Managerial Auditing Journal - Vol 20 No. 1 2005: Auditing standards and perceptions

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ISBN 1-84544-072-2

ISSN 0268-6902

Volume 20 Number 1 2005

Managerial Auditing Journal Auditing standards and perceptions Editor: Gerald Vinten

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Managerial Auditing Journal

ISSN 0268-6902 Volume 20 Number 1 2005

Auditing standards and perceptions Editor Gerald Vinten

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Editorial advisory board _________________________

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The effect of audit outcomes on evaluators’ perceptions Keith T. Jones and Clement C. Chen ______________________________

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Audit anticipation: does it impact job performance? Adolph A. Neidermeyer and Presha E. Neidermeyer _________________

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Investment appraisal under conditions of continuous and discrete cash flows and discounting Tariq Ismail and Melinda Cline __________________________________

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Auditing standards in Poland: past, present and future Richard G. Brody, Stephen Moscove and Robert Wnek _______________

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Earnings management: evidence from SFAS No. 142 reporting Suzanne Sevin and Richard Schroeder ____________________________

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CONTENTS

CONTENTS continued

Real-option valuation of research and development investments: implications for performance measurement Hemantha S.B. Herath and Wayne G. Bremser _____________________

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Auditors’ perception of fraud risk indicators: Malaysian evidence Malcolm Smith, Normah Haji Omar, Syed Iskandar Zulkarnain Sayd Idris and Ithnahaini Baharuddin _____________________________________

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Audit quality and earnings management for Taiwan IPO firms Ken Y. Chen, Kuen-Lin Lin and Jian Zhou_________________________

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Managerial Auditing Journal Vol. 20 No. 1, 2005 p. 4 # Emerald Group Publishing Limited 0268-6902

EDITORIAL ADVISORY BOARD

Michael P. Cangemi Editor, IS Audit & Control Journal, Illinois, USA Dr Stanley Y. Chang Associate Professor of Accountancy, ASU West, Phoenix, Arizona, USA Jianmin Cui National Audit Office of PRC, China C.A. Grim Chairman, Atsui Solutions Limited, UK Dr George Holmes Professor Keith A. Houghton University of Melbourne, Australia Professor William Keogh School of Management, Heriot-Watt University, Edinburgh, UK Gerard E. McElwee University of Humberside, UK

Professor Charles Margerison International Management Centres, UK Dr John A. Mitchell Potters Bar, Herts, UK Dr Samuel M. Natale Adelphi University, School of Business, NY, USA Tudor Rickards Professor of Creativity and Change Management, Manchester Business School, Booth Street West, Manchester, UK Professor Malcolm Smith Dean (Research), Division of Business and Enterprise, University of South Australia, Adelaide, Australia Dr Ruth Taplin Centre for Japanese and East Asian Studies, Pinner, UK

The Emerald Research Register for this journal is available at www.emeraldinsight.com/researchregister

The current issue and full text archive of this journal is available at www.emeraldinsight.com/0268-6902.htm

The effect of audit outcomes on evaluators’ perceptions

The effect of audit outcomes

Keith T. Jones Department of Accounting, Finance and Information Systems, Eastern Kentucky University, Richmond, Kentucky, USA, and

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Clement C. Chen School of Management, University of Michigan, Flint, Michigan, USA Abstract Purpose – Examines the effects of the outcome of an over-budget audit on supervisors’ perceptions of the auditor’s performance. Design/methodology/approach – Uses a cognitive model developed by Lipe. In a computer-based experiment and an external audit context, professional auditors assumed the role of a supervisor evaluating a subordinate. Participants assessed the excess audit time in terms of perceived benefits to the firm and subsequently evaluated the job performance of the auditor. Findings – The results provide partial support for Lipe’s model, but differ in some respects. Interestingly, the effect of audit findings on the perceived benefit to the firm was not significant after considering experience in public accounting, but experience was not related to the actual performance evaluation. Instead, the audit outcome significantly affects the evaluation. Originality/value – The level of benefit perceived from the audit was also associated with framing the audit time in terms of a “cost” or “loss”. Finally, as subjects tended toward framing the excess time as a “cost”, they evaluated the auditor more favorably. Keywords Auditing, Performance appraisal, External auditing Paper type Research paper

Introduction Performance evaluation is arguably one of the most important processes in public accounting. Auditors are often evaluated on every engagement, and such evaluations become a primary input into periodic evaluations made for the purpose of promotions and raises (Wright, 1980; Hunt, 1995). If completed appropriately and objectively, performance evaluations may assist in quality control and may direct employees toward desired job behaviors (Hunt, 1995). Several streams of literature suggest that performance evaluations may be subject to biases often inherent in forming perceptions of others. For instance, evaluations of others’ decisions often occur after information about outcomes is available (Buchheit and Richardson, 2002). A bias may result when there is an “outcome effect”, which refers to the systematic overweighting of outcome knowledge by the evaluator in assessing another’s decision or performance (Ghosh and Ray, 2002; Hawkins and Hastie, 1990). When objective measures such as outcomes not controllable by a decision maker are used for subjective evaluations of performance, the outcome does not necessarily reflect performance. Therefore, its use may result in incorrectly rewarding or penalizing the person or group being evaluated, and the performance evaluation and control systems are suboptimal (Ghosh and Ray, 2002). In an audit context, the pressure to meet time budgets may lead auditors to forego audit

Managerial Auditing Journal Vol. 20 No. 1, 2005 pp. 5-18 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900410537801

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procedures that might otherwise be desirable if they fear that that they will be penalized in the event that a “clean opinion” ultimately results. The purpose of the current study is to extend an earlier study by Lipe (1993) that advanced a cognitive model to explain how outcomes of decisions affect perceptions. Specifically, this study manipulates the findings of an audit that is significantly over the time budget. The intent is to examine the impact of differing audit results on supervisors’ perceptions of benefits accruing to the firm as a result of the excess audit time. Lipe’s model is further tested to determine if perceptions of benefit are associated with “loss” or “cost” frames, which in turn are expected to be associated with the actual performance evaluation and the extent to which a supervisor would want to work with the same auditor in the future. Whether Lipe’s cognitive model extends to the context of evaluating a subordinate auditor’s engagement performance is unclear. First, her study focused on a managerial accounting context and used cost accounting students and business professionals. To some extent, the performance of a specific audit necessitates a short-term focus with a primary concern for managing risk on that specific audit. The idea of benefits and costs of each decision may not be as salient to the auditor in the performance of his/her normal responsibilities as auditors focus on complying with standards applicable to each individual audit. Second, because auditing standards require considerable documentation, the decision process in a “real” audit is arguably more observable to the evaluator than in many contexts. The evaluator is then in a better position to evaluate the process exclusive of the outcome. Consistent with the results of prior studies in other areas, the outcome of an over-budget audit affected performance evaluations positively when the audit resulted in significant financial statement adjustments and a qualified opinion as opposed to a clean opinion. Also, subjects indicated more strongly that they would like to work with the auditor on a future audit when the audit disclosed significant financial statement adjustments. The results provide some support for Lipe’s (1993) cognitive model in the audit context, but not in all respects. Specifically, subjects told that the audit resulted in significant financial statement adjustments associated a greater level of benefit accruing to the firm, which in turn was positively associated with the performance evaluation and subjects’ indications as to whether they would work with the auditor on a future assignment. However, the effect of audit findings on the benefit assessment was no longer significant after considering experience in public accounting, although the audit findings significantly affected the final performance rating. The level of benefit was further correlated with subjects’ framing of the additional audit time as a “cost” or a “loss”. The judgment of loss/cost was further associated positively with the performance evaluation such that, as the judgment tended toward “cost”, the performance evaluation increased in a moderately significant manner. The study also extends an earlier study by Kaplan and Reckers (1985) by incorporating the outcome of the audit. Kaplan and Reckers (1985) examined evaluators’ causal attributions as to whether a hypothetical subordinate was responsible for a time budget overrun, but did not vary the outcome of the audit in terms of financial statement adjustments and type of report issued. The results of the current study suggest that the results of an audit may change an evaluator’s perception of the excess time spent such that a benefit is perceived for the firm when the audit discloses problems. In turn, these changed perceptions appear to mitigate a tendency to perceive a budget overrun as substandard performance.

The following sections provide the theoretical development, hypotheses tested, and the experimental design used to test the hypotheses, followed by the results of statistical tests and a discussion of the implications of the results. Theory and hypothesis development Based largely on the early work of Fischoff (1975), several accounting studies (e.g. Brown and Solomon, 1987; Lowe and Reckers, 1994; Anderson et al., 1997; Frederickson et al., 1999; Ghosh and Lusch, 2000) find that evaluators’ perceptions of accountants and/or managers are influenced by outcomes. A bias may occur when one’s knowledge of the outcome of a decision influences the evaluator’s perceptions and the outcome is not informative about the decision (Baron and Hershey, 1988; Hershey and Baron, 1992). When the decision process is observable, decision theories suggest that outcomes should be excluded from the assessment of decision quality (Brown and Solomon, 1987). Most recent studies in the accounting literature have focused on how the effects of outcomes are exacerbated or mitigated. For example, Brown and Solomon (1987) and Fisher and Selling (1993) demonstrate that observability of the decision process can indeed mitigate the outcome effect. Few studies have modeled the outcome effect from a cognitive standpoint, with two notable exceptions. In a managerial context, Brown et al. (1993) found that outcome effects are associated with “cognitive reconstruction”. In another managerial accounting study, Lipe (1993) found that the outcome of a variance investigation affects cognitively-perceived benefits resulting from the investigation expenditure, which in turn are related to how an evaluator frames the investigation as a “cost” or a “loss”. In the context of a specific audit, the “outcome” could be viewed as whether or not significant findings resulted from the audit. If an auditor exceeds a time budget, yet finds significant issues resulting in a qualified opinion, past research relating to outcomes suggests that he/she will be rated more favorably if the audit yields significant findings. Earlier studies by Kaplan and Reckers (1985, 1991, 1993) based on attribution theory assume that exceeding the time budget and failing to meet the client-imposed deadline necessarily constitutes poor performance. They then test subjects’ attributions as to the cause of the substandard performance. However, their scenarios indicated only that a clean opinion resulted. Although a supervisor may indeed blame the subordinate for such behaviors as exceeding the budget when no significant findings result, research on outcome effects suggests that a positive (negative) outcome from the additional time spent may modify these attributions or temper (exacerbate) their effects on the performance evaluation. The evaluator may actually view the excess time differently, as suggested by Lipe’s (1993) finding in a managerial accounting context, and evaluate the subordinate accordingly. The first hypothesis is intended to document that outcome effects indeed extend to auditing. H1. Evaluators will provide higher performance ratings when an over-budget audit results in significant findings than when no significant findings are indicated. Kaplan and Reckers (1991, 1993) further suggest that an important performance-related judgment is whether or not the evaluator would desire to work with an auditor on future assignments. They note that such informal decisions are important in scheduling audits and that the most promising auditors are assigned to

The effect of audit outcomes

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the most desirable engagements. They found that respondents were more (less) likely to seek the senior on future assignments if poor performance was attributed to an external (internal) cause. That is, if poor performance can be attributed to causes outside the subordinate’s control, evaluators are less likely to blame the subordinate and more likely to seek him/her out on future assignments. Again, however, their studies did not include information about the outcome of the audit in terms of findings and type of report issued. If a “positive” outcome is indicated from the excess audit time, and indeed changes an evaluator’s perceptions of the audit performance, then evaluators will likely have more desire to work with the subordinate in the future. This argument leads to the following hypothesis: H2. Evaluators will be more likely to seek an over-budget auditor on future audit assignments when the audit results in significant findings than when no significant findings are indicated. Based on earlier work in what is referred to as “mental accounting” (Hirst et al., 1994; Tversky and Kahneman, 1981; Thaler, 1985; Thaler, 1990; Mowen and Mowen, 1986), Lipe (1993) posits that an investigation expenditure incurred relative to a production variance may be framed as a cost or a loss. Specifically, if a benefit is posted to the “psychological account” containing the expenditure, the investigation should be framed as a “cost” as opposed to a “loss”. The decision to investigate the variance would then be considered more appropriate and the resulting performance evaluation would be higher when the expenditure was framed as a cost. Consistent with expectations, a greater benefit was associated with the expenditure when the system was found to be out of control than when no problems were noted. The benefit rating was then significantly correlated with the judgment of loss/cost, which in turn was positively related to the performance evaluation. In the context of an audit that is over budget, auditor evaluators may be more likely to associate a benefit with the additional time spent when significant financial statement adjustments result from the audit. Given auditors’ loss functions (Anderson and Kida, 1989), significant audit adjustments may be associated with reducing the firm’s risk, and the use of additional time may be thought appropriate because the firm has received something in return for the excess audit time. That is, the audit findings may be viewed as an enhancement to the effectiveness of the audit. On the other hand, given firms’ concerns for efficiency, a lack of findings may be associated with an imprudent use of time and little or no increase in audit effectiveness. This argument leads to the following hypothesis. H3. A greater benefit to the firm will be perceived when significant audit time over budget results in significant findings than when no findings resulted. Lipe (1993) found that a greater perceived benefit of a variance investigation was associated with the framing of an investigation expenditure as a “cost”, as opposed to a “loss”. Applying her theory to the audit context, evaluators of other auditors’ performance are likely to view a qualified opinion as a benefit to the firm in the form of reduced exposure to risk, because the audit has put report users on notice regarding apparent departures from applicable criteria. Therefore, they are more likely to view the additional time as an investment as opposed to a loss. On the other hand, the same evaluators are less likely to perceive a clean opinion as resulting in any real benefit to

the firm unless they attribute sound judgment to the auditor and take into account that the additional time could just as easily have disclosed significant problems. As a result, they are expected to lean more toward framing the additional time as merely a loss to the firm. These arguments lead to the following hypothesis: H4. As a greater benefit is associated with excess audit time, evaluators will tend more toward a “cost” frame than a “loss” frame.

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Also consistent with Lipe (1993), the framing of additional time spent should be associated with the performance evaluation such that a tendency toward a cost frame should be associated with a higher evaluation and a greater likelihood that the evaluator will seek to work with the auditor on a future engagement. In contrast, the auditor held responsible for a “loss” is likely to be evaluated relatively less favorably and the evaluator may be less inclined to seek the auditor in the future. These arguments lead to the following hypotheses: H5. Performance evaluations will be positively associated with the tendency to frame excess audit time as a “cost” rather than a “loss”. H6. Intentions to seek an over-budget auditor on future audit assignments will be positively associated with the tendency to frame excess audit time as a “cost” rather than a “loss”. Figure 1 shows a diagram of the model pertinent to the current study, adapted from Lipe’s (1993) cognitive model. Design and subjects The experiment was conducted using a computer-based instrument included as part of a larger project relating to performance evaluation in auditing. Subjects read a short case (Appendix 1) describing an audit that significantly exceeded the time budget. The case was adapted from Kaplan and Reckers (1985) and changed to include a manipulation for whether the audit disclosed major findings (i.e. significant financial statement adjustments and a qualified opinion). In the “no findings” treatment, the case indicates that an unqualified opinion was ultimately issued without significant financial statement adjustments. In the “findings” treatment, the case indicates that significant statement adjustments resulted and a qualified opinion was issued. To

Figure 1. Hypothesised relationships

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demonstrate that any outcome effects noted are “non-normative” (Hershey and Baron, 1992), each treatment indicated that the additional work performed was reasonable based on information encountered in the audit, and that the time to complete the additional steps was reasonable. After reading the case, subjects proceeded to another screen that solicited their perceptions as to how much benefit the firm received as a result of the audit, on an 11-point scale (Appendix 2) adapted from Lipe (1993). This screen also asked subjects to indicate the extent to which they viewed the additional time as a “cost” rather than a “loss” (Appendix 2). Again, this scale was the same as that used in Lipe (1993), adapted to the audit context. Following this screen was a separate screen (Appendix 3) asking for subjects’ assessments of overall performance on the audit on a seven-point scale from 1 (poor) to seven (outstanding) and the extent to which subjects would want to work with the subordinate in the future, also on a seven-point scale (1 ¼ not at all; 7 ¼ to a great extent). Subjects provided responses to demographic information following their completion of the overall experiment. A total of 138 diskettes were mailed to a central contact point at one big five firm, who then distributed the diskettes to senior auditors at 17 offices of the firm, located primarily in the mid-west and south-east. Subjects mailed the diskettes directly to the researcher, who did not know their identity. A total of 62 auditors returned diskettes, 11 who indicated that they chose not to complete the experiment. Another four indicated that they completed the experiment; however, the diskette contained no output file, apparently because the subject pulled the diskette prior to proceeding to the final screen. The result was 47 usable responses, for an effective response rate of 34 percent. Descriptive information Following the completion of all tasks in the experiment, subjects responded to a number of questions seeking demographic information and their perceptions of the overall experiment. Of the 47 participants, 30 were male and 17 were female. Subjects indicated an average of 35 months’ experience in public accounting and 19 performance evaluations previously prepared on the job. A total of 35 participants were certified public accountants[1]. Hypothesis tests Because experience has been studied extensively in previous literature with varying results (Choo, 1989; Davis and Solomon, 1989; Colbert, 1989; and Bonner and Pennington, 1991 provide reviews), two measures of experience were used to assess whether experience should be included as a control variable. The first measure was the number of performance evaluations previously prepared on the job, as reported by subjects. The second measure was the number of months of experience subjects had in public accounting. Separate regression analyses were used for each of the primary dependent variables of interest in the study. An indicator variable was used for the findings treatment with “0” indicating “no findings” and “1” indicating “significant findings”. The results of these regression analyses will be discussed separately in the following paragraphs in relation to the discussion of specific hypothesis tests. Consistent with prior literature on the effects of outcomes in managerial accounting (e.g. Lipe, 1993), the first hypothesis predicts that subjects in the “significant findings” condition will provide higher ratings of audit performance than will subjects in the “no findings” condition. H2 then predicts that subjects in the “significant findings”

condition will be more likely to want to work with the auditor on future assignments. Table I provides the mean performance evaluation and standard deviation for subjects in the two groups. The table also provides similar information with respect to the extent to which subjects would seek out the auditor on a future engagement. As shown in Table I, subjects who read that the audit disclosed significant findings provided an average performance rating of 5.48, while those who read that there were no significant findings provided an average rating of 4.50. A t-test indicates that the difference is significant (t ¼ 3.76; p , 0.001, one-tailed; df ¼ 45). When the performance evaluation is regressed on the findings treatment and the experience variables (separately for the two experience measures), experience is not significant while the findings treatment remains significant ( p , 0.05, two-tailed). Neither experience measure interacts significantly with the findings treatment. Therefore, H1 is strongly supported. Table I shows that subjects in the “significant findings” condition provided a mean response of 5.43 when asked the extent to which they would seek out the auditor on a future engagement. Subjects in the “no findings” condition provided a mean response of 4.58. This difference is significant (t ¼ 2.84; p , 0.005, one-tailed; df ¼ 45). As was the case for H1, when the desire to work with the subordinate in the future is regressed on the findings treatment and the experience variables (separately), experience is not significant while the findings treatment is significant ( p , 0.05, two-tailed). These results provide strong support for H2. H3 predicts that subjects will perceive a greater benefit to the firm when excess audit time results in significant findings than when no significant findings are indicated. As shown in Table I, subjects in the “significant findings” condition provided a mean benefit rating of 77.83, while subjects in the “no findings” conditions provided a mean rating of 64.58. This difference is statistically significant (t ¼ 2.23; p , 0.02, one-tailed; df ¼ 45). The regression analysis shown in Table II indicates that only experience (months in public accounting) is significant in assessing the level of benefit derived from the excess audit time. The interaction between the findings treatment and the experience variable is not significant, nor is the findings treatment. The variable labeled “EXPER” indicates the relationship between months of experience and the perceived benefit when there are no findings from the audit. In this case, experience bears a significant positive relationship to the benefit rating ( p , 0.03 two-tailed). A separate analysis using only the responses from the “significant findings” treatment shows that the relationship between the experience measure and the benefit rating remains positive and marginally significant (t ¼ 1.80; p , 0.10, two-tailed; df ¼ 22). These results suggest that, after accounting for months of public accounting experience, the findings

Treatment

n

Findings No findings

23 24

Perfeval Mean SD 5.48 4.50

0.73 1.02

Seeknext Mean SD 5.43 4.58

0.90 1.14

Benefit Mean SD

Mean

SD

77.83 64.58

72.61 60.42

21.37 24.58

20.66 20.00

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Cost

Notes: perfeval ¼ engagement performance rating on seven-point scale from 1 (poor) to 7 (outstanding); seeknext ¼ extent to which evaluator would wish to work with the auditor in the future on a seven-point scale from 1 (not at all) to 7 (to a great extent); benefit ¼ perceived benefit to the firm of excess audit time, on a 100-point scale from 0 (no, there was no benefit) to 100 (yes, there was a benefit); cost ¼ perception of excess audit time on a 100-point scale from 0 (loss) to 100 (cost)

Table I. Mean subject responses by treatment condition

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Table II. Regression results for H3

Unstandardized coefficients B Std error

Standardized coefficients Beta

t

p-value

Dependent variable: perceived benefit to the firm resulting from excess audit time, on a 100-point scale from 0 (no, there was no benefit) to 100 (yes, there was a benefit) (Constant) 48.084 8.202 5.863 0.000 FIND1 14.097 13.264 0.336 1.140 0.261 EXPER 0.488 0.214 0.413 2.282 0.028 FINDXEXP 2 0.060 0.313 20.063 20.191 0.849 Notes: FIND1 ¼ indicator variable for findings treatment: 0 ¼ no findings; 1 ¼ findings; EXPER ¼ number of months’ experience in public accounting, as reported by subjects. Variable represents the effect of experience when FIND1 ¼ 0, i.e. no significant findings; FINDXEXP ¼ interaction between findings treatment and experience

treatment does not affect the assessment of benefit derived from the excess audit time. Therefore, H3 is not supported after considering experience. Consistent with Lipe’s (1993) model, H4 predicts that those associating a higher level of benefit with the over-budget audit will be in a “cost” frame as opposed to a “loss” frame for those associating a lower level of benefit with the audit. The Pearson correlation of 0.229 is not significant ( p , 0.10, two-tailed). However, the “benefit” and “cost” variables appear to deviate from normality because there were a disproportionate number of responses above 50 on both scales (37 responses on the benefits scale and 35 responses on the cost/loss scale). In this instance, a Spearman’s rho is appropriate. This correlation (0.293) is significant ( p , 0.05, two-tailed). The results provide support for H4[2]. H5 predicts that, the more subjects tend to frame excess audit time as a “cost” as opposed to a “loss”, the higher they will rate the performance of the auditor. Panel A of Table III provides the results of regressing the performance evaluation on subjects’ assessments of loss/cost associated with the audit. As expected, the assessment of loss/cost is positively related to the evaluation of audit performance. The regression is moderately significant ( p , 0.06, two-tailed), providing support for H5. H6 predicts that the more subjects tend to frame excess audit time as a “cost” as opposed to a “loss”, the more likely they will seek out the auditor on a future audit.

Coefficients

Table III. Results of regression analysis for H5 and H6

Unstandardized coefficients B Std error

Standardized coefficients Beta

t

p-value

Panel A (for H5). Dependent variable: evaluation of audit performance on a seven-point scale from 1 (poor) to 7 (outstanding) (Constant) 4.187 0.431 9.717 0.000 COST 1.193E-02 0.006 0.279 1.948 0.058 Panel B (for H6). Dependent variable: extent to which evaluator would wish to work with the auditor in the future on a seven-point scale from 1 (not at all) to 7 (to a great extent) (Constant) 4.095 0.469 8.741 0.000 COST 1.363E-02 0.007 0.292 2.047 0.047 Note: COST ¼ perception of excess audit time on a 100-point scale from 0 (loss) to 100 (cost)

Panel B of Table III provides the results of regressing subjects’ intentions to seek out the auditor on subjects’ assessments of loss/cost associated with the additional audit time spent. The regression is significant ( p , 0.05, two-tailed) and indicates the expected positive relationship. Therefore, H6 is supported.

The effect of audit outcomes

Discussion and conclusions The research findings demonstrate the robustness of the theory on outcome effects to the context of evaluating audit engagement performance and provide evidence that evaluators may differentially “frame” a significant time budget overrun depending on the outcome, thereby affecting the performance evaluation. The results suggest that evaluations of an over-budget auditor may suffer unless the additional time spent on the audit ultimately discloses significant problems. Performance evaluations and intentions to seek out the auditor on future engagements were both significantly affected by the outcome of the additional audit time, providing strong support for the first two hypotheses. If an audit is well-documented, the evaluator has considerable information regarding the decision process of the original decision maker, which arguably should outweigh the effects of the outcome (Brown and Solomon, 1987). However, the effects of the audit outcome occurred despite information suggesting that the decision to spend the additional time was reasonable, ex-ante. Lipe’s (1993) cognitive model may provide some explanation as to how these tendencies occur. Specifically, the outcome of the audit appears to affect how the excess audit time is framed in an evaluator’s mind, thereby affecting their perceptions of audit performance. However, the model partially breaks down in the current study when some of the intermediate relationships are tested. First, with respect to the assessment of benefit derived by the firm from the excess audit time, experience (months in public accounting) appears to “swamp” any effect of audit findings on the benefit assessment, although experience bears no significant relationship with the actual performance evaluation. Second, relating the benefit assessment to the loss/cost “frame” was problematic because the auditor/evaluators disproportionately responded on the positive half of both scales, regardless of experimental treatment. Lipe’s results using cost accounting students and business persons indicated that more distinct loss/cost “frames” were discernible in her study. With regard to the lack of more distinct frames, perhaps the professional auditors involved in the current study – who were predominately seniors – had a greater empathy for the auditor who exceeded the time budget because they cope with these budgets on a daily basis. If so, their understanding of the situation could explain why most subjects tended toward the positive half of the benefits and cost/loss scales. Nevertheless, it still appears they were ultimately influenced by the outcome of the audit when they actually assigned a performance rating. It is also likely that auditors are not conditioned to think in the same terms on a daily basis as managerial accountants due to different risks and priorities. While profitability is certainly important to accounting firms as to any other for-profit business at the firm level, auditors’ somewhat unique risks likely lead to very different conditioning. Such terms as “losses” and “profitability” are arguably more important and salient in the short-term for managerial accountants than for senior-level auditors with respect to their daily responsibilities. Ghosh and Ray (2002) further argue that evaluators may view an expenditure as merely another item of expense rather than as a “cost” or “loss”, unless the labels are explicitly brought to the evaluator’s attention.

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The findings regarding experience in public accounting are perhaps particularly noteworthy. As stated previously, experience is significantly and positively associated with the level of benefit perceived from excess audit time. However, this experience is not significantly associated with the final performance evaluation or the extent to which subjects would like to work with the senior on future audits. Also, experience does not interact with the findings treatment with respect to any of the primary judgments examined in this study. Therefore, although experienced auditors may better understand why the subordinate exceeded the time budget and perceive more benefit to the firm, there is no corresponding increase in the evaluation of the subordinate. Instead, the findings treatment affects these important judgments significantly. The findings of the current study must be interpreted in light of certain limitations. First, participants were from one large firm and were primarily seniors. Therefore, the results are not necessarily generalizable to other public accounting firms or to managers and partners. Second, there may be other variables that would affect evaluators’ perceptions. For example, the experience of the subordinate may affect subjects’ perceptions such that subordinates with relatively less experience will be evaluated in a more lenient manner. Future studies should perhaps vary the experience level of the subordinate to determine if there are interactive effects between this experience level and the treatments applied in the current study. Finally, the trend toward “continuous auditing” has likely increased the level of up-front attention by those supervising audits, and may reduce the cognitive tendencies noted in the current paper. As stated, however, the outcome effects occurred despite information suggesting that the decision to spend the time was reasonable, ex-ante. In addition to the variables mentioned in the previous paragraph, future studies should look more closely at the factors that tend to mitigate or exacerbate the effects of outcomes. As Brown and Solomon (1987) point out, these factors may be more informative than simply documenting the effect. In a managerial accounting context, they found that the effects of outcomes were reduced when the evaluator had prior involvement with the decision. Similarly, Fisher and Selling (1993) found that observability of the decision process mitigated the outcome effect in a bankruptcy prediction task. The results of the current study deviate somewhat from these two prior studies in that outcome effects occurred although subjects in both treatments had at least some information suggesting that the decision process was reasonable. Finally, since the assessed business risk in an audit may be affected by the overall size and other aspects of the client, future researchers should consider varying these aspects of the client. Notes 1. The gender of the evaluator and CPA designation (yes/no) were tested with respect to the primary dependent variables in this study. Neither variable was significant at conventional levels. Therefore, these variables were excluded from subsequent analyses. 2. Also consistent with Lipe (1993), the responses were further categorized as “no benefit” or “loss” when the response was below 50 and “benefit” or “cost” when the response was above 50. A Chi-square test was then used to assess the relation between perceived benefit and frame. The Chi-square statistic is not significant, indicating that the perceived benefit and cost/loss frames are independent (Yates corrected Chi – square2 ¼ 0:000, df ¼ 1, p ¼ 1:000, two-sided). In the current study, there were disproportionately fewer responses that fell below 50 on either of the two scales. Therefore, the lack of consistency with Lipe’s findings for this test may be partially due to the skewed distribution of responses.

