I. Take home (50 points). Turn in with part II of the final exam (or before), maximum 2 pages.
The market model is r = ? + ?r + e. How is ―e‖ used by: (1) Leftwich (1981) to analyze business itIimtitcombination standard setting on loan agreements; (2) Choi and Jeter (1992) to evaluate qualified opinions; and (3) Kasznik and Lev (1995) to evaluate ―earnings surprise‖ on ―bad news‖ firms. What does this tell us about the development of market return/event models since Ball and Brown (1968)?
II. Answer any 2 (25 points each).
1. Altman (1968) used a matched-pair design. Flagg et al. (1991) did not. Why? Contrast the
experimental design of the two projects.
2. Ashton (1974) evaluated auditor judgment based on consensus and stability. Did Ashton adequately measure judgment using his survey techniques and psychology theory? Explain.
3. Dummy variables are used frequently in multivariate accounting research models. Lowballing, time
dummies, bankrupt/non-bankrupt are typical examples. What is a dummy variable and how is it
interpreted in an OLS regression model? Assume that you want to evaluate four levels of bond
rating in an OLS model. How can dummies be used?
4. What is an efficient contract? What is the effect of accounting regulation on writing management
compensation contracts efficiently?
I. Ball & Brown (1968) used the market model to measure ―good news‖ and ―bad news‖? Leftwich
(1981) used a 2-stage approach for his accounting choice study. Explain Leftwich’s method. How did
it differ from B&B? More recently, earnings response coefficients (ERCs) have been used (e.g., Choi
& Jeter, 1992). Explain how ERCs analysis compares to B&B. Is ERCs useful to explain earnings
quality? Explain. (50 points)
II. Answer any 2 (25 points each).
1. Healy (1985), Dechow et al. (1995), and others focus on accruals to measure earnings
management. What is earnings management? How are accruals measured and used in these
2. Assume you’re studying lowballing using audit economics. Explain the rationale of
lowballing according to DeAngelo (1981). Explain how efficient contracting could be used as
a theoretical structure when analyzing lowballing.
3. Altman (1968) and most empirical bankruptcy studies use a matched pair design, claiming to
―predict‖ bankruptcy. In fact, this is a ―classification‖ model. Why? What additional steps
typically are used to validate ―classification‖ accuracy.
I. Aspects of auditing research relate to capital market pricing and efficient contracting. Hogan (1997)
analyzes the self selection of Big Eight auditors for the IPO market. Choi and Jeter (1992) use earnings
response coefficients to analyze qualified audit opinions. Wilkins (1997) finds a relationship of debt
covenant violation waivers to going concern opinions. Wells and Loudder (1997) find a market effect
associated with auditor resignations. Flagg et al. (1991) find a relationship between going concern
qualifications and bankruptcy. Describe the importance of financial auditing to financial accounting
research based on these studies. (50 points)
II. Answer any two (25 points each)
a. Capital market theory suggests that increasing accounting disclosure should reduce the cost of capital.
Why? How did Botosan (1997) test this relationship? Under what circumstances did Botosan (1997)
find this relationship to be true? Explain.
b. What is earnings management? Healy (1985) considers bonus schemes. Gaver and Gaver (1998)
analyze CEO cash compensation. Han and Wang (1998) consider political costs related to oil and gas
firms during the Persian Gulf war. What do these studies tell us about earnings management?
c. Both Ball and Brown (1968) and Kasznik and Lev (1995) look at ―good news‖ and ―bad news‖ firms.
Compare how ―bad news‖ is defined in both studies. How did the management of the ―bad news‖ firms
react (i.e., disclose) in the Kasznik and Lev sample? What was the market reaction for ―bad new‖ firms
in the Kasznik and Lev sample?
I. The focus on cumulative abnormal returns (CARS) [API in Ball & Brown, other
terminology in various studies] is fundamental to capital markets research. What is a
CAR? How is it used by Ball and Brown (1968) and Beaver (1968)? How is it used by
Choi and Jeter (1992) and Kasznik and Lev (1995)? (50 points)
CAR is the standardized residual from the market model: R = α + ßR + e ; the residual e being itImtitconsidered the abnormal return (e.g., positive "e"s indicating above average return). CAR = Σ e over some ittime horizon, often days 0 and -1. Ball & Brown used the standardized residuals (called abnormal
performance index) for 2 portfolios: (1) Goods News and (2) Bad News, associated with (1) earnings above
expectations or (2) below expectations. A positive API was predicted for the Goods News portfolio and
negative for Bad News. Over 12 months the Good News portfolio increased (about 5%) and the Bad New
portfolio decreased (about 11%), as expected. Thus, stock price was associated with accounting earnings.
