Research in Accounting Regulation, Volume 14 (Research in Accounting Regulation) 0762307358, 9780762307357, 9780080546247

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RESEARCH IN ACCOUNTING REGULATION

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

10th Anniversary Special

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RESEARCH IN ACCOUNTING REGULATION VOLUME 14

RESEARCH IN ACCOUNTING REGULATION EDITED BY

GARY J. PREVITS Case Western Reserve University, Cleveland, USA ASSOCIATE EDITOR

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

NANDANI CHANDAR School of Management, Rutgers University, USA

2000

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

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ELSEVIER SCIENCE Inc. 655 Avenue of the Americas New York, NY 10010, USA © 2000 Elsevier Science Inc. All rights reserved. This work is protected under copyright by Elsevier Science, and the following terms and conditions apply to its use: Photocopying Single photocopies of single chapters may be made for personal use as allowed by national copyright laws. Permission of the Publisher and payment of a fee is required for all other photocopying, including multiple or systematic copying, copying for advertising or promotional purposes, resale, and all forms of document delivery. Special rates are available for educational institutions that wish to make photocopies for non-profit educational classroom use. Permissions may be sought directly from Elsevier Science Global Rights Department, PO Box 800, Oxford OX5 1DX, UK; phone: (+44) 1865 843830, fax: (+44) 1865 853333, e-mail: [email protected]. You may also contact Global Rights directly through Elsevier’s home page (http://www.elsevier.nl), by selecting ‘Obtaining Permissions’. In the USA, users may clear permissions and make payments through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; phone: (978) 7508400, fax: (978) 7504744, and in the UK through the Copyright Licensing Agency Rapid Clearance Service (CLARCS), 90 Tottenham Court Road, London W1P 0LP, UK; phone: (+44) 207 631 5555; fax: (+44) 207 631 5500. Other countries may have a local reprographic rights agency for payments. Derivative Works Tables of contents may be reproduced for internal circulation, but permission of Elsevier Science is required for external resale or distribution of such material. Permission of the Publisher is required for all other derivative works, including compilations and translations. Electronic Storage or Usage Permission of the Publisher is required to store or use electronically any material contained in this work, including any chapter or part of a chapter. Except as outlined above, no part of this work may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the Publisher. Address permissions requests to: Elsevier Science Global Rights Department, at the mail, fax and e-mail addresses noted above. Notice No responsibility is assumed by the Publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent verification of diagnoses and drug dosages should be made. First edition 2000 Library of Congress Cataloging in Publication Data A catalog record from the Library of Congress has been applied for. ISBN: 0-7623-0735-8 ISSN: 1052-0457 ⬁ The paper used in this publication meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper). Printed in The Netherlands.

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CONTENTS EDITORIAL BOARD

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LIST OF CONTRIBUTORS

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INVITED REFEREES FOR VOLUME 14

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

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

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

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

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LIST OF CONTRIBUTORS

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

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

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

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ACCOUNTING: CONTINUITY AND TRANSITION Shyam Sunder

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

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QUO VADIS CPA? Gary John Previts

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

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

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

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

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

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

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LIST OF CONTRIBUTORS

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List of Contributors

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

Assistant Editor Nandani Chandar Rutgers University

EDITORIAL BOARD Dennis R. Beresford University of Georgia

Paul A. Pacter International Accounting Standards Committee

Peter Bible General Motors Corporation

Larry M. Parker Case Western Reserve University

Jacob Birnberg University of Pittsburgh

Robert H. Parker University of Exeter, England

Michael P. Bohan Deloitte & Touche, LLC

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

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

Robert Sack University of Virginia–Darden School

Timothy Fogarty Case Western Reserve University

E. Kent St. Pierre University of Delaware

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

William J. L. Swirsky Canadian Institute of Chartered Accountants

Harry T. Magill Arizona State University

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

Donald L. Neebes Ernst & Young, LLP

Wanda Wallace College of William and Mary

Hiroshi F. Okano Osaka City University, Japan

Yuksel Koc Yalkin University of Ankara ix

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LIST OF CONTRIBUTORS

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List of Contributors

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LIST OF CONTRIBUTORS

Asokan Anandarajan

New Jersey Institute of Technology

S. Douglas Beets

Wake Forest University

Michael E. Doran

Case Western Reserve University

Robert K. Elliott

American Institute of CPAs

Robert C. Elmore

Tennessee Technological University

Michael Ettredge

University of Kansas

Timothy J. Fogarty

Case Western Reserve University

Ross D. Fuerman

Frank Sawyer School of Management, Suffolk University

Lori Holder-Webb

Texas A&M University

J. Edward Ketz

Penn State University

Gary Kleinman

Fairleigh Dickinson University

Joseph Legoria

Mississippi State University

Paul L. Lejuez

Credit Suisse First Boston

Jimmy W. Martin

University of Montevallo

Barry Melancon

American Institute of CPAs,

Rahmadi Murwanto

Case Western Reserve University xi

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LIST OF CONTRIBUTORS

Dan Palmon

Rutgers - The State University of New Jersey

Larry Parker

Case Western Reserve University

Thomas L. Porter

Financial Accounting Standards Board

Gary John Previts

Case Western Reserve University

Robert J. Ramsay

University of Kentucky

Zabihollah Rezaee

Middle Tennessee State University

Vernon J. Richardson

University of Kansas

Kim R. Robertson

Trinity University

Arnold Schneider

Georgia Institute of Technology

Susan Scholz

University of Kansas

Pamela A. Smith

Northern Illinois University

Edward P. Swanson

Texas A&M University

Shyam Sunder

Yale University

Joseph Z. Szendi

Booz, Allen & Hamilton Inc.

