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ASBBS eJournal 

Volume 4, No.1, 2008 

Editors 

Pani Chakrapani, University of Redlands 

Wali I. Mondal, National University 

Assistant Editor 

Matthew Parcher, University of California, Santa Cruz

The Supreme Court Grants Certiorari To Resolve A Split Among The Circuit Courts Over The 

Deductibility Of Investment Fees Incurred by A Trust by Aquilio, Mark 1 

The Virtual Office: Challenges and Opportunity for Faculty 

by Browning, Michelle C. 12 

The Information Content of Quarterly Earnings Announcements: A Test of Market Efficiency 

by Dhareshwar, Priya, R. and Bacon, Frank 20 

Naming Names: Which Schools Are Publishing In Management Journals And What Does It Mean? 

by Fekula, Michael J. “Mick” and Hornyak, Martin 32 

Id Theft and Its Financial Implications 

by Grady, Shawna, Maniam, Balasundram and Leavell, Hadley 46 

Mining For Knowledge in Higher Education 

by Huebner, Richard A. 56 

The Importance of Internal Controls: Yesterday and Today 

by King, Darwin L. and Case, Carl J. 74 

Stock Repurchase Announcements: A Test of Market Efficiency 

by Kinsler, Nicholas A. and Bacon, Frank W. 94 

Wealth, Poverty, And Sub-Saharan African Conflicts: Cases of Angola, Congo, And Sierra Leone 

by Koyame-Marsh, Rita O. 106 

Teaching Notes: Experiences in Online Teaching by Lavin, David 128 

A Study of the Relationship between Strategic Cost Structure Choice and Stock Return Behavior 

in the Transportation Industry: Preliminary Results 

by MacArthur, John B. Houmes, Robert E.and Stranahan, Harriet A. 124 

The Spiritual Dimension of Quality: A Biblical Perspective by Maguad, Ben A. 131 

Housing Investment and Property Taxes In Indiana: A Cross-County Comparison 

by McGrath, Paul 141 

Major Trends In Hotel Guestroom Technology: An Analysis of Customer Demand and Satisfaction 

by Mills, Richard J. 149 

An Historical Perspective of Accounting For Income Taxes From 1920 Through 1984 

by Myers, Joan K. and Collins, Mary K. 161 

Sustainable Growth Modeling: A Longitudinal Analysis of Harley-Davidson, Inc. 

by Pickett, Michael C. 171 

Firm Expansion and Regional Development: Re-Discovering The Importance of Geographic 

Space and Location by Walecki, Julius M. 177 

Innovative Hrm: How Hr Activities Can Be Embe dded Into The Overall Strategic Thrust Of 

The Firm by Zomorrodian, Asghar Ph.D. (Dr. Z) 197

THE SUPREME COURT GRANTS CERTIORARI TO 

RESOLVE A SPLIT AMONG THE CIRCUIT COURTS 

OVER THE DEDUCTIBILITY OF INVESTMENT FEES 

INCURRED BY A TRUST 

ABSTRACT 

Aquilio, Mark 

St. John’s University 

aquiliom@stjohns.edu 

The Supreme Court in Knight, Trustee of the William L. Rudkin Testamentary Trust v. Commissioner of 

Internal Revenue, 127 S.Ct. 3005 (2007) recently granted certiorari to resolve a split among the circuit 

courts of appeals over whether investment fees incurred by a trust should be deducted in full to determine 

the trust’s adjusted gross income or as a miscellaneous itemized deduction, which in the aggregate are 

reduced by 2 percent of adjusted gross income. The decision of the Supreme Court will result in a 

determination affecting the deductibility of millions of dollars of investment advisory fees, thus impacting 

the tax liability of thousands of trusts and determining whether millions of dollars of tax revenues will be 

collected. 

Most recently in William L. Rudkin Testamentary Trust et al., v. Commissioner of Internal Revenue, 467 

F.3d 149 (CA-2, 2006), cert. granted 127 S.Ct. 3005 (2007) the Second Circuit ruled that the fees are a 

miscellaneous itemized deduction. It reasoned that pursuant to Section 67(e)(1) of the Internal Revenue 

Code of 1986, as Amended, only investment fees incurred by a trust that could not have been incurred if 

the property were held by an individual are deductible in determining adjusted gross income. Previously, 

in Scott v. U.S., 328 F.3d 132 (CA-4, 2003) the Fourth Circuit held the fees to be a miscellaneous 

itemized deduction as they constitute expenses commonly incurred by individuals. Furthermore, in 

Mellon Bank, N.A. v. United States, 265 F.3d 1 275 (CA-Fed., 2001) the Federal Circuit ruled that the 

fees are a miscellaneous itemized deduction opining that only those trust-related administrative expenses 

that are unique to the administration of a trust and not customarily incurred outside of trusts by 

individuals are fully deductible in determining adjusted gross income.. 

Conversely, in O'Neill v. Comm., 994 F.2d 302, 304 (CA-6, 1993) the Sixth Circuit held that the 

investment advisory fees were costs incurred because the property was held in trust, thus deductible in 

full when determining adjusted gross income. The Sixth Circuit reasoned that because a trustee has a 

fiduciary duty to manage trust assets as a "prudent investor,” investment advisory fees are "necessary to” 

the trust's administration and "caused by” the fiduciary duty of the trustee. The court reasoned further 

that although individual investors often incur costs for investment advice, "they are not required to 

consult advisors and suffer no penalties or potential liability if they act negligently for themselves.” 

ASBBS E-Journal, Volume 4, No.1, 2008 1

Aquilio 

INTRODUCTION 

Trustees empowered by a trust instrument to invest t he corpus of the trust have a fiduciary responsibility 

to act prudently. In Harvard College v. Amory, 26 Mass. 446 (Mass. 1830) the Massachusetts Supreme 

Judicial Court established this prudence standard an d ruled t hat t rustees should "observe how men of 

prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard 

to the permanent disposition of their f unds." Id at 4 61. The Uniform Prudent Investor Act incorporated 

much of this language, and has been subsequently adopted by thirty-six states. For exam ple, the trustee's 

fiduciary duties under the Connecticut Uniform Pru dent Investor Act, Conn. Gen. Stat. §§ 45a-541 t o 

45a-541l (2 005), subjects trustees to a prudent man st andard an d requires them to manage trusts with 

diligence and care. In Knight, Trustee of the William L. Rudkin Testamentary Trust v. Commissioner of 

Internal Revenue, 127 S .Ct. 3005 (20 07) the Supr eme Court granted certiorari to determine whether 

investment advisor y fees incurred by t rustees in sa tisfying their fiduciary responsibilit y to prudent ly 

invest the tr ust corpus ar e deductible in full to determine the trust’ s adjuste d gross income or as a 

miscellaneous item ized deduction, wh ich in the aggreg ate are r educed by 2 percent of adjusted gros s 

income. 

Section 1 of the Internal Revenue Code of 1986, as Amended (Code) imposes a tax on all taxable income 

of individuals and trusts. The starting point in calculating taxable income is to determ ine the am ount of 

gross incom e, which is de fined in Co de § 61(a) as "all incom e from whatever source derived." T he 

taxpayer then subtracts from gross inco me certain "a bove-the-line" deductions as enumerated in Code § 

62(a) to calculate adjusted gross income (AGI). Taxable income is then calculated pursuant to Code § 63 

by subtracting from adjus ted gross inc ome the grea ter of the standard deduction or any it emized (or 

"below-the-line") deductions and the personal exemptions allowed b y Code § 151. In the case of an 

individual, itemized deductions include, am ong others, "all the ordinar y and necessary expenses paid or 

incurred duri ng the taxab le y ear- (1) for the prod uction of inc ome; (2) . . . for the management, 

conservation, or maintenance of property held for the production of income or …" as provided in Code § 

212. 

Code § 67(a) provides that “[i]n the case of an individual, the miscellaneous itemized deductions for any 

taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2 percent 

of adjusted gross inco me." Thus, Code § 67(a) cr eates a two-percent of AGI floor for an individ ual's 

miscellaneous item ized deductions. Code Section 67(b) exem pts from the two-percent of AGI floor 

certain specifically enumerated itemized deductions. 

Pursuant to Reg. § 1.212-1(g), (i) and Te mp.Treas.Reg. § 1.67-1T(a)(1)(ii), invest ment advisory fees 

incurred b y individ uals are generally treated as miscellaneous item ized de ductions under Code § 212 , 

which are no t exempted by Code Secti on 67(b) from the two-percent of AGI floor. How ever, Code § 

67(e) provides in relevant part: 

“The adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an 

individual, except that - 

(1) the deductions for costs which are paid or incurre d in connection with the adm inistration of the estate 

or trust and which would not have been incurred if the property were not held in such trust or estate . . . 

shall be treated as allowable in arriving at adjusted gross income.” 


Deductibility of investment fees…Trust 

Accordingly, trusts are generally subject to the sa me rules for calculating adjusted gros s incom e tha t 

apply to individuals, except that a tr ust's costs are fully deductible, rath er than subject to the two-percent 

of AGI floor, if they satisfy both of the following two requirements: (1) they are "paid or incurred in 

connection with the ad ministration of the . . . trust" ; and (2) they "would not have been incurred if the 

property were not held in such tr ust." Generally, there is no dis pute that the investment advisory fees 

incurred by a trust meet the requirement of the first clause, i.e., that the fees were incurred in connection 

with the administration of the trust. However, a split has developed among the circuit courts over whether 

the investment advisor y fees also satisfy the requi rement of the second clause of Code § 67(e)(1) and 

therefore are full y ded uctible in determining AGI without regard to the two- percent of AGI floor as 

provided in Code § 67(a) for miscellaneous itemized deductions. 

The Sixth Circuit was the first federal court of app eals to address the deduct ibility of the invest ment 

advisory fees by a trust in O'Neill v. Comm., 994 F.2d 3 02 (C A-6, 199 3). Reversing the tax court ’s 

decision in O'Neill v. Comm., 98 T.C. 227 (1992) the court held that the fees were costs incurred because 

the property was held in trust, t hus deductible in full under Code § 67(e)(1) when determ ining adjusted 

gross income. Then, in Mellon Bank, N.A. v. United States, 265 F.3d 1275 (CA-Fed., 2001) the Federal 

Circuit ruled that the investment advisory fees are a miscellaneous itemized deduction subject to the twopercent 

of A GI floor opining that only those trust-related administrative expenses that are unique to the 

administration of a trust and not customarily incurred outside of trusts by individuals are fully deductible. 

The Fourth Circuit then ruled in Scott v. U.S., 328 F.3d 132 (CA-4, 2003) that the invest ment advisory 

fees are miscellaneous it emized deduction subject to the two- percent of AGI floor as they constitute 

expenses commonly incurred by individuals. Most recently in William L. Rudkin Testamentary Trust et 

al., v. Commissioner of Internal Revenue, 467 F .3d 149 (CA-2 , 2006) , cert. granted 127 S.Ct. 3005 

(2007) the Second Circuit ruled that the fees are a miscellaneous itemized deduction subject to the twopercent 

of AGI floor as onl y investment fees incurred by a trust that could no t have been incurred if the 

property wer e held b y an indi vidual a re deductible in f ull whe n determ ining adjusted gross income . 

William L. Rudkin Testamentary Trust was appeal ed to the Supre me Court and it granted certiorari i n 

Knight, Trustee of the William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue, 127 

S.Ct. 3005 (2007) to resolve the split among the circuit courts of appeals. Clearly, the Court’s ruling will 

impact the tax liability of thousands of trusts as it wi ll result in a determination affecting the deductibility 

of millions of dollars of invest ment fees and a m ultitude of other expenses incurred by a trust that could 

fall under Code § 67 (e)(1). 

In rendering its decision the Suprem e Court will have to constr ue the statutor y intent of Congress in 

enacting Code § 67(e)(1). The Supreme Court will utilize the same standards of statutory construction that 

the lower co urts em ployed. Before analy zing the circuit court opinions a discussion of the rules of 

statutory construction is necessary. 


Aquilio 

RULES OF STATUTORY CONSTRUCTION 

The judiciary is e mpowered with the authority to in terpret the statutes that Co ngress enacts. The court’ s 

responsibility is to determine and implement the intent of Congress. Brown & Williamson Tobacco Corp. 

v. FDA, 529 U.S. 120, 146 L. Ed. 2d 121, 120 S. Ct. 1291 (2000). The court must first determine whether 

the statutory language has a plain and unambiguous meaning. Thus, it always starts with the language of 

the statute. Williams v. Taylor, 529 U.S. 420, 12 0 S. Ct. 1 479, 14 6 L. E d. 2d 435 ( 2000). The Co urt 

stated, "[w ]e give the words of a stat ute their ‘o rdinary, contem porary, common meaning,’ absent an 

indication C ongress intended them t o bear so me different i mport. Walters v. Metropolitan Ed. 

Enterprises, Inc., 519 U.S. 202, 207, 136 L. Ed. 2d 644, 117 S. Ct. 660 (1997) (quoting Pioneer 

Investment Services Co. v. Brunswick Associates Ltd. Partnership, 507 U.S. 380, 123 L. Ed. 2d 

74, 113 S. Ct. 1489 (1993) )." Id. at 431. The court’s inquiry is completed “if the statutory language is 

unambiguous and t he statutory scheme is coherent an d consistent." Barnhart v. Sigmon Coal Co., Inc., 

534 U.S. 438, 151 L. Ed. 2d 908, 122 S. Ct. 941 (2002); Williams v. Taylor, 529 U.S. 420, 146 L. Ed. 2d 

435, 120 S. Ct. 1479 (2000); and Robinson v. Shell Oil Co., 519 U.S. 337, 340, 117 S. Ct. 843, 136 L. Ed. 

2d 808 (1997). 

The Supreme Court has stated that "[ t]he plainness or ambiguity of statutory language is deter mined by 

reference to the language itself, the specific contex t in which t hat language is used, and the broader 

context of the statute as a whole." Id. at 341. In Toibb v. Radloff, 501 U.S. 157, 162, 111 S. Ct. 2197, 115 

L. Ed. 2d 145 (1991) the Court opined that while “a court appropriately may refer to a statute's legislative 

history to re solve statutory am biguity, there is no need to do so" when the statutor y language is 

unambiguous. In addition, if feasible t he court m ust give proper effect to each provision and word in a 

statute and avoid any int erpretation that may rende r any statut ory term s meaningless or superfluous. 

Hence, the court ’s interpr etation m ust provide f ull effect to the entire statute as enacted by Congress. 

Freytag v. Comm., 501 U .S. 868, 115 L.Ed. 2d 764, 111 S.Ct. 2631 (1991) and Kawaauhau v. Geiger, 

523 U.S. 57, 62, 118 S. Ct. 974, 140 L. Ed. 2d 90 (1998). 

THE SPLIT AMONG THE CIRCUIT COURTS 

As noted previously, the Sixth Circuit was the first circuit court to address the deductibility of investment 

advisory fees by a trust in O'Neill v. Comm., 994 F.2d 302, 30 4 (CA-6, 19 93). I n reve rsing the Tax 

Court’s decision i n O'Neill v. Comm., 98 T.C. 22 7 (1992) it held that t he fe es were deductible in fu ll 

under Code § 67(e)(1) when determining adjusted gross income. The Tax Cou rt in O’Neill v. Comm., 98 

T.C. at 23 0-231determined that t he in vestment fees were not d eductible in f ull u nder Co de § 6 7(e)(1) 

stating “[w]e believe that the thrust of the language of section 67(e) is that only those cost s which are 

unique to the administration of an estate or trust are to be ded ucted from gross income without being 

subject to the 2-percent floor on itemized deductions set forth at section 6 7(a). Examples of items unique 

to the ad ministration of a trust or estat e would be t he fee s paid to a trustee a nd trust acco unting fees 

mandated by law or the trust agreement. Indivi dual investors routinely incur co sts for investment advice 

as an integral part of their investm ent activities. Co nsequently, it cannot be argued that such costs are 

somehow unique to the administration of an esta te or trust sim ply becaus e a fiduciary might feel 

compelled to incur such e xpenses in order to meet the prudent person standar ds imposed by State law.” 

(emphasis added). The T ax Court also noted that the governing Ohio statutes provi ded a t rustee with a 

“detailed list of pre-approved investments” that the tr ustee could investment in. Thus, there was no need 

to incur investment advice fees. 



The Sixth Circuit noted that “expenses such as trustee fees, costs of construction proceedings and judicial 

accountings are examples of expenses peculiar to a trust and, therefore, ar e subject to t he § 67(e) 

exception.” It viewed the i nvestment advisor fees pa id by the trust as incurred because the property was 

held in trust. Hence, the court ruled that they qualified under the exception provi ded in Code § 67(e) and 

were deductible in full. 

The court noted that “the mere sel ection of an ap proved invest ment does n ot autom atically m eet the 

prudent investor standard. The trustee is not limited to this list of investment options and has some duty to 

diversify the invest ment o f trust asset s so as to ‘dis tribute the risk of loss wit hin the trust.’ ... Where a 

trustee la cks experience in invest ment matters, pr ofessional a ssistance may be warranted. The trustees 

here lacked experience in investing and m anaging large sum s of m oney a nd, t herefore, sough t the 

assistance of an investment advisor. Without WPHA's management, the co-trustees would have put at risk 

the assets of the Trust. Thus, the investment advisory fees were neces sary to the continued growth of the 

Trust and were caused by the fiduciary duties of the co-trustees.” Id. at 304. 

The court re jected the T ax Court’ s reasoning that "[i]ndividual investors routinely inc ur costs for 

investment a dvice as an integral part of their inv estment activities." It stat ed “[n ]evertheless, they 

(individual investors) are n ot required to consult advisors and suffer no penalties or potential liabilit y if 

they act negligently for the mselves. Therefore, fiduciaries uniquely occupy a p osition of tru st for others 

and have an obligation to the beneficiaries to exerci se proper skill and care with the assets of the trust.” 

Id. at 304 (em phasis added). Accordingly, the Sixth Ci rcuit ruled that the inve stment advisory fees were 

deductible in full under Code § 67(e) “as the expenses for the investm ent management advice would not 

have been incurred if the property had not been held in trust.” 

Eight years after the Sixth Circuit’ s decision in O’Neill the Federal Circuit Court of Appeals in Mellon 

Bank, N.A. et al v. United States, 265 F.3d 1275 (CA-Fed., 2001) affirmed the decision of the Court of 

Federal Claims and ruled that the investment advisory fees are a miscellaneous itemized deduction subject 

to the two- percent of AGI floor. The c ourt opined that only those trust-related adm inistrative expenses 

that are unique to the administration of a trust a nd not customarily incurred outside of trusts by 

individuals are fully deductible. It rejected Mellon Bank’ s argument that “trustee fees are merely a label 

for fiduciary services performed by the trustee” thus “there are really no unique ‘trustee’ services--all are 

requirements of state fiduciary law” a nd “services delegated by the trustee re main subjec t to fiduciary 

standards and are fiducia ry services under governi ng la w. Ther efore, pay ments for outside fiduciar y 

services are in fact, trustee fees, and should be fully deductible under section 67(e)(1).” Id. at 1279. 

The court reasoned that a ll expenses d ue to the fiduc iary duties of the trustees would sati sfy the first 

requirement of Code § 67(e)(1) as “costs which are paid or incurred in connection with the administration 

of the estate or trust.” However, the co urt opined t hat its statutory construction would have to “give full 

effect to the full statute” and the second requirem ent of Code § 67(e) providing that the cost “would not 

have been incurred if the propert y were not held in such trust” must be satisfied for the invest ment 

advisory fee to be treated as allowable in arriving at adjusted g ross inco me. The court stated, “ [t]he 

second clause of section 67(e)(1) serves as a filter, a llowing a full deduction onl y if such fees are costs 

that ‘would not have been incurred if th e property were not held in such trust or estate.’ The requirem ent 


Aquilio 

focuses not on the relationship between the trust and costs, but the type of costs , and whether those costs 

would have b een incurred even if the assets were not held in a trust. Therefore, the second requirem ent 

treats as fully deductible onl y t hose trust-re lated adm inistrative expenses that are unique to the 

administration of a trust and not customarily incurred outside of trusts. Id. at 1280-128 1(emphasis 

added). The court furthe r provided t hat, “[ i]nvestment advice and management fees are co mmonly 

incurred outside of trusts. An individual taxpayer, not bound by a fiduciary duty, is likely to incur these 

expenses wh en managing a large su m of m oney. Therefore, these costs are not exem pt under section 

67(e)(1) and are required to meet the two percent floor of section 67(a).” Id. at 1281. 

The Federal Circuit also rejected Mello n Bank’s attempt to utilize the legislative histor y of Code § 67(e) 

to support its position. The court outlined the rel evant legislative history and reasoned that to allow the 

fees to be deducted in full as any costs associated with a trust are tied to the trustees fiduciary duty would 

render the second requirement of Code § 67(e) superfluous. Th e court stated that, “[ t]his is contrary to 

the legislative intent to equate the taxat ion of trusts with the taxation of indivi duals, limit the ability of 

sophisticated taxpayers to use trusts or other complex arrangements to lower their tax burden compared to 

similarly situated individuals, and to minimize the impact of the tax code on econom ic decision making.” 

Id. at 1281. 

In Scott v. U.S., 328 F.3d 132 (CA-4, 2003) the Fourth Circuit was in agreement with the reasoning of the 

Federal Circuit in Mellon Bank and affirmed the decision in Scott v. U.S., 186 F. Supp. 2d 664 (E.D. Va., 

2002). It held that the investment advisory fees are miscellaneous itemized deduction subject to the twopercent 

of AGI floor as they constitute expenses commonly incurred by individuals. The court opined 

that, “the costs must have been expenses ‘which would not have been incurred if the property were not 

held in such trust.’… The verb ‘would’ in the context of § 67(e)(1) expresses concepts such as custom, 

habit, natural disposition, or probability. Webster's Third New International Dictionary 481 (1976); 

American Heritage Dictionary of the English Language 20-42, 2059 (3d ed. 1992). Thus, ‘the second 

requirement treats as fully deductible only those trust-related administrative expenses that are unique to 

the administration of a trust and not customarily incurred outside of trusts.’… Put simply, trust-related 

administrative expenses are subject to the 2% floor if they constitute expenses commonly incurred by 

individual taxpayers. Because investment-advice fees are commonly incurred outside the context of trust 

administration, they are subject to the 2% floor created by § 67(a). Other costs ordinarily incurred by 

trusts, such as fees paid to trustees, expenses associated with judicial accountings, and the costs of 

preparing and filing fiduciary income tax returns, are not ordinarily incurred by individual taxpayers, and 

they would be fully deductible under the exception created by § 67(e). Such trust-related administrative 

expenses are solely attributable to a trustee's fiduciary duties, and as such are fully deductible under § 

67(e). Investment-advice fees, by contrast, are often incurred by individual taxpayers in the management 

of income-producing property not held in trust.” Id. at 139-140. 

As in Mellon Bank, the court was concerned with n ot interpreting the statute so as to rend er the second 

requirement in Code § 67( e)(1) superfluous by holding that a trust's investm ent advisory fees were fully 

deductible as all trust-related ad ministrative expenses could be attributed to a trustee's fiduciary duties. 

Furthermore, the court expressed its disa greement with the reasoning utilized in O’Neill. In opinin g that 

the reasoning in O’Neill contained a “fatal flaw” th e court provided that, “trustees often (a nd perhaps 

must) seek outside investment advice. But the sec ond requirement of § 67(e )(1) does not ask whether 

costs are commonly incurred in the adm inistration of trusts. Instead, it asks whether costs ar e commonly 

incurred outside the administration of trusts. As the Federa l Circuit decided in M ellon Bank, investmentadvice 

fees are commonly incurred outside the ad ministration of trusts, and they are therefore subject to 

the 2% floor established by § 67(a).” Id. at 140. 



Most recently in William L. Rudkin Testamentary Trust et al., v. Commissioner of Internal Revenue, 467 

F.3d 14 9 (CA-2, 2006), cert. granted 127 S.Ct. 3005 (20 07) t he Second Circuit affirmed William L. 

Rudkin Testamentary Trust et al., v. Commissioner of Internal Revenue, 124 T.C. 304 (200 5) and ruled 

that the fee s are a miscellaneous itemized deduction. It reasoned that pursuant to Code § 67(e)(1) only 

investment fees incurred by a tr ust that could n ot h ave been incurred if the property were held b y an 

individual are deductible in determining adjusted gross income. 

The court was not convinced by the taxpayer’s argument that Congress intended to allow a full deduction 

for the administrative costs of a trust attr ibutable to the trustee’s fiduciary duty. It rejected the taxpayer’s 

argument that “the statute sets forth a "but for" cau sal test: if the cost would not have be en incurred 

without the trustee, then it is attributable to the trustee's performance of its fiduciary duty and is thus fully 

deductible under § 67(e)(1).” Id. at 154. The court stated that, “ [a]ccording to the Trust, therefore, the 

second prong of § 67(e)(1) requires no consideration of whether a generic indi vidual owner of the sam e 

assets may have incurred the cost at is sue. Rather, th e Trust contends that the causation test "plainly" 

entails "a si mple exercise of removing the trustee from the property and seeing which costs re main and 

which ones disappear without him ." The Trust poi nts to specific statutory la nguage in ad vancing this 

view. It reads the statut e's use of the language "such trust " to refer t o the specifi c trust un der 

consideration, its trustee and that tr ustee's duties, rather than to the ge neric trust of § 67(e)'s introductory 

language, that is, a trust o f the ty pe to which § 67(e) is applicable. Under the Trust's construction, th e 

statute requires consideration of whether a particular cost would have been incurred if the trustee had 

never existed. It would ignore, however, how an individual property owner managing the sa me a ssets 

would have acted. For the following reasons, we find the Trust's interpretation unreasonable.” Id. at 154- 

155. 

In rejecting the taxpay er’s “but for” causation test the court rejected the taxpay er’s contention that the 

word "such" in Code § 67(e)(1) refers to "the" trust mentioned in the first clause of Code § 67(e)(1) which 

the taxpayer understands to refer not to the generic trust mentioned in the introductory language of Code 

§ 67(e)(1) but rather to the particular trust at issue. It held that "such trust" is best understood as referring 

to the generi c trust of the statute’s intr oductory la nguage and n ot to the actual trust that incurred the 

expense at issue. The cou rt reasoned that a “but for” test is not evident based on the statute’s “ordinary, 

common meaning” and ha d Congress intended such a test it could have provi ded one in the statute with 

language clearly indicating such a test. 

The court fur ther reasoned that, “the st atute does no t require a su bjective and hypothetical inquiry into 

whether a particular, individual asset owner would have incurred the particular cost at issue. Nothing in 

the statute indicates that Congress intended the test f or the exception to the two-percent floor to give rise 

to factual disputes about whether an individual asset owner (or owners) is insufficiently financially savvy 

or the assets sufficiently large such that he or sh e unquestionably would have sought invest ment advice. 

Instead, the plain meaning of § 67(e)(1)'s second clause excludes from full deduction those costs of a type 

that could be incurred if the propert y were held in dividually rather than in trust. In other words, for the 

trust to avoid the two-percent floor and have advantage of the full deduction, the plain lang uage of the 

statute requires certainty that a particul ar cost "would not have been incurred" if the property were not 


Aquilio 

held in trust. For that reason, the statute demands not a subjective and hy pothetical inquiry, but rather an 

objective determ ination of whether the particular cost is one t hat is peculiar to trusts and one that 

individuals are incapable of incurring. In other words, the statute sets an objective limit on the availability 

of a full deduction and, as the source of that limit, looks to those costs that individual property holders are 

capable of incurring and permitted to deduct from adjusted gross income. For exam ple, the fact that 

investment-advice fees a re subject to the two-percent floor under regulations applicable to individual 

taxpayers proves the fees to be a cost that individu al taxpay ers are capable o f incurring. Investmentadvice 

fees and other costs that individual taxpay ers are capable of incurring are, therefor e, not fully 

deductible p ursuant to § 67(e)(1) wh en incurred by a trust. By contrast, costs that individuals are 

incapable of incurring, like ‘fees paid t o trustees, expenses associated with judicial accountings, and the 

costs of preparing and filing fiduciary income tax returns,’ … are fully deductible.” Id. at 154-155. 

The Second Circuit went even farther than the Federal Circuit in Mellon Bank and the Fourth Circuit in 

Scott in restri cting the deductibility of expenses incur red by a trust under Code § 67 (e)(1). Rather than 

interpreting the statute to permit the de duction of inv estment advisory fees in full which ar e “unique to 

the administration of a trust and not custo marily incurred outside of trusts b y individuals" or expenses 

other than those “commonly incurred by individual taxpayers", the Second Ci rcuit held t hat a trust m ay 

take a full deduction only for those costs that “could not have be en incurred b y an individual property 

owner.” 

The court did not address the t axpayer’s argument that bas ed on the legislat ive history of the s econd 

requirement of Code § 67(e)(1) Congress’ intent in adding the second requirement was to restrict a trust's 

use of pass-through entities to avoid the two-percent of AGI floor and not to limit the deductibility of any 

other administrative costs. It reasoned that the statute’s language was “clear and unambiguous”, thus it 

did not need to address the legislative history argument. However, the court went on to state that even if 

it the statute was not “clear and unam biguous,” the le gislative histor y doesn’t sup port t he taxpay er’s 

interpretation of Code § 67(e)(1). It reasoned that it wasn’ t Congress’ intent that ad ministrative costs 

incurred by a trust ar e not subject to th e two-percent of AG I floor, unless those costs are incurred by a 

pass-through entity subject to the two-percent of AGI floor, such as a partnership, S corporation, common 

trust fund, or nonpublic mutual funds entity, in which the trust has invested. The court stated that if it was 

Congress’ int ent it could have drafted the second requirement of Code § 67(e)(1) more narrowly t o 

express its intent. 

CONCLUSION 

Code § 67(e) provides in relevant part: 

“The adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an 

individual, except that - 



(1) the deductions for costs which are paid or incurre d in connection with the adm inistration of the estate 

or trust and which would not have been incurred if the property were not held in such trust or estate . . . 

shall be treated as allowable in arriving at adjusted gross income.” (emphasis added). 

Accordingly, a trust's costs are fully deductible in determining AGI, rather than subject to the two-percent 

of AGI floor provided b y Code § 67(a) for miscellaneous item ized deductions, if they satisfy Code § 

67(e)(1). A split has developed between the Sixth Circuit on one side and the Second, Fourth, and 

Federal Circuits on the other side over whether invest ment advisory fees incurred by a trust satisfy the 

requirement that they “would not have been incurred if the property were not held in such trust.” 

In O'Neill the Sixth Circ uit ruled that the invest ment advisory fees w ere co sts incurred because the 

property was held in trust, thus deductible in full when deter mining adjusted gross inco me. The court 

reasoned that because a t rustee has a fiduciary duty to m anage trust assets as a "prudent investor,” 

investment advisory fees are "necessary to” the trus t's administration and "caused by ” the fiduciary duty 

of the trustee. The court opined that while indi viduals often incur costs for invest ment advice, "they are 

not required to consult advisors a nd suffer no penal ties or potent ial liability if they act negligentl y for 

themselves.” 

In Mellon Bank the Federal Circuit split from the Sixth Circuit and ruled that the investment advisory fees 

are a miscellaneous itemized deduction subject to the two-percent of AGI floor opining that only those 

trust-related administrative expenses th at are unique to the ad ministration of a trust and not customarily 

incurred outs ide of trusts by in dividuals are fully deductible. I n Scott the Fourth Circuit joined t he 

Federal Circuit in a sim ilarly reasoned decision holdi ng the invest ment advisory fees do not fall within 

Code § 67 (e)(1) as they constitute expenses commonly incurred by individuals as opposed to costs which 

“would not have been incurred if the property were not held in such trust.” 

In William L. Rudkin Testamentary Trust the Second Circuit recentl y ruled t hat the investment advisor y 

fees are a miscellaneous itemized deduction subject to the two-pe rcent of AGI floor reasoning that only 

investment fees incurred by a tr ust that could n ot h ave been incurred if the property were held b y an 

individual are costs which “would not have been incurred if the property were not held in such trust.” 

The Supreme Court i n Knight, Trustee of the William L. Rudkin Testamentary Trust v. Commissioner of 

Internal Revenue, 127 S.Ct. 3005 (2007) has granted certiorari and will review the decision of the Second 

Circuit’s decision to resolve the split am ong the circ uit courts of appeals over whether investment 

advisory fees incurred by a trust should be dedu cted in full to determ ine the trust’s AGI or as a 

miscellaneous item ized deduction, wh ich in the aggreg ate are r educed by 2 percent of adjusted gros s 

income. 

Individuals contemplating forming a trust, whether it be an inter vivos or testamentary trust and trustees 

and those with an i nterest in existing trusts should be aware of the im pending Supreme Court decision 

with regard to Rudkin as it will have a major impact on the tax liability of the trust and thus the corpus of 

the trust. The Court’s decision will impact more than merely the deductibility of investment advisory fees, 

but also a my riad of other expenses incurred by a tr ust. If the Court adopts the reasoning of the Sixth 

Circuit in O’Neill it would open t he door to the deductibility of almost any expense incurred by a trust 


Aquilio 

related to the fiduciary duty of the trus tee. Conve rsely, if the Court agrees with the reasoning of the 

Federal Circuit in Mellon Bank and the Fourth Circuit in Scott it would greatly limit the deductibilit y of 

expenses incurred by a trust, but still leave the prove rbial door open a bit for the deductibility of certain 

trust related expenses tha t an individual might al so incur which are either generally unique to the 

administration of a trust and not cu stomarily incurre d outside of trusts by i ndividuals or are not 

commonly incurred by individuals. However, if the Court goes as far as the Second Circuit i n Rudkin and 

sets the threshold for a trust to deduct e xpenses only if they could not have been incurred if the property 

were held by an indi vidual, then the proverbia l door on the deductibilit y of trust expenses that an 

individual might also have incurred will be shut tight. 

It will be interesting to see how the Court statutorily construes Code § 67 (e)(1). Will the word would be 

interpreted to mean could as in Rudkin? It could, but would that be what Congress intended? Soon the 

Supreme Co urt will rule and we’ ll be out of t he woods. But t hen if Congr ess doesn’ t agree with the 

Court’s interpretation of Code § 67 (e)(1) will it amend the statute once again and possibl y put us back in 

the “woulds”? It could! 

REFERENCES 

Barnhart v. Sigmon Coal Co., Inc., 534 U.S. 438, 151 L. Ed. 2d 908, 122 S. Ct. 941 (2002) 

Brown & Williamson Tobacco Corp. v. FDA, 529 U.S. 120, 146 L. Ed. 2d 121, 120 S. Ct. 1291 (2000) 

Code § 1 

Code § 61 

Code § 62 

Code § 63 

Code § 67 (a), (b), (e)(1) 

Code § 151 

Code § 212 

Freytag v. Comm., 501 U.S. 868, 115 L.Ed. 2d 764, 111 S.Ct. 2631 (1991) 

Harvard College v. Amory, 26 Mass. 446 (Mass. 1830) 

Kawaauhau v. Geiger, 523 U.S. 57, 62, 118 S. Ct. 974, 140 L. Ed. 2d 90 (1998). 

Knight, Trustee of the William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue, 127 

S.Ct. 3005 (2007) 


Mellon Bank, N.A. v. United States, 265 F.3d 1275 (CA-Fed., 2001) 

O'Neill v. Comm., 98 T.C. 227 (1992) 

O'Neill v. Comm., 994 F.2d 302 (CA-6, 1993) 

Reg. § 1.212-1(g), (i) 


Robinson v. Shell Oil Co., 519 U.S. 337, 340, 117 S. Ct. 843, 136 L. Ed. 2d 808 (1997) 

Scott v. U.S., 328 F.3d 132 (CA-4, 2003) 

Scott v. U.S., 186 F. Supp. 2d 664 (E.D. Va., 2002) 

Temp.Treas.Reg. § 1.67-1T(a)(1)(ii) 

Toibb v. Radloff, 501 U.S. 157, 162, 111 S. Ct. 2197, 115 L. Ed. 2d 145 (1991) 

Williams v. Taylor, 529 U.S. 420, 120 S. Ct. 1479, 146 L. Ed. 2d 435 (2000) 

William L. Rudkin Testamentary Trust et al., v. Commissioner of Internal Revenue, 467 F.3d 149 (CA-2, 

2006), cert. granted 127 S.Ct. 3005 (2007) 


THE VIRTUAL OFFICE: CHALLENGES AND 

OPPORTUNITY FOR FACULTY 

Browning, Michelle C. 

National University 

mbrownin@nu.edu 

ABSTRACT 

This paper explores the challenges and opportunities of virtual office space for faculty in a higher 

education setting. The virtual office, also known as a distributed work environment, has the 

potential to fulfill all of the roles of the traditional, onsite/centralized office. With the virtual 

office, employees work off site and in a home office and collaborate, for the most part, 

electronically with occasional to no physical contact with other groups or individuals. 

Opportunities for faculty functioning within the virtual office environment include employee self 

management, increased productivity and collegiality, faculty recruitment, achievement of student 

learning needs, and integration of diversity. Despite the many opportunities and advantages of 

the virtual office, there are key challenges in a virtual office environment for faculty. Among the 

challenges are technological inconsistencies, issues of trust and opportunities for abuse, student 

advisement difficulties, and struggles with the quest to balance work and family life. The fact 

remains that an increasing number of institutions are integrating virtual office hours into faculty 

workload agreements. In this paper, through a review of the literature, a wide range of virtual 

office issues are explored. Recommendations for next steps including the development of trust 

and accreditation guidelines are presented with a focus on enhancing faculty and institutional 

effectiveness within the virtual office setting. 

INTRODUCTION 

Faculty who are able to answer “yes” to the following questions may be ripe candidates for the 

virtual office. Is more than 50% of the required workload accomplished via computer? Is more 

than 25% of faculty time spent on the phone in conversation with students, fellow colleagues, and 

constituents? Is more than 50% of the teaching load in an online course format? The reality is 

that the role of faculty in higher education is shifting to meet the needs of an increasing number 

of online students, and adult learners. 

Twigg and Oblinger (1996) explain that an immense opportunity exists for institutions to 

establish new forms of electronic based collaboration from the student level to the institutional 

level. The most likely future is one that accommodates more options for learners and faculty. 

Working adults are opting entirely for online educational experiences that provide them with the 

education and flexibility they need. Additionally, students in both on site and on ground classes 

have increased expectations related to frequency and timeliness of contact with faculty. There is 

an abundance of literature and research on the pros and cons of online teaching and distant 

learning. There is, however, relatively little research on the more specific element of the virtual 

office space for faculty in higher education. The following review of the literature seeks to 

highlight those aspects of the faculty virtual office that present opportunities and challenges. 


Browning 

Questions for consideration at the institutional level along with recommendations for next steps 

are summarized in the concluding section. 

TERMINOLOGY 

Higher education is overflowing with terminology that often finds its way into our day to day 

conversation without introduction or definition. Porter, Hedegaard, and Straut (1997) explain that 

the virtual campus is where students, faculty and staff learn, instruct and administer in a virtual 

space rather than in brick and mortar buildings. The virtual office fulfills all of the roles of t e 

traditional, centralized office although the employees work, for the most part, at a home office or 

other offsite location and collaborate electronically with occasional to no physical contact with 

other employees. In both the traditional and virtual office, the organization’s mission remains the 

same, but some business procedures change in the latter to accommodate collaboration at a 

distance. Telecommuting involves communicating, collaborating, and working while 

geographically separated from the central office via electronic devices such as e-mail, faxes, 

videoconferencing, or modems. Telecommuting is more relevant to periodic remote employment, 

where the employee spends the majority of the required work time in a central office. Distance 

learning is defined as that educational process that occurs when instruction is delivered to 

students physically remote from the main campus. Distributed learning is not just a new term to 

replace distance learning. Distributed learning is an instructional model that allows instructors, 

students, and content to be located in different, non-centralized locations so that instruction and 

learning occur independent of time and place. The distributed learning model can be used in 

combination with traditional classroom-based courses, with tradition distance learning courses, or 

it can be used to create wholly virtual classrooms. As we continue through the 21 st century, 

institutions of higher education cannot rely solely on traditional methods, approaches, and onsite 

faculty office space. What, then, are the opportunities and challenges associated with the virtual 

faculty office? 

OPPORTUNITIES 

Self-Management with Guidance: Management is defined by businessdictionary.com (2007) as 

the organization and coordination of the activities of an enterprise in accordance with certain 

policies and achievement of clearly defined objectives. Faculty members who function within the 

virtual office setting ideally manage their work by achieving clearly defined objectives but 

without the micro management that often occurs within the traditional office setting. 

Additionally, the virtual office setting allows for increased opportunities of uninterrupted time in 

which faculty may more fully develop ideas, conduct research, and engage in online dialogue. 

Nonetheless, self-managed faculty members do not function without guidance. Faculty guidance 

may be accomplished through daily online contact via e-mail or as scheduled within the virtual 

meeting format. Further evidence of the importance of self managed work is discussed by Trunk 

(2006). Trunk asserts that workers will continue quit regular jobs to gain more control over their 

time because quality of life in general increases when individuals have a work life that they can 

control. 

Productivity: According to Bergman (2004) of the United States Census Bureau, 4.2 million 

people worked at home in 2000, up from 3.4 million in 1990. There is no doubt that 

telecommuting is becoming more widely accepted in the U.S. and worldwide. Although little 

data exists as to the number of institutions of higher education involved in virtual office spaces 

for faculty, there are significant savings associated with the option. With declining budgets and 

increasing enrollment in higher education, there is a continual push to find ways to get more 

scholar for the dollar. Demands for increased levels of faculty productivity continue to be heard 

with greater frequency than anytime in the past. Additionally, institutions need to find new ways 

to accomplish their missions while competing with other institutions for a limited pool of funds. 


Along with the focus on productivity is greater emphasis on the bottom line. Facilities cost 

money to configure and maintain and may be difficult to evolve or scale as the institution 

evolves. A home office makes it easy to get to work, meaning more work may be done over a 

day since employees can readily access their computing environment. The virtual office space 

enables the office to be readily available nearly anywhere the faculty member travels. In 

addition, the stress and cost associated with the commute are eliminated. One of the key savings 

to faculty is in the form of decreased travel and gasoline expenses. With the high costs of fuel, 

such savings represent a major portion of the family budget. The savings at the institutional level 

would ideally be passed on the student in the form of limited increases in tuition and fees. 

Collegiality: Collegiality can be defined as respect for one’s colleagues and for their professional 

endeavors (Kouchokos, 2002). The American Association of University Professors (1999) 

describes collegiality as collaboration and constructive cooperation but not as a distinct capacity 

to be assessed independently of scholarship, teaching, and service. There are countless 

opportunities for collaboration and constructive cooperation within the virtual office environment 

with limited barriers for communication across the globe. This is not always the case within the 

onsite office where fellow faculty members and students are often in different buildings, or 

campuses, and thus too far away for the ease of face-to-face communications. Within the virtual 

office, faculty may communicate via e-mail, group or individual online chats, and interact in 

virtual meeting rooms, common within the virtual office setting. Increased interaction brings 

added opportunities for faculty to support one another toward enhanced collegiality. 

An additional component of collegiality is highlighted by Neal (1996) in his statement to new 

faculty. Neal encourages faculty members to involve students in collegial relationships in ways 

that bring them into the intellectual community as research partners. Neal asserts that collegiality 

is a rare but precious commodity among faculty who are committed to the world of ideas and who 

are involved in the creative sharing and exchange of information. The virtual office space 

enables this type of information sharing to be possible where faculty, students, and graduates 

collaborate without physical barriers. 

Human Resources: Recruiting a qualified diverse group of faculty may be easier to accomplish 

when the expectations placed on faculty do no include onsite office hours. Faculty may be more 

likely to consider working for an institution located out of state or in another country when the 

expectations do not include physical relocation. Faculty training and orientation is yet another 

key aspect for human resource professionals seeking to recruit and retain qualified faculty. In a 

centralized office, training is usually accomplished by bringing a group of new faculty members 

to an on campus meeting place. Videoconferencing provides a reasonable alternative for training 

faculty who work in a virtual office setting. As with any employee, the needs of the family 

members are paramount. Unfortunately, far too many faculty leave institutions after years of 

dedicated service due to personal and family circumstances and the need to relocate away from 

the geographic proximity of the institution. This creates higher faculty turnover rates and 

associated costs. Ultimately the institution thrives when a more diverse group of faculty are 

recruited, oriented, and retained. 

Student Learning Needs: Faculty can promote student-faculty contact within the virtual office 

environment by building communication mechanisms into the course and by encouraging 

students to make frequent visits to the virtual office. Such practices ultimately lead to enhanced 

student learning. Chickering and Gamson (1999) discuss the seven principles for good practice in 

undergraduate education. Faculty members who function within a virtual office environment have 

ample opportunities through e-mail, phone calls, online group discussions and videoconferencing 

Virtual Office 


Browning 

to fully realize each of the following seven principles. Good practice encourages student-faculty 

contact; Good practice encourages cooperation among students; Good practice encourages active 

learning; Good practice gives prompt feedback; God practice emphasizes time on task; Good 

practice communicates high expectations and; Good practice respects diverse talents and ways of 

leaning. These seven principles can serve as guideposts to ensure that undergraduate and 

graduate level faculty functioning within a virtual office environment meet student learning 

needs. 

Related to the seven principles of good practice is Colvin’s work (1998). Colvin recognizes 

interaction as an integral part of learning and suggests that faculty maximize their interactions 

with learners to help facilitate learning. With the virtual office, faculty no longer have to rely on 

face-to-face interaction with students. A cooperative learning environment is one where learners 

work together in pairs or groups to achieve a learning outcome or objective. According to 

Hatfield and Hatfield (1995), there are benefits to learners engaged in cooperative learning. 

Faculty can create cooperative learning communities by promoting virtual student teams which 

can be facilitated and monitored by faculty within their virtual office space. 

The Embrace of Diversity: Ehrmann (1999) explains that technologies such as e-mail and phone 

conferencing make it possible to draw together more diverse students and faculty. Ehrmann 

further asserts that many feel protected by the facelessness. For example, faculty and students 

who are physically challenged and unable to walk long distances to the on campus office space 

may seek great comfort in the virtual office space. Also, with the wide range of religions and 

days of worship in today’s society, the virtual office enables individuals to honor their spiritual 

obligations without missing days from the physical workplace. One of the keys to respecting 

diversity is in understanding. By engaging in dialogue before seeing, individuals are less likely to 

make assumptions based on physical appearance. Race, gender, age, and other ways in which we 

are physically different should be celebrated but are less likely to create barriers within the virtual 

office setting. In the virtual office setting, there is an increased opportunity to focus on character 

through dialogue. Such a focus paves the way for understanding, thereby making room for the 

embrace of diversity including diverse beliefs and ways of life. 

CHALLENGES 

Technology: In the virtual office, the majority of faculty members utilize their own equipment. 

To meet the rapid growth of technology, an increasing number of institutions issue lap top 

computers, headsets, microphones and web cameras to faculty members as a resource for online 

teaching and offsite work. Yet, every faculty member bears some responsibility for set up, 

maintenance, and internet connection. Additional challenges arise for faculty members in rural 

areas or limited internet connectivity. These inconsistencies diminish predictability and 

dependability needed for quality faculty student interactions. The wide range of technological 

challenges is present for faculty functioning within the traditional on-site office setting as well as 

the home office setting. As such, the majority of institutions allocate substantial resources for 

yearly improvements in technology. 

Opportunity for abuse: Are faculty really working 100% when distracted by TV, family, perfect 

weather and the like? Although abuses can happen in onsite workplaces as well, it may be less 

common with management’s close presence. The issue here is trust. Institutions must hire 

faculty members they can trust and, as pointed out by Tschannen-Moran (2001), trust is crucial in 

facilitating cooperation. A review of the literature on trust (Tschannen-Moran & Hoy, 1998) led 

to the identification of a host of different definitions. Most definitions are based on common 

beliefs that individuals or groups would act in ways that were in the best interest of the concerned 

party. In addition to reducing instances of abuse, an added benefit of trust is employee job 


satisfaction and productivity. Policies and procedures are needed to insure that faculty members 

are available in their virtual office space during business hours or leave appropriate messages to 

inform students and colleagues when they will return. Monitoring machine activity and usage is a 

common practice in many institutions. Such practices are unpopular and require monitoring 

computers which may also contain employee personal correspondence. Faculty need to know 

what is expected of them, what the guidelines are, and need periodic feedback. Ultimately, one of 

the most effective ways to reduce or eliminate abuse is to develop a culture of mutual trust. 

Student Advisement: While academic advisement need not be face-to-face to be effective, faculty 

functioning in the virtual office environment must communicate clearly and frequently with 

students to ensure that goals and expectations are met. Faculty advisors within the virtual office 

setting may have to take on new roles and be prepared to discuss or provide referrals for non 

academic related matters (Porter, Hedegaard and Straut, 1997). Communication is an essential 

element within the advisement process. Students enrolled in online classes have come to expect 

online interaction with faculty members. However, students enrolled in onsite classes may have 

the expectation that advisement, like instruction will take place in a face-to-face modality. Many 

feel that communication sparked by proximity is at least sometimes very useful if not necessary. 

Consistent student advisement processes and protocol will need to be developed to aid faculty 

members functioning in the virtual office setting. Developing shared tasks, asking frequent openended 

questions to stimulate e-mail dialogue, and sending student status reports will aid in 

opening and maintaining lines of communication within the student advisement process. 

Employee work environment: Not all faculty members are cut out to work in a virtual office. 

Faculty must have self discipline and be self motivated. Creating policies to support a sense of 

community and sharing in higher education is one of the more troubling institutional challenges 

(Ehrmann, 1999). Working from home day after day is not the same as occasional 

telecommuting. There is also the aspect of family members having the faculty member around 

the house all day and night, constantly typing away on the computer or talking to students and 

colleagues over the phone. The American Association of University Professors (2004) explains 

that the work of faculty members is virtually unbounded. They highlight the fact that faculty 

members, like anyone else, should not be defined entirely by their professional pursuits. Rather, 

they are members of families with obligations to care for and devote time to their loved ones. 

Making choices toward the achievement of balance between work and personal life is an essential 

component for faculty members opting for the virtual office workplace. 

CONCLUSION AND RECOMMENDATIONS 

In addition to opportunities and challenges for faculty, this review of the literature yielded several 

questions for institutions to consider. How can effective communication between students, 

faculty and fellow colleagues be maintained within the virtual office setting? What are the 

critical elements within supervisory and management systems to ensure success within the virtual 

office setting? What do the accrediting agencies say about the virtual office place for faculty? 

To meet the needs and lifestyles of learners, higher education must be delivered in a timely 

manner and at the convenience of the consumer. Higher education must compete in the 

nontraditional environment if it is to survive (Twigg, 1995). This includes meeting the needs of 

an increasingly diverse pool of faculty. Those believing in the responsiveness of the higher 

educational system suggest that change will be incremental. 

If faculty members do not routinely see students and colleagues physically in the virtual office, 

they still must maintain comparably effective communications. Several obvious surrogate media 

have emerged from the literature. Email, shared file systems, and the web are mainstays. While 



Browning 

email and document exchange work well for communications, they require composition and 

thought yet do not require immediate feedback. Also, these media can be broadcast to an entire 

group of students or colleagues as easily as one. Voice mail provides a second effective delayed 

communication technology. Similarly, fax provides an immediate means of moving physical 

documents and overnight delivery service does the same for larger documents such as text books. 

Scanners can convert documents from physical to electronic form. The phone is used less than 

one might suppose since it is often perceived as intrusive. Many faculty members have voice 

mail systems which, like e-mail, must be checked and answered daily to ensure that student and 

colleague needs are met. Overall, there are many resources to enhance communications for the 

faculty members opting for the virtual office setting. 

The issue of trust appears time and time again throughout the literature on distance learning, 

distributive learning, and virtual offices. Trust is an essential element between employees and 

faculty at all levels of the institution (Virtual Office International, 2007). A recommended 

guideline for institutions seeking to develop policies for faculty within the virtual office setting is 

the integration of the five facets of trust as detailed by Tschannon-Moran and Hoy (2001). The 

five facets are benevolence, reliability, competence, honesty, and openness. Each one has far 

reaching applications for those involved in the virtual office environment. Benevolence is 

confidence that one’s well being or something one cares about will be protected and not harmed 

by the trusted party. Reliability at its most basic level has to do with predictability, consistency 

of behavior and knowing what to expect from others. Competence is the ability to perform as 

expected and according to standards. Honesty is the person’s character, integrity and 

authenticity. And finally, openness is the extent to which relevant information is shared. With 

the many opportunities for effectiveness in the virtual office setting, and with trust as a guidepost, 

higher levels of success may be achieved. 

The Western Association for Schools and Colleges (WASC) offers limited guidelines for 

technology-mediated instruction but nothing specific regarding the virtual office space for 

faculty. The WASC policy for on and off campus programs offered via distance learning 

modalities requires that all degree programs in which 50 percent or more of the program by any 

means – satellite, video, internet, or any other kind of technology-mediated modality – be 

submitted to the Substantive Change Committee for approval (WASC, 2001). One of the key 

components of accreditation is to ensure that student learning outcomes are clearly defined and 

appropriately met. To what extent should the virtual office place for faculty fall under guidelines 

of accrediting agencies? What is the appropriate role of the institution and who will determine 

which faculty members receive approval for functioning entirely within a virtual office setting? 

The use of distributed resources within higher education is expanding daily and enhanced by 

human creativity. No one institution can do all the research it needs by itself. It makes sense for 

different institutions to focus on different research problems and share data openly and freely. 

Accrediting agencies can facilitate this kind of sharing and help inform a larger public on 

institutional best practices (Ehrmann, 1999). Collaborative involvement at all levels of the 

institution are needed including faculty, administration, students, and accrediting agencies toward 

the development of institutional virtual office policies and procedures to guide faculty members 

and ensure institutional success within the virtual office setting. 

REFERENCES 

American Association of University Professors. 2004. Balancing Family and Academic 

Work. Issues in Higher Education. 


American Association of University Professors. 1999. Committee on Academic Freedom and 

Tenure. 

Bergman, M. 2004. Information on home workers. U.S. Census Bureau Press Release. 

Businessdictonary.com. 2007. 

Chickering, A.W., Gamson, Z.F. 1999. Development and adaptations of the seven principles for 

good practice in undergraduate education. New Directions for Teaching and Learning. (Winter 

(80), 75-81. 

Colvin, A.V. 1998. Learning is not a spectator spor t: Strategies f or teacher- student interaction. 

Journal of Physical Education, Recreation & Dance, 16(3), 61-63. 

Ehrmann, S. 1999. Technology’s grand challenges in academe. Bulletin of the American 

Association of University Professors. Sept. pp 42-46. 

Hatfield, S., Hatfield, T. 1995. Cooperative learning communities. In S. Hartfield (Ed.), 

Improving undergraduate education: The seven principles in action. Bolton, MA: Anker Press. 

Karoly, L.A., Panis, C.W.A. 2004. The 21 st century at work: forces shaping the future workforce 

in the United States. Santa Monica, CA: RAND Corporation. 

Kouchoukos, N.. 2002. What is happening to collegiality? The Cardio Thoracic Surgery 

Network. 

Neal, H.A. 1996. Innovation, collegiality and creativity. New Faculty Orientation. University of 

Michigan. 

Porter, J.H., Hedegaard, T., Straut, T.T. 1997. Administrative systems in the virtual university: 

best practices. Presented at the CAUSE Annual Conference. 

Roussean, D., Sitkion, S.B., Burt, R.R., Cammerer, C. 1998. Not so different after all: a crossdiscipline 

view of trust. The Academy of Management Review, 23(3) 393-404. 

Rotter, J.B. 1967. A new scale for the measurement of interpersonal trust. Journal of Personality, 

35, 651-665. 

Tschannan-Moran, M. 2001. Collaboration and the need for trust. Journal of Educational 

Administration, 39, 308-331. 

Tschannan-Moran, M., Hoy, W.K. 1998. A conceptual amd empirical analysis of trust in school. 

Journal of Educational Administration, 36, 334-352. 

Trunk, P. 2006. Virtual office is what you make it. The Boston Globe. October 2006. 

Twigg, C., Oblinger, D.G. 1996. A Report from a Joint Educon/IBM Roundtable. Washington 

D.C. November 5-6. 



Browning 

VirtualOfficeInternational.com. 2007. How to run a successful virtual office: Some Important 

Tips. 

WASC. 2001. Handbook of Accreditation. Western Association of Schools and Colleges. 


The Information Content of 

Quarterly Earnings Announcements: 

A Test of Market Efficiency 

Dhareshwar, Priya, R. 

Virginia Commonwealth University 

dhareshwarpr@vcu.edu 

Bacon, Frank 

Longwood University 

baconfw@longwood.edu 

ABSTRACT 

The purpose of this study was to test for the existence of the post earnings announcement 

drift (PEAD) in the case of positive earnings surprise and negative earnings surprise stocks for at 

least 30 days after the earnings announcement. Numerous past studies suggest that 

there is a tendency for stocks to earn above average abnormal returns in the three quarters 

subsequent to positive earnings surprises, and, more strongly, to earn below average abnormal 

returns in the three quarters subsequent to negative earnings surprises Thus PEAD contradicts 

market efficiency theory which states that a company’s stock price is not based on past prices and 

information. PEAD is one of the most robust anomalies in asset pricing literature. This study also 

examines the information content of quarterly earnings announcement by establishing a 

correlation between the observed change in market value of the company and the information 

about quarterly earnings. 

INTRODUCTION 

Post earnings announcement drift (PEAD), also known as earnings momentum, is the 

tendency for stocks to earn above average abnormal returns in the three quarters subsequent to 

positive earnings surprises, and, more strongly, to earn below average abnormal returns in the 

three quarters subsequent to negative earnings surprises. PEAD is one of the most robust 

anomalies in asset pricing literature. Early studies try to interpret PEAD in the context of efficient 

market theories, Ball and Brown (1968), Joy, Litzenberger and McEnally (1977). PEAD appears 

to represent a form of mispricing and the accumulated evidence is inconsistent with the traditional 

view that stock prices immediately reflect all publicly available information suggesting that 

capital markets are semi-strong form efficient. 

Recent research on behavioral finance attribute the cause of PEAD to investor under 

reaction to earnings news (Bernard and Thomas 1989, 1990; Barberis, Shleifer and Vishny 1998, 

and Daniel, Hirshleifer and Subramanian 1998). Recent work by Chan, Jegadeesh and 

Lakonishok (1996) also relate the evidence of momentum in stock prices to the evidence on the 

market’s under reaction to earnings-related information. For instance, Latane and Jones (1978), 

Bernard and Thomas (1989), and Bernard, Thomas and Wahlen (1995), among others, find that 

firms reporting unexpectedly high earnings consistently outperform firms reporting unexpectedly 


Dhareshwar and Bacon 

poor earnings so there is ‘momentum’ in stock prices. Investment strategies that exploit such 

momentum, by buying past winners and selling past losers, predate the scientific evidence and 

have been implemented by many professional investors. Liang (2003) hypothesizes that the 

predictable stock price drifts increase with 1) divergence in analyst’s beliefs 2) the reliability of 

publicly reported quarterly earnings. 

According to Fama (1970), market efficiency can take on three forms: weak form, semistrong 

form, and strong form efficiency. According to the efficient market hypothesis, the stock 

market should immediately respond to public announcements of quarterly earnings making it 

impossible for an investor to “beat the market” or to make an above normal return on their 

investment by acting on such information. This study investigates whether an investor can 

achieve an above normal return by capitalizing on public announcements of quarterly earnings. 

The study tests the efficient market hypothesis by assessing the investor’s ability to earn an above 

normal return in the short run by acting on earnings announcement news. 

BACKGROUND AND PURPOSE 

The purpose of this event study is to test market efficiency theory by analyzing the 

impact of a sample of 90 quartely earnings announcements on the firms’ stock price using the 

standard risk adjusted event study methodology. Specifically, how fast does the market price of 

the firms’ stock react to the sample of quarterly earnings announcements examined? This 

research also tests whether quarterly earnings announcements directly incorporate the strong 

form, semi-strong form, or weak form of the efficient market hypothesis based on the timing of 

the announcements and the modifications in stock price that occur. 

LITERATURE REVIEW 

Fama (1970, 1976) defined market efficiency in three forms: weak-form, semi-strongform 

and strong-form. Weak-form efficiency deals with the notion that no investor can earn an 

above normal, economic return by developing trading rules based on past price or return 

information. Numerous studies (Fama, 1965; Alexander, 1961; Fama and Blume, 1966; Granger 

and Morgenstern, 1970) support the random walk theory in support of weak form efficiency. If 

the market is weak form efficient, then stock price reacts so fast to all past information that no 

investor can earn an above normal return (i.e. higher than the market or the return on the S&P 

1500 index) by acting on this type of information. 

Semi-strong-form market efficiency states that no investor can earn an above normal, 

economic return based on any publicly available information. Tests of semi-strong form 

efficiency (Fama, Fisher, Jensen, and Roll, 1969; Ball and Brown, 1968; Aharony and Swary, 

1980; Joy, Litzenberger, and McEnally, 1977; Watts, 1978; Patell and Wolfson, 1979; Scholes, 

1972; Kraus and Stoll, 1972; Mikkelson and Partch, 1985; Dann, Mayers, and Raab, 1977) 

document the claim that no investor can earn an above normal return on publicly available 

information such as accounting statements, stock split announcements, dividend announcements, 

sale of stock announcements, repurchase of stock announcements, block trades, and earnings 

announcements. 

Strong-form efficiency theory suggests that no investor can earn an above normal, 

economic return using any information, public or private. Studies on the validity of strong form 

efficiency offer mixed results (Jaffe, 1974; Finnerty, 1976; Givoly and Palmon, 1985; Friend, 

Blume, and Crockett, 1970; Jensen, 1968). If the market is strong form efficient, then stock 

prices react so fast to all information (public and private) that no investor can earn an above 

normal return (i.e. higher than the market or the return on the S&P 1500 composite index in this 

by acting on this type of information. In this case, the market reacts to an event within the 

confines of the firm when it occurs even before it is publicly announced. For this to occur, 

investors must act on insider information, which is illegal. If an investor is to buy the stock on 


Quarterly Earnings Announcements 

the event of inside information, and still does not make an above normal return, the market is 

strong form efficient. 

“Because information is reflected in prices immediately, investors should only expect to 

obtain a normal rate of return” (Ross, 342). However, does market efficiency hold for public 

announcements of quarterly earnings? Semi-strong form efficiency states that a company’s stock 

price reflects all publicly available information, while strong form efficiency argues that the price 

is a reflection of all information, public and private. While efficient market theories have merit, 

this study confirms the existence of the post earnings announcement drift in the case of positive 

earnings surprise and negative earnings surprise stocks for at least 30 days after the earnings 

announcement. This study also confirms the information content of quarterly earnings 

announcement by establishing a correlation between observed change in market value of the 

company and the information about quarterly earnings. 

METHODOLOGY AND STUDY SAMPLE 

In this study, if earnings disclosures have information content, higher than expected 

quarterly earnings would be associated with increases in the value of the equity and lower than 

expected earnings with decreases. To capture this association each earnings announcement is 

assigned to one of 3 categories: 

1)good news: If actual earnings exceed expected earnings by more than 5% 

2)bad news: If actual earnings fall short of expected earnings by more than 5% 

3)no news:If actual earnings equal expected earnings. 

This study sample includes 30 randomly selected quaterly earnings announcements in each 

category between the time period February 1, 2007 and August 1, 2007. The random sample was 

selected from quartely earnings announcements for stocks traded either on the NYSE or 

NASDAQ. The stocks selected are of small, medium and large market capitalization companies. 

Table 1: DESCRIPTION OF STUDY SAMPLE 

Good 

News Good News Companies 

Date: Name Ticker 

market 

cap 

1 5-Feb-07 Telephone and Data Systems TDS 7.66 b 

2 12-Feb-07 Potlatch Corp PCH 1.76 b 

3 26-Feb-07 Abraxis Bioscience ABBI 3.35 b 

4 27-Feb-07 Astek Industries ASTE 1.14 b 

5 5-Mar-07 Maidenform Brands MFB 393.53 m 

6 12-Mar-07 Take-Two Interactive Software TTWO 1.08 b 

7 22-Mar-07 General Mills Inc. GIS 18.46 b 

8 30-Mar-07 Global Payments Inc. GPN 3.20 b 

9 4-Apr-07 Immucor Inc BLUD 2.31 b 



10 11-Apr-07 Genetec Inc DNA 78.78 b 

11 16-Apr-07 Adtran Inc. ADTN 1.83 b 

12 24-Apr-07 AT&T Inc. T 243.17 b 

13 30-Apr-07 Tyson Foods Inc. TSN 7.70 b 

14 2-May-07 Symantec Corp. SYMC 16.60 b 

15 8-May-07 

16-May- 

Walt Disney Company DIS 65.22 b 

16 07 

21-May- 

First Service Corp. FSRV 962 m 

17 07 

24-May- 

Calgon Carbon Inc. CCC 539.38 m 

18 07 

31-May- 

Barnes & Nobles Inc. BKS 2.37 b 

19 07 Dell, Inc. DELL 63.11 b 

20 4-Jun-07 Bob Evans Farms Inc. BOBE 1.15 b 

21 

Integrated Silicon Solutions 

5-Jun-07 Inc. ISSI 236.72 m 

22 11-Jun-07 MFRI Inc. MFRI 121.05 m 

23 20-Jun-07 Morgan Stanley MS 71.18 b 

24 28-Jun-07 Rite Aid Corp. RAD 3.51 b 

25 9-Jul-07 Schnitzer Steel 

J P Morgan Chase and 

SCHN 2.21 b 

26 18-Jul-07 Company JPM 150.65 b 

27 26-Jul-07 Cummins Corp. CMI 12.32 b 

28 27-Jul-07 Transalta Corp. TAC 5.74 b 

29 31-Jul-07 General motors Corp GM 17.39 b 

30 1-Aug-07 Garmin Ltd. GRMN 22.06 b 

Bad News Bad News Companies 

Date: Name Ticker 

1 5-Feb-07 ESCO Technologies Inc. ESE 

2 12-Feb-07 Micrus Endovascular Inc. MEND 

Market 

Cap 

805.03 

m 

283.77 

m 


3 27-Feb-07 Ambassadors Intl. Inc. AMIE 

4 5-Mar-07 Akorn Inc AKRX 

5 16-Mar-07 Wheeling Pittsburg Corp. WPSC 

6 22-Mar-07 Georgia Gulf Company GGC 

7 3-Apr-07 Oxford Industries Inc. OXM 


272.64 

m 

652.53 

m 

293.20 

m 

510.09 

m 

670.09 

m 

8 12-Apr-07 Cascade Bancorp CACB 682.4 m 

236.24 

9 16-Apr-07 Citigroup Inc C b 

10 17-Apr-07 Yahoo Inc. YHOO 34.99 b 

11 19-Apr-07 Capital One Financial Corp. COF 28.83 b 

12 24-Apr-07 Graco Inc. 