In place of a CAR, Beaver used the residual to develop a U statistic, where U = e22 / σ (residual squared /
residual variance from estimated market model). For his sample, U was 1.6, indicating significantly higher
price movements during the week of the earnings announcement, again indicating stock price reacting to
Choi and Jeter and Kasznik and Lev used 2-stage approaches, where the CAR became the dependent
variable in the second regression run. In Choi and Jeter, the 2nd stage is an earnings response coefficient
model, where CAR = f(Unexpected Earnings)--in this case measuring unexpected earnings associated with
pre- and post-qualified opinions. The change in ß (which decreased as expected) represented a measure of nd"earnings quality". Kasznik and Lev used a larger 2 stage model to measure earnings surprise for good-
and bad-news firms. Generally, market response (CARs) were associated with unexpected earnings and
other factors (e.g., firm size, discretionary disclosure type).
II. Answer any 2 (25 points each)
1. When using regression, what is ß (Beta)? How are direction and magnitude measured?
Why are they important?
In regression, Y = a + ßX + e, where ß is the slope on the independent variable. To measure the
relationship the sign on the coefficient measures direction (to determine if the relationship is positive or
negative) and magnitude can be measured by the coefficient (e.g., as a measure of elasticity for log models)
or significance level of the coefficient (based on t-value). These usually are the most important tests
associated with the prediction of theoretical relationships.
2. Assume you want to focus on audit economics using audit fees and some measure of
audit quality. What will be your sample [note: it's your choice]? Where will you find
audit fees? How and where will you find and measure audit quality? Are fees and
quality related? Explain.
Answers will vary based on selections. Fee data is accumulated on some data bases. Otherwise, this is
usually determined by questionnaire. Direct (ex post) quality measures are available only for select government audits that are reviewed by superior governments. Following De Angelo (1981) Big 6 could be
considered a quality surrogate. A case can be made for specialization as an alternative quality measure. If
3. Pick some accounting area of interest for research. Define this research in the
context of the Scientific Method. Why is theory important? What theory will be used product differentiation exists, then fees and quality are simultaneously determined before an audit contract
for your area and how will it be tested? is signed. If the audit is a commodity, the contract goes to the lowest bid and quality is irrelevant.
Answer will vary by area chosen, but should focus on the Scientific Method. This should include a
discussion of theory construction and theory verification. Testable hypotheses come from theory
construction; i.e., theory is important to predict specific outcomes. Verification comes from empirical testing, based on statistics in accounting research. Much of the theory in accounting comes from economics, where analytical models are used to develop relationships associated with micro- and macro-constructs.
4. Accounting researchers assume efficient markets in the semi-strong form. What are
efficient markets? Does market efficiency really exist? Why is the semi-strong form
important for accounting research?
Markets are efficient when information is impounded into price immediately and in an unbiased fashion. In the semi-strong form, the focus is on publicly available information. As with most economic constructs, the concept of market efficiency is over-simplified. Evidence suggests that the largest firms are widely tracked by analysts and stock prices generally behave as if markets were efficient. This seems to be less true for smalle firms, perhaps because there is less financial analysis. Some empirical evidence (e.g., Beaver 1968 focuses only on firms with fewer that 20 annual public announcements) seems to support this view).
Accounting is interested in the semi-strong form, because of the importance of publicly available financial information, especially earnings.
I. Parfet (2000), when describing a preparer’s perspective on earnings
management, stated that: ―We are not scoundrels‖. (1) what is earnings
management & how does it relate to agency theory & efficient markets? (2)
Contrast the viewpoint on earnings management of preparers, users, regulators,
& accounting researchers. (3) How is earnings management related to auditor
litigation according to Heninger (2001)? (50 points)
(1) Given management incentives for self-interest or opportunism, managers can
manipulate accounting earnings to achieve their own best interests, such as
bonuses. Managers are agents of the stockholders (the principals).
