Advances in Accounting, Volume 21 0762312033, 9780762312030, 9780080460512

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CONTENTS ix

LIST OF CONTRIBUTORS EDITORIAL BOARD

xiii

STATEMENT OF PURPOSE AND REVIEW PROCEDURES

xvii

EDITORIAL POLICY AND MANUSCRIPT FORM GUIDELINES

xix

THE EFFECT OF PARTNER PREFERENCES ON THE DEVELOPMENT OF RISK-ADJUSTED PROGRAM PLANS James L. Bierstaker and Arnold Wright THE VALUE RELEVANCE OF EARNINGS AND BOOK VALUE UNDER POOLING AND PURCHASE ACCOUNTING C. S. Agnes Cheng, Kenneth R. Ferris, Su-Jane Hsieh and Yuli Su EARNINGS MANAGEMENT AND FORCED CEO DISMISSAL Liming Guan, Charlotte J. Wright and Shannon L. Leikam THE DECISION TO DISCLOSE ENVIRONMENTAL INFORMATION: A RESEARCH REVIEW AND AGENDA Tanya M. Lee and Paul D. Hutchison v

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CONTENTS

THE VOLUNTARY DISCLOSURE OF ADVERTISING EXPENDITURES: THE CASE OF THE PHARMACEUTICAL INDUSTRY AND HEALTHCARE REFORM Joseph Legoria

113

AN ANALYSIS OF THE FIRST TWO DECADES OF ADVANCES IN ACCOUNTING Michael J. Meyer, John T. Rigsby and D. Jordan Lowe

147

THE RELATIVE ACCURACY OF ANALYSTS’ PUBLISHED FORECASTS VERSUS WHISPER FORECASTS SURROUNDING THE ADOPTION OF REGULATION FD Lynn Rees and Davit Adut

173

THE IMPACT OF MANAGEMENT IMAGE AND NON-AUDIT SERVICE FEES ON INVESTORS’ PERCEPTIONS OF EARNINGS QUALITY Sandra Solomon, Philip M. J. Reckers and D. Jordan Lowe

199

PERSPECTIVES ON EDUCATION THE ‘‘SHOCK’’ FACTOR IN STUDENTS’ PERFORMANCE IN ACCOUNTING EXAMINATIONS Alexander M. G. Gelardi and Craig E. N. Emby

219

ELECTRONIC-COMMERCE EDUCATION: INSIGHTS FROM ACADEMICIANS AND PRACTITIONERS Zabihollah Rezaee, Rick Elam and Judith H. Cassidy

233

SOME IDEAS FOR USING CASES IN THE CLASSROOM Pamela A. Smith

259

Contents

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TECHNOLOGY AND THE ACCOUNTING CURRICULUM: WHERE IT IS AND WHERE IT NEEDS TO BE Christian Ille Hastings and Lanny Solomon

275

INTERNATIONAL PERSPECTIVES CORPORATE CHARACTERISTICS, GOVERNANCE RULES AND THE EXTENT OF VOLUNTARY DISCLOSURE IN SPAIN M. Rosario Babı´o Arcay and M. Flora Muin˜o Va´zquez

299

THE IMPORTANCE OF PROCEDURAL FAIRNESS IN BUDGETING Chong M. Lau and Sharon L. C. Tan

333

RESEARCH NOTE HIGH IMPACT BEHAVIORAL ACCOUNTING ARTICLES AND AUTHORS Philip M. J. Reckers and Sandra Solomon

359

LIST OF CONTRIBUTORS Davit Adut

Kogod School of Business, American University, Washington, DC, USA

M. Rosario Babı´o Arcay

University of Santiago de Compostela

James L. Bierstaker

Department of Accounting, College of Commerce & Finance, Villanova University, Villanova, USA

Judith H. Cassidy

Faculty of Accounting, University of Mississippi, MS, USA

C. S. Agnes Cheng

Bauer College of Business, University of Houston, TX, USA

Rick Elam

Faculty of Accountancy, University of Mississippi, USA

Craig E. N. Emby

Faculty of Business Administration, Simon Fraser University, Burnaby, CANADA

Kenneth R. Ferris

American Garvin School of International Management, Glendale, USA

Alexander Gelardi

Accounting Department, University of St. Thomas, Minneapolis, USA

Liming Guan

University of Hawaii, HI, USA

Christian Ille Hastings

Arizona State University, AZ, USA

Su-Jane Hsieh

College of Business, San Francisco State University, USA

Paul Hutchison

Department of Accounting, University of North Texas, Denton, USA ix

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LIST OF CONTRIBUTORS

Chong M. Lau

UWA Business School, University of Western Australia, Australia

Tanya M. Lee

Department of Accounting, University of North Texas, Denton, USA

Joseph Legoria

Department of Accounting, Louisiana State University, LA, USA

Shannon L. Leikam

Brigham Young University

D. Jordan Lowe

School of Global Management and Leadership, Arizona State University, AZ, USA

Michael J. Meyer

School of Accountancy, Ohio University, OH, USA

Philip M. J. Reckers

School of Accountancy & Information Management, Arizona State University, AZ, USA

Lynn Rees

Department of Accounting, Texas A&M University, TX, USA

Zabihollah Rezaee

Fogelhan College of Business and Economics, University of Memphis, Memphis, USA

John T. Rigsby

School of Accountancy, Mississippi State University, USA

Lanny Solomon

Department of Accountancy, University of Missouri-Kansas City, MO, USA

Sandra Solomon

School of Accountancy & Information & Management, Arizona State University, AZ, USA

Pamela Smith

Department of Accountancy, Northern Illinois University, IL, USA

Yuli Su

San Francisco State University, USA

List of Contributors

xi

Sharon L. C. Tan

School of Business, Singapore Polytechnic, Singapore

M. Flora Muin˜o Va´squez

Departamento de Economia de la Empresa, Universidad Carlos III de Madrid, Madrid, Spain

Arnold Wright

Boston College, USA

Charlotte J. Wright

Oklahoma State University, USA

EDITORIAL BOARD Richard Brody Central Connecticut State University

M. J. Abdolmohammadi Bentley College Mark Anderson University of Texas at Dallas

Anthony H. Catanach, Jr. Villanova University

Vairam Arunachalam University of Missouri-Columbia

C.S. Agnes Cheng University of Houston

Susan Ayers University of San Diego

Alan Cherry Loyola Marymount University

Frances L. Ayres University of Oklahoma

Eugene C. Chewning, Jr. University of South Carolina

Steve Baginski University of Georgia

Jeffrey Cohen Boston College

Charles Bailey University of Memphis

Maribeth Coller University of South Carolina

Terry Baker Wake Forest University

James W. Deitrick University of Texas at Austin

Alan Bathke Florida State University

William Dilla Iowa State University

Jean Professor Jean Bedard Northern University

Gordon Leon Duke University of Minnesota

Timothy B. Biggart University of North Carolina at Greensboro

Cindy Durtschi Florida State University

Cindy Blanthorne North Carolina State Charlotte

Timothy J. Fogarty Case Western Reserve University

Bruce Branson North Carolina State University

Robert Greenberg Washington State University xiii

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EDITORIAL BOARD

Thomas Hall University of Texas-Arlington

D. Jordan Lowe Arizona State University-West

Bart P. Hartman Saint Joseph’s University

James Martin University of South Florida

John M. Hassell Indiana University Charlene Henderson University of Texas at Austin William Hillison Florida State University Karen Hooks Florida Atlantic University Venkataraman Iyer North Carolina at Greensboro Khondkar E. Karim Rochester Institute of Technology Tim Kelley University of San Diego

Jeff Miller University of Notre Dame H. Fred Mittelstaedt University of Notre Dame Dennis Murray University of Colorado at Denver Jane Mutchler Georgia State University Carl Pacini Florida Gulf Coast University Don Pagach North Carolina State University

Inder K. Khurana University of Missouri

Kurt Pany Arizona State University

Thomas E. Kida University of Massachusetts

William Pasewark University of Houston

Tanya Lee University of North Texas

Robert Ramsay University of Kentucky

Chao-Shin Liu University of Notre Dame

William J. Read Bentley College

Thomas Lopez University of South Carolina

Jane Reimers Rollins College

Kenneth Lorek Northern Arizona University

H. Sami Temple University

Editorial Board

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Debra Sanders Washington State University

Thomas L. Strober University of Notre Dame

Arnold Schneider Georgia Institute of Technology

Brad M. Tuttle University of South Carolina

Richard Schroeder University of North Carolina-Charlotte

Sandra Vera-Munoz University of Notre Dame

Ken Schwartz Boston College Gerry Searfoss University of Utah

Mary Jeanne Welsh La Salle University Stephen W. Wheeler University of the Pacific

David B. Smith Iowa State University

Stacey Whitecotton Arizona State University

Rajendra P. Srivastava University of Kansas

David Williams Ohio State University

Tom Stober University of Notre Dame

Lee Willinger University of Oklahoma

David Stout Youngstown State University

Bernard Wong-On-Wing Washington State University

STATEMENT OF PURPOSE AND REVIEW PROCEDURES Advances in Accounting (AIA) is a research series publication providing academics and practitioners a forum to address current and emerging issues in accounting. Manuscripts may embrace any research methodology and examine any accounting-related subject. Manuscripts may range from empirical to analytical; timely replications will be considered. Manuscripts must be readable, relevant, and reliable. To be readable, manuscripts must be understandable and concise. To be relevant, manuscripts must be related to problems facing the accounting and business community. To be reliable, conclusions must follow logically from the evidence and arguments presented. For empirical reports, sound research design and execution are critical. For theoretical treatises, reasonable assumptions and logical developments are essential.

REVIEW PROCEDURES AIA intends to provide authors with timely reviews clearly indicating the acceptance status of their manuscripts. The results of initial reviews normally will be reported to authors within 90 days from the date the manuscript is received. All manuscripts are blind reviewed by two members of the editorial board and an Associate Editor. Editorial correspondence pertaining to manuscripts should be sent to the, editor. A $50 submission fee is required. Editorial correspondence pertaining to manuscripts should be sent to: Philip M. J. Reckers School of Accountancy & Information Management, W. P. Carey School of Business, Arizona State University, Box 873606, Tempe, AZ 85287-3606

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EDITORIAL POLICY AND MANUSCRIPT FORM GUIDELINES 1. Manuscripts should be typewritten and double-spaced on 8! ‘‘by 11’’ white paper. Only one side of a page should be used. Margins should be set to facilitate editing and duplication except as noted: a. Tables, figures, and exhibits should appear on a separate page. Each should be numbered and have a title. b. Footnote should be presented by citing the author’s name and the year of publication in the body of the text; for example, Schwartz (1989); Lowe, Reckers and Whitecotton (2002). 2. Manuscripts should include a cover page which indicates the author’s name and affiliation. 3. Manuscripts should include on a separate lead page an abstract not exceeding 200 words. The author’s name and affiliation should not appear on the abstract. 4. Topical headings and subheadings should be used. Main headings in the manuscript should be centered, secondary headings should be flushed with the left hand margin. (As a guide to usage and style, refer to William Strunk, Jr., and E.B. White, The Elements of Style.) 5. Manuscripts must include a list of references which contains only those works actually cited. (As a helpful guide in preparing a list of references, refer to Kate L. Turabian, A Manual for Writers of Term Papers, Theses, and Dissertations.) 6. In order to be assured of an anonymous review, authors should not identify themselves directly or indirectly. Reference to unpublished working papers and dissertations should be avoided. If necessary, authors may indicate that the reference is being withheld for the reasons cited above. 7. Accepted manuscripts ultimately must be submitted on disk. 8. Manuscripts currently under review by other publications should not be submitted. Complete reports of research presented at a national or regional conference of a professional association and ‘‘State of the Art’’ papers are acceptable. 9. Four copies of each manuscript should be submitted to the Editor-InChief. Copies of any and all research instruments should also be included. 10. The author should send a check for $50.00 made payable to Advances in Accounting as a submission fee. xix

THE EFFECT OF PARTNER PREFERENCES ON THE DEVELOPMENT OF RISKADJUSTED PROGRAM PLANS James L. Bierstaker and Arnold Wright ABSTRACT Professional standards require auditors to tailor audit testing to the level of assessed risks. The purpose of this experimental study is to explore the impact of a partner preference on the extent to which program plans are risk-adjusted. Partner preferences for either efficiency or a ‘‘balanced’’ approach (consideration of both effectiveness and efficiency) were manipulated. Sixty-one auditors completed a case where they were asked to perform program planning for the revenue cycle. The results show that there was a significant interaction between auditors’ risk assessments and partner preferences. When there was an incentive for efficiency as prompted by the partner, even though auditors recognized higher risks compared to the prior year, they did not correspondingly alter audit program plans. In contrast, a balanced partner preference led to higher risk assessments and a greater number of tests and hours than for the efficiency condition.

Advances in Accounting Advances in Accounting, Volume 21, 1–23 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21001-5

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INTRODUCTION Over the past two decades, auditors have faced significant pressures to reduce costs due to competition among auditing firms as a result of bidding, advertising, and direct solicitation, as well as from merger activity in the corporate sector, which reduces the number of available audit clients (Houston, 1999; Adams, Hermanson, & Turner, 1987). A primary concern is that competitive pressures will result in audit work that is insufficient to address client risks (i.e., program plans that are not properly risk-adjusted), which may impair audit effectiveness and expose the firm to potential litigation and loss of reputation. In practice, program planning decisions such as determining the nature and extent of testing are not made in a vacuum but rather in an environment of complex accountabilities (Gibbins & Newton, 1994). These decisions are initially made by an audit senior (Abdolmohammadi & Usoff, 2001), who is accountable to an immediate supervisor, the partner, the firm, the client, and ultimately to financial statement users such as investors and creditors. The senior must weigh these competing forces, which may provide counteracting pressures to achieve effectiveness and efficiency (McNair, 1991). While prior research has examined the impact of fee pressure on audit program planning (Houston, 1999), relatively little consideration has been given to the influence of the organizational setting. As the leader of the audit team, the partner is expected to set the tone for an engagement and have considerable impact on how seniors weigh and reconcile competing pressures. Recent findings suggest that accountability can have a deleterious effect when a superior’s views are known in advance, since individuals may make judgments to conform to the views of others to curry the favor of those to whom they are held accountable (Lerner & Tetlock, 1999). Thus, it is hypothesized that audit staff are strongly influenced by a partner’s preference. Given a reduction in audit fees as a result of competition, the partner may choose to provide an explicit suggestion to improve efficiency and, thus, attempt to preserve the level of profitability on the engagement. In contrast, the partner may be more concerned with ensuring the audit properly addresses client risks, despite the reduction in fees, and focus staff on maintaining audit effectiveness. Finally, the partner may emphasize a ‘‘balanced’’ approach where both efficiency and effectiveness are concurrently considered. Therefore, since pressures for greater efficiency are pervasive in the audit environment, a partner can play a key role in either accentuating or mitigating potential negative effects of such pressures.

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As a result of conscious or unconscious desires to please the partner, a preference for efficiency is expected to lead to lower risk assessments, reductions in testing, and less responsiveness of program plans to client risks than if a partner expresses a balanced preference for both effectiveness and efficiency. Thus, we posit an interaction between a partner preference and auditor risk assessments on program planning decisions. The current study extends prior research by explicitly considering the impact of a partner preference in response to competitive pressures (reduced audit fees). Further, the setting is one of increasing client risks posing the potential for adverse consequences in reducing audit testing. To investigate these issues, 61 audit seniors participated in an experiment in which they were asked to perform program planning for the revenue cycle where client risks increased from the prior year. As a result of competition, audit fees were reduced on the engagement. Partner preferences were manipulated in a between-subjects design as either a focus on efficiency or a balance between effectiveness and efficiency. The results supported our expectations. These findings extend prior research by suggesting that partner preferences influence audit planning by moderating the relationship between auditors’ risk assessments and program planning decisions. The remainder of the paper is divided into four sections. The next section provides an overview of prior research and identifies the research hypotheses. The method is then described, followed by presentation of the results. The final section is devoted to a discussion of the major findings and their implications for practice and future research.

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT Impact of a Partner Preference Given the pervasive nature of accountability in auditing, there has been an extensive body of research on the impact of accountability on judgments and decisions. Prior research suggests that accountability can have a positive impact by inducing individuals to exert greater effort and increase the complexity of cognitive processing, thereby improving performance (e.g. Gibbins & Newton, 1994; Kennedy, 1993; Ashton 1992; Tetlock, Skitka, & Boetiger, 1989; Tetlock & Kim, 1987). However, more recent findings

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suggest potential negative affects if audience views are known in advance, since individuals may take inappropriate actions to please those to whom they are held accountable (Lerner & Tetlock, 1999). For instance, as a result of the pervasive need for justification, auditors may tailor the audit conclusions, documentation, and supporting tests to comply with the perceived views of a superior (Rich, Solomon, & Trotman, 1997; Ashton, 1990). In this vein, Lord and DeZoort (2001) report that auditors are significantly affected by ‘‘obedience pressure’’ from superiors to allow a client to reflect a highly questionable asset on its balance sheet. Peecher (1996) also provides evidence that auditors may attempt to enhance audit efficiency in response to partner preferences. In an analytical procedures context, he finds that, for higher integrity clients, when the partner encouraged reliance on the client, auditors’ likelihood assessments of the sufficiency of a client explanation for an unusual account balance fluctuation were higher, and the search for alternative explanations was reduced as compared to when the partner did not provide encouragement. This increased reliance could be interpreted as a mechanism to justify a reduction in audit effort. Similarly, Turner (2001) finds that when reviewers encourage reliance on client-provided explanations, auditors examined fewer evidence items and followed a more client-prompted search when assessing past-due customer balances than auditors whose reviewers expressed a preference for skepticism or unknown preferences. In addition, she finds that auditors examine fewer items and spend less time per item when they are required to take an action (e.g., write off an account receivable) rather than express a belief (e.g., assess the probability that an account receivable will not be collectible). Turner also theorizes that certain tasks, such as assessing control risk, necessitate a particular course of action, so there should be no cognitive distinction between belief and action for these types of tasks. However, she does not consider potential interactions between auditors’ beliefs and actions. This is important because beliefs are expected to influence actions. Further, a partner preference may disrupt this relationship. Finally, Wilks (2002) suggests that auditors who learn the partner’s views prior to evaluating evidence unconsciously interpret evidence in a way that is more consistent with the partner’s view than auditors who receive the partner preference after evaluating evidence. Research in psychology refers to this subconscious behavior as ‘‘pre-decisional distortion of information’’ (Russo, Medvec, & Meloy, 1996). Wilks finds evidence consistent with this effect in auditor going-concern judgments.

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Impact of Competitive Pressures on Partner Preferences A partner must decide on how to respond to competitive pressures to attain the optimal balance between audit efficiency and effectiveness. If the partner chooses to communicate the need for efficiency, it is likely that the audit team will make efforts to comply. Kermis and Mahapatra (1985), for example, found that a general directive to reduce hours by 30% from the previous year significantly affected auditors’ time budgets. In addition, Hill (2001) reports that auditors reduced planned current year hours below prior year actual hours in response to a general request to be efficient, even when a prior year material error was highlighted on the trial balance. A variety of factors appear to influence the way in which a partner ‘‘manages’’ competitive pressures. For example, partner aggressiveness toward practice development may depend on the existing client base (Cohen & Trompeter, 1998), the competitiveness of the local audit market (Knapp, 1985; Shockley, 1981), and risk tolerances (Asare, Hackenbrack, & Knechel, 1994). Further, accountability to partners with lower risk tolerances may lead subordinates to more conservative judgments (Cohen & Trompeter, 1998). As a result of significant litigation risk, some partners may be risk averse and focus on audit quality (Marxen, 1990; Arthur et al., 1993). Thus, partner preferences for efficiency or effectiveness may vary depending on a variety of factors including: the profitability of the client, percentage of partner, and firm revenues represented by the client, the partner’s risk preferences, and the partner’s concerns about litigation (Farmer, Rittenberg, & Trompeter, 1987). If the partner is highly concerned about risks associated with a particular client and potential litigation, she/he may communicate to the audit team that effectiveness is of the utmost priority. There have been only two prior studies on the impact of partner preferences on audit planning in a competitive pressure situation. Gramling (1999) examined the degree of reliance placed on an internal audit staff to reduce substantive audit testing in light of partner preferences for efficiency or effectiveness. Information order regarding the quality of internal audit was also manipulated (positive evidence followed by negative evidence and vice versa). The findings were mixed. Specifically, there was a difference in reduction of planned hours across order conditions when the partner preference focused on efficiency but, contrary to expectations, there was no effect on planned reliance when the focus was on effectiveness. Further, this study investigates the extent of reliance on internal auditors and not the more generic program-planning context.

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A second study by Bierstaker and Wright (2001) found that auditors significantly (marginally) reduced planned tests (budgeted hours) in response to a partner preference for efficiency. In addition, Bierstaker and Wright present exploratory findings that suggest auditors may reduce (increase) the hours of more (less) experienced personnel to improve audit efficiency. In all, these findings suggest that partner preferences may influence the extent of audit work. However, Bierstaker and Wright did not examine the effect of a partner preference for effectiveness. Further, it is important to establish that a reduction in testing may have an adverse effect on audit quality. In the Bierstaker and Wright study, it was not clear whether the level of risks were assessed by auditors as low enough to justify reduced testing, and there was no benchmark or measure taken to ensure that a reduction in testing was not appropriate.

The Impact of a Partner Preference on Auditors’ Program Planning Decisions It is well established by professional standards (AICPA, SAS No. 47, 1993) that program planning decisions regarding the nature, extent, staffing, and timing of tests should be responsive to client risks. Given the tendency for individuals to want to please superiors, partner preferences are expected to interact with auditors’ risk assessments to influence auditors’ program planning decisions. For example, if the senior perceives client risks as higher than the prior engagement, and the engagement partner stresses the importance of a balance between audit effectiveness and efficiency (herein referred to as the ‘‘balanced’’ condition), the auditor is expected to increase budgeted hours and planned tests to some extent when compared to the prior period. However, if the senior perceives client risks as higher, and the engagement partner encourages improvements to audit efficiency, the senior may be less likely to increase budgeted hours and planned tests, and may even choose to decrease audit effort in response to the preferences of the partner. Therefore, auditors in the efficiency condition are likely to be less responsive to actual client risks than auditors in the balanced condition. Faced with a partner preference for efficiency, auditors may justify reductions in testing by assessing inherent and control risks at a lower level than actually perceived. Findings consistent with this expectation are provided by Kachelmeier and Messier (1990) and Messier, Kachelmeier, and Jensen (2001), who report a phenomenon they refer to as ‘‘working backwards’’ in which auditors determine a desired action and then support this

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by altering decision parameters. In this case, auditors may consciously lower the risk assessments to justify the reduced audit work that they perceive the partner desires. Alternatively, in the efficiency condition, hours and tests may be lowered unconsciously as a result of pre-decisional distortion, as discussed earlier (Wilks, 2002) (see Fig. 1). In the end, a preference for efficiency calls for a lower level of testing. If risks are clearly increasing, the situation examined in this study, the auditor faces a dilemma. On the one hand, he wishes to lower testing. On the other, he may be reluctant to assess risks at a low level, leading to questions by a superior of his or her competency. Thus, whether conscious or not, a partner preference is expected to interact with risk assessments in affecting program plans. Specifically, in the efficiency condition, audit plans will appear less risk adjusted (i.e., there will be a tendency to reduce audit testing relatively

Partner Preference

Partner Preference

Balanced or efficiency

Balanced or efficiency

Risk Assessment

Risk Assessment

High in balanced condition/ low in efficiency condition

High in balanced condition/ low in efficiency condition

Budgeted Hours

Planned Tests

Increased (balanced) /decreased (efficiency)

Increased (balanced) /decreased (efficiency)

Fig. 1.

Ex ante model of the Relationship between Partner Preferences, Risk Assessments, and Program Plans

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more than corresponding risk assessments) than in the balanced condition, leading to our research hypotheses. H1. There will be a significant interaction between risk assessments and partner preference affecting the nature of tests (number of planned tests) reflecting more risk-adjusted program plans (positive association between risks and program plans) when there is a balanced partner preference than when there is a preference for efficiency. H2. There will be a significant interaction between risk assessments and partner preference in affecting the extent of tests (budgeted hours) reflecting more risk-adjusted program plans when there is a balanced partner preference than when there is a preference for efficiency.

METHODS Participants Sixty-one auditors with an average of 47.2 months of experience (standard deviation of 8.8 months) participated in the study.1 Auditors with between 3 and 5 years of experience were sought because they were typically assigned to perform initial audit program planning, the task examined in this study (Abdolmohammadi & Usoff, 2001).2 All participants came from a single Big 5 firm, and the experiment was conducted under controlled conditions during staff training sessions.

Experimental Design Based on prior research (Peecher, 1996; Cohen & Trompeter, 1998), two principal mechanisms were used to induce accountability: (1) all auditors were informed that a sample of individual responses, along with a summary of the results, would be forwarded to an audit partner at their home offices, and (2) auditors were directed to indicate their name, business address, and business telephone number.3 Auditors were randomly assigned to one of two partner preference conditions: efficiency or balanced.4 Auditors in the efficiency condition were informed that: ‘‘The partner in charge of the audit expects that greater efficiency can be achieved during the current engagement.’’ Auditors in the

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balanced condition were informed that: ‘‘The partner in charge of the audit recognizes there is a need for efficiency but stresses that, nonetheless, achieving a quality audit is of the utmost importance during the current engagement.’’ These manipulations were developed based on discussions with firm personnel to reflect realistic, moderate level preferences from a partner. The manipulations are conservative in nature and, thus, test the power of somewhat subtle prompts by superiors on the behaviors of subordinates. As such, the moderate manipulations serve, if anything, to bias against findings that support the hypotheses.5 There is also a concern that auditors may interpret these manipulations as directives by a knowledgeable partner as to what should be done. For instance, the efficiency manipulation may potentially imply that the previous year program plan was inefficient and could be cut. However, as will be discussed more fully, client risks in the experimental case were increasing, suggesting reductions in testing are questionable. Further, although the partner preference may convey information about risk, the correlation between partner preference and seniors’ assessments of client risk is only marginally significant (r ¼
0:21; p ¼ 0:10). Finally, by design detailed audit planning decisions are delegated to seniors so that an independent judgment can be made of the work needed, given the client situation. If seniors are appropriately performing their job, partner preferences should, thus, not dictate program-planning decisions. The influence of such preferences is the essence of the research issue examined in the current study. The information pertaining to the treatment conditions was provided to participants prior to completing the tasks described below. Since the manipulation of a partner preference for efficiency or a balance would have transparent implications and thereby result in potential demand effects, a between-subjects design was employed. Tasks An experienced manager was consulted extensively during development of the audit case. The case focuses on the revenue cycle and is based on an actual client. Subjects received background information on the client (New England Company) in its seventh year under audit by the participants’ accounting firm, a narrative description of the client’s accounting procedures for the revenue cycle, selected account balances and financial ratios, and the previous year’s time budget for the revenue cycle. Importantly, in both conditions participants were informed that audit fees were reduced from $70,000 to $60,000, or about 12.5%. The magnitude of this decrease in

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fees is substantial but representative of competitive fee changes in practice (Houston, 1999; Simon & Francis, 1988). In addition, as noted, the case was designed to indicate an increase in client risks from the previous year. The background information noted that president and controller of New England Company resigned during the past year, and the newly hired individuals for these important positions have only been with the company for a few months, executive compensation is linked to company profitability as of the current year, and there has been some turnover among the accounting personnel. In addition, compared to the previous year, the cash balance decreased by 40% and accounts receivable increased by 25%.6 Consistent with the approach of the participating firm, auditors were asked to make a combined assessment of inherent and control risk. Consistent with prior research (e.g. Bierstaker & Wright, 2001), a continuous scale (0 to 100%) with verbal end anchors (low to maximum) was used to allow for more powerful testing and more precise measurement of responses. Auditors then prepared a time budget and developed an audit program for the current year’s audit of the revenue cycle.7 To prevent potential confounding inferences of reliance on other ways to enhance efficiency, subjects were told to assume that: (1) assistance from the client will not increase over the previous year, (2) further efficiency improvements are not possible through the use of computer audit technology, and (3) staff competence is consistent with the previous years. The time budget was based on an actual engagement and included a list of 19 tests to choose from, as well as space where additional tests could be added if so desired. The number of budgeted hours in the previous year for first-year staff, second-year staff, and the senior were also provided based on the standard program of the participating firm. There were a total of 128 hours and 19 tests in the audit program for the previous year. Auditors were given information about the previous year’s audit because, as is common in practice, the participating firm develops preliminary audit programs based on previous year information (Hirst & Koonce, 1996; Mock & Wright, 1993). Debriefing questions gathered information about participants’ program planning experience.

Dependent and Independent Variables Consistent with previous research (Bierstaker & Wright, 2001; Mock & Wright, 1999), the main dependent variables are percentage change in

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budgeted hours (HOURS) and number of planned tests from the previous year (TESTS). Percentage changes in hours and tests were used because they indicate the relative change in program plans. However, results are identical regardless of whether actual levels or percentage change were used. In addition, the correlation between auditors’ budgeted hours and planned tests is positive and significant (r ¼ 0:312; p ¼ 0:014), indicating convergent validity between these two surrogates for the theoretical construct of audit program plans.

RESULTS Manipulation Checks Partner Preference To examine the effectiveness of the partner preference manipulation, auditors were asked to respond on a seven point Likert scale to the following statement: ‘‘In the situation presented in the New England Company case, the partner in charge of the audit was primarily focused on: efficiency (1) or effectiveness (7).’’ The mean for the efficiency condition is significantly lower than that of the balanced condition (2.74 vs. 4.42; t ¼ 5:72; p ¼ 0:0001) and the mean value of the balanced condition was about in the middle of the scale, reflecting a concern for both effectiveness and efficiency and indicating the partner preference manipulations were successful. Change in Risk from the Prior Year Since the case was designed to show an increase in client risks from the previous year, auditors were asked a debriefing question: how the risk of material misstatement in the current year compared with the previous year, with 1 being lower than the previous year and 7 being higher. Auditors’ mean response to this question (5.7) was significantly higher than the midpoint of the scale (t ¼ 18:04; p ¼ 0:0001), indicating that on average they perceived that risk had increased from the previous year as intended. Auditors in the balanced condition did not have significantly higher ratings for this item than auditors in the efficiency condition (5.7 vs. 5.6; t ¼ 0:29; p ¼ 0:77). Therefore, auditors in both conditions acknowledged that the risk of material misstatement was higher in the current year than in the previous year and to the same extent. Client Risk Assessment As discussed, to justify a reduction in testing as a result of a partner preference for efficiency, auditors may assess lower client risks than when a

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balance between effectiveness and efficiency is stressed. Auditors risk assessments in the balanced condition were significantly higher than in the efficiency condition (mean 54.6% (standard deviation 19.6) vs. mean 46.3% (standard deviation 18.8); t ¼ 1:69; p ¼ 0:05 one-tailed). These findings are particularly interesting given that both groups acknowledged that risks had increased compared to the previous year. Hypothesis Tests Percentage Change in the Planned Number of Tests from the Prior Year (H1) The means for the percentage change in the planned number of tests from the previous year are shown in Panel A of Table 1. Auditors reduced the number of tests on average across both conditions, despite increasing client risks from the previous year.8 As shown in of Table 1(B), a regression analysis reveals the interaction between risk and partner preferences is highly significant ðp ¼ 0:01Þ: The nature of this interaction, as shown in Table 1, suggests that the expected positive relationship between planned tests and perceived risk is stronger in the balanced condition than in the efficiency condition, supporting H1. To understand the nature of the interaction, the association between risk assessments and the planned number of tests was examined through a correlation analysis. In the efficiency condition, there was a significant (r ¼
0:39; p ¼ 0:03) negative relationship between planned tests and risks, strongly suggesting program plans were responsive to the partner preference. In contrast, the correlation between planned tests and risks in the balanced condition is positive although not significant (r ¼ 0:214; p ¼ 0:13), suggesting weakly risk-adjusted program plans. To explore the findings further a two-stage regression approach was also used where risk assessments were first regressed against partner preference and then the effect of the risk assessments on number of tests, after adjusting for the effect of partner preferences, was considered. The results indicate that risk is not significantly related to planned tests when the effect of the partner preference is controlled for (t ¼ 0:90; p ¼ 0:18), suggesting that auditors’ planned tests are not significantly adjusted for the level of assessed risks. These results are consistent with Mock and Wright (1999), who found that 99% of tests are repeated from year to year; suggesting that the number of audit tests performed may not be sensitive to client risks.9 While, as noted, auditors in the efficiency condition may have been attempting to eliminate less effective tests and focus on more persuasive evidence (especially in a higher risk setting), a Delphi panel of three experienced audit managers rated 16 out of 19 of the tests contained in

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Table 1. Percentage Change in Planned Number of Tests from the Prior Year. Panel A: Mean (Standard Deviation) [sample size] by Experimental Condition Partner Preference

Total Planned Tests

Percentage Change

18.2 (2.6) [31] 18.4 (3.0) [30]


4.1 (13.8) [31]
3.0 (15.7) [30]

Efficiency Balanced Previous year’s planned tests ¼ 19:

Panel B: Regression Analysis Regression model: TESTS ¼ f (RISK, PARTNER, RISK*PARTNER) Variable INTERCEPT RISK PARTNER RISK*PARTNER

b

t

p


0.12 0.23 0.74
0.84


1.57 1.23 2.06
2.36

0.12 0.22 0.04 0.01

Key: Tests ¼ percentage change in planned number of tests from the prior year Risk ¼ combined inherent and control risk assessment (0 to 100%) Partner ¼ partner preference (0 ¼ balanced; 1 ¼ efficiency) Note: One-tailed tests are used when the results support directional expectations, otherwise twotailed tests are employed.  Two-tailed.  One-tailed.

the previous year’s audit program as very important, and none of the tests were rated as unimportant. The reduction in number of tests in the efficiency condition is consistent with the results of Asare, Trompeter, and Wright (2000), who find that time budget pressures lead to a reduction in the number of tests. Percentage Change in Budgeted Hours from the Previous Year (H2) The means for percentage change in budgeted hours from the previous year are shown in panel A of Table 2. Auditors who received a balanced partner preference reduced budgeted hours by 4.5% on average, whereas those who received a partner preference for efficiency reduced budgeted hours by 9.1%. It is noteworthy that across both conditions auditors reduced hours, consistent with prior research (Mock & Wright, 1993; Bedard & Wright,

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Table 2.

JAMES L. BIERSTAKER AND ARNOLD WRIGHT

Percentage Change in Budgeted Hours from the Prior Year.

Panel A: Mean (Standard Deviation) [sample size] by Experimental Condition Partner Preference

N

Total Budgeted Hours

Percentage Change

Efficiency Balanced

31 30

112.7 (21.2) [31] 118.5 (17.3) [30]


9.1 (17.1) [31]
4.5 (13.9) [30]

Previous year’s budgeted hours ¼ 128: Panel B: Regression Analysis Regression model: HOURS ¼ f (RISK, PARTNER, RISK*PARTNER) Variable INTERCEPT RISK PARTNER RISK*PARTNER

b

t

p


0.16 0.25 0.44
0.62


1.84 1.39 1.22
1.72

0.07 0.16 0.22 0.045

Key: Hours ¼ percentage change in budgeted hours from the prior year Risk ¼ combined inherent and control risk assessment (0 to 100%) Partner ¼ partner preference (0 ¼ balanced; 1 ¼ efficient). Note: One-tailed tests are used when the results support directional expectations, otherwise twotailed tests are employed.  Two-tailed.  One-tailed.

1994). As shown in panel B of Table 2, a regression analysis reveals, as posited, that the interaction between risk and partner preferences is significant ðp ¼ 0:045Þ:10 When the partner stresses a balanced approach, budgeted hours marginally increased with higher assessed risk, consistent with a risk-adjusted program plan (r ¼ 0:29; p ¼ 0:06). In contrast, when the partner stresses efficiency, there is once again a significant negative relationship between budgeted hours and assessed risk (r ¼
0:17; p ¼ 0:35). As before, a two-stage regression approach was also used where risk assessments were first regressed against partner preference and then the effect of the risk assessments on budgeted hours, after adjusting for the effect of partner preferences, was considered. The results indicate risk is positively related to budgeted hours when auditors’ risk assessments are adjusted for the partner preference (t ¼ 1:7; p ¼ 0:05), indicating auditors program plans as to audit extent are risk-adjusted. These results further

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support H2 with respect to planned hours. Further, the overall pattern of the second stage regression results is consistent with prior research (Mock & Wright, 1993, 1999) where program plans for extent are significantly adjusted for risk but not for nature. A summary flowchart describing the overall results is shown in Fig. 2. As shown, the two-stage analysis revealed that partner preferences significantly impacted risk assessments as expected (i.e., lower risk assessments for the efficiency than the balanced condition). However, risks adjusted for partner preference had a significant affect on extent but not the nature of testing.

Exploratory results Additional analysis of budgeted hours was performed based on Bierstaker and Wright (2001), who report that auditors subject to competitive pressures reduce the budgeted hours of more experienced staff. Exploratory findings in the current study suggest that while auditors in the balanced condition increased the hours of more experienced staff with higher assessed risks; auditors in the efficiency condition did not. Specifically, the results indicate

Partner Preference

Significant p = 0.05

Risk Assessment Moderate in both conditions but higher in balanced condition

Significant after adjusting for partner preference p < 0.05

Budgeted Hours Decrease in both conditions, greater reduction in efficiency condition

Fig. 2.

Partner Preference

Significant p = 0.05

Risk Assessment Moderate in both conditions but higher in balanced condition

Not significant after adjusting for partner preference p >0.05

Planned Tests Decrease in both conditions, greater reduction in efficiency condition

Ex post model of the Relationship between Partner Preferences, Risk Assessments, and Program Plans (Two stage Regression Findings)

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that there is a significant difference between the budgeted hours of second year (more experienced) staff between auditors in the balanced and the efficiency condition (73.9 vs. 55.0; t ¼ 1:78; p ¼ 0:05 one-tailed) when client risks are assessed as relatively high (i.e., over 50%). These findings are consistent with Bierstaker and Wright (2001) and suggest that staffing may also be affected by partner preferences, in that auditors in the efficiency condition were reluctant to increase the hours of more experienced (and costly) staff, even when they assessed risks as relatively high.

CONCLUSIONS This study investigated the effects of a partner preference for efficiency or a balanced focus on effectiveness and efficiency on auditors’ risk assessments and program planning decisions in a difficult situation of strong competitive pressures to reduce testing and also increasing client risks. Consistent with expectations, there was a significant interaction between auditors’ risk assessments and partner preferences. The nature of this interaction indicated a stronger positive relationship between auditors’ risk assessments and budgeted hours, but not number of tests, when there was a balanced partner preference than when there was a partner preference for efficiency. This finding occurred despite the fact that auditors in each experimental condition recognized risks were increasing from the previous year. These results suggest that the preferences of the engagement partner can influence the planning decisions of the audit senior by affecting the relationship between the senior’s assessed risk and the extent of the work planned. For instance, when auditors assessed risks to be higher, partner preferences for a balanced focus on effectiveness and efficiency seem to reinforce concerns for addressing these risks. In this setting, auditors only minimally reduce hours and tests in audit plans. Thus, a partner expression of concern for effectiveness appears to be a way to mitigate but not eliminate the effects of competitive pressures. In contrast, a preference for efficiency appears to exacerbate the situation by leading to program plans that are not risk-adjusted, i.e., lack of a positive relationship between risk assessments and program plans. This raises concerns that audit plans may not provide sufficient evidence to arrive at appropriate audit conclusions. Importantly, even in the balanced condition, auditors on average reduced program plans despite an increase in client risks. Further, there was a weak association between assessed risks and program plans. Thus, competitive pressures apparently provide a signal that program reductions are expected,

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irrespective of increasing client risks. Firms must be careful in managing the planning implications of a fee reduction for staff and consider whether the existence and magnitude of such a reduction should be communicated at all below the manager level. In addition to expressing a partner preference for a balance between audit effectiveness and efficiency, not communicating audit fees to staff may therefore be another effective way to mitigate potential dysfunctional effects of competitive pressures. Ideally, the audit plan should be developed by the staff to address client risks. The manager and partner may then decide whether to revise the plan in light of competitive (business) pressures. The findings have both theoretical and practical implications. From a theoretical standpoint, while previous research has suggested that accountability to one’s superiors may provide pressures to enhance audit effectiveness (Kennedy, 1993; Ashton, 1992; Turner, 2001) or efficiency (Bierstaker & Wright, 2001; Peecher, 1996; Gramling, 1999; Wilks, 2002), our findings add to this research by suggesting that partner preferences may influence auditor judgments through impacting auditors’ risk assessments and planned audit effort. These findings may help to explain the results of previous archival auditing research, which has not found a strong relationship between audit programs and assessed client risks (Bedard, 1989; Mock & Wright, 1993, 1999; O’Keefe, Simunic, & Stein, 1994). In addition, a partner’s concern for effectiveness may mitigate, but not eliminate, the effect of competitive pressures. From a practical standpoint, auditors may attempt to enhance audit efficiency, while maintaining audit effectiveness, by decreasing effort to less effective audit procedures and low risk audit areas (Houston, 1999; Hill, 2001). Therefore, a reduction in budgeted hours and planned tests may reduce audit costs and improve audit efficiency by possibly eliminating overauditing and budgetary slack. In addition, the recent dramatic failures of large corporations such as Enron and WorldCom as well as the significant number of earnings restatements (Palmrose & Scholz, 2002; Wu, 2002) suggest a new climate of pressures from investors, regulators, and other parties for quality reporting and auditing, resulting in increased pressures for audit effectiveness. However, there are a number of reasons to expect that significant pressures for efficiency will remain, e.g., the audit market is mature (Carson, Simnett, Soo, & Wright, 2004), the value of the audit opinion tied to financial statements is seen as less relevant in the information age, and there will be a significant decrease in lucrative non-audit fees placing renewed pressures on auditors to enhance profitability of audits. Therefore, the effect of changes in forces for audit efficiency and

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effectiveness on audit planning brought about by recent events is an empirical question and an interesting topic for future research. While a Delphi panel of experienced managers indicated that all of the available tests were relatively important, this study does not possess an established normative benchmark to evaluate audit effectiveness, a common, complex problem facing program planning studies (Bedard, Mock, & Wright, 1999). In addition, other measures of the nature of testing could be used besides total number of tests, which was employed in this study based on prior research (Bierstaker & Wright, 2001, Bedard et al., 1999). However, when hours and tests are reduced (especially in the face of increasing client risks, as in this study), there is the potential to jeopardize audit effectiveness, increasing the risk of audit failure, damage to the firm’s reputation, and future litigation. Finally, a limitation of the current study is the design does not allow us to determine the underlying behavioral mechanism (working backward or predecisional distortion) resulting in the significant interaction found between risk assessments and partner preference. This is because the experimental case reflected an increase in client risks, limiting the acceptability of substantially lowering risk assessments to justify reduced testing in the efficiency condition that would be reflective of a working backward strategy. The decision to portray increased client risks was made to provide a normative benchmark to evaluate risk assessments and program plans against, i.e., a partner preference that leads to decreased testing in this context is likely to impair audit effectiveness. Future research such as a process tracing approach is needed to determine the impact of a partner preference on the nature of the underlying decision process and whether it is more representative of the working backward or predecisional distortion phenomenon. The findings suggest that audit partners and managers should carefully weigh the formal and informal communications they have with seniors regarding audit efficiency. If audit programs become too constrained in response to competitive pressures, auditors may be more likely to engage in behaviors that interfere with the proper conduct of the audit, such as excessively reducing planned audit testing. Further, to the extent that audit fees are a function of reported time, underreporting of time could lead to additional reductions in audit fees, leading to a downward spiral in budgeted audit hours. Although the accountability mechanisms may have led to exaggerated partner preference effects, auditors were consulted to develop realistic, moderate level preferences. To that extent, the manipulations are conservative in nature and to some extent subtle.

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Additional research is needed to investigate the role of the review process and competitive pressures on audit program planning. Superiors generally assist in establishing the initial audit program. Marxen (1990), for example, suggests concerns about an excessive focus on efficiency, and the potentially more salient threat of future lawsuits, may lead more experienced auditors to revise the audit plans of their subordinates to improve audit effectiveness. However, information asymmetry between preparers and superiors may prevent managers or partners from appropriately revising the preliminary audit program (Rich et al., 1997). Furthermore, given competitive pressures and the need to maintain good client relations, superiors may also revise budgeted hours and planned tests downward to further enhance efficiency. Thus, future research is needed to investigate the impact of competitive pressures on partners’ and managers’ revisions to seniors’ audit programs. Moreover, since a limitation of this study is that seniors could not interact with their superiors regarding specific areas where audit efficiency could be improved, future research involving groups of seniors, managers, and partners would be valuable.

ACKNOWLEDGMENTS We wish to gratefully acknowledge the valuable comments received from participants at the 2001 Annual Meeting of the American Accounting Association and the 2001 Auditing Mid-Year meeting, as well as those provided by Mary Callahan Hill and the anonymous reviewers at the Mid-Year meeting. We also thank the auditors who participated in this study.

NOTES 1. The significance of the results for the independent variables was unaffected when months of auditing experience was included in the regression equations. Longevity of experience was not significant as a covariate, and the interaction between experience and partner preference was not significant in the hypothesis testing models. 2. Subjects were also asked to respond on a seven-point Likert scale to the following statements (with 1 indicating disagree and 7 indicating agree): (1) We decide how many hours to include in preliminary time budgets (mean ¼ 5:1; standard deviation 1.30); (2) We decide which tests to include in preliminary time budgets (mean ¼ 4:8; standard deviation 1.1). Responses indicate these auditors are involved in program planning and means are significantly higher that the midpoint of the scale

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JAMES L. BIERSTAKER AND ARNOLD WRIGHT

for hours (t ¼ 6:59; p ¼ 0:0001) and tests (t ¼ 5:87; p ¼ 0:0001). Neither of these measures of task experience were significant in the hypothesis testing models. 3. Consistent with Peecher (1996) and Tan, Jubb, and Houghton (1997), auditor responses were reviewed by accounting faculty. Although firm personnel would also be appropriate as reviewers, it was more expedient to use faculty reviewers. The review was one of the measures employed to instill accountability among subjects. The faculty review, provision of summary responses to a partner of the firm (which was accomplished after the data were collected and analyzed), as well as requiring auditors to provide their names were viewed as sufficient to accomplish this objective. 4. In performing program planning, a senior desires a positive performance evaluation from his immediate superior, a manager. However, the senior is also accountable to the partner, who wields greater power and influence in the firm than the manager. Further, the manager is likely to convey the wishes of the partner to the senior, since the partner is the manager’s immediate superior. While the preferences of the manager may not always be aligned with those of the partner, for the purposes of this study, we assume that as the leader of the audit team, the partner will strongly influence the preferences of the manager. 5. Extreme partner pressures (e.g. ‘‘cut the hours by 30% or else!’’) were not used because they would be likely to lead to demand effects and, based on our discussions with firm personnel, are unlikely to occur in practice. 6. Prior research (e.g. Houston, 1999) and an audit manager were consulted regarding the development of the experimental instrument including the items used to signal an increase in client risks. 7. Auditors were also asked to indicate their planned level of reliance on internal control. On a scale of one (no reliance) to seven (maximum reliance), the means for internal control reliance are significantly different (t ¼ 1:78; p ¼ 0:04) between the auditors who received a partner preference for effectiveness (2.8) and efficiency (3.4). This finding is consistent with lower control risk assessment for the efficiency condition, as expected. The difference in means for the effectiveness vs. efficiency group is also significant for budgeted hours of control testing (5.7 vs. 10.6; t ¼ 1:83; p ¼ 0:04) and for mean budgeted hours of control testing for staff2 auditors (2.0 vs. 6.4; t ¼ 2:1; p ¼ 0:02), but not for staff1 hours (3.7 vs. 4.2; t ¼ 0:31; p ¼ 0:37) or the number of planned tests of controls (0.83 vs. 1.06; t ¼ 0:8; p ¼ 0:22). (p values are one-tailed if the direction of the results is consistent with expectations.) 8. Differences in the specific tests planned, tests of external vs. internal evidence, and the number of tests added to the audit program were not statistically significant across the two conditions. 9. A limitation of this study is that hours per test was not measured. However, the results suggest that on average hours per test decreased, since budgeted hours were decreased by a greater extent than planned tests for both conditions. Therefore, auditors may have attempted to improve audit efficiency primarily through reductions to budgeted hours. 10. The results of a MANOVA including both number of tests and budgeted hours as dependent variables are qualitatively similar to the regression results (i.e. the interaction between risk and partner pressure is significant ðpo0:05Þ:

The Effect of Partner Preferences

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REFERENCES Abdolmohammadi, M., & Usoff, C. (2001). The assessment of task structure, knowledge base, and decision aids for a comprehensive inventory of audit tasks. Wesport, CT: Quorum Books. Adams, E. L., Hermanson, R., & Turner, D. (1987). Whither accounting? – the CPA’s changing world. Business(April–June), 51–53. American Institute of Certified Public Accountants (AICPA). (1993). SAS No. 47: Materiality and audit risk. Codification of Statements on Auditing Standards. New York, NY: AICPA. Arthur Andersen & Co., Coopers & Lybrand, Deloitte & Touche, Ernst & Young, KPMG Peat Marwick, and Price Waterhouse. (1993). The liability crisis in the U.S.: Impact on the accounting profession (A statement of position). Reprinted by Journal of Accountancy, 174 (5): 19–23. Asare, S., Hackenbrack, K., & Knechel, W. (1994). Client Acceptance and Continuation Decisions. Deloitte and Touche/University of Kansas Symposium on Auditing Problems (pp. 163–178). Asare, S., Trompeter, G., & Wright, A. (2000). The effect of accountability and time budgets on auditors’ testing strategies judgments. Contemporary Accounting Research(winter), 539–560. Ashton, R. H. (1990). Pressure and performance in accounting decision settings: Paradoxical effect of incentives, feedback, and justification. Journal of Accounting Research(Suppl.), 148–180. Ashton, R. H. (1992). Effects of justification and a mechanical aid on judgment performance. Organizational Behavior and Human Decision Processes, 52, 292–306. Bedard, J. (1989). An archival investigation of audit program planning. Auditing: A Journal of Practice and Theory, 9(1), 57–71. Bedard, J., Mock, T., & Wright, A. (1999). Evidential planning in auditing: A review of the empirical research. Journal of Accounting Literature, 96–142. Bedard, J., & Wright, A. (1994). The functionality of decision heuristics: Reliance on prior audit adjustments in evidential planning. Behavioral Research in Auditing, 6, 62–89. Bierstaker, J., & Wright, A. (2001). The effects of fee pressure and reviewer preferences on audit planning decisions. Advances in Accounting, 25–46. Carson, E., Simnett, R., Soo, B., & Wright, A. (2004). A longitudinal investigation of the audit and non-audit services fee markets (1984 to 1999). Working paper, Boston College. Cohen, J., & Trompeter, G. (1998). An examination of factors affecting audit practice development. Contemporary Accounting Research(Winter), 481–504. Farmer, T., Rittenberg, L., & Trompeter, G. (1987). An investigation of the impact of economic and organizational factors on auditor independence. Auditing: A Journal of Practice & Theory(Fall), 1–11. Gibbins, M., & Newton, J. (1994). An empirical exploration of complex accountability in public accounting. Journal of Accounting Research, 32(Autumn), 165–186. Gramling, A. (1999). External auditors’ reliance on work performed by internal auditors: The influence of fee pressure on this reliance decision. Auditing: A Journal of Practice & Theory(Supplement), 117–136. Hill, M. C. (2001). Planned audit hours: Do auditors use a same as last year strategy? Advances in Accounting Behavioral Research, 4, 281–302.

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Hirst, E., & Koonce, L. (1996). Audit analytical procedures: A field investigation. Contemporary Accounting Research(Fall), 457–486. Houston, R. (1999). The effect of fee pressure and client risk on audit seniors’ time budget decisions. Auditing: A Journal of Practice and Theory(Fall), 70–86. Kachelmeier, S., & Messier, W. (1990). An investigation of the influence of a nonstatistical decision aid on auditor sample size decisions. The Accounting Review, 65(January), 209–226. Kennedy, J. (1993). Debiasing audit judgment with accountability: A framework and experimental results. Journal of Accounting Research(Autumn), 231–245. Kermis, G., & Mahapatra, S. (1985). An empirical study of the effects of time pressure on audit time allocations. Advances in Accounting, 2, 261–273. Knapp, M. (1985). Audit conflict: An empirical study of the perceived ability of auditors to resist management pressure. Accounting Review(April), 202–211. Lerner, J., & Tetlock, P. (1999). Accounting for the effects of accountability. Psychological Bulletin, 125(2), 255–275. Lord, A., & DeZoort, T. (2001). The impact of commitment and moral reasoning on auditors’ responses to social influence pressure. Accounting, Organizations and Society, 215–235. Marxen, D. E. (1990). A behavioral investigation of time budget preparation in a competitive audit environment. Accounting Horizons, 47–57. Messier, W. F., Kachelmeier, S. J., & Jensen, K. (2001). An experimental assessment of recent professional developments in nonstatistical audit sampling guidance. Auditing: A Journal of Practice and Theory(March), 81–96. McNair, C. J. (1991). Proper compromises: The management control dilemma in public accounting and its impact on auditor behavior. Accounting, Organizations and Society, 16(7), 635–653. Mock, T., & Wright, A. (1993). An exploratory study of auditor evidential planning. Auditing: A Journal of Practice and Theory(Fall), 39–61. Mock, T., & Wright, A. (1999). Are audit program plans risk-adjusted? Auditing: A Journal of Practice and Theory(Spring), 55–74. O’Keefe, T., Simunic, D., & Stein, M. (1994). The production of audit services: Evidence from a major public accounting firm. Journal of Accounting Research(Autumn), 241–261. Palmrose, Z., & Scholz, S. (2002). The circumstances and legal consequences of non-GAAP reporting: Evidence from restatements. Contemporary Accounting Research, 21(1) (Spring), 139–180. Peecher, M. (1996). The influence of auditors’ justification processes on their decisions: A cognitive model and experimental evidence. Journal of Accounting Research(Spring), 125–140. Rich, J., Solomon, I., & Trotman, K. (1997). The audit review process: A characterization from the persuasion perspective. Accounting, Organizations & Society(22), 481–505. Russo, J., Medvec, V., & Meloy, M. (1996). The distortion of information during decisions. Organizational Behavior and Human Decision Processes, 66(1), 102–110. Shockley, R. (1981). Perceptions of auditor’s independence: An empirical analysis. Accountng Review(October), 785–800. Simon, D., & Francis, J. (1988). The effects of auditor change on audit fees: Tests of price cutting and price recovery. The Accounting Review(April), 255–269. Tan, C., Jubb, C., & Houghton, K. (1997). Auditor judgments: The effects of the partner’s views on decision outcomes and cognitive effort. Behavioral Research in Accounting, 9(Suppl.), 157–175.

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Tetlock, P., & Kim, J. (1987). Accountability and judgment processes in a personality prediction task. Journal of Personality and Social Psychology(April), 700–709. Tetlock, P., Skitka, L., & Boetiger, R. (1989). Social and cognitive strategies for coping with accountability. Journal of Personality and Social Psychology(October), 632–640. Turner, C. (2001). Accountability demands and the auditor’s evidence search strategy: The influence of reviewer preferences and the nature of the response (Belief vs. Action). Journal of Accounting Research(December), 683–706. Wilks, J. (2002). Predicisional distortion of evidence as a consequence of real-time audit review. The Accounting Review(January), 51–71. Wu, M. (2002). Earnings restatements: A capital market perspective. Working paper, New York University.

THE VALUE RELEVANCE OF EARNINGS AND BOOK VALUE UNDER POOLING AND PURCHASE ACCOUNTING C. S. Agnes Cheng, Kenneth R. Ferris, Su-Jane Hsieh and Yuli Su ABSTRACT This study examines the value relevance of reported earnings and book value under pooling-of-interests and purchase accounting. Using a sample of 110 merger or acquisition transactions from the period 1988 to 1996, the value relevance of the two accounting approaches is investigated by examining the correlation of post-merger earnings and book value with share price. Regression analysis using Ohlson’s (1995) valuation model is conducted for the merger year (m) and the subsequent year (m þ 1) using three samples (pooling only, purchase only and a combined sample). The results are as follows:
When pooling accounting is used, only earnings are value relevant, and the results are consistent with earnings under pooling being more value relevant than book value.
When purchase accounting is used, both earnings and book value are value relevant and no significant difference was found between the value relevance of earnings and book value.

Advances in Accounting Advances in Accounting, Volume 21, 25–59 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21002-7

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A Vuong test indicates that the adjusted R2 of the valuation model under purchase accounting significantly exceeds that under pooling for the merger year only for the combined sample. Thus, this result provides weak evidence that the earnings and book value under purchase accounting better explain firm value than those under pooling.
The relative value relevance of earnings and book value under the two methods is pooling earnings4purchase earnings and purchase book value4pooling book value.
Using proxy variables for earnings and book value reflecting the consolidation framework of Statement of Financial Accounting Standards (SFAS) Nos. 141 and 142, the results indicate that the proxy variables yield earnings and book value data that better explain firm value than those produced using either pooling accounting or purchase accounting for half of the testing periods and sample groups. Thus, our results provide some evidence to support the FASB’s decision to eliminate pooling accounting.

INTRODUCTION According to Ohlson (1995) and Ohlson and Zhang (1998), firm share price can be explained by both earnings and book value. Prior studies (Barth, Beaver, & Landsman, 1993; Barth, Beaver, & Landsman, 1998; Collins, Morton, & Xie, 1999; Chamberlain & Hsieh, 2001) have shown empirically that both earnings and book value explain share price. However, only a few studies have investigated the relative weights of earnings and book value in firm valuation (Burgstahler & Dichev, 1997; Collins, Maydew, & Weiss, 1997; Barth et al., 1998; and Cheng, Hsieh, & Yip, 2003). Collins et al. (1997), for example, found that the relative value relevance of earnings and book value shifted from earnings to book value using a sample of firms for the period of 1953–1993. Their evidence indicates that the shift was due to an increase in one-time items and negative earnings. Using a sample of firms from 1974 to 1993, Barth et al. (1998) also report that the value relevance of earnings and book value shifted from earnings to book value as the financial health of a firm declines. This study extends these previous studies by investigating whether the accounting choice for business combination (i.e., pooling-of-interests accounting or purchase accounting) affects the relative value relevance of earnings and book value, and perhaps, total firm value. We first investigate

The Value Relevance of Earnings and Book Value

27

the relative value relevance of pooling earnings (EPooling) versus pooling book value (BPooling) and the relative value relevance of purchase earnings (EPurchase) versus purchase book value (BPurchase).1 Our results indicate that when pooling accounting is used, only earnings are value relevant, and the results are consistent with earnings being more value relevant than book value. However, when purchase accounting is used, both earnings and book value are in general value relevant, and these two accounting variables are equally value relevant. This result is consistent with Ohlson and Zhang (1998), who suggest that the relative weights for earnings and book value may vary for different accounting methods depending upon how well those earnings reflect a firm’s permanent earnings. The incremental value relevance of earnings over book value (or vice versa) under pooling and purchase accounting is also studied. Our results suggest that, when pooling is used, earnings have incremental value relevance over book value, but not vice versa. When purchase accounting is used, earnings have incremental value relevance over book value. However, our empirical evidence does not suggest that book value has incremental value relevance over earnings, except for the combined sample. Second, we compare the combined explanatory power of earnings and book value under pooling versus purchase accounting to investigate whether the accounting choice for business combination affects the combined value relevance of earnings and book value. We find that the purchase method has a significantly higher adjusted R2 for the acquisition year only. Thus, our finding weakly suggests that firm value is more closely associated with earnings and book value under purchase accounting than under pooling. Lev (1989) observes that when investors perceive deficiencies in reported earnings (e.g. a one-time earnings increase from early adoption of SFAS 87), investors may use an adjusted earnings measure for valuation purposes. To evaluate which earnings and book value (i.e. pooling or purchase accounting) is more value relevant, we compare the relative value relevance of EPooling versus EPurchase and BPooling versus BPurchase. We find that EPooling is more value relevant than EPurchase but BPurchase is more value relevant than BPooling. This result suggests that EPooling and BPurchase are more correlated with firm value than EPurchase and BPooling, regardless of which method is adopted to account for a business combination. The Financial Accounting Standards Board’s (FASB) decision to eliminate pooling has had little (if any) empirical support to date (Wahlen, Boatsman, Herz, Jennings, Jonas, Palepu, Petroni, Ryan, & Schipper, 1999). In an attempt to provide some empirical evidence regarding the new

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consolidation standard, we evaluate the FASB’s consolidation reporting approach that purchase accounting, without required amortization of goodwill, be used to account for all business combinations (i.e., SFAS Nos. 141 and 142). In the absence of required periodic amortization of goodwill, the new reporting framework should yield earnings that are closer to EPooling than to EPurchase.2 Therefore, a valuation model with EPooling and BPurchase used as proxies for the earnings and book value under SFAS No. 141/142 is utilized to evaluate the new framework. The adjusted R2 from this proxy model is investigated to see whether it is significantly greater than that of either pooling accounting or purchase accounting. We find that the earnings and book value of the proxy framework better explains share price than that from either pooling or purchase accounting for half of our testing samples and years. From a value-relevance prospective, this finding provides some evidence to support the FASB’s position that purchase accounting, without required amortization of goodwill be used to account for business combinations.

BACKGROUND AND PRIOR STUDIES The accounting for business combinations has long been one of the most controversial financial reporting issues. At the center of the controversy is Accounting Principles Board (APB) Opinion No. 16, issued in 1970. This opinion permits acquiring companies to use either purchase accounting or pooling-of-interests accounting to account for merger and acquisition transactions.3 The principal differences between the two methods involve the accounting for any premium paid in the transaction and the valuation assigned to the acquired net assets. Under pooling accounting, any acquisition premium is ignored and the acquired firm’s net assets are consolidated at their existing book value. Under purchase accounting, the acquisition premium is recognized as goodwill and the acquired net assets are recorded at their fair market value.4 Thus, the book value of the consolidated net assets under pooling will typically be less than those reported under purchase accounting (i.e., BPoolingoBPurchase) immediately following an acquisition transaction. And, differences in the post-merger consolidated earnings will result from the amortization of any purchased goodwill and the depreciation associated with any revaluation of acquired net assets. The additional amortization and depreciation charges usually cause post-merger consolidated earnings under purchase accounting to be lower than those reported under pooling (i.e., EPurchaseoEPooling).

The Value Relevance of Earnings and Book Value

29

Since earnings is a key metric used to evaluate firm and managerial performance, managers of acquiring firms usually prefer the pooling method because it frequently enables the consolidated entity to report higher postmerger earnings. This reporting result occurs despite an absence of any real cash flow difference between the two methods.5 Further, although purchase accounting does yield higher consolidated book values than does pooling, acquiring firm managers rarely value this financial outcome, in part because the purchase method often results in a lower return-on-equity (ROE) and market-to-book ratio (Ayers, Lefanowicz, & Robinson, 2000), which are financial metrics frequently used to assess firm and managerial performance.6 The FASB has been debating the merits of the two consolidation frameworks for years. The Board has expressed concern over the flexibility in accounting treatment permitted by APB Opinion No. 16 and with the noncomparability of post-merger consolidated financial statements when different consolidation treatments are used. A related concern is that pooling may distort the economic reality of some transactions because it fails to recognize the goodwill clearly present in some merger transactions. Despite strong industry opposition, especially from the banking and technology industries, the FASB unanimously voted in 1999 to eliminate the use of pooling (SFAS No. 141, ‘‘Business Combinations’’). It has been predicted that the elimination of pooling as a consolidation framework could slow the pace of mergers and acquisitions in some industries, and consequently, hamper the growth of some acquisition-oriented companies. Vincent (1997), for example, reports that some acquisition transactions were canceled when approval of the use of pooling accounting could not be obtained from regulatory authorities. To counter these market-related concerns, the FASB proposed that any goodwill recognized under the purchase method not be subject to writedown unless an impairment of that asset occurred. One consequence of this is that acquirers using the purchase method would be able to report higher consolidated book values as compared to pooling accounting while also reporting higher post-merger consolidated earnings than was previously possible under purchase accounting. Thus, purchase-based earnings under SFAS No. 142, ‘‘Goodwill and Other Intangible Assets,’’ would more closely approximate those reported under pooling, ignoring the additional depreciation associated with any revalued net assets. Empirical studies to date have failed to obtain conclusive evidence indicating that the post-merger accounting numbers produced using the

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C. S. AGNES CHENG ET AL.

purchase method are more value-relevant than those under pooling.7 In an attempt to provide such evidence, we compare the combined value relevance of earnings and book value under pooling and purchase accounting with that of a proxy representing the SFAS No. 141/142 framework.

Prior Studies Ayers et al. (2002) document that acquiring firms sometimes paid a premium to obtain the use of the pooling method, thus suggesting the expected receipt of certain financial benefits from use of the method (e.g. an increase in share price around the acquisition date). However, Hopkins, Houston, and Peters (2000) suggest that no direct financial benefits are associated with the use of pooling. Similarly, Hong, Kaplan, and Mandelker (1978) and Davis (1990) both report that higher share prices were associated with firms adopting the purchase method, but not with the pooling method, during the period preceding merger announcement date. Other related studies evaluate the information content of goodwill and goodwill amortization. Jennings, Robinson, Thompson, and Duvall (1996), for example, provide evidence that recorded goodwill is positively associated with market value. Vincent (1997) observed that while the imputed AAP for pooling transactions is not value-relevant, the reported AAP for purchase transactions is undervalued and positively, significantly correlated with share price for the 3 years following an acquisition. Similarly, Henning, Lewis and Autumn (2000) found a significant, positive association between market values both with going-concern goodwill and synergy goodwill (i.e., core goodwill). Thus, the preponderance of evidence suggests that goodwill be reported on the balance sheet as an asset and is value relevant. On the other hand, a majority of studies examining the value relevance of goodwill amortization conclude that goodwill amortization is not value relevant. For example, Linderberg and Ross (1999) conclude that goodwill amortization is irrelevant in firm valuation. Similarly, Henning et al. (2000) found that market value is not associated with the amortization of core goodwill.8 And, Jennings, LeClere and Thompson (2001) found no incremental usefulness of goodwill amortization for explaining share price, concluding that goodwill amortization adds noise to earnings measurement in explaining share price. Finally, Moehrle, ReynoldsMoehrle, and Wallace (2001) found that earnings before extraordinary

The Value Relevance of Earnings and Book Value

31

items are equally informative in explaining market adjusted returns as earnings before extraordinary items and goodwill amortization. Contrary to these studies, Vincent (1997) found that AAP amortization for purchase transactions is not only negatively associated with market value but is also understated for the two years following an acquisition. Thus, with the exception of Vincent (1997), most prior studies suggest that investors perceive goodwill amortization to be irrelevant in firm valuation. In summary, prior research provides empirical evidence to support the claim that purchased goodwill is value relevant but goodwill amortization is not. However, the question of whether the choice of business combination method affects the value of the combined entity and which earnings/book value (purchase or pooling accounting) is more value relevant remain unanswered.

Contributions of the Current Study to the Extant Literature This study differs from prior studies regarding the value relevance of goodwill and goodwill amortization in that it investigates the value relevance of the accounting acquisition premium (i.e., goodwill plus any step-up in asset value). The study extends the literature concerning the study of the relative weights of earnings and book value on firm valuation by examining the relative value relevance of earnings and book value under alternative consolidation accounting methods. This study investigates the incremental value relevance of earnings over book value (or vice versa) under the pooling and the purchase accounting. We also study whether the accounting choice of business combination method affects the combined value relevance of earnings and book value, and compare EPooling versus EPurchase and BPooling versus BPurcahse to assess which variables (i.e. EPooling or EPurchase; BPooling or BPurcahse) are more correlated with firm value regardless of the method adopted to account for a business combination. Finally, this study provides evidence to evaluate the FASB’s decision to eliminate pooling accounting and to abandon goodwill amortization. The next section describes the research questions studied and the methodology used. The method of sample selection and financial characteristics of the sample firms are then described, followed by the empirical analyses and results. A final section presents the study conclusions.

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C. S. AGNES CHENG ET AL.

RESEARCH QUESTIONS AND METHODOLOGY Estimated Earnings and Book Value under Alternative Consolidation Treatments When purchase accounting is used in an acquisition transaction, the accounting acquisition premium (AAP) is reported on the consolidated balance sheet in the form of any revalued net assets or as goodwill. While the accounting for the AAP increases the book value of the consolidated entity under purchase accounting, the amortization/depreciation of the AAP decreases future consolidated earnings. On the other hand, use of the pooling method in a merger transaction requires the acquirer to report only the book value of the acquired firm in the consolidated financial statements and ignores the AAP. As a consequence, post-merger earnings under pooling are not dampened by the amortization/depreciation of any implied AAP and the acquired net assets are not revalued. Thus, for a merger/acquisition transaction with positive AAP, adopting the purchase method should result in a higher reported book value but lower earnings than if pooling were used. The estimated difference in annual earnings between the two consolidation methods can be proxied by the annual amortization of the AAP; and, the difference in reported book value can be proxied by the unamortized AAP. To estimate AAP, we subtract the most recently available book value of the target firm prior to acquisition from the publicly reported purchase price to derive the accounting acquisition premium (AAP).9 We then add the estimated AAP to the reported book value of the consolidated entity in the pooling sample (BPooling) to proxy for consolidated book value as if the purchase method had been used (BPurchase). On the other hand, we subtract the AAP from the reported book value of the consolidated entity in the purchase sample (BPurchase) to proxy for consolidated book value as if the pooling method had been used (BPooling). Although AAP amortization can be computed in several ways (i.e., Vincent, 1997), consistent with the FASB’s proposed 1999 disclosure standard for goodwill, we amortize the AAP over 20 years to estimate the differential between EPooling and EPurchase for each transaction. Thus, the relationship of EPooling (reported earnings under pooling), Purchase (reported earnings under purchase), BPooling (reported book value E under pooling) and BPurchase (reported book value under purchase) can be summarized as follows: E Purchase ¼ E Pooling  AAP=20 BPurchase ¼ BPooling þ unamortized AAP

The Value Relevance of Earnings and Book Value

33

where EPurchase ¼ reported (for purchase firms) or estimated (for pooling firms) net income using the purchase method EPooling ¼ reported (for pooling firms) or estimated (for purchase firms) net income using the pooling method BPurchase ¼ reported or estimated book value using the purchase method BPooling ¼ reported or estimated book value using the pooling method AAP ¼ purchase pricebook value of the acquiree AAP/20 ¼ amortization of AAP10 For the pooling sample, EPooling and BPooling are reported numbers while EPurchase and BPurchaseare estimated (derived); and, for the purchase sample, EPurchase and BPurchase are reported numbers and EPooling and BPooling are estimated similarly.

Research Questions 1 and 2 and Test Models – The Relative and Incremental Value Relevance of Book Value and Earnings The following two questions are investigated to evaluate the relative value relevance of earnings and book value under pooling and purchase accounting:11 Question 1. Is the value relevance (weight) of EPooling equal to the value relevance of BPooling when pooling accounting is used? Question 2. Is the value relevance (weight) of EPurchase equal to the value relevance of BPurchase when purchase accounting is used? The following two questions are investigated to evaluate the incremental value relevance of earnings over book value, or vice versa:12 Question 3. Is the combined value relevance of EPooling and BPooling greater than that of EPooling or BPooling ? Question 4. Is the combined value relevance of EPurchase and BPurchase greater that of EPurchase or BPurchase ? As indicated in Biddle, Seow and Siegel (1995), two variables can be equally value relevant (with the same information content) but both are incremental or neither is incremental. On the other hand, it is possible that one variable has greater information content than the other and only the variable with the greater information content is incremental or both are incremental.

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C. S. AGNES CHENG ET AL.

Thus, a relative value relevance test provides different information from that provided by an incremental value relevance test. Since AAP constitutes a significant proportion of an acquirer’s book value as of the beginning of the acquisition year (115% and 92% for the pooling and purchase samples, respectively; see Table 2), and since goodwill has been documented as an asset in prior studies, the omission of the AAP from the consolidated balance sheet under pooling could constitute a material understatement of total assets. As a consequence, we expect investors to place little (or no) weight on this potentially misvalued variable (i.e., BPooling). On the other hand, since the AAP is reported on the consolidated balance sheet under purchase accounting, we expect investors to value the informational content of BPurchase. Further, since the information content of earnings relative to share price is well established, we expect investors to value both EPurchase and EPooling, although the relevance of EPurchase is of some question given that researchers have consistently found goodwill amortization not to be value relevant (Henning et al., 2000; Jennings et al., 2001). However, since the magnitude of the AAP amortization is small relative to the size of the AAP and a previous study found that earnings with or without goodwill amortization are equally informative in explaining adjusted returns (Moehrle et al., 2001), we expect EPurchase to be value relevant13. The model used to evaluate the value relevance of earnings and book value was developed by Ohlson (1995):14 Pjt ¼ a þ bnE jt þ cnBjt þ jt where: Pjt Ejt Bjt ejt

¼ ¼ ¼ ¼

Market value of firm j at a 3-month lag of fiscal year-end t. Earnings (excluding extraordinary items) of firm j at fiscal year-end t. Book value of firm j at fiscal year-end t. The residual term.

The following models are used to compare the weights of earnings and book value under pooling and purchase accounting: For pooling: Model A:1 :

Pjt ¼ d0 þ d1 nE Pooling þ d3 nSIZEjt1 þ mjt jt

Model A:2 :

Pjt ¼ d0 þ d2 nBPooling þ d3 nSIZEjt1 þ mjt jt

Model A:3 :

Pjt ¼ d0 þ d1 nE Pooling þ d2 nBPooling þ d3 nSIZEjt1 þ mjt jt jt

The Value Relevance of Earnings and Book Value

35

For purchase: Model B:1 :

Pjt ¼ y0 þ y1 nE Purchase þ y3 nSIZEjt1 þ njt jt

Model B:2 :

þ y3 nSIZEjt1 þ njt Pjt ¼ y0 þ y2 nBPurchase jt

Model B:3 :

þ y3 nSIZEjt1 þ njt þ y2 nBPurchase Pjt ¼ y0 þ y1 nE Purchase jt jt

where: Pjt EPooling BPooling EPurchase BPurchase SIZEjt1 t

¼ Market value of firm j at 3-month lag of fiscal year-end t, deflated by shares outstanding.15 ¼ Reported (i.e., for pooling sample) or estimated earnings (i.e., for purchase sample) using the pooling method, deflated by shares outstanding. ¼ Reported or estimated book value using the pooling method, deflated by shares outstanding. ¼ Reported (i.e., for purchase sample) or estimated (i.e., for pooling sample) earnings using the purchase method, deflated by shares outstanding. ¼ Reported or estimated book value using the purchase method, deflated by shares outstanding. ¼ The market capitalization of the acquiring firm at the end of year t  1: ¼ Year m or m þ 1; m is the acquisition year.

Thus, the market price (P), earnings (E) and book values (B) are all in per share form to control for heteroscedasticity. Also, we add an additional size variable, the market capitalization of the acquirer, to further control for any market capitalization- related scale effect which may still exist in a per-share model.16 For purposes of this study, the value relevance of accounting data is evaluated by the correlation of post-merger earnings and book value with share price during the merger year (m) and one year following merger (m þ 1). Based on the assumption that a firm’s current share price reflects all available economic information about the firm, the higher the correlation of earnings and book value with share price (i.e., the higher the explanatory power of earnings and book value), the more value-relevant the accounting data can be assumed to be.

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Since the derived measures are likely to contain measurement errors,17 we not only analyze the data using a combined sample for year m and m þ 1; but we also analyze the data on the basis of segmented samples (i.e., pooling and purchase samples). Thus, three samples – a combined pooling and purchase sample, a pooling sample, and a purchase sample – are used for each model. The adjusted R2 values of Models A.1 and A.2 are compared using the Vuong (1989) test to assess the relative value relevance of earnings and book value for the pooling method (i.e., EPooling versus BPooling).18 A similar test is performed for Models B.1 and B.2 for the purchase method (i.e., EPurchase versus BPurchase). In addition, adjusted R2 values of Models A.1 and A.3 and the adjusted R2 values of Models A.2 and A.3 are compared using Vuong (1989) tests, which is suitable for both nested and nonnested regression models. These analyses investigate whether Model A.3 (with both EPooling and BPooling in the model) has incremental explanatory power over model A.1 (with only EPooling) or Model A.2 (with only BPooling). Similar tests are also performed for the adjusted R2 values of Models B.1 and B.3 and the adjusted R2 of Models B.2 and B.3 to investigate whether Model B.3 (including both EPurchase versus BPurchase) has incremental explanatory power over Model B.1 (with only EPurchase) or Model B.2 (with only BPurchase).

Research Question 5 and Test Model – Comparing the Total Value Relevance of Book Value and Earnings To investigate the question of which consolidation accounting method can better explain post-transaction share price, the value relevance of combined earnings and book value under each method is investigated. Consequently, our fifth research question is Question 5. Is the value relevance of combined earnings and book value the same under pooling and purchase accounting? Models A.3 (pooling) and B.3 (purchase) are used to investigate this question. The adjusted R2 for both models are compared using three samples (combined, pooling, and purchase). Vuong (1989) likelihood ratio tests are conducted to evaluate the combined earnings and book value explanatory power of the two methods.

The Value Relevance of Earnings and Book Value

37

Research Questions 6 and 7 and Test Models – A Comparison of E Pooling with E Purchase and BPooling with BPurchase Lev (1989) observes that when investors perceive deficiencies in the predictive ability of reported earnings, investors may use adjusted earnings (rather than reported earnings) for valuation purposes. Hence, an examination of the relative value relevance of EPooling versus EPurchase and BPooling versus BPurchase can reveal whether the reported or the derived earnings and book value are used by investors when assessing firm value under the two business combination methods. If EPooling is more value relevant than EPurchase, this would suggest that investors use reported (derived) earnings when assessing firm value for firms adopting pooling (purchase) and vice versa. Similarly, if BPooling is more value relevant than BPurchase, this would suggest that investors use the reported (derived) book value when assessing firm value for firms adopting pooling (purchase) and vice versa. Thus, our sixth and seventh research questions are: Question 6. Is the value relevance of EPooling equal to EPurchase ? Question 7. Is the value relevance of BPooling equal to BPurchase ? To study these research questions, the following models are employed using the combined sample: Model A:1 :

þ d3 nSIZEjt1 þ mjt Pjt ¼ d0 þ d1 nE Pooling jt

Model B:1 :

þ y3 nSIZEjt1 þ njt Pjt ¼ y0 þ y1 nE Purchase jt

Model A:2 :

Pjt ¼ d0 þ d2 nBPooling þ d3 nSIZEjt1 þ mjt jt

Model B:2 :

þ y3 nSIZEjt1 þ njt Pjt ¼ y0 þ y2 nBPurchase jt

Vuong (1989) tests are then used to compare the adjusted R2 of Model A.1 with that of B.1, and to compare the adjusted R2 of Model A.2 with that of B.2.

Research Question 8 and Test Model – Studying the Value Relevance of Earnings and Book Value under the SFAS No. 141/142 Proxy Framework In 2001, the FASB voted to eliminate the use of pooling accounting for consolidation accounting purposes (i.e., SFAS No. 141). Further, the Board

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concluded that any goodwill capitalized to the balance sheet in an acquisition transaction would not be subject to periodic amortization, but instead would be evaluated annually for any impairment in value (i.e., SFAS No. 142). Under the new framework, the pooling method is eliminated and goodwill is not subject to amortization. In an attempt to study whether the SFAS No. 141/142 framework provides more value relevant data than either pooling or purchase accounting, BPurchase and EPooling were used to proxy for the book value and earnings under the new framework.19 Our research question for the new framework is: Question 8. Is the value relevance of the proxy FASB framework greater than, equal to, or less than that of pooling accounting or purchase accounting? The following model is used to evaluate the value relevance of the new proxy framework: Model C :

Pjt ¼ g0 þ g1 nE Pooling þ g2 nBPurchase þ g3 nSIZEjt1 þ Zjt jt jt

The explanatory power of Model C is compared with that of Model A.3 (pooling) and that of Model B.3 (purchase) using a Vuong likelihood ratio test (1989). Significant Z values from the Vuong tests would imply that the combined earnings and book value of Model C are more value relevant than those of either Model A.3 or B.3. Sample Selection and Financial Characteristics of Sample Firms Sample Selection The sample firms used in this study were selected from the 100 largest transactions based on reported purchase price published annually by Mergers and Acquisitions magazine for the period 1988–1996. Because of their size, these acquisitions are likely to receive extensive news coverage, be followed by financial analysts, and gain the attention of investors regarding the potential earnings and financial ratio impact from an acquirer’s consolidation accounting method. Thus, the share price of the firms associated with these transactions is more likely to reflect the economic impact of the consolidation accounting method than that of smaller size transactions. In addition, the following criteria were imposed for purposes of sample selection: 1. The acquirer must obtain at least 50% of the acquiree’s outstanding shares in a single transaction.

