An Income Strategy Approach to the Positive Theory

8/2/2019 An Income Strategy Approach to the Positive Theory

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J o u r n a l o f A c c o u n t in g a n d E c o n o m i c s 3 (1 98 1) 1 2 9- 1 4 9. N o r t h - H o l l a n d P u b l i s h i n g C o m p a n y

A N I N C O M E S T R A T E G Y A P P R O A C H T O T H E P O S I T I V E T H E O R YOF ACCOUNTING STANDARD SETTING/CHOICEMark E. ZMIJEWSKI and Robert L. HAGERMAN*

State University of New York at Buffalo, NY 14214, USA

Received M ay 1979 , f ina l vers ion rece ived Apr i l 1981

Th is paper i s des igned to p rov ide add i t iona l ev idence on the pos i t ive theo ry o f accoun t ingpo l icy cho ice by combin ing ind iv idua l a ccoun t ing p r inc ip les in to f i rm income s t ra teg ies . T heses t ra teg ies were the dependen t var iab le in a p rob i t ana lys i s where the independen t var iab les weres ize , managemen t compensa t ion , indus t ry concen t ra t ion ra t io , sy s temat ic r i sk , cap i t a l in tens i tyand the to ta l de b t to to ta l as se t ra t io . The resu l t s ind ica te tha t fou r o f these fac to rs ( si ze ,m a n a g e m e n t c o m p e n s a t i o n , c o n c e n t r a t i o n r a t i o , a n d t h e t o t a l d e b t t o t o t a l a s s e t r a t i o ) h a v e as ign if ica la t a s soc ia t ion w i th the ch o ice o f a fi rm 's incom e s t ra tegy . Th i s t es t p rov id es s t rongev idence cons i s ten t wi th the pos i t ive theo ry o f accoun t ing s t anda rd se t t ing /cho ice . W e a l sop resen t ev idence tha t sm al le r f i rms and /o r f i rms in l es s conce n t ra ted indus t r ies do n o t app ear toma ke a ccoun t ing po l i cy cho ice dec i s ions tha t a re cons i s t en t wi th th i s theo ry .

1 . I n t r o d u c t i o nA recent series of articles has re-examined and augmented thephenomenon first addressed by Gordon (1964), when he proposed a theorywhich attempted to manifest the economic incentives which motivatemanagers' choices of accounting principles. 1 These papers have extendedGordon's query by attempting to determine the economic incentives whichmotivate managers' concern with the set of accounting principles utilized togenerate the firms' financial statements. This concern is exhibited throughtwo economic phenomena. The first is the firms' lobbying activities for oragainst a proposed accounting standard. These actions are designed to

influence the set of generally accepted accounting principles (GAAP) fromwhich a firm may choose. The second is the choice of, and/or changes in, theset of accounting principles utilized by a firm. Both phenomena involve realeconomic costs to the firm. The question is, assuming economic rationality,what are the benefits justifying these costs? In response to this question a*We wou ld l ike to thank J . Boness , L . Brown , D. Dhal iwal , L . Kel ly , R . Wat t s and J .Z i m m e r m a n a n d t h e m e m b e r s o f t h e A c c o u n t in g a n d F i n a n c e W o r k s h o p a t th e S t a t e U n i v e r s i t yo f N e w Y o r k a t B u f f a lo f o r th e i r h e lp f u l c o m m e n t s a n d s u g g e s t i o n s1See W at t s (1974 , 1977) , W at t s a nd Zim merm an (1978), Ha germ an and Z mi jew sk i (1979) andDhaliwal (1980).

0165-4101/81/0000-0000/$02.50 f~ North-Holland


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13 0 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choicepositive theory of the determination and choice of accounting principles isbeing developed.The purpose of this paper is to further develop and test this positivetheory of accounting by using an income strategy approach. This approachtreats the firm's set of accounting choices as a single comprehensivedecision. 2 We also test whether or not this theory is generally applicable toall firms.

A positive theory of accounting that explains why firms lobby for andchoose particular accounting principles could be very useful. Such a theorycould identify the economic motives that influence managers to make certainchoices and thus indicate how these incentives could be altered. This theorycould also be used by accounting regulatory bodies and other accountingpolicy-makers to predict how corporations and possibly other related parties,i.e., auditors, would react to proposed changes in accounting rules and hence,predict the economic effect of these changes. Such forecasts could aid policy-makers in anticipating which corporations are most likely to lobby for oragainst a given proposal.

The paper is organized as follows. In section 2 we discuss the positivetheory of accounting and the previous empirical tests. Next we discuss themulti-dimensional nature of the accounting policy decisions made bymanagers and develop our income strategy approach. Section 4 contains theresults of our empirical tests. Finally, in section 5 we present a summary andour conclusions.

2 . Pr i or w ork

2.1. A positive theory o f accounting, policy choiceGordon (1964) was the first to seriously analyze the economic motives

management might have in choosing accounting principles. He concludedthat managers will choose accounting principles that smooth the net incomeseries. Gordon's analysis is suspect because it implicitly assumes thatinvestors cannot, or will not, fully adjust for alternative accountingprinciples. The empirical work conducted by Ball (1972), Sunder (1975), andothers, indicate that, at the aggregate market level, adjustments are made inaccordance with the efficient market hypothesis. 3 Thus, managers areprobably not motivated to choose accounting principles which necessarilysmooth income or growth for this reason.

2T hi s t ype o f a pp r o a c h c ou l d a l s o be a pp l i e d t o t he f o l low i ng a r e a s o f re s e a r c h : pos i ti vet he o r y o f a c c oun t i ng , i nc om e s m oo t h i ng , a nd c ha nge s i n a c c ou n t i ng p r i nci p le s .S in addi t ion , the incom e sm oo thin g research su ch as : Cope la nd (1968), Cush ing (1969), Wh i te(1970) , Ba l l and W at t s (1972), Bare f ie ld and Co m iske y (1972) , and Smi th (1976), has bee n l essthan conc lus ive on th i s i s sue .


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M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice 131

W a t t s a n d Z i m m e r m a n ( 19 78 ), h e re a f te r W - Z , f o r m a l l y d e v e l o p e d a t h e o r yhypothes iz ing the economic incen t ives managers have in s e lec t ing accoun t ing .p r i n c ip l e s a n d d e v e l o p e d a n e m p i r i c a ll y t e st a b le m o d e l . W - Z t e s te d t h i sm o d e l o n m a n a g e r ' s l o b b y i n g p o s i t i o n s t h a t w e r e s u b m i t t e d t o t h e F A S Bconcern ing the gene ra l p r ice l eve l accoun t ing (GPLA) exposure d ra f t .H a g e r m a n a n d Z m i j e w s k i ( 1 9 7 9 ) , h e r e a f t e r H - Z , e x t e n d e d t h i s t h e o r y a n dtes ted i t on the m anag ers ' cho ice o f ind iv idua l accoun t ing po l ic ie s .

T h e t h e o r y d e v e l o p e d b y W - Z is b a s ed o n t h e p r o p o s i t i o n t h a t m a n a g e r sa t t empt to maximize the i r u t i l i ty which i s d i rec t ly re la ted to the i rc o m p e n s a t i o n a n d h e n c e w e a l t h . M a n a g e m e n t c o m p e n s a t i o n i s i n c r e a s e d b ye i t h e r in c r e a si n g th e v a l u e o f m a n a g e m e n t s t o c k o p t i o n p l a n s a n d / o r b yinc reas ing the cash pa id th rou gh incen tive cash bonuses . There fore , W -Zargued tha t the fo l lowing fac to rs would inc rease management wea l th : ( i )dec reased o r de layed t ax payments , ( i i ) favorab le government regu la t ions , ( i i i )dec reased po l i t i ca l cos t s , e .g ., th rea t s o f na t iona l iza t ion , ex prop r ia t ion , an t i -t rus t su it s , e t c. , (iv) dec reased in fo rm at ion p rod uc t ion cos ts , and (v) inc reases inthe income measure used a s the base fo r the incen t ive bonus p lans . Inc reasedf i rm cash f lows f rom the f i r s t four fac to rs would , ce te r i s pa r ibus , l ead toh ighe r s tock p r ices , whi le the l a s t fac to r would re su l t in a d i rec t inc reasei n m a n a g e m e n t c o m p e n s a t i o n .

Based on th i s log ic , managers wi l l lobby fo r and choose those accoun t ingpo l ic ie s which dec rease o r de fe r t ax payments , he lp s ecure favorab leregu la t ions (o r dec i s ions by regu la to rs ) , dec rease po l i t i ca l cos t s , dec reasei n f o r m a t i o n p r o d u c t i o n c o s t s , a n d / o r i n c r e a s e m a n a g e r s ' c a s h b o n u s e s .E x c e p t f o r t h e r e d u c t i o n o f i n f o r m a t i o n p r o d u c t i o n c o s t s w h i c h d i r e c t l ydec rease cash ou t f lows , accoun t ing po l ic ie s a f fec t these fac to rs by the impac tt h e y h a v e o n r e p o r t e d n e t i n c o m e . A n a c c o u n ti n g p o l i c y w h i c h r e d u c e si n c o m e c a n r e d u c e o r d e l a y a f i r m ' s t a x p a y m e n t s ( a s s u m i n g i t m u s t b e u s e dfor bo th accou n t ing and t ax pu rposes , i .e . , L IF O) . I f a fi rm is regu la ted ,a c c o u n t i n g p o l i c i e s w h i c h r e d u c e n e t i n c o m e w o u l d a l l o w m a n a g e m e n t t oa rgue tha t p ro f i t s a re too low an d tha t a p r ice inc rease is jus ti f ied . Lo we rea rn ings a l so reduce po l i t i ca l cos t s because the f i rm i s l e s s v i s ib le and henceless l ike ly to be a t t ac ked by po l i t ica l ac t iv i s ts than a re f irms w i th h ig he rea rn ings . F ina l ly , if a com pa ny bases i ts incen tive p lan on rep or ted ea rn ing s ,m a n a g e r s h a v e a n i n c e n t i v e t o f a v o r t h o s e m e t h o d s w h i c h i n c r e a s e r e p o r t e di n c o m e .

