ACCOUNTING INFORMATION & MANAGEMENT
Keith I. DeLashmutt Professor of Accounting Information & Management
Director, Accounting Research Center
Professor Magee’s research focuses on the use of accounting information in contracting relationships, and in facilitating decision making and control within organizations and on issues in regulation of the audit market. His recent publications examine the market for audit services, the effects of auditors’ fee structures on their independence, and the use of cost allocations in motivating managerial behavior and assessing product profitability.
Professor Magee has published articles in The Accounting Review, the Journal of Accounting Research, the Journal of Accounting and Economics and a variety of other journals. He is the author of Advanced Managerial Accounting and co-author of Efficient Capital Markets and Accounting: A Critical Analysis. The latter book received the Notable Contribution to the Accounting Literature Award from the American Institute of Certified Public Accountants in 1978.
Professor Magee has served on the editorial boards of The Accounting Review, the Journal of Accounting Research, the Journal of Accounting and Economics and the Journal of Accounting, Auditing and Finance. From 1994 to 1996 he served as editor of The Accounting Review, the quarterly research journal of the American Accounting Association. He received the American Accounting Association’s Outstanding Accounting Educator Award in 1999 and the Illinois CPA Society Outstanding Educator Award in 2000. At Kellogg, Professor Magee received the Levy Teaching Award in 1996 and the Chairs’ Core Teaching Award in 1998 and again in 2001.
Professor Magee received his A.B., M.S. and PhD from Cornell University.
Financial Reporting
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During the spring of 2000, the Internet Stock Index declined 45% in 10 weeks. Using a sample of direct and support (infrastructure) internet firms, this paper investigates whether the stock market decline could be attributed to new disclosures over the period (earnings reports, buy/sell recommendations, analyst forecast revisions, and web-traffic measures) or to a "reassessment" of the implications of pre-existing accounting information. We find only modest evidence that the spring 2000 decline was associated with new disclosures of web-traffic statistics, earnings, earnings forecasts, or auditors’ going-concern qualifications. We find that stock prices after the price decline and returns during the price drop are more significantly explained by 1999 annual report data then by new information. The traditional financial measures do not significantly outperform the explanatory power of New Economy measures when net income is used to proxy for earnings. However, when earnings are decomposed into gross profit, marketing expenses, research and development expenses and other, then the financial information significantly outstrips the non-financial information in describing Spring 2000 returns and valuations in March and May of 2000.
Professor Lambert provides a very useful synthesis of the major issues in managerial accounting and the insights that agency theory has provided on those issues. In this discussion, I highlight some of the limitations of these models in examining accounting measurement questions. Lambert calls for additional work in multiperiod contracting models, and I discuss some of the modeling choices that must be made in such work. Finally, I present some thoughts on the relation between contract models and empirical research.
Issues surrounding the allocation of sunk capacity costs to products are among the oldest in managerial accounting. On the one hand, such costs are generally deemed to be irrelevant, but on the other hand, actual accounting systems commonly make these allocations. This paper examines a decision maker who incurs costs to acquire capacity and then uses an opportunity cost to allocate that capacity among a sequence of product proposals. Under specified circumstances, the sunk cost of capacity is shown to approximate the optimal opportunity cost of capacity. As the number of product proposals grows, the expected opportunity loss from using a simple sunk cost-based capacity allocation rule goes to zero. The model is extended to consider different types of products and a multiperiod setting.
Presents an overview on accounting for defense contracts. Opportunities for accounting scholarship in the defense industry; Regulation in the industry; Possibility of efficient behavior in the industry; Contracting frictions; Product costing's impact on factor choice incentives.
In a single period agency model in which the agent has some discretion regarding how to report his period's performance, we show when the agent's contract is increasing in his report regardless of the characteristics of his production technology, and how to rank changes in the agent's reporting technology according to the expected cost of compensating the agent.
The article presents an exploration into the auditor-client response to report-contingent audit contracts within an audit market model. Factors concerning positive and negative incentives to initiate such contracts are mentioned. The discrepancies inherent within the model between auditor's public issued estimates and personal opinions are analyzed and their impact on market competition for audit services is outlined. An application of Gresham's Law to auditing is presented, wherein poor quality services hinder legitimate services. Conclusions are offered regarding predictions of auditor attitudes towards standards due to revenue-based externalities.
