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Voluntary income increasing accounting changes : theory and further empirical investigation Coulombe, Daniel 1987

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VOLUNTARY INCOME INCREASING ACCOUNTING CHANGES: THEORY AND FURTHER EMPIRICAL INVESTIGATION By DANIEL COULOMBE C.A. B.A., Laval U n i v e r s i t y , 1979 A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY i n THE FACULTY OF GRADUATE STUDIES (Faculty of Commerce and Business Administration) We accept t h i s thesis as conforming to the required standard THE UNIVERSIT/Y\ OF BRITISH COLUMBIA March .1987 . © Daniel Coulombe, 1987 In presenting this thesis in partial fulfilment of the requirements for an advanced degree at the University of British Columbia, I agree that the Library shall make it freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the head of my department or by his or her representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. Department of C<3>AAA Cfc The University of British Columbia 1956 Main Mall Vancouver, Canada V6T 1Y3 Date Abstract This thesis presents a three step analysis of voluntary income increasing accounting changes. We f i r s t propose a theory as to why managers would e l e c t to modify t h e i r reporting strategy. This theory b u i l d s on research on the economic factors motivating accounting choices, since i t i s assumed that accounting choices are a function of p o l i t i c a l costs, manager's compensation plans and debt c o n s t r a i n t s . S p e c i f i c a l l y , we claim that adversity motivates the manager to e f f e c t an income increasing accounting change. Secondly, the thesis proposes a t h e o r e t i c a l analysis of the p o t e n t i a l market responses to a change announcement. The stock p r i c e e f f e c t of a change announcement i s examined as a function of investors' r a t i o n a l a n t i c i p a t i o n s of the manager's reporting actions and as a function of the l e v e l of information about adversity that investors may have p r i o r to a change announcement. An empirical analysis i s presented i n the t h i r d step of t h i s t h e s i s . Our empirical findings are that: 1- Change announcements, on average, have no s i g n i f i c a n t impact on the market. 2- Rela t i v e to the Compustat population as a whole, firms that v o l u n t a r i l y adopt income increasing accounting changes e x h i b i t symptoms of f i n a n c i a l d i s t r e s s , suggesting that such change announcements are associated with financial adversity. 3- Firms which voluntarily adopt income increasing accounting changes tend to exhibit symptoms of financial distress one or more years prior to the change year, suggesting that change announcements tend not to be a timely source of information conveying distress to the market. 4- There is a significant negative association between investors' proxies for prior information about adversity and the market impact of the change, especially for the subset of firms with above average leverage, suggesting that the information content of the accounting change signal is inversely related to investors prior information about adversity. The empirical results thus support the view that investors, at the time a change occurs, have information about the prevailing state of the world, and that they have rational anticipations with respect to the manager's reporting behavior. In this respect, the accounting change i s , on average, an inconsequential signal that adds l i t t l e to what investors already knew before the change announcement. i v Table of Contents Abstract i i L i s t of Tables v i i L i s t of figures v i i i Acknowledgements i x CHAPTER I: INTRODUCTION 1 CHAPTER I I : OVERVIEW OF THE LITERATURE ON ACCOUNTING CHOICES AND SUBSEQUENT CHANGES 4 1. Economic factors motivating accounting choices .... 4 2. Theories of c a p i t a l market reactions 11 CHAPTER I I I : THEORY OF THE MANAGER'S MOTIVATION TO CHANGE ACCOUNTING METHODS AND OF THE MARKET REACTION TO SUCH CHANGE 18 1. Introduction 18 2. D e s c r i p t i o n of the model 21 2.1 Overview of the economy 21 2.2 Reporting choices 27 • 2.3 Economic motivations f o r accounting choices .. 29 3. Manager's d e c i s i o n problem 34 3.1 The manager's reporting d e c i s i o n problem 35 3.2 The manager's i n i t i a l reporting strategy 36 3.3 Manager's reporting choice a f t e r the r e c e i p t of the information 37 4. Investors' r e a c t i o n to accounting changes 43 4.1 The analysis of p o t e n t i a l market responses to the announcement of income increasing accounting changes as a function of investors' r a t i o n a l a n t i c i p a t i o n s and investors' p r i o r information 43 4.2 The information revealing hypothesis 51 CHAPTER IV: EMPIRICAL ANALYSIS 55 1. Empirical strategy and design 55 1.1 Empirical t e s t i n v o l v i n g the o v e r a l l market re a c t i o n to changes announcement 55 1.2 Cross-sectional t e s t s a s s o c i a t i o n 58 1.3 Power of the empirical t e s t s 60 2. Sample 64 3. Variables measurement 74 3.1 Measures of adversity 74 3.2 Measurement of the market r e a c t i o n to the announcement of the accounting change 75 3.3 Measurement and con t r o l f o r unexpected earnings 79 3.4 Measurement of investors' p r i o r information about adversity 80 4. Empirical r e s u l t s 82 4.1 Results of the tes t s on the o v e r a l l market re a c t i o n to the announcement of accounting changes 82 4.2 Empirical r e s u l t s of our c r o s s - s e c t i o n a l tests of a s s o c i a t i o n 85 5. Conclusion 90 CHAPTER VI: CONCLUSION 93 1. Overview of thesis objectives and r e s u l t s 93 2. Comparison of our empirical r e s u l t s with p r i o r studies 96 2.1 Mechanistic hypothesis 96 2.2 Holthausen (1981) 97 2.3 Harrison (1977) 97 3. General conclusion 99 Bibliography 102 v i i LIST OF TABLES 1 Results of studies on the manager's motivation f o r accounting choices 7,8 2 Previous hypotheses of market r e a c t i o n to income increasing accounting changes and t h e i r s i g n p r e d i c t i o n 16 3 Market reactions as a function of investors' r a t i o n a l a n t i c i p a t i o n s of the manager's actions, and investors' p r i o r information 48 4 Sample fi r m e l i m i n a t i o n 67 5 Sample of firms by type of accounting changes 68 6 Sample of firms by stated reasons f o r changing methods 69 7 Median dif f e r e n c e s between sample fi r m r a t i o s and average Compustat population r a t i o s 71 8 Average sample market response to the announcement of income increasing accounting changes 83 9 Frequency d i s t r i b u t i o n of abnormal return c o e f f i c i e n t s 84 10 F i t t e d c r o s s - s e c t i o n a l model of the r e l a t i o n s h i p of investors' p r i o r information with the market response to the accounting change announcement (Unadjusted f o r he t e r o s c e d a s t i c i t y ) 86 11 F i t t e d c r o s s - s e c t i o n a l model of the r e l a t i o n s h i p of investors' p r i o r information with the market response to the accounting change announcement (Adjusted f o r het e r o s c e d a s t i c i t y ) 89 LIST OF FIGURES v i i i 1 Time path of the model 25 2 The e f f e c t of adversity on the d i s t r i b u t i o n of outcomes 26 3 Shareholders' claim as a function of the state of the world and reporting actions 45 ACKNOWLEDGEMENTS I wish to express my gratitude to the members of my thesis committee, Peter Cheng, Georges Gorelik, Steve Sefcik and e s p e c i a l l y to my thesis supervisor Gordon Richardson, f o r t h e i r guidance and support. I also wish to thank Workshop p a r t i c i p a n t s at The U n i v e r s i t y of B r i t i s h Columbia, i n p a r t i c u l a r Rex Thompson, John S. Hughes and Gerald Feltham, for t h e i r valuable comments. F i n a l l y , I want to acknowledge the constant encouragement of my wife Marie throughout these years of study at UBC. Because of her presence at my side the Doctoral Program was not only a f i r s t -rate i n t e l l e c t u a l experience but also an enjoyable personal adventure. 1 CHAPTER I  INTRODUCTION Every f i r m uses a set of accounting methods i n compiling accounting information and preparing f i n a n c i a l statements. A firm's choice of methods i s l i m i t e d to a r e s t r i c t e d set of accounting procedures c a l l e d Generally Accepted Accounting P r i n c i p l e s (GAAP). Some firms may e l e c t to change t h e i r reporting methods from time to time. As a r e s u l t of such change, the reported income may increase, decrease or i t may remain unchanged. Accounting l i t e r a t u r e has analyzed market responses to the announcement of voluntary income increasing accounting changes. Research on the issue has been mainly empirical. There i s l i t t l e current theory p r e d i c t i n g the timing and magnitude of the c a p i t a l market r e a c t i o n to accounting changes, however, and there i s no c l e a r empirical evidence favoring any of the known c a p i t a l market empirical hypotheses. The purpose of t h i s thesis i s to further investigate market r e a c t i o n to voluntary accounting changes. There are three steps i n our methodology. F i r s t , a theory explaining why managers might change accounting methods i s elaborated. This theory b u i l d s on the research on economic factors motivating the choice of accounting methods. Second, we analyze p o t e n t i a l market responses to the announcement of income increasing accounting changes. One 2 c o n t r i b u t i o n of t h i s thesis i s that a l i n k i s made between the manager's motivation to e f f e c t the change and the market r e a c t i o n to the change announcement. This i s why we analyze market response as a function of investors' r a t i o n a l a n t i c i p a t i o n s of the manager's reporting actions. We further demonstrate that investors' information about the p r e v a i l i n g state of the world, p r i o r to the change announcement, i s a key element i n determining a stock p r i c e e f f e c t r e l a t e d to income increasing accounting changes. F i n a l l y , t h i s thesis performs some empirical tests of the p o t e n t i a l market responses proposed i n the second step of our ana l y s i s . Our empirical data describe a world i n which investors have r a t i o n a l a n t i c i p a t i o n s with respect to the manager's repor t i n g actions, and i n which investors have information about the p r e v a i l i n g state of the world p r i o r to the change announcement. The existence of these two conditions implies that the accounting change has no incremental information content beyond what i s already known to investors before the announcement. Organization of the thesis Chapter II reviews the relevant theories of accounting choices and subsequent changes. Attention i s focused on the l i t e r a t u r e analyzing the economic motivations f o r s e l e c t i n g accounting methods, and on the l i t e r a t u r e that examines market response to the announcement of voluntary income increasing accounting changes. 3 The formal a n a l y t i c a l model i s presented i n Chapter I I I . The manager's reporting d e c i s i o n problem i s analyzed and the impact of adversity on the equilibrium reporting strategy i s investigated. F i n a l l y , the conditions leading to d i f f e r e n t market reactions to accounting changes are discussed. Chapter IV presents the empirical analysis designed to t e s t the empirical implications of our model and Chapter V concludes the t h e s i s . 4 CHAPTER II OVERVIEW OF THE LITERATURE ON ACCOUNTING CHOICES AND SUBSEQUENT CHANGES The l i t e r a t u r e dealing with the s e l e c t i o n of accounting methods can be divided into two categories. There i s l i t e r a t u r e on the economic factors motivating the manager to choose a p a r t i c u l a r accounting method, and there are studies analyzing the c a p i t a l market re a c t i o n to the announcement of voluntary accounting changes. Section 1 of t h i s Chapter reviews the research on the economic factors motivating accounting choices. Section 2 analyzes the theories of market re a c t i o n to voluntary accounting changes. 1 Economic factors motivating accounting choices The l i t e r a t u r e on accounting choices has demonstrated that the s e l e c t i o n of accounting methods i s at l e a s t p a r t i a l l y motivated by economic f a c t o r s . Watts and Zimmerman (1978) postulated that some economic factors may motivate a manager to s e l e c t p a r t i c u l a r accounting methods. As subsequent researchers took an i n t e r e s t i n the subject, the l i s t of factors was 5 expanded^". The major factors associated with voluntary choices of accounting methods thus f a r i d e n t i f i e d are taxation, p o l i t i c a l costs, management compensation plans, and debt c o n s t r a i n t s . 2 "Taxable income" determines the amount of tax that a f i r m must pay i n a given period. I t i s then hypothesized that firms would s e l e c t income reducing methods to minimize t h e i r tax burden. That f a c t o r , however, i s not of great importance to t h i s study for we focus only on accounting changes that have no d i r e c t tax i m p l i c a t i o n . P o l i t i c a l costs i s the term Watts and Zimmerman (1978) use to describe the impact that d i f f e r e n t lobby groups may have on the p o l i t i c a l sector to e f f e c t transfers of wealth between various members of the economy, such as unions or competitors. They assert that a p o l i t i c a l l y v i s i b l e firm, which they define as a large f i r m , w i l l be subject to such p o l i t i c a l wealth r e d i s t r i b u t i o n s . The existence of these costs thus creates an incentive to lower reported income i n order to minimize p o l i t i c a l v i s i b i l i t y . P r i n c i p a l studies on the subject include Hagerman and Zmijewski (1979), Dhaliwal (1980), Bowen, Noreen and Lacey (1981), Zmijewski and Hagerman (1981), Dhaliwal, Salamon and Smith (1982), and L i l i e n and Pastena (1982). 2 Taxable income i s determined by a d i f f e r e n t set of rules ( i . e . , the Internal Revenue Code and not GAAP). A firm's change i n accounting methods us u a l l y a f f e c t s reported income only, not taxable income. A large f i r m i s defined i n the l i t e r a t u r e i n terms of e i t h e r assets or income. 