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BALL
AND
GEORGE
FOSTERt
1. Introduction
Our assigned task is a methodological review of current empirical
research in the corporate financial reporting area. In this introductory
section, we clarify our interpretation of the task and describe how the
review is organized.
A methodological review entails using the literature's body of research
methods as data: methodology is inquiry into method. 1 Our aim therefore
University of New South Wales; +Stanford University. This paper benefited from
comments of participants in workshops at Baruch College CUNY, Cornell University,
Monash University, Stanford University, University of Chicago, University of New South
Wales, University of Pennsylvania, University of Rochester, and Washington University. A
special thanks is due to detailed criticisms from G. Biddle, S. Datar, L. DeAngelo, P. Dodd,
N. Dopuch, J. Elliott, N. Gonedes, C. Horngren, M. Jensen, A. Kirby, R. Leftwich, J.
Magliolo, R. Morris, C. Purvis, K. Schipper, D. Shores, R. Watts, G. Whittred, M. Wolfson,
and J. Zimmerman. Foster's contribution was sponsored by the Stanford Program in
Accounting, contributors to which are: Arthur Andersen & Co.; Arthur Young & Company;
Coopers & Lybrand; Deloitte Haskins & Sells; Ernst & Whinney; Peat, Marwick, Mitchell
& Co.; and Price Waterhouse & Co.
I Buchler [1961, p. 125] distinguishes "method" and "methodology" in these terms: " ...
in the broadest sense 'methodological' questions are those dealing with methods as their
subject matter, questions pertaining to the origin, scope, nature and relative value of
methods." Webster's Third New International Dictionary defines method as "a procedure
or process for attaining an object ... a particular approach to problems of truth or
knowledge." Methodology is defined as "a body of methods, procedures. working concepts,
rules and postulates employed by a science, art or discipline ... a science on the study of
method." We take "research methods" to include the selection of dependent and indepen
dent variables, sample selection, choice of functional forms, experimental controls, statistical
inference, etc.
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Copyright , Institute of Professional Accounting 1983
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1982
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tolerate relatively little anomaly and will abandon the data relatively
quickly. The researcher with relatively strong external loyalty (i.e., to
external groups such as the accounting profession, managers or policy
makers) also will tolerate relatively little anomaly but will abandon the
theory relatively quickly. The researcher who has loyalty in both direc
tions and the ability to tolerate the consequently higher degree of
anomaly will persist longer with the attempt to fit data and theory
together.
In making choices of research method, the empirical researcher there
fore must recognize that "good" accounting research might not satisfy
either the disciplinary purist or the practicing accountant: it might seem
overly concerned with both explaining institutionalized data and finding
structure to the data. "Good" research methods in accounting will strike
a pragmatic balance between both extremes. In confronting theory with
data that lie in the institutional domain, the accounting researcher will
be fascinated by neither theory nor data alone and will be prepared to
sacrifice elements of both. We therefore believe that research in account
ing requires a different set of trade-offs than those made in the basic
disciplines and, at the other extreme, in accounting practice.
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This observation is not new. See Hakansson [1973] and Gonedes and Dopuch (1974).
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etc. These new data bases, however, raise issues of data coding not
previously addressed. For example, if one adopts the perspective that
these contracts are the starting point of an ongoing relationship between
the various parties (the opening rules of the game), then there is ambi
guity about how to code specific clauses in the contracts. Moreover, in
some cases, a researcher might have only partial information on these
contracts. For instance, many proxy statements do not provide full details
of management compensation agreements. The researcher has to decide
whether these types of problems can be solved satisfactorily: there can
be a distinct trade-off between the level of interest and innovation in a
research program and the availability of reliable and relevant data.
