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 policymakers 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, antitrust 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 sample # ~o # ~o 5 7 H-Z sample Classification of strategies bq 9
e~ ga.

iZombination

Pension Depreciation Inventory costs

Investment tax credit

Most decreasing
0 0 0 0

0 0 0 1 0 1 0 1 0
1 0 1 1

0 0 0 0 1 0 1 0 1

1 0 1 0 0 1 1 0 0

0 1 1 0 0 0 0 1 1

t~

Most increasing

2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 0 1 1 1 1 34
1

1 1 1 1 1

1 0 1 0 1

1 0 0 1 1

4 2 0 0 0 0 4 2 4 0 6 0 1 1 2 8 100~o 300 100~o

11.77 5.88 0.00 0.00 0.00 0.00 11.77 5.88 11.77 0.00 17.64 0.00 2.94 2.94 5.88 23.53

10 0 9 1 29 11 8 1 68 12 24 1 17 7 75 27

3.33 0.00 3.00 0.33 9.67 3.67 2.67 0.33 22.67 4.00 8.00 0.33 5.67 2.33 25.00 9.00

1 2 2 3 2 2 3 3 3 3 4 4 3 4 4 5

1 2 2 3 3 3 4 4 4 4 5 5 5 6 6 7

1 2 2 3 4 4 5 5 5 5 6 6 7 8 8 9

g~

where

Policy

0 Income decreasing policy Accelerated method LIFO Less than 30 years Deferral method

Income increasing policy Straight line method FIFO 30 years or more Flow-through method

t~

Depreciation Inventory Amortization of past costs Investment tax credit

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 chisquare 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 NewtonRalphson 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 Size CI TD
e

= Systematic risk, = Log of net sales (proxy for political costs), =Capital intensity (gross fixed assets/sales), = Total debt/total assets, = 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 tstatistics 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 Constant Management compensation ( + )a Concentration ratio ( - ) Systematic risk-beta ( - )
S i z e - l o g ' o f net sales ( - ) 5 strategy case 3.10356 b (7.515) 0.31259 (2.409) - 0.63437 ( - 2.214) - 0.13656 ( - 0.765) -0.32095 ( - 2.638) - 0.12651 ( - 0.959) 0.35747 (1.718) 0.09030 26.3675 40.00 ~ 300

7 strategy case
3.03981 (7.598) 0.26812 (2.112) - 0.61523 ( - 2.193) -0.09032 ( - 0.518) -0.32406 ( - 2.720) -0.12218 ( - 0.945) 0.40935 (2.005) 0.09066 26.5813 33.00 ~o 300

9 strategy case
3.03283 (7.592) 0.26055 (2.055) - 0.61678 ( - 2.200) - 0.08168 ( - 0.469) -0.32351 ( - 2.717) - 0.12091 ( - 0.935) 0.40930 (2.005) 0.08983 26.3490 33.00 300

Capital intensity ( - ) Total debt to total assets ( + ) Estimated R 2 Probit analysis X2 (d.f. = 6) ~o correctly classified Sample size 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 First Second Third Fourth Fifth Sixth Seventh Five strategy case Seven strategy case Nine strategy case

0.00000-1.02335 a (7.396) 1.02335-2.06368 (6.112) 2.06368-3.32887 (5.376) N.A. b N.A. N.A. N.A.

0.00000-0.31626 (3.103) 0.31626-1.02697 (4.354) 1.02697-1.90344 (5.219) 1.90344-2.28248 (2.114) 2.28248-3.32511 (4.167) N.A. N.A.

0.00000-0.31611 (3A03) 0.31611-0.34278 (0.173) 0.34278-1.02498 (4.180) 1.02498-1.90135 (5.225) 1.90135-2.12352 (1.261) 2.12352-2.28009 (0.855) 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 Income strategy 4.440" (2.166) 4.880 (2.066) 4.387 (1.917) 4.933 (2.262) 0.4645 (0.0211) 0.5933 (0.2413) 0.9564 (0.1257) 0.5561 (0.1553) 0.8422 (0.0124) 0.6200 (0.2356) 0.9687 (0.1210) 0.6225 (0.2967) 0.5958 (0.0653) 0.5133 (0.2598) 0.8951 (0.1519) 0.5762 (0.3196) 2.400 (0.0759) 2.981 (0.3368) 2.678 (0.2137) O.7108 (0.0329) O.7000 (0.2100) 1.030 (0.0871) 0.6024 (0.1343) 3.259 (0.1519) Concentration ratio Management profit Risk sharing (beta) Capital intensity Size log of net sales Total debt to total assets 0.4518 (0.0259) 0.4747 (0.1535) 0.4563 (0.0649) 0.4702 (0.1146)
3'
c~

Criterion variables

Large

Size

Small

High

Concentration ratio

Low

aMean (variance).