A principal-agent relation is analyzed where the agent chooses an unobservable effort level and an observable level of utilization of a resource supplied by the principal. When the agent has private information about the usefulness of the principal's resource, it is shown that the optimal compensation function must include the resource level as an argument. That is, some form of "cost allocation" appears to be part of the optimal solution to the principal's problem. Further analysis shows that standard cost allocation techniques (where the agent is allocated more costs if he or she uses more of the resource) may not be efficient in motivating the agent's choices. In some circumstances, it may be optimal to pay the agent more if he or she used more of the principal's resource.
In this paper, a service department chooses a fixed/variable cost combination based on the forecasts of two operating departments. The operating departments then make service usage decisions, and the service department provides the level of service demanded. The allocation of fixed and variable service department costs is used to: (1) encourage efficient short term use of the service and (2) encourage accurate forecasting by the operating departments. Three approaches are used to achieve these objectives - incentive compatible allocations, a modified Soviet incentive scheme, and a Groves allocation scheme - and we discuss conditions under which these schemes are successful.
Certain characteristics of managerial employment arrangements and of the managerial labor market make shareholder wealth dependent on an executive's continued employment. These wealth effects are investigated by examining the common stock price reaction to unexpected deaths of senior corporate executives. Abnormal stock price changes are documented for a sample of fifty-three events. These abnormal stock price changes are associated with the executive's status as a corporate founder and with measures of the executive's ‘talents’ and decision-making responsibility, and of the transaction costs associated with renegotiating or terminating the employment agreement.
The article discusses Pareto-optimality in budget-based incentive systems for executive compensation and the principle-agent relationship where the business owner is the principle and the manager is the agent. Utility functions illustrate the effect of different budget models on a manager's behavior and the owner's expected payoff, as well as the role of uncertainty and value of knowing local conditions when estimating profitability. The budget participation game and equilibrium problem refers to the acceptance of a manager's report on local conditions as being accurate and not "padded." Probability functions for two participation games are explained. How the budget-based incentive scheme is less effective than profit-sharing when the agent is risk-neutral is mentioned.
This article presents a methodology for utilization review which aids the local Professional Standards Review Organization (PSRO) in selecting optimal timing of Concurrent Stay certification by diagnosis. This procedure is accomplished by modeling patients' admissions, inpatients stays and discharges for each diagnosis as a stochastic process which is audited under the PSRO by three utilization review techniques: preadmission, concurrent and retrospective review. The timing of concurrent stay certification is determined so that the maximum benefits are derived for the utilization review cost expended. The methodology presented here is a tool to aid local PSRO management in determining the most cost-beneficial utilization review process to be utilized in their jurisdiction. It is not an attempt to demonstrate the effectiveness of our utilization review policy over another in general. On the contrary, while the model is generalizable to every PSRO, the utilization review policies resulting from any application are situation-specific. The major contributions of this article are new insight into modeling the utilization review process and the provision of a methodology for which computer programs exist and are readily available to any PSRO that should desire to determine its utilization review procedure in this cost-benefit framework. In order to apply the model it is necessary that certain parameters specific to the application site be estimated or assumed. Exact procedures to aid the PSRO in parameter estimation is the subject of current investigation.
In most organizations, the accounting system is the primary source of "observables," such as payoffs, actions, etc. This paper explores the effects of one aspect of accounting systems, namely the method of valuation of assets and liabilities, on the structure of incentives. It is found that the employee's allocation of effort will be different under historical cost valuation than under current valuation methods, but that under some conditions, the owner's payoff is not necessarily higher under the current value system, even if such a system is no more expensive than a historical cost system.
The article discusses experimental research concerning the effect of compensation plans on managers' selection of problem-solving strategies. The study, which is designed to evaluate two compensation plans, choices such as decision models and heuristics or rules of thumb from previous experiences, behavior in uncertain environments, and cost variance investigations, tests employees' decision-making ability in a cost control setting. Bias in heuristics, conditioning by reward systems, Markov processes, t-tests, and implications of the study for understanding human information processing, the influence of accounting systems on behavior, and deviations from optimal choice models are mentioned.
