Journal of Accounting and Economics 3 (1981) 129-149.

North-Holland Publishing Company

A N I N C O M E STRATEGY A P P R O A C H TO THE POSITIVE T H E O R Y

OF ACCOUNTING STANDARD SETTING/CHOICE

Mark E. ZMIJEWSKI and Robert L. HAGERMAN*

State University of New York at Buffalo, N Y 14214, USA

Received May 1979, final version received April 1981

This paper is designed to provide additional evidence on the positive theory of accounting
policy choice by combining individual accounting principles into firm income strategies. These
strategies were the dependent variable in a probit analysis where the independent variables were
size, management compensation, industry concentration ratio, systematic risk, capital intensity
and the total debt to total asset ratio. The results indicate that four of these factors (size,
management compensation, concentration ratio, and the total debt to total asset ratio) have a
significalat association with the choice of a firm's income strategy. This test provides strong
evidence consistent with the positive theory of accounting standard setting/choice. We also
present evidence that smaller firms and/or firms in less concentrated industries do not appear to
make accounting policy choice decisions that are consistent with this theory.

1. Introduction
A recent series of articles has re-examined and augmented the
phenomenon first addressed by Gordon (1964), when he proposed a theory
which attempted to manifest the economic incentives which motivate
managers' choices of accounting principles. 1 These papers have extended
Gordon's query by attempting to determine the economic incentives which
motivate managers' concern with the set of accounting principles utilized to
generate the firms' financial statements. This concern is exhibited through
two economic phenomena. The first is the firms' lobbying activities for or
against a proposed accounting standard. These actions are designed to
influence the set of generally accepted accounting principles (GAAP) from
which a firm may choose. The second is the choice of, and/or changes in, the
set of accounting principles utilized by a firm. Both phenomena involve real
economic costs to the firm. The question is, assuming economic rationality,
what are the benefits justifying these costs? In response to this question a

*We would like to thank J. Boness, L. Brown, D. Dhaliwal, L. Kelly, R. Watts and J.
Zimmerman and the members of the Accounting and Finance Workshop at the State University
of New York at Buffalo for their helpful comments and suggestions
1See Watts (1974, 1977), Watts and Zimmerman (1978), Hagerman and Zmijewski (1979) and
Dhaliwal (1980).

0165-4101/81/0000-0000/$02.50 f~ North-Holland
130 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

positive theory of the determination and choice of accounting principles is

being developed.
The purpose of this paper is to further develop and test this positive
theory of accounting by using an income strategy approach. This approach
treats the firm's set of accounting choices as a single comprehensive
decision. 2 We also test whether or not this theory is generally applicable to
all firms.
A positive theory of accounting that explains why firms lobby for and
choose particular accounting principles could be very useful. Such a theory
could identify the economic motives that influence managers to make certain
choices and thus indicate how these incentives could be altered. This theory
could also be used by accounting regulatory bodies and other accounting
policy-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 or
against a given proposal.
The paper is organized as follows. In section 2 we discuss the positive
theory of accounting and the previous empirical tests. Next we discuss the
multi-dimensional nature of the accounting policy decisions made by
managers and develop our income strategy approach. Section 4 contains the
results of our empirical tests. Finally, in section 5 we present a summary and
our conclusions.

2. Prior work

2.1. A positive theory of accounting, policy choice

Gordon (1964) was the first to seriously analyze the economic motives
management might have in choosing accounting principles. He concluded
that managers will choose accounting principles that smooth the net income
series. Gordon's analysis is suspect because it implicitly assumes that
investors cannot, or will not, fully adjust for alternative accounting
principles. The empirical work conducted by Ball (1972), Sunder (1975), and
others, indicate that, at the aggregate market level, adjustments are made in
accordance with the efficient market hypothesis. 3 Thus, managers are
probably not motivated to choose accounting principles which necessarily
smooth income or growth for this reason.

2This type of approach could also be applied to the following areas of research: positive
theory of accounting, income smoothing, and changes in accounting principles.
Sin addition, the income smoothing research such as: Copeland (1968), Cushing (1969), White
(1970), Ball and Watts (1972), Barefield and Comiskey (1972), and Smith (1976), has been less
than conclusive on this issue.
 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice 131