References Anderson, B. and Kida, T. (1989), “An examination of the strategies used by auditors to test inherited hypotheses”, unpublished manuscript. Anderson, J.C., Jennings, M.M., Lowe, D.J. and Reckers, P.M.J. (1997), “The mitigation of hindsight bias in judges’ evaluation of auditor decisions”, Auditing: A Journal of Practice and Theory, Vol. 16 No. 2, pp. 20-39. Baron, J. and Hershey, J.C. (1988), “Outcome bias in decision evaluation”, Journal of Personality and Social Psychology, Vol. 54 No. 4, pp. 569-79. Bonner, S.E. and Pennington, N. (1991), “Cognitive processes and knowledge as determinants of auditor expertise”, Journal of Accounting Literature, Vol. 10, pp. 1-50. Brown, C.E. and Solomon, I. (1987), “Effects of outcome information on evaluations of managerial decisions”, The Accounting Review, Vol. 62 No. 3, pp. 564-77. Brown, C.E., Solomon, I. and Jamal, K. (1993), “An experimental investigation of explanations for outcome effects on appraisals of capital-budgeting decisions”, Contemporary Accounting Research, Vol. 10 No. 1, pp. 83-111. Buchheit, S. and Richardson, B. (2002), “Outcome effects and capacity cost reporting”, Managerial Finance, Vol. 27 No. 5, pp. 3-17. Choo, F. (1989), “Expert-novice differences in judgment/decision making research”, Journal of Accounting Literature, Vol. 8, pp. 106-36. Colbert, J.L. (1989), “The effect of experience on auditors’ judgments”, Journal of Accounting Literature, Vol. 8, pp. 137-49. Davis, J.S. and Solomon, I. (1989), “Experience, expertise, and expert-performance research in public accounting”, Journal of Accounting Literature, Vol. 8, pp. 150-64. Fischoff, B. (1975), “Hindsight – foresight: the effect of outcome knowledge on judgment under uncertainty”, Journal of Experimental Psychology, Vol. 1 No. 3, pp. 288-99. Fisher, J. and Selling, T. (1993), “The outcome effect in performance evaluation: decision process observability and consensus”, Behavioral Research in Accounting, Vol. 5, pp. 58-77. Frederickson, J.R., Peffer, S.A. and Pratt, J. (1999), “Performance evaluation judgments: effects of prior experience under different performance evaluation schemes and feedback frequencies”, Journal of Accounting Research, Vol. 37 No. 1, pp. 1-15. Ghosh, D. and Lusch, R.F. (2000), “Outcome effect, controllability and performance evaluation of managers: some field evidence from multi-outlet businesses”, Accounting, Organizations and Society, Vol. 25, pp. 411-25. Ghosh, D. and Ray, M. (2002), “Evaluating managerial performance: mitigating the ‘outcome effect’”, Journal of Managerial Issues, Vol. 12 No. 2, pp. 247-60. Hawkins, S.A. and Hastie, R. (1990), “Hindsight: biased judgments of past events after the outcomes are known”, Psychological Bulletin, Vol. 107 No. 3, pp. 311-27. Hershey, J.C. and Baron, J. (1992), “Judgment by outcomes: when is it justified?”, Organizational Behavior and Human Decision Processes, Vol. 53, pp. 89-93. Hirst, D.E., Joyce, E.J. and Schadewald, M.S. (1994), “Mental accounting and outcome contiguity in consumer-borrowing decisions”, Organizational Behavior and Human Decision Processes, Vol. 58, pp. 136-52. Hunt, S.C. (1995), “A review and synthesis of research in performance evaluation in public accounting”, Journal of Accounting Literature, Vol. 14, pp. 107-39. Kaplan, S.E. and Reckers, P.M.J. (1985), “An examination of auditor performance evaluation”, The Accounting Review, Vol. 60, July, pp. 477-87.

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Kaplan, S.E. and Reckers, P.M.J. (1991), “An attributional analysis of the performance evaluation process”, Advances in Accounting, Vol. 9, pp. 227-48. Kaplan, S.E. and Reckers, P.M.J. (1993), “An examination of the effects of accountability tactics on performance evaluation judgments in public accounting”, Behavioral Research in Accounting, Vol. 5, pp. 101-23. Lipe, M.G. (1993), “Analyzing the variance investigation decision: the effects of outcomes, mental accounting, and framing”, The Accounting Review, Vol. 68 No. 4, pp. 748-64. Lowe, D.J. and Reckers, P.M.J. (1994), “The effects of hindsight bias on jurors’ evaluations of auditors decisions”, Decision Sciences, Vol. 25 No. 3, pp. 401-26. Mowen, M. and Mowen, J. (1986), “An empirical examination of the biasing effects of framing on business decisions”, Decision Sciences, Vol. 17, pp. 596-602. Thaler, R. (1985), “Mental accounting and consumer choice”, Marketing Science, Vol. 4 No. 3, pp. 199-214. Thaler, R. (1990), “Anomalies: saving, fungibility, and mental accounts”, Journal of Economic Perspectives, Vol. 4 No. 1, pp. 193-205. Tversky, A. and Kahneman, D. (1981), “The framing of decisions and the psychology of choice”, Science, Vol. 211 No. 30, pp. 453-8. Wright, A. (1980), “Performance appraisal of staff auditors”, The CPA Journal, Vol. 50, November, pp. 37-43.

Appendix 1

Figure A1. Initial screen – “no findings” treatment

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Figure A2. Initial screen – “significant findings” treatment

Appendix 2

Figure A3. Screen two – benefit rating and “cost/loss” scale

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Figure A4. Screen three – performance evaluation and desire to work with the auditor on future engagements

Appendix 3

The Emerald Research Register for this journal is available at www.emeraldinsight.com/researchregister

The current issue and full text archive of this journal is available at www.emeraldinsight.com/0268-6902.htm

Audit anticipation: does it impact job performance?

Audit anticipation

Adolph A. Neidermeyer Department of Accounting, West Virginia University, Morgantown, West Virginia, USA, and

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Presha E. Neidermeyer School of Business, The Graduate Management College of Union University, Schenectady, New York, USA Abstract Purpose – To determine if the anticipation of an initial audit affects an individual’s accuracy in preparing vouchers – an accounting task – in a business environment. Design/methodology/approach – A laboratory setting was chosen to maintain greater control over the variables influencing an individual’s performance of a typical accounting activity. Findings – The results of the analyses indicated that anticipation of the audit does influence accuracy of performance of the participants, who made a statistically significant smaller number of errors than their counterparts not anticipating an audit. The research design involved varying the content and source of the communications which subjects received describing the purpose and conduct of the audit. The subjects chosen for the experiment were 90 College of Business and Economics students. Research limitations/implications – The study uses students to surrogate for internal audit personnel and it is based in the USA, which may limit its usefulness elsewhere. Practical implications – The results of this study indicate that management should continue or consider using an audit as a component of its overall control system. Further, they should be as forthcoming as possible concerning the scope of the audit since study results indicate that employees are inclined to focus on management-provided measurement points. Originality/value – This paper helps fill a void in the literature as to whether audits improve performance. Keywords Auditing, Performance management Paper type Research paper

Performance changes resulting from anticipation of an audit Although the audit has become a prevalent organizational phenomenon, little is known of the impact that the anticipation and/or actual occurrence of an audit has on the performance of individuals within the audited firm. The purpose of this exploratory paper is to determine if the anticipation of an audit affects an individual’s accuracy in performing an accounting task. A laboratory setting was chosen to maintain greater control over the variables influencing an individual’s performance of a typical accounting activity, the preparation of vouchers. This study’s audit staff is described as being interested in reviewing support documentation (i.e. vouchers) from the firm’s accounting records. Variation in the accuracy of performing the accounting task will be measured by documenting the number of errors made by each individual clerk in processing the assigned vouchers.

Managerial Auditing Journal Vol. 20 No. 1, 2005 pp. 19-29 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510570669

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To allow for both the isolation of the effects anticipation of an audit has on performance and an explanation of any changes in performance, the following behavioral variable was manipulated in the experiment. Variations in the communication provided to subjects: (1) No communication that the audit would occur. (2) Communication that audit would occur: . slight information about the audit; and . complete information about the audit. The individual’s accuracy of performance, the number of processing errors committed, under each scenario was then measured. Varying communications concerning the purpose and conduct of the audit were designed to represent potential information sets existing in an actual organizational setting. The variations in communications in this study ranged from no information about the audit being communicated to the subjects, to a setting where detailed information concerning the conduct and purpose of the audit were communicated. A description of the accounting task given to each participant and the various communications may be found in Appendices 1-5. This investigation concentrated upon one component of the dependent variable designated as performance: accuracy. Performance of these individuals was defined by the accuracy and speed of their work. For this experiment, accuracy was identified by tabulating the errors[1] each subject made in performing voucher preparation. Theoretical model A theoretical model of the impending audit situation within the accounting framework interfaces the psychology and work management disciplines. This initial study suggests that the accounting clerks in the audited firm were experiencing the audit for the first time. Therefore, a typical accounting clerk might be somewhat uncertain about the audit effect. Ambiguity was experienced by the accounting clerk since an established work environment with a well-defined work role was changed by the impending presence of an outsider (the auditor) to the organization. As the auditor reviewed the inputs to and outputs of the accounting system of the firm, the accounting personnel might experience confusion about the audit’s potential impact because of uncertainty over: . the audit’s purpose; . the audit techniques; or . how management might use audit results. Prior literature has suggested that individuals encountering a changed environment from their prior state will seek information to clarify their new position and reduce their organizational stress. Role conflict and role ambiguity are the two primary sources of organizational stress (Jackson and Schuler, 1985; Tubre and Collins 2000). Role conflict refers to inconsistent job performance as compared to evaluation criterion (Kahn et al., 1964). In the current testing environment, this would be the potential unknown way in which the inputs prepared to the system would be used and how this might impact their job evaluation. Role ambiguity suggests that the information required to fulfill the requirements of the job are inadequate. Within the current task, this is illustrated through the unknown nature of the work done by a new person (the

auditor) with process within the known work environment. Both these types of stressors divert an employee’s job performance effort toward coping with the stressors themselves. Thus the presence of more of less information about the use of the documentation prepared by the accounting clerk should yield a differentiation in the number of errors made. Mints (1972) used a laboratory setting to review three styles of auditing (traditional, current-moderate, and participative) to determine the time required to complete a task. The participative method was shown to be more effective and efficient. Morgan and Pattison (1975) used a pilot study to explore whether personal frames of reference for individuals anticipating an audit working in four separate departments within a firm differed. Findings indicate substantial variation. These two studies suggest that an audit did influence employee behavior in a variety of ways. The current study will add to this limited knowledge. Additional information concerning the behavior of the individual facing an audit has been drawn from Heider’s balance theory. Heider depicted the individual as possessing unit and sentiment relations in his cognitive state (Heidner, 1958). His theory identified the possible sentiments (i.e. likes, dislikes) that existed between the unit relations (cognitive categories) of the individual. Heider’s main thrust for discussion was that an individual strives for a balance in these perceived relationships. The assumption for the cognitive state of accounting personnel was that they were operating in a balanced cognitive state before becoming aware that an audit would occur. When the individual became aware of the impending occurrence of an audit, this disrupted the balance in the individual’s cognitive state. Heider theorized that the individual would initiate activity to restore balance to his cognitive state. If this were true, the accounting clerk who experienced an element of ambiguity in his audit situation was likely to deal with the lack of information by actively seeking or responding to information, which reduced this ambiguity. If the sought-after information was acquired, it might serve as the basis for restoring balance to the individual’s cognitive state. Festinger’s discussion of predecision behavior indicated that an individual faced with a choice in behavior (Festinger and Maceoby, 1964) was receptive to information concerning the behavioral alternatives. In the present study, the clerks operated within a wide spectrum of informedness about the audit. The least informed position would come from an individual accounting clerk unaware that the audit was taking place thus continuing to operate in his/her known realm. Once informed of the impending audit, the clerk might either seek out information themselves or be informed by one (or several) of three groups: (1) Fellow employees. (2) Management. (3) The auditors. The information garnered could range from no information; incomplete information; or complete information. No information would be represented by an individual without knowledge of the impending audit. Partial information might range from knowing what the auditors would be looking at but not knowing the purpose of their inquiry or vice versa. Complete information would suggest that both, coverage and purpose of review, would be known. The degree of awareness of review criteria on the part of the accounting clerk was dependent upon the extensiveness of the information secured or provided. The more complete the information, the better positioned a clerk was to direct his/her efforts

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toward meeting the new expectations (i.e. improved voucher accuracy). The preceding discussion has provided support for the schema of individual behavior in an impending audit situation as follows: anticipation of audit ! ambiguity ! information seeking ! changes in work behavior. This brief review and the preceding theoretical development and empirical findings have led to the following hypotheses: H1. If the individual were not aware of an impending audit, they would commit a statistically significant greater number of errors than those individuals who were aware of an impending audit. H2. For individuals receiving information concerning an impending audit, the individuals who received slight information would commit a statistically significant greater number of errors than individuals who received complete information. Experimental grouping of subjects The research design (see Table I) involved varying the content and source of the communications which subjects received describing the purpose and conduct of the audit. Essentially these communications helped the participants establish how the audit would affect them. The independent variable was variations in the communications provided to subjects: . no communication that an audit would occur; and . additional information about the purpose and conduct of the audit, offered in varying levels of specificity to subjects told that an audit would occur. The subjects chosen for the experiment were 90 College of Business and Economics students. Potential participants were required to have completed two semesters of principles of accounting courses. The upper limit on the requirement was that the students were to be currently taking their first upper-division accounting course – intermediate accounting. The reasons for imposing these requirements were: . to assure some basic knowledge of the accounting process and the task they were to perform; and . to attempt to affect an analogy between the level of expertise of the student and “real world” accounting clerks by placing an upper limit on the formal accounting knowledge of the subjects. The subjects were approached with an open solicitation to participate in the study for remuneration. A total of 90 subjects, ten for each experimental cell were chosen randomly

Input from auditor Table I. Communications by source for the experimental cells

No input Slight input Complete input

No input 1* 4 7

Input from management Slight input

Complete input

2 5 8

Note: *These numbers served to identify each cell for purposes of subsequent discussion

3 6 9

from the volunteers to participate in the study. There was only information available from managers and auditors within the experiment since no peer interaction was possible. Statistical model The research design depicted in Table I was a fixed-effects model (Ostle, 1963), which is appropriate in determining the effects that levels of the independent variables (communications from management and communications from the auditor) on accuracy of participant performance in this study. This design required that the participants be assigned completely at random to the treatments being studied, and in this study 90 participants were randomly assigned, ten to each cell. The statistical model was depicted as follows:

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 þ MIi þ AIj þ ðMIi ÞðAIj Þ þ eijk Aijk ¼ A Aijk was the observed accuracy of the kth clerk in the ith MI (management information) class and the jth AI (auditor information) class. A is the overall mean of the Aijk’s. MIi is the differential effect of the ith level of management information; AIj is the differential effect of the jth level of auditor information; (MIi) (AIj) is the differential effect of the interaction between the ith level of management information and the jth level of auditor information; eijk is the unexplained error. Experimental results Orthogonal contrasts were utilized to test the null hypotheses (Ostle, 1963). The results of the contrasts revealed whether or not the treatment exerted a statistically significant effect on the measures of accuracy of performance, which have been adjusted for differences in speed. The results of the contrasts have been summarized in Table II (Barr and Goodnight, 1972). This researcher was interested in being able to answer the question: if the participants varied greatly with respect to speed of performance during the experiment, how do we know that differences in the initial measures of accuracy (numbers of errors) reflected the effects of different amounts and sources of communications rather than just varying speeds of performance? We had two related

Source of variation C1** C2 C3 Experimental error

Degrees of freedom

Sum of squares

Mean square

1** 1 1 83***

4.84884499 0.653093357 0.56376427 95.11540460

4.84884499 0.653093357 0.56376427 1.11900476

F value

Significant at the 5 percent level (one-tailed test)

4.33318 0.58364 0.50281

Yes No No

Notes: *The subscripts to the reported contrasts (c) indicate the major hypotheses being tested; **(C1-cell 1 vs cells 2-9), (C2-cells 2, 5, 8 vs cells 3, 6, 9), (C3-cells 4, 5, 6 vs cells 7, 8, 9); ***The experimental error term has 83 rather than 85 degrees of freedom because 2 degrees of freedom were used in the regression analysis used to estimate the relationship between accuracy and speed

Table II. Analysis of variance table for the contrasts testing the major hypotheses*

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measures of performance and a primary concern was to seek a method to express any functional relationship between these variables. Regression analysis is an acceptable method to adjust the measures of the independent variable, the number of errors, for differences in speed because this analysis provides a basis for selection of the most appropriate adjustment model. An adjustment seems likely because of a probable relationship that may be asserted to exist between accuracy and speed (i.e. as speed increases accuracy would probably decrease and as speed decreases accuracy of performance would probably increase for this type of task). Several regression analyses were performed to determine whether the independent variable of speed had an effect on the dependent variable, accuracy. The coefficient of determination (r 2) was employed as the basis for determining which form of the equation would be employed to adjust accuracy for differences in speed: . Linear model: A
¼ Bo þ B1 R þ e; . Second degree polynomial: A ¼ Bo þ B1 R þ B2 R 2 þ e; . Semi-log model: A ¼ Bo þ B1 ðlogRÞ þ e; or . Double log model log: A ¼ Bo þ B1 ðlogRÞ þ e: *A represents accuracy and R represents speed of performance. The results of the several regression analyses indicated that the double log model offers a coefficient of determination (r 2 ¼ 0:210) that exceeds the coefficients of determination of the other models. The double log model provides an additional benefit in that the transformation of observed values to their logs overcame a problem of heteroscadasity. These results led this researcher to employ the simple double log regression model (D above) to adjust the number of errors of each of the participants for differences in speed. The formula for adjusting the number of errors measured for each participant is: logA ¼ 21:729 þ 1:046ðlogRÞ þ e The adjusted values for the number of errors are reported in Table III. In the analyses the researcher used the number of errors adjusted for covariance. The first null hypothesis to be tested (contrast 1 in Table II) was designed to determine if the receipt of information concerning the audit situation exerted a measurably different effect on performance than that exerted by no receipt of information. The null hypothesis was related as following:

Table III. Adjusted values of number of errors

Cell 1

Cell 2

Cell 3

Cell 4

Cell 5

Cell 6

Cell 7

Cell 8

Cell 9

4.28693 7.97184 5.14458 6.00860 4.71490 6.66027 4.92953 5.57585 4.07364 7.09630

5.14458 6.22549 6.00860 4.71490 3.86083 4.92953 6.66027 7.75254 4.92953 5.36003

4.28693 2.17972 5.36003 4.92953 4.28693 5.36003 4.28693 5.57585 3.86083 5.36003

3.86083 6.44272 4.07364 4.71490 6.66027 4.71490 3.86083 6.00860 6.00860 5.57585

4.92953 4.50069 4.50069 6.00860 4.71490 4.28693 4.71490 5.57585 5.79205 6.44272

3.22563 4.28693 5.79205 4.28693 2.38742 3.86083 4.71490 5.79205 4.50069 6.44272

6.00860 4.71490 5.57585 5.57585 4.92953 4.50069 3.22563 6.22549 6.87831 3.43680

5.36003 5.14458 4.50069 4.28693 5.57585 4.71490 4.92953 4.50069 4.07364 3.86083

3.86083 3.43680 4.92953 5.14458 3.43680 4.71490 3.22563 4.07364 6.66027 5.36003

The average number of errors (adjusted for differences in speed) committed by individuals receiving no communications about that occurrence of an audit will be equal to or less than the average number of errors (adjusted for differences in speed) committed by individuals receiving communications about the occurrence of an audit.

Audit anticipation

H0. A’ (cell receiving no information) # A’ (cell receiving information). The F value from the table (see Table II) means that the null hypothesis that the subject receiving no communications about the audit situation would commit an equal or lesser number of errors than the subjects receiving information about the audit situation can be rejected. The conclusion from the test of H1 was that the receipt of a communications from management and/or the auditor caused the participants to significantly decrease the number of errors (adjusted for differences in speed) made in preparing the vouchers for the accounting system. The second null hypothesis to be tested was designed to determine if the receipt of highly-detailed information about the audit situation from management and/or the auditor would cause participants to commit an equal or lesser number of errors than those participants receiving only slight information concerning the conduct of the audit. The null hypothesis was related as follows: The average number of errors (adjusted for differences in speed) committed by individuals receiving slight information concerning the conduct of the audit will equal to or less than the average number of errors (adjusted for differences in speed) committed by individuals receiving complete information about the conduct of an audit.

H0. A’ (slightly-detailed information from management) # A’ (highly-detailed information from management). H0. A’ (slightly-detailed information from auditor) # A’ (highly-detailed information from auditor). The initial comparison involved comparing the mean for errors (adjusted for speed differences) of cells receiving slightly detailed information from management with the mean for errors adjusted for speed differences of cells receiving highly detailed information from management (see Table I and contrast of Table II). In additions to the above comparison, the means for errors adjusted for differences in speed for the cells receiving slightly detailed information from the auditor were compared with the means for errors adjusted for differences in speed for cells receiving highly detailed information from the auditor (see Table I and contrast 3 of Table II). The F value from Table II indicated that there could be no rejection of the null hypothesis that individuals receiving slightly detailed information from management concerning the conduct of the audit will commit an equal or fewer number of errors than individuals receiving highly detailed information from management concerning the conduct of the audit. The result suggested that the receipt of highly-detailed information from management does not cause participants to commit a statistically significant fewer number of errors in comparison to the number of errors committed by participants receiving only slightly-detailed information from management. The next comparison made in testing H2 was between the cells receiving slightly-detailed information from the auditor and the cells receiving highly-detailed

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information from the auditor. The F value from Table II signifies that there could be no rejection of the null hypothesis that individuals receiving slightly-detailed information from the auditor concerning the conduct of the audit will commit an equal or fewer number of errors than individuals receiving highly-detailed information from the auditor concerning the conduct of the audit. It was concluded that the receipt of highly-detailed information about the audit situation from the auditor does not cause participants to commit a significantly smaller number of errors than those committed by participants receiving only slightly-detailed information from the auditor. Findings Information provided to employees preceding an audit appears to improve the performance of the individual. Accordingly, management should be sensitive to these results and hold informational meetings where the expectations of the auditor and management are discussed. Such discourse should result in statistically fewer errors than would occur in a situation wherein no such meetings were held. Interestingly the current state of the financial markets may provide some unique opportunities to apply the findings of this study. As the financial markets recover and the number of initial public offerings increase, so too does the number of initial audits and opportunity to benefit from intra firm discussion of management and auditor expectations of performance. Secondly with a record number of firms being taken from public to privately held companies, the requirement by the SEC to have an annual audit will no longer exist. These firms may want to continue the audit as a management control device. To do so, management must consider the economic trade-offs beneficial to the firm, in terms of speed versus accuracy of performance. Limitations of the study Because this study was conducted in a laboratory environment composed of university students, the ability to generalize regarding the performance effects of anticipation of an audit in an actual organizational environment was limited. This study assumed that the performance of students who have completed at least one semester of accounting at the university level possessed technical skills similar to typical clerks; and therefore, the performance of these students should be a reasonable approximation of the performance exhibited by typical accounting clerks. This assumption needs consideration only if the discussion and conclusions were applied to an existing organization. A second possible limitation hinged upon the validity of the assumption that accuracy was a major component of individual performance in the type of task situation this investigation utilized. Unless accuracy was accepted as a major component of performance, the findings and recommendations could be misdirected in measuring and influencing performance. A third limitation hinged upon the validity of the assumption of an initial audit exposure. This study assumed that the employees of the audited firms experienced the audit situation to purposely facilitate the research effort. In an initial audit environment, it was assumed that fellow employees lacked knowledge of the impact or conduct of an audit. Thus the initial audit assumption enables the elimination of fellow employees as a potential source of information. This constraint possibly limited the applicability of the findings, but this study was an initial inquiry to be expanded in subsequent research.

Note 1. An error was defined as any incorrect completion of the entries required on the voucher. References Barr, A. and Goodnight, J. (1972), Statistical Analysis Systems, North Carolina State University, Raleigh, NC. Festinger, L. and Maceoby, N. (1964), “On resistance to persuasive communications”, The Journal for Abnormal and Social Psychology, Vol. 68 No. 4, pp. 359-66. Heidner, F. (1958), The Psychology of Interpersonal Relations, Wiley & Sons, New York, NY. Jackson, S. and Schuler, R. (1985), “A meta-analysis and conceptual critique of research on role ambiguity and role conflict in work settings”, Organizational Behavior and Human Decision Processes, Vol. 36, pp. 16-78. Kahn, R., Wolfe, D., Wuinn, R., Snoek, D. and Rosenthal, R. (1964), Organisational Stress: Studies in Role Conflict and Ambiguity, Wiley, London. Mints, F. (1972), Research Report, No. 17, Institute of Internal Auditors, Altamonte Springs, FL. Morgan, G. and Pattison, B. (1975), The Role and Objectives of an Internal Audit: A Behavioural Approach, CIPFA, London. Ostle, B. (1963), Statistics in Research, Iowa State University Press, Ames, IA. Tubre, T. and Collins, J. (2000), “Jackson and Schuler revisited: a meta-analysis of the relationship between role ambiguity, role conflict and job performance”, Journal of Management, Vol. 26, pp. 155-69. Appendix 1. Slightly detailed information from Deere & Co., management Deere & Co. Interoffice memo To: Accounting Division personnel From: Barry F. Larsen, VP Finance Deere & Co. will be audited sometime during this operating period. An audit is the process of having an independent certified public accounting firm examine and evaluate our accounting records. Management regards this review of our accounting records as necessary to provide the CPA firm with a basis for a decision on the type of opinion they will issue concerning the reliability of our records. A favorable opinion is required to satisfy New York Stock Exchange regulations and to permit our company to obtain credit when we require it. The auditors may come to your voucher preparation section and observe your work. They may ask you to selectively pull some vouchers from them and ask you questions about how you perform your work. The management of Deere & Co. requests that you cooperate with them fully because we do need to receive a favorable report. Appendix 2. Slightly detailed information from Tanner & Tanner, certified public accountants Tanner & Tanner Certified public accountants 281 Monongahela Building Strawberry Point, Iowa Information letter Ref: upcoming audit of Deere & Co. by Tanner & Tanner, CPAs Tanner & Tanner relies on the following general categories of items in reviewing a client’s accounting records:

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(1) The internal controls of the client. (2) The examination of accounting records and transactions and their underlying evidences for authority and validity. (3) The examination of other financial and nonfinancial documents and records and their underlying evidences for authority and validity. (4) Evidence obtained from outside sources – banks, customers, and creditors. The objective of Tanner & Tanner in reviewing your accounting records is to assess their reliability. Once this reliability has been determined we can decide the type of opinion we will issue on your financial statements. Appendix 3. Highly detailed information from Deere & Co., management Deere & Co. Interoffice memo To: Accounting division personnel From: Barry F. Larsen, VP Finance Deere & Co. will be audited sometime during the time you are an accounting clerk. An audit is the process of having an independent certified public accounting firm examine and evaluate our firm’s accounting records. This review will provide the CPA firm with a basis for a decision on the type of opinion they will issue concerning the reliability of our accounting records. A favorable opinion is required to satisfy New York Stock Exchange regulations and to permit Deere & Co. to obtain credit when we require it. The auditors will come to your voucher preparation section and observe your work. They will probably ask you to pull some vouchers for them and proceed to check your work to determine if you have been preparing the vouchers correctly. The auditors will recompute selected transactions to determine if your mathematical operations are correct. They will review the vouchers to determine if you have correctly verified authorization signatures and classified the effects of the financial events in the correct accounts. The management of Deere & Co. requests that you cooperate with the auditors to the fullest extent possible. Appendix 4. Highly detailed information from Tanner & Tanner, certified public accountants Tanner & Tanner Certified public accountants 281 Monongahela Building Strawberry Point, Iowa Information letter Ref: upcoming audit of Deere & Co. by Tanner & Tanner, CPAs The objective of Tanner & Tanner in reviewing the accounting records of your company is to assess the reliability of those records. Once this reliability has been determined, Tanner & Tanner can decide what type of opinion we will issue on the Deere & Co. financial statements. In reviewing your accounting records, Tanner & Tanner will rely on the following general categories of items: (1) The internal controls of Deere & Co. (i.e. we will have our auditors review organizational activities to determine if assets (cash, merchandise, etc.) are being safeguarded and also determine if Deere & Co. policies are being followed. (2) The examination of accounting records and transactions and their underlying evidences for authority and validity (i.e. our auditors will selectively examine the handling of

transactions through the entire administrative process to determine if they have been correctly recorded – this review will include a screening of vouchers). In screening the vouchers our auditors will be looking for any accounting errors that you may have made and thus they will be checking on how well you have performed your assigned duties. (3) The examination of other financial and nonfinancial documents and records and their underlying evidences for authority and validity (i.e. our auditors will selectively review leases and other contractual agreements to determine if any disclosure is required. (4) Evidence obtained from outside sources – banks, customers, and creditors (i.e. our auditors may choose to talk with the firm’s banker to get another view of the financial position of Deere & Co.). The review of the accounting records will be as detailed as Tanner & Tanner auditors believe necessary. The primary consideration is to secure a sufficient amount of information about the accuracy of the accounting function in order that an opinion can be issued on your company’s financial statements.

Appendix 5. Background information concerning the role of the accounting clerk You are an accounting clerk in the home office of John Deere & Co. in Moline, Illinois. The Deere & Co. is heavily dependent upon sales to farms and farm-oriented businesses in their marketing channel. You have a very important role to play in the management structure of Deere & Co., in that you help to implement the internal control system. Your responsibility is to assemble the supporting documents (i.e. requisitions, purchase orders, invoices, and receiving reports), determine that they have been properly certified and that the monetary amounts have been entered, extended, and footed correctly and finally prepare a voucher which summarizes the supporting information into monetary amounts and the accounts to be affected. The purpose of this elaborate system is to minimize, and hopefully eliminate, the possibility of Deere & Co. paying for something that they did not receive or which was not requested through the proper channels. By careful performance in your position you can make an important contribution to safeguarding the assets of Deere & Co.

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Investment appraisal under conditions of continuous and discrete cash flows and discounting Tariq Ismail Faculty of Commerce, Cairo University, Cairo, Egypt, and

Melinda Cline Information Technology and Decision Sciences Department, University of North Texas, Denton, Texas, USA Abstract Purpose – This research furthers scholarly discourse which discusses the most effective way(s) to calculate investment returns under conditions of continuous and/or discrete cash flows with continuous and/or discrete discounting. Design/methodology/approach – Discusses Pogue’s work on the methods for investment analysis. Findings – Pogue’s article of discrete versus continuous calculation of investment returns discusses limitations of the traditional assumption that cash flows in investment appraisal occur at the end of each period and points to a more realistic assumption that cash flows occur on a continuous basis. Pogue then proposes a formula for managers to use when calculating investment returns. Finds that Pogue’s suggested method of calculation is neither supported by prior literature nor sound in its implications. Originality/value – Provides further analysis of discrete and continuous discounting models in investment decisions. Keywords Investment appraisal, Cash flow, Discounted cash flow Paper type Literature review

Introduction Pogue’s recent article of discrete versus continuous calculation of investment returns (Pogue, 2004) discusses limitations of the traditional assumption that cash flows in investment appraisal occur at the end of each period and points to a more realistic assumption that cash flows occur on a continuous basis. Pogue then proposes a formula for managers to use when calculating investment returns. While this is an important area of research, Pogue’s suggested method of calculation is neither supported by prior literature nor sound in its implications.

