THE EVOLUTION OF ECONOMICS-BASED EMPIRICAL RESEARCH
Ross L. Watts
Associate Professor, Graduate School of Management,
University of Rochester
An enormous change has occurred in accounting research since I first
came to this country in 1966. This change is well illustrated by the
difference in the composition of the participants at the first Chicago
Annual Conference on Empirical Research I attended (1967) and the
most recent Accounting Conference I attended at the University of
Chicago, the 1982 Conference on Current Research Methodologies in
Accounting. The first conference included the Managing Director of
the AICPA among those presenting papers and among the discussants,
three accounting practitioners, two finance practitioners, one economist
and one behavioral scientist. The most recent conference included
a well known economist and a well known behavioral scientist among
those giving papers and three top financial economists and a behavioral
scientist as discussants. Further, several well known economists even
paid their own expenses to attend the Conference (including my own
colleague Bill Schwert). No practitioners (finance or accounting)
appeared on the program in 1982. (1)
Accounting research has attained a degree of academic respectability
among economists far greater than I would have thought possible in
1967. But, at the same time it has become more removed from the practitioner.
What are the reasons for those changes? First, accounting research
has become much more scientific; more rigorous and sophisticated in
its analysis and empirical work. This has gained the respect of economists,
but at the same time it has made it much more difficult for practitioners
to read and understand the literature. (2)
Second, the topics addressed by accounting researchers are
very important to the economists' new found interest in the theory
of the firm. This has attracted the interest of the economist, but
the result of this recent shift in topics has not yet begun to be
translated for professional consumption. Practitioners are still confronted
with the view that the EMH implies that if accounting procedures do
not affect taxes they do not affect stock prices.
The application of scientific methodology to interesting accounting
topics has not only gained the respect of economists, it has produced
some robust empirical results which were previously unknown (to me
at least). An example is the result that the higher the leverage of
a firm the more likely it is to use accounting procedures which increase
the present value of reported earnings. Such results, together with
the insights produced by the analysis, suggest that the current thrust
of economics-based accounting research will provide a better explanation
for accounting practice. If it does, I expect practitioners to be
more actively involved in the accounting research process.
The economics-based empirically-oriented research literature which
attracted top economists to the 1982 Chicago Conference did not emerge
full blown, it was an evolutionary process. The process followed naturally
not only from the greater training accounting researchers received
in the discipline of economics, but also (from the mid-60's on) from
those researchers' exposure to the oral empirical tradition, to the
research methods used in science.
This exposure to the research methods of science came not from formal
courses in scientific method, but from exposure to numerous workshops
where empirical studies in finance and economics were criticized and
from the advice of experienced empirical researchers. However, I would
hasten to add that as the area has matured, or better, perhaps, as
some of us have grown old, accounting empiricists have read the philosophy
of science literature. That is appropriate in my opinion because an
understanding of that literature is difficult unless one has had experience
of empirical work.
The objective of this talk is to trace the evolution of economics-based
empirical research in accounting and to relate it to the oral tradition,
as I perceive it, and to developments in financial economics. An understanding
of this evolutionary process is important to the practitioner who
wants to understand the empirical literature in accounting. It is
crucial to the accounting student who aspires to become a successful
researcher. An understanding of the process enables the researcher
to identify and pursue important new research topics, rather than
replicate the studies of others.
Before I trace the evolution of the empirical work and relate it
to the oral tradition, let me give a brief outline of my view of theory
under the oral tradition.
2. THE NATURE OF THEORY
a) Objective of theory.
Under the oral tradition a theory is designed to:
i) explain associations between observable variables, for
example between firms' debt/equity ratios and their use of straight-line
or accelerated depreciation. Such explanations allow one to attach
causality to a variable (e.g., that differences in debt/equity ratios
cause differences in depreciation methods);
ii) provide predictions about relationships not yet observed.
For example, before investigating and observing stock prices, some
researchers predict based on their theory that a change to straight-line
depreciation, per se, does not affect stock prices because it does
not affect the firm's cash flows.
A theory of accounting should explain why different firms and industries
use different accounting procedures. For example, it should explain
why firms in the mining and construction industry recognize profit
at production and other firms recognize profit at sale. Further, it
should enable one to predict which procedures firms with particular
characteristics will use.
b) Importance of theory
The corporate manager trying to be successful in his own career often
has to make accounting decisions, for example, the choice between
accelerated and straight-line depreciation. In making those decisions,
the manager would like to know the effect of his choice on his career.