Pinnacle West Capital 

GGG 2.51 b 

13 25-Apr-07 Corp. PNW 4.02 b 

815.54 

14 27-Apr-07 Titan Intl Inc. TWI m 

15 1-May-07 Pilgrims Pride Corp PPC 2.31 b 

16 3-May-07 MGM Mirage MGM 24.39 b 

17 4-May-07 Weyerhauser Corp 

Dobson Communications 

WY 15.64 b 

18 7-May-07 Inc. DCEL 2.19 b 

19 8-May-07 El Paso Corp. EP 12.08 b 

20 16-May-07 Macy's Inc. M 14.36 b 

21 21-May-07 Apollo Group Inc. APOL 10.18 b 

22 31-May-07 Activision Inc. ATVI 6.33 b 

23 7-Jun-07 Forest City Enterprises FCE-A 5.78 b 

24 19-Jun-07 Best Buy Co. Inc. BBY 22.24 b 

25 26-Jun-07 Lennar Corp. 

Marvell Tecnology group 

LEN 3.73 b 

26 2-Jul-07 Ltd. MRVL 9.73 b 

27 12-Jul-07 Progressive Group PGR 14.12 b 



28 20-Jul-07 Caterpillar Inc. CAT 50.52 b 

29 23-Jul-07 Lifepoint Hospital Inc. LPNT 1.73 b 

30 1-Aug-07 

LandAmerica Financial 

Group Inc. LFG 

No News No News companies 

Date Name Ticker 

695.08 

m 

Market 

Cap 

1 5-Feb-07 PMI Group PMI 2.77 b 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

12 

13 

14 

15 

14-Feb- 

07 

Penn Virginia Resource 

Partners PVR 1.30 b 

16-Mar- 

07 Vector Group Ltd. VGR 1.33 b 

28-Mar- 

07 Sonic Corporation SONC 1.41 b 

29-Mar- Worthington 

07 

Industries,Inc. WOR 1.84 b 

5-Apr-07 

18-Apr- 

RPM international Inc. RPM 2.81 b 

07 

23-Apr- 

Motorola Inc. MOT 39.86 b 

07 

25-Apr- 

Boston Scientific Corp. BSX 19.60 b 

07 

26-Apr- 

Colgate Palmolive Co. CL 33.63 b 

07 Dow Chemicals DOW 40.67b 

3-May- 

293.57 

07 

7-May- 

Midas Inc. MDS m 

07 Pride International inc. PDE 6.11 b 

15-May- 

178.97 

07 

22-May- 

Walmart Stores WMT b 

07 

31-May- 

Dycom Industries DY 1.32b 

07 H J Heinz Co. HNZ 14.43 b 

16 5-Jun-06 Ryan Air Holdings Plc. RYAAY 13.86 b 

17 8-Jun-07 

14-Jun- 

Vail resorts Inc MTN 2.22b 

18 07 

19-Jun- 

Del Monte Foods Inc. DLM 2.08 b 

19 07 Progress Software Corp PRGS 1.34 b 


20 

21 

20-Jun- 

07 

26-Jun- 

Carmax Inc. KMX 5.10 b 

07 H B Fueller Co. FUL 1.81 b 

22 11-Jul-07 Wolverine Worldwide Inc. WWW 1.41 b 

122.13 

23 17-Jul-07 Wells Fargo and Co. WFC b 

630.45 

24 19-Jul-07 Media General Inc. MEG m 

25 23-Jul-07 W R Berkley corp. BER 5.67 b 

26 24-Jul-07 Western Union Co. WU 15.28 b 

27 26-Jul-07 BorgWarner Inc. BWA 4.88 b 

28 27-Jul-07 Ingersoll Rand Co. Ltd. IR 14.89 b 

29 30-Jul-07 

Verizon Communications 

Inc VZ 


124.32 

b 

30 1-Aug-07 Dominion Resources Inc. D 30.03 b 

To test weak form market efficiency with respect to public announcements of quarterly 

earnings of companies and to examine the effect of quarterly earnings announcements on stock 

return around the announcement date, this study proposes the following null and alternate 

hypotheses: 

H10: The risk adjusted return of the stock price of the sample of firms announcing quarterly 

earnings is not significantly affected by this type of information on the announcement date. 


earnings is significantly affected by this type of information on the announcement date. 


earnings is not significantly affected by this type of information around the announcement date as 

defined by the event period. 


earnings is significantly affected by this type of information around the announcement date as 

defined by the event period . 

This study uses the standard risk adjusted event study methodology from the finance 

literature. The announcement date (day 0), obtained from http://finance.yahoo.com , is the date of 

the firm’s announcement of its quarterly earnings. The required historical financial data, i.e. the 

stock price and S&P 1500 composite index during the event study period was also obtained from 

the internet website http://finance.yahoo.com. The S&P 1500 composite index is used in this 



study as it is considered to more appropriately representative of market return for the large 

,medium and small market capitalization companies that are part of the study sample. 

1. The historical stock prices of the sample companies for each category, and S&P 1500 

composite index, for the event study duration of -180 to +30 days (with day –30 to day +30 

defined as the event period and day 0 the announcement date) were obtained. 

2. Then, holding period returns of the companies (R) and the corresponding S&P 1500 index 

(Rm) for each day in this study period were calculated using the following formula: 

Current daily return = (current day close price – previous day close price) 

previous day close price 

A regression analysis was performed using the actual daily return of each company (dependent 

variable) and the corresponding S&P 1500 daily return (independent variable) over the pre-event 

period (day –180 to –31 or period prior to the event period of day –30 to day +30) to obtain the 

intercept alpha and the standardized coefficient beta. 

3. For this study, in order to get the normal expected returns, the risk-adjusted method (market 

model) was used. The expected return for each stock, for each day of the event period from 

day -30 to day +30, was calculated as: E(R) = alpha + Beta (Rm), where Rm is the return on 

the market i.e. the S&P 1500 composite index. 

4. Then, the Excess return (ER) was calculated as: 

ER = the Actual Return (R) – Expected Return E(R) 

5. Average Excess Returns (AER) were calculated (for each day from -30 to +30) by averaging 

the excess returns for all the firms for a given day in each category. 

6. AER = Sum of Excess Return for given day / n, 

where n = number of firms is sample i.e. 30 in this case in each category 

7. Also, Cumulative Average Excess Return (CAER) was calculated by adding the AERs for 

each day from -30 to +30. 

8. Graphs of AER and Cumulative AER were plotted for the event period i.e. day -30 to day 

+30 for each category of firms. 

QUANTITATIVE TESTS AND RESULTS 

Did the market react to the announcements of quarterly earnings? Was the information 

surrounding the event significant? A’priori, one would expect there to be a significant difference 

in the Actual Average Daily Returns (Day -30 to Day +30) and the Expected Average Daily 

Returns (Day -30 to Day +30) if the information surrounding the event impounds new, significant 

information on the market price of the firms' stock . If a significant risk adjusted difference is 

observed, then it supports the hypothesis that this type of information did in fact significantly 

either increase or decrease stock price. To statistically test for a difference in the Actual Daily 

Average Returns and the Expected Daily Average Returns for the firms over the time periods day 

-30 to day +30, we conducted a paired sample t-test and found a significant difference at the 5% 

level between actual average daily returns and the risk adjusted expected average daily returns for 

positive earnings surprise or good news category of firms and negative earnings surprise or bad 

news category of firms. The results here support the alternate hypothesis H21: The risk adjusted 

return of the stock price of the sample of firms announcing quarterly earnings is significantly 

affected around the announcement date as defined by the event period. This finding supports the 

significance of the information around the event since the market’s reaction was observed. For 

the no news category of firms, the results of the paired T-test were not significant at the 5% level. 

Another purpose of this analysis was to test the efficiency of the market in reacting to the 

announcement of quarterly earnings announcements for the good news and bad news category of 

firms. Specifically, do we observe weak, semi-strong, or strong form market efficiency as 

defined by Fama, 1970, in the efficient market hypothesis? The key in the analysis is to determine 

if the AER (Average Excess Return) and CAER (Cumulative Average Excess Return) for each 



category of firms are significantly different from zero or that there is a visible graphical or 

statistical relationship between time and either AER or CAER for each category. See AER and 

CAER graphs for the good news and bad news category in Charts 1 through 4 below. 

CHART 1:Good News Stocks: AER over Event period 

AER 

0.025 

0.02 

0.015 

0.01 

0.005 

0 

-0.005 

-0.01 

-0.015 

AER v/s Time 

-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 

CHART 2: Good News Stocks : CAER over event period 

CAER 

0.07 

0.06 

0.05 

0.04 

0.03 

0.02 

0.01 

0 

-0.01 

CAER v/s time 

-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 

time 

CHART 3: Bad News Stocks : AER over Event period 

ASBBS E-Journal, Volume 4, No.1, 2008 28 

time


AER 

0 

-0.02 

-0.03 

-0.04 

-0.05 

AER v/s Time 

-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 

-0.01 

CHART 4: Bad News Stocks : CAER over event period 

CAER 

-1 

-1.5 

-2 

CAER v/s Time 

0 

-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 

-0.5 

The graphs in Charts 1 and 2 demonstrate that the “good news” announcements of 

quarterly earnings had a significant positive impact on the firms’ share price on announcement 

day 0 and up to at least 30 days after announcement day 0. As for the bad news category of firms, 

the announcement of quarterly earnings had a significant negative impact on the firms’ share 

price upto atleast 30 days after the earnings announcement day 0. Thus the post earnings 

announcement drift phenomenon is evident in this sample of firms.The evidence supports the 

alternate hypothesis H11: The risk adjusted return of the stock price of the sample of firms 

announcing quarterly earnings is significantly affected by this type of information on the 

announcement date when made public. This is consistent with the weak form market efficiency 

hypothesis which states that the stock price reflects all past information. For the sample of firms 

analyzed, an investor maybe able to earn an above normal risk adjusted return by acting on the 

public announcement of quarterly earnings using price momentum strategies. As for the no news 

category of firms, no significant impact is observed on or around the quarterly earnings 

announcement day 0 as seen in the graph of CAER for the No News category in chart 6 below. 


time 

CHART 5: No News Stocks : AER over Event period 

time

AER 

AER v/s time 


0.008 

0.006 

0.004 

0.002 

0 

-0.002 -30 

-0.004 

-0.006 

-0.008 

-25 -20 -15 -10 -5 0 5 10 15 20 25 30 

CHART 6: No News Stocks : CAER over event period 

CAER 

-0.02 

-0.025 

-0.03 

-0.035 

CAER v/s Time 

0 

-0.005 -30 

-0.01 

-0.015 

-25 -20 -15 -10 -5 0 5 10 15 20 25 30 

Tests of correlation between time (the event period) and Cumulative Average Excess 

Return (CAER) reveal a strong positive correlation between time and CAER for the good news 

category of firms, a strong negative correlation between time and CAER for the bad news 

category of firms and a weak negative correlation between time and CAER for the no news 

category of firms. 

CONCLUSION: 

This study tested the effect of quarterly earnings announcements on the stock price’s risk 

adjusted rate of return for a randomly selected sample of 90 firms, 30 in each of 3 categories 

(good news, bad news, and no news), from the time period February 1, 2007 to August 1, 2007. 

These stocks were of small, medium, and large market capitalization companies and traded on the 

NYSE or NASDAQ. Using standard risk adjusted event study methodology with the market 

model, the study analyzed 37,980 recent observations on the 90 publicly traded firms and the 

S&P 1500 composite market index. Appropriate statistical tests for significance were conducted. 

Results show a significant positive market reaction up to at least 30 days after the firms’ 

announcement of positive surprise quarterly earnings for the good news sample of firms and a 

siginificant negative market reaction up to at least 30 days after the firms’ announcement of 

negative surprise quarterly earnings for the bad news sample of firms. Findings also support 

efficient market theory at the weak form level as documented by Fama (1970). This study thus 


time 

Time


shows the existence of the post earnings announcement drift, one of the most puzzling anamolies 

in asset pricing literature. 

For the no news control sample of firms whose quarterly earnings announcements exactly 

met expectations, no significant impact on the firms' stock price was observed on or around the 

quarterly earnings announcement day. Higher than expected quarterly earnings are associated 

with increases in the value of the equity, lower than expected earnings with decreases in equity 

value and no significant changes in equity value are associated with earnings as per expectations. 

Results show a clear correlation between observed change in market value of the company and 

the information about quarterly earnings thus providing further confirmation of the information 

content of quarterly earnings disclosures. This study suggests that the market is not semi-strong 

form efficient with respect to surprise quarterly earnings announcements in the short term. 

Results here question the strength of market efficiency and may offer additional evidence in 

support of the behavioral challenge to efficient market theory. 

REFERENCES 

Aharony, J., and I. Swary (1980). “Quarterly Dividend and Earning Announcements and 

Stockholders’ Returns: An Empirical Analysis.” Journal of Finance, March, 1-12. 

Ball, R., and P. Brown (1968). “An Empirical Evaluation of Accounting Income Numbers.” 

Journal of Accounting Research, Autumn, 159-178. 

Bodie, Z., A Kane., and A. Marcus (2007). Essentials of Investing (The McGraw-Hill Irwin 

Series in Finance, 6 th ed.) United States: Mcgraw-Hill Irwin. 

Fama, E. F. (1970). “Efficient Capital Markets: A Review of Theory and Empirical Work.” 

Journal of Finance, Volume 25 (May), 383-417. 

Fama, E. F. (1998). “Market Efficiency, Long-Term Returns, and Behavioral Finance.” Journal 

of Financial Economics, Volume 39, Number 3 (September), 283-306. 

Joy, M., R. Litzenberger, and R. McEnally (1977). “The Adjustment of Stock Prices to 

Announcements of Unanticipated Changes in Quarterly Earnings.” Journal of Accounting 

Research, Autumn, 207-225. 

Watts, R. (1978). “Systematic ‘Abnormal’ Returns after Quarterly Earnings Announcements.” 

Journal of Financial Economics, June/September, 127-150. 

Chan, L, Jegadeesh, N, and Lakonishok, J (1996). “Momentum Strategies.” The Journal of 

Finance, December 1996, 1681-1713. 

MacKinley,A.C.(1997).“Event Studies in Economics and Finance.” Journal of Economic 

Literature,March 1997, 13-39. 

Lihong, L, (2003). “Post Earnings Announcement Drift and Market Participants’ 

Information Processing Biases Processing biases.” Review of Accounting Studies, 

Volume 8, June 2003, 321-345. 

Hirshleifer, David; Myers, James, N.; Myers, Linda, A.; Teoh, Hong, Siew.(2002) “Do 

Individual Investors Drive Post Earnings Announcement Drift?” OSU Finance 

Working Paper, January 2002. 1-49. 


NAMING NAMES: WHICH SCHOOLS ARE 

PUBLISHING IN MANAGEMENT JOURNALS AND 

WHAT DOES IT MEAN? 

ASBBS E-Journal, Volume 4, No.1, 2008 

Fekula, Michael J. “Mick” 

University of South Carolina Aiken 

mickf@usca.edu 

Hornyak, Martin 

University of West Florida 

mhornyak@uwf.edu 

ABSTRACT 

A past study revealed that 10% percent of the schools account for more than 50% of the published 

articles in select management journals, while 50% of the schools account for more than 90% of those 

articles. This study further examines the distribution of publishing for over 600 institutions, 3000 

authors, and 1400 articles in ten different management journals from 2000 through 2004. Schools and 

authors are analyzed by rank and name to determine the degree to which top-tier schools are publishing 

at significantly higher rates in the more prestigious journals. Since journal prestige is determined by 

circulation rates, there is some evidence to propose that the research efforts of authors at lower ranked 

institutions are obscured. Among other issues, this begs the question as to why some teaching institutions 

require that their faculty conduct research which is potentially obscure since it has a low probability of 

publication in journals with high circulation rates. 

INTRODUCTION 

In a descriptive analy sis of the au thorship and affiliation of selec t published articles, previous research 

(Fekula & Horn yak, 2007) has shown that approxima tely 50% of the published articles were accounted 

for by only 10% of the schools, while approximately 50% of the schools accounted for m ore than 90% of 

the articles. This trend seems somewhat steady over time since past research (Fekula & Hornyak, 1996) 

confirmed a correlation between top-ranked schools and publishing frequency. However, the trend that 

seems unsteady is the research and publishing expe ctations of schools that are traditionally known as 

teaching schools. The im plications of this shift are as si mple as “the folly of rewarding A, while hopi ng 

for B” (Kerr, 1995). It is fairly clear that university professors, like any other human beings will do those 

things for w hich the y get rewarded at the expen se of those activities which fail to y ield significan t 

rewards. 

One of the objectives of this stud y is t o provide ev idence to show that the traditional rese arch powerhouses 

continue to dom inate the frequ ency of publishing in top-tier journals. Since the st udy is based 

upon the num bers of published articles, there is no empirical evidence to suggest the actual reasons for 

this phenom enon; howeve r, so me of t he reasons can be inferred. The top-ranked schools have the 

resources to allow lighter teaching loads, as well as fa culty support for research. This translates not only 

into more frequent research, but also higher quality research. At no time is it our intention to suggest that 

journals overlook hi gh quality research if the review ers beli eve it is done by pr ofessors at teaching 

schools. We do not have a co mplaint against the j ournal s ystem and suggest onl y that t he abilit y to 

achieve publication in top journals rests in the resour ces and time made available by the university. The 

likelihood of abundant time and resources is higher at traditional resear ch schools. In turn, the likelihood 

32

Fekula and Hornyak 

of qualit y research being published thr ough abundant time and r esources is n ot onl y hi gher, but has a 

greater probability of acceptance into top-tier journals. We also expect that the best researchers would be 

hired by the top institutions, which can afford to offer greater compensation. 

In sum, it is no surprise t hat top schoo ls with abund ant resources have prod uctive faculty who have the 

time, resources, and capabilit y t o generate research that can be published in top-tier journals. The 

evidence in this study and others (Fekula & Hornyak, 2007) bears this out. So, the real issue of concern is 

not what the top schools are doing, but what th e lower-ranked schools are cap able of doing in the 

publishing realm. 

It is not only the rec ent years that have seen a change in faculty performance expectations. Historically, 

faculty members at small institutions have expressed concern about increased publication expectations, 

which impact promotion, tenure, and ultimately retention (Buzza, 1989). In more recent years, faculty 

members have identified an increa se in faculty productivi ty amidst dim inishing financial resources 

(Elmes-Crahall, 1992). Reductions in financial r esources and university -supported publication outlets 

have been ch aracterized as a “near crisis” in pu blishing (Alonso, Davidson, Unsworth & W ithey, 2003). 

Although some suggest that these phenom ena are li mited to the traditional resear ch scho ols, a major 

collegiate report cites increasing demands for research productivity that have had a ripple effect impacting 

even the trad itional teaching institutions wher e publication has taken on increased i mportance over t he 

past 10 years (Modern Language Association, 2007). 

No one would argue that scholarship and research are not good things (Nelson, 2004), but there are tradeoffs 

to be m ade. Some evidence suggests that quant ity is supplanting qualit y. In court, a professor won 

her tenure decision case because the school did not specify in advance that a number of publications were 

required for tenure. She argued that ha d the criteria been quantified, she could have published numerous 

articles from her work instead of just the one top-tier publication that she had managed to achieve (Euben, 

2002). When viewed as a numbers game, excessive demands reduce publications to a highly sought-after 

commodity (Burgan, 2003) and the process of research to the status of a competition (Nelson, 2004). As 

one professor puts it: 

With my teaching load, if I 'm going t o do resear ch and publis h, it' s going to happen in the 

summer. Do you think I' m going to r ead widely and see what strikes me? Of course not! I'm 

going to find the first dozen or so articles and boo ks and write my journal article from them...for 

good or for bad. Is that anti-intellectual? Ther e's n othing i ntellectual about this process. The 

pressure for increased publication has nothi ng to do with increasing hum an knowledge; it' s 

strictly about some weird academic commerce that doesn't even make economic sense! (S haviro, 

2004, para. 4) 

As indicated in the Modern Language Association (MLA) report, publication should not be the reason for 

scholarship; scholarship should be t he reason for publication (Withey , 2007). In addition to the potential 

impact upon scholarship, the ever-increasing dem ands for both teaching and publication (Howard, 2006) 

can distill faculty efforts in all areas. One student concludes that Harvard has much to learn about 

teaching because tenured professors de vote themselves to intensive resear ch (Metrailler, n.d.). Given 

Harvard’s resources, we would expec t the prob lem to be com pounded at universities with fewer 

resources. In the face of excessive demands, new f aculty members might even question whether getting 

tenure is worth the trou ble it takes (Burgan, 20 03), especially when other performance criteria c an 

misdirect faculty behavior. One professor laments the fact that she spent any time at all doing things other 

than publishi ng. E ven aft er buildi ng a highl y acclai med university progra m, she found herself job 

searching. “Like countless other assistant professors be fore me, I walked right into the s ervice trap ” 

(Murphy, 2007, para. 23). 


33

Publishing in Management Journals 

So, the problem is not research productivity, but its implications. Beyond the understanding that research 

activity can hamper teaching effectiveness, there st ill exist issues that plague faculty m embers. Our 

experience is that there appear to be ample outlets in term s of both conferences and journals for the 

presentation and publicati on of our scholarship. So, getting published is not the problem . Although we 

agree with the argu ment that scholarship is critical to effective teaching (Nelson, 2004), we also submit 

that it be r espectable scholarship. As previously stated, the potential exists for publishing to be 

accomplished irrespective of scholarship, which relegates publications to the status of commodities. If we 

accept that only the best scholarship gets published in top-tier journals, then less than the best scholarship 

gets publishe d in lesser known journa ls. This begs the question, what is the objective of publ ishing 

something that does not get read? 

The argument that scholarship is critical to effectiv e teaching rests on effective scholarship. The reviews 

above and t he evidence below suggest that onl y the top schools will consistently publish effective 

scholarship simply because they have the resources to do so. Although it is not the objective of this study 

to prescribe t enure and prom otion policy, it is reasonabl e to conclude that faculty at traditional teaching 

schools should be rewarded for the consu mption of published research, as opposed to the p roduction of 

peer-reviewed publications. The proba bility of great numbers of teaching faculty publishing in journals 

with high circulation rates is low. The remainder of this paper shows the evidence for that. 

METHODOLOGY 

The methodology cited he re is the same as that used in our previous study (Fekula & Horn yak, 2007) 

since the database is the same for both analyses. Portions of the methodology text are taken verbatim from 

the previous study when there is no bet ter way to state the method. Based upon circulation rates, the 10 

journals examined in this study represent thre e di stinct tier s of prestig e a s follow: (a) Ti er 1: 

Administrative Science Quarterly, Academy of Management Journal, and Academy of Management 

Review; (b) Tier 2: Journal of Management, Journal of Applied Behavioral Science, Human Relations, 

and Journal of Management Inquiry; (c) Tier 3: Business and Society, Group and Organization 

Management, and Organization Science. 

The journals cover the five-y ear period from 2000 through 20 04. The top 100 periodic als listed in 

Emerald Management Reviews (2004) were reviewed to first de termine which qualified as scholarly 

journals. Ne xt, journals were selected to ensure th at they represented the fiel d of general manage ment. 

Then journals were chosen based upon the level of prestige determined by the authors’ experience with 

the journals, as well as their knowledge of the views of other professors in the management field. In order 

to collect data in a reasonable amount of time, the journals were also chosen based upon their availability 

in electronic form . The final selection criterion was to ensure that enough j ournals were chosen to 

reasonably represent three possible tiers of prestige. Although various criteria such as acceptance rate, 

numbers and types of reviewers, frequency of publishing, and circulation (Cabell’s, 2001) could be used, 

ultimately the authors ch ose circulatio n rate as th e criteria for tier assignment because t here is l ess 

variance reported for that measure. The chosen journals fell clearly into the three circulation categories to 

yield three tiers. Tier 1 journals ra nge from 10 to 25 thousand copi es circulated, Tier 2 from three to four 

thousand copies, and Tier 3 from one to two thousand copies (Fekula & Hornyak, 2007). 

After the journals wer e chosen the following data w as recorded by reviewing each journal article or its 

tables of contents: journal title, date, volume, author last name and first initial, and the affiliation of each 

author. In some cases, affiliations were unavailable and the researchers searched the internet to determine 

the affiliation of an author. 

The data was then coded and input to a spreadsheet as follows: (a) each journal date and volum e wa s 

given a unique identifier; (b) Each au thor’s name and affiliation were entered; (c) First authors were 

coded as such; (d) Su bsequent authors were coded as such, but only first authors were given a specific 


34


order of authorship. Each school was assigned credit for a journal based upon the affiliation of the author. 

Un-weighted and weighted assignments were made. In the case of un-weighted assignments, each school 

received equal weight according to the number of author s. In the weighted cases, e ach first author was 

given .6 of the credit, while the remaining .4 was distributed equally among the other authors. 

The current stud y used the top 1 20 rated schools an d the 31 5 peer rated U.S. schools as determ ined by 

U.S. News and World Report, “America’s Best Colleges 2005” ( 2005). T he data was analy zed to 

determine the number of schools publ ishing in each t ier, according to school or institution type. Because 

the m ain reference point for our stud y is fam iliar prom otion an d tenure s ystems, the percentages o f 

schools publi shing were calculated as proportions o f U. S. schools onl y. Sim ilarly, an analy sis of the 

percentages of articles published in e ach tier relative to U.S. totals for each school type was calculated. 

Finally, an assessment of the relative publishing fre quency of the top 120 and t he 315 peer-rated school s 

was conducted. The firs t assessment of t his data (Fekula & Hornyak, 2007) revealed a correlation 

between publication frequency and s chool rank ( r=.535, p


dominance in the higher tiers. The higher the tier, the more likely that top schools will account for greater 

proportions of the publishing in those tiers. 

Table 2 

Number of Articles that were Published in each Tier According to the Type of School by Rank/Rating 

in Tier 1 in Tier 2 in Tier 3 

Author‐Articles Published # % # % # % 

From the Top 120 Rated Schools 318 81% 351 72% 136 55% 

From the 315 Peer Rated U.S. Schools 388 99% 478 98% 237 96% 

By All U.S. Schools that published 393 490 247 

By Organizations or Non‐U.S. Schools 93 160 65 

Total Articles Published 

Note 1: % is out of U.S. Total 

486 650 312 

Note 2: 3086 different authors are represented across all 3 Tiers 

Note 3: 1448 distinct articles are published across all 3 Tiers 

Table 3 examines the c umulative pe rcentage of articles published in each tier according to fine r 

gradations of rank and peer ratings. For example, there are 21 schools ranked in the top 25 that published 

in Tier 1, w hich account for 26 .1% of the articles published by all U.S. s chools. This sam e group 

accounts for 26.5% of all Tier 1 articles published among the 315 peer-rated schools and 32.3% of all Tier 

1 articles published b y the 86 schools ranked am ong the top 120 U.S. schools. The Tier 1 portion of the 

table generally indicates that the highest of the t op-ranked schools account for proportionally more of the 

publishing, as indicated b y the cum ulative totals. Relatively similar results are borne out in the peer 

rating portio n of the Tier 1 results. The higher the p eer rating, the higher the relative percentage o f 

publishing that is done in Tier 1. For example, 35% (62 school s) account fo r 65% of the publishing, 

while 67% (115 schools) account for 86% of the publishe d articles. In this case, the additional 53 schools 

account for only an additional 21% of the articles. 

Table 3 

The Cumulative Percentage of Articles by Category of School Type in each Tier 

that were Published by various Rank/Rating Categories and Number of Schools 


36


Cumulative % of Tier 1 Articles 

Top 120 Rank # Schools of Top 120 of 315 Peer of all U.S. Schools of all 

1‐25 21 32.3 26.5 26.1 21.1 

1‐50 37 61.6 50.5 49.9 40.3 

1‐75 60 86 70.6 69.7 56.3 

1‐120 86 100 82 81 65.5 

Peer Rating 

4.0‐4.9 29 36.9 36.4 29.5 

3.5‐4.9 62 65.8 65 52.5 

3.0‐4.9 115 87.2 86.1 69.6 

2.0‐4.9 173 100 98.6 79.7 



1‐25 23 32.5 23.8 23.3 17.5 

1‐50 45 55 40.4 39.4 29.7 

1‐75 68 84 61.7 60.2 45.4 

1‐120 102 100 73.6 71.8 54.1 

Peer Rating 

4.0‐4.9 33 28.8 28 21.1 

3.5‐4.9 71 54 52.7 39.7 

3.0‐4.9 132 78.8 76.9 57.9 

2.0‐4.9 219 100 97.5 73.5 



1‐25 16 24.1 13.8 13.3 10.5 

1‐50 31 53.3 30.6 29.4 23.2 

1‐75 53 77.1 44.3 42.5 33.6 

1‐120 81 100 57.5 55.2 43.7 

Peer Rating 

4.0‐4.9 27 20.5 19.7 15.6 

3.5‐4.9 58 45.1 43.3 34.3 

3.0‐4.9 110 70.5 67.7 53.6 

2.0‐4.9 182 100 96.1 76 

Similar to the results described in Table 2, the cumulative trend changes in Tiers 2 and 3. The 16 schools 

ranked in the top 25 com prise 20% of the top schools publis hing in Tier 3. In contrast to Tier 1 where 

24% of these top schools accounted for 26% of t he articles, in Tier 3, 20% (16 schools) account for only 

13.3% of the articles. Similar trends exist for the peer-rated schools, thus indicating that e ven amongst 

themselves, the categories of top-rated schools publish according to their ranking. 

Figure 1 shows conclusions similar to the above with trend lines. In addition, the figure illustrates that out 

of all the articles published b y U.S. schools, m ost are published b y top schoo ls and most of those are 

published in Tier 1 with fewer in Tiers 2 and 3 resp ectively. Fin ally, the hi gher a school’s ranking, the 

greater the relative percentage of higher tier articles published. This conclusion is more evident in Figure 

2. 


37


Figure 1. Percentage of publishing done in each tier by U.S. schools ranked in the top 120 accompanied 

by trend lines between tiers. 

Figure 2. Percentage of publishing done only by U.S. schools ranked in the top 120. 

The objective of Figure 2 i s to compare schools ranked in the top 120 to each ot her in order to determine 

whether gradations am ong high-ranked schools matter. The top-r anked schools provide the foundation 

for each pill ar in Figure 2. As rank drops, t he relative frequency of publication also decreases fro m 

bottom to top. The excepti ons to this occur in Tiers 2 and 3 where the percentage increas es from 23% to 

29% and 24% to 29% res pectively. H owever, these results are n ot unexpected because the trend occurs 

from left to right, as well as bottom to top. In the case of both Tiers 2 and 3, fewer articles are published 

among those schools ranked from 1 to 50, than are published b y the same group in Tier 1. Thoug h the 

difference between Tiers 2 and 3 is slight for schools in t he top 50, the increase in l ower tier publ ishing 

for the schools ranked 51 to 120 is noticeable. 


38

Fekula and Hornyak 3 

Figure 3 allows us to view publication data am ong many m ore schools since there are 3 15 peer-rated 

schools. The findings for all peer rated schools are similar to those for schools ranked in the top 120 . 

The higher the peer rating, the more these schools publish in higher tier journals. 

Figure 3. Percentage of articles published in each tier by peer rated category accompanied by trend lines. 

The Tier 1 trend line reveals a ste ady decrease in the percentage of Tier 1 publ ications from high to low 

peer-rated schools. Tier 2 shows a change from high to low, with som e constancy in t he middle peer 

groups. Finally, Tier 3 shows a steady increase in the number of Tier 3 publications when going from 

high to low peer-rated schools. All of these trends are consistent with the idea that top rated schools 

publish more frequently in top tier journals and lower rated schools publish m ore frequently in lower tier 

journals. 

CONCLUSIONS 

Prior analyses indicated that top-ranked schools publish most of the articles in top-tier journals (Fekula & 

Hornyak, 2007), which is not surprising. As argued earlier, top s chools can afford to give their faculty 

abundant time and resources, which sho uld translate into high quality research publications. The analy sis 

in this paper focused upon the nu mber of schools wh ich occupy particular categories and the publishing 

trends associated with those categories. The results reveal that only 4% of the U.S. schools publishi ng in 

Tier 1 jo urnals were unranked or unr ated. Thus , only a ver y small percen tage of u nranked schools 

published in any of the jo urnals appearing in t he three tiers of this study. Thi s does not bo de well for 

low-rated or unranked schools because the evidence suggests that the higher the publishing tier, the more 

likely that hi gher-ranked schools will account for the publis hing done in that t ier. Si milarly, the higher 

the school rating, the m ore likely that such a school will account for relatively more of the higher tier 

publications. 

The results of this analysis suggest that there exists a pecking-order even among the schools rated in th e 

top 120. This is particular ly interesting because we would not expect the re source differences to be so 

great as to cause a disparit y in publishing frequency amongst these schools. Despite that, the evidence 

suggests that higher ranked schools amongst the highest ranked schools publish relatively more frequently 

in higher tier journals. T he reasons for this curious conclusion are bey ond the scope of this paper, but 

worthy of future research. 

The trend line analy sis indicates a line ar trend from hi gh to low tiers for all categories of the top 120 


39


schools regardless of their rank within those top 120. So, top schools publish more frequently in top tier 

journals and less frequently in lower tier journals. The trend results are very similar for al l peer-rated 

schools with the exception that the trend between peer groups 3.0 to 3.4 and 3.5 to 4.0 is steady for Tier 2 

versus Tier 3 publishin g frequency . This may sim ply be the result of con current “m iddle grounds” 

converging for both tier and school ratings. 

These conclu sions point to the idea t hat the probab ility of faculty publishing in journals with high 

circulation rates depends u pon the ra nking or rating of the faculty member’s institution. This is logical 

because traditionally high-ranked schools have the resources which can allow ample opportunity for their 

faculty to co nduct qualit y research leading to high-tier publications. Althou gh facult y pr omotion and 

tenure is not always contingent upon top-tier publications, the growing trend toward increased publication 

requirements even at traditional reaching schools m andates some form of research and publi cation. The 

results of our study suggest that there is a low proba bility of publication in highly circulated journals 

when faculty members teach at lower ranked instituti ons. So, t his begs the question as to why such 

faculty should be required to do research that has a low probability of being read. Even though t hree of 

the journals used in this s tudy are cons idered Tier 3 , they are stil l respected and oft cited j ournals. In 

contrast, there are likel y m any other peer-reviewed journals that are less cited and respected. 

Unfortunately, we suspect that f aculty at lower ranked school s are relegated to pu blishing i n such 

journals. With that in mind, we offer the list of schools (See Appendix) repr esented in this study and 

ranked by the number of articles published in each tier along with the peer rating of each school. As seen 

in the ap pendix, it is the generally th e nationa lly well-known schools that are topping t he list with 

multiple publications in all tiers. Toward the bottom of the lists, and especially at the point where schools 

have one or fewer articles published, we find regional and l esser-known schools that are usuall y 

characterized as teaching schools; however, teaching status is not empirically assessed in this study. 

There are so me exceptions to the gene ralizations made above, b ut they are few. For example, there are 

some regional schools and branch cam puses of major universities that have produced top-tier 

publications. But in most cases we see schools with low peer ratings and few t o only fractions of articles 

being published in these 10 journals. In addition, many peer-rated schools show no publications in these 

journals from 2000 through 2004. St ill, the current tre nd seems to b e that faculty mem bers at these 

schools are required to pr oduce peer-reviewed publications; further conclusions and im plications are left 

to the reader. 

LIMITATIONS 

The authors acknowledge that there are lim itations to this study. The journal s chosen for exam ination 

will naturally exclude all articles publ ished by other authors and schools in a variety of ot her outlets. 

Also, the perception of top-tier journals will vary . Although we like to think that circulation rates are a 

good measure because they relate to the exposure of published work, it is also possible that this could be 

seen as flawed in a worl d where electronic journal distribution has come into vogue. Further, the years 

chosen for this analysis could skew the results. Next, the school rankings do not directly reflect the assets 

of business schools or management departments in particular. In addition, the criteria for the rankings are 

also limited and not nece ssarily relevant to management faculty members. More effective measures of 

business school ratings c ould be used to pr oduce scales for the meaningful com parison of disparate 

schools and their research productivity. For exam ple, the number of faculty members certainly impacts 

the num ber of publications produced by a school. These f actors are not acco unted for in the presen t 

study. Our defense is that we are not at top-tier schools with the abundant resources to permit that kind of 

rigor in our research. 

REFERENCES 


40


Alonso, C.J., Davidson, C.N., Unsworth, J.M., & Withey, L. (2003). “Crises and Opportunities: The 

Futures of Scholarly Publishing.” American Council of Learned Societies Occasional Paper, 57. 

Retrieved December 8, 2007, from http://www.acls.org/op57.pdf. 

“America’s Best Colleges 2005” (2005). U.S. News and World Report. Retrieved December 15, 2004, 

from http:/www.usnews.com/usnews/edu/college/rankings/premium. 

Burgan, M.A. (2003, November-December). “From the General Secretary: Tenure and Its Discontents.” 

Academe. Retrieved December 8, 2007, from 

http://www.aaup.org/AAUP/pubsres/academe/2003/ND/Col/ftgs.htm. 

Buzza, B.W. (1989). “Faculty Perceptions of Publication Expectations in the Small College Setting: Have 

the Rules Changed?” Retrieved December 11, 2007, from 

http://www.eric.ed.gov/ERICDocs/data/ericdocs2sql/content_storage_01/0000019b/80/1f/d1/4e.p 

df. 

Cabell’s Directory of Publishing Opportunities (2001). In D.W.E. Cabell and D.L. English (Eds.) 

Cabell’s Directory of Publishing Opportunities in Management 2001-2002 (8 th Ed.), Vol A-G. 

Beaumont, TX: Cabell Publishing Co. 

Elmes-Crahall, J. (1992). “Faculty-Undergraduate Research Collaboration as a Response to the Tension 

of Twelve-Plus Hour Teaching Loads and Publishing Expectations.” Retrieved December 11, 

2007, from 

http://www.eric.ed.gov/ERICDocs/data/ericdocs2sql/content_storage_01/0000019b/80/12/fd/24.p 

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Euben, D.R. (2002, July-August). “Publish or perish: The ever-higher publications hurdle for tenure.” 

Academe. Retrieved December 11, 2007, from 

http://www.aaup.org/AAUP/pubsres/academe/2002/JA/Col/LW.htm. 

Fekula, M.J. & Hornyak, M.J. (2007). “Publishing is a Concentrated Industry: A 5-Year Review Of 

Management Journals.” Proceedings of the American Society of Business and Behavioral 

Sciences Annual Meeting, 2007. 

Fekula, M.J., & Hornyak, M.J. (1996). “Social Inequality and Publishing in the Organizational 

Sciences.” Proceedings of the American Society of Business and Behavioral Sciences Annual 

Meeting, 1996. 

Howard, J. (2006, December 15). “MLA Panel Finds No 'Lost Generation of Scholars' From the Tenure 

Track.” The Chronicle of Higher Education, Volume 53, Issue 17, A16. Retrieved December 8, 

2007, from http://chronicle.com/weekly/v53/i17/17a01601.htm. 

Kerr, S. (1995). “On the folly of rewarding A, while hoping for B.” Academy of Management Executive, 

1995, Volume 9, Number 3, 7-14. 

Metrailler, E. (n.d.). “Tenure vs Teaching Ability.” Retrieved December 8, 2007, from 

http://www.digitas.harvard.edu/~salient/issues/950313/page7.html. 

Modern Language Association of America (2007). “Report of the MLA Task Force on Evaluating 


41



Scholarship for Tenure and Promotion.” MLA Task Force on Evaluating Scholarship for Tenure and 

Promotion. Retrieved December 11, 2007 from 

http://www.mla.org/pdf/task_force_tenure_promo.pdf. 

Murphy, L.. (2007, February 23). “Like countless other assistant professors before me, I walked right into 

the trap.” The Chronicle of Higher Education, Volume 53, Issue 25, C3. Retrieved December 8, 

2007, from http://chronicle.com/weekly/v53/i25/25c00301.htm. 

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from http://www.aaup.org/AAUP/pubsres/academe/2004/JF/LTE/nels.htm. 

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“The Emerald Management Reviews 400: Accredited Journal Coverage List: General Management” 

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Exchange Online: The Newsletter of the Association of American University Presses. Retrieved 

December 8, 2007, from http://aaupblog.aaupnet.org/?p=26. 

APPENDIX 

Schools Ranked by Number of Articles Published in Each Tier Accompanied by Peer Rating 

Peer # Tier 1 

Peer # Tier 

Peer # Tier 3 

School 

Rating Arts School 

Rating 2 Arts School 

Rating Arts 

Penn 4.6 13.08 Penn 4.6 15.70 NYU 3.8 8.75 

TX 4.1 11.75 Harvard 4.9 12.67 BC 3.6 6.17 

IL 4 11.75 MI 4.6 11.08 PSU 3.8 6.04 

MI 4.6 10.92 OSU 3.7 10.83 MI 4.6 5.67 

WA 3.9 10.75 PSU 3.8 10.23 Cornell 4.6 5.50 

Harvard 4.9 10.25 Rutgers 3.3 10.17 ASU 3.3 4.17 

Stanford 4.9 10.25 MD 3.7 10.17 NM 2.6 4.13 

TX A&M 3.5 10.13 Stanford 4.9 9.61 Pitt 3.4 4.08 

ASU 3.3 8.75 IL 4 9.39 Portland 3.7 3.67 

NYU 3.8 8.45 Boston U 3.4 9.39 GA Tech 4 3.58 

Columbia 4.7 8.28 MIT 4.9 9.33 ME 2.6 3.50 

WI 4.2 7.92 FSU 3.1 8.77 GA 3.5 3.17 

MD 3.7 7.75 USC 3.9 8.77 Santa Clara 4 3.03 

MI ST 3.5 7.15 Columbia 4.7 8.50 Carnegie Mellon 4.3 3.00 

Cornell 4.6 6.70 IN 3.8 8.25 Cal Northridge 3.1 2.93 

USC 3.9 6.67 TX A&M 3.5 7.32 Northwestern 4.4 2.75 

PSU 3.8 6.25 Cornell 4.6 6.87 AL-Birm 2.8 2.67 

Emory 4 6.23 CT 3.2 6.50 VA 4.3 2.50 

MIT 4.9 5.58 MI ST 3.5 6.17 OSU 3.7 2.50 

Boston U 3.4 5.50 NYU 3.8 5.33 Case Western 3.6 2.50 

Purdue 3.8 5.42 GA St 2.7 5.03 Auburn 3 2.50 

MN 3.8 5.17 DE 3.2 4.83 Loyola Marymount 3.8 2.33 

OSU 3.7 5.08 BC 3.6 4.67 Cal Irvine 3.6 2.33 

GA Tech 4 5.00 Case Western 3.6 4.58 Wake Forest 3.5 2.33 

Cal Davis 3.8 5.00 LSU 2.9 4.42 MD 3.7 2.33 

Cal Berkley 4.8 4.50 ASU 3.3 4.31 MI ST 3.5 2.33 

IN 3.8 4.50 WA 3.9 4.25 George WA 3.4 2.25 

CT 3.2 4.33 George Mason 3 4.25 Boston U 3.4 2.20 

Cal Irvine 3.6 4.25 Cal Irvine 3.6 4.20 Temple 2.9 2.20 

Chicago 4.6 4.00 UCFL 2.4 4.17 USC 3.9 2.17 

Rutgers 3.3 4.00 Northwestern 4.4 4.08 Harvard 4.9 2.00 

42


WA St Louis 4.1 3.50 NV 2.5 4.00 Stanford 4.9 2.00 

BYU 3 3.42 VA 4.3 3.83 Rochester tech 4.1 2.00 

Northwestern 4.4 3.42 WI 4.2 3.83 WA 3.9 2.00 

NC 4.2 3.42 Miami 3.2 3.83 Hood 3 2.00 

FL 3.6 3.33 OK 3 3.78 NV 2.5 2.00 

Case Western 3.6 3.17 TX 4.1 3.67 Nat Louis 1.9 2.00 

Carnegie Mellon 4.3 3.08 Emory 4 3.65 MIT 4.9 2.00 

KY 3 3.08 GA Tech 4 3.58 Old Dominion 2.7 2.00 

OK 3 3.00 Carnegie Mellon 4.3 3.50 Duquesne 2.6 2.00 

S. Carolina 3 3.00 IL Chi 3.1 3.42 SIU 2.6 2.00 

Cinn 2.7 2.92 WA ST 3 3.33 St Thomas 2.5 2.00 

CO Denver 2.7 2.83 Houston 2.6 3.25 VA Tech 3.4 1.92 

BC 3.6 2.83 ASU West #N/A 3.17 OK 3 1.67 

Rice 4.2 2.67 Vanderbilt 4.1 3.08 IL Tech 2.9 1.67 

Temple 2.9 2.67 Cal Riverside 3.2 3.00 Penn 4.6 1.50 

FSU 3.1 2.50 BYU 3 3.00 Rice 4.2 1.50 

IL Chi 3.1 2.50 Witchita St 2.3 3.00 Richmond 4.2 1.50 

NC St 3.1 2.50 CO 3.5 2.94 Villanova 4.2 1.50 

GA St 2.7 2.50 Temple 2.9 2.83 Creighton 4.1 1.50 

OR 3.4 2.17 MN 3.8 2.67 MO 3.3 1.50 

Pitt 3.4 2.17 Cinn 2.7 2.67 Chapman 3.2 1.50 

NC-Charlotte 3.6 2.00 Notre Dame 3.9 2.58 DE 3.2 1.50 

San Jose St 3.3 2.00 Tulane 3.5 2.57 American 3 1.50 

Miami 3.2 2.00 KY 3 2.53 BYU 3 1.50 

Naval Post Grad 1 2.00 Yale 4.9 2.50 WA ST 3 1.50 

Memphis 2.4 2.00 Duke 4.6 2.50 TX Tech 2.7 1.50 

Duke 4.6 1.92 Cal Davis 3.8 2.50 CO Denver 2.7 1.50 

Notre Dame 3.9 1.92 FL 3.6 2.50 MN 3.8 1.33 

UT 3.1 1.92 OR 3.4 2.50 MA 3.3 1.33 

LA Tech 2.2 1.92 George WA 3.4 2.50 George Mason 3 1.33 

VA Tech 3.4 1.83 CO Denver 2.7 2.50 Marquette 2.9 1.33 

TX Arling 2.5 1.83 GA 3.5 2.42 USFL 2.6 1.33 

Syracuse 3.4 1.83 Wake Forest 3.5 2.37 New Haven 2.3 1.33 

NE 3.2 1.75 Rice 4.2 2.33 N. IA 3.2 1.25 

AZ 3.6 1.67 Dartmouth 4.4 2.25 KY 3 1.25 

Yale 4.9 1.58 TX Arling 2.5 2.25 LSU 2.9 1.25 

UCLA 4.3 1.58 Georgetown 4 2.20 TX-Dal 2.7 1.25 

GA 3.5 1.58 NC 4.2 2.17 FL Int 2.3 1.25 

VA 4.3 1.50 SMU 3.1 2.17 SD ST 2.3 1.25 

Tulane 3.5 1.50 New Orleans 2.3 2.17 TX Arling 2.5 1.17 

American 3 1.50 Cal Berkley 4.8 2.00 NC 4.2 1.08 

Houston 2.6 1.50 VA Tech 3.4 2.00 IN 3.8 1.08 

IA 3.7 1.42 Denver 2.6 2.00 UCFL 2.4 1.08 

UCFL 2.4 1.37 Saginaw Valley 2.6 2.00 New Orleans 2.3 1.08 

Richmond 4.2 1.33 MO St Louis 2.5 2.00 Columbia 4.7 1.00 

Vanderbilt 4.1 1.33 E TN ST 2 2.00 Dartmouth 4.4 1.00 

MO 3.3 1.33 Upper IA 2 2.00 Georgetown 4 1.00 

TN 3.2 1.33 Thunderbird #N/A 2.00 IA 3.7 1.00 

SUNY Buf 3.1 1.33 MO 3.3 2.00 NC-Charlotte 3.6 1.00 

Clark 3 1.33 NC St 3.1 1.92 Tulane 3.5 1.00 

AR 2.8 1.33 UCLA 4.3 1.83 KS 3.4 1.00 

Northeastern 3 1.33 WA St Louis 4.1 1.83 OR 3.4 1.00 

SD ST 2.3 1.25 TN 3.2 1.83 St Joseph's 3.4 1.00 

George WA 3.4 1.25 OK St 2.7 1.83 Rutgers 3.3 1.00 

Wake Forest 3.5 1.17 Tulsa 2.6 1.83 San Jose St 3.3 1.00 

Drexel 3 1.17 NM St 2.6 1.83 Baylor 3.2 1.00 

WA ST 3 1.17 Chicago 4.6 1.75 NE 3.2 1.00 

NC-Greensboro 2.7 1.17 Clemson 3.1 1.69 TN 3.2 1.00 

FL Int 2.3 1.17 Appalachian St 3.5 1.67 N. IA 3.2 1.00 

Cleveland St 2.2 1.17 S. Carolina 3 1.67 IL Chi 3.1 1.00 

St Mary's 3.6 1.00 Northeastern 3 1.67 TX-San Ant 3.1 1.00 

Cal Riverside 3.2 1.00 Drexel 3 1.58 Clark 3 1.00 

MI-Dearborn 3 1.00 New Haven 2.3 1.50 SUNY-New Paltz 3 1.00 

MN-ST Mankato 2.8 1.00 Mercer 3.7 1.33 CSU 2.9 1.00 

NM 2.6 1.00 Pepperdine 3.2 1.33 OR-St 2.9 1.00 

Saginaw Valley 2.6 1.00 TX-San Ant 3.1 1.33 Rider 2.9 1.00 

Wayne St 2.6 1.00 Loyola Chi 2.8 1.33 Suffolk 2.9 1.00 

MT ST 2.6 1.00 DePaul 2.8 1.33 DePaul 2.8 1.00 

LA-Laf 2.1 1.00 FL Atlantic 2.2 1.33 Loyola Chi 2.8 1.00 

Thunderbird 1 1.00 UT St 2.6 1.28 SW-MO 2.8 1.00 


43


Marquette 2.9 0.87 AZ 3.6 1.25 USC-Aiken 2.8 1.00 

WI Mil 2.8 0.87 KS St 2.9 1.25 Cal Hayward 2.8 1.00 

CO 3.5 0.83 Oakland 2.2 1.25 Ashland 2.7 1.00 

Bryant 3.2 0.83 Cal Santa Barbara 3.5 1.20 MA-Boston 2.6 1.00 

Clemson 3.1 0.83 Dayton 2.6 1.17 AL-Hunts 2.5 1.00 

CSU 2.9 0.83 IA 3.7 1.17 E NM 2.5 1.00 

W. IL 2.9 0.83 San Jose St 3.3 1.17 Hartford 2.3 1.00 

DE 3.2 0.75 Memphis 2.4 1.17 ASU West #N/A 1.00 

SIU 2.6 0.75 Richmond 4.2 1.08 Baruch Col #N/A 1.00 

Towson 3.1 0.67 Rensselaer 3.6 1.08 Pace #N/A 1.00 

KS St 2.9 0.67 American 3 1.08 S. CO #N/A 1.00 

AL 3.1 0.64 Portland St 2.5 1.08 WA St - Vancouver #N/A 1.00 

S. OR 2.8 0.58 Bradley 3.7 1.00 WI Milw #N/A 1.00 

Rensselaer 3.6 0.53 Fairfield 3.5 1.00 Wichita ST #N/A 1.00 

Villanova 4.2 0.50 Miami-OH 3.4 1.00 FSU 3.1 0.88 

Berry College 3.8 0.50 W WA 3.3 1.00 IA St 3.3 0.83 

Xavier 3.8 0.50 Kennesaw St 3.2 1.00 Regent #N/A 0.83 

Cal Santa Barbara 3.5 0.50 UT 3.1 1.00 UCLA 4.3 0.67 

CO-CS 3.2 0.50 SUNY Buf 3.1 1.00 TX 4.1 0.67 

Fordham 3.1 0.50 Towson 3.1 1.00 Syracuse 3.4 0.67 

MN-Duluth 3.1 0.50 Cal Northridge 3.1 1.00 W. KY 3.2 0.67 

Radford 3.1 0.50 SUNY-Bing 3.1 1.00 TCU 2.7 0.67 

Cal St Fresno 3 0.50 NE-Omaha 3 1.00 N IL 2.4 0.67 

Mass-Dartmouth 3 0.50 IN-IN-Purdue 2.9 1.00 WA-St Pullman #N/A 0.67 

SIU-Edwardsville 3 0.50 Springfield Col 2.9 1.00 MS 2.8 0.64 

St Louis 3 0.50 Sacred Heart U 2.8 1.00 CO 3.5 0.53 

SUNY 3 0.50 Cal Hayward 2.8 1.00 Yale 4.9 0.50 

WI-Stevens Pt 3 0.50 TCU 2.7 1.00 IL 4 0.50 

Keene St 2.8 0.50 ID 2.7 1.00 Gonzaga 3.8 0.50 

Loyola Chi 2.8 0.50 NJ Tech 2.6 1.00 St Mary's 3.6 0.50 

New School 2.8 0.50 C.W. Post 2.5 1.00 TX A&M 3.5 0.50 

NC-Ashville 2.7 0.50 East Carolina 2.3 1.00 Bentley Col 3.3 0.50 

Bowling Green 2.6 0.50 Hartford 2.3 1.00 Quinnipac Col 3.3 0.50 

Dayton 2.6 0.50 LA Tech 2.2 1.00 Clemson 3.1 0.50 

Denver 2.6 0.50 TN St 2.1 1.00 GA Col & St 3.1 0.50 

NJ Tech 2.6 0.50 Cal St Long Beach 3.2 0.92 Towson 3.1 0.50 

U of the Pacific 2.6 0.50 WVA 2.7 0.87 Northeastern 3 0.50 

IL ST 2.4 0.50 Santa Clara 4 0.83 Millsaps 2.9 0.50 

N TX 2.3 0.50 Loyola Marymount 3.8 0.83 E. WA 2.8 0.50 

Piedmont 2.3 0.50 Baylor 3.2 0.83 Monmouth 2.8 0.50 

Toledo 2.3 0.50 NC Wilmington 3.2 0.83 St Ambrose 2.8 0.50 

Wright St 2.3 0.50 Fordham 3.1 0.83 WVA 2.7 0.50 

Oakland 2.2 0.50 Benedictine 3 0.83 Denver 2.6 0.50 

Barber Col 1 0.50 NH 2.9 0.83 MT ST 2.6 0.50 

George Madison 1 0.50 TX Tech 2.7 0.83 NJ Tech 2.6 0.50 

Birmingham 1 0.50 SIU 2.6 0.83 E. Conn St 2.5 0.50 

Georgetown 4 0.45 USFL 2.6 0.83 St Josep's ME 2.5 0.50 

James Madison 4 0.33 W MI 2.5 0.83 Morgan ST 2.4 0.50 

Santa Clara 4 0.33 Cleveland St 2.2 0.83 ND ST 2.4 0.50 

Bradley 3.7 0.33 Loyola-New Orleans 3.5 0.80 FL Tech 2.3 0.50 

Seattle 3.6 0.33 AL-Birm 2.8 0.80 Long Island 2.3 0.50 

Chapman 3.2 0.33 Babson #N/A 0.78 FL Atlantic 2.2 0.50 

WI Eau Claire 3.2 0.33 Purdue 3.8 0.75 HI-Hilo 2.2 0.50 

Cal Northridge 3.1 0.33 FL A&M 2.8 0.75 LA Tech 2.2 0.50 

Farleigh-Dick 3.1 0.33 Wayne St 2.6 0.75 City U of NY #N/A 0.50 

George Mason 3 0.33 Akron 2.2 0.75 Boise St 3.1 0.43 

OR-St 2.9 0.33 Suffolk 2.9 0.70 WI 4.2 0.33 

SF 2.9 0.33 WI Mil 2.8 0.70 Claremont-McKenna 3.9 0.33 

WI-Whitewater 2.9 0.33 Brandeis 3.6 0.67 Purdue 3.8 0.33 

WA & Jefferson 2.8 0.33 MA 3.3 0.67 Ithaca Col 3.5 0.33 

Dallas 2.5 0.33 VT 3 0.67 Loyola-New Orleans 3.5 0.33 

Portland St 2.5 0.33 N. AL 2.8 0.67 Uconn 3.2 0.33 

Witchita St 2.3 0.33 VA Commonwealth 2.8 0.67 Cal Riverside 3.2 0.33 

Baltimore 1 0.33 FL Int 2.3 0.67 AL 3.1 0.33 

Cal SD 3.8 0.25 Mid TN St 2.1 0.67 Ohio 3.1 0.33 

Butler 3.7 0.25 SUNY-Albany #N/A 0.67 SUNY-Bing 3.1 0.33 

SMU 3.1 0.25 St Louis 3 0.61 TN-Chatt 3.1 0.33 

TX-San Ant 3.1 0.25 CMU 2.2 0.58 Cal Fullerton 3.1 0.33 

Suffolk 2.9 0.25 Swarthmore 4.6 0.50 Longwood Col 2.9 0.33 

Clayton Col & St 2.8 0.25 William & Mary 3.8 0.50 SF 2.9 0.33 


44


VA Commonwealth 2.8 0.25 Cal SD 3.8 0.50 SUNY Albany 2.9 0.33 

Hofstra 2.7 0.25 Tufts 3.6 0.50 Tulsa 2.6 0.33 

TX-Dal 2.7 0.25 NC Charlotte 3.6 0.50 Clarion of PA 2.4 0.33 

Louisville 2.6 0.25 KS 3.4 0.50 WA-ST Tricities #N/A 0.33 

Nichols St 2.5 0.25 CO-CS 3.2 0.50 AZ 3.6 0.25 

TX A&M Int 2.5 0.25 Ohio 3.1 0.50 Elon 3.6 0.25 

MS ST 2.4 0.25 Detroit-Mercy 3 0.50 FL 3.6 0.25 

ASU West 1 0.25 Meredith 3 0.50 Col of NJ 3.4 0.25 

Cal Sacramento 3 0.20 TX A&M CC 3 0.50 Radford 3.1 0.25 

WA-Bothell 1 0.20 Cal St - LA 2.9 0.50 KS St 2.9 0.25 

WI-Whitewater 2.9 0.50 W. IL 2.9 0.25 

AR 2.8 0.50 Montclair 2.8 0.25 

Lynchberg Col 2.8 0.50 GA St 2.7 0.25 

Seton Hall 2.8 0.50 SE LA 2.6 0.25 

Clarkson 2.7 0.50 Nichols St 2.5 0.25 

HI-Mahoa 2.7 0.50 MS ST 2.4 0.25 

Hofstra 2.7 0.50 Oakland 2.2 0.25 

Bowling Green 2.6 0.50 Coastal Carolina 2 0.25 

NM 2.6 0.50 Lexington Com Col #N/A 0.25 

ND ST 2.4 0.50 Cal Tech 4.7 0.20 

IN of PA 2.3 0.50 Loyola- MD 3.6 0.20 

Long Island 2.3 0.50 NM St 2.6 0.20 

Atlanta Metro #N/A 0.50 James Madison 4 0.13 

Baruch Col #N/A 0.50 

CAL-Merced #N/A 0.50 

City U of NY #N/A 0.50 

Houston-Victoria #N/A 0.50 

WA-Tacoma #N/A 0.50 

WPI #N/A 0.50 

MS 2.8 0.45 

Marquette 2.9 0.36 

Villanova 4.2 0.33 

Creighton 4.1 0.33 

Drake 4 0.33 

Xavier 3.8 0.33 

CO College 3.7 0.33 

Bryant 3.2 0.33 

WI-Lacrosse 3.1 0.33 

Auburn 3 0.33 

Birmingham Southern 3 0.33 

Tampa 3 0.33 

UT Valley St 3 0.33 

Niagara 2.9 0.33 

St Cloud St 2.8 0.33 

WA & Jefferson 2.8 0.33 

NE Kearny 2.7 0.33 

Roosevelt 2.7 0.33 

Cal St San Marcos 2.7 0.33 

U of the Pacific 2.6 0.33 

IN St 2.5 0.33 

N IL 2.4 0.33 

Buffalo #N/A 0.33 

PSU-Great Valley #N/A 0.33 

USC Beaufort #N/A 0.33 

Cal Tech 4.7 0.25 

WI Eau Claire 3.2 0.25 

CA Lutheran 3.1 0.25 

CSU 2.9 0.25 

WY 2.6 0.25 

SE OK ST 2.5 0.25 

N TX 2.3 0.25 

C WY Col #N/A 0.25 

NY City #N/A 0.25 

St Joseph's 3.4 0.20 


45

ID THEFT AND ITS FINANCIAL IMPLICATIONS 

Grady, Shawna 

Sam Houston State University 

gba_bxm@shsu.edu 

Maniam, Balasundram 


maniam@shsu.edu 

Leavell, Hadley 


leavell@shsu.edu 

ABSTRACT 

Identity theft is a crime that has been victimizing millions each year. This paper will address the 

methods that criminals use to access identity information and how they are using this information 

to commit theft and fraud. This paper will also address the financial impact that identity theft has 

on consumers, businesses, and governments. The laws that are currently in effect relating to 

identity theft will be covered and new ideas for the prevention of identity theft and the 

safeguarding of identity information will be addressed. 

INTRODUCTION 

Imagine that you are at a bank appl ying for a lo an and they access your credit report. The l oan 

officer informs y ou that, due to your credit history, they will not be able to grant you the loan. 

After reviewing the report, you realize that there are numerous item s included that y ou do not 

recognize. Only then do you realize that you are a victim of identity theft. This means that now 

you have joined the elite class of at least 7 million victim s of identit y theft and that group is 

growing rapidly. 

Identity theft has grown at an alar ming rate ove r the last decade. The m ajor reason for this 

growth is attributable to the ease of o btaining pertinent information n eeded to commit ide ntity 

theft. These criminals are obtaining and using this information for their own personal gain, while 

harming the reputation and fina ncial standing of the indivi dual whose identit y has been 

compromised. 

We usually only hear about t he indi viduals that have been victims of ident ity theft: however, 

individuals are not the onl y victim s. Businesses and governm ents are also victi ms suff ering 

losses in the billions each year due to the effects of identity theft. Included in the losses are cost s 

that businesses and gover nments have incurred in effort to stop identit y thef t from occur ring. 

Preventative measures have been put into operation, but even these cannot guarantee a world free 

of identity theft. 

This paper will demonstrate how easy it is to obtain the information necessary to commit identity 

theft. It will demonstrate how financial institu tions and businesses are be ing affected by identity 

theft. It will show how i dentity theft affects their operations and what procedures the y have in 

effect that can deter financial loss from identit y theft. This paper will also explain that there are 


Grady, Maniam and Leavell 

economic i mpacts of identit y theft not onl y to businesses, but also to the general public and 

consumers who suffer from the bottom line. 


Fogarty, Ortiz, and Carter (2002) examine the regulation of identity systems in the United States. 

Their article identifies what they believe to be the United States Congress’ onl y response to 

identity theft was the Identit y Theft and Assu mption Deterrence Act of 1998. The paper also 

analyzes how cri minals can easily acces s one’ s so cial se curity number or driver’ s lic ense 

information, and the legal actions that have occurred in response to the public’s concern. 

Sovern (2004) evaluates the rules of common law, such as the traditional l oss allocation, in order 

to find a way to reduce identity theft. He believes that people have a right to expect that creditors 

and credit bureaus will not include trans actions, made by identity thieves, in the reports made on 

customers who have had their identit y stolen. Th is would help ensure that the credit industry 

takes steps for the purpose of preventing future identity theft. 

Cheney (20 03) exam ines the Pay ment Cards Cent er’s workshop on identit y t heft. The paper 

begins with a differentiation between identit y theft and pa yment fraud. C heney then c overs 

methods used to steal identification and account information, including the growing use of the 

Internet. N ext, the paper covers the extent and financial i mpact of identit y theft and an 

assessment of the real co st of identity theft to consu mers, merchants, and credit providers . 

Cheney concludes the paper with the methods used to fight against identity theft. 

Milne, Rohm, and Bahl (2004) examine online behaviors that have an effect on o nline identity 

theft. The authors conducted three su rveys wh ich show that protection against online id entity 

theft will vary by consumer. The paper exam ines factors that affect a consu mer’s inclination to 

guard privacy and identity online, including attitudes, behaviors, and demographics. The authors 

also make suggestions for consumers, b usinesses, and governments on protecting online pri vacy 

and reducing identity theft. 

ACCESSING IDENTITY INFORMATION 

As Sovern (2004) defines it, “Identity theft can be defined as the appropriation of someone else’s 

identity to commit fraud or theft” (p. 233). There are several different categories of identity theft 

including: credit and debit cards, medical, phone and utilities, em ployment, tax returns, and 

numerous more. This act of “stealing” so meone else’s identity ha s grown over the years as the 

ability to obtain personal information has become easier, especially with the use of the Internet. 

In order for identit y thieves to be successful, they must first obtain an indivi dual’s identification 

information and then use that inform ation to comm it fraud or theft. At the least, the thief m ust 

know the name and address, as well as an item of identification believed to be known only by that 

individual to pass the identification test. The most common form of identification used to commit 

these crimes is the social security number, followed by the driver’s license. 

Businesses and governments use the so cial security number to id entify individuals, causing it to 

be the form of identification identi ty t hieves utilize (Fogart y, 2002). Unive rsities, the IRS, 

criminal databases, student loan ad ministrators, credit bureaus, and additional co mpanies all 

employ the social security num ber in their record s. An individual’ s social security num ber is 

used by these co mpanies to identify and different iate between other customers. Due to the 

obvious use by these com panies as i dentifiers, soci al security numbers h ave beco me easier t o 

obtain, making them more susceptible to identity theft. The social security number is believed to 


e unique and known only by the individual it has been issued to, but once a criminal has access 

to that information, then the thief can virtually become that individual. 

Information on a driver’s license alone is usually enough for identity thieves to commit numerous 

acts of fr aud. The infor mation on a driver’ s license consists of the na me, address, date of birth, 

and license num ber of the individual it identifies. The driver’s license is pre ferred by criminals 

because it is the form of identification that contai ns an image of th e owner, according to Berghel 

(2006). Whe n a license h as been obtai ned, criminals only need t o replace the picture with their 

own to make the license appear credible. Cri minals also cr eate counterfeit licenses with either 

actual or fictitious information for the same purpose. 

Victims who knew how th eir information was stolen claim the identity thieves used si mple and 

common methods. These techniques include: lost or stolen wallets, mail intercepts, and thef t by 

individuals who had a relationship with the victi m (Cheney, 2003). At one time cri minals were 

even able to obtain information neede d to co mmit identity theft by purchasing an individual’s 

driving record from the Department of Motor Vehicles. However, this changed with the Driver’s 

Privacy Protection Act of 1994, which limited access to m otor vehicle records. We are now in 

the Information Age, where criminals have all the information needed to commit identit y right at 

their fingertips, courtesy of the Internet. 