6 A number of proxies were used to te s t t h i s concept, the most important one being s i z e . Hagerman and Zmijewski (1979) also be l i e v e d that firms with higher systematic r i s k may be subject to higher accounting return, and are thus subject to negative wealth r e d i s t r i b u t i o n s . The findings presented i n Table 1^ show that there i s a s i g n i f i c a n t degree of a s s o c i a t i o n between s i z e and the s e l e c t i o n of income decreasing accounting methods. The next f a c t o r taken into consideration i s lending agreements. Some debt r e s t r i c t i o n s are functions of accounting numbers. The most common r e s t r i c t i o n s include a maximum leverage r a t i o ( t o t a l long term debt over t o t a l long term assets or equity), a minimum current r a t i o (current assets over current l i a b i l i t i e s ) , and dividend c o n s t r a i n t s . There i s obviously some incentive f o r the manager to avoid a v i o l a t i o n of such con s t r a i n t s , f o r v i o l a t i o n gives debt holders the opportunity to take over the firm. This incentive should be manifested by the choice of income increasing accounting methods i f such constraints are present. The v a r i a b l e most often used to proxy f or the existence of debt covenants was leverage. Other measures such as i n t e r e s t coverage r a t i o s and proxies for dividend constraints were also used. As Table 1 shows, leverage was found to be s i g n i f i c a n t l y r e l a t e d to the choice of income increasing accounting methods i n Table 1 presents some r e s u l t s of the studies of the economic motivation f o r accounting choices. TABLE 1 Results of studies on the manager's motivation f o r accounting choices FACTORS POLITICAL COSTS COMPENSATION PLAN DEBT CONSTRAINTS Proxy Size Risk Man comp Corp Control Leverage Expected association (-) (-) (+) (+) (+) of factors with accounting choices, (-) factor favors income decreasing methods, (+) factor favors income increasing methods. PAPERS Hagerman and Zmijewski (1919} Depreciation ( -#) ( -#) (-H§) Investment c r e d i t ( -@) ( -ns) (+ns) Pension funds ( -ns) ( -ns) (+#) Dhaliwal (1980) Succ e f f o r t vs (+@) F u l l costs Zmij ewski and Hagerman (1981) Income strategy (-!) (-ns) (+#) (+#) Bowen et a l . (1981) Interest expense (-)l (+)2* (+#) TABLE 1 (continued) Results of studies on the manager's motivation for accounting choices FACTORS POLITICAL COSTS COMPENSATION PLAN DEBT CONSTRAINTS Proxy Expected a s s o c i a t i o n of factors with accounting choices, (-) factor favors income decreasing methods, (+) factor favors income increasing methods. Size Risk Man comp Corp Control Leverage (-) (-) (+) (+) (+) PAPERS Dhaliwal et a l . (1982) Depreciation (-&) (+@) (+@) L i l i e n and Pastena (1982) O i l and Gas (-#) (+#) Daley and V i g i l e n d (1983) Research and Development costs (-#) (+#) Notes: 1: For firms i n the o i l and gas industry 2: For firms not i n the o i l and gas industry ns: Not s i g n i f i c a n t ! : S i g n i f i c a n t below or equal to 1% #: S i g n i f i c a n t between 1% and 5% @: S i g n i f i c a n t between 5% and 10% &: S i g n i f i c a n t between 10% and 15% *: Results inconsistent with the theory 9 a l l occurrences, which stresses the importance of t h i s economic fa c t o r i n accounting choices. F i n a l l y , the argument underlying the manager's compensation plans f a c t o r i s that i f h i s compensation i s dependent upon accounting numbers (e.g., bonus plan), the manager w i l l have an incentive to pick income increasing accounting methods. Healy, Kang and Palepu (1986) found evidence that managers may increase t h e i r remuneration by s e l e c t i n g income increasing accounting methods. Their analysis r e j e c t s the hypothesis that the compensation committee adjusts the bonus income base to undo the e f f e c t of the accounting change that has occurred. In the l i t e r a t u r e , the proxy measures used f o r the manager's compensation were e x i s t i n g bonus plans and ownership co n t r o l status. In the l a t t e r case, i t i s argued that managers of firms with d i f f u s e ownership w i l l maximize t h e i r monetary and non-monetary compensation by maximizing income. As Table 1 shows, there i s some empirical evidence supporting the manager's compensation plan as a fac t o r motivating accounting choices. Analysis E m p i r i c a l l y , the objective of research on economic factors i s to look f o r an a s s o c i a t i o n between these factors and the choice of income increasing or decreasing methods. The focus i s us u a l l y on two methods of accounting f o r the same event, one of which i s income increasing and the other, income decreasing. There i s a weakness i n t h i s procedure. Firms must make many accounting choices. I t i s the whole reporting strategy rather than a s i n g l e method that i s a function of the above mentioned economic f a c t o r s . Consequently, focusing on one method only, as most of the above studies do, reduces the power of the empirical t e s t s . The r e s u l t s of Table 1 nevertheless provide some evidence that economic factors motivate the manager's choice of accounting methods. This t h e s i s adopts a perspective that circumvents the problem of focusing on one p a r t i c u l a r accounting method: we have chosen to focus on the manager's motivation to change accounting methods. Our model assumes that accounting choices are motivated by the p o l i t i c a l costs, debt r e s t r i c t i o n s and manager's compensation mentioned above. I t i s then postulated that, i n the event of adversity, the manager w i l l e f f e c t an, income increasing accounting change (see propositions 1 and 2 subsection 3.3, Chapter I I I ) . Our analysis, however, allows the manager to react by changing any accounting method. The second objective of t h i s research i s to investigate p o t e n t i a l market responses to the announcement of income increasing accounting changes. The following s e c t i o n reviews the previous l i t e r a t u r e on t h i s subject. 11 2 Theories of c a p i t a l market reactions Since many reporting decisions have no income tax 5 implications to a firm, t h e i r impact on income was i n i t i a l l y hypothesized to be cosmetic. This i s why e a r l i e r studies such as B a l l (1972), Archibald (1972) and Kaplan and R o l l (1972) focused t h e i r analysis on t e s t i n g whether investors would react p o s i t i v e l y to income increasing accounting changes. This market conjecture i s c a l l e d the mechanistic hypothesis. I t i s aimed at t e s t i n g whether investors are duped by a change i n accounting methods that has no cash flow implications. In other words, investors are hypothesized to react "mechanistically" to the income e f f e c t of an accounting change. Stated i n i t s n u l l form, the hypothesis asserts that there should be no market r e a c t i o n i n the event of a voluntary income increasing accounting change that has no cash flow implications to the firm. Archibald (1972) r e f e r s to t h i s n u l l v e r s i o n as the " e f f i c i e n t market By tax implications we mean the increase or decrease i n tax payments f o r the firm which are caused by the change i n accounting methods. Not a l l changes i n accounting methods a f f e c t the c a l c u l a t i o n of taxable income, however. hypothesis". But as Foster (1978) writes, one must be c a r e f u l i n i n t e r p r e t i n g t h i s n u l l hypothesis: Tests of the mechanistic hypothesis, v i a accounting change studies, have examined i f p o s i t i v e earnings changes for change firms were associated with p o s i t i v e p r i c e changes and v i c e versa. To r e j e c t the hypothesis i t was s u f f i c i e n t to f i n d no such p o s i t i v e a s s o c i a t i o n . . . . The question of whether these studies are consistent with c a p i t a l market e f f i c i e n c y i s a much deeper issue, one would need to independently p r e d i c t the "appropriate r e a c t i o n " . . . . The notion of an "appropriate" r e a c t i o n i s i l l - d e f i n e d and, as yet, poorly operationalized. For t h i s reason, we choose to i n t e r p r e t the accounting change l i t e r a t u r e as tests of the mechanistic hypothesis rather than as tests of market e f f i c i e n c y , (p.357) The r e s u l t s of the studies mentioned above provide no c l e a r evidence supporting the mechanistic hypothesis. As Foster mentions, however, the r e s u l t s are not n e c e s s a r i l y consistent with market e f f i c i e n c y . More recent l i t e r a t u r e on accounting choices has focused on the analysis of economic factors that could motivate the choice of p a r t i c u l a r accounting techniques as demonstrated i n s e c t i o n 1 above, namely debt r e s t r i c t i o n s , p o l i t i c a l costs and manager's compensation. These p o t e n t i a l economic impacts of accounting choices l e d Holthausen (1981) to develop a theory p r e d i c t i n g a p o s i t i v e market r e a c t i o n to an income increasing accounting change. He states that: "Recent evidence suggests that there are economic be n e f i t s associated with the choice of accounting procedures which have not been s a t i s f a c t o r i l y explored." [p 46]. The impact of the change of d i f f e r e n t accounting methods on income has accordingly evolved from a cosmetic (mechanistic hypothesis) to an economic impact, for i t i s now b e l i e v e d that d i f f e r e n t accounting methods may have economic implications without having d i r e c t cash flow (income tax) imp l i c a t i o n s . Holthausen conjectures that the market should react p o s i t i v e l y to a voluntary accounting change from the accelerated to the s t r a i g h t l i n e depreciation method, which i s an income increasing accounting change. His theory p r e d i c t s that shareholders' wealth would increase as a r e s u l t of t h i s income increasing accounting change. His argument i s contingent on the c o n f l i c t of i n t e r e s t between shareholders and bondholders. More p r e c i s e l y , he asserts that a manager faced with constraints on investment and financing decisions has an incentive to r e l a x those constraints i f the value of equity can be increased^. Equity holders would therefore b e n e f i t i n terms of wealth trans f e r from relaxed c o n s t r a i n t s , which holding constant the value of the firm, would i n turn reduce the debt holders' claim. Wealth t r a n s f e r s , for example, could occur by paying higher dividends or by taking on r i s k i e r projects when constraints are relaxed. Holthausen hypothesizes that the stock market r e a c t i o n should be p o s i t i v e l y associated with, among other things, leverage as a proxy f o r covenant tightness. In Holthausen's model, the manager maximizes equity value. Holthausen's r e s u l t s are weak and inconsistent with h i s hypothesis. He could not provide evidence favorable to a wealth t r a n s f e r hypothesis. Furthermore, and contrary to expectations, he finds a negative and s i g n i f i c a n t a s s o c i a t i o n between leverage and the market impact on accounting changers. Holthausen's theory does not consider the p o s s i b i l i t y that debt holders and shareholders may have had r a t i o n a l a n t i c i p a t i o n s with respect to the manager's reporting actions at the time they entered into the o r i g i n a l contracts. I f that were the case, the act of changing accounting methods could convey to the market information about the firm's s i t u a t i o n that l e d the manager to e f f e c t the change i n the f i r s t place. Harrison (1977) proposed a s i g n a l i n g r o l e f o r accounting changes, but without the b e n e f i t of a model to demonstrate why such acts are c r e d i b l e as sig n a l s . As he states: Discretionary [accounting changes] can serve as signals regarding firm's production-investment decisions or expectations about future cash flows (e.g., tax payments). A l t e r n a t i v e l y , they may be made i n order to conform to l e g a l requirements, such as debt or other covenants, or they may be induced by the desire to smooth income i n unusually p r o f i t a b l e periods or to keep an earnings trend from tapering o f f . . . . Therefore, while [accounting changes], per se, may appear to have no substantive e f f e c t on the e n t i t y , the j o i n t i m p l i c a t i o n of the change and other events i n the fi r m may have some substance. For t h i s reason, p r e d i c t i n g the market e f f e c t s of most d i s c r e t i o n a r y [accounting changes] i s a very tenuous a c t i v i t y . [p 85] Harrison's intent was to show that the d i s c r e t i o n a r y c h a r a c t e r i s t i c could be one determinant of market r e a c t i o n to an accounting change. As we mentioned above, he does not set out a formal model c l a r i f y i n g h i s p r e d i c t i o n s and t h e i r genesis. His findings reveal a s i g n i f i c a n t negative market r e a c t i o n to income increasing accounting changers, although h i s r e s u l t s are subject to some methodological c r i t i c i s m ^ . Analysis Up to present time, there have been two c l e a r sign p r e d i c t i o n s with respect to market re a c t i o n to the announcement of income increasing accounting changes: these are a p o s i t i v e r e a c t i o n and a zero r e a c t i o n (see Table 2). The t h e o r e t i c a l arguments underlying these p r e d i c t i o n s — t h e mechanistic hypothesis, the wealth transfer hypothesis and the no e f f e c t h y p o t h e s i s — a r e incomplete since they ignore the manager's i n i t i a l motivation to e f f e c t a change. They also ignore possible existence of investors' r a t i o n a l a n t i c i p a t i o n s with respect to the manager's motivations to e f f e c t an income increasing accounting change. This thesis d i f f e r s from e a r l i e r research on c a p i t a l market impact i n two ways. F i r s t , we consider the p o t e n t i a l investors' r a t i o n a l a n t i c i p a t i o n s with respect to the manager's reporting behavior. I f investors' r a t i o n a l a n t i c i p a t i o n s e x i s t s , the stock p r i c e e f f e c t of the accounting change announcement i s a function of the manager's motivation to e f f e c t the change. Second, we We discuss Harrison's r e s u l t s i n Chapter V. 16 TABLE 2 Previous hypotheses of market re a c t i o n to income increasing accounting changes and t h e i r sign p r e d i c t i o n HYPOTHESES PREDICTIONS Mechanistic No e f f e c t Wealth t r a n s f e r (Holthausen (1981)) + demonstrate that the level of information investors have about the state of the world is also a key element in determining market reaction to accounting changes. Our theory is presented in Chapter III. CHAPTER III THEORY OF THE MANAGER'S MOTIVATION TO CHANGE ACCOUNTING METHODS  AND OF THE MARKET REACTION TO SUCH CHANGE This Chapter presents a model that analyzes the manager's repor t i n g actions and evaluates investor r e a c t i o n to the announcement of an income increasing accounting change. We postulate that adversity i s an economic event that motivates the manager to e f f e c t an income increasing accounting change. We then analyze the market r e a c t i o n to an income increasing accounting change as a function of investors' information about the p r e v a i l i n g state of the world before the announcement of the change, and as a function of investors' r a t i o n a l a n t i c i p a t i o n s of the manager's reporting actions. The Chapter i s organized as follows. Section 1 provides an in t r o d u c t i o n documenting the motivation f o r our model. The model i s presented i n se c t i o n 2. Section 3 analyzes the manager's repor t i n g d e c i s i o n as adversity sets i n . The market theory of investors' reactions to income increasing accounting changes follows i n se c t i o n 4. 1. INTRODUCTION E a r l i e r conjectures about the market impact of income increasing accounting changes were that investors are naive and would react p o s i t i v e l y to the change announcement or that a change would not induce any r e a c t i o n since i t has no cash flow implications to the firm. More recently, Holthausen (1981) developed a market hypothesis based on research on economic motivations f o r s e l e c t i n g accounting methods, that p r e d i c t s a p o s i t i v e market r e a c t i o n to voluntary income increasing accounting changes. The following quote from Foster (1986), however, c r i t i c i z e s the recent development of market theories of accounting changes: The subsequent l i t e r a t u r e (subsequent to the l i t e r a t u r e on the mechanistic hypothesis) has hypothesized that accounting changes are associated with factors that have cash flow consequences, f o r example, taxation payments, borrowing costs, management compensation costs, and p o l i t i c a l costs.... At present, there i s l i t t l e i n the form of a developed theory to p r e d i c t the magnitude and timing of the c a p i t a l market r e a c t i o n to the hypothesized cash flow consequences of accounting changes. (p396-397) The c o n t r i b u t i o n of the model i n t h i s thesis i s that i t provides some of the missing theory alluded to by Foster. The model generates new testable implications and also provides a t h e o r e t i c a l framework from which to i n t e r p r e t e x i s t i n g empirical work. The f i r s t objective of the model i s to demonstrate that, under c e r t a i n conditions, adversity w i l l lead a manager to e f f e c t an income increasing accounting change, i f the i n i t i a l choice of r e p o r t i n g methods i s a function of the economic factors discussed i n Chapter I I : the manager's compensation, p o l i t i c a l costs and debt r e s t r i c t i o n s . Proposition 1 demonstrates that where there are no r e s t r i c t i v e debt covenants, adversity w i l l motivate the manager to change the reporting strategy by adopting an income increasing accounting change, provided that expected remuneration can be a l t e r e d by the change. Proposition 2 shows that i f adversity i s accompanied by a s t r i c t l y p o s i t i v e p r o b a b i l i t y of t e c h n i c a l default, the manager w i l l adopt an income increasing accounting change that produces a reported income higher than otherwise ( i f adversity does not create a p o s i t i v e p r o b a b i l i t y of d e f a u l t ) . The second objective of the model i s to analyze the market r e a c t i o n to income increasing accounting changes. This study examines the idea that the market's r e a c t i o n to an accounting change i s l i n k e d to the manager's motivation f o r e f f e c t i n g the change^-. We therefore evaluate p o t e n t i a l market r e a c t i o n as a function of investors' information about the state of the economy p r i o r to the change announcement, and as a function of investors' r a t i o n a l a n t i c i p a t i o n s of the manager's reporting behavior. S p e c i f i c a l l y , we claim that i f investors have r a t i o n a l a n t i c i p a t i o n s with respect to the manager's future reporting actions at the contracting time and i f information asymmetry p r e v a i l s , the accounting change w i l l convey information about adversity to the market. Proposition 3 demonstrates that the I am indebted to Professor Rex Thompson for e a r l y discussions about t h i s idea, e s p e c i a l l y the notion that the market's predicted r e a c t i o n to any voluntary p o l i c y change by management i s confounded by market inferences about what new information l e d to a change i n p o l i c y . market r e a c t i o n i n such a case w i l l be negative. Proposition 4 shows that the magnitude of the market impact w i l l be an inverse function of investors' p r i o r knowledge of adversity before the accounting change. 