Corporate Financial Reporting Bay Ball

Journal of Accounting Research
Vol, 20 Supplement 1982

Printed in U.SJi,
Corporate Financial Reporting: A

Methodological Review of
Empirical Research
RAY BALL* AND GEORGE FOSTERf
/. Introduction
Our assigned task is a methodological review of current empirical
research in the corporate financial reporting area. In this introductory
section, we clarify our interpretation of the task and describe how the
review is organized.
A methodological review entails using the literature's hody of research
methods as data: methodology is inquiry into method.^ Our aim therefore
* University of New South Wales; ^Stanford University, This paper benefited from
comments of participants in workshops at Baruch College CUNY, Cornell University,
Monash University, Stanford University, University of Chicago, University of New South
Wales, University of Pennsylvania, University of Rochester, and Washington University, A
special thanks is due to detailed criticisms from G, Biddle, S, Datar, L, DeAngelo, P, Dodd,
N, Dopuch, J, Elliott, N, Gonedes, C, Homgren, M, Jensen, A, Kirby, R, Leftwich, J,
Magliolo, R. Morris, C. Purvis, K, Schipper, D, Shores, R, Watts, G, Whittred, M. Wolfson,
and J, Zimmerman, Foster's contribution was sponsored by the Stanford Program in
Accounting, contributors to which are: Arthur Andersen & Co,; Arthur Young & Company;
Coopers & Lybrand; Deloitte Haskins & Sells; Ernst & Whinney; Peat, Marwick, Mitchell
& Co,; and Price Waterhouse & Co,
' Buchler [1961, p, 125] distinguishes "method" and "'methodology" in these terms: ",,,
in the broadest sense 'methodological' questions are those dealing with methods as their
subject matter, questions pertaining to the origin, scope, nature and relative value of
methods," Webster's Third New International Dictionary defines method as ''a procedure
or process for attaining an object . . . a particular approach to problems of truth or
knowledge," Methodology is defined as ''a body of methods, procedures, working concepts,
rules and postulates employed by a science, art or discipline , , , a science on the study of
method." We take "research methods" to include the selection of dependent and indepen-
dent variables, sample selection, choice of functional forms, experimental controls, statistical
inference, etc,
161
Copyright , Institute of Professional AccountinK 1983
162 CURRENT RESEARCH METHODOLOGIES IN ACCOUNTING: 1982
is not simply to describe or categorize research methods, for two reasons

First, the literature being reviewed contains a bewildering assortment of
method, with little coherence across topic areas or (sometimes) within
them. To review a literature with such fragmentation at the level of
method would require more space than is available. Second, we are more
interested in methodological questions such as the validity of experiments
and the maturity of existing research paradigms, than we are with
cataloging methods themselves.
We attempt to impose as little selection by taste as possible, again for
two reasons. First, our task is to survey the entire literature in the
assigned areas, not simply the subset that we find "interesting." Second,
while researchers do not choose topics independently of research
methods, our task is to focus on their choices of research methods and
not to evaluate their choices of topics. A related issue is that we do not
attempt either a chronological survey or a balanced evaluation of individ-
ual works. Nor do we attempt a survey of empirical results; we refer to
results when they shed light on the choice of research methods.
We interpret "current" research to include work that has been pub-
lished in approximately the past decade. Although studies published since
1970 are emphasized, earlier research also is discussed when we wish to
comment on the rate of progress or innovation in a particular research
area.
The term "empirical" is a key qualifier in our statement of task.
Webster's Third New International Dictionary defines it thus:
"originating in or relying on factual information, observation, or direct
sense experience as opposed to theoretical knowledge." Under this defi-
nition, the works of (say) Chambers [1973] and Briloff [1976] are classified
as empirical, even though their processes of observation are more subjec-
tive and less verifiable than those in (say) the many studies presented at
the Empirical Research in Accounting conferences held at the University
of Chicago from 1966 to 1973. We use the term "empirical" in this broader
sense and discuss the process of observation as one issue that arises in
empirical research.
For the purpose of this review, we have classified the corporate financial
reporting literature into four topic areas: (a) corporate disclosure, (b)
accounting method choice, (c) time-series analysis, and (d) financial
distress analysis. These areas are neither mutually exclusive nor exhaus-
tive, in terms of both topics and research methods. Given the size and
fragmentation of the financial reporting literature, some type of classifi-
cation scheme is necessary to describe the data. The above scheme is
motivated, in part, by the tendency of the literature to self-select into the
four areas.^ A feature common to each topic area is that financial
' By "self-select" we mean that there are considerable within-topic-area citations of prior
studies relative to between-topic-area citations. This "tendency" of the literature is baaed
on "casual" observation, but could be subject to citation and other analyses if time
permitted.
CORPORATE FINANCIAL REPORTING 163
statements comprise a major part of the data base in the empirical

research.
For several reasons (notably, to keep our task manageable and to not
cover topic areas assigned to other participants at this conference),
several major topic areas using financial statement data are not discussed
in detail. The principal areas excluded are auditing, capital market
research, and laboratory experiments. The four included areas are de-
scribed in Appendix A, with a view to providing a synthesized data base
for the review. Included in this Appendix is a classified bibliography of
empirical studies (published subsequent to 1969) in each of the topic
areis. Those who are not familiar with these areas should read Appendix
A before proceeding to section II.
The remainder of the paper is structvu-ed into the following sections
and suhsections:
II. Empirical Research in Accounting
III. The Genesis of Empirical Research Ideas
1. Importance to External Parties
2. Importance to Research Communities
3. Availability of Theory to Guide the Empirical Research
4. Availahility of Data
5. Availability of Econometric or Statistical Techniques
6. Summary: Choosing a Research Topic
IV. Importance of Methodological Awareness in Accounting Re-
search
1. Many Competing Views of the World
2. World Views Not Well Articulated for Empirical Research
3. Quasi-Experimental Nature of Research
4. Institutional Domain of Data
5. Summary: Developing Methodological Awareness
V. The Validity of Experiments
1. Internal Validity
2. Construct Validity
3. Statistical Conclusion Validity
4. External Validity
5. Summary: Trade-offs Among Types of Validity
VI. Tests Against Competing Hypotheses
VII. The Maturity of Existing Research Paradigms
VIII. Concluding Comments
A key theme in this paper is the distinction between accounting and
nonaccounting research. Section II seeks to establish one distinctive
feature of accounting research, with the object of obtaining insight into
the empirical literature as a whole and individual experiments within it.
The comments made in Section II are central to appreciating the issues
faced and the trade-offs made hy empirical researchers in corporate
financial reporting.
Our objectives in reviewing empirical research methods are to provide
164 R. BALL AND G. FOSTER
a methodological evaluation of current research and to provide some

guidance for the researcher (particularly doctoral students) in choice of
research method.
//. Empirical Research in Accounting

In this section, we ask the question of how accounting research differs
from research in the basic disciplines and, at the other extreme, accoimt-
ing practice. Our objective is to obtain insights into the trade-offs that
accounting researchers make in experimental design.
If there are to be researchers who call themselves accounft'ng research-
ers, journals called accounting journals and conferences called account-
ing conferences, then there must be something that distinguishes the
domain of accounting research from that of the basic disciplines upon
which it draws. If we exclude behavioral research because it is reviewed
elsewhere in this conference, then those basic disciplines are economics,
mathematics, and statistics. It is instructive to observe how accounting
research differs from the reseeurch in these basic disciplines.
A principal difference between accounting research and research in the
above-mentioned basic disciplines is that accounting research requires a
mapping into the "institutional" domain in which accounting information
is produced or used. For example, the economist's notions of "information
asymmetry," "signaling," "adverse selection" and "competitor response
functions" are considerably more abstract than a decision by a high-
technology firm to release profit margin forecasts on a product-by-prod-
uct basisa decision that involves issues such as the SEC's "safe-harbor"
rules and a firm's procedures to allocate overhead costs across products.
If there is to be distinctively "accounting" research on corporate
financial reporting, then presumably that research must map into the
institutional environment in which financial reports are produced or used.
The data base in empirical research includes the financial statements
themselves. These statements arise within the context of accounting,
fineincial, corporate, and governmental institutions. One area where re-
searchers in accounting face potentially difficult trade-offs, therefore, is
in the integration of these institutional aspects with the models and other
advances made in the basic disciplines of economics, mathematics, and
statistics.
We do not wish to revive the long-standing issue of the definition of
"accounting." We merely observe that if there is to be both "accounting"
and "nonaccounting" research, then there must be a source of the
distinction; and a likely candidate is the greater emphasis upon institu-
tional phenomena in "accounting" research vis-a-vis the research in the
basic disciplines upon which it draws.^ This distinction implies that
^ We are not asserting that the basic disciplines do not attempt to incorporate institu-
tional aspects. Rather, we are asserting that the specific segments of research in the basic
disciplines that accounting draws on typically show limited concern with accounting
institutional aspects. Examples of studies in the basic disciplines that have been important
accounting researchers and the empirical literature in accounting face a

