Accounting Conservatism, the Quality of Earnings, and Stock Returns

 

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Accounting Conservatism, the Quality of Earnings, and Stock Returns 

STEPHEN H. PENMAN
Columbia University - Department of Accounting
XIAO-JUN ZHANG
University of California, Berkeley - Accounting Group

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December 1999

Abstract:     
Quality of earnings questions arise when firms that practice conservative accounting change the level of their investment in net operating assets: increases in net operating assets create "hidden reserves," depressing earnings, and decreases in investment release hidden reserves into earnings. This paper develops diagnostics that capture this joint effect of investment and conservative accounting and finds that the diagnostics forecast differences in future return on net operating assets from the current return on net operating assets. Moreover, the diagnostics forecast stock returns, indicating that the stock market does not appreciate how conservatism and investment combine to raise quality questions about reported earnings.

JEL Classifications: M41, G12, G14

Working Paper Series  

An Analytical Model for External Auditor Evaluation of the Internal Audit Function Using Belief Func

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An Analytical Model for External Auditor Evaluation of the

Internal Audit Function Using Belief Functions

VIKRAM DESAI
University of Central Florida - Kenneth G. Dixon School of Accounting
ROBIN W. ROBERTS
University of Central Florida - Kenneth G. Dixon School of Accounting
RAJENDRA P. SRIVASTAVA
University of Kansas - Accounting and Information Systems Area

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September 2006

Abstract:     
The primary purpose of this paper is to advance research in internal audit (IA) evaluation by developing an IA assessment model that considers interrelationships among specific factors used by external auditors when evaluating the strength of the IA function. The model is built on three factors previously identified by auditing standards and prior academic research: Competence, Work Performance, and Objectivity (SAS 65 1991; Messier and Schneider 1988; Krishnamoorthy 2002). Our model generates an overall judgment concerning the strength of the IA function that can aid the external auditor in assessing the reliability of a client's internal control system. Because evaluating the IA function entails a process of gathering items of evidence pertaining to each IA factor and aggregating the evidence to make an overall judgment, we develop the IA assessment model using a conceptual framework based on the prior literature and develop an analytical expression under the belief function framework. By using this framework, we overcome limitations of prior research regarding the modelling of interrelationships among factors and regarding difficulties in application. The results of our analysis revealed that modelling the “And” relationship is essential for assessing the strength of the IA function. As far as interrelationships are concerned, the analysis revealed that when the three factors have a strong or a perfect relationship, the strength of the IA function remains high even if we have positive or negative evidence about one of the factors. This result holds as long as we have high levels of beliefs about the other two factors

Keywords: Internal Audit, Belief Functions, Evidential Reasoning Approach, Reliance Decision

JEL Classifications: M49, C11, C51, G34

Working Paper Series  .