The Internet has opened new avenue s for criminals that have made it easier to obtain personal 

information needed to commit identity theft. Online transactions have risen over the past dec ade, 

increasing the am ount of inform ation available to thieves. In 2002, the U.S. Depart ment of 

Commerce claimed that In ternet sales grew at a r ate of 25 percent (Cheney , 2003). This means 

that more consumers are using the Internet to purchase items, leaving a trail for identity thieves to 

follow. Consu mers need to be aware that Intern et transactions pose threat s to their inf ormation 

due to computer hackers, cookies, and other forms of online theft (Milne, 2004). 

Consumers who do busine ss online become vulnera ble to identity theft because inform ation on 

their personal computer, as well as their business computer, may be accessed by criminals (Milne, 

2004). The reason for this vulnerabilit y can be attributed to the fact that while online, a 

consumer’s inform ation, if not properl y protected, is susceptible to theft. Consum ers provide 

credit card numbers and other personal inform ation when completing online transactions that can 

be easily intercepted or com promised due to l ackadaisical co mputer security . An easy way to 

improve security is to install a firewall and remove spyware frequently, as well as installing virus 

protection. 

Identification information is also at risk afte r an online transaction occu rs. Com pany’s records 

now contain customer information, where their own com puter sy stem is a t risk for theft. 

According to White (2005), “Intruders attack a typical US firm ’s co mputer security numerous 

times in a week” (p. 850) . A business’ s computers are just as susceptible to identit y theft as a 

personal computer, but they are required to have immense security measures in place to safeguard 

their custo mer’s personal identity information. Ho wever, data t heft by em ployees and thieves 

hacking into company databases, are more serious threats for identity theft to c ustomers (Milne, 

2004). 

Another concern with online transactions is th e lack of face-to-face co mmunication between the 

two parties involved . Th e supplier is placing c onfidence in the indivi dual purchasing goods off 

the Internet. This raises the dilemma of custom er authentica tion. Wit hout the face-to- face 

contact, customer authentication becomes virtua lly unreliable. The absenc e of face-to- face 

communication gives identity thieves an open door to pose as another indivi dual. Simply stated, 


ID Theft


my brother, an 18 y ear-old male, could easily pose as a 26 y ear-old female with a lower risk of 

detection, due to the anonymous nature of the Internet. However, if he were to attempt to use that 

identification in an actual face-to-face transaction, there is a great er possibility that he will get 

caught. 

Criminals have become more creative with methods used to commit identity theft. Web spoofing 

and phishing are two results of these criminal’s creative thinking. Web spoofing occurs when the 

criminal creates a bogus Web site that is sim ilar to a legitim ate site , to retrieve personal 

information from individuals who do n ot realize th e site is a sham . The FBI named spoofing to 

be the bigge st cause of t he rise in identit y th eft a nd ot her frauds committed on t he Int ernet 

(Dinev, 2006). 

Responses to phishing attacks account for 20 percent of online methods of identity theft (Mercuri, 

2006). Phishing occurs when em ail messages that appear to be legitimate are sent, in bulk, t o 

Internet users. These e mails usually contain info rmation that appears to be i mportant regarding 

their user accounts, such as “there are problema tic activities,” in an attempt to scare the user 

enough to respond t o the message (Dinev, 2 006, p. 81). The re cipient becomes distressed and 

visits the site, revealing identit y inf ormation, and does not tho roughly inve stigate the site to 

ensure its authenticity. 

FINANCIAL IMPACT OF IDENTITY THEFT 

Consumers, businesses, and governments are all victims of identity theft. Consumers suffer from 

the im pact of identit y thef t, both em otionally and fi nancially, as their reputation and finan cial 

standing are injured. Businesses and governm ents suffer greater financial loss than consumers 

due to the costs incurred t o restore the damage from identity theft and costs for taking measures 

to prevent i dentity theft. A survey conducte d by t he FTC in 2003 claim s t hat businesses and 

financial institutions have lost at least $47 b illion, while the tot al am ount spent by indi vidual 

victims is about $5 billion yearly in identity theft related costs (Newman, 2004). 

Consumers are the ultimate victims of identity theft due to the severity of the damage caused by 

the crime. T hese identity theft victi ms suffer little financial loss compared to t heir business and 

government counterparts, but they do suffer from a disruption of t heir lives and the hindrance in 

the ability to obtain further credit. Victims have experienced pain and suffering from banks, debt 

collectors, and even law enforcement due to identity theft (Newman, 2004). 

There are tw o measures of identity theft for cons umers: time and dollars spent resear ching and 

defending their cases. It i s estimated that identity theft has cost Americans at least five bil lion 

dollars. Also, victims have claimed to have spent, on average, 600 hours and $1400 in an attempt 

to correct their credit (White, 2005). These are just the averages; there is evidence that there are 

some individuals who have spent in excess of 10,000 hours and $30,000 to clear the damage from 

identity theft. 

The burden of proof is the responsibility of the vi ctim, meaning that all the costs associat ed with 

proving their innocence are paid for out-of-poc ket. These out-of-pocket costs might include 

travel expenses, police reports, and certified mail, t o name a f ew (Identity T heft, 2003) . The 

amount of c osts incurred have been anywhere fr om as low as $4 to $ 30,000 and hi gher, 

depending on the severity of the crime. The costs could be recovered if the thief is caught and 

sentenced, but the likelihood that the thief has the money for retribution is very low, resulting in 

total loss for some victims. 


There are ad ditional costs that should be included in estimating the time and am ount of mone y 

victims spend on defending their cases. These could include hours of work missed, vacation and 

personal ti me used, and the use of medical services. A sur vey conducted resulted i n 82 

respondents or approxim ately 49 percent of tho se surveyed reporting, on average, 389 hou rs of 

missed work (Identit y Theft, 2003). This cri me has al so left some victi ms jobless due to th e 

amount of time need ed to defend their case. This same survey reported that 37 percent used an 

average leave time of 74 hours, and 21percent re ported time lost due to seeking related m edical 

services. Me dical services are most likely sought due to the e motional trauma inflicted by the 

crime. 

State, local, and federal g overnments also suffer losses due to id entity theft. Law enforce ment 

agencies spend anywhere from $15,000 to $25,000, more in so me cases, on identit y theft cases 

(Newman, 2004). This is just the cost to inves tigate the case, there ar e also costs incurred to 

charge the criminal. When the crim inal is actually caught and indicted, the government then has 

to assume the costs of housing and feeding this cr iminal in pris on. There is also the tim e and 

money involved in proposing and enacting new laws dealing with identity theft. 

According to the law, financial institutions a nd businesses ar e th e principal victi ms of identity 

theft, not the individual w hose identity was stolen (Krause, 2006). Fina ncial institutions suffer 

losses in th e billions from the cost s of puttin g a stop to identity theft, as well as the 

reimbursement of m oney to b oth retailers and consumers who ar e victi ms of identit y theft. 

Retailers who accept credit cards also suffer losses fro m interchange fees related to identity theft, 

as well as los ses from transactions that were not authenticated and reim bursement to cons umers 

that were victimized. 

Retailers pay interchange fees for ever y customer transaction paid by credit card, a price paid in 

order to use t he payment networks of th e credit companies like Visa or Master card (Cashiered, 

2007). The interchange fees are nonref undable, even if the transaction was a result of identit y 

theft. These fees totaled $56 billion in 2006, and will continue to rise as transactions on cr edit 

increase. Merchants involved in online transactions are charged a steep 65 percent more in bank 

interchange fees (Cheney , 2003). This is due to the unauthenticated transactions, meaning that 

there was no face-to-face communication to verify the identity of the customer. 

Losses due t o identity theft transactions that are done in-store, fal l to the credit issuer, requiring 

them to refund the m oney back to the retailer. When identit y theft transacti ons are perfor med 

online the retailers can also be refunde d the m oney by the credit issuer. This is due to the fact 

that there is no way to ensure the identity of the consumer. If the retailer had used a program like 

Verified by Visa, they would be held responsible and suffer the loss because the y received the 

password for that consumer. All retailers should implement this type of program to decrease th e 

occurrence of identity theft. Transactions have also been turned a way that looked suspicious, to 

prevent the acquisition of losses due to identity theft. As consu mers f ears of identity theft 

continue to grow, Internet transa ctions may decr ease, threate ning the ove rall growth of ecommerce 

(Cheney, 2003). 

Credit firms send out mass mailings of pre-approved credit offers. Several of these fir ms opt not 

to verify the identity of consumers who accept the offer due to growing com petitive pressures, 

causing a rise in identi ty theft, especially credit card fraud. Businesses say fraudulent credit card 

use is a cost of doing business in order to have the ability to write off losses (Berg, 2003). These 

losses ar e si mply written off on the income statemen t, just as other losses are, once they have 

been realized . However, businesses co mpensate fo r these losse s by labeling the m as a cos t of 

doing busi ness and passing them on to their customer s through f ees and higher interest rates. 


ID Theft


Financial institutions are also reluctant to put preventative measur es in place b ecause they ar e 

afraid it will scare off possible custo mers. Businesses are making enough money, even with the 

losses from identity theft, so they choose to take a chance instead of place preventative measures 

in place. 

CURRENT LAWS 

The Fair Credit Reporting Act (FCRA), enacted in 1970, was one of the gove rnment’s earliest 

attempts to prevent identity theft. The act put the Federal Trade Commission (FTC) in charge of 

enforcing FCRA regulations. FCRA gave victim s the optio n of pursing restitution from credit 

companies who aided in the process of identity theft. The FC RA suffers fro m a short statute of 

limitations, causing the application of the law to cases of identity theft difficult (White, 2005). 

This means that when the victim actually discovered that identity theft had occurred, it was o ften 

too late to make any claims against the credit companies. FCRA also limits a victim’s course of 

action by placing financial institutions, such as credit bureaus a nd lenders, off lim its to any 

claims, only allowing the victim to pursue credit reporting agencies. 

The Identit y Theft and Assu mption Deterrence Act of 1998 ( ITADA) was enacted to make 

identity theft a federal crime. “Its central pr ovision states that “whoever knowi ngly transfers or 

uses, without lawful authorit y, a means of identif ication of another person with the intent to 

commit, or to aid and abet, any unlawful activity that constitutes a violation of federal law, or that 

constitutes a felony under any applicable State or local law” shall be punished” (Fogarty, 2002, p. 

2). Social security numbers and driver’ s license inform ation are not the only “m eans o f 

identification” na med in the ITADA, biometric dat a, passport i nformation, alien registra tion 

number, and others are also listed. 

The ITADA designated the Federal Trade Co mmission (FTC) to receive and disseminate 

information regarding iden tity theft to t he appropriate parties. Th e FTC is also responsible for 

educating citizens on how to prevent identity thef t and the steps to take in the instance that 

identity theft has alr eady occurred. T he act also provides the victi ms with the right to receive 

restitution and gives law enforcem ent agencies the ability to deal with identity theft on their own 

level. 

The Fair and Accurate Credit Transactions Act (FACTA) was passed by Congress in 2003. This 

act e stablishes per manent credit reporting standa rds and addresse s proble ms r elated to ide ntity 

theft on a federal level (Linnhoff, 2004). FACTA is an amendment to the Fair Credit Reporting 

Act which extends consumers’ rights re garding identity theft. Thi s paper will concentrate on the 

items, included in the act, that are concerned with identity theft. 

Receipts for purchases on credit once contained the customer’s full credit card number. This was 

the first step in the crim inal’s process of retr ieving identity information. The enact ment of 

FACTA eliminated this practice by requiring that credit card numbers on receipts be truncated, as 

well as remo ving expiration dates. However, the receipts that are printed m anually still c ontain 

the full card number and are still susceptible to thieves who rummage through trash. 

Criminals often use postal services to aid in the process of committing identity theft. Once thes e 

criminals have an individual’s name and address, they can easily send a change of address to the 

credit co mpany and reque st an additional card be s ent to that address. Card issuers are now 

required to s end notification to both the new and old address that an additional card has been 

requested and help customers when errors have been discovered (Linnhoff, 2004). In theory, this 

requirement will reduce, and eventually put a halt to, this form of identity theft from occurring. 


Identity theft causes the destruction of an indivi dual’s credit history. Many consum ers do not 

discover that identit y the ft has occurred until the damage has already been do ne. W hen 

consumers actually realize what has ha ppened, they contact a c redit reporting agency to infor m 

them of the criminal action. Once a cr edit reporting agency has been info rmed by the consumer, 

FACTA requires that the agency include a fraud alert in their record s. This fraud alert informs 

anyone who accesses that information that identity theft has occurred. Credito rs will go to great 

lengths to verify the ident ity of the consumer who has a fraud alert on their record. This is a 

nuisance for the consumer, but hinders criminals from committing further identity theft. 

FACTA also addresses the concerns of those consumers whose cr edit reports have a fraud a lert 

attached. FACTA allow s consu mers to take c ontrol of their cr edit by preve nting i nformation 

related to identity theft from being distribut ed. Consum ers wa nting to stop acce ss to their 

fraudulent d ata onl y need to tur n in a police report (Lin nhoff, 200 4). FACTA also aids 

consumers b y eventually erasing the inform ation r elated to identit y theft fr om their fil e. It 

requires that credit repor ting agencies block the information related to identit y theft on the 

consumer’s credit report. 

The best line of defense against identit y theft is for consumers to vigilantl y look at their credit 

report. Prior to the passage of FACTA, consumers had to purchase a copy of their credit report in 

order to keep track of their cr edit history. Only when there was suspicion of fraudulent activit y 

did consumers have the right to a free report. FA CTA extends the right to a free credit report to 

anyone who requests one. The sad realit y is that even though credit reports are now free, there 

are still consumers that do not access that information to ensure that their credit is indeed correct. 

FUTURE DIRECTIONS 

According to Lacey (2004) “In the United States id entity theft was described as growing at a rate 

of 30 percent per year, with its losses esti mated at reaching $8 billion by 2005” (p. 247). 

Businesses and governments, as well a s individuals, have been working to fi nd solutions to help 

prevent identity theft. Congress has e nacted severa l laws that address the situation, but e ven 

these la ws d o not address every aspect of identity theft. Businesses have pla ced preventat ive 

measures into operation, but these still do not guarantee the demise of identity theft. Consumer s 

need to examine their own situations and modify the level of security accordingly. 

One possible technique to help combat identity theft is the verification of an individual’s identity 

by the use of biom etric technolog y (S overn, 20 04). This sy stem would be a trem endous step 

forward in verify ing identities as w ell as preventi ng further identity theft. The only drawback 

would be th e cost of in stallation and mainte nance. Not only do some com panies lack the 

resources necessary to obtain biom etric technology, but the c osts of devel oping this s ystem 

usually outweigh the benefits received. In most instances, the costs incurred due to identity theft 

are less than the costs required to acquire a biometric system. 

Another sug gested remedy, which attem pts to pr edict identit y theft, is called cross industry 

pattern recognition (Cheney , 2003). T his would assem ble data across industries allowing each 

company to observe the path of possible identit y thieves. This approach will com bine individual 

acts together, that when compared as a whole appears fraudulent, but the individual acts alone do 

not raise suspicion. This will reveal fraudulent patterns of behavior that com panies can identif y 

and stop before further activity occurs. 

The best fight against identity theft is for cons umers to be aware of their credit history and 

employ practices to s afeguard their identity inform ation. The first line of defense i s to keep 

personal information in a safe location. A si mple mistake that people make is to keep their social 


ID Theft


security cards in their wallets, along with their dr iver’s licenses and credit cards. If the wallet 

were to be stolen, all the data a criminal requires to commit identity theft is readily available. The 

next step is to shred all do cuments containing personal information and possibly even separating 

the remnants to prevent thieves from assembling the pieces to retrieve that information. 

Consumers need to under stand and ensure that requests for id entity inform ation are valid 

(Cheney, 2003). This means that the consumer should exercise all means necessary to verify the 

identity of th e person or com pany requesting the in formation. They also need to have a c lear 

understanding of how the person or com pany will use the information provi ded and if it will be 

shared with a third party . If there is no explana tion for the use of identit y information, or if the 

consumer does not feel comfortable, the data should not be given to the interested party. 

Further, there are support s ystems to aid identit y theft victims and to educate citizens on how to 

prevent identity theft. Many police departm ents, as well as co mmunity service groups, provide 

information to educate citizens on identity theft. There are also many online venues citizens can 

use for the s ame purpose. The Federa l Trade Commission allows free ac cess to Identity Theft: 

When Bad Things Happen to Your Good Name, a publication on preventi ng identit y theft 

(Newman, 2004). The Identit y Theft Resource Cent er is an organ ization which gives consumers 

an opportunity to give advice, seek help, and shar e stories on the topic of identi ty theft (Cheney, 

2003). 

Businesses a nd governm ents also need to do thei r part in the fight against identity theft. 

Consumers place their trust in these businesses and expect their personal information to be held in 

a safe environment. When that trust h as been broken, consumers expect different government 

agencies to act quickl y to find the thie f and punish them accordingly. However, identit y theft 

continues to occur and co nsumers are left fee ling that nothing has been done to im prove the 

problem. 

There are numerous storie s of disgruntled e mployees stealing information before they leave their 

jobs, placing the busi ness in an awkw ard position. On top of employee the ft, is the out side 

intrusion provided by the internet. Businesses n eed to take steps to prevent data misuse by 

employees, as well as outside intrusion into their computer systems (Newman, 2004). The first 

action businesses could take would be to pe rform background checks on new e mployees to 

determine if they are a risk and where they should be placed. Business es could regulat e 

employee theft by proper training and performing routine checks to ensure that the information is 

handled properly and limiting the access to inform ation by em ployee job des cription. The la st 

step businesses should take is to have a disposal method, such as document shredding, to dispose 

of personal information in a way that prevents thieves from having direct access. 

There is still the problem of outside intrusion via the Internet. Businesses need to have programs 

in place to safeguard against hackers or other intruders. Stronger authentication procedures could 

help reduce theft from outside intrusion, but th ieves still find wa ys to access t his inform ation. 

Today, businesses still have not found a fool proof method to stop identity thieves on the Internet. 

Businesses need to work together, along with the government, to find a solution that is both cost 

effective and actually works to bring identity theft to an end. 

Local, state, and federal governments are all impacted by the crime of identity theft. “Due to this 

impact, identity t heft crimes fall under the authority of m any di fferent agencies, including the 

local police, Secret Service, Postal Inspection Service, FBI, Homeland Security, local government 

offices, and motor vehicl e depart ments, to name j ust a f ew” ( Newman, 2004). The law 

enforcement agencies all need to work together, along with businesses and consumers, to battl e 


identity theft. The first step that could be taken is to stop the use of social security numbers as the 

key iden tifier and requirement to obtain forms of identification. Restri cting acc ess to birth 

certificates will also hinde r criminal’s ability to commit identit y theft (Newman, 2004). T hese 

two identifiers, in the ha nds of an identit y thie f, can be used to acquire a driver’ s lic ense, 

employment, health insura nce cards, and ot her types of i dentification needed to commit identit y 

theft. Governments, along with businesses, also need to remove any sensitive data, such as social 

security numbers, from p aychecks, ide ntification badges, and any other item that contains this 

sensitive material, and replace it with an employee assigned number. 

SUMMARY AND CONCLUSION 

Identity theft continues to haunt i ndividuals, bus inesses, and governments. It will continue to 

grow unless action is tak en by all pa rties. There are nu merous way s thieves obtain identity 

information and use it to c ommit theft or fraud. Th e two main forms of identification, the social 

security number and the driver’s license, are e asily acce ssible f or crim inals. The inform ation 

retrieved from these is us ually enough for the criminal to commit identity theft. The Internet has 

opened new doors to obtain this information from both businesses and consumers. 

This act of identity theft leaves large los ses behind. Consumers w ho have been victim ized must 

spend m oney out-of-p ocket to defend t heir nam es. They also spend valuable time a way from 

work and fa mily, usually dipping into their vacation tim e to defend their case. Victi ms s uffer 

emotional pain, as well as damage to their financial reputation, and often require medical 

attention. This medical attention must also be paid for by the consumer. 

Businesses and governm ents also suffer losses due to identity thef t, ranging in the billions. 

Governments suffer losses to investigate each c ase that is reported, as well as the costs incurred 

for proposing and enactin g new laws. Financial institutions and the reta ilers who accept their 

credit cards f or purchases often battle over who is held responsible for the losses incurred f rom 

identity theft. Instead of battling between one another, these businesses need t o work together to 

find a solution to this problem. 

Laws do exis t to deal with identity theft, but even these la ws do not address every detail. The 

FCRA gave victims of identit y theft t he right t o restitution, but had a short statute of lim itations 

and did not allow the victims to go after financia l institutions. The ITADA made identity theft a 

federal criminal offense and placed the FTC in ch arge of receiving and distributing identity theft 

information. The FACTA is an amendment to the FCRA and extends consumers rights regarding 

identity theft. FACTA requires credit card numbers on receipts t o be truncated, card issuer s to 

inform the cardholder regarding addre ss chang es and requests for additional cards, and credit 

agencies to put fraud alert s in their r ecords when informed by the consumer. It also prevents the 

release of inf ormation related to i dentity theft from being d istributed and extends the ri ght to a 

free credit report to everyone. 

These laws are a step toward the right direction, but progress can be made. There are many new 

ideas on how to prevent identity theft i ncluding biometric technology and cross industr y pattern 

recognition. However, the best line of defense still lies with the consum er. Co nsumers need to 

take steps to better protect themselves against identity theft, as well as working with busines ses 

and governments, to find a solution to bring an end to identity theft. 

REFERENCES 

Berg, S. (2003). "Identity Theft: Business Victi mization." Enterprise Security. . 


ID Theft


Berghel, H. ( 2006). "Fungible Credentials and Next-Generation Fraud." Communications of the 

ACM, Number 49, 15-19. 

"Cashiered." (2007). Economist, 383, Academic Search Premier. EBSCO. 

Cheney, J. S. (2003). "Ide ntity Theft: a Pernicious and Costly Fraud." Federal Reserve Bank of 

Philadelphia. . 

Dinev, T. (2 004). "Wh y Spoofing is Serious Internet Fraud." Communications of the ACM 

Number 49, 77-82 

Fogarty, S., Ortiz, D. R. and Carter, J. C. (2002). "Stealing the Self: I dentity T heft and 

Restrictions on Using and Dissem inating Personal Identifiers." Markle Foundation Task 

Force on National Security in the Information Age. . 

"Identity Th eft: the Afterm ath of 2003." (2 3 Sept. 20 03). Identity Theft Resource Center. 

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Krause, J. (2006). "Stolen Lives." ABA Journal, Volume 92, 36-64. Acade mic Search Pre mier. 

EBSCO. 

Lacey, D., and Cuganesan, S. (2004). "The Role of Organizations in Identity Theft Response: the 

Organization-Individual Victim Dy namic." Journal of Consumer Affairs, Volume 38, 

244-261. 

Linnhoff, S., and Langen derfer, J. (2004). "Identit y Theft Legislation: the Fair and Accurate 

Credit Transactions Act o f 2003 and t he Road Not Taken." The Journal of Consumer 

Affairs, Volume 38, 204-216. 

Mercuri, R. (2006). "Scoping Identity Theft." Communications of the ACM, Volume 49, 17-21. 

Milne, G. R., Rohm , A. J. and Bahl, S. (2004) "Consumers' Protection of Onli ne Privacy a nd 

Identity." The Journal of Consumer Affairs, Volume 38, 217-232. 

Milne, G. R. (2003). "How Well Do Consum ers Protect Themselves Fro m Identity Theft?" The 

Journal of Consumer Affairs, Volume 37, 388-402. 

Newman, G. R. (June 2004). "Identit y Theft." Center for Problem-Oriented Policing. . 

Ryst, S. (4 April 2006). "Stopping a Scam From Spreading." Business Week Online, 3. 

Sovern, J. ( 2004) "Stopping Identity Theft." The Journal of Consumer Affairs, Volume 38, 233- 

243. 

White, A. E. (2005). "The Recognition of a Neg ligence Cause of Action for Victims of Identit y 

Theft: So meone Stole My Identity, Now Who is Going to Pa y for It?" Marquette Law 

Review, Volume 88, 847-866. 


MINING FOR KNOWLEDGE IN HIGHER EDUCATION 

Huebner, Richard A. 

Norwich University 

rhuebner@norwich.edu 

ABSTRACT 

Data mining is used as a strategic decision-making tool in many public and private firms across 

multiple industries. Even though it is used frequently in business and government, the use of data 

mining is lacking in higher education. Higher educational institutions could see many benefits 

through the use of data mining. A significant amount of time appears to be wasted using only 

Microsoft Excel and Access to analyze data. This paper focuses on how higher education can 

adopt data mining with very few barriers. Additionally, this paper focuses on the numerous 

benefits data mining can provide specifically within higher education. It is expected that data 

mining can provide a way for educational organizations to learn a great deal about their 

customers and target customers. 

INTRODUCTION 

Data mining (DM) is a set of techniques used to find patterns, trends, or relationships in large 

data sets. DM also describes the underlying algorithms that accomplish the aforementioned tasks. 

DM may be called data analytics, or knowledge discovery, but these are not the same. Dunham 

(2003) noted that knowledge discovery and data mining are distinct ideas. Knowledge discovery 

in databases (KDD) “is the process of finding useful information and patterns in data” and data 

mining is “the use of algorithms to extract information and patterns derived by the KDD process” 

(p. 9). The KDD process includes five steps: selection, preprocessing, transformation, data 

mining, and interpretation (Fayyad, Piatetsky-Shapiro, & Smyth, 1996). A considerable amount 

of time must be spent on pre-data mining work in order to make DM results useful. Selection and 

pre-processing of data involve determining which data are to be used and which data are to be 

excluded. Additionally, data must be cleansed to ensure high data quality and reliability. 

Data mining is frequently used in conjunction with data warehouses (Elmasri & Navathe, 2007). 

Data warehouses, however, contain transformed data. An extract, transform, load (ETL) process 

converts transactional data into data suitable for a data warehouse. ETL is a series of steps that 

transforms the data into aggregate or summarized form. Additionally, the data analyst (or 

database administrator) must scrub or cleanse the data. The process also helps to make data 

mining more efficient. Elmasri and Navathe (2007) note, “data mining applications should be 

strongly considered early, during the design of a data warehouse” (p. 960). 

Why does an organization need data mining? The reasons are threefold: to support strategic 

decision-making, to support knowledge discovery, and to gain a competitive advantage (Nemati 

& Barko, 2004b). Another reason is that failure to turn raw data into actionable information may 

result in missed opportunities. As easy as it is to collect large amounts of data, it is not as easy to 

convert all that data into actionable information. Thus, organizations need methods and tools to 

make sense out of that data. DM can be used to explore patterns, find trends or relationships 

among data, or summarize and categorize data. Witten and Frank (2005) noted, “there is a 

growing gap between the generation of data and our understanding of it….and as the volume 

increases, the proportion of it that people understand decreases” (Witten & Frank, 2005, p. 4). 


Mining for Knowledge..Higher Ed 

should. Association rule mining can also be applied to retail transaction data for optimal product 

placement (Chen, et al, 2006). 

Marketing departments can also benefit from data mining. Ways that marketing departments 

might use data mining include customer profiling, targeting, and market-basket analysis. 

Customer profiling helps organizations identify customers that will be the most profitable. It is 

also a significant aspect of customer relationship management (CRM). According to Olson and 

Shi (2007), CRM is about “targeting customers for special treatment based on their anticipated 

future value to the firm” (p. 194). For example, marketing professionals can use data mining 

techniques to help determine which customers might respond to a given advertisement or 

promotion. By gathering customer demographic information and comparing it to recent sales 

data, marketing staff are able to predict which customers to target for their next advertisement. In 

this type of application of data mining, highly accurate data is required in order to produce an 

accurate prediction model. Additionally, data quality has a significant impact on data mining 

results. Database marketing is an application of data mining in which marketing data is used for 

customer acquisition, development, and retention (Lo, 2002). Customer segmentation was one of 

the first uses of data mining. In this scenario, data mining tools take massive amounts of data and 

segment the data into categories, which can then be used to predict responses to advertising 

campaigns (Olson & Shi, 2007). Through the use of customer relationship management (CRM), 

organizations can also analyze the expected churn of its customers. According to Olson and Shi 

(2007), large customers are “often targets of intense competition, and thus are high risks for 

churn” (p. 195). Some of the data mining tasks used to analyze church include neural networks 

and regression analysis. 

According to a GAO Report (2004), many government agencies use data mining. Each year, 

government agencies are surveyed to determine how each is using data mining. For example, the 

Defense Intelligence Agency (DIA) had three operational data mining systems that are used for 

“analyzing intelligence and detecting terrorist activities” (GAO, 2004, p. 30). One system at the 

DIA, called PATHFINDER, is designed to analyze large volumes of government and private 

sector databases rapidly. This particular system analyzes patterns related to terrorist activities. It 

also contains personal information about citizens and matches data with data from other agencies. 

Another example found in the Department of the Air Force is called the Integrated Space Warfare 

Center Information System (SWC), designed to improve performance and service related to 

personnel and warfighter needs. Most of these systems do not use private sector data, but do 

contain personal information about individuals. 

Solomon et al. (2006) investigated data mining as it pertains to traffic safety improvement. The 

research examined how data mining can evaluate the effectiveness of cameras installed at 

intersections in reducing driver and pedestrian fatalities. Solomon et al. applied a variety of data 

mining models to traffic data gathered from the Washington, D.C. area after traffic lights were 

installed at several busy intersections. Solomon’s research team applied decision tree models, kmeans 

clustering, neural network, and market basket analysis to demonstrate how data mining 

models can be used to reduce fatalities at traffic signal intersections. Results suggested that 

installing cameras at strategically chosen intersections did, in fact, reduce fatalities. These 

conclusions were based on real fatal accident data used for the data mining tasks. Finally, 

Solomon et al. noted that it is imperative to collect data in a consistent and complete manner 

when engaging in data mining (Solomon, Nguyen et al., 2006). 

The retail industry uses data mining for strategic and tactical decision-making. A study by Chen 

et al. (2006) investigated the spatial relationships between adjacent items on store shelves. While 

much work has been done on the use of data mining in retail, prior work has not considered 


Huebner 

spatial relationships on item sales. Thus, data mining can and should be used to investigate the 

visual effects of placing certain products next to other products (Chen, Chen et al., 2006). In this 

research, retail transactional data was assumed to include spatial elements, such as product-toshelf 

assignments. However, real-world retail transactional data may not contain this information. 

While this may limit the applicability of the research to actual practice, this exploratory research 

demonstrates the feasibility of using data mining for such purposes. 

Ordonez (2006) showed how association rules and decision trees can be used for disease 

prediction. This research is unique in that most medical datasets are mined using classifier trees, 

clustering, or regression. Rarely are association rules used to mine medical data. One challenge 

with producing association rules for medical data is that many of the rules produced are 

irrelevant. Thus, it is necessary for any association algorithms used in this domain to produce 

only the most significant rules. Ordonez (2006) introduced search constraints to determine what 

the most significant rules might be. In heart disease prediction, Ordonez’ research found that 

when comparing decision trees to association rules, the association rule approach was able to 

produce simpler rules that were easier to interpret and had higher reliability than the decision tree 

approach (Ordonez, 2006). 

Data mining is useful in a wide variety of areas outside industry and government. Dringus and 

Ellis (2005) investigated the use of data mining in an academic environment to assess student 

posts within an asynchronous discussion forum. The initial problem focused on the fact that 

instructors spent a considerable amount of time reading through student posts throughout the 

duration of the semester. This research team found that data mining could aid the instructor in 

evaluating student’s discussion forum posts (Dringus & Ellis, 2005). 

DATA MINING REQUIREMENTS 

As noted earlier, data quality has a significant impact on data mining output. This is why under 

most circumstances, a preprocessing phase should take place to conduct the ETL steps. This 

preprocessing phase is designed to help improve data quality through sanitizing, or cleansing the 

data. Underlying data mining algorithms depend on high quality data to provide high quality 

output. The worst-case scenario would be that data mining output provides bogus data. 

How does missing or perturbed data affect data mining? Brown and Kros (2003) concur with 

others that the accuracy of data mining models is based on the quality of underlying data. It is 

important or data mining users to understand how underlying data affects the model. Data mining 

users must address inaccurate and missing data issues before applying data mining algorithms to a 

dataset (Brown & Kros, 2003). There are different kinds of missing data, such as data missing at 

random. One could also decide to treat outliers as missing data, or simply use complete records 

only. Missing and perturbed data impact data mining approaches including clustering, association 

rule mining, decision trees, neural networks, and k-nearest neighbor (kNN) (Brown & Kros, 

2003). In fact, any missing or perturbed data will compromise the utility of any data mining 

output. 

Alshawi et al. (2003) noted that the healthcare industry has seen a growing demand for advanced 

analysis of patient information. To this end, Alshwi et al. noted that the healthcare industry has 

embraced customer relationship management (CRM). In order to accomplish some of the goals of 

CRM, the healthcare industry has to investigate integration and data quality issues. So, prior to 

using data mining, healthcare organizations must first integrate data from different sources and 

ensure that data is of high quality (Alshawi, Missi et al., 2003). Important data quality factors 

include data completeness, consistency, accuracy, timeliness, and verifiability. Alshawi et al. 

provide a framework that can be used to evaluate data quality and integration within the 



healthcare industry. Even though the framework was initially developed for the healthcare 

industry, the framework could also be applied to other industries. 

A firm grasp of the overall data mining process is necessary before engaging in this type of 

strategic program. CRISP-DM (CRoss Industry Standard Process for Data Mining) was 

developed in 1996 by three organizations including SPSS, DaimlerChrysler, and NCR. The goal 

was to develop a standardized process for the growing field of data mining. CRISP-DM is 

intended to be an industry tool and is vendor neutral. The process model outlined in CRISP-DM 

provides step-by-step guidelines for executing data mining projects. CRISP-DM is based on 

practical, real-world applications of how data mining projects should work. The methodology 

breaks down data mining activities into manageable tasks ranging from four different levels of 

abstraction: phase, generic task, specialized task, and process instance. CRISP-DM focuses on a 

data mining life cycle (DMLC) that contains various phases of a project. Phases of a data mining 

project include business understanding, data understanding, data preparation, modeling, 

evaluation, and deployment. Data mining is often an iterative process as well so that during an 

evaluation phase of a data mining project, the results may indicate that additional data 

understanding or data preparation is necessary. 

There are six major steps to the CRISP-DM methodology. The methodology introduces major 

tasks associated with each step in the overall data mining process. The first step in a data mining 

project should begin with an understanding of the business, including business objectives, 

situation assessment, goals for data mining, and a project plan. Each step in the methodology has 

multiple tasks associated with it. For example, an assessment of the current business situation 

may review an inventory of resources, examine contingencies and risks associated with a data 

mining project, and conduct a cost and benefits analysis. 

During the second step of the CRISP-DM methodology, one should gain a thorough 

understanding of the data. One can do this by collecting an initial set of data, using descriptive 

statistics to describe the data, explore the data, and verify data quality. This step is important 

because data quality has a significant impact on data mining output (SPSS, 2006). 

The third step in the CRISP-DM methodology requires one to prepare the data. This involves a 

detailed analysis and preparation of data before it is mined. Data sets are selected, cleansed, 

reconstructed, or new data may be derived from existing data. Reformatting or data integration 

may also take place during this step. At this point, one must address problems with the data such 

as missing data, corrupt data, or noisy data. One might choose to ignore missing data and decide 

how to deal with special values. Once data has been prepared, one can move onto the next phase, 

where modeling occurs. (SPSS, 2006) 

During the fourth phase, a modeling technique is selected such as a decision-tree or neural 

network. Also, one must decide whether clustering, classification, or association rule mining 

should be used at this point. The business understanding and goals for the data mining project 

would have already been outlined at this step, so it should not be difficult to choose which 

modeling technique to use. The model should then be tested for quality and validity, to ensure 

that datasets can be separated into training datasets and full datasets. Parameters for each 

modeling technique should also be carefully selected at this point in the process. (SPSS, 2006) 

The fifth step in the process that proceeds from modeling is the evaluation phase. During the 

evaluation phase, one must evaluate the results of the model, review the entire process, and then 

determine what steps to take next. As per the CRISP-DM model, a good way of thinking about 

data mining results is by using the equation: RESULTS = MODELS + FINDINGS (SPSS, 2006). 


Huebner 

This phase examines the accuracy, and generality of the model output. Therefore, the models are 

not the only output, but the findings such as what worked and what did not. Additionally, the data 

mining user should examine, as part of the evaluation phase, any misleading results or failures in 

the overall data mining process. 

The sixth and final step in the CRISP-DM methodology is the deployment phase, in which the 

data mining results are deployed or disseminated back to the business. The tasks involved during 

this stage include summarizing the results, determining how the results will be disseminated and 

in what format, and determining how data mining activities will be monitored and maintained in 

future projects. Monitoring and maintenance are an important aspect of ongoing data mining 

activities within an organization, so time should be spent considering these. As with other types 

of projects, data mining projects should be reviewed after results have been reviewed and 

disseminated (SPSS, 2006). This is the part of a project where best practices can be learned over 

time. A data mining project’s documentation as well as a project review can help a project team 

develop best practices. 

In addition to understanding a DMLC process, the data mining user must also understand 

statistics and underlying data mining algorithms. It is not always possible to have an employee 

(who will be using the data mining software) who understands the intricate details of the data 

mining algorithms. However, it is advisable for the user to have a firm grasp of statistics in order 

to at least understand what is happening and how data mining provides its output. Some of the 

statistics used in data mining include linear and multiple regression, principal component analysis 

(PCA), Beyesian approaches, and discriminant analysis. Methods from artificial intelligence are 

also used in data mining, such as neural networks, rule induction (decision trees), and genetic 

algorithms. 

CHALLENGES AND RECOMMENDATIONS 

In higher education, data may include private or sensitive attributes about students. Given the fact 

that data mining is geared toward discovering new patterns and relationships among data, one 

concern may be that data mining could allow the user to infer something new about a particular 

student or group of students. For example, one argument against the use of data mining within 

higher education is that it may violate FERPA law. FERPA law essentially states two things: (1) 

students have certain rights with respect to information that universities or colleges maintain 

about them; and (2) the privacy of those records are preserved. Therefore, in order to comply with 

FERPA law, data mining output must maintain privacy of individual student records. Anyone 

reading the data mining output should not be able to identify nor infer information about a 

specific student. Since data mining is designed to provide output in an aggregate or summarized 

form, normally this would not be an issue. One way to protect individual privacy of student 

records (and comply with FERPA law) is to sanitize records by removing student names. This is 

simple and can be done during the data preparation phase of a data mining project. 

One argument against data mining may be that the software is too expensive. This comment is 

simply not true especially if one wants to engage in data mining on a smaller scale. Data mining 

does not necessarily have to consume large amounts of resources to be effective. Free software 

applications are available for data mining, including Weka (available at 

http://www.cs.waikato.ac.nz/ml/weka/) and Orange (available at http://www.ailab.si/orange/). 

These software packages are open source, meaning that if one wants to modify them to suit one’s 

own needs, it is acceptable to do so. The one drawback to open source toolkits such as these is 

that receiving support is difficult or practically non-existent. However, the software has an easyto-use 

user interface. 



Another argument against data mining is that some people feel that the software is too difficult to 

learn. The open source software mentioned above comes with documentation, and has additional 

documentation on its associated web sites. There are sample data sets that come with both Weka 

and Orange so that one can “play around” with data in order to learn the software first, before 

engaging in data mining with their own data. Weka and Orange also have graphical user 

interfaces (GUI), so that one can visually inspect data through a series of menu choices and 

dialog boxes. As mentioned above, with open source software there may be little to no support if 

something goes wrong. This is not entirely true. There are online FAQs, discussion boards, and 

blog sites where users of the software discuss issues and often another user will post a potential 

solution to the problem. Not having access to formal technical support should not prohibit an 

organization from using open source software. 

“We don’t have the resources to implement data mining” is another argument against using data 

mining. However, financial resources and human resources should not be an excuse for avoiding 

implementing software and systems that can provide significant insight into organizational data. 

If one’s argument is against data mining because of financial limitations, there are several opensource 

tools to get organizations “on board” with data mining (see answer above to this 

argument). Human resource limitations are a difficult argument to rebut. However, one needs to 

be somewhat familiar with data mining process and interpretation of data mining output. Anyone 

venturing into the world of data mining should have a firm understanding of and background in 

statistical methods and informatics. 

Trying to get quick results from data mining is strongly discouraged. It is preferable to take the 

time to understand the data and follow a pre-defined process (such as CRISP-DM) to be able to 

get useful outputs. Even though using data mining may be time consuming, the results should be 

well worth the effort. 

Admissions departments can use data mining to help them quantitatively determine the type of 

students to admit. By organizing student data and preprocessing it to include such items as SAT 

or ACT scores, GPA, grades, and so forth, one could use regression to determine how placement 

scores might predict success in college (in terms of GPA). While admissions staff may not always 

be quantitatively “inclined”, the data mining software would have to be accessible to those 

individuals who do not necessarily know all of the intricate details of data mining. In other words, 

there must be some way to make data mining more user-friendly. Tools such as SPSS Clementine 

provide a graphical user interface (GUI) that is easy to use. Even though the product is costly, one 

will receive technical and product support with the purchase. 

Registrars and admissions departments could also use data mining help identify groups of at-risk 

students (students who might be at risk for being placed on academic probation or potentially 

dismissed from the university). The following are a few ideas in which exploratory data mining 

might prove useful: 

• What percentage of students who passed calculus I also passed calculus II? 

• What groups of students (freshman, sophomores, juniors, or seniors) are more at-risk for 

being placed on academic probation? 

• Who should we admit? 

• How can we better focus our finances and market to those high school students who are 

more inclined to come to our type of school? 

• Is an ACT or SAT score a “good” predictor of college success? Are they an indicator of 

success based on current students at our school? 


Huebner 

Exploratory data mining is specifically designed to help the user explore the data and find 

interesting information buried within the large data that he or she is sifting through. There is so 

much data that we have within higher educational institutions, that we ought to begin converting 

that data into useful information and subsequently, knowledge! Data mining is clearly one way 

that higher education can gain much more knowledge about its customers and target customers. 

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Nemati & C. Barko (Eds.), Organizational Data Mining. Hershey, PA: Idea Group 

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(2nd ed.). San Francisco, CA: Morgan Kaufmann. 


WILL FAILURE ENABLE SUCCESS? 

MOVING ONWARD FROM WTO’S DOHA FAILURE 

William J. Kehoe 

University of Virginia 

Linda K. Whitten 

Skyline College 

ABSTRACT 

This manuscript addresses the World Trade Organization’s Doha failure. More specifically, the 

research examines events leading to the failure of the fourth WTO Ministerial Conference’s Doha 

Development Agenda and the steps taken to revive the process. 

INTRODUCTION 

At the time of the 60 th anniversary (January 1, 2008) of the world’s multilateral trading system, a 

system framed by the General Agreement on Tariffs and Trade (GATT) and its successor the 

World Trade Organization (WTO), this manuscript examines whether the WTO’s recent Doha 

Development Agenda’s failure will be revived and what that bodes for continued development 

and growth of the multilateral trading system; that is, whether from failure will come eventual 

success? The GATT/WTO multilateral trading system is a story (GATT/WTO at Sixty, 2007) “of 

remarkable change and adaptation, of a system that has contributed significantly to post war 

prosperity, but which has not delivered all it could and which still faces formidable challenges.” 

One of its most formidable challenges, the failure of the fourth WTO Ministerial Conference’s 

Doha Development Agenda, is the focus of this manuscript. 

In examining Doha’s failure and questioning whether failure will enable success, this research 

was deliberately focused only on the WTO’s actions before and during the period of failure. That 

is, the research examined the WTO’s reactions to the Doha failure as well as steps taken to revive 

the Doha negotiations, primarily through the activities of the WTO Director-General’s office. 

This research does not examine the many arguments for and against the WTO that were spawned 

by the Doha failure. Those arguments, many of which are important and interesting, will be 

addressed in subsequent manuscripts. 

Earlier manuscripts (Kehoe, 1998; Kehoe, 2004; Kehoe, 2006) examined the role of global and 

regional economic integration in facilitating international trade and comity. These manuscripts 

explored the activities and structure of the General Agreement on Tariffs and Trade (GATT) and 

the World Trade Organization (WTO) in facilitating friendly relations among nations in the 

conduct of global trade. The GATT used a series of eight GATT Rounds and the WTO uses its 

Ministerial Conferences to facilitate trade. Each of these processes is discussed in more detail 

below. 

What would happen if the trade-facilitating processes of the WTO were to fail or, perhaps more 

drastically, if the WTO ceased to exist? Kehoe (2006) raised this question in an earlier article 

asking: “Consider for a moment a world in which nations are unable to find any common ground 

upon which to conduct international trade. Consider a situation where there is no trust between 

nations, no agreements, and no facilitating agencies for trade. It is every nation for itself with no 

concern how its actions might impact on other nations.” A situation described by a former WTO 

Director General (Moore, 1999) as conducting international trade under the “rule of the jungle.” 

Does the apparent failure of the Doha Development Agenda bring the world closer to a situation 


Kehoe and Whitten 

of no trust between nations, no agreements, and no facilitating agencies for trade? Or, having 

experienced the failure of a WTO trade-facilitating process in the Doha situation is the world 

moving onward from the Doha failure; that is, will the failure enable success? 

THE WTO AND DOHA 

The WTO, established on January 1, 1995, emerged as GATT’s successor at the conclusion of 

GATT’s Uruguay Round. Over its half century of activity (1947 to 1995), the GATT conducted 

eight rounds of trade discussions. 

GATT Rounds: The GATT rounds included (Kehoe, 2004): 

• The First Round (Geneva Round: April 1947 to September 1948) 

• The Second Round (Annecy Round: April-August 1949) 

• The Third Round (Torquay Round: September 1950 to April 1951) 

• The Fourth Round (Geneva Round: January-May 1956) 

• The Fifth Round (Dillon Round: September 1960 to July 1962) 

• The Sixth Round (Kennedy Round: May 1964 to June 1967) 

• The Seventh Round (Tokyo Round: September 1973 to November 1979) 

• The Eight Round (Uruguay Round: September 1986 to December 1993) 

The WTO: As the GATT’s successor, the WTO (WTO About, 2007) is the “only global 

international organization dealing with the rules of trade between nations. At its heart are the 

WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in 

their parliaments. The goal is to help producers of goods and services, exporters, and importers 

conduct their business.” Structured around Ministerial Conferences held at least every two years, 

the WTO is comprised today of 151 member nations (WTO Member Nations, 2007). Among 

responsibilities of the WTO are: administering WTO trade agreements; forum for trade 

negotiations; handling trade disputes; monitoring national trade policies; technical assistance and 

training for developing countries; and cooperation with other international organizations (WTO 

About, 2007). The WTO offers the world’s trading nations a forum (WTO at Sixty, 2007) “to 

reduce uncertainty, facilitate negotiations, disseminate information, reduce transaction costs in 

various ways, help to settle disputes, administer agreements, monitor policies and act as an agent 

for surveillance.” All of these activities are under the purview of the WTO’s Ministerial 

Conferences. 

WTO Ministerial Conferences: The WTO Ministerial Conferences to date: 

• First WTO Ministerial Conference, Singapore, December 9 to 13, 1996. 

• Second WTO Ministerial Conference, Geneva, May 18 to 20, 1998. 

• Third WTO Ministerial Conference, Seattle, November 30 to December 3, 1999. 

• Fourth WTO Ministerial Conference, Doha, Qatar, November 9 to 13, 2001. (This 

Ministerial Conference initiated the Doha Development Agenda.) 

• Fifth WTO Ministerial Conference, Cancún, Mexico, September 10 to 14, 2003. (This 

Ministerial Conference reviewed the program of work under the Doha Development 

Agenda and specified the remaining work.) 

• Sixth WTO Ministerial Conference, Hong Kong, China, December 13 to 18, 2005. (This 

Ministerial Conference sought primarily to find common ground for a 2006 Doha 

conclusion (Doha Work Program, 2006). 

DOHA AND AGRICULTURE 

There are twenty-one areas for discussion specified under the Doha Development Agenda (WTO 

Doha, 2007a). Perhaps the most sensitive area is agriculture wherein “member governments 

commit themselves to comprehensive negotiations aimed at: 1. Market access: substantial 



reductions. 2. Exports subsidies: reductions of, with a view to phasing out, all forms of these. 3. 

Domestic support: substantial reductions for supports that distort trade.” 

The charge for agricultural discussions, quoted from the Ministerial Declaration of November 14, 

2001 (WTO Doha, 2007b), was: “We recognize the work already undertaken in the negotiations 

initiated in early 2000 under Article 20 of the Agreement on Agriculture, including the large 

number of negotiating proposals submitted on behalf of a total of 121 members. We recall the 

long-term objective referred to in the Agreement to establish a fair and market-oriented trading 

system through a programme of fundamental reform encompassing strengthened rules and 

specific commitments on support and protection in order to correct and prevent restrictions and 

distortions in world agricultural markets. We reconfirm our commitment to this programme. 

Building on the work carried out to date and without prejudging the outcome of the negotiations 

we commit ourselves to comprehensive negotiations aimed at: substantial improvements in 

market access; reductions of, with a view to phasing out, all forms of export subsidies; and 

substantial reductions in trade-distorting domestic support. We agree that special and differential 

treatment for developing countries shall be an integral part of all elements of the negotiations and 

shall be embodied in the schedules of concessions and commitments and as appropriate in the 

rules and disciplines to be negotiated, so as to be operationally effective and to enable developing 

countries to effectively take account of their development needs, including food security and rural 

development. We take note of the non-trade concerns reflected in the negotiating proposals 

submitted by Members and confirm that non-trade concerns will be taken into account in the 

negotiations as provided for in the Agreement on Agriculture.” Put simply, the charge for 

agriculture was: 

• Phase out all forms of export subsidies on agriculture. 

• Achieve reductions in trade-distorting domestic support for agriculture. 

• Ensure for differential treatment for developing countries. 

THE DOHA COLLAPSE 

The collapse of the Doha Development Agenda in July 2006 was a failure of trade negotiations 

initiated at the Fourth WTO Ministerial Conference in Doha, Qatar in November 2001 and 

carried forward to the Fifth WTO Ministerial Conference in Cancún, Mexico in September 2003 

and to Sixth WTO Ministerial Conference in Hong Kong, China in December 2005. 

In an article in Foreign Affairs, Bergsten (2005) signaled looming troubles for the Doha 

Development Agenda: “Virtually all observers concur that the Doha Round of multilateral trade 

negotiations in the World Trade Organization is faltering badly. Agreements may have been 

reached on the principle (although not the date) of eliminating export subsidies for agriculture, 

but very little have been resolved since the talks were launched four years ago. Almost nothing 

has been proposed, let alone settled, in the crucial service sector.” 

Two years earlier, The Economist foreshadowed Bergsten’s concerns about Doha (Economist 

Article, 2003): “The fault lines in the Doha round are deep. America wants to slash tariffs, 

arguing (rightly) that the best way to help poor countries is through more open markets. Since 

America's tariffs are already low, that puts the onus on the European Union (EU) to cut farm 

tariffs and on big emerging economies to reduce barriers on farm goods and industrial products. 

Emerging economies, in contrast, want fewer farm subsidies and lower tariffs in rich countries, 

but are loath to reduce their own barriers much. Countries such as India argue that in a pro-poor 

Doha round they need do little. The EU chides America both for demanding unrealistically large 

tariff cuts from others and for offering too little farm-subsidy reform of its own. In principle, a 

compromise was there for the taking. Indeed, Mr. Lamy has informally laid out its contours: more 

subsidy cuts than America has offered and more ambitious tariff cuts by the EU and big emerging 



economies. So why has nothing happened? One reason is genuine differences over whether the 

interests of poor people are best served by lower tariffs or more special protection. But the 

explanation lies chiefly in the failure of countries to face down their own powerful protectionist 

lobbies, particularly farmers.” 

And, then it came - the Doha collapse on July 24, 2006 (Economist Article, 2006a): “At last it is 

official. After stumbling on for months, the Doha trade talks have collapsed. On July 24th, at the 

end of yet another futile gathering of trade ministers in Geneva, Pascal Lamy, the World Trade 

Organization’s director general, formally suspended the negotiations. He set no date for their 

resumption. As Kamal Nath, India's trade minister put it, the Doha round ‘is definitely between 

intensive care and the crematorium’.” 

In another article, The Economist (Economist Article, 2006b) reduced the collapse to a single 

sentence: “The Doha round of trade talks is in taters, because farm protection is still too 

precious.” Kuttner (2006) attributed the collapse to “greedy U. S. and European farmers 

influencing governments to refuse to cut subsidies.” Blustein (2006) announced: “So now its 

official. Global trade talks are suspended, perhaps never to resume.” 

REVIVING DOHA 

Is the Doha Round never to resume? This arguably may be a reasonable conclusion, particularly 

given that the Doha Round collapsed without setting a date for resumption. With 151 WTO 

member nations, a collapse with no agreed resumption date means that first there must be a date 

established for a meeting to talk about setting a meeting to set a resumption date. This likely may 

be a difficult task, especially given that trade ministers walked out of the Doha Round’s 

discussions without a date set to return. Hence, setting a date to talk about agreeing to a date for 

resumption likely will be arduous and may require prolonged debate. 

Lessons from the Collapse: Several months after the Doha Round’s collapse, WTO Director- 

General Pascal Lamy began exercising his Director-General’s bully pulpit. He first commented 

about what was learned from the collapse of Doha and cautioned about the cost of not resuming 

negotiations. He noted (Lamy, 2006) “the suspension (of the Doha Round) has resulted in three 

important developments: collective reflection on the cost of a failure; a series of calls for 

resumption; and the beginnings, albeit tenuous, of a reassessment of negotiating positions. The 

prospect of a failure of the negotiations, brandished rhetorically before July, is now seen by many 

countries as a serious hypothesis, and the consequences of such a failure are now emerging more 

clearly - not as a major economic shock that would precipitate any particular market crisis, or a 

breakdown in trade or in the operating environment in the short-term, but rather as a slowly 

developing disease that would progressively sap the strength of the multilateral trading system 

built up over the past 50 years, damaging its economic lungs, its political heart, and its systemic 

bone structure.” 

Resumption Announced: Throughout the summer and fall after the collapse, the Director- 

General made other impassionate pleas to resume the Doha Round. These pleas enabled a 

favorable report to the WTO General Council on February 7, 2007 where Lamy (2007a) 

announced, “we have resumed our negotiations fully across the board … political conditions are 

now more favorable for the conclusion of the Round than they have been for a long time.” 

Having revived the Doha Round in early February 2007, the Director-General (Lamy, 2007b), 

continuing to use his bully pulpit, spoke optimistically about the potential for success in a mid- 

March New Delhi speech: “Since February the negotiations have resumed in full mode in all 

negotiating groups. Members are also working bilaterally, touching base and checking the impact 



of possible compromise numbers on products of their major export interests and main import 

sensitivities. There is also renewed engagement and support at the highest political level.” 

Doha’s Progress: Revived in February, optimistic in March, so now how goes progress on the 

Doha Round? In early October 2007, the Director-General said (Lamy, 2007c) that he believes 

completing Doha is a “political must.” He cautioned about not engaging in deadline setting at this 

time. Rather, he argued that the process of negotiation must go forward at a “text-driven” level in 

the Negotiating Groups. “I think it should be clear to all of us that completing the Round is not 

only technically possible, but also a political must. Over the last few weeks, we have continued to 

hear this message from the highest levels, reflecting a strong commitment to a successful and 

ambitious outcome to the Round.” Lamy continued, “At this stage, I do not believe that it would 

useful to try to fix deadlines or negotiate a detailed roadmap. We cannot afford to let ourselves be 

distracted from the main tasks at hand. We all know what we have to do to conclude the Round, 

and I believe we must maintain our focus fully on substance. There is an active process going on 

in the Negotiating Groups, and this deserves all our attention. This process is now text-driven, 

and texts are substance-driven. Getting into a process debate now would, I believe, risk impeding 

that progress.” 

Q&A about Doha’s Progress: Other insights into progress of the Doha Round are found in an 

on-line chat conducted November 16, 2007 wherein WTO Director General Lamy answered 

questions from a world-wide audience. Here are salient questions and answers about the Doha 

Round, taken verbatim for accuracy from the transcript (WTO Chat, 2007) rather than 

summarizing what was asked and answered. While not presented within quotation marks, the 

following questions and answers are direct quotes from the transcript and are available at WTO 

Chat (2007): 

Question: It’s now over six years when Doha development round was launched. Where do you 

see the negotiation is heading? Do you see any possibility of the conclusion of the round? 

Answer: Not surprising that a negotiation on 20 topics between 151 Members who have to agree 

by consensus takes a bit of time. Remember the previous Round with much less actors and many 

fewer topics took 8 years. We are clearly now entering the final phase of the negotiations with 

compromise texts appearing on the table and the challenge is to keep both the level of ambition 

and the development dimension together. Is this doable so that a conclusion takes place next 

year? Yes. Am I sure it will get done? It is for members to decide. 

Another question probed the issue a bit deeper seeking comment about the main stumbling block 

facing the Doha negotiations. In reply, a bridge-building metaphor was offered. 

Question: What in your view is the main stumbling block for the Doha round? 

Answer: The upcoming end of year holidays! More seriously, the most difficult element now is to 

find the good balance between the reductions in agriculture subsidies, as tariffs and industrial 

tariffs. It is like trying to build a bridge with three pillars: to hold the bridge together we need to 

ensure that the three pillars are capable of sustaining the bridge which will also have to carry 

many other topics such as services, anti-dumping rules, simplification of customs procedures, 

tackling of fishery subsidies which contribute to the depletion of our oceans or reducing obstacles 

to environmental goods and technology. As you can see, a complex bridge! The good news, 

though, is that we are seeing continuous progress in the building of the bridge. 

Another question continues probing about Doha’s progress and the bridge-building metaphor: 

Question: My question relates to the bridge building you mentioned earlier. Much of this requires 

cooperation and collaboration with other international organizations, so that the WTO and its 

Members can learn about fisheries policies when designing its new subsidies rules, and so on. In 



your view, what is the basis (legal or otherwise) for the WTO Secretariat to engage in this kind of 

"external" collaboration? 

Answer: We received a formal mandate for cooperation at the end of the Uruguay Round, in a 

Ministerial Decision on the WTO contributing to greater "Coherence" in global economic policymaking. 

You can find the decision on our website, search for "Coherence". Our traditional 

partners have been the Bretton Woods organisations, but we have greatly expanded our 

cooperation and today we work closely with just about all other UN agencies and other IGOs. In 

each case, the mandate comes also from what our member governments tell us they want us to do, 

since don't forget that our members are also the same governments that are the members of the 

other IGOs. Taking your example, of fishery subsidies, our Members insist that we must work 

closely with the FAO in this area, naturally since while the WTO knows a great deal about 

subsidies and how they affect international trade, we need the FAO's expertise to help us 

understand how those subsidies affect fishery policies and stocks. 

Next was a somewhat technical question about the concepts of “ambitious” and “developmentoriented” 

in a Doha context. The question introduced NAMA (Non-Agricultural Market Access, 

2007) as an example. “NAMA refers to all products not covered by the Agreement on 

Agriculture. It includes manufacturing products, fuels and mining products, fish and fish 

products, and forestry products ... sometimes referred to as industrial products or manufactured 

goods.” 

Question: I’m interested in the use of the terms “ambitious” and “development-oriented” in 

relation to Doha Round negotiations. Because it seems to me that those parts of the negotiations 

that might be termed ambitious are not necessarily development-oriented (e.g. NAMA) and those 

that might be development-oriented are not ambitious enough (e.g. agriculture or aid for trade). 

Answer: hmmm, seems to me that this is only one-way of looking at it. Let me try to give you 

another perspective; on development. I guess nobody can say that developing countries like 

Brazil, South Africa or Uruguay are unambitious on agriculture, or that an ambitious deal on 

agriculture will not help the development of Brazil, South Africa or Uruguay. The same can be 

said of India or Egypt on services, or China and Colombia on industrial goods. This Round is 

ambitious because its results could exceed by two or three times the results of the Uruguay 

Round; it is a development round because it rebalances the world trading system in favor of 

developing countries, addressing first and foremost their concerns. Now, these concerns are not 

only defensive, they are also offensive. If not, how did they manage to put top of the agenda the 

issue of agriculture subsidies? Food for thought? 

Then a question was asked about the Director-General’s satisfaction with progress in trying to 

achieve Doha’s conclusion. 

Question: Mr. Lamy, you have been trying very hard for the conclusion of Doha round and 

promotion of the principle of free trade? Are you satisfied with what you have achieved as the 

Director General of the WTO? 

Answer: I have been pushing and pulling in order to ensure that the mandate agreed in Doha is 

fulfilled. This is my duty, and I also believe that more open trade works for sustainable 

development. After 2 years we are not yet there, but for sure much nearer than we were in 2005. 

And the time for final assessment of what I'm trying to achieve has not come. 

At the on-line chat’s conclusion, a direct question asked about the earliest date Doha can be 

completed. 

Question: And finally, when is the earliest the Doha Round can be completed (there were reports 

of you saying that 'time is running out’)? 

Answer: Time is indeed running out! I would hope that Chairs of the negotiating groups table 

their revised papers shortly, so as to allow us to agree on the modalities for Agriculture and 



NAMA, which would pave the way for the conclusion of the round -- including other important 

and key issues such as services, rules, trade facilitation and trade and environment. I really hope 

this can be done as soon as possible! 

IMPLICATIONS 

In an earlier paper, we posited implications about Doha’s collapse. Several of the implications, 

taken from the earlier paper, are offered once again below. 

Will A Weakened WTO Bring Bilateralism in Trade? - The Doha collapse arguable weakened 

the WTO as a global-arching trade authority (Kehoe, 1998). Soon-Yong (2006), Director General 

of Korea’s KOTRA trade promotion strategy team stated that the suspension of Doha “has hurt 

the image of the WTO on the whole, as well as its authority to mediate trade disputes. Therefore, 

it is possible that the global trade body’s decisions can weaken, inciting a global shift towards 

free trade areas.” What this means is that a weakened WTO may bring a shift away from 

multilateralism toward bilateralism in trade. As one example, India and the European Union 

opened bilateral trade talks shortly after Doha’ collapse (Miller, 2006). 

Will There Be A Rise In Protectionism? - Will renewed bilateralism bring a wave of 

protectionism among the world’s nations, protectionism manifest in increasing tariff and nontariff 

trade barriers? Tariff and non-tariff increases bring additional cost to international trade, 

cost eventually passed on to consumers in the form of higher prices. 

Is There Possibility of Trade Wars? - With a possible rise in protectionism, will there be an 

outbreak of trade wars? With a weakened WTO multilateral system, a system that Blustein (2006) 

says “governed global commerce for the past six decades,” is there “increasing chances that 

countries will resort to tit-for-tat trade wars that could disrupt the global economy?” 

Will There Be A Loss of Comity? - Will there then be a loss of comity in international trade? 

Comity (Kehoe, 2006) is “friendly civility,” wherein nations “maintain courtesy, friendship and 

respect” in the conduct of trade and are open “to other nations for their products and services 

without creating oppressive levels of tariff and/or non-tariff barriers to such trade.” 

Will Peace and Prosperity Be Diminished? - With a loss of comity, what are implications for 

globalization and for peace and prosperity? Will the world’s nations find diminished respect for 

each other and will latent hostility manifest in aggressive actions? 

Will Nations and Individuals Be Diminished? - If there is a loss of comity between nations, and 

if a loss of comity brings a diminishment in trade, arguably are nations also diminished as well as 

individual citizens diminished too? And, with nations and individuals being diminished, is not the 

common good damaged, perhaps for generations? 

CONCLUSION 

Hill (2005) argues that all U.S. citizens should be in favor of Doha’s success: “Self-interest alone 

should persuade Americans to urge their government to push the Doha negotiations to a 

successful conclusion. Hufbauer's studies calculate that, going forward, open global trade would 

raise U.S. income by $500 billion per year, making the average U.S. household richer by an 

additional $4,500 per year. No other policy decision could come close to having such a positive 

impact on the United States' economic well being.” Beyond United States’ interest, Hill (2005) 

stresses Doha’s importance for the world community: “In addition to boosting growth, a broad 

agreement in the Doha Round could help reduce poverty worldwide. The Doha Round is uniquely 

focused on the need to alleviate poverty by integrating poor nations into the global trading 



system. Two factors drove this emphasis on poverty reduction. First, trade ministers launched this 

round of multilateral trade negotiations in Doha, Qatar, two months after the attacks of September 

11, 2001, a time when there was widespread agreement that poverty creates conditions hostile to 

peace. Second, by focusing on poverty alleviation, ministers were able to persuade leaders of 

developing countries who were skeptical about the benefits of a new trade round to join the 

negotiations.” 

The Doha Round is revived, but yet a tremendous amount of works remains for a successful Doha 

conclusion. This manuscript focused primarily on the agriculture issues in Doha, issues largely 

responsible for Doha’s collapse. Nothing was examined about trade in services, a subject for 

future research. The services arena is as complex and controversial as is agriculture. Lamy 

(2007d) stated at a London School of Economics conference on October 15, 2007 “services are a 

critical component of the Doha Round. There is therefore no doubt that a successful conclusion of 

the Doha Round must include satisfactory results on services. This is what we agreed as part of 

the Doha mandate.” 

In a recent report celebrating the sixtieth anniversary of the multilateral trading system 

(GATT/WTO at Sixty, 2007), future challenges are recognized “ranging from the short-term 

imperative to complete the Doha Round to systemic issues that have been part of GATT/WTO 

deliberations for many decades. But the trading system has to look ahead too, and new issues will 

emerge. Such issues are likely to include the relationship between environmental challenges such 

as global warming and trade, and trade and energy. There are likely to be pressures on the system 

to build on work that has already started, such as how to deepen and strengthen the multilateral 

rules on trade in services.” 

So, how do nations go forward toward the tomorrow’s beyond in an age (Kehoe, 2006) in which 

there is the “the ability to exchange good and services globally; to ship products to distant ports 

aboard massive container ships; the opportunity to shift production to other countries, often to 

least-cost locations?” In such an age of expansive globalization, we are confident that some type 

of world-arching trade organization such as the WTO is an imperative. We believe the evidence 

presented in this research argues that the world moving onward from the Doha failure; that is, 

failure is enabling success. 

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Volume 84, Number 7, December 2005. 

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2006, D1 and D10. 

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Number 7, December 2005. 

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Business, Spring, 1998, 67-76. 

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International Business Research, Volume 3, Number 1 (2004), pp. 19-30. 

Kehoe, William J. (2006). “The Role of Global and Regional Economic Integration in 

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Number 2 (Fall 2006), pp. 62-73. 

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Tribune, July 31, 2006. (Accessed July 31, 2006.) 

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2006.) http://www.wto.org/english/news_e/sppl_e/sppl44_e.htm 

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13, 2007.) 