The Value Relevance of Earnings and Book Value

39

2. The merger/acquisition footnote information is available on the Lexis/ Nexis database, and the consolidation accounting method and effective date of the transaction can be clearly identified. 3. In the case of multiple transactions in the merger year (year m) and subsequent year (m þ 1), one of the following two situations must exist in order to include the transaction in the sample: (a) all mergers/acquisitions in those years are accounted for using the same consolidation accounting method (i.e., all using purchase or all pooling); (b) the total purchase price of any alternatively accounted transactions may not exceed 15% of the purchase price of the merger/acquisition transaction under study (i.e., a materiality criterion). 4. Both the acquirer and acquiree firms have data available on the Compustat tapes. Specifically, to be included in the sample, the acquirer must have the lagged market capitalization value available at year m (that is, the first quarter market value at year m þ 1),20 as well as the earnings, dividends, and book value available at the end of year m. On the other hand, the acquiree must have its book value available at year m. Criterion 1 was imposed to insure homogeneity in transaction pricing (i.e., all transactions involved a controlling interest and hence would be priced to reflect the presence of a control premium). Criteria 2 and 4 were imposed to insure consistency in the availability of transaction data. Finally, criterion 3 was imposed to constrain the effects of alternative merger/ acquisition transactions on post-merger share price. Based on these criteria, 111 transactions were selected, of which 45 used pooling-of-interests accounting and the remaining 66 used purchase accounting. Of the 66 purchase firms, one appears to be an outlier. When adjusting the book values of the purchase sample (BPurchase) firms to the ‘‘as if’’ pooling book value (BPooling), this firm’s ‘‘as if’’ pooling book value equals $-4951.75 million (unscaled). When including this firm, the coefficient of ‘‘as if’’ pooling book value is negative for both years. When the firm is removed from the sample (i.e., N ¼ 65), the coefficients change to positive. Thus, this firm was deleted and the final sample consists of 45 pooling and 65 purchase firms.21 Table 1 details the sample selection process (Panel A) and an industry breakdown of the sample (Panel B). Financial Characteristics of Sample Selected preacquisition financial variables, including total assets (TA), market value (MV) and book value (B), were obtained for both the acquirer

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Table 1.

Description of Sample.

Panel A. Sample Selection Process 1. 2. 3. 4. 5. 6.

Number of merger and acquisition transactions identified from Mergers and Acquisitions from 1988–1996. Number of merger and acquisition transactions not meeting the criteria that at least 50% of the target company’s ownership is acquired. Number of merger and acquisition transactions for which data are unavailable on the Lexis/Nexis database. Number of merger and acquisition transactions not meeting the materiality criterion for multiple mergers or acquisitions. Numbers of merger and acquisition transactions for which financial data are unavailable on Compustat and CRSP. Outlier removal Final sample

900 335 252 61 141 1 110

Panel B. Final Sample by Industry SIC Code

10–14 15–17 20–39 41–49 50–51 52–59 60–67 70–89 91–97

Industry

Pooling sample

Purchase sample

Number

(%)

Number

(%)

Mineral industry Construction industries Manufacturing Transportation, communication & utilities Wholesale trade Retail trade Finance, insurance & real estate Service industries Public admin., conglomerates

2 0 11 5 0 2 19 5 1

4.44 0.00 24.44 11.11 0.00 4.44 42.22 11.11 2.22

1 0 28 13 4 4 8 6 1

1.54 0.00 43.08 20.00 6.15 6.15 12.31 9.23 1.54

Total

45

100.00

65

100.00

and acquiree firms. Except for the book value of the acquiree, all variables are measured as of the end of year m  1; where m is the transaction year. The book value of the acquiree is measured as of the most closely available quarter preceding the transaction date. In addition, the market value ratio (i.e., AAP/market value of acquirer),22 purchase price, the AAP, amortized AAP, AAP/book value of the acquirer, and the amortized AAP/net income ratio were also obtained. Panel A of Table 2 reports these variables. At time m  1; the size of the acquirers using the purchase method is, in general, greater than those using pooling, as indicated by the significantly higher mean values of market value and book value. On the other hand, the size of the acquirees for both the

The Value Relevance of Earnings and Book Value

41

purchase and pooling samples are similar, with none of the t-values for firm size significant. Also, acquirers using the purchase method have a significantly higher net income than those using pooling. No significant differences between the two samples are observed for the purchase price, AAP, AAP scaled by the book value, amortized AAP, or amortized AAP scaled by the net income.23 Thus, we conclude that, for our sample, neither the purchase price nor any of the AAP or AAPrelated variables is a determinant of an acquirer’s consolidation accounting policy choice. Prior studies (Davis, 1990; Dunne, 1990; Nathan & Dunne, 1991) have used various financial variables to explain the choice of consolidation accounting method. The results of these studies suggest that the use of pooling accounting results in higher post-merger earnings but lower postmerger assets. Thus, pooling will tend to be preferred by acquirers with a low return on investment (ROI or ROA) low earnings growth in prior years, or a low interest coverage ratio. On the other hand, income-sensitive firms (e.g. firms with a concern for political costs) may tend to prefer purchase accounting for its income-reducing effect. In addition, acquirers concerned about violating debt covenant provisions involving total assets or book value, may also prefer purchase accounting for its asset-increasing effect. Thus, to gain a further understanding of the characteristics of the sample firms, data for the following financial variables for the acquirers in our sample were obtained: ROA, ROI, earnings per share (EPS) and earnings growth (EPSG), interest coverage ratio (ICR), and the net tangible assets/ debt ratio. The mean and standard deviation were calculated for each variable for the prior year (m  1) and the transaction year (m). Panel B of Table 2 reports the mean of these variables; the t-value for the difference between the mean values for the pooling and purchase samples is also provided. For year m  1; none of the mean values are significantly different. For year m, only the t-value for the net tangible assets/debt ratio is significant, but the result is opposite to expectation. Consequently, this analysis failed to unambiguously identify any financial variable as a determinant of consolidation accounting method choice for the sample used in this study.

EMPIRICAL ANALYSES AND RESULTS Table 3 reports the descriptive statistics for the variables used in the regression models for year m (Panel A) and year m þ 1 (Panel B). t-tests

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Table 2.

Sample Firm Characteristics.

Pooling sample No. of obs.

Mean

SD

No. of obs.

Mean

SD

18348.00 8974.50 2909.30 325.65 11662.00 2012.20 891.86 2448.20 2107.10 1.47 41.18 105.35 7.17

65 65 65 65 65 65 65 65 65 63 65 65 65

17595.00 9619.20 3810.20 556.40 4043.50 1888.90 482.71 2072.30 1669.50 0.91 37.01 83.48 0.20

30852.00 14310.00 5159.40 1017.10 11903.00 2226.20 805.09 2227.30 1983.50 0.96 54.38 99.17 0.66

0.49 1.84! 2.12 2.16 0.68 0.80 0.35 0.35 0.71 0.97 1.22 0.71 1.04

C. S. AGNES CHENG ET AL.

Panel A: Firm characteristics, AAP and AAP-related variables TA(A)m1 45 15274.00 MV(A)m1 45 5523.20 BV(A)m1 45 2169.40 NI(A)m1 45 264.41 TA(T)m 45 5594.60 MV(T)m 45 1556.70 45 540.65 BV(T)m PurPrice 45 1914.30 AAP 45 1387.30 44 1.15 AAP/BV(A)m1 45 25.89 Amortized AAPm Amortized AAPm+1 45 69.37 Amortized AAP/NI(A)m+1 44 1.32

t-stat

Purchase sample

0.13 0.05 0.04 0.01 2.34 1.78 0.89 0.20 8.18 5.49 6.01 6.04

0.15 0.48 0.09 0.16 1.73 2.04 4.84 1.38 15.71 9.96 10.71 12.43

64 65 64 65 65 65 64 65 64 64 63 64

0.14 0.10 0.05 0.03 2.16 1.91 0.07 0.14 8.71 5.36 6.25 1.19

0.17 0.21 0.06 0.05 2.40 1.94 1.17 1.35 13.33 6.91 19.32 2.97

0.11 0.60 0.70 0.88 0.46 0.33 1.10 0.24 0.18 0.07 0.08 2.48

Due to data availability, the sample size varies from 41–45 for the Pooling sample and from 63–65 for the Purchase sample. Dollar amount is in millions. TA(A)m1, MV(A)m1, BV(A)m1, and NI(A)m1 represents the total asset, the market value, the book value, and the net income of acquirer firm at year m1, respectively. Year m is the acquisition year. TA(T)m, MV(T)m, and BV(T)m represents the total asset, the market value, and the book value of the target firm at the closest available quarter to the acquisition date at year m or m  1: PurPrice ¼ the purchase price. AAP ¼ Accounting acquisition premium ¼ PurPrice%BV(T)m. AAP/BV(A)m1, is referred to as the bargaining strength. Amortized AAP ¼ AAP/20 where partial year amortization is applied for the acquisition year m. Amortized AAP/NI(A) ¼ amortized accounting acquisition premium/Net income of the acquirer firm. ROI ¼ Return on Investment. ROA ¼ Return on Asset. EPS ¼ Primary Earnings Per Share excluding extraordinary items. EPSG ¼ EPS growth rate ¼ (EPSmEPSm1)/|EPSm1|. ICR ¼ Interest Coverage Ratio ¼ (net income before income tax and interest charges)/interest charges. TAD ¼ Net tangible assets/debt.  : denotes statistical significance at the 5% level; !: denotes statistical significance at the 10% level.

The Value Relevance of Earnings and Book Value

Panel B: Selected financial ratios for acquirer firms ROIm1 45 45 ROIm ROAm1 45 45 ROAm EPSm1 45 EPSm 45 45 EPSGm1 45 EPSGm ICRm1 43 ICRm 42 41 TADm1 42 TADm

43

44

Table 3.

Summary Statistics for Variables used in the Regression Analysis. Original measures (Unscaled Measures) Pooling sample

Mean

BPurchase jm SIZEjm1 DE jm DBjm

Min

Max

Mean

SD

Min

Max

19.39 [14297.24] 2.06

0.59 [32.84] 5.09

100.87 [75795.81] 7.07

65 38.62 [11539.96] 2.35

16.82 [15957.95] 2.08

7.25 [322.44] 4.06

84.00 [97722.06] 8.16

[688.56] 9.43

[439.54] 1.33

[3807.00] 43.54

[583.80] 7.61

[802.74] 12.67

[420.00] 33.16

[3637.92] 46.76

[3516.55] 2.08

[96.42] 5.15

[18921.00] 6.94

[2909.88] 2.09

[5166.01] 1.94

[3515.29] 4.16

[27813.47] 7.22

[373.55] 22.01

[676.55] 9.20

[444.67] 6.07

[3792.22] 46.93

[546.79] 18.23

[792.40] 9.10

[429.90] 1.75

[3510.00] 47.40

[4138.28] [6298.60]

[4546.10] [9737.24]

[429.44] [67.55]

[19260.88] [53859.92]

[4542.39] [9763.73]

[5262.05] [13945.83]

[84.76] [272.99]

[30244.00] [81196.05]

0.15 [25.89] 7.25 [1361.44]

0.13 [41.18] 6.19 [2081.93]

0.00 [0.00] 30.67 [10902.66]

0.49 [212.05] 0.25 [65.36]

0.26 [37.01] 10.62 [1632.51]

0.40 [54.38] 12.43 [1945.16]

0.00 [0.00] 70.28 [9098.88]

2.11 [254.10] 0.45 [61.18]

C. S. AGNES CHENG ET AL.

Panel A: Year m N 45 Pjm 39.32 [9348.15] 1.66 E Pooling jm [399.44] 14.76 BPooling jm [2776.84] 1.52 E Purchase jm

SD

Purchase sample

N Pjm+1 E Pooling jmþ1

45 41.52 [11423.40] 2.02

24.90 [17010.77] 1.79

0.47 [27.38] 2.81

118.69 [69310.38] 5.05

65 44.66 [14129.08] 2.06

22.09 [17633.42] 3.35

4.88 [497.67] 13.33

112.50 [72832.50] 8.41

BPooling jmþ1

[325.14] 14.25

[823.38] 8.20

[3794.00] 0.27

[1748.00] 32.36

[718.88] 9.22

[1245.79] 12.07

[912.39] 23.41

[6065.95] 46.51

E Purchase jmþ1

[2849.96] 1.69

[3008.00] 1.76

[20.09] 2.82

[13850.00] 4.84

[3248.94] 1.55

[5619.63] 3.31

[1836.30] 14.52

[30752.40] 8.16

BPurchase jmþ1

[255.77] 20.24

[782.96] 7.52

[3811.73] 6.28

[1406.42] 36.36

[635.39] 18.71

[1221.16] 9.92

[930.00] 3.01

[5908.00] 47.08

SIZEjm

[4142.04] [9348.15]

[4164.19] [14297.24]

[466.91] [32.84]

[15768.62] [75795.81]

[4798.24] [11471.17]

[5762.44] [15968.53]

[313.10] [322.44]

[33055.00] [97722.06]

0.33 [69.37] 6.00 [1292.08]

0.26 [105.35] 4.82 [1976.59]

0.01 [3.41] 22.08 [10350.62]

1.18 [552.03] 0.24 [61.95]

0.59 [99.17] 10.91 [1845.93]

0.02 [3.10] 58.29 [8632.83]

3.17 [466.05] 0.43 [58.09]

DE jmþ1 DBjmþ1

0.51 [83.50] 9.49 [1549.30]

The Value Relevance of Earnings and Book Value

Panel B: Year m þ 1

Unscaled measures ¼ original measures*shares outstanding. N represents the number of firm observations for each year. Dollar amount is in millions. P is the 3-month lagged price. EPooling and BPooling are the earnings per share and book value per share based on pooling method. For firms in the pooling sample, these are the reported measures whereas derived measures are calculated for firms in the purchase sample. EPurchase and BPurchase are the earnings per share and book value per share based on purchase method. SIZE is the total market capitalization at the end of previous year. DE ¼ E Pooling  E Purchase : DB ¼ BPooling  BPurchase :  : denotes statistical significance at the 1% level.

45

46

C. S. AGNES CHENG ET AL.

were conducted for the mean difference of the reported accounting numbers and the ‘‘as if’’ accounting numbers (i.e., EPurchase and BPurchase for the pooling sample, and EPooling and BPooling for the purchase sample). All t-values for the mean difference between the reported net income numbers and the ‘‘as if’’ net income numbers are significant at the one percent level for both years m and m þ 1: Similar results are also obtained for the book value variable. These results suggest that the consolidation accounting method did have a significant effect on post-merger earnings and book value.

Empirical Results of the Relative and Incremental Value Relevance of Earnings and Book Value – Research Questions 1–4 Table 4 reports the regression results of Models A.1, A.2 and A.3 using the combined sample (Panel A), the pooling sample (Panel B) and the purchase sample (Panel C). Each regression is conducted using year m (the merger year) and m þ 1 data. The regression results of Model A.1 indicate that when using the pooling method, earnings are value relevant (i.e., significant at the one percent level) across all samples and for both periods. The adjusted R2 values are in the range of 27–69%. However, the regression results of Model A.2 indicate that when using the pooling method, book value is value relevant only for the pooling sample and the adjusted R2 values are in the range of 11–36% (i.e., much lower adjusted R2 values than those of Model A.1 with EPooling).The control variable, market capitalization, is value relevant across the different samples and different time periods for both Models A.1 and A.2. The regression results of Model A.3 indicate that when both earnings and book value are included, only earnings are value relevant while book value is not, across all samples and for both years. Further, the adjusted R2 values are in the range of 26–69%, which are not materially different from those of Model A.1 (with only EPooling ). A Vuong (1989) test was conducted to compare the adjusted R2 of Model A.1 and A.2 (a relative value relevance test). The result indicates a significant difference between the adjusted R2 of Model A.1 (with only EPooling) and that of Model A.2 (with only BPooling) for all samples and years tested except for year m and m þ 1 of the pooling and purchase sample, respectively. This suggests that market participants assign more weight to earnings than to book value for valuation purposes when using the pooling method.24 Thus, we conclude that the value relevance of EPooling is greater than that of

Year

Value Relevance of Earnings and Book values – Regression Analysis Based on Pooling Method.

N

Model A.1 Adj. R

2

Panel A: Combined sample m 110 0.44 mþ1

110

0.35

Panel B: Pooling sample m 45 0.46 mþ1

45

0.69

Panel C: Purchase sample m 65 0.46 mþ1

65

0.27

Model A.2 4

d1

d3  10

4.76 (7.72) 3.42 (5.31)

4.36 (4.21) 5.92 (5.01)

5.50 (5.13) 8.82 (7.42)

5.41 (2.39)* 11.20 (7.55)

4.56 (6.12) 2.70 (3.73)

4.32 (3.88) 3.81 (2.51)*

Adj. R

0.16 0.19

0.25 0.36

0.13 0.11

Model A:1 :

2

d2

Model A.3 4

d3  10

2

Adj. R

d1

0.44

4.64 (7.42) 3.40 (5.18)

0.12 (1.13) 0.04 (0.22)

4.26 (4.10) 5.90 (4.95)

5.89 (4.02) 9.89 (6.79)

0.12 (0.40) 0.39 (1.25)

5.19 (2.20)* 11.20 (7.60)

4.55 (6.07) 2.69 (3.69)

0.07 (0.57) 0.04 (0.18)

4.17 (3.62) 3.75 (2.41)*

0.26 (2.00)* 0.18 (0.97)

5.11 (4.04) 6.58 (4.98)

0.72 (2.69)* 0.86 (2.33)*

8.16 (3.13) 10.00 (4.75)

0.45

0.10 (0.61) 0.06 (0.28)

4.54 (3.15) 4.95 (2.96)

0.45

Pjt ¼ d0 þ

Model A:2 :

Pjt ¼ d0 þ

Model A:3 :

Pjt ¼ d0 þ

d1 nE Pooling jt Pooling d2 nBjt d1 nE Pooling jt

Vuong tests 4

0.35

0.69

0.26

d2

d3  10

A.1 v A.2

A.1 v A.3

A.2 v A.3

2.59*

0.58

2.79

1.85!

0.10

1.89!

1.34

0.19

1.29

3.96

0.67

3.86

2.17*

0.29

2.22*

1.58

0.08

1.62

The Value Relevance of Earnings and Book Value

Table 4.

þ d3 nSIZEjt1 þ mjt þ d3 nSIZEjt1 þ mjt þ d2 nBPooling þ d3 nSIZEjt1 þ mjt jt

47

N represents the number of firm observations for each year. t-statistics is in parenthesis. Pjm is the 3-month lagged price for firm j at year m. E Pooling and BPooling are the earnings per share and book value per share based on pooling method for firm j in year m. For firms in the pooling jm jm sample, these are the reported measures whereas derived measures are calculated for firms in the purchase sample. E Purchase and BPurchase are jm jm the earnings per share and book value per share based on purchase method for firm j in year m. SIZEjm1 is the total market capitalization for firm j at year m  1: Z-value reported in the ‘‘A.1 v A.2’’ column tests the hypothesis that adjusted R2 of model A.1 is equal to that of model A.2. Z-value reported in the ‘‘A.1 v A.3’’ column tests the hypothesis that adjusted R2 of model A.1 is equal to that of model A.3. Z-value reported in the ‘‘A.2 v A.3’’ column tests the hypothesis that adjusted R2 of model A.2 is equal to that of model A.3. All Vuong tests are twotailed test. : denotes statistical significance at the 1% level; *at the 5% level; !at the 10% level.

48

C. S. AGNES CHENG ET AL.

BPooling , possibly because goodwill is not accounted for under pooling accounting. An incremental value relevance test comparing the adjusted R2 of Model A.1 (with EPooling) and that of Model A.3 (with both EPooling and BPooling) was conducted using the Vuong test (1989). No significant difference was found for all samples and testing years. However, significant differences were found for the adjusted R2 of Model A.2 versus A.3 for most samples and years tested. These results suggest that pooling book value does not possess incremental explanatory power over pooling earnings, whereas pooling earnings possess incremental explanatory power over pooling book value. Most prior studies investigating the value relevance of goodwill indicate that goodwill is value relevant (Jennings et al., 1996). The consolidated book value under pooling excludes the AAP, which, in general, is a substantial component of an acquirer’s balance sheet.25 Thus, it is plausible to observe that book value under pooling is not value relevant since a significant portion of the value of acquired assets (i.e., AAP) is omitted from the consolidated book value. On the other hand, a majority of prior studies found that goodwill amortization is irrelevant in firm valuation (Linderberg & Ross, 1999; Henning et al., 2000) and that earnings including or excluding the goodwill amortization are equally informative (Moehrle et al., 2001). Thus, our finding of value relevant earnings under the pooling method is consistent with these prior studies. Table 5 reports the regression results of Models B.1, B.2 and B.3 (purchase method) using the combined sample (Panel A), the pooling sample (Panel B), and the purchase sample (Panel C), respectively. The regression results of Models B.1, B.2 and B.3 indicate that earnings and book value are both value relevant (i.e., significant at the 0.01 or 0.05 level) regardless of whether the model includes only earnings (as in Model B.1), book value (as in Model B.2) or both earnings and book value (as in Model B.3).26,27 Further, the control variable (size) is value relevant for all samples and all periods. The adjusted R2 values are in the range of 23–65%, 25–55%, and 32–64% for Models B.1, B.2 and B.3, respectively. This result is quite different from that of the pooling method in which only earnings were found to be value relevant. To evaluate whether market participants assign different weights to earnings and book value when using the purchase method, Vuong (1989) tests are conducted to compare the adjusted R2 values of Model B.1 versus B.2. Although the adjusted R2 of model B.2 is greater than that of model B.1 for most samples and years, the Vuong (1989) test results

Year

N

Model B.1 2

Adj. R

Panel A: Combined sample m 110 0.44 mþ1

110

0.32

Panel B: Pooling sample m 45 0.46 mþ1

45

0.65

Panel C: Purchase sample m 65 0.44 mþ1

65

0.23

y1

Model B.2 4

y3  10

2

Model B.3 4

2

Adj. R

y2

y3  10

0.44

1.07 (7.74) 1.02 (5.08)

5.93 (5.76) 6.96 (5.88)

1.35 (6.33) 1.55 (4.42)

8.62 (4.26) 10.00 (5.40)

0.56

0.90 (4.89) 0.83 (3.45)

4.94 (4.13) 5.21 (3.47)

0.49

4.96 (7.67) 3.08 (4.59)

4.11 (3.95) 5.83 (4.78)

5.46 (5.14) 8.59 (6.75)

5.33 (2.35)* 11.30 (7.20)

0.55

4.80 (5.88) 2.43 (3.21)

4.03 (3.55) 3.69 (2.35)

0.37

0.34

0.50

0.25

Model B:1 :

Pjt ¼ y0 þ

Model B:2 :

Pjt ¼ y0 þ

Model B:3 :

Pjt ¼ y0 þ

Vuong tests 4

Adj. R

y1

y2

y3  10

0.52

3.13 (4.28) 2.23 (3.34)

0.68 (4.38) 0.80 (3.94)

4.93 (5.03) 6.27 (5.45)

2.04 (1.44) 8.06 (4.20)

1.02 (3.27) 0.17 (0.38)

7.49 (3.48) 11.20 (7.04)

3.55 (3.85) 1.97 (2.68)

0.50 (2.54)* 0.69 (2.94)

4.33 (3.95) 4.09 (2.74)

0.40

0.64

0.32

y1 nE Purchase jt y2 nBPurchase jt y1 nE Purchase jt

B.1 v B.2

B.1 v B.3

B.2 v B.3

B.3 v A.3

0.05

1.88!

1.89!

1.89!

0.36

1.67!

2.11*

0.93

0.94

1.64

0.63

1.52

2.80

0.22

2.98

0.78

1.11

1.79!

0.90

!

0.87

0.19

1.44

1.94

1.56

The Value Relevance of Earnings and Book Value

Table 5. Value Relevance of Earnings and Book Values – Regression Analysis Based on Purchase Method.

þ y3 nSIZEjt1 þ njt þ y3 nSIZEjt1 þ njt þ y2 nBPurchase þ y3 nSIZEjt1 þ njt jt

49

N represents the number of firm observations for each year. t-statistics is in parenthesis. Pjm is the 3-month lagged price for firm j at year m. E Pooling and BPooling are the earnings per share and book value per share based on pooling method for firm j in year m. For firms in the pooling jm jm sample, these are the reported measures whereas derived measures are calculated for firms in the purchase sample. E Purchase and BPurchase are the jm jm earnings per share and book value per share based on purchase method for firm j in year m. SIZEjm1 is the total market capitalization for firm j at year m  1: Z-value reported in the ‘‘B.1 v B.2’’ column tests the hypothesis that adjusted R2 of model B.1 is equal to that of model B.2. Zvalue reported in the ‘‘B.1 v B.3’’ column tests the hypothesis that adjusted R2 of model B.1 is equal to that of model B.3. Z-value reported in the ‘‘B.2 v B.3’’ column tests the hypothesis that adjusted R2 of model B.2 is equal to that of model B.3. Z-value reported in the ‘‘B.3 v A.3’’ column tests the hypothesis that adjusted R2 of model B.3 is equal to that of model A.3 (reported in Table 4). All Vuong tests are two-tailed test.  Significance at the 1% level; *at the 5% level; !at the 10% level.

50

C. S. AGNES CHENG ET AL.

indicate that the difference is not significant, except for year m þ 1 of the pooling sample. Thus, it appears that investors do not assign different weights to earnings and book value when valuing the consolidated entity under the purchase method. Thus, we conclude that when using the purchase method, both earnings and book value are value relevant and the value relevance of EPurchase equals the value relevance of BPurchase. Incremental value relevance tests were also conducted by comparing the adjusted R2 of Model B.1 (with EPurchase) with that of Model B.3 (with both EPurchase and BPurchase) and the adjusted R2 of Model B.2 (with BPurchase) with that of Model B.3. Vuong (1989) tests indicate a significant difference between the adjusted R2 of Model B.1 and that of Model B.3 for the combined sample only, but a significant difference for the adjusted R2 of Model B.2 versus B.3 for all samples and years tested except for year m of the pooling sample. These results suggest that under purchase accounting, earnings have incremental explanatory power over book value. However, book value does not have incremental value relevance over earnings, except for the combined sample. Empirical Results of Total Value Relevance of Earnings and Book Value – Research Question 5 Although the adjusted R2 values under the purchase method are, in general, higher than those under the pooling method across all samples and for all years (except for year m þ 1 of the pooling sample), the test results (reported in the last column of Table 5) indicate that the earnings and book value under purchase accounting better explain the market value of the sample firms than those using pooling accounting for year m of the combined sample only.28 Thus, our empirical results provide weak evidence to support the notion that earnings and book value under purchase accounting are more value relevant than those under pooling accounting. In summary, based on the regression results of Models A.1, A.2, A.3 (pooling method) and B.1, B.2 and B.3 (purchase method), we conclude the following: 1. When pooling accounting is used, only earnings are value relevant and the results are consistent with earnings under pooling being more value relevant than book value. In addition, earnings have incremental value relevance over book value but not vice versa. This is likely due to the omission of goodwill from pooling book value.

The Value Relevance of Earnings and Book Value

51

2. When purchase accounting is used, both earnings and book value are value relevant, and there is no significant difference between the value relevance of book value and earnings. In addition, earnings have incremental explanatory power over book value; however, our evidence does not suggest that book value has incremental explanatory power over earnings, except for the combined sample. 3. Earnings and book value under purchase accounting better explain firm value than those under pooling only for the acquisition year of the combined sample. Consequently, our findings only weakly support the notion that earnings and book value under purchase accounting are more value relevant than those under pooling.

Empirical Results of a Comparison of E Pooling with E Purchase and BPooling with BPurchase – Research Questions 6 and 7 Using the combined sample, the Vuong test for the difference in the adjusted R2 of Model A.1 (EPooling only) and B.1 (EPurchase only) (see Tables 4 and 5 for the adjusted R2s) results in a Z value of 2.14 (significant at the 5% level) for year m þ 1:29 The Vuong test for the difference in the adjusted R2 of Model A.2 (BPooling only) and B.2 (BPurchase only) (see Tables 4 and 5 for the adjusted R2s) yields a Z value of 3.07 and 3.08 (significant at the 1% level) for year m and m þ 1; respectively. Thus, the empirical evidence suggests that the value relevance of EPooling is greater than that of EPurchase and the value relevance of BPurchase is greater than that of BPooling. In summary, our results indicate that earnings under pooling accounting are more value relevant than earnings under purchase accounting while both are value relevant in firm valuation. Further, our empirical evidence also indicates that purchase book value (BPurchase) is more value relevant than pooling book value (BPooling). Thus, we conclude that EPooling and BPurchase are more highly correlated with firm value than EPurchase and BPooling regardless of which method is adopted to account for a business combination.

Empirical Results of the Value Relevance of Earnings and Book Value Under the SFAS No. 141/142 Proxy Framework – Research Question 8 Table 6 reports the regression results of Model C. The independent variables of Model C (a proxy for the SFAS No. 141/142 framework) are EPooling and

52

C. S. AGNES CHENG ET AL.

Table 6. Value Relevance of Earnings and Book values–Regression Analysis Based on SFAS No. 141/142 Proxy Framework. Year

N

Model C Adj. R

2

g0

Panel A: Combined sample m 110 0.52 15.12 (5.03) m þ 1 110 0.42 17.37 (4.09) Panel B: Pooling sample m 45 0.56 8.60 (1.39) mþ1 45 0.68 13.78 (2.01)! Panel C: Purchase sample m 65 0.49 17.88 (5.03) mþ1 65 0.34 23.46 (4.60) Model C :

g1

Vuong test g2

g3  104

3.00 (4.24) 2.55 (3.88)

0.67 (4.26) 0.73 (3.60)

5.08 (5.21) 6.30 (5.59)

2.00 (1.38) 8.96 (4.87)

1.03 (3.24) 0.04 (0.10)

7.55 (3.51) 11.20 (7.43)

3.45 (3.94) 2.17 (3.04)

0.45 (2.25)* 0.64 (2.71)

4.52 (4.18) 4.17 (2.88)

C v A.3

1.90* 1.45!

1.48! 0.71

C v B.3

0.18 1.78*

-0.65 2.49*

1.05

0.34

1.27

1.35!

Pjt ¼ g0 þ g1 nE Pooling þ g2 nBPurchase þ g3 nSIZEjt1 þ Zit jt jt

N represents the number of firm observations for each year. Pjm is the 3-month lagged price for firm j at year m. E Pooling and BPooling are the earnings per share and book value per share based jm jm on pooling method for firm j in year m. For firms in the pooling sample, these are the reported measures whereas derived measures are calculated for firms in the purchase sample. E Purchase jm and BPurchase are the earnings per share and book value per share based on purchase method for jm firm j in year m. SIZEjm1 is the total market capitalization for firm j at year m  1: Z-value reported in the ‘‘C v A.3’’ column tests the hypothesis that adjusted R2 of Model C is less than or equal to that of Model A.3 (reported in Table 4). Z-value reported in the ‘‘C v B.3’’ column tests the hypothesis that adjusted R2 of Model C is less than or equal to that of Model B.3 (reported in Table 5). Both Vuong tests are one-tailed test.  Significance at the 1% level; *at the 5% level; !at the 10% level.

BPurchase, which are the two most value relevant accounting numbers as indicated by the previous test results. Thus, as expected, the coefficients of EPooling and BPurchase are all significant at the 1 or 5% level for all samples except for the earnings of year m and the book value of year m þ 1 of the pooling sample.30 Similar to the previous regressions, the coefficient of the control variable (SIZE) is significant for all samples and all periods. The adjusted R2 values are in the range of 34–68%. These adjusted R2 values are all higher than the adjusted R2 values for Model A.3 (pooling) or Model B.3 (purchase) except for year m þ 1 of the pooling sample. The Vuong

The Value Relevance of Earnings and Book Value

53

likelihood ratio tests indicate, however, that the explanatory power of Model C is significantly higher than that under pooling accounting only for both years of the combined sample and year m of the pooling sample. The explanatory power of Model C is significantly higher than that under purchase accounting only for year m þ 1 of the combined sample, the pooling sample and year m þ 1 of the purchase sample.31 Our empirical evidence provides moderate support to the notion that the value relevance of information under the SFAS No. 141/142 proxy framework is greater than that under either pooling or purchase accounting, and provides some support for the decision of the FASB to eliminate pooling accounting and goodwill amortization.

CONCLUSIONS This study extends the extant literature on the relative value relevance of earnings and book value by investigating the impact of accounting choice for business combinations. We also investigate the combined value relevance of earnings and book value under pooling versus purchase accounting. In addition, a comparison of EPooling versus EPurchase and BPooling versus BPurchase is conducted to reveal which accounting variable (i.e., EPooling or EPurchase) is more value relevant. Finally, the appropriateness of eliminating pooling accounting and goodwill amortization (SFAS Nos. 141 and 142) is evaluated by comparing the value relevance of financial information under a proxy for SFAS Nos. 141 and 142 with that of pooling and purchase accounting. Using 110 sample firms from the period of 1988–1996, our empirical evidence suggests the following: 1. When pooling accounting is used, only earnings are value relevant; and the results are consistent with earnings under pooling being more value relevant than book value. The incremental value relevance test indicates that earnings possess incremental value relevance over book value but not vice versa. This is likely due to the omission of goodwill in the pooling book value. 2. When purchase accounting is used, both earnings and book value are value relevant, and no significant difference is observed between the value relevance of book value and earnings. The incremental value relevance test indicates that earnings have incremental explanatory power over book value. However, the empirical evidence does not suggest that book

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value has incremental explanatory over earnings, except for the combined sample. 3. Using the combined sample, the combined earnings and book value under purchase accounting better explain firm value than those under pooling method only for the adoption year. Therefore, our empirical results only weakly support that notion that purchase accounting is more value relevant than pooling accounting. 4. The relative value relevance of earnings and book value under the two methods is E Pooling 4E Purchase and BPurchase 4BPooling This finding suggests that EPooling and BPurchase are more correlated with firm value than EPurchase and BPooling regardless of which method was adopted to account for business combination. 5. A proxy for the SFAS Nos. 141 and 142 consolidation reporting framework was found to produce earnings and book value data that better explain firm value than those produced either by the pooling method or by the purchase method for half of the samples and tested years. Therefore, from a value relevance perspective, our empirical findings provide some evidence to support the new consolidation framework in which the pooling method is eliminated and goodwill is not subject to annual amortization.

NOTES 1. EPooling and BPooling are reported numbers for the pooling sample while they are derived (as if pooling method is adopted) numbers for the purchase sample. On the other hand, EPurchase and BPurchase are reported numbers for the purchase sample while they are derived (as if purchase method is adopted) numbers for the pooling sample. The procedures for deriving EPooling (EPurchase) and BPooling (BPurchase) for the purchase (pooling) sample are detailed in the following section. 2. Under SFAS Nos. 141 and 142, purchase-accounted transactions may still result in lower earnings than under pooling due to the higher depreciation charges associated with any net asset revaluation characteristic of purchase-accounted acquisitions. Since the size of the asset step-up is available for only a limited number of observations in our sample, we assume that the majority of the premium over book value paid in an acquisition (referred to as the accounting acquisition premium, or AAP) is attributable to goodwill rather than to any asset step-up. Thus, earnings under the new FASB framework should be closer to earnings under the pooling method (i.e., EPooling) than to those under the purchase method (i.e., EPurchase). As a result, we use EPooling to proxy for earnings under the new FASB framework. Our assumption that the majority

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of the AAP is attributable to goodwill is supported by the findings of Henning, Lewis, and Autumn (2000). They found that, on average, about 81% of the AAP is attributable to goodwill, with only 19% attributable to asset step-up. 3. To qualify for pooling treatment under APB No. 16, an acquisition had to meet 12 conditions. Of the 12 conditions, the most difficult for acquirers to meet were (1) the transaction be a stock-for-stock exchange and (2) at least 90% of the target firm’s voting shares be acquired. 4. In this study, the sum of the premium paid in an acquisition and any step-up in net asset value (i.e., where the fair market value of the target firm exceeds its book value) is referred to as the accounting acquisition premium (AAP). Thus, AAP equals the purchase price minus the book value (proportionate to the acquisition percentage) of the acquired firm. For the merger year m, AAP ¼ BPurchase 2BPooling ; where BPurchase is the reported (estimated) book value and BPooling is the estimated (reported) book value when purchase (pooling) accounting is used. 5. The tax benefits of a stock-swap acquisition are the same regardless of the consolidation method used unless the acquirer buys the (net or gross) assets directly from the target firm and places those assets in a newly created subsidiary, wherein the new subsidiary may claim additional tax depreciation on the stepped-up asset values implied by the transaction. 6. Managers may prefer the purchase method when the total debt-to-total assets ratio or the debt-to-equity ratio is high; purchase accounting causes these ratios to decline following many acquisition transactions. 7. The only study we know of that addresses this issue is Vincent (1997). Due to inconsistent results, Vincent’s study was unable to provide definitive conclusions. 8. They found an association between market value and the amortization of ‘‘residual goodwill’’ (calculated as purchase price minus any asset step-up and core goodwill). 9. If an acquisition is less than 100%, the acquisition ownership percentage is multiplied by the book value of the acquired firm and then subtracted from the purchase price to estimate the AAP. 10. In our models, we adopt 20 years as the amortization period for the AAP as this was consistent with the goodwill amortization proposal of the FASB immediately prior to the adoption of SFAS No. 142. We also used a 10-year amortization period in earlier versions of the paper and the results are similar. Since the amortization period is a constant applied to all firms in calculating the adjusted earnings, the choice of the period should not affect the significance level of the coefficient of earnings or the conclusions of our study. 11. Specifically, we investigate which variable, earnings or book value, is more value relevant (i.e., possesses more information content) under the pooling and purchase methods. This test is similar to the test of relative information content performed in Biddle, Seow, and Siegel (1995). 12. We are studying whether one variable has information content beyond that provided by another (i.e., does earnings have incremental value relevance over book value? If it does, the adjusted R2 of the model including both earnings and book value should be significantly greater than that of model with only book value). This is similar to the incremental information content test performed in Biddle et al. (1995).

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13. The required footnote disclosures under purchase accounting generally enable investors to develop comparative pro forma information as if pooling accounting had been used, whereas the reverse is generally not possible under pooling. 14. Ohlson (1995) derived his model using the notion that the current market value of a firm is equal to the present value of future expected dividends. This valuation model has been applied in many empirical studies (e.g., Aboody, 1996; Vincent, 1997; Collins, Maydew, & Weiss, 1997; Chamberlain and Hsieh, 1999; Collins et al., 1999). When the model is implemented, all variables are scaled by the shares outstanding to avoid heteroscedasticity. 15. To simplify the symbols, we use P for market value deflated by shares outstanding in Models A.1–A.3 and B.1–B.3 and also in Model C. A similar practice applies to earnings (E) and book value (B). 16. Barth and Clinch (2001) indicate that share-deflated price specifications (i.e., market price deflated by shares outstanding) are most effective to mitigate equityrelated heteroscedasticity (a form of scale effect). Thus, we deflate variables in the test model by shares outstanding to control for heteroscedasticity. In addition, we also add market capitalization (SIZE, at the end of year m  1) as an independent variable to control for market capitalization-related scale effects. 17. When estimating our proxy for consolidated book value, measurement errors may arise from timing differences relating to the ‘‘most recently available book value;’’ that is, the actual book value of a target firm at the specific transaction date may never be reported and is not observable by the researchers. To mitigate this problem, we use the most recently reported book value. We cannot unambiguously conclude whether the derived book value is biased upward or downward for each method; however, we can predict the direction of bias for the earnings’ proxy. Note that the AAP includes both goodwill and any net asset revaluation, with the latter typically requiring a faster write-off than goodwill. Hence, the inferred depreciation is likely to be slower than the actual depreciation, suggesting that the estimated EPurchase for the Pooling sample is likely to be biased upward and the estimated EPooling for the Purchase sample is likely to be biased downward. In addition to these potential measurement errors, there may be other measurement errors caused by the assumptions adopted by the researchers in calculating these estimates. 18. Since SIZE is the common variable in Models A.1 and A.2, any difference in the adjusted R2 of these two models would be attributable to the EPooling (in Model A.1) and BPooling (in Model A.2). 19. Because of incremental depreciation resulting from any asset revaluation, earnings under the new framework should be less than that under EPooling. However, we assume that the majority of the AAP is attributable to goodwill and thus use EPooling as a proxy for SFAS No. 141 earnings. This assumption is consistent with the data of Henning et al. (2000). 20. The valuation model (Ohlson, 1995) used in this study regresses market value on earnings and book value. Annual earnings are, in general, available a few months after fiscal year-end. In order to allow sufficient time for the securities market to fully reflect the annual earnings in share price, we use a 3-month lagged market capitalization value (i.e., a 3-month lagged share price times the number of shares outstanding).

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21. The amount of purchase price and the ownership percentage were hand collected from the same source, whereas the Lexis/Nexis database was used to identify the choice of accounting method. Further, additional mergers and acquisitions occurring in the same year were hand-collected from Lexis/Nexis. All other financial data were obtained from Compustat tapes and CRSP. 22. This ratio is referred to as the bargaining strength power by Davis (1990). He found that the higher the bargaining strength ratio, the more likely an acquirer would use pooling to avoid the significant negative impact on post-merger earnings associated with the amortization/depreciation of the AAP. 23. The ratio for the year m þ 1 is reported because the equivalent ratio for year m would be misleading; the amortization of the AAP for year m is only a partial year amortization for many transactions due to a mid-year acquisition date. 24. A scale effect would inflate the R2 under OLS regression if this effect is not controlled (Brown, Lo, & Lys, 1999). Thus, when Vuong tests are used to study the difference of R2 for two regression models with different scale effects, the tests could be problematic. However, since our models use the scaled data of the same sample, the bias in the R2 should be similar for these models, and hence, not affect our statistical inference on the differences between the two models. 25. Ayers et al. (2000) indicate that unrecognized assets (i.e., referred to as the AAP in our study) represent in excess of 30 percent of the acquirers’ book value for six of eight industries they studied. For our sample, the AAP represents about 115% of the acquirers’ book value for the pooling sample (see Panel A of Table 2). Thus, the amount of assets not recognized under pooling is substantial. 26. With the exception of earnings under the pooling sample for year m and book value for year m þ 1 under Model B.3. 27. Note that the magnitudes of the coefficients of BPooling are much smaller that those of BPurchase. For example, using the combined sample, the coefficients of BPooling are 0.12 (year m) and 0.04 (year m þ 1) while they are 0.68 (year m) and 0.80 (year m þ 1) for BPurchase. This is consistent with our expectation that BPooling is not value relevant. 28. In general, the adjusted R2s under the purchase method are higher than those under the pooling method across all samples and for all years (except for year m þ 1of the pooling sample). 29. For year m, the Z value for comparing the value relevance of EPooling and Purchase E is not significant. The difference between EPooling and EPurchase is attributed to the amortization of AAP. Since many of our sample firms have a partial year amortization for year m (because the acquisition occurred during the year), the difference between EPooling and EPurchase is less material for year m than for year m þ 1 (see Table 3 for detailed numbers). This may explain why the Vuong test indicates that the Z is significant for year m þ 1 only when comparing the adjusted R2 of Model A.1with that of Model B.1. 30. For purposes of this analysis, we use EPooling as a proxy for SFAS No. 141 earnings. A limitation of our proxy is that it fails to provide for goodwill impairment; however, a review of the financial disclosures for the purchase sample revealed that none of the firms recorded a goodwill impairment charge during the study period (i.e., years m and m þ 1), suggesting that EPooling is a good proxy for SFAS No. 141 earnings for the period studied.

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31. The independent variable which distinguishes Model C from Model B (the purchase method) is earnings (i.e., EPooling for Model C and EPurchase for Model B) and the difference is attributed to the amortization of AAP. Since many of our sample firms have only a partial year amortization for year m since the acquisition occurred in the mid-year, the difference between EPooling and EPurchase is more material for year m þ 1 than for year m (see Table 3 for detailed numbers). This may explain why the Vuong test indicates that the Z is significant for year m þ 1 only when comparing the adjusted R2 of Model C with that of Model B.

REFERENCES Accounting Principles Board. (1970). Opinion No. 16: Business combinations. New York, NY: American Institute of Certified Public Accountants. Aboody, D. (1996). Market valuation of employee stock options. Journal of Accounting and Economics, 22(special issue), 357–391. Ayers, B., Lefanowicz, C., & Robinson, J. (2000). The financial statement effects of eliminating the pooling-of-interests method of acquisition accounting. Accounting Horizons, 14(1), 1–19. Ayers, B., Lefanowicz, C., & Robinson, J. (2002). Do firms purchase the pooling method? Review of Accounting Studies, 7, 2002. Barth, M., Beaver, E., & Landsman, W. (1993). Structural analysis of SFAS 87 pension disclosures and their relation to share prices. Financial Analysts Journal, 49(1), 18–26. Barth, M., Beaver, E., & Landsman, W. (1998). Relative valuation roles of equity book value and net income as a function of financial health. Journal of Accounting and Economics, 25(1), 1–34. Barth, M., & Clinch, G. (2001). Scale effects in capital markets-based accounting research. Working paper, Stanford University. Biddle, G. C., Seow, G. S., & Siegel, A. F. (1995). Relative versus Incremental Information Content. Contemporary Accounting Research, 12(1), 1–23. Brown, S., Lo, K., & Lys, T. (1999). Use of R2 in accounting research: measuring changes in value relevance over the last four decades. Journal of Accounting and Economics, 28(2), 83–115. Burgstahler, D. C., & Dichev, I. D. (1997). Earnings, adaptation and equity value. The Accounting Review, 72(2), 187–226. Cheng, C. S., Hsieh, S. J., & Yip, Y. (2003) The impact of discretionary accounting reporting choice of the transition obligation on the quality of earnings and book value. Working Paper, University of Houston. Chamberlain, S., & Hsieh, S. J. (2001). The effectiveness of Disclosure under SFAS 123. Working paper, University of British Columbia. Collins, D. W., Maydew, E. L., & Weiss, I. S. (1997). Changes in the value-relevance of earnings and book values over the past forty years. Journal of Accounting and Economics, 24(1), 39–67. Collins, D. W., Morton, P., & Xie, H. (1999). Equity valuation and negative earnings: the role of book value of equity. The Accounting Review, 74(1), 29–61. Davis, M. L. (1990). Differential market reaction to pooling and purchase method. The Accounting Review, 65(3), 696–709.

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Dunne, K. (1990). An empirical analysis of management’s choice of accounting treatment for business combinations. Journal of Accounting and Public Policy, 9, 111–133. Financial Accounting Standards Board (2001). Statement No. 141: Business Combinations. Norwalk, Connecticut. Financial Accounting Standards Board (2001). Statement No. 142: Goodwill and Other Intangible Assets. Norwalk, Connecticut. Henning, S., Lewis, B., & Autumn, W. S. (2000). Valuation of the components of purchased goodwill. Journal of Accounting and Research, 38(2), 375–386. Hong, H., Kaplan, R. S., & Mandelker, G. (1978). Pooling vs. purchase: the effects of accounting for mergers on stock prices. The Accounting Review, 53(1), 31–47. Hopkins, E. P., Houston, R., & Peters, M. F. (2000). Purchase, pooling and equity analysts’ valuation judgments. Accounting Review, 75(3), 257–281. Jennings, R., Robinson, J., Thompson, R., & Duvall, L. (1996). The relation between accounting goodwill numbers and equity values. Journal of Business Finance & Accounting, 23(4), 513–534. Jennings, R., LeClere, M., & Thompson, R. (2001). Goodwill amortization and the usefulness of earnings. Financial Analysts Journal September/October, 20–28. Lev, B. (1989). On the usefulness of earnings and earnings research: lessons and directions from two decades of empirical research. Journal of Accounting Research, 27(Suppl.), 153–192. Linderberg, E., & Ross, M. (1999). To purchase or to pool: does it matter? Journal of Applied Corporate Finance, 12(2), 32–47. Moehrle, S., Reynolds-Moehrle, J. A., & Wallace, J. S. (2001). How informative are earnings numbers that exclude goodwill amortization? Accounting Horizons, 15(3), 243–255. Nathan, K., & Dunne, K. (1991). The purchase-pooling choice: some explanatory variables. Journal of Accounting and Public Policy, 10, 309–323. Ohlson, J. A. (1995). Earnings, book values and dividends in equity valuation. Contemporary Accounting Research, 11(2), 661–687. Ohlson, J. A., & Zhang, X. J. (1998). Accrual accounting and equity valuation. Journal of Accounting Research, 36(Suppl.), 85–116. Vincent, L. (1997). Equity valuation implications of purchase versus pooling accounting. The Journal of Financial Statement Analysis, 5–19. Vuong, Q. H. (1989). Likelihood ratio tests for model selection and non-nested hypotheses. Econmetrica, 57(2), 307–333. Wahlen, J., Boatsman, J., Herz, R., Jennings, R., Jonas, G., Palepu, K., Petroni, K., Ryan, S., & Schipper, K. (1999). Response to FASB invitation to comment on methods of accounting for business combinations: recommendations of the G4+1 for achieving convergence. Accounting Horizons, 13(3), 299–303.

EARNINGS MANAGEMENT AND FORCED CEO DISMISSAL$ Liming Guan, Charlotte J. Wright and Shannon L. Leikam ABSTRACT This study examines the discretionary accounting choices made by CEOs facing forced dismissal. The results support the notion that CEOs who are faced with termination engage in income-increasing earnings management in the year prior to termination. We also examine Murphy and Zimmerman’s (1993) argument that poor firm performance may have led to both the CEO turnover and the discretion over accounting choices. The results indicate that firm performance and other company-specific confounding factors cannot explain away the discretionary accruals observed in firms prior to forced CEO dismissals. We also find evidence suggesting that the incoming CEOs deliberately depress earnings, i.e. taking a ‘‘big bath,’’ in the transition year.

1. INTRODUCTION This study examines top executives’ propensity to manage earnings in situations involving nonroutine CEO turnover and forced CEO dismissal. $

Data used in this study can be requested from the authors.

Advances in Accounting Advances in Accounting, Volume 21, 61–81 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21003-9

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Specifically, this study investigates discretionary accounting accruals made by firms experiencing the nonroutine turnover of their top management. Further this study seeks to determine whether CEOs faced with forced dismissal engage in earnings management in the period leading up to their termination. Prior research has investigated earnings management related to CEO changes resulting from a variety of factors. For example, Elliott and Shaw (1988) and Strong and Meyer (1987) find that large discretionary write offs are generally associated with executive turnover. Murphy and Zimmerman (1993) find that CEO turnover-related changes in R&D, advertising, capital expenditures and accounting accruals are related to poor firm performance. Reitenga and Tearney (2003) document evidence suggesting that CEOs facing mandatory retirement engage in income increasing earnings management in an attempt to retain his/her board seat after retirement. Pourciau’s (1993) findings, on the other hand, are contrary to the notion that CEOs who are in jeopardy of losing their position seek to increase earnings in order to avoid termination. We believe that, in order to fully explore the management of earnings by exiting CEOs, it is necessary to identify the dynamics behind the turnover. This is consistent with Pourciau’s (1993) argument that research seeking to detect earnings management related to CEO turnover requires the segregation of the executive changes between those that are routine and those that are nonroutine. Seemingly, a CEO who is faced with forced dismissal faces a set of dynamics that differ significantly from those faced by a CEO who is leaving the firm for voluntary reasons. Accordingly, in this study we examine the discretionary accruals of a sample of firms experiencing nonroutine CEO turnover. We further refine our sample of nonroutine turnover firms by identifying a subsample of firms whose nonroutine turnover involved forced CEO dismissal. This study extends the research of Pourciau (1993) and Murphy and Zimmerman (1993). We believe that the results reported by those studies are influenced by the use of overly broad definitions of nonroutine turnover that include firms whose CEOs’ are not faced with forced dismissal and, thus, whose incentives to manage earnings are ambiguous. Additionally, the models we use to estimate discretionary accruals differ from those used in previous studies in that we use a more refined accrual estimation model (i.e. modified Jones model) as compared to a random walk model used in Pourciau (1993). Our results are consistent with the cover-up theory and indicate that managers facing forced dismissal make opportunistic accounting-related decisions. This study extends the stream of research

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examining earnings management in a CEO turnover environment by focusing on nonroutine turnover, especially those situations where CEOs are unwillingly severed from the firm. This study contributes to the body of research regarding earnings management in situations involving executive turnover by confirming the theory that, when faced with forced dismissal, CEOs seek to manage earnings upward.

2. EXECUTIVE TURNOVER AND EARNINGS MANAGEMENT Jackson and Pitman (2001) indicate that when CEOs are effective in maximizing stockholders’ wealth, they tend to make accounting decisions that result in the fair presentation of firms’ operating results. However, when CEOs are not achieving the desired level of value creation, they may rely on manipulation of generally accepted accounting choices in an effort to affect the reported results. Since auditing is imperfect, the use of judgment by managers creates the possibility of opportunistic accounting choices and earnings management. Accordingly, managers may choose reporting methods and estimates that do not necessarily reflect their firm’s underlying economics (Healy & Wahlen, 1999).1 Researchers have identified a number of scenarios wherein managers have incentives to manage earnings. These situations include firms involved in management buyouts and hostile takeovers (DeAngelo, 1986; Perry & Williams, 1994; Wu, 1997; Groff & Wright, 1989), firms involved in proxy contests (DeAngelo, 1988), firms facing anti-trust lawsuits (Cahan, 1992), firms involved in labor union contract negotiations (Liberty & Zimmerman, 1986) and firms facing managerial turnover (Elliott & Shaw, 1988; Strong & Meyer, 1987). Generally, the findings of these studies support the researchers’ expectation of existence of earnings management. Pourciau (1993) and Murphy and Zimmerman (1993) question whether the circumstances associated with certain types of CEO turnover provide incumbent or successor managers the incentives to make opportunistic accounting choices. Pourciau (1993) identifies the rationale for management at the helm of poorly performing companies to make income-increasing discretionary accounting choices. First, opportunistic managers may attempt to avoid or delay a forced resignation. If managers believe that the board views any increase in earnings positively, they may act opportunistically by opting for income-increasing accounting policies. This

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strategy would not be effective if the board recognizes and discounts the effects of such policy choices. However, these policy choices may not be readily identifiable in an environment where multiple (and perhaps contradictory) signals of management performance are present. The effects of discretionary accounting choices made in such an environment may add additional noise to performance signals selected by the board. Pourciau (1993) refers to this as the ‘‘opportunism’’ view of managerial behavior. Pourciau (1993) also indicates that managerial ‘‘signaling’’ is another potential explanation. Applying this strategy, managers exercise their discretion over accounting-related choices in such a manner so as to increase earnings during periods of poor performance. This technique allows managers to convey information to the market regarding their insider information relative to the future profitability of the firm. Pourciau (1993) indicates that opportunism and signaling provide potential motivation to CEOs to increase earnings during their final years. Murphy and Zimmerman (1993) identify three possible explanations for the association between financial performance and CEO turnover. First is the ‘‘horizon’’ issue where CEOs who are approaching a known, planned departure date seek to increase current period earnings at the expense of future earnings (Dechow & Sloan, 1991). Second is the ‘‘big bath’’ theory suggesting that incoming CEOs may take the opportunity to write off certain capitalized costs during their transition year so as to positively influence earnings in future periods. Third is the ‘‘cover-up’’ theory, where CEOs of poorly performing firms seek to increase earnings in order to avoid threatened termination. This cover-up theory is consistent with the ‘‘opportunism’’ view of Pourciau (1993). We believe that the cover-up theory and managerial signaling provide reasonable explanations of managerial behavior prior to the CEO turnover. However, Pourciau’s (1993) and Murphy and Zimmerman’s (1993) empirical results do not support these explanations. Our research extends Pourciau (1993) and Murphy and Zimmerman (1993) by refining their definition of nonroutine turnover and addressing certain model design issues. In order to effectively evaluate earnings management associated with CEO change it is necessary to consider the situation-specific factors that potentially provide incentives and opportunities for CEOs to manipulate earnings. Pourciau (1993) suggests one situation-specific factor to be considered is whether the executive change is of a routine versus nonroutine nature. Routine changes are those associated with the retirement of the top executive in a planned, orderly transition. On the other hand, nonroutine CEO changes include most resignations whether voluntary or involuntary.

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Since nonroutine changes are not planned, it is unlikely that the board can effectively minimize the exiting CEO’s ability to engage in earnings management. We agree with Pourciau’s (1993) suggestion that research investigating earnings management in association with CEO turnover should reflect the circumstances surrounding the CEO change. We believe, however, that since Pourciau’s definition of nonroutine executive turnover is broad, use of a more refined definition may provide evidence that departing CEOs do manage earnings, supporting the opportunism and cover-up theories. We agree with Denis and Denis’ (1995) position that executive turnover classified as nonroutine should be restricted to forced resignations or dismissals. If the definition of nonroutine turnover captures a substantial number of routine CEO turnovers, then any test seeking to identify significant discretionary accruals has low power. We believe that failure to sufficiently isolate the factors underlying the nonroutine turnover, at least partially, explain the fact that Pourciau (1993) and Murphy and Zimmerman’s (1993) results do not support opportunism, managerial signaling and/or the cover-up theory. Furthermore, Pourciau’s (1993) results may be, at least in part, attributed to the use of rather crude measures of unexpected accruals and unexpected earnings. Pourciau measures each of these by simply computing the change from one year to the next. This random-walk assumption about earnings and normal accruals ignores the possibility that economic conditions may have necessitated changes in the nondiscretionary component of accruals.2 We believe that use of a more refined method to estimate discretionary accruals (e.g. the modified Jones model) allows for more effective identification of discretionary accruals and detection of earnings management in situations where forced CEO dismissals have occurred. The objective of this study is to examine the discretionary accounting choices made by such executives during their final year with the company. It would appear that situations where CEOs are unwillingly severed from the firm provide an opportunity to investigate the extent to which earnings management actually occurs. When an executive is performing poorly, the board usually gives the manager a grace period in which to improve performance (Vancil, 1987). Since the length of such grace periods is not known, we expect that the final year that the CEO is in an executive position is the year that the departing managers have the strongest incentive to increase reported earnings. Thus, the hypothesis that we propose (in the alternative form) is: HA. Discretionary accruals are income increasing during the year prior to the forced dismissal of top management.

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3. RESEARCH METHODOLOGY 3.1. Definition of Nonroutine Executive Dismissal and Choice of Final Year Warner, Watts, and Wruck (1988) define various categories of executive turnover. These include situations where: (1) the CEO retires, (2) the CEO resigns but continues to serve the company as a member of the board of directors or in a consulting capacity, (3) the CEO is terminated, (4) the CEO leaves due to policy-related differences, (5) the CEO leaves due to health problems, (6) the CEO leaves to take a position in another firm or to pursue other interests, and (7) the CEO turnover is related to a change in majority stock ownership. Murphy and Zimmerman (1993) assume that executive turnover is routine when the age of the departing executive is between 64 and 66. Thus, retirement-related turnover is treated as routine and all other turnover is classified as nonroutine. Pourciau (1993) defines routine turnover as being ‘‘planned’’ and therefore related to either retirements or resignations where the executive is allowed to continue to serve the company in some other capacity (e.g. as a consultant or as a member of the company’s board of directors). All other, nonplanned turnovers are treated as nonroutine. Thus, while the nonroutine turnover classification used by Pourciau is somewhat more restrictive than that used by Murphy and Zimmerman (1993), it nonetheless includes numerous executive change scenarios where there is no clear theoretical explanation for the direction of any associated earnings management. Use of such a broad definition of nonroutine turnover is likely to mitigate against detection of any hypothesized earnings management. In this study we focus on nonroutine turnover involving forced CEO dismissal. Our sample is made up of firms experiencing nonroutine turnover as defined by Pourciau (1993). However, we further divide the nonroutine turnover sample between those firms whose nonroutine turnover was a consequence of forced CEO dismissal versus all other reasons. In our study, in order to be classified as a forced CEO dismissal the reason cited for the turnover must be (1) forced resignation and/or (2) poor performance. Thus our classification process meets Denis and Denis’ (1995) definition of a clean announcement. We define the CEO’s final year as the last year that the CEO is with the firm for a period of 3 months beyond fiscal year end (Pourciau, 1993). This criterion for defining the final year is designed to capture the last year that the departing manager had effective control of the year-end financial statements. The notation that we use to represent the executive’s transition year is T. Year T
1 represents the final year the executive had control of the

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firm’s year-end financial statements. HA is supported if the discretionary accruals made by the departing executive in year T
1 were income increasing.

3.2. Data Collection We used the following process to identify firms experiencing nonroutine CEO turnover. First, we searched the Wall Street Journal (WSJ) Index from 1990 to 1998 in order to identify all firms experiencing CEO turnover.3 Once we identified a news report indicating that a CEO had left a firm but where there was no indication that the reason was related to retirement, we reviewed the entire Wall Street Journal article. If the reasons given for the departure met Pourciau’s (1993) definition of nonroutine turnover, we included the firm in our sample as having experienced nonroutine CEO turnover. This process yielded 395 nonroutine CEO turnovers. Lack of available data resulted in 215 observations being dropped from the sample. Of the remaining observations, eight reported multiple changes of top executives within a 3-year period. For those firms, only the first change was included in the analysis. The final sample of firms experiencing nonroutine executive turnover consisted of 172 firms. Next, we divided the sample into two groups – those whose turnover was related to a forced dismissal (94 firms) versus those whose nonroutine turnover was related to other reasons (78 firms). We then identified of a group of matched control firms, not experiencing executive turnover. This process involved matching each sample firm with a control firm based on four-digit SIC code, fiscal year, and total assets of year prior to the final year that the departing executive may have influence on the financial statements. We derived financial data for the firms from the Compustat and/or CRSP databases.

3.3. Model Dechow, Sloan, and Sweeney (1995) assess the relative performance of five alternative discretionary accrual models for detecting earnings management. They conclude that a modified version of the Jones (1991) model provides the most powerful tests of earnings management. Therefore, in this study we use the modified Jones (1991) model and the cross-sectional estimation method to measure discretionary accruals.4 We measure total accruals (TA)

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as the change in noncash working capital (excluding current maturities of long-term debt) less total depreciation expense for the current period in year t, scaled by total assets at the end of year t
1; that is, TAt ¼ ½ðDCAt
DCASH t Þ
ðDCLt
DCMLT Dt Þ
DEPt =At
1

(1)

where TAt are the total accruals in year t, DCAt the change in current assets in year t, DCASHt the change in cash in year t, DCLt the change in current liabilities in year t, DCMLTDt the change in current portion of long-term debt in year t, DEPt the depreciation and amortization expense in year t and At
1 the total assets at the end of year t
1. The expected nondiscretionary accruals for firm i in year t (NDAit) are then: NDAit ¼ ait ð1=Ait
1 Þ þ b1it ðDREV it =Ait
1
DREC it =Ait
1 Þ þ b2it ðPPE it =Ait
1 Þ

ð2Þ

where DREVit is the change in revenue for firm i in year t, DRECit the change in net receivables for firm i in year t, PPEit the gross property, plant, and equipment for firm i at the end of year t and ait ; b1it ; b2it are firm-specific parameters for firm i in year t. We cross-sectionally estimate the firm-specific parameters, ait ; b1it ; and b2it ; for every sample firm i in year t, using all other firms (j and jai) in the same two-digit SIC as firm i: TAjt ¼ ait ð1=Ajt
1 Þ þ b1it ðDREV jt =Ajt
1
DREC jt =Ajt
1 Þ þ b2it ðPPE jt =Ajt
1 Þ þ jt

ð3Þ

Discretionary accruals for firm i in year t (DAit) are the prediction error DAit ¼ TAit
NDAit

(4)

4. EMPIRICAL RESULTS 4.1. Primary Findings Table 1 provides a profile of the companies experiencing nonroutine CEO turnover along with information for the sub-sample of forced CEO dismissal companies. Panels A reports descriptive statistics of four primary financial variables (total assets, debt/equity ratio, return on equity, and cash flows from operating activities) of the nonroutine executive turnover firms and the corresponding control firms for year T
1. The nonroutine CEO

Profile of Sample Firms Experiencing Nonroutine Executive Turnover over the Period 1990–1998.

Panel A: Primary Financial Variables for Firms Having Nonroutine CEO Turnover in Year T
1 ðn ¼ 172Þ

Total assets ($ millions) Nonroutine change Control firms Test of differences Debt/equity ratio (%) Nonroutine change Control firms Test of differences Return on equity (%) Nonroutine change Control firms Test of differences Cash flows from operations ($ millions) Nonroutine change Control firms Test of differences

Mean

Std. dev.

2,708.91 2,469.86 p ¼ 0.720

6,632.14 5,694.09

94.97 67.75 p ¼ 0.290

Min.

Median

Max.

5.68 5.68

432.27 422.26 p ¼ 0.861

55,552.00 41,858.00

300.08 153.62


497.35
212.47

31.06 33.56 p ¼ 0.792

2,141.00 1,610.44

0.32 1.99 p ¼ 0.770

66.76 35.04


477.50
316.57

8.83 8.57 p ¼ 0.815

316.28 113.78

276.99 269.01 p ¼ 0.929

845.57 819.89


638.00
198.42

14.54 18.45 p ¼ 0.579

6,867.00 6,559.00

Earnings Management and Forced CEO Dismissal

Table 1.

Panel B: Primary Financial Variables for Firms Having Forced CEO Dismissals in Year T
1 (n ¼ 94)

1,593.60 1,479.35 p ¼ 0.820

3,569.75 3,301.48

10.46 8.75

352.96 336.41 p ¼ 0.878

23,138.00 17,246.00

53.57 46.86 p ¼ 0.760

125.65 171.62


198.29
212.47

18.72 17.82 p ¼ 0.337

1,021.40 1,610.44

69

Total assets ($ millions) Dismissal Control firms Test of differences Debt/equity ratio (%) Dismissal Control firms Test of differences

70

Table 1. (Continued )

Return on equity (%) Dismissal Control firms Test of differences Cash flows from operations ($ millions) Dismissal Control firms Test of differences

Mean

Std. dev.

4.04
2.71 p ¼ 0.296

41.42 46.64

146.85 176.39 p ¼ 0.738

528.50 670.34

Min.

Median

Max.


168.46
288.49

7.86 7.97 p ¼ 0.937

253.81 64.22


638.00
101.31

4.98 10.72 p ¼ 0.365

3,366.00 4,689.00

Panel C: Exchange Listings Last Year Before CEO Departure 1989 1990 1991

Cumulative Percentage

Exchange Listing

Number of Firms

15 (5) 9 (4) 15 (8)

8.7 (5.3) 14.0 (9.6) 22.7 (18.1)

NYSE ASE OTC

80 (37) 8 (3) 84 (54)

37.8 (35.1) 51.2 (48.9) 58.7 (57.4) 72.7 (72.3) 89.5 (89.4) 100.0 (100.0)

Total

172 (94)

1992 1993 1994 1995 1996 1997

26 (16) 23 (13) 13 (8) 24 (14) 29 (16) 18 (10)

Total

172 (94)

Cumulative Percentage 46.5 (39.4) 51.2 (42.6) 100.0 (100.0)

LIMING GUAN ET AL.

Number of Firms

2-digit SIC 10 13 15 20 23 24 26 27 28 29 30 31 33 34 35 36 37

Number of Firms

Cumulative Percentage

2-digit SIC

Firm Name

Number of Firms

Cumulative Percentage

Metal mining Oil and gas extraction Building construction Food products Apparel Lumber products Paper products Printing and publishing Chemical products Petroleum refining Rubber and plastic Leather products Primary metal ind. Fabricated metal Machine, computer eq. Electronics Transportation eq. Measurement instrum.

1(0.0) 1(0.0)

0.6(0.0) 1.2(0.0)

48 49

Communications Electric, gas services

9(4.0) 3(3.0)

59.9(54.3) 61.6(57.4)

1(1.0)

1.7(1.1)

50

Wholesale – durable

1(1.0)

62.2(58.5)

5(2.0) 5(5.0) 1(1.0) 3(1.0) 2(0.0)

4.7(3.2) 7.6(8.5) 8.1(9.6) 9.9(10.6) 11.0(10.6)

51 53 54 55 56

Wholesale – nondurable Merchandise stores Food stores Auto dealers Apparel stores

3(2.0) 5(4.0) 3(0.0) 1(0.0) 8(7.0)

64.0(60.6) 66.9(64.9) 68.6(64.9) 69.2(64.9) 73.8(72.3)

11(6.0)

17.4(17.0)

57

Home furniture stores

1(1.0)

74.4(73.4)

2(0.0)

18.6(17.0)

58

Eating and drinking

5(5.0)

77.3(78.7)

5(3.0)

21.5(20.2)

59

Misc. retail

8(6.0)

82.0(85.1)

3(0.0) 1(0.0)

23.3(20.2) 23.8(20.2)

62 67

Security broker Other investment offices

1(0.0) 2(0.0)

82.6(85.1) 83.7(85.1)

1(1.0) 17(9.0)

24.4(21.3) 34.3(30.9)

70 72

Hotels Personal services

1(0.0) 1(0.0)

84.3(85.1) 84.9(85.1)

13(7.0) 2(0.0)

41.9(38.3) 43.0(38.3)

73 78

Business services Motion pictures

13(10) 3(1.0)

92.4(95.7) 94.2(96.8)

9(6.0)

48.3(44.7)

79

Recreation services

4(1.0)

96.5(97.9)

71

38

Firm Name

Earnings Management and Forced CEO Dismissal

Panel D: Industry Composition

72

Table 1. (Continued ) 2-digit SIC 39 40 42 45

Firm Name

Number of Firms

Cumulative Percentage

2-digit SIC

Misc manufacturing Railroad Freight transportation Air transportation

3(1.0)

50.0(45.7)

80

1(0.0) 1(0.0)

50.6(45.7) 51.2(45.7)

6(4.0)

54.7(50.0)

Firm Name

Number of Firms

Cumulative Percentage

Health services

3(2.0)

98.3(100.0)

82 87

Educational services Other general services

1(0.0) 1(0.0)

98.8(100.0) 99.4(100.0)

99

Other establishments

1(0.0)

100.0(100.0)

Total

172(94)

Note: The t-test is used to evaluate differences in means, and Wilcoxon rank-sums test is used to evaluate the differences in medians. Firms are identified in the WSJ index. There are 172 firms that had nonroutine top management turnover, among which 94 were forced dismissals. Top management is defined as the set of individuals holding the titles CEO, president, or chairman of the board. Routine turnovers includes retirements and resignations when the executive was reported to continue to serve the company in some other capacity (e.g. as a consultant or serve on the company’s board of directors). Any executive turnovers not classified as routine is considered nonroutine. Top management turnovers are designated forced dismissals if the reason given for the change is forced resignation or poor performance. In panels C and D, information about forced dismissal firms appear in parentheses.  Forced dismissal are in parentheses.

LIMING GUAN ET AL.

Earnings Management and Forced CEO Dismissal

73

turnover firms have higher total assets and debt/equity ratios than the control firms. However, the means and the medians of all four financial variables are not significantly different between the two groups. Panel B of Table 1 provides a profile of the companies experiencing forced CEO dismissal and the respective control firms. The descriptive statistics include the four financial variables. Again, none of these variables is significantly different between the two groups of firms. Panel C sorts the firms based on year of CEO departure and stock exchange listing while Panel D reports the number of firms by industry. We report the information about firms experiencing forced CEO dismissals in parentheses in both panels C and D. Table 2 reports the discretionary accruals of the nonroutine CEO turnover sample and the forced dismissal sample during the 3-year period surrounding the last year the departing executive had control of the firm’s financial statements (year T
1). In panel A, the mean and median of both the nonroutine executive turnover sample and the forced dismissal sample are not statistically significant in year T
2. Additionally, these two measures are not significantly different from those of the control groups. Panel B reports the estimated discretionary accruals in year T
1. These results are used to test HA. For the sample of firms experiencing nonroutine executive turnover, neither the mean nor the median of the discretionary accruals is significantly different from zero or significantly different from the control sample. However, when the analysis is applied to only those firms where the nonroutine turnover resulted from forced CEO dismissal, both the mean and the median of the discretionary accruals (2.8% and 0.7%) are positive and significantly larger than those of the control group at the 0.01 and 0.05 levels, respectively. This result is consistent with the notion that discretionary accruals are income increasing during the year prior to the forced CEO dismissal. Thus, our empirical results support HA. This result also suggests that Pourciau’s (1993) failure to find evidence to support the cover-up theory may be due to the fact the definition of nonroutine executive change used in her study resulted in the inclusion of a significant number of firms whose CEOs were not facing forced dismissal. After using only the firms with clean announcements of forced CEO dismissals, we find evidence consistent with the cover-up theory. As mentioned earlier, when an executive is performing poorly, the board usually gives the executives a grace period to improve his/her performance. It is likely that the executive will immediately begin to manipulate earnings upward once it becomes apparent that his/her job is in jeopardy. Ideally, we would identify the starting point of the grace period and track the earnings

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LIMING GUAN ET AL.

Table 2. Discretionary Accruals for Nonroutine Executive Turnover and Forced Dismissals around the Last Year of Departure. Mean

Std. dev.

Min.

Q1

Median

Q3

Max.

Panel A. Discretionary Accruals in Year T
2 Nonroutine exec. turnover Control sample Test of differences ðn ¼ 165Þ


0.002 0.014 p ¼ 0.240

0.140 0.110


0.407
0.282


0.072
0.036


0.004
0.001 p ¼ 0.154

0.049 0.048

0.786 0.621

Forced dismissals Control sample Test of differences ðn ¼ 90Þ

0.015 0.011 p ¼ 0.828

0.153 0.109


0.322
0.282


0.033
0.038


0.004 0.005 p ¼ 0.567

0.061 0.060

0.732 0.352

Panel B. Discretionary Accruals in Year T
1 (Final Year of Executive Turnover) Nonroutine exec. turnover Control sample Test of differences ðn ¼ 172Þ

0.004
0.009 p ¼ 0.450

0.117 0.196


0.598
1.524


0.058
0.066


0.002
0.007 p ¼ 0.660

0.057 0.041

0.392 1.668

Forced dismissals Control sample Test of differences ðn ¼ 94Þ

0.028***
0.011 p ¼ 0.029

0.092 0.138


0.218
1.344


0.035
0.075

0.007**
0.008 p ¼ 0.022

0.074 0.045

0.320 0.288

Panel C. Discretionary Accruals in Year T (Transition Year) Nonroutine exec. turnover Control sample Test of differences ðn ¼ 169Þ


0.059***
0.014 p ¼ 0.007

0.155 0.150


0.782
0.667


0.114
0.077


0.041***
0.010 p ¼ 0.012

0.010 0.029

0.694 0.775

Forced dismissals Control sample Test of differences ðn ¼ 91Þ


0.060***
0.017 p ¼ 0.032

0.142 0.132


0.782
0.539


0.110
0.078


0.050***
0.012 p ¼ 0.020

0.009 0.048

0.371 0.634

Note: (i) Top management is defined as the set of individuals holding the titles CEO, president, or chairman of the board. Routine turnovers include retirements and resignations wherein the executive was reported to continue to serve the company in some other capacity (e.g. as a consultant or serve on the company’s board of directors). Any executive turnover not classified as routine is considered nonroutine. Top management changes are designated forced dismissals if the reason given for the change is forced resignation or poor performance. (ii) The t-test is used to evaluate differences in means, and Wilcoxon rank-sums test is used to evaluate the differences in medians. ***, **Significant at 0.01 and 0.05, respectively, two-tailed test.

management behavior over time. However, since the length of the grace period is unknown to us and since the grace period is likely to be heterogeneous among firms, using the cross-sectional examination of discretionary accruals prior to year T
1 will inevitably include firms whose grace period is a year or less. This reduces the likelihood that we will detect earnings management in those years. Although results in panel A of Table 1

Earnings Management and Forced CEO Dismissal

75

do not reveal significant earnings management for either the nonroutine change or the forced dismissal groups in year T
2, it is likely that some firms, indeed, managed earnings in year T
2. It is when the departing executive started to manage earnings upward to cover-up the poor performance that the income-increasing discretionary accruals are the most prominent. This behavior appears to peak in year T
1. Panel C of Table 2 reports the discretionary accruals for the nonroutine executive turnover and forced dismissal groups in year T, the transition year. The mean and median of the discretionary accrual variables are negatively significant for both groups and are significantly lower than those of the control firms. Consistent with Pourciau (1993), this result suggests that the incoming managers may have the incentive to reduce reported earnings (i.e. take a ‘‘big bath’’) in the transition year. By consciously depressing reported earnings, the incoming executive can attribute the poor performance to his/her predecessor thereby lowering the benchmark against which his/her future performance will be measured (Elliott & Shaw, 1988). The caveat, however, of using results in Panel C to infer the ‘‘big bath’’ behavior is that the income-decreasing discretionary accruals observed in the transition year (T) could be due to the reversal of the income-increasing discretionary accruals made in year T
1. According to the ‘‘Conservation of Income’’ theorem (Sunder, 1997), the sum of accounting earnings over the firm’s life is not affected by accounting choices. In other words, any accruals made in a prior year will reverse in a later year (Arya, Glover, & Sunder, 2003). Since the reversal of some accruals takes longer than one year, the discretionary accruals made in the final year of the CEO turnover (year T
1) represent the upper bound of the reversal effect in year T. Therefore, if discretionary accruals made in year T
1 are fully reversed in year T, the additional discretionary accruals made by the incoming executive in year T amount to
5.5% ( ¼
5.9%+0.4%) of prior year assets for the nonroutine turnover firms and
3.2% ( ¼
6.0%+2.8%) of prior year assets for the forced dismissal firms. Thus, the ‘‘big bath’’ phenomenon is still observed even after taking away the possible reversal effect of the prior year income-increasing discretionary accruals.

4.2. Additional Analysis Our primary findings suggest that the departing executives engaged in income-increasing manipulation to cover up his/her poor performance in the

76

LIMING GUAN ET AL.

last year prior to the forced dismissal. We use the cross-sectional modified Jones model to measure the extent of the discretionary accounting manipulations. Prior research has documented that manager’s accounting policy choices may be affected by company-specific variables such as size, debt-to-equity, profitability and operating cash flows, among other factors. Since these variables are not included in the model used to estimate discretionary accruals, they may potentially affect the precision with which discretionary accruals are estimated. Moreover, Murphy and Zimmerman (1993) argue that poor firm performance may have led to the CEO change as well as the discretion exerted over accounting choices. In considering these confounding variables, we extended our analysis to include these factors in a regression model. This testing is intended to examine whether the evidence of opportunistic earnings management still existed in year T
1 when controlling for these variables. We specify the model used to compare the difference in discretionary accruals between the executive change firms and the control firms as follows: ! ! Debt to Total DAi;T
1 ¼ b0 þ b1 þ b2 equity assets i;T
1 i;T
1 ! ! Operating return þ b4 þ b3 cash flows on equity i;T
1 i;T
1 ! ! Change Market adjusted þ b6 þ b5 in earnings stock return i;T
1 i;T
1 ! ! Change in Change þ b8 þ b7 Op cash flows in sales i;T
1 i;T
1 þ b9 ðFirm typeÞi;T
1 þ i;T
1

ð5Þ

In this model, we use four variables to control for firm performance: market adjusted stock return (using value-weighted CRSP index to proxy for the market), change in earnings, change in sales, and change in operating cash flows. We assigned Firm Type a value of ‘‘1’’ for firms in the executive change group and ‘‘0’’ for firms in the control group. A statistically significant estimate of the coefficient of Firm Type indicates that significant difference existed in the discretionary accruals between the two sets of firms after controlling for other confounding factors. Table 3 reports the results of this analysis. Panel A provides the results for the entire nonroutine CEO

Earnings Management and Forced CEO Dismissal

77

turnover sample. The parameter estimate of Firm Type is insignificant, confirming that there is not much difference between the discretionary accruals of the nonroutine CEO turnover firms and firms in the control group. Panel B of Table 3 presents the results of the model run over the forced CEO dismissal sub sample and the corresponding control firms. Here the parameter estimate of Firm Type is 0.03868 and marginally significant at the p ¼ 0:0654 level. This result, although weaker, is consistent with the initial analysis and suggests that the confounding factors cannot explain away the difference in discretionary accruals between the forced CEO dismissal firms and the control firms during the last year prior to the executive’s departure. Additionally, the insignificance of the extraneous accounting variables suggests that the cross sectional-modified Jones model is likely to have captured the effect of these variables on estimating the discretionary accruals. However, the results in Panel B also indicate that the parameter estimate of market adjusted stock returns is negatively significant in year T
1, suggesting that poor stock performance was significantly associated with the effort made by the departing executive to manage earnings upward. Murphy and Zimmerman (1993) also find this variable to be important in explaining poor firm performance leading up to both the CEO’s departure and the discretionary choice of accounting accruals. This may also indicate that the model we used to estimate discretionary accruals could be somewhat misspecified in the forced CEO dismissal scenario. However, Table 3. Regression Results of Variables Affecting Discretionary Accruals between Executive Turnover Firms and Control Firms. Variable

Parameter Estimate

Std. Error

t-stat

P4jtj


0.52 0.18 0.73 1.61
0.60
0.19 0.13 0.35 0.03 0.73

0.6005 0.8564 0.4648 0.1082 0.5472 0.8523 0.8949 0.7291 0.9795 0.4659

Panel A. Nonroutine Executive Turnover in Year T
1 (n ¼ 172  2) Intercept Total assets Debt/Equity Return on equity Operating cash flows Market-adjusted return Change in earnings Change in revenue Change in Op. cash flows Firm type Adjusted R2 ¼ 0:0032


0.00814 6.61E
07 3.359E
05 0.0003317
1.721E
05
0.0000335 0.0000049 3.64E
06 1.29E
06 0.01521

0.01554 3.65E
06 0.0000459 0.0002059 2.856E
05 0.0001798 3.703E
05 0.0000105 4.989E
05 0.02083

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LIMING GUAN ET AL.