different set of issues from those faced by researchers in the basic
disciplines. The research and the researcher are judged hy a different set
of standards and require a different set of skills. Different experimental
trade-offs are made. In particular, the researcher must attempt to match
the constructs of the discipline with institutionalized data and must be
prepared to live with the anomalies arising from the imperfect match.'*
Viewed against research in the basic disciplines, accounting research
tends to emphasize the mapping of theory into institutional data.
It is also helpful to consider how accounting research differs from work
undertaken for (or by) accounting practitioners, consultants, etc. Much
of this work consists of data summarization, description, or adjustment,
with limited evaluative inferences. The many CPA firm publications
summarizing the ASR No. 190 and the SFAS No. 33 disclosures are
examples of this work. While the documentation of empirical regularities
(if any are uncovered) is valuable to subsequent researchers, this type of
work is less likely to lead to "scientific progress" in the sense described
by Kuhn [1970]. Viewed against this other extreme, accounting research
tends to emphasize the framework of analysis provided by the basic
disciplines.
Consider the problems created by the lack of one-to-one correspond-
ence between the constructs employed in economic theory (e.g.,
"information production") and the data supplied by the institutionalized
research domain (e.g., "capitalized R&D expenditures, as mandated by
SFAS No. 2"). Empirical research confronts theory with data and thus
requires some degree of construct-data correspondence. Because the
laboratory environment is unavailable, the solution cannot be to "purify"
the data from a theoretical perspective. The researcher must attempt to
reduce the level of anomaly implied hy the imperfect construct-data
correspondence, but also will have to decide how much anomaly is
tolerable. The researcher with relatively strong internal loyalty (i.e., to
the scientific community or, alternatively stated, to the discipline) will
in accounting include Box and Jenkins [1970], Spence [1973; 1974], and Jensen and Meckling
[1976],
* This perspective could help explain the relatively low rate of supply of new accounting
faculty and their relatively high price. In explaining the current market for accounting
academics and its persistence for several years, one has to explain the absence of successful
crossovers from economics. The entry costs (in terms of institutional knowledge) are high;
but in addition, we argue that the accounting researcher requires a combination of economic
training and other skills such as the ability to tolerate and work with the anomalies and
ambiguities that attempts to match theoretical constructs with institutional data can be
expected to produce. If, in contrast, the accounting research environment was simply one
of accountants improving their skills in economics, econometrics, and finance, then it would
not be possible to explain the existence of accounting researchas distinct from economics,
econometrics, and finance. Furthermore, it would not be possible to explain why the
resolution of accounting research problems has not been greatly facilitated by crossovers
from those areas. Wolfson [1981] discusses some related issues in a subsection of his paper
entitled "And You Thought That Research in Economics Was Tough!"
tolerate relatively little anomaly and will abandon the data relatively
quickly. The researcher with relatively strong external loyalty (i.e., to
external groups such as the accounting profession, managers or policy-
makers) also will tolerate relatively little anomaly but will abandon the
theory relatively quickly. The researcher who has loyalty in both direc-
tions and the ability to tolerate the consequently higher degree of
anomaly will persist longer with the attempt to fit data and theory
together.
In making choices of research method, the empirical researcher there-
fore must recognize that "good" accounting research might not satisfy
either the disciplinary purist or the practicing accountant: it might seem
overly concerned with both explaining institutionalized data and finding
structure to the data. "Good" research methods in accounting will strike
a pragmatic balance between both extremes. In confronting theory with
data that lie in the institutional domain, the accounting researcher wiU
be fascinated by neither theory nor data alone and will be prepared to
sacrifice elements of both. We therefore believe that research in account-
ing requires a different set of trade-offs than those made in the basic
disciplines and, at the other extreme, in accounting practice.
///. The Genesis of Empirical Research Ideas

Why are certain topics the subject of empirical research at a particular
time? Discussion of this question provides further insight into the tjT)es
of trade-offs made in empirical research in the financial reporting area.
We consider five motivations to empirical research: (1) importance of the
topic to external parties such as the accounting profession, corporate
management, or the investment and credit community; (2) importance of
the topic or research method to a research community; (3) availability of
theoretical structure to guide the empirical research; (4) availability of
data bases; and (5) availability of econometric or statistical techniques to
analyze the data. We discuss each in turn and return to the notion of
trade-offs among motives in a concluding subsection.
1. IMPORTANCE TO EXTERNAL PARTIES
A frequent topic of debate in the literature is the impact of accounting
research on the accounting profession; the general conclusion is that the
direct impact has been minimal.^ There is much less dehate on the impact
of the accounting profession and other external parties on accounting
research. Based on the literature reviewed in this paper, that impact has
been considerable. It is most marked for the corporate disclosure and
accounting method choice topic areas.
A common rationale presented hy authors for their undertaking an
empirical project is the relevance of the results to issues facing the
" See the proceedings of a 1976 conference at Duke University (Abdel-khalik and Keller
[1978]) and a 1981 Arthur Young Professors' RoundUble Conference (Buckley [1981]),
accounting profession at the time. Indeed, in some cases, the research is

sponsored by the profession. Related to this motivation for empirical
research, there is potential conflict between many of the issues that the
profession views as important and those for which there is a refined
experimental methodology.^
As an illustration, consider the "flexibility versus uniformity" of ac-
counting methods debate that occupied center stage of the profession's
concerns in the 1960s. A typical statement in this debate is the following
by an AICPA [1965, p. 16] committee: "Variations in treatment of
accounting items generally should be confined to those justified by
substantial differences in factual circumstances." No operational defini-
tion of "substantial differences in factual circumstances" is given by the
AICPA committee. Nor is it given elsewhere in the literature. Given the
high degree of concern expressed by the profession, it is not surprising
that associated empirical research was undertaken nevertheless. For
instance, Mautz [1972] reports a study that includes an extensive ques-
tionnaire (sent to 500 financial analysts, 500 CPAs, and 500 corporate
executives) and a series of case studies. The research is an "attempt to
tap informed and concerned sources of relevant information in ways
which heretofore have not been exploited" [1972, p. 3]. Apart from
arraying the opinions of the participants interviewed, Mautz was able to
do little more than restate the basic dilemma he viewed as the initial
motivation for his research.
As a second illustration, consider the burgeoning empirical literature
on the economic consequences of accounting standeu-ds. In introducing a
FASB conference on this issue, Staubus [1978, p. i] notes that "concern
about the economic consequences of financial accounting standards is not
new. It plagued the Accounting Principles Board and has permeated
responses to FASB discussion memoranda and exposure drafts since the
Board's inception." Empirical research in this area has been sponsored
by the FASB, the SEC, and lobbying groups attempting to affect the
decisions made by accounting policy groups. For instance, by 1979 there
were at least 13 studies on SFAS No. 8.^ At the time of their sponsorship,
the theoretical underpinnings of many research studies in this area were
Clearly, the rationales presented by authors need not be their actual rationfiles. One
factor that can cause "relevance to the accounting profession'' rationales to be included in
papers is the review process. Papers submitted to accounting journals often have such
rationales added due to requests from reviewers to better motivate the research,
' This conflict exists in vju-ying degrees. For instance, Deakin [1979, p, 722] examines the
descriptive validity of arguments presented at FASB, SEC, and DOE public hearings on oil
and gas accounting, e.g., "the fuU cost companies argued that they were more aggressive in
exploration, newer, and in greater need of external fimds than successful efforts companies,"
If this research is used only to conclude that statements by X or Y are descriptively valid
or invalid, the conflict noted in the text is minimal. If the results are used to make inferences
above how full cost firms might behave if successful efforts were mandated, then the conflict
exiata in the extreme,
" See Griffin [1979],
at a very early stage of development. It is not surprising that inferences

drawn fi-om much of this research have been relatively unreliable.
We do not question researchers examining the concerns of the account-
ing profession when making topic choices. However, these concerns can
create a demand for research when, given the state of the art, research is
incapable of yielding reliable inferences. This situation is very apparent
with sponsored research studies where reliability of inferences might not
even be a major motivation for sponsorship. Sponsoring a research study
could be one means by which a policy body exhibits its responsiveness to
the concerns of its various constituents. It could also be a means of
delaying (until after the research is completed) the placement of an issue
on the agenda of items to be decided.
In contrast to the corporate disclosure and accounting method choice
areas, research in the time-series and distress prediction areas appears
less directly linked to issues facing the accounting profession.'" However,
parties external to a research community might still have an important
infiuence on the decisions made by empirical researchers in these areas.
For instance, several studies in the distress prediction literature focused
on predicting the solvency status of regulated institutions such as banks,
insurance companies, and savings and loan institutions, as in Sinkey
[19756, 1977]. From a regulator's viewpoint, a technique such as discrim-
inant analysis can be very attractive if it enables an improvement in
decision-making capabilities. The existence of a tight theoretical under-
pinning for the discriminant model is neither a necessary nor a sufficient
condition for this improvement to occur. Methodological soundness (such
as construct validity, discussed in section V) also is not necessary for the
discriminant model to facilitate an improvement. In this context, an
external party such as an FDIC regulator has a different focus than a
researcher wishing to maintain a strong allegiance to the values of a
research community.
2. IMPORTANCE TO RESEARCH COMMUNITIES
In several topic areas, there is evidence of researchers operating under
a shared research paradigm. This is most clearly the case with research
under the "stewardship-contract monitoring" paradigm: for example.
Watts and Zimmerman [1978], Hagerman and Zmijewski [1979], Dhaliwal
^See Ball [1980] and Foster [1980], A compounding problem is the time pressure
individuals face when conducting sponsored studies. Consider SFAS No, 19, The FASB
"released" the exposure draft on July 19,1977, and issued the final statement in December
1977. Included in the December 1977 statement were the results of an empirical research
project (by T, R. Dyckman) on the capital market impact of the July 1977 exposure draft
A short turnaround time on a project of this difficulty means that methodological consid-
erations are less Ukely to be explored.
'" Some linkages are observable. For example, see the Altman and McGough [1974] study
linking distress prediction analysis to "going-concern" decisions by auditors and the Kinney
[1978] study linking Box-Jenkins analysis to analytical review decisions by auditors.
[1980], Bowen, Noreen, and Lacey [1981], Leftwich, Watts, and Zimmer-
man [1981], Zmijewski and Hagerman [1981], and Chow [1982]. The
immediate relevance of the results in these papers to external parties
such as the accounting profession does not appear to be important to
these researchers. The accounting profession in the 1980s hardly seems
concerned with either (i) variables associated with the voluntary issuance
of interim reports in 1948 (as are Leftwich, Watts, and Zimmerman
[1981]) or (M) variables associated with the voluntary issuance of auditor's
report in 1926 (as is Chow [1982]). Such research is better explained by
attempts to probe the descriptive validity of predictions associated with
the stewardship paradigm.
Segments of the time-series and distress prediction literatures also
exhihit behavior consistent with researchers sharing a common paradigm.
For instance, there is evidence of common agreement among researchers
that time-series tools such as Box-Jenkins and classificatory techniques
such as discriminant analysis are appropriate and interesting ways of
addressing a variety of issues. There also is considerable citing of prior
studies in these literatures and evidence of attempts to improve the
technical aspects of these prior studies, suggesting progress via a shared
commitment to a paradigm. Researchers operating in these areas also
appear to value the judgments of their colleagues considerably more than
those of individuals operating outside their paradigms. For example,
researchers using Box-Jenkins time-series tools often face trenchant
criticism when their papers are reviewed by those not sympathetic to
their highly technique-oriented approach. Consider also Leftwich's [1981,
p. 241] comments on the distress prediction literature: "I find the research
intellectually unsatisfying because it is primarily a statistical exercise.
There is no theory to guide the selection of variables for inclusion in the
discriminant function, and, even if we discover variables that "work' well
(in terms of discriminating or predicting), it is not clear what we learn
from the exercise." A prediction of Kuhn's [1970] theory of scientific
behavior is that such criticisms are ignored; only the opinions of those
operating under the shared paradigm are viewed as important."
3. AVAILABILITY OF THEORY TO GUIDE THE EMPIRICAL