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http://www.wto.org/english/news_e/sppl_e/sppl56_e.htm 

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2007.) 

http://www.wto.org/english/news_e/news07_e/tnc_chair_report_oct07_e.htm 

Lamy, Pascal (2007d). Speech at a London School of Economics conference, October 15, 2007. 

(Accessed October 20, 2007.) 

http://www.wto.org/english/news_e/sppl_e/sppl77_e.htm 

Miller, John W. (2006). “India, EU Work Toward Trade Pact: Bib for Agreement by 2009 

Underlines Bilateral Focus in Wake of Doha Collapse,” Wall Street Journal, October 13, 2006, 

A6. 

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of Making It One,” WTO Press Release 155, November 29, 1999. (Accessed April 20, 2006.) 

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Soon-Yond, Hong (2006). “Doha Failure Posed to Spur FTAs,” Trade Law Center for Southern 

Africa, April 8, 2006. (Accessed November 14, 2006.) 

http://www.tralac.org/scripts/contents.php?id+5142 

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WTO Doha (2007a). (Accessed August 15, 2007.) 

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Acknowledgements: The first author acknowledges support from the McIntire School of 

Commerce, University of Virginia and thanks Dean Carl P. Zeithaml, Senior Associate Dean 

Adelaide Wilcox King, and Area Coordinator John H. Lindgren, Jr. The second author thanks 

Dean Margery Meadows, Skyline College, for her encouragement and support. 


THE IMPORTANCE OF INTERNAL CONTROLS: 

YESTERDAY AND TODAY 

King, Darwin L. 

St. Bonaventure University 

dking@sbu.edu 

Case, Carl J. 

St. Bonaventure University 

ccase@sbu.edu 

ABSTRACT 

Modern businesses must endeavor to operate an efficient system of internal controls. An effective 

system of internal controls allows the firm to accomplish its goals including the safeguarding of 

its assets. Internal controls were also critical to the U.S. Army during the Civil War in an effort to 

manage its two primary assets that were “men and materials.” This paper reviews the internal 

controls utilized by company accounting clerks and regimental quartermasters during the Civil 

War and their effect on controls that are in operation today. Modern internal controls, such as 

the segregation of incompatible duties, were recognized by the Union Army in the 1860’s as 

being necessary in order to minimize errors, omissions, and frauds. A significant number of 

accounting internal controls were developed and refined by the U.S. Army during the Civil War 

in an effort to control enormous expenditures. 

INTRODUCTION 

The Committee of Sponsoring Organizations (COSO) has defined internal control as a process, 

effected by an entity’s board of directors, management and other personnel, designed to provide 

reasonable assurance regarding the achievement of objectives in the following categories: 

reliability of financial reporting, compliance with applicable laws and regulations, and 

effectiveness and efficiency of operations (COSO, 1987). Internal control has been an especially 

important concept during the past twenty years given the number and size of accounting scandals 

such as Enron and Adelphia. However, internal control concepts are not new. They had their 

origins prior to the Civil War. Since internal controls have evolved over a significant period of 

time, this paper attempts to review controls used by the Union Army during the Civil War and 

their influence on current control systems. The Union Army relied on accounting clerks and 

regimental quartermasters to maintain the internal control system of the period. Military 

recordkeeping and accounting practices originated at the company level. Controls were expanded 

at the larger regimental level. In order to provide the reader with a better understanding of the 

company accounting clerk and regimental quartermaster positions, the following paragraphs 

discuss the basic organization of the army. 

The U.S. Army is organized into corps, divisions, brigades, regiments, and companies 

(Regulations, 1861). A corps is the largest form of military unit. It is made up of two or three 

divisions under the direction of a Major General (Union) or a Lieutenant General (Confederate). 

A division is composed of two or three brigades. Each division is led by a Major General or 

Senior Brigade General. A brigade is a military unit consisting of two to six regiments. Either a 


King and Case 

Brigadier General or a senior Colonel commands it. A regiment is typically composed of 800 to 

1,000 men. The commanding officer of the regiment is normally a Colonel. When the Civil War 

began, a regiment was at full strength with 1,000 men. The regimental quartermaster, therefore, 

was responsible for the clothing, ammunition, and all other supplies for these 1,000 soldiers. 

Finally, a regiment can be broken down into the smallest military unit that is called a company. 

Infantry regiments normally included ten companies and heavy artillery regiments typically 

included twelve companies (Regulations, 21). The company became the basic unit for providing 

adequate records for the U.S. Army necessitating the selection of a company accounting clerk for 

each. Internal controls were employed at the company level in an effort to safeguard both human 

and physical resources. Frequent inventories of men (multiple daily roll calls), horses, wagons, 

arms, and all other equipment provided some assurance that the army’s assets were safeguarded. 

In the Union Army, a company was at full maximum strength with 98 enlisted men and three 

officers for the infantry, 100 enlisted men and three officers for a cavalry unit, and 147 enlisted 

men and three officers for a battery of artillery (Kautz, Clerk, 132). The minimum strength of a 

new company was 83 total members. A typical company normally included one captain, one first 

lieutenant, one second lieutenant, one first sergeant, four sergeants, eight corporals, two 

musicians, and one wagoner. The company accounting clerk was responsible for the majority of 

recordkeeping, while the three officers were often entrusted with the duties of custody and 

authorization. In this manner, the primary internal control of “segregation of incompatible duties” 

was maintained even at the company level. 

Early in the war, the individual soldiers of the company elected their officers. This practice was 

soon replaced in 1862 by a system of examinations in an effort to eliminate incompetent officers 

who were elected to the position by friends. Prior to the examination system, there were no 

controls on selecting the most competent men to serve as officers of the company. It was simply a 

popularity contest. Finally, the company was broken into four smaller groups that were called 

squads for specialized tasks such as target practice and guard duty (Regulations, 21). The 

company clerk’s duties involved both recordkeeping and internal control in an effort to safeguard 

the army’s assets and improve the efficiency and effectiveness of the company’s operations. 

THE COMPANY ACCOUNTING CLERK 

During the Civil War, the U.S. Army wanted to maintain accurate and adequate accounting 

records in order to improve the decision-making abilities of its officers. In order to accomplish 

this, Washington officials developed a system of internal controls that was instituted at the 

company level. This accounting system with related internal controls was the Generally Accepted 

Accounting Principles (GAAP) of the period. To maintain good order in the accounting and 

internal control systems, the army attempted to select competent men to serve as company 

accounting clerks. 

The company accounting clerk position required a man who was either a non-commissioned 

officer or soldier who was known to have good penmanship and a capacity for keeping good 

reports and records (Kautz, Clerk, 9). This basically meant that privates (soldiers), corporals, or 

sergeants (non-commissioned officers) were allowed to hold the position of company clerk. He 

was normally supervised by either the commanding officer of the company (i.e. captain) or the 

first sergeant. The basic internal control of “proper and adequate supervision” was important to 

the army during the Civil War and was emphasized in all of the regulations. 

The clerk’s position was one that had a fairly high rate of turnover. Some of the historical 

documents reviewed by the authors mentioned that a new accounting clerk was needed due to the 


Importance of Internal Controls 

previous clerk having very poor penmanship, being lazy in report preparation, or having a 

problem locating documents and reports when they were required. This position was so critical to 

maintaining an adequate and accurate accounting and internal control system that soldiers who 

did not perform well in this position were quickly removed and replaced. 

Company accounting clerks were “experienced penmen selected from the companies to assist the 

first sergeants in the making out their returns, reports, muster-rolls and other documents” (Kautz, 

Customs, 42). Normally, one clerk per company was sufficient to complete the requirements of 

the position. The clerk was often freed from tasks such as guard and kitchen duty due to their 

responsibility of preparing numerous reports and statements on a daily basis. However, the 

accounting clerk did not receive any additional pay for the extensive work required (Kautz, Clerk, 

9). Regimental accounting clerks, however, were paid a significant bonus. Since clerks were 

considered to have the best opportunity of leaning the administrative duties of the army, they 

normally had a better chance for promotion through the ranks (Kautz, Customs, 94). Therefore, if 

an accounting clerk position opened, there were typically numerous men who applied for the 

position. 

The company clerk was required to maintain numerous books, reports, returns, rolls, and papers 

(Kautz, Clerk, 10). Primary recordkeeping was completed utilizing a set of nine separate books. 

The Morning Report Book, Sick Book, Rosters, Descriptive Book, Clothing Book, Order Book, 

Account Book of Company Fund, Register of Articles Issued to Soldiers, and Record Book of 

Target Practice were the responsibility of the company clerk and required entries on a daily basis 

(Kautz, Clerk, 11). The clerk position emphasized internal controls that require the accounting 

system to maintain “adequate documents and records.” Just the external recordkeeping necessary 

to provide adequate communications to headquarters in Washington was enormous. Each of the 

following books was intended to improve internal controls concerning men and materials. 

The Morning Report Book was prepared daily and sent to the regimental adjutant’s office after 

sick call but no later than 8 a.m. The book included the daily fitness status of each soldier in the 

company. This journal included a “Remarks” column that described the reason for every officer 

or soldier not available for duty whether present or absent. For example, a soldier may not have 

been available for duty because of illness or hospitalization. Further, the soldier may not have 

been available for duty because of being transferred to another location for “special or extra 

duty.” 

Extra duty was a situation where soldiers were assigned to some continuous labor, in addition to 

their normal duties, for a period of ten days or longer (Kautz, Customs, 43). In most cases this 

involved employment in the Quartermaster’s department serving as mechanics, laborers, or 

teamsters. Soldiers received extra pay for this additional work until the practice was discontinued 

by the Act of March 3, 1863. Special duty involved a soldier being employed on duties that were 

not strictly military including serving as mechanics, general laborers, cooks, attendants in 

hospitals, clerks, officers’ servants, pioneers, scouts, or spies (Kautz, Customs, 91). 

By utilizing the extra duty system, soldiers were rotated among a number of different jobs in 

order to increase their skills in various areas. One area where job rotation was regularly practiced 

was the position of chief cook. Section 9 of Military Act March 3, 1863 required that head cooks 

be rotated every ten days (Kautz, Customs, 90). The purpose of this was to ensure that all of the 

soldiers learned how to cook. The practice of job rotation is utilized today in an effort to train 

employees in all aspects of the business and also uncover errors, omissions, and frauds within the 

company. 


King and Case 

The Morning Report Book also listed any soldier who was under arrest, away with and without 

leave, killed in action, wounded, hospitalized, and sick. As a proper authorization control, the 

Regimental Surgeon had the sole responsibility of excusing soldiers from duty due to illness. The 

Captain of the company and other officers were unable to do so. Company officers did have the 

power to excuse men from duty when they were assigned to other jobs such as company clerk or 

blacksmith (Kautz, Clerk, 13). It was a major recordkeeping task to manage soldiers who may 

have been available for duty, sick or in the hospital, or working on some special duty job. 

The following paragraphs discuss the other eight journals or books prepared by the company 

clerk. Each of these was prepared utilizing a very complete set of internal controls. Notice the 

military’s use of the segregation of incompatible duties where three different soldiers were given 

the responsibilities for custody, authorization, and recordkeeping. Proper authorization, a vital 

internal control, was also maintained in all of the army’s documents and reports by requiring an 

officer’s signature on the bottom of each. The army prided itself on its ability to maintain 

adequate documents and 

records in an effort to 

safeguard all of its 

assets. 

The Sick Book 

contained the names of 

ill soldiers with entries 

made on a daily basis. 

The Regimental Surgeon 

examined the men and 

made a decision if they 

were excused from 

active duty or available 

for duty. For duty meant 

that the man was fit for 

all typical duties of a 

soldier including guard 

duty, drills, parades, and 

detached service (Kautz, 

Clerk, 15). Detached 

service was a situation 

where soldiers were sent Civil War Quartermster’s Camp, Library of Congress Photo 

away from their companies 

to perform duties at another post, camp, or garrison (Kautz, Customs, 43). The Sick Book also 

described situations where soldiers were only partially incapacitated and could perform certain 

duties but were excused from others such as horse riding or guard duty. Proper authorization by 

the surgeon was a major internal control utilized on a daily basis. 

The Roster Book showed the names of each man in the company down the left side of the page 

and each day of the month running across the top from left to right. This book recorded three 

classes of duty including guard, detachments, and fatigue. Normally, a separate Roster was 

maintained for each duty class (Kautz, Clerk, 17). Fatigue was a term applied to all duties not 

strictly military that included laboring making roads, foraging for supplies and materials, and 

working on improving the grounds near a camp or post (Kautz, Customs, 40). This simple journal 

provided a quick review of who was available for duty, absent on detached service of some type, 

or excused from duty (such as the accounting clerk). This provided a control for the allocation of 

passes and furloughs, since the soldiers with the most time off were the first required to report for 


duty (Kautz, Clerk, 15). 


The Descriptive Book was a blank journal book that was provided by the Quartermaster’s 

Department. The names of all non-commissioned officers and enlisted men in the company were 

listed in alphabetical order. Each man was described based on age, height, complexion, and color 

of eyes and hair (Kautz, Clerk, 31). In addition, the soldier’s birthplace, occupation prior to 

military service, and dates of enlistment were also included. Finally, information concerning 

promotions, court-martial punishments, appointments, and medals earned was also included. This 

journal served as an important control since it provided a “correct history of the men” (Ibid.). It is 

similar to modern human resource databases that describe all positive and negative aspects of 

each employee. 

The company Clothing Book was prepared by the accounting clerk in order to maintain a record 

of “the issues of clothing to the non-commissioned officers and privates of the company (Kautz, 

Clerk, 17). One of the major expenditures for the U.S. Army during the Civil War was the 

clothing worn by each of its soldiers. General Orders, No. 364, Washington, November 12, 1863 

provided a detailed statement of the cost of each article of clothing. Internal controls were 

necessary in order to reduce the opportunity for fraudulently selling military clothing. This 

General Order clearly stated the amount of clothing that was provided to each soldier depending 

on their rank and area of service. For example, during a five-year enlistment period, $194.85 of 

clothing was provided to privates in the artillery or infantry, $198.90 for privates in the cavalry, 

and $201.05 in the engineering divisions (Kautz, Clerk, 21). 

The internal controls included a specified clothing allotment per year that could not be exceeded 

without a payment by the soldier to the army. For example, a corporal in the cavalry received a 

total clothing allowance of $202.70 for a five-year enlistment period (Kautz, Clerk, 21). Clothing 

costs were carefully controlled with soldiers first requesting an issue of clothing (by making a 

requisition for the items), the request was then approved by the commanding officer, and the 

clothing was issued by the Regimental Quartermaster (who maintained physical control over the 

clothing inventory) to the company commander who distributed the clothing to the soldier. This 

process insured that the incompatible duties of custody, authorization, and recordkeeping were 

carefully separated. The soldier received custody of the goods following authorization by the 

company commander and the recordkeeping completed by the accounting clerks and 

quartermasters. Separation of incompatible duties continues to be a critically important internal 

control today. 

The major internal control proved by the Clothing Book was the determination of whether the 

soldier was “over-issued” or “under-issued.” An over-issued situation existed when a soldier 

requested clothing in excess of his annual allotment. For example, the corporal in the cavalry 

(discussed above) was over-issued in the first year when he took possession of more than $55.38 

of clothing. This created a payable (debt) to the army that had to be repaid through a payroll 

deduction. The debt was collected from the soldier at the next payroll muster that occurred on the 

last day of February, April, June, August, October, and December (Regulations, 49). 

Accounting clerks maintained the Clothing Book to show either a receivable to the soldier or a 

payable to the government based upon the amount of clothing received in a given year. The 

receivable called “due the soldier for clothing not drawn” or the payable termed “due the U.S. for 

clothing overdrawn” was calculated for each member of the company. This book served as a vital 

internal control over the distribution of all types of articles of clothing including hats, trousers, 

coats, stockings, boots, blankets, ponchos, and various undergarments (Kautz, Clerk, 19). 


King and Case 

Since soldiers were given nearly a full year’s clothing allowance when they entered military 

service, the army carefully reviewed any man who developed a disability shortly after enlistment. 

Many unethical men joined the military in order to receive a full year’s clothing allowance and 

then faked a major disability. If the disability was determined to be legitimate and the “disability 

was the result of no indiscretion on his part,” the soldier was allowed to keep the clothing upon 

his termination from service with no deduction taken from his final wage statement (Kautz, Clerk, 

23). If, however, the soldier was found to have been of “unworthy character” and the disability 

was fraudulent, a deduction was taken from his final payroll payment. This again shows the need 

for internal controls in order to reduce fraudulent behavior. The army promoted an “ethical 

climate” similar to the “control environment” component of the COSO definition of internal 

control (Arens, et.al., 2008). 

A final control was required to safeguard military clothing involved soldiers who were “careless 

and improvident” and resorted to selling their clothing to earn some extra money. This problem 

existed in certain areas where retail clothing stores were not common. In these areas, local 

residents were anxious to purchase clothing at prices significantly higher than the army’s internal 

cost (Kautz, Clerk, 24). This allowed soldiers to profit on the sale of clothing since the internal 

cost was substantially less than the market price to local residents. An internal control to reduce 

this opportunity was the “frequent inspection of soldier’s clothing” by the officers of the 

company. Soldiers were questioned regularly (clothing audits) if any of their clothing was 

missing (Ibid). The concept of “independent reviews and audits” continues to be a major control 

activity in modern business operations. 

Penalties were very severe if a soldier was convicted of selling clothing. The Act of January 11, 

1812 prohibited the purchase of military clothing by any person not serving in active duty. The 

punishment included a penalty of three hundred dollars and one year’s imprisonment (Ibid.). This, 

however, did not eliminate the black market in military clothing. Penalties for the soldier, under 

the 38 th Article of War, also applied if they were found guilty of selling clothing. Section 23 of 

the Act of March 3, 1863 authorizes military officers to seize any “clothes, arms, military outfits 

and accoutrements” previously issued to soldiers but now in the hands of civilians. A significant 

number of internal controls were required to safeguard the army’s clothing inventory. 

The next book or journal was called the Order Book that contained all of the general orders 

received from regimental headquarters and also any special company orders or assignments. For 

example, any soldier taken from the company for special duty elsewhere would appear in the 

Order Book. This document was either organized chronologically based on date of the orders or 

by type of order. Again, internal controls require that “adequate documents and records” be 

maintained on a continuous basis. 

The Company Fund Account Book was a cash fund utilized by the unit for the purchase of 

necessities that were not furnished by the Army (Kautz, Clerk, 25). It had two sides similar to a 

modern general ledger account. On the left or debit side, the sources of company funds were 

listed. This side began with the fund’s beginning balance and listed the sources of cash such as 

money transferred from the Regimental Fund and funds withdrawn from the company savings 

account. This fund also increased as a result of the sale of unused company rations and surplus 

vegetables raised in a company garden if the company was stationed in a single location for an 

extended period. Cash expenditures were recorded on the right or credit side and were typically 

for products not normally provided by the army such as fresh vegetables, brooms, carpenter’s 

tools, and food condiments. This book was an important record for the company and served as a 

control over cash similar to a petty cash fund utilized by businesses today. 



The Return of Company Fund was prepared whenever a new officer took command of the 

company (Kautz, Clerk, 27). In addition, it was prepared whenever the company was removed 

from the regiment for an extended period and at the end of April, August, and December. The 

recordkeeping was done by the company accounting clerk and approval provided by the 

company’s commanding officer. This report summarized the transactions recorded in the 

Company Fund Account Book. The formal report was completed in duplicate so that one copy 

remained with the company and the other was sent to regimental commanders who forwarded the 

document to a brigade. The army required that all expenditures were supported by receipts. These 

receipts were required to remain with the Company Fund Account Book. Again, the internal 

control of maintaining “adequate documents and records” was of prime importance to the army. 

The Register of Public Property Issued to Soldiers was a journal book that was used for the 

purpose of “keeping an account of the arms and accoutrements issued to soldiers” (Kautz, Clerk, 

27). The book provided a record all of the rifles, pistols, swords, and other arms issued to each 

soldier. This register was maintained using two separate forms. Form 4 was a record of all arms 

and accoutrements including muskets, bayonets, swords, cap-boxes, cartridge-boxes, gun slings, 

waist belts, and small tools such as screwdrivers used to maintain the weapons. If any item had a 

serial number or letter, this was recorded in the register to “prevent exchanges or pilfering of 

accoutrements or arms” (Ibid.). 

The second form (Form 5) was used to record all camp and garrison equipage issued to the 

soldiers. Forms 4 and 5 were similar in format and merely pertained to different types of tangible 

personal property issued to the soldiers. Form 5 included items such as bugles, knapsacks, 

haversacks, canteens, spades, axes, hatchets, camp-kettles, and mess-pans (Kautz, Clerk, 29). 

Regular inspections were performed in an effort to ensure that these items were retained and 

properly maintained. Internal controls required that soldiers pay for any items lost unless the 

soldier’s commanding officer deems that sufficient reason existed for the loss of the item. In that 

case, the soldier was required to file an affidavit that represented the officer’s authorization to 

remove the item from the property inventory of the soldier. The officers were encouraged, in 

most cases, to charge the soldier for the lost item in an effort to encourage “comrades to refrain 

from pilfering and look well after each other’s property” (Kautz, Clerk, 30). 

In an effort to safeguard assets following an engagement, internal controls required that the 

officers of the company, as one of their first duties, gather up all military property of those 

soldiers killed or wounded in battle (Ibid.). Also, it was the duty of the company commanding 

officer to collect all ordnance property of those soldiers who suffered from severe illness or 

wounds and were sent to a regimental hospital. The paragraphs above demonstrate the importance 

of internal controls in an effort to safeguard all arms and accoutrements issued to the soldiers. 

The final journal book maintained by the company clerk is the Record Book of Target Practice. 

This journal was furnished by the Regimental Quartermaster. It was used for recording “the target 

practice of the company” (Kautz, Clerk, 32). The target practice required that each soldier fire 

rounds at targets ranging from 150 to 400 yards. Based upon the number of hits to the target, the 

company was reformed in an effort to know the “good from the bad marksmen.” The soldier with 

the most number of hits to the target received a company prize that was a brass medal (called a 

stadia). Company marksmen were allowed to compete for a regimental prize that was a silver 

medal. This internal control allowed commanding officers to know who were the best marksmen. 

This information was used in battles so the company commanding officer could select the best 

shots for critical locations on the field. Independent reviews of this book were completed by 

regimental officers on at least a weekly basis (Kautz, Clerk, 33). 


King and Case 

It is evident from the information discussed above that the maintenance of effective and efficient 

internal controls was important to the U.S. Army. The company accounting clerk was the first 

line of enforcement of these controls. At the regimental level, the clerks and quartermasters 

summarized the information prepared by the individual companies. In addition to the 

maintenance of these nine books or journals, the clerk was responsible for numerous other 

reports, returns, rolls, and papers. For example, quarterly returns were required for clothing, camp 

and garrison equipage, ordnance and ordnance stores, quartermaster’s property, deceased soldiers, 

and the descriptive list of men joined (Kautz, Clerk, 10). Various papers required included 

certificates of disability, final statements, discharges, descriptive rolls, furloughs and passes, 

inventories of deceased soldiers, requisitions for forage, fuel, stationery, straw and all other types 

of property, inventories of damaged goods, letters of soldier’s complaints, muster rolls, and many 

other specialty reports (Ibid). 

Each of these reports was necessary in order to maintain efficient internal control and provide the 

army with the necessary documents and records to promote effective decision making. Without 

this wealth of documentation, logical decisions would not have been possible. For example, 

Muster Rolls (payroll reports) were normally prepared every two months in an effort to pay the 

soldiers on a regular basis. These payroll reports included deductions for additional clothing 

beyond their annual allotment, payments owed to sutlers (traveling merchants who sold their 

goods to soldiers), and even money owed to washerwomen. Regulations allowed four 

washerwomen for each company who cared for the soldier’s clothing on a daily basis 

(Regulations, 24). Significant internal controls were implemented to ensure that the army, 

sutlers, and washerwomen received the funds due them on a timely basis. 

BASIC ACCOUNTING PRINCIPLES OF CLERKS AND QUARTERMASTERS 

Company accounting clerks were required to follow five basic recordkeeping principles that 

served to establish a basic system of internal controls (Kautz, Clerk, 11). First, clerks were 

required to get invoices for all property they received from other military units. This provided the 

control for accurate inventory calculations. It was critical that inventory removed from the 

quartermaster’s storeroom be traced to the regiment and company receiving the item. Second, 

clerks were required to take receipts for all military property transferred to other companies or 

regiments. Again, this provided a control on the location of inventory that may have been 

transferred to a given regiment and later sent to another regiment that was in dire need of the 

item. This was common for items like boots and coats with the arrival of colder weather. 

The third principle required the accounting clerks to get certificates for personal property of any 

soldier that was lost or destroyed. These certificates described the situation where clothing, arms, 

or other ordnance equipment was lost or destroyed. It was common following a battle that 

soldiers lost clothing, guns, canteens, and other equipment. In an effort to reduce the theft and 

sale of such property, the regulations required that a signed certificate be prepared (Kautz, Clerk, 

12). These documents, if possible, were to be prepared by company or regimental officers. This 

provided adequate authorization to remove the item from the soldier’s inventory of property. 

Replacement property would then be provided to the soldier. If the company or regimental officer 

was not able to attest to the loss, an affidavit from a fellow soldier or local citizen who witnessed 

the destruction or loss was an acceptable alternative. As a last resort, an affidavit from the soldier 

who suffered the loss of property was allowed. This was the least desirable option since the army 

realized that an “independent review” by an officer or fellow soldier would be more objective 

than a statement from the soldier who suffered the loss. Independent reviews by an objective 

party continue to serve as an important internal control today. 



The fourth recordkeeping principle was the proper maintenance of adequate records and 

documents. This principle stated that property from different departments must not be mixed on 

the same report or statement. This included Ordinance, Quartermaster’s property or Clothing, and 

Camp and Garrison Equipage departments. This policy is equivalent to a modern day accountant 

mixing financial information from various divisions of the business. This internal control practice 

aided in the calculation and valuation of various department inventories. 

The fifth and final general recordkeeping principle required the clerks to not allow unserviceable 

property to accumulate. Following an engagement, it was common for many pieces of arms and 

related equipment to be inoperable. In an effort to safeguard assets, the clerk was to present the 

items to a company or regimental inspection officer at his earliest opportunity. The inspection 

officer then decided which items would be repaired, rebuilt, or scrapped. These five principles 

allowed the accounting clerks to create a basic system of internal controls. These practices 

allowed the army to safeguard its assets and prepare accurate and reliable accounting reports and 

statements. 

THE REGIMENTAL QUARTERMASTER 

This next section of the paper will discuss the internal controls employed at the regimental level. 

The previously discussed recordkeeping practices were also employed by the Regimental 

Quartermaster and the Regimental Accounting Clerk. These two individuals worked to provide an 

efficient system of internal controls at the regimental level. The following paragraphs describe the 

operations of the quartermaster’s department and the internal controls employed in an effort to 

safeguard the army’s assets. 

The quartermaster’s department was responsible for a vast number of duties. Some of this 

department’s duties included providing the “quarters (lodging) and transportation for all the 

officers and soldiers; transporting and storing all of the army’s supplies, army clothing; camp and 

garrison equipage; cavalry and artillery horses; fuel; forage; straw; material for bedding, and 

stationery (Regulations, 159). The department is also responsible for paying all incidental 

expenses such as per diem extra-duty pay to soldiers, postage, expenses of court-martials, costs of 

pursuit and apprehension of deserters, burials of officers and soldiers, and any other expenses for 

the movements and operations of the army not expressly assigned to any other department (Ibid.). 

Since the duties of the quartermaster’s department were so extensive, an efficient system of 

internal controls was absolutely necessary. 

One of the first internal controls encountered by a new Regimental Quartermaster is the 

requirement that he be properly bonded. Since the quartermasters handled a significant amount of 

cash and other valuable property, the army realized the need to obtain a “good and sufficient 

bond” for every quartermaster (Case, 11). For an Assistant Quartermaster, the amount of the bond 

was normally ten thousand dollars. The amount of the bond increased with promotions and 

assigned responsibility. The bond was renewable every four years based upon the “faithful 

performance of his duties” (Ibid.). The quartermaster was required to provide collateral that was 

worth at least double the amount of the bond. Therefore, a new Assistant Quartermaster was 

required to provide twenty thousand dollars of collateral. The internal control of bonding 

employees handing significant cash and other valuable property continues today. 

Another example of early internal controls employed by quartermasters involved the retirement of 

officers. The quartermaster was required to prepare an affidavit, signed by the retiree’s 

commanding officer, to provide for a last payment for salary owed. In addition to his final salary, 

the retiree also was provided with a travel allowance based on a standard mileage rate. For 


King and Case 

example, officers who traveled more than ten miles from their home were paid ten cents per mile 

travel allowance (Regulations, 165). An additional control required that the mileage be calculated 

by the shortest mail route as found in the “General Post-Office” book. This process reduced the 

opportunity for fraud in the payment of travel expenses of officers. 

Since the use of “adequate documents and records” was an important internal control for the 

army, it was logical that special reports would be required for all types of property. For example, 

quartermasters prepared reports for the requisition of forage for all the animals. The ration was 

fourteen pounds of hay and twelve pounds of oats, corn, or barley for each horse (Regulations, 

166). Mules were allowed the same amount of hay per day but only nine pounds of grain. In 

addition to being harder workers, mules survived on significantly less food per day. This was the 

reason that most military units employed more mules than horses. Special reports for the use of 

straw also provided controls over the use of this product. For example, twelve pounds of straw 

per month was allowed for bedding for all non-commission officers, musicians, and privates 

(Ibid.). The standard allowance of straw for bedding for each horse was one hundred pounds per 

month. These pound limit controls ensured that forage and straw were not wasted. 

Another important resource of the accounting clerks and quartermasters was the stationery they 

required to provide the necessary documents and records. Significant internal controls were 

employed in this area to eliminate the opportunity for theft and sale of these items. Stationery was 

issued on a quarterly basis. The amount and type of stationery issued depended on the size of the 

military unit. For example, an officer commanding a regiment with at least five companies was 

allowed ten quires (about 25 pages) of writing paper, one quire of envelope paper, 40 quill pens, 

six ounces of sealing wax, and two rolls (pieces) of office tape (Regulations, 167). These 

limitations were strictly enforced in an effort to control the amount of office products used. A 

typical accounting clerk or quartermaster’s office was allowed one inkstand, one stamp, one 

paper-folder, and as many lead pencils as required, not to exceed four per year (Ibid.). Stringent 

limits like four pencils per year certainly aided the army in safeguarding its assets. 

Controls were also in place to limit the amount of food available for the soldier’s meals. 

Company and regimental officers provided ¾ pound of pork or bacon per day to each soldier 

(Kautz, Clerk, 97). In addition, one pound of hard bread or 18 ounces of soft bread was allowed 

on a daily basis. In addition, “extra issues” of food and drink was permissible. For example, 

whiskey was provided (one gill daily – ¼ pint) to each soldier in case of “excessive fatigue or 

exposure” (Kautz, Clerk, 98). It was not surprising that many soldiers reported fatigue on a 

regular basis in order to receive this extra issue of spirits. 

Finally, clothing was another asset that required strong internal controls to protect and safeguard. 

Regulations allowed a very conservative number of clothing articles per year for each soldier. As 

mentioned earlier in the discussion of the company accounting clerk’s clothing book, any clothing 

requested by the soldier that exceeded the annual allocation was billed to the soldier. 

Quartermasters were allowed to provide soldiers with four pairs of stocking and three flannel 

shirts per year (Regulations, 170). For a five year enlistment period, one blanket was allocated the 

first year and one was allowed the third year. Two blankets for a five year period was certainly a 

very conservative allocation of assets. 

The following section of this paper reviews a number of actual Civil War reports that clearly 

show the amount of internal controls employed. The army realized the importance of segregation 

of incompatible duties so efforts were made to separate custody, authorization, and 

recordkeeping. Quartermasters normally performed the custody function and managed the 

warehousing of all forms of tangible personal property. Accounting clerks were assigned the 



recordkeeping function and were responsible for the volume of documents and records. Finally, 

the authorization function was assigned to the commanding officer of the company or regiment. 

In this way, the army’s system of internal controls operated reasonably efficiently. 

EXAMPLES OF CIVIL WAR INTERNAL CONTROLS 

The appendix of this paper contains five examples of Civil War documents that 

exemplify the types of internal controls utilized during this period. The first report is a 

circular sent from Quartermaster General’s Office, Division of Clothing and Equipage, in 

Washington D.C. on January 20, 1865. This document emphasizes the importance of 

internal controls. It reminds all company and regimental commanders to prepare three 

copies of each report in an effort to maintain an adequate audit trail. The first copy was 

retained by the company that originated the report. The second copy was held at the 

appropriate regimental level. The third copy of each report was supposed to be sent to the 

Quartermaster General’s Office in Washington. This was evidently an internal control 

that was commonly ignored by units in the field who would often forget to send a copy to 

Washington. This circular reminded each unit that this three-copy policy must be 

followed in order to maintain adequate internal controls. The circular stated that the three 

copy policy was established in General Orders, No. 357, issued on November 5, 1863. 

Multiple copies (either paper or digital) are utilized in modern business to ensure an 

accurate audit trail. 

Report two in the appendix is a good example of one of the basic recordkeeping or 

accounting practices required of accounting clerks and quartermasters. As mentioned 

earlier, a receipt or invoice was to be given for all property received. Prior to the receipt 

of property, a requisition was prepared to order the item. This actual Civil War record 

was prepared in March of 1862. It is a requisition of hay for bedding for the U.S. General 

Hospital at Hilton Head, South Carolina. Based on the standard allowance of 12 pounds 

of bedding per month for each non-commissioned officer, musician, and private, a total 

of 540 pounds of hay was requisitioned. Normally straw would have been used for 

bedding but a note of the report states that “there being no straw on hand, hay is required 

for instead.” The requisition received proper authorization (another important internal 

control) with signatures of a Colonel and the Assistant Surgeon. The bottom portion of 

the requisition contains the receipt for the 540 pounds of hay. The authors reviewed over 

one hundred Civil War documents that clearly showed that the army made every effort to 

operate an effective internal control system during the Civil War. 

The third report is a good example of a final payroll statement of a soldier who was 

discharged due to battle wounds received. This document represents the final wage 

payment of $16.68 to Private Richard S. Hawkins of Company D of the first artillery 

regiment of Rhode Island Volunteers. Not pictured in the appendix is the discharge 

certificate stating that because of battle wounds Richard was discharged on February 11, 

1862. This “final settlement” form was an important control document prepared to ensure 

that the soldier received an accurate final wage payment. This final accounting involved 

not only the normal wages of $13.00 per month for a private but also a final clothing 

settlement and wage and subsistence payment for travel days to return home. Notice that 

the bottom of the form served as the receipt signed by Hawkins that he received the 

$16.68 from Major D.M. Cline, army paymaster. 


King and Case 

In an effort to control the travel costs of discharged soldiers, the final settlement 

statement shows that during the 21 day trip to his home in Providence, RI he was paid his 

normal $13 monthly rate (apportioned $9.10). In addition, regulations provided for 

subsistence rations of 50 cents per day. In summary, the Private Hawkins was paid his 

salary from January 1 to February 11 ($17.76), travel salary (for 21 days) of $9.10, travel 

ration allowance of $10.50 (for 21 days), and a reimbursement for the annual clothing 

allotment that was not used ($18.38). From this $55.74 total owed to Private Hawkins, 

$39.06 was deducted for the portion of the annual clothing allowance withdrawn prior to 

discharge. The difference between these final two figures is the amount of his final 

settlement payment of $16.68. This form is a good example of the army’s payroll controls 

that were in operation to make certain that only the appropriate amount of cash was paid 

to discharged soldiers. 

The fourth document in the appendix is a good example of an inventory report. In an 

effort to make logical decisions when allocating all forms of property, monthly inventory 

reports from all military units were reviewed by army headquarters. This report is a 

“means of transportation” inventory summary that lists the wagons, ambulances, mules, 

various horses, and harnesses for various regiments of Ohio and Kentucky volunteers. It 

provided a wealth of information to senior officers who had to decide where scarce 

resources were most needed. For example, the 14 th Ohio volunteer regiment had eight 

wagons, one ambulance, 48 mules, 17 horses, and 50 harnesses. It is interesting to note 

that the army found that mules were more desirable since they were more “sure-footed” 

and required less food per day (9 pounds of grain verses 12 pounds) than a horse. This 

inventory report shows that, of the 535 total animals on hand, there were 311 mules 

compared to only 224 horses. 

Since army headquarters needed information on such things as extra or surplus 

equipment, this report quickly communicated that these regiments had only six 

ambulances (2 nd Brigade headquarters had none) and only one extra harness set. The 

report was submitted by Lieutenant E.B. Kirk of the 14 th Ohio volunteers who served as 

the Adjutant Assistant Quartermaster (AAQM) for the 3 rd Division, 14 th Army Corp. 

Commanding officers who reviewed this form were quickly informed that these divisions 

had no small wagons (4 or 2 horse/mule), small ambulances (2 mule), or four horse/mule 

harness sets. Inventory reports such as these represented important controls in the effort 

to most efficiently allocate scarce resources. 

The fifth and final document in the appendix is a prime example of the importance placed 

on the services of accounting clerks. The normal monthly pay was $13 for privates, $14 

for corporals, and $17 for sergeants. This pay receipt shows that Thomas Norbury 

received $125 per month for his work as an accounting clerk in the Quartermaster’s 

Department. In comparison, a surgeon with ten years experience earned only $80 per 

month. The payment was authorized by the Assistant Quartermaster Captain C.K. Smith. 

The payment was made by Lieutenant Colonel A.J. MacKay (Chief Quartermaster) who 

served as paymaster. This document also shows the army’s concern to utilize the critical 

internal control of “separation of incompatible duties.” The authorization function was 



provided by Capt. Smith and the custodial function was accomplished by Lt.Col. 

MacKay. This principle remains the cornerstone of an effective system of internal 

controls today. 

HISTORICAL INFLUENCES ON CURRENT INTERNAL CONTROLS 

The previous review of actual Civil War documents emphasizes the importance of maintaining an 

efficient system of controls. The army’s control based accounting system was later replicated by 

American businesses. Many of the senior officers from both Union and Confederate armies 

entered the business world following the war. They logically employed the accounting and 

internal control systems that were familiar to them. Most of these men were graduates of West 

Point who were perhaps the best-trained minds in these subjects. According to Hoskin and Macve 

(1988), a new form of “managerialism” emerged with these men. In particular, attention to 

financial details and a serious attempt to safeguard assets resulted from the emergence of these 

military officers as executives in numerous U.S. businesses. 

The accounting control system utilized by the army in the Civil War was documented in three 

instructional guides. One of these was the “Revised Regulations for the Army of the United 

States” published in 1861 (Regulations, 1861). According to Simon Cameron, Secretary of War, 

this was the “sole and standing authority” for military operations. The Regulations contained a 

description of the many types of accounting internal controls used by the army. The second 

instructional text was “The Quartermaster’s Guide” that was issued near the end of the war (Case, 

1865). The third and final publication issued for the benefit of company accounting clerks was 

titled “The Company Clerk” authored by August V. Kautz in 1865. These three publications 

emphasized the need to safeguard all of the army’s assets and produce accounting reports that are 

accurate and reliable. Even at this early time in our history, the army realized that it needed a 

system to safeguard all of its assets and allow it to operate more efficiently. 

The importance of internal controls has continued to increase in business firms today. In 1985, 

the Committee of Sponsoring Organizations (COSO) was formed to sponsor the National 

Commission on Fraudulent Financial Reporting. One of their first recommendations was that a 

comprehensive framework of internal control be developed (COSO, 1985). The COSO definition 

of internal control included five components that are discussed in a majority of modern auditing 

texts (Rittenberg, 2008). First, the “control environment” or “tone at the top” involves the ethical 

climate within the firm. If an ethical climate does not exist at the top management level, the 

quality of internal controls is likely to be poor. 

The second COSO component of internal control is “risk assessment.” This involves the 

identification of material risks within the organization that would hinder the firm from 

accomplishing its objectives. The third and fourth elements are “information and communication” 

and “monitoring.” These stress the preparation of needed information in the form of reports and 

statements that are communicated to the appropriate managers. The key is “getting the right 

information to the right people.” Monitoring involves ongoing efforts to provide feedback on the 

effectiveness of the entire internal control system. The fifth and final component of internal 

control is the area of “control activities.” These represent a number of pervasive internal control 

activities that were utilized by the U.S. Army during the Civil War and continue to be of prime 

importance today (Arens, 2008). These include segregation of duties, proper authorization policy, 

independent checks, physical safeguards, and adequate documents and records. These activities 

are also especially important is the effort to reduce the opportunity for fraud within an 

organization (Albrecht, 41). 


King and Case 

The first control activity mentioned in the previous paragraph is often considered the cornerstone 

of an entity’s internal control system. The separation of incompatible duties including custody, 

authorization, and recordkeeping continues to be one of the most critical tasks that a firm must 

accomplish if it expects to safeguard all of its assets. The army during the Civil War was very 

aware of this fact. For example, three different soldiers were normally involved in the completion 

of the three incompatible duties of custody, authorization, and recordkeeping. The accounting 

clerk typically prepared the reports (recordkeeping), an officer of the company or regiment signed 

the documents (authorization), and quartermasters normally were had possession (custody) of all 

forms of tangible personal property. This allowed the army to safeguard all of its assets including 

arms, clothing, and supplies of all types. 

In addition to a system that segregated incompatible duties, the military accounting structure 

required that a higher-ranking officer authorize all transactions and reports. This second control 

activity exists today when business firms require proper authorization of all financial transaction 

by a supervisor. The third control activity of utilizing independent checks also existed during the 

Civil War when officers conducted surprise audits of various assets and prepared an assortment of 

reconciliations in an effort to safeguard all assets. The majority of business firms utilize this 

policy today when surprise cash counts or regular reconciliations of receivables and other assets 

are completed. The use of physical safeguards over all assets (fourth control activity) was also 

employed during the Civil War. The U.S. Army required that most tangible assets be under the 

control of a quartermaster who managed a locked inventory storeroom. The quartermasters 

provided limited access to items ranging from arms and ammunition to clothing in an effort to 

minimize losses. This policy is used by modern businesses as they use various security measures 

to limit the loss of inventory. 

The fifth and final control activity is the use of adequate documents and records. U.S. Army 

military regulations contained hundreds of pages pertaining to the proper preparation of various 

statements. Reports were required to document the use of supplies, clothing, camp and garrison 

equipage, horses, fuel, forage, straw, bedding material, stationery, and numerous other items. 

Other statements described the activities and compensation of the men. Current accounting and 

internal control systems also consider this to be critical. The importance of these five control 

activities has continued to increase with the complexity of modern business operations. With each 

advance in technology, the opportunity for employees to commit a fraudulent act increases. 

Modern accounting texts also emphasize that a good accounting system ensures that all financial 

transactions are valid, properly authorized, complete, properly classified, recorded in the proper 

period, properly valued, and summarized correctly (Albrecht, 40). These characteristics also 

existed in the U.S. Army Regulations of 1863. They reflected the education provided to the 

officers at West Point and set a quality standard at the early date in our history. As mentioned 

earlier, these officers used this knowledge as they entered the business world following the 

conclusion of the war. Each of these army documents was designed to accomplish the objectives 

mentioned above. Each report was prepared with the goals of safeguarding assets and ensuring 

accurate accounting records in mind. This philosophy has continued today as firms strive to 

accomplish this difficult objective. 

SUMMARY 

This paper has reviewed the importance of internal controls from the Civil War period to the 

present. History provides us with insight into the rationale for systems currently in use. This is 

especially true with the typical internal control systems of modern business enterprises. Military 

leaders in the 1860’s instituted an accounting system that they learned at institutions such as West 

Point. This was a very advanced control system for its time. Modern auditing texts discuss control 



activities that were utilized by the U.S. Army many years ago. This sophisticated accounting 

control system was introduced to American businesses by military leaders who searched for 

employment following the end of the war. A review of history can provide modern accountants 

with a better understanding of the internal control systems in operation today. 

REFERENCES 

Albrecht, W. S. (2003). Fraud Examination. Mason, OH: South-Western Publishing. 

41-44. 

Arens, Alvin A., Elder Randal J. and Beasley Mark S. (2008). Auditing and Assurance 

Services. Pearson-Prentice Hall. 294-302. 

Bradley, W. J. (1990). The Civil War. New York, NY: Military Press. 

Case, Theo S., A.Q.M. (1865). The Quartermaster’s Guide: Army Regulations, 

St. Louis, MO: P.M. Pinkard Co. 

Committee of Sponsoring Organizations (COSO), (1985-2005). http://www.coso.org 

Harris, T.H. (1865). Circular: Head-Quarters District of Columbia: 16 th Army Corps. 

Columbus, Ky. J.B. Lippincott & Co. 

Kautz, August V. (1865). The Company Clerk. Philadelphia, PA: J.B. Lippincott & Co. 

Kautz, August V. (1865). Customs of Service for Non-Commissioned Officers and 

Soldiers. Philadelphia, PA.: Lippincott & Co. 

Katcher, P. (1986). American Civil War Armies: Staff, Specialist and Maritime Services. 

London, England: Osprey Publishing Ltd. 

Rittenberg, Larry E., Schwieger Bradley J. and Johnstone Karla M. (2008). Auditing: A 

Business Risk Approach. Thompson-South-Western, 191-202. 

War Department, (1861). Revised Regulations for the Army of the United States. JGL 

Brown, Printer, Philadelphia. 


King and Case 

APPENDIX – REPORT 

1 


APPENDIX - REPORT 2 



King and Case 

APPENDIX – REPORT 3 





King and Case 



STOCK REPURCHASE ANNOUNCEMENTS: A 

TEST OF MARKET EFFICIENCY 

Kinsler, Nicholas A. 


NKinsler@wellscoleman.com 

Bacon, Frank W. 


baconfw@longwood.edu 

ABSTRACT 

The purpose of this study was to test the semi-strong form efficient market hypothesis by 

analyzing the effects of stock repurchase announcements on stock price. Specifically, is it 

possible to earn an above normal return on a publicly traded stock when the firm announces a 

stock repurchase? Numerous past studies suggest that with a stock repurchase announcement 

goes a positive signal about the company’s future, thereby significantly increasing the firm’s 

stock price. Firms repurchase undervalued stock, thus raising the stock price. According to the 

semi-strong form efficient market hypothesis, it is not possible to consistently outperform the 

market – adjusted appropriately for risk – by using publicly available information such as stock 

repurchase announcements. This type of information should impound stock price sufficiently fast 

to disallow any investor’s earning an above normal risk adjusted return. Evidence here supports 

the positive signal associated with the sample stock repurchase announcements examined. 

Likewise, the study results support the semi-strong form efficient market hypothesis and suggest 

the possibility of trading on this information up to 30 days prior to the announcement. 

Specifically, for this study the announcement of a stock repurchase is viewed with a mixed signal, 

negative before the announcement and immediate positive reaction afterwards. 

INTRODUCTION 

A stock repu rchase oc curs when a company with excess ca sh buy s back stock for any 

number of reasons. Once a corporatio n bu ys back its stock, it is ter med trea sury stock and is 

ineligible to collect dividends. Some reasons corporations repurchase stock include: preventing a 

hostile takeover, acquiring shares for fu ture distribution for employee options, and for converting 

securities. T he main benefits fro m buy ing back stock are raisi ng the earnings per share on 

remaining sh ares outstand ing and eliminating the dividend burden on the shares r epurchased. 

Likewise, a stock repurchase c an be an effective tool used by companies, espe cially in tim es of 

undervaluation and high taxes to attempt to raise the market price of their stock. 

How fast does stock price react to corporate stock repurchase announcem ents? It follows 

that the information embedded in a stock repurchase announcement could be tested to determine 

how fast stock price reacts to this news and whether the reaction is weak, sem i-strong, or strong 

form efficient. Previous research suggests that the market is semi-strong for m efficient with 

respect to stock repurchase announcements. 


Kinsler and Bacon 

The purpose of this study is to test the market efficiency theory by analyzing the impact 

of a sam ple of 85 stock repurchase an nouncements on the firms’ stock price. Particularly , how 

fast does the market price of the firm s’ stock react to the sa mple of regula r stock repurchase 

announcements examined? Using the standard ri sk adjusted ev ent study methodolo gy, this 

research will test whether the announc ement of stock repurchases conforms to the sem i-strong 

form efficient market hy pothesis. Evidence here suggests that the market reaction to the stock 

repurchase announcement is negative prior to the announcement and positive afterwards. 


Companies are per mitted to repurchase their stoc k by most state statues at the discretion 

of its directors if the company has a s urplus of funds to repurchase the stock (Brudne y, 1983). 

Companies can purchase t heir stock back through privately negotiated purchases, purchases on 

the secondary m arket (like the New York Stock Exchange), or t hrough tende r offers. Tender 

offer stock r epurchase pr ograms are characterized by a solicitation for sha res by offering a 

premium above market pr ice. Those accepting te nder offers ar e said to tender their stock for 

purchase. Com panies purchasing their stock back through the secondary m arkets, such as t he 

New York Stock Exchange, face reg ulations a nd restrictions. The main regulation requires 

companies to release information pertinent to th e stock repurchase ten da ys after the acquisition 

of five percent of the compan y’s outstanding stock. This differs from the tender offer in order to 

provide a stable free and open market for the buyer and seller where the extent of their interest in 

the transaction is not disclosed (Brudney, 1983). 

Regardless o f its legal de finition, a st ock repurcha se is a non-r outine transf er of cash 

from the fir m to the stockholder. In addition, according to the effi cient-market hy pothesis, 

repurchase announcement information should be re flected in prices i mmediately and invest ors 

should not e xpect to earn a return hig her than the normal rate of return as measured by The 

Standard and Poor’s 500 Index. Stock prices will adjust before an investor has time to trade, even 

with awar eness of information (Ross, 2005) . Efficiency is defined by how fast the market 

responds to different types of information: past, public, and all information. Market efficiency is 

defined in three forms: weak, semi-strong, and strong form. The market is weak form efficient if 

stock price reacts so fast to past information that n o investor can earn an above norm al return by 

acting on such news. Semi-strong form efficiency is satisfied if st ock prices immediately reflect 

all publicly available information as well as past info rmation. Strong form efficiency is satisfied 

if stock prices reflect all information, whether public or private (Ross, 2005). 

Another academ ic cam p provid ing documentation of anom alies questionin g market 

efficiency adheres to what has recentl y become known as the behavioral challenge to m arket 

efficiency. That is, not all investors are rational, a critical assu mption underpinning the behavior 

necessary to make the market efficient. Many investors buy, not necessarily when the stock price 

is below its economic value, but when they get their tax refund and sell to raise money for a down 

payment on a car. Many overreact based on too few observations driving stock price either down 

too low or up too high for extended periods of time. The bubble in internet stocks in the 1990s is 

an exa mple. Likewise, ot hers ar e too conservative, motivating the m to del ay their re action to 

valid economic information too l ong, resulting in holding winne rs and losers too long. T hey 

appear to develop an emotional attachment to a position in their portfolio and hold on too long in 

the face of significant positive or negative news . These psy chological behavioral patterns could 

explain the numerous anomalies cit ed in the fina nce literature. For a co mplete review of the 

behavioral conditions that impact market efficiency, see Shleifer (2000). 

An investor’s reaction to a stock repurchase announcem ent provides a method of testing 

efficient market theor y against the behavioral challenges cited in the literature. If the stock 


Stock Repurchase Announcements 

repurchase sends a positive signal, then fir ms may use this method to increase the market value. 

Thus, the com pany uses the stock repurchase a nnouncement as an implicit signal to the m arket 

with the objective of raising the value of their stock (Liano, 2003). 

There are other reasons why companies repurchase their stock. The most common reason 

is excess cap ital. The com pany can feel that the stock is undervalued, so the best use of ex cess 

cash is to purchase stock back thereby resulting in higher stock prices for that company. Another 

purpose of the repurchase decision is to revise the firm’s capital structure. Repurchases can cause 

adjustments in firm s’ capital structures by increasing leverage and adjus ting ownership interest. 

Buying in stock reduces the firm’s equity while at the same time increases the level of debt in the 

capital structure. The increased level of debt (or financial leverage) allows the firm to increas e 

profitability and earnings per shar e (Dittmar, 2000). Stock repurchases also r esult in favorable 

tax treatment for the indiv idual investor since an y gains are generally taxed at the lower capital 

gains rate. Firms that participate in stock repurchases typically have less leverage, poor operating 

performance, and slow growth compared to companies that do not purchase back stock. 

Research on the impact and efficiency of stock repurchase announcements on stock price 

is mixed. Studies based on large tender offer stock repurchase s resulted in an i mmediate and 

significant positive effect on stockhol ders’ wealth (Dielman, 1980). Likewise, Masulis (1980) 

suggests stock repurchase announcem ents illicit signi ficant positive stock price reactions at the 

semi-strong level of market efficiency. Comment (1991) argues that there is a positive reaction to 

the announcement of a sto ck repurchase agreemen t. Through the use of a regression anal ysis, 

Comment defends his posit ion that stock repurchases announcem ents supports increases in stock 

prices. Hi s research sup ports the idea that a firm’s stock price will increase because o f the 

signaling sent by management that their stock is undervalued. 

Using a random coefficient regression, Diel man (1980) investigated the effects of stock 

repurchasing on the rates of return on the stock be ing repurchased. His findings conclude that 

open market repurchases resulted in no econo mic significance with the rate of returns for e ach 

firm studied being negli gible (Dielman, 1980). Stewart (1976) discovered that in the short term , 

stock prices remain neutr al fro m the effects of the repurchase. His study concludes that the 

market remains rather inefficient in regards to the stock repurchase and takes several months for 

the benefits of the repurchase to appear. By stud ying b oth open market and tender offer 

repurchases, Marks (1976) was able to conclude that open market repurchases had no signif icant 

price effect on the market and tender offers had a temporary positive price effect for the length of 

the offer. However, Rosenberg (1976) found th at tender offer stock repurchases resulted in a 

neutral price effect for his sam ple. Overall, most literature supports th e idea that an investor 

cannot earn an abnormal return from the announcement of a stock repurchase. This study extends 

previous studies by examining the effects of a sam ple of 85 stoc k repurchase announcements on 

the firms’ stock price to determine if an investor is able to earn an abnormal return by acting this 

type of information. 

METHODOLOGY AND STUDY SAMPLE 

In order to te st the level of market efficiency surrounding a sam ple of stock repurchas e 

announcements this study uses the standard event study methodology from the finance literat ure. 

As such, the first goal of t he event study is to select either a common event with a single e vent 

date or a common event with different event da tes. For the purpose of this study, a comm on 

event with different event dates applies. Th e common event is the firm ’s announcement of a 

stock repurchase. Since fir ms make these announcements at random , t he dates of the 

announcements will differ. 



The study selects a sample of com panies that have announced a stock repurchase fro m 

http://finance.yahoo.com/ or other business and finance sources. In order to provide the sufficient 

number of daily price observations before and after the repurchase announcem ent to 

accommodate the event study methodology, the sample of repurc hase announcements is li mited 

to firms at least a y ear old. Likewise, t he sample of companies announcing the repurchase must 

be traded on a major exchange such as the NYSE, NASDAQ, or the AMEX. 

Table 1: DESCRIPTION OF STUDY SAMPLE 

Ticker 

Symbol Firm Name 

Announcement 

Date 

Trade 

Index 

KO Coca-Cola Corporation April 11, 1996 NYSE 

MCD McDonald's Corporation September 29, 1998 NYSE 

BBT BB&T Corporation January 27, 1999 NYSE 

AAPL Apple Incorporate July 15, 1999 NASDAQ 

GM General Motors Corporation February 1, 2000 NYSE 

BUD Anheuser-Busch Companies Incorporate February 23, 2000 NYSE 

SMP Standard Motor Products Incorporate 

Hanover Capital Mortgage Holdings 

March 6, 2000 NYSE 

HCM Incorporate April 20, 2000 AMEX 

STLD Steel Dynamics Incorporate June 7, 2000 NASDAQ 

PTIX Performance Technologies Incorporate August 14, 2000 NASDAQ 

IOM Iomega Corporation September 8, 2000 NYSE 

F Ford Motor Company September 14, 2000 NYSE 

WWE World Wrestling Entertainment Incorporate September 28, 2000 NYSE 

JAKK Jakk's Pacific Incorporate April 23, 2001 NASDAQ 

CSCO Cisco System September 14, 2001 * NASDAQ 

SCSC ScanSource Incorporate September 27, 2001 NASDAQ 

ESST ESS Technology October 24, 2001 NASDAQ 

ENWV Endwave Corporation January 23, 2002 NASDAQ 

AVSR Avistar Communications Corporation July 1, 2002 NASDAQ 

HCC HCC Insurance Holdings Incorporate July 10, 2002 NYSE 

ENTU Entrust July 29, 2002 NASDAQ 

AMWD American Woodmark Corporation September 4, 2002 NASDAQ 

COGN Cognos Incorporate October 3, 2002 NASDAQ 

ASVI ASV Incorporate October 7, 2002 NASDAQ 

AZO AutoZone Incorporate October 17, 2002 NYSE 

ARBA Ariba Incorporate October 22, 2002 NASDAQ 

ACXM Acxiom November 14, 2002 NASDAQ 

UTEK Ultratech Incorporate January 30, 2003 NASDAQ 

PETD Petroleum Development March 13, 2003 NASDAQ 

ECL Ecolab Incorporate March 18, 2003 NYSE 

ZLC Zale Corporation March 18, 2003 NYSE 

PEP Pepsico Incorporate May 28, 2003 NYSE 



HRLY Herely Industries Incorporate May 30, 2003 NASDAQ 

WMT Wal-Mart June 5, 2003 NYSE 

BORL Borlan Software Corporation August 7, 2003 NASDAQ 

GTIV Gentiva Health Services Incorporate August 7, 2003 NASDAQ 

CHKP Check Point Software Technologies October 28, 2003 NASDAQ 

ELNK Earthlink Incorporate April 23, 2004 NASDAQ 

SYNP Synplicity May 25, 2004 NASDAQ 

INFA Informatica Corporation July 2, 2004 NASDAQ 

ELON Ecelon Corporation September 1, 2004 NASDAQ 

ACME ACME Communication November 8, 2004 NASDAQ 

ITIC Investors Title Company November 11, 2004 NASDAQ 

PLUS.PK ePlus Incorporate November 18, 2004 NASDAQ 

GE General Electric Company December 10, 2004 NYSE 

CYMI Cymer Incorporate January 27, 2005 NASDAQ 

OPNT OPNET Technologies Incorporate January 31, 2005 NASDAQ 

YHOO Yahoo! Incorporate March 24, 2005 NASDAQ 

ALOG Analogic Corporation June 7, 2005 NASDAQ 

VRSN VeriSign Incorporate August 9, 2005 NASDAQ 

HPQ Hewlett-Packard Company August 26, 2005 NYSE 

SSYS Stratasys Incorporate October 28, 2005 NASDAQ 

X United States Steal Corporation January 31, 2006 NYSE 

BAC Bank of America Corporation April 26, 2006 NYSE 

NKE Nike Incorporate June 19, 2006 NYSE 

VOXX Audiovox Corporation July 10, 2006 NASDAQ 

STEC STEC Incorporate July 10, 2006 NASDAQ 

MSFT Microsoft Corporation July 20, 2006 NASDAQ 

ALDA Aldila Incorporate July 28, 2006 NASDAQ 

CPWR Compuware Corporation August 22, 2006 NASDAQ 

K Kellogg Corporation December 11, 2006 NYSE 

ALCO Alico Incorporate January 4, 2007 NASDAQ 

KFT Kraft Foods Incorporate February 20, 2007 NYSE 

WSBC WesBanco Incorporate March 22, 2007 NASDAQ 

DNA Genentech Incorporate April 20, 2007 NYSE 

NVDA NVIDIA Corporation May 21, 2007 NASDAQ 

IBM International Business Machines May 29, 2007 NYSE 

BKC Burger King Corporation June 1, 2007 NYSE 

HOME Home Depot June 19, 2007 NASDAQ 

WGO Winnebago Industries July 2, 2007 NYSE 

JNJ Johnson & Johnson July 10, 2007 NYSE 

COP ConocoPhillips July 10, 2007 NYSE 

SHLD Sears July 10, 2007 NASDAQ 



AA Alcoa July 12, 2007 NYSE 

TLGD Tollgrade Communications Incorporate July 26, 2007 NASDAQ 

PAYX Paychex Incorporate August 3, 2007 NASDAQ 

TKLC Tekelec August 10, 2007 NASDAQ 

SAPE Sapient August 20, 2007 NASDAQ 

ATML Atmel August 27, 2007 NASDAQ 

QCOM Qualcomm Incorporate August 27, 2007 NASDAQ 

CVX Chevron Corporation September 27, 2007 NYSE 

HW Headwaters Incorporate October 22, 2007 NYSE 

DELL Dell Incorporate December 4, 2007 NASDAQ 

MRT Morton's Restaurant Group January 15, 2008 NYSE 

TRMB Trimble Navigation Ltd January 23, 2008 NASDAQ 

To test semi-strong form market efficiency with respect to public announcements of stock 

repurchases and to examine the effect of stock repurchase announcements on stock return around 

the announcement date, this study proposes the following null and alternate hypotheses: 

H10: The risk adjusted return of t he stock price of the sample of firms announcing stock 

repurchases is not significantly affected by this type of information on the announcement date. 

H11: The risk adjusted return of the stock price of the sample of firms announcing stock 

repurchases is significantly positively affected by this type of infor mation on the announcement 

date. 


repurchases i s not signific antly affected by t his t ype of inform ation around t he announce ment 

date as defined by the event period. 


repurchases is significantly positivel y affected around the announcem ent date as defined by the 

event period. 

The annou ncement date (day 0), is th e da te of the firm ’s announcem ent of the stock 

repurchase. The required historical financial da ta, the fir ms’ stock prices and the corresponding 

time matched S&P 500 index values for each obser vation for the event study, will be obtained 

from the internet website http://finance.yahoo.com/. The historic al stock pric es of the sam ple 

companies announcing stock repurchases, and the correspondin g S&P 500 in dex values, for the 

event study duration of -180 to +30 days (with day –30 to day +30 defined as the event pe riod 

and day 0 th e announcement date) were obtained. The holding p eriod returns of the co mpanies 

(R) and the corresponding S&P 500 index (Rm) for each day in this study period were calculated 

using the following formula: 

or 

Current daily stock return = (current day close price – previous day close price) 


Current daily S&P 500 return = (current day close price – previous day close price) 


A regression analysis was performed using the act ual daily return of ea ch company (dependent 

variable) and the correspo nding S&P 5 00 daily return (independent variable) over the pre-event 

period (day -180 to day -31) to obtain the required alpha and beta coefficients. 


Table 2: ALPHAS AND BETAS OF SAMPLE STUDY 

Firm Alpha Beta 

KO -0.000997896 0.367242654 

MCD 0.001452809 0.687107057 

BBT -0.002192372 1.020852623 

AAPL 0.001635307 1.08772784 

GM -0.000335242 0.735931552 

BUD -0.000450786 0.449482927 

SMP -0.002754333 0.169517558 

HCM 0.000270621 0.017018403 

STLD -0.0022766 0.607929068 

PTIX 0.001205689 1.522388945 

IOM 0.001901318 0.584998466 

F -0.002549631 0.263181509 

WWE 0.001159044 0.377814878 

JAKK 0.001144381 1.122401369 

CSCO -0.000298548 2.088965647 

SCSC 0.002083845 0.768038663 

ESST 0.007634321 1.329888342 

ENWV -0.002097398 0.254261582 

AVSR -0.002649402 0.519862965 

HCC -0.000362124 0 

ENTU 0.002700623 1.773714321 

AMWD 0.000844081 0.669685843 

COGN 0.000222903 0.134231009 

ASVI -0.001274543 -0.0170995 

AZO 0.001961116 0.617335438 

ARBA 0.001888536 1.440209211 

ACXM 0.001519324 0.788341133 

UTEK 0.00061807 1.167988981 

PETD 0.000731597 0.194305498 

ECL 0.000867974 0.80791061 

ZLC 0.000194213 0.568464184 

PEP 0.000834711 0.335456028 

HRLY -0.000285157 0.365310341 

WMT -8.77E-05 0.716318717 

BORL -0.001323831 1.107039257 

GTIV 0.039151363 1.934826931 

CHKP -6.07E-05 1.156327111 

ELNK 0.001011716 1.77653952 

SYNP -0.000723645 -0.44473305 

INFA -0.001833592 1.96403177 




ELON -0.00155802 1.499934977 

ACME -0.002127432 0.306104413 

ITIC 0.000605365 -0.31532446 

PLUS.PK -0.000215631 0.148022083 

GE 0.00078211 0.765171714 

CYMI -0.001218191 1.825537872 

OPNT -0.003441312 1.218524707 

YHOO 0.00026925 1.240890066 

ALOG 0.000168265 1.204349244 

VRSN -0.001752097 1.291257783 

HPQ 0.001296649 0.485182193 

SSYS -0.001053431 0.731744904 

X 0.001042672 1.596426129 

BAC 0.000492901 0.660545987 

NKE -0.000223904 0.460833445 

VOXX -0.00019708 1.413967612 

STEC 0.002225553 0.382100553 

MSFT -2.33144E-05 0.484329017 

ALDA -0.001467573 0.962706766 

CPWR -0.000829701 0.600586682 

K 0.000308135 0.370058593 

ALCO 0.000184364 0.677765135 

KFT -0.000589103 0.526390178 

WSBC -0.000772212 1.231918238 

DNA -0.000336862 0.348806663 

NVDA 0.001240226 1.543165532 

IBM 0.001071257 0.584660448 

BKC 0.0020237 0.66095009 

HOME -0.000790249 1.126490832 

WGO -0.001226906 0.987777988 

JNJ -0.000396381 0.452838794 

COP 0.001098237 0.80235576 

SHLD -0.001003899 0.718915771 

AA 0.001179264 0.968170257 

TLGD 0.001361676 0.710662139 

PAYX 0.000308601 0.66602998 

TKLC -0.001603313 0.829168159 

SAPE 0.000900494 0.977706477 

ATML -0.000289634 0.736844168 

QCOM 0.000463236 0.553397838 

CVX 0.000909759 0.83030035 

HW -0.003225915 0.934231501 

DELL -0.000143209 0.812796612 

MRT -0.002895692 0.893510663 


TRMB 0.000476247 0.918065855 


In order to g et the normal expected returns, th e risk-adjusted method was used. The expected 

return for each stock, for each day of the event period (day -30 to day +30) was calculated as: 

E(R) = alpha + Beta (Rm), 

Rm is the return on the market (S&P 500 index). 

Then, the excess return (ER) was calculated as: ER = Actual Daily Return (R) – Expected Return 

E(R). Average Excess Returns ( AER) was calculated (for e ach day fro m -30 to +30) b y 

averaging the excess r eturns for all the firms for the given day. AER = Su m of Excess Re turns 

for the given day / num ber of firms in sam ple. Cum ulative AER ( CAER) was calculat ed by 

adding or accumulating the AERs for each day from -30 to +30. Graphs of AER and Cumulative 

AER are plotted for the event period to display how the market performs each day of the event 

period (day -30 to +30). 