Table 3. (Continued ) Variable

Parameter Estimate

Std. Error

t-stat

P4jtj

0.01553 5.51E
06 7.379E
05 0.0002481 4.158E
05 0.0001897 3.883E
05 2.879E
05 7.163E
05 0.02086


1.25
0.50 0.12 0.83
0.56
4.59
0.19 0.54 0.73 1.85

0.2131 0.6212 0.9013 0.4050 0.5789 o.0001 0.8477 0.5883 0.4641 0.0654

Panel B. ForcedDismissals in Year T
1 ðn ¼ 94  2Þ Intercept Total assets Debt/Equity Return on equity Operating cash flows Market-adjusted return Change in earnings Change in revenue Change in Op. cash flows Firm type


0.0194
2.73E
06 9.16E
06 0.0002071
2.312E
05
0.0008705***
7.47E
06 1.561E
05 5.255E
05 0.03868*

Adjusted R2 ¼ 0:1106 ***, *Significant at 0.01 and 0.10, respectively, two-tailed test. Model: ! ! Debt to Total þ b2 DAi;T
1 ¼ b0 þ b1 equity assets i;T
1 i;T
1 ! ! return Operating þ b3 þ b4 on equity cash flows i;T
1 i;T
1 ! ! Change Market adjusted þ b6 þ b5 in earnings stock return i;T
1 i;T
1 ! ! Change in Change þ b7 þ b8 Op: cash flows in sales i;T
1

i;T
1

þ b9 ðFirm typeÞi;T
1 þ i;T
1 where ‘‘Firm type’’ equals 1 for the executive turnover firm, and 0 for the control firm, and t
1 stands for the last year the departing executive has control over the firm’s financial statements (i.e. year T
1). The market-adjusted stock return is the difference between the firm’s stock return and the change of value-weighted CRSP index. Top management is defined as the set of individuals holding the titles CEO, president, or chairman of the board. Routine turnovers include retirements and resignations when the executive was reported to continue to serve the company in some other capacity (e.g. as a consultant or serve on the company’s board of directors). Any executive turnover not classified as routine is considered nonroutine. Top management turnovers are designated as forced dismissals if the reason given for the change is forced resignation or poor performance.

prominent income-increasing earnings manipulation is nevertheless observed among the forced CEO dismissal firms even after the effect of this capital market variable was controlled.

Earnings Management and Forced CEO Dismissal

79

5. SUMMARY AND CONCLUSIONS This study extends the stream of research examining earnings management in a CEO turnover environment by focusing on nonroutine turnover, especially those situations involving forced CEO dismissals. The study seeks to further research examining the use of discretionary accounting choices made by departing executives during their final year with the company and to further test for the cover-up theory. In this study we find evidence to support the cover-up theory in the case of nonroutine turnover involving forced CEO dismissal. When we compare the discretionary accruals made by firms involved in nonroutine CEO turnover to a control sample of firms, we do not detect evidence of earnings management. These results are consistent with Pourciau (1993). However when we compare the discretionary accruals of a subset of firms experiencing forced CEO dismissal to a control sample of firms, the results are significant and indicate that CEOs faced with termination do, in fact, engage in earnings management. Pourciau’s (1993) failure to find evidence to support the cover-up theory may be due to the fact that her definition of nonroutine executive change is too broad in that it includes firms whose CEO’s departure is ‘‘routine,’’ or at least not forced. Since Murphy and Zimmerman (1993) argue that poor firm performance may have led to both the CEO change and the discretion over accounting choices, we perform a second analysis. Specifically, we run a regression on the discretionary accruals of the pooled sample of the CEO turnover firms and the control firms in year T
1, controlling for firm performance and other company-specific variables that have been shown in prior literature to influence discretionary accounting choices. When the sample includes all firms experiencing nonroutine CEO turnover, the firm-type variable (turnover vs. control) is not significantly different from zero. However, when we repeat the analysis over the sub sample including only those firms experiencing forced CEO dismissal, the results indicate that firm performance and other company-specific confounding factors cannot explain away the difference in discretionary accruals of firms experiencing forced CEO dismissals and the control firms. Overall, these results suggest that the failure of prior studies to find evidence of earnings management in situations involving nonroutine CEO turnover is most likely a consequence of the researchers’ use of definitions of nonroutine turnover that are overly broad and include firms whose CEOs’ incentives to manage earnings are not clear. Additionally, the models used by those researchers to estimate discretionary accruals may be less accurate and therefore ineffective at measuring the hypothesized effects. Our study

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LIMING GUAN ET AL.

contributes to the growing body of literature on examining the managerial incentives related to earnings management.

NOTES 1. Healy and Wahlen (1999) define earnings management as ‘‘earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers’’ (p. 368). 2. The random-walk assumption for accruals was found inappropriate by Murphy and Zimmerman (1993, p. 283). 3. It should be noted that prior studies have documented that the WSJ has a largefirm tendency in its news coverage. Although the WSJ allows us to identify the primary reasons of the executive’s departure, its large-firm bias may limit the generalizability of the findings of the study. 4. Subramanyam (1996) reports that the cross-sectional variation of the modified Jones (1991) model provides better estimates of the normal accruals than the timeseries model. Additionally, Bartov, Gul, and Tsui (2000) find that the cross-sectional modified Jones model outperforms the time-series modified Jones model for identifying firms with qualified audit opinions. We ran our tests using the timeseries modified Jones (1991) model and obtained similar results. However, since the time-series modified Jones (1991) model suffers from nonstationarity in parameter estimations (Shaw, 2002), we have limited our discussion to the results obtained using the cross-sectional estimation process.

ACKNOWLEDGMENTS The authors are grateful to Noah Barsky, Erv Black, Sharon Cox, Shirley Daniel, Caixing Liu, Hamid Pourjalali, Alan Reinstein, the participants of the annual conference of the American Accounting Association (August 2003) for their helpful comments on earlier versions of this paper, as well as to the Advances in Accounting editor, associate editor and three anonymous reviewers for their benevolent comments and constructive suggestions. The authors also gratefully acknowledge financial support from the CIBER at University of Hawaii and from Oklahoma State University.

REFERENCES Arya, A., Glover, J., & Sunder, S. (2003). Are unmanaged earnings always better for shareholders? Accounting Horizons, 17(Suppl.), 111–116. Bartov, E., Gul, F., & Tsui, J. (2000). Discretionary-accruals models and audit qualifications. Journal of Accounting and Economics, 30, 421–452.

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Cahan, S. (1992). The effect of antitrust investigations on discretionary accruals: A refined test of the political-cost hypothesis. The Accounting Review, 67, 77–95. DeAngelo, L. (1986). Accounting numbers as market valuation substitutes: A study of management buyouts of public stockholders. The Accounting Review, 61, 400–420. DeAngelo, L. (1988). Managerial competition, information costs, and corporate governance: The use of accounting performance measures in proxy contests. Journal of Accounting and Economics, 10, 3–36. Dechow, P., & Sloan, R. (1991). Executive incentives and the horizon problem: An empirical investigation. Journal of Accounting and Economics, 14, 51–89. Dechow, P., Sloan, R., & Sweeney, A. (1995). Detecting earnings management. The Accounting Review, 70, 193–225. Denis, D., & Denis, D. (1995). Performance changes following top management dismissals. Journal of Finance, 50(4), 1029–1057. Elliott, J., & Shaw, W. (1988). Write-offs as accounting procedures to manage perceptions. Journal of Accounting Research, 26(Suppl.), 91–119. Groff, J., & Wright, C. (1989). The market for corporate control and its implications for accounting policy choice. Advances In Accounting, 7, 3–22. Healy, P., & Wahlen, J. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons, 13(4), 365–383. Jackson, S., & Pitman, M. (2001). Auditors and earnings management. The CPA Journal, 71(7), 39–44. Jones, J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29, 193–228. Liberty, S., & Zimmerman, J. (1986). Labor union contract negotiations and accounting choices. The Accounting Review, 61, 692–712. Murphy, K., & Zimmerman, J. (1993). Financial performance surrounding CEO turnover. Journal of Accounting and Economics, 16, 273–315. Perry, S., & Williams, T. (1994). Earnings management preceding management buyout offers. Journal of Accounting and Economics, 18, 157–179. Pourciau, S. (1993). Earnings management and nonroutine executive changes. Journal of Accounting and Economics, 16, 317–336. Reitenga, A., & Tearney, M. (2003). Mandatory CEO retirements, discretionary accruals and corporate governance mechanisms. Journal of Accounting, Auditing and Finance, 18(2), 255–280. Shaw, J. (2002). An investigation of discretionary accrual models and the accrual anomaly. Unpublished doctoral dissertation, Oklahoma State University, Stillwater, OK. Strong, J., & Meyer, J. (1987). Asset writedowns: Managerial incentives and security returns. Journal of Finance, 20, 643–663. Subramanyam, K. (1996). The pricing of discretionary accruals. Journal of Accounting and Economics, 22, 249–282. Sunder, S. (1997). Theory of accounting and control. Cincinnati, OH: South-Western Publishing. Vancil, R. (1987). Passing the baton: Managing the process of CEO succession. Cambridge, MA: Harvard Business School Press. Warner, J., Watts, R., & Wruck, K. (1988). Stock prices and top management changes. Journal of Financial Economics, 20, 461–492. Wu, Y. (1997). Management buyouts and earnings management. Journal of Accounting, Auditing, and Finance, 12, 373–389.

THE DECISION TO DISCLOSE ENVIRONMENTAL INFORMATION: A RESEARCH REVIEW AND AGENDA Tanya M. Lee and Paul D. Hutchison ABSTRACT Environmental accounting issues related to financial disclosure and reporting are increasingly relevant to a multitude of firm stakeholders (e.g., employees, management, investors, creditors, regulators, unions, public interest groups, etc.). Environmental disclosures by firms are one means of communicating such information to these stakeholders. While many studies have examined environmental disclosures, a number of research questions still remain. This study categorizes and provides the results of prior studies, addressing the forces affecting the decision to disclose environmental information, and provides suggestions for future research. The categories used include: (1) laws and regulations, (2) legitimacy, public pressure, and publicity, (3) firm/industry characteristics, (4) rational cost-benefit analysis, and (5) cultural forces and attitudes. Research from outside the accounting discipline is often included to provide background or indicate related information from other academic disciplines.

Advances in Accounting Advances in Accounting, Volume 21, 83–111 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21004-0

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1. INTRODUCTION Environmental costs and liabilities are significant and likely to increase in the future. Pollution control and cleanup costs in the United States (U.S.) alone now exceed $130 billion a year, roughly 2% of U.S. gross national product (Moynihan, 1993). Additionally, it is estimated that cleaning up toxic waste sites could cost $500 billion over the next 50 years (U.S. Office of Technology Assessment, 1989). Numerous examples of the relevance of environmental costs to firms can be found in the business press (e.g., Machalaba, 1999; Carley, 1997; Starkman, 1997; Norman, 1991). The importance of these issues to the accounting profession is amplified by demand for the timely disclosure of firm information, including environmental data, by various stakeholder groups – employees, management, investors, creditors, regulators, unions, public-interest groups, etc. This demand seems to be on the increase in the 2000s (Sutton, 2000). Despite the importance of environmental information to meet the information needs of stakeholders, companies, possibly out of fear of potential legal reprisals, generally provide only very limited environmental disclosures and reporting. Disclosure of relevant information is an important capital market issue. In fact, as Verrecchia (2001) states, disclosure can be considered as playing a central role in accounting, and this role is evidenced by numerous capital market research studies examining various forms of accounting disclosure. For example, Hope and Pope (2003) find a positive relationship between the level of disclosure in annual reports and analyst forecast accuracy, while Balsam, Bartov, and Marquardt (2002) find a relationship between firm 10Q disclosures and stock returns. Konar and Cohen (1997) provide evidence on the effects of environmental disclosure on future firm behavior with respect to toxic release levels, and explain these effects by noting the capital market impact of disclosures. Due to recent public concerns about limited firm disclosures, accounting standard-setters have issued studies, and are actively pursuing disclosurerelated research projects. Both the Securities and Exchange Commission (SEC) (2003) and the Financial Accounting Standards Board (FASB) (2003) have examined the potential for a principles-based approach of reporting to improve disclosures. The Governmental Accounting Standards Board (GASB) (2003) recently issued a special report on ‘‘Reporting Performance Information: Suggested Criteria for Effective Communication’’ and has research projects underway that examine ‘‘Intangible Assets’’ and ‘‘Pollution Remediation Obligations.’’ These studies and projects are likely to directly impact future environmental reporting in the U.S.

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Due to the importance of environmental disclosures, the purpose of this research review and agenda is to present prior literature related to the decision to disclose environmental information and to encourage future research in this area. This study begins with a discussion of the data collection and is followed by the theoretical framework and prior research with future directions. A conclusion and limitations of the study are also presented.

2. DATA COLLECTION The authors conducted literature searches for relevant academic articles using electronic databases and physical examinations of journals not available in electronic indices. This resulted in the identification and categorization of the academic environmental articles included in this study. Note that not all studies cited are from the accounting discipline. Some are included as background, while others provide knowledge from other academic areas that could be applied in an accounting context. Although articles could often be placed in a number of topical areas, the authors sought to categorize articles in only one or two major areas. The intention was to be concise and limit page-length.

3. THEORETICAL FRAMEWORK AND PRIOR RESEARCH WITH FUTURE DIRECTIONS Verrecchia (2001) categorizes accounting research on disclosure as association-based, efficiency-based, and discretionary-based. Association-based research addresses the effects of disclosure on investors’ actions. Efficiencybased research considers which disclosure practices are preferred, given no knowledge of the information that could/would be disclosed. Discretionarybased research examines ‘‘how managers and/or firms exercise discretion with regard to the disclosure of information about which they may have knowledge’’ (Verrecchia, 2001, p. 97). Discretionary-based research is the subject of the present study. Societal, firm/industry, and individual factors can, individually and working in concert, influence the decision to disclose environmental information. These relationships are illustrated in Fig. 1. Organizations operate within the confines of society and aspects of those societies, both formal and informal, and affect the operations of these organizations. Formal aspects include laws and regulations prescribing or

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Societal Factors Laws and Regulations Legitimacy Public Pressure Publicity Firm/Industry Factors Characteristics Rational Cost/Benefit Analysis

Decision to Disclose Whether to Disclose? What to Disclose? When to Disclose? Where to Disclose? How Much to Disclose?

Individual Factors Culture Attitudes

Fig. 1.

Factors Affecting the Decision to Disclose Environmental Information.

prohibiting actions. Informal societal influences include publicity and public pressure combined with organizations’ desire for legitimacy. Laws and regulations have been shown to affect firm behavior in other arenas. Tax laws affect the timing of discretionary accruals (Lopez, Regier, & Lee, 1998), the location and activity of research and development intensive corporate units (Grubert, 2003), and corporate structure (Desai & Hines, 2002). Further, both positive and negative publicity based on firm behavior can impact society’s view of a company and its future viability (Vendrzyk, 1993; Stice, 1991). Discrediting events, such as the Alaskan oil spill (Patten, 1992) and environmental fines (Warsame, Neu, & Simmons, 2002) can also provide a source of pressure affecting disclosures. Thus, a number of factors could affect the decision to disclose environmental information including: societal factors pertaining to laws and regulations and the desire for legitimacy, public pressure, and publicity; firm/ industry factors such as ownership status, size, industry affiliation, risk, and the use of rational cost/benefit analysis; and individual factors such as culture and attitudes. Each of these with suggestions for related future research will be addressed below.

3.1. Societal Factors: Laws and Regulations Of major importance in environmental accounting is the effect of laws and regulations on disclosure practices. Without laws and regulations,

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disclosures are voluntary and are unlikely to be uniform and comparable across firms. With laws and regulations, disclosures are required, yet the wording and interpretations of these laws and regulations can affect the value of disclosures to interested, external parties. Specific issues that arise in the interpretation of these, when translating general requirements into industry specific disclosures, are the level of ambiguity in the laws and regulations and the susceptibility of these to misinterpretation or manipulation, leading to bias in reporting. A number of studies address the level of ambiguity in environmental laws and regulations. The oil and gas industry, in particular, faces difficulties in this area. Wright (1982, 1998) and Wright and Wright (2000) describe what they call challenging and perplexing issues related to the treatment of the costs of site closure and reclamation in the oil and gas industry. Golemon (1990) discusses current pollution regulations, their interpretation, and the consequent need for risk management on the part of affected firms. This paper provides information on federal regulations, the political processes affecting them, their economic and social implications, and the relationships between these and several industries including oil and gas, automobile, electric utilities, and coal. The author predicts continued difficulties in determining what firms must do to comply and an increase in relevant state legislation. Golemon (1991, p. 79) speculates that amendments to the 1990 Clean Air Act indicate the U.S. Congress ‘‘believed that air pollution laws were becoming so complicated’’ that an operating permit bureaucracy was needed to interpret them. Johnson (1993), research manager at the FASB, discusses current guidance for environmental reporting and the need for research to assist in determining the appropriate treatment for both current and future environmental costs. The author notes considerable ambiguity in determining when such obligations should be recognized, the lack of explicit guidance for recognizing future costs in industries other than oil, gas, coal, and electric utilities, and the difficulties organizations could face in measuring future liabilities. Blossom (1994, p. 117) discusses regulations and laws and what environmental due diligence might require, noting that ‘‘full disclosure of all existing or potential liabilities’’ is desirable. However, given the difficulties listed by Johnson (1993), this is problematic as well as desirable. Grinnell and Hunt (2002, p. 211) examine the issue of accounting for gifted pollution permits, a ‘‘controversial and unresolved issue,’’ and use guidance from the FASB to recommend recording them as both assets and liabilities (to society). Hutchison (2000) reports on current environmental regulations and disclosure requirements, indicating the diversity of regulations that could

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apply. Barth, McNichols, and Wilson (1997) find that regulation, the information available to management concerning firm liability, and concerns with litigation and external financing influence the decision to disclose for firms with Superfund responsibilities. Their evidence indicates a substantial regulatory impact coupled with substantial discretion concerning environmental disclosures. Given this ambiguity, there is a significant potential for bias in disclosure. Bagby, Murray, and Andrews (1995) motivate the desirability of environmental disclosures based on the need for fully informed participants to make market-based programs work (e.g., tradable sulfur dioxide pollution rights or reduction of current pollution sources to allow (offset) new sources). The authors contrast public disclosures required by environmental laws with financial statement requirements, and conclude that current environmental requirements allow considerable management discretion. As an example, SEC requirements under Regulation S-K include (1) a description of the environmental effects of the business, (2) disclosure of material current legal actions, and (3) inclusion of potential environmental issues in the management discussion and analysis (MD&A) section of the annual report. Two sources of discretion emerge under Regulation S-K. Although one might assume designation as a Potentially Responsible Party (PRP) under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA or Superfund) would require disclosure under the second requirement, it does not trigger an SEC requirement for disclosure. The third, the inclusion of environmental issues in the MD&A, allows management to decide what qualifies, enabling considerable discretion in what is disclosed. Five years later, a study that discusses possible motivations to disclose environmental information notes that ‘‘specific guidelines to environmental disclosures are lacking’’ (Mitra, 2000, p. 452). The following studies illustrate the opportunity for biased disclosures and the omission of information relevant to stakeholders’ decision-making in reporting. Deegan and Gordon (1996) report on environmental disclosures by Australian firms and find increasing volume over time but with a positive (to the firm) bias. Nichols and Gallun (1997) review prior research on firm practices with respect to reclamation costs for offshore drilling and production platforms and compare these practices to proposed rules. The authors note that generally accepted accounting principles (GAAP) do not, except in theory, require capitalization of reclamation costs given an asset that will result in such costs, and that there is no required method for estimation of future reclamation costs. Rouse and Weirich (1997, p. 754) discuss current disclosure requirements for oil and gas companies, provide

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examples of such disclosures, and note that these ‘‘present challenges’’ and that ‘‘actual implementation remains subject to interpretation.’’ Deegan (1997), in an overview of a report, discusses a lack of specific environmental reporting requirements for Australian firms and indicates a deficiency in the objectivity of the information that is disclosed.1 Thus, environmental reporting requirements are ambiguous, subject to management discretion, and have been addressed primarily in environmentally sensitive industries, even though environmental issues affect a broad range of industries (Abelson, 1991; Sikich, 1991). This could result in disclosures that do not adequately serve the needs of stakeholders. Management discretion alone has been shown to lead to opportunistic behavior in other reporting arenas.2 Therefore, a crucial issue is whether current environmental disclosures are adequate. With this in mind, future research could address two related areas. One is a determination of what should be disclosed and the second, a comparison of recommended to actual disclosures to determine the significance of any information gap. There are two possible approaches to the first suggestion, both industry-based. One could gain access to one or more firms in an industry, examine materials, processes, and products to identify environmental issues and risks and use this data to extrapolate what should be disclosed in a particular industry. Another is to use publicly available information on firms in a given industry related to environmental problems and costs, and develop a composite of these to determine relevant risks and appropriate categories of disclosure in that industry. Information on legal actions, such as enforcement actions, court cases, and fines; information from governmental agencies, such as lists of Superfund sites; and information from the press could be used to provide a range of appropriate disclosures. While either of these two methods would necessarily be inexact, a rough estimate of appropriate categories of environmental information by industry could provide some indication of the adequacy of current disclosures. If comparison of these recommendations to actual disclosures indicates inadequate disclosure, the causal factor could be investigated. Management discretion as a causal factor would indicate a need for enforcement-based remedies or improved incentives for disclosure, while an inability to identify and quantify environmental liabilities, a need for the creation of a standardized framework to aid in the identification and estimation of such risks and liabilities. A few studies have addressed the variability of environmental laws and regulations across nations. Niskala and Pretes (1995) discuss the influence of the Finnish government on environmental reporting. Sack et al. (1995) report on financial accounting requirements and the SEC viewpoint with

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respect to environmental costs. Jenkins (1999) provides information on a draft of the European Union’s (EU) White Paper on Environmental Liability and its reporting requirements. Other information can be gleaned from environmental research in other sections of this study, but no systematic examination of cross boundary differences has been done. There is a study related to the variability of reporting for intangibles (Stolowy & JenyCazavan, 2001), but nothing similar appears to exist for environmental disclosure. Future research to address the variability of national requirements for environmental disclosures could be very useful. The current move to harmonize accounting requirements across nations to allow easier access to financial markets and greater transparency could be facilitated by information on how requirements for environmental disclosure differ. Issues of interest include what is required, level of management discretion enabled, and whether these differ systematically by characteristics such as the nature of the investors being served, level of industrialization of the nation, or type of legal system. Also of interest would be whether the growth of multinationals and compliance with the most stringent nation of operations environmental disclosure requirements is decreasing differences across nations. Environmental laws and regulations should affect actual firm environmental disclosures. Policy reasons for forcing disclosures may include a belief that such disclosure encourages firms to reduce hazardous waste generation for reputational reasons (see legitimacy section below) and/or a desire to provide sufficient information on environmental liabilities to enable informed decisions by investors and other interested external parties. There is some evidence on the impact of regulations on firm environmental activities. Bowman and Haire (1976) test the relationship between social disclosures and actual firm activity for food manufacturing companies. They find a greater percentage of commentary devoted to socially responsible activities in annual reports of firms on a list of those named as outstanding in social responsibility published in The New York Times. This relationship suggests that such disclosures may serve as a reasonable proxy for actual firm behavior in these areas. However, alternatively and given the cross-sectional nature of the data, the reputation may be affected by the disclosures rather than representing actual behavior. Balcke (1988) examines the problems CERCLA has in obtaining desired results, discusses the laws and processes involved in the clean-up activities, efforts on the part of government to encourage negotiated resolution of contamination problems, and the lack of desired outcomes from this process. Stafford (2002) examines the

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relationship between hazardous waste violations and the Environmental Protection Agency’s (EPA) increase in associated penalties. Penalties increased as much as ten times while compliance increases were in the range of 10 to 20%. While this study finds an increase in compliance, there are sizable differences in effects related to location. Some regions have quite different inspection and violation probabilities, indicating this variability in effect may relate to differences in enforcement practices. Several studies address the effect of laws and regulations on actual environmental information disclosed. It appears that the largely voluntary nature of environmental disclosure often leads to non-disclosure, even when the probability of liability seems high. Rockness, Schlachter, and Rockness (1986), in a study of firms in the chemical industry, compare annual report environmental disclosures, including both required and voluntary ones, to two measures of hazardous waste. One is a self-report by firms of waste disposal sites for a U.S. Congressional Survey and the other is compiled from EPA information on Superfund sites. Much of the information in the two hazardous waste measures was not found in the annual reports. The authors note that, given the size of potential liabilities, this lack of relevant information should be of concern. Beets (2001) reports that many firms trading in emissions allowances do not disclose this process to the public in their financial statements. Mitchell (1994), in a review of research on accounting by firms for Superfund liabilities, and Freedman and Stagliano (1995) both provide evidence that a number of firms subject to Superfund cleanup requirements, according to information from the EPA, do not disclose this liability in their annual reports or SEC filings. Stanny (1998) finds that most firms with Superfund involvement did not report reserved amounts to cover their liabilities and the aggregate amount reported by all firms was only 2% of the estimated costs. Similarly, Tilleman and Wright (1993, 1994) report that a substantial portion of oil and gas firms were not complying with a site restoration disclosure reporting standard. Larrinaga et al. (2002) find low compliance by Spanish firms with a regulation requiring environmental disclosures. Tilt and Symes (1999) suggest that Australian mining companies may disclose environmental costs related to rehabilitation of mining sites in order to justify the deductions for beneficial tax treatment. It may be that other environmental costs, without such incentives, remain undisclosed. Wilmshurst and Frost (2000), in a survey of Chief Financial Officers of Australian companies, find legal necessity named as one factor influencing the decision to disclose environmental information. Mitra (2000) discusses legal requirements as an influence on the disclosure of environmental information.

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Thus, the issue of whether there is a relationship between disclosure and firm environmental behavior remains unresolved, and the actual environmental information disclosed appears to be, at least in some instances, inadequate for accurate determination of future liabilities and risk. This presents areas with potential for future research in addition to those discussed in the previous section. Is the relationship between environmental disclosure and actual firm behavior affected by potential or actual penalties incurred by similar firms in lawsuits, fines, or regulatory proceedings by governmental bodies such as the EPA? If these do affect the relationship, laboratory experiments or case studies could investigate whether perceived personal risk or expectations of potential liability (there is now a triple penalty for discovered, as opposed to freely reported, violations) affect the strength of this relationship. Factors affecting this relationship might also affect environmental cost tracking and reporting as a means of demonstrating ‘‘due diligence’’ as a potential defense against future liability claims. Environmental reporting can be voluntary or regulated and this choice could be influenced by a consideration of stakeholder informational needs. Several articles provide arguments for and/or evidence in support of some form of standardization, generally with respect to investor need for comparable and reliable information concerning environmental liabilities and practices. Parker (1986) provides a discussion of the development of social accounting, problems with it, and evidence on practice. Owen (1994) argues in favor of standardization in disclosure for items like corporate environmental policy, a name of someone responsible for environmental issues, firm environmental objectives, extent of compliance, and environmental risks not disclosed as contingent liabilities. Gallhofer and Haslam (1997) argue for the necessity of some form of regulation requiring disclosure and audit to force environmental action. Ilinitch, Soderstrom, and Thomas (1998) note a current focus on contingent liabilities and that information on other areas, such as capital for ongoing process spending on environmental issues, may or may not be disclosed, making firm comparisons difficult. White (1999) discusses shifts in corporate accountability, the role of the SEC and FASB, and other stakeholder groups in this process. The study notes inadequacies of required environmental disclosures, like compliance reporting, since these are lagging indicators, while actions taken to reduce future pollution (not required) are leading indicators of environmental performance and relevant to stakeholder decisions. Admati and Pfleiderer (2000) examine a model of voluntary and regulated disclosure using analytics and find firm conditions affect their relative desirability. The model involves firms whose values are correlated so that

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disclosures by one are relevant for valuation of others and indicates potential problems of information asymmetry (when some disclose and some do not). Puxty (1986) argues that a reasonable case for requiring standards for social accounting has not been made. This study notes the potential for discussion of such standards to be limited by the interests of some of the parties involved, biasing the outcomes, and difficulty in demonstrating what would be accomplished by such standardized reporting. There are opportunities for future studies to address what should be included in standard environmental reporting. However, a caveat must be entered here. As seen above, disclosures under current regulations appear to be less complete than the regulations would seem to require. Therefore, issues of compliance and enforcement may be crucial to whether requirements for more standardized disclosures will actually produce improved disclosures. Given this, the effect of more/less complete reporting on financial statement users actions could be examined. Does more complete disclosure by one firm in an industry versus another result in risk reducing behavior (not purchasing, increased diversification) or in a change in willingness to pay for a security? Or is disclosure by one firm in an industry taken as information on environmental risk for all firms in that industry? Do stakeholders use information provided on capital expenditures related to pollution abatement or prevention similarly to those on future environmental liabilities? Do stakeholder groups vary in their responses?

3.2. Societal Factors: Legitimacy, Public Pressure, and Publicity A desire for legitimacy and public pressure have been suggested as factors affecting firm environmental disclosures. Deegan (2002) provides an overview of legitimacy theory with respect to environmental disclosures and associated research. Survey results by Toms (2002) suggest that environmental disclosures in annual reports do affect environmental reputation. The author uses ratings for Community and Environmental Responsibility (CER) published in an article on Britain’s Most Admired Companies as a proxy for environmental reputation. Quality of disclosure (quantifiable and verifiable) and firm risk (beta) are found to be associated with a high CER rating. Milne and Patten (2002) examine the impact of negative and positive environmental disclosures on perceived firm legitimacy using practicing accountants and find that positive disclosures can improve perceived legitimacy. However, Milne (2002), in a discussion of research in the area, considers the relationship between political cost theory

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and social and environmental accounting and finds it lacking in explanatory power. Public pressure can also influence disclosure. Ullman (1979) discusses possible stakeholder influence on social reporting in Germany. Guthrie and Parker (1989) examine social reporting by an Australian mining firm and find public pressure and environmental reporting associated during some periods but not others. In another study, they (Guthrie & Parker, 1990) use a survey to examine cross national differences in social disclosure in the United Kingdom (U.K.), U.S., and Australia and conclude most disclosures appear to be reactions to governmental or public pressure, while Arnold (1990) discusses possible alternative interpretations of their data. Prior studies indicate pressure groups (Tilt, 1994) and shareholders (Epstein & Freedman, 1994) want more social and environmental, respectively, disclosures, and for these to be required and verified. Patten (1995) finds a significant decrease in the number of firms engaging in social disclosure during the Reagan administration in the U.S., supporting the influence of (lack of) public policy pressure on such disclosures. Larrinaga-Gonzalez et al. (2001) find environmental accounting by Spanish firms appears to be related to firm desire to shape the public environmental agenda pursued. O’Donovan (2002) notes managers in Australian firms consider the desire to affect firm legitimacy through disclosures reasonable. Owen, Swift, and Hunt (2001) interpret results of interviews with managers and other professionals as suggesting current social reporting is done primarily to manage public perceptions. However, O’Dwyer (2002), examining motivations for environmental disclosure in Irish firms, finds little support for legitimacy as a significant influence. Deegan (1997), in an overview of a report, notes evidence that communities do desire environmental performance disclosures, discusses the lack of specific environmental reporting requirements for Australian firms, and indicates the information that is disclosed is primarily provided to influence public image. Buhr (1998) finds a firm involved in natural resource extraction which responded to regulation reactively at first and then proactively, developing technology to comply with expected future and more stringent regulations. The author suggests that this is the result of beliefs about the direction of public policy pressure and its expected impact on regulations. Publicity also appears to have an influence on environmental disclosures. Estes and Zenz (1978) note that an offer to allow access to internal social and environmental data was withdrawn when it appeared that some might not be favorable from the firm’s viewpoint. Brown and Deegan (1998) find higher levels of media attention to environmental effects in Australia

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generally associated with higher levels of annual report disclosures. Patten (2002) examined the relationship between media exposure and environmental disclosures and found that even after controlling for media coverage, publication of Toxic Release Inventory figures is still significantly associated with environmental disclosure levels. Deegan, Rankin, and Tobin (2002), considering BHP Ltd., find a significant positive correlation between environmental disclosures and media attention, and find positive environmental disclosures related to negative media information. Neu, Warsame, and Pedwell (1998) find evidence that shareholder and regulatory concerns, and degree of public attention to environmental issues are associated with the level of such disclosures by Canadian firms in environmentally sensitive industries. A number of studies examine the influence of a discrediting event, such as an environmental disaster, and its associated publicity on firm environmental disclosures and other activities. Patten and Trompeter (2003) review the relationship between the environmental disaster in Bhopal, India and earnings management by chemical firms and find significant negative accruals after the incident. This was mitigated for firms with higher levels of preincident environmental disclosures. The Exxon Valdez oil spill was followed by significant differences in quantity and quality of environmental disclosures in the chemical, consumer products, forest products, and oil industries (Walden & Schwartz, 1997). Both financial and nonfinancial disclosures increased in the oil and forest products industries, and nonfinancial disclosures in the chemical and consumer products industries. Patten (1992) finds an increase in environmental disclosures by oil firms after the Exxon Valdez oil spill, with the amount of change related to involvement in the Alyeska Pipeline Service Company. Studies find the use of environmental disclosures to manage public perceptions of the firm surrounding events such as environmental fines (Warsame et al., 2002), prosecution by the Australian EPA (Deegan & Rankin, 1996), environmental disasters for Australian firms (Deegan, Rankin, & Voght, 2000), and negative media coverage of environmental fines in Canada (Neu et al., 1998). While it appears that environmental disclosures can affect firm reputation and companies often appear to provide such disclosures in response to public pressure or negative publicity, questions concerning this area still remain. One is whether it is reasonable to conclude environmental reputation matters. Does environmental reputation actually affect the decisions and actions of current and/or potential stakeholders? Pressure could come from the perceptions of management, investors, the general public, environmental groups, the actions of competitors, or the press and attention to

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the various sources could vary. One might expect firms with growing sales, production facilities needs, and processes that can be hazardous to react to public pressure and negative publicity more strongly that firms without a continuing need for new production facilities. Similarly one might expect firms in highly competitive industries to react more strongly than firms where competitive pressure is lower. Another question relates to the factors associated with the level of pressure felt by firm decision-makers. Is pressure to react to threats to firm reputation associated with perceived firm risk? Does the type of environmental risk influence the level of pressure, either types of environmental problem – air or water pollution, radiation, or noise – or types of consequences – loss of life, health problems, or quality of life? Effects that are more difficult to reverse or to remediate should result in greater perceived pressure to engage in activities to reduce environmental risks and to publicize (disclose) these.

3.3. Firm/Industry Factors: Characteristics A number of studies have examined the relationship between environmental disclosures and firm and/or industry characteristics. One such characteristic is firm ownership structure. Cormier and Gordon (2001) find evidence that ownership status (public versus private) affects environmental reporting, with publicly held electric utility companies providing more disclosures. Freedman and Stagliano (2002) expect Initial Public Offering (IPO) status, with its consequent greater scrutiny of public disclosures, to affect environmental disclosures for those involved in Superfund sites but find no such effect. Cormier and Magnan (2003) find ownership dispersion (French/ foreign) positively associated with environmental disclosures in annual reports for French firms. Firm size is another characteristic that appears to influence environmental activities. Teoh and Thong (1984), interviewing managers of firms in Malaysia, find managers of larger firms more likely to describe their firms as having major involvement in environmental areas. Trotman and Bradley (1981), examining social reporting in annual reports by large Australian firms, find increasing size of firm associated with a greater likelihood of making social disclosures and with higher levels of disclosure. Patten (1991), examining annual reports for a similar group of firms and using a dichotomy of high and low disclosure levels with the midrange excluded, finds a significant positive effect for size. Adams, Hill, and Roberts (1998),

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examining social disclosures in the annual reports of firms in six European countries, find large firms more likely to disclose environmental information. Hackston and Milne (1996) examine social disclosures in annual reports for the 50 largest New Zealand companies. The authors find several measures of size positively correlated with quantity of disclosure. Cormier and Magnan (2003) find size positively associated with environmental disclosures in annual and environmental reports for French firms. Contrary evidence is provided by Cowen, Ferreri, and Parker (1987) who examine annual reports of 134 U.S. firms in various industries and find total social disclosures negatively associated with size. Size (using Fortune 500 rank), however, was examined for the entire sample and this may have obscured relationships within industries. The size of the effect by industry far exceeded that for firm size. Various types of firm risk have been investigated with respect to environmental disclosures. Trotman and Bradley (1981) find higher firm risk (beta) associated with a greater likelihood of making social disclosures but not with the level of these. Cormier and Magnan (2003) find risk positively associated and leverage negatively associated with environmental disclosures in annual and environmental reports for French firms. Li and McConomy (1999) find environmental standard adoption related to firm financial health, and level of uncertainty with respect to the environmental liabilities faced. Industry affiliation has been found to have an influence on environmental disclosures. Trotman and Bradley (1981) find the level of such disclosures was higher for those in more environmentally sensitive industries. Cowen et al. (1987) find total social disclosures positively associated with membership in the chemical industry. Patten (1991) noted a significant positive effect for industry classification, with firms divided into those in environmentally sensitive industries (oil, chemical, forest, and paper products) and others. Roberts (1992), using a Council of Economic Priorities (CEP) measure of social disclosures, finds larger disclosures associated with being in the automobile, airline, or oil industry. Adams et al. (1998), examining social disclosures in the annual reports of firms in six European countries, find firms in more environmentally sensitive industries (auto manufacturing and oil/chemical/metal/power) disclosing more. Hackston and Milne (1996) examine social disclosures in annual reports for the 50 largest New Zealand companies. The authors find firms in high profile industries (environmentally sensitive and/or others with high public visibility) disclosed more social information than those in other industries. These results uniformly support an effect on environmental disclosures by industry affiliation.

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Patten (1991), examining annual reports for a group of Fortune 500 firms drawn from several industries and using a dichotomy of high and low disclosure levels with the midrange excluded, finds no effect on voluntary social disclosures for profitability. Hackston and Milne (1996) examine social disclosures in annual reports for the 50 largest New Zealand companies. The authors find none of the profitability measures significantly correlated with disclosures. Buhr (2002) investigated the motivations for two Canadian pulp and paper firms to initiate environmental reports. One firm noted that profitability was an issue that influenced the timing of the report, as its expense was an issue. Gray, Javad, Power, and Sinclair (2001) provide an overview of the research on social and environmental disclosures and size, industry, and profitability, comment on why differences in findings may have occurred, and examine hypotheses regarding prior results. Using a Centre for Social and Environmental Accounting Research database of annual report disclosures for large U.K. firms, they provide a year-by-year examination of the relationships between disclosures and firm characteristics, demonstrating differences across years, indicating unstable relationships. In particular, three or four of the measures used (turnover, capital employed, net income before interest and taxes, and employees) were significantly related to environmental disclosures in 1988 to1990, while only one or two were so related in 1991 to 1995. The authors comment on the low explanatory power for these characteristics and that using industry specific analysis greatly improves explanatory power. Thus far, the results on the effects of firm/industry characteristics on environmental disclosure have been mixed. Future research could address the issues of size, industry affiliation, and firm risk as a group. Size has generally been found to be positively correlated with disclosure (Australian, Malaysian, U.S., European, U.K., and French firms in at least one study) as has industry affiliation. However, differences in concentration by industry exist. In some, a relatively few firms account for a significant percentage of the sales in that industry, while in others, many more firms are required to account for a similar percentage of industry sales. A systematic analysis of incremental explanatory power of size, given industry affiliation, could shed light on the independent effects of these factors. The effect of firm beta could be examined similarly. Industry classification has been found to be related to environmental disclosures, with those in environmentally sensitive industries disclosing more than those in other industries. While one might assume this is due to the existence of more substantial environmental risks in these industries, the nature of this relationship has not been investigated. Is

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the volume of disclosures or the range of disclosures (from current known liabilities to materials and processes likely to involve future environmental risks) related to the magnitude of expected future liabilities in an industry? With the number/magnitude of environmental court cases? With the level of toxic waste discharges reported by regulatory bodies? Profitability was found not relevant for disclosures for New Zealand firms (Hackston & Milne, 1996), firm financial health relevant to environmental standard adoption (Li & McConomy, 1999), and leverage negatively associated with disclosures (Cormier & Magnan, 2003). Buhr (2002) provides evidence that profitability impacted the timing of disclosures by affecting funds available to provide them. This leaves the role of profitability in environmental disclosure incompletely explained. Future research questions: Two studies indicate the availability of resources is relevant to environmental disclosure and one that higher leverage has a negative impact. Is this because such disclosures are seen as optional? Or because firms with financial resources do a better job in controlling environmental effects and seek credit for this? Or because controlling environmental problems and notifying investors of this is seen as part of rational management of a firm and those with better performance are simply better at all aspects of firm management?

3.4. Firm/Industry Factors: Rational Cost/Benefit Analysis Rational cost/benefit analysis could also lead to environmental disclosure and is an area that could be considered either as a firm/industry characteristic or as an individual/attitudinal one. Such disclosures could be the result of firms facing relatively high political costs. Roberts (1992), using a CEP measure of social disclosures, finds concern for governmental regulation, proxied by contribution to a political action committee, significantly related to increased disclosure, but with a relatively small impact. Being a corporate sponsor of a philanthropic organization was also significant and had a much larger impact. Li and McConomy (1999) find early adoption of environmental reporting standards in Canada related to firm financial health and low uncertainty with respect to the future, both likely to contribute to an ability to estimate and control environmental costs. McKeown (1999), in a commentary, notes that early adoption could be considered a signal relating to firm condition. Tilt and Symes (1999) discuss tax benefits as motivators for disclosure of environmental information. Buhr (1998) examines disclosures by Falconbridge, a firm involved in natural resource extraction, in a case study. The author finds the firm

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initially responded to regulation by developing technology to comply. It then continued to develop technology to comply with expected changes in regulations. The firm wanted to have sufficient time to develop the most appropriate technology, a benefit forgone if they waited for the rules to be enacted. The author suggests that this is the result of beliefs about the expected impact of public policy pressure on regulations. This could be considered as response to public pressure or rational cost/benefit analysis. Several studies, as noted earlier, address information costs in relation to environmental disclosures. Cormier and Magnan (1999) find evidence that higher information costs (more dispersed ownership) are associated with greater environmental disclosure. Cormier and Gordon (2001) provide evidence that social and environmental reporting by three electric utilities appears to be related to information costs, with the publicly held firms providing more disclosures. Cormier and Magnan (2003) examine factors that affect environmental reporting for French firms and find information costs (shareholder dispersion and trading volume) and media visibility positively associated with such reporting. Both increase the need to communicate with outside parties. Modeling has been used to examine cost/benefit and disclosure. Harford (1987) develops a profit-based model of a firm facing imperfectly enforceable regulations and draws implications for disclosure from it, depending on the structure of the fines levied. Li, Richardson, and Thornton (1997) model the decision to disclose environmental information as a sequential game involving pressure by the financial market (cost of capital) and other outside parties. They suggest an increased likelihood of disclosure with increases in pollution generated and in outside knowledge of what is done, and with decreases in the risk of outside negative reactions, though Hughes (1997) questions some of the assumptions of their model. Cormier and Magnan (1999) provide some support for Li et al. (1997), finding higher levels of pollution marginally associated with higher disclosure levels. Future investigations of environmental disclosure as a rational decision could follow several lines of inquiry. One is the influence of information available from third parties. There are a number of environmentally active groups, such as The Council on Economic Priorities and Coalition for Environmentally Responsible Economies. Does the availability of information on environmental performance from environmental groups affect disclosure decisions? The EPA has an agreement with the SEC to supply it with information on its list of Superfund PRPs. Has the potential for the use of EPA information under the agreement to supply information on violators to the SEC affected disclosure decisions?

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Another is the means organizations use to make such disclosure decisions. Do firms use formal committees, an informal process, or decisions by top management to decide what should be disclosed? If practice differs, is this variation associated with differences in disclosure either in volume or type (future liabilities, processes likely to result in environmental issues, or capital investment in pollution abatement or prevention)? Do practices vary with industry or firm profitability, both of which could relate to political costs? Or with firm complexity (e.g., number of product lines) or capital structure, both of which could affect information costs? A third line of inquiry is the input used to make the decision. Does the information included as input or the process employed vary with industry or type of risk? Do some solicit input from managers across the firm as to what might create future liabilities and others examine what competitors do? One would expect broader involvement in the process in industries where the identification of environmental risks is more difficult.

3.5. Individual Factors: Culture and Attitudes The influence of cultural forces and management attitudes on environmental disclosures has also been examined. Several studies find differences by nation, which could be due to culture. Culture could affect environmental disclosures through legal requirements or through impact on individuals’ attitudes toward such disclosures. Mathews and Reynolds (2001) explore ethical attitudes toward sustainability and environmental accounting in the timber industry in Scandinavian countries and the U.S. and find cultural differences with respect to perceived public pressure and confidentiality. Buhr and Freedman (2001) compare environmental disclosures by U.S. and Canadian firms over time and find higher growth in disclosures, particularly voluntary disclosures, by Canadian firms. An investigation of social disclosures in the annual reports of firms in six European countries (Adams et al., 1998) suggest that nation of origin influences social reporting practices. German firms were most likely to provide quantified disclosures and provided the greatest total number of disclosures, with French and Dutch firms providing the least number and the fewest quantified disclosures. Teoh and Thong (1984), surveying managers in Malaysia, report that national origin of owners affects social reporting practices. Chief Executive Officers (CEOs) of firms with majority ownership in Malaysia were most likely to respond that they include social reporting in their annual reports, while CEOs of firms primarily owned by those in Japan, Holland, and

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Singapore were least likely to respond positively. The authors of the study find attitudes of top management have the largest impact on firm social awareness, with legislation as the second. They also find differences in beliefs about firm social responsibilities across nations, with 20% of Malaysian firms agreeing with a statement that attention to profits is the only responsibility of management and none of the firms owned by British, U.S., Japanese, Dutch, Australian, or Singaporean interests agreeing. When asked about involvement with issues affecting the physical environment, 30% of Malaysian, 44% of British, 43% of U.S., 50% of Japanese, and none of Dutch, Australian, and Singaporean firms described it as a ‘‘major’’ area of involvement. Larrinaga-Gonzalez et al. (2001), using interview data, report on the attitudes of managers of Spanish firms toward the importance of the environment. The authors find a consideration for the environment coupled with a denial that their firms create any environmental problems. Firm ‘‘attitudes’’ may also affect environmental reporting. Trotman and Bradley (1981) find that firms whose managers place greater emphasis on long-term results of decisions were more likely to make social disclosures and the greater this emphasis, the higher the level of disclosure. Li and McConomy (1999) find environmental standard adoption related to firm environmental commitment as disclosed in annual reports. Buhr (2002) provides information from two case studies examining what influenced Canadian pulp and paper firms to initiate environmental reports. One firm expressed its motivations as a felt need to enable stakeholders, internal and external, to understand the firm’s environmental activities, and a desire to be an industry leader in this area. The second firm also noted a desire to provide information on their environmental actions. Wilmshurst and Frost (2000) survey Chief Financial Officers of Australian companies to determine factors influencing the decision to disclose environmental information. They find that shareholders’ right to information and concerns with community attitudes were both influential. Mitra (2000) discusses possible motivations to disclose environmental information, including firm commitment to such disclosure, desire to influence public perceptions, and investor need for information. However, some indicators of firm ‘‘attitude’’ have been found not to be associated with environmental disclosures. Cowen et al. (1987) find total social disclosures unaffected by the presence or absence of a corporate social responsibility committee. Tilt (2001) looks for an association between a firm having an official environmental policy and its annual report disclosure of environmental information but finds none. Solomon (2000) surveyed interested parties in the U.K. on their attitudes toward environmental reporting. These include a wide range of groups:

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environmental consultants, academics, people in environmental pressure groups, bankers, and employees of firms in all major industries. The results indicate some agreement on who would be users of such information (employees, legislators, regulators, and local communities) and on desirable disclosure characteristics (understandable, objective, and accurate). Results also indicate a desire for verification but no consensus on how this should be provided. O’Dwyer (2000), in a discussion of Solomon (2000), suggests that such an approach may limit the positive outcomes achieved by such reporting. The study notes a lack of emphasis by those surveyed on shareholders as a group to which such reporting should be directed, while the relevant U.K. Statement of Position claims that the needs of a wide range of users can be met by providing what investors want. Thus, financial reporting standards for environmental disclosures may or may not meet the needs of all stakeholders. Tenbrunsel, Wade-Benzoni, Messick, and Bazerman (2000) provide some support for O’Dwyer in a study using graduate students with business experience. The authors find solutions to environmental problems conforming to standards are more attractive simply by virtue of conforming, artificially reducing the attractiveness of other potential solutions. Deegan and Rankin (1999) find annual report users more likely than preparers to describe environmental disclosures as important and to feel they should be regulated. Stone (2001) reports on the issues considered by mutual fund managers of socially responsible funds and shows a desire on the part of one group of users for such information. Changes in what is considered appropriate reporting can also affect environmental disclosure. Neu and Simmons (1996) attempt to explain firm behavior using a web of social relations that surrounds managers, using a specific instance of accounting for site restoration as an example. The authors note that managerial behavior is typically addressed in accounting studies as the result of incentives related to managerial compensation contracts, debt contracts, and power relationships. This approach assumes rational economic self-interest on the part of managers, and ignores the potential influence of social relationships on choices. Friedman and Miles (2001) examine the trend in socially responsible investing. Using interviews with fund managers for socially responsible investment funds, people who advise pension funds on corporate governance, and individuals who provide corporate social reporting benchmarking schema, they provide evidence of the potential for an increase in demand for social disclosures. Buhr (2002) finds a Canadian pulp and paper firm initiated environmental reports partly because another firm in their industry was publishing such a report, leading to pressure to do the same. Campbell (2000) examines social disclosure by

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Marks and Spencer Plc over time and finds variability related to changes in the chief executive officer of the firm. Thus, there is evidence that national culture affects environmental reporting and that attitudes of individuals within cultures can also have an effect. Future research with respect to the influence of culture and attitudes on environmental reporting might consider two general issues. One is the source of this effect and another its strength. Is the effect related to attitudes toward the preservation of life or of the physical environment? Are these consistent across national boundaries? Does any effect grow with the increased presence of environmentally sensitive industries in an area? Is it reduced when competitive pressures increase? Or with increases in the level of potential liabilities involved?

4. CONCLUSION If academic articles, dissertations, and manuscript presentations at national and/or regional accounting academic meetings are indicative, interest in environmental accounting research ebbed in the mid-1990s. Limited progress is currently being made in this important area, although many research questions still remain and the potential benefits of addressing these issues are significant. This was the underlying motivation of this literature review and research agenda: to stimulate discussion, encourage environmental research from all areas of accounting, and thus, to contribute to the advancement of accounting knowledge. In this study, a framework was developed and utilized to categorize environmental academic studies as to: (1) laws and regulations, (2) legitimacy, public pressure, and publicity, (3) firm/industry characteristics, (4) rational cost/benefit analysis, and (5) cultural forces and attitudes. Opportunities for future research in the environmental area are many and varied, and noted throughout this article. The authors believe the accounting profession and academia are well placed, as independent parties external to firms, to address these research issues and suggest improvements in environmental reporting and disclosure. Accounting is a primary data source for external stakeholders, and those involved in accounting have the expertise to address questions of what should be disclosed, how it should be disclosed, and the effects of such disclosure. Information on what encourages or discourages environmental disclosures by companies and individuals could have a direct influence on future firm reporting and its ability to meet the needs of external decision makers.

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In summary, environmental accounting issues related to financial reporting and disclosure continue to increase in importance to both firms and stakeholders – firms seek to control environmental risks, while stakeholders want more relevant and timely information. Both of these motivations suggest that the accounting profession and academia can play a substantive role in addressing these issues and meeting the environmental information needs of both firms and their stakeholders.

5. LIMITATIONS In common with other articles attempting to summarize the relevant literature, there are several limitations to the literature review and research agenda presented in this study. The authors subjectively developed the classification scheme used, identified and selected academic articles to include, and categorized them by topical areas. Working papers and professional articles were not included. Relevant publications may have been overlooked or omitted, and some areas of interest not addressed. While the authors did make a diligent effort to be concise and identify primary contributions of each article, misinterpretations may have occurred. While some future research questions are presented, those identified by the authors are far from all-encompassing.

NOTES 1. See Deegan and Newson (1996). 2. Areas such as allowing capitalization or expensing of research and development (R&D) costs and allowing choice in how to account for mergers and acquisitions.

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Patten, D. M. (2002). Media exposure, public policy pressure, and environmental disclosure: An examination of the impact of TRI data availability. Accounting Forum, 26(2 (June)), 152–171. Patten, D. M., & Trompeter, G. (2003). Corporate responses to political costs: An examination of the relation between environmental disclosure and earnings management. Journal of Accounting and Public Policy, 22(1 (January)), 83–94. Puxty, A. G. (1986). Social accounting as immanent legitimation: A critique of a technicist ideology. Advances in Public Interest Accounting, 1, 95–111. Roberts, R. W. (1992). Determinants of corporate social responsibility disclosure: An application of stakeholder theory. Accounting, Organizations and Society, 17(6 (August)), 596–612. Rockness, J. W., Schlachter, P., & Rockness, H. O. (1986). Hazardous waste disposal corporate disclosure, and financial performance in the chemical industry. Advances in Public Interest Accounting, 1, 167–191. Rouse, R. W., & Weirich, T. R. (1997). Current environmental disclosures in the oil & gas industry. Oil, Gas & Energy Quarterly, 45(4 (May)), 737–754. Sack, R. J., Boatsman, J. R., Fell, R. S., Krogstad, J. L., Martin, S. J., & Niles, M. S. (1995). Mountaintop issues: From the perspective of the SEC. Accounting Horizons, 9(1 (March)), 79–86. Securities and Exchange Commission. (2003). Study pursuant to section 108(d) of the SarbanesOxley Act of 2002 on the adoption by the United States financial reporting system of a principles-based accounting system. Washington, DC: Securities and Exchange Commission. Sikich, Geary W. (1991). Reducing environmental vulnerability. New Accountant(March), 8–42. Solomon, A. (2000). Could corporate environmental reporting shadow financial reporting? Accounting Forum, 24(1 (March)), 30–55. Stafford, S. L. (2002). The effect of punishment on firm compliance with hazardous waste regulations. Journal of Environmental Economics and Management, 44(2 (September)), 290–308. Stanny, E. (1998). Effect of regulation on changes in disclosure of and reserved amounts for environmental liabilities. Journal of Financial Statement Analysis, 3(4 (Summer)), 34–49. Starkman, D. (1997). Pollution case highlights trend to let employees take the rap. The Wall Street Journal(October 9), B10. Stice, E. (1991). The market reaction to 10-K and 10-Q filings and to subsequent. The Wall Street Journal earnings announcements. The Accounting Review, 66(January), 42–55. Stolowy, H., & Jeny-Cazavan, A. (2001). International accounting disharmony: The case of intangibles. Accounting, Auditing & Accountability Journal, 14(4), 477–496. Stone, B. A. (2001). A special-purpose taxonomy of corporate social performance concepts. Accounting and the Public Interest, 1(July), 42–72. Sutton, S. G. (2000). The changing face of accounting in an information technology dominated world. International Journal of Accounting Information Systems, 1(1 (March)), 1–8. Tenbrunsel, A. E., Wade-Benzoni, K. A., Messick, D. M., & Bazerman, M. H. (2000). Understanding the influence of environmental standards on judgments and choices. Academy of Management Journal, 43(5 (October)), 854–866. Teoh, H., & Thong, G. (1984). Another look at corporate social responsibility and reporting: An empirical study in a developing country. Accounting, Organizations and Society, 9(2), 189–206.

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Tilleman, W. A., & Wright, M. E. (1993). Disclosure of the future removal and site restoration cost liability by Canadian oil and gas companies. Petroleum Accounting and Financial Management Journal, 12(3 (Fall/Winter)), 57–81. Tilleman, W. A., & Wright, M. E. (1994). Disclosure of the future removal and site restoration cost liability by Canadian oil and gas companies: A replication and extension. Petroleum Accounting and Financial Management Journal, 13(3 (Fall/Winter)), 98–116. Tilt, C. A. (1994). The influence of external pressure groups on corporate social disclosure; Some empirical evidence. Accounting, Auditing & Accountability Journal, 7(4), 47–72. Tilt, C. A. (2001). The content and disclosure of Australian corporate environmental policies. Accounting, Auditing & Accountability Journal, 14(2), 190–212. Tilt, C. A., & Symes, C. F. (1999). Environmental disclosure by Australian mining companies: Environmental conscience or commercial reality? Accounting Forum, 23(2 (June)), 137–154. Toms, J. S. (2002). Firm resources, quality signals and the determinants of corporate environmental reputation: Some UK evidence. The British Accounting Review, 34(3 (September)), 257–282. Trotman, K. T., & Bradley, G. W. (1981). Associations between social responsibility disclosure and characteristics of companies. Accounting, Organizations and Society, 6(4), 355–362. Ullman, A. A. (1979). Corporate social reporting: Political interests and conflicts in Germany. Accounting, Organizations and Society, 4(1/2), 123–133. U.S. Office of Technology Assessment. (1989). Coming clean: Superfund problems can be solved. Washington, DC: U.S. Government Printing Office. Vendrzyk, V. P. (1993). An examination of the information content of allegations of procurement fraud in the defense contracting industry. Ph.D. dissertation, Texas A&M University. Verrecchia, R. E. (2001). Essays on disclosure. Journal of Accounting and Economics, 32, 97–180. Walden, W. D., & Schwartz, B. N. (1997). Environmental disclosures and public policy pressure. Journal of Accounting and Public Policy, 16(2 (Summer)), 125–154. Warsame, H., Neu, D., & Simmons, C. (2002). Responding to Discrediting events: Annual report disclosure responses to environmental fines. Accounting and the Public Interest, 2(April), 1–20. White, A. L. (1999). Sustainability and the accountable corporation: Society’s rising expectations of business. Environment, 41(8 (October)), 30–43. Wilmshurst, T. D., & Frost, G. R. (2000). Corporate environmental reporting; A test of legitimacy theory. Accounting, Auditing & Accountability Journal, 13(1), 10–26. Wright, C. J. (1982). Accounting for reclamation costs of oil and gas operations. Petroleum Accounting and Financial Management Journal, 1(1 (Spring)), 77–105. Wright, C. J. (1998). Environmental accounting in the oil and gas industry. Petroleum Accounting and Financial Management Journal, 17(2 (Summer)), 30–49. Wright, C. J., & Wright, S. T. (2000). Accounting for site closure and environmental costs: A new maze of standards and requirements. Oil, Gas & Energy Quarterly, 48(3 (February)), 481–494.

THE VOLUNTARY DISCLOSURE OF ADVERTISING EXPENDITURES: THE CASE OF THE PHARMACEUTICAL INDUSTRY AND HEALTHCARE REFORM Joseph Legoria ABSTRACT This paper investigates whether pharmaceutical firms were less likely to disclose advertising costs in response to the debate over healthcare reform. In 1994, the Securities and Exchange Commission (SEC) issued Financial Reporting Release No. 44 (FRR No. 44), which no longer required the disclosure of advertising. The results indicate that starting in 1994 the disclosure of advertising declined for all firms. This finding is consistent with all firms facing a level of proprietary costs and discontinuing the disclosure of advertising after FRR No. 44 was issued. However, for larger and more profitable pharmaceutical firms, there is an incremental effect as those firms were less likely to disclose advertising suggesting that these firms potentially faced increased-political costs and responded by not disclosing advertising costs consistent with the research hypotheses.

Advances in Accounting Advances in Accounting, Volume 21, 113–146 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21005-2

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1. INTRODUCTION This study examines the voluntary disclosure of advertising expenditures made by firms in the pharmaceutical industry during the period from 1989 to 1997 in order to determine whether the disclosure practices of drug firms were affected by the debate over healthcare reform. Prior to 1994 the SEC required firms to disclose material advertising costs in Schedule X of the annual Form 10-K. Beginning in 1994 the SEC dropped this requirement, thus allowing pharmaceutical and other firms to discontinue disclosing material advertising expenses if desired.1 Shortly before the SEC’s rule change (i.e. during 1992–1993), candidate Clinton attacked large advertising expenditures, and resulting profits, made by pharmaceutical firms. These circumstances combined to provide pharmaceutical firms with both the motive and opportunity to discontinue disclosing their advertising expenditures. Theoretical research (e.g. Verrecchia, 1983) suggests that managers should not fully disclose information because of the existence of proprietary costs. These costs are the result of disclosing information, which may negatively affect the firm if parties outside the firm become aware of that information. Healy and Palepu (2001) posit that the proprietary costs hypothesis can be extended to the political process and provide a theoretical foundation for firms changing their disclosure policies in response to political costs. The case of the pharmaceutical industry and healthcare reform provides a unique setting to test whether firms follow a policy of nondisclosure when faced with the existence of additional proprietary costs that are the result of the political process. Healthcare reform was a major issue used by candidate Clinton to get elected in 1992 and the major piece of domestic public policy legislation he submitted to Congress during 1993. As part of his strategy to get a healthcare reform plan passed by Congress, the President and his administration attempted to influence public opinion by routinely attacking the pharmaceutical industry as the major source of rising healthcare costs, with a specific criticism of the industry’s spending on advertising (Greenberg, 1993; Birnbaum & Waldholz, 1993; The Center For Public Integrity, 1994). By disclosing advertising expenditures, firms could increase their proprietary costs consistent with the arguments of Verrecchia (1983). Conversely, withholding this information could help prevent the industry’s opponents (e.g. President Clinton and Congress) from imposing regulations that would result in wealth transfers from the industry to the government (e.g. Wagenhofer, 1990). Thus, by not disclosing their advertising costs, pharmaceutical firms were perhaps trying to avoid providing their critics

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with information that could be used to justify increased regulation of the industry. The decision to not disclose advertising costs may be immaterial to the company as investors and analysts are more likely interested in a pharmaceutical firm’s research and development activities (R&D) when valuing a drug firm’s stock. Investors and analysts can probably determine how successful a firm’s advertising is by analyzing sales information from financial statements and other sources or may not be interested in this information at all because advertising expenditures tend to have little effect on future earnings (Bublitz & Ettredge, 1989). The disclosure of advertising expenditures may be value relevant to some investors since some firms have disclosed them in the past and some continue to do so. However, even these investors may be willing to forgo this information in situations in which advertising expenditures are being attacked by politicians and regulators. Accordingly, not disclosing advertising expenditures may have been an optimal strategy for the pharmaceutical industry to follow during this period. While the SEC’s release of FRR No. 44 in 1994 was the event that allowed firms to discontinue disclosure of advertising costs, it also represents a potential confounding event since its release coincides with the increase in political costs for pharmaceutical firms. In addition, the SEC’s rule change allowed the pharmaceutical firms to discontinue disclosing advertising costs consistent with the political cost hypothesis and allowed all other firms facing any variety of proprietary costs to also discontinue separate disclosure. Thus, to better test whether increased political costs arising from the healthcare reform debate, as opposed to FRR No. 44, resulted in pharmaceutical firms not disclosing their advertising costs, both pharmaceutical firms and a control set of firms from other industries are analyzed together. A Chamberlain two-way fixed-effects logistic regression model was used in the analysis. The results indicate an overall decrease in the level of disclosure of advertising expenditures for all firms during the period from 1994 to 1997, but do not indicate that pharmaceutical firms were less likely to disclose advertising than firms in other industries. Thus, this paper finds no evidence of ‘‘industry membership’’ increasing a firm’s political cost. Rather, the results are consistent with all firms facing a level of proprietary costs and discontinuing to disclose information that is not required to reduce those costs (Verrecchia, 1983). However, the findings confirm the predicted relation between larger and more profitable firms in the pharmaceutical industry being less likely to disclose advertising costs in the time period from 1994 to 1997. The results show that the probability of these firms disclosing

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advertising costs, compared to firms in other industries, was significantly lower in the period from 1994 to 1997 than it was prior to 1994. These findings suggest the change in disclosure of advertising costs observed for the control firms was the result of FRR No. 44 and that political costs were not a factor in the control firms’ voluntary disclosure decisions. These findings are consistent with the proprietary cost hypothesis and control firms discontinuing separate disclosure of advertising to minimize nonpolitical proprietary costs. On the other hand, the findings suggest that for certain firms in the pharmaceutical industry there was an incremental effect consistent with increased political costs resulting in larger and more profitable firms in that industry decreasing their voluntary disclosure of advertising expenditures. This study contributes to the literature by investigating the impact of political costs on firms’ voluntary disclosures of accounting information (i.e. advertising costs), an issue on which there is limited empirical evidence. The findings of this study are consistent with: (1) the political process affecting the voluntary disclosure of financial information by larger and more profitable firms in a politically sensitive industry, and (2) that those firms will discontinue disclosing information that their critics (e.g. politicians and pharmaceutical industry) could use to justify regulations against them. The remainder of this paper proceeds as follows. Section 2 reviews the prior research on voluntary disclosure. Section 3 develops and presents the research hypothesis. Section 4 describes the data and methodology. Section 5 presents the research findings, and Section 6 concludes the paper.

2. PRIOR RESEARCH ON VOLUNTARY DISCLOSURE 2.1. Theoretical Background Analytical research in economics on voluntary disclosure of information has demonstrated that in the absence of costs, managers should follow a strategy of full disclosure (e.g. Grossman, 1981; Milgrom, 1981). Casual observation and empirical findings indicate that managers do not fully disclose all information.2 Verrecchia (1983) attempts to reconcile the differences between the theoretical models and the empirical findings by arguing that the existence of proprietary costs results in managers not fully disclosing information. These proprietary costs, which are costs associated with the disclosure of information, may have a negative impact on firm value if parties other than investors (e.g. competitors and regulators) become aware of that

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information. Thus, Verrecchia (1983) shows that managers will only disclose information if the benefits from its release exceed the proprietary costs incurred because of the disclosure. According to Verrecchia (1983) failure to disclose information does not negatively affect the firm because investors and other potential users of the firm’s information are unable to determine whether this lack of disclosure suggests the firm is refraining from releasing bad news or that the firm’s information represents good news, but without the substance to warrant the proprietary costs associated with the disclosure.3 Watts and Zimmerman (1986) argue that firms concerned about political costs might not fully disclosure financial information in order to minimize political exposure. Wagenhofer (1990) points out that firms may respond to increased political costs by following a strategy of non-disclosure. He argues that if the risk of adverse action by an opponent (e.g. government regulatory agency) is relatively low ex ante, and the proprietary costs are rather high, then the firm’s strategy will be to prevent the opponent from taking adverse action against the firm by not disclosing information. More recently, Healy and Palepu (2001) note that the proprietary cost hypothesis can be extended to include other externalities from information disclosure, and thus, it might be useful in providing a theoretical framework for explaining how political costs affect voluntary disclosure. For example, rather than viewing proprietary costs in the context of competitive markets where a particular firm is concerned that full disclosure may damage its position relative to other firms, one can view proprietary costs in the context where if a firm fully discloses information, the government can use that information to justify increased regulation of that particular firm or that firm’s industry. As a result, firms facing political exposure may not fully disclose information.

2.2. Empirical Findings of Prior Research Prior research has examined managers’ voluntary disclosure decisions in many contexts. Prior studies have examined why managers voluntarily release earnings forecasts (e.g. Penman, 1980; Waymire, 1984; Lev & Penman, 1990) and have found that managers release good news forecasts more often than bad ones. However, more recent studies have shown that in addition to disclosing good news earnings forecasts, managers also voluntarily disclose bad news forecasts (e.g. Pownall, Wasley, & Waymire, 1993; Skinner, 1994). In addition, research on voluntary disclosure has begun examining other issues besides earnings forecasts. For example, Frost (1997) examined the

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disclosure practices of 81 U.K. firms that received qualified audit opinions and found that most of these firms voluntarily disclose this information before the release of the annual report. Additional issues examined in voluntary disclosure literature include the association between firm characteristics and its disclosure strategies and how that disclosure strategy is interpreted by financial analysts when rating the firm (Lang & Lundholm, 1993), the relation between disclosure and shareholder litigation (Francis, Philbrick, & Schipper, 1994), and disclosure policy before the release of a large earnings surprise (Kasznik & Lev, 1995). There have been few studies that have examined the impact of political costs on voluntary disclosure decisions. One notable exception is the study by Wong (1988) who examined the incentives for voluntary disclosure of current cost information in New Zealand. During the 1970s, New Zealand experienced rapidly changing price levels and, as a result, the New Zealand government allowed firms to make current cost adjustments to financial statements, which, in general, were income decreasing. He found that tax considerations and political cost considerations were major motivations for New Zealand firms to voluntarily disclose current cost information. As a result, his findings are consistent with the notion that firms use their voluntary disclosure policies to prevent wealth transfers via government regulation.4

3. HYPOTHESIS DEVELOPMENT Watts and Zimmerman (1986) contend that government regulators and politicians use accounting information to support their criticism of a firm or industry that is making ‘‘excess profits’’ resulting in the political cost hypothesis (PCH). They contend that firms will make accounting choices that reduce earnings in order to reduce political exposure. There are many studies in the extant accounting literature with findings that support the PCH.5 Although the accounting choice in this study, the voluntary disclosure of advertising expenditures, is not one that will reduce earnings, it is an accounting choice (i.e. disclosure choice) that firms in the pharmaceutical industry could use to help reduce their political costs (e.g. Wagenhofer, 1990), and it is consistent with the arguments of Watts and Zimmerman (1986). This section of the paper develops the research hypotheses and demonstrates that the criticisms of the pharmaceutical industry provided incentives for the industry to discontinue disclosing their advertising expenditures in order to prevent increased regulation of the industry consistent with the theoretical reasons underlying the PCH.

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3.1. Healthcare Reform and the Pharmaceutical Industry The pharmaceutical industry’s pricing of drugs was routinely criticized by both Candidate Clinton and members of Congress during the Presidential and Congressional campaigns of 1992. Shortly after his inauguration, President Clinton questioned the pharmaceutical industry’s motives and attacked the industry’s ‘high profitability.’ In a speech delivered in February of 1993, the President noted that the pharmaceutical industry’s spending on advertising and marketing exceeded its spending on research and development by $1 billion (Birnbaum & Waldholz, 1993). In addition, the President cited a 1992 Congressional staff report entitled Prescription Drug Costs: A Bitter Pill To Swallow pointing out that the pharmaceutical industry’s profits were rising four times faster than the profits of the average Fortune 500 company. The President accused the industry of ‘shocking’ prices and called for the industry to change its spending priorities because ‘we cannot have profits at the expense of our children’ (Birnbaum & Waldholz, 1993; Greenberg, 1993). From the President’s perspective, the industry’s spending on advertising was partially responsible for inflating revenues, which resulted in what President Clinton’s Administration felt were ‘excessive profits.’ Throughout 1993 the President, his aides, and government agencies continued to attack the pharmaceutical industry.6 Finally, on September 22, 1993, the President officially released his plan for reforming healthcare which included federally mandated prices for new drugs; a 15–17% rebate from pharmaceutical firms (estimated at $2.5 billion) to the government for drugs covered in the Medicare and Medicaid programs; the exclusion of ‘excessively priced’ new prescription drugs from the Medicare and Medicaid programs. These proposals brought immediate reaction from the pharmaceutical industry. For example, Lodewijk de Vink, President and Chief Operating Officer of Warner-Lambert Co., stated ‘we are talking about regulations that could affect the very survival of an industry that used to be very successful’ (Waldholz, 1993). And Leigh Thompson, chief scientific officer of Eli Lilly & Co. responded to President Clinton’s plan by stating ‘it is crippling, it’s absolutely devastating’ (Tanouye, 1993).

3.2. Research Hypotheses Ball and Foster (1982) suggest that industry membership may be an indication of a firm’s sensitivity to the political process. The previous discussion provides evidence that the pharmaceutical industry faced increased political

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costs because of the President’s healthcare reform plan. As part of his strategy to gather public support for his plan, the President and other regulators used accounting information to justify that government action was the best way to reform the U.S. healthcare system. The industry’s advertising spending was specifically cited as evidence that the industry was more concerned about earning profits than spending money on R&D to develop new and better drugs (Greenberg, 1993; Birnbaum & Waldholz, 1993; The Center For Public Integrity, 1994). However, unlike R&D, firms are not required by the FASB or the SEC to disclose their level of advertising expenditures. Accordingly, if pharmaceutical firms voluntarily disclosed their advertising expenditures, this disclosure would allow President Clinton and other industry critics to compare a particular firm’s and the industry’s advertising spending to other spending (e.g. spending on R&D). Wagenhofer (1990) shows that the firm can prevent an opponent (i.e. government regulators) from taking adverse action against them by not disclosing information while Verrecchia (1983) indicates that non-disclosure of information is preferable when proprietary costs exist. FRR No. 44’s removal of required disclosure of advertising costs allowed all firms facing any variety of proprietary cost to discontinue separate disclosure of advertising. Thus, control firms also have incentives to reduce their proprietary costs by discontinuing their disclosure of advertising costs. However, in the case of the pharmaceutical industry and the debate over healthcare reform, pharmaceutical firms faced additional proprietary costs that were the result of the political process and were thus political costs. Thus, given the attacks faced by the industry during 1993, pharmaceutical firms had additional incentives to not disclose their level of advertising expenditures. The discussion above leads to the following two hypotheses: H1A. Ceteris paribus, there is a lower probability of control firms disclosing advertising expenditures in the years from 1994 to 1997 than in the years before 1994. H1B. Ceteris paribus, there is a lower probability of pharmaceutical firms, compared to firms in other industries, disclosing advertising expenditures in the years from 1994 to 1997 than in the years before 1994. Watts and Zimmerman (1986) argue that the higher a firm or industry’s profitability, the greater its political cost. They argue that this provides managers with incentives to make accounting choices that reduce income to help reduce political costs. Prior research (e.g. Watts & Zimmerman, 1986, 1990) has shown that firms with increased political costs make accounting

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choices to reduce those costs. The most profitable pharmaceutical firms were possibly more sensitive to President Clinton’s attacks on their advertising spending.7 This leads to the following hypothesis: H2. Ceteris paribus, the higher the profitability the lower the probability of a pharmaceutical firm, compared to firms in other industries, disclosing advertising expenditures in the years from 1994 to 1997 than in the years before 1994. Prior research (e.g. Watts & Zimmerman, 1986) has used firm size as a proxy for political costs. Larger firms are more likely to attract the attention of politicians and regulators and are thus more sensitive to the political process. During the healthcare debate larger pharmaceutical firms may have had more incentives to not disclose their advertising expenditures. This leads to the following hypothesis: H3. Ceteris paribus, the larger the firm the lower the probability of a pharmaceutical firm, compared to firms in other industries, disclosing advertising expenditures in the years from 1994 to 1997 than in the years before 1994. Theoretically, the year 1993 should be the first year to test the hypotheses for the following reasons. First, although the pharmaceutical industry was criticized during 1992, President Clinton was not elected until November of that year, and he did not give any specifics as to how he would reform healthcare until after he was inaugurated. Second, some pharmaceutical executives gave their endorsements to Candidate Clinton while others expressed a willingness to work with the President to help achieve his goals.8 Finally, after President Clinton began attacking the pharmaceutical industry in early 1993, even those in the industry that had supported him in 1992 began to publicly express their disappointment over President Clinton’s attacks.9 However, before 1994 the SEC required firms to disclose advertising costs. Thus, 1994 is the first year used to test the hypotheses since the political costs facing the industry in 1993 had not subsided and non-disclosure of advertising was now an option available to firms to respond to the increased political costs.10 Although President Clinton’s healthcare reform plan was defeated in September of 1994 and the Republicans took over Congress in November of that year, managers in the pharmaceutical industry were still expected to avoid disclosing their advertising expenditures during the years from 1995 to 1997. The pharmaceutical industry, at that time, probably wanted to avoid giving their critics additional information to use against them after

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healthcare reform had just been defeated. In addition, since healthcare was/ is still a major unresolved public policy issue and President Clinton ran for re-election in 1996, the industry had incentives to continue the policy of not disclosing advertising expenditures until after the 1996 elections.11

4. DATA AND METHOD 4.1. Sample Selection To select the sample, all firms in the pharmaceutical industry (SIC code 2834) that were included in the Compustat Industrial PST and Research file for the years 1989–1997 were identified. A review of the 1998 Compustat Company coverage file revealed 190 publicly traded pharmaceutical firms. To remain in the sample, firms had to have sufficient data for all years from 1989 to 1997 to calculate the variables described in the research design section.12 This selection procedure resulted in a final sample of 85 pharmaceutical firms.13 Any decreased disclosure of advertising costs observed in the pharmaceutical industry could be the result of the change in regulatory environment (i.e. FRR No. 44) in 1994. Also, it is possible that macro-economic or political factors beginning in 1993 were such that firms in other industries also changed their disclosure practices with respect to advertising expenditures. To determine whether pharmaceutical firms voluntarily disclosed advertising expenditures less often than firms in other industries during the period from 1994 to 1997, and were thus facing greater political costs, a control sample of firms outside the pharmaceutical industry was obtained. The control firms were selected from among all 1997 active Compustat firms in the manufacturing sector (SIC 2000–3999) using the following criteria. First, the firm must be in an industry that had a mean advertising to sales ratio greater than zero in the period before 1994.14 Firms in any industry that had a mean advertising-to-sales ratio greater than zero were selected to be included in the control sample. Second, firms had to have complete data available on Compustat for the period from 1989 to 1997. After applying the sample selection criteria, 1,525 firms remained in the control sample.

4.2. Variable Selection and Variable Measurement Prior research on voluntary disclosure (e.g. Holthausen & Leftwich, 1983; Kelly, 1983) predicts that firms use discretionary disclosure to control

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agency conflicts among managers, stockholders and debtors and thus, agency costs. Control variables that have been hypothesized or shown in the prior literature to affect voluntary disclosure by influencing the level of agency costs are included in the logistic regression model. A measure to control for industry competition is also incorporated into the model. Return on equity (ROE), measured as net income divided by total stockholders’ equity controls for differences in the level of voluntary disclosure due to the profitability of the firm. Firms that are highly profitable may want to provide investors as much information as possible and suggest that these firms will disclose more information about advertisement spending. The predicted sign for ROE is positive. Firm size (SIZE), measured as the log of total assets, is included in the model to control for the differences in agency costs due to firm size. Jensen and Meckling (1976) show analytically that as the percentage of capital that is raised outside the firm increases, agency costs also increase. Leftwich, Watts, and Zimmerman (1981) suggest that larger firms have more outside capital. As a result, the level of voluntary disclosure should be positively related to SIZE since increased disclosure would reduce agency costs and provide benefits to management, shareholders, and debtholders. Prior studies that have shown this relation include McNally, Eng, and Hasseldine (1982) and Chow and Wong-Boren (1987). The predicted sign for SIZE is positive. Leverage (LEV), measured as the book value of debt divided by total assets, controls for differences in agency costs among firms due to the level of debt they have in their capital structure. Agency theory (e.g. Jensen & Meckling, 1976; Smith & Warner, 1979) suggests that firms with larger amounts of debt in their capital structure face greater agency costs, which dictates providing more information to those outside the firm. Thus, in order to reduce agency costs the level of voluntary disclosure should be positively related to LEV. Assets in place (ASSETPL), measured as the level of fixed assets, net of depreciation, divided by total assets controls for differences in agency costs among firms due to the level of assets a firm has in place. Myers (1977) suggests that agency costs are lower for firms with large amounts of assets in place. As a result, Chow and Wong-Boren (1987) theorize that the level of voluntary disclosure should be negatively related to the firms’ proportion of assets in place. The expected coefficient on ASSETPL is negative. Theoretical research suggests that competition (COMP) affects whether a firm voluntary discloses information. The period from 1993 to 1997, during which the pharmaceutical industry faced increased political costs, was also a

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period where the U.S. economy and corporate profits grew at record rates. These factors typically result in increased competition for firms in profitable industries, and as firms face greater competition, they are less likely to disclose information. On the other hand, competition may result in firms disclosing more information in order to prevent new competition in their industry (e.g. Darrough & Stoughton, 1990). Thus, not controlling for competition could result in a correlated omitted variable. The Herfindahl–Hirschmann Index (HHI) is used as a proxy for competition.15 The HHI ranges between 10,000 for pure monopolies and zero for an industry with an infinite number of small firms. An industry with an HHI of below 1,000 can be viewed as unconcentrated and thus, having significant competition. The variable COMP is calculated by subtracting the HHI from 10,000. Larger values of COMP represent firms that are in very competitive industries. However, because of the uncertainty of how competition affects disclosure, there is no predicted sign for COMP.