RESEARCH
Advances of a theoretical kind can be an important motivation for

undertaking empirical research. For instance, theoretical developments
relating to the two-parameter asset-pricing model and the option-pricing
model provided important stimuli to much suhsequent empirical work in
the finance literature.'^ This stimulus has not been important in the
" An interesting puzzle is how the existence of this paradigmatic behavior by researchers
in the 'stewardship-contract monitoring," time-series, and distress prediction areas is
consistent with the "market for excuses" notion advanced by Watts and Zimmerman
[1979],
'^ See Jensen [1972] and C, W, Smith [1976],
literature reviewed in this paper. Indeed, a frequent observation through-

out this review is the limited role played by theory in explicitly guiding
empirical research projects in corporate financial reporting.'^ In the few
areas where researchers draw on the underlying disciplines, their models
suppress much of the richness of the institutional environment in which
financial statements are produced or used. For instance, we stiU do not
have models that incorporate into the signaling literature (e.g., Spence
[1973]) such basic features of corporate disclosure decisions as the exist-
ence of competing information sources (earnings, dividends, forecasts,
etc.) and the differential role played by auditors in relation to these
competing sources.
In sum, empiricists who require their research to be explicitly guided
by theories that relate to the institutional environment generating the
data being examined would probably seek out research areas other than
those examined in this paper. Empiricists working in the areas examined
have to be able to accept a relatively high degree of uncertainty in
important research choices including the variables to examine, the quasi-
experimental design to use, and the inferences that can be drawn.
4. AVAILABILITY OF DATA
An important component of an empirical research project is the rele-
vant data base. As new bases are developed, the issues that can be
addressed can expand; it can also be possible to revisit previously re-
searched topics in a more systematic way. The development of the
Compustat Tape facilitated accounting researchers' use of larger samples
and examination of longer time periods than previously was typical in
the literature. The availability of the NAARS data file has enabled
researchers to obtain larger (and possibly more representative) samples
of firms using specific accounting methods, making accounting changes
of a specific type, etc. The development of the Earnings Forecaster data
base by Standard and Poors and the I/B/E/S data base by Lynch, Jones,
and Ryan has expanded the set of issues that can be reliably addressed
in the earnings forecast area. Not all new data bases need be in machine-
readable form. One of the innovative features of the Watts and Zimmer-
man [1978] paper was the use of the FASB's Public Record data base.
This data base includes correspondence between the FASB juid its
various constituencies, submissions by external parties on policy issues,
and related data.
Different "views of the world" can imply that different data bases are
of interest. For instance, one consequence of adopting a "stewardship-
contract monitoring" perspective in the corporate disclosure and account-
ing method choice areas is that contracts between various parties asso-
ciated with a firm become important data points. The researcher then
requires data on loan agreements, management compensation schemes.
" This observation is not new. See Hakansson [1973] and Gonedes and Dopuch [1974],
etc. These new data bases, however, raise issues of data coding not
previously addressed. For example, if one adopts the perspective that
these contracts are the starting point of an ongoing relationship between
the various parties (the opening rules of the game), then there is ambi-
guity about how to code specific clauses in the contracts. Moreover, in
some cases, a researcher might have only partial information on these
contracts. For instance, many proxy statements do not provide full details
of management compensation agreements. The researcher has to decide
whether these types of problems can be solved satisfactorily: there can
be a distinct trade-off between the level of interest and innovation in a
research program and the availability of reliable and relevant data.
Other data of special interest to researchers associated with the
"stewardship" paradigm are the financial statements issued by corpora-
tions prior to regulatory interventions such as the Securities Exchange
Act of 1934, as in Benston [1969] and Watts [1977]. Again, potentially
troublesome data issues arise when conducting research in this area. For
example: (i) the term "financial statement" needs to be defined precisely
since some companies issued financial information only in narrative form
while others included a balance sheet and income statement, and (ii)
even of the suhset of companies still surviving, not all have records of
their early financial statements let alone details of to whom they were
sent."
Data quality issues also arise in the time-series and distress prediction
areas. For instance. Box and Jenkins [1970] discuss identification and
estimation issues for stationary time series. Given the high level of
acquisition and divestiture activity of some firms, an assumption of
stationarity for even a ten-year period might appear extreme. Yet, ten
years provides only ten annual earnings observations, and one cannot
expect such a small data base to teU a very refined story about the
behavior of the series over time. The researcher needs to make these
kinds of trade-offs.
5. AVAILABILITY OF ECONOMETRIC OR STATISTICAL TECHNIQUES

Developments in other disciplines are an important source of research
ideas in the corporate financial reporting literature. This subsection
discusses the role of such developments at the technique level. These
developments have affected the time-series and distress prediction liter-
atures most.
The development of data analysis tools by econometricians and stat-
isticians has been an important stimulus to many time-series studies in
accounting. The ready availahility of Box-Jenkins univariate time-series
algorithms was a major factor in the explosion of manuscripts in this area
'* Cook and Campbell [1979, pp, 230-32] discuss some of these issues under the heading
of "Limitations of Much Archival Data,"
in the mid and late 1970s. In the late 1970s, algorithms for Box-Jenkins
multivariate time-series analysis became readily available. The account-
ing literature now reflects papers using this technique to examine (or
reexamine) a variety of issues, including earnings forecasting and the
importance of industry and economy factors in the behavior of the
earnings of individual firms.
Technique developments hy econometricians and statisticians also
appear important in the distress prediction literature. Early multivariate
studies in this area used linear discriminant analysis, as an Altman [1968]
and Deakin [1972]. One of the stated motivations given in several sub-
sequent studies was the use of "recent advances" in discriminant analysis.
For instance, Altman, Haldeman, and Narayanan [1977, p. 29] examine
the use of quadratic discriminant analysis and the "explicit introduction
of prior probabilities of group membership." Subsequent studies also give
advances in technique as a major reason for undertaking the research, as
in Ohlson [1980, p. 109], which uses "maximum likelihood estimation of
the so-called conditional logit model."
Improvements in econometric and statistical techniques are a legiti-
mate source of new accounting research. However, there is always the
danger that the technique itself becomes the focus of attention. This
danger is especially apparent in literatures such as time-series analysis
and distress prediction, where the economic underpinning of the research
can be minimal. In some cases the research contribution is more to the
econometrics and/or statistics literatures than to the accounting litera-
ture.
6. SUMMARY: CHOOSING A RESEARCH TOPIC
We have identified five motives for particular empirical research pro-
jects in accounting. Presumably there are others. Several of the motives
discussed relate to the skills of a specific researcher or the value set of
the specific institution with which the researcher is associated. For
instance, a researcher with limited analjîcal skills might restrict topic
choices to areas where developed models are already available in the
literature, whereas a researcher with strong analytical skills might work
on model development as part of the research project. As a second
example, a researcher in an environment sympathetic to Box-Jenkins
time-series research might undertake a project that individuals at other
institutions would label as a "data searching exercise that will yield no
new economic insights."
It is unlikely that a single empirical project (1) will be of high interest
to an external party such as the accounting profession, (2) will be of high
interest to a research community, (3) will have models available explicitly
to guide both the research design and the drawing of inferences from the
research, (4) will have high-quality data available, and (5) will have
appropriate econometric or statistical tools available to analyze the data.
In general, trade-offs among these factors are inevitable. One interesting
feature of the papers reviewed in Appendix A is how different trade-offs

have heen made and how these differences affect the "validity" of the
research conclusions. A dimension of the choice is the relative infancy of
the particular research area, a topic explored more fully in section VII. In
general, a new area of research (an aspirant paradigm?) will appear
relatively weak on a significant subset of the above five variables; for
example, it will have less theoretical guidance, fewer data sources that
are reliable and relevant, or more trouble in selecting appropriate tech-
niques.
IV. Importance of Methodological Awareness in

Accounting Research
In paradigm-based research, the individual researcher is supplied with
a set of solutions to many questions of experimental method and is
relatively assured that further work will provide solutions to the remain-
der.^^ This section develops the theme that, in many areas of corporate
financial reporting, an individual has very limited guidance fi*om the
literature in designing an empirical research project and in interpreting
its results. Section V offers some constructive suggestions on experimental
method.
1. MANY COMPETING VIEWS OF THE WORLD
In several topic areas, there are many competing "views of the world"
which have implications for the types of data that are "interesting," for
the dependent and independent variables to be investigated, for func-
tional forms and other experimental matters. For example, consider the
issue of "why firms choose a specific set of accounting methods." At least
six different ways of viewing accounting method choice by managers can
be identified in the literature: (i) Accounting Model View. This view
posits that method choices are made using accounting model notions
such as matching costs and revenues and conservatism. The accounting
literature has included this perspective for many years, as in Gilman
[1939] and Hendriksen [1977]. (w) Economic Reality/Truth View. This
view also has a long tradition in the literature. For instance, an oft-heard
criticism of the historical cost accounting model is that under infiationary
conditions it misstates "economic" or "true" earnings. As early as 1918,
Middleditch argued that disregarding "the changing dollar in accounts
does not permit the true condition of affairs to be set forth" [1918, p.
115]. More recent statements of this view are in discussions of accounting
for foreign exchange translation.' {iii) Fair Presentation/Comparability
'" See Kuhn [1970] for elaboration of this point and for some definitions of the term
'paradigm," for which "accepted theory" can be loosely substituted,
"See Financial Accounting Standards Board [1981]. Hercules makes the following
comment in its 1981 Annual Report: "The company has adopted [SFAS No, 52] because
it more appropriately reflects the economic realities of managing a multinational company,"
View. This view posits that an important factor in accounting method

choice is interfirm or interperiod comparability. The "uniformity versus
diversity in accounting method" debate in the 1960s contained many
statements consistent with this perspective." (iv) Economic Conse-
guences to the Firm's Stockholders View. One approach to expositing
this view has been to assume that management makes accounting method
decisions in the same way that it makes other resource allocation deci-
sions. For instance, if a firm uses a discounted cash fiow/net present
value criterion in its plant investment decisions, it would also use this
criterion in (say) its depreciation, inventory, and pension fund accounting
method choices. The taxation implications of the LIFO inventory deci-
sion are a well-known example of how cash flows can be affected by
accounting method choices, {v) Economic Conseguences to Management
View. An explicit statement of this view is in Gordon [1964, p. 261]: "The
criterion a corporate management uses in selecting among accounting
principles is the maximization of its utility or welfare." Management
welfare may be affected by accounting method choice in a variety of
ways, for example, (a) if the choices impact parts of a management
compensation package such as a bonus plan based on financial state-
ments, and (6) if the choices impact the probability of takeovers occur-
ring,'** (vi) Regulatory Compliance View. When a body like the FASB or
SEC mandates a new accounting method choice, management must
decide whether to comply with that mandate. While compliance is most
t3rpical, other options include (a) evasion, (6) a qualified audit report,
and (c) a private listing.
These six viewpoints are neither mutually exclusive nor exhaustive of
those in the literature.'* They have different implications for empirical
research, even to the point of implying that different data sets are of
interest. For instance, under the accounting model view, the data could
well be the accounting methods adopted and statements by managements
about the reasons for their adoption.^ Under the comparability view, the
" See the Autumn 1965 issue of Law and Contemporary Problems on "Uniformity in
Financial Reporting,'' In its 1979 Annual Report, Anheuser Busch gives the following as
one rationale for an investment tax credit change: "[the change will result] in its financial
reporting being more consistent with that of most industrial companies and particularly
those companies in the beverage and food industry."
'* Johnson [1966, p, 92] provides an early discussion that recognizes the self-interest
motives of management: "There is nothing particularly sinister in the bias on external
measurements that stems naturally from managerial self-interest,"
'" Other viewpoints include (j) "innovation diffusion" and (ii) the dominant personality
approach. Examples of (i) include Tritschler [1970], Copeland and Shank [1971], and
Comiskey and Groves [1972]; {ii) typictdly is cited in anecdotal discussions of accounting
method choice. Yet another viewpoint is the "garbage can" model of organization choice of
Cohen, March, and Olsen [1972, p, 1]: "Organizations can be viewed for some purposes as
collections of choices looking for problems, issues and feelings looking for decision situations
in which they might be aired, solutions looking for issues to which they might be an answer,
and decision makers looking for work,"
''' For example, "The Company changed its method of accounting for returnable pack-
data would include the financial statements of other "comparable"