Managerial Auditing Journal Vol. 20 No. 1, 2005 pp. 30-35 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510570678

Continuous and discrete cash flows and discounts When evaluating the present value of cash flow, two considerations are important. These are the type of cash flows and the method of discounting. Cash flows may be continuous over time or it may occur at discrete instances in time. Likewise, discounting may be continuous throughout a given period or occur at discrete intervals. Combining these two considerations, the present value analysis of cash flows may then be divided into four categories:

(1) (2) (3) (4)

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Discrete cash flows with discrete discounting. Discrete cash flows with continuous discounting. Continuous cash flows with discrete discounting. Continuous cash flows with continuous discounting.

Traditional models of discounting (net present value, internal rate of return) assume discrete cash flows with discrete discounting. This assumption is made primarily to simplify computations. However, in practice, project cash flows often do not occur conveniently at the end of each period but rather occur on a continuous basis. Ismail (1993) has surveyed the largest 250 þ UK quoted businesses on the question of continuous returns. The study examines: . whether companies consider differences among continuous and discrete models of discounting; and . how the use of an inappropriate discounting model affects investment decision outcome. The results indicate that 88 percent of companies having projects with continuous cash flow applied ill-fitting discrete discounting models and that this misapplication lead to incorrect decisions being made on a significant scale. The study also found that the majority of decision makers would support continuous models and they are able to recognize the flaw of using the traditional discrete models. Unfortunately, managers do not have a simple, understandable method to compute continuous investment returns and discounts. The purpose of this paper is to review the prior literature on this topic, point out the weaknesses of Pogue’s assumptions and methods, and further the scholarly discussion of investment analysis methods. Discussion of prior literature and the weaknesses of Pogue’s (2004) model While it is important to develop a computationally simplistic method to compute present value based on continuous discounting of continuous cash flows, Pogue’s model is neither new nor sound. The prior research stream reveals important considerations related to Pogue’s assumptions, formula, and analysis. Among these studies are Grant and Ireson (1960), De La Mare (1975), Levy and Sarnat (1978), Wilkes (1983), and Ismail (1994) who applied the integration method, Remer et al. (1984) who used numerical methods, and Buck and Hill (1971) who applied the Laplace transformation method. Table I shows the mathematical formulae used in previous studies to compute present value of continuous cash flows. In addition to not providing new insight, Pogue’s model fallaciously uses continuous discounting in the belief that it represents continuous cash flows. Pogue’s model suffers from the shortcomings of Levy and Sarnat’ model, as the model deals only with continuous discounting and does not takes into account the nature of continuity of the cash flows. The general form of Pouge’s model is as follows: PV ¼

Z

t

edt

ð1Þ

0

Referring to equation (1), it will be noted that cash flow is still only assumed to occur as an end-of-period lump sum. Further extension of Pouge’s model is required to take into

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Study Grant and Ireson (1960)

e 21 re rn

32

De La Mare (1975)




Buck and Hill (1971)

Levy and Sarnat (1978)

Present value

Comments

r

The model is based on nominal rates rather than effective rates of interest. It should use effective interest rates when continuous discounting is applied

n
n21 1 2 1þr
 1 loge 1þr

The model is based on effective rates of interest. It appears complex and this may hamper its widespread use. Therefore, a more simplified version of the model is required

1 1þr

   1  2Lr e 2 e 2Mr r2    1  ðL 2 SÞe 2Lr 2 ðM 2 SÞe 2Mr þ r Zn

The model assumes continuous cash flows but takes into account only continuous discounting. The cash flows are integrated as a lump sum at the end of each period

st e 2kt dt

0

Table I. Present value formulae used to compute continuous discounting of continuous cash flows

The model is a special model rather than a general model of discounting. It deals with a pattern of cash flows that increases with a constant percentage over time (ramp cash flows)

Wilkes (1983)

1 2 e 2r 2ðn21Þr e r

The model is based on nominal rates rather than effective rates of interest. This may lead to incorrect decisions.

Remer et al. (1984)

Aðe rn 2 1Þ re rn

The model deals only with annuity cash flows and needs further extension to deal with other patterns of cash flows

Ismail (1994)

r loge ð1 þ rÞn

The model can easily transform end of year discount factors into continuous discounting factors of continuous cash flows. The model deals with effective interest rates rather than nominal interest rates

Notes: e ¼ the base for natural logarithms (2.71828); r ¼ interest rate; n ¼ time; L ¼ starting-point of realizing cash flow in period L; M ¼ ending point of realizing cash flow at the end of period M; S ¼ a point of time; S t ¼ cash flow invested in period (t); k ¼ continuous discount rate; dt ¼ interval period of time; A ¼ annuity cash flows

consideration the continuity nature of the cash flows. An examination of the way in which the continuous discounting formula is derived shows, however, that it does feature continuous discounting but without the treatment of continuous cash flows. The Appendix shows the derivation of the present value of continuous cash flows based on continuous discounting using Pouge’s formula, using calculus for its derivation, this is: PV ¼

er 2 1 re rt

ð2Þ

It is clear that the derived model looks like Grants and Ireson’s model and is based on the nominal interest rates rather than the effective interest rates. The effective interest rates are recommended in discounted cash flow models based on continuous discounting of continuous cash flows; as these rates gives a more realistic picture of the productivity of an investment than the nominal rates. Therefore, further extension of the derivation process is required to deal with effective interest rates to help user to incorporate conventional interest tables such as found in standard textbooks on the mathematics of finance with the newly developed models. Ismail (1994) simplifies the calculation of NPV/IRR models based on continuous discounting factors by deriving a formula based on implicit differentiation (L’hoˆpital rule). This formula satisfies the business needs of a simple model of discounting, easy to understand, applicable, deals with continuous cash flows, based on effective interest rates, and overcome the flaws of currently used models. The derived formula that represents the present value of £1 realized continuously over time is: Continuous discounting factor ¼

r ð1 logð1þrÞ e

þ rÞn

ð3Þ

The simplest computational form for continuous discounting factors can be achieved by separating formula (3) into two discounting components as follows:     r 1 Continuous discounting factor ¼ ð4Þ * ð1 þ rÞn logð1þrÞ e The first component in formula (4) is a bias factor for correcting end of year discounting factors into continuous cash flow discount factors, whereas the second component is the present value of £1 received at the end of year (n) according to the traditional present value tables of discrete discounting. So, the present value of continuous cash flows can be obtained by multiplying the conventional end of year discount factor, by the bias factor (interested readers may contact the authors to have a more comprehensive list of this bias factor). Furthermore, Pogue compares continuous and discrete discounting factors and concludes that: . the difference between the two discounting factors increases as the interest rate increases, thereby increasing the divergence between the present values of net cash flow; . the difference between the two factors decreases as time increases and even reverses at higher rates in more distant periods; and . the NPV/IRR based on continuous discounting is higher than NPV/IRR based on traditional discrete discounting. Unfortunately, Pogue oversimplifies the comparisons between continuous and discrete discounting factors and his examples were based on different interest rates and using a time span of five years. In fact, such illustration should take into account the pattern of cash flow, as this will change Pogue’s conclusions. Ismail (1994) has investigated the relationship between continuous and discrete discounting factors in-depth and arrived at the conclusion that the present value model is a function of the following variables:

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. . .

34

the investment life; the discount rate; and the cash flow pattern.

Therefore, the bias factor in formula (4) will not necessarily lead to real NPV (based on continuous discounting) being higher than traditional NPV (based on discrete discounting). The analysis supports that the relationship between continuous and discrete models of discounting is unbounded in one direction; i.e. the continuous NPV/IRR may be equal, lower than, or higher than the traditional NPV/IRR. This relationship depends heavily on the temporal patterns of cash flows (level pattern of cash flows, increasing pattern of cash flows, decreasing pattern of cash flows). However, the degree of possible difference between the real and traditional NPV/IRR is greater when net cash flows decrease overtime, investment lives are short, and the discount factor is high. Ismail’s results are supported by the interesting figures shown in Table I in Pogue’s article; where the percentage difference between continuous and discrete discount factors is negative under a discount rate of 25 percent and time span of five years. Conclusion In conclusion, the NPV/IRR of investment analysis is not necessarily higher when cash flows are realized continuously and discounting is performed continuously during the year. However, the difference in results between appropriately applied discrete and continuous discounting models does influence the soundness of investment decisions. Management may accept/reject investment projects that should be rejected/accepted when ill fitting discounting models that do not take into consideration the nature and pattern of the cash flows are applied. This continues to be an important topic of research. References Buck, J.R. and Hill, T.W. (1971), “Laplace transforms for the economic analysis of deterministic problems in engineering”, Engineering Economist, Vol. 16 No. 4, pp. 247-63. De La Mare, R.F. (1975), “An investigation into the discounting formulae used in capital budgeting models”, Journal of Business Finance and Accounting, Vol. 2 No. 3, pp. 203-16. Grant, E. and Ireson, W. (1960), Principles of Engineering Economics, Ronald Press, New York, NY. Ismail, T. (1993), “A UK study on assumed cash flow conditions and the application of the traditional discounting cash flow model”, working paper, Department of Accounting and Finance, University of Birmingham, Birmingham, April. Ismail, T. (1994), “The refinement of discounted cash flow techniques”, unpublished doctoral thesis, Department of Accounting, Faculty of Commerce, Cairo University, Cairo. Levy, H. and Sarnat, M. (1978), Capital Investments and Financial Decisions, Prentice-Hall, Englewood Cliffs, NJ. Pogue, M. (2004), “Investment appraisal: a new approach”, Managerial Auditing Journal, Vol. 19 No. 4, pp. 565-9. Remer, D. et al. (1984), “The state-of-the-art of present worth analysis of cash flow distribution”, Engineering Costs and Production Economics, Vol. 7 No. 4, pp. 257-78. Wilkes, F.M. (1983), Capital Budgeting Techniques, Wiley, Chichester.

Appendix Mathematical derivation of discounting factors based on continuous cash flows and continuous discounting according to Pogue formula is: PV ¼

Zt

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e2rn dt

0

 t 1 ¼ 2 e 2rn r t21  1  2rt ¼ 2 e 2 e 2rðt21Þ r  1 ¼ 2 e 2rt ð1 2 e r Þ r  1 ¼ 2 e 2rt ðe r 2 1Þ r er 2 1 : ¼ re rt

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Auditing standards in Poland: past, present and future Richard G. Brody

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University of South Florida, St Petersburg, Florida, USA, and

Stephen Moscove and Robert Wnek University of New Haven, West Haven, Connecticut, USA Abstract Purpose – To describe and discuss historical, current and possible future auditing standards and related issues in Poland so that investors, auditors and others are aware of the specific needs and limitations facing the country. Design/methodology/approach – The accounting and auditing history of Poland is provided as background information and then more recent developments since the fall of Communism to the present day are discussed to demonstrate that progress has been made. Future needs are outlined and various suggestions are made. Findings – Provides specific details as to the current state of the auditing standards in Poland as they relate to the standards in other countries. Recognizes the need for time to make improvements but highlights areas of critical importance. Practical implications – A comprehensive analysis of the state of auditing standards in Poland. Useful for academics and others who might have a desire to participate/assist in the development of new standards. Provides perspective with respect to the development of these standards in an emerging capital market country. Originality/value – This paper provides information that is not well-disseminated and offers practical advice to those dealing with Polish companies, including auditors and financial statement users. The material is of interest to practitioners, academics and students. Keywords Auditing standards, Poland Paper type General review

Managerial Auditing Journal Vol. 20 No. 1, 2005 pp. 36-46 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510570687

Introduction Accounting scandals in both the US (e.g. Enron, WorldCom) and Europe (e.g. Ahold and Parmalat) have been headline news on a regular basis. Major changes have been put into effect to regain public confidence and prevent future scandals as the ultimate goal is to improve the quality of external audits. In the US, the Sarbanes-Oxley Act has redefined the role of both auditors and corporate executives. The Public Company Accounting Oversight Board is now the national watchdog in the US and many changes are either underway or forthcoming for both publicly held companies and their accounting firms. Similar efforts are being made by the European Union (EU), and while each EU country and the European Parliament still need to approve a legislative proposal that mirrors much of Sarbanes-Oxley, a great deal of common ground has been recognized. The development of accounting principles and reporting practices in different countries is influenced by numerous factors including the culture of the country, the nature and source of financing, the size and structure and complexity of businesses, the capital markets, the tax laws, and the regulatory environment. These differences in

operating environments of countries lead to differences in audit objectives, standards, and practices. Financial statement users need to be aware of these differences if they are to make informed decisions. This caveat is especially relevant to the emerging capital markets of Central and Eastern European countries, which have been attracting a variety of foreign investors. One of these countries is Poland. Due to a high level of direct foreign investment in Poland, it is critical that investors are provided with adequate audit assurance. Furthermore, the potential for accounting scandals in Poland increases the importance of auditors providing this assurance. As an example of a Polish accounting scandal, Jacek Kruszczynski was arrested in April of 2003 for allegedly defrauding a Polish corporation known as Pollena by taking $304,000 worth of household chemical products and selling them on the black market. Kruszczynski and his associates were accused of paying bribes and kickbacks to a Pollena executive who allegedly helped them take possession of the chemical products. This executive also worked to subvert Pollena’s efforts to collect payment for these products. Polish authorities indicated that Kruszczynski did business under the name “Jeans Centrum,” a company registered in Poland under his wife’s name. Jeans Centrum provided false accounting information as part of the scam, according to Polish authorities. Another high profile scandal occurred in February 2002 when the head of Poland’s biggest oil company was arrested as part of an insider trading scandal. Some argued that the charges were made for political reasons in order to force the executive to resign. The BBC news agency reported that: Volatile emerging markets in Eastern Europe are extremely sensitive to scandals around large companies, which are usually involved in domestic politics (BBC News, 2002).

Prior to the economic transformation in Poland, accounting rules facilitated the information needs of a centrally planned economy. The launching of economic reform for market economic transformation in Poland during the late 1980 s was accompanied by the introduction of various market-oriented regulatory actions, including new rules of accounting and auditing. Moreover, the process of economic reform in Poland has been expedited by its preparation for European Union accession. Poland began the process of negotiating entry to the EU in the spring of 1998. The first phase of this process involved identifying differences in the legal systems of the EU and Poland so that these differences could be eliminated. The end objective of the process was the adapting of Polish law to be consistent with the EU legislative heritage (i.e. acquis communitaire – a package of regulations that describe the functioning of a uniform market). Poland became a member of the EU in 2004. The economy in Poland has changed dramatically since the fall of communism. Poland moved from its centrally planned economy to a free-market based economy. Overall, a dynamic and growing private sector now dominates Poland’s economy. In certain sectors of Poland’s economy, however, state-owned enterprises still play a decisive role. Poland’s goal is to raise its living standards closer to the EU’s average. The rise in its living standards will be dependent on how Poland handles its economic challenges. Currently, the country is committed to structural reform of its educational system as well as reforming both its health care and pension systems. Prior to examining

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accounting and auditing issues associated with Poland, a brief overview of Poland’s economy is first presented. The economy of Poland – an overview Poland has consistently pursued a policy of economic liberalization throughout the 1990 s. As a result, it stands out today as the greatest success story among the former communist states. However, much still remains to be accomplished. The privatization of small- and medium-sized state-owned companies and a liberal law on establishing new organizations have encouraged the development of the private business sector, which has been the main drive for Poland’s economic growth. On the negative side, the agricultural sector of Poland remains handicapped by structural problems, inefficient small farms, surplus labor, and a lack of investment. In addition, restructuring and privatization of sensitive sectors, such as coal mining, has been slow, but current foreign investments in energy and steel have begun to turn the tide. Recent reforms in education, health care, state administration, and the pension system have caused larger than expected fiscal pressures for Poland. Relieving these fiscal pressures are priorities of the Polish government. Progress in the public finance area depends largely on privatization of Poland’s remaining state sectors, the reduction of state employment, and an overhaul of Poland’s tax code to include, for example, farmers, many of whom pay no taxes. Poland is a net exporter of processed fruit and vegetables, confectionery, meat, and dairy products. It is the leading European producer of potatoes and rye and is one of the world’s largest producers of sugar beets. Poland is also a significant producer of grains, cattle, and hogs. The country’s efforts to increase domestic feed grain production are hindered by the short growing season, poor soil, and the small size of farms. As a consequence of Poland’s growth and investment-friendly environment, it has received over $50 billion in direct foreign investment since 1990. However, Poland’s government continues to play a significant role in the country’s economy, as reflected in unnecessary red tape and the high level of politicization in many business decisions. Investors in Poland frequently complain that state regulation is neither transparent nor predictable. Furthermore, these investors believe that the Polish economy suffers from a lack of competition in many of its sectors, especially telecommunications. The Polish government announced a new set of economic reforms in 2002 that were designed in many ways to finish the process launched in 1990 (which was a comprehensive reform program to replace the centralized command economy with a market-oriented economic system). These reforms recognize the need to improve Poland’s investment climate (particularly the conditions for small- and medium-sized firms) and better prepare the Polish economy to compete as an EU member. Accounting and auditing history The maintenance of bookkeeping records in Poland can be tracked back to the fifteenth century. Merchant books were found dated back to 1421-1454. Accounting began in the sixteenth century when the state treasury of Poland was separated from the household treasury. In the seventeenth century, Polish accounting served as a model for other European countries. Unfortunately, in 1873, Poland lost its independence for the first time to the countries of Russia, Prussia, and Austria. As a result, for 150 years, these

countries had regulated accounting practices in the different areas of Poland that were portioned. The regulatory phase in Poland prior to 1990 was characterized by a turbulent political history, engendered in frequent regulation changes. The impact on Poland of the first world war was very significant; in 1918, a free Polish state was re-established after 150 years of partition. The 20 years of existence of the Second Republic (1918-1939) were characterized by governmental interventionism in economic development, with particular emphasis on credit protection and tax collection. The accounting and auditing legislation of Poland was consolidated in the Commercial Code 1934, which was influenced by the German Code. In 1907, the Polish Association of Accountants, a professional organization comprised of accountants, was established. Until 1989, a communist rule and a centrally planned economy existed in Poland. Prior to 1989, Polish accounting consisted of a very detailed set of rules. The version of socialism adapted by Poland after 1956 created conditions for the increased autonomy of state-owned enterprises, which enabled management and other personnel to participate in the distribution of profits generated by these enterprises. It became the state’s concern to ensure that surpluses were calculated at the end of each financial year in accordance with set targets of long-term central plans (Ministry Decree on the Principles of Accounting, 1973). In 1957, the Institution of Audit Experts was established in Poland to verify accounts of state-owned enterprises with the appointment of the State Authorized Accountants (SAA). The SAA did not create an independent profession; rather, they were employed on a full-time basis within the accounting divisions of the state enterprise. The role of the SAA was ascertaining appropriation of profits and verification of the achievements of centrally planned targets. The audit function was focused on certifying the appropriateness of enterprises’ financial statements with the law through the means of certificates of correctness, ensuring that these enterprises had correctly accounted for all transactions with the state budget. The next significant phase of accounting and auditing development in Poland was between 1991 and 1994. These years in particular were influenced by the mass privatization of state-owned enterprises and an on-going harmonization process within the provisions of European law. New legislation consisted of Ustawa z dnia 19 pazdziernika 1991 r. o. badaniu I oglaszaniu sprawozdan finansowych oraz bieglych rewidentach I ich samorzadzie (i.e. the Audit and Publication of Financial Statements, Statutory Auditors and their Self Regulation Act 1991) and Rozporzadzenie Ministra Finansow z dnia 15 stycznia 1991 r. o. rachunkowosci (i.e. the Decree of Ministry of Finance, 15 January 1991, on the Principles of Accounting). The key phase of the formation of Polish auditing standards started in January 1995 with the introduction of a new legal act driven by the incentive of fast accession to the EU. The new parliamentary act, Ustawa z dnia 29 pazdziernika 1994 r. o. bieglych rewidentach I ich samorzadzie (i.e. the Statutory Auditors and their Self Regulation Act 1994), superseded and expanded the auditing regulations contained in the Audit Act 1991. In September 2000, the new Audit Act (Ustawa z dnia 21 wrzesnia o bieglych rewidentach) was issued. This act required that the process of issuing audit standards by the Polish Chamber of Auditors needed to involve consultation, not only with the

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Ministry of Finance, as required by the Audit Act 1994, but also with the Polish Securities and Exchange Commission and relevant bank and insurance authorities. Regulatory framework The Audit Act of September 2000 and the comprehensive amendments to the Accounting Act adopted on November 9, 2000 have brought Polish accounting and auditing regulations more in line with international standards. The accounting regulations have moved the focus of Polish accounting away from an emphasis on tax compliance toward a more business-oriented approach, directed at meeting the information needs of various stakeholders in a Polish market economy. The Audit Act 2000 introduced standard wording for the short-form and long-form formats of audit reports due to the differences between the legally required contents of these reports. A short-form audit report provides a written opinion on the correctness and truth of an enterprise’s financial statements, including the date and place of their preparation. A long-form audit report contains a statement that the enterprise’s financial statements were prepared in accordance with the law and generally accepted accounting principles (GAAP). This latter report also includes an opinion on the correctness and truth of the enterprise’s financial statements with the specification that data, which in comparison with the previous accounting period, indicated circumstances which materially and negatively impacted on operating results and the financial situation of the reporting entity. These differences in the contents of the audit reports are dictated by their public availability. The short-form audit report is to be made available to shareholders while the long-form audit report is submitted to the Polish treasury office as a tax regulation requirement only. In summary, under the present Polish regulation framework, audit opinions are required to state whether the accounts of enterprises present a true and fair view on the basis of correctly maintained accounting records and comply with law and accounting regulations. Additionally, Audit Act 2000 regulated operation of the National Chamber of Statutory Auditors (NCSA). The NCSA is independent in performing its duties and acts in compliance with the provisions of the law and its statutes. However, the Ministry of Finance is responsible for NCSA supervision. Membership within the NCSA is compulsory and becomes effective following registration on the list of statutory auditors. The NCSA is a legal entity, with its register offices in the capital city of Warsaw. The duties of the NCSA include: . representing the members of the chamber and protecting their professional interests; . establishing professional standards for auditors; . establishing principles of professional ethics for auditors; . prescribing the theoretical and practical requirements to be met by candidates statutory auditors and the granting of the title of statutory auditor; . supervision of appropriate professional conduct by members of the chamber; . professional training of the members of the NCSA; and . imposing disciplinary penalties on chamber members for breeches of law, professional standards, or professional ethics (Izba Bieglych Rewidentow Krajowa, 2000).

Amendments to Poland’s Accounting Act of 29 September 1994 have eliminated audit requirements for small-sized enterprises. The threshold for an enterprise to be subject to annual statutory auditing is meeting at least two of the following three conditions during the immediate past financial year: (1) Annual average of 50 full-time employees. (2) Total assets at fiscal year end of at least the Polish Zloty equivalent of Euro 2,500,000. (3) Net sales revenue and financial income of at least the Polish Zloty equivalent of Euro 5,000,000 (The Accounting Act of 29 September 1994). Prior to the amendments in the Accounting Act of 1994, a large number of smaller-sized enterprises were required to have statutory audits once every three years. Additionally, the Accounting Act of 1994 requires annual statutory audits of banks, insurance companies, investment funds, pension funds, holding companies, joint stock companies, and publicly traded companies. Regarding publicly traded companies, there are special requirements. These companies are required to have semi-annual financial statements reviewed by independent auditors and to submit these statements to the Securities and Exchange Commission. Moreover, between 2001 and 2002, these companies were required to include in their financial statements a description of major differences between their adopted accounting policies and international accounting standards requirements. The auditing profession In 1960, the Ministry of Finance in Poland introduced the chartered accountant designation. Prior to the reforms in Poland, chartered accountants tended to hold managerial positions in accounting departments of enterprises. To obtain the chartered accountants’ designation, individuals had to pass examinations in accounting, commercial law, and controls. The chartered accountants examined and issued certificates of correctness of enterprises’ financial statements on behalf of the Finance Ministry during a special three-week release time from their own place of work. The new market economy in Poland forced changes in the auditing profession. In 1992, chartered accountants became certified public accountants (CPAs). Subsequently, they underwent training in the new rules of taxation, accounting, and auditing. In order to practice auditing in Poland, an accountant must belong to the NCSA. Moreover, an actively practicing certified public accountant cannot work for a non-CPA entity, except for a university. Many American and European auditing firms have offices in major Polish cities. Foreign accountants can obtain auditing licenses in Poland if they posses auditing licenses in their own countries. However, prior to obtaining a Polish auditing license, a foreign accountant must first pass an examination in commercial and tax law given in Polish. Most enterprises with foreign capital hire foreign auditors, as do many large Polish companies. Of the auditors of 1999 financial statements of the top-100 companies listed on the Warsaw Stock Exchange, 70 percent of these auditors came from big-4 auditing firms and 20 percent came from other internationally affiliated auditing firms. Foreign auditing firms are selected because of their experience, name recognition, and breadth of services, even though these firms charge higher billing rates than Polish auditing firms (Gottlieb, 1999). The Polish offices of foreign auditing

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firms are expected to grow significantly over the next few years, far faster than the growth of foreign auditing firms in Western Europe and the US. Unfortunately, the demand for skilled accountants and professionally qualified auditors in Poland is greater than the supply of these individuals. The publicly traded companies and financial institutions of Poland try to employ skilled accountants for internal financial control and external financial reporting. However, the availability of such professionals remains somewhat limited and relatively expensive. In the recent past, better opportunities in the auditing profession of Poland have inspired talented college students to become qualified auditors (Cairns, 1999). Since the qualification period ranges between five and seven years, the supply of Polish auditors continues to lag behind the demand. A recent study reported that the average age of about 75 percent of the NCSA members is 60 years! Professional education and training The required academic standards for entering the auditing profession in Poland appear to be high. However, a current shortage of experienced university accounting instructors affects adversely the quality of accountancy education throughout Poland. Enrollment as a candidate for professional examination to become a statutory auditor requires a university degree, although the candidate is not required to have prior academic training in economics, accounting, or related subjects. In response to the needs of the market economy, the higher education institutions in Poland have introduced new courses covering subjects taught in business schools in Europe and the US. While a few Polish universities have world-standard accounting instructors, many of them suffer from a scarcity of experienced full-time professors. Moreover, a large number of the full-time instructors teaching accounting in Poland are involved in auditing practice, and many of these instructors are employed in part-time teaching jobs at several educational institutions. Cairns (1999) argues that there is a need in Poland for improving the curriculum of professional accounting education and the focus of the statutory auditor examination. These improvements should be made to fit the Polish guidelines that have been established for the purpose of specifying qualification requirements for statutory auditors. The NCSA prepares and administers the statutory auditor examination. The candidates for this examination need to pass tests on ten subjects in four phases. The examination is heavily focused on memory work of the Polish national rules and regulations, with less testing of candidates’ critical thinking abilities. As reported by Urzad Statystyczny Glowny (2001) for the period 1994-2000, about 4,350 candidates were enrolled in statutory auditor examinations. During the early years of this examination period, the pass rates of candidates were low, resulting in only a small number of accountants gaining membership in the NCSA. By April 2000, however, a total of 550 candidates had successfully passed the statutory auditor examination and became new members of the NCSA. In addition to the educational requirements, there are also practical experience requirements for entry into the auditing profession. Prior to obtaining their professional designations as statutory auditors, candidates are required to gain practical work experience for at least three years, broken down as follows: at least one year as an accountant in an organization and at least two years of professional training under the supervision of a statutory auditor. The practical training of individual

candidates needs to be approved by the examination commission of the NCSA. In special cases, the NCSA may waive the one-year experience requirement working as an accountant in an organization; however, the two-year professional training requirement with a statutory auditor cannot be waived. Each practicing member of the NCSA is required to attend 30 hours of continuing professional education every year. The NCSA strictly enforces this requirement. The NCSA encourages its members to undertake professional training courses offered by the Association of Accountants of Poland, qualified audit firms, and regional NCSA offices. Frequently, the large audit firms in Poland offer in-house training programs, attendance of which is generally approved by the NCSA as a fulfillment of the continuing professional education requirement. Establishing auditing standards The NCSA is legally authorized to set auditing standards for Poland. It performs this function in consultation with the Ministry of Finance, the Securities and Exchange Commission, and the Banking Supervision Commission. In the process of drafting auditing standards, efforts are made to adapt internationally recognized standards to Poland’s own circumstances. Listed below are eight auditing standards issued by the NCSA: (1) General principles on auditing of annual financial statements. (2) Auditor’s short-form report and long-form report on annual financial statements of an entity other than a bank or an insurance company. (3) Auditor’s short-form report and long-form report on annual financial statements of an insurance company. (4) Auditor’s short-form report and long-form report on annual financial statements of a bank. (5) Auditing of consolidated financial statements. (6) General principles in relation to the review of interim financial statements. (7) Auditing of annual financial statements of entities that are not subject to the mandatory annual audit. (8) Auditor’s short-form report and long-form report on annual financial statements of investment or pension funds. When particular auditing issues are not covered by any of Poland’s audit standards, the NCSA permits the use of appropriate International Standards on Auditing (ISA). Compliance with auditing standards The statutory regulatory bodies of Poland rely heavily on the auditors for ensuring compliance with the established accounting and disclosure requirements. Krzywda et al. (1998) believe that due to a lack of legal limitations and the independence of statutory auditors guaranteed by the legal acts, these regulatory bodies rarely enforce actions against those statutory auditors who fail in ensuring compliance with the accounting and auditing requirements. Within specific circumstances, the NCSA is empowered to take disciplinary actions for enforcing the code of professional ethics and auditing standards. According to the act of 13 October 1994 on statutory auditors and their self-regulation (MacLullich,