W atts (1977), us ing the resu l ts of Jensen an d M eckl ing (1976), was th e f i rs tto sugges t tha t deb t co ven an ts m igh t a l so in fluence the cho ice o f acc ou n t in gpo l ic ie s . Co l l ins , Roze f f and Dha l iwa l (1980) , Dha l iwa l (1980) , Hol thausen(1980) , and Lef twich (1980) made the a rgument tha t the h ighe r i s thed e b t / e q u i t y r a t i o o f t h e f ir m , t h e m o r e b i n d i n g a r e t h e d e b t c o v e n a n t s o n t h ef i rm . The f i rm can a t t em pt to loosen some of these covenan ts , e .g ., thed i v i d e n d c o v e n a n t , b y c h o o s i n g a c c o u n t i n g p o l i c i e s t h a t i n c r e a s e r e p o r t e d


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13 2 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choicei ncome . H ence , t hey hypo the s i zed tha t h igh deb t / equ i ty r a t io s a re a ssoc ia t edw i th income inc rea s ing accoun t ing a l t e rna t ive s and , w i th the excep t ion o fH o l thausen (1980), they found th a t deb t / eq u i ty r a t io w as s ign i fi c an t i n thevar ious i ssues they tes ted .2.2 . Empir ica l t es t s

W - Z t e s t e d t h e i r p o s i t i v e t h e o r y o f a c c o u n t i n g b y e x a m i n i n g t h e l o b b y i n gpos i t ion c_ the f i rms w h ich mad e subm iss ions to the FA SB a bou t thep r o p o s ed G P L A s t a n d a r d . T h e y e x a m i n e d t h e e m p i r ic a l re l a ti o n s h ip o f af i rm ' s ad jus t ed lobby ing pos i t ion (ad jus t ed fo r t he e f fec t G PLA w ou ld haveon i t s income) to s ize and marke t share , used as proxy var iab les for pol i t ica lcost s, the ex is t ence o f a man agem en t p ro f i t - sh a r ing p lan , tw o p roxy va r i ab le sfor possib le tax e ffects, a nd wh ethe r or no t the f i rm was regula ted . 4 Theva r i ab le w i th the mos t d i sc r imina t ing pow er w as f i rm s i ze , w i th the l a rge rf i rms lobby ing fo r low er e a rn ings . The o the r va r i ab le s had l i t t l e exp lana to rypower .

H age rman and Zmi jew sk i (1979) a l so t e s t ed th i s t heo ry . They used p rob i tana lysis to de te r min e i f the choice o f four indiv idua l acco unt in g pol ic ies ( i.e. ,dep rec ia tion and inven to ry me thod s , t he t r e a tme n t o f t he inves tmen t t axcredit , and the am ort iz a t ion of pas t se rv ice costs) by 300 f i rms could beexp la ined by the theo ry . The H - Z m ode l cons i s t ed o f f i rm s ize andm a n a g e m e n t i n ce n ti v e p la n v a r ia b l e s a s d i d t h e W - Z m o d e l . H - Z s u b s t i tu t e dan e igh t f i rm concen t ra t ion ra t io va r i ab le fo r t he W-Z marke t sha re va r i ab le .The concen t ra t ion ra t io i s a ssumed to be a p ro xy va r i ab le for t he ab i li t y o f af i rm to ea rn monopo ly ren t s , w h ich can re su l t i n l a rge po l i t i c a l cos t s .C o r p o r a t i o n s w h i c h e a r n m o n o p o l y r e n t s a n d r e p o r t t h e m a r e m o r e l ik e ly t oface an t i - t ru s t a c t ion and en t ry by o the r f i rms . Thus i t w as hypo the s i zed tha tco rpo ra t ions w h ich ea rn monopo ly ren t s w i l l choose accoun t ing p r inc ip le sw h ich reduce repo r t ed income to fo re s t a l l en t ry a s w e l l a s an t i - t ru s t su i t s .Tw o add i t iona l va r i ab le s w e re t e s t ed by H -Z: sys t ema t i c r i sk and cap i t a lin t ens i ty . R i sk ie r f i rms w i l l t end to e a rn h ighe r r e tu rns to compensa te themfor the add i t iona l sy s t ema t i c r i sk they bea r . The re fo re , t o the ex ten t t ha taccount ing income re f lec ts economic income, r i sk ie r f i rms wi l l show higheraccount ing prof i t s . Likewise , capi ta l in tensive f i rms wi l l appear to earnh ighe r p ro f i ts t han l abo r in t ens ive f i rms becau se the to t a l cos t o f c ap i t a l i snot a recognized expense in comput ing ne t income. Since r i sk ie r f i rms andmore cap i t a l i n t ens ive f i rms w i l l appea r to e a rn abnorma l p ro f i t s , t hey w i l lhave an incen t ive to choose those accoun t ing p r inc ip le s tha t w i l l r educerepor t ed income .

H - Z t r e a t e d L a s t - I n - F i r s t - O u t ( L I F O ) , a c c e l e r a t e d d e p r e c i a t i o n , t h ede fer ral o f t he inves tm en t t ax c red i t , and the am or t i z a t ion o f pa s t se rv ice

4 T h e G P L A e f f e c t o n i n c o m e w a s e s t i m a t e d v i a t h e a d j u s t i n g p r o c e d u r e d e v e l o p e d b yD a v i d s o n a n d W e i l ( 1 9 7 5 a, b ), a n d D a v i d s o n , S t i c k e n y a n d W e i l ( 1 97 6 ).


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M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice 133c o s t s o v e r a p e r i o d o f l es s t h a n 3 0 y e a r s a s i n c o m e d e f l a t in g a l te r n a t i v e s . T h ei n c o m e i n f l a t i n g c h o ic e s w e r e F i r s t - I n - F i r s t - O u t ( F I F O ) , s t r a ig h t - l in ed e p r e c i a t i o n , t h e f l o w - t h r o u g h m e t h o d f o r th e i n v e s tm e n t t a x c r e di t, a n da m o r t i z a t i o n p e r i o d s o f 3 0 y e a r s o r m o r e f o r p e n s i o n p a s t s e r v i c e c o st s. T h em o d e l w a s s t a t i s t ic a l l y s i g n i f i c a n t f o r o n l y t w o o f t h e f o u r p o l i c i es : i n v e n t o r ya n d d e p r e c i a t i o n m e t h o d s . W h a t w a s e v e n m o r e d i s t u r b i n g w a s t h e fa c t t h a tt h e s a m e v a r i a b l e s w e r e n o t c o n s i s t e n t l y s i g n i fi c a n t a c r o s s e a c h o f t h e f o u rp o l i c i e s te s t ed . T h i s e v i d e n c e in d i c a t e s t h a t , w h i l e t h e i n d e p e n d e n t v a r i a b l e sm a y h a v e e x p l a n a t o r y p o w e r i n g e n e r al , t h e y a r e n o t i n d i v i d u a l l y c o n s i s t en td e t e r m i n a n t s o f a c c o u n t i n g p o l i c y c h o i ce . T h i s c o u l d b e i n t e r p r e t e d t o i n f e rt h a t e i t h e r d i f f e re n t d e c i s i o n p r o c e s s e s a r e u s e d f o r e a c h a c c o u n t i n g p o l i c yc h o i c e ( w h i c h s e e m s u n l i k e l y ) o r t h a t t h e a c c o u n t i n g p o l i c i e s w h i c h w e r et e s t e d a r e n o t i n d i v i d u a l d e c i s i o n s .

3. Th e incom e s trategy approach3.1 . In com e s tra teg ies

A l t h o u g h m a n y s t ud i es h a v e a s s u m e d t h a t t h e ch o i c e o f a c c o u n t i n gp o l i c i e s a r e i n d e p e n d e n t , 5 i t is u n l i k e l y t h a t m a n a g e r s a c t i n t h i s m a n n e r . I fm a n a g e m e n t u s e s t h e H - Z o r t h e W - Z m o d e l i n t h ei r ac c o u n ti n g p o li c yl o b b y i n g a n d c h o i ce d e c is i o ns , t h e se d e c i s io n s w il l n o t b e i n d e p e n d e n tb e c a u s e t h e v a l u e s o f t h e m o d e l ' s i n d e p e n d e n t v a r i a b l e s a r e i d e n t i c a l f o r e a c hd e c i s i o n . B a s e d o n t h e e c o n o m i c f a c t o r s w h i c h in f l u e n c e t h e s e d e c i si o n s ,m a n a g e r s w i l l a t t e m p t t o a c h i e v e t h e o p t i m a l r ep o r te d n e t i n c o m e o v e r t i m ea n d w i l l c h o o s e a s et o f a c c o u n t i n g p o l ic i e s a c c o r d i n g l y . E s s e n t i a l ly ,m a n a g e m e n t w i l l a d o p t a m u l t i - d i m e n s i o n a l i n c o m e s tr a te g y f o r t h e f ir m ,w i t h e a c h p o l i c y b e i n g o n e d i m e n s i o n o f t h a t d e c i si o n.

B o t h W - Z a n d H - Z m o d e l s m a d e t he a s s um p t i o n o f i n d ep e n d en c e . W - Zd i d n o t d i s c u s s t h e e f f e c t o f t h e o t h e r p o l i c y d e c i s i o n s m a d e b y t h e f i r m . Af i r m w o u l d n o t i n c u r l o b b y i n g c o s t s i f i t c o u l d c o u n t e r a c t t h e e f fe ct o f ad e c i s i o n m a d e b y t h e F A S B b y c h a n g i n g i t s se t of a c c o u n t i n g p r i n c i p le s ift h e c o s t o f t h i s c h a n g e w o u l d b e l e s s t h a n t h e co s t of l o b b y i n g . H - Z a s s u m e dt h a t m a n a g e r s w o u l d c h o o se a n a c c o u n t i n g p r i n c ip l e b a s e d o n i t s i n d i v i d u a le f fe c t o n r e p o r t e d i n c o m e a n d t h e e c o n o m i c v a r i a b l e s o f t h e m o d e l . S i n c e t h es e t o f i n d e p e n d e n t v a r i a b l e s is t h e s a m e f o r e a c h f i r m at a n y p o i n t i n t im e ,t h e m o d e l s h o u l d p r e d i c t e i t h e r a l l i n c o m e i n c r e a s i n g o r a l l i n c o m ed e c r e a s i n g a c c o u n t i n g p o l i c y c h o i c e s f or e a c h o f t h e f i rm s . T h e r e fo r e , f o r ap a r t i c u l a r f i r m , th e m o d e l w o u l d i n f e r a c o n s e r v a ti v e ( al l i n c o m e d e c r e a s i n gp o l i c i e s ) o r l i b e r a l ( a ll i n c o m e i n c r e a s i n g p o l i ci e s) f i r m i n c o m e s t r at e g y .

SSee for example: A bdel-khalik and M cK eow n (1978), Ball (1972), Cushing and D eak in(1974), Eggleton, Penm an an d T wo mb y (1976), and Ka plan an d Roll (197 2) (changes inacc oun ting principle); W atts and Zim m erm an (1978) ( lobbying decisions); and H ager ma n andZm ijewsk i (1979) (accounting policy cho ice decisions) .


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134 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choiceHow e ve r , on ly 12 .33 ~o o f t he H -Z sa mp le f e ll i n to the se e x t re m e c a te go r i e s(see tab le 1) . This resu l t i s consis ten t wi th our a rgument tha t f i rms fo l low anovera l l income s t ra tegy .An op t ima l s t r a t e gy ne e d n o t be e x t re m e be c a u se o f t he t ra de -of f s t hema na ge rs f a c e . Some va r i a b le s suc h a s s i z e induc e ma na ge rs to u se de f l a t ingpo l i c i e s wh i l e o the r va r i a b le s suc h a s ma na ge me n t c ompe nsa t ion p l a nse nc oura ge ma na ge rs to c hoose inc ome in f l a t ing a l t e rna t ive s . The re su l t o fthe se t ra de-o ff s me a n tha t a ny c o m bina t io n o f t he a va i l a b le se t o f a l t e rna t iveG A A P m a y b e o p t i m a l f o r a g i v e n f i r m .

