PRWATE INVESTORS“ BEHAVIORAL RESPONSE TO FINANCIAL FORECASTS AND. RELATED AUDITOR’S REPORTS Bissertatian for the Degree of Ph. D. MTCHTGAN STATE UNIVERSITY SALVATORE THOMAS ANTHGNY CIANCIOLO 1975 This is to certify that the thesis entitled PRIVATE INVESTORS' BEHAVIORAL RESPONSE TO FINANCIAL FORECASTS AND RELATED AUDITOR'S REPORTS presented by Salvatore Thomas Anthony Cianciolo has been accepted towards fulfillment of the requirements for Ph.D. degree in Business (Accounting) MM Major plrol‘e&r\l Date M 0-7639 HUAG & SflNS’ BOOK BlNUERY INC. ll! LzuaAnv' BENDERS ‘PRIRGPORT. IEIIGII ABSTRACT PRIVATE INVESTORS‘ BEHAVIORAL RESPONSE TO FINANCIAL FORECASTS AND RELATED AUDITOR'S REPORTS by Salvatore Thomas Anthony Cianciolo In recent years there has been a vast amount of research on the objectives of financial reporting. These effects have reaffirmed the belief that the small investor should have access to financial infor- mation sufficient to make informed investment decisions. Moreover, there is a trend favoring the publication of forecasted financial statements, as well as conventional historical statements. Concurrent with this trend, commentators have suggested extending the attest func- tion to include forecasted financial statements. However, at least one very important area has been neglected. Little is known about how the small investor makes his decisions, and nothing is known about how he reacts to forecasted information and attestation thereto. This study attempts to determine what signifi- cance the small investor places on forecasted financial statements and the inclusion of an auditor's report. The study is in the form of a behavioral field experiment, using a sample of small investors as test subjects. Investors are randomly assigned to twenty-two cells in the design. Each investor within a given cell receives a data packet of financial information about two hypothetical firms. In addition to Salvatore Thomas Anthony Cianciolo broker advice, each data packet contains for each of the firms a simu- lated annual report. Based on the data packet, the investor is asked to determine in which of the two firms he would prefer to invest, and the strength of his preference. These investment decisions and prefer- ences are the dependent variables used in the study. The independent variables are broker advice (two levels), and one-year financial fore— casts (three levels), and auditor's reports (ten levels), with five types of auditor's reports nested within two forecast levels. The factors of greatest interest are forecast levels and auditor's report levels; the broker levels are included as an independent variable to add mundane reality. The technique of analysis of variance is used to measure the effect of the factors on the dependent variables. The empirical results suggest that broker advice dominates all other forms of financial information. Forecasts and auditor's reports have some influence on the investor, depending on the company, type of forecast and type of auditor's report. In addition, there appears to be a systematic misinterpretation of the various types of auditor's reports employed. The generalization of the sample results to the total population is limited because of bias in the sample selection and responses. However, it appears that the individuals in the sample should be at least as capable as the total population of small investors in their understanding of financial information. Therefore, to the extent that the sample results suggest a lack of understanding of the independent variables, these results can be attributed to the total population of small investors. PRIVATE INVESTORS' BEHAVIORAL RESPONSE TO FINANCIAL FORECASTS AND RELATED AUDITOR'S REPORTS By Salvatore Thomas Anthony Cianciolo A DISSERTATION Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1975 © COpyright by SALVATORE THOMAS ANTHONY CIANCIOLO 1975 ACKNOWLEDGMENTS I wish to express my gratitude to Professor George Mead, my academic advisor, who first planted the seeds of ideas which resulted in this dissertation; to Professor William B. Schmidt and Professor Mel O'Connor, members of my dissertation committee who helped clarify my thinking and made understandable my results; and especially to Professor Hugo Nurnberg, my dissertation committee chairman. He gave most generously of himself, providing many valuable insights, arguing cogently, and demanding preciseness. My thanks and appreciation also go to Professors Ronald M. Horwitz and James P. Jennings who, as successive department chairmen at the University of Detroit, provided me with financial support and an environment enabling me to successfully complete the dissertation; to the Michigan Accountancy Foundation for financial support; and to my wife, Marilyn, without whom the thesis might have been finished much earlier and without whom it might never have been completed; and to the many others who helped. To all these individuals my warmest thanks. The usual caveat regarding errors applies. ii TABLE OF CONTENTS Page LIST OF TABLES. . . . . . . . . . . . . . . . . . . . . . . . v LIST OF FIGURES o o o o o o o o o o o o o o o o o o o o o o o Vii LIST OF EXHIBITS. . . . . . . . . . . . . . . . . . . . . . . viii Chapter I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . l 2 Purpose of the Study Scope of the Study Methodology of the Study Plan of the Study Summary II. STATEMENT OF THE PROBLEM . . . . . . . . . . . . . . 6 The Role of Published Financial Forecasts The Need for Attestation The Small Investors Right to Know Summary 111. EARLIER STUDIES. . . . . . . . . . . . . . . . . . . 21 Introduction Empirical Studies Behavioral Studies IV. THE EXPERIMENT METHODOLOGY . . . . . . . . . . . . . 34 Forecast Variable Auditor's Report Variable Broker Advice Variable Data Packets Dependent Variables The Questionnaire The Experimental Population Response Rates iii The Testing Process -- General Comments Post hoc Procedures Research Hypotheses V. ANALYSIS AND CONCLUSIONS . . . . . . . . . . . . . Hypotheses Testing and Test Results Respondent Beliefs Inference from the Sample to the Population Overall Conclusions VI. LIMITATIONS AND SUGGESTIONS FOR FURTHER RESEARCH . Limitations Experimental Reality Internal Validity External Validity Mundane Reality Suggestions for Further Research APPENDIX A. FIMNC IAIJ STATEMENTS O O O O O O O O O 0 O O O O O B O BROKER ' S ADVICE O O O O O O O O O O O O O O O O O I C O AUDITOR ' 3 REPORTS 0 O O I O O O O O O O O O O O O O D O QUEST IONNAIRES O O O O O O O O O O O O O O O O O O E. LETTERS OF NOTIFICATION . . . . . . . . . . . . . F . PRESIDENTS ' LETTERS 0 O O O O O O O O O O O O O O O G 0 POST HOC COMPARISONS O O O O O I O O O O O O O O O H, OBSERVED CELL MEANS -- ALL TWO FACTORS MODELS. . . SELECTED BIBLIOGRAPHY . . . . . . . . . . . . . . . . . . . iv 53 81 90 121 125 135 139 141 151 162 163 Table II III IV VI VII VIII IX XI XII XIII XIV XVII LIST OF TABLES Factors Used in Investment Analysis . Percent of Respondents Indicating Belief in Selected Variance Ranges for Fore- casted Data . . . . . . . . . . . . . . Absolute and Relative Earnings Per Share. Hypothetical Cell Means . . . Factor Combinations . . . . . . . . . . . . . Response Rates for Individual Cells . . . . . Observed Cell Means, ICP-Variable . . Observed Cell Means, IPI-Variable . . . . . Three-Factor Model ANOVA Results, Investor Choice PrOportions, Cell Means (ICPj) . . . Three-Factor Model ANOVA Results, Investor Preference Index (IPIij)' . . . . . . Summary of Observed Cell Means. . . . . . . . Auditor's Report Levels . . . . . . Two-Factor Model ANOVA Results, ICP-Variable, Individual Observations (ICPij Two-Factor Model ANOVA Results, IPI-Variable, Non-Replicated. . . . . . . . . . . . . . . Two-Factor Model ANOVA Results, ICP-Variable, Individual Observations (ICPij Two-Factor Model ANOVA Results, ICP-Variable, Cell Means (ICPj), Replicated . . . . . . . Two-Factor Model ANOVA Results, IPI-Variable, Replicated. . . . . . . . . . . . . . . . . ), Non-Replicated ), Replicated . Page 24 26 35 37 40 46 54 54 55 55 6O 62 69 69 7O 7O 71 Table I Page XVIII Chi-Square Tests for Significant Difference in Investor Characteristics . . . . . . . . . . . . 77 G-I Post Hoc Comparisons, Investor Choice Proportions -- Original Data, Broker by Forecast Interaction . . . . . . . . . . . . . . 151 G-II Post Hoc Comparisons, Investor Choice Proportions -- Log Transformed Data, Broker by Forecast Interaction. . . . . . . . . . . 152 G-III Post Hoc Comparisons, Investor Preference Index, Broker by Forecast Interaction . . . . . . . 153 G-IV Post Hoc Comparisons, Investor Choice Proportions, All Audit in Forecast ++ Pairwise Contrasts. . . . . . . . . . . . . . . . . 154 G—V Post Hoc Comparisons, Investor Choice Proportions -- Log Transformed Data, All Audit in Forecast, Pairwise Contrasts . . . . . . . 155 G-VI Post Hoc Comparisons, Investor Choice Proportions -- Non-Replicated, Individual Observations, Broker by Forecast Interaction . . . . . . . . . . . . . . 156 G-VII Post Hoc Comparisons, Investor Preference Index -- Non-Replicated, Broker by Forecast Interaction . . . . . . . . . . . . . . 157 G-VIII Post Hoc Comparisons, Investor Choice Proportions (Individual Observations), Replicated, Broker by Forecast Interaction. . . . . 158 G-IX Investor Choice Proportions (Cell Means) -- Original Data, Replicated, Broker by Forecast Interaction. . . . . . . . . . . . . . . . 159 G-X Investor Choice Proportions (Cell Means) -- Arcsin Transformation, Replicated, Broker by Forecast Interaction. . . . . . . . . . . 160 G-XI Post Hoc Comparisons, Investor Preference Index -- Replicated, Broker by Forecast Interaction . . . . . . . . . . . . . . . . . . . . 161 H-I Observed Cell Means -- All Two Factors Models . . . . 162 vi Figure II III IV VI VII VIII IX LIST OF FIGURES Forecasting Principles Suggested by Ijiri . Observed Combined Cell Means, ICP-Variable. Observed Combined Cell Means, IPI-Variable. Observed Combined Cell Means, ICP-Variable. Possible ICP or IPI Response Patterns Under F++ . . . . . . . . . . . . . . Original Data, Observed ICP Values. . . Observed ICP Values Under F++ by Broker Advice Level. . . . . . . . . . . . . Observed ICP Values Under F_+ by Broker Advice Level. . . . . . . . . . . . . Observed Cell Means for Non-Replication Replication Models, ICP-Variable. . . Observed Cell Means for Non-Replication Replication Models, IPI-Variable. . . vii and and Page 12 57 58 59 63 64 65 66 72 73 Exhibit A-I A-II ArIII A-IV C-III C-IV LIST OF EXHIBITS Historical Financial Statements and Footnotes for Both Companies, Level F0 . . . . . . . Historical and Positive Forecasted Financial Statements for Carter Communications Company and Subsidiaries, Level F++ . . . Historical and Negative Forecasted Financial Statements for Carter Communications Company and Subsidiaries, Level F“+ . . . Historical and Positive Forecasted Financial Statements for SRN, Inc. and Subsidiaries, Level F++ and Level F_+ . . . . . . . . . B +_: Broker Recommends Carter Over SRN. . . B-+: Broker Recommends SRN Over Carter. Level A and A , A Standard Unqualified Auditor's Report for both Companies. . . Level A and A , A Standard Unqualified Auditor's Report With a Middle Paragraph Disclaimer on the Forecasted Data for Both Companies . . . . . . . . . . . . . . Level A and A , A Standard Unqualified Auditor's Report Whose Scope and Opinion Paragraphs are Expanded to Mention the Examination of and Include an Unqualified Opinion on Internalities of One-Year Finan- cial Forecasts for Both Companies. . . . Level A and A , A Standard Unqualified Auditor's Report Whose Sc0pe and Opinion Paragraphs are Expanded to Mention the Examination of and Include an Unqualified Opinion on the Internalities and Exter- nalities of the One-Year Forecasts for Both Companies . . . . . . . . . . . . . . viii Page 90 109 113 117 121 123 125 127 129 131 Exhibit Page C-V Level A and A1 , For SRN, the Same Type of ReporE as Useg in A (A ). For Carter, an Adverse Opinion Based on an Examination of Both the Internalities and Externalities of the One-Year Financial Forecast . . . . . . . . . 133 D-I Questionnaire - Level F0 . . . . . . . . . . . . . . . 135 D-II Questionnaire - Levels F++ and F_+ . . . . . . . . . . 137 E-I Original Cover Letter. . . . . . . . . . . . . . . . . 139 E-II Second Request Letter. . . . . . . . . . . . . . . . . 140 F-I Presidents' Letters to Accompany Historical Financial Statements . . . . . . . . . . . 141 F-II Presidents' Letters to Accompany Historical and Positive Forecasted Financial Statements. . . . . . . . . . . . . . . . . 145 F-III Presidents' Letters to Accompany Historical and Negative Forecasted Financial Statements. . . . . . . . . . . . . . . . . 149 ix CHAPTER I INTRODUCTION Purpose of the Study This study examines the reactions of small private investors to attestation of one-year financial forecasts. More specifically, it examines the hypothesis that the type of auditor's report on one—year financial forecasts is associated with small private investors' invest- ment decisions. This hypothesis is examined within two levels of financial forecasts and across two levels of broker's advice. Attestation to forecasts is a complex issue because of the myriad forms of attestation that are possible. Attestation could be limited to the accuracy of compilations and consistent application of accounting principles. It could be expanded to include, in addition to the above, an opinion on care employed in the selection of assump— tions and/or on the reasonableness of the assumptions themselves. Still further expansion is conceivable by attesting to the achiev- ability of the forecast itself. Objection to the publication of forecasts has been based on several contentions. Corporate managers feel that publication of forecasts will put them at a competitive disadvantage, generate addi— tional insurmountable legal problems, and be misunderstood by the 2 typical investor.1 Others feel that since the earnings of a typical firm for one year are only a small part of the total expected return on investment in that firm, that knowledge of this amount should not overly affect investor decisions; and that investors will overreact to changes in estimates of one-year earnings.2 Still others argue that investors themselves should make the projections; management should simply supply facts of past events to be used as a basis for these projections.3 Forecast publication could also be objected to on the basis that the stockmarket is already efficient. That is, it could be argued that publication of forecasts has little or no effect on mar— ket prices because the data reported in forecasts is already reflected in market prices by actions of large, sophisticated investors.4 Because forecasts are published occasionally, and attestation may follow, it appears judicious to examine on an experimental basis, the reaction of small private investors to attestation of one-year 1A. T. Kearney, Inc. and Sidley & Austin, Public Disclosure of Business Forecasts, Financial Executives Research Foundation (New York: 1972), pp. 41-51. 2Leonard Spacek, "No Benefits Flow to Public Stockholders from One-Year Earnings Forecasts," Paper read before the meeting of the Financial Executives Institute, Milwaukee, Wisconsin, December 12, 1972, pp. 6, 21. 3Harvey Kapnick, "Before the Securities and Exchange Commission: In the Matter of the Hot Issues Securities Market," File No. 4-148 (March 22, 1972), p. 3. 4For a detailed analysis of how the efficient market hypothesis affects accounting data see William H. Beaver, "The Behavior of Secu- rity Prices and its Implications for Accounting Research (Methods)," Chapter II in"Report of the Committee on Research Methodology in Accounting," The Accountinngeview, Supplement to Vol. XLVII (1972), pp. 407-437, esp. pp. 426-427. financial forecasts. Other research of a survey nature indicates that the small private investor relies much more heavily on stockbroker advice than on any other source of information.5 Because of its apparent sig- nificance to the private investor, broker advice is included in this study to add mundane reality. Scope of the Study This study is not concerned with the usefulness of published forecasts per se. Forecasts are being published, and it appears that the number of firms publishing forecasts will increase.6 Only three levels of forecasts were employed in the study: (1) no forecast, (2) a material positive forecast, and (3) a material negative fore- cast. These levels were selected because they represent the reason- able extremes possible, and therefore allow for greater generalization of the auditor's report effects than, say, only levels (1) and (2) or (1) and (3). The main focus of the study is on user reactions to auditor's reports. Five levels of attestation are employed within the positive and the negative forecast levels. These levels represent the major alternative forms of attestation which have been proposed. The standard two paragraph audit report format is used. In addition, 5H. Kent Baker and John A. Haslem, "Information Needs of Indi- vidual Investors," Journal of Accountancy, CXXXVI, No. 15 (November 1973), pp. 64-69, esp. p. 68. 6Frank T. weston, "Ideas for Action: Prepare for the Financial Accounting Revolution," Harvard Business Review, LII, No. 5 (September- October 1974), p. 7. 4 one level represents an adverse opinion. Although this type of opinion is rarely seen, its inclusion increases the generalizability of the study concerning auditor's report effects. Methodologygof the Study The study is empirical and behavioral in nature. Small private investors are asked to select one of two companies in basically the same industry for investment. Their investment decision is to be based on any and all of the following three factors: (1) detailed forecasted financial statements, (2) related auditor's report, and (3) broker advice. The relative importance of each factor is measured in the study through observation of the dependent variable (the in- vestors' decisions) as these factors are manipulated. The technique of analysis of variance (ANOVA) is used to analyze this threedway ANOVA model. Graphing the dependent variable and post hoc comparisons are used to investigate main effects and interactions. In addition, investors are asked to complete a questionnaire concerning investor characteristics such as age, education, income, etc. Chi- square tests are used to compare the characteristics of test subjects with those of private investors in general. These techniques are widely accepted and routinely applied to this type of research problem. Plan of the Study In the discussion that follows, Chapter II outlines the positions of important authoritative bodies and others regarding the role of forecasts, their attestation, and the investors' right to know. Chapter III contains two major sections. The first section outlines prior studies dealing specifically with small private investor use and 5 understanding of forecasts with related attestation and other percep- tions about relevant information for making investment decisions. The second section outlines prior behavioral research studies in accounting which employ the same basic methodology as the current research. The design of the experiment is discussed in Chapter IV. The independent and dependent variables are described along with the rationale for their selection. The testing procedures are briefly described, and the hypotheses to be tested are stated. The test results are presented and analyzed in Chapter V. The basis for logical inference to the total population of small private investors is examined and overall conclusions are stated. Chapter VI discusses the limitations of the present study and possible areas for further research. Summary To the extent that the three~way ANOVA model results in signifi- cance for the main effects (auditor's reports, forecasts, and broker advice), the null hypotheses stated in Chapter IV are rejected. How- ever, if interaction exists, nothing can be said about main effects. If any or all of the factors show no significance, then several con- clusions are possible. These possibilities are discussed in Chapters .V and VI. Regardless of the research findings, statistical generalization to other levels of the independent variables cannot be made because a fixed effect model is employed. However, since the levels selected are of specific interest to the researcher, this loss of generalization is expected and unimportant. CHAPTER II STATEMENT OF THE PROBLEM The development of financial reporting has been a slow process. It has evolved and changed in order to address itself to new and dif- ferent requirements by decision makers. The Role of Published Financial Forecasts In recent years both the American Institute of Certified Public Accountants (AICPA)l and the Securities and Exchange Commission (SEC)2 have recognized what financial and economic theoreticians have been stating for some time; namely, that investors' investment decision- models are based on a judgment about the expected future economic performance of the company under consideration. Until February 1973, the SEC did not officially recognize the need for the inclusion of projections with prospectuses and reports. After extensive hearings in the latter part of 1972, the SEC came to the conclusion that "management's assessment of a company's future 1Accounting Objectives Study Group, Objectives of Financial Statements (New York: American Institute of Certified Public Accountants 1973), pp. 19-20. 2U. 8., Securities and Exchange Commission, Statement by the Commission on the Disclosure of Projections of Future Economic Per- formance, Securities Act of 1933, Rel. No. 5362 and Securities Exchange Act of 1934, Rel. No. 9984, February 2, 1973. 31bid. T..< .Nx .u.“ 7 performance is information of significant importance to the investor, [and] that such assessment should be able to be understood [by the investor] in light of the assumptions made..."4 In 1975, the SEC proposed amendments to various registration forms and periodic reports to provide for voluntary publication of forecasts of future earnings. The latter proposal permits reference to third-party review of the forecast information;5 this constitutes a reversal of earlier pronounce— ments prohibiting attestation of published forecasts. In addition, publishing forecasts has been given formal recogni- tion by the Objectives Study Group of the AICPA in its report, "Objec- tives of Financial Statements." One of the primary conclusions of this report is that the basic objective of financial statements is to provide information useful for making economic decisions.6 It is noted that user needs for information are not known with any degree of certainty, and that the specific role played by financial statements in the economic decision-making process has not been precisely identified. Given the above uncertainties and based on its underlying research, the Objectives Study Group makes the following assumptions:7 Users of financial statements seek to predict, compare, and evaluate the "cash consequences" of their economic decisions. 4Ibid. 5U. 8., Securities and Exchange Commission, Proposed Rules to Igplement the Statement by the Commission on the Disclosure of Pro- .1gctions of Future Economic Performance, Securities Act of 1933, Rel. bk» 5581 and Securities Exchange Act of 1934, Rel. No. 11374, APril 28, 1975. 6Accounting Objectives Study Group, op. cit., p. 13. 71bido, pp. 13-14. 8 Information about the cash consequences of decisions made by the enterprise is useful for predicting, comparing, and evaluating cash flows to users. . . . Financial statements are more useful if they include but distinguish, information that is primarily factual, and therefore can be measured objectively, from information that is primarily interpretive. One specific objective derived from the above assumptions is as follows: An objective of financial statements is to provide infor- mation useful for the predictive process. Financial forecasts should be provided when they will enhance the reliability of users' predictions.8 Although these pronouncements by the SEC and AICPA concur in calling for the presentation of forecasted financial statements, both are cautious pronouncements. For example, the SEC does not plan to require forecasts;9 the Objectives Study Group believes that forecasts should only be presented when extrapolation of prior revenue and cost trends is not valid for the coming year.10 On the other hand, a survey sponsored by the Financial Executives Institute indicates that corporate managements generally oppose public disclosure of forecasts for the following reasons:11 81bid., p. 46. 9 U. 8., Securities and Exchange Commission, loc. cit., February 2, 1973. 10This belief was related to the researcher in a conversation with Martin S. Cans, Administrative Director of the Objectives Study Group. 11 _ A. T. Kearney, Inc., and Sidley & Austin, Public Disclosure of Business Forecasts (New York: Financial Executives Research Foundation, 1972), p. 41. 9 (1) Public disclosure of forecasts would be disadvantageous to corporate interests due to the release of information to competitors and others. (2) The lack of credibility of forecasts would have destabi- lizing effects on the stock market. (3) There is a conflict in the use of projections for internal and external purposes. (4) There are legal problems with regard to the release of forecasts. (5) There are gamesmanship-type problems inherent in the release of forecasts. Some empirical evidence bears on the validity of at least two of the five objections listed above, although inconclusively. The second objection consists of two parts, (1) credibility of forecasts and (2) the destabilizing effects. Regarding the credibility of fore- casts, McDonald found that 49% of the corporations included in his study predicted earnings within 10% of actual and, further, that 35% were within 5%. On the other hand, he found that 40% missed their forecasted figure by more than 15%.12 He also found that overprediction occurred more frequently than underprediction.l3 Daily found similar results in his study.14 Therefore, the credibility of forecasts remains an unresolved empirical question. The fourth objection concerns legal problems. Presently the 12Charles L. McDonald, "An Empirical Examination of Published Predictions of Future Earnings" (unpublished Ph.D. dissertation, Department of Accounting and Financial Administration, Michigan State university, 1972), p. 57. 