4.3. Model Development The model used to test the research hypotheses explains the variance in disclosure of advertising (ADVT) for the control firms in the pre-1994 period as follows: ADVT ¼ f ðIntercept; ROE; SIZE; LEV; ASSETPL; COMPÞ

(1A)

Model (1A) allows for the possibility that the continuous variables could be significant in the pre-period for the following reasons: (1) these variables may proxy for material advertising expense in the pre-period; (2) some firms did not comply with mandatory disclosure in the pre-period and acted as if disclosure was voluntary, and (3) some firms that disclosed advertising expense in the pre-period may have had immaterial advertising costs and yet still chose to voluntary disclose. To determine whether control firms were more likely to discontinue disclosing advertising expenditures after FRR No. 44, the indicator variable PCOST was created and interacted with SIZE and ROE. PCOST, coded 1 for years from 1994 to 1997 and 0 otherwise, represents a measure of how FRR No. 44 affected control firms and whether those firms were less likely to disclose advertising beginning in 1994. The predicted sign for PCOST is negative since control firms are likely to view the ability to discontinue disclosing their advertising expense as a means to reduce their proprietary cost.

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The voluntary disclosure literature suggests that the control firms should disclose their advertising expenditures consistent with the predictions above. For example, in the absence of political costs, both larger (SIZE) and more profitable (ROE) firms would be expected to disclose their advertising expenditures. Still, the model allows for the possibility that the control firms experienced shifts in coefficients for SIZE and ROE by interacting those two variables with PCOST. PCSIZE, is calculated as PCOSTSIZE, and PCROE is calculated as PCOSTROE. The model assumes that there is no change in the coefficients for LEV, ASSETPL, and COMP. Therefore, model (1B) explains the variance in ADVT for control firms in the postperiod (1994–1997) as follows: ADVT ¼ f ðPCOST; PCROE; PCSIZE; LEV; ASSETPL; COMPÞ (1B) To determine whether pharmaceutical firms were more likely to discontinue disclosing advertising expenditures compared to the control firms, the indicator variable PHARM was created and then interacted with other variables to measure the marginal effect of political costs on the disclosure of advertising by firms in pharmaceutical industry. PHARM is set to 1 if the firm is in the pharmaceutical industry (SIC 2834) and 0 otherwise. There is no predicted sign for PHARM as it is not included in the model since it is time invariant with the individual firm intercepts resulting in perfect collinearity.16 The indicator variable PHARM is then interacted with ROE, SIZE, LEV, ASSETPL, and COMP creating the variables PHARMROE, PHARMSIZE, PHARMLEV, PHARMASSETPL, and PHARMCOMP. Model (1C) explains the variance in ADVT for test firms in the pre-period (1989–1993) as follows: ADVT ¼ f ðPHARMROE; PHARMSIZE; PHARMLEV, PHARMASSETPL; PHARMCOMPÞ

ð1CÞ

The indicator variable PHARM is then interacted with PCOST, PCSIZE, and PCROE creating the variables, PHARMPCOST, PHARMPCSIZE, and PHARMPCROE, respectively. Model (1D) explains the variance in ADVT for pharmaceutical firms in the post-period as follows: ADVT ¼ f ðPHARMPCOST; PHARMPCROE; PHARMPCSIZE, PHARMLEV; PHARMASSETPL; PHARMCOMPÞ

ð1DÞ

The variables of interest in this study are PHARMPCOST, PHARMPCSIZE, and PCPHARMROE, respectively. The coefficient for PHARMPCOST must be interpreted along with PCOST to determine whether

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pharmaceutical firms were less likely to disclose advertising costs after 1993. If the netting of the coefficients on PCOST and PHARMPCOST is negative and the coefficient on PHARMPCOST is negative and significantly different from zero, this would suggest that political costs were industry wide and not restricted to only a few select firms and provide some support for H1. PHARMPCSIZE, and PHARMPCROE are both interaction variables and are used to test H2 and H3, respectively. PHARMPCSIZE, calculated as PHARMPCSIZE, represents a measure to determine whether larger pharmaceutical firms were more sensitive to President Clinton’s attacks. Positive accounting research (e.g. Watts & Zimmerman, 1986, 1990) has shown that larger firms make accounting choices that reduce their political costs. Thus, this would suggest that after the President’s election and criticism of the pharmaceutical industry larger firms would have incentives to not disclose advertising costs. A negative and significant coefficient on PHARMPCSIZE is consistent with H2 and the larger pharmaceutical firms having the brunt of political costs. PHARMPCROE, calculated as PCROEPHARM, represents a measure to determine whether the most profitable pharmaceutical firms were more sensitive to political attacks. Positive accounting research (e.g. Watts & Zimmerman, 1986, 1990) indicates that firms in profitable industries (e.g. oil & gas in the 1970s) make income-decreasing accounting choices to reduce political costs. Profitable pharmaceutical firms may be those that spend large amounts on advertising making them sensitive to political attacks in which case there is an incentive to not voluntarily disclose advertising expenditures in response to the increased political costs. A negative and significant coefficient on PHARMPCROE supports the hypothesis that the more profitable pharmaceutical firms were more sensitive to these political costs.

4.4. Logistic Regression Model Logistic regression analysis is used in this study since the dependent variable, ADVT, is dichotomous (see Maddala, 1991). ADVT is measured as an indicator variable set equal to one if the firm reports its advertising expenditures and zero otherwise. The logistic regression is estimated using the 1,610 pharmaceutical and control firms as a pooled time-series cross-sectional sample (i.e. panel data set). Model 2, which combines models (1A), (1B), (1C), and (1D), is used to test whether healthcare reform impacted the level of voluntary disclosure of advertising expenditures of firms in the

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127

pharmaceutical industry described in the hypotheses can be expressed as follows: ADVTit ¼

1;610 X

ai þ b1 ROEit þ b2 SIZEit þ b3 LEVit þ b4 ASSETPLit

1

þ b5 COMPit þ b6 PCOSTit þ b7 PCROEit þ b8 PCSIZEit þ b9 PHARMPCOSTit þ b10 PHARMPCROEit þ b11 PHARMPCSIZEit þ b12 PHARMROEit þ b13 PHARMSIZEit þ b14 PHARMLEVit þ b15 PHARMASSETPL þ b16 PHARMCOMP þ it

ð2Þ

where ADVT

ai ROE SIZE LEV ASSETPL COMP PCOST PCROE PCSIZE PHARMPCOST

PHARMPCROE PHARMPCSIZE PHARMROE

an indicator variable set equal to one if firm discloses the level of its advertising expenditures and a value of zero otherwise firm-specific intercept for firm 1 through 1,610 net income divided by the book value of stockholders’ equity natural log of total assets the book value of debt divided by total assets the book value of fixed assets, net of depreciation, divided by total assets 10,000 – Herfindahl–Hirschmann Index (HHI) an indicator variable set equal to 1 if year is from 1994 to 1997 and a value of zero otherwise an interaction variable measured as PCOST times return on equity (ROE) an interaction variable measured as PCOST times firm size (SIZE) an interaction variable measured as PCOST times PHARM, which is an indicator variable set equal to 1 if firm is in SIC 2834 and 0 otherwise an interaction variable measured as PCROE times PHARM an interaction variable measured as PCSIZE times PHARM an interaction variable measured as PHARM times ROE

128

PHARMSIZE PHARMLEV PHARMASSETPL PHARMCOMP 

JOSEPH LEGORIA

an interaction SIZE an interaction LEV an interaction ASSETPL an interaction COMP the residual

variable measured as PHARM times variable measured as PHARM times variable measured PHARM times variable measured PHARM times

Panel data usually are characterized by heterogeneity across individual firms (i.e. fixed effects exist). A pharmaceutical firm’s frequency of disclosing advertising expenditures in years from 1994 to 1997 may be associated with its reporting of advertising expenditures in years prior to 1994.17 If fixed effects do exist, estimating model 1 with an overall intercept results in omitted variables (e.g. Chamberlain, 1980). To control for the possibility of heterogeneity, the intercept term in model 1 is allowed to vary by firm, thus measuring the firm effect for the 1,610 sample firms regarding a firm’s frequency of reporting advertising expenditures. Since model 1 is nonlinear, it is not possible to sweep out the heterogeneity by taking differences or deviations from group means as can be done in a linear-fixed effects model.18 Chamberlain (1980) points out that maximum likelihood estimation of model 1 is inconsistent; therefore, to address these concerns the ‘‘conditional’’ maximum likelihood (CML) estimator developed by Chamberlain (1980) is used. Parameter estimates obtained from the Chamberlain two-way fixed-effects logit model are interpreted in the same way as the traditional logit model. Also, a w2 test can be used to test the model’s goodness of fit.19

5. FINDINGS 5.1. Descriptive Statistics Table 1 presents summary statistics for selected logistic regression variables in Eq. (1) for the pharmaceutical and control firms separately. Panels A and B of the table shows that for the pharmaceutical and the control firms, the mean for ADVT is 0.33 and 0.32, respectively, which indicates that for the entire period from 1989 to 1997, there was not any disclosure of advertising expenditures for two-thirds of the firm-years in the sample. The disclosure of

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129

advertising costs by the pharmaceutical and control firms did not differ in the pre- and post-FRR No. 44 periods. Results (not tabulated) indicate in the pre FRR No. 44 period (1989 to 1993), 43 of 85 pharmaceutical firms and 781 of 1,525 control firms (51%) disclosed advertising in at least one year, respectively. In the post-FRR No. 44 period (1994 to 1997), 21 of 85 pharmaceutical firms (25%) and 414 of 1,525 (27%) control firms disclosed advertising costs in at least 1 year. Panel A of Table 1 also indicates that the pharmaceutical sample consists primarily of larger firms as the mean assets and sales are $1.7 billion and $1.48 billion, respectively. For the 1,525 control firms, the mean assets and sales are $2.12 billion and $1.94 billion, respectively. Although the means for the pharmaceutical industry are less than the means for the control sample, these still are larger than the average compustat firm.20 This seems reasonable given that there were 190 firms in the pharmaceutical industry in 1997 versus 110 in 1989.21 Thus, pharmaceutical firms in the sample, which were required to have complete data from 1989 to 1997, would consist of larger and more established firms rather than start up firms. Table 1 also shows that the pharmaceutical industry is more profitable, is more competitive and is less leveraged than the control industries. On the other hand, the pharmaceutical industry has fewer assets in place compared to the control industry. The lower assets-in-place in the pharmaceutical industry compared to the control industry is not surprising given the large amounts spent on R&D by the pharmaceutical industry and the fact that U.S. GAAP requires the immediate expensing of R&D. Panel C of Table 1 compares the pharmaceutical and control firms’ preand post-FRR No. 44. Univariate tests do not reveal any unexpected differences between the two groups. The pharmaceutical industry had fewer assets in place (ASSETPL) and was more competitive (COMP) than the industry’s, which the control firms compete in both periods. For the pre FRR No. 44 period, firms in the pharmaceutical industry were smaller (SIZE) than the firms in the other industries in the sample.

5.2. Frequency of Disclosure of Advertising by Year, Size and Roe To better visualize the effect of the SEC’s FRR No. 44, on both the pharmaceutical and control firms, the frequency of disclosing advertising costs by ROE and SIZE quintiles and year are reported. Table 2 presents the results for the ROE quintiles. Notice that there appears to be a significant change in the propensity to disclose advertising beginning in 1994. Also, it

130

Table 1.

Descriptive Statistics and Variable Definitions. Mean

Standard Deviation

Panel A: Descriptive statistics for selected variables-pharmaceutical firms (85 firms Dependent variable ADVT

Median

Q1

Q3

 9 years ¼ 765 firm-year observations)

0.33

0.47

0.00

0.00

1.00

Independent variables ROE SIZE LEV ASSETPL COMP

0.12 4.35 0.23 0.23 9,381

4.82 2.82 0.78 0.15 50.16

0.06 3.79 0.12 0.25 9,386


0.34 2.38 0.01 0.10 9,337

0.22 6.42 0.28 0.34 9,401

Descriptive variables Total assets (in millions) Total sales (in millions)

1,742.23 1,486.64

4,108.83 3,552.01

44.15 25.43

10.79 2.68

613.41 440.19

Panel B: Descriptive statistics for selected variables-control firms (1,525 firms Dependent variable ADVT

 9 years ¼ 13,725 firm-year observations) 0.46

0.00

0.00

1.00

0.07 4.64 0.52 0.56 7,349

9.72 2.44 25.09 0.36 1,814

0.09 4.50 0.20 0.49 7,816


0.02 2.87 0.06 0.31 6,522

0.17 6.25 0.35 0.74 8,643

Descriptive variables Total assets (in millions) Total sales (in millions)

2,124.53 1,948.66

11,755 8,839.01

89.16 114.19

17.70 19.77

510.20 622.90

JOSEPH LEGORIA

0.32

Independent variables ROE SIZE LEV ASSETPL COMP

PCOST ¼ 0 PHARM ¼ 1

ADVT ROE SIZE LEV ASSETPL COMP

PCOST ¼ 1 PHARM ¼ 0

PHARM ¼ 1

PHARM ¼ 0

Mean

Std. Dev

Mean

Std. Dev

t-stat

Mean

Std. Dev

Mean

Std. Dev

t-stat

0.44
0.06 4.02 0.23 0.24 9,366

0.49 1.8 2.82 1.41 0.15 61.92

0.43 0.12 4.47 0.36 0.55 7,216

0.49 12.85 2.43 33.26 0.35 1,937


0.76 1.08 3.28*** 0.33 38.52***
96.01***

0.19 0.36 4.75 0.22 0.23 9,399

0.40 6.93 2.76 6.38 0.15 16.16

0.18 0.01 4.84 0.57 0.57 7,513

0.39 2.30 2.43 0.38 0.38 1,638


0.21
0.91 0.59 1.43 36.06***
89.80***

Panel D: Variable definitions for regression models ADVT ROE SIZE LEV ASSETPL COMP PCOST PCROE PCSIZE PHARMPCOST

131

PHARMPCROE PHARMPCSIZE PHARMROE PHARMSIZE PHARMLEV PHARMASSETPL PHARMCOMP

an indicator variable set equal to one if firm discloses the level of its advertising expenditures and a value of zero otherwise net income divided by the book value of stockholders’ equity natural log of total assets the book value of debt divided by total assets the book value of fixed assets, net of depreciation, divided by total assets 10,000 – Herfindahl–Hirschmann Index (HHI) an indicator variable set equal to one if year is from 1994 to 1997 and a value of zero otherwise an interaction variable measured as PCOST times return on equity (ROE) an interaction variable measured as PCOST times firm size (SIZE) an interaction variable measured as PCOST times PHARM, which is an indicator variable set equal to one if firm is in SIC 2834 and zero otherwise an interaction variable measured as PCROE times PHARM an interaction variable measured as PCSIZE times PHARM an interaction variable measured as PHARM times ROE an interaction variable measured as PHARM times SIZE an interaction variable measured as PHARM times LEV an interaction variable measured PHARM times ASSETPL an interaction variable measured PHARM times COMP

The Voluntary Disclosure of Advertising Expenditures

Panel C: Descriptive statistics for pharmaceutical and control firms’ pre-FRR No. 44 (PCOST ¼ 0) and post-FRR No. 44 (PCOST ¼ 1) and test for differences on selected variables before and after the release of FRR No. 44

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Table 2. Frequency of Disclosure of Advertising Expenditures By Year and ROE Quintiles. ROE

ADVT

1989

1990

1991

1992

1993

1994

1995

1996

1997

Panel A: Pharmaceutical firms (85 firms) Quintile 1 (lowest)

1 0

3 14

2 15

2 15

3 14

3 14

2 15

2 15

3 14

2 15

1 0

4 13

5 12

5 12

4 13

4 13

3 14

2 15

0 17

1 16

1 0

5 12

8 9

10 7

9 8

9 8

5 12

5 12

4 13

3 14

1 0

14 3

13 4

9 8

11 6

13 4

3 14

4 13

6 11

5 12

1 0

11 6

13 4

11 6

8 9

9 8

4 13

3 14

5 12

4 13

Range:
24.2 to
0.44 Quintile 2 Range:
0.42 to
0.06 Quintile 3 Range:
0.05 to 0.12 Quintile 4 0.12–0.26 Quintile 5 (highest) 0.27–66 Panel B: Non-pharmaceutical firms (1,525 firms) Quintile 1 (lowest)

1 0

134 171

142 163

127 178

118 187

106 199

52 253

41 264

43 262

51 254

1 0

143 163

135 171

131 175

115 191

119 187

58 248

60 246

70 236

61 245

1 0

129 177

131 175

132 174

131 175

117 189

69 237

53 253

63 243

54 252

1 0

132 174

137 169

138 168

117 189

119 187

66 240

52 254

46 260

51 255

1 0

153 152

144 161

151 154

151 154

127 178

71 234

63 242

68 237

72 233

Range:
195 to
0.07 Quintile 2 Range:
0.06 to 0.06 Quintile 3 0.06–0.12 Quintile 4 0.13–0.19 Quintile 5 (highest) 0.20–16.41

ADVT ¼ 1 if firm disclosed advertising expenditures and 0 otherwise. ROE ¼ net income divided by the book value of stockholders’ equity. Range ¼ The range for each quintile.

The Voluntary Disclosure of Advertising Expenditures

133

appears that the more profitable pharmaceutical firms were the ones that were more likely to discontinue disclosing advertising expenditures starting in 1994. For the control firms, profitability does not seem to impact whether a firm discloses advertising expenditures. Table 3 reports the results for the SIZE quintiles. Again, the results indicate that there was a change in behavior with respect to the disclosing of advertising costs after FRR No. 44 became effective. However, there does not appear to be a difference in the frequency of disclosure by pharmaceutical and control firms with respect to size quintile. These results provide support for the notion that there was a change in the propensity for all firms to disclose advertising costs as a result of the SEC’s FRR No. 44. Also, it appears that there is some evidence consistent with the hypothesis that the more profitable pharmaceutical firms were less likely to disclose advertising costs consistent with an increase in political costs for those firms. Still, while the results from Tables 2 and 3 provide evidence of a change in the propensity to disclose advertising costs, these results do not provide enough evidence to support the hypotheses that after 1993, pharmaceutical firms, and in particular, larger and more profitable pharmaceutical firms, were less likely to disclose advertising because of increased political costs.

5.3. Two-Way Fixed-Effects Logistic Regression Results Table 4 reports the results from the Chamberlain two-way fixed-effects logistic regression model for the 1,610 firms over the time period from 1989 to 1997 (14,490 firm-year observations). The w2 test for the model’s fit is 1,486.04 (16 degrees of freedom) and is significantly different from zero (po 0.001). Thus, the hypothesis that the coefficients on the independent variables are simultaneously equal to zero is rejected. Since the individual firm intercepts are not easily interpretable, they are not reported. The coefficient for PCOST is negative and significant and indicates that control firms were less likely to disclose advertising costs beginning in 1994 consistent with H1A and the proprietary costs arguments of Verrechia (1983). The coefficient on PHARMPCOST is positive, contrary to expectations, but, when added to the coefficient on PCOST, the net of those two coefficients is negative indicating that pharmaceutical firms were less likely to disclose their advertising starting in 1994. However, the results do not indicate that firms in the pharmaceutical industry were less likely to disclose advertising costs beginning in 1994 compared to control firms. Thus, the

134

Table 3.

JOSEPH LEGORIA

Frequency of Disclosure of Advertising Expenditures by Year and Size Quintiles.

SIZE (log of Assets)

ADVT

1989

1990

1991

1992

1993

1994

1995

1996

1997

Panel A: Pharmaceutical firms (85 firms) Quintile 1 (lowest)

1 0

3 14

3 14

2 15

4 13

5 12

1 16

0 17

0 17

1 16

1 0

4 13

6 11

6 11

5 12

6 11

3 14

1 16

2 15

1 16

1 0

4 13

6 11

5 12

2 15

2 15

1 16

4 13

3 14

3 14

1 0

10 7

10 7

8 9

8 9

9 8

4 13

3 14

4 13

3 14

1 0

16 1

16 1

16 1

16 1

16 1

8 9

8 9

9 8

7 10

Range:
2.65–2.08 Quintile 2 2.13–3.27 Quintile 3 3.32–4.56 Quintile 4 4.63–7.19 Quintile 5 (Highest) 7.38–10.15 Panel B: Non-pharmaceutical firms (1,525 firms) Quintile 1 (lowest)

1 0

138 167

149 156

149 156

111 194

87 218

52 253

46 259

49 256

46 259

1 0

134 172

135 171

126 180

131 175

127 179

64 242

46 260

46 260

48 258

1 0

137 169

134 172

138 168

127 179

121 185

59 247

50 255

61 245

65 241

1 0

139 167

134 172

133 173

133 173

127 179

69 237

45 261

45 261

49 257

1 0

143 162

137 168

133 172

130 175

126 179

72 233

82 223

85 220

81 224

Range:
1.51–2.59 Quintile 2 2.68–3.94 Quintile 3 3.99–5.22 Quintile 4 5.29–6.82 Quintile 5 (highest) 6.93–12.62

ADVT ¼ 1 if firm disclosed advertising expenditures and 0 otherwise. SIZE ¼ natural log of Total Assets. Range ¼ The range for each quintile.

The Voluntary Disclosure of Advertising Expenditures

135

Table 4. Fixed-Effects Logistic Regression Results 14,490 Firm-Year Observations Model 2. ADVTit ¼

1610 X

ai þ b1 ROEit þ b2 SIZEit þ b3 LEVit þ b4 ASSETPLit þ b5 COMPit

1

þ b6 PCOSTit þ b7 PCROEit þ b8 PCSIZEit þ b9 PHARMPCOSTit þ b10 PHARMPCROEit þ b11 PHARMPCSIZEit þ b12 PHARMROEit þ b13 PHARMSIZEit þ b14 PHARMLEVit þ b15 PHARMASSETPL þ b16 PHARMCOMP þ it Variable ROE SIZE LEV ASSETPL COMP PCOST PCROE PCSIZE PHARMPCOST PHARMPCROE PHARMPCSIZE PHARMROE PHARMSIZE PHARMLEV PHARMASSETPL PHARMCOMP w2 test of model’s fit

Expected Sign

Coefficient

+ + +
?
? ?


? + +
?


0.034 0.111
0.025
0.637
0.001
2.449 0.028
0.094 0.630
0.850
0.198
0.002 0.383 2.639 1.436
0.005 1486.04***

t- Statistics
0.57 1.35*
0.49
2.35**
2.71***
14.04*** 1.13
2.65 0.75
2.02**
1.32*
0.02 1.37* 1.96** 0.67
1.48 (16 degrees of freedom)

***, **, * Statistically significant at or below the 0.01, 0.05, and 0.10 level, respectively. Onetailed test when expected sign is + or
. Variable definitions ADVT ROE SIZE LEV ASSETPL COMP PCOST PCROE

an indicator variable set equal to one if firm discloses the level of it advertising expenditures and a value of zero otherwise net income divided by the book value of stockholders’ equity natural log of total assets the book value of debt divided by total assets the book value of fixed assets, net of depreciation, divided by total assets 10,000 - Herfindahl–Hirschmann Index (HHI) an indicator variable set equal to one if year is from 1994 to 1997 and a value of zero otherwise an interaction variable measured as PCOST times return on equity (ROE)

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JOSEPH LEGORIA

Table 4. (Continued ) PCSIZE PHARMPCOST

PHARMPCROE PHARMPCSIZE PHARMROE PHARMSIZE PHARMLEV PHARMASSETPL PHARMCOMP

an interaction variable measured as PCOST times firm size (SIZE) an interaction variable measured as PCOST times PHARM, which is an indicator variable set equal to 1 if firm is in SIC 2834 and 0 otherwise an interaction variable measured as PCROE times PHARM an interaction variable measured as PCSIZE times PHARM an interaction variable measured as PHARM times ROE an interaction variable measured as PHARM times SIZE an interaction variable measured as PHARM times LEV an interaction variable measured PHARM times ASSETPL an interaction variable measured PHARM times COMP

results do not provide support for an ‘‘industry membership’’ effect and H1B is not supported. The results indicate that there was a change in the reporting environment beginning in 1994 for both pharmaceutical and control firms suggesting that all firms faced a certain level of proprietary costs and attempted to reduce those costs by not disclosing advertising costs. These results provide support for H1A. However, the results of the test of H1B do not allow for any inferences to be drawn about whether the decreased disclosure of advertising costs observed by pharmaceutical firms was the result of increased political costs or the SEC’s FRR No. 44. The variables ROE, PCROE, PHARMPCROE and PHARMROE are the four variables that relate to H2, the profitability hypothesis. The coefficients on ROE and PCROE are negative and positive, respectively, and both insignificant. These findings indicate that disclosure of advertising costs by control firms was independent of ROE throughout the period 1989 to 1997 and confirm the findings reported in panel B of Table 2. PHARMMROE is negative and not significantly different from zero indicating that prior to 1994, profitability did not affect the disclosure of advertising by pharmaceutical firms. ROE, PCROE, and PHARMROE, serve as baseline and allow for a test of H2 to determine whether more profitable firms in the pharmaceutical industry were facing an increase in political costs and whether there was an incremental effect from those political costs resulting in a decrease in the disclosure of advertising expenditures for those firms in that industry. If larger pharmaceutical firms were facing increased political costs, then the coefficient on PHARMPCROE should be negative and significantly different from zero.

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137

The coefficient on PHARMPCROE is negative and significantly different from zero (po0.05) consistent with H2. This finding and the insignificant coefficient on PCROE implies that after 1994, the most profitable pharmaceutical firms were less likely, compared to firms in other industries, to disclose their advertising expenditures than they were before 1994. These findings are consistent with pharmaceutical firms facing greater political costs and not that more profitable firms face greater political costs in general. The variables SIZE, PCSIZE, PHARMPCSIZE and PHARMSIZE are the four variables that relate to H3, the size hypothesis. The coefficients on SIZE and PCSIZE are positive and negative and significantly different from zero (po0.10; 0.01), respectively. These findings indicate that larger control firms were more likely to disclose advertising costs before 1994, but this regularity disappears in the post FRR No. 44 period (1994 to 1997). The empirical results also confirm the findings reported in panel B of Table 3, which indicated that disclosure by control firms was related to SIZE before 1994 and that firms of all sizes were less likely to disclose in the period after 1993. PHARMSIZE is positive and significantly different from zero (po0.10) and indicates that larger pharmaceutical firms were more likely to disclose advertising in the pre FRR No. 44 period than were larger control firms. Combining SIZE and PHARMSIZE indicates that larger pharmaceutical firms were more likely to disclose advertising costs before 1994 compared to smaller pharmaceutical firms. SIZE, PCSIZE, and PHARMSIZE serve as baseline and allow for a test of H3 to determine whether larger firms in the pharmaceutical industry were facing an increase in political costs and whether there was an incremental effect from those political costs resulting in a decrease in the disclosure of advertising expenditures for those firms in that industry. If larger pharmaceutical firms were facing increased political costs, then the coefficient on PHARMPCSIZE should be negative and significantly different from zero. The coefficient on PHARMPCSIZE is negative and significantly different from zero (po0.10). This finding along with the negative and significant coefficient on PCSIZE indicates that there was an incremental decline in separate disclosure among the larger pharmaceutical firms starting in 1994. Taken together, these findings indicate that at least part of the decrease in disclosure of advertising costs among the larger pharmaceutical firms may have been due to political costs consistent with H3. The results from Table 4 are, for the most part, consistent with the findings from Tables 2 and 3. Panel A of Table 2 reveals that disclosure by pharmaceutical firms was independent of ROE before 1994. However,

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JOSEPH LEGORIA

beginning in 1994, the more profitable pharmaceutical firms were less likely to disclose advertising costs compared to less profitable pharmaceutical firms. Panel A of Table 3 indicates that larger pharmaceutical firms were more likely than smaller firms to disclose advertising before 1994. In the post period, both large and small pharmaceutical firms were less likely to disclose. Together, the findings related to PHARMPCROE and PHARMPCSIZE suggest that the more profitable and larger pharmaceutical firms viewed President Clinton’s criticism of their spending on advertising and his proposed healthcare reform plan as a threat to their industry. By not disclosing their advertising expenditures, the larger and more profitable pharmaceutical firms were perhaps trying to avoid providing their critics with information to use to justify increased regulation of their industry. Additional analysis of the 17 largest pharmaceutical firms (Quintile 5 of panel A of Table 3) was also performed to provide further support for H2 and H3 by dividing those firms into two groups. Group 1 consist of the nine largest pharmaceutical firms that disclosed in all years from 1989 to 1997 while Group 2 consisted of those firms that discontinued disclosing beginning in 1994. Results (not tabulated) indicate that while these firms were not systematically different in size (SIZE), R&D intensity and advertising intensity, they were significantly different (t-stat 2.02, po0.05) with respect to profitability (ROE). The mean ROE for Group 2 was 0.29 whereas the mean ROE for Group 1 was 0.106. This finding supports H2 and H3 and is consistent with the political cost hypothesis. The results also suggest that the more profitable and larger firms within the pharmaceutical industry used a disclosure strategy to deter President Clinton, Congressional critics, and other proponents of government healthcare reform from taking adverse action against them. This behavior is consistent with the theoretical arguments of Verrecchia (1983) and Wagenhofer (1990) and the empirical results of Wong (1988). Also, the results suggest that the political cost hypothesis posited by Watts and Zimmerman (1986) may not only result in a firm making income-decreasing accounting choices, but may also affect a firm’s disclosure strategy.22 The coefficients for the control variables ASSETPL, COMP, and PHARMLEV are significantly different from zero while the coefficients for LEV, PHARMSSETPL, and PHARMCOMP are not. The negative and significant coefficient on ASSETPL (po0.05) is consistent with theoretical arguments of Chow and Wong (1987) and indicates that firms with large amounts of assets in place make fewer voluntary disclosures. The sign on COMP is negative and significantly different from zero (po0.01) and

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139

indicates that as firms face greater competition, they are less likely to disclose advertising information. This finding is also consistent with the proprietary cost hypothesis (e.g. Verrecchia, 1983) that firms facing intense competition do not disclose information. The positive and significant coefficient on PHARMLEV indicates that after controlling for other factors, more highly leveraged pharmaceutical firms are more likely to disclose their advertising expenditures. The findings reported in Table 4 are consistent with the notion that the voluntary disclosures of larger and more profitable firms in politically sensitive industries are influenced by the political process. This implies that certain firms in politically sensitive industries will attempt to prevent adverse action being taken against them by politicians and regulators by discontinuing to disclose information that could be used by those same politicians and regulators to justify increased regulation of their firm or industry.23 Prior research (e.g. Watts & Zimmerman, 1990) has consistently shown that larger and more profitable firms face greater political costs; however, for the control firms, there is no relation between firm size and disclosure of advertising, and no relation between profitability and disclosure of advertising, respectively. Firm size and profitability both impacted the disclosure of advertising expenditures in the pharmaceutical industry consistent with the theoretical arguments of Watts and Zimmerman (1986, 1990) and prior empirical research on the relation between political costs and accounting choice. Given the SEC’s release of FRR No. 44 in 1994, which no longer required firms to disclose advertising costs, and given the significance of the variables PHARMPCROE and PHARMPCSIZE, the change in disclosure of advertising costs observed for the control firms appears to be related to proprietary costs unrelated to political costs. On the other hand, while the SEC regulatory change may have also impacted the disclosure decisions of firms in the pharmaceutical industry, the results also suggest that the change in disclosure of advertising costs observed in the more profitable and larger pharmaceutical firms was due to an increase in that industry’s political costs.

6. CONCLUSIONS The results of this study are consistent with larger and more profitable firms in the pharmaceutical industry being less likely to disclose their

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advertising costs in response to President Clinton’s criticisms of the industry’s advertising spending during his attempt to gain passage of a healthcare reform plan. Results from a Chamberlain two-way fixed-effects logistic regression indicate that the level of disclosure of advertising expenditures for those firms, compared to firms in other industries, was significantly lower in the years from 1994 to 1997 compared to years prior to 1994. This finding suggests that the larger and more profitable pharmaceutical firms were sensitive to the attacks being levied by President Clinton and other politicians regarding the amount they were spending on advertising. As a result, these firms adopted a strategy to not disclose this advertising in order to avoid providing government regulators and industry critics with information that could be used to justify the regulation of their industry. For the control firms, the results indicated that the level of disclosure with respect to advertising expenditures decreased consistent with those firms facing a level of proprietary costs and attempting to reduce those costs by not disclosing advertising. However, for the control firms there was no relation between firm size and profitability and disclosure of advertising expenditures. These findings are consistent with the change in the regulatory environment due to the SEC releasing FRR No. 44, as opposed to an increase in political costs, resulting in control firms decreasing their level of disclosure with respect to advertising costs. The results of this study are consistent with the theoretical arguments of Verrecchia (1983) that voluntarily disclosing information can result in proprietary costs; therefore, firms should refrain from disclosing information that is not required by standard setters since that information could be used against the firm. More specifically, the paper’s findings suggest: (1) that the disclosure of financial information not required by standard setters (e.g. FASB and SEC) is sensitive to the political process, and (2) that larger and more profitable firms in politically sensitive industries will adopt disclosure strategies that prevent politicians and regulators from obtaining information that could be used by those in the political process to justify regulation of their firm or industry. Finally, the results are consistent with Healy and Palepu’s (2001) theoretical arguments that the proprietary hypothesis can be extended to include other externalities from information disclosure such as political costs. The results suggest that the political cost hypothesis posited by Watts and Zimmerman (1986) not only provides incentives for managers to make income-decreasing accounting choices, but also affects their voluntary disclosure decisions.

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NOTES 1. The Financial Accounting Standards Board (FASB) never has required disclosure of advertising costs. The reporting requirements for commercial and industrial firms are governed by Article 5 of Regulation S-X. In 1994, the SEC (1994) issued Financial Reporting Release Number 44 (FRR No. 44), which amended Section 210.5-04 (which lists what schedules are to be filed by Article 5 firms) and no longer requires advertising costs to be disclosed by industrial/commercial firms. The SEC announced that FRR No. 44 was adopted to extend accommodations that were recently adopted with respect to filings by foreign companies to US domestic companies. In revising Section 210.5-04, FRR No. 44 removed numerous schedules including Schedule X (Supplementary Profit and Loss Information) for Commercial/ Industrial firms. Article 12 of Regulation S-X, which is where Schedule X (Supplementary Profit and Loss Information) is described, is now only required as Pro Forma financial information for certain investment companies. 2. Empirical findings on voluntary disclosure are reviewed in the next section. 3. Skinner (1994) notes that Verrecchia’s (1983) model implies that managers will only disclose good news. Darrough and Stoughton (DS) (1990) provide a model which managers disclose bad news in order to prevent competition in their industry. Thus, competition results in full disclosure. However, Verrecchia (1990) points out that (DS’s) model only consider competition resulting from potential entry, whereas in Verrecchia (1983), the model assumes that firms are already facing competition. Thus, Verrecchia argues that the DS model does not provide us with a complete theory of voluntary disclosure in an environment when firms are already engaged in competition. 4. Prior research in the voluntary disclosure area has documented why firms disclose bad news. In most of these studies, firms disclose such news for cost of capital or agency reasons. Since these studies examined situations where the bad news (e.g. negative earnings and qualified audit opinion) will eventually become public, managers had incentives to voluntarily disclose this information. In the case of the pharmaceutical industry and healthcare reform, the disclosure of advertising expenditures, in the absence of political costs, does not represent either good or bad news. Rather, it is only the political climate surrounding healthcare reform that makes the disclosure of advertising costly for the firm (i.e. bad news). Also, since starting in 1994 this information is not required to be disclosed by the SEC; thus it never becomes public information; firms facing increased proprietary and/or political costs are expected to not disclose this information. 5. Watts and Zimmerman (1990) provide a review of this literature through 1990. More recent studies supporting the PCH include Cahan (1992), Key (1997) and Hall and Stammerjohan (1997). 6. For example, in March of 1993 the Office of Technology Assessment (OTA) released a report entitled, Pharmaceutical R&D: Costs, Risks and Rewards, which concluded that the industry had been making ‘‘excess profits’’ of $2 billion a year. During that same month, President Clinton proposed that the federal government become the sole buyer of childhood vaccines at a federally mandated price (Stout, 1993). Finally, the President’s aides were quoted as saying that the President’s attacks on the pharmaceutical industry were part of his strategy to gather public

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support for his healthcare reforms (Waldholz, 1993). For example, the President’s chief campaign strategist James Carville was quoted as saying, ‘‘We’ll be trying to change the healthcare 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). 7. Persons (1999) and Legoria (2000) found that pharmaceutical companies made accounting choices that reduced reported profits in 1993 consistent with the political cost hypothesis (e.g. Watts & Zimmerman, 1986). 8. For example, Waldholz (1993) and Greenberg (1993) reported that Merck & CO’s chief executive officer, P. Roy Vagelos publicly gave Candidate Clinton his endorsement at Merck headquarters. Also, during the campaign leading drug companies such as Merck and Pfizer, and five other pharmaceutical firms pledged to work with Candidate Clinton to control drug prices (Cutaia, 1993). 9. For example, after President Clinton stated that pharmaceutical firms were earning ‘‘shocking’’ profits and that companies had made ‘‘profits at the expense of children,’’ Vagelos responded by stating he felt very disappointed and pained by the President’s attacks on the industry saying ‘‘it was awful’’ (Waldholz, 1993). Greenberg (1993) reported that on February 19, 1993, Vagelos published an open letter to President Clinton in five major U.S. newspapers advising the President that ‘‘We need a search for truth, not scapegoats.’’ 10. As described in earlier sections of the paper, the SEC’s FRR No. 44 no longer requires disclosure of advertising costs. In the Research Design Section (Section 4.2) and remainder of the paper, the years from 1994 to 1997 are defined as the period when the pharmaceutical industry was subject to political costs in order to avoid having to reiterate that the SEC changed its reporting requirements in 1994. 11. Consistent with this idea, in July of 1999 President Clinton proposed to add prescription drugs to Medicare. Tanouye and McGinley (1999) reported while the pharmaceutical industry was concerned about the plan, they did not want to appear ‘‘obstructionist’’ and provoke a backlash from consumers to give their critics information to again label them as ‘‘price gougers.’’ In addition, they pointed out that industry strategy was a major issue at a meeting of the Pharmaceutical Research and Manufacturers of America. Tanouye and McGinley (1999) reported that once again, the drug firms were concerned that they could become the targets of attacks by some politicians who they feel, may be trying to make healthcare a top issue in the 2000 elections as they did in the 1992 elections. 12. The amount of firms publicly traded in SIC 2834 increased from 108 firms in 1990 to 190 in 1997 indicating a large increase in the number of firms in this industry during the sample period. The period from 1989 to 1997 was chosen to balance the considerations of number of firm-year observations and a reasonable number of years both before and after 1994. Using 1988 as the first year would have resulted in 73 firms and thus 730 firm-year observations. If 1998 is included in the sample period (1989–1998), the final sample is 80 firms. Although including 1998 in the sample period increases the firm-year observations to 800, the tradeoff of keeping 85 firms for 9 years appears justified and thus the sample period used was 1989–1997. 13. 1997 10-K’s were reviewed to determine the pharmaceutical firms primary or core business. Seventy-seven of the eighty-five sample firms were engaged in the research, development and marketing of innovative products. The other eight firms

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were either primarily biotech firms or generic drug manufacturers. Rather than delete the eight biotech/generic firms from the sample, I determine how robust the results are to including those firms in the additional analysis section. 14. The years from 1989 to 1993 represent the period before the change in the political cost environment or regulatory environment. No cut-off values were used for the advertising-to-sales ratio when selecting the control sample. 15. The HHI is computed by summing all of the squared market shares for all firms in an industry. It is one of the measures used by the U.S. Department of Justice when evaluating mergers to determine whether such mergers substantially reduce competition in a given industry. The Census of Manufacturers reports the HHI by four-digit SIC codes. This reporting has been done every five years since 1967, for years ending in 2 and 7. The last available HHIs are from the 1992 Census of Manufacturers report (MC92-S-2). This information is available at http://www.census.gov/mcd/mancen/download/mc92cr.sum. Thus, for this study, HHI is defined as the sum of the squared market shares of all firms and following Samuelson and Marks (1999) can be expressed as follows: HHI ¼ S21 þ S 22 þ    þ S2n ; where Si denotes the market share of each firm and n denotes the number of firms. Market share was measured using total sales consistent with the Census of Manufacturers Report and is calculated each year during the period from 1989 to 1997 (nine periods). HHI is an industry specific measure that is constant for all firms in a given year but changes across time. Harris (1998) used the HHI to measure competition in her study that investigated the association between competition and managers’ segment reporting decisions. 16. For example, since the model already allows for the intercept to vary by individual firm, including the industry indicator variable PHARM would also allow for the intercept to vary by industry. The result of allowing the intercept to vary by both firm and industry would result in having two summations, the summation of the individual firm intercepts and the industry intercepts, equal to one resulting in perfect collinearity. 17. Leftwich et al. (1981) documented an ‘‘inertia’’ effect in which firms that reported interim information tended to have always done so. 18. Greene (1993) notes that estimating individual effects for each firm in large samples becomes problematic for maximum likelihood estimators, whose only desirable properties are asymptotic. 19. Greene (1993, pp. 655–656) describes this model in more detail. See Christian and Gupta (1993) for an example of this model used in an accounting/tax context. 20. The mean assets and sales for all 1997 Compustat firms, excluding firms in the utilities (SIC 4911–4941), banking and financial services (SIC 6021–6282), insurance (SIC 6311–6411), and real estate (SIC 6500–6799) industries, were $1.36 billion and $1.27 billion, respectively. The mean assets and sales for all Pharmaceutical firms listed on Compustat in 1997 were $1.54 and $1.21 billion, respectively. 21. These numbers are based on the number of actively traded firms in SIC 2834 on COMPUSTAT for those two years. 22. Since the two-way fixed-effects estimation should control for firm ‘‘inertia’’ effects, the findings are less likely to be the result of ingrained firm disclosure strategies.

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23. Stone and Rasp (1991) note that in large samples, logistic regression estimates compared to OLS are similar. Thus, to test the robustness of our results, we estimate model 2 using OLS, and those results are qualitatively similar to the results reported in Table 4.

ACKNOWLEDGMENTS I would like to thank Jeff Boone, Charlene Henderson, Tim Louwers, Tracy Manly, Kenny Reynolds, William Stammerjohan, the editor, three anonymous reviewers and workshop participants at the University of Arkansas, Louisiana State University, Mississippi State University and the American Accounting Association’s 2000 Annual Meeting for helpful comments on earlier drafts of this paper.

REFERENCES Ball, R., & Foster, G. (1982). Corporate financial reporting: A methodological review of empirical research. Journal of Accounting Research, 20(Suppl.), 161–234. Birnbaum, J.H., & Waldholz, M. (1993). Harsh medicine: Attack on drug prices opens Clinton’s fight for healthcare plan. Wall Street Journal, February 16, A(1). Bublitz, B., & Ettredge, M. (1989). The information in discretion outlays: Advertising, research and development. The Accounting Review, 64, 108–124. 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. Chamberlain, G. (1980). Analysis of covariance with qualitative data. Review of Economic Studies, 47, 225–238. Chow, C. W., & Wong-Boren, A. (1987). Voluntary disclosure by Mexican corporations. The Accounting Review, 63(3), 533–541. Christian, C. W., & Gupta, S. (1993). New evidence on ‘‘secondary evasion’’. The Journal of the American Taxation Association, 15(1), 72–93. Cutaia, J. H. (1993). Swallowing a bitter pill. Business Week, January 11, 82. Darrough, M. N., & Stoughton, N. M. (1990). Financial disclosure policy in an entry game. Journal of Accounting and Economics, 12, 219–243. Francis, J., Philbrick, D., & Schipper, K. (1994). Shareholder litigation and corporate disclosures. Journal of Accounting Research, 32, 137–164. Frost, C. A. (1997). Disclosure policy choices of U.K. firms receiving modified audit reports. Journal of Accounting and Economics, 23, 163–187. Greene, W. H. (1993). Econometric analysis (2nd ed.). New York, NY: Macmillan. Greenberg, D. S. (1993). The Clintons target the pharmaceutical industry. Lancet, 341, 548. Grossman, S. J. (1981). The informational role of warranties and private disclosure about product quality. Journal of Law and Economics, 24(3), 461–483. Hall, S. C., & Stammerjohan, W. W. (1997). Damage awards and earnings management in the oil industry. The Accounting Review, 72, 47–65.

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Harris, Mary, S. (1998). The association between competition and managers’ business segment reporting decisions. Journal of Accounting Research, 36(1), 111–128. Healy, P. M., & Palepu, K. G. (2001). Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature. Journal of Accounting and Economics, 31, 405–440. Holthausen, R., & Leftwich, R. (1983). The economic consequences of accounting choice: Implications of costly contracting and monitoring. Journal of Accounting and Economics, 5, 77–117. Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3, 305–360. Kasznik, R., & Lev, B. (1995). To warn or not to warn: Management disclosures in the face of an earnings surprise. The Accounting Review, 70, 115–134. Kelly, L. (1983). The development of a positive theory of corporate management’s role in external financial reporting. Journal of Accounting Literature, Spring, 111–150. Key, K. G. (1997). Political cost incentives for earnings management in the cable television industry. Journal of Accounting and Economics, 23, 309–337. Lang, M., & Lundholm, R. (1993). Cross-sectional determinants of analysts ratings of corporate disclosures. Journal of Accounting Research, 31, 246–271. Leftwich, R. W., Watts, R. L., & Zimmerman, J. L. (1981). Voluntary corporate disclosure: The case of interim reporting. Journal of Accounting Research, 19(Supplement), 50–77. Legoria, J. (2000). Earnings management, the pharmaceutical industry and healthcare reform: A test of the political cost hypothesis. Research In Accounting Regulation, 14, 101–131. Lev, B., & Penman, S. H. (1990). Voluntary forecasts disclosures, nondisclosure, and stock prices. Journal of Accounting Research, 28, 49–76. Maddala, G. S. (1991). A perspective on the use of limited-dependent and qualitative variables models in accounting research. The Accounting Review, 66(4), 788–807. McNally, G. M., Eng, L. H., & Hasseldine, C. R. (1982). Corporate financial reporting in New Zealand: An analysis of user preferences, corporate characteristics and disclosure practices for discretionary information. Accounting and Business Research, Winter, 11–20. Milgrom, P. (1981). Good news and bad news: Representation theorems and applications. Bell Journal of Economics, 12(Autumn), 380–391. Myers, S. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5(2), 147–175. Penman, S. H. (1980). An empirical investigation of the voluntary disclosure of corporate earnings forecasts. Journal of Accounting Research, 18, 132–160. Persons, O. S. (1999). Political cost incentives for earnings management In the pharmaceutical industry during the 1993 campaign for healthcare reform. Research In Accounting Regulation, 13, 127–148. Pownall, G. C., Wasley, C., & Waymire, G. (1993). The stock price effects of alternative types of management earnings forecasts. The Accounting Review, 68, 896–912. Samuelson, W. F., & Marks, S. G. (1999). Managerial economics (3rd ed.). Fort Worth, TX: The Dryden Press. Securities and Exchange Commission (SEC). (1994). Financial statements of significant foreign equity investees and acquired foreign business of domestic issuers and financial schedules. Release Nos. 33-7118; 34-35094; IC-20766; FRR-44 (December 13, 1994). Washington, DC: Securities Exchange Commission.

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Skinner, D. J. (1994). Why firms voluntarily disclose bad news. Journal of Accounting Research, 32, 38–60. Smith, C., & Warner, J. (1979). On financial contracting: An analysis of Bond Covenants. Journal of Financial Economics, 7(2), 117–161. Stone, M., & Rasp, J. (1991). Tradeoffs in the choice between logit and OLS for accounting choice studies. The Accounting Review, 66(1), 170–187. Stout, H. (1993). Drug concerns express anger at plan for government to buy childhood vaccines. Wall Street Journal, April 12, B(6). Tanouye, E. (1993) Drug industry darkens view of Clinton health care plan. Wall Street Journal, October 29, B(4). Tanouye, E., & McGinley, L. (1999). Drug firms, worried by Clinton medicare plan, seek strategy that won’t spark public backlash. Wall Street Journal, July 14, A(24). The Center For Public Integrity. (1994). Well-healed: Inside lobbying for healthcare reform, Washington, DC, ISBN 1-882583-05-01. US Office of Technology Assessment (OTA). (1993). Pharmaceutical R&D costs risks and rewards. Washington, DC: US Government Printing Office. Verrecchia, R. E. (1983). Discretionary disclosure. Journal of Accounting and Economics, 5, 179– 194. Verrecchia, R. E. (1990). Endogenous proprietary costs through firm interdependence. Journal of Accounting and Economics, 12, 245–250. Wagenhofer, A. (1990). Voluntary disclosure with a strategic opponent. Journal of Accounting and Economics, 12, 341–363. Waldholz, M. (1993). Wall Street Journal, February 19, B(2). Watts, R. L., & Zimmerman, J. L. (1986). Positive accounting theory. Englewood Cliffs, NJ: Prentice-Hall. Watts, R. L., & Zimmerman, J. L. (1990). Positive accounting theory: A ten-year perspective. The Accounting Review, 65, 131–156. Waymire, G. (1984). Additional evidence on the information content of management earnings forecasts. Journal of Accounting Research, 22, 703–718. Wong, J. (1988). Economic incentives for the voluntary disclosure of current cost financial statements. Journal of Accounting and Economics, 10, 151–167.

AN ANALYSIS OF THE FIRST TWO DECADES OF ADVANCES IN ACCOUNTING Michael J. Meyer, John T. Rigsby and D. Jordan Lowe ABSTRACT This study reports the results of a content and citation analysis of the 295 articles appearing in the first 20 years of Advances in Accounting (AIA). A content analysis provides a taxonomy of the main research areas examined and research methods used in the articles published in the journal during its first two decades, i.e. from 1984 to 2003. Information is also summarized indicating contributing authors, their academic affiliation, and where they earned their doctoral degrees. Citation analysis is then used to classify the sources and types of citations most frequently used in AIA. In addition, citation of AIA articles is examined in seven leading journals covering related research topics over this period of time. Finally, findings and conclusions are discussed.

INTRODUCTION Advances in Accounting (AIA) published it 20th volume this past year. This is a significant milestone for any journal. In light of this, we have prepared a Advances in Accounting Advances in Accounting, Volume 21, 147–171 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21006-4

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summary and analysis of AIA’s first 20 years. We look not only at the content of AIA, but also the authors who published in AIA and the citations of the articles published in the journal. Prior to examining the content, we will present a history of AIA to help put the content into proper context. Dyckman and Zeff (1984) provides an interesting snapshot into the research environment of the early 1980s. The major research outlets consisted of The Accounting Review, the Journal of Accounting Research, and the Journal of Accountancy. Enhanced research methods were being utilized to a greater degree and personal computers were allowing researchers to perform more rigorous research. Further, the quantity and quality of graduates of doctoral programs was increasing as was the number of doctoral programs.1 Tenure and promotion guidelines had begun to include requirements for publication of scholarly research, but the available outlets were limited. As a result of these circumstances, the market for new quality accounting academic journals flourished. Between 1981 and 1984 several high quality journals were started including Auditing: A Journal of Practice and Theory, Journal of Accounting Literature, Journal of Accounting and Public Policy, Advances in Accounting, and Contemporary Accounting Research (Dyckman & Zeff, 1984, p. 249). In the early 1980s, Phil Reckers and Bill Schwartz began to be concerned with the publication and editorial process of existing accounting journals. They began to collaborate together and discussed the possibility of creating a new journal. The primary objective of this proposed journal was to be accessible to all researchers and especially open to newer faculty who lacked the ability to deal with the editorial process of some of the more established accounting academic journals. The editors felt a less arduous editorial process would entice and maintain a stream of high-quality submissions. Phil Reckers and Bill Schwartz traveled to Boston to pitch the new journal to JAI, a small academic publisher. JAI offered total editorial freedom to the potential editors, though the journal was to be a bound annual journal. The editorial mission was (and still is) to identify novel ideas in all areas of research and not to simply publish the nth enhancement of a research design. Owing to the strong attraction to quality submissions, the editors suggested and JAI agreed to expand AIA to a family of journals specializing in various accounting academic sub-fields (education, managerial accounting, taxation, systems, etc.). Though there has been some trading of submissions among the various journals in the Advances family, AIA has maintained the ability to publish quality articles covering all topics (i.e. financial, auditing, managerial, educational, and tax) in almost every volume.

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More recently, competitive factors have caused the publishers and editors to re-evaluate the expanded journal family as well as to capitalize on new opportunities. One of the most significant factors affecting AIA in the last two decades has been the expansion of alternative research outlets. For instance, from 1984 to 1996 there were 56 accounting-related journals introduced to the academic community (Zeff, 1996). The American Accounting Association began publishing quality journals aimed at accounting academic sub-fields (e.g. Behavioral Research in Accounting, Journal of Information Systems, Journal of Management Accounting Research, etc.). State funding for higher education has been stale or decreasing, causing university libraries to reduce holdings of academic journals. Further, the number of new Ph.Ds awarded has declined to under 100 per year (Hasselback, 2004). Taken together, these factors have contributed to slowing the stream of submissions to AIA. Thus, the first 20 years has fluctuated from an era of changing focus to accommodate other new journals, to the ebb and flow of research focus in the academic community and to recent declines in state funding and in Ph.D. output. However, the basic editorial policy and editorial board of AIA has remained relatively consistent that allows it to continue to appeal to academic researchers as a high-quality research outlet. The remainder of the paper is organized as follows. First we present an analysis of the article content followed by a discussion of research methods used in the articles. Then an analysis of the authors is presented, followed by an examination of the citations contained in the published articles. The last section discusses findings and conclusions.

ARTICLE CONTENT AIA has published a total of 295 articles in its 20 year history. There have been 20 annual volumes of AIA, plus a supplement to Volume 7. Of the 295 articles published, 112 (37.9%) of the articles were on auditing topics, 104 (35.3%) were on financial accounting topics, 51 (17.3%) were on educational topics, 25 (8.5%) were on managerial accounting topics and 3 (1.0%) were on tax topics. Table 1 provides a breakdown of the article topics published in each of the volumes. Auditing Studies Table 2 provides a breakdown of the auditing studies’ topics. Thirty-one (27.7%) of the auditing studies examine audit testing. More specifically,

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Table 1. Breakdown of Articles by Subject. Volume

1 2 3 4 5 6 7 Supplement 8 9 10 11 12 13 14 15 16 17 18 19 20 Total

Subject of Article

Total

Auditing

Financial

Managerial

Education

Tax

6 6 2 6 3 4 6 12 6 3 7 3 9 5 6 6 7 3 5 2 5

3 2 10 3 6 6 6 0 7 3 6 8 5 6 5 6 3 7 6 3 3

2 1 3 0 1 1 0 0 0 2 2 0 0 1 3 1 1 0 0 5 2

4 5 2 6 4 5 2 0 5 6 2 0 3 1 0 0 1 1 1 1 2

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

15 14 17 16 14 16 15 12 18 14 17 11 17 13 14 13 12 11 12 12 12

112

104

25

51

3

295

these studies examine areas such as audit planning, analytical review, statistical sampling, decision support systems and fraud detection. The aim of these studies is to aid auditors in identifying additional tools that could be useful in the evaluation and analysis of financial information. These studies also examine matters related to audit risk and the use of information technology to aid in audit testing. Twenty-one (18.8%) of the studies were auditor decision/judgment studies. In general, this category of studies examines auditors’ ability to identify information adequately that should be evaluated (i.e., search strategies) and/ or auditors’ ability to evaluate properly the information in the presence of factors that may alter their perception. These studies typically use an experimental design and employ auditors as research subjects. Eighteen (16.1%) of the auditing studies relate to audit firm internal matters. These studies focus on CPA firm human resource development.

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Table 2. Topics of Auditing Studies. Topic

No. of Articles

(%)

31 21 18 17 12 5 8

27.7 18.8 16.1 15.2 10.6 4.5 7.1

112

100.0

Audit Testing Studies Auditor Decision Making/Judgment Studies Audit Firm Internal Matters Studies CPA Services Markets Studies Audit Reporting Studies Auditor Time Pressure Studies Other Total

That is, these studies examine matters such as hiring, evaluating, motivating and promoting CPA firm staff employees. Furthermore, a number of studies examine the topic of staff turnover. Two studies examine gender issues in the public accounting profession. Seventeen (15.2%) of the auditing studies examine the CPA services market. These studies examine matters such as competition and product differentiation within the market for CPA services, audit fees, client acceptance and new services provided by CPA firms (i.e., IT audits). Twelve (10.6%) of the audit studies examine audit reporting matters. The majority of these studies examine the impact and importance of receiving a going concern/qualified opinion. This includes market reactions to report disclosures, the consequences of bankruptcy, and perceptual differences as to going concern thresholds among financial statement readers. Five (4.5%) of the audit studies examine the impact of time pressure on auditors. In particular, these studies examine the dysfunctional behaviors (i.e., premature signoffs, reducing audit planning, under reporting of time) that can result from audit and tax staff working under severe time pressure. Finally, eight (7.1%) of the studies do not fit into any of the above categories. These studies examine matters such as auditor litigation, auditor conflict, internal audit, and future research.

Financial Accounting Studies Table 3 provides a breakdown of the content of the 104 financial accounting studies published in AIA in its first 20 years. The largest proportion of these studies (25 or 24.0%) examine matters relating to accounting method

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Table 3. Topics of Financial Accounting Studies. Topic Accounting Method Choice Studies Financial Statement Analysis Market Reaction Studies History/Opinion Articles Disclosure/Footnote Disclosure Studies Bond Studies Management Forecast Studies Other Total

No. of Articles

(%)

25 21 14 14 12 8 7 3

24.0 20.2 13.5 13.5 11.5 7.7 6.7 2.9

104

100.0

choice. These studies primarily investigate issues related to selecting, adopting, and interpreting various accounting standards as well as studies that examine characteristics of company management to explain accounting decisions. The majority of accounting choice studies relate to accounting for income taxes (SFAS 96) and pension accounting (SFAS 87). However, there are also studies that examine issues such as LIFO inventory, leases, research and development costs, debt conversion, bad debt allowances and stock options. Several of these studies examine measurement issues related to an accounting choice (i.e., examining various ways to measure accounting statement items such as cash flow, economic income, pension liabilities, LIFO inventory, and depreciation). Twenty-one (20.2%) studies relate to financial statement analysis. These studies are grouped together because of their overarching purpose to use the financial statements to evaluate firms. These studies examine a variety of issues including failure prediction, the importance of various financial statement components to market valuation, prediction of future earnings, analyst forecasting, lending decisions, and intra/inter industry information transfers. Fourteen (13.5%) studies examine stock market reactions to corporate disclosures and other significant events. These studies include examinations of the stock price reaction to (1) implementation of new accounting standards, (2) earnings/cash flow differences (i.e., earnings management), (3) environmental disclosures, (4) dividend policies, and (5) earnings release timing. Fourteen (13.5%) articles present historical perspectives and/or personal opinions. These articles span a variety of topics including opinions of accounting standards and standard setting, new accounting method

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approaches, and advances in governmental and international accounting research. Twelve (11.5%) studies examine financial statement disclosure issues, including those related to footnote disclosure. These articles include examinations of fair value disclosures, actuarial disclosures for retirement and post-retirement benefits, environmental disclosures, segment disclosures, write-down disclosures, and asset composition. Eight (7.7%) studies examine bond ratings and interest rates related to bond issuances. These studies attempt to explain interest rates (or changes in interest rates) and or bond ratings (or changes in bond ratings) as a function of a variety of factors, including unfunded pension obligations, market risk, earnings management, and disclosure policies. Seven (6.7%) studies examine management forecasts. Primarily, the focus of these studies is on the accuracy of management forecasts, though there are also studies on information transfer of management forecasts and explanations for management making a forecast. An additional three studies do not fit into any of the above categories. Two of these studies are meta-analyses, and one examines exchange listings and price volatility.

Educational Research Studies Table 4 presents a breakdown of the educational research studies published in AIA in its first 20 years. A total of 51 studies were published. The greatest percentage of these studies examined pedagogy issues (12 articles, 23.5%). These studies provide assistance to accounting faculty by providing

Table 4.

Topics of Education Research Studies.

Topic

No. of Articles

(%)

Pedagogy Studies Determinants of Student/Professional Success Studies Faculty Member Development Studies Program/School Evaluations Studies Research Methods CPA Exam Studies Other

12 9 9 8 3 3 7

23.5 17.6 17.6 15.7 5.9 5.9 13.8

Total

51

100.0

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guidance and/or resources on novel approaches to teaching various courses such as principles of accounting, intermediate accounting, accounting information systems, taxation, and managerial accounting. There are also studies that examine different types of assignments that could be included in an accounting curriculum (e.g., consulting, group, and computer-based assignments). Nine (17.6%) studies examine the determinants of student success in an accounting curriculum. Many of these studies examine issues such as the impact of test-item sequencing on test scores in a variety of different accounting courses including principles of accounting, intermediate accounting, and managerial accounting. Other studies examine issues such as student performance following internships, the impact of learning styles on student performance, the importance of undergra duate accounting on MBA student performance, communications in the recruiting process, and perceptions by high school teachers on different career choices. Nine (17.6%) studies examine faculty member development. These studies examine issues such as the economic status of accounting educators, contract terms for incoming faculty, research productivity, job satisfaction, and faculty evaluations. With respect to research productivity, not only are there studies examining the quantity of research produced but also factors that motivate the production of academic research, and sources of research funding. Eight (15.7%) studies examine various aspects of accounting programs including honors and graduate programs. The hallmark of many of these studies is their ranking of accounting programs. Many of these studies focus on various aspects of a doctoral program such as doctoral students’ demographics and experiences, post-graduation research productivity, and trends in dissertations. Three (5.9%) studies examine research methods. The topics include the use of repeated measures in accounting policy research, evaluating the effect of multicollinearity in ridge regression, and interpreting disordinal interactions in behavioral research. An additional three studies examine various aspects of the CPA exam, including profiles of successful candidates, the impact of graduate education on exam performance, and the impact of exam changes on the accounting curriculum. Seven (13.8%) studies do not fit into any of the above categories. These studies examine matters such as accreditation, contributions of the FASB, 5-year programs, controllership education, and accounting stereotyping.

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Managerial Accounting Studies Table 5 provides a breakdown of topics of the 25 managerial accounting articles published in AIA in its first 20 years. The largest group of studies examined budgetary matters (7 articles, 28.0%). The focus of many of the budgetary studies relate to the use and outcomes resulting from participative budgeting. Several other studies examine factors that affect the creation of budgetary slack, such as performance cues, social influences, budget-based compensation, and organizational commitment. Six (24.0%) studies examine applications of management accounting techniques. For example, these studies examine how companies apply topics often covered in managerial accounting courses including the materials price variance, economic order quantity, transfer pricing, product decisions, cost allocation, and implications of backorders. Four (16.0%) studies examine issues related to executive/employee evaluation. The studies examining executive compensation focus on the uncertainty inherent in the evaluation process using existing managerial accounting and financial accounting data. One study examines the evaluation process in CPA firms. Eight (32%) studies do not fit into any of the aforementioned categories. These studies include topics such as an examination of applied management accounting research, ethical reasoning of certified management accountants, and human resource accounting by professional sports teams. These studies are generally not empirical. Tax Research Studies Somewhat surprisingly, there were only three tax related studies published in AIA during its first 20 years. One study examined tax evasion, the second

Table 5. Topics of Managerial Accounting Studies. Topic Budgeting Studies Practice Issue Studies Executive/Employee Evaluation Studies Other Total

No. of Articles

(%)

7 6 4 8

28.0 24.0 16.0 32.0

25

100.0

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MICHAEL J. MEYER ET AL.

examined factors affecting tax fees, and the third examined tax preparer decisions.

RESEARCH METHOD Our analysis of the research method employed in the published articles consists of examining the research methods used, the type of subjects used for experiments and survey/questionnaire studies, and the sample sizes used for empirical studies. Table 6 presents a breakdown of the research methods by topic employed in articles published AIA. Overall, 239 (81.0%) of the studies were empirical, 5 (1.7%) were analytical and 54 (18.3%) were theoretical/opinion articles. Three articles employed multiple methods and are included in the aforementioned totals. When examining the methods employed for each topic, the auditing studies showed the most variability with 39 experimental designs, 29 survey/questionnaire designs, 21 archival designs, 19 theoretical/ opinion articles, and 4 analytical designs. As expected, the vast majority of the financial studies used archival designs (75), followed by 16 theoretical/ opinion articles, 10 experimental designs, and 4 survey/questionnaire designs. Almost half of the managerial studies employed a survey/questionnaire design (12), followed by 6 theoretical/opinion articles, 3 archival Table 6.

Breakdown of Research Method Used by Research Subject. Method

Topic

Auditing Financial Managerial Education Tax Total a

Empirical studies Opinion Analytical Theory/ Multiple Total Opinion Methodsa survey/ Questionnaire

Archival

Experimental

21 75 3 6 0

39 10 3 1 3

29 4 12 32 1

4 0 1 0 0

19 16 6 13 0

0 1 0 1 1

112 104 25 51 3

105

56

78

5

54

3

295

Three studies employed multiple methods. This column was added to assure that the total column adds to the total number of articles.

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157

designs, 3 experimental designs, and 1 analytical design. Most of the education articles employed a survey/questionnaire design (32) followed by 13 theoretical/opinion articles, 6 archival designs, and 1 experiment. All three of the tax articles employed an experimental design, although one of the articles also included a survey/questionnaire. Table 7 provides a summary of the subjects used in experimental and survey/questionnaire designed studies by topic. Most of the auditing studies (see Table 7, Panel A) used auditors as subjects; some of these studies confined their samples to partners and/or partners and managers. The majority of the educational studies (see Table 7, Panel B) relied on students, faculty, and departmental chairs as subjects. Of the non-archival designed financial studies (see Table 7, Panel C), students and bank loan officers were most often used. Most of the managerial studies (Table 7, Panel D) used managers and students as subjects. For the three tax studies, one used students and two used CPAs/tax professionals. Table 8 provides an analysis of the average sample sizes used for empirical studies published in AIA. Overall, the largest sample sizes were found in educational studies. Furthermore, the sample sizes of the experiments were smaller than both the archival and survey/questionnaire designed studies. Of course, given the cost of experiments and the difficulty in accessing subjects willing to participate, this result is not surprising.

AUTHORS There were 449 different individuals appearing as an author (co-author) among the 295 articles published in AIA in its first 20 years. Our analysis includes identifying the most prolific authors in AIA, their present school of affiliation, and their schools of degree. We also provide an analysis of gender and authorship order for multiple authored articles and of gender for single author articles. Table 9 provides a list of those authors (co-authors) of at least 3 articles. For the purposes of this analysis, no preferences were given for authorship order. The authors who have published five or more studies include John M. Hassell (9), Mohammad Abdolmohammadi (5), Stephen P. Baginski (5), Steven E. Kaplan (5), and Kenneth S. Lorek (5). Table 10 provides a list of the current schools of affiliation of the authors. This table includes the number of different articles published from faculty of each school, number of different authors from each school, and total authorships from each school. The table lists those schools where authors have

158

Table 7.

MICHAEL J. MEYER ET AL.

Type of Subjects for Experiments and Survey/Questionnaire Design Studies.

Type of Subjects

Experiments

Survey/Questionnaire

Auditors/CPAs Partners Only Partners and Managers All Levels Internal Auditors Bankers Students Other Multiple typesa

3 2 21 2 5 7 1 2

0 3 21 1 2 1 4 3

Total

39

29

Students Academics/Faculty Departmental Chairs Other Multiple typesa

1 0 0 0 0

9 8 5 12 2

Total

1

32

5 3 0 2 0

0 2 2 3 3

10

4

Students Managers Others Multiple typesa

3 0 0 0

0 6 8 2

Total

3

12

Panel A: Auditing Studies

Panel B: Educational Studies

Panel C: Financial Studies Students Bankers/Loan Officers Financial Officers Other Multiple typesa Total Panel D: Managerial Studies

a

Denotes samples where more than one type of subject was used. By subtracting these multiple samples, the total can be traced to the total number of studies in Table 6.

An Analysis of the First Two Decades of Advances in Accounting

Table 8. Topic

Audit Financial Managerial Educational Tax

159

Sample Sizes for Empirical Studies.

Archival

Experimental

Survey/Questionnaire

Mean sample size

Median sample size

Mean sample size

Median sample size

Mean sample size

Median sample size

617 1346 915 2508 N/A

140 213 247 2500 N/A

101 83 95 100 131

86 70 106 100 138

385 142 138 2497 71

291 140 77 252 71

published more than five different articles. The top five schools of affiliation of authors are Florida State (14), Arizona State (13), South Carolina (9), North Texas (9), and Bentley College (9). The number of different authors is presented to indicate the possible impact of a few prolific authors. Table 11 provides a list of the schools of degree of the authors. This table includes the number of articles published from graduates of each school, the number of different authors who graduated from each school, and total authorships from graduates of each school. The table lists those schools of degree where graduates have published more than five different articles. The top five schools of degree are Illinois (43), Arizona State (27), Indiana (27), Florida State (18), and Florida (18). Table 12 provides a summary of the authorship order and gender mix for multiple authored articles and the gender of single authored articles. Among the 218 multiple authored articles, 147 (67.4%) list the authors in alphabetical order.2 Regarding gender, 155 (71.1%) of the multiple authored articles are comprised of all male researchers, 55 (25.2%) are comprised of a mixture of male and female researchers, and 8 (3.7%) are comprised of all female researchers. Of the 77 single authored articles, 63 (81.8%) of the authors are male and 14 (18.2%) of the authors are female.

CITATION ANALYSIS Examining a journal’s citations allows one to evaluate the sources of the ideas published in the journal. A citation is as objective a measure as academics have in determining influences on research. Citations have been used to evaluate the impact of authors, articles, journals, and

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Table 9.

Authors of Three or More Articles.

Author John M. Hassell Mohammad Abdolmohammadi Stephen P. Baginski Steven E. Kaplan Kenneth S. Lorek Allen W. Bathke, Jr J. Edward Ketz Loren Margheim John D. Neill Kurt Pany K.K. Raman David E. Stout Jerry R. Strawser Michael T. Dugan Martin Freedman Marshall A. Geiger G. William Glezen Thomas W. Hall Thomas E. King D. Jordan Lowe Jeffrey J. McMillan Theodore J. Mock Susan Pourciau K. Raghunandan Alan Reinstein Thomas F. Schaefer Philip H. Siegel Stephen W. Wheeler Donald E. Wygal

Number of Articles 9 5 5 5 5 4 4 4 4 4 4 4 4 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3

Note: We gave full authorship credit for all co-authors, regardless of the order of the names listed on the title page. We excluded from the analysis authorships of individuals who were editors for an edition in which they were published.

books/monographs of a number of accounting academic journals including the Journal of Accounting Research (Dyckman & Zeff, 1984), Auditing: A Journal of Practice & Theory (Krogstad & Smith, 2003), Behavioral Research in Accounting (Meyer & Rigsby, 2001), and the Journal of Information Systems (Samuels & Steinbart, 2002). Our study examines all of the citations listed in the 295 articles published in AIA. Since AIA’s citations are not included in the social sciences citation index, we created a database of these citations manually. We also excluded official pronouncements from our

An Analysis of the First Two Decades of Advances in Accounting

Table 10.

Florida State Arizona State South Carolina North Texas Bentley Southern Illinois Villanova Arkansas Auburn Florida Atlantic Memphis Oklahoma Alabama Penn State Tennessee USC

161

Author Current School of Affiliation.

No. of Different Articles

No. of Different Authors

Total Authorships

14 13 9 9 9 8 7 6 6 6 6 6 6 6 6 6

8 8 8 6 4 5 4 6 5 5 5 5 4 4 4 4

14 15 11 9 10 10 7 8 7 6 6 6 6 8 6 6

Note: This table provides the current schools of affiliation of the authors as of the 2003 edition of the Hasselback Accounting Faculty Directory. The table is sorted by number of different articles and only provides those schools that have more than five articles published.

analysis. In total, there were 7,299 citations in our database, among which 6,139 were journal articles citations and 1,160 were books/monographs citations. In our analysis, we examined the most cited authors, most cited articles, most cited journals, and most cited books/monographs. In addition, we examined AIA articles that were cited in seven other accounting journals publishing in related topic areas, i.e., The Accounting Review, Journal of Accounting Research, Accounting, Organizations and Society, Auditing: A Journal of Practice & Theory, Journal of Management Accounting Research, Behavioral Research in Accounting, and Issues in Accounting Education. Table 13 provides a list of the top 25 most cited authors. The eclectic nature of AIA is reflected in the variety of authors with different research interests generating the articles published. No one type of research dominates the list that includes a number of well known financial accounting researchers (e.g., Beaver, Watts, Zimmerman, etc.) as well as a number of researchers who often publish auditing behavioral research (e.g., Ashton, Libby, etc.). Most of these researchers have published in all areas of research during their careers.

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Table 11.

Illinois Arizona State Indiana Florida State Florida Texas Austin Tennessee Ohio State Georgia State Oklahoma State Arkansas UCLA LSU Oklahoma USC Virginia Tech Michigan State Penn State South Carolina Houston Iowa Kentucky UC Berkeley Pittsburgh Nebraska North Texas Colorado Missouri

Author School of Degree.

No. of Different Articles

No. of Different Authors

Total Authorships

43 27 27 18 18 17 14 11 10 10 10 10 9 9 9 9 8 8 8 7 7 7 7 7 6 6 6 6

26 18 12 16 12 15 10 9 10 10 9 8 7 7 6 5 7 7 6 8 6 6 5 5 8 6 5 5

50 33 31 23 18 18 15 11 10 12 13 10 9 9 10 9 8 9 11 9 9 9 7 10 8 6 6 6

Note: This table provides the school of degree of the authors. The table is sorted by number of different articles. To be included in this table a school of degree must have more than five different articles.

Table 14 provides a list of articles that were cited at least seven times in AIA over the 20 year period. Providing a list of most cited research can be used by academics and future academics (i.e., doctoral students) to determine a body of knowledge necessary to be an informed consumer and producer of academic research. Table 15 provides a list of the books/monographs cited at least seven times. Where a book has been published in several editions, all editions of the book that were cited were included as a citation for that book. The list

An Analysis of the First Two Decades of Advances in Accounting

Table 12.

163

Author Gender and Author Order.

Panel A: Multiple Author Articles Multiple Authors Authorship order Alphabetical 147

Gender of authors Other

All male

All female

Mix

71

155

8

55

Panel B: Single Author Articles Single Authors Male 63

Female

Total

14

77

includes the Hasselback Accounting Faculty Directory, several statistical and research design texts and monographs, as well as several path-breaking monographs on accounting and auditing. Table 16 provides a list of the top 50 most cited journals. AIA is often excluded from citation analysis studies because the journal is not included in the Social Sciences Citation Index, often the source of citation analyses. As such, it is noteworthy to note that AIA is listed as the 16th most cited journal. Though self-citation is not an unbiased source, it does provide support for the fact that the journal has had an impact on research. In addition, we were somewhat surprised by the number of citations in two practitioner journals, the Journal of Accountancy (6th) and The CPA Journal (13th). Table 17 provides a list of those articles published in AIA that were cited by other prestigious academic accounting journals. Our source journals were: The Accounting Review, Journal of Accounting Research, Accounting, Organizations and Society, Auditing: A Journal of Practice & Theory, Journal of Management Accounting Research, Behavioral Research in Accounting, and Issues in Accounting Education. Since AIA publishes research covering all accounting research topics (i.e., financial accounting, auditing, managerial accounting, accounting education, and taxation) we believed it was necessary to examine journals that cover all of these topics. In total, 55 unique articles were cited at least once by the source journals (18.6%).3 Table 17 lists those AIA articles that were cited more than once.

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Table 13.

Top 25 Most Cited Authors.

Author

No. of Citations

Reckers, P. M. J. Kinney, W. R. Ashton, R. H. Beaver, W. H. Watts, R. L. Pany, K. Libby, R. Wright, A. Loebbecke, J. K. Zimmerman, J. L. Zmijewski, M. E. Messier, W. F. Brown, L. D. Mock, T. J. Mutchler, J. F. Harrell, A. M. Ingram, R. W. Francis, J. R. Ferris, K. R. Kaplan, S. E. Wallace,W. A. Kaplan, R. S. Mckeown, J. C. Hopwood, W. Joyce, E. J.

65 60 49 49 46 45 44 43 39 38 38 37 35 35 35 34 34 32 31 30 30 29 29 28 28

Note: The number of citations was based upon a database created by the authors and does not discriminate by authorship order.

CONCLUSIONS This paper analyzed the content of AIA over the last two decades. Our objective was to provide insights concerning the types of studies published, the research methods used, authors and schools providing the most contribution, and citation analysis. Overall, our findings suggest that AIA has developed into a high-quality journal that provides researchers with an open forum to address broad issues in several accounting contexts. First, the articles cover a wide variety of accounting areas, with emphasis on auditing and financial articles. The only accounting area that was significantly

An Analysis of the First Two Decades of Advances in Accounting

Table 14.

165

Articles Cited At Least Seven Times. Article Citation

Number of Citations

Kaplan, S. E. and Reckers, P. M. J. An Examination of Information Search During Initial Audit Planning. Accounting, Organizations, and Society 1989. Foster, G. Quarterly Accounting Data: Time Series Properties and Predictive Ability Results. The Accounting Review 1977. Simunic, D. A. The Pricing of Audit Services: Theory and Evidence. Journal of Accounting Research 1980. Jiambalvo, J. Performance Evaluation and Directed Job Effort: Model Development and Analysis In A CPA Firm Setting. Journal of Accounting Research 1979. Tversky, A. and Kahneman, D. Judgment Under Uncertainty: Heuristics and Biases. Science. 1974. White, H. A Heteroscedasticity-Consistent Covariance. Econometrica. 1980. Cronbach, L. Coefficient Alpha and the Internal Structure of Tests. Psychometrika. 1951. Collins, D. W. and Kothari, S. P. An Analysis of the Intertemporal and CrossSectional Determinants of Earnings Response Coefficients. Journal of Accounting and Economics 1989. Easton, P. and Zmijewski, M. Cross-Sectional Variation in the Stock Market Response to Accounting Earnings Announcements. Journal of Accounting and Economics 1989. Healy, P. M. The Effect of Bonus Schemes on Accounting Decisions. Journal of Accounting and Economics 1985. Mutchler, J. F. A Multivariate Analysis of the Auditor’s Going Concern Opinion Decision. Journal of Accounting Research 1985. Zmijewski, M. E. Methodological Issues Related to the Estimation of Financial Distress Prediction Models. Journal of Accounting Research 1984. Kinney, W. R. and Uecker, W. C. Mitigating the Consequences of Anchoring in Auditor Judgments. The Accounting Review 1982. Joyce, E. and Biddle G. C. Anchoring and Adjustment in Probabilistic Inferences in Auditing. Journal of Accounting Research 1981. Joyce, E. J. and Biddle G. C. Are Auditors Judgments Sufficiently Regressive? Journal of Accounting Research 1981. Ohlson, J. A. Financial Ratios and the Probabilistic Prediction of Bankruptcy. Journal of Accounting Research 1980. Wright, A. Performance Appraisal of Staff Auditors. The CPA Journal. 1980. Brown, L. Rozeff, M. Univariate Time Series Models of Quarterly Accounting Earnings Per Share: A Proposed Model. Journal of Accounting Research 1979. Watts, R. and Zimmerman, J. J. Toward a Positive Theory of the Determination of Accounting Standards. The Accounting Review 1978.