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2001), the NCSA may impose the following disciplinary penalties against delinquent auditors: . admonishment; . reprimand; . suspension for one to three years from auditing profession; and . cancellation of auditing license. Moreover, as a part of its monitoring mechanism, the NCSA organizes and performs practice reviews of statutory auditors and audits firms once every three years through the National Supervisory Commission. The members of this commission are entitled to examine all documents relating to audits performed by statutory auditors. Currently, the results of these practice reviews are kept confidential by the NCSA. It is widely recognized that efforts are needed to improve statutory auditors’ compliance with Polish auditing standards. Over the past few years, visible steps forward have been made in developing Polish audits into a practice consistent with international standards. However, there are still many instances today where auditors do not comply with Polish auditing standards. The most common problems identified during the past three years in the course of audit practice reviews included deficiencies in the form and content of audit working papers, a breach of the professional code of ethics, and noncompliance with various other professional practice norms (Reczek, 2000). The most frequent penalties for these violations were admonition and reprimand. It could be argued that the major reason for the gap between established auditing standards and actual practices is caused by the inability of many practicing Polish auditors to properly apply audit standards. This inability is likely due to insufficient training of Polish auditors and too many retired auditors who continue to work on audits without upgraded skills. In comparison to the ISA, Polish auditing standards provide only general guidelines on audit objectives and procedures. Unlike the ISA, the Polish audit standards are not structured to cover separate audit areas. Moreover, the Polish auditing standards contain a provision that requires statutory auditors to be guided by the knowledge enriched through the professional literature and especially the ISA. In this respect, there is a need for the development of guidelines to assist practitioners in conducting audits. The NCSA, in addition to issuing auditing standards, has issued guidelines on the following areas associated with the audit function: . auditing of a company’s assumptions regarding going-concern assessment; . wording of the short-form opinion on annual financial statements; . wording and content of long-form auditor’s report on annual financial statements; . auditor’s participation in physical inventory count; and . auditing of balance sheet and income statement items. Unfortunately, even if statutory auditors comply with all of the Polish auditing standards, the deficiencies in these standards may adversely affect the quality of the audit function. Some of the major deficiencies in Polish auditing standards, in reference to the ISA, are described below:

ISA 220: Quality control for audit work. There are no Polish auditing standards covering comparable requirements. ISA 240: Fraud and error. Polish auditing standards do not cover the important issues of fraud and error as separate sources for material misstatements and withdrawal from audit engagements in situations of fraud occurrence. The requirements under Polish auditing standards on reporting fraud or error to management and to users of the auditor’s report are generic and relate only to the actually detected fraud or error, and not to suspected fraud or error. ISA 401: Auditing in a computer information system environment. There are no Polish auditing standards covering comparable requirements. ISA 510: Initial engagements. Polish auditing standards do not cover specific procedures for first time audit engagements and for situations where another auditor worked on a company’s financial statements in the prior period. ISA 530: Auditing sampling and other selective testing procedures. There are no Polish auditing standards covering comparable requirements. ISA 540: Audit of accounting estimates. There are no Polish auditing standards covering comparable requirements. ISA 550: Related parties. There are no Polish auditing standards covering comparable requirements. ISA 610: Considering the work of internal auditing. There are no Polish auditing standards covering comparable requirements. ISA 620: Using the work of an expert. There are no Polish auditing standards covering comparable requirements. ISA 710: Comparatives. There are no Polish auditing standards covering comparable requirements. ISA 720: Other information in documents containing audited financial statements. There are no Polish auditing standards covering comparable requirements. Concluding comments Poland has taken steps in the past several years to reduce the gap between Polish auditing standards and the ISA. However, there are still no Polish auditing standards for approximately one-third of the areas covered by the ISA. Furthermore, most of the existing audit standards of Poland require updating so they will be aligned with the international audit standards. Practicing Polish statutory auditors generally comply with the strict wording of written Polish auditing standards. But, the lack of detailed audit standards and the shortage of practical-oriented implementation guidelines for these standards appear to be constraints in the application of high quality audit methodology. In view of the fact that Poland’s membership in the European Union in 2004 necessitates its complying with the requirements of the International Accounting Standards Board, there is a definite need for further development of Polish auditing

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standards. Regarding Poland’s recent membership into the EU, it should be noted that different groups of Poles have varying opinions on this membership. To illustrate, Poles in the construction and shipbuilding industries believe that EU membership will have a positive affect on Poland’s economy. On the other hand, groups such as the power generation industry and farmers are not very optimistic. These groups express concerns over meeting EU standards while dealing with layoffs and rising debt in Poland. MacLullich (2001) states that: It would be more meaningful and efficient for Poland to translate and adopt all International Federation of Accountants (IFAC)-issued auditing standards and related guidelines without any country-related modifications. This way scarce local resources of Poland could be devoted to the development and dissemination of implementing guidelines and audit practice manuals.

It is a reasonable conclusion that work is currently in process to develop further the Polish standards for the audit function. However, it is going to take considerable time to accomplish this goal in its entirety. The problem, as is so often true with emerging countries, is not so much in the development and introduction of the necessary legislation, but the difficulties of achieving effective practical implementation of audit standards in a way that will benefit the Polish economy. It has to be emphasized that Poland, like many other Eastern Europe countries, is just now setting out to do, in short order, what in the developed countries have taken 100 years or more to accomplish. Additionally, the generational problems are important. Positive changes here will hopefully come when the youth of Poland attend universities (to study modern ideas associated with the accounting and auditing profession), graduate, and begin to take over the audit function in Poland. Finally, accounting and audit rules and practices cannot be improved on their own. Rather, they have to be accomplished by parallel improvements in rules and practices of other professions, such as law, banking, insurance, and financial services. References BBC News (2002), available at: news.bbc.co.uk/1/hi/business/1809348.stm (accessed 8 February). Cairns, D. (1999), “Improving financial reporting in transitional economics”, Law in Transition, European Bank for Reconstruction and Development, London. Gottlieb, M. (1999), “Accountancy in Poland’s economy”, The CPA Journal, Vol. 69 No. 7, pp. 34-8. Izba Bieglych Rewidentow Krajowa (2000), National Chamber of Statutory Auditors, available at: http://kibr.org.pl/index.phtml Krzywda, D., Bailey, D. and Schroeder, M. (1998), “The development of the role of the statutory audit in the transitional Polish economy”, The European Accounting Review, Vol. 7 No. 3, pp. 407-40. MacLullich, K. (2001), “Truth and fairness in accounting: a case of Polish transition economy”, Center for Economic Research and Transformation, available at: www.som.hw.ac.uk/cert/wpa/2001 Reczek, A. (2000), “Three for transparency”, PriceWaterhouseCoopers, available at: www.pwcglobal.com/extweb/frmclp11.nst Urzad Statystyczny Glowny (2001), Central Statistical Office, available at: www.gus.pl. statystyka/zawody Ustawa z dnia 29 wrzesnia (1994), r. o rachunkowosci, The Accounting Act of September 29, 1994, Dziennik Ustaw, No. 121, Item 591. Zarzadzenie Ministra Finansow z dnia 23 wrzesnia (1972), r. o. rachunkowosci jednostek gospodarki uspolecznionej, 1973.

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Earnings management: evidence from SFAS No. 142 reporting

Earnings management

Suzanne Sevin and Richard Schroeder Department of Accounting, Belk College of Business, University of North Carolina at Charlotte, Charlotte, North Carolina, USA

47

Abstract Purpose – To examine whether the provisions of SFAS No. 142 allow for the earnings management technique termed “big bath” and whether firm size plays a role in earnings management. Design/methodology/approach – A random selection of companies with December 31, 2002 fiscal year-ends yielded 120 firms that reported goodwill impairments in 2002 and 82 firms that did not. The firms are then stratified into two groups. Analysis consists of measuring the magnitude of the 2002 goodwill impairment loss, comparing financial metrics of impaired and non-impaired firms, and calculating the proportion of firms with negative versus positive earnings. Findings – The results suggest that SFAS No. 142 adoption allowed companies to engage in earnings management. Findings indicate that small firms experienced a significantly greater negative impact and were much more likely than large firms to take big bath charges. Originality/value – This study provides evidence on the use of newly issued accounting standards to manage earnings. Keywords Earnings, Goodwill accounting Paper type Research paper

In June 2001, the Financial Accounting Standards Board (FASB) issued the Statement of Financial Accounting Standards No. 142, “Goodwill and other intangible assets” (SFAS 142) (Financial Accounting Standards Board, 2001). This statement changes the method of accounting for goodwill from an amortization period not to exceed 40 years, to an approach that requires, at a minimum, annual testing for impairment. This impairment test is to be performed at the reporting unit level. The reporting unit level is defined as an operating segment or one level below an operating segment. Under the provisions of SFAS 142, the test for goodwill impairment is a two-step process that involves: (1) A comparison of the fair value of the reporting unit to its carrying value. In the event fair value exceeds carrying value, no further testing is required. However, if the carrying value of the reporting unit exceeds its fair value, step two is required. (2) A calculation of the implied fair value of goodwill by measuring the fair value of the net assets other than goodwill and subtracting this amount from the fair value of the reporting unit. In determining fair value, the FASB noted that the fair value of a reporting unit is the amount at which the whole unit could be bought or sold in a current transaction. As a result, quoted market prices in active markets were described as the best evidence of fair value. The FASB further indicated that if quoted market prices are not available, fair value should be based on the best available information such as the present value measurements outlined in Statement of Financial Accounting Concepts No. 7, “Using

Managerial Auditing Journal Vol. 20 No. 1, 2005 pp. 47-54 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510570696

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cash flow information and present value in accounting measurements”, or a multiple of earnings[1]. SFAS 142 was effective for all companies whose fiscal years begin after December 15, 2001. Consequently, December 31, 2002, was the first reporting date for most companies under its provisions. In the year SFAS 142 is initially applied, two separate impairment tests are required. First, a transitional goodwill test is conducted to determine if the goodwill that existed at the date of adoption is impaired. Any transitional impairment loss is reported as a change in accounting principles. Second, the required annual impairment test is conducted. Any annual impairment losses are reported as a component of income from continuing operations. Additionally, impairment may be tested on less than an annual basis whenever it is warranted by special circumstances. There are certain indications which suggest that an impairment exists, including significant underperformance relative to historical or projected future operating results, significant changes in the manner of the company’s use of underlying assets, and significant adverse industry or market economic trends. The goodwill impairment test requires companies to assess whether the cash flows their reporting units are expected to generate can support the values assigned to those units. If the carrying value of assets is determined to be unrecoverable, the company must estimate the fair value of the assets of the reporting unit and record an impairment charge for the excess of the carrying value over the fair value. The estimate of fair value requires management to make a number of assumptions and/or projections, such as future revenues, future earnings, and the probability of outcomes in contingency situations. These estimations open the door to possible earnings manipulations. The purpose of this paper is to examine the financial impact of goodwill impairments to a sample of firms. Additionally, we examine if the negative financial reporting implications of goodwill impairments contribute to the use of big baths and if there is a difference in big bath earnings management with respect to goodwill impairments between large and small firms.

Earnings management Earnings management is the attempt by corporate officers to influence short-term reported income. During the 1990s many corporate executives faced extreme pressure to attain targeted earnings and to reach financial analysts’ earnings projections for their companies. In response, some managers turned to the use of aggressive and even fraudulent financial reporting practices. Healy and Wahlen (1999) suggest that earnings management occurs for a variety of reasons, including influencing the stock market, increasing management compensation, reducing the likelihood of violating lending agreements, and avoiding intervention by government regulators. Managers may attempt to manage earnings because they believe reported earnings influence investor and creditor decisions. A variety of studies have found that earnings management techniques are designed to improve reported income effects and/or to lower the company’s cost of capital (Healey, 1985; Moses, 1987; Trueman and Titman, 1988; Fudenberg and Tirole, 1995). Arthur Levitt (1998) the former Chair of the SEC, outlined five earnings management techniques that he described as threatening the integrity of financial reporting:

(1) Taking a bath. The one-time overstatement of charges against income to reduce assets, which reduces future expenses. The expectation is that the one-time loss is discounted in the marketplace by analysts and investors who will focus on future earnings. (2) Creative acquisition accounting. Avoiding future expenses by one-time charges for in-process research and development. (3) “Cookie jar” reserves. Overstating sales returns or warranty costs in good times and using those overstatements in bad times to reduce similar charges. (4) Abusing the materiality concept. Deliberately recording errors or ignoring mistakes in the financial statements under the assumption that their impact is not significant. (5) Improper revenue recognition. Recording revenue before it is earned. It was noted that over half of the SEC’s enforcement cases filed in 1999 and 2000 involved improper revenue recognition issues. This study focuses on the use of the first of these techniques, managing earnings by taking big bath charges. Big bath charges are typically taken in a year when profits are low or non-existent, and usually result in either increased or smoothed future earnings. Several studies have addressed the issue of big bath charges. Walsch et al. (1991) examined the reporting of extraordinary items for a sample of Australian firms and concluded that there was a strong correlation between these gains and losses and the level of current year earnings. That is, companies with relatively low current year earnings were more likely to record large extraordinary losses while companies with unusually high earnings were more likely to record large extraordinary gains. Kirshenheiter and Melumad (2002) provided a model of financial reporting whereby firms with low earnings will under report earnings by the maximum amount possible, thus taking a big bath. When earnings are not low, the company will act to smooth earnings rather than take a big bath. SFAS No. 142 and financial statements The non-amortization of goodwill and subsequent impairment testing has been seen as increasing the representational faithfulness of reported net income (Wilson et al., 2002) and improving the transparency of financial statements (DeMark, 2002). Within SFAS 142, the FASB asserts that the new reporting requirements will: . provide better balance sheet valuations of goodwill; . remove the arbitrarily determined straight-line amortization from the income statement; and . allow users to better understand expectations about changes in a company’s assets over time, thereby improving their ability to assess future profitability and cash flows. Despite these claims, Massoud and Raiborn (2003 p. 28) maintain that SFAS 142 provides management with significant leeway in making estimations and assumptions with respect to the identity of its reporting units, the allocation of assets, liabilities, and goodwill to reporting units, the identity of events that would trigger the need for interim impairment testing, and the fair value measurement of reporting units and

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49

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assets. As a result, the possibility exists that management may opt to manage earnings through selective application of the provision of SFAS 142 when operations are at a downturn or are substantially above financial analysts expectations. This possibility is enhanced in the year of SFAS 142 adoption because it requires companies to record the effects of changing to the new standard as a cumulative effect change that does not affect operating income. Jordan and Clark (2004) examined the impact of SFAS 142 for the Fortune 100 companies. They divided this sample of companies into two groups, those that recorded goodwill impairments and those that did not. They then compared the earnings levels of the two groups for 2002 and 2001 using two measures, return on assets (ROA) and return on sales (ROS). They found that firms reporting goodwill impairment charges in 2002 possessed significantly lower earnings in 2002 than did the firms not recording goodwill write-downs. They also found that the firms recording goodwill write-downs had a significantly higher proportion of negative earnings in 2002 than did those firms not taking the write-down. However, in 2001, prior to the requirement to record goodwill impairments, both groups had similar proportions of firms with negative earnings. Jordan and Clark (2004 p. 68) maintain that their results provide compelling evidence that firms practiced big bath earnings management in 2002. They also suggest that future research should be undertaken to test Elliott and Shaw’s (1988) finding that larger firms are more likely to take big baths than are smaller firms. This study contributes to the literature by expanding on Jordan and Clark (2004) and by considering Elliott and Shaw’s (1988) finding within the context of goodwill impairment charges. The sample A random selection of companies with December 31, 2002, fiscal years identified 120 (59.4 percent) firms that reported goodwill impairments in 2002 and 82 (40.6 percent) that did not[2]. To test the argument that larger firms are more likely to take big baths than smaller firms, the 120 firms that reported goodwill impairments in 2002 were divided into two groups. Large firms are defined as those with total assets greater than or equal to $450 million and small firms as those with total assets less than $450 million. Results Table I provides an indication on the magnitude of 2002 goodwill impairment losses. Mean and median results were calculated, but due to the sample being skewed by a few large firms (see Table II), we focus on median results. In 2002, sample firms wrote off a sizeable amount of reported 2001 goodwill. For the overall sample, median impairment losses (i.e. goodwill written off) approach 57 percent of 2001 reported goodwill. While large firms wrote off 27 percent of 2001 goodwill, small firms wrote off an astonishing 73 percent of 2001 goodwill, a significantly larger amount. This suggests that smaller firms may have been disproportionately impacted by the standard’s implementation. The impact of SFAS 142 adoption was noteworthy to both the balance sheets and income statements of sample firms. The amount of goodwill impairments equal 7.2 percent and 8.9 percent of 2002 total assets and sales, respectively, for the overall sample, but dividing the sample into the two size strata provides vastly different

Impaired sample % n ¼ 120

Ratio (median results) Impairment loss Impairment loss Impairment loss Impairment loss income (loss)**

to to to to

2001 2002 2002 2002

goodwill* total assets sales operating

Large firms % n ¼ 60

Earnings management

Small firms % n ¼ 60

a level

56.8 7.2 8.9

76 120 120

27.5 1.7 2.4

37 60 60

73.0 17.9 16.4

39 60 60

0.0339 0.0001 0.0001

0.1

118

5.2

59

2 47.6

59

0.0036

Notes: a level is the significance level for a test of differences between the large firm median and the small firm median results; *Results based on sample firms that reported goodwill separately on their 2001 balance-sheet; **Results based on sample firms for which operating income could be determined

Small impaired firms Large impaired firms All impaired firms

Mean

Median

5.5 483.3 236.8

4.2 62.6 4.8

results. Impairment losses to 2002 total assets are 1.7 percent and 17.9 percent, respectively, and impairment losses to 2002 sales are 2.4 percent and 16.4 percent, respectively, for large and small firms. Both metrics again suggest that smaller firms were impacted at levels significantly greater than larger firms. Holstrum and Messier (1982) maintain that an item’s effect on income is the most important factor in determining the materiality of that item. Their survey of auditors, preparers and users indicated that items affecting income by 10 percent or more are material. Table I reveals that impairment loss to 2002 operating income (loss) for the overall sample is small, only 0.1 percent, and thus by Holstrum and Messier (1982) standards, immaterial. However, results are again inversely related to firm size: 5.2 percent and 2 47.6 percent for large and small firms, respectively, and again the results are significantly different. In summary, Table I suggests that implementation of SFAS 142 has a significantly greater negative impact on the financial statements of smaller firms than on the statements of larger firms. Table III presents the median 2002 results for three metrics, goodwill to total assets, ROA, and ROS, for the 120 firms recording impairment losses in 2002 as well as for the 82 firms that did not. These results are presented for the total sample (panel A) and by firm size (panels B and C). For the overall sample, our results are similar to those reported by Jordan and Clark (2004). In 2001, there was no significant difference for any of the three ratios between the impaired and non-impaired groups. In 2002, however, ratio results between the two groups are significantly different for each of the ratios. Additionally, our results indicate even higher significance between the profitability ratios (i.e. big bath indicators) than reported by Jordan and Clark (2004), possibly due to our use of a more diverse sample. More specifically, the overall goodwill to total assets ratio decreased for both impaired and non-impaired firms from 2001 to 2002, but not surprisingly, the decrease

51 Table I. Significance of the total 2002 impairment loss

Table II. The mean and median 2002 operating income (loss) in millions by strata

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Panel A: total sample Goodwill to total assets Return on assets Return on sales

Impaired (%) 6.1 0.1 0.0

2001 Non-impaired (%) 8.9 1.2 1.9

Panel B: large firms (total assets greater than or equal Goodwill to total assets 2.6 18.3 Return on assets 2.2 4.3 Return on sales 2.5 6.3

Table III. Profitability of the impairment and non-impairment groups of firms

a level

Impaired (%)

2002 Non-impaired (%)

a level

0.2295 0.4725 0.6664

3.3 2 10.0 2 11.3

8.1 2 0.6 2 0.6

0.0868 0.0122 0.0052

to $450 million) 0.0087 2.0 0.1428 2 0.5 0.0776 2 0.7

10.9 1.7 3.5

0.0012 0.1236 0.0890

4.8 2 10.7 2 10.3

0.3199 0.0080 0.0446

Panel C: small firms (total assets less than $450 million) Goodwill to total assets 12.0 8.8 0.6397 Return on assets 2 10.5 2 11.1 0.7063 Return on sales 2 14.5 2 10.8 0.7847

4.8 2 36.9 2 32.4

Note: a level is the significance level for a test of differences between the impairment group median and the non-impairment group median within the same year

in the impaired group is much higher (almost 50 percent) than the decrease in the non-impaired group (approximately 9 percent). In our sample, larger firms experienced a significant difference between the impaired and non-impaired groups for both 2001 and 2002, while the differences between the two groups for smaller firms were insignificant in both years. Both big bath indicator ratios (ROA and ROS) suggest the presence of earnings management for the overall sample, but once the sample is segregated into size, it appears that smaller firms profitability ratios decreased more than larger firms. While prior research suggests that primarily larger firms engage in big bath earnings management, our results suggest otherwise. Specifically, for larger firms, results of comparisons between the two groups are qualitatively the same for 2001 and 2002, suggesting that with respect to goodwill impairments, no earnings management took place. The results when only smaller firms are analyzed, however, strongly suggest the presence of earnings management. In 2001, there is no significant difference for the big bath indicators between the two groups but in 2002, the results are significantly different for both indicators. Table IV reports the proportion of negative earnings firms between the two groups (impairment versus non-impairment) for each of the two years, and our results are similar to those reported by Jordan and Clark (2004) for the total sample. There is a significant difference between the proportion of firms reporting negative earnings in 2002, but not in 2001, for the overall sample, which suggests that big bath earnings management occurred in 2002. However, when we analyze the data based on the two size strata, we find varying results. There is no significant difference between the proportion for large firms with negative earnings in 2002 when compared to 2001. For small firms, however, we do find a significant difference between the proportion of firms with negative earnings in 2002 when compared to the number in 2001. These results suggest that it is the earnings management of smaller firms that drives the overall results.

Number (percentage) of firms with: Panel A: total sample Negative earnings Positive earnings Total a level Panel B: large firms Negative earnings Positive earnings Total a level Panel C: small firms Negative earnings Positive earnings Total a level

Impaired % n 59.2 40.8

71 49 120

2001 Non-impaired % n 57.3 42.7

47 35 82

2002 %

Impaired n

74.2 25.8

89 31 120

0.7879 50.0 50.0

30 30 60

37.5 62.5

41 19 60

76.2 23.8 0.3841

61.0 39.0

50 32 82

52.3 47.6

22 20 40

70.0 30.0

28 12 42

53

0.0467 15 25 40

60.0 40.0

36 24 60

0.2184 68.3 31.7

Non-impaired % n

Earnings management

0.4397 32 10 42

88.3 11.7

53 7 60 0.0224

Note: a levels are for two-tailed proportions test to determine if the proportion of negative earnings firms differed between the impairment group and non-impairment group. One test was performed for 2001, and another test was performed for 2002

Summary, conclusion, and suggestions for future research The current study utilizes the context of SFAS 142 adoption to expand the accounting literature on the big bath theory of earnings management and provide additional evidence of its existence. While prior studies have documented firms utilizing big baths for earnings management (Walsch et al., 1991; Kirshenheiter and Melumad, 2002), research has suggested that it is used more by larger firms than by smaller firms (Elliott and Shaw, 1988). Our study specifically contributes to the literature by providing evidence countering that intuition. We find that a significantly greater proportion of small firms reported negative earnings in the year of SFAS 142 adoption, as opposed to the prior year, but that there was no significant difference between the year-to-year proportions of large firms reporting negative earnings. These findings suggest that the negative reporting impact of the standard’s adoption was used more by small firms as part of a big bath strategy. There are two alternative explanations for our results. First, it is possible that, relative to larger firms, smaller firms have a higher percentage of total assets consisting of goodwill. If true, then the adoption of SFAS 142 would intuitively have a larger impact on smaller firms, particularly if impairments were identified. Second, it is possible that there was a greater decline in the profitability of smaller firms as opposed to larger firms, and that adoption of SFAS 142 simply exacerbated an already unfavorable outcome. Both alternative explanations stem from the possibility that smaller firms were impacted disproportionately by the standard. These are interesting considerations and may be endogenous factors to be considered by future research.

Table IV. Negative versus positive earnings for the impairment and non-impairment groups

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Notes 1. Various approaches to determining fair value are discussed in AAA Financial Accounting Standards Committee (2001), and in Lander and Reinstein (2003). 2. This sample was selected as part of an effort to determine the impact of SFAS 142 on reported earnings (reference withheld to maintain anonymity).

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References DeMark, E. (2002), “What you need to know about new FASB pronouncements that target business combinations and goodwill”, The CPA Journal, Vol. 72 No. 2, p. 10. Elliott, J. and Shaw, W. (1988), “Write-offs as accounting procedures to manage expectations”, Journal of Accounting Research, Vol. 26, Supplement, pp. 91-119. Financial Accounting Standards Board (FASB) (2001), “Goodwill and other intangible assets”, Statement of Financial Accounting Standards, No. 142, FASB, Norwalk, CT. Fudenberg, D. and Tirole, J. (1995), “A theory of income and dividend smoothing based on incumbency rents”, Journal of Political Economy, Vol. 103 No. 1, pp. 75-93. Healey, P. (1985), “The effects of bonus schemes on accounting decisions”, Journal of Accounting and Economics, Vol. 7 No. 1-3, pp. 85-107. Healy, P. and Wahlen, J. (1999), “A review of the earnings management literature and its implications for standard setting”, Accounting Horizons, Vol. 13 No. 4, pp. 365-83. Holstrum, G. and Messier, W. (1982), “A review and integration of empirical research on materiality”, Auditing: A Journal of Practice and Theory, Vol. 2 No. 1, pp. 45-63. Jordan, C. and Clark, S. (2004), “Big bath earnings management: the case of goodwill impairment under SFAS No. 142”, Journal of Applied Business Research, Vol. 20 No. 2, pp. 63-9. Kirshenheiter, M. and Melumad, N. (2002), “Can ‘big bath’ and earnings smoothing co-exist as equilibrium financial reporting strategies?”, Journal of Accounting Research, Vol. 40 No. 3, pp. 761-97. Lander, G. and Reinstein, A. (2003), “Models to measure goodwill impairment”, International Advances in Economic Research, Vol. 9 No. 3, pp. 227-32. Levitt, A. (1998), “The numbers game”, remarks by Chairman Arthur Levitt, Securities and Exchange Commission, delivered at the NYU Center for Law and Business, New York, NY, 28 September. Massoud, M. and Raiborn, C. (2003), “Accounting for goodwill: are we better off?”, Review of Business, Vol. 24 No. 2, pp. 26-32. Moses, O. (1987), “Income smoothing and incentives: empirical tests using accounting changes”, The Accounting Review, Vol. 62 No. 2, pp. 358-77. Trueman, B. and Titman, S. (1988), “An explanation of accounting income smoothing”, Journal of Accounting Research, Vol. 26 No. 3, Supplement, pp. 127-39. Walsch, P., Craig, R. and Clark, F. (1991), “Big bath accounting using extraordinary items adjustments: Australian empirical evidence”, Journal of Business Finance and Accounting, Vol. 18 No. 2, pp. 173-89. Wilson, A., Heitger, D. and Gregory, B. (2002), “Financial accounting impact of new accounting for business combinations and intangible assets”, Ohio CPA Journal, Vol. 61 No. 1, pp. 52-4.

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The current issue and full text archive of this journal is available at www.emeraldinsight.com/0268-6902.htm

Real-option valuation of research and development investments

Real-option valuation

Implications for performance measurement Hemantha S.B. Herath

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Department of Accounting, Faculty of Business, Brock University, St Catharines, Canada, and

Wayne G. Bremser Department of Accountancy, Villanova University, College of Commerce & Finance, Villanova, Pennsylvania, USA Abstract Purpose – Aims to promote an integrated performance measurement system. Design/methodology/approach – The literature on R&D performance measurement identifies the need for an integrated performance measurement system for strategy implementation. Develops a theoretical framework for R&D performance measures, incorporating real options to define strategic net present value, which values the plan to make R&D investments. Findings – Real options techniques can be used to value managers’ options to shelter investments from adverse effects and exploit upside potential. The shift in valuation paradigms from a naı¨ve net present value model to active risk management implicit in real options requires performance measures that reflect real option value and defines strategic value created (SVC), which is based on residual income concepts. Since residual income is known to be superior to ROI in motivating goal congruence, infers that SVC has similar advantages. Originality/value – Illustrates how SVC would be used as a performance measure for a new drug in the commercialization stage, considers several relevant questions and discusses how SVC could be used in a firm’s balanced scorecard. Keywords Income, Performance measures, Research and development Paper type Research paper

Introduction Research and development (R&D) investment decisions usually have a profound impact on a firm’s competitive position in the market. In a global environment of more intense competition, R&D is a key strategic issue. Consequently, R&D performance measurement and accountability is an important concern for strategy implementation (Werner and Souder, 1997; Brown and Svenson, 1998; Kerssens-van Drongelen and Bilderbeek, 1999; Pearson et al., 2000; Kerssens-van Drongelen et al., 2000; Bremser and Barsky, 2004). The inherent uncertainty and uniqueness of R&D investments are sources of complexity in performance measurement and evaluation of managers who make operating and investment decisions. Accounting performance measures influence investment decision-making. The managerial control literature supports residual income (RI) as a better measure than return on investment (ROI) for motivating goal congruence. ROI measures can create suboptimization problems by encouraging managers to make investments that make their divisions look good that are not in the firm’s best interest (Merchant, 1998). Reichelstein (1997) shows that RI in several

Managerial Auditing Journal Vol. 20 No. 1, 2005 pp. 55-72 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510570704

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respects is the only performance measure that induces a manager to invest in profitable projects and reject unprofitable projects. Firm profitability and value is increased by acceptance of positive net present value (NPV) projects. Lundholm and O’Keefe (2001) argue that the discounted cash flow and RI models yield identical valuations for firms when properly implemented. NPV has limitations as a decision criterion for investments under uncertainty. In recent years, management accounting and corporate finance academics have reasoned that the conventional discounted cash flow techniques do not adequately capture the value of managerial flexibility to respond to risks and uncertainty in investment and operating decisions. An emerging branch of research in capital budgeting called real options has been developed to overcome these limitations (Busby and Pitts, 1997; Brabazon, 1999; Booth, 1999). Real options techniques value managers’ options to shelter investments from adverse effects and exploit upside potential. When investments provide the flexibility to expand, contract, delay and learn, management decisions can create value. The insight from real options is that a business investment opportunity can be conceptually compared to a financial option. For example, when flexibility to defer a project exists, the intrinsic value of a real option is shown to be equal to the NPV (Luehrman, 1998). Consequently, NPV ignores the time value of the deferral option undervaluing the investment opportunity. Starting with the seminal paper by Myers (1977), proponents of real option theory have demonstrated that the real option technique is a better decision tool when making decisions under uncertainty. R&D investment opportunities exhibit real option characteristics, including lumpy initial investments with no immediate payoffs to justify the investments, highly uncertain project cash flows, existence of multiple sources of uncertainty at different project phases and long time horizons. Consequently, real option pricing has been proposed for valuing R&D investments in the capital budgeting literature (Myers, 1984, 1996; Faulkner, 1996; Herath and Park, 1999; Angelis, 2000; Boer, 2000, 2002a, b, c). R&D investments were modeled as simple European call options in earlier literature. More recently, researchers have emphasized that R&D, should be modeled as compound options (see Cortazar and Schwartz, 1993; Copeland and Keenan, 1998; Damodaran, 2000; Copeland and Antikarov, 2001; Herath and Park, 2002). Compound options are options whose value depends on other options. Most capital investment decisions including R&D are sequential compound options. When the first option is exercised it creates another option. Several researches have considered performance measures that support optimal decision-making in a real option setting. Grinyer and Walker (1990) construct a performance measure in limited real options context by considering the abandonment option. Stark (2000), suggests that a residual income type measure can be designed to support optimal investment and dis-investment decision making in a real option framework involving option to delay and to abandon. Stark’s measurement model main limitations are: . It is a single period model; . It does not clearly show how to derive the model values; and . It makes strong assumption on the existence of statistical distribution of variables without stating what these distributions are or how they arise.