13Ibid., p. 68. l 4R. Austin Daily, "The Feasibility of Reporting Forecasted Information," The Accounting Review, XLVI, No. 4 (October 1971), PP. 686-92 0 it: D... 10 American Law Institute is engaged in a project to recodify securities laws, in part with the expectation of limiting accounting liability.15 In addition, case law appears to indicate that corporations need not fear civil action when forecasts are not achieved, as long as they are properly prepared.16 The forecasting controversy even extends to the representatives of major accounting firms and their managing partners. Kapnick of Arthur Andersen & Co. states that forecasts and related auditor's reports would not give investors useful data,17 whereas Defliese of Coopers & Lybrand states that forecasts may ultimately be useful to the investing public, "but only when the relative degree of certainty and uncertainty entailed in financial forecasts can be clearly defined, expressed, and understood by the investing public."18 Obviously, both the usefulness of forecasts and the role of accountants in their preparation are far from settled issues. The Need for Attestation An important issue related to forecast publication is the effect on reliability of attestion by an independent certified public 1SLee Barton and James P. Roscow, "Annual Reporting: Braced for Improvements," Financial World, CXLII, No. 17 (October 30, 1974), p. 98. 6See for example, Levy v. Douglas Aircraft Company, Inc., Egderal Supplement, Volume 374 (West Publishing Co., St. Paul, 1974), p. 345. 17Harvey Kapnick, "Before the Securities and Exchange Commis- sion: In the Matter of the Hot Issues Securities Market," File No. 4-148 (March 22, 1972), p. 3. 18Philip L. Defliese, "Forecasting; The Lybrand Position," ‘bestimony provided to the Securities and Exchange Commission (December 12, 1972), p. 1. 11 accountant. Bevis states that "the social importance of the attest function and the changing economic environment strongly suggest the expansion of its use."19 Consistent with this line of reasoning, Wilkinson and Doney (WSD) advocate extension of attestation to include forecasted financial statements; they suggest comparison between his- torical statements and prior forecasted statements, along with explan- ation of differences in a long-form type of report.20 In a 1968 article, Ijiri distinguishes between the determination of generally accepted forecasting principles and procedures and the development of generally accepted forecasting audit standards and pro- cedures.21 Ijiri favors the presentation of comparative historical and forecast financial statements in adjoining columns on the same page, arguing that this presentation facilitates comparison and assessment of reliability of prior forecasts.22 He points out that auditing of forecasts is essentially a review of management's fore- casting work and determining whether or not management's inferences about the future are reasonable.23 A schemata implied by the fore- casting principles Ijiri suggests follows:24 19Herman W. Bevis, "The CPA's Attest Function in MOdern Accounting," The Journal of Accountancy, CXIII, No. 2 (February 1962), p. 35. 20James R. Wilkinson and Lloyd D. Doney, "Extending Audit and Reporting Boundaries," The Accounting Review, XL, No. 4 (October 1965), pp. 753-56, esp. p. 753. 21Yuji Ijiri, "On Budgeting Principles and Budget-Auditing Standards," The Accounting Review, XLIII, No. 4 (October 1968), PP. 662-67 0 221bid., p. 663. 23Ibid., p. 664. 241616., pp. 664-65. FORECASTING PRINCIPLES SUGGESTED BY IJIRI 12 FIGURE 1 !Subsequent recording of w‘ l r 3 l same accounting prin- ciples & procedures used- in forecasting events Forecasted events 1 An inference process ievents must use the is used in predicting events r 1 The inference process must be explicit The inference process must be consistent F 'sistency necessary ‘ l l Internal con- is ...c—--~ - ‘- External con— . sistency is necessary I 7 i l 'historical - ,consistency :between cur- }rent and pasts estimates 2 current - consistency of 'consistency forecast esti- among current mates with estimates industry factors b - . -W. consistency of forecast esti- mates with general economic factors w---— -Av— .“-- ‘The schemata infers three major areas of importance in the development (If forecasted financial statements: (1) explicitness of the inference process, (2) consistency of the inference process, and (3) consistency (If the application of accounting principles between the forecasted and historical statements . Explicitness is akin to the concept of l3 disclosure. In order to judge the quality of management's fore- casting efforts and to assess the reasonableness of resulting revenue and profit estimates, detailed knowledge of the basis for the fore- casted statements is indispensible. Consistency of the inference process depends on both its internal and external consistency. Internal consistency is concerned with the relationship of current estimates to past estimates and current estimates to one another. This concept of consistency is referred to throughout the rest of this study as "internalities." External consistency is concerned with the relationship of company estimates with industry general economic factors. This concept of consistency is referred to throughout the rest of this study as "externalities." Like audits of historical statements, audits of forecasts should determine whether or not the forecasting process and forecasted state- ments are in conformity with generally accepted forecast reporting principles. And the audit must be conducted in accordance with gen- erally accepted forecast auditing standards and procedures. Ijiri suggests that forecast auditing standards are like generally accepted auditing standards and procedures for conventional historical financial statements; both should define (l) the methods of examination, (2) the related evidence, (3) the extent of audit scope, and (4) the reporting standards.25 Even where the need for some form of forecast attestation is generally recognized, controversy would remain concerning the nature (Jf that attestation. Stone suggests that attestation should consist 25Ibid., p. 665. 14 of a statement as to whether (1) a budget system exists, and (2) whether the forecast was prepared comprehensively and carefully.26 On the other hand, Cooper, Dopuch, and Keller suggest that . . .the test of budgetary adequacy would consist of (a) a procedural test in advance-i.e., a review of the procedures followed in the preparation of the budget-and (b) a comparison of the budgeted figures against the documented results.27 Wilkinson and Doney go further and suggest that the auditor addition- ally should express an Opinion on the reasonableness of management's forecasts for the coming year.28 However, this concept of reasonable- ness was not defined in the article. After summarizing the literature through 1970, Nurnberg concludes that forecasts will be published eventually, and, once published, auditors will be called upon to attest to them.29 The SEC has also considered the feasibility of attestation in the hearings mentioned earlier. The Commission is concerned with the meaningfulness of attestation, since the current state of the art is such that there are no generally accepted forecast auditing standards. 0 However, the Commission has indicated that progress has been made 26Williard E. Stone, "Depth Auditing: (Appraisal of Management Performance)," The New York Certified Public Accountant, XXI, No. 8 (August 1961), pp. 521-28, esp. p. 525. 27W. W. COOper, 'N. Dopuch, and T. F. Keller, "Budgetary Disclosure and Other Suggestions for Improving Accounting Reports," The Accounting Review, XLIII, No. 4 (October 1968), pp. 640—48, esp. p. 646. 28 Wilkinson and Doney, op. cit., p. 755. 29Hugo Nurnberg, "The Independent Auditor's Attest Function: Its Prospects For Extension," The New York Certified Public Accountant, XLI (October 1971), pp. 727-32, 783-8, esp. p. 786. 15 toward the development of standards regarding the preparation and presentation of forecasts. Mbreover, efforts are also being expended toward the develOpment of auditing standards. Consequently the Com- mission plans to allow third-party review.30 The position of AICPA is reflected by Rule 204 of its Code of Professional Ethics, which states that: [a] member shall not permit his name to be used in conjunc- tion with any forecast of future transactions in a manner which may lead to the belief that the member vouches for the achievability of the forecast.31 The official interpretation of Rule 204 states that AICPA members are not prohibited from preparing or assisting in the preparation of fore- casts, but that they should presume that forecasted data may be used by outside parties; accordingly, full disclosure must be made of infor— mation sources, major underlying assumptions, the character of the audit work performed, and degree of responsibility taken by the auditor.32 Therefore it would appear that as far as the AICPA is concerned, the auditor is free to report on forecasts and can, in fact, enhance the credibility of published forecasts by giving users assurance on those elements of a forecast, but cannot attest to its achievability.33 The Accountants International Study Group, made up 300. 8., Securities and Exchange Commission, loc. cit., April 28, 1975. 31 American Institute of Certified Public Accountants, Code of Professional Ethics (New York: The Institute 1973). 32Ibid. 33D. R. Carmichael, "Financial Forecasts -- The Potential Role of Independent CPAs," The Journal of Accountancy, CXXXVIII, No. 3 (September 1974), p. 86. 16 of professional Accounting bodies in Canada, the United Kingdom and the United States has issued a report which recommends that profit forecasts be reported on by independent public accountants.34 On the other hand, the Committee on Basic Auditing Concepts of the American Accounting Association maintains that auditors should not attest to forecasts.35 However, the Committee appears to object to attestation of forecast achievability, a form of attestation that no one has seriously suggested. Moreover, the Committee appears to be concerned with limitations of the current state of the art; the latter will be eliminated in time. It is noteworthy that academic spokesmen oppose this extension of the attest function, whereas prac- titioner spokesmen favor it; usually, the reverse situation prevails, with academic spokesmen favoring and practioner spokesmen opposing extention of audit boundaries. A survey of attitudes was conducted by Asebrook and Carmichael.36 Twenty-four hundred questionnaires were sent to randomly selected members of the Institute of Chartered Financial Analysts, the Finan- cial Executives Institute and the American Institute of CPA's. A response rate of 36% was obtained. Among other things, the survey attempted to measure the attitude of the members of the three groups relative to attestation of earnings forecasts by CPA's. Two approaches 34"News Report," The Journal of Accountangy, CXXXIX (March 1975), PP. 18—20, esp. p. 18. 35Joseph A. Silvoso, "The Role of Auditing," Chapter II in "Report of the Committee on Basic Auditing Concepts," The Accounting Review, supplement to Vol. XLVII (1972), pp. 24-34, esp. p. 31. 36Richard J. Asebrook and D. R. Carmichael, "Reporting on Forecasts: A Survey of Attitudes," The Journal of Accountancy, CXXXVII, No. 2 (August 1973), pp. 38-48. 17 to attestation were presented to the survey participants. The first approach dealt with attestation of compilations only.37 In this context the CPA has four responsibilities. First, he must determine that there is adequate disclosure of important assumptions, estimates and information supporting the forecast. Second, he must evaluate the above items, but make no explicit attes- tation on their reasonableness. Third, he should attest to the proper compilation of the forecast and the consistent use of accounting prin- ciples. Fourth, the CPA must make an explicit disclaimer of respon- sibility for the achievability of the forecast. The second approach differs from the first in only one respect, the second responsibility previously enumerated. Under the second approach, the CPA explicitly attests to the appropriateness and care exercised by management in the preparation of the forecast, including assumptions, estimates and underlying information.38 The results indicated that a small majority of CPA's and CPA's agree that attestation serves a useful purpose, whereas a majority of FEI members disagree.39 All three groups believe that the average user would place excessive reliance upon the accuracy of the forecasts, even if the first approach to attestation is used, and would not distinguish it from the second approach.40 37Ibid., p. 42. 38Ibid. 39Ibid., p. 45, 47. 40Ibid. 18 The Small Investor's Right to Know With the advent of the modern corporation, financial reporting has become increasingly concerned with a large number of individuals making relatively small investments--the so-called small investors. The importance of the small investor cannot be ignored. The private investor group amounts to over 31,000,000 individuals, and accounts for approximately 23% of the annual volume on the New York Stock Exchange.41 Although the size of individual investors relative to other investors has decreased recently, the absolute size of the former group has increased dramatically in the last fifteen years. Concurrent with the recognition of a need for reporting to the small investor, concern has been expressed for providing financial information that is relevant to his investment decisions. As discussed earlier, it is generally agreed that the most relevant information is future-oriented. Forecast information available to investors can be divided into two groups, direct and indirect. Direct information is given to the investor by management, such as the "President's Letter" in the annual report. Indirect information is given to the investor by other sources such as investment services, brokers' advice, and the financial press. Small investors usually have neither the time nor the money to obtain direct forecast information other than that mentioned above. Moreover, indirect forecast information is typically overly condensed and sprinkled with too many personal biases to be as useful as 41New York Stock Exchange, Share-ownership - 1970 (New York: The Exchange, 1970), p. 1. l9 forecast information received directly from the reporting company. Unlike small investors, major creditors, investors, and underwriters receive other direct forecast information. The SEC and the AICPA recognize this inequity in the distribution of direct forecast infor- mation. The Commission is concerned that all investors do not have equal access to forecasts,42 and proposes to require that companies which disclose forecasts to the public through the financial press and financial analysts also file such forecasts with the Commission.43 A major objective of financial reporting enumerated by the AICPA Objectives Study Group . . .is to serve primarily those users who have limited authority, ability, or resources to obtain information and who rely on financial statements as their principal source of information about an enterprise's economic activities. The Asebrook and Carmichael survey found that the majority of the three groups queried believe that "disclosure of earnings projections to financial analysts without the simultaneous release to stockholders is prejudicial to stockholders' interests"; somewhat inconsistently, however, they found that the most widely held argument against the publication of earnings forecasts is that the typical investor would misinterpret such forecasts. 42 1973. 43Ibid. U. 8., Securities and Commission, loc. cit., February 2, 4 4Accounting Objectives Study Group, op. cit., p. 17. asAsebrook and Carmichael, op. cit., p. 43. 20 Summagy The recent pronouncements of SEC and the AICPA have added to the controversy over forecasting, rather than resolve it. There appear to be four major positions on the issues of publishing forecasts and related attestation: (1) No forecasts should be published; (2) Publish forecasts without attestation; (3) Publish forecasts with attestation limited to internalities of the forecasts; (4) Publish forecasts with attestation to both internalities and externalities of the forecasts. The evaluation of the arguments favoring and opposing these four positions will not be explored here, since that is beyond the scope of this research. This research assumes the feasibility of publishing forecasts for the following reasons: (1) The SEC, as stated earlier, proposes to allow forecasting; (2) The AICPA Objectives Study Group believes that there are times when forecasts are helpful; and (3) Some forecasts are in fact published. Indeed, in Great Britain and Ireland, forecasts have been included in prospectuses for many years and are attested to in some form by inde- pendent auditors."6 The problem to which this study is addressed is how the small private investor reacts to published financial forecasts in conjunction with various forms of attestation. The next chapter will review prior research directly related to this problem. 6 See John P. Grenside "Accountants' Reports on Profit Forecasts in tile U.K.," The Journal of Accountanpy, CXXXIX, No. 5 (May 1970), PP- 47-53, esp. p. 48. CHAPTER III EARLIER STUDIES Introduction The purpose of this chapter is (l) to review previous empirical studies dealing with small private investor use and understanding of forecasts and related attestation by independent auditors: and (2) to review previous behavioral research in accounting which employ the same basic methodology used in this research. There are several data collection methods available in the be- havioral sciences that are applicable to accounting research.1 Two of particular interest to this study are questionnaires and field experiments. When used with large samples, questionnaires are economical and offer two types of information: factual and opinion. When the ques- tionnaire method is used to survey opinion, it has the disadvantage of possibly not accurately reflecting how respondents will be affected by real-life situations. This lack of isomorphism with real-life re- action can occur because people often do not realize that what they do is different from what they say they do. 1See John Grant Rhode, "Behavioral Science Methodologies with .Application for Accounting Research: References and Source Materials,’ Chapter VII in'Report of the Committee on Research Methodology in AccountingJ'The Accounting Review, supplement to Vol. XLVII (1972), PP- 494-504. 21 22 On the other hand, field experiments place test subjects in simulated life-like situations. Observation of test subjects' reactions (the dependent variable) is then made as predetermined independent vari- ables are manipulated. The major advantages of this type of investiga- tion are that the observations are made of what test subjects do, not what they say they do; and exogenous variables may be more readily excluded; its major disadvantages include a possible lack of realism in the experimental setting, and the relatively high cost of running the experiment. Empirical Studies At least three earlier empirical studies addressed themselves to the subject area encompassed by this dissertation. The first study, conducted by Baker and Haslem (B & H), investigated the information needs of individual investors.2 In addition, the study attempted to identify "important sources of information used by investors in their analyses of common stock."3 The test subjects were individual common stock investors in the greater washington D.C. area. They were sent a questionnaire containing 33 factors used in investment analysis, and were asked to specify the relative importance of each factor on a five-point scale as fol]ows: Point value Importance scale 1 of no importance 2 of slight importance 3 of moderate importance 4 of great importance 5 of maximum importance 2H. Kent Baker and John A. Haslem, "Information Needs of Individ- ual Investors," Journal of Accounting, CXXXVI, No. 15 (November 1973), pp. 64-69. 31bid., p. 65. 23 Eight hundred and fifty-one responses were obtained out of a systematic sample of 1623 individual investors. B & H arbitrarily divided the factors into three categories: great importance, moderate importance and little importance. A listing of the factors by importance is shown in Table I.4 B S H also examined the sources of information used by investors in making investment decisions, and found that brokers command an over- whelming influence with investors; 47% of the respondents listed stock- brokers as the most important source of information. Other sources receiving more than 5% were advisory services - 16%; newspapers - 11%; friends and/or relatives - 10%; and financial statements - 8%.5 Note the lowly position of financial statements. The following conclusions are offered by B & H: (1) Individual investors used many different factors in the analysis of common stock, but expectational factors dominate. (2) The findings support a recent action which permits companies to include voluntary sales and earnings forecasts in reports filed with the SEC. However, more meaningful information than will be provided only by forecasts of sales and earnings is needed by investors in their analyses of common stock. (3) User information requirements for investment analysis may very well differ. Comparisons with other research findings suggest that individual investors may have different information needs than professional analysts. Because of the nature of their study, B & H recognize that their con- clusions are tentative. Nevertheless they feel that their conclusions 41bid.’ p. 67. 5Ibid., p. 68. 61bid., pp. 68, 69. 24 TABLE I FACTORS USED IN INVESTMENT ANALYSIS Standard Coefficient Rank Pactor Mean deviation of variation 0f great importance 1 Future economic outlook of the company 4.34 .72 .16 2 Quality of management 4.13 .97 .23 3 Future economic outlook of the industry in which the firm is a part 4.05 .82 .20 Of moderate importance 4 Expected future growth in sales 3.93 .86 .21 5 Financial strength of the company 3.81 .86 .22 6 Expected future percentage growth in the company's earnings per share 3.78 .99 .26 7 Reputation of the company 3.76 .97 .25 8 General business outlook in the United States 3.67 .97 .26 9 Risk of losing money on the stock 3.62 .94 .25 10 Price behavior of the stock during the past 12 months 3.58 .92 .25 11 Current price-earnings ratio of the stock 3.56 .95 .26 12 Past percentage growth of the company's earnings per share 3.56 .97 .27 13 Stability of company's earnings per share 3.29 1.02 .31 14 Rate of return the company earns on its assets 3.27 1.01 .30 15 Stability of the market price of the stock 3.15 .99 .31 16 Base with which the stock can be sold 3.12 1.09 .34 17 Portion of the firm's assets financed by debt (leverage) 3.11 1.01 .32 18 Involvement of the firm in active research and development 3.03 1.07 .35 Of slight importance 19 Listing of the stock on a stock exchange 2.99 1.15 .38 20 Expected percentage growth of the company's future dividends 2.96 1.09 .36 21 Expected future percentage return from dividends (yield) 2.91 1.12 .38 22 Activity of the stock in terms of trading volume 2.88 1.05 .36 23 Effect of personal long-term capital gains taxation 2.88 1.17 .40 24 Percentage of earnings the company uses for reinvestment 2.84 1.05 .36 25 Past percentage growth of dividends per share 2.77 1.04 .37 26 Current percentage return from dividends (yield) 2.76 1.03 .37 27 Stability of past dividends 2.75 1.06 .38 28 Past percentage return from dividends (yield) 2.66 1.02 .38 29 Portion of the company's annual earnings paid out in dividends 2.61 .97 .37 30 Value of a share of stock based on the company's accounting records (book value) 2.55 1.05 .41 31 Expected future level of long—term interest rates on corporate bonds 2.48 1.08 .43 32 Size of the company 2.31 .92 .39 33 Ease with which the company can sell its assets in case of failure 2.23 1.15 .51 25 have several important implications. They believe that providing in- vestors with more meaningful financial statements and earnings forecasts alone is not sufficient. Because expectational factors dominate in in- vestment decisions, investors also need information on the general busi- ness outlook for the firm and industry, along with projections of growth rates for sales, earnings and dividends.7 B & H recognize that manage- ment cannot supply all of this information. But without such disclo- sures, they feel that imperfections in the securities market may exist. The second study was conducted by Nickerson, Pointer and Strawser (N,P, 6 S) and investigated the current attitude of investors toward published forecasts.8 N,P, & S were especially interested in (l) fore- cast accuracy anticipated by investors, (2) investors' beliefs about factors affecting forecast accuracy, and (3) investors' beliefs about possible methods for improving forecast accuracy. The population of interest was the shareholders of Fuqua Corporation, from which a sample of 2,000 was drawn. This population was selected because Fuqua was the first publicly-owned company to provide forecasts of sales and earnings in a formal report directed to its shareholders. A questionnaire solicited investors' Opinions concerning the issues above; there was a 23.3 per cent response rate. The results of the N,P 8 S study on attitudes on forecast accu- racy are presented in Table 11.9 7Ibid., p. 69. 8Charles A. Nickerson, Larry G. Pointer, and Robert H. Strawser, "Published Forecasts: Choice or Obligation?" Financial Executive, XLII, No. 2 (February 1974), pp. 70-73. 9Ibid., pp. 71, 72. 26 TABLE II PERCENT OF RESPONDENTS INDICATING BELIEF IN SELECTED VARIANCE RANGES FOR FORECASTED DATA Percent of Respondents Indication Maximum Vari- ance of Forecast From Actual Anticipated Percent Variance of Forecast From Actual Sales Earnings i10% 93% 94% i 5% 64% 62% i 3% 16% 21% Note the seemingly strong confidence in forecast data; for ex- ample, 94% of the respondents believe that actual earnings will not vary by more than 10% from forecasted earnings. In addition, N,P & S asked respondents whether CPAs should conment on the fairness of fore- casts. About 66% of the respondents favored this practice.10 N,P & S conclude that investors regard published forecasts as a part of the regular management reporting process implied in the stewardship theory of responsibility.11 The N,P & S study is the first to deal directly with the attitudes of individual investors concerning forecasts. However, its results lack generalizability for several reasons. First, investors were asked about their beliefs on Fuqua's forecasting accuracy; accuracy beliefs about forecasting in general may be substantially different from those con- cerning a forecast by Fuqua. Second, the sample was not selected loIbid. ’ p. 72. l 11bid.’ p. 73. 