Objectives: Understand the efficient market hypothesis and it

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Towards a Positive Theory of the Determination of Accounting Standards Author(s): Ross L. Watts and Jerold L. Zimmerman Source: The Accounting Review, Vol. 53, No. 1 (Jan., 1978), pp. 112-134 Published by: American Accounting Association Stable URL: http://www.jstor.org/stable/245729 Accessed: 18-02-2017 02:32 UTC

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THE ACCOUNTING REVIEW Vol. Lill, No. I January 1978

Towards a Positive Theory of the

Determination of Accounting

Standards

Ross L. Watts and Jerold L. Zimmerman

ABSTRACT: This article provides the beginnings of a positive theory of accounting by exploring those factors influencing management's attitudes on accounting standards which are likely to affect corporate lobbying on accounting standards. Certain factors are expected to affect a firm's cashflows and in turn are affected by accounting standards. These factors are taxes, regulation, management compensation plans, bookkeeping costs, and political costs, and they are combined into a model which predicts that large firms which experience reduced earnings due to changed accounting standards favor the change. All other firms oppose the change if the additional bookkeeping costs justify the cost of lobbying. This prediction was tested using the corporate submissions to the FASB's Discussion Memorandum on General Price Level Adjustments. The empirical results are consistent with the theory.

ACCOUNTING standards in the United States have resulted from a com- plex interaction among numerous

parties including agencies of the Federal government (notably the Securities and Exchange Commission and Treasury Department), state regulatory commis- sions, public accountants, quasi-public accounting standard-setting boards (the Committee on Accounting Procedures (CAP), the Accounting Principles Board (APB), and the Financial Accounting

Standards Board (FASB)), and cor- porate managements. These parties have, in the past, and continue to expend re- sources to influence the setting of ac- counting standards. Moonitz [1974], Horngren [1973] and [1976], Armstrong [1976] and Zeff [1972] document the sometimes intense pressure exerted on the "private" accounting standard-set- ting bodies (i.e., CAP, APB, FASB). These pressures have led to several re- organizations of the standard-setting

boards. Ultimately, we seek to develop a posi-

tive theory of the determination of ac- counting standards.' Such a theory will help us to understand better the source of the pressures driving the accounting standard-setting process, the effects of various accounting standards on different groups of individuals and the allocation of resources, and why various groups are willing to expend resources trying to affect the standard-setting process. This understanding is necessary to determine if prescriptions from normative theories

We wish to thank members of the Finance Workshop at the University of Rochester, members of the Account- ing Seminar at the University of Michigan and, in par- ticular, George Benston, Ken Gaver, Nicholas Gonedes, Michael Jensen, Keith Leffler, Martin Geisel, Cliff Smith and an anonymous referee for their helpful suggestions.

' See Jensen [1976] and Horngren [1976].

Ross L. Watts and Jerold L. Zimmer-

man are Assistant Professors of Account- ing at the University of Rochester.

112

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Watts and Zimmerman 113

(e.g., current cash equivalents) are feasi- ble.

Watts [1974] and [1977] has started to develop such a theory. This paper ex- pands on this initial work by focusing on the costs and benefits generated by ac- counting standards which accrue to managements, thereby contributing to our understanding of the incentives of management to oppose or support vari- ous standards. Management, we believe, plays a central role in the determination of standards. Moonitz supports this view:

Management is central to any discussion of financial reporting, whether at the statutory or regulatory level, or at the level of offi- cial pronouncements of accounting bodies. [Moonitz, 1974, p. 64]

Hence, it seems appropriate that a pre- condition of a positive theory of stan- dard-setting is understanding manage- ment's incentives.

The next section introduces those fac- tors (e.g., tax, regulatory, political con- siderations) which economic theory leads us to believe are the underlying determin- ants affecting managements' welfare and, thereby, their decision to consume re- sources trying to affect the standard- setting process. Next, a model is pre- sented incorporating these factors. The predictions of this model are then tested using the positions taken by corporations regarding the FASB's Discussion Mem- orandum on General Price Level Adjust- ments (GPLA). The last section contains the conclusions of the study.