If f i rms fo l low an o vera l l f i rm incom e s t ra teg y , then the f i rm's s t ra teg iesshou ld be u se d a s the de pe nde n t va r i a b le in a s t a t i s t i c a l a na ly s i s c onduc te dto tes t the choice of acco unt in g pr inc ip les . T his w i ll p ro vide a s t ronger tes t o fthe hypo the s i s . Give n the fou r po l i c y c ho ic e s a na lyz e d by H-Z (de p re c ia t ion ,inve n to ry , i nve s tme n t t a x c re d i t , a nd pe ns ion pa s t se rv ic e c os t s ) a nd twoc ho ic e s fo r e a c h po l i c y ( inc ome inc re a s ing o r i nc ome de c re a s ing ) the re a re 24o r 16 c ombina t ions tha t f i rms c ou ld fo l low. I t i s ne c e ssa ry to c ons ide r howthe se 16 c omb ina t ions c a n be pa r t i t i one d in to a n o rd ina l r a nk in g o f d i s t inc tincom e s t ra teg ies across a l l fi rms. 6 Th e f i rs t se t o f s t ra teg ies we tes t i s basedon the a ssumpt ion tha t t he c ho ice s o f i nve n to ry a nd d e p re c ia t ion m e thods ,the a mor t i z a t ion o f pe ns ion c os t s , a nd th e t r e a tm e n t o f t he inve s tme n t t a xcredi t , a l l have an equa l e f fec t on repor ted income. This assumpt ion y ie ldsf ive a l te rna t ive s t ra teg ies , each w i th a d i f fe ren t m ag ni tu de of e ffec t onrepor ted income. The f ive s t ra teg ies a re : income decreasing pol ic ies for a l lfou r me thods , one inc ome inc re a s ing po l i c y a nd th re e inc ome de c re a s ingpol ic ies , two income increasing pol ic ies and two income decreasing pol ic ies ,three increasing pol ic ies and one decreasing pol icy , and f ina l ly , a l l incomeinc re a s ing po li ci es . The c om bina t ion s o f po l ic i e s tha t m a ke up the se f ivest ra teg ies a re shown in tab le 1 .

The a ssumpt ion tha t a l l t he a l t e rna t ive a c c oun t ing p r inc ip le s ha ve a nequa l e f fec t on repor ted income is a rb i t ra ry . However , as i t i s no t possib le tome a su re the e xa c t ef fe ct s o f t he va r ious a c c ou n t ing p r inc ip le s , we ma ke twoa dd i t iona l set s o f a ssum pt ions r e ga rd in g the imp a c t o f a l t e rna t ive p r incip le s .W e the n tes t the resu l t ing se ts of s t ra teg ies to see if the resu l t s a re sensi t iveto the a ssumpt ions o f t he ind iv idua l a c c oun t ing po l i ci e s on the a l t e rna t ivea gg re ga t ion p roc e du re s . The f i r s t a dd i t io na l se t o f a ssum pt ions is t ha t t hepe ns ion c os t a nd inve s tme n t t a x c re d i t a l t e rna t ive s ha ve e xa c t ly one -ha l f o fthe e ffec t o f t he inve n to ry a nd de p re c ia t ion a l t e rna t ive s . Th i s a s sum pt ionre su lt s i n a se t o f se ven d i s t inc t s t r a te g ie s . The c om bina t ion o f a c c oun t ingpr inc ip les choices th /~ t m ake up th ese seven s t ra teg ies a re a lso presented in

6 W e h a v e r e v ie w e d t h e l i te r a t u r e f o r a r ti c le s a n d e m p i r i c a l e v i d e n c e w h i c h w o u l d p r o v i d e u sw i t h a m e t h o d o l o g y w h i c h w o u l d d i v i d e th e 1 6 c o m b i n a t i o n s o f a c c o u n t i n g p o l ic i es i n t o a no r d i n a l r a n k i n g o f f ir m i n c o m e s t ra t e gi e s. U n f o r t u n a t e l y , w e w e r e u n a b l e t o f i n d a n y s u c hr e f er e n ce s . A l t h o u g h th e a s s u m p t i o n s w h i c h w e h a v e m a d e m a y a p p e a r s o m e w h a t a d hoc, w ef ee l t h a t t h e y a r e r a t i o n a l a n d a r e a d e q u a t e s u r r o g a t e s f o r t h e t r u e o r d i n a l r a n k i n g s .


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8/21

136 M.E. Zmijewski and R.L. Hagerman, Income strategy anti accounting choicet ab l e 1. Th e secon d a l t e rn a tiv e se t o f as su m p t io n s is t h a t t h e p en s io n co s t san d t ax c red i t s h av e an eq u a l b u t l e s s t h an o n e-h a l f o f t h e e f f ec t t h a tin v en to ry an d d ep rec i a t io n a l t e rn a t iv es h av e o n r ep o r t ed in co me. Th i sassu m p t io n y i e ld s a se t o f n in e s t r a teg i es . Th e c o m b in a t io n s t h a t m ak e u pth ese s t r a t eg i es a re ag a in sh o wn in t ab l e 1 .

W e p r o p o s e t o t e s t t h e m o d e l p r e v i o u s l y d e v e l o p e d b y H - Z a u g m e n t e dw i t h t h e d e b t / e q u i t y r a t i o o n t h e i n c o m e s t r a t e g y a d o p t e d b y t h e f i r m , r a t h e rth an o n th e in d iv id u a l l o b b y in g o r p o l i cy ch o ice d ec i s io n s . We asse r t t h a tacc o u n t in g p o l i cy d ec is io n s mu s t b e an a ly zed as p a r t o f an o v era l l fi rms t r a t eg y an d n o t as i n d ep en d en t d ec i s io n s . I f , i n f ac t , t h e f i rm d o es mak e i t sacc o u n t in g p o l i cy d ec is ion s v i a so me ty p e o f i n co m e s t r a t eg y d ec i s io np ro cess , t h e mo d e l sh o u ld b e ab l e t o c l as s i fy t h e f i rms acco rd in g to t h es t ra teg ies chosen .3 . 2 . M e t hodo l og i c a l c ons i de r a t i ons

Th ese s t r a t eg i es , g iv en o u r p rev io u s as su mp t io n s , can b e r an k ed in t h eo rd er o f t h e as su med m ag n i tu d e o f t h e e f fect o n n e t i n co m e. Th e f i rs ts t r a t eg y i s t h e mo s t i n co me d ecreas in g p o ss ib i l i t y wh i l e t h e l a s t s t r a t eg y i sth e mo s t i n co me in c reas in g s t ra t eg y . Th i s t r ea tm en t o f t h e f i rms ' i n co mes t r a t eg i es h as r esu l t ed in ce r t a in d a t a l imi t a t i o n s wh ich wi l l b e a d e t e rmin an tin t h e ch o ice o f an ap p ro p r i a t e s t a t i s ti ca l me th o d o lo g y .

Th e f i rs t limi t a t io n i s t h a t t h e ac tu a l e f fect o n r ep o r t ed in co m e o f ap ar t i cu l a r s t r a t eg y can n o t b e o b serv ed . Becau se o f t h i s , we a re o n ly ab l e t oh y p o th e s i ze t h e r an k in g o f t h e s t ra t eg i es. Th e seco n d l imi t a t i o n is t h a t , a tb es t , t h e h y p o th es i zed r an k in g s a re o rd in a l . Hen ce , t h e ch o ice to as s ig n th esame s i ze i n t e rv a l t o each s t r a t eg y can n o t b e u sed to i n fe r t h a t each s t r a t eg ywi ll h av e th e same mag n i tu d e o f e ff ec t o n r ep o r t e d in co m e.

Giv en th ese d a t a l imi t a t i o n s , r eg ress io n an a ly s i s i s an in ap p ro p r i a t es t a t i s t i ca l t ech n iq u e fo r t h e fo l lo win g two reaso n s . F i r s t , t h e re i s a v io l a t io no f t h e a s s u m p t i o n s w h i c h m u s t b e m a d e a b o u t t h e p r o p e r t i e s o f t h e e r r o rt e rms in r eg ress io n an a ly s i s . Th e e r ro r t e rms in t h e r eg ress io n mo d e l wh erethe dependent var iab le i s categor ical : ( i ) wi l l n o t h a v e a n e x p e c t e d v a l u e o fzero, (ii) will n o t b e n o rmal ly d i s t r i b u ted b u t i n f ac t h av e a d i sc re t ed i s t r i b u t io n , an d ( i ii ) w i ll b e h e t e ro sk ed as t i c . Th e sev er i t y o f th ese v io l a t io n swi ll d ec rease as t h e n u m b er o f ca t eg o r i es i s ex p a n d ed . Th i s can b e in tu i t iv e lyseen b y ex p an d in g th e n u m b er o f ca t eg o r i es t o t h e l imi t , i.e ., wh e n th en u m b er o f ca t ego r ies ap p ro ach es i n fin ity , t h e d ep e n d e n t v a r i ab l e b eco mesco n t in u o u s an d th e v io l a t io n s n o lo n g e r ex is t . Hen ce , o n e m ay ju s t i f iab lyu t il ize r eg ress io n an a ly s i s i f t h e d ep en d e n t v a r i ab l e h as a su f f ic i en t n u m b er o fca t eg o r i es t o r ed u ce th e sev er it y o f t h i s p ro b lem. Th e seco n d p ro b lem is t h a tr eg ress io n an a ly s is imp l i c it ly as su mes th a t t h e d ep e n d e n t v a r i ab l e h as acard inal scale .

An a l t e rn a t iv e s t a t i s t i ca l t ech n iq u e i s t h e n -ch o to mo u s p ro b i t an a ly s i sd ev e lo p ed b y McKelv ey an d Za v io n a (1 97 5) . Th e as su m p t io n o f t h is


9/21

M.E. Zmi iewsk i aml R .L . Hagerman , Income s t ra tegy and accoun t ing cho ice 137

m e t h o d o l o g y is t h a t , a l t h o u g h u n o b s e rv a b l e , t h e d e p e n d e n t v a r ia b le h a s aco n t in u o u s u n d er ly in g n o rm al d i s t r i b u t io n . H en ce , i f t h e tru e v a lu es co u ld b eo b serv ed , t h e p rev io u s ly d i scu ssed r eg ress io n mo d e l w o u ld sa t is fy t h en ecessa ry as su m p t io n s . Giv en th i s as su mp t io n , t h e o b jec tiv e o f n -ch o to m o u sp ro b i t an a ly s i s i s t o s im u l t an e o u s ly es t imate t h e r eg ress io n coeff ic ients o f t h et ru e u n d er ly in g r eg ress io n m o d e l as we ll a s th e p a ra m ete r s o f t h e ca rd in a lsca le o f ca t e g o ry in t e rv a l s . Th e r esu l ti n g es t imated p aram ete r s wil l p ro v id ea n e s t i m a t i o n o f t h e p r o b a b i l i t y t h a t a n o b s e r v e d v e c to r o f i n d e p e n d e n tv a r i a b le s i s w i th i n a n y p a r t i c u l a r c a t e g o r y b o u n d e d b y t h a t c a te g o r y ' ses t imated ca rd in a l i n t e rv a l s .