27 randomly from the population of all private investors, but only from Fuqua Corporation shareholders. Mbreover, the attitudes concerning the relationship of auditors to forecasted statements were obtained from a very general statement concerning whether CPAs should comment on the fairness of forecasts. There is no way to determine whether Fuqua investors feel attestation should cover internalities, externalities, or both. Although investors indicate that forecasts and some form of attestation are useful, there is no indication of when they would be useful. That is, when does a forecast and/or the type of attestation cause an investor to change his investment decision? In fact, there is nothing in the N,P 6 S study to indicate whether or not investors even understood the implications of the various possible forms of attestation. The third study was conducted by Corless and Norgaard (C & N).12 The emphasis was placed on the examination of user reactions to attes- tation of forecasts. The research addressed itself to the following questions: (1) How does the report of a CPA affect users' con- fidence in the reliability of forecast data? (2) What role do users of forecast data assume the CPA plays when he reports on such data? (3) What should the CPA's legal liability be when he reports on forecasts? (4) What are the perceived effects on the CPA's inde- pendence when he reports on forecasts? 12John C. Corless and Corine T. Norgaard, "User Reactions to CPA Reports on Forecasts," Journal of Accountangy, CXXXVIII, No. 2 (August 1974), pp. 46-54. 28 (5) WOuld a change in the style of the CPA's fore- cast report affect the responses to questions 1 through 4? (6) WOuld different types of users of the CPA's forecast re ort respond differently to questions 1 through 4?15 C & N used two types of test subjects: financial analysts, to represent the SOphisticated investors; and MBA students, to represent the less sophisticated investors.14 Questionnaires were sent to 750 financial analysts who were members of the Financial Analysts Federa- tion. In addition, 80 students enrolled in the evening MBA program at the University of Connecticut participated in the study. Each participant received one of three types of audit reports. After studying the auditor's report, the test subject was asked a series of questions. Three types of auditor's reports were used. The first type is used in the United Kingdom. The report is a single para- graph, and indicates that the auditors have reviewed accounting bases and calculations. The auditor's opinion is limited to the compilation of forecast data based on management's assumptions and presented in a manner consistent with accounting practices followed in preparing con- ventional historical statements. The second type is labeled "positive assurance." Its form is two paragraphs, one for scope and the other for opinion. The scope paragraph differs little from the specifications of scope in the United Kingdom type report, but the Opinion paragraph includes an explicit statement about the care with which management has selected its assumptions in addition to those areas attested to in the 13Ibid., p. 46. 14rbid., p. 47. 29 United Kingdom report. The third type is labeled "negative assurance." The scope paragraph is similar to that of the other two types, but in the opinion paragraph, only negative assurance is given concerning the reasonableness of assumptions. The opinion paragraph states in part that . . .nothing came to our attention as a result of our study that caused us to believe that such assumptions, which have been selected by management, do not constitute reasonable bases for the preparation of the estimates in the projected statement of operations.15 C 6 N found that differences among responses given by respondents of different report types and differences between the responses of analysts and MBA students were generally insignificant.16 C 6 N also investigated how attestation to forecast data would affect user confidence by asking that test subjects to "compare a fore- cast accompanied by a CPA's report with (l) a forecast not accompanied by a CPA's report, and (2) a forecast generated by a financial analyst."17 Fifty-eight percent of the respondents indicated that they had greater confidence in the forecast when accompanied by a CPA's report. On the other hand, 42% indicated that they had greater confidence in a forecast when prepared by a financial analyst. It appears that confidence remains generally constant between an attested forecast and a forecast generated by a financial analyst. Test subjects were also asked to compare their confidence in audited forecasts with their confidence in audited historical finan- cial statements; 14% indicated equal confidence, while 86% indicated 151616., pp. 47, 48. 16Ibid., p. 48. 17Ibid. 30 that they had less confidence in the forecasted statements.l8 Test subjects who indicated that they did not have equal confidence in forecasted financial statements as compared to historical financial statements were asked to state the reasons for their lack of confi- dence in the former. About 75% of the respondents indicated that the reason for their lack of confidence in forecasts was due to their tentative nature.19 Additionally, several respondents indicated that, in judging the reliability of forecast data, the nature of the company itself, its industry and the period covered by the forecast are much more important than the presence or absence of the CPA's report. C 8 N concluded that the presence of an auditor's report has very little effect on increasing investor confidence. Several questions were included in the questionnaire to determine user perceptions of the role which the auditor assumed in relation to forecast data. Users of auditor's reports on forecasted financial statements appear to assume that the auditor has reviewed the assump- tions and verified computational accuracy, regardless of type of report issued; the U.K. report type involved the least ambiguity regarding the role of the auditor in attesting to forecasts.20 The C 6 N study suffers from several limitations. First, the auditor's reports are really quite vague and, therefore, are not meaningful to the user. Second, the test subjects may not have con- sidered the situation realistic, since it appears that they were only 18Ibid. 19Ibid., p. 49. 20Ibid., p. 51. 31 given the audit report and asked to imagine the related forecasted and historical financial data. Third, the test subjects were asked for an opinion, rather than required to face a decision situation. Behavioral Studies Several studies have been made in accounting of a behavioral nature employing the same basic methodology used in this study. The citation of these previous studies is intended solely to demonstrate that behavioral studies have been used to explore financial reporting hypotheses, and that the method of analysis (analysis of variance) used in this study is generally accepted. One of the earliest studies was made by Jensen, who examined the responses of security analysts to alternative methods of accounting for inventories and depreciable assets, using analysis of variance techniques.21 The analysts were provided with detailed information on two hypothetical firms which were identical, save for inventory and depreciation accounting methods. For a hypothetical investor with a fixed dollar amount to invest and stated investment objectives, the analyst's task was to indicate the advice he would offer as to how much of each security should be purchased. There were sixteen experimental classes representing combina- tions of inventory and depreciation methods, with twenty-one analysts randomly assigned to each class. Analysts expressed substantial differences in investment advice, differences attributed solely to 21Robert E. Jensen, "A Study of Effects of Alternative Accounting Systems on Security Analysis and Portfolio Selection Decisions" (Unpublished Ph.D. dissertation, Stanford University, Palo Alto, 1966). 32 inventory and depreciation accounting methods. Jensen concluded that: (1) Accounting variations give rise to substantial differences in various financial attributes; (2) The apparent income differences caused by reporting differences affect the decisions made by professional financial analysts; (3) Greater uniformity in basic accounting state- ments should be initiated. In a subsequent study, Dyckman investigated the effects on invest- ment analysis of alternate reporting methods related to general price level changes.22 The test subjects, financial analysts, were asked to select between two hypothetical firms. Each analyst was given one of three sets of reports, as follows: (1) both firms reporting in terms of conventional unadjusted historical cost; (2) both firms reporting in terms of conventional unadjusted historical cost with supplementary statements in terms of general price level adjusted historical cost; and (3) both firms reporting in terms of general price level adjusted historical cost. The null hypothesis was that price-level adjustments do not influence investment evaluations. Dyckman concluded that price— level statements influenced investment evaluation, but that the effect was not very strong. Again, analysis of variance was employed. Still another important study was made by Abdel-Khalik.23 He investigated the effect of linear aggregation of accounting data on 2 2T. R. Dyckman, Investment Analysis and General Price Level Adjustments: A Behavioral Study ("Studies in Accounting Research," Vol. 1; American Accounting Association, 1969). 23Ahmed Rashad Abdel-Khalik, "The Effect of Linear Aggregation of Accounting Data on the Quality of Decisions" (Unpublished Ph.D. dissertation, University of Illinois at Urbana-Champaign, 1972). 33 business loan decisions made by commercial loan officers of commercial banks. The major purpose of his study was to systematically evaluate the effect on some specified decisions of aggregation of data contained in external reports. Abdel-Khalik analyzed decisions in terms of the information loss due to aggregation. Using two pairs of firms of comparable size from the same industry and in the same risk class, data were aggregated at three different levels. The loan officers were asked to allocate scarce loanable funds between the firms and to esti- mate the probability of default on the loan. Analysis of variance was used to test for differences in attributes between levels. Abdel-Khalik concluded that disaggregated data is more useful whenever the firm is a marginal or high-risk customer. It is interesting to note that Rhode classified the first two studies as laboratory experiments although the authors referred to them as field experiments.24 There is an obvious overlapping between laboratory and field experiments. However, for all three studies, the better classification appears to be field experiments, because the respondents completed questionnaires in the field at their own con- venience rather than in a controlled setting. 24Rhode, op. cit., p. 499. CHAPTER IV THE EXPERIMENT METHODOLOGY The empirical study is in the form of a behavioral field experi- ment, using a sample of individual private investors as test subjects. Three factors (independent variables) are incorporated into the design of the experiment: (1) one-year financial forecasts; (2) auditor's reports; and (3) broker advices. The underlying financial statements for the hypothetical firms, broker advices, and auditor's reports are found in Appendices A, B, and C respectively. The number of levels used for these three factors are as follows: three levels for forecasts; ten levels for auditor's reports, and two levels for broker advices. Forecast Variable The one-year financial forecast variable is included in the experiment at three levels, F0, F++, and F_+. These levels represent the following situations: F0 A one-year financial forecast is not included in the information packet given the investor (See Appendix A- Exhibit I). F A one-year financial forecast projecting a $.77 (30%) H increase in earnings per share for Carter Communications Company (Appendix A--Exhibit II), and a one-year finan- cial forecast projecting a $.17 (10%) increase in earnings per share for SRN, Inc. (Appendix A-Exhibit IV). F_+ A one-year financial forecast projecting a $.33 (13%) decrease in earnings per share for Carter Communications Company (Appendix A--Exhibit III), and a one-year 34 35 financial forecast projecting a $.17 (10% increase in earnings per share for SRN, Inc.--the same fore- cast included in F . -H- Two reasons underlie the choice of these levels. First, com- paring the F0 level with the F++ and the F_+ levels allows for a general comparison of the present state of the art with the proposed forecast state. Second, comparing the F++ and F_+ levels, because they involve changes in direction for one firm while the other is held constant, allows for a more sensitive test than comparing the F++ and F__ levels. The absolute and relative magnitudes of earnings per share for the two firms under the three forecast levels are shown in Table III. TABLE III ABSOLUTE AND RELATIVE EARNINGS PER SHARE EPS Prior Year F0 F++ F-+ $2.53 x $3.30 $2.20 carter 100% x 130% 87% SRN $1.63 x $1.80 $1.80 100% x 110% 110% Of course, the magnitude of forecast variations in the F++ and F__+ levels could have been much more extreme. The concept of materiality as applied to accounting information is not a settled issue.1 The FOr a summary of relevant issues and suggestions for research in this area see; Melvin C. O'Connor and Daniel W. Collins, "Toward Establishing User-oriented Materiality Standards," Journal of Accountancy, CXXXVIII, No. 6 (December 1974), pp. 67-75. 36 magnitudes were selected because they represent reasonably significant, but not extreme variations. It is hoped that by avoiding extreme vari- ations, respondents will find the experiment to be realistic. Variations in the magnitude of forecasts are obviously infinite. Limiting the variations to those which are thought to be representative of magnitudes important to the decision-maker provides for a clearer analysis of the experimental results and is a common practice in statis- tical experiments. It is to be recognized, however, that there is an off-setting limitation to this design: when the levels of a factor are fixed, the statistical inferences are limited to only those levels of the factor; all inferences to other levels of the factor are logical inferences, not statistical inferences. Therefore, any conclusions are statistically generalizable only to the specific F++ and F_+ levels, although the latter are shown to maximize the reasonableness of logical inferences to other forecast levels. Auditor's Report Variable The auditor's report variable is included in the experiment at ten levels, A , A2, A3, A4, A5, A6, A7, A8, A9 and A10, with A1 through A nested in F++ and A through A10 nested in F_+. These levels repre- 5 6 sent auditor's report combination types as follows: A1 and A6 - a standard unqualified auditor's report for both companies. A2 and A6 - a standard unqualified auditor's report with a middle paragraph disclaimer on the fore- casted data for both companies. A3 and A8 - a standard unqualified auditor's report whose scope and opinion paragraphs are expanded to mention the examination of and include an un- qualified opinion on internalities of one- year financial forecasts for both companies. 37 A4 and A.9 - a standard unqualified auditor's report whose scope and opinion paragraphs are expanded to mention the examination of and include an un— qualified opinion on the internalities and externalities of the one-year forecasts for both companies. A and A - for SRN, the same type of report as used in A above. For Carter, an adverse opinion based on an examination of both the internalities and externalities of the one year financial forecast. The auditors' reports wording was developed with the help of Mr. Ralph F. Bonanata, an audit partner in the Detroit office of Arthur Andersen 6 Co. Note that there are actually five levels of auditor's reports, but 10 subscript designations. This occurs because the audit factor is nested in the forecast factor. The nested design, one in which all the levels of one factor are included within a level of another factor, is used because the dependent variable, expressed as the percentage of respondents who select Carter for investment, is pushed in opposite directions by some of the audit report levels under each forecast level. For example, consider the hypothetical values of the dependent variables in Table IV. TABLE IV HYPOTHETICAL CELL MEANS F ++ F_+ A1 A2 A3 A4 A5 A6 A7 8 A9 A10 B +_ 7 7 8 .9 3 . 5 4 3 2 B_+ 5 6 . 2 3 2 1 Ave. 6 7 8 .25 4 3 25 15 A1A6 A2A7 A3A8 A4A9 ASAIO Combined Average .5 .5 .5 .5 .2 38 Levels A3 and A4 of the auditor's report factor are expected to favor Carter, whereas levels A and A are expected to favor SRN, Inc. 8 9 Levels A , A2, A6 and A7 are expected to be neutral. Note that the nested factor is expected to show an increasing average under F++ and a decreasing average under F_+, although no change is readily observ- able when the columns under each forecast level are combined, except for level A5(A10). This latter phenomenon could result, if a crossed design were used for analysis. However, nesting of the audit factor within the forecast factor does not allow for separate statistical analysis for main effects. This occurs because the audit report levels, although nested, are not independent of the forecast levels. Therefore one overall P-value is computed in order to determine the significance of the nested factors. The A1(A6) level is used for two reasons. First, it represents the type of audit report usually seen in the FO state. Second, it is included in the F++ and F_+ states as a comparison with A2(A7). The ordering of the annual report varied for A1(A6) and A2(A7). For A F l-H- and A6F-+’ the forecasted statements followed on separate pages after the historical statements and auditor's report; it would not be realistic for an auditor to omit mention of a forecast in his report on historical data if the forecasted data were presented in columnar form alongside the attested historical data. For A21?++ and A7F_+, A3F++ and ASF—+’ A4F++ and A9F_+, and ASF++ and A10F_+, however, the historical and forecasted information are presented next to each other in columnar form, consistent with the columnar format recommended by Ijiri, Wilkinson and Doney, and Cooper, Dopuch and Keller, discussed in Chapter II. 39 The A2(A7), A3(A8), and A4(A9) levels represent each of three possible auditor reports that could be issued on forecasted financial statements, also discussed in Chapter 11. Level A5(A10) is included to determine whether the audit report has any significance whatsoever for the investor. Individual private investors may not comprehend distinctions between A2(A7), A3(A8), and A4(A9). On the other hand, an adverse opinion, such as A5(A10)’ should have significance to even the most naive investor. Therefore, even though an adverse opinion is almost never issued in practice, it is included in the experiment to see if auditor's reports are at least read with some understanding. Because the A5(Alo) level involves an adverse opinion only for Carter, whereas an unqualified report relating to both internalities and externalities is presented for SRN, Inc.; it should provide for optimum sensitivity. Level Fo does not include a one-year financial forecast. The only auditor's report level which can be used with F0 is A1(A6), since the remaining four audit report combinations A2(A7), A3(A8), A4(A9). and A5(A10) include attestations to forecasted statements. Broker Advice Variable The broker advice variable is included at two levels B+_ and B . These levels represent the following situations: B Broker gives a favorable recommendation for Carter over SRN (Appendix B -— Exhibit I); and B Broker gives a favorable recommendation for SRN over Carter (Appendix B -- Exhibit 11). The broker factor is included in the experiment for two reasons. First, its inclusion increases mundane reality. The investor 40 participating in the experiment could look at the broker advice instead of the annual report, if this is how he typically makes investment decisions. That is, the investor is not forced to look at the annual report. Second, a recent questionnaire-type study by Baker and Haslem (BSH) discloses that the broker is by far the single most influential factor in the investment decision of the private investor.2 The present study should additional evidence concerning the validity of the results of the BSH study. The cell combinations formed by these variables are shown in Table V. TABLE v FACTOR COMBINATIONS B+_ F0 A1(A6) B+_ F4+ A1 B+_ F_+ A6 B+_ F++ A2 B+_ F_+ A7 B+_ F_H_ A3 B+_ F_+ A8 B+_ F++ A4 B+_ F__? A9 B+- F++ A5 B4— F-+ A10 B_+FOA1(A6) B_+F_H_A1 B_+F_+A6 B_+ F4+ A2 B_+ F_+ A7 E_+ F++ A3 E_+ F_+ A8 B-+ F++ A4 -+ F-+ A9 B--+ F++ A5 B-+ F-+ A10 I 2 H. Kent Baker and John A. Haslem, "Information Needs of Indi- Vidual Investors," Journal of Accounting, CXXXVI, No. 15 (November 1973). P. 68. 41 Data Packets Investors are randomly assigned to twenty-two cells in the design. Each investor within a given cell receives a packet of finan- cial information about the two hypothetical firms. In addition to broker advice, each financial data packet contains for each of the firms, simulated annual reports which include the following items: (1) a letter to stockholders from the president; (2) a five-year financial summary; (3) historical and, where indicated, forecasted statements of financial position, income and retained earnings, changes in financial position, and appropriate footnotes; (4) an auditor's report. Copies of all items included in the data packet appear in Appendices A through F. Based on the financial data packet, the investor is asked to determine in which of the two firms he would prefer to invest and the strength of his preference. These investment decisions and preferences are the dependent variables used in the study. Dependent Variables The investment decision choice dependent variable is expressed as a proportion and labeled the investment choice proportion (ICP). The ICP, for each of the 22 cells is computed as follows: 2 ICP . ICP . = investment choice, coded as l, 1 13 13 . ICP =._______ if Carter was chosen or 0, 1f 3 nj SRN was chosen; nj = the number of respondents in cell j. WHERE i = l,2,...,n l,2,...,22 1.1. II 42 If there are no significant differences in the twenty-two ICPj dependent variables, then the independent variables have no bearing on investor investment decisions. The second or alternative dependent variable is an investor preference index for the two companies. After selecting one of the two companies for investment, the investor is asked to indicate his preference for the company selected. ‘The choices available are strong, moderate, and weak. These are coded as follows to develop the investor preference index (IPI): £352; Response Carter strong Carter moderate Carter weak SRN weak SRN moderate SRN strong I-‘NUJbUIO‘ This coding procedure is common in applied psychology.3 The average of the coded responses (IPI ) is determined for each cell as 3 follows: E IPIij IPIij = coded preference expressed IPI = i by each investor; J n3 nj = number of respondents in cell j. WHERE i = l,2,...,n j j = 1,2,...,22 The IPI variable is used because it might be a more sensitive dependent variable than the ICP variable. In addition, ICP is dichotomous whereas 3See, for example, Paul Slovic, "Analyzing the Expert Judge: A Descriptive Study of a Stockbroker's Decision Process," Journal of Applied Psycholggy (August 1969). PP. 255-63. 43 IPI is not. Use of dichotomous dependent variables in an ANOVA design raises questions about the validity of the homoscedasticity assumption underlying the procedure. The Questionnaire The questionnaires are shown in Appendix D. Two questionnaires were required because no forecasted data were presented under F0. Accordingly, there was no mention of forecasts in the first paragraph and in question five for F packets. The questionnaires were designed O with the help of Professor Charles G. Eberly of the Evaluation Services Office at Michigan State University. They were pre-tested on an in- formal basis by several associates of the researcher in order to reduce the possibility of misinterpretation of questions by study participants. There are seventeen questions for the investor to answer. The first two questions deal with the selection of the alternative dependent variables ICP and IPI respectively. The third question is included to test for consistency in the specifications of the ICP and IPI. That is, for example, the specified share value for Carter should be higher than that for SRN when Carter is selected for investment. Unfortunately, the respondents misunder- stood the question and it could not be used. The fourth question is included to determine whether or not the test subject spent a reasonable amount of time reviewing the financial data packet. Questions 5 and 6 are included for two reasons. Responses to the fifth question can be compared to the significance testing of the independent variables on the dependent variable in order to determine 44 the consistency between what the investor did versus what he says he did. Comparison of questions 5 and 6 should give an indication of how the investors reacted in this study compared to what they usually do when making investment decisions. Question 6 can also be compared with a recent study by Baker and Haslem,4 to determine the representa- tiveness of the investment decision influences of the sample population as compared with all private investors. Question 7 was included to help explain differences between questions 5 and 6. Questions 8 through 12 were included to gain an understanding of the investing experience of the participants and to test for homogeneity of the respondents across the cells used in the design. Questions 13 through 17 were included in order to determine the representativeness of the sample population to the total population of individual private investors; in Chapter V, the responses to these questions are compared to a study done by the New York Stock Exchange.5 The Experimental Population The population of interest is all individual private investors. It is not practical to obtain a listing of this population from which a random sample could be drawn. As a substitute, an important sub- group of this population was used. The National Association of Invest- ment Clubs (NAIC) provided its membership list. The NAIC represents approximately 25 percent of all investment clubs whose total membership 4Baker and Haslem, loc. cit. 5New York Stock Exchange, Share-ownership - 1970 (New York: The Exchange, 1970). 