Professional Documents
Culture Documents
/. Introduction
Our assigned task is a methodological review of current empirical
research in the corporate financial reporting area. In this introductory
section, we clarify our interpretation of the task and describe how the
review is organized.
A methodological review entails using the literature's hody of research
methods as data: methodology is inquiry into method.^ Our aim therefore
* University of New South Wales; ^Stanford University, This paper benefited from
comments of participants in workshops at Baruch College CUNY, Cornell University,
Monash University, Stanford University, University of Chicago, University of New South
Wales, University of Pennsylvania, University of Rochester, and Washington University, A
special thanks is due to detailed criticisms from G, Biddle, S, Datar, L, DeAngelo, P, Dodd,
N, Dopuch, J, Elliott, N, Gonedes, C, Homgren, M, Jensen, A, Kirby, R, Leftwich, J,
Magliolo, R. Morris, C. Purvis, K, Schipper, D, Shores, R, Watts, G, Whittred, M. Wolfson,
and J, Zimmerman, Foster's contribution was sponsored by the Stanford Program in
Accounting, contributors to which are: Arthur Andersen & Co,; Arthur Young & Company;
Coopers & Lybrand; Deloitte Haskins & Sells; Ernst & Whinney; Peat, Marwick, Mitchell
& Co,; and Price Waterhouse & Co,
' Buchler [1961, p, 125] distinguishes "method" and "'methodology" in these terms: ",,,
in the broadest sense 'methodological' questions are those dealing with methods as their
subject matter, questions pertaining to the origin, scope, nature and relative value of
methods," Webster's Third New International Dictionary defines method as ''a procedure
or process for attaining an object . . . a particular approach to problems of truth or
knowledge," Methodology is defined as ''a body of methods, procedures, working concepts,
rules and postulates employed by a science, art or discipline , , , a science on the study of
method." We take "research methods" to include the selection of dependent and indepen-
dent variables, sample selection, choice of functional forms, experimental controls, statistical
inference, etc,
161
Copyright , Institute of Professional AccountinK 1983
162 CURRENT RESEARCH METHODOLOGIES IN ACCOUNTING: 1982
' By "self-select" we mean that there are considerable within-topic-area citations of prior
studies relative to between-topic-area citations. This "tendency" of the literature is baaed
on "casual" observation, but could be subject to citation and other analyses if time
permitted.
CORPORATE FINANCIAL REPORTING 163
in accounting include Box and Jenkins [1970], Spence [1973; 1974], and Jensen and Meckling
[1976],
* This perspective could help explain the relatively low rate of supply of new accounting
faculty and their relatively high price. In explaining the current market for accounting
academics and its persistence for several years, one has to explain the absence of successful
crossovers from economics. The entry costs (in terms of institutional knowledge) are high;
but in addition, we argue that the accounting researcher requires a combination of economic
training and other skills such as the ability to tolerate and work with the anomalies and
ambiguities that attempts to match theoretical constructs with institutional data can be
expected to produce. If, in contrast, the accounting research environment was simply one
of accountants improving their skills in economics, econometrics, and finance, then it would
not be possible to explain the existence of accounting researchas distinct from economics,
econometrics, and finance. Furthermore, it would not be possible to explain why the
resolution of accounting research problems has not been greatly facilitated by crossovers
from those areas. Wolfson [1981] discusses some related issues in a subsection of his paper
entitled "And You Thought That Research in Economics Was Tough!"
166 R. BALL AND G. FOSTER
tolerate relatively little anomaly and will abandon the data relatively
quickly. The researcher with relatively strong external loyalty (i.e., to
external groups such as the accounting profession, managers or policy-
makers) also will tolerate relatively little anomaly but will abandon the
theory relatively quickly. The researcher who has loyalty in both direc-
tions and the ability to tolerate the consequently higher degree of
anomaly will persist longer with the attempt to fit data and theory
together.
In making choices of research method, the empirical researcher there-
fore must recognize that "good" accounting research might not satisfy
either the disciplinary purist or the practicing accountant: it might seem
overly concerned with both explaining institutionalized data and finding
structure to the data. "Good" research methods in accounting will strike
a pragmatic balance between both extremes. In confronting theory with
data that lie in the institutional domain, the accounting researcher wiU
be fascinated by neither theory nor data alone and will be prepared to
sacrifice elements of both. We therefore believe that research in account-
ing requires a different set of trade-offs than those made in the basic
disciplines and, at the other extreme, in accounting practice.