Other data of special interest to researchers associated with the
"stewardship" paradigm are the financial statements issued by corpora
tions prior to regulatory interventions such as the Securities Exchange
Act of 1934, as in Benston [1969] and Watts [1977]. Again, potentially
troublesome data issues arise when conducting research in this area. For
example: (i) the term "financial statement" needs to be defined precisely
since some companies issued financial information only in narrative form
while others included a balance sheet and income statement, and (ii)
even of the subset of companies still surviving, not all have records of
their early financial statements let alone details of to whom they were
sent. 14
Data quality issues also arise in the time-series and distress prediction
areas. For instance, Box and Jenkins [1970] discuss identification and
estimation issues for stationary time series. Given the high level of
acquisition and divestiture activity of some firms, an assumption of
stationarity for even a ten-year period might appear extreme. Yet, ten
years provides only ten annual earnings observations, and one cannot
expect such a small data base to tell a very refined story about the
behavior of the series over time. The researcher needs to make these
kinds of trade-offs.
5. AVAILABILITY OF ECONOMETRIC OR STATISTICAL TECHNIQUES
Developments in other disciplines are an important source of research
ideas in the corporate fmancial reporting literature. This subsection
discusses the role of such developments at the technique level. These
developments have affected the time-series and distress prediction liter
atures most.
The development of data analysis tools by econometricians and stat
isticians has been an important stimulus to many time-series studies in
accounting. The ready availability of Box-Jenkins univariate time-series
algorithms was a major factor in the explosion of manuscripts in this area
14 Cook and Campbell [1979, pp. 230-32] discuss some of these issues under the heading
of "Limitations of Much Archival Data."
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in the mid and late 1970s. In the late 1970s, algorithms for Box-Jenkins
multivariate time-series analysis became readily available. The account
ing literature now reflects papers using this technique to examine (or
reexamine) a variety of issues, including earnings forecasting and the
importance of industry and economy factors in the behavior of the
earnings of individual firms.
Technique developments by econometricians and statisticians also
appear important in the distress prediction literature. Early multivariate
studies in this area used linear discriminant analysis, as an Altman [1968]
and Deakin [1972]. One of the stated motivations given in several sub
sequent studies was the use of "recent advances" in discriminant analysis.
For instance, Altman, Haldeman, and Narayanan [1977, p. 29] examine
the use of quadratic discriminant analysis and the "explicit introduction
of prior probabilities of group membership." Subsequent studies also give
advances in technique as a major reason for undertaking the research, as
in Ohlson [1980, p. 109], which uses "maximum likelihood estimation of
the so-called conditionallogit model."
Improvements in econometric and statistical techniques are a legiti
mate source of new accounting research. However, there is always the
danger that the technique itself becomes the focus of attention. This
danger is especially apparent in literatures such as time-series analysis
and distress prediction, where the economic underpinning of the research
can be minimal. In some cases the research contribution is more to the
econometrics and! or statistics literatures than to the accounting litera
ture.
6. SUMMARY: CHOOSING A RESEARCH TOPIC
We have identified five motives for particular empirical research pro
jects in accounting. Presumably there are others. Several of the motives
discussed relate to the skills of a specific researcher or the value set of
the specific institution with which the researcher is associated. For
instance, a researcher with limited analytical skills might restrict topic
choices to areas where developed models are already available in the
literature, whereas a researcher with strong analytical skills might work
on model development as part of the research project. As a second
example, a researcher in an environment sympathetic to Box-Jenkins
time-series research might undertake a project that individuals at other
institutions would label as a "data searching exercise that will yield no
new economic insights."
It is unlikely that a single empirical project (1) will be of high interest
to an external party such as the accounting profession, (2) will be of high
interest to a research community, (3) will have models available explicitly
to guide both the research design and the drawing of inferences from the
research, (4) will have high-quality data available, and (5) will have
appropriate econometric or statistical tools available to analyze the data.