45 is about 200,000 individuals.6 There is no a priori reason to believe that this group is not typical of private investors generally. Since the club is national, a random sample could have been selected which would have been representative of the population of all NAIC members. However, a nationally drawn random sample would have introduced another variable into the problem, geographic location, which might be a significant factor in investor behavioral patterns. In addition, response follow-up is potentially more effective and less costly if the sample is drawn from a more limited geographical region, particularly if the use of a telephone is necessary to generate responses. Accordingly the Detroit Metropolitan area is chosen, for the following reasons: (1) 77 percent of all shareowners live in metro- politan areas; (2) among the top twenty-five metropolitan areas in the United States Detroit is ranked sixth in terms of absolute numbers of investors and fifteenth in terms of percent of shareowners to area population;7 (3) this area is readily accessible to the researcher for follow-up procedures. Although statistically not generalizable beyond Detroit NAIC members, the study should be interesting per se and logically generalizable to the entire population of investors throughout the United States. The NAIC has approximately 6,000 members in the Detroit Metro- politan area. Of these, 1,540 were selected at random and randomly 6Richard A. Stevenson, "Investment Clubs and Their Importance to Management," MSU Business Topics, XX (Winter 1972), p. 30. 7New York Stock Exchange, op. cit., p. 10. 46 assigned to one of the twenty-two cells described earlier in the chapter. This procedure provided for a cell size of 70. Multivariate analysis by cell of respondents' profiles and firm selection as dis— closed by the questionnaire indicated that the cells are homogeneous. Response Rates Returned usable responses totaled 360 or 23.4% of the total sample. An additional 1.5% were returned but are not usable. Initial response was 15%. After two weeks, a reminder was sent and an addi- tional 10% of the questionnaires were returned; see Appendix E, Exhibit II. Use of a telephone to generate responses was found unnecessary. Response rates for individual cells varied from 17% to 31%, as indicated in Table VI. TABLE VI RESPONSE RATES FOR INDIVIDUAL CELLS F F0 F++ —+ A A A1(A6) A1 A2 A3 A4 A5 A6 A7 8 9 10 3+_ 232 192 242 21% 242 19% 26% 26% 19% 30% 23% B_+ 242 23% 30% 24% 17% 27% 20% 31% 192 23% 21% The return of 23.4% appears reasonable. Whether the lack of response by the 76.6% of the test subjects indicates a response bias is an Open question characteristic of this type of research. When the response rates are grouped by the various independent variables they show almost no variation as compared to the investor 47 choice proportion discussed in Chapter V. The investor choice propor- tion showed greater variation but the significance of the independent variables was largely marginal. Therefore, the response rates across cells appear to indicate only random variation. The respondents, on average, spent 1.2 hours reviewing the data packet. One respondent indicated that he had spent sixteen hours. Mbst spent between one-half and one and one-half hours. The amount of time spent tends to indicate that the respondents made a reasonable attempt to study data packet information. The Testing Process - General Comments Since the independent variables (1) broker advice (B),(2) fore- cast combination levels (F),(3) Auditor's reports (A) are qualitative, the technique of analysis of variance is used to measure the effect of these factors on the dependent variable (ICP or IPI). The multifactor analysis of variance models should disclose whether there are inter- actions among the factors and which factors are significant. There are basically three analysis of variance models which could be selected, 1) fixed effects, 2) random effects, and 3) mixed effects. As mentioned previously, the fixed effects model is used in this research because the factor levels chosen are of specific interest. This limits statistical generalization to only these levels8 but, since they represent levels of interest, this limitation is reasonable; additionally, logical inference to other levels appears reasonable. 8Gene V. Glass and Julian C. Stanley, Statistical Methods in Education and Psychology (Englewood Cliffs, N. J. Prentice-Hall, Inc., 1970), p. 473. 48 Analysis of variance procedures are based on three statistical assumptions.9 These assumptions are as follows: (1) Independence, observations randomly chosen. (2) Normality, the within-cell distributions of the errors are normal. (3) Homoscedasticity, i.e., variances of within cell distributions are equal. The homoscedasticity assumption is likely to be violated in the case of dichotomous dependent variables. In order to alleviate this problem, at least two possible courses of action exist, and both are used in this study: (1) The data are transformed, using either a log trans- formation or Bartlett's arcsin transformation;10 (2) (IPI) is studied, as well as (ICP), since the former is not dichotomously scored data. Because this research design has three independent variables (B,F,A), interactions may exist. An interaction exists when the factor effects are not additive. One of several techniques for the interpre- tation of interactions is the graphing technique.11 When the factor level lines in a graph are not parallel, an interaction exists. When an interaction exists, the main effects cannot be interpreted. 9Ibid., p. 340. 10For in depth discussion of this problem see M. S. Bartlett, "The Use of"Iransformations," ‘Biometrics, III (1947), pp. 39-53; G. H. Lunney, "Using Analysis of Variance with a Dichotomous Dependent Variable: An Empirical Study," Journal of Education Measurement (Winter 1970), pp. 263-269; and Ralph B. D'Agostino, "A Second Look at Analysis of Variance on Dichotomous Data," Journal of Educational Measurement (Winter 1971), pp. 327-333. 11 Glass and Stanley, op. cit., p. 408. 49 Post hoc Procedures Incidental or post-hoe comparisons in data are a common tech- nique in this type of experimentation.12 When the overall F-test is significant, post-hoc comparisons can be used to find the sources of the effect and determine their meaning. Any comparison F, independent or not, can be made. The Scheffe’ method is used because it can handle cells of unequal size, and is fairly insensitive to violations of the normality and homogeneity of variance assumptions.13 The significance of a comparison is determined by constructing a confidence interval around the comparison value. The comparison is not significant if the confidence interval at a specified significance a level includes zero. Two formulas are used for constructing confidence intervals,14 one for comparison of interaction effects and the other for comparison of cell means within a row or column. The formula used to calculate the confi- dence interval for comparison of interaction effects is: i i . AB VII-l)(J-1)1_GF(I_1)(J_1),v JVAR (pAB) WHERE a. '/v— C2 VHAR (TAB) = (MS error) (2123 11) n 13 and i = rows c = cell weight, Zcij = O a 1 13 j co umns nij = number of observations per cell 12 William L. Hays, Statistics (New York: Holt, Rinehart, Winston, 1963). PP- 483-485. 13Ibid., p. 484. 14 Linda Glendening, "Posthoc: A Fortran IV Program for Generating Confidence Intervals Using Either Tukey or Scheffe’ Multiple Comparison Procedures," Occasional Paper No. 20, Office of Research Consultation, School of Advanced Studies, College of Education (East Lansing, Michigan: Michigan State University, 1973), esp. p. 6-7. 50 The formula used to calculate the confidence interval for comparisons of cell means within a row of column is: «VAR (T) Q i 'QEJ'1)1-a F(IJ-1),v WHERE «VAR (V) = 7(MS error) (2123 i) n 1.1 and i - rows Cij = cell weight, Zcij = 0 j = columns nij = number of observations per cell These confidence intervals are interpreted differently from the usual confidence interval. That is, if all possible comparisons are deter- mined and, for each comparison a confidence interval at a significance level is calculated, the chances are 1-0 that every one of these confi- dence intervals would contain the true value for that comparison. In other words, the probability of committing a Type I error for one or more comparisons is exactly a. There must be some comparison P signifi- cant at or beyond the a level used in the overall F-test when the overall F-test is significant.15 However, finding a statistically significant comparison does not necessarily indicate that the compari— son is meaningful to financial reporting. These post hoc procedures will be employed to explore the sources of the effect whenever the overall F-test is significant at a = 0.10 level. Typically an a level of .05 is used. However, since this study is exploratory in nature, observations that are significant at o = 0.10 are explored because of their possible importance to financial 15Hays, op. cit., p. 484. 51 reporting, although they are only marginally significant from a statis- tical point of view. Research Hypotheses This research is concerned with investor reaction to (1) broker's advice, (2) one-year financial forecasts and (3) auditor's reports. Therefore the research hypotheses relate to these factors. To the extent that the following null hypotheses are rejected, broker advices, one-year financial forecasts and auditor's reports are shown to be rele- vant to private investor decision models. The general term u is used, since each hypothesis tested uses the dependent variable ICP and IPI. Each hypothesis is expressed verbally in the null form. (1) Broker's advices have no effect on investors' decisions. Hl- = 0' “8+- “B—+ 1. H1' “B+— I “B-+ 2(A) Variations in one-year financial forecasts have no effect on investors' decisions. 2A_ 0 ° “F++ 2A. * 1 ' “F++ “F~+ H = “F—+ H 2(B) One-year financial forecasts added to historical finan- cial statements have no effect on investors' decisions. HZB: 0 “F++ = “F0 = “ F-+ 2B H1 ° “F++ I “F0 I “F-+ 3(A) Auditor's attestation to one-year financial forecasts, when both forecasts are positive (F ), has no effect , -++ on investors decisions. H3A° _ 0 ' “A1 7 “A2 = “A3 = “A4 = “A5 52 3A H1 . “A1 7‘ “A2 7‘ u“ 7‘ 14M 7‘ HAS 3(B) Auditor's attestation to one-year financial forecasts, when one forecast is negative (F ), has no effect on , -+ investors decisions. H33 0 a: a a = o ' “A6 “A7 “A8 “A9 “A10 38. H0 ° “A6 T “A7 T “A8 * “A9 I “A10 4(A) Various combinations of broker advice and forecast levels have no effect on investors' decisions. H4A 0 . No interaction exists between broker advice and forecast levels. 4A H1 : An interaction exists. 4(B) Various combinations of broker advice and forecast levels, including no forecast, have no effect on investors' decisions. H48: No interaction between broker advice and forecast 0 levels exists. 4B H1 : An interaction exists. (5) Various combinations of broker advice and auditor's report within each forecast level have no effect on investors' decisions. H : No broker by audit within forecast interaction exists. : An interaction exists. Analysis of test results, including conclusions and implications, is found in Chapter V. CHAPTER V ANALYSIS AND CONCLUSIONS The purposes of this chapter are l) to describe and analyze the test results of the experiment, and 2) to state the overall con- clusions. Hypothesis Testipg and Test Results Hypotheses related to the more general three factor model will be discussed first, followed by the two factor model. A schematic of the test design used to examine the three factor model hypotheses out- lined in Chapter IV follows: orecaSt fez-'8 Re +7- .+ Broker pm" A1 A2 A3 A4 A5 A6 A7 A8 A9 A10 B+- B-+ The observed cell means for each of the dependent variables, investor choice proportion (ICP) and investor preference index (IPI) appear in Tables VII and VIII. 53 54 TABLE VII OBSERVED CELL MEANS - ICP VARIABLE 7 8 9 10 B+_ .54 .77 .53 .77 .39 .60 .50 .50 .62 .43 .35 .48 B_+ ..29 .24 .25 .16 .21 ..23 .23 .25 .13 .24 Average .335 .53 .385 .51 .275 .405 .43 .365 .425 .34 .24 .36 TABLE VIII OBSERVED CELL MEANS - IPI VARIABLE. A A A A A Avg. A6 A7 A8 A9 A10 Avg. B 3.85 4.41 3.66 4.29 2.92 3.83 3.33 3.56 3.85 3.19 3.06 3.40 B_+ .2.67 2.29 2.75 2.05 2.34 .2.64 2.46 2.56 2.07 2.50 Average 2.90 3.54 2.98 3.52 2.49 3.09 3.06 3.10 3.16 2.88 2.57 2.95 Analysis of variance (ANOVA) techniques were applied separately to each of these dependent variables. The three-way ANOVA results are shown in Tables IX and X. 55 TABLE IX THREE-FACTOR MODEL ANOVA RESULTS - INVESTOR CHOICE PROPORTIONS, CELL MEANS (ICPj) Log Transformation Sources Original Data* Data* d.f. MS F P MS F P B - Broker 1 .4898 82.99 .0001 3.952 110.78 .0001 F - Forecast 1 .0099 1.69 .2305 .008 .22 .6530 A - Audit in Forecast 8 .0179 3.03 .0688 .150 4.21 .0290 B x F l .0269 4.56 .0652 .137 3.83 .0862 B x A(F) 8 .0059 .036 *In this and in the following tables "Original Data" refers to ANOVA results based on the original cell prOportions and "Log Trans- formation Data" refers to ANOVA results based on cell proportions transformed by log. TABLE X THREE - FACTOR MODEL ANOVA RESULTS - INVESTOR PREFERENCE INDEX (IPIij) Sources d.f. MS F P B - Broker 1 116.305 45.98 .0001 F - Forecast 1 1.948 .77 .3809 A - Audit in Forecast 8 4.192 1.66 .1083 B x F 1 8.027 3.17 .0759 B x A (F) 8 1.0716 .42 .9066 R: B x A (F) 307 2.5297 56 Hypotheses 5 and 4 concerning interaction effects will be considered prior to hypotheses 1, 2, and 3 concerning main effects. The reason for this ordering of the discussion is that nothing can be said about main effects when interaction exists. Hypothesis 5: Various combinations of broker advice and auditor's reports within each forecast level have no effect on investors' decisions. Hg: No broker by audit within forecast interaction exists. Hi: An interaction exists. The ANOVA tables for IPI above indicate that H5 is pop 13 0 rejected because the computed P-value of .9066 exceeds the critical P-value of .10. It is concluded, therefore, that there is no broker by audit within forecast interaction. Hypothesis 4(A): Various combinations of broker advice and forecast levels have no effect on investors' decisions. HgA: No interaction exists between broker advice and forecast levels. 4A . H ' An interaction exists. 1 . Since the computed P-values are, .0652, .0862 and .0759 for the B X F interaction in Tables IX and X, HgA is rejected at the .10 level but not at the .05 level. Therefore, this interaction deserves further investigation because of its marginal statistical significance. A graph of the relationship between broker advice and forecast levels for the ICP variable appears in Figure 11. 57 FIGURE 11 OBSERVED COMBINED CELL MEANS ICP - VARIABLE . 6 \ 8+- .4 ICP .2 e—- ' B_+ .0‘“‘ PH F-+ Forecast Levels The larger difference between observed cell means under F as compared ++ to F_+, indicates the interaction, and it occurs because of the strange ) and F ) shown circled in values obtained for cells (F++B_+A1 -+B-+A6 Table VII. If these values had been more in line with other cell values, this marginally significant interaction would not exist. Post hoc comparisons (Tables G-1 and G-II of Appendix G) support this con- clusion. Within column variation is significant for both columns. However, within row variation is not significant for either row, but borders on significance for the (B+_F++) - (B+_F_+) contrast. The accounting significance of this interaction may be that when a published forecast differs from broker advice for a speculative company such as Carter, investors' decisions are affected by the forecast, whereas in the absence of such differences, investors' decisions are not affected by the forecast. 58 The analysis of the interaction for the IPI dependent variable is similar. A graph of the broker-forecast relationship appears in Figure 111. FIGURE III OBSERVED COMBINED CELL MEANS IPI - VARIABLE 4.0 \ IPI 2.0 B 0.0 F++ F_+ Forecast Levels As before, if it were not for the unusual values observed in cells (B ) and (B F _+_F++A1 _+ -+A6)’ shown circled in Table VIII, the marginal interaction would not exist. On the other hand, post hoc comparisons of observed cell means (Table G-III of Appendix G) within each broker level, indicate that the only significant difference in forecast levels occurs within broker level B+_. Therefore, the preceding conclusions and implications for the ICP variable also apply here to the IPI variable. But since HgA is not rejected at the .05 level, discussion of main effects follows: Hypothesis 1: Broker advices have no effect on investors' decisions. 1. “1' “B+— * “B-+ 59 H3 is soundly rejected in all the testing, given a P value of (.0001. A graph of the ICP variable by broker's advice appears in Figure IV. FIGURE IV OBSERVED COMBINED CELL MEANS ICP - VARIABLE 1.0 ICP 0.5 0.0 B+- B-+ Broker Advice Levels Results using IPI as the dependent variable are similar. The influence of this factor on the dependent variables supports the results of Baker's study.l Hypothesis 2(A): Variations in one-year financial forecasts have no effect on investors' decisions. HZA. ' = 0 ' “F++ “F—+ 2A H : # u 1 “F++ F-+ The null hypothesis is not rejected in the three-way analysis of variance model with P<.2305, P<.6530, and P<.3809. Investors do not 1H. Kent Baker and John A. Haslem, "Information Needs of Indi— vidual.Investors," Journal of Accountancy, CXXXVI, No. 15 (November 1973), p. 68. 60 appear to recognize the difference between F++ and F_+ as important. However, if one considers the interaction mentioned earlier and reviews Tables VII and VIII as summarized in Table XI, it is apparent that the interaction of F and F_+ with B__+ tends to smooth out the forecast ++- factor effect. TABLE XI SUMMARY OF OBSERVED CELL MEANS ICP IPI Diff. F++ F_+ Diff. F++ F__,+ B .60 .48 .12 3.83 3.40 .43 +- B .21 .24 .03 2.34 2.50 .16 .+ Average .405 .36 .05 3.09 2.95 .14 Additionally, the post hoc analysis (Table G-III of Appendix G) indi— cates that the within-row (B+_) variation for the IPI dependent vari- able is significant at the .05 level. ' Another factor affecting the significance of forecasts in this study is that the particular forecast levels chosen for this research may not have been extreme enough, given the two companies from which the investor was forced to choose. Therefore, because of the possible effect of interaction and the fixed effects design, generalization to all levels of forecasts may be capricious. Hypothesis 3: (A) Auditor's attestation to one-year forecasts, when both forecasts are positive (F++), has no effect on investors' decisions. qu =11 =11 =11 =1: 0 A1 A2 A3 A4 A5 34,11 7‘11 7‘11 7‘11 7‘11 H1 . A1 A2 A3 A4 A5 (B) Auditor's attestation to one-year forecasts, when one forecast is negative, (F_+) has no effect on investors' decisions. 1138' ll = U = l1 = U = 11 38 H : u 7‘ u 7‘ u 7‘ n 7‘ u 1 A6 A7 A8 A9 A10 The three-way ANOVA model was used to test these hypotheses on a combined basis. The ANOVA results are shown in Tables IX and X. A summary of the P values for audit within forecast follows, ICP IPI Original Log Transformed Data Data Audit within forecast P<.O688 P<.0290 P<.1083 The results are generally consistent and appear to indicate that the null hypotheses should be rejected. However, it is necessary to apply post hoc procedures to discover the cause of this rejection. First, let us review the auditor's report levels used within each level of the forecast factor which were originally described in Chapter IV and summarized in Table XII below: 62 TABLE XII AUDITOR'S REPORT LEVELS V F4+ F__+ Nature of Auditor 3 Report A1 A6 Unqualified on historical statements for both companies A2 A7 Unqualified on historical statements for both companies with disclaimer on forecasted state- ments for both companies. A Unqualified on historical statements for both companies with attestation to internalities only of forecasted statements for both companies. A Unqualified on historical statements for both companies with attestations to internalities and externalities of forecasted statements for both companies. Unqualified on historical statements for both companies. Attestation to internalities and externalities of forecasted statements for one company and an adverse opinion on the forecasted statements of the other company. 10 Since report combinations A1(A6) and A2(A7) are essentially the same, the only real differences are in the ordering of the report and an explicit disclaimer on the forecasted statements in A2 and A7, but not in A1 and A Therefore, a priori, the ICP and IPI variables should 6' not change significantly. On the other hand, auditor's report combina- tions A3(A8) and A4(A9) should tend to reduce uncertainties about both companies. It is impossible to say in which direction the ICP and IPI variables will go for either company but, a priori, they should con- tinue in the same direction through A4. That is, as indicated in Figure V, the auditor's report combination levels A1 through A4 should result in either (1) no change in the ICP variable, if they had no 63 significance to the investor, such as line 1; or (2) a continual posi- tive or negative trend when they were significant, such as lines 2a or 2b. The A5 auditor's report combination should go in an opposite direction from the first four reports if the investors favor Carter Communications, such as line Za; and in the same direction if investors favor SRN, Inc., such as line 2b. 1.0 ICP 0.5 0.0 FIGURE V POSSIBLE ICP OR IPI RESPONSE PATTERNS UNDER F++ e—---- e— 1 2a 2b A1 A2 A3 A4 A5 Auditor's Report Levels The observed values of the ICP and IPI variables are shown in Table VII and VIII; a graph of the combined ICP values under F and H F__+ appears in Figure VI. 64 FIGURE VI ORIGINAL DATA OBSERVED ICP VALUES ICP .3 F A1(A6) A2(A7) A3(A8) A4(A9) A5(A10) Auditor's Report Levels Note that the observed values do not resemble any of the.a priori patterns. Level A2(A7) appears to be out of line. It was not expected to differ significantly from level A1(A6). Levels A3(A8) through A5(A10) were expected to differ significantly from A1(A6) and A2(A7), and from each other, provided that each auditor's report combination level had an effect on investors' behavior. Examination of the graph indicates the greatest difference within each forecast level occurred between Az-AS and between A6-Alo. This difference is understandable, since A5(A10) is the only level containing an adverse Opinion. Tables G-IV and G-V show all possible pairwise contrasts of audit in forecast levels. These post hoc comparisons indicate that significant variation occurs between A5(Alo) and a few other auditor's report levels. But the accounting importance of these contrasts is obscure, as discussed in- 'I’a: the 65 above. Nevertheless, within the context of this study, examination of the underlying patterns is enlightening. The dependent variable, ICP, observed under each auditor's report levels within F++ classified by broker advice is presented in Figure VII. FIGURE VII OBSERVED ICP VALUES UNDER F++ BY BROKER ADVICE LEVEL ICP B A1 A2 A3 A4 5 Auditor Report Levels The patterns are very similar for F under each broker level, but ++ somewhat puzzling. Level A2 (disclaimer) has the same effect as level A4 (attestation to both externalities and internalities). Level Al (no opinion on forecasts) has the same effect as level A3 (opinion on internalities). A possible explanation for these results is that the investors interpret the auditor's reports incorrectly. This hypothesis was tested using IPI as the dependent variable, with results that are the same as those for the ICP variable. The dependent variable, ICP, observed under auditor's report 66 levels within F_+ classified by broker advice follows in Figure VIII: FIGURE VIII OBSERVED ICP VALUES UNDER F-+ BY BROKER ADVICE LEVEL ICP B A6 A7 A8 A9 A10 Auditor's Report Levels Although not significant, note the striking difference in pattern, both from a comparison to the F++ values shown in previously in Figures VI and VII, and for the two broker levels with F_+ in Figure VII. The only similarity of effect on the ICP values by auditor's report levels under F++ and F_+ appears to be report level A5(Alo), the adverse opinion. In summary, the audit report levels within F++ and F_+ cause a statistically significant, but possibly meaningless variation in the ICP values. The underlying patterns suggest that auditor's reports have an effect which defies explanation; perhaps investors do not fully comprehend the informational content of auditor's reports. Since cell proportions under F were erratic and unintelligible, .