Clearly, the rationales presented by authors need not be their actual rationfiles. One
factor that can cause "relevance to the accounting profession'' rationales to be included in
papers is the review process. Papers submitted to accounting journals often have such
rationales added due to requests from reviewers to better motivate the research,
' This conflict exists in vju-ying degrees. For instance, Deakin [1979, p, 722] examines the
descriptive validity of arguments presented at FASB, SEC, and DOE public hearings on oil
and gas accounting, e.g., "the fuU cost companies argued that they were more aggressive in
exploration, newer, and in greater need of external fimds than successful efforts companies,"
If this research is used only to conclude that statements by X or Y are descriptively valid
or invalid, the conflict noted in the text is minimal. If the results are used to make inferences
above how full cost firms might behave if successful efforts were mandated, then the conflict
exiata in the extreme,
" See Griffin [1979],
168 R. BALL AND G. FOSTER
^See Ball [1980] and Foster [1980], A compounding problem is the time pressure
individuals face when conducting sponsored studies. Consider SFAS No, 19, The FASB
"released" the exposure draft on July 19,1977, and issued the final statement in December
1977. Included in the December 1977 statement were the results of an empirical research
project (by T, R. Dyckman) on the capital market impact of the July 1977 exposure draft
A short turnaround time on a project of this difficulty means that methodological consid-
erations are less Ukely to be explored.
'" Some linkages are observable. For example, see the Altman and McGough [1974] study
linking distress prediction analysis to "going-concern" decisions by auditors and the Kinney
[1978] study linking Box-Jenkins analysis to analytical review decisions by auditors.
CORPORATE FINANCIAL REPORTING 169
[1980], Bowen, Noreen, and Lacey [1981], Leftwich, Watts, and Zimmer-
man [1981], Zmijewski and Hagerman [1981], and Chow [1982]. The
immediate relevance of the results in these papers to external parties
such as the accounting profession does not appear to be important to
these researchers. The accounting profession in the 1980s hardly seems
concerned with either (i) variables associated with the voluntary issuance
of interim reports in 1948 (as are Leftwich, Watts, and Zimmerman
[1981]) or (M) variables associated with the voluntary issuance of auditor's
report in 1926 (as is Chow [1982]). Such research is better explained by
attempts to probe the descriptive validity of predictions associated with
the stewardship paradigm.
Segments of the time-series and distress prediction literatures also
exhihit behavior consistent with researchers sharing a common paradigm.
For instance, there is evidence of common agreement among researchers
that time-series tools such as Box-Jenkins and classificatory techniques
such as discriminant analysis are appropriate and interesting ways of
addressing a variety of issues. There also is considerable citing of prior
studies in these literatures and evidence of attempts to improve the
technical aspects of these prior studies, suggesting progress via a shared
commitment to a paradigm. Researchers operating in these areas also
appear to value the judgments of their colleagues considerably more than
those of individuals operating outside their paradigms. For example,
researchers using Box-Jenkins time-series tools often face trenchant
criticism when their papers are reviewed by those not sympathetic to
their highly technique-oriented approach. Consider also Leftwich's [1981,
p. 241] comments on the distress prediction literature: "I find the research
intellectually unsatisfying because it is primarily a statistical exercise.
There is no theory to guide the selection of variables for inclusion in the
discriminant function, and, even if we discover variables that "work' well
(in terms of discriminating or predicting), it is not clear what we learn
from the exercise." A prediction of Kuhn's [1970] theory of scientific
behavior is that such criticisms are ignored; only the opinions of those
operating under the shared paradigm are viewed as important."
etc. These new data bases, however, raise issues of data coding not
previously addressed. For example, if one adopts the perspective that
these contracts are the starting point of an ongoing relationship between
the various parties (the opening rules of the game), then there is ambi-
guity about how to code specific clauses in the contracts. Moreover, in
some cases, a researcher might have only partial information on these
contracts. For instance, many proxy statements do not provide full details
of management compensation agreements. The researcher has to decide
whether these types of problems can be solved satisfactorily: there can
be a distinct trade-off between the level of interest and innovation in a
research program and the availability of reliable and relevant data.
Other data of special interest to researchers associated with the
"stewardship" paradigm are the financial statements issued by corpora-
tions prior to regulatory interventions such as the Securities Exchange
Act of 1934, as in Benston [1969] and Watts [1977]. Again, potentially
troublesome data issues arise when conducting research in this area. For
example: (i) the term "financial statement" needs to be defined precisely
since some companies issued financial information only in narrative form
while others included a balance sheet and income statement, and (ii)
even of the suhset of companies still surviving, not all have records of
their early financial statements let alone details of to whom they were
sent."
Data quality issues also arise in the time-series and distress prediction
areas. For instance. Box and Jenkins [1970] discuss identification and
estimation issues for stationary time series. Given the high level of
acquisition and divestiture activity of some firms, an assumption of
stationarity for even a ten-year period might appear extreme. Yet, ten
years provides only ten annual earnings observations, and one cannot
expect such a small data base to teU a very refined story about the
behavior of the series over time. The researcher needs to make these
kinds of trade-offs.
'* Cook and Campbell [1979, pp, 230-32] discuss some of these issues under the heading
of "Limitations of Much Archival Data,"
172 R. BALL AND G. FOSTER
in the mid and late 1970s. In the late 1970s, algorithms for Box-Jenkins
multivariate time-series analysis became readily available. The account-
ing literature now reflects papers using this technique to examine (or
reexamine) a variety of issues, including earnings forecasting and the
importance of industry and economy factors in the behavior of the
earnings of individual firms.