firms.^' Under the economic consequences to management view, the data
could include management compensation schemes in addition to the
financial statements of the firms being examined. These different data
bases could also entail different modes of analyzing the data and different
problems in drawing inferences from the data.'^^
Even within each competing view, an empirical researcher can face
considerable uncertainty. For instance, within the economic conse-
quences to the firm's stockholders view and the economic consequences
to management view, there are the foUowing unresolved issues: (i) should
the analysis proceed at the single-period level or should a multiperiod
perspective be adopted, and (ii) should the analysis proceed at the single-
accounting method level or should a multiaccounting method perspective
be adopted? At this stage, a single-period, single-accounting method
perspective has been the dominant mode of empirical research. Amershi,
Demski, and Wolfson [1981, p. 18] discuss the alternative of a multiperiod,
multiaccounting method perspective, but make "little progress in dealing
with the model specification problem." The pros and cons of alternative
research modes in this area have not been extensively debated in the
accounting literature,^^ despite the potential differences in the research
aging materials in order to more closely match the cost of these materials to revenues" 1980
Annual Report of Pittsburgh Brewing Co,
^' "U,S, Steel's Bracy Smith argues that it was impossible for U,S, Steel to stand alone
against the crowd unless it was willing to see its stock suffer, 'We would be very happy if
they would make the rule that everyone has to take accelerated depreciation on their books
,,, But you can't have just one company doing it'" (Minard and Wilson [1980, p, 97]),
^' We are not asserting that the coexistence of these many competing views is unique to
the accounting method choice literature in particular or even to the corporate financial
reporting literature in general. However, based on our experience with information content-
capital market research, it is our belief that an empirical researcher in the accounting
method choice area does face a relatively high degree of uncertainty on both research
design issues and the reliability of inferences drawn from any chosen design. The level of
uncertainty faced is certainly much higher than that described by Kuhn [1970] for several
"pure science'' disciplines, Kuhn's descriptions, however, might represent an unrealistic
Nirvana to an empirical researcher in corporate financial reporting. In addition, the Kuhn
[1970] perspective is not without its critics, as described in Blaug [1980],
" Wolfson [1981, pp, 213-14] takes a very strong position on this issue: "If a model of
accounting method choice is to have any empirical validity, several ingredients seem
essential: Observation is costly,,,, The choice of financial reporting methods is decentral-
ized The setting is a multi-period one. Those readers familiar with economic theory will
recognize immediately that classical equilibrium-analytical approaches will not work. Game-
theoretic solution concepts must be employed because of differentially informed players.
Although such approaches are often intractable, I believe that accounting researchers
interested in learning about accounting choices will have to get used to this,"
How an empirical researcher is to be guided by an approach that is "often intractable"
is not discussed by Wolfson, Note that his comment about the necessary ingredients for a
model to have "any empirical validity" raises important issues of model choice. An
alternative perspective would be concerned with the predictions of a model incorporating
the above ingredients vis-a-vis the predictions of competing modelssee Friedman [1953]
and Blaug [1980, chap, 4],
designs between (say) a single-period/single-issue perspective and a mul-

tiperiod/multiissue perspective.^''
2. WORLD VIEWS NOT WELL ARTICULATED FOR EMPIRICAL
RESEARCH
From an empiricist's perspective, analytical research can play several
important roles.^* One role is to develop "theories" that guide decisions
pertaining to the variables to examine, the form of the model to use, etc.
There is limited evidence of analytical research plajang this role in the
literature surveyed in Appendix A. A second role is to guide the inference-
drawing process. There are several areas in the corporate financial
reporting literature where such guidance could occur.
Consider the corporate disclosure area. A common theme in much of
the early empirical literature was that "more disclosure is better." An
extreme expression of this perspective is the literature computing disclo-
sure indexes and then using the index scores to make inferences about
disclosure adequacy. However, analytical research has demonstrated that
"more disclosure is not necessarily better." Baiman [1975] demonstrates
that whereas in a single-person setting the provision of additional costless
information cannot decrease utility, in a multiperson setting the same
conclusion does not always hold. The literature on social versus private
value of information also documents instances where more disclosure is
Pareto inferior to less disclosure, as in Hirshleifer [1971]. At a minimum,
these results should make an empirical researcher more cautious when
drawing inferences from studies using disclosure indexes.
At one level (inference drawing), the above analytical studies provide
important guidance to an empirical researcher. At another level (research
design), however, they have added to the uncertainty faced by an empir-
ical researcher. A constant theme in such research is the complexity of
the world when we admit to the existence of multiple principals, multiple
agents, multiple periods, strategic behavior, costly information, uncer-
tainty, imperfect markets, and so on: "When one goes from the anal3rsis
of information systems in a one-person world to the analysis in a multi-
^ For instance. Watts and Zimmerman [1978] code firms' submissions to the FASB on
their position on GPLA alone. Several firms, however, gave, a no-vote to GPLA in
conjunction with a yes-vote on replacement cost. For instance, the submission by Standaid
Oil of Indiana included the foUowing comment: "Adjusting historical cost statements by
application of an overall general price index . , , does not produce information which is
relevant to the intended user We would suggest that to the extent that data supple-
mental to historical cost statements would be helpful, they should appropriately embrace
a replacement cost concept," We are indebted to Marsha Puro for this example.
A multiperiod, multimethod perspective would incorporate this (no on GPLA/yes on
replacement cost) observation as a single unit of analysis. In contrast, a single-period,
single-method perspective would treat the no/yes as two independent observations.
^ Clearly, the same individual can undertake both analytical and empirical research,
although in the studies outlined in Appendix A there is limited evidence of both types of
research being undertaken in the same paper.
person world, the attendant complexities greatly increase" (Baiman [1975,

p. 14]). "In a rich setting we would view each regulatory action taken by
the FASB, the SEC, the AICPA, a particular industrial firm, a particular
CPA firm, and so on as a single move in a multi-move 'political regulatory
game.' Few would deny this characterization. Equally clear is the over-
whelming complexity of introducing multi-move considerations into this
type of research" (Amershi, Demski, and Wolfson [1981, pp. 1-2]).
An empirical researcher, used to living with an unclear picture of the
world and the existence of plausible rival hypotheses,^ does not find a
comment that the world is complex very informative.^^ Although there is
a trend in the analytic literature toward recognizing more rather than
less complexity in the world, researchers in this literature have not placed
a high priority on helping guide the construction of empirical research
designs that, in the light of their observations, provide more rather than
less reliable inferences. The relative absence of such efforts contributes
to the uncertainty about experimental design that is faced by empirical
researchers in corporate financial reporting. In part, these problems are
due to the early stage of development of some of the "world views" that
are candidates to guide empirical research in accounting, an issue dis-
cussed in section VII. In part, they also are problems that can be expected
to persist.
3. QUASI-EXPERIMENTAL NATURE OF RESEARCH
Nonlaboratory research in corporate financial reporting generally can-
not manipulate experimental variables. Consequently, more reliance is
placed on theories and models for experimental control. Consider Ben-
ston's [1969; 1973] work on the effects of regulation which involved
comparing pre- and post-1930s phenomena. Not being able to manipulate
and Campbell [1979, p, 23] express this perspective thus: "The only process
available for establishing a scientific theory is one of eliminating plausible rival hypotheses.
Since these are never enumerable in advance, or at all, and since these are usufdly quite
particular and require unique modes of elimination, this is inevitably a rather unsatisfactory
and inconclusive procedure,"
^' There are deeply held differences on how seriously an empirical researcher should
even concern himself with results in several areas of analytic research, Jensen [1976, p, 14]
is very explicit on this score: "Most of the [state-preference-related] literature on [infor-
mation production and disclosure] has little or nothing to do with substantive accounting
problems, even though it has pretensions in that direction. Most of it amounts to the
generation of 'possibility theorems' The other major thrust of this analysis is in the
delineation of the set of assumptions which must be made on the form of individual utility
functions, distribution of resources, etc., in order to draw some specified set of implications.
But this work is little more than the rigorous manipulation of toy logical structures which
entirely lack empirical content. It leads to no new understanding of the workings of the
world. To this I ask: Why do we care?"
Blaug [1980, p, 192] makes some similar points in relation to general equilibrium theory
in economics: "Its leading characteristic has been the endless formalization of purely logical
problems without the slightest regard for the production of falsifiable theorems about actual
economic behavior, which, we insist, remains the fundamental task of economics,"
the experiment so that two otherwise identical worlds are compared

one with and the other without an SEC (and accompanying legislation)
Benston has several options, notably: (a) assume that the world is
stationary and that the introduction of the SEC is like a random act of
nature, occurring independently of the phenomena under investigation,
or (b) model the phenomena that led to the SEC.
If the SEC was created in response to (say) an increase in perceived
risk to investors (see Officer [1973]), adopting the first option could
attribute increased disclosure to the SEC rather than to the phenomena
that led to its creation. Under the second option, the researcher would be
interested in the predicted level of disclosure, conditional upon post-SEC
risk levels in the economy. Given the difficulties of making these predic-
tions, it is not surprising that Benston and other early researchers adopt
the first option. However, the subsequent literature contains little debate
on the pros and cons of these two experimental options.^ Nor have
empirical studies been conducted using the second option, so we have
few insights available about whether (and how) the inferences drawn by
Benston are sensitive to edtemative experimental designs. Our purpose is
not to speculate on the reasons for the formation of the SEC at a
particular point in time; rather, we wish to observe that it is unlikely to
be a random act of nature and the researcher on regulation is likely to be
forced into a quasi-experimental design in order to control for important
veu-iables.
The above topic area is but one of msmy in corporate financial reporting
in which quasi-experimental research designs predominate. These designs
place greater reliance on "theories" or "world views" relative to experi-
mental designs in which randomization is possible, as discussed in Cook
and Campbell [1979]. In subsections IV.l and IV.2, we argued that such
reliance currently is difficult to obtain.
4. INSTITUTIONAL DOMAIN OF DATA
As argued in section II, data in accounting are rich in institutional
detail. This richness typically is not captured in the models that guide
the research in this area. Consider the time-series literature. The Box
and Jenkins [1970] work that underlies this literatvire concentrates on
model identification and estimation for stationary time series; there is
very little analysis of the implications of specific "shocks" in the process
generating the time series examined for either identification or estimation.
Such "shocks" are potentially many in a financial reporting context. An
empirical researcher analyzing the reported interim earnings series of
I.T.T. for the 1970 to 1982 period, for example, would find that it includes
many accounting changes (e.g., the pre-SFAS No. 8 era, the SFAS No. 8
era, and then the SFAS No. 52 era). It also includes many acquisitions
'" Ball [1980] discusses these issues with specific reference to the effect of SFAS No, 2
{Accounting for Research and Development Costs) on management decisions.
and divestitures hy I.T.T. It is unreasonable to expect Box and Jenkins