T h e e s t i m a t i o n o f t h e se p a r a m e t e r s is c a l c u la t e d b y u s e o f t h e m a x i m u ml i k e li h o o d e s t i m a t i o n p r o c e d u r e v i a t h e N e w t o n - R a l p h s o n i te r at iv e m e t h o do f s o l u t i o n f o r n o n l i n e a r s y s te m s . 7 T h e a d v a n t a g e o f u si n g p a r a m e t e r ses t im ated b y th i s m eth o d i s t h e ap p ea l in g s t a t is t i ca l p ro p ert i e s o f t h ees t imato r s . Th ese es t imates a re asy mp to t i ca l ly e f f i c i en t an d h av e a k n o wnasy m p to t i c sam p l in g d i s t r i b u t io n . Th ere fo re , we a re ab le t o p e r fo rmh y p o th es i s t e s t s o n th e s ig n if i can ce o f b o th th e o v era l l mo d e l an d th ein d iv id u a l i n d ep e n d e n t v a r i ab l es . An o th er ap p ea l in g f ea tu re o f t h is t ech n iq u ei s t h a t i t i s p o ss ib l e t o m ak e ce r t a in i n fe ren ces ab o u t t h e es t imated s ize o f t h ein t e rv a l s ch o sen . W e a re ab l e t o t e s t t h e h y p o th es i s t h a t t h e si ze o f t h ees t imated ca rd in a l i n t e rv a l i s s ig n i f i can t ly d i f f e ren t f ro m zero . Th i s t e s t wi l lp ro v id e so m e in d i r ec t ev id en ce o n th e ap p ro p r i a t en ess o f o u r ch o ice o fin co me s t r a t eg i es .

To t es t t h e o v era l l mo d e l t h e l i k e l ih o o d r a t io wi l l b e u sed . Th i s i s d o n e b ytak in g min u s two t imes th e lo g l i k e l ih o o d r a t io wh ich i s d i s t r i b u ted as a ch i -s q u a r e w i t h k - 1 ( k b e i n g th e n u m b e r o f i n d e p e n d e n t v a r ia b le s ) d e gr e es o ff r eed o m, c f . , McKelv ey an d Zav o n ia (1 9 7 5 ) . Th e asy mp to t i c t - t e s t wi l l b eused to tes t the s ign i f icance of bo th the es t im ated coefficien ts o f thein d e p en d en t v a r i ab l es an d th e s i ze o f t h e es t im ated ca rd in a l i n te rv a ls . 8

Th e in d ep en d en t v a r i ab l es a re measu red in t h e fo l lo win g way s . S i ze i sm easu red b y th e lo g o f n e t sa l es. Cap i t a l i n t en s i ty i s ca l cu l a ted b y th e r a t i oof g ross f ixed assets to sales . Co nc en t rat i on ra t io , w hich i s def ined as thep e r c e n t a g e o f t o t a l i n d u s t r y s a le s m a d e u p b y t h e t o p e i g h t f i r m s , 9 i s ourp ro x y fo r t h e f i rm ' s ab i l i t y t o ea rn mo n o p o ly r en t s . Th e d eb t / eq u i ty r a t i o i sd ef in ed as t o t a l d e b t t o t o t a l a s se ts . Th e sy s t emat i c r i sk o f t h e co rp o ra t io n is

7For an excellent discussion of both categorical dependent variables and the Newton-Ralphson method of nonlinear estimation, see Maddala (1977, pp. 162-166, 171-174).8One may question our choice of n-chotomous probit analysis over multiple discriminantanalysis (MDA). The decision is quite clear, MDA does not provide a direct statistical test ofeither the coefficients of the individual independent variables or the size of the estimatedintervals. Furthermore, the MDA model assumes that all of the independent variables arenormally distributed. Given our binary management profit-sharing variable, this assumptionwould be violated.9Concentration ratios have obvious shortcomings as measures of monopoly rents but they arewidely used because no better proxy is readily available.


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138 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choicem e a s u r e d b y b e t a e s ti m a t e d f r o m t h e m a r k e t m o d e l . A z e r o -o n e d u m m yv a r i a b l e r e p r e s e n t s t h e e x i s t e n c e o r n o n - e x i s t e n c e o f a m a n a g e m e n t p r o f i ts h a r i n g p l a n b a s e d o n r e p o r t e d n e t i n c o m e .

4 . E m p i r i c a l t e s t s4 .1 . Da ta

T h e d a t a u s e d i n o u r a n a l y s es c o n s is t o f t h e 3 4 u n r e g u l a t e d f i r m s o f W - Za n d t h e 3 0 0 u n r e g u l a te d f ir m s o f H - Z . l F o r e a c h o f t h e f i rm s , t h ep r e v i o u s l y d i s c u s s e d e c o n o m i c v a r i a b l e s a n d t h e c h o i c e o f t h e f o u ra c c o u n t i n g p r i n c i p l e s w e r e c o l le c t ed f r o m e i t h e r t h e f i r m s ' 1 9 7 5 S E C 1 0 K o ra n n u a l r e p o r ts . I t s h o u l d b e n o t e d t h a t t h e 3 0 0 H - Z f i r m s r ep r e s e n t ar a n d o m s a m p l e o f f ir m s , w h i le t h e 3 4 W - Z f i rm s r e p r e s e n t t h e p o p u l a t i o n o fu n r e g u l a t e d f ir m s w h i c h m a d e s u b m i s s i o n s t o t h e F A S B i n r e g a r d t o t h eG P L A d i s cu s s io n m e m o r a n d u m (a n o n - r a n d o m s a m p le ) . T h e r ef o re , i t i si n t e r e s t i n g t o c o m p a r e t h e t w o s a m p l e s a n d t h e c h a r a c t e r i s t i c s o f t h e d a t a .

S i n c e f i r m s w i t h e x t r e m e s t r a t e g i e s ( a l l i n c r e a s i n g o r d e c r e a s i n g p o l i c yc h o i ce s ) h a v e l es s a b i l i t y t o c o u n t e r a c t t h e e f fe ct o f a m a n d a t e d a c c o u n t i n gp o l ic y c h a n g e / s t a n d a r d , o n e m a y a n t i c i p a t e t h a t f i rm s w h i c h m a d es u b m i s s i o n s t o t h e F A S B t e n d t o h a v e e x t r e m e p o l ic i es . T h i s h y p o t h e s i s c a nb e te s t e d b y e x a m i n i n g th e d i s t r i b u t i o n s o f t h e f i r m s t r a t e g i e s o f th e t w os a m p l e s. T h e d i s t r ib u t i o n o f t h e 1 6 p o s s i b l e c o m b i n a t i o n s o f t h e f o u ra c c o u n t i n g p o l i c i e s f o r th e tw o s a m p l e s i s s h o w n i n t a b l e 1. T h e d i s t r i b u t i o n sf o r t h e f iv e , s e v en , a n d n i n e s t r at e g y c a s e s c a n a l s o b e e a s i l y d e r i v e d f r o mt h i s t a b l e . T h e m a i n d if f e re n c e b e t w e e n t h e d i s t r i b u t i o n s o f t h e t w o s a m p l e si s t h e p e r c e n t ag e o f W - Z o b s e r v a ti o n s i n th e t w o e x t r e m e s t r at e g ie s . T h e W -Z s a m p l e h a s a m u c h l a r g e r p e r c e n t a g e o f f i r m s i n t h e s e t w o s t r a t e g i es t h a nd o e s t h e H - Z s a m p l e . T h i s s up p o r t s o u r h y p o t h e s i s t h a t f i r m s w i t h e x t re m es t r a te g i e s w i l l t e n d t o m a k e s u b m i s s i o n s t o t h e F A S B .

T o t e s t t h e s t a t is t i c a l s ig n i f ic a n c e o f th i s d i f f e re n c e , t h e b i n o m i a l t e s t w a su s ed . T h e p r o p o r t i o n o f f ir m s i n e ac h c o m b i n a t i o n ( s t ra t eg y ) o f t h e H - Zs a m p l e w a s u s e d a s a n u n b i a s e d e s t i m a t o r o f t h e p r o b a b i l i t y o f t h ep o p u l a t i o n ' s c o m b i n a t i o n (s tr at eg y ). U s i n g t h e C l o p p e r - P e a r s o nm e t h o d o l o g y , a 9 5 ~ c o n f i d e n c e i n t e r v a l w a s c a l c u l a t e d f o r t h e e s t i m a t o r , i lT h e u p p e r b o u n d o f t h e 95 ~ c o n f id e n c e i n t e r v a l w a s t h e n u s e d a s t h ee s t i m a t e d p o p u l a t i o n p r o b a b i l i t y o f t h e t w o e x t r e m e c o m b i n a t i o n s f o r t h eb i n o m i a l t es t . T h i s w a s d o n e t o i n t e n t i o n a l l y b i a s t h e e s t i m a t o r i n f a v o r o ft h e n u l l h y p o t h e s i s t o p r o v i d e f o r a s t r o n g e r t e s t. T h e u p p e r b o u n d o f t h e9 5~ o c o n f id e n c e i n te r v a l f o r th e e x t r e m e i n c o m e d e f l a t i n g a n d i n c o m ei n f l a t i n g c o m b i n a t i o n s a r e 0.0 53 a n d 0 .1 2 3, r e s p e c ti v e l y . B a s i n g t h e b i n o m i a l

iTwenty-one of the 34 W-Z firms were also in the H-Z sample.l iSee Hollander and Wolfe (1973, pp. 15-24).


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t e s t s o n t h e s e p r o b a b i l i t i e s r e s u l t e d i n r e j e c t i n g t h e n u l l h y p o t h e s i s f o r b o t ho f t h e e x t r e m e c o m b i n a t i o n s . T h e i n c o m e d e f la t in g c o m b i n a t i o n w a s r e je c te da t t h e 0 . 0 4 75 l e v e l o f s ig n i f i c a n c e a n d t h e i n c o m e i n f l a t i n g c o m b i n a t i o n w a sr e je c t e d a t t h e 0 .0 2 3 9 le v e l. T h u s t h e d a t a i n d i c a t e t h a t t h e W - Z s a m p l e h a ss i g n i f ic a n t l y m o r e f i rm s w i t h e x t r e m e s t ra t eg i e s t h a n c a n b e e x p e c te d( a s s u m i n g th a t t h e H - Z s a m p l e i s r e p r es e n t a ti v e o f t h e p o p u l a t i o n ) .