Technique developments hy econometricians and statisticians also
appear important in the distress prediction literature. Early multivariate
studies in this area used linear discriminant analysis, as an Altman [1968]
and Deakin [1972]. One of the stated motivations given in several sub-
sequent studies was the use of "recent advances" in discriminant analysis.
For instance, Altman, Haldeman, and Narayanan [1977, p. 29] examine
the use of quadratic discriminant analysis and the "explicit introduction
of prior probabilities of group membership." Subsequent studies also give
advances in technique as a major reason for undertaking the research, as
in Ohlson [1980, p. 109], which uses "maximum likelihood estimation of
the so-called conditional logit model."
Improvements in econometric and statistical techniques are a legiti-
mate source of new accounting research. However, there is always the
danger that the technique itself becomes the focus of attention. This
danger is especially apparent in literatures such as time-series analysis
and distress prediction, where the economic underpinning of the research
can be minimal. In some cases the research contribution is more to the
econometrics and/or statistics literatures than to the accounting litera-
ture.
6. SUMMARY: CHOOSING A RESEARCH TOPIC
We have identified five motives for particular empirical research pro-
jects in accounting. Presumably there are others. Several of the motives
discussed relate to the skills of a specific researcher or the value set of
the specific institution with which the researcher is associated. For
instance, a researcher with limited analj^ical skills might restrict topic
choices to areas where developed models are already available in the
literature, whereas a researcher with strong analytical skills might work
on model development as part of the research project. As a second
example, a researcher in an environment sympathetic to Box-Jenkins
time-series research might undertake a project that individuals at other
institutions would label as a "data searching exercise that will yield no
new economic insights."
It is unlikely that a single empirical project (1) will be of high interest
to an external party such as the accounting profession, (2) will be of high
interest to a research community, (3) will have models available explicitly
to guide both the research design and the drawing of inferences from the
research, (4) will have high-quality data available, and (5) will have
appropriate econometric or statistical tools available to analyze the data.
In general, trade-offs among these factors are inevitable. One interesting
CORPORATE FINANCIAL REPORTING 173
'" See Kuhn [1970] for elaboration of this point and for some definitions of the term
'paradigm," for which "accepted theory" can be loosely substituted,
"See Financial Accounting Standards Board [1981]. Hercules makes the following
comment in its 1981 Annual Report: "The company has adopted [SFAS No, 52] because
it more appropriately reflects the economic realities of managing a multinational company,"
174 R. BALL AND G. FOSTER
aging materials in order to more closely match the cost of these materials to revenues" 1980
Annual Report of Pittsburgh Brewing Co,
^' "U,S, Steel's Bracy Smith argues that it was impossible for U,S, Steel to stand alone
against the crowd unless it was willing to see its stock suffer, 'We would be very happy if
they would make the rule that everyone has to take accelerated depreciation on their books
,,, But you can't have just one company doing it'" (Minard and Wilson [1980, p, 97]),
^' We are not asserting that the coexistence of these many competing views is unique to
the accounting method choice literature in particular or even to the corporate financial
reporting literature in general. However, based on our experience with information content-
capital market research, it is our belief that an empirical researcher in the accounting
method choice area does face a relatively high degree of uncertainty on both research
design issues and the reliability of inferences drawn from any chosen design. The level of
uncertainty faced is certainly much higher than that described by Kuhn [1970] for several
"pure science'' disciplines, Kuhn's descriptions, however, might represent an unrealistic
Nirvana to an empirical researcher in corporate financial reporting. In addition, the Kuhn
[1970] perspective is not without its critics, as described in Blaug [1980],
" Wolfson [1981, pp, 213-14] takes a very strong position on this issue: "If a model of
accounting method choice is to have any empirical validity, several ingredients seem
essential: Observation is costly,,,, The choice of financial reporting methods is decentral-
ized The setting is a multi-period one. Those readers familiar with economic theory will
recognize immediately that classical equilibrium-analytical approaches will not work. Game-
theoretic solution concepts must be employed because of differentially informed players.
Although such approaches are often intractable, I believe that accounting researchers
interested in learning about accounting choices will have to get used to this,"
How an empirical researcher is to be guided by an approach that is "often intractable"
is not discussed by Wolfson, Note that his comment about the necessary ingredients for a
model to have "any empirical validity" raises important issues of model choice. An
alternative perspective would be concerned with the predictions of a model incorporating
the above ingredients vis-a-vis the predictions of competing modelssee Friedman [1953]
and Blaug [1980, chap, 4],
176 R. BALL AND G. FOSTER
^ For instance. Watts and Zimmerman [1978] code firms' submissions to the FASB on
their position on GPLA alone. Several firms, however, gave, a no-vote to GPLA in
conjunction with a yes-vote on replacement cost. For instance, the submission by Standaid
Oil of Indiana included the foUowing comment: "Adjusting historical cost statements by
application of an overall general price index . , , does not produce information which is
relevant to the intended user We would suggest that to the extent that data supple-
mental to historical cost statements would be helpful, they should appropriately embrace
a replacement cost concept," We are indebted to Marsha Puro for this example.
A multiperiod, multimethod perspective would incorporate this (no on GPLA/yes on
replacement cost) observation as a single unit of analysis. In contrast, a single-period,
single-method perspective would treat the no/yes as two independent observations.