Using a sample of 3,000 firms, Ramezani (2003) considers how the existence of real options affects financial measures of firms’ performance. He finds that financial ratios seem to reflect the value of firm’s real options and that performance measures for firms with valuable real options are significantly higher. The R&D management literature presents various approaches to measuring R&D performance (Foster et al., 1985; Moser, 1985; Brown and Svenson, 1998; Griffin and Page, 1993; Schumann et al., 1995; Chiesa et al., 1996). Werner and Souder (1997) reviewed the literature from 1956 to 1995 on measuring R&D performance. They concluded that integrated metrics that combine several types of quantitative and qualitative measures are the most effective, and they noted that these measures are generally the most complex and costly to develop and use. They identified important factors in the choice of R&D measurement metrics as the need for comprehensiveness of measurement, the type of R&D being measured, life stage of an R&D effort, the available data, and the perceived information cost/benefit. In a competitive environment requiring innovation, R&D is a critical determinant of strategic success. Blake (1999) surveyed 230 Industrial Research Institute member company representatives and reported that managing R&D for business growth, balancing long-term and short-term R&D objectives focus, and integration of technology planning with business strategy were the biggest problems currently faced as technology leaders. Pearson et al. (2000) report a trend that researchers and practitioners are emphasizing the importance of linking technology to competitive and corporate strategy. Several studies report and/or advocate a shift from R&D performance measurement methods that tend to emphasize past-oriented cost data (e.g. Chan et al., 1990; Doukas and Switzer, 1992; Woolridge and Snow, 1992) to forward-looking strategic performance measures. In this paper, we consider forward-looking strategic performance measures for R&D investments. Specifically, we develop the theoretical framework for performance measures, incorporating real options for R&D projects. Since pharmaceutical and biotech firms have taken a leadership role in adopting real option methodology (Boer, 2002c), we use an example of marketing a new drug. A firm that uses real options thinking and models takes an active risk management view. We reason that the shift in valuation paradigms from a naı¨ve NPV to active risk management implicit in real options requires performance measures that reflect real option value. Based on our theoretical framework, we define strategic value created (SVC), which is based on residual income concepts. Since residual income is known to be superior to ROI in motivating goal congruence, we infer that SVC has similar advantages. We illustrate how SVC would be used as a performance measurement in the commercialization stage and consider several relevant questions. The theoretical model To develop our theoretical model in the presence of real options for R&D, we consider a generic opportunity to market a drug after a successful clinical phase at times. Definition of variables P s:

project being evaluated at times.

E(Rs,t): expected operating revenues at time t þ s.

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Os,t:

operating expenses at time t þ s.

E(Cs,t): expected net cash flows of project at time t þ s. Is :

Initial investment of project undertaken at times.

r:

discount rate.

rf:

risk-free rate.

t:

tax rate.

Bs,t:

book value at time t þ s.

ds,t:

tax depreciation charge.

Ds,t:

EVAe depreciation charge on the capitalized investment over the projects life[1].

The marketing phases costs are $Os,t each year (time t þ s) and last for a period of T years. The successful drug provides a stream of revenue Rs,t which evolves according to the following stochastic differential equation: dRs;t ¼ mðR; tÞdt þ sðR; tÞdW pffiffiffiffi where dW is a Weiner process with dW ¼ 1 dt ; 1 , Nð0; 1Þ, and mðR; tÞ ¼ mRs;t and sðR; tÞ ¼ sRs;t are the instantaneous drift and standard deviation of Rs,t. Let Rs,0 be the initial value of the underlying asset. The time interval [0, T ] is divided into n equal time steps of size Dt ¼ T=n. The movement of the underlying asset Rs,t can be modeled in discrete time as a binomial lattice. In the binomial lattice approach Rs,t is assumed follow a random walk: it takes one of two values one period from now, an up-value uRs,0 with actual probability q, or down-value dRs,0 with actual probability (12 q). The risk neutral probabilities ( p) and values for u and d are as follows: pffiffiffiffi u ¼ e s Dt pffiffiffiffi d ¼ e 2s Dt e rf Dt 2 d p¼ u2d In the binomial approach, the dynamics of the underlying assets Rs,t takes the j ¼ Rs;0 u j d t2j be the revenue at time t in the jth node from following form. Let Rs;t bottom and 0 # j # t. Let V js;t be the operating option value at the same node. In order to price the value of commercialization opportunity we need to find V 0s;0 knowing V js;t for each t and j. The risk free probability at each node is given by pjt ¼ p j ð1 2 pÞt2j and the corresponding actual probability is qtj ¼ q j ð1 2 qÞt2j for 0 # j # t. First, we will apply the traditional NPV technique to the drug commercialization opportunity. Next, we present the real options valuation approach. NPV technique The expected after tax cash flows in period t for from commercializing the drug are given by:





E C s;t ¼

t X

j

q ð1 2 qÞ

t2j

C js;t

Real-option valuation

j¼1

where h i j j j j C js;t ¼ ð1 2 tÞ Rs;t 2 Os;t 2 d s;t þ d s;t are the expected revenues are computed using the actual probabilities (q) instead of the risk neutral probabilities ( p)[2]. In this theoretical setting, investment decisions should be made from the point of view of the stockholders (owners) rather than the short-range managerial (agent) point of view (Treynor and Black, 1976)[3]. Therefore, the owner would like the manager to invest in a project (Ps) if and only if, its NPV is non-negative Reichelstein (1997). Therefore, NPVðP s Þ ¼

T X   E C s;t g t 2 I s $ 0 t¼1

t

t

where g ¼ ð1 þ kÞ and k is the interest rate applied by the owner. Assuming clean surplus accounting the changes in book values are given by: Bs;t ¼ Bs:t21 2 Ds;t þ I s;t where Ds;o ¼ 0; Bs;21 ¼ 0 and Bs;o ¼ I s . Next we consider the residual income (RI) performance measure based on the concept of economic profit. In The Economic Value Added (EVAe) version of the RI model, investment expenditures are reallocated from the periods that they are incurred over the periods where net benefits are expected to occur. The residual income is income minus a required dollar return on the investment (imputed cost). The return on investment is the interest charge for the book value of assets employed. The residual income measure for t $ 1 is given by:   FRI s;t ¼ E C s;t 2 Ds;t 2 rBs;t21 h i Pt j j j t2j j FRI Rs;t 2 Os;t 2 d s;t þ ðd s;t 2 Ds;t Þ 2 rBs;t21 s;t ¼ ð1 2 tÞ j¼1 q ð1 2 qÞ where ds;t ¼

t X

j q j ð1 2 qÞt2j ds;t . When Ds;t ¼ d s;t the second term of the residual

j¼1

income vanishes. When the two depreciation schedules are not equal the difference between tax and EVAe depreciation has to be added to net operating profit after tax (Shrieves and Wachowicz, 2001). The residual income measure has a well know equivalence property[4], i.e. the net present value of a project is equal to the present value of its future residual incomes. Formally, NPVðP s Þ ¼

T X t¼1

t FRI s;t g $ 0

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Real options Like the net present value method, the real option approach is founded on the theoretical framework that investment decisions should be made from the point of view of the stockholders. However, there is one fundamental difference. The NPV method implicitly assumes passive management, but the real option framework recognizes that management has the flexibility to choose the best course of action at various points in time. For example, the manager has the discretion to continue or stop marketing in the commercialization of a drug. From an options perspective, the manager can exercise an operating option to continue to spend on marketing the drug only if it is profitable to do so. To illustrate our point, without loss of generalization let us ignore the tax effect of depreciation, then clearly, if Rs;t . Os;t þ d s;t the manager will spend on marketing and will not spend if Rs;t , Os;t þ ds;t . Therefore, the manager has a yearly option on the drug revenues to continue to market the drug with an exercise price equal to annual marketing cost. If the project is valued taking into consideration mangers flexibility, then we obtain the strategic net present (SNPV) value or the NPV with flexibility. The value of the R&D commercialization option is therefore equal to: SNPV ¼ NPV ðwithout flexibilityÞ þ operating option ðvalue of flexibilityÞ Consider the cash flow from commercializing the drug in the jth node from down in period t given by: h i j j j 2 d s;t C js;t ¼ ð1 2 tÞ Rs;0 u j d t2j 2 Os;t þ ds;t Notice that the manager’s flexibility creates an asymmetry in the cash flows by taking only the upside potential. On the other hand for the NPV we take the average of the two outcomes, up and down side potential. In modeling the option to commercialize the drug the following initial and boundary conditions apply. The initial condition is given as, if Rs;0 ¼ 0 then V ðRs;0 ; tÞ ¼ 0. The terminal payoff of the commercialization option at t ¼ N is: V js;N ¼ maxðC js;t ; 0Þ for all 0 # j # N for 0 # t , N 2 1 payoff value at each node is: n o   j V js;t ¼ max C js;t ; 0 þ e 2rDt pV jþ1 þ ð1 2 pÞV s;tþ1 s;tþ1 for all 0 # j # N 2 1 SNPV value can be found using the above backward recursions as V 0s;0 . To show the existence of a residual income type measure with real options, we mathematically express SNPV as: SNPVðP s Þ ¼

t¼1

where EðC þ s;t Þ ¼

T   X t E Cþ s;t g 2 I s . 0

t X j¼1

n o h i j j j max ð1 2 tÞ Rs;0 u j d t2j 2 Os;t 2 ds;t ; 0 p j ð1 2 pÞt2j þ ds;t

Notice that SNPV is strictly positive because the option value is always positive and by definition managers invest only in non-negative NPV projects. Proposition 1: for any project Ps there exists a residual income type performance measure (f RO) in the presence of real options: SNPVðP s Þ ¼

T X

FRO s;t gr $ 0

t¼1

where g tr ¼ ð1 þ r Þt and r is the risk-free rate used for valuing options consistent with risk-free arbitrage pricing. Proof: consider a residual income type measure in the presence of real options defined as:   þ FRO s;t ¼ E C s;t 2 D s;t 2 rBs;t21 The residual income measure for t $ 1 is given by:

FRO s;t ¼

t X

n o h i j j j max ð1 2 tÞ Rs;0 u j d t2j 2 Os;t 2 ds;t ; 0 p j ð1 2 pÞt2j 2 Ds;t 2 rBs;t21 þ d s;t

j¼1

FRO s;t ¼

t X

n h i o j j max ð1 2 tÞ Rs;0 u j d t2j 2 Os;t 2 ds;t ; 0 p j ð1 2 pÞt2j þ d s;t 2 Ds;t 2 rBs;t21

j¼1

For the equivalence we need to show that: Is ¼

t X

ðDs;t 2 rBs;t21 Þg t

t¼1

which follows directly from the clean surplus relationship. Proposition 2: the performance measure RI (with real options) will be higher than the performance measure RI when managerial flexibility is ignored, i.e. f RO $ f RI . Proof: let us assume that f RO , f RI . Since C þ s;t . C s;t (option value is always positive) and NPV $ 0 for all t, by definition we get SNPV . NPV. Consider the following two instances: (1) SNPV ¼ NPV, then the option value is zero and f RO ¼ f RI . (2) SNPV . NPV, then the option value is positive and f RO . f RI . From (1) and (2) f RO $ f RI and we get the required proof. Strategic value created Our theoretical model for the SNPV provides the basis for defining strategic value created (SVC). We define SVC as a periodic (residual income based) performance measurement to be used over the life of the project in the presence of real options. The SVC is based upon our theoretical model for the SNPV. The SNPV of a project can be decomposed into component periodic SVC measurements. The SVC for year t is calculated as follows:

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SVCt ¼ PV of E ðcash flowÞt 2 PV of ðEVA type depreciationÞt 2 PV ðcapital chargeÞt

62

We will illustrate how SVC is calculated and used to measure performance with a biotechnology project application. A biotechnology application In this section, we illustrate the valuation of a biotechnology project in the commercialization stage using a stylized example developed by Benninga and Tolkowsky (2002). Residual income measures without and with real options are used for valuation. A firm is considering the initiation of a new drug, which involves a discovery phase (stage 1), clinical phase (stage 2) and a marketing phase (stage 3): . Discovery phase: preliminary research on viability of the idea is expected to take one year and cost $1,000 at the beginning of the year. There is a 50 percent probability that the research will be positive and would proceed to the clinical phase. . Clinical phase: next, the drug will be tested. This stage is expected to last one year and cost $2,000 at the beginning of the year, with 30 percent probability of succeeding to the marketing phase. . Marketing phase: the drug will be sold in the market for a period of five years. The marketing phase is expected to cost $4,000 per year at the beginning of each year and earn annual net revenue (net of production costs) of $7,000 at the end of the year. The net revenue is expected to have an annual mean growth of 20 percent and standard deviation of 80 percent. The expected return on similar project is 15 percent and the risk-free rate is 7 percent. Traditional NPV approach In the commercialization of a drug, the manager has the discretion to continue or stop marketing. However, in the traditional NPV approach the project will be evaluated ignoring there annual operating options, assuming that the managers will continue to market the product without halting. The NPV of the project based on traditional DCF ignoring the managerial flexibility in the marketing stage is shown below. The present value of both R&D and marketing costs are: PVðcostsÞ ¼ 1;000 þ ð0:50Þ

4 X 2;000 1 4;000 þ ð0:50Þð0:30Þ ð1 þ 0:07Þ ð1 þ 0:15Þ2 t¼0 ð1 þ 0:015Þt

¼ $3;683 Notice that the cash flows in pertaining to R&D costs are discounted at the risk-free rate since the market risk premium is 0. Next we evaluate the value of the proceeds from the project conditional on reaching the marketing stage using the project cost of capital of 15 percent:

Real-option valuation

4 X 1 7;000ð1 þ 0:20Þt PVðproceedsÞ ¼ ¼ $3;765 2 ð1 þ 0:15Þ t¼0 ð1 þ 0:015Þt

Based on the above the expected NPV of the project is found to be $82[5], which indicates that the project should be accepted. Next, we compute the residual income performance measures over the life of the project. The expected net revenues in Table I have been discounted to the beginning of the year using the cost of capital to be consistent with the marketing expenses. The cash flows have been multiplied by a probability factor (50 percent £ 30 percent) to reflect the 50 percent probability that the research will proceed to the clinical phase and the 30 percent probability of succeeding to the marketing phase. Since corporate taxes are being ignored for simplicity, we have to only be concerned with the EVA type depreciation adjustment since the R&D would be capitalized instead of being expensed. Notice that only the R&D costs are capitalized. The present value of capitalized R&D is: PVðR&D costsÞ ¼ 1; 000 þ ð0:50Þ

63

2;000 ¼ $1;935 ð1 þ 0:07Þ

The project generates cash flows in year 2, and hence for computation of residual income we capitalize the year 2 values of R&D outflows which is: PVðR&D costs at year 2Þ ¼ 1;935ð1 þ 0:15Þ1 ¼ $2;225 We use the cost of capital of 15 percent and not the risk-free rate of 7 percent to find the interest earned over the two-year period. Assuming straight line EVA type depreciation over the five-year period, required adjustment for R&D in each year is $445. The residual income measure under the traditional NPV method is shown in Table I, with the sum of the PV(RI) shown as $82. Real options approach In the real options approach to R&D valuation, management recognizes that each stage provides an opportunity to choose whether to continue the project or not. In options terminology, the managers at each stage exercise the operating option to continue if the t¼2

t¼3

t¼4

t¼5

t¼6

Revenues $6,087 $7,304 $8,765 $1,0518 $1,2622 Marketing expenses 2 4,000 2 4,000 24,000 2 4,000 24,000 Cash flows 2,087 3,304 4,765 6,518 8,622 Probability 0.15 0.15 0.15 0.15 0.15 Expected (cash flows) 313 496 715 978 1293 Less depreciation 445 445 445 445 445 Operating income 2 132 51 270 533 848 Asset at beginning 2,225 1,780 1,335 890 445 Capital charge (15 percent) 334 267 200 133 67 RI 2 466 2 216 70 399 782 PV(RI) $ 2 352 $ 2 142 $40 $199 $338

Total NPV

$82

Table I. Multi-year analysis of RI without real options

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value from exercising the option exceeds the exercise price. Since the economic value from exercising is based on the future optimal decisions, the real option value of the project is derived from backward recursion. The first step in the real option valuation is to construct the binomial lattice for the value of the project. The following binomial tree is assumed to depict the random walk movement of the revenues. The project revenue at the beginning of year 3 equals $7,000 and is expected to grow at either 100 percent (if market is good) with a probability of 50 percent or decrease by 60 percent per year with a probability of 50 percent. The drug earns revenue over five years, and afterward it is expected to die. The corresponding values for the up- and the down-moves of the binomial lattice are u ¼ 2 and d ¼ 0:4. These values are equivalent to an annual mean growth of 20 percent and a standard deviation of 80 percent for revenues. In Table II, we present the binomial lattice depicting the random diffusion of revenues. An up move is shown to the left and a down move is shown to the left and one step down. We next compute the risk free probability of an up-move as: p¼

1:07 2 0:4 ¼ 0:418 2 2 0:4

In order to price the operating option to market the drug only if it is profitable we compute the state prices. The state price (qu) is the prices today of a $ to be paid in the up-state and the state price (qd) is the price of a $ to be paid in the down-state. We use the following property of the state price which states that they are consistent with risk-free interest rate where: q u þ qd ¼

1 p 12p ; implying that qu ¼ ¼ 0:39; qd ¼ ¼ 0:54 1 þ rf 1 þ rf 1 þ rf

Since we are using the state prices instead of the risk-free probabilities we do not need to discount the payoffs to find the value of the option since state prices are already discounted. In order to value the operating option we first find the terminal payoff values as:   V 5s;t¼6 ¼ max 112;000 2 4;000;0 ¼ $108;000 Then we find at value each of the other nodes as:   V 4s;t¼5 ¼ maxf56;000 2 4;000;0g þ 0:39 £ 108;000 þ 0:54 £ 18;400 ¼ $104;522:7

Table II. Binomial lattice for project revenues

t¼2

t¼3

t¼4

t¼5

t¼6

$7,000

$14,000 2,800

$28,000 5,600 1,120

$56,000 11,200 2,240 448

$11,2000 22,400 4,480 896 179

In Table III, we show the present value of cash flows when managers market with operating options. We can now find the value of the R&D project with managerial flexibility to halt marketing as: SNPV ¼ 1;000 þ ð0:50Þ

2;000 21;534 þ ð0:50Þð0:30Þ ¼ $507:8 ð1 þ 0:07Þ ð1 þ 0:15Þ2

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Notice that the value of the R&D project when real options are considered is much higher that the value obtained if the real option were ignored under the traditional approach. The aggregate influence of introducing the managerial options to abandon during the clinical phase or marketing phase is to increase the proposed project’s value, reflecting value created by managers taking an active risk management role. Next, we compute strategic value created by decomposing the SNPV of the project into component periodic SVC measurements. The present value of the expected cash flows in Table IV reflects the probability factors (as above 15 percent ¼ 50 percent £ 30 percent) and an annual mean growth of 20 percent with a standard deviation of 80 percent for revenues. Since we have we ignored corporate taxes (as above), we have to only be concerned with the EVA type depreciation adjustment for R&D. The present value of capitalized R&D is: PVðR&D costsÞ ¼ 1;000 þ ð0:50Þ

2;000 ¼ $1;935 ð1 þ 0:07Þ

The project generates cash flows in year 2, and hence for computation of residual income we capitalize the year 2 values of R&D outflows using the risk-free rate of 7 percent to find the interest earned over the two-year period that is: t¼2

t¼3

t¼4

t¼5

t¼6

$21,534

$42,899 2,999

$73,160 7,503 75

$10,4523 14,714 189 0

$10,8000 18,400 480 0 0

PV of E (cash flow) PV of depreciation PV of operating income Assets at beginning Capital charge (7 percent) PV (capital charge) Strategic value created (SVC) Note: PV at t ¼ 0

t¼2

t¼3

t¼4

t¼5

t¼6

Total SNPV

$341 362 2 21 2,070 145 127 $ 2 148

$447 338 109 1,656 116 94 $15

$500 316 184 1,242 87 66 $118

$567 295 272 828 58 41 $231

$587 276 311 414 29 19 $292

$508

Table III. Binomial lattice – present value of cash flows

Table IV. Multi-year analysis with real options

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PVðR&D costs at year 2Þ ¼ $1;935 ð1 þ 0:07Þ1 ¼ $2;070 The straight line EVA type depreciation adjustment over the five-year period in each year is $414, shown discounted and deducted from expected cash flows to get periodic PV of operating income measurements in Table IV, Deducting the PV of the capital charge, we get the periodic SVC components of SNPV, shown as $508. In this biotechnology example, the value of the R&D project under the real option framework (SNPV and SVC) is higher than the traditional net present value approach because the option approach recognizes that uncertainty creates valuable risk management opportunities for managers. Integrated performance measurement system Our framework emphasizes active risk management. At the time a project is initiated, our framework provides periodic SVC performance measurement benchmarks that are higher than traditional residual income based measures. In this section, we discuss how SVC fits into an integrated performance measurement system for firms with strategic R&D investments. Integrated performance measurement system Kerssens-van Drongelen and Bilderbeek (1999) report on an empirical study on the effectiveness of R&D performance measurement practices in The Netherlands at the team and department levels. They identified the most important characteristic of effective systems to be a customer focus. Kerssens-van Drongelen et al. (2000) review the R&D literature and discuss the limitations of popular corporate strategic planning and performance measurement tools used in practice. Kerssens-van Drongelen et al. (2000 p. 138) observe that a “limitation of the literature on R&D evaluation is that it fails to reflect adequately the current trends in R&D management and practice.” They acknowledge that various approaches link R&D to corporate strategy, making R&D a strategic issue, but they point out that strategy implementation requires the integration and support of many organizational components. Pearson et al. (2000) observe that there has been a shift by some firms from centrally funded R&D departments that are cost centers to profit centers. They view R&D management becoming more systematic and disciplined, emphasizing the contribution to shareholder value and customer value. They suggest that firms need a mix of strategic performance measures that “focus on processes and outputs, on growth drivers and cash flows, on tangible and intangible assets” to ensure that R&D relevant to customer needs is conducted. These studies coupled with the literature cited in the R&D performance measurement section of this paper suggest the need for an integrated performance measurement system. An integrated performance measurement system will include financial measures. While many firms use ROI as their primary measure of profit center financial performance, there are relatively few firms that use RI or EVA (Hatfield, 2002). Merchant (1998 p. 548) notes that RI overcomes the suboptimization limitation of ROI, but accounting profitability measurement problems remain. Stern Stewart’s EVA management system uses some accounting adjustments to RI to calculate EVA, and management compensation is based on achieving EVA goals. Merchant (1998 p. 549) notes that EVA is not economic income, which reflects changes in future cash flow potentials. Boer (2002c) views Stern Stewart’s EVA approach to R&D as an advance

because it treats R&D projects as investments, which are amortized over the useful life of the technology. The result is to reduce management’s incentives to slash R&D to improve short-term earnings. While this is an improvement, Boer warns that EVA is a cost-based valuation that does not reflect the true value of the technology. Consequently, Boer presents a model to value the firm using NPV and real options. SVC is responsive to the issues raised by Merchant and Boer. SVC is residual income based and includes EVA type of depreciation adjustments. Since periodic SVC benchmarks add up to equal SNPV, there is a linkage to cash flow, which diminishes concerns about accounting profitability measurement problems. The SNPV and SVC measures reflect the economic value of technology by using real options methodology. In our example, SVC reflects the value of the R&D project with managerial flexibility to halt marketing. Thus, SVC provides an integrated performance measurement across the value chain. Using the SVC benchmark The periodic SVC performance measurement benchmarks presented in Table IV illustrate our model. They are higher than traditional residual income based measures (Table I) for every year except t ¼ 6. Looking at t ¼ 2, we see a benchmark SVC of $2148. If the project went exactly as planned, there would have been a R&D investment of $3,000 followed by revenues of $7,000 and marketing expenses of $4,000 at t ¼ 3. To calculate SVC, these actual amounts would be adjusted using the original probabilities, discount factors and rates of return to get an SVC of $ 2 148. There would be a 0 variance because everything went as planned. Using the original probabilities, discount factors and rates of return causes the numbers to be smaller than unadjusted numbers. Some managers may have perception difficulties with the adjusted numbers. An alternative is to make upward adjustments to SVC to reflect the successful passage through the clinical stage into the commercialization stage. If the project went exactly as planned for t ¼ 3, the SVC would be $15. Next, assume that marketing expenses in t ¼ 4 were $4,000 and revenue was higher than planned. Consequently, SVC would be higher than the $118 benchmark shown in Table IV. There would be a favorable variance, which could be due to controllable factors such as improved marketing efforts or uncontrollable factor such failures by competitors. The firm’s integrated performance measurement system would need to have metrics and methods for assessing and reporting the root cause for this increase in strategic value. There is an opportunity for organizational learning, evaluating managerial performance, and rewarding managers. Assume that a new product is introduced at the beginning of t ¼ 5 that makes the firm’s product obsolete. Product marketing executives forecast that the revenues for t ¼ 5 would not justify continuing, and they abandon the product. Consequently, the SVC would equal $0, and there would be an unfavorable variance of $231, signaling a decline in strategic value. Since the SVC benchmark for t ¼ 6 is $292, this value is also lost. In this case, the root cause may be viewed uncontrollable by the product marketing executives. If a competitor introduced the new product, the root cause may be that R&D management miscalculated the competitor’s capabilities. Since the active management played out in accordance with the original “real options thinking”, the system would not automatically view the decline in strategic value as a negative factor in evaluating managerial performance. To do so would defeat goal congruence

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objectives. We argue that the “real options thinking” environment associated with using the SVC benchmark motivates goal congruent thinking, assuming rational behavior. In t ¼ 5, the firm may decide to evaluate the product marketing executives as satisfactory performance or higher because they made the right decision. At a higher level in the organization, a strategic business unit manager is responsible for a portfolio. The SBU manager’s benchmark SVC is the sum of the component project benchmarks. At this level, the manager can be expected to have a portfolio SVC the equals or exceeds the portfolio benchmark SVC in most years. Balanced scorecard example A high-profile approach to an integrated performance measurement system is the balanced scorecard (BSC) (Kaplan and Norton, 1996a, b, 2001a, b, c). The BSC framework is used to implement strategy using financial and non-financial metrics for four perspectives: (1) Customer. (2) Internal business processes. (3) Learning and growth. (4) Financial performance. The highest-level scorecard is usually at the corporate level, but the BSC may be implemented at the strategic business unit (SBU) or division level. Starting at the highest level, there is a cascading downward process to develop scorecards at lower levels to achieve integration. The BSC is an integrated performance measurement system that is designed to align R&D, production, marketing and other traditional functional areas with corporate strategic goals using both future performance drivers (leading indicators) and outcome measures (lagging indicators of performance). The BSC model has received considerable attention in recent years and many firms use some version of it. Business intelligence software is available to implement the BSC model using benchmarks or goals for performance measures. If the firm uses real options thinking in strategy formulation and implementation, it makes sense to measure value created by investing in R&D. For the financial perspective, a key BSC outcome measure is usually some version of ROI, but some firms use EVA. When firms have material R&D investments, a case can be made for using SVC at the firm, SBU, and investment center levels. At higher levels, the SVC is aggregative for many projects: and at a lower level, there may be only one project. Since SVC places a value on flexibility and active management, the BSC also needs financial and non-financial measures at various levels for the customer and internal business processes perspectives to measure managers’ efficiency and effectiveness in active management of R&D investments. Bremser and Barsky (2004) provide an example of a balanced scorecard for the R&D department that is aligned with strategic indicators at the firm level. They advocate using financial outcome measures that reflect value creation at the firm and R&D department level. The SNPV is a meaningful measure of value creation. In our example, the SNPV of $508 values the plan to make R&D investments in the discovery and clinical phases that will produce a marketable drug. Since the financial perspective of a balanced scorecard may have three or four outcome measures, SVC can be used to complement other financial measures.