Watts and Zimmerman (1978), hereafter W-Z, formally developed a theory

hypothesizing the economic incentives managers have in selecting accounting.
principles and developed an empirically testable model. W-Z tested this
model on manager's lobbying positions that were submitted to the FASB
concerning the general price level accounting (GPLA) exposure draft.
Hagerman and Zmijewski (1979), hereafter H-Z, extended this theory and
tested it on the managers' choice of individual accounting policies.
The theory developed by W-Z is based on the proposition that managers
attempt to maximize their utility which is directly related to their
compensation and hence wealth. Management compensation is increased by
either increasing the value of management stock option plans and/or by
increasing the cash paid through incentive cash bonuses. Therefore, W-Z
argued that the following factors would increase management wealth: (i)
decreased or delayed tax payments, (ii) favorable government regulations, (iii)
decreased political costs, e.g., threats of nationalization, expropriation, anti-
trust suits, etc., (iv) decreased information production costs, and (v) increases in
the income measure used as the base for the incentive bonus plans. Increased
firm cash flows from the first four factors would, ceteris paribus, lead to
higher stock prices, while the last factor would result in a direct increase
in management compensation.
Based on this logic, managers will lobby for and choose those accounting
policies which decrease or defer tax payments, help secure favorable
regulations (or decisions by regulators), decrease political costs, decrease
information production costs, and/or increase managers' cash bonuses.
Except for the reduction of information production costs which directly
decrease cash outflows, accounting policies affect these factors by the impact
they have on reported net income. An accounting policy which reduces
income can reduce or delay a firm's tax payments (assuming it must be used
for both accounting and tax purposes, i.e., LIFO). If a firm is regulated,
accounting policies which reduce net income would allow management to
argue that profits are too low and that a price increase is justified. Lower
earnings also reduce political costs because the firm is less visible and hence
less likely to be attacked by political activists than are firms with higher
earnings. Finally, if a company bases its incentive plan on reported earnings,
managers have an incentive to favor those methods which increase reported
income.
Watts (1977), using the results of Jensen and Meckling (1976), was the first
to suggest that debt covenants might also influence the choice of accounting
policies. Collins, Rozeff and Dhaliwal (1980), Dhaliwal (1980), Holthausen
(1980), and Leftwich (1980) made the argument that the higher is the
debt/equity ratio of the firm, the more binding are the debt covenants on the
firm. The firm can attempt to loosen some of these covenants, e.g., the
dividend covenant, by choosing accounting policies that increase reported
132 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

income. Hence, they hypothesized that high debt/equity ratios are associated
with income increasing accounting alternatives and, with the exception of
Holthausen (1980), they found that debt/equity ratio was significant in the
various issues they tested.

2.2. Empirical tests

W-Z tested their positive theory of accounting by examining the lobbying
position c_ the firms which made submissions to the FASB about the
proposed GPLA standard. They examined the empirical relationship of a
firm's adjusted lobbying position (adjusted for the effect GPLA would have
on its income) to size and market share, used as proxy variables for political
costs, the existence of a management profit-sharing plan, two proxy variables
for possible tax effects, and whether or not the firm was regulated. 4 The
variable with the most discriminating power was firm size, with the larger
firms lobbying for lower earnings. The other variables had little explanatory
power.
Hagerman and Zmijewski (1979) also tested this theory. They used probit
analysis to determine if the choice of four individual accounting policies (i.e.,
depreciation and inventory methods, the treatment of the investment tax
credit, and the amortization of past service costs) by 300 firms could be
explained by the theory. The H - Z model consisted of firm size and
management incentive plan variables as did the W - Z model. H-Z substituted
an eight firm concentration ratio variable for the W-Z market share variable.
The concentration ratio is assumed to be a proxy variable for the ability of a
firm to earn monopoly rents, which can result in large political costs.
Corporations which earn monopoly rents and report them are more likely to
face anti-trust action and entry by other firms. Thus it was hypothesized that
corporations which earn monopoly rents will choose accounting principles
which reduce reported income to forestall entry as well as anti-trust suits.
Two additional variables were tested by H - Z : systematic risk and capital
intensity. Riskier firms will tend to earn higher returns to compensate them
for the additional systematic risk they bear. Therefore, to the extent that
accounting income reflects economic income, riskier firms will show higher
accounting profits. Likewise, capital intensive firms will appear to earn
higher profits than labor intensive firms because the total cost of capital is
not a recognized expense in computing net income. Since riskier firms and
more capital intensive firms will appear to earn abnormal profits, they will
have an incentive to choose those accounting principles that will reduce
reported income.
H-Z treated Last-In-First-Out (LIFO), accelerated depreciation, the
deferral of the investment tax credit, and the amortization of past service
4The GPLA effect on income was estimated via the adjusting procedure developed by
Davidson and Weil (1975a, b), and Davidson, Stickeny and Weil (1976).
 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice 133

costs over a period of less than 30 years as income deflating alternatives. The
income inflating choices were First-In-First-Out (FIFO), straight-line
depreciation, the flow-through method for the investment tax credit, and
amortization periods of 30 years or more for pension past service costs. The
model was statistically significant for only two of the four policies: inventory
and depreciation methods. What was even more disturbing was the fact that
the same variables were not consistently significant across each of the four
policies tested. This evidence indicates that, while the independent variables
m a y have explanatory power in general, they are not individually consistent
determinants of accounting policy choice. This could be interpreted to infer
that either different decision processes are used for each accounting policy
choice (which seems unlikely) or that the accounting policies which were
tested are not individual decisions.

3. The income strategy approach

3.1. Income strategies

Although many studies have assumed that the choice of accounting
policies are independent, 5 it is unlikely that managers act in this manner. If
management uses the H - Z or the W - Z model in their accounting policy
lobbying and choice decisions, these decisions will not be independent
because the values of the model's independent variables are identical for each
decision. Based on the economic factors which influence these decisions,
managers will attempt to achieve the optimal reported net income over time
and will choose a set of accounting policies accordingly. Essentially,
management will adopt a multi-dimensional income strategy for the firm,
with each policy being one dimension of that decision.
Both W - Z and H - Z models made the assumption of independence. W - Z
did not discuss the effect of the other policy decisions made by the firm. A
firm would not incur lobbying costs if it could counteract the effect of a
decision made by the FASB by changing its set of accounting principles if
the cost of this change would be less than the cost of lobbying. H - Z assumed
that managers would choose an accounting principle based on its individual
effect on reported income and the economic variables of the model. Since the
set of independent variables is the same for each firm at any point in time,
the model should predict either all income increasing or all income
decreasing accounting policy choices for each of the firms. Therefore, for a
particular firm, the model would infer a conservative (all income decreasing
policies) or liberal (all income increasing policies) firm income strategy.