2 DESCRIPTION OF THE MODEL We analyze the choice of reporting methods i n an economy where there i s only one fir m and one manager. An overview of t h i s economy follows i n subsection 2.1. A d e s c r i p t i o n of the reporting a c t i o n i s presented i n subsection 2.2. The economic motivations underlying the choice of accounting methods are presented i n subsection 2.3. 2.1 Overview of the economy o This i s a two period model . At time t-=0, the manager presents an investment project to investors (shareholders and debt holders) who supply funds to the manager. There i s symmetry of information at the contracting time. The outcomes are uncertain. There are two possible states of the world: e i t h e r the economy i s good (state "g") or adversity sets i n and the economy i s bad (state "b"). At time t=0 a f t e r contracting, the manager takes one productive a c t i o n that i s unobservable to investors and a f f e c t s 2 The model can best be seen as a two period window of a multi-period model. the outcome of both periods, and one reporting a c t i o n that i s observable to investors. The manager learns which state of the world w i l l p r e v a i l over the next two periods, s h o r t l y a f t e r choosing h i s productive act and i n i t i a l r eporting strategy. The manager i s allowed to adjust h i s reporting strategy i n response to h i s new p r i v a t e information on r e c e i v i n g t h i s information. He i s not allowed to fu r t h e r modify h i s reporting strategy and the rev i s e d s e l e c t i o n w i l l predominate u n t i l the end of period two. Only the manager observes the r e a l outcomes of the two periods. A f t e r learning the outcomes of each period, the manager, using h i s re v i s e d reporting strategy, computes the reported outcome that w i l l be reported to shareholders and bondholders. I t i s assumed that the reported outcome w i l l be independently v e r i f i e d by an external auditor to ensure that i t i s t r u t h f u l l y represented and consistent with the manager's announced reporting strategy. Investors do not receive any information s i g n a l as to which 3 state of the world p r e v a i l s and observe only the reported outcome prepared by the manager. I t i s assumed that investors cannot i n f e r the r e a l outcome from t h e i r observation of the reported This assumption i s relaxed i n propositions 3 and 4. outcome and of the manager's reporting strategy . Consequently, there is information asymmetry after time t=0. The manager's modification to the reporting strategy, however, is observable by investors'* who can then react by revising the value of their claim to the project outcome. The project outcome for the f i r s t period is realized at time t=l. The manager computes the reported outcome and reports i t to investors. He then receives his compensation as a function of that reported outcome. If there is technical default on bond covenants written on the reported outcome, the firm is taken over by the debt holders and the manager is dismissed, although he s t i l l receives his remuneration for period one. If default occurs at the end of period one, however, i t is assumed that the manager cannot earn his opportunity wage elsewhere for the second period. Since he loses his second period remuneration, the manager's u t i l i t y is adversely affected by bankruptcy^. If there is no default, the l i f e of the firm continues. At the end of period two, the manager is remunerated as a function of the reported outcome of period two, and pays back his debt or renegotiates a ^ This assumption is based on the stylized empirical fact that a summary of the major accounting methods used by management is disclosed in the financial statements along with reported outcome. However, such information is not sufficient for one to infer the real outcome to the firm for the period. When an accounting change occurs, the firm reports both the news of the change and the effect that the change had on the reported outcome for the period. ^ This could be interpreted as an adverse effect of bankruptcy on a manager's reputation. new set of contracts f o r future periods. Figure 1 indicates the time path f o r the two periods of t h i s model. Notation We w i l l use the following notation throughout the a n a l y s i s : B = The amount invested by debt holders, (there i s no i n t e r e s t i n t h i s model). X t = The end of period t cash flow to the fi r m which cannot be negative. I t i s assumed that X-^  and X2 e [a,/3] where a,fS >0. f ( X t ) = The density function of the outcome X t. I t i s assumed that X^ and X2 are independent^. r — The i n i t i a l r eporting strategy. r' = The re v i s e d reporting strategy. r X t = The reported value of X t. Adversity In t h i s t h e s i s , adversity i s assumed to be a s t r i c t f i r s t order s t o c h a s t i c s h i f t i n the d i s t r i b u t i o n of outcome as i l l u s t r a t e d by Figure 2. The expected r e a l outcome under the good state i s The density function of the outcomes i s assumed to s a t i s f y the standard properties of a continuous density function. The cumulative d i s t r i b u t i o n function i s assumed to be d i f f e r e n t i a b l e with respect to outcome X. Time path of the model FIGURE 1 t=0 t=l t=2 Contracts are signed Manager's choice of productive action Manager's i n i t i a l choice of reporting strategy Information Revision of the reporting strategy Investors' reaction to the change Realization of Xj The manager i s remunerated If default the manager i s dismissed - Realization of X 2 - The manager receives his remuneration FIGURE 2 - The effect of adversity on the distribution of outcomes and under the bad state is "th- f W x t ) d x f C l e a r l y , by f i r s t order stochastic dominance, / i t > A*tD-2.2 Reporting choices The manager of a fi r m must make a number of reporting choices. Some reporting methods are income increasing and others are income decreasing. The choice of accounting methods i n any given period has repercussions on future periods, i n that income can only be s h i f t e d back and f o r t h through time with d i f f e r e n t accounting procedures. The s e l e c t i o n of income increasing accounting procedures i n the f i r s t period of a firm's l i f e , f o r example, w i l l lower the reported income i n future periods. We model the accounting choices i n a two period model and we do not allow f o r the s e l e c t i o n of methods i n the f i r s t period to catch up i n the second period f o r the following reasons: 1- To take the catching up e f f e c t into account, one would have to model accounting choices i n a multi-period economy with more than one firm, since managers have short term appointments, and we do observe managers moving from f i r m to firm. I f a manager leaves a firm, h i s replacement has to deal with the s e l e c t i o n of methods l e f t by the o l d manager. I t 28 seems l o g i c a l , therefore, to assume that managers make t h e i r choices of reporting methods over a l i m i t e d time horizon. I f such i s the case, the catching up e f f e c t i s u n l i k e l y to occur over the same time horizon. 2- The length of a firm's l i f e i s never known i n advance. I f a fi r m continues to expand, and therefore to c a p i t a l i z e assets, the catching up e f f e c t of e a r l y accounting choices can be postponed even furt h e r into the future. Modeling accounting choices over a two period horizon has merit f o r the reasons c i t e d above. Our model can then be seen as a two period window of a multi-period model our manager uses as the time horizon i n h i s reporting decisions. For a n a l y t i c a l purposes, we have reduced the choice of accounting methods to the s e l e c t i o n of one reporting strategy " r " . The choice of using a l l methods that increase reported income w i l l Q be c a l l e d the most income increasing strategy . The most income reducing strategy i s the choice of a l l allowable methods that reduce the value of reported income. These reporting s t r a t e g i e s w i l l be represented as: r = The most income increasing strategy r L = The most income reducing strategy Q The reporting methods that a manager may choose are assumed to be r e s t r i c t e d to the Generally Accepted Accounting P r i n c i p l e s . 29 and r > . The manager Is free to choose any reporting strategy between r and r ^ . 2.3 Economic motivations for accounting choices The basic motivation underlying the reporting d e c i s i o n i s b e l i e v e d to be economic, i n that the reporting strategy may a f f e c t future cash flows to the firm. Holthausen and Leftwich (1983) suggest three causal l i n k s between firms' cash flows and reported q f i g u r e s . They are : - p o l i t i c a l v i s i b i l i t y , -lending agreements, and -management compensation plans. Our analysis assumes that the manager's reporting behavior i s motivated by these three economic f a c t o r s . P o l i t i c a l v i s i b i l i t y P o l i t i c a l v i s i b i l i t y i s the term used to describe the impact of reported accounting numbers on the way d i f f e r e n t lobby groups such as employees, consumers, unions or p o l i t i c i a n s react. These groups can induce p o l i t i c i a n s to e f f e c t adverse wealth r e d i s t r i b u t i o n s . I t i s believed that p o l i t i c a l l y v i s i b l e firms have incentives to choose income reducing accounting methods to Q A fourth l i n k i s also mentioned, but i t p r i m a r i l y concerns u t i l i t y companies. This fourth l i n k , which i s very close to p o l i t i c a l v i s i b i l i t y , w i l l be not be treated separately i n t h i s study. avoid the p r o b a b i l i t y of being adversely a f f e c t e d by wealth r e d i s t r i b u t i o n s . Previous l i t e r a t u r e assumes that p o l i t i c a l v i s i b i l i t y i s a function of the reported income, f o r a high reported income could t r i g g e r high p o l i t i c a l costs. In our model, the manager i s assumed to take these p o t e n t i a l t r a n s f e r s of resources into account i n h i s s e l e c t i o n of accounting methods, since p o l i t i c a l costs reduce cash flows to the fi r m thereby lowering the reported outcome f o r a given reporting strategy. This decrease i n reported outcome w i l l i n turn reduce the manager's remuneration. The fi r m i n our model i s assumed to be a f f e c t e d by p o l i t i c a l costs as a function of i t s p o l i t i c a l v i s i b i l i t y . I t seems reasonable to assume that a firm i s p o l i t i c a l l y v i s i b l e i f i t s past reported outcomes were high. We assume i n t h i s t hesis that p o l i t i c a l costs are defined as PC(X 1,X 2) - ( a r X 1 ) ( r X 2 ) , (1) where "a" represents a firm s p e c i f i c f a c t o r . The term (arX^) represents the p o l i t i c a l v i s i b i l i t y f a c t o r and i s a function of the period one reported outcome. In other words, the p o l i t i c a l sector observes the reported outcome of period one, and from t h i s observation decides how much to tax the fi r m i n period two. Actual p o l i t i c a l costs occur i n period two. The reported outcome of period two, with the tax rate c a l c u l a t e d from the outcome of period one, determines the total p o l i t i c a l costs as defined i n (1). P o l i t i c a l costs have the following properties: 3PC/3r > 0 3PC/3X-L > 0 3Pc/ax 2 > o, The higher the reported outcome, the higher the p o l i t i c a l cost. It is also assumed that the p o l i t i c a l costs in period two cannot exceed the reported outcome for period two. That i s , rX 2 - (arX 1)(rX 2) >0, or that (arX x) < 1. (2) Lending agreements Lending agreements often restr i c t the activities of the firm and many of these restrictions are expressed in terms of accounting numbers. The violation of a restriction places the firm in a position of technical default, which in turn gives bondholders the right to repossess the firm. The existence of such restrictions is believed to motivate the manager to select income increasing accounting methods. In our two period model, we assume a debt constraint exists that requires the reported outcome at time one (rX^) to be equal to or greater than debt value B. If default occurs, debt holders take over the firm. The manager's contract is terminated; he receives h i s remuneration f o r period one but loses h i s remuneration f o r period two^. The following notation i s then added: S «= The lowest possible value of X^ that would not t r i g g e r d e f a u l t f o r period one. In terms of the d e f i n i t i o n of debt covenant, we have: B - v8 = 0 so, Hence, 8 i s a function of the selected reporting strategy as the debt r e s t r i c t i o n i s a function of the reported outcome. Through these r e l a t i o n s h i p s , the manager, by h i s s e l e c t i o n of reporting methods, can have some control over the v a r i a b l e 8 . S p e c i f i c a l l y , the p a r t i a l d e r i v a t i v e of 5 with respect to r i s 8 - B/r (3) 38/dx = -B/r"1 < 0. (4) Then, since (4) i s negative, the manager reduces the debt co n s t r a i n t by increasing r. The p r o b a b i l i t y of default can now be defined as: a (5) As mentioned i n footnote 4, the manager i s assumed to be penalized i n the event of t e c h n i c a l default on debt covenants. 33 and i t s partial derivative with respect to r is 3F(S)/dr - f(S)8S/dr < 0. (6) The manager can clearly reduce the probability of default by increasing his reporting strategy. The management compensation plan Management compensation plans often provide for the sharing of profits in excess of a target level. The bonus calculation is frequently based on reported accounting income. It is therefore hypothesized that the presence of a profit sharing plan induces the manager to select income increasing accounting methods. In our model, the manager takes two actions, one productive action and one reporting action. Our manager is assumed to be risk averse. If he is to be motivated to select the optimal 11 productive act for the firm under moral hazard , i t is well known that his remuneration must be dependent upon the risky outcome. The manager's compensation, function Z in our model, is consequently assumed to be monotone increasing in reported outcome in order to solve the moral hazard problem on his productive 12 13 action ' . To simplify the mathematics in our model, i t is ^ His productive act is assumed to be unobservable by investors. 12 The manager's remuneration function Z is assumed to be the solution of a typical principal agent problem as studied, for example, by Harris and Raviv (1979) or Holmstrom (1979). 13 Conditions under which monotonic contracts are optimal can be found in Grossman and Hart (1982). assumed that the manager has a l i n e a r remuneration function i n the form Z(rX t) = ZrX t where 0 < Z < 1. I t i s further assumed that the reported outcome i s subject to an independent audit, which eliminates the p o t e n t i a l source of furth e r information asymmetry, namely, a s i t u a t i o n whereby the manager can misrepresent the reported outcome. The information asymmetry which now remains and cannot be eliminated i s the manager's p r i v a t e knowledge of the state of the w o r l d ^ . The next s e c t i o n presents the manager's de c i s i o n problem. 3 MANAGER'S DECISION PROBLEM This s e c t i o n analyzes the manager's reporting decisions. The manager's problem i s presented i n subsection 3.1. The i n i t i a l r e p o r t i n g strategy i s analyzed i n subsection 3.2. In subsection 3.3, we evaluate the manager's reporting strategy a f t e r he receives information about the state of the world. To induce t r u t h f u l r e v e l a t i o n of t h i s p r i v a t e information, the p r i n c i p a l has to compensate the manager independently of the reported outcome. Unfortunately, such a contract would induce a minimum productive e f f o r t from the manager (see Ng and Stockenius (1979)). 