Empirical research on accounting choice☆
Introduction
Research on accounting choice addresses the fundamental question of whether accounting matters. With complete and perfect markets, there is no substantive role for financial disclosures and thus no demand for accounting or accounting regulation.1 However, in our world of imperfect and incomplete markets, the demand for accounting and accounting regulation implies that accounting disclosures and accounting-based contracts are efficient ways of addressing market imperfections.
To analyze the role of accounting, we need a definition of accounting choice. For the purpose of this review, we choose a broad definition:
An accounting choice is any decision whose primary purpose is to influence (either in form or substance) the output of the accounting system in a particular way, including not only financial statements published in accordance with GAAP, but also tax returns and regulatory filings.
This definition is broad enough to include the choice of LIFO vs. FIFO, the choice to structure a lease so that it qualifies for operating lease treatment, choices affecting the level of disclosure, and choices in the timing of adoption of new standards. We also include real decisions made primarily for the purpose of affecting the accounting numbers in this definition. Examples of real decisions include increasing production to reduce cost of goods sold by reducing per unit fixed costs and reducing R&D expenditures to increase earnings. Managerial intent is key to this definition of accounting choice, particularly with respect to real decisions; that is, whether the impetus behind the decision is to affect the output of the accounting system or whether the impetus derives from other motives. For example, does a firm reduce its R&D expenditures primarily in order to alter accounting disclosures or primarily because of lower expected future returns to the R&D investment?
Questions about the determinants and implications of accounting choice have motivated accounting research since at least the 1960s.2 Using our definition of accounting choice, we tabulate the research published in the 1990s and find that roughly 10 percent of papers in the three top accounting journals directly address questions relating to accounting choice.3 Even with this scholarly attention and effort, our understanding of these questions remains limited despite improvements in research methods, data sources, and computing power. For example, there is still no consensus on what purposes accounting choices serve. For example, managers whose incentives are consistent with those of the firms’ owners may exercise accounting choices to convey private information to investors; other managers may use discretion opportunistically, possibly inflating earnings to increase their compensation.
In this paper, we provide a structure and approach for analyzing the outstanding issues relating to accounting choice in the context of research results to date. We review and summarize the results of research bearing on accounting choice, focusing on the 1990s, as the basis for our conclusions about the implications of this research.4 We also assess the extent to which knowledge of the importance of accounting choice has increased beyond that of the 1970s and 1980s. We then articulate our own conclusions about the importance and implications of accounting choice research, anticipating that our conclusions will be used as benchmarks for other, perhaps conflicting, points of view. Finally, we provide suggestions for future avenues of research into accounting choice.
We organize our review by classifying the accounting choice literature into three groups based on the market imperfection that makes accounting important in a given setting—agency costs, information asymmetries, and externalities affecting non-contracting parties.5 We interpret the three categories as follows. Agency costs are generally related to contractual issues such as managerial compensation and debt covenants. Information asymmetries generally are associated with the relation between (better informed) managers and (less well informed) investors. Finally, other externalities are generally related to third-party contractual and non-contractual relations.
This classification results from our hypothesis that accounting is important for at least three reasons. First, accounting plays a significant role in the contractual relations that form the modern corporation, presumably to mitigate agency costs (Jensen and Meckling, 1976; Smith and Warner, 1979; Watts and Zimmerman, 1986). Second, accounting provides an avenue through which managers disseminate privately held information, and the specific accounting method choice can play a key role in that communication process. Third, regulation of accounting affects the quality and quantity of financial disclosures, which in turn have welfare and policy implications in the presence of externalities.6
We believe this taxonomy provides useful insights into the existing accounting literature. The rationale for this approach is our belief that there are greater similarities among the problems and their solutions within each category than there are across categories. This allows researchers to analyze each category in isolation. Although the demarcations among the three categories are not precise, this heuristic is useful to simplify the analysis of complex relations absent a comprehensive theory.