SSee for example: Abdel-khalik and McKeown (1978), Ball (1972), Cushing and Deakin
(1974), Eggleton, Penman and Twomby (1976), and Kaplan and Roll (1972) (changes in
accounting principle); Watts and Zimmerman (1978) (lobbying decisions); and Hagerman and
Zmijewski (1979) (accounting policy choice decisions).
 134 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

However, only 12.33 ~o of the H-Z sample fell into these extreme categories
(see table 1). This result is consistent with our argument that firms follow an
overall income strategy.
An optimal strategy need not be extreme because of the trade-offs the
managers face. Some variables such as size induce managers to use deflating
policies while other variables such as management compensation plans
encourage managers to choose income inflating alternatives. The result of
these trade-offs mean that any combination of the available set of alternative
GAAP may be optimal for a given firm.
If firms follow an overall firm income strategy, then the firm's strategies
should be used as the dependent variable in a statistical analysis conducted
to test the choice of accounting principles. This will provide a stronger test of
the hypothesis. Given the four policy choices analyzed by H - Z (depreciation,
inventory, investment tax credit, and pension past service costs) and two
choices for each policy (income increasing or income decreasing) there are 24 ,
or 16 combinations that firms could follow. It is necessary to consider how
these 16 combinations can be partitioned into an ordinal ranking of distinct
income strategies across all firms. 6 The first set of strategies we test is based
on the assumption that the choices of inventory and depreciation methods,
the amortization of pension costs, and the treatment of the investment tax
credit, all have an equal effect on reported income. This assumption yields
five alternative strategies, each with a different magnitude of effect on
reported income. The five strategies are: income decreasing policies for all
four methods, one income increasing policy and three income decreasing
policies, two income increasing policies and two income decreasing policies,
three increasing policies and one decreasing policy, and finally, all income
increasing policies. The combinations of policies that make up these five
strategies are shown in table 1.
The assumption that all the alternative accounting principles have an
equal effect on reported income is arbitrary. However, as it is not possible to
measure the exact effects of the various accounting principles, we make two
additional sets of assumptions regarding the impact of alternative principles.
We then test the resulting sets of strategies to see if the results are sensitive
to the assumptions of the individual accounting policies on the alternative
aggregation procedures. The first additional set of assumptions is that the
pension cost and investment tax credit alternatives have exactly one-half of
the effect of the inventory and depreciation alternatives. This assumption
results in a set of seven distinct strategies. The combination of accounting
principles choices th/~t make up these seven strategies are also presented in
6We have reviewed the literature for articles and empirical evidence which would provide us
with a methodology which would divide the 16 combinations of accounting policies into an
ordinal ranking of firm income strategies. Unfortunately, we were unable to find any such
references. Although the assumptions which we have made may appear somewhat ad hoc, we
feel that they are rational and are adequate surrogates for the true ordinal rankings.
 Table 1
Alternative combinations of accounting policies and income strategies for Watts-Zimmerman (W-Z) and Hagerman-Zmijewski (H-Z)
samples.

Possible policy alternatives

W-Z H-Z Classification
sample sample of strategies
Investment
bq
Pension tax
iZombination Depreciation Inventory costs credit # ~o # ~o 5 7 9

Most
e~
decreasing 1 0 0 0 0 4 11.77 10 3.33 1 1 1
ga.
2 0 0 1 0 2 5.88 0 0.00 2 2 2
3 0 0 0 1 0 0.00 9 3.00 2 2 2
4 0 0 1 1 0 0.00 1 0.33 3 3 3
5 1 0 0 0 0 0.00 29 9.67 2 3 4
6 0 1 0 0 0 0.00 11 3.67 2 3 4
7 1 0 1 0 4 11.77 8 2.67 3 4 5
8 0 1 1 0 2 5.88 1 0.33 3 4 5
9 1 0 0 1 4 11.77 68 22.67 3 4 5
10 0 1 0 1 0 0.00 12 4.00 3 4 5
11 1 0 1 1 6 17.64 24 8.00 4 5 6
12 0 1 1 1 0 0.00 1 0.33 4 5 6
13 1 1 0 0 1 2.94 17 5.67 3 5 7 t~
14 1 1 1 0 1 2.94 7 2.33 4 6 8
15 1 1 0 1 2 5.88 75 25.00 4 6 8 g~

Most 16 1 1 1 1 8 23.53 27 9.00 5 7 9

increasing
34 100~o 300 100~o
where
0 1
Income decreasing Income increasing
Policy policy policy t~

Depreciation Accelerated method Straight line method

Inventory LIFO FIFO
Amortization of past costs Less than 30 years 30 years or more
Investment tax credit Deferral method Flow-through method
136 M.E. Zmijewski and R.L. Hagerman, Income strategy anti accounting choice

table 1. The second alternative set of assumptions is that the pension costs
and tax credits have an equal but less than one-half of the effect that
inventory and depreciation alternatives have on reported income. This
assumption yields a set of nine strategies. The combinations that make up
these strategies are again shown in table 1.
We propose to test the model previously developed by H - Z augmented
with the debt/equity ratio on the income strategy adopted by the firm, rather
than on the individual lobbying or policy choice decisions. We assert that
accounting policy decisions must be analyzed as part of an overall firm
strategy and not as independent decisions. If, in fact, the firm does make its
accounting policy decisions via some type of income strategy decision
process, the model should be able to classify the firms according to the
strategies chosen.