^ Clearly, the same individual can undertake both analytical and empirical research,
although in the studies outlined in Appendix A there is limited evidence of both types of
research being undertaken in the same paper.
CORPORATE FINANCIAL REPORTING 177
and Campbell [1979, p, 23] express this perspective thus: "The only process
available for establishing a scientific theory is one of eliminating plausible rival hypotheses.
Since these are never enumerable in advance, or at all, and since these are usufdly quite
particular and require unique modes of elimination, this is inevitably a rather unsatisfactory
and inconclusive procedure,"
^' There are deeply held differences on how seriously an empirical researcher should
even concern himself with results in several areas of analytic research, Jensen [1976, p, 14]
is very explicit on this score: "Most of the [state-preference-related] literature on [infor-
mation production and disclosure] has little or nothing to do with substantive accounting
problems, even though it has pretensions in that direction. Most of it amounts to the
generation of 'possibility theorems' The other major thrust of this analysis is in the
delineation of the set of assumptions which must be made on the form of individual utility
functions, distribution of resources, etc., in order to draw some specified set of implications.
But this work is little more than the rigorous manipulation of toy logical structures which
entirely lack empirical content. It leads to no new understanding of the workings of the
world. To this I ask: Why do we care?"
Blaug [1980, p, 192] makes some similar points in relation to general equilibrium theory
in economics: "Its leading characteristic has been the endless formalization of purely logical
problems without the slightest regard for the production of falsifiable theorems about actual
economic behavior, which, we insist, remains the fundamental task of economics,"
178 R. BALL AND G. FOSTER
'" Ball [1980] discusses these issues with specific reference to the effect of SFAS No, 2
{Accounting for Research and Development Costs) on management decisions.
CORPORATE FINANCIAL REPORTING 179
^ The numerical effect of these adjustments can appear "large," Several companies that
appeared in Fortune's (May 5,1980, p, 93) list of "The Champion Monpy Losers" had line-
items associated with plant closings, divestitures, and expropriations. For example. Ana-
conda (1971 net loss = $356,4 million). Singer (1975 net loss = $451,9 million), and
Bethlehem Steel (1977 net loss = $448,2 million).
180 R. BALL AND G. FOSTER
^ In this section, the terms "valid" and "invalid" refer to end zones of a spectrum rather
than endpoints (in the one-zero sense). Cook and Campbell [1979, p, 37] note that "when
we use the terms valid and invalid, they should always be understood to be prefaced by the
modifiers 'approximately' or 'tentatively.'"
CORPORATE FINANCIAL REPORTING 181
^' This example illustrates the overlap between the concepts of internal and external
validity,
^^ A severe problem in a control group design arises if industry pairing is attempted when
the industry is homogeneous in terms of the attribute of concern, Biddle [1980, p, 251]
notes that "in several industries (e.g., chemicals and glass) nearly all of the COMPUSTAT
firms were either already using LIFO to some extent or simultaneously adopted
LIFO Control group counterparts were not available for forty-two of the treatment
group firms," If there is a firm available to match, it might well be a sign that the control
firm is no longer in the same industry as the experimental firm even though it has the same
SIC code.
182 R. BALL AND G. FOSTER
are not unaware of this problem. The empirical work could be viewed as
a "data reduction" exercise in which the sole ohject is to predict reliably
an event like loan default; "reliable" is defined relative to an alternative
empirical-based model or the judgment of an individual. At a pragmatic
level, we have no quarrel with this approach. The error is when inferences
are drawn from such studies about the underlying attributes that distin-
guish (say) financially distressed from nondistressed firms, in such a way
as to imply valid inferences of causality.
Cook and Campbell [1979, pp. 55-56] recommend that:
Estimating the internal validity of a relationship is a deductive process in which the
investigator has to systematically think through how each of the internal validity threats
may have influenced the data. Then, the investigator has to examine the data to test which
relevant threats can be ruled out. In all of this process, the researcher has to be his or her
own best critic, trenchantly examining all of the threats he or she can imagine. When all of
the threats can plausibly be eliminated, it is possible to make confident conclusions about
whether a relationship is probably causal. When all of them cannot, perhaps because the
appropriate data are not available or because the data indicate that a particular threat may
indeed have operated, then the investigator has to conclude that a demonstrated relation-
ship between two variables may or may not be causal.
sales of $100 million to generate the same political costs (as a percentage
of sales) as a firm with $10 billion of sales. Casual empiricism suggests
that Superior Oil Company (1974 sales of $333 million) incurs consider-
ably less costs from anti-trust, 'corporate responsibility,* affirmative
action, etc. than Exxon with sales of $42 billion." They cite three sources
of evidence of the linkage between their construct and its operationali-
zation: Siegfried's [1975] evidence, an article in a financial weekly (pub-
lished five years before the experimental date), and a bill that was
unsuccessfully introduced in the U.S. Congress one year after the exper-
imental date and was not enacted by the Congress.