FACTORS INFLUENCING MANAGEMENT ATTITUDES TOWARDS FINANCIAL

ACCOUNTING STANDARDS

In this paper, we assume that individ- uals act to maximize their own utility. In doing so, they are resourceful and in- novative.2 The obvious implication of this assumption is that management

lobbies on accounting standards based on its own self-interest. For simplicity, (since this is an early attempt to provide a positive theory) it could be argued that we should assume that management's self-interest on accounting standards is congruent with that of the shareholders. After all, that assumption has provided hypotheses consistent with the evidence in finance (e.g., the risk/return relation- ship of the various capital asset pricing models). However, one function of finan- cial reporting is to constrain manage- ment to act in the shareholders' interest. (For example, see Benston [1975], Watts [1974], and Jensen and Meckling [1976a].) Consequently, assuming con- gruence of management and shareholder interests without further investigation may cause us to omit from our lobbying model important predictive variables. To reduce this possibility, we will examine next the effects of accounting standards on management's self-interest without the congruence assumption. The purpose of the examination is to identify factors which are likely to be important predic- tors of lobbying behavior so that we can include them in our formal model.

The assumption that management se- lects accounting procedures to maximize its own utility is used by Gordon [1964, p. 261] in an early attempt to derive a positive theory of accounting. There have been several attempts to test empirically Gordon's model, or variants of it, which we call the "smoothing" literature.3 Problems in the specification of the em-

2 Many economic models assume a rather limited version of economic man. In particular, they assume that man maximizes his own welfare when he is constrained to play by certain rules and in certain institutional set-

tings, ignoring his incentives to avoid or change the rules. setting. etc. Meckling [1976] analyzes this issue.

3 Ball and Watts [1972]; Barefield and Comiskey [1972]; Barnea, Ronen and Sadan [1975]; Beidleman

t1973]; Copeland [1968]; Cushing [1969]; Dasher and Malcom [1970]; Gordon [1964]; Gordon, Horwitz and Meyers [1966].

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114 The Accounting Review, January 1978

pirical tests in the smoothing literature leave the Gordon model essentially un- confirmed.4 Also, certain aspects of the Gordon model contribute to the model's lack of confirmation. Essentially, Gordon [1964] assumed that shareholder satis- faction (and, presumably, wealth) is solely a positive function of accounting income. This assumption avoids the con- flict between shareholders and manage- ment by implying that increases in stock prices always accompany increases in accounting income. However, recent re- search casts serious doubt on the ability of management to manipulate directly share prices via changes in accounting procedures.5

We assume that management's utility is a positive function of the expected compensation in future periods (or wealth) and a negative function of the dispersion of future compensation (or wealth). The question is how do account- ing standards affect management's wealth?6 Management's total compensa- tion from the firm consists of wages, in- centive compensation (cash bonuses and stock or stock options), and nonpecuni- ary income, including perquisites (dis- cussed in Jensen-Meckling, 1976a). Since it is unclear what role accounting stan- dards play in the level of nonpecuniary income, we exclude it and focus on the first two forms of compensation. To the extent that management can increase either the level of incentive compensa- tion or the firm's share price via its choice of accounting standards, they are made better off.

This analysis distinguishes between mechanisms which increase manage- ment's wealth: 1) via increases in share price (i.e., stock and stock options are more valuable) and 2) via increases in in- centive cash bonuses. The choice of ac- counting standards can affect both of these forms of compensation indirectly

through i) taxes, ii) regulatory procedures

if the firm is regulated, iii) political costs, iv) information production costs, and directly via v) management compensa- tion plans. The first four factors increase managerial wealth by increasing the cashflows and, hence, share price. The last factor can increase managerial wealth by altering the terms of the incentive compensation. Each of these five factors are discussed in turn.

Factors Affecting Management Wealth' Taxes. Tax laws are not directly tied to

financial accounting standards except in a few cases (e.g., the last-in-first-out in- ventory valuation method). However, the indirect relationship is well documented Zeff [1972] and Moonitz [1974]. The adoption of a given procedure for finan- cial accounting does not decrease the likelihood of that procedure's being

4 For these defects see Ball and Watts [1972], Gonedes [1972] and Gonedes and Dopuch [19741.

5 Fama [1970] and Goedes and Dopuch [19741. Further, the results of studies by Kaplan and Roll [19721, Ball [1972] and Sunder [1975] which address the specific issue support the hypothesis that the stock market can discriminate between real events and changes in account- ing procedures. Given that the market can on average discriminate, then it must be concluded that managers (on average) expect the market to discriminate. Obvious- ly, managers do and will attempt to influence their share price by direct accounting manipulation, but if these attempts consume resources, then incentives exist to eliminate these inefficient allocations.