+ the randomness of investor assignment to cells became suspect. A 67 multivariate one-way analysis of variance test was performed on investor profiles. These profiles (dependent variables) are a composite of ten characteristics as follows: (1) time spent reviewing the data packet; (2) number of years as an investment club member; (3) investments held in addition to club holdings; (4) number of years making personal investments; (5) length of time securities are typically held; (6) major investment purpose, dividends or price appreciation; (7) portfolio market value; (8) amount of education; (9) age; and (10) income level. The mean value of each of these characteristics is computed and included in a vector for each cell (the independent variables). The multivariate test of equality of mean vectors with 210 and 2535.4, degrees of freedom resulted in a P-value of .4865, indicating that the cells are not statis- tically different. Hypothesis 4(B): Various combinations of broker advice and forecast levels, including no forecast, have no effect on investors' decisions. H : No interaction between broker advice and forecast levels exists. H : An interaction exists. In order to test this hypothesis, the experimental design is modified to include three levels of the forecast variable and eliminate the auditor's report variable. The additional forecast level needed is Fo (i.e., no forecast, only historical financial statements). Since FO does not include forecasted financial statements, the auditor's report variable is dropped from the design. However, there are two ways to change the design. The first method is to include only those observations which incorporated the A1(A6) auditor's report level, 68 since these are exactly the same type of auditor's report. The design would then be: FH F0011) (A6) F—I-(A6) The second method is to consider the various auditor's report levels as replications within each forecast level F++ and F_+. That is, the various auditor's report levels included under F++(A1,A2,A3, A4,A5) were considered simple replications of the F++ experiment. The treatment of each of the auditor's report levels as replications of each forecast level is possible because (1) each level of the auditor's report is nested under each forecast level, and (2) the auditor's reports were only marginally significant. Thus the design would then be: F++ 1'0 F4 B five one five +- replications replication replications B five one five -+ replications replication replications The observed cell means for each model using both dependent variables were generally similar. These values are presented in Appendix H, Table H-I. The results of application of analysis of variance tech- niques are shown in Tables XIII through XVII. Table XIII presents 69 the results for the ICP dependent variable for the non-replicated model. TABLE XIII TWO-FACTOR MODEL ANOVA RESULTS ICP-VARIABLE, INDIVIDUAL OBSERVATIONS (ICPi.) NON-REPLICATED 3 Sources d.f. MS F P-Value F - Forecast 2 .3886 1.95 .1479 B x F 2 .4978 2.50 .0877 R : BF 88 .1989 Table XIV presents the results of using IPI as the dependent variable, and is consistent with Table XIII. TABLE XIV TWO-FACTOR MODEL ANOVA RESULTS IPI-VARIABLE NON-REPLICATED Sources d.f. MS F P-Value B - Broker 1 53.90 22.96 .0001 F - Forecast 2 6.86 2.92 .0591 B x F 2 5.63 2.40 .0969 R: BF 87 2.348 70 Tables XV, XVI, and XVII present the results for both dependent variables (ICP and IPI) when the replicated model is used. Note the general consistency of the results disclosed in these tables, and con- sistency with Tables XIII and XIV. TABLE XV TWO-FACTOR MODEL ANOVA RESULTS ICP-VARIABLE, INDIVIDUAL OBSERVATIONS (ICPij) REPLICATED Sources d.f. MS F P-Value B - Broker 1 10.5341 51.12 .0001 F - Forecast 2 .5732 2.78 .0634 B x F 2 .6795 3.30 .0382 R: BF 354 .2061 TABLE XVI TWO-FACTOR MODEL ANOVA RESULTS ICP-VARIABLE, CELL MEANS (ICPj) REPLICATED Arcsin Transformation Sources Original Data Data d.f. MS F P-Value MS F P-Value B - Broker 1 .6460 54.29 .0001 .8527 49.91 .0001 F - Forecast B x F R: BF —_ .0323 2.71 .0968 .0653 3.82 .0441 2 .0378 3.17 .0691 .0723 4.23 .0335 16 .0119 .0171 71 TABLE XVII TWO-FACTOR MODEL ANOVA RESULTS IPI-VARIABLE, REPLICATED Sources d.f. MS F P B - Broker 1 145.07 58.13 .0001 F - Forecast 2 8.37 3.35 .0361 B x F 2 7.80 3.12 .0453 R: BF 353 2.50 Review of the ANOVA tables indicates that the non-replicated 2—way model was less sensitive than the replicated 2-way model. The null hypothesis 4(B) is rejected as the a = .05 level in most cases under the replicated 2-way model, while it is not rejected at the a = .05 level in the non-replicated model. Increased sensitivity occurs in the replicated model because of the replications, while cell values remain approximately the same. The general consistency of the broker by fore- cast factor across these ANOVA tables and the consistency of these results with the results in the 3—way model, tend to indicate the presence of an interaction. Further examination of the interaction is carried out by graphical and post hoc techniques. In Figure IX, the cell means of the ICP variable are graphed using both the non-replication and replication methods of collapsing the three-way ANOVA model into a two-way ANOVA MODEL. 72 FIGURE IX OBSERVED CELL MEANS FOR NON-REPLICATION AND REPLICATION MODELS ICP-VARIABLE Non-Replication Replication ICP .5 B ICP -+ F++ F0 F-+ F++ F0 F-+ Forecast Levels Forecast Levels The relationship between the IPI variables is similar, as indicated in Figure X. 73 FIGURE X OBSERVED CELL MEANS FOR NON-REPLICATION AND REPLICATION MODELS IPI-VARIABLE Non-Replication Replication .5 .5 -4 /\ '4 0/\ .3 B+— .3 .”’,,.-”‘L“-—_‘ 3+- B IPI .2 vii/,z”/'-—fl—"—fl. —+ IPI.2 B_+ .l .l .O .0 If F++ F0 F_+ F++ F0 F_f+ Forecast Levels Forecast Levels It is interesting to note that the F forecast level (no forecast) 0 resulted in more respondents selecting Carter than when a positive fore— cast (F++) was presented within broker level B+_ (broker advice favoring Carter over SRN). Within broker level B__+ (broker advice favoring SRN over Carter) the negative forecast for Carter (F_+) appears to encourage more people to select Carter than either the F++ or F0 forecast levels, thus the interaction is indicated. Post hoc comparisons (Tables G—VI through G-XI) further emphasize these relationships. Generally, interaction occurs between the F0 and the F_+ levels. Post hoc comparisons within rows generally indicate the only significant variation occurs between F0 and B+_F_+. The various B+- forecast levels within B_+ are not significantly different from each other. Post hoc comparisons within columns indicate that the broker has a significant effect under F++ and F but not under F_ 0’ +. Interpretation of the relative cell values under positive broker 74 advice is quite simple. The investors had greater expectations for Carter, based on the broker advice than they had when presented with a one-year financial forecast for that firm. However, the F++ level was slightly favored over the F_+ level. Interpretation of the relative cell values under B_+ is baffling. Two possible explanations are: (1) there is no real difference in these cell values (i.e., the negative broker advice eliminated any effect the forecast might have); or (2) somehow, investors felt that a negative forecast combined with a negative broker's advice was too pessi- mestic, and therefore believed the stock to be undervalued. This re- sulted in a higher ICP and IPI value for F_+ than F++ within B_+. But it is important to recognize that these findings are situation-specific due to the expression of ICP and IPI variables in terms of Carter. A negative broker advice for Carter is equivalent to a positive broker advice for SRN. Therefore, if the ICP or IPI variable is stated in terms of SRN instead of Carter, the forecast has a greater effect when combined with negative broker advice than when combined with positive broker advice, which is outwardly the reverse of the above. The result is that generalizations cannot be made about the interaction effects of broker advice and forecasts. Hypothesis 2(B): One—year financial forecasts added to historical finan- cial statements have no effect on investors' decisions. 2B Ho . uF — uFO — uF_+ 28 H1. FH7‘ F07‘ F_+ Nothing can be said about this main effect, since interaction is present at the .10 level for the non-replicated model and at the .05 75 level for the replicated model. Respondent Beliefs It is interesting to note that 50.3% of the respondents stated that the financial statements were the single most influential source in their hypothetical investment decision. Also 29.9% of the respon- dents stated that financial statements are the single most influential source of investing information that they normally use in making actual security selection decisions. These statements are at odds both with what the respondents actually did in the present study and with what 2 respondents said they did in the Baker and Haslem study. Inference from the Sample to the Population In Chapter IV the method of drawing the sample is described. A summary of that description is repeated here. The sample was randomly drawn from Metropolitan Detroit members of the National Association of Investment Clubs (NAIC). Because the NAIC is national, but the sample was limited to Detroit, the results of the study are not statistically generalizable to the national membership. In addition, by the same reasoning, the experimental results are not statistically generalizable to the total population of private investors. But if certain character- istics of the sample population are shown to be similar to those of the total population, a strong case for logical inference could be made. Several characteristics of the investor which might affect his investment behavior are: (1) Education, (2) Income, (3) Age, (4) Port- folio size, and (5) Occupation. In 1970, the New York Stock Exchange 2lbid. 76 (NYSE) accumulated statistics on these five characteristics in a survey of shareholders of public corporations with more than 300 shareholders of record and $1,000,000 in assets.3 The questionnaire sent to the NAIC members in the present study also included questions on these five characteristics. A chi-square goodness of fit test at the a = .05 significance level was performed on the distribution of each of these characteristics in both the NYSE survey and the present study. The expected frequency used in the chi-square tests is obtained by taking the percentage that each of the various levels of the characteristic occur in the NYSE sur- vey and multiplying this by the total number of respondents in the present study. The expected frequency indicates the number of respon- dents in the present study who should exhibit these characteristics, if they have similar characteristics to respondents of the NYSE survey which in turn are used as surrogates of the population of all investors. Table XVIII (a) indicates that the sample population is better-educated than the total population. There is a large shift out of the two lowest levels into the highest level. Table XVIII (b) indicates that the income of the sample population is skewed upward toward the two highest levels. There are probably two factors responsible for this variation. First, money income levels have risen since the NYSE study in 1970. Frequencies based on real incomes would be better, but that data is not available. Second, given the higher education level of the sample population, one would expect incomes to be higher. Table XVIII (c) indicates that the age of the sample population also is skewed toward the upper levels. 3 New York Stock Exchange, op. cit., p. 25. CHI-SQUARE TESTS FOR SIGNIFICANT DIFFERENCE IN INVESTOR CHARACTERISTICS ‘77 TABLE XVIII Significant level 0§27 g 14.07 Characteristic Observed Expected X2 Frequency Frequency Education Less than four years of high school 11 44 24.75 High school completed 49 107 31.44 Less than four years of college 87 73 2.68 Four years college or more 200 123 48.20 Total x2 - 107.07 significant 347 347 107.07 2 ==== ==== ======= 2 7.82 Significant levelo§ 3d.f. Income Under $5,000 5 30 20.83 $ 5,000 - $9,999 8 71 55.90 $10,000 - $14,999 21 102 64.32 $15,000 - $24,999 233 94 82.92 $25,000 and over 80 50 18.00 Total x2 - 241.97 significant .331 347 241.97 Significant level x2 z 9.49 .05 Hd.f. Age Under 21 years 1 26 24.03 21 through 34 years 51 52 .02 35 through 44 years 62 66 .24 45 through 54 years 112 '86 7.86 55 through 64 years 97 69 11.36 65 years and over 25 49 11.76 Total x2 - 55.27 significant 348 348 55.27 Significant level x2 3 11.07 .05 5d.f. Portfolio Size Under $5,000 86 43 43.00 $ 5,000 through $9,999 70 104 11.16 $10,000 through $24,999 95 70 8.93 $25,000 and over 86 120 9.63 Total x2 - 72.72 significant 337 337 72.72 51 ificant level 2 > 7.82 gn .03 3d.£. ' Occupation Professional and technical 164 79 91.46 Clerical and sales 34 55 8.02 Managers, officials and proprietors 64 50 3.92 Craftsmen and foremen 28 17 7.12 Operatives and laborers 2 10 6.40 Service workers 4 8 2.00 Housewives, retired persons and non- employed adults 53 128 43.95 Farmers and farm laborers - 2 2.00 Total x2 - 164.87 significant 349 349 164.87 78 There appears to be a concentration of members in the 45 through 64 year range. Table XVIII (d) indicates a greater number of portfolios in the smaller classification and fewer in the highest classification. Table XVIII (e) indicates fewer housewives, retired persons and non- employed adults and more professional and technical respondents in the present study than in the NYSE study. In summary, as compared to investors surveyed by the NYSE, the respondents in the present study (1) are better-educated, (2) earn higher incomes, (3) are more concentrated in age, (4) are more profes- sionally oriented, and (5) have a higher concentration of smaller-sized portfolios. With the possible exception of portfolio size, the evi- dence suggests that the respondents in the present study are at least as well-qualified to make investment decisions as investors in the NYSE study which is used as a surrogate for the total population of investors. Although the results of the chi-square analyses indicate that the sample population is different from the population of total investors, and therefore broad generalization of the results of the study cannot be made, some important implications remain. First, since the sample population of better-educated and higher income earning individuals does not understand the differences in audit report levels A1 through A4, the total population of investors most likely would not understand them. Second, since these respondents rely so heavily on broker advice, the total population of investors most likely also relies on broker advice. Third, because the respondents are better-educated, they are more likely to examine financial information on the firms under con- sideration for investment, than investors in general. 79 Overall Conclusions The study addresses itself to three major questions. First, are small private investors influenced by broker advice? Second, are they influenced by one-year financial statement forecasts? Third, are they influenced by auditor's reports on the one-year forecast? The results of the experiment indicate that broker advice is a highly significant factor. This result is consistent with a previous questionnaire study and the a priori beliefs of the researcher. Financial forecasts have some influence on investor decisions, but do not appear to be a cogent factor in the participants' investment decision models. The direction and the amount of significance of the forecast are difficult to predict. It depends in part on its relation- ship to broker advice, the type of company being evaluated, and invest— ment alternatives. Auditor's reports appear to be of little significance except when an adverse opinion is given on a positive forecast. However, the lack of auditor report significance may also be due to the experimental design. Each test subject was given the same type of audit report for both firms, except those receiving combination level A5(A10), which contained an adverse opinion for Carter and an unqualified opinion (the same as A4(A9)) for SRN. Therefore, within audit levels A1(A6) through A4(A9), the inability of the investOr to discriminate on a basis of audit reports might be due to the fact that the same type of report were used by both firms. Perhaps the audit reports would only influence investors who might otherwise have serious reservations about the fore- cast of one of the two firms. Investors appear to lack an intelligent understanding of the significance of audit reports. This conclusion 80 raises several policy questions for the AICPA. Enlightened self- interest should suggest that action be taken to correct the situation. The first step would be to examine the problem further because several possibilities exist which may be responsible for the lack of under- standing by the investor. The report wording may need improvement. Possibly the format could be improved. Maybe greater education of investors would solve the problem. The respondents in the study were on average better-educated, more professionally oriented, higher income earners, younger and more homogeneous than surrogates to the total population of private investors. Therefore, although generalization of the study's results to all private investors is somewhat precarious, it would appear that the understanding by the respondents of the factors employed in this study must be at least as good, if not superior, to private investors in general. CHAPTER VI LIMITATIONS AND SUGGESTIONS FOR FURTHER RESEARCH Although some insights have been obtained regarding private investor reactions to one-year forecasts and related auditor's reports, additional research remains. This additional research is logically divisable into two categories: (1) reducing or eliminating limitations in the present study; and (2) extending research beyond the scope of the present study. Limitations The limitations of the present study are in turn divisable into two categories: (1) the problems inherent in all field experiments; and (2) the possible lack of conformity of this field experiment to established criteria for this type of research methodology. Report V of the Committee on Research Methodology in Accounting stated that the major problem of field experiments is surrogation.1 Four characteristics of surrogation are enumerated: experimental reality, internal validity, external validity and mundane reality. Experimental reality refers to the degree of involve- ment of the subject in the experiment.... Internal 1John N. Dickhaut, John Leslie Livingstone, and David J. H. Watson, "On the Use of Surrogates in Behavioral Experimentation," Chapter V in "Report of the Committee on Research Methodology in Accounting," The Accounting Review, supplement to Vol. XLVII (1972), pp. 455-71. 81 82 validity is concerned with whether the experimental con- ditions, in fact, cause the observed outcomes... External validity refers to the extent to which results of the experiment can be translated and extended to situations and conditions beyond the experiment... Mundane reality refers to the attempt to include in an experiment any particular aspect of an environment on the presumption that the aspect makes the experimental environment more real... The extent to which the present study resolves these surrogation problems is discussed below. Experimental Reality Experimental reality has been an unsettled issue for some time. Like the studies cited in Chapter III, the test subjects used in this study were motivated only by a plea for serious involvement. The respondents spent a reasonable amount of time reviewing the financial information packet and the questionnaire, which was properly completed in almost all cases. Perhaps the respondents spent even more time reviewing the financial information in the experiment than they do in the real world. Internal Validity The internal validity of the study is on reasonably solid ground. A fixed factor model is used in order to provide for ease in analysis of results. The test subjects are randomly selected and randomly assigned to the various cells. Analysis of variance procedures are used to determine and analyze the test results. 21bid., p. 458. 83 External Validity As mentioned earlier, a fixed factor ANOVA model is used in this research. Along with two levels of broker advice and three levels of forecasts, the study contains five possible types of audit reports. Briefly, they were (1) a standard report on historical data, (2) a standard report with an explicit disclaimer on forecast data, and (3) a standard report with the opinion on forecast data limited to internali— ties, (4) a standard report with the opinion on forecast data covering both internalities and externalities and (5) a standard report with an adverse opinion on forecast data for one firm and a number (4) type opinion for the other firm. Only an adverse opinion combined with a positive forecast caused a statistically significant reaction in the investor's decision choice. But AS(A_ which was the only auditor's report level to include an 10) . adverse opinion, was the only level to combine different types of audit reports for each company. All other levels incorporated the same type of auditor's report for each company. This method, of combining the same type of audit reports at each level, may cause the investors to be insensitive to the type of audit report. That is, since both firms have the same type of audit report at the other levels investors must discriminate on some other factor such as the forecast or broker advice. In addition, moving from one audit report combination level to another might only reinforce investors' prior feelings about each company rather than change them. On the other hand, since Carter appeared to be the more speculative and promised the possibility of a greater return, the a priori belief of the researcher was that the more comprehensive the audit report, the more respondents would select Carter. 84 Presenting test subjects in choice situations with financial statements of two firms at the same level of the independent variable has been followed in other studies. For example, Abdel-kalik used the same level of data aggregation for each firm in each choice situation;3 Dyckman used the same level of reporting method for each firm in each choice situation.4 Lack of significance of the various types of audit reports could also be attributed to investor confusion caused by the wording or format. For example, the standard two-paragraph format is used at all levels except A2(A7), which includes a middle paragraph disclaimer on the forecasted data. Therefore, a three-paragraph format was used. Other formats could have been used. For example, a four-paragraph format could have been employed for report levels A3(A8), A4(A9), and A5(A10); two paragraphs for scope and opinion on historical data could have been combined with two paragraphs for scope and opinion on forecast data. Of course, the results observed in this study may be transitory. That is, as investors become increasingly familiar with forecasts and attestations thereunto through experience or education, the results of a similar study could yield substantially different results. Another factor held constant in the present study was the ordering of the independent experimental variables. That is, every potential respondent received the broker advice, the historical and forecasted 3Ahmed Rashad Abdel-Khalik, "The Effect of Linear Aggregation of Accounting Data on the Quality of Decisions" (Unpublished Ph.D. disser— tation, University of Illinois at Urbana-Champaign, 1972), p. 49. 4T. R. Dyckman, Investment Analysis and General Price Level Adjustments: A Behavioral Study ("Studies in Accounting Research," Vol. I; American Accounting Association, 1969), p. 5. 85 financial statements and the related auditor's report in almost exactly the same order. The only exception is level A1(A6) where the fore- casted statements followed after the auditor's report on the historical statements. Perhaps if this ordering was changed, the relative effect of the independent variables might also change. The investigation of ordering effects has been carried out by several psychological studies.5 In addition, Purdy, Smith and Gray performed a behavioral study which considered the placement of disclo- sure type items in reports to users. (i.e., before or after financial statements); they found that post-statement disclosure was significantly superior to pre-statement disclosure.6 Currently, a dissertation is in progress that extends the work of Purdy, et. al. and examines the effect of audit report order on receivers' evaluations of the credibility of the financial-statement messages.7 The comments on format and ordering also apply to the financial statements themselves. In the data packet sent to respondents, the historical statements are presented in rather typical fashion. 5For example see Charles A. Kiesler and Sara B. Kiesler, "Role of Forewarning in Persuasive Communications," Journal of Abnormal and Social Psychology, LXVIII, No. 5 (1964), pp. 547-549, and Jonathan Freedman and David 0. Sears, "Warning, Distraction and Resistance to Influence," Journal of Personality and Social Psychology, I (1965), pp. 262-66. 6Charles R. Purdy, Jay M. Smith, and Jack Gray, "The Visibility of the Auditor's Disclosure of Deviance from APB Opinion: An Empiri- cal Test," Empirical Research in Accounting: Selected Studies 1969 (The Institute of Professional Accounting: Graduate School of Business, University of Chicago, 1969), pp. 1-18, esp. pp. 8-9. 7William T. Bailey, "An Examination of the Effect of Audit Opinions on Receivers' Perceptions of Source and Content Credibility of Accounting Messages" (Dissertation Proposal, The University of Texas at Austin, 1974), pp. 10-13. 86 However, the forecasted statements are incorporated into the historical financial statements and presented in columnar format beside the his- torical numbers. ‘Management's assumptions about the economy and its effects on the company are presented in the president's letter. Many alternative presentations could have been used, any one of which could have caused the independent variable to be more or less significant. The format used in the present study is favored by Ijiri.8 In the real world the broker will probably be reviewing the fore- casted financial statements and summarizing this information for the investor. Accordingly, there is a probable confounding of broker and forecast variables, which is ignored in this study. The questionnaire instructions were ambiguous regarding the possible risk level associated with the investment. That is, the test subjects were not explicitly told to consider the investment choice to pertain to a one-security portfolio or to present portfolios. However, the interpretations made should be consistent across the cells in the design and therefore should have no effect on the results. As indicated in Chapter IV, 23.4% of the test subjects responded. The question which cannot be answered is why the remaining 76.6% did not respond. If the non-respondents reflect a group which react differ- ently to the experimental variables, there is a non-response bias and the results of the experiment cannot be generalized. However, this problem is intrinsic to this type of research. As indicated in Chapter V, the respondents were better educated 8Yuji Ijiri, "0n Budgeting Principles and Budget-Auditing Standards," The Accounting Review, XLIII, No. 4 (October 1968), pp. 662-67. 