Haoling Tan

Case Western Reserve University

Bob R.C.J. Van den Brand

Tilburg University

Michael S. Wilkins

Texas A&M University

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Contents

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

Jimmy W. Martin University of Montevallo

Aaron Ames Ernst & Young, LLP

Mary Medley Colorado Society of CPAs

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

Albert Nagy John Carroll University

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

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

Reza Espahbodi Indiana University

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AUTHOR

Going Concern Auditor Reports at Corporate Web Sites

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MAIN PAPERS

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MICHAEL ETTREDGE, VERNON J. RICHARDSON & SUSAN SCHOLZ

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

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

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

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MICHAEL ETTREDGE, VERNON J. RICHARDSON & SUSAN SCHOLZ

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

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

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

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

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

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

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

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MICHAEL ETTREDGE, VERNON J. RICHARDSON & SUSAN SCHOLZ

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

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

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

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MICHAEL ETTREDGE, VERNON J. RICHARDSON & SUSAN SCHOLZ

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

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

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Going Concern Auditor Reports at Corporate Web Sites

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

Number of Number of Web Web sites sought sites found

Percent

Going concern report companies Matched unmodified report companies

249 185

100 100

40 54

Total

434

200

46

Panel B: Industry Distribution of Sample SIC Codes

Sample %

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

4 18 33 8 6 3 24 4 0

Total

100

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

Descriptive Statistics of Web site Accounting Variables

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

Overall Percent

Chi-squared p-value 0.11 0.89 0.05

LEVEL0 LEVEL1 LEVEL2

32 53 15

22 52 26

27 52 21

Total sites

100

100

100

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

32 30 12 17 46 32 0 15

22 44 10 6 50 38 1 26

Overall Percent

Chi-squared p-value

27 37 11 12 48 35 1 21

0.11 0.04 0.65 0.01 0.57 0.37 n/a 0.05

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

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

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Table 3.

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

Unmodified n = 100

Sales (millions) Mean Median Std. Deviation

41.9 3.9 163.0

27.7 5.5 63.2

Net Income (millions) Mean Median Std. Deviation

–12.4 –5.4 29.6

–11.7 –4.0 29.1

Z-score Mean1 Median Std. Deviation

–5.7 –1.3 15.0

13.0 3.2 27.4

Analysts Mean1 Median Std. Deviation

0.2 0.0 0.6

1.0 0.0 1.8

Shareholders Mean Median Std. Deviation

1.4 0.6 2.1

1.1 0.6 1.4

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

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

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

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

LEVEL0

LEVEL1

0.4412 –0.6241 –0.7728 0.0044 –0.0198 –0.6674

*

0.3599 0.1807 0.7049 0.0046 0.1449 –0.6888

11.529

**

10.069

* *

LEVEL2

**

* *

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

**

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

GC

0.7069

GC

*

Independent variables Constant None

–0.1831 0.8682

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

–0.3606 0.6512 1.6291 *** 0.7415 0.0419 –6.2875

Full financial statements

–1.0334

LEVEL1

–0.2233

LEVEL2

–1.0270

ZSCORE

–0.1090 ***

ZSCORE

–0.1078 ***

SIZE

–0.1078

SIZE

–0.0980

Model Chi–square

**

60.132 ***

Model Chi–square

**

72.508 ***

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

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

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

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

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

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

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

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

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

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

Model 2:

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

Model 3:

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

Model 4:

GC

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

Model 5:

GC

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

LEVEL0

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

LEVEL1

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

LEVEL2

= = = = = =

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

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

GC

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

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Test and Control Variables GC

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

RETAIL

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

ANALYST

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

ZSCORE

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

SIZE

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Design A full factorial design would entail 144 treatments (2⫻3⫻2⫻2⫻2⫻3). To obtain five responses per cell would necessitate a total of 720 participants for a between subjects design. Since it would be extremely difficult and costly to obtain this total, we employed a fractional factorial design using 41 different versions of the instrument (40 treatments as well as one control group). This allowed analysis of all main effects between subjects.