[1970] or the other time-series literature outside of accounting to incor-
porate this degree of institutional detail into its analysis.
The onus is clearly on the accounting research community to incor-
porate institutional aspects such as those noted above into the research.
However, there is limited guidance in the accounting literature on how
(and even whether) this incorporation should proceed. As a result, we
observe many different approaches used. Some studies appear simply to
ignore accounting changes, acquisitions, divestitures, etc. Other studies
adopt empirical-based rules for handling these "shocks," such as exam-
ining earnings before extraordinary items. Another institutional feature
that arises in an accounting context is "material asset write-downs" and
"fourth quarter adjustments."^* We observe little discussion in the liter-
ature on how to "handle" such items when identifying and estimating
time-series models. The absence of this discussion is symptomatic of the
lack of theoretical guidance in many areas and underscores our general
conclusion that there is a relatively low level of debate on methodological
issues in several major strands of the financial reporting literature.
5. SUMMARY: DEVELOPING METHODOLOGICAL AWARENESS

Unlike paradigm-based research, where paradigmatic guidance in ex-
perimental design makes the task similar to Kuhn's [1970] concept of
"puzzle-solving," empirical research in the areas we have surveyed re-
quires that choices be made under relatively high uncertainty. There is
imcertainty about choice of "world view," and there are problems caused
by imperfect translation from world views to the empirical and (espe-
cially) the institutional domain. There is greater reliance placed on these
"world views," arising from the quasi-experimental research designs that
predominate in this area of accounting research. These observations
suggest the need for empirical researchers in accounting to develop
considerable methodological awareness. In the following section, we
describe guidelines that are suggested by the experience of empirical
researchers in other fields.
V. The Validity of Experiments

The conclusion from prior sections is that, in many areas, an empirical
researcher is provided with limited guidance ahout choice of experimental
method. Given this conclusion and the quasi-experimental nature of most
^ The numerical effect of these adjustments can appear "large," Several companies that
appeared in Fortune's (May 5,1980, p, 93) list of "The Champion Monpy Losers" had line-
items associated with plant closings, divestitures, and expropriations. For example. Ana-
conda (1971 net loss = $356,4 million). Singer (1975 net loss = $451,9 million), and
Bethlehem Steel (1977 net loss = $448,2 million).
corporate financial reporting studies, considerable benefit is to be ex-

pected from conscious thought about method choice. In this subsection,
we illustrate this ohservation in relation to a key dimension of experi-
ments: their "validity." This term is used as in Cook and Campbell [1979,
p. 37], referring to the degree of approximate truth of propositions made
by the experimenter in relation to the experiment (e.g., the proposition
"X partly causes Y").''" We use the terminology and structure of these
authors throughout, though we note their reservations (principally [1979,
pp. 80-82 and 85-91]) concerning their taxonomy.
Cook and Campbell [1979, pp. 37-39] distinguish four types of validity:
(1) internal validity, (2) construct validity, (3) statistical conclusion
validity, and (4) external validity. We discuss each in tum, providing
illustrations from the accounting literature. We then note the difficult
issue of the trade-off between different types of validity.
1. INTERNAL VALIDITY
Internal validity "refers to the approximate validity with which we
infer that a relationship between two variables is causal or that the
absence of a relationship implies the absence of cause" (Cook and
Campbell [1979, p. 37]). Cook and Campbell observe that "accounting for
third-variable alternative interpretations of presumed (causal) relation-
ships is the essence of internal validity" [1979, p. 50]. They also note
"with quasi-experimental groups, the situation is quite different. Instead
of reljdng on randomization to rule out most internal validity threats, the
investigator has to make all the threats explicit and then rule them out
one by one. His task is, therefore, more laborious" [1979, p. 56]. Cook and
Campbell discuss several typical sources of threat to internal validity. To
illustrate, we consider two: "selection" and "ambiguity about the direction
of causal inference."
Selection. This threat to internal validity occurs when "an effect may
be due to the difference between the kinds of people in one experimental
group as opposed to another" (Cook and Campbell [1979, p. 53]). Consider
studies in the financial distress analysis area that employ a paired sample
design, in which failed and nonfailed firms are represented in equal
frequencies. In relation to variables such as debt/equity ratios, standard
deviation of EPS (or of any variable), and "beta" (of the security return
or accounting EPS)which are proxies for variability but do not in
themselves have the capacity to predict the direction oi firms' future
performancethe 50/50 sample design imparts directional prediction
within the selected sample. The proxies for variability will tend to
discriminate between the high-variance (failed) firms and the average-
^ In this section, the terms "valid" and "invalid" refer to end zones of a spectrum rather
than endpoints (in the one-zero sense). Cook and Campbell [1979, p, 37] note that "when
we use the terms valid and invalid, they should always be understood to be prefaced by the
modifiers 'approximately' or 'tentatively.'"
variance (nonfailed firms), though they might not distinguish high-vari-

ance (failed) firms from high-variance (very successful) firms. Given the
selection criteria, to infer a relation between variables that proxy for
variance and the direction of future firm performance is invalid.*'
A related issue is the failure in much of the corporate financial reporting
literature to motivate the implicit assumptions ahout exogenous versus
endogenous variables when firms are selected using control group ap-
proaches. With a control group those variahles used for pairing treatment
and control firms are precluded from being endogenous in the experiment.
Early distress prediction studies which paired firms on industry and size
(or required at least five years prefailure data to be available) are
examples where the resultant discriminant function excludes variables
potentially important in understanding the underlying attributes of fi-
nancially distressed versus nondistressed firms. More recent examples
occur in the accounting method choice area. For instance, Bremser [1975]
studies the earnings characteristics of firms making accounting changes.
A matched-pairs design is used with industry membership chosen as the
matching variable. Note, however, that if industries differ in earnings
variability and if there is an industry factor in the change of accounting
method, this matching will control for a variable that may be an important
determinant of the change decision.^^
Ambiguity about the direction of causal inference. This threat to
internal validity occurs particularly in cross-sectional experiments, where
temporal tests of direction of causality are not available (Cook and
Campbell [1979, pp. 53-54]). This is a particularly important threat to
internal validity in the accounting method choice literature. As argued
more fiilly in Ball [1980], the literature tends to perceive causality as
running from accounting method choice to (say) R&D expenditure, when
there also is reason to perceive it as running in the other direction.
In several areas of corporate financial reporting research, the validity
of statements concerning causal relationships is threatened, almost in the
extreme, hy the absence or near-absence of prior beliefs concerning
causality versus (say) chance relationships. One illustration is in the
distress prediction and credit scoring model literatures where n inde-
pendent variahles have heen used in conjunction with a step-wise regres-
sion or discriminant function (where n is "large"). Authors in these areas
^' This example illustrates the overlap between the concepts of internal and external
validity,
^^ A severe problem in a control group design arises if industry pairing is attempted when
the industry is homogeneous in terms of the attribute of concern, Biddle [1980, p, 251]
notes that "in several industries (e.g., chemicals and glass) nearly all of the COMPUSTAT
firms were either already using LIFO to some extent or simultaneously adopted
LIFO Control group counterparts were not available for forty-two of the treatment
group firms," If there is a firm available to match, it might well be a sign that the control
firm is no longer in the same industry as the experimental firm even though it has the same
SIC code.
are not unaware of this problem. The empirical work could be viewed as
a "data reduction" exercise in which the sole ohject is to predict reliably
an event like loan default; "reliable" is defined relative to an alternative
empirical-based model or the judgment of an individual. At a pragmatic
level, we have no quarrel with this approach. The error is when inferences
are drawn from such studies about the underlying attributes that distin-
guish (say) financially distressed from nondistressed firms, in such a way
as to imply valid inferences of causality.
Cook and Campbell [1979, pp. 55-56] recommend that:
Estimating the internal validity of a relationship is a deductive process in which the
investigator has to systematically think through how each of the internal validity threats
may have influenced the data. Then, the investigator has to examine the data to test which
relevant threats can be ruled out. In all of this process, the researcher has to be his or her
own best critic, trenchantly examining all of the threats he or she can imagine. When all of
the threats can plausibly be eliminated, it is possible to make confident conclusions about
whether a relationship is probably causal. When all of them cannot, perhaps because the
appropriate data are not available or because the data indicate that a particular threat may
indeed have operated, then the investigator has to conclude that a demonstrated relation-
ship between two variables may or may not be causal.
Based on our review of the studies discussed in Appendix A, we observe