QUANTITATIVE TESTS AND RESULTS 

Did the m arket react to the stock repurchase announcem ents? Was the inf ormation 

surrounding the event significant? A’priori, one would expect there to be a sig nificant difference 

in the Actual Average D aily Returns (Day -30 to Day +30) and the Expected Average Daily 

Returns (Day -30 to Day +30) if the information surrounding the event impounds new, significant 

information on the m arket price of the fir ms' stock (see AER graph in Cha rt 1 below). If a 

significant risk adjusted di fference is o bserved, then we support our hypothesis that this t ype of 

information did in fact sig nificantly either increas e or decrease stock price. To statistically test 

for a difference in the Actual Daily Average Returns (for the firms over the time periods day -30 

to day +30) and the Expected Daily Average Returns (for the firms over the time periods day -30 

to day +3 0), we conducted a paired sam ple t-test and fo und a significant dif ference at th e 5% 

level between actual average daily returns and the risk adjusted expected average daily returns 

over the event period. R esults here support t he alternative hyp othesis H21: The risk adjusted 

return of the stock price of the sam ple of firms an nouncing sto ck repurchases is significantly 

discernable around the announcem ent date as defined by the event period. This finding supports 

the significance of the information around the event since the market’s reaction was observed. 

Is it possible to isolate and observe the sample’s daily response to the announcement of a 

stock repurchase from day -30 to day +30? If so, at what level of efficiency (weak, semi-strong, 

strong form according to e fficient market theory) did the market respond to the information and 

what are the im plications for market efficiency? Another purpose of this analy sis was to test the 

efficiency of the market in reacting to the repurchase announcement. Specifically, do we observe 

weak, semi-strong, or stro ng form market efficiency as d efined by Fama (1970) in the efficient 

market hypothesis? The key in the analy sis or t ests is to deter mine if the AE R (Average Excess 

Return) and CAER (Cu mulative Average Excess R eturn) are significantly different from zero or 

that there is a visible graphical or statistical relationship between time and either AER or CAER. 

See AER an d CAER graphs in Charts 1 and 2 below. T-tests of AER and CAER both t ested 

different from zero at the 1% level of significance. Likewise, observation of Chart 2 (graph of 

CAER from day –30 to day +30) confirms the significant reaction of the risk-adjusted returns of 

the sample of firms tested to the announcement of stock repurchases. 



Chart 1: AVERAGE EXCESS RETURN OVER EVENT PERIOD 

Chart 2: CUMULATIVEAVERAGE EXCESS RETURN OVER EVENT PERIOD 

Chart 2 sho ws a decrease in stock pr ice fo r the sam ple of firms announcing a stock 

repurchase fr om day -30 t o the announcement da te followed by an i mmediate and significant 

price increase on the an nouncement day 0. F ollowing the an nouncement, the sam ple of 

repurchase fi rms maintained and slightly elev ated the significant positive im pact on ret urn 

(apparently triggered by the news) for t he majority of the event period to da y +21. The evidence 

supports the alternative hypothesis H11: The risk adjusted return of the stock price of the sam ple 

of firms announcing stock repurchases i s significantly affected by this type of information on the 

announcement date. For t he sample of firms anal yzed, an invest or is unable t o earn an above 

normal risk adjusted return by acting on the public announcement of a stock repurchase. After 



the announcement date, t he fir ms’ stock prices tr ended upward slightl y to day +21. This i s 

consistent with the semi-strong form market efficiency h ypothesis, whic h states that the stock 

price reflects all publicl y available information. Results here suggest that stock repurchas e 

announcements illicit significant positive stock price reactions at the semi-strong level of market 

efficiency. 

CONCLUSION 

This study tested the effect of stock repu rchase announcements on the stock price’ s risk 

adjusted rate of return for a sample of 85 firms. These stocks were traded on the NYSE, AM EX, 

or the NASDAQ. Using standard risk adjusted event study methodology with the market model, 

the study analy zed 35,870 recent observations on eight y-five publicly traded fir ms and the 

corresponding S&P 500 market index. Appropria te statistical tests of significance were 

conducted. Results show a negativ e market re action pri or t o the firm s’ stock repur chase 

announcement and a positive reaction on and after the announcement. Findings support efficient 

market theory at the semi -strong form level as documented by Fama (1970). Stock repurchase 

announcements illicit significant positive stock price reactions at the semi-strong level of market 

efficiency. 

Specifically, for this study the announcement of stock repurchase is viewed with a m ixed 

signal, negative before the a nnouncement and positive afterwards. Investors appear unsure as to 

management’s motivation implied by the repurchase decision. Unlike previous literature on this 

issue, there is no consist ent positive signal associated with th e repurchase announcements 

observed in t his stud y. E vidence here is mixed possibly d ue to sam ple selection bias or the 

behavioral challenge to efficient market theory . This study suggests that the market i s not 

efficient with respect to announcem ents of stock re purchases in the short te rm. Results here 

question the strength of market efficiency and may offer additi onal evidence in support of the 

behavioral challenge to efficient market theory. 

REFERENCES 

Brudney, Victor. (1983). “Equal Treatment of Shareholders in Corporate Distributions and 

Reorganizations.” California Law Review, Vol. 71, No. 4, The Supreme Court of 

California (July), 1072-1133. 

Comment, R., and G.A. Jarrell. (1991). "The Relative Signaling Power of Dutch-Auction and 

Fixed-Price Self-Tender Offers and Open-Market Share Repurchases." Journal of 

Finance (September), 1243-1271. 

Dielman, Nantell, and Roger L. Wright. (1980) “Price Effects of Stock Repurchasing: A Random 

Coefficient Regression Approach.” The Journal of Financial and Quantitative Analysis, 

Vol. 15, No. 1 (March), pp. 175-189. 

Dittmar, Amy K. (2000). "Why Do Firms Repurchase Stock." The Journal of Business (July). 

Fama, E. F. (1970). “Effi cient Capital Markets: A Review of Theory and Em pirical Work.” 

Journal of Finance, Volume 25 (May), 383-417. 

Friedman, Louis P. (1986). “Defensive Stock Repurchase Programs: Tender Offers in Need of 

Regulation.” Stanford Law Review, Vol. 38, No. 2 (January), 535-594. 



Marks, Kenneth R. (1976). “The Stock Price Performance of Firms Repurchasing Their Own 

Shares.” New York University Bulletin. 

Masulis, Ronald W. (1980). “Stock Repurchase by Tender Offer: An Analysis of the Causes 

of Common Stock Price Changes.” The Journal of Finance, Vol. 35, No. 2, Papers 

and Proceedings Thirty-Eighth Annual Meeting American Finance Association, Atlanta, 

Georgia, December 28-30, 1979 (May), 305-319. 

Liano, Kartono, Gow-cheng Huang, and Herman Manakyan. (2003). "Market reaction to open 

market stock repurchases and industry affiliation." Quarterly Journal of Business and 

Economics (Winter-Spring). 

Personal Finance. (2007). Yahoo! Finance, (April), 

http://finance.yahoo.com/personal-finance/glossary?gloss_ind=t. 

Rosenberg, Marvin, and Allen E. Young. (1976). “The Performance of Common Stocks 

Subsequent to Repurchase by Recent Tender Offers.” Quarterly Review of Economics 

and Business (Spring), 109 -113. 

Ross, S. (2005). Corporate Finance (Stephen A. Ross, Randolph W. Westerfield, Jeffery Jaffe. - 

7 th ed.). United States: McGraw-Hill Companies. 

Stewart, Samuel S. (1976). “Should a Corporation Repurchase Its Own Stock.” Journal of 

Finance, Vol. 31, No. 3 (June), 911 -921. 


WEALTH, POVERTY, AND SUB-SAHARAN 

AFRICAN CONFLICTS: CASES OF ANGOLA, 

CONGO, AND SIERRA LEONE 

Rita O. Koyame-Marsh 

Florida Memorial University 

rkoyame@hotmail.com 

ABSTRACT 

This paper analyses the pre-war and post-war economic conditions of three sub-Saharan African 

countries that had been devastated by internal conflicts during the 1990s. The paper shows that 

these countries, while rich in natural resources, are plague with low GDP per capita, higher 

inflation rate, high level of poverty, and income inequality. These poor economic conditions are 

considered as some of the key factors that lead to conflicts in these countries. The paper uses the 

case of conflicts in Angola, Democratic Republic of Congo (Congo) and Sierra Leone to 

demonstrate this trend. In addition, the paper demonstrates that revenues from the illegal trade of 

natural resources by the rebel groups helped sustain wars in these countries. 

INTRODUCTION 

Sub-Saharan Africa has seen its shares of civil wars in the last three decades. Countries such as 

Angola, the Democratic Republic of Congo (Congo), and Sierra Leone have had some of the 

bloodiest conflicts in the world. These three countries share similar pre-conflict economic 

conditions: they are some of the poorest countries in the world in spite of their rich natural 

resources endowment. Indeed, higher levels of corruption and government abuse of public funds 

have lead to inequality in the distribution of income and greater poverty in these countries. In fact 

only a small fraction of the population, the elite running the country gets the most benefit from 

these resources. There is, hence, a prevalent belief in these countries that the only way to have 

access to the piece of the pie is either by being part of the governing group, which is not that 

simple because of lack of democracy, or by force. The latter option is obviously the most 

successful one thus, the start of conflicts and civil unrest in these countries. 

Collier (1999) pointed out that when it comes to the distribution of economic resources, leaders, 

even in poor countries, often compete with one another for control of the available economic 

excess, small as that might be. And when the available surplus is little, as in poor countries or 

where there has been terrible sprawl, competition for it can be extremely intense, and a violent 

escalation might be a likely result. The violence in Liberia (1989 – 1997), the war in Sierra Leone 

(1991-2002), the three-decade war in Angola (1975-2002), the cycles of brutality in Rwanda and 

Burundi, and Congo’s armed conflict (1998 – 2002) are some of the many examples of this 

phenomenon. 

Poor pre-war economic conditions that potentially triggered rebellion and civil unrest in these 

countries could only worsen during the war. Indeed, the paper shows that government spending 

on social services had a sharp decline during the war compared to national defense budget, which 

increased substantially. In addition, a decrease in production of key natural resources, as the 

rebels seized resource rich areas, lead to more poverty and suffering for the people of these 

countries. In 2001, Sierra Leone was counted last in United Nations Human development index, 


Koyame-Marsh 

with Angola and Congo not far from the bottom of the list. (United Nations Development 

Programme, 2003) 

Moreover, the endowment of natural resources such as petroleum and precious mineral, while 

incapable of deterring poverty and inequality, has helped sustain conflicts in these countries by 

providing revenues to the rebel groups. The latter had relied heavily on the trade of natural 

resources such as gold, diamond, and petroleum to sustain their war efforts. They have used 

revenues from the sale of these resources to purchase weapons and food for the soldiers. For 

example, the three-decade civil war in Angola was almost totally financed by the illegal sales of 

diamonds by the rebel group. Like in Angola, the illegal trade in diamonds also fueled the civil 

war in Sierra Leone. The Sierra Leone conflict lasted for about a decade starting in 1991 and 

ending in 2002. In the Democratic Republic of Congo (Congo), the second civil war of post 

Mobutu era that started in 1998 still continued its course also thanks to the trade of natural 

resources such as timber, diamond, gold, and columbo-tantalite (coltan) by the rebel groups. 

Thus, given the role played by the control of natural resources in these conflicts, it is imperative 

that cease-fire agreements take into account the interests of the rebel groups and the long-term 

economic conditions of the people in order to be successful. Any conflict resolution that neglects 

to confront theses factors is bound for failure. Indeed, a rebel group that has the most to lose after 

the cease-fire would be the one most likely to break the agreement and continue the war. 

According to Smith (2001), there are many different reasons why wars resume after conclusion of 

cease-fires or apparent peace agreements. One of the main reasons is the failure of addressing the 

underlying long-term causes of armed conflict. Some of these long-term causes of armed conflicts 

can be ethnic, environmental, political (especially lack of democracy), and economic. However, 

overall, the economic state of affairs transpires as the most important explanatory issues. 

Hauge and Ellingsen (1998) also insisted that low level of economic development seems to be the 

key issue in armed conflicts. They added that the low level of economic development is generally 

shown by conditions such a low average per capita Gross Domestic Product (GDP), a 

disproportionately large agriculture sector, and higher level of inequality in the distribution of 

resources. The three countries chosen for this study; Angola, Congo, and Sierra Leone; have all 

experienced low levels of economic development before their respective conflict. Thus, since low 

level of economic development seemed to be the key long-term causes of internal armed conflicts 

in these countries, failure to address them meant that all efforts at reconstruction were at best 

worthless and peace agreements were most likely to be broken. 

It is worth noting that not all poor countries are prone to armed conflicts. Indeed, there are 

countries that are both extremely poor and repressed but in which there is no war. Just like there 

are countries that are not among the poorest or the most repressive of the world but in which there 

have been internal armed conflicts (the example of Ireland and Yugoslavia). There are, hence, 

many causes to armed conflicts, however we shall focus only on the underlying long-term 

economic and social conditions in this paper because there are most likely the causes of conflicts 

in the three countries analyzed here. 

Each country’s socio-economic data before and during the war are presented in Box 1. 


Angola, Congo and Sierra Leone 

Box 1 Selected Pre-war and War Time Socio-Economic Indicators 

Angola Congo Sierra Leone 

Population in millions (2001) 14 52 5 

Inflation Rate-Implicit GDP Deflator (1986) -9.1% 28.5% 78.5% 

Inflation Rate-Implicit GDP Deflator (1996). 5,399.5% 638.2% 25.6% 

GDP per Capita (PPP US$, 2001) $2,040 $680 $470 

GDP per Capita Growth Rate (1980-1990) 3.4% 1.6% 1.2% 

GDP per Capita Growth Rate (1990-1999) 0.4% -5.1% -4.7% 

Agriculture Growth Rate (1980-1990) 0.5% 2.5% 3.1% 

Agriculture Growth Rate (1990-1999) -3.0% 2.9% 1.0% 

Industry Growth Rate (1980-1990) 6.4% 0.9% 1.7% 

Industry Growth Rate (1990-1999) 2.7% -11.7% -4.6% 

Services Growth Rate (1980-1990) 1.3% 1.3% -2.7% 

Services Growth Rate (1990-1999) -2.4% -15.2% -10.8% 

Population living on less than a $1/day (1989) NA% NA% 57% 

Population living on less than a $2/day (1989) NA% NA% 74.5% 

Gini Coefficient (1989) NA% NA% 62.9 

Life Expectancy at Birth (Years, 2001) 40.2 40.6 34.5 

Adult Literacy Rate (2001) 42.0% 62.7% 36% 

Human Development Index (2001) 0.377 0.363 0.275 

Human Development Index Rank 164 167 175 

(Out of 175 Countries, 2001) 

Corruption Perception Index (2002) 1.7 NA NA 

Sources: United Nations Development Programme 2003, World Bank World Development Indicators 2001 and 2003, 

and Transparency International 2002. 

ANGOLA’S PRE-WAR AND WAR TIME SOCIO-ECONOMIC CONDITIONS 

The pre-war socio-economic conditions in Angola are a bit different from the ones in Congo and 

Sierra Leone. The decade prior to the war, Angola was a Portuguese colony where economic 

development did not translate into social development for the people of Angola. Racial 

antagonisms were the norm in the Portuguese regime just like in any other European colony in 

Africa. Fed up with the Portuguese regime, Angolans decided to ask for independence in early 

1960 but had to fight for it until 1975 when the Portuguese finally decided to withdraw from 

Angola. On November 11, 1975, the Popular Movement for the Liberation of Angola (MPLA) 

proclaimed the independence of Angola with Agostino Neto as its President. However, Jona 

Malheiro Savimbi, the leader of the political party called the National Union for the Total 

Independence of Angola (UNITA) and Holden Roberto, the leader of the National Liberation 

Front of Angola (NFLA) couldn’t accept defeat and started their fights against MPLA thereafter 

the independence. However, UNITA’s fight was the longest and lasted for about 27 years until 

the death of Savimbi in 2002. 

The plantation economy that was the basis for economic development in Angola during the 

prewar colonial era couldn’t continue to strive because of the war. The mining sector developed 

by the Portuguese during mid-20 th century remained the major sector for economic development 


Koyame-Marsh 

in the 1980s while the agricultural sector continued to struggle. Agricultural activities almost 

stopped altogether due to the severe wartime conditions, especially, the spread of landmines all 

over the countryside, forcing the country to import much of its food. The harmful effects of the 

war on Angola’s agricultural sector are also demonstrated by the negative growth rate in 

agriculture sector during the 1990s as shown in Box 1. This caused a large majority of the 

population in Angola to depend on subsistence agriculture and humanitarian food assistance. 

In the 19 90s, Angola con centrated its efforts in the producti on of oil and di amonds. Oil and 

diamond in dustries became the basis for econom ic development in Ang ola despite the war. 

Angola was the second largest producer of petroleu m in Africa after Niger ia in early 2000s. 

Indeed, according to t he U.S. Depart ment of Stat e (2004), the Angola’ s petroleu m industr y 

produced around 993,000 barrels (bpd), which accounted for about 51.7% of its GNP, 90% of its 

exports, and 90% of its g overnment revenues. The remaining export revenues came mostly from 

diamond production. Angola’s revenues from petroleum and diamond production including their 

share in exports during mid 1990s are presented in Table A1 and A2. These data not only show a 

high capacity in the production of these two ke y natural resources but a lso a ris e in their 

production and sale despite the war. However, diamond production was still far below Angola’s 

capacity because so me of t he productions were or iginating from rebel-controlled areas and wer e 

not accounted for. 

Table A1. Angola’s Oil and Diamond Production, 1995-99 (Millions of Kwanza) 

1995 1996 1997 1998 1999 

Diamonds 1 28 76 137 1,36 5 

Oil and Liquefied 8 484 842 956 9,60 3 

Petroleum Gas 

Sources: IMF Staff Country Report No. 00/111 

Table A2. Angola Oil and Diamonds’ Sales as Share of Exports, 1995-99 

1995 1996 1997 1998 1999 

Crude Oil 92% 91.4% 90% 85.2% 86.3% 

Diamonds 4.5% 5.2% 6.9% 12.2% 11.8% 

Source: Computed using data from IMF Staff Country Report No. 00/111 

The 27 years civil war had its mark not only on the industrial sector in Angola but also on its 

economy as a whole. Angola’s level of real GDP per capita in 2001 was about US$2,040 in 

purchasing power parity (PPP) with an average growth rate of 0.4% in the 1990s as shown in Box 

1. Beside the stagnating real GDP per capita, Angola also experienced high level of inflation 

during the 1990s. According to the US Department of State (2004), inflation in Angola rose from 

135 percent in 1998 to 329 percent in 1999, causing more social hardship for the people. In 

addition, because of the civil war, public services, especially health and education were more and 

more of lower priority to the government of Angola. When the share for public services in the 

government budget was seeing a steady decline, the share for defense and public order (the armed 

forces and police) was on the rise. The latter continued to rise and reached about 41 percent of 

government budget in 1999, while education received only 4.8 percent of the budget and health 

2.8 percent. Consequently, in 2001, amid all the oil and diamond revenues, the United Nation 



Development Programme (UNDP) ranked Angola 164 out of 175 countries in Human 

Development Index. 

Moreover, only a very small number of elite in Angola has amassed enormous fortunes through 

oil, diamonds, weapons, and other illicit business deals, while the rest of the people remained 

poor, sick, and out of school. Indeed, a 2001 survey of 6,600 Angolan households carried out by 

the National Institute for Statistics in collaboration with the United Nations Children’s Fund 

(UNICEF) provided some alarming social statistics on Angola following the three decades of 

civil war (United Nations OCHA and IRIN 2002). Data from survey show among other things 

that 50 percent of rural children and 40 percent of urban children did not attend school. Two out 

of every 10 pregnant women do not see any healthcare provider at all, and more than 50 percent 

of mothers give birth without medical assistance. The survey also showed that malnutrition 

affected 30 percents of children and Child mortality rate was about 250 per 1,000 live births, the 

third worst rate in the world. Moreover, the survey found that 75,000 children aged 0-14 years 

have lost one or both parents, about 100,000 of them have lost parents to AIDS. The effects of the 

war and AIDS epidemic were the main causes of low life expectancy at birth, which was about 

40.2 years in 2001. 

CONGO’S PRE-WAR AND WAR TIME SOCIO-ECONOMIC CONDITIONS 

Congo, the third largest country in Africa is rich in natural resources and minerals. Industry, 

particularly mining, is the main source of revenues and wealth in Congo. The country produces 

mineral such as copper, cobalt, diamonds, gold, uranium, and other base metals. In the 1980s, the 

decade prior to the war, Congo was the fourth-largest producer of industrial diamonds and 

diamonds was the largest source of export earnings especially after 1985 when the production of 

most of the minerals declined. The decline in the mining sector that started in the 1980s deepened 

in early 1990s and by late 1990s, copper production fell to 25,000 tons, which represents a 95 per 

cent decrease from its 1985 output level of more than 500,000 tons. Cobalt’ production declined 

by 70 percent to about 5,000 tons per year during the same time period, the production of gold 

was virtually nil, compared to a capacity of 6 tons per year. Congo, which has a capacity of 

360,000 tons per year in Manganese production, discontinued its production in the late 1990s. 

(IMF country report No 01/123) 

In mid 1990s, few years prior to the war, diamonds provided about 50 per cent of export revenues 

in Congo, followed by copper and cobalt, which together, contribute to about 20% of export 

revenues as shown in Table B2. The agricultural sector was in far better shape than the industrial 

sector not only in the 1980s but also in the 1990s. The agricultural sector had a growth rate of 2.5 

% in the 1980s compared with 0.9% in the industrial sector as presented in Box 1. Moreover, the 

industrial sector had a negative growth of 11.7% in the 1990s while the agricultural sector 

continued its positive trend with a growth rate of 2.9%. According to the World Bank, Congo’s 

agricultural sector, which employs about two-third of the labor force, accounted for about 58% of 

GDP in 1999 (World Bank WDI 2001). Coffee, palm oil, rubber, cotton, sugar, tea, and cocoa 

constitute the main cash crops in Congo. While cassava, plantains, maize, groundnuts, and rice 

are part of the food crops. 

Congo experienced a slow growth in real GDP per capita in the 80s and a negative growth of 

5.1% in the 90s mostly due to the war. Congo’s dismal pre-war economic conditions in spite of 

its large endowment of natural resources were mainly due to widespread corruption, misdirected 

economic and financial policies, and the diversion of public resources for personal gain, 

especially during the Mobutu’s regime. Social indicators were also very low prior to the war with 

higher level of poverty and inequality in the late 80s and early 90s. In addition, the country was 

plague with higher inflation rates that started in early 1990s and reached a record 638.2% in 


Koyame-Marsh 

Table B1. Congo’s Key Mineral Production, 1995-99 

1995 1996 1997 1998 1999 

Diamonds (Millions 22.0 22.2 22.0 29.4 18.5 

of Carats) 

Copper (Thousands 35.0 40.2 37.7 36.1 23.8 

of Tons) 

Cobalt (Thousands 4.0 4.1 3.0 4.7 1.8 

of Tons) 

Sources: Economic Intelligence Unit, 2000. 

Table B2. Congo Mineral Sales as Share of Exports, 1995-99 (In percentage) 

1995 1996 1997 1998 1999 

Diamonds 46.7 49.4 51.6 61.2 59.8 

Copper + Cobalt 19.5 16.9 18.2 20.3 14.8 

Source: Computed using data from Economic Intelligence Unit, 2000. 

1996 (see Box 1). Such hyperinflation could only lead to the worsening of the already acute level 

of poverty that was rampant in the country. 

The decreases in output, income, and social indicators became even worse during the civil war 

(1998 – 2002) because of the partial collapse of government control over public finances and 

public enterprises. There was virtually no government infrastructure or services left in most of the 

country. According to the Economist Intelligence Unit (1999), Congo’s government spending 

allocated to health and education fell to less than 1%. The majority of schools became nonoperational 

causing generation of schoolchildren to become illiterate. In 2001, amid the richness 

of its soil and all the revenues from diamonds, Congo ranked 167 out of 175 countries in the 

UNDP Human Development Index. Congo’s real GDP per capita was about US$680 (in PPP) in 

2001. In addition, most of the transportation infrastructures were damaged during the war making 

the economic and commercial links among the various sections of the country almost impossible. 

This situation led to major problem for foods supply in the country and to a higher level of 

malnutrition especially in Kinshasa, the capital of Congo. According to the World Food 

Programme (2000), 32% of children in Congo were affected by moderate malnutrition and 10% 

with acute malnutrition in 1999. For more on the economic effects of the Congo war see Koyame 

and Clark (2002). 

SIERRA LEONE’S PRE-WAR AND WAR TIME SOCIO-ECONOMIC CONDITIONS 

Sierra Leone, a major producer of gem-qualit y diamonds, is also rich in other minerals such as 

rutile, bauxite, gold, platinum and chromite. The mining sector is the key industry in Sierra Leone 

and diam ond production is the main activity in t his industr y. According t o the U.S. State 

Department (2003), Sierra Leone has an est imated annual diamond produc tion capacit y that 

ranges between US$250-300 million. However, most of the diamonds are produced and traded in 

the informal sector and only a small portion is tr aded through the formal export channels. Sierra 

Leone also h as the world’s largest dep osits of rutile, a titaniu m ore used as p aint pigment and 

welding rod coatings, whose production is contro lled by a con sortium of U.S. and Euro pean 

investors. In 1990, Sierra Leone exported 88,000 t ons of ru tile worth $75 million (US State 

Department, 2003). However, the invasion of th e mining sites by the rebels in 1995 led to 

suspension of the production of rutile. Data on so me of Sierra Leone mineral productions and 

their share in export revenues are presented in Tables C1 and C2. 



Table C1. Sierra Leone’s Mineral Production (In Thousands) 

1988/89 1989/90 1990/91 1991/92 1992/93 

Diamonds (carats) 66 124 162 343 201 

Bauxite (tons) 1460 1518 1401 1260 1322 

Rutile (tons) 133 133 151 143 158 

Sources: IMF Staff Country Report No. 97/47 

Table C2. Sierra Leone Minerals’ Sales as Share of Exports, 1989-93 

1989 1990 1991 1992 1993 

Rutile 45.8% 53.7% 49.4% 43.6% 48.6% 

Bauxite 17.3% 18.6% 17.0% 25.6% 20.5% 

Diamonds 15.8% 8.7% 22.0% 20.7% 16.5% 

Source: Computed using data from IMF Staff Country Report No. 97/47 

In addition to minerals, Sierra Leone produces agricultural products such as coffee, cocoa, ginger, 

and others. Agriculture sector in Sierra Leone employs about two-third of the population who are 

mostly engaged in subsistence agriculture. Si erra Leone experienced a slowdown in econom ic 

activities that began in the 70s, continued in th e 80s, and worsen during the war. There was a 

decline in all sectors of the econo my including m ining, services, and agriculture during the war. 

As indicated in Box 1; the agriculture sector, which grew at a rate of 3.1% in the 80s (the decade 

prior to the war), had a g rowth rate of 1% dur ing the decade of war while the industr y (mining) 

and services sectors had negative growth during wa r. The decline in the growth of agricultural 

sector during the war resulted in a 38% fall in its output and a fall in sel f-sufficiency production 

in rice, the main staple, from 69 percent in 1990 to 20 percent in 2000 (IMF and IDA, 2001). 

Sierra Leone also had a lo wer rate of g rowth in GDP per capita of 1.2% in the 80s that became 

negative during the war. According to a World Bank 1989/90 survey of Sierra Leone households, 

about 57% of the population in Sierra Leone lived on less than US$1 a day or below poverty line 

and about 74.5 percent live on less than US2$ a day in 1989 as shown in Box 1. The percentages 

of people living below poverty line should be expected to rise during the war. Thus, Sierra Leone 

did not only endure a further decline in its eco nomic activities during t he civil war but also 

degradation in the standard of livin g of its people and its socio-economic infrastructures. Indeed, 

because of the war, Sierra Leone experienced a pe rvasive nature of poverty substantiated by low 

daily per capita food int ake, high rate of malnutrition, high rate of infan t mortality, and 

inadequate access to basic public services. Life expectancy at birth in Sierra Leone was the lowest 

in the world at about 34.5 years in 200 1. Sierra Leo ne real per capita GDP was only about US$ 

470 (PPP) in 2001. As a r esult of the war, Sierra Leone was ranked last in human development 

index among 175 countries in 2001. 

ANGOLA’S WAR FINANCING AND PEACE AGREEMENTS 

As mentioned in the previous section, the civil war in Angola started right after its independence 

from Portugal in 1975 and continued until early 2002. In this war, the Marxist Popular Movement 

for the Liberation of Angola (MPLA), the leg itimate government of Angola, was backed 

politically and financially by Cuba and the Sovi et Union, while National Un ion for the Total 

Independence of Angola (UNITA) was supported politically and financially by the United States 

and South Africa’ s white-minority regime. The war lasted for 27 years regardless of two peac e 

agreements signed between MPLA and UNITA and despite UN sanctions against UNITA. 


Koyame-Marsh 

UNITA’s war against the government of Angola was mainly financed by its illegal sales of rough 

diamonds. According to Global Witness, diam ond trade generated about US$3.7 bil lion for the 

Angolan rebel m ovement UNITA fro m 1992 to 1997 (Global Witness 2002). Funds from the 

sales of diamonds made it possible for UNITA to restock its munitions and to maintain a complex 

military oper ation in the region, m aking any progre ss towards p eace in Angola i mpossible. In 

fact, UNITA’ s war again st the legitimate govern ment of Angola never ceased even after the 

withdrawal of foreign troops in 1989 and the si gning of Bicesse Accord in 1991, accord that l aid 

out an electo ral process f or a dem ocratic A ngola under the supervision of the United Nations. 

Indeed, Jonas Savim bi, who failed to win the fi rst round of election in 19 92, called the election 

fraudulent and decided t o go back to war. In addit ion, in 1994, UNITA decided once aga in to 

avoid meetin g its obligations under th e Lusaka c ease-fire protocol signed between MPLA and 

UNITA and continued the war. Thus, UNITA, being financially and military strong, was able to 

continue the war regardl ess of any signed p eace agreement. It wa s only after the de ath of 

Savimbi, the founder and l eader of UNITA, on February 22, 2002, that the Angola ’s civil war 

ended. 

One of the reasons for the failure of the va rious peace agree ments between U NITA and MPL A 

was Savimbi’s fear of losing the economic and financial power that UNITA had from diamonds’ 

production. Thus, as long as it was possible for UN ITA to hold on to its economic power, peace 

could not be achieved. Even the UN Security Co uncil (UNSC) sanctions against UNITA’s 

unofficial diamond sales (UNSC 1998 resolutions 1173 and 1176), could not deter Savimbi from 

continuing the war. Savi mbi continued its diamonds’ trade in spit e of the em bargo because he 

mainly traded with com panies it trusted and w ith whom it had long-standing business relati ons. 

Thus, the tra de of em bargoed diamonds continued both by air an d trough neighboring countries 

such as Zambia, Congo, and Congo-Brazaville, providing UNITA with enough funds to keep the 

war going. In paragraph 141 of its report S/200 1/966 concerni ng the situation in Angola , th e 

UNSC mentioned that the CEO of th e Angola Selling Corpora tion attested that between $1 

million and 1.2 million of embargoed diamonds leave Angola each day , that is, an equivalent o f 

$350 million to $420 million a year. 

After the death of Savim bi, the remaining members of UNITA decided on April 5, 200 2, to sign 

the Luena Mem orandum of Understanding (MOU) with the Govern ment of Angola. The MOU 

signified the end of the 27 years of civil wa r and t he reco mmitment of UNITA to the pe ace 

framework spelled out in t he 1994 Lusaka Protocol. In September 2002, after the demobilization 

of all UNITA military personnel, the Angolan government an d UNITA agreed, under a UNsponsored 

Joint Comm ission, t o resol ve all outstanding pol itical issues under the Lus aka 

Protocol. All outstanding political issues were decl ared resolved and the Lusaka Protocol full y 

implemented on November 21, 2002. 

CONGO’S WAR FINANCING AND PEACE AGREEMENTS 

Congo’s civil war of the post-Mobutu e ra, which broke out in 1998 and ende d in 2 002, had a 

horrific humanitarian effect while at the same time destroying most of the economic and political 

institutions i n the countr y. It was esti mated that, as of Septem ber 2002, the number of excess 

deaths in the five eastern provinces of the Congo al one was between 3 and 3.5 m illion people 

(UN OCHA and IRIN, November 2002). Like in A ngola, the civ il war in Congo, was fueled b y 

revenues from the illicit trade of diamonds and other minerals such as gold and coltan. In fact, the 

war in Congo, which allegedly started because of the insecurity in its border with Rwanda and 

Uganda, evolved into a fi ght over the control of natural resources. Diam onds trade became the 

main source of revenues for the purchase of weapons by different rebel factions that fought 

against the legitimate government of Congo. T he strategic control of the di amond-producing 



areas in Congo becam e one of the key driving for ces in the confl ict and was critical to a lasting 

negotiated peace settlement. 

The war for the control of mineral-rich areas in Congo was mainly fought on two fronts: (1) the 

fight between the government forces with its a llies (Zimbabwe, Angola, and Namibia. Namibia, 

however, pooled its troops out of Congo in 2000) and the rebels with their Ugandan and Rwandan 

allies; and (2) the fight between the two rebe l m ovements, the RCD-Go ma with its Rwandan 

allies and the RCD-ML with its Ugandan allies. For instance, RCD-Goma and RCD-ML initiated 

attacks against each other positions in eastern C ongo in order to conquer additi onal mineral-rich 

areas, as the need for additional funding for the purchase of weapons became eminent. From 1998 

to 2000, the UNSC believ ed that Congo desk, r un by Rwanda in eastern Congo during the war, 

received about $4 m illion monthly as direct payment from diamond mining licenses in the areas 

under its control, that is, an average of $200,000 per month per diam ond comptoir. In additi on, 

there was a mandatory 5 per cent tax paid to the Congo desk by ever y dia mond dealer who 

wanted to purchase diam onds in t he eastern Congo. Rwanda pocketed all these revenues until 

after July 2000 when the RCD-Go ma decided to claim its share and began to receive 50 percent 

of the take (UNSC 12 April 2001 report, & 127 and 128). Such revenues were substantial enough 

for RCD-Goma and its Rwandan ally to sustain the war and their control of eastern Congo. 

Beside the fee and tax on diamonds received by Rwanda, the latter was also selling some of the 

diamonds mined in Congo as part of its exports to sustain its war effort in eastern Congo. Data 

from several organizations such as the World Trade Organization, the Hoge Raad voor 

Diamant (HRD) also called Diamond High Council and the Belgian statistics, consistently 

showed that Rwanda, which does not produce diamonds, had been exporting diamonds since 

1996, when it was granted mineral concessions by the late President Laurent Kabila of Congo. 

Data from HRD showed that the exploitation of Congolese diamonds by Rwanda expanded after 

its 1998 occupation of the southeastern Congo. Indeed, Rwanda exported about 13,060.39 carats 

of rough diamonds in 1997, 166.07 carats in 1998, 2500.83 carats in 1999, and 30,491.22 carats 

in 2000. These diamonds were valued at US$720,425 in 1997, US$16,606 in 1998, US$439,347 

in 1999, and US$1,788,036 (UNSC 12 April 2001 report, & 104 and Table 5). Nevertheless, 

diamond was not the only mineral that provided Rwanda with the means to fight the war in 

Congo. Indeed, according the UNSC, between late 1999 and late 2000, Rwandan army through 

Rwanda Metals was exporting at least 100 tons of Congo’s coltan per month at an average price 

of US$200 a kilo. The UNSC panel estimated that Rwandan army made at least US$250 million 

over a period of 18 months (UNSC 12 April 2001 report, & 130). This is a large amount of 

money enough by itself to finance the war. 

Unlike Rwanda, Uganda funded its presence in Congo m ainly t hrough t he re-exportation 

economy, that is, the repackaging and exporting of natural resources extracted from Congo as 

Ugandan natural resources. According to the UNSC, the re-exportation econo my played a great 

role in im proving Uganda’ s GDP and in fina ncing its war in Congo by increasing Ugandan 

defense budget. While the official Ugandan exports statistics did not clearly reflect the extent of 

the re-export ation economy, data colle cted b y countries that imported diam onds from Ugand a 

were very com pelling. For instance, data fro m HRD in Belgium shows that Uganda, which 

produces no diam onds, had been exporting a la rge quantit y of rough dia monds since its 

occupation of the eastern Congo in 1998. According to HRD, Uganda exported 1,511.34 carats of 

rough diamonds in 1997, 11,303.86 carats in 1998, 11,024.46 carats in 1999, and 9,387.51 carats 

in 2000. These exports t ranslated into US$1, 440,000 in 1998, US$1,81 3,500 in 1999, and 

US$1,263,385 in 2000 (UNSC 12 April 2001 report, & 98 and Table 2). 


Koyame-Marsh 

Given the fact that foreign troops played a major role in Congo’s civil war, their withdrawal from 

Congo’s territory was capital to a successful cease-fire and the rebuilding of Congo’s institutions. 

In July 1999, a peac e agr eement that asked for the withdrawal of all foreign forces fro m the 

national territor y of Co ngo was signed in Lusak a. However, the parties to the Lusaka Pe ace 

accord failed to act according to its m andate. After the failure of the Lusaka Peace accord, new 

negotiation amongst the fighting forces in Congo were undertaken with the help of Sout h Africa. 

Thus, on 30 July 2002, Rwandan President, Paul Kagame, and Congolese President, Joseph 

Kabila, signed a peace agreement in Pretoria on t he withdrawal of Rwandan troops from the 

territory of Congo and the dismantling of the ex -Far (Rwandan Armed Forces) and Interahamwe 

forces (Rwanda Hutu Militia) in Congo. 

However, in order to secure the success of the Pretoria peace accord, the UN and South Africa; in 

a joint communiqué released in August 9, 2002; announced the setting up of a joint secretariat to 

implement the July peace agreement between the Congo and Rwanda. The UN and South Africa 

worked closely to gether to supervise and up hold the implementation of the co mmitments made 

by bot h parties. Like Rwanda, Uganda and other countries inv olved in Con go’s conflict also 

needed to pul l their troo ps out of Congo. Hence, on 6 September 2002, after more negotiati ons, 

Presidents Joseph Kabila of Congo and Yoweri Museveni of Uganda signed a peace ac cord in 

Luanda, Angola, for the t otal withdrawal of Ugandan troops fr om eastern Congo. Under the 

accord, the government of Angola agreed to supervise its implementation, while the governments 

of Kabila an d Museveni agreed to res pectively submit regular r eports on the progress of the 

Ugandan retraction. The UN also called on other African countries involved in Congo’s conflict, 

countries such as Angola and Zim babwe, which deployed troops in Congo i n 1998 in support of 

the late Laurent Kabila, to discuss the prac tical im plementation of the 1999 Lusaka peace 

agreement and to withdraw their troops from Congo’s territory. 

Finally, Congolese rebel gr oups and the government of Congo had to agree on possible ways of 

rebuilding C ongo’s economic and poli tical institu tions if a lasti ng peace was to be achie ved. 

Thus, after difficult negoti ations in Pretoria, Sout h Africa, the Glo bal and Inclusive Agree ment, 

whose implementation led to the formation of th e Government of National Un ity in Congo was 

signed on 1 7 Decem ber 2002 between the rebe l gr oups and the governm ent of Co ngo. The 

Government of National Unity was, however, in augurated on June 30, 20 03. The latter worked 

well into achieving the reunification of the Con go because it included all the key players of the 

different rebel grou ps. The inclusion of rebel leaders in the Gover nment of National Unit y was 

the only way to guaranty the respect of the agreement and the non-return to violence in Congo. In 

fact, despite some sporadi c fights in the east ern Congo, the Governm ent o f National Unit y 

succeeded in reunif y Congo and in consolid ating t he peace process. Congo had a successful 

presidential election in summer of 2006. 

SIERRA LEONE’S WAR FINANCING AND PEACE AGREEMENTS 

The decade long civil war in Sierra Leone caused about 75,000 deaths, forced half million people 

to become refugees, and displaced about 2 million people (Smillie et all 2000). The war began in 

1991 when t he Revolutio nary United Front (RUF), a small group of m en lead b y a f ormercorporal 

named Foday Sankoh, started attacking v illages in eastern Sierra Leone on the Liberian 

Border. After few months of fighting, the RUF gained control of the diamond mines in the Kono 

district. With the control of the diamond mines, the RUF became financially powerful and able to 

continue the war against the governm ent of Sierra Leone. RUF used revenues from the sales of 

high-value gem diamonds to equip itself with hi gh-power weapons. During the war, RUF raised 

an estimated US$25 m illion to US$125 m illion per y ear fro m the sale of diamonds, with a 

reported high of $200 m illion (Amnesty International 2002). Funds fro m the sales of diam onds 



also made it possible for RUF to restock its m unitions and to maintain a co mplex m ilitary 

operation in the region that kept the conflict going and led to a total destabilization of the country. 

RUF rebels sold their diamonds mainly via Liberia and Ivory Coast. Liberia, which was known as 

a main crim inal warehouse for diam onds, gu ns, money launderi ng, terror an d other f orms of 

organized crimes, had diam ond-export levels that surpassed its di amond production capability at 

the tim e. Annual Liberian diam ond mining cap acity was between 100 thousands and 15 0 

thousand carats at the ti me, however the HRD recorded over 31 m illion carats of Liberian 

diamond im ports into Bel gium between 19 94 and 1998. This w as an averag e of m ore th an 6 

million carats a y ear (Smillie et all, 2000). It was believed that many of the so-called ‘Liberian 

diamonds were of Sierra Leone or igin, and others were allegedly being originated from as far as 

Angola. In view of the role played by Liberia in the illicit trade of Sierra Leone diamonds, the UN 

decided on 7 March 2001 , throu gh i ts resolution 1 343, t o im pose a full em bargo on Liberian 

diamonds. Like Liberian diamonds, most of Ivory Coast diamonds were known to have originated 

from Sierra Leone and th e revenues used by RU F to fund the war. Ivory C oast is not a big 

producer of diamonds. However, according the HRD record, Ivory Coast, seemingly, exported an 

average of more than 1.5 million carats of diamonds to Belgium between 1995 and 1997 (Smillie 

et all, 2000). This was a clear sign that Diamonds originated in other countries, especially Sierra 

Leone, were exported by Ivory Coast. 

In 1999, with the assistance of the inte rnational community, President Kabbah of Sierra Leone 

and RUF leader Sankoh negotiated th e Lo me Peace Agreement, which was signed on Ju ly 7 , 

1999. However, in 2000, RUF decided to avoi d meeting its obli gations under the Lom e P eace 

Agreement by refusing to disarm and to demobilize. In May 2000, the agreement collapsed when 

RUF rebels capture 500 UN peacekeepers in the re gion, seizing their arms and ammunition. As a 

result Sankoh and other senior members of the RUF were arrested. After the events of May 2000, 

a new cease-fire agreement was de emed necessary in order to revive the peac e process. A new 

peace agreement was signed in Abuja in Novem ber of 2001 and on January 18, 2002, President 

Kabbah decl ared the civil war official ly over . The Abuja c ease-fire agre ement’s success was 

facilitated by the closed up of rebels’ diamonds trade by UNSC sanctions on L iberian diamonds 

and the estab lishment of t he Ki mberley Process cer tificate of ori gin schem e t hat distinguis hed 

official Sierra Leone diam onds from the illicit one s. To show their willingness to abide by the 

Abuja cease-fire agreement, the government of Si erra Leone and RUF decided to m eet again in 

Abuja on 2 May 2002 to discuss further the cease-fi re protocols. The Abuja Cease-fire Accord 

resulted in a large-scal e disar mament and dem obilization of R UF, which caused a significant 

reduction in hostilities. 

ANGOLA’S POST-WAR SOCIO-ECONOMIC CONDITIONS 

The post-war socio-economic data for all the three countries are presented in Box 2. 

Angola is working hard to rebuild t he infrastructures destroyed by the 27- year civil war. Risin g 

petroleum production and record oil prices are ke y contributors to the rebuilding of Angola’ s 

economy. Oil production supported 12% growth in GDP in 2004, 19% in 2005, and 14% in 2006 

(CIA 2007). This post-war reconstruction boom was not limited to petroleum production only but 

was extended to other sect ors of the econom y as we ll, sectors such as agricu lture and service as 

shown in Box 2. In addition, Angola is experiencing higher growth with a per capita GDP growth 

rate of 17.2% in 2005 compared with 3.4% in the 80s and 0.4% in the 90s. However, Angola still 

has a long way to go. Indeed, much of its infrastructure is still damaged or undeveloped due to the 

war. Even though, Angola has experience a 17% growth in agriculture in 2005, almost half of its 

food still has to be im ported. Most people in Angola still depend on subsis tence agriculture for 

their livelihood. In addition, widespread landmines in the countryside do not make things any 


Koyame-Marsh 

Box 2. Selected Socio-Economic Indicators (Post-War) 

Angola Congo Sierra Leone 

Population in millions (2006) 16.4 59.3 5.6 

Inflation Rate-Implicit GDP Deflator (2005) 34.1% 21.6% 13.1% 

Inflation Rate-Implicit GDP Deflator (2006) 14.7% 13.1% 13.4% 

GDP per Capita (PPP US$, 2004) $2,180 $705 $561 

GDP per Capita Growth Rate (2005) 17.2% 3.3% 3.8% 

GDP per Capita Growth Rate (2006) 15.3% 1.9% 4.9% 

Agriculture Growth Rate (1996-2006) 11.1% -1.5% NA% 

Agriculture Growth Rate (2005) 17.0% 2.9% NA% 

Industry Growth Rate (1996-2006) 9.2% 4.1% NA% 

Industry Growth Rate (2005) 23.4% 8.9% NA% 

Services Growth Rate (1996-2006) 2.9% -0.1% NA% 

Services Growth Rate (2005) 14.3% 9.0% NA% 

Poverty-Percent of Population below NA% NA% 70% 

National poverty line (2000-06) 

Life Expectancy at Birth (Years, 2004) 41.0 43.5 41 

Adult Literacy Rate (2004) 67.4 67.2 35.1% 

Human Development Index (2004) 0.439 0.391 0.335 

Human Development Index Rank 161 167 176 

(Out of 177 Countries, 2004) 

Corruption perception index (2006) 2.2 2.0 2.2 

Sources: United Nations Development Programme 2006, World Bank: Angola at a glance 2006, World Bank: Congo at 

a glance 2006, World Bank: Sierra Leone at a glance 2006, Transparency International 2006 

easier when i t comes to agriculture. Nonetheless, the recovery in inflation rates which decreased 

from about 5,399. 5% in 1996 to about 14.7% in 2006 shows that Angola is o n the right track. 

This trem endous decline in inflation rate w as mainly t he result of a 200 3 exchange rate 

stabilization program im plemented by Angola’s cen tral bank that became more sustainable in 

2005 due to strong oil export earnings. 

Unfortunately, after 3 years of peace, Angola is still one of the poorest countries in the world. 

Indeed, had only a slight increase in its per capita real GDP, which rose from US$2,040 in 2001 

to US$2,180 in 2004. In addition, Angola ranked 161 in human development index out of 177 

countries, a slight improvement from the rank of 164 out of 175 countries in 2001. Life 

expectancy at birth, which was 41 years in 2004 did not show much improvement from its 2001 

value mostly due to AIDS related deaths. Adult literacy rate has improved from 42% in 2001 to 

67.4 % in 2004. There is still widespread corruption in Angola that continues to hinder economic 

development and poverty reduction. Indeed, according to Transparency International, Angola has 

a higher level of corruption, with a corruption perception index of 2.2 in 2006. A corruption 

perception index (CPI) ranks from zero to ten. A CPI of ten means that a country has perfect 

institutions and zero means a country has highly corrupt institutions. Angola, thus, still needs to 

reform its institutions through greater transparency in government spending and serious fight 

against corruption. It’s only then that Angola will take full advantage of its vast natural resource 



endowment and use the generated revenues to fund education and rebuild infrastructures 

necessary for economic development. 

CONGO’S POST-WAR SOCIO-ECONOMIC CONDITIONS 

Congo is also rebuilding its infrastructures after the five-year war despite some continuing 

sporadic tensions in the east part of the country. The conflict severely reduced the level of 

national economy and the level of government revenues. However, since the end of the war in 

2002, the economy of Congo is slowly improving. Even though most of the economic activities 

still occur in the informal sector, thus not counted in the official measurement of GDP, Congo’s 

per capita GDP, which had a negative growth of 5.1% in the 90s, had a positive growth of 3.3% 

in 2005 and of 1.9% in 2006. Congo’s GDP per capita increased from US$680 in 2001 to 

US$705 in 2004. The industry and service sectors that had negative growth in the 1990s now are 

experiencing positive growth due to the political stability and government reforms introduced by 

president Kabila. Mining activities, main source of export revenues before the war, have been 

reactivated, providing the government with much needed revenue for the rebuilding of 

infrastructures. 

However, despite positive post-war economic growth, Congo is s till one of the poorest countries 

in the world. Indeed, Con go ranked 1 67 in hum an developm ent index out of 177 cou ntries in 

2004, same rank as in 2001 out of 175 countries. Adult literacy rate has improved from 62.7% in 

2001 to 67.2 % in 2004. Congo ’s slow economic growth, 1.9% per capita GDP growth rate in 

2006 for example, also stem from uncertain legal framework that keeps foreign businesses at bay, 

widespread corruption, and lack of transp arency in government policy. Accordin g to 

Transparency International, Congo had higher level of corruption with a 2.0 corruption perception 

index in 2006. Thus, government refo rm to curt ail corruption and im proved infrastructures are 

necessary for a strong econom ic growth and a better standard of living for the people of Congo. 

Indeed, the 2004 increase in life expectancy at birth from 40.6 years in 2001 to 43.5 years in 

2004, is exp ected to be even higher i n the fu ture as long as Congo co ntinues in the path of 

improved security and rebuilding of infrastructures. 

SIERRA LEONE’S POST-WAR SOCIO-ECONOMIC CONDITIONS 

The end of the Sierra Leone civil war and the r ecovery of its diamond industry led to a moderate 

improvement in t he soc io-economic conditi ons in post-war Sierra Leone. In deed, after 

experiencing negative per capita GDP growth rate during the war, Sierra Leone had a positive per 

capita growth rate of 4.9% in 2006, a rise fro m a 3.8% growth in 2005. Sierra Leone per capita 

real GDP also rose from US$470 in 2001 to US$561 in 2004. This sustained economic growth is 

mostly due t o alluvial di amond mining activities, which accou nt for m ost of Sierra Leone’ s 

export revenues. The industry and service sectors that had negativ e growth in t he 1990s are also 

experiencing positive growth after the war. Life expectancy at birth has also i mproved from 34.5 

years in 2001 to 41 years in 2004. 

However, Sierra Leone still has undeveloped economic and social infrastructures that continue to 

hamper economic and social development. Indeed , Sierra Leone still rem ains one of t he poorest 

countries in the world despite sustained econom ic growth over th e 3 y ears following the end of 

the war. Sierra Leone ranked 176 in human development index o ut of 17 7 countries in 200 4, an 

improvement from ranking last out of 175 countries in 2001. In addition, continued serious social 

disorders in t he countr y might have contributed to the deterior ation in the l evel of educ ation 

causing adult literacy rate to fall fro m 36% in 2001 to 35.1% in 2004. Sierra Leone is also 

affected by widespread corruption show n by a corruption perception index of 2 .2 in 2006. Thus, 

like Angola and Congo, Sierra Leone must, in addition to political stability, reform its institutions 

to curtail corruption if it wants to achieve greater economic growth and poverty reduction. 


Koyame-Marsh 

CONCLUSION 

The paper analy ses the pre-war and postwar econom ic conditions in Angol a, Congo, and Sierra 

Leone and the role play ed by natural resour ces in their respect ive conflict. These three sub- 

Saharan Afri can countries are rich i n natura l resources endowm ent with mineral such as 

diamonds, petroleum , gold, bauxite, r utile, coltan and m ore. However, in spite of their rich 

natural resources endowment, these countries’ pre-war economic conditions were charact erized, 

among other things, by low level of per capita GDP, higher level of poverty, inequalit y in the 

distribution of income, higher inflation rate, disproportionately large agricu lture sector, and 

widespread corruption of government i nstitutions. T hese long-term poor econom ic conditions 

were considered to be amongst the factors that caused rebellion and conflicts in these countries. 

The paper also shows that the civil w ars led to more suffering for the people of these three 

countries by worsening t he already degenerate d prewar socio-econom ic co nditions. Indeed, 

during the war, Congo an d Sierra Leone had, among ot her thin gs, negative per capita GDP 

growth rates while Angola’s per capita GDP had almost zero growth. In the 3 years of peace after 

the war; Congo, Ang ola, and Sierra Leo ne have focu sed on rebuil ding their infrastructures. This 

led to the growth in per capita GDP and great improvement in the industry and service sectors of 

these countries. However, they still ha ve a long wa y t o go. Indeed, they are still so me of the 

poorest coun tries in the world when it comes to their hum an developm ent indexes. Their 

agriculture sectors are recovering but a t a very slow rate. These countries also need to reform 

their institutions through greater transparency in government spending and serious fight against 

corruption so that government revenues can be spent efficiently for the benefit of all. 

Moreover, this paper dem onstrates that economic and financial power held by rebel groups fro m 

the control of minerals and their trade led to th e failure of several signed peace agreements. Even 

UNSC sanctions against the illicit trade in diam onds by rebel gr oups in these countries were, at 

time, not suc cessful in curbing the war because of the lack of r espect for these sanctions by the 

international community. Indeed, rebel groups i n these countries were doing all the y can to hold 

on to their economic power regardless of the UNCS san ctions. This was difficult but not 

impossible to do as we dem onstrated in this pape r. Thus, given the failure of UNSC sanctions in 

curbing the war other determinants of war had to be factored into cease-fire agreements if peace 

was to be achieved. Thus, if it is true that long-term poor economic conditions were am ong the 

factors that l ed to these c onflicts, a su ccessful peace a ccord had to put the m at the cente r of 

negotiations. An im portant polic y im plication of this study is tha t, for any conflict resolution 

agreement to be succes sful in civil w ars, econo mic issues r elated to the conflicts have to be 

addressed. It’s only then that a lasting peace could possibly be achieved. 

Finally, the sim ple coincidence that th e war in An gola, Congo, and Sierra Leone all en ded in 

2002 should not be overlooked. Indeed, we believe that UNSC sanctions against the illicit trade in 

diamonds and the establish ment of the certificat e of origin for diam onds by t he Kim berley 

Process worked together to force the end of conflicts in these countries, especially in Congo and 

Sierra Leone. Indeed, as previously mentioned UNSC sanctions alone were not very successful at 

curbing the illicit trade in diamonds. However, when UNSC sanctions were eventually combined 

with the certificate of orig in for diam onds, trade in blood d iamonds became even harder if not 

impossible to do. This created financial problem s for rebel groups and made it difficult for them 

to continue the war. How ever, it is worth m entioning that m any other natural resources such as 

petroleum, c oltan, and gold, were at the hear t of these conflicts in addition to diam onds, 

providing revenues to the rebel groups for the r estocking of weapons. However, diam onds were 

the main source of revenues for rebel groups in t hese conflicts b ecause of their higher m arket 

value. Thus, funds from the sales of diam onds c ontributed exten sively t o the fueling and the 

continuing of conflicts in these countries and made any progress towards peace very difficult. 


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Koyame-Marsh 

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A STUDY OF THE RELATIONSHIP BETWEEN 

STRATEGIC COST STRUCTURE CHOICE AND 

STOCK RETURN BEHAVIOR IN THE 

TRANSPORTATION INDUSTRY: PRELIMINARY 

RESULTS 

MacArthur, John B. 

University of North Florida 

jmacarth@unf.edu 

Houmes, Robert E. 

Jacksonville University 

rhoumes@ju.edu 

Stranahan, Harriet A. 

University of North Florida 

hstranaha@unf.edu 

ABSTRACT: MacArthur (2006) compared the risk-return performance of two successful 

companies in the transportation sector, J.B. Hunt Transport Services, Inc. (Hunt) and Landstar 

System, Inc. (Landstar) that made different strategic cost structure choices. The analysis 

presented in MacArthur (2006) showed expected higher returns for Hunt but at the cost of higher 

operating income volatility (risk), as compared to Landstar. MacArthur (2006) is extended in our 

study which investigates the impact of different strategic cost structure choices (degree of 

operating leverage) on variability of stock returns (beta) using a sample of trucking companies. 

The initial results suggest a positive relationship between the degree of operating leverage and a 

firm’s beta. 

INTRODUCTION 

MacArthur (2006) compared the risk-return performance of two successful companies in the 

transportation sector, J.B. Hunt Transport Services, Inc. (Hunt) and Landstar System, Inc. 

(Landstar) that made different strategic cost structure choices. Landstar owns no tractors and a 

relatively small number of trailers, conducting its operations with a high variable cost, low fixed 

cost structure. Landstar’s strategy is to use independent contractors and other third party capacity 

providers in its carrier segment. In contrast, Hunt predominantly uses company owned tractors 

driven by employees, which results in a higher fixed operating cost structure. 

MacArthur (2006) compared Hunt and Landstar over 1996-2004 to explore the risk-return tradeoff 

from different cost structures. The analysis showed expected higher returns (operating margin 

percentage) for Hunt but also higher operating income volatility (risk), as compared to Landstar. 

The implications of cost structure choice on cost management systems preferences are also 

considered in this article. Our article extends MacArthur (2006) using a limited sample of 

trucking companies to better understand the impact of cost structure choice on stock return 


MacArthur, Houmes and Stranahan 

volatility. This may help inform transportation company managers concerned with the impact 

their strategic cost structure decisions have on stockholders’ returns and returns volatility. 

The trucking portion of the transportation sector is an excellent choice for examining the riskreturn 

implications of different cost structures because top managers have a high degree of 

discretion in selecting the proportion of fixed and variable costs, as evidenced by Hunt and 

Landstar. This is not true of other industries and even other parts of the transportation sector. For 

example, it would be inconceivable for the airline industry to be able to hire independent 

contractor pilots who own their own aircraft in a similar fashion to the trucking industry hiring 

independent truck and tractor owners, in order for airline companies to reduce their “huge 

operating leverage” (Lee and Jang, 2007). Railroad companies are in a similar position with no 

alternative to owning their own equipment. The hotel industry is a non-transportation sector 

example where fixed costs are unavoidably “huge” (Nicolau 2005). 

EXTENSION OF MACARTHUR (2006) 

A logical extension of MacArthur (2006) is to investigate the impact of profit volatility resulting 

from different cost structures on stock return variability. A cursory comparison of the beta of 

Hunt’s (0.864) and Landstar’s (0.566) stock returns over the same time period (1996-2004) as in 

MacArthur (2006), indicates the expected result of higher stock return volatility for Hunt in 

comparison with Landstar. 1 This suggests that Hunt’s cost structure preferences are associated 

with higher profit variability but also a higher beta. This preliminary study investigates whether 

this relationship holds true for not just these two firms, but also for a small sample of trucking 

companies. 

HYPOTHESIS DEVELOPMENT 

Gahlon and Gentry (1982) reviewed the extant conceptual and empirical literature on security 

systematic risk determinants. In addition, the authors presented a conceptual model that explicitly 

incorporated the degree of operating leverage (DOL) and the degree of financial leverage (DFL) 

as important variables in determining the systematic risk—beta (β)—of securities. Along the 

same lines, Mandelker and Rhee (1984) found that DOL and DFL explained a high proportion of 

beta variation in their statistical analysis of 255 manufacturing firms during 1957-1976. 

Hung and Liu (2005) used a Tobit regression to explore factors expected to explain beta values 

for Taiwan’s two listed airlines over the 1993-2004 time-periods. The results from the statistical 

tests were largely consistent with expectations of a positive and mostly significant relationship 

between the changing betas and explanatory variables, which included the business cycle, DOL, 

DFL, and capital structure (debt/equity). Not surprisingly, airplane crashes experienced by one of 

the airlines appeared to affect beta values, too. 

Within the context of the literature, we use a similar methodology to explore the relationship 

between the firm’s beta and their strategic cost structure choices. We expect that transportation 

firms with higher operating leverage are likely to have higher betas, all else equal. 

PRELIMINARY TESTS AND RESULTS 

Using Compustat’s Research Files of North American firms with 4-digit SIC code 4213 

(Trucking, except local) we use a sample of variables from the period 2001 to 2006. Forty one 

companies were used in the tests that resulted in 121 firm year observations. In these initial tests, 

OLS was utilized to examine and measure the contemporaneous association between cost 


Transportation Industry…Cost Structure, Stock Return 

structures, other control variables shown to be important in previous studies and returns 

variability measured by the firm’s beta. The variables and model are as follows. 

Control Variables 

Including controls allows their effects to be separately estimated from the effects of other 

independent variables and reduces the likelihood that they may be surrogates for alternative 

determinants of the dependent variable. The following control variables are included in this study. 

lnMVEit: Fama and French (1993) showed that smaller capitalization stocks outperform large 

capitalization stocks. Keim (1983) earlier showed, however, that most of the negative relationship 

between market value of equity and abnormal returns occurs in January. Although the 

relationship is slightly negative over the following eleven months the relationship is unstable, 

with even a few months in the 1963-1979 research period displaying significant positive 

relationships. We control for size by including the firm’s end of fiscal year market value of 

equity. We measure this variable as number of common shares outstanding multiplied by price 

per share. Since inconsistent variances violate the OLS constant variance assumption, we attempt 

to mitigate this outcome by using the log of market value of equity, i.e., lnMVEit. 

LEVit: As mentioned above financial leverage has been shown to be correlated with beta. We 

include financial leverage and measure this variable as each firm’s end of fiscal year total longterm 

debt scaled by its end of fiscal year total assets. 

TURNit: Denis and Kadlec (1994) showed that beta estimates are significantly related to changes 

in trading activity. Cremers and Mei (2007) assert that share turnover and systematic risk are 

related. To assess the impact of share turnover on returns variance for the firms of our study, 

TURNit, defined as the average daily share volume divided by the average shares outstanding, is 

included in the regression. 

lnSHOLDit: Using a CAPM framework, Amihud and Mendelson (1989) provide evidence that 

asset returns increase with their illiquidity as measured by the bid-ask spread. O’Hara (2003) 

argues that liquidity is priced by the market. Chordia, et al. (2001) showed a statistically 

significantly negative relationship between stock returns and variability of liquidity. Since shares 

which are thinly held may be subject to larger bid-ask price spreads and hence reduced liquidity, 

we control for this potential effect by including the log of the number of total common 

shareholders for each firm, at end of fiscal year t. 

MBit: Fama and French (1993) showed that beta and book-to-market are positively correlated and 

included this ratio in their model. We add market-to-book ratio to our model and measure this 

variable as the firm’s end of fiscal year market value divided by its end of fiscal year book value. 

YEAR: Campbell and Hentschel (1992) provide evidence that expected returns and stock return 

volatility change over time. Year dummy variables are used to control for temporal variation of 

betas across the years of this study. 

Variables of Interest 

BETAit: Month-end closing prices are used to measure the sensitivity of a firm’s stock price to 

changes in the S&P 500 index. Using monthly returns, beta is calculated for a five year time 

period. If less than five years of data is available then beta is calculated for as few as 24 months. 



OLit: Two alternative measures are used as proxies for operating leverage: the ratio of changes in 

operating income to changes in sales and the ratio of fixed asset to total stockholders equity. 

Model 

Ordinary Least Squares is used to estimate the following model. 

BETAit = α0 + α1 lnMVEit + α2LEVit + α3TURNit + α4lnSHOLDit + α5MBit + α6YEAR + α7OLit + εit 

Results 

The results are shown in Table 1 except for the year dummies. 

TABLE 1: BETA REGRESSED ON CONTROL VARIABLES AND TWO 

ALTERNATIVE OPERATING LEVERAGE PROXY VARIABLES 

N = 121 Proxy Variables Used to Measure Degree of Operating 

Leverage 

Independent 

variable 

Regression #1 

Fixed assets to total 

stockholders equity 

Regression #2 

∆ operating income / 

∆ sales 

constant .185 .235 

(.680) (.605) 

lnMVEit .044 .067 

(.260) (.075) 

LEVit -.166 -.191 

(.605) (.559) 

TURNit -.629 -1.582 

(.969) (.922) 

lnSHOLDit .030 .022 

(.336) (.487) 

MBit .022 -.001 

OLit 

(.118) (.934) 

.014 

(.019) 

Adjusted R 2 

.071 

F 

1.769 

p-values are in parentheses. p-values for OL are one tailed. 

.020 

(.044) 

.060 

1.924 

Only a few of the variables are significant in these preliminary regression results. The coefficient 

of the size variable, lnMVE, is positive in both regressions but only in Regression #2 is there 

evidence of a positive relationship at the

Transportation Industry…Cost Structure, Stock Return 

suggest the need for additional transportation industry data and further study of our methodology 

in order to more confidently access the relationship of these variables and beta. 

Interestingly, the coefficient on operating leverage (OL) is positive and significant at the < 5 % 

level (one tailed) in both regressions. This suggests that transportation firms with a higher degree 

of operating leverage are likely to have higher betas. This is an encouraging result, given our 

limited data set, and supports further exploration of the relationship between beta and operating 

leverage in the transportation industry. 

CONCLUSIONS AND FUTURE RESEARCH 

The preliminary operating leverage results are in line with the hypothesis that firms choosing 

higher operating leverage may also have higher betas. However, the regression results with regard 

to other theoretically important determinants of beta (our control variables) leave us with more 

questions than answers. In order to better frame this study within the current literature, we are 

currently gathering data to fill in missing years and adding transportation firms to the data set. To 

gather these data we are perusing firms’ annual reports, utilizing other publicly available data 

sources as well as using an updated Compustat data source. Our hope is that a more complete 

data set will provide a more accurate assessment of the relationship between beta and a strategy 

of cost management that favors higher operating leverage for firms in the transportation industry. 

REFERENCES 

Amihud, Yakov and Haim Mendelson (1989). “The Effects of Beta, Bid-Ask Spread, Residual 

Risk, and Size on Stock Returns.” The Journal of Finance, Volume 44, Number 2, 479-486. 

Campbell, John Y. and Ludger Hentschel (1992). “No News Is Good News: An Asymmetric 

Model Of Changing Volatility In Stock Returns.” Journal of Financial Economics, Volume 31, 

Number 3, 281-318. 

Chordia, Tarun, Avanidhar Subrahmanyam, and V. Ravi Anshuman (2001). “Trading Activity 

and Expected Stock Returns.” Journal of Financial Economics, Volume 59, Number 1, 3-32. 