35 3.1 The manager's reporting d e c i s i o n problem Since the manager's compensation i s a function of reported outcome only, he i s assumed to maximize h i s remuneration i n h i s choice of r and r ' . The expected r e a l outcome for periods one and two are u-^ and u2- P o l i t i c a l costs as indi c a t e d by equation (1) reduce the r e a l outcome of period two. The manager's expected p o l i t i c a l costs at time t=0 are axu-^ru^) . The manager computes the reported outcome from the r e a l outcome using the reporting function r. Hence, the expected reported outcome f o r the whole project i s r / i x + ru2 - a r / i 1 ( r / i 2 ) . (7) The manager derives no d i s u t i l i t y f o r h i s reporting a c t i o n r and r ' . As the issues of moral hazard and information asymmetry with respect to the t r u t h f u l and consistent reporting of r X t have been eliminated, the manager's u t i l i t y w i l l increase as ZrX t increases. The maximization of h i s expected u t i l i t y i s therefore equivalent to the maximization of h i s expected remuneration. His expected remuneration at time t=0 i s then Z [ r ^ + ru2 - a r / i - ^ r ^ ) ] • (8) Without los s of generality, the analysis of the manager's repor t i n g d e c i s i o n w i l l be c a r r i e d out as i f the manager were r i s k neutral. The manager is assumed to solve the following problem when he selects his reporting strategy: Maximize E[Z]= Z[r/i^ + r ^ 2 - ar/i-^ (r / i 2 ) ] , (9) (r) subject to: u r L < r < r . 3.2 The manager's i n i t i a l reporting strategy In our model, the i n i t i a l choice of a reporting strategy is assumed to be a function of the various forces imposed on the firm by the three links discussed above. From one perspective, the manager may i n i t i a l l y adopt income reducing reporting methods in order to minimize p o l i t i c a l costs. From another perspective, the manager may want to adopt income increasing reporting methods to counter other economic pressures such as the probability of technical default, or to maximize his remuneration. For example, i f the firm is not affected by a debt restriction or i f the violation of such a constraint is unlikely, the manager w i l l consider the remaining two forces, p o l i t i c a l costs and his remuneration, in his selection of a reporting strategy. If the firm is affected by p o l i t i c a l costs, the manager LI might choose to report lower than the maximum r in order to reduce the p o l i t i c a l costs burden. If, in turn, the firm is affected by a positive probability of default, the i n i t i a l reporting strategy that the manager s e l e c t s w i l l be higher than the one selected when there i s no such p r o b a b i l i t y of default as from (6) above: the p r o b a b i l i t y of d e f a u l t i s shown to decrease as the reporting strategy increases. Consequently, these economic pressures motivating the choice of accounting methods are f i r m s p e c i f i c and, depending on the trade-off between these pressures, some managers w i l l i n i t i a l l y s e l e c t an income reducing reporting strategy while others w i l l i n i t i a l l y s e l e c t an income increasing reporting s t r a t e g y ^ . We assume that a reporting system i s i n place for the manager's i n i t i a l s e l e c t i o n of a reporting strategy, which i s not a matter of choice i n our model. 3.3 Manager's reporting choice a f t e r the r e c e i p t of the  information Case A: no p r o b a b i l i t y of default The f i r s t objective of the model i s to analyze how the manager v a r i e s h i s optimal reporting strategy as he learns that adversity i s s e t t i n g i n . Let us assume that the i n i t i a l s o l u t i o n We b e l i e v e that the existence of p o l i t i c a l costs as a motivation to report low i s not c r i t i c a l f o r the a n a l y s i s . Another l i n e of reasoning i s that the manager may r e t a i n f l e x i b i l i t y , e s p e c i a l l y on income increasing accounting choices, i n order to adjust f o r d i s t r e s s when i t occurs. The choice of an income increasing reporting strategy before the period i n which a bad state occurs might be suboptimal as i t s h i f t s income from future periods to the current period, reducing the p o s s i b i l i t y to face a bad state of the world i n the future. Nevertheless, we pursue the analysis with p o l i t i c a l costs as we r e l y on p r i o r research i n the area f o r the existence of such costs. to problem (9) is an interior solution. At the optimal i n i t i a l choice r , we have The optimal reporting strategy as shown by equation (10) is the one for which the marginal gain in expected remuneration in period one and two, from higher reported profits, equals the marginal loss in remuneration from p o l i t i c a l costs. The manager's gain in remuneration comes from the increase in r multiplied by the expected real outcome for the whole project. The marginal loss from p o l i t i c a l costs arises because p o l i t i c a l v i s i b i l i t y rises with r, thereby increasing the tax rate of period two. From (10), the optimal i n i t i a l reporting strategy i s ^ The optimal reporting strategy is then a function of the expected real outcome to the firm. If the expected outcome is high, the reporting strategy r w i l l be low, because of the greater exposure to p o l i t i c a l costs. If the expected outcome is low, r w i l l be high as the burden of p o l i t i c a l costs is lower, and the manager wants to increase his remuneration. Equation (11) leads to the following proposition. 9E[Z]/3r # - Z(/i L + u2) - 2Zar/i1/*2 =0. (10) r* - l/ap. (11) Equation (11) uses the equality / i ^ - ~ t1 ( D v assumption) . Proposition 1 Under the assumptions of the model''"'', i f the i n i t i a l choice of reporting methods r i s an i n t e r i o r s o l u t i o n , then the manager, i n the event of adversity, w i l l increase h i s reporting strategy. Proof Let r be the optimal s o l u t i o n to (10) such that * H r ^ < r < r . Adversity i s defined as a downward s h i f t i n the mean of the d i s t r i b u t i o n of outcomes, which we represent by p-h. Equation (11) can then be rewritten as r * = l / [ a ( M - b ) ] . (12) Thus, the p a r t i a l d e r i v a t i v e of (12) with respect to b y i e l d s 3r*/3b = l / [ a ( M - b ) 2 ] > 0. (13) Consequently, as adversity increases, the optimal reporting 18 strategy increases . Hence, the revised reporting strategy w i l l be higher than the i n i t i a l choice: r' > r . • The assumptions of the model are assumed to hold f o r a l l of the remaining propositions as well. 18 I t i s obvious that i f the manager made h i s i n i t i a l choice as i f adversity p r e v a i l e d , we would not observe a change i n h i s reporting strategy a f t e r the r e c e i p t of his information. 1 Q The r e s u l t of t h i s p r o p o s i t i o n i s i n t u i t i v e . The^manager f i r s t s e l e c t s an i n i t i a l optimal reporting strategy r that e q u i l i b r a t e s the marginal p o l i t i c a l costs with h i s marginal gain i n remuneration. When adversity occurs, the f i r s t order s t o c h a s t i c s h i f t decreases the marginal expected p o l i t i c a l costs. The manager can then increase the reporting strategy to reach a new equi l i b r i u m between the marginal expected p o l i t i c a l costs and hi s marginal gain i n remuneration. 40 Case B: When adversity creates a p o s i t i v e p r o b a b i l i t y of d e f a u l t Proposition 1 i s derived when there i s no p r o b a b i l i t y of d e f a u l t . Hence, the existence of debt i s not necessary to motivate an income increasing accounting change. I f , however, adversity creates a p o s i t i v e p r o b a b i l i t y of default, 6 > a, i t should provide the manager with a d d i t i o n a l incentive to report a higher outcome, since he may lose h i s second period remuneration. We formalize t h i s i n a second proposition. Proposition 2 Let r' be the optimal r e v i s i o n of reporting strategy a f t e r adversity sets i n with no p r o b a b i l i t y of default (see P r o p o s i t i o n 1 above). Supposing that r L < r' < r H , the manager w i l l choose a higher revised reporting strategy r " , where r" > r ' , i f adversity causes a p o s i t i v e p r o b a b i l i t y of default. Proof Let E[Z|fi] = Z { r " / i l b + ( l - F ( 5 ) ) ( r " / i 2 b - a r ' > l b r > 2 b ) } (14) be the manager's expected remuneration under adversity with a s t r i c t l y p o s i t i v e p r o b a b i l i t y of default. The manager's problem at time zero, given adversity and a p o s i t i v e p r o b a b i l i t y of default, i s Maximize E[Z|5] {r"} Subject to: r T < r" < From equation (14) 3E[Z|5]/3r tl Z ( ^ l b + e2b - 2ar"ulbu2h } - Z O F ( 5 ) / a r " ) ( r > 2 b " a r > l b r > 2 b > - Z F ( 5 ) ( / i 2 b - 2 a r ' > l b ^ 2 b ) -Expression (15) represents the rate of change, of the manager expected remuneration with respect to h i s choice of r" under adversity and a p o s i t i v e p r o b a b i l i t y of default. Since the optimal manager's choice of reporting strategy i n the event adversity with no p r o b a b i l i t y of default i s r ' , which i s the s o l u t i o n to Z ( ^ i b + A*2b) " 2 Z a r ' ^ l b ^ 2 b = °' evaluating (15) at r" = r ' , we obtain 3E[Z|S]/dr tt -Z3F(5)/3r'[r'M 2 b - a r ' M i b r ' M 2 b ] - Z F ( S ) [ / i 2 b - 2ar'ulhu2h). We have 1- 3F(6)/3r' < 0 from (6) above, 2- r'/i2b " a r ' ^ l b r ' ^ 2 b > u ky assumption (2), and 3- /x 2 b - 2 a r > l b / i 2 b < 0, since /* l b + ^ 2 b - 2 a r > l b p 2 b = 0 i n equation (16) and / i - ^ b > 0. Therefore, 3E[Z|5]/3r" > 0. r"=r' 9 0 Since (14) i s a concave function with respect to r, i t implies that the manager w i l l have incentive to choose an r" such that r" > r ' . • Proposition 2 states that i f the manager learns that adversity w i l l p r e v a i l and that i t may t r i g g e r t e c h n i c a l default on the bond covenant, h i s revised reporting strategy w i l l be r" so that r" > r and r" > r ' . The reporting strategy r' would be h i s choice i f adversity would not t r i g g e r t e c h n i c a l default on the debt covenant. Hence, the manager i s w i l l i n g to increase the 9 0 9 9 The function (14) i s concave i f we have 3 F(5)/3r^ >0. 3 2 F ( S ) / 3 r 2 = - [ 3 f ( S ) / 3 r ] ( B / r 2 ) +2f(5)(B/r 3). Hence, 3f(6)/3r < 0 i s s u f f i c i e n t to have concavity of ( 1 4 ) . This i s equivalent to the assumption that the density function f(X) i s monotone increasing at X=5; for example, i f f(X) i s normal, we would have concavity of (14) for any 6 < X. 43 reported outcome and incur more p o l i t i c a l costs because of the def a u l t threat. 4 INVESTORS' REACTION TO ACCOUNTING CHANGES The e n t i r e issue of market r e a c t i o n to voluntary accounting changes can be analyzed i n the perspective of investors' r a t i o n a l a n t i c i p a t i o n s of the managers' reporting actions. The market r e a c t i o n w i l l vary depending on whether one assumes that investors have r a t i o n a l a n t i c i p a t i o n s or not. Moreover, investors' p r i o r information i s also a key element i n determining market reactio n . 4.1 The analysis of p o t e n t i a l market responses to the  announcement of income increasing accounting changes as a function  of investors' r a t i o n a l a n t i c i p a t i o n s and investors' p r i o r  information Consider our two period model with the following example. We demonstrate i n propositions 1 and 2 that the manager would adopt an income increasing accounting change i f the bad state occurs. To s i m p l i f y our i l l u s t r a t i o n , we temporarily assume that the manager under the bad state of the world w i l l s e l e c t reporting strategy r . We further assume that state b represents a f i r s t order s t o c h a s t i c s h i f t to the l e f t i n the d i s t r i b u t i o n of outcomes. Hence, i f we l e t S be the value of the shareholders' claim , we can say that S g > S b . This means that the shareholders' claim i s higher under the good state than under the bad state. Furthermore, Holthausen's wealth t r a n s f e r argument states that an income increasing change relaxes debt constraints and thereby permits the manager to take actions favoring 29 shareholders . We i l l u s t r a t e t h i s p o s s i b i l i t y by S b ( r H ) > S b ( r ) f o r r < r H , where: S b ( r ) - i s the shareholders' claim i f reporting method r i s used by the manager. This means that the manager, i n using r under the bad state of the world, and hence reporting a higher outcome, would make shareholders b e t t e r o f f . We pi c t u r e three probable outcomes of t h i s example i n Figure 3. The reporting method r represents the current method that i s used and r < r . Sg= the shareholders' claim under the good state of the world S b= the shareholders' claim under the bad state of the world. 22 Example of such actions include s u b s t i t u t i n g high f o r low variance p r o j e c t s , or paying extra dividends. FIGURE 3 S(r) = Shareholders' expected claim at time=0, given the current reporting strategy r. S^(r) = Shareholders' claim under state b i f method r i s used. S ^ ( r H ) = Shareholders' claim under state b i f method r* 1 i s used. S (r) = Shareholders' claim under state g i f method r i s used. 46 CASE A: Market re a c t i o n to an accounting change when investors  have r a t i o n a l a n t i c i p a t i o n s of the manager's actions. I f bondholders have r a t i o n a l a n t i c i p a t i o n s (RA) with respect to the manager's reporting action, they know the manager w i l l be i n t e r e s t e d i n changing accounting methods i n the event of adversity as Propositions 1 and 2 demonstrate. At the contracting time, they w i l l c a l c u l a t e the expected costs of subsequent actions the manager might take that would not be i n t h e i r advantage. They w i l l then consider a lower claim value under a bad state as managers w i l l t r a n s f e r wealth to shareholders. The non-zero p r o b a b i l i t y of wealth trans f e r i s therefore a n t i c i p a t e d at the contracting time. The shareholders claim under the bad state of the world i s s i m i l a r l y higher i f the manager uses income increasing accounting methods which delay t e c h n i c a l default and allow the manager to 23 take actions favoring them . At contracting time, they a n t i c i p a t e the manager's behavior and p r i c e t h e i r claim accordingly. Case when investors have p r i o r information (PI) about the bad  state of the world Suppose shareholders learn that state b w i l l p r e v a i l before an accounting change occurs. As soon as they learn of state b, oo See Holthausen (1981) for more descriptions of wealth-tr a n s f e r s . they w i l l r evise t h e i r claim value from S(r) to S^(r ) (see Figure 3), even i f the manager i s s t i l l using method r. This i s because shareholders know that the manager w i l l eventually change to method r , as h i s contract motivates him to do so. The market reaction, at the time investors l e a r n of adversity (the occurrence u of state b), i s negative, since S(r) > S^(r ). When the manager a c t u a l l y adopts method r , there i s no further r e a c t i o n . Thus the predicted p r i c e response to the accounting change i s zero, given these assumptions. See the upper l e f t hand quadrant of Table 3. Such a p r e d i c t i o n i s also consistent with the no e f f e c t hypothesis. There i s no predicted market reaction, however, not because the change does not have any cash flow implications to the firm, but rather because the market has already reacted to what motivated the manager to e f f e c t the accounting change. The accounting change i s then redundant information as the market already knows the state of the firm. Case when investors have no p r i o r information (NPI) about the bad  state of the world Suppose that investors have no knowledge of state b p r i o r to observing the manager changing reporting methods to method r . As they know the manager's motivation to s e l e c t method r i n the event of state b, they w i l l i n f e r that state b predominates and re v i s e t h e i r claim value from S(r) to S^(r ). This r e v i s i o n i s u negative, as S^(r ) < S(r) (see Figure 3), and occurs when the TABLE 3 Market reactions as a function of investors' r a t i o n a l a n t i c i p a t i o n s of the manager's reporting actions, and investors' p r i o r information INVESTORS' PRIOR INFORMATION YES NO INVESTORS' RATIONAL ANTICIPATIONS OF THE MANAGER'S REPORTING ACTIONS YES NO 0 -+ ? change i s announced to the market f o r the f i r s t time. See the upper r i g h t hand quadrant of Table 3. In t h i s case we p r e d i c t a negative market reaction, which occurs because the change conveys information to the market about the p r e v a i l i n g adversity. We name t h i s hypothesis the information r e v e a l i n g hypothesis. CASE B: Market reactions when investors have no r a t i o n a l  a n t i c i p a t i o n (NRA) of the manager's actions In the case of no r a t i o n a l a n t i c i p a t i o n (NRA), investors do not a n t i c i p a t e which actions the manager w i l l use under e i t h e r state of the world. The predicted market r e a c t i o n then depends c r u c i a l l y on whether or not investors have p r i o r information, as discussed below. Case when investors have no p r i o r information about the bad state  of the world In t h i s case, i t i s hard to p r e d i c t a market reaction. I f one assumes that the accounting change w i l l convey to the market information that adversity has set i n , investors w i l l then re v i s e t h e i r claim from S(r) to S b ( r ) . Hence, there i s a predicted negative market reacti o n . However, i f one does not assume that the change conveys to the market information about the current state of the world, the market re a c t i o n i s unpredictable. See the lower r i g h t hand quadrant of Table 3. 