Stockholders want to guard themselves against agency costs. A basic
incentive of managers is to raise current bonuses by increasing accounting
earnings. Aggressive revenue recognition (recognizing revenues early in the
business cycle), capitalizing rather than expensing current costs, or allocating
costs over longer periods (e.g., straight line rather than accelerated
depreciation) are common examples of potential earnings management.
(2) Managers & preparers are agents of the stockholders with specific incentives,
especially to increasing compensation by enhancing accounting income. This
can be achieved through improved operations or managing accounting
earnings. This is expected. In the extreme managers/preparers can manipulate
earnings & perhaps violate the law. Users include owners, regulators,
investment advisors & raters, almost all of which want complete & accurate
financial information (―transparency‖ is a common term)—to promote the
interests of the principals. Regulators have the added goal of insuring that
transparency is achieved, as directed from federal securities regulations &
other sources. Researchers attempt to model information content within
specific theoretical perspectives that include market analysis. A key problem
is finding empirical surrogates to effectively measure earnings management.
(3) Heninger looks at companies where their auditor was sued (vs. a control
sample) & uses a logit model (dependent variable=1 when auditor was sued)
measured against abnormal accruals (modified Jones method) as a measure of
earnings management & a set of control variables. Results indicate that
litigation was associated with firms that had higher abnormal accruals,
basically asserting that auditor-sued firms used earnings management to a
greater degree than comparable firms.
II. Answer any 2 (25 points each)
1. According to Jensen & Meckling (1976) corporations write efficient
contracts. What are efficient contracts & why are they important to
financial accounting? Watts & Zimmerman (1986, Chapter 10) describe
the importance of the political process on agency theory & efficient
contracts. What is the relationship of the political process to efficient
contracting/agency theory & how can it be tested?
Efficient contracting: writing contracts to accomplish something (e.g., based on bounded
rationality) with minimum transaction & agency costs. Transaction cost economics
focuses on the contracting transaction as the basic unit of analysis (goods and services
transferred across a technologically separate interface (Williamson 1985)). Transaction
costs are contracting costs and transactions are optimized through efficient contracting
(writing contract to accomplish something with minimum transaction and agency costs).
Contracting costs include drafting, negotiating, and safeguarding a contract, costs of
governance structures, and agency costs. Contracts have a principal and an agent. In a
corporation, owners are principals and employees agents. The principal attempts to
maximize wealth and contracts to avoid conflicts. Agency costs include: (1) information
asymmetries (limited or misinformed information by one side—note the role of
accounting to limit asymmetries), (2) adverse selection (such as the ―market for lemons‖),
and (3) moral hazard (such as shirking or ethics violations). Agency costs can be reduced
by: (1) better acquisition decisions, (2) monitoring such as a financial audit, (3) align
preferences of agents with principals (such as management compensation based on
performance or employee stock ownership), and (4) control devices (such as budgets).
Political costs can be considered agency costs, assuming that corporations, especially
large companies & companies in certain industries are subject to the political process. In
most cases it is assumed that size is a measure of political costs (specific industries or 2. What does ―event date‖ mean in Ball & Brown (1968)? Beaver (1968)? other specific indicators also could be used) & some measure of size is typically used in
Leftwich (1981)? efficient contracting/agency studies.
Event dates are associated with specific disclosure dates to test the stock market reaction
to these events. Ball & Brown used the annual earnings report date as disclosed in the
Wall Street Journal. They tested abnormal returns using the announcement month as date
0 & testing from –12 to +6. Beaver also used annual earnings report date as ) &
measured his ―U‖ statistic from week –8 to +8. Leftwich used 21 selected dates
associated with APB ruling on business combinations (resulting in APB Opinion 16).
Dates were 1 or more days around this disclosure from –5 to +5. They all used a market
model to determine the relationship of ―abnormal return‖ to the events under study.
3. Going concern audit qualifications and troubled debt restructuring are two
events related to business failure. How can they be tested in an analysis of
business failure? Are they expected to be good predictors of bankruptcy?