There are several reasons for construct validity issues being an impor-
tant concern in the Watts and Zimmerman [1978] experiment. First, the
firm size operationalization ignores industry membership, which may be
a key determinant. The oil industry supplied a majority of the large firms
in their sample. An "excess profits tax" was applied to the industry; but
the tax rate was not an increasing function of size: Superior Oil Company
was taxed at the same rate as Exxon.^^ Second, if there are fixed costs of
complying with government regulations, the relative cost of those regu-
lations could decrease rather than increase with firm size.** Third, our
interpretation of Siegfried's [1975] evidence is diametrically opposed to
that of Watts and Zimmerman. His major conclusion [1975, p. 572]
appears to be that an earlier study, in which size and profit variables did
predict antitrust action, has an obvious statistical bias. His conclusions
are based on regressions which "explain only about seven percent of the
linear variation" in antitrust action frequency, in which the coefficient on
total assets is negative (Watts and Zimmerman assume it to be positive)
and in which "none of the coefficients is very robust in this whole
analysis" [1975, p. 573]hardly evidence for a positive relationship
between size and political costs. Fourth, it seems reasonable to distinguish
(at least in terms of magnitude of political costs) between the statements
of individual politicians and the majority decision as implied in enacted
legislation.
Given the complexity of modeling the political cost phenomenon,
caution in making inferences from a finding that an asset size variable is
significant is clearly warranted.^* Equally warranted is a less casual
addition, the coefficient,,, is the most stable across various realizations and subsamples
which leads us to conclude that firm size is the most important variable." This result is not
consistent in other related studies. For instance, Bowen, Noreen, and Lacey [1981, p. 178]
find differences within their sample ''as expected, the largest firms in the oil industry
avoided use of the (typically) income and asset enhancing interest capitalization method
, , , not as expected, outside the oil industry, the larger firms were more likely to capitalise
interest,"
Firm size was reported to be imftortant in Ture's [1967] study of the adoption of
accelerated depreciation for tax after the 1954 legislation: "A larger proportion of the
property of big corporations than of small ones wtis being depreciated under the accelerated
methods in 1959 ,,." [1967, p, 25],
'^ Section VI discusses attributes other than political cost for which firm size has been
used as a proxy,
^^ Watts and Zimmerman [1978], Hagerman and Zmijewski [1979], and Bowen, Noreen,
and Lacey [1981] report insignificant results. Zmijewski and Hagerman [1981, p. 143] report
CORPORATE FINANCIAL REPORTING 185
that "it appears that the existence of management incentive plans does influence the choice
of accounting principles." As noted in Appendix A, the interpretation of the significance of
their results turns on the choice of the appropriate benchmark for their probit analysis.
186 R. BALL AND G. FOSTER
Beaver[1966]: 1954-64
Altman [1968]: 1946-65
Wilcox[1973]: 1948-72
^ We are not asserting that all areas of capital market research are blessed with large
data bases that strengthen the statistical conclusions validity of their experiments. For
instance, research on the capital market impact of accounting policy decisions such as
SFAS No, 5 (Accounting for Contingencies) and SFAS No, 19 (Financial Accounting by
Oil and Gas Producing Companies) faces severe problems with regard to statistical
conclusion validity. See Foster [1980],
188 R. BALL AND G. FOSTER
4. EXTERNAL VALIDITY
External validity "refers to the approximate validity with which we can
infer that the presumed causal relationship can be generalized to and
across alternate measures of the cause and effect and across different
types of persons, settings, and times" (Cook and Campbell [1979, p.
37]). External validity issues do not arise in projects whose sole object is
to describe a particular data base. Many of the studies presenting sum-
mary statistics on accounting method choice or corporate disclosures of
firms fall in this category. Projects which deal with populations also do
not raise external validity problems; an example would be a study that
examined all the submissions on a particular FASB agenda item and was
concerned only with drawing inferences about those who suhmitted on
that agenda item. Typically, however, authors (or readers) do seek to
generalize the findings of a study beyond the sample of firms examined
or the time period covered. This subsection provides examples of research
design choices in several topic areas that have implications for the
generalizability of the results.
Sample selection is an obvious area where the generalizability of the
results can be compromised. For instance, Kiger [1974] computes volatil-
ity measures of quarterly net income to provide evidence pertaining to
alternative interim income concepts. In the sample selection he excludes
firms that had "losses during any quarter" [1974, p. 3] in the time period.
The motivation for this exclusion criterion is not discussed but appears
to be that a transformation used on the earnings variable is not defined
for nonpositive earnings. Evidence is not given about the effect of this
exclusion criterion on the results presented about the "substantial vola-
tility" of quarterly earnings. The external validity of the experiment thus
is unclear. One way that authors could address such an issue would be to
present profile statistics pertaining to a random sample of the population
vis-a-vis the specific sample examined.
A second example of problems in external validity arises in techniques
that tend to "overfit" relative to a particular sample. This issue has
received considerable attention in the literature on classificatory tech-
niques such as discriminant analysis. Methods along the lines of Lach-
enbruch [1967] have been developed, one purpose of which is to improve
the external validity of inferences drawn from a specific sample. Yet, we
StiU observe accounting studies in this area using classificatory designs
without the use of nonoverlapping holdout samples or techniques such as
that proposed by Lachenbruch. For instance. Watts and Zimmerman
[1978, table 4] report results from seven alternative combinations of
variables in multiple discriminant functions, but do not control for the
attendant problems of overfitting the data by using a holdout sample.