50 Case when investors have p r i o r information about the bad state of  the world I f investors l e a r n that state b predominates p r i o r to the accounting change, they w i l l revise t h e i r claim downward from S(r) to S^(r) (see Figure 3). A subsequent accounting change from method r to r w i l l induce shareholders to revise t h e i r claim value from S^(r) to S b ( r ). This r e v i s i o n i s p o s i t i v e , as S^(r ) > S b ( r ) by d e f i n i t i o n of a wealth t r a n s f e r . See the lower l e f t quadrant of Table 3. In our s e t t i n g , t h i s i s the case when we have an unambiguous p o s i t i v e reaction induced by the p o t e n t i a l t r a n s f e r of wealth from bondholders to shareholders, such as Holthausen (1981) hypothesized, that i s , when NRA and PI p r e v a i l . Such a p o s i t i v e r e a c t i o n i s also predicted by the mechanistic hypothesis. However, we consider the argument that investors are naive and would react mechanically to the income e f f e c t of an accounting change as somewhat u n r e a l i s t i c . The mechanistic argument i s s i l e n t on how contracts based on accounting information a f f e c t p r i c e s . The empirical objective of t h i s study i s to i d e n t i f y which of these p o s s i b i l i t i e s best represents the actual phenomena of market r e a c t i o n to the announcement of income increasing accounting changes. The next subsection formalizes the information r e v e a l i n g hypothesis. 51 4.2 Information revealing hypothesis In our model, the shareholders' expected claim at t=0, given the reporting strategy r, can be represented by 2^ f S(r) = (l-Zr)X 1f(X 1)dX 1 + [ 1-F(5) ] [ (1-Z) (u2 - a r ^ r ^ ) ] (18) (1-F(5))B. Equation (18) implies that i f default occurs, shareholders lose their entire investment. Here we make the assumption that adversity reduces the expected outcome to the firm more than i t reduces the p o l i t i c a l costs, hence (Mig+ M2g)-(Mib+ M2b) > a r 2 ^ l g ' i 2 g " ' ilb A t2b ) f o r rL~ r - r H - <19> Assumption (19) implies that for a given reporting strategy, the firm value decreases in the event of adversity . Consequently, adversity implies that for any reporting strategy r, S b < S g. (20) Our previous discussion then leads to the following propositions. Equation (18) implies that i f default does not occur, the outcomes to the firm w i l l more than cover the debt repayment B at the end of period two. Without this assumption, i t would be possible that shareholders be better off under the bad state of the world; this contradicts the definition of a bad state. Proposition 3 I f there i s no p r i o r information about the state of the world (NPI) and shareholders have r a t i o n a l a n t i c i p a t i o n s (RA) with respect to the manager's reporting actions, the market r e a c t i o n to an income increasing accounting change w i l l be negative. Proof Let <f>^ and <£b be the shareholders p r i o r p r o b a b i l i t i e s of the good and bad states r e s p e c t i v e l y . Assume that information asymmetry i s represented by d> > 0 and <f>. > 0. Suppose the manager receives the s i g n a l that state b w i l l predominate and e f f e c t s an income increasing accounting change. As a r e s u l t of t h i s a c t i o n and given t h e i r r a t i o n a l a n t i c i p a t i o n s , investors revise t h e i r p r i o r b e l i e f s as to which state of the world p r e v a i l s . The revised expectations are <j>' — the re v i s e d p r o b a b i l i t y of the good state, 4>^ = the revised p r o b a b i l i t y of the bad state. The shareholders' r a t i o n a l a n t i c i p a t i o n s imply that 6' < d> and <£' > <b, g R b r b (21) From (20) and (21) we have 4>a S + 4. S g g D O g g b b' (22) hence, the market rea c t i o n w i l l be negative. • Proposition 4 The negative market rea c t i o n to an income increasing accounting change i s inversely r e l a t e d to the amount of information investors have about adversity, p r i o r to the accounting change. Proof The shareholders' knowledge of adversity i s represented by <£b. From (22), the magnitude of the market r e a c t i o n can be represented by (1"Vsg + Vb • [ * g s g + W = M > 0 ( 2 3 ) From (23), we have dn/84h - s b - s g (24) which i s smaller than zero by f i r s t order s t o c h a s t i c dominance. Hence, the magnitude of the market reaction decreases as investors' knowledge of adversity before the accounting change increases. • Proposition 3 demonstrates that, i f investors have r a t i o n a l a n t i c i p a t i o n s with respect to the manager's reporting actions and information asymmetry p r e v a i l s , the market response to an income increasing accounting change motivated by adversity w i l l be negative. Proposition 4 i n turn states that the market response to the change announcement diminishes as shareholders' information about adversity, before the accounting change, increases. The remainder of this thesis w i l l test the empirical implications our model. 55 CHAPTER IV  EMPIRICAL ANALYSIS 1. Empirical strategy and design 1.1 Empirical t e s t i n v o l v i n g the o v e r a l l market re a c t i o n to change  announcements From our previous discussion of p o t e n t i a l market reactions to the announcement of income increasing accounting changes, we have been able to c l e a r l y i d e n t i f y the sign of the market r e a c t i o n i n three cases. I f we l e t A^ represent f i r m i ' s market r e a c t i o n to the announcement of an accounting change^", our three o p o s s i b i l i t i e s are : 1- I f investors know that the bad state of the world p r e v a i l s p r i o r to the announcement of the accounting change ( i . e . , PI) and i f they are aware of the manager's motivation to increase the reported outcome i n the event of adversity ( i . e . , RA), then the announcement of the accounting change i s predicted to have no impact on the market. "Accounting change" means "voluntary income increasing accounting change" i n t h i s t h e s i s . 2 See Table 3 Chapter I I I . 2- I f investors do not know that the bad state of the world p r e v a i l s p r i o r to the announcement of the accounting change ( i . e . , NPI) and i f they are aware of the manager's motivation to increase the reported outcome i n the event of adversity ( i . e . , RA), then the market r e a c t i o n to the announcement of the accounting change i s predicted to be negative. X± < 0 3- I f investors know that the bad state of the world p r e v a i l s p r i o r to the announcement of the accounting change ( i . e . , PI) but cannot p r e d i c t that the manager w i l l increase the reported income i n the event of adversity ( i . e . , NRA), then the market r e a c t i o n to the announcement of the accounting change i s predicted to be p o s i t i v e . A L > 0 Our empirical task i s to i d e n t i f y which of these three p o s s i b i l i t i e s best represents the actual phenomena of the market r e a c t i o n to accounting change announcements. Our f i r s t e mpirical hypothesis i s then formulated as HJ A - 0, (25) A * 0, 57 where A represents the average market impact for a sample of changers. The formulation of the hypothesis in (25) above allows us to discriminate between the three p o s s i b i l i t i e s . Empirically, we w i l l attempt to reject a zero market reaction (the null hypothesis) in favor of either a positive or a negative market reaction. Hence, a significantly positive market response would provide evidence favoring NRA and PI. Similarly, a clearly negative response would favor RA and NPI. A market reaction not s t a t i s t i c a l l y different from zero would only provide weak evidence consistent with RA and PI since i t does not allow the rejection of the two alternate hypotheses. The reason is that although NRA-PI predicts a positive market response, i t is silent on the magnitude of the market response. Hence a very small positive reaction could be consistent with both RA-PI, because the response is not s t a t i s t i c a l l y different from zero, and NRA-PI, because the response is positive. Similarly, RA-NPI predicts a negative market response reaction but i t , too, is silent as to the magnitude of the market reaction. Consequently, a small negative number is evidence consistent with both RA-NPI, because the response is negative and RA-PI, because the response is not significantly different from zero. In an attempt to surmount this shortcoming, we supplement the tests on the average market impact with the cross-sectional tests of association discussed below. 58 The model does not make predictions for the case of no prior information (NPI) and no rational anticipations (NRA). Therefore, our empirical tests cannot be used to reject this fourth poss i b i l i t y . Nevertheless, we w i l l argue (see section 5 below) that the evidence does not support this possibility. 1.2 Cross-sectional tests of association When moving to cross-sectional analyses, the ideal would be to test and reject a null hypothesis that is implied by one of our theories in favor of an alternate hypothesis that is in turn an implication of a competing theory. In this way, the tests would be used to supplement the above test on overall change impact and to further discriminate between competing theories. Unfortunately, no such cross-sectional test is available. We therefore resort to a second-best strategy as described in the following paragraph. For the case where rational anticipations prevail (RA), the model indicates an inverse relationship between the market reaction to an accounting change and the extent of prior information about adversity (PI). We therefore apply the following test of association using proxy measures for the extent of PI (variables selection is discussed in section 3 below). We w i l l test for a negative association between the observed market r e a c t i o n to the change and the PI proxy . This would only c o n s t i t u t e weak evidence i n favor of RA, because i n our model NRA makes no p r e d i c t i o n about the as s o c i a t i o n between the observed market r e a c t i o n to the change announcement and the PI proxy. As a r e s u l t , t h i s c r o s s - s e c t i o n a l t e s t does not o f f e r the p o t e n t i a l to discriminate between competing theories. We p o s i t the following l i n e a r r e l a t i o n s h i p between the market impact to the announcement of an income increasing accounting change and investors' p r i o r information: A i " ^0 + T l U E i + T 2 P I i + H> (26> where: — fi r m i ' s abnormal returns due to the change announcement, UE^ - f i r m i ' s unexpected earnings v a r i a b l e (a con t r o l v a r i a b l e which we discuss i n section 3 of the present chapter), PI^ — the extent of p r i o r information about adversity, / i^ = an erro r term assumed to be independent across firms and normally d i s t r i b u t e d with mean zero. Proposition 4 pr e d i c t s a negative r e l a t i o n s h i p between the magnitude of the market rea c t i o n to change announcements and investors' l e v e l of information about adversity. What we t e s t i n t h i s c r o s s - s e c t i o n a l analysis i s i f investors reacted to adversity p r i o r to the change announcement, t h e i r r e a c t i o n to the announcement should be close to zero according to our theory. However, i f investors d i d not react to adversity before the change announcement, t h e i r r e a c t i o n to the announcement i s predicted to be negative i f RA p r e v a i l s . We then formulate our second empirical hypothesis as: (27) 1.3 Power of the empirical tests Our theory, developed i n Chapter I I I , states that adversity w i l l induce an income increasing accounting change. Not a l l accounting changes are made because of adversity, however. There might be other reasons f o r changing accounting procedures although we be l i e v e that adversity i s an important one. For example, with i n the context of our model, a change i n the p o l i t i c a l costs structure could induce an accounting change. Furthermore, v a r i a b l e s not treated s p e c i f i c a l l y i n our model, such as the auditor's preferences f o r accounting methods or a manager's attempt to avoid l o s i n g the benefits of a tax loss carry forward, are also p o t e n t i a l motivations for a change i n accounting procedures. Given our sampling c r i t e r i a (see s e c t i o n 2 below), our sample of changers i s l i k e l y to include some accounting changes that are not motivated by adversity. The i n c l u s i o n of other p o t e n t i a l motives adds noise to our empirical t e s t s . For our t e s t on the o v e r a l l market impact of the announcement of an accounting change (our f i r s t hypothesis), the bias of i n c l u d i n g changes not motivated by adversity i s unpredictable. We do not have a theory that would i n d i c a t e how the market should react to the announcement of these accounting changes. However, for our cross-sectional tests involving prior information and the market response to the change announcement (our second hypothesis), including changes not motivated by adversity would bias the test results toward a failure to reject the null hypothesis^. To increase the power of our tests, we would like to be able to identify the firms in our sample for which adversity was the motive for the accounting change. Indeed, discerning the motivation for change at the time of the change is the investors' problem as well. There i s , however, no systematic mechanism available either to investors at the time of the change, or to researchers ex-post, by which to unambiguously ascertain the change motivation. Nevertheless, we employ two partitioning strategies in an attempt to focus on the subset of firms for which adversity was l i k e l y to have b een the motivation for the change. We propose the following partitioning approaches: 1- A partitioning based on the stated reasons for changing methods. 