He wants to know the answer to what if questions. If
he chooses accelerated depreciation what is its effect on the
firm's cash flows, its stock price and his own welfare. The manager
will have his own ideas about those effects and will make decisions
on the basis of those ideas. However, if a theory is produced which
"better" predicts and explains the effects than his own
implicit theory, he will tend to use the new theory. If he doesn't,
he will tend to be surpassed by managers who do use the new theory.
So "better" theories are important to the manager.
The public accountant would also like to know the effect of accounting
decisions such as the choice of accelerated or straight-line depreciation.
If he is to recommend the method to a client he would like to know
the effects of the method on the client and himself.
Those who would demand accounting theories include lending officers
of financial institutions, financial analysts, investors and those
who regulate accounting and promulgate accounting standards. I think
the FASB members would have liked to be able to predict the reaction
to FASB Statement number 8.
c) The success of theories
How do researchers determine which are the "best" theories?
A simple answer to this question is that in the long term the researchers
do not have the choice, the users will determine which theories are
Users of theories will not wait for a perfect theory (i.e., one which
predicts and explains every observation). They will choose the one
out of the available imperfect set which is best for them. For example,
suppose a given model of bankruptcy predicts a firm will go bankrupt
within a year and there is substantial evidence that model's predictions
are right 95 percent of the time. Would a lending officer who, before
learning of the model's prediction, predicted a probability of bankruptcy
of .01, ignore the model's prediction of bankruptcy? No. He'll use
the model if it is more accurate than his own predictions and weigh
the expected costs of type I and type II errors in making his investment
The successful theory is the one which is most useful to users. As
Popper (1959, p. 108) writes: "We choose the theory which best
holds its own in competition with other theories; the one which, by
natural selection, proves itself the fittest to survive." This
suggests that there is no natural significance level for hypothesis
testing such as the commonly used five or 10 percent. If there are
no better theories available 20 percent could be acceptable. The choice
is always between imperfect theories or between an imperfect theory
and no theory at all.
The acceptance of imperfect theories by users is not unique to the
social sciences. For example, Newtonian physics are still used for
many purposes. And, theories of aerodynamics were used despite the
fact that until recently they predicted that the bumble bee would
not fly. The issue is one of costs versus benefits to the user.
d) Role of a Meory's assumptions
In developing a theory researchers make assumptions, define variables
and then use logic (including mathematics) to derive relationships
between variables. Finally, substantive hypotheses are derived for
empirical testing. Of necessity assumptions are not completely realistic.
Theories try to generalize across more than one observation, so they
abstract from certain characteristics of variables and concentrate
on others. In choosing assumptions the researcher tries to capture
the essence of the Phenomena. For example, the assumptions of perfect
competition while not perfectly descriptive may capture the essence
of the competition among a large number of traders in the commodities
markets and as a result produce a theory which has substantial predictive
and explanatory power for many purposes.
Because of their abstractions, all our theories in economics and
accounting will not explain every observation. We will always be able
to find contrary examples. This is something non-empiricists and practitioners
find very hard to understand.
Assumptions are very important in developing a theory. Contrary to
Friedman (1953) we do not have to worry as to how descriptive they
are because that will affect their ability to predict and explain
e) Role of mathematics
The use of mathematics, per se, is not a criterion in determining
the success of a theory. Mathematics is one way of applying logic
to the assumptions and definitions to derive propositions. An important
criterion in choosing among theories is simplicity. If a point can
be made without complex mathematics it should be made in that fashion.
Complexity, per se, is "bad" because it imposes costs on
the user of a theory. Unless the complexity provides additional insights
or testable propositions it should not be employed. This point is
frequently overlooked by our colleagues involved in model building.
f) Relationship between theory and normative propositions
Over the years accounting research has been driven by the desire
to make normative propositions, to answer the question, what accounting
method should be used? Pressures have been put on the SEC, the CAP,
the APB and the FASB to reduce the diversity of accounting procedures
and this led the researchers of those bodies to seek guidance from
accounting researchers as to what procedures should be allowed. Likewise
as indicated previously, corporate managers also seek the answer as
to what procedure should they use.