Conclusion and further research The theoretical framework incorporating real options presented in this paper provides the basis for forward-looking strategic performance measures for R&D investments. The SNPV values the plan to make R&D investments. We defined strategic value created and used an example of a drug in the discovery, clinical, and marketing phases. Since SVC is based on residual income concepts, it can be expected to have advantages in motivating goal congruence. Our framework emphasizes active risk management associated with the real options model. At the time the project is initiated, the framework provides periodic SVC performance measurement benchmarks. SVC and SNPV are useful measures for an integrated performance measurement system for R&D management. We argue that the “real options thinking” environment associated with using the SVC benchmark motivates goal congruent thinking, assuming rationality. There are limitations associated with the proposed forward-looking strategic performance measures. Since they are based on real options valuation models, the limitations associated with these models apply to the SNPV and SVC. Since the measures used in the real options model involve forecasts and judgment, there are opportunities for gaming. These limitations suggest opportunities for future behavioral research on gaming in a real options thinking environment. A related research question is how to integrate negotiation analysis models with performance measurement? Another research question is how SVC and SNPV could be linked to the reward structure? We have provided examples on how SVC and SNPV could be used in a balanced scorecard, but future research is needed to examine this application in more depth. More research is needed on how performance measures for R&D at the portfolio and project level fit into an integrated performance measurement system. Notes 1. Two deprecation schedules are used by Shrieves and Wachowicz (2001) to resolve the concern that present value of residual income equals NPV only under very limited conditions as claimed by Dillion and Owers (1997). 2. Alternatively one can use the state price approach, where the expected value is based on the discounted risk free probabilities or state prices. 3. This is the equivalent to Reichelstein’s statement that all cash in- and out-flows are received (issued) by the principal (owner of the firm). 4. For more on the conservation property of RI see Reichelstein (1997). 5. Alternatively, we could have estimated the present value of the proceeds at time 2 using a binomial tree and state prices. The NPV under both methods are identical because in the state prices approach the state prices (or probabilities) would be adjusted for both time value and risk, and the risk free rate would be used to discount the value on the binomial lattice. References Angelis, D.I. (2000), “Capturing the option value of R&D”, Research Technology Management, Vol. 43 No. 4, pp. 31-4. Benninga, S. and Tolkowsky, E. (2002), “Real options: an introduction and application to R&D valuation”, The Engineering Economist, Vol. 47 No. 2, pp. 151-68. Blake, G. (1999), “Ten ‘biggest’ problems technology leaders face”, Research Technology Management, Vol. 42 No. 6, pp. 13-14.

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Boer, F.P. (2000), “Valuation of technology using ‘real options’”, Research Technology Management, Vol. 43 No. 4, pp. 20-30. Boer, F.P. (2002a), The Real Options Solution: Finding Total Value in a High-Risk World, John Wiley & Sons, New York, NY. Boer, F.P. (2002b), “Real options: the IT investment risk-buster”, Financial Management, Vol. 9, July, pp. 64-6. Boer, F.P. (2002c), “Financial management of R&D”, Research Technology Management, Vol. 45 No. 4, pp. 23-9. Booth, R. (1999), “Avoiding pitfalls in investment appraisal”, Management Accounting, November, pp. 22-3. Brabazon, T. (1999), “Real options: valuing flexibility in capital investment decisions”, Accountancy Ireland, Vol. 31 No. 6, pp. 16-18. Bremser, W.G. and Barsky, N. (2004), “Utilizing the balanced scorecard for R&D performance measurement”, R&D Management, Vol. 34, pp. 229-38. Brown, M.G. and Svenson, R.A. (1998), “Measuring R&D productivity”, Research Technology Management, Vol. 41 No. 6, pp. 30-5. Busby, J. and Pitts, C. (1997), “Real options in practice: an exploratory survey of how decision makers in industry think about flexibility”, Management Accounting Research, Vol. 8 No. 2, pp. 169-86. Chan, S.H., Martin, J. and Kensinger, J. (1990), “Corporate research and development expenditures and share value”, Journal of Financial Economics, Vol. 26, August, pp. 255-77. Chiesa, V., Coughlan, P. and Voss, C.A. (1996), “Development of a technical innovation audit”, Journal of Product Innovation Management, Vol. 13 No. 2, pp. 105-36. Copeland, T. and Antikarov, V. (2001), Real Options: A Practitioner’s Guide, Texere Publishing Limited, New York, NY. Copeland, T.E. and Keenan, P.T. (1998), “Making real options real”, The McKinsey Quarterly, Vol. 3, pp. 128-41. Cortazar, G. and Schwartz, E.S. (1993), “A compound option model of production and intermediate inventories”, Journal of Business, Vol. 66 No. 4, pp. 517-40. Damodaran, A. (2000), “The promise of real options”, Journal of Applied Corporate Finance, Vol. 13 No. 2, pp. 29-44. Dillion, R.D. and Owers, J.E. (1997), “EVA as a financial metric: attributes, utilization, and relationship to NPV”, Financial Practice and Education, Vol. 7, pp. 32-40. Doukas, J. and Switzer, L. (1992), “The stock market’s valuation of R&D spending and market concentration”, Journal of Economics and Business, Vol. 44 No. 2, pp. 95-114. Faulkner, T.W. (1996), “Applying ‘options thinking’ to R&D valuation”, Research – Technology Management, Vol. 39 No. 3, pp. 50-6. Foster, R.N., Linden, L.H., Whitely, R.L. and Kantrow, A.M. (1985), “Improving the return on R&D”, Research – Technology Management, Vol. 28 No. 1, pp. 12-17. Griffin, A. and Page, A.L. (1993), “An interim report on measuring product development successes and failure”, Journal of Product Innovation Management, Vol. 10, pp. 291-308. Grinyer, J.R. and Walker, M. (1990), “Deprival value accounting rates of return”, Economics Journal, Vol. 100 No. 3, pp. 918-22. Hatfield, G.R. (2002), “R&D in an EVA world”, Research – Technology Management, Vol. 45 No. 1, pp. 41-7.

Herath, H.S.B. and Park, C.S. (1999), “Economic analysis of R&D projects: an options approach”, The Engineering Economist, Vol. 44 No. 1, pp. 1-35. Herath, H.S.B. and Park, C.S. (2002), “Multi-stage capital investment opportunities as compound real options”, The Engineering Economist, Vol. 47, pp. 1-27. Kaplan, R.S. and Norton, D.P. (1996a), “Using the balanced scorecard as a strategic management system”, Harvard Business Review, Vol. 74 No. 1, pp. 75-85. Kaplan, R.S. and Norton, D.P. (1996b), The Balanced Scorecard, Harvard Business School Press, Boston, MA. Kaplan, R.S. and Norton, D.P. (2001a), The Strategy Focused Organization, Harvard Business School Press, Boston, MA. Kaplan, R.S. and Norton, D.P. (2001b), “Transforming the balanced scorecard from performance measurement to strategic management: part I”, Accounting Horizons, Vol. 15 No. 1, pp. 87-104. Kaplan, R.S. and Norton, D.P. (2001c), “Transforming the balanced scorecard from performance measurement to strategic management: part II”, Accounting Horizons, Vol. 15 No. 2, pp. 147-60. Kerssens-van Drongelen, I.C. and Bilderbeek, J. (1999), “R&D performance measurement: more than choosing a set of metrics”, R&D Management, Vol. 29 No. 1, pp. 35-46. Kerssens-van Drongelen, I.C., Nixon, B. and Pearson, A. (2000), “Performance measurement in industrial R&D”, International Journal of Management Reviews, Vol. 2, pp. 111-43. Luehrman, T.A. (1998), “Strategy as a portfolio of real options”, Harvard Business Review, Vol. 76, September-October, pp. 89-99. Lundholm, R.L. and O’Keefe, T. (2001), “Reconciling value estimates from the discounted cash flow model and the residual income model”, Contemporary Accounting Research, Vol. 18, pp. 311-35. Merchant, K.A. (1998), Modern Management Central Systems: Text and Cases, Prentice-Hall, Upper Saddle River, NJ. Moser, M.R. (1985), “Measuring performance in R&D settings”, Research and Technology Management, Vol. 28 No. 5, pp. 31-4. Myers, S.C. (1977), “Determinants of corporate borrowing”, Journal of Financial Economics, Vol. 5 No. 2, pp. 147-76. Myers, S.C. (1984), “Financial theory and financial strategy”, Interface, Vol. 14 No. 1, pp. 126-37. Myers, S.C. (1996), “Fischer Black’s contribution to corporate finance”, Financial Management, Vol. 25, Winter, pp. 95-103. Pearson, A.W., Nixon, W.A. and Kerssens-van Drongelen, I.C. (2000), “R&D as a business: what are the implications for performance measurement?”, R&D Management, Vol. 30, October, pp. 355-66. Ramezani, C.A. (2003), “Real options, corporate performance and shareholder value creation”, working paper, California Polytechnic State University, San Luis Obispo, CA. Reichelstein, S. (1997), “Investment decisions and managerial performance evaluation”, Review of Accounting Studies, Vol. 2 No. 2, pp. 157-80. Schumann, P., Ransley, D. and Prestwood, D. (1995), “Measuring R&D performance”, Research Technology Management, Vol. 38 No. 3, pp. 45-54. Shrieves, R.E. and Wachowicz, J.M. Jr (2001), “Free cash flow (FCF), economic value added (EVAe), and net present value (NPV): a reconciliation of variations of discounted-cash-flow (DCF) valuation”, The Engineering Economist, Vol. 46, pp. 33-52.

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Stark, A.W. (2000), “Real options, (dis)investment decision-making and accounting”, Journal of Business Finance and Accounting, Vol. 27 No. 3/4, pp. 313-31. Treynor, J.L. and Black, F. (1976), “Corporate investment decisions”, in Myers, S.C. (Ed.), Modern Developments in Financial Management, Praeger, New York, NY, pp. 310-27. Werner, B.M. and Souder, W.E. (1997), “Measuring R&D performance: state-of-the-art”, Research – Technology Management, Vol. 40, March-April, pp. 34-42. Woolridge, J.R. and Snow, C.W. (1992), “Stock market reaction to strategic investment decisions”, Strategic Management Journal, Vol. 11, pp. 353-63. Further reading Boer, F.P. (1998), “Traps, pitfalls and snares in the valuation technology”, Research Technology – Management, Vol. 41 No. 5, pp. 45-50. Davila, A. (2000), “An empirical study on the drivers of management control systems’ design in new product development”, Accounting, Organizations and Society, Vol. 25, pp. 383-409. Kellogg, D. and Charnes, J.M. (2000), “Real-options valuation for a biotechnology company”, Financial Analysts Journal, Vol. 56 No. 3, p. 76. Stewart, G.B. (1991), The Quest for Value: The EVA Management Guide, HarperCollins Publishers, Inc., New York, NY.

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Auditors’ perception of fraud risk indicators

Auditors’ perception of fraud indicators

Malaysian evidence Malcolm Smith

73

Leicester Business School, Bede Island Graduate Centre, De Montfort University, Leicester, UK, and

Normah Haji Omar, Syed Iskandar Zulkarnain Sayd Idris and Ithnahaini Baharuddin Faculty of Accountancy, MARA University of Technology, Johor, Malaysia Abstract Purpose – Aims to identify the most important red flags as individually perceived by auditors, and explores whether auditors’ demographic factors might impact on their perception of the relative importance of red flags in Malaysia, particularly in the Klang Valley area. Design/methodology/approach – This study employed a mailed survey as a method of data collection. The respondents to this survey are practicing auditors from audit firms in Kuala Lumpur. The sample of auditors is taken from the population of domestic listed audit firms with the Malaysian Institute of Accountants as of 27 March 2003. A simple random technique is applied to construct the sample. Findings – In general, subjects indicated that the operating and financial stability category was judged as most important, followed by management characteristics and influence over the control environment, and then finally by industry characteristics. Originality/value – It would be interesting to examine whether these fraud risk indicators are indeed helpful in the investigation of reported misconduct and fraudulent cases in Malaysia. The findings may help researchers to develop a new fraud risk indicator that takes into consideration actual instances of fraud in Malaysia. Keywords Auditors, Fraud, Perception Paper type Research paper

Introduction Fraud is defined by the Malaysian Approved Standards on Auditing (2001), AI No. 240, as: An intentional act by one or more individuals among management, employees, or third parties, which results in a misrepresentation of financial statements.

Fraud is believed to be amongst the most serious corporate problems, and challenges in today’s business environment, indeed Palshikar (2002) suggests that: Fraud or scam is a dominant white collar crime in today’s business environment . . . many businesses and government organisations, particularly in financial and related services, suffer from fraud of various kinds.

The phenomenon is empirically supported by a number of studies; for example, Cain (1999) and the KPMG Australia fraud survey (KPMG, 2002) each indicate that over 50 per cent of all respondents surveyed believed that fraud is a major business problem. Similarly, reviews of fraud cases by Rezaee (2004) revealed that financial statement

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fraud has cost market participants more than $500 billion during recent years, with serious litigation consequences for associated auditors. It is clear that accountants, auditors and the accounting profession need to take proactive steps to curb corporate fraud, steps which may involve increased regulation. In the US, for example, the official release of Statement on Auditing Standards (SAS) No. 99: Consideration of Fraud in a Financial Statement Audit, by American Institute of Certified Public Accountant (AICPA) in 2002 provides explicit evidence that the accounting profession is serious about the matter. This statement supersedes the two previous statements on fraud detection, namely SAS No. 82 (1997) and SAS No. 53 (1988), and paragraph 1 states that: The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements, whether caused by error of fraud.

However, paragraph 31 also states that “because fraud is usually concealed, material misstatements due to fraud are difficult to detect” thus auditors need to consider events or conditions that indicate the existence of “incentives/pressures to perpetrate fraud, opportunities to carry out the fraud or attitudes/rationalizations to justify a fraudulent action” (paragraph 31), such events being referred to as “fraud risk factors”. Auditors, due to the nature of their work, cannot run away from the fact that they are among the parties that can detect fraud at the earliest stages from the unaudited final accounts. Even so, the responsibility to detect fraud is generally not part of the auditors’ brief, since the responsibility for detection rests firmly with management through the implementation of sound internal control procedures. However, the ability of the auditors to alert management to the warning signs of fraud, combined with “professional scepticism” can be beneficial in the early detection of fraud. In their study, Shaub and Lawrence (1996) found that the existence of a related party transaction and clients subject to financial stress (as exhibited by fraud risk factors) among other factors, had resulted in increasing scepticism among the auditors. Fraud has increasingly become a major problem in Malaysia; the New Straits Times (Management Times, 2001) reported that: More than 60 per cent of the Malaysian listed companies surveyed had experienced some form of fraud. Of the companies surveyed, almost a quarter were found to have lost more than RM 1 million each to fraud.

In the year 2001, the Malaysian Institute of Accountants (MIA) issued the Malaysia Approved Standards on Auditing AI 240 “Fraud and Error” to provide a general guideline for auditors. This standard provides examples or events, which indicate increased risk of fraud. However, there is no specific guideline given on what constitutes the most significant fraud risk indicator (red flag). As such auditors may assume that all the indicators are equally important, thus, limiting the predictive usefulness of the system. Knowledge of the most important warning signs should help auditors do a better job in assessing fraud risk (Heiman-Hoffman et al., 1996) and this could contribute towards the ongoing improvement of auditing standards which guide the fraud risk assessment process (Apostolou et al., 2001b). The purpose of this study is twofold: first it aims to identify the most important red flags as individually perceived by auditors, and second it explores whether auditors demographic factors (e.g. gender, auditors experience, auditors tenure, type of audit

firm and fraud experience) might impact on auditors’ perception of the relative importance of red flags in Malaysia, particularly in the Klang Valley area. This area has been chosen as the centre of the study, specifically because most of the medium-sized Malaysian audit firms, and all of the “big four” head offices are situated there. The remainder of this paper is organized in the following sections: literature review, research method, results/data analysis, comparison of results to prior research, summary and conclusion. Literature review SAS 99 requires the auditor to gather information necessary to identify risks of material misstatement due to fraud (para 20 through 34) and apply their professional judgement to consider the attributes of the risk. Para 40 of the same section identifies three major attributes of risk: (1) Type of risk (fraudulent financial reporting or misappropriation of assets). (2) Significance of the risk (whether it will lead to material misstatement). (3) Likelihood of the risk resulting in a material misstatement. It is important to note that the presence of fraud risk factors do not necessarily indicate the existence of fraud, however, they are often present in those circumstances where fraud does exist (SAS 99, para 31); Bell and Carcello (2000) provide a comprehensive set of significant, and insignificant, risk factors. Thus the availability of fraud indicators can make auditors more aware of the possibility of the existence of fraud. As proposed by Palshikar (2002): Fraud management involves a whole gamut of activities; early warning and alarms; tell tale symptoms and patterns of various types of fraud; . . .

Similarly Burns (1997) hypothesized that the more red flags that exist in a business, the more likely that fraud will be taking place. The NACD Blue Ribbon Commission on Audit Committee Report, American Institute of Certified Public Accountant (2002) reported that there were possibly 16 red flags apparent prior to the collapse of Enron. The availability of the red flags will alert the auditors to the likelihood of fraud taking place thus, facilitating early warning to the clients. Consequently, the risk of not detecting fraud will decrease if the auditors understand the red flags and apply their “skepticism” in a professional manner. To improve their understanding of the red flags auditors should be aware of the thoughts of other auditors, when it comes to expressing the relative importance of the flags in alerting them to possible fraud (Heiman-Hoffman et al., 1996). The problem is that, although long lists of red flags have been provided in the SAS, neither SAS 82 nor the related implementation guide offers any guidance about how to weight or prioritise the 25 management fraud risk factors. Thus, auditors may interpret SAS 82 as indicating that all risk factors are equally important, whereas in any specific audit that is most unlikely. Similarly, para 33 of SAS 99 states that: The order of the examples of risk factors provided is not intended to reflect their relative importance or frequency of occurrence.

Such empirical evidence as exists suggests that audit firms feels that assessment of fraud risk will be more effective once consensus has been achieved on the distinguishing risk factors and their relative weights (e.g. Hackenbrack, 1993; Shelton et al., 2001).

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76

Many researchers (e.g. Romney et al., 1980; Loebbecke et al., 1989; Heiman-Hoffman et al., 1996; Abdul Majid and Tsui, 2001; Apostolou et al., 2001a, b) have used SAS-based red flag systems in their research. For example Loebbecke et al. (1989) used indicators from SAS No. 53 and Apostolou et al. (2001a,b) those from SAS 82. Loebbecke et al. (1989) asked respondents to describe the presence of red flag indicators and found that most of the red flags included in the survey listing had a relatively high frequency of occurrence. Similarly Apostolou et al. (2001b) found that respondents rated “known history of securities law violation”, “significant compensation tied to aggressive accounting practices” and “management’s failure to display appropriate attitude about internal control” as the three most important red flags. Their results also indicates that red flags relating to management characteristics, and influence over the control environment were considered more important than those relating to operating and financial stability characteristics and industry conditions. In another study, Heiman-Hoffman et al. (1996) asked auditors to rank 30 commonly cited potential red flags as to their relative importance for spotting fraudulent financial reporting. They found that respondents perceived “attitude factors” such as dishonest, hostile, aggressive and unreasonable management attitudes to be more important warning signs than “situational factors”. The findings of this study conflict with those of Abdul Majid and Tsui (2001) which revealed situational factors such as “difficult to audit transaction” and “indication of going concern” to be more important than “attitude factors”. Different economic environments may contribute to these different findings since these last two studies were conducted in US and Hong Kong, respectively. Apart from studies seeking to identify the most important red flags, other research has sought to identify the presence of red flags in actual incidences of fraud. Weisenborn and Norris (1997) subjectively applied 86 red flags to 30 known fraud cases and found the presence of these red flags in most of the cases. Some of the red flags, notably “dishonest or unethical management” and “inadequate internal controls or failure to enforce controls” are considered prime indicators for the great majority of fraud cases. Beasley et al. (2000) compare the company governance mechanisms of known fraud cases with “no-fraud” industry benchmarks; they found that companies who exhibited fraud had fewer audit committees, fewer independent audit committees, fewer audit committee meetings, less frequent internal audit support and fewer independent board members. Empirical evidence had also shown that the proportion of outside members on the board of directors is lower for firms experiencing financial statement fraud. Bell and Carcello (2000) developed and tested a logistic regression to estimate the likelihood of fraudulent financial reporting using a sample of 77 fraud engagements and 305 non-fraud engagements, using the incidence of red flags as explanatory variables. They found that the significant red flags that effectively discriminated between fraud and non fraud engagements were: . management lied to the auditor; . a weak internal control environment; . an unduly aggressive management attitude; . undue management emphasis on meeting earning projections; and . significant difficult-to-audit transactions. Church et al. (2001) provide further evidence that internal auditors are sensitive to factors that affect the possibility of fraudulent financial reporting. In a situation where

operating income is greater than expected, an earnings-based bonus plan is used, and debt covenants are restrictive, internal auditors assigned a higher likelihood of fraud. Another stream of red flags research is the use of a red flags checklist for assessing the possibility of fraud. Romney et al. (1980) proposed a fraud risk evaluation questionnaire that will be beneficial to auditors in identifying potential fraud perpetrators. Pincus (1989) sees the “red flag” questionnaire as an audit tool that adds structure to the auditor’s consideration of the risk of material fraud; he conducted a field experiment to examine the efficacy of the red flags questionnaire for assessing the risk of material fraud between fraud cases and no-fraud cases, which revealed no significant difference in the assessed risk of fraud by questionnaire users and non-users for a no-fraud case; the non-users outperformed the questionnaire users for the fraud case. A number of researchers have subsequently conducted independent studies of the effectiveness of the red flag questionnaire: Eining et al. (1997, p. 4) stated that “[a] checklist give no mechanical assistance for weighting and combining the red flags cues into an overall assessment” and suggest that a decision aid (e.g. fraud checklist) should mechanically combine those red flags in a manner that enhances the auditor’s reliance on the decision aid. They believe that by identifying the most important red flags, and the least important red flags, they can make the red flags questionnaire more useful. Shelton et al. (2001) report that the fraud checklist has been found to be a widely-used practice aid for most firms in assessing fraud risk during the client – acceptance/continuance stage Auditors may have different perceptions of the significance of fraud indicator levels and this could be explained by many individual factors. Only Apostolou et al. (2001b) has systematically sought to determine whether demographics factor such as type of firm, years of audit experience, job position, industry specialization, etc., impact on the auditors rating of the relative importance of red flags. However, their results were insensitive to such factors. Research in other fraud-related areas has also examined the effect of demographic factors (e.g. Ansah et al., 2002; Knapp and Knapp, 2001; and Moyes and Hasan, 1996). Moyes and Hasan (1996) reveal that experience of auditors and prior success in detecting fraud are consistently significant variables in detecting fraud for each audit cycle and combined cycle estimates. Knapp and Knapp (2001) conducted an experiment that examined the effects of audit experience and explicit risk assessment in detecting fraud with analytical procedures; their results suggest that audit managers are more effective than audit seniors in assessing the risk of fraud with analytical procedures. Ansah et al. (2002) investigate the relative influence of the size of audit firms, auditor’s position tenure and auditor’s year of experience in auditing on the likelihood of detecting fraud in the stock and warehouse cycle. They found that such factors are statistically significant predictors of the likelihood of detecting fraud, and increase the likelihood of fraud detection. In other research related to the audit field, Choo and Trotman (1991) examine the recall of typical and atypical information by experienced and inexperienced auditors within the context of a going-concern situation and then relate this measure of memory to the inferences and predictive judgments made by auditors. They found that experienced auditors recalled more atypical items than inexperienced auditors. Chung and Monroe (2001) examine the effects of gender and task complexity on the accuracy of audit judgment. They found that there is a difference on judgment accuracy as result of differences in both gender and task complexity; in particular they note an interaction effect whereby females are more accurate than males when processing complex audit tasks.

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The evidence relating to the relative importance of red flags is thus inconsistent, while that relating to auditor demographic factors (e.g. gender, auditors tenure and experience, type of audit firm) is conflicting. Thus this study examines both area and seeks to provide further evidence for the Malaysian experience.

78

Research method This study employed a mailed survey as a method of data collection. The mail questionnaire method allows for confidentiality, which encourage frankness and is widely used in auditing research. The survey method is particularly appropriate in these circumstances since it is designed with the intention of operationaliseing definitions of concepts that reflects the strength of attitudes, perceptions, views and opinions. The respondents of this survey are practicing auditors from audit firms in Kuala Lumpur. The sample of auditors is taken from the population of domestic listed audit firms with the Malaysian Institute of Accountant as of 27 March 2003. A simple random technique is applied to construct the sample. The survey instrument, comprised a cover letter, a pre-paid envelope and questionnaire, and was mailed to 200 auditors. In order to encourage a high response rate, the correspondence was personalised by hand-signing each letter (Dillman, 1999). Anonymity was promised to all respondents in the survey. A total of 48 auditors responded with usable questionnaires, representing a 24 per cent response rate. A comparison of the responses from “early” and “late” respondents suggested that non-response bias would not be an issue in this study. The questionnaire consisted of three parts: (1) The first part collects demographic information about the respondent. (2) The second part asks whether the auditors have experienced fraud during their audit engagement, and also solicits the respondents’ perception of the degree of importance of the red flags (using those red flags adopted by Apostolou et al., 2001a, b). Since these red flags have already been tested on practicing auditors and forensic experts, the construct validity of the questionnaire should be increased, and the reliability of the findings improved. Also the similarity of these red flags with those exhibited in Malaysia Approved Standards on Auditing AI 240 “Fraud and error”, suggests that they will be particularly appropriate in this study. The respondents were asked to indicate their opinion on the degree of importance of the 25 red flags on a four-point Likert-scale denoted by “1” not important at all, “2” generally not important, “3” generally important and “4” extremely important. The researchers did not use a five-scale interval to avoid “no opinion” or neutral response. Krosnick et al. (2002) suggest that the inclusion of no opinion options in attitude measures may not enhance data quality and instead may preclude measurement of some meaningful opinions; consequently this option was not provided. (3) The third part of the questionnaire provides a series of specific questions: . open-ended questions allowing respondents to both express opinions and to make recommendations about other red flags that were not listed in the questionnaire; and . closed questions to gather respondents’ opinions on whether it is necessary or not to have a red flags checklist during their audit engagement.

Results and data analysis A normality test to check the distribution of the data establishes that it is normal. In order to determine the internal reliability of the multi item variables, Cronbach’s Alpha was used. This statistical measure yields 0.8280, which mean that the items that make up the scale are internally consistent.

Auditors’ perception of fraud indicators

General findings Table I provides demographic information regarding the respondents. The respondents in this study comprise of 27 male and 21 female auditors. A total of 26 auditors have less than three years audit working experience while 22 auditors (45.8 per cent) have above three years working experience. A total of 23 of the respondents were audit juniors, another 13 were supervisors and only one was a partner. A total of 81.3 per cent of the respondents work with local firms and the remainder (18.8 per cent) are attached to one of the big four international affiliated firms. A total of 20 respondents had came across fraud cases before, while the other 28 had never experienced instances of fraud. Of the 25 fraud indicators listed in the questionnaire, Table II shows that only seven have an average score of 3.00 (generally important). Only one indicator came from the management influence over the control environment group while the other six came from the operating and financial stability characteristics group. None of the items from the industry conditions group was ranked as important fraud risk indicators (score below 3.00). This grouping of items is more apparent from Table III. “Management’s failure to display appropriate attitude about internal control” (mean ¼ 3:375) from the management influence over the control environment group was ranked as the most important fraud risk indicator in helping auditors to predict the presence of fraudulent event. The auditors seem to perceive that “weak internal

79

Auditors (n ¼ 48) Gender Male Female

27 21

Experience , 3 years . 3 years

26 22

Job title Partner Manager Supervisor Audit junior

1 11 13 23

Type of firm Local International

39 9

Experience fraud Yes No

20 28

Table I. Demographic information items

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Rank 1

80

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

Table II. Ranking of fraud risk indicators

20 21 22 23 24 25

Type of fraud indicators/red flags Management failure to display appropriate attitude about internal control Unusually high dependence on debt Significant-related – party transaction Significant pressure to obtain capital Poor/deteriorating financial position with management guarantee of firm’s debt Negative operating cash flow but reported earnings Threat of imminent bankruptcy Difficulty in determining organisational control Potential adverse consequences of poor financial results Significant accounts based on estimates Known history of securities law violations “Substance over form” questions Significant compensation tied to aggressive accounting practices Unusually rapid growth/profitability relative to industry Strained management/auditor relationship Bank accounts or operations in tax-haven jurisdictions Non-financial management’s influence over GAAP principle or estimates High turnover of senior management Effects of new accounting requirements on financial stability/profitability High degree of competition/market saturation and declining margins High vulnerability to interest rates Overly complex organisation Presence of aggressive incentive programs Company in declining industry Rapid changes in industry and vulnerability to changing technology

Mean 3.375 3.271 3.149 3.128 3.104 3.083 3.064 2.957 2.934 2.830 2.826 2.796 2.760 2.740 2.730 2.720 2.696 2.644 2.630 2.617 2.587 2.522 2.489 2.417 2.283

control” and “wrong attitude toward their importance” will cause greater risk for the going concern of the organisation. The other six important fraud risk indicators were “unusually high dependence on debt” (mean ¼ 3:271), “significant related-party transaction” (mean ¼ 3:149), “significant pressure to obtain capital” (mean ¼ 3:128) and “poor/deteriorating financial position with management guarantee of firm’s debt” (mean ¼ 3:104), “negative operating cash flow but reported earnings” (mean ¼ 3:083) and “threat of imminent bankruptcy” (mean ¼ 3:064) (all from operating and financial stability characteristics group). The auditors clearly viewed the operating and financial instability of the organisation as a potential red flag factor of fraud. Items from the external industry condition group were considered by the auditors as the least important fraud red flags. Variables under this category were considered as external to the organisation and normally beyond their control. The last three items ranked by the auditors were “presence of aggressive incentive programs” (mean ¼ 2:489), “company in declining industry” (mean ¼ 2:417) and “rapid changes in industry and vulnerability to changing technology and product obsolescence” (mean ¼ 2:283), which all came from this group.