2- A partitioning based on the extent of leverage. The partitioning based on the stated reasons for changing methods allows us to eliminate accounting changes that were For the firms with changes not motivated by adversity, there is a predicted zero association between the market impact of the change and the PI proxy. supposedly made f o r obvious reasons other than p o t e n t i a l d i s t r e s s reasons. The p a r t i t i o n i n g based on the extent of leverage i s motivated by our second t h e o r e t i c a l p r o p o s i t i o n which demonstrates that when adversity occurs, the closeness of debt r e s t r i c t i o n s i s a motivation to e f f e c t an income increasing accounting change. Hence, the p r o b a b i l i t y that an accounting change i s made i n response to adversity should be higher f o r firms c l o s e r to t h e i r debt r e s t r i c t i o n s . This p a r t i t i o n i n g also implies that the market i s more l i k e l y to i n t e r p r e t the accounting change as a s i g n a l of d i s t r e s s i f the fir m making the change i s close to v i o l a t i n g i t s debt r e s t r i c t i o n s ; the accounting change i s then int e r p r e t e d as a j o i n t s i g n a l of adversity. Consistent with p r i o r empirical research, we use the extent of leverage to proxy f o r the closeness to debt r e s t r i c t i o n s " * . Debt r e s t r i c t i o n s , however, might be s p e c i f i e d i n terms of (TAP) t a i l o r e d accounting p r i n c i p l e s ^ . This means that debt r e s t r i c t i o n s are c a l c u l a t e d i n terms of s p e c i f i c accounting methods rather than GAAP which are used f o r reporting purposes. Consequently, i f a l l debt r e s t r i c t i o n s are i n terms of TAP, the manager cannot change accounting methods to relax debt c o n s t r a i n t s . D For example, Holthausen (1981), Dhaliwal et a l . (1982), Bowen et a l . (1981). ^ For example, see Thornton and Bryant (1986). I t i s not c l e a r how our empirical r e s u l t s would be a f f e c t e d i f our subsample of hig h l y levered firms contained firms f o r which a l l debt r e s t r i c t i o n s are wr i t t e n i n terms of TAP. The existence of TAP does not preclude adversity as a possible motivation f o r the accounting change, i f the manager's remuneration i s a f f e c t e d by the change. On the other hand, the i n c l u s i o n of TAP firms could p o t e n t i a l l y reduce the power of the empirical tests f o r our subsample of h i g h l y levered firms i f the motivation f o r the change i s not adversity, since the leverage r a t i o might be a bad proxy f o r closeness to debt r e s t r i c t i o n s w r i t t e n i n terms of TAP. Previous evidence suggests that i t i s u n l i k e l y that a l l debt r e s t r i c t i o n s are wr i t t e n i n terms of TAP. Leftwich (1983) claims that p r i v a t e lending agreements often include TAP measures, but he also mentions that there i s no unanimity among lenders as to which measures to r e s t r i c t . Leftwich's evidence on accounting methods used i n debt agreements does not come from the debt agreements themselves, however, but from commentaries, a reference manual designed to provide advice to lenders who renegotiate r e s t r i c t i v e covenants i n lending agreements. Thornton and Bryant (1986), i n turn, look at lending agreements of Canadian firms. They observe that 34 out of 71 firms have debt r e s t r i c t i o n s w r i t t e n i n terms of TAP with respect to the method of accounting f o r leases. I t i s po s s i b l e , however, that there are other debt r e s t r i c t i o n s w r i t t e n i n terms of GAAP which would create an incentive f o r managers to e f f e c t accounting changes (for example, maximum leverage, minimum working c a p i t a l r a t i o , e t c . ) ^ . S t i l l , the p o t e n t i a l existence of TAP i n debt agreements adds noise to the sample p a r t i t i o n i n g based on fi r m leverage, explained i n s e c t i o n 1.3 of t h i s Chapter. We w i l l return to t h i s issue when i n t e r p r e t i n g our c r o s s - s e c t i o n a l r e s u l t s a f t e r p a r t i t i o n i n g . 2. Sample The Compustat i n d u s t r i a l (primary, supplementary and t e r t i a r y f i l e s ) and the Compustat research f i l e were used to i d e n t i f y firms that had made a change i n accounting procedures. I f a f i r m makes an accounting change i n a p a r t i c u l a r year, Compustat reports a code i d e n t i f y i n g the item that i s subject to the change. A t o t a l of s i x items can be noted: sales, cost of goods sold, depreciation, i n t e r e s t expense, income tax, and earnings before extraordinary items. These codes, however, do not s p e c i f y whether the accounting change i s mandatory or voluntary. Most of the firms i n our sample mentioned the existence of debt r e s t r i c t i o n s i n t h e i r f i n a n c i a l statements. We asked each fi r m i n our sample to f i l l out a questionnaire r e q u i r i n g d e t a i l e d information about the c a l c u l a t i o n of debt r e s t r i c t i o n s . However, only 10% of the firms i n the sample answered the questionnaire. This obviously makes drawing inferences about debt r e s t r i c t i o n s d i f f i c u l t . In order to be e l i g i b l e f o r t h i s study, a f i r m had to meet the following requirements: -The f i r m had to have data a v a i l a b l e on the Compustat annual i n d u s t r i a l primary, supplementary, t e r t i a r y , or o research f i l e . -The f i r m had to be l i s t e d on e i t h e r the New York Stock Exchange (NYSE) or the American Stock Exchange (AMEX) (as i d e n t i f i e d by Compustat). -The f i r m had to have a code i d e n t i f y i n g an accounting change f o r the period 1977 to 1984, on at l e a s t one of 9 10 the following four items ' : cost of goods sold; depreciation; The Compustat research f i l e contains firms that e i t h e r went bankrupt or were l i q u i d a t e d , and are therefore no longer i n the population r e g u l a r l y covered by Compustat. The sample includes 9 of these firms. Hence our sampling c r i t e r i a do not preclude firms which eventually went bankrupt. Given the nature of the research task, excluding bankrupt firms would be an undesirable sampling r e s t r i c t i o n . o We do not consider the remaining two items. The firms i d e n t i f i e d with a code on the i n t e r e s t expense item were deleted since most of the changes were due to the issuance of FASB # 34 which required the c a p i t a l i z a t i o n of i n t e r e s t during the construction phase of a project. Further, some of the firms with a note on the sale items were examined and very few turned out to have had voluntary accounting changes. ^ Firms from the o i l and gas industry were systematically deleted f o r the years 1977 to 1980. In that time period, the SEC and FASB released a number of pronouncements regarding the use of the f u l l cost as opposed to the successful e f f o r t s method. Consequently, changes i n accounting methods i n that period f o r those firms were beli e v e d to be mandatory, and not s u i t a b l e f o r t h i s a n a l y s i s . income tax; earnings before extraordinary items. Firms meeting a l l these requirements were sorted from the Compustat tape. From this procedure, we identified 1488 potential accounting changers. The financial statements for these firms were read to identify the changes that were voluntary as opposed to mandatory. Table 4 summarizes the result of this procedure; 651 firms were deleted because the accounting code reflected a mandatory accounting change. The financial statements of 192 firms were not available. Another 223 firms adopted LIFO and did not qualify for this a n a l y s i s ^ . No accounting change could be identified for 173 firms. Finally, 125 firms were deleted because of missing daily returns and 15 because the accounting change decreased income and our theory is for income increasing accounting changes only. Hence, after investigation, 109 firms satisfied the requirements. Table 5 shows the f i n a l sample by type of change. The "other changes" category includes changes of accounting methods for o i l and gas, pension plans, and capitalization of items that were previously expensed. Table 6 presents the various reasons given to motivate the accounting changes. I am grateful to Professor William E. Ricks and Professor John S. Hughes for providing me with a l i s t of LIFO changers for the years 1977 to 1979. The procedure identified 66 LIFO changers in that period. 67 TABLE 4 Sample fi r m e l i m i n a t i o n TOTAL NUMBER OF FIRMS FROM COMPUSTAT 1488 FIRMS DELETED MANDATED CHANGES FASB #8 7 FASB #13 29 FASB #25 8 FASB #34 6 FASB #43 84 FASB #52 358 O i l & Gas (SEC) 22 Other Mandatory 137 TOTAL MANDATORY CHANGES 651 LIFO adopters 223 Firms f o r which no change was i d e n t i f i e d 173 Missing microfiches 192 Missing d a i l y returns 125 Income decreasing changers 15 TOTAL DELETED 1379 FIRMS REMAINING IN THE SAMPLE 109 T A B L E 5 Sample of firms by type of accounting changes NUMBER OF FIRMS INVENTORY 23 ADOPTION OF FLOW THROUGH 26 DEPRECIATION 31 OTHER CHANGES 29 TOTAL 1Q9 69 TABLE 6 Sample of firms by stated reasons for changing methods NUMBER OF FIRMS No reason 27 Better matching of costs and revenues 35 Consistency with industry practices 38 Consistency with the firm's choices of methods for income tax purposes 4 Consistency of methods within the consolidated group 5 TOTAL 109 70 Relevant p r o f i l e s t a t i s t i c s concerning the sample of changers We e s t a b l i s h the p r o f i l e of the changers i n our sample f o r a period surrounding the accounting change using the following three 12 r a t i o s : 1- Rate of return measure (net income/net worth) 2- F i n a n c i a l leverage ( t o t a l d ebt/total assets) 3- Fixed payment coverage (funds from o p e r a t i o n s / t o t a l debt) Under adversity, the rate of return and f i x e d payment coverage r a t i o s w i l l be lower and the leverage r a t i o higher. For each f i r m i n the sample, these three r a t i o s were c a l c u l a t e d f o r the period s t a r t i n g f i v e years before the change and running to three years a f t e r . We computed the differ e n c e i n the r a t i o s between our sample firms and the average Compustat population f or the corresponding years. Table 7 presents the median of the differences between our sample f i r m r a t i o s and the average Compustat population r a t i o s , Zmijewski (1983) measured the differ e n c e i n 75 v a r i a b l e s between a sample of bankrupt and non bankrupt firms. These three r a t i o s showed consistent differences between bankrupt and non bankrupt firms. TABLE 7 Median differences between the sample firm r a t i o s and the average compustat population r a t i o s Ratios Years r e l a t i v e of the accounting chang e year (year 0) -5 -4 -3 -2 -1 0 +1 +2 +3 Rate of return (net income/net worth) -.0024 .0129 .0105 .0215 -.017 -.0341 -.0086 .0173 .028 Number of observations 91 91 93 94 107 106 86 68 43 Wilcoxon Z S t a t i s t i c -.54 1.77 2.02 2.42 -2.27 -3.04 -1.68 1.89 2.17 (Prob > |zl) (.584) (.07) (.04) (.015) (.02) (.002) (.09) (.05) (.02) Fi n a n c i a l leverage ( t o t a l debt/total assets) .0165 .00385 .0072 .0142 .0361 .02 79 .022 7 .0242 .0047 Number of observations 90 92 95 95 109 109 90 70 44 Wilcoxon Z S t a t i s t i c 1.09 .54 .936 1.74 1.87 1.62 .82 .62 .38 (Prob > |zl) (.27) (.58) (.34) (.08) .(.06) (.10) (.40) (.53) (.69) Fixed payment coverage (Funds from oper/tot debt) -1.805 -1.79 -1.93 -1.87 -1.77 -1.85 -1.76 -1. 73 -1. 79 Number of observations 85 87 89 92 92 93 88 66 42 Wilcoxon Z S t a t i s t i c -11.18 -11.05 -11.48 -11.43 -11.43 -11.23 -10.85 -9.30 -7.22 (Prob > |Z|) (.0000) (.0000) (.0000) (.0000) (.0000) (.0000) (.0000) (.0000) (.0000) along with a Wilcoxon Z s t a t i s t i c . For the rate of return r a t i o , the median differ e n c e indicates that our sample of changers, on average, tends to perform s i g n i f i c a n t l y worse than the Compustat population f o r the years surrounding the change year (years -1 to +1). The r e s u l t s also show that our sample has, on average, a higher leverage r a t i o than the average Compustat population, and the median differ e n c e i s s i g n i f i c a n t l y greater than zero f o r the years surrounding the accounting change year (year -2 to 0). Probably as a consequence of t h e i r high leverage r a t i o , our sample of changers has, on average, a s i g n i f i c a n t l y lower f i x e d payment coverage r a t i o than the average Compustat population. Hence, the r e s u l t s of t h i s analysis provide evidence favoring our theory that adversity induces income increasing accounting changes. They are also consistent with Bremser (1975) who reports that a sample of 80 firms reporting d i s c r e t i o n a r y accounting changes exhibited a poorer pattern or trend of primary earnings per share (EPS) than a random sample of companies with no reported accounting changes during the same period. S i m i l a r l y , A r c h i b a l d (1976) reports that the majority of firms switching back from accelerated depreciation to s t r a i g h t l i n e depreciation e x h i b i t e d unfavorable net income performance v i s a v i s a benchmark net income measured f or each firm's industry. The Wilcoxon s t a t i s t i c tests i f the differences i n r a t i o s are equal to zero. We also analyze our sample market returns behavior for the period of approximately 3 y e a r s ^ prior to the change announcement (the period ends 3 days before the public announcement of the accounting change). To analyze prior returns, we compute the following market model for each firm in our sample: R_ - o. + p.R _ + e._ (28) i t l * i mt i t where: R^t — firm i's return for period t, - component of the firm i's returns unrelated to the market returns, R m t = the market return for period t, e^ t = an error term assumed to be independent and normally distributed with mean zero. The estimated intercept coefficients were averaged for a l l firms in our sample. The average i s ^ : - -.000672 t(statistic)= -5.33 Pr>|t|= .0001. The negative average intercept coefficient indicates that, on average, our sample of changers performed worse than the market for the period preceding the accounting changes. This result also ^ The period consists of 600 trading days. The minimum estimation period is 300 trading days. 15 a represents an average daily return component unrelated to the market returns. suggests that investors had information about the p o t e n t i a l adversity a f f e c t i n g the average fi r m (as demonstrated by Table 7) at the time of the accounting change announcement^. 3. Variables measurement 3.1 Measures of adversity In subsection 1.4, we proposed the following p a r t i t i o n i n g approaches to increase the power of our empirical t e s t s : 1- A p a r t i t i o n i n g based on the stated reasons f o r changing accounting methods. 2- A p a r t i t i o n i n g based on the extent of leverage. P a r t i t i o n i n g based on the stated reasons for changing methods Table 6 c l a s s i f i e s the reasons given by management to motivate the accounting change. Among those, we r e t a i n the following two p o t e n t i a l explanations as candidates f o r adversity: 1- No reason given 2- Better matching of costs and revenues In the f i r s t case, the absence of motivation leaves unanswered the question of why management changed accounting methods. In the second case, changing accounting methods to ^ This r e s u l t appears to be consistent with B a l l (1972), who reports that h i s sample of 267 changers had experienced r e l a t i v e decline i n s e c u r i t y p r i c e s i n the f i v e year period p r i o r to the accounting change. 75 achieve a b e t t e r matching of costs and revenues i s a general reason that can be used by managers to camouflage the true motive of t h e i r acts. On the other hand, the three other reasons—consistency with industry p r a c t i c e s , consistency with the firm's choices of methods fo r income tax purposes and consistency of methods wit h i n the consolidated group—appeal to a s p e c i f i c motive. As a r e s u l t , i t would be hard to j u s t i f y these reasons i f they were not true, since the auditor must concur with the change and the stated reasons. P a r t i t i o n i n g based on the extent of leverage For the p a r t i t i o n i n g based on the extent of leverage, we use the average Compustat population leverage r a t i o as a benchmark. S p e c i f i c a l l y , i f a fir m has a leverage r a t i o f o r the year preceding the change year that i s higher than the average Compustat population f o r the same year, the fir m i s c l a s s i f i e d i n the high leverage group. There are 61 firms i n t h i s sample p a r t i t i o n . Again, we s e l e c t the leverage r a t i o at the end of year -1 because the market must know t h i s information at the time of the change i n order to i n t e r p r e t the j o i n t s i g n a l . 