As accounting researchers have come to recognize (see Beaver and
Demski), theory alone cannot answer these questions. In order for
the theorist to answer his question, the user (FASB or manager) has
to specify the objective function. This makes the question a "what
if" type and theory can be used. If the manager specifies the
objective as maximizing the value of the firm, an accounting theory
which explains the effect of accounting methods on stock prices can
provide an answer. The "what if" question is testable and
evidence can be applied.
Having briefly outlined some aspects of theory as I see it viewed
in the oral tradition, let me now turn to the evolution of empirical
research based on economics.
3. THE EVOLUTION OF EMPIRICAL RESEARCH
Accounting research has always tended to borrow from economics rather
than lend to economics and the beginning of economics-based empirical
research in accounting is no different. There were a smattering of
economics-based empirical studies appearing in the mid-60's on income
smoothing (Gordon, Horowitz and Meyers, 1966) and on financial distress
prediction (Beaver, 1966) and even one on the relationship between
earnings and stock prices (Benston, 1967) but the paper which generated
accounting researchers' interest in empirical work based on financial
economics was Ball and Brown (1968). A recent informal survey of leading
accounting academics by Dyckman and Zeff (1983) found that Ball and
Brown was cited as one of the most important contributions to accounting
in the last two decades more often than any other article. In fact,
it received more than twice as many votes as its nearest competitor.
The Ball and Brown paper led to an outpouring of economics-based
empirical work in accounting. The paper was originally rejected by
the Accounting Review because it was not an accounting manuscript.
Hence, it was accepted by the Journal of Accounting Research
(see Dyckman and Zeff, 1982, p. 22) and the flood of research which
followed helped carry the JAR to prominence as the leading
academic accounting journal. In fact, I suspect the JAR played
an important innovative role in developing empirical research.
Given the role of the Ball and Brown paper in generating research
it is instructive to evaluate the paper in terms of the oral tradition
on the evolution of research.
a) Ball and Brown (1968)
In the 1960's most of the papers published in the Accounting Review
or the JAR were what Dyckman and Zeff (1983) call "a priori"
research. They were concerned with arguing for or against particular
accounting procedures. The best of these papers assumed an objective
function, assumed that certain hypotheses about the use of accounting
data and other phenomena were correct and attempted to logically derive
which methods would maximize the objective function. Of course, given
their objective function and that their logic is correct, the prescriptions
of these papers (e.g., current value accounting) are only as good
as the weakest of the hypotheses underlying them. If one hypothesis
is not descriptive, the prescriptions would not achieve the objective.
From the early to mid-60's on some Ph.D. programs placed emphasis
on finance and economics training for their accountants. Ball and
Brown recognized from their finance training that many of the "a
priori" papers relied on an hypothesis that was at odds with
an hypothesis which had a great deal of supporting evidence in the
financial economics literature the efficient markets hypothesis. In
particular, many accounting researchers assumed that published accounting
numbers are the only source of information on a firm. Hence, they
assumed managers could adopt an accounting procedure which increased
earnings but didn't affect cash flows (for example, a switchback to
straight-line depreciation for reporting) and increase stock prices.
In essence, share prices would react mechanistically to published
earnings. The essence of the Efficient Markets Hypothesis is that
there is competition for information in the capital markets and information
which is readily available to a large number of people (such as a
change in depreciation methods) which would be recognized and impounded
in the firm's share price. Hence, in assessing a firm's earnings the
stock market would discount the effects of any change in depreciation
methods if it were announced. If it weren't announced the market would
make a prediction as to the likelihood the firm had changed and its
estimate, on average, would be correct.
The efficient markets hypothesis and the mechanistic hypothesis are
competing hypotheses about the reaction of stock prices to accounting
earnings. Since they give different predictions for those reactions,
under the oral tradition the expected procedure for Ball and Brown
to follow would be to test which reaction is consistent with the evidence,
to discriminate among the theories. But, they didn't do this. Instead,
they examined the stock price reaction to earnings announcements and
interpreted the results assuming the Efficient Markets Hypothesis
was correct. They learned that changes in earnings and stock prices
were highly associated, that much of the stock price change occurred
before the announcement and the rest at the time of the earnings announcement,
but they didn't discriminate between the hypotheses.
One can speculate why Ball and Brown did not attempt to discriminate.