11 11 9 9

9 8 8 7

7

7 7 7 7 7 7 7 7 7

7

Note: This information was obtained from a database created by the authors of all citations in all articles published by AIA in its first 20 years.

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Table 15.

Books and Monographs Cited at Least Seven Times.

Authors

Title of Book/Monographa

Number of Citations

Hasselback, J. R. Cushing, B. E. and Loebbecke, J. K.

Accounting Faculty Directory. Comparison of Audit Methodologies of Large Accounting Firms. Positive Accounting Theory. Regression Diagnostics, Identifying Influential Data and Sources. Accounting and Human Information Processing: Theory and Applications. Human Information Processing in Accounting. Applied Linear Statistical Models.

14 13

Watts, R. L. and Zimmerman, J. L. Belsley, D., Kuh, E., and Welsch, R. Libby, R. Ashton, R. H. Neter, J., Wasserman, W., and Kutner, M. K. Arens, A. A. and Loebbecke J. K. Kirk, R. E. Oppenheim, A. N

Auditing: An Integrated Approach. Experimental Design: Procedures for the Behavioral Sciences. Questionnaire Design and Attitude.

13 12 10 9 8 7 7 7

Note: A database of all citations in AIA was created by the authors. A total of 1160 citations were to books monographs. a For those books with multiple editions, all editions were considered together.

underrepresented was tax research. It is possible that the low number of tax articles in AIA may be due to the existence of Advances in Taxation. In addition, the articles often reflect present and emerging ideas and innovative approaches. Second, a wide range of research methods were utilized across topical areas. Auditing articles were the most diverse, relying upon an even mix of experimental, survey, archival, and theoretical methods. As expected financial articles primarily used archival methods; education and managerial articles relied upon survey/questionnaire methods. Third, the authors that have contributed the most articles (as well as those cited the most) over the years are generally recognized as prolific researchers in their fields. Thus, AIA appears to be an attractive outlet for research scholars from several accounting disciplines. Fourth, the authors’ university affiliations are generally from well-respected schools but are not inclusive to elite schools. Finally, the journals most cited in AIA are the most prestigious accounting journals (e.g., The Accounting Review, Journal of Accounting Research, Journal of Accounting Economics, Auditing; A Journal of Practice & Theory, Accounting, Organizations and Society).

An Analysis of the First Two Decades of Advances in Accounting

Top 50 Most Cited Journals.

Table 16. Journal Title

The Accounting Review Journal of Accounting Research Journal of Accounting and Economics Auditing: A Journal of Practice and Theory Accounting, Organizations and Society Journal of Accountancy Journal of Finance Accounting Horizons Contemporary Accounting Research Journal of Applied Psychology Journal of Financial Economics Journal of Accounting Literature The CPA Journal Issues in Accounting Education Psychological Bulletin Advances in Accounting Journal of Accounting Auditing and Finance Org. Behavior & Human Performance Decision Sciences Academy of Management Journal Management Accounting Journal of Accounting Education Journal of Personality and Social Psych. Management Science Wall Street Journal Journal of Fin. and Quantitative Analysis

167

Topic of Article Creating the Citation Citations

Auditing

Financial Managerial Educational Tax

774 669

244 251

331 304

92 70

106 41

1 3

261

39

210

8

4

0

245

213

14

3

15

0

209

84

31

72

20

2

182 124 100 85

94 20 45 38

54 101 36 33

4 1 4 13

29 2 13 1

1 0 2 0

83

51

6

10

16

0

73

15

55

1

2

0

66

27

24

11

3

1

65 62

44 11

15 2

4 8

2 41

0 0

62 60 58

38 30 26

9 17 29

7 1 0

8 12 3

0 0 0

55

38

3

7

7

0

54 50

25 20

12 10

12 10

5 10

0 0

50 48

9 4

15 0

8 3

18 41

0 0

48

20

7

10

10

1

48 46 45

15 28 4

11 13 39

18 3 1

4 2 1

0 0 0

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MICHAEL J. MEYER ET AL.

Table 16. (Continued ) Journal Title

Accounting and Business Research Behavioral Research in Accounting Journal of Business Financial Analysts Journal Financial Management Journal of Marketing Research Administrative Sciences Quarterly Harvard Business Review Journal of Business Finance and Accounting Econometrica Org. Behavior and Human Dec. Processes Journal of Accounting and Public Policy American Economic Review Journal of The American Stat. Association Journal of Political Economy Journal of Vocational Behavior Science Academy of Management Review Annual Review of Psychology Personnel Psychology Psychological Review Communications of the ACM Journal of Marketing Ohio CPA Journal

Topic of Article Creating the Citation Citations

Auditing

Financial Managerial Educational Tax

43

19

12

9

2

1

42

23

5

12

2

0

36 33 33 29

6 1 4 19

25 31 23 3

3 0 3 3

2 1 3 4

0 0 0 0

27

11

6

8

2

0

26 26

7 6

12 15

4 5

2 0

1 0

25 25

7 15

12 6

5 4

1 0

0 0

24

6

17

1

0

0

22 20

2 3

17 5

2 6

1 6

0 0

18

3

12

1

2

0

18

15

0

3

0

0

18 17

6 5

3 6

5 5

4 1

0 0

17

11

1

3

2

0

17 17 16

12 11 6

0 1 4

4 1 1

1 4 5

0 0 0

16 16

15 6

0 6

1 0

0 4

0 0

Note: All citations were analyzed from a database created by the authors. There were a total of 7299 citations analyzed from the 295 articles published in AIA, 6139 of these citations were to journals.

An Analysis of the First Two Decades of Advances in Accounting

169

Table 17. Articles Cited More than Once in Other Journals. Article

Number of Citations

Coakley, J. R., and J. K. Loebbecke. 1985. The expectation of accounting errors in medium-sized manufacturing firms. Vol. 2: 199–245. Kelley, T., and L. Margheim. 1987. The effect of audit billing arrangement on underreporting of time and audit quality reduction acts. Vol. 5: 221–233. Ponemon, L. A. 1993. The influence of ethical reasoning on auditors’ perceptions of management’s integrity and competence. Vol. 11: 1–29. Stout, D., A. Sumutka, and D. Wygal. 1991. Experiential evidence on the use of writing assignments in upper-level accounting courses. Vol. 9: 125–141. Albrecht, W. S., and M. B. Romney. 1986. Red-flagging management fraud: A validation. Vol. 3: 323–333. Biggs, S. F. 1985. Improving auditor judgment through research: A problem and some potential solutions. Vol. 2: 169–183. Mattessich, R. 1991. Social Reality and the Measurement of Its Phenomena. Vol. 9: 3–17. Deitrick, J. W., and R. H. Tabor. 1987. Improving the writing skills of accounting majors: One school’s approach. Vol. 4: 97–110. Harrell, A. 1990. A longitudinal examination of large CPA firm auditors’ personnel turnover. Vol. 8: 233–246. Kermis, G. F. & Mahapatra, S. 1985. An Empirical Study on the Effects of Time Pressure on Audit Time Allocations. Vol. 2: 261–273. Bedard, J. C., and S. F. Biggs and J. DePietro. 1998. The effects of hypothesis quality, client management explanations and industry experience on audit planning decisions. Vol. 16: 49–73. Benke, R., and J. Rhode. 1984. Intent to turnover among higher level employees in large CPA firms. Vol. 1: 157–174. Benson, E, B. Marks, and K. Raman. 1986. The MFOA Certificate of Conformance and Municipal Borrowing Costs. Vol. 3: 221–232. Briloff, A. J. 1986. Standards without Standards, Principles without Principles, Fairness without Fairness. Vol. 3: 33–17. Sterling, R. R. 1988. Confessions of a Failed Empiricist. Vol. 6: 3–35.

13 6 6 6 4 4 4 3 3 3 2

2 2 2 2

Note: We examined all citations in The Accounting Review, Journal of Accounting Research, Accounting, Organizations and Society, Auditing: A Journal of Practice & Theory, Journal of Management Accounting Research, Behavioral Research in Accounting, and Issues in Accounting Education. A total of 55 articles published in AIA (of the total 295 articles published) were cited at least once in these aforementioned journals.

As a result of the quality of the authors and articles, AIA has evolved into being recognized as a very respectable academic journal. Having began as a journal in 1984, AIA was already ranked 35th in journal quality by 1990 (Hull & Wright, 1990). In 1995, AIA was ranked 24th (Hasselback &

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Reinstein, 1995), in 2000 it was ranked 24th (Barniv & Fetyko, 2000) and in 2004 it was ranked 25th (Reinstein & Calderon, 2004). This is in spite of the journal not having an AAA section sponsorship and having to compete with several new outlets for accounting research, including multiple Advances series journals. While the future of AIA is difficult to predict, we conjecture the following. First, it appears that the journal is making an effort to expand to more of an international focus as a European associate editor has recently been assigned to handle the international submissions. Second, while the quality of submissions for the journal has been relatively consistent over the years, this is changing for AIA as well as other accounting journals. The emergence of several new accounting journals in the last several years coupled with a predicted severe shortage in the supply of accounting PhDs over the next 10 years (Felix, 2004), suggests that the competition for quality manuscripts will continue to be fierce. Third, Phil Reckers has been the editor (or coeditor) since the inception of the journal. His leadership as well as that of his associate editors should continue to provide stability during the uncertain times ahead.

NOTES 1. For example, the number of graduates from doctoral programs between 1976– 1985 almost equals the total number of graduates prior to 1976 (Hasselback, 1996). 2. See Meyer and McMahon (forthcoming) for a discussion of authorship order. 3. As a basis of comparison, Meyer and Rigsby (2001) indicate that in Behavioral Research in Accounting (BRIA) first 10 years, 32% of BRIA’s articles were cited in The Accounting Review, Journal of Accounting Research, Auditing: A Journal of Practice & Theory, and Accounting, Organizations and Society.

REFERENCES Barniv, R., & Fetyko, D. (2000). Changes in the perceived quality of accounting journals. Working Paper, Kent State University. Dyckman, T., & Zeff, S. (1984). Two decades of the Journal of Accounting Research. Journal of Accounting Research, 22(1), 225–289. Felix, W.L. (2004). President’s message. Accounting Education News, (Winter), 1. Hasselback, J. R. (2004). Accounting faculty directory 2004–2005. Upper Saddle River, NJ: Prentice Hall. Hasselback, J. R., & Reinstein, A. (1995). A proposal for measuring scholarly productivity of accounting faculty. Issues in Accounting Education, 10(2), 269–305.

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Hull, R. P., & Wright, G. B. (1990). Faculty perceptions of journal quality: An update. Accounting Horizons, 4(1), 77–98. Krogstad, J. L., & Smith, G. (2003). Assessing the influence of Auditing: A Journal of Practice & Theory. Auditing: A Journal of Practice & Theory, 22(1), 195–204. Meyer, M. J., & McMahon, D. (2004). An examination of ethical research conduct by experienced and novice accounting academics. Issues in Accounting Education, 19(4), 413–442. Meyer, M. J., & Rigsby, J. T. (2001). A descriptive analysis of the content and contributors of Behavioral Research in Accounting: 1989–1998. Behavioral Research in Accounting, 13, 253–278. Reinstein, A., & Calderon, T. G. (2004). Examining accounting departments’ rankings of the quality of accounting journals. Working Paper, Wayne State University. Samuels, J. A., & Steinbart, P. J. (2002). The Journal of Information Systems: A review of the first 15 years. Journal of Information Systems, 16(2), 97–116. Zeff, S. A. (1996). A study of academic research journals in accounting. Accounting Horizons, 10(3), 158–177.

THE RELATIVE ACCURACY OF ANALYSTS’ PUBLISHED FORECASTS VERSUS WHISPER FORECASTS SURROUNDING THE ADOPTION OF REGULATION FD Lynn Rees and Davit Adut ABSTRACT This paper examines the accuracy and information content of analysts’ published forecasts relative to whisper forecasts before and after the effective date of Regulation Fair Disclosure (Reg FD). We find that whisper forecasts are generally more accurate than analysts’ consensus forecasts in our pre-Reg FD period (consistent with prior literature), but less accurate during the post-Reg FD period. We also find in the post-Reg FD period that analysts’ forecast errors earn significantly larger abnormal returns compared to whisper forecast errors. These results suggest that Reg FD has had its desired effect of mitigating private communications from management to market participants.

Advances in Accounting Advances in Accounting, Volume 21, 173–197 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21007-6

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1. INTRODUCTION The U.S. Securities and Exchange Commission’s (SEC) official release entitled ‘‘Selective Disclosure and Insider Trading,’’ commonly known as Regulation Fair Disclosure (or Reg FD), was adopted on August 10, 2000 and became effective on October 23, 2000. A primary objective of Reg FD is to eliminate selective disclosure of all material information about companies’ past and future operating performance and thereby, level the playing field between analysts, institutional investors, and individual investors.1 This paper examines the accuracy and information content of analysts’ published forecasts relative to whisper forecasts before and after the effective date of Reg FD. Our investigation provides evidence with respect to the Regulation’s effect on the dissemination of information from company managers to financial markets and the effectiveness of analysts’ in measuring market expectations in their published forecasts subsequent to Reg FD’s implementation. Whisper forecasts (or whisper numbers) are earnings forecasts that are not officially published by analysts. As a company’s scheduled earnings announcement approaches, these informal forecasts begin to circulate among analysts and investors and can be substantially different than the published mean consensus forecast. Using whisper numbers gathered from several sources, including financial websites, press releases, and messages posted on the internet, Bagnoli, Beneish, and Watts (1999) (BBW) find that whisper forecasts are more accurate than analysts’ forecasts as published by First Call. In addition, results from a non-implementable trading strategy suggest that whisper forecasts are better proxies for the market’s expectations. We examine the effect of Reg FD on the information characteristics of analysts’ forecasts relative to whisper forecasts. The most obvious effect of Reg FD on published analysts’ forecasts is that when developing their earnings forecasts, analysts will no longer have the benefit of accessing material information from private communications with management. In fact, some critics of Reg FD claim that management will cut off all communications to analysts for fear of violating Reg FD, which suggests that analysts’ published forecasts will continue to be less accurate relative to whisper forecasts post-Reg FD. Others argue that the total information offered to the market will increase since management will ensure that all information is available to all market participants. Heflin, Subramanyam, and Zhang (2003) provide evidence indicating that Reg FD has not resulted in a deterioration of the information environment available to analysts. In addition, Shane, Soderstrom, and Yoon (2002) document evidence

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consistent with analysts increasing their private information post-Reg FD by accessing substitute and unbiased information sources or exerting more effort that compensates for what was lost due to the elimination of private communications with management. This evidence suggests that Reg FD might have the effect of increasing the accuracy of analysts’ published forecasts relative to whisper forecasts. Reg FD also has a potential effect on the accuracy of whisper forecasts. A possible explanation for the superiority of whisper forecasts in BBW’s preReg FD sample period is that private management communications was a significant factor in determining whisper forecasts. Articles from the financial press tend to confirm this conjecture (e.g. Edmonston, 2001).2 Prior to Reg FD, if analysts were producing and disseminating behind-closed-doors forecasts based on private interviews with company management, then the adoption of Reg FD has the potential to significantly alter the information content of whisper numbers. We hypothesize that the superiority of whisper forecasts relative to published analysts’ forecasts will decrease in post-Reg FD periods. This hypothesis assumes that the primary input to whisper numbers is a private information from company management. However, using a different assumption, an alternative hypothesis can be developed. Some have argued that Reg FD, while restricting private communications with management, will increase the amount of total information provided to all market participants (Edmonston, 2001). Since whisper forecasts are meant to capture overall investor sentiment, an increase in the level of information could potentially increase the relative accuracy of whisper forecasts. This counter argument assumes that whisper forecasts are primarily the product of word-of-mouth projections spread by a broad cross-section of investor participants. By using a large sample of whisper forecasts obtained from EarningsWhispers.com for the period January 2000 through June 2001, we find that whisper forecasts are generally more accurate than analysts’ consensus forecasts in our pre-Reg FD period. This result is consistent with BBW, despite our investigation of a different time period that is characterized as a bear market, our use of whisper forecasts obtained from a different source, and our sample having a broader representation of industries. A contribution of this study is we document a significant shift in relative accuracy from the pre-Reg FD period to the post-Reg FD period. This result is robust to several different specifications of forecast errors. Moreover, these results are consistent when we restrict our analysis to various subsamples of the data including, both profit and loss firms and only observations where the whisper forecast does not equal the I/B/E/S consensus forecast.

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Since whisper forecasts are generally released relatively close to the earnings announcement, they potentially benefit from a timing advantage relative to analysts’ forecasts.3 In contrast to results documented in BBW, when we compare the accuracy of whisper forecasts to analysts’ forecasts made within 5 days of the earnings announcement, we find weak evidence that the analysts’ forecasts are more accurate in the pre-Reg FD period. However, even with this subsample, we document a significant shift in the relative accuracy from the pre- to post-Reg FD periods. We investigate the relative superiority of whisper and analysts’ forecasts as a proxy for market expectations by examining abnormal returns to a non-implementable investment strategy within a narrow window surrounding the earnings announcement. In the pre-Reg FD period, we find no significant difference in abnormal returns between an investment strategy based on whisper forecast errors and an investment strategy based on analysts’ forecast errors. However, in the post-Reg FD period, an investment strategy based on analysts’ forecast errors earns significantly larger abnormal returns compared to an investment strategy based on whisper forecast errors. Finally, we regress whisper forecast errors and analysts’ forecast errors on short-window abnormal returns surrounding the earnings announcement to examine whether the information contained in one forecast error subsumes information in the other. Consistent with our other analyses, we find evidence that the analysts’ forecast errors provide more information to the market; however, in all periods, both analysts’ forecast errors and whisper forecast errors provide information that is incremental to the other. Our results should be of interest to a broad range of market participants, particularly to investors. A great deal of attention has been given to whisper forecasts as a better predictor of actual earnings. Our results provide evidence that Reg FD has affected the dissemination of information to market participants and has adversely affected the relative accuracy of whisper forecasts. Capital market researchers should also find our results interesting since much of their research requires the use of a proxy for market earnings expectations. Our results indicate that analysts’ forecasts are a superior measure of market expectations in the post-Reg FD period. However, although evidence indicates that analysts’ forecasts contain more information, the information contained in whisper forecasts is incremental to that contained in analysts’ forecasts. Therefore, if available, investors and capital market researchers might benefit from including both earnings expectations proxies in their models.

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The next section of the paper provides more detail on whisper forecasts and Reg FD, and develops our hypotheses. Section 3 describes the data used in the study. Sections 4 and 5 present our main results and conclusions, respectively.

2. LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT 2.1. Whisper Forecasts Whisper forecasts are informal earnings forecasts circulated by analysts and investors and offer an alternative measure for the market’s expectations. In addition to quoting the published consensus analyst forecast, financial newsletters and websites often refer to a company’s whisper number to benchmark the company’s latest quarterly performance (Ip 1997; Anders 1998; Louis 2000).4 Although the buzz surrounding whisper numbers has attenuated since the significant price decline in high tech stocks beginning in 2000, the demand for whisper forecasts remains high. Several companies have emerged during the past few years that specialize in providing whisper numbers to investors. BBW (1999) provide evidence that compared to First Call published analyst forecasts, whisper numbers are more accurate and represent a better proxy for market expectations. Due to the informal nature of whisper forecasts, it is difficult, if not impossible, to determine exactly how they are derived. Just as two different analysts might publish unequal forecasts for the same firm/quarter, whisper forecasts can also differ depending on the source. Vendors that supply whisper numbers indicate they combine qualitative and quantitative data from multiple sources to obtain a measure of the market sentiment just prior to the company’s scheduled earnings release. Since the whisper forecast data provided by these vendors are proprietary, explanations on how their whisper numbers are produced are purposely vague. However, the process typically includes (along with perhaps other analyses) surveys of both analysts and investors.5 In periods prior to Reg FD, many speculated that analysts were receiving inside information about a company’s earnings that they could use to disseminate to favored clients, which could have been a significant factor in the evolution of the whisper number.6

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2.2. Regulation Fair Disclosure Reg FD is a product of former SEC chairman Arthur Levitt who during his tenure expressed deep concern about companies’ selective disclosure. In issuing Reg FD, the SEC stated they were increasingly concerned about advanced warnings from company management to large institutional shareholders and analysts that would alert them to important earnings trends before earnings are reported. Allegedly, analysts and their favored clients could ‘‘make a profit or avoid a loss at the expense of those kept in the dark.’’7 Reg FD requires that SEC registrants disclose material nonpublic information through an 8-K filing or press release either simultaneously or before the information is made available to analysts, institutional investors, or shareholders. If a company unintentionally provides material information to select individuals, the same information must be made available to the entire market within 24 hours or the opening of the market, whichever is later. Critics of Reg FD have suggested that it will have a detrimental effect on capital markets. Several response letters to the SEC’s proposal that ultimately led to Reg FD predicted that the regulation would have a ‘‘chilling effect’’ on the disclosure of information by companies. The basis for this argument is that the term ‘‘material’’ cannot be clearly defined and thus, rather than face potential lawsuits from violating Reg FD, companies would choose to merely cut off communications with market participants. The supposed consequence from this result would be less information in the overall market, wider dispersion of analysts’ published forecasts, and increased volatility in equity prices. Several recent academic studies investigate the effect of Reg FD on the information environment. Heflin et al. (2003) report that after Reg FD’s effective date, return volatility surrounding earnings announcements was lower, post-announcement price convergence was faster, analyst forecast bias, accuracy, and dispersion remained relatively unchanged, and the quantity of voluntary forward-looking disclosures by companies increased. Overall, the authors conclude that Reg FD has not resulted in a deterioration of the information environment. Shane et al. (2002) find that long-term absolute forecast errors are higher in the post-Reg FD periods relative to the errors documented in 1999. However, after controlling for the long-term uncertainty and the sign of the short-term earnings forecast error, they find that short-term absolute forecast errors are significantly lower in the post-Reg FD period compared to the preceding year. In addition, Shane et al. (2002) find a smaller absolute

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price response to earnings announcements in the post-Reg FD period compared to the preceding year. Taken together, these results suggest that Reg FD has reduced the amount of private information available to analysts at the beginning of the earnings period, however, analysts are able to compensate by gathering more information throughout the period until ultimately, the level of publicly available information prior to the earnings announcement is as high or higher than the pre-Reg FD periods. Mohanram and Sunder (2001) find that while absolute forecast errors and forecast dispersion increase after Reg FD, All-Star analysts were less impacted and better able to distinguish themselves. Mohanram and Sunder also find that the importance of analysts’ private information in developing forecasts increases after Reg FD, which is consistent with the results in Shane, et al. (2002) that analysts have placed a greater reliance on individual analysis in the post-Reg FD period. Zitzewitz (2002) finds that, consistent with the intended affects of Reg FD, the percentage of analysts forecasts that occurred on days when no other analyst issued a forecast changed from 70% in the pre-Reg FD period to 50% in the post-Reg FD period. Furthermore, the amount of new information about earnings contained in these ‘‘lone-forecasts’’ changed from 65% in the pre-Reg FD period to 27% in the post-Reg FD period. In summary, most of the early evidence on the effects of Reg FD on the information environment indicates that Reg FD has not had a detrimental effect. Further, a growing amount of evidence indicates that it has resulted in analysts gathering more private information from sources other than direct communications with management. Our study differs from the above research in that we do not assess Reg FD’s effect on the overall information environment. In fact, we examine whether Reg FD’s requirement to eliminate selective disclosure has affected the information characteristics of published analysts’ forecasts relative to whisper forecasts.

2.3. Hypotheses Reg FD could potentially affect the accuracy of both whisper and analysts’ published forecasts. However, we expect the greatest effect will be the dilution of the information content of whisper forecasts relative to published analysts’ forecasts. This expectation is based on the assumption that is consistent with the comments made in the financial press. Private

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communication with company management was likely a significant factor in whisper forecasts deviating from (and improving upon) published analysts’ forecasts during the pre-Reg FD period.8 In addition, early evidence on the effect of Reg FD on published analysts’ forecasts indicates that analysts’ forecasts consist of more private information in the post-Reg FD periods, which should improve their relative accuracy (Shane, 2002; Mohanram & Sunder, 2001; Zitzewitz, 2002). Alternatively, if Reg FD increases the level of information to the overall market, whisper forecasts might increase in relative accuracy due to more information provided to all market participants, who can then influence whisper forecasts. This argument assumes that the value of whispers comes from the fact that they are developed from a broad range of investors instead of just analysts. The formal hypotheses that we examine in this study, stated in the alternative form, are listed as follows: H1. Regulation FD has changed the accuracy of analysts’ published forecasts relative to whisper forecasts. H2. Regulation FD has changed the usefulness of analysts’ published forecasts relative to whisper forecasts as proxies for market expectations. An important extension of BBW that is provided in this study is the sample period employed. Whereas, BBW’s sample period is during a bull market, where high-tech stocks were realizing extremely high returns, our sample period corresponds with a significant market decline. The increased accuracy of whisper forecasts in BBW’s study could be the result of optimism by market participants that eliminated the pessimistic bias in analysts’ forecasts documented in DeGeorge, Patel, and Zeckhauser (1999), Brown (2001), and others. Preliminary evidence in Shane et al. (2002) suggests that the pessimistic bias in analysts’ forecasts persists in an economic downturn; however, it is unclear whether the whisper forecasts will be more optimistic than published forecasts during a bear market. In addition, research has found that firms tend to pre-announce bad news (Tan, Libby, Hunton & Walther, 2002; Soffer et al., 2000; Kasznik & Lev, 1995; Skinner, 1994). The market downturn has resulted in many more preannouncements of earnings by firms, which could affect the relative accuracy of whisper forecasts relative to analysts’ published forecasts. Although this macro-economic factor could affect how our results compare to BBW, it should not affect the conclusions made in this study since both our pre- and post-Reg FD periods are characterized as bear markets.

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3. DESCRIPTION OF DATA Our sample of whisper forecasts was purchased from EarningsWhispers. com (a firm that surveys analysts and other market participants to determine market sentiment about a particular company immediately prior to its scheduled earnings announcement) for the period beginning January 2000 and extending through June 2001.9 We define our pre-Reg FD period as all observations where the quarter ended prior to October 1, 2000. The period from October 1, 2000, to November 30, 2000, is excluded from our analysis and serves as a transitional period for companies to become familiar with the requirements of Reg FD. All other observations that occur subsequent to November 30, 2000, is defined as the post-Reg FD period. The database provided by EarningsWhispers.com includes the whisper forecast, the earnings announcement date, the published analyst consensus forecast as of the release date, and actual EPS. The number of firm/quarter observations obtained from EarningsWhisper.com was 19,606. From this initial sample, we deleted observations with missing forecast data from the I/B/E/S History Detail database, financial statement data from the COMPUSTAT Quarterly database, and returns data from CRSP. We also delete observations where the quarter ended within our transitional period as defined above. Table 1 provides descriptive statistics for our sample. Panel A summarizes the sample selection criteria and their effects on the overall sample size. Our full sample of 10,540 firm-quarter observations have the necessary data on I/B/E/S, COMPUSTAT, and CRSP to conduct tests for all hypotheses. Panel B of Table 1 shows the distribution of full sample across industries. Our sample is not concentrated to high-tech companies and represents a wide range of industries. Table 2 provides some general statistics on firm size, growth prospects, risk, and analysts’ forecast properties for the different sub-periods that we examine. Not surprisingly for a large sample, both size measures – total assets and market value of equity (MVE) – show considerable skewness in large firms. Both the mean and median values for total assets have increased over the sample period; however, only the median value of MVE has shown a consistent increase. In tandem, the changes in total assets and MVE have contributed to an overall decrease in the mean and median market-to-book ratio over the sample period. Also, the market model beta shows a persistent increase over the sample period. We have no a-priori reason to expect these changes in firm characteristics to influence our results. Moreover, even if, for

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Table 1.

Description of Sample.

Panel A: Sample Selection Process Firms

Observations

Total number of whisper forecasts in database Insufficient analysts’ forecasts from I/B/E/S CRSP data unavailable COMPUSTAT data unavailable Excluding transitional period 9/1/00 to 11/30/00

5174 (909) (157) (243) (50)

19,606 (4136) (470) (2330) (2130)

Full sample

3815

10,540

Panel B: Distribution of Full Sample Over Industries 2-digit SIC Code 10, 12, 14 13, 29 15–17 20–21 22–23 24–25 26–27 28 30–31 32 33–34 35 36 37, 40–47 38–39 48 49 50–51 52–59 60-67 73 70–72, 74–87 99

Industry Description

No. of Firms

%

Mining Energy Construction Food & Tobacco Textile & Apparel Lumber & Wood Products Paper & Publishing Chemicals & Pharmaceuticals Rubber, Plastic, & Leather Glass, Cement, & Ceramic Steel, Metalworks, & Parts Industrial & Office Machinery Electrical Machinery Transportation Manufacturing & Services Misc. Manufacturing Telecommunications Utilities Wholesalers Retail Services Financial Services Cleaning, Advertising, & Business Services Other Services Non-classified

37 116 38 70 51 37 85 253 38 25 98 207 287 155 229 119 126 119 269 601 628 220 7

1.0 3.0 1.0 1.8 1.3 1.0 2.2 6.6 1.0 0.7 2.6 5.4 7.5 4.1 6.0 3.1 3.3 3.1 7.1 15.8 16.5 5.8 0.2

Total

3815

100

example, firm size was to affect forecast errors, our research design compares analysts’ published and whisper forecast errors for the same firm and thus, each firm serves as its own control in each sub-period.

The Relative Accuracy of Analysts’ Published Forecasts

Table 2.

183

Descriptive Statistics.

Panel A: General Descriptive Statistics Pre-Reg FD period

Total assets MVE MB ratio Beta afe_c afe_r wfe

Post-Reg FD period

N

Mean

Median

N

Mean

Median

5864 5864 5864 5864 5864 5864 5864

$5914 $5380 4.62 0.81 0.050 0.203 0.035

$605 $644 2.26 0.59 0.041 0.041 0.000

4676 4676 4676 4676 4676 4676 4676

$8750 $5087 2.61 1.00
0.009
0.007
0.109

$887 $735 2.01 0.75 0.016 0.022 0.000

Panel B: Comparison of Whisper Forecasts with Analysts’ Forecasts

% % % %

WF4AF_C WF ¼ AF_C WF4AF_R WF ¼ AF_R

Pre-Reg FD period ðN ¼ 5864Þ %

Post-Reg FD period ðN ¼ 4676Þ %

53.0 26.0 57.8 17.5

49.0 31.1 57.7 19.6

The sample consists of firm-quarter observations from January 2000 to June 2001 (excluding a Reg-FD transitional period from September through November of 2000) that have daily price data on CRSP, quarterly analyst forecast data on I/B/E/S, financial statement data on Compustat, and quarterly whisper forecast data as obtained from EarningsWhispers.com. MVE is equal to market value of common equity at the end of the fiscal quarter; MB ratio is equal to the market value of common equity divided by the book value of common equity at the end of the fiscal quarter; Beta is the market model beta using daily prices during the fiscal quarter and where the market portfolio is equal to the CRSP equally-weighted portfolio. AF_C is the mean analyst forecast and determined by taking the latest quarterly forecast provided by analyst j for company i in the I/B/E/S Detail History file and calculating the mean of all forecasts by analysts 1 through j. AF_R is the latest forecast for company i provided by any analyst. afe_c (afe_r) is the difference between actual earnings as obtained from I/B/E/S and AF_C (AF_R) deflated by the absolute value of actual earnings. All I/B/E/S data are adjusted for stock splits and/or dividends using adjustment factors provided by I/B/E/S and comparing actual earnings data provided by both I/B/E/S and EarningsWhispers.com. WF is a consensus whisper forecast as provided by EarningsWhispers.com. wfe is the difference between actual earnings as obtained from the EarningsWhispers.com database and WF deflated by the absolute value of actual earnings. The pre-Reg FD (post-Reg FD) period is defined as all fiscal quarters where the earnings announcement is before (after) September 1, 2000 (December 1, 2000).

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The different forecast errors in Panel A (afe_c, afe_r, and wfe) are deflated by the absolute value of actual earnings as reported by the respective databases. All the forecast error metrics show a decrease from the pre- to the post-Reg FD period (i.e. actual earnings decreases relative to forecasts), indicating more optimism in analysts’ forecasts in the post-Reg FD period. Of course, the deteriorating economic conditions probably has some influence on the sign of the forecast error. Note that the median whisper forecast error is zero for both the periods. This result could be due to a bias in the EarningsWhispers.com database of reporting actual earnings that are similar to the whisper forecast. We employ various actual earnings numbers in our primary analyses in an effort to mitigate the effects of any potential reporting bias in both the I/B/E/S and EarningsWhispers.com databases. Panel B of Table 2 provides information about the relative magnitude of the whisper forecasts compared to the analysts’ published forecasts. Two different measures of analysts’ forecasts are used throughout the study. A mean forecast (AF_C) is the mean of the most recent forecast made for every analyst j that follows firm i in quarter t, and the most recent analyst forecast (AF_R) is the most timely forecast for firm i in quarter t made by any analyst. The whisper forecasts are generally more optimistic than the analysts’ forecasts in both periods regardless of which analyst forecast measure is used. The percentage of whisper forecasts that is greater (less) than AF_C in the pre-Reg FD and post-Reg FD periods are 53.0% and 49.0% (21.0% and 19.9%), respectively. It is also the case that the percentage of observations where the whisper forecasts are exactly equal to the analysts’ forecasts has increased in the post-Reg FD period.10 This latter result is consistent with the notion that the level of private information in the market to develop a whisper forecast that is not already impounded in analysts’ forecasts has decreased in the post-Reg FD period.

4. EMPIRICAL RESULTS 4.1. Effect of Reg FD on the Relative Accuracy of Analysts’ Published Forecasts to Whisper Forecasts We test the first hypothesis (H1) by investigating whether Reg FD has affected the accuracy of analysts’ published forecasts relative to whisper forecasts. We provide evidence with respect to this issue by examining squared forecast errors in the pre-Reg FD and post-Reg FD periods.

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Forecast errors are defined as the difference between the analysts’ published forecasts (AF_C and AF_R) or whisper forecasts (WF) and actual earnings. The definition for actual earnings, however, is complicated by the fact that we have several reported earnings numbers to choose from. When employing I/B/E/S analysts’ forecasts, most researchers use actual earnings as reported by I/B/E/S to maintain consistency in the earnings construct that is being forecasted and reported. However, EarningsWhispers.com reports actual earnings that are sometimes different from what is reported by I/B/E/S and one could argue that this actual earnings number most closely corresponds with the whisper forecasts. On the other hand, a skeptic might argue that both I/B/E/S and EarningsWhispers.com report actual earnings that are biased in minimizing their respective forecast errors. Throughout the paper, we report results using actual earnings from both I/B/E/S and EarningsWhispers.com. In addition, although not reported in the tables, we used a third measure; earnings before extraordinary items as reported in COMPUSTAT. Forecast errors using actual earnings from COMPUSTAT are expected to be relatively larger in absolute value; however, this earnings measure is independent of any potential biases that might arise from using actual earnings from the other sources.11 All conclusions using COMPUSTAT actual earnings remain qualitatively identical to what is reported in the paper. Panel A of Table 3 compares the accuracy of analysts’ forecasts and whisper forecasts in different sample periods for the full sample using various measures of squared forecast errors. In the pre-Reg FD period, the evidence suggests that the whisper forecasts are more accurate than the analysts’ forecasts. When actual earnings is obtained from I/B/E/S (EIBES), no significant differences in accuracy are found between whisper forecasts and analysts’ forecasts. However, when actual earnings is obtained from EarningsWhispers.com (EWH), the mean whisper squared forecast error is significantly less than the corresponding values for both AF_C and AF_R and the median whisper squared forecast error is significantly less than the corresponding value for AF_R.12 These results are consistent with BBW who also find that whisper forecasts are more accurate than analysts’ forecasts during their sample period.13 During the post-Reg FD period, we find a definite shift in relative accuracy between analysts’ and whisper forecasts such that analysts’ forecasts become significantly more accurate. Specifically, the result that analysts’ squared forecast errors are significantly less than whisper squared forecast errors is robust to all definitions for analysts’ forecasts and actual earnings.

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Panels B and C of Table 3 present results for the same analysis presented in Panel A for different sub-samples. In Panel B, we attempt to increase the power of our tests by retaining only those observations where the whisper forecast differs from the I/B/E/S Consensus forecast. The results employing this sub-sample are qualitatively equivalent to our main results presented in Panel A. That is, whisper forecasts are generally more accurate than analysts’ forecasts in the pre-Reg FD period but become less accurate postReg FD. In Panel C, we compare the accuracy of whisper with analysts’ forecasts that were made within 5 days of the earnings announcement. BBW provide a similar analysis since whisper forecasts potentially benefit from a timing advantage given that they are typically made within a short time period surrounding the earnings announcement. BBW find that although the difference in squared forecast errors between whisper and analysts’ forecasts Table 3.

Squared Forecast Errors.

Panel A: Full Sample Pre-Reg FD period ðN ¼ 5864Þ Mean IBES 2

(AF_C–E ) (AF_C–EWH)2

0.0054 0.0055

(AF_R–EIBES)2 (AF_R–EWH)2 (WF–EIBES)2 (WF–EWH)2

Median

Post-Reg FD period ðN ¼ 4676Þ Mean

Median

0.0004 0.0004

+

0.0058 0.0063+

0.0004+ 0.0004+

0.0054 0.0055

0.0004 0.0004

0.0060+ 0.0065+

0.0004+ 0.0004+

0.0054 0.0053,

0.0004 0.0004

0.0071 0.0073

0.0004 0.0004

Panel B: Whisper Forecast6¼I/B/E/S Consensus Pre-Reg FD period ðN ¼ 5063Þ Mean IBES 2

) (AF_C–E (AF_C–EWH)2

0.0058 0.0060

(AF_R–EIBES)2 (AF_R–EWH)2 (WF–EIBES)2 (WF–EWH)2

Median

Post-Reg FD period ðN ¼ 3897Þ Mean

Median

0.0004 0.0004

+

0.0066 0.0069+

0.0004+ 0.0004+

0.0058 0.0059

0.0004 0.0004

0.0068+ 0.0072+

0.0004+ 0.0004+

0.0058 0.0056, 

0.0009 0.0009

0.0080 0.0081

0.0009 0.0009

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187

Table 3. (Continued ) Panel C: Most Recent I/B/E/S Forecast is within 5 days of Earnings Announcement Pre-Reg FD period ðN ¼ 812Þ

Post-Reg FD period ðN ¼ 588Þ

Mean

Median

Mean

Median

(AF_C–EIBES)2 (AF_C–EWH)2

0.0057 0.0060

0.0004+ 0.0004

0.0054+ 0.0060+

0.0004+ 0.0004+

(AF_R–EIBES)2 (AF_R–EWH)2

0.0049+ 0.0054

0.0004+ 0.0004+

0.0054+ 0.0063+

0.0004+ 0.0004+

(WF–EIBES)2 (WF–EWH)2

0.0063 0.0061

0.0009 0.0009

0.0078 0.0084

0.0009 0.0009

The complete sample consists of 10,540 firm-quarter observations from January 2000 to June 2001 (excluding observations that fall within a transitional period of September through November of 2000). The pre-Reg FD (post-Reg FD) period is defined as all fiscal quarters where the earnings announcement are before (after) September 1, 2000 (December 1, 2000). WF is a consensus whisper forecast as provided by EarningsWhispers.com. AF_C is a consensus analyst forecast and is determined by taking the latest quarterly forecast provided by analyst j for company i in the I/B/E/S Detail History file and calculating the mean of all forecasts by analysts 1 through j. AF_R is the latest forecast for company i provided by any analyst. E represents actual earnings as reported by company i. Since actual earnings will differ across various sources, the superscript to E indicates the source of actual earnings: IBES ¼ I/B/E/S; WH ¼ EarningsWhispers.com. All forecast errors are winsorized at the extreme two percent tails. All data obtained from I/B/E/S are adjusted for stock splits and/or dividends using the adjustment factors provided by I/B/E/S and comparing actual earnings data provided by both I/B/E/S and EarningsWhispers.com.  Indicates that the squared unscaled whisper forecast error is significantly less than the corresponding squared unscaled I/B/E/S consensus forecast error at the a ¼ 0:05 level.  Indicates that the squared unscaled whisper forecast error is significantly less than the corresponding squared unscaled I/B/E/S most recent forecast error at the a ¼ 0:05 level. + Indicates that the squared unscaled analyst forecast error is significantly less than the corresponding squared unscaled whisper forecast error at the a ¼ 0:05 level.

are reduced when using the most recent analyst forecast, whisper forecasts are still more accurate. The results for our sample presented in Panel C of Table 3 differ from BBW. In the pre-Reg FD period, the only significant differences we document indicate that analysts’ forecasts are more accurate than whisper forecasts; however, this is not always the case when actual earnings are defined as EWH. More importantly for purposes of this study, we continue to document a significant shift from the pre-Reg FD period to

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the post-Reg FD period, no matter how we define actual earnings and analyst forecast, the forecast errors using analysts’ forecasts are significantly less than those using whisper forecasts in the post-Reg FD period. Brown (2001) shows that during the latter part of the 1990’s, analysts’ forecasts generally have a pessimistic bias for profit firms; whereas, no bias is documented for loss firms. We examine whether Reg FD has had a differential effect on profit versus loss firms by replicating the analysis in Table 3 partitioned on the profit status of the firm. The results from this analysis, presented in Table 4, provide the same general conclusion that Reg FD has positively affected the accuracy of analysts’ forecasts relative to whisper forecasts. Panels A and B of Table 4 also show that this shift in relative accuracy does not depend on the profit status of the firm. Similar to results in Table 3, when the sample is restricted to observations where the analyst forecast is made within 5 days of the earnings announcement, Panel

Table 4.

Squared Forecast Errors Partitioned on Profit Status of Firm.

Panel A: Full Sample Pre-Reg FD period Profit ðN ¼ 4341Þ

Loss ðN ¼ 1523Þ

Post-Reg FD period Profit ðN ¼ 3266Þ

Loss ðN ¼ 1410Þ

(AF_C–EIBES)2 (AF_C–EWH)2

0.0041 0.0042

0.0090 0.0093

0.0038+ 0.0040+

0.0106+ 0.0116+

(AF_R–EIBES)2 (AF_R–EWH)2

0.0040 0.0041

0.0093 0.0095

0.0041+ 0.0043+

0.0105+ 0.0117+

(WF–EIBES)2 (WF–EWH)2

0.0042 0.0040

0.0090 0.0087

0.0050 0.0050

0.0119 0.0126

Panel B: Whisper Forecase6¼I/B/E/S Consensus Pre-Reg FD period Profit ðN ¼ 3746Þ

Loss ðN ¼ 1317Þ

Post-Reg FD period Profit ðN ¼ 2741Þ

Loss ðN ¼ 1156Þ

(AF_C–EIBES)2 (AF_C–EWH)2

0.0045 0.0046

0.0095 0.0098

0.0043+ 0.0044+

0.0120+ 0.0129+

(AF_R–EIBES)2 (AF_R–EWH)2

0.0044 0.0045

0.0098 0.0100

0.0046+ 0.0048+

0.0118+ 0.0129+

(WF–EIBES)2 (WF–EWH)2

0.0045 0.0044

0.0095 0.0092

0.0056 0.0055

0.0136 0.0141

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Table 4. (Continued ) Panel C: Most Recent I/B/E/S Forecast is within 5 days of Earnings Announcement Pre-Reg FD period Profit ðN ¼ 606Þ IBES 2

Post-Reg FD period

Loss ðN ¼ 206Þ

Profit ðN ¼ 427Þ

+

+

Loss ðN ¼ 161Þ

(AF_C–E ) (AF_C–EWH)2

0.0048 0.0048

0.0084 0.0094

0.0042 0.0045+

0.0086 0.0101

(AF_R–EIBES)2 (AF_R–EWH)2

0.0040+ 0.0042

0.0075+ 0.0089

0.0046+ 0.0050+

0.0078 0.0098

(WF–EIBES)2 (WF–EWH)2

0.0050 0.0049

0.0103 0.0096

0.0064 0.0065

0.0116 0.0134

The complete sample consists of 10,540 firm-quarter observations from January 2000 to June 2001 (excluding observations that fall within a transitional period of September through November of 2000). The pre-Reg FD (post-Reg FD) period is defined as all fiscal quarters where the earnings announcement are before (after) September 1, 2000 (December 1, 2000). WF is a consensus whisper forecast as provided by EarningsWhispers.com. AF_C is a consensus analyst forecast and is determined by taking the latest quarterly forecast provided by analyst j for company i in the I/B/E/S Detail History file and calculating the mean of all forecasts by analysts 1 through j. AF_R is the latest forecast for company i provided by any analyst. E represents actual earnings as reported by company i. Since actual earnings will differ across various sources, the superscript to E indicates the source of actual earnings: IBES ¼ 4 I/B/E/S; WH ¼ EarningsWhispers.com. All forecast errors are winsorized at the extreme two percent tails. All data obtained from I/B/E/S are adjusted for stock splits and/or dividends using the adjustment factors provided by I/B/E/S and comparing actual earnings data provided by both I/B/E/S and EarningsWhispers.com. * Indicates that the squared unscaled whisper forecast error is significantly less than the squared unscaled I/B/E/S consensus forecast error at the a ¼ 0:05 level.  Indicates that the squared unscaled whisper forecast error is significantly less than the squared unscaled I/B/E/S most recent forecast error at the a ¼ 0:05 level. + Indicates that the squared unscaled analyst forecast error is significantly less than the squared unscaled whisper forecast error at the a ¼ 0:05 level.

C of Table 4 shows significantly lower squared forecast errors for analysts’ forecasts in the pre-Reg FD period; however, only when actual earnings is defined as EIBES. In the post-Reg FD period, no differences in forecast accuracy is documented for loss firms; however, this result might be a function of low power due to small sample size.

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4.2. Effect of Reg FD on Whisper Forecasts as a Proxy for Market Expectations This section examines how Reg FD has affected the usefulness of whisper forecasts relative to analysts’ published forecasts as a proxy for the market’s expectations of earnings (a test of H2). Similar to BBW, we adopt three nonimplementable trading strategies based on the errors of whisper and analysts’ forecasts and compare the strategies to determine which one results in the largest abnormal return. The first trading strategy involves buying (selling short) firms that report earnings greater (less) than the analysts’ mean published forecast (AF_C) and selling short (buying) the CRSP-equally-weighted market portfolio index and holding this portfolio for 3 days surrounding the earnings announcement (from day
1 to day +1 relative to the earnings announcement). The second and third trading strategies are equivalent to the first but based on the most recent analyst forecast (AF_R) and whisper forecast (WF). It is expected that all three forecasts (AF_C, AF_R, and WF) are correlated with market expectations and therefore, each trading strategy should result in a significantly positive abnormal return. However, the forecast error that results in the largest market surprise should produce the largest abnormal return surrounding the earnings announcement. In their pre-Reg FD sample period, BBW follow a similar trading strategy and document higher mean abnormal returns for the strategy based on whisper forecasts compared to analysts’ published mean forecasts. Table 5 reports our results for the two separate periods. Panel A presents results for the entire sample. As expected, all three trading strategies result in a highly significant and positive abnormal return within the 3-day window. We are unable to document a significant difference in the trading strategies during the pre-Reg FD period. After the implementation of Reg FD, we find significantly higher mean abnormal returns for the trading strategies based on analysts’ published forecasts compared to the trading strategy based on whisper forecasts. Consistent with H2, these results suggest that Reg FD has affected the relative usefulness of whisper forecasts compared to analysts’ published forecasts as a proxy for market expectations. In an attempt to increase power, Panel B of Table 5 restricts the sample to only those observations where the whisper forecast and most recent analyst published forecast differ by at least 3 cents. The results from Panel B are qualitatively identical to those for the full sample.

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As an alternative test for H2, we examine the association of whisper and analysts’ forecast errors with abnormal returns surrounding the earnings announcement using the following least-squares regressions: CARit ¼ a0 þ a1 AFEit þ it

(5)

CARit ¼ b0 þ b1 WFEit þ fit

(6)

CARit ¼ g0 þ g1 AFEit þ g2 WFEit þ jit

(7)

where CAR ¼ 3-day market adjusted return surrounding the earnings announcement, AFE ¼ analyst forecast error: defined as actual earnings as obtained from I/B/E/S minus analysts’ mean published forecast deflated by beginning of period price,14 WFE ¼ whisper forecast error: defined as actual earnings as obtained from I/B/E/S minus whisper forecast deflated by beginning of period price. Comparing the adjusted R2 values of Eqs. (5) and (6) provides an indication of the relative usefulness of AF_C and WF as proxies for market Table 5.

Abnormal Returns to Trading Strategy Based on Whisper and Analysts’ Forecasts and Actual Earnings.

Panel A: Full Sample Pre-Reg FD ðN ¼ 5864Þ

Post-Reg FD ðN ¼ 4676Þ

AF_C Return t-statistic

2.08% 14.5**

1.85% 12.1**

AF_R Return t-statistic

1.82% 12.6**

1.99% 13.1**

WF Return t-statistic

1.91% 13.2**

1.53% 9.96**

t-statistic for differences: WF–AF_C WF–AF_R


1.43 0.71


2.18*
3.04**

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Table 5. (Continued ) Panel B: Large Differences Between Whisper and Analysts’ Forecasts Pre-Reg FD ðN ¼ 2022Þ

Post-Reg FD ðN ¼ 1605Þ

AF_C Return t-statistic

1.88% 8.24**

1.73% 6.63**

AF_R Return t-statistic

1.52% 6.63**

1.79% 6.88**

WF Return t-statistic

1.50% 6.55**

0.93% 3.53**

t-statistic for differences WF–AF_C WF–AF_R


1.54
0.06


2.88**
2.66**

The complete sample consists of 10,540 firm-quarter observations from January 2000 to June 2001 (excluding a transitional period from September through November of 2000). The pre-Reg FD (post-Reg FD) period is defined as all fiscal quarters where the earnings announcement is before (after) September 1, 2000 (December 1, 2000). Return represents a 3-day return surrounding the earnings announcement to a trading strategy of buying (selling short) stocks where the analyst or whisper forecasts are greater (less) than actual earnings as reported by I/B/E/S and selling short (buying) the CRSP equally weighted market portfolio index. WF is a consensus whisper forecast as provided by EarningsWhispers.com. AF_C is a consensus analyst forecast and is determined by taking the latest quarterly forecast provided by analyst j for company i in the I/B/E/S Detail History file and calculating the mean of all forecasts by analysts 1 through j. AF_R is the latest forecast for company i provided by any analyst. Observations where the most recent analyst forecast and whisper forecast differ by 3 cents in absolute value are defined as large. + * ** , , Indicate significant at the a ¼ 0:10; 0.05, and 0.01 levels, respectively.

expectations. Estimating Eq. (7) allows us to assess the incremental usefulness of WFE and AFE given that the other forecast error is already in the model. Table 6 reports the results from estimating Eqs. (5)–(7). Comparing the adjusted R2 values from Eqs. (5) and (6), we find that AFE provides more explanatory power for abnormal returns surrounding the earnings announcement than does WFE for both periods. The results from estimating Eq. (7) indicate that AFE has larger incremental usefulness than does WFE. In each period, the coefficient magnitude and t-statistic for AFE is larger

OLS Regressions of Earnings Announcement Abnormal Returns on Whisper and Analysts’ Forecast Errors. Regression Equations CARit ¼ a0 þ a1 AFEit þ it CARit ¼ b0 þ b1 WFEit þ fit CARit ¼ g0 þ g1 AFEit þ g2 WFEit þ jit Eq. (5) a1 (t-stat)

Adj-R2

Eq. (6) b1 (t-stat)

Adj-R2

(5) (6) (7) F-tests

Eq. (7) g1 (t-stat)

g2 (t-stat)

Adj-R2

Eq. (7) vs. Eq. (5)

Eq. (7) vs. Eq. (6)

Pre-Reg FD period ðN ¼ 5864Þ

3.96 (14.5)

3.43%

3.43 (13.5)

3.01%

2.72 (6.25)

1.48 3.69

3.64%

13.62*

39.07*

Post-Reg FD period ðN ¼ 4676Þ

3.40 (13.4)

3.66%

2.84 (12.5)

3.20%

2.34 (5.88)

1.23 (3.47)

3.89%

12.03*

34.62*

The Relative Accuracy of Analysts’ Published Forecasts

Table 6.

The sample and period definitions are as defined in previous tables. CAR ¼ 3-day market adjusted return surrounding the earnings announcement; WFE ¼ whisper forecast error, defined as actual earnings from I/B/E/S minus whisper forecast deflated by beginning of period price; AFE ¼ analyst forecast error; defined as actual earnings from I/B/E/S minus analysts’ mean published forecast deflated by beginning of period price. All regression variables are winsorized at the extreme five percent tails.  indicates significance at the a ¼ 0:01 level.

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than WFE. The F-tests in the last two columns of Table 6 show that AFE provides incremental explanatory power for returns in both periods with F-statistics of 39.07 and 34.62. WFE also provides incremental explanatory power in both periods but the values of the F-statistics are much smaller; 13.62 and 12.03, respectively. These results suggest that analysts’ published forecasts are a better proxy for market expectations even in the pre-Reg FD period when whisper forecasts provided more accuracy. In addition, the results in Table 6 do not indicate that Reg FD has caused a shift in usefulness since analysts’ published forecasts appear to be more useful in the post-Reg FD period, too. Although evidence in Table 6 indicates analysts’ published forecasts are a better proxy for market expectations, the incremental significance of WFE in Eq. (7) for both periods is also interesting. This result suggests that when available, whisper forecasts used concurrently with analysts’ published forecasts can be useful in measuring market expectations and is consistent with results in Brown, Griffin, Hagerman, and Zmijewski (1987) that measurement error in unexpected earnings can be reduced (particularly in shortwindow designs) by including multiple proxies for unexpected earnings in earnings/returns regressions.

5. SUMMARY AND CONCLUSIONS Reg FD has as a primary objective to eliminate selective disclosure of all material information about companies’ past and future operating performance and thereby, level the playing field between analysts, institutional investors, and individual investors. Extant research that investigates the effect of Reg FD on the overall information environment indicates that it has accomplished its intended effects (e.g. Heflin et al., 2003; Eleswarapu, Thompson & Venkataraman, 2004).15 In this study, we hypothesize that Reg FD will affect the accuracy of whisper forecasts and their usefulness as proxies for market expectations relative to analysts’ published forecasts. We examine analysts’ published forecasts and whisper forecasts before and after the official implementation of Reg FD and document results consistent with our hypothesis. Our results are robust to alternative specifications of forecast errors and profit status of the firm. We also investigate the effect of Reg FD on the relative superiority of whisper and analysts’ forecasts as proxies for market expectations by examining abnormal returns to a non-implementable investment strategy

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within a short window surrounding the earnings announcement. In the pre-Reg FD period, we find no significant difference in abnormal returns between an investment strategy based on whisper forecast errors and investment strategies based on analysts’ published forecast errors. However, in the post-Reg FD period, an investment strategy based on analysts’ published forecast errors earns significantly larger abnormal returns compared to an investment strategy based on whisper forecast errors. This result is consistent with Reg FD reducing the amount of private information communicated to market participants that allow them to develop whisper forecasts that contain information not available in analysts’ published forecasts. Finally, we regress whisper forecast errors and analysts’ published forecast errors on short-window abnormal returns surrounding the earnings announcement to examine whether the information contained in one forecast error subsumes information in the other. Consistent with our other analyses, we find evidence that analysts’ published forecast errors provide more information to the market. Despite the relative superiority of analysts’ published forecasts; however, we find that in both periods examined, whisper forecast errors provide information that is incremental to analysts’ published forecast errors. This result suggests that when available, whisper forecasts used concurrently with analysts’ published forecasts can be useful in measuring market expectations and is consistent with results in Brown et al. (1987) that measurement error in unexpected earnings can be reduced (particularly in short-window designs) by including multiple proxies for unexpected earnings in earnings/returns regressions.

NOTES 1. The SEC’s definition of ‘‘materiality’’ is based on a Supreme Court ruling that stipulates materiality encompasses anything that a reasonable investor would need to know in order to make an informed decision. 2. Other factors that have been proposed to influence the difference between the whisper number and a consensus forecast are (a) realized earnings by industry competitors, (b) a company’s propensity to meet or beat earnings in prior periods, and (c) investor ‘‘word of mouth.’’ 3. EarningsWhispers.com did not provide us with dates indicating the release of the whisper forecasts; however, in their manual search for whisper forecasts, BBW indicate that they are generally released close to the earnings announcement. 4. Ip (1997) cites Michael Moe, a growth stock strategist at Montgomery Securities: ‘‘the whisper...becomes in effect more important than the published number. The whisper is increasingly becoming the true expectation.’’

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5. Examples of vendors that provide whisper number data are TheWhisperNumber.com, EarningsWhispers.com, and WhisperNumber.com. 6. See, for example, Nocera (2000), O’Keefe (2001), and Edmonston (2001). 7. Securities and Exchange Commission, ‘‘Selective Disclosure and Insider Trading,’’ Section II.A. 8. See Nocera (2000), O’Keefe (2001), and Edmonston (2001). 9. We decided to cut off our sample period at June 2001 so as to avoid the confounding factors that would accompany the September 11, 2001 tragedy. 10. A w2 test indicates these percentage changes are statistically significant. 11. The mean actual earnings per share as reported by I/B/E/S and EarningsWhispers.com is $0.2337 and $0.24919, respectively. The Spearman correlation coefficient between these measures is 0.99235. The mean actual earnings per share as reported by COMPUSTAT is $0.17239 and its Spearman correlation coefficient between I/B/E/S and EarningsWhispers.com actual earnings is 0.915 and 0.917, respectively. 12. Although the median values are the same across the different forecasts, the test for significance (Wilcoxon Signed Rank test) considers the deviation magnitude from the median of other observations. Thus, it is not unusual that the test statistic is significant even when the medians are equal. 13. Our results also indicate that the lowest forecast errors arise when I/B/E/S actuals are used with I/B/E/S forecasts and whisper actuals are used with whisper forecasts. 14. The results presented for these tests are similar when both AFE and WFE are defined using different constructs of actual earnings. 15. Heflin et al. (2001) provide evidence that there is an increase in the quantity of firms’ voluntary forward-looking disclosures. On the other hand, Eleswarapu et al. (2004) provide no evidence that Regulation Fair Disclosure has caused information asymmetry.

ACKNOWLEDGMENT We thank Naomi Soderstrom, Mike Wilkins, Chris Wolfe, and workshop participants at University of Texas-Austin, and Texas A&M University for helpful comments. The authors acknowledge financial support from Mays Business School Summer Research Grant program. We appreciate the contribution of Thomson Financial Corporation for providing earnings per share forecast data available through the Institutional Brokers Estimate System. This data has been provided as part of a broad academic program to encourage earnings expectations research.

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REFERENCES Anders, J. (1998). Web site posts the earnings estimates that most sources will only whisper. The Wall Street Journal, October 19, E1. Bagnoli, M., Messod, D. B., & Susan, G. W. (1999). Whisper forecasts of quarterly earnings per share. Journal of Accounting and Economics, 28(1), 27–50. Brown, L. D. (2001). A temporal analysis of earnings surprises: Profits versus losses. Journal of Accounting Research, 39(2), 221–241. Brown, L., Griffin, P., Hagerman, R., & Zmijewski, M. (1987). An evaluation of alternative proxies for the market’s assessment of unexpected earnings. Journal of Accounting and Economics, 9(1), 159–194. DeGeorge, F., Patel, J., & Zeckhauser, R. (1999). Earnings manipulation to exceed thresholds. Journal of Business, 72(1), 1–33. Edmonston, P. (2001). Shhh! Focus on ‘whisper numbers’ fades as pundits sidestep the informal targets, The Wall Street Journal, July 26, C1. Eleswarapu, V., Thompson, R., & Venkataraman, K. (2004). The impact of regulation Fair Disclosure: trading costs and information asymmetry. Journal of Financial and Quantitative Analysis, 39(2), 209. Heflin, F. L., Subramanyam, K. R., & Zhang, Y. (2003). Regulation FD and the financial information environment: Early evidence. The Accounting Review, 78, 1–37. Ip, G. (1997). Many traders ignore official estimate on earnings, act on whispered number. The Wall Street Journal, January 16, C1. Kasznik, R., & Baruch, L. (1995). To warn or not to warn: Management disclosures in the face of an earnings surprise. The Accounting Review, 70, 113–134. Louis, A. (2000). Heard the latest? The San Francisco Chronicle, April 25, E1. Mohanram, P. S., & Sunder, S. V. (2001). Has regulation fair disclosure affected financial analysts’ ability to forecast earnings? Working Paper, New York University. Nocera, J. (2000). No whispering allowed. Money, 29(13), 71–74. O’Keefe, B. (2001). Is Reg FD wrecking your portfolio? Fortune, 143(8), 392. Shane, P., Soderstrom, N., & Yoon, S. W. (2202). The effects of Reg. FD on earnings management, analysts’ earnings forecasts errors and the market’s earnings surprise: A preliminary analysis, Working Paper. University of Colorado. Skinner, D. J. (1994). Why firms voluntarily disclose bad news. Journal of Accounting Research, 32, 38–60. Soffer, L. C., Thiagarajan, S. R., & Walther, B. R. (2000). Earnings preannouncement strategies. Review of Accounting Studies, 5, 5–26. Tan, H. T., Libby, R., & Hunton, J. E. (2002). Analysts’ reactions to earnings preannouncement strategies. Journal of Accounting Research, 40(1), 223–243. Zitzewitz, E., (2002). Regulation fair disclosure and the private information of analysts, Working Paper. Stanford University.

THE IMPACT OF MANAGEMENT IMAGE AND NON-AUDIT SERVICE FEES ON INVESTORS’ PERCEPTIONS OF EARNINGS QUALITY Sandra Solomon, Philip M. J. Reckers and D. Jordan Lowe ABSTRACT This research examines the extent to which the perceived credibility of a corporation’s audited financial statements is a function of the public’s perception of the corporation’s leadership and/or the auditor’s independence. We look specifically at the public image of the CEO as projected in the press, and the perception of auditor independence as projected by mandated public information about non-audit services. We conducted an experiment to examine these two types of publicly available information for their potential effect on the perceived confidence that third year law students have in corporate financial information. The results reveal that even in an environment fully compliant with Sarbanes-Oxley (2002) reforms, public perceptions of the integrity of management and the independence of auditors influence individuals’ confidence in the financial Advances in Accounting Advances in Accounting, Volume 21, 199–216 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21008-8

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statements. The implications of this research for practice and for future research are also discussed.

INTRODUCTION Evaluative decisions about the credibility of financial statements are made based on a wide variety of information both internal and external to the company. Mandatory financial statements are arguably the initial source from which stakeholders begin to formulate impressions about the corporation. The earnings history of corporations in conjunction with other information provides constituents with the opportunity to assess the credibility of the company’s reported earnings. The extant literature has examined many potential contributors to investor behavior; however, seldom in the accounting literature has the effect of the public image of a corporation’s leadership been examined as a cue to vision, ability or integrity. Anecdotal evidence suggests that the status of Chief Executive Officers (CEOs) has been raised to a level such that their name is synonymous with the company’s reputation (Benezra & Gilbert, 2002). Today’s CEOs are more powerful, more visible and play a more integral role in shaping their companies’ image. Despite the relative importance of the impact of the executive’s image on the credibility of financial statements, there has been limited empirical research to date that provides an understanding of the relationship between public image and investor behavior, or for that matter, employee and/or auditor behavior. This research examines the extent to which the perceived credibility of a corporation’s audited financial statements is a function of the public’s perception of the corporation’s leadership and/or the auditor’s independence. CEOs influence public policy and legislation and even run for political office propelled by that same public image (e.g. presidential and vice-presidential candidates Ross Perot, Dick Cheney). Longstanding auditing standards and recent Sarbanes-Oxley Act (SOX) reforms are clear: the leadership and integrity of corporate management is highly germane to decisions relating to the scope of audit testing, financial statement reliability, and capital market efficiency. But what process do people follow to assess that leadership and integrity? SOX attempts to ensure the ethical behavior of management by requiring management to implement a code of ethics for senior-level officers, to opine personally on the adequacy of internal controls

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and to report all violations or misconduct as well as any breach of fiduciary duty (SOX, 2002). Audit standards explicitly require auditors to conduct an assessment of management integrity and the likelihood of intentional misstatements in determining scope of audit testing. The extant literature has examined how media attention affects the corporation’s reputation (Wartick, 1992; Renkema & Hoeken, 1998), investors’ impressions (Pollock & Rindova, 2003), and the auditor’s opinion (Joe, 2003). Our research looks beyond the macro level of the corporation and looks specifically at the CEO. The integrity of an organization’s leadership and the public’s perceptions of him (her) has potential significant outcomes – personal financial ruin and national loss of confidence in capital markets. Some argue that the media is a proximate cause of the exuberant behavior of investors because they fuel a crisis of confidence (Stock, 2002) and morph CEOs into celebrities (Quarrels, 2002). Whether the media chooses to report information that is flattering of a CEO or disparaging, the impact of this additional information is worthy of inquiry. Investment decisions arguably are also made on the basis of inferences about auditor independence with non-audit services and its influence on financial statement quality. Prior research examining the relationship between non-audit service fees and auditor independence has been mixed. In both experimental and archival studies, some researchers have found that nonaudit service fees do not impair the independence of auditors, or perceptions thereof (see McKinley, Pany & Reckers, 1985; Jenkins & Krawczyk, 2002; Chung & Kallapur, 2003). Other research (Beeler & Hunton, 2000; Frankel, Johnson & Nelson, 2002) has found that auditors with economic incentives are more likely to allow their clients to misrepresent their earnings. This study is designed to complement past (pre-SOX) studies that have examined the relationship between non-audit service fees and perceived earnings quality. Frankel et al. (2002) point out that their methodology cannot account for any inferences that investors may make about management. We explore the question of investors’ inferences regarding perceived confidence in the quality of audited financial statements given information about both the audit fee structure and management’s character. We designed this experiment so that the hypothetical company presented in the case scenarios is compliant with the reforms of SOX. If the SOX reforms are sufficient to improve investor confidence, then the corporate environment presented would tend to bias the outcome of this study against finding any differences in perceived confidence based on management’s image or audit fee structure. That is, we have designed strong tests of the treatments. Still, we find that participants exhibit more confidence in

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earnings when management’s character is portrayed as generous and benevolent. Similarly, participants exhibit more confidence in earnings when auditor’s fees do not include any non-audit related tax advisory services.

RESEARCH QUESTION DEVELOPMENT Image Investors rely on a myriad of information in many accounting decisionmaking contexts. Financial considerations and social influences both motivate behavior and contribute to the formulation of impressions about the corporation’s credibility, trustworthiness, and ability to satisfy shareholder interests. In this post-Enron Era, companies are concerned not only about their corporate image, but also the image of their CEOs and its effects on investor behavior and confidence. One of the objectives of this research is to examine and motivate future research on the relationship between the character of the company’s CEO (non-financial information) and the perceived credibility of reported financial earnings.1 Increasingly, corporations seek to manage the image and reputation that is conveyed to the public. The need to be more visible and increase credibility has made the issue of identity and image salient for organizations (Cheney & Christensen, 1999). It is not enough for companies to establish foundations and fund research projects to promote a responsible image. Companies must also manage the image of the CEO as it contributes to almost half of the overall image of the corporation (Burson-Marsteller, 2001). Academics, practitioners, and media all agree that the CEO plays an intricate part in the overall performance and credibility of the corporation (Park & Berger, 2004). Some suggest that the present reform environment has further heightened the role of and reliance on the CEO’s character for decision-making. For instance, more than 90% of Wall Street analysts and institutional investors state that they were more likely to buy or recommend a stock based on a positive CEO image (Burson-Marsteller, 2001). The recent accounting scandals and fall of the once highly praised CEOs have led to increased corporate accountability as a result of the reforms of SOX. CEOs have an increased likelihood of penalties and confinement as a result of financial failures and restatements (SOX, 2002). Thus, companies have increased reluctance about making statements related to financial performance and are likely to focus more on non-financial measures that provide cues to the financial performance of the organization. The caution

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about claims regarding earnings optimism has led firms to focus on managing firm and management image (Malinoski, 2004). Furthermore, managing public image and presenting the most positive image possible is not limited to the large public firms. In fact, the frequency of press coverage of CEOs, for smaller companies, was equal to or greater than the press coverage received by Fortune 500 companies during the period 1990–2000 (Park & Berger, 2004). Burson-Marsteller (2001) conducted a ‘‘CEO Reputation Survey’’ to assess the role of the CEO’s pervasiveness both inside and outside the company. The company surveyed 1100 U.S. participants (CEOs, managers, financial analysts, institutional investors, business journalists, and government representatives) and found that the CEO’s image not only affected perceived corporate reputation, but also analyst behavior and employee behavior. A vast majority (95%) of analysts responded that they based their stock purchase recommendations on their perceptions of the company’s CEO. A positive impression of the CEO also accounted for 88% of the respondents recommending the company as a potential employer. Many constituent groups rely on the image of the CEO as part of their decision-making process. That is, it’s not just investors and employees, but customers, government regulators, and board members all have to believe in the CEO and be inspired by him (her) (Investor Relations Business 2000). The CEO puts a face on the company and is key to shaping the company’s reputation (Hoffman, 1999). Thus, the CEO is arguably the most important factor associated with the company’s character and image (Garbett 1988). Media Influences We gain our understanding about the character of CEOs primarily from the various media sources. Media coverage of CEOs by four prominent newspapers (Wall Street Journal, New York Times, USA Today, and Houston Chronicle) increased 5-fold from 1990–2000 (Park & Berger, 2004). Deephouse (2000) suggests that the media not only convey information about CEOs, but also makes and presents a reputational assessment. Moreover, we are often provided with more information about the personal and private lives of CEOs than the financial information of their corresponding companies. The business press has often turned CEOs into monuments larger than life, the law, and perfect in every way (Quarrels, 2002). Furthermore, the saliency of positive attributes of the CEO in the media spreads the character of the CEO across a wide range of audience. Public opinion is formed as a result of salient cues from the media and thus the prominence of the media influences perceptions of the CEO’s image.

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The media presents flattering or disparaging characteristics about the image of the CEO that elicit affective reactions. Affect represents a broad category of affective processes including emotions, moods and evaluations (Fiske & Taylor, 1991).2 Although the influence of affect has been largely ignored in accounting research, recently researchers have shown that introducing affective attributes into the decision context alters predictions and provides better explanations of various behavioral outcomes (see Kadous, 2001; Moreno, Kida, & Smith, 2002). Kida and Smith (1995) propose an affect model of financial decision-making, which argues that investors encode into memory an event and the associated affective reaction. They predict that the affective reaction will influence the investors’ overall behavior. Anderson and Thompson (2004) further suggest that positive affective characteristics signal a greater level of trustworthiness. Thus, it is our proposition that decision-making is affected by more than just bounded rationality, but affective processes are also involved. Decisions contain an essential emotional component and decision makers tend to do what feels right (Kisfalvi & Pitcher, 2003). Just as prior research has found that positive affective attributes elicit positive feelings, we believe that positive attributes of the CEO will elicit positive feelings about the CEO and the company. This reasoning leads to the first research question: RQ1. Will investors exhibit greater confidence in a company’s earnings when manager’s image is portrayed as ‘‘outwardly model’’ (generous and benevolent)? Audit Fee Structure A major concern of the Securities and Exchange Commission (SEC) is that auditors have become involved in too many aspects of their clients’ businesses. As a result, the auditors allegedly have lost a certain requisite level of skepticism and are viewed by others as a vendor that does whatever it takes to make the sale and satisfy the client SEC (2000a). The SEC’s view is clear and explicit: ‘‘The rapid rise in the growth of non-audit services has increased the economic incentives for the auditor to preserve a relationship with the audit client, thereby increasing the risk that the auditor will be less inclined to be objective’’ (SEC, 2000b).

To address these concerns the SEC issued Section 201 of SOX that outlines the services that auditors are prohibited from providing to publicly held companies. The SEC subsequently issued detailed rules related to the prohibition and disclosure of non-audit fees (SEC, 2003). Specifically, the SEC (2003) prohibited registrants from purchasing financial information systems

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design and implementation services or internal audit outsourcing from the incumbent external auditor. Firms may still purchase many types of nonaudit services (NAS) including tax compliance and consulting; however, the corporate board must explicitly authorize any tax or consulting services procured from its external auditor (SOX, 2002). Regardless, these services remain highly contentious issues. These recent actions by legislators and the SEC bear witness to continuing concerns that NAS have the potential to influence inappropriately audit judgments in favor of their clients. DeAngelo (1981) suggests that a reasonable measure of independence is the market perceived assessment of the joint probability that an auditor will discover a misstatement and report it. In terms of audit quality, auditors lacking independence may be reluctant to report a discovered breach or they may apply less effort to discover one. Perceptions of auditor independence could affect assessments of audit quality and thereby perceived financial statement reliability. Extensive research has examined and found mixed results regarding the effect of NAS on auditor independence. We highlight a few of these studies with emphasis on recent research utilizing more rigorous methodology. These studies all collected their data pre-SOX. Frankel et al. (2002) utilize discretionary accruals as a measure of auditor independence. They find an association between higher amounts of NAS and higher levels of discretionary accruals, suggesting that NAS impairs independence. They also find a positive association between fees paid for NAS and instances where firms just meet or marginally beat earnings expectations. The more firms paid their auditors for NAS, the more likely they were to just meet or beat earnings expectations. The authors suggest that these findings are consistent with propositions that auditors were more willing to help firms engage in earnings management when it is in their own financial interests. Beeler and Hunton (2003) found experimentally that audit partners exhibited more biased decision-making in the presence of potential non-audit revenue. They find evidence that audit partners’ evaluation of evidence (i.e. searched more supportively, weighted confirmatory evidence more heavily, and made more elaborate arguments) was affected by the audit fee structure. The potential for significant future opportunities for non-audit fees also affected going concern judgments. The authors concluded that the provision of NAS creates a perceived lack of auditor independence. Conversely, other studies have concluded that NAS does not influence perceived auditor independence or corresponding concerns related to financial statement reliability. McKinley et al. (1985) showed that the provision of NAS does not necessarily lead to perceptions of a lack of

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independence. The authors provided loan officers with firm information and requested that they consider a loan decision. The results show that loan officers’ lending decisions were unaffected by the provision of NAS. Similarly, Jenkins and Krawczyk (2002) find that accounting professionals and investors’ perceptions of auditors’ independence and objectivity were not impaired by the existence of additional non-audit fees. The authors provided participants with scenarios that encompass a wide range of audit services (audit only, material NAS, nominal NAS – actuarial services, legal services, internal audit outsourcing, and software training). The results illustrated a positive relationship between NAS and perceptions of independence. These results suggest that NAS fees do not impair perceptions of independence but may actually enhance them as the auditor has more to lose in terms of reputation by compromising independence. From a sample of 1,871 firms, Chung and Kallapur (2003) failed to find any relationship between unexpected accruals and auditors’ independence. The authors measured client significance based on client importance to the audit firm as a whole and found no significant association with abnormal accruals. Even for subsets of firms, the authors failed to detect any association between NAS fees and earnings management. They concluded that reputational concerns are the limiting factor for auditor behavior. Although academic research is mixed, regulators clearly believe that NAS fees have the potential to impact auditor independence. In spite of efforts to increase investor confidence through the implementation of reforms by SOX, we believe that the recent accounting scandals have made investors more skeptical and, if so, they may scrutinize all available information more closely and incorporate this information into their decisions. We conjecture that NAS fees in the post-SOX era will negatively influence investors’ perceptions of auditor’s independence, and potentially flavor perceptions of management integrity as well. This leads us to our second research question: RQ2. Will investors exhibit greater confidence in a company’s earnings when auditors do not provide NAS?

METHOD Participants Ninety-five law students from a large southwestern university participated in this experiment. Students participated in the study during their regular class

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time; no financial remuneration was offered. We selected law students for several reasons. First, they are members of the investing public (more than 68% of the participants presently or previously owned stock). Second, they are trained in principles of sound reasoning, and thus arguably are in a better position to differentiate germane (from non-germane) information and integrate it into decisions. Third, by the time of this writing, these individuals are practicing members of the legal profession. Given the magnitude of legal costs to public accounting firms, the views of members of the legal profession seem particularly relevant.

Case Instrument Participants were provided with an experimental case describing a manufacturing company that has been in business for 12 years. The instrument included the following background information: industry growth, management’s compensation scheme, audit and non-audit fees, audit opinion, number of board members (independent and non-independent), number of board meetings per year, auditor rotation status, and management characteristics. The instrument reflected a company with a control environment that meets SOX’s requirements for corporate governance. After reading this information, participants were asked to evaluate the credibility of the firm’s financial statements and whether they believed that the company is a good investment.

Design The experimental design was a 2
3 between subjects design. This study manipulated two independent variables – auditor’s fees and management’s image. We provided participants one condition wherein there are no nonaudit fees (AuditOnly) and one condition wherein there are both audit fees and non-audit related tax service fees (AuditPlusTax). Under the (AuditOnly) condition, audit services provided to the company resulted in fees totaling $1:3 M: In the (AuditPlusTax) condition, in addition to audit fees of $1:3 M; there were audit related tax fees of $200 K and non-audit tax fees were $1:7 M: This audit versus non-audit fee structure is consistent with practice. It is also important to note that SOX does not specifically prohibit tax-related services.

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For management’s image, participants were presented with three different characterizations: an ‘‘outwardly model’’ CEO hereinafter referred to as GOOD, a CEO of questionable ethics hereinafter referred to as BAD, and a control condition (see Appendix A). A GOOD CEO was described with positive affective characteristics such as benevolent and generous to the community (CEO Magazine man of the year and a board member for the United Way and Christian Children’s Fund). A BAD CEO was described with negative affective characteristics related to prior allegations of misreporting financial statements. The SEC required the CEO to restate the company’s financial statements in one prior dispute. Finally, the control condition presented no additional information about the CEO’s characteristics. The dependent variables required participants to respond to two questions on Likert scales. The first question is a direct question about participants’ confidence in reported earnings; the second is an indirect question regarding their personal willingness to invest in the company. 1. (Direct) How confident are you under these conditions that the financial statements of the corporation are free of material error or omission? No Confidence 0yy1yy2yy3yy4yy5yy6yy7yy8yy9yy10 Complete Confidence

2. (Indirect) How willing would you be to invest significant personal funds, assuming funds availability? Not Willing At All 0yy1yy2yy3yy4yy5yy6yy7yy8yy9yy10 Very Willing

In addition to the primary dependent variables, participants were also asked to respond to survey questions designed to measure any pre-existing attitudes (see Appendix B). These pre-existing attitudes were examined in order to determine if any of the variance in our dependent measures could be explained by investors’ pre-existing attitudes or if the treatments were conditional on pre-existing attitudes. These questions had been used in prior accounting research (see Anderson, Jennings & Reckers, 1993; Anderson, Jennings, Lowe & Reckers, 1997; Lowe & Reckers 1994; Reckers, Jennings & Pany, 2004). We factor analyzed the results to reduce the number of dimensions. Three factors emerged which we characterized as relating to: (1) the auditor’s role as a Watchdog (questions 2 and 8), (2) attitudes regarding strict liability judicial philosophy (i.e. the Insurance Hypothesis: questions 4 and 6), and (3) the perceived current Standards of Performance (questions 3 and 5).

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RESULTS To examine whether audit fee structure and management’s image influence perceived financial statement credibility, we performed separate analysis of covariance (ANCOVA) on both the direct and indirect measures of confidence. To control for any pre-existing attitudes regarding the accounting profession, we examined the three factors that resulted from our factor analysis to determine their suitability as covariates for our models. Initial analysis revealed that the Insurance Hypothesis and the Standards of Performance factors were correlated with the dependent variables.3 We modeled the Insurance Hypothesis factor as a categorical variable partitioned at the median because of its nonlinear relationship. We included the Standards of Performance in the model as a continuous covariate. Direct Question Table 1 presents the ANCOVA findings and related treatment means, standard deviations, and cell sizes. As indicated in Table 1, participants’ confidence in the credibility of the reported earnings was dependent on the CEO’s image (F ¼ 3:66; P ¼ 0:015).4 Participants provided significantly greater confidence when the CEO’s image was GOOD (6.08) as compared with when it was BAD (4.29). The control condition (5.33) was between these two means and not significantly different to either. A main effect for audit fee was also significant (F ¼ 3:30; P ¼ 0:036). As expected, participants expressed greater confidence in reported earnings under the AuditOnly condition (5.73) than when it also provided non-audit (tax) services AuditPlus (4.74). In addition, the Standards of Performance factor was found to be a significant covariate in the model (F ¼ 5:75; P ¼ 0:010). No significant interactions were found. Indirect Question A willingness to invest with personal funds is perceived as an operationally important indirect measure of the participants’ confidence in reported earnings. Indirect questions have the potential to overcome potential instrumentation demand effects. We reasoned that the more willing the participants were to invest, the more confident they would be in the reported earnings. The results of this indirect question were significant for management’s image (F ¼ 2:47; P ¼ 0:046). Participants exhibited greater

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Table 1.