Individual mean

Fraud risk factors/red flags Management influence over the control environment Significant compensation tied to aggressive accounting practices Management failure to display appropriate attitude about internal control Non-financial management’s influence over GAAP principle or estimates High turnover of senior management Strained management/auditor relationship Known history of securities law violations Operating and financial stability characteristics Significant accounts based on estimates Significant related-party transaction “Substance over form” questions Presence of aggressive incentive programs Potential adverse consequences of poor financial results High vulnerability to interest rates Unusually high dependence on debt Threat of imminent bankruptcy Poor/deteriorating financial position with management guarantee of firm’s debt Bank accounts or operations in tax-haven jurisdictions Overly complex organisation Difficulty in determining organisational control Negative operating cash flow but reported earnings Significant pressure to obtain capital Unusually rapid growth/profitability relative to industry Industry conditions Effects of new accounting requirements on financial stability/profitability High degree of competition/market saturation and declining margins Company in declining industry Rapid changes in industry and vulnerability to changing technology and product obsolescense

Group mean 2.914

Auditors’ perception of fraud indicators

2.760

81

3.375 2.696 2.644 2.730 2.826 2.935 2.830 3.149 2.796 2.489 2.934 2.587 3.271 3.064 3.104 2.720 2.522 2.957 3.083 3.128 2.740 2.496 2.630 2.617 2.417

Table III. Fraud risk indicators by group

2.283

Table III shows that the operating and financial stability characteristics red flags (mean ¼ 2:935) are perceived to be more important than management characteristics and influence over the control environment red flags (mean ¼ 2:914) and industry conditions red flags (mean ¼ 2:496). However, as revealed by Table IV, the only statistically significant between group differences were those associated with the industry conditions group. Fraud risk factor group

T-value

Significance level

Management influence vs industry conditions Management influence vs operating and financial Industry conditions vs operating and financial

4.164 2 0.282 2 4.942

0.000 0.780 0.000

Table IV. T-test result

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Fraud risk indicator check-list Of the 48 respondents, 37 stated that they agreed that when an auditor is performing audit work, it is necessary for them to go through the fraud risk indicator checklist. Five of the respondents thought it unnecessary to go through the checklist and another five were undecided. This finding suggests that the vast majority of auditors see benefits in using the checklist when conducting an audit.

82 Relationship between demographics and importance level Analysis of variance (ANOVA) was conducted to determine whether auditors’ perception of the red flags was influenced by their demographic characteristics. It was found that gender, auditors tenure and auditor year of experience do not appear to have a significant impact on auditors perception. In general, neither did the “type of audit firms” except that two red flags, namely, “presence of aggressive incentive programs” (F prob ¼ 0:021 Sig. at p , 0:05 level) and “high vulnerability to interest rates” (F prob ¼ 0:039 Sig. at p , 0:05 level) were significant. Auditors experience of fraud did not appear to have any impact on auditor’s perception either, except for the one red flag “high turnover of senior management” (F prob ¼ 0:037 Sig. at p , 0:05). Limitations The findings of this preliminary study are subject to the normal limitations associated with mail surveys. Additionally, the relatively low rate of response (24 per cent overall) and low response in particular from the more “senior” auditors and those from the “big four” group, were a disappointment. Furthermore, auditors with less than three years work experience dominated the composition of respondents; they may not be representative of the whole population of auditors, so that the findings may not be generalisable. Comparisons of results with prior research Three prior studies that are particularly relevant to this one are: Apostolou et al., 2001b; Abdul Majid and Tsui, 2001; and Heiman-Hoffman et al., 1996. Comparing the results of Apostolou et al. (2001b) with those above shows that operating and financial stability characteristics red flags (operating characteristics) are perceived to be more important than management characteristics and influence over the control environment red flags (management characteristics), whereas Apostolou et al. (2001b) found the opposite. This may indicate that a different economic environment may have impacted on the results. However, similar findings with Apostolou et al. (2001b) were apparent in the relative lack of importance accorded red flags associated with industry condition (industry characteristics). In terms of the individual red flags, in both studies it was found that management’s failure to display an appropriate attitude about internal control is perceived to be among the top three important red flags. One interesting finding, though, was that “significant compensation tied to aggressive accounting practices” was ranked number 13 in their study, whereas the Apostolou study ranked it at number 2. This significant difference might be as a result of different in respondent. Most of the respondents in the Apostolou study were at manager level or above (i.e. managers and partners represented 43.9 percent of respondents) whereas in our study the majority of the respondents were audit juniors

(47.9 percent). Their lack of audit experience may have lead them to be unable to recognise this red flag as one of the most important ones. The red flags used by Abdul Majid and Tsui (2001) and Heiman-Hoffman et al. (1996) did not correspond exactly with the red flags used in this study. They both found that “difficult to audit transactions” was the most important red flags. This factor is most closely associated with “difficulty in determining organisational control” and in our study, with a factor mean of 2.958, this was generally not considered important. However, the three most important red flags in Abdul Majid and Tsui (2001) were all associated with operating and financial stability characteristics. The results of our study are largely consistent with this finding, indicating that the operating and financial stability red flags are of greatest importance to the auditors in the two Asian countries, Hong Kong and Malaysia. An analysis of Heiman-Hoffman et al. (1996) showed that the four of the top five red flags (ranked 1, 2, 4 and 5) were closely associated with “strained management/auditor relationship” while the other red flag (ranked 3) is related to “significant compensation tied to aggressive accounting practices”. However, our study ranks these two red flags areas at numbers 15 and 13 respectively. The top five ranks for Heiman-Hoffman et al. (1996) red flags can be classified as “management characteristics” which may show why they are not perceived as important in our study. Summary and conclusion In this study, we obtained responses from auditors about the relative importance of the fraud risk indicators associated with the potential for management fraud. We found that, in general, subjects indicated that the operating and financial stability category was judged as most important, followed by management characteristics and influenced over the control environment, and then finally by industry characteristics. The perception of the auditors was not found to be influenced by their demographic background, as represented by gender, years of experience or type of audit firm. The results are based upon auditors’ general experience with management fraud, and suggest that auditors should pay particular attention to red flags relating to the operating and financial stability category. However, “management failure to display appropriate attitude toward internal control” is consistently ranked the most important individual red flag. This implies that auditors should not focus exclusively on operating and financial stability characteristics red flags when making their fraud risk assessment. This finding also demonstrates the importance of good internal control within an organisation if fraud is to be avoided. The results motivate several areas of future research. First, it would be interesting to examine whether these fraud risk indicators are indeed helpful in the investigation of reported misconduct and fraudulent cases in Malaysia. Perhaps these findings may help researchers to develop a new fraud risk indicator that takes into consideration actual instances of fraud Malaysia. References Abdul Majid, G.F.A. and Tsui, J.S.L. (2001), “An analysis of Hong Kong auditors’ perceptions of the importance of selected red flag factors in risk assessment”, Journal of Business Ethics, Vol. 32, pp. 263-74.

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American Institute of Certified Public Accountant’s (2002), “Consideration of fraud in a financial statement audit”, Statement on Auditing Standards, No. 99, AICPA, New York, NY.

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Apostolou, B., Hassell, J. and Webber, S. (2001a), “Management fraud risk factors: ratings by forensic experts”, The CPA Journal, October, pp. 48-52.

Ansah, S.O., Moyes, G.D., Oyelere, P.B. and Hay, D. (2002), “An empirical analysis of the likelihood of detecting fraud in New Zealand”, Managerial Auditing Journal, Vol. 17 No. 4, pp. 192-204.

Apostolou, B., Hassell, J., Webber, S. and Sumners, G.E. (2001b), “The relative importance of management fraud risk factors”, Behavioral Research in Accounting, Vol. 13, pp. 1-24. Beasley, M.S., Carcello, J.V., Hermanson, D.R. and Lapides, P.D. (2000), “Fraudulent financial reporting: consideration of industry traits and corporate governance mechanisms”, Accounting Horizons, Vol. 14 No. 4, pp. 441-54. Bell, T.B. and Carcello, J.V. (2000), “A decision aid for assessing the likelihood of fraudulent financial reporting”, Auditing: A Journal of Practice & Theory, Vol. 19 No. 1, pp. 169-84. Burns, S. (1997), “The honourable fraudsters”, Accountancy, September, p. 39. Cain, S. (1999), “Fraud in the workplace”, Orange County Business Journal, Vol. 22 No. 16, p. 78. Choo, F. and Trotman, K.T. (1991), “The relationship between knowledge structure and judgments for experienced and inexperienced auditors”, The Accounting Review, Vol. 66 No. 3, pp. 464-85. Chung, J. and Monroe, G.S. (2001), “A research note on the effects of gender and task complexity on an audit judgment”, Behavioral Research in Accounting, Vol. 13, pp. 111-25. Church, B.K., McMillan, J.J. and Schneider, A. (2001), “Factors affecting internal auditors’ consideration of fraudulent financial reporting during analytical procedures”, Auditing: A Journal of Practice & Theory, Vol. 20 No. 1, pp. 65-80. Dillman, D.A. (1999), Mail and Internet Surveys: The Tailored Design Method, 2nd ed., Wiley, New York, NY. Eining, M.M., Jones, D.R. and Loebbecke, J.K. (1997), “Reliance on decision aids: an examination of auditors’ assessment of management fraud”, Auditing: A Journal of Practice & Theory, Vol. 16 No. 2, pp. 1-19. Hackenbrack, K. (1993), “The effect of experience with different sized clients on auditor evaluations of fraudulent financial reporting indicators”, Auditing: A Journal of Practice & Theory, Vol. 12 No. 1, pp. 99-110. Heiman-Hoffman, B.V., Morgan, P.K. and Patton, M.J. (1996), “The warning signs of fraudulent financial reporting”, Journal of Accountancy, October, pp. 75-6. Knapp, C.A. and Knapp, M.C. (2001), “The effects of experience and explicit fraud risk assessment in detecting fraud with analytical procedure”, Accounting, Organizations and Society, Vol. 26, pp. 25-37. KPMG (2002), Fraud Survey 2002, KPMG, Darwin. Krosnick, J.A., Holbrook, A.L., Berent, M.K., Carson, R.T., Hanemann, W.M., Kopp, R.J., Mitchell, R.C., Presser, S., Ruud, P.A., Smith, V.K., Moody, W.R., Green, M.C. and Conaway, M. (2002), “The impact of ‘no opinion’ response options on data quality”, Public Opinion Quarterly, Vol. 63, pp. 371-403. Loebbecke, K.J., Eining, M.M. and Willingham, J. (1989), “Auditors’ experience with material irregularities: frequency, nature, and detectability”, Auditing: A Journal of Practice & Theory, Vol. 9 No. 1, pp. 1-28.

Malaysian Approved Standards on Auditing (2001), AI 240 Fraud and Error, Malaysian Institute of Accountants, Kuala Lumpur. Management Times (2001), “Fraud hits 62 per cent of listed firms”, New Straits Times, 6 June, Kuala Lumpur. Moyes, G.D. and Hasan, I. (1996), “An empirical analysis of fraud detection likelihood”, Managerial Auditing Journal, Vol. 11 No. 3, pp. 41-6. Palshikar, G.K. (2002), “The hidden truth”, Intelligent Enterprise.com, 28 May, pp. 46-51. Pincus, V.K. (1989), “The efficacy of a red flags questionnaire for assessing the possibility of fraud”, Accounting Organizations and Society, Vol. 14 No. 1/2, pp. 153-63. Rezaee, Z. (2004), “Causes, consequences and deterrence of financial statement fraud”, Critical Perspective on Accounting (in press). Romney, B.M., Albrecht, W.S. and Cherrington, D.J. (1980), “Auditors and the detection of fraud”, The Journal of Accountancy, May, pp. 63-9. Shaub, M.K. and Lawrence, J.E. (1996), “Ethics, experience and professional skepticism: a situational analysis”, Behavioral Research in Accounting, Vol. 8, Supplement, pp. 125-57. Shelton, S.W., Whittington, O.R. and Landsittel, D. (2001), “Auditing firms’ fraud risk assessment practices”, Accounting Horizons, Vol. 15 No. 1, pp. 19-33. Weisenborn, D. and Norris, D.M. (1997), “Red flags of management fraud”, NPA, Vol. 42 No. 2, pp. 29-34.

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Audit quality and earnings management for Taiwan IPO firms

86

Ken Y. Chen College of Management, National Cheng Kung University, Tainan, Taiwan

Kuen-Lin Lin School of Management, Cheng Shiu University, Kaohsiung, Taiwan, and

Jian Zhou School of Management, SUNY at Binghamton, Binghamton, New York, USA Abstract Purpose – This paper investigates the relationship between audit quality (as measured by auditor size and industry specialization) and earnings management (as measured by unexpected accruals) for Taiwan IPO firms. Design/methodology/approach – First uses unexpected accruals in the modified Jones model to measure earnings management in the IPO process. Then uses auditor type (big five versus non-big five) and industry specialist to measure audit quality. The hypothesis predicts that Taiwanese firms with higher quality auditors engage less in earnings management in the IPO process. The sample consists of 367 new issues between 1999 and 2002 from the Taiwan Economic Journal database. Findings – It is found that big five auditors are related to less earnings management in the IPO year in Taiwan. This shows that higher quality auditors constrain earnings management for Taiwan IPO firms. Research limitations/implications – The finding shows that high quality auditors constrain earnings management and provide more precise information. This is important, given that management has incentive to engage in earnings management in the IPO process to garner greater proceeds and at-issue earnings management is negatively related to post-issue earnings performance and stock returns. Practical implications – The research might be of interest to investors in IPO firms, given that at-issue unexpected accruals are opportunistic. Originality/value – The study contributes to the literature in that it shows that audit firm size is an important determinant in earnings management for Taiwan IPO firms. Keywords Quality audit, Earnings, Taiwan Paper type Research paper

Managerial Auditing Journal Vol. 20 No. 1, 2005 pp. 86-104 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510570722

I. Introduction Going public is a major corporate event for a company to raise additional capital to fund its growth and enhance the entrepreneur’s personal wealth, where an offering prospectus including externally audited financial statements for up to a certain period (different among different jurisdictions) is needed to be prepared in the initial public offering (IPO) process. Accrual accounting provides management with discretion in the reporting of earnings, and thus provides opportunity for managers to engage in earnings management in an IPO. Earnings management in general and earnings management in the IPO process in particular, have attracted growing attention in the accounting research[1]. The current study is motivated by a study by Zhou and Elder (2003), which

finds that big five auditors and industry specialist auditors constrain earnings management for IPO firms in the US. Given the different environments across countries and regions, it is useful to conduct an earnings management study for IPO firms besides the US. Therefore, the current study investigates whether the relationship between audit quality and earnings management in the fiscal year of IPO exists in Taiwan. Audit quality has become a concern after scandals such as Enron, WorldCom, and Ahold, etc. These scandals raised concerns about audit quality even among the big five accounting firms, which are normally considered the premier accounting firms and associated with higher audit quality. Among all these scandals, the Enron scandal attracted the greatest attention partly because it was associated with the collapse of Arthur Andersen. We briefly summarize the Enron and Andersen events as follows. On October 16, 2001, Enron announced that third-quarter earnings would include an unexpected nonrecurring charge of $1.01 billion after tax, which triggered the informal inquiry of SEC the next day. SEC changed its informal inquiry into a formal investigation on October 31. On December 2, Enron filed for chapter 11 bankruptcy protection. On January 10, 2002, Andersen notified the SEC and the Department of Justice that the Houston office had shredded a significant number of documents related to the Enron audit. On February 2, the Powers report provided by a special investigation committee of Enron’s board of directors was released suggesting that the headquarters of Andersen were aware of the problems with Enron audit. Andersen was indicted for obstruction of justice on March 14 and was found guilty on June 15, 2002. Andersen ceased conducting audits of public companies by August 31, 2002. The increased lack of investor confidence in financial statement information resulting from these corporate scandals involving once well-respected companies such as Enron and WorldCom, and auditors such as Arthur Andersen served as a catalyst for the Sarbanes-Oxley Act that was signed into law on July 30, 2002. The primary goal of the Sarbanes-Oxley Act is to help restore investors’ confidence in the integrity of financial information, and auditors play an important role in the process. So it is important to investigate whether there is audit quality difference, especially during IPO process where firms are found to engage in opportunistic earnings management. We choose 1999-2002 as the sample period since IPOs are relatively clustered for this period. The average number of IPOs is around 90 each year for this period compared to the average number of 40 for 1991-1998. The Enron fiasco and the enacted Sarbanes-Oxley Act of 2002 may not affect the IPO market in Taiwan for our current study, because the regulation and procedures with regard to the IPO firms have been enacted before the Enron scandal. However, the demand for higher auditor quality can be reasonably expected for Taiwanese companies listed in three major stock exchanges in the post-Enron era. There are significant differences in the IPO process between US and Taiwan with regard to the listing procedures and regulations. First, there exists procedural difference for a firm to go public and to be listed in the Taiwan Stock Exchange (TSE) compared to being listed in a US stock exchange. In the US, the listing stock exchange is already decided when a firm goes public. However, it is not the same in Taiwan. A firm goes public first, then the firm files registration statements to the Securities and Futures Commission[2] (SFC, the SEC counterpart in Taiwan). If it meets the listing requirements of the Taiwan Stock Exchange, it will be listed there. Second, there are also regulation differences with regard to the audited financial statements in the

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registration statements. The auditor report in the registration statements to SFC in Taiwan is signed by two audit partners in addition to a signature representative of the audit firm, whereas only a signature representative of the audit firm is required in US. Third, prior studies suggest that in well-developed capital markets such as the US, there is information asymmetry between management and investors (Leland and Pyle, 1977), and between informed and uninformed investors (e.g. Rock, 1986; Beatty and Ritter, 1986), and such information asymmetry is a necessary condition for earnings management. The capital market is less developed and the average listed company size is much smaller in Taiwan than in the US major stock exchanges, so the information intermediary role played by the auditor is maybe even more important in Taiwan. The three areas of differences between the US and Taiwan make it interesting to examine whether audit quality constrains earnings management in Taiwan. Earnings management in the IPO process is of particular concern for several reasons. First, management has incentives to engage in income increasing earnings management to ensure that the issue is fully subscribed and/or priced higher to garner greater proceeds, because their compensation and/or reputation depend on the success of the IPO. Second, at the issuing stage, earnings management is found to be negatively related to post issue earnings performance (Teoh et al., 1998b) and post issue stock returns (Teoh et al., 1998a). As a result, at the issuing stage, earnings management has significant resource allocation implication. Third, APB 20 allows IPO firms to change accounting principles in the prospectus as long as financial statements of previous years are restated. This may give management an opportunity to engage in earnings management. Fourth, there is significant information asymmetry between the owners-managers and investors (Leland and Pyle, 1977), and between informed and uninformed investors (Rock, 1986; Beatty and Ritter, 1986). Theoretical research shows that auditors play an important role in reducing the adverse impact of information asymmetry in the IPO process. Titman and Trueman (1986) develop a model in which the price of shares in an IPO is increasing in tandem with the quality of information provided by the offering company. Datar et al. (1991) find that the information asymmetry in the IPO process is mitigated by the role of auditor and audit quality. The choice of auditor is made jointly with other decisions such as the percentage of retained ownership in the offering (Copley and Douthett, 2002). Empirical evidence indicates an increased demand for audit quality at the time of the IPO; companies frequently change to a big five auditor at the time of an IPO (Carpenter and Strawser, 1971; Menon and Williams, 1991)[3]. Audit quality research has focused primarily on differences between big five and non-big five firms. Research in the Australian audit market (Craswell et al., 1995) indicates that industry specialist auditors receive a fee premium that represents a significant portion of the premium to big five firms in the Australian audit market[4,5]. Elder (1999) finds that IPO underpricing is lower for companies that use an industry specialist auditor. This evidence indicates that industry specialist auditors provide higher quality of audits compared with non-industry specialist auditors. Becker et al. (1998) find that unexpected accruals are reduced when existing publicly-traded companies use a big five auditor. They find that clients of non-big five auditors report unexpected accruals that are higher than unexpected accruals of clients of big five auditors. They interpret this as indicating that lower audit quality is associated with greater accounting flexibility.

Our study differs from Becker et al. (1998) in several respects. First, we use an industry specialist variable in addition to a big five/non-big five measure. Previous literature finds that audit firms devote significant resources to the development of industry expertise (Craswell et al., 1995) and audit firms promote themselves as industry specialists. Second, we focus on a setting where the direction of earnings management is clear, specifically, IPO companies have incentives to engage in income increasing behavior. In contrast, non-IPO companies may not always engage in income increasing behavior. For example, DeFond and Park (1997) find that firms engage in income smoothing behavior because of managers’ job security concerns[6]. Third, there are significant resource allocation concerns in the IPO process. Managers/owners can benefit from higher IPO proceeds; however investors may make incorrect decisions based on reported earnings. Fourth, unexpected accruals have been found on average to be opportunistic for IPO companies. Teoh et al. (1998b) find that earnings at the time of the IPO are high because of high unexpected accruals, and earnings after the issue are low because the earlier high unexpected accruals are not sustained. Teoh et al. (1998a) find that at-issue earnings management is significantly negatively related to post-issue stock returns. Using a sample of IPO firms from 1996-1998 from the December 1998 Compact D New Issue database, Zhou and Elder (2003) find that unexpected accruals for IPO firms are lower when big five auditors are used, suggesting that the big five auditors are associated with reduced management discretion over earnings. They also find that firms audited by industry specialist auditors engage in less earnings management. Similar to Zhou and Elder (2003), we seek to address these two research questions: (1) Do big five auditors constrain earnings management in the IPO process? (2) Do industry specialist auditors provide higher quality of audits in the IPO process as evidenced by less earnings management? Using 367 IPO observations satisfying all the data requirements from 1999-2002, we find that unexpected accruals for IPO firms are lower when big five auditors are used, suggesting that the big five auditors are associated with reduced management discretion over earnings. However, we do not find that firms audited by industry specialist auditors engage in less earnings management. The remainder of the paper is organized as follows. The next section describes earnings management in the IPO environment and reviews research on audit quality and introduces the research hypotheses. Section III describes the research design. Sample selection and tests of the relation between auditor reputation and unexpected accruals are discussed in section IV. Section V is the summary and conclusion. II. Earnings management, audit quality and IPOs Earnings management and initial public offerings An extensive body of earnings management literature has developed (see Healy and Wahlen (1999) for a review of the literature). Most earnings management studies examine whether companies manage earnings in response to some economic incentive. One setting where management has an incentive to manipulate earnings is at the time of an IPO, since greater earnings may be reflected in a higher offering price and greater proceeds to the company and offering shareholders. Whether a company benefits from earnings management depends upon whether the market can see through the earnings manipulation. The IPO environment is

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characterized by information asymmetry between management and investors (Leland and Pyle, 1977), and between informed and uninformed investors (Rock, 1986; Beatty and Ritter, 1986). Several analytical models demonstrate that the extent of earnings management increases with the level of information asymmetry. For example, Dye (1988) and Trueman and Titman (1988) demonstrate that the existence of information asymmetry between management and shareholders is a necessary condition for earnings management, because shareholders cannot perfectly observe a firm’s performance and prospects in an environment in which they have less information than management. In such an environment, management can use its flexibility to manage reported earnings. Furthermore, management’s discretionary ability to manage earnings increases as the information asymmetry between management and shareholders increases. Richardson (2000) provides empirical evidence consistent with this line of reasoning. He finds that the extent of information asymmetry, as measured by the bid-ask spread and the dispersion in analysts’ forecasts, is positively related to the degree of earnings management. The information asymmetry in the IPO environment creates an opportunity for management to engage in earnings management because it is difficult for related stakeholders (especially shareholders) to undo this behavior. Teoh et al. (1998b) evaluate whether accounting accrual choices during an IPO are informative to investors or opportunistic. They find evidence consistent with opportunism. They find that the net income of IPO firms are significantly higher during the issuing year relative to subsequent years, and to non-issuing industry peers. IPO firms are able to report high earnings during the IPO by reporting unexpected accruals aggressively. The IPO firms’ earnings under-perform relative to their matched firms and non-issuing industry peers when high unexpected accruals at issue cannot be sustained in the following periods. More importantly, they find that unexpected accruals explain the post-issue underperformance in earnings. In a related paper, Teoh et al. (1998a) find that at issue earnings management is negatively related to post issue stock returns. A possible interpretation of their findings is that at issue earnings management helps the company receive a higher issuing price. When at issue earnings performance attributable to earnings management cannot be sustained in the following periods, this is negatively reflected in the stock price. Audit quality and earnings management Auditor firm size. In Taiwan, the big five audit firms are T.N. Soong & Co. (member of Arthur Andersen), PricewaterhouseCoopers, KPMG, Deloitte and Touche, and Diwan Ernst & Young. Due to the Enron scandal and ceased operation of Andersen on August 31, 2002, T.N. Soong & Co. merged into Deloitte and Touche and became Deloitte and Touche on June 1, 2003. The clients of T.N. Soong were also transferred to Deloitte and Touche, which is different from the situation in the US, where Andersen’s clients chose other big five or non-big five audit firms as successor auditors. Given quality monitoring systems which operate across all accountancy forms, the client’s demand for auditor reputation and auditor quality should not have changed, since all Andersen’s clients in Taiwan were transferred to Deloitte and Touche. Becker et al. (1998) find that companies with non-big five auditors (a proxy for lower audit quality) report unexpected accruals that significantly increase income compared to companies with big

five auditors. In Taiwan, non-big five auditors, especially for those local or regional audit firms instead of national audit firms, are usually recognized as lower quality auditors when compared to big five auditors, which can be evidenced by the clients’ selection of big five auditors for their IPO process. They also find that managers respond to debt contracting and income-smoothing incentives by strategically reporting unexpected accruals. In addition, companies with incentives to smooth earnings upwards (downwards) report significantly greater income-increasing (decreasing) unexpected accruals when they have non-big five auditors. Francis et al. (1999) argue that high-accrual firms have greater opportunity for opportunistic earnings management and have an incentive to hire a big five auditor to provide assurance that earnings are credible. They find that high accrual firms are more likely to hire a big five auditor, but report lower unexpected accruals, consistent with big five auditors constraining opportunistic reporting of accruals. The Becker et al. (1998) and Francis et al. (1999) studies provide evidence in non-IPO settings that higher quality auditors are associated with reduced levels of earnings management. Previous research suggests that the auditor can play a role in reducing information asymmetry at the time of the IPO. Balvers et al. (1998) and Hogan (1997) find that big five auditors are associated with lower under-pricing of the offering. Balvers et al. (1998) argue that a high quality auditor provides better information about earnings, which makes it easier for the investment banker to price the issue correctly and preserve reputation quality. This information argument is consistent with the model in Titman and Trueman (1986), in which the price of the shares in an IPO is increasing with the quality of the information provided by the offering company, which they argue is partially determined by the quality of the auditor. Evidence that big five auditors are associated with lower unexpected accruals for IPO firms would further support the information hypothesis. Zhou and Elder (2003) provide evidence supporting the information hypothesis that audit quality provided by big five audit firms is an important constraint in earnings management in the IPO process in the US. Therefore, we expect that IPO companies in Taiwan that use big five audit firms will engage in less earnings management than IPO companies with non-big five auditors: H1. IPO firms in Taiwan audited by big five audit firms engage less in earnings management than firms audited by non-big five auditors. Auditor industry specialization. Recent audit quality research has focused on the role of auditor industry specialization. Hogan and Jeter (1999) find that measures of specialization have increased in both regulated and unregulated industries, consistent with returns to specialization. Craswell et al. (1995) argue that audit firms market themselves in terms of both a general reputation and industry expertise. In a test of audit fees in the Australian audit market, they find that industry specialists receive a significant fee premium, and that this fee premium is a significant component of the fee premium received by big five firms. Industry specialization is acknowledged in DeAngelo (1981) as one possible reason for the selection of big five auditors by IPO companies. In the Titman and Trueman (1986) model, in which the pricing of an IPO is increasing with the quality of information associated with the expertise of the auditor, they suggest that industry knowledge is one element of auditor expertise. Elder (1999) finds that IPO

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under-pricing is lower for companies that use an industry specialist auditor. Zhou and Elder (2003) find that auditor industry specialists can be used to constrain earnings management in the IPO process in the US. Because of the expertise and experience of industry specialists, we also expect that industry specialists are likely to constrain earnings management in the IPO process. This leads into the second hypothesis: H2. Firms audited by industry specialist engage less in earnings management in the initial public offering process in Taiwan. The following section describes the research design, including the model used to estimate unexpected accruals and models used to test the research hypotheses. III. Research design Unexpected accruals We first use unexpected accruals to measure earnings management in the IPO process. Unexpected accruals (also called discretionary accruals) are used in earnings management studies such as Jones (1991) and Subramanyam (1996). Dechow et al. (1995) provide evidence that the modified Jones model is the most powerful to detect earnings management among the alternative models to measure unexpected accruals. The model is estimated as follows: TACC it ¼ ðDCAit 2 DCASH it 2 DCLit 2 DSTDit 2 DEP it Þ=TAit21 TACC it ¼ a1 ð1=TAit21 Þ þ a2 ðDREV it 2 DREC it Þ=TAit21 þ a3 PPE it =TAit21 þ 1it where: TACC it

¼ total accruals for firm i in year t, defined as above.

DCAit

¼ change in current assets for firm i in year t.

DCASH it ¼ change in cash for firm i in year t. DCLit

¼ change in current liabilities for firm i in year t.

DSTDit

¼ change in short-term debt for firm i in year t.

DEP it

¼ change in depreciation for firm i in year t.

DREV it

¼ change in revenue for firm i in year t.

DREC it

¼ change in receivables for firm i in year t.

PPE it

¼ net property, plant and equipment for firm i in year t.

TAit21

¼ total assets for firm i in year t-1.