With hindsight, it appears obvious that they should have tried. However,
the paper was partially inspired by a paper in finance by Fama, Fisher,
Jensen and Roll (1969) which used a new event methodology to look
at the stock price effect of stock dividends. In their haste to introduce
the new methodology into accounting, Ball and Brown may have overlooked
the step of discriminating between the competing hypotheses.
While Ball and Brown did not discriminate between the competing hypotheses
they did follow a rule which is important in first investigations
of an area-start with simple aggregate models and look for large aggregate
relationships first. Additional complexity increases the number of
assumptions necessary and the likelihood of introducing assumptions
which are not descriptive. Under the Efficient Markets Hypothesis
the market reacts to unexpected earnings on the announcement date.
Hence, Ball and Brown required a model for the market's expectation
of earnings. They chose a very simple model -- the earnings are expected
to be the same as the earnings of last year. With hindsight we know
that is a very good model for predicting earnings, and had they chose
a more complex model they might not have observed the expected relationship
between earnings and stock price. (4)
Attempts to remedy the failure of Ball and Brown to attempt to discriminate
between the mechanistic and Efficient Markets hypotheses were eventually
forthcoming in 1972 in the studies of Ball and Kaplan and Roll. These
were followed by a whole spate of studies of the stock price effects
of changes in accounting techniques.
b) Studies of changes in accounting procedures
Ball and Kaplan and Roll attempted tests which would directly discriminate
between the mechanistic and Efficient Markets hypotheses. The basic
proposition was that changes in accounting procedures such as switchbacks
to accelerated depreciation for reporting purposes do not affect cash
flows and therefore under the Efficient Market Hypothesis should not
affect stock prices on average. Under the mechanistic hypothesis such
changes would affect stock prices in the direction the change affected
earnings. If it increased earnings stock prices should rise, if it
decreased earnings stock prices should fall.
Despite their conclusions to the contrary, the Ball and Kaplan and
Roll studies did not distinguish between the two hypotheses. The studies
have too many methodological problems (see Watts and Zimmerman, 1983)
for us to discuss here, but one important defect is related to what
is called an "ex post selection bias." Both studies found
that firms which change procedures have on average been performing
poorly over a long period of time. By selecting firms which change,
you select losers. However, Ball's evidence indicated that firms which
switch to LIFO have been superior stock price performers in the year
before the change. Later studies confirmed that LIFO switchers are
also superior earnings performers. Thus, in looking at the stock price
effect of any particular type of procedure one would want to adjust
for the earnings announced at the same time. The early studies did
not make that adjustment.
These studies showed us that discriminating between the two hypotheses
was not easy. It emphasized that theories are not developed and tested
in any one study. Patterns only begin to emerge from a series of studies.
Hopefully, each study learns from the studies which precede it. Ball
and Kaplan and Roll narrowed in on the discrimination among theories
neglected by Ball and Brown. Later studies try to remedy the lack
of earnings control and problems which were indicated by the Ball
and Kaplan and Roll studies -- it is an iterative process. The journey
has to begin with one small step and Ball and Brown was that step.
The Ball and Kaplan and Roll studies and those which followed began
to raise even more serious questions about accounting. Those studies
were aimed at discriminating between an hypothesis for which there
was considerable empirical support in the finance literature and an
assumption of the "a priori" accounting literature. In that
sense, they served to eliminate non-descriptive hypotheses from accounting
theory. However, with that non-descriptive hypotheses they eliminated
explanations for why managers choose particular accounting procedures.
As a result they left a vacuum, they did not provide any explanation
for the choice of accounting procedures. The finance theory underlying
most of these researchers' view of accounting was the capital asset
pricing model. In that model information is costlessly available to
everyone and there are no costs of organizing firms or contracting,
In short, there is no role for accounting. Accounting is irrelevant.
The preceding conclusion is what practitioners, forced to confront
the Efficient Markets Hypothesis studies, regard as an implication
of that hypothesis. It is not. It is the CAPM and the Modigliani and
Miller (1956) worlds which led to the interpretation that accounting
procedures do not have cash flow effects and therefore do not affect
stock prices. The Efficient Markets Hypothesis is an hypothesis about
the level of competition in the capital markets and does not assume
no cash flow effects for accounting procedures.
For an accountant trained in the oral tradition the vacuum left by
the assumptions of the change studies was intolerable. Accounting
and auditing existed for centuries before they were required by law.
