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North-Holland
Robert W. HOLTHAUSEN
UtCuersi(vof Pennsylvania, Phiiudebhia, PA 19104, USA
Three alternative, but not mutually exclusive, perspectives on accounting method choice are
contrasted: the opportunistic behavior, efficient contracting, and information perspectives. Much
of the empirical work on accounting method choice is based on the opportunistic behavior
perspective. The Malmquist and Mian and Smith papers are attempts to view accounting method
choice as a means of improving the monitoring capabilities of contracts which rely on accounting
numbers. The papers serve as useful vehicles for illustrating the difficulties of delineating a set of
maintained assumptions that result in hypotheses about how accounting method choice affects the
monitoring characteristics of contracts, and distinguishing between hypotheses based on the three
perspectives on accounting method choice.
1. Introduction
Efficient contracting was the general premise underlying some of the early
work on the economic consequences of accounting method choice. This work
examined the incentives to choose among accounting methods because of the
explicit and implicit contracts that relied on accounting numbers. The efficient
contracting perspective with respect to accounting choice implies that account-
ing methods, like the form of organization chosen or the form of contracts
written, will be selected to minimize agency costs amongst the various parties
to the firm. This optimization will result in maximizing the value of the firm.
For example, Watts (1977) makes predictions about the likelihood that a
company will present financial statements and about the content of those
financial statements based on minimizing the agency costs between managers,
shareholders, and bondholders.. The questions posed ask what types of con-
tracts and accounting methods would reduce the potential loss which arises
from the conflicts of interest between various parties in an organization. Watts
predicts that the more fixed assets an organization controls, the more likely the
financial statements will contain charges for maintenance and depreciation in
*The comments of ClitT Smith, Ro Verrecchia, Ross Watts, and Jerry Zimmerman are gratefully
acknowledged.
order to reduce the incentive managers might have for allowing equipment to
deteriorate. Leftwich (1983) discusses the accounting measurement rules that
are negotiated in private corporate lending agreements in order to more
efficiently monitor the stockholder-bondholder conflict. He determines that
private lending agreements which rely on accounting numbers often deviate
from the set of generally accepted accounting principles in order to more
efficiently monitor the conflict of interests between stockholders and bond-
holders.
The notion that accounting method choice and the form of financial
statements could be driven by opportunistic behavior was also visible in the
field’s early work. For example, Watts and Zimmerman (1978) take the view
that managers lobby for accounting standards so as to maximize their own
utility, where a manager’s utility is affected by the firm’s stock price and the
manager’s compensation. Unless one is willing to assume that a manager’s
human capital declines by the amount of any loss in firm value which results
from the opportunistic choice of accounting methods as opposed to the most
efficient choice of accounting methods (such that Jim value is maximized), a
self-interest theory of accounting choice need not lead to the same predictions
about the selected set of procedures as the efficiency perspective.
Motivating accounting choice on opportunistic behavior gained further
favor when researchers started to take the form of the contracts the firm has
outstanding as given and did not explicitly consider the implications of a
multiperiod horizon. Under these conditions, the accounting method a man-
ager would choose is driven by how the choice affects the existing contracts
without considering how future contracts might be written. From this perspec-
tive and some additional assumptions come hypotheses such as: managers will
tend to choose more income-increasing techniques the greater the firm’s
leverage in an effort to reduce the extent to which accounting-based debt
covenants are binding, or managers choose income-increasing techniques to
increase their bonuses if their compensation is directly tied to accounting
earnings. These hypotheses arise not from maximization of firm value but
from a transfer of wealth between bondholders, shareholders, and manage-
ment which increases management’s utility because of their holdings of stock
and stock options and because of their bonus compensation plans.
Another rationale for accounting choice is the information perspective
discussed in Holthausen and Leftwich (1983). If managers have a comparative
advantage in providing information about their firms, we would expect them
to be compensated in part on the basis of their ability to provide information
about the future cash flows of the firm. Thus, the information perspective
suggests that accounting methods are chosen to reveal managers’ expectations
about the future cash flows of the firm. Note that the contracting and
information perspectives agree that there is an association between accounting
R. W. Holthausen, Accounting method choice 209
methods and cash flows, but they disagree on the causality. The contracting
perspectives (either efficient contracting or opportunistic behavior) suggest
that the accounting methods chosen affect the firm’s cash flows (choose the
most efficient methods to maximize firm value or behave opportunistically to
transfer wealth), while the information perspective suggests the methods
chosen provide information about the future cash flows of the firm, but do not
affect them directly.