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

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

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

N

Mean

Median

Standard Deviation

CONFIDENCE PROBLINE MAXLINE

193 193 193

6.74 48.92 $242,381

8 50 $200,000

2.51 34.62 $92,263

RATE EXPERIENCE CAPITAL STRUCTURE

193 193 193

1.27% 9.7 6.95

1.25% 9 7

0.62% 6.95 1.46

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

CONFIDENCE =

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

Table 2b. Personal Data Education Level High School

Bachelor’s Degree

Master’s or higher

116

70

7

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

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

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

Greater than $1,000,000,000

25

16

142

Average Loan Size Approved Less than $100,000 8

$100,000 to $200,000

$200,000 to $400,000

Greater than $400,000

18

50

117

Note: Cells indicate number of subjects in those groups.

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

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

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

Qualified Opinion

No Peer/Quality Review

Reputable Reviewer

Not Reputable Reviewer

Reputable Reviewer

Not Reputable Reviewer

CONFIDENCE Mean Standard Dev. Median Range

7.16 (1.80) 8 3–9

8.33 (1.62) 9 2–10

6.36 (2.48) 7 0–10

5.89 (2.72) 7 2–10

6.03 (2.68) 7 1–10

PROBLINE Mean Standard Dev. Median Range

44.32% (42.23%) 45% 0%–100%

52.28% (32.0%) 60% 0%–95%

50.09% (33.80%) 57.5% 0%–98%

50.57% (34.29%) 50% 0%–100%

45.10% (35.76%) 50% 0%–100%

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

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

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

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

1.05% (0.66%) 1% 0%–2%

1.36% (0.61%) 1.5% 0.25%–3%

1.31% (0.59%) 1.25% 0%–3%

1.19% (0.57%) 1.25% 0%–2%

1.30% (0.68%) 1.5% 0%–3%

19

46

46

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Table 1. Characteristics of Respondents NUMBER OF RESPONSES

PERCENTAGE

A. State supported or private State supported Private

115 175

39.7 60.3

B. Commuting or noncommuting Commuting Noncommuting

122 145

45.7 54.3

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

2 62 76 149

1.0 21.4 26.2 51.4

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

120 72 43 26 19 10

41.4 24.8 14.8 9.0 6.6 3.4

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

163 94 27 27 23 10 3

35.9 32.8 9.4 9.4 8.0 3.5 1.0

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

163 60 16 5

66.8 24.6 6.6 2.0

11 25 51 95 37 50 22

3.8 8.6 17.5 32.6 12.7 17.2 7.6

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

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

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

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

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Table 3.

Attributes of Audit Committees

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

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

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

PERCENTAGE 15.9 17.8 30.7 12.1 5.1 18.5 Mean Response = 3.280

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

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

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

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

45.2 32.9 21.6 16.8 8.6

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

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

4.015 3.878 3.821 3.628 3.527 3.198 3.010 2.804 2.625 2.487

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

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

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

CHI-SQUARE

n=115 3.7600 3.2500 2.8667

n=175 2.2674 2.5517 2.2222

19.9645** 6.1797* 0.5126

3.4545 2.0000 3.6667

2.5762 1.4804 2.0400

7.1195* 5.0739** 15.6158*

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

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

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Table 7.

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

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

CHI-SQUARE

n=115 3.2206 2.4203 3.5714

n=175 4.1349 2.7280 2.9841

25.6288** 1.3391 9.8109**

2.8261

2.7823

.0561

3.5441

4.2578

10.6928**

4.1176

3.1770

17.4479**

3.9275

3.8413

.6288

3.8696

3.4841

5.2928*

3.0725

2.9606

.3333

2.3676

2.5492

.7958

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

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

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

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

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

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

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Vicknair, D., Hickman, K., & Carnes, K. (1993). A Note On Audit Committee Independence: Evidence from the NYSE on “Grey” Area Directors. Accounting Horizons, (March), 53–57. Wagner, N. A., O’Keefe, H. A., & Bostock, W. J. (1988). Audit Committee Functions for Municipalities, Hospitals, and Banks. CPA Journal, (June), 58(6), 46–53. Wild, J. J. (1996). The Audit Committee and Earnings Quality. Journal of Accounting, Auditing and Finance, (Winter), 247–276. Wright, D. W. (1996). Evidence on the Relation Between Corporate Governance Characteristics and the Quality of Financial Reporting. Working paper, University of Michigan. Zahra, S. A., & Pearce, J. A. (1989). The Board of Directors and Corporate Performance: A Review and Integrative Model. Journal of Management, (June), 15(2), 291–334.

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

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

Research in Accounting Regulation, Volume 14, pages 61–80. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0735-8

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

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

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

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

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

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

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

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

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

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Table 1.

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

Phase 1 Units Fuel Utilization SO2 Emissions (mmBtu)

Transfers of EAs

Granted by Fed. Gov’t

EAs Carried over to 1998

emissions/ mmbtu

emissions/ EAs granted

EAs carried EA transfers/ over/ EAs granted EAs granted

(A)

(B)

(C)

(D)

(E)

(A/B)

(A/D)

(C/D)

(E/D)

1 2 3 4 mean p-value1

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