Therefore under one of the most useful tautologies in science (the
survival of the fittest -- see Jensen, 1983) it must have some benefits.
Further, in examining Kaplan and Roll's changes we found whole industries
(paper and steel) changing depreciation methods in one year. Such
systematic change suggested some systematic benefit to the managers.
One alternative is that managers obtain some satisfaction out of
changing accounting methods. However, that seems unlikely and empirical
work has taught us that explaining phenomena in terms of individual's
preferences is unlikely to produce predictive theories. The other
alternative is that accounting procedures have cash flow effects.
Fortunately, at the same time as accounting researchers were undergoing
a search for cash flow effects of accounting procedures, financial
economists were engaged in a similar search. The Miller and Modigliani
papers had eliminated the fuzzy logic that had previously supported
the notion of optimal debt/equity ratios. But, financial economists
still observed that debt/equity ratios varied systematically across
industries (e.g., utilities have much larger leverage ratios than
computer software companies). This led to the introduction of costs
into the finance literature to explain optimal debt/equity ratios.
The first was the cost of bankruptcy. Then the costs of contracting
were introduced. Together with taxes these costs could explain cross-sectional
variations in debt/equity ratios.
The introduction of the costs of contracting provided a potential
explanation for changes in accounting procedures and for there being
stock price effects of those changes. They opened up the potential
for a theory of accounting in the absence of government regulation.
They could not explain the SEC's ASR's and Standards issued by the
FASB. However, at the same time as these costs were introduced, the
interaction of the empirical evidence and the normative demand for
prescriptions for regulatory purposes was producing a fledgling theory
to explain the effect of regulation on accounting practice.
c) The effect of the normative demand on accounting theory
Prior to Ball and Brown and the Efficient Markets Hypothesis, accounting
researchers had justified the regulation of disclosure in terms of
the managers' monopoly over information on the firm, naive investors,
the claimed mechanical relationship between earnings and stock prices
and other arguments which failed under the Efficient Market Hypothesis.
Leftwich (1981) gives a full explanation for the failure of each of
these arguments, but a notion of why they fail can be obtained by
considering the argument that the diversity of accounting procedures
enables managers to mislead investors.
If the capital market has rational expectations, as implied by the
Efficient Markets Hypothesis, its assessment of the implications of
each firm's accounting numbers for the value of the firm will on average
be correct. Hence, the investor can protect himself against the effects
of diversity by holding a portfolio of securities so the markets'
errors in expectation will average out. The market price of securities
will adjust for the diversity of procedures and managers cannot systematically
use that diversity to mislead investors. If you want to protect the
small investor, require him to hold a descriptive portfolio rather
than regulate disclosure.
The demand for theories to support regulation led to accounting researchers
adopting arguments from economics which are consistent with the Efficient
Markets hypothesis. These arguments are market failure arguments.
A market failure exists when the quantity or quality of a good produced
in a free market differs from the supposed social optimum. The social
optimum is defined in terms of some social welfare function. Optimum
is only attained if the price of good produced equals their social
marginal costs. Individuals will produce a good to the point where
their own private marginal benefit equals their private marginal cost.
If private costs are less than social costs, too much will be produced
(overproduction) and if private benefits are less than social
benefits, too little will be produced (underproduction).
An example often used to demonstrate a market failure is that of
the bee keeper and apple grower. A bee keeper keeps his bees in a
field adjacent to an apple orchard and the bees pollinate the apple
orchard. The bee keeper isn't paid for this pollination service so
he makes his decision on how many bees to keep and how much honey
to produce ignoring the benefit of the pollination service. As a result
he under produces. Social benefits are larger than private benefits.
Two types of market failure arguments have been made in accounting,
the public good argument and the signalling (or speculation) argument.
The public good argument is the bees argument. Information in accounting
reports provides benefits to investors other than the shareholders
who pay for it. Those other investors receive the benefit for free.
They can read the information in the Wall Street Journal. Because
shareholders are not rewarded for the information produced for outsiders
their marginal benefit from the information is less than the benefits
to society, hence there is an underproduction of information.
The signalling problem involves situations where one party to a transaction
has more information than another. As a result an individual who has
information that he is more productive or a manager who has information
that his firm is worth more than its current market value engages
in costly underproductive efforts to discriminate him or his firm.
There is overproduction of information.