little evidence of the financial reporting literature having a tradition of
detailed discussion of internal validity issues.
2. CONSTRUCT VALIDITY
Construct validity "refers to the possibility that the operations which
are meant to represent a particular cause or effect construct can be
construed in terms of more than one construct... What one investigator
interprets as a causal relationship between the theoretical constructs
labeled A and B, another investigator might interpret as a causal rela-
tionship between constructs A and Y or between X and B or even
between X and Y" (Cook and Campbell [1979, p. 59]). When making
inferences from empirical research, the tightness of the linkage between
theoretical constructs and their operational proxies is a major concern.
We give several examples from the literature surveyed to illustrate the
importance of researchers considering construct validity issues.
Political costfirm size. The first example we examine to illustrate
construct validity issues is the use of firm size to operationalize the
concept of "political costs." The notion that political costs associated
with excess profits taxation, antitrust action, etc., can affect accounting
method choice has existed for some time (for example, see Lindhe
[1963]), and researchers commonly have used firm size as a proxy in their
experiments. For instance, Gagnon [1971, p. 54] states that "large firms
are more vulnerable than small ones to government implicit and explicit
regulation." Watts and Zimmerman [1978, pp. 115-16] argue thus: "The
magnitude of the political costs is highly dependent on firm size. Even as
a percentage of total assets or sales, we would not expect a firm with
sales of $100 million to generate the same political costs (as a percentage
of sales) as a firm with $10 billion of sales. Casual empiricism suggests
that Superior Oil Company (1974 sales of $333 million) incurs consider-
ably less costs from anti-trust, 'corporate responsibility,* affirmative
action, etc. than Exxon with sales of $42 billion." They cite three sources
of evidence of the linkage between their construct and its operationali-
zation: Siegfried's [1975] evidence, an article in a financial weekly (pub-
lished five years before the experimental date), and a bill that was
unsuccessfully introduced in the U.S. Congress one year after the exper-
imental date and was not enacted by the Congress.
There are several reasons for construct validity issues being an impor-
tant concern in the Watts and Zimmerman [1978] experiment. First, the
firm size operationalization ignores industry membership, which may be
a key determinant. The oil industry supplied a majority of the large firms
in their sample. An "excess profits tax" was applied to the industry; but
the tax rate was not an increasing function of size: Superior Oil Company
was taxed at the same rate as Exxon.^^ Second, if there are fixed costs of
complying with government regulations, the relative cost of those regu-
lations could decrease rather than increase with firm size.** Third, our
interpretation of Siegfried's [1975] evidence is diametrically opposed to
that of Watts and Zimmerman. His major conclusion [1975, p. 572]
appears to be that an earlier study, in which size and profit variables did
predict antitrust action, has an obvious statistical bias. His conclusions
are based on regressions which "explain only about seven percent of the
linear variation" in antitrust action frequency, in which the coefficient on
total assets is negative (Watts and Zimmerman assume it to be positive)
and in which "none of the coefficients is very robust in this whole
analysis" [1975, p. 573]hardly evidence for a positive relationship
between size and political costs. Fourth, it seems reasonable to distinguish
(at least in terms of magnitude of political costs) between the statements
of individual politicians and the majority decision as implied in enacted
legislation.
Given the complexity of modeling the political cost phenomenon,
caution in making inferences from a finding that an asset size variable is
significant is clearly warranted.^* Equally warranted is a less casual
^ Indeed, Watts and Zimmerman [1978, p, 127] recognize industry membership as a

determinant of political cost when they engage in ex post rationalizing why U,S, Steel did
not make a GPLA submission "a more likely explanation of U,S, Steel's failure to submit
is the fact that the steel industry was not as politically sensitive as the oil industry (for
example) at the time,"
" Despite the large amount of rhetoric in this area, there is little detailed evidence,
Chilton and Weidenbaum [1980, p. 1] conclude that "a great deal of government regulation
has disproportionately adverse effects on smaller businesses" but do not provide numerical
estimates to support their conclusion,
'^ Watts and Zimmerman [1978, p, 129] report that the coefficient on their firm size
variable "ia positive , , , and has the highest (-statistic of all the independent variables. In
approach to the operationalizing of a major construct in the theory. This

caution is especially warranted in the financial statement literature given
the many other attributes for which the firm size variable has been
assumed to be a proxy .^
Management compensationCompensation plan dummy variable.
The second example relating to construct validity is the use of zero-one
dummy variable to represent the existence of a "compensation plan"
proxying for the "effect of accounting method choice on management
compensation" construct. For instance, Hagerman and Zmijewski [1979,
p. 147] use a zero-one dummy variable based on whether "the notes to
the financial statements and the lOK reports" disclosed the "existence of
a profit sharing plan for management based on accounting income." This
variable is said to capture the following model construct: "A final factor
that may infiuence management's choice of accounting principles is
whether or not the corporation has an incentive compensation plan. If
management incentive schemes are related to accounting earnings we
expect that management has an incentive to use accounting principles
that increase accounting earnings if part of their income is derived from
incentive plans" (Hagerman and Zmijewski [1979, p. 145]).
We find the zero-one measurement of the "incentive compensation
effect" to be simplistic at best (even if we accept the notion that those
who administer the plans are fixated on reported earnings). Compensation
plans typically consist of various components (for example, salary, bonus,
and stock options) and it appears a considerable simplification to focus
on only one component of the plans. For instance, because a plan does
not explicitly include "profit sharing based on accounting income" does
not mean that "accounting income" is not implicitly or explicitly used in
determining the base salary, the stock options granted, promotion pros-
pects, job security, prerequisites, and other rewU*ds. Moreover, the exist-
ence of a profit plan does not imply that provisions in the plan cannot
subsequently be adjusted by the plan administrators.
At this stage, most papers using the zero-one variable operationaliza-
tion have reported insignificant results.^^ However, these insignificant
addition, the coefficient,,, is the most stable across various realizations and subsamples
which leads us to conclude that firm size is the most important variable." This result is not
consistent in other related studies. For instance, Bowen, Noreen, and Lacey [1981, p. 178]
find differences within their sample ''as expected, the largest firms in the oil industry
avoided use of the (typically) income and asset enhancing interest capitalization method
, , , not as expected, outside the oil industry, the larger firms were more likely to capitalise
interest,"
Firm size was reported to be imftortant in Ture's [1967] study of the adoption of
accelerated depreciation for tax after the 1954 legislation: "A larger proportion of the
property of big corporations than of small ones wtis being depreciated under the accelerated
methods in 1959 ,,." [1967, p, 25],
'^ Section VI discusses attributes other than political cost for which firm size has been
used as a proxy,
^^ Watts and Zimmerman [1978], Hagerman and Zmijewski [1979], and Bowen, Noreen,
and Lacey [1981] report insignificant results. Zmijewski and Hagerman [1981, p. 143] report
results could be occurring because of the severe construct validity issues

discussed above. Conversely, there is the problem that any significant
results that are obtained from a zero-one compensation variable could be
due to it proxying for some omitted variable. In particular, if we assume
that most firms tie compensation in some way to reported income, then
the zero-one variahle can proxy for size, organizational structure, or even
the decision of whether or not to disclose the compensation parameters.
A disturhing aspect of the existing set of studies is the failure of successive
researchers to attempt to develop better proxies than the zero-one
dummy variable dichotomy for management compensation effects.
The issue of how, in empirical research, to code contracts between
management and the company is important but little discussed. For
instance, we observe limited debate on the pros and cons of making a
detailed analysis of specific provisions versus assuming that there is little
diversity across firms given that they have an explicit contract. Similarly,
there is minimal guidance in the literature as to the types of changes that
either party might make if a researcher wishes to recognize that the
written contract is but the starting point for an ongoing relationship,
which can change over time. While changes in compensation schemes
are often mentioned in proxy statements and the financial press, the
empirical researcher currently cannot access in a low-cost way a data
base that systematically documents the types of changes made and the
variables associated with these changes.
Disclosure regulationact of forming the SEC. The third example of
experimental problems of construct validity is the relationship between
the concept of "regulation of disclosure" and the operational proxy of
"the act of forming the SEC." It seems reasonable to presume that the
level and structure of regulation of disclosure are random variables over
time. There certainly was regulation pre-SEC and there certainly has
been variation in the level and structure of regulation post-SEC. Yet the
early experiments of Benston [1969; 1973], which assume that regulation
can be operationalized as a zero-one variable switching in the early 1930s,
do not appear to have been succeeded by researchers attempting to refine
the operationalization of the regulation construct. It would be possible,
we suppose, to view "the act of creating the SEC" as the construct, but
(o) we are unaware of any theory with this degree of institutional detail
in its constructs; and (b) inferences then could not be drawn concerning
"regulation of disclosure," rather than "the act of creating the SEC."
Aggregate process inferencesindividual actor experiments. The fi-
nal example of the need to be careful about construct validity arises from
the distinction between the individual and the aggregate. In several of
the topic areas surveyed, especially corporate disclosure and accounting
method choice, it is not clear whether the ohject of inference is the set of
that "it appears that the existence of management incentive plans does influence the choice
of accounting principles." As noted in Appendix A, the interpretation of the significance of
their results turns on the choice of the appropriate benchmark for their probit analysis.
acts of individuals or of aggregate processes such as markets. For instance,

Mautz and May [1978] conduct questionnaire and interview studies at
the individual manager or firm level to gain insight into competitive
disadvantage issues associated with corporate disclosure. They then
proceed to make inferences from these studies to policy decisions on
corporate disclosure at the "total economy" level [1978, p. 4]. As argued
by Alchian [1950], among others, the process of aggregating from the
individual to the aggregate level raises many unresolved questions. We
are not taking a position on the issue of whether research such as Mautz
and May [1978] should proceed at the individual or the aggregate level.
However, we do believe that researchers should take care to determine
that inferences concerning one level are not drawn from data concerning
the other (or, if they are, to address the implied assumptions about the
process of aggregation or disaggregation).
The above four examples illustrate some of the difficulties of establish-
ing construct validity in empirical research on corporate financial report-
ing. In the absence of theories whose constructs come close to mapping
into the institutional domain in which financial reports are produced or
used, the search for operational versions of theoretical constructs is far
from easy. The disappointing observation, however, is the limited evi-
dence of researchers devoting resources to the analysis of construct
validity issues in their experiments.
3. STATISTICAL CONCLUSION VALIDITY
Cook and Campbell [1979, p. 39] introduce the "statistical conclusion
validity" section of their monograph thus: "In evaluating any experiment,
three decisions about covariation have to be made with the sample data
on hand: (1) Is the study sensitive enough to permit reasonable state-
ments about covariation? (2) If it is sensitive enough, is there any
reasonable evidence from which to infer that the presumed cause and
effect covary? and (3) If there is such evidence, how strongly do the two
variables covary?" A key factor in accounting research is the number of
observations available to make inferences about covariation. Increasing
the number of observations is one means of increasing the power of a
statistical test.
In some areas, accounting researchers are afforded the luxury of being
able to examine relatively large samples. Consider the capital market
studies on the information content of earnings announcements, where
the basic observation unit is an earnings announcement of one firm. The
Ball and Brown [1968] study includes over 2,300 observations. The Foster
[1977] study includes over 3,300 observations. In contrast, most research
areas in corporate financial reporting are not so well endowed. For
instance, the basic observation unit in the income smoothing literature is
the earnings series of one firm. The number of such observation units in
several income smoothing studies are Dascher and Malcom [1970] with
52 observations and Smith [1976] with 110 observations. Holding other
attributes of (i) the information content of earnings research designs and