In general, trade-oft's among these factors are inevitable. One interesting
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In several topic areas, there are many competing "views of the world"
which have implications for the types of data that are "interesting," for
the dependent and independent variables to be investigated, for func
tional forms and other experimental matters. For example, consider the
issue of "why firms choose a specific set of accounting methods." At least
six different ways of viewing accounting method choice by managers can
be identified in the literature: (i) Accounting Model View. This view
posits that method choices are made using accounting model notions
such as matching costs and revenues and conservatism. The accounting
literature has included this perspective for many years, as in Gilman
[1939] and Hendriksen [1977]. (ii) Economic Reality/Truth View. This
view also has a long tradition in the literature. For instance, an oft-heard
criticism of the historical cost accounting model is that under inflationary
conditions it misstates "economic" or "true" earnings. As early as 1918,
Middleditch argued that disregarding "the changing dollar in accounts
does not permit the true condition of affairs to be set forth" [1918, p.
115]. More recent statements of this view are in discussions of accounting
for foreign exchange translation." (iii) Fair Presentation/ Comparability
15 See Kuhn [1970] for elaboration of this point and for some definitions of the term
"paradigm," for which "accepted theory" can be loosely substituted.
18 See Financial Accounting Standards Board [1981]. Hercules makes the following
comment in its 1981 Annual Report: "The company has adopted [SFAS No. 52] because
it more appropriately reflects the economic realities of managing a multinational company."
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NATURE OF RESEARCH
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DEVELOPING
METHODOLOGICAL AWARENESS
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are not unaware of this problem. The empirical work could be viewed as
a "data reduction" exercise in which the sole object is to predict reliably
an event like loan default; "reliable" is defined relative to an alternative
empirical-based model or the judgment of an individual. At a pragmatic
level, we have no quarrel with this approach. The error is when inferences
are drawn from such studies about the underlying attributes that distin
guish (say) financially distressed from nondistressed firms, in such a way
as to imply valid inferences of causality.
Cook and Campbell [1979, pp. 55-56] recommend that:
Estimating the internal validity of a relationship is a deductive process in which the
investigator has to systematically think through how each of the internal validity threats
may have influenced the data. Then, the investigator has to examine the data to test which
relevant threats can be ruled out. In all of this process, the researcher has to be his or her
own best critic, trenchantly examining all of the threats he or she can imagine. When all of
the threats can plausibly be eliminated, it is possible to make confident conclusions about
whether a relationship is probably causal. When all of them cannot, perhaps because the
appropriate data are not available or because the data indicate that a particular threat may
indeed have operated, then the investigator has to conclude that a demonstrated relation
ship between two variables mayor may not be causal.
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sales of $100 million to generate the same political costs (as a percentage
of sales) as a firm with $10 billion of sales. Casual empiricism suggests
that Superior Oil Company (1974 sales of $333 million) incurs consider
ably less costs from anti-trust, 'corporate responsibility,' affirmative
action, etc. than Exxon with sales of $42 billion." They cite three sources
of evidence of the linkage between their construct and its operationali
zation: Siegfried's [1975] evidence, an article in a financial weekly (pub
lished five years before the experimental date), and a bill that was
unsuccessfully introduced in the U.S. Congress one year after the exper
imental date and was not enacted by the Congress.
There are several reasons for construct validity issues being an impor
tant concern in the Watts and Zimmerman [1978] experiment. First, the
firm size operationalization ignores industry membership, which may be
a key determinant. The oil industry supplied a majority of the large firms
in their sample. An "excess profits tax" was applied to the industry; but
the tax rate was not an increasing function of size: Superior Oil Company
was taxed at the same rate as Exxon." Second, if there are fixed costs of
complying with government regulations, the relative cost of those regu
lations could decrease rather than increase with firm size." Third, our
interpretation of Siegfried's [1975] evidence is diametrically opposed to
that of Watts and Zimmerman. His major conclusion [1975, p. 572]
appears to be that an earlier study, in which size and profit variables did
predict antitrust action, has an obvious statistical bias. His conclusions
are based on regressions which "explain only about seven percent of the
linear variation" in antitrust action frequency, in which the coefficient on
total assets is negative (Watts and Zimmerman assume it to be positive)
and in which "none of the coefficients is very robust in this whole
analysis" [1975, p. 573]-hardly evidence for a positive relationship
between size and political costs. Fourth, it seems reasonable to distinguish
(at least in terms of magnitude of political costs) between the statements
of individual politicians and the majority decision as implied in enacted
legislation.