The presentation of these arguments led to further analysis in economics
and it was perceived that once contracting and information costs are
considered it is not clear there is a market failure. For example,
consider the bees argument. Why doesn't the bee keeper charge the
apple grower for the bees' service? Presumably because it is too costly
to write and enforce those contracts. Given those costs, regulation
can only improve welfare if the government can, through its regulations,
achieve the same or higher level of production more cheaply. The question
becomes one of relative costs of government and private actions. "A
priori" it is not clear that government action is cheaper.
Disillusionment with these new rationales for regulation led economists
to ask whether in practice regulation was designed to remedy market
failure. They looked at the regulation of such industries as the taxi
cab industry and found that regulation was very difficult to explain
in terms of a market failure. What was the market failure in taxi
cabs? These questions led economists to consider the government not
as one person, but as a set of interactions among individuals who
are all motivated by self-interest. Politicians are considered to
be no different from businessmen in that they also maximize their
utility. Politics itself is viewed as a competition for the use of
the coercive power of the government to maximize self-interest.
The disillusionment with the view of government as an individual
interested in remedying market failures and maximizing social welfare
and the alternative view of government as a competition among individuals
has been adopted by some accountants who have begun to use it to try
to predict and explain accounting practice to the extent it is affected
by regulation. In that view of the political process, information
costs enable accounting procedures and standards to affect the outcome
of the competition for the use of the coercive power to transfer wealth.
As a consequence, accounting procedures can affect a firm's cash flows.
a) Summary of the evolution of empirical research in accounting
From the preceding we observe the influence of financial economics
and industrial economics on the development of accounting research.
The empirical work in accounting which followed from the development
of the Efficient Markets Hypothesis and the CAPM in finance led to
the discarding of old theories about the relationship between accounting
procedures and stock prices. However, the CAPM world left no place
Fortunately, at the same time, financial economists realized that
the CAPM and the Miller/Modigliani world (even with taxes) gave no
explanation for systematic variations in debt/equity ratios and other
financial policies. They introduced the costs of contracting as a
factor which, with taxes, could explain those variables.
Contracting costs also enable accounting procedures to have cash
flow effects and therefore could also explain cross-sectional variables
in accounting practice and why firms and industries change accounting
procedures. As a consequence, accountants eagerly adopted contracting
costs as an explanation for accounting; as a building block in an
accounting theory. As we shall see that role for accounting is essentially
the old stewardship function which was given prime place in early
At the same time as the contracting explanation for accounting was
being developed, developments in the economic analysis of government
regulation were also producing a means by which accounting could affect
cash flows (i.e., via its effects on government regulation). Accountants
also adopted this potential explanation for the choice of accounting
4. A VERY BRIEF OUTLINE OF THE ACCOUNTING THEORY BUILT ON CONTRACTING
AND POLITICAL COSTS
In the last five years much research has gone into development of
a theory of accounting based on contracting costs. This research has
taken two major complementary directions. One is a mathematical modelling
approach, the other is an empirical approach. Because of the limited
time and my relative abilities I shall summarize only the empirical
Under this approach there is no such thing as a firm. Instead it
is a collection of contracts between various parties, shareholders,
bondholders, managers, employees, suppliers, customers, etc. By working
together the parties can increase the size of the pie to be split
amongst them. However, the individual parties can also take opportunistic
actions which are designed to increase their share of the pie at the
expense of the size itself. The contracts between the parties are
designed to encourage value increasing actions and discourage opportunistic
The contracts do not emerge by accident. In capital markets characterized
by rational expectations, on average the price of share of a newly
floated firm will reflect the opportunistic actions the market expects
the promoter/manager to take after the firm goes public. Hence, the
promoter bears the effect of those actions on the value of the firm
in a reduced selling price for the shares. This encourages him to
write contracts which restrict those actions. The contracts take the
form of the corporate by-laws, incentive compensation schemes, etc.
Likewise bondholders will be price protected and this will encourage
managers to write debt contracts which also restrict their actions.
In general, the losses which occur by opportunistic actions encourage
all parties to try to contract to restrict those actions.
Contracts will not be expected to be effective unless they are monitored
and enforced. Herein enters accounting and auditing. Accounting numbers
are used to restrict actions in by-laws and debt contracts and are
used to encourage the manager to maximize the value of the firm in
Different accounting procedures can be optimal for different firms.
To illustrate this consider a sand mining firm I audited in Australia.