(ii) the income smoothing research designs constant, it is apparent that
the latter studies wUl have less power in their statistical tests.^ Studies
in the financial distress prediction literature also encounter considerahle
statistical conclusion validity problems due to the relatively small number
of distress firm observations. For example, Altman's [1973] sample in-
cludes 21 bankrupt railroads, Wilcox's [1973] sample includes 52 bankrupt
industrials, while Castagna and Matolcsy's [1981] sample includes only
21 failed industrials. Issues relating to statistical conclusion validity are
especially important in those areas of financial reporting research in
which (due to lack of articulated theories) almost exclusive weight has to
be placed on the sample evidence, notably the time-series and distress
prediction topic areas.
An interesting aspect of statistical conclusion validity is the distinction
between the validity of conclusions drawn from individual experiments
and those drawn from the literature. In the latter case, the degree of
overlap of data bases, computer programs, sample selection procedures,
time periods examined, and other experimental methods is an important
issue. N individual experiments may not provide iV independent data
points about a specific phenomenon. Consider the financial distress
Einalysis literature, where there has been considerable overlap in time
periods examined. For example:
Beaver[1966]: 1954-64
Altman [1968]: 1946-65
Wilcox[1973]: 1948-72
In this context, subsequent researchers can make a useful contribution

by presenting subsample results that relate to time periods not previously
examined. A related observation is that the frequent use of the same data
base {Compustat) in time-series work can result in the potentiedly mis-
leading impression of independent confirmation when N individual ex-
periments come to the same conclusion (for example, that annual earn-
ings, on average, behave as a random walk). In this context, a very
healthy trend in the literature is the existence of researchers in different
countries examining similar questions; for example, the random-walk
result has been reported to be a robust mean-median result on U.K. data
(Little [1962]), U.S. data (Ball and Watts [1972]), Australian data
(Whittred [1978]), and New Zealand data (Caird and Emanuel [1981]).
^ We are not asserting that all areas of capital market research are blessed with large
data bases that strengthen the statistical conclusions validity of their experiments. For
instance, research on the capital market impact of accounting policy decisions such as
SFAS No, 5 (Accounting for Contingencies) and SFAS No, 19 (Financial Accounting by
Oil and Gas Producing Companies) faces severe problems with regard to statistical
conclusion validity. See Foster [1980],
4. EXTERNAL VALIDITY
External validity "refers to the approximate validity with which we can
infer that the presumed causal relationship can be generalized to and
across alternate measures of the cause and effect and across different
types of persons, settings, and times" (Cook and Campbell [1979, p.
37]). External validity issues do not arise in projects whose sole object is
to describe a particular data base. Many of the studies presenting sum-
mary statistics on accounting method choice or corporate disclosures of
firms fall in this category. Projects which deal with populations also do
not raise external validity problems; an example would be a study that
examined all the submissions on a particular FASB agenda item and was
concerned only with drawing inferences about those who suhmitted on
that agenda item. Typically, however, authors (or readers) do seek to
generalize the findings of a study beyond the sample of firms examined
or the time period covered. This subsection provides examples of research
design choices in several topic areas that have implications for the
generalizability of the results.
Sample selection is an obvious area where the generalizability of the
results can be compromised. For instance, Kiger [1974] computes volatil-
ity measures of quarterly net income to provide evidence pertaining to
alternative interim income concepts. In the sample selection he excludes
firms that had "losses during any quarter" [1974, p. 3] in the time period.
The motivation for this exclusion criterion is not discussed but appears
to be that a transformation used on the earnings variable is not defined
for nonpositive earnings. Evidence is not given about the effect of this
exclusion criterion on the results presented about the "substantial vola-
tility" of quarterly earnings. The external validity of the experiment thus
is unclear. One way that authors could address such an issue would be to
present profile statistics pertaining to a random sample of the population
vis-a-vis the specific sample examined.
A second example of problems in external validity arises in techniques
that tend to "overfit" relative to a particular sample. This issue has
received considerable attention in the literature on classificatory tech-
niques such as discriminant analysis. Methods along the lines of Lach-
enbruch [1967] have been developed, one purpose of which is to improve
the external validity of inferences drawn from a specific sample. Yet, we
StiU observe accounting studies in this area using classificatory designs
without the use of nonoverlapping holdout samples or techniques such as
that proposed by Lachenbruch. For instance. Watts and Zimmerman
[1978, table 4] report results from seven alternative combinations of
variables in multiple discriminant functions, but do not control for the
attendant problems of overfitting the data by using a holdout sample.
The third example is taken from time-series research. While allxisions
to "structural change" are made in this literature, our understanding of
the economic factors that cause structural change and how they might
limit the generalizahility of the results of any specific time-series study is

limited. Consider the time periods examined in several studies analyzing
annual earnings data:
Beaver[1970]: 1949-68
Watts and Leftwich [1977]: 1908-74
Brooks and Buckmaster [1980]: 1955-74
The above studies cover time periods that potentially differ in factors
such as (i) the rate of inflation, {ii) the frequency of acquisitions and
divestitures, and (iw) the degree of regulation. The generalizability of the
findings of a study covering any one combination of (i), {ii), and {iii) is
very much an unresolved issue. Despite these unresolved issues, we
continue to observe authors citing (say) the results of a study based on
1949-68 data as the rationale for using a random-walk benchmark in a
study examining data from the 1970s, without any evidence of concern
for the validity of the extrapolation.
5. SUMMARY: TRADE-OFFS AMONG TYPES OF VALIDITY
In many instance, choices of experimental method that improve one
type of validity do so at the expense of others. In such instances, the
researcher must have some idea of priorities. Cook and Campbell [1979,
pp. 82-84] suggest that researchers with theoretical interests would rank
types of validity in this order: (1) internal, (2) construct, (3) statistical
conclusion, and (4) external; applied researchers would rank them: (1)
internal, (2) external, (3) construct validity of the affected (dependent)
variable, (4) statistical conclusion, and (5) construct validity of the causal
(independent) variable. They note that it is "unrealistic to expect that a
single piece of research will effectively answer all the validity questions
surrounding even the simplest causal relationship" [1979, p. 83].
The assumption underlying these rankings is that the researcher's
interest is focused on testing causal inferences associated with a body of
theory. Giving the first priority to internal validity is, therefore, hardly
surprising. In sections II and III we observed that in financial reporting
research, the search for causal inferences can be subjugated to the
criterion of providing answers for accountants, managers, and other
groups that are external to the research community. If the objective of
the research is to meet the needs of these groups, then external validity
increases in importance. Questions wiU arise about the validity of gener-
alizing from (say) the sample time period of the experiment to the horizon
of the policymaker's decision, or from a sample of NYSE listed firms to
firms in general.
Frequently, the researcher will be less interested in experimenting
within the context of a precise body of theory, for the simple reason that
it might not exist. For example, the researcher might wish to explain
relatively detailed institutional phenomena that are not captured hy any
theory. In this case, it is inevitable that internal and construct validity

will be sacrificed to a greater degree. This, of course, is not to suggest
that anjy experimental behavior is legitimate.
Cook and Campbell [1979] readily admit that their validity types
overlap and that trade-offs among them are required.^ Nevertheless, our
view is that their classification scheme assists the researcher in scrutiniz-
ing experimental method. At a minimum, it assisted us in our task of a
methodological review of the corporate financial reporting literature.
However, we view the specific classification scheme that a researcher
adopts as less important than the willingness to engage in scrutiny of
experimental method in an explicit and articulated manner. Furthermore,
we note in section VII that the trade-offs required wiU depend on the
degree of maturity of the particular research area.
VI. Tests Against Competing Hypotheses

A difficult area is the responsibility of the individual researcher to test
against competing hypotheses. Typically, a researcher will wish to test
explicitly against a competing hypothesis only if the objective is to
displace a competing theory. In that regard, there is considerable debate
about whether "the new must compete with the old."** Given the rapid
transformation in the accounting literature, competing views of the world
frequently are so ill specified as to make comparative evaluation prohib-
itive.
Nevertheless, in an indirect sense the recognition of competing hy-
potheses can be important even when the objective is not to di^lact-
competing theories. Consider the "construct validity" issues that arise in
Watts and Zimmerman's [1978] use of firm size as a proxy for political
costs. While those authors face no general responsibility for testing
against competing views and can quite correctly claim that it would be
too costly for them to develop competing views to the point of testability,
they do face a responsibility under their theory to convince the reader
that size is a valid proxy for political costs. Recall that their theory deals
with political costs as a variable (not size) and that they wish to draw
valid inferences about the political domain rather than size per se.
Many hypotheses have been advanced to explain differences across
firms in their accounting method and corporate disclosure decisions. A
single variable (firm size) has been used as an operationalizing variable
for many of these h5rpotheses. For example: competitive advantage: "The
competitive advantage of larger firms may he less endangered by more
adequate disclosure than would be the case for small firms" (Belkaoui
and Kahl [1978; p. 42]); infonnation production cost: "Collecting and
disseminating information is a costly exercise and perhaps it is the larger
firms who can best afford such expenses. Large firms are quite likely to
'^ Cook and Campbell [1979, pp, 85-94] discuss these criticisms,
*" Cook and Campbell [1979, pp, 22-23] provide a useful discussion.
collect the information needed for corporate report disclosure for their
internal management systems and hence little extra cost may be incurred"
(Firth [19796, p. 273]); management ability and advice: "Large compa-
nies .. are more likely to have the advice of well-qualified accounting
specialists" (Butters and Niland [1949, p. 90]); andpolitical costs: "Large
firms are now more vulnerable than small ones to government implicit
and explicit regulation" (Gagnon [1971, p. 54]).
The reader, in this context, having seen the same variable used to
proxy for many (apparently) different and competing constructs, has
good reason to expect the authors to present cogent arguments or
evidence why an inference from (say) firm size to political cost is a
credible one within their experiment. In this sense, competing theories
always are relevant in empirical work, even if the researcher does not
wish to test against those theories per se.
VII. The Maturity of Existing Research Paradigms