6 For earlier discussions of this question see Watts [1974 ] and Gonedes [ 1976 ].

We have purposefully excluded from the set of fac- tors being examined the information content effect of an accounting standard on stock prices. We have done this because at present the economic theories of information and capital market equilibrium are not sufficiently de- veloped to allow predictions to be made regarding the influence an accounting standard on the capital market's assessment of the distributions of returns (see Gonedes and Dopuch, 1974). We believe that a theory of the determination of account ng standards can be developed and tested ignoring the information content factor. If at some future date, the information content factor can be specified and included in the theory, then the predictions and our understanding of the process will be improved. But we see no reason to delay the development of a theory until information content is specified.

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Watts and Zimmerman 115

adopted in future Internal Revenue codes, and more likely, will increase the chance of adoption. To the extent that management expects a proposed finan- cial accounting procedure to influence future tax laws, their lobbying behavior is affected by the future tax law effects.

Regulation.8 Most public utility com- missions base their rate-setting formulas on accounting determined costs. A new accounting standard which reduces a utility's reported income may provide its management with an "excuse" to argue for increased rates. Whether the utility commission grants the increase depends on whether groups opposed to the rate increase (e.g., consumer groups) are able to exert political pressure on the com- mission.9 This depends on such factors as information costs (to be discussed later). However, to the extent that there is some probability of a rate (and hence cashflow) increase (either temporary or permanent) as the result of an accounting standards change, utilities have an incen- tive to favor that change. Similarly, they have an incentive to oppose changes in accounting standards which might lead to a rate decrease.

Political Costs. The political sector has the power to effect wealth transfers be- tween various groups. The corporate sector is especially vulnerable to these wealth redistributions. Certain groups of voters have an incentive to lobby for the nationalization, expropriation, break-up or regulation of an industry or corpora- tion.'0 This in turn provides an incentive for elected officials to propose such ac- tions. To counter these potential govern- ment intrusions, corporations employ a number of devices, such as social re- sponsibility campaigns in the media, government lobbying and selection of ac- counting procedures to minimize re- ported earnings." By avoiding the atten- tion that "high" profits draw because of

the public's association of high reported profits and monopoly rents, manage- ment can reduce the likelihood of adverse political actions and, thereby, reduce its expected costs (including the legal costs the firm would incur opposing the politi- cal actions). Included in political costs are the costs labor unions impose through increased demands generated by large reported profits.

The magnitude of the political costs is highly dependent on firm size.12 Even as a percentage of total assets or sales, we would not expect a firm with sales of $100 million to generate the same political costs (as a percentage of sales) as a firm with $10 billion of sales. Casual empiri-

8 We deal in this paper with public utility regulation and the forms of rate regulation employed. Other in- dustries (e.g., banking and insurance) are regulated dif- ferently and these industries are ignored in this paper to simplify the analysis.

' For the economic theory of regulation upon which this discussion is based see Stigler [1971], Posner [1974] and Peltzman [1975]. Also, Horngren [1976].

10 Stigler [1971], Peltzman [1975], and Jensen and Meckling [1976b]. An example of an industry facing such action is the oil industry.

l' For an alleged example of this, see Jack Anderson, Syndicated Column, United Features (New York, April 10. 1976).

12 Several studies document the association between size and anti-trust [Siegfried 1975]. In proposed anti- trust legislation, size per se has been mentioned specifical- ly as a criterion for action against corporations. See the "Curse of Bigness," Barron's, June 30, 1969. pp. 1 and 8. Also see a bill introduced into the Senate by Senator Bayh (U.S. Congress, Senate, Subcommittee on Anti- trust and Monopoly (1975), pp. 5-13) would require divesture for oil firms with annual production and/or sales above certain absolute numbers. In the hearings on that bill, Professor Mencke of Tufts University argued that absolute and not relative accounting profits are the relevant variable for explaining political action against corporations.

Menke said, "Nevertheless, precisely because the actions of large firms are so visible, the American public has always equated absolute size with monopoly power. The major oil companies are among the very largest and most visible companies doing business in the United States.

Huge accounting profits, but not high profit rates, are an inevitable corollary of large absolute firm size. This

makes these companies obvious targets for public criticism." (U.S. Congress, Senate, Subcommittee on Anti-trust and Monopoly (1976), p. 1893).