That firm prepared weekly financial statements based on the recognition
of profit at production. To avoid problems with the auditors they
would have a ship load all their inventories at the end of the fiscal
year so that the production basis produced the same net income as
the sale basis. When I asked the controller why they used the production
basis he pointed out that they had contracted with DuPont for the
sale of all of their production of their main product, titanium dioxide,
for several years into the future at the prevailing world price. The
major variables the managers could control were the level and cost
of production. So as a result they had a bonus scheme based on profits
recognized at production which went all the way down to the foremen.
The controller's argument is sensible, but imagine what would happen
if we implemented recognition of profit at production and a bonus
scheme in a normal manufacturing firm. The manager would have every
incentive to produce for inventory and no incentive to sell. The results
would be disastrous.
From the preceding example you can see that a change in an accounting
procedure could potentially affect the value of the firm; the size
of the pie. Changes in accounting procedures can also affect the size
of the pie, the share of one part to the firm. For example, a manager
could change accounting procedures and increase the size of his bonus
which depends on accounting numbers, if the compensation committee
of the board of directors does not always adjust bonuses for changes
in accounting techniques. If the manager is successful his wealth
is increased and the shareholders' reduced.
The preceding examples only provide a small extremely simplified
glimpse of the volume of analysis underlying the contracting effects
of accounting procedures, but they should be sufficient to explain
how accounting procedures can have cash flows or wealth effects.
b) Political Process
The analysis of the political process is not as well developed as
that of the contracting process. However, as the contracting effects
of accounting procedures depend on the costs of contracting, information
and monitoring, the political effects of accounting procedures depend
on the costs of forming coalitions and costs of information in the
political process. The basic proposition is that the incentive to
gather information in the political process is less than in the market
process, so that those costs become very important. To illustrate
this point consider a firm whose management is inefficient. Individuals
in the market have incentives to invest in gathering such information
because they can, by buying shares of the firm, assuming control and
changing the management's policies, capture the gain from elimination
of the inefficiencies. Those individuals could be wealthy individual
entrepreneurs (e.g., the Pritzkers) or managers of corporations whose
compensation is highly dependent on their corporation's share price
(e.g., by options).
Now consider an inefficiency in government. For convenience assume
that the City of Rochester provides a garbage collection service which
has a market value of $750,000 but the service costs the city and
the city charges the taxpayers $1 million for the service (ignore
any tax deductibility). There is an inefficiency of $250,000 a year,
the present value of which will be impounded in the market value of
land in the city. Can any individual gain the present value of the
$250,000 by discovering the inefficiency? No! To capture that value
the individual would have to buy all the land in Rochester (to capture
the increase in value when rates are reduced), then bribe enough voters
to have the garbage service and the $1 million charges eliminated.
The relative cost of performing that feat is prohibitive. Consequently,
individuals will not invest as much in learning of these inefficiencies
as in learning of undervalued corporations. The incentives are not
as great. If we extend the problem to the State and Federal government
the likelihood of individuals being able to capture the benefit of
eliminating inefficiencies is even smaller and the incentives poorer.
Of course while taxpayers may not be informed of the benefits from
eliminating the garbage service because it doesn't pay them individually,
the union of municipal employees who run the garbage trucks will be
informed as to the costs to them of the service being eliminated.
The relative amount they stand to gain per person by being informed
is more and because the union is already organized the marginal cost
of acquiring information and lobbying is much less. Hence, any politician
considering making the inefficient garbage collection an issue stands
to lose the votes of the municipal employees without gaining many
votes from taxpayers (who rationally discount his story).
Given these information costs, accounting can play an important role
in the political process. It is used in many situations to regulate
price (e.g., utilities). Further, reported profits affect the likelihood
of costly government regulations and taxes being passed. As a consequence,
changes in accounting procedures and standards can affect a firm's
As an example, consider the release of the third quarter profits
of oil companies in 1979. At the time of the release of Exxon's profits
the House had decontrolled the pump price of gas. After the report
of a 200 percent increase in Exxon's profit over the third quarter
of 1978, profits which the media labelled "pornographic,"
controls were reimposed on the pump price.