The most articulated paradigm guiding the empirical research surveyed
in Appendix A is associated with the "stewardship-contract monitoring"
literature. Yet the results of empirical exercises guided by this paradigm
have not been impressive. Not one single "stewardship"-related variable
has been found to be consistently significant in the studies surveyed. One
explanation of this result is that it refiects the early stage of the devel-
opment of this paradigm as it applies to corporate financial reporting.
The theoretical papers underl3ang the "stewardship-contract monitor-
ing" paradigm discuss how a principal can have an incentive to monitor
the behavior of an agent and how an agent can have an incentive to
precommit to some form of monitoring.''^ The theoretical results do not
stipulate that the monitoring wUl be done by audited (or unaudited)
financial statements (or how it wiU he done in general). Financial state-
ments are but one of many monitoring devices avaUable. The board of
directors, corporate lenders, and security analysts aU potentiaUy can
provide information about management behavior. Nonfinancial state-
ment information, such as physical production reports and market share
details, may also be used to monitor management. There are, in addition,
mechanisms that can reduce the propensity of management to make
decisions that are not in the best interests of shareholders, for example,
the external labor market and the use of incentive measures such as stock
options that are aimed at aligning managerial and shareholder interests.
Moreover, within the firm itself, individual managers can serve as moni-
tors for each other. At present, the research paradigm does not provide
guidance to the empirical researcher on those areas where fâncial
statements are expected to have a comparative advantage in monitoring.
This is clearly no easy task to undertake and remains very much a yet-
to-be-explored research area. In summary, the theoretical models do not
'*' For example, Jensen and Meckling [1976],
map into the institutional domain in which corporate financial statements

are produced or used. These models operate at a relatively high level of
abstraction in which much of the richness of this institutional environ-
ment is suppressed.^^
Given that the objective of much of this research is to develop analyt-
ical structures that "explain" institutional arrangements, the state of
affairs evident in our survey of the literature must he interpreted in terms
of the relative immaturity of this literature, rather than an intrinsic
faUure of the paradigm.
A further effect of the relatively early stage of the development of the
"stewardship-contract monitoring" paradigm is the limited analysis of
how its predictions are different from those of other hypotheses advanced
to explain the provision offinancialstatements. Watts [1977], for instance,
argues that the emphasis in the "stewardship" approach is different from
the "information for investment" approach,**^ and also that "I doubt that
the information hypothesis has as much potential as the agency cost
[stewardship] hypothesis for explaining corporate financial statements
. . . " [1977, p. 63]. However, Watts does not outline how the predictions
of the "stewardship hypothesis" and the "investment hypothesis" differ.
If they lead to equivalent predictions, they are indistinguishahle at an
empirical level.
A second example of the relatively early stage of the development of
the "stewardship-contract monitoring" paradigm is the limited credibility
of some of the "stories" told by researchers operating in this area. To
iUustrate, consider the "competition factor" that Hagerman and Zmi-
jewski [1979] argue is a consideration in accounting method decisions by
management. These authors assvmie that "management wiU, in its own
self interest, want to reduce potential competition" [1979, p. 144]. It is
then argued that management could use accounting method choice to
reduce the potential for new entry into their industry [1979, p. 144]: "The
evidence Mansfield [1962] developed .. indicates that the number of
"^ Schipper makes this point clearly when discussing the Leftwich, Watts, and Zimmer-
man [1981] paper: "I think many of the problems with this paper occur because the theory
of agency and monitoring has not been developed sufficiently to make unambiguous
predictions on the level of detail considered in this paper" (Schipper [1981, p, 88]), L, Kelly
[1981, p, 2] also makes similar observations: "Impeding progressis the lack of a fiilly
developed model which explains the cash flow implications to the firm of alternative
accounting procedures, the concomitant effect on management's utility, and thus manage-
ment's choices from allowable alternatives or reactions to proposed and enacted standards."
*^ "The emphasis is different. Information for monitoring bonding covenants is contracted
for in advance as part of a mechanism by which the manager restricts the extent to which
his actions deviate firom the interests of shareholders or bondholders. The emphasis is on
information its part of a management control mechanism. In the alternative infonnation
function the emphasis is on the provision of information to investors to enable them to
value securities and make 'rational' investment decisions. The emphasis is on information
for market valuation" (Watts [1977, p, 63]),
finns entering an industry is positively related to the accounting profit of

the industry. Thus, since the existing finns do not want to encourage
entry hy revealing profitahle opportunities, they have an incentive to
reduce reported eamings by the appropriate selection of accounting
principles."
This argument posits a mechanistic relation between reported account-
ing eamings and entry decisions by potential competitors; it appears that
either potential entrants are fixated on reported eamings or that the
costs of using competing information sources on the profitabUity of the
industry are prohibitive. We find it puzzling that the authors do not
discuss how this assumed mechanistic relation is consistent with an
assumption that the management of potential entrants comprises
"resourceful, evaluative, maximizing" individuals.
Using concentration ratios as an empirical proxy, Hagerman and Zrni-
jewski [1979] do not find significant evidence that the "competition
factor" affects accounting method choice. One way the contract monitor-
ing paradigm could evidence increasing maturity would be to examine
possible reasons for this and the many other insignificant results being
reported; for example, are they due to: (i) the basic story ignoring
competing information sources about profitability, {ii) the crudity of
concentration ratios as a measure of competition, or {iii) the assumption
that management examines accounting method choices on a single issue
basis?
Attempts to explain or understand evidence anomalous with respect to
a specific paradigm can have several outcomes, for example, {i) refine-
ment of the methods of testing the predictions of the paradigm, {ii)
refinement in the paradigm itself, or {iii) abandonment of the paradigm.*^
At this stage, it is too early to make judgments about which of these (or
other outcomes) is likely, in part because the literature has not system-
atically adopted the perspective of detaUed foUow-ups of anomalous
evidence. The Zmijewski and Hagerman [1981] paper is the only known
example of authors revisiting a prior work in an attempt to resolve
evidence anomalous with respect to the "stewardship-contract monitor-
ing" paradigm.**
**At any one stage, it might not be possible to delineate whether ((), (ii), or {iii) is
occurring individually or collectively. Blaug [1980] provides discussion of this issue with
specific references to reformulations of Kuhnieui ideas, both by Kuhn himself and others,
" The Leftwich, Watts, and Zimmerman [1981] paper contains several important anom-
alies that warrant further investigation. For instance, a significant variable in their analysis
of voluntary interim report disclosure was "the historical reporting frequency of the firm,''
The variable was included "to capture any 'inertia' effect [1981, p, 62], ITie significance of
this variable raises the troublesome question of how "managerial inertia" is consistent with
the stewardship paradigm assumption of "resourceful, evaluative, maximizing" managerial
behavior. It is interesting to note that Butters and Niland [1949, p, 90] report a similar
variable as significant in their field study of firms' inventory decisions: "management inertia
and ignorance have been major reasons that LIFO has not been more extensively employed."
VII. Concluding Comments

(1) This paper argues that accounting research is different from the
extremes of research in the basic disciplines and work undertaken by or
for practitioners. Our hypothesis is that "accounting research" has ele-
ments of both; for example, accounting is an institutional form of infor-
mation production, and research in accounting involves fitting the theory
of information production to institutionalized data. In this context, "good"
empirical research might not satisfy either the disciplinary purist or the
practicing accountant. In confronting theory with data that Ue in the
institutional domain, the empirical researcher wiU be fascinated by nei-
ther theory nor data alone and wiU be prepared to sacrifice elements of
both.
(2) An empirical researcher in corporate financial reporting faces
considerable uncertainty on many important aspects of research. One
source of this uncertainty arises from gaps in knowledge levels in the
basic disciplines of behavioral science, economics, mathematics, and
statistics. For instance, the economics Uterature has made limited pro-
gress in modeUng the multiprincipal, multiagent settings that characterize
pubUcly held corporations. A second source of uncertainty arises from
accounting researchers making very limited progress in modeling even
part of the institutional environment in which financial statements are
produced or used. For instance, we stiU do not have models that incor-
porate into the signaling Uterature such basic features of the institutional
environment as the existence of competing information sources and the
differential role played by auditors in relation to these competing sources.
In addition, there are many of the famiUar sources of uncertainty in
empirical research, such as those associated with smaU samples and
nonstationary data. An empirical researcher who has limited tolerance
for ambiguity, and who wishes to be guided by tight theoretical models,
would not be attracted to many areas of the Uterature reviewed in this
paper.
(3) Other aspects of "accounting research" imply that special care must
be given to methodological issues. These aspects are developed in sections
III and IV. Sections V to VII discuss several aspects that we beUeve can
assist the careful experimenter: Cook and CampheU's concepts of exper-
imental validity, including trade-offs among them (section V), test against
competing hypotheses (section VI), and the influence of the relative
maturity of particular research paradigms (section VII).
(4) Much research in corporate financial reporting reflects the tension
between the value set of an extemal party such as the accounting
profession and the value set of a researcher having an allegiance to a
research community. This tension is especiaUy marked in the corporate
disclosure and accounting method choice areas. Extemal parties typically
place more weight on relevance to contemportu-y problems than on the
existence of a tight theoretical model to guide the research; extemal
vaUdity is a more important concern than intemal validity and construct

vaUdity. However, a subset of the corporate financial reporting literature
is exhihiting more concem with testing the predictions of research para-
digms than with addressing "subjects of immediate concem to practicing
accountants." There is a douhle-sided benefit to such paradigm-based
research. First, such research can provide valuable experimental settings
for theories arising in the basic discipUnes. Second, there is the potential
to gain a deeper understanding of the basic forces operating in corporate
financial reporting, of which the current list of topics on the FASB's
agenda may be but a transient reflection.
(5) There is a Umited tradition of debate over methodological issues in
corporate financial reporting research. Indeed, some experiments in this
area appear to be Uttle more than mechanical activities in which meth-
odological issues appear to be suppressed. Other experiments that appear
more creative in outlook devote few resources to seemingly important
issues as intemal vaUdity and construct vaUdity. We do not assert that
substantial improvements in the quality of research inferences necessarily
win arise from researchers devoting more resources to these issues.
However, we do beUeve that resource aUocation decisions by empirical
researchers would be more informed if there were a tradition of research-
ers discussing methodological issues in an articulated and expUcit manner.
APPENDIX A
Survey of Topic Areas
This appendix provides an overview of the research issues being ad-
dressed in each of the four topic areas: (a) corporate disclosure, (6)
accoimting method choice, (c) time-series analysis; and {d) financial
distress analysis. Given the size of the Uterature in each area, the focus
is on general trends rather than specific papers.*^
A. Corporate Disclosure
Empirical studies pertaining to corporate disclosure are classified in
table 1 into four main areas: (1) content of disclosure and variables
associated with differential content, (2) disclosure indexes and variables
following journals were examined when developing the tables presented in
Apftendix A: Abacus; Accounting and Business Research; Accounting and Finance;
Accounting, Organizations and Society; The Accounting Review; Australian Journal of
Management; Conference Proceedings of The American Accounting Association; Finan-
cial Analysts' Journal; Financial Management; International Journal of Accounting
Education and Research; Journal of Accountancy; Journal of Accounting, Auditing and
Finance; Journal ofAccounting and Economics; Journal ofAccounting Research; Journal
of Banking and Finance; Journal of Business; Journal of Business, Finance and Account-
ing; Journal of Finance; Journal of Financial Economics; and Journal of Financial and
Quantitative Analysis. As with any classified bibliography, arbitrary decisions about both
(i) inclusion/exclusion and (it) classification to a specific category are made.
I
198 R. BALL AND G. FOSTEk
associated with different index scores, (3) timing of disclosure and vari-
ables associated with differential timing, and (4) responses to interviews
or questionnaires about corporate disclosure. An overview of these areas