Given the complexity of modeling the political cost phenomenon,
caution in making inferences from a finding that an asset size variable is
significant is clearly warranted." Equally warranted is a less casual
aaIndeed, Watts and Zimmerman [1978, p. 127] recognize industry membership as a
determinant of political cost when they engage in ex post rationalizing why U.S. Steel did
not make a GPLA submission "a more likely explanation of U.S. Steel's failure to submit
is the fact that the steel industry was not as politically sensitive as the oil industry (for
example) at the time."
:w Despite the large amount of rhetoric in this area, there is little detailed evidence,
Chilton and Weidenbaum [1980, p. 1] conclude that "a great deal of government regulation
has disproportionately adverse effects on smaller businesses" but do not provide numerical
estimates to support their conclusion.
36 Watts and Zimmerman
[1978, p. 129] report that the coefficient on their firm size
variable "is positive ... and has the highest t-statistic of all the independent variables. In
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1954-64
1946-65
1948-72
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4. EXTERNAL VALIDITY
External validity "refers to the approximate validity with which we can
infer that the presumed causal relationship can be generalized to and
across alternate measures of the cause and effect and across different
types of persons, settings, and times" (Cook and Campbell [1979, p.
37]). External validity issues do not arise in projects whose sole object is
to describe a particular data base. Many of the studies presenting sum
mary statistics on accounting method choice or corporate disclosures of
firms fall in this category. Projects which deal with populations also do
not raise external validity problems; an example would be a study that
examined all the submissions on a particular FASB agenda item and was
concerned only with drawing inferences about those who submitted on
that agenda item. Typically, however, authors (or readers) do seek to
generalize the findings of a study beyond the sample of firms examined
or the time period covered. This subsection provides examples of research
design choices in several topic areas that have implications for the
generalizability of the results.
Sample selection is an obvious area where the generalizability of the
results can be compromised. For instance, Kiger [1974] computes volatil
ity measures of quarterly net income to provide evidence pertaining to
alternative interim income concepts. In the sample selection he excludes
firms that had "losses during any quarter" [1974, p. 3] in the time period.
The motivation for this exclusion criterion is not discussed but appears
to be that a transformation used on the earnings variable is not defined
for nonpositive earnings. Evidence is not given about the effect of this
exclusion criterion on the results presented about the "substantial vola
tility" of quarterly earnings. The external validity of the experiment thus
is unclear. One way that authors could address such an issue would be to
present profile statistics pertaining to a random sample of the population
vis-a-vis the specific sample examined.
A second example of problems in external validity arises in techniques
that tend to "overfit" relative to a particular sample. This issue has
received considerable attention in the literature on classificatory tech
niques such as discriminant analysis. Methods along the lines of Lach
enbruch [1967] have been developed, one purpose of which is to improve
the external validity of inferences drawn from a specific sample. Yet, we
still observe accounting studies in this area using classificatory designs
without the use of nonoverlapping holdout samples or techniques such as
that proposed by Lachenbruch. For instance, Watts and Zimmerman
[1978, table 4] report results from seven alternative combinations of
variables in multiple discriminant functions, but do not control for the
attendant problems of overfitting the data by using a holdout sample.
The third example is taken from time-series research. While allusions
to "structural change" are made in this literature, our understanding of
the economic factors that cause structural change and how they might
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1949-68
1908-74
1955-74
The above studies cover time periods that potentially differ in factors
such as (i) the rate of inflation, (ii) the frequency of acquisitions and
divestitures, and (iii) the degree of regulation. The generalizability of the
findings of a study covering anyone combination of (i), (ii), and (iii) is
very much an unresolved issue. Despite these unresolved issues, we
continue to observe authors citing (say) the results of a study based on
1949-68 data as the rationale for using a random-walk benchmark in a
study examining data from the 1970s, without any evidence of concern
for the validity of the extrapolation.