I n t h e i r d i s c u s s i o n o f f i r m s iz e , W - Z a s s e rt e d t h a t s m a l l e r f i rm s w o u l de i th e r n o t m a k e a s u b m i s s i o n o r m a k e a n u n f a v o r a b l e s u b m i s s i o n t o th eF A S B r e g a r d i n g t h e G P L A d i s c u s s i o n m e m o r a n d u m . T h e r e f o r e , o n e w o u l dh y p o t h e s i z e t h a t t h e m e a n s iz e o f t h e W - Z s a m p l e w o u l d b e m u c h l a rg e rt h a n t h a t o f t h e H - Z s a m p l e . W e p e r fo r m e d t h e M a n n - W h i t n e y U te st t ot e st th i s h y p o t h e s i s . T h e m e a n s i z e o f t h e W - Z s a m p l e is m o r e t h a n t w ic et h a t o f t h e H - Z s a m p l e . T h e n u l l h y p o t h e s i s w a s r e je c t e d a t t h e 0 .0 01 l ev e l o fs i g n if i ca n c e . T h e f a c t t h a t t h e f i r m s i n t h e W - Z s a m p l e a r e s o l a rg e m a ye x p l a i n w h y W - Z d i d n o t f in d th e m a n a g e m e n t c o m p e n s a t i o n o r r e g u la t o ryp r o x y v a r i a b l e s u s e f u l i n c l a s s i f y i n g t h e f i rm s ' l o b b y i n g c h o i c es . T h e p o t e n t i a lp o l i t i c a l c o s t s b o r n e b y l a r g e f i r m s m a y b e s o l a r g e t h a t t h e y d o m i n a t e t h eb e n e f i ts f r o m i n c r e a s i n g r e p o r t e d i n c o m e . I n a d d i t i o n , t h e p o l i t ic a l p re s s u re sf o r la r ge f i r m s m a y be so g r ea t a s t o i nd uce t he f i r m s t o ac t a s i f t hey w er er e g u la t ed . T h u s , t h e r e g u l a t o r y a n d c o m p e n s a t i o n v a r i a b le s c o u ld b ei n s ig n i f ic a n t f or t h e f i r m s e x a m i n e d b y W - Z .

T h e M a n n - W h i t n e y U t e s t w a s a ls o p e r f o rm e d o n t h e o th e r e co n o m i cva r i ab l e s d i s cus sed ( t he f i ve , s even and n i ne s t r a t egy cases , concen t r a t i onr a t i o , cap i t a l i n t ens i t y , t o t a l de b t t o t o t a l a s se ts , an d r i sk ) bu t w e w er e no ta b l e t o r e j e ct t h e n u l l h y p o t h e s i s w i t h a n y r e a s o n a b l e d e g r e e o f s ig n i fi c an c e .

4 .2 . E m p i r i c a l t e s t o f t h e i n c o m e s t r a t e g y a p p r o a c hI f o u r p r o p o s e d i n c o m e s t ra t e g i e s a re r e p r e s e n t a t i v e o f m a n a g e m e n t s '

i n c o m e s t r at e g ie s , a n d i f t h e s e i n c o m e s t ra t e gi e s a r e g e n e r a t e d b y t h e d e c i s i o np r o c e s s r e p r e s e n t e d b y t h e m o d e l , t h e n o n e w o u l d e x p e c t t h a t t h i s m o d e lw o u l d b e a b l e t o c l a s si f y f i r m s a c c o r d i n g t o t h e i r c h o i c e o f a p a r ti c u l a rs t r a t egy .

Spec i f i ca ll y , t he m od e l i sS t ra t eg Y i = So + ~ 1 M G T C + o ~ 2 C o n c -t- o~3B eta

+ c t4S ize + ~5 C I + t~6 T D + e ,w h e r eS t r a t e g y i = In co m e s t ra te gy ( i = 5 , 7 , or 9) ,M G T C = M a n a g e m e n t c o m p e n s a t i o n p l a n (0 = n o , 1 = ye s) ,C o n c = E i g h t - f i r m c o n c e n t r a t i o n r a t i o ,


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14 0 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

BetaSizeCITDe

T h i s

= S y s t e m a t i c r i sk ,= Log o f ne t s a le s ( p r oxy f o r po l i t i c a l c o s t s ) ,= Ca p i ta l in te ns i ty ( g r os s f ixe d a s s e t s / s a le s ) ,= T o t a l d e b t / t o t a l a ss e ts ,= E r r o r t e r m

h y p o t h e s i s w a s te s te d b y u s in g th e 3 0 0 f i r m H - Z s a m p l e a n de s t i m a t i n g t h e c o e f fi c ie n t s o f t h e m o d e l w i t h f i r m i n c o m e s t r a t e g y a s t h ed e p e n d e n t v a r i a b l e . T h e c o e ff ic ie n ts , e s t i m a t e d v i a n - c h o t o m o u s p r o b i ta n a l y s i s , a n d t h e o t h e r r e s u lt s o f t h e te s ts a r e p r e s e n t e d i n t a b l e 2 . W h a t i si m m e d i a t e l y c l e a r f r o m t h e d a t a i s t h a t t h e r e su l t s f o r f iv e , s e v en , a n d n i n es t r at e g i e s a r e v i r t u a l l y i d e n t i c a l. T h i s e v id e n c e i n d i c a t e s t h a t o u r r e s u l t s a r en o t s e n s it i v e t o t h e a d m i t t e d l y a r b i t r a r y c h o i c e o f i n c o m e s t ra t e g ie s .

S o m e i n fe r e n c e s c a n b e m a d e a b o u t t h e a p p r o p r i a t e n e s s o f o u r s t r a t e g i e sb y e x a m i n i n g t h e s i gn i fi c an c e o f t h e m a g n i t u d e o f t h e b o u n d e d c a r d i n a li n t e r v a l s e s t i m a t e d b y t h e n - c h o t o m o u s p r o b i t a n a l y s i s . T h e r a n g e s o f t h ee s t i m a t e d c a r d i n a l i n t e r v a l s a n d t h e i r t - s t a t i s t i c s a r e p r e s e n t e d i n t a b l e 3 .N o t e t h a t t h e r e a r e t w o l e ss b o u n d e d i n t e r v a l s t h a n t h e m i m b e r o f s t r a t e g i e si n e a c h c a s e . T h i s i s b e c a u s e t h e t w o o u t e r s t r a t e g i e s a r e o n l y b o u n d e d o no n e s id e a n d m u s t t h e r ef o r e, h a v e s t a t is t i c al l y s i g n i f i c a n t m a g n i t u d e s . T h e t -s t a ti s t ic s i n d i c a t e t h a t a l l b o u n d e d e s t i m a t e d c a r d i n a l i n t e r v a l s a r es t a t i st i c a l ly s i g n i f i c a n t f o r b o t h t h e fi v e a n d s e v e n s t r a te g y c a se s . T h e n i n es t r a t e g y c a s e h a s t h r e e i n t e r v a l s w h i c h a r e n o t s t a t i s t ic a l l y s ig n i f i c a n t . T h i sm a y s u g ge s t t h a t s o m e o f t h e s t ra t eg i e s o f t h i s c a s e a re n o t u n i q u e . T h e d a t aind ic a te tha t in the f ive a n d s e ve n s t r a te gy c a s e s the s t r a te g ie s a r e , in f a c t ,d i f fe r e n t f r o m o n e a n o t h e r , a l t h o u g h w e c a n n o t s t a te i f t h e y a r e i n f a c t t h e' t r ue ' s t r a te g ie s . G iv e n the s e r e su l t s , howe v e r , we f e e l tha t th e s t r a te gya s s u m p t i o n s p r e v i o u s l y d is c u ss e d a r e ac c e p ta b l e a n d t h a t t h e m o d e l i s n o tb i a s e d b y t h e c h o i c e o f a p a r t i c u l a r se t o f a s s u m p t i o n s r e g a r d i n g t h e e f f ec t o ft h e a c c o u n t i n g p o l i c i e s o n n e t i n c o m e .

Th e m ode l i s s t a t i s t i c a l ly s ign i f i c a n t a t the 0 .001 l e ve l f o r a l l th r e e c a s e ste s te d . 12 Fo r the f ive s t r a te gy c a se , 409 /o o f the s a m p le ob s e r v a t io ns we r ep r o p e r l y c l a ss i fi e d . T h e p e r c e n t c o r r e c tl y c l a ss i fi e d f o r b o t h t h e s e v e n a n dn i n e s t r a t eg y c a s e w a s 3 3 9 /o . O n e w a y t o d e t e r m i n e h o w g o o d t h e s ep r e d i c ti o n s a r e is t o c o m p a r e t h e m t o a n a i v e p o l i c y w h i c h a s s u m e s a n e q u a lp r o b a b i l i t y o f e a c h s t r a t e gy . T h e p r e d i c t i o n r a t e s o f t h e m o d e l a r e m u c hb e t t e r t h a n u n d e r t h i s n a i v e cl a s si f ic a t io n a n d t h e d i f f e re n c e s a r e v e r ys i g n if i c a n t. A n a l t e r n a t i v e c o m p a r i s o n i s t o a s s u m e t h a t t h e n a i v e f o r e c a s t e rw i l l a l w a y s c h o o s e t h e m o s t c o m m o n s t r at e g y i n t h e s a m p l e . T h e m o d e l ' sp r e d i c t i o n s a r e b e t t e r t h a n t h o s e f r o m t h is a p p r o a c h a n d a r e s i g n i f i c a n t a t

12This leve l of s igni fi cance i s mu ch g rea te r than the l eve l of s igni f i cance repo r ted byH a g e r m a n a n d Z m i j e w s k i ( 19 7 9) w h e n t h e y t e s te d t h e p o l i c y d e c i s io n s i n d i v id u a l ly . T h e l a r g e s tof the ch i - squares rep or te d in the H -Z ana lys i s was 16 .944, whi l e the smal l es t o f these t e s t s i s26 .35 . B oth s tudies used the s am e sample of fi rms .


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T a b l e 2Pr ob i t ana lys i s o f ac c ou nt ing s tr a te g ie s.

Independent variablesand s tatis t icsDe pe nde nt var iab le5 s trategy case 7 s trategy case 9 s trategy case

C o n s t a n tM a n a g e m e n t c o m p e n s a t i o n ( + )aConc e ntr a t ion r a t io ( - )Sys te mat ic r i s k-be ta ( - )S i z e - l o g ' o f net sales ( - )Capital intens ity ( - )T ota l de bt to to ta l a s s e t s ( + )Estimated R 2Pr obi t ana lys i s X2 ( d . f . = 6 )~o correctly classifiedSample s i z e

3 . 1 0 3 5 6 b 3 . 0 3 9 8 1 3 . 0 3 2 8 3( 7 . 5 1 5 ) ( 7 . 5 9 8 ) ( 7 . 5 9 2 )0 . 3 1 2 5 9 0 . 2 6 8 1 2 0 . 2 6 0 5 5

( 2 . 4 0 9 ) ( 2 . 1 1 2 ) ( 2 . 0 5 5 )- 0 . 6 3 4 3 7 - 0 . 6 1 5 2 3 - 0 . 6 1 6 7 8

( - 2 . 2 1 4 ) ( - 2 . 1 9 3 ) ( - 2 . 2 0 0 )- 0 . 1 3 6 5 6 - 0 . 0 9 0 3 2 - 0 . 0 8 1 68

( - 0 . 7 6 5 ) ( - 0 . 5 1 8 ) ( - 0 . 4 6 9 )- 0 . 3 2 0 9 5 - 0 . 3 2 4 0 6 - 0 . 3 2 3 5 1

( - 2 . 6 3 8 ) ( - 2 . 7 2 0 ) ( - 2 . 7 1 7 )- 0 . 1 2 6 5 1 - 0 . 1 2 2 1 8 - 0 . 1 2 0 9 1

( - 0 . 9 5 9 ) ( - 0 . 9 4 5 ) ( - 0 . 9 3 5 )0 . 3 5 7 4 7 0 . 4 0 9 3 5 0 . 4 0 9 3 0

( 1 . 7 1 8 ) ( 2 . 0 0 5 ) ( 2 . 0 0 5 )0 . 0 9 0 3 0 0 . 0 9 0 6 6 0 . 0 8 9 8 3

2 6 . 3 6 7 5 2 6 . 5 8 1 3 2 6 . 3 4 9 04 0 . 0 0 ~ 3 3 . 0 0 ~ o 3 3 . 0 0

3 0 0 3 0 0 3 0 0aExpected s ign o f coeff ic ient .bCoefficient(asymptotic t-s tatis t ic ) .

t h e 2 5 ~ l e v e l. T h e e s t i m a t e d R z f o r t h e f i v e , s e v e n a n d n i n e s t r a t e g y c a s e sa r e 0 . 0 9 0 3 , 0 . 0 9 0 7 , a n d 0 . 0 8 9 8 , r e s p e c t i v e l y .