Cremers, K. J. Martijn and Jianping Mei (2007). “Turning Over Turnover.” The Review of 

Financial Studies, Volume 20, Number 6, 1749-1782. 

Denis, David J. and Gregory B. Kadlec (1994). “Corporate Events, Trading Activity, and the 

Estimation of Systematic Risk: Evidence From Equity Offerings and Share Repurchases.” The 

Journal of Finance, Volume 49, Number 5, 1787-1811. 

Fama, Eugene F. and Kenneth R. French (1993). “Common Risk Factors in the Returns on Stocks 

and Bonds.” Journal of Financial Economics, Volume 33, Number 1, 3-56. 

Gahlon, James M. and James A. Gentry (1982). “On the Relationship Between Systematic Risk 

and the Degree of Operating Leverage and Financial Leverage.” Financial Management, Volume 

11, Number 2 (Summer), 15-23. 

Hung, Jung-Hua and Yong-Chin Liu (2005). “An Examination of Factors Influencing Airline 

Beta Values.” Journal of Air Transport Management, Volume 11, 291-296. 



Keim, Donald B. (1983). “Size-Related Anomalies and Stock Return Seasonality: Further 

Empirical Evidence.” Journal of Financial Economics, Volume 12, Number 1, 13-32. 

Lee, Jin-Soo and SooCheng (Shawn) Jang (2007). “The Systematic-Risk Determinants of the US 

Airline Industry.” Tourism Management, Volume 28, 434-442. 

MacArthur, John B. (2006). “Strategic Cost Structure Choice in Service Organizations: The Case 

of the Transportation Industry.” International Journal of Strategic Cost Management (Spring), 

26-36. 

Mandelker, Gershon N. and S. Ghon Rhee (1984). “The Impact of the Degrees of Operating and 

Financial Leverage on Systematic Risk.” Journal of Financial and Quantitative Analysis, Volume 

19, Number 1, 45-57. 

Nicolau, Juann L. (2005). “Leveraging Profit from the Fixed-Variable Ratio: The Case of New 

Hotels in Spain.” Tourism Management, Volume 26, 105-111. 

O’Hara, Maureen (2003). “Presidential Address: Liquidity and Price Discovery.” The Journal of 

Finance, Volume 58, Number 4, 1335-1354. 

1 

The betas were based on daily returns over 1996-2004 with the S&P 500 Index representing the 

market. 

Acknowledgements: The authors thank Dr. Reinhold Lamb and Dr. Bobby E. Waldrup, 

University of North Florida, for their help with the article. 


TEACHING NOTES: EXPERIENCES 

IN ONLINE TEACHING 

Lavin, David 

Florida International University, Retired 

lavin@fiu.edu 

ABSTRACT 

Last year at Florida International University (FIU), I created and taught an Online Intermediate 

Accounting class. After over 30 years of teaching, I felt that an Online approach could not 

possibly accomplish what a traditional live face-to-face class can do. The problem was that I 

was thinking inside the box and not willing to do things differently. An Online course has its 

advantages and disadvantages. This paper will explore what I did to create and teach the course 

and present these advantages and disadvantages of an Online accounting course. 

INTRODUCTION 

Last year I created and taught an Online Intermediate Accounting class. After over 30 years of 

teaching, I felt that an Online approach could not possibly accomplish what a traditional live face- 

to-face class can do. The problem was that I was thinking inside the box and not willing to do 

things differently. An Online course has its advantages and disadvantages. This paper will 

explore what I did to create and teach the course and present these advantages and disadvantages 

of an Online accounting course. 

My teaching of accounting has primarily been in the financial area. I have taught both the 

graduate and the undergraduate. I have taught large and medium size classes since only twice 

have I had fewer than 20 students in a class in my teaching career. In addition, I have prepared 

students for the CPA exam and have taught continuing education of CPAs. All of these teachings 

were live classes. Even when I taught hybrid classes, they were live with the use of a computer in 

the classroom for current events and exams. 

Since I was one of the top teachers in accounting, I was approached by the Assistant Director to 

create and teach an Online Intermediate Accounting class. I was not very excited to take on this 

task since I felt that my teaching success came from my lively lectures and knowing every student 

in the class. All of the other Online classes in the College of Business have been more of a self- 

study class with little interface between the students and the professor. The students worked 

independently on their own and in some cases the professor would join the class in a chat room. 

After a few weeks of pondering how I could improve on the existing approach to the Online 

courses, accomplish my task and still maintain my teaching successes, I came up with the idea of 

video taping my lectures. 

I had video taped a couple of my classes many years ago. One was done in a studio while others 

were done during a class. The one that was done in a studio was very sterile. I was forced to stay 

in one place and it was done in the infancy of the University when the equipment was not that 

sophisticated. My later tapes were very lively and animated. The camera was portable and 

capable of following my movements and was also able to capture my writings on the overhead 

projector. I was able to stop the taping and ask the class for questions. I then used those questions 

to explain the subject better in the taping that followed. The students that used these tapes and 

knew my style of teaching often said to me that it was as if they were actually in the classroom. 

Many often remarked that by the end of the lecture any questions that they had had during the 

lecture were answered by the end of the lecture. 

Now I had to deal with studio taping once again since I did not have a live class to perform in 

front of while the tape was rolling. I was fearful that the taping would be cold and sterile as it 


Lavin 

was in prior years. When I got to the studio for the taping, I realized that the equipment was more 

sophisticated and I was a more seasoned lecturer. I found that I was able to be myself even 

without a classroom audience. I was able to use the overhead projector, joke and have facial 

expressions and movements to match a live class. 

The classes consisted of video lectures using some of the non-assigned exercises to demonstrate 

the subject. As in my live lectures, I was able to go beyond the normal requirements of the 

exercise to explain not only the learning concept but also many “what ifs” as I changed some of 

the assumptions. In addition, tapes were made of me going over the homework where I again 

lectured as I worked through the answers. Often I would change some of the facts to reinforce 

critical thinking skills. Students did not have access to the homework tape until they handed in 

their homework assignment. Both my lecture and homework videos were well organized and 

followed a consistent pattern. Students often thought that I was reading from a script because I 

looked into the camera and spoke without the usual “uhs”. Some students commented that this 

was not like the other Online classes because of the taped lectures. 

In order to have the students keep up in the class, exams were given every other week. The 

exams consisted of multiple-choice questions that covered the text, Gleim and my lectures. 

Exams were timed so the student did not have sufficient time to research the exam questions. The 

Online software allowed me to view the students as they were taking the exam as well as give me 

information as to the time spent on each question. It was obvious that some of the students were 

cheating by using their texts and possible outside support help. If a question involved a definition 

or classification of a term, it should not take 7-9 minutes to answer unless the student is using 

some other source to respond. Also, for a complicated calculation, it should not take 10 seconds 

to answer. The guideline to answer a multiple-choice question is somewhere between 2 and 3 

minutes. Observing some of the students’ response times made me suspicious of their academic 

honesty. 

For the final exam, the students had to be physically present in the computer lab room on 

campus. I thought that this would eliminate some of problems of cheating that were observed 

when the students took the exams Online. The University hired a proctor. IDs were checked but 

in hindsight this did not insure that the proper student actually was present for the exam since 

computer generated fake IDs could easily be made today. Another problem that was very 

difficult to monitor was when a student used another computer source to answer the exam. For 

example, email to a friend or a file that had a cheat sheet. I was suspicious of a couple of students 

because of their past history and taking 9 minutes to answer the first question but took seconds to 

answer a series of complicated questions. In addition, many students heard during the exam 

“You’ve got mail” but did not know where it was coming from. These irregularities were 

investigated but nothing came of them since the evidence could not be supported at the level 

needed under the guidelines of academic misconduct. 

CONCLUSION 

Overall my experience with an Online course was quite good. In my case, there were advantages 

in that once I prepared the videos, most of the work was done. Students were able to view the 

videos when it was convenient to them as well as review the videos as often as they liked. The 

work is done at the students’ convenience and not the strict schedule of a face-to-face class. 

Commuting time to campus is saved since attendance at the University is not expected. Students 

are continuously and conveniently in touch with other students as well as the professor through 

emails, the blackboard and chat rooms. 

There are disadvantages in Online classes in general. Students do not get a chance to be in an 

academic environment where they get to interface in a classroom setting or on campus. As a 

result, the students cannot develop oral speaking skills and the professor is not able to observe 

immediately any problems in the class. 


Online Teaching 

The problems of cheating are a problem in general in all universities. Just like regular university 

classes there are also cheating issues in Online classes that may never be resolved. Precautions 

are taken to prevent cheating but there are always going to be students taking advantage of the 

situation. 

REFERENCES 

Gleim, Irvin N. and William A. Collins, Financial Accounting Exam Questions and 

Explanations, Gleim Publications, Inc. 2006, 12th Ed. 


THE SPIRITUAL DIMENSION OF QUALITY: 

A BIBLICAL PERSPECTIVE 

Maguad, Ben A. 

Andrews University 

maguad@andrews.edu 

ABSTRACT 

The spiritual dimension of quality is probably the most powerful and most pervasive of all the 

product and service quality dimensions. It forces us to look beyond ourselves and our narrow 

self-interests. Powerful though may be, the spiritual dimension is perhaps still the most humane 

of all the dimensions. It helps us to realize how connected we are to one another and to the 

world outside of ourselves. 

INTRODUCTION 

Quality is a complex concept. Its meaning varies with different people and organizations. For 

example, a common notio n of qualit y is that it is synon ymous with superior ity or excellence 

(Evans and Lindsay, 1999). It is something that is intuitively understood but almost impossible to 

communicate to others (Foster, 2007). This view is referred to as the transcendent definition of 

quality. You may not be able to define it precisely but “you know it when you see it” (Pirsig, 

1974, p. 185). Another definition of quality is that it is a function of a specific, measurable 

variable. Thi s product-bas ed approach views qualit y as the presence or absence of a particular 

desired attribute. The greater the am ount of a desired attribute possessed by a product or service, 

the better the quality. 

The m anufacturing-based approach defines quality as conformance to a set of requirements or 

specifications and “making it right the first time” (Crosby, 1979, p. 15). Any deviation from these 

requirements or specifications im plies lack of quality. According to th e user-based approach, 

quality “lies in the eyes of the beholder” (Garvin, 1988, p. 43). The quality of a product or service 

depends on its ability to satisfy the preferen ces of individual consum ers. The user-based 

definition is one that is highly subjective. The value-based approach, on the other hand, de fines 

quality in terms of cost and price. A quality product or service is one that “performs or conforms” 

at an acceptable cost or price. 

Product quality can be described in ter ms of eight dimensions or categories (Garvin, 1988). They 

are perfor mance, features, reliability , conformance, durability , serviceability, aesthetics, and 

perceived quality . Although this list i s the most widely cited and used, i t is by no means 

exhaustive. Service quality, on the ot her hand, can be disaggregated into five key dim ensions 

(Zeithamel, Parasuraman, and Berry, 1984). They are tangibles, service reliability, responsiveness, 

assurance, and em pathy. This list is also by no means exhaustive. A major challenge assoc iated 

with m ultiple definitions and dim ensions of quality is commu nication (Fos ter, 2007). When 

communication is weak, it is difficult to devise a c oherent strategic plan relating to q uality. If 

different units in the organization unde rstand quality differently, the strategic p lan will not be in 

alignment. Therefore, as a m atter o f necessity , the existence of m ultiple definitions and 

dimensions should allow f or measures to be ta ken to work towards a common quality definition 

and a common quality goal. 


Maguad 

When quality definitions and dimensions were first developed, they were designed to provide manufacturing 

and service firms a sound theoretical foundation for quality initiatives like total quality management 

(TQM). Unfortunately, many of these initiatives have been deemed to be failures (Koch, 2003). 

While a n umber of businesses have exp erimented with the a pproach and have become world class 

competitors, many others have no t performed according to e xpectations. W orker opinion surve ys 

pointed to m anagement attitude as a m ajor source of grievances (Holoviak, 1995). Of course, t his is 

hardly what we would expect to happen in a TQM world. It seemed as if m any TQM programs in the 

United States have focused too much on intensifying work and failed to address adequatel y the plight 

of those who did the work. It also appeared that the TQM structure that emerged from years of application 

resulted in more control by management instead of more opportunities given to workers t o influence 

the direction and focus of their TQM efforts. There has been little or no shift at all in the attitudes 

of people at w ork (Holoviak, 1995). Because of ap parent failures of TQM in the United States, it has 

become fashionable to m ock it as a passing fad (Giro ux, 2006). Holoviak (1995) gave a soberin g observation 

that “what we have is an attitude problem and that “it doesn’t matter if you start with the president 

of the company or the entry level job. If the new philosophy of life doesn’t catch on and then lead 

to behavior w hich reflects t he phil osophy, t he TQM pr ogram will fa il. I t’s a bout how people value 

people.” It can be postulated therefore that the key to success in any quality initiative lies beyond training, 

quality certification, statistical process control, or customer focus. Perhaps m odern quality management 

initiatives need to reconsider an important dimension that has proven to be effective over the 

centuries – the spiritual dimensi on. The spiritual dimension is pe rhaps the m issing piece that toda y’s 

organizations need to have to effect change in the behaviors or attitudes of their w orkers from the top 

executive to the entry-le vel employee. After all, “qua lity is about relationships” and “the engine that 

drives all m ajor decisions” (Aiken s, 2006, p. 3). How this dimension can be infused into the existing 

structure of an organization is the focus of this paper. 

PRODUCT AND SERVICE QUALITY DIMENSIONS 

Product q uality can be dec omposed i nto eig ht dim ensions (Garvi n, 1988; F oster, 2007; E vans and 

Lindsay, 2008). Service quality, on the other hand, can be decomposed into five (Zeithamel, Parasuraman, 

and Berry, 1984; Foster, 2007; Evans and Lindsay, 2008). Decomposition provides a descriptive 

framework that leads to a better understanding of the concept. It also allows for research, test, and discussion 

of quality. The dimensions further provide a framework for examining a product or a service. 

The eight product quality dimensions are described below: 

1. Performance. Performance refers to the primary operating characteristics of the product. 

It norm ally involves objective and measurable product and service attributes and 

combines elements of product-based and u ser-based approaches described earlier. 

Whether performance difference s can be transl ated into q uality differences depends on 

the circumstances as well as on individual preferences. 

2. Features. Features are secondar y characteristics that augment the basic operation of a 

product. Lik e performance, features involve objec tive and m easurable product and 

service attributes. The y are usually m easured in ter ms of variety and the str ength of 

their appeal. Co mpared wi th other dimensions, feat ures are more volatile as they can 

quickly turn into one of the product’ s prim ary characte ristics over tim e. I n m any 

instances, it is difficult to draw the line between a product ’s performance and features. 

Whether product characteristics are primary or secondary depends largely on the degree 

of importance attached to them by the user. Whether feature diff erences are p erceived 

as quality differences depends normally on individual preferences. 

3. Reliability. This dimension reflects the probability of failure or malfunction of a product 

over a specified period of tim e. Reliab ility increases in signifi cance as maintenance, 

downtime, predictability or timeliness becomes more important to the customer. 


Spiritual Dimension ..Biblical Perspective 

4. Conformance. Conformance is perhaps the most traditional dim ension of qual ity. It is 

the degree to which ph ysical and perform ance characteristics of a prod uct match preestablished 

s tandards. When a product is designed, certain numeric dimen sions or 

specifications such as cap acity, speed, size, durability, or the li ke will be established. 

Specifications are norm ally allowed t o var y a small am ount called a tolerance. If a 

particular dimension falls within the allowable range of tolerance, then it conforms. 

5. Durability. Durabilit y has both technica l and economic di mensions. From a technical 

viewpoint, durability is the amount of use of a product before its physical deterioration. 

From an economic angle, it refers to the amount of use of a product before such product 

breaks down and replacement is prefe rred over continued repair. W ith products that 

cannot be repaired, the technical life and economic life are the same. With products 

which can be repaired, the users co mpare the expected costs of f uture repairs with the 

investment in and operating expenses of a ne wer, more reliable model. Durability and 

reliability ar e closely related. A product that fails frequentl y i s more likely t o be 

replaced earlier than one that is more reliable. 

6. Serviceability. Serviceability refers to the speed, courtesy, com petence, and ease of 

repair of a product. Examples of measures of serviceability are mean time until a service 

representative arrives, me an time to repair, average number of service calls required to 

correct problems, and mean waiting time to spe ak to a custo mer-service representative 

when calling about problems. Pe rsonal behavior su ch as courtesy particularl y in the 

handling of c omplaints is often the m ost critical asp ect of perceived serviceability and 

can be a powerful competitive advantage. 

7. Aesthetics. Aesthetics pertains to how a product looks, feels, sounds, tastes, or smells. It 

is related to the user-based approach to quality. A very subjective dimension, aesthetics 

is purely a matter of personal judgement and a reflection of individual preferences. 

8. Perceived Quality. Very often consum ers do n ot have com plete inform ation about a 

product or service. They t herefore rely on i ndirect sources of inf ormation such as the 

various tangible and intangible aspects of the product as well as signals from the 

company. Typical sources of information include company or brand information, image, 

advertising, warranties, and guarantees. Reputation is considered to be one of the 

primary contributors to perceived quality. It is often used by consu mers as an anchor 

point from which to evaluate a company’s products or services. 

Service quality is more difficult to define than product quality. Services are known to have mor e 

diverse quality attributes r esulting from wide vari ation due to high customer involvement. The 

Parasuraman, Zeithamel, and Berry (1984) dimensions are one of the most widely recognized set 

of service quality dimensions. Service design strives to address these different service 

dimensions simultaneously (Foster, 2007). 

1. Tangibles. These include the physical appearance of the service facility, the equipment, the 

personnel, and the comm unication m aterials. Attracti ve facilities, s uitably dressed em - 

ployees, and well-designed forms contribute to perception of higher quality. 

2. Service Reliability. This dimension relates to the ability of the service provider t o deliver 

the promised service dependably and accurately. 

3. Responsiveness. This is t he willi ngness of the service pr ovider t o provide hel pful and 

prompt service. High responsiveness includes resolving problems rapidly such as crediting 

returned merchandise promptly and replacing defective products quickly. 


Maguad 

4. Assurance. This pertains to the knowledge and courtesy of employees as well as their ability 

to inspire trust and confidence. Assurance includes having the prerequisite knowledge 

to answer questions confidently and the ability to stay calm, polite, a nd pleasant during 

customer transactions. 

5. Empathy. Empathy refers to the ability of the service firm to provide caring and personalized 

attention to customers that will make them want to return again and again. 

SPIRITUALITY AND THE SPIRITUAL EXPERIENCE 

Merriam-Webster dictionary defines spiritual as “of, relating to, consisting of, or affecting the spirit; of 

or relating t o sacred matters; concerned w ith religious values; of or re lating to su pernatural beings or 

phenomena” and spiri t as “t he immaterial intelligent or sentient part of a pers on; soul.” These definitions 

denote the duality of the nature of human beings: material and s piritual. From a Judeo-C hristian 

perspective (the perspective taken in this paper), a human being is not to be regarded “as a body plus a 

spirit (soul) but as matter made real by a spirit (soul) resulting in a unique person” (Kanunco and Medonca, 

1994, p. 165). Spirituality, therefore, should not be taken as so mething separate from the body. 

“In its truest sense, spirituality gives expression to the being that is in us; it has to do with feelings, with 

the power that comes from within, with knowing our deepest selves and what is sacred to us” (Roof, 

1993, p. 64). It could be said that spirituality “is experienced in those moments when we literally transcend 

ourselves (exceed the usual limits of our self-interest), such as in selfless love or social justice, or 

when we are able to exte nd our vision and feelings beyond the ordinary to discern an extraordinary , 

godly presence in our lives, and universe” (Conger, 1994, p. 10). The Christian spiritual experience is a 

journey where one submits one’s life to Christ and cultivates Christ-like virtues like love, humility, patience, 

and forgiveness. Moreover, this spiritual journey hinges on the firm belief that Jesus Christ is the 

Savior of this world and that salvation is possible only through Him. 

The spiritual experience can be manifested and realized at three levels: cognitive, affective, and in outward 

behavior (Kanungo and Medonca, 1994). At the cognitive level, we recognize that there is a set of 

cardinal virtues that human beings should live by and capital vices that human beings should overcome. 

Virtues, suc h as prudence, justice, fortitude, and tem perance, are th e good habits that e nable us to 

achieve our full potential. At the affective level, the spiritual experience represents a complete trust and 

dependence on these virtues – a com plete identification with these values or with an individual embodying 

these values. At the behavioral level, the spiritual experience finds expression in the norms, principles, 

and standards of human behavior that fall within the realm of moral science or ethics. “Ethics is 

the discipline that deals with what is good and bad and with m oral duty and obli gation” (Carroll and 

Buchholtz, 2006, p. 173). 

BIBLICAL APPROACHES TO QUALITY 

Many of the insights found in this paper come from the Bible where many sound management principles 

still remain unexplored. God Himself wrote the Ten Commandments on two tablets of stone with 

His own fi nger. He is the One who gave us the m ost powerful principles of sound management as 

demonstrated in the lives of godly men and women of the Bible. It is thus fitting to tap this vast repository 

of knowledge and wisdom and explore the divine principles which can be used by organizations to 

improve the quality of their various operations. 

The approach to quality will be structured around the Malcolm Baldrige National Quality Award criteria. 

The Baldrige Award is the highest honor an organization can receive in the United States. Since it 

was first created by Public Law 100-107 in 1987, the Baldrige has evolved over the years to become an 

award for overall effectiveness of an organization. Its dual goals are “to improve value to customers, 

which results in marketplace success, and to improve overall financia l and com pany performance to 



meet the nee ds of s hareholders, owners, and other stakeholders” (Brown, 2005, p. 2). The Baldrige 

program is evolving toward an overall model of how to run an effective organization. 

The literature is filled wi th volumes of books wr itten by recognized authorit ies, professionals, professors, 

and practitioners on how to run a successful organization. And many organizations have done well 

by heeding their advice. However , the Bible is ofte n “hardly consulted for t he wealth of m anagement 

wisdom hidden between its covers” (Xavier, 2002, p. xi). It is the intent of this paper to explore those 

sound management principles found in the sacred writings which can help leaders to manage their organizations 

for quality and performance excellence. Biblical refere nces come mainly from the New 

Living Translation, copyright 2004, published by Tyndale House Publishers and occasionally from the 

New King James Version, copyright 1982, published by Thomas Nelson, Inc. 

Leadership 

The ideal relationship that man should have with God and with his fellowmen is defined in the commandments, 

“And you must love the Lord your God with all your heart, all your soul, all your mind, 

and all your strength” (Mark 12:30) and “Love your neighbor as yourself” Mark 12:31). So it is important 

that the leadership of the organization, just like the rest of the workforce, knows who the Supreme 

Leader is and loves and respects Him. It is also important to know who the neighbor is and to love him 

as well. The leader understands that he is accountable to a higher authority for his actions. “Yes, each of 

us will give a personal account to God” (Romans 14:12). 

Spiritually guided leaders ought to be individuals who are faithful (1 Corinthians 4:2), “known for their 

wisdom and u nderstanding” (Deuteronomy 1:13), and people of integrity at the highest level (Xavier , 

2002). They identify with a set of values that raise them to higher le vels of m otivation and m orality 

(Kanungo and Mendonca, 1994). Joshua demonstrated this commitment when, before his death, as the 

Israelites settled in the Promised Land, challenged them to “choose today whom you will ser ve … as 

for me and my family, we will serve the Lord” (Joshua 24:15). As it deals with the organizational workforce, 

the leadership is admonished to be lowly, gentle, and patient, “making allowance for each other’s 

faults because of your love” (Ephesians 4:2). “But among you it will be different. Those who are the 

greatest among you should take the lowest rank, and the leader should be like a servant” (Luke 22:26). 

“The greatest am ong you must be a servant” (Matthew 23:11). At the heart of servant leadership is 

openness, an ability to listen, and an ability to speak in a way that engages people directly affected by 

the choices to be made. 

With the business world changing so rapidly and so drastically, it seemed to me that 

we need creative and innovative role models now more than ever before. I believe the 

world is crying out for leaders whose goals are to build up, not to tear down; to nurture, 

not to exploit; to undergird and enhance, rather than to dominate. Jesus as a 

leader struck me as the noblest of them all (Jones, 1995, p. XV). 

From the di vine perspective, whoever humbles himself like a ch ild is the greatest in the kingdom of 

heaven (Matthew 18:4). Leaders must therefore set a good exam ple. Of model leaders, the f ollowing 

will be aptly spoken: “Remember your leaders who taught you the word of God. Think of all the good 

that has come from their lives, and follow the example of their faith” (Hebrews 13:7). Leaders should 

model, promote, and ensure ethical behavior. They are commanded to adhere to the golden rule of human 

relationships which is to “do to others as you would like them to do to you” (Luke 6:31). The person 

who truly serves earns justifiable trust. Trust given and received in this manner fosters a climate for 

service at the deepest level. 

The organizational leadership has the responsi bility to protect the i nterest of the or ganization’s stakeholders, 

to act ively support and strengthen its key communities, and to address the possible adverse 


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impact of its operations to society and the environment. This is important for “the earth is the LORD’s, 

and everything in it” (1 Corinthians 10:26), for “all t he animals of t he forest are m ine, and I own the 

cattle on a thousand hills” (Psalm 50:10), that “and all the animals of the field are mine” (Psalm 50:11), 

and “for all the world is mine and everything in it” (Psalm 50:12). Leaders are accountable to God for 

their actions that destroy the earth. “The nations were filled with wrath, but now the time of your wrath 

has come. It i s time to ju dge the dea d and reward your servants the prophets, as well as your holy 

people, and all who fear your name, from the least to the greatest, It is t ime to destroy all who have 

caused destruction on the earth” (Revelation 11:18). 

Strategic Planning 

“Where there is no vision, the people perish” (Proverbs 29:18). Strategic planning focuses on the 

development of strategic objectives and action plans and their dep loyment. It begins with a firm 

commitment from leaders and the workforce that everyone will be included in the transformation 

and that a trusting and open environment will be maintained. If the organization commits its plans 

to the Lord, its plans will succeed (Proverbs 16:3). It is advised to seek the Lord for wisdom when 

it develops its plans. “If you need wisdom, ask our generous God, and He will give it to you. He 

will not rebuke you f or asking” (James 1:5). God will show us what to do and cause our plans to 

succeed. He knows things that we can never know and knows how to make these things work for 

us. “For I know the plans I have for you, sa ys the Lord. T hey a re plans for good and not for 

disaster, to gi ve you a f uture and a hope” (Jeremiah 29:11) . The Bible clearly states that “good 

planning and hard work lead to prosper ity” (Proverbs 21:5) and t hat He will work out His plans 

for our lives (Psalm 138:8). “We can make our own plans, but the Lord gives the right answer” 

(Proverbs 16:1). “We can make our plans, but the Lord determ ines our steps” (Proverbs 16:9). 

“Listen to me, all you people of Judah and Jerusalem! Believe in the Lord your God, and you will 

be able to stand firm . Believe in his prophets, and you will succeed” (2 Chr onicles 20:20). Good 

planning and hard work lead to prosperity (Proverbs 21:5). 

God wrote for hum ankind the first qualit y manual which em bodies His key pri nciples (Ten 

Commandments) for a healthy relation ship betw een God and man and between man and his 

fellow beings. These are s ummarized in the followi ng: “And you must love t he Lord your God 

with all your heart, all your soul, all your mind, and all your strength” (Mark 12:30) and “Love 

your neighbor as yourself” Mark 12:31). These commandments provi de the basis for the 

operationalization of these relationships. 

Customer and Market Focus 

The ultimate goal of managing for quality and pe rformance excellence is customer satisfacti on. 

This is the real measure of whether or not the mission and goals of the organization are being met. 

The Bible does advise us (can also be applied to t he organizatio n as a who le) to do to ot hers 

whatever we would like the m to do to us (Matthew 7:12). This is the essence of all that is taught 

in the law and the prop hets. We should love our neighbor as ourselves (Mark 12:31). T he law of 

love calls for the devotion of bod y, mind, and soul to the service of God and our fellow men 

(White, 1960 ).We should be thinkin g o f others as b etter than ourselves (Philippians 2:3). This 

principle “inspires us to at tempt to grant to others the regard in which we hold ourselves – a 

beginning po int for the customer-conscious” (C orts, 1992, p . 2) . According to Feigenbaum , 

quality is what the customer says it is, not what an engineer or marketer, or general manager says 

it is. If we want to find o ut about our quality, we should go out and ask our cu stomer because he 

is the one most affected by the quality of our products and services on a daily basis. 

Strategies should begin with extensive research to find out who the customer is, what is of value 

to him and h ow he bu ys. The providing organization must respect and unders tand its custo mers 

enough to listen to their values and understand their satisfactions (Drucker, 1990). “Owe nothing 



to anyone—except for your obligation t o love one another. If you love your neighbor, you will 

fulfill the requirements of God’s law” ( Romas 13:8). “Fools think their own way is right, but the 

wise listen to others (Proverbs 12:15). 

Measurement, Analysis, and Data Management 

Data and information are the forces that driv e quality excellence and organizational performance 

(Evans and Lindsay, 2008). One Boeing m anager once noted t hat the data will set y ou free 

(Useem, 2000). Knowledge is the fundam ental build ing m aterial that helps t he organizati on t o 

sustain a competitive advantage. “All organizations have it, but most don’t know what they know, 

don’t use what they do know, and don’t reuse the knowledge they have” (Harrington, 2003; cited 

in Evans and Lindsa y, 2008). “My pe ople are d estroyed for lack of knowledge” (Hosea 4:6). 

Because they have no knowledge, even honorable m en are famished (Isaiah 5:13). But the fear of 

the Lord is the beginnin g of wisdom and knowledge (Proverbs 1:7; 9:1 0). “God gives wisdom , 

knowledge and wisdom to those who please hi m” (Ecclesiastes 2:26). “And you will know the 

truth, and the truth will set you free (John 8:32). 

Wise people treasure knowledge (Proverbs 10:14). “Wise words satisfy like a good m eal; the 

right words b ring satisfaction (Proverbs 18:20). Inde ed, it is “wonderful to be wise, to analy ze 

and interpret things” (Ecclesiastes 8:1). Wisdom an d knowledge will provide stability f or our 

times (I saiah 33:6). The organization must therefor e test and exa mine its wa ys (Lamentation s 

3:40) and use data and knowledge assets to achie ve its key business r esults and strategic objectives. 

Data and inf ormation should be used carefully for with the same measure that we u se, it 

will be measured back to us (Luke 6: 38). Know ledge about be st practices o ught t o be s hared 

among others performing similar jobs. The benefit can be tremendous not only for the recipient of 

such knowledge but also on the sharer of the knowledge himself. “Give, and it will be given unto 

you: good measure, pressed down, shaken together, and running over will be put int o your bosom” 

(Luke 6:38). If we are willing, God will put His instructions deep within us, and write them 

in our hearts” (Jeremiah 31:33). Process i mprovement requires new knowledge t o result in better 

processes and procedures (Evans and L indsay, 2008). “I know all the things you do. I have seen 

your love, your faith, your service, and your patient endurance. And I can see your constant improvement 

in all these things” (Revelation 2:19). 

Workforce Focus 

Quality organizations help their wor kers to unde rstand their role in the organization and enable 

them to do their best work. Workers who are valued, who understand the importance of their job, 

and who have the freedom and the tools needed to do t hem will be committed and m otivated to 

do great work. The Bible exhorts all em ployees to work with enthusiasm as though the y were 

working for the Lord rather than for peo ple (Ephesians 6:7). They should work hard so that they 

can present themselves to God and receive His approval, to be a good worker, one who does need 

to be ashamed (2 Timothy 2:15). All are God’ s workers (1 Corinthians 3:9). No one should think 

that he is better than he really is (Romans 12:3) . “Let y our light s o shine before men, that t hey 

may see your good works and glorify your Father in heaven” (Matthew 5:16). Workers who protect 

their employer’s interests will be rewarded (Proverbs 27:18). 

In quality organizations, leaders get th eir workers involved i n a vigoro us program of the education 

and self-improvement. They remove barriers that rob their workers of their right to prid e in 

workmanship. They recognize that everyone wants to do a quality job. This is where the concept 

of service becomes paramount. “For even the Son of Man came not to be served but to serve others 

and to give His life as a ransom for many” (Matthew 20:28). And for the workers, the admonition 

is “If your gift is ser ving others, serve them well” (Ro mans 12:7). Quality organizations 

promote team building. The synergy developed within effective teams in terms of rel ationships, 


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trust, and support can exceed the original expectations of the team. Closely-knit organizations are 

likened to the human body which consists of di fferent parts functioning together. “He makes the 

whole body fit together perfectly . As each part does its own spe cial work, it helps other parts 

grow, so that the whole body is healthy and growing and full of love” (Ephesians 4:16). Maximizing 

team involvement, cohesiveness, and effectiveness requires training and support. While physical 

training is good, traini ng for godliness is much better, promising benefits in this life and in 

the life to come (1 Timothy 4:8). Therefore, “Let us think of ways to motivate one another to acts 

of love and good works” (Hebrews 10:24). 

Process Management 

According to Deming and Juran (Evans and Lindsay, 2008), the overwhelming majority of quality 

problems are asso ciated with processes. Few are caused by the workers themselve s. Management 

has the responsibilit y for the design and continuous improvement of proc esses with which 

individuals work. To a certain extent, i t shares this responsibility with the workforce. Unless the 

process is changed, no one should expect the results to change. The organizational leadership may 

do well to he ed the biblical advice that “Unless the Lord builds t he house, the work of the builders 

is wasted. Unless the Lord protects a city , guarding it with sentries will do no good” (Psalm 

127:1). Divine guidance is there for the asking. “Keep on asking, and you will receive what you 

ask for. Keep on seeking, and you will find. Keep on knocki ng, and the door will be opened to 

you” (Matthew 7:7). As we work with our colleagues in the production line, it is good to heed the 

warning: “Don’t t hink you are better than you rea lly are. Be honest in your ev aluation of yourselves, 

measuring yourselves by the fait h God has given us” (Romans 12:3). Quality means continuous 

process improvement which applies not only to the organization but to our personal lives 

as well. “I kn ow all the things you do . I have se en your love, your faith, y our service, and your 

patient endur ance. And I can see y our constant improvement in all these things” (Revelation 

2:19). 

Results 

Workers are counseled to work with en thusiasm as thoug h they were working for the Lor d and 

not for the people for the Lord w ill reward each of the m for the work they do (Ephesians 6:7, 8). 

He who is gr eatest among them should be as th e younger and he who g overns as the one who 

serves (Luke 22:26). We need to pay attention to our own work for then we will get the satisfaction 

of a job well done and we won’t need to compare ourselves to anyone else (Galatians 6:4). If 

we serve Christ with the ri ght attitude, we will please God and others will approve of us too (Romans 

14:18). “Love your neighbor as yourself” (Romans 13:9). This command admonishes us to 

treat others in the sam e way we would like to be treated ourselves (Luke 6:31) . An organization 

that builds its “house” upon the r ock is wise indeed. Although the rain m ay descend, the floods 

come, or the winds blow and beat on the house, it will not fall because it is built on the solid rock 

of morality and integrity (Matthew 7:24-25). 

Those who work for the Lord will not work in vain, and their children will not be doomed to misfortune. 

They will be considered people blessed by the Lord and their children too will be blessed 

(Isaiah 65:23). They will bear the following fruits in their lives: love, joy, peace, patience, kindness, 

goodness, faithfulness, gentleness, and self-co ntrol (Galatians 5:22). “You will live in joy 

and peace. The m ountains and hills wil l burst int o song, and the trees of the field will clap their 

hands” (Isaiah 55:12). The ultimate goal of quality is customer satisfaction, regardless of whether 

the customer is external (fi nal user of th e good or service) or inter nal (employees within the organization). 

Whatever their lot in the organization, blessings (Matthew 5:3-11) are pronounced 

upon those who trust in the Lord with all their heart, who do not depend on their own understanding, 

and who seek His will in all they do (Proverbs 3:5, 6). 



Blessed are the poor in spirit, for theirs is the kingdom of heaven. 

Blessed are those who mourn, for they shall be comforted. 

Blessed are the meek, for they shall inherit the earth. 

Blessed are those who hunger and thirst for righteousness, for they shall be filled. 

Blessed are the merciful, for they shall obtain mercy. 

Blessed are the pure in heart, for they shall see God. 

Blessed are the peacemakers, for they shall be called sons of God. 

Blessed are those who are persecuted for righteousness’ sake, for theirs is the 

kingdom of heaven. 

Blessed are you when they revile and persecute you, and say all kinds of evil 

against you falsely for My sake. Rejoice and be exceedingly glad, for great is 

your reward in heaven, for so they persecuted the prophets who were before you. 

CONCLUSION 

In the past, work was the place where one earns a living and not a place to experience 

spirituality. The daily workplace chores, the looming deadlines, the bureaucracy, the materialistic 

ambitions, the layoffs and other forces make it difficult for organizational participants 

to become part of a supportive and interconnected community. During the last 

century and the beginning of this century, the field of quality management has concerned 

itself with improving the quality of work life and enhancing the sense of community in 

organizations. It promoted a strategy which utilized the talents of all employees for the 

benefit of both organization and society. The spiritual dimension of quality is probably 

the most powerful and most pervasive of all the product and service quality dimensions. 

It forces us to look beyond ourselves and our narrow self-interests. Though powerful, the 

spiritual dimension is perhaps also the most humane of all the dimensions. It helps us to 

realize how connected we are to one another and to the world outside of ourselves. 

REFERENCES 

Aikens, C. H. (200 6). Quality: A corporate force. Upper Saddle River, NJ: Pearson, Education, 

Inc. 

Brown, M.H. (2005) Baldrige Award Winning Quality: How to Interpret the Malcolm Baldrige 

Criteria for Performance Excellence (14 th Ed). New York, NY: Productivity Press. 

Carroll, A. B. and Buchholtz, A. K. (2006). Business and society: Ethics and stakeholder 

management (6 th ed.). Mason, OH: South-Western. 

Conger, J. A. (1994). Intr oduction: Our search for spiritual commu nity. In In J. A. Conger (E d.) 

Spirit at work: Discovering the spirituality in leadership (pp. 1-18). San Frans isco, CA: 

Jossey-Bass Publishers. 

Corts, T. E. ( 1992) Customers: You Can’t Do Wit hout Them. In J. W. Harris and J. M. Baggett 

(Eds.), Quality Quest in the Academic Process. Birmingham, AL: Samford University, pp 

1-6. 

Crosby, P. B. (1979). Quality is free. New York, NY: New American Library. 


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Drucker, P. F. (1990). Managing the non-profit organization: Practices and principles. New 

York, NY: HarperCollins. 

Evans, J. R. and Lindsay, W. M. (1999). The Management and Control of Quality (4 th ed.). 

Cincinnati, OH: South-Western College Publishing. 

Evans, J. R. and Lindsay, W. M. (2008). The Management and Control of Quality (7 th ed.). 

Cincinnati, OH: South-Western College Publishing. 

Feigenbaum, A.V. (1991) Total Quality Control. New York, NY: McGraw-Hill. 

Foster, S. T. (2007). Managing Quality: Integrating the Supply Chain (3 rd ed.). Upper Saddle 

River, NJ: Pearson Education, Inc. 

Garvin, D.A. (1988) Managing Quality: The Strategic and Competitive Edge. New York, NY: 

Free Press. 

Giroux, H. (2006). ‘It was such a handy term’: Management fashions and pragmatic ambiguity. 

Journal of Management Studies, 43(6), 1227-1260. 

Holoviak, S. J. (1995, July/August). Why TQM fails to change behaviors or attitudes. Journal for 

Quality and Participation, 18(4). Retrieved February 6, 2007 from EBSCOHost 

Academic Search Elite Database. 

Jones, L. B. (1994) Jesus CEO: Using Ancient Wisdom for Visionary Leadership. New York, NY: 

Hyperion. 

Kanunco, R. N. and Mendonca, M. (1994). What leaders cannot do without: The spiritual 

dimensions of leadership. In J. A. Conger (Ed.) Spirit at work: Discovering the 

spirituality in leadership (pp. 162-198). San Fransisco, CA: Jossey-Bass Publishers. 

Koch, J. (2003). TQM: Why is its impact in higher education so small?” The TQM Magazine, 

15(5), 325-333. 

Pirsig, R. M. (1974). Zen and the Art of Motorcycle Maintenance: An Inquiry Into Values. New 

York, NY: William Morrow & Co. 

Roof, W. C. (1993). A generation of seekers: The spiritual journeys of the baby boom generation. 

San Fransisco, CA: HarperCollins. 

White, E. G. (1995) Education. Kalispell, MT: Remnant Publications. 

Xavier, K. (2002). Quality management from the beginning to modern times: Biblical approaches. 

New York, NY: Vantage Press, Inc. 

Zeithamel, V., Parasuraman, A., and Berry, L. (1990). Delivering Quality Service. New York, 

NY: The Free Press. 


HOUSING INVESTMENT AND PROPERTY TAXES 

IN INDIANA: A CROSS-COUNTY COMPARISION 

McGrath, Paul 

Purdue University Calumet 

pmcgrat@calumet.purdue.edu 

ABSTRACT 

The main purpose of this paper is to begin an examination of the relationship between 

new housing construction and county property tax rates in Indiana. The relationship has become 

of great interest to homeowners, policy makers, and the home construction industry in Lake 

County, Indiana this decade due to sharp increases in property tax burdens for homeowners. 

Ceteris paribus, we hypothesize that a higher property tax rate would discourage 

construction of new housing. Using Department of Census data, plus data from additional 

sources, we relate new housing investment by county in 2003 to county property taxes plus other 

relevant variables. We find no evidence to support the hypothesis. We do report evidence that 

other socio-economic variables appear to be important in determining housing investment. 

Measures of purchasing power, economic activity, and construction cost perform as one might 

expect. Median household income positively influences new housing construction. But higher 

county unemployment and higher construction costs discourage new housing investment. 

INTRODUCTION 

Lake Count y is located in the far northwest corner of Indiana, adjacent to Chicago’s 

Cook Count y and boun ded b y Lake Michigan to the north. Two property tax p olicy shifts 

occurred in Lake Count y beginning in 2002. First, to provide some relief for corporations in the 

area and to attract new b usinesses, some property tax burden w as shifted from businesse s to 

homeowners, with the latter experienci ng an increase in the tax rate, itself. At roughly the same 

time, the state forced the count y to reassess all homes, arguing that m any hom es had been 

severely under-assessed. The result was a sharp increase in property tax bills for hom eowners in 

the state’s second largest county. In addition to the possibilities of increasing mortgage defaults 

and declining home values in Lake County, there was an understandable fear that the tax increase 

would reduce new housing construction at a time when the county was attracting many young 

professionals from the greater Chicago-land area in neighboring Illinois due to a lower cost of 

home ownership. 

Studies generally focus o n the price an d income elasticities of th e demand for housing 

overall – whether it be existing owner occupied housing, rental, or new construction. Permanent 

income and housing expenses (taxes, utilities, insurance) were t he subjects of deLeeuw’ s 1971 

study. He reported that o wner-occupied housing was generally a luxury good, except for small 

households of two individuals. Polinsky’s (1977) use of spatial analysis indicates why household 

income and housing prices are likely to be positively linked. Mayo’s (1981) thorough review of 

the literature shows both high and low sensitivity of housing demand to income and prices. Mayo 

also thoroughly examined the price effect findi ng an inelastic response to the price of housing 

services. The studies indicate that purchasing pow er and the cost of housing services must be 

addressed in any aggregate study of housing demand. 


McGrath 

Himmelberg, Mayer, and Sinai (2005) recent study on the subject of high housing prices 

and bubbles outlines how the im puted rent – a measure of the an nual cost of homeownership – 

would be determined. One of the six components of the annual imputed rent is the annual cost of 

property taxes. 

DATA 

Indiana is com prised of 92 counties. Three counties have populatio ns greater than 

200,000 individuals. The y are, in order, Marion (Indianapolis), Lake (Hammond/Gary), and St. 

Joseph (South Bend). In Table 1, we present summary statistics of the data with which we began 

the analysis. 

On average, count y populations gr ew by 9.2% through the 199 0s in Indian a 

(POPGRWTH). Based upon p opulation growth t hrough the 1990s the counties surroundin g 

Marion Count y, such as Hamilton (67.7%), He ndricks (37.5%), Johns on (30.8%), Hancock 

(21.7%), and Boone (20.9 %), have experienced sig nificant popu lation influx. Lake County’s 

population growth for the decade of the 1990s was only 1.9% implying that Lake County’s ability 

to attract new residence s was w eak (whether they chose to build new hom es, purchase exis ting 

stock, or rent) well before the change in propert y taxes. Neighboring Lake Count y to the east is 

Porter County which enjoy ed an increase in it s population of 14% over the same ti me period. 

The construction of new houses adds to the existing stock of housing and thus to the tax 

base and may be thought of as an indicator as to the overall attractiveness of an area, as well as an 

engine of future growth. Housing investment studied here is measured as the percentage increase 

in the num ber of new sin gle fam ily houses built in 2003 relati ve to the previous year’s stock 

(NEWINV). The data for the num ber of new singl e family houses built and the previous year’s 

stock is provided by the U.S. Census. The average across the 91 counties for which we have data 

is 1.03% . Data for Green e County for 2003 was not available, thus Greene County has been 

dropped from further analysis. 

As mentioned above, Hendricks County, which lies just west of Indianapolis, experienced 

a relative housing boom in 2003 with NEWINV equal to 5.5% to lead all counties. Following 

Hendricks County in such investment are Hamilton (4.4%), Hancock (3.7%), Switzerland (2.7%), 

Boone (2.3%), and Johnson (2.2%) counties. Of these only Switzerland County, which is located 

in the far sou theast corner of Indiana, is not directly adjacent to Marion County. Lake Co unty 

experienced a 0.78% investment rate, which is below the average, but is roughly within one-half a 

standard deviation from the mean. 

In order to e xamine to w hat extent co unty property tax differen ces may play in these 

differing rates of investment, we will relate the housing investment measure to the gross property 

tax rate by county, as well as other variables of ten cited as determinants of housing demand and 

supply. We will assume that capital markets are efficient. And since the data is cross sectional, 

borrowing costs – mortgage rates, fees, etc - will not be directly included. To some extent such 

costs may differ by the prospective homebuilder’s income level. As such, m edian income may 

capture access to capital, as well as purchasing power. 

County property tax rates for 200 1 (payable 2002) are from the Indiana Department of 

Revenue and can be located at STATSIndiana at www.st ats.indiana.edu. The state’ s mean 

property tax rate (PROPTAX) was 2.93% with a st andard deviation of 0. 47%. Lake County’s 


Table 1. Summary Statistics of Socio-economic Characteristics for Indiana 

Counties and Lake County 

Dependent 

Variable 

State 

Mean 

Std 

deviation 

Lake 

County 

Mean 

Description 

NEWINV 1.026% 0.871% 0.78% Ratio of new single family 

homes to existing stock for 

2003 

Explanatory 

Variables 

Tax Structure 

PROPTAX 2.93% 0.471% 4.44% 2002 county property tax rate 

INCTAX 1.03% 0.315% 1.00% 2002 county income tax rate 

Cost 

variables 

COST $122,789 $29,543 $156.921 County mean construction cost 

2002 

MEDVAL $87,835 $19,152 $97,500 County median home value for 

2000 

OWNRATE 76.43% 5.53% 69.0% Home ownership rate for 2000 

COMMUTE 23.7 min 3.93 min 27.1 min County mean-travel-to-work 

times in minutes per day, 2000 

Purchasing 

Power 

INCOME $40,727 $6,009 $41,829 County median household 

income for 2000 

EDUC 14.61% 6.71% 16.2% Percent with bachelor’s degree 

Economic 

Activity 

POPGRWTH 9.30% 9.92% 1.9% 10-year population growth rate 

1990-1999 

RETAIL $7,562 $3,129 $9,100 Retail sales per capita for 2000 

UE 4.97% 0.90% 6.2% Unemployment rate, 2000 

POVERTY 8.79% 2.96% 12.2% Percent of persons below 

poverty level, 1999 

Other 

SMEHOUS 58.90% 5.20% 61.5% Percent living in same house in 

1995 and 2000 

MULTIUNIT 12.23% 6.50% 24.2% Percent housing units in multiunit 

structures, 2000 

DENSITY 168 p/m 2 267 p/m 2 975 p/m 2 Persons per square mile, 2000 

AGE18- 25.97% 2.17% 26.8% Percent of population 18 or 

younger 

AGE65+ 13.20% 1.81% 13.0% Percent of population 65 or 

older 

Property Taxes in Indiana 


McGrath 

rate of 4.4% was the state’s highest. Onl y two other counties had tax rates averaging above 4% 

and they were St. Joseph (South Bend area) and De laware (Muncie). It is also the case that each 

of these three counties experienced less than average housing investment rates. However, with 

the exception of Harrison County’s pro perty tax rate of 2.3% , the counties experiencing rapid 

investment mentioned earlier – Hendricks, Hamilton, Hancock, Switzerland, Boone, and Johnson 

did not have rates very different than the state mean. In fact, a simple correlation coefficient of ρ 

= -0.13 between NEWINV and PROPTAX points to rather weak relationship b y m agnitude. 

County income tax rates also differ in Indiana, b ut the rates average roughl y one-third 

that of pro perty taxes. The INCTAX variable is provided t hrough STATSIn diana. The statewide 

average count y i ncome tax rate is 1.03% with Lake Cou nty’s rate at an even 1. 0%. 

The cost of building a new ho me wo uld be expected to be negatively relat ed to the 

investment rate, ceteris par ibus. The mean unit cost of a new single fa mily home wa s available 

from the Census by county for the year 2000. The mean unit cost (UNITCOST) was $122,789 in 

2000. The average median value of an exis ting hom e (MEDVAL), perhaps a substitute to 

building a new ho me, was $87,835. Ham ilton Co unty had bot h the highest median valu e at 

$166,300 while new ho mes in Boone County were, on average, the most expensive to build at 

$205,276. New ho mes in Lake County were also significantly more expensive than average to 

build at a co st of $ 156,921. No attem pt has y et been made here to contro l for t he diff erent 

attributes (square feet, lot size, rooms, etc) of new homes across counties. 

A county with a high rate of homeownership (OWNRATE for 20 00) may imply that the 

infrastructure (schools, utilities, etc) i s in pl ace to provide the services a new ho mebuilder is 

likely to demand. However, OWNRATE is onl y weakly positively correlated with NEWINV ( ρ 

= 0.15). An additional cost of building a ne w home is the i mplied commute to workplace. The 

U.S. Census provides data as to the mean travel-to-work time in minutes per day (COMMUTE) 

for the year 2000. COMMUTE has a low, positive correlation with NEWINV with ρ = 0.14. On 

average Lak e Count y’s homeownership rate wa s below the state’s average at 69% and the 

average commute time was a little longer at 27 minutes. 

Balancing the building cost of a new home and other expenses may be the homebuilder’s 

purchasing power, both present and future. Count y median household incom e (INCOME) and 

the percentage of the county’ s population holding at least a bachelors degree ( EDUC) may both 

represent purchasing power. Lake County’s median household income and education levels were 

both slightly higher than the state averages. While the Census provides data for both variables for 

the year 2000, the simple correlation coefficient between the two is somewhat high at 0.52, as one 

would expect. The EDUC variable is also highly correlated with median home value (MEDVAL) 

as the correlation coefficient is 0.71. 

A county’s economic activity may either attract new residents or attract business which in 

turn pushes h omeowners to neighb oring counties and to comm uting. POPGRWTH was defined 

above as the count y’s po pulation growth for the 1990s. Li ke EDUC, POPGRWTH is highl y 

correlated with other varia bles, principally m edian household i ncome (ρ = 0.72), m edian home 

value (0.74), percent of population over 65 years of age (ρ = - 0.74). But POPGRWTH measured 

for the 1 990s is also strongl y correlated w ith NEWINV in 20 03 likel y impl ying conti nued 

momentum into the new decade (ρ = 0.72). 

In addition to population growth, we examined the roles that county retail activit y, the 

county unemployment rate and the cou nty poverty rate may play in encouraging or discouraging 



new housing construction. Reta il sales per capita (RETAIL) for 2000, the unemployment rate 

(UE) for 2000, and the percent of persons below the poverty level (POVERTY) for 1999 are each 

available from the U.S. Census. Of these three measures of economic activity, the unemployment 

rate has the highest (negative) degr ee of correlati on with NEWINV with 

ρ= -0.51. The correlation coefficients between each pair of these three variables, as well as with 

POPGRWTH, are each on the low side and each below ρ = 0.50. It is interestin g to note that the 

variable RETAIL is strongly ne gatively correlated with COMMUTE ( ρ = - 0.61) and the 

percentage of housing in multi-unit struc tures (ρ = - 0.57), but strongly positively correlated with 

homeownership rates (ρ = 0.58). 

Relative to the state as a whole, Lake Count y’s economic situation is a mixed bag. Lake 

County’s unemployment rate and poverty rate are about one standard deviatio n higher than the 

state’s averages, and as mentioned earlier the county’s pop ulation growth has been anem ic. 

However, the county’s median income is somewhat higher, as is the education level. The median 

single unit hom e is also valued a bit highe r and retail acti vity is respectable. 

As additional characteristics of each county, we collected infor mation on the stability of 

the county in regards to its population’s age structure, immobility, and density. A county with an 

older population (the percent of population 65 years of age or older = AGE65+ vs. the percent of 

population 18 y ears of age or y ounger = AGE18-), a longer ten ure in the same ho me (percent 

living in same house in 2000 as in 1995 = SAMHOUS), and a greater density (persons per square 

mile = DENSITY) is likely more stable. We may expect less new construction in such a county, 

ceteris paribus. The data for each of these s eries is provided by the U.S. Cens us. Here w e find 

sharp differences between the state and Lake Count y. Almost one-fourth of the county’s housing 

units are in multi-unit structures which is double th e state average. And the county’s population 

density is fiv e times the state average (975 persons per square mile vs. 168). The count y has a 

slightly younger population profile with a larger proportion of its population less than 18 years of 

age and a smaller population 65 years of age or older. 

Due to the high correlations between many pairs and grou ps of potential explanator y 

variables, a smaller set of variables to c hosen as determ inants on new housing investment. 1 The 

following rel ationship wil l be the o ne estimated so as to explore how certain variables impact 

new housing investment: 

NEWINV = f (PROPTAX, INCTAX, COST, MEDVAL, INCOME, UE, AGE65) (1). 

ESTIMATION 

In Table 2 we report the Ordinary Least Squares estimates of relationship (1). We report 

that the property tax rate is actually positively associated with new housing construction. This is 

evidenced by the positive and statistically signif icant coefficient, albeit at the 90% level of 

confidence. This is not as one would anticipate if PROPTAX is to capture a component of the 

cost of hom e ownership. The coefficient of th e county income tax rate (INCTAX) is posi tive, 

too, but not significant. 

Homeowners self-select communities based in part upon the quality, quantity, and mix of 

public services offered through and paid by pr operty taxes and i ncome taxes. As m entioned 

above, though, we have not yet included any controls for the qual ity of services received for the 

county’s tax burden. If counties that offer the best schools, pu blic safety, and infrastructure also 

have the highest property and income tax rates, th e rate s the mselves may not discourage new 

construction. 


McGrath 

Table 2. OLS Estimates of the Determinants of New Housing Investment in 

Indiana for 2003 

Variable C oefficient Standard error 

PROPTAX 0.236* 0.120 

INCTAX 0.141 0.174 

COST - 6.52E-06*** 2.28E-06 

MEDVAL 1.16E- 05 7.24E-06 

INCOME 6.54E- 05*** 1.84E-05 

UE - 0.162** 0.073 

AGE65+ - 0.102** 0.047 

Constant - 0.531 1.104 

Notes 

Observations 91 

Adj R 2 0.66 

R 2 0.69 

DW 2.05 

* = significant at the 90% level of confidence 

** = significant at the 95% level of confidence 

*** = significant at the 99% level of confidence 

We report th at, ceteris paribus, the cost of new ho me construction decreases investment 

rates. The coefficient of the COST va riable is nega tive and stati stically significant at the 9 9% 

level of confidence. However, we cannot show evidence that the median value of existing homes 

in the county influences the de mand for new cons truction. The c oefficient for MEDVAL i s not 

statistically significant. 

Offsetting the cost variables to some extent, m edian count y incom e is positively 

associated with new housing investment. The coefficient of INCOME is positive and statistically 

significant. Since both t he INCOME and COST variables ar e measured in the sa me units – 

simply dollars – we can say that the positive impact of a one-dollar increase in income outweighs 

the negative i mpact of a one-dollar increase in construction costs, based upon the coefficients. 

This is to be expected as this period ’s income is a strong indicator of the futur e income stream 

and, in turn, the ability to purchase the asset. 

Higher rates of county unemployment seem to discourage new housing construction. The 

coefficient f or the UE variable is ne gative a nd statistically significant. Each one percent 

difference in the count y unemployment rate tr anslates into a 0.16 percent decrease in new 

housing investment. 

Finally, t he percentage of count y residents 65 years of age o r older is negatively 

associated with new housing construction. This result is not surprising as an older population is 

less mobile. The statistic may also point to the mix of public services offered by the county. The 

mix demanded by an older population is likely not the same as the mix demanded by a younger 

population – the population most likely to build new homes. 

SUMMARY AND IMPLICATIONS FOR FURTHUR RESEARCH 



In 20 03 new housin g in vestment in L ake Count y f ell about 0. 25% below th e state’ s 

average of 1.03%. It was argued at the time that this shortfall is due to the sharp increase in the 

tax burden i mposed on h omeowners. Indeed, pr operty tax rat es in Lake Count y were (and 

remain) higher than the state’s average and new housing investment was lower. However, the 

coefficient for the property tax variable is actually positive and significant. Likely this means that 

prospective homebuilders view the higher rate as indicative of public services offered in the 

county. Unless we include controls for the services offered, interpretation of this result is unclear, 

if not useless. 

Using the coefficients in Table 2 an d basic data regarding Lake County vs. other 

counties, it is actually Lake County’s higher unemployment rate and higher unit construction cost 

that explain the vast m ajority of this shortfall and actually ove rshoots the difference. Lake 

County’s unemployment rate was 1.2% higher than the rest of the state. Given the coefficient for 

the UE variable, this translates into roughly a .20% shortfall in new investment, or about 80% of 

the 0.25% deficit. Also, Lake Count y’s significantly higher unit construction costs account for 

0.22%. It is important to remember we have not controlled for the size of the homes being built 

or land value s. Lake Count y’s slightly higher median income, younger p opulation profile and 

higher median home value work to partially counteract the unem ployment and cost effects. In 

sum, Lake Count y’s unemployment rate and cons truction costs are enough to m ore than explain 

the short-fall in new investment. 

Ideally, to m ore full y understand the re lationship b etween property tax rates and new 

housing investment additional data needs to be included in the study. As mentioned above, it will 

be necessary to include controls for the quality and mix of public services purch ased by property 

taxes. Proxies might include county expenditures, school performance measures, crime statistics, 

and the li ke. As well, it would be ideal if land prices and new housing characteristi cs could be 

included. 

Different estimation techniques may be advantageous, too. The variables comprising our 

simple model presented in Table 2 were chosen in a somewhat ad hoc fashion. While not always 

favored in the econo mic l iterature, both stepwise regression or factor analy sis offer alte rnative 

approaches to the problem of significant correlation among explana tory variables. 

Finally, the proxim ity of Lake Count y to Chi cago and th e rather high cost of 

homeownership in Illinois, account ing for liv ing costs, econom ic act ivity and r elated 

characteristics of neighboring areas would add rigo r. Given the rapid housing growth in the 

counties neighborin g India napolis’ Mari on Count y – but not Marion itself – may indicate that 

suburbanization is an important component. 

REFERENCES 

deLeeuw, F. and Ekanem , N. F. (19 73). “The Demand for Ho using – A Revi ew of the Cross- 

Section Evidence.” Review of Economics and Statistics, Volume 53, Number 1, 1 – 10. 

Himmelberg, C., Mayer, C. and Sinai, T. (2005). “Assessing High Housing Prices: Bubbles, 

Fundamentals, and Misperceptions.” The Journal of Economic Perspectives, V olume 

19, Number 4, 67 – 92. 

Lee, T. H. and Kong, C. M. (1977). “Elasticities of Housing Demand.” Southern Economic 

Journal, Volume 43, 298 – 305. 


McGrath 

Mayo, S. K. (1981). “Theory and Estimation in the Economics of Housing Demand.” 

Journal of Urban Economics, Volume 10, Number 1, 95 – 116. 

Polinsky, A. M. (1 977). “The Demand for Housing: A Stud y in Specification and 

Grouping.” Econometrica, Volume 45, Number 2, 447 – 462. 


ABSTRACT 

Major trends in hotel guestroom technology: an 

analysis of customer demand and satisfaction 

Mills, Richard J. 

Robert Morris University 

mills@rmu.edu 

This research discusses current trends and innovations in information technology that are 

affecting and changing the hotel industry in relationship to customer demand and 

satisfaction. The challenges of providing global information technology solutions and 

providing some practical considerations and project management guidelines require hotel 

futurist who study emerging technologies and their impacts to address and stay 

competitive within the hotel customer network. The research will discuss some leading 

trends taking place as a result of the digital convergence and the importance of electronic 

commerce and relationship marketing that has emphasized the importance of marketing 

to hotel customer demands and information technologies solutions that have developed to 

meet the need for customer-centric solutions and hotel marketing distribution channel 

management. Information Technology is the single greatest force driving change and 

complexity in the hotel industry. This research will advance and up-date this growning 

trend to advance the idea that technology has and will continue to be a major marketing 

advantage to customer satisfaction and repeat business. 

INTRODUCTION 

This paper discusses the history of hotel technology; innovative technologies and 

customer satisfaction in the hotel industry; types and styles of in-room technology; and future 

technologies associated with the customer and their hotel experience. Guestroom 2010 will be 


Mills 

featured as an example of the hotel room of the future. In this concept, the hotel room is 

transformed into a dream environment with every technological experience included to make the 

hotel guest experience one of wonder and convenience. 

This essay will discuss technology’s impact on hotel guests and guestrooms from 1995 to 

2007. Several early articles are included to show the progression of technology and the guest to 

better understand the complexities of what might ultimately happen in the future. Technological 

innovations will be included to show the progress from 1995 to 2007. 

Finally, the essay will include information from Guestroom 2010; this experimental room 

demonstrates the technological advances that may or will happen within the guestroom 

environment. This guestroom was produced by Hospitality Financial and Technology 

Professionals (HFTP) and shows how technology goes beyond the amenities found on the 

guestroom desk to that of fast Internet connections, high-definition television and in-room 

concierge services. 


Richard Siegel, Hotel & Motel Management, 1995, discusses technology: the year in 

review. The issue of safety and security, the VingCard and Computerized Security Systems 

seems to have become another “top tier” provider. In-room entertainment such as SpectraVision, 

LodgeNet and On Command Video offers the guest an interactive path to play games and receive 

pay movies. Siegel also discusses new software for marketing food and beverages and sales and 

catering. In 1995, the industry explores central reservations, the Internet, property-management 

and other issues that are impacted by new technology. For example, the Internet marketing of the 

hotel room was becoming popular and competitive; many hotel companies are in the process of 

developing a booking process to make it easier for the consumer to book with a PC and a modem 

(Siegel, 1995). David Caffey, Microsoft states, “It seems that the hotel industry is finally starting 

to embrace technology and seems ripe for change” (Siegel, 1995). 


Hotel Guestroom Technology 

The impact of technology on hotel guests and managers increases daily as both consumer 

and service employees strive to keep up with the trends in the industry. In 2000, hotel roundtable 

participants met in Chicago to discuss the impact of technology on the industry. The Roundtable 

convened in December in the sophisticated boardroom of the Sutton Place Hotel. The group 

consisted of the Roundtable and their sponsor, Rob Grimes, chairman and CEO of Cyntergy 

Corporation. The group addressed the complexities and controversies experienced in the high- 

tech Information Age. The question: What are the greatest technological challenges facing your 

properties right now? The participants were concerned about the impact of email and how the 

hotel might address the problem of instant communication. Also in 2000, a big issue was the 

internet and high speed access, video conferencing in meeting rooms and ultimately, the training 

of personnel in each of these areas. As they discussed in-room technology, the questions of how 

the room might keep up with technology was also a concern (Marsan, Joan. Hotel Magazine, Feb. 

2000). 

The International Hotel and Restaurant’s (IH&RA) fourth annual Technology Think 

Tank was held in Lausanne, Switzerland in 2001. At this time the resounding theme throughout 

the week was that IT is the single greatest force driving change and complexity in our industry. 

The problems dealing with how we will do business in the future, regardless of company size, 

industry segment, or geographical location were explored. The costs of IT were given special 

attention and revealed that this is a perplexing and frustrating issue for many executives. 

Dominique Bourdais, Associate Director of HVS International attempted to address this issue by 

discussing IT’s return on investment (ROI) and the how to calculate the return: “IT must be 

aligned with the key strategic drivers of the business. We cannot deploy technology for 

technology’s sake, but rather, we must have sound business rationale supporting our use of 

technology to enhance firm value, customer service, and lasting loyalty while differentiating 

ourselves from our competitors” (Buhalis, Dimitriosi, 2000). 


Mills 

Some hotels have less flexibility as their infrastructures cannot enable strategy, 

connectivity, and new opportunities. The costs become problematic for the value chain; hotels 

must look for new ways to exploit IT. It is suggested that a convergence of portable devices, 

common appliances, computer hardware, software, telecommunications, media, and content are 

bringing about new and exciting capabilities. Carlson’s Scott Heintzeman says that this requires 

new ways of thinking, such as, more integrated or cross-functional thinking, which will be 

essential in launching e-business solutions. Dan Rothfeld and Brad Douglas, both vice-presidents 

at Choice Hotels International, shared innovative approaches utilized by Choice for web-based 

purchasing; Mike Clouser, founder of iLodging.com, discussed innovative web-based 

applications for marketing, procurement, and outsourcing to support the restaurant’s chain. The 

issues associated with the Internet enforce the idea the “the customer is king” and has zero 

tolerance for errors or poor service delivery. The issues prior to 2000 and those that survived 

Y2K are long forgotten, but issues surrounding the EURO still are prevalent. Guillaume Lepecq, 

Director of Corporate Relations for the Association of the Monetary Union of Europe, and Hasa 

Alemar, Senior Manager of Visa’s Euro Single Currency Unit presented challenges of how to 

afford technology and sophisticated and demanding technology needs. This conference paved the 

way for the questions and exciting times of the future in technological service; that time is here 

now. 

As we reflect on these major issues, it is apparent that the concerns in 2000 are still 

prevalent, but new obstacles are now added to the already complex problems of technology and 

the hotel guest. For example, the subject of the internet and marketing the property were 

important then and are increasingly urgent today. Auction sights and outside investors were of a 

major concern and are increasingly important in 2007. The 2000 meeting of the Roundtable 

discussed the HITIS (Hotel Industry Technology Integration Standard and how it would impact 

jobs and companies; primarily how technology initiative put forward standardize interfaces 

between systems. One participant said, “One of the concerns I would have is we’re putting 



ourselves in a little box that says this is what we can do” (Marsin, Joan. Hotel Magazine, Feb., 

2000). 