3.2 Measurement of the market reaction to the announcement of the  accounting change. The model that i s used to measure the abnormal returns f o r each fi r m i s : R_ - a. + 0. R + P.R + 0 R + \.6._ + (29) i t 1 K i ni .. K i ni ^ i n - i i t i t ' t-1 t t+1 where: R ^ T •= fi r m i ' s return f o r period t, RJJJ «= the market return f or period t, — announcement v a r i a b l e (which takes the value of one i n the announcement period and zero otherwise), A^ = the event parameter which measures the abnormal returns over the event period, - an er r o r term assumed to be independent and normally d i s t r i b u t e d with mean zero. Thompson (1985) mentions that under weak stationary assumptions, a l l of the parameters of a r e s i d u a l analysis have the same asymptotic expectations as the parameters of (29)^ . To estimate (29), we use a post estimation period s i m i l a r to the procedure followed by Richardson, Sefcik and Thompson (1986). The period of estimation ranges from 2 days before the 18 announcement to 242 days a f t e r . Hence, no p r i o r data i s used. In a r e s i d u a l a n a l y s i s , we compute the market model (28) over a peri o d outside the event window to estimate the parameters and p^. We then use the parameter estimates of t h i s f i r s t pass, and to compute the abnormal returns for the event period: ARi = | ( R i t - aL - P ^ ) , f o r a l l t included i n the event period (AR^ stands f o r f i r m i ' s p e r i o d t abnormal return). The minimum estimation period i s 100 days. The announcement period runs from 2 days before the announcement to 2 days after (a 5 day period including the announcement day). This model is best suited for the analysis performed in this thesis for the following reasons: -The use of a post estimation period minimizes the s t a b i l i t y of the 0's problem. The market model and our model (29) above assume the s t a b i l i t y of the parameter p. However, the accounting change may be associated with a ft shift as documented by Ball (1972), Sunder (1973) and Holthausen (1981). Focusing on post data only should help to correct this potential bias. -According to the theory presented in Chapter III, the market impact is believed to vary depending on the investors' knowledge of adversity before the change. The use of post data in the estimation of (29) above allows the possibility of taking variables prior to the accounting change, and therefore, independent of the abnormal returns measured by (29) above, as proxies for investors' knowledge of adversity. Finally, the equation (29) is intended to capture the lagged dependence between security returns and the market index when there is infrequent trading (see Scholes and Williams (1977) and Dimson (1979)). A s i m i l a r procedure i s used by Holthausen (1981) 19 and Richardson, Sefcik and Thompson (1986) Announcement dates and d a i l y returns In t h i s t h e s i s , s p e c i a l care i s taken to i d e n t i f y the event dates as we t e s t f o r the stock p r i c e e f f e c t of the announcement of a voluntary accounting change. The Wall Street Journal Index and the Wall Street Journal were used to i d e n t i f y the announcement dates f o r each fi r m i n the sample. This procedure i s important because the analysis i s performed with d a i l y data and abnormal returns are computed over a f i v e day window. Announcement dates were found f o r 86 firms. For the 23 firms with no announcement date, i t i s assumed that the 20 announcement occurred at year end . The empirical analysis i s 21 c a r r i e d out with and without these 23 firms . We also measured the abnormal market r e a c t i o n to change announcements without consideration f o r non-synchronous trading and our empirical r e s u l t s were not affected. This i s consistent with the r e s u l t s of Brown and Warner (1985) who found no evidence suggesting that not accounting f o r non-synchronous trading would bias the r e s u l t s . 90 A s i m i l a r procedure i s used by Holthausen (1981). ^ The i n c l u s i o n of the 23 firms d i d not s i g n i f i c a n t l y modify the r e s u l t s . 79 3.3 Measurement and control for unexpected earnings Most of the accounting change announcements in our sample come at the same time as earnings announcements. The abnormal returns parameter as measured by (29) above contains (1) the market impact of the unexpected portion of earnings and (2) the market impact of the accounting change announcement. In this thesis, we use the following seasonal random walk measure of 22 earnings expectations : E t R i q ] - Riq-4 where E[R^q] - expected value of firm i's earnings (primary earnings per share) for quarter q. The change announcement occurs concurrently to the earnings release of quarter q. Riq-4 = f i r m i ' s earnings per share one year before quarter q (four quarters before the announcement quarter q). Hence, the unexpected earnings variable UE is calculated as: UE. = [(R i q - YI±) - R l q . 4 ] / P i q . (30) where: 22 We also performed our test using analyst forecasts (Value line investment survey) as a measure of earnings expectations, but we present the results of our test using the seasonal random walk model. The reason is that the mechanical seasonal random walk shows a stronger association with the dependent variable in our model than the analyst forecast. This result is consistent with the study of Hughes and Ricks (1987) who could not demonstrate that an analyst forecast measure of unexpected earnings would perform better than a simple seasonal random walk model. P^q = the share price for firm i at the end of the quarter q. YI^ - firm i's change impact on income for the year of the 23 change 3.4 Measurement of investors' prior information about adversity We use the prior capital gain or loss in share prices for the period prior to the accounting change announcement to proxy for investors' prior information about adversity. The period considered starts at the end of three f i s c a l year prior to the change year (year T-3) and continues up to the change announcement (approximately a three year period). Specifically, P l r [ P i T - P i T _ 3 ] / P i T _ 3 (31) where P^j. and 3 stand for the share price at the announcement date and the share price at the end of three years prior to the change year (year T-3) respectively. The choice of a time period over which to compute our PI proxy remains arbitrary, but as Foster (1986) reports, the financial ratios of bankrupt firms start to exhibit behavior different from that of non-bankrupt firms as early as three to The accounting change modifies the results of the year in which i t occurs. In order to have a better estimate of unexpected earnings, we subtract the effect of the accounting change on the income for the change year. However, the variable YI does not include the cumulative impact of accounting changes on prior years as this impact does not appear in the calculation of the primary earnings per share. five years prior to bankruptcy. Furthermore, Westerfield (1970) shows that, in each of the 60 months prior to bankruptcy, the monthly cumulative abnormal returns of 20 bankrupt firms were negative suggesting that the capital market revises i t s valuation of these companies downward well before the bankruptcy announcement. It is then possible that the market learns of adversity for our sample of changers as early as three years before the change announcement. As a sensitivity analysis, however, we reperform our tests calculating the PI proxy on a two year and on a one year period before the change announcement. The results of these estimations are discussed in the next section. Finally, our proxy PI does not include the dividend returns over the same period. We consider the share price (or the market value of the firm at one point in time) as the expected value of future cash flows to the firm. Hence a decrease in price would imply a decrease in expected future cash flows to the firm. However, we reperform our tests using a PI measure that includes dividends and we report the results of this estimation in the next section. 82 4 Empirical results 4.1 Results of the tests on the overall market reaction to the  announcement of accounting changes. Table 8 presents the sample average abnormal returns to the announcement of income increasing accounting changes. In panel A, our whole-sample results indicate an average abnormal return coefficient, as measured by equation (29), that is negative but not significantly different from zero. The same holds for the partitioning based on the stated reasons for the change in panel B, and for the firms reporting a leverage ratio higher than the average Compustat population in panel C where the average overall market response to the change announcement is not significantly different from zero. Table 9 displays some sta t i s t i c s of the overall market impact to the announcement of accounting changes. Following Richardson, Sefcik and Thompson (1987), we f i r s t test whether each true coefficient equals zero. Assuming that the coefficient estimates A^ are independent across firms with expected value of zero, the average t - s t a t i s t i c on A^ is approximately normally distributed with standard deviation of l/7n, where n is the number of firms in each sample partition. The average t - s t a t i s t i c is less than one standard deviation away from zero in a l l sample partitions, as shown on Table 9. Consequently, we cannot reject the null hypothesis that the true A^ are zero. We now test the less restrictive hypothesis 83 TABLE 8 Average sample market response to the announcement of income increasing accounting changes The v a r i a b l e A i s the market impact c o e f f i c i e n t measured by the equation (29) i n the text f o r each firm: R i t - a i t + 0 i l R m t . l + f>i*mt + P i \ t + 1 + V i + £ i = where R^t and R m t represent firm i ' s return and market return r e s p e c t i v e l y f o r the period t, 6^t takes the value of 1 i f t i s i n the event window (5 days) and 0 otherwise, A^ measures the market r e a c t i o n to the change announcement. We estimate t h i s equation over a period of 245 days i n c l u d i n g a 5 day event period. Number of observations Average estimate Average t - s t a t Percent s i g n i f i c a n t (at the a=.10 l e v e l ) N A ( t - s t a t ) P o s i t i v e Negative PANEL A Whole-sample 109 -.00018 (-.14) .06912 10.09 5.50 PANEL B P a r t i t i o n i n g based on the stated 62 reasons f o r -.00008 (-.04) .05505 13.11 6.55 changing methods PANEL C P a r t i t i o n i n g based on the extent 61 .00099 .08808 9.67 6.45 of leverage (.49) 84 TABLE 9 Frequency distribution of abnormal return coefficients. The coefficients are taken from regression (29) i n the text: R i t - Q i + ^ i V ^ A i * i t + e i f ALL PARTITIONING PARTITIONING FIRMS BASED ON THE STATED REASONS BASED ON THE EXTENT OF LEVERAGE NUMBER OF FIRMS "n" 109 62 61 ANNOUNCEMENT COEFFICIENT \ L Maximum .0765 .0765 .0765 3rd Quartile .00534 .00565 .00745 Median -.0009 -.00065 - .001 1st Quartile -.0074 -.00767 -.0062 Minimum -.0608 -.0608 -.0332 Mean -.00018 -.000088 .000997 F- s t a t i s t i c * .018 .001 .28 (degrees of freedom) (1,25425) (1,14137) (1,14124) z-s t a t i s t i c .7217 .4334 .6873 Under the null hypothesis of a zero mean, Richardson, Sefcik and Thompson (1987), report that the test s t a t i s t i c (sSi) 2 F (Ea 2(A.)) is distributed as F, where a* is the standard error of A^ estimated from the time-series regressions (29) above. Assuming cross-sectional independence, under the null hypothesis that each coefficient is zero, the average t - s t a t i s t i c across the sample for a given coefficient is approximately normally distributed with mean zero and standard deviation of 1/Jri, where n is the number of firms. that the sum of the true coefficients equals zero. Using an F-statistic reported on Table 9, for every sample partition, we cannot reject the hypothesis that the average X^ is zero. 4.2 Empirical results of our cross-sectional tests of association The overall market impact results above do not allow us to clearly identify which conditions presented in section 1 above best explain the phenomenon of the market reaction to accounting changes. We must acknowledge the fact that the unexpected earnings surprise is also included in the overall market impact response to change announcements as measured by model (29) in the text. In an attempt to account for unexpected earnings and better estimate which conditions prevail with respect to market responses to accounting change announcements, we compute the cross-sectional model (26). The results of estimating our cross-sectional model (26) are shown in Table 10 2 4. In panel A, the estimated coefficient 7 2 has the predicted sign and is significantly negative at the a=.l level (one-tailed test). In panel B, for the partitioning based on the stated reasons for changing methods, the coefficient is 24 The correlation coefficients among the independent variables are PANEL A PANEL B PANEL C .011 .087 - .048 TABLE 10 (Unadjusted f o r heteroscedasticity) F i t t e d c r o s s - s e c t i o n a l model of the r e l a t i o n s h i p of investors' p r i o r information with the market response to the accounting change announcement The r e s u l t s are for regression (26) i n text: A. = 7 „ + 7-UE. + 7„PI. + ii. , where : 1 O i l 2 l l A^ = fir m i ' s market response to the change announcement as measured by (29) i n the text, UE^ = unexpected earnings proxy as measured by equation (30) i n the text, PI^ = investors' p r i o r information proxy as measured by equation (31) i n the text, 7-^ = l i n e a r c o n t r i b u t i o n of the unexpected earnings proxy to the abnormal market rea c t i o n to the change announcement, 7 2 = l i n e a r c o n t r i b u t i o n of the proxy for investors' p r i o r information to the abnormal market rea c t i o n to the change announcement, = an error term assumed to be independent across firms and normally d i s t r i b u t e d with mean zero. Panel A presents the r e s u l t s for the e n t i r e sample, panel B presents the r e s u l t s f o r the sample p a r t i t i o n i n g based on the stated reasons f o r the change and panel C presents the r e s u l t s f o r the sample p a r t i t i o n i n g based on the extent of leverage. „ Number 7 Q 7 X 7 2 F ADJ o f (t s t a t ) a (t s t a t ) a (t s t a t ) a R 2 cases Predicted sign (+) (-) PANEL A .0003 .021 .0020 4. ,47* .06 109 ( .288) (2.56)* ( -1.57)# PANEL B .0008 .035 _ .0016 3. .69@ .08 62 (• .387) (2.66)* ( -.766) PANEL C .0016 .022 _ .0033 5. .33* .13 61 ( .877) (2.37)@ ( -2.12)@ a One-tail t e s t * s i g n i f i c a n t at the a=.01 l e v e l @ s i g n i f i c a n t at the a=.05 l e v e l # s i g n i f i c a n t at the a=.10 l e v e l negative but not s t a t i s t i c a l l y different from zero . Finally, in panel C for the partitioning based on the extent of leverage, the PI coefficient is negative and s t a t i s t i c a l l y different from zero at the a=.05 level. We are therefore able to reject our second null hypothesis that there is a zero or a positive relationship between the extent of prior information and the market impact of the change for a l l firms and for the sample partitioning based on the extent of leverage. We also note that the coefficient for A unexpected earnings y2 is positive, as one would predict, and significant in a l l cases . Test for standard assumptions involving residuals The t - s t a t i s t i c shown on Table 10 assumes normality of the residuals. We test for and reject normality using a Kolmogorov-Smirnov test. We also perform an F-test for the equality of estimated variances of A^, and we reject the null hypothesis of equality of variances. Hence, heteroscedasticity is a potential We acknowledge the fact that any of the reasons provided by management as explanations for the accounting change might be excuses. We therefore reperformed our cross-sectional empirical tests for a l l changers with the following reasons: no stated reason, better matching of costs and revenues, and consistency with the firm's choices of methods for tax purposes. The results are unchanged. We would expect to find such a positive association as the market should react positively i f unexpected earnings are positive and vice-versa. We also reperformed our analysis using the Value Line Investment Survey earnings forecast to compute the unexpected earnings proxy variable. The results for the 78 firms with sufficient information are similar to those shown in Table 10 with the exception that the coefficient on unexpected earnings is positive but not s t a t i s t i c a l l y different from zero. problem. We perform a transformation to correct for heteroscedasticity and reduce the excess kurtosis and skewness of the distribution of our error term. Following Richardson, Sefcik and Thompson (1987), both sides of (26) are divided by the estimated standard deviation of A^, a^(X^), computed with the time series regressions (29) . The results of this estimation procedure are shown in Table 11. The results for the PI coefficient are similar to the results of Table 10. Hence, we conclude that our results for equation regression (26) are robust to alternative 27 model specifications . O Q Results using different time period for calculating the PI proxy We reperform the analysis calculating the capital gain or loss on one and two year periods respectively. For the two year period, the coefficient 7 2 *-s negative but only s t a t i s t i c a l l y different from zero for the sample partitioning based on the extent of leverage (but not s t a t i s t i c a l l y different from zero for the transformed models). For the one year period, the same parameter is negative but not significantly different from zero 27 We also reject the normality assumption for the transformed model. However, the departure from normality is not serious as the distribution of our residuals has thin t a i l s , which produce a bias towards not rejecting the null hypothesis. Nevertheless we find significant results for our PI proxy coefficient. 