T h e ' tr u e' r a n k i n g o f t h e c o m b i n a t i o n s o f a c c o u n t i n g p o l i c i e s , a n d h e n c et h e ' t r u e ' s t r a t e g i e s m a y d i f f e r f r o m t h e p r o p o s e d s t r a t e g i e s f o r t w o r e a s o n s .The f i rs t i s that the a d h o e a s s u m p t i o n s w h i c h w e r e m a d e a b o u t t h em a g n i t u d e o f t h e e f fe c t o f th e a c c o u n t i n g p o l i c i e s o n n e t i n c o m e a c r o s s a llf ir m s m a y h a v e b e e n i n c o r r e c t . T h e r e s u l t o f t h i s t y p e o f e r r o r w o u l d b e t h a tm a n y o f t h e e s t im a t e d c a r d i n a l i n t e r v a l s w o u l d n o t b e s t a t i st i c a ll y s i g n if ic a n t .A s p r e v i o u s l y d i s c u s s e d , w e d o n o t f e e l w e h a v e a s e r io u s p r o b l e m o f t h isn a t u r e. T h e s e c o n d r e a s o n t h a t a n y o f th e s t r a t e g i e s t e s te d m a y d i f fe r f r o mt h e 't r u e' s t r a t e g i e s is b e c a u s e o f i n d i v i d u a l f i r m e ff e c ts o f t h e a c c o u n t i n gp o l i c i e s . F o r a s p e c i f i c f i r m t h e i n v e n t o r y e f f e c t c o u l d b e l a r g e r t h a n , l e s st h a n , o r e q u a l t o t h e d e p r e c i a t i o n e f f e c t . T h e s a m e h o l d s f o r t h e o t h e rp o l ic i e s. T o e x a m i n e t h e e f f e c t o f t h i s e r r o r, t h e n u m b e r o f f ir m s w h i c h w e r ec l a ss if ie d w i t h i n o n e s t r a t e g y w a s c a l c u l a t e d . T h e p e r c e n t a g e o f c o r r e c t l yc l a ss if ie d f ir m s fo r th e f iv e , s e v e n , a n d n i n e s t r a t eg y c a s e s w a s 8 8 . 3 3 ~ ,6 8 . 67 ~ , a n d 5 6 . 6 7 ~ , r e s p e c t i v e l y .


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1 4 2 M .E . Zmijewski and R.L. Hagerman, Income strategy and accounting choiceT a b l e 3

S i g n i fi c a n c e o f b o u n d e d e s t im a t e d c a r d in a l i n te r v a ls f r o m p r o b i t a n a l y s i s .B o u n d e d i n t e r v a l F i v e s t r a t e g y c a s e S e v e n s t r a t e g y c a s e N i n e s t r a t e g y c a s eF i r s t 0 . 0 0 0 0 0 - 1 . 0 2 3 3 5 a 0 . 0 0 0 0 0 - 0 . 3 1 6 2 6 0 . 0 0 0 0 0 - 0 . 3 1 6 1 1(7 . 3 9 6 ) (3 . 1 0 3 ) (3 A 0 3 )S e c o n d 1 . 0 2 3 3 5 - 2 . 0 6 3 6 8 0 . 3 1 6 2 6 - 1 . 0 2 6 9 7 0 . 3 1 6 1 1 - 0 . 3 4 2 7 8(6 . 1 1 2 ) (4 . 3 5 4 ) (0 . 1 7 3 )T h i r d 2 . 0 6 3 6 8 - 3 . 3 2 8 8 7 1 . 0 2 69 7 - 1 .9 0 3 4 4 0 . 3 4 2 7 8 - 1 . 0 2 4 9 8(5 . 3 7 6 ) (5 . 2 1 9 ) (4 . 1 8 0 )F o u r t h N . A . b 1 . 9 0 3 4 4 - 2 . 2 8 2 4 8 1 . 0 2 4 9 8 - 1 . 9 0 1 3 5(2 . 1 1 4 ) (5 . 2 2 5 )F i f t h N . A . 2 . 2 8 2 4 8 - 3 . 3 2 5 1 1 1 . 9 0 1 3 5 - 2 . 1 2 3 5 2(4 . 1 6 7 ) (1 . 2 6 1 )S i x t h N . A . N . A . 2 . 1 2 3 5 2 - 2 . 2 8 0 0 9

(0 . 8 5 5 )S e v e n t h N . A . N . A . 2 . 2 8 0 0 9 - 3 . 3 2 2 8 1(4 . 1 8 6 )

~ R a n g e o f e s t i m a t e d c a r d i n a l i n t e r v a l( t - s ta t l s t i c ) .b N . A . - - N o t a p p l i c a b l e.

A h o l d - o u t s a m p l e w a s a l so u s e d t o te st t h is m o d e l . T h e m o d e l w a se s t i m a t e d u s i n g 1 5 0 o b s e r v a t i o n s a n d th e n w a s u s e d t o p r e d i c t t h ea c c o u n t i n g s t ra t e g ie s o f t h e r e m a i n i n g 1 5 0 h o l d - o u t s a m p l e fi rm s . T h i s w a sr e p e a t e d b y u s i n g th e fi rs t h o l d - o u t s a m p l e t o e s ti m a t e t h e m o d e l a n d t h e np r e d i c t i n g t h e s t r a te g i e s fo r t h e o t h e r 1 5 0 f ir m s . T h e p e r c e n t a g e o f c o r r e c tp r e d i c t i o n s w a s 3 9 ? /o , 3 0 ?/o a n d 2 8 . 6 ~ o, f o r t h e f iv e , s e v e n , a n d n i n e s t r a t e g i e s ,r e s p e c t i v e l y . T h i s i s s i g n i f i c a n t l y d i f fe r e n t a t th e 5 ~ o l e v e l f r o m t h e n a i v ec l a s s i fi c a t io n m o d e l o f e q u a l p r o b a b i l it y f o r e a c h s t r a t e g y f o r a ll t h r e es t r a t e g i e s . T h u s , o u r m o d e l a l s o a p p e a r s t o h a v e s i g n i f i c a n t p r e d i c t i v e a b i l i t y .

W h a t i s o f m o s t i n t e re s t in th e f o r m u l a t i o n o f a p o s i t i v e t h e o r y o fa c c o u n t i n g i s t h e s ta t i st ic a l s i g n i fi c a n c e o f t h e o v e r a l l m o d e l a n d o f t h ei n d i v i d u a l i n d e p e n d e n t v a r i a b le s w h i c h w e re h y p o t h e s i z e d t o b e i m p o r t a n tf a c t o r s i n th e f ir m ' s c h o i c e o f a c c o u n t i n g p o l i ci e s . T h e r e f o r e , o u r m a i nc o n c e r n i s w i t h t h e s i g n if i ca n c e o f th e i n d i v i d u a l i n d e p e n d e n t v a r i a b l e s . 13T h e l o g o f n e t s a le s is n e g a t i v e l y r e la t e d t o t h e c h o i c e o f a c c o u n t i n gs t r a t e g i e s a t t h e 1 ~ l e v e l o f s i g n i f i c a n c e i n a ll th r e e c a s e s . 1 4 T h i s s u p p o r t s13To u s e t h e a s y m p t o t i c t - te s t , t h e r e s i d u a l s o f t h e p r o b i t a n a l y s i s a r e a s s u m e d t o b e n o r m a l l y

d i s t r i b u t e d . W e t e s t e d t h e r e s id u a l s o f t h e f iv e , s e v e n , a n d n i n e s t r a t e g y c a s e s u s i n g t h eK o l m o g o r o v - S m i r n o v g o o d n e s s o f f it t e st . T h e n u l l h y p o t h e s i s , t h a t t h e sa m p l e i s n o r m a l l yd i s t r i b u t e d c o u l d n o t b e r e j e c t e d a t a n y r e a s o n a b l e l e v e l o f s ig n if ic a _nc e [ s e e H o l l a n de r a n dW o l f e ( 1 9 7 3 , p p . 2 1 9 -2 2 8 ) - I .1 4 N e t s a l e s w a s a l s o t e s t e d i n p l a c e o f t h e l o g o f n e t s al e s v a r ia b l e . T h i s s u b s t i t u t i o n r e s u l t e di n a l o w e r a s y m p t o t i c t - v a l u e f o r t h i s v a r i a b l e a n d a s l i g h t l y l o w e r c h i - s q u a r e v a l u e f o r t h eo v e r a l l s i g n i f i c a n c e o f t h e m o d e l .


15/21

M.E. Zm!jewski and R.L. Hagerman, Income strategy and accounting choice 143t h e a r g u m e n t t h a t l a r g e r f ir m s h a v e i n c e n t i v e s to r e d u c e a c c o u n t i n g p r o f i t s .T h i s is i d e n t ic a l t o t h e r e su l t o f b o t h t h e W - Z a n d H - Z a n a ly s e s . T h u s ,t h e r e i s c o n s i d e r a b l e e v i d e n c e t h a t l a r g e f i r m s f a c e p o l i t i c a l c o s t s w h i c h t h e ya t t e m p t t o m i n i m i z e b y r e d u c i n g n e t i n c o m e .