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116 The Accounting Review, January 1978

cism suggests that Superior Oil Com- pany (1974 sales of $333 million) incurs considerably less costs from anti-trust, ''corporate responsibility,'' affirmative action, etc., than Exxon with sales of $42 billion.

Information Production (i.e., bookkeep- ing) Costs. Changes in accounting pro- cedures are not costless to firms. Ac- counting standard changes which either increase disclosure or require corpora- tions to change accounting methods in- crease the firms' bookkeeping costs (in- cluding any necessary increases in accountants' salaries to compensate for additional training).13

Management Compensation Plans. A major component of management com- pensation is incentive (bonus) plan in- come (Conference Board [1974]), and these plans are based on accounting in- come. Our survey of 52 firms in our sample indicates that the majority of the companies formally incorporate account- ing income into the compensation plan. 4 Hence, a change in accounting standards which increase the firm's reported earn- ings would, ceteris paribus, lead to greater incentive income. But this would reduce the firm's cashflows and share prices would fall. As long as the per manager present value of the after tax incentive income is greater than the decline in each manager's portfolio, we would expect management to favor such an accounting change. 5 But this assumes that the share- holders and nonmanager directors do not oppose such an accounting change or do not adjust the compensation plans for the change in earnings. 6 In fact, the in- creased cashflows resulting from the political costs, regulatory process and tax effects of an accounting change as- sumes that various politicians/bureau- crats (i.e., the electorate) do not fully adjust for the change. A crucial assump- tion of our analysis is that the sharehold-

ers and nonmanaging directors have more incentive to adjust for and control increases in reported earnings due to changes in accounting standards than do politicians and bureaucrats.

Incentives for Various Groups to Adjust for a Change in Accounting Standards

An individual (whether a shareholder, nonmanaging director, or politician) will adjust a firm's accounting numbers for a change in accounting standards up to the point that the marginal cost of making the adjustment equals the marginal bene- fits. Consider the incentives of the outside directors to adjust bonus compensation plans due to a change in accounting standards. If these directors do not adjust the plans, management compensation rises and share price falls by the full dis- counted present value of the additional compensation."7 Each outside director's wealth declines to the extent of his owner- ship in the firm and there is a greater chance of his removal from the board. 18

13 We are assuming that any change in accounting standards does not reduce the firm's information produc- tion costs. Although there may be cases where a firm is using a costly procedure which is eliminated by a simpler, cheaper procedure, information production costs in this case may decline, but we expect these situations to be rare.

14 The frequency is 69 percent. '5 At this early stage in the development of the theory,

we assume that management of the firm is composed of homogeneous (i.e., identical) individuals to simplify the problem.

16 Our examination of the description of 16 manage- ment compensation plans indicated that all the plans were administered by the nonmanaging directors.

17 Likewise, we would expect the outside directors to adjust the incentive compensation targets in those cir- cumstances when it is in the shareholders' interest to report lower earnings (e.g., LIFO), thereby not reducing the managers' incentive via bonus earnings to adopt LIFO.

18 Our analysis indicates that outside (nonmanaging) directors are "efficient" monitors of management, Watts 11977]. If this were not the case, the capital market would quickly discount the presence of outside directors. As far as we can determine, firms are not required by the New York Stock Exchange listing requirements or Federal regulations to have outside directors. Paragraph 2495G

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Watts and Zimmerman 117

If nonmanaging directors did not con- trol management (including adjusting the compensation plans for changes in accounting standards), the decline in firm value offers incentives for an out- sider or group to tender for control of the firm and install outside directors who will eliminate those managerial activities which are not in the best interest of the shareholders.19 This group would then gain a proportionate share of the full capitalized value of the eliminated abuses (e.g., the present value of the incremental compensation resulting from the change in accounting standards). Therefore, the benefits for shareholders and nonman- aging directors to adjust compensation plans for changes in accounting stan- dards are immediate and direct, if there is an efficient capital market for equity claims.