The rapid increase in health care costs in recent years may be attributed to a number of factors, for example, increases in the costs of inputs and the creation of new and more expensive technology. However, another possible reason for the cost increases is the lack of incentives for hospital managers to control costs and to promote efficient operation of facilities. This lack of incentive has been attributed to the "cost-reimbursement" method of payment for services by third party payers. As a result, a number of "prospective-payment" schemes have been suggested to encourage hospitals to become more cost conscious. In essence, prospective-payment plans shift some part of the risk for health are costs to those who may be in a better position to control those costs. The behavior of hospital management when making a decision under risky conditions may not yield the types of outcomes desired by the third-party payers. This paper is addressed to this point. In essence, the problem amounts to finding a performance-evaluation system, that is, a payment plan that will encourage the hospital administrator to choose desired actions under conditions of uncertainty. In such a setting, the concept of risk sharing between the parties is introduced.
Computer-based financial statement generators constitute one of the most widely used class of computer-based decision aids. Surveys reveal most planners using these models are concerned with ease of use, especially greater flexibility, reduced data-entry burden, increased understandability, and enhanced sensitivity analysis. This article includes data generation functions, sensitivity analysis capabilities, and illustrative planner-computer dialogues designed to cope with these problems.
A variety of decision models for cost variance investigations have been suggested in the accounting literature. However, few of these models explicitly have recognized that users of these models seldom have perfect knowledge of the model parameters, particularly parameters such as the average cost when "out of control." In this paper, the issue of parameter uncertainty in cost control is addressed in two ways. First, the expected cost (or loss) arising from misestimating the parameters is estimated using two methods (numerical approximation and simulation). Then a model comparison scheme is introduced for using reported costs to make inferences about the parameters of the cost process, resulting in a "learning model" by which a manager may use an investigation to find out about the cost process, as well as to correct an out-of-control situation.
An evaluation of the professional offering "Financial Distress in Private Colleges" by Katherine Schipper is presented.
Most cost variance investigation models have considered only one cost process at a time. However, there are many reasons why cost variances from two cost processes may be correlated and why a model which exploits these commonalities may be expected to reduce expected costs. Such a model is described in this paper, and some examples are used to illustrate the effects of different factors on the cost savings.
The article presents a simulation analysis of alternative cost variance investigation models. In past some authors have suggested that the lack of application of more complex cost variance investigation models could be due either to management's lack of awareness or to the fact that the stochastic cost processes assumed by these models are not descriptive of processes which generate actual costs. Results of some studies made in this field indicate a number of other possibilities for the lack of application. A rational manager who is evaluated on the basis of his or her operating results or on the number of times he or she makes the budget may well prefer a naive cost investigation rule. More important, a manager who is concerned with all costs could very well prefer a less complex investigation rule. As a result, survey research, which seeks to determine the acceptance of the more sophisticated cost investigation models, also should determine the basis on which the decision-maker is evaluated and rewarded, since this will affect his or her model choice. These same considerations should be taken into account in the development of cost variance investigation models which employ more complex stochastic processes.
The article examines the utility of cost-volume-profit (CVP) analysis in managerial decision making, proposing an alternative application of its methodology to measure firm risks through covariant profit analysis and market portfolio security returns. An overview of previous research concerning CVP analysis is given, outlining its focus on comparing various profit activity levels and to incorporate risk for better operation in uncertain environments. The author presents research and models to advocate capital asset pricing theory in combination with CVP for use in short-term business planning.
The article presents the author's comments on the William R. Scott's report "Auditor's Loss Functions Implicit in Consumption-Investment Models," included in the issue, responding to Scott's views on the occupational and economic role of auditors within the broader structure of the firm. Questions are raised regarding the scope of Scott's proposed model, questioning the presence of multiple risky assets.
Dynamic programming models of bond refunding have been given by Weingartner, Kalymon and Elton and Gruber. This paper gives a formulation of this problem that lends itself to extensions including the term structure of interest rates, delayed-call provisions, and "rolling over" the outstanding debt. Finally, the cost of computation is examined, along with some examples.