C o n c e n t r a t i o n r a t i o , w h i c h i s o u r p r o x y f o r th e a b i l i t y o f a fi r m t o e a r nm o n o p o l y r e n t s, i s s i g n i fi c a n t a t t h e 5 ~ l e v e l i n a l l t h r e e c a se s . T h e s i g n o ft he m a x i m u m l i k e li h o o d e st im a t e ( M L E ) i n d ic a te s t h a t f i rm s i n m o r ec o n c e n t r a t e d i n d u s t r i e s t e n d t o a d o p t a c c o u n t i n g s t r at e g i e s t h a t r e d u c e n e ti n c om e . T h i s is c o n s i s t en t w i t h o u r r e a s o n i n g t h a t s u c h f i r m s w il l a t t e m p t t or e d u c e r e p o r t e d p r o f i t s i n o r d e r t o a v o i d e n t r y a n d a n t i - t r u s t a c t i o n . T h i sr e s u lt i s o f p a r t i c u l a r ' i n t e r e s t t o s t u d e n t s o f i n d u s t r i a l o r g a n i z a t i o n s i n c e i ti n d i c a t e s a b i a s a g a i n s t f i n d i n g a p o s i t i v e r e l a t i o n s h i p b e t w e e n p r o f i t a b i l i t ya n d c o n c e n t ra t i o n . T h i s i s i n c o n s i s t e n t w i t h t h e r e s u l ts "of H a g e r m a n a n dS e n b e t ( 1 9 76 ) w h i ch :, i n d i c a t e t h a t c o n c e n t r a t i o n r a t i o s a n d t h e c h o i c e o fa c c o u n t i n g p r in c i p l es a r e i n d e p e n d e n t , a l t h o u g h t h e y d i d n o t c o n t r o l f o r s iz eo r a n y o f th e o t h e r i n d e p e n d e n t v a r i a b l e s .

T h e e x is t en c e of a m a n a g e m e n t p r o f i t - s h a r i n g p l a n i s s i g n i fi c a n t a t t h e 5 ~ol e ve l i n a ll t h r e e c a s es . T h e s i g n o f t h e M L E i n d i c a t e s t h a t m a n a g e r s a r em o r e l i k e l y t o c h o o s e a c c o u n t i n g s t r a t e g i e s t h a t i n c r e a s e n e t i n c o m e i f s u c hp l a n s a r e a v a i l a b l e t o t h e m . T h i s r e s u l t i s n o t c o n s i s t e n t w i t h t h e re s u l t s o fW - Z . T h u s i t ap p e a rs t h a t t h e e x i st e n ce o f m a n a g e m e n t i n ce n ti v e p l a n s d o e si n fl u e n ce t h e c h o ic e o f a c c o u n t i n g p r i n c i p l e s w h e n a r a n d o m s a m p l e o f f ir m si s e x a m i n e d .

T o t a l d e b t t o t o t a l a s s e ts i s s i g n i f i c a n t a t t h e 1 0 ~ l e v e l i n t h e f iv e s t r a t e g yc a se a n d i s s ig n i f i ca n t ' a t t h e 5 ~ l e v e l in th e se v e n a n d n in e s t r a t e g y c a se s .T h e s i g n o f t h e c o e f fi c ie n t o f t h i s f a c t o r i s p o s i t i v e w h i c h s u g g es t s t h a t f i r m sw h i c h u s e r e la t iv e l y m o r e d e b t f i n a n c i n g c h o o s e a c c o u n t i n g p o l ic i es w h i c ht e n d t o i n c r e a s e n e t i n c o m e . T h i s i s c o n s i s t e n t w i t h t h e h y p o t h e s i s t h a t f i r m sw i t h m o r e d e b t a r e m o r e c o n s t r a i n e d b y t h e i r d e b t c o v e n a n t s , a n d h e n c e ,a t t e m p t t o l o o s e n t h e se c o n s t r a i n t s b y c h o o s i n g a c c o u n t i n g p o l i ci e s w h i c hin c re a se n e t in c o me .1 5

T h e t w o r e m a i n i n g v a r ia b l e s , b e t a a n d c a p i t a l i n t en s i t y , a r e n o t s i g n i f i c a n ta l t h o u g h t h e y a r e o f t h e e x p e c t e d s i g n . I t m a y w e l l b e t h a t t h e e ff ec t o f r is ka n d c a p i t a l i n t e n s i t y o n p r o f i t s , a s r e f l e ct e d i n n e t i n c o m e m a y b e to o s m a l lt o i n d u c e m a n a g e r s t o u s e a c c o u n t i n g p r i n c i p l e s t o r e d u c e t h e r e p o r t e di n c o m e .

T h e s e re s u lt s s u p p o r t o u r h y p o t h e s i s t h a t f i rm s a c t a s th o u g h t h e y c h o o s ea c c o u n t i n g p o l i c i e s r e l a t iv e t o a n i n c o m e s t r a t e g y d e c i s i o n p r o c e ss . T h e

1 5 E q u i v a l e n t r e s u l t s w e r e o b t a i n e d w h e n t o t a l d e b t t o e q u i t y w a s u s e d f o r l e v e r a g e i n s t e a d o ft o t a l d e b t t o t o t a l a s s e t s . S u b s t i t u t i n g e i t h e r l o n g - t e r m d e b t t o e q u i t y o r l o n g - t e r m d e b t t o t o t a la s s et s f o r t h e l e v e r a g e f a c t o r w a s n o t s i g n i f ic a n t .


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144 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choicec o m b i n a t i o n o f a c c o u n t i n g p o l ic y d e c is io n s m a d e b y a f ir m a p p e a r t o b easso c i a t ed wi th a f i rm in co me s t r a t eg y . 16

4.3. G eneral applicability o f the modelT h e p o s i ti v e t h e o r y o f a c c o u n t i n g d e v e lo p e d b y W - Z p r e d ic t s t h a t f i r m s

wi ll a t t e m p t t o r ep o r t l o wer i n co m e v i a th e ch o ice o f acco u n t in g p r in c ip l es i ft h ey a re r eg u la t ed o r su b jec t t o p o l i t i ca l p res su re . W -Z s t a t e : ' I n smal l ( i.e .,l o w p o l i t i ca l co s t ) u n reg u la t ed f i rms we wo u ld ex p ec t t h a t man ag er s d o h av ein cen t iv es t o se lec t acco u n t in g s t an d ar d s wh ich r ep o r t h ig h er ea rn in g s , i f t h eex p ec ted g a in in i n cen t iv e co mp en sa t io n i s g rea t e r t h an th e fo reg o n e t axc o n s e q u e n c e s ' . 1 7 T h i s i s i n t e r p r e t e d t o m e a n t h a t t h e m a n a g e m e n tc o m p e n s a t i o n v a r i a b l e w o u l d b e m o r e i m p o r t a n t f o r f i r m s f a c i n g l o wpol i t ical cos ts than those facing h igh po l i t ical cos ts . Likewise, o ther var iab lessh o u ld b e mo re imp o r t an t fo r t h e h ig h p o l i t i ca l co s t f i rms th an fo r l o wp o l i t i ca l co s t f i rms . To t es t t h i s h y p o th es i s , we p ar t i t i o n ed o u r samp le in tolo w p o l i t ica l co s t f i rms an d h ig h p o l i ti ca l co s t f irms to see i f t h e sam e mo d e lf i t s b o th su b - samp les .

Th e f i rms in t h e H-Z samp le were p ar t i t i o n ed in to h ig h an d lo w p o l i t i ca lco s t su b samp les b y r an k in g th e f i rms o n a p o l i t i ca l co s t v a r i ab l e , d iv id in g th esam p le a t t h e m ed ian an d c l as s i fy in g f i rms ab o v e (be low) th e med ian ash av in g h ig h ( lo w) p o l i t i ca l co s t s . S in ce b o th s i ze an d co n cen t r a t io n r a t i o s a rep ro x y v ar i ab l es fo r p o l i t i ca l co s t s t h e d iv i s io n was d o n e twice , o n ce b y u s in gs ize t o p a r t i t i o n th e samp le an d th en b y p ar t it i o n in g th e samp le b ased o nco n cen t r a t io n r a t i o s . Th u s , fo u r p ro b i t an a ly ses were co n d u c ted .Th e su b samp le mean s an d v ar i an ces fo r t h e i n co me s t r a t eg i es an d th ein d ep en d en t v a r i ab l es a re r ep o r t ed fo r each su b samp le in t ab l e 4 . Th e d a t ash o w th a t t h e l a rg e s ize f i rms an d th e f i rms in h ig h ly co n ce n t r a t ed in d u s t r i esfo l lo w, o n av erag e , mo re in co me d ef l a t i n g s t r a t eg i es t h an smal l e r f i rms o r f i rmsin less concent rated indust r ies . These d i f ferences are s ta t i s t ical ly s ign i f ican t a tthe 5 ~ level. Th is i s expected s ince the h igh po l i tical cos t g rou ps have m orein cen t iv es t o r ed u ce r ep o r t ed n e t i n co me. Th ese d a t a a l so sh o w th a t l a rg ef i rms t en d to b e in mo re h ig h ly co n cen t r a t ed in d u s t r i es t h an smal l e r f i rms .This s ta t i s t ical ly s ign i f ican t d i f ference suggests an associat ion between s izea n d c o n c e n t r a t i o n r a t i o s .

Th e r esu l t s o f th e fo u r p ro b i t an a ly ses a re p resen ted in t ab l e 5 . I t i s q u i t eap p are n t t h a t t h e mo d e l is s ig n i f ican t fo r b o th o f t h e h ig h p o l i ti ca l co s tsu b sam p les an d n o t s ig n if i cant fo r e i t h e r o f t h e l o w p o l i ti ca l co s t su b sam p lesa t t h e 5 ~ l eve l . Th u s , t h e ev id en ce in d ica t es t h a t t h e mo d e l i s n o t g en era l lyappl icab le to a l l f i rms.

1 6 R e g r e s s i o n a n a l y s i s w a s a l s o u s e d a n d t h e r e s u l t s w e r e e q u i v a l e n t t o t h o s e r e p o r t e d i n t h et e x t .1 7 W a t t s a n d Z i m m e r m a n ( 1 97 8 , p . 1 1 8 ).


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18/21

14 6 M . E . Zmijewski and R.L. Hagerman, Income strategy and accounting choiceT a b l e 5

P r o b i t a n a l y s i s o f h i g h a n d l o w p o l i t i c a l c o s t s u b s a m p l e s ; s e v e n s t r a t e g y c a s e .C r i t e r i on var i ab l e sSize (net sales ) C o n c e n t r a t i o n r a t ioI n d e p e n d e n t v a r ia b l es

a n d s t a t is t i c s L a r g e S m a l l H i g h L o wC o n s t a n tM a n a g e m e n t c o m p e n s a t i o n ( + )aC o n c e n t r a t i o n r a t i o ( - )S y s t e m a t i c r i s k - b e t a ( - )S i z e - l o g o f n e t s a l e s ( - )C a p i t a l i n t e n s i t y ( - )T o t a l d e b t t o t o t a l a s s e t s ( + )E s t i m a t e d R EP r o b i t a n a l y s i s Z z (d.f. = 6)~o c o r r e c t l y p r e d i c t edS a m p l e s i z e

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aE xp e c t e d s i gn o f c oe f f ic i e nt .bC oe f f i c i e nt( as ym pt ot i c t - s t a t i s t i c ) .