Credibility of Financial Statements.

Panel A: Analysis of Variance Model Source of Variation AuditFee Image Insurance Performance

Sum of Squares

Df

Mean Square

F

P

19.56 43.40 2.89 34.10

1 2 1 1

19.56 21.70 2.89 34.10

3.30 3.66 0.49 5.75

0.036 0.015 0.244 0.010

Panel B: Treatment Means (S.D.) Audit Fee

N

Mean

S.D.

AuditOnly AuditPlus

47 45

5.73 4.74

2.51 2.78

Panel C: Treatment Means (S.D.) Image

N

Mean

S.D.

Good Control Bad

31 31 30

6.08 5.33 4.29

2.68 2.65 2.48

confidence in the reported earnings when the CEO’s image was GOOD (5.48) than when it was BAD (3.96). The control mean (4.85) was not significantly different when compared with the other two means. Results also revealed that the manipulation of audit fee structure provided significant results (F ¼ 6:35; P ¼ 0:007). Participants expressed greater confidence in reported earnings when the auditor only provides audit services AuditOnly (5.47) than when it also provided non-audit (tax) services AuditPlus (4.06). No significant interactions were noted. As before, the Standards of Performance factor was found to be a significant covariate in the model (F ¼ 4:55; P ¼ 0:018). The results of the ANCOVAs suggest that existing attitudes about the standards of performance impact perceptions and decisions of potential investors (Table 2).

DISCUSSION AND IMPLICATIONS In this study, we examined the relationship between public information related to the CEO’s character and inferences of auditor independence that might be drawn from the performance of NAS, and perceived credibility of

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Table 2.

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Willingness to Invest.

Panel A: Analysis of Variance Model Source of Variation Audit Fee Image Insurance Performance

Sum of Squares

Df

Mean Square

F

P

40.00 31.10 7.94 28.64

1 2 1 1

40.00 15.55 7.94 28.64

6.35 2.47 1.26 4.55

0.007 0.046 0.132 0.018

Panel B: Treatment Means (S.D.) Audit Fee

N

Mean

S.D.

AuditOnly AuditPlus

47 45

5.47 4.06

2.37 2.89

Panel C: Treatment Means (S.D.) Image

N

Mean

S.D.

Good Control Bad

31 31 30

5.48 4.85 3.96

2.75 2.48 2.79

corporate financial earnings. We found that participants showed increased confidence in corporate financial earnings under conditions in which the CEO is portrayed as a generous, benevolent, and a community-oriented corporate leader compared with conditions of negative publicity. We also found that participants have less confidence in financial information audited by firms that simultaneously provide significant non-audit (tax) services, suggesting that auditors are perceived to be less independent when they provide additional NAS. As the accounting profession has evolved so has the role that the media plays in defining the image of CEO’s. The results of this study are only an initial attempt at examining the role of the media in the overall decisionmaking process of investors. We believe that the role of the CEO has and continues to evolve, and that the image of the CEO is integral to how we view the financial health of an organization. Therefore, examining how stakeholders react to cues relating to the CEO’s character and/or ability is important for understanding what factors are incorporated into individuals’ decision-making process. Given the exploratory nature of this study, future research is clearly needed to examine how and to what extent management

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image affects perceptions of the credibility of financial information. For instance, research could provide more definitive evidence on (1) which specific management characteristics are the most influential to investors, (2) whether this influence is conducted primarily thorough affective processes, and (3) whether other types of information could effectively overshadow or mitigate the influence of CEO’s image, particularly when this image is portrayed in a rather negative manner. Our results may also be useful to regulators who are concerned with auditor independence implications from the performance of NAS. Financial statements users value auditor independence because it provides some assurance that financial statements are free of material misstatements. We sought to determine how non-audit fees affect investors’ perceptions. We looked specifically at tax services because these services are not specifically prohibited by SOX, but were the basis of heated debate by legislators and regulators. Our results imply that tax services should be considered to be listed with the other prohibited services (e.g. bookkeeping, information systems design, internal audits, actuarial services) SOX specifies as problematic for auditors to provide their publicly held clients. Future research is clearly needed to determine if our results replicate and to provide additional insights.

NOTES 1. For the purpose of this research, we adopt Newell and Goldsmith’s (2001) definition of credibility as, ‘‘the extent to which constituents feel that the firm can be trusted to tell the truth or not.’’ We also use the words character, reputation, and image interchangeably (Park & Berger, 2004). 2. Evaluations are simply positive or negative reactions that an individual has toward a target. Moods are generally not a reaction to data, but the affective state that the individual brings to a task. Emotions include a variety of affects toward a target. 3. These factors were not correlated with the independent variables. 4. One-tail directional tests were performed for the ANOVAs presented in this study.

REFERENCES Anderson, C., & Thompson, L. L. (2004). Affect from the top down: How powerful individuals’ positive affect shapes negotiations. Organizational Behavior and Human Decision Processes, 95(2), 125–139. Anderson, J. C., Jennings, M. M., Lowe, D. J., & Reckers, P. M. J. (1997). The mitigation of hindsight bias in judges’ evaluation of auditor decisions. Auditing: A Journal of Practice and Theory, 18(2), 20–39.

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Anderson, J. C., Jennings, M. M., & Reckers, P. M. J. (1993). The presence of hindsight bias in peer and judicial evaluation in public accounting litigation. Tort and Insurance Law Journal, 28(3), 462–479. Beeler, J. D., & Hunton, J. E. (2000). Contingent economic rents: Insidious threats to auditor independence. Advances in Accounting Behavioral Research, 5, 21–50. Benezra, K. Gilbert, J. (2002). The CEO as brand. Chief Executive, 174, 22–26. Burson-Marsteller. (2001). CEO Reputation Survey. Burson Marsteller Public Relations and Public Affairs Firm. Cheney, G., & Christensen, L. T. (1999). Identity at issue: Linkages between internal and external organizational communication. New Handbook of Organization Communication. Newbury Park, CA: Sage Publication. Chung, H., & Kallapur, S. (2003). Client importance, nonaudit services, and abnormal accruals. The Accounting Review, 78(4), 931–955. DeAngelo, L. (1981). Auditor independence, ‘‘low balling’’, and disclosure regulation. Journal of Accounting & Economics, 3(2), 113–127. Deephouse, D. L. (2000). Media reputation as a strategic resource: An integration of mass communication and resource based theories. Journal of Management, 26(6), 1091–1112. Fiske, S. T., & Taylor, S. E. (1991). Social cognition. New York, NY: McGraw-Hill. Frankel, R. M., Johnson, M. F., & Nelson, K. K. (2002). The relation between auditors’ fees for non-audit services and earnings management. The Accounting Review, 77(Suppl.), 71–105. Garbett, T. (1988). How to build a corporations’ identity and protect its image. Lexington, MA: Lexington Books. Hoffman, L. (1999). Reputation starts with the CEO. MC Technology Marketing Intelligence, 19(7), 56–58. Investor Relations Business staff. (2000). CEOs make up half of corporate reputations. Investor Relations Business, (June), 1. Jenkins, J. G., & Krawczyk, K. (2002). The relationship between nonaudit services and perceived auditor independence. Views of nonprofessional investors and auditors. Journal of Business and Economic Perspectives, (Fall/Winter), 25–36. Joe, J. (2003). Why press coverage of a client influences the audit opinion. Journal of Accounting Research, 41(1), 109–133. Kadous, K. (2001). Improving jurors’ evaluations of auditors in negligence cases. Contemporary Accounting Research, 18(3), 425–444. Kida, T., & Smith, J. F. (1995). The encoding and retrieval of numerical data for decision making in accounting contexts: Model development. Accounting, Organizations and Society, 20(7/8), 585. Kisfalvi, V., & Pitcher, P. (2003). Doing what feels right: The influence of CEO character and emotions on top management team dynamics. Journal of Management Inquiry, 12(1), 42–66. Lowe, D. J., & Reckers, P. M. J. (1994). The effects of hindsight bias on jurors’ evaluations of auditor decisions. Decision Sciences, 25(3), 401–426. Malinoski, P. (2004). It’s all about ethics. The Manufacturer.com (March), 33. McKinley, S., Pany, K., & Reckers, P. M. J. (1985). An examination of the influence of CPA firm type, size, and MAS provision on loan officer decisions and perceptions. Journal of Accounting Research, 23(2), 887–896.

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Moreno, K., Kida, T., & Smith, J. (2002). The impact of affective reactions on risky decision making in accounting contexts. Journal of Accounting Research, 40(5), 1331–1349. Newell, S., & Goldsmith, R. (2001). The development of a scale to measure perceived corporate credibility. Journal of Business Research, 52, 235–247. Park, D., & Berger, B. (2004). The presentation of CEOs in the press, 1990–2000: Increasing salience, positive valence, and a focus on competency and personal dimensions of image. Journal of Public Relations Research, 16(1), 93–125. Pollock, T. G., & Rindova, V. P. (2003). Media legitimation effects in the market for initial public offerings. Academy of Management Journal, 46(5), 631. Quarrels, E. (2002). Covering ethical cover-ups: Media focus on shining CEO stars leaves us in the dark about their practices. Across the Board, 39(5), 49–50. Reckers, P. M. J., Jennings, M. M., & Pany, K. (2004). Legislating auditor independence through corporate governance and audit firm rotation: Views of U.S. judges. Working paper, Arizona State University. Renkema, J., & Hoeken, H. (1998). The influence of negative newspaper publicity on corporate image in the Netherlands. The Journal of Business Communication, 35(4), 521–535. Sarbanes-Oxley Act. (2002). Public Law No: 107–204. Washington, DC: Government Printing Office. Securities and Exchange Commission (SEC). (2000a). Proposed rule: Revision of the commission’s Auditor Independence Requirements. Available at: http://www.sec.gov/rules/proposed/34-42994.html Securities and Exchange Commission (SEC). (2000b). Final rule: Revision of the commission’s Auditor Independence Requirements. Available at: http://www.sec.gov/rules/final/337919.html Securities and Exchange Commission (SEC). (2003). Strengthening the Commission’s Requirements Regarding Auditor Independence. Available at: http://www.sec.gov/rules/final/338183.html Stock, H. (2002). Media inconsistency is hurting recovery. Investor Relations Business, (December), 1. Wartick, S. (1992). The relationship between intense media exposure and change in corporate reputation. Business and Society, 31(1), 33–49.

APPENDIX A BCA Corporation manufactures a variety of hi-tech embedded computing devices used in manufacturing, and retail operations. This 12-year old NASDAQ firm employs cutting edge technology. Firm information and recent performance:

High Growth Industry 19 Consecutive quarters of increased profit Stock market price multiple of 40 (market ave ¼ 16)

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BAD SEC enforcement actions:

GOOD BCA Chairman & CEO

Management:

Action taken against firm in 1997 requiring restatement of prior financial statements. CEO Farrel alleged to have over-ridden internal controls and directed aggressive and inappropriate revenue recognition practices in 1995/96. Colin Farrel, Harvard MBA CEO Magazine, Man of the Year, 2001 Chair, Greater Denver United Way Campaign, 2000/01 Member of the Board, Intl. Christian Children’s Fund Lucrative bonuses tied to increased profit increase 35% of CEO’s personal wealth held in BCA stock

Corporate Board of Directors: Chairman of Board Colin Farrel, BCA CEO Independent of 7 of 12 Members Management No Financial Interest in 7 of 12 Members BCA Last Reorganization 2002 (in response to Sarbanes-Oxley legislation) Compensation $65,000 (Last raise (10%) in 2002) Meetings per Year 5 Auditor Firm: Audit Fee Audit-Related Tax Compliance Services Non-Audit Related Tax Planning Services Tenure as Auditor

215

$1,300,000 200,000 (Excluded for AuditOnly) 1,700,000 (Excluded for AuditOnly) 12 years

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Status

Continuing Engagement of Audit Firm & Partner in Charge of Audit, Mandatory Rotation of Partner in Charge of Audit in 2006.

Audit Opinion Report on Internal Controls

Favorable (‘‘Clean’’) No Deficiencies Cited

1. How confident are you under these conditions that the financial statements of BCA are free of material error or omission? No Confidence 0y1y2y3y4y5y6y7y8y9y10 Complete Confidence

2. How willing would you be to invest significant personal funds, assuming funds availability? Not Willing at All 0y1y2y3y4y5y6y7y8y9y10 Very Willing

APPENDIX B. ATTITUDE QUESTIONS This set of questions has been used in a number of prior studies including but not limited to the following: Anderson et al. (1993, 1997), Lowe and Reckers (1994), and Reckers et al. (2004). 1. The financial statements contained in the annual report to stockholders are primarily the responsibility of corporate management, and not of the external auditor (CPA). 2. The role of the external auditor is to be a public watchdog. 3. The present standards of audit practice are very high. 4. The big audit firms make plenty of money in the good times, so they should share in the stockholders’ losses too in the bad times. 5. External auditors cannot look at every client transaction. They must rely on samples and tests of relationship in conducting an audit. 6. One role of the auditor is to be an insurer against large stockholder losses. 7. The big corporations and their big auditors (CPAs) work hand in glove and only tell the public what they want to tell them. 8. One role of the auditor is to actively search for fraud, no matter how small.

THE ‘‘SHOCK’’ FACTOR IN STUDENTS’ PERFORMANCE IN ACCOUNTING EXAMINATIONS Alexander M. G. Gelardi and Craig E. N. Emby ABSTRACT This paper examines, in an accounting context, possible bias due to students’ receiving questions in course-coverage order versus random order. This paper extends prior research by combining longitudinal analysis with an independent measure of student ability to examine the interaction between ability and question order by student scores where some students receive questions in consecutive examinations in the same order pattern whereas other students receive questions in consecutive examinations in different order patterns. The results show what could be termed a ‘‘shock’’ factor. This ‘‘shock’’ factor interacts with student ability to the benefit of higher-ability students and to the detriment of middle-ability students. The performance of lower-ability students was not affected.

1. INTRODUCTION This paper provides further evidence on the effect of ordering of multiplechoice and problem-solving questions in introductory accounting courses. It Advances in Accounting Advances in Accounting, Volume 21, 219–231 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21009-X

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extends prior research by performing longitudinal analysis, focusing on the effect of the interaction of presentation order and student ability. The paper analyzes student scores where some students receive questions in two consecutive examinations in the same order format (course-coverage order or random order) whereas other students receive the same questions in different order formats (course-coverage order followed by random order or vice versa).1 It is possible that a student who receives the examination questions in different orders in consecutive examinations would be surprised by that change, which would affect his or her performance. This surprise effect could be called a ‘‘shock’’ factor. The most interesting results are revealed by examination of the interaction between changes in presentation order and student ability (as measured by CGPA – Cumulative Grade Point Average). The rest of the paper is organized as follows. The next section sets out a brief overview of the literature. Section 3 presents the hypotheses. This is followed by the methodology in Section 4 and the results of the analysis in Section 5. Section 6 gives the discussion and conclusion.

2. BACKGROUND AND LITERATURE REVIEW A change from random order question presentation to course-coverage question sequencing or vice versa may create an ‘‘order effect.’’ Two relevant streams of research based in cognitive psychology (both of which have been extended to the applied areas of accounting and auditing) are research into order effects and recency effects. With respect to order effects, research has focused on the effects of different items of information on an individual’s judgements/decisions when those judgements/decisions result from receiving the same information in different orders (in cognitive psychology, Hogarth & Einhorn, 1992; in accounting, Ashton & Ashton, 1988). Recency-effects research can be considered to be a subset of order-effects research. It has been found that information received closer to the time of the judgement/decision point has a greater influence on that judgement/decision (Tubbs et al., 1990). Extracting the implications of this research for the existence or nonexistence of order effects in responses to examination questions presented in different orders is not clear-cut as the contexts are quite different. However, it may be that questions presented in CC, because of their consistency with the order in which the material was initially learned, do promote a better recall of the material. If this is true, then questions in CC would result in

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better scores, and consistency between formats in mid-term and final examinations would reinforce these better results. However, the literature on the effects of differing question orders in accounting examinations has reported varied results. We have chosen to extend our research in two areas where prior research has produced conflicting results – results over a sequence of two examinations, and the interaction of question order and student ability. Prior research regarding question-order effects in accounting examinations has examined both the interaction of question order and student ability, and, separately, the effect of question order over a sequence of examinations. For example, in a ‘‘one-shot’’ study looking only at a single examination, Baldwin and Howard (1983) surrogated student ability by CGPA and found an interaction effect between question order and ability with the scores of higher CGPA students being positively affected by CC question ordering whereas the scores of lower CGPA students were not. Gruber (1987) surrogated ability by past examination performance and found no interaction between question order and ability, a result supported by the findings of Gelardi (1998). Baldwin, Pattison and Toolson (1989) examined the order effect over a sequence of three examinations. They found no effect for question order for any of the examinations individually or for all three combined. Nor did they observe an individual or combined interaction effect between question order and student ability for a sub-sample of 75 of the 282 students. However, their dependent variable for the longitudinal analysis was the student’s cumulative score over the three examinations. Using cumulative scores may mask the effects of the changes and for that reason our design focuses on the result of the change in question order. We examine the effect of question order for both multiple-choice questions and problems combined. Most prior studies (e.g. Balch, 1989; Carlson & Ostrosky, 1992; Ingram & Petersen, 1987; Stout & Battista, 1991) have tended to focus on multiple-choice questions.

3. HYPOTHESIS The objective of this study is to examine the effects of the interaction of changes in question order and student ability over a sequence of two examinations – a mid-term examination and a final examination. As the students would not know that the format had changed from mid-term to final

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until the final examination, the hypothesis concerns the scores in the final examination only, to isolate any ‘‘shock’’ factor bias. Our primary focus is on the potential existence of differential results among students of different ability. Whether students of different ability would be affected differentially by such a ‘‘shock’’ is not known. It may be that a stronger mastery of the subject material would result in a degree of immunity to such influences and that higher-ability students would be less likely to be affected by a change in question order. Medium- and lowerability students might be more reliant on more mechanical or rote memory and would find such a change somewhat disconcerting. This would be particularly true for a switch from CC in the mid-term examination to R in the final examination, but may even result from a switch from R in the mid-term to CC in the final. Differential effects would be evidenced by an interaction between ability and question order. Since differential effects render the interpretation of main effects (for example, a question-order main effect) problematic, the question of the interaction of order effects and student ability is examined by means of the following hypothesis, stated in the null form: H1. There will be no difference in the mean scores of students of different ability who receive multiple-choice questions or problems presented in one order format in the mid-term examination and the another format in the final examination (CC/R or R/CC) from the mean scores of students of different ability who receive multiple-choice questions or problems in the same order format in both examinations (CC/CC or R/R).

4. METHODOLOGY The participants were 189 undergraduate students enrolled in a single introductory managerial accounting class in a medium-sized Canadian university. The gender distribution was 96 (51%) male and 93 (49%) female. Following the approach of previous research (e.g. Baldwin & Howard, 1983; Baldwin et al., 1989; Stout & Wygal, 1990, 1994), for analysis purposes, the students were sorted into three groups – high, medium and low ability – by student CGPA at the beginning of the semester in which the course was given. There was an equal number of students in each CGPA group. The examinations were regular mid-term and final examinations (i.e. they were used for grading purposes). Both the mid-term and final examinations were presented in two different versions. One version of each examination

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had the multiple-choice questions and problems presented in the same order as the material was covered in class. In the second version of each examination, the multiple-choice questions and the problems were presented randomly. It should be noted that randomness was not a between-groups variable – all students in the ‘‘random’’ groups received the same random order and all students in the ‘‘CC’’ groups received the same CC.2 The students were assigned to the different conditions on a random basis. The examination scores were standardized such that the mean score for each part (multiple-choice and problem-solving questions) was made to be 100. The examinations were constructed from the test banks that came with the textbook. In the examinations used in this study, the order of difficulty of the questions was non-systematic, or random. Monk and Stallings (1970) compared systematic ordering of multiple-choice questions (i.e. ordered according to level of difficulty) versus non-systematic ordering, and found no significant difference in student scores. The dependent variables were the standardized scores for both the multiple-choice questions and the problems in the final examination. The independent variables were whether the student received both examinations in the same order format or different order formats (CONTR) and the student’s CGPA.

5. RESULTS The dependent variable to test this hypothesis was the standardized mean scores of the final examination. Table 1 shows the standardized scores by version and Table 2 present the results of the ANOVAs. Note that in Table 1 the standardized scores are pooled for a two-way analysis, consistent with the statements of the hypotheses, that is the scores of the students who received either the CC/CC order or the R/R order are combined, as are the scores of the students who received the CC/R order or the R/CC order. Before examining Hypothesis H1, which predicts no interaction between ability and order, we should look at the main effects. The independent variable for the same or different versions of the examinations is labelled CONTR (for contrasting versions). The main effect for CONTR is not statistically significant ðp ¼ 0:776Þ: This is consistent with the results of Gruber (1987) and Gelardi (1998) but inconsistent with the results of Baldwin and Howard (1983). As might be expected there is a significant main effect for CGPA ðp ¼ 0:000Þ:

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Table 1.

Standardized Final Examination Score Means by Contrasting Formats. Mean of Standardized Scores (Standard deviation)

No. of Observations

Same (CC/CC or R/R) Panel A Total

100.71 (21.93)

Panel B CGPA High

Low

99.31 (24.19)

93

110.14 (18.06) 106.63 (16.46) 83.91 (22.11)

Medium

Different (CC/R or R/CC)

96

121.71 (19.50) 91.88 (18.35) 84.77 (16.64)

31 33 29

32 30 34

CC/CC – course-coverage order in mid-term and final examinations; R/R – random order in mid-term and final examinations; CC/R – course-coverage order in the mid-term examination and random order in the final examination; R/CC – random order in the mid-term examination and CC in the final examination.

Table 2. Source of Variation CONTR CGPA CONTR*CGPA Error

ANOVA Results on Final Examination Scores. SS

df

F

p

28 31,367 2,756 62,833

1 2 2 177

0.081 45.679 8.026

0.776 0.000 0.000

CONTR is the contrasting order of presentation – either CC/CC or R/R (same order format) or CC/R or R/CC (different order format).

However, there was a significant interaction between CONTR and CGPA ðp ¼ 0:000Þ; as shown in Table 2.3 Thus, the main effect results may not be interpretable. Furthermore, this result is not consistent with the predictions of Hypothesis H1. On further analysis, the standardized mean scores for each of the three CGPA groups (Panel B of Table 1) reveal some interesting patterns. These are highlighted graphically in Fig. 1.

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130

120 High CGPA

110 Means

Medium CGPA Low CGPA

100

90

80

70 Same

Different Same/Different

Fig. 1. Means of Standardized Scores. Same indicates CC/CC or R/R: that is CC (or R) in both the mid-term and final examinations. Different indicates CC/R or R/CC: that is CC in the mid-term examination and R in the final examination or vice versa.

The ‘‘High’’ row (on Panel B of Table 1) shows that the high CGPA students who received consecutive examinations with the questions in the same order (CC/CC or R/R) in both examinations did not perform as well in the final examination as the high CGPA students who received different question orders (CC/R or R/CC) in the two examinations. The results of a one-way ANOVA on the mean scores of this sub-group, with CONTR as the independent variable, shown in the ‘‘High’’ row of Table 3, indicates that the average difference of 11.57 was significant at p ¼ 0:017: Additionally, the size of the effect is clearly enough to matter and could easily translate into a difference of half a grade or more. The results of the medium CGPA students are in contrast to those of the high CGPA students. The medium CGPA students who received the questions in the same order in both exams performed better on the final exam than those who received the examination with questions in different orders. This was statistically significant ðp ¼ 0:001Þ as can be seen in the ‘‘Medium’’

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Table 3.

Final Examination by CGPA Sub-group and Contrasting Formats. ANOVA TABLES

CGPA High Medium Low

Source of Variation

SS

df

F

p

CONTR Error CONTR Error CONTR Error

2,110 21,568 3,418 18,435 12 22,829

1 61 1 61 1 61

6.135

0.017

11.309

0.001

0.031

0.860

row of Table 3. Again, the difference in the average difference of 14.75 is substantial and could affect the grade achieved by the student. The results of the low CGPA students differ from both the high CGPA and from the medium CGPA students. The low CGPA students performed at the same level whether they received their questions in the same order in both examinations or whether the order of questions differed between examinations. The ‘‘Low’’ row of Panel B of Table 1 shows that the means of the standardized scores were 83.91 (CC/CC or R/R) versus 84.77 (CC/R or R/CC), a difference of 0.86. The difference was not statistically significant ðp ¼ 0:860Þ; nor would it be likely to make a difference in the student’s grade. In summary, it appears that the ‘‘shock’’ factor operated to the benefit of the high CGPA students and to the detriment of the medium CGPA students. The ‘‘shock’’ factor did not, however, affect on the low CGPA students, who performed poorly with whatever version or combination of versions they received. Thus, overall, the predictions of hypothesis 1 are rejected – the change in order of questions from the mid-term to the final does affect students of different ability levels differently.

Additional Exploratory Analysis We decomposed the results by CGPA to see whether the significant ‘‘shock factor’’ interaction effect was due to a particular switch, e.g. from CC in the mid-term examination to R in the final examination, or from R in the midterm examination to CC in the final examination. Panel A of Table 4 sets out the standardized means by version types CC/CC, CC/R, R/R and

Final Examination Mean Scores.

Means of Standardized Scores (Standard deviation)

Means of Standardized Scores

No. of Observations

(Standard deviation)

Panel A: Means of Standardized Scores ORD(M) CC CGPA

ORD(F) - CC: CC/CC

105.03 (20.43) Medium 107.74 (18.83) Low 89.56 (21.22) Panel B: ANOVA Results

ORD(M) R

ORD(F) - R: CC/R

High

123.10 (19.29) 90.54 (19.68) 87.64 (18.33)

16 16 15

17 14 20

ORD(F) - R: R/R 115.59 (13.78) 105.58 (14.39) 77.85 (13.46)

15 17 14

ORD(M) - CC

Source of Variation

High

ORD(F) Error ORD(F) Error ORD(F) Error

Medium Low

ORD(F) - CC: R/CC 120.14 (20.28) 93.05 (17.67) 80.67 (13.46)

15 16 14

ORD(M) - R

ORD(F) - CC v. ORD(F) - R [CC/CC v. CC/R] CGPA

No. of Observations

ORD(F) - R v.

ORD(F) - CC [R/R v. R/CC]

SS

df

F

p

SS

df

F

p

2,691 12,217 2,209 10,351 31 12,690

1 31 1 28 1 33

6.828

0.014

0.478

0.021

5.013

0.032

0.082

0.776

1 28 1 31 1 26

0.518

5.975

156 8,418 1,298 7,999 56 8,748

0.166

0.687

227

ORD(M) is the order in which the questions were presented, either in CC or R, in the mid-term examination. ORD(F) is the order in which the questions were presented, either in CC or R, in the final examination.

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Table 4.

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R/CC and by CGPA group. Panel B of Table 4 presents the results of the ANOVA. As can be seen from the ‘‘High’’ row of Panel A of Table 4, the effect occurred regardless of the direction of the change. The high CGPA students who received the CC version in the mid-term examination and R version in the final examination (CC/R) achieved higher scores in the final examination than those students who received CC in both examinations (CC/CC), a difference of 18.07. This finer decomposition reduced the sample sizes by one-half, but was still statistically significance (p ¼ 0:014; as shown in Panel B, Table 4). The high CGPA students who received the R version in the midterm examination and the CC version in the final examination (R/CC) also achieved higher scores than those students who received the R version (R/R) in both examinations, a difference of 4.55. This difference was not significant ðp ¼ 0:478Þ: Looking at this result, it can be noted that the ‘‘shock’’ factor was consistent in that the switching group outperformed the nonswitching group. The magnitude of the gain was greatest in the case of those students who went from CC in the mid-term to R in the final. Those students who received CC in both the mid-term and the final performed worst on the final. The medium CGPA students had somewhat different results from the high CGPA students. The ‘‘Medium’’ row of Panel A of Table 4 shows that the medium CGPA students who received the CC/R order in the examinations performed worse than those students who received the CC/CC order. The difference of
17.20 was statistically significant at p ¼ 0:021: The medium CGPA students who received the R/CC order pattern of the examinations performed significantly worse than those who received the R/R order pattern. The difference of
12.53 was statistically significant at p ¼ 0:032: In both cases the size of the difference could affect the grade achieved by a half grade or more. In sum, there was a ‘‘shock’’ factor for the medium CGPA students as well, at least as great as for the high CGPA students, although it had the reverse effect from its effect on the high CGPA students. The change of order in the examinations did not affect the low CGPA students’ scores. With respect to the multiple choice questions, Table 4 shows that the low CGPA students who received the CC/R order pattern performed approximately the same as those who received the CC/CC order pattern. The difference of
1.92 was not significant at p ¼ 0:776: The students who received the R/CC order pattern performed similarly to those who received the R/R order pattern (a difference of 2.82, not significant
p ¼ 0:687). For the low achievers, it appears there is no ‘‘shock’’ factor. It made no difference to the scores whether the order patterns were consistent

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or inconsistent between examinations. The grades achieved would be unlikely to be affected.

6. DISCUSSION AND CONCLUSION This paper looked at the results of students receiving examinations with both the multiple-choice questions and problems in different orders. The results suggest that ordering in examinations and between examinations (or papers) may be of some importance. Although initial analysis found no main effect for change in question order on student examination scores, the results show that there was a significant interaction between change in question order and ability. Further analysis of this interaction showed that the higher ability students (high CGPA) performed better on the final examination when it contained questions in a different order from the mid-term examination while average (medium CGPA) students performed worse on the final examination when it contained questions in a different order from the mid-term examination. The reason that the significant result was not observed in the main effect analysis was that the effects of the ‘‘shock’’ factor moved in opposite directions for the high CGPA students and the medium CGPA students (see Fig. 1). Consequently in the overall analysis, these opposite movements cancelled each other out, hiding the interaction. The lower ability students were not affected by the ‘‘shock’’ factor. There was not statistical significant difference in the scores of the students in this group taking the examinations in a consistent order pattern to those taking the examinations in different order patterns. The results of this study do have a practical importance for students. For the higher ability student, the difference in results due to different exam formats may result in a difference in grade (say, B+ instead of an A). In the highly competitive market of entry accounting positions, this difference could well affect the student’s chances of being employed by a preferred firm. The scores of the middle ability group results straddle the class average (Table 1). Thus, an adverse performance, solely due to the ‘‘shock’’ factor, may place a student in the lower half of the class instead of the top half. This again could affect the student’s employability or even whether the student continues in accounting. Not unexpectedly, we found that the students with different abilities perform differentially. The better students obtained higher marks than the medium ability students who in turn performed better than the lower ability

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students. This is apparent in the ANOVA results shown in Table 2, but is essentially tautological. The results of this study should be interpreted in light of its limitations. One professor, in one university, carried out the study on one class. Whether the results were idiosyncratic, or can be generalized, is a question that can only be resolved by replication and further testing. The order in which a student actually answered the questions was not controlled (as these were standard examinations in which students could deviate from a sequential order if they chose to do so). However, it was noted by observation that the multiple-choice questions were read in the order presented, and most of the questions were answered in order. It was also noted that the students read the problems in the order presented, and most answered them in that manner. It is likely that any ‘‘shock’’ would have occurred at the time a student read the questions. If the results of this study are confirmed by replication in future studies, the effects found due to the ‘‘shock’’ factor should serve as a caution authors of examinations. These authors should be careful that there is consistency in the order pattern of questions for different papers within an examination (and for different examinations within a series). The findings of this study are relevant for authors of examination papers both within an academic environment and for professional examinations.

NOTES 1. Course-coverage order means that the coverage of the questions is in the same order as the topics were presented in class. Hereinafter, course-coverage order is denoted by CC and random order is denoted by R. 2. The multiple-choice questions and the problems were not intermingled – randomness refers to the question order within each type of question. In all cases the examinations presented the multiple-choice questions before the problems. Stout and Wygal (1994) had found that students tended to answer the multiple-choice questions before any problems even if the problems had been presented first. 3. This contrasts with Baldwin et al. (1989), who found ‘‘no significant interaction between topical ordering and CGPA’’ (p. 89).

ACKNOWLEDGMENTS The authors to thank the editor and two anonymous reviewers for their valuable suggestions and comments. The authors would also like to thank

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the participants of the Spring 2003 Conference of the North West Accounting Research Group for helpful comments. The authors would like to acknowledge financial assistance for this research from the Institute of Chartered Accountants of British Columbia.

REFERENCES Balch, W. R. (1989). Item order affects performance on multiple-choice exams. Teaching of Psychology, 16(2), 75–77. Baldwin, B. A., & Howard, T. P. (1983). Intertopical sequencing of examination questions: An empirical evaluation. Journal of Accounting Education, 1(2), 89–95. Baldwin, B. A., Pattison, D. D., & Toolson, R. B. (1989). Intertopical ordering effects: The case of managerial accounting. Journal of Accounting Education, 7, 83–91. Carlson, J.L. & Ostrosky, A.L. (1992) Item sequence and student performance on multiplechoice exams: Further evidence. Journal of Economic Education (Summer), 232–235. Gelardi, A. M. G. (1998). The effects of item order, gender, change of format and ability on student performance in multiple choice tests in managerial accounting. Accounting Educators’ Journal, 10, 33–46. Gruber, R. A. (1987). Sequencing exam questions relative to topic presentation. Journal of Accounting Education, 5, 77–86. Ingram, R. W., & Petersen, R. J. (1987). An evaluations of AICPA tests for predicting the performance of accounting majors. The Accounting Review, 62(1), 215–223. Monk, J. J., & Stallings, W. M. (1970). Effect of item order on test scores. Journal of Educational Measurement, 7, 113–118. Stout, D. E., & Battista, M. S. (1991). Empirical evidence on the effect of test-item sequencing on performance scores in intermediate accounting. Advances in Accounting, 9, 105–123. Stout, D. E., & Wygal, D. E. (1990). Additional empirical evidence on the relationship between exam question sequencing and accounting student performance. Advances in Accounting, 8, 133–152. Stout, D. E., & Wygal, D. E. (1994). An empirical evaluation of test item sequencing effect in the managerial accounting classroom: Further evidence and extensions. Advances in Accounting, 12, 105–122. Tubbs, R. M., Messier, W. F., & Knechel, W. R. (1990). Recency effects in the auditor’s belief revision process. The Accounting Review, 65, 452–460.

ELECTRONIC-COMMERCE EDUCATION: INSIGHTS FROM ACADEMICIANS AND PRACTITIONERS Zabihollah Rezaee, Rick Elam and Judith H. Cassidy ABSTRACT The e-commerce marketplace is creating tremendous career opportunities, and business schools and accounting programs nationwide are redesigning their curriculum to provide adequate e-commerce education for accounting/business students. This study gathers opinions of both academicians (accounting faculty) and practitioners (practicing CPAs) regarding the importance, relevance, and delivery of e-commerce education. Results reveal that (1) the demand for and interest in e-commerce education is expected to increase; (2) more universities are planning to provide e-commerce education; and (3) the majority of the 36 suggested e-commerce topics should be offered or required for accounting majors in one or a combination of ways: (1) required core curriculum, (2) optional specialized courses, and/or (3) e-commerce degree programs. Only minor differences of opinion were found regarding which of 36 e-commerce topics should be covered in e-commerce education.

Advances in Accounting Advances in Accounting, Volume 21, 233–258 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21010-6

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ELECTRONIC-COMMERCE EDUCATION: INSIGHTS FROM ACADEMICIANS AND PRACTITIONERS Information technology (IT) has changed and will continue to change every facet of how companies do business. Business schools and accounting programs face pressures and threats as business and the accounting profession adjust to the emerging digital economy. Internet-enabled e-commerce has transformed business by providing instantaneous, worldwide, and almostfree commercial interaction and exchange. Accounting graduates must leave the university prepared to make informed decisions in a constantly changing e-commerce environment. Recent studies (Albrecht & Sack, 2000; Walker & Ainsworth, 2001; Hastings, Reckers, & Solomon, 2003; David, Maccraken & Reckers, 2003) reemphasize the importance and relevance of technology integration in business and accounting curricula. E-commerce is identified in these studies as one of the most important topics that has not received adequate coverage in the business and accounting curricula as demanded by the marketplace.1 The exponential growth in the use of e-commerce across all industries underscores the importance of e-commerce strategies for business and the apparent need for e-commerce education in business schools and accounting programs. E-commerce has become a critical component of a business graduates’ knowledge base. Thus, insights from practitioners (practicing CPAs) and academicians (accounting faculty) regarding the future direction, role, and pedagogy of e-commerce education are useful as many business schools continue to offer e-commerce courses and programs. This study addresses the integration of e-commerce education into the business and accounting curricula. Despite the significant support for the coverage of e-commerce education, curriculum design of e-commerce has not received proper attention in the literature. Relatively, little work has been done in assessing the content and delivery of e-commerce education and particularly whether academicians’ views and actions are consistent with the views and needs of practitioners. This study examines the status and future direction of e-commerce education by (1) reviewing recent information technology and e-commerce literature and analyzing more than 50 e-commerce syllabi to identify topics that may be relevant to future accounting graduates; (2) conducting a survey of accounting practitioners and academicians, which solicited opinions regarding benefits, coverage, and delivery of e-commerce topics; and (3) analyzing the views of accounting academicians and practitioners regarding the importance of suggested ecommerce topics and how these topics should be integrated into the business

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and/or accounting curriculum. Business schools generally recognize the value of practitioner input when designing program content, because their recommendations can improve the relevance of programs, ensure graduates’ marketability, and reduce employers’ criticism about programs being out of touch with reality. As of this writing, no research has been published that reveals curriculum requirements, topical content, and delivery of e-commerce education. This chapter begins the dialog by reporting results of a survey of both academicians and practitioners, and their views of the importance, relevance, and delivery of e-commerce education and its integration into the business and accounting curricula. Results indicate that (1) both academicians and practitioners expect that future demand for and interest in e-commerce education will increase, and they believe e-commerce education is important in preparing students for challenges awaiting them; (2) the majority of academic respondents indicate that their institution is currently offering e-commerce courses at both graduate and undergraduate levels; (3) those business schools that are not currently offering any e-commerce courses were expecting to add one or more courses within the next few years; (4) the majority of the 36 suggested ecommerce topics are considered important enough to be included in core curriculum requirements, specialized courses, or degree programs; and (5) only minor differences of opinion between academicians and practitioners are found regarding the topical content of e-commerce education. These results are important and relevant to the development of e-commerce courses and programs because no academic work is yet available to assist business schools in delivering e-commerce education.

THE EMERGENCE OF E-COMMERCE The emergence of e-commerce in the past decade has changed the way organizations carry out their day-to-day operations. E-commerce has become one of the most critical aspects of managerial strategy as organizations search for ways to compete more effectively in the global marketplace. The business environment has transformed from a ‘‘brick-and-mortar’’ infrastructure to ‘‘brick-and-click’’ capabilities enabling organizations to effectively compete using internet-based technology. E-commerce has spawned opportunities for established companies to offer products and services online, and encouraged emerging ‘‘dot-com’’ companies (e.g. Amazon.com) to operate entirely over the Internet. The importance of e-commerce technologies and strategies in the Internet economy has been documented in

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business reports (e.g. eMarketer, 2001). The total online retail revenue in the United States in 2002 was more than $72 billion, about a 41% increase from the previous year (Wingfield, 2002). Forrester research reports that global ecommerce revenues were about $650 billion in 2000, and estimates that number to grow to $6.8 trillion by 2004 (Forrester, 2000). Furthermore, eMarketer reports that the global business-to-consumer (B2C) market will grow to $428 billion by 2004 (eMarketer, 2001). Since, organizations started conducting internet transactions in 1995, the growth of business to business (B2B) has been impressive. The supply-chain models within electronic marketplaces enable organizations to substantially reduce procurement costs, increase operating efficiencies, and improve performance. B2B strategies streamline the supply chain by reducing the time to match buyers and sellers, lowering inventory levels, and expanding global business opportunities. B2B e-commerce is expected to account for more than 80% of total e-commerce with a significant impact on the U.S. economy (Brookes & Wahhaj, 2000). B2B strategies can be classified into vertical and horizontal. Prior studies (e.g. Lucking-Reiley & Spulber, 2001; Brookes & Wahhaj, 2000) discuss the following benefits of both vertical and horizontal B2B strategies: (1) exposing sellers in one marketplace to all potential buyers; (2) reducing time-to-market; (3) creating extensive distributions for products and services; (4) providing customers with fast response, high cost efficiency, and superior service; (5) improving operating efficiency; and (6) reducing operating costs, inventory levels, and cycle times.2 Several reports (AICPA, 1998; Albrecht & Sack, 2000; AICPA, 2001a,b; IFAC, 2002) have examined IT preparation (and readiness of accounting students) and its specific application, including e-commerce. The 1998 Vision Project of the AICPA states that technological advances including the internet and e-commerce are significant forces affecting the accounting profession (AICPA, 1998). The report, entitled ‘‘Accounting Education: Charting the Course through a Perilous Future,’’ views the three fundamental drivers of change in the business environment as technology, globalization, and concentration of market power in large pension and mutual funds (Albrecht & Sack, 2000). This report concludes that accounting students are not sufficiently exposed to the impacts of technology on business and recommends that technological frontiers (e.g. the internet, e-commerce) be integrated into accounting and business curricula. Academic studies (e.g. Walker & Ainsworth, 2001) have underscored the importance of technologies to accounting students and the methods of integrating technologies to the accounting curriculum. The demand for integrating technology into the

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accounting curriculum is shared by practitioners and professional organizations (e.g. AICPA, 2001a,b; IFAC, 1995, 2002). Recent studies (e.g. AICPA, 2001a,b; IFAC, 2002; David et al., 2003; Hastings et al., 2003) rank e-business among the ten most important technological challenges and opportunities affecting the business environment and the accounting profession. The rapid emergence of e-commerce, particularly in the late 1990s, has resulted in universities searching for the best way to ensure their graduates have appropriate exposure to IT related topics. One may argue that e-commerce was most important several years ago when accounting programs and business schools attempted to capitalize on the dot-com craze. However, the Wall Street Journal reports that e-commerce focuses on the Internet’s role at brick-and-mortar companies, and finds that e-commerce courses and programs are very much alive and are a strong presence at some business schools (Alsop, 2001). The exponential growth in e-commerce increases the demand for individuals possessing adequate knowledge and experience in e-commerce. The development of ecommerce presents business schools an opportunity to create new courses or programs in e-commerce. Individuals with a specialization in e-commerce are expected to be qualified to manage in an IT setting or assist organizations in the development and implementation of B2B and B2C strategies. The review of existing literature underscores the importance of e-commerce education and the need for its integration into the business and accounting curriculum.

METHODS AND PROCEDURES This study conducted a nationwide survey of accounting academicians and practitioners (practicing CPAs) to determine the demand, benefits, coverage, and delivery of e-commerce education. A questionnaire was mailed to a random sample of 1574 accounting faculty, teaching primarily auditing, financial and/or information systems, chosen from the 2001 Hasselback’s Accounting Faculty Directory (Hasselback, 2001). A slightly different questionnaire was sent to a sample of 1,000 practicing CPAs purchased from the AICPA. Practitioners were all CPAs, primarily partners and managers of public accounting firms throughout the nation. Thus, they are assumed to have adequate understanding of both business and accounting courses offered in universities as well as curriculum content and design of business schools. Each questionnaire was accompanied by a cover letter stating the survey

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objectives, assuring the confidentiality of the responses, agreeing to share the summary of findings, giving the approximate time needed to complete the questionnaire, and providing a pre-addressed postage-paid return envelope. The survey objective specified in the cover letter to both groups of participants was to ‘‘determine the coverage of e-commerce education in the business and accounting curricula and suggest the proper content of such coverage.’’ A two-page questionnaire was prepared, pre-tested, revised, and then mailed to the subjects: (Appendix A presents the two versions of the questionnaire).3 Question 1 sought participants’ perceptions of future demand and interest in e-commerce education. Question 2 asked respondents’ perception of the importance of e-commerce education. Questions 3 and 4 dealt with methods of delivery of e-commerce education. Question 5 provided respondents with a list of 36 e-commerce topics compiled from an extensive review of the literature, and asked them to indicate which topic(s) should be included in (1) the core curriculum required of all business majors; (2) optional e-commerce course(s); and/or (3) e-commerce degree programs (e.g. B.S., M.B.A., M.S.). Question 6 asked for comments on e-commerce education. Table 1 shows the response rate by respondent groups. Two hundred seventy-nine useable responses were returned from academicians, providing a response rate of 17.8%. Useable questionnaires were returned by 97 practitioners, resulting in about a 10% practitioner response rate.4 The overall response rate is about 15%. While this response rate is lower than might be desired, response rates of this level are not uncommon when certain types of individuals are surveyed (Hodge, 2003). Non-response bias was tested by comparing late responses with early responses, assuming that late respondents are similar to non-responses. We find no evidence of nonresponse bias. Nevertheless, the problem with anonymous surveys is that it is difficult to evaluate the possible impact of non-response bias.

Table 1.

Total mailed Returns Potential responses Actual responses Response rate (%)

Responses.

Academicians

Practitioners

Total

1574 4 1570 279 17.8

1000 5 995 97 9.8

2574 9 2565 376 14.7

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RESULTS AND DISCUSSION Results of this research are presented in the following four sections: (1) demand for e-commerce education; (2) perceived importance of e-commerce education; (3) methods of integrating e-commerce education into the business curriculum; and (4) content of e-commerce education.

Demand for E-Commerce Education Table 2 presents responses from academicians and practitioners regarding future demand and interest in e-commerce education. The majority of academicians and practitioners (about 90%) perceived an increasing demand for and interest in e-commerce education, while less than 10% felt that such demand and interest will decrease. These results suggest that there is a strong demand for and interest in e-commerce education despite the recent negative dot-com stigma. These results are consistent with those of Hastings et al. (2003), which indicate strong support for inclusion of ebusiness concepts and hands-on applications in the accounting curriculum at both undergraduate and graduate levels.

Importance of E-Commerce Education Table 3 presents responses to a series of questions regarding reasons why ecommerce education may be important. These questions use the five-point Likert scale ranging from ‘‘very important’’ to ‘‘not important.’’ A mean response greater than ‘‘4’’ means the topic is being perceived to be very important. Respondents, both academicians and practitioners, believe that e-commerce education is important for the following reasons listed in order Table 2.

Demand for E-commerce Education. Percentage Practitioners

Academicians

Future Demand and Interest in E-Commerce Education will: Increase Remain the same Decrease

91.7 0.0 8.3

88.3 2.2 9.5

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Table 3.

Perceived Importance of E-commerce Education. Academicians

a. Prepare students to be able to continue Professionally in an IT era. b. Make students more desirable in the marketplace. c. More organizations use e-commerce for their business activities. d. Coverage of e-commerce in business curriculum is required to stay academically competitive. e. Job openings in e-commerce are numerous. f. Meet accreditation education requirements (e.g. AACSB).

Practitioners

w2

Mean Response

Standard Deviation

Mean Response

Standard Deviation

4.41

0.24

4.33

0.22

3.02

4.27

0.23

4.08

0.19

7.03

4.13

0.21

3.95

0.21

5.17

4.12

0.19

3.88

0.16

3.81

3.68

0.19

3.50

0.16

5.46

2.80

0.15

3.35

0.16

14.70

 Significant at 0.10.  Significant at 0.01.

of significance: (1) preparing students to be able to continue professionally in an IT era; (2) making students more desirable in the marketplace; (3) more organizations use e-commerce for their business activities; and (4) coverage of e-commerce in business curriculum to stay academically competitive. Both groups of respondents rated ‘‘meeting accreditation education requirements’’ as the least important reason for providing e-commerce education. Academicians placed less importance on accreditation requirements than practitioners, with the mean response of 2.8 and 3.3, respectively. The difference in the mean responses between the groups is statistically

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significant at the 1% level. This may suggest that academicians have not seen a strong commitment by the AACSB regarding integration of e-commerce into business curriculum.

Approaches to Integrating E-Commerce into the Curriculum Given the importance for e-commerce education, an issue is how to integrate e-commerce education into business curriculum and thereby make it available to accounting majors. The business curriculum is the focus because at most universities the accounting faculty and undergraduate degree are part of the overall business school. Accounting faculty have the most direct and powerful influence over accounting courses, but they also participate in decisions regarding the core requirements for all business majors, which include accounting majors. One approach assuring accounting majors are exposed to e-commerce topics is to infuse those topics into the core business curriculum required of all business and accounting majors. A second approach is to offer optional specialized e-commerce courses at undergraduate, graduate, or both undergraduate and graduate levels. The optional courses could be selected as electives by students majoring in a number of disciplines (e.g. accounting, finance, information systems, management, and marketing). A third approach is to view e-commerce as a unique major within the business school requiring the establishment of a separate degree program in e-commerce. An example of an e-commerce degree program is ‘‘Managing Electronic Commerce’’ offered at the Wharton School of the University of Pennsylvania as part of its M.B.A. program, and requires five course credit units and four credit units from among the set of electives. Business schools can also provide tracks within the e-commerce programs. E-commerce tracks may vary from a very specific track such as B2B to a more generic track such as e-commerce entrepreneurial. The majority of academic respondents (about 58%) indicated that their institution is currently offering e-commerce courses at both undergraduate and graduate levels. Panel A of Table 4 presents responses from academicians to the question of how their institution currently offers e-commerce courses or degree programs if any. More than 26% reported that their institution offers e-commerce courses at the undergraduate level while 14% indicated e-commerce course offerings at the graduate level only. Approximately 20% reported their institution is not currently offering any e-commerce courses, but they are expecting to add one or more courses, within the next few years. Fewer than 6% reported that no e-commerce courses are

242

Table 4. E-commerce Course Offerings. Panel A: Responses from Academicians Does your institution offer business majors any courses devoted to e-commerce? Percentage of Respondents Both graduate and undergraduate level At undergraduate level only No, but expected to add one or more courses within next few years At graduate level only No current courses and no plans to offer any

57.8 26.6 19.8 14.1 5.8

Panel B: Method of Delivery of E-Commerce Education (Responses from Practitioners) Percentages Strongly Disagree

Mean Response

1

2

3

4

d. Integrate e-commerce through business courses at graduate and/or undergraduate level a. Offer a separate e-commerce course at the undergraduate level b. Offer a separate e-commerce course at the graduate level c. Offer a separate e-commerce course at the undergraduate and graduate level f. Offer an e-commerce concentration (track) at the graduate level h. Offer an e-commerce degree program (e.g. MS, MBA) at the graduate level e. Offer an e-commerce concentration (track) at the undergraduate level g. Offer an e-commerce concentration (track) at both the undergraduate and graduate level i. Offer an e-commerce undergraduate degree program j. Do not cover e-commerce at all

1.1

8.4

12.6

47.4

30.5

3.979

2.1 2.1 3.1 10.4 11.5 9.5 12.5

10.5 12.6 8.3 18.8 26.0 30.5 28.1

13.7 14.7 21.9 26.0 32.3 28.4 27.1

40.0 35.8 34.4 31.3 18.8 23.2 22.9

33.7 34.9 32.3 13.5 11.5 8.4 9.4

3.926 3.884 3.840 3.188 2.927 2.905 2.885

10.4 79.6

38.5 6.5

31.3 5.4

14.6 3.2

5.2 5.4

2.656 1.484

ZABIHOLLAH REZAEE ET AL.

Method

Strongly Agree 5

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currently being offered and they are not planning to offer such courses in the near future. More than 25% of the sampled institutions are currently offering degree programs with emphasis in e-commerce. The business schools that offer e-commerce degree programs (not reported) provide a BS, MBA, MS, or concentration degree in e-commerce (25.5, 25.8, 14.3, and 11%, respectively).5 Panel B of Table 4 reports responses from practitioners to a number of questions pertaining to alternate approaches to the delivery of e-commerce education by using a five-point Likert scaling of ‘‘1’’ indicating strongly disagree and ‘‘5’’ indicating strong agreement. Practitioners agree that ecommerce should be integrated into the business curriculum through most approaches offered in the questionnaire. Panel B of Table 4 reports that practitioners support: (1) offering business courses at the undergraduate and/or graduate level, (2) offering a separate e-commerce course at the undergraduate level, (3) offering a separate e-commerce course at the graduate level, and/or (4) offering a separate e-commerce course at the undergraduate and graduate level (all with mean responses close to 4). Practitioners were indifferent with regard to the approach of offering an e-commerce concentration (track) at either the undergraduate or graduate level or offering an e-commerce degree program (e.g. M.S., M.B.A.) at the graduate level (mean response about 3). Practitioners slightly disagree with offering an e-commerce undergraduate program or offering an e-commerce concentration (track) at both the undergraduate and graduate level (mean response less than three). Practitioners strongly disagree with the concept that universities should not cover e-commerce education in the business curriculum at all.

E-Commerce Topics Given that the purpose of e-commerce education is to provide students with a broad understanding and in-depth knowledge-based foundation of the technological and business infrastructure that make e-commerce possible, a relevant question is: what specific topics should make up the content of ecommerce education? Topics that might be important for e-commerce courses were identified for this research by a review of related literature and analysis of e-commerce course syllabi available online with ISWORLDNET.6 The review of related literature and content analysis of more than 50 e-commerce course syllabi identified over 80 e-commerce topics being presented in existing e-commerce courses.7 Overlapping and redundant topics

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were eliminated leaving 36 unique e-commerce-related topics to be used in this research. The respondents were asked which of the 36 e-commerce topics shown in Table 5 should be included in (1) the core curriculum required of all business majors; (2) an optional specialized e-commerce course; and/or (3) e-commerce degree programs. Respondents could indicate that a topic should be in any combination of the three options or not be included at all. The most important e-commerce topics chosen by both groups of respondents (academicians and practitioners) to be included in the core curriculum required of all business majors, in the order of significance, are: (1) introduction to the Internet; (2) introduction to e-commerce; (3) legal and ethical issues in e-commerce; (4) e-commerce opportunities and strategies; (5) themes and trends in e-commerce; (6) e-commerce in various industries; (7) marketing on the Internet; (8) online privacy standards, policies, and systems; (9) Internet risk and security; (10) telecommuting through the Internet; and (11) electronic payment systems (e-money, smart cards). Results presented in Table 5 reveal that although the relative importance of e-commerce topics varied between academicians and practitioners, there is a general consensus as to the relevance of these topics for infusion into core curriculum requirements for all business majors. Both groups of respondents were asked to indicate which of the 36 ecommerce topics should be included in specialized e-commerce courses. The majority of respondents felt that almost all of the 36 topics listed in Table 5 should be included, but the aforementioned introductory e-commerce topics should be covered in core curriculum requirements. The top 15 topics selected as important for e-commerce courses are: (1) extensible markup language (XML); (2) extensible business reporting language (XBRL); (3) virtual reality modeling language (VRM); (4) accounting and taxation for ecommerce; (5) Java Script and Java programming language; (6) design and maintenance of e-commerce; (7) authentication and security aspects of ecommerce; (8) e-commerce security (cryptographing, digital signatures, and fire walls); (9) intelligent information agents; (10) cyberbanking and personal finances; (11) encryption; (12) hyper text markup language (HTML); (13) just-in-time and e-commerce; (14) enterprise resource planning (ERP); and (15) Web page design, navigation, and browsers. In summary, practitioners favored the more in-depth coverage that is possible in a specialized course for intelligent information systems, distance learning on the Internet, supply chain management, web page design, navigation and browsers, intranets and extranets, and HTML. Academicians perceive a greater need for

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Table 5. Integration of E-Commerce Topics. Topic

Introduction to the Internet Introduction to e-commerce Legal and ethical issues in e-commerce E-commerce opportunities and strategies Themes and trends in e-commerce E-commerce in various industries Marketing on the Internet Privacy standards, policies, and systems Electronic data interchange (EDI) Internet risk and security E-commerce emerging issues and technology Telecommuting through the Internet Supply chain management Electronic payment systems (e-money, smart cards) Intellectual property protection and copyrights Web page design, navigation, and browsers Intranets and Extranets Enterprise resource planning (ERP) Customer relationship management system Data communication and networking Cyber banking and personal finance Data base design and management Distance education on the Internet Just-in-time and e-commerce Hyper text markup language (HTML) E-commerce security (cryptography, digital signature, and firewalls) Encryption Architecture of electronic commerce Authentication and security aspects of electronic commerce Accounting and taxation for e-commerce Intelligent information agents Design and maintenance of e-commerce Extensible markup language (XML) Extensible business reporting language (XBRL) Java Script and Java programming language Virtual reality modeling language (VRML)

Core Curriculum (%) Academicians Practitioners 94.0 95.5 84.9 93.3 64.3 58.6 57.9 63.5 56.7 51.2 54.7 50.0 51.8 34.5 49.2 56.3 48.8 45.2 48.6 52.8 48.0 48.2

Specialized Courses (%) Academicians Practitioners 17.2 14.8 24.8 18.0 41.5 48.3 47.2 35.3 44.6 47.6 45.3 50.0 55.3 69.0 52.4 44.8 52.9 53.6 58.1 51.7 52.0 47.0

46.7 44.3 44.0

61.5 19.5 52.4

45.2 53.7 58.9

43.6 73.2 53.7

42.7

28.6

59.0

63.6

40.3 39.2 34.3 33.3 32.9 32.3 30.3 29.9 29.2 27.0 24.7

24.7 31.0 24.7 24.1 34.6 31.6 23.8 28.2 25.0 6.3 24.1

61.3 59.1 64.3 61.7 61.3 65.9 65.2 53.0 63.0 63.5 69.3

74.1 64.3 66.7 68.4 59.3 68.4 72.5 67.6 71.1 86.1 68.7

23.1 20.5 18.1

12.6 18.3 11.3

69.7 62.4 71.6

80.5 70.7 71.3

15.9 15.1 11.2 9.4 6.6

32.1 14.8 14.5 7.3 12.0

75.5 67.9 74.1 79.8 79.3

58.3 79.0 80.3 82.9 81.9

5.5 3.7

6.3 6.4

75.0 77.0

81.0 83.3

Note: Shaded cells represent those with 450% of the respondents recommending this option.  Responses to the ‘‘Degree Program’’ option are not reported, primarily because about 20% of the respondents recommended offering degree programs in e-commerce and less than 50% suggested the inclusion of the selected 36 e-commerce topics in such degree programs.

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specialized courses on the topics of e-commerce opportunities and strategies and accounting and taxation for e-commerce.

Curriculum Design of E-Commerce Education Three fundamental questions are relevant to the curriculum design of ecommerce education. The primary question is ‘‘should business schools and particularly accounting programs integrate e-commerce education into their curricula?’’ The answer is definitely yes. Anecdotal evidence (AICPA, 2001a,b; IFAC, 2002; Alsop, 2001; Harrington, 2001), prior studies (Albrecht & Sack, 2000; Hastings et al., 2003; David et al., 2003), and results of this study (see Table 2) provide strong support for and interest in the coverage of e-commerce education in the business and accounting curricula as demanded by the marketplace. The second question is that given the demand for and interest in e-commerce education, ‘‘What are the important and relevant e-commerce topics that should be covered in e-commerce education?’’ This study identifies 36 distinct e-commerce topics that should make up the content of e-commerce education by analyzing more than 50 existing e-commerce course syllabi. Both groups of our respondents reported these topics (see Table 5) as important for consideration by business schools and accounting programs in developing their e-commerce curricula. These suggested topics should be classified into small subsets or modules based on their similarities, pedagogical goals, faculty preferences, and potential curriculum design impediments. The modules can then be used individually or in groups to allow business schools and accounting programs to customize their e-commerce education. We also suggest that business schools and accounting programs use some systematic approach to develop a taxonomy of e-commerce topics germane to their academic disciplines. The suggested topics presented in Table 5 should assist in the proper development of e-commerce taxonomy(ies). Conceptually and administratively, an e-commerce course can be designed differently for a specific discipline such as accounting, economics, finance, management, marketing, and supply chain management. For example, an e-commerce course developed for accounting majors should focus more on the financial, managerial, taxation, and auditing aspects of e-commerce education. The final question is ‘‘How can e-commerce education be delivered?’’ Three methods to the delivery of e-commerce education have been developed. These methods are: (1) e-commerce degree programs; (2) e-commerce

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courses; and (3) integration of e-commerce into the core business curriculum. Other approaches such as joint e-commerce programs offered with cooperation from business schools, computer science, engineering, and/or law schools are also being suggested. The first approach of developing e-commerce education as a stand-alone discipline by requiring the establishment of a separate degree program (e.g. bachelor, masters, and certification) in e-commerce was popular in the early stage of the e-commerce phenomenon. Critics of e-commerce degree programs argue that these degree programs have grown exponentially and, while popular with students, may not succeed as initially expected and will probably disappear in five years (Melymuka, 2000). Furthermore, the enrollment in e-commerce degree programs at several business schools was down in 2000 compared with the previous years (Alsop, 2001; Harrington, 2001). For example, enrollment in the Internet marketing class at MIT’s School of Management was down about 29% from the previous year. One perceived reason for such reduction is the recent failure of many dot-coms. However, the dot-com debacle should not encourage business schools to deemphasize the importance of e-commerce education. Results of our study are consistent with and support this trend of diminishing interest and demand in recent years, particularly after the dot-com debacles, for offering ecommerce degree programs. Results presented in Panel B of Table 4 indicate that our respondents slightly disagreed with this approach of offering ecommerce degree programs (e.g. BS, MS, MBA) or e-commerce concentration (track) at either graduate or undergraduate levels (with mean responses less than three). These results suggest that perhaps the recent decline in the market value of dot-com companies has encouraged business schools to refocus their attention away from offering specialized e-commerce degrees. The second approach is to offer distinct e-commerce course(s) at undergraduate, graduate, or both undergraduate and graduate levels. Responses from both groups of practitioners and academicians support this approach in providing e-commerce education to students. The majority of responding academicians (about 80%) reported that their schools are currently offering e-commerce course(s) at graduate and/or undergraduate levels and the remainder schools (14%) are planning to offer such courses within a few years (see Panel A of Table 4). The majority of responding practitioners preferred offering a separate e-commerce course at either the undergraduate or graduate level. This approach gives more focus to e-commerce topics and emphasizes the relative importance of e-commerce education. One relevant question for business schools offering, or planning to offer, an e-commerce course is whether they offer such a course at the undergraduate or graduate

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level. There is no strong preference toward offering an e-commerce course at either level. Each approach has its own merit, is aimed toward a special class of students, and serves its own purpose. The graduate course in e-commerce would build on graduate students’ understanding of business and stimulate graduate students’ to conduct research in many emerging areas of e-commerce. The rationale for offering an e-commerce course at the graduate level is that business students should have a thorough understanding of the various business courses including accounting, finance, management, marketing, operational research, and information systems covered at the undergraduate level before they are permitted to take e-commerce courses. The third approach is to integrate e-commerce education throughout the business curriculum as part of the core curriculum requirements of all business majors. This approach received the highest preference by our responded practitioners (Panel B of Table 4) and was generally supported by the business community. Harrington (2001, p. 10), for example, states that ‘‘the bursting of the dot-com bubble means that the nation’s top business schools, which just two years ago rushed to pepper their curriculum with e-commerce case studies, courses, and even majors, are now downplaying these changes and planning to absorb e-education into the general curriculum.’’ The rationale for suggesting this approach is that technological advances, including e-commerce, are fundamentally affecting all aspects of today’s business, and thus e-commerce education should be added to the business curriculum. E-commerce topics, under this approach, are infused into existing business courses in all disciplines (e.g. accounting, economics, finance, marketing, management, and information systems). In summary, our results support either the integration of e-commerce education into the core business curriculum or offering a separate e-commerce course. Although these two approaches are viewed as preferred methods of covering e-commerce education in the business and accounting curricula, each has its own merit and pedagogical goals and impediments. For example, adding e-commerce topics to existing business courses can overburden faculty and students alike in dealing with courses already saturated with related information. Many faculty may not wish to add ecommerce topics to their courses because of their own lack of comfort with technology-related subjects, and there may also be a lack of proper coordination among faculty and disciplines in business schools. Adding a new ecommerce course can create a challenge for many schools in deciding how to fit another course into their already saturated curriculum or in deciding what other course should be dropped from the curriculum in order to add a new course on e-commerce. We suggest business schools and accounting

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programs assess their own pedagogical goals and impediments in deciding to either offer a stand-alone e-commerce course or the integration of e-commerce topics throughout the business and accounting curricula.

Limitations of the Study This study is subject to the normal limitations of any survey research. First, the apparently homogeneous subjects (accounting faculty and CPA practitioners) may have systematic biases in their perceptions as to the coverage of e-commerce in the business and accounting curricula. While this should not negate interest in the survey results, the generalization of findings beyond that population may be limited. Second, a nonresponse bias may be present in the results. However, responses were tested using an accumulated ANOVA test and found to be free of nonresponse bias. It is not possible to determine how nonrespondents would have answered. Nevertheless, as a test of nonresponse bias, later responses were compared with early responses, assuming that late responses are similar to nonresponses (Solomon, 1990). There were no significant differences in the responses of early respondents and late respondents. Third, the sample may include more than one faculty member from the same school. These apparently homogeneous subjects may, because of their role in teaching auditing, financial, and accounting information systems, have systematic biases in their perceptions as to the content and delivery of e-commerce education. Furthermore, an e-commerce course can be designed differently for a specific discipline (e.g. accounting, finance, information systems, economics, management, and marketing) or for a specific degree program (BS, MBA, MS accounting). Thus, faculty of different disciplines can have very different views on the integration of e-commerce education into their curriculum. It is also possible that faculty members at institutions that do not have any e-commerce offerings would be much less likely to complete this survey. This type of nonresponse bias cannot be addressed by comparing early respondents with late respondents. Fourth, the findings from this study should be applied with care due to the sample size (279 academicians and 97 practitioners) and response rate (17.8% and 9.8%) respectively. Finally, the 36 e-commerce topics reported in Table 5 are derived from the review of related literature and content analysis of more than 50 online e-commerce syllabi. It is possible that these topics do not represent all of the topics that should be covered in e-commerce education. The list of selected topics is by no means all-inclusive, even

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though respondents were asked to add topics not covered in the list. If the ecommerce topics listed in Table 5 represent the major topics that should be covered in e-commerce education, the results of this study should be interpreted more as a referendum on the perceived importance of certain ecommerce topics than as a measure of the topics generally covered in an ecommerce course and/or degree program. Given the dynamic advances in Internet-based technology and continuing focus on e-commerce, additional research into the methods of delivery of e-commerce education as well as the proper content and topical coverage is needed.

CONCLUSION E-commerce education has not received adequate coverage in the business and accounting curricula as demanded by the marketplace. Our results indicate that the demand for and interest in e-commerce education is expected to increase. The rapid emergence of e-commerce, particularly in the late 1990s, encouraged business schools and accounting programs to capitalize on the dot-com craze by offering courses and degree programs (e.g. BS, MS) in e-commerce. Courses and degree programs have emerged in the same fashion as international accounting courses and programs did in the 1980s, with individual faculty and departments designing courses based on their interests, skills, philosophies, and demands. Three approaches to curriculum design of e-commerce have been developed. These approaches are: (1) ecommerce degree programs; (2) e-commerce course(s); and (3) the integration of e-commerce into the core curricula. This study finds more support for the integration of e-commerce education (the suggested 36 topics) into either the core business curriculum for all disciplines of the business school or as a separate course for each discipline. This study provides insights from both academicians (accounting faculty) and practitioners (practicing CPAs) regarding the importance, relevance, and delivery of e-commerce education. While this study is subject to the normal limitations of any survey research, the insights from a diverse group of accounting academicians and practitioners should prove useful to any curriculum committee designing e-commerce education.

NOTES 1. The terms ‘‘e-commerce’’ and ‘‘e-business’’ have been interchangeably used in the academic literature and by popular press and professional organizations. This

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study takes no position on what the proper term should be and the purpose is to shed light on the coverage of this important area of business. 2. Vertical strategies focus on a particular industry (chemicals, plastic, and steel) by bringing potential buyers and sellers together to conduct business. Horizontal strategies focus on creating an exchange for goods and services across industries. 3. The initial questionnaire was pilot-tested by sending it for review and criticism to several academicians known to the authors. Suggestions and comments of the participants, primarily related to wording, scaling, and organization, were incorporated into the final version of the questionnaire. We sent the questionnaire to the subjects in the spring of 2001 right after the dot-com crash, and when its impacts were already incorporated into e-commerce programs at many universities. 4. The relatively low response rate of 17.8% for academicians and 10% for practitioners is typical of most survey studies including this study due to the task presented. A comparison of early with late respondents suggests no evidence of nonresponse bias. Internal consistency reliabilities were calculated for all of the questions and were considered acceptable for testing the relationships. 5. These percentages do not represent the actual percentage of schools offering degree programs in e-commerce, primarily because we might have received more than one response from some schools. AACSB reports that about 20% of business schools offer e-commerce degree programs. 6. Universities worldwide may choose to have their e-commerce course syllabi listed online with ISWORLDNET at http://dossantos.cbpa.Louisville.edu/ISNET/Ecomm/ 7. The web site sources utilized in identifying over 50 e-commerce syllabi are: (1) http://www.misprofessor.com/ecomm/univprgm; (2) http://som.csudh.edu/fac/ 7press/temp/ecommercedocs/university.htm; (3) http://www.aucsb.edu/ebusiness/ index.html; and (4) http://dossantos.cbpa.Louisville.edu/ISNET/Ecomm/

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eMarketer. (2001). Global B2C: Slow and steady wins the race. Available http://www. emarketer.com/estatnews/estats/eglobal/20010727_emark.html. Forrester Research, Inc. (2000). NRF/Forrester Online Retail Index (August). Available http:// www.forrester.com. Harrington, A. (2001). E-curriculum: Easy come, easy go. Fortune (April 16), 10. Hastings, C. I., Reckers, P. M. J., & Solomon, L. (2003). The state of accounting curriculum: Where it is and where it needs to be. Working Paper, Arizona State University. Hasselback, J. (2001). Prentice Hall accounting faculty directory. Upper Saddle River, NJ: Prentice-Hall. Hodge, F. D. (2003). Investors’ perceptions of earnings quality, auditor independence, and the usefulness of audited financial information. Accounting Horizons, 17(Suppl), 37–48. International Federation of Accountants (IFAC). (1995). Education Guideline No. 11: Information technology in the accounting curriculum. New York, NY: IFAC. International Federation of Accountants (IFAC). (2002). Professional skills and general education: Proposed international education standards for professional accountants. (June). Available http://www.ifac.org. Lucking-Reiley, D., & Spulber, D. F. (2001). Business to business electronic commerce. Journal of Economic Perspectives (Winter), 55–68. Melymuka, K. (2000). Mastering e-commerce by degrees. Computerworld (November 20), 34(46), 48. Solomon, J. (1990). Discussion of the jointness of audit fees and demand for MAS: A selfselection analysis. Contemporary Accounting Research (Spring), 6(2), 323–328. Walker, K., & Ainsworth, P. (2001). Developing a process approach in the business core curriculum. Issues in Accounting Education (February), 16(1), 41–66. Wingfield, N. (2002). Online retailing is still growing despite some losses last year. Wall Street Journal Online, (June 12). Available at http://online.wsj.com/article_print/ 0,,SB1023828339638741520,00.html.

APPENDIX A. E-COMMERCE EDUCATION QUESTIONNAIRE This questionnaire is designed to determine the coverage of e-commerce in the business curriculum. Following completion of this questionnaire, please enclose it in the pre-addressed, postage-paid envelope provided. Thank you for your assistance, cooperation, and valuable input. 1. Do you expect future demand and interest in e-commerce education among the business community, practitioners, and academicians to Increase? a. Business Community b. Practitioners c. Academicians

Decrease? Remain the Same?

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2. Please indicate the importance of e-commerce education by using the fivepoint scaling 1 ¼ not important and 5 ¼ very important. Not Important a. b.

c. d.

f. g.

h.

Make students more desirable in the marketplace Prepare students to be able to continue professionally in an IT era Meet accreditation education requirements (e.g. AACSB) More organizations use e-commerce for their business activities. Job openings in e-commerce are numerous. Coverage of e-commerce in business curriculum is required to stay academically competitive. Others (please specify) ________

Very Important

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3. Please indicate the extent you would agree with the following method(s) of nitrating e-commerce into the business curriculum by circling 1 for strongly disagree through 5 for strongly agree. Offer a separate e-commerce course at the undergraduate level. Offer a separate e-commerce course at the graduate level. Offer a separate e-commerce course at the undergraduate and graduate level. Integrate e-commerce through business courses at graduate and/or undergraduate level. Offer an e-commerce concentration (track) at the undergraduate level. Offer an e-commerce concentration (track) at the graduate level. Offer an e-commerce concentration (track) at both the undergraduate and graduate level.

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Offer an e-commerce degree program (e.g. MS, MBA) at the graduate level. Offer an e-commerce undergraduate degree program. Do not cover e-commerce at all. Others (please specify) ____________________ 4. Please indicate which of the following topics should be included in (1) the core curriculum required of all business majors, (2) optional specialized e-commerce course, and (3) e-commerce degree programs (BS, MBA, MS). Please check all that apply. Core Curriculum Requirements 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.

Specialized Course

Degree Program

Introduction to the Internet Internet risk and security Encryption Privacy standards, policies and systems Electronic data interchange (EDI) Marketing on the Internet Intelligent information agents Distance education on the Internet Telecommuting through the Internet Introduction to e-commerce Extensible markup language (XML) Extensible business reporting language (XBRL) Java Script and Java programming language E-commerce opportunities and strategies E-commerce security (cryptography, digital signatures, and fire walls) Electronic payment systems (e-money, smart cards) E-commerce in various industries Architecture of electronic commerce Authentication and security aspects of electronic commerce Legal and ethical issues in e-commerce Supply chain management Web page design, navigation and browsers E-commerce emerging issues and technology Enterprise resource planning (ERP)

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Customer relationship management system Themes and trends in e-commerce Accounting and taxation for e-commerce Design and maintenance of e-commerce Intranets and Extranets Data communication and networking Database design and management Intellectual property protection and copyrights Cyber banking and personal finance Just-in-time and e-commerce Virtual reality modeling language (VRML) Hyper text markup language (HTML)

5. Comments: Please feel free to comment on the e-commerce education and enclose a copy of your course syllabi or any related materials for ecommerce coverage. Thank you for your cooperation and assistance. If you wish to receive a copy of the results of this study, please check the following space and enclose a business card [ ]. E-Commerce Education Questionnaire This questionnaire is designed to determine the coverage of e-commerce in the business curriculum. Following completion of this questionnaire, please enclose it in the pre-addressed, postage-paid envelope provided. Thank you for your assistance, cooperation, and valuable input. 1. Do you expect future demand and interest in e-commerce education among the business community, practitioners, and academicians to Increase? a. Business Community b. Practitioners c. Academicians

Decrease?

Remain the Same?

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Please indicate the importance of e-commerce education by using the five-point scaling 1 ¼ not important and 5 ¼ very important. Not Important a.

b.

c.

d.

f. g.

h.

Make students more desirable in the marketplace Prepare students to be able to continue professionally in an IT era Meet accreditation education requirements (e.g. AACSB) More organizations use e-commerce for their business activities. Job openings in e-commerce are numerous. Coverage of e-commerce in business curriculum is required to stay academically competitive. Others (please specify) ________

Very Important

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________ both graduate and undergraduate level ________ No, but expected to add one or more courses within the next few years ________ No current courses and no plans to offer any

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4. Check all degree programs with emphasis in e-commerce offered by your institution ______ BS ______ MBA ______ MS ______ Concentration (track) ________ Others (please specify) ________________ ________ None now, but expect to offer the following degrees/ concentrations beginning during the next few years. Please list expected programs below. 5. Please indicate which of the following topics should be included in (1) the core curriculum required of all business majors, (2) optional specialized e-commerce course, and (3) e-commerce degree programs (BS, MBA, MS). Please check all that apply. Core Curriculum Requirements 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21.

Specialized Course

Degree Program

Introduction to the Internet Internet risk and security Encryption Privacy standards, policies and systems Electronic data interchange (EDI) Marketing on the Internet Intelligent information agents Distance education on the Internet Telecommuting through the Internet Introduction to e-commerce Extensible markup language (XML) Extensible business reporting language (XBRL) Java Script and Java programming language E-commerce opportunities and strategies E-commerce security (cryptography, digital signatures, and fire walls) Electronic payment systems (e-money, smart cards) E-commerce in various industries Architecture of electronic commerce Authentication and security aspects of electronic commerce Legal and ethical issues in e-commerce Supply chain management

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22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36.

Web page design, navigation and browsers E-commerce emerging issues and technology Enterprise resource planning (ERP) Customer relationship management system Themes and trends in e-commerce Accounting and taxation for e-commerce Design and maintenance of e-commerce Intranets and Extranets Data communication and networking Database design and management Intellectual property protection and copyrights Cyber banking and personal finance Just-in-time and e-commerce Virtual reality modeling language (VRML) Hyper text markup language (HTML)

6. Comments: Please feel free to comment on the e-commerce education and enclose a copy of your course syllabi or any related materials for e-commerce coverage. Thank you for your cooperation and assistance. If you wish to receive a copy of the results of this study, please check the following space and enclose a business card [ ].

SOME IDEAS FOR USING CASES IN THE CLASSROOM Pamela A. Smith ABSTRACT This chapter provides ideas about how to use cases in the classroom. The more ‘‘alive’’ the learning experience, the more the students are interested and involved in their own learning. Cases can provide the realism that can make a topic come alive. This chapter describes five mechanisms used in the development and implementation of cases in the classroom. These mechanisms help the students develop technical skills, professional conduct, critical thinking, and problem-solving skills. The five mechanisms are: use of practitioners, use of consultations, use of role-playing, use of peer evaluations, and use of grading sheets.

INTRODUCTION This chapter provides ideas about how to use cases in the classroom. The more ‘‘alive’’ the cases, the more the students are interested and involved in learning. This chapter describes five mechanisms used in the development and implementation of cases in the classroom. These mechanisms help the students develop technical skills, professional conduct, critical thinking, and problem-solving skills. The five mechanisms are: Advances in Accounting Advances in Accounting, Volume 21, 259–273 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21011-8

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1. Utilize practitioners to provide input in the development and evaluation of case content. Input from a practitioner will make the content current and relevant so the students can see the importance of the topic. By making the content more realistic, the students’ technical and problemsolving skills are strengthened. 2. Conduct formal consultations between the student teams and the professor as the students prepare for the case. The team consultations give the students guidance and direction, so they are less likely to feel lost and frustrated. The consultation mirrors the real world, where an expert is consulted for guidance. The students must conduct the consultation in a thoughtful, organized, and professional manner. 3. Require active role-playing so that the students empathize with alternate points of view. The use of role-playing encourages students’ creativity, so the case material is fun and entertaining as well as educational. Assign teams different roles for the same case so that the students can critically analyze differing perspectives. 4. Require team contracts and peer evaluation. The use of team contracts and peer evaluations based on that contract instills a sense of accountability and responsibility. Responsibility to the team helps develop the students’ professionalism. 5. Utilize faculty grading sheets. The development and use of grading sheets requires the faculty to think through expectations and produces grading consistency and reduced grade appeals. To some extent all these mechanisms have been used in both case development and execution, so the mechanisms are not new. However, this chapter describes a manner in which all items can be used and integrated in one case application. In the sections that follow each item is described in detail. The appendices provide an example of application of the mechanisms described using a Trueblood case on revenue recognition. Use of Practitioners Practitioners can provide input on issues that are current, unique, and interesting to the students. Through interaction with these in practice, the faculty member can ask about examples or scenarios that can be used to display a topic that is being covered in class. Input from a practitioner can be initiated at alumni events, professional meetings or casual associations. With the practitioner’s permission, the faculty member can sanitize the scenario and tailor it to the classroom learning objectives. Based on

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conversations with the practitioner, the faculty member can develop a case and the practitioner can review any documents created by the faculty to assure anonymity (if this is an issue) and completeness. This is a great way to get alumni involved with the department or college and to develop a case for use in the classroom. Practitioner developed cases are also available through the AICPA’s Professor/Practitioner Case Program or the Deloitte Foundation’s Trueblood cases. Appendix A presents the instructions for a Trueblood case on revenue recognition. It should be emphasized that the ‘‘case’’ does not have to be elaborate or involved. It could be a specific scenario to help exemplify an accounting issue. Some examples may include: estimation of an allowance account, implementation of an inventory valuation method (retail method or dollar value LIFO), estimation of warranty liability, factors involved in weighting debt versus equity financing, or revenue recognition issues. Often, the practitioner can provide insight as to how various constituents view one scenario from vastly different perspectives. This input is valuable when determining what roles to assign to students. For example, constituent groups affected by a financial accounting issue could include the company management, the auditor, the investor, and the Securities and Exchange Commission. When the students know that a practitioner is involved in the development of a case, and it is a real-world scenario, they often pay more attention to details and ask more questions. This is a great opportunity to work on unstructured problem-solving skills and help the students become comfortable with accepting that there is no ‘‘right’’ solution or answer. Practitioner involvement helps the students see the relevance of what they are learning and how that topic impacts various groups of individuals such as management, the consumer, government etc. In order to mirror real-world settings as much as possible, invite the practitioner to attend class on the day of the case presentations or discussion to provide feedback to the students. When the students know that there will be an outside observer (who is also familiar with the case), their attention to the case is heightened. I ask the practitioner to complete a grading sheet if the case is presented (see Use of Grading Sheets). I also provide the students with a copy of the practitioner’s grading sheet if it appears that the feedback would be valuable to the students. Use of Consultations Each team is required to set up a ‘‘consultation’’ with the professor to receive guidance and feedback as they prepare their case presentation. The

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professor plays the role of the consultant. The student team meets the consultant with issues identified, plausible solutions outlined, and questions that need to be answered from the perspective of their assigned role. A sign-up sheet for the consultation is distributed during the class. The objective of the consultation is to place the responsibility on the students to have fully researched the issue and to come to the meeting prepared. A portion of the team’s points is assigned to the consultation and the points earned are based on the level of preparedness and professionalism for the consultation appointment. The consultations are intended to mimic scenarios where a partner, vice president, or outside expert is consulted for guidance. The person consulted is in a position of authority and expertise (and often quite expensive). Therefore, the students need to be prepared, organized and focused on the information needed from the consultant. In order to optimize the faculty’s time, hold the consultation in a conference room in 30 to 45-minute increments back to back. The consultations will replace office hours for that week. All team members do not have to participate during the consultation. Often it will flow more smoothly if representative(s) of the team conduct the meeting on behalf of the team. However, all team members must attend the consultation; any absences will be detrimental to the grade of the absent individual. The assignment of who conducts the consultation could be part of the team contract (see Use of Team Contracts and Peer Evaluation).