5.
SUMMARY: TRADE-OFFS
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collect the information needed for corporate report disclosure for their
internal management systems and hence little extra cost may be incurred"
(Firth [1979b,p. 273]); management ability and advice: "Large compa
nies .. are more likely to have the advice of well-qualified accounting
specialists" (Butters and Niland [1949,p. 90]); and political costs: "Large
firms are now more vulnerable than small ones to government implicit
and explicit regulation" (Gagnon [1971, p. 54]).
The reader, in this context, having seen the same variable used to
proxy for many (apparently) different and competing constructs, has
good reason to expect the authors to present cogent arguments or
evidence why an inference from (say) firm size to political cost is a
credible one within their experiment. In this sense, competing theories
always are relevant in empirical work, even if the researcher does not
wish to test against those theories per se.
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A. Corporate Disclosure
Empirical studies pertaining to corporate disclosure are classified in
table 1 into four main areas: (1) content of disclosure and variables
associated with differential content, (2) disclosure indexes and variables
46 The following journals were examined when developing the tables presented in
Appendix A: Abacus; Accounting and Business Research; Accounting and Finance;
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associated with different index scores, (3) timing of disclosure and vari
ables associated with differential timing, and (4) responses to interviews
or questionnaires about corporate disclosure. An overview of these areas
is presented in this subsection.
CONTENT OF DISCLOSURES AND DISCLOSURE INDEXES
One strand of this literature presents case studies on the content of the
disclosures of individual firms. These case studies typically are used to
support arguments about the inadequacies of existing disclosure practices
or to illustrate the proposition that managers use the financial reporting
system to present themselves in the most favorable light. An early
example is the literature discussing the disclosure implications of the
Royal Mail case litigated in the U.K. in the 19308.47Examples of single
company analyses in the 1970s and 1980s are the Briloff critiques pub
lished in Barron's/" The problems of generalizing from single instances
are many; for example, (i) the single instance may be idiosyncratic, and
(ii) it is impossible to distinguish which of several possible causes best
explains a single instance. An obvious approach to reduce these problems
is to examine the disclosure practices of many firms. One style is to cite
selectively individual instances that are consistent with a specific hypoth
esis (argument or value belief). For instance, this style is used by Ripley
[1927], Briloff [1972; 1976], and Chambers [1973].49The specific instances
cited by these authors are neither presented as the explicit source of the
hypotheses discussed nor as the data by which the hypotheses are
confirmed." These studies typically also do not leave an "audit trail" to
indicate how the cited instances were chosen; nor is information provided
about how representative they are of the population of all companies
reporting information to outside parties.
Another strand of this literature contains surveys of company disclo
sures in which details of sample selection are given and in which statistics
pertaining to the whole sample are presented. In many instances, these
surveys attempt to array the data with limited evaluative inferences. The
annual editions of Trends and Techniques (published since 1948) and
many of the current publications of accounting firms fall in this category.
Another use of survey evidence has been to document disclosure levels
under different "regulatory regimes," as in Benston [1969; 1973; 1976].
Note that with this style of analysis the reader who may disagree with
47 For example, The Accountant
(August 8, 1931 and March 5,1932) .
See Foster [1979, table 1) for citations to 11 Briloff articles published in the 1970s. A
more recent example is "Lost and Found" in Barron's (July 6, 1981).
49 For example, Ripley [1927, p. 208) argued that "shareholders are entitled to adequate
information" and noted the "existing impublicity of corporations." Briloff (1972, p. 306]
argued that "many of our publicly owned corporations fail their responsibility for full and
fair and prompt accountability."
1\0 For debate on this point, see the exchange between Anderson and Leftwich [197'(] and
Chambers [1974].
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Benston's inferences may still use the tables summarizing the disclosures
of firms.
A frequent use of evidence on the disclosures of firms is to make
inferences about disclosure adequacy. A heuristic framework of "more
disclosure is better" appears to guide many statements in this area. This
heuristic framework is most apparent in studies using disclosure indexes.