28 Proxy variables represent the true variable only up to a certain error. We must therefore bear in mind, when interpreting the results, the potential bias and inconsistency in the parameter estimates that this problem of error in variable problem might cause. TABLE 11 (Adjusted f o r heteroscedasticity) F i t t e d c r o s s - s e c t i o n a l model of the r e l a t i o n s h i p of investors' p r i o r information with the market response to the accounting change announcement The r e s u l t s are for regression (26) i n text a f t e r d i v i d i n g both sides of the model by the standard deviation of the parameter A^ estimated by equation (29) i n text. Equation (26) i s : A. = 7_+ 7,UE. + 7„PI. + u., where: l ' O i l '2 l ' l ' A^ = fir m i ' s market response to the change announcement as measured by (29) i n the text, UE^ = unexpected earnings proxy as measured by equation (30) i n the text, PI^ = investors' p r i o r information proxy as measured by equation (31) i n the text, 7^ = l i n e a r c o n t r i b u t i o n of the unexpected earnings proxy to the abnormal market rea c t i o n to the change announcement, 7 2 = l i n e a r c o n t r i b u t i o n of the proxy f o r investors' p r i o r information to the abnormal market r e a c t i o n to the change announcement, = an error term assumed to be independent across firms and normally d i s t r i b u t e d with mean zero. Panel A presents the r e s u l t s for the e n t i r e sample, panel B presents the r e s u l t s f o r the sample p a r t i t i o n i n g based on the stated reasons f o r the change and panel C presents the r e s u l t s f o r the sample p a r t i t i o n i n g based on the extent of leverage. Predicted sign A 70 (t s t a t ) a A 7 1 (t s t a t ) a ( + ) A 72 (t s t a t ) a (-) F ADJ R 2 Number of cases PANEL A .1038 (1.013) .0147 (1.55)# -.0009 (-.969) 1, .733 .01 109 PANEL B .0894 (.662) .021 (1.47)# -.0004 (-.345) 1. .16 .003 62 PANEL C .1416 (1.07) .014 (1.46)# -.0025 (-l.96)@ 3. .26@ .07 61 a One-tail t e s t * s i g n i f i c a n t at the a=.01 l e v e l @ s i g n i f i c a n t at the a=.05 l e v e l # s i g n i f i c a n t at the a=.10 l e v e l 90 for any sample partitioning. The results are then sensitive to the time horizon choice for measuring PI in that the significance levels decrease with the time horizon. This result is consistent with the Westerfield (1970) results about the market's early detection of the potential effect of adversity affecting bankrupt firms. Although our sample does not include only bankrupt firms, we report in section 2 of this Chapter that, on average, our sample of firms shows signs of distress prior to the accounting change announcement. Results of using PI proxy including dividends. We also reperform the tests using the stock returns, including dividends, over a similar time horizon to compute the PI proxy. Specifically, we compute the average returns on the market for each firm over a three year period preceding the accounting change announcement. The results of the tests using such a measure for PI proxy do not dif f e r from the results shown in Tables 10 and 11. We then conclude that our tests are robust to the definition of the PI proxy, with or without dividends. 5 Conclusion The results of the tests on the overall market impact of the accounting change announcement do not allow us to reject a zero market reaction in favor of either a positive or a negative market impact. As we have already mentioned, such results provide only 91 weak evidence in favor of a world in which rational anticipations of the manager's reporting actions prevail and in which investors have prior information about the current state of the firm. The po s s i b i l i t y of investors' prior information is further emphasized by our profile results demonstrating that, on average, our sample of changers performed worse in terms of market returns than the market population in the three year period prior to the change announcement. Our cross-sectional analysis provides further evidence consistent with RA and PI. We are able to reject the null hypothesis of a zero or positive association between the market response and the investors' prior information proxy, for the sample as a whole and for the subset of sample firms with above average leverage. We s t i l l find a significant negative association for the sample partitioning based on the extent of 29 leverage for the transformed model . However, we must acknowledge the fact that the cross-sectional results rely heavily on the v a l i d i t y of selected proxy measures: the use of the unexpected earnings proxy to represent the investors' surprise due to the earnings announcement and the use of prior capital gain or loss in share price as a proxy for shareholders' prior information about the current state of the firm. We must acknowledge the fact that the potential inclusion of TAP firms in this sample partitioning would bias the results towards the acceptance of the null hypothesis. However, we s t i l l find significant results for this subsample. Finally, our model does not generate a prediction for the NPI-NRA case and we cannot formally reject this possibility with our empirical tests. However, our profile results in section 2 suggest that, on average, prior information about adversity is available for our sample of firms. Furthermore, our cross-sectional empirical results provide evidence consistent with rational anticipations. It is therefore less l i k e l y that this theoretical po s s i b i l i t y could explain our sample results. 93 CHAPTER V  CONCLUSION 1 Overview of thesis objectives and r e s u l t s In t h i s thesis we present a three step analysis of voluntary income increasing accounting changes. We f i r s t propose a theory as to why managers would e l e c t to increase the reported income through an accounting change. We demonstrate that i f adversity sets i n and i f accounting choices are a function of p o l i t i c a l costs and the manager's compensation plans, i t would be i n the i n t e r e s t of a u t i l i t y maximizing manager to e f f e c t an income incr e a s i n g accounting change. Our f i n d i n g i s further strengthened when we add a t h i r d motivation, a debt r e s t r i c t i o n w r i t t e n on the reported outcome. The t h e o r e t i c a l issue of why managers would change accounting methods has not been addressed by previous empirical work i n the area. In the second step of t h i s t h e s i s , a t h e o r e t i c a l model i s used to analyze p o t e n t i a l market responses to the announcement of an income increasing accounting change i s presented. In t h i s part, we motivate the stock p r i c e e f f e c t of an accounting change by the t h e o r e t i c a l conclusions of the f i r s t step analysis which states that adversity motivates the manager to e f f e c t an income incr e a s i n g accounting change. Our analysis d i f f e r s markedly from previous research i n that a l i n k i s made between the manager's motivation to change methods and the potential market reactions to the change announcement. We also consider the l i k e l y effect of investors' prior information about the state of the world on market response. The consideration of the investors' level of information was not present in prior empirical work. In the theoretical model, we demonstrate that the change w i l l convey information about adversity to the market i f investors have rational anticipations of the manager's reporting behavior (RA). In such a case, the model predicts that the change w i l l induce a negative market reaction. The model also demonstrates that the market response w i l l vary as an inverse function of investors' information about adversity prior to the change announcement. For example, i f investors had complete information about prevailing adversity prior to the change announcement, we predict that the change w i l l not induce a market reaction, since the negative market reaction would have occurred at the time investors learned about the adversity. If, on the other hand, investors have no rational anticipations of the manager's reporting behavior (NRA), the model and subsequent discussions indicate that the change would induce a positive market response, similar to that predicted by Holthausen (1981) (wealth transfer), provided that investors were aware of the prevailing adversity prior to the change announcement (PI). In the third step of our analysis, we present an empirical analysis designed to test the conclusions derived in the theoretical market response analysis above. Our empirical findings are that: 1- On average, the market response to the change announcement is not s t a t i s t i c a l l y different from zero. 2- Relative to the Compustat population as a whole, firms which voluntarily adopt income increasing accounting changes exhibit symptoms of financial distress, suggesting that such change announcements are associated with financial adversity. 3- Firms which voluntarily adopt income increasing accounting changes tend to exhibit symptoms of financial distress one or more years prior to the change year, suggesting that change announcements tend not to be a timely source of information conveying distress to the market. 4- Our cross-sectional tests of association, as predicted, find a significant inverse association between the market reaction to the change announcement and investors' prior information proxy, especially for firms with a leverage ratio that is higher than the Compustat population average. These results lead us to conclude that our data, on average, best describe a world in which investors have rational anticipations with respect to the managers' reporting actions and in which, on average, prior information about adversity prevailed before the change announcement. Our analysis also suggests that, while a voluntary income increasing accounting change appears to be associated with financial distress, such changes are not a timely source of information conveying distress to the market. 2 Comparison of our empirical results with prior  studies 2.1 Mechanistic hypothesis Archibald (1972) and Ball (1972), who evaluated abnormal returns to change announcements with monthly data and who used a wide event window (4 and 12 years respectively), concluded that the announcement of the change had no apparent effect on market prices. Kaplan and Roll (1972) used weekly data and found a 31 week cumulative abnormal return, ending with the announcement week, which was not s t a t i s t i c a l l y different from zero. Our f i r s t empirical result is consistent with the results of the three studies above. We also find no apparent market reaction to the announcement of accounting changes, even with methodological refinements including the use of daily data and a substantially smaller estimation period. Unlike previous studies, we can conclude that the change announcement has no apparent market impact as we measure the market reaction over a five day event window^ ". Previous studies cumulated abnormal returns over a large period making any conclusion about the change announcement per se d i f f i c u l t . 97 2.2 Holthausen (1981") Our i n i t i a l result is comparable to the result of Holthausen (1981), who found an average abnormal market response to accounting change announcements that was not significantly different from zero over an event period similar to ours. We are, like Holthausen, unable to reject the null hypothesis of a zero market response to the change announcement. We consequently replicate Holthausen's result as to the overall market impact of the change. A zero market impact, however, is explained by our theoretical arguments when RA and PI prevail. Our cross-sectional analysis then complements this f i r s t result by testing an implication of RA, namely, the predicted negative association between investors' prior information and market response to the change announcement. As mentioned above, we observe such a negative association. In conclusion, our study complements Holthausen's study in presenting theoretical arguments as to why the market reaction to a change announcement would be zero, and by providing empirical tests for these arguments. 2.3 Harrison (1977') Harrison (1977), using a non-changers control group, found a significant negative difference in returns for voluntary income increasing changers. He averaged the return differences over a thirteen month period, however, as opposed to the five day period 2 in this study . Such a measure is unrefined in the light of recent evidence of less than two day assimilation of information contained in earnings announcements (I.e., Morse (1981)). Harrison's significant negative finding might be explained by the fact that his use of a control sample to measure market reaction to voluntary accounting changes creates a self-selection bias problem in that firms themselves select the group to which they belong (i.e., changers or non-changers). Harrison used no clear theory to identify potential dissimilarities between 3 changers and non-changers . The control variables in his study are therefore unlikely to account for a l l differences, and as Ricks and Biddle (1985) point out, i t is d i f f i c u l t to predict how the differences not accounted for w i l l affect the variations in stock returns. If our theory that adversity induces accounting changes is valid, the proportion of firms affected by adversity should in fact be greater i n Harrison's sample of changers than in his He used monthly returns and computed an average abnormal monthly return for the thirteen month period surrounding the second month after year end, which was assumed to be the announcement month. o His control variables were relative risk, industry and f i s c a l year end. control group . His results capture what we consider to be investors' prior information in this study, namely the investors' reaction to other information about adversity released in the period prior to the change announcement, as well as the marginal signal of the announcement of an accounting change, which would explain his significant negative result. 3 General conclusion This thesis adopts a different perspective on examining market reaction to accounting changes, namely, focusing on the information transmission potential of an income increasing accounting change. This possibility has been considered to some extent in prior research, but never in depth. We must, however, pay tribute to Harrison (1977) for his insight into the issue. Our analysis responds to a need in the accounting literature by providing a theory as to why information can be transmitted through an accounting change. The f i r s t element in this theory is an investigation of the manager's motivation to effect an income increasing revision in his reporting strategy. The second element is the presentation of sufficient conditions for information to be transmitted with the change announcement, that is investors' * Ball (1972), Archibald (1972) and Kaplan and Roll (1972) found that their sample of changers, on average, performed poorly in the period prior to the accounting change. We also provide s t a t i s t i c s suggesting adverse conditions affecting our sample of changers prior to the change announcement in section 2 of Chapter IV. 100 rational anticipations of the manager's reporting actions and investors not having prior information about the prevailing state of the world. Our theoretical setting also specifies the conditions under which a wealth transfer such as that presented by Holthausen (1981) would occur. Our empirical analysis is designed to eliminate one set of conditions in favor of another set of conditions. Our empirical findings favor an interpretation of investors' rational anticipations of the manager's reporting actions and investors' prior information about the state of the world. Finally, the result of our cross-sectional analysis provides further, although weak, evidence consistent with investors' rationality with respect to the manager's reporting actions. Our sample st a t i s t i c s on stock returns prior to the change announcement also provide additional support for the view that, on average, information about adversity was available to investors at the time of the change. One interpretation of our results is that the accounting change is a manifestation of the manager's reaction to a situation that is already known to investors. 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"An Income Strategy Approach to the Positive Theory of Accounting Standard Setting/choice", Journal of Accounting and Economics. August 1981, 129-149. Zmijewski, M.E., "Predicting Corporate Bankruptcy: An Empirical Comparison of the Extant Financial Distress Models", Working  Paper. State University of New York at Buffalo. 1983. 

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