3.2. Methodological considerations

These strategies, given our previous assumptions, can be ranked in the
order of the assumed magnitude of the effect on net income. The first
strategy is the most income decreasing possibility while the last strategy is
the most income increasing strategy. This treatment of the firms' income
strategies has resulted in certain data limitations which will be a determinant
in the choice of an appropriate statistical methodology.
The first limitation is that the actual effect on reported income of a
particular strategy cannot be observed. Because of this, we are only able to
hypothesize the ranking of the strategies. The second limitation is that, at
best, the hypothesized rankings are ordinal. Hence, the choice to assign the
same size interval to each strategy cannot be used to infer that each strategy
will have the same magnitude of effect on reported income.
Given these data limitations, regression analysis is an inappropriate
statistical technique for the following two reasons. First, there is a violation
of the assumptions which must be made about the properties of the error
terms in regression analysis. The error terms in the regression model where
the dependent variable is categorical: (i) will not have an expected value of
zero, (ii) will not be normally distributed but in fact have a discrete
distribution, and (iii) will be heteroskedastic. The severity of these violations
will decrease as the number of categories is expanded. This can be intuitively
seen by expanding the number of categories to the limit, i.e., when the
number of categories approaches infinity, the dependent variable becomes
continuous and the violations no longer exist. Hence, one may justifiably
utilize regression analysis if the dependent variable has a sufficient number of
categories to reduce the severity of this problem. The second problem is that
regression analysis implicitly assumes that the dependent variable has a
cardinal scale.
An alternative statistical technique is the n-chotomous probit analysis
developed by McKelvey and Zaviona (1975). The assumption of this
 M.E. Zmiiewski aml R.L. Hagerman, Income strategy and accounting choice 137

methodology is that, although unobservable, the dependent variable has a

continuous underlying normal distribution. Hence, if the true values could be
observed, the previously discussed regression model would satisfy the
necessary assumptions. Given this assumption, the objective of n-chotomous
probit analysis is to simultaneously estimate the regression coefficients of the
true underlying regression model as well as the parameters of the cardinal
scale of category intervals. The resulting estimated parameters will provide
an estimation of the probability that an observed vector of independent
variables is within any particular category bounded by that category's
estimated cardinal intervals.
The estimation of these parameters is calculated by use of the maximum
likelihood estimation procedure via the Newton-Ralphson iterative method
of solution for nonlinear systems. 7 The advantage of using parameters
estimated by this method is the appealing statistical properties of the
estimators. These estimates are asymptotically efficient and have a known
asymptotic sampling distribution. Therefore, we are able to perform
hypothesis tests on the significance of both the overall model and the
individual independent variables. Another appealing feature of this technique
is that it is possible to make certain inferences about the estimated size of the
intervals chosen. We are able to test the hypothesis that the size of the
estimated cardinal interval is significantly different from zero. This test will
provide some indirect evidence on the appropriateness of our choice of
income strategies.
To test the overall model the likelihood ratio will be used. This is done by
taking minus two times the log likelihood ratio which is distributed as a chi-
square with k - 1 (k being the number of independent variables) degrees of
freedom, cf., McKelvey and Zavonia (1975). The asymptotic t-test will be
used to test the significance of both the estimated coefficients of the
independent variables and the size of the estimated cardinal intervals. 8
The independent variables are measured in the following ways. Size is
measured by the log of net sales. Capital intensity is calculated by the ratio
of gross fixed assets to sales. Concentration ratio, which is defined as the
percentage of total industry sales made up by the top eight firms, 9 is our
proxy for the firm's ability to earn monopoly rents. The debt/equity ratio is
defined as total debt to total assets. The systematic risk of the corporation 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 discriminant
analysis (MDA). The decision is quite clear, MDA does not provide a direct statistical test of
either the coefficients of the individual independent variables or the size of the estimated
intervals. Furthermore, the MDA model assumes that all of the independent variables are
normally distributed. Given our binary management profit-sharing variable, this assumption
would be violated.
9Concentration ratios have obvious shortcomings as measures of monopoly rents but they are
widely used because no better proxy is readily available.
138 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

measured by beta estimated from the market model. A zero-one dummy

variable represents the existence or non-existence of a management profit
sharing plan based on reported net income.