The third example is taken from time-series research. While allxisions
to "structural change" are made in this literature, our understanding of
the economic factors that cause structural change and how they might
CORPORATE FINANCIAL REPORTING 189
collect the information needed for corporate report disclosure for their
internal management systems and hence little extra cost may be incurred"
(Firth [19796, p. 273]); management ability and advice: "Large compa-
nies .. are more likely to have the advice of well-qualified accounting
specialists" (Butters and Niland [1949, p. 90]); andpolitical costs: "Large
firms are now more vulnerable than small ones to government implicit
and explicit regulation" (Gagnon [1971, p. 54]).
The reader, in this context, having seen the same variable used to
proxy for many (apparently) different and competing constructs, has
good reason to expect the authors to present cogent arguments or
evidence why an inference from (say) firm size to political cost is a
credible one within their experiment. In this sense, competing theories
always are relevant in empirical work, even if the researcher does not
wish to test against those theories per se.
"^ Schipper makes this point clearly when discussing the Leftwich, Watts, and Zimmer-
man [1981] paper: "I think many of the problems with this paper occur because the theory
of agency and monitoring has not been developed sufficiently to make unambiguous
predictions on the level of detail considered in this paper" (Schipper [1981, p, 88]), L, Kelly
[1981, p, 2] also makes similar observations: "Impeding progressis the lack of a fiilly
developed model which explains the cash flow implications to the firm of alternative
accounting procedures, the concomitant effect on management's utility, and thus manage-
ment's choices from allowable alternatives or reactions to proposed and enacted standards."
*^ "The emphasis is different. Information for monitoring bonding covenants is contracted
for in advance as part of a mechanism by which the manager restricts the extent to which
his actions deviate firom the interests of shareholders or bondholders. The emphasis is on
information its part of a management control mechanism. In the alternative infonnation
function the emphasis is on the provision of information to investors to enable them to
value securities and make 'rational' investment decisions. The emphasis is on information
for market valuation" (Watts [1977, p, 63]),
CORPORATE FINANCIAL REPORTING 193
APPENDIX A
Survey of Topic Areas
This appendix provides an overview of the research issues being ad-
dressed in each of the four topic areas: (a) corporate disclosure, (6)
accoimting method choice, (c) time-series analysis; and {d) financial
distress analysis. Given the size of the Uterature in each area, the focus
is on general trends rather than specific papers.*^
A. Corporate Disclosure
Empirical studies pertaining to corporate disclosure are classified in
table 1 into four main areas: (1) content of disclosure and variables
associated with differential content, (2) disclosure indexes and variables
following journals were examined when developing the tables presented in
Apftendix A: Abacus; Accounting and Business Research; Accounting and Finance;
Accounting, Organizations and Society; The Accounting Review; Australian Journal of
Management; Conference Proceedings of The American Accounting Association; Finan-
cial Analysts' Journal; Financial Management; International Journal of Accounting
Education and Research; Journal of Accountancy; Journal of Accounting, Auditing and
Finance; Journal ofAccounting and Economics; Journal ofAccounting Research; Journal
of Banking and Finance; Journal of Business; Journal of Business, Finance and Account-
ing; Journal of Finance; Journal of Financial Economics; and Journal of Financial and
Quantitative Analysis. As with any classified bibliography, arbitrary decisions about both
(i) inclusion/exclusion and (it) classification to a specific category are made.
196 R. BALL AND G. FOSTER
CORPORATE FINANCIAL REPORTING 197
I
198 R. BALL AND G. FOSTEk
associated with different index scores, (3) timing of disclosure and vari-
ables associated with differential timing, and (4) responses to interviews
or questionnaires about corporate disclosure. An overview of these areas
is presented in this subsection.
CONTENT OF DISCLOSURES AND DISCLOSURE INDEXES
One strand of this literature presents case studies on the content of the
disclosures of individual firms. These case studies typically are used to
support arguments about the inadequacies of existing disclosure practices
or to iUustrate the proposition that managers use the financial reporting
system to present themselves in the most favorable Ught. An early
example is the literature discussing the disclosure impUcations of the
Royal Mail case litigated in the U.K. in the 1930s.^^ Examples of single-
company analyses in the 1970s and 1980s are the Briloff critiques pub-
lished in Barron's.*^ The problems of generalizing from single instances
are many; for example, (i) the single instance may be idiosjoicratic, and
{ii) it is impossible to distinguish which of several possible causes best
explains a single instance. An obvious approach to reduce these prohlems
is to examine the disclosure practices of many firms. One style is to cite
selectively individual instances that are consistent with a specific hypoth-
esis (argument or value beUef). For instance, this style is used by Ripley
[1927], Briloff [1972; 1976], and Chambers [1973].'*^ The specific instances
cited by these authors are neither presented as the expUcit source of the
hypotheses discussed nor as the data by which the hypotheses are
confirmed.^ These studies typicaUy also do not leave an "audit trail" to
indicate how the cited instances were chosen; nor is information provided
about how representative they are of the population of aU companies
reporting information to outside parties.