Based on our review of prior work, we conclude that accounting research has made modest progress in advancing the state of knowledge beyond what was known in the 1970s and 1980s. As such, our conclusions are generally consistent with those of Holthausen and Leftwich (1983) and of Watts and Zimmerman (1990), reached more than a decade earlier.
We conclude that one reason for the lack of progress in the 1990s is that researchers generally focus on refining knowledge of specific accounting choices or on narrow problems that accounting choices are presumed to address. Consistent with the acknowledged complexity of the task, there have been few attempts to take an integrated perspective (i.e., multiple goals) on accounting choice. A second reason is that accounting research generally fail to distinguish appropriately between what is endogenous and exogenous (e.g., CEO departure is treated as exogenous and R&D funding is measured relative to CEO tenure). Finally, absent a theory, researchers apparently limit their inquiries to the pathological, and perhaps less frequent, use of accounting choice and ignore the major role of accounting in normal, day-to-day situations. Obviously, what is called for is a comprehensive theory that investigates the role of accounting in a world with market imperfections. However, such a comprehensive theory is currently unavailable and possibly unattainable.
We believe that there are opportunities for future research that will advance our knowledge of accounting choice. First, we suggest that evidence be gathered on whether the alleged attempts to manage financial disclosures by self-interested managers are successful; that is, what are the economic implications of the accounting choices? Second, we believe there should be more emphasis on the costs and benefits of addressing the three types of market imperfections driving accounting choice. We suspect that these costs and benefits vary over choices, over time, and across firms. Third, we suggest that researchers develop better theoretical models and more refined econometric techniques with the explicit goal of guiding empirical research and articulating expected results from such empirical research.
This paper proceeds as follows. The next section discusses reasons for accounting choice and Section 3 provides a taxonomy based on the motivation for the accounting choice. Section 4 discusses the results and implications of prior research, organized by the categories of accounting choice provided in Section 3. Section 5 outlines the impediments to progress in research into accounting choice. Finally, Section 6 provides suggestions for future research.
Section snippets
Reasons for accounting choice
Generally accepted accounting principles (GAAP) often require that judgment be exercised in preparing financial statements. For example, that judgment may relate to the amount of accounts receivable that are likely to be collected, the appropriate allocation pattern for the cost of equipment, or how long a marketable security is likely to be held.
In turn, exercising such judgments provides information to outsiders when information asymmetries are present. This is self-evident when the decision-
Classification of accounting choice
Our classification of the accounting choice literature is grounded in the economics of the firm and in the theories developed by Modigliani and Miller (1958) (MM). With complete and perfect markets, there is no role for accounting, much less for accounting choice. If accounting exists and is relevant to at least some economic decision-makers, then one or more of the MM conditions are violated. We use the MM conditions to derive a taxonomy to classify accounting choice issues by the purpose they
Accounting choice research in the 1990s
We structure our review around the three primary motivations for accounting choice set forth in Section 3. After a brief discussion of prior literature reviews, we consider papers that address contractual motivations (including the effects of compensation agreements and debt contracts). The next subsection considers accounting choices motivated by asset pricing considerations. The final subsection discusses cases in which the impact on third parties other than potential investors (e.g.,
Impediments to progress
We believe that in the last decade researchers have made only modest progress toward improved understanding of the implications of accounting choice and we describe several reasons for this lack of progress. In this section we discuss the research design difficulties directly as well as the more innovative work that has tried to advance our understanding of accounting choice.
Conclusions and suggestions for future work
We do not want to leave the impression that researchers have gained no knowledge of the role and the importance of accounting choice. Rather, our concern is that progress has slowed. In part, this is due to unambitious attempts to expand the field. For example, testing the implications of one more accounting standard adds very little to the cumulative knowledge. A more intransigent problem is the difficulty in specifying research designs that accommodate the complexity of the task at hand: that
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We are grateful for comments received from Ronald Dye, participants of the 2000 Journal of Accounting and Economics conference, the editors Ross Watts and Douglas Skinner, and the discussant Jennifer Francis. Financial support from the Accounting Research Center at the Kellogg Graduate School of Management, Northwestern University is gratefully acknowledged.