In 2003, the subject of hotels Internet, television, and hotel guests is discussed in Talking 

Technology. The hotel industry has always led the way in innovation; for example, hotels were 

the first to install gas lamps; the first to replace them with electric light; they were among the first 

to buy color televisions and to add plasma screens. Now, as guests go online, the hotel has an 

opportunity to earn revenue by charging for access to the Internet. The demand for high-speed 

internet access (HSIA) in hotel rooms presents the option for hotels to charge for access. The 

investment of hardware and software is needed to access the internet and also, to deliver online 

information to the guest TV scree. These computers do the work of finding the information, 

news, film or internet service that the guest has chosen and ultimately, put it on his bedroom TV 

screen (Caterer & Hotelkeeper, 2003). 

An American Express survey in 2004 reveals that hoteliers are getting better at providing 

decent in-room technology and business facilities. The company’s Corporate Travel Barometer 

survey shows that almost 60% of business travelers think that technology offerings in guest 

bedrooms have improved over the past 12 months. Just over half surveyed say that security in 

hotel accommodation had improved over the last year. Hans Lindh, head of hotel and restaurant 

industry at American Express said: “it is encouraging to see that hotels are working harder than 

ever to deliver better facilities to the business traveler and that they are placing greater 

importance on winning loyalty through improved service” (Caterer & Hotelkeeper, 2004). 

In 2005, video-on-demand technology became popular in hotels because of new and 

innovative technology. Historically, what was once marketed as video-on-demand was not as 

expansive as suggested. The VCR player was programmed to play 10 or 15 movies; now, hotel 

room VOD has entered the digital era. Venders such as LodgeNet Entertainment Corp. and Kool 

Connect offer products that feed movies via satellite to properties and then, to televisions in the 

individual rooms. Guests may now enjoy: a variety of content from sports and movies to high- 


Mills 

definition; a scalable solution that will grow and expand with hotel needs; customizability to 

create a personalized viewing experience for your guest; quality services that delivers the highest 

quality signal, security, and. stability from an experienced provider. As the year 2005 emerged, 

so did an innovative technology for hotel guests (H & MM, Guestroom Connectivity, 2005). 

Technology’s pivotal role in improving business is more than a necessary cost of doing 

business in today’s market. Many owners and operators acknowledge that there are inherent risks 

in making significant technology investments because it is a moving target. This applies to the 

“back of the house” with an effort to achieve a seamless, converged platform of operation. Many 

of the advancements are guest driven, such as the flat screen televisions, video-on-demand and 

self service kiosks. However, the decision to incorporate these innovations is ultimately made by 

the brands. Higher end properties and a more refined customer initiates the changes made within 

the industry (Hotel Business, 2007). 

According to Hotels special report, Smith Travel Research and Price-Waterhouse 

Coopers, the demand slowdown that started in 2006 will carry over into this year. This 

phenomenon was discussed by Jan Willem Den Ridder, Marriott International;’s London based 

regional vice president says that Marriott projects average RevPAR gains of 6% to 8%; Mark 

Wells, InterContinental Hotels Group’s HG senior vice president of brand management, foresees 

decent performance for 2007, not as good as 2006, but still good by most standards. Den Ridder 

shares this optimism: “Supply is slow to come to market in the luxury and full-service categories. 

So, these sectors should do well as demand increases” (Scoviak, 2007). 

Hard-working, full-service hotels with abundant meeting space could be among 2007’s 

winners. Another feature that is gaining popularity is “Go Green” which influences many 

environmentally sensitive customers. Going green will have a marketing bonus that crosses from 

the leisure to the urban segments, says Benjamin Graves, president, Minneapolis-based Graves 

Hotels Resorts. Health issues in food and beverage and spas are the new initiatives for managers 

and guests. The next major topic for yield managers will be distribution costs, using all in 



booking cost alongside revenue production to get at the true profitability of a reservation. Online 

initiatives will be placing more emphasis on a one-to-one customer approach (Scoviak, 2007). 

New Innovations in Technology: 

High-tech hotels are the wave of the future. For example, The Hotel Valley Ho, 

Scottsdale, Az, has undergone a technology makeover. The Valley Ho built in the 1950s is an 

unassuming property that has become more competitive by going high-tech. The profile of the 

hotel guest is split between leisure and corporate including guests that are visiting Major League 

baseball training sites. The hotel’s rates are largely seasonal with the 21 studio suites ranging 

from the high- $300’s to mid-$400’s. The hotel is now equipped with a number of technological 

amenities: high speed internet is wired into each room; each standard guestroom also features 32” 

flat-screen TV’s; suites have 42” versions. All guestrooms have high-definition programming 

from LodgeNet. The hotel also has four boardrooms with flat-screen TV’s mounted to the wall. 

All of these features are examples of how new technology helps keep smaller venues competitive 

and in the game (Hotel Business, 2006). 

Innovations in Technology for the Hotel Guest: 

LodgeNet claims to be “always on” providing unsurpassed picture and sound in an easy- 

to-use guestroom HDTV solution. This is one entertainment claim that is expressed by various 

properties. In addition to the connectiveness of a media outlet, there are other concerns for the 

hotel guest. The bathroom is considered to be essential for overall comfort. The round Bacino 

washbasid allows a great deal of scope when designing a bathrooms’s washing area. Less space is 

needed and the surface is free for other amenities. The shape of the tub is essential for overall 

comfort. All of these features are only part of the complex issues addressed by hoteliers and 

managers. One thing that has become apparent is the dramatic change that has taken place 

through digital media; the mainstreaming of digital media might represent hoteliers’ next great 

challenge. 


Mills 

Hoteliers try to appeal to technological demands of travelers with centralized multimedia 

panels. Marriott International in particular is making a big marketing push over its new plug in 

panels, nicknamed “Jack Packs” (hotel magazine, June 2007). The Jack Packs give guests some 

ideas about how to take advantage of all they have to offer. The panels are to be installed in most 

U. S. and Canada Marriott hotels by the end of this year. The LG manufactured desktop panels, 

which are integrated with the brands’ new standard 32-inch LCD high-definition televisions, 

feature outlets for AC power, Ethernet, audio, video, S-video, PC video, digital video, high- 

definition interface and even a standard phone jack. Guests can use the inputs to surf the Internet 

using the TVs as either monitors, and especially handy development for users of Slingbox and 

other streaming media. Content from portable DVD players and video game consoles can be 

displayed easily on the TV, as can digital cameras and camcorders. Digital music can also be 

played through connected 25-watt speakers (Kirby, Adam. Hotel Magazine, June 2007). 

Luxurious lodgings are not only established by the plush surroundings of a room along 

with fluffy pillows and bedding. Casino properties lure business travelers, conventioneers and 

high-end vacationers with seductively high-tech amenities. “Building a megaresort requires a 

long-term commitment to infrastructure” said Peter Finamore, vice president of hospitality at the 

Borgata Hotel Casino & Spa (Solutions, 2007). Guests can specify at checkin specifications such 

as room termperature or type of music played. The technology infrastructure will include 

Category 5 cabling, which can provide high-speed Internet, high-definition TV and telephone 

service over a single broadband connection. Other enhancements being considered are Slingbox 

type technology that can provide TV and radio channels from any city, and layered marketing 

information that can welcome guests by name and provide digital high-definition videos about 

restaurants, entertainment or slot machines based on the customer’s known preferences. 

Guestroom 2010 was produced by Hospitality Financial and Technology Professionals 

(HFTP) The following information is taken from the brochure for Guestroom 2010. 



Most people define technology in terms of computers and electronic devices, but in fact, 

technology reaches beyond the well known concepts when applied to a hotel environment. The 

American Heritage Science Dictionary defines technology as any use of scientific knowledge to 

solve practical problems. Guestroom 2010 was conceived by Hospitality Financial and 

Technology Professionals (2007) and debuted at Hospitality Industry Technology Exposition and 

Conference (HITEC) 2006 in Minneapolis, Minnesota. This exhibit was devised by the HITEC 

Advisory Council, and the board believed its validity because of their goal to be the global source 

of information for hospitality finance and technology. 

The exclusive sponsor of the initial guestroom was IBM who continues their sponsorship 

in 2007. The 2007 display will include updates of the 2006 guestroom. Each product in the 

exhibit has been carefully chosen to represent technology innovations in design, function, 

usability, energy efficiency or products reflecting a wide range of technology from “green” to 

electronics to nanotechnology. Exhibition space was added after increased demand for the new 

Guestroom 2010 initiative, which will include a 90 ft. x 40 ft. pavilion featuring some of the latest 

and near future technologies. 

The focus on the guestroom of the future begs the question of whether hoteliers can 

accurately predict what is coming in the future as far as technology, and whether it is possible to 

prepare for it. 

The Hotel Technology Next Generation (HTNG) In-Room Technology Work group sees 

a converged Internet Protocol network as the center for the guestroom of the future. “A 

converged network based on open standards is the best bet to make additional technology 

purchases even more interoperable,” reads that group’s white paper titled Convergence: Hotel 

Technology for Today and Tomorrow. Hotel 1000 heeded that advice; the hotel will feature a 

fully converged IP with integrated technology offerings in guestrooms. This includes: wired and 

wireless high-speed Internet access, VoIP touchscreen color-display telephones, 40 inch LCD 

monitors for unified messaging. MTM Luxury Lodging worked within the parameters defined by 


Mills 

HTNG by bringing together forward looking technology vendors to cooperate in constructing the 

fully integrated system (Gale, Derek. Hotel Magazine, June 2006). 

A tour of Guestroom 2010 begins with the room layout. The overall room is uniquely 

designed to give the guests well-designed space that allows them to interact with the room 

seamlessly. This footprint contains some unusual living areas. For example, the frequent traveler 

group indicated they did not like the hotel delivery staff passing by their bathroom when they 

entered the room. The guestroom 2010 features the bathroom in the back of the space. Frequent 

travelers also expressed that they preferred natural light in the bathroom; the bathroom now has 

large windows with Polytronix Inc.’s Switchable Privacy Glass. Also, the LUX-UDA mirage 

system found in the entryway window demonstrates a decorative alternative to this feature. 

Also in the entryway, a number of current technologies in innovative ways to solve 

common hotel issues are utilized. First, RIFD technology is used to alert room service staff of 

empty food trays which may clutter the hallway. Axxess Industries, Inc.Empty-Food-Tray 

Detection System has trays equipped with special transmitters that communicate with a small 

receiver located right under the room number on the door. Also, in the doorway is the First View 

Security, Inc.’s Digital Door Viewer; This easy to install flat-screen monitor and digital camera 

helps the guest see instantly who is at the door and also, in the surrounding hallway. 

While HD flatscreeen TVs are found in many hotel rooms, providing sound to match the 

screen is sometimes difficult. Phillips Soundbar DVD Hotel Theater offers a great solution to 

this problem providing surround sound in one unit. When used with its HDTV Pro: Idiom Flat 

Screen with its own stable of technologies to please the guest, the combination reduces power 

consumption by 30 percent. 

Refreshments, primarily a cup of coffee is important to the whole room ambiance; 

Melitta’s Smart Mill & Brew Coffeemaker grinds whole beans, providing a fresher cup of coffee; 

there are displays with up-to-the-minute weather forecasts transmitted by an MSNBC FM signal 

to the display on the screen, helping you prepare for the coming day 



Minibar System’s Smartcube Minibar provides refreshments any time of the day within 

the guestroom. The fully automated unit helps the hotel manage inventory while keeping a 

guest’s favorites in stock. This includes the special pricing during happy hour. 

While green products have become popular, incorporating them into energy and water 

saving items can also help the property’s bottom line. Andis Company Quiet Ionic Lighted Hair 

Dryer dries hair more quickly by breaking up water molecules. Water saving technologies 

include Sharper Image’s Oxygenics Resort Spa Self –Pressurizing Showerhead saving up to 70 

percent water , and the Electronic Ice Bucket cools drinks without wasting water from ice. 

Another environmentally friendly features are InterfaceFlor’s Recyclable Modular Carpet which 

is made of corn-based polymers and is treated with stain inhibitors. Not only is the carpet made 

from recycled material, but when it wears out, the hotel can pull up the carpet and send it back to 

the company to recycle into new carpet. 

CONCLUSION 

This paper explores the changes in technology and the guest room. The 

interconnectiveness of the guest and management is evident as guests’ demands dictate 

managements’ choices in providing comfort and necessity. The hotel guests’ complaints and 

needs have driven the industry’s choices in technological advancement. The growth of the 

industry is demonstrated in the rapid expansion of the Internet and other communication devices. 

It is of particular interest that technology has moved from the flat screen TV to the front door and 

the bathroom. All of these devices are cost effective as new developments bring guests to the 

property. 

REFERENCES 

Buhalis, Dimitrios (2000). “Major Trends and IT Issues Facing the Hospitality Industry in the 

new Economy: a Review of the 5 th Annual Pan –Wuropean Hospitality Technology 

Exhibition and Conference (EURHOTEC 2000). John Wiley & sons, Ltd. 


Mills 

Caterer & Hotelkeeper. (2003). Vol. 192 Issue 4294, p.88. Reed business Information UK, Ltd. 

A division of Reed Elsevier, Inc. 

Caterer & Hotelkeeper (2004). Vol. 193 Issue 4322, p10-10, 1/8p. Reed Business Information 

UK, Ltd., a division of Reed Elsevier, Inc. 

Gale, Derek(2006). Hotels Magazine June 2006. “HITEC 2000: Spotlight On The Guestroom 

Of The Future.” www.hotelsmag.com 

Guestroom 2010. Hospitality Financial and Technology Professionals. 2006 Minneapolis, MN. 

Hotel Business (2005). HITEC Coverage. July 21-August 6, 2005. 

HotelBusiness (2006). “Hotel Valley Ho Unergoes A Technology Makeover.” March 21-April 6, 

2006. www.hotelbusiness.com 

HotelBusiness (2007). “Technology Challenges.” www.hotelsbusiness.com. 

H&MM (2005). “Guestroom Connectivity” July 18, 2005. HotelMotel.com 

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AN HISTORICAL PERSPECTIVE OF 

ACCOUNTING FOR INCOME TAXES FROM 1920 

THROUGH 1984 

Myers, Joan K. 

Le Moyne College 

myersjk@lemoyne.edu 

Collins, Mary K. 

Le Moyne College 

collinsm@lemoyne.edu 

ABSTRACT 

In this paper, the literature is reviewed to chronicle the development of accounting for income 

taxes from 1920 through 1984. The reporting of income taxes has been a controversial topic 

since the advent of taxation. This paper follows the evolution of reporting from the early taxation 

years through APB 11 and the post-APB 11 environment. Specifically, opinions from both 

theoreticians and practitioners are cited as the standards are developed. 

INTRODUCTION 

The purpose of this paper is to chronicle the regulatory and standard setting environm ent that 

influenced accounting for income taxes fro m 1920 through 198 4. A historical review of the 

literature encompassed not only regulatory and promulgated standards regarding accounting for 

income taxes, but also the oretical articl es and the articles by pra ctitioners. Political pressures 

voiced by the practitioner co mmunity that im pacted the standard setting environm ent are 

highlighted. 

THE EARLY YEARS (1920 – 1967) 

How should income taxes be reported? That question is almost as old as the first laws instituting 

a Federal Income Tax. Ini tially, income taxes were regarded as a distribution of profits. Special 

Bulletin No. 1, January 1920, of the American Inst itute of Acco untants stated, “It is apparently 

the theory of the governm ent that it is t aking part of the profits, t hat it is asking the taxpa yer to 

share his profits with the governm ent. These taxes, therefore, are not ordinary expenses, such as 

would be deducted as a matter of course determ ining t he prof its in which the manager of the 

company would share,” ( Winborne and Kleespie, 1966). In 1936, the American Institu te of 

Accountants, in its publication, “Examination of F inancial Statements,” then perm itted income 

taxes to be shown as “other charges.” In that same year, the American Ac counting Association 

(AAA) cla ssified inco me t axes as an operating e xpense. The AAA subsequently changed thi s 

perspective in 1941, statin g that tax was not in the nature of an operating expense and should be 

shown on the income statement only in the amount currently payable. 


Myers and Collins 

The topic of income taxes gained im portance in the World War II era bec ause of an increa se in 

the marginal corporate tax rate fro m 19% to 38% (Schultz and Johnson, 1998). The Security and 

Exchange Commission’ s (SEC) Regulation S-X, passed in 1940, held that the provision for 

income taxe s was to be r eported as th e last ite m before net inc ome. Accounting Resear ch 

Bulletin (ARB) No. 18 “Unam ortized Discount and Redem ption Premium on Bonds Refunded 

(Supplement)” first intro duced the concepts of interperiod and intraperio d tax allocation 

(Rayburn, 1986). Previously, two m ethods of accounting for discounts and premiums on b onds 

refunded were accepted: (1) imm ediate write-off to i ncome or retained earnings, and (2) 

amortization over the life of the bonds. The p urpose of ARB 18 was the resolution o f the 

distortion of incom e that could result from i mmediate write-off of t he dis count t o retained 

earnings. ARB 18 held that the charge to retain ed earnings should be net of taxes and that the 

reduction in current taxes from the refunding of the bonds should be charged to income. Rayburn 

(1986) held t hat the tax-effected charg e to ear ned surplus is an early exam ple of interperiod 

allocation. T hen, in 1942, the Account ing Resear ch Study (ARS) No. 3 i ncluded taxes in the 

definition of an expense: “the decrease in net assets as a result of the use of economic services in 

the creation of revenues or of t he imposition of taxes b y g overnmental units,” (Winborne and 

Kleespie, 1966). The Committee on Accounting Pr ocedure of the AI CPA issued Accounting 

Research Bul letin (ARB) No. 23 in 1944. In this publication, inco me taxe s were de clared “an 

expense which should be allocated, when necess ary and practicable, to i ncome and other 

accounts, as other expenses are allocated.” The SEC answered ARB No. 23 b y issuing 

Accounting Series Release (ASR) No. 53 in 1945 which attacked the process of tax allocation on 

the grounds t hat it allowed equalization or norm alization of periodic incom e. Fro m this point 

until 1954, the issue lay fairly dormant. No consensus had been reached by accounting theorists, 

practitioners, or regulator y bodies regarding ho w income taxes should be classified in the 

financial statements. 

The Revenue Act of 1954 com pounded the problem by all owing t he use of accelerated 

depreciation methods for tax purposes. The di fference between book and tax i ncome could be 

quite material if alternative methods of depreci ation were elected for reporting on the finan cial 

statements as opposed to the depreciation methods used and reported on the tax return. The issue 

of whether or not to allocate th is difference, and how this diffe rence should be allocated, became 

a matter which needed resolution. As deferred ta xes appeared more frequently in t he financial 

statements, both practitioner and academic journa l articles debated how they should be handled 

(Schultz and Johnson, 1 998). Recommendations to resolve the “tim ing difference” in the 

literature were diverse. Arguments for and against interperiod tax allocation began to arise from 

theoreticians and practitioners alike. 

Moonitz (19 57) disting uished between perm anent differences and tim ing differences and 

advocated matching as th e method of resolution of for timing differences. Mateer (1965) then 

proposed the two obvious alternatives: 

1) Deduct tax as determined by the accounting income figure; 

2) Deduct only the legal tax liability. 

He stated that the motivation for tax allocation comes from the belief that the accounting concept 

of income is correct, i.e., that net income is properly determined when period revenues are related 

to period expenses. In order to support the notion that taxes should be all ocated for pr oper 

matching, it m ust be shown that taxes are an e xpense. Mateer (1965) believed that taxes were 

expenses. This argument was bas ed on the fact that taxes are pai d to perpetua te the sy stem; the 

government administers the monetary sy stem and provides an environm ent in which the 

organization can exist. 


Accounting for Income Taxes 1920-1984 

Winborne and Kleespie (1966) also supported ta x allocation based upon the m atching principle 

because income tax as an expense should be accrued when the related taxable income is realized, 

even thoug h it is not yet taxable. They su ggested that to argue otherwise was analogous to 

arguing that income should be recogni zed on the c ash basis rat her than the accrual basis. The 

going concern or continuity assumption was also used to support the argument for tax allocation 

because it assumed the entity will survive to see the reversal of the differences. 

Additionally, Masheb (1966) supported the tax allo cation alternative by concluding that deferred 

taxes are truly a liabilit y and should be classified as “other liabilities.” He suggested that the 

permanence of the account is because it is constantly “revol ving,” analogous to accounts 

receivable or accounts pay able, not because it is not reversing. L ybrand, Ross Brothers and 

Montgomery (Septem ber 1967) sup ported tax alloca tion, stating that not to require allocation 

would be calling for a “return” to the cash basis of accounting which became obsolete because “it 

does not present to stockholders a corporation’s true earnings and financial condition.” 

The final and m ost inter esting co mmentary s upporting tax allocation came fro m a financial 

analyst. Jerst on (1965) com plained that analy sts cannot easily figure the y ear-to-year change in 

the deferred tax account; t hey only derive the net change. He suggested a further breakdown of 

the income tax figures into: taxes pay able from the current year; deferred taxes from the curr ent 

year; and deferred taxes currently due or no longer applicable. In summary, the arguments during 

this time period supporting tax allocation rested primarily upon the matching principle and proper 

accrual accounting, although the going concern assumption was also mentioned. 

Arguments against interperiod allocation were pr imarily voiced by practitioners and centered on 

the idea of misleading investors. Perr y (1966) di scussed the fact that the credit balance i n the 

deferred tax account is not a true li ability. He also noted that in the case of a growing business, 

the tendenc y will be for deferred tax accounts to continue t o grow and t hus questione d the 

validity of recording a liability that is indefinitely postponed. 

Price Waterh ouse & Co. (1967) opposed record ing the tax d eferral except where boo k-tax 

differences are expected with reasonable certainty to affect the flow of corporate resources in the 

near future, i.e., partial allocation. Citing a st udy, conducted by the firm, of one hundred Fortune 

500 com panies fro m 1954 to 196 6, t hey determ ined that with respect to depreciation an d 

installment s ales, aggrega te pay backs had been minute in com parison with the charges. Price 

Waterhouse & Co. concluded that earnings and st ockholders’ equity were being reduced and a 

liability was being established for what was in esse nce a rem ote contingency. Therefore, the y 

decided that accrual of taxes when uncertainty existed as to whe n, or if am ounts would ever be 

paid, was misleading to investors. 

The Treasury Depart ment (1967), additi onally, opposed tax deferral based on t heir perspective 

that corporati ons paid far less tax in r eality than t he am ount r eported on t heir book i ncome. 

“Because the effective tax rate is less than the statutory rate, the Treasury Department believes 

that financial accounting should recognize th is – both because it is f act and because t he 

stimulative effects resulting from tax reduc tion should not be obscured,” (Journal of 

Accountancy, December 1967, pg. 8). Thus, the primary arguments against allocation were based 

upon the questionable status of the deferred ta x account as a liabilit y and the fact tha t the 

statutory rate was very rarely the am ount of tax the corporation paid. Accruing a liabilit y for an 

uncertain amount and event could prove misleading to the investor. 



THE ADVENT OF APB OPINION NO. 11 (1967) 

As has been previously discussed, since passage of the Revenue Act of 1954, there had been little 

agreement in the field of accounting regarding whether or not to accrue for book- tax ti ming 

differences. Within this context, the APB promulgated Opinion No. 11 “Accounting for Deferred 

Taxes” in 1967. The Board’ s m ajor objective in issuing this opinion was that “incom e tax 

expense should include the tax effect s of reve nue and expense transaction s included in the 

determination of pre-tax inco me” (Financial Executive, Feb ruary 19 68). Since income 

determination was the foc us of the da y, the Boar d’s main concer n at the time was to facili tate 

proper m atching. Also, APB Opinion No. 11 ’s issuance w as just prior to the Trueblood 

Committee Report which focused on providing the financial statement user (assumed not to have 

a high level of sophistication) with inf ormation for “predicting, com paring, and evaluating cash 

flows” (Accounting Standards, 1986). In summary, the APB was issued on th e strength of the 

matching principle as well as alerting financial statement users that cash flows will change due to 

timing differences in corporate book and tax return figures. 

To address these proble ms the Board re ached the fo llowing conclusions with regard to defe rred 

taxes: 

• Interperiod tax allocation is an integral part of the determination of income tax expense, 

and income tax expense should include the effects of revenue and expense transactions 

included in the determination of pre-tax accounting income. 

• Interperiod tax allocation procedures should follow the deferred method, both in the 

manner in which tax effects are initially recognized and in the manner in which deferred 

taxes are amortized in future periods. 

• Financial statement presentations of income tax expense and related deferred taxes 

should disclose: 

1. the composition of income tax expense as between amounts currently 

payable and amounts representing tax effects allocable to the period, and 

2. the classification of deferred taxes into a net current amount and a net noncurrent 

amount. 

The dissenting opinions pa ralleled the issues on whic h theorists and practitioners had previously 

disagreed. P rimarily, Board members disagreed with using com prehensive allocation instead of 

partial allocation. This was because co mprehensive allocation would have resulted in accounts 

carried as assets which had no demonstrable value and which were never expected to be reali zed. 

Also, these accounts could have been carried as l iabilities which were no m ore than mere 

contingencies and there would be corres ponding charges to income for these contingent amounts. 

They also be lieved that to require clas sification of deferred taxe s as curr ent asset s or current 

liabilities would have contributed to a lack of under standing of working capi tal because t here 

would have been a co mmingling of contingent items. Most post opinion criticisms of Opinion 

No. 11 revolved around t he same old argu ments: creation of essentially meaningless bal ance 

sheet accounts and criticism of the concept of interperiod allocation itself. 

THE ENVIRONMENT POST APB OPINION NO. 11 (1968 – 1984) 

Shortly after APB Opinion No. 11 was is sued, cri ticisms st arted to be voiced. Most of the 

disagreements with the Opinion f ollowed the di ssents in the Opinion itself. Waugh (1968) 

mentioned th at there m ight be problems in effectively im plementing t he Opinion . The main 

focus of his article, however, questioned the classification of deferred taxes as a liability. 

Payables do have a li mited life; the y do mature; they are replaced. The deferred tax 

liability may possess these qualities; it may not. Where all available evidence points to a 



continuing deferral with no foreseeable m aturity date, the roll over concept is obviously 

inapplicable. Under these conditions no measurable liability exists; none should be 

recorded….. The si mple f act that the acc ounting r eport makes no distinctio n between 

deferred tax liabilities which will have to be faced in the near future, and those which, in 

all probability, will not materialize in t he foreseeable future is n ot a useful report; it is 

misleading (Waugh, 1968, pg. 538). 

Another argument citing problems with the deferred tax account was given by Revsine (1969). In 

his article, he rebutted Hawkins’ (1968) view th at deferred taxes represent a source of funds and 

should thus be recorded, as the Board had suggested. Revsine’s (1969, p g. 357) argument was 

based on the fact that the deferred tax account arose as a consequence of im plementing the 

Board’s belief that “income tax should include the tax effects of revenue and expense transactions 

included in the deter mination of pre-tax accounting income.” He further stat ed that “this cash 

benefit materializes only when we compare a firm’s cash position after it utilizes these permissive 

regulations with its hypothetical position were it to ignore such opportunities,” (Revsine 1969, pg. 

356-7). Revsine (1969) suggested to instead credit (or debit) retained earnings, as follows: 

Dr. Income Tax Expense $ based on book income 

Cr. Income Taxes Payable $ actual liability 

Cr. Retained Earnings $ the difference 

This, Revsine felt, gave the desired inco me statement effect without introducing an “esoteric and 

inexplicable” balance sheet account. It treate d the deferred tax accrual entry p urely as a 

reclassification. The prob lem that could have arisen if Revsine’s suggestion was followed is 

similar to wh at began to happen to the deferred tax account in reality : the account was buil ding 

up. If it n ever reversed out , woul dn’t stockh olders’ equit y be buil ding without ade quate 

justification? 

The early practitioner-oriented articles also echoe d the “it ’s not a liabilit y” sentiment. For 

instance, even though Hawkins (1968) supported APB Opinion No. 11, he criticized the fact that 

deferred tax item s were not liabilities in the conve ntional sense. There was no legal liability to 

pay as the government’s claim for taxes extended only to th ose on a company’s tax return. He 

further predicted that APB Opinion No. 11 woul d not put an end to the deferred tax accounting 

controversy due to this failure to adequately deal with the nature of deferrals. 

Simonetti (1 968) and a commentary published in the Financial Executives Institute (January 

1968) suggested the APB defer action on Opini on No. 11 f or further study . Reasons mentioned 

were the questionable validity of interperiod allocation, the practical difficulties of implementing 

it, its possible effects on the econom y, and the belief that book-tax differences arose because tax 

reductions were in eff ect subsidies to various types of businesse s or clas ses of individuals to 

stimulate investments (which questions the nature of taxes as an expense of doing business). 

However, not all were opposed to APB Opinion 11. Savoie (1968), for instance, supported the 

APB in their efforts “to i mprove re porting standards and narrow area s of difference and 

inconsistency in accountin g practices,” (Savoie, 1968, pg. 38). He also pointed to the scenario 

that may be closer to the heart of the issue, especially as it related to standard setting. He 

mentioned the governm ent’s im portant role in accounting regula tion and how the SEC was a 

strong suppo rter of APB Opinion 11 . Also, Savoie (1968) indi cated that th e establish ment of 

accounting principles did not have to be undertaken by the profession, but it would be far superior 

to having the government do it. 



Perhaps the APB was in too much of a hurry, and left the classification of the resulting deferred 

tax account arising from the journal entry which achieves their matching objective, not 

sufficiently resolved? Whatever the reason, the FASB later went back to “put out the fire,” so to 

speak, and published FAS 37 (Accounting Standards, 1986) in December 1980 in order to clarify 

its position on the classification of deferred taxes on the balance sheet. FAS 37 (Accounting 

Standards, 1986) stated that “deferred income taxes related to an asset or liability are classified 

the same as the related asset or liability. Deferred income taxes that are not related to an asset or 

liability are classified according to the expected reversal date of the timing difference,” 

(Accounting Standards, 1986). Clarification, however, was not enough. The Opinion still 

received criticism. Questions like “How much deferred taxes, if any, should be recognized?” 

were still alive and well. Thus, the FASB issued a Discussion Memorandum in 1983 on 

accounting for income taxes (Financial Executive, November 1983). 

The 1983 Di scussion Memorandum on accounting for income taxes opened t he floodgates for a 

resurgence of literature on the topic. However now, the Conceptual Framework project was out 

and/or well under way, providing a basis for theoretical comparison which did not exist in such a 

well-developed form in 1 967. Addi tionally, b y 1 983, a large num ber of financial statements 

issued under APB No. 1 1 existed, thus providi ng a data base of inform ation to exam ine and 

thereby determine the behavior of the deferred tax account. Public hearings and special meetings 

were held in April and May of 1984 to discuss th e topic with preparers and users of financial 

statements, as well as auditors (Rayburn, 1986). 

Most of the literature opposed the ex isting method of accounting for income t axes. Those 

looking at the behavior of the account found that it was not reversing out as the APB had thought 

it would. In their study, Davidson, Rasch and Weil (1984) found that in less than 3% of the cases 

in which ther e was an entry in the deferred tax acco unt, did the entr y result from a reversal of 

depreciation timing differences. 

Reversals of depreciation tim ing differences occu r if the co mpany fails to acquire 

depreciable assets in dollar am ounts equal to acquisitions in previous years…This 

effectively means that reversals of depreciation timing differences occur only when there 

is a decrease in the gross plant account…Even when there is a decrease in the gross plant 

account leading to a decrease in the d eferred tax account balance, taxes will beco me 

payable only if there is taxable incom e in that year. No taxes are paid in m any cases in 

which plant acquisitions are declining b ecause the com pany is no longer profitable 

(Davidson, Rasch and Weil, 1984, pp. 138 - 140). 

Yet, the deferred tax account had been building up year after year becoming a material amount in 

the liabilities section of corporate balance shee ts. For instance, Co mbustion Engineering and 

Grumman each had deferred taxes of about $200 million in 1984 (Andresky, 1984). Volkan and 

Rue (1985) also illustrated how the deferred tax account can grow over tim e. The y concluded 

that “the resulting deferred tax liability will not be paid unless the company, (as illustrated in their 

example), fails to replace a machine as it is worn out” (Volkan and Rue, 1985, pg. 32). However, 

if the company is expanding it will need to add more machines, which will increase the deferred 

tax liability. Even if the co mpany decided to hold its capacity stable, it would need to acquire 

new machines as the old ones wear out. The new machines would most likely be more expensive 

and would lead to a further increase in the deferre d tax liability. The authors concluded that the 

deferred tax account does not provide useful information and that one of the major short comings 

of APB Opinion No. 11 had been the large accumulation in the deferred tax account. 



Another point of controversy has been whether or not the deferred tax account fits the definition 

of a liability. This was argued in the early litera ture and remains a point of disagreement. Smith 

(1984) pointed out that deferred taxes barely even fit the criteria of FAS No. 5 for a conting ency, 

yet it was being accrued as a full-fledge d liability. Recall that before a loss contingency could be 

recorded it m ust be: 1) probable and 2) reasonably estim ated. Sm ith (1985) argued th at the 

comprehensive tax allocation ap proach is neither and suggested that, at best, retained earnings 

might be appropriate. 

Other authors used the Conceptual Fra mework to argue the deferred tax issue; Rosenfield and 

Dent (1983) argued against it, Defliese (Defliese, Rosenfield and Dent, 1983) and Wyatt, Dieter 

and Stewart (1984) sup ported the opinion. Wy att, Dieter and Stewart (1984) first discussed the 

need for comprehensive allocation based on Concept Statement No. 1. 

The FASB has concluded in SFAC No. 1 that the primary focus of financial reporting is 

information about earnin gs and its com ponents; and that inf ormation abou t earnings 

based on accrual accounti ng generally provid es a better indicat ion of an enterprise’ s 

present and c ontinuing ability to generate favorable cash flows than information lim ited 

to the financial effects of cash receipts and payments. We believe the “no allocation” and 

partial tax allocation approaches are not b ased on sound prem ises, often produce results 

that are not meaningful, and result in mis matching of benefits and costs (Wyatt, Dieter 

and Stewart, 1984, p. 1). 

They also us ed SFAC No . 3’s definiti on of liab ilities to justify recording deferred taxes as a 

liability. 

Deferred taxes payable for this type of timing difference meet the definition of a liability. 

Their extinction will i nvolve a future s acrifice of econom ic benefits as a result of past 

transactions or events. T he past trans actions or ev ents are those that gener ated pre-tax 

accounting income (Wyatt, Dieter and Stewart, 1984, p. 16). 

Rosenfield and Dent (Def liese, Rosenfi eld and De nt, 1983) took issue with whether or not the 

obligation ha s already be en incurred. The y re iterated the FASB’s definition of a liabili ty as 

“probable future sacrifices of econom ic benefits arising from present obligations of a particular 

entity to transfer assets or provide services to other entities in the future as a result of past 

transactions or events” (SFAC No. 3 , par. 28, in Rosenfield and Dent, 1983, p. 4 7). This 

definition basically stipulates three criteria for a liability: 

1.) Probable future sacrifice; 

2.) Obligation to another entity; 

3.) Obligation has already been incurred. 

Rosenfield and Dent (19 83) concurred that the firs t two have been satisfied, but argued tha t the 

last criterion had not been fulfilled. The third cr iterion results from the stat ements that it is a 

“present obligation” that is “a result of past trans actions or events.” The authors stated tha t this 

requires “the obligation to be a result so lely of past events and not to be a r esult of future events, 

alone or in conjunction with past events,” (Rosenfield and Dent, 1983, p. 47). The reasoning they 

gave for deferred taxes not to fit this criterion was as follows: 

Taxable revenue would h ave to be earned in the f uture for the en terprise to have an 

obligation for income taxes that would appear in its future income tax returns. Earning 

the future revenue wouldn’t be m erely ancillary to the obligation. The obligation for all 



of the future income taxes would be a result of earning the taxabl e revenue in the future, 

in conjunction with the past events. The th ird criterion, that the obligation for future 

income taxe s must not be a r esult of f uture events, alone or in conjunction with past 

events, wouldn’t be met (Rosenfield and Dent, 1983, p. 50). 

On this basis, Rosenfield and Dent (Rosenfi eld and Dent, 19 83) supp orted elim inating APB 

Opinion No. 11 from GAAP. 

In summary, the responses to t he discussion memorandum showed that t he ghosts of discontent 

surrounding the income tax issue had not been laid to rest. This was the FASB’s chance to clarify 

this hotly debated issue, but, alas, they did not. In 1984, the FASB “decided tha t things are best 

left alone” (Gleick, 1984). What appears to have happened is that the FASB received many 

negative comments from corporate officials. 

Many corpor ate officials were reluctan t to give their inco me figures this boost. They 

prefer to use conservative esti mates in case they cannot continue to purchase new as sets, 

or depreciation laws change. After listen ing to such negative co mments, the board 

moved recently to retain the old method of accounting for deferred tax liabilities (Gleick, 

1984, p. 119). 

The FASB obviously was swayed more by public pressure than by normative accounting theory. 

Businesses are obviously more concerned with how difficult a standard is to i mplement and how 

it will make them look in co mparison to other companies, rather than wh ether or not the 

presentation in the statem ent is a fair reflection of their position. They were com fortable with 

deferred taxes. 

“We’ve lived with deferred taxes for 16 y ears, we understand them now and we don’t 

want drastic revisions”, say s Eugene Flegm , dep uty assistant com ptroller at General 

Motors. “Businesses don’t like to keep changing the size of the playing field” (Andresky, 

1984, p. 206). 

CONCLUSION 

Regardless of how corporate officials felt about the deferred tax issue and how change would 

impact their organization, it was apparent that the deferred tax account was growing to a material 

amount on many balance sheets. If the account was not reversing out as originally thought, 

because of both larger and larger purchases of group assets and changes in tax rates by the time 

any of the account did reverse, then something needed to change. The FASB, realizing the 

complexities still requiring resolution, replaced APB Opinion No. 11 with SFAS 96 in 1987. 

Delayed three times from implementation, SFAS 96 was replaced in 1992 by SFAS 109. But the 

standard setting environment and political pressures surrounding these pronouncements is but 

another story yet to be told. 

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(Trueblood Committee) (1973). Study Group on the Objectives of Financial Statements Report. 

American Institute of Certified Public Accountants. 

Volkan, Ara G. and Joseph C. Rue (1985). "The Case against Deferred Taxes." Management 

Accounting, March, 30-35. 

Waugh, James B. (1968). "The Interperiod Allocation of Corporate Income Taxes: A Proposal." 

The Accounting Review, July, 535-39. 

Winborne, Marilynn G. and Dee L. Kleespie (1966). "Tax Allocation in Perspective." The 

Accounting Review, October, 737-44. 

Wyatt, Arthur R.; Richard Dieter and John E. Stewart (1984). "Tax Allocation Revisited." The 

CPA Journal, March, 10-18. 


SUSTAINABLE GROWTH MODELING: A 

LONGITUDINAL ANALYSIS OF HARLEY- 

DAVIDSON, INC. 

Pickett, Michael C. 

National University 

mpickett@nu.edu 

ABSTRACT 

This paper presents an application of sustainable growth modeling presented by Van Horne. Van 

Horne (1998) has defined sustainable growth rate (SGR) as “...the maximum annual percentage 

increase in sales that can be achieved based on target operating, debt, and dividend-payout 

ratios” (p. 744). 

Harley-Davidson vice-president, Willie G. Davidson, in a Business Week magazine 

(Melcher, 1996) stated that, given the significant and unexpected increases in sales over the last 

few quarters, they plan to ship 200,000 motorcycles in the year 2003. However, this paper 

presents a dichotomy based on the company’s financial performance prior to the article’s 

publication and the articulated goals to provide a possible insight to the magic and mystique of a 

competitive marketing advantage. 

Historical financial date is analyzed to identify the subtle relationship between strategic 

marketing and maximizing operating efficiencies. 

INTRODUCTION 

According to Van Horne (1998, p. 743), “[t]he management of growth requires careful balancing 

of the sales objectives of the firm with its operating efficiency and financial resources”. 

Additionally, Van Horne (1998) argues the “...trick is to determine what sales growth rate is 

constant with the realities of the company and of the financial marketplace” (p. 743). The 

“realities” Van Horne mentions, according to H. Igor Ansoff, from a strategic management 

perspective can be calculated, in contrast, Henry Mintzberg argued that organizations are unable 

to calculate turbulent cycles (Academy of Management, 1998). Regardless, financial managers 

still need to identify opportunities to forecast growth potential of a company. 

The purpose of this paper is comparative and longitudinal in nature. A financial analysis 

technique known as sustainable growth modeling (Van Horne, 1998) will be applied to Harley- 

Davidson, Inc. Initially this methodology was proposed as a “litmus test” to identify if the 

specific target proposed by the company of an output goal of 200,000 motorcycles by 2003 was a 

feasible endeavor; however, when applied over a period of 10 years, the sustainable growth rate 

model provides greater insights into the mystique of the American-made motorcycle created by 

four men in 1903. 

BACKGROUND 

Harley-Davidson, Inc, as the focus of this research, exists as an American producer in a 

seemingly never-ending sea of imports. The focus on growth within a specific market espouses 

concepts from two very distinct, yet related areas in literature; financial growth and marketing. 

GROWTH MODELS 


Pickett 

From a macro-perspective, Bueler (1993) argues that a sustainable society must meet certain 

“...ecological and political requirements” (p. 322) and also sees our current growth model in the 

United States, i.e., perpetual growth, as being replaced by one of sustainable growth. The 

differentiation between “perpetual” and “sustainable” is explained as “... [perpetual] growth...is 

seen as essential to the solution of our economic problems” (p.322), whereas sustainable growth 

“stresses limits and equality” (p. 334). In other words, the former identifying a limitless potential 

and the later describing and organization’s boundaries encountered through the environment or 

competition. 

Matsuyama (1999) argues that there are two views of growth, “...one based on factor 

accumulation and the other on innovation” (p. 335). The factor accumulation model is referred to 

as neoclassical whereas the innovation model is referred to as the neo-Schumpetarian model. 

Interestingly enough, Matsuyama’s research found the following: 

It is shown, under an empirically plausible condition that the balanced growth 

path is unstable and the economy achieves sustainable growth through cycles, 

perpetually moving back and forth between two phases. In one phase, when 

output and investment grow faster, there is no innovation and the market 

structure is competitive, as in the neoclassical model. In the other phase, when 

growth rates of output and investment are lower, innovation takes place, and the 

market structure is more monopolistic, as in the neo-Schumpetarian model. 

(p.335) 

Essentially, Matsuyama (1999) found the overall “...economy grows faster along the 

cycles than along the (unstable) balanced growth path, [and] both investment and innovation is 

essential in sustaining growth indefinitely” (p. 335). 

From a different perspective, Eicher and Turnovsky (1999) researched scaled and nonscaled 

growth models and found that long-run “...scaled growth rate is responsive to the 

economy” (p. 413), whereas, non-scaled growth is obtained depending on three separate 

conditions (p. 413): 

1. No restriction on production function, but requires constant returns to scale on all 

factors 

2. When two sectors grow at differential constant rates and, 

3. Where two production functions are separable and homogeneous 

In other words, much like industry indicators have implications for determining a 

company’s level of financial distress (Whitaker, 1999); overall growth of a specific market or 

sector has an effect of non-scale growth whereas the overall economy has the determining factual 

effect on scaled growth for a particular company. 

Van Horne (1998) has defined sustainable growth rate (SGR) as “...the maximum annual 

percentage increase in sales that can be achieved based on target operating, debt, and dividendpayout 

ratios” (p. 744). Given this definition, a company can determine if their projected sales are 

a realistic goal. Additionally, Van Horne (1998) provides two models for determining SGR, one 

that represents a steady state and a model that takes changing assumptions into consideration. 

MARKET ORIENTATION 

Jaworski, Kohli and Sahay (2000) discuss the differences between a company being marketdriven 

and a company driving markets. The former referring to a company that understands and 

reacts to the preferences of the consumer while the later influences the structure and behaviors in 

the respective market. 


Growth …Analysis of Harley-Davidson 

Being aware of one’s market strategy, competition, customer preferences and overall 

market orientation, Webster (2000) studied the relationships between brands, consumers and 

retailers. Webster (2000) found that there is a definite tradeoff in brand pricing strategies, where 

consumers may relate lowering prices to lower value, however in some cases, Webster (2000) 

found that a “...higher price may actually provide higher utility for the consumer” (p. 17). 

Taking into consideration the implications and convolutions of the overall economic 

environment, growth modeling, market orientation, and the relationships between one’s product 

and one’s consumers, companies must develop relationships with their consumers that will 

maximize perceived value. Value in this respect may not always equate to value in pricing alone; 

but the overall “value” provided by the manufacturer and retailer working as partners. 

Lastly, when a product’s value is determined by the above criteria, driving a competitive 

market with higher pricing strategies, while gaining market share, is a competitive advantage that 

cannot be easily replicated by competitors. 

BACKGROUND TO RESEARCH PROBLEM 

Harley-Davidson began in 1903 in a small shack that still stands within the grounds of the main 

plant. Through the years, Harley-Davidson has had its share of ups and downs however, over the 

past 10 years the company has enjoyed increasing returns and record profits. 

Harley-Davidson, in a recent magazine review stated that, given the significant and 

unexpected increases in sales over the last few quarters, they plan to ship 200,000 motorcycles in 

the year 2003. 

RESEARCH PROBLEM 

Given the unexpected increases in profits recently, in spite of market-share increases, can Harley- 

Davidson, in fact, achieve the stated goal based on Van Horne’s (1998) steady-state SGR model? 

METHODS 

The data that will be utilized is the Harley-Davidson 1998 Annual Report and the 1999 Quarterly 

Income Statement and Balance Sheets which were downloaded from the Harley-Davidson 

website. 

FORMULA AND CALCULATION 

From the Harley-Davidson financial reports, the researcher will apply Van Horne’s (1998) 

steady-state SGR model to the relevant variables to provide an answer the research question. 

VARIABLES. The first four variables that are used in Van Horne’s (1998, p. 744) model 

are termed “target variables” (p. 744). Target variables are considered to be the financial ratios 

that, when calculated, provide a snapshot of a company’s financial situation. However, they are 

industry specific and care must be taken not to compare apples and oranges. The sustained growth 

model employs the following variables: 

1. A/S = the total assets-to-sales ratio 

2. NP/S = net profit margin (net sales divided by sales) 

3. b = retention rate earnings (1-b is divided by the dividend-payout ratio) 

4. D/Eq. = debt-to-equity ratio 

5. So = most recent annual sales (beginning sales) 

6. ∆S = absolute change in sales from the most recent annual sales 

Given the above variables, the formula that will be applied appears as: 


Pickett 

⎛ A ⎞ ⎛ NP ⎞ ⎡ ⎛ NP ⎞ ⎤ D 

∆ S⎜ ⎟ = b⎜ 

⎟( 

So 

+ ∆S 

) + b ( So 

S ) 

S S 

⎢ ⎜ ⎟ + ∆ 

S 

⎥ 

⎝ ⎠ ⎝ ⎠ ⎣ ⎝ ⎠ ⎦ Eq. 

-or- 

⎛ NP ⎞⎛ 

D ⎞ 

b⎜ 

⎟⎜1+ 

⎟ 

∆S 

⎝ S ⎠⎝ 

Eq. 

orSGR= 

⎠ 

So 

⎛ A ⎞ ⎡ ⎛ NP ⎞⎛ 

D ⎞⎤ 

⎜ ⎟ − ⎢b⎜ 

⎟⎜1+ 

⎟⎥ 

⎝ S ⎠ ⎣ ⎝ S ⎠⎝ 

Eq. 

⎠⎦ 

Figure 1. Steady-State Sustainable Growth Model. 

Source: Van Horne, J. (1998, p.745). 

DATA UTILIZED. The data that was utilized for this research is as follows: 

1. A/S = 1,920,209/2,063,956 

2. NP/S = 213,500/2,063,956 

3. b = .885 

4. D/Eq. = 440,887/1,029,911 

5. So = 2,063,956 

6. ∆S = 301,387 

MOTORCYCLE SHIPMENTS. The 10 years of motorcycle shipments from 1988 to 

1998 are displayed in Table 1. As can be seen, the growth rates range from a low of 6% in 1990 

to 17% in the years 1989 and 1994. Table 2 displays a forecast of what the shipment rates should 

be to achieve the 200,000 goal by the year 2003. 

Table 1. Actual Motorcycle Shipments. 

Year 88 89 90 91 92 93 94 95 96 97 98 

Shipments 50517 58925 62458 68626 76495 81696 95811 105104 118771 132285 150818 

% Change 0.17 0.06 0.10 0.11 0.07 0.17 0.10 0.13 0.11 0.14 

Source: Harley-Davidson, Inc. (1999). 

Table 2. Motorcycle Shipments Based on Projected Sales. 

Year 99 00 01 02 03 

Shipments 160654 170491 180327 190164 200000 

% Change 0.07 0.06 0.06 0.05 0.05 

RESULTS AND DISCUSSION 

The results from the steady-state SGR model consisting of the asset increase component of the 

model (∆S/So) calculated to 14% while the retained earnings and increase in debt component 

calculated to 16%. These values are significantly higher than the forecasted growth strategy 

(Table 2) that looks toward an average of approximately 6% growth rate. 

According to Van Horne (1998), “...the management of growth requires careful balancing 

of the sales objectives of the firm with its operating efficiency and financial resources” (p. 743). It 

overwhelmingly appears that Harley-Davidson is under estimating their sales potential not only 

based on the sustained growth modeling calculations presented by Van Horne (1998), but also 

with naïve forecasting sales strategies based on previous sales. 


Growth …Analysis of Harley-Davidson 

POST 100 TH ANNIVERSARY 

In 2003, Harley-Davidson celebrated its 100 th anniversary. How did the company perform in the 

subsequent years? 

Table 3. Actual Motorcycle Shipments. 

Year 99 00 01 02 03 04 05 06 

Shipments 177200 204600 234500 263700 291100 317300 329000 349200 

% Change 0.17 0.15 0.15 0.12 0.10 0.09 0.04 0.06 

Source: Harley-Davidson, Inc. (2007). 

Table 3 illustrates an alarming issue for Harley-Davidson. Even prior to the celebrated 

100 th anniversary milestone, sales began to diminish and eventually slowed to the predicted levels 

of the 1996 sales goal. With 2003 sales 91,100 greater than projected values, we still observe 

declining sales at an unprecedented rate. Yet Harley’s market share is holding consistently at 

approximately 49% of the motorcycles in the larger the 650cc category (Harley-Davidson, Inc., 

2006). 

SUMMARY AND CONCLUSIONS 

It is not apparent through the financial data provided to understand the reasoning behind Harley- 

Davidson’s strategy to ship 200,000 motorcycles by the year 2003 when they had the potential to 

grow their sales to match their operating efficiencies. Why the low forecasts? Are they to ensure 

“exceeding their goals” or “higher than expected sales”? Or, simply, could it be avoid over 

production? 

Van Horne (1998) also warns that companies should not automatically grow based only 

on the financial calculations of the SGR modeling capabilities without first considering their 

market and competitive environment, that is, “Is the product in demand?” Is this the strategy? 

With a 3-month waiting period before you can get a motorcycle, Harley-Davidson has a long list 

of buyers waiting their turn on the “Made in America” allure of turning a personalized Harley 

into the dream of a lifetime. 

REFERENCES 

Academy of Management Conference. August 1998. Presentation by Drs. Igor Ansoff & Henry 

Mintzberg. San Diego, Ca. 

Blackburn, K. & Hung, V. (1998). A theory of growth, financial development and trade. 

Economica, 65 (24). 107-134. 

Bueler, W. (1993). Model for a sustainable future. The Midwest Quarterly, 34 (3). 322-335. 

Eicher, T. & Turnovsky, S. (1999). Non-scale models of economic growth. The Economic 

Journal, 109 (July) 394-415. 

Jawarski, B., Kohli, A. & Sahay, A. (2000). Journal of the Academy of Marketing Science, 28 (1) 

45-54. 

Harley-Davidson 1998 Annual Report. (1999). ON-LINE. available: http://www.harleydavidson.com/company/investor/ar/1998/default.asp 

Harley-Davidson, Inc. Unaudited Historical Data as of Q2 2007. Available Online: 

http://investor.harley-davidson.com/downloads/factsheet.pdf 


Pickett 

Harley-Davidson, Inc. 2006 Summary Annual Report. Available Online: http://www.harleydavidson.com/en_US/Media/downloads/Annual_Reports/2006/HD_AR_2006.pdf?locale 

=en_US&bmLocale=en_US 

Karras, G. (1999). Taxes and growth: Testing the neoclassical and endogenous growth models. 

Contemporary Economic Policy, 17 (2). 177-188. 

Matsuuyama, K. (1999). Growing through cycles. Econometrica, 67 (2). 335-347. 

Melcher, R. "Tune Up Time for Harley," Business Week, April 8, 1996, page 90. 

Penn, R. (1999). A glimpse of the future. Journal of Accountancy. (July) 35-40. 

Van Horne, J. (1998). Financial management and policy. (11 th ed.). London: Prentice-Hall. 

Webster, F. (2000). Understanding the relationships among brands, consumers, and resellers. 

Journal of the Academy of Marketing Science, 28 (1). 17-23. 

Whitaker, R. (1999). The early stages of financial distress. Journal of Economics and Finance, 23 

(2). 123-133. 


FIRM EXPANSION AND REGIONAL 

DEVELOPMENT: RE-DISCOVERING THE 

IMPORTANCE OF GEOGRAPHIC SPACE AND 

LOCATION 

Walecki, Julius M. 

University of La Verne 

waleckij@ulv.edu 

ABSTRACT 

There is enough evidence today proving that geographic space plays a very important role in 

business expansion, yet, this area continues to be neglected by many business schools. 

During the last decade a renewed interest in the role of geographic space in business and 

economic development has brought out issues such as agglomeration economies, firm location 

and industry clusters to the attention of the mainstream economics and top business experts. The 

new research has been often led by Paul Krugman and Michael Porter. Krugman has 

emphasized the importance of the ‘new economic geography’, while Porter’s main attention has 

been devoted to investigating the role of clusters in firm expansion and regional growth. Both 

Krugman and Porter have many followers who have made important contributions to the 

development of the main concepts. 

There is a lot more work that needs to be done to fully integrate geographic and economic 

spaces, which is necessary to successful business expansion and regional growth. In the 

meantime, many government agencies have been anxious to take advantage of the ’new’ concepts 

and have tried to apply some of the suggested tools in regional development with various degrees 

of success. As usually is the case, it is not easy to translate the ‘developing theory’ into practice 

as our reality is always far more complex than the theoretical models. The existing experiences 

seem to suggest that in order to have a positive impact on economic development governments 

need to get more involved in improving their understanding of complex relationships within not 

only geographic- but also economic spaces. At the same time, from a perspective of private 

business, most firms should be paying more, not less, attention to geographic space, which 

clearly will affect their future. 

INTRODUCTION 

The main stream business education and traditional economics had stayed clear for a long time 

from adding spatial dimension into their theoretical considerations of key issues in business 

decision making and economic growth. Firm and industry location, as well as regional economic 

development, have been mostly left to other fields, such as economic geography, regional science 

and often less known regional or spatial economics. Most business schools today still do not 

include spatial considerations and the role of firm location in their academic curricula. The 

economic and business texts often fail to properly address the importance of geographic space in 

firm and industry growth. For example, a very popular textbook by Michael Baye “Managerial 

Economics and Business Strategy” gives almost no consideration to the role of firm location 

(Baye, 2006). The spatial aspects of business development, agglomeration economies, and even 


Walecki 

the impact of industry clusters are nowhere to be found in this important book. As a result 

concepts such as firm and industry location, agglomeration and localization economies, and even 

clusters are little known to many business and economics graduates. 

However, in recent years there have been some encouraging signs that may change the way 

academia, as well as private and public organizations, look at business and economic growth. 

New powerful voices, including prominent economists such as Paul Krugman and Michael 

Porter, have been raised since 1990s to highlight the importance of geography in economic 

development. Krugman initially started warning us that even international trade theory could not 

be complete without including economic geography (Krugman, 1991b). His more recent work 

together with Fujita has focused on re-defining the role of geographic space through the ‘new 

economic geography’ (Fujita & Krugman, 2004). At the same time, Michael Porter in his quest 

for causes of increased competitiveness has also discovered the importance of geography, firm 

location, and especially clusters to business and economic development, whether at the regional 

or national levels (Porter, 1998a & 2000b). Today, there are many more professionals and 

academics supporting an unprecedented increase in the study of the role of geographic space in 

business growth and economic expansion. 

ECONOMIC VERSUS GEOGRAPHIC SPACE 

For the purpose of this paper geographic space is defined as the actual physical space in which all 

economic activities take place and the allocation of resources is decided by the main economic 

players, i.e. individuals/ households, firms and governments. The full understanding of the role 

of a given geographic space, such as a region, cannot be limited to traditional factors based on 

transportation costs, or a mere accounting of natural resources, current factor endowments, and 

even an existing infrastructure and externalities. It must be supported by a full assessment of the 

role of physical environment and should consider potential factor shifts and future trends that will 

impact the region, including changes in its comparative and competitive advantages. On the other 

hand, economic space is determined by factors related to business environments and economic 

relations and exchanges that take place between economic agents. The size of economic space of 

a firm is not fixed and continues to change as businesses grow and decline. Following business 

expansion within its economic space, its geographic space may also expand, but it could also stay 

the same or even contract. One of the currently available technical tools that allows better 

bridging of economic and geographic spaces is the Geographic Information Systems (GIS). 

Most economists have traditionally devoted their main attention to the study of relationships 

within economic spaces, often defined along the sectoral or industrial boundaries, while the 

treatment of geographic space has been largely absent from their considerations. In the past only 

a very limited number of economic studies took on spatial dimensions more seriously. At present 

new theoreticians in addition to Krugman and Porter are slowly changing old perceptions. 

McCann insists that economics must consider geographical and sectoral factors if the field is to 

explain industrial location (McCann, 2002). Behrens and Thiesse emphasize that any analysis of 

regional issues must recognize differences between spatial units and it requires the minimum of 

two regions (Behrens and Thiesse, 2007). 

Geographic and economic spaces have different meanings to governments and businesses. While 

firms have a lot more freedom in terms of their spatial behavior, most governments face serious 

spatial limitations as they are restricted by their limited geographic and economic spaces. Those 

geographic spaces are usually constant with very few exceptions, mostly available to regional and 

local governments, such as expanding into previously unincorporated areas, acquiring additional 

land that could be developed, or discovering new natural resources. In most cases, a limited 


Importance of Geographic Space and Location 

geographic space and a matching economic space are usually the main focus of regional 

development programs. In general, it has not seemed rational for governments to take interest in 

investigating economic spaces of other regional agents, such as firms. The economic spaces 

particularly of larger players are usually beyond the local public control or even influence. As a 

consequence public agencies have seldom tried to assess potential impacts of firms’ overall 

economic relations on their regions. Unfortunately, such prevailing approaches have revealed 

serious limitations in regional development initiatives. At the same time, business firms are by 

their very nature forced to pay a lot more attention to their economic spaces, as they have to 

constantly evaluate their economic relationships, which include main competitors, suppliers and 

consumers. In theory firms also are free to expand their economic spaces and move within or 

between geographic spaces, which may tend to explain their relatively low priority and often less 

attachment given to any particular physical location. 

Some ‘global’ experts would like to proclaim that geographic space is slowly becoming 

irrelevant, at least for businesses, because of a significant progress in transportation. However, 

this could not be further from the truth. As competition between firms, entire countries and 

regions intensifies, the inclusion of geographic space into all economic and business equations 

and plans becomes vital. Porter admits that: “paradoxically, the enduring competitive advantages 

in a global economy lie increasingly in local things – knowledge, relationships, and motivation 

that distant rivals cannot match” (Porter, 1998a, p. 77). There is strong evidence showing that the 

age of Internet has actually increased, and not decreased, the importance of geographic space 

(Currah, 2007; Zook, 2005). 

‘NEW ECONOMIC GEOGRAPHY’ 

The main focus of economic geography has always been the location of economic activities and 

regional economic development, while most traditional economists and business experts have 

paid almost no attention to the role of location in business growth and even the general study of 

where economic activities take place in geographic space and why. The emergence of the ‘new 

economic geography’ (NEG) in 1990s, thanks to works of Krugman, Fujita, Porter and many 

others, has changed many perceptions and opened the field of spatial economic research to 

previous infidels. However, it is a rather challenging task to try to define the ‘new economic 

geography’ as very different from the traditional economic geography. For more seasoned 

regional experts, NEG is simply an extension and a continuation of many previous years of 

research and empirical findings, as it builds on the significant progress made prior to 1990s in 

better understanding of the role of space in economic development. 

In a Krugman-Fujita framework “the defining issue of the new economic geography is how to 

explain the formation of a large variety of economic agglomeration (or concentration) in 

geographical space” (Fujita, 2007b, p. 4; Fujita and Krugman, 2004, p.140; Krugman, 2000; 

Clark et al, 2000). Both authors claim that the main purpose of the new field is to design a 

modeling approach, and more specifically a general equilibrium model of the spatial economy. 

Krugman, Fujita and Venables suggest a theme of ‘Dixit-Stiglitz, icebergs, evolution and the 

computer’ for the study of main issues within the ‘new economic geography’. The ‘Dixit- 

Stiglitz’ part refers to the reliance on the analytical models of monopolistic competition, the 

‘icebergs’ are based on Paul Samuelson’s simplified treatment of transportation costs, the 

‘evolution’ suggests adding new models with multiple equilibria, and finally ‘the computer’ 

represents high-technology numerical examples and models. They further present three types of 

models: regional, urban and international, but admit that the main focus in each one of those is on 

explaining the location of economic activities (Fujita, Krugman & Venables, 1999). According to 

Fujita the ‘new economic geography’ is concerned mostly with researching and understanding 


Walecki 

agglomeration (i.e. centripetal) forces, and NEG usually pays little or no attention to dispersion 

(i.e. centrifugal) forces. Krugman’s basic model considers only ‘linkages’ on the side of 

centripetal forces and ‘immobile factors’ as determinants within centrifugal forces. Fujita 

assumes that the dispersion forces, such as the increase in factor prices and the increase in 

congestion, can be easily explained by the traditional economic theory, therefore in his approach 

this area requires less additional work (Fujita, 2007b). Alonso-Villar notes that the majority of 

NEG’s literature and models indeed focus on the centripetal forces to justify agglomeration, but 

she shows that even the Dixit-Stiglitz framework as well as Ottaviano’s model depend heavily on 

the centrifugal forces as well. In addition, the limitations of a two-region model are apparent 

according to her, as many conclusions from a two-location economy may not be relevant in a 

multi-location environment (Alonso-Villar, 2007). 

The ‘new economic geography’ is presented as “one of the most exciting areas of contemporary 

economics” (Fujita, 2007b, p.4; Fujita, Krugman & Venables, 1999). NEG uses many well 

known concepts borrowed from the traditional economic geography and other related disciplines. 

For example Krugman uses ‘the core-periphery model’ and ‘forward and backward linkages’, 

which have been very popular in geography, as well as in trade theory and development 

economics. However, these concepts are often re-defined to serve the needs of NEG (Krugman, 

1991a; Fujita & Krugman, 2004). Krugman and Fujita further see the future of NEG not only as 

a comprehensive theory of spatial economics, but also the one that recognizes the importance of 

the knowledge and the brain power society (Fujita, 2007a; Fujita & Krugman, 2004). The latter 

two aspects of NEG seem to have been added to the original framework of the ‘Dixit-Stiglitz, 

icebergs, evolution and the computer’. However, even with this new addition, NEG still tends to 

brush aside other important socio-economic characteristics of individual regions and distinct 

natural features within and between geographic spaces. 

In spite of several shortcomings, there have been some encouraging results with testing of the 

‘new economic geography’ models. Pons et al use the Spanish industrial data and the NEG 

model to demonstrate the existence of forward linkages (i.e. centripetal forces). Their work 

reinforces the importance of cumulative agglomeration forces and shows a strong direct 

relationship between workers’ migration patterns and the market power of the destination regions 

(Pons et al, 2007). Amiti demonstrates that NEG can be expanded by introducing trade 

liberalization models with vertical linkages based on the Heckscher-Ohlin framework and shows 

the benefits of agglomeration and the lack of the factor price convergence (Amiti, 2005). 

Unlike many practitioners, and some of his colleagues, Krugman has been rather cautious about 

the policy implications of the ‘new economic geography’ and specifically about designing new 

interventionist policies. He admits that this is a reflection of “a strong sense of how difficult it is 

to go from suggestive small models to empirically based models that can be used to evaluate 

specific policies” (Fujita & Krugman, 2004, p.156). In other words, regional development 

policies and programs may still have to wait, as they must be based on a comprehensive 

assessment of complex relationships within geographic and economic spaces, and at this time 

NEG may not be able to deliver yet. 

In summary, many re-defined concepts and basic foundations of the ‘new economic geography’ 

may be somewhat disturbing to regional academics who have spent most of their professional 

lives studying firm and industry location and regional economic development, yet, the greater 

good of opening this important field to businesses and governments, and making all relevant 

knowledge available to other disciplines as well, should be more important to most professionals. 



FIRM LOCATION 

Many new studies have clearly confirmed that the firm’s economic success and growth are 

significantly influenced not only by traditional ‘purely economic factors’, but also by its location 

(Audretsch and Dohse, 2007). 

In the past, the theory of industry location has found a lot more attention within the fields of 

economic geography and regional science, rather than business and traditional economics. The 

location theory has greatly benefited from the following concepts: 

(i) least cost approach based on locational factors, such as transportation, labor costs 

and agglomeration economies (Weberian model); 

(ii) market-area analysis based on the spatial distribution of demand (e.g. Hoover); 

(iii) international trade theory and comparative advantage (e.g. Heckscher-Ohlin 

factor endowments); 

(iv) land use models (van Thunen), and urban development patterns, such as the 

central place theory (Losch & Christaller). 

Under the first approach, according to Weber and his followers, firms would choose those 

locations that minimize their transportation costs. Labor costs were the so called first distortion 

to the original model. Heavy industries would usually locate close to the sources of their inputs, 

while labor intensive industries would have chosen locations closer to huge pools of labor. 