Another strand of this literature contains surveys of company disclo-
sures in which details of sjunple selection axe given and in which statistics
pertaining to the whole seunple are presented. In many instances, these
surveys attempt to array the data with limited evaluative inferences. The
annual editions of Trends and Technigues (published since 1948) and
many of the current publications of accounting firms faU in this category.
Another use of survey evidence has been to document disclosure levels
under different "regulatory regimes," as in Benston [1969; 1973; 1976].
Note that with this style of analysis the reader who may disagree with
" For example. The Accountant (August 8, 1931 and March 5, 1932),
*" See Foster [1979, table 1] for citations to 11 Briloff articles published in the 1970s, A
more recent example is "Lost and Found" in Barron'a (July 6,1981),
'" For example, Ripley [1927, p, 208] argued that "shareholders are entitled to adequate
information" and noted the "existing impublicity of corporations." Briloff [1972, p. 306]
argued that "many of our publicly owned corporations fail their responsibility for f^ and
fair and prompt accountability,"
'*" For debate on this point, see the exchange between Anderson and Leftwich [1974] and
Chambers [1974],
CORPORATE FINANCIAL REPORTING 199
Benston's inferences may stiU use the tables summarizing the disclosures
of firms.
A frequent use of evidence on the disclosures of firms is to make
inferences about disclosure adequacy. A heuristic framework of "more
disclosure is better" appears to guide many statements in this area. This
heuristic framework is most apparent in studies using disclosure indexes.
Cerf [1961], for instance, develops a system of points for the disclosure of
31 individual items and computed index scores for 527 U.S. companies.
One purpose of the study is to determine "the characteristics associated
with relatively superior disclosure to determine where educational and
other methods to improve disclosure should be concentrated" [1961, p.
19]. Superior disclosure is operationalized as a higher index score. A more
recent example is the Kahl and Belkaoui [1981] study on the disclosure
practices of 70 banks incorporated in 18 different countries. The authors
refer to the "superiority of U.S. banks" [1981, p. 193], because U.S. banks
have higher average disclosure index scores than the banks of the other
17 countries examined. Such an inference is the "more disclosure is
better" perspective taken to its extreme!^'
The Cerf [1961], Kahl and Belkaoui [1981], and similar studies examine
disclosure of many items. Other studies focus on specific areas such as
social responsibility disclosures or replacement cost disclosures. For
instance, KeUy-Newton [1980] conducts a content analysis of the com-
ments made by management in relation to the replacement cost disclo-
sures mandated by the SEC under ASR No. 190; the conclusion is that
"the attitudes communicated by management reveal that reservations
centered around the reUability and relevance of the disclosures" [1980, p.
318].
VARIABLES ASSOCIATED WITH DIFFERENTIAL CONTENT OF
DISCLOSURE
" The "more disclosure is better" perspective has a long tradition in the literature. An
early example is the Kaplan and Reaugh [1939] survey of the content of the 1930 and 1937
financial statements issued by 70 U.S, companies. The authors concluded that 'on vital
counte, investors are left conjecturingsales, cost of sales, depreciation, inventories and
surplus generally are so inadequately described that an investor does not have a minimum
of information upon which to form an intelligent opinion on buying or selling" [1939, p.
200 R. BALL AND G. FOSTER
" Typically, in these questionnaire studies, very little attempt is made to determine the
reasomng underlying the stated preferences of the respondents, Homgren [1955 p 575] is
one of the few efforts in this area-the concem is understanding the "security analysts'
MT,*""* "^a^^'^i **"*^ P^oPoo^ price level adjustments to financial sUtements," Lees
[1981, p. 36] seeks reasons for security analysts not favoring "mandatory disclosure of
company prepared eamings forecaste," Note that analysts can have a vested interest in
opposmg extensions of company disclosures if these disclosures compete with products
bemg marketed by themselves, wuvi*
202 R. BALL AND G. FOSTER
" A related strand of this literature aims to adjust the financial statement of all firms in
a sample to a uniform set of accounting methods. There is little recognition in these studies
of management having substantive reasons for choosing nonuniform sets of accounting
methods.
204 R. BALL AND G. FOSTER
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CORPORATE FINANCIAL REPORTING 205
206 R. BALL AND G. FOSTER
'^ This honesty problem has not gone unnoticed. One response is to be cautious when
interpreting statements by management. For instance, Lindhe [1963, p, 145] notes: "changes
in profit-sharing rates [in compensation plans] sometimes were followed by a change in
depreciation policy. Since the motives of the decision-makers are in question, there is no
true way of resolving the cause of the action," KeUy-Newton [1980, p. 318] notes: "the
arguments offered by management,,, may differ from its true reasons and motivations."
'''^ Clendenin [1941] is an early example of an author attempting to go behind "accounting
model" based rationalizations for accounting method choice.