87 than the investor surveyed in the New York Stock Exchange study. Perhaps the 76.6% who did not respond may be less educated people who comprise the majority of private investors. But there is no reason to believe that reaction by non-respondents to the independent vari- ables would differ from that of the respondents. Lack of generalizability is also caused by the specificity of the experimental decision situation. However, specificity is common to behavioral research. The test subjects were asked to make an investment choice between two firms. If these firms were in different industries, other things being equal, the effect on the test subjects' choice caused by the independent variables may have been different. In addition, the test subjects made their choice at a specific point in time and under specific economic conditions. If these factors were different, the significance of the independent variables may have changed. Only investors associated with the NAIC were selected to partici— pate in this experiment. Therefore, statistical inference cannot be made to the total population of private investors. But as indicated in the last section of Chapter V, logical inference appears to be reasonable. Mundane Reality Several steps were taken to provide for mundane reality. The data packet given the test subjects contained complete financial statements, including a president's letter and a five-year summary of earnings. Test subjects were also given broker advices, supposedly the single most influential source of investing information. The broker advice variable 88 is not of central importance to the study per se. But, since other studies indicate that broker's advice is a significant factor influ- encing investor decisions, a great loss in mundane reality would have resulted if it were excluded. Suggestions for Further Research Topics for further research are partially suggested by the limitations of the current research. Experimentation with various formats of auditor's reports might prove very enlightening. The format of these reports should be based on the communicative and behavioral qualities of those who read them. Empirical research is needed to un- cover these qualities. The ordering of information is a separate problem intrinsically involved with format. Optimum forecast or auditor's report format is difficult to determine without considering the ordering of the separate components. For example, separation of historical and forecasted data might have a profound effect. Certainly further research is needed in this area. Tests having greater sensitivity should be performed. Several factors affect test sensitivity. Both formatting and ordering, which are discussed above, may significantly affect sensitivity. 'Another facet or sensitivity is the experimental design. Two components of the experimental design need to be considered. First, increased repli- cations under each of the factor combinations would increase statis— tical sensitivity. Second, the decision-state would be more sensitive if different types of audit reports were used for each of the two companies. 89 This study demonstrates that one-year financial forecasts and related auditor's reports do affect investor investment choices in some circumstances. Because forecasts are used in decision models by private investors, their publication by management and attestation by auditors are suggested, but both are justified only if the benefits exceed the costs. There have been several attempts to investigate the costs and benefits of providing management forecast data to investors, but defini— tive conclusions are lacking. Therefore, additional research is needed to determine the costs and benefits, and to whom they accrue. APPENDICES APPENDIX A FINANCIAL STATEMENTS 90 APPENDIX A FINANCIAL STATEMENTS EXHIBIT A-I Historical Financial Statements and Footnotes for Both Companies Level F0 .oHaHnmouaan when: m\H umouoos ow ooocsou can moaovH>Hu Moowm can uvHHam noovm now poemswv< Avv .xoopm connouonm < noHnom uo conno>c00 wcHssmmu casinos» an mauvsopmaso menace noeeoo Amv .hamo oucooH>Hv nooam use oufiaau Mucus uOu copmswv< Amy .uooz on» mawusv maHuscpmvso AxoOHm oouuououm oHnHouo>coo < oowuom can mcoHpmo Mooamv upcoHa>Hsuo macaw cOEEOo m>HusHHc can xoOpm moaaou uo mousse uo Hopeso ouauo>a couanos on» com: comam AHV .mvconH>Hu moon» was nuHHnu xuovo .uvnououcH go mwdHHoom uooHuou o» uoamswoo munch HH< ov~.~H 4mm.4H mHm.vH no~.nH Hco.nH nccsoHnEH v\m-mH - m\c-q~ m\H-~H - wa-o~ mxm-oH - «\H-c~ m\c-H~ - «\n-on «\n-nH - m\n-n~ Haw Hoosn 9l ooeaoo ho swamp ooHum ooH.m con.“ How.“ 00m.n new.“ cco-ncoa «8 nnccHoncnccm "Hcmmzmo OMH.mn HqH.mn cmn.mm moc.nn ooc.nn an noncan noaaoc unansqc< 4pc.H mco.~ «no.4 cum.m cmn.n HNV pecans nonccn co oasHo> ~mn.0 » ~c~.n » use.» » Hon.m » ~c«.oH » chn ncnan>Hc ance ”anccnnoce nHV cn «oz mvo.ov nom.ov ch.~q ovv.nq men.m« moans posooun senescenopsu -mmoq mom.MHn moH.m~n nm0.c0c an.mmc ocn.qnn noano>ou nnono mom.mm ooc.mm 084.00 «no.4oH Hmn.o~H nonao 04H.mo omo.moH H44.-H Hmc.onH coq.mo~ nooseonn sconce can aannnuuz cw~.HoH mMH_ooH Hmm.moH www.mmH ocH.-H nHoom moH.0m~» HHm.Hm~» mcn.qq~» Ncm.om~» NoH.m0mn unuacnnuoz "Hacccnaoce aHe muazm>mm Hn.o mm.c mH.m oH.o mv.oH suHaao .nncpHoccnczm Hoosm «N. am. am. cm. Hm. Ame cncu uncncuH>Ha cH.H » on. » so.H » n~.H » mo.H » HHV neoccH so: "Hh Wwamcoo u: can u .m .m mouoz n xaHaom .mxmaqommmcH HHsN.vcH.vH» - mnoH Hwoc.mqo.cH» - «noHv .mcuseou moon on: nauseous Hauunsoc .uapo>«ooou nauseoo< moaawuaosn oHpuvoxuaz ammo umhmwm< BZMmmau m H m m m < 93 EXHIBIT A—I (cont'd.) SRN, INC. AND SUBSIDIARIES STATEMENT OF CONSOLIDATED INCOME AND RETAINED EARNINGS Year Ended May 31 1 9 7 4 1 9 7 3 REVENUES: Operating revenues $695,959,447 $605,171,816 Other income 10,107,119 5,903,341 706,066,566 611,075,157 COSTS AND EXPENSES: Cost of sales 431,882,883 381,228,803 Selling, administrative and general expenses 138,632,175 121,761,829 Provision for depreciation, amortization and depletion - Note A 28,300,309 23,019,746 Interest on long-term debt 2,611,518 2,710,502 601,426,885 528,720,880 Income before income taxes 104,639,681 82,354,277 INCOME TAXES - Notes A and D: Federal 42,119,871 36,018,607 State 7,613,228 4,286,754 49,733,099 40,305,361 Net income 54,906,582 42,048,916 RETAINED EARNINGS, at beginning of year 245,234,605 212,186,039 300,141,187 254,234,955 CASH DIVIDENDS PAID: Common stock ($.31 a share 1974, $.26 a share 1973) (9,691,650) (8,106,591) Convertible preferred stock, Series A - $.70 a share (770,783) (828,509) Convertible preferred stock, Series B - $25.00 a share - (65,250) (10,462,433) (9,000,350) RETAINED EARNINGS, at end of year EARNINGS PER SHARE - Note K __—-_ See notes to financial statements. 94 EXHIBIT A-I (cont'd.) SRN, INC. AND SUBSIDIARIES STATEMENT OF CONSOLIDATED CHANGES IN FINANCIAL POSITION SOURCE OF FUNDS: From operations- Net income Add charges not requiring outlay of of funds- Depreciation, amortization and depletion - Note A Noncurrent deferred income taxes Total from operations Increase in other deferred credits Increase in long-term debt Issuance of Common Stock under executive stock option and restricted stock plans, net of shares repurchased - Notes 0 and H Net book value of property, plant and equipment sold Total source of funds APPLICATION OF FUNDS: Net noncurrent assets of business purchased (A) Purchase of property, plant and equipment Decrease in long-term debt Redemption of Convertible Preferred Stock, Series 8 Cash dividends paid Other - net Total application of funds INCREASE IN WORKING CAPITAL (B) (A) The net noncurrent assets of businesses purchased at dates of acquisition are summarized as follows - Note 8 Property, plant and equipment Goodwill Other assets (liabilities) (B) The increase (decrease) in working capital is summarized as follows Current assets- Cash and marketable securities Accounts receivable Inventories Prepaid expenses Current liabilities- Accounts payable Salaries, wages and amounts withheld from employees Income taxes Other taxes Portion of long-term debt payable within one year INCREASE IN WORKING CAPITAL Year Ended May 31 1 9 7 4, 1 9 7 3 $54,906,582 342,048,916 28,300,309 23,019,746 3,500,902 3,497,045 86,707,793 68,565,707 2,214,482 2,596,057 8,228,487 3,253,994 38,928 4,037,991 2,610,847 2,417,214 99,800,537 80,870,963 20,223,980 5,500,000 45,104,015 41,155,102 9,556,533 9,099,702 - 2,610,000 10,462,433 8,951,350 1,484,578 866,625 86,831,539 68,182,779 $12,968,998 $12,688,184 312,477,139 3 - 8,020,693 4,269,229 (273,852) 1,230,771 $20,223,980 $ 5,500,000 $21,133,687 3 2,251,063 5,392,835 8,391,584 1,243,358 3,104,593 1,387,561 2,259,714 29,157,441 16,006,954 (10,151,710) (5,058,291) (2,130,032) (2,789,236) (2,556,660) 3,627,443 (489.181) 44.244 (860,860) 857,070 (16,188,443) (3,318,770) $12,968,998 $12,688,184 See notes to financial statements. 9S EXHIBIT A-I (cont'd.) NOTES TO FINANCIAL STATEMENTS NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and all subsidiaries except European subsidiaries (ac- counted for on the equity method) whose assets and operations are not material. All significant intercompany profits, transactions and account balances have been eliminated in consolidation. MARRETABLE SECURITIES Marketable securities are carried at cost which approxi- mates market at the respective balance sheet dates. INVENTORIES Inventories are priced generallv at the lower of cost (first-in, first-out method) or market. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are carried on the basis of cost. Generally, depreciation is provided (I) on the straight—line method for buildings, machinery and equipment acquired prior to 1954 and subse- quent to 1967, and (2) on accelerated methods for new buildings, machinery and equipment acquired between January 1, 1954 and December 31, 1967. Depletion of timberlands is provided on the unit-of-production method based upon estimated recoverable timber. Depreciation, amortization and depletion have been provid- ed for in amounts sufficient to amortize the cost of the related assets over their estimated useful lives. GOODNILL Goodwill is considered to be an intangible asset with an indefinite life and is not being amortized, except for $12,106,354 at December 31, 1973 and $4,229,126 at December 31, 1972 (net of amortization of $176,067 and $40,103 re- spectively) arising subsequent to October 31, 1970, which is being amortized over a period of 40 years. INVESTMENT CREDIT The investment tax credit is recognized on the flow-through method as a reduction of the provision for federal income taxes. BOOK AND MAGAZINE REVENUE Revenues from book sales, less provisions for estimat- ed returns, are recorded at the time of shipment. Revenues from magazine subscrip- tions are deferred as unearned income at the time of sale. As magazines are de- livered to subscribers, the prOportionate share of the subscription price is taken into revenue. Subscription selling expenses are deferred and amortized to expense over the same period that the related subscription income is recorded as earned. EMPLOYEE RETIREMENT PLANS The Company has various retirement plans covering sub- stantially all employees. The costs charged to earnings relative to such plans include current service costs and the amortization of past service costs over periods ranging from ten to twenty-five years. It is the Company's policy to fund substantially all pension costs accrued. NOTE B - ACOUISITIONS AND DISCONTINUED OPERATIONS In transactions accounted for as purchases in fiscal 1974, the Company acquired a television station (KSBB-TV) in Dallas, Texas and certain assets (principally timberlands) in Washington for an aggregate cost of $10,760,148. Operations of the acquired businesses have been included in consolidated operations since dates of acquisition. Assuming that the acquisitions had been consummated on June 1, 1972, the effect on 1974 and 1973 consolidated revenues and net income would not have been material. 96 EXHIBIT A-I (cont'd.) During fiscal 1974 The Zenith Publishing Company, a wholly-owned subsidiary, dis- continued, sold or agreed to sell a substantial portion of its business, resulting in unusual write-downs and losses of $6,836,000, less applicable income tax cre- dits of $3,282,000. Included in fiscal 1974 consolidated operations are revenues and net loss applicable to Zentih of $11,251,000 and $5,185,000 respectively. NOTE C - INVENTORIES A summary of inventories follows: 1 H131 1974 1973 Newsprint and paper $10,063,545 $ 7,938,583 Books and other finished products 22,102,458 27,918,204 Lumber, veneer and plywood 3,445,556 1,458,124 Work in process 7,788,028 7,913,151 Raw materials and logs 21,993,219 18,921,386 $65,392,806 $64,149,448 NOTE D - INCOME TAXES The Company reports certain income and expense items in dif- ferent years for financial and tax reporting purposes. Such items relate principal- ly to depreciation and amortization, magazine subscription expenses, deferred com- pensation, book returns, and prepaid compensation related to the sale of restricted stock and the 1972 Executive Stock Option Plan. Provisions for income taxes for 1974 and 1973 include amounts deferred of $824,000 and $3,095,000. Tax provisions have been reduced $1,119,000 and $1,653,000 for investment tax credits. NOTE E - LONG-TERM DEBT AND DIVIDEND RESTRICTIONS Long-term debt, exclusive of amounts payable within one year, consisted of the following 1, "a: 31 1974 1973 4 1/22 Sinking Fund Debentures due June 1, 1991 $33,685,000 $34,745,000 Note payable, due $800,000 annually through 1979 and $1,000,000 on May 1, 1980, plus interest at 62 5,100,000 5,900,000 Publishing contracts without interest ' and no fixed term 2,434,234 3,168,376 Other, maturing through 1993 with interest from 32 to 92 7 604 955 6 044 077 $48,824,189 $49,857,453 The Debentures are redeemable at the option of the Company in whole or in part at any time, upon not less than 30 days' notice. Redemption prices (102.102 prior to June 1, 1974) decrease periodically to no premium after 1984. The Company is required to pay into a sinking fund a sum sufficient to retire on June 1, in each year 1974 through 1989, $1,675,000 principal amount of Debentures, and may pay an additional sum of up to $1,675,000 into the sinking fund in each of these years. As of May 31, 1974, the Company had repurchased $2,965,000 of Debentures on the open market thus satisfying the sinking fund requirement in full for fiscal 1974 and in part for fiscal 1975. 97 EXHIBIT A—I (cont'd.) The Indenture relating to the Debentures places certain restrictions on the in- currence of funded debt and other indebtedness, on the acquisition of the Company's own stock and on the payment of cash dividends. At May 31, 1974, retained earnings in the approximate amount of $88,800,000 were available for the payment of cash di- vidends. NOTE P - CAPITAL STOCK Authorized and outstanding shares of capital stock at May 31, 1974 and 1973 are as follows: Outstanding Authorized 1974 1973 Convertible preferred stock, without par value 4,500,000 Series A - convertible into 2.222 shares of common stock redemption and liquidation value at $50.00 a share (aggregate value $52,294,300 at May 31, 1974), cumulative annual dividend rate at $.70 a share 1,045,886 1,151,439 Common stock, without par value 40,000,000 31,385,264 31,144,538 Convertible Preferred Stock is issuable in series under such terms and conditions as the Board of Directors may determine. The holders of Series A possess full voting rights at the rate of one vote per share. At May 31, 1974, 2,760,708 shares of Common Stock were reserved for conversion of preferred shares and for stock option and restricted stock plans. NOTE C - STOCK OPTIONS The executive stock option plans adopted prior to 1971 are qualified plans and provide that options may be granted to key executive employees to purchase shares of the Company's Common Stock at a price at least equal to the fair market value of the Stock at date of grant. The 1971 Executive Stock Option Plan (a non-qualified plan) provides that options may be granted to key executive employees to purchase shares of the Company's Common Stock at a price at least equal to 751 of the fair market value at the date of grant. In general, the op- tions under all plans are not exercisable until one year after date of grant and thereafter are exercisable in whole or in increments over a period not to exceed five years, dependent upon the terms of each option. The following tabulation sets forth information for the years 1974 and 1973 rela- tive to the plans: Option Price Number of Shares Per Share 1974 I973 1974 1974 At beginning of year: Options outstanding 212,530 408,256 12.13 to 29.81 12.13 to 26.25 Changes during the year: Options granted 90,716 2,000 16.63 to 22.25 26.13 to 29.81 Options exercised 7,200 179,976 17.44 to 20.25 12.13 to 26.25 Options cancelled 95,980 17,750 17.44 to 25.25 17.35 to 26.25 At end of year: Options outstanding* 200,066 212,530 12.13 to 29.81 12.13 to 29.81 **Includes 120,250 and 187,330 shares exercisable at May 31, 1974 and 1973 98 EXHIBIT A-I (cont'd.) In addition, at May 31, 1974, there were 105,684 shares reserved for future grants under executive stock option plans. Accounting entries are made only when options are exercised under the qualified plans. For options granted under the 1971 Plan, the difference between the market price and the option price is charged to operations over the period from the date of grant until the option becomes exercisable. Operations were charged $13,931 and $191,133 in 1974 and 1973 for such grants. NOTE M - RESTRICTED STOCK PLAN The 1971 Restricted Stock Plan provides for the sale to key executive employees of a maximum of 230,000 shares of the Company's Common Stock at a price not less than five cents a share. The stock received by the employee may not be sold or encumbered until all restirctions are terminated or expired. The restrictions are for a period of five years and are removed an- nually in cumulative 252 increments commencing after the second anniversary from the date of sale. Under the Plan, the Company (1) sold 2,500 shares in 1973 and (2) repurchased 1,000 shares in 1974 and 6,500 shares in 1973. At May 31, 1974, 131,000 shares were reserved for future sale. The difference between the sale price and fair market value of the stock is charged to operations over the period during which restrictions are in effect. In connection with the Plan, operations were charged $460,749 in 1974, and $450,343 in 1973. NOTE I - EMPLOYEE RETIREMENT PLANS Total cost for employee retirement plans for 1974 and 1973 amounted to $10,434,000 and $8,475,000. As of May 31, 1974 and 1973, the actuarially computed value of vested benefits for certain plans exceeded the total of the related pension funds by $3,239,000 and $3,127,000. All other plans are fully funded. NOTE J - LEASES Total rental expense for all leases for 1974 and 1973 amounted to $6,134,719 and $5,898,200. The future minimum rental commitments as of May 31, 1974 for all noncancelable leases are as follows: Building and Machinery and Office Space Equipment 1975 $ 2,287,239 ‘$‘ 905,341 1976 1,977,464 895,278 1977 1,819,409 783,075 1978 1,670,825 109,760 1979 1,596,222 60,212 1980 - 1984 7,143,318 3,300 1985 - 1989 4,537,624 3,300 1990 - 1994 594,310 3,300 Thereafter 1 965 636 -—- $23,592,047 $2,763,566 NOTE K - EARNINGS PER SNARE Earnings per share computations are based upon the weighted average number of shares of Common Stock and dilutive common stock equivalents (stock options and Series A Convertible Preferred Stock) outstanding during the year. Fully diluted earnings per share are the same as the earnings per share indicated. 99 WOH.m A. A new”. ms 9. MMWHHMOQM W OOMsWHFaM bNqu QOMu 6 mea mmafi m mmwufl m w a Hon. no . on.m mmm.m oo.mn .H n m HHo. no . oo. o m » mmmHHom.MHa www.mob.m «Ho.m A sow.mso. m N a omH.mmH.mHa name eh. m 00.» 0mm. 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Carter is currently selling at $21 a share which is only 8 times earnings. In the past. it has usually sold for about 17 times earnings and as high as 22 times earnings. This stock has never sold for less than 8 times earnings. The company is somewhat diversified. It owns several television and radio stations in major cities across the country and is engaged in movie and TV prod- uction. Last year Carter opened Picnic Island Amusement Park which proved to be a fantastic success. while the income from broadcasting is substantial, there appears to be onlv moderate growth opportunity in this area. On the other hand, the amusement park revenues show real promise over the next several vears. The Company appears to be in a significant earnings growth phase. Earnings and average market price per share have been as follows: 1972 1973 1976 Earnings per share $1.80 $1.95 $2.53 Average market price $26 $43 $39 The current market price of $21 reflects uncertainty about future earnings due to the troubled economy and the overall downturn in the stock market. Our research department feels that, while there are uncertainties for the upcoming year, over the next three to five years the companies aggressive expansion policies in the broadcasting and amusement park area will pay-off handsomely. Carter is installing major additions at Picnic Island and opening a new park in 1°75. We believe the market has overdiscounted earnings prospects and that the 122 EXHIBIT B-I (cont'd.) current market price is too negative an appraisal for a company whose revenues and earnings were the highest in its history! SRN, Inc. is well established and for the year ended May 31, 1976 enjoyed the highest return on net worth it has had since 1965. However, one major factor causing the increase in earnings was the brief rise in plywood prices at the beginning of the year. Large demand for homes caused prices to rise to excessive levels. With the reduction in new home construction the prices fell back to normal levels. This company is larger than Carter and also diversified. It is involved in the production of newsprint and paper products, lumber, and the publication of books, newspapers, and magazines. It also is involved in radio and TV broadcasting including cable television. The current price for a share of SRN, Inc. stock is $16 which is ten times earnings. The stock normally has sold for twenty times earnings with little varia- tion. Earnings and average market price per share have been as follows: 1972 1973 1975 Earnings per share $1.06 $1.25 $1.63 Average market price $25 $30 $20 These market prices reflect the belief that there is little growth potential in the lines of business in which SRN participates. Although we feel that SRN is a stable company, Carter provides a better investment opportunity for most invest- ment objectives. l23 EXHIBIT B-II B_ ° Broker Recommends SRN Over Carter BROKER ADVICE YOUR FAVORITE BROKER STATES - While both companies merit attention, we believe investment in SRN, Inc. offers the greatest potential return. SRN, Inc. is well established and enjoyed the highest return on net worth for the year ended May 31, 1976 that it has had since 1965. The company is large and well diversified. It is involved in the production of newsprint and paper products, lumber. and the publication of books, newspapers and magazines. It is also involved in radio and TV broadcasting, including cable television. SRN, Inc. is currently selling at $16 a share which is only 10 times earnings. In the past it has usually sold for about 20 times earnings. This stock has never sold for less than ten times earnings. Earnings and average market price per share have been as follows: 1972 1973 1974 Earnings per share $1.04 $1.25 $1.63 Average market price $25 $30 $20 The Company appears to be in a significant earnings growth phase. The current market price of $16 reflects uncertainty about future earnings due to the troubled economy and the overall downturn in the stock market. Our research department feels that the company's earnings will continue to grow over the next three to five years. The future earnings prospects appear bright. The ownership of vast amounts of timberland and the lifting of price controls should help the company in this in- flationary period. We believe the market has overdiscounted earnings prospects, and that the current market price is too negative an appraisal for this fine company. Carter is also diversified with its major source of revenues from radio and 124 EXHIBIT B-II (cont'd.) TV broadcasting. The company owns several television and radio stations in major cities across the country and is engaged in movie and TV production. Carter's revenues and earnings in fiscal 1976 were the highest in its history. However, a large portion of that revenue and income was generated by the amusement park opera— tions. With the decrease projected in decretionary income and the higher cost of gasoline the revenues from this part of the business should not be very promising in the next several years. In addition, the company will be affected by the higher cost of energy used in running its amusement parks and higher wage rates due to the increase in the minimum wage to $2.00 per hour from $1.75. Earnings and average market price per share have been as follows: 1972 1973 1974 Earnings per share $1.80 $1.95 $2.53 Average market price $26 $43 $39 The market price is now down to $21 a share reflecting the belief that this company is in a high risk situation because of rapid inflation and the possible effects on its business from the potentially explosive Middle East situation. In conclusion, we feel SRN, Inc. provides a better investment Opportunity for most investment objectives. APPENDIX C AUDITOR'S REPORTS kl'u. a\".- - .0' I 125 .APPETHILX C AUDITOR'S REPORTS EXHIBIT C-I Level A1 and A6 A Standard Unqualified Auditor's Report for both Companies AUDITORS' REPORT To the Directors and Stockholders of Carter Communications Company We have examined the consolidated balance sheets of Carter Communications Company and subsidiaries as of May 31, 1974 and 1973 and the related consoli- dated statements of earnings and retained earnings and changes in financial posi- tion for the years then ended. Our examination was made in accordance with generally accepted auditing_standards, and accordingly included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. In our opinion, the aforementioned financial statements present fairly the consolidated financial position of Carter Communications Company and subsidiaries at May 31, 1976 and 1973 and the consolidated results of their operations and changes in financial position for the years then ended, in conformity with general- ly accepted accounting principles applied on a consistent basis. 