These three explanations for accounting technique choice are not mutually
exclusive. All may be partial explanations of observed accounting choices and
lobbying behavior in the standard setting process. In looking at the literature
in retrospect, it appears that more of the published research has been predi-
cated on the opportunistic behavior of managers rather than from an efficient
contracting perspective. The information perspective has not been tested. This
may be the case because testable predictions based on the efficient contracting
and information perspectives have eluded researchers to a great extent. The
papers by Malmquist (1990) and Mian and Smith (1990) both take an efficient
contracting view of the world, and thus serve as useful tools for discussing the
potential merits and problems associated with trying to address accounting
choice from this perspective. Both papers experience two difficulties in varying
degrees:
These assumptions taken together form the basis of Malmquist’s five hy-
potheses. Some of these assumptions have been used in the accounting choice
literature previously. For example, Assumptions 4 and 5 have appeared
repeatedly. Assumption 1 has not appeared in the literature before, but it is
not unlike other assumptions that have been used in this literature, in that it
introduces some imperfection or cost of information or contracting. In this
case, it is assumed that it is costly to convince a court that differences in stated
book values due solely to differences in accounting methods are irrelevant for
valuation purposes. This is very similar in spirit to the assumptions which
drive the ‘political cost’ prediction.
Other assumptions in the Malmquist paper are different from much of the
previous work. In particular, Assumptions 2 and 3 rely on assumptions about
the ability of accounting numbers, based on either full cost or successful
efforts, to accurately signal financial distress and managerial performance
under different conditions. Personally, I question whether the accuracy of
signalling financial distress or managerial performance using full cost or
successful efforts is adequately captured by the debt to net tangible assets ratio
and the relative proportion invested in exploration and production. Moreover,
why don’t estimates based on proven reserves more accurately signal financial
distress than either successful efforts or full cost accounting in a cost-efficient
manner? Perhaps the estimates based on proven reserves are more accurate but
are not cost-effective because of the cost of producing those statements.’
Malmquist’s difficulty in structuring his arguments illustrates the problems
researchers have faced in providing empirical tests of the notion that account-
ing choice is driven by efficiency considerations. First, relatively little is known
about the tradeoffs involved in writing and monitoring contracts. Second, the
empirical tests do not reflect detailed knowledge of how alternative accounting
methods affect the financial statements of firms under different conditions.
Thus, it is questionable whether the tests adequately address whether a
particular accounting choice affects the monitoring capabilities of those con-
tracts. Malmquist’s difficulty in-structuring his tests arises because in general,
we know relatively little about how the choice of a particular accounting
method will more accurately signal financial distress, managerial performance,
or some other attribute that a contract is attempting to monitor. If Malmquist’s
‘It is interesting to note that Malmquist’s limited examination of the contracts, along with the
work of Frost and Bernard (1988) and Press and Weintrop (1990) suggest that bond covenants for
oil and gas firms are more often based on accounting numbers than on the market value of proven
reserves. The sample in Foster (1980) suggests the opposite.
212 R. W. Holthawen, Accounting method choice
maintained assumptions about the conditions under which full cost or success-
ful efforts more accurately reflect financial distress or performance are incor-
rect, then of course his tests are misspecified.
If researchers are going to succeed in demonstrating that accounting meth-
ods are chosen to increase the monitoring capability of various contracts,
progress will have to be made regarding the effects of different accounting
methods on the monitoring characteristics of those accounting-based con-
tracts. Absent that, it seems unlikely that an accounting choice literature based
on economic efficiency will make much progress.
2Malmquist does report one test to address this issue in section 6. He reestimates his basic
regressions including dummy variables for various types of management compensation plans,
which indicate whether those plans are tied to market value, accounting earnings, both market
value and accounting earnings, or neither. None of the compensation variables are significant.
Malmquist states that ‘the results provide no hint that choice of accounting methods in this
industry is the result of managers’ abiity to enrich themselves by this choice (full cost or
successful effort) through accounting-based management compensation plans’. I view those tests
as inconclusive given the use of dummy variables to proxy for the more complicated schemes used
in most compensation agreements. [See Healy (1985).]
R. W. Hdthausen, Accounting method choice 213
‘AsI stated previously, I am not taking the view that the assumptions of a theory have to be
proven in order lo validate the theory. Theories are supported by consistent evidence. However,
when there are alternative explanations that are consistent with the same evideqce, readers till
tend lo choose among the theories based on the assumptions that underlie the theory.
214 R. W. Holthausen, Accounting method choice
formed subsidiaries and then test hypotheses based on the degree of interde-
pendence between the parent and subsidiary. They argue, however, that the
activities of a firm are more interdependent in a divisional&d firm than in one
where the firm organizes into a parent and subsidiaries. If the same financial
activities take place within both types of firms, some element other than
interdependence must be an important influence on organizational form, and
could be influencing the consolidation decision as well. Hence, there could be
an important omitted variable in the analysis. Since we know relatively little
about the tradeoffs involved in choosing among organizational forms, docu-
menting whether these activities take place within divisionalized firms would
be useful evidence for assessing whether the sample selection procedure leads
to any problems of inference. Despite these potential limitations, it is useful to
see how Mian and Smith deal with the problems of obtaining testable
predictions based on efficiency grounds and in distinguishing between alterna-
tive hypotheses.
rather than just the income of the subsidiary, the more interdependent the
activities of the parent and the subsidiary.4 Since this is a critical assumption
in the analysis and is of interest in its own right, it would be interesting to
know about the extent of cross-sectional variation in the terms of contracts
across firms as a function of their organizational form. (I am not suggesting
Mian and Smith could have done this easily given the data is not generally
available.)