This equation is estimated cross-sectionally each year for each two-digit Taiwan Economic Journal (TEJ) code industry using all available firms. At least ten firm year observations are required in a two-digit TEJ code. The residual from the regression is the unexpected accruals. Normal levels of working capital accruals related to sales are controlled through the changes in revenue adjusted for changes in accounts receivable. Normal levels of depreciation expense and related deferred tax accruals are controlled through the gross property, plant and equipment. In addition the total assets of the

previous period are used as a deflator to control for potential scale bias. The cross-sectional model reflects common industry factors applied to unexpected accruals. As a result, estimated unexpected accruals are more likely to reflect management’s choice rather than industry factors. Also, since the model is estimated year-by-year, changes in industry conditions are also factored in the model.

Audit quality for Taiwan IPO firms

Auditor industry specialization Craswell et al. (1995), and Ferguson and Stokes (2002) use the percentage of the audit firm’s share of total industry audit fees as an industry specialist measure. This measure incorporates size weighting into market share (weighted by audit fees). They define an auditor to be an industry specialist if the auditor attains a 10 percent market share from either or both of these two measures. Since the audit fee data is not available to us, we cannot use this procedure and instead use a sales-based industry specialist measure. Since the Taiwan market is comparatively smaller than the US market, we require there to be at least ten firms in a two-digit TEJ code industry for an auditor to qualify as an industry specialist, rather than the 30 US firms used in Zhou and Elder (2003). Audit firm industry specialization is defined as follows:

93

J ik qffiffiffiffiffiffiffi X Aijk

MS ik ¼

j¼1 Ik X J ik qffiffiffiffiffiffiffi X Aijk i¼1 j¼1

where: Aijk

¼ total sales of client firm j in industry k audit by auditor i.

i ¼ 1; 2; . . . ; I ¼ an index for audit firms. j ¼ 1; 2; . . . ; J ¼ an index for client firms. k ¼ 1; 2; . . . ; K ¼ an index for client industry. Ik

¼ the number of audit firms i in industry k.

J ik

¼ the number of clients served by audit firm i in industry k.

Industry specialists are calculated yearly based on the firm-year observations from the TEJ database. When auditor j’s market share is greater than 15 percent in a two-digit TEJ code industry, the auditor j is treated as an industry specialist. Approach to testing Our hypotheses relate earnings management as measured by unexpected accruals to audit quality as measured by auditor type and industry specialization. Many other variables may play a role in management’s unexpected accruals decision in the IPO process. Becker et al. (1998) find that operating cash flows are significantly different for firms audited by big five versus firms audited by non-big five firms. The absolute value of total accruals is used as a control variable because Becker et al. (1998) provide evidence that this is significantly negatively related to unexpected accruals. Also

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Francis et al. (1999) find that the likelihood of using a big five auditor is increasing in firms’ endogenous propensity for accruals. Burgstahler and Dichev (1997) find that firms manage reported earnings to avoid reporting earnings decreases and losses. Accordingly, loss and income change indicator are added as control variables to account for managers’ incentive to avoid earnings decreases and losses. Market-to-book value at the end of the IPO offering year is used as a surrogate for growth opportunity because information communication might play a role in some managers’ earnings management decisions, even though Teoh et al. (1998b) find that managers use unexpected accruals opportunistically in the IPO process. Managers may try to signal the firm’s future prospects through unexpected accruals. The log of sales is used as an independent variable to control for the possible effect of size on earnings management in the IPO process. Large firms may have less incentive to engage in earnings management because they are subject to more scrutiny from financial analysts and investors. Leverage may also be associated with earnings management in the IPO process. DeFond and Jiambalvo (1994) and Sweeney (1994) find that managers use unexpected accruals to satisfy debt covenant requirements. The electronics industry (ELEC) is the largest industry in Taiwan, and the matter of earnings management is more likely to be a concern. Therefore, ELEC is also used as a control variable. Further, Taiwan Stock Exchange (TSE) is used as a control variable because of the requirements to be a listed firm in TSE is stricter than the firms in the over-the-counter market, and thus earnings management is more likely to be constrained in TSE. Inclusion of these control variables results in the following regression model: DAC it ¼ b0 þ b1 BIG5 þ b2 SPEC it þ b3 OCF it þ b4 ABSTAit þ b5 LOSS it þ b6 INCCHGit þ b7 MTBit þ b8 SIZE it þ b9 LEV it þ b10 ELEC þ b11 TSE þ 1it DAC it

¼ unexpected accruals.

BIG5it

¼ 1 if the auditor is member of big five; 0 otherwise.

SPEC it

¼ 1 if the auditor is an industry specialist; 0 otherwise.

OCF it

¼ operating cash flow deflated by lagged total assets.

ABSTAit ¼ absolute value of total accruals. LOSS it

¼ 1 if the firm incurs a loss; 0 otherwise.

INCCHGit ¼ 1 if this year’s income is greater than previous year’s income; 0 otherwise. MTBit

¼ market to book ratio.

SIZE it

¼ log of total sales.

LEV it

¼ leverage, defined as total liabilities over total assets.

ELEC it

¼ 1 if the firm is member of electronic industry; 0 otherwise.

TSE it

¼ 1 if the firm is member of TSE; 0 otherwise.

The model is estimated using unexpected accruals (DAC) as the dependent variable. The main research variables of interest are BIG5 and SPEC. Consistent with the two research hypotheses, the coefficients on these two variables are predicted to be negative because firms audited by big five auditors and industry specialists are expected to engage in less earnings management in the IPO process.

Audit quality for Taiwan IPO firms 95

IV. Sample selection and results The sample consists of 367 observations of new issues between 1999 and 2002 from the Taiwan Economic Journal (TEJ) database satisfying the following criteria: . IPO date, and the auditor for the IPO are available from the database; and . necessary data for calculating total accruals, unexpected accruals, industry specialist, market-to-book ratio and leverage are available from the database. Table I provides details about the sample selection. After deleting 21 financial services and insurance companies (as in previous literature, the unexpected accruals does not apply to financial industries) and 42 companies with missing data, the final sample between 1999 and 2002 amounted to the 367 firm-year observations. Table II provides details about the sample distribution by year and by auditor type. The number of IPO companies is around 80 each year from 1999 to 2001, down to 56 in the year 2002. The big five auditors audit more than 80 percent of the IPOs in any given year, except for the year 2002, which is around 90 percent of the IPOs. Table III provides the industry distribution of the sample firms. The sample includes 17 separate TEJ industry codes, indicating a wide distribution of industries. Electronics industry has the largest concentration of IPOs, with more than 66 percent of the total observations. The remaining sample firms are widely distributed across

1999-2002 IPOs Financial services and insurance Missing data Total

430 21 42 367

Note: Sample characteristics for 367 firms conducting initial public offerings during the period of 1999 to 2002 from December 2002 Taiwan Economic Journal (TEJ) database

1999

2000

2001

2002

Total

Year

n

%

n

%

n

%

n

%

n

%

B5 NB5 Total Freq

84 19 103

81.55 18.45

83 24 107

77.57 22.43

77 18 95

81.05 18.95

56 6 62

90.32 9.68

300 67 367

81.74 18.26

28.06

29.15

25.89

Table I. Sample selection

16.90

100

Table II. Sample IPO firms by year and by auditor

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Table III. TEJ codes distribution

Industry Food Plastics Textiles Electrical and machinery Chemicals Steel and iron Electronics Constructions Transportations All others Total

TEJ codes

Freq.

%

B5

NB5

SPEC

12 13 14 15, 16 17 20 23 25 26 11, 18, 21, 22, 27, 29, 40

3 8 21 20 21 7 245 17 4 21 367

0.82 2.18 5.72 5.45 5.72 1.91 66.76 4.63 1.09 5.72 100.00

2 7 16 14 14 3 218 10 3 13 300

1 1 5 6 7 4 27 7 1 8 67

2 2 11 3 0 2 159 5 2 7 193

TEJ industry codes; no other TEJ industry code contains more than 6 percent of the sample firms. Table IV presents the distributions of auditors operating in different industries. As evident from Table IV, not every big five auditors are industry specialist auditors. For example, all the big five audit IPO firms in the electronics industry, Deloitte & Touche is not an industry specialist auditor. Table V provides descriptive statistics for the sample. The average total accruals are 0.047. The average unexpected accruals are 0.083 and the median of unexpected accruals is 0.062. Big five auditors are used by 81.7 percent of the sample firms, and around 53 percent of firms use industry specialist as auditors. The mean and median operating cash flows are 0.046 and 0.058. The mean and median of absolute value of total accruals are 0.294 and 0.153 respectively. The median firm has positive net income and positive income change in the IPO year. The average market-to-book ratio at the end of the offering year is 2.251, and the average log of sales is 14.126. The mean and median leverage are 0.393 and 0.384, respectively. The sample companies from the electronics industry are 66.8 percentage of the sample, and there are 30 percentage of the sample companies listed in the Taiwan Stock Exchange.

Table IV. Auditors operating in different industries in Taiwan

Industry

B5 (Freq.)

NB5 (Freq)

SPEC (Freq)

Food Plastics Textiles Electrical and machinery Chemicals Steel and iron Electronics Constructions Transportations

PWC, DT AA, KPMG, PWC, EY, DT AA, KPMG, PWC, EY, DT

Other MRI MRI, CH, other

PWC, DT AA, KPMG AA, KPMG, DT KPMG, PWC

AA, KPMG, PWC, AA, KPMG, PWC, AA, KPMG, EY AA, KPMG, PWC, AA, KPMG, PWC, KPMG, PWC

BDO, BDO, RSM, BDO, RSM, other

EY EY, DT EY, DT EY

other other other RSM, CH, MRI, other other

AA, KPMG AA, KPMG PWC, EY AA, KPMG KPMG

Notes: AA (merged into Deloitte and Touche, June 1, 2003); KPMG; PWC; Diwan EY; Deloitte and Touche (DT); BDO Taiwan Union & Co.; RSM International; Chien Hsing (CH); Pyramid (MRI_Moores Rowland International); TC (MRI)

Var

Mean

STD

Lower quartile

Median

Upper quartile

TAC DAC BIG5 SPEC OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE

0.047 0.083 0.817 0.526 0.046 0.294 0.109 0.564 2.251 14.126 0.393 0.668 0.300

0.503 0.504 0.387 0.500 0.170 0.410 0.312 0.497 2.321 1.295 0.155 0.472 0.459

20.113 20.084 1 0 20.023 0.064 0 0 1.067 13.476 0.269 0 0

0.036 0.062 1 1 0.058 0.153 0 1 1.443 14.042 0.384 1 0

0.193 0.238 1 1 0.125 0.344 0 1 2.592 14.751 0.516 1 1

Notes: TAC: total accruals, defined as ðDCAit 2 DCASH it 2 DCLit 2 DSTDit 2 DEP it Þ=TAit21 ; DAC: unexpected accruals; BIG5: 1 if the auditor is member of big five; 0 otherwise; SPEC: 1 if the auditor is an industry specialist; 0 otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: 1 if the firm incurs a loss; 0 otherwise; INCCHG: 1 if this year’s income is greater than previous year’s income; 0 otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: 1 if the firm is member of electronic industry; 0 otherwise; TSE: 1 if the firm is member of TSE; 0 otherwise

Table VI shows the correlation among the dependent and independent variables. Total accruals and unexpected accruals are significantly positively correlated with each other. The big five variable is negatively related to total accruals and unexpected accruals. Industry specialist is insignificantly and negatively related to total accruals and unexpected accruals. This suggests that big five auditors constrain earnings management in the IPO process, although the formal analyses are based on multivariate analyses. As expected, there is a positive correlation (0.50) between the big 5 and industry specialist variables. As described in Table V, 81.7 percent of the sample firms (300/367) audited by big five firms, and around 53 percent of firms (193/367) use industry specialist as auditors. That is, there are 107 firms out of 300 big five audited firms are not industry specialists. Tests of the research hypotheses using unexpected accruals in the fiscal year of IPO offering as the dependent variable are reported in Table VII. The first two columns report the results using separate big five and industry specialist auditor reputation measures, and the last column reports the results using both measures. The big five measure is associated with lower unexpected accruals at the 5 percent level or better in both model specifications. These results suggest that big five auditors are associated with lower unexpected accruals in the fiscal year of IPO offering, and audit quality plays an important role in reducing earnings management. The coefficient on the industry specialist variable is insignificantly negative when the big five variable is excluded, and is insignificantly positive when both big five and SPEC variables are included. This is not consistent with the findings in Zhou and Elder (2003) and Craswell et al. (1995) that industry specialization is an important element in auditor quality. The possible explanation is that the Taiwan audit market is comparatively smaller than the US, or the industry specialization is not well recognized

Audit quality for Taiwan IPO firms 97

Table V. Variable descriptive statistics (n ¼ 367)

0.00 0.10 0.54 0.17 0.00 0.03 0.04 0.00 0.26 0.20 0.50 0.74

1 20.09 20.04 20.06 0.20 20.11 0.11 0.16 0.03 20.06 20.06 0.03 0.08 0.42 0.22 0.00 0.03 0.04 0.00 0.51 0.24 0.24 0.62

1 0.50 20.02 0.05 0.07 0.03 0.14 0.06 20.03 0.27 0.05 0.00 0.77 0.38 0.15 0.63 0.01 0.26 0.58 0.00 0.36

1 0.10 0.03 0.12 20.08 0.08 0.12 20.02 0.35 20.01 0.06 0.53 0.02 0.15 0.11 0.02 0.72 0.00 0.85

1 20.03 20.14 0.13 0.23 0.04 20.26 20.04 0.05

OCF

0.55 0.01 0.01 0.00 0.40 0.00 0.47 0.37

1 20.05 0.09 0.09 20.06 0.01 0.01 20.24 0.33 0.09 0.09 0.24 0.86 0.81 0.00

ABSTA

1 20.38 20.12 20.21 0.05 0.10 20.11

0.00 0.02 0.00 0.34 0.06 0.03

LOSS

1 0.30 0.23 0.04 0.16 0.17

0.00 0.00 0.40 0.00 0.00

INCCHG

1 0.06 20.18 0.26 0.27

0.29 0.00 0.00 0.00

MTB

1 0.35 0.17 0.20

0.00 0.00 0.00

SIZE

1 2 0.06 2 0.16

0.27 0.00

1 0.05

0.39

ELEC

1

TSE

Notes: TAC: total accruals, defined as ðDCAit 2 DCASH it 2 DCLit 2 DSTDit 2 DEP it Þ=TAit21 ; DAC: unexpected accruals; BIG5: 1 if the auditor is member of big five; 0 otherwise; SPEC: 1 if the auditor is an industry specialist; 0 otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: 1 if the firm incurs a loss; 0 otherwise; INCCHG: 1 if this year’s income is greater than previous year’s income; 0 otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: 1 if the firm is member of electronic industry; 0 otherwise; TSE: 1 if the firm is member of TSE; 0 otherwise

1 0.97 20.09 20.03 20.07 0.18 20.11 0.11 0.17 0.06 20.07 20.03 0.02

SPEC

Table VI. Pearson correlation matrix for dependent and independent variable (n ¼ 367)

TAC DAC BIG5 SPEC OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE

BIG5

LEV

DAC

98

TAC

MAJ 20,1

DAC INTERCEPT (t-statistic) BIG5 SPEC OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE Adj. R-sq.

20.225 20.134

20.754 21.966**

20.447 0.222 20.066 0.050 0.038 0.035 20.365 20.121 20.011 8.4

22.772*** 3.429*** 20.722 0.842 3.044*** 1.506* 21.896** 22.021** 20.171

DAC 20.293

2 0.982

20.002 20.441 0.216 20.076 0.052 0.036 0.034 20.360 20.146 20.014 7.4

2 0.039 2 2.692*** 3.314*** 2 0.829 0.869 2.896*** 1.432* 2 1.859** 2 2.340*** 2 0.226

DAC 20.191 20.167 0.060 20.473 0.220 20.071 0.058 0.039 0.033 20.367 20.137 20.009 8.4

2 0.634 2 2.186** 0.959 2 2.892*** 3.389*** 2 0.770 0.975 3.071*** 1.404* 2 1.905** 2 2.203** 2 0.148

Notes: Significant at the *0.10, **0.05, 0.01 level based on a one-tail test; DAC: unexpected accruals; BIG5: 1 if the auditor is member of big five; 0 otherwise; SPEC: 1 if the auditor is an industry specialist; 0 otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: 1 if the firm incurs a loss; 0 otherwise; INCCHG: 1 if this year’s income is greater than previous year’s income; 0 otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: 1 if the firm is member of electronic industry; 0 otherwise; TSE: 1 if the firm is member of TSE; 0 otherwise

as an important element of audit quality by the IPO companies in Taiwan. The multivariate regression results in Table VII indicate that big five auditors reduce earnings management for IPO firms in the offering year. Several control variables are significantly related to unexpected accruals. Operating cash flow is found to be negatively related to unexpected accruals, which suggests firms with strong operating cash flow position are less likely to use unexpected accruals to increase earnings in the IPO offering year. Firm size is found to be positively related to earnings management, suggesting large firms engage more in income increasing earnings management in the IPO year. Leverage is found to be negatively related to earnings management, suggesting that these firms are not using earnings management to satisfy debt covenant requirements. This shows that earnings management in the IPO year is unlikely due to concern over debt covenants. ELEC is significantly and negatively related to unexpected accruals, indicating electronics companies engage in income increasing earnings management more than companies in other industries in the IPO year. Additional analyses In Table VIII, we test for variable difference between big five and non-big five clients. We find that the DAC for big five clients is significantly different from that of non-big five clients, which further supports our finding in Table VII that big five auditors reduce earnings management for IPO firms in the offering year. Interestingly, we find that industry specialists for big five clients is significantly different from those of non-big five clients, which indicates that industry specialist firms are highly recognized by big five clients.

Audit quality for Taiwan IPO firms 99

Table VII. Regression of unexpected accruals on auditor size and industry specialization (using 15 percent industry specialization ratio) (n ¼ 367)

MAJ 20,1 DAC SPEC

100

OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE

Table VIII. Test for variable difference between big five and non-big five clients

BIG5

n

Mean

STD

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

300 67 300 67 300 67 300 67 300 67 300 67 300 67 300 67 300 67 300 67 300 67

0.061 0.181 0.643 0 0.044 0.051 0.302 0.254 0.120 0.060 0.570 0.537 2.401 1.582 14.162 13.967 0.391 0.403 0.727 0.403 0.310 0.254

0.490 0.555 0.480 0 0.183 0.096 0.387 0.503 0.326 0.239 0.496 0.502 2.494 1.075 1.381 0.793 0.159 0.139 0.446 0.494 0.463 0.438

t-statistic 2 1.767* 10.963*** 2 0.290 0.872 1.432 0.487 2.630*** 1.117 2 0.552 5.260*** 0.907

Notes: Significant at the *0.10, **0.05, 0.01 level based on a two-tail test; TAC: total accruals, defined as ðDCAit 2 DCASH it 2 DCLit 2 DSTDit 2 DEP it Þ=TAit21 ; DAC: unexpected accruals; SPEC: 1 if the auditor is an industry specialist; 0 otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: 1 if the firm incurs a loss; 0 otherwise; INCCHG: 1 if this year’s income is greater than previous year’s income; 0 otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: 1 if the firm is member of electronic industry; 0 otherwise; TSE: 1 if the firm is member of TSE; 0 otherwise

In Table IX, we regresses unexpected accruals on industry specialization for big five clients only, and subdivide big five variable by using four dummy variables to examine whether specific big five is recognized by its client as more likely to constrain earnings management in the IPO process in Taiwan. We find that EY is the only big five firm that is recognized by its client to constrain earnings management, although the coefficients of AA, DT, and PWC are insignificantly and negatively related to unexpected accruals. We also use total accruals as the dependent variable to test our hypotheses and conduct additional analyses, and the results (not reported) are qualitatively similar to the unexpected accruals. V. Summary and conclusions In this study, we examine whether auditor size and industry specialization are associated with lower earnings management (lower unexpected accruals) for IPO companies in Taiwan. We find that auditor size is associated with lower unexpected

DAC INTERCEPT SPEC AA DT EY KPMG OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE Adj. R-sq. (%)

20.286 0.065

20.606 20.072 20.086 0.088 0.038 0.037 20.510 20.118 20.058 5.8

20.943 1.048

23.591*** 20.960 20.895 1.339* 2.993*** 1.557* 22.458*** 21.685* 20.840

DAC 2 0.195

2 0.628

2 0.073 2 0.077 2 0.112 0.033 2 0.571 2 0.079 2 0.072 0.085 0.037 0.036 2 0.544 2 0.098 2 0.046 5.7

2 0.828 2 0.892 2 1.236 0.393 2 3.415*** 2 1.041 2 0.744 1.314* 2.869** 1.524* 2 2.594*** 2 1.452* 2 0.664

DAC 2 0.198 0.015 2 0.074 2 0.067 2 0.106 0.030 2 0.577 2 0.079 2 0.073 0.088 0.037 0.036 2 0.544 2 0.103 2 0.046 5.4

2 0.636 0.181 2 0.835 2 0.655 2 1.109 0.360 2 3.388*** 2 1.038 2 0.752 1.323* 2.868*** 1.495* 2 2.590*** 2 1.408* 2 0.663

Notes: Significant at the *0.10, **0.05, 0.01 level based on a one-tail test; DAC: unexpected accruals; SPEC: 1 if the auditor is an industry specialist; 0 otherwise; AA: 1 if the auditor is AA; 0 otherwise; DT: 1 if the auditor is DT; 0 otherwise; EY: 1 if the auditor is EY; 0 otherwise; KPMG: 1 if the auditor is KPMG; 0 otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: 1 if the firm incurs a loss; 0 otherwise; INCCHG: 1 if this year’s income is greater than previous year’s income; 0 otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: 1 if the firm is member of electronic industry; 0 otherwise; TSE: 1 if the firm is member of TSE; 0 otherwise

accruals, consistent with high quality auditors constraining earnings management and providing more precise information. This is important given that management has incentive to engage in earnings management in the IPO process to garner greater proceeds and at issue earnings management is negatively related to post issue earnings performance and stock returns. This is also important given investors have very little information about these firms prior to the IPO process to evaluate or undo the earnings management. Our research might be of interest to investors in IPO firms, given that at issue unexpected accruals are opportunistic, and Teoh et al. (1998a) find that at issue unexpected accruals are negatively related to post issue earnings performance and stock return. Our study also contributes to the literature by showing that auditor quality constrains earnings management in Taiwan, thus complementing the findings in Zhou and Elder (2003). Notes 1. See Healy and Wahlen (1999), Beneish (2001) for a review of the earnings management literature, and Teoh et al. (1998b) and Teoh et al. (1998a) for a discussion of earnings management for IPO companies. 2. On July 1, 2004, Security and Future Commission has been renamed as Securities and Futures Bureau, which is directly governed by the Financial Supervisory Commission, Executive Yuan. Self-regulated bodies of the accounting profession include National Federation of Certified Public Accounts Association of the ROC, which govern the

Audit quality for Taiwan IPO firms 101

Table IX. Regression of unexpected accruals on industry specialization for big five clients only (n ¼ 300)

MAJ 20,1

102 3.

4.

5. 6.

performance of professional services by the members. The Statements of Financial Accounting Standards and Statements of Auditing Standards are issued by the Financial Accounting Standard Committee and Auditing Standard Committee of the Accounting Research and Development Foundation. There are three stock markets in Taiwan: Taiwan Stock Exchange (TSE), Over-The Counter (OTC), and Emerging Stock. The IPO criteria such as net worth, profitability, and diversification of stock ownership for securities listings in the three major stocks are different where the strictest criteria apples to the listed firms in Taiwan Stock Exchange. Other signals in addition to auditor choice, such as the percentage of retained ownership, can be used as signals to reduce the extent of information asymmetry. Copley and Douthett (2002) find that auditor choice and retained ownership are substitutes that are jointly chosen to minimize the cost to the entrepreneur. CPA firms typically market themselves as industry specialists. For example, PricewaterhouseCoopers’ homepage indicates that “we have organized ourselves to deliver our industry expertise to some 24 market sectors and have grouped these market sectors into three clusters consistent with effective delivery to the marketplace”. Quote is available at: www.pwcglobal.com/gx/eng/about/ind/index.html Ferguson and Stokes (2002) do not find strong support for the presence of industry specialist premiums in the post big eight/six mergers. Income smoothing is different from income increasing behavior because income smoothing also includes income decreasing behavior when current performance is relatively good and future expected performance is relatively poor.

References Balvers, R., McDonald, B. and Miller, R. (1998), “Underpricing of new issues and the choice of auditor as a signal of investment banker reputation”, The Accounting Review, Vol. 63, October, pp. 605-22. Beatty, R. and Ritter, J. (1986), “Investment banking, reputation, and the underpricing of initial public offerings”, Journal of Financial Economics, Vol. 15 No. 1/2, pp. 213-32. Becker, C., DeFond, M., Jiambalvo, J. and Subramanyam, K.R. (1998), “The effect of audit quality on earnings management”, Contemporary Accounting Research, Vol. 15, Spring, pp. 1-24. Beneish, M. (2001), “Earnings management: a perspective”, Managerial Finance, Vol. 27, pp. 3-17. Burgstahler, D. and Dichev, I. (1997), “Earnings management to avoid earnings decreases and losses”, Journal of Accounting and Economics, Vol. 24 No. 1, pp. 99-126. Carpenter, C. and Strawser, R. (1971), “Displacement of auditors when clients go public”, Journal of Accountancy, June, pp. 55-8. Copley, P. and Douthett, E. Jr (2002), “The association between auditor choice, ownership retained, and earnings disclosure by firms making initial public offerings”, Contemporary Accounting Research, Vol. 19 No. 1, pp. 49-75. Craswell, A., Francis, J. and Taylor, S. (1995), “Auditor brand name reputations and industry specializations”, Journal of Accounting and Economics, Vol. 20 No. 3, pp. 297-322. Datar, S.M., Feltham, G.A. and Hughs, J.S. (1991), “The role of audits and audit quality in valuing new issues”, Journal of Accounting and Economics, Vol. 14 No. 1, pp. 3-49. DeAngelo, L. (1981), “Auditor size and auditor quality”, Journal of Accounting and Economics, Vol. 3 No. 3, pp. 183-99.

DeFond, M. and Jiambalvo, J. (1994), “Debt covenant effects and the manipulation of accruals”, Journal of Accounting and Economics, Vol. 17 No. 1/2, pp. 145-76. DeFond, M. and Park, C. (1997), “Smoothing income in anticipation of future earnings”, Journal of Accounting and Economics, Vol. 23 No. 2, pp. 115-39. Dechow, P., Sloan, R. and Sweeney, A. (1995), “Detecting earnings management”, The Accounting Review, Vol. 70, April, pp. 193-225. Dye, R. (1988), “Earnings management in an overlapping generations model”, Journal of Accounting Research, Vol. 26, Autumn, pp. 195-235. Elder, R. (1999), “Audit firm size, industry specialization and initial public offerings of common stock”, working paper, Syracuse University, Syracuse, NY. Ferguson, A. and Stokes, D. (2002), “Brand name audit pricing, industry specialization and leadership premiums post-big 8 and big 6 mergers”, Contemporary Accounting Research, Vol. 19 No. 1, pp. 77-110. Francis, J., Maydew, E. and Sparks, H. (1999), “The role of big 6 auditors in the credible reporting of accruals”, Auditing: A Journal of Practice and Theory, Vol. 18 No. 2, pp. 17-34. Healy, P. and Wahlen, J. (1999), “A review of the earnings management literature and its implications for standard setting”, Accounting Horizons, Vol. 13 No. 4, pp. 365-83. Hogan, C. (1997), “Costs and benefits of audit quality in the IPO market: a self-selection analysis”, The Accounting Review, Vol. 72, January, pp. 67-86. Hogan, C. and Jeter, D. (1999), “Industry specialization by auditors”, Auditing: A Journal of Practice and Theory, Vol. 18 No. 1, pp. 1-17. Jones, J. (1991), “Earnings management during import relief investigations”, Journal of Accounting Research, Vol. 29, Autumn, pp. 193-228. Leland, H. and Pyle, D. (1977), “Informational asymmetries, financial structure, and financial intermediation”, The Journal of Finance, Vol. 32 No. 2, pp. 371-87. Menon, K. and Williams, D. (1991), “Auditor credibility and initial public offerings”, The Accounting Review, Vol. 66, April, pp. 313-32. Richardson, V. (2000), “Information asymmetry and earnings management: some evidence”, Review of Quantitative Finance and Accounting, Vol. 15 No. 4, pp. 325-47. Rock, K. (1986), “Why new issues are underpriced”, Journal of Financial Economics, Vol. 15 No. 1/2, pp. 187-212. Subramanyam, K.R. (1996), “The pricing of discretionary accruals”, Journal of Accounting and Economics, Vol. 22, pp. 249-81. Sweeney, A. (1994), “Debt covenant violations and managers’ accounting responses”, Journal of Accounting and Economics, Vol. 17, May, pp. 281-308. Teoh, S.H., Welch, J. and Wong, T.J. (1998a), “Earnings management and the long-run market performance of initial public offerings”, Journal of Finance, Vol. 53, December, pp. 1935-74. Teoh, S., Wong, T.J. and Rao, G. (1998b), “Are accruals during initial public offerings opportunistic?”, Review of Accounting Studies, Vol. 3, pp. 175-208. Titman, S. and Trueman, B. (1986), “Information quality and the valuation of new issues”, Journal of Accounting and Economics, Vol. 8 No. 2, pp. 159-72. Trueman, B. and Titman, S. (1988), “An explanation for accounting income smoothing”, Journal of Accounting Research, Vol. 26, Supplement, pp. 127-32. Zhou, J. and Elder, R. (2003), “Audit firm size, industry specialization and earnings management by initial public offering firms”, working paper, Syracuse University, Syracuse, NY and SUNY-Binghamton, Binghamton, NY.

Audit quality for Taiwan IPO firms 103

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104

Further reading Dechow, P. (1994), “Accounting earnings and cash flows as measures of firm performance: the role of accounting accruals”, Journal of Accounting and Economics, Vol. 18 No. 1, pp. 3-42. Willenborg, M. (2002), “Discussion of ‘Brand name audit pricing, industry specialization, and leadership premiums post-big 8 and big 6 mergers’”, Contemporary Accounting Research, Spring, pp. 111-16.