Cerf [1961], for instance, develops a system of points for the disclosure of
31 individual items and computed index scores for 527 U.S. companies.
One purpose of the study is to determine "the characteristics associated
with relatively superior disclosure to determine where educational and
other methods to improve disclosure should be concentrated" [1961, p.
19]. Superior disclosure is operationalized as a higher index score. A more
recent example is the Kahl and Belkaoui [1981] study on the disclosure
practices of 70 banks incorporated in 18 different countries. The authors
refer to the "superiority of U.S. banks" [1981, p. 193], because U.S. banks
have higher average disclosure index scores than the banks of the other
17 countries examined. Such an inference is the "more disclosure is
better" perspective taken to its extreme!"
The Cerf [1961], Kahl and Belkaoui [1981], and similar studies examine
disclosure of many items. Other studies focus on specific areas such as
social responsibility disclosures or replacement cost disclosures. For
instance, Kelly-Newton [1980] conducts a content analysis of the com
ments made by management in relation to the replacement cost disclo
sures mandated by the SEC under ASR No. 190; the conclusion is that
"the attitudes communicated by management reveal that reservations
centered around the reliability and relevance of the disclosures" [1980, p.
318].
VARIABLES ASSOCIATEDWITH DIFFERENTIAL CONTENT OF
DISCLOSURE
234].
200
OF CORPORATE DISCLOSURES
While the accounting literature has long debated the issue of what
should be the periodicity of reporting, research on the timing of report
dissemination to external parties is a relatively recent phenomenon. 53
One motivation for accounting researchers to become concerned with
timing issues was the rapid growth of capital market research in the late
1960s and 1970s. As a by-product of this research, descriptive statistics
pertaining to time lags between the fiscal year end and public dissemi
nation of earnings information are presented, for example by Ball and
Brown [1968, table 3].
Studies reporting variables correlated with differential timing of disclo
sures are primarily a post-1970 phenomenon. Researchers in this area
have not been able to access an articulated theory pertaining to corporate
decisions about the timing of information releases. They appear to have
relied on heuristic notions suggested in the popular press or the academic
52 Salamon and Dhaliwal [1980] give stewardship as one rationale for a correlation
existing between firm size and the voluntary disclosure/nondisclosure of segment data by
multiproduct firms. They report finding that "diversified firms which voluntarily disclosed
segmental sales and earnings data are significantly larger than the diversified finns which
did not voluntarily disclose such data" [1980, p. 561].
5."1 Concern with the information
dissemination process was evidenced by the stock
exchanges, the SEC, and the legal profession (insider trading litigation) long before it
became a topic of mainstream accounting research-see
Loss [1OOl}.An early detailed
questionnaire survey of "corporate news handling practices" is reported in Burson [1966];
this study, conducted by Burson Marsteller Associates, was said to be "probably the first
comprehensive portrait of corporate disclosure patterns" [1966, p. 39).
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OR QUESTIONNAIRES
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suggest that the managers of firms that adopted LIFO chose to hold
larger inventories than their control group counterparts" [1980, p. 273].62
Future empirical (and theoretical) work in this area faces the difficult
challenge of recognizing interactions among the accounting method
choice, taxation, and financing-investment-production
decisions of
firms."
ACCOUNTING METHOD CHOICE AND DECISION
MAKING
The major focus in these and many similar studies is documenting the
existence of an effect (if it exists) rather than probing explanations for
any effects that are observed. This focus reduces the ability to generalize
from the results of individual studies in this area. Detailed discussion of
methodological issues in this area is reported in the proceedings of the
1980 University of Chicago conference on Studies on Economic Conse
c. Time-Series Analysis
The literature on the time-series properties of financial statement
numbers is predominantly a post-1960 phenomenon. Table 3 classifies
empirical studies into three main categories: (1) time-series modeling of
annual and interim data, (2) aggregation issues in time-series analysis,
and (3) smoothing, earnings management, and time-series analysis. Re
search in each category is discussed below. 64
62 When using any model to guide empirical research, it is important to recognize that
observing results not consistent with the model can say as much about the ability of the
model to capture the economic context managers face as about the rationality of manage
ment. This observation is important when interpreting Biddle's [1980, p. 273] statement
that "many firms have voluntarily paid tens of millions of dollars in additional income taxes
by continuing to use FIFO rather than switching to LIFO."