4. Empirical tests

4.1. Data
The data used in our analyses consist of the 34 unregulated firms of W - Z
and the 300 unregulated firms of H-Z. l For each of the firms, the
previously discussed economic variables and the choice of the four
accounting principles were collected from either the firms' 1975 SEC 10K or
annual reports. It should be noted that the 300 H - Z firms represent a
random sample of firms, while the 34 W - Z firms represent the population of
unregulated firms which made submissions to the FASB in regard to the
GPLA discussion memorandum (a non-random sample). Therefore, it is
interesting to compare the two samples and the characteristics of the data.
Since firms with extreme strategies (all increasing or decreasing policy
choices) have less ability to counteract the effect of a mandated accounting
policy change/standard, one may anticipate that firms which made
submissions to the FASB tend to have extreme policies. This hypothesis can
be tested by examining the distributions of the firm strategies of the two
samples. The distribution of the 16 possible combinations of the four
accounting policies for the two samples is shown in table 1. The distributions
for the five, seven, and nine strategy cases can also be easily derived from
this table. The main difference between the distributions of the two samples
is the percentage of W - Z observations in the two extreme strategies. The W -
Z sample has a much larger percentage of firms in these two strategies than
does the H - Z sample. This supports our hypothesis that firms with extreme
strategies will tend to make submissions to the FASB.
To test the statistical significance of this difference, the binomial test was
used. The proportion of firms in each combination (strategy) of the H - Z
sample was used as an unbiased estimator of the probability of the
population's combination (strategy). Using the Clopper-Pearson
methodology, a 95 ~ confidence interval was calculated for the estimator, il
The upper bound of the 95 ~ confidence interval was then used as the
estimated population probability of the two extreme combinations for the
binomial test. This was done to intentionally bias the estimator in favor of
the null hypothesis to provide for a stronger test. The upper bound of the
95~o confidence interval for the extreme income deflating and income
inflating combinations are 0.053 and 0.123, respectively. Basing the binomial

iTwenty-one of the 34 W-Z firms were also in the H - Z sample.

l iSee Hollander and Wolfe (1973, pp. 15-24).
 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice 139

tests on these probabilities resulted in rejecting the null hypothesis for both
of the extreme combinations. The income deflating combination was rejected
at the 0.0475 level of significance and the income inflating combination was
rejected at the 0.0239 level. Thus the data indicate that the W - Z sample has
significantly more firms with extreme strategies than can be expected
(assuming that the H - Z sample is representative of the population).
In their discussion of firm size, W - Z asserted that smaller firms would
either not make a submission or make an unfavorable submission to the
FASB regarding the G P L A discussion memorandum. Therefore, one would
hypothesize that the mean size of the W - Z sample would be much larger
than that of the H - Z sample. We performed the M a n n - W h i t n e y U test to
test this hypothesis. The mean size of the W - Z sample is more than twice
that of the H - Z sample. The null hypothesis was rejected at the 0.001 level of
significance. The fact that the firms in the W - Z sample are so large may
explain why W - Z did not find the management compensation or regulatory
proxy variables useful in classifying the firms' lobbying choices. The potential
political costs borne by large firms may be so large that they dominate the
benefits from increasing reported income. In addition, the political pressures
for large firms may be so great as to induce the firms to act as if they were
regulated. Thus, the regulatory and compensation variables could be
insignificant for the firms examined by W-Z.
The Mann-Whitney U test was also performed on the other economic
variables discussed (the five, seven and nine strategy cases, concentration
ratio, capital intensity, total debt to total assets, and risk) but we were not
able to reject the null hypothesis with any reasonable degree of significance.

4.2. Empirical test of the income strategy approach

If our proposed income strategies are representative of managements'

income strategies, and if these income strategies are generated by the decision
process represented by the model, then one would expect that this model
would be able to classify firms according to their choice of a particular
strategy.
Specifically, the model is

StrategYi = So + ~ 1 M G T C + o~2Conc -t- o~3Beta

+ ct4Size + ~5 CI + t~6 TD + e,
where

Strategyi= Income strategy (i = 5, 7, or 9),

M G T C = Management compensation plan (0 = no, 1 = yes),
Conc = Eight-firm concentration ratio,
140 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

Beta = Systematic risk,

Size = Log of net sales (proxy for political costs),
CI =Capital intensity (gross fixed assets/sales),
TD = Total debt/total assets,
e = Error term
This hypothesis was tested by using the 300 firm H - Z sample and
estimating the coefficients of the model with firm income strategy as the
dependent variable. The coefficients, estimated via n-chotomous probit
analysis, and the other results of the tests are presented in table 2. W h a t is
immediately clear from the data is that the results for five, seven, and nine
strategies are virtually identical. This evidence indicates that our results are
not sensitive to the admittedly arbitrary choice of income strategies.
Some inferences can be made about the appropriateness of our strategies
by examining the significance of the magnitude of the bounded cardinal
intervals estimated by the n-chotomous probit analysis. The ranges of the
estimated cardinal intervals and their t-statistics are presented in table 3.
Note that there are two less bounded intervals than the mimber of strategies
in each case. This is because the two outer strategies are only bounded on
one side and must therefore, have statistically significant magnitudes. The t-
statistics indicate that all bounded estimated cardinal intervals are
statistically significant for both the five and seven strategy cases. The nine
strategy case has three intervals which are not statistically significant. This
may suggest that some of the strategies of this case are not unique. The data
indicate that in the five and seven strategy cases the strategies are, in fact,
different from one another, although we cannot state if they are in fact the
'true' strategies. Given these results, however, we feel that the strategy
assumptions previously discussed are acceptable and that the model is not
biased by the choice of a particular set of assumptions regarding the effect of
the accounting policies on net income.
The model is statistically significant at the 0.001 level for all three cases
tested. 12 For the five strategy case, 409/o of the sample observations were
properly classified. The percent correctly classified for both the seven and
nine strategy case was 339/o. One way to determine how good these
predictions are is to compare them to a naive policy which assumes an equal
probability of each strategy. The prediction rates of the model are much
better than under this naive classification and the differences are very
significant. An alternative comparison is to assume that the naive forecaster
will always choose the most common strategy in the sample. The model's
predictions are better than those from this approach and are significant at

12This level of significance is much greater than the level of significance reported by
Hagerman and Zmijewski (1979) when they tested the policy decisions individually. The largest
of the chi-squares reported in the H - Z analysis was 16.944, while the smallest of these tests is
26.35. Both studies used the same sample of firms.
 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice 141

Table 2
Probit analysis of accounting strategies.