Use of Role-Playing If the case is presented, assign each team to different roles. Some example roles are: company management (this can be split into various positions within the company), the consumer, the government, an oversight agency, etc. Assigning the student teams to a particular role helps them take ownership of a certain perspective. Often the case requires the teams to make recommendations. As each team completes their presentation in their assigned role, their recommendation is listed on the board. After all teams have presented their recommendation, the class can discuss the alternatives presented and try to come to a compromise solution. Appendix B provides a description of the roles used in the Trueblood revenue recognition case. In addition to presenting the case from the assigned perspective, the team must anticipate the counterarguments from the perspective of the roles assigned to the other teams. Each team must anticipate these counterarguments and how their team will handle those arguments. Part of the presentation

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grade is allocated to how well the team handles the negotiations toward a solution with the other teams. This part of the role-playing gives the students opportunity to think on their feet, present differing positions in a productive professional manner, and support their arguments with logic and reason. Before the presentations, discuss with each team (perhaps during the consultation) how they will present the material from their assigned perspective. Encourage creativity and give examples of ways to make their roleplaying more fun. Often with very little encouragement and just a few brief examples, the students take off on their own creative adventures. The students enjoy learning when they are having fun. An example role-play is a team that was assigned to represent the investors in Enron. The team had a panel of individuals at a front table and had names placed on table tents indicating that one of the students represented Warren Buffet. Among the audience were two students from the team with nametags labeling them Ma and Pa Kettle, 0.0001% ownership. Each person dressed and spoke in dialect appropriate for their role. During the presentation, the students brought up issues on financial statement disclosures from the sophisticated versus unsophisticated investor’s viewpoint. Other teams have used props such as golf clubs, music to develop the setting, sunglasses, cowboy hats, and paper shredders.

Use of Team Contracts and Peer Evaluations An area that is often troublesome is the allocation of work when students are assigned to teams.1 The use of team contracts and peer evaluations can help the students to take ownership of their role in the team and responsibility to the team. Knowing that there is a peer evaluation that is based on the team contract helps the team members recognize that they are accountable to the rest of the team. Appendix C contains an example team contract developed by a student team. The teams are instructed to develop and turn in a contract that outlines the responsibilities, deadlines, and deliverables of each team member. The contract must be agreed upon and signed by all members of the team and turned in. The contract can be modified because of unforeseen circumstances if everyone is in agreement. Each team member will submit his or her evaluation of the other team members’ performance based upon the contract. The evaluation is due on the next class day after the project due date. Evaluation of another’s performance is a serious and significant activity. If the evaluation is viewed to be cursory, the evaluator’s grade will be penalized.

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Appendix D contains an example peer evaluation form and Appendix E contains guidance for faculty evaluation. The three major areas that are most important to the success of any team environment are: attendance, attitude, and contributions. Attitude is important in any team setting. First, a team member should have a positive outlook and commitment to the project. This includes their overall disposition toward the project. Second, a team member should have a willingness to assume responsibilities. This involves the individual’s effort to take on responsibilities voluntarily and to help in areas he/she may not initially have been designated as responsible. Finally, a team member should have an ability to work with others. This includes the individual’s willingness to work with all members of the group, including willingness to listen and consider the ideas of others. It also involves the resolution of any conflicts in a mature and productive manner without interfering with the productivity of the overall work at hand. Attendance at planned team meetings and scheduled events includes being on time for and present during the entire meetings. Other attendance is responsiveness to emails and phone calls in a timely fashion. Often work will be partitioned off to subgroups. It is imperative that the individuals are available and responsive to communication with each other. Being part of a team goes beyond just showing up: each team member needs to make contributions. Contributions can be made during the team meetings including involvement in the discussion and decisions during these meetings. In addition, preparation for the meetings, including, the individual’s effort to understand the material and be prepared ahead of time to help the team progress to the completion of the project is a critical contribution. Finally, completion of the task assigned to the individual per team contract and evidence that effort was undertaken to complete their assigned task in a quality manner and in a timely fashion. Use of Grading Sheets Appendix F is an example faculty grading sheet for this case. The following are some of the benefits of using a grade sheet for cases, papers and projects: - Keeps the grading for content consistent from presentation to presentation (or paper to paper). - Forces the faculty member to think about what their expectations are with regard to the project.

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- Allocates a specific component to presentation, grammar, organization etc. Often it is easy to have a poorly written paper be down graded as unfair even though the content is there. - Significantly reduces student requests for re-grades. - Provides guidance for independent grader (e.g. grad student or practitioner). The point allocation is just to provide an example and can be modified based on the case content and classroom focus. The students are not provided the grade sheets before hand. Experience has shown that if the grade sheets are distributed before the assignment is turned in, the students’ focus on how to maximize points according to the grade sheet, rather than completing the assigned task.

CONCLUSION This chapter provides examples of ways to use cases in the classroom that promotes a more realistic setting for problem solving and student involvement. Any one of the mechanisms could be used alone or in conjunction with other tools for teaching cases. These mechanisms can be used with previously developed case materials or with materials that the instructor develops in conjunction with a practitioner. Most importantly, the cases do not have to be long and involved. There are pedagogical benefits from short content-focused cases that the instructor designs, based on conversations with practitioners. In many ways cases that are focused on current and emerging issues can be the most interesting. Even more so, using some of the mechanisms described in this chapter can make the learning experience fun.

NOTES 1. Note I did not say ‘‘groups.’’ I have totally purged ‘‘group’’ from my reference to the case assignments. The students are members of a ‘‘team,’’ including all of the connotations that go with the concept of a team. I want them to be in a team mentality and figuratively.

APPENDIX A. DIGISNAP Digisnap is a small digital camera manufacturer. Digisnap recently developed a high-end camera that allows customers to produce videos or pictures

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that can be distributed over the internet, in addition to producing traditional paper prints of pictures using existing photo processing laboratories. As a result, the customer avoids additional purchases of special printers and other equipment as with other digital cameras. These cases are a modification of Trueblood Cases provided by the Deloitte Foundation, 2002 and are used with permission of the Foundation. Solutions to the case are available through the Deloitte Foundation. Digisnap entered into an agreement on January 2 to sell digital cameras to Home Electronics (a reseller) for $400 per unit. Digisnap previously had not sold product to Home Electronics. As part of the agreement, Digisnap granted warrants to purchase 100,000 shares of Digisnap common stock to Home Electronics as a ‘‘slotting’’ arrangement in order to obtain shelf space at Home Electronics. The warrants will vest and become exercisable only if Home Electronics purchases more than 25,000 digital cameras in the 12month period ending on December 31. Based on the market analysis performed separately by both companies, it appears likely that Home Electronics will purchase more than the 25,000 digital cameras required for vesting in the warrants. While both companies expect that the number of units purchased by Home Electronics will exceed 25,000, Home Electronics has no commitment to purchase any minimum number of units. Further, the agreement indicates that Home Electronics can cancel the ‘‘slotting’’ arrangement at any time during the 12-month period without penalty. Accordingly, no measurement date for the warrants has occurred since the agreement does not contain a performance commitment. A measurement date for the warrants will be achieved when Home Electronics has purchased 25,000 digital cameras (the date the performance is complete). Digisnap performed a Black-Scholes analysis to value the warrants on the date of the agreement (January 2) and determined the fair value to be $10 per warrant (or $1,000,000). During the first quarter, Home Electronics purchased 10,000 digital cameras for $4,000,000. At the end of the first quarter, Digisnap performed another Black-Scholes analysis indicating that the fair value of the warrants had increased to $20 (or $2,000,000). Required Discuss the case facts from your assigned perspective. Discuss the reporting objectives from your perspective. Discuss the amount, timing and classification of the sales incentive that should be recognized. Support your position with the appropriate literature.

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Under what circumstances would you change your position on the accounting and reporting of this transaction?

APPENDIX B. ROLE ASSIGNMENTS The role assignments will be the company management, the auditor, and the SEC. Each role requires the group to research the accounting and reporting issues related to the transaction and present the accounting treatment you advocate. In order to make a compelling argument each group should have a thorough understanding of the position that may be advocated by the other roles to adequately dispel the validity of the counterarguments. Each group will have 20 min to present their position. After all presentations there will be a 20-min class discussion of the issues raised. Each group is required to set up a ‘‘consultation’’ to receive guidance and feedback. A sign-up sheet will be distributed in class. The objective is to place much of the responsibility on you to have fully researched the issue and to come to the meeting prepared with questions for guidance. This mimics the real world where the time of upper management or outside consultants is limited and valuable. I strongly recommend that you be prepared for your consultation, as it is the major guidance you will receive. All group members must attend the consultation; any absences will be detrimental to the grade of the absent individual. Group Roles The management group will be responsible for explaining the details of the revenue transaction to the rest of the class and present their preferred accounting treatment supported by the appropriate authoritative literature. This group will explain management’s reporting objectives and why the accounting treatment is critical to obtain those objectives. The auditing group will represent a firm that was just sanctioned by the SEC in the audit of another client that was recognizing revenue aggressively. This group will explain how the role of the auditor has changed in the current environment and how that change has affected the firm’s stance on this issue. The auditors will present their preferred accounting treatment supported by the appropriate literature. The SEC enforcement division has been closely scrutinizing the clients of the auditing firm ever since the sanction was levied. This group will consult GAAP and the SEC literature as guidance to support their position of the accounting treatment that is acceptable by the SEC.

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Class Discussion After the role-playing we will hold an open discussion of the issues presented by the groups. Be prepared to discuss the following:






the revenue recognition issues raised during the presentations, principles versus rules-based accounting, conflict resolution in today’s environment, ethical issues encountered as you tried to support your position, the lifelong learning skills needed to complete a research assignment.

APPENDIX C. EXAMPLE TEAM CONTRACT General Group Member Responsibilities: 1. Attend every group session, be on time, and remain throughout the session. If a member cannot be present, call or e-mail the other group members so your absence will be known ahead of time. 2. Participate actively in discussions related to our group’s recommendation for the case we are presenting. Encourage discussion and participation by all members of the group. Consider the merits of every member’s contributions, oral or written. 3. Respect and consider the suggestions presented by each group member. 4. Maintain the confidentiality of any communications of a personal nature presented during the group meeting time. 5. Assist in the development of ideas, facts, and research needed to develop an informed recommendation concerning the proper revenue recognition treatment for our particular case. 6. Research, document, and disseminate to the other group members the relevant research issues that are discovered in independent research. 7. Incorporate all the relevant and necessary research into a thorough presentation of the case. The final presentation will include a defensible, logical and supportable decision on how to properly record revenue recognition in our case. 8. Complete all the above-mentioned in a professional and ethical manner, adhering to the code of ethical conduct. Signatures _____________

Date _____________

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Individual Contract for Research Coordinator I, the undersigned, _________, being of sound mind and body, do declare to take on the responsibility of being the Research Coordinator for the Revenue Recognition Module, which is one of the modules in the ____________ course, under the supervision of Dr. ______________. My duties will specifically include, but may not be limited to, the following: 1. I will be primarily responsible for overseeing the research necessary to develop our final revenue recognition recommendation for the case assigned. 2. I will compile, compress, and combine information, ideas, research, and standards into a defensible and logical recommendation to the class on (insert date) based on all the information discussed and agreed upon as a group. 3. I will take it upon myself to research, document, and disseminate to the other group members the relevant current accounting literature and press releases that are essential to reaching a supportable recommendation. 4. I will make sure a group consensus is reached based on all relevant financial accounting research before finalizing our recommendation. 5. I will do my best to coordinate, prompt and lead discussions related to our group’s recommendation for the case we are presenting. 6. All the preceding I myself will complete in a professional and ethical manner, adhering to my own, as well as this University’s, code of ethical conduct. Signed _____________

Date _____________

Contract for the Presentation Coordinator I, the undersigned, __________, being of sound mind and body, do declare to take on the responsibility of being the Presentation Coordinator for the Revenue Recognition Module, which is one of the modules in the _____________ course, under the supervision of Dr. _________. My duties will specifically include, but may not be limited to, the following: 1. I will be primarily responsible for synthesizing all the group’s research and recommendations into a clear, complete and appealing PowerPoint format.

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2. I will allow adequate time for other group members to comment and proofread the PowerPoint presentation, and make timely revisions as necessary. 3. I will come to class prepared with the above-mentioned PowerPoint presentations on a workable computer disk on ðinsert dateÞ: 4. I will arrange for a practice presentation session as deemed necessary by a consensus of the members of the group. 5. I will research the relevant SEC rules and regulations regarding proper revenue recognition treatment for our case. 6. All the preceding I myself will complete in a professional and ethical manner, adhering to my own, as well as this University’s, code of ethical conduct. Signed _____________

Date _____________

Contract for the Assistant Researcher I, the undersigned, _________, being of sound mind and body, do declare to take on the responsibility of being the Assistant Researcher for the Revenue Recognition Module, which is one of the modules in ______________ course, under the supervision of Dr. ____________. My duties will specifically include, but may not be limited to, the following: 1. I will assist the research coordinator in the research and preparation of the recommendation for proper revenue recognition. 2. I will research the relevant professional financing accounting practices and rules using up-to-date information and proper accounting sources. 3. I will submit my writings and correspondence to the research and presentation coordinators in a timely manner. 4. I will participate in discussion and contribute research findings and knowledge to other members in order to reach a common understanding of the accounting rules. 5. I will assist the presentation coordinator in the preparation and presentation of the PowerPoint on ðinsert dateÞ: 6. All the preceding I myself will complete in a professional and ethical manner, adhering to my own, as well as this University’s, code of ethical conduct. Signed _____________

Date _____________

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APPENDIX D. PEER EVALUATION OF TEAM MEMBERS (EXAMPLE FORM) Area (Points possible) Attitude: Positive outlook (.5) Willingness to assume responsibilities (1.0) Ability to work with others (1.0)

Attendance: To planned meetings (1.0) To communications (.5)

Contributions: Involvement during meetings (2.0) Preparation for meetings (2.0) Completion of assigned tasks (2.0)

Total points

(10.0 possible)

Team Member A

Team Member B

Team Myself Member C

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APPENDIX E. PEER EVALUATION OF TEAM MEMBERS (FACULTY GUIDANCE) Below is an example grid used to determine the point allocation to the team members. Student evaluators are guaranteed anonymity. Therefore, the student knows only the average peer score assigned to them, not the individual scores. If a student’s score is reduced because they did not perform as an evaluator, that student is informed of the penalty applied (e.g. student ‘‘C’’).

Points Allocated by →

A

B

C

D

E

Average

10

10

10

9.68

9

7

8.72

8

8.23 - 1.0 = 7.23

Points Allocated to ↓ A

9.5

B

8.3

9.3

C

8.6

8.3

10

D

10

9.1

10

10

E

9.4

9.1

10

10

9.82 10

Student ‘‘A’’ allocated points to students A through E at 9.5, 8.3, 8.6, 10, and 9.4 respectively. Student ‘‘A’’ received an average score of 9.68. The student’s evaluation of himself or herself may be included or excluded from the average scores. In this example, the student’s evaluation of himself or herself is included in the average score. There may be situations, where you may choose to base the students average peer score excluding their own score.

Student ‘‘C’’ gave everyone a 10. However, the other team members gave this student one of the lowest scores. This student gave every team member a 10 with no written reasons for the allocation. This student self score was not included in the average (because his point allocation was not deemed valid) and was penalized one point because the student’s evaluation showed no discretion or thought to the evaluation process. Written comments are provided with each student’s point allocation of their peers. Based on a 10 point scale, this group had 3 A’s, one B and one C. I have found this system helps students objectively and thoughtfully to evaluate their own and others contributions to the team.

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APPENDIX F. FACULTY GRADE SHEET (EXAMPLE – 100 POINT ALLOCATION) Consultation 10___11___12___13___14___15 •

Issues identified: How to treat, how to value, and when to recognize cost of warrants Solutions proposed: Organization:

• •

Presentation Clear identification of issues • •

15___16___17___18___19___20

SFAC #5 Slotting fees

Thorough analysis of issues 21___22___23___24___25___26___27___28___29___30 •

EITF 96-18 Measure at FV of incentive or warrant – commitment date is measurement date EITF 01-9 Systematically reduce revenue as cash rebate is earned EITF 84-8 Date of agreement is not appropriate measurement date

• •

Recommendation and support •

9___10___11___12___13___14___15

Ability to provide counterarguments and respond to challenges and questions

Organization, flow, and understandability 5___6___7___8___9___10 •

Ability to convey understanding of the material in a clear, concise, and succinct manner.

Individual Peer Score Total score

5___6___7___8___9___10 ______

TECHNOLOGY AND THE ACCOUNTING CURRICULUM: WHERE IT IS AND WHERE IT NEEDS TO BE Christian Ille Hastings and Lanny Solomon ABSTRACT This study looks at technology/systems coverage in accounting programs throughout the country. Much of the study focuses on a questionnaire that was sent to directors of accounting programs and practicing professionals, with the professionals being sampled from the corporate arena, consulting firms, and public accounting. The results indicate that some sizable differences exist with respect to current and desired coverage of selected topics, and with respect to educator and practitioner preferences. The study also queries program directors on various impediments to technology implementation at their respective schools, along with how programs cover technology and systems at the graduate level.

INTRODUCTION The business environment is rapidly changing and with it the accounting profession, which serves business, has had to change. Globalization has Advances in Accounting Advances in Accounting, Volume 21, 275–296 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21012-X

275

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increased levels of competition, and technology has dramatically changed daily operations. What was ‘‘good enough’’ in the past is not ‘‘good enough’’ today, as evidenced by bankruptcies, buyouts and forced mergers that have stripped household names from the American scene. A critical question is whether educators are keeping pace. Put simply, organizations that fail to respond to the changing needs of the market often face a diminished future role. Albrecht and Sack (2000) paint a dismal portrait of a discipline stuck in the past, in their call to arms: Accounting Education: Charting the Course through a Perilous Future. They observe that technological innovation has drastically reduced the costs of information gathering and reporting in today’s business environment. Technology allows massive quantities of data to be efficiently entered, securely stored and retrieved on demand from huge databases. Many of the traditional roles served by accountants in these processes have been eliminated or can be performed by line personnel. Accountants must be armed with new skills if they are to find a role in today’s competitive environment. Albrecht and Sack conclude yif accounting education is to keep up with changes occurring in the business world, educators must understand what types of services their graduates will perform in the future (p. 15).

Reckers (2002, p.1), long an advocate for increased technology exposure in accounting programs, notes the following: It came as a thief in the night. Its effects were gradual and went unrecognized by many until the erosion left gaping holes in the landscape of our profession. Technological innovation was the relentless rain that pummeled our discipline’s currency and eroded the value of our producty. Too many academics, for far too long, were complacent: willing to excuse inaction with a litany of alleged justifications. We clung to arguments that curriculum innovation was unnecessary; that Albrecht and Sack and a legion of others, were wrong! But, we refused to invest our time and efforts to know whether it was true or not. We steadfastly, as a group, refused to educate ourselves about the changing business landscape in which our students functioned and respond to ity. The seeds of our current problems lie not with what we have done, but with what many of us have not done.

Albrecht, Sack, and Reckers observe that accounting curricula must embrace the unfolding technology revolution. Others in the profession recognize this as well. Recently, for example, Robert Half International (2005) surveyed 1,400 CFOs. When asked what skill other than financial expertise was most critical for an accountant’s success, the overwhelming choice was technological expertise.

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LITERATURE REVIEW Unfortunately, despite the enthusiasm and significant support for technology in accounting programs, relatively little is known about the current state of affairs – particularly how educator views match up against those of practicing professionals. Several earlier educator/practitioner studies in systems/technology focused on the content of the accounting information systems (AIS) course. Heagy and McMickle (1988), for example, surveyed 59 topics that could be covered in such a course, including programming, manual accounting systems, computer fundamentals, internal control and tools of systems analysis and design. Practitioners contacted by Heagy and McMickle were queried about the topics’ usefulness in preparing individuals for careers in accounting. The practitioners were CPAs relatively new to the profession, having three or fewer years’ experience and holding at least a four-year college degree. In a similar type of survey, Theuri and Gunn (1998) also studied the content of the AIS course; however, these researchers directed their questionnaire at more experienced personnel who had responsibility for recruiting accounting graduates. In addition, the survey instrument was updated to reflect selected new developments and topics (e.g., database management concepts, networks and decision support systems) as well as factors that could influence course design (such as CPA exam content, accreditation requirements, unique job requirements and textbook availability). To gather more insight into respondent feedback, Theuri and Gunn subdivided survey participants and results into four categories based on an individual’s primary employment base: education, public accounting, government and the corporate arena. In a recent study, Jackson and Cherrington (2002) noted that considerable research has focused on information systems (IS) fundamentals as taught in the AIS course. Relatively little work has been done, however, in assessing the content of subsequent systems courses and the more advanced IS skills required for accounting students. These researchers focused on the IS Tools and Applications course at Brigham Young University (BYU), a masters-level course that (1) builds on two earlier MIS and AIS offerings and (2) consists of 36 separate modules. Because of the wide variety of skills, background and desires of course participants, students are free to select the modules they want to complete (much like a cafeteria plan) and sign a contract with the instructor. In an effort to assess the effectiveness and relevance of the course, Jackson and Cherrington surveyed 132 BYU graduates to determine whether skills

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are being provided in the right software applications with respect to fulfilling job responsibilities. Graduates responded that the course was very effective and that in part because of this course, they were as prepared or better prepared than their peers from other institutions. While the study produced a number of interesting findings, the response to the following statement – My IS skills are NOT an important part of my job – is perhaps the most eye opening. The question had a very strong negative response (85%), and it was the only question posed by the researchers that had zero responses in the Strongly Agree category. In another recent study, Bain, Blankley, and Smith (2002) overviewed the introductory accounting information systems (AIS) course, the content of 12 AIS textbooks, syllabi from instructors and the results of a survey of faculty and professionals. Findings indicate that the introduction to systems, internal control and transaction processing are the most important topics to be covered. Additionally, the emphasis placed on the topics of systems analysis and design are still important although now less than in the past. Lee, Trauth, and Farwell (1995) surveyed IS professionals and found that many IS (not accounting) curricula were not well aligned with the needs of business. Many technical subjects emphasized in a typical IS curriculum, including decision support systems and expert systems, were given relatively low priorities by the survey respondents. Also, IS curricula often lagged behind practice when introducing critical new technologies (such as networking and telecommunications) and failed to prepare graduates with the necessary depth and breadth across the fields of business, human resources and technology. In reaching these conclusions, the researchers sampled professionals in only one region of the United States and did not conduct a separate formal survey of educators. Finally, Goldsworthy (1996) reports on a study conducted by the Information Management and Technology Centre of Excellence – a study that surveyed information technology professionals and coverage of selected subject matter in Australian university accounting programs. This survey was important for educators because as part of its accreditation process, the Australian Society of CPAs requires selected coursework with at least 5% content of (undefined) IT topics for graduates to qualify as associate member status within the Society. Among the study’s findings, relatively little attention was paid to the integration of IT theory into traditional accounting units (e.g., describing the features of a general ledger package in a financial accounting course), and more class time should be devoted to practical IT components (such as spreadsheet usage).

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PURPOSE AND DEMOGRAPHICS OF CURRENT STUDY Despite the efforts of the researchers cited, systems and technology coverage in today’s accounting curricula remains blurry and unknown, with extensive variety (perhaps too much variety) among educators being the rule rather than the exception. Much has changed in recent years. Topics that may have been relevant for inclusion in an accounting systems course taught in the mid-1980s are no longer relevant today. Additionally, topics that are now commonplace were often unknown commodities during this earlier time period, with ‘‘technology’’ being a prime example. To further complicate matters the systems/technology field has expanded considerably, requiring universities that are interested in assuming a leadership role to develop accounting courses that go well beyond the coverage of the typical introductory offering(s). Are universities proceeding down the correct path? While both educator and practitioner surveys can often play a key role in answering this question, today’s educators are hampered when making important systems/technology curricula decisions because of dated results or what could be viewed as ‘‘narrowness’’ when it comes to past sample characteristics and/or the audience surveyed. Generally speaking, there is little current background data available with respect to integration of technology into the accounting curricula and more so, whether educator actions are consistent with the needs of practitioners. As a result of this situation, the authors, via a survey questionnaire, examined with greater specificity the current and desired state of accounting education through the eyes of accounting program chairs/directors and practicing professionals. The questionnaire probed an undergraduate accounting major’s exposure to technology subject matter, both currently and desired, in the near-term future. The authors also explored, among other things, the existence and attributes of selected standalone graduatelevel courses.

Educators Questionnaires were mailed to the administrators of accounting programs as identified in the Prentice Hall Accounting Faculty Directory (Hasselback, 2001). One hundred fifty-one (151) responses were received, resulting in a

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response rate approximating 25%. Of the responses, the accounting degrees offered by the respective institutions were as follows: Ph.D. institutions Masters and undergraduate institutions Undergraduate-only institutions

34 85 32 151

Practicing Professionals Our sample of practicing professionals was compiled from several different sources. Selected alumni from three universities located in the East, Midwest and Southwest were contacted via personal appeal of the academic department chair or notable faculty. Also, alumni were selected for inclusion on the basis of past cooperation/participation in school-sponsored activities and to achieve a representative set of successful graduates. Finally, the Institute of Management Accountants solicited participation from a sample of representative members. We received 62 usable responses from a wide variety of firms (corporations, consulting firms and accounting firms) as well as from individuals who have a broad range of backgrounds (CFOs, corporate controllers and partners from large and mid-range CPA firms). The end result was a response rate of approximately 70%. Other data about the respondents appear in Table 1.

SURVEY RESULTS Current and Desired Technology Exposure: Program Administrators Program administrators were asked to evaluate the technology exposure that their undergraduate students currently receive in accounting courses or elsewhere in the business curriculum. Fourteen technologies and concepts were presented, and administrators were given the following response options: (1) no exposure, (2) 1–2 weeks’ exposure, (3) 3–4 weeks’ exposure, and (4) 4 weeks or more exposure. (Responses are shown in Table 2, panel A.) Administrators also were asked to indicate the amount of exposure that is desirable. Their tabulated responses appear in Table 2, panel B.

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Table 1.

281

Attributes of Respondents: Practicing Professionals.

Affiliation Corporate industry Public accounting/consulting

Gross revenue of employer $10+ billion $1–10 billion $500 million–$1 billion $100–$500 million $10–$100 million o$10 million

70% 30% 100%

13% 19% 15% 16% 35% 2% 100%

Majority of job duties Internal audit Information systems Consulting Taxation Performance measurement External audit Corporate accounting/finance Financial reporting

3% 3% 6% 6% 14% 15% 22% 31% 100%

A majority of respondents (50% or more) indicated that current attention to a technology or concept reached or exceeded 3 weeks in only one area. Twenty-four percent of respondents indicated that their students received 3– 4 weeks of Excel exposure and another 53% indicated exposure in excess of 4 weeks. In no other technology area did a majority of students (50% or more) currently receive the equivalent of 3 weeks’ exposure or more. Current exposure, however, did vary somewhat by type of institution. For Undergraduate-only institutions, three areas topped the 50% threshold: Excel (86%), Tax Software (56%) and Computerized General Ledger Packages (55%). See Appendix A. For institutions that offer both undergraduate and masters degree programs, a majority of students received 3 or more weeks’ exposure to Excel (79%) and Access (51%). At Ph.D.-granting institutions, only Excel (52%) is given 3 or more weeks’ attention for a majority of students. Thus, irrespective of the type of institution, only very modest attention is afforded to technology in today’s accounting classrooms. Panel B of Table 2 reports on levels of exposure desired by administrators. Based on data aggregated across all institutions, five areas were seen by a majority (50% or more) of respondents as needing coverage equivalent to 3 weeks or more: Excel (84%) Access (74%) E-business concepts (61%) Systems security (52%) Business process analysis (66%)

282

Table 2.

CHRISTIAN ILLE HASTINGS AND LANNY SOLOMON

Academic Preparation in Various Technology/Concept Areas. None (%)

1–2 weeks (%)

3–4 weeks (%)

44 weeks (%)

Panel A: Current Exposure Excel Access Oracle database ERP concepts ERP software (hands-on applications) Computerized general ledger package Computer programming E-business concepts E-business software (hands-on) Systems security Business process analysis Audit software Tax software Management consulting

4 13 84 49 82 33 66 26 72 24 28 37 28 68

19 41 14 44 9 29 13 60 22 53 36 44 38 24

24 23 2 5 6 22 8 8 3 16 20 14 23 6

53 23 0 2 3 16 13 6 3 7 17 5 12 2

Panel B: Desired Exposure Excel Access Oracle database ERP concepts ERP software (hands-on applications) Computerized general ledger package Computer programming E-business concepts E-business software (hands-on) Systems security Business process analysis Audit software Tax software Management consulting

0 0 37 5 21 11 44 0 21 6 9 6 8 20

16 26 43 60 52 44 25 39 52 42 25 51 47 41

26 41 13 21 17 29 13 39 22 33 32 28 31 29

58 33 7 15 10 16 19 22 4 19 34 15 14 10

Again, however, responses varied by type of institution. Among Undergraduate-only institutions, seven topics met or exceeded the 50% threshold. These topics, in descending order, are: Excel (88%) Access (67%) Tax software (61%) Audit software (60%)

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E-business concepts (57%) Computerized general ledger software (54%) Systems security (50%) Among institutions offering undergraduate and masters programs, six topics were included (in descending order): Excel (85%) Access (79%) E-business concepts (67%) Business process analysis (65%) Systems security (55%) Tax software (50%) Finally, among Ph.D.-granting institutions, six technologies met or exceeded the 50% threshold (in descending order): Business process analysis (72%) Excel (65%) Access (64%) Computer programming (59%) E-business concepts (53%) Systems security (50%) Omissions include ERP Concepts, ERP Hands-on Applications and Handson Applications of E-business Software. Combining ERP Concepts and ERP Hands-on Applications into one category, however, suggests that significant prospective interest exists in ERP. Changes in perceptions of the need to expose students to ERP systems clearly appear to be in process. Currently, about 80% of undergraduate and between 30 and 40% of masters and Ph.D.-granting institutions offer no exposure to ERP. The number of administrators at these institutions who desire to continue no coverage, however, drops to only 20% and 10%, respectively. The overall conclusion from participants’ responses: The current level of exposure that accounting students have to accounting-related technologies, across different types of institutions, is very limited. Outside of the most basic software applications, which are likely delivered as part of the business core IS requirements in non-accounting courses, there has been, at best, modest response to market changes in the area of technology. At the same time there is a desire to increase the attention given to technology in every area – even with those topics that currently have the heaviest exposure.1

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Participant responses appear to reflect recognition of the growing importance that technology plays in not only business but also accounting.

Input from the Practicing Profession All the before-mentioned data and discussion have centered on the views of administrators of accounting programs. These perspectives may or may not be congruent with the actual needs of the current marketplace. Yet, it is important that accountancy programs be aligned with the needs of the market if the programs are to survive and thrive. Accordingly, we turn next to the opinions of players in the market: practicing professionals. Practicing professionals were asked to evaluate the identical technologies and concepts that were given to accounting program administrators, using the same evaluation scale: None, 1–2 weeks, 3–4 weeks, and more than 4 weeks. Table 3 displays participant responses to the following questions:
Consider the knowledge areas that are listed in Table 3. For each knowledge area, use the letter ‘‘X’’ to indicate your estimate of topical coverage within a typical undergraduate accounting program today.
Next, for each knowledge area, use the letter ‘‘F’’ to indicate your belief of the desired level of coverage in the near-term future, specifically, within 3 years. The second question was framed in terms of the near-term future to avoid any participant reticence to a candid response, which could be construed as an indictment of current university efforts. The 3-year window also provides a realistic lag time for most forthcoming curriculum efforts to reach fruition. Regarding the current state, practicing professionals estimate that less time is devoted to Excel, Access, ERP Hands-on Applications, Systems Security and Tax Software than program administrators indicate is the case, and more time is being spent on the other topics listed.2 More important, though, to the decisions currently confronting accounting administrators are the views of practicing professionals regarding what programs should be doing in the near future. Meaningful contrasts may develop between the expressed desires of the practicing profession and what accounting administrators perceive the desires of the market to be. From panel B of Tables 2 and 3 and from Table 4, one can discern some congruence and some differences in near-term (i.e., future) goals. Over 50% of academics responding express the desire for 3 weeks or more of class time for Excel, Access, E-business Concepts, Systems Security and Business

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Table 3.

285

Practicing Professionals: Perceptions of Current Academic Exposure and Near-Term Desires. None (%)

1–2 weeks (%)

3–4 weeks (%)

44 weeks (%)

Panel A: Current Exposure Excel Access Oracle database ERP concepts ERP software (hands-on applications) Computerized general ledger package Computer programming E-business concepts E-business software (hands-on) Systems security Business process analysis Audit software Tax software Management consulting

8 19 67 32 55 23 38 21 28 37 21 26 31 42

31 40 26 54 34 43 27 61 46 48 37 53 52 37

37 31 7 8 7 28 8 11 15 12 25 16 11 16

24 10 0 5 4 5 27 7 11 3 17 5 6 5

Panel B: Desired Exposure Excel Access Oracle database ERP concepts ERP software (hands-on applications) Computerized general ledger package Computer programming E-business concepts E-business software (hands-on) Systems security Business process analysis Audit software Tax software Management consulting

0 4 38 4 22 9 24 2 7 5 2 12 16 9

19 27 29 38 38 23 43 31 30 50 16 39 43 34

28 41 25 42 26 39 9 47 31 28 33 40 38 36

53 29 8 17 14 29 24 20 31 17 52 9 4 21

Process Analysis. Professionals concurred with the need for coverage in four of these five areas (Systems Security is the exception), but also noted the need for 3 or more weeks of class time for ERP Concepts, Computerized General Ledger Packages, E-business Hands-on Applications and Management Consulting. Thus, there were some differences – which is expected – and some sizable ones at that. For example, only 36% of academics believe 3 or more weeks should be devoted to ERP Concepts. Comparable figures

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Table 4. Academics vs. Professionals: Near-Term Desires of Three or More Weeks’ Class Time Devoted to Various Technology/Concept Areas. Technology/Concept Excel Access Oracle database ERP concepts ERP software (hands-on applications) Computerized general ledger package Computer programming E-business concepts E-business software (hands-on) Systems security Business process analysis Audit software Tax software Management consulting a

Academics (%)

Professionals (%)

Difference (%)a

84 74 20 36 27 45 32 61 26 52 66 43 45 39

81 70 33 59 40 68 33 67 62 45 85 49 42 57

+3 +4 13 23 13 23 1 6 36 +7 19 6 +3 18

Percent of academics minus percent of professionals.

among professionals swell to 59%. A 23% difference also exists for Computerized General Ledger Packages, and an even greater difference arises for hands-on applications related to E-business Software (26% for academics vs. 62% for professionals). Perhaps more significant, comparing the near-term desires of practicing professionals to current levels of curriculum coverage leads to the clear conclusion that a great deal of change needs to occur (see Table 5). In five areas, a difference score of nearly 50% or more is observed: ERP Concepts, E-business Concepts, E-business Hands-on Applications, Business Process Analysis and Management Consulting. Currently, only 7% of programs provide 3 weeks or more of ERP exposure; however, 59% of professionals advocate that level of attention (plus 40% call for an additional 3 weeks or more of Hands-on ERP experience). Where only 14% and 6% of schools, respectively, provide 3 or more weeks’ coverage of E-business Concepts and E-business Software, 67% and 62% of professionals prescribe similar coverage for these respective areas. And finally, sizable differences also exist for Business Process Analysis (48%) and Management Consulting (49%), with professionals’ future desires greatly exceeding the current attention in academic programs.

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Table 5. Three or More Weeks’ Class Time Devoted to Various Technology/Concept Areas: Current Coverage vs. Near-Term Desires of Professionals. Technology/Concept

Excel Access Oracle database ERP concepts ERP software (hands-on applications) Computerized general ledger package Computer programming E-business concepts E-business software (hands-on) Systems security Business process analysis Audit software Tax software Management consulting a

Current Coverage (%)

Professionals’ Desires (%)

Difference (%)a

77 46 2 7 9

81 70 33 59 40

4 24 31 52 31

38

68

30

21 14 6 23 37 19 35 8

33 67 62 45 85 49 42 57

12 53 56 22 48 30 7 49

Percent of current coverage minus percent of professionals’ desires.

Graduate Curricula Design The survey reported in this paper also asked that department chairs/division directors provide feedback regarding their masters programs. Among the institutions that offer undergraduate and masters degrees, 73% offered a masters in accountancy, with about one-third of the schools providing a concentration in accounting information systems. The percentages increased for Ph.D.-granting institutions, with 89% having a masters degree in accountancy and 56% of these programs providing an AIS focus area or track. Masters-degree education has received heightened attention in recent years, as the profession’s 150-hour requirement for CPA licensing becomes effective in most states. From a benchmarking, best-practices perspective, course content in new and revised masters degree programs in accountancy assumes an increased importance. Accordingly, participants were asked to indicate the status of selected standalone courses that may be offered at their university, either in the business school or elsewhere on campus. More specifically, the courses were to be evaluated as being required, electives, or not

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Table 6.

Course Content in Masters Programs: Systems and NonSystems Concentrations. Systems Concentration (%)

Course

Non-Systems Concentration (%)

Required

Electives

Required

Electives

44 39 28 22 11 28 22 0 56 33 28 6 22 61 11

50 50 61 33 44 39 17 22 28 33 6 17 17 28 6

50 50 50 7 0 0 7 7 7 0 0 0 0 7 7

43 36 43 21 71 71 21 29 86 71 29 36 43 86 7

Advanced auditing Advanced financial accounting Advanced managerial accounting Business process analysis Computer networking Computer programming Computer security Consulting Database concepts E-business commerce Enterprise solutions Intelligent systems Strategic risk management Systems analysis and design Other courses

available/not applicable to students as part of their program. Table 6 displays tabulated responses, partitioned by AIS and non-systems concentrations. In programs that have systems concentrations, the courses most frequently required (in descending order) are: Systems analysis and design (61%) Database concepts (56%) Advanced auditing (44%) Other courses noted often as either required or electives include: Advanced Financial Accounting, Advanced Managerial Accounting, Business Process Analysis, Computer Networking, Computer Programming and E-business Commerce. Each of the systems/technology courses also appears frequently among electives in non-system concentrations, with the exception of Business Process Analysis. Often available (but not necessarily heavily subscribed) electives include Systems Analysis and Design (86%), Database Concepts (86%),

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289

Computer Programming (71%), Computer Networking (71%), and E-business Commerce (71%).

Technology Impediments: A Program Administrator Perspective Are schools able to add new systems/technology courses to maintain their leadership position among accounting programs? Do schools have the financial and faculty resources to modify curricula and, where needed, better address the near-term desires of practicing professionals? Will students continue to be attracted to universities that are unable to keep up with technological advances? These issues prompted the authors to explore existing impediments to desired curriculum change. Program administrators were asked to rate selected potential impediments to the integration of systems/technology at their schools by using a 1–5 scale, where 1 ¼ not an impediment and 5 ¼ a major impediment. Table 7 displays tabulated responses by type of program. In light of the noted shortfall of current curricula to achieve desired levels of technology integration in accounting programs, it is surprising that our survey failed to find any dominant impediments to change. Among Undergraduate-only institutions, the categories most commonly raised as a major impediment (but by only 19% of respondents) were economic feasibility and administrative support. Nineteen percent of participants from institutions offering masters degrees (panel B) also cited economic feasibility as a sizable problem. Faculty expertise was more of a concern for these schools, with 35% of respondents classifying it as a significant factor. In comparison with Undergraduate-only institutions, lack of administrative support as an impediment diminished among this group. Finally, respondents from Ph.D.granting institutions similarly cited the lack of faculty expertise as the foremost impediment, with 25% of respondents listing it as a major problem. By and large, software availability and technology infrastructure were not identified as impediments or perhaps only as a minor impediment. Frequently, vendors provide their software free of charge or at low cost. In addition, software is being made available over the web with increasing frequency, thus reducing demands on a university’s technology infrastructure. Most surprising to the authors were the low scores assigned to pedagogical objectives and administrative support. This suggests that a vision for change exists and has general support from the administration. Based on these data, ‘‘the’’ principal impediment to change would seem to be lack of faculty expertise and/or an implied unwillingness on the part of faculty to develop the needed expertise.

290

Table 7.

Impediments to Change.

Scaled Responses (1–5) 1 ¼ not an impediment 5 ¼ major impediment

Pedagogical Objectives (%)

Administration’s Support (%)

Faculty Expertise (%)

Software Availability (%)

Economic Feasibility (%)

38 8 27 15 12

31 15 19 15 19

19 15 23 35 8

38 31 19 8 4

15 15 27 23 19

Panel B: Undergraduate and Masters Programs 1 44 27 2 17 21 3 19 27 4 17 14 5 3 12

33 22 25 7 12

6 10 33 15 35

36 22 29 12 1

20 16 20 24 19

Panel C: Ph.D.-Granting Institutions 1 44 2 19 3 19 4 6 5 13

38 22 22 16 3

3 9 34 28 25

42 26 26 6 0

22 19 31 25 3

Panel A: Undergraduate-only 1 52 2 16 3 16 4 12 5 4

31 25 28 13 3

CHRISTIAN ILLE HASTINGS AND LANNY SOLOMON

Technology Infrastructure (%)

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LIMITATIONS OF STUDY No study has ever been designed and executed in flawless fashion, and this project is no exception. Beginning with our questionnaire, we discovered after the fact that we had unintentionally listed specific software packages (e.g., Excel, Access, and Oracle database) among the technologies and concepts to be evaluated. This error may have caused some confusion on the part of respondents. For example, with the latter two products just cited, was the goal to teach these particular packages or to provide instruction in relational database management systems (RDMS)? As one reviewer noted, If asked whether we should teach Access or Oracle, I might say ‘‘no.’’ If asked whether we should teach [relational database], I might say ‘‘yes.’’ Even that does not get at the major issue of what should be included, however. RDMS includes many concepts. Only some of those are relevant to accounting.

Another possible problem may have arisen when considering our request to determine the degree of a student’s exposure to specific subject matter. The intent was to explore the class time that should be devoted to a topic. Unfortunately, the instructions were not clear in this regard, as class-time exposure of, say, 3 weeks could be magnified significantly by the inclusion of related out-of-class assignments that incorporate appropriate hands-on problems/projects. Some respondents may have taken this into account whereas others did not. Although we achieved a very high response rate (70%) from practicing professionals, our respondents may not have constituted a representative sample. Many of the professionals contacted (not all) were alumni or ‘‘friends’’ of the three accounting programs used in this study. While we had a good cross section of firm types, sizes and locations, and employee job duties, the respondent pool was fairly small and may have yielded biased results. Furthermore, there may have been some difficulties in the way that practitioners responded to the survey instrument. That is, some practitioners may have responded by expressing their thoughts on what is best for all accounting students at the university whereas others might have expressed what would be best for their specific organizations. These responses, of course, could be quite different. Finally, with regard to curriculum, our research explored standalone courses that are made available to graduate students. We could have explored undergraduate offerings as well, although speculation holds that beyond the traditional AIS course, accounting departments have little room to offer such niche courses in a bachelors program. Additionally, at the

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graduate level, we failed to explore differences, if any, among those programs that are freestanding in nature and those that may have less accounting exposure because of being housed as a concentration within the (typically) more generalized MBA.

SUGGESTIONS FOR FUTURE RESEARCH Our study sought to provide preliminary evidence germane to the question, ‘‘How serious is the problem?’’ Given the differences found between the educational and practicing arms of the profession with respect to what academia must do in its own interest and the interests of its students, further attention to the issues raised in this paper appears warranted. Several projects could easily revolve around the shortcomings addressed in the previous section of this manuscript. Others, in contrast, could focus on the following topics:
The professional sample could be greatly enlarged, and the results subdivided and studied based on the respondent’s place of employment: the corporate sector, consulting firm, large public accounting firm, or mid-tier public accounting firm.
Educators can do only so much with a single ‘‘one-size-fits-all’’ curriculum, particularly when it comes to satisfying significant differences among student backgrounds and course-enrollment objectives. It would be interesting to explore the usefulness of different tracks and options among professionals.
Projects could be undertaken to study the results achieved by schools that have changed dramatically to meet the needs of practicing professionals and those that have not.
Several accounting departments, particularly those that are sizable and heavily involved in technology/systems, offer their own database and systems analysis and design courses. It may be interesting to compare material coverage and overall satisfaction levels with these offerings versus similar courses taught elsewhere in the business school and even across campus. With the budget woes that are hitting many universities, accounting programs may be able to satisfactorily rely on courses of other disciplines and thus free up resources for other uses. Also, such a practice would be consistent with that found in contemporary business – that is, abandonment of functional silos in favor of integration and cross-functional teams.

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A future project could focus on various timing and structural issues, for example, the optimal time to devote to a particular technology and/or concept. Are standalone courses the correct answer, or should a particular technology or concept be spread over a sequence of offerings? Finally, as our ‘‘common body of technology knowledge’’ continues to expand, should any material be dropped from courses and/or programs to keep total curriculum at a manageable length?
For those programs that have not yet taken a heavy plunge into technology instruction, it may appropriate for a research team to address what constitutes the ‘‘ideal’’ curriculum in terms of courses/subject matter and associated learning objectives. Such a project could incorporate the identification and exploration of related pedagogical aids such as cases and tutorials.

CONCLUDING COMMENTS This study has shown that accounting educators and practicing professionals have some different ideas – sometimes quite different – when it comes to desirable coverage of technology and systems concepts. Although determination of the proper coverage in the proper format can be likened to trying to hit a moving target, educators and practitioners must nonetheless work together to narrow the gap. The result, of course, will be a better-prepared student for the changing workplace. Departmental advisory boards, university-partnering arrangements with the corporate sector and accounting and consulting firms, and faculty internships are but three of the vehicles for achieving this end. To conclude, we must be mindful of the admonitions of Kevin Kelley (1998, p.1), who noted: This new economy represents a tectonic upheaval in our common wealth, a far more turbulent reordering than mere digital hardware has produced. The new economic order has its own distinct opportunities and pitfalls. If past economic transformations are any guide, those who play by the new rules will prosper, while those who ignore them will not. The mighty tumble, the once confident are left desperate for guidance, and the nimble are given a chance to prevail.

NOTES 1. A weighted-average analysis of the data that appear in panels A and B of Table 2 forms the basis for this observation. The analysis revealed that with regard to

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desired increased emphasis, E-Business Concepts heads the list, trailed closely by Management Consulting, ERP Concepts, and ERP Hands-on Applications. 2. A weighted-average analysis of the data in Tables 2 and 3, panel A, forms the basis for this conclusion.

REFERENCES Albrecht, W. S., & Sack, R. J. (2000). Accounting education: Charting the course through a perilous future. Accounting Education Series, 16. Sarasota, FL: American Accounting Association. Bain, C., Blankley, A., & Smith, L. M. (2002). An examination of topical coverage for the first accounting information systems course. Journal of Information Systems, 16(2), 143–164. Goldsworthy, A. (1996). IT knowledge: What do graduates need? Australian Accountant, 66(9), 24–26. Hasselback, J. (2001). Prentice Hall accounting faculty directory. Upper Saddle River, New Jersey: Prentice-Hall. Heagy, C., & McMickle, P. (1988). An empirical investigation of the accounting systems course: Academic practice versus practitioner needs. Issues in Accounting Education, 3(2), 96– 107. Jackson, R., & Cherrington, J. O. (2002). IT instruction methodology and minimum competency for accounting students. Journal of Information Systems Education, 12(4), 213–221. Kelley, K. (1998). New rules for the new economy. New York: Viking Press, Penguin Group, Penguin Putnam, Inc. Lee, D., Trauth, E., & Farwell, D. (1995). Critical skills and knowledge requirements of IS professionals: A joint academic/industry investigation. MIS Quarterly, 19(3), 313–340. Reckers, P. M. J. (2002). President’s message: Reflections on our times. FSA Newsletter, Federation of Schools of Accountancy, Fall, 1. Robert Half International, Inc. (2005). Future Finance Professionals will be visionaries, strategists and Technical Experts. http://www.collegerecruiter.com/pages/articles/ article415.html. Theuri, P., & Gunn, R. (1998). Accounting information systems course structure and employer systems skills expectations. Journal of Accounting Education, 16(1), 101–121.

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APPENDIX A. CURRENT EXPOSURE TO VARIOUS TECHNOLOGIES/CONCEPTS: COMPARISON ACROSS PROGRAMS Undergraduate Only Undergraduate B & Masters C Ph.D. Granting More than 4 weeks of exposure 3-4 weeks of exposure 1-2 weeks of exposure No exposure A

100 90

Percentage

80 70 60 50 40 30 20 10 0 A

B

C

A

Excel

B

C

Access

A

B

C

Oracle Database

A

B

C

ERP Concepts

Undergraduate Only Undergraduate B & Masters C Ph.D. Granting More than 4 weeks of exposure 3-4 weeks of exposure 1-2 weeks of exposure No exposure A

100 90

Percentage

80 70 60 50 40 30 20 10 0 A

B

C

ERP Software (hands-on)

A

B

C

A

B

C

Computerized General Computer Ledger Package Programming

A

B

C

E-Business Concepts

296

CHRISTIAN ILLE HASTINGS AND LANNY SOLOMON Undergraduate Only Undergraduate B & Masters C Ph.D. Granting More than 4 weeks of exposure 3-4 weeks of exposure 1-2 weeks of exposure No exposure A

100 90

Percentage

80 70 60 50 40 30 20 10 0 A

B

C

A

B

C

E-Business Software Systems Security (hands-on)

A

B

C

Business Process Analysis

A

B

C

Audit Software

Undergraduate Only Undergraduate B & Masters C Ph.D. Granting More than 4 weeks of exposure 3-4 weeks of exposure 1-2 weeks of exposure No exposure A

100 90

Percentage

80 70 60 50 40 30 20 10 0 A

B

C

Tax Software

A

B

C

Management Consulting

CORPORATE CHARACTERISTICS, GOVERNANCE RULES AND THE EXTENT OF VOLUNTARY DISCLOSURE IN SPAIN M. Rosario Babı´ o Arcay and M. Flora Muin˜o Va´zquez ABSTRACT This study examines the relationships among corporate characteristics, the governance structure of the firm, and its disclosure policy. Empirical evidence supporting this investigation has been gathered from a sample of Spanish firms listed on the Madrid Stock Exchange. This setting is of interest because of its low level of investor protection, high ownership concentration, and poorly developed capital market. Our results show that a firm’s size, along with some mechanisms of corporate governance such as the proportion of independents on the board, the appointment of an audit committee, and directors’ shareholdings and stock option plans, are positively related to voluntary disclosure. We have also observed that these governance practices are significantly influenced by cross-listings and by the ownership structure of the firm.

Advances in Accounting Advances in Accounting, Volume 21, 299–331 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21013-1

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1. INTRODUCTION Corporate disclosure is of critical importance for the efficient functioning of capital markets. The Special Committee on Financial Reporting of the American Institute of Certified Public Accountants (AICPA) stated: Few areas are more central to the national economic interest than the role of business reporting in promoting an effective process of capital allocation (AICPA, 1994, p. 2).

Although regulators have enforced legislation to ensure that companies provide at least a minimum set of information to third parties,1 legal requirements do not always satisfy stakeholder demands.2 Not surprisingly, there is considerable variation among companies in the disclosure of information that is not legally required. Research on the determinants of voluntary disclosure initially focused on corporate characteristics.3 The basic assumption is that corporate disclosure policy is determined by a trade-off between the costs and benefits associated with disclosure,4 for which corporate characteristics such as company size (Depoers, 2000), listing status (Meek, Roberts & Gray, 1995), and a firm’s performance (Singhvi & Desai, 1971) may serve as useful proxies. On the other hand, recent research suggests that factors other than cost-benefit analysis may determine a firm’s disclosure policy. In particular, corporate governance mechanisms may exert some control over a manager’s actions (Core, 2001, p. 444), and such mechanisms may help to fulfil the informational demands of stakeholders. For example, Watts and Zimmerman (1990), drawing on the insights of the theory of the firm, suggest that managers make accounting choices that can be considered to be efficient when they maximize the value of the firm, or opportunistic if they enhance the manager’s welfare at the expense of other contracting parties. Therefore, the argument of efficiency assumes an alignment between organizational and managerial goals. The board of directors is regarded as a relevant mechanism in the oversight of managerial actions5 (Fama & Jensen, 1983). Researchers have examined the role played by certain practices aimed at enhancing the monitoring role of the board on the provision of voluntary information (Chen & Jaggi, 2000; Ho & Wong, 2001; Nagar, Nanda & Wysocki, 2003). Comparisons among these studies provide some interesting insights. For example, Chen and Jaggi (2000) found that the appointment of nonexecutive directors was significantly related to disclosure, whereas Ho and Wong (2001) did not find it to be a significant variable in explaining corporate disclosure. Moreover, previous research focused on a particular

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corporate governance mechanism (i.e. the board of directors), but as Bushman and Smith (2001, p. 286) stated, a complete understanding of the role played by corporate governance requires an explicit recognition of interactions across different mechanisms. In this paper, we seek to extend previous research in three different ways: (1) by exploring the role played by a number of good governance practices in enhancing corporate disclosure, (2) by examining the role of majority shareholders in the adoption of practices of good governance, and (3) by analysing the direct and indirect effects of various corporate characteristics on voluntary disclosure. First, we analyse the role played by the board of directors in enhancing corporate disclosure by examining a wide range of practices of good governance: the appointment of independent directors, the formation of an audit committee, the separation of the functions of CEO and chairman of the board, the participation of board members in the capital of the company, the establishment of stock option plans as a means of directors’ remuneration, and the size of the board. Nonetheless, the individual analysis of a particular practice of good governance does not allow for a full assessment of its role in promoting transparency, inasmuch as complementarities and substitutability between them make the whole worthier than the mere aggregation of its individual constituents.6 In this study, we have employed confirmatory factor analysis to reduce governance practices to a single factor for the assessment of their global effect on corporate disclosure. Second, our analysis takes into account the role played by majority shareholders in corporate governance, as well as interactions between the adoption of good governance practices and the ownership structure of the company. Evidence is gathered from Spain, a country especially suited to the development of this analysis. In contrast with common law countries, the Spanish institutional setting has in common with other European Continental countries a relatively low number of listed companies,7 an illiquid capital market, the existence of a large number of inter-corporate shareholdings and, above all, a high level of concentration in corporate shareholdings8 (Leech & Manjo´n, 2002, p. 169). Research has shown that unlike civil-law nations, common-law countries enact rules and legislation to shield the informational rights of investors. As noted by La Porta, Lopez-de Silanes, Shleifer and Vishny (1998), civil-law countries enforce loose legislation because of the determinant role of ownership concentration9 and ownership structure determines the governance practices followed by their companies. Wymeersch (2002) argues that compliance with the recommendations of codes of good governance in European countries is more difficult

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than in the U.K. because of the greater presence of majority shareholders in Europe – investors who do not wish to see their influence reduced by the appointment of independent directors. Moreover, non-compliance with recommendations such as the separation of the functions of the CEO and the chairman of the board may not be as negatively assessed in civil-law countries as it is in common-law countries, which have been the focus of more studies. For example, the Spanish code of good governance recognizes that the combining of CEO and chairman positions is a common practice in Spain, because it is thought to support leadership both internally and externally (Olivencia Committee, 1998). Finally, our analysis of the determinants of voluntary disclosure focuses on such general company characteristics as size, cross-listing status, and the industry in which it operates. We employed structural equation modeling to analyse both the direct and indirect effects of these characteristics on corporate disclosure. In contrast with previous research, which focused on the direct effect attributed to the balance between benefits and costs linked to the provision of information, we also recognize the effect that these characteristics exert on the firms’ practices of good governance (Denis & Sarin, 1999; Doige, 2004), which in turn would affect corporate disclosure policy. Corporate governance in Spain has relied heavily upon the role played by majority shareholders who were usually involved in the management of the company. Nevertheless, during the 1990s, free floating capital started to represent a significant proportion of equity in some listed companies, giving rise to greater concern about corporate governance and the protection of investors’ interests. Hence, Spain provides a suitable environment in which to test for the existence of interactions among corporate characteristics, good governance rules, and corporate disclosure. The remainder of the paper is structured as follows: Section 2 presents a review of the literature and the development of hypotheses to be tested; Section 3 provides a description of the data and methodology used in this study; Section 4 contains the empirical results of the study; and in Section 5 we discuss the results and conclusions.

2. CORPORATE DISCLOSURE AND FIRM CHARACTERISTICS Agency costs arising from the separation of ownership and control in modern corporate forms may be reduced by strengthening the monitoring and

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overseeing functions of the board of directors.10 In large corporations, shareholders are not involved in the management and control of the corporation, but delegate such responsibilities to the board of directors to ensure goal congruence between shareholders’ interests and management actions. The corporate board’s role of overseeing is particularly relevant in protecting the interests of powerless minority shareholders.11 In fact, commissions charged with the preparation of the so-called codes of good governance focused their attention on the composition and functioning of the board of directors. Practices such as the appointment of non-executive directors, the separation of the functions of chairman of the board and CEO, or the creation of specialized committees inside the board, such as the audit committee and the compensation committee, were considered as essential mechanisms to improve the monitoring of management.12 They reduce the manager’s latitude to act opportunistically and contribute to the alignment of the internal and external interests of the organization (Denis, 2001, p. 195). Independent non-executive directors. Codes of good governance include a number of recommendations, one of them being the appointment of nonexecutive directors, an inclusion designed to reduce agency conflicts between managers and shareholders (Gregory & Simmelkjaer, 2002, p. 53). Arguably, boards controlled by management may result in practices of collusion, among them the expropriation of shareholders’ wealth. Under such rationality, the inclusion of outsiders on the board should reduce the likelihood of collusive arrangements, inasmuch as non-executive directors are disciplined by the market, which assesses and rewards performance (Fama, 1980, pp. 2993–2294). The extant literature provides empirical evidence supporting the role of non-executive directors in promoting higher transparency and better disclosure policies. Chen and Jaggi (2000) found a positive association between the proportion of independent directors on the board and the extent of a firm’s disclosure. The proportion of outside directors on corporate boards was also negatively associated with indicators that measured the (poor) quality of the information disclosed, such as the publication of fraudulent or defective financial statements (Beasley, 1996; Peasnell, Pope, & Young, 2001), as well as measures of earnings management (Peasnell, Pope, & Young, 2000). These results suggest that companies with a higher proportion of independents on the board show a greater concern for disclosure. Hence, we hypothesize that: H1a. voluntary disclosure is positively related to the proportion of independent directors on the board.

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Audit committee. The audit committee operates as a monitoring mechanism to improve the quality of information conveyed to external parties (Pincus, Rusbarsky, & Wong, 1989) and oversees the preparation and communication of financial information to third parties to ensure that such data fulfils the requisites of clarity and the completeness of disclosure (Smith Report, 2003, p. 12). Empirical evidence indicates that voluntary disclosure is positively related to the functioning of an audit committee (Ho & Wong, 2001). Furthermore, Dechow, Sloan and Sweeney (1996) and Peasnell, Pope, & Young (2001) observed that audit committees help to reduce the likelihood of accounting fraud. These factors lead us to hypothesize: H1b. voluntary disclosure is positively related to the existence of an audit committee. Chairman of the board and chief executive officer being the same person. Separating the positions of CEO and chairman of the board arguably helps to improve the monitoring function of the board. Jensen (1993) argues that conflicts of interests and difficulties in performing the monitoring function over management arise when the same individual holds both positions. This dual-role situation is quite common in some European countries (U.K., France, Spain, and Italy), but it may require a balance. The Olivencia Code of 1998 states, for example, that these dual roles may support leadership within the organization and towards external parties, but recommends the appointment of independent directors in order to balance the dominance of the CEO/chairman of the board. A number of studies have identified the combining of these two positions with poor disclosure practices. For example, Forker (1992) found a significant negative relationship between the combination of the two roles and the extent of disclosure. Furthermore, Ho and Wong (2001) observed a negative relationship, albeit a non-significant one, between corporate disclosure and the presence of a dominant personality on the firm’s board. Therefore, we are led to hypothesize: H1c. voluntary disclosure is positively related to the separation of the functions of CEO and chairman. Board participation in the capital of the company. Directors’ shareholdings constitute a relevant vehicle for monitoring the management, as it tends to restrain managerial incentives to divert resources that may ultimately jeopardize the attainment of shareholder value maximization (Jensen & Meckling, 1976). Furthermore, directors’ shareholdings help to align goals and financial incentives of board members with those of outside shareholders (Bushman, Chen, Engel, & Smith, 2004, p. 177). Shivdasani (1993)

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observed that, relative to a control sample, outside directors in firms that are targets of hostile takeovers have lower ownership stakes. Bhagat, Carey and Elson (1999) found a positive correlation between the directors’ stock ownership and firm’s performance, as well as a positive correlation between director’s personal equity holdings and the likelihood of a disciplinary-type CEO succession in poorly performing companies. On the other hand, the examination of insider shareholdings has shown the existence of a non-linear relationship between ownership and a firm’s value – as ownership increases, firm value rises up to a point, and then decreases (McConnell & Servaes, 1990; Short & Keasey, 1999; Faccio & Lasfer, 1999). The authors of these studies considered the non-linearity between a firm’s value and ownership to be a consequence of the entrenchment effect associated with high levels of managerial ownership. In cases of low levels of director ownership, therefore, the monitoring role of the board is strengthened, which has a positive effect on voluntary corporate disclosure. Hence, we hypothesize that: H1d. voluntary disclosure is positively related to board participation in the capital of the company. Stock option plans as directors’ pay. Stock option plans serve the purpose of compensating board members by aligning their interests with the firm’s performance; increases in share prices lead to greater compensation for board members (Jensen & Murphy, 1990; Tosi & Gomez-Mejia, 1989). Gutie´rrez, Llore´ns and Arago´n (2000, p. 426) suggest that the linkage of management compensation to performance results in a transfer of risk to management and acts as a deterrent to opportunistic behaviour. In this respect, empirical evidence shows that stock option plans for outside directors improves a firm’s value (Fich & Shivdasani, 2004) and increases the monitoring role played by the board (Perry, 2000). Moreover, a number of studies examines the relationship between stock options and disclosure practices. Nagar, Nanda and Wysocki (2003, p. 287) argue that general stock-priced-based incentives represent an effective means of encouraging both good and bad news disclosures; stock price appreciation promotes the release of good news, whereas withholding bad news may lead to litigation costs and a decrease in stock price, because investors may interpret nondisclosure as ‘‘worse’’ news (Verrechia, 1983). In this respect, Miller and Piotroski (2000) and Nagar, Nanda and Wysocki (2003) report a positive association between corporate disclosure and the proportion of CEO compensation affected by stock price. Although these studies refer to the compensation of managers rather than the compensation of directors, we expect

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to observe the same type of incentives to disclosure when directors benefit from stock option plans. This leads us to hypothesize: H1e. voluntary disclosure is positively related to the establishment of stock option plans as directors’ remuneration. Board size. In addition to the foregoing mechanisms for aligning management and shareholder interests, codes of good governance usually recommend limitations to the size of a board.13 By restricting the number of directors, it is believed that the exchange of ideas between board members will be enhanced, as well as flexibility in the decision-making process. Jensen (1993, p. 865) argues that small boards are more effective in monitoring the CEO and are tougher for the CEO or the chairman to manipulate. In a similar vein, Yermack (1996) has shown that firms with smaller boards are valued more highly by the market than are their counterparts with larger boards; whereas Vafeas (2000) has observed that investors place higher value on earnings information when provided by firms with smaller boards. Investigations have also examined the quality of disclosure and its relationship with board size. For example, Peasnell, Pope and Young (2001) found a tendency, albeit statistically non-significant, for mean board size to be higher for firms reporting defective financial statements than for those included in their control sample. The strength of these arguments, however, leads us to hypothesize: H1f. voluntary disclosure is negatively related to the size of the board. The adoption of any one of the above-mentioned practices of good governance does not exclude the assumption of others. In contrast, the effect of some practices may be strengthened when other rules are observed. As an example, Peasnell, Pope and Young (2000) observed that the role played by independent directors was enhanced by the functioning of a board audit committee. Moreover, non-compliance with some rules of good governance may be partially offset by the adoption of others. Gul and Leung (2004) have shown that the presence of highly experienced non-executive directors on the board tends to moderate the negative effect of combining the positions of CEO and chairman. As a consequence, we expect that the greater the degree of compliance with codes of good governance, the greater the improvement in corporate disclosure. Hence, we formulate the following general hypothesis: H1. voluntary disclosure is positively related to the adoption of rules of good governance.

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The ownership structure of a firm may be a possible determinant of organizational disclosure (Raffournier, 1995). At one extreme, high levels of concentration of capital may be accompanied by the owner’s considerable involvement in the firm’s management, which, in turn, may lead to unrestricted access to information. Under these circumstances, the demand for information would be very low, or even absent, particularly if the manager owns all the firm’s shares. On the other hand, in cases of dispersion of ownership, investors lack first-hand access to information, and this may lead to increased demands for organizational information that can be used to monitor management (Gelb, 2000, p. 169). In this respect, McKinnon and Dalimunthe (1993, p. 37) suggest that voluntary disclosure may be helpful in reducing conflicts between managers and shareholders that arise when a firm’s shares are widely held. Furthermore, ownership dispersion may influence the supply of information. For example, Craswell and Taylor (1992, p. 299) argue that increases in the separation of ownership and control are likely to be accompanied by additional disclosures of information to third parties. By overcoming owners’ perceived asymmetry of information, management expects to reduce the discount implicit in its compensation package. Additionally, the ownership structure may have a significant impact on the adoption of rules of good governance which, in turn, will affect corporate disclosure. As suggested by Wymeersch (2002), compliance with the recommendations of codes of good governance is more difficult when a significant proportion of a firm’s equity is held by a majority shareholder. Therefore, we are led to hypothesize: H2. voluntary disclosure is negatively related to the level of ownership concentration. Corporate size was commonly used as an explanatory factor for voluntary disclosure. Ball and Foster’s (1982) review shows that firm size has been regarded as an adequate proxy for the costs and benefits linked to the provision of information. The cost of gathering and preparing detailed information and the risk of creating a competitive disadvantage through disclosure will be lower for larger companies that prepare the information for internal use and invest large amounts of resources in fixed assets and innovation processes. This large company advantage, it is argued, acts not only as an entry barrier towards smaller companies (Depoers, 2000, p. 251), but it also enables larger firms to benefit from the salutary effects of better disclosure because the provision of information facilitates access to capital markets (Singhvi & Desai, 1971, p. 131). Additionally, corporate disclosure leads to the allaying of public criticism or government intervention (Watts &

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Zimmerman, 1986). Therefore, the balance between benefits and costs linked to the provision of information is expected to be more favourable for large than for small companies. Furthermore, codes of good governance may also lead large companies to provide more voluntary information than their smaller counterparts do. Research has shown the existence of a positive association between a firm’s size and the adoption of some practices of good governance, such as the appointment of independent directors or the separation of the functions of CEO and chairman (Denis & Sarin, 1999; Dehaene, De Vuyst, & Ooghe, 2001). Thus, the size of the company may exert an indirect influence on disclosure. Therefore, we hypothesize: H3. voluntary disclosure is positively related to the size of the company. A number of studies regard listing status as a determinant of disclosure variability (Firth, 1979; Cooke, 1991; Meek, Roberts & Gray, 1995). Listed companies must comply with stock market regulations that require far more information disclosure than applies to unlisted companies. Additionally, listed firms voluntarily disclose information in order to garner investors’ trust and to obtain better financing conditions (Raffournier, 1995, p. 263). Empirical studies have shown that firms that more readily practice voluntary information disclosure enjoy such beneficial effects as increased stock prices (Healy, Hutton, & Palepu, 1999; Lang & Lundholm, 2000), higher analyst following (Lang & Lundholm, 1996), improvements in stock liquidity (Welker, 1995), and a reduction in the cost of capital (Botosan, 1997; Botosan & Plumlee, 2002). Our study focuses on listed companies, but we attempt to examine differences in disclosure between firms that are only traded domestically and firms that are both traded domestically and cross-listed internationally. Meek, Roberts and Gray (1995) suggest that listed companies face additional capital market pressures for the provision of information. Furthermore, such pressures will arguably increase with the efficiency of the markets in which the firms are traded, as may be the case for firms trading in foreign stock markets as opposed to those trading solely on the Madrid Stock Exchange.14 Therefore, once a firm discloses information voluntarily to foreign stock markets, it would incur only a marginal cost increase if it also reported such information in its domestic market. Empirical research has shown evidence of greater information disclosure for companies that are listed both domestically and in foreign stock exchanges (Cooke, 1991). In a similar vein, Khanna, Palepu, and Srinivasan (2004) found a positive association between disclosure and a U.S. listing for a sample of European and Asian-Pacific companies.

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The positive association between cross-listing and disclosure can be explained not only by the trade off between benefits and costs, but also by the improvement in corporate governance practices that follow cross-listing. Wo´jcik, Clark, and Bauer (2004) found, for instance, that European companies that are cross-listed on U.S. exchanges have higher corporate governance ratings than firms without such U.S. cross-listing. For non-U.S. firms, Doidge (2004) observed that cross-listing on U.S. exchanges enhances the protection afforded to minority investors and reduces the private benefits of control. These arguments and evidence lead us to test the following hypothesis: H4. voluntary disclosure is positively related to listing on foreign stock exchanges. Industry sector may explain disclosure differences among companies. For example, financial entities may be encouraged to provide voluntary information in order to garner client trust. In a similar vein, firms operating in regulated markets are exposed to thorough scrutiny from stakeholders, who may advise them to provide external parties with additional information about their activities and outcomes. Finally, the strategic importance of some industries (e.g. oil) may attract disproportionate surveillance measures by governmental agencies and interest groups, and this surveillance may lead these companies to favour high levels of reporting to third parties (Watts & Zimmerman, 1986, p. 239). Furthermore, disclosure of organizational information involves hidden costs, such as those related to revealing crucial information to competitors, which, in turn, may lead to competitive disadvantages. Research in this area demonstrates that the effects of such disclosure vary across industries (Meek, Roberts & Gray, 1995). Additionally, operating in a regulated industry might have an indirect effect on disclosure through its influence on the governance rules of firms. Companies operating in regulated industries have greater visibility and may be more easily encouraged to adopt practices of good governance than would firms operating in unregulated sectors. In fact, the report of the governing body of the Madrid Stock Exchange – the Comisio´n Nacional del Mercado de Valores – on compliance with the Good Governance Code (CNMV, 2000), shows that the highest levels of compliance correspond to companies operating in regulated sectors. Thus, we hypothesize that: H5. voluntary disclosure is positively related to operating in regulated industries.

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3. DATA AND METHODOLOGY 3.1. Sample Our sample consists of 117 firms that were indexed in the Actualidad Econo´mica15 Index in 1999,16 all of which operate in the continuous (electronic) market of the Madrid Stock Exchange. We obtained information on corporate characteristics and governance practices from the CNMV. For firms that did not submit this information to the CNMV,17 we requested their data directly. Overall, we collected data on 91 of the 117 firms listed on the Actualidad Eco´nomica Index. These companies constituted the sample for our study. As we missed data from some firms included in the Actualidad Econo´mica Index, we tested for sample bias. Arguably, firms that did not submit their data to the CNMV could be reluctant to disclose voluntary information. Comparison of mean indexes through the Student t-test for companies included in our study and those omitted from it revealed significant differences (p ¼ 0:06). The lowest mean corresponded to firms excluded from our study (Table 1), which led us to control for firm size, measured by the natural logarithm of total assets. The results indicate that firms in our study are significantly larger than those from which we did not gather data (po0.001), which in turn indicates that our findings cannot be extrapolated to small firms. Arguably, there seems to be less concern about the provision of voluntary information to external parties in small firms than in their larger counterparts.

3.2. Operationalization of Variables 3.2.1. Disclosure Index Actualidad Econo´mica prepares a disclosure index that consists of 18 indicators. The index, however, embraces issues that have little to do with Table 1. Selection Bias. Variable

Companies

N

Mean

S.D.

t

Sig. (bilateral)

INDEX

Excluded Analysed Excluded Analysed

26 91 26 91

42.385 48.242 4364 6806

14.458 13.861 2629 2018

–1.882

0.062

–5.072

0.000

LASSETS

311

Corporate Characteristics, Governance Rules

voluntary disclosure: auditor’s opinion (Indicator #2), clarity in the presentation of data (Indicator #9), design of the report (Indicator #10), and use of additional venues to make the annual report visible to the public opinion (Indicator #18). To measure the amount of information provided by the company, we set these indicators aside.18 Although some of the items refer to compulsory information (i.e. information on shareholders, subsidiaries, remuneration to board members, and analysis of operations), the degree of detail captured by the Actualidad Econo´mica Index is much greater than that required by the Spanish legislation. Therefore, the resulting index constitutes a measure of voluntary disclosure. 3.2.2. General Corporate Characteristics Company size was measured in this study by total assets (ASSETS), as has been done in other studies on voluntary disclosure (Depoers, 2000; Ho & Wong, 2001). We used dichotomous variables to account for the firm’s cross-listing status (LISTING) (Khanna, Palepu & Srinivasan, 2004) and industry (INDUSTRY) (Eng & Mak, 2003), giving variables a value of one (1) if the firm was listed on foreign stock exchanges or operated in a regulated industry, and zero (0) otherwise. The Herfindahl index was used as a measure of stock dispersion (OWNERSHIP). Following Santerre and Neun (1986), our use of the Herfindahl index relied on the following formula: OWNERSHIP ¼

n X

ðPi =0:51Þ2 ,

i¼1

where Pi is the percentage of the firm’s stock that is held by the ith largest stockholder so that the sum of the Pi is equal to 51% (majority control). The index takes the value of one (1) when a single shareholder owns the majority of the shares of the company and it approaches zero (0) when corporate stock is widely dispersed – that is, when there is a large number of shareholders, each owning a small proportion of the firm’s stock. 3.2.3. Governance Rules We used the definition of independent directors included in the Olivencia Code (1998, par.2.1) – those who are not related to the management team or to the hard core of shareholders – measured through the ratio of independent directors to total number of directors (Peasnell, Pope & Young, 2001; Eng & Mak, 2003). We used dummy variables to account for the existence of an audit committee (AUDITCOM) (Ho & Wong, 2001), the separation of the functions of chairman of the board and the CEO or president

312

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(CHAIRM) (Beasley, 1996), and the establishment of stock option plans as a means of directors’ remuneration (OPTION) (Fich & Shivdasani, 2004). These variables assumed a value of one (1) if the good governance practice was adopted, and a zero (0) otherwise. Equity held by board members is usually measured through the total number of shares owned by directors, scaled by the total number of outstanding shares (O’ Sullivan, 2000; Coles, McWilliams, & Sen, 2001). Nevertheless, in order to measure directors’ ownership that would help to strengthen the monitoring function of the board, we departed from this common measure by using a dummy variable (BEQUITY), which assumed a value of one (1) if the directors’ participation in the equity exists but is lower than 3%,19 and zero (0) otherwise. In this manner, we measured for the directors’ participation in the firm’s capital in situations in which they do not have control of the firm or a significant influence on its developments.20 Finally, the total number of directors is usually employed as a measure of board size (Vafeas, 2000; Peasnell, Pope & Young, 2001). Nevertheless, due to the extremely small board size of some Spanish companies, we used a dummy variable (SIZEB), with a value of one (1) if the size of the board fits within the recommendations of the Olivencia Code (i.e. the number of board members should range from 5 to 15), and zero (0) otherwise. 3.3. Methods We employed univariate and multivariate techniques for data analysis in this study, using a one-factor ANOVA as well as the Kruskal–Wallis nonparametric test to examine the association between each of the independent variables and the disclosure index. We then applied a technique of structural-equations modelling, path analysis, to test simultaneously for existing relationships among the variables included in our study (Hoskisson, Johnson & Moesel, 1994; Bisbe & Otley, 2004). Structural equations, which have been widely employed in areas such as marketing or psychology, are increasingly being used in accounting studies (Hunton, Wier, & Stone, 2000; Baines & Langfield-Smith, 2003; Widener, 2004). In this study, structural equations are particularly suitable for at least two reasons: (1) A model of structural equations allows for the simultaneous analysis of a series of multiple regression equations and is particularly useful when the dependent variable in one equation becomes an independent variable in subsequent ones. (2) Path analysis allows for confirmatory factor analysis, facilitating the introduction of non-observed concepts (latent constructs), accounting for the measurement error in the estimation process.

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313

4. EMPIRICAL RESULTS Table 2 shows the variables included in our study as well as the descriptive statistics. Descriptive statistics show that companies in our study are widely distributed regarding the provision of voluntary information. There are also large differences in corporate size, measured by total assets, ranging from 30 to 287,155 million Euros, and we employed the natural logarithm to account for this difference. The Herfindahl index of stock dispersion also exhibits substantial cross-sectional variation, ranging from zero (0) in cases of widely dispersed companies, to one (1) for firms in which a single shareholder owns the majority of equity. We observed a value of 1 for 26 of the 91 companies included in our sample, which in turn indicates a high level of ownership concentration in firms listed on the Madrid Stock Exchange. Descriptive statistics also show that compliance with recommendations of the Olivencia Code for appointing an audit committee and for limiting the size of the board are common practices in firms included in our sample (i.e. 75% have an audit committee, and the total number of directors in 76% of the firms is between 5 and 15). Finally, we observed high variability in the proportion of independent directors on the board. The mean value for this variable is 36%, but 11 companies in our study did not have any independent directors. We conducted a series of one-way ANOVAs21 using the index as the dependent variable and each of the governance rules considered in our study as a factor.22 The Kruskal–Wallis test and ANOVA results (Table 3) show that the mean disclosure index is significantly higher (po0.01) for companies with a higher proportion of independent directors on the board, providing support for Hypothesis 1a. The disclosure index is also significantly higher (po0.01) for firms that have appointed an audit committee than for those in which such committee was not formed. These results support Hypothesis 1b. We found significant differences in disclosure (po0.05) between companies in which directors have a participation in their capital lower than 3% relative to their counterparts with no director participation or with director participation that is higher than 3%. These results provide support for Hypothesis 1d. Table 3 also shows that the mean disclosure index is significantly higher (po0.01) for those companies that have established a stock option plan as a means of director remuneration, thereby providing support for Hypothesis 1e. Comparisons of mean disclosure indexes are non-significant between firms that separate the functions of CEO and chairman and their counterparts that combine both posts. Furthermore, the relationship between the index and the independent variable is opposite to the direction

INDEX ASSETS LASSETS OWNERSHIP LOWNERSHIP LISTING INDUSTRY OUTSIDE BEQUITY AUDITCOM OPTION CHAIRM SIZEBOARD

Descriptive Statistics.

N

Mean

S.D.