3:.”‘2'1f‘1’332m with] 61% V 126 EXHIBIT C-I (cont'd.) Acch'rANrs ' REPORT To the Board of Directors and Shareholders of SRN, Inc. We have examined the consolidated balance sheet of SRN, Inc. and subsidiaries as of May 31, 1976 and 1973 and the related consolidated statement of income and retained earnings and changes in financial position for the years then ended. Our examination was made in accordance with generally accepted auditing standards, and accordingly included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. In our opinion, the aforementioned financial statements present fairly the consolidated financial position of SRN, Inc. and subsidiaries at May 31, 1976 and 1973 and the consolidated results of their operations and changes in financial position for the years then ended, in conformity with generally accepted account- ing principles applied on a consistent basis. Emma: was M bk“ 127 EXHIBIT C-II Level A2 and A7 A Standard Unqualified Auditor's Report With a Middle Paragraph Disclaimer on the Forecasted Data for Both Companies AUDITORS' REPORT To the Directors and Stockholders of Carter Communications Company We have examined the historical consolidated balance sheets of Carter Communications Company and subsidiaries as of May 31, 1976 and 1973 and the re- lated consolidated statements of earnings and retained earnings and changes in financial position for the years then ended. Our examination was made in accor- dance with generally accepted auditing standards, and accordingly included such tests of the accounting records and such other auditing procedures as we con- sidered necessary in the circumstances. Included in the accompanying report are forecasted financial statements for the year to end May 31, 1975. Inasmuch as such financial statements relate to the future, we are not in a position to, and we do not express any opinion on such forecasted statements, or on how closely the forecast may approximate actual re- sults. In our opinion, the aforementioned historical financial statements present fairly the consolidated financial position of Carter Communications Company and subsidiaries at May 31, 1974 and 1973 and the consolidated results of their opera- tions and changes in financial position for the years then ended, in conformity with generally accepted accounting principles applied on a consistent basis. n.....,c.1..... m 5’11 gt (a- June 21, 1974 128 EXHIBIT C-II (cont'd.) ACCOUNTANTS ' REPORT To the Board of Directors and Shareholders of SRN, Inc. We have examined the historical consolidated balance sheet of SRN, Inc. and subsidiaries as of May 31, 1974 and 1973 and the related consolidated statement of income and retained earnings and changes in financial position for the years then ended. Our examination was made in accordance with generally accepted auditing standards, and accordingly included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. Included in the accompanying report are forecasted consolidated financial statements for the year to and May 31, 1975. Inasmuch as such financial statements relate to the future, we are not in a position to, and we do not express any opi- nion on such forecasted statements, or on how closely the forecast may approximate actual results. In our opinion, the aforementioned historical financial statements present fairly the consolidated financial position of SRN, Inc. and subsidiaries at May 31, 1974 and 1973 and the consolidated results of their operations and changes in financial position for the years then ended, in conformity with generally accepted accounting principles applied on a consistent basis. $3,135,123. W M VDW$ 129 EXHIBIT C-III Level A3 and A8 A Standard Unqualified Auditor's Report Whose Scope and Opinion Paragraphs are Expanded to Mention the Examination of and Include an Unqualified Opinion on Internalities of One-Year Financial Forecasts for Both Companies AUDITORS' REPORT To the Directors and Stockholders of Carter Communications Company We have examined the historical consolidated balance sheets of Carter Communications Company and subsidiaries as of May 31, 1974 and 1973 and the re- lated consolidated statements of earnings and retained earnings and changes in financial position for the years then ended. Our examination was made in accor- dance with generally accepted auditing standards, and accordingly included such tests of the accounting records and such other auditing procedures as we con- sidered necessary in the circumstances. We also have reviewed the accounting principles applied and the calculations made in preparing the forecasted consoli- dated balance sheet of Carter Communications Company and subsidiaries for May 31, 1975 and the related statements of forecasted consolidated earnings and retained earnings and changes in financial position for the year then ended. In our opinion, the aforementioned historical financial statements present fairly the consolidated financial position of Carter Communications Company and subsidiaries at May 31, 1976 and 1973 and the consolidated results of their opera- tions and changes in financial position for the years then ended, in conformity with generally accepted accounting principles applied on a consistent basis. In our opinion, the aforementioned forecasted financial statements, so far as the accounting principles and the calculations are concerned, have been compiled on the basis on the assumptions made by the Company and are presented on a basis con- sistent with the accounting principles used by the Company in the preparation of its historical financial statements for the year ended May 31, 1974. Inasmuch as the forecasted statements and the assumptions on which they are based relate to. the future and may be affected by unforeseen events, we can express no opinion on how closely the forecasted statements will correspond with actual results, or on the assumptions on which they are based. Basins?“ M fl/fl °‘ I” 130 EXHIBIT C-III (cont'd.) ACCOUNTANTS' REPORT To the Board of Directors and Shareholders of SRN, Inc. We have examined the historical consolidated balance sheet of SRN, Inc. and subsidiaries as of May 31, 1974 and 1973 and the related statements of historical consolidated income and retained earnings and changes in financial position for the years then ended. Our examination was made in accordance with generally ac- cepted auditing standards, and accordingly included such tests of accounting re- cords and such other auditing procedures as we considered necessary in the cirb cumstances. We also have reviewed the accounting principles applied and the cal- culations made in preparing the forecasted consolidated balance sheet of SRN, Inc. and subsidiaries for May 31, 1975 and the related statements of forecasted conso- lidated income and retained earnings and changes in financial position for the year then ended. In our opinion, the aforementioned historical financial statements present fairly the financial position of SRN, Inc. and subsidiaries at May 31, 1976 and 1973 and the consolidated results of their operations and changes in financial position for the years then ended, in conformity with generally accepted account- ing principles applied on a consistent basis. Furthermore, in our opinion, the aforementioned forecasted financial statements, so far as the accounting principles and the calculations are concerned, have been compiled on the basis of the assump- tions made by the Company and are presented on a basis consistent with the account- ing principles used by the Company in the preparation of its historical financial statements for the year ended May 31, 1976. Inasmuch as the forecasted statements and the assumptions on which they are based relate to the future and may be af- fected by unforeseen events, we can express no opinion on how closely the forecast- ed statements will correspond with actual results, or on the assumptions on which they are based. Emma: 3K QM.» wk 15% _ __—_-mn_“a- 131 EXHIBIT C—IV Level A4 and A9 A Standard Unqualified Auditor's Report Whose Scope and Opinion Paragraphs are Expanded to Mention the Examination of and In- clude an Unqualified Opinion on the Internalities and_Exter- nalities of the One-Year Forecasts for Both Companies AUDITOIS' snort To the Directors and Stockholders of Carter Marion County We have examined the historical consolidated balance sheets of Carter Con-micstions Comany and subsidiaries as of my 31, 197A and 1973 and the re- lated consolidated statements of earnings and retained earnings and changes in fin-Icisl position for the years then ended. Our exsninstion was made in accor- dance with generally accepted auditing standards, and accordingly included such tests of the sccmmting records and such other auditing procedures as we con- sidered necessary in the circumstances. We also have reviewed the assumptions eqloyed, the sccomting principles applied and the calculations made in pro- paring the forecasted consolidated balance sheet of Carter Cometmicstions Conny and sduidisries for May 31, 1975 and the related statements of forecasted con- solidated earnings and retained earnings and chasm in financial position for the year then ended: In our opinion, the aforementioned historical financial statements present fairly the consolidated financial position of Carter Comicstions Company and subsidiaries st May 31, 1976 ad 1973 and the consolidated results of their opera- tions and changes in financial position for the years then ended, in conformity with generally accepted sccouting principles applied on a consistent basis. Furthermore, in our opinion, (1) the Coqsny's assqtions employed in the fore- casted financisl statements are reasonable mud were selected with due care and consideration and, (2) the forecasted financial statements are properly compiled and give effect to the stated assumptions on a basis consistent with the account- ing principles used by the Company in preparation of its historical financial statuents for the year ended May 31, 197‘. Inasmuch as the forecasted statements relate to the future and may be affected by \mforesesn events, we cm: express no opinion on how closely the forecasted statements will correspond with actual results. .- mm“ m @M + (o- 132 EXHIBIT C-IV (cont'd.) ACCOUNTANTS' REPORT To the Board of Directors and Shareholders of SRN,.Inc. We have examined the historical consolidated balance sheet of SRN, Inc. and subsidiaries as of Hay 31, 1974 and 1973 and the related historical consolidated statement of income and retained earnings and changes in financial position for l- the years then ended. Our examination was made in accordance with generally ac- cepted auditing standards, and accordingly included such tests of the accounting records and such other auditing procedures as we considered necessary in the cir- cumstances. We also have reviewed the assumptions employed, the accounting prin- ciples applied and the calculations made in preparing the forecasted consolidated balance sheet of SRN, Inc. and subsidiaries for May 31, 1975 and the related state- ments of forecasted consolidated income and retained earnings and changes in fi- nancial position for the year then ended. In our opinion, the aforementioned historical financial statements present fairly the consolidated financial position of SRN, Inc. and subsidiaries at May 31, 1976 and 1973 and the consolidated results of their operations and changes in financial position for the years then ended, in conformity with generally accept- ed sccounting principles applied on a consistent basis. Furthermore, in our opinion, (1) the Company's assumptions employed in the forecasted financial state- ments are reasonable and were selected with due care and consideration and, (2) the forecasted financial statements are prOperly compiled and give effect to the stated assumptions on a basis consistent with the accounting principles used by the Company in preparation of its historical financial statements for the year ended May 31, 197‘. Inasmuch as the forecasted‘statements relate to the future and may be affected by unforeseen events, we can express no opinion on how closely the forecasted statements will correspond with actual results. Dallas , Tamas . June 28, 1976 133 EXHIBIT C-V Level A5 and A10 For SRN, the Same Type of Report as Used in A4(A9). For Carter, an Adverse Opinion Based on an Examination of Both the Internalities and Externalities of the One-Year Financial Forecast 134 EXHIBIT C—V .AIIDl‘l'OIS' anon To the Directors and Stockholders of Carter Communications Cos-pony We have examined the historical consolidated balance sheet of Carter Co-micstions Conny and swsidisries as of May 31, 1976 and l9?) and the related historical consolidated statement of earnings and retained earnings and chnges in financial position for the years then ended. Our examination was made in accordance with generally accepted auditing stand- ards, and accordingly included such tests of the sccomting records and such other auditing procedures so we considered necessary is the titer-stances. We also have reviewed the as- swtions eploysd, the sccomting principles applied and the calculations made in preparing the forecasted consolidated balance sheet of Carter Co-sricstions Conny mid subsidiaries for May ll, 1975 and the related statements of forecasted consolidated earnings and retain“ earnings and changes in financial position for the year then ended. In the Capsny's letter to stockholders, the sssuqtions underlying the forecasted financial statements are disclosed. to of these ssswtions states: ”Psnonsl disposable income will remain content.” however, nothing is said about an element of personal dis- possbls income labeled personal discretionary income. Personal discretionary income is the income individuals have available for son-essential expenditures such as recreation. Accord- ing to the United States Department of Com-arcs this type of income has been declining since January, 1975. In addition, the forecasted revenues are based on estimated amusement park capacity utilisation of 902 whereas the American federation of Amusement Parks is projecting m utilisation for the indutry. The Company has traditionally experience capacity utilise- tions similar to those of the industry. had these alternate sssuwtions been used in pro- psring the sccoqmrying forecasted financial statements, forecasted revenues mid earnings would have,besn reduced significantly from those forecasted by the Conny for the fiscal year ending Hay 31, 1975. In our opinion, the afor-sntioned historical financial statements present fairly the conelideted financial position of Carter Co-unicstions Coqsny and subsidiaries at Hay 31, 197A and 197) and the consolidated results of their operations and charges in financial posi- tion for the years then ended, in conformity with generally accepted sccornrting principles applied on a consistent basis. furthermore, because of the sipificsncs of the utters re- ferred to in the above paragraph, in our opinion. the sccoqsnying forecasted financial stat-ants have‘oot been prepared on a basis of reasonable sssqtions and estimates. inse- mud as the forecssted statements relate to the future mud may be affected not only by the monsblsmsu of the auntie- wsed but also by nforusesn events as well, we can express no spinion on how closely the forecasted stat-sacs will correspond with actual results. W 59% V- (at Denver, blotch APPENDIX D QUESTIONNAIRES 135 APPENDIX D QUEST IONNAIRES EXHIBIT D-I Questionnaire - Level F0 QUE STION N AIRE Instructions: Your task is to select one of two hypothetical capaniea in which you prefer to invest. This investment decision is to be based on the enclosed material con- cerning the two ceqanies. Ihe laterial enclosed consists of, l) broker advice, 2) presidents letter, 3) historical financial statemts, 4) and auditor's report. first review the eaterial listed above, then newer the following questions. Mower the questions in order. he not look at the next question until you have eeqletcd the one before it. Do not change my newers. be very careful to fill out the questionnaire accurately and ceqletely. Incorrect or incomplete ques- tiomaires cannot be used in the study. Place the cenlete questionnaire in the stewed return addressed envelope. Please do it toda . be d no be too late to include in the M. IfyouwoaaIIhsacopyo res ts,paceac inthe sonthe outside of the return addressed envelope and return your questionnaire 227L11- S_t_¢-»g. Please look at the any material now. luv-ing a current market price of $21 for Carter and $16 for SI], in which company uould you prefer to invest? B Carter Ce-uicatiena D sen. Inc. 21%.: do you describe this preference? D Strong D Moderate D Weak 301m only the information provided you, what value or price per share would you place on the cm stock? Carter Communications 3 SRN, Inc. 3 431a: much time did you spend reviewing the financial information before newer- ing questions 1 and 2 above? hour(s) 50f the infer-tion in the packet, uhich was the single neat influential source in your investment decision? D Broker advice D Presidents letter B Auditor's report [3 Historical finncial stat-ants The remaining questions are of a personal nature, but are necessary to insure the statistical validity of the study. Let us assure you that cenlete con- fidentiality will be maintained. 6%“ is the sin le most inflmntiel source of investing information you nor- nally use in :51}; your security selection decisions? D friend ndlor relatives D Adviser services E] Investment club eeaeciates D Stock broker a financial stat-ante D Newepapers [:jnueunrunn [:30flur 7ft may be that your answer to question 5 differs fru your answer to question 6. If there is a difference, indicate the reasons here. 136 EXHIBIT D-I (cont'd.) Show many years have you been a “er of an investment club? 9]» you own securities in addition to those owned in common by the club? DY“ Duo If the answer to question 9 above is yesJ answer questions 10 through 13 relative to the securities which belong to you. If the answer above is no, answer the same questions relative to the securities which the club owns in come. 1 many years have you been making investments in corporate securities? D Under one year :3 Three years up to five years B One year up to three years C] five years and over 1111a! long do you typically held a security in your portfolio? D Under six months B One year up to three years D Six months m to one year [3 Three years and over 12Wch m of the following best describes your basis for selecting a security? E Market price appreciation D Dividends 13h which of the following ranges does the total market value of all of your securities fall? D Under $5,000 [:1 $5,000 thru $9,999 [:1 $10,000 thru $10,999 C] $15,000 thru $19,999 D $20,000 thru $26,999 [:1 shove $25,000 1 Which of the following best describes your formal education? C3 Less than four years of high school B High school coqleted D Less than four years of college D College cleeted (major ) D Post-graduate degree (major area ) l5flhat is your age bracket? [:1 Ihder 21 D 21 thru 34. C] 35 thru u. [:1 05 thru 51. [:1 55 cm 64 C] 65 or more 16hich of the following cqtions best describes your occwatien? C] farnr or farm worker a Professional or teclmician D'Craftsman or foreman a Clerical or sales person a Service uorker D Housewife, retired or non- qloyed adult G Manager, official or proprietor D Laborer or operative 17in which of the following ranges does your annual incue fall? [:1 0.4.: 95,000 D 35.000 to 97,999 [:1 $0,000 to 99.999 [:1 $10,000 to 31A.999 B 315,000 to $25,000 [:1 Over $25,000 137 EXHIBIT D-II QUESTIONNAIRE - LEVELS F «H- and F _+ QUESTIONNAIRE Instructions: Your task is to select on of two hypothetical capaies in which' you prefer to invest. This investnent decision is to be based on the enclosed material con- cerning the two coaaies. The eaterial enclosed consists of, l) broker advice, 2) presidents letter, 3) historical financial statements, 0 auditor‘s report, ad 5) forecasted finacial stat-ants. first review the natarial listed above, then aswer the following questions. Answer the questions in order. he not look at the next question until you have cealeted the one before it. Do not chage ay aswers. Be very careful to fill out the questionnaire accurately and coaletely. Incorrect or incomplete ques- tionnaires cannot be used in the study. Place the cealete questionnaire in the stewed return addressed envelope. Please do it {5%. De1_eze_d_ figs may be too late to include in the M. you acepyo res ts,p ea in soothe outside of the return addressed envelope ad return your questionnaire m. M. Please look at the on”! material now. lAesrang a currat market price of $21 for Carter ad 816 for SIM, in which company would you prefer to invest? [:1 Carter Ce-nications [3 sex. Inc. Zflew do you describe this preference? D Strong U Moderate D Weak 3Civen aly the information provided you, what value or price per share would you place on the can stock? Carter Nations 5 SIM, Inc. 8 4How much time did you spend reviewing the finacial information before aswer- ing questions 1 ad 2 above? heur(s) 50f the information in the packet, which was the single most influential source in your investant decision? C] Broker advice D Praeidats letter B Auditor's report [3 Historical finacial stat-ants D forecasted finacial state-ants The remaining questions are of a personal nature, but are necessary to insure the statistical validity of the study. Let me assure you that coaletc con- fidentielity will be aintained. 6%“ is the sings most influential source of investing inferation you agr- ally use in your security selection decisions? D friend adler relatives D Adviser services I: Invest-ant clrb associates D Stock broker C] finacial stat-ants D Newspapers G Tips and rumors D Other 7ft say be that your aswer to question 5 differs fra your aswer to question 6. If there is a difference, indicate the reason here. 138 EXHIBIT D-II (cont'd.) shayyearshaveyeubeaaaaerofainvestmat club? 9!» you own securities in addition to those earned in cm by the club? [:3 .r- C] lo If the aswer to question 9 above is 1.0, aswer questions 10 through 13 relative to the securities which belong to you. If the answer above is no, aswer the _s_as_ questions relative to the securities which the club owns in cease. 10in nay years have you baa nking investments in corporate securities? D Under one year ' C3 Ihree years up to five years B One year up to three years D five years ad over llllew long do you typically held a security in your portfolio? D Under sin anths B One year up to three years DSixanthswtoonsyear D‘rhraeyearsadovar 12llIich m of the following best describes your basis for selecting a security? [:1 mm: price cppnciccioc [fl Dividends 13h uhich of the following rages does the total market value of all of your securities fall? D lhder 35,000 D $5,000 thru 39.999 [:1 $10,000 thru $15999 B 815,000 thru 319.999 [:1 $20,000 thru 325999 B above $25,000 141nm: of the following best describes your formal education? D less than four years of high school D high school coalated [3 less tha four years of college D College coaleted (ajor ) D Pest-graduate degree (major area ) 155st is your age bracket? . [:1 um: 21 [:1 21 thru 34» [:1 35 thru u Dram“ assumes absorare 16hich of the following cation best describes your occwatien? D farar or farm worker a Professiaal or teclniicia D'Craftsan or fore-n [2 Clerical or sales person E Service worker D housewife, retired or non- qloyed adult D lhnsgsr, official or propriater D Laborer or operative 1711: “rich of the following rages does your meal ineae fall? [:1 0.4.: 33,000 D 35.000 to 37.999 [3 30.000 to 39,999 [:1 $10,000 to 815,999 [:1 $15,000 to 825.000 [:1 Over $25,000 APPENDIX E LETTERS OF NOTIFICATION $139 LETTERS OF NOTIFICATION EXHIBIT E—I Original Cover Letter / (jg! w/I/zrfl/ WM 1515 EAST ELEVEN MILE ROAD ROYAL OAK, MICHIGAN 48067 Dear Member: I ask you to read the following letter very carefully. You have been se- lected to participate in a study dealing with financial reporting and its effect on investors' decisions. we strongly feel that the results of this study may help point the way toward improvement in financial reporting for the individual private investor. This project is being conducted by Mr. S. Thomas A. Cianciolo who came to us highly recommended by George A. Nicholson, CPA, a Partner in the Detroit office of Arthur Andersen & Co. Mr. Cianciolo is a CPA and is currently a Ph.D. candidate at Michigan State University. His Doctoral dissertation will include the results of this study. Enclosed with this letter is a questionnaire and related material. Please review the material and complete the questionnaire. Others in your area or club may be receiving a similar packet. Please do not discuss the contents of your packet with another member until both of you have completed and returned the ques- tionnaire. Discussion between participants in the study will destroy its statis- tical validity and its potential value for improving financial reporting fer the individual private investor. neturn addressed envelopes are coded so that the effect of financial report— ing variations can be analyzed and so that the results of the study can be mailed to those participants who request them. NAIC employees are handling the mailing and sealed return envelopes will be received directly by our office where our em- ployees will check-off the coding and "results requested" on a master list. The sealed return envel0pes will then be forwarded to Mr. Cianciolo. In other words, our employees will see only the names and Mr. Cianciolo will see only the re- sponses. Complete anonymity is assured. Your completion of Mr. Cianciolo's questionnaire will be both a service to him in completing his dissertation and, in a very real sense, a service to all private investors. Thank you in advance for your cooperation. Yours very truly, / . Jim“ amen, Thomas E. O'Hara TDszk Chairman, Board of Trustees Encls. 