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) Independent variables and statistics Constant Management compensation ( + )a Concentration ratio ( - ) Systematic risk-beta ( - ) Size-log of net sales ( - ) Capital intensity ( - ) Total debt to total assets ( + ) Estimated R E Probit analysis Zz (d.f. = 6) ~o correctly predicted Sample size aExpected sign of coefficient. bCoefficient (asymptotic t-statistic). Large
4.46783 b (5.142) 0.43603 (2.289) -0.43965 ( - 0.897) -0.45036 ( - 1.532) -0.60938 ( - 2.652) -0.40863 ( - 1.675)

Concentration ratio Small

1.94250 (2.302) 0.17400 (0.979) -0.71274 ( - 2.058) 0.15334 (0.692) 0.13515 (0.429) -0.00183 (-0.012) 0.46989 (2.095) 0.08039 11.4547 2,0.67 ~o 150

High
3.61505 (4.056) 0.63754 (3.354) -0.83081 ( - 1.025) -0.14823 (-0.585) -0.48054 ( - 3.015) 0.11850 (0.713) 0.43733 (1.275) 0.13219 19.4534 38.67 ~o 150

Low
2.4801 (4.124) - 0.00657 (-0.037)

- 0.06863 (-0.105)
- 0.04759 (-0.192) -0.14675 (-0.732) -0.51667 (-2.337) 0.35128 (1.346) 0.06695 9.7193 34.67 ~o 150

- 0.08460 (-0.154)
0.12369 18.4801 33.33 ~o 150

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.

References
Abdel-khalik, A.R. and J.C. McKeown, 1978, Understanding accounting changes in an efficient market: Evidence of differential reaction, The Accounting Review 53, 851-868. Alchian, Armen A. and Reuben A. Kessel, 1959, Redistribution of wealth through inflation, Science 130, 535-539. Ball, R., 1972, Changes in accounting techniques and stock prices, e~npirical research in accounting: Selected studies 1972, Supplement to the Journal of Accounting Research 10, 138. Ball, R. and R. Watts, 1972, Some time series properties of accounting income, Journal of Finance 28, 633-682. Barefield, R.M. and E.E. Comiskey, 1972, The income smoothing hypothesis: An alternative test, The Accounting Review 47, 291-298. Collins, Daniel W., Michael S. Rozeff and Dan Dhaliwal, 1980, The economic determinants of market reaction to propose mandatory accounting changes in the oil and gas industry{ A cross-sectional analysis, Journal of Accounting and Economics 3, 37-71. Copeland, R., 1968, Income smoothing, Journal of Accounting Research 5, 101-116. Cushing, B.E., 1969, An empirical study of changes in accounting policy, Journal of Accounting Research 6, 196-203. Cushing, B.E. and E.B. Deakin, 1974, Firms making accounting changes: A comment, The Accounting Review 49, 104-112. Davidson, Sidney and Roman L. Weil, 1975a, Inflation accounting: What will general price level adjusted income statements show?, Financial Analysts Journal 31, 27-31, 70-81. Davidson, Sidney and Roman L. Weil, 1975b, Inflation accounting: Public utilities, Financial Analysts Journal 31, 30-34, 62. Davidson, Sidney, Clyde P. Stickney and Roman L. Weil, 1976, Inflation accounting (McGrawHill, New York). Dhaliwal, D.S., 1980, The effect of the firm's capital structure on the choice of accounting methods, The Accounting Review 55, 78 85. Eggleton, J.R., S.H~ Penman and J.R. Twombly, 1976, Accounting changes and stock prices: An examination of selected uncontrolled variables, Journal of Accounting Research 14, 89-137.

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

149

Gordon, Myron J., 1964, Postulates, principles and research in accounting, The Accounting Review 39, 251-263. Hagerman, R. and L. Senbet, 1976, A test of accounting bias and market structure, Journal of Business 49, 509-514. Hagerman, R. and M. Zmijewski, 1979, Some economic determinants of accounting policy choice, Journal of Accounting and Economics 1, 142~-161. Hollander, M. and D.A. Wolfe, 1973, Nonparametric statistical methods (Wiley, New York). Holthausen, Robert W., 1980, Theory and evidence on the effect of bond covenants and management compensation contracts on the choice of accounting techniques: The case of the depreciation switch-back, Unpublished Ph.D. dissertation (University of Rochester, Rochester, NY). Kaplan, R.S. and R. Roll, 1972, Investor evaluation of accounting information: Some empirical evidence, Journal of Business 45, 225-257. Leftwich, Richard, 1980, Private determination of accounting methods in corporate bond indentures, Unpublished Ph.D. dissertation (University of Rochester, Rochester, NY). Maddala, G., 1977, Econometrics (McGraw-Hill, New York). McKelvey, R. and W. Zavoina, 1975, A statistical model for the analysis of ordinal level dependent variables, Journal of Mathematical Sociology 4, 146-163. Smith, D.E., 1976, The effect of the separation of ownership from control on accounting policy decisions, The Accounting Review 51, 707-723. Sunder, S., 1975, Empirical analysis of stock price and risk as they relate to accounting changes in inventory valuation, The Ac~zountingReview 50, 305-315. Watts, Ross, 1974, Accounting objectives, Working paper series no. 7408 (Graduate School of Management, University of Rochester, Rochester, NY). Watts, Ross, 1977, Corporate financial statements: Product of market and political processes, Australian Journal of Management, 53075. Watts, Ross and Jerold Zimmerman, 1978, Toward a positive theory of the determination of accounting standards, The Accounting Review, 53. Watts, Ross and Jerold Zimmerman, 1979, The demand and supply of accounting theories: The market for excuses, The Accounting Review 54, 273-305. White, G., 1970, Discretionary accounting decisions and income normalization, Journal of Accounting Research 8, 260-275.