Dependent variable
Independent variables
and statistics 5 strategy case 7 strategy case 9 strategy case

Constant 3.10356 b 3.03981 3.03283

(7.515) (7.598) (7.592)
Management compensation ( + )a 0.31259 0.26812 0.26055
(2.409) (2.112) (2.055)
Concentration ratio ( - ) - 0.63437 - 0.61523 - 0.61678
( - 2.214) ( - 2.193) ( - 2.200)
Systematic risk-beta ( - ) - 0.13656 -0.09032 - 0.08168
( - 0.765) ( - 0.518) ( - 0.469)
S i z e - l o g ' o f net sales ( - ) -0.32095 -0.32406 -0.32351
( - 2.638) ( - 2.720) ( - 2.717)
Capital intensity ( - ) - 0.12651 -0.12218 - 0.12091
( - 0.959) ( - 0.945) ( - 0.935)
Total debt to total assets ( + ) 0.35747 0.40935 0.40930
(1.718) (2.005) (2.005)
Estimated R 2 0.09030 0.09066 0.08983
Probit analysis X2 (d.f. = 6) 26.3675 26.5813 26.3490
~o correctly classified 40.00 ~ 33.00 ~o 33.00
Sample size 300 300 300

aExpected sign of coefficient.

bCoefficient
(asymptotic t-statistic).

the 25 ~ level. The estimated R z for the five, seven and nine strategy cases
are 0.0903, 0.0907, and 0.0898, respectively.
The 'true' ranking of the combinations of accounting policies, and hence
the 'true' strategies may differ from the proposed strategies for two reasons.
The first is that the ad hoe assumptions which were made about the
magnitude of the effect of the accounting policies on net income across all
firms may have been incorrect. The result of this type of error would be that
many of the estimated cardinal intervals would not be statistically significant.
As previously discussed, we do not feel we have a serious problem of this
nature. The second reason that any of the strategies tested may differ from
the 'true' strategies is because of individual firm effects of the accounting
policies. For a specific firm the inventory effect could be larger than, less
than, or equal to the depreciation effect. The same holds for the other
policies. To examine the effect of this error, the number of firms which were
classified within one strategy was calculated. The percentage of correctly
classified firms for the five, seven, and nine strategy cases was 88.33~,
68.67 ~ , and 56.67 ~ , respectively.
142 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

Table 3
Significance of bounded estimated cardinal intervals from probit analysis.

Bounded interval Five strategy case Seven strategy case Nine strategy case

First 0.00000-1.02335 a 0.00000-0.31626 0.00000-0.31611

(7.396) (3.103) (3A03)
Second 1.02335-2.06368 0.31626-1.02697 0.31611-0.34278
(6.112) (4.354) (0.173)
Third 2.06368-3.32887 1.02697-1.90344 0.34278-1.02498
(5.376) (5.219) (4.180)
Fourth N.A. b 1.90344-2.28248 1.02498-1.90135
(2.114) (5.225)
Fifth N.A. 2.28248-3.32511 1.90135-2.12352
(4.167) (1.261)
Sixth N.A. N.A. 2.12352-2.28009
(0.855)
Seventh N.A. N.A. 2.28009-3.32281
(4.186)
~Range of estimated cardinal interval
(t-statlstic).
bN.A. - - Not applicable.

A hold-out sample was also used to test this model. The model was
estimated using 150 observations and then was used to predict the
accounting strategies of the remaining 150 hold-out sample firms. This was
repeated by using the first hold-out sample to estimate the model and then
predicting the strategies for the other 150 firms. The percentage of correct
predictions was 39 ?/o, 30 ?/o and 28.6 ~o, for the five, seven, and nine strategies,
respectively. This is significantly different at the 5 ~o level from the naive
classification model of equal probability for each strategy for all three
strategies. Thus, our model also appears to have significant predictive ability.
What is of most interest in the formulation of a positive theory of
accounting is the statistical significance of the overall model and of the
individual independent variables which were hypothesized to be important
factors in the firm's choice of accounting policies. Therefore, our main
concern is with the significance of the individual independent variables. 13
The log of net sales is negatively related to the choice of accounting
strategies at the 1 ~ level of significance in all three cases. 14 This supports