With regard to the second assumption, Mian and Smith argue that audit
costs will be reduced and more efficient monitoring will result if the firm
chooses the same form of reporting for most (all) of their contracts. With
regard to the audit costs, an auditor would typically audit the subsidiaries of a
company regardless of whether the financial statements are consolidated or
not. If the statements are to be consolidated the auditor would typically start
with the audited financial statements of all the individual units and then
consolidate them, being careful to eliminate intercompany transactions. Thus,
it is not clear that the audits of a company on a consolidated and unconsoli-
dated basis would be very different or that their costs would be significantly
different.’
With regard to the assumption that firms use the same basis of reporting
across all contracts we know that, in general, there is some variation in the
reporting methods used across the contracts that firms write, for example
public and private debt contracts. However, the evidence in table 8 of Mian
and Smith is interesting because it indicates that firms tend to choose the same
basis of reporting (consolidated or unconsolidated) for external reporting
purposes and for contracting purposes in public debt agreements.6 It would be
4While Mian and Smith’s assumption may be correct. I believe it is likely that the financial
statements of a subsidiary produced on a stand-alone basis are important in organizations
regardless of the consolidation decision. We know, for example, that even within divisionalized
companies (which I would argue are more integrated than in an organization with parents and
subsidiaries), the financial performance of divisions are used for assessing the performance of
division managers and for controlling the assets of the organization. Thus, I anticipate that the
financial performance of a subsidiary, judged on a stand-alone basis, is an important component
of control within an organization, regardless of the degree of interdependence between the
subsidiary and the parent.
‘Two dih’erences that could arise are that materiality considerations may drive an auditor to
audit an unconsolidated subsidiary more than if that subsidiary were consolidated, and an auditor
may devote more resources to auditing intercompany transactions if the financial statements are to
be presented on a consolidated basis. At a minimum, companies reporting on a consolidated basis
have both the unconsolidated and consolidated numbers. It is conceivable that companies which
report on an unconsolidated basis never generate the consolidated numbers.
6Table 8 indicates that in public debt agreements, firms which report only unconsolidated
subsidiaries always use separate entity balance sheet data in their bond covenants if they use
balance sheet data at all, and firms which report only consolidated subsidiaries always use
consolidated balance sheet data, if they use balance sheet data at all. This evidence is consistent
with Mian and Smith’s maintained assumption that firms will in general use one method of
reporting for a variety of purposes.
216 R. W. Holthawen, Accounting method choice
‘Mian and Smith argue in section 2.2 that the most informative statements are unconsolidated
financial statements if complete disclosure of intercompany transactions is provided. The informa-
tion perspective, as I discuss it, suggests the manager’s choice of consolidated or unconsolidated
financial statements provides information about how the manager believes the future cash flows of
the firm can best be predicted (i.e., using separate entity or consolidated results). As the operations
of the subsidiary and parent become more interdependent (due, for example, to price discrimina-
tion effected through a credit subsidiary) the consolidated statements become more informative.
R. W. Hdthawen, Accounting method choice 217
4. Concluding remarks
In summary, the strength of the two appears is in their attempt to structure
a set of tests which assume that accounting methods are chosen to increase the
efficiency of contracts in monitoring the conflicts of interest among agents in
the firm. There have been relatively few attempts to test efficiency-based
arguments in the accounting literature. In structuring those tests, the papers
must deal with two difficulties:
The papers achieve varying degrees of success in dealing with these two issues.
Because of that, it is difficult to interpret the papers as strong evidence of
accounting method choice being driven by efficiency considerations. Neverthe-
less, the attempts to relate accounting technique choice to an efficient contract-
ing perspective are interesting.
The accounting choice literature, which arose from a literature on efficient
contracting as a means of dealing with the conflicts of interest among agents,
has nearly abandoned the view that accounting choice is based on efficiency
considerations in favor of hypotheses based on opportunistic behavior. The
literature on accounting method choice would be enhanced by further at-
tempts to structure tests from the efficient contracting perspective, as
Malmquist and Mian and Smith have attempted, or from the information
perspective.8 Hopefully, these papers will stimulate future research in this
area.
‘Additional prescriptions for improving the literature can be found in Holtbausen and Leftwicb
(1983) and Watts and Zimmerman (1989).
218 R. W. Holthauren, Accounting method choice
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