There are different ways to test this relationship, such as in a standard bankruptcy model
of a set of bankrupt firms to a matched set of non-bankrupt firms. Thus, the dependent
variable is a dummy where 1=bankrupt firm. In this method going concern & TDR could
also be dummies, used as independent variables. In that case, going concern would be
predicted to be positive (i.e., increase the probability of bankruptcy), but TDR is more
difficult, since the point of a TDR is an attempt be avoid bankruptcy.
4. In the Rose and Wolfe (2000) study, they make clear that it is well known
that learning-by-doing occurs at a higher rate when using standard text
based materials, than when using an automated decision aid. How does
their research problem make use of this fact? In your answer, state their
research problem, its relationship to the above statement, and it’s
This is Chris Wolfe’s question. He’s the authority here.
I. Much of the capital market literature focuses on the error term from the market model.
What does the error term tell us and how can it be interpreted? Be sure to include an
analysis from Ball & Brown (1968) and Beaver (1968) to more modern studies. Be sure
to include an analysis of both direction and magnitude (e.g., as measured by earnings
response coefficients) in you analysis.
Other areas of accounting research also use the error term from a regression model for
analysis (Jones 1991 is an example). How is the error term from the ―Jones Model‖ used
for analysis and how does it differ from the market model use above? [Discuss other
examples if you want.] (50 points)
II. Answer any two (25 points each).
a. Theories associated with accounting choice can relate to efficient contracting or
agency costs (Fields, 2001). Explain why. Consider management compensation,
corporate debt and disclosure levels in your answer.
b. What is earnings management? Healy (1985) considers bonus schemes. Jones
(1991) looks at import regulation relief. What does the literature tell us about
earnings management? (Use either the Healy & Wahlen 1999 or the McNichols 2000
approach to the literature—or both.)
c. What is an efficient market? Kasznik (2001) provides conflicting evidence on market
efficiency. Why? Develop an argument for market inefficiency and defend this
I. Beginning with Ball & Brown (1968) and Beaver (1968), market efficiency has been
assumed. What is market efficiency and how is it relevant to the analysis of earnings and
other accounting information?
More recent literature suggests that market efficiency is not clear-cut and challenges to
market efficiency exist (summarized in Beaver 2002). What evidence exists that markets
are not efficient? Is this important to capital markets research? Explain. (50 points)
II. Answer any two (25 points each)
1. What are principles-based accounting standards? Many observers criticize US GAAP
as being rules-based. Schipper (2000) makes a case that US GAAP is indeed principles-
based. Why is this controversy of importance to the accounting profession and to
2. What is ―the cost of capital?‖ Are there basic empirical measures that can be used to
estimate cost of capital? How is cost of capital measured by Botoson (1997)? Why is cost
of capital important in her study?
3. What is earnings management? How is earnings management tested by Jones (1991)?
How does the Jones study fit into the framework established by McNichols (2000)?
Answer any four (25 points each).
1. Accruals can be used in a number of contexts. Jones (1991) used an accruals model to test earnings management. Myers et al. (2003) used accruals as a measure of audit quality. Fields et al. (2001) reviewed several studies that used accrual models for accounting choice studies. What are some of the basic characteristics of accruals models? Explain how accruals models are used in different contexts. Are they effective measures of the proposed theoretical constructs?
2. Lynn Rees suggests that psychology can be incorporated in archival financial accounting research. For example, prospect theory may explain certain types of behavior better than standard finance theories. Several market efficiency anomalies have been identified. What are market efficiency anomalies? What is prospect theory? How can prospect theory be used to better explain these anomalies?
3. Determining and testing audit quality has been an important part of auditing research. What is audit quality? The British authority audit paper (2004) identifies a direct measure of audit quality, while most studies use various quality surrogates. What are these surrogates? What do these studies tell us about audit economics characteristics (consider for example, Myers et al.; Mayhew & Wilkins; and Giroux & Jones).
4. Like Altman’s bankruptcy studies, Kinney uses a matched-pairs design in a couple of
managerial studies. Why and how is matched-pairs design used? In the JIT study (Kinney & Wempe, 2001), how did they measure the impact of JIT on performance?
5. Mary Lea McAnally considers the importance of earnings management decisions as accounting choices. Why do companies manage earnings (include some discussion on conflicting incentives)? In the Hodder et al. (2004) paper, they consider stock option input decisions as accounting choices. What are their basic findings?