Agglomeration economies by offering additional benefits would encourage industrial 

concentration of different firms. It has been recognized that as the costs of transportation have 

diminished over the years, many firms have become more flexible in terms of their locational 

decisions. The market area analysis questioned Weber’s one market approach and a lack of 

attention to spatial variations in demand (Hoover, 1975). According to this approach, as 

consumers are found in different geographic areas, the firm’s optimal decision depends on 

locating as close as possible to the largest concentrations of buyers. The international trade 

theory has added comparative advantage and differences in factor endowments among regions 

and nations, which helped explain international specialization and industry location. The trade 

theory usually assumed zero factor mobility in its basic models and had to rely on transportation 

costs of moving goods. In the fourth approach, van Thunen findings were based on a land use 

model which was developed in contrast to the traditional trade theory. Van Thunen’s model 

assumed labor mobility within a region and there were no costs to labor migrations. His 

innovative concepts and the central place theory have made a major contribution to the 

understanding of land use patterns, business location and regional development. 

In recent years, much attention has been given to investigating in more detail the role of 

agglomerations, and particularly agglomeration economies in firm and industry location. There 

are generally two trends that explain the emergence and expansion of agglomerations. The 

agglomeration of businesses and people can be caused by favorable natural features, including 

natural resources, while man-made ‘agglomeration economies’ show benefits of being in the 

same location (Roos, 2005). The theoretical work further distinguishes between general 

agglomeration or urbanization economies, which influence most sectors, and localization 

economies, which are specific to individual industries, such as inter- and intra-industry linkages 

(Giarratani, 2007; Funderburg, 2006; Fujita & Thiesse, 2002; Conkling & Yeates, 1976). 

The transaction costs, which are usually discussed in the main stream economic texts also have an 

important spatial dimension according to Wood. He argues that “institutional, commercial, 

cultural and language characteristics are differentiated across the geographic space separating 

market agents” and therefore require additional attention (Wood & Parr, 2005, p. 1). Some 

contemporary research focuses on incorporating spatial dimensions in econometric models of 


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monopolistic competition, such as in the Stackelberg-Cournot framework, with a typical leader 

and followers (Miller et al, 2007). 

Despite increased business returns due to specific locations, many firms continue to consider 

geographic space only at a later stage in their decision making process and the firm’s location 

determination is often accomplished through out-sourcing to so called locational experts. This 

could be one of the main reasons for the lack of in-house expertise and even serious mistakes, 

which a lot of firms make when it comes to their location. In most cases, the firm’s 

understanding of differences between and within geographic spaces is often non existent. There 

could be some exceptions, such as the real estate industry and perhaps the traditional retail sector. 

The real estate industry relies on geographic space and it often claims to understand very well the 

importance of ‘location, location, location’. The retail sector even with its total reliance on the 

markets is still subject to questionable locational choices. However, the main issue remains that 

any particular location, often based on costs, constitutes only one factor within geographic space 

and does not represent other important spatial considerations, including shifting comparative and 

competitive advantages over time, which influence industry and firm prosperity. 

Business experts who specialize in industry location usually identify four factors which are 

crucial to locational decisions: 

(a) minimization of one time costs, such as real estate, construction, moving, etc.; 

(b) minimization of future operating costs, including labor, transportation, taxes, etc.; 

(c) minimization of economic and political risks; 

(d) maximization of future opportunities, which relies on the contribution of the firm’s 

location to its overall business strategy and its market success. 

The site selection professionals admit that much more work needs to be done to understand the 

importance of geographic space to businesses: “these premises (i.e. four factors above) seem 

sensible and relatively simple, but as always, the devil is in the details-which have a way of 

snow-balling into major catastrophes very quickly. And the stakes are higher now ... because you 

can get yourself into deep trouble in a hurry and there's very little time to recover" (Talley-Seijn, 

2004, p. 26-27). In general location specialists may have a reasonably good knowledge of 

specific physical sites, but their knowledge of economic space of a particular firm, or industry, is 

usually non-existent. There are no incentives for them to investigate the interdependence of 

geographic and economic spaces, and they usually do not even have access to the company’s 

information, including competitors and customers to make more thorough recommendations. 

There are very few industries that are impacted by a single location factor, such as for example 

primary energy resources, as the role of geographic space is usually far more complex. Martinek 

and Orlando identify a number of energy dependent industries, which tend to locate near primary 

energy resources, but conclude that in general there is a rather limited relationship between the 

primary energy resources and firm location (Martinek and Orlando, 2002). Boschma and 

Wentig’s extensive work on the British automobile industry shows that spatial factors such as 

agglomeration economies and spinoff dynamics had a positive impact on the automotive 

producers during 1895 to 1968 (Boschma and Wenting, 2007). 

New empirical studies show the importance of geographic space to high-tech industries as well: 

“place becomes even more important in the area of the digital economy, due to the need for 

spatial proximity in the transfer of tacit knowledge” (Park, 2003, p. 223). Zook shows a strong 

correlation between the Internet industry and the employment and population densities (Zook, 

2005). Audretsch and Dohse conclude that the expansion of high tech firms is dependent on what 

they call ‘locational characteristics’ as well as ‘characteristics specific to the firm and the 

industry’. They point out that: “the empirical evidence suggests that being located in an 



agglomeration rich in knowledge resources is more conducive to firm growth than being located 

in a region that is less endowed with knowledge resources” (Audretsch and Dohse, 2007, p. 79; 

Polese & Shearmur, 2006). 

Many other industries, such as the entertainment industry have found themselves confronted not 

only by the new technology, but also by spatial determinants. Currah suggests that for the most 

part the Hollywood studios are not ready to explore new opportunities (here: within economic and 

geographic spaces) and, instead, they have been fighting a rapid spatial expansion of new 

ventures made possible by Internet. According to Currah the studios’ main goal is to establish a 

‘closed sphere’ (or closed space) of innovation at a global level. He further asserts that 

Hollywood already has been successful in creating and legitimizing a similar ‘closed sphere’ 

(space) at a regional level in Los Angeles (Currah, 2007). 

Finally, it has been well documented that firm’s location is substantially influenced by qualitative 

factors as well, such as various amenities offered in different locations. Those geographically 

based amenities including safe environment, cultural and recreational opportunities, etc., which 

are not necessarily found in all urban centers, impact on employees’ satisfaction and productivity 

and affect final locational choices. 

INDUSTRY CLUSTERS 

In modern literature the notion of industry clusters, based in geographic space, is usually traced 

back to Marshall and his Principles of Economics, which was published more than a century ago. 

However, Marshall was not the first one to emphasize the importance of externalities and 

agglomerations. It was actually van Thunen who back in 1826 provided a detailed account of 

main reasons behind economic agglomerations (Fujita & Krugman, 2004). Industrial 

concentrations and industry clusters are not quite new as they were part of the standard textbooks 

in economic geography and regional economics in the second half of the twentieth century 

(Conkling & Yeates, 1976; Hoover, 1975). 

In addition, there were a number of very important related concepts, which in some cases 

attempted to reconcile the importance of economic and geographic spaces. Some of the most 

influential ideas in regional policies were based on the notion of growth poles and growth centers. 

The theory of growth centers was very popular in regional development and economic geography 

especially in 1960s and 1970s. There are few examples of those powerful concepts applied in the 

real world with the support and often leadership of different government agencies and even the 

assistance from the leading U.S. universities. For example, Ciudad Guyana in Venezuela was 

developed because of the Venezuelan government plan based on the theory of growth centers and 

with the help from U.S. consultants. Ciudad Guyana stands today as a testimony to the power, 

and also some limitations, of the theory of growth centers and the possibilities of a coordinated 

intervention in geographic space. Unfortunately, some of those innovative concepts, which gave 

birth to the theory of growth centers and contributed to their popularity are relatively little known, 

or perhaps remembered in the English speaking world today. It was actually French economist 

Francois Perroux who was behind the original theory of growth poles, which he clearly defined 

within economic rather than geographic space. Perroux viewed ‘dynamic growth poles’ as true 

engines of the economy, but unfortunately his outstanding ideas were never fully translated into 

geographic space. In the end, a simplified theory of growth centers based in geographic space 

and influenced by potential benefits of spatial concentration of economic activities became far 

more popular and was often adopted by practitioners, but this was only a much weaker substitute 

to Perroux’ growth poles (Walecki, 2001). 


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The popularity of the growth center theory had gradually diminished, but the attention to 

geographic space and industrial concentrations continued in the remaining part of the XXth 

century in geography and regional science. In the U.S. the federal government also contributed to 

a better understanding of spatially based economic development by sponsoring important 

research projects on industry clusters. In 1996 the U.S. Department of Commerce report 

optimistically identified 380 clusters which drove the U.S. economy. According to the study, 

these clusters accounted for 57% of the U.S. labor force, they produced 61% of the national 

output and generated 78% of the U.S. exports (U.S. Dept. of Commerce, 1996; Gollub, 1997). 

Despite many other similar projects at regional and local levels and the existing vast body of 

research on geographic concentrations of economic activities, including agglomeration and 

localization economies, the very concept of industry cluster within geographic space would 

probably have still escaped the attention of economics and the business world had it not been for 

catching the interest of Michael Porter and his followers. According to Porter’s definition: 

“clusters are geographic concentrations of interconnected companies, specialized suppliers, 

service providers, firms in related industries, and associated institutions (e.g. universities, 

standards agencies, trade associations) in a particular field that compete but also cooperate” 

(Porter, 2000b, p. 15). This is one of the broader definitions of industry cluster that serves many 

purposes. It is important to notice that Porter’s definition includes universities, while some 

studies may exclude academic institutions (SANDAG, 2001). Ketels adds specific benefits of 

clusters and defines them as: “groups of companies and institutions co-located in a specific 

geographic region and linked by interdependencies in providing a related group of products 

and/or services. Because of the proximity among them - both in terms of geography and of 

activities - clusters constituents enjoy the economic benefits of several types of positive locationspecific 

externalities” (Ketels, 2003, p. 3-4). 

The theory of industry clusters and location-specific externalities has its strong roots in 

geography and Porter admits that despite an assumed decline in the importance of location, 

geographic space continues to play an important role in economic advancement and business 

growth: “clusters ... are a striking feature of virtually every national, regional, state, and even 

metropolitan economy, especially in more advanced nations” (Porter, 2000b, p. 15). In his earlier 

works Porter attempts to place clusters within what he calls the ‘new economics of competition’ 

rather than regional economics, or economic geography (Porter, 1998a). He tends to overlook the 

contribution of the location theory and is interested in only certain aspects of geographic space 

and even clusters, but nevertheless his attention to geographic space, even if limited in scope, 

signifies an enormous progress in expanding the horizons of economists and business experts. 

Other researchers, including Porter’s colleagues and even his DBA students have often tried to 

build on his research and clarify different concepts within the theory of clusters. For example 

Ketels attempts to add natural resources to explain the creation and evolution of clusters (Ketels, 

2003). Many studies show that clusters have not only a positive impact on productivity growth, 

but they also stimulate innovation and contribute to new business creation (Ketelhohn, 2002; 

Porter, 1998a & 1998b; Porter and Stern, 2001). Porter goes beyond clusters’ impact on firms 

and claims that: “clusters represent a new way of thinking about national, state, and local 

economies, and they necessitate new roles for companies, for various levels of government, and 

for other institutions in enhancing competitiveness. For companies, thinking about competition 

and strategy has been dominated by what goes on inside the organization. Clusters suggest that a 

good deal of competitive advantage lies outside companies and even outside their industries, 

residing instead in the location at which their business units are based” (Porter, 2000b, p.16 & 

2000a). He seems to move easily between the role of clusters for individual companies and their 

importance to regional growth, as if there were no conflicts at all between various economic 



players. Porter even attempts to apply his approach to general economic policies. He makes a 

strong distinction between the policy based on clusters and the traditional industrial policy and 

seems to favor cluster-based development initiatives. However, the above approach may be 

questionable, as these two policies should be seen as complimentary rather than mutually 

exclusive, and therefore would need to be coordinated to be of greater use to economic 

development programs. What is important to remember is that industrial policy is primarily 

rooted in economic space, while clusters are based in geographic space, but both are often equally 

important. 

The additional cluster literature has been instrumental and could be viewed as not only clarifying 

some of the key definitions, but also making progress in bridging geographic and economic 

spaces. There are numerous empirical studies that look at different aspects of industry clusters 

and the relevance of the suggested concepts. Haussler and Zademach have examined 

biotechnology firms and conclude that the success of a cluster depends on its ability to evolve by 

changing its structure and also by achieving a desired balance between science and capital. They 

further conclude that firms which are more open to cooperation with both for profit and nonprofit 

economic partners are usually more successful (Haussler and Zademach, 2007). Patti 

shows the economic benefits of building local supplier and client relationships, and further 

confirms that clusters gain from both cooperation and competition (Patti, 2006). The importance 

of geographic space in the cluster literature has also been extended to other areas, such as general 

management issues and entrepreneurship. Rosenthal and Strange have found that both 

urbanization, such as the density of local employment, and localization expressed as the density 

of employment in an individual industry, have positive impact on entrepreneurship (Rosenthal & 

Strange, 2005). Gittelman has investigated the role of geographic space for science-based firms 

and also shows different spatial patterns in biotechnology (Gittelman, 2007). Minerva expands 

his model to include international trade and posits that regional economic integration and free 

trade may indeed support spatial concentration of industries (Minerva, 2007). 

The cluster theory has its critics as well and not all recommendations are free of controversy, as 

noted previously. Ketels warns that: “while cluster-based economic policy has a lot of potential, 

it is no panacea. In fact, the largest danger for this approach may be its current use as the 

fashionable next ‘new thing’ in economic development” (Ketels, 2003, p. 20). Some other 

criticism focuses on a rather vague definition of clusters and therefore its limited use for regional 

development policies. Martin and Sunley suggest that the cluster theory should have a ‘public 

policy health warning’ (Martin & Sunley, 2003). Lall and Chakravorty add that the ‘Porter style’ 

competitive analysis and ‘specialized clusters’ may be less successful in peripheral areas, while 

government programs targeting mixed industrial clusters or districts could be more appropriate 

for those regions (Lall and Chakravorty, 2005). Porter’s assumption that today the nature of 

agglomeration economies has moved away from urban and industry focus and more toward the 

clusters is also questionable. All three concepts are often interconnected and remain very 

important for decision making and should be carefully considered by businesses and governments 

alike. For example, it has been well documented that agglomeration economies are crucial for 

certain economic activities, but localization or industry specific economies could be far more 

significant for others. The general cluster literature may also be subject to criticism for not 

addressing properly environmental issues and concerns. 

Several studies show that not all existing business cases support the necessity of cluster 

development. Goetz and Rupasingha warn that not all industries need to be concentrated in 

geographic clusters: “manufacturers of computers and peripheral equipment appear to avoid both 

firms from their own industry and overall high-tech industry firms in their location decisions” 

(Goetz and Rupasingha, 2002, p.1236). Almazan et al, after investigating the role of skilled labor 


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as a locational factor, concluded that there could be an incentive to locate away from clusters 

when firms need to bear high training costs (Almazan et al, 2007). Other researchers suggest 

different spatial models and question some of the previous findings. For example, Stam proposes 

a ‘developmental approach’ for studying spatial behavior of entrepreneurial firms. His 

evolutionary approach is linked to firm’s expansion, and its spatial organization co-evolves with 

‘the accumulation of the firm’s capabilities’. He claims that “contrary to what is found in the 

literature on industrial clusters and embeddedness, interorganizational networks hardly play a role 

in explaining the spatial organization of entrepreneurial firms” (Stam, 2007, p. 38). 

In general, despite the above criticism, the recent work on the role of industry clusters is a huge 

step forward in recognizing the importance of geographic space in business growth and economic 

development. Porter and other cluster experts are anxious to see the application side of the ‘new’ 

theory and they are already sharing their knowledge with economic policy makers (Flowers & 

Easterling, 2006). However, there is a real danger that, if not properly defined and tested, the 

cluster based regional development theory and planning may be repeating the great history of the 

rise and fall of the theory of growth centers and growth poles. The hype and unrealistic cluster 

expectations are also counter productive and self-defeating. 

INTERNATIONAL TRADE AND FOREIGN INVESTMENT 

Most countries, regions and even cities have to compete today, whether they like it or not, on a 

global stage in terms of international trade and foreign investment. The law of comparative 

advantage, which recognizes differences in factor endowments and other differences in 

geographic space between countries and regions is more, not less, important in today’s world. 

Krugman showed us long time ago that to understand international business one must include 

geographic space (Krugman, 1991b & 1997; Frankel, 1997). 

The fear of regionalization, globalization and free trade agreements has often been associated 

with firm and industry relocation decisions between countries and competing geographic 

locations. However, what is often forgotten is that these processes have always been part of our 

economic landscape as entire countries, regions and even individual cities constantly evolve 

based on powerful changes that take place within economic and geographic spaces (Barbier & 

Hultberg, 2007; Partridge, 2007; Walecki, 2007). With the increase in regionalization and 

globalization businesses can no longer disregard international developments and need to be aware 

of their place within the world business community. Economic integration has created new 

opportunities in terms of optimal firm location and more efficient use of limited resources that are 

dependent on geographic space. These new developments are not only affecting big firms, but 

their impact can be felt by small entities as well, as no longer anybody is immune from 

international environment and more intense competition (Talley-Seijn, 2004; MacLeod, 2001). 

Unfortunately, in the U.S. relocation decisions and loss of jobs to other countries through 

outsourcing in less competitive industries has attracted a lot of attention and bad publicity, and 

may even lead to some politically motivated protectionist measures in the future. Yet, the other 

side of the equation showing enormous new opportunities for exporters in rapidly growing 

international markets has been almost of no interest to many public decision makers and the 

media. The blaming of international trade for the country’s economic misfortunes is a reflection 

of the lack of understanding of complex relationships within geographic and economic spaces. 

In theory foreign investment is also very sensitive to spatial differences and many mistakes have 

been made even by the biggest companies on the one side, and also national and regional 

governments on the other side, which have tried to attract foreign companies to their jurisdictions. 



Foreign investors much like domestic firms are subject to different locational factors. In her 

study of investment in China Cheng demonstrates that Japanese investors, once they decide on 

expanding in China due to cheap inputs, they are usually attracted to a province that has more 

favorable economic and business environment, such as skilled labor, business friendly policies, 

more solid infrastructure and higher quality of life. She suggests that: “conventional economic 

factors, like market potential, wages and land cost, only impose limited, if not negligible, impacts 

on Japanese investors’ location selection in China” (Cheng, 2007, p. 69). Cheng is skeptical 

about the Chinese government’s ability to attract more foreign investment to the central and 

western regions because of such crucial spatial considerations as the lack of agglomeration 

economies, the non-existence of industrial clusters in the interior, and a less favorable business 

climate. 

Several studies confirm that promotional efforts and agglomeration economies, including both 

urbanization and localization economies, play an important role in attracting foreign investment. 

Kim et al use a conditional logit regression model and their findings suggest that for smaller 

states the lack of agglomeration economies and locational disadvantages can be partly offset by 

foreign investment attraction programs (Kim et al, 2007). 

The importance of foreign investment to the country’s economy has been finally recognized by 

the U.S. federal government as well, as it created the ‘Invest in America’ initiative within the 

U.S. Department of Commerce in March 2007. According to the federal government estimates 

foreign subsidiaries in the U.S. provided more than 5 million jobs for Americans. Many state 

governments also try to market themselves to foreign investors. For example the state of Georgia 

has been reported in the news to spend about $6 million last year to attract foreign investment. 

Some of the Southern states have been very successful in bringing in foreign auto manufacturers. 

The State of California has a number of programs through the California Business Investment 

Services (CalBIS) supporting foreign investment, which include assistance with the site selection 

and logistics, business consulting, networking with other economic actors, and providing essential 

economic and social data. CalBIS claims that they: “assist firms with expanding their existing 

operations and help them to compete more effectively and profitably in domestic and 

international markets. CalBIS provides technical assistance services to help businesses grow and 

prosper” (Cal. Lab., 2007). It is not clear how much CalBIS knows about firm location and 

especially economic and geographic spaces of those industries and firms that it tries to attract to 

California. Many regional and local governments also attempt to encourage foreign investment 

and they usually rely on various incentive packages, which are offered to potential investors 

(Talley-Seijn, 2004). 

The main problem with traditional approaches and business attraction programs targeting foreign 

investment is the lack of any serious consideration of interdependence of geographic and 

economic spaces and almost no attention to economic spaces of different foreign firms singled 

out by public agencies and their respective industries. All these efforts will most likely have a 

limited success if they fail to incorporate the most important relationships between different 

economic agents and shifting comparative and competitive advantages within and between 

geographic and economic spaces. 

REGIONAL DEVELOPMENT EFFORTS 

Local and regional governments have traditionally been the only government agencies that relied 

heavily on geographic space in their development strategies. At the same time, in spite of the 

main focus on geographic space those governments often lack a clear understanding of their 

region’s potential and especially future opportunities. Yet, if their knowledge of the geographic 


Walecki 

space is inadequate, their understanding of economic spaces of businesses is basically lacking. In 

his book Kotkin warned that some urban centers could experience declines if governments did not 

pay attention to changing growth patterns and locational factors (Kotkin, 2000). 

The end results of most regional development programs have often been mixed. It seems that 

government agencies have received rather limited support from business schools over the years, 

which may have been partly due to a lack of interest and even expertise in regional economic 

development. As a result it was often up to public agencies to take on a leadership position and 

try to identify major regional economic challenges and come up with solutions. Today the 

increased interest in the ‘new economic geography’ and the theory of clusters may finally bring 

some help. Michael Porter has not only provided much needed leadership in regional economic 

development, but also recognized the important role of governments. He reminds us that: 

“governments have a great stake in the influence of location in competition, because it is 

governments that are directly responsible for improving the well being of citizens in particular 

geographic areas” (Porter, 1998b, p.11 & 2003). Porter is convinced that economic growth is 

strongly affected by regional clusters, which stimulate productivity growth and innovation. He 

has been quite active in designing new regional development strategies based on clusters, such as 

the South Carolina’s tourism program. Porter’s cluster’s strategy for the state emphasizes the 

importance of local infrastructure, as a key factor (Flowers and Easterling, 2006). Harmut and 

Falkinger’s study also confirms the impact of public infrastructure and subsidies on firm location 

decisions, and shows that they may indeed alter initial locational factors and lower international 

outsourcing (Hartmut & Falkinger, 2006). 

At the same time, throughout the recent history there has always been a danger for consultants 

and practitioners to overstate the importance of one tool in regional development. In that sense 

the contribution of the theory of clusters at this time may not be much different from the previous 

rather simplistic solutions. The main concepts are still subject to various misinterpretations and 

often lack clarity needed for policy making, which may lead to unintended results. For example, 

the notion that ‘all clusters can be desirable’ and should be supported by governments (Porter, 

2000b) may encourage some local authorities, interested in protecting their regional employment 

levels, to hold on to inefficient industries as long as these economic activities are identified as 

part of the existing clusters. 

There are some success stories too when it comes to regional development initiatives, which 

reveal a significant progress in our understanding of the spatial dimensions of economic and 

business growth. In California and other states there are examples of regional and local 

development strategies that are innovative and have already generated positive results. For 

example, among the local governments in the greater Los Angeles area the City of Irvine and the 

City of Ontario have taken a pro-active role in business and regional development by focusing on 

their competitive and comparative advantages. In both cases geographic space and particularly 

open land have played a crucial role in attracting new investments. The City of Irvine is a clear 

example of the importance of agglomeration economies, but it also shows non-traditional location 

factors that firms are considering when deciding on their physical location, including different 

amenities. At the same time both cities will still have to invest a lot more in learning about 

interdependencies between geographic and economic spaces if they want to assure sustainable 

economic development in the future. 

There are encouraging news at a higher regional level as well, as different local governments 

team up together, work on solving regional challenges and plan for their common future. For 

example, in 2004 the Southern California Association of Governments (SCAG) came up with a 

new regional development program named “Compass, Charting the Course for a Sustainable 



Southland”. SCAG’s plan has been presented as the ‘most ambitious growth visioning effort in 

California’ (SCAG, 2004). Unfortunately, the major part of the project is still deeply rooted in 

the traditional transportation planning and, as a result, the SCAG’s plan recommends growth 

patterns that rely heavily on the existing transportation networks and infrastructure. The old 

stereotype of ‘if we build it they will come’ tends to dominate the main philosophy behind the 

key initiatives. SCAG fails to identify comparative and competitive advantages of the region and 

it provides very little information on the type of businesses it wants to see in the region. It gives 

almost no attention to economic spaces of current and future industries. 

The San Diego Association of Governments (SANDAG) may in some ways represent a more 

progressive approach. SANDAG’s strategy appears to take advantage of the basic cluster concept 

and identifies 16 most important clusters within the greater San Diego economy (SANDAG, 2001 

& 2004). The plan also recognizes the importance of exports to the regional economy, but it 

stops short of identifying potential opportunities in foreign markets. SANDAG uses the term 

‘employment clusters’ rather than ‘industry clusters’, which is misleading as it tends to change 

the focus of the cluster theory from the production side to employment. In addition some of the 

identified clusters are questionable in terms of their role in the regional economy. For example, 

the ‘fruits and vegetables’ and ‘horticulture’ are identified as two separate clusters while the 

higher education, which is extremely important to San Diego’s economy is basically excluded as 

not meeting the rigid standards of SANDAG’s cluster. Another questionable cluster entry is the 

‘uniformed military’, which is not even concentrated in one area of the county but scattered 

throughout the region. SANDAG’s definitions appear to confuse geographic and economic 

spaces. They are often too subjective and seem to be influenced by political factors. SANDAG’s 

regional development approach still requires a lot more work and its recommendations are not 

free of controversy. SANDAG’s case may also prove that the reliance on the concept of industry 

clusters alone does not address all regional development needs and challenges. 

FUTURE OF REGIONAL INITIATIVES AND CLUSTERS 

Despite serious challenges facing individual regions, there are new hopes and expectations as 

more progress is made in understanding the role of geographic space in regional economic 

development. A good example of a new project in Southern California may prove to be the 

Green Valley Initiative (GVI), which relies on a different approach than those adopted by SCAG 

and SANDAG. The 2007 GVI program outline tries to incorporate multiple stakeholders, 

including businesses, public agencies, academic institutions and environmental groups from 

Riverside and San Bernardino counties and gives all participants equal voice in regional planning 

(GVI, 2007). However, it is too early to judge what theoretical concepts will be used in the future 

and whether this new initiative with ambitious goals and an emphasis on sustainable development 

will be able to live up to its own high standards and expectations, and especially whether GVI 

will succeed in fully integrating economic and geographic spaces. 

There is no question that more theoretical work will be required in the future as well to support 

regional development initiatives. A recent study commissioned by the U.S. Department of 

Commerce suggests a need for developing the “Regionalism-Industrial-Cluster focused 

curriculum” to assist public officials involved in economic development. The report based on the 

existing experiences shows some common purpose in regional development, but also a variety of 

priorities, opinions and approaches used by practitioners when trying to address regional 

challenges. According to the survey conducted by the authors close to 40% of public agencies 

involved in regional development have conducted or commissioned a study on industry clusters 

within their region and some even claim using detailed cluster based strategies (U.S. Dept. of 


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Commerce, 2007a & 2007b). It is not clear what kind of concepts and theoretical foundations 

have exactly been used in those regional development programs. 

The supporters of the cluster based development will most likely continue to face serious 

challenges in a real life with the application side of the theory. Gollub insists that for regional 

development to be successful it must move to the second stage, which he calls Clusters 2.0. He 

sees the first stage of cluster based development strategies as more of a ‘wishful thinking’, which 

was often limited to a mere description of the existing clusters. Gollub suggests that the second 

stage should focus on implementation and it must not only include a better understanding of the 

overall regional performance, but also a solid assessment of other competing regions. He sees all 

regional economic actors working together and supporting each other (Gollub, 2004). In that 

sense, the Green Valley Initiative may have a potential to advance to that second generation of 

clusters as it seems to satisfy some of the above conditions, but a strong leadership and political 

will would still be needed to bring all participants together to agree on common regional goals 

and necessary actions to implement future recommendations. 

If Clusters 2.0 are capable of adding a better understanding of the region’s geographic space and 

its competitive position, then there is perhaps already a need for Clusters 3.0, which would fully 

integrate geographic and economic spaces of individual regions and also its main economic 

actors. Clusters 3.0 would require government agencies and other stakeholders to go beyond 

traditional regional interests and invest more in learning about economic spaces of all regional 

agents, including business firms and other stakeholders. They would need to incorporate current 

and future environmental concerns and focus on sustainable development. Clusters 3.0 would 

have to consider new trends in location patterns in their geographic territory, as well as within 

competing regions, countries and even trade/ economic blocs. A very little progress has been 

made so far trying to predict future shifts in comparative and competitive advantages of particular 

regions and individual firms, which is crucial to regional- as well as business sustainability and 

prosperity. More than a quarter century ago Welles suggested that: “the most difficult factor to 

weigh is an area’s future, because high-growth areas can change overnight” (Welles, 1981, p. 

163). This observation is as true today as ever before, and would have to be taken seriously by all 

economic actors. 

Finally, regional development faces new challenges today that are often international in nature. A 

rapid progress in both globalization and regionalization demonstrate the need to understand 

important changes within geographic and economic spaces. At the international level Fujita 

identifies three cores of the regional integration as NAFTA, EU, and East Asia (Fujita, 2007b), 

rather than one unified global market. These powerful regional cores will continue to have 

serious implications for business expansion and economic development. Rather than fighting 

regionalization and globalization all levels of governments need to learn how to adapt better to 

those new trends and how to identify new opportunities, as suggested by Peter Drucker over ten 

years ago (Drucker, 1997). Unfortunately, the continuous lack of sufficient attention to 

geographic space is also clearly demonstrated by an enormous economic progress in some 

countries and regions and a disturbing increase in poverty in other areas. Governments will have 

to move beyond the investigation of the existence of industry clusters to be able to understand 

their economic and geographic environments and to plan for sustainable future development. 

CONCLUSIONS 

There is sufficient evidence and many empirical studies that clearly show the benefits and even 

the necessity of including geographic space in business education and management decision 



making, yet the majority of business and management schools does not seem to be rushing to 

make any substantial changes to their academic programs. 

The recent research under the name of the ‘new economic geography’ (NEG) has a potential to 

challenge the old perceptions and finally prove the importance of geographic space to business 

growth and economic development. This is perhaps the most important role for both NEG and 

the theory of clusters, even if some current theoretical conclusions are limiting in scope and 

sometimes controversial. Both Krugman and Porter may have presented rather simplified models 

of regional development and firm location so far, but their contribution to our understanding of 

the importance of geographic space is invaluable. 

In the so called real world, there are already some positive signs of change in regional 

development thinking and business expansion strategies, but it still will be a major challenge to 

convince governments to go beyond just ‘naming clusters’ and expand their understanding of 

interdependencies between geographic and economic spaces. Governments, restricted by their 

geographic space, often look for simplified solutions to complex problems, and current fiscal 

challenges make it extremely difficult to change old attitudes and add new programs. On the 

other hand, businesses already have a luxury of mobility within and between geographic spaces, 

and in their case a greater understanding of spatial factors could produce additional benefits and 

reveal new opportunities for firm expansion. In recent years, regionalization and globalization 

have been changing locational equations for many firms and entire industries by allowing them 

more efficient use of resources, but a more responsible corporate behavior has not always 

followed. The need for better understanding of geographic space and location has not 

diminished, and most likely it will become even more important in the future. 

It is already apparent that the ‘new economic geography’ may not be quite new and clusters are 

not a panacea for all business growth and regional needs. At the same time, we have only seen 

the first stage of this ‘new’ spatially based development theory. A lot more research has to be 

undertaken to understand the role of geography in business and economic expansion and to fully 

integrate economic and geographic spaces into one model. In the meantime, practitioners may 

well end up to be just one step ahead of the academia in their quest for finding easy solutions and 

in testing the most popular new concepts. 

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INNOVATIVE HRM: HOW HR ACTIVITIES 

CAN BE EMBEDDED INTO THE OVERALL 

STRATEGIC THRUST OF THE FIRM 

Asghar Zomorrodian, Ph.D. (Dr. Z) 

Union Institute and University 

Asghar.zomorrodian@tui.edu 

ABSTRACT 

This paper explores the design and implementation of strategic HR in line with the overall 

corporate and business strategies of the firm in achieving the competitive advantage. The main 

thrust in crafting and implementing the business strategies via strategic planning and other 

means will be presented first. Next the tie between such strategies and effective HR strategic will 

be explored by focusing on two strategic HR processes of compensation and performance 

management as outstanding examples. The paper makes clear references to the application of 

recent models in both areas like “broadbanding”, “36-degree feedback”, and “balanced score 

cards” The leadership factor and creating a high performance model in the organization as 

manifested by the significant role that strategic HR plays are the other focus of the paper. 

STRATEGIC APPROACH TO MANAGEMENT 

So much has been said, written and preached about strategic management in the past few 

decades. It seems that Strategic ap proach to manage ment i s now-a-days a modus 

operandi in most organizations. However, in spite of its pervasiveness, one wonders why 

so many or ganizations, public, privat e, nonpr ofits, and ot hers fail to achieve their 

strategic goa ls and objectives the wa y they planned to achieve. Aside f orm the 

complexity of this management process a nd the nuances involved in its im plementation, 

there are a few major factors, so common to any effective management approach, that are 

normally ov erlooked b y m ost organ izations when it com es to pursuin g a strategic 

approach. Major among them are factors related to strategy implementation and different, 

mostly new, sy stems that must be put i n place to accommodate the demands raised by 

new strategies. Factors like different or modified organizatio n structure, team and 

organizational culture, re ward sy stem, perfo rmance manage ment sy stem and may be 

most important of all, the “leadership” factor are known culprits. Often top management 

and executive tea ms take these factors for granted a nd assume that well crafted sets o f 

strategies, norm ally as manifested by strategic plan , will safeguard the att ainment of 

strategic goals. In this respect an increasing problem or need that arises relate to the lack 

of well est ablished holistic as sessment and ev aluation process that can help providing 

continuous feedback and correction mechanisms during t he strategy im plementation 

phase. For most part organizations stick to the existing management and business models 

including old-fashioned performance appraisal system that may not be co mpatible with 

the new demands for prop er strategy implementation. The thrust of this paper is to focus 

on Human Resources Policies and Practices, not only as an integral part of the strat egic 

process, but to highlight their vital role in th e make or break of any strategy and strategic 

plan of t he firm. The paper thou gh starts with some general overview of the definition 

and process of strategic management bot h in ter m so strategic planning and 


Zomorrodian 

implementation first, and then lead the discussion to the specific role of the str ategic HR 

in that process. 

What is strategic management? Harrison et. al. provide a sim ple definition f or strategic 

management as a process that involves form ulation of a set of objectives for 

organizational performance and continue that it is based on results or objectives initiated 

by the strategy formulation process. This is true because it is difficult to develop any 

strategy if management does not know what results are to be achieved. (1997) Normally 

strategic dec isions are being m ade by the CEO or leader ship tea m, and then 

communicated down the line. Harrison et al. (1997) also state that the m anagement 

teams at all l evel must be regarded as “participants” in decision making if it is to be 

conducive to strategic ion success. 

Management, all along the different lines of report in the organization, are required to have a 

good understanding of their roles from a strategic stand point and how they relate to the their 

team members as well as other organizational members. As management progresses in 

understanding the corporate strategy they can begin implementing changes that will help move 

the organization forward. Management helps employees see the vision, help employees to catch 

this vision and objectives and buy-in to the process of implementing the new strategies and 

relevant programs. 

Barney and Hesterly focus on what a good strategy is. They state that while most can agree that a 

firm’s ability to survive and prosper depends critically on choosing and implementing a good 

strategy, there is less agreement about what a strategy is and even less agreement on what is a 

good strategy (2006) Their approach to defining strategy is somehow adopted from what Drucker 

defined it (1994) as a theory about how to gain competitive advantages (P.5) 

This way one can assume that a good strategy as applied and followed by successful firms is the 

one that actually generates such advantage. A competitive advantage is what enables the firm to 

create more economic value that rival firms. Economic values then would be the difference 

between the perceived benefits gained by a customer that perchance a firm’s product or service 

and the full economic cost of these products or services as defined by Barney (19 91) , Porter 

(1985), Peteraf (2001) as well as many others. 

In comparing different firms, Barney and Hesterly identify three types of competitive advantage: 

Competitive Advantage, when a firm creates more economic value than rivals; Competitive Parity 

when a firm creates the same economic value as it rivals; and Competitive Disadvantage when 

the firm creates less economic value than rival (p. 13). In each case such advantage or 

disadvantage can be temporary or sustained. Of course the real aim of strategic management is to 

achieve substantiality and in fact such factor is the prime test for a successful strategy crafting 

and implementation. 

The overall strategic management process involves several interdependent stages that start with 

the Mission, then Objectives followed by external and internal analyses, normally know as 

SWOT analysis, and then strategic choice and strategy implementation, all aimed at creating 

competitive Advantage. 

STRATEGIC PLANNING 

Generally speaking the most visible manifestation for an organization deciding to engage in 

strategic management process is developing a strategic plan to gain efficiency, effectiveness and 

naturally a sustainable competitive advantage through utilizing its resources to the fullest. At the 

same time such plan and approach might be a response to the threats facing the organization now 

or in the future. Strategic planning is the process of developing the direction the organization 

wants or needs to follow in order to thrive. Luther states, “A strategic planning process describes 

an organization’s destination, assesses the barriers that stand in the way of that destination, and 

ultimately selects approaches for moving forward by dealing with the barriers” (1995). This 

process helps organization determine how it can gain or maintain its competitive advantage. The 


Innovative HRM 

intention would be to create more value by improving the product or service in order to stay 

competitive. 

Several steps are required in preparing this plan, similar to the ones mentioned above for strategic 

management process. The first of which is having a good vision and understanding of the 

organization’s purpose. There are many ways of developing this including group brainstorming 

sessions and revising existing mission or vision statements to help creating a focus. A few key 

elements like direction, time frame and how to proceed must come from this planning endeavor. 

Luther’s second step would be to create premises. These premises are developed using the 

familiar SWOT Analysis, which takes a look at an organization’s Strengths, Weaknesses, 

Opportunities and Threats, also know as the External and Internal Analysis (1995) Additionally 

what Barney and Hesterly (2006) refer to as VRIO can be plugged into this equation. They state 

that “the questions of value, rarity, imitateability, and organization can be brought together into a 

single framework” (P.92) This framework takes things a step further and looks at the potential 

of core competencies, rates its value as a resource as well as that of competitive advantage. 

Knowing this information will help in making educated strategic choices. 

After defining the objectives, it really helps to visualize the outcome. Weather written or just 

visual, creating the desired outcome helps bring out the reality of achieving your goals. Feelings 

of success can motivate. If management is able to break these goals into smaller 

accomplishments achievable by employees they will be motivated to participate. It is not only 

desirable, but necessary to share these objectives and potential outcomes with all employees to 

help generate additional buy-in. Studies have shown that productivity increases when employees 

have a high level of ownership of the outcome of their task. Generating this buy-in will help in 

the implementation process of strategic plan, which will be discussed later. 

The next step in the process is to create strategies. According to Luther (1995), “The task is to 

put in place the strategies or approaches required to accomplish each objective”. So now the 

strategic planning team is faced with dealing the questions like who, what, when, how, and 

where? Barney et al. (2006), count two types of strategies that need to be looked at: businesslevel 

and corporate-level strategies. These strategies vary based on the outcome of internal and 

external analysis and the type of organization in question. For example if the organization has 

only one business in one market or industry then the focus would be on business-level strategy. 

Organizations that are located in many different regions and industries, like multinational or 

global would focus on developing the corporate-level strategies. In either case, choosing a 

strategy can be based on four main criteria: 

(1) supports the firm’s mission 

(2) is consistent with the firms objectives 

(3) exploits opportunities in a firm’s environment with a firms strengths 

(4) neutralizes threats in a firm’s environment while avoiding a firm’s weaknesses 

(Barney et al., 2008, P.10) 

An important point in the whole process of strategic planning has to do with resource allocation 

and potential need forecast. One big implication of such allocation relates to human resources 

both in terms of new needs and reallocation of existing human resources across units, programs 

and activities. That is why the HR department must generally be present and involved in 

discussing such needs during the strategy formulation stage. This in turn will have a decisive 

impact on the implementation stage of the strategy as will be discussed next. When HR people 

engage in the strategic process, part of their work will include generating a strategy typically 

called workforce planning. With this plan they can begin to implement their portion of a larger 

strategic plan that may require additional or different human capitol to achieve their objectives. 

STRATEGY IMPLEMENTATION 

Looking at the rate of strategic success of different organizations one can find how 

implementation plays such an important role in this process. In fact most organizations are 


Zomorrodian 

successful in coming up with right strategies, but can go wrong and fail to implement those 

strategies. Why Implementation is so difficult? Because it has to do with creating a set of 

effective support systems as well as institutionalizing the right (and may be different) culture 

compatible with the new strategic outlook as well as a sound and perceptive leadership in the 

organization. Thompson and Strickland emphasize two sets of provisions for successful 

implementation of strategies. The first set includes establishing processes like linking budget to 

strategy, crafting strategy supportive policies and procedures, commitment to continuous 

improvement and sticking to the best practices (2005) The second set includes creating the state 

of art support systems that can be a basis for gaining the competitive advantage. They include 

installing adequate information system and performance tracking and control systems, designing 

appropriate reward system, and linking reward system to performance outcomes (P. 400-11) 

Thompson and Strickland also (2005) look at creating the right corporate culture and leadership 

as keys to effective strategy execution. Essential is creating an environment conducive to 

commitment and motivation on one hand, and an effective leadership approach to tune the 

organization in a high performance entity in achieving the intended strategic goals on the other. 

Beers and Eisenstat also take the issue of implementation as vital to the success of strategic 

success. They explain why most implementations fail and what organization can do to help them 

succeed. They cite that many times “senior managers get lulled into believing that a wellconceived 

strategy communicated to the organization equals implementation… [and] …they, 

(employees & managers) approach change in a narrow, non-systemic and programmatic manner 

that does not address root causes” (2000) 

According to them there are six silent barriers that hinder implementation: 

• Top Down or laissez-faire senior management styles 

• Unclear strategy and conflicting priorities 

• An ineffective senior management team 

• Poor vertical communication 

• Poor coordination across functions, businesses or borders 

• Inadequate down-the-line leadership skills and development 

Most important of all they see these sic factors as interacting with each other as 

depicted in Figure 1. 

Figure 1: Adopted from Beer and Eise nstat (2000) : Barriers to Strate gy Implementation 

As for leadership Factor t here are many s uggestion as what leadership st yle will help 


strategy implementation best. It seems the main factor have to do with situational factors 

as they determine the fit between a given leader ship style and factors like, the nature of 

task, technology , size of the organization, industr y, etc,., am ong them the ty pe do the 

followers is the most i mportant one. Beer and Eisenstat h owever, considerer the 

following as main ingredients that the le adership team must incorporate in the leadership 

process for strategic success: 

• Clear strategy, clear priorities. The t op team formulates the strat egy as a group 

and spends significant amounts of time discussing it with lower levels. 

• An effective top team , whose me mbers posse ss a genera l-management 

orientation. T hrough const ructive confli ct, the team arrives at a common voic e 

and creates a nd m aintains the organiza tional context needed to im plement the 

strategy. 

• Open vertical communication. The top team and lower levels are engaged in an 

open dialogue about the organizations effectiveness. 

• Effective coordination. Effective teamwork integrates activities around 

customers, products or m arkets across diverse functions, localities and 

businesses. 

• Down-the-line leadership. Mid-level ma nagers with the potent ial to develo p 

leadership skills and a general-mana gement p erspective are given cl ear 

accountability and authority. 

(Beer and Eisenstat, 2000) 


STRATEGIC MANAGEMENT: HR IMPLICATIONS 

Like any other aspect of strategic approach to management, HR strategic approach is considered 

as a process of developing HR strategies in such a way to support the business strategies. Wright 

et. al., based on some 20 companies study describe the generic approach to Strategic HR as 

somewhat consist with process for developing business strategies (Right, 2001) Noe et.al. 

depict 5 basic stages in identifying the HR strategy beginning from Scanning the external 

environment to identifying strategic business issues leading to identification of peoples issue and 

then developing and communicating HR strategies, (See Figure 2) 

Scan the 

external 

environment 

Basic Basic Process Process for HR Strategy Strategy 

Identify 

strategic 

business 

issues 

Identify 

people 

issues 

Develop 

HR 

strategy 

Communicate 

the HR 

strategy 

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc. All rights reserved. 


Zomorrodian 

Figure 2: Adopted from: Noe et. al. (2005) Human Resources Management 

How important is strategic HR for the organization? Do HR strategies enable a company to 

achieve a competitive advantage? Kearns states “Many businesses are very successful without 

any formal HR Strategy, but maximizing potential organizational value will only come from a 

combination of effective business strategy and an effective HR strategy” (2003, P. 19). He 

emphasizes that the value of human resources particularly by building a high-performance culture 

and implementing a Performance Management system that can meet its strategic business 

objectives. His argument is that assessment of the system must be addressed in terms of 

measuring human performance specifically as it produces added value to the bottom line of the 

organization. If we wish to create an organization that generates high levels of value, we have to 

design a high performance culture that engages its employees to continuously improve. 

Additionally, the effectiveness of this strategy must be measurable and must be measured in 

terms of added value or it is not a worthwhile strategy (Kearns, 2003, p. 180). Keams emphasis 

on performance management is very well-based as this paper will address this issue as one of the 

focal elements of Strategic HR later. 

To provide a kind of clear-cut comparison between Strategic HR approach as compared to more 

traditional (non-strategic) Noe et. al. depict a picture as how the three sets of activities they refer 

to can illustrate the level of engagement by any organization in strategic and non-strategic 

activities. The three categories they refer to are: 

Transactional activities dealing with record keeping benefit admin/ employee services. 

Traditional Activities dealing with recruitment and selection, training, performance management, 

compensation and employees relations, and 

Transformational Activities dealing with knowledge management, strategic redirection and 

renewal cultural change and management development as depicted in Figure 3. 

Categories Categories of of HRM HRM Activities 

Activities 

Transformational 

Knowledge management 

Cultural Change 

Strategic redirection and renewal 

Management development 

Traditional 

Recruitment and selection 

Training 

Performance management 

Compensation 

Employee relations 

Transactional 

Benefits administration 

Record keeping 

Employee services 

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc. All rights reserved. 

Firute.3: Adopted from Noe et. al. (2005) Human Resources Management 



It must be noted that the emphasis and time spent on each of these dimensions may vary from one 

organization to another deepening how strategic HR system is designed and how much emphasis 

is needed on each category dispending on the particular situation of a given organization. 

ALIGNING HR STRATEGIES WITH BUSINESS STRATEGIES 

While aligning HR Strategies with corporate and particularly business strategies can be achieved 

by following different routes depending on the type of organization and industry we can focus on 

a few examples to see how this process can be followed. Kearns (2003) refers to computer softer 

industry and state that in this industry there is a need to attract, retain and motivate employees 

because it is heavily dependent on the knowledge base and expertise of the employees and as 

such there is a need for building a kind of high performance culture based on a strategic mission. 

As how this can be applied to a firm, Starczak (2007) refers to Fetch Technologies as a perfect 

example of a company that could benefit from a HR strategy of building a high performance 

culture. She states that Fetch’s vision is to be a leader in the field of Data Extraction and 

Integration. Its business strategy is to create innovative Data Extraction Technologies then are 

faster and more efficient than anything currently existing and to be the first to market with 

applications using these technologies. In order to realize these goals, Fetch must be able to 

employ the highest quality software developers they can find. In addition, there must be a way to 

tap into and realize the full potential of their developers. This is where the HR strategy of 

building a high performance culture comes into play. A high performing team can give a 

competitive edge to a company that relies on intellectual capital and an effective performance 

management process that is in alignment, can provide the framework needed to implement this 

strategy. Assessing performance will provide a way to measure if there is value being added or 

not. In order to manage performance effectively and maximize the value, there must be a way of 

measuring it (Kearns, 2003, p. 175). Later we will address the HR strategy of building high 

performance culture as a way to achieve competitive advantage and how this would get 

implemented into a performance management system and assessed in terms of its added value. 

THE LEADERSHIP FACTOR 

Zomorrodian (1998) argues that while the role of leadership is vital in strategy development, such 

a role becomes more visible and crucial when it comes to strategy implementation. He furthers 

states that strategic leadership has as a decisive role in implementation process. The role of top 

leadership in tht respect is both symbolic and substantive in that the leader's action and perceived 

seriousness of his or her commitment to chose strategy significantly influence the intensity of 

subordinate mangers’ commitment to the implementation of strategy (P. 34) 

Many authors, however, share different views as to what makes a good strategic leader. Guillot 

(2003) shares his theory of what he considers to be the anatomy of a strategic leadership as 

depicted in Figure 4. 

Figure 4: Adopted from: Guillot (2003). “Strategic leadership: defining the challenge” 


Zomorrodian 

From his pyramid we see that he calls out many traits found in standard leadership. Better known 

as the Leadership Trait Theory, which boasts many of the same skills found here, and needed 

according for a strategic decision maker. The one difference between what Guillot (2003) says 

and what others may consider to be an added benefit would be the trait of experience. One does 

not have to have experience, but can find the help he needs to make effective decision. This 

could be said of other proposed traits as well. Generally speaking different authors see identical 

traits butt each may come up with different theories as how strategic leadership decisions are 

made in the organization. Guillot concept is somehow close to the definition and the role that 

Transformational Leader plays in the whole area of strategic management. Transformational 

leadership is, may be as the best example that one can depicts as how leadership can take an 

strategic turn in fulfilling the firm’s strategic objectives.. Transformational leaders have the 

ability to lead changes in the organization’s vision, strategy, and culture as well as promoting 

innovation. That is why normally this type of leadership is considered a necessity for major and 

fundamental changes facing the organization or social entity in dealing with their challenges. By 

nature, this type of leadership is strategic and in that sense it can be equated to strategic 

leadership since the leader has to facilitate the process of strategy implementation through 

creating and fostering the right culture in the organizations. (Zomorrodian, 2006) Daft states that 

Transformational leader (TL) can take the organization through several major changes by 

successfully achieving the following: 

1. Create compelling vision 

2. Mobilize Commitment 

3. Empower Employees 

4. Institutionalize a Culture of change ( Daft, 2005, PP. 507-8) 

Thus Transformational leadership is not only forward-looking, but at the same time can be seen 

as inspirational and ethical based on the legitimate values and leader’s credibility enabling the 

followers to internalize those values as well. 

EXAMPLES OF STRATEGIC APPROACHES TO SELECTED HR AREAS 

While adopting strategic HR permeate all aspects of the system in the organization, just for the 

sake of illustration the paper brings two specific examples as how strategic HR may affect its 

very important direction and thrust on these two components of the HR system. These two 

examples deal with specific aspect of the compensation and performance management processes. 

Compensation: In every organization one might say that strategy is one of the top goals they are 

working to reach. As was mentioned before strategy is a theory about how to gain competitive 

advantage, and a good strategy is actually generating such advantages. However, the pursuit of 

strategy is constant and a business should not be satisfied if it has reached some form of 

competitive advantage because the market is forever changing. Strategies will always need to be 

devised in order for a business to stay aggressive and to meet the needs of changing consumer 

demands and market structure. One particular piece to the strategic puzzle, the one that may be 

deemed the most important, is compensation. Since attraction and retention of highly qualified 

people are top priority for strategic success, competitive compensation and its alignment with 

overall business strategy lay at the heart of HR strategic approach. Added to this is the fact that at 

the present since baby boomers retiring and fewer people entering the workforce the labor market 

has become extremely tight in the last few years, making recruitment and retention a top strategic 

issue for businesses in general and in specific industries in particular. This change has forced 

organizations to deeply analyze their compensation strategies to see how they faire in their 

competitive industries and if they are meeting the needs of potential candidates and employees. 

While many innovative approaches to the design and redesign of compensation system exist, one 

popular and relevant innovation in recent years is known as “braodbanding” This innovative 


approach to compensation does not only have a big strategic implication in retaining high caliber 

cadres, but at the same time provides the leadership with a big latitude for flexibility. 

Braodbanding offers a high potential in developing a competitive advantage over others in a 

given industry or organization by decreasing the number of job categories available and 

increasing the salary ranges for those bands. Paying employees under a broadband system can 

result in harder workers, increased skills and abilities, better career mobility, improved products 

and higher profits, all of which can help a firm to gain an advantage over its competitors. 

Von Plato reports how this approach work and help Tecolote Research, Inc. to achieve the 

company’s mission in delivering reliable quantitative solution to the clients in an environment of 

constantly changing budgets and priorities. The company considers people as its primary 

resource and investing in extensive training programs, pleasant work environments, generous 

benefits and cutting-edge tools. All this aims at achieving a very high employee retention rate and 

a stable work force that brings added value to our clients (2007 ) 

For Tecolote, as an aerospace division of a larger company with high expectation from qualified 

staff, broadbanding seems to be an excellent strategic choice to curve that competition and to 

regain their competitive advantage over them. Research shows that, “broadbanding has been 

successfully implemented in large, hierarchical organizations that attempt to flatten their 

organizations and remove levels of management and small organizations where there are good 

controls and a desire to be an attractive alternative to larger competitors” (Rosenthal, n.d.). When 

companies are struggling with salary structures and cannot pay their employees, or potential new 

employees, at market levels, they need to consider broadbanding as an option. For example, 

organizations that formerly had twelve levels of management could band them together, enlarge 

the salary ranges for the remaining six or so levels, and place each employee into one of the new 

bands. “The wider bands lessen the focus of those employees that become fixated on having their 

position constantly reevaluated to see if their position can be moved up a range upon the addition 

of any new duties” (Rosenthal, n.d.). By introducing broadbanding, Tecolote can emphasize their 

efforts to:“… facilitate change, avoid multiple pay structures, drive pay decision-making 

downward…provide greater latitude in management pay decisions, promote lateral moves or ingrade 

promotions, reduce use of promotions to increase pay, promote career development/ 

learning, reduce the need for precise job analysis/evaluation…focus on the person instead of the 

job and facilitate quick responses to changing goals and circumstances” (Stern & Associates, in 

Van Plato, 2007). If Tecolote wants to expand its growth potential, acquire new business and 

generate a higher profit, they will need to think outside of the box and make some strategic 

choices regarding their current compensation structures. This is where the proposal of 

broadbanding enters the scene. As was stated before, broadbanding is “of particular use [when] a 

company has gone through a major change such as a merger or acquisition or where there is a 

need for a new organizational/business model” (Wyatt, 2003). The focus Tecolote Research needs 

to take to meet market demand is to not necessarily break down and minimize job categories to 

flatten the organization, but to focus more on expanding the salary caps on each individual band. 

Tecolote currently has seven Analyst categories and three upper management categories. These 

jobs can be broken down into smaller bands, if necessary, as long as larger salary minimums and 

maximums are established as well. This move alone would increase the mobility and capability of 

analysts “trapped” in the same category for long periods of time by allowing them to move more 

freely across the division and to increase their earning potential. New employees also would 

benefit because they would more easily fit into the internal structure already in place and be more 

likely to accept an offer from the company. When choosing the strategic choice of broadbanding, 

Tecolote Research, Inc. must consider the business-level strategies that fit this compensation 

model: do they want to focus more on cost leadership or on product differentiation when 

considering the goals of broadbanding. Cost leadership is defined as a business strategy that 

focuses on gaining advantage by reducing its costs to below those of all its competitors (Barney 

& Hesterly, 2006, p. 116). Pursuing this type of a strategy would mean that Tecolote would need 



Zomorrodian 

to focus their sights on keeping costs extremely low, and broadbanding could make this focus a 

possibility. As bands are widened more analysts will have the ability to earn more money per 

hour from their government customers. Their higher category eligibility would generate higher 

profits for the company and offset a portion of the higher payroll distribution. Likewise, it would 

be a similar situation for analysts who would be forced to move down to a lower, thus losing 

some profits at the same time. However, depending upon the number of analysts in each category, 

the profit margin may end up being a wash with employees still having the opportunity to earn 

more income. In either case, the strategy would have to be closely monitored in order for the 

company to sustain its level of business. 

Performance Management: Through performance management an organization can 

ensure that its employees are producing successfully and in turn acting as effective agents 

for the entire organization. Performance management is a process in which employee’s 

performance is evaluated against standards and is a process that aids employees in 

developing an action plan to focus on any discrepancies that are recognized 

(Gowan,2001) Heathfield criticizes the traditional performance evaluation and states that 

performance management is a process and a system, not just a yearly appraisal. The 

process begins when a job is defined as needed and ends when the employment is 

terminated (Heathfield, 2007) The objective of performance is to attain the company 

mission and vision and keep it strategically aligned. Heathfield states that “an effective 

performance management system sets new employees up to succeed, so they can help 

your organization succeed. An effective performance management system provides 

enough guidance so people understand what is expected of them. It provides enough 

flexibility and wiggle room so that individual creativity and strengths are nurtured. It 

provides enough control so that people understand what the organization is trying to 

accomplish” (2007) This new revolution in Human Resources is where the “performance 

appraisal” is being phased out and replaced with “performance management”. The oneway, 

once a year, “report card” has been substituted with a two-way, continuous 

observation, assessment and feedback across the individuals, teams and the total system. 

Williams sees performance management involves thinking, planning, and coaching that is 

on-going throughout the year. He looks at continuous feedback/conversations as 

supporting the performance of employees and allows the employer to express 

expectations and for the employee to adjust behavior as a result of each conversation 

throughout the year (2007) In the past ten years, among several performance assessment 

tools that appeared in HR field, the 360-degree feedback has transformed performance 

management. 

360-degree feedback is an overall comprehensive review that gathers input not only from 

managers, but peers, direct reports, and sometimes the “customers” (Prewitt,2007; 

Peiperl,2007). The philosophy behind this method is that most employees work with a 

wide range of people, from peers to the customers you are servicing. According to 

Prewitt, the 360 sets out to get a broader view than traditional methods. He outlines 

essential tips on implementing the 360 to ensure its effectiveness(2007) Zomorrodian 

explored the application of 360 feedback to the process of executive mentoring (2003) 

and referred to it as a performance feedback tool that warrants consideration and a review 

as its popularity continues to expand among firms, signaling that it has exceptional merit 

and worth. This method of performance management has been introduced in the majority 

of Fortune 1000 companies. Examples of organizations currently using the tool include 

but are not limited to the following notable companies: McDonnell-Douglas, AT&T, 


Allied Signal, Dupont, Honeywell, Boeing and Intel (Mondy et. al, 02) Thus, as 

demonstrated by these companies, the feedback tool is appropriate across various 

industries. The 360-degree feedback tool is a multi-rater evaluation that involves 

feedback from various levels in the organization, including one's managers, peers and 

direct reports. The type of information targeted in the feedback questionnaire should be 

limited to knowledge, skills and behaviors, while avoiding personality traits or styles 

(360” FAO, 02) Knowledge refers to an individual's level of familiarity with the job, 

industry and company, while skills refer to the individual's level of proficiency of the 

required tasks. Behaviors are patterns in relating to the environment, such as energy, 

optimism and trustworthiness. When preparing the information to include in the feedback 

tool, the organization must outline the criteria relevant to the job being performed and 

exercise caution to avoid including irrelevant information that could hinder the process. It 

is imperative to remember that this feedback system is not intended to rate individual 

personalities; rather, it is designed to help the individual identify areas of strength and 

areas needing development, which are related to job performance. While normally there 

seems to be two different angles of the tool's purpose: decision-making and development 

(Zomorrodian 03), it seems that this powerful feedback method can play an strategic role 

for organization if it is integrated to a kind of system-wide holistic performance 

management system that goes well beyond the individual appraisal and covers units and 

the total system levels. 

Balanced Score Card (BSC) is another strategic oriented model that directly affects HR 

in the area of performance management. This model ties organizational achievements in 

terms of customer satisfaction, financial goals, effectiveness of internal process, and 

learning and growth all together within the scope of the firm’s strategy. Balanced Score 

Card Institute considers the method a valuable and effective measurement-based 

management that builds on some key concepts of previous management ideas such as 

Total Quality Management (TQM), including customer-defined quality, continuous 

improvement, employee empowerment, and -- primarily -- measurement-based 

management and feedback (BSCI, 07)The model consists of three major characteristics as 

follows: 

1. Double-Loop Feedback: In traditional industrial activity, "quality control" and "zero 

defects" were the watchwords. In order to shield the customer from receiving poor 

quality products, aggressive efforts were focused on inspection and testing at the end of 

the production line. The problem with this approach is that the true causes of defects 

could never be identified, and there would always be inefficiencies due to the rejection of 

defects. What Deming saw was that variation is created at every step in a production 

process, and the causes of variation need to be identified and fixed…. To establish such a 

process, Deming emphasized that all business processes should be part of a system with 

feedback loops. The feedback data should be examined by managers to determine the 

causes of variation, what are the processes with significant problems, and then they can 

focus attention on fixing that subset of processes. The balanced scorecard incorporates 

feedback around internal business process outputs, as in TQM, but also adds a feedback 

loop around the outcomes of business strategies. This creates a "double-loop feedback" 

process in the balanced scorecard. 

2. Outcome Metrics: You can't improve what you can't measure. So metrics must be 

developed based on the priorities of the strategic plan, which provides the key business 

drivers and criteria for metrics that managers most desire to watch. Processes are then 



Zomorrodian 

designed to collect information relevant to these metrics and reduce it to numerical form 

for storage, display, and analysis. Decision makers examine the outcomes of various 

measured processes and strategies and track the results to guide the company and provide 

feedback. 

So the value of metrics is in their ability to provide a factual basis for defining: 

• Strategic feedback to show the present status of the organization from many perspectives 

for decision makers 

• Diagnostic feedback into various processes to guide improvements on a continuous basis 

• Trends in performance over time as the metrics are tracked 

• Feedback around the measurement methods themselves, and which metrics should be 

tracked Quantitative inputs to forecasting methods and models for decision 

support systems 

3. Management by Fact: The goal of making measurements is to permit managers to see 

their company more clearly -- from many perspectives -- and hence to make wiser longterm 

decisions. The Baldrige Criteria (1997) booklet reiterates this concept of fact-based 

management:” Modern businesses depend upon measurement and analysis of performance. 

Measurements must derive from the company's strategy and provide critical data and information 

about key processes, outputs and results. Data and information needed for performance 

measurement and improvement are of many types, including: customer, product and service 

performance, operations, market, competitive comparisons, supplier, employee-related, and cost 

and financial. Analysis entails using data to determine trends, projections, and cause and effect -- 

that might not be evident without analysis. Data and analysis support a variety of company 

purposes, such as planning, reviewing company performance, improving operations, and 

comparing company performance with competitors' or with 'best practices' benchmarks." "A 

major consideration in performance improvement involves the creation and use of performance 

measures or indicators. Performance measures or indicators are measurable characteristics of 

products, services, processes, and operations the company uses to track and improve 

performance. The measures or indicators should be selected to best represent the factors that lead 

to improved customer, operational, and financial performance. A comprehensive set of measures 

or indicators tied to customer and/or company performance requirements represents a clear basis 

for aligning all activities with the company's goals. Through the analysis of data from the tracking 

processes, the measures or indicators themselves may be evaluated and changed to better support 

such goals."Figure 5 depicts the general schemata of BSC that can be modified and applied to a 

particular situation of an organization (BSCI, 07) 


Figure 5: General Schemata of BSC: adopted from: BSC Institute 2007 

http://www.balancedscorecard.org/basics/bsc1.html 


Strategic Management and the High Performance Model 

Gaining competitive advantage then becomes the focal guiding light for strategic HR. At the heart 

of the matter lies the fact that how we can create and sustain the high performance organization. 

Buzzotta (1999) offers high a model that can be use as a foundation for creating a performance 

management system that supports our HR strategy. The model uses “Trust” as the cornerstone of 

creating the high performance system. There are four major interacting processes that the 

organization and top management must get involved in order to achieve such a high performance 

system as indicated in Figure 6 and brief explanation that follows: 


Zomorrodian 

Figure 6: High Performance Model, adopted from Buzzotta: 1999 

1. Know where you’re going: Buzzotta states that The CEO must clearly communicate the 

business goals and vision of the company to all employees and show a commitment to implement 

them. The vision and the strategic business plan is something that must be incorporated into the 

culture and throughout the performance management system. Specifically, it should be included 

in such things the job descriptions and whenever communicating performance and expectations to 

the employees. 

2. Ensure People Have What It Takes to Get Where They are going: this is the second process in 

Buzzotta’s model (p. 2). This covers a wide range of training and development needs, facilities 

and equipment, right and encouraging environment as well as management support. 

3. Develop and Enable them: the third process of has to with giving employees opportunity to 

learn and help each other and elevate to their maximum potential. This is what we normally refer 

to as empowering the employees and if done right and the learning and contribution of each 

member of the organization is valued and encourage ultimately we get to point that learning 

occurs at all three levels of individual, tem and total organization and we move toward the true 

learning organization (Zomorrodian, 1999) 

4. Help Keep Them On Track: In a high performance culture, an effective appraisal system will 

ensure that the human resources are managed in a way that optimizes the value for the 

organization. It must be designed to support the strategy of creating a high performance culture 

and there must be a way to measure performance against the added value. For example, during 

the appraisal process, relevant goals must be created by the management with input from the 

employee. Performance must be continuously monitored and measured and employees need to be 

given ongoing quality feedback that is clearly communicated and relevant to how well the desired 

results are being achieved (SHRM, 2006, p. 107). The process must support the culture; a strong 

management team that is skilled in mentoring and coaching is essential to build a high 

performance team. This is where managers have an opportunity to really motivate their team in 

the way they communicate with them, listen to what they have to say, and the way they provide 

support and encouragement (Bruce & Pepitone, 1999, p. 52). This is the place where good 

relationships are created and the management team must be well indoctrinated on the HR strategy 



where open communication and innovative thinking is encouraged. At the team and total 

organizational level appraisal and assessment models like 360-degre and BSC are very relevant in 

achieving the strategic objectives. 

CONCLUSION 

Strategic HR is becoming the modus operandi of any progressive and high performance 

organizations. Adopting sound and effective HR strategies bade on the overall corporate and 

business strategies are the foundation for success and achieving the competitive advantage for 

any organization that wants to survive and prosper. This paper focuses on a few specific models 

that can help designing and implementing such strategic approach. Specific emphasis was on two 

major HR process: Compensation and performance management as examples of how strategic 

HR approach these two crucial activities in the organization. Leadership factor was considered as 

the key element for make or break of the organization strategy in general and HR strategies in 

particular. High performance model was touched upon as a basis for moving the organization in 

that direction with four major processes to be followed. One last point that needs to be addressed 

with regard to such high performance system has to with Reward and Recognition and nurturing 

an environment of trust. The former is essential in supporting our HR strategy by providing 

strong reinforcement for the high performance standards set. The rewards must not be confined 

to only extrinsic one like compensation, rather a host of intrinsic ones that fits the needs and 

expectations of diverse employees. The later has to with the impact of leadership in creating a 

culture conclusive to creating trust among employees and management that eventually will result 

in commitment to the mission and objectives. One cannot overemphasize the role of ethical and 

honest leadership in achieving such ends. Integrity must be the focal value of the organization and 

it should be manifested in leadership practices at all levels to set the example for all 

organizational members. 

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