However, for the politicians and bu- reaucrats, our analysis suggests that the lack of a capital market which capitalizes the effects on the voters' future cashflows reduces the benefits accruing to the politicians of monitoring accounting standards, and the result is that they will perform less adjustments for changes in accounting standards.20 For example, what are the benefits accruing to a utility regulator for adjusting a utility's account- ing numbers for a change in standards? In the previous case of an outside direc- tor, the share price will fall by the dis- counted presented value of the increased compensation resulting for an incom- plete (or inaccurate) adjustment of the compensation plan. But if the regulator does not completely adjust for a change in accounting standards and allows the utility's rates to increase (resulting in a wealth transfer from consumers to the utility's owners), then the only cost the regulator is likely to incur is removal from office due to his incomplete adjust- ment. He incurs no direct wealth change.

For small rate increases, the per capita coalition costs each consumer (or some group of consumers) would bear lobby- ing for the regulator's removal would vastly outweigh the small per capita bene- fits they would receive via lower regulated rates. Hence, rational consumers would not incur large monitoring costs of their regulators and other politicians (Downs [1957]; Alchian [1969]; and Alchian and Demsetz [1972]). Knowing this, it is not in the regulators' and politicians' interests to adjust changes in accounting standards as fully as if they were con- fronted with the same change in account- ing standards in the role of outside di- rectors or shareholders in the firm. The benefits of adjusting for changes in ac- counting standards are lower in the politi- cal sector than in the private sector.2' Hence, there is a greater likelihood that a given accounting standard change will result in increased tax, regulatory, and political benefits than will the same change result in increased management compensation. For a given accounting standard change, managers should expect their own shareholders and outside di-

of Commerce Clearing House, Volume 2, New York Stock Exchange encourages listed firms to appoint out- side directors. "Full disclosure of corporate affairs for the information of the investing public is, of course, normal and usual procedure for listed companies. Many com- panies have found this procedure has been greatly aided by having at least two outside directors whose functions on the board would include particular attention to such matters.- This listing statement is consistent with our observation that outside directors provide monitoring benefits.

19 This assumes, of course, that such takeovers earn a fair rate of return net of transactions costs.

20 See Zimmerman [ 1977 ] and Watts [ 19771 for further discussion of this issue.

21 It could also be argued that politicians and regu- lators have a higher marginal cost of adjusting than do shareholders, nonmanaging directors, and other capital market participants since the former group does not necessarily have a comparative advantage of adjusting financial statements, whereas, existing capital market participants probably have a comparative advantage at such activities.

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118 The Accounting Review, January 1978

rectors to make a more complete adjust- ment than politicians.

Given this analysis, we predict that managers have greater incentives to choose accounting standards which re- port lower earnings (thereby increasing cashflows, firm value, and their welfare) due to tax, political, and regulatory con- siderations than to choose accounting standards which report higher earnings and, thereby, increase their incentive compensation. However, this prediction is conditional upon the firm being regul- ated or subject to political pressure. In small, (i.e., low political costs) unregul- ated firms, we would expect that man- agers do have incentives to select ac- counting standards which report higher earnings, if the expected gain in incentive compensation is greater than the fore- gone expected tax consequences. Finally, we expect management also to consider the accounting standard's impact on the firm's bookkeeping costs (and hence their own welfare).

The next section combines these five factors into a model of corporate lobby- ing standards.

A POSITIVE THEORY OF MANAGEMENT LOBBYING ON ACCOUNTING STANDARDS

Given a proposed accounting stan- dard, management's position depends on the size of the firm (which affects the magnitude of the political costs) and whether the proposed standard increases or decreases the firm's reported earn- ings.22 Figure I separates the standard's impact on earnings into decreases (1A) and increases (IB). The curve GB in Figure IA (earnings decrease) denotes the proposed accounting standard's pres- ent value to management including the tax, regulatory, political, and compensa- tion effects as a function of firm size. For small firms (below size E), not subject to much political pressure, these managers

have an incentive to oppose the standard since their bonus compensation plans will have to be adjusted (a costly process), if their incomes are to remain unchanged by the new standard. Above size E, the political, regulatory, and tax benefits of reporting lower earnings due to the new standard are assumed to dominate the incentive compensation factor.

The benefits (costs) of a proposed ac- counting standard are expected to vary with the firm's size. This relationship can exist for two reasons: (1) the magnitude of the reported income change may be larger for larger firms and (2) for an in- come change of a given magnitude, the benefits (costs) vary with firm size.23 Hence, the present value of the stream of benefits (or costs) to the firm, GB, are an increasing function of firm size.24

Information production costs, curve IC, are also expected to vary to some ex- tent with firm size due to the increased complexity and volume of the larger

22 The expected effect of an acc

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