13To use the asymptotic t-test, the residuals of the probit analysis are assumed to be normally
distributed. We tested the residuals of the five, seven, and nine strategy cases using the
Kolmogorov-Smirnov goodness of fit test. The null hypothesis, that the sample is normally
distributed could not be rejected at any reasonable level of significa_nce [see Hollander and
Wolfe (1973, pp. 219-228)-I.
14Net sales was also tested in place of the log of net sales variable. This substitution resulted
in a lower asymptotic t-value for this variable and a slightly lower chi-square value for the
overall significance of the model.
 M.E. Zm!jewski and R.L. Hagerman, Income strategy and accounting choice 143

the argument that larger firms have incentives to reduce accounting profits.
This is identical to the result of both the W - Z and H - Z analyses. Thus,
there is considerable evidence that large firms face political costs which they
attempt to minimize by reducing net income.
Concentration ratio, which is our proxy for the ability of a firm to earn
monopoly rents, is significant at the 5 ~ level in all three cases. The sign of
the maximum likelihood estimate (MLE) indicates that firms in more
concentrated industries tend to adopt accounting strategies that reduce net
income. This is consistent with our reasoning that such firms will attempt to
reduce reported profits in order to avoid entry and anti-trust action. This
result is of particular' interest to students of industrial organization since it
indicates a bias against finding a positive relationship between profitability
and concentration. This is inconsistent with the results "of Hagerman and
Senbet (1976) which:, indicate that concentration ratios and the choice of
accounting principles are independent, although they did not control for size
or any of the other independent variables.
The existence of a management profit-sharing plan is significant at the 5 ~o
level in all three cases. The sign of the MLE indicates that managers are
more likely to choose accounting strategies that increase net income if such
plans are available to them. This result is not consistent with the results of
W-Z. Thus it appears t h a t the existence of management incentive plans does
influence the choice of accounting principles when a random sample of firms
is examined.
Total debt to total assets is significant at the 10 ~ level in the five strategy
case and is significant' at the 5 ~ level in the seven and nine strategy cases.
The sign of the coefficient of this factor is positive which suggests that firms
which use relatively more debt financing choose accounting policies which
tend to increase net income. This is consistent with the hypothesis that firms
with more debt are more constrained by their debt covenants, and hence,
attempt to loosen these constraints by choosing accounting policies which
increase net income.15
The two remaining variables, beta and capital intensity, are not significant
although they are of the expected sign. It may well be that the effect of risk
and capital intensity on profits, as reflected in net income may be too small
to induce managers to use accounting principles to reduce the reported
income.
These results support our hypothesis that firms act as though they choose
accounting policies relative to an income strategy decision process. The

15Equivalent results were obtained when total debt to equity was used for leverage instead of
total debt to total assets. Substituting either long-term debt to equity or long-term debt to total
assets for the leverage factor was not significant.
144 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

combination of accounting policy decisions made by a firm appear to be

associated with a firm income strategy. 16

4.3. General applicability of the model

The positive theory of accounting developed by W-Z predicts that firms
will attempt to report lower income via the choice of accounting principles if
they are regulated or subject to political pressure. W-Z state: 'In small (i.e.,
low political cost) unregulated firms we would expect that managers do have
incentives to select accounting standards which report higher earnings, if the
expected gain in incentive compensation is greater than the foregone tax
consequences'.17 This is interpreted to mean that the management
compensation variable would be more important for firms facing low
political costs than those facing high political costs. Likewise, other variables
should be more important for the high political cost firms than for low
political cost firms. To test this hypothesis, we partitioned our sample into
low political cost firms and high political cost firms to see if the same model
fits both sub-samples.
The firms in the H-Z sample were partitioned into high and low political
cost subsamples by ranking the firms on a political cost variable, dividing the
sample at the median and classifying firms above (below) the median as
having high (low) political costs. Since both size and concentration ratios are
proxy variables for political costs the division was done twice, once by using
size to partition the sample and then by partitioning the sample based on
concentration ratios. Thus, four probit analyses were conducted.
The subsample means and variances for the income strategies and the
independent variables are reported for each subsample in table 4. The data
show that the large size firms and the firms in highly concentrated industries
follow, on average, more income deflating strategies than smaller firms or firms
in less concentrated industries. These differences are statistically significant at
the 5 ~ level. This is expected since the high political cost groups have more
incentives to reduce reported net income. These data also show that large
firms tend to be in more highly concentrated industries than smaller firms.
This statistically significant difference suggests an association between size
and concentration ratios.
The results of the four probit analyses are presented in table 5. It is quite
apparent that t h e model is significant for both of the high political cost
subsamples and not significant for either of the low political cost subsamples
at the 5 ~ level. Thus, the evidence indicates that the model is not generally
applicable to all firms.

16Regression analysis was also used and the results were equivalent to those reported in the
text.
17Watt s and Zimmerman (1978, p. 118).
 N
Table 4
Descriptive statistics of economic variables partitioned on political cost proxy variables; seven strategy case.

Economic variables

Management
Criterion Income Concentration profit Risk Capital Size log of Total debt to
variables strategy ratio sharing (beta) intensity net sales total assets

Large 4.440" O.7108 O.7000 1.030 0.6024 3.259 0.4518

(2.166) (0.0329) (0.2100) (0.0871) (0.1343) (0.1519) (0.0259)
Size
Small 4.880 0.5958 0.5133 0.8951 0.5762 2.400 0.4747
(2.066) (0.0653) (0.2598) (0.1519) (0.3196) (0.0759) (0.1535)

High 4.387 0.8422 0.6200 0.9687 0.6225 2.981 0.4563 c~

Concentration (1.917) (0.0124) (0.2356) (0.1210) (0.2967) (0.3368) (0.0649)
ratio
Low 4.933 0.4645 0.5933 0.9564 0.5561 2.678 0.4702
(2.262) (0.0211) (0.2413) (0.1257) (0.1553) (0.2137) (0.1146)

aMean
(variance). 3'
146 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

Table 5
Probit analysis of high and low political cost subsamples; seven strategy case.