CORPORATE FINANCIAL REPORTING 207
expensers. In inferring that this result supports a debt covenant violation effect the authors
do not analyze the actual bond covenants of the firms in their sample, Tliey appear to
assume that the same set of specific covenant restrictions applies equally to interest
capitalizers and interest expensers and hence any difference in the three financial ratios
between the two groups represents a difference in closeness of the actual ratios to their
covenant restrictions,
" The authors also report that (using equal probability benchmarks) their model is "only
significant for large firms and those in highly concentrated industries" [1981, p. 148],
CORPORATE FINANCIAL REPORTING 209
suggest that the managers of firms that adopted LIFO chose to hold
larger inventories than their control group counterparts" [1980, p. 273].
Future empirical (and theoretical) work in this area faces the difficult
chaUenge of recognizing interactions among the accounting method
choice, taxation, and financing-investment-production decisions of
finns.^
ACCOUNTING METHOD CHOICE AND DECISION MAKING
A very sizable Uterature examines how the choice of accounting method
may affect decisions made by investors, creditors, and management.
Much of this Uterature is outside the domain of this paper (see Lev and
Ohlson [1982] on capital market studies and Swieringa and Weick [1982]
on lahoratory studies). Quasi-experimental studies examining the associ-
ation between accounting policy decisions and management decisions
have been conducted on many accounting method topics, for example:
SFAS No. 2 (Accounting for Research and Development Costs)Dukes,
Dyckman, and EUiott [1980] and Horwitz and Kolodny [1980], and SFAS
No. 13 (Accounting for Leases)Ahdel-khalik [1981].
The major focus in these and many similar studies is documenting the
existence of an effect (if it exists) rather than probing explanations for
any effects that are observed. This focus reduces the abiUty to generalize
from the results of individusd studies in this area. Detailed discussion of
methodological issues in this area is reported in the proceedings of the
1980 University of Chicago conference on Studies on Economic Conse-
guences of Financial and Managerial Accounting: Effects on Corporate
Incentives and Decisions (see especiaUy the comments of BaU, MarshEdl,
and Wolfson and the repUes hy Dukes, Dyckman, and ElUott and Horwitz
and Kolodny).
C. Time-Series Analysis
The Uterature on the time-series properties of financial statement
numbers is predominantly a post-1960 phenomenon. Table 3 classifies
empirical studies into three main categories: (1) time-series modeling of
annual and interim data, (2) aggregation issues in time-series analysis,
and (3) smoothing, eamings management, and time-series analysis. Re-
search in each category is discussed below.**
^ When using any model to guide empirical research, it is important to recognize that
observing results not consistent with the model can say as much about the ability of the
model to capture the economic context managers face as about the rationality of manage-
ment. This observation is important when interpreting Biddle's [1980, p, 273] statement
that "many firms have voluntarily paid tens of millions of dollars in additional income taxes
by continuing to use FIFO rather than switching to LIFO,"
^ See Cohen and Halperin [1980] and Gonedes [1980] for discussion,
*" Surveys of this literature include Abdel-khalik [1980], Lorek, Kee, and Vass [1981],
and Hopwood and McKeown [1981a].
210 R. BALL AND G. FOSTER
CORPORATE FINANCIAL REPORTING 211
"See also Beaver, Lambert, and Morse [1980] and Freeman, Ohlson, and Penman
[1982],
212 R. BALL AND G. FOSTER
^ For example: "Apart from the risk characteristics of any company's operations and
financing, surely the most fundamental of these fundamentals were prospects for growth in
eamings and dividends Our markets were zooming and the real rockets were the
Polaroids and Xeroxes with the fastest growth records. The fast growth companies were
ones with distinctive products, aggressive managements, and many of the attributes asso-
ciated with (products) market power,,,, Exceptions to purely competitive static models
were not regarded as merely random nor strictly transient" (lintner and Glauber [1967, p.
2]).
CORPORATE FINANCIAL REPORTING 213
*' For one exception, see Barnea, Dyckman, and Magee [1972],
^ See Hopwood, McKeown, and Newbold [1982] for research on intertemporal disaggre-
gation.
214 R. BALL AND G, FOSTER
"" See, for instance, discussions of the Royal Mail case in Brooks [1933].
^^ For example: "Some of the most common and most pervasive manipulative practices
in accounting are designed to affect the presentation of eamings trends The income-
smoothing process is a rather sophisticated and insidious device" (Bernstein [1978, p, 229-
30]).
^' A detailed discussion of this literature is in Ronen and Sadan [1981],
CORPORATE FINANCIAL REPORTING 215
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CORPORATE FINANCIAL REPORTING 217
"Elam [1975] by Altman [1976], Norton and Smith [1979] by Solomon and Beck
[1980], and Ketz [1978a] by Bildersee [1978] and PateU [1978], The Bildersee [1978] and
PateU [1978] criticisms occurred as a consequence of the conference format in which Ketz
[1978] appeared. The Altman [1976] and Solomon and Beck [1980] criticisms were individ-
ually submitted to The Accounting Review,
CORPORATE FINANCIAL REPORTING 219
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CORPORATE FINANCIAL REPORTING 223