This article comments on the article "Cost of Information and Security Prices: Market Association Tests for Accounting Policy Decisions," by Robert G. May and Gary L. Sundem, published in the January 1973 issue of the journal "The Accounting Review." May and Sundem presented an analysis of the information set underlying a set of market-clearing security prices. The authors conclude that choosing between accounting alternatives on the basis of benefits and costs to society is a complicated procedure and that alternative accounting procedures may lead to alternative sets of market-clearing prices, so that the market association of an unreported accounting alternative may not reflect its actual information content. It is found that the conditions under which market association measures are valid are not as restricted as those found by May and Sundem. It was found that the conditions under which market association measures are valid are not as restricted as those found by May and Sundem. In cases where an unreported accounting alternative provides more timely information than the currently reported alternative, market associations are valid if they are measured over an appropriate time period.
The article examines the effects of industry-wide commonalities on earnings in order to assess the significance of these commonalities and how they affect firms' earnings numbers. The article makes a distinction between economy-wide events such as government monetary policy that affect all firms in an economy, industry-wide events such as changes in consumer tastes that affect only the earnings in one industry, and firm-wide events, such as management changes that only affect one firm. The author suggests that industry commonalities are no less significant than economy-wide commonalities in explaining changes in firms' earnings numbers. These economic factors can even be reflected in security prices. The former studies were of interest to accounting researchers considering the distributional properties of accounting numbers, but the latest research may help estimate the value of industry information to investors studying the effect of these factors on firms' security prices.
This article shows that if all variables that determine a firm's future cash flows are not contractible, it can be ex ante optimal to design a financial contract that admits debtholders waiving debt covenants on a discretionary basis and firms investing opportunistically subsequent to contracting. Further, as the contractible variable becomes less informative, the contract attaches greater significance to it. Finally, uncertainty in the magnitude of reporting latitude induces aggressive reporting by the firm to avoid violating the covenant or to enhance the chances of a waiver. The debtholders respond by sometimes not allowing the firm to implement mutually beneficial projects.
This paper presents a model in which asset/liability recognition is a means for a risk-neutral entrepreneur to communicate with risk-averse investors about the riskiness of investments or the uncertainty of future obligations. The model shows that more conservative accounting may produce less conservative investing and lower expected payoffs for the entrepreneur. While the desired uncertainty-based recognition hurdle is increasing in an asset's expected payoff, it is decreasing in a liability's expected magnitude. The impact of further sub-categorization of recognized assets is also considered. While finer classification of assets produces no direct benefit, it may provide a cost-effective means to reduce the entrepreneur's incentives to engage in costly voluntary disclosure.
Academic research in managerial accounting has focused on the search for general principles or general procedures that can be brought to bear in making accounting decisions in a variety of particular settings. Because managerial accounting does not consist of a set of codified practices, we expect these principles and procedures to address the costs and benefits that they create. This cost/benefit orientation has come to be embodied in managerial accounting theory by the information economics model. The principal message of this paper is that the information economics model is not sufficient to guide decision makers in solving many accounting problems. It focuses on the definition of a solution rather than on the process by which a solution may be found. In this paper, we address directly the complexity of the cost system design problem and find that it falls into the category of problems for which no known algorithm exists to solve all cases. We examine the performance of well-established cost accounting heuristics, and develop a different algorithm for making cost system choices. These algorithms are evaluated using simulations.
This paper examines the role of state incorporation laws in determining the impact of accounting changes on stock prices.
This course counts toward the following majors: Accounting.
This course acquaints students with the process used to construct and understand the financial reports of organizations. The objective is to understand the decisions that must be made in the financial reporting process and to develop the ability to evaluate and use accounting data. Emphasis is placed on understanding the breadth of accounting measurement practices and on being able to make the adjustments necessary for careful analysis. The course highlights the linkages between accounting information and management planning, and decision making and control.
Turbo Accounting (ACCT-434-0)
An accelerated version of the core accounting course (430), intended for students with recent exposure to accounting principles. In contrast to 430, this course assumes students already have a working knowledge of the journal entry process. The course explores the principles of financial accounting and the structure and meaning of financial statements and footnote disclosures. The additional time made available by not covering the journal entry process allows for an in-dept study of many financial reporting issues, and for extra coverage of current financial accounting topics.
In this survey of empirical research on positive accounting theory, students learn how to assess empirical studies and initiate and develop research projects by leading research paper discussions and replicating and extending existing research studies.
Financial Reporting Systems introduces generally accepted accounting principles and concepts and trains students to analyze financial statements.
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