F o r t h e h i g h p o l i t ic a l c o s t s u b s a m p l e p a r t i t i o n e d o n s iz e , a l l i n d e p e n d e n tv a r i a b l e s e x c e p t c o n c e n t r a t i o n r a t i o a n d d e b t t O t o t a l a s s e ts a r e s i g n if ic a n t a tt h e 1 5 ~ l e v e l o r le s s. C o n c e n t r a t i o n r a t i o m a y n o t b e s ig n i fi c a n t b e c a u s e t h ea d d i t i o n a l p o l i t i c a l c o s t s d u e t o e a r n i n g p o t e n t i a l m o n o p o l y p r o f i t s m a y b es m a l l i f t h e c o m p a n y i s a lr e a d y v e r y v i s i b l e t o p o l i ti c a l a c t i v is t s b e c a u s e o f it s si z e .T h i s e v i d e n c e i n d i c a t e s t h a t , f o r l a r g e f ir m s , t h e c o n c e n t r a t i o n r a t io p r o x y f o rp o l i t i c a l c o s t s p r o v i d e s n o i n f o r m a t i o n b e y o n d t h a t p r o v i d e d b y t h e s i z ev a r i a b l e . T h i s c o u l d e x p l a i n t h e r e s u l t s o f W - Z . T h e y d i d n o t fi n d as i g n i f ic a n t a m o u n t o f d i s c r i m i n a t o r y p o w e r f o r t h e m a r k e t sh a r e v a r ia b l e b u tt h e e v i d e n c e a b o v e i n d i c a t e s t h a t t h e s i z e o f t h e u n r e g u l a t e d f ir m s o f t h e W -Z s t u d y w a s v e r y l a r g e .

F o r t h e l o w p o l i t i c a l c o s t s u b s a m p l e p a r t i o n e d o n s i z e , o n l y t h ec o n c e n t r a t i o n r a t i o a n d t h e d e b t t o a s s e t r a t i o w e r e s i g n i f i c a n t a n d t h eo v e r a l l m o d e l i s n o t s ig n i fi c a n t. T h i s s u g g e s t s t h a t s m a l l e r f i rm s o n l yc o n s i d e r p o t e n t i a l c o m p e t i t i o n , a n t i - t r u s t a c t i o n a n d d e b t c o v e n a n t s w h e nt h e y d e c i d e o n t h e s et o f a c c o u n t i n g p r i n c i p l e s t o f o l l o w . T h i s e v i d e n c e a l s o


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M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice 147i n d i c a t e s t h a t c o n c e n t r a t i o n r a t i o p r o v i d e s i n f o r m a t i o n b e y o n d t h a t p r o v i d e db y f i rm s ize wh en s i ze i s b e lo w th e th resh o ld p o in t fo r p o l i t ica l co s t s . Th i sresu l t i s ex p ec ted s in ce co n cen t r a t io n r a t i o may b e a p ro x y v ar i ab l e fo rin d u s t ry p o l i t i ca l co s t s an d h en ce , a l l f i rms wi th in a co n cen t r a t ed in d u s t rym ay b e sc ru t in i zed b y r eg u la to r s , p o l i ti ca l ac t iv i s ts , e t c .F o r t h e h i g h p o l i t i c a l c o s t s s u b s a m p l e p a r t i t i o n e d o n c o n c e n t r a t i o n r a t i o ,two v ar i ab l es (man ag emen t p ro f i t sh a r in g an d s i ze ) a r e s ig n i f i can t a t t h e15 % level o r less and the overa l l m odel i s s ign i f ican t . Th ese resu l t s a re ve rys imi l a r t o t h e h ig h p o l i t i ca l co s t su b samp le p ar t i t i o n ed o n s i ze . Th i s may b ed u e to t h e s imi l a r p a r t i t i o n in g o f t h e s ize v a r i ab l e fo r b o th o f t h e h ig hp o l i t i ca l co s t su b samp les . Th e r easo n s i ze i s s ig n i f i can t may b e d u e to t h efac t t h a t i t i s t h e l a rg er f i rms in co n cen t r a t ed in d u s t r i es t h a t f ace th e majo rpol i t ical cos ts . This suggests po l i t ical cos ts are a funct ion of s ize , g iven thec o n c e n t r a t i o n o f t h e i n d u st r y .

F o r t h e l o w p o l i t i c a l c o s t s u b s a m p l e p a r t i t i o n e d o n c o n c e n t r a t i o n r a t i o ,on ly cap i ta l in tens i ty i s s ign i f ican t . Again , the overal l model fo r th issu b samp le i s n o t s ig n i f i can t . Wh at i s u n ex p ec ted in t h e two lo w p o l i t i ca l co s tsu b sam p les i s l ack o f s ign i fi cance o f t h e m an ag em en t p ro f i t - sh ar in g v ar i ab le .T h e s e r e s u l ts a r e in c o n s is t en t w i t h t h e c o n t e n t i o n o f W - Z w h o a r g u e t h a tth i s v a r i ab l e sh o u ld b e mo re imp o r t an t fo r f i rms th a t f ace lo wer p o l i t i ca lco s t s . On e p o ss ib l e ex p lan a t io n i s t h a t smal l e r f i rms t en d to b e o wn erco n t ro l l ed , mak in g p ro f i t - sh ar in g p l an s l e s s imp o r t an t t o t h ese man ag er s . 1 8

Th ese r esu l t s co n f i rm W-Z ' s a rg u men t t h a t t h e re i s a t h resh o ld e f f ec t . Th a ti s , smal l e r f i rms an d f i rms in l e s s co n cen t r a t ed in d u s t r i es d o n o t ch o o seacco u n t in g p r in c ip les as if t h ey co n s id ered p o l i t i ca l co s ts . Th e mo d e l ,h o wev er , w o rk s v ery wel l fo r la rg e f i rms a n d f i rms in h ig h ly co n cen t r a t edin d u s t r i es . Th u s , t h e mo d e l i s n o t g en era l ly ap p l i cab le t o a l l f i rms an d fu r th e rresearch i s r eq u i r ed to d e t e rmin e wh a t i n f lu en ces th e ch o ice o f acco u n t in gp r in c ip l es b y m an ag er s o f smal l e r f i rms .

5. Summary and conclusionsT h i s p a p e r i s a n a t t e m p t t o a n s w e r t w o q u e s t i o n s . F i r s t , a r e a c c o u n t i n g

p o l i cy d ec i s io n s mad e jo in t ly ? By d ev e lo p in g a v a r i e ty o f a l t e rn a t iv eacco u n t in g s t r a t eg i es we t es t ed th em ag a in s t t h e p ro p o sed p o s i t i v e t h eo ry .Th e r esu l ts i n d i ca t ed th a t s ize, th e ex i s t en ce o f a p ro f i t - sh ar in g p l an , d eg reeo f co n cen t r a t io n an d d eb t t o t o t a l a s se t s r a t i o a l l i n f lu en ce th e acco u n t in gs t r a t eg y o f a firm. Th ese r esu l ts a r e mu ch s t ro n g er t h a n wh en in d iv id u a lp o l i cy ch o ices a re t e s ted , i . e . , H ag e rm an an d Zm i jews k i (19 79 ). Th u s i tap p ear s t h a t f i rms ch o o se an o v era l l i n co me s t r a t eg y .

18This analysis was also conducted on the five and nine strategy cases. The results areequivalent to those reported for the seven strategy case.


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14 8 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choiceW e a l s o c o n d u c t e d t e s t s t o a s c e r t a i n i f t h e m o d e l w a s g e n e r a l l y a p p l i c a b l e

t o a l l f i r m s ( i . e . , s m a l l f i r m s o r f i r m s i n l e s s c o n c e n t r a t e d i n d u s t r i e s ) a n df o u n d t h a t i t w a s o n l y s i g n i f i c a n t f o r l a r g e f i r m s a n d t h o s e i n h i g h l yc o n c e n t r a t e d i n d u s t r i e s .

T h u s , t h e e v i d e n c e i n t h i s s t u d y s u g g e s t s t h a t i n d i v i d u a l a c c o u n t i n g p o l i c yc h o i c e d e c i s i o n s a r e p a r t o f a n o v e r a l l f ir m s t r a t e g y . A l t h o u g h f u r t h err e f i n e m e n t s m u s t s t i l l b e m a d e ( e . g . , t e s t i n g f o r t h e a c t u a l d o l l a r e f f e c t s o n n e ti n c o m e a n d c o n s i d e r i n g a l l a c c o u n t i n g p o l i c y d e c i s i o n s ) , th i s e v i d e n c e isi m p o r t a n t t o r e s e a r c h e r s e x a m i n i n g i n c o m e s m o o t h i n g , ch a n g e s ina c c o u n t i n g p r i n c i p l e s , a n d t h e e f f e ct s o f a c c o u n t i n g s t an d a r d s e tt in g .I n d i v i d u a l a c c o u n t i n g p o l i c i e s s h o u l d b e e x a m i n e d a s p a r t o f a n o v e r a l l f ir ms t r a te g y . A s e c o n d p o i n t t o b e c o n s i d e r e d i s t h a t t h e m o d e l , i n i ts p r e s e n tf o r m , i s n o t u n i v e r s a l l y a p p l i c a b l e . I t a p p e a r s a s t h o u g h o n l y t h e l a r g e r f ir m sa n d t h o s e i n m o r e c o n c e n t r a t e d i n d u s t r i e s f i t t h e m o d e l . A d d i t i o n a l f a c t o r sm u s t b e a d d e d t o t h e m o d e l s o t h a t i t c a n b e a p p l i e d t o a l l fir m s. F i n a l ly , iti s a p p a r e n t t h a t n e i t h e r s i z e n o r c o n c e n t r a t i o n r a t i o in d i v i d u a l ly r e p r e s e n tp e r f e c t p r o x y v a r i a b l e s f o r p o l i t i c a l c o s t s . T h u s , f u r t h e r r e s e a r c h i n t o t h em e a s u r e m e n t a n d q u a n t i f i c a t io n o f p o l i ti c a l c o s t s i s n e e d e d .

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Research 6 , 196-203.C ush ing , B . E . a nd E . B . D e a k in , 1974 , F i r m s m a k ing a c c oun t ing c ha nge s : A c om m e n t , TheAccount ing Review 49, 104-112.Davidson, S idney and Roman L. Wei l , 1975a , Inf la t ion account ing: What wi l l genera l pr ice leve ladjus ted in com e s ta tem ents show ? , F inanc ia l Ana lys ts Jou rna l 31 , 27-31, 70-81.Dav idson , S idney and Ro m an L. Weil , 1975b, Inf la t ion accou nt ing : Publ ic ut il it ie s , F inanc ia lAna lys ts Journa l 31 , 30-34, 62 .D a v idson , S idne y , C lyde P . S t i c kne y a nd R om a n L . W e il , 1976 , I n f l a ti on a c c oun t ing ( M c G r a w -Hil l , New York) .Dha l iw a l , D.S ., 198 0, Th e e f fec t of the f irm 's capi ta l s t ruc tu re o n th e choice of account ingmeth ods , Th e Acc oun t ing Review 55, 78 85 .Eggle ton , J .R . , S .H~ Pe nm an and J .R . Twom bly , 1976, Acc oun t ing change s and s tock pr ices : Anexam ina t ion of se lec ted uncontro l led va r iables , Jou rna l of Ac coun t ing Research 14 , 89-137.


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An Income Strategy Approach to the Positive Theory

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