Criterion variables

Size (net sales) Concentration ratio

Independent variables
and statistics Large Small High Low

Constant 4.46783 b 1.94250 3.61505 2.4801

(5.142) (2.302) (4.056) (4.124)
Management compensation ( + )a 0.43603 0.17400 0.63754 - 0.00657
(2.289) (0.979) (3.354) (-0.037)
Concentration ratio ( - ) -0.43965 -0.71274 -0.83081 - 0.06863
( - 0.897) ( - 2.058) ( - 1.025) (-0.105)
Systematic risk-beta ( - ) -0.45036 0.15334 -0.14823 - 0.04759
( - 1.532) (0.692) (-0.585) (-0.192)
Size-log of net sales ( - ) -0.60938 0.13515 -0.48054 -0.14675
( - 2.652) (0.429) ( - 3.015) (-0.732)
Capital intensity ( - ) -0.40863 -0.00183 0.11850 -0.51667
( - 1.675) (-0.012) (0.713) (-2.337)
Total debt to total assets ( + ) - 0.08460 0.46989 0.43733 0.35128
(-0.154) (2.095) (1.275) (1.346)
Estimated R E 0.12369 0.08039 0.13219 0.06695
Probit analysis Zz (d.f. = 6) 18.4801 11.4547 19.4534 9.7193
~o correctly predicted 33.33 ~o 2,0.67 ~o 38.67 ~o 34.67 ~o
Sample size 150 150 150 150

aExpected sign of coefficient.

bCoefficient
(asymptotic t-statistic).

For the high political cost subsample partitioned on size, all independent
variables except concentration ratio and debt tO total assets are significant at
the 15 ~ level or less. Concentration ratio may not be significant because the
additional political costs due to earning potential monopoly profits may be
small if the company is already very visible to political activists because of its size.
This evidence indicates that, for large firms, the concentration ratio proxy for
political costs provides no information beyond that provided by the size
variable. This could explain the results of W-Z. They did not find a
significant amount of discriminatory power for the market share variable but
the evidence above indicates that the size of the unregulated firms of the W -
Z study was very large.
For the low political cost subsample partioned on size, only the
concentration ratio and the debt to asset ratio were significant and the
overall model is not significant. This suggests that smaller firms only
consider potential competition, anti-trust action and debt covenants when
they decide on the set of accounting principles to follow. This evidence also
 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice 147

indicates that concentration ratio provides information beyond that provided

by firm size when size is below the threshold point for political costs. This
result is expected since concentration ratio may be a proxy variable for
industry political costs and hence, all firms within a concentrated industry
may be scrutinized by regulators, political activists, etc.
For the high political costs subsample partitioned on concentration ratio,
two variables (management profit sharing and size) are significant at the
15 % level or less and the overall model is significant. These results are very
similar to the high political cost subsample partitioned on size. This may be
due to the similar partitioning of the size variable for both of the high
political cost subsamples. The reason size is significant may be due to the
fact that it is the larger firms in concentrated industries that face the major
political costs. This suggests political costs are a function of size, given the
concentration of the industry.
For the low political cost subsample partitioned on concentration ratio,
only capital intensity is significant. Again, the overall model for this
subsample is not significant. What is unexpected in the two low political cost
subsamples is lack of significance of the management profit-sharing variable.
These results are inconsistent with the contention of W - Z who argue that
this variable should be more important for firms that face lower political
costs. One possible explanation is that smaller firms tend to be owner
controlled, making profit-sharing plans less important to these managers.18
These results confirm W-Z's argument that there is a threshold effect. That
is, smaller firms and firms in less concentrated industries do not choose
accounting principles as if they considered political costs. The model,
however, works very well for large firms and firms in highly concentrated
industries. Thus, the model is not generally applicable to all firms and further
research is required to determine what influences the choice of accounting
principles by managers of smaller firms.

5. Summary and conclusions

This paper is an attempt to answer two questions. First, are accounting
policy decisions made jointly? By developing a variety of alternative
accounting strategies we tested them against the proposed positive theory.
The results indicated that size, the existence of a profit-sharing plan, degree
of concentration and debt to total assets ratio all influence the accounting
strategy of a firm. These results are much stronger than when individual
policy choices are tested, i.e., Hagerman and Zmijewski (1979). Thus it
appears that firms choose an overall income strategy.

18This analysis was also conducted on the five and nine strategy cases. The results are
equivalent to those reported for the seven strategy case.
148 M.E. Zmijewski and R.L. Hagerman, Income strategy and accounting choice

We also conducted tests to ascertain if the model was generally applicable

to all firms (i.e., small firms or firms in less concentrated industries) and
found that it was only significant for large firms and those in highly
concentrated industries.
Thus, the evidence in this study suggests that individual accounting policy
choice decisions are part of an overall firm strategy. Although further
refinements must still be made (e.g., testing for the actual dollar effects on net
income and considering all accounting policy decisions), this evidence is
important to researchers examining income smoothing, changes in
accounting principles, and the effects of accounting standard setting.
Individual accounting policies should be examined as part of an overall firm
strategy. A second point to be considered is that the model, in its present
form, is not universally applicable. It appears as though only the larger firms
and those in more concentrated industries fit the model. Additional factors
must be added to the model so that it can be applied to all firms. Finally, it
is apparent that neither size nor concentration ratio individually represent
perfect proxy variables for political costs. Thus, further research into the
measurement and quantification of political costs is needed.

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