Minimum

Q1

Median

Q3

91 91 91 91 91 91 91 91 91 91 91 91 91

48.242 9436 6.806 0.494 –1.319 0.308 0.264 35.758 0.538 0.747 0.297 0.593 0.758

13.861 35338 2.018 0.396 1.385

13 30 3.40 0 –5.81

39 224 5.41 0.104 –2.263

47 607 6.41 0.417 –0.875

58 3589 8.186 1 0

18.18

33.33

23.464

0

50

Maximum

Skewness Kurtosis

82 287155 12.568 1 0

–0.026 6.421 0.640 0.200 –0.962

–0.025 45.974 0.014 –1.680 0.303

100

0.369

–0.293

Company’s aggregate score. Total assets (millions of Euros) Natural logarithm of total assets Herfindahl index of stock dispersion Natural logarithm of the Herfindahl index of stock dispersion Binary variable: 1 if the company is cross-listed, 0 otherwise Binary variable: 1 if regulated industry, 0 otherwise Proportion of independent directors on the board Binary variable: 1 if the board participates in the equity of the company and its participation is lower than 3%, 0 otherwise Binary variable: 1 if audit committee exists, 0 otherwise Binary variable: 1 if stock option plan exists, 0 otherwise Binary variable: 1 if the chairman and the CEO are not the same person, 0 otherwise Binary variable: 1 if 5 p number of the members on the board p 15, 0 otherwise

M. ROSARIO BABI´O ARCAY AND M. FLORA MUIN˜O VA´ZQUEZ

INDEX ASSETS LASSETS OWNERSHIP LOWNERSHIP LISTING INDUSTRY OUTSIDE BEQUITY AUDITCOM OPTION CHAIRMAN SIZEBOARD

314

Table 2.

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Corporate Characteristics, Governance Rules

Table 3. Relationship Between the Disclosure Index and Corporate Governance Rules. Group Dependent variable: INDEX INDEP 0 1 AUDITCOM 0 1 CHAIRMAN 0 1 OPTION 0 1 BEQUITY 0 1 SIZEBOARD 0 1

N

Mean

S.D.

F

Sig.

w2

Sig.

44 47 23 68 37 54 64 27 42 49 22 69

43.386 52.787 39.087 51.338 50.865 46.444 45.281 55.259 44.62 51.35 49.909 47.71

12.787 13.395 11.774 13.194 14.174 13.48 13.273 12.865 14.368 12.752 13.55 14.015

11.695

0.001

9.505

0.002

15.604

0.000

13.190

0.000

2.264

0.136

2.549

0.110

10.924

0.001

9.469

0.002

5.600

0.020

5.921

0.015

0.417

0.520

0.131

0.718

expected – that is, the highest mean index corresponds to firms in which both functions are combined. Therefore, Hypothesis 1c is not supported. Finally, there were no significant differences in disclosure between companies that complied versus those that did not comply with the Olivencia Code recommendations regarding the size of the board. Results contradict our prediction because the highest mean corresponds to firms with larger boards Therefore, Hypothesis 1f is not supported. We conducted the same type of analysis using each one of the general corporate characteristics analysed as a factor, recoding the continuous variables (i.e. total assets and ownership concentration) into discrete variables by using percentiles 33.33 and 66.67%.23 Results of the ANOVA and the Kruskal–Wallis tests are shown in Table 4. Results show the existence of significant differences in disclosure as a consequence of the ownership structure of the firm. Hypothesis 2 stated that voluntary disclosure is negatively related to the level of ownership concentration. Our findings show that the highest mean disclosure index corresponds to Group 1 – that is, to firms with widely dispersed ownership (Table 4). Nevertheless, the lowest mean disclosure index does not correspond to Group 3 (those entities with the highest level of ownership concentration), but to Group 2. The Bonferroni test shows that the mean disclosure index for Group 1 is significantly higher (po0.05) than that corresponding to Group 2.

316

M. ROSARIO BABI´O ARCAY AND M. FLORA MUIN˜O VA´ZQUEZ

Table 4.

Relationship between the Disclosure Index and the Characteristics of the Firm. Group

Dependent variable: INDEX LOWNERSHIP 1 2 3 LASSETS 1 2 3 LISTING 0 1 INDUSTRY 0 1

N

Mean

S.D.

F

Sig.

w2

Sig.

30 31 30 30 31 30 63 28 67 24

53.530 44.420 46.900 42.733 47.677 54.333 44.937 55.679 45.925 54.708

15.213 14.773 9.625 14.893 12.448 12.004 13.464 11.889 13.682 12.467

3.717

0.028

6.529

0.038

5.863

0.004

10.109

0.006

13.223

0.000

12.110

0.001

7.616

0.007

7.211

0.007

We also found significant differences in disclosure between large and small firms. The highest mean corresponds to the largest companies in our study (Group 3). The post-hoc Bonferroni test revealed significant differences between Groups 1 and 3, after performing pairwise comparisons. Thus, we found significant differences between the largest and the smallest companies in our sample, providing support for Hypothesis 3. The mean disclosure index is also higher for cross-listed entities than for firms listed solely on the Madrid Stock Exchange. Both the ANOVA and the nonparametric tests show that this difference is highly significant (po0.001), providing support for Hypothesis 4. Finally, both the ANOVA results and the non-parametric test show that the mean disclosure index is significantly higher (po0.01) for companies operating in regulated sectors than for those in unregulated industries, providing support for Hypothesis 5. In addition to the univariate analyses, we deployed path analysis to test simultaneously for the relationships among all variables included in our study. Path analysis requires the design of a path graphic representing all the relationships among variables that are expected by the researcher. Based on our hypotheses and on the results of the univariate analysis, we plotted the model shown in Fig. 1, showing a positive association between the disclosure index and the size of the company (LASSETS), its listing status (LISTING), the industry in which it operates (INDUSTRY), and its ownership structure (OWNERSHIP). We also found that the disclosure index was significantly associated with the adoption of some practices of good governance. Because of the high correlation coefficients observed among these variables (Table 5), we have included a non-observed variable in our

317

Corporate Characteristics, Governance Rules

z2 e1

e2

OUTSIDE

e3 1

1

1

AUDITCOM

OPTION

e4 1

e5

1 BEQUITY

1 CHAIRMAN

e6 1 SIZEB

1 GOVERNANCE

LOWNERSHIP

z1 1 LISTING INDEX

INDUSTRY

LASSETS

Fig. 1.

PATH analysis (I)

analysis (GOVERNANCE), aimed at representing the governance practices followed by the company. We have also included relationships in the path diagram in order to measure the influence of the ownership structure, listing status, industry, and size of the company on the governance factor. Finally, we have added correlations between the independent variables: LASSETS, LISTING, INDUSTRY, and OWNERSHIP. The model was estimated (maximum likelihood estimation) by using AMOS 4.0 through the SPSS 10.0 and a bootstrapping technique run to avoid problems derived from non-fulfilment of the normality conditions of the variables. The estimates were non-significant for the following regressions24: GOVERNANCE GOVERNANCE INDUSTRY INDUSTRY LASSETS LISTING LOWNERSHIP LOWNERSHIP LOWNERSHIP

2 2

CHAIRMAN SIZEB GOVERNANCE INDEX GOVERNANCE INDEX INDEX LISTING LASSETS

318

INDEX INDEX 1.000 OUTSIDE 0.306 BEQUITY 0.256 AUDITCOM 0.383 OPTION 0.324 CHAIRMAN –0.168 SIZEBOARD –0.038 LASSETS 0.395 LOWNERSHIP –0.217 LISTING 0.367 INDUSTRY 0.283

Correlation Matrix (Spearman Correlation Coefficients).

OUTSIDE BEQUITY AUDITCOM OPTION CHAIRMAN SIZEBOARD LASSETS LOWNERSHIP LISTING INDUSTRY 0.306 1.000 0.023 0.353 0.263 –0.088 –0.082 0.078 -0.350 0.130 0.058

 Significant at 0.01 level.  Significant at 0.05 level.

0.256 0.023 1.000 0.172 0.215 0.086 –0.111 0.343 0.014 0.283 0.204

0.383 0.353 0.172 1.000 0.322 –0.18 0.085 0.167 0.144 0.223 0.061

0.324 0.263 0.215 0.322 1.000 –0.099 –0.139 0.253 –0.182 0.401 0.048

–0.168 –0.088 0.086 –0.018 –0.099 1.000 –0.049 0.032 0.195 –0.175 0.140

–0.038 –0.082 –0.111 0.085 –0.139 –0.049 1.000 –0.340 0.019 –0.346 –0.361

0.395 0.078 0.343 0.167 0.253 0.032 –0.340 1.000 –0.035 0.450 0.546

–0.217 –0.350 0.14 –0.144 –0.182 0.195 0.019 –0.035 1.000 –0.115 –0.175

0.367 0.130 0.283 0.223 0.401 –0.175 –0.346 0.450 –0.115 1.000 0.303

0.283 0.058 0.204 0.061 0.048 0.140 –0.361 0.546 –0.175 0.303 1.000

M. ROSARIO BABI´O ARCAY AND M. FLORA MUIN˜O VA´ZQUEZ

Table 5.

319

Corporate Characteristics, Governance Rules

Drawing on these results, we developed a model, as shown in Fig. 2. The Goodness of Fit test (Table 6) shows that the model is fitted to the data.25 The level of significance of the w2 test of overall model fit (w2 ¼ 22:945; df ¼ 19; p ¼ 0:240) suggests the existence of an acceptable fit between the estimated and the actual data matrix.26 The sensitivity of the w2 test to sample size led us to complement it with other descriptive measures of global fit: the Goodness of Fit Index (GFI) and the Root Mean Square Error of Approximation (RMSEA). Two measures of incremental fit were also examined: the Adjusted Goodness of Fit Index (AGFI) and the Tucker–Lewis Index (TLI). Additionally, we analysed two measures of parsimony: the Comparative Fit Index (CFI) and the Akaike Information Criterion

z2 e1

e2 1

1 OUTSIDE

AUDITCOM

e3 1

1 OPTION

e4 1 BEQUITY

1 GOVERNANCE

LOWNERSHIP

z1 1 LISTING INDEX

LASSETS

Fig. 2.

PATH analysis (II)

Table 6. Goodness of Fit Tests. w2 independence test Goodness of fit test (GFI) Root mean square error of approximation (RMSEA) Adjusted goodness of fit index (AGFI) Tucker–Lewis index (TLI) Comparative fit index (CFI) Akaike information criterion (AIC)

22.945 (df ¼ 19; p ¼ 0:240) 0.942 0.048 0.891 0.944 0.962 56.945 (saturated model 72.000)

320

M. ROSARIO BABI´O ARCAY AND M. FLORA MUIN˜O VA´ZQUEZ

(AIC). Values observed for these indexes indicate that the model fits to the data.27 Table 7 shows the estimated regressions. Standardized regression weights and standard errors are shown in Table 8. The governance factor obtained from the model exerted some influence on corporate disclosure. As shown in Fig. 2, however, not all governance factors were included in our model – for example, the size of the board and the combination of the functions of chairman and CEO were not included. These results conform to those obtained from the univariate analysis and, hence, Hypotheses 1c and 1f must be rejected. The other four practices of good governance remain in the model and have significant coefficients (Table 8), a result that could be inferred from the ANOVA and from examination of the correlation matrix. We reduced these practices to a governance factor that was positively associated with disclosure, and suggest that the appointment of independent directors, the formation of an audit committee, the participation of the board in the equity of the company, and the establishment of stock option plans as a means of directors’

Table 7. Estimated Equations. OUTSIDE ¼ b1 GOVERNANCE+e1 AUDITCOM ¼ b2 GOVERNANCE+e2 BEQUITY ¼ b3 GOVERNANCE+e2 OPTION ¼ b4 GOVERNANCE+e3 GOVERNANCE ¼ b5 LISTING+ b6 OWNERSHIP+Z2 INDEX ¼ b7 LASSETS+b8 GOVERNANCE+Z1

Table 8.

Standardized (Beta) Weights. Standard Regression Weights

Regression: LASSETS - INDEX Regression: GOVERNANCE - INDEX Regression: LOWNERSHIP - GOVERNANCE Regression: LISTING - GOVERNANCE Correlation: LISTING 2 ASSETS Factorial: GOVERNANCE - OUTSIDE Factorial: GOVERNANCE - AUDITCOM Factorial: GOVERNANCE - BEQUITY Factorial: GOVERNANCE - OPTION

0.285 0.481 –0.364 0.453 0.482 0.487 0.541 0.297 0.600

S.E.

0.095 0.133 0.140 0.144 0.089 0.150 0.100 0.148 0.107

Critical Ratios

3.000 3.616 2.600 3.146 5.415 3.246 5.410 2.006 5.607

321

Corporate Characteristics, Governance Rules

remuneration are positively related to the provision of voluntary information. These findings endorse the findings shown above for Hypotheses 1a, 1b, 1d and 1e. Therefore our general Hypothesis 1, stating that voluntary disclosure is positively related to the adoption of good governance practices is partially supported. Path analysis shows that company size is a significant variable in explaining corporate disclosure variability (po0.01), a result that could be inferred from the ANOVA. The sign of the coefficient indicates that, as hypothesized, a positive association exists between corporate size and disclosure, thereby adding support for Hypothesis 3. Results also show that both listing status and ownership concentration exert a significant influence on the governance factor, accounting for 38% of its variability (Table 9). Considering that the governance factor influences the disclosure policy of firms, listing status and ownership structure have an effect on disclosure, although this impact is mediated by the governance practices followed by the company. This finding provides supports for the results provided by the univariate analysis for Hypotheses 3 and 4. Finally, despite the results of the univariate analysis, the industry variable was nonsignificant in explaining disclosure variability and was therefore eliminated from the model. Therefore, Hypothesis 5 must be rejected. Square multiple correlation coefficients (Table 9) show that, taken together, the size of the entity and the factor representing its governance rules account for a significant proportion of the variability in the disclosure index (39.4%). Results are similar using the unadjusted Actualidad Econo´mica Index, and indicate that the size of the company, along with its governance structure, are important factors in explaining not only the amount of voluntary information provided but also the disclosure strategy of the company regarding the design and presentation of reports.

Table 9. Variable INDEX GOVERNANCE OUTSIDE AUDITCOM BEQUITY OPTION

Squared Multiple Correlations. Squared Multiple Correlations 39.4 37.8 25.9 30.3 11.0 37.1

322

M. ROSARIO BABI´O ARCAY AND M. FLORA MUIN˜O VA´ZQUEZ

5. DISCUSSION AND CONCLUSIONS The results of this study indicate that corporate decisions regarding the provision of voluntary information are complex processes affected by a number of interrelated factors: the governance rules followed by the firm, corporate size, cross-listing status, and the ownership structure of the firm. Our results show that the adoption of a number of good governance practices such as the appointment of independent directors, the formation of audit committees, participation of the board in the capital of the company, and establishment of stock option plans as a means of director remuneration exert a significant influence on corporate voluntary disclosure. As expected, independent directors and audit committees strengthen the monitoring function of the board, so that firms become more responsive to stakeholders’ demands for information. As for directors’ participation in the capital of the company and stock option plans, our results suggest that both mechanisms contribute to the alignment of managers’ and shareholders’ interests, inasmuch as they reduce management reluctance to disclose voluntary information. Contrary to expectations, neither the separation of the functions of CEO and chairman, nor compliance with the recommendation of the Olivencia Code (1998) regarding the size of the board is significantly associated with the provision of voluntary information. Two corporate features stated by the Olivencia Code may explain this finding. First, a high ownership concentration in Spanish companies, along with a low separation between ownership and management, especially in family-owned firms, has led to the combined CEO-chairman role in a number of firms. Second, the appointment of outside directors who do not act as substitutes for existing directors, but fill additional positions is a possible reason for the large boards in our study. Our findings clarify prior inconclusive evidence regarding the effect of the adoption of practices such as the appointment of outside directors or the formation of an audit committee on the provision of voluntary information. Empirical evidence supporting this study was gathered in Spain, a country where corporate compliance with good governance rules is much lower than that observed in common-law countries (Deminor Rating, 2003). However, our findings reveal that practices of good governance have a significant influence on voluntary disclosure. Furthermore, our results indicate that, as consequence of complementarities and substitutability between practices of good governance, their beneficial effects on disclosure cannot be fully assessed unless we examine the global set of practices followed by the entity.

Corporate Characteristics, Governance Rules

323

Our findings reveal that the ownership structure of firms and cross-listings have a significant influence on governance practices, and thereby exert an indirect effect on corporate disclosure. As expected, ownership concentration is negatively associated with the adoption of practices of good governance, suggesting that firms with a majority shareholder do not achieve the same levels of compliance with recommendations of the good governance code as do their widely dispersed counterparts. Therefore, the positive association between corporate ownership structure and disclosure is explained by the influence exercised by the dispersion of ownership on the adoption of rules of good governance that, in the end, strengthens the disclosure policy of the company. Cross-listing in foreign stock markets also exerts a significant influence on the adoption of practices of good governance. Spanish companies listed on foreign stock markets seem to be willing to achieve a system of corporate governance in accordance with usual standards in use in foreign stock exchanges. Moreover, the necessity of attracting investors’ confidence and of avoiding any mistrust relative to the protection of their interests may explain the eagerness of cross-listed companies to adopt recommendations aimed at protecting shareholders’ interests. Our results extend those obtained in previous studies (Cooke, 1991; Khanna, Palepu & Srinivasan, 2004), and suggest that it is not the cost-benefit trade-off that explains the positive association between cross-listing and disclosure, but the improvement in corporate governance that is realized after cross-listing occurs. Additionally, our findings reveal that corporate size is a significant determinant of corporate disclosure. However, and contrary to our prediction, corporate size does not have a significant impact on the adoption of rules of good governance. These results are consistent with those obtained in previous research (Ahmed & Courtis, 1999) and suggest that large companies, as opposed to small entities, face a more favourable balance between costs and benefits when disclosing information. In contrast with the results we obtained for our univariate analysis (i.e. significant differences were observed between companies operating in regulated and unregulated sectors), path analysis shows that operating in a regulated industry does not have a significant effect on the provision of voluntary information. A high correlation between this variable and company size may explain its absence from the final model (Table 5). In the Spanish economy, companies operating in regulated industries such as finance, gas, power utility, oil, and telecommunications are the largest firms in this country. Therefore, the industry variable may not be adding significant information to that contained in the firm’s size.

324

M. ROSARIO BABI´O ARCAY AND M. FLORA MUIN˜O VA´ZQUEZ

Our study has some limitations that suggest a need for future work. Our sample consists of 91 companies listed on the electronic market of the Madrid Stock Exchange. Companies in our analysis are significantly larger than those excluded, and the mean disclosure index corresponding to the excluded companies is also lower than that for companies analysed. Therefore, until further research is developed, the results of our study should not be directly extrapolated to small entities, firms that seem to be less concerned about the provision of voluntary information. Lack of data prevented us from distinguishing between the participation of inside and outside directors in the capital of the company and from obtaining a measure of the amount of stock-price-based compensation received by directors. Hence, we could not assess the impact of inside shareholdings and the amount of stock option incentives on the provision of voluntary information. It is not only the establishment of stock option plans, but the amount of remuneration received that encourages directors to provide information. Future research could, then, improve the measurement of stock price incentives and directors’ shareholdings. Finally, our analysis was focused on the amount of voluntary information disclosed but this quantitative definition may not always be associated with higher quality information. Therefore, further research is needed to provide evidence on the determinants of high quality disclosure. This study was focused on the analysis of the factors that may explain differences in voluntary disclosure among companies. By developing this analysis in Spain, a country where corporate ownership is highly concentrated, we were able to analyse the interaction between the existence of majority shareholders and the adoption of practices of good governance, a key factor in explaining corporate disclosure variability. Our results suggest that high levels of compliance with corporate governance codes and, as a consequence, high levels of transparency, are expected to follow increases in the proportion of free float capital observed in listed companies. These results would be helpful in guiding European authorities in their actions aimed at improving transparency in publicly traded companies – an important concern for the European Commission at this moment.

NOTES 1. The mission of regulatory bodies is, precisely, to issue accounting standards that require companies to provide transparent and comparable financial information to external users. Nevertheless, the debate over the need for financial disclosure

Corporate Characteristics, Governance Rules

325

regulation and the extent of its coverage is still far from concluded (Admati & Pfleiderer, 2000). 2. The Financial Accounting Standards Board (FASB, 2001) recognizes that users’ needs are not being met by present financial standards. 3. A meta-analysis of these studies is provided by Ahmed and Courtis (1999). 4. Empirical research devoted to the analysis of managers’ perceptions has shown that they expect to obtain benefits when disclosing information, but that they are also concerned with the possibility of facing high costs when disclosing certain items of information (Gray & Roberts, 1989; Edwards & Smith, 1996). 5. Other mechanisms of corporate governance are institutional shareholders, auditors, auditing and accounting information, and the market for corporate control (Keasey & Wright, 1993). 6. The effectiveness of a particular rule of good governance may be enhanced when other rules are adopted. As an example, the role played by independent directors in promoting transparency is strengthened when an audit committee is appointed (Peasnell, Pope & Young, 2000). 7. According to the World Federation of Exchanges, annual market capitalization for the year 2003 was US$ 11,328,953 for the NYSE, US$ 2,460,064 for the London Stock Exchange and US$ 726,243 for Spanish Exchanges. 8. According to Faccio and Lang (2001), who analysed the ultimate ownership of 13 Western European countries, widely held corporations represent 26.42% of Spanish publicly traded companies, as opposed to the 63.08% found for a commonlaw country, the U.K. 9. Ownership concentration substitutes for legal protection because only large shareholders expect to receive a return on their investment (La Porta, Lopezde-Silanes, Shleifer & Vishny, 1998, p. 1145) 10. Agency conflicts arise because of owners’ difficulties in assuring that their resources are not expropriated by managers (Shleifer & Vishny, 1997, p. 741). 11. In those systems characterized by concentrated ownership and control (Continental Europe and Japan), collusive agreements between large shareholders can lead to the expropriation of wealth from minority shareholders. Therefore, the basic conflict in these countries lies between the controlling shareholders and the weak, minority shareholders (Maher & Anderson, 2002). 12. The existence of these monitoring mechanisms is also considered to be extremely important in increasing investor confidence. Because of that, codes of good governance include recommendations that provide stakeholders with information about a company’s compliance with their recommendations. 13. In Spain, the Olivencia Code recommends that boards should be composed of 5–15 members. 14. European companies listed on other markets inside the European Union are not required to provide information other than that demanded by the legislation enacted in their home country. In the case of cross-listings of European firms in the U.S.A., they are not subject to the same requirements as are U.S. companies. 15. Actualidad Econo´mica is a Spanish magazine comparable to Fortune magazine and its publishing firm, Grupo Recoletos, has a strategic alliance with the Financial Times.

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16. This index was taken on 12/02/2002 from: http://www.expansiondirecto.com/ ae/memorias/memoria4.html 17. Companies listed on the Spanish stock exchange are encouraged by the CNMV to prepare an explanatory report on the implementation of the Olivencia Code, which is the legal framework for corporate governance practices in this country. Importantly, recommendations in the Olivencia Code are merely recommendations. 18. To test for the robustness of our results, we performed the same analyses by including this index, without any adjustment, as the dependent variable. 19. Referring to disclosure rules in the U.K., Faccio and Lasfer (1999) employed the same threshold when defining a blockholder as a shareholder, other than a director, who individually holds at least 3% of a company’s ordinary shares. 20. Instead of aligning management and shareholder interests, director participation higher than 3% might lead to a new conflict between large and minority shareholders. 21. We also performed a non-parametric test alternative to one-way ANOVA, Kruskal–Wallis, with similar results. 22. Median was used to recode the continuous variable that represents the proportion of independent directors on the board into a dichotomous variable (INDEP) that takes a value of one (1) when the proportion is equal to or higher than median (33.33%), and a value of zero (0) otherwise. 23. Group 1 includes the smallest entities and those with a lower ownership concentration (lower Herfindahl index of stock dispersion), respectively. 24. The model was also estimated by including, instead of the SIZEB dichotomous variable, a continuous variable that accounted for the total number of directors; that estimation was also found to be non-significant. 25. A detailed reference to model fit indexes can be found in Bollen (1989). 26. A low w2 value and a high p-value indicate a good correspondence between the model and the data. 27. These fit indexes are similar to those reported by Hunton and Gibson (1999) or Hunton, Wier and Stone (2000).

ACKNOWLEDGMENTS We are grateful to Salvador Carmona for his advice and valuable comments on earlier drafts of this paper. We would also like to thank the three anonymous referees of Advances in Accounting for their very helpful suggestions. Earlier versions of this paper were presented at the Euroconference on Financial Reporting and Regulatory Practices in Europe, the EIASM Workshop on Accounting and Economics, and at the research seminar series at University Carlos III de Madrid. We thank Ma Luisa del Rı´ o and Leandro Benito for their help with data analysis.

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APPENDIX List of items considered in the Actualidad Econo´mica Index: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.

President’s Letter (from 0–6 points) Auditing report (from 0–6 points) Historical data (from 0–6 points) Basic data (from 0–8 points) Profit and loss account presented as a list (from 0–6 points) Shareholders (from 0–6 points) Shares owned by board members (from 0–6 points) Management report (from 0–12 points) Organization and clarity of the report (from 0–3 points) Report design (from 0–2 points) Subsidiaries (from 0–6 points) Board members’ remuneration (from 0–6 points) Retribution linked to stock (from 0–4 points) Rules of good governance (from 0–5 points) Stock market evolution (from 0–6 points) Analysis of operations (from 0–4 points) Other information (from 0–4 points) Information on line (from 0–4 points)

THE IMPORTANCE OF PROCEDURAL FAIRNESS IN BUDGETING Chong M. Lau and Sharon L. C. Tan ABSTRACT The importance of organizational commitment in enhancing management accounting systems effectiveness has received increased attention in recent years. Surprisingly, no research has investigated whether budgetary participation, by itself, affects organizational commitment, and the process by which this occurs. Procedural justice literature suggests that participation may affect procedural fairness which, in turn, may affect job satisfaction and organizational commitment. This study therefore proposes that budgetary participation affects job satisfaction indirectly through procedural fairness. It also proposes that the effects of participation on organizational commitment are indirect through procedural fairness and job satisfaction. The results provide support for these propositions.

INTRODUCTION Several management accounting studies have underscored the importance of organizational commitment in enhancing the effectiveness of management Advances in Accounting Advances in Accounting, Volume 21, 333–356 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21014-3

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accounting systems (e.g. Ferris, 1981; Ferris & Larcker, 1983; Nouri & Parker, 1996, 1998). These studies have found that organizational commitment generally has positive effects on employee attitudes and behaviors. For instance, Nouri’s (1994) results indicate that when managers are highly committed, job involvement is associated with a decreased level of budgetary slack. Nouri and Parker (1996) similarly found that managers who were highly committed did not exploit their high budgetary participation privileges to create budgetary slack. With respect to job performance, Nouri and Parker (1998) found that organizational commitment was positively related to performance. Considering the positive role of organizational commitment in enhancing management accounting systems effectiveness, there is therefore a need for management accounting researchers to pay increased attention on those variables which influence organizational commitment to assist top management to increase their employees’ commitment. The management accounting literature has consistently maintained that budgetary participation may have important attitudinal effects on organizational members (Brownell, 1982a). It is therefore likely that budgetary participation may enhance employee attitudes such as job satisfaction and organizational commitment. A variable of crucial importance to the understanding of the process by which budgetary participation affects job satisfaction and organizational commitment is procedural fairness. Procedural fairness is a part of organizational justice (fairness) theory. This theory suggests that there are two forms of fairness – procedural and distributive. Distributive fairness theory proposes that with respect to decisions involving allocation, people are primarily concerned with and affected by the fairness of the outcomes. As long as the outcome is fair (equitable), people are satisfied. In contrast, procedural fairness theory suggests that people are concerned with the means or processes by which decisions are made and the outcomes determined. As long as the means and processes are considered fair, people are satisfied (Lissak, Mendes, & Lind, 1983; Alexander & Ruderman, 1987). Procedural fairness theory has been relied upon extensively to explain attitudinal and behavioral issues in a variety of disciplines including the legal, psychology, political and organizational behavior. Specifically, it has been used extensively in these disciplines to explain the behavioral consequences of participative decision-making. The research results from these disciplines have consistently shown statistically significant relationships between participation and perceptions of procedural fairness. For instance, based on their review of procedural fairness research, Lind and Tyler (1988, pp. 196–197) concluded that ‘‘procedures that provide for either control or

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expression (participation) are seen as fairer yThe effects are so robust and so straightforward y’’ Perception of procedural fairness may therefore help to explain the process by which budgetary participation influences job satisfaction and organizational commitment. Several prior management accounting studies have investigated the importance of budgetary participation in fairness-related issues. However, these studies have generally considered only the interaction (joint) effects of budgetary participation (Magner, Welker, & Campbell, 1995; Lindquist, 1995; Libby, 1999; Lau & Lim, 2002). They have therefore assumed that the effects of procedural fairness are conditional upon other variables. With Wentzel (2002), organizational commitment and job satisfaction were not studied. With Magner and Welker (1994) and Libby (2001), budgetary participation was not investigated. This means that no prior management accounting studies have investigated the likelihood that budgetary participation, through procedural fairness, may affect two important employee attitudes, namely, job satisfaction and organizational commitment. Hence, the fundamental question of whether budgetary participation, by itself, has any effect on organizational commitment has remained unanswered. More importantly, the process by which budgetary participation influences job satisfaction and organizational commitment has also remained unexplained. Pedhazur (1982, p. 174) noted that ‘‘explanation is probably the ultimate goal of scientific inquiryyit is the key for creating the requisite conditions for the achievement of specific objectives. Only by identifying the variables and understanding the processes by which they lead to the (achievement of the dependent variable) is there promises of creating the conditions most conducive toythe achievement of the goals deemed desirable and beneficialy’’ (Parentheses and italics added). A study to address the aforementioned unexplained issues is therefore needed. An understanding of whether, and the process by which budgetary participation influences job satisfaction and organizational commitment would assist management accounting researchers to develop richer theoretical models, and enable practising managers to focus on areas which have the greatest impact on job satisfaction and organizational commitment. Our study is therefore designed to investigate the process by which budgetary participation, through procedural fairness, influences job satisfaction and ultimately, organizational commitment. Specifically, it proposes that the effect of budgetary participation on employee job satisfaction is indirect through procedural fairness. It also proposes that the effect of budgetary participation on employee organizational commitment is indirect through (1) procedural fairness and (2) job satisfaction. Fig. 1 presents the model which

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Procedural fairness

A

B

C Budgetary participation

Fig. 1.

Job satisfaction

E

D Organizational commitment

Theoretical Model: Intervening Effects of Procedural Fairness on Participation and Organizational Commitment.

incorporates these propositions. Job satisfaction is included in the model because there is strong theoretical support that procedural fairness is likely to have a strong impact, not only on organizational commitment, but also on satisfaction, which in turn, is likely to affect organizational commitment. According to Lind and Tyler (1988, p. 191), the most important role of procedural fairness is to enhance both employee satisfaction and organizational commitment. They concluded that ‘‘notwithstanding the importance of performance in organizational settings, the great practical value of procedural justice lies in its capacity to enhance the quality of work life and in its value as a source of both satisfaction and positive evaluations of organizationy’’ (emphasis added). The next section of the paper examines the relevant literature to develop the theoretical justification for the hypotheses to be tested. Subsequent sections, respectively, describe the method, results and the theoretical and practical implications of the study.

HYPOTHESES DEVELOPMENT Participation and Organizational Commitment (see Fig. 1) Mowday, Steers, and Porter (1979, p. 226) defined organizational commitment as ‘‘the relative strength of an individual’s identification with and involvement in a particular organization.’’ They suggested that organizationally committed individual may exhibit certain behavior including ‘‘(1) a

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strong belief in and acceptance of the organizational goals and values; (2) a willingness to exert considerable effort on behalf of the organization; and (3) a strong desire to maintain membership in the organization.’’ Prior research has suggested a positive association between participation and organizational commitment (e.g. March & Simon, 1985; Lincoln & Kalleberg, 1985; Boshoff & Mels, 1995). For instance, March and Simon (1985, p. 74) suggested that ‘‘the more participation of subordinates in making policy decisions, the stronger the tendency of subordinates to identify with the organization.’’ Lincoln and Kalleberg (1985, p. 754) similarly suggested that participation is related to organizational commitment because it ‘‘serves to integrate workers in the organization and commit them to organizational decisions.’’ However, although budgetary participation may be related to organizational commitment, the process through which participation affects organizational commitment is not well understood. This study proposes that the relationship between budgetary participation and organizational commitment may be indirect through (1) perception of procedural fairness and (2) job satisfaction. The following sections provide the theoretical justification for these propositions.

Budgetary Participation and Procedural Fairness (see ‘A’ in Fig. 1) Procedural fairness is concerned with the fairness of the process by which these outcomes are determined. Lind and Tyler (1988, p. 3) described procedural fairness and its behavioral implications as follows: Procedural justice begins with the hypothesis that there is a class of psychological reactions to adherence to or violation of norms that prescribe certain patterns of treatment or certain patterns of allocation. Such reactions have long been known to exert a powerful influence on human cognitions and behaviory The norms that form the basis of the justice response can be divided into two categories, those dealing with social outcomes (distributive justice) and those dealing with social process, that is, the proper behavior and treatment of people (procedural justice). (Emphasis and parentheses added).

Early procedural fairness studies originated mainly in the legal discipline and focused primarily on the importance of participation in enhancing procedural fairness so that fair outcomes are achieved. For instance, much of the seminal work of Thibaut and Walker (1975) was on the impact of participation on procedural justice judgments. They argued that for disputes involving conflict of interest, procedures which allow those affected by the decision/outcome to control or participate in the process would be perceived

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as fair. For outcomes to be equitable, all relevant information should be given due consideration. Since those affected may have individualized information which are not known to others, giving these people process control (participation) would enable them to disclose their individualized information so that the most equitable outcomes are achieved. Hence, procedures which place control of the process in the hand of those affected are likely to be perceived as high in procedural fairness because they promote fair outcomes. In other words, procedures involving participation are perceived as fair because they are instrumental in achieving the most equitable outcomes. Subsequent studies suggested and found that participation enhanced perception of high procedural fairness regardless of whether the final outcomes were equitable or not. This means that the act of allowing those who are affected by the decision to participate in the decision process, in itself, is sufficient to induce perception of high procedural fairness (Tyler, Rasinski, & Spodick, 1985; Lind & Tyler, 1988). These are regarded as the non-instrumental effects of procedural fairness. Lind and Tyler (1988, p. 193) suggested that the non-instrumental effects of procedural fairness occur because allowing one to participate ‘‘fulfills a desire to be heard and to have one’s views considered, regardless of whether the expression influences the decision maker.’’ In their Group Value Model on procedural fairness, they explained the non-instrumental effects of participation as follows: ythere are some values so basic to life in groups that they will occur in all group settingsy in general people value participation in the life of their group and that they value their status as group members. Procedures that allow voice are seen as fair because they provide opportunities for participation in group process and because the opportunity to exercise voice constitutes a visible marker of group membership. In contrast, mute procedures are seen as improper and therefore unjust because they frustrate the desire to participate in group process and because they appear to deny full membership rights to those denied voicey.If it is group participation and status affirmation that are important, these are obtained as soon as it is obvious that one’s views are expressed and considered; there is no need for a positive outcome to confirm these values.

Empirically, there is considerable support for the positive association between participation and procedural fairness (Lind, Erickson, Friedland, & Dickenberger, 1978; Tyler et al., 1985; Kanfer et al., 1987). The robustness of such findings has led Lind and Tyler (1988, p. 9) to conclude that ‘‘one of the most reliable findings in research on procedural justice (is) that people react more favorably to procedures that give them considerable freedom in communicating their views and arguments.’’ (Parenthesis added).

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Based on the above discussion, it is reasonable to conclude that budgetary participation is likely to be positively associated with procedural fairness (see ‘A’ in Fig. 1). The following hypothesis is therefore tested: H1. Budgetary participation is positively related to perception of procedural fairness. Procedural Fairness and Job Satisfaction (see ‘B’ in Fig. 1) Perception of procedural fairness is likely to be associated with the subordinates’ job satisfaction. Organizational justice theory suggests that fairness is a major social concern and that people’s satisfaction is likely to be affected by their perceptions of procedural fairness. Lind and Tyler (1988, p. 191) suggested that ‘‘procedural justice judgments affect a variety of very important beliefs and attitudes in organizations. In organizations, as in other settings, procedural justice appears to be a major concern, and the experience of procedural justice or injustice is a critical element in the organizational psychology of decision making.’’ Based on their review of the procedural fairness literature, they concluded that ‘‘the researchyhas shown that satisfaction is one of the principal consequences of procedural fairness.’’ McFarlin and Sweeney (1992) similarly suggested that because superiors have some control over their subordinates’ perception of procedural fairness, they might be able to affect their subordinates’ satisfaction. They can achieve this by developing and employing procedures which are perceived as fair by their subordinates. Procedural fairness is likely to be associated with job satisfaction because it may ameliorate discontent among organization members (Lau & Lim, 2002). Subordinates may also experience higher job satisfaction with fair procedures because such procedures may (1) lead to more equitable outcomes, a process known as the ‘‘fair process’’ effect (Folger, 1977; Folger et al., 1979; Greenberg & Folger, 1983; Lindquist, 1995), and (2) satisfy people’s need to be treated in an appropriate and polite manner (Lind & Tyler, 1988). There is also considerable empirical evidence to support the proposition that procedural fairness is positively associated with satisfaction. Early procedural fairness research in the legal arena found that procedural fairness was associated with satisfaction (Thibaut & Walker, 1975). Similar results were found in other disciplines and other settings (e.g. Lissak et al., 1983; Alexander & Ruderman, 1987). More importantly, studies by

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Lissak et al. (1983) and Alexander and Ruderman (1987) both indicated that not only was procedural fairness significantly related to job satisfaction, but the effect was stronger than that of distributive fairness. Based on the above discussion, it is reasonable to conclude that procedural fairness is likely to be associated with job satisfaction (see B in Fig. 1). The following hypothesis is therefore tested: H2. Perception of procedural fairness is positively related to job satisfaction. Budgetary Participation and Job Satisfaction (see ‘C’ in Fig. 1) Early research in budgeting had suggested that budgetary participation is likely to be associated with favorable behavioral outcomes because of the greater subordinates’ acceptance of budget targets which they help to set (Becker & Green, 1962; Vroom, 1964). For instance, Vroom (1964) suggested that budgetary participation is likely to be associated with increased subordinates job satisfaction because participation enables the subordinates to be more involved with their organizational activities and more independent and less dominated by their superiors. Cherrington and Cherrington (1973) relied on the principles of operant conditioning to provide the theoretical support for the positive behavioral effects of budgetary participation. According to them, appropriate reinforcement is provided when subordinates whose rewards are contingent on their budgets also participate in the setting of their budgets. Budgetary participation may affect job satisfaction in several ways. It may improve morale and group cohesiveness (Becker & Green, 1962). It may also provide opportunities for the subordinates to exchange or gain information from their superiors. This may help to clarify the task objectives and the means to achieve these task objectives (Kenis, 1979; Kren, 1992). This may lead to increased goal commitment. It may also motivate the subordinates to disclose their private information to their superiors. This may lead to more difficult goals and hence better performance (Kren & Liao, 1988). All these functional effects associated with budgetary participation are likely to lead to increased job satisfaction for the subordinates. French, Israel, and As (1960) provided early empirical evidence that participation was associated with increased job satisfaction among Norwegian workers because it satisfied important needs such as the need to be valued and appreciated. Several subsequent studies found similar positive association between participation and job satisfaction (e.g. Cherrington &

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Cherrington, 1973; Milani, 1975; Kenis, 1979). Based on their review of the management accounting literature, Kren and Liao (1988, p. 288) concluded that ‘‘the positive effect of participation on job satisfaction has had consistent support in empirical testing. The results indicate that subordinates like to participate and are more satisfied with their jobs when participation is present.’’ Based on the above discussion, budgetary participation is likely to be positively associated with the subordinates’ job satisfaction. The following hypothesis is therefore tested: H3. Budgetary participation is positively related to job satisfaction. Job Satisfaction and Organizational Commitment (see ‘D’ in Fig. 1) There is considerable empirical support for a significant and positive relationship between job satisfaction and organizational commitment (e.g. Mathieu & Zajac, 1990; Myer, Allen, & Smith, 1993; Ketchand & Strawser, 2001). Ketchand and Strawser (2001) suggested that while the temporal ordering is unclear, the strength of the relationship is generally unequivocal. Among the various dimensions of organizational commitment (affective, continuance and normative), Mathieu and Zajac (1990) found that the positive association between job satisfaction and organizational commitment is strongest for affective commitment. Ketchand and Strawser (2001) suggested that subordinates who are satisfied with their jobs may develop emotional attachments (high affective commitment) to their organizations. Myer, Allen, and Smith (1993) suggested that the development of affective commitment is likely to be preceded by job satisfaction because subordinates who find satisfaction in their jobs are generally those who are allowed the chance to do satisfying work or afforded the opportunity to develop valued skills, for instance, through the opportunities to participate in their organizational affairs. Job satisfaction is therefore likely to be positively associated with affective organizational commitment. The following hypothesis is therefore tested: H4. Job satisfaction is positively related to organizational commitment. Procedural Fairness and Organizational Commitment (see ‘E’ in Fig. 1) Procedures are developed and implemented by organizations. It is therefore likely that the subordinates’ perceptions of fairness in the procedures

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developed and employed by their organizations will affect their attitudes especially their commitment to their organizations. If employees can be guaranteed fair procedural treatment, they are more likely to be loyal and committed to their organizations. McFarlin and Sweeney (1992, p. 634) argued that employee resentment against injustice requires ‘‘the ability to identify other people and the procedures that they use as the source of poor outcomes. Thus, organizational outcomes may represent a clear target to blamey.By definition, organizational outcomes make salient the institutional sources of the procedures that affect employees.’’ Kim and Mauborgne (1993) similarly suggested and found that perception of high procedural fairness in head office procedures was positively associated with branch managers’ organizational commitment. Libby (1999, p. 127) argued that when perception of procedural fairness is low, subordinates may take destructive actions which may lead to ‘‘negative organizational consequences including reduced commitment to the organization.’’ Magner, Welker, and Campbell (1995, p. 613) similarly incorporated organizational commitment as one of the consequences of unfair procedures in their study. They argued that, apart from the employees’ immediate supervisors, employee resentment against unfair procedures may also be manifested in negative attitudes toward ‘‘many of the officials residing above the employee’s immediate supervisor in the organizational hierarchy’’ and that these officials ‘‘are likely to be seen as having a significant role in establishingybudgetary procedures such as participationyand are held culpable forylow level of budgetary participation.’’ Additional theoretical support for the hypothesis that procedural fairness is positively associated with organizational commitment is provided by the Group Value model on procedural justice developed by Lind and Tyer (1988, pp. 231–232). This model suggests that: Humans are by their very nature affiliative creatures, and they devote much of their energy to understanding the functioning of the various groups to which they belong and to participating in social processes within those groupy.Group procedures specify the authority relations and the formal and informal social processes that regulate much of the group’s activitiesy Because procedures are very important aspects of the perception of groups, evaluations of procedures, in the form of procedural justice judgments, would be expected to have strong effects on other group-relevant attitudes. It is hardly surprising, then, that procedural justice judgments affect evaluations of leaders and institutions. Indeed according to the group value model, overall attitudes toward the group itself would be expected to be shaped in substantial part by procedural justice judgments. To the extent to which group procedures are seen as unjust, which is to say that the procedures are contrary to basic group or individual values, evaluation of the group and

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commitment to it will suffer. To the extent that group procedures are fair, evaluation of the group and commitment and loyalty to the group will increase. (Emphasis added).

There is also much empirical support for an association between procedural fairness and evaluation of authorities and institutions responsible for decision-making (e.g. Alexander & Ruderman, 1987; Folger & Konovsky, 1989; MacFarlin & Sweeney, 1992; Magner et al., 1994, 1995; Tang & Sarsfield-Baldwin, 1996). Based on their review of the procedural fairness literature, Lind and Tyler (1988, p. 179) concluded as follows: The general finding seen in all of these studies has been that procedural justice is a remarkably potent determinant of affective reactions to decision making and that procedural justice has especially strong effects on attitudes about institutions and authoritiesyThese findings lead us to suspect thatya number of other organizational attitudes are affected by procedural justice judgmentsy..we believe that attitudes toward the organization as a whole, including such things as organizational commitment, loyalty and work group cohesiveness, are strongly affected by procedural justice judgments. (Emphasis added)

Based on the above discussion, it is possible to conclude that perception of procedural fairness is likely to be positively associated with organizational commitment. The following hypothesis is therefore tested: H5. Procedural fairness is positively related to organizational commitment. Mediating Effects of Procedural Fairness and Job Satisfaction Overall, the discussion in the previous few sections and Fig. 1 suggest the following. First, budgetary participation is likely to be related to procedural fairness (see A in Fig. 1), which in turn, is likely to be related to job satisfaction (see B). This means that the effect of budgetary participation on job satisfaction (see C) may be indirect through procedural fairness. Accordingly, the following hypothesis is tested: H6. The effect of budgetary participation on job satisfaction is indirect through procedural fairness. Second, procedural fairness is related to job satisfaction (see B), which in turn, is related to organizational commitment (see D). This means that the effect of procedural fairness on organizational commitment (see E) may be indirect through job satisfaction. Accordingly, the following hypothesis is tested:

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H7. The effect of procedural fairness on organizational commitment is indirect through job satisfaction. Finally, the discussion and Fig. 1 suggest that budgetary participation is related to both procedural fairness (see A) and job satisfaction (see C). Both procedural fairness and job satisfaction, in turn, are related to organizational commitment (see E and D). Taken together, these relationships suggest that the effect of budgetary participation on organizational commitment is indirect through (1) procedural fairness and (2) job satisfaction. Accordingly, the following hypothesis is tested: H8. The effect of budgetary participation on organizational commitment is indirect through (1) procedural fairness and (2) job satisfaction.

METHOD A survey questionnaire was employed with a sample of 100 organizations. The sample was selected randomly from the list of manufacturing organizations in Kompass Singapore 2000. The manufacturing sector was the largest sector listed in the directory. In order to provide some degree of control over the size of the organizations, only organizations with more than 100 employees each were selected. Since surveys involving real managers generally yield relatively low response rates, the approach of addressing these managers by their names and mailing the questionnaire directly to them was adopted to enhance the response rate. Hence, telephone calls were made to the selected organizations to obtain the names of an average of three functional heads (e.g., manufacturing manager, sales manager, marketing manager, personnel manager) from each organization. Functional heads were selected to provide some degree of control over the level of management. A total of 300 functional heads’ names were obtained from those organizations which were willing to supply the researchers with the names of some of their managers. A questionnaire with a covering letter assuring confidentiality in the responses provided was mailed to each of the 300 functional heads. After three week of the initial mailing, follow-up by telephone calls were made to those functional heads who had not responded. A total of 156 responses were received. Four of these responses were not usable as the respondents had failed to complete various parts of the questionnaire. This leaves the study with 152 usable responses and an overall response rate of 50.7%.

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In order to ensure that non-response bias was not present, t-tests on the variables studied were undertaken to ascertain if the early responses were significantly different from the late responses. This approach has been recommended by Oppenheim (1992) as a useful test for non-response bias. Our results indicated that no significant differences were found. Hence, there was no non-response bias in the responses received. The demographic data indicated that mean age of the respondents was 40.6 years. They had held their current positions for an average of 6.4 years, had an average of 10.3 years of experience in their areas of responsibility and were each responsible for an average of 87 employees. Most of them (93%) had either tertiary or professional qualifications. Based on these data, it is reasonable to conclude that the respondents were in general relatively senior, experienced and well qualified managers in their organizations.

MEASUREMENT INSTRUMENTS Budgetary Participation The Milani (1975) six-item instrument was employed to measure budgetary participation. This is one of the most widely used instruments in management accounting research on budgetary participation. Management accounting studies which have employed this instrument include Brownell (1982b), Chenhall and Brownell (1988); Frucot and Shearon (1991); Harrison (1992), Kren (1992) and Nouri and Parker (1996) and Lau and Buckland (2001). Consistent with several prior studies which had demonstrated the instrument’s high internal consistency as measured in terms of the Cronbach alpha statistic, our studies found a relatively high Cronbach alpha of 0.94 for the six items of the instrument. The factor analysis results indicate that all six items loaded satisfactorily on a single factor (Eigen value ¼ 4.6; variance explained: 76%). Procedural Fairness The four-item instrument developed by McFarlin and Sweeney (1992) was employed to measure perception of procedural fairness. The four items ask the managers to rate the fairness of the procedures used by their superiors to communicate performance feedback, determine pay increases, evaluate performance and promotability. A Cronbach alpha of 0.90 was obtained for

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the four items. This demonstrates the high internal consistency among the four items of the instrument. The factor analysis results indicate the unidimensional nature of the instrument as all four items loaded satisfactorily on a single factor (Eigenvalue ¼ 3.07; variance explained: 77%).

Job Satisfaction This variable was measured by the 20-item short-form version of the Minnesota Satisfaction Questionnaire (MSQ) developed by Weiss, Dawis, England, and Lofquist (1967). It measures the degree of managers’ satisfaction with 20 different job facets. It has been adopted by several management accounting studies including Brownell (1982b); Frucot and Shearon (1991) and Harrison (1992). Scarpello and Campbell (1983) found that this instrument had more success than other instruments in predicting overall job satisfaction with facets of the job. Weiss et al. (1967) found that it had high levels of reliability when tested with a sample of 27 norm groups and a specific group of managers. Dunham, Smith, and Blackburn (1977) found it provided the highest level of convergent validity and outperformed other measures in tests of discriminant validity. The Cronbach alpha of 0.95 obtained for this instrument in our study indicates high internal consistency. As noted above, this instrument comprises 20 items with each item representing a different job facet. This means that the 20 items constitute 20 different job facets e.g. ability utilization, achievement, activity, advancement (Weiss et al., 1967). Hence, factor analysis, which seeks to reduce the list of items into categories (factors), is inappropriate here because from a theoretical perspective each of these 20 items is already a category by itself. Consequently, factor analysis was not undertaken for this variable.

Organizational Commitment This variable was measured by the nine-item short-form version of Organizational Commitment Questionnaire (OCQ) developed by Mowday et al. (1979). Myer et al. (1993, p. 152) regarded this instrument as the ‘‘most widely used measure of affective commitment to date.’’ Both Mowday et al. (1979) and Angle and Perry (1981) suggested that OCQ has good psychometric properties. High levels of Cronbach alphas were found for this instrument by several prior studies (e.g. Nouri, 1994; Nouri & Parker, 1996, 1998). Consistent with these prior studies, the Cronbach alpha of 0.91

The Importance of Procedural Fairness in Budgeting

Table 1. Variables

Descriptive Statistics and Cronbach Alpha. Mean

Participation Procedural fairness Job satisfaction Organizational commitment

347

26.98 13.64 66.06 45.92

Std Dev

Theoretical Range

8.45 2.98 12.46 9.48

Actual Range

Min

Max

Min

Max

6 4 20 9

42 20 100 63

6 4 36 16

42 20 97 63

Cronbach Alpha

0.94 0.90 0.95 0.91

Pearsons Correlations among Variables.

Table 2.

Procedural fairness Job satisfaction Organizational commitment

Participation

Procedural Fairness

Job Satisfaction

0.404 0.465 0.338

0.519 0.480

0.647

 po0.01 (2-tailed).

obtained in our study indicates the high internal consistency of the nine items in the instrument. A factor analysis was undertaken for the nine items. All items loaded satisfactorily on a single factor (Eigenvalue ¼ 5.43; variance explained ¼ 60%). Descriptive statistics of the above variables are presented in Table 1. Table 2 presents the Pearsons correlation matrix among these variables.

RESULTS Hypotheses H1, H2, H3, H4, H5 The first five hypotheses predict positive relationships among budgetary participation, procedural fairness, job satisfaction and organizational commitment. The univariate results of the Pearsons correlation matrix as presented in Table 2 are used to ascertain if these hypotheses are supported. The results indicate the following. For Hypothesis H1, the relationship between budgetary participation and procedural fairness is positive and significant (0.404; po0.01). For Hypothesis H2, the relationship between procedural fairness and job satisfaction is positive and significant (0.519; po0.01). For Hypothesis H3, the relationship between budgetary

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participation and job satisfaction is positive and significant (0.465; po0.01). For Hypothesis H4, the relationship between job satisfaction and organizational commitment is positive and significant (0.647; po0.01). Finally, for Hypothesis H5, the relationship between procedural fairness and organizational commitment is positive and significant (0.480; po0.01). Hence, Hypotheses H1, H2, H3, H4 and H5 are all supported.

Hypotheses H6, H7 and H8 Hypotheses H6, H7 and H8 all involve intervening relationships. In order to ascertain if these hypotheses are supported, it was necessary to decompose the total effects of these relationships into direct and indirect effects. Structural equation modeling is an appropriate technique for these tests. Hence, the EQS computer software program (Bentler, 1995) was employed. Tests of the structural model as depicted in Fig. 1 were first undertaken. The results indicate that the w2 of the model is 0.014 (1df; po0.90). Hence, the w2 p-value (0.90) is substantially higher than the recommended value of 40.05 (Bentler, 1995). The fit indices are: normed fix index ¼ 1; nonnormed fit index ¼ 1.034; comparative fit index ¼ 1. These fit indices are all higher than the recommended value of 40.90 (Bentler, 1995). Based on these results, it is possible to conclude that the structural model is a very good fit. Table 3 presents the results from the structural equation models showing the total effects, direct effects and indirect effects for the various relationships. These results indicate the following. First, the relationship between budgetary participation and job satisfaction has a total effect of 0.465. This can be decomposed into a direct effect of 0.305 and an indirect effect of 0.160. The indirect effect can be computed from the path coefficients (see Fig. 2 or Table 4) as follows: BP-PF-JS ¼ 0.404
0.396 ¼ 0.160. As this value is in excess of 0.05 (Bartol, 1983; Pedhazur, 1982), the indirect effect is meaningful. Hence, Hypothesis H6, which states that the effect of budgetary participation on job satisfaction is indirect through procedural fairness, is supported. The results in Table 3 also indicate that the relationship between procedural fairness and organizational commitment has a total effect of 0.412. This can be decomposed into a direct effect of 0.197 and an indirect effect of 0.215. The indirect effect can be computed from the path coefficients (see Fig. 2 or Table 4) as follows: PF-JS-OC ¼ 0.396
0.545 ¼ 0.215. As this value is in excess of 0.05 (Bartol, 1983), the indirect effect is meaningful. Hence, Hypothesis H7, which states that the effect of procedural fairness on organizational commitment is indirect through job satisfaction, is supported.

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Table 3. Total Effects, Direct Effects and Indirect Effects. Dependent Variables

Independent Variables

Total Effects

Direct Effects

Indirect Effects

BP PF BP PF JS BP

0.404 0.396 0.465 0.412 0.545 0.333

0.404 0.396 0.305 0.197 0.545 0.000

— — 0.160 0.215 — 0.333

PF JS JS OC OC OC

BP ¼ budgetary participation; JS ¼ job satisfaction; PF ¼ procedural fairness; OC ¼ organizational commitment.

Procedural fairness

0.404**

0.396**

0.305** Budgetary participation

Job satisfaction

0.197**

0.545** Organizational commitment

** p< 0.01 (2-tailed)

Fig. 2.

Structural Model with Standardized Path Coefficients.

Finally, Table 3 indicates that the relationship between budgetary participation and organizational commitment has a total effect of 0.333, which is composed entirely of indirect effect. Based on the values of the path coefficients in Table 4 and Fig. 2, the decomposition of the indirect effect of 0.333 by the various paths in Fig. 2 are computed as follows: Path (1) Path (2) Path (3)

BP-PF-OC BP-JS-OC BP-PF-JS-OC

Total indirect effect

0.404
0.197 0.305
0.545 0.404
0.396
0.545

0.080 0.166 0.087 0.333

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Table 4. Dependent Variables PF JS OC

Standardized Solutions.

Independent Variables

Path Coefficients

R2

BP PF BP PF JS

0.404 0.396 0.305 0.197 0.545

0.163 0.347 0.447

BP ¼ budgetary participation; JS ¼ job satisfaction; PF ¼ procedural fairness; OC ¼ organizational commitment.

Baron and Kenny (1986) suggested that a full mediation occurs if a significant relationship between two variables becomes insignificant after controlling for the indirect effects. Since a significant correlation exists between budgetary participation and organizational commitment (see Table 2), but this significant relationship is reduced to zero after controlling for the indirect effects through procedural fairness and job satisfaction, a full mediation is deemed to have occurred. Based on these results, Hypothesis H8, which states that the effect of budgetary participation on organizational commitment is indirect through procedural fairness and job satisfaction, is therefore supported.

CONCLUSION Since budgetary participation, procedural fairness, job satisfaction and organizational commitment are some of the most important variables in budgeting, there is an expectation that the relationships among them would have already been studied by management accounting researchers. Yet this is not the case. The fundamental questions of (1) whether budgetary participation, by itself, has any effect on job satisfaction, and ultimately on organizational commitment, and (2) if so, the process by which this occurs, have generally been overlooked by prior management accounting studies. This study therefore seeks to address these important unexplained issues. Specifically, it investigates if the effects of budgetary participation on employee organizational commitment are indirect through procedural fairness and job satisfaction. It also considers the relative importance of procedural fairness in explaining the relationships between (1) budgetary participation

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and job satisfaction, and (2) budgetary participation and organizational commitment. The results support the hypotheses and the expectation of this study that procedural fairness plays an important role in influencing subordinates’ attitudes and behaviors in participative budgeting. Procedural fairness was found to affect subordinates’ attitudes in three ways. First, our results indicate that budgetary participation significantly affected job satisfaction. However, a substantial proportion of these effects was indirect through procedural fairness (0.160 in Table 3) (see Hypothesis H6). This means that budgetary participation significantly affected procedural fairness, which then affected job satisfaction. Second, the results indicate that apart from its direct effect on organizational commitment (0.197 in Table 3), procedural fairness also affected organizational commitment indirectly through job satisfaction (0.215 in Table 3) (see Hypothesis H7). Finally, the results indicate that procedural fairness, together with job satisfaction, were able to explain almost all the effects of budgetary participation on subordinates’ organizational commitment. They indicate that procedural fairness and job satisfaction mediated fully the relationship between budgetary participation and organizational commitment (see Hypothesis H8). These results are important as they help to explain the process by which budgetary participation affects employee job satisfaction and organizational commitment. They are generally consistent with the theories developed in other disciplines which have highlighted the importance of procedural fairness in influencing employee attitudes and behaviors. Lind and Tyler (1988, p. 141) suggested that ‘‘wherever research has examined procedural justice, it has been found that peoples care about the fairness of procedures. People may give different weight to various concerns as they decide in different situations what constitutes procedural justice, but they appear always to make procedural justice judgments and these judgments are always important to them.’’ Management accounting researchers should therefore pay more attention to role of fairness in the study of management accounting issues. From a theoretical perspective, the results provide the empirical support for management accounting researchers to place greater reliance on organizational justice theory as it may be important in explaining and resolving many management accounting issues (Hopwood, 1972; Otley, 1978). Considering the myriad of management accounting procedures in most organizations, there are many opportunities for management accounting researchers to not only play an important role in the further development of theories on fairness, but also provide fresh insights into many fairness

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issues which are not discernible by research in other disciplines. As noted by Lindquist (1995, p. 143), ‘‘through a recognition of the desire for fairness in the workplace as an antecedent of participative budgeting, we can gain new knowledge and move forward toward a better understanding of the entire budgetary process.’’ From a practical perspective, our study suggests that consideration of fairness issues in the design of management accounting procedures may be far more important than previously thought. Lind and Tyler (1988, pp. 200–201) suggested that: yorganizational designers look to procedural justice research for effective means to enhance and maintain the quality of work life and the internal cohesiveness of organizations. The researchyshows that when procedures are fair, the organization can expect to see greater employee satisfaction, less conflict and more obedience to procedures and decisions. These benefits can be realized at very little cost to the organization - in fact, it is quite likely that the investment of organizational resources in the achievement of procedural justice would produce much greater benefit on these dimensions at less cost than would most other changes in organizational policy or practice. (Emphasis added).

Practicing management accountants can therefore enhance employee satisfaction and organizational commitment not necessarily by increasing compensations or rewards, but by designing and implementing procedures that are perceived as fair. As indicated by the results of this study, the employment of procedures which involve the subordinates’ participation in the budget setting process is likely to enhance employee job satisfaction and organizational commitment without having to increase the amount of compensation and rewards the subordinates received. Lind and Tyler (1988, p. 75) summed this up as follows: The enhancement of satisfaction by procedural fairness is a remarkable phenomenon that suggests a host of potential beneficial applications y.in essence, the existence of the effect means that we can increase the net satisfaction of all those who come in contact with the law by designing procedures so that they can lead to judgments of greater procedural fairness. Because we now know that it is possible to produce a net gain in satisfaction by proper procedural design, we have more reason than ever to study the relationship between the characteristics of a procedure and the judgment that the procedure is fair. (Emphasis added).

As with most research, our study has some limitations. First, our study is based on survey data which are subject to the usual limitations associated with cross-sectional survey method. Second, our sample was selected from manufacturing organizations and from senior management level. Hence, caution should be exercised in generalizing the results to other sectors and other levels of management. Third, although our study has incorporated the

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mediating effects of procedural fairness and job satisfaction, other potential mediating variables, such as goal commitment, role ambiguity and job relevant information, may also be important. Notwithstanding the aforementioned limitations, our study provides important empirical evidence pertaining to the role and importance of procedural fairness in management accounting control systems in general, and in explaining the process by which budgetary participation affects important employee attitudes including job satisfaction and organizational commitment. These findings may assist in the development of richer theoretical models and in the enhancement of more positive employee attitudes and behaviors in the workplace. They may also help to promote a greater interest and more research on the importance of perceptions of fairness in the design and implementation of management accounting control systems.

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Libby, T. (1999). The influence of voice and explanation on performance in a participative budgeting setting. Accounting, Organizations and Society, 24, 125–137. Libby, T. (2001). Referent cognitions and budgetary fairness: A research note. Journal of Management Accounting Research, 13, 91–105. Lincoln, J. R., & Kalleberg, A. L. (1985). Work organization and workplace commitment: A study of plants and employees in the US and Japan. American Sociology Sociological Reviews, 50, 738–760. Lind, E. A., Erickson, B. E., Friedland, N., & Dickenberger, M. (1978). Reactions to procedural models for adjudicative conflict resolution: A cross-national study. Journal of Conflict Resolution, 22, 318–341. Lind, E. A., & Tyler, T. R. (1988). The social psychology of procedural justice. New York: Plenum Press. Lindquist, T. M. (1995). Fairness as an antecedent to participative budgeting: Examining the effects of distributive justice, procedural justice and referent cognitions on satisfaction and performance. Journal of Management Accounting Research, 7, 122–147. Lissak, R. I., Mendes, H., & Lind, E. A. (1983). Organizational and non organizational influences on attitudes toward work. Champaign: University of Illinois. McFarlin, D. B., & Sweeney, P. D. (1992). Distributive and procedural justice as predictors of satisfaction with personal and organizational outcomes. Academy of Management Journal, 35(3), 626–637. Magner, N., & Welker, R. B. (1994). Responsibility center manager’s reactions to justice in budgetary resource allocation. Advances in Management Accounting, 3, 237–253. Magner, N., Welker, R. B., & Campbell, T. L. (1995). The interactive effect of budgetary participation and budget favorability on attitudes toward budgetary decision makers: A research note. Accounting, Organizations and Society, 20(7/8), 611–618. March, J. G., & Simon, H. A. (1985). Organizations. New York: Wiley. Mathieu, J. E., & Zajac, D. M. (1990). A review and meta-analysis of the antecedents, correlates, and consequences of organizational commitment. Psychological Bulletin, 108(2), 171–194. Milani, K. W. (1975). The relationship of participation in budget-setting to industrial supervisor performance and attitudes: A field study. The Accounting Review, 50(2), 274–284. Mowday, R. T., Steers, R. M., & Porter, L. W. (1979). The measurement of organizational commitment. Journal of Vocational Behavior, 14(2), 224–247. Myer, J. P., Allen, N. J., & Smith, C. A. (1993). Commitment to organization and occupations: Extension and test of a three-component conceptualizations. Journal of Applied Psychology, 78(4), 538–551. Nouri, H. (1994). Using organizational commitment and job involvement to predict budgetary slack: A research note. Accounting, Organizations and Society, 19(3), 289–295. Nouri, H., & Parker, R. J. (1996). The effect of organizational commitment on the relation between budgetary participation and budgetary slack. Behavioral Research in Accounting, 8, 74–90. Nouri, H., & Parker, R. J. (1998). The relationship between budget participation and job performance: The roles of budget adequacy and organizational commitment. Accounting, Organizations and Society, 23(5/6), 467–483. Oppenheim, A. N. (1992). Questionnaire design, interviewing and attitude measurement. London: Pinter Publishers.

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Otley, D. T. (1978). Budget use and managerial performance. Journal of Accounting Research, 16(1), 122–149. Pedhazur, E. (1982). Multiple regression in behavioral research explanation and prediction (2nd ed.). New York: Holt, Rinehart and Winston. Scarpello, V., & Campbell, J. P. (1983). Job satisfaction: Are all the parts there? Personnel Psychology, 36(3), 577–600. Tang, T. L., & Sarsfield-Baldwin, L. J. (1996). Distributive and procedural justice as related to satisfaction and commitment. SAM Advanced Management Journal, 61(3), 25–31. Thibaut, J., & Walker, L. (1975). Procedural justice: A psychological analysis. Hillside, NJ: Lawrence Erlbaum Associates. Tyler, T. R., Rasinski, K., & Spodick, N. (1985). The influence of voice on satisfaction with leaders: Exploring the meaning of process control. Journal of Personality and Social Psychology, 48, 72–81. Vroom, V. H. (1964). Work and motivation. New York: Wiley. Weiss, D. J., Dawis, R. V., England, G. W., & Lofquist, L. H. (1967). Manual for the Minnesota satisfaction questionnaire. Minnesota studies in vocational rehabilitation 22. Minneapolis: University of Minnesota, Industrial Relations Center, Work Adjustment Project. Wentzel, K. (2002). The influence of fairness perceptions and goal commitment on managers’ performance in a budget setting. Behavioral Research In Accounting, 14, 247–271.

HIGH IMPACT BEHAVIORAL ACCOUNTING ARTICLES AND AUTHORS Philip M. J. Reckers and Sandra Solomon ABSTRACT In an effort to propagate best practices, the Accounting, Behavior and Organizations Section of the American Accounting Association endeavors to make available to interested faculty via their website syllabi for research seminars in behavioral accounting taught at prominent institutions. As of December 1, 2004, 23 syllabi could be found at the website; 20 provided detailed article reference lists. This note identifies the major research foci found on those syllabi, and the most frequently referenced and highest impact articles and authors.

INTRODUCTION The academic accounting community has committed significant resources, financial and personnel, to production and dissemination of relevant and rigorous research. Additional significant resources are devoted by our institutions and faculty to the assimilation of extant research and knowledge transfer of extant research and research methods to a new generation of Advances in Accounting Advances in Accounting, Volume 21, 359–366 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21015-5

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faculty. For those who teach in our institutions’ doctoral programs, the selection of research articles to which to commit precious seminar time is a significant task. One purpose of this note is to reduce that burden. On December 1, 2004, via the website of the Accounting, Behavior and Organizations Section of the American Accounting Association, the 20 doctoral granting institutions listed in Table 1 shared their syllabi and lists of required reading for doctoral students in the behavioral accounting arena.

PROMINENT ARTICLES AND SYLLABI FEATURES Six hundred and seventy-five articles were referenced as required reading for doctoral students. About half of the articles were referenced by only one institution. On the other hand, 22 articles were cited by six or more institutions and 57 articles were identified by four or more institutions. Those top 57 articles are identified by the author and frequency in Table 2.

Table 1. Institution

Arizona State University University of Arkansas Cornell University Florida Atlantic University University of Georgia Georgia State University University of Illinois University of Iowa Indiana University University of Kentucky Michigan State University Nanyang Technological University University of Oklahoma Ohio State University University of Pittsburgh University of Southern California University of Texas University of Texas at San Antonio University of Utah University of Wisconsin

Contributing Institutions. Required Reading (# of articles) 35 84 42 86 34 54 48 92 37 35 61 30 44 42 69 68 74 48 28 68

High Impact Behavioral Accounting Articles and Authors

Table 2.

361

Most Frequently Cited Articles.

Article Libby, R., & Luft, J. (1993). Determinants of judgment performance in accounting settings: Ability, knowledge, motivation, and environment. Accounting, Organizations and Society, 18(5), 425–450. Luft, J. L., & Shields, M. D. (2001). Why does fixation persist? Experimental evidence on the judgment performance effects of expensing intangibles. The Accounting Review, 76(October), 561–587. Tan, H.-T., & Libby, R. (1997). Tacit managerial versus technical knowledge as determinants of audit expertise in the field. Journal of Accounting Research, (Spring), 35(1), 97–114. Bonner, S., & Lewis, B. (1990). Determinants of auditor expertise. Journal of Accounting Research, 28(Suppl.), 1–20. Hopkins, P. E. (1996). The effect of financial statement classification of hybrid financial instruments on financial analysts’ stock price judgments. Journal of Accounting Research, 34, (Suppl.), 33–50. Hunton, J. E., & McEwen, R. A. (1997). An assessment of the relation between analysts’ earnings forecast accuracy, motivational incentives and cognitive information search strategy. The Accounting Review, 72(4), 497–515. Kennedy, J. (1993). Debiasing audit judgment with accountability: A framework and experimental results. Journal of Accounting Research, 31(2), 231–245. Libby, R., Bloomfield, R., & Nelson, M. (2002). Experimental research in financial accounting. Accounting, Organizations and Society, 27, 775–810. Peecher, M. (1996). The influence of auditors’ justification processes on their decisions: A cognitive model and experimental evidence. Journal of Accounting Research, 34(1), 125–140. Kennedy, J. (1995). Debiasing the curse of knowledge in audit judgment. The Accounting Review, 70, 249–274. Lipe, M., & Salterio, S. (2000). The balanced scorecard: Judgmental effects of common and unique performance measures. The Accounting Review, 75(July), 283–298. Sprinkle, G. (2000). The effect of incentive contracts on learning and performance. The Accounting Review, 75(3), 323–345. Kinney, W. (1986). Empirical accounting research Design for PhD students. The Accounting Review, 61(April), 338–350. Evans, J. H., Hannan, R. L., Krishnan, R., & Moser, D. V. (2001). Honesty in managerial reporting. The Accounting Review, 76, 537–560. Frederickson, J. R., Peffer, S. A., & Pratt, J. (1999). Performance evaluation judgments: Effects of prior experience under different performance evaluation schemes and feedback frequencies. Journal of Accounting Research, 37, 151–166. Hogarth, R. (1993). Accounting for decisions and decisions for accounting. Accounting, Organizations, and Society, 18(5), 407–424. Maines, L. A., & McDaniel, L. S. (2000). Effects of comprehensive-income characteristics on nonprofessional investors’ judgments: The role of financialstatement presentation format. The Accounting Review, 75(April), 179–207.

Frequency 12

11

10

9 9

9

9 9 9

8 8

8 7 6 6

6 6

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Table 2. (Continued ) Article Smith, J., & Kida, T. (1991). Heuristics and biases: Expertise and task realism in auditing. Psychological Review, 109(May), 472–489. Tan, H. T., & Jamal, K. (2001). Do auditors objectively evaluate their subordinates’ work? The Accounting Review, 76(1), 99–110. Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and Biases. Science, 185, 1124–1131. Bonner, S. (1999). Judgment and decision-making research in accounting. Accounting Horizons, 13(December), 385–398. Bonner, S. E., & Pennington, N. (1991). Cognitive processes and knowledge as determinants of auditor expertise. Journal of Accounting Literature, 1–50. Camerer, C., Loewenstein, G., & Weber, M. (1989). The curse of knowledge in economic settings: An experimental analysis. Journal of Political Economy, 97(5), 1232–1254. Cuccia, A. D., & McGill, G. A. (2000). The role of decision strategies in understanding professionals’ susceptibility to judgment biases. Journal of Accounting Research, 38(2), 419–435. Frederick, D. M. (1991). Auditors’ representation and retrieval of internal control knowledge. The Accounting Review, (April), 66, 240–258. Hirst, E., & Hopkins, P. (1998). Comprehensive income reporting and analysts’ valuation judgments. Journal of Accounting Research, 36(Suppl.), 47–75. Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica 47(March), 263–291. Libby, R., & Tan, H. (1999). Analysts’ reactions to warnings of negative earnings surprises. Journal of Accounting Research, 37, 415–435. Tan, H-T., & Kao, A. (1999). Accountability effects on auditors’ performance: The influence of knowledge, problem-solving ability, and task complexity. Journal of Accounting Research, (Spring), 209–224. Wilks, J. (2002). Predecisional distortion of evidence as a consequence of realtime audit review. The Accounting Review, 77(1), 51–71. Bonner, S. E., Libby, R., & Nelson, M. (1996). Using decision aids to improve auditors’ conditional probability judgments. The Accounting Review, 71(2), 221–240. Bonner, S. E., & Sprinkle, G. B. (2002). The effects of monetary incentives on task performance: Theories, evidence, and a framework for research. Accounting, Organizations and Society 27(May/July), 303–345. Cloyd, C. B. (1997). Performance in tax research tasks: The joint effects of knowledge and accountability. The Accounting Review, 72(1), 111–131. Cuccia, A., Hackenbrack, K., & Nelson, M. (1995). The ability of professional standards to mitigate aggressive financial reporting. The Accounting Review, 70(2), 227–248. Fisher, J., Maines, L., Peffer, S., & Sprinkle, G. (2002). Using budgets for performance evaluation: Effects of resource allocation and horizontal information asymmetry on budget proposals, budget slack and performance. The Accounting Review, 77(4), 847–866.

Frequency 6 6 6 5 5 5

5

5 5 5 5 5

5 4

4

4 4

4

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Table 2. (Continued ) Article Fredrickson, J. R., & Miller, J. S. (2002). Pro forma earnings disclosures: Do analysts and nonprofessional investors react differently? Working paper, Hong Kong University of Science and Technology. Ganguly, A., Kagel, J., & Moser, D. (1994). The effects of biases in probability judgments on market prices. Accounting, Organizations, and Society, 19(8), 675–700. Hackenbrack, K., & Nelson, M. W. (1996). Auditors’ incentives and their application of financial accounting standards. The Accounting Review, 71(1), 43–60. Hodge, F. D. (2001). Hyperlinking unaudited information to audited financial statements: Effects on investor judgments. The Accounting Review, (October), 76(4), 675–691. Kachelmeier, S. J., & Towry, K. L. (2002). Negotiated transfer pricing: Is fairness easier said than done? The Accounting Review, 77(July), 571–593. Kennedy, J., Mitchell, T., & Sefcik, S. E. (1998). Disclosure of contingent environmental liabilities: Some unintended consequences? Journal of Accounting Research, (Autumn), 36, 257–277. Kennedy, J., & Peecher, M. E. (1997). Judging Auditors’ Technical Knowledge. Journal of Accounting Research, (Autumn), 35, 279–294. Kennedy, J., Kleinmuntz, D. N., & Peecher, M. E. (1997). Determinants of the justifiability of performance in Ill-structured audit tasks. Journal of Accounting Research, (Suppl.), 35, 105–123. Krische, S. (2002). Investors’ evaluations of strategic prior-period benchmark disclosures in earnings announcements. Working paper. University of Illinois Urbana-Champaign. Libby, R., & Lipe, M. G. (1992). Incentives, effort, and the cognitive processes involved in accounting-related judgments. Journal of Accounting Research, 30, 249–273. Libby, R., & Kinney, W. R. (2000). Does mandated audit communication reduce opportunistic corrections to manage earnings to forecasts? The Accounting Review, 75(4), 383–404. Libby, R. (1985). Availability and the generation of hypotheses in analytical review. Journal of Accounting Research, (Autumn), 23(2), 648–667. Libby, R., & Trotman, K. T. (1993). The review process as a control for differential recall of evidence in auditor judgments. Accounting Organizations and Society, 18(6), 559–574. Libby, R., Tan, H., Hunton, J. (2002). Analysts’ reactions to earnings preannouncement strategies. The Accounting Review, 40(1), 223–246. Luft, J. (1994). Bonus and penalty incentives contract choice by employees. Journal of Accounting & Economics 18(September), 181–206. Luft, J. L., & Libby, R. (1997). Profit comparisons, market prices and managers’ judgments about negotiated transfer prices. The Accounting Review, 72(2), 217– 229.

Frequency 4

4

4

4

4 4

4 4

4

4

4

4 4

4 4 4

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Table 2. (Continued ) Article

Frequency

Maines, L., & Hand, J. (1996). Individuals’ perceptions and misperceptions of the time series properties of quarterly earnings. The Accounting Review, 71(July), 317–336. Mercer, M. (2003). The credibility of consequences of managers’ decisions to provide warnings about unexpected earnings. Working paper, Emory University. Sedor, L. M. (2002). An explanation for unintentional optimism in analysts’ earnings forecasts. The Accounting Review, 77(4), 731–753. Solomon, I., Shields, M. D., & Whittington, O. R. (1999). What do industryspecialist auditors know? Journal of Accounting Research, 37(1), 191–208. Sprinkle, G. B. (2003). Perspectives on experimental research in managerial accounting. Accounting, Organizations and Society, 28(February–April), 287–318. Vera-Munoz, S. C., Kinney, W. R., & Bonner, S. E. (2001). The effects of domain experience and task presentation format on accountants’ information relevance judgments. The Accounting Review, (July), 76, 405–430.

4

4

4 4 4

4

Table 3. Percentage of Articles by Identified Sub-Discipline Focus. Auditing (%) Financial accounting (%) Managerial accounting (%) Taxation (%) General theory (%) Other: education, IS (%)

42 25 17 3 12 1

Including all the articles identified on the 20 syllabi and required reading lists, Table 3 provides a breakdown of by sub-area covered by the syllabi. Table 4 lists topical areas frequently found among syllabi.

PROMINENT AUTHORS It has become an increasingly common practice to use citation analyses as a barometer of research performance. Normally, citation analyses focuses on the number of references to an article or author appearing in other articles in some sub-set of prestigious journals. In Table 5, we provide a variant of

High Impact Behavioral Accounting Articles and Authors

Table 4.

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Articles by Identified Topical Focus.

Consensual or Nearly Consensual Topics Accountability Budgets and negotiations Experience/expertise Framing effects (inc. outcome bias) Judgment and decision-making processes Heuristics, biases and belief revision Performance incentives Signaling and voluntary disclosures Frequently Included Topics Auditor independence Diagnostic reasoning and hypothesis generation Decision making in financial markets Learning Litigation Memory Motivated reasoning Probabilistic revision Research methods Trading markets Uncertainty and ambiguity Infrequently Included Topics Agency theory Ethics Education Modeling Psychological measurement

citation analyses that relies on a different type of article referencing: inclusion in required reading by doctoral students at the prominent institutions listed in Table 1. Thus, each author’s score is the sum of each article cited multiplied by the number of syllabi on which it was cited. No distinction is made between single authorship and co-authorship. The preponderance of these articles were written in the last 10 years. What greater accolade can an author receive than recognition of the merit of their research by that research being presented as models of excellence to the next generation of researchers.

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Table 5. Author Libby, Robert Bonner, Sarah E. Tan, Hun-Tong Kennedy, Jane Luft, Joan L. Nelson, Mark W. Bloomfield, Robert J. Sprinkle, Geoffrey Maines, Laureen A. Peecher, Mark E. Hunton, James E Moser, Donald V. Lipe, Marlys G. Shields, Michael D. Solomon, Ira Kachelmeier, Steven J. Kinney, William Hopkins, Patrick E King, Ronald R. Trotman, Ken T. Hirst, D. Eric Kahneman, Daniel Kida, Thomas E. Hogarth, Robin M Koonce, Lisa Peffer, Sean A. Tversky, Amos Pratt, Jamie H. Tubbs, Richard M. Frederick, David M. Frederickson, James R. Salterio, Steven Smith, James F. Young, Susan M. Lewis, Barry L. McDaniel, Linda S. McEwen, Ruth Ann Waller, William S. Ashton, Robert H. Camerer, Colin Jamal Karim Kleinmuntz, Don N. Wilks, T. Jeffrey

Most Frequently Cited Authors. Frequency 90 51 48 37 37 36 32 30 28 27 26 22 21 21 21 19 19 18 18 18 16 16 16 15 15 14 14 13 13 12 12 12 12 12 11 11 11 11 10 10 10 10 10