63 See Cohen and Halperin [1980] and Gonedes [1980] for discussion.
64 Surveys of this literature include Abdel-khalik [1980], Lorek, Kee, and Vass [1981],
and Hopwood and McKeown [1981a].
210
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The main development in the empirical studies in this area is an
increasing recognition of the many ways management can affect the
reported earnings series, for example, via transactions with suppliers and
creditors, via decisions regarding discretionary expenditure items like
research and development and exploration budgets, via the accounting
methods adopted, and via the classification of expenditures as ordinary
or extraordinary. There has not been a similar development in analytical
models or research designs to handle this increasing recognition of the
very complex environment empirical researchers face in this area. Despite
the limited progress to date, interest in the design of more reliable
research designs is considerable, in part due to the development of the
"stewardship-contract monitoring" paradigm in which conflicts between
management and other parties are explicitly recognized.
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MODELING
One major research thrust in this area has been to seek empirically
validated characteristics that distinguish financially distressed from non
distressed firms. Both univariate (e.g., Beaver [1966]) and multivariate
(e.g., Altman [1968] and Ohlson [1980]) studies have been conducted. A
typical conclusion is: "it was possible to identify four basic factors as
being statistically significant ... these are (i) the size of the company; (ii)
a measure(s) of the financial structure; (iii) a measure(s) of performance;
(iv) a measure(s) of current liquidity" (Ohlson [1980, p. 110]).
Most studies in this area are exercises in descriptive statistics, in part
due to the absence of an articulated economic theory of financial distress.
Ohlson [1980, pp. 109, 111] is refreshingly frank on this point:
This paper presents some empirical results of a study predicting corporate failure as
evidenced by the event of bankruptcy .... One might ask a basic and possibly embarrassing
question: Why forecast bankruptcy? This is a difficult question, and no answer or justifi
cation is given here.... Most of the analysis should simply be viewed as descriptive
statistiCS-Which, may, to some extent, include estimated prediction error-rates-and
no
"theories" of bankruptcy or usefulness of financial ratios are tested.
216
CORPORATE
FINANCIAL
REPORTING
217
218
One of the motivations for the large number of empirical studies in this
area appears to be a relatively direct link between the research outputs
(e.g., predictions about financial distress) and decisions made in a variety
of practical decision contexts: commercial loan decisions (e.g., Altman
[1980], monitoring the solvency of banks (e.g., Dince and Fortson [1972]
and Sinkey [1977], and monitoring the solvency of insurance companies
(e.g., Pinches and Trieschmann [1974; 1977]).
In such decision contexts, pragmatic justifications for undertaking
research are likely to be encountered. For instance, the absence of
economic theory notwithstanding, a technique such as discriminant anal
ysis can be a cost-effective data reduction tool to a loan officer, an FDIC
official, or a state insurance commissioner. Discriminant-analysis-based
models have the potential to provide improvements in several areas over
existing procedures used in such contexts; for example, (i) they can
process information quicker and at a lower cost than do individual loan
officers or bank examiners, (ii) they can process information in a more
consistent manner, and (iii) they can facilitate decisions about loss
functions being made at more senior levels of management.
72 Elam [1975] by Altman [1976], Norton and Smith [1979] by Solomon and Beck
[1980], and Ketz [1978a] by Bildersee [1978] and PateD [1978]. The Bildersee [1978] and
Patell [1978] criticisms occurred 88 a consequence of the conference format in which Ketz
[1978] appeared. The Altman [1976] and Solomon and Beck [1980] criticisms were individ
ually submitted to The Accounting Review.
CORPORATE
FINANCIAL
REPORTING
219
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