An explanation of the article in Barron's on October 29, 1979,
suggests that much of the increase in Exxon's profits was due to accounting
standards rather than changes in Exxon's cash flows. In July of 1979
the FASB (in FASB Statement No. 31) had ruled that certain deferred
taxes on oil inventories forgiven by the British government had to
be brought into the third quarter earnings of the oil firms. The present
value of these deferred taxes was undoubtedly much less than their
book value. In addition, part of the third quarter profits were due
to exchange gains under FASB Statement No. 8.
Exxon did not try to explain to the voters that much of their profits
were just book despite the effect of the profits on government action.
The individual voter has little incentive to be informed and as we
all know the cost of understanding FASB statements is large to accountants
let alone a layman.
The preceding example gives an idea of the way accounting procedures
and standards can affect cash flows via the political process. It
is a simple caricature and does not capture the full subtlety of the
arguments, but it does convey the primary idea.
5. EMPIRICAL REGULARITIES FOUND IN TESTING THE CONTRACTING AND POLITICAL
COST THEORIES OF ACCOUNTING
Under some very strong simplifying assumptions testable propositions
or hypotheses have been derived from the theory of accounting outlined
above. Two of those hypotheses have been consistently confirmed by
empirical studies (see Watts and Zimmerman, 1983, Chapter 11).
The first of those is the one mentioned in the beginning of the talk,
the higher the firm's debt/equity ratio the more likely the firm is
to choose accounting procedures which increase the present value of
reported earnings. This association is predicted on the basis of debt
contracts. Basically firms with higher leverage have incentives to
be closer to the constraints in the debt agreements, including the
constraint on leverage and are therefore more likely to have to use
earnings increasing procedures to avoid default.
The second hypothesis which has been consistently confirmed is that
the larger the firm the more likely the firm is to use and lobby for
accounting procedures which reduce the present value of reported earnings.
This association is predicted on the basis of the proposition that
large firms are more susceptible to wealth transfers in the political
process and therefore have a greater incentive to reduce reported
profits to reduce attention from the media. There is a threshold effect
in this result (i.e., only firms above a certain large size level
exhibit the tendency). In addition the results suggest that the association
is primarily driven by the oil industry (see Watts and Zimmerman,
1983, Chapter 11).
Another hypothesis for which there is some supporting evidence is
that managers influence the firm's net accruals (the difference between
net income and operating cash flows) in a manner consistent with them
maximizing the present value of their bonuses (Healy, 1982).
Empirical research testing these hypotheses is in the early stages
and is relatively crude. It is possible that the associations found
are the result of forces other than those hypothesized. However, the
observation of empirical regularities in accounting procedures so
early in the literature's history does suggest that the research will
be very productive.
6. SUMMARY AND CONCLUSIONS
The history of the evolution of economics-based empirical research
that I have related to you is very selective. I concentrated on a
very narrow group of the empirical studies applying financial economics
to accounting following the Ball and Brown paper. There have been
several other avenues of research apart from the stock price effects
of changes in accounting techniques including large literatures on
the time series of accounting numbers, on the prediction of financial
distress, on the association between accounting numbers and measures
of risk and on the information content of earnings, among others.
The narrow concentration has been a deliberate attempt to focus on
how the research has evolved, how the conclusions are based on aggregate
data rather than single observations, and on the studies in general
rather than one study, how one study builds on another and how accounting
follows the trends in economics, particularly financial economics.
My intention has been to give a "feeling" for the research
process to those involved in the process and to give the beginnings
of an understanding of the process to practitioners. I hope I have
had some success.
(1) The absence of
practitioners from the Chicago Conference in 1982 was partially due
to the nature of the topic, but the decline in the number of practitioners
appearing at the influential Chicago Conference is well documented
by Dyckman and Zeff.
(2) Oscar Gellein,
a retired FASB member, recently wrote "standard setters and auditors,
despite considerable efforts, on the part of some at least, to understand
the results, have not been able to reach a level of understanding
sufficient to establish confidence in the results... They wonder because
they do not understand. They do not understand partly because what
they read is not geared to their training and experience.... This
is a plea, however, for attention by EMH researchers to ways of communicating
with lay parties who are very much interested in the research."
(Gellein, 1981, p, 49)
(3) Note Gellein's
plea in fn. 1, above.
(4) The lack of association
Benston (1967) found between earnings announcements and stock price
changes can be partially attributed to overly complex earnings expectation
models. Ball and Brown did have some evidence of the predictive ability
of this model from the evidence in Brown and Ball (1967).