140 EXHIBIT E-II SECOND REQUEST LETTER L_ 1515 ROYA um: W W '::::::.':: /flm W 69M”, EAST ELEVEN MILE ROAD L OAK, MICHIGAN 48067 Augus t 5 , 19 74 Dear Menber, Your help is urgently needed. Recently a packet containing a questionnaire was mailed to you. The completed questionnaire will be the major input into a study dealing with financial reporting variations and the small, private investor. Dur master list indicates that we have not received your response. Without your response, the tine and money spent on this study will be completely wasted and any potential benefits to the small, private investor will be lost. PLEASE SEND IN YOUR RESPGYSE TODAY. Yours very truly, "’xm”,Z.J/IIZM4/ Thomas E. O'Hara Chaiman, Board of Trustees Taizkk INVESTMENT EDUCATION FOR EVERY AMERICAN APPENDIX F PRESIDENTS' LETTERS 141 EXHIBIT F-I PRESIDENTS' LETTERS TO ACCOMPANY HISTORICAL FINANCIAL STATEMENTS CARTER COMMUNICATIONS TO OUR STOCKHOLDERS In the fiscal year just ended, Carter Communications Company's revenues and earnings were the highest in its history. Revenues reached $70,525,040, an in- crease of 322 over the last fiscal year, and earnings before an extraordinary credit were $10,331,209, an increase of 381. This resulted in earnings per share before extraordinary credit of $2.53 vs. $1.95 last year. This increase is par- ticularly significant in view of the fact that the weighted average number of shares outstanding this year exceeded the number outstanding last year by 301,874. In addition, in the fiscal year the Company realized a gain from the sale of its AM and PM stations in Richmond, Virginia of $1,086,455 net of applicable income taxes, or 26¢ per share. After the extraordinary item, total earnings per share in the fiscal year were $2.79. These achievements were especially gratifying because they resulted from a combination of strong performances by our major operating divisions. The Broad- casting Division had a record year in sales and profits and, at the same time, significantly improved its facilities position by occupying new television studios in Cleveland and Atlanta. we continue to regard broadcasting as our primary pro- fit center and are actively seeking to expand our complement of radio properties. The Child Life Division had the best year in its history, financially and creative- ly. It continued its pre-eminent position in network television children's pro- gramming, successfully released its first full-length theatrical motion picture, and continued to expand its merchandising and syndication operations. In perhaps the single most exciting development of the fiscal year, our Picnic Island Amusement Center opened successfully and on schedule and enjoyed a first year's performance which exceeded all of our projections. Progress to date has been excellent on the construction of our second family entertainment center, Pic- nic Place, located north of Dallas, Texas. This is the first venture of Leisure Centers, our joint venture with Leisure Enterprises. It is anticipated that Picnic Place will open in the spring of 1975. In July we completed a public offering of 300,000 shares of our common stock and simultaneously warrants for 60,001 shares were exercised. The proceeds from this offering and exercise of warrants enabled us to retire all of our short term bank debt and gave us expansion and development. As a result, we are in a strong cash position as we enter the new fiscal year. In addition, we had a net reduc- tion in our long term debt (including current portion) of $2,132,607 during the fiscal year and it now stands at $33,231,750, approximately 392 of stockholders' equity. - As the new fiscal year began, business continued to be strong. The second year for Picnic Island and the new Cleveland and Atlanta television studios should greatly increase revenues and earnings in the upcoming fiscal year. Management is recommending the addition of Fred G. Mott to our Board of Directors. Mr. Mott, a Vice President of Carter, is the head of our Picnic Is- land operation. He has an outstanding reputation in his field and we believe he will he a strong and contributing addition to our Board. 142 EXHIBIT F-I (cont'd.) Our basic corporate policy remains unchanged - to maintain and improve our strong base in broadcasting, to expand and diversify in the leisure time field, and to continue to seek out compatible and profitable new opportunities for growth. we feel that the accomplishments of the last fiscal year and the pros- pects for the future justify our continued adherence to this policy. As always, our success is possible only through the continued loyalty and support of our employees and stockholders. Ronald B. Steinberg s P. Kettering Chairman of the Board President 143 EXHIBIT F-I (cont'd.) SRN, Inc. TO OUR SHAREHOLDERS SW OF FISCAL 1974 In its 90th year of operations ending May 31, 1974, SRN, Inc. recorded the best performance in its history. Net income increased 312 to reach an all-time high of $55 million or $1.63 per share. Revenues for the year also reached an all-time high of $706 million. By comparison, net income in 1973 amounted to $42 million, or $1.25 per share, on revenues of $611 million. The strongest contri- butions to the Company's record-breaking performance came from Newsprint and Forest Products and from Newspaper Publishing. Newspaper revenues rose to $303 million in 1974 from $280 million in 1973 pre- tax profit of $50 million in 1974, compared with $44 million in 1973. All four SRN, Inc. newspapers enjoyed their best year in history in 1974. Advertising lin- age of each newspaper achieved all-time high levels in 1974. Revenues from Newsprint and Forest Products rose to $208 million in 1974 with pretax income of $40 million, more than double the pretax income of $19 million in 1973. Revenues from pulp and paper operations in 1974 were up modestly over the prior year, despite a brief strike at one of the Company's two mills. Largest revenue gains came from lumber manufacturing. Log sales and plywood manufacturing also generated increased revenues, especially in the first part of 1974. Revenues from Book Publishing remained almost constant at $122 million but pretax income was down to $6 million, compared with $11 million in 1973. Results of operations from Book Publishing were heavily influenced by developments at The Zenith Publishing Company. During 1974, Zenith discontinued, sold or agreed to sell a substantial portion of its business. Revenues of Zenith of $11 million and a net loss of $5 million are included in 1974 consolidated operations. The net loss includes unusual write downs and losses of $3 million, after applicable in- come tax credits, in connection with the discontinuance and sale. Revenues from other operations, including information services, magazine pub- lishing, directory printing, television broadcasting, and cable communications, advanced to $121 million in 1974, compared with $105 million in 1973, while pretax income remained constant at $7 million. Excellent results were recorded by most companies in this category, although magazine publishing was adversely affected by losses . Prices charged by all SRN, Inc. divisions and subsidiaries were subject to the Phase 4 regulation under the Economic Stabilization Act during 1973, except that lumber and plywood prices were decontrolled on August 13, 1973. In February, 1974 prices of various SRN, Inc. products began to be decontrolled, and by March 15, 1974 all controls on prices charged by SRN, Inc. units were removed. During the imposition of Page 4, prices could not be raised sufficiently to fully recover increased costs. CASH DIVIDENDS The Board of Directors increased the cash dividend on the coupon stock from 6 1/2 cents per share paid quarterly in fiscal 1973 to 7 1/2 cents per share dur- ing the first two quarters of fiscal 1974 and to 8 cents per share during the last two quarters of fiscal 1974. 144 EXHIBIT F-I (cont'd.) BOARD OF DIRECTORS Paul S. Bogg, Los Angeles investor,‘was elected to the Board of Directors on July 28, 1973. THE YEAR AHEAD we remain confident of the future. This confidence is based on the nature of our business: providing useful and essential information to those who need it. The need for excellent newspapers, books, magazines, television and cable communications, directories, and other information services has never been great- er. Over the long run, we believe we are well positioned.with the resources to maintain and increase this flow of information. Finally, our Newsprint and Forest Products operations, based upon a signi- ficant timberlands base - a renewable natural resource - and the ability to pro- duce newsprint for a ready market (with the attendant certainty of supply of a vital material) have grown dramatically and offer great future promise. We extend our appreciation to the shareholders and to all the employees of SRN, Inc. for their continuing support and encouragement. Chairman David G. MBaIes President 145 EXHIBIT F-II PRESIDENTS' LETTERS TO ACCOMPANY HISTORICAL AND POSITIVE FORECASTED FINANCIAL STATEMENTS CARTER COMMUNICATIONS To Our Stockholders In the fiscal year just ended, Carter Communications Company's revenues and earnings were the highest in its history. Revenues reached $70,525,040, an in- crease of 322 over the last fiscal year, and earnings before an extraordinary credit were $10,331,209, an increase of 382. This resulted in earnings per share before extraordinary credit of $2.53 vs. $1.95 last year. This increase is par- ticularly significant in view of the fact that the weighted average number of shares outstanding this year exceeded the number outstanding last year by 301,874. In addition, in the fiscal year the Company realized a gain from the sale of its AM and PM stations in Richmond, Virginia of $1,086,455 net of applicable income taxes, or 26¢ per share. After the extraordinary item, total earnings per share in the fiscal year were $2.79. These achievements were especially gratifying because they resulted from a com- bination of strong performances by our major operating divisions. The Broadcasting Division had a record year in sales and profits and, at the same time, significantly improved its facilities position by occupying new television studios in Cleveland and Atlanta, We continue to regard broadcasting as our primary profit center and are actively seeking to expand our complement of radio properties. The Child LIfe Division had the best year in its history, financially and creatively. It contin- ued its pre-eminent position in network television children's programming, success- fully released its first full-length theatrical motion picture, and continued to expand its merchandising and syndication operations. In perhaps the single most exciting development of the fiscal year, our Picnic Island Amusement Center opened successfully and on schedule and enjoyed a first year's performance which exceeded all of our projections. Progress to date has been excel- lent on the construction of our second family entertainment center, Picnic Place, located north of Dallas, Texas. This is the first venture of Leisure Centers, our joint venture with Leisure Enterprises. It is anticipated that Picnic Place will open in the spring of 1975. In July we completed a public offering of 300,000 shares of our common stock and simultaneously warrants for 60,001 shares were exercised. The proceeds from this offering and exercise of warrants enable us to retire all of our short term bank debt and gave us expansion and development. As a result, we are in a strong cash position as we enter the new fiscal year. In addition, we had a net reduction in our long term debt (including current portion) of $2,132,607 during the fiscal year and it now stands at $33,231,750, approximately 392 of stockholders' equity. As recently as fiscal 1971, long term debt amounted to 492 of stockholders' equity. Our actual earnings per share of $2.79 was $.19 greater than what was fore— casted at the beginning of fiscal 1974. While revenues from broadcasting and tele- vision and motion picture production posted gains, the most significant unexpected gain was in amusement park revenues. Both the number of visitors to our new Picnic Island facility and their per capita expenditure exceeded all expectations. The higher volume of business along with higher than anticipated resource prices caused total cost levels to exceed the forecast. 146 EXHIBIT F-II (cont'd.) Our assumptions about general economic conditions for fiscal 1975 are as follows: gross national product will increase about 92, but this increase will be largely due to inflation. Personal disposable income will remain constant. Gasoline will be readily available during the summer at about its present price per gallon. We believe that annual vacations have a high priority among the American people. Therefore we estimate, based on the assumptions stated earlier, that re- venues will increase by $20.5 million or 302 and will be caused by several fac- tors. He expect to distribute the second of our Child-Life full length motion pictures. The major additions at Picnic Island, as discussed in footnote 11 (A) of the financial statements, will be in operations. Lastly, the new Cleveland and Atlanta television stations, will be in operation for the full year. we estimate costs to increase by $16.4 million or 322. In particular, staf- fing and depreciation charges for the new additions at Picnic Island and the new television stations will cause significant increases in costs. In addition, both energy and labor costs will increase in fiscal 1975. The combined effect of these estimations should result in an increase in earnings per share before extraordinary items of $.77 to $3.30 for fiscal 1975 up from $2.53 in 1974. Management is recommending the addition of Fred G. Mott to our Board of Directors. Mr. Mott, a Vice President of Carter, is the head of our Picnic Is- land operation. He has an outstanding reputation in his field and we believe he will be a strong and contributing addition to our Board. Our basic corporate policy remains unchanged - to maintain and improve our strong base in broadcasting, to expand and diversify in the leisure time field, and to continue to seek out compatible and profitable new opportunities for growth. We feel that the accomplishments of the last fiscal year and the pros- pacts for the future justify our continued adherence to this policy. As always, our success is possible only through the continued loyalty and support of our employees and stockholders. > / ' lbc'd‘k/W 1%"! 4 [’0 .Ulflfl ”17” ('1 Ronald R. Steinberg ;///f James P. Kettering/ ¢/// Chairman of the Board President 147 EXHIBIT F-II (cont'd.) sun, Inc. TO OUR SHAREHOLDERS SUIHARY OF FISCAL 1974 In its 90th year of operations ending May 31, 1974, SRN, Inc. recorded the best performance in its history. Net income increased 312 to reach an all-time high of $55 million or $1.63 per share. Revenues for the year also reached an all-time high of $706 million. By comparison, net income in 1973 amounted to $42 million, or $1. 25 per share, on revenues of $611 million. The strongest contri- butions to the Company's record-breaking performance came from Newsprint and Forest Products and from Newspaper Publishing. Newspaper revenues rose to $303 million in 1974 from $280 million in 1973 pre- tax profit of $50 million in 1974, compared with $44 million in 1973. All four SRN, Inc. newspapers enjoyed their best year in history in 1974. Advertising lin- age of each newspaper achieved all-time high levels in 1974. Revenues from Newsprint and Forest Products rose to $208 million in 1974 with pretax income of $40 million, more than double the pretax income of $19 million in 1973. Revenues from pulp and paper operations in 1974 were up modestly over the prior year, despite a brief strike at one of the Company's two mills. Largest revenue gains came from lumber manufacturing. Log sales and plywood manufacturing also generated increased revenues, especially in the first part of 1974. Revenues from Book Publishing remained almost constant at $122 million but pretax income was down to $6 million, compared with $11 million in 1973. Results of operations from Book Publishing were heavily influenced by developments at The Zenith Publishing Company. During 1974, Zenith discontinued, sold or agreed to sell a substantial portion of its business. Revenues of Zenith of $11 million and a net loss of $5 million are included in 1974 consolidated operations. The net loss includes unusual write downs and losses of $3 million, after applicable in- come tax credits, in connection with the discontinuance and sale. Revenues from other operations, including information services, magazine pub- lishing, directory printing, television broadcasting, and cable communications, advanced to $121 million in 1974, compared with $105 million in 1973, while pretax income remained constant at $7 million. Excellent results were recorded by most companies in this category, although magazine publishing was adversely affected by losses. Prices charged by all SRN, Inc. divisions and subsidiaries were subject to the Phase 4 regulation under the Economic Stabilization Act during 1973, except that lumber and plywood prices were decontrolled on August 13, 1973. In February, 1974 prices of various SRN, Inc. products began to be decontrolled, and by March 15, 1974 all controls on prices charged by SRN, Inc. units were removed. During the imposition of Page 4, prices could not be raised sufficiently to fully recover increased costs. CASH DIVIDENDS The Board of Directors increased the cash dividend on the common stock from 6 1/2 cents per share paid quarterly in fiscal 1973 to 7 1/2 cents per share dur- ing the first two quarters of fiscal 1974 and to 8 cents per share during the last two quarters of fiscal 1974. 148 EXHIBIT F-II (cont'd.) COMPARISON OF THE 1974 FORECAST WITH ACTUAL RESULTS - A major deviation from the 1974 forecast was the level of operating revenue. Actual revenue was $45 million (72) higher than forecast. The basic reason for this variation was the underestimated demand for plywood and consequent excessive price increases. Actual cost was $10 million (62) higher than forecasted. This was caused by a greater than expected increase in newsprint prices. The result on earnings per share was an increase to $1.63 instead of the $1.50 projected, an increase of nearly 92. THE YEAR AHEAD - we remain confident of the future. This confidence is based on the mantra of our business: providing useful and essential information to those who need it. The need for excellent newspapers, books, magazines, television and cable communications, telephone directories, and other information services has never been greater. Over the long run, we believe we are well positioned with re- sources to maintain and increase this flow of information. Our Newsprint and Forest Products operations, based upon a significant timber- lands base - a renewable natural resource - and the ability to produce newsprint for a ready market (with the attendant certainty of supply of a vital material) have grown dramatically and offer great future promise. Our assumptions about the general economic outlook for fiscal 1975 follows: we expect some slowing of the economy with little growth in gross national product in real terms. The general rate of inflation should approximate 102. The govern- ment will not re-impose general price controls. we estimate revenues to increase by $92 million (132). This increase will largely result from an average increase of 92 in the rates of our various cate- gories of newspaper advertising. These rate increases were made at the end of fiscal 1974 when the newspaper industry was relieved of price controls. Most of these rate increases were covered by applications pending with the Cost of Living Council. However, we estimate costs to increase by $83 million (142). This increase will be largely caused by newsprint prices which are still rising dramatically. The effect of dramatically rising wage rates will continue to be substantially off- set by technological advances. Two advances of importance are the use of photocom- position and plastic printing plates. The increase in revenues and costs, caused primarily by price increases, will also be pushed higher by added volume caused by increases in advertising linage and lumber production. The resulting earnings per share should approximate $1.80, an increase of_lO2. BOARD OF DIRECTORS - Paul S. Bogg, Los Angeles investor, was elected to the Board of Directors on July 28, 1973. we extend our appreciation to the shareholders and to all employees of SRN, Inc. for their continuing support and encouragement. Donald B. Cai David G. Bales Chairman President 149 EXHIBIT F-III PRESIDENT'S LETTER TO ACCOMPANY HISTORICAL AND NEGATIVE FORECASTED FINANCIAL STATEMENTS CARTER COMMUNICATIONS To Our Stockholders In the fiscal year just ended, Carter Communications Company's revenues and earnings were the highest in its history. Revenues reached $70,525,040, an in- crease of 322 over the last fiscal year, and earnings before an extraordinary credit were $10,331,209, an increase of 382. This resulted in earnings per share before extraordinary credit of $2.53 vs. $1.95 last year. This increase is par- ticularly significant in view of the fact that the weighted average number of shares outstanding this year exceeded the number outstanding last year by 301,874. In addition, in the fiscal year the Company realized a gain from the sale of its AM and PH stations in Richmond, Virginia of $1,086,455 net of applicable income taxes, or 26¢ per share. After the extraordinary item, total earnings per share in the fiscal year were $2.79. These achievements were especially gratifying because they resulted from a com! bination of strong performances by our major operating divisions. The Broadcasting Division had a record year in sales and profits and, at the same time, significantly improved its facilities position by occupying new television studios in Cleveland and Atlanta, We continue to regard broadcasting as our primary profit center and are actively seeking to expand our complement of radio properties. The Child LIfe Division had the best year in its history, financially and creatively. It contin- ued its pre-eminent position in network television children‘s programming, success- fully released its first full-length theatrical motion picture, and continued to expand its merchandising and syndication operations. In perhaps the single most exciting development of the fiscal year, our Picnic Island Amusement Center opened successfully and on schedule and enjoyed a first year's perfoaamnce which exceeded all of our projections. Progress to date has been excel- lent on the construction of our second family entertainment center, Picnic Place, located north of Dallas, Texas. This is the first venture of Leisure Centers, our joint venture with Leisure Enterprises. It is anticipated that Picnic Place will open in the spring of 1975. In July we completed a public offering of 300,000 shares of our common stock and simultaneously warrants for 60,001 shares were exercised. The proceeds from this offering and exercise of warrants enable us to retire all of our short term bank debt and gave us expansion and development. As a result, we are in a strong cash position as we enter the new fiscal year. In addition, we had a net reduction in our long term debt (including current portion) of $2,132,607 during the fiscal year and it now stands at $33,231,750, approximately 392 of stockholders' equity. As recently as fiscal 1971, long term debt amounted to 492 of stockholders' equity. Our actual earnings per share of $2.79 was $.19 greater than what was fore- casted at the beginning of fiscal 1974. While revenues from broadcasting and tele- vision and motion picture production posted gains, the most significant unexpected gain was in amusement park revenues. Both the number of visitors to our new Picnic Island facility and their per capita expenditure exceeded all expectations. The higher volume of business along with higher than anticipated resource prices caused total cost levels to exceed the forecast. ILSO EXHIBIT F-III (cont'd.) Our assumptions about general economic conditions for fiscal 1975 are as follows: gross national product will increase about 92, but this increase will be largely due to inflation. Personal disposable income will remain constant. Energy costs will continue to increase. Based on these assumptions, we estimate revenues to increase by a net of $5.5 million or 82, and this net increase will be caused by several factors. 0n the positive side we expect to distribute the second of our Child-Life full length motion pictures. The major additions at Picnic Island, as discussed in footnote 11 (A) of the financial statements, will be in operation. Lastly, the new Cleve- land and Atlanta television stations will be in operation for the full year. On the negative side, broadcasting revenues will decrease by continued slippage in national spot radio advertising. The total revenues at Picnic Island will suffer from lower attendance caused by reduction in vacation expenditures of consumers faced with decreases in discretionary income. we estimate costs to increase by $8 million or 182. In particular, staffing and depreciation charges for the new additions at Picnic Island and the new tele- vision stations will cause significant increases in costs. In addition, both energy and labor costs will increase in fiscal 1975. The combined effect of these estimations should result in a decrease in earnings per share before extraordinary items of $.33 down from $2.53 for 1974 to $2.20 for 1975. Management is recommending the addition of Fred G. Mott to our Board of Directors. Mr. Mott, a Vice President of Carter, is the head of our Picnic Island operation. He has an outstanding reputation in his field and we believe he will be a strong and contributing addition to our Board. a. .fi‘g/J/«ZZW ”5%,?” Ronald B. Steinberg James P. ‘ettering Chairmen of the Board President APPENDIX C POST HOC COMPARISONS 151 TABLE G-I POST HOC COMPARISONS INVESTOR CHOICE PROPORTIONS -- ORIGINAL DATA BROKER BY FORECAST INTERACTION Interaction: A Final Contrast w i/l .90F1,3 VVARm Calculations (B+_F - B+_P_+) - (B_+R++ - B_+F_+) til (3.458) “.0047 Within column variation: V F VVARw Contrast w H- .90 3,8 (B;_F++) - (B_+E++) iV3 (2.924) V.0024 (E+_F_+) - (B_+F_+) iV3 (2.924) V.0024 Within row variation: Contrast II! iV3 ,90F3,8 V6AR$ (B+_P++) - (B+_F_+) i¢3 (2.924) ¢.0024 (B_+P++) - (B_+P_+) i¢3 (2.924) “.0024 *.15 .022<@<.278 Final Calculations **.39 .245<$<.535 ***.24 .095<@<.385 Final Calculations .12 -.025<$<.265 -.03 -.175<@<.115 *Significant at the .10 level. **Significant at the .10 and the .001 level. ***Significant at the .10 and the .01 level. 152 TABLE G-II POST HOC COMPARISONS INVESTOR CHOICE PROPORTIONS -- LOG TRANSFORMED DATA BROKER BY FORECAST INTERACTION Interaction: A Final Contrast w ill .90F1.8 JVAR$ Calculations (B+_F++ - B+_F_+) - (n_+_I-‘++ - B_+F_+) 2/1 (3.458) /.0288 *.330 .014