward to the companies that pollute relatively less. This study indicates, however, that those companies with excess EAs were not necessarily more proﬁtable than other companies. The extent of SO2 emissions was not strongly related to company size or proﬁtability; i.e. at the end of 1997, the heavier-polluting companies did not differ signiﬁcantly from those that polluted less with regard to operating revenues, net income, or total assets. This may be the result of: (1) the FERC requirement, discussed previously, that annual EA receipts from the federal government are assigned no value in corporate ﬁnancial statements; (2) banking of excess EAs by many companies rather than selling them; and (3) relatively low EA market values. In the future, companies’ proﬁtability and total assets may be more closely associated with their extent of pollution if modiﬁcations or changes occur in one or more of the three factors mentioned in the preceding paragraph. First, the FASB or the SEC may examine the issue of EAs and inﬂuence the FERC to modify its requirement regarding EA disclosure and valuation in ﬁnancial statements. Addressing the topic of undisclosed environmental issues, SEC Commissioner Richard Roberts (1993) commented: While the aggregate numbers concerning potential environmental costs are staggering, what is almost just as frightening is the massive amount of acknowledged environmental cost that has yet to be reﬂected in corporate ﬁnancial statements.

Because EAs are market-valued resources with future economic value that result from past events, one may argue, as did Sansing and Strauss (1998), that they should be accounted for as assets, and valued according to prevailing market prices. Such a change may favorably affect the ﬁnancial position and operations of less-polluting companies because of banked EAs and the revenue from the sale of unneeded EAs. Heavily-polluting companies, on the other hand, may be unfavorably affected by the reﬂection of EA market values on ﬁnancial statements because of consumption and purchases of needed EAs. Banking or long-term retention of EAs is also a factor that may partially explain why total assets and proﬁtability did not signiﬁcantly differ between companies that pollute relatively more or less. In the study, most of the Phase I public companies had saved, for future purposes, thousands of EAs that were received from other companies or granted to them by the government related to emissions of 1997 and earlier years. On average, each of these companies carried more than 44,000 EAs, worth approximately 4.4 million 73

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dollars, into 1998 after the number of EAs commensurate with 1997 emissions were submitted to the federal government. Dividing the EA carryovers from the current and prior periods by the amount of EAs granted in the current period reveals that, on average, the companies retained an amount of EAs equivalent to approximately 64% of the total granted by the government during the year. The retention of EAs by less-polluting companies may not have affected favorably their ﬁnancial position or operations because the FERC rule discussed previously stipulates that government-granted EAs that are carried forward from period to period are considered to have no value on the ﬁnancial statements. If these companies had decided to sell their excess EAs rather than retain them, the resulting cash and revenue generated would be reﬂected on the ﬁnancial statements, possibly enhancing their ﬁnancial position and proﬁtability as reﬂected in ﬁnancial statements.

THE INCEPTION OF PHASE II OF THE CAAA Another reason for corporate EA retention may be the advent of Phase II of the CAAA, which began January 1, 2000. As explained previously, one component of the implementation of Phase II is that the federal government is now issuing less than half of the quantity of EAs to companies that received allowances during Phase I. Additionally, the number of companies and organizations involved in allowance trading has been expanded from the original 110 plants affected by Phase I to practically all large utility plants in the United States. Considering the EA information in Table 1, the federal government, during Phase I, was relatively generous in granting EAs. As mentioned previously, each Phase I public company was issued an average of 83,500 EAs in 1997 when only about 63,400 EAs were needed for the SO2 emissions of that year. This annual excess of EAs presented many companies with attractive options: some companies sold or gave away some of their unneeded EAs, some companies saved their EAs for the future. In Phase II, the federal government’s EA generosity has moderated as each company annually receives less than half of the number of EAs that were received under Phase I. If, for example, emissions levels in 2000 are the same as in 1997, each company will receive an average number of EAs less than 41,000 but will need approximately 63,400 EAs to remit to the government. Obviously, with the transition from Phase I to Phase II of the CAAA, many companies will evolve from sellers and donators of excess EAs to purchasers of needed EAs, as they may need more allowances than the government annually

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issues. This phenomenon may partially explain why, as discussed previously, several of the Phase I public companies were banking many of their excess 1997 allowances for the future rather than transferring them to others. Demand for EAs during Phase II of the CAAA may be greater than under Phase I because more companies will be issued fewer EAs than they will need for their level of emissions. Correspondingly, EA prices may increase with demand for these allowances, and evidence of such an increase is already apparent. The market value of EAs at the end of 1997 was approximately $100, and this value is incorporated into prior discussion in this paper regarding the value of EAs granted, sold or given away, purchased, and held for future purposes. By January 2000, however, the market value of EAs had increased to around $140, signifying that the materiality of allowance transactions is increasing (EPA 2000). With the beginning of Phase II of the CAAA, corporate managers are likely considering their options for having adequate EA holdings related to their SO2 emissions when the need for those allowances occurs. One related strategy is to acquire EAs from others and hold them until required by the federal government. The risk in this strategy is that the market value of EAs may increase materially, especially if many other companies pursue this option and thereby increase the demand for allowances. This ‘buy-when-needed’ strategy may have caused the allowances for nitrogen oxide to increase from $1500 in January 1998 to $7600 in March of 1999 (Golden, 1999). Another option available to corporate managers for ensuring an adequate bank of EAs is reduction of company SO2 emissions. This may be accomplished by some combination of: (1) the use of expensive, low-sulfur coal; (2) replacement of older power-generating equipment with more modern equipment that produces less pollution; and (3) acquiring scrubbing equipment that cleans the emissions of existing equipment. Table 2 provides evidence that some combination of the latter two options may have occurred during the three-year period from 1995 through 1997. One of the ratios displayed in that table is 1995–1997 cash outﬂows for PPE additions/PPE book value. This ratio was smaller for the heaviest-polluting companies and larger for the least-polluting companies, indicating that one possible explanation for a company’s reduced level of emissions is their investment in additional equipment in recent years. Such an EA management strategy, while requiring extensive investment in equipment in the short run, could yield the beneﬁt of generating excess, unneeded EAs for several years that could be sold for substantial amounts, depending on the demand for the allowances and the related market price. Public Service Company of New Hampshire, for example, was one of the few companies to install equipment, in 1998, designed to reduce nitrogen oxide emissions. 75

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The resulting reduction in emissions yielded 9,000 unneeded allowances which, when sold, effectively paid for the $27 million additional equipment (Golden, 1999). Such successful results are encouraging companies to invest in pollution abatement facilities and facilitating hopes of increased sales for manufacturers of such equipment (Deutsch, 1997). Possibly because of anticipation of EA shortages with the inception of Phase II, the volume of EA trading activity has increased materially every year since the inception of the CAAA. While many of the Phase I public companies in the study banked some of their excess EAs for future periods, many of these companies also sold or gave away EAs. On average, each company transferred more than 14,000 EAs during the year, which was more than one quarter of the average annual amount granted by the federal government. Some of these EAs were sold to the heaviest-polluting companies, which, for the year, acquired more EAs than they sold or gave away. The least-polluting companies, on the other hand, transferred an average of two thirds of the government-granted EAs during the year. All these transactions took place in 1997, during which EAs had a market value of about $90 at the beginning of the year, a high of $110, a low of $88, and a year-end value of approximately $100 (EPA, 2000).

THE NEED FOR ENHANCED DISCLOSURE OF EMISSION ALLOWANCES From the prior discussion, one may deduce that millions of dollars of transactions and value are not currently reﬂected in the ﬁnancial statements of many Phase I public companies. While the value of emission allowances is determined by market forces, each company’s annual receipt of thousands of these commodities is not recorded in its ﬁnancial statements because of existing accounting rules. As a result of the CAAA, most companies have received annually more allowances than they needed for their level of pollution. Many companies have accumulated these annual excess allowances and currently have an inventory of tens of thousands of EAs. These EA holdings are not reported on the ﬁnancial statements but could be sold at the prevailing market price which was around $100 each at the end of 1997 and has continued to increase in subsequent months. This lack of ﬁnancial statement disclosure may, to some degree, suppress the expansion of the pollution allowance market as investors and companies struggle to utilize relevant information about corporate EA holdings and trading activity (Solomon, 1994). To determine the EA disclosure of the 62 Phase I public companies, their 1997 ﬁnancial statements which were included in their annual SEC 10K ﬁling

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were perused. None of these companies had any line item related to emission allowances on their income statement, balance sheet, statement of cash ﬂows, or statement of retained earnings. Fifteen of the companies mentioned EAs in the notes to ﬁnancial statements, but only two of those deﬁned EAs. One company indicated the amount paid for EAs in the notes to their statements, although the number of EAs purchased was not disclosed. None of the companies indicated the amount of EAs received from the federal government in the current year, the number of EAs carried forward from prior years, the amount of EAs required for current pollution, or the market value of EAs. With the exception of the one company mentioned previously, there was also no mention in any of the statements regarding EA trading: number of EAs purchased, number of EAs sold, or related costs and prices. These ﬁndings are consistent with those of Kreuze et al. (1996) who concluded that most companies do not disclose any environmental information in their annual ﬁnancial reports. Even though EA prices and trading activity have both increased considerably in the last several months, one may argue that the EA holdings and activity are immaterial to the ﬁnancial statements of most public utility companies. As mentioned previously, average EA holdings at the end of 1997 for the Phase I public companies was approximately 44 thousand. Considering the year-end EA market value of $100, these holdings were worth approximately 4.4 million dollars at a time when the average total assets for these companies were more than 5 billion dollars. In considering the magnitude and effects of this information, however, a review of the deﬁnition of materiality in FASB Statement 2 may be appropriate. FASB Statement 2 deﬁned materiality as the magnitude of omitted or misstated information that probably would have made a difference in the judgment of someone relying on that information. To an investor or shareholder who is concerned about corporate environmental matters, consequently, materiality of EA holdings and transactions may have less to do with dollar magnitude and more to do with information regarding corporate environmental performance. Even with investors who are relatively indifferent to corporate environmental issues, EA holdings and transactions may be considered revealing dimensions of corporate performance of which they should be informed, particularly in light of the increasing market values and trading activity. As mentioned previously, the market price of nitrogen oxide allowances increased more than 500 percent in less than 18 months in 1998 and 1999. If a similar value increase occurred with regard to SO2 allowances, shareholders and investors could be frustrated that ﬁnancial statements and disclosures do not accurately reﬂect the value of corporate EA holdings and activity. A material increase in the value of EAs is 77

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possible since Phase II of the CAAA has begun because more utilities are now competing for allowances, and the companies that were affected by Phase I now annually receive less than half of the EAs that the federal government had distributed to them in the ﬁrst phase. Finally, trading of pollution rights may soon affect many corporations in varied industries. While the issue of SO2 emission allowances previously affected only 62 companies whose stock is publicly traded, Phase II of the CAAA began in January 2000 and affects practically all utility companies. Further, as mentioned previously, the federal government also issues emission allowances for nitrogen oxide, and several coalitions of states and groups of nations are currently designing emission trading programs related to ozone, greenhouse gases, smog, and other pollutants. Emissions trading, consequently, may soon be a signiﬁcant dimension of all businesses that pollute, and their ﬁnancial statements should accurately reﬂect that dimension.

CONCLUSION In 1997, the public utility companies affected by the ﬁrst phase of the CAAA varied signiﬁcantly with regard to their emission levels, EA receipts from the government, trading activity, and EA holdings. This information, however, was not adequately disclosed in their ﬁnancial statements, although many investors and stockholders may consider such disclosures informative and inﬂuential. Current accounting and SEC rules regarding disclosures of EAs are minimal. Companies are currently required to account for these allowances at their historical cost which, in the case of EAs received from the government, is zero. Current market value of these commodities, however, is in excess of $140 each, and many companies have banked thousands of EAs each year since the inception of Phase I of the CAAA. The second phase of the CAAA began in January of 2000. This phase encompasses practically all public utility companies, and the federal government is less generous in EA distribution under Phase II than it was during Phase I. Demand for EAs, trading activity, and EA market values may increase as a result of Phase II, but shareholders and investors may be minimally informed of such information because of the extant negligible disclosure requirements. Because of the perceived successful effects of the CAAA, similar additional legislation promoting emissions trading is possible, and such laws could affect many companies that pollute air, water, and land resources. Because many investors are responsive to corporate environmental records, adequate disclosures regarding pollution allowances and the related trading activity are critical

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to informative ﬁnancial statements. Such disclosure would be an important improvement in corporate communication with the investment community.

REFERENCES The Accountant (1998). Going Green. (April): 14. Ackerman, F., & Moomaw, W. (1997). SO2 emissions trading: Does it work? Electricity Journal, (August/September), 61–66. Beets, S. D., & Souther, C. C. (1999). Corporate Environmental Reports: The Need for Standards and an Environmental Assurance Service. Accounting Horizons, (June), 129–145. Burkhart, L. A. (1993). SO2 Emission Allowance Accounting Rules Adopted. Public Utilities Fortnightly, (May 1), 43. Deutsch, C. H. (1997). Belated EPA War on Pollutants May Infuse Value into Companies. New York Times, (October 17), 26. Deutsch, C. H. (1998). For Wall Street, Increasing Evidence That Green Begets Green. New York Times, (July 19), 7. Environmental Protection Agency Internet Site (www.epa.gov) (2000). Ewer, S. R., Nance, J. R., & Hamlin, S. J. (1992). Accounting for Tomorrow’s Pollution Control. Journal of Accountancy, (July), 69–74. Fialka, J. J. (1997). Certiﬁcate Trading Program Reduces Acid Rain Emissions. Wall Street Journal, (October 3), B1. Fischer, C., Kerr, S., & Toman, M. (1998). Using Emissions Trading to Regulate U.S. Greenhouse Gas Emissions: An Overview of Policy Design and Implementation Issues. National Tax Journal, (September), 453–464. Golden, M. (1999). Dirty Dealings. Wall Street Journal, (September 13), R13. Harder, C., & Golden, M. (1998). Bids for Emission Allowances at Auction Surprise Brokers as Premiums are Paid. Wall Street Journal, (March 27), B2. Investors Chronicle (1998). Survey – Ethical Investment: Pensions with Principles. (July 17), 44. Johnson, S. J., & Ewer, S. R. (1992). Internal Auditing of Emission Allowances Under the Clean Air Act. Internal Auditing, (Summer), 48–52. Kreuze, J. G., Newell, G. E., & Nevell, S. J. (1996). What Companies are Reporting: Environmental Disclosures. Management Accounting, (July), 37–43. Kruger, J., & Dean, M. (1997). Looking Back on SO2 Trading: What’s Good for the Environment is Good for the Market. Public Utilities Fortnightly, (August 12), 30–37. Krumsiek, B. J. (1998). The Emergence of a New Era in Mutual Fund Investing: Socially Responsible Investing Comes of Age. Journal of Investing, (Winter), 84–99. Mastrandonas, A., & Strife, P. T. (1992). Corporate Environmental Communications: Lessons from Investors. Columbia Journal of World Business, (Fall/Winter), 234–240. Nelson, G. L. (1993). Taxing Sulfur Dioxide Emission Allowances. Public Utilities Fortnightly, (September 15), 46–47. Passell, P. (1997). Trading Emissions Rights a Key Factor in Global Warming Talks. New York Times, (October 24), 16. Repetto, R., Rothmen, D., Faeth, P., & Austin, D. (1997). Has environmental protection really reduced productivity growth? Challenge, (January 11), 46. Rich. M. (1999). Utilities Battle for Georgia Credits on Emissions. Wall Street Journal, (May 5), S1, S3.

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Roberts, R. Y. (1993). Overview of Environmental Liability Disclosure Requirements, Recent Developments and Materiality. Speech delivered at the Annual Meeting of the American Bar Association, New York City, New York (August 9). Sansing, R. C., & Strauss, T. (1998). How Tax Policy Can Thwart Regulatory Reform: The Case of Sulfur Dioxide Emissions Allowances. Journal of the American Taxation Association, (Spring), 49–59. Solomon, B. D. (1994). SO2 Allowance Trading: What Rules Apply? Public Utilities Fortnightly, (September 15), 22–25.

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CORPORATE DISCLOSURE OF THE DECISION TO CHANGE THE FISCAL YEAR-END Thomas L. Porter, Edward P. Swanson, Michael S. Wilkins and Lori Holder-Webb

ABSTRACT This study investigates whether registrants comply with SEC rules designed to provide timely notiﬁcation and transparent disclosure of the effects of a change in ﬁscal year-end. For a sample of 79 ﬁrms, the Form 8-K announcement of the change was ﬁled late 25% of the time and no announcement was available for an additional 14% of the ﬁrms. In the subsequent Form 10-K, roughly half of the ﬁrms did not report operating results for both the transition period and a comparative period from the prior year, as required by the SEC. The rate of non-compliance was higher for ﬁrms audited by non-Big–6 ﬁrms. Non-compliance is more important if poor disclosure occurs in conjunction with income management. In this regard, we found an unusually high frequency of losses reported in the transition period that results from a ﬁscal year change (relative both to the ﬁrms’ prior experience and to other COMPUSTAT ﬁrms).

Research in Accounting Regulation, Volume 14, pages 81–100. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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INTRODUCTION A fundamental assumption of ﬁnancial reporting is that the economic activities of an enterprise can be divided into artiﬁcial time periods (i.e. the ‘periodicity assumption’). Managers control the calendar period over which they report results by choosing a ﬁscal year-end. Over time, they establish what becomes a consistent pattern of ﬁnancial reporting; users, in turn, rely on this pattern in evaluating trends in ﬁrm performance. The SEC has issued rules designed to provide users with timely and transparent disclosures when a company changes its year-end. The high proﬁle case of Robert Maxwell, the late British publishing magnate, illustrates the need for such rules. In early 1991, he changed the ﬁscal year-end of two of his public companies. He then removed assets from their pension funds to ﬁnance operations in another failing ﬁrm. Investors and creditors did not receive timely information about what the Wall Street Journal referred to as the “looting” of the pension funds because the change in year-end delayed audits of the companies (Berton, 1991). More recently, Schroeder and Spiro wrote a lengthy exposé in Business Week (April 28, 1997) about the operating activities and accounting practices of one of the ﬁrms in our sample, SafeCard Services Inc. (formerly known as Ideon, Inc.). Faced with a write-off that exceeded net income, they comment: “. . . SafeCard would use a clever technique to record the write-off. It said that it was moving the end of its ﬁscal year from Oct. 31 to Dec. 31. This created a ‘stub’ period, a two-month black hole that was not part of 1994 or 1995.” These two high proﬁle cases illustrate that, by changing their ﬁscal year-end, ﬁrms can delay issuing audited ﬁnancial reports and can present unfavorable results in a ‘stub period’ rather than in an audited annual period. The Maxwell case led us to investigate how often ﬁrms change their yearend. Using the COMPUSTAT tapes, we found that approximately 1% of the ﬁrms on the COMPUSTAT database change their ﬁscal year-end each year. Between 1976 and 1995, almost 2,300 ﬁrms changed their ﬁscal year-end. To put these numbers in context, we compare them to the frequency of accounting method changes. Both year-end changes and accounting method changes impair the comparability of accounting information provided to users. Pincus & Wasley (1994) investigated the number of voluntary accounting method changes among COMPUSTAT ﬁrms over the 20-year time period from 1969–88. They identiﬁed 3231 voluntary accounting method changes of all types. Inventory method changes were by far the most frequent type of change at 1230, with about half occurring during three years, 1973–75. ‘Reporting Entity-Various’ were next at 306. Depreciation method changes, which along with inventory changes have been widely studied in the academic literature, occurred 168 times. The

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frequency of year-end changes is therefore sufﬁciently high, particularly relative to that of the traditional set of accounting method changes, to warrant attention from accounting policy makers.1 Given the change in information ﬂow resulting from ﬁscal year-end changes and the possibility of abuses of the practice (noted above), the purpose of this study is to investigate both the nature and the adequacy of corporate disclosures of the decision to change the ﬁscal year-end. Our study contributes to a developing literature investigating corporate disclosure practices and compliance with SEC reporting rules (e.g. Alford et al., 1994; Frost & Pownall, 1993; Frost & Kinney, 1996; and Schwartz & Soo, 1995, 1996). The remaining sections of the chapter are organized as follows. The next section discusses the importance of timely and transparent disclosures in the context of how a disruption in information ﬂow could affect ﬁnancial analysts, independent investors, and other users. The third section summarizes the rules that SEC registrants must follow in reporting a change in ﬁscal year-end. The summary should be useful to practicing accountants in complying with these reporting requirements.2 The fourth section investigates reporting practices, evaluating compliance with SEC rules for announcing the change decision and for reporting transition period operating results. The ﬁfth section discusses the auditor’s responsibility for compliance with these SEC rules. The sixth section provides evidence about whether noncompliance is related to audit quality (i.e. whether the ﬁrm uses a non-Big–6 audit ﬁrm). In the seventh section, we address the ﬁnancial performance of ﬁscal year-end changers during their transition period. The ﬁnal section summarizes the results and presents recommendations to improve reporting of ﬁscal year-end changes.

INSTITUTIONAL BACKGROUND Over time, companies develop a predictable pattern of ﬁnancial reporting and users rely on this pattern in evaluating trends in ﬁrm performance. For example, ﬁnancial analysts provide stock recommendations and predictions of quarterly and annual earnings. Several earnings forecast vendors, including I/B/E/S International Inc., First Call Corp., and Zacks Investment Research, collect analysts’ predictions and provide information to investors. Earnings-related news stories typically report the current earnings ﬁgure relative to both the consensus forecast (i.e. the extent of the ‘earnings surprise’) and the prior year’s comparative ﬁgure.3 Stock price responses to this information are reported daily by the business press, and academic studies have conﬁrmed that market prices do reﬂect this information (e.g. Kasznik & McNichols, 1998). 83

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If announcements of a decision to change the year-end are not made on a timely basis, or not made at all, information asymmetry may arise. For example, some ﬁnancial analysts and investors are likely to learn of the decision because of ties they have to the ﬁrm. They may obtain value-relevant information from management, including the reason for the change, performance during the transition period, and guidance in developing forecasts for the new annual reporting period. Consequently, if a ﬁrm fails to make timely, public disclosures concerning its change in reporting period, it may seriously compromise the ‘level playing ﬁeld’ advocated by regulatory agencies. In addition to timely reporting of the change decision, when ﬁnancial statements are subsequently issued, users need transparent reporting of the effects of the change. In particular, fundamental security analysis uses comparative data to examine historical trends in revenues, margins, and net income. This information plays an important role in estimating future growth rates and in making pro forma earnings projections under different growth assumptions. Investors must have directly comparable data to be able to evaluate whether transition period operations differ from past experience and, as a result, whether expectations for the future should be revised. If this information is not provided, investors’ decision-making abilities are likely to be compromised. Lenders may also be affected by delayed or incomplete reports. Lenders typically base their debt covenant restrictions on audited accounting numbers that appear in annual reports. Because the reporting regulations for ﬁscal year changes vary depending on the length of the transition period (see next section), some ﬁrms may be able to postpone audits of their ﬁnancial statements. At a minimum, lenders should be aware of this possibility when they are dealing with ﬁrms that have changed their reporting period. In sum, because ﬁscal yearend changes interrupt the reporting cycle, many users – analysts, investors, and lenders at a minimum – must incur greater costs to obtain and evaluate the information they need. This is particularly true if ﬁrms do not comply with the SEC mandated announcement and reporting requirements.

RULES FOR REPORTING FISCAL YEAR-END CHANGES Generally accepted accounting principles do not address ﬁscal year-end changes.4 For ﬁrms that fall under the purview of the Securities and Exchange Commission, Rules 13a–10 and 15d–10 of the 1934 Act (as amended in April 1989) require ﬁrms to announce the decision to change their ﬁscal year-end in a timely manner (Jennings & Marsh, 1994). These rules also provide speciﬁc

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guidance about how to report transition period operating results. The rules, which are summarized in Table 1, are complex. We provide a detailed discussion to assist practicing accountants in applying these rules and to provide a basis for our tests of compliance (presented in a later section of the paper). Announcement Disclosures Registrants are required to complete Item 8 on Form 8-K, or report this information on either Form 10-Q or Form 10-K, and ﬁle the form with the SEC within 15 days of the date of the decision.5 The registrant must specify the date the decision was made, the date of the new ﬁscal year-end, and the form on which the ﬁrm plans to ﬁle transition period operating results. The SEC does not require ﬁrms to state the reason for the change. Transition Period Operating Results Managers have several options for reporting transition period operating results, as summarized in Table 1. If the transition period is six months or longer, however, no options exist. Firms must ﬁle audited transition period results on a separate Form 10-K within 90 days. This deadline is measured from the close of the transition period or from the date of the decision to change the ﬁscal year-end, whichever date is later. If the transition period is greater than one month but less than six months, three options exist, each requiring that a separate report be ﬁled with transition period operating results. Firms can ﬁle audited, transition period ﬁnancial statements on either a separate Form 10-K within 90 days or a Form 10-Q within 45 days. Alternatively, unaudited results can be presented on Form 10-Q within 45 days with audited transition period results reported on the next Form 10-K. Under this last option, audited results can be delayed until a Form 10-K is ﬁled for the new annual period. For transition periods of one month or less, ﬁrms have ﬁve options – the three options described in the paragraph above as well as the following two options. Audited transition period results can be included in the Form 10-K for the newly adopted ﬁscal year-end, if this is the ﬁrst report required to be ﬁled after the date of the decision to change the ﬁscal year. Alternatively, ﬁrms can include unaudited results in the next Form 10-Q under the new ﬁscal year-end, with audited transition period results included in the next Form 10-K. The rules for reporting operating results for the transition period are complex and are written in highly technical language. From Table 1, it is apparent that 85

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Table 1.

SEC Reporting Requirements for a Change in Fiscal Year

Length of Financial Transition Period1

Announcement of Change2

Options for the Transition Period Report3

Six months or longer

Form 8-K (within 15 days of decision) Form 8-K (within 15 days of decision)

• 10-K within 90 days (audited)

Greater than one month but less than six months

One month or less

Form 8-K (within 15 days of decision)

• 10-K within 90 days (audited) • 10-Q within 45 days (audited)4 • 10-Q within 45 days (unaudited) with audited transition period results in next 10-K4 • Same three options as available for transition periods less than six months (see above) • Include with annual 10-K under new ﬁscal year-end if this is the ﬁrst required report after the ﬁscal year change (audited)5 • Include in next 10-Q under new ﬁscal year-end (unaudited) with audited transition period results in next 10-K4,5

1

The transition period is from the day after the end of the most recently concluded ﬁscal year to the day before the beginning of the new ﬁscal year. For example, if a ﬁrm changes its ﬁscal year-end from December 31, 1995 to March 31, 1996, it creates a three-month transition period that extends from January 1, 1996 to March 31, 1996. (The rules in this table also apply to the case where a successor registrant has a different ﬁscal year-end than its predecessor.) 2 Form 8-K must state the new ﬁscal year-end, the intended form to be used for transition period reports (10-K or 10-Q), and the date of the decision to change the ﬁscal year-end. SEC rules also allow for 8-K events to be reported in a Form 10-Q (Item 5) or Form 10-K (Item 14), if ﬁled within the 8-K deadline. 3 Filing periods are measured from the close of the transition period or the date of the determination to change the ﬁscal year-end, whichever is later. Some additional rules about quarterly reporting options and foreign registrants are not included in the table. 4 A separate audited balance sheet as of the end of the transition period would need to be ﬁled in the annual report only if the audited balance sheet as of the end of the ﬁscal year prior to the transition period is not ﬁled. 5 Under these options, a separate report covering the transition period is not required. Note that transition period results would be reported later under these two options than if separate 10-Q or 10-K reports were required.

managers cannot avoid an audit of transition period results, although they can delay reporting audited results for a year if the transition period is less than six months (by electing to include them with the Form 10-K for the new annual period). The fact that audited results must eventually be ﬁled provides some discipline for managers who might otherwise report unaudited results that are inaccurate.

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Comparative Disclosures As previously discussed, users need comparative data from prior periods in order to update their estimates for future periods. Both Form 10-K and Form 10-Q, the two forms used to report transition period operating results, include general provisions for reporting comparative data from prior periods.6 SEC rules also include speciﬁc provisions applicable when these two forms are used to report ﬁnancial information for a transition period resulting from a change in ﬁscal year. Firms with transition periods of six months or longer must ﬁle a Form 10-K and include comparative operating data for the corresponding months of the prior year. This comparative data may be unaudited and may be reported in a footnote or on the income statement. The company must state the comparative period from the prior year, revenues, gross proﬁts, income taxes, income or loss from continuing operations before extraordinary items and cumulative effect of a change in accounting principles, and net income or loss (SEC Rule 13a–10, paragraph b). The rules for reporting comparative data are less stringent for transition periods of less than six months. SEC rules state that “(I)f it is not practicable or cannot be cost-justiﬁed to furnish ﬁnancial statements for corresponding periods of the prior year where required, ﬁnancial statements may be furnished for the quarters of the preceding ﬁscal year that most nearly are comparable if the issuer furnishes an adequate discussion of seasonal and other factors that could affect the comparability of information or trends reﬂected, an assessment of the comparability of the data, and a representation as to the reason recasting has not been undertaken” (SEC rule 13a–10, paragraph e). While managers have some ﬂexibility in providing comparative data for transition periods of less than six months, they must furnish relevant comparable information from the prior year.

REPORTING PRACTICES Because the process of obtaining and analyzing the ﬁnancial disclosures required by the SEC is very labor-intensive, we selected one year for analysis. Using COMPUSTAT, we identiﬁed 79 ﬁrms that changed their ﬁscal year-end during the 1995 data year, the most recent year available when we began this study.7,8 In this section, we document the type of information provided by this sample of ﬁrms and comment on compliance with SEC regulations. We ﬁrst consider the timeliness of the initial announcement of the change decision. We then report on the adequacy of ﬁnancial disclosures about operations for the transition 87

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period. We present our data separately for ﬁrms involved in mergers and ﬁrms not involved in mergers as needed to convey differences in the types of disclosures provided (even though the same SEC rules apply).9 Initial Announcements As stated previously, SEC rules require that a formal announcement be ﬁled within 15 days of a ﬁrm’s decision to change its ﬁscal year-end. Our search of the EDGAR and NAARS databases revealed such ﬁlings for 68 of the 79 COMPUSTAT ﬁrms changing their year-end during 1995. Panel A of Table 2 reveals that 54 of these ﬁlings were reported on Form 8-K, nine were reported on Form 10-Q, and ﬁve were reported on Form 10-K. Merger ﬁrms used the Form 8-K for the announcement relatively more frequently than non-merger ﬁrms (80% versus 64%). Panel B of Table 2 shows that, of the 54 ﬁrms announcing changes on Form 8-K, nine (17%) ﬁled after the 15-day deadline. For these ﬁrms, the delay between the decision date and the Form 8-K ﬁling date ranged from 17 to 75 days. Of the nine ﬁrms announcing their changes on Form 10-Q, ﬁve (56%) exceeded the 15-day deadline, with the delay between the decision date and the Form 10-Q ﬁling date ranging from 27 to 194 days. For the ﬁve ﬁrms using a Form 10-K to announce the decision, three (60%) were late with a range of 101 to 122 days. In total, at least 25% (17 of 68) of the ﬁrms announcing a change in ﬁscal year-end failed to do so within the period required by SEC rules. The rate is higher (up to 35%) if some or all of the 11 observations for which no disclosures were available represent ﬁrms that neglected to ﬁle at all. The rates of late ﬁlings are very similar for merger and no merger ﬁrms. The high rate of late announcements by ﬁrms using Form 10-Q and Form 10-K might suggest that the SEC should only allow use of the Form 8-K for announcements. On the other hand, these ﬁrms might have missed the 15-day deadline for a Form 8-K and not realized it until ﬁling Forms 10-Q or 10-K. If using other forms were not an option, these ﬁrms might never have ﬁled an announcement.10 Although SEC rules do not require ﬁrms to provide reasons for their ﬁscal year-end changes, some ﬁrms elected to make such disclosures in the form used to announce the change. Of the nine ﬁrms providing a rationale for the yearend change decision, six were involved in merger activity. The remaining three ﬁrms changed ﬁscal year-ends for the following reasons: • “ . . . to correspond the Company’s ﬁscal year with the Company’s new annual business cycle and to allow the Company to best match the costs and expenses

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Table 2. Announcement of the Change Decision Panel A: SEC Form Used to Announce the Fiscal Year-End Change*

No Merger Firms

Merger Firms

All Firms

Form 8-K Form 10-Q Form 10-K Total Announcements No Change Announcement Found Total Firms Changing Fiscal Year-End

38 (64%) 8 (14%) 5 (8%) 51 (86%) 8 (14%) 59 (100%)

16 (80%) 1 (5%) ———17 (85%) 3 (15%) 20 (100%)

54 (68%) 9 (12%) 5 (7%) 68 (86%) 11 (14%) 79 (100%)

Panel B: Late Filings by Form Type

No Merger Firms

Merger Firms

All Firms

6 of 38 (16%) 4 of 8 (50%) 3 of 5 (60%) 13 of 51 (25%) 8 21 of 59 (36%)

3 of 16 (19%) 1 of 1 (100%) ——— (———) 4 of 20 (25%) 3 7 of 20 (35%)

9 of 54 (17%) 5 of 9 (56%) 3 of 5 (60%) 17 of 68 (25%) 11 28 of 79 (35%)

No Merger Firms

Merger Firms

All Firms

3 48 51

6 11 17

9 64 68

Form 8-K Filed Late Form 10-Q Filed Late Form 10-K Filed Late Total Announcements No Change Announcement Found Total Firms Without a Timely Announcement

Panel C: Firms Providing a Rationale with the Change Announcement Rationale stated (although not required by SEC) No rationale stated Total Announcements

* The SEC allows a Form 10-Q or 10-K to be used instead of a Form 8-K if the form is ﬁled within the 15day deadline.

associated with growing each year’s crop with the revenues expected to be generated from the anticipated sales . . .” • “. . . to provide shareholders with information on a basis more comparable to other public entities in the specialized automobile ﬁnance industry . . .” • “. . . to align the accounting year with the tax year.” Financial Statement Disclosures As discussed previously, SEC rules require income statement data for the transition period in all instances. Comparative data from the prior year are also 89

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required. The comparative data must correspond to the exact months of the transition period for transition periods of six months or longer. For periods of less than six months, information can be provided about quarters of the preceding year that are most nearly comparable to the transition period, if managers provide an adequate discussion of seasonality and other factors that may limit the comparability of those quarters. We summarize the types of disclosures provided by the sample ﬁrms in Table 3. Three formats were widely used in Form 10-K ﬁlings. Thirty-seven ﬁrms (52%) report operating results for the current transition period and a comparative period from the previous year, as well as prior annual periods under the old year-end. Twenty-six ﬁrms (37%) present operating results for only the current transition period and prior annual periods and, therefore, are not in compliance with SEC rules requiring comparative data for the transition period. If the reason for the omission is that comparative disclosures would not be costbeneﬁcial, we should have observed ﬁrms presenting previously reported quarterly data with a discussion of the extent of its comparability (which is allowed by the SEC). However, we observed no instances of this type of disclosure. Eight ﬁrms (11%) are also in violation of SEC rules because they omit both transition period results and comparative data for the transition period. All of these ﬁrms instead report pro forma annual results ending on the month of the new ﬁscal year-end for all years presented (subsequently referred to as ‘pro forma annuals’). A user examining these statements often would not realize the ﬁrm’s year-end had been changed. Table 3. Types of Disclosure Formats and Rates of Compliance with SEC Rules Format Type

Firms reporting results for transition period and for comparative period from prior year (as required by SEC) Firms reporting results for transition period but without comparative results from prior year* Firms not reporting for transition period but reporting proforma annual results for prior years as if the new ﬁscal year-end had been in effect* Financial Disclosures Available 10-K Not Available Total Firms Changing Fiscal Year-End * These formats are not in compliance with SEC rules.

No Merger Firms

Merger Firms

All Firms

30 (59%)

7 (35%) 37 (52%)

18 (35%)

8 (40%) 26 (37%)

3 (6%)

5 (25%) 8 (11%)

51 (100%) 20 (100%)71 (100%) 6 2 8 57 22 79

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Merger ﬁrms more frequently present pro forma annuals than no merger ﬁrms (25% versus 6%). Although this practice increases the rate of noncompliance with SEC rules by merger ﬁrms, this format has the advantage of providing users with a basis for interperiod comparisons for the combined entity under the new year-end.

THE AUDITOR’S RESPONSIBILITY Another issue in reporting quality concerns the adequacy of disclosures in the audit opinion. Speciﬁcally, should the auditor’s report cite the ﬁscal year-end change in a separate explanatory paragraph? Opinion modiﬁcations are required for many changes that affect consistency, including changes in an accounting principle, a change in reporting entity, correction of an error in principle, and changes in items treated as cash equivalents in presenting cash ﬂows. The auditing literature, however, does not comment directly on a change in yearend. Some auditors may believe that a separate paragraph is unnecessary because both the scope and opinion paragraphs cite the dates of the ﬁnancial statements. That is, readers should note that the dates for the transition period (and the new annual period, if included) differ from the dates for the prior annual periods. Even if an explanatory paragraph is not required for ﬁscal year-end changes as a general practice, should a paragraph be included if the company omits comparative data? The third standard of reporting is: “Informative disclosures in the ﬁnancial statements are to be regarded as reasonably adequate unless otherwise stated in the report.” Under this standard, the auditor would have to believe that disclosures are reasonably adequate without comparative data. Since comparative disclosures are such a fundamental part of ﬁnancial reporting, the third standard would seem to require disclosure of their omission in the audit report. Statement on Auditing Standards No. 58, Reports on Audited Financial Statements (AICPA 1988), provides more speciﬁc guidance on when disclosures of accounting changes are required in the auditors’ report. Although a change in ﬁscal year-end does not constitute a change in “accounting principles” as that term is used in GAAP, SAS no. 58 (para. 37) indicates that auditors may include an explanatory paragraph to emphasize some matters including “. . . an accounting matter affecting the comparability of the ﬁnancial statements with those of the preceding period.” This provision would seem to include ﬁscal year-end changes. One other provision in the authoritative auditing literature appears to be relevant by analogy. Section 558, Required Supplementary Information (para. 8), states the auditor’s report should be expanded for omission of supplementary information required by FASB or GASB. 91

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To determine the types of audit report disclosures provided in practice, we reviewed the audit reports for all the ﬁrms in our sample. The occurrence of a change in ﬁscal year-end was cited in an explanatory paragraph in the audit report for only two companies in our sample. No audit report mentions the omission of comparative data. Based on conversations with several auditing partners, a likely reason is that those data are required by an SEC rule (not a GAAP rule) and are labeled as “unaudited.”

RELATION BETWEEN DISCLOSURE PRACTICES AND USE OF A BIG–6 AUDITOR The SEC rules for reporting a ﬁscal year-end change are unusually complicated. Big-6 ﬁrms have more experience than non-Big-6 ﬁrms with SEC ﬁlings, and they also have national staffs that handle technical inquiries and interact frequently with the SEC. Several academic studies have investigated whether these and other factors result in Big-6 ﬁrms providing a ‘higher quality’ audit. In general, surprisingly few studies provide empirical support for an audit quality difference between Big-6 and non-Big-6 ﬁrms. Of direct relevance to our study, however, Kunitake (1987) found that betweeen 70 to 80% of SEC sanctions against accounting ﬁrms were brought against non-Big eight ﬁrms. The reporting of ﬁscal year changes provides a good setting to revisit the effect of audit ﬁrm size on audit quality. Table 4 summarizes reporting practices by type of audit ﬁrm. Since the sample includes relatively few ﬁrms that used a non-Big-6 auditor, statistical power is limited. The descriptive results nevertheless provide some indication of whether differences may exist between Big-6 and non-Big-6 ﬁrms.11 Panel A reports on the timeliness of reports announcing the change in year-end. Although the 79% rate of timely ﬁling (within the 15-day deadline) is higher for ﬁrms using Big–6 auditors than the 60% rate for ﬁrms using non-Big–6 auditors, the difference is signiﬁcant at only the 12% level. Therefore, the data only weakly support the notion of more timely ﬁlings by ﬁrms having ‘higher quality’ audits. Panel B provides a comparison of the formats used to report operating results. Among the 63 ﬁrms that report transition period operating results, 64% of those audited by Big-6 ﬁrms include comparative results as required by the SEC, while only 30% of those audited by non-Big-6 ﬁrms do so.12 This difference is statistically signiﬁcant at the 5% level using a Chi-Square test. Thus, the evidence suggests that differences do exist in the appropriateness of formats used by companies audited by Big-6 and non-Big-6 ﬁrms; that is, companies

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Table 4. Compliance With SEC Rules and Use of a Big-6 Auditor Panel A: Timely Announcement of Change Decision Big–6 Within 15-day Deadline Filed Late or No Announcement Firms announcing the change(a) Chi-square p-value = 0.129

42 (79%) 11 (21%) 53 (100%)

Non-Big–6 9 (60%) 6 (40%) 15 (100%)

Total 51 (75%) 17 (25%) 68 (100%)

Panel B: Presentation of Transition Period Operating Results Big–6 Firms reporting results for transition period and for 34 (64%) comparative period from prior year (as required by SEC) Firms reporting results for transition period but without 19 (36%) comparative results from prior year Firms reporting a transition period(b) 53 (100%) Chi-square p-value = 0.044

Non-Big–6

Total

3 (30%)

37 (59%)

7 (70%)

26 (41%)

10 (100%)

63 (100%)

Panel C: Timely Announcement and Presentation of Transition Period Operating Results

In full compliance Not in full compliance Firms announcing the change and reporting a transition period(c) Chi-square p-value = 0.055

Big–6

Non-Big–6

19 (42%) 26 (58%) 45 (100%)

1 (10%) 9 (90%) 10 (100%)

Total 20 (36%) 35 (64%) 55 (100%)

(a) This total excludes 11 ﬁrms that failed to announce the year-end change (as per Table 2). (b) This total excludes eight ﬁrms for which an audit report was not available and a different eight ﬁrms reporting proforma annual results (which is also not in compliance with SEC rules). (c) This total excludes all ﬁrms represented by the intersection of notes (a) and (b).

that use higher quality auditors are more likely to provide comparative disclosures that are in compliance with SEC regulations. This conclusion is supported further by the data presented in Panel C, which document that 42% of Big-6-audited ﬁrms comply fully with all SEC regulations (that is, both make a timely announcement and ﬁle appropriate comparative disclosures) compared to only 10% of ﬁrms handled by non-Big-6 auditors (p < 0.055). Across both types of auditors, however, the overall compliance rates are surprisingly low. The next section examines whether the incomplete disclosures are occurring under conditions in which high quality disclosures are particularly important. 93

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ARE TRANSITION PERIODS USED TO MANAGE INCOME? By changing the year-end, managers can report poor operating results in a transition period that is not part of any annual period. Anecdotal evidence that this has been done is provided by the case of SafeCard (discussed in the introduction and appendix). In this section, we provide evidence about the frequency with which the sample ﬁrms reported net losses during the transition period. Our contention is that if the rate of net losses in transition periods is abnormally high relative to certain ‘benchmark’ rates, ﬁrms may be intentionally dumping unfavorable results into transition periods to artiﬁcially improve their annual results.13 Complete and transparent disclosures would be particularly important if this is the case. Table 5 details the frequency with which net losses are reported in transition periods. This information is not available for ﬁrms presenting pro forma annuals and ﬁrms for which we could not obtain a Form 10-K. The 63 remaining ﬁrms use one of the two formats listed in the ﬁrst two rows of Table 3. Panel A of Table 5 shows that 62% (39 of 63) of the ﬁrms disclosing transition period results reported net losses in the transition period. To obtain a benchmark normal rate of loss occurrence, we used the population of ﬁrms covered by the COMPUSTAT tapes. Approximately 34% of all COMPUSTAT ﬁrms reported net losses in the 1995 data year. The 62% proportion of ﬁscal year-end changers reporting transition period losses is signiﬁcantly higher (p < 0.001) than the 38.3% benchmark proportion of COMPUSTAT ﬁrms. That is, the tests support the notion that net losses are reported in transition periods much more frequently than would be expected by chance. As an additional test, in Panel B of Table 5 we deﬁne the benchmark rate as the rate of losses among the sample of ﬁscal year-end changers during the prior annual period. In other words, the benchmark used in Panel B is the ﬁscalyear-change ﬁrm’s prior annual performance, rather than that of the population of COMPUSTAT ﬁrms. The results indicate that the 62% rate of transition period losses is signiﬁcantly greater (p < 0.001) than the 35% rate of losses reported during the prior annual period. We also ﬁnd, but do not report in Table 5, that the 35% proportion of losses reported by ﬁscal year-end changers during the prior annual period (1994) is virtually identical to the 32% proportion of losses among COMPUSTAT ﬁrms as a whole in the 1994 data year.14 In total, the results presented in Panels A and B of Table 5 indicate that ﬁscal year-end changers reported losses at a rate similar to that of other ﬁrms in periods prior to the change; however, during the transition period, losses were reported at almost twice the benchmark rate (whether the benchmark

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Table 5.

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Earnings Performance of Firms Changing Their Fiscal Year-Ends

Panel A: Net Loss Frequency in Transition Period Relative to All COMPUSTAT Firms Number of Firms Firms reporting net loss in transition period produced by 1995 ﬁscal year-end change COMPUSTAT ﬁrms reporting net loss in 1995 data year Difference in proportions p-value = 0.001

39 of 63 (62%) 3809 of 11,289 (34%)

Panel B: Net Loss Frequency in Transition Period and Prior Year Number of Firms Fiscal year-end change ﬁrms reporting net loss in transition period Fiscal year-end change ﬁrms reporting net loss in prior annual period Difference in proportions p-value = 0.001

39 of 63 (62%) 22 of 62 (35%)*

* We were unable to locate the prior year’s 10-K ﬁling for one ﬁrm.

is deﬁned as the COMPUSTAT rate or the within-sample rate). These comparisons suggest that ﬁrms may be using transition periods as a ‘dumping ground’ for unfavorable operating results. In this setting, disclosure quality assumes increased importance.15

CONCLUSION AND COMMENTS Despite the relatively frequent occurrence of ﬁscal year-end changes (almost 2300 COMPUSTAT ﬁrms between 1976 and 1995), disclosure practices by these ﬁrms have received no attention in the accounting literature. The high rate of ﬁscal year changes has also escaped the attention of accounting practitioners and standard-setters, based on our conversations with several staff members at the SEC and FASB and with experienced public accounting partners. Several individuals told us they had encountered a few ﬁscal year-end changes but did not realize that they were so common. Although the SEC has rules for notifying investors of a change in ﬁscal yearend, the rate of noncompliance is high. The SEC requires that ﬁrms ﬁle a Form 8-K within 15 days to announce the change. We were able to ﬁnd announcements for 68 of the 79 ﬁrms in our sample. The form was ﬁled late by 17 of the 68 ﬁrms (25%). If many of the other 11 ﬁrms never ﬁled, the rate of noncompliance could be even higher (up to 35%). Timely notiﬁcation of the decision to change the ﬁscal year-end is important because some users are likely 95

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to learn of the change while others are not. For example, analysts could obtain value-relevant information from the managers, including the reasons for the change and guidance in developing forecasts for the new reporting period. Less informed users would not know they are at an information disadvantage. The SEC also has rules for reporting operating results for the transition period, but again, the rate of noncompliance is very high. In fact, only 52% of the ﬁrms in our sample fully complied with SEC rules that require income statement data for both the transition period and a comparative period from the prior year. The most frequent type of noncompliance (37%) was omission of comparative data for the transition period. The remaining 11% of ﬁrms did not report either transition period results or comparative results, but instead reported pro forma results for annual periods closing on the new year-end. Financial analysts and other users may have trouble evaluating a ﬁrm’s performance and developing accurate estimates of future earnings if they do not have both transition-period operating results and comparative data from the year earlier. At a minimum, investors and creditors must incur greater costs to obtain and evaluate the information they need. The high-proﬁle case of SafeCard (see Appendix) illustrates that ﬁrms can manage income by reporting losses in transition periods. Empirically, we ﬁnd that in the year prior to the ﬁscal year-end change, the rate of losses among ﬁscal year-end changers does not differ from that of the COMPUSTAT population. However, the rate of losses reported in transition periods is abnormally high relative to both the within-sample rate corresponding to the last annual period and the rate for the population of COMPUSTAT ﬁrms. These results suggest that ﬁrms may be reporting poor operating results in transition periods to improve the operating results for annual periods. If some ﬁrms are managing income, disclosure quality assumes increased importance. Due to the high rate of noncompliance with SEC rules, we recommend that the SEC increase enforcement activity by closely monitoring ﬁrms that report a change in their ﬁscal year. Since numerous ﬁrms are not covered by SEC rules, we recommend that the FASB (or AcSEC) add a project to its agenda to develop standards for reporting a change in ﬁscal year-end. In addition to providing guidelines for non-SEC ﬁrms, auditors would likely do a better job of enforcing compliance among SEC ﬁlers if the rules are a part of GAAP. An accounting standard should specify the types of ﬁnancial statement disclosures needed, including a requirement for comparative results. A standard also might want to specify conditions that should be present to justify a change in ﬁscal year-end. And ﬁnally, we recommend that the Auditing Standards Board explicitly require an explanatory paragraph in the audit report (after the opinion paragraph) stating the year-end has been changed and referring to a footnote

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for further explanation. The current provision in SAS 58 does not appear to be sufﬁcient.

ACKNOWLEDGEMENTS The views expressed in the study are those of Mr. Porter. Ofﬁcial positions of the FASB are determined only after extensive due process and deliberation. The authors would like to acknowledge helpful discussions with Mike Ashﬁeld of Coopers & Lybrand, LLP, and with workshop participants at Texas A&M University and the University of Texas.

NOTES 1. During breaks at the 1995 SEC Mountaintop Issues CPE program, one of the authors spoke brieﬂy with Walter Schuetze, former Chief Accountant, Ofﬁce of the Chief Accountant, SEC (now Chief Accountant, Division of Enforcement); George Diacont, Jr., former Chief Accountant, Division of Enforcement, SEC; and Glen Perry, former Chief Accountant, Division of Enforcement, SEC. They all expressed surprise at the high frequency of ﬁscal year-end changes. 2. A former student, who is a manager with a Big–6 ﬁrm, pointed out this contribution to us and told us that they requested help from the national ofﬁce in interpreting these rules for a client. He also conﬁrmed the accuracy of our summary of the rules. 3. For example, a recent Reuters story detailing the quarterly earnings of Wal-Mart Stores notes, ‘before the market opened, the company reported net income of $1.92 billion, or 43 cents per share, versus $1.56 billion, or 35 cents per share, in the year-ago quarter. Total sales climbed to $51.39 billion, a 26 percent hike from $40.79 billion in the yearago period. Analysts had pegged Wal-Mart’s earnings at 42 cents per share for the fourth quarter ended Jan. 31, according to research ﬁrm First Call/Thomson Financial.’ 4. We searched the computerized database of a Big–6 ﬁrm, the FASB’s database (i.e., FARS) and contacted the Technical Information Hotline at the American Institute of Certiﬁed Public Accountants. The AICPA specialist conﬁrmed that there were no ofﬁcial accounting or auditing requirements for ﬁscal year-end changes. 5. Although SEC Rule 13a–10 speciﬁes the use of Form 8-K, the instructions to that form (instruction B.3) state that Form 8-K is not required for information that has been previously reported. Both Form 10-Q (Item 5) and Form 10-K (Item 14) have sections for reporting 8-K information. Therefore, if the information is reported on another form within the 15 day deadline, an 8-K is not required. 6. The general rules for Form 10-K require comparative balance sheets for the current and previous ﬁscal year-ends; income statements for the previous three ﬁscal year-ends; and cash ﬂow statements ‘as applicable in support of (the) primary ﬁnancial statements’ (SEC ¶ 41120). The general rules for Form 10-Q require comparative balance sheets as of the end of the current quarter and as of the end of the preceding ﬁscal year; income statements for the current quarter and year-to-date plus the corresponding quarter of the preceding year and previous year-to-date; and cash ﬂow statements for the year-to-date and the previous year-to-date.

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7. The COMPUSTAT data year is not identical to a calendar year. COMPUSTAT codes year-ends based on a June to May cycle. For example, a ﬁrm whose ﬁscal yearend is February 28, 1995 would have a data year code of 94 in COMPUSTAT. 8. Previous compliance studies also examine one or more years in depth, rather than taking a sample of disclosures from several years. For example, Frost & Kinney (1996) examine SEC ﬁlings by 156 foreign registrants in 1989 and 1990, and Frost & Pownall (1994) study 1989 disclosures by 107 foreign ﬁrms with securities traded in the U.S. and/or the U.K. 9. Merger ﬁrms are those that acquired another ﬁrm or were acquired themselves. Some ﬁrms stated a merger as the rationale for the year-end change in the Form 8-K and others discussed the merger in the Form 10-K. 10. The only other published studies that examined timely ﬁling of the Form 8-K are both by Schwartz & Soo (1995, 1996). The 1996 study found that 35% of their sample ﬁled a Form 8-K to report an auditor change after the deadline. Surprisingly, the rate of noncompliance did not change after the deadline was reduced from 15 days to ﬁve days. (Since their sample was obtained from ﬁrms with a Form 8-K in Lexis, they did not attempt to identify ﬁrms without a change announcement.) Their 1995 study found that failing ﬁrms are more likely to submit a late Form 8-K to report an auditor change than a matched sample of non-failing ﬁrms. Some evidence also exists about the rate of late ﬁling of other SEC forms. Alford, Jones & Zmijewski (1994) found that 20% of Form 10-Ks were ﬁled after the 90-day statutory date; 68% of these ﬁrms were not in compliance with SEC rules because they did not ﬁle a timely Form 12b–25 to provide notiﬁcation of the delay. 11. Since statistical signiﬁcance is at least somewhat inﬂuenced by sample size, even with large samples the emphasis should be on the economic meaningfulness of the observed differences. 12. Big–6 ﬁrms audited all of the eight companies using the pro-forma format. Recall that this format is not in accord with SEC rules because it omits transition period results (instead reporting 12-month periods as if the new year-end had been used in all prior periods). 13. A ﬁner measure of strategic reporting would consider whether operating results are below those for the same months in the prior year. Unfortunately, the high rate of non-compliance with the SEC requirement for comparative data precludes our use of this measure (and further illustrates the need for comparative data). 14. We also made these comparisons after ﬁltering the COMPUSTAT population to be representative of the size and industry mix of our sample ﬁrms. The ﬁndings are robust with respect to size and industry mix. 15. Accountants, lawyers, and other professionals who are associated with disclosures that violate applicable professional standards may be censored, suspended, or barred from practicing before the SEC. Under Rule 102(e)(1)(ii) the SEC considers whether the violation occurs under circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted. Transition period losses, particularly by a ﬁrm that has been proﬁtable in the prior year, would seem to warrant heightened scrutiny.

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REFERENCES AICPA (1988). Reports on Audited Financial Statements. Statement on Auditing Standards No. 58. New York: AICPA. Alford, A. A., Jones, J. J., & Zmijewski, M. E. (1994). Extensions and violations of the statutory SEC Form 10-K ﬁling requirements. Journal of Accounting and Economics, 17, (January), 229–254. Berton, L. (1991). Maxwell’s accounting, audit expertise helped keep empire intact some say. The Wall Street Journal, 12, A4. Cready, W. M., & Mynatt, P. G. (1991). The information content of annual reports: A price and trading volume response analysis. The Accounting Review, (April), 291–312. Frost, C. A., & Kinney, W. R. (1996). Disclosure choices of foreign registrants in the United States. Journal of Accounting Research, (Spring), 67–84. Frost, C.A., & Pownall, G. (1993). Accounting disclosure practices in the United States and the United Kingdom. Journal of Accounting Research, (Spring), 75–102. Jennings, R.W., & Marsh, H. Jr. (Eds). (1994). Selected Statutes, Rules, and Forms under the Federal Securities Laws. Westbury, NY: The Foundation Press. Kasznik, R., & McNichols, M. (1998). Does meeting expectations matter: Evidence from analyst revisions and share prices. Working Paper. Stanford University, CA. Kunitake, W. K. (1987). SEC accounting-related enforcement actions 1934–1985: A summary. Research in Accounting Regulation, 79–87. Pincus, M., & Wasley, C. (1994). The Incidence of Accounting Changes and Characteristics of Firms Making Accounting Changes, Accounting Horizons, (June), 1–24. Schroeder, M., & Spiro, L. N. (1997). Trouble: How incompetence and greed undid credit-card insurer SafeCard Services. Business Week, (April 28). Schwartz, K. B., & Soo, B. S. (1995). An analysis of Form 8-K disclosures of auditor changes by ﬁrms approaching bankruptcy. Auditing: A Journal of Practice and Theory and Practice, 14 (Spring), 125–136. Schwartz, K. B., & Soo, B. S. (1996). Evidence of regulatory noncompliance with SEC disclosure rules on auditor changes. The Accounting Review, (October), 555–572.

APPENDIX Use of a Fiscal Year Change by SafeCard Services, Inc The following text consists of excerpts from a lengthy exposé by Business Week (April 28, 1997) regarding one of the ﬁrms in our sample. More disturbing, [SafeCard’s] $20 million proﬁt was a ﬁction. SafeCard was amortizing the marketing costs of acquiring new subscribers over a 10-year period. But because it was losing customers and had begun to spend on marketing to retain them, SafeCard could no longer justify stretching the amortization out that long. This meant that the company needed to write down the deferred subscriber acquisition costs of $195 million over a much shorter period, according to an accounting expert. Indeed, a March, 1995, letter from the SEC 99

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shows that the agency had been corresponding with SafeCard about shortening the amortization period in April, 1994. ACCOUNTING TRICKS? SafeCard in a press release issued on Dec. 14, 1994, said that it was considering changing the amortization period, which would result in an aftertax charge of about $45 million (about $65 million before taxes). On Dec. 22, it ﬁled the same information in an 8-K with the SEC. If the company had taken the hit in its normal 1994 ﬁscal year, ended Oct. 31, it would have shown a $25 million loss – not a $20 million proﬁt. But SafeCard would use a clever technique to record the write-off. It said that it was moving the end of its ﬁscal year from Oct. 31 to Dec. 31. This created a ‘stub’ period, a two-month black hole that was not part of 1994 or 1995. And indeed, on Jan. 25, 1995, the company announced that a $65 million pretax charge from the change would be recorded in this two-month transition period. But only six days before, on Jan. 19, SafeCard had ﬁled a 10-K with the SEC detailing its results for the ﬁscal year ended Oct. 31, 1994 – without taking the writeoff. Is it likely that the company knew on Jan. 19 that it would be making the change? If it did know, why didn’t it include the $65 million charge in the 10-K? ‘You have to ask yourself, who knew what when,’ says Abe Mastbaum, senior vice-president of American Securities LP and an accounting expert. The company’s annual report sent to shareholders in February, 1995, dated Jan. 25, made no mention of either change. The company, in a Feb. 9 press release, reported a loss of $49.9 million for the two-month period and ﬁled a Form 10-Q reporting the loss on Feb. 13.

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EARNINGS MANAGEMENT, THE PHARMACEUTICAL INDUSTRY AND HEALTH CARE REFORM: A TEST OF THE POLITICAL COST HYPOTHESIS Joseph Legoria

ABSTRACT This study tests the political cost hypothesis (PCH) by examining how the debate over health care reform impacted the earnings reported by the pharmaceutical industry. The chapter examines whether discretionary accruals and research and development (R&D) expenditures were used to manage earnings. The results show that R&D was not used to manipulate earnings in 1993. However, the results indicate that discretionary accruals were used to manage earnings during 1993 consistent with the PCH. In addition, the pharmaceutical industry’s sales in 1993 grew at a slower rate than in control years and the industry took more restructuring charges in 1993 than in control years and a set of control ﬁrms in other industries. In summary, the evidence for 1993 is consistent with the PCH and indicates that the pharmaceutical industry responded to the potential of increased political regulation by taking steps to reduce their reported earnings.

Research in Accounting Regulation, Volume 14, pages 101–131. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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INTRODUCTION This study tests the political cost hypothesis (PCH) by examining whether ﬁrms in the pharmaceutical industry managed earnings in response to the political pressures of health care reform during 1993. Positive accounting theory predicts that ﬁrms subjected to increased political costs will make income-decreasing accounting choices in order to reduce potential wealth transfers (Watts and Zimmerman, 1986).1 Thus, the political debate over health care reform provides an opportunity to investigate ex-ante how pharmaceutical ﬁrms reacted to proposed legislation. Health care reform emerged as a central issue of the 1992 presidential campaign. Bill Clinton used the health care issue to help win his party’s nomination for President. With his election, the future of health carerelated industries became uncertain as he promised to push for government reform, rather than market reform, of the health care system. Substantial effort was made by his administration to inﬂuence public opinion and ensure passage of the President’s proposals. As part of this strategy, the pharmaceutical industry was attacked as the major culprit for the rising cost of health care, with an emphasis placed on the industry’s high levels of proﬁtability.2 Summary ﬁnancial information such as net earnings, earnings per share, or especially changes in those measures are easily understood by the general public and thus widely used by politicians in the political debate. However, it is unlikely that the general public is aware of the discretion that management has to manipulate these aggregate measures or that regulators and politicians can frequently adjust for management’s ability to manipulate them. Prior research has examined whether ﬁrms manipulate reported proﬁts in response to government regulations (e.g. Jones, 1991; Cahan, 1992). This study differs from that research by extending earnings management research into the American political arena as opposed to examining how ﬁrms responded ex-post to increased political costs resulting from a particular regulatory body investigation. This study provides a rigorous and somewhat unique test of the PCH by examining an industry that may have been motivated to manipulate earnings to inﬂuence public policy and preclude passage of legislation that would impose political costs on their industry.3 Earlier research has also examined whether ﬁrms manipulate reported proﬁts in response to contracting processes such as debt covenants (e.g. Sweeney, 1994), bonus plans (e.g. Healy, 1985; Gaver et al., 1995; Holthausen et al., 1995) and litigation (e.g. Hall & Stammerjohan, 1997). In addition to the well deﬁned contracting process, prior studies have shown that some managers prefer to report all ‘bad news’ in the ﬁnancials at the same time, a phenomenon dubbed the “big bath” (e.g., Elliot & Shaw, 1988).4 This study controls for these other

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incentives the literature has shown affect accounting choices. In doing so, the PCH was more cleanly tested and permitted the empirical ﬁndings to be related to this hypothesis and not the result of correlated omitted variables. The analysis indicates that managers did not use and research and development (R&D) expenditures to manipulate earnings downward in 1993. On the other hand, discretionary accruals were used to manage earnings in 1993, a result consistent with the PCH. In addition, individual accounting choices and operating decisions were examined to document particular methods managers used to manage earnings. The results indicate that the change in revenue in 1993 was much lower than the control years which suggests that the pharmaceutical industry may have delayed revenue recognition in 1993 by postponing sales from the fourth quarter of 1993 until the ﬁrst quarter of 1994. Further evidence indicates that the pharmaceutical industry took more restructuring charges in 1993 than in the control years and that these charges where greater than the amount of restructuring charges taken by control ﬁrms in 1993. In summary, the evidence presented for 1993 in this study is generally consistent with the PCH and indicates that the pharmaceutical industry responded to proposed health care legislation by managing reported earnings. The remainder of this chapter is divided into six sections. Section 2 discusses the PCH. Section 3 describes the political climate surrounding health care reform and how the pharmaceutical industry’s proﬁts increased its political costs. Hypotheses are developed in Section 4. Section 5 describes the sample and the research methodology. Section 6 reports the research ﬁndings and section 7 summarizes and concludes the chapter.

POLITICAL COST HYPOTHESIS Watts & Zimmerman (1986) posit that the use of reported earnings by politicians and regulators provides managers with incentives to make accounting choices that reduce income. By reducing reported proﬁts, ﬁrms facing increased political pressure may be able to reduce their political costs and reduce the likelihood of government action being taken against their ﬁrm or particular industry. To test the sensitivity of a ﬁrm to the political process, researchers have typically used ﬁrm size to proxy for political costs. A number of studies have found a positive association between ﬁrm size and the use of income-decreasing accounting choices. Watts & Zimmerman (1986; 1990) conclude that, in general, these ﬁndings provide empirical evidence supporting the PCH. Other authors have cited evidence contrary to the PCH.5 Watts & Zimmerman (1986) countered that the inconsistent results of the PCH suggest that size may be a weak proxy for political costs. Ball & Foster (1982) suggest that industry 103

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membership may be a more important determinant of a ﬁrm’s sensitivity in the political process. To reconcile the inconsistencies in the literature, Watts & Zimmerman (1986) and Christie (1990) suggested researchers to develop stronger proxies for political costs, such as subsidies, tax credits, and deductions as possibilities. Recently, researchers have begun to examine alternative proxies for political costs and identify situations where ﬁrms were targets of government regulation. For example, Wong (1988) examined the New Zealand tax reform movement from 1980–1985 and found that reported tax rates and export credit sales were associated with a ﬁrm’s political costs. Sutton (1988) showed that U.K. ﬁrms with high proﬁt margins were likely to encounter government scrutiny, suggesting that a ﬁrm’s proﬁt margin may be an important proxy for political cost. Cahan (1992) provides perhaps the most rigorous test of the PCH to date by investigating the accrual choices of ﬁrms that were the target of antitrust investigations. He found that accruals were income decreasing during the anti-trust investigations. Although Cahan’s (1992) study clearly demonstrated how a group of ﬁrms respond to political pressure, he notes that his results may be limited for two reasons. First, his study only examined one type of political action and therefore may not be generalizable to other political actions. Second, his study examined how ﬁrms reacted to anti-trust investigations once those investigations commenced, not what brought on the investigations or how ﬁrms preclude such investigations. Finally, he suggested that investigating the effect of congressional and legislative actions on accounting choices may be a more rigorous and unique test of the PCH.6

HEALTH CARE REFORM AND THE PHARMACEUTICAL INDUSTRY During the presidential and congressional campaigns of 1992, both (candidate) Clinton and members of Congress continually attacked the pharmaceutical industry’s pricing of drugs. For example, during a speech to workers at Merck Pharmaceutical, Clinton asserted that drug prices were too high for many elderly couples (The Center For Public Integrity, 1994). Representative Ron Wyden (D-Ore) protested Bristol-Myers pricing of a new cancer drug and Sen. David Pryor (D-Ark) introduced legislation designed to stop ‘price gouging’ by limiting R&D tax breaks for ﬁrms that raise their prices above the rate of inﬂation.7 The pharmaceutical industry’s initial response to these attacks was to contribute millions of dollars into then-President Bush’s campaign (Birnbaum & Waldholz, 1993).8

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Shortly after his inauguration, President Clinton continued questioning the pharmaceutical industry’s motives and attacking the industry’s “high profitability” levels. In February of 1993, Clinton delivered a speech attacking the pharmaceutical industry for spending $1 billion more on advertising and lobbying than on developing new and better drugs (Birnbaum & Waldholz, 1993). Citing a 1992 congressional staff report entitled Prescription Drug Costs: A Bitter Pill To Swallow, he pointed out that the pharmaceutical industry’s proﬁts were rising four times faster than those of the average Fortune 500 company and called for the drug industry to change its priorities because “we cannot have proﬁts at the expense of our children” (Birnbaum & Waldholz, 1993). In early March of 1993, the Ofﬁce of Technology Assessment (OTA) released a report entitled, Pharmaceutical R&D: Costs, Risks and Rewards, which concluded that the pharmaceutical industry had been making ‘excess proﬁts’ of $2 billion a year. In that same month, the Clinton administration proposed to make the federal government the sole buyer of childhood vaccines at a federally mandated price (Stout, 1993). Drug companies claimed that such a proposal would hurt their proﬁts and eventually affect their ability to continue R&D on future childhood vaccines (Stout, 1993). Clinton aides were quoted as saying that the President had targeted the pharmaceutical industry as part of his plan to gather public support for health-care reform (Waldholz, 1993). In referring to President Clinton’s public attacks on the pharmaceutical industry, Clinton’s chief campaign strategist James Carville was quoted as saying “We’ll be trying to change the health-care system. Those who get in your way, you try to run over by saying they are putting their self-interest against the national interest.” (Birnbaum & Waldholz, 1993). A Wall Street Journal/NBC news poll in early March of 1993 showed that the president’s strategy was working. The poll found that 50% of the people surveyed had negative views towards pharmaceutical ﬁrms whereas only 18% had positive views (Shafer, 1993). On September 22, 1993, President Clinton ofﬁcially released his health-care plan which included federal regulation of prices for breakthrough drugs; a 15% to 17% rebate from pharmaceutical ﬁrms (estimated at $2.5 billion annually) to the government for drugs covered in the Medicare and Medicaid programs; exclusion of newly developed prescription medicines from the Medicare program if prices were deemed to be to excessive. Leading pharmaceutical industry executives reacted angrily to these proposals. For example, Lodewijk de Vink, President and Chief Operating Ofﬁcer of Warner-Lambert Co., was quoted as saying, “we are talking about regulations that could affect the very survival of an industry that used to be very successful” (Waldholz, 1993). Leigh Thompson, chief scientiﬁc ofﬁcer of Eli Lilly & Co., when referring to Clinton’s 105

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health-care reform plan, was quoted as saying, “it is crippling, it’s absolutely devastating” (Tanouye, 1993). A sampling of quotes from corporate annual reports provides additional evidence that the pharmaceutical industry perceived President Clinton’s proposals as a serious threat to their industry. While many objectives of reform are being met in the marketplace, we believe certain proposals contained in the plan would lower the general quality of care for patients and make the research-based health care industry risk averse – and therefore less likely to discover breakthrough discoveries (Pﬁzer, 1993 Annual Report). We believe that a market-based approach is the best way to reform the U.S. health care system. We oppose global budgets and other artiﬁcial price control mechanisms. Most important, private sector innovation in health care technology must be encouraged in any new legislation (Abbott, 1993 Annual Report). A more nebulous challenge in 1994 is health care reform. We continue to contest the idea of a break through drug pricing committee and other aspects of reform that are veiled price controls (Genentech, 1993 Annual Report).

The above discussion provides evidence that politicians used the pharmaceutical industry’s ‘large proﬁts’ to justify that government action was the best way to reform the health care system. The reactions of industry executives suggest that the pharmaceutical industry viewed health care reform as a major threat to their industry. This evidence is consistent with the contention of Watts & Zimmerman (1986) that politicians use an industry’s reported proﬁts as evidence of a ‘crisis’ that only government can resolve.

EARNINGS MANAGEMENT TECHNIQUES AND HYPOTHESES DEVELOPMENT Discretionary Accruals Schipper (1989) deﬁnes earnings management as the purposeful intervention in the external ﬁnancial reporting process, with the intent of obtaining some private gain. Managers can manipulate reported earnings using a variety of techniques which include both accounting and non-accounting techniques (e.g. timing of the sale of ﬁxed assets). Among the accounting techniques available to managers are changing accounting methods, changing estimates of costs and manipulating accruals to modify the timing of reported earnings. Managing earnings by changing accounting methods and accounting estimates will perhaps provide the greatest and most permanent impact on earnings (Worthy, 1984). However, disclosure is required.9 On the other hand, accruals are less observable than changes in accounting principles and accounting estimates. As Healy (1985) pointed out, earnings management using accruals

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is less costly to a ﬁrm compared to changes of accounting principles and estimates and allows the ﬁrm to manage earnings without having to directly report the accrual decisions or the effects of those accrual decisions on the ﬁnancial statements. In addition, Schipper (1989) points out that the accounting data needed to undo managers’ earnings manipulation using accruals are not readily available. As a result, the income effect of managers’ accrual decisions are less likely to be noticed by a ﬁrm’s or industry’s critics. Research and Development Expenditures Prior research has shown that managers use R&D expenditures to manipulate earnings. For example, DeChow & Sloan (1991) identiﬁed a group of ﬁrms that have signiﬁcant ongoing R&D expenditures and management compensation plans based on earnings. They found that CEOs spend less on R&D during their last years in ofﬁce in order to improve proﬁts. Baber et al. (1991) ﬁnd that when spending on R&D may result in the inability of managers to report positive income or an increase in income, they reduce R&D expenditures so as to report stronger earnings. Since R&D represents a major cost for pharmaceutical ﬁrms, managers may use real investment decisions, such as R&D spending, to manipulate earnings. The use of R&D by pharmaceutical ﬁrms to reduce income is particularly useful and interesting in this study. For example, accelerating R&D both reduces reported earnings, and at the same time, supports an obvious industry rebuttal to political charges that high proﬁts are not being reinvested in the development of new and better drugs. Thus, the pharmaceutical industry can argue that it is acting in a manner that in the long-run will save lives and/or reduce health care costs. Hypotheses The criticism of the pharmaceutical industry heightened during the political campaigns of 1992. President (then candidate) Clinton included health care reform as a major theme of his speeches throughout the 1992 presidential campaign. Although President Clinton was not elected until November of 1992 and he did not give any speciﬁcs as to how he planned to reform the health care system, he indicated that health care reform would be a major priority of his administration.10 However, the lack of speciﬁcs by President Clinton resulted in some executives in the pharmaceutical industry supporting Clinton in the 1992 election while others expressed a willingness to work with the new administration on health care reform.11 Also, Persons (1999) notes that the 107

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Pharmaceutical Manufacturers Association (PMA) indicated to Congress that 17 of its members which account for approximately two-thirds of the market had voluntarily pledged to not increase prices above the level of general inﬂation. Therefore, given the fact that Clinton was not elected until November 1992 and Clinton did not give any speciﬁcs about how he planned to reform health care, many leading pharmaceutical ﬁrms indicated a willingness to work with the president. Thus, the study does not predict that managers had overriding incentives to manage earnings downward during 1992. On January 25, 1993, President Clinton formed the Task Force on National Health Care Reform with Hillary Rodham Clinton as chair. In addition, by September 1993, President Clinton submitted his health care reform plan to Congress. Further, a Clinton administration combined with a reform-minded congress would make the possibility of health care legislation more likely than in the past.12 These facts would suggest that during 1993 the political cost motivation should have had an effect on manager’s accounting choices. As Larcker & Revsine (1983) argue, if accounting proﬁts inﬂuence public opinion, then reducing reported income may change public opinion. Thus, by reducing reported earnings managers may be able to change the public’s attitude toward them and decrease pressure on regulatory or legislative bodies. Consequently, managers of pharmaceutical ﬁrms had incentives to reduce their 1993 reported earnings. The discussion presented above leads to the following hypotheses: H1: Managers of pharmaceutical ﬁrms made discretionary accounting accrual choices that decreased reported proﬁts for the ﬁscal year ended 1993. H2: Managers of pharmaceutical ﬁrms used R&D expenditures to decrease reported proﬁts for the ﬁscal year ended 1993. The defeat of President Clinton’s health-care reform plan in September of 1994 and the Republican takeover of Congress in November of 1994 suggests that pharmaceutical ﬁrms would perceive health care reform as a decreased threat and thus become less motivated to manipulate earnings downward. As Pﬁzer CEO William C. Steere Jr. was quoted as saying, “The GOP will be less apt to attack the industry’s pricing and marketing practices” (Weber & Hamilton, 1995). Therefore, no hypothesis was formulated predicting that pharmaceutical ﬁrms had incentives to reduce income in 1994, 1995, or 1996.13 In formulating the hypotheses, the assumption is that during 1993 managers had greater incentives to reduce reported proﬁts than they did in other years and that their incentives to reduce proﬁts were greater than the other incentives to increase income. However, prior research has demonstrated that managers manipulate earnings upward in response to other incentives (e.g. debt covenants and bonuses). This study controls for these other incentives that inﬂuence

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managers decisions to manipulate earnings. In addition, it is possible that political costs may have impacted manager’s accounting choices in other years besides 1993.

SAMPLE SELECTION AND METHODOLOGY Sample selection The population of interest in this study is all ﬁrms in the pharmaceutical industry (SIC-2834). A review of the 1996 Compustat Company coverage ﬁle revealed 187 publicly traded pharmaceutical ﬁrms (SIC 2834).14 Panel A of Table 1 summarizes the sample selection process. To select the sample, the following criteria were used. First, ﬁrms that reported to the Securities and Exchange Commission (SEC) on their Form 10-K as a development stage company during any year of the sample period were eliminated since, these ﬁrms would have little or no earnings to manage.15 This resulted in the elimination of 87 ﬁrms. Second, 9 ﬁrms that were primarily engaged in the manufacture of nonprescription drugs were eliminated. Third, ﬁrms must have had complete data available for all years beginning from 1986 through 1996 resulting in the elimination of 57 ﬁrms. Finally, 2 ﬁrms with no R&D expenditures in at least one-year for period from 1986 to 1996 were eliminated. After applying the sample selection criteria, 35 ﬁrms remained in the sample. Panel B of Table 1 shows that the sample ﬁrms’ assets, sales and other measures represent a large fraction of the pharmaceutical ﬁrms listed on Compustat for 1990, 1993 and 1996. For example, the sample ﬁrms comprise 72% or more of 1990, 1993 and 1996 industry total assets, total sales, R&D expenditures, net income and book-value of equity. Panel C of Table 1 provides a proﬁle of 35 pharmaceutical ﬁrms included in the sample. Descriptive statistics are provided for the ten-year period from 1987 to 1996. Appendix A lists the ﬁrms included in the sample. The 35 sample ﬁrms include all of the large pharmaceutical ﬁrms that would most likely be subject to political costs as well as some of the smaller ﬁrms. Research Design When attempting to manage earnings, managers have a large set of manipulation methods from which they can choose. Prior research has typically examined whether managers use a particular manipulation method to manage earnings in response to the earnings management incentive being tested. These studies fail to take into account that the decision to use one earnings management 109

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Table 1. Data on Sample Firms Panel A: Summary of sample selection of pharmaceutical ﬁrms Total Number of pharmaceutical ﬁrms (SIC 2834) on Compustat in 1996 Firms that were development stage per 10-K

190 (87) 103 Firms that primarily manufacture over the counter vitamins and food supplements (9) 94 Firms without complete data for the period from 1986 to 1996 (57) 37 Firms with no R&D expenditures in at least one year for the period from 1986 to 1996 2 Final Sample 35

Panel B: Percentage of total assets, sales, net income, and book value of equity sample (N = 35) comprise relative tot total for all publicy traded pharmaceutical ﬁrms (SIC 2834) listed on compustat in 1990 (n=108), 1993 (n=148) and 1996 (n=187)

Total assets (sample ﬁrms) / Total assets (all SIC 2834 ﬁrms) Total sales (sample ﬁrms) / Total sales (all SIC 2834 ﬁrms) Total R&D (sample ﬁrms) / Total R&D (all SIC 2834 ﬁrms) Total net income (sample ﬁrms) / Total net Income (all SIC 2834 ﬁrms) Total book value of equity (sample ﬁrms) / Total book value of equity (all SIC 2834 ﬁrms)

1990

1993

1996

97.50%

77.72%

77.75%

98.32%

83.51%

82.41%

96.05%

76.99%

75.42%

100.07%

85.59%

85.77%

97.00%

74.12%

72.04%

Panel C: Descriptive statistics on Sample ﬁrms for period from 1987 to 1996, all amounts in $millions except ratios Mean Median Std. Dev Q1 Q3 Total Assets Sales Book Value of Equity Market Value of Equity Net Income Return on Equity R&D/Sales

3,661.94 3,144.50 1,645.17 8,935.69 441.62 0.19 0.11

792.45 588.21 477.34 1,698.21 57.22 0.14 0.08

4,920.79 4,196.27 2,232.04 14,166.69 692.66 0.87 0.34

102.74 91.08 54.98 151.65 2.046 0.07 0.05

5848.00 5,500.53 2,581.00 12,412.27 708.70 0.27 0.13

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technique is not independent of the other available techniques. For example, if the hypothesis that managers manipulate earnings is maintained as true, then R&D expenditures and discretionary accruals are related since both of these can be used to manipulate earnings. If the amount of discretionary accruals and the amount of R&D depend upon one another, then these variables are endogenous (jointly determined). Estimation using ordinary least-squares would result in inconsistent estimates of the parameters. To address the research question, this study adapts the modiﬁed Jones model (DeChow et al., 1995) to estimate discretionary accruals.16 A second model was developed to test whether managers used R&D expenditures to manipulate earnings. These models permitted the isolation of the effects of the political costs of health care reform during 1993 and controlled for the various factors that inﬂuence managers’ decision to manipulate earnings (e.g. debt covenants, bonus considerations). However, to address the potential simultaneity, two simultaneous regressions are necessary. The dependent variables for the two equations reﬂect the ability of managers to manipulate earnings using discretionary accruals and R&D expenditures. Panel A of Table 2 deﬁnes each variable. These regression equations are represented as follows: TACCi,t = 0+1CHGRDi,t+2CHSALEi,t+3GPPEi,t+4SIZEi,t+5DEi,t + 6CEOCHGi,t+7BONUS1i,t+8BONUS2i,t+9POL92i,t+

(1)

10POL93i,t+11FIRM1+ . . . +44FIRM34+i,t CHGRDi,t = 0+1TACCi,t+2LRDi,t+3PROFi,t+4SIZEi,t+5DEi,t +6CEOCHGi,t+7BONUS1i,t+8BONUS2i,t+9POL92i,t

(2)

+10POL93i,t+11FIRM1+ . . . +44FIRM34+i,t Variable Description and Measurement The dependent (endogenous, or jointly determined) variables are denoted TACC and CHGRD for total accruals and change in R&D, respectively. The simultaneity of their relationship is controlled for by inclusion of total accruals (change in R&D) as an explanatory variable in the change in R&D (total accruals) equation. The independent variables are denoted GPPE, CHSALE, LRD, PROF, DE, SIZE, CEOCHG, BONUS1 and BONUS2. The next section cites the relevant literature for inclusion of these variables in the model. POL93, coded 1 for year t (t=1993) and zero otherwise, is a year dummy variable and serves as the variable of interest. The remaining years (1987–1992; 1994–1996) 111

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Table 2 Deﬁnitions of and descriptive statistics for variables Panel A: Deﬁnitions of variables (compustat item # in parentheses) 1. TACC

2. CHGRD 3 GPPE 4 CHSALE 5 LRD 6 PROF 7 DE 8 SIZE 9. CEOCHG 10. BONUS1

11. BONUS2

= chg. Current assets(4)- chg. Cash equivalents(1)- chg. Current liabilities(5) + chg. Current maturities of LT. Debt(44) + chg. Income taxes payable(71)- Depreciation and Amortization(14)/ Total Assetst–1(6) = [RDt(46)-RDt–1(46)] / Salest–1(12) = Gross Property Plant & Equipment(7)/Total Assetst–1(6) = [chg. Sales(12) – chg. Receivables(151)]/Total Assetst–1(6) = RDt–1(46) / Salest–1(12) = Net incomet–1(172) / Stockholders’ Equityt–1(216) = Total Debt(9+34) / Stockholders’ Equity(216) = Log of Sales(12) = An indicator variable set equal to 1 if CEO change occurred in a year and 0 otherwise = The assumed upper bound of bonus plan – pre-tax income(170)/market value of equity (199*25). Bonus1 is set equal to zero if pre-tax income does not exceed the lower bound. Lower and Upper bound are calculated as 10% and 20% of Networth, respectively. Networth equals Total Assets(6) – Total Liabilities (181). = An indicator variable set equal to 1 if the lower bound of the plan exceeds pre-tax income and zero otherwise (For how bounds are calculated see BONUS1 deﬁnition.

Panel B: Cross-sectional distribution statistics on regression variables.

Endogenous variables TACC CHGRD GPPE CHSALE LRD PROF DE SIZE CEOCHG BONUS1 BONUS2

Mean

Std. Dev

Median

Q1

Q3

–0.021 0.020 0.565 0.120 0.109 0.142 0.298 6.367 0.009 –0.024 0.257

0.123 0.076 0.227 0.199 0.107 0.767 5.433 2.387 0.092 0.038 0.437

–0.024 0.010 0.544 0.092 0.081 0.143 0.364 6.377 0.000 –0.016 0.000

–0.071 0.003 0.434 0.037 0.047 0.059 0.153 4.511 0.000 –0.044 0.000

0.025 0.021 0.675 0.182 0.127 0.265 0.679 8.612 0.000 0.000 1.000

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which are captured in the intercept provide a baseline for comparison of the test variable POL93. The FIRM indicator variables control for any ﬁrm speciﬁc effect. Dependent (endogenous variables) Consistent with prior studies (Jones, 1991; Gaver et al. 1995; Holthausen et al. 1995), total accruals (TACC) are calculated as the change in noncash working capital before income taxes payable, less depreciation expense (scaled by lagged total assets). The change in noncash working capital before taxes is the change in current assets, other than cash and cash equivalents, less the change in current liabilities other than current maturities of long-term debt and taxes payable. The variable CHGRD is measured as the change in the ratio of R&D to sales (DeChow & Sloan, 1991). Independent (exogenous variables) Prior research has demonstrated that accruals and R&D expenditures are inﬂuenced by numerous factors, requiring a number of independent variables. This section identiﬁes variables that have been shown in the literature to affect accruals and R&D expenditures. Thus, assuming that the hypotheses are supported, controlling for the other variables that cause earnings to be managed allows for a stronger and cleaner test of the PCH. CHSALE and GPPE: To estimate nondiscretionary accruals, Jones (1991) regressed total accruals on changes in revenues and levels of ﬁxed assets to control for changes in nondiscretionary accruals due to changing economic conditions. Jones (1991) uses revenues to control for the economic environment of the ﬁrm because they are the most objective available measure of the ﬁrm’s operations before earnings manipulation. Revenues will effect total accruals since changes in working capital accounts such as accounts receivable, inventory and accounts payable depend to some extent on changes in revenues. Gross property, plant, and equipment is included in the model to control for nondiscretionary depreciation expense. However, as Jones (1991) notes, revenues are not completely exogenous and may be affected by management’s attempt to manage earnings. To control for earnings management through the use of postponing sales until subsequent periods, DeChow et al. (1995) modify the Jones model by subtracting the change in receivables in the event period from the change in revenues. 113

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LRD and PROF: Berger (1993) found that prior year’s R&D expenditures were a signiﬁcant explanatory variable in predicting current years R&D expenditures. LRD is measured as Lag (R&D/Sales). R&D research in the economics area has demonstrated that last year’s proﬁts are a signiﬁcant explanatory variable for R&D (e.g. Grabowski, 1968). PROF is measured as lagged return on equity (net income/total equity). SIZE: Prior research has used ﬁrm size to proxy for political costs. By including size in the model as a control variable, it is possible to test how robust size is as a proxy for political cost in this research context and whether there is a freerider effect. If, after controlling for size the various hypotheses are supported, then it can be concluded, at least in this research context, that size (larger pharmaceutical ﬁrms) were not the only ﬁrms manipulating earnings in response to the increased political costs of Clinton’s health care reform legislation. Consistent with prior research, SIZE is measured as the log of total sales (e.g. Watts & Zimmerman, 1986). DE: Watts & Zimmerman (1986) propose that accounting choices are impacted by accounting-based debt constraints, resulting in the debt-equity hypothesis. Most accounting researchers have used a leverage ratio as a proxy for testing this hypothesis. The use of debt/equity ratios to proxy for accounting-based debt constraints has been empirically supported by Press & Weintrop (1990) and Duke & Hunt (1990). Positive accounting theory predicts that the larger a ﬁrm’s debt/equity ratio, the more likely its manager will make income-increasing accounting choices.17 The variable DE is measured as the book value of debt over the book value of equity (e.g. Watts & Zimmerman, 1986). CEOCHG: Studies by DeAngelo (1988), Pourciau (1993) and Murphy & Zimmerman (1993) have shown that changes in management may result in new manager’s taking an ‘earnings bath’ the ﬁrst year in ofﬁce. As a result, it is possible that if any earnings manipulation is detected in the event years, some of it may be attributed to management change rather than increased political cost. Accordingly, an indicator variable is set equal to 1 if a ﬁrm had a CEO change in any year, and zero otherwise.

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BONUS1 and BONUS2: To control for the incentives managers have to manipulate earnings under bonus plans requires detailed knowledge regarding a ﬁrm’s management compensation plan. Since this information is conﬁdential, the method advanced by Bartov (1993) is used to control for the effects of bonus plans. The lower bound and upper bound of the plan is assumed to be equal to 10% and 20% of the ﬁrm’ net worth, respectively, and the bonus is assumed to be based on pre-tax income. BONUS1 is an indicator variable used to measure the incentives for ﬁrms to manipulate earnings when pre-tax income exceeds their lower bound. BONUS1 represents the upper bound of the bonus plan less pre-tax income, scaled by total market value of equity at the end of the year. BONUS1 is set equal to zero for ﬁrms whose pre-tax income does not exceed their lower bound. BONUS2 is an indicator variable used to control for situations in which actual pre-tax income is less than the lower bound of the plan. In this situation, managers may be motivated to manipulate earnings down this year since any income-increasing earnings management will not be enough to help managers obtain their bonus. BONUS2 is set equal to 1 if the lower bound of the plan exceeds pre-tax income, and zero otherwise. Descriptive Statistics and regression diagnostics Panel B of Table 2 reports the descriptive statistics on the regression variables. White’s (1980) test was used to test for heteroskedasticity and revealed no serious problems.18 Table 3 presents the Pearson correlations for the regression variables and does not indicate any extremely high correlations among the variables. In addition, the primary variable of interest, POL93 was free of linear dependency. Also, the procedure outline by Belsley et al. (1980) was used to determine whether multicollinearity was present among the variables. They suggest that a condition index of 30 or more and a associated component that contributes 50% or more to the variance of two or more variables indicates serious multicollinearity. The largest condition index was 11 suggesting no serious multicollinearity among the variables

FINDINGS The dependent and independent variables are measured for each ﬁrm over the ten ﬁscal-year period. The data were pooled over time (i.e. panel data set) resulting in 350 observations for each equation. A two-way ﬁxed effects model similar to Cahan (1992) was used to estimate both equations. However, estimation of the parameters of equations 1 and 2 using ordinary least squares 115

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Table 3. TACC CHGRD GPPE CHSALE POL93 LRD PROF DE SIZE CEOCHG BONUS1 BONUS2 1

TACC CHGRD 1 –0.03 1 0.08 –0.03 0.19*** 0.09* –0.09* –0.06 0.07 0.04 –0.11 0.00 0.07 0.02 –0.06 –0.01 0.01 –0.01 –0.08 0.05 –0.13 0.14

GPPE

1 0.19 –0.01 0.08 0.02 –0.01 –0.06 –0.02 –0.02 0.13***

CHSALE POL93

1 –0.06 0.03 –0.08 0.03 –0.04 –0.08 –0.20 –0.10

1 0.01 0.02 –0.00 0.03 –0.03 0.02 0.09

Pearson Correlations1 LRD

1 –0.16*** 0.02 –0.19*** 0.15*** 0.22** 0.29**

PROF

1 –0.28*** 0.20*** 0.01 –0.05 –0.07

DE

1 0.06 0.00 0.00 –0.11**

SIZE CEOCHG BONUS1 BONUS2

1 –0.06 –0.27*** –0.59***

1 0.01 0.02

1 0.36***

1

Signiﬁcant at the 10%(*), 5%(**), 1%(***).

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(OLS) is inconsistent if there are endogenous variables included on the righthand side of the equation since some of the independent variables are correlated with the disturbances. If the dependent variables in equations 1 and 2 are jointly determined, then estimation using simultaneous equations can be used to obtain consistent and efﬁcient estimates of the parameters. Thus, to determine whether the dependent variables are jointly determined, the Hausman F-test is used (Greene, 1993). Table 3 reports the results of the Hauseman test and indicates that for the accruals model, the F-statistic is signiﬁcant at the 0.01 level, but is not signiﬁcant for the R&D model. Thus, since there is some evidence that the dependent variables in equation 1 are jointly determined, but not in equation 2, results from the three-stage least-squares estimation (3SLS) are reported for equation 1 while OLS results are reported for equation 2.19 Accruals Equation Table 3 reports the results of simultaneously estimating the two equations using 3SLS. The operational test of H1 is whether the coefﬁcients on POL93 is negative and statistically different from zero. If the estimated coefﬁcient is negative and statistically signiﬁcant and all appropriate control variables for competing earnings management incentives have been included in the model, the results provide evidence supporting the PCH. The results from the accruals model (equation 1) indicate the coefﬁcient on POL93 is negative and signiﬁcantly different from zero at the 0.05 level. This result indicates that managers used discretionary accruals to reduce earnings in response to increased political costs 1993. CHSALES is positive and signiﬁcant, consistent with prior research. The signiﬁcant negative coefﬁcient on CHGRD in the total accruals equation is consistent with discretionary accruals being dependent on the level of R&D expense. With the exception of BONUS2 and DE, none of the control variables were signiﬁcant. The coefﬁcients on BONUS2 and DE had the expected signs and were signiﬁcant at the 0.05 and 0.10 level, respectively. The negative coefﬁcient on BONUS2 is consistent with the notion that managers reduce earnings when there is little chance of realizing the earnings level to obtain their bonus (e.g. Healy, 1985; Bartov, 1993). The positive coefﬁcient on DE is consistent with the prediction that pharmaceutical ﬁrms with higher debt ratios made income-increasing discretionary accruals. Change in R&D Equation The operational test of H2 is whether the coefﬁcient POL93 is positive and statistically different from zero. The results of estimating equation 2 indicate 117

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that the coefﬁcient POL93 is negative. These ﬁndings suggest that managers did not use R&D expenditures to manage earnings during 1993 and thus, H2 is not supported. The estimated coefﬁcient on TACC in the R&D equation is positive and signiﬁcant, but it has the wrong sign. This result indicates that the level of R&D spending does not depend upon discretionary accruals and is related more to cash expenditures than accruals. With the exception of LRD, SIZE and BONUS2, none of the other control variables are signiﬁcant. The negative coefﬁcient on LRD suggests that ﬁrms with higher R&D/Sales ratios did not increase R&D spending as much as ﬁrms with lower R&D/Sales ratios. The positive coefﬁcient on SIZE indicates that larger pharmaceutical ﬁrms accelerated R&D at a faster rate than smaller ones. This ﬁnding may indicate that the larger pharmaceutical ﬁrms were more sensitive to President Clinton’s criticism of the industry’s spending priorities and thus, they increased their R&D expenditures to be able to refute his attacks that the industry spends more on advertising and lobbying than it does on developing new and better drugs. The positive coefﬁcient on BONUS2 indicates that when managers are unable to obtain their bonus they reduce earnings consistent with the results presented for the accruals equation and prior research. (e.g. Healy, 1985; Bartov, 1993).

Additional Tests Additional tests were performed to gather further evidence that the pharmaceutical industry manipulated earnings during 1993 in response to the debate over health care reform. Freudeheim (1995) reported that 1994 proﬁt increases in the drug industry were due in part to pharmaceutical ﬁrms increasing drug prices that year. This suggests that sales may have grown at a slower rate during 1993 than in other years. CHSALES is used to capture change in revenue and is measured as sales in year t less sales in yeart–1, scaled by lagged total assets. To test whether CHSALES during 1993 is signiﬁcantly different than CHSALES in other years, the mean CHSALES for 1993 and the control years (1987–1992; 1994–1996) is computed. Analysis of Variance (ANOVA) was used to test whether CHSALES was signiﬁcantly different during 1993 compared to the control years. The results in Table 4 indicate that CHSALES during 1993 was signiﬁcantly different than CHSALES in the control years (p = 0.077). To determine whether the change in revenue during 1993 was due to lower prices or lower volume, the variable GRMARG, which indicates gross margin and is measured as salest less cost of goods soldt divided by salest, is calculated for the years from 1987 to 1996.

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Table 4. Regression Results (350 ﬁrm year observations)

Independent Variable1

Dependent Variable TACC CHGRD Predicted Predicted Sign Coeff. T-Value Sign Coeff.

Intercept Endogenous variables TACC CHGRD

?

0.089

0.25

–

–0.733

–2.42***

Test variables POL93

–

–0.039

–1.80**

– +

0.017 0.109

0.38 2.53**

Control variables GPPE CHSALE LRD PROF DE SIZE CEOCHG BONUS1 BONUS2

+ – – + –

1st-stage adj. R2

17.72%

System R2

30.89%

Hausman F-Test for endogeneity

0.002 –0.002 0.015 0.081 –0.060

1.48* –0.64 0.19 0.41 –2.73**

T-Value

?

0.74

2.61***

–

0.44

1.77**

+

–0.01

–0.41

– + – + + – +

–0.38 0.007 0.000 0.008 –0.005 0.087 0.078

–4.53*** 1.09 0.32 3.78*** –0.10 0.65 2.97***

13.88%

9.80***

2.11

1

Variables are deﬁned in Table 2. 2 Signiﬁcant at the 10%(*), 5%(**), 1%(***) level or less (one tailed when predicted sign is + or -, two tailed otherwise).

Assuming that the cost per unit remained constant in 1993 compared to prior years, then if pharmaceutical ﬁrms were charging lower prices during 1993, then gross margin should be lower in 1993 than in other years. The results from Table 4 indicate no signiﬁcant difference between GRMARG in 1993 compared to the control years. Thus, this ﬁnding suggests that pharmaceutical ﬁrms deferred sales during the fourth quarter of 1993 in order to shift revenues into the ﬁscal year 1994 and to avoid reporting additional sales revenue in the 1993 ﬁnancial statements. This evidence is consistent with the idea that the pharmaceutical industry responded to the debate over health care reform and attempted to reduce reported proﬁts in 1993. Also, it lends further support to the evidence presented in Table 3 that discretionary accruals were 119

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Table 5. Analyses of Variance Results1 Panel A: POL93 is the independent variable and is coded 1 if year equal 1993 and zero otherwise (for t=1987 to 1996). 1 = 1993 0=Otherwise (N=35) (N=315) Dependent variables2 CHSALES GRMARG SGAMARG RES

Means 0.063 0.545 0.363 0.024

0.126 0.531 0.369 0.007

F-statistic3 3.15* 0.12 0.03 5.31**

p-value 0.077 0.731 0.870 0.022

1

The general linear model was used to adjust for unequal sample sizes. Variable deﬁnitions for Table 4 are as follows: CHSALES = Sales in year t minus sales in yeart–1 scaled by lagged total assets. GRMARG = Sales in year t minus cost of goods sold in year t scaled by sales in year t. SGAMARG = Selling, general & administrative expenses in year t scaled by sales in year t. RES = Restructuring charges in year t scaled by lagged total sales. 3 Signiﬁcant at the 10%(*) or 5%(**) level or less. 2

income-decreasing during 1993 as opposed to being reversals of prior year accruals. Table 4 also presents the results of the tests to determine whether selling, general & administrative expenses (SGAMARG) and restructuring charges (RES) were greater during 1993 than in the control years. SGAMARG, measured as (SGAt)/Salest, was not signiﬁcantly different during 1993 compared to the control years. However, RES, measured as the amount of restructuring charges reported in year t scaled by lagged total sales, is signiﬁcantly different in 1993 than in the control years.20 This result indicates perhaps that the pharmaceutical industry viewed the changing political climate and the possibility of price controls as necessitating the need for major restructuring.21 However, it is possible that macro-economic factors during 1993 were such that ﬁrms in various industries began major restructuring programs. To test whether the pharmaceutical industry recorded greater restructuring charges during 1993 than other industries, a control set of ﬁrms was obtained.22 Table 5 presents the results of the ANOVA for this test.23 The results indicate that POL93 and IND are signiﬁcantly different than the control years and control ﬁrms, respectively (p = 0.002; p = 0.005, respectively). This ﬁnding indicates that although there were substantial restructuring charges during 1993 for both the pharmaceutical industry and the control set of ﬁrms, the pharmaceutical industry appears to have made larger restructuring charges than the control set of ﬁrms. However, the most important ﬁnding is that the interaction term, POL93*IND, is statistically signiﬁcant, which indicates that during 1993 the

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Table 6. Analyses of Variance Results To Test Whether Firms In The Pharmaceutical Industry Made Restructuring Charges In Excess of Control Firms1 Dependent Variable: RES2 Factors: POL93 IND Interaction POL93*IND

F-Statistic3

One-tailed p-value

7.98*** 6.60***

0.002 0.005

2.31*

0.064

1

The general linear model was used to adjust for unequal sample sizes. 2 Variable deﬁnitions for Table 5 are as follows: POL93 = An indicator variable set equal to one if year equals 1993 and zero otherwise. IND = An indicator variable set equal to one if ﬁrm is in the pharmaceutical industry (SIC=2834) and zero otherwise. POL93*IND = An interaction term obtained by multiplying POL93 times IND. RES = Restructuring charges in year t scaled by lagged total sales. 3 Signiﬁcant at the 10%(*) or 5%(**) level or less.

pharmaceutical industry had restructuring charges greater than the control set of ﬁrms. Thus, the proposed health care reform during 1993 could have been responsible for the pharmaceutical industry making large restructuring charges during that year. To better visualize the effect of health care reform on the sample ﬁrms for the period from 1987 to 1996, mean residuals, R&D/Sales, and return on equity (ROE) are plotted in Figure 1.24 Notice the marked decline in discretionary accruals in 1993, which coincides with a decrease in ROE in 1993. These results provide additional support for the notion that the pharmaceutical ﬁrms managed discretionary accruals, used restructuring charges, and delayed sales recognition to reduce earnings during 1993, which was perhaps the year of the most intense debate over health care reform

Sensitivity Analysis In 3SLS, any misspeciﬁcation in an equation is transferred throughout the entire system, while with 2SLS, the misspeciﬁcation is constrained to that particular equation. Signiﬁcant differences between 2SLS estimation and 3SLS estimation may indicate misspeciﬁcation. Thus, the equations were estimated using 2SLS. The results were quantitatively similar to those obtained using the 3SLS estimation, which suggests minimal misspeciﬁcation in the equations. 121

122

Plot of RD/Sales, Return on Equity, and Discretionary accruals.

JOSEPH LEGORIA

Figure 1.

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Nevertheless, to assess the robustness of the ﬁndings to possible speciﬁcation errors and to provide further evidence in support of the ﬁndings, additional tests were conducted. A potential source of misspeciﬁcation is the failure to include cash ﬂows in the model.25 Thus, equations 1 and 2 were modiﬁed to include lagged cash ﬂows as an additional explanatory variable. The addition of lagged cash ﬂows in the model did not change the results. The accruals equation was modiﬁed to include intangible assets as an additional control variable. Like gross property, plant and equipment was included to control for nondiscretionary depreciation expense, intangible assets should have captured that portion of amortization expense that was nondiscretionary.26 The results were not affected by including intangible assets in the accruals equation. Finally, managers may want to avoid reporting large ﬂuctuations in their reported earnings and thus attempt to smooth income. To rule out this alternative, the variable EARNCHG was included in both models. EARNCHG was measured as the change in return on assets (ROA) and the change in return on equity (ROE). If pharmaceutical ﬁrms adopted a strategy of income smoothing, the coefﬁcient on EARNCHG should be negative and signiﬁcant. The results from the estimations using the alternative measures of EARNCHG did not affect the results as the coefﬁcient on POL93 was negative and signiﬁcant at the 5% level for both estimations. Further, the sign on EARNCHG using ROE was negative but not signiﬁcant and it was positive and signiﬁcant using ROA. Thus, there was no evidence of income-smoothing.

CONCLUSIONS This study investigates whether managers in the pharmaceutical industry used discretionary accruals and R&D to manipulate earnings downward during the debate over health care reform. This paper provides no direct evidence that managers used R&D to reduce reported earnings in 1993. On the other hand, the ﬁndings indicate discretionary accruals were income-decreasing during 1993, consistent with the PCH. To provide further evidence consistent with the managers manipulating earnings downward during 1993, additional tests were performed. The results from those test suggest that the pharmaceutical industry (1) delayed revenue recognition in 1993 by postponing sales until the next ﬁscal year, (2) took greater restructuring charges during 1993 than a set of control ﬁrms, and (3) restructuring charges were greater during 1993 than control years. Visual analysis also indicated that ROE decreased during 1993. Collectively, the results are consistent with the PCH and provide some support for the notion that ﬁrms act to discourage legislation that opposes their economic interests. 123

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In addition, the study provides evidence supporting Ball & Foster (1982) that size does not always capture political costs and that industry membership is an important determinant of a ﬁrm’s political costs. The results provide no evidence that only the largest pharmaceutical ﬁrms attempted to manipulate earnings using discretionary accruals. The results have implications for future research studies of the PCH suggesting that a key factor in determining which ﬁrms are subject to increased or changing political costs is the political process itself (i.e. Congressional debates). An industry’s political costs are likely related to the association between its industry membership and the public policy issues being debated by legislative bodies. The evidence presented in this paper indicates that managers will act to prevent passage of legislation that threatens their ﬁrms ‘proﬁtability. Thus, managers in the pharmaceutical industry viewed health care reform as a major threat and did not wait until President Clinton and Congress passed a health care reform bill to begin attempting to manipulate earnings in order to reduce their political costs. Finally, possible extensions of this research include examining how health care reform impacted ﬁrms in other industries (e.g. health insurance, biotechnology). For example, did ﬁrms similarly threatened by health care reform react by manipulating earnings? If not, then why not? Also, critics of the pharmaceutical industry argue that drug prices in the U.S. are higher than other parts of the world. Thus, the pharmaceutical ﬁrms had incentives during the recent debate over health care to reduce their selling prices. The evidence presented in this paper did not indicate that managers reduced their selling prices. However, future research could examine in more detail whether the pharmaceutical industry changed its pricing policies during the debate over health care reform.

ACKNOWLEDGMENTS This chapter is from my dissertation completed at the University of Arkansas. I wish to thank the members of my dissertation committee for their insightful comments and suggestions: Keith Sellers (chair), Rien Bouwman, and Craig Schulman. I would also like to thank Noel Addy, Bill Baber, Jeff Boone, Steven Cahan, G. William Glezen, Karen Pincus, William Stammerjohan, and workshop participants at the University of Arkansas, Georgia Southern University, Mississippi State University, and Oklahoma State University for helpful comments on previous drafts.

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NOTES 1. Watts & Zimmerman (1986, 1990) provide a review of this literature through 1990. 2. Baber & Kang (1996) demonstrate that during the period from 1976 to 1987, the pharmaceutical industry’s returns exceeded returns of comparable U.S. industrial ﬁrms. 3. Han & Wang (1998) is a similar type study. They found that oil ﬁrms’ used accruals to reduce quarterly earnings during the Persian Gulf crisis to reduce the likelihood of potential regulation. However, as Watts & Zimmerman (1986) document the oil industry has faced speciﬁc regulations in the past such as price controls and reductions in the depletion allowance. Thus, given the long standing tension between the oil industry and congress their results were not unexpected. On the other hand, the pharmaceutical industry has not faced such targeted regulations in the past. 4. Watts & Zimmerman (1986) argue that the contracting process includes management’s incentives to manipulate earnings in response to debt covenants (debt-equity hypothesis) and bonus plans based on net income (bonus hypothesis). The debt-equity hypothesis predicts the higher the ﬁrm’s debt/equity ratio, the more likely managers make accounting choices that increase reported income. The Bonus Plan hypothesis predicts that managers with bonus plans are more likely to make accounting choices that increase reported income. The tests of the debt/equity and bonus plan hypothesis are generally consistent. For a complete review of the early tests of the debt/equity and bonus plan hypothesis refer to Watts & Zimmerman (1986, 1990). 5. See, e.g. Bowen et al. (1981), Zimmer (1986) and Moyer (1990) 6. Key (1997) is a recent study consistent with this suggestion. She ﬁnds that the cable television industry, during the late 1980s and early 1990s, responded to the congressional scrutiny of that period by managing earnings. However, this was not enough to prevent congress from overriding President Bush’s veto and thus prevent the increased regulation of the industry. 7. See, e.g. Washington Post (October 29, 11D) and The New York Times (December 15, 12B). 8. To illustrate the magnitude of the pharmaceutical industry’s activity in the 1992 elections, The Wall Street Journal (August 16, 1994 1A), citing a study from the Center for Responsive Politics, reported that during the 1991–1992 election cycle, six pharmaceutical companies (Eli-Lilly, Pﬁzer, Schering-Plough, Glaxo, Merck and Bristol-Myers) and some of their corporate executives were among the top 20 contributors from the health care sector. 9. Accounting Principles Board Opinion No. 20 (1971) states that the cumulative income effect from voluntary changes in accounting principles must be disclosed as a separate item in the company’s income statement between the captions ‘extraordinary items’ and ‘net income’. In addition, there must be a footnote in the ﬁnancial statements describing each voluntary accounting change. Although no cumulative effect item in the ﬁnancial statements is used to account for a change in accounting estimate, APB Opinion No. 20 requires that changes in accounting estimates that have a material effect on the ﬁnancial statements be disclosed in the footnotes. 10. President Clinton’s acceptance speech of his party’s nomination provides evidence of then candidate Clinton’s attentions. In his speech, Clinton suggested that, if elected, “he would take on the health care proﬁteers and make health care affordable to everyone whereas then-President Bush would not” (The Center For Public Integrity, 1994).

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11. Waldholz (1993) reported that Merck & Co’s chief executive ofﬁcer, P. Roy Vagelos publicly gave Clinton his endorsement at Merck headquraters and that they had discussed ways to control drug prices. In addition to Merck, Pﬁzer and ﬁve other pharmaceutical ﬁrms agreed to work with the administration to control drug prices (Cutaia, 1993). However, after President Clinton was quoted as saying that drug ﬁrms proﬁts were “shocking” and that companies had made ‘proﬁts at the expense of children’, Vagelos was quoted as saying he felt very disappointed and pained by the President’s attacks on the industry and was quoted as saying “It was awful” (Waldholz, 1993). 12. The previous twelve years (1981–1993) before President Clinton was inaugurated were Republican administrations that were less likely to use the government to regulate industry. During this period, any legislation that the executive branch of government felt consisted of excessive government controls would face the threat of a veto. As a result, health care reform of the magnitude that President Clinton proposed was not politically possible during this time period. 13. There is evidence in the ﬁnancial press that after the defeat of health care reform pharmaceutical ﬁrms became less sensitive to reporting large proﬁts. For example, in October of 1994 shortly after three large pharmaceutical ﬁrms released their third quarter proﬁts, which rose about 15% from last third quarters proﬁts, Senator David Pryor (D-Ark) renewed his efforts to introduce legislation to “reform the industry” (Weber 1994). However, health care reform did not appear to be on most voters’ minds as they elected Republicans to both the House and Senate. After Pﬁzer, Merck, Johnson & Johnson, and Warner-Lambert each posted double-digit earnings increases in the fourth quarter of 1994, David Saks, a pharmaceutical analyst stated ‘It’s the best quarter in two years for the drug companies (Freudenheim 1995a). These developments prompted industry critics, such as Ron Wyden (D-Oregon), to once again lash out at the pharmaceutical industry for proﬁteering. Representative Wyden was quoted as saying “My sense is that some of these big drug companies are saying the heat’s off now. They’re saying that Congress didn’t pass a health care bill last session; they’ve got a lot of new allies in the Congress, and they can get away with more than they could before” (Freudenheim, 1995b, p. 1D). 14. Three ﬁrms not classiﬁed as SIC 2834 ﬁrms by Compustat remained in the sample. A review of these ﬁrms annual reports indicates that these ﬁrms were appropriately included in the ﬁnal sample. 15. Statement of Financial Accounting Standards No. 7: Accounting and Reporting by Development Stage Enterprises (SFAS No. 7) deﬁnes an enterprise as in the development stage if it is devoting all of its efforts to establishing a new business and either of the following conditions exists: (a) Planned principal operations have not commenced and (b) Planned principal operations have commenced, but there has been no signiﬁcant revenue therefrom (par. 8. a and b). SFAS NO. 7 goes on to say that the ﬁnancial statements shall be identiﬁed as those of a development stage enterprise and shall include a description of the nature of the development stage activities in which the enterprise is engaged (par. 12). 16. The modiﬁed Jones model is based on the model developed by Jones (1991) which attempts to control for the nondiscretionary component of total accruals. Dechow et al. (1995) demonstrate that these approaches improved upon the earlier research on discretionary accruals which assumed that nondiscretionary accruals were constant across time (e.g. see Healy, 1985). 17. Watts & Zimmerman (1986, 1990) show that the empirical tests of the debt-equity hypothesis are consistent across most studies.

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18. The White (1980) test for heteroscedasticity was obtained from the OLS estimates from the ﬁrst-stage of the 3SLS estimation. 19. 3SLS involves the following. First, Two-stage least squares (2-SLS) estimates are obtained. The 2SLS estimates are obtained using the instrumental variable (IV) method. In this approach, an instrument (a different explanatory variable) is chosen to substitute for the variable that may be endogenous. A successful instrument is one that should not be correlated with the error term. Greene (1993) suggests that an appropriate candidate would be the predicted values of endogenous variable obtained in the ﬁrst stage of the regression by regressing it on the remaining independent (exogenous) variables. In the second stage, the predicted values of the endogenous variable are then substituted in the right-hand side of the equation for the endogenous variable yielding consistent estimates of the parameters. 3SLS is essentially applying Seemingly Unrelated Regression (SUR) estimation to the 2SLS by allowing for cross-equation correlation. Thus, if cross-equation correlation exists 3SLS will provide efﬁcient estimates of the parameters and if there is none, 2SLS and 3SLS are equivalent. 20. Restructuring charges were obtained from either, company annual reports or, Form 10-Ks. The SEC, in Staff Accounting Bulletin No. 67, Income Statement Presentation of Restructuring Charges (SAB 67), concluded that restructuring charges should be reported as a separate line item within continuing operations. 21. A review of annual reports suggests this. For example, Eli-Lilly reported in its 1993 Review of Operations that it made a strategic decision to streamline its operations by taking major restructuring in 1993 in response to the major changes occurring in the health care industry (Eli-Lilly, 1993 Annual Report). Warner-Lambert (1993 Annual Report) reported in its Management’s Discussion and Analysis (MDA) that it undertook major restructuring in response to rapid and profound changes in the company’s competitive environment such as the growing impact of managed health care and other cost-containment efforts in the U.S. 22. Firms were selected from among all 1996 active compustat ﬁrms that were not in SIC 2834 and pair-matched based on total assets. Next, the control ﬁrms had to have ﬁnancial statements available on lexis-nexis so that restructuring charges could be obtained from company ﬁnancial statements. 23. The variables used in this ANOVA are as follows: (1) POL93, an indicator variable set equal to one if year equal 1993 and zero otherwise, (2) IND, an indicator variable set equal to one if pharmaceutical ﬁrm and zero otherwise, and (3) POL93*IND, an interaction term between POL93 and IND. 24. The residuals plotted in ﬁgure 1 are obtained from estimating the model TACCi,t = 0+1CHSALEi,t+2GPPEi,t+i,t 25. DeChow (1994) found a signiﬁcant negative correlation between changes in total accruals and change in lagged cash ﬂows. Following, Gaver et al. (1995), lagged cash ﬂows were used to modify the Jones model (equation 1). Berger (1993) found that lagged cash ﬂows were a signiﬁcant predictor of R&D. Consistent with Berger (1993) the measure of cash ﬂows in equation 2 was deﬁned as income before extraordinary items + R&D + depreciation. 26. Compustat item 14 includes both depreciation and amortization expense. However, the modiﬁed Jones model only controls for nondiscretionary depreciation expense by including gross property, plant and equipment in the model. Since intangible assets 127

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comprise a substantial amount of pharmaceutical ﬁrm’s assets, the inclusion of intangible assets in the accruals model seems warranted.

REFERENCES Accounting Principles Board (APB) (1971). Accounting Changes, APB Opinion No. 20, New York, American Institute of Certiﬁed Public Accountants. Baber, W. R., Fairﬁeld, P. M., & Haggard, J. A. (1991). The Effect of Concern about Reported Income on Discretionary Spending Decisions: The Case of Research and Development, The Accounting Review, 66, 818–829. Baber, W. R., & Kang, S. H. (1996). Estimates of Economic Rates of Return for the U.S. Pharmaceutical Industry, 1976–1987. Journal of Accounting and Public Policy, 15, 327–365 Ball, R., & Foster, G. (1982). Corporate Financial Reporting: A Methodological Review of Empirical Research, Journal of Accounting Research (Suppl.), 161–234. Bartov, E. (1993). The Timing of Asset Sales and Earnings Manipulation. The Accounting Review, 68, 840–855. Belsley, D. A., Kuh, E., & Welsch, R. E. (1980). Regression Diagnostics. John Wiley and Sons, Inc, New York, NY. Berger, P. (1993). Explicit and Implicit Tax Effects on the R&D Tax Credit. Journal of Accounting Research, 31, 131–171. 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. Bowen, R. E. N., & Lacey, J. (1981). Determinants of the Corporate Decision to Capitalize Interest. Journal of Accounting and Economics, 3, 151–179. Cahan, S. F. (1992). The Effect of Antitrust Investigations on Discretionary Accruals: A Reﬁned Test of the Political-Cost Hypothesis. The Accounting Review, 67, 77–95. Christie, A. A. (1990). Aggregation Of Test Statistics: An Evaluation of the Evidence on Contracting and Size Hypotheses. Journal of Accounting and Economics, 12, 15–36. Cutaia, J. H. (1993). Swallowing a Bitter Pill. Business Week, January 11, 82. DeAngelo, L. E. (1988). Managerial Competition, Information Costs, And Corporate Governance. Journal of Accounting and Economics, 10, 3–36. Dechow, P. M., & Sloan, R. G. (1991). Executive Incentives and the Horizon Problem: An Empirical Investigation. Journal of Accounting and Economics, 14, 51–89. Dechow, P. M. (1994). Accounting earnings and cash ﬂows as measures of ﬁrm performance: The role of accounting accruals. Journal of Accounting and Economics, 18, 3–42. DeChow, P. M., Sloan, R. G., & Sweeney, A. P. (1995). Detecting Earnings Management. The Accounting Review, 70, 193–225. Drug discounts mandated for Medicaid (1990). Congressional Quarterly Almanac, 570. Duke, J., & Hunt, H. III. (1990). An Empirical Examination of Debt Covenant Restrictions and Accounting-Related Debt Proxies. Journal of Accounting and Economics, 12, 45–63. Elliot, J. A., & Shaw, W. H. (1988). Write-Offs as Accounting Procedures to Manage Perceptions. Journal of Accounting Research (Suppl.), 91–119. Financial Accounting Standards Board (1975). Statement of Financial Accounting Standards No. 7. Accounting and Reporting by Development Stage Enterprises. Stamford, CT, FASB. Freudenheim, M. (1995a). 3 Health Care Companies Report Big Proﬁt Advances. The New York Times, January 25. Freudenheim, M. (1995b). Some Drugs Rise In Price At Fast Pace. The New York Times, March 16.

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Gaver, J. J., Gaver, K. M., & J. R. Austin. (1995). Additional Evidence on Bonus Plans and Income Management. Journal of Accounting and Economics, 19, 3–28. Generic drug legislation cleared by Congress (1984). Congressional Quarterly Almanac, 451–453. Grabowski, H. (1968). The Determinants of Industrial Research and Development: A Study of the Chemical, Drug, and Petroleum Industries. Journal of Political Economy, 76, 292–306. Greene, W. H. (1993). Econometric Analysis, 2nd ed. (Macmillan, New York, NY). Han, J. C. Y., & Wang, S. W. (1998). Political Costs and Earnings Management of Oil Companies During the 1990 Persian Gulf Crisis. The Accounting Review, 73, 103–117. Hall, S. C., & Stammerjohan, W. W. (1997). Damage Awards and Earnings Management in the Oil Industry. The Accounting Review, 72, 47–65. Healy, P. (1985). The Effect Of Bonus Schemes on Accounting Decisions. Journal of Accounting and Economics, 7, 85–107. Holthausen, R. W., Larker, D. F., & Sloan, R. G. (1995). Annual Bonus Schemes and The Manipulation of Earnings. Journal of Accounting and Economics, 19, 29–74. Jones, J. J. (1991). Earnings Management During Import Relief Investigations. Journal of Accounting Research, 29, 193–228. Judge, G. C., Hill, R. C., Grifﬁths, W. E., Lutkepohl, H., & Lee, T. C. (1988). Introduction to the Theory and Practice of Econometrics, 2nd ed. (John Wiley & Sons, Inc, New York, NY). Key, K. G. (1997). Political cost incentives for earnings management in the cable television industry. Journal of Accounting and Economics, 23, 309–337. Larcker, D. F., & Revsine, L. (1983). The oil and gas accounting controversy. The Accounting Review, 58, 706–732. Moyer, S. E. (1990). Capital Adequacy Ratio Regulations and Accounting Choices in Commercial Banks. Journal of Accounting and Economics, 13, 123–154. Murphy, K. J., & Zimmerman, J. (1993). Financial Performance Surrounding CEO Turnover. Journal of Accounting and Economics, 16, 273–315. Pear, R. (1992). Clinton Team to Tackle Drug Pricing. The New York Times, December 15. Persons, O. S. (1999). Political Cost Incentives For Earnings Management In The Pharmaceutical Industry During The 1993 Campaign For Health Care Reform. Research in Accounting Regulation, 13, 127–148. Pourciau, S. (1993). Earnings Management and Nonroutine Executive Changes. Journal of Accounting and Economics, 16, 317–336. Press, E., & Weintrop, J. (1990). Accounting-based Constraints in Public and Private Debt Agreements: Their Association with Leverage and Impact on Accounting Choice. Journal of Accounting and Economics, 12, 65–95. Schipper, K., (1989). Commentary on Earnings Management. Accounting Horizons, 3, 91–102. Securities and Exchange Commission (1986). Interpretations regarding restructuring charges. Staff Accounting Bulletin No. 67, Washington DC., SEC. Shafer, R. G. (1993). Washington Wire. Wall Street Journal, March 12. Stout, H. (1993). Drug Concerns Express Anger at Plan for Government to Buy Childhood Vaccines. Wall Street Journal, April 2. Sugawara, S. (1992). The Drug Industry’s Worsening Headache. Washington Post, October 29. Sutton, T. (1988). The Proposed Introduction of Current Cost Accounting in the U.K: Determinants of Corporate Preference Journal of Accounting and Economics, 10, 127–149. Sweeney, A. P. (1994). Debt Covenant Violations and Manager’s Accounting Responses. Journal of Accounting and Economics, 17, 281–308. Tanouye, E. (1993). Drug Industry Darkens View of Clinton Health Care Plan. Wall Street Journal, October 29.

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U.S. Ofﬁce of Technology Assessment (OTA) (1993). Pharmaceutical R&D Costs, Risks, and Rewards. Washington, DC, U.S. Government Printing Ofﬁce. U.S. Senate (1993). Earning a Failing Grade: A Report Card on 1992 Drug Manufacturer Price Inﬂation. Staff Report to the Special Committee on Aging, U.S. Senate. Washington, DC, U.S. Government Printing Ofﬁce. Waldholz, M. (1993). Wall Street Journal, February 19. Watts, R. L., & Zimmerman, J. L. (1986). Positive Accounting Theory. Prentice-Hall, Englewood Cliffs, NJ. Watts, R. L., & Zimmerman, J. L. (1990). Positive Accounting Theory: A Ten Year Perspective. The Accounting Review, 65, 131–156. Weber, J. (1994). Whinning All The Way To The Bank: Sales pose a political problem for breastbeating drug makers. Business Week, November 7. Weber, J., & Hamilton, J. O. C. (1995). Take Two Aspirin and Call In the Morning: Drugmakers have little in the pipeline, lots of expiring patents, and plenty of competition. Business Week, January 9. Well-Healed: Inside Lobbying for Health Care Reform. (1994). The Center For Public Integrity. Wong, J. (1988). Political Costs and an Intraperiod Accounting Choice for Export Tax Credits. Journal of Accounting and Economics, 10, 37–51. Worthy, F. S. (1984). Manipulating Proﬁts: How It’s Done. Fortune, June 25, 50–54. Zimmer, I. (1986). Accounting for Interest by Real Estate Developers. Journal of Accounting and Economics, 8, 37–51.

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APPENDIX A Sample Firms Used in Study

Abbott Laboratories Alpharma Incorporated Alza Corporation American Home Products Barr Laboratories Baxter International Incorporated Bristol Myers Squibb Carrington Labs Carter-Wallace International Chattem Incorporated Forest Laboratories Genentech Incorporated Genzyme Corporation Glaxo Wellcome Halsey Drug Company ICN Pharmaceuticals Incorporated Johnson & Johnson KV Pharmaceuticals Lilly (Eli) & Co. Mallinckrodt Incorporated Merck & Co. Mylan Laboratories Novo-Nordisk Pﬁzer Incorporated Pharmaceutical Formula Incorporated Pharmaceutical Resources Incorporated Pharmacia & Upjohn Incorporated Polydex Pharmaceuticals Rhone-Poulenc Rorer Scherer RP Schering-Plough Smithkline Beecham PLC Teva Pharmaceutical Unimed Pharmaceuticals Incorporated Warner-Lambert Co. 131

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ANALOGIES DRAWN BETWEEN MARKETING AND FINANCIAL REPORTING RESEARCH – POSSIBLE IMPLICATIONS ON REPORTING COMPREHENSIVE INCOME Pamela A. Smith and Kim R. Robertson

ABSTRACT The issues surrounding the format and presentation of ﬁnancial statement information are similar to those identiﬁed in the literature related to nutrition labeling. The regulatory objective of nutrition labeling and ﬁnancial reporting are the same: to provide information that increases decision effectiveness. This report presents some ﬁndings from research on nutrition labeling to identify some implications of reporting comprehensive income. The Financial Accounting Standards Board (FASB) recently issued a standard requiring ﬁrms to report comprehensive income. This all-inclusive measure of performance was requested by users and streamlines ﬁnancial performance measures. Findings in the nutrition labeling literature indicates that, although users may request such information, they do not necessarily use or comprehend it. Presentation formats that reduce information processing load do seem to enhance some aspects of decision efﬁciency. However, it appears that ﬁnancial analysts

Research in Accounting Regulation, Volume 14, pages 135–150. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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most likely to make use of newly formatted ﬁnancial information are precisely the ones most likely to already be using this information in its present format. Frequently, accounting researchers measure the effect of accounting information on the ﬁnancial statement users through the capital markets. Marketing researchers study the decision effects at the individual consumer level. Accounting research supports earnings management behaviors, but there are still unanswered questions regarding if those actions inﬂuence the user of that information. The ﬁndings from the nutrition labeling studies present a different perspective on how users of information are or are not inﬂuenced. The approaches taken in the nutrition information studies may be a way for accounting researchers to address these questions.

INTRODUCTION This research report draws analogies between the regulation of nutrition labeling and ﬁnancial reporting, and then provide a summary of the ﬁndings marketing researchers have discovered regarding consumer perception of this information. The purpose of this exercise is to provoke thought and perhaps generate ideas about how to approach accounting research issues. Perhaps from this research report someone will think of a new way to address old questions. Accounting researchers are interested in the effects of presentation and format of ﬁnancial statement information on the users’ perception of that information. Marketing researchers have a similar interest; to study the effects of presentation and format of product information on the consumers’ decision-making. The regulation of ﬁnancial accounting and consumer product information directly impact the manner in which that information is presented. Although the decision related to making a product choice or an investment choice are different, there are similarities as to how the presentation of the information impacts the user’s perception of that information. Furthermore, marketing a product is different than marketing a ﬁrm’s ﬁnancial performance. However, there are many similarities in the regulation of the presentation of both product information and ﬁnancial accounting information. This report presents analogies between both bodies of research in hope to identify research questions and methods that address the effect of presentation on the ﬁnancial statement user’s decision and to provide feedback to accounting standard setters. The Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) play a role similar to that of the Federal Trade Commission (FTC) and Federal Drug Administration (FDA). The most compelling similarity is the goals and objectives of the FASB with the goals

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Table 1.

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Analogies Drawn Between Financial Reporting and Consumer Labeling

Quality or Characteristic Government Oversight

Financial Reporting

Consumer Labelling

Regulation

1. Financial Accounting Standards Board 2. Securities and Exchange Commission 1. Setting standards for ﬁnancial accounting and reporting 2. Enforcement of ﬁnancial accounting and reporting standards. Consumer protection Relevant, reliable, complete, timely, and understandable.

1. Federal Trade Commission 2. Food and Drug Administration

Jurisdiction

Objective Information qualities

1. Antitrust and restraint of trade. 2. Food and drug approval and regulation regarding public health and nutrition. Consumer protection Accurate and not misleading.

Characteristics of Quantitative Information Relative benchmarks Presentation style Quantitative objective

Analysts’ forecasts Varies across companies Measure of ﬁrm performance

FDA percentage values Varies across brands Measure of product quality

Earnings performance

Nutritionally quality

Trained vs. not trained Financial Analysts

Educated vs. non-educated Consumer or Purchaser

Toward more involvement individual level –> more choices

Toward more choice alternatives

Characteristics of Preparer Desire to present most favorable measure of Characteristics of User Level of sophistication User with highest level of involvement Recent trends

of the FTC and FDA. The objective of the FTC and FDA is to protect the consumer by providing the information that has the most meaning and relevance, in an understandable manner, so that consumers can make a more informed (and efﬁcient) decision in the marketplace. The commonalties between ﬁnancial reporting and consumer labeling extends beyond the regulatory objective. Both nutrition and ﬁnancial information deal with detailed numerical information, users of both types of information can be sophisticated or nonsophisticated, the information can be presented favorably or unfavorably, and 137

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management desires to present such information in the most favorable light. Furthermore, both ﬁnancial and nutritional information can be compared to relative benchmarks which may assist the user in evaluating the information. For nutrition labeling, the benchmark may be the percentage daily allowance or daily value, for ﬁnancial information, the benchmark may be analyst forecasts or industry norms. Both accounting and nutrition information is often reported within the context of additional information (e.g., annual reports or packaging claims) which can either reinforce or contradict numerical information. Finally, with the advent of resources such as the internet, the aging population, and the desire to control one’s ﬁnancial resources, many individuals are managing their own investment portfolios. This shift to more individuals handling their investments has placed the decision-making role of ﬁnancial statement users closer to the role of a consumer with numerous choice alternatives. The FASB recently issued a standard, SFAS 130, Comprehensive Income Reporting, that requires a change in the presentation of ﬁnancial statement information. Comprehensive income reporting was requested by users and streamlines the reporting of certain ﬁnancial performance measures. Only the reporting format has changed, the substance of what is reported remains the same. Similar changes have occurred with the labeling of consumer products; speciﬁcally, the format and presentation of nutritional label information. Implementation of comprehensive reporting is a prime opportunity to explore if the format of information presented in the ﬁnancial statements inﬂuences the user’s perception of that information. Because of the similarities between ﬁnancial and nutrition label information, and the extensive research on the format effects in the nutrition labeling literature, this is a body of research from which accounting researchers can draw to explore the potential effects of ﬁnancial information format. This chapter is organized as follows. First we present a brief overview of the questions and conclusions of the research in the nutritional labeling literature. Then we present a discussion of these ﬁndings for accounting researcher in the context of the usefulness of comprehensive income reporting.

NUTRITION INFORMATION Marketing researchers have used a variety of techniques and methodologies in studying consumer reactions to nutrition information. Subjects have sometimes been students or other university personnel (Barone et al., 1996; Ford et al., 1996; Moorman, 1990). More commonly used subjects, however, include supermarket shoppers (Asam & Bucklin, 1973; Lenahan et al., 1973; Mathios, 1996; Muller, 1985; Russo et al., 1986), and samples of the general public selected

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randomly, or drawn from church groups, community organizations, shopping malls, research panels, etc. (Cole & Gaeth, 1990; Keller et al., 1997; Levy, Fein & Schucker, 1991; Quelch, 1978; Scammon, 1977; Szykman et al., 1997). Consumers have been examined in laboratory settings (Cole & Gaeth, 1990; Moorman, 1990; Scammon, 1977), ﬁeld settings (Asam & Bucklin, 1973; Lenahan et al., 1973; Moorman, 1996; Muller, 1985; Russo et al., 1986), or in combinations of settings (Cole & Balsubramanian, 1993; Jacoby et al., 1977). The research approaches of experimentation (Ford et al., 1996; Muller, 1985; Russo et al., 1986; Scammon, 1977), observation (Cole & Balsubramanian, 1993; Mathios, 1996) and surveys (Bender & Derby, 1992; Lenahan et al., 1973; Moorman, 1996) have all been utilized, as have subject-contact methods of mail (Keller et al., 1997), telephone (Szykman et al., 1997), and in-person (Levy et al., 1991). Marketing researchers have extensively investigated how consumers use (or don’t use) nutritional label information. Reported ﬁndings are organized into four general areas with potential implications for ﬁnancial reporting of comprehensive income. These areas concern ﬁndings related to: amount, use and comprehension of information, behavioral and context effects, consumer characteristics, descriptive and comparative information. Information: Amount/Use/Comprehension A main ﬁnding in the nutrition labeling literature has found that although users may request certain information, they do not necessarily use or comprehend it. Asam & Bucklin (1973) found few differences in the effects of additional nutrient information on consumer perceptions and preferences. Scammon (1977) also found consumers’ ability to select the most nutritious brand to be largely unaffected by the amount of information provided. Scammon not only found that additional information failed to enhance nutritional choices, but it also led to less accurate recall of information, decreased consumer satisfaction with their brand choice, and less consumer certainty that the best choice was made. There is, some indication that although consumers may not be very efﬁcient at utilizing additional nutrition information, they feel more conﬁdent in their brand selections because more information is available (Lenahan et al., 1973). Theoretically, because of cognitive limits, at some point additional information will induce ‘information overload’ and cause the user to be less efﬁcient in processing and using the additional information. Information overload has been widely debated in the literature (Muller, 1985; Scammon, 1977). Whether or not information overload is the best explanation of observed effects, or some other explanation, such as consumer motivation (Muller, 1985), or time available 139

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Table 2. Selected Findings of Nutritional Information Studies Related To

General Findings

Literature Examples

Amount of Information

• Presenting more information does not necessarily enhance consumer decision making. • Increased amounts of information may lead to decreased satisfaction with decision. • Increased amounts of information may lead to decreased certainty of choice. • Increased amounts of information may lead to increased conﬁdence in decision.

Asam & Bucklin (1973); Muller (1985) Scammon (1977)

Use/Comprehension of Information

• Use and comprehension of information is low.

Jacoby, Chestnut & Silberman (1977); Miller (1978)

Behavioral Effects

• Very few behavioral effects observed.

Peterson (1977); Scammon (1977); Quelch (1978); Russo et al. (1986)

Context Effects

• Information effects are independent of related health claim effects.

Ford et al. (1996)

Consumer Characteristics • Demographics such as age, education, gender, and income have mixed relationships with information effects.

Scammon (1977) Lenahan et al. (1973)

Lenahan et al. (1973); Fusillo & Beloian(1977); Jacoby, Chestnut & Silberman (1977); Klopp & MacDonald (1981); Russo et al. (1986); Cole & Gaeth (1990); Moorman (1990); Levy, Fein & Schucker (1991); Bender & Derby (1992); Cole & Balsubramanian (1993); Mathios (1996) • Extent of prior knowledge may increase. Jacoby, Chestnut & comprehension of information, but have little Silberman (1977); effect on use, elaboration, or decision quality Moorman (1990)

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Table 2. Continued Related To

General Findings

Literature Examples

• High motivation to process information may increase awareness and use of information.

Russo et al. (1986); Moorman (1996)

• Skeptical consumers presented with information may be pessimistic about nutritional quality and reduce acquisition of information. Descriptive Information

Moorman (1996)

• Formats preferred by consumers may not be the most effective.

Levy, Fein & Schucker (1996)

• Easily processed information is used more efﬁciently

Russo et al. (1986); Moorman (1990); Levy, Fein & Schucker (1996) Russo et al. (1986); Barone et al. (1996); Ford et al. (1996) Asam & Bucklin (1973); Scammon (1977); Ford et al. (1996) Moorman (1990)

• Numerical listings and simple summary Measures show comparatively small effects • Adjective descriptions such as high or low have mixed effects.

• Providing consequence information may increase use of information and decision quality, but not comprehension. • Negative information has more impact than positive information Comparative Information • Percentage of recommended daily allowance (%RDA), or daily value (%DV) has more impact than simple descriptive information, but speciﬁc perceptual effects are variable

• Comparison to average values enhances perceptual effects • Comparison to other brands enhances use of information and efﬁciency of choice.

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Russo et al. (1986); Moorman (1990) Scammon (1977); Moorman (1990); Barone et al. (1996); Levy, Fein & Schucker (1996) Barone et al. (1996) Muller (1985); Russo et al. (1986)

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(Scammon, 1977) is more reasonable, the fact remains that “. . . a large proportion of the public wants information to be available and has a positive attitude toward it, but using such information to make choices is considerable smaller.” (Muller, p. 144) Over two decades of marketing research clearly indicates that providing more information is no guarantee that the user will actually acquire, comprehend, or use that information (Moorman, 1996). Explanations for the low incidence of use center upon consumer and information format characteristics. When consumers perceive cognitive or other costs associated with the acquisition and use of information the beneﬁts must outweigh the costs or consumers will make decisions without fully utilizing all available information (Russo et al., 1986). Behavioral and Context Effects Ultimately, the goal of information requirements is some sort of behavioral effect. From a public policy viewpoint it is hoped that provided information will alter behaviors so that consumer welfare is enhanced. In the case of nutrition information, it is hoped that a more nutritionally balanced, and healthy, diet is actually consumed. A variety of cognitive effects have been related to nutrition information, but observed behavioral effects are relatively rare (Peterson, 1977; Quelch, 1978; Russo et al., 1986; Scammon, 1977). There is some anecdotal evidence that consumers are making healthier purchasing decisions (Silverglade, 1996). However, it is not clear whether this behavioral change occurred because of required nutrient information disclosures, rising consumer education about nutrition, or other factors. Research indicates that the effect of nutrition disclosures depend on the information format, the consumer, and the context of the information. The context refers to the alternative information that is typically presented on a food package. The alternative information competes for the consumer’s attention and forms an overall context which might enhance, or detract from, the efﬁcient use of nutrition information. Testing for context effects, Ford et al. (1996) investigated whether or not the effects of a “health claim” contained on a label (e.g., “good for your heart”) were independent of the effects of nutrition information. In general, the authors found that the effects of a health claim on consumer beliefs were independent of the effects of nutritional information. These ﬁndings imply that consumer beliefs can be inﬂuenced by nutrition information; even if that information is contradicted by a stated health claim. On the other hand, independence of the effects implies that if consumers form negative beliefs on nutrition information, those beliefs could be tempered somewhat through the use of a positive health claim.

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Consumer Characteristics Speciﬁc consumer characteristics related to nutrition information use, comprehension, and effects have been widely studied. Consumer demographics (age, income, gender, education, etc.) have mixed relationships with nutrition information effects. A relatively consistent ﬁnding is that a consumer’s age is negatively associated with use and comprehension of nutrition information (Bender & Derby, 1992; Cole & Balasubramanian, 1993; Fusillo & Beloian, 1977; Jacoby, Chestnut & Silberman, 1977; Mathios, 1996; Moorman, 1990). However, age has been found to have no effect on decision quality (Levy et al., 1991) or on awareness of nutrition information (Russo et al., 1986). Although there is some evidence to the contrary (Levy et al., 1991), there is also strong research support for consumer education being positively related to use and comprehension of nutrition information (Bender & Derby, 1992; Klopp & MacDonald, 1981; Lenahan et al., 1973; Moorman, 1990). Consumer income has been found to be positively associated with nutrition information use (Fusillo & Beloian, 1977) but not associated with information awareness (Russo et al., 1986). Finally, use of nutrition information has been found to be more likely among females (Fusillo & Beloian, 1977) but Levy et al. (1991) found no gender effects on decision quality or efﬁciency of use of nutrition information. Moving beyond simple demographics, it has been proposed that some consumers may be more motivated to attend to and process nutrition information. Motivation may be increased if that consumer is currently experiencing health problems. Motivated consumers have generally been found to be more aware of nutrition information and to make more use of such information (Moorman, 1996; Russo et al., 1986). However, as noted by Moorman, “. . . it appears that in a well-designed information environment, comprehension is not highly dependent on the level of motivation consumers exhibit toward the information processing task” (1996, p. 40). It would also seem that consumers with high amounts of prior nutrition knowledge would respond differently to nutrition information. Such prior knowledge has been associated with increased comprehension (Jacoby, Chestnut & Silberman, 1977) but Moorman (1990) found no relationship between prior knowledge and information use, elaboration, or decision quality. Moorman (1996), studied the link between consumer attitude and nutrition information by examining consumer “skepticism” and the extent of acquisition of information. In a marketing sense, skepticism has been conceptualized as a “general trust or cynicism toward commercial activities.” Moorman examined nutritional information acquisition by skeptical consumers before and after the 143

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implementation of the Nutrition Labeling and Education Act (NLEA) of 1990 and found a positive association between consumer skepticism and information acquisition in the pre-NLEA environment. In the post-NLEA environment, a negative relationship emerged. Interpreting these ﬁndings, Moorman states: If consumers remain skeptical while operating in a muniﬁcent information environment (post-NLEA), they are likely to be pessimistic about the nutritional quality of food products, which in turn reduces their information acquisition activities. On the other hand, if consumers are skeptical while operating in a lean information environment (pre-NLEA), their skepticism is more optimistic and it appears to drive them to acquire more information (p. 41).

Szykman, Bloom & Levy (1997) investigated the relationship between skepticism toward a health claim and usage of nutrition label information. They found that consumers who were skeptical of stated health claims were more likely to utilize nutrition label information. Interestingly though, the (positive) relationship between use of label and use of claim information was weaker for skeptical consumers. In interpreting this ﬁnding, the authors state: “This suggests that there is a segment of consumers that uses the information that is easiest to use, even if they are skeptical of its accuracy” (p. 236). Descriptive and Comparative Information In addition to consumer characteristics, the effect of presentation formats have been examined. Before turning to speciﬁc ﬁndings it should be noted that formats preferred by consumers do not result in more effective or efﬁcient decisions. It would seem that a more preferred format would be more likely to be used by consumers and, therefore, have more impact on behavior. In a test of seven alternative nutrition information formats, Levy, et al. (1996) found that use of consumer-preferred formats did not enhance decision making. This ﬁnding highlights a basic tenant when considering the type of information to provide: “Many people say they want and would use the largest amount of information offered, but tests often ﬁnd that the preferred amount of information leads to poorer performance” (Levy et al., 1996, p. 9). Research consistently indicates that any format which results in reduced information processing ‘costs’ will enhance efﬁcient use of information (Barone et al., 1996; Ford et al., 1996; Russo et al., 1986). Information that has been simpliﬁed and already summarized (i.e. processed) for the consumer is utilized more than complex, raw, numerical information (Scammon, 1977). However, simplifying information does not, in and of itself, guarantee efﬁcient use. Russo et al. (1986) found a negative association between decision efﬁciency and presentation of a simpliﬁed, summary ‘nutrition quotient’ (i.e. a single performance measure).

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Adjective descriptors of nutrient content (e.g. high/low) should, theoretically, be easier for consumers to process than numerical information and, therefore, enhance decision making. However, the research evidence is mixed. Asam & Bucklin (1973) found adjective labels to be less effective than detailed numerical listings. However, Scammon (1977) found adjective descriptors to be more efﬁcient than percentage recommended daily allowance (%RDA) descriptors. Ford et al. (1996) also found that adjective descriptors (when added to numerical information) reduced the ambiguity of presented information. Moorman (1990) expanded the notion of adjective descriptors by including additional (non-numerical) ‘consequence’ information. Subjects were provided with a nutrient statement (e.g. ‘hot dogs contain added sodium’) coupled with a consequence statement (e.g. ‘the American Medical Association has found that excessive sodium may be linked to the onset of health problems’) signiﬁcant positive effects on decision quality were found. In the Moorman (1990) study, negative consequence information was presented. It has been recognized that negative information has a more dramatic effect upon consumer decision making than positive information (Arndt, 1967). This sensitivity to negative information may be explained by Kahneman & Tversky’s (1979) “prospect theory.” Heimbach & Stokes (1982) found consumers had a strong interest in information regarding “negative nutrients.” Russo et al. (1986) found that nutrition matrices which emphasized negative nutrients “were twice as effective in causing the purchase of more nutritious foods” (p. 67). Frequently, researchers in the area of nutrition information utilize comparative, rather than simple descriptive, information about nutrient qualities. In general, comparative information appears to provide consumers with reference points and results in enhanced consumer perceptions and decision making (see Barone et al. 1996 for a recent review of studies using reference information). A wide variety of reference points have been investigated, ranging from product category averages (or other comparisons across brands) to percentage formats expressing nutrients as percentages of recommended daily values. Percentage formats such as percentage of recommended daily allowance (%RDA) and percentage daily value (%DV) have been well studied with mixed results. Scammon (1977) found %RDA to be superior to adjective descriptors in aiding selection of the most nutritious product and recall of information. However, no differences in the effects of %RDA and adjective information were found for expressed brand preferences. Research by Brucks, Mitchell and Staelin (1984) indicated no effect of %RDA upon consumer beliefs regarding nutritiousness. Moorman (1990) found that %RDA enhanced consumer comprehension of information with comprehension increasing with education. 145

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Comparison information related to other brands and/or average values (expressed as either absolute amounts or % RDA/DV) has been associated with enhanced decision making. Utilizing brand comparison nutrient information signs in supermarkets Muller (1985) found that sales of the nutritionally superior brands signiﬁcantly increased. This outcome was minimized when nutrition differences among brands were low. Russo et al. (1986) found increased consumer awareness, knowledge and attitudes using comparative brand information but actual consumer purchases remained unaffected. Finally, Barone et al. (1996) investigated the effectiveness of nutrient comparisons to an ‘average value’ (versus speciﬁc comparisons). Barone et al found the average values to be signiﬁcantly more effective in inﬂuencing consumer perceptions of healthiness, attitudes towards brands, and purchase intentions.

CONCLUSIONS AND IMPLICATIONS This chapter identiﬁes the commonalties between the reporting of ﬁnancial information and nutrition information. A large body of accounting research strives to determine if a reported measure is useful and relevant to ﬁnancial statement users. Accounting researchers also strive to determine if the management or manipulation of the reported ﬁnancial information affects the user’s perception of that information. The outcome of these studies provide information to the accounting standard setters about what information should be reported because it has decision-usefulness to the users of the ﬁnancial statements. There is similar motivation for research on nutritional label information. Accounting researchers measure the effect of accounting information on the ﬁnancial statement users through the capital markets. Marketing researchers study the decision effects at the individual consumer level. Accounting research supports earnings management behaviors, but there are still unanswered questions regarding if those actions inﬂuence the user of that information. The ﬁndings from the nutrition labeling studies present a different perspective on how users of information are or are not inﬂuenced. The approaches taken in the nutrition information studies may be a way for accounting researchers to address these questions. The nutrition labeling literature has one clear conclusion: the provision of additional information will not ensure consumer use or comprehension, even if the user of the information requests it. Furthermore, although provided information may have some cognitive or perceptual effects, those effects rarely result in changed behaviors or more efﬁcient decisions. These ﬁndings could be interpreted to indicate that although the users of the ﬁnancial information requested comprehensive income information, this

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information will not necessarily be used or comprehended, let alone result in modiﬁed investment behaviors or decisions. In fact, in some cases, additional information may actually decrease satisfaction with decisions and reduce the user’s perceived certainty that the best decision was made. At other times, additional information may lead to an increased feeling of conﬁdence in decisions, even when that decision is not efﬁcient. It is also clear that users are likely to be biased in their use of provided information, selectively attending to negative information or that type of information felt to be most useful in decision making (even if other information is equally, or more, relevant to the decision at hand). Studies do show that information presentation formats which reduce information processing load can enhance decision efﬁciency. SFAS 130 comprehensive income reporting formats seem to achieve that load-reduction objective by getting comprehensive income items out of stockholders’ equity and on to a statement of performance, thereby reducing the information processing load required to obtain and use the information. However, even with this reduction in processing load, the individuals most likely to use and comprehend provided information are those who would probably beneﬁt the least. For example, the sophistication level of the user (in terms of education, knowledge and motivation) appears to have an effect on both comprehension and use of the information. Education was found to be positively related to the use of detailed nutrition information and motivation positively related to comprehension. Therefore, motivated and more educated ﬁnancial analysts will be the ones most likely to make use of the new comprehensive income disclosures. The motivated analyst is precisely the one most likely to already be using this information in its present format. The question remains what statement format will be preferred. The preparer may resist the one statement approach so that the focus on the ‘bottom line’ of comprehensive income is minimized. From the users’ perspective, a one statement approach may be preferred, but even a two statement approach is much simpler and easier to understand than the presentation formats pre-SFAS 130. However, nutrition label researchers have found that simplicity alone does not guarantee decision efﬁciency or effectiveness, and in some cases simpliﬁed information can actually be negatively correlated with decision efﬁciency. Furthermore, other forms of ﬁnancial information, such as summaries provided by ﬁrm management, may be even more easily processed than SFAS 130 related information and, as noted in our literature review, there is likely to be a group of information users who will concentrate on the easiest-to-use information, even if they are skeptical regarding that information The marketing researchers clearly indicate that the effects of required information formats can not be examined in isolation. Rather, whether format makes 147

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a difference to the decision maker depends on the context of the information and additional contextual information provided. For example, the effects of management-controlled information (such as performance claims contained in an annual report) are likely to be independent of the effects associated with information required by accounting standards. It should also be noted that there appears to be a generally positive correlation between a reader’s use of contextual information in an initial investment decision. Some forms of contextual information may actually decrease the probability of a user attending to the ﬁnancial information. The use of comparative reference points to aid decision making has been an important consideration. In nutrition studies, when comparisons are made to other speciﬁc brands, decision efﬁciency can be enhanced. However, when comparisons are made to standardized benchmarks like the % RDA, decision efﬁciency may or may not be aided. This ﬁnding indicates that the comparison of comprehensive income information to a speciﬁc competitor rather than industry norms may be more useful to the decision maker. Overall, consumers evaluating food purchases and analyst/investors evaluating ﬁrm ﬁnancial performance are both likely to enter the marketplace with various levels of motivation and preconceived attitudes, impressions, biases, loyalties, and knowledge levels. Regardless of the information which regulators require ﬁrms to provide, or the speciﬁc format of that information, the fact remains that these consumer-related factors will inﬂuence information use, comprehension, and ultimate decisions. One might argue that ﬁnancial analysts are more highly trained than ordinary consumers, and more sophisticated in their approach to the marketplace. However, even the ‘sophisticated consumer’ is likely to be inﬂuenced by prior impressions. Detailed numerical information which conﬂicts with these prior impressions is likely to be ignored, discounted, or misperceived; thereby having little effect on decision making. Presenting ﬁnancial information in easy-to-process formats may increase the probability of its use, but such information still competes with prior impressions, and even easier-to-process information such as word of mouth, ﬁnancial press reports, and management-controlled press releases and annual reports.

REFERENCES Alchian, A. A., & Kessel, R. (1962). Competition, Monopoly and the Pursuit of Money. In Aspects of Labor Economics (pp. 157–175). Princeton University Press: Princeton, N.J. Arndt, J. (1967). Role of Product-Related Conversations in the Diffusion of a New Product. Journal of Marketing Research, 4 (August), 291–295.

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Asam, E. H., & Bucklin, L. P. (1973). Nutrition Labeling for Canned Goods: A Study of Consumer Response. Journal of Marketing, 37, (April), 32–37. Association for Investment Management Research (1993). Financial Reporting in the 1990’s and Beyond. Barone, M. J., Rose, R. L., Manning, K. C., & Miniard, P. W. (1996). Another Look at the Impact of Reference Information on Consumer Impressions of Nutrition Information. Journal of Public Policy & Marketing, 15(1), 55–62. Bender, M., & Derby, B. (1992). Prevalence of Reading Nutrition and Ingredient Information on Food Labels: 1982–1988. Journal of Nutrition Education, 24(6), 292–297. Brucks, M., Mitchell, A. A., & Staelin, R. (1984). The Effect of Nutritional Information Disclosure in Advertising: An Information Processing Approach. Journal of Public Policy & Marketing, 3, 1–25. Cole, C. A., & Balasubramanian, S. K. (1993). Age Differences in Consumers’ Search for Information: Public Policy Implications. Journal of Consumer Research, 20 (June), 157–169. Cole, C. A., & Gaeth, G. J. (1990). Cognitive and Age-Related Differences in the Ability to Use Nutritional Information in a Complex Environment. Journal of Marketing Research, 27, (May), 175–184. Ford, G. T., Hastak, M., Mitra, A., & Ringold, D. J. (1996). Can Consumers Interpret Nutrition Information in the Presence of a Health Claim? A Laboratory Investigation. Journal of Public Policy & Marketing, 15(1), 16–27. Fusillo, A. E., & Beloian, A. M. (1977). Consumer Nutrition Knowledge and Self-Reported Shopping Behavior. American Journal of Public Health, 67(9), 846–850. Jacoby, J. R., Chestnut, W., & Silberman, W. (1977). Consumer Use and Comprehension of Nutrition Information. Journal of Consumer Research, 4 (September), 119–128. Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decisions Under Risk. Econometrica 47, (March), 263–291. Keller, S. B., Landry, M., Olson, J., Velliquette, A. M., Burton, S., & Andrews, J. C. (1997). The Effects of Nutrition Package Claims, Nutrition Facts Panels, and Motivation to Process Information on Consumer Product Evaluations. Journal of Public Policy & Marketing, 16 (Fall), 256–269. Klopp, P., & MacDonald, M. (1981). Nutrition Labels: An Exploratory Study of Consumer Reasons for Nonuse. Journal of Consumer Affairs, 15(2), 301–316. Lenahan, R. J., Thomas, J. A., Taylor, D. A., Call, D. L., & Padberg, D. I. (1973). Consumer Reaction to Nutritional Labels on Food Products. Journal of Consumer Affairs, 7, (Spring), 1–12. Levy, A. S., Fein, S. B., & Schucker. R. E. (1991). Nutrition Labeling Formats: Performance and Preference. Food Technology, 45 (July), 116–121. Levy, A. S., Fein, S. B., & Schucker, R. E. (1996). Performance Characteristics of Seven Nutrition Label Formats. Journal of Public Policy & Marketing, 15(1), 1–15. Mathios, A. D. (1996). Socioeconomic Factors, Nutrition, and Food Choices: An Analysis of the Salad Dressing Market. Journal of Public Policy & Marketing, 15(1), 45–54. Miller, J. A. (1978). Labeling Research: The State of the Art, Report No. 78–115, Cambridge, MA: Marketing Science Institute. Moorman, C. (1990). The Effects of Stimulus and Consumer Characteristics on the Utilization of Nutrition Information. Journal of Consumer Research, 17, (December), 362–374. Moorman, C. (1996). A Quasi Experiment to Assess the Consumer and Informational Determinants of Nutrition Information Processing Activities: The Case of the Nutrition Labeling and Education Act. Journal of Public Policy & Marketing, 15(1), 28–44.

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Muller, T. E. (1985). Structural Information Factors Which Stimulate the Use of Nutrition Information: A Field Experiment. Journal of Marketing Research, 22 (May), 143–157. Peterson, R. A. (1977). Consumer Perceptions as a Function of Product Color, Price, and Nutrition Labeling. in Advances in Consumer Research, 4, W. D. Perreault, Jr., (Ed.), Atlanta: Association for Consumer Research: 61–63. Quelch, J. A. (1978). Behavioral and Attitudinal Measures of the Relative Importance of Product Attributes: The Case of Cold Breakfast Cereals, Report No. 78–109, Cambridge, MA: Marketing Science Institute. Russo, J. E., Staelin, R., Nolan, C. A., Russell, G. J., & Metcalf, B. L. (1986). Nutrition Information in the Supermarket. Journal of Consumer Research, 13, (June), 48–70. Scammon, D. L. (1977). Information Load and Consumers. Journal of Consumer Research, 4 (December), 148–155. Silverglade, B. A. (1996). The Nutritional Labeling and Education Act – Progress to Date and Challenges for the Future. Journal of Public Policy & Marketing, 15(1), 148–150. Szykman, L. R., Bloom, P. N., & Levy, A. S., (1997). A Proposed Model of the Use of Package Claims and Nutrition Labels. Journal of Public Policy & Marketing, 16 (Fall), 228–241.

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A SELECTED ANNOTATED BIBLIOGRAPHY OF SEC ACCOUNTING RESEARCH J. Edward Ketz and Jimmy W. Martin

ABSTRACT In 1934, when Congress passed legislation creating the Securities and Exchange Commission, it is probable that few legislators or even President Roosevelt fully realized the impact that this agency would have on capital markets for the remainder of the twentieth century. The SEC’s inﬂuence on the evolution of the accounting profession in the United States cannot be overly emphasized. As a result of its prominent role since its inception, the SEC has been the focal point of many research efforts on the part of accounting scholars. Undoubtedly, this research interest will continue into the next century. As we enter a new century, it is appropriate to look back and recognize the efforts of researchers who have studied the effects of SEC regulation of the accounting profession during the twentieth century. This chapter presents an annotated bibliography of selected SEC research efforts that have been published since the Commission’s inception. Any effort of this nature is subject to certain constraints. First, the scope of the bibliography is restricted to journal articles. Texts have been omitted due to their voluminous contents and the resulting difﬁculty of summarizing them in a

Research in Accounting Regulation, Volume 14, pages 151–198. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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few lines which is necessary for a bibliographic work of this nature. Second, the bibliography is limited to articles whose primary theme relates to the accounting profession. Thus, research on issues such as insider trading and market regulation have been omitted. In selecting particular articles, an effort is made to include published works that cover the entire period since the SEC’s inception; thus, research from each decade from the thirties through the nineties are represented. Articles that offer insights into twenty-ﬁrst century problems have been especially favored. Finally, articles from SEC Commissioners and SEC Chief Accountants, as well as leaders in the academic and professional world are included. Hopefully, the bibliography will serve as a reference point for future SEC research efforts.

BIBLIOGRAPHY American Accounting Association’s Securities and Exchange Commission Liaison Committee. (1995). Mountaintop Issues: From the Perspective of the SEC. Accounting Horizons 9(1), 79–86. The AAA’s SEC Liaison Committee comments on critical issues confronting the SEC in this 1995 article. Derivatives, environmental liabilities, international accounting, auditor independence, restructurings, and speciﬁc AAERs comprise the key topics. An Exchange Between the Honorable Edward J. Markey, Chairman, U.S. House of Representatives Subcommittee on Telecommunications and Finance, Committee on Energy and Commerce and the Honorable Arthur Levitt, Jr., Chairman, Securities and Exchange Commission. (1995). Accounting Horizons 9(1), 71–78. Congressman Markey describes his views of the roles of the FASB and the SEC and poses probing questions to Chairman Levitt in this exchange of letters. Among these questions are the following: (1) Should the SEC consider accounting proposals in a broader context than the FASB?; (2) What policies guide the SEC when reviewing FASB decisions?; (3) Does the SEC consider social and economic consequences when it reviews new accounting standards? In reply, Levitt says that the FASB, while not ignoring national priorities, must focus on setting accounting standards that will produce unbiased, politicallyneutral ﬁnancial information that will give investors useful information; to do

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otherwise could diminish the credibility of ﬁnancial information and thus impair the efﬁcient allocation of capital. Armstrong, Marshall S. (1974). Will Washington Listen to the Private Sector? Financial Executive (March): 52–58. The author expresses concern that, despite the SEC’s stated intention to allow the private sector to promulgate accounting principles, they are taking a much more active role in establishing accounting standards. He recognizes that both the FASB and the SEC share the common goal of establishing standards of ﬁnancial reporting to provide a reliable basis for economic decisions, however, their divergence on two major issues is addressed. First the SEC distinguishes between accounting disclosure and accounting measurement, implying that the SEC might establish standards of disclosure while the FASB deals with measurement issues. Second, the SEC distinguishes between professional analysts and average investors as users of ﬁnancial statements while the FASB advocates general-purpose ﬁnancial statements. Armstrong concludes that the likelihood of the FASB retaining its standard-setting authority will depend on its ability to resolve issues on a timely basis and its capacity to address fundamental conceptual issues. Arnold, Jerry L. (1985). Exempt Offerings: Going Public Privately. Harvard Business Review (January-February): 16–30. The issuance of exempt offerings has been offered as an alternative to going public as a means for smaller, growing companies to raise capital. Regulation D, adopted by the SEC in 1982, establishes the terms and conditions of exempt offerings. The requirements of Regulation D are brieﬂy discussed, and the advantages and limitations of exempt offerings are examined. Situations where exempt offerings would be preferable to going public are presented. Arnold, Jerry L. and Holder, William H. (1997). The Effects of Financial Reporting Disputes with the SEC on the Informativeness of Earnings. Research in Accounting Regulation (volume 11), pp. 223–230. In some circumstances, the SEC requires that acquiring entities ﬁle audited ﬁnancial statements of business or portions of businesses acquired. This article addresses the nature and content of the applicable SEC rules, difﬁculties in compliance, and recommendations for entities, auditors, and policy-setters. 153

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Bagby, John W. and P. L. Kintzele. (1987). Management Discussion and Analysis: Discretionary Disclosures and the Business Segment. Accounting Horizons 1(1), 51–60. This article discusses the basic requirements for MD&A; namely, liquidity and capital resources, results of operations, forward-looking information, and inﬂation. The authors’ study of 100 annual reports from six different industries indicates that in many cases, items that the SEC wants to be discussed are not covered in MD&A. Disclosures regarding known trends, uncertainties, and commitments in the liquidity area were especially deﬁcient.

Banerjee, Ajeyo. (1995). Changes in SEC Disclosure Rules for Executive Stock Options: Implications for Valuation. Journal of Accounting, Auditing & Finance 10(2), 321–42. This paper traces the development of SEC disclosure rules relating to executive stock options from 1978 to 1992. Changes in disclosure requirements are considered in the context of the desirability for full disclosure. The author suggests methods of ascertaining approximate values of the number of outstanding options and their weighted average exercise price from other data about executive stock options that are disclosed in the proxy statement. Existing methods for valuation of executive stock options are examined, with a view toward identifying an appropriate method for valuing outstanding executive stock options.

Barden, Ronald S., J.E. Copeland and R.H. Hermanson. (1984). Going Public – What It Involves. Journal of Accountancy (March): 63–76. The paper provides information to accountants so that they can more effectively assist companies wishing to go public. The major advantages and disadvantages and the cost of going public are discussed. An overview of the process of going public, from the initial decision to the ﬁnal offering is given. Advice on selection of an underwriter and legal counsel is offered, and the SEC’s requirements and procedures are brieﬂy discussed. Barr, Andrew. (1979). Relations Between the Development of Accounting Principles and the Activities of the SEC. In: W.W. Cooper & Y. Ijiri (Eds), Eric Kohler: Accounting’s Man of Principles, 41–57. Reston, VA: Reston Publishing Co.

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Andrew Barr, the SEC’s Chief Accountant from 1956 to 1972, examines the early steps taken toward the development of accounting principles, explaining in detail the inﬂuence of the major participants in the process, including the SEC. He reveals the cooperative efforts of the accounting profession and the SEC as well as areas of conﬂict. One interesting note is that he attributes the use of the word ‘generally’, as used in generally accepted accounting principles in the audit report, to the SEC’s suggestion that ‘generally’ would convey the idea that more than limited acceptance was intended.

Barr, Andrew and Koch, E. (1959). Accounting and the SEC. George Washington Law Review 28, 176–193. This paper examines the provisions of the principal acts administered by the SEC and the authority invested in the SEC under the Securities and Exchange Act of 1934. The authors discuss the development of Regulation S-X and describe accounting problems confronted by the SEC. They point out that the SEC’s prescribed rules are to be followed only in certain basic respects; that the SEC depends mainly on the application of generally accepted accounting principles in the preparation of reports. Regarding the audit function, the SEC subjects auditing procedures to inquiry only when there is evidence that ﬁnancial statements have ben improperly prepared or carelessly certiﬁed. Several cases are cited where decisions have resulted in standards outlining the basic responsibilities of auditors.

Barrett, Jr., Michael F. (1984). The SEC and the Accounting Profession: Issues For Congress. In: The SEC and Accounting: The First 50 Years – 1984 Proceedings of the Arthur Young Professors’ Roundtable. New York: NorthHolland, 1986. Barrett, the Chief Counsel and Staff Director for the Subcommittee on Oversight and Investigations of the House Committee on Energy and Oversight, begins by discussing why Congress is responsible for oversight of government agencies such as the SEC and describes how this oversight is exercised. He addresses the question of whether the SEC is properly exercising its own oversight responsibilities over the accounting profession. He states that the securities acts were amended in 1975 in order to give the SEC the power to override the accounting rules of other federal regulatory agencies such as the Interstate Commerce Commission. Due to bank failures and other problems of the early 1980s, Barrett reports that his subcommittee has been asked to assess the effectiveness of the 155

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ﬁnancial reporting system. He seems concerned that the SEC may be giving too much deference to other federal agencies regarding accounting disclosure issues. He concludes by stressing the importance of auditor independence and cites several problems, especially consulting services, that casts doubt on how well independence is being maintained.

Bayless, Robert, et al. (1996). International Access to U.S. Capital Markets – An AAA Forum on Accounting Policy. Accounting Horizons 10(1), 75–94. This article presents views expressed in a forum on whether the SEC should amend its policies with regard to registration of foreign companies to sell securities in the U.S. Robert Bayless, the SEC’s Chief Accountant of the Division of Corporate Finance, defends the SEC’s current practices. He cites Rule 144, exemptions from U.S. proxy rules and section 16 reporting requirements, and a reduction on the number of years that key numbers must be reconciled to GAAP as important amendments to SEC requirements that have been made to ease the reporting burden of foreign ﬁrms. Other parties submitting views in this interesting debate include Jim Cochrane of the New York Stock Exchange, Trevor Harris of Columbia University, Jim Leisenring of the FASB, Joseph McLaughlin from Brown and Wood, and Jean Pierre Wirtz from Holderbank.

Beaver, William H. (1977). The Reporting Responsibility of the SEC. Financial Executive (March): 14–19. The author suggests that, as an important public agency, the SEC has a responsibility to establish a reporting system that allows its regulations to be evaluated. He examines the potential consequences of disclosure regulation as a prerequisite for establishing disclosure objectives. Beaver proposes a reporting system for the SEC that contains three stages: (1) a statement of objectives and their relation to the speciﬁc disclosure regulations; (2) a statement of predicted consequences; (3) a statement of actual consequences. Potential problems associated with this proposed reporting system are presented. Beaver concludes that, despite the potential problems, the SEC’s responsibility to the public requires some type of reporting system whose efﬁciency can be evaluated.

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Benston, George J. (1973). Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934. American Economic Review (March): 132–155. The underlying assumption of the disclosure requirements of the Securities and Exchange Act of 1934 is that disclosure is necessary to prevent fraud and ﬁnancial manipulation and to provide investors and speculators with sufﬁcient information to allow them to make rational economic decisions. This study examines, with respect to the 1934 Act, whether these objectives can be achieved by ﬁnancial disclosure and, if so, whether they have been achieved. Benston’s review of existing evidence lends no support to the claim that ﬁnancial statements issued prior to 1934 were fraudulent. This does not imply they were not misleading. However, the author asserts that statements issued after the 1934 Act are more misleading in that, in the exercise of conservatism, accountants do not include relevant information such as forecasts. Benston’s empirical evidence supports the conclusion that the disclosures are either not useful, not timely, or both. He further concludes that the 1934 Act neither increased investors’ conﬁdence in securities nor did it affect the fairness of the market.

Benston, George J. (1976). Public (U.S.) Compared to Private (U.K.) Regulation of Corporation Financial Disclosure. Accounting Review LI(3): 483–98. The public regulation of corporate disclosure in the United States (SEC) is compared with private regulation in the United Kingdom (The Stock Exchange). An examination of the legal requirements for public disclosure of corporate information and an estimation of the costs of these requirements is presented for both countries. The paper concludes that in the U.S., the costs of public disclosure are greater for both corporations and society as a whole. Advocates for the U.S. system claim that beneﬁts of public regulation exceed these costs. Seven purported beneﬁts of public regulation are described and analyzed. The analysis emphasizes that these same beneﬁts may be derived from private regulation of corporate disclosures. Based on this analysis, it is concluded that the beneﬁts derived from public regulation of corporate disclosure do not exceed the costs. The paper advocates that the U.S. move toward private regulation of corporate disclosure by limiting the authority and power of the SEC and redeﬁning its role as an agency to which corporations report what has been disclosed as opposed to an agency which dictates what will be disclosed.

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Beresford, Dennis R. and Neary, R.D. (1985). Going Public? Plan for a Successful Offering. Financial Executive (September): 6–9. This article is written to help private companies determine if they are ready to go public and show these companies how to position themselves for an initial public offering. A review of what investors look for in potential investment companies is presented. Several factors which must be considered when going public are examined. Areas where advanced planning is recommended are explored.

Blough, Carmen G. (1937). The Relationship of the Securities and Exchange Commission to the Accountant. Journal of Accountancy (January): 23–29. The SEC’s ﬁrst Chief Accountant states his views on the purposes of the 1933 and 1934 Acts and the Public Utility Holding Act of 1935. He discusses some of the problems confronted by the SEC in regard to qualiﬁcations of accountants, content of the certifying accountant’s certiﬁcate, and application or choice of proper accounting principles. He concludes by encouraging public accountants to work with the SEC in improving accounting practices. This is a useful article for researchers seeking a ﬂavor for the type of problems faced by the Commission in its early days.

Boone, Michael M. (1973). Management Accountants and the Securities Laws. Management Accounting (June): 18–22. Management accountants face many of the same legal liabilities, both civil and criminal, in the preparation of ﬁnancial statements as do independent accountants. This article examines the basic legal responsibilities that management accountants face under the Federal Securities Laws. The concept of fair ﬁnancial disclosure is discussed. The antifraud provisions of the securities laws having the greatest effect on management accountants are explained.

Brinkman, Donald R. (1975). Replacement Cost and Current-Value Measurement: How To Do It. Financial Executive (October): 20–26. The article asserts that current-value accounting is a feasible means of providing objective, relevant ﬁnancial information. The use of price-level accounting for monetary assets and current-value accounting for nonmonetary assets is advocated. The need for complete, comprehensive, and veriﬁable economic

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information is stressed. Modern systems-technology is presented as a costeffective means of implementing a current-value measurement system.

Brown, Paul R. and Calderon, J.A. (1993). An Analysis of SEC Disciplinary Proceedings. The CPA Journal (July): 54–58. The authors analyze 156 Rule 2(e) proceedings taken against accountants from 1935 to 1989. Among the more common auditing deﬁciencies cited are the following: a lack of auditor independence; failure to exercise skepticism; placing improper reliance on management; failure to gather sufﬁcient evidence; failure to provide adequate supervision; and the lack of disclosure of related party transactions. The article also summarizes sanctions that the SEC imposed in these proceedings. Researchers desiring an overview of Rule (e) proceedings through 1989 will ﬁnd this article useful.

Brown, Paul R. and Calderon, J.A. (1996). Heightened SEC Disciplinary Activity in the 1990s. The CPA Journal (June): 55–57. The authors provide an update of their earlier 1993 article in which they reviewed the results of SEC Rule 2(e) proceedings. The 1996 article extends their study to the 1990–1994 period. As in their earlier article, they cite some of the primary causes of auditor mistakes as well as common accounting-related problems. They found that a much larger number of corporate accountants were subjected to SEC disciplinary actions during the 1990–1994 period than in prior periods.

Brownlee II, Richard E. and Young, S.D. (1987). The SEC and Mandated Disclosure: At the Crossroads. Accounting Horizons 1(3), 17–24. The authors question the need for the SEC’s mandated disclosure system. The article relies heavily on prior works by Stigler, Jarrell, and Benston to refute the need for mandatory disclosures. The paper asserts that corporate ﬁnancial information may not be a public good as many claim since it may not possess the characteristics of nonexclusivity and joint consumption. Thus, government regulation of ﬁnancial disclosures may not be needed to assure that sufﬁcient amounts of ﬁnancial data will be produced. The authors believe that the present disclosure structure should be reviewed and justiﬁed before any further expansion in its scope is considered. 159

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Burton, John C. (1974). The SEC and the World of Accounting in 1974. From Statements in Quotes. Journal of Accountancy (July): 59–60. Burton, the SEC’s Chief Accountant at the time of this article, discusses problems and areas of special interest that should be addressed by auditors. He presents the SEC as an active participant in the resolution of problems and the clariﬁcation of certain auditing concepts. Burton, John C. (1975). SEC Enforcement and Professional Accountants: Philosophy, Objectives and Approach. The Vanderbilt Law Review (January): 1929. Burton gives an excellent overview of the SEC’s enforcement program in this paper. He discusses the basic philosophy, objectives, and approach in implementing enforcement actions. He indicates that while auditors are not named in a majority of enforcement actions, this fact does not mean they have performed an effective audit. He states that the need to maintain public conﬁdence in the SEC serves as a deterrent against bringing enforcement actions against auditors in marginal cases where auditors are guilty of errors in judgment. Burton concludes that the impact of the SEC’s enforcement program has been to strengthen the quality of professional performance. Burton, John C. and Reiling, H.B. (1972). Financial Statements: Signposts as Well as Milestones. Harvard Business Review (Nov.-Dec.): 45–54. The authors assert that while ﬁnancial statements provide valuable information regarding past performance, they are inadequate for predicting future performance or for valuing securities. Deﬁciencies of historical cost accounting are analyzed and suggestions for improvements in many areas are made, speciﬁcally in the area of increased disclosures. It is suggested that additional disclosures, including managements’ predictions concerning performance and forecasted ﬁnancial information, be ﬁled with the SEC to be available to any interested party and that supplemental reports be prepared which could be sent to shareholders on request. Seven ground rules to be adopted in determining the disclosure format for forecasts are presented and explained. The legal implications of employing forecasts are discussed. Carmichael, Douglas R. (1998). A Conceptual Framework for Independence. The CPA Journal (March): 16–23. This article provides background information on the formation of the Independence Standards Board (ISB). Highlights of the AICPA’s White Paper

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on issues that the ISB must address are discussed along with ways that the white paper might be strengthened. In particular, Carmichael takes issue with the White Paper’s contention that there is no evidence that audit failures have been caused by lack of independence. In addition, Carmichael believes that the expansion of independent auditors into outsourcing can, potentially, enhance the effectiveness of audits. Finally, the article provides a sidebar that contains SEC comments on the AICPA White Paper. Carmichael, Douglas R. (1999). In Search of Auditor Independence. The CPA Journal (May): 39–43. The author takes issue with Elliott and Jacobson (See their December 1998 CPA Journal article) on the following points: the objective of an audit, the effect of appearance of independence on information risk, the appropriateness of regulating the appearance of independence, and the appropriateness of viewing integrity, objectivity, and independence as mutually exclusive qualities. Carmichael stresses the importance of distinguishing between reliability and credibility (enhancing conﬁdence in reliability). He states that the objective of an audit is not only to improve reliability, but also to add credibility to the ﬁnancial statements. Since credibility is vital, the appearance of auditor independence becomes a critical issue. He concludes that capital markets could be undermined if the public’s perception of auditor independence is not maintained. Carmichael, Douglas R. (1999). Hocus Pocus Accounting. The Journal of Accountancy (October): 59–65. In this article, Carmichael discusses revenue manipulation schemes and audit techniques for discovering the schemes or verifying the propriety of revenue recognition. He focuses on two problem areas: bill and hold transactions and sham revenue transactions. The article provides a short, but useful, discussion of fraud detection techniques for revenue transactions. Guidelines from AAER No. 108 are used to clarify when bill and hold transactions may legitimately be recorded as revenue. A short bibliography of SEC and AICPA documents that are pertinent to revenue-recognition fraud is provided. Chastain, Clark E. (1975). Corporate Accounting for Environmental Information. Financial Executive (May): 45–50. The increased emphasis on social responsibility, especially on maintaining the quality of the environment, has created new problems of measurement and 161

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disclosure. In addition to society’s demands for information, the SEC requires disclosure if compliance with environmental protection laws will involve substantial capital outlays or may be expected to affect business. Future implications of accounting for environmental costs are explored.

Chastain, Clark E. (1985). M & A: Is Federal Legislation Needed? Financial Executive (May): 14–17. This article examines the question of whether federal legislation is needed to control mergers and acquisitions. In 1983, an Advisory Committee formed by the SEC conducted a study on corporate takeovers. Based on this Committee’s recommendations, the House Subcommittee on Telecommunications, Consumer Protection, and Finance drafted a bill directed toward control of corporate takeovers. The requirements of this bill are outlined. Differences between supporters of this bill and those who do not support legislative control are examined.

Chenok, Philip B. and Harnek, R.F. (1976). SEC Commentary – Replacement Cost Disclosure Requirements. The CPA Journal (July): 57–60. An historical background for the rising interest in replacement-cost accounting is presented. The requirements of ASR No. 190, which required disclosure by certain companies of selected replacement-cost data, are outlined. Companies affected by these rules are deﬁned. The disclosure requirements, form of disclosure, and methods of implementation are presented and discussed. The SEC’s objectives in requiring replacement-cost information are summarized. This article provides historical context for those researching the SEC’s experiment with selected replacement cost data.

Chetkovich, Michael N. (1955). Standards of Disclosure and Their Development. Journal of Accountancy (December): 48–52. Disclosure is deﬁned as the aspect of ﬁnancial reporting which presents descriptive or supplemental data. A standard of disclosure should measure the adequacy of the information to determine that it is not misleading to an interested and reasonably informed reader. Standards of disclosure have gradually improved with the growth of the accounting profession. This paper traces the evolution of standards of disclosure with emphasis on events and organizations which have inﬂuenced fuller disclosure in ﬁnancial reporting.

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Chow, Chee W. (1983). The Impacts of Accounting Regulation on Bondholder and Shareholder Wealth: The Case of the Securities Acts. The Accounting Review LVIII(3): 485–520. This study investigates how the 1933 and 1934 Securities Acts affected investor wealth around the time of their enactment. The author gathers empirical evidence to test several hypotheses. The evidence indicates that the ‘33 Act’s accounting provisions reduced returns to exchange-listed stocks through interﬁrm wealth transfers, out-of-pocket compliance costs, and reduced opportunity sets. The evidence weakly suggests that the ‘33 Act enhanced bondholder wealth. Within the time frame of the study, the ‘34 Act was not associated with a signiﬁcant change in average returns to listed stocks and bonds. Coffey, William J., Illiano, G., and Schier, L. (1995). The SEC’s Annual Report to Congress. The CPA Journal (December): 42–46. The article provides an overview of the SEC’s 1994 Annual Report to Congress. The review focuses on three SEC departments: The Division of Corporation Finance, The Ofﬁce of the Chief Accountant, and the Division of Enforcement. Changes in reporting requirements are cited such as the elimination of several ﬁnancial schedules. Summary information is provided for 1994 registration activity as well as staff reviews. The efforts of the Chief Accountant’s ofﬁce to facilitate the work of private sector groups are brieﬂy discussed along with various international initiatives that were undertaken during the year. The article concludes by summarizing SEC enforcement activities during 1994. Coffey, William J. and Schier, L. (1995). Small Business Initiatives Under the Securities Acts. The CPA Journal (January): 46–49. The authors review the SEC’s small business initiatives program which was adopted in 1992; limited coverage is given to changes made to Regulations A and D. Requirements for using Forms SB–1 and SB–2 are given, along with the advantages of ﬁling under Regulation A. The article provides a brief, but useful summary of alternative means that small companies should consider before entering the capital markets. Cook, J. Michael. (1984). The Securities and Exchange Commission’s First Fifty Years: An Accountant’s Viewpoint. The SEC and Accounting: The First 50 Years – 1984 Proceedings of the Arthur Young Professors’ Roundtable. New York: North-Holland, 1986. 163

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Cook provides an historical review of three of the SEC’s primary areas of responsibility: 1) the establishment of accounting principles; 2) the establishment of auditing standards; 3) the regulation of the accounting profession through enforcement actions. Regarding its oversight role, he states that the SEC was relatively passive for its ﬁrst three decades, but took a more active role under Barr and Burton. Cook credits the Commission for providing support and direction to the accounting profession in establishing its self-regulatory framework during the 1970s. The author concludes that, while occasional differences have arisen, the SEC and the profession have maintained a cooperative working relationship over the years. Cooper, William D. (1984). George C. Mathews: An Early Commissioner of the SEC. Accounting Historians Journal 11(2), 117–127. George C. Mathews, one of the ﬁrst commissioners of the Securities and Exchange Commission, was charged with general supervision over accounting matters brought before the Commission. Under his leadership, the ofﬁce of Chief Accountant was established, Accounting Series Releases were initiated, and the basic framework for handling accounting matters was formulated. (Abstract). Craig, James L. (1999). The CPA and Independence: Illusion or Reality? The CPA Journal (March): 14–23. The article presents highlights from a symposium sponsored by the New York State Society of CPAs. The symposium began with Richard Walker, the SEC’s enforcement director, and William T. Allen, the Chairman of the Independence Standards Board, giving their views on critical independence issues. This was followed by a panel discussion, moderated by Professor Gary J. Previts. The article presents a useful dialogue on independence issues as expressed by professional leaders from the SEC, AICPA, ISB, POB, and NYSE, as well as industry and investment sectors. Craig, James L. and Carmichael, D.R. (1998). Auditor Independence As the SEC Chief Sees It. The CPA Journal (December): 46–51. This article comprises an interview conducted by the editors of the CPA Journal with Lynn Turner, the SEC’s Chief Accountant. Turner cites two new trends in enforcement cases that have arisen in the 1990s: in-process research and

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development write-offs and improper use of reserves. He also mentions one old problem area, revenue recognition accounting, as being in need of more guidance. Other issues addressed in the interview are materiality, timely reviews of quarterly information, reports on internal control of quarterly information, reports on internal control systems, and a brief assessment of the work of the Independence Standards Board.

Craig, James L. and Carmichael, D.R. (1998). A Status Report on the Work of the Independence Standards Board. The CPA Journal (December): 20–25. The article consists of an interview conducted by the editors of the CPA Journal with William T. Allen, Chairman of the Independence Standards Board (ISB). Allen provides background information on the formation of the ISB, and the composition of the Board. He gives an assessment of the progress made to date and cites as a key goal the establishment of a conceptual framework that will allow the Board to effectively address speciﬁc issues. In addition, the Chairman discusses other projects that the Board is currently addressing.

Cox, Charles C. (1984). Accounting Standards From an Economist’s’ Perspective. The SEC and Accounting: The First 50 Years – 1984 Proceedings of the Arthur Young Professors’ Roundtable. New York: North-Holland, 1986. Cox, an SEC Commissioner during the 1980s, gives his views on two important accounting issues: (1) evaluating the tradeoff between relevance and reliability of ﬁnancial information; (2) determining whether ﬁnancial information should be disclosed in the ﬁnancial statements or in the footnotes to the statements. In discussing the ﬁrst subject, Cox uses junior stock and contingent stock purchase warrants to illustrate his views. Regarding the second issue, he focuses on in-substance defeasance of debt and the reversion of excess pension plan assets to a corporation after a restructuring of its pension plan. He states that, from an economist’s perspective, it doesn’t matter where information is disclosed, since an efﬁcient market will digest the signiﬁcance of the data in either case. Finally, Cox addresses the question of whether the effects of ﬁnancial reporting should affect the rules that govern such reporting. He asserts that, as an SEC Commissioner, the social consequences of any rule are subject to consideration; however, before the social impact is to alter the accounting rule, one “should be prepared to demonstrate that alternatives are not practicable and that the beneﬁts of his proposal outweigh the costs.” 165

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Diamond, Michael A. and Arnold, J.L. (1979). Replacement Cost Data in the Bank Loan Pricing Decision. Journal of Commercial Bank Lending 62(3), 42–49. This study reﬂects empirical evidence gathered regarding long-term loan decisions of bank loan ofﬁcers. The research objective is to determine the impact of replacement cost data on their loan decisions. The results indicate that the loan ofﬁcers ignored replacement cost data in making their decisions. This article is relevant to researchers exploring the pros and cons of the SEC’s push for replacement cost data in the late 1970s. Doran, Michael, Collins, D.W. and Dhaliwal, D.S. (1988). The Information of Historical Cost Earnings Relevant to Supplemental Reserve-Based Accounting Data in the Extractive Petroleum Industry. The Accounting Review LXIII(3): 389–413. The SEC states in ASR Nos. 253 and 269 that historical cost measures are of limited usefulness in determining future cash ﬂows of oil and gas companies. The authors present evidence to refute this assertion, and they conclude that income based on historical cost is a valid measure of oil and gas earnings. This particular study supports the view that historical cost earnings as well as reservebased measures derived from RRA data are useful to investors. Douglas, William O. (1959). Foreword to Symposium on the Securities and Exchange Commission. George Washington Law Review 28 (October): 1–5. The author recounts events of the earliest days of the SEC. Initial court cases which established the constitutionality of the Securities Act of 1933 and the Securities Exchange Act of 1934 are presented. Events leading to the enactment of several of the lesser acts and rules are described. Drogin, Steven. (1977). SEC Commentary – Form 10-Q – You’ve Come a Long Way, Baby! The CPA Journal (August): 70–73. Form 10-Q, the general form used for reporting quarterly information, was originally adopted for years ending after December 31, 1970. This article examines the development of the Form 10-Q into the current comprehensive document. Reasons for incorporating various changes in the document are discussed. This article is relevant to anyone exploring the evolution of the SEC’s Form 10-Q.

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Elliott, Robert K. and Jacobson, P.D. (1998). SEC Independence Concepts. The CPA Journal (April): 14–20. The authors explore important independence concepts, including the following: mutual interests and conﬂicting interests between auditors and their clients; the appearance of independence; objectivity; knowledge of all related facts. Views that may seem controversial to some are advanced. For example, the authors take issue with the SEC’s focus on appearance as a separate, sufﬁcient cause for regulation. Furthermore, the view by some SEC staff members that auditors should have neither mutual nor conﬂicting interests with their audit clients is criticized. This article will be useful to anyone researching the basic concepts underlying auditor independence.

Elliott, Robert K. and Jacobson, P.D. (1998). Audit Independence Concepts. The CPA Journal (December): 30–37. The authors discuss the objective of auditor independence and provide a deﬁnition for audit independence. They assert that the concept of appearance of independence need not necessarily be included in a conceptual framework of independence. Furthermore, they state that appearance of independence does not affect objectivity, audit quality, integrity, or information risk. The authors conclude by listing nine principles which they believe should become part of any conceptual framework on independence.

Evans, John R. (1984). An Evaluation of SEC Accounting Policies and Regulation. In: The SEC and Accounting: The First 50 Years – 1984 Proceedings of the Arthur Young Professors’ Roundtable. New York: North-Holland, 1986. Evans, a former SEC Commissioner, examines the nature of the relationship between the SEC and accounting profession in this paper. He asserts that the decision of the Commission to rely on the private sector to set accounting principles was proper since the private sector had the resources and expertise to do the job. Evans discusses SEC mistakes such as failing to act promptly in the 1960s and early 1970s to deal with inadequacies in accounting principles. He stresses that in order to execute its oversight role, the Commission must be constantly involved. He concludes by making several recommendations such as an expanded role for the Public Oversight Board that would increase the effectiveness of the accounting profession.

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Fedders, John M. and Perry, L.G. (1984). Policing Financial Disclosure Fraud: The SEC’s Top Priority. Journal of Accountancy (July): 58–64. This article, written only a few years after the SEC implemented its integrated disclosure project, reﬂects the importance of MD&A to the SEC. The authors indicate that the SEC emphasizes its review of MD&A when searching for ﬁnancial fraud. The article discusses areas within MD&A that receive the closest scrutiny and brieﬂy describes 12 cases where the SEC discovered ﬁnancial fraud during the 1982–1984 period. Feroz, Ehsan H., Park, K. and Pastena, V.S. (1991). The Financial and Market Effects of the SEC’s Accounting and Auditing Enforcement Releases. Journal of Accounting Research 29 (Supp.): 107–148. This paper explores three questions related to the SEC’s accounting enforcement program: (1) what types of accounting and auditing problems motivate enforcement actions?; (2) what are the consequences of investigations on targets’ ﬁnancial statements, managers and auditors?; (3) how do investors and other market agents view the SEC’s actions? The authors found that premature revenue recognition and/or overstatement of current assets, such as receivables and inventories, were the most frequent causes of AAER-related accounting problems. Their study shows that managers responsible for improper accounting typically suffered negative consequences such as job loss and lawsuits. When the SEC detected audit failures, the auditors were normally censured or barred from SEC practice, and auditors from smaller ﬁrms usually received the most severe penalties. Finally, the ﬁrms that were guilty of improper reporting experienced a typical two-day –13% market return associated with the ﬁrst disclosure of the alleged reporting violation. The declines in the market returns were positively associated with the relative income impact of the accounting dispute. Frost, Carol A. and Lang, Mark H. (1996). Foreign Companies and U.S. Securities Markets: Financial Reporting Policy Issues and Suggestions for Research. Accounting Horizons 10(1), 95–109. The article focuses on the SEC’s requirement that foreign companies provide quantitative reconciliations to U.S. GAAP before selling securities in the U.S. Major questions are raised that are relevant to the SEC’s primary goals of investor protection and market quality. The authors then assess various empirical research studies that relate to these questions. In addition, several questions are posed which seem fruitful for future research efforts. Among those are the

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following: Are global equity markets informationally efﬁcient?; Are international accounting standards a viable substitute for U.S. GAAP? Gadsby, Edward N. (1959). Historical Development of the SEC – The Government’s View. George Washington Law Review 28 (October): 6–17. Written in the SEC’s 25th year, this work details events leading up to the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934. Provisions of the acts administered by the SEC are outlined. The objectives of the Public Utility Act of 1935, the Trust Indenture Act of 1939, and the Investment Advisers Act of 1940 are explained. In describing their activities, the SEC is credited with establishing better relationships between businesses and communities and with advancing capitalism. Gafford, W. Wade and Finan, M.A. (1985). Statement in Quotes – How to Find Answers to SEC Questions. Journal of Accountancy (April): 104–106+. To become efﬁcient in answering questions pertaining to the SEC, the accountant must be familiar with various resource materials and know which ones to use in particular circumstances. This article summarizes ﬁve distinct categories of federal securities laws: federal statutes, interpretative case law, SEC rules and regulations, the Commission’s published views and interpretations and SEC staff policy. Various resource materials are presented and discussed for each category. Garrett, Ray Jr. (1975). Disclosure Rules and Annual Reports: Present Impact. Financial Executive (April): 16–21. Garrett summarizes the SEC’s amended rules relating to content of ﬁnancial statements and their distribution to shareholders. He explains that the SEC’s objectives in adopting these amendments are to insure a minimum quantity of business and ﬁnancial information in all ﬁnancial statements and to insure that all shareholders have equal access to these statements. The issue of maintaining a certain level of business ethics through the use of disclosure rules and regulations is discussed. Glezen, G. William and Millar, James A. (1985). An Empirical Investigation of Stockholder Reaction to Disclosures Required by ASR No. 250. Journal of Accounting Research (Autumn): 859–870. 169

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ASR No. 250 required public companies to disclose in their proxy statements the percentage of fees for nonaudit services in relation to the audit fee and whether the board of directors or its audit committee approved these services. ASR No. 250 was subsequently withdrawn due to the SEC’s concern that the information supplied was not utilized. This article reports the results of an empirical study examining whether ASR No. 250 information disclosures adversely affected stockholders’ approval of auditors. Results of the study indicate that independence of the auditors is not important to stockholders or stockholders do not perceive nonaudit services as affecting independence of the auditors.

Gorton, Donald E. (1991). The SEC Decision Not to Support SFAS 19: A Case Study of the Effect of Lobbying on Standard Setting. Accounting Horizons 5(1), 29–41. Gorton seeks to determine whether intense lobbying caused the SEC to reject SFAS 19 or whether the rejection was due to a dislike of statement 19 itself. Gorton provides the historical background that led to the adoption of SFAS 19 and its later rejection by the SEC. He discloses the results of interviews with key participants in the energy-accounting debate; conversations with FASB Chairman, Donald Kirk, SEC Chairman, Harold Williams, and SEC Chief Accountant, Clarence Sampson are analyzed to determine why SFAS 19 was rejected. The author concludes that the lobbying efforts may not have spelled the doom of SFAS 19, but rather, may have provided an opportunity for the SEC to break with tradition and refrain from supporting the FASB and thereby pursue a more-favored current value approach to oil and gas accounting.

Guzzardi, Walter. (1974). The SEC’s Crusade on Wall Street. Fortune (November): 139–141 and 242–253. This article reports that the SEC is engaged in extending its authority, not only over the securities market, but also over accountants and lawyers who practice before the SEC. The SEC has asserted its purpose as that of a prime agent in maintaining the health of capital markets. The article criticizes the SEC for not explaining why this should be the SEC’s role and why they are competent to discharge it. The backgrounds of the (then) present commissioners are presented. The activities of the SEC through the 1960’s and early 1970’s are explored in detail.

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Guzzardi, Walter. (1974). Those Zealous Cops on the Securities Beat. Fortune (December): 144–147 and 192–202. This article reports on how the SEC is attempting to impose additional responsibilities for detecting and reporting fraud on accountants and lawyers. The investigative proceedings of the SEC are reviewed. The use of civil injunctions by the SEC is explained. The SEC is criticized for the methods used in policing the securities markets, especially the use of press releases directed against a defendant’s public reputation. It is suggested that the SEC adopt certain measures of improvement including a complete reform of its policies and practices. Herz, Robert. Chairman of SEC-GAAP Redundancies Working Group. (1999). Report of the SEC-GAAP Redundancies Working Group. This working group was part of the FASB-approved Business Reporting Research Project. The group’s primary goal was to identify areas of disclosure where SEC and GAAP reporting requirements were duplicative. Redundant reporting requirements were found in the following areas: income taxes, contingencies, equity method investees, earnings per share computations, segment information, research and development, and the allowance for doubtful accounts. In addition, the working group reported on duplicative disclosure requirements for bank holding companies. The group recommended that the most efﬁcient way to eliminate the redundancies was to have the SEC amend its regulations. The group concluded its report by recommending a reorganization of Form 10-K, so that the material deemed most critical to users would be placed at the front of the document. Hooks, Karen L. and Moon, J.E. (1993). A Classiﬁcation Scheme to Examine Management Discussion and Analysis Compliance. Accounting Horizons 7(2), 41–59. The authors’ research project had two primary objectives: (1) to develop a classiﬁcation scheme that could be used to measure MD&A disclosure frequencies and (2) to assess compliance with FRR 36 disclosure requirements. Thirty companies were randomly chosen and examined for the inclusion of speciﬁc disclosures required by FRR 36 and Item 303 of Regulation S-K. These disclosure items pertain to the ﬁrms’ capital resources, liquidity, results of operations, business structure, leveraged transactions and federal ﬁnancial assistance, and forward-looking disclosure items. The authors concluded that ﬁrms in their 171

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sample appeared to be responding to FRR 36 by including more required and voluntary disclosures in MD&A.

Iannaconi, Teresa E. (1993). The SEC’s Expanded Role in Small Business Capital Formation. Journal of Accountancy (August): 47–51. Written by a director of the SEC’s Division of Corporation Finance, the article describes the SEC’s effort to ease reporting requirements for small businesses who attempt to raise capital. The changes include the following: adoption of regulation S-B to replace regulation S-K and S-X for small businesses, amendments to rule 504 of regulation D and to regulation A, and modiﬁcation of safe harbor provisions so as to apply to ﬁnancial statements submitted under a regulation A ﬁling. In essence, the revised rules allow more small companies to raise more capital (regulation A now allows $5 million to be raised) with less stringent accounting and auditing requirements.

Ingram, Robert W., and Chewning, E.G. (1983). The Effect of Financial Disclosure Regulation on Security Market Behavior. The Accounting Review LVIII (2): 562–579. This study reports on an empirical test of the effects of the Securities Act of 1933 and the Securities and Exchange Act of 1934 on investor behavior as revealed by security returns. The study differs from previous research into the effects of the Acts primarily by examining the percentage of annual cumulative abnormal returns that occurred during each month of test periods for years before and after the Acts. For ﬁrms with positive cumulative abnormal returns, aggregate market responses occurred earlier during ﬁscal years of the pre-Act periods tested (1926–1933) than during the ﬁscal years of post-Act periods tested (1935–1940). These results were robust to a variety of sampling and testing procedures. Implications and limitations of the study are discussed.

Kaplan, Maurice C. and Reaugh, D.M. (1939). Accounting, Reports to Stockholders, and the SEC. The Accounting Review 14 (September): 203–236. This article describes the substantial differences between accounting reports ﬁled with the SEC and those made available to stockholders. A study of balance sheets and income statements from the 1930s indicates that the reports to stockholders are less informative than reports to the SEC. Several limitations of the

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accounting information supplied to investors are discussed, including vague terminology and accounting concepts that allow manipulation and distortion of information. The authors advocate the use of single-purpose statements, which will vary according to the purpose for which they are issued. They conclude that the SEC should take action to insure that accounting information is directed toward the needs of investors.

King, Earle C. (1950). Current Accounting Problems. The Accounting Review (January): 35–44. This article, written by a former chief accountant of the SEC, gives a ﬂavor of the type of problems confronting the Commission at the middle of the century. King ascribes the SEC’s ‘current problems’ to either new methods of doing business or to matters that have been controversial for many years. He focuses on inconsistencies in accounting and how public accountants have reported on those inconsistencies. Particular attention is given to inventories and depreciation practices. King concludes that many CPA ﬁrms have solved the problem of inconsistent accounting applications by stating the change and its effect on income or other accounts or by referring to a footnote and stating that they approve of the change.

King, Ronald R. and Schwartz, R. (1997). The Private Securities Litigation Reform Act of 1995: A Discussion of Three Provisions. Accounting Horizons 11(1), 92–106. The authors focus on three provisions of the Private Securities Litigation Reform Act of 1995: (1) the ‘fair share’ proportionate liability rule; (2) the deployment of damage caps; (3) the requirement for fraud detection and disclosure. Regarding the ﬁrst provision, they describe the approach used to allocate liability in court and describe circumstances in which a co-defendant may still be liable jointly and severally for acts of other defendants. Regarding damage caps, the authors discuss the manner in which damage caps are applied and show how these caps may limit damages that liable parties must pay. The third section of the paper, the auditor’s fraud detection responsibilities, discusses how the Reform Act may change auditors’ liability. Three key audit requirements are mentioned, and the authors conclude that auditors are required not only to detect illegal acts of any sort, but also to determine an appropriate and timely remedial response for management.

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Kinney, Jr., William R. (1999). Auditor Independence: A Burdensome Constraint or Core Value? Accounting Horizons 13(1), 69–75. Two alternative views of auditor independence are presented. First, independence may be viewed as a necessary constraint upon auditor activities. Here, regulatory groups such as the SEC proscribe various relationships that might impair auditor independence. A second view is that independence is a core value component of a CPA’s reputation and is central to his or her value as a professional. Under this view, CPAs have a vested interest in developing ways to enhance their independence reputations. The article suggests the following six questions as fruitful for future research efforts: (1) Should individual CPA ﬁrms set their own independence standards?; (2) Should the auditor be independent of the client or independent of the information being audited?; (3) Who is hurt by appearances?; (4) Do other countries have better independence regulatory systems?; (5) How can the importance of independence be instilled in CPA ﬁrm staff?; What is the value of CPAs’ independence reputations for nonattest services?

Kohler, E. L. (1951). Amendment of Regulation S-X. Illinois Certiﬁed Public Accountant (March): 50–55. Kohler discusses the changes made to Regulation S-X as a result of Accounting Series Release No. 70. The article details changes in the content of the income statement and balance sheet along with changes affecting consolidated ﬁnancial statements. In addition, changes to rules 1.02 on auditor independence and 2.02 on accountants’ certiﬁcates are described. Many of the topics discussed, from the SEC’s acceptance of the all-inclusive income statement to materiality concepts and the omission of certain disclosures in the audit report, remain relevant to accountants today.

Kramer, Allan. (1976). The Signiﬁcance of the Hochfelder Decision. The CPA Journal (August): 11–14. Kramer presents a summary of the Hochfelder case in which the Supreme court reversed the decision of the Court of Appeals for the Seventh Circuit, ﬁnding in favor of Ernst and Ernst. This case is seen as signiﬁcant for two reasons: ﬁrst, the Supreme court found that whether there was negligence or not, Ernst was not liable to defrauded investors because there was no intent to deceive, manipulate, or defraud; and, secondly, the case is viewed as a reversal of a

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1970s trend to increase the boundaries of accountants’ statutory liability. Several questions left unanswered by the case are presented and discussed.

Kripke, Homer. (1976). A Search for a Meaningful Securities Disclosure Policy. Business Lawyer (November): 293–317. This article explains that the SEC’s control of the securities market is based on the assumptions that the past can reasonably predict the future; and, historical cost accounting is realistic and the net income ﬁgure produced can be used to predict security values. An historical background of accounting and its effect on the SEC is provided. It is concluded that the SEC places too much emphasis on historical cost accounting as a conveyor of ﬁnancial information. The use of current value accounting, management projections, and forecasts coupled with a corresponding reduction in the legal liabilities associated with this type of information is advocated. The author asserts that if the SEC views the ﬁnancial reports produced under its regulations as guides to securities investments, emphasis must be placed on making future predictions. If these reports are not viewed as a basis for making investment decisions, their value must be questioned.

Kunitake, Walter K. (1987). SEC Accounting Related Enforcement Actions 1934–1985: A Summary. Research in Accounting Regulation 1, 79–87. The paper summarizes SEC enforcement actions taken against individual auditors as well as CPA ﬁrms. The author studied actions taken from the SEC’s inception through 1985. The paper gives an overview of the enforcement process and the type of remedial actions that the SEC may prescribe. Of the cases brought against ﬁrms, 70% involved non-Big Eight ﬁrms. The author concluded that if enforcement proceedings were made public, speciﬁc classiﬁcations of audit violations could be identiﬁed and related to speciﬁc audit standards.

Landis, James M. (1959). The Legislative History of the Securities Act of 1933. George Washington Law Review (October): 29–49. A history of the creation and subsequent administration of the Securities Act of 1933, based on the recollections of an active participant in the process, is presented. This article offers insightful information into the dealings between the men responsible for drafting the Securities Act of 1933. The evolution of 175

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the basic structure of the 1933 Act is presented, which allows a better understanding of its purpose. Levitt, Arthur. (1998). The Importance of High Quality Accounting Standards. Accounting Horizons 12(1), 79–82. This short article proclaims the beneﬁts of rigorously-applied, high-quality accounting standards; namely, investor conﬁdence, greater market liquidity and lower capital costs. Regarding international accounting standards, Levitt cites three key objectives that international standards must meet to gain wide acceptance. First, such standards must constitute a comprehensive generally accepted basis of accounting. Second, international standards must be of high quality, provide full disclosure, and result in comparability and transparency of ﬁnancial information. Third, the standards must be rigorously interpreted and applied. Levitt concludes by asserting that high-quality standards must not be sacriﬁced. Levitt, Arthur. (1998). The Numbers Game. The CPA Journal (December): 14–19. This article was adapted from a speech made by the SEC’s Chairman, Arthur Levitt, on September 28, 1998. Levitt warns of the possibility of loss of trust in earnings numbers. He discusses ﬁve common methods that are used to manage earnings: ‘big bath’ restructuring charges, creative acquisition accounting, ‘cookie jar’ reserves, ‘immaterial’ misapplication of accounting principles, and the premature recognition of revenue. Levitt calls for a ninepoint action plan which he believes will help to maintain the reliability of America’s ﬁnancial system. Lipe, Robert C. (1998). Some Recent Financial Reporting Issues at the Securities and Exchange Commission. Accounting Horizons 12(4), 419–428. In this article, Lipe describes his experience with the SEC. After a brief review of the SEC’s Ofﬁce of the Chief Accountant (OCA), Lipe discusses four of the key accounting issues that the OCA dealt with during his one-year tenure as the SEC’s Academic Fellow. The four issues are as follows: internationalization of accounting standards, accounting for derivatives, electric utilities, and securitization. Lipe presents a brief summary of securitization issues as well as an example of a company securitizing prepaid assets. He stresses the impact that

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securitization can have on ﬁnancial statements and urges educators to introduce this topic to their students. Melumad, Nahum D. and Shibano, T. (1994). The Securities and Exchange Commission and the Financial Accounting Standards Board: Regulation Through Veto-Based Delegation. Journal of Accounting Research 32(1), 1–37. This paper presents a model that reﬂects the interaction between the SEC and FASB in the setting of accounting standards. The delegation of standard-setting authority by the SEC is purportedly inﬂuenced by three factors: the preference divergence between the SEC and FASB, the SEC’s commitment ability, and the set of default accounting standards. The SEC’s retention of veto power over FASB actions is characterized as veto-based delegation. The authors assert that if the SEC and FASB have sufﬁciently similar preferences and if the SEC can commit to an optimal default set, then veto based delegation is an optimal arrangement. They conclude that the SEC may not have delegated enough standard-setting power to the FASB, and that full retention of veto power has reduced the effectiveness of the standard-setting process. Merino, Barbara D., Koch, B.S. and MacRitchie, K.L. (1987). Historical Analysis – A Diagnostic Tool for ‘Events’ Studies: The Impact of the Securities Act of 1933. The Accounting Review LXII (4): 748–762. The authors critique a 1983 study by Chee Chow entitled, ‘The Inputs of Accounting Regulations of Bondholder and Shareholder Wealth: The Case of the Securities Acts’. The objective of the Merino study is to show that an adequate historical inquiry must be considered in any ‘events’ study. Three major criticisms are made of Chow’s study: (1) the absence of a proper control group; (2) an unsubstantiated test period; (3) apparent misclassiﬁcation of events during the test period. The authors conclude that, because of these ﬂaws, Chow’s conclusions may be invalid, and future researchers are cautioned against relying on Chow’s ﬁndings. McGahran, Kathleen T. (1988). SEC Disclosure Regulation and Management Perquisites. The Accounting Review LXIII (1): 23–41. In 1978, the SEC issued a release requiring that total compensation include cash compensation plus options, rights, personal beneﬁts and contingent remunerations. The release required that perquisites be included in total remuneration and 177

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that the perquisites be disclosed. These additional disclosures made it practical for the IRS to tax these perquisites. McGahran poses the hypothesis that the compensation of a ﬁrm’s CEO shifts from perquisites to a monetary form as a result of the combined effects of the SEC’s 1978 disclosure requirements and the ensuing IRS decision to tax perquisites. A study of the proxy statements of 85 companies indicates that this hypothesis is true. Miller, Paul B.W. and Robertson, J. (1989). A Guide to SEC Regulations and Publications: Mastering the Maze. Research in Accounting Regulation 3, 239–249. The authors, both former SEC Academic Fellows, organize and clarify the various publications and reporting requirements of the SEC. Four levels of information are discussed: statutes, regulations and forms, Commission Releases, and staff advice. The article contains an organization chart that depicts the relationships among the four information levels. Ten tables are included that provide detail examples of each information source; for example, one table lists the items required by Regulation S-K. The paper provides excellent structure of SEC regulations for those who struggle with the Commission’s diverse reporting requirements. Mims, Robert. (1984). The SEC and Corporate Financial Disclosure: A View From the Press. In: The SEC and Accounting: The First 50 Years – 1984 Proceedings of the Arthur Young Professors’ Roundtable. New York: NorthHolland, 1986. Mims, a ﬁnancial editor for Business Week, assesses the success of the SEC’s efforts to improve ﬁnancial disclosures during the 1970s and early 1980s. He applauds certain changes such as improved quarterly data, annual reports that are more similar to Form 10-Ks, and audited balance sheets for the two most recent years. On the other hand, he criticizes the SEC for its inadequate efforts to foster inﬂation accounting, its mishandling of the oil and gas accounting issue, and for its encouragement of ﬁnancial forecasts. Regarding the last criticism, Mims believes that once management commits itself to a forecast, it will take precipitous, and perhaps ill-advised actions to achieve the forecast. Thus, he believes forecasts should be discouraged.

Moran, Mark and Previts, G.J. (1984). The SEC and the Profession, 1934–1984: The Realities of Self-Regulation. Journal of Accountancy (July): 68–80.

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The authors review the relationship between the SEC and the accounting profession. An historical evaluation of the SEC’s oversight of the accounting profession is presented. The inﬂuences on the establishment of accounting principles exerted by the accounting profession and the SEC are examined. It is concluded that despite its process of self-regulation, the accounting profession has only partially inﬂuenced accounting policies and practices. The article calls for more research to provide a better understanding of the relationships between the public and private sectors as a means of identifying and implementing new reporting techniques.

Moreland, Keith A. (1997). The Effect of SEC Enforcement on Auditor IPO Market Share. Research in Accounting Regulation (volume 11): pp. 73–98. When an auditor performs a substandard audit, the auditor is subject to disciplinary actions by the SEC. This study examines whether the auditor also experiences a decreased market share of IPO audits following the publication of SEC enforcement actions. After controlling for various factors, the results suggest that reports of SEC enforcement actions negatively affect IPO market shares during the period from one to three years after the sanction. Mulford, Charles W. (1992). Bridging the Gap Between Accounting Education and Practice: The SEC Academic Fellow Program. Accounting Horizons 6(4), 86–92. This article provides an overview of the SEC Academic Fellow Program. A brief overview of the SEC’s organization is followed by a short description of the role of the Ofﬁce of the Chief Accountant. The article then describes typical experiences that an SEC Academic Fellow might expect. The information is based partly on a survey of former SEC Academic Fellows in which their views were solicited on their primary project responsibilities, unique experiences, skills and attributes necessary to work in the SEC environment, and impact of their SEC experience on their teaching and research activities.

Newman, D. P. (1981). The SEC’s Inﬂuence on Accounting Standards: The Power of the Veto. Journal of Accounting Research 19 (Supp.): 134–156. In this research project, Newman uses constructs or ‘power’ indices developed by political scientists for the purpose of assessing the following: (1) the ranking 179

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of the SEC and the private-sector policy body in the voting games used to determine accounting standards, assuming a veto role by the SEC; (2) the effect on these rankings of rule and structure changes; (3) the effects of voting ‘blocs’ in the FASB, which always vote similarly on an issue; (4) the effects of formation of homogeneous groups in the FASB; (5) the relative effects on the SEC and FASB as the probability of afﬁrmative votes increases. The author asserts that these indices demonstrate that the SEC’s position improved with the structural change from the APB to the FASB. He concludes that the SEC’s position improved again when the FASB revised its voting rules from 5/7 to 4/7 regarding necessary votes for passage of a standard. The power indices indicate that the coalition formation within the FASB had no impact on these conclusions.

Onis, Linda M. (1984). Why Go Private? Management Accounting (September): 51–54. Going private is a process by which corporations reduce the number of shareholders to a minimal amount so that the corporation is privately held. Several reasons for going private are examined. Methods of going private and the required disclosures to the SEC are reviewed. Advantages and disadvantages of going private are presented and discussed.

Orben, Robert A. (1984). An Evaluation of the SEC’s Performance – A Project of Leadership. The SEC and Accounting: The First 50 Years – 1984 Proceedings of the Arthur Young Professors’ Roundtable. New York: North-Holland, 1986. Orben partly ascribes the accounting performance of the SEC to the leadership attributes of the Chief Accountants. Under Andrew Barr and his predecessors, the SEC was engaged in establishing rules in accounting and auditing matters. He describes the Burton era as one where the status quo was challenged and broad initiatives were taken in the disclosure area. Under Clarence Sampson, the SEC reinforced the role of due process in making changes to reporting requirements. The major initiatives of Barr, Burton and Sampson are described, and he concludes that each man was effective in the role of Chief Accountant. Despite the successes, the author does discuss some initiatives that have been ill-conceived, such as the elevation of the authority of AICPA issue papers to that of ﬁnancial accounting standards. He asserts that the issue papers have not been exposed to traditional due process and may not reﬂect either consensus or the best solution.

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Perry, L. Glenn. (1984). The Regulations of the Accounting Profession and the Problem of Enforcement. The SEC and Accounting: The First 50 Years – 1984 Proceedings of the Arthur Young Professors’ Roundtable. New York: NorthHolland, 1986. Perry, a former Chief Accountant of the SEC’s Division of Enforcement, describes various forms of regulation of accountants and the accounting profession. He discusses six basic forms of regulation as follows: self-regulation, peer regulation, state licensing authorities, private litigation, federal government oversight, and federal government enforcement. Perry concludes that, while the accounting profession has improved its system of regulation, additional steps, such as an increased role by state licensing boards to ensure the competency of newly certiﬁed public accountants, are needed. He believes additional steps must be taken to strengthen the monitoring of the profession and to avoid increased federal intervention.

Perry, L. Glenn. (1984). The SEC’s Enforcement Activities. The CPA Journal (April): 9–13. The (then) Chief Accountant of the SEC’s Division of Enforcement explains the current enforcement activities of the SEC. The SEC’s enforcement priorities are listed, and the area of ﬁnancial fraud, the Commission’s most important enforcement priority, is discussed. The increasing instances of middle-management fraud are examined. Responsibilities of accountants in detecting fraud are presented, and suggestions are made for accountants to utilize in improving their performance.

Persons, Obeua S. (1997). The Effects of Financial Reporting Disputes with the SEC on the Informativeness of Earnings. Research in Accounting Regulation (volume 11): 99–123. This study examines the effect of ﬁnancial reporting disputes with the SEC on the perceived informativeness of earnings. An earnings response coefﬁcient model and an analyst earnings revision model are used to test this possible effect. Results strongly support the hypothesis that reporting disputes are likely to increase the perceived uncertainty in earnings so that market and analyst reactions following dispute disclosures are less pronounced than those before the disclosures.

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Pincus, Karen V., Holder, W.W. and Mock, T.J. (1988). The SEC and Fraudulent Financial Reporting. Research in Accounting Regulation 2, 167–185. The article presents ﬁndings from a study that was performed for the National Commission on Fraudulent Financial Reporting. The study focuses on two key questions: (1) How effective are current SEC policies/activities at preventing, detecting and disciplining fraud, and (2) What potential changes to current SEC policies would be effective in improving fraud deterrence and detection? The article presents the results of a questionnaire (with selected follow-up interviews) that was sent to four different groups: management, CPAs, attorneys, and internal auditors. The results indicated that SEC policies were perceived as at least somewhat effective, but could be improved by requiring stiffer penalties for those participating in fraudulent activities. The evidence also indicated that corporate audit committees should be comprised of a majority of outside directors.

Pownall, Grace and Schipper, Katherine. (1999). Implications of Accounting Research for the SEC’s Consideration of International Accounting Standards for U.S. Securities Offerings. Accounting Horizons 13(3), (September): 259–280. In 1996, the SEC announced that it would apply three criteria in its consideration of the use of international accounting standards for registration purposes. The criteria were as follows: (1) comprehensiveness; (2) high quality, operationalized in terms of comparability, transparency and full disclosure; (3) rigorous interpretation and application. In this 1999 article, Pownall and Schipper survey and analyze empirical archival accounting research and discuss its implications for the SEC’s assessment of international standards. After pointing out the current literature’s limitations in meeting SEC needs, the authors discuss the SEC’s three criteria from the perspective of accounting research. They identify three broad questions addressed by researchers and link the questions to the SEC’s criteria. The research questions are stated as follows: (1) What are the frequencies, magnitudes and value relevance of reconciliations of non-U.S. ﬁrm earnings and shareholders’ equity to U.S. GAAP?; (2) What is the value relevance of non-U.S. GAAP accounting information to non-U.S. and U.S. investors?; (3) Do the interpretation/application and enforcement of accounting standards differ across jurisdictions? The authors conclude that while most of the research does not directly address the SEC’s three criteria, the research efforts have provided indirect evidence that is pertinent to the SEC’s assessment.

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Previts, Gary J. And Thibault, R.H. (1977). Congress and the SEC: An Analysis of Policy Issues and Developments. Accountants Magazine (April): 153–155. Several signiﬁcant events involving the accounting profession, the SEC, and Congress are reviewed to provide an understanding of the environment in which the accounting profession functioned. Critical professional issues of the mid-seventies are outlined. The authors conclude that the impact of political processes, already prominently felt on a national level, will soon affect accountants on a transnational basis. Previts, Gary J. (1978). The SEC and its Chief Accountants: Historical Impressions. Journal of Accountancy (August): 83–91. The paper presents a brief history of events leading to the enactment of he Securities Act of 1933 and the Securities and Exchange Act of 1934. The history of the ofﬁce of Chief Accountant is traced from Carman G. Blough, who accepted the newly created position in 1935 to John C. Burton, who served from June 1972 to September 1976. The backgrounds of the Chief Accountants and their major accomplishments are presented. The paper also traces the evolution of accountancy as a profession and as an economic institution through the major events occurring within the SEC and the profession during each Chief Accountant’s tenure. Previts, Gary J. (1982). Carmen G. Blough: Architect of Financial Disclosure. Journal of Accountancy (January): 92–96. The professional career of Carmen G. Blough, the ﬁrst Chief Accountant of the SEC is presented. Blough’s role in designing the structure of ﬁnancial reporting and related disclosure standards and processes is discussed. Previts, Gary J. (1998). Auditor Independence: A Perspective on Its Origins and Orientations. Research in Accounting Regulation 12, 299–317. This paper provides an historical perspective for the concept of auditor independence. The focus is two-fold: (1) to explain the evolution of the U.S. capital markets and the CPA profession’s role of providing attest and advisory services during the twentieth century; (2) to focus on the origins of auditor independence and how the SEC and the accounting profession have viewed and managed the issue during the past century. In developing the independence concept, the author relies heavily on the writings of Carey and Barr. The second 183

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part of the paper describes and interprets developments in both private and public sectors from early industrial America to the present time. Several key differences in the current professional environment that may diminish the relevance of historical perspective for future standard-setting are presented. The paper concludes by encouraging the Independence Standards Board to consider audit independence from a new perspective, as opposed to the historical one.

The Profession’s Future: New SEC Chairman Harold Williams Speaks Out. (1977). Journal of Accountancy (September): 42–46. This article consists of an interview with Harold Williams that was conducted by the editors of the Journal of Accountancy approximately ﬁve months after he had become chairman of the SEC. Williams’s background and opinions on issues such as illegal payments, peer reviews, and inﬂation accounting are presented. He states that he would like to see the accounting profession become self-governing and self-disciplining. In addition, William’s views on the operations of the SEC and the SEC’s relationship with the accounting profession are expressed. This interview is a valuable resource for researchers seeking the SEC’s perspective on critical issues during the late seventies.

Rajgopal, Shivaram. (1999). Early Evidence on the Informativeness of the SEC’s Market Risk Disclosures: The Case of Commodity Price Risk Exposure of Oil and Gas Producers. The Accounting Review (July): 251–280. This research paper provides evidence that is relevant to the SEC’s 1997 decision to require registrants to disclose quantitative data about their market risk exposure from derivative securities. The research focuses on two of the three permitted disclosure formats; namely, tabular presentations and sensitivity analysis. SEC critics have raised questions concerning the effectiveness of these disclosures; in particular, whether the data could be misleading and whether two similar ﬁrms would have different quantitative analyses because of the alternative reporting options allowed. In an attempt to gather early evidence pertinent to the critics’ questions, the author uses data provided by oil and gas ﬁrms as proxies for required SEC disclosures. The test results indicate that some risk measures that proxy for the SEC-required disclosures are associated with the ﬁrm’s underlying risk exposures, thus indicating that the SEC disclosures will not be misleading. In addition, the test results indicate that each of the alternative formats provide incremental information. Thus, one format may not be a replacement for the

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other and could mean that investors will have difﬁculty comparing risk management activities of ﬁrms that use different reporting formats. Revsine, Lawrence. (1977). The Preferability Dilemma. Journal of Accountancy (September): 80–89. ASR. No 177 requires the independent auditor to ﬁle a letter indicating whether or not, in the auditor’s judgment, a client’s change from one accounting principle to another is preferable under the circumstances. This article examines the issues involved in determining preferability of an accounting principle. Implementation problems associated with the SEC’s preferability rules are discussed. The author states that, given the implementation difﬁculties, the SEC’s objectives in enacting these rules will not be achieved. He asserts that the SEC should temporarily suspend these rules until deﬁnite objectives of ﬁnancial statements are established. He believes a consensus on objectives would facilitate the establishment of accounting principles preferable in given circumstances. Robinson, Haldon G. (1974). Impact of the SEC on Accounting Principles and Auditing Standards. In: Haskins & Sells – Selected Papers – 1974: (November): 65–76. Robinson examines the inﬂuence of the SEC on the development of accounting principles and auditing standards. He gives a brief historical review of the development of accounting principles and auditing standards and discusses the SEC’s policy of relying on the private sector for the promulgation of these technical standards. The author objects to two aspects of the SEC’s philosophy. First, he believes that the SEC views measurement issues as the primary concern of the private sector, whereas, disclosure issues are seen as the primary concern of the SEC. Robinson believes that disclosure matters are an integral part of GAAP and should also be a primary responsibility of the private sector. Second, he disagrees with SEC positions taken in ASR Nos. 148 and 149, where certain disclosure requirements were aimed at professional analysts as opposed to ‘average investors’. He believes that ﬁnancial statement disclosures should be designed to serve reasonably well-informed investors, as opposed to special groups. If special groups need supplemental information, this should be presented separately from the basic ﬁnancial statements. Roulstone, Darren T. (1999). Effect of SEC Financial Reporting Release No. 48 on Derivative and Market Risk Disclosures. Accounting Horizons 13(4), (December): pp. 343–363. 185

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The author selected 25 large SEC registrants and compared disclosures about derivatives and market risk for 1996 and 1997, the year before and the year they adopted FRR No. 48. The study addressed three questions: 1) How did registrants 1997 accounting disclosures compare to their 1996 disclosures?; 2) Did registrants’ FRR No. 48 disclosures accomplish the SEC’s objectives?; 3) Did the registrants’ disclosures display any systematic compliance weaknesses? The author asserted that the quality of the disclosures was less than satisfactory in regard to the amount of detail concerning quantitative measures of market risk. In addition, the registrants failed to adequately discuss their riskmanagement activities. The study concluded that the disclosures did not satisfy the SEC’s goals in issuing FRR No. 48.

Ruhnka, John and Bagby, J.W. (1986). Disclosure: Damned if You Do, Damned if You Don’t. Harvard Business Review (September-October): 34–44. In making public disclosures, management must weigh corporate interests against ﬁnancial market interests. The decision of whether or not to disclose involves legal and economic ramiﬁcations. Knowledge of disclosure requirements established by the SEC and the courts is useful in making disclosure decisions. This article presents important disclosure requirements. Several court cases involving disclosure are summarized. Common mistakes made by managers which lead to disclosure problems are outlined and procedures useful in avoiding these problems are examined.

Sack, Robert J. (1987). The SEC and the Profession: An Exercise in Balance. Research in Accounting Regulation 1, 167–175. The author, who at this writing was the Chief Accountant of the SEC’s Enforcement Division, provides his views on the role of the SEC in the regulation of the profession. He provides brief insights into why the profession’s private sector was given the lead role in the audit area, as opposed to the alternative of having a federal audit core. Sack discusses the SEC’s relationship with auditors by focusing on two landmark cases: Touche Ross & Co. v. SEC and SEC v. Arthur Young & Co. Sack provides his personal view that GAAS goes beyond AICPA pronouncements and includes articles and texts. The author expresses his concerns about revenue recognition problems and calls for the profession to expand its guidelines on revenue recognition. The article concludes with a call for more self-regulation and for a more effective, more visible selfdisciplinary program.

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Sampson, A. Clarence. (1979). The Internal Auditing Profession: Challenges and Opportunities. The Internal Auditor (October): 28–34. Sampson discusses the impact of the Foreign Corrupt Practices Act on internal auditors. He enumerates ﬁve key phases of an effective evaluation of a control system and seven factors that are critical to the effective functioning of an internal control system. He downplays the importance of distinguishing between accounting and administrative controls, stating that the focus should be on whether internal control objectives, such as safeguarding of assets, are achieved. Sampson encourages internal auditors to step forward to meet their expanding responsibilities and stresses that this will require that they function as objectively as possible within the organization. Sanders, T. H. (1936). Inﬂuence of the Securities and Exchange Commission Upon Accounting Principles. The Accounting Review (March): 66–73. This article provides an early and favorable assessment of the SEC’s efforts at regulating accounting practices. The author states that the SEC’s success as a regulatory body will, to a great degree, depend on the development and acceptance of a body of principles upon which it can rely in the administration of its charge. The paper discusses the SEC’s views on various accounting principles and concludes that SEC regulation may strengthen the efforts of the accounting profession in establishing generally accepted accounting principles. Saudagaran, Shahrokh M. (1991). The SEC and the Globalization of Financial Markets. Research in Accounting Regulation 5, 31–53. This article focuses on SEC actions during the 1980s that were aimed at increasing access to U.S. securities markets by foreign companies. The author provides an overview of trends toward globalization of capital markets that began to accelerate in the 1970s and early 1980s. He discusses the impact of globalization on the SEC’s historic neutral stance regarding foreign investments in the U.S. While the SEC desires to facilitate efﬁcient capital markets, conﬂicts arise between this objective and the SEC’s mandate to protect U.S. investors. The paper also discusses the SEC’s move to an integrated disclosure system in 1982 and its impact on foreign registrants. Six key burdensome requirements which hamper foreign registrations are analyzed, and the author credits the SEC for modifying its requirements in most of these problem areas. The author concludes by discussing the SEC’s attempt to resolve differences in 187

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international accounting and auditing practices by participating in the International Organization of Securities Commissions. Schechtman, Daniel. (1977). SEC Commentary – SEC Staff Accounting Bulletins. The CPA Journal (August): 49–50. This article explains that the Staff Accounting Bulletins (SABs) instituted by the SEC Division of Corporation Finance and the Ofﬁce of Chief Accountant represent interpretations and practices followed in administering the disclosure requirements of the federal securities laws. Subjects covered by the SABs issued through June 1976 are summarized. An excerpt from one SAB is presented to illustrate the format used. Schroeder, Nicholas and Gibson, C. (1990). Readability of Management’s Discussion and Analysis. Accounting Horizons 4(4), 78–83. This paper provides a brief, but interesting history of the SEC required MD&A section of the annual report. However, the main purpose of the paper is to assess the readability of MD&A presentations. A sample of 40 ﬁrms was chosen for analysis. The MD&A of each company was compared with that ﬁrm’s ﬁnancial footnotes and to the President’s Letter. Three aspects of the writing style were compared: use of the passive voice, work length, and sentence length. The results indicated that the President’s Letters were signiﬁcantly more readable than either the ﬁnancial statement footnotes or the MD&A. Schuetze, Walter P. (1993). Reporting By Internal Auditors on Internal Controls. The CPA Journal (October): 40–44. Schuetze, a former Chief Accountant at the SEC, states his view that auditor reports on internal controls may not be cost-beneﬁcial. He argues that fraudulent reporting is caused by dishonest management who take advantage of subjective accounting principles. In his view, internal control reports will not alleviate this problem. Considering the incremental costs of auditor reports on internal controls and the dubious beneﬁts, Schuetze is not persuaded that the SEC should require such reports. Seamons, Quinton F. and Rouse, Robert W. (1997). The SEC’s Longest Running Battle: The Savin Case. The CPA Journal (August): 64–66. This article provides the basic facts underlying an SEC administrative action under Rule 2(e) involving an auditor’s standard of professional conduct. After

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an enforcement action was issued by the SEC in 1985, the auditors appealed the case to an appellate court. After a review, the appellate court remanded the case to the SEC, requiring the Commission to deﬁne the standard of conduct under a Rule 2(e), now 102(e), proceeding. In a 2 to 1 ruling, the SEC concluded that under certain circumstances, negligence may constitute improper professional conduct; thus, scienter is not required for a Rule 102(e) violation. Securities and Exchange Commission Requirements. (1935). Journal of Accountancy (February): 81–82. In this 1935 editorial, the requirements under which corporations apply for permanent registration of their securities are described as reasonable and drafted in a manner which implies that the SEC desires maximum information for investors at a minimum burden for the corporation. According to the editorial, the SEC places emphasis on the substance of the required data as opposed to strict regulation concerning its form. Seidler, Lee J. and Wissen, J.L. (1976). The SEC’s Fight Against Unemployment. Harvard Business Review (January-February): 122–134. This is a humorous view of 35 new or expanded positions which have opened up in ﬁrms which serve SEC registrants as a result of the need for personnel who can meet the SEC’s changing concepts of appropriate corporate behavior. Examples of these positions include corporate ﬂagellants, retroactive rectitude strategists, continuous disclosure exhibitionists, and knowing wink and afﬁrmative nod detectors. Seligman, Joel. (1984). The SEC and Accounting: A Historical Perspective. In: The SEC and Accounting: The First 50 Years – 1984 Proceedings of the Professors’ Roundtable. New York: North-Holland, 1986. Seligman addresses the question of whether management has sufﬁcient incentives to voluntarily disclose ﬁnancial information required by investors. After examining these incentives, he states that they are not adequate to ensure proper disclosures and do not hold up when tested empirically. He concludes that SECmandated disclosures are necessary. In the second part of the paper, Seligman describes the evolution toward the SEC’s decision to allow the private sector to set the accounting rules while the Commission retains an oversight role. He then addresses the question of SEC effectiveness in its oversight role. Seligman traces the key events affecting the purchase versus pooling issue and gives 189

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reasons why the SEC did not step in to resolve the controversy. He believes that the SEC was too passive in dealing with accounting controversies of the 1960s and concludes that the Commission should be more aggressive in helping the accounting profession establish accounting principles. Simonetti, Jr., Gilbert, and Andrews, A.R. (1994). A System in Jeopardy – The Tale of Abusive Securities Fraud Suits. Journal of Accountancy (April): 50–54. The article discusses various problems created by abusive lawsuits and calls for reform of the system. The authors cite key provisions in various legislative proposals that have been made to curb abusive securities fraud suits and state three basic objectives that any effective plan for reform must achieve; namely, make it more difﬁcult for professional plaintiffs to ﬁle frivolous suits, make it more difﬁcult for attorneys to use peripheral defendants to increase and coerce settlements, and assure that damages are apportioned in a manner that is fair to both plaintiffs and defendants. The reader should note that this article was written before the Securities Law Reform Act of 1995 was passed. Smith, David B. (1988). An Investigation of Securities and Exchange Commission Regulation of Auditor Change Disclosures: The Case of Accounting Series Release No. 165. Journal of Accounting Research 26(1), 134–145. The SEC issued ASR No. 165 for the purpose of improving the timeliness of reporting potential bad news such as a dispute over an accounting principle which led to a change in auditors. The SEC believed that the pre-ASR 165 requirement that Form 8-K did not have to be ﬁled until a new auditor was hired was causing a delay in reporting negative information to investors. In ASR No. 165, the SEC requires that the 8-K be ﬁled at the termination of the ﬁrm’s predecessor auditor, thus speeding up the release of this information. The purpose of the author’s study is to provide evidence about the need for the change in reporting requirements of ASR 165. After studying hundreds of situations where auditor changes were made, the author concludes that his empirical evidence reﬂects the need for the more timely release of ‘bad news’ disclosure surrounding auditor changes. Sommer, Jr., A.A. (1974). Financial Reporting and the Stock Market: The Other Side. Financial Executive (May): 36–40. This article addresses the criticisms directed toward the disclosure requirements mandated under federal securities laws. In particular, the work of Benston is

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evaluated. Sommer provides major weaknesses which, he believes, invalidate Benston’s ﬁndings. He concludes that disclosure requirements have created an extensive pool of information which investors and analysts can use in evaluating individual securities. The author contends that this pool of information would not be as extensive or accurate if disclosures were not mandated by law. Southern, Douglas G. (1973). SEC Commentary – ASR 147 – Disclosure of Leases. The CPA Journal (December): 1125–1128. New types of leasing arrangements and the increasing practice of ﬁnancing through leasing arrangements created a need for criteria to determine the nature and extent of disclosures of leases in ﬁnancial statements. Despite the private sector’s actions concerning accounting for leases, the SEC issued ASR 147 requiring extended disclosure of lease information. The disclosures required by ASR 147 are presented and discussed. Sprouse, Robert T. (1987). The SEC-FASB Partnership. Accounting Horizons 1(4), 92–95. In this article, Sprouse describes the relationship between the SEC and the FASB as one of cooperation in which the FASB is responsible for setting accounting standards, while the SEC, with the aid of independent auditors, enforces the standards. Sprouse states that the SEC is an important source for identifying transactions that need standards. He identiﬁes three situations where the SEC may ask the FASB for better guidelines. First, where there is a lack of uniformity in accounting for similar events, FASB action may be needed to eliminate ambiguities. Second, the SEC may ask the FASB for standards when a questionable trend of ﬁnancial reporting is discerned. Third, new transactions such as ‘in-substance defeasance’ may create the need for new standards. Sprouse believes that the FASB should not attempt to determine the SEC’s position before issuing a new standard, nor should the SEC attempt to limit the FASB’s alternatives to positions that it favors. Steinberg, Reva and Van Brunt, Roy. (2000). 1999 AICPA National Conference on SEC Developments. The CPA Journal (March): 32–38. This article provides an overview of the SEC’s primary accounting concerns at the end of the twentieth century. The paper covers the main topics discussed at the AICPA sponsored National Conference of SEC Developments which was held in December, 1999. The common thread of the many presentations seemed 191

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to focus on the need for transparent, high-quality ﬁnancial reporting with special emphasis given to revenue recognition. A representative of the SEC’s Division of Corporation Finance listed the following areas of concentration for his division: earnings management, revenue recognition, plain English, management’s discussion and analysis, pro forma ﬁnancial presentations, alternative measures of performance, ﬁnancial statement captioning, loan loss reserves, segment disclosures, and auditor independence. Stice, Earl K. (1991). The Market Reaction to 10-K and 10-Q Filings and to Subsequent The Wall Street Journal Announcements. The Accounting Review 66(1), 42–55. This study focuses on the question of whether the price and volume reactions to earnings announcements occur at the date the 10-K or 10-Q is ﬁled with the SEC or, if later, when the announcement is made in The Wall Street Journal. Tests were performed on daily price and volume data for 342 ﬁrm-quarters for which the SEC ﬁling date preceded the WSJ announcement date by at least four trading days. While the results indicate that there was no signiﬁcant market reaction at the SEC ﬁling date, there was a market reaction at the subsequent WSJ date. The author cautions that almost all ﬁrms included in the sample are small, but concludes that in this speciﬁc set of circumstances, data disclosed as part of an SEC-mandated ﬁling are not fully reﬂected in prices until a subsequent media disclosure is made. Sutton, Michael H. (1997). Auditor Independence: The Challenge of Fact and Appearance. Accounting Horizons 11(1), 86–91. Sutton, the SEC’s Chief Accountant at the time the article was written, comments on problems the public accounting profession faces in the independence area. He states that a changing business environment where public accounting ﬁrms are expanding their list of services and growing into larger multi-service ﬁrms raises two key questions. First, what does the declining relative economic performance of the auditing function mean to the future of the profession? Second, what is the impact on auditor objectivity of business relationships that may create a mutuality of interests between the auditor and client management. Sutton focuses on auditor outsourcing and discusses problems of this new trend. The AICPA’s ethics interpretation dealing with outsourcing is presented, but the author believes the guidelines may be useful in theory, but difﬁcult to maintain in practice. Sutton believes that the public as well as the profession would be better served if services such as internal auditing were

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provided only to non-audit clients. He doubts that ‘ﬁrewalls’ would be recognized by the public as credible, and therefore, not effective at addressing perceptions of conﬂict of interest. Sutton concludes that the profession must avoid solutions that sound good but which are devoid of meaningful constraints. Swaminathan, Siva. (1991). The Impact of SEC Mandated Segment Data on Price Variability and Divergence of Beliefs. The Accounting Review 66(1), 23–41. This article presents evidence regarding the economic effects of disclosing the SEC-mandated segment data. The SEC required segment disclosures in 1970 and the author hypothesized that the release of this data would result in an increase in price variability and that this increased variability is positively correlated with the number of segments. Further, he hypothesized that these segment disclosures decreased divergence of beliefs among market participants and that the magnitude of this belief is positively correlated with the number of segments presented. In each case, the empirical evidence supported the hypothesis. The author concluded that segment data were associated with a reduction in the systematic risk, increase in the accuracy of earnings forecasts, a lower divergence of beliefs, and an increase in price variability around the dates of release of 10-K reports containing segment data. Taylor, J. R. (1941). Some Antecedents of the Securities and Exchange Commission. The Accounting Review (June 1941): 188–196. This paper explores relevant events which occurred in the areas of accountants’ duties and increasing legal responsibilities prior to enactment of the Securities Act of 1933. The purpose is to provide an historical perspective from which to view the development of accounting standards and legal responsibilities under the SEC legislation. The Ultramares case is presented as the ﬁrst indication of accountants’ increasing responsibilities. The author concludes that if the historical trends had been clearer, the enactment of the Securities Act of 1933 would not have been so surprising. Testimony Before the Subcommittee on Commerce and Finance of the Committee on Interstate and Foreign Commerce, House of Representatives. (1964). Statements in Quotes – Uniformity in Accounting. Journal of Accountancy (June): 56–61. A transcript of the testimony of the Chairman and Chief Accountant of the SEC at House hearings is presented. The Committee expresses concern over the lack 193

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of uniformity in accounting principles and requests information from the SEC pertaining to those areas of accounting where alternative practices could produce materially different results under generally accepted accounting principles. This information, as provided by the SEC, is presented. Thomas, Barbara S. (1983). SEC Oversight Role in Self-Regulation. The CPA Journal (May): 10–15. The self-regulation procedures of the accounting profession are reviewed. Beneﬁts of self-regulation to the accounting profession, the SEC, and the public are examined. The SEC Practice Section of the AICPA Division for Firms and the Public Oversight Board are acknowledged as effective means of self-regulation which are relied on by the SEC in fulﬁlling its regulatory responsibilities. Turner, Lynn E. and Godwin, Joseph H. (1999). Auditing, Earnings Management and International Accounting Issues at the Securities and Exchange Commission. Accounting Horizons 13(3) (September): 281–297. This article discusses efforts underway in the SEC’s Ofﬁce of the Chief Accountant at the end of the twentieth century to improve the SEC’s oversight role and enhance the transparency of ﬁnancial statements. The paper is divided into three parts: 1) a discussion of issues related to audit committees and auditors; 2) a report on ﬁve accounting issues that the SEC has recently focused on; namely, allowances for loan losses, loss accruals, goodwill, in-process research and development, and revenue recognition; 3) a brief assessment of the International Accounting Standards Committee’s core standards. The authors conclude by providing a list of research questions that would be fruitful for additional investigation. Wallace, Wanda A. (1989). A Historical View of the SEC’s Reports to Congress on Oversight of the Profession’s Self-Regulatory Process. Accounting Horizons 3(4), 24–39. The author reviews efforts of the SEC to provide oversight to the accounting profession’s self-regulatory process. The primary sources of the author’s perspectives are the SEC’s annual report to congress and the Public Oversight Board’s annual reports. The time frame for the review is the 1980–1985 period. The initial focus of the article is on the degree of participation in the SECPS, but Wallace proceeds to discuss the SEC’s attitude toward the peer review process, the role of the Special Investigations Committee (SIC), and the SEC’s

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interest in sanctions. She concludes by discussing historical patterns that were discerned along with implications for future SEC regulatory efforts. Weidenhammer, Robert. (1933). The Accountant and the Securities Act. The Accounting Review (April): 272–278. The Securities Act of 1933 is criticized for its oppressive features. It is stated that the risk which must be assumed by the accountant signing the registration statement is much greater than any possible beneﬁts that may be derived from the accountant’s services. A summary of the Securities Act of 1933 is presented. Opposition to the Act, concerning its impositions of liability, is discussed. It is concluded that the liability provisions of the Act should apply only to the issuance of bonds, not stocks. The author contends that applying these liability provisions to the issuance of stocks will unduly restrict the ﬂow of capital from private investors. Werntz, William W. (1953). The Impact of Federal Legislation Upon Accounting. The Accounting Review (April): 159–169. This paper is concerned with the nature of governmental inﬂuence exerted directly or indirectly on accounting thought and its reﬂection in accounting theory and practice; how this inﬂuence has been brought to bear; and, whether this inﬂuence has had harmful or helpful short-term and long-term effects. The development of a concept of accounting is presented to demonstrate the beneﬁcial and non-beneﬁcial inﬂuences exerted by administrative agencies. Werntz describes three non-beneﬁcial inﬂuences and two beneﬁcial inﬂuences. He concludes that the non-beneﬁcial and beneﬁcial inﬂuences counterbalance each other and allow accounting concepts and practice to develop further, and faster than would otherwise be possible. Wheat, Francis M. (1967). ‘Truth in Securities’ Three Decades Later. Howard Law Journal, 13. Wheat, a former SEC commissioner, discusses some of the highlights of the Securities Acts Amendments of 1964. He notes that the 1964 legislation extended the disclosure requirements of the Securities Exchange Act of 1934 to larger over-the-counter companies. Wheat also discusses how professional groups such as the AICPA have aided the SEC in its effort to improve ﬁnancial practices and disclosures. 195

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Williams, Harold M. (1977). Audit Committees – The Public Sector’s View. Journal of Accountancy (September): 71–74. Williams, the Chairman of the SEC at the time of this article, begins by reviewing the evolution of the concept of audit committees. The SEC ﬁrst recommended that audit committees be established in 1940. The author discusses the potential beneﬁts of audit committees from the perspective of the company, the board of directors, and both internal and external auditors. He states that all audit committees should be charged with seven minimal responsibilities. Williams concludes that audit committees should operate in an oversight and advisory role and avoid intruding into the realm of management decisionmaking. Wriston, Kathryn D., Domenick, J.E., and Fox, J.L. (1996). How Objective Are Outside Auditors?. Journal of Accountancy (February): 36–38. In 1994, the SEC’s Chief Accountant, Walter Schuetze, gave a speech in which he questioned the objectivity and independence of outside auditors. In response, the Public Oversight Board appointed an advisory panel to study the problem and to make recommendations for improvements. The present article gives the views of three prominent individuals involved in the ﬁnancial reporting process and presents their thoughts on the POB advisory panel’s recommendations. In general, the three respondents believe that the auditors, for the most part, are objective and exercise independent judgment; however, two of the respondents disagree with speciﬁc proposals made by the advisory panel. Wyatt, Arthur R. (1991). The SEC Says: Mark to Market!. Accounting Horizons 5(1), 80–84. In this article, Arthur Wyatt comments on the movement toward mark to market accounting for certain investment securities. He believes that the use of different accounting rules in different industries has led to an uneven playing ﬁeld. He argues that the failure to use mark to market in the S & L industry may have led to bad management decisions and exacerbated the S & L debacle. The primary focus of the article is on the testimony of SEC Chairman Richard C. Breeden in which Breeden called for the adoption of market-based measures of accounting, especially for bank and thrift institutions. The article also provides a brief narrative on the evolution of mark to market accounting. Wyatt concludes by posing several questions that merit attention by accounting researchers regarding mark to market accounting.

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Wyatt, Arthur R. and Craig, J.L. (1996). The Future of Private Sector Standard Setting. The CPA Journal (December): 26–33. This article consists of an interview of Arthur Wyatt by James Craig, an editor of The CPA Journal. In the interview, Wyatt gives his views on the ability of the private sector to continue to formulate accounting principles. Wyatt gives an interesting historical perspective on the role of the Financial Accounting Foundation (FAF) and provides candid insights into problems that the FASB has been forced to confront. He concludes that the appointment of two new public members to the FAF along with the appointment of a new FASB chairman may enable the private sector to continue its standard-setting role into the next century. Youngdahl, Curtis E. (1965). The CPA and the Securities Acts Amendments. Financial Executive (April): 10–16+. The major provisions of the Securities Acts Amendments of 1964 are presented. These Amendments substantially increase the number of companies who must register their securities with the SEC; extends the SEC’s regulations to these newly registered companies and the companies with unlisted securities previously registered with the SEC; changes certain reporting requirements; and, increases the SEC’s control of brokers and dealers in securities. The effects of these Amendments are examined as they apply to four classes of companies: unlisted companies not previously reporting to the SEC (other than special industries); special industries; unlisted companies already reporting to the SEC; and, listed companies. It is emphasized that the requirements for initial registration of securities under the Securities Act of 1933 have not been reduced by the Amendments. Zecher, J. Richard. (1984). An Economic Perspective of SEC Corporate Disclosure. The SEC and Accounting: The First 50 Years – 1984 Proceedings of the Arthur Young Professors’ Roundtable. New York: North-Holland, 1986. Zecher, a former Chief Economist at the SEC, states that modern corporate ﬁnance theory provides a framework for analyzing the SEC’s corporate disclosure system. He discusses recent changes in corporate ﬁnance theory and their relevance to the SEC’s disclosure system. These changes include portfolio theory, capital asset pricing theory, efﬁcient market theory, and agency theory. Zecher concludes that these theories present numerous questions that remain to be answered by future research. 197

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Zeff, Stephen A. (1995). A Perspective on the U.S. Public/Private-Sector Approach to the Regulation of Financial Reporting. Accounting Horizons 9(1), 52–70. The author describes the ﬁnancial reporting system in the U.S. whereby the FASB collaborates with the SEC to establish accounting standards. The corroborative effort is basically described as cooperative, although disagreements arise occasionally. The SEC is described as heavy-handed in its enforcement efforts. Zeff believes this approach has fostered ‘a climate of conformity’ and has discouraged experimentation with unique approaches to measuring and disclosing accounting data. The SEC’s attitude is attributed to its focus on preventing misleading ﬁnancial statements. The author concludes the article by comparing the U.S. approach to ﬁnancial reporting to approaches used in other countries. The comparison is made along four lines of thought: 1) the breadth of the user group; 2) factors that led to more detailed and numerous rule-making in the U.S.; 3) the effects of differential rule-making climates; 4) the effect of the SEC’s rigorous enforcement system.

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AUDITORS AND THE POST-LITIGATION REFORM ACT ENVIRONMENT Ross D. Fuerman

ABSTRACT The Private Securities Litigation Reform Act of 1995, which became law on December 22, 1995, is the ﬁrst comprehensive revision of the federal securities laws since their enactment 65 years ago. The post-Reform Act period ended when the Securities Litigation Uniform Standards Act of 1998 became law on November 3, 1998. The role of auditors in the ﬁnancial disclosure private securities class action lawsuits commenced during the post-Reform Act period is the subject of this study. The analysis, which includes multiple logistic regression of 468 private securities class actions in the United States and Canada, suggests several trends. First, the deep pockets motivation is weakening, and auditor quality (a component in determining auditor culpability) is strengthening, as determinants in naming auditors defendants. In addition, auditors are less likely to be named defendants in federal-only lawsuits than in parallel proceedings. These both suggest a reduced auditor liability exposure in the future. Conversely, a larger number of private securities class actions are being ﬁled, which suggests an increased auditor liability exposure in the future. Also, foreign companies are increasingly being sued in private securities class actions.

Research in Accounting Regulation, Volume 14, pages 199–218. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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1. INTRODUCTION On December 22, 1995, the United States Congress overrode President Clinton’s veto and passed the Private Securities Litigation Reform Act of 1995 (‘Reform Act’). The Reform Act is the ﬁrst comprehensive revision of the federal securities laws since their enactment 65 years ago (Phillips & Miller, 1996). On November 3, 1998, President Clinton signed into law the Securities Litigation Uniform Standards Act of 1998 (‘Uniform Standards Act’). The role of auditors in the ﬁnancial disclosure private securities class action lawsuits commenced between these two dates (‘post-Reform Act period’) is the subject of this chapter. It is premature to conclusively study the post-Reform Act period, as the resolution of many of these lawsuits has not yet occurred. However, litigants, their counsel, and academics need to understand, to the extent possible, what happened during the post-Reform Act period. By studying the post-Reform Act Period, we have our best likelihood of ﬁguring out how the future might differ from past patterns, or, more correctly, what are generally perceived as past patterns. The general perception of past patterns of litigation involving auditors has, by necessity, been largely formed by researchers that collected litigation data from secondary sources or, at best, visited a few federal courthouses.1 However, the Public Access to Court Electronic Records (‘PACER’) system is now nearing completion. Eighty-eight of the ninety-four United States District Courts can now be visited electronically via modem.2 Researchers can inspect all of these courts’ recent docket sheets. There is no longer any guesswork as to whom, in a federally ﬁled securities class action, was named a defendant and when and in which United States District Court this occurred. There is no longer any guesswork as to when the litigation commenced. Also, because of the notice provisions of the Reform Act, Section 21(D)(A)(3)(a)(i) of the Securities Exchange Act of 1934, the complaints ﬁled against auditors that don’t name the company itself, whose docket sheets were formerly incomprehensible, can now easily be correctly matched with the appropriate body of litigation. Good securities litigation research requires good securities litigation data. The securities litigation data of the pre-Reform Act period is inferior securities litigation data, compared to the securities litigation data of the Post-Reform Act Period. Absent special circumstances, it should be avoided by researchers and the results of studies that did use it should be viewed with caution. Congress, persuaded that many frivolous securities class actions had been ﬁled, determined to make it more difﬁcult for plaintiffs to successfully litigate these lawsuits. This was expected to deter the ﬁling of frivolous private securities class actions, while permitting meritorious suits to proceed. The provisions

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intended to achieve this result were primarily changes in the legal standards for deciding pre-trial motions, changes in the discovery rules, and a change from (very roughly speaking) joint and several liability to proportionate liability. All of these changes were intended to give a pro-defendant tilt to private securities class action litigation.3 Shortly after the passage of the Reform Act, plaintiffs began ﬁling private securities class actions in unprecedented numbers in the state courts. This dramatic change was perceived by many observers as motivated by plaintiffs’ desire to avoid application of the Reform Act, which by its terms only applies to private securities class actions ﬁled in the federal courts. Congress was persuaded that it needed to put a stop to this migration to the state courts. Finally, on November 3, 1998, President Clinton signed into law the Uniform Standards Act. The Uniform Standards Act, with few exceptions, prevents the litigation of any signiﬁcant private securities class action in a state court.4 This study investigates the role of auditors in private securities class actions in the post-Reform Act period. The results of the study, based on 468 private securities class actions commenced during the post-Reform Act period, indicate that the issuance by the Securities and Exchange Commission (‘SEC’) of an Accounting and Auditing Enforcement Release (‘AAER’), bankruptcy of the defendant company, the length of the plaintiff class period, and the restatement of a previously issued audited annual ﬁnancial statement are all positively associated with naming the auditor a defendant. In addition, the presence of a Big Six auditor is negatively associated with naming the auditor a defendant. The study proceeds as follows. The next section discusses prior literature. Section 3 develops the study’s hypotheses. Section 4 describes the method of data analysis. Section 5 presents the empirical model. Section 6 reports the results of the empirical tests. In the ﬁnal section, conclusions, implications of the ﬁndings, limitations and the need for further research are discussed.

2. PRIOR SECURITIES LITIGATION STUDIES FOCUSING ON THE ROLE OF THE AUDITOR Fuerman (1997) studied 476 private securities class actions ﬁled in state and federal courts in the United States from April 1992 to April 1995. The PACER system, though less complete then than it is today, was used to enhance the data collection. The results of the study indicated that the issuance of an Accounting and Auditing Enforcement Release (‘AAER’) naming the auditor a defendant, the issuance of an AAER naming company management defendants, bankruptcy of the defendant company, the length of the plaintiff 201

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class period, and the restatement of a previously issued audited annual ﬁnancial statement were all positively associated with naming the auditor a defendant. The meaning of these ﬁndings is not conclusive, as there is not a one-to-one correspondence between the constructs developed to explain why auditors are named defendants in some private securities class actions, and the measures or operationalizations of those constructs. Auditor culpability is a factor, and it is most clearly measured by the SEC issuing an AAER naming the auditor a defendant in an enforcement action. Deep pockets motivation is also a factor, and it is most clearly measured by bankruptcy of the defendant company. Finally, but not so obviously, management culpability is a factor, and it is most clearly measured by the SEC issuing an AAER naming management defendants in enforcement action. Management is more culpable for fraud than errors. As Young (2000) observes, ﬁnancial disclosure fraud starts out small, in hazy areas of ﬁnancial reporting, where the application of GAAP is unclear. It then escalates, perhaps to premature revenue recognition, escalates further, perhaps to ﬁctitious revenue recognition, and from misstated quarters to misstated annual statements. Concommitantly, of course, management culpability is increasing, but additionally, auditor culpability is increasing. At some point, the auditor becomes responsible to detect and reveal the fraudulent ﬁnancial disclosure. The exact point is a matter of law and the relevant facts and, in most private securities class actions, is hotly disputed. Nonetheless, it seems logical for plaintiffs to use heavy, or obvious management culpability, as a crude heuristic for deciding to name auditors as defendants. Bonner et al. (1998) studied AAER’s issued by the Securities and Exchange Commission from 1982 to 1995. With respect to some AAER’s, a private securities class action was ﬁled, and in some of the class actions, the auditor was named a defendant. As the average AAER issuance is preceded by three years by its associated private securities class action (Fuerman, 1997), the time period of the commencement of the private securities class actions was roughly 1979 to 1992. Very few of the United States District Courts maintain pre-1990 docket sheets in their databases (which in turn are accessed via the PACER system). Thus, the private securities litigation data used in Bonner et al. (1998) cannot be as accurate as that of Fuerman (1997). Yet, AAER’s are an unsurpassed data source for the details of the ﬁnancial disclosure fraud. In contrast, in private securities class action documents (for example, complaints and briefs), there is often a dispute as to whether a ﬁnancial disclosure misstatement occurred, in addition to whether it was an error or a fraud, as well as the accounts affected. Bonner et al. (1998) found, as did Fuerman (1997), that bankruptcy of the defendant company, and the SEC naming the auditor a defendant in its enforcement action, were both positively associated with naming the auditor a defendant

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in the private securities class action. They also found the presence of allegedly misstated annual ﬁnancial statements, a ‘severe’ action by the SEC, ﬁctitious transactions (for example, ﬁctitious revenues), and misstated revenue (whether ﬁctitious or prematurely recognized) to be associated with naming the auditor a defendant. Fuerman (1998) provided limited evidence on the naming of auditors as defendants in the post-Reform Act period. One ﬁnding was no change, through October 21, 1996, in the proportion of auditor defendants in the private securities class actions. Bankruptcy, restatement of audited annual ﬁnancial statements, and class period length were used as control variables. The current study extends Fuerman (1998) along three dimensions. First, it examines the entire post-Reform Act period (i.e. through November 2, 1998). Second, it tests a variable that has not previously been examined in this context: the presence of a Big Six5 auditor. Third, the study provides insights into what to expect in the post-Uniform Standards Act period by identifying trends that developed during the post-Reform Act period.

3. DEVELOPMENT OF THE HYPOTHESES Auditor culpability, management culpability and the deep pockets motivation are the important factors in the plaintiff deciding to name the auditor a defendant. The most clear measure of auditor culpability is the issuance of an AAER naming the auditor a defendant in an enforcement action. However, this is such a rare event in the data used for this research that it appears, for now, to be an impractical measure. The most clear measure for management culpability is the issuance of an AAER naming management defendants in an SEC enforcement action. As in Fuerman (1997), the hypothesis is as follows: H1: The issuance of an AAER naming management defendants in an SEC enforcement action is positively associated with naming the auditor a defendant. In multidefendant litigation, a plaintiff must consider both the resources of the potential auditor defendant as well as the resources of other actual or potential defendants. The deep pockets motivation to name the auditor a defendant is strong if the resources of the auditor are substantial and/or if the resources of other actual or potential defendants are insubstantial, relative to the potential liability exposure. With respect to the other defendants, the company itself is of primary importance, because other potential defendants cannot be more 203

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culpable and thus legally vulnerable, than the company itself. Thus, the most clear measure for deep pockets motivation is bankruptcy of the defendant company. As in Fuerman (1997), the hypothesis is as follows: H2: Company bankruptcy is positively associated with naming the auditor a defendant. A Big Six auditor has more substantial resources than other auditors. However, a Big Six auditor also theoretically provides higher audit quality than other auditors (DeAngelo, 1981) and should thus tend to be less often culpable. Although Palmrose (1988) demonstrated this in a litigation context, her analysis was unconvincing because it was univariate. Attempts by Stice (1991) and Heninger (1997) to demonstrate in multivariate analysis a negative association of Big Six auditors with pre-Reform Act auditor litigation failed. Apparently, the higher audit quality construct could not overcome the deep pockets construct in this measure. However, with the institution of proportionate liability, and the concommitant reduction in the importance of the deep pockets motivation, the analysis of post-Reform Act period litigation data should lead to a different result. This leads to the third hypothesis: H3: A Big Six auditor is negatively associated with naming the auditor a defendant. Multivariate analysis requires additional control variables. The ﬁrst of these is company size. Big Six auditors are the auditors of the relatively large companies. Company size is thus a necessary control variable, to measure the association of Big Six auditor with naming the auditor a defendant, separate and distinct from the association of company size with naming the auditor a defendant. Restatement of audited annual ﬁnancial statements, in non-routine circumstances, is a tacit admission of management culpability and, arguably, auditor culpability.6 This is a less than ideal measure, as it operationalizes two constructs, not one, but its inclusion is necessary because it has been shown in prior research (Fuerman, 1997) to be positively associated with naming the auditor a defendant. Finally, plaintiff class period length has also been shown in prior research (Fuerman, 1997) to be positively associated with naming the auditor a defendant. The class period refers to the time period that deﬁnes which investors may be included as plaintiffs in a securities class action. It begins with the issuance of the ﬁrst false statement that allegedly inﬂated the security’s price and it ends when the security’s price is alleged to reﬂect the corrected information. Arguably, this measure operationalizes all three constructs, but its inclusion is needed because of its demonstrated positive signiﬁcance in prior research (Fuerman, 1997).

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Data constraints require the omission of several variables shown to be significant in Bonner et al. (1998). The determination of whether the misstated ﬁnancial statements were quarterly or annual is difﬁcult with a large number of observations. The same situation applies to analysis of the particular accounts misstated and whether the misstatements were premature or ﬁctitious. Finally, insufﬁcient observations have an AAER associated with them to meaningfully categorize the severity of the SEC action.

4. METHOD OF DATA ANALYSIS The sample of securities class actions was taken from the February 1996 through November 1999 issues of Securities Class Action Alert.7 All of the lawsuits concerned allegedly deﬁcient ﬁnancial disclosure by companies. For example, securities lawsuits that solely concerned oppression of minority shareholders, unfair merger terms, or unfair tactics used during takeovers, were excluded.8 All of the lawsuits are private (i.e. not SEC enforcement actions) securities class actions. Also, all of the lawsuits were commenced (the initial complaint was ﬁled) December 22, 1995 through November 2, 1998 in federal or state courts in the United States.9 The litigation data were collected from SCAA, PACER, LEXIS NEXIS, and Internet sites securities.stanford.edu and www.milberg.com. The accounting, auditing and bankruptcy data were obtained from all the above sources except PACER. In addition, LASER D was used, as well as contacts with courts and attorneys. The total number of private securities class actions was 478. Due to incomplete data, as well as some lawsuits involving companies whose annual ﬁnancial statements were unaudited, the ﬁnal sample was reduced to 468.

5. THE EMPIRICAL MODEL The hypotheses were tested using a multiple logistic regression model. The model is as follows: NAMED

= β0 + β1AAER + β2BANKRUPT + β3BIGSIX + β4CLASS + β5LNTA + β6RESTATE+ e

The variables are deﬁned as follows: NAMED AAER

= 1 = auditor named defendant; 0 = otherwise; = 1 = management named defendants in SEC enforcement action; 0 = otherwise; 205

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BANKRUPT

BIGSIX CLASS LNTA RESTATE

ROSS D. FUERMAN

= 1 = defendant company experienced bankruptcy within one year before or after the ﬁling of the lawsuit; 0 = otherwise; = 1 = Big Six auditor; 0 = otherwise; = plaintiff class period in months; = natural log of total assets; and = 1 = culpable restatement of audited annual ﬁnancial statements; 0 = otherwise.

With respect to H1, it is predicted that β1AAER has a positive association with NAMED. With respect to H2, it is predicted that β2BANKRUPT has a positive association with NAMED. With respect to H3, it is predicted that β3BIGSIX has a negative association with NAMED. Control variables CLASS and RESTATE are included in the model, as each has been found positively associated with naming auditors defendants in private securities class actions. The control variable LNTA is needed to meaningfully measure the association of BIGSIX with NAMED, as large companies (compared to small companies) tend to have Big Six auditors.

6. EMPIRICAL RESULTS Table 1 reports means, standard deviations, and univariate analysis based on simple logistic regression Wald probability values, for each explanatory variable. With the exception of LNTA, the company size variable, each is associated with naming the auditor a defendant at a one percent level of signiﬁcance. In one of the AAER’s (Systems of Excellence), the auditor, in addition to management, was named a defendant in the enforcement action, as well as in the private securities class action. There are relatively few (17) AAER’s with management defendants because AAER’s lag the commencement of litigation by three years on average (Fuerman, 1997) and data was collected one year after the end of the period under study. In contrast, in Fuerman (1997), the data were collected two and one half years after the period studied and there were 51 AAER’s. Also, compared to Foster et al. (undated), there are few observations with RESTATE. Foster et al. (undated) provide scant information on restatements, but it appears that they counted both quarterly and annual restatements. This study counts only annual restatements. Table 2 presents the results of multivariate analysis. Hypotheses 1, 2 and 3 are supported. AAER has a positive association with naming the auditor a defendant, BANKRUPT has a positive association with naming the auditor a defendant, and BIGSIX has a negative association with naming the auditor

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Table 1. Descriptive and Univariate Statistics Variable and direction (+ or –) of association with response variable NAMED

All Lawsuits (n=468) Mean or % (Std Dev)

Auditor Not Named Defendant (n=385) Mean or % (Std Dev)

Auditor Named Defendant (n=83) Mean or % (Std Dev)

Wald p-value Simple Logistic Regression

AAER1 +

3.6% (0.2)

0.8% (0.1)

17.0% (0.4)

0.0001

BANKRUPT1 +

9.4% (0.3)

6.5% (0.2)

22.9% (0.4)

0.0056

BIGSIX1 –

87.6% (0.3)

89.6% (0.3)

78.3% (0.4)

0.0045

CLASS +

11.6 (10.0)

9.7 (7.6)

20.4 (14.2)

0.0001

LNTA –

11.9 (2.1)

11.9 (2.2)

11.8 (2.1)

0.6114

13.0% (0.3)

6.2% (0.2)

44.6% (0.5)

0.0001

RESTATE1 + 1

Dichotomous explanatory variable. First row indicates percentage having a value of 1.

NAMED AAER BANKRUPT BIGSIX CLASS LNTA RESTATE

= = = = = = =

1 = auditor named defendant; 0 = auditor not defendant (response variable) 1 = management defendants in AAER issued by SEC; 0 = otherwise 1 = bankruptcy one year before or after ﬁling of lawsuit; 0 = otherwise 1 = Big Six auditor; 0 = other auditor plaintiff class period in months natural log of thousands of dollars of total assets 1 = culpable restatement of audited annual ﬁnancial statements; 0 = otherwise.

a defendant. For each, the association is signiﬁcant at a one percent level. The model is signiﬁcant. Its classiﬁcation accuracy is 81% and its adjusted pseudoR2 is 0.46.10 Researchers have asserted, without offering convincing evidence, that there is an association between the industry sector and the occurrence of a private securities class action and/or naming the auditor a defendant in a lawsuit. Table 3 shows a breakdown, by four digit Standard Industrial Code, of industry sectors. There is a lack of consensus as to what really comprises the high technology sectors and the ﬁnancial services sectors, but both the deﬁnitions used by Jones and Weingram (1996) and Bonner et al. (1998) are fairly consistent. Auditors 207

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Table 2. Multiple Logistic Regression Results Response Variable: Auditor Named Defendant (1) versus Auditor not Named Defendant (0) Explanatory Variable

Parameter Estimate

Standard Error

Wald Chi-Square

Probability Value

Odds Ratio

Intercept AAER BANKRUPT BIGSIX CLASS LNTA RESTATE

–3.8368 2.6807 1.2990 –1.3134 0.0819 0.1161 2.6297

0.9712 0.7904 0.4228 0.4621 0.0148 0.0849 0.3745

15.6054 11.5031 9.4407 8.0782 30.5071 1.8678 49.3070

0.0001 0.0007 0.0021 0.0045 0.0001 0.1717 0.0001

14.595 3.666 0.269 1.085 1.123 13.870

NAMED AAER BANKRUPT BIGSIX CLASS LNTA RESTATE

= = = = = = =

1 = auditor named defendant; 0 = auditor not defendant (response variable) 1 = management defendants in AAER issued by SEC; 0 = otherwise 1 = bankruptcy one year before or after ﬁling of lawsuit; 0 = otherwise 1 = Big Six auditor; 0 = other auditor plaintiff class period in months natural log of thousands of dollars of total assets 1 = culpable restatement of audited annual ﬁnancial statements; 0 = otherwise.

Number of Observations –2 Log Likelihood Chi-Square for Model (6 degrees of freedom) p-Value Percentage Correctly Classiﬁed (at .136 relative frequency of naming of auditors) Pseudo R2 Pseudo Adjusted R2

468 285 153 0.0001 81% 0.28 0.46

have a propensity to be named defendants in class actions involving companies in ﬁnancial services. Conversely, they tend to not be named defendants in class actions involving high technology companies. However, the latter statement is simplistic. More accurately, auditors tend to not be named defendants in class actions involving high technology companies, with the exception of SIC 7372, Prepackaged Software. In SIC 7372, auditors tend to be named defendants in class actions. Jones & Weingram (1996) explained the high prevelance of securities class actions in the high technology sectors as due to these sectors having a relatively high estimated cumulative turnover of shares traded (which can lead to relatively high estimated damages and concommitant settlements). Their explanation may help to explain why auditors are named defendants. Possibly, estimated cumulative turnover is the key, industry sectors are irrelevant, and a detailed analysis would show that SIC 7372 does not have a relatively high estimated cumulative turnover, in contrast to all of the other high technology sectors.

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Table 3. Industry Sector Analysis Industry Sector

SIC

Suits

Auditor Def

Veterinary Services for Animal Specialties Gold Ores Silver Ores Crude Petroleum and Natural Gas Drilling Oil and Gas Wells Oil and Gas Field Services, NEC Bridge, Tunnel, and Elevated Highway Construction Electrical Work Special Trade Contractors, NEC Frozen Specialties, NEC Animal and Marine Fats and Oils Malt Beverages Bottled and Canned Soft Drinks and Carbonated Waters Broadwoven Fabric Mills, Manmade Fiber and Silk Lace and Warp Knit Fabric Mills Men’s and Boys’ Underwear and Nightwear Men’s and Boys’ Clothing, NEC Women’s, Misses’ and Juniors’ Suits, Skirts, and Coats Women’s, Misses’, and Juniors’ Outerwear, NEC Ofﬁce Furniture, Except Wood Stationery, Tablets, and Related Products Periodicals: Publishing, or Publishing and Printing Books: Publishing, or Publishing and Printing Commercial Printing, NEC Plastics Material and Synthetic Resins, and Nonvulcanizable Elastomers Pharmaceutical Preparations In Vitro and In Vivo Diagnostic Substances Biological Products, Except Diagnostic Substances Soaps and Other Detergents, Except Speciality Cleaners Chemicals and Chemical Preparations, NEC Luggage Pressed and Blown Glass and Glassware, NEC Nonmetallic Mineral Products, NEC Cold-Rolled Steel Sheet, Strip, and Bars Drawing and Insulating of Nonferrous Wire Metal Shipping Barrels, Drums, Kegs, and Pails Hardware, NEC Iron and Steel Forgings Coating, Engraving, and Allied Services, NEC

742 1041 1044 1311 1381 1389 1622 1731 1799 2038 2077 2082

1 4 1 4 1 1 1 1 1 1 1 1

0 0 1 0 0 1 0 0 0 0 0 0

0 0 100 0 0 100 0 0 0 0 0 0

2086 2221 2258 2322 2329

2 2 1 1 2

1 0 0 0 0

50 0 0 0 0

2337 2339 2522 2678 2721 2731 2759

1 2 1 2 1 2 1

0 1 0 0 0 0 0

0 50 0 0 0 0 0

2821 2834 2835 2836

1 11 1 1

0 1 0 0

0 9 0 0

2841 2899 3161 3229 3299 3316 3357 3412 3429 3462 3479

1 2 1 1 1 1 1 1 1 1 1

0 0 0 0 1 0 0 0 0 1 0

0 0 0 0 100 0 0 0 0 100 0

209

Percent

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Table 3. Continued Industry Sector

SIC

Suits

Auditor Def

Percent

Paper Industries Machinery Printing Trades Machinery and Equipment Special Industry Machinery, NEC Electronic Computers Computer Storage Devices Computer Terminals Computer Peripheral Equipment, NEC Motors and Generators Carbon and Graphite Products Electric Housewares and Fans Household Audio and Video Equipment Phonograph Records and Prerecorded Audio Tapes and Disks Telephone and Telegraph Apparatus Radio and Television Broadcasting and Communications Equipment Communications Equipment, NEC Printed Circuit Boards Semiconductors and Related Devices Electronic Components, NEC Storage Batteries Magnetic and Optical Recording Media Truck and Bus Bodies Aircraft Industrial Instruments for Measurement, Display, and Control of Process Variables; and Related Products Instruments for Measuring and Testing of Electricity and Electrical Signals Laboratory Analytical Instruments Optical Instruments and Lenses Measuring and Controlling Devices, NEC Surgical and Medical Instruments and Apparatus Orthopedic, Prosthetic, and Surgical Appliances and Supplies Dental Equipment and Supplies Electromedical and Electrotherapeutic Apparatus Ophthalmic Goods Photographic Equipment and Supplies Games, Toys, and Children’s Vehicles, Except Dolls and Bicycles Sporting and Athletic Goods, NEC Manufacturing Industries, NEC Railroads, Line-haul Operating

3554 3555 3559 3571 3572 3575 3577 3621 3624 3634 3651

1 3 2 4 7 1 15 1 1 1 2

1 1 0 0 0 0 1 0 0 1 2

100 33 0 0 0 0 7 0 0 100 100

3652 3661

1 13

0 1

0 8

3663 3669 3672 3674 3679 3691 3695 3713 3721

10 4 1 13 1 2 2 1 3

0 2 0 1 0 0 0 0 0

0 50 0 8 0 0 0 0 0

3823

1

0

0

3825 3826 3827 3829 3841

2 1 2 1 2

0 0 1 0 0

0 0 50 0 0

3842 3843 3845 3851 3861

4 2 11 1 1

0 1 0 0 0

0 50 0 0 0

3944 3949 3999 4011

1 2 3 2

0 0 0 0

0 0 0 0

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211

Table 3. Continued Industry Sector

SIC

Suits

Auditor Def

Local Passenger Transportation, NEC Courier Services Except by Air Air Transportation, Scheduled Arrangement of Transportation of Freight and Cargo Radiotelephone Communications Telephone Communications, Except Radiotelephone Cable and Other Pay Television Services Communications Services, NEC Electric Services Refuse Systems Sanitary Services, NEC Lumber, Plywood, Millwork, and Wood Panels Ofﬁce Equipment Computers and Computer Peripheral Equipment and Software Medical, Dental, and Hospital Equipment and Supplies Electronic Parts and Equipment, NEC Transportation Equipment and Supplies, Except Motor Vehicles Sporting and Recreational Goods and Supplies Scrap and Waste Materials Printing and Writing Paper Stationery and Ofﬁce Supplies Drugs, Drug Proprietaries, and Druggists’ Sundries Men’s and Boys’ Clothing and Furnishings Groceries, General Line Groceries and Related Products, NEC Lumber and Other Building Materials Dealers Department Stores Motor Vehicle Dealers (New and Used) Women’s Clothing Stores Children’s and Infants’ Wear Stores Family Clothing Stores Shoe Stores Computer and Computer Software Stores Record and Prerecorded Tape Stores Drug Stores and Proprietary Stores Jewelry Stores Miscellaneous Retail Stores, NEC Functions Related to Deposit Banking, NEC Personal Credit Institutions Short-Term Business Credit Institutions, Except Agricultural

4119 4215 4512 4731 4812 4813 4841 4899 4911 4953 4959 5031 5044

1 1 1 1 3 5 3 3 1 2 2 1 1

0 0 0 0 1 0 1 1 0 2 0 0 0

0 0 0 0 33 0 33 33 0 100 0 0 0

5045 5047 5065

3 3 3

1 0 1

33 0 33

5088 5091 5093 5111 5112 5122 5136 5141 5149 5211 5311 5511 5621 5641 5651 5661 5734 5735 5912 5944 5999 6099 6141

1 1 2 1 3 1 1 1 1 2 1 1 1 1 1 1 2 1 10 1 3 1 4

1 1 1 1 1 0 0 0 0 0 0 0 0 0 0 0 0 0 3 0 0 0 1

100 100 50 100 33 0 0 0 0 0 0 0 0 0 0 0 0 0 30 0 0 0 25

6153

7

0

0

211

Percent

212

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Table 3. Continued Industry Sector

SIC

Suits

Auditor Def

Percent

Miscellaneous Business Credit Institutions Mortgage Bankers and Loan Correspondents Life Insurance Accident and Health Insurance Hospital and Medical Service Plans Fire, Marine, and Casualty Insurance Surety Insurance Real Estate Agents and Managers Ofﬁces of Bank Holding Companies Ofﬁces of Holding Companies, NEC Unit Investment Trusts, Face-Amount Certiﬁcate Ofﬁces, and Closed-End Management Investment Ofﬁces Patent Owners and Lessors Real Estate Investment Trusts Investors, NEC Hotels and Motels Miscellaneous Personal Services, NEC Equipment Rental and Leasing, NEC Help Supply Services Prepackaged Software Computer Integrated Systems Design Computer Processing and Data Preparation and Processing Services Information Retrieval Services Computer Related Services, NEC Business Services, NEC Carwashes Motion Picture and Video Tape Production Motion Picture and Video Tape Distribution Video Tape Rental Theatrical Producers (Except Motion Picture) and Miscellaneous Theatrical Services Professional Sports Clubs and Promoters Public Golf Courses Coin-Operated Amusement Devices Membership Sports and Recreation Clubs Amusement and Recreation Services, NEC Ofﬁces and Clinics of Doctors of Medicine Skilled Nursing Care Facilities General Medical and Surgical Hospitals Psychiatric Hospitals Specialty Hospitals, Except Psychiatric

6159 6162 6311 6321 6324 6331 6351 6531 6712 6719

4 6 1 2 8 5 1 1 1 1

3 1 0 0 2 2 1 0 0 0

75 17 0 0 25 40 100 0 0 0

6726 6794 6798 6799 7011 7299 7359 7363 7372 7373

1 3 2 2 2 2 3 1 64 15

0 1 1 2 0 2 2 0 14 1

0 33 50 100 0 100 67 0 22 7

7374 7375 7379 7389 7542 7812 7822 7841

3 5 1 6 1 2 2 1

0 1 0 0 0 0 2 0

0 20 0 0 0 0 100 0

7922 7941 7992 7993 7997 7999 8011 8051 8062 8063 8069

1 1 1 2 1 5 1 3 3 1 3

1 0 1 0 1 0 0 1 2 0 0

100 0 100 0 100 0 0 33 67 0 0

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Table 3. Continued Industry Sector

SIC

Suits

Medical Laboratories Home Health Care Services Specialty Outpatient Facilities, NEC Health and Allied Services, NEC Junior Colleges and Technical Institutes Data Processing Schools Schools and Educational Services, NEC Engineering Services Accounting, Auditing, and Bookkeeping Services Commercial Physical and Biological Research Management Services Management Consulting Services Total Jones and Weingram (1996) High Technology Bonner et al. (1998) High Technology Jones and Weingram (1996) Financial Services Bonner et al. (1998) Financial Services

8071 8082 8093 8099 8222 8243 8299 8711 8721 8731 8741 8742

1 5 3 5 1 1 1 1 1 4 4 3 468 172 115 40 49

Auditor Def 0 0 0 4 0 0 0 0 0 1 2 0 83 22 17 10 14

Percent

0 0 0 80 0 0 0 0 0 25 50 0 18 13 15 25 29

Thus, auditors may tend to not be named defendants if a company has a high estimated cumulative turnover of shares traded, because this factor is so seemingly frivolous and utterly unrelated to the factors of auditor culpability, management culpability, and deep pockets. Substantial further research is needed to test this conjecture. Figure 1 depicts an emerging, intra-post-Reform Act period trend. In 1996, the sum of state-only and parallel proceedings private securities class actions exceeded the federal-only private securities class actions. In 1998, through November 2, 1998 (the last day of the post-Reform Act period), the federalonly class actions overwhelmed the other two categories, reducing them to an almost de minimus level. Also, auditors were named defendants in a smaller percentage of the federal-only lawsuits than in the parallel proceedings. This suggests the emergence of a lower level of liability exposure for auditors in the future with respect to the private securities class actions that will be commenced. However, another emerging trend is the commencement of greater number of private securities class actions each year, which suggests a higher level of liability exposure for auditors in the future. The fact that auditors are named defendants in a lower percentage of class actions in 1998 than in previous years must be interpreted cautiously, because auditors are often 213

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Figure 1 Securities Class Actions in the Post-Reform Act Period (12/22/95–11/2/98): State vs. Parallel Proceedings vs. Federal.

named defendants after a substantial lag. In the class actions commenced in 1996, where auditors were named defendants after the commencement date, they were named after an average lag of six months. Figure 2 depicts another emerging trend, the globalization of private securities class actions. During the post-Reform Act period, the ﬁrst three ﬁnancial disclosure (as contrasted with governance) private securities class actions against companies, that I am aware of, were ﬁled in non-United States courts. Complaints against Livent, Bre-X Minerals and Philip Services (auditors were named defendants in Livent and Philip Services) were ﬁled in Canadian provincial courts. In addition, an increasing number of foreign companies were sued in courts in the United States. The numbers are currently small, but they will, if the trend continues, soon become signiﬁcant.

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Figure 2

215

Company Defendants in Securities Class Actions Commenced in the PostReform Act Period (12/22/95–11/2/98): Foreign vs. United States.

7. CONCLUSION, LIMITATIONS, IMPLICATIONS AND THE NEED FOR FURTHER RESEARCH The deep pockets motivation for naming auditors defendants in private securities class has decreased and audit quality, an integral component of auditor culpability, has concommitantly increased in importance. This, as well as the fact that auditors are named defendants less in federal-only class actions than in parallel proceedings, suggests a reduced auditor liability exposure can be 215

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expected in the future, because there will be only a trivial number of class actions that are not federal-only after November 2, 1998. Conversely, a larger number of private securities class actions appear to be being ﬁled, which suggests an increased auditor liability exposure in the future. In Figures 1 and 2, the dynamic nature of auditor liability is depicted. It is constantly evolving. For example, it can be conjectured that the October 1999 verdict for BDO Seidman in the Health Management private securities class action (see MacDonald, 1999) will alter plaintiff cost/beneﬁt calculations and lead to a reduced naming of auditor defendants. If auditors, over the next few years, try a few more of these cases, and prevail in all of them, then this will certainly lead to a reduced naming of auditor defendants. A limitation of this study is that the number of state-only class actions is understated, the number of parallel proceedings is understated, and the number of auditor defendants in both genres of class actions is understated. Whether these understatements are material can only be conjectured. One reason for these understatements is that state courts are not part of PACER. The other reason is that plaintiffs ﬁling in state courts are not bound by the Reform Act’s notice provision (Section 21(D)(A)(3)(a)(i) of the Securities Exchange Act of 1934). An obvious limitation of this study is the insufﬁcient passage of time to permit analysis of the resolution of many of these securities class actions. Further research is needed to determine if estimated cumulative turnover of shares traded and/or industry sector have an important role in the naming of auditor defendants in private securities class actions. If either of these is an important factor, it is important to understand why. Also, the current classiﬁcation of industry sectors by SIC is inaccurate since it does not recognize e-business as a sector (Mesenbourg undated) and is being replaced by the North American Industry Classiﬁcation System (‘NAICS’). Finally, the experience of foreign companies in private securities class actions has not been empirically studied, and deserves careful analysis when sufﬁcient data become available.

NOTES 1. Most lawsuits are processed with judicial opinions delivered from the bench (orally) and/or written but not provided to the LEXIS NEXIS and WESLAW databases (unreported). 2. The United States District Courts of Arkansas (Western), Guam, Idaho, Indiana (Southern), Nevada, and the Northern Mariana Islands are still not PACER-accessible, as of November 20, 1999. I have visited Indiana (Southern) and a dozen other United States District Courts as well. PACER information is available at http://pacer.psc.uscourts.gov. 3. Phillips and Miller (1996) comprehensively discuss the provisions of the Reform Act and its legislative history.

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4. Levine & Pritchard (1998) comprehensively discuss the provisions of the Uniform Standards Act and its legislative history. 5. As of the July 1, 1998 merger of Coopers & Lybrand and Price Waterhouse, the Big Six are now the Big Five. With respect to the performance of the audits, the largest public accounting ﬁrms were the Big Six during the period of this study and thus are referred to as the Big Six throughout the study. 6. The restatement of previously issued audited annual ﬁnancial statements is required by APB No. 20 (AICPA 1971) to apply certain new accounting standards, and sometimes for pooling of interests mergers, sales of divisions, stock splits, stock dividends, and similar routine purposes. However, a restatement for other reasons is a tacit admission of culpability for the originally issued materially misstated ﬁnancial statements. 7. Seventeen of the observations were reported long after the commencement of the litigation, sometimes as late as the settlement of the litigation. SCAA has been used by many researchers for securities litigation research. The publisher of SCAA claimed in O’Brien & Hodges (1991) that 90% of securities class actions were included in SCAA. That is an overstatement for the pre-Reform Act period, especially for the late 1980s and early 1990s, but correct for the post-Reform Act period. 8. Foster et al. (undated) aggregate both of these genres of private securities class actions, which precludes a direct comparison with this research. 9. ABS Industries was the ﬁrst complaint ﬁled, on January 19, 1996. Several securities class action complaints were ﬁled in Canadian provincial courts, but none was the ﬁrst ﬁled in a particular body of litigation. 10. The magnitude of the pearson correlations (not shown in a table) are low, except that company size (LNTA) and BIGSIX are positively correlated at r = 0.39. However, no variance inﬂation factor exceeded 1.23 and no condition number exceeded 16, suggesting that multicollinearity was not a serious problem (Judge et al. 1988, pp. 868–871).

REFERENCES American Institute of Certiﬁed Public Accountants (AICPA) (1971). Opinions of the Accounting Principles Board No. 20: Accounting Changes. New York: American Institute of Certiﬁed Public Accountants. Bonner, S.E., Palmrose, Z. V., & Young, S. M. (1998). Fraud type and auditor litigation: An analysis of SEC accounting and auditing enforcement releases. The Accounting Review, 73(4), 503–532. DeAngelo, L. E. (1981). Auditor size and audit quality. Journal of Accounting and Economics, (December), 183–199. Foster, T. S., Martin, D. N., Juneja, V.M., & Dunbar, F.C. (Undated). Recent trends VI: What explains ﬁlings and settlements in shareholder class actions? New York: National Economic Research Associates. Posted at http://www.nera.com/recenttrends/downloads/Trends6.pdf. Fuerman, R. D. (1997). Naming auditor defendants in securities class actions. Journal of Legal Economics, 7(1), 72–91. Fuerman, R. D. (1998) . The effect of the Reform Act and Central Bank on naming auditor defendants in securities class actions. Research in Accounting Regulation, 12, 179–191. Heninger, W. G. (1997). The effect of earnings management on auditor litigation. Working paper, State University of New York at Buffalo (June).

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Jones, C. L., & S. E. Weingram. (1996). Why 10b–5 litigation risk is higher for technology and ﬁnancial services ﬁrms. Working paper, Stanford Law School (May). Judge, G. G., Hill, C., Grifﬁths, W. E., Lutkepohl, H., & Lee, T. (1988). Introduction to the Theory and Practice of Econometrics. New York: John Wiley & Sons. LASER D. Bethesda, MD: Disclosure, Inc. LEXIS NEXIS Research Software. London, UK: Reed Elsevier. Levine, D. M., & Pritchard, A. C. The securities litigation uniform standards act of 1998: the sun sets on California’s blue sky. The Business Lawyer, 54, 1–22. MacDonald, E. (1999). Federal jury exonerates BDO Seidman in accounting suit over audit of ﬁrm. The Wall Street Journal (Oct 28th). Mesenbourg, T. L. (Undated). Measuring electronic business: Deﬁnitions, underlying concepts, and measurement plans. United States Bureau of the Census. Posted at http://www.census.gov/ epcd/www/ebusines.htm. Milberg Weiss Securities Class Action Designated Internet Site. Posted at http://www.milberg.com. O’Brien, P., & Hodges, R. W. (1991). A study of class action securities fraud cases. Working paper, Law and Economics Consulting Group and Optimal Economics. Palmrose, Z. V. Jan. (1988). An analysis of auditor litigation and audit service quality. The Accounting Review, 63(1), 55–73. Phillips, R. M., & Miller, G. C. (Aug. 1996). The private securities litigation reform act of 1995: Rebalancing litigation risks and rewards for class action plaintiffs, defendants and lawyers. The Business Lawyer, 51, 1009–1069. Private Securities Litigation Reform Act of 1995, Pub. L. No. 104–67, 109 Stat. 737 (1995). Public Access to Court Electronic Records (PACER). Description posted at http://pacer.psc. uscourts.gov. Securities Class Action Alert. Upper Saddle River, NJ: Investors Research Bureau, Inc. Securities Class Action Clearinghouse. Posted at http://securities.stanford.edu. Securities Exchange Act of 1934. 15 U.S.C. 78a–7811 (1988). Securities Litigation Uniform Standards Act of 1998. P.L. 105–353. Stice, J. D. (1991). Using ﬁnancial and market information to identify pre-engagement factors associated with lawsuits against auditors. The Accounting Review, 66(3), 516–533. United States Bureau of the Census. North American Industry Classiﬁcation System. Posted at http://www.census.gov/epcd/www/naics.html. Young, M. R. (2000). The origin of ﬁnancial fraud. In: M.R. Young (Ed.), Accounting Irregularities and Financial Fraud. New York: Harcourt Brace Professional Publishing.

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PERSPECTIVES

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REMARKS ON AICPA RECOGNITION OF FASAB Robert K. Elliott and Barry Melancon

ABSTRACT At the July 1998 AICPA Board of Directors meeting, the chair of the Federal Accounting Standards Advisory Board (FASAB) and representatives from the U.S. General Accounting Ofﬁce (GAO) discussed the federal government’s interest in having the accounting profession designate the FASAB as a body to establish generally accepted accounting principles (GAAP) for the federal government. The AICPA’s Council has previously designated only two accounting standards-setters: the Financial Accounting Standards Board (FASB) in 1973 for nongovernmental entities and the Governmental Accounting Standards Board (ASB) in 1986 for state and local governments. Auditors of the federal agencies had been using ‘other comprehensive basis of accounting’ methods. GAAP is a technical accounting term that encompasses the conventions, rules, and procedures necessary to deﬁne accepted accounting practice at a particular time. It includes not only broad guidelines of general application, but also detailed practices and procedures. GAAP is the most widely recognized method of accounting in the U.S. The move toward stronger federal ﬁnancial management, through a series of continuous ﬁnancial reporting improvements, is driven by four major pieces of legislation. They are the Chief Financial Ofﬁcers Act of 1990, the Government Performance and results Act of 1993, the

Research in Accounting Regulation, Volume 14, pages 221–227. 2000 by Elsevier Science Inc. ISBN: 0-7623-0735-8

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Government Management Reform act of 1994, and the Federal Financial management Improvement Act of 1996. One of the speciﬁc mandates of these reform laws was the requirement that annual independent audits of the ﬁnancial statements of federal agencies be conducted. On October 19, 1999, the AICPA’s governing Council adopted a resolution recognizing the Federal Accounting Standards Advisory Board (FASAB) as the body designated to establish generally accepted accounting principles for federal government entities under Rule 203 of its Code of Conduct. Pursuant to the resolution, statements of federal ﬁnancial accounting standards are recognized as GAAP for the applicable federal government entities. The following text relates the remarks of Robert K. Elliott and Barry Melancon at the December 14, 1999 ceremony recognizing the FASAB.

AT THE OFFICIAL CEREMONY December 14, 1999 Main Treasury Building 3:30 pm to 5:00 pm • To the Honorable Dave Walker – Comptroller General of the United States • To the Honorable Gary Gensler – Under Secretary for Domestic Finance for the Department of Treasury • To the Honorable Josh Gotbaum – OMB Executive Associate director • Members of the Federal Accounting Standards Advisory Board • Ladies and Gentlemen I am Robert K. Elliott, Chairman of the American Institute of Certiﬁed Public Accountants. It is indeed a pleasure to be here with you today, as we celebrate this momentous and historic event for the federal government, as well as the accounting profession. A certiﬁed Public Accountant signiﬁes that ﬁnancial statements are a suitable foundation for ﬁnancial decision-making by stating the opinion that they are “in conformity with generally accepted accounting principles” – which we usually abbreviate to GAAP.

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A CPA, however, may say this only if the ﬁnancial statements are prepared in conformity with accounting principles promulgated by a standard-setting body recognized by the AICPA. Heretofore, the AICPA has recognized only two such authorities: the Financial Accounting Standards Board and the Government Accounting Standards Board – neither of which has jurisdiction over Federal government ﬁnancial reporting. Thus CPAs could not report that Federal ﬁnancial statements were in conformity with GAAP. However, at its most recent meeting, the AICPA’s governing Council granted that authority to the Federal Accounting Standards Advisory Board. Our action to recognize FASAB is an afﬁrmative statement by the accounting profession that FASAB’s structure and process will provide an independent, objective, and open process to establish federal ﬁnancial accountability. Our recognition of FASAB as an accounting standards-setting body was the result of a tremendous private/public sector effort by many outstanding persons. I want to especially thank David Mosso, Wendy Comes, Phil Calder, Gary Previts, members of the AICPA Board task force, Ian MacKay and Wendy Frederick for their efforts, representatives of the principals (Dave Walker for his strong support, Sheila Conley from OMB, Don Hammond and Bob Reid from Treasury). The AICPA engaged in an extensive and rigorous evaluation of FASAB to determine the appropriateness of recognizing its standards as GAAP. Much was learned and gained from the process. The AICPA’s interests and efforts to assists the Federal government in identifying ways to improve how it provides ﬁnancial and other relevant information to its citizens, taxpayers, and policymakers dates back to the late 1980s. At that time, the AICPA established a task force to recommend improvements to federal ﬁnancial management, and sponsored a colloquium with members of Congress, the Administration, the new media, and other interested parties. The task force’s recommendations also responded to the GAO’s 1989 proposed framework for establishing federal government accounting standards. In 1997, the AICPA established the Federal Accounting and Auditing Subcommittee to work with federal representatives in areas related to federal accounting and auditing matters. Our recognition of FASAB was subject to the agreement of FASAB and its principle agencies that the principals explicitly recognize FASAB as the agency whose accounting standards, principles, statements and interpretations, and practices are authoritative for its domain, having substantial authoritative support. This agreed-upon model of authoritative structure is consistent with that established for generally accepted accounting principles under the SEC relationship with the FASB. 223

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Our action means that now, for the ﬁrst time, AICPA members, as preparers or auditors of federal-entity ﬁnancial statements that comply with FASAB’s accounting standards can express an opinion that such federal ﬁnancial statements are in conformity with GAAP. With the completion of the AICPA’s assessment and recognition of FASAB, our work and involvement with FASAB has just begun. Shortly I will be appointing a Transition Task Force to work with FASAB during the coming months to put into operation the various agreed-upon recommendations made to you by the AICPA. This task force’s main goal will be to foster continuous improvement of ﬁnancial accounting and reporting standards applicable to federal government entities. The AICPA looks forward to working with FASAB in its efforts to: • Continue in the development of high quality standards, • Maintain the reputation of FASAB’s integrity, and • Continue its commitment to achieve a majority representation of FASAB Board members, who are “materially independent.” By this, we mean members whose principal interest is in high quality, reporting, and who have no other signiﬁcant interest in the principles developed. For example, a representative of a federal agency with no peculiar accounting issues and one that is immaterial to the federal ﬁnancial statements – for example, the SEC but not the Department of Defense – could be “materially independent” for this purpose. It is our view that FASAB’s constituencies, including Congress, federal agencies, the accounting profession, other standard-setters, and citizens must perceive the federal standards-setting process to be free of undue inﬂuence by any particular segment of its constituency. I want to reafﬁrm here today the AICPA’s commitment to work with FASAB, the GAO, Treasury, and OMB to improve the foundations of federal accounting and auditing in order for FASAB to ensure that the federal government provides credible and reliable ﬁnancial information to its constituencies. In closing, I would like to quote the following observation: I think it an object of great importance . . . to simplify our system of ﬁnance, and to bring it within the comprehension of every member of Congress . . . The whole system [has been] involved in an impenetrable fog. [T]here is a point . . . on which I should wish to keep my eye . . . a simpliﬁcation of the form of accounts . . . so as to bring everything to a single center [;] we might hope to see the ﬁnances of the Union as clear and intelligible as a merchant’s books, so that every member of Congress, and every man of any mind in the Union, should be able to comprehend them to investigate abuses, and consequently to control them.

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The author of this quotation was Thomas Jefferson in a letter to Secretary of the Treasury, Albert Gallatin, in 1802. That is the continuing challenge for FASAB going into the new millennium. FASAB must ensure that the federal government provides credible and reliable ﬁnancial information. It has been my pleasure to be with you here today for this very special occasion, and I congratulate FASAB on its recognition by the accounting profession.

BARRY MELANCON’S SUGGESTED REMARKS TO THE FASAB RULE 203 DESIGNATION OFFICIAL CEREMONY DECEMBER 14, 1999 MAIN TREASURY BUILDING 3:30 PM TO 5:00 PM CLOSING REMARKS It is indeed a pleasure to be with you all here today as we help to celebrate this tremendous achievement and collaborative effort between the federal government and the accounting profession. (Humorous Quips) As I was preparing my remarks for you today, I was reminded of the essentials of a good speech . . . A good speech is deﬁned as a beginning and a conclusion placed not too far apart! Therefore, I will be brief, be sincere and BE SEATED! The AICPA is the national professional organization of CPA’s with more than 331,000 members in public practice, industry, education and a signiﬁcant portion representing the government. I’d like to brieﬂy: • Recognize the contributions of CPAs in government and their efforts towards promoting federal ﬁnancial improvements; • Highlight key roles CPAs play in serving the federal government; and • Identify the key skills and knowledge CPAs in the federal government possess as they relate to the Vision of the accounting profession. Contributions Each year we recognize the achievements of CPAs employed in government by presenting an individual with the Outstanding CPA in Government award during our annual Government Accounting and Auditing Conference. This award is given to an individual whose contributions promote increased efﬁciency 225

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and effectiveness at their government organizations, and the growth and enhancement of the accounting profession. Three of the recipients of this high honor have contributed signiﬁcantly toward improving federal ﬁnancial management. Chuck Bowsher, the former Comptroller General, was very instrumental in the establishment of the FASAB by the principals. Woody Jackson contributed signiﬁcant achievements while at the OMB in advocating and establishing government-wide policy on federal ﬁnancial improvements. Also Linda Blessing, with the State of Arizona, served as a public member on the FASAB. It is also important to note a majority of board members of the FASAB are CPAs. Key Roles CPAs in federal government face many of the same challenges as CPAs in practice and industry. They recognize that effective decision-making must take into consideration signiﬁcant ﬁnancial, social, technological and economic issues and demand sound business and governmental practices. The fact that CPAs in federal government serve the public interest reafﬁrms the importance of competency, effectiveness, integrity and broad business knowledge. Federal government CPAs have earned a unique level of public trust, as they prepare or audit information that is used to make public policy decisions, which impact the citizenry as a whole as well as foreign business and economic interests. They are uniquely equipped to deal with accountability for taxpayer dollars invested in the federal government and have the competency, integrity and objectivity required to carry out this important responsibility. CPAs in the federal government also develop performance measures, design evaluations and make recommendations for governmental operations and management effectiveness. They are instrumental in the design, development and implementation of technological improvements, which aid governments in improving their business practices to provide more efﬁcient services to their constituents. Key Skills and Knowledge The AICPA has launched a grassroots-developed Vision Process that identiﬁes key values, skills and services that are essential in taking the accounting profession into the next century. As part of this process, we’ve translated the Vision as it relates to CPAs in the federal government. CPAs in the federal government bring a business perspective to managing investments and cash ﬂows and contributing to the development of cost-effective

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operations. Federal government CPAs leverage their knowledge of government operations and technology and effectively communicate their ideas to the federal government work smarter and better. They are also professionals who go beyond the numbers to understand the challenges their departments and organizations face. They provide information on the cost of various programs and activities, link the cost to the output and outcomes of these programs and activities and provide decision-makers with cost/beneﬁt information for budgetary and oversight activities. In closing, with this milestone accomplishment as well as our collaborative efforts involving the Vision process, I want to re-emphasize the AICPA’s commitment to continued involvement in the federal accounting and auditing arena. The AICPA’s federal government members are important to us. I look forward to out continuing efforts to seek improvements in federal accountability and reporting.

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ACCOUNTING: CONTINUITY AND TRANSITION1 Shyam Sunder

ABSTRACT This study considers accounting in the new information economy. The basic framework of accounting for ﬁrms reﬂects a set of contracts and it helps deﬁne, implement and enforce these contracts. This framework is stable, and unlikely to change soon. However, the new information technology has been transforming the markets in which ﬁrms operate, and opening up new markets. We use a taxonomy identiﬁed with Hatﬁeld (1924) and based on markets for managerial talent, investment capital and products. It helps develop a perspective on the changes in organizations and accounting systems. Five aspects of accounting in the new economy are considered. Technology; Information and Efﬁciency; New organization design for web commerce; New cost structures and management; and Experimentation with the market for standards. I am delighted to attend the International Symposium on Chinese Accounting in the New Century. Professor Wei suggested that I speak about the future of accounting in the United States. The future is difﬁcult to predict. A Chinese friend told me: you never know at whose hands a deer will die. As recently as twenty years ago, even Bill Gates could not think of why anyone would need more than 56 kilobytes of memory in their computer! Most predictions become obsolete within a short period of time.

Research in Accounting Regulation, Volume 14, pages 229–243. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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On the other hand, the Spanish like to say: he who does not look ahead remains behind. In spite of its risks, we must evaluate the past and make judgments about the future. I would, therefore, like to talk about both continuity as well as changes in accounting. Because my knowledge of the long history of accounting in China is limited, I shall conﬁne myself to the U.S. experience. First, I shall outline my perspective on accounting in the context of the theory of organizations. I shall use this perspective to create a taxonomy of organizations on the basis of markets in which they operate, and the accounting systems developed to serve the needs of each type of organization. These types of organizations have survived over the history, and are likely to remain. I shall list the functions of accounting, which serve organizations’ needs. Accounting is not only the oldest but also the most stable of the management disciplines. In spite of its stability and continuity, accounting has seen major changes during the past hundred years. It would be surprising if a hundred years from now, accounting is the same as today. Although we cannot look so far ahead, we can analyze the current conditions for clues about what to expect in the next decade or two. The second part of my remarks will be focused on current transitions and expected changes in accounting induced by the new information economy. I shall conclude my remarks by listing some interesting areas of study and research for scholars as well as the practitioners and the accounting rule makers around the world.

CONTINUITY Things change, and yet they stay the same. To gain perspective, let us ﬁrst look at the theory of organizations, and the role of accounting and control in functioning of the organizations. Organizations vary in many respects. However, it is useful to classify them by the market criteria because such distinctions have existed for a long, and are likely to persist. Corresponding to each type of organization is a form of accounting effectively to serve its needs. So accounting and control systems can also be classiﬁed by the same three market criteria. I shall examine the reasonably stable correspondence between organizations and accounting systems before discussing transitions in accounting likely to be induced by the information economy. Contract View of Organizations We can think about each organization as a set of contracts among various participants (see Figure 1). The basic idea was introduced to the management literature in a book, Functions of the Executive, by Chester Barnard over sixty

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Figure 1.

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Firm as a Set of Contracts. (Source: Sunder, 1997, p. 15)

years ago. In a business organization, for example, the participants are employees, shareholders, customers, vendors, managers, creditors, auditors, government, etc. In a university, they are students, professors, staff, administration, government, etc. In a city, the participants are citizens, business organizations, political leaders, and civil servants. With some adjustment, this basic idea can be applied to all types of organizations. Contracting individuals pursue their own goals. They join an organization only when they prefer the expected consequences of their participation. In this concept of organizations it is not necessary to assign a goal to the organization itself. Each party in the contract agrees to contribute resources. For example, in a business ﬁrm, employees and managers contribute skills, shareholders and creditors contribute capital, vendors provide machinery and materials, and customers provide cash. Each participant demands an inducement at least as large as the opportunity value of his contribution to the organization. For an 231

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organization to succeed, its production technology and set of contracts must satisfy each one of its participants. If she can get more else where, she will quit the organization. If enough people quit, the organization collapses.

Role of Accounting and Control in Organizations Accounting is necessary to assemble, implement, enforce, modify, and maintain the contract set of organization. How does accounting perform these functions? How do these functions relate to what we know about accounting systems in business organizations? Contributions from and incentives to participants take a variety of forms. The ﬁrst requirement of control is to devise a system of measuring the contributions made by each agent. It should also determine the amount of incentive due to them, and monitor the distribution of inducements so that each agent receives his due, no more and no less. In addition, accounting helps compare the contributions made and the incentives received by each participant and distributing this information. Fourth, accounting distributes information to various factor markets to keep them liquid and ﬁnd replacements for participants who leave. Finally, accounting makes some information available in the form of common knowledge or public disclosure to help reduce conﬂict among participants at the time they renegotiate their contracts. In business organizations contributions of goods and supplies are reckoned and recorded into the accounting system at the receiving dock. Money from the customers is handled by the cashier, the accounts receivables, and customer accounts. Contributions of labor might be measured at the punch clock, inspection, or the point of transfer of goods from factory to the ﬁnished goods warehouse. In its second function, the accounting system measures, records, and controls the outﬂow of resources from the organization. Payroll and beneﬁt accounts for employees, shipping to customers, accounts payable to suppliers, and tax accounts measure the outﬂow of resources to the government. In its third function, the accounting system compares the data on resource inﬂows and outﬂows to determine who has fulﬁlled his contract and to what degree. The accounting system prepares comparative reports on resource inﬂows and outﬂows related to various individuals in the organization. These statements are used to evaluate and adjust the contracts of these individuals. In a fourth function, accounting helps assemble and maintain the contract set by ﬁnding the appropriate participants in the factor markets for labor, managers, customers, supplies, and investors etc. All these people must be convinced that participating in such an enterprise is in their own best interests. Pro forma

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ﬁnancial statements, business plans, and budgets prepared by the entrepreneur before the enterprise starts functioning help agents assess the costs and beneﬁts of participating in the proposed enterprise in various roles. When contractual slots fall vacant, they must be ﬁlled from the factor markets. Finally, when contract terms expire, they are often renegotiated under changed circumstances. Agents are tempted to issue threats, to quit their position in the organization if their terms were not revised in their favor. Such bluffs and threats sometimes lead to deadlock in negotiations, strikes, and therefore deadweight losses to society. Accounting performs its ﬁfth function by sharing at least a minimal set of information among the negotiating parties to make it common knowledge, and help reduce the chances of breakdown. This is the primary purpose of public disclosure in larger organizations. To summarize, we can think of all organizations as a set of contracts or alliances among many people who join them with the expectation of gain. We can think about accounting as the mechanism to deﬁne, implement, enforce, modify, and maintain this system of contracts. Organizations differ in their design, depending on the goals and resources of their participants and the markets in which they operate. So do their accounting systems. A Taxonomy of Organizations and Their Accounting Organizations and their accounting systems can be classiﬁed by the extent of development of the markets in which they operate. Just like different kinds of buildings need different electrical systems, different kinds of organizations need different kinds of accounting and control. In our taxonomy, we classify organizations on the basis of markets for managers and capital, as suggested by Hatﬁeld (1924), and markets for their products. Classiﬁcation by Market for Managers When there is no market for managers, owners of business must manage it themselves. When there is a liquid market for services of managers, it is possible for proprietors to hire professional managers. The classical double entry bookkeeping model of accounting serves the needs of proprietorships. Accounting originated with traders who traded with many people, often repeatedly or on credit. Accounting was differentiated from mere counting by establishing the cause-and-effect relationship between the sacriﬁce and beneﬁt aspects of each transaction (see Ijiri, 1975). This cause-and-effectdriven organization of transactions in double-entry bookkeeping gave it balance 233

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and usefulness as a powerful instrument of control over the ﬂow of resources. This form of accounting, designed to implement the contract set of simple organizations, is bookkeeping. Most ﬁrms belong to this category. When an organization expands to include two or more levels of management, its accounting must be adjusted to stewardship form to manage their divergent interests. This form of accounting developed to handle the accounts of temples and sovereigns since antiquity, as well as merchants or landed gentry who employed stewards to handle their estates. Organizations involve actions, thoughts, information, and motives of more than one person. Stewardship accounting handles this problem. Planning and budgeting, divisional and managerial performance evaluation and compensation, decentralization, transfer pricing, capital budgeting, and activity-based costing are all concerned with the problem of control in organizations with managerial hierarchy. Stewardship or managerial accounting is built on the foundation of bookkeeping. But accounting needs of hierarchical organizations include the above-mentioned additional features absent in Paciolo’s description of the ﬁfteenth-century European accounting practice. With the development of labor markets, of managerial labor market in particular, with commerce and business schools to supply this market, this form of hierarchical organization and stewardship accounting becomes more common and important in the economy. Over the past century, development of this aspect of accounting in U.S. has closely paralleled the development of the managerial market. Classiﬁcation by Market for Capital When there is no market for capital, a single owner, or his personal friends, must provide all the capital. They can directly manage the ﬁrm, and give effective direction and supervision to hired managers. As the capital markets develop and become more liquid, the number of individual sources of capital multiply. It is difﬁcult for a large group of shareholders to manage the ﬁrm themselves, or to give effective direction to hired managers. Financial reporting model of accounting developed to meet this need. Publicly held corporations place new demands on accounting systems. Investors who are distant from the operations of the ﬁrm need an accounting system to protect their capital and to enforce the contract set. To protect themselves against nonperformance or malfeasance by managers they hardly know, they resort to rules and standards of ﬁnancial reporting. Use of rules and standards limits the exercise of judgment by managers, and therefore the informativeness of the reports, even as the rule makers strive to improve the value

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of ﬁnancial reports. Fearing self-serving manipulation by managers, ﬁnancial reporting rule makers have progressively narrowed the bands of managerial discretion. Elimination of discretionary reporting is a double-edged sword; even self-serving reports by managers in a discretionary regime end up revealing what kind of managers they are (Levine, 1996). In active capital markets investors search for information about the prospects of the ﬁrm. Financial reports remain an important source of information, but there are other sources also. This competition attenuates, but does not eliminate the investor reliance on ﬁnancial reports as a source of information. When shares of stock are actively traded in low transaction cost capital markets, stock price can respond to information about the ﬁrm within minutes or hours. In the early years of development of the ﬁnancial reporting model, corporate managers use secret reserves to smooth out the ﬁnancial reports over time to minimize share price movements in response to transient events. As capital markets develop, such practices become increasingly impermissible. A third consequence of the ﬁnancial reporting model has been the shift of emphasis from stock to ﬂow variables (balance sheet to income and cash ﬂow statements). When markets for ﬁxed assets of industrial corporations are imperfect, their historical book values become poor indicators of the future earning power of the corporation. Projection of current earnings and cash ﬂows into future for the purpose of security valuation carries its own signiﬁcant risks. Investors’ and analysts’ need for a sustainable earnings ﬁgure that can be projected into the future gives rise to lengthy debates and detailed rules on isolation of nonrecurring elements of income from the others. Market-based research has inﬂuenced accounting thought by making the accountants aware of the existence of the alternative sources of information for the stock market, the complex interaction among these sources, and the behavior of stock markets. It has replaced mechanical thinking by economic thinking about information. Accounting reports can mislead investors, but the existence of the market limits the extent to which this can happen. Development of markets for securities as well as for goods and services has led some to argue, especially during periods of signiﬁcant price movements, that the historical cost valuation be replaced by market valuation of assets and liabilities. Because all markets are imperfect in varying degrees, errors of measurement in market-based prices must be weighed against the errors of ignoring inﬂation (Lim & Sunder, 1990, 1991). Second, the beneﬁts of inﬂation accounting for security valuation must be weighed against any reduction in the effectiveness of the ﬁnancial reporting system for implementing and enforcing the ﬁrm’s contract set. While several proposals for market valuation have been tried out in the United States, none have survived. 235

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For the vast majority of ﬁrms in the United States, or in any other economy, ownership shares are not traded in liquid markets. They do not use the ﬁnancial reporting model of accounting. Classiﬁcation by Markets for Products Accounting and control for organizations that produce private goods, such as cars or furniture, is different from accounting for organizations that produce public goods such as security or clean air. Organizations that produce private goods have customers who can withhold revenue from the ﬁrm if they are not satisﬁed with the good or services they receive. Organizations that produce public goods have beneﬁciaries, instead of customers, who do not have the power to directly withhold revenue. Therefore, the beneﬁciaries are not able to impose the kind of direct discipline on the managers that the customers can impose. Such organizations use a bureaucratic management. This fundamental difference leads to very different organizational structures and accounting and control systems in the two types of organizations. More generally, the design of organization and its accounting and control system depends on the amount of market power the organization has in its product market. The lower the market power, easier it is for the organization to use the techniques of private good organizations. As the market power increases, alternative designs become necessary to install adequate control on management to ensure efﬁciency of operations. Accounting for private and public good organizations provide the two ends of the spectrum. The basic framework of accounting – view of organizations as a set of contracts, functions of accounting in operating organizations, and the variations in organizations according to the managerial, capital and product markets in which they operate – are not likely to change. These aspects of accounting will continue into the future.

TRANSITION What will change is the extent to which various markets develop in different economies. Markets, organizations and accounting have an organic relationship in which it is not always easy to disentangle the direction of causes and the effects. They develop in step, inﬂuencing one another. What are the changes we have seen, and what more might be ahead of us? So many changes are taking place in business and accounting. I shall limit my attention to ﬁve aspects of accounting associated with the information economy: technology, information, and efﬁciency; new organization designs; accounting

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for web commerce; new cost structures and management; and experimentation with the market for standards.

Technology, Information and Market Efﬁciency Advances in computer and communications technology have been called an information revolution. We now have access to more information from more sources. Are the investors better informed as a result? Has the stock market become more efﬁcient? I read many newspapers on my computer every day. I can get the stock price quotations, the price and ﬁnancial statistics, and detailed reports of analysts, on many securities within seconds. I can trade stocks through my computer within seconds of placing an order. So can millions of others who have the same information and technological capability. What is the impact of cheap and abundant information on market efﬁciency? There are good reasons for speculating why efﬁciency may, and may not improve. I shall focus on why not. Supply is only one side of the information equation, demand and use being the other. While the computing and communications technology has made it easier to produce and distribute more information and to lower its price, it has had less impact on the ability of human brain to process the information. Herbert Simon suggests that the real bottleneck for most people is not the lack of information but the time and ability to process the information. Unless more information is incorporated into investment decisions, market efﬁciency will not improve. A second problem is the quality of the data made available for free or very cheaply. As vendors of information compete with each other to gain customers for their wares, they may lower the price as well as quality, because the quality of information is not easily observable to the customers. Even if the information technology increases the efﬁciency of existing markets, through lower costs it induces more markets to be opened. Just like the effect of building fast highways in big cities is to encourage people to live at and commute from longer distances, the gains of information technology may also be used up through opening of newer, albeit thinly traded, markets. Fourth, the same technology that makes it easier to disseminate information also makes it easier to disseminate misinformation. This is what has happened to the ‘free’ information provided on the world wide web and the chat rooms. We cannot assume, without evidence, that cheaper computers will necessarily lead to better accounting, stock market information, or more efﬁcient stock markets. We need to investigate and ﬁnd out. 237

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New Organizational Designs Information technology has had a major impact on the development of existing and new capital as well as managerial labor markets. These developments have multiple consequences for design and governance of organizations. On one hand, the technology has thinned out the ranks of middle managers and clerical staff from corporations, who layoff employees no longer needed to deliver a given amount of goods or services. These employment cuts and savings in labor costs have increased the proﬁtability of many corporations. The unprecedented increase in the U.S. stock prices over a long period of time is attributed to these operational efﬁciencies driven by technology. Second, information technology has made it possible to harvest large gains from economies of scale in operations. Once a bank or a mutual fund develops a computer program to run its operations by spending, say, a billion dollars on software, the same program can be used to run two or three or ten banks or mutual funds without additional costs. The result of these economies of scale has been the mergers of the recent years, which have now reached the scale of 100 billion dollars for a single transaction, creating giant-sized corporations. On the other hand, the development of venture capital markets, again encouraged by the same technology, is making it easier for entrepreneurs with ideas to go into business themselves using other people’s money. Existence of a large and liquid labor market of well-trained scientists, engineers, programmers and M.B.A.s is the other driver in this phenomenon. Such small-scale technology startup ﬁrms have become an important engine of economic growth in the U.S. Their small size, ﬂexibility, quick decision-making, and performance-oriented incentives have resulted in a large number of rag-to-riches legends. For the ﬁrst time in many years, and in spite of a booming U.S. economy, several prestigious U.S. business schools reported a drop in applications or rise in the number of students who do not return for the second year of their education. At the heart of the enormous creation of wealth through small entrepreneurial ﬁrms in the U.S. is the greater transparency of accounting that makes it possible for small new upstarts to gain conﬁdence of investors. As reliable information becomes available widely, and barriers to movement of capital are lowered, new companies can attract investment capital from around the world because of the conﬁdence created in the information they provide. These developments suggest a movement toward an economy consisting of a large number of small sized, fast-moving, well-ﬁnanced entrepreneurial ﬁrms, even as large corporations grow in the banking, pharmaceutical, telephone, and oil industries. Technology does not necessarily mean larger or smaller

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organizations, just different organizations, and different accounting and control systems to run them. Accounting for Web-Commerce Electronic commerce presents many new challenges for accounting and auditing. In accounting, the well-established delivery-based revenue recognition criterion is likely to continue. However, in web-based transactions, the questions about what is to be regarded as the time of transaction and delivery will have to be addressed again. Under the current accounting standards, all research and development costs are capitalized. Given the intangible nature of web-related assets, on which ﬁrms spend huge amounts of developmental funds, questions about capitalization and amortization of such costs will present thorny problems for the industry and the accountants. Deﬁnition of the revenue for web-based merchants itself has become a matter of some controversy. On December 3,1999, the U.S. Securities and Exchange Commission issued a bulletin clarifying that web-based merchants who simply gather and transfer orders can take only their commission as revenue, and not the total price of the merchandise. Thus, if a web-merchant obtains and transmits an order for a $100 piece of merchandise to earn a $10 commission, it would be permitted to show only $10 as revenue, unless it bears the risk and rewards of ownership of the merchandise. Other such questions will crop up about accounting for web-commerce. In the U.S., FASB is currently considering elimination of pooling of interest accounting. This means that accounting for mergers and acquisitions of companies engaged in web-commerce, using purchase method of accounting will create a large amortizable asset on the post-merger balance sheets. Given the precarious nature of the balance sheets of most web-commerce ﬁrms, and the high prices they tend to command in the mergers and acquisition market, this accounting change may dampen the enthusiasm for such investments. However, the political muscle of these ﬁrms may make it difﬁcult to enact an accounting standard which is so distasteful to them. New Cost Structures and Management Cost and asset structure of high technology industries is different, giving rise to important new accounting and management issues. Consider two such changes. First, consider the changes in the ratio of variable to ﬁxed costs. In software industry for example, the cost of development of software is ﬁxed; it does not 239

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depend on the number of copies of the software to be made. The variable cost of software is practically zero. Our current management and accounting control practices were developed for industries with substantially higher (e.g. 40–60%) variable costs. Techniques of tracking factory costs, building cost standards, measuring variances with a view to control managerial performance, analyzing ﬁnancial reports, proﬁt margins, and valuation are all based on a signiﬁcant part of the costs being variable. By contrast, in the software industry, virtually all costs are incurred in development, and there is no guarantee of any revenue when these costs are incurred. Furthermore, it is difﬁcult to forecast and control these costs. Lack of familiarity with accounting and control for management of such industries may be one reason for the high level of prices of Internet stocks currently prevailing in the U.S. markets. Second, consider the structure of assets in the new industries. As compared to more traditional industries, assets of high tech industries tend to be more specialized, less marketable, and often intangible. The most important resources of such ﬁrms may take the form of software, personnel, or contractual arrangements with other organizations, none of them capitalizable for most part. As a result, the balance sheet of such ﬁrms is not particularly informative of their ﬁnancial status. There is little for a creditor to hold on to in case of default. Fast cycle time in such industries renders revenue stream volatile and difﬁcult to project into the future. A new, better or faster product from a competitor may make the investment in plant of software worthless overnight. A new challenge for accounting is to develop effective controls and methods of reporting on the ﬁnances of such organizations.

A Market for Accounting Standards Until not too long ago, most countries of the world allowed legal or de facto monopoly for their own national accounting standards. In the U.S., this is still the case. Globalization of capital ﬂows calls for better harmonization of accounting standards across national jurisdictions in order to reduce the cost of capital. International Accounting Standards Committee was set up to address this problem, and many countries have permitted their own ﬁrms to report under IASC’s standards, and in some cases, incorporated IASC’s standards into their own. In the United States, the Financial Accounting Standards Board, and its predecessor bodies, have developed their own set of comprehensive standards. Difﬁcult as it is to obtain agreement at FASB, agreement on common standards at IASC is even more difﬁcult, given the diversity of business environments

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in its member countries. Not surprisingly, many people in the U.S. see IASC’s standards as weak, and inappropriate for use in the U.S. Development of the new information economy is also the time to review the beneﬁts and costs of the monopoly approach to accounting standards, and think about the consequences of using possible alternatives. Some forty years ago, George Sorter suggested events approach to accounting. He anticipated a time when a ﬁrm could maintain a database of its transactions, and the software would permit different users with different needs to aggregate that data in different ways to arrive at ﬁnancial statements best suited to their own needs. We could also think about a competitive model for accounting standards. Countries could permit some two or three sets of ﬁnancial reporting standards to compete for the attention of their ﬁrms (who will have to clearly mark their ﬁnancial statements with the standards they conform to) and investors. Such an arrangement will encourage standard setters to think hard about the costs and beneﬁts of standards they issue, and to experiment with newer approaches in an orderly fashion. In United States, development of laws that govern corporate charters was greatly facilitated by competition among the ﬁfty states because this was a subject left to them by the constitution. Is it not the time for us to allow the market to decide which of the few well-thought out and available standards provides more valuable information to the investors. Investors should lower the cost of capital of ﬁrms using better standards, and such standards should attract more adherents from the industry.

CONCLUDING REMARKS Consideration of transition and changes reveals more of our ignorance than knowledge. The new information economy presents scholars with the challenges to ﬁnd answers to important new questions. For example, What are the effects on market efﬁciency? Since it is often assumed that the effect of cheaper information on market efﬁciency should be positive, I mentioned a few reasons why it may go the other way. We need to ﬁnd out. Second, are there better models of accounting for the new entrepreneurial part of the economy? Rick Antle once said, only half jokingly, “losses are good for Internet companies; larger the losses, greater the value.” Was he totally wrong? How do we explain and understand the valuation of Internet ﬁrms given the nature of their assets and cost structures. Do we have a ﬁnancial reporting model that will give reasonable information about such ﬁrms? Third, how will control be established, and how will contracts be deﬁned for this part of the economy, which is characterized by ﬁrms with low variable costs, high intangible assets? 241

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Fourth, what are the possible alternatives to national or international monopolies in the ﬁeld of ﬁnancial accounting standards? What are the alternatives, and what are the likely consequences of implementing such alternative standards? Let me summarize. The basic framework of accounting in which ﬁrms operate as a set of contracts among various participants, and accounting helps deﬁne, implement and enforce these contracts is stable, and unlikely to change soon. However, the new information technology has been transforming the markets in which ﬁrms operate, and opening up new markets. Development of these markets gives rise to new organizational forms. The need for innovative solutions to establish effective accounting control and management in such organizations follows. Scholars must address the questions that arise from these developments, help understand their consequences, and perhaps assist policy makers. The challenge for the policy makers is to avoid getting stuck in solutions that may have worked well in the past, but are inappropriate for the new environment. It is equally important for them to stay away from making unnecessary rules, or imposing them without careful evaluation of their efﬁcacy. Accounting has played a key role in creating and sustaining the modern industrial economy. Accounting is what makes organization possible. If scholars, accountants and policy makers help make the right decisions, accounting will continue to improve the welfare of society in the new information economy. Thank you for your kind attention, and the opportunity to share these thoughts.

NOTE 1. Prepared as the plenary address for The International Symposium on Chinese Accounting in the New Century, Zhongshan University, Guanzhou, China, December 1012, 1999. A PDF version of this paper can be downloaded from http://www.som.yale.edu/ faculty/sunder/research.html. Contact email: [email protected]. I am grateful to Zhaoyang Gu, Yuanyuan Jiang, Jingrong Lin, Manjula Shyam, Xijia Su, Lijia Wang and Yun Zhang for their help.

REFERENCES Hatﬁeld, H. R. (1977). An Historical Defense of Bookkeeping, Journal of Accountancy, 34(4), (April 1924), Reprinted in W. T. Baxter & S. Davidson (Eds), Studies in Accounting. (241–253). London: Institute of Chartered Accountants in England and Wales. Ijiri, Y. (1975). Theory of Accounting Measurement. Sarasota, FL: American Accounting Association. Levine, C. (1996). Conservatism, Contracts, and Information Revelation. Ph.D. Dissertation, Carnegie Mellon University.

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Lim, S. S., & Sunder, S. (1990). Accuracy of Linear Valuation Rules in Industry-Segmented Environments: Industry- vs. Economy-Weighted Indexes, Journal of Accounting and Economics, 13(2) (July), 167–188. Lim, S. S., & Sunder, S. (1991). Efﬁciency of Asset Valuation Rules under Price Movement and Measurement Errors The Accounting Review, 66(4) (Oct.), 669–693. Simon, H. A. (1996). The Sciences of the Artiﬁcial. Third Edition. Cambridge, Mass.: MIT Press. Sorter, G. (1969). An Events Approach to Basic Accounting Theory, The Accounting Review, (January), 12–19. Sunder, S. (1997). Theory of Accounting and Control. Cincinnati: Southwest College Publishing.

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INVESTORS’ EXPECTATIONS AND THE CORPORATE INFORMATION DISCLOSURE GAP: A PERSPECTIVE Asokan Anandarajan, Gary Kleinman and Dan Palmon

ABSTRACT Many parties rely on corporate ﬁnancial statements in making their investing and lending decisions. Are ﬁnancial statement users receiving the information that they desire and understand? Do they expect either quantity or quality of information that they are not getting? The existence of an ‘expectations gap’ between the needs of users and the priorities of ﬁnancial statement preparers is not contested. This expectations gap is the main issue of this chapter. We argue here that several things cause the expectation gap. First, there are deﬁciencies in the auditing/ﬁnancial statement preparation/measurement tools available to auditors and preparers. Second, there is a lack of motivation to completely use these tools. Third, user ability to best use the information maybe limited by their lack of experience, knowledge, and/or training on the part of ﬁnancial statement users. We present some recommendations for addressing the problems.

INTRODUCTION The focal point of this study is the existence of an expectations gap between what users of ﬁnancial statements expect to receive and what they actually get.

Research in Accounting Regulation, Volume 14, pages 245–260. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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While there is no one authoritative publication on this issue, a search on the World-Wide Web resulted in over 7,000 hits, suggesting that the topic is of great concern to many. We believe that there are three contributing factors to the gap. These contributing factors are listed below: • Deﬁciencies in the auditing and reporting standards • Lack of motivation to completely adhere to the standards • Lack of ﬁnancial literacy (experience and, knowledge), training (including computer competency), and cognitive limitations or preferences of ﬁnancial statement users. The deﬁciency in the standards reﬂects the difﬁculties in meeting the goal of providing users with information useful in making economic decisions. The complexities of today’s businesses are difﬁcult to capture. Issues such as accounting for intangibles are yet to be resolved. In addition, regulators have provided little constructive guidance for ﬁnancial statement preparers, particularly with reference to the growing number of so-called dot com companies. The fact that there is no single user community compounds the problem. Even if preparers were cognizant of the ‘perfect information set’ it is almost impossible to identify the ‘perfect user’ to read it. Ultimately, then, we have a situation in which the information set that is being delivered may not be the best information set deliverable. With respect to motivation, there are several reasons why management may not be motivated to provide information to the user. First there is the well-known agency model that explains why managers act in their own interest rather than in the interest of the company. Second, clearly management has no motivation to release information that can beneﬁt their competitors. The ability of the accountant to force disclosure in this situation is limited because of the asymmetry of information (with management having superior information over the auditor) and the fact that the auditor is hired, paid, and can be ﬁred by the manager. With respect to ﬁnancial literacy, it is important to note that regardless of whether or not the information production mechanism delivers the optimal information attainable, many users of ﬁnancial statements may not accurately perceive the quality of information that they currently receive, and may not know what information would be best for them. This may stem from differences in educational attainment, prior investing experience, learning, cognitive complexity, and the amount of time available to devote to understanding ﬁnancial statement elements. The issues addressed in this chapter are important to practitioners, regulators, investors, and the academic community. To the extent that all parties agree

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on an overriding goal of providing information useful in making economic decisions, then understanding how and where the process falls short should be a beneﬁt to all. A further beneﬁt of this chapter is that it presents a more complex picture of the expectation gap between preparers and users. We discuss not only failings in the ﬁnancial statement generation process itself, for example the treatment of intangibles, but also the user’s perception of the information that is received and why such perceptions may differ from person to person. An important premise of the study is that future ﬁnancial reports and audit reports should have the ﬂexibility to cater to the needs of a multiplicity of users with different priorities, perspectives, motivations, and levels of understanding. The current view of ‘one size ﬁtting all’ may not be appropriate in the current ﬁnancial environment. We start by discussing the aims of ﬁnancial reporting and then review the deﬁciencies of the existing reporting structure. Then, we discuss the ways that these deﬁciencies affect ﬁnancial statement users and the requirements of different user categories. We cite relevant empirical studies and conclude by discussing recent attempts to improve ﬁnancial reporting, including the SEC’s ﬁnancial literacy initiative and the proposed new standard for ﬁnancial reporting. We brieﬂy discuss the shortcomings of these developments. Then we provide recommendations for improving the existing reporting structure to meet the demands of different categories of users.

AIMS OF FINANCIAL REPORTING – THE REGULATORS’ VIEWPOINT The aim of ﬁnancial regulation is two-fold. Laura S. Unger, Commissioner, U.S. Securities and Exchange Commission, notes that the SEC has described these dual objectives as follows. On the one hand, she said, the SEC wishes to protect investors even if doing so requires the imposition of additional regulation. On the other hand, Unger states that promoting fair and efﬁcient markets may require the commission to refrain from imposing regulations. In fact, this objective may actually require a regulation ‘roll back’. Attempting to achieve a suitable balance forms the crux of the problem for regulators. Laura S. Unger did not specify whom the investor is that the SEC wishes to protect. Those who believe the markets are efﬁcient may argue that the SEC should not be concerned about the unsophisticated investors. Why? Because in an efﬁcient market, unsophisticated investors receive the same return on their investment as sophisticated investors. It seems, however, that the Security and Exchange Commission is concerned with all investors, including the unsophisticated ones, as evidenced by its ﬁnancial literacy initiative. While the market 247

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may, or may not, be efﬁcient, the perception of the fairness of the market for equities is important in that it promotes investor perception of a level-playing ﬁeld. The emphasis on fostering perceived fairness in the markets is consonant with the broader societal perception that individuals, whether as voters, investors, patients, or consumers, should be fully and fairly informed of information that affects their lives.

CURRENT PROBLEMS IN THE REPORTING SYSTEM This section argues that the information currently being provided by the accounting information system can be improved, thereby narrowing the expectation gap. Speciﬁcally, we review selected reporting problems. These include pressures to manage earnings, (non) disclosure of off-balance sheet assets or liabilities, loose compliance with SEC reporting directives, and the omission of corporate value drivers such as non-tangible assets. Pressure to Manage Earnings Shaun F. O’Malley, head of the Panel on Audit Effectiveness of the Public Oversights Board, and former chairman of Price Waterhouse LLP, has stated that there is enormous pressure on companies to report earnings that meet analysts’ expectations, rather than just improving earnings compared to the last quarter or the same quarter a year ago (see Fleming, 1999). With market multiples at an unprecedented high, a miss of a few cents can cost a company billions of dollars in market capitalization over night. In O’Malley’s view, the pressure on companies is even greater because many managers receive signiﬁcant bonuses based on earnings or stock prices. Declining ‘Quality’ of Corporate Earnings A bonus structure based on earnings or stock price encourages earnings management, which causes a decline in the quality of reported corporate earnings. Elly and Waymire (1999) observe that corporate earnings have little relevance in terms of information content. Calling for a fundamental cultural change on the part of corporate management, Chairman of the SEC, Arthur Levitt (1998) has outlined a plan of action to deal with his concern about the declining quality of corporate earnings. While the plan includes improved auditing as part of the ﬁnancial reporting process, he cites issues such as managed earnings, cookiejar measures, purchased R&D write-offs, and abuse of the materiality concept as factors that remain prevalent in the existing reporting environment.

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Deﬁciencies in Reporting Certain Types of Information According to a recent survey by the ﬁnancial analyst’s association, public companies do poorly with regard to reporting certain types of information deemed vital by investment professionals (Anonymous, 2000). For example, the survey indicated that 91 percent of buy-side and sell-side analysts felt that public companies do not do enough to explain the implications of extraordinary, unusual, or non-recurring charges. Further, most companies were not seen as doing an adequate job with respect to disclosing off-balance sheet assets or liabilities. Whereas 80% of analysts said this reporting is extremely important, only 25% of companies were seen as delivering the information satisfactorily. Reporting Systems that Obfuscate rather than Enlighten Arthur Levitt asserts that, while security regulators continue to send a clear message of concern to the corporate community, ﬁnancial reporting in North America does more to obfuscate than enlighten. SFAS 131 illustrates this point. This statement takes a “management approach” to segment reporting. Its goal is to help outsiders to make better predictions of a company’s cash ﬂows by aligning external and internal segment reporting. Sanders, Alexander & Clark (1999), however, argue that the new rules are ambiguous enough to allow wide disparities in the quantity and quality of segment information disclosed by similar companies. Thus, companies can comply with SFAS 131 despite presenting very different information sets. In summary, they state that the broader disclosure rules have not been adopted uniformly. Unsuitable Reporting Models Current reporting models are more suited to a manufacturing economy than one based on services and knowledge because they measure the historical cost of ﬁxed assets, but ignore key drivers of corporate value such as know-how and market share. Stewart (1998) and Nally (1999) argue that recent dramatic changes, particularly in information technology and the global economy, continue to redeﬁne how markets operate. Nally states that today’s ﬁnancial reporting should reﬂect to these changes. But key drivers of corporate value, especially non-ﬁnancial measures, cannot and should not be ignored. Banker, Potter & Srinivasan (2000), for example, ﬁnd that non-ﬁnancial measures are signiﬁcantly associated with future ﬁnancial performance, and contain information not reﬂected in traditional ﬁnancial measures. Nally argues that the net result of not including a variety of measures 249

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is a corporate disclosure gap, which reports incomplete or distorted information about a company’s worth and therefore has diminished relevance to investors. Lundholm (1999) agrees that the historical model, which works well in an industrial economy, fails to capture the creation of knowledge-based value in a timely fashion. This view has been echoed elsewhere in the academic literature (Elliott & Jacobson, 1991; Rimerman, 1990; Jenkins, 1994). Omission of Non-Tangible Constructs The present ﬁnancial reporting system is incomplete because it ignores intangible and non-ﬁnancial measures altogether. As previously mentioned, historical costs are not relevant to investors because they do not reﬂect management activities to create shareholder value. Biggs (1999), citing John Whitney, the executive director of Columbia Business School’s Deming Center, states that the inadequacy of our accounting is not new. What is new is that the forces driving us toward a global economy have raised the potential value of intangible assets. This is not reﬂected in ‘traditional’ ﬁnancial statements. As Arthur Levitt (1998) states, we need to change both the type of information provided and the way it is presented. In a world driven by globalization and technology, where opportunities and risks are bigger, more varied, and more complex, we simply cannot rely on a reporting model that is based purely on tangible constructs. Predomination of Backward-Looking Information Whitney (1997) notes, “accountants have been mired in ﬁnancial history while their constituencies have been asking for a look at the future.” Present accounting practices force ﬁnancial statement users to rely on other resources in order to learn whether a company’s technologies, knowledge capital, and procedures are pertinent to the markets they serve. Although measures like research and development expenditures and capital spending are reported, these historical measures are not indicators of future spending. It would be more relevant if disclosures about these measures were more forward-looking. Examples of more relevant information would include future research and development expenditure plans. ‘One Size Fits All’ Philosophy The accounting profession assumes that one ﬁnancial reporting format will satisfy the information needs of a wide variety of investors. However, this ‘one

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size ﬁts all’ approach is obsolete because of the different types of ﬁnancial statement users who need information for diverse reasons. For example, on the one hand, institutional investors and rating agencies may want full reports that will allow them to plug raw data into their own ﬁnancial models. Licensing or regulatory bodies and retail investors, on the other hand, may want summary reports. Therefore, the accounting profession should consider developing different types of ﬁnancial statement formats that could present user groups with the speciﬁc information and level of detail that they need. Perceived Lack of Proper Involvement of the Audit Process High proﬁle ﬁnancial frauds have raised serious questions about the efﬁcacy of the audit process (Wahlen et al., 1999). The SEC has been said to be concerned about whether the current audit model, which emphasizes risk assessments and analyses over more intensive fact checking and number veriﬁcation, can continue to assure investors that the public is receiving reliable ﬁnancial information. The role of the auditor, and the public’s perceptions of that role, has received intense scrutiny since the early 1980’s. The litigation crises of the 1980’s and early 1990’s (e.g. Holder-Webb, 1995), the recurrent doubts about the independence of the auditor (see Kleinman, Palmon & Anandarajan, 1998, for a review), and the continuing controversies about the public’s understanding of the true meaning of an unqualiﬁed audit report can collectively be regarded as the auditing credibility gap. This credibility gap includes a subset of issues known as the expectations gap. The gap between the users’ beliefs about the meaning of the audit report and its actual meaning led to a major revision of the wording of the audit report during the 1980s. This revision, known as the ‘expectations gap auditing standards’, sought to explain more clearly the way that the auditing process was undertaken and the actual intent of the audit report. Investors need a certain level of ﬁnancial literacy in order to understand both the ﬁnancial statements themselves and the accompanying audit report. As evidence of this point, the Securities and Exchange Commission has created a ﬁnancial literacy campaign. What then are the characteristics of the various subgroups within the broadly deﬁned user community? And why does the existence of these subgroups matter? In the next section we discuss the different categories of investors and examine how the problems described previously are compounded in the presence of a multiplicity of needs and uses.

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Types of Investors Research suggests that experience inﬂuences the way that investors react to ﬁnancial statement information. Pava & Epstein (1993), for example, note that experienced investors rely more on ﬁnancial statements than management discussion and analysis (MD&A). While they read the management discussion and analysis section, they rate the ﬁnancial statement as more useful for investment decision-making. Less experienced investors, however, appear to rely on the MD&A disclosures because they lack the quantitative skills and professional training needed to analyze a company’s ﬁnancial statements in a meaningful way. The fact that unsophisticated investors rely upon MD&A should be a matter of serious concern to securities regulators and company management, especially given the SEC’s recent sanctions against companies for selective disclosure and poor segment reporting in its MD&A section. Inexperienced investors would be more vulnerable to selective information disclosed in the MD&A. In addition, unlike experienced analysts, they may be less proﬁcient at obtaining supplementary and corroborative information from trade groups, competitors, web sites devoted to ﬁnancial information and tutoring (e.g. www.FinancialLearning.Com. Appendix A provides a partial list of ﬁnancial literacy-related web sites), national statistics and other sources outside the ﬁrm (e.g. the Fortune 500 listings). In the next section, we examine corroborating evidence from recently published studies.

EVIDENCE FROM THE ACADEMIC LITERATURE Lev & Zarowin (1999) investigate answers to the research question ‘Does ﬁnancial reporting convey information that investors ﬁnd useful?’ They examine three fundamental elements of reported ﬁnancial information, namely, earnings, cash ﬂow, and the book value of companies to determine the correlations between these variables and changes in the companies’ stock prices. They conclude that the association between these variables and both stock returns and stock prices has been declining for the last 20 years. Lev & Zarowin suggest that change and innovation have contributed to the lack of incremental information in earnings, cash ﬂow and book value. They ﬁnd that accounting information is more useful for evaluating mature ﬁrms than it is for assessing new companies that are in a state of ﬂux, (as measured by changes in relative book or market value), and/or signiﬁcantly change the amount they invest in innovation (measured by R&D intensity). Barth, Kasznik & McNichols (1999) provide supporting evidence. They conclude that, since

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the value of intangibles is rarely accounted for or disclosed, the ﬁnancial reports of knowledge-intensive companies reveal less about ﬁrm value than the ﬁnancial reports of traditional companies do. Therefore, these statements are less useful for predicting future growth. After controlling for company size, the authors ﬁnd that sophisticated ﬁnancial statement users on Wall Street do more research on companies that invest heavily in R&D and advertising (two proxies for intellectual capital), compared to traditional industrial companies. Thus, less experienced and more unsophisticated investors are at a distinct disadvantage. Lev (1999) sees accounting rules as partly responsible for the fact that knowledge intensive companies are hard to evaluate. With respect to research and development, Aboody & Lev (2000) note “this accounting treatment, amounting to an assumption of a 100% amortization rate for intangible capital, denies investors timely and vital information on the success of the projects under development.” We now discuss current changes in the corporate reporting environment and discuss the implications for ﬁnancial accounting.

CHANGES IN THE CORPORATE REPORTING ENVIRONMENT SEC’s Financial Literacy Initiative The number of people who are investing and actively managing their portfolios is growing rapidly due to ease of access to the trading ﬂoor via on-line brokers and the concomitant reduction in brokerage fees. This trend highlights the need for greater ﬁnancial literacy among the investing public. As new and unsophisticated investors enter the market, the average level of investors’ ﬁnancial ‘savvy’ will decline. Thus, the ability of the market to distribute capital optimally among competing uses may deteriorate. While this is speculation, it is quite plausible. In this scenario, the SEC’s concern with ﬁnancial literacy stems from the need to ensure that investors can signiﬁcantly improve their investing decisions, which will help assure that investment capital is more optimally allocated, and hence, generate an increase in national wealth as a result of optimal allocation. At a minimum, the ﬁnancial literacy initiative should foster the perception that individuals have the opportunity to gather and understand the information that they need to make better investment decisions. The Security and Exchange Commission’s ﬁnancial literacy initiative pertains to the ﬁnancial statements and the audit report. The assumption is that misunderstandings of the ﬁnancial statements and the audit report may be caused in part by the relatively low level of ﬁnancial literacy among investors. For 253

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example, the public may believe that the audit report provides a client with a ‘clean bill of health’. However, the auditors do not have a similar perception. Their view is that the purpose of the report is to ensure that the ﬁnancial statements present the results of ﬁrm operations fairly in accordance with GAAP. A better-informed investing public would be less likely to make this error. Greater ﬁnancial literacy on the part of the investing public, either from the literacy efforts of the SEC, or from access to additional information on the web, should also lead to a greater understanding of how to read and interpret the ﬁnancial statements. Financial literacy should improve investors’ ability to make decisions based on the statements. Further, the investor’s understanding of the relationship between the ﬁnancial information and actual ﬁrm performance will be more accurate. Proposed New Standard for Financial Statements A consortium led by the American Institute of Certiﬁed Public Accountants and the Big Five accounting ﬁrms recently proposed a new standard for ﬁnancial statements. The standard is, in effect, a multi-platform computer language known as XBRL. It operates like an Internet search engine for ﬁnancial statement numbers. Companies that publish ﬁgures electronically will now tag each number with a code, enabling users to cull numbers quickly from a range of industries and time frames. Barrons (April 10, 2000) cites Mike Wallis, a PriceWaterhouse-Coopers partner who chaired the group’s steering committee, as stating that XBRL should reduce the cost of Internet publishing by thirty to ﬁfty percent. Further, it will enable ‘retail investors’ to do their own ﬁnancial analysis. This proposed standard for a computerized ﬁnancial reporting database might create a wider expectations gap if investors lack both ﬁnancial knowledge and the requisite computer skills. In this scenario we could end up with a multitiered structure of investor knowledge: complete ignorance, either traditional accounting knowledge or computer skill, and a top tier of investors with sufﬁcient computer skills and accounting knowledge to enable them to take advantage of the capabilities of the XBRL easily. The most important drivers for investing success relate to people’s desire to master accounting data and their cognitive aptitude for integrating information from a variety of sources both on and off the Internet. However, family and work demands may limit people’s time and energy, and decrease their opportunity to seek and master the available information. Even with a favorable resource for gaining additional information, however, people tolerate different levels of information before becoming victims of information overload. Numerous studies have shown that information overload can lead to a dimin-

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ished ability to make accurate decisions. Unsophisticated individual investors are more likely to experience information overload since they lack the decision rules used by sophisticated investors to navigate through complex and copious information (see Belkaoui, 1989). In addition, individual learning styles may vary widely. More intuitive individuals may need a different presentation of materials than more sensing individuals (see Ryckman, 1978). These considerations are not reﬂected in the current regulatory discussions about improving ﬁnancial literacy or ﬁnancial reporting. The issue of the expectation gap, therefore, may be as much a function of the individual’s resource constraints (time, energy, motivation, intellectual ability, and opportunity) as it is of current knowledge of ﬁnancial reporting and auditing issues, and the complexity of the auditing process and ﬁnancial reporting rules. As ﬁnancial reporting grows more complex, and the pool of active investors increases, the ability of the average user to understand ﬁnancial information may diminish over time. The deﬁciencies in the ﬁnancial reporting process itself, and the structural, intellectual, and motivational issues that impair the ability of the average investor to perceive ﬁnancial and audit information accurately, or to assess what information would be beneﬁcial, suggest that the regulatory community has major, perhaps intractable, problems to resolve before it can achieve the goals of its ﬁnancial literacy campaign.

RECOMMENDATIONS The ﬁrst set of recommendations involves the gap between the ﬁnancial statements as they are currently delivered and the ﬁnancial statements as, perhaps, they should be presented. The second set of recommendations addresses the expectations gap experienced by the user of the statements. Lev (1999) notes that ﬁnancial statements have become more complex and harder to comprehend in recent years. Interestingly, there has not been a groundswell of complaints from investors about poor disclosure. In our opinion, this may be due to the tremendous growth in corporate earnings and the corresponding increase in share prices. In good times, few investors read annual reports carefully. The stock price says it all, and until recently, its story has been good news for most investors. This year, however, has seen tremendous volatility in the global ﬁnancial market. Accordingly, nervous investors who usually rely on sophisticated technological tools and professional analysts to do much of their quantitative investigations, would be more likely to read the corporate disclosures more carefully than before. In this context, improvement in several areas may be beneﬁcial. 255

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Amend the Financial Reporting Model to Report on Ex Post Accuracy of Prior Estimates Lundholm (1999) states that discretion in the current model’s reporting makes the results unreliable. Accruals permit the model to report wealth creation or depletion in a timelier manner. Yet they also allow abuse when the underlying estimates are intentionally distorted. Lundholm notes that, surprisingly, the accuracy of the estimates underlying the accruals is never examined; rather, current accruals are mixed together with the reversals of prior accruals. Lundholm proposes that the ﬁnancial reporting model be amended to report on the ex post accuracy of a ﬁrm’s prior estimates. Doing so, in his opinion, will identify ﬁrms that have abused their reporting discretion in the past and provide valuable information about the expected credibility of the ﬁrm’s disclosures in the present. Firms will also have a greater incentive to make accurate estimates and accruals if they know that opportunistic estimates will be explicitly revealed later. Finally, Lundholm notes that accounting regulators might be more inclined to recognize nontraditional assets in the ﬁnancial statements if a system is in place that gives ﬁrms the incentive to estimate the value of these assets accurately. More Auditor Involvement Company management should consider working more closely with their auditors, especially in the management discussion and analysis (MD&A) section. Auditors should not only verify that the ﬁnancial information in MD&A reconciles with the ﬁnancial statements. They should also draw from their extensive ‘hands on’ knowledge of each client’s business and ﬁnancial affairs to critique their client’s MD&A objectively. Auditors can also compare MD&A disclosure to SEC requirements, use benchmarks against an industry peer group, and review industry trends and corporate developments to identify possible disclosure improvements. Use of Technology to Provide More Expansive Information Companies should use technology to make annual reports and other investor information available on the Internet. While the XBRL project moves technological corporate reporting forward by ‘tagging’ accounting numbers, the data provided should be far more extensive, and should comprise both ﬁnancial and non-ﬁnancial measures. Data should include market share and growth, both historical and projected with emphasis on critical success factors such as

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branding, penetration in emerging markets, new or improved distribution channels, and signiﬁcant joint ventures or alliances. It should also include information about intellectual capital, including recruitment and retention of key personnel and the scope of management initiatives. Finally, it should include information about customer and employee satisfaction, including such metrics as retention rates and customer reorder rates. Use Graphics and Other Visual Aids in Addition to Numbers The behavioral/human information processing literature demonstrates that numbers are not always the most useful way to present ﬁnancial data (Beattie & Jones, 1996; Jarett, 1993; Wainer & Thissen, 1981). These authors state that the use of graphics depicting ﬁnancial ratios may foster a better user understanding of the ﬁnancial statements. With the improvement in web page graphic presentation tools, it is theoretically possible to enhance the presentation of ﬁnancial information so that it is clearer to users. Analyst reports and educational tools available on the Internet help to give even the most naive ﬁnancial statement user a better understanding of the ﬁrm. This includes the context within which the earnings process took place, not just of the accounting numbers themselves. If ﬁnancial statement users have different learning styles, then web-based ﬁnancial documents powered by ﬂexible scripts and web programs may allow users to select ﬁnancial displays that best suit their needs. Information would be more fully conveyed because ﬁnancial statement users could choose their own mode for presenting the information. Such improvements will narrow the expectations gap. As these tools become more powerful, they will accelerate the learning process. The goal is for users to gain from each learning experience so that they will be able to determine which qualitative and quantitative information is needed in order to make optimal investment allocation decisions.

CONCLUSION Leif Edvinsson and Michael Malone discuss an important issue facing the profession in their book Intellectual Capital. They cite a 1996 survey that they conducted with corporate controllers and other sophisticated ﬁnancial statement users. Nearly 64% were experimenting with new ways to measure ﬁrm performance other than conventional accounting analysis. Edvinsson & Malone state that sophisticated investors have grown wealthy based on their understanding of the gap between perceived value and accounting value. In a dynamic market in which entire companies and product categories disappear quickly, the authors 257

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note the irony that the income statement and balance sheet offer only snapshots of the company’s recent past. The traditional reporting model has served ﬁnancial statement users well in global capital markets. Yet recent dramatic changes, particularly in information technology and the global economy, continue to redeﬁne how markets operate and are making the traditional model obsolete. In particular the traditional model ignores key drivers of corporate value such as knowledge, skill, and market share. The result is a corporate disclosure gap that reports incomplete or distorted information, and therefore offers diminished relevance to investors. This problem is compounded for less sophisticated investors. Different investors will want and need different information. For example, institutional investors and rating agencies will want different information than regulatory bodies or retail investors. This makes the current paradigm of a single ﬁnancial reporting model obsolete. The problem is exacerbated by differences in the decision-making abilities of experienced and inexperienced investors. During a speech in Seattle on October 19, 1999, Robert K. Elliott, the new chairman of the American Institute of Certiﬁed Public Accountants, explained why the need to respond to change is important by creating an analogy between the accounting profession and the medical profession. Elliott noted that the American Medical Association preferred to cling to its old values even though it faced major changes in the market place resulting from dramatic innovations in technology, changing social needs and values, and a potential rearrangement of the health care paradigm. The AMA, in Elliott’s opinion, “tried to hold back the hands on the clock.” But it could not resist the powerful forces of change. The result? The AMA lost inﬂuence and membership. Many of its members have become the equivalent of hourly workers in health-care conglomerates, not independent professionals. This situation can occur for the accounting profession too unless it responds to the forces of change in the market place. In conclusion, both investors and public companies operate under regulations governing the content and process of companies’ communications with shareholders. In this chapter we seek to provide insights for enhancing corporate disclosure as a ﬁrst step towards creating a ‘different sizes for different needs’ model for ﬁnancial reporting.

REFERENCES Aboody, D., & Lev, B. (2000.) Information asymmetry, R&D and insider gains. The Journal of Finance (forthcoming). Aboody, D., & Lev, B. (1998). The value relevance of intangibles: The case of software capitalization. Journal of Accounting Research (Supplement), 161–191.

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Anonymous. (2000). Corporate reporting: IROs criticized by analysts. Investor Relations Business (February 21), 1, 18. Banker, R. D., Potter, G., & Srinivasan, D. (2000). An empirical investigation of an incentive plan that includes nonﬁnancial performance measures. The Accounting Review, 75(1), 65–92. Barrons, (2000). Talking the talk may soon be easier ﬁnancially speaking (April 10th), 11. Barth, M. E., Kasznick, R., & McNichols, M. F. (1999). Analyst coverage and intangible assets. Working paper. Stanford University Graduate School of Business, Stanford, CA. Beattie, V. A., & Jones, M. J. (1996). Financial graphs in corporate annual reports: A review of practice in six countries. London: The Institute of Chartered Accountants in England and Wales. Biggs, K. (1998). The true picture. CMA Magazine, November 72(9), 7. Elliot, R., & Jacobson, P. (1991). U. S. accounting: A national emergency. Journal of Accountancy (November), 54–58. Ely, K., & Waymire, G. (1999). Special section on the relevance of ﬁnancial statements: Accounting standard-setting organizations and earnings relevance: longitudinal evidence from NYSE. Journal of Accounting Research Autumn, 37(2), 293–317. Fleming. P. (1999). POB panel begins evaluation of audit process. Journal of Accountancy, July 188(1), 12–13. Holder-Webb, L. (1995). Substance and abuse: Accounting ﬁrms and fraud suits. Journal of Accounting Education, 13(4), 509–518. Jarett, I. M. (1993). Computer graphics and reporting ﬁnancial data. New York: John Wiley and Sons, Inc. Jenkins, E. (1994). An information highway in need of capital improvements. Journal of Accountancy (May), 77–80, 82. Kleinman, G., Palmon, D., & Anandarajan, A. (1998). Auditor Independence: A Synthesis of Theory and Empirical Research. Research in Accounting Regulation, 12, 3–42. Lev, B. (1999). R&D and capital markets. Journal of Applied Corporate Finance (Winter), 21–35. Lev, B., & Zarowin, P. (1999). The boundaries of ﬁnancial reporting and how to extend them. Journal of Accounting Research, Autumn, 37(2), 353–385. Levitt, A. (1998). Arthur Levitt addresses illusions. Journal of Accountancy, December 1998, 17. Lundholm, R. J. (1999). Reporting on the past: A new approach to improving accounting today. Accounting Horizons, December, 13(4), 315–322. Nally, D. M. (1999). Time for global reform. Accountancy, June, 123(1270), 79. O’Brien, P. C. (1998). Analysing the analysts. CA Magazine, November, 131(9), 42–45. Pava, M. L., & M. J. Epstein. (1993). How good is MD&A as an investment tool? Journal of Accountancy, 175(3), 51–53. Rimerman, T. (1990). The changing signiﬁcance of ﬁnancial statements. Journal of Accountancy, (April), 82–83. Ryckman, R. M. (1978). Theories of Personality. NY: D. Van Nostrand Company. Sanders, J., Alexander, S., & Clark, S. (1999). New segment reporting: Is it working? Strategic Finance, December, 81(6), 35–38. Sanford, D., & Eprile, B. (1999). 7 steps to better disclosure. CMA Management April, 73(3), 18–22. Saudagaran, S., & Biddle, G.C. (1992). Financial disclosure levels and foreign stock exchange listing decisions. Journal of International Financial Management and Accounting, 4(2), 106–147. Stewart, T. A. (1998). Real assets, unreal reporting. Fortune, July, 138(1), 207–208. Unger, L. S. (1999). Corporate communications without violations: how much should issuers tell their analysts and when. Speech at the 19th Annual Ray Garret Jr. Corporate and Securities Law Institute (April 23).

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Wahlen, J. M., Boatsman, J. R., Herz, J. R., & Jennings, R. H. (1999). American Accounting Associations’s Financial Accounting Standards Committee. Accounting Horizons, December, 13(4), 443–452. Wainer, H. C. & Thissen, D. (1981). Graphical data analysis. Annual Review of Psychology, 32, 191–241.

APPENDIX A: FINANCIAL LITERACY-RELATED INTERNET SITES GE Center for Financial Literacy: WWW.FINANCIALLEARNING.COM This site provides planning tools, interactive on-line courses, a ﬁnancial dictionary, investment and ﬁnancial planning information. Building Blocks to Financial Literacy: WWW.POWERSOURCE.COM/CCS/FINLIT/DEFAULT.HTML Web site compiled by the Consumer Credit Counseling Service in Houston, TX. Includes a range of ﬁnancial literacy programs for children, students and adults. The Center for Debt Management: MEMBERS.AOL.COM/DEBTRELIEF/INDEX.HTML Provides much information and advice on debt management. Finance Center: WWW.FINANCENTER.COM Provides over twenty ﬁnancial calculators that help consumers answer such questions as: Should I buy or lease a car? What mortgage amount can I afford? Should I reﬁnance my current mortgage? Securities and Exchange Commission: WWW.SEC.GOV Presents detailed ﬁnancial information, including all required federal ﬁnancial ﬁlings, search tools, details of SEC enforcement actions against accountants, auditors, and ﬁrms. Women’s Financial Network: WWW.WFN.COM WFN is a female-oriented site. It describes its mission as providing women with the insight, advice, and other resources needed to increase one’s wealth through increasing one’s understanding about ﬁnances. Money Magazine: WWW.MONEY.COM Money.com provides a variety of tools, articles, and discussion of investing, taxation, money management and related topics. Also, it provides interactive lessons on various ﬁnancial and money management topics.

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QUO VADIS CPA? Gary John Previts

ABSTRACT Dynamic opportunities for change in the marketplace for CPA services are causing, once again, an examination of the scope of those services. Proposals are being made to transform the profession and to be responsive to the marketplace as a key to transcending traditional mandates. In such free enterprise systems where the right to own private productive property is the constitutional cornerstone of economic enterprise, the CPA’s role is fundamentally aligned with an information right inherent when such property is invested. This study considers the implications such information rights have upon the scope of CPA services. With legislation from the era of the New Deal, such as the Glass Steagall Act, being replaced by open competitive realignment for services, it is no wonder that the architecture of the CPA profession’s Scope of Service, based as it has been for decades upon the ‘audit franchise,’ is once again under examination. The Integrated Electronic Global Economy, with new business forms and instant worldwide transactional access, appears to have shaken the foundations of the legislative social contracts, at State and Federal levels, which provide purpose and identity to CPAs. The historical reality of course is that the Scope of CPA Services has been dynamic since its inception, but the image of a CPA as a busier examiner of details, remains . . . much to the dismay of the visionary leadership of professional

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organizations who perceive virtual transformation of the profession not only a necessity but perhaps even a certainty. Since a conversation with the Chairman of the Public Oversight Board in late April, I have been more closely following the reports about the current controversy related to CPA Independence and Scope of Service. As a member of the AICPA’s Group of 100 and as an elected member at large of the AICPA’s Governing Council, I have had several recent experiences related to the latest round of futurism and professional self scrutiny about what is essential about the CPA Profession, including its limitations and its need for a broader global identity. The process of responding and developing appears to me to be strongly inﬂuenced by outcomes anticipated in this year’s national elections. Betting on which party will control the White House, the House and the Senate, and weighing the likelihood of legislation accordingly serves as a platform for decisions. I am concerned that this approach will not provide a strategic solution to the long term role for our profession in a dynamic society, albeit I understand that everything in our system considers the exercise of the public’s franchise . . . and in such times as these, even more so. For the CPA profession to prosper, nay, even survive, it will require identifying its unique social mandate . . . one which aligns three elements: the public interest, the knowledge, skills and abilities of individual CPAs, and the needs of the marketplace. In the case of a legal profession this mandate is contained in the performance of the role as advocate of the individual’s constitutional rights under our system. In the case of the health care professions [physicians, psychiatrists, nurses, dentists, etc.] the mandate is in preserving the ‘well being’ of the patient, physically, emotionally/mentally. No similar social mandate to support our Scope of Services has been readily identiﬁed or accepted by the CPA profession. Indeed, instead, it waivers from the edge of being process/ operations engineering at one end, to the practice of tax attorneys at another. It may be helpful therefore to observe that a mandate for the CPA Profession does exists in the United States because under our constitutional system, the Property Right of each individual [the right to own private productive property] is protected. In today’s Investor Fund Society, where nearly every individual with retirement or e-trading funds touches the public markets, and where individuals are separated from the custody of their capital property by intermediaries, one is separated from knowledge about one’s property and therefore in the position where one must trust the information provided by intermediaries and by agents of massive public capital market institutions. For a Property Right without a corresponding Information Right, is at risk. Herein the role of the CPA Profession has already become recognized as a unique and market mandated one, as the trusted profession.

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The CPA Profession’s social contract and mandate is it’s role to support the information right of the individual investor, and thereby provide a basis from which the highest and best use can be made of scarce global capital investment resources needed beneﬁt all by providing a higher standard of living, and improved knowledge to individuals about their investment property. The public interest and the market place both need a broadly educated profession with high technically proﬁciency and the moral capacity to oversee the ﬂow of information which sustains the individual’s property right, the constitutional basis of individual incentive and responsibility in free enterprise. A CPA Scope of Service rationale with its core focus related to information rights, therefore provides the Profession in all truly democratic systems, which constitutionally recognize the individual right to own private productive property, with its core purpose, its social mandate. The work of the CPA profession is fundamentally dedicated to the preparation, assessment, analysis and dissemination of decision information, relevant to ﬁnancial and performance measures used by those who invest and manage the resources of a competitive free enterprise system. True professionals involved in all activities related to these information ﬂows are de facto members of this profession. Services beyond those which can be demonstrably related to the ‘information right’ may be appropriate, but are ancillary, and may be regarded as such in terms of the public interest.

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THE TYRANNY OF THE ANALYSTS: VALUE DRIVING INFORMATION Larry M. Parker and Gary John Previts

ABSTRACT A variety of views exist as to the price setting processes in public capital markets. This study examines the role and inﬂuence of the analysts on price setting in relation to other groups. It inquires into the implications of ‘value driver’ information as a component of publicly available information, in part as a response to concerns about selective disclosure within the investment community. Despite the possible rationale for such disclosure, the road to acceptance and implementation of such information seems likely to be lengthy and controversial. Are publicly traded stock prices ‘set’ by analysts? If so, what is the role of the day trader? The e-trader? Are analysts the link between companies and individual investors? What differential do we assign to the inﬂuence of buy side versus sell side analysts? Analysts have information channels to help gather certain information that is not readily available to individuals. Management has incentives to communicate with analysts, presumably to ensure their company is well and properly valued. A misinterpretation by analysts could create a signiﬁcant effect on stock price. Once the analysts make their projections, companies ‘target’ those projections, or suffer the consequences. The recent SEC initiatives regarding ‘selective’ disclosure and the SEC Staff Accounting Bulletin number 101 (revenue recognition) address parts of the

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fair and full information problem. Other components of the market are ‘the individual investor’ who ‘take’ the price set by analysts and the ﬁnancial managers who respond to analysts projections. If the system which arms the analyst with price setting power does not equally permit the ﬁnancial manager and individual investor countervailing inﬂuence and wide access to information, then the new state of the market could well be the tyranny of the analysts. This reasoning can go further. Some have argued that today’s accounting standards, and the ﬁnancial reporting resulting from those standards, are overloaded – too complicated for anyone except for the professional, the analyst (Samuel A. Derieux, Journal of Accountancy, May, 2000). Only the most ﬁnancially literate understand the complex ﬁnancial information that is generated. But the above reasoning comes against an unusual economic backdrop. Today’s e-market valuations are not tied to traditional (NPV, ROI) ﬁnancial accounting measures. So the small investor who is somewhat literate has no ready equivalent to the advantages which professionals employ in developing nontraditional measures of valuation, and is left to be a market price taker, with little hope of being a price maker in the public market. Perhaps it is a reality worth considering – especially since large institutional investors, since 1990, have to themselves an entire second market of unregistered securities (permitted under SEC rule 144a) in which they also trade among themselves. That is, the market is not a single one, but two markets. One market is a private market for the sophisticated and institutions and their analysts, and another, additional, public market where prices are made by analysts – and smaller individual investors place their funds as well. In such a two tiered market the use of public information and the rights of individual investors seem more at risk today, given the channeled dependency on analysts. Analysts are generally inﬂuential, small individual investors are likely to be ﬁnancially less literate, and the market is in an unprecedented state. Furthermore, the overall valuation of an e-business does not seem to be as ‘rational’ (in terms of ﬁnancial information provided in ﬁnancial reports). Perhaps the real concern is not tyranny, literacy, information overload, or volatility in the market. The problem may be ‘What information is appropriate for this new e-market?’ How well does the traditional ﬁnancial information mode communicate about the underlying value drivers of a publicly traded company? That is, historical ﬁnancial information is an indirect measure of the most critical aspects of the company, namely information about what ‘drives’ the perception of the company’s value. Financial information is only a reﬂection or a result of the value drivers. Value drivers themselves should become more explicitly a part of the information contained in the reports of businesses which

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are supplied to the individual shareholders who’s public market participation is essential to our system of capital markets. The value drivers of a company are the factors which will determine its long term success. These items of information are the ingredients of successful analyses and the cornerstone of understanding what makes a company a valuable investment. Various lists of value drivers can be found and include such items as: Quality and execution of strategy Quality and credibility of management Market share Industry economic outlook Effectiveness and efﬁciency of key processes Proper organizational structure to achieve strategy and promote ﬂexibility Ability to attract and retain top talent Ability to research and innovate Ability of the corporate culture to adapt to international imperatives Ability to develop and utilize intangibles such as networks and human capital Each generic value driver is, of course, tailored to a speciﬁc industry. For example, the textile industry might need to address value driver issues of brand recognition, use of top designers, ability to maintain supply and control costs, among others. The automotive industry might look speciﬁcally at global productive capacity of the industry and outsourcing issues, work force relationships, environmental concerns, new products, supply chain outsourcing, vehicle platform development, and so forth. As the business reporting model assumes a greater role in communication between operating companies and individual shareholders, it seems that timely and speciﬁc communication about value drivers are connected with overcoming concerns about selected disclosures and concentration of information in the hands of the few – the analysts. Financial reporting related to a value driver model which communicates directly to investors (and analysts), but can only be truly effective if the alignment of value driver information are readily understood and employed by individual investors who are able and willing to substitute their own best judgment for that of the current information intermediary – the analyst – making the inﬂuence of the communication middlemen, analysts, less signiﬁcant. There could be potentially signiﬁcant ‘disintermediations’ to implementing a value driver based business report. One is potential loss of competitive advantage. For example, companies that trade on non-USA exchanges are certainly not going to have to bear the cost of providing all the non-ﬁnancial 267

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information, and perhaps fewer international companies will be interested in trading on USA exchanges. Would companies be reluctant to provide information on the value drivers to competitors? For example, there is a saying that a strategy that is generally known is no longer a strategy, and a company that discusses its strategy may throw away its strategic advantage. Another difﬁculty is that traditional audit techniques most often seem related to ﬁnancial performance measures and not non-ﬁnancial information as such. Would the value driver information be auditable? Auditors generally are not expected to provide an evaluation of strategy or other management intangibles such as talent retention, corporate structure, marketing initiatives, etc. Even if auditors could develop the requisite abilities, it is not clear what price, if any, investors would be willing to pay for an auditor’s opinion related to value driver performance measurement. Indeed, it is not clear that an audit of such information is practical – if cost effective at all. Disclosure and communication in a business reporting model which includes value drivers is a timely idea! Yet the preparer and analyst communities might well be opposed. Auditors could fear increased liability. How would this align with the AICPA, with its emphasis on an extensible business reporting language (XBRL)? How would the SEC view ‘value driven information?’ The academic community might well favor such an approach, but its inﬂuence is limited compared to the other groups. The FASB, as well as the leadership of the Business Reporting Research Project have an opportunity, once again, to challenge the status quo. The challenge would be one which would be elementary – and would require a patient attitude oft described in the philosophy of those who compare solving major problems to the philosophy of elephant eating. It’s best done one small bite at a time.

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Corporate Social Awareness and Financial Outcomes by Ahmed Riahi-Belkaoui (Quorum Books Westport Connecticut, 1999, 208 pages) Price $65.00. ISBN 1–56720–243–8 Reviewed by Timothy J. Fogarty Continuing a long series of monographs with Quorum Books, A. Belkaoui’s new book addresses corporate social behavior. This topic has intrigued, but yet confused, many accounting researchers that are more accustomed to the study of proﬁt-seeking behaviors. The position of the corporation as a key repository of wealth and important initiator of action in the modern era suggests that positive social outcomes should be expected from those organizations. Accordingly, a better understanding of corporate social performance is needed. The book consists of nine chapters of approximate equal length. The ﬁrst few chapters attempt to frame the basic issues. Corporate social performance is, for the most part, addressed by the author as their level of awareness of social cost. Although pollution and its abatement provide the best example, Belkaoui’s deﬁnitions are broad enough to consider much different elements such as corporate reputation. The next chapters attempt to translate social awareness into standard corporate outcomes such as CEO compensation and asset development. The book then focuses on the disclosure of socioeconomic performance, considering it as both an independent and a dependent variable. In the last two chapters, the author considers whether socioeconomic information is associated with abnormal market returns, regulatory costs and corporate exposure levels. Thus conﬁgured, the book carves out a broad and ambitious domain. Although the publication of this book should be successful in heightening readers’ attention to what is still a quite neglected area, Belkaoui’s treatment leaves quite a bit to be desired in its development of the topics. The book is not as ‘user-friendly’ as it should be, nor are deﬁnitions established at the beginning with care. Most importantly, several of the chapters of the book are modiﬁed presentations of materials published by the author over the years. Since these republished chapters are empirical studies originally intended as standalone works, their juxtaposition in this book is problematic. Together they take the reader on a rather bumpy journey of differing topics, differing measures

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and differing assumptions. The book does not build upon itself in the way that monographs should. For example, the material in the ﬁrst few chapters (done especially for this book) has only a suggestive relationship to the subsequent parts of the book. The author makes no attempt to conclude the book with a summary of what has preceded. Therefore, the best way to understand the book is as a series of essays and empirical treatments. Although the attempt to force the book to ‘hang together’ is a natural one, it will not be very successful in this case. The inﬂuences of this book will be limited by the fact that it is surprisingly dated. The theoretical conceptions used in the ﬁrst two chapters are derived from an economic literature that could now be called classic. Although such work may be new to some accounting academics, Belkaoui has little to add to that which has been done by economists over the last two decades. The empirical work is seriously dated, with some materials employing measures developed by Ernst & Ernst in 1973. My understanding of the area is that it is highly dynamic. The value added of reprinting old studies as chapters in a book is questionable. A reader would have to wonder if the change in corporate attitudes towards disclosure, combined with intensifying efforts by external monitoring agencies, would have altered the relationships explored in the past. The age of some of the materials collected in this book necessitates that its substantive conclusions be treated with some degree of skepticism. New measurements have been developed. We are no longer as dependent as we were when Belkaoui’s original work was done on rankings done under unknown circumstances. The ability to access raw data necessitates the continual construction of new measures. The means of data analysis has also progressed dramatically since that time. This book is also difﬁcult to understand. As is typical in other Belkaoui books, descriptions and literature developments are highly idiosyncratic. In other words, it is challenging to map Belkaoui’s treatments into those more frequently found in the literature. Those that have the patience to work this through will probably be rewarded with a more robust appreciation for the central constructs. I recommend this book for limited purposes. Those that are interested in the history of academic attempts in this area would ﬁnd it interesting. The author was one of the pioneers of social awareness at a point when very few others cared. The footnotes and references tend to be a good portrait of what was done up through 1990. Those completely unaware of social accounting will be surprised to see the breadth of its emergence. Such readers might ﬁnd the book not sufﬁciently user-friendly as an introduction to the area. Even so, the author should be congratulated in producing another timely effort.

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Earnings Measurement, Determination, Management, and Usefulness: An Empirical Approach by Ahmed Riahi-Belkaoui (Westport, CT; Quorum Books, $65.00 1999 184pp., ISBN 1567203302) Reviewed by Bob R.C.J. Van den Brand, Tilburg University, the Netherlands Ahmed Riahi-Belkaoui’s book, Earnings Measurement Determination, Management and Usefulness: An Empirical Approach, consists of 13 chapters of new and published papers with topics related to earnings management and usefulness. The book can be roughly divided into ﬁve parts; the ﬁrst chapter, the income statement, can be seen as part one. The second chapter, which covers earnings measurement and price level changes, is the second part. The third chapter which evaluates accruals and cash ﬂow based models is part three. Chapters four through seven, the fourth part, illustrate income smoothing and earnings management. The ﬁfth part consists of chapters eight through thirteen, which deal with several topics in the ﬁeld of usefulness of earnings. Chapters three, seven, and nine through thirteen are previously published papers and chapters from his books from the 80s and 90s related to the topic of income smoothing and earnings management. I will discuss and evaluate the contents of the book chapter by chapter accompanied by my own opinion. The ﬁrst chapter gives a description of the income statement, discussing in a refreshing way a variety of relevant elements and methods. The author starts ﬁrst explaining the two concepts of income: the transactional approach and the capital maintenance approach. In the ﬁrst chapter, the transactional approach is discussed. The ﬁrst part of the chapter gives deﬁnitions and practical examples of basic concepts like accrual, matching and allocation. The recognition of revenues is divided by events or points in time. Five critical points, are: during production, at the completion of production, at the time of sale, when cash is collected and when a future event occurs. The recognition of revenues during production of long-term contracts is deﬁned and illustrated by a theoretical example of the percentage of completion method and completed contract method. The remaining sections discuss several closely related subjects to such as current operating proﬁt versus the all-inclusive concept, formats, extraordinary items, results from discontinuing operations,

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prior period adjustments and accounting changes. Each of these subjects is discussed and sometimes illustrated, which is useful for the more empirical part of the book. The chapter concludes with the earnings per share (EPS) and a note on the FASB standard. Although the chapter covers a wide variety of topics, they are discussed in a limited number of pages. The transactional approach to income is handled particularly well. The second chapter by Riahi -Belkaoui discusses earnings measurement and price level changes. Capital maintenance consists of ﬁnancial capital maintenance (units of money) and physical capital maintenance (units of purchasing power). The author combines these two units of capital maintenance with the four attributes of asset and liability valuation (historical cost, current entry price, current exit price and capitalized or present value of expected cash ﬂows) to eight alternative asset valuation and income determination. Six out of eight models are discussed. The present value expected cash ﬂows (in units money and units of purchasing power) is not dealt with because some assumptions must be made. The six models are evaluated and compared on timing errors, measuring unit errors, interpretability (understandable in meaning and use) and relevance (usefulness). All six models are discussed and illustrated well by means of an income statement and a balance sheet. Numbers of dollars and command of goods as described by Chambers’ are used to measure interpretability and relevance. The use of these two measures for the comparison and evaluation makes the outcome of the ‘best’ model predictable, General Price-Level-Adjusted- Net Realizable-Value Accounting. (GPLA-NRV). In other words, General Price Level Adjusted accounting combined with the exit value model of Chambers and Sterling yields the best results. A detailed overview of FASB Standard No. 33, Financial Reporting and Changing Prices (1979) is given. Riahi-Belkaloui reviews some of the pitfalls of FASB standard No. 33, in adopting GPLA-NRV instead of requiring disclosure of the effects of inﬂation and speciﬁc price changes. In my opinion, even today, where accounting and price level changes in some parts of the world seem to be less important than in the 70s, this chapter is still very valuable in understanding the basics of the main valuation systems. Some of these valuation systems are ‘newly’ practiced today. In the third chapter, Earnings Determination Following Wealth Measurement, the idea that earnings are determined as a response to the wealth generated by the ﬁrm is presented. The earnings are measured by net value added plus a process of adjustments to the previous earnings level. The net value added-earnings policy model is tested for the period 1976 through 1995, and represents 3998 ﬁrm/year observations from non-ﬁnancial ﬁrms listed on the NYSE and AMEX. Belkaoui’s conclusions are twofold. Firstly, there is a

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positive proportional relation between the earnings and the level of wealth generated (as measured by the net value added). Secondly, Belkaoui management deﬁnes the level of earnings in a certain year by the level of earnings in the previous year. In the fourth, ﬁfth and sixth chapters the author investigates the relation between income smoothing and earnings management on the one hand, and multinationality and corporate reputation on the other hand. In chapter four, ‘Contextual Accruals and Cash Flow Based Valuation Models: Impact of Multinationality and Reputation’, Belkaoui examines the generality and robustness of an accrual and a cash ﬂow based model that includes multinationality and corporate reputation (68). The author argues that the impact of multinationality on market value is positive. This is due to the fact that multinational ﬁrms show a lower systematic risk and unsystematic risk compared to purely domestic ﬁrms, multinationality is measured by ﬁve variables. For example, one variable is foreign sales to total sales. The author argues that the right impression or the right reputation based on accounting and market information gives a competitive advantage in industry by means of equity. Corporate reputation is measured by eight variables, for example, quality of management, scaled from 0 (poor) to 10 (excellent). Results are obtained from three models. In Chapter ﬁve, ‘Multinationality and Earnings Management’, the author focuses on and tests the hypotheses that unlike managers of low multinationality ﬁrms managers of high multinationality ﬁrms make accounting choices to reduce reported earnings. Income-decreasing accruals are used to reduce/affect the net income and thereby the political risk and political costs associated with high multinationality. In chapter six, ‘Earnings Management and Reputation Building’, it is argued that corporate reputation is negatively associated with accruals and positively associated with cash ﬂows. The result of this study shows that of the high corporate reputation of a ﬁrm’s management makes accounting choices to reduce reported earnings and thereby try to reduce political costs. In chapter seven, ‘The Smoothing of Income Numbers’, Riahi-Belkaoui indicates the effects of a dual economy on income numbers. The economy is divided into two distinct sectors: the core sector and the periphery sector. High profitability, high proﬁts, intensive utilization of capital and high wages characterize the former sector. Periphery industries lack almost all of these characteristics. Smoothing is measured by operating expenses, ordinary expenses, operating expenses plus ordinary expenses vis-à-vis ordinary income and operating income. Over a period of 20 years, 171 U.S. ﬁrms (114 core and 57 periphery) were investigated by the time trend model and the market trend model. A majority of the ﬁrms resorted income smoothing with a higher number in the 275

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periphery sector. In the author’s opinion this study attempts to add organizational characteristics to differentiate ﬁrms in their income-smoothing behavior. In my opinion this paper clearly illustrates smoothing ‘methods’ using 13 exhibits divided into core and periphery sectors. Chapter eight, ‘The Relevance of Earnings Levels versus Earning Changes as an Explanatory Variable for Returns’, examines two different models. Model A links security returns to changes in earnings (change) or abnormal returns to unexpected earnings. Model B links security returns to the earnings level (level). The results of the study are as follows: Both models play a role in valuing securities; future earnings and change in earnings are signiﬁcantly explanatory for stock returns, and Model A has a better association with stock returns (based on R2) than model B. In chapter nine, ‘Accrual Accounting and Cash Flow Accounting’, RiahiBelkaoui evaluates the differences between cash ﬂow numbers and income statement numbers compared to the balance sheet number based on accrual or cash ﬂow accounting. The difference between the latter is signiﬁcantly less than the former, so Riahi-Belkaoui believes that standard setters should take an ‘asset/liability’ view of earnings rather than a revenue/expense on cash ﬂow view. In chapter ten, ‘Cash Flow, Earnings, and Corporate Control’, the relation between target ﬁrms’ earnings and cash ﬂows to these measures in industries is investigated. Riahi-Belkaoui ﬁnds evidence, based on data collected from 63 ﬁrms between 1977 and 1989, that the cash ﬂow and earnings to total assets ratios of target ﬁrms are below their industry average. A second ﬁnding is that shareholders of a target ﬁrm get abnormal returns during the takeover period. In chapter eleven, ‘The Information Content of Value Added, Earnings, and Cash Flow: US Evidence’, the relative and incremental content of value added, earnings and cash ﬂow is discussed. This study investigated 4,325 ﬁrm-year observations for the period 1981–1987. Riahi-Belkaoui concludes that, in terms of incremental information content, the value added information dominates the earnings and cash ﬂows. The author argues that ﬁrms should disclose underlying value added data. In chapter twelve, ‘Earnings-Returns Relation versus Net-Value AddedReturns Relation: The case for a Nonlinear Speciﬁcation’, the author discusses the beneﬁts of the value- added statement. He rearranges the income statement in terms of gross and net value added. This information is then related to market returns. In chapter thirteen, ‘Accrual Accounting, Modiﬁed Cash Basis of Accounting and Loan Decision’, Riahi-Belkaoui investigates the perception of users confronted with either accrual accounting information or information based on

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the modiﬁed cash basis of accounting. Accrual information is preferable to modiﬁed cash ﬂow accounting by loan ofﬁcers for examining the results of a ﬁrm. Riahi-Belkoui’s book gives a comprehensive overview of earnings management from a cash ﬂow and income statement perspective. Previous papers and articles substantially contribute to the subject, with ideas for standard setters and accounting scholars. Every chapter ends with a few lines with approaches for researchers and/or standard setters. As stated earlier the beginning of the book points deﬁnes terms and concepts clearly and concisely. The empirical approach in the later part) is well explained and well illustrated for all accountants. In my opinion, the chapters, on reputation and multinationality (4, 5 and 6) are excellent in that may explore new territory. The use of already published papers and chapters has advantages and disadvantages.

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The Art and Science of Business Valuation by Albert N. Link and Michael B. Boger Foreword by James H. Ogburn ISBN 1–56720–171–7 Quorum Books 1999, Westport, Conn. 152 pp., $58.00 Reviewed by Haoling Tan Case Western Reserve University How much of a business valuation should be art and how much should be science? Albert N. Link, a Economics professor of the University of North Carolina, and Michael B. Boger, a Certiﬁed Valuation Analyst, both believe that any comprehensive valuation can not exclude either. This book provides an introductory overview of business valuation methods that point to the limitations of valuation and the strength and weaknesses of various valuation methods. Using plain English, easy-to-follow steps and fully illustrated samples, the authors provide valuable tools for novice valuators and individuals interested in business valuations. The book starts with a brieﬂy discussion of the elements of business valuation by listing ﬁve general areas in which business valuations are important: Mergers and Acquisitions, Buy/Sell Agreements, Acquisition of Capital, Estate Planning and Litigation Support issues. The ‘Overview of the Book’ section at the end of the introduction lays out the topics covered in each of the following 11 chapters – a useful site-map for readers to pinpoint interested issues or to decide if they should switch to a more technically advanced book. The following two chapters are still designed to refresh readers by explaining of basic concepts of business models and the four basic tools used in a business valuations: Forecasting, Weighted Averages, Present Value and Capitalization. Anyone who may had Economis 101 in high school or college and forgets every thing about Micro or Macro, should be warmed up and in good shape to continue to explore the world of business valuation. To facilitate the discussions of business valuation in Chapters 5 to 11, Link and Boger constructed three hypothetical businesses: Gate City Widget Company, Gate City Video Rental and Gate Orthopedic Clinic in Chapter 4. As the authors point out, these companies are designed to serve the purpose of illustration, and readers should not make generalizations or comparisons

Research in Accounting Regulation, Volume 14, pages 279–281. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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between the ﬁnancial speciﬁcs of these hypothetical businesses and particular valuations. Link and Boger use an easy to follow pattern in discussing different valuation methods through Chapters 5 and 11 – introduction/background information, mathematical expression and applied samples. This approach serves the reader well since it explains illustrates and summarizes each situation, so that at the end of each chapter the reader walks away with a full understanding of each method that has been discussed. Chapter 5 Trends in Financial Data discusses Forecasting and Weighted Average methods in a more detailed fashion based on the three business examples presented in Chapter 4. The authors select Revenues, Net Income and Stockholder’s Equity for detailed illustration because they believe these three ﬁnancial measures are among those that are most likely to be forecasted. The authors spend most of Chapter 6 explaining the determination of risk assessment. They emphasize the importance of a thorough understanding of the nature of risk as related to discount rates and capitalization rates. Samples are also given for the calculations of Return on Investment, the Risk-Return Tradeoff and the Build-up Method for Determining Discount Rates and Capitalization Rates. Chapter 7 Comparability provides detailed ratio analysis in the following three categories: liquidity ratios, capital structure ratios and proﬁtability ratios. Link and Boger do not merely list the formula for P/E or ROA or EPS calculation, more importantly they provide the interpretations to help the readers to understand the meaning of these ratios. The authors believe that it is science to understand how to calculate a ﬁnancial ratio, however, it is art to know how to use and how not to use a ﬁnancial ratio. They illustrate these approaches in terms of the three hypothetically constructed business examples. Link and Boger also point out that one ﬁnancial ratio that may be important when valuing a business and generally not listed is the ratio of offers/directors compensation to sales. In such case, a potential buyer might normalize the business’s income statement and impute a reasonable level of compensation, thus lowering net income and the offer price. More advanced valuation methods, including Present Value of Adjusted Future Earnings, Price-to-Earnings Ratio Method, Capitalization of Excess Earnings Valuations Method and Adjusted Net Asset Method are discussed in Chapter 8. Each method is discussed in terms of its underlying assumptions, its relevance to particular valuation exercise, and ﬁnally in terms of scientiﬁc implementation. The authors believe that the calculated value of business would generally have to be adjusted, and they discuss the following two adjustments at the end of the chapter: an Adjustment for Ownership Control and an Adjustment for Transfer Marketability.

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In Chapters 9 through 11, the authors apply the appropriate valuation methods from previous chapter to each of the three hypothetical businesses. The Present Value of Adjusted Future Earnings and Price-to-Earning Ratio methods are used for Gate City Widget Company; the Adjusted Net Asset Valuation Method is used for Gate City Video Rental Company; and the Capitalization of Excess Earnings Valuation Method is used for Gate City Orthopedic Clinic. By following these three carefully illustrated samples, readers should gain the full understanding of various valuation methods discussed and quickly adopt to the process how to apply mathematical expression to real life situations, and start to appreciate the art and science of business valuation. Link and Boger summarize their points about the art and science of business at the end of this book in Chapter 12. They restate the importance that the ﬁnancial data describe a company should be understood not only in terms of the accounting connections used in its preparation, but also in terms of the economic environment of the entire business. The authors emphasized that the most contemplated aspect of a business valuation is the quantiﬁcation of the risk of the business, and that there are many dimensions of comparability as related to business valuation while these dimensions are broader than a simpler industry standards. The authors conclude the book stating that no single valuation method is applicable to all valuations, and that judgement based on experience will serve the valuators well in practice. The Art and Science of Business Valuation provides an overview of business valuation methods, as well as their strength and weakness at the elementary level. If you are planning entering the ﬁeld of business valuation, then this book will provide valuable exposure at the introductory level.

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Value Added Reporting and Research: State of the Art by Ahmed Riahi-Belkaoui (Westport, CT: Quorum Books, 1999, $65.00, 200 pp., ISBN 0899306519) Reviewed by Michael E. Doron Case Western Reserve University Ahmed Riahi-Belkaoui’s Value Added Reporting and Research is an introduction to the subject for an American audience. It promotes the value added statement, an alternative to the traditional Income Statement that emphasizes all a company’s stakeholders rather than focusing on capital providers. Chapter One discusses the development of value added reporting, tracing its modern origins (he writes that “suggestions can be traced as far back as the eighteenth century”) to Europe in the 1970’s. The Corporate Report published in 1975 by the Accounting Standards Steering Committee (now the Accounting Standards Committee) of the United Kingdom recommended the use of a value added statement. Chapter One also gives a brief explication of value added reporting and discusses the increased comparability of ﬁnancial statements with macro-economic information if value added is used, as value added focuses on wealth creation. Chapter Three is an overview of the research on value added. Belkaoui divides the existing literature into three categories: ‘Value Added Performance of Firms’, ‘Market Valuation and Value Added versus Conventional Data’, and ‘Predictive Ability of Value Added Data’. Belkaoui discusses each of these topics and the appendix reproduces several papers. Three chapters demonstrate the intended applications of value added, including the application of price change models and improved analytical analysis (Chapter 2), Earnings Determination (Chapter 3), and Valuation (Chapter 5). The concluding chapter (Chapter 6) investigates why value added is not more commonly used and concludes that while value added is more intuitive than the traditional Income Statement, accountants reject it because it is not what they are used to dealing with. The value added statement is best understood by its accounting equation: Sales – Bought In Materials and Services – Depreciation = Wages + Interest + Dividends + Taxes + Retained Earnings

Research in Accounting Regulation, Volume 14, pages 283–284. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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This highlights the wealth created by the ﬁrm for all the parties affected: government (taxes), creditors (interest), shareholders (dividends) and the ﬁrm (retained earnings). Belkaoui writes that value added has found acceptance in Europe and is gaining popularity in the United States because ‘the importance of shareholders has slightly diminished’ and goes on to argue: If the company’s objective remains the maximization of shareholder return, then the focus will remain the proﬁt of the ﬁrm. But if the company’s objective shifts to a consideration of the welfare of the total production team [the stakeholders in the equation above], then the focus will shift to the value added of total return to the ﬁrm.

But Belkaoui’s advocacy cannot hide the fact that value added is essentially a political paradigm that would have difﬁculty demosntrating impact on accounting or, one suspects, upon the readers of value added ﬁnancial statements. As the equation above makes clear, value added is simply a rearrangement of the accounts shown in a traditional income statement. Though Belkaoui does make intermittent attempts to justify value added as information added, the book, and the many papers reproduced in its appendices, fail to provide evidence which would be sufﬁcient to convince this reviewer. One of the few sources Belkaoui cites to demonstrate American support for value added, the American Accounting Association Committee on Accounting and Auditing Measurement 1989–90, makes a much better case for reorienting ﬁnancial statements towards stakeholders. Their report gives examples of annual reports that feature voluntary disclosures on the ﬁrm’s treatment of workers and production’s impact on local natural resources, changes that might ﬁnd broad support in the United States.

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Mexico for the Global Investor: Emerging Market Theory and Practice by Timothy Heyman (Editorial Milenio, S. A. de C. V., 1999, $49.95, 397 pp., ISBN 9686141103) Reviewed by Rahmadi Murwanto An American investor who wants to make an investment in foreign countries, especially in emerging markets, must understand the characteristics of those markets. This text discusses various aspects of the Mexican market, an emerging market that is considered to be unknown to average American investors and international investors. The text provides an overview of the background, history, and the development of Mexican ﬁnancial and capital markets. In discussing the Mexican market, the author compares the various aspects of this market with the American market. This text also discusses various ﬁnance concepts and techniques and their application in the Mexican market setting. The purpose of the book as stated by the author is to help the global investor, both institutional and individual, understand and beneﬁt from investment opportunities in an emerging market such as Mexico. The text opens by discussing the background settings in which the author decided to write the text. As an analyst and an academician, the author thinks it is necessary to write every known aspect of investing in an emerging market. Using Mexico as his model, he tries to present the investment theory and application in an emerging market. The author considers Mexico to be an emerging market pioneer in the globalization because: • Mexico was the ﬁrst issuer of Brady bonds in 1990 in debt markets. • Telmex, a Mexican company, was the ﬁrst company of important emerging markets that issued and had its ADR listed on the New York Stock Exchange in 1991 in the equity markets. • The ﬁrst emerging markets derivatives to be exchanged in the Chicago futures market were derivatives of the Mexican peso in 1995 and derivatives of the Mexican market index (IPC) in 1996. The text can be divided into three parts. The ﬁrst part talks about the Mexican market as a whole as an emerging market. The second part talks about of the main investment classes in the Mexican markets. The last part talks about

Research in Accounting Regulation, Volume 14, pages 285–290. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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the investors and their actions in investment markets and the corresponding application of these terms to the Mexican market. The ﬁrst chapter discusses detailed analysis of globalization, including the general description of globalization, the historical and geographical of globalization, and the arguments that Mexico is considered to be pioneering participants in this process. In discussing the emerging markets, the author talks about the concept and the deﬁnition of emerging markets, the deﬁnition, and the economic potentials, including the prospects and the problems/crisis. In the second chapter, the author reviews some basic ﬁnance concepts, such as return, risk, term, liquidity, Net Present Value, Modern Portfolio Theory, Capital Assets Pricing Model, Efﬁcient Market Hypothesis, and the concept of active and passive management, all with special reference to emerging markets and Mexico. The author also makes comparison between the application of the concepts in the Mexican market and in the U.S. market The next chapter discusses various measures used in measuring the country risk. In this chapter, the author tries to apply some modern investment theories into the analysis of Mexican market risk, and comparing it to other countries’ risk proﬁles. In doing this, the author ﬁrst discusses the various techniques in measuring country risks, including the assessment of the debt rating, the analysis of some economic indicators, the assessment of the country risk rating, and the analysis of the real interest rate. Then, the author tries to use the concepts discussed to analyze the Mexican risks and to compare the Mexican proﬁle of risks and return with the risk proﬁle of the U.S., other developed countries, and other emerging markets. This chapter ends with a brief proﬁle of the risks in the Mexican investment setting. The last chapter in the ﬁrst part of the text discusses the analysis of the investment problem over time using the cycle concept, the application of the cycle concept to the Mexican market, and the development of various economic scenarios for Mexican market using the cycle concept. The chapter opens with the introduction of the simplest form of the cycle (the kondratieff cycle) and the application of this form of cycle in the U.S. economy to make the readers understand the concept of cycle. In addition, the author also presents the application of this form of cycle to liquidity cycle in the portfolio investment, emerging markets, and interest rates. This is followed by the discussion of the identiﬁed cycles in the Mexican investment setting. Here, the author explains his identiﬁed cycles in the Mexican market. The second part of the text, which is covered in the ﬁve chapters, discusses the analysis of what in the author’s opinion are the main Mexican asset classes: debt, stock, and derivatives. Each asset class is discussed in two parts. The ﬁrst part talks about the history and the description of asset classes. The second part

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talks about the technical description of various classes of assets and some detailed valuation techniques that can be used in valuing those assets in Mexican market setting. The historical approach that author uses in analyzing each asset class, which in author opinion, stems from two ﬁrm convictions. First, it is important to see how, why, and when the development of emerging market occurred because all markets were emerging at some time or other and now they become developed markets. Second, it is important to understand that markets and instruments are dynamic and ﬂexible, especially in a time of rapid change of both in the global setting and in Mexican setting. The ﬁrst asset class discussed is debt, which is discussed in chapters 5 and 6. The author opens chapter 5 with discussions about the global debt history and the corresponding history in the Mexican market. Here, we can understand which phase the debt instrument is developed in Mexican market, by comparing its current development with the development phases of the debts in other emerging and developed markets. Next, the author explains the features of the debt securities and the Spanish jargon for each feature. The discussion is followed by a brief description about the government debt securities (cetes, bondes, adjustabono, and udibono) and the comparison of those securities with the U.S. governmental securities. This chapter ends with the discussion about Mexican corporate peso debt securities and other special debt securities (Brady bonds and Eurobonds), and their characteristics. In chapter 6, the author tries to classify Mexican debt securities according to the classiﬁcation used in typical ﬁnance textbooks. In addition, the author presents the use of some forecasting techniques in the interest rate forecasting that can be used in the Mexican market and the discussion of risk and return of the market with the corresponding benchmarks typically used in that market. In chapters 7 and 8, the author discusses the second asset class: stocks. In these chapters, the author presents the history of global stock market and Mexican stock market, some background information about the market, the discussion about primary and secondary Mexican stock market, and the development of foreign investment in the stock market, both for Mexican stocks traded outside Mexico and foreign stocks traded in Mexican Stock Exchange. In addition, the author presents his review of some basic concepts of market valuation and stock valuation. In relation to the market and stock valuation, the author also explains how to do research to get the required information to be used in the valuations. The discussion ends with an extensive description of the application of the valuation techniques to the Mexican market, including the valuation for the overall Mexican market, the Mexican market sectors, and individual Mexican stocks. 287

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The last chapter in second section, chapter 9, discusses the last asset class: derivatives. This asset class is the new asset class introduced to the Mexican market in 1977. The chapter opens with a brief discussion about the global history of derivatives and the structure of derivatives markets in various countries. The discussion is followed by the description about the history and structure of Mexican derivatives market. In the last part of this chapter, the author tries to explain some ﬁnance concepts and theories about derivatives without any discussion about the application of those concepts and theories in the Mexican market setting. Therefore, it is best to present this material as an appendix of the text because the material presented has limited content, if any, about the Mexican derivatives. The last part of the text deals with investors in the Mexican market and the problem of irrationality of the investor in those markets. This part discusses the one psychological aspect of investment decisions that is often forgotten in the dynamic world of ﬁnancial markets in which human nature remains immutable. The author also presents the analysis of different types of institutional and individual investors globally and in the Mexican market setting, especially the potential development of institutional investment in the Mexican market through the development of a new pension fund system. The text ends with the description of investment management process and author’s opinion about what is important in the investment decision in the emerging markets in general and in Mexican market in particular. Through the presentation of irrationality history throughout the history of ﬁnancial market in chapter 10, the author shows that the investors are not always rational in their decision-making. The problem of irrationality always happens even in an advanced ﬁnancial market such as the U.S. market. The Mexican stock market also experienced the same phenomenon of irrationality, at least three times according to the author’s opinion. In the Mexican peso market, the same problem also occurred at least twice. In chapter 11, the author presents the concepts and theory that explain the characteristics and trends of individual and institutional investors, at least in the U.S. market setting. The presentation is followed by the discussion the history and the proﬁle of individual and institutional investors in the Mexican market, especially the role of the institutional investors, which are the biggest investors in the market. The author also discusses the latest trends in institutional investors through the development of SAR, a special type pension fund similar to 401(k) pension plan in the U.S. This new pension fund will play an important role in the future of the Mexican ﬁnancial markets. The last chapter of the text explains the application of the investment decision in Mexican market setting. The author presents the planning approaches and the

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control approaches that can be used. In addition, the author explains about the system and the organization of a typical investment management. The chapter ends with the ﬁve rules developed and suggested by the author for investment in emerging markets, using Mexican market as a context. The rules are: • Term. The riskiest investments generally offer higher return than less risky investments and the emerging markets, which are riskier, offer high returns than the developed markets. However, this only holds in the long term. • Diversiﬁcation. The ﬁnance theory tells us that in order to reduce the volatility of the investment, the investor should use diversiﬁcation, especially diversifying the portfolio with some emerging market securities that have favorable correlation with the existing portfolios. • Discipline. The investors should be disciplined in managing their investment; otherwise, the consequences of doing something wrong will be much higher form the investment in the emerging markets, comparing it with the investment in the developed markets. • Knowledge and understanding. The investor should know the right information to be used in the investment decision-making and should know the right place to ﬁnd the needed information. • Contrary Opinion. Sometimes it is good for an investor to follow his/her own ‘hunch’ in the investment decision-making. On the other hand, sometimes it is not wise for an investor to follow his/her own judgment because the problem of irrationality. Taken as a whole, the text is useful for American and global investor as a source of the concepts and applications of how to invest in emerging markets because the text covers broad and diverse subjects. This text is a good reference because the discussion is not too deep, but still covers some important material elements of a good investment decision-making. Analysts or emerging market administrators can use this text as a model on how to create useful disclosures for their target investors. One of the main point of this text is the coverage of some advanced ﬁnance concepts in the appendices that is useful for readers who want to know more about these concepts. The main weakness of the text is the presentation of detailed techniques and concepts in the body of the text that sometimes distorts the focus of the discussions. In addition, the lack of the discussion of comparable references to other emerging markets in each discussion makes the reader ﬁnd it hard to make some comparisons of the Mexican market with other emerging markets. Another weakness is the lack of economic, social, and political discussion as a background for presenting the materials. The author must assume the reader familiar with the economic, social, and political situations in the Mexico. 289

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Overall, the author should be praised in his attempt to present the use of ﬁnance theory that is developed in advanced markets to the emerging markets. If ﬁnance theories are universal, then their application in emerging markets will have similar results and consequences as those in the developed markets. Otherwise, we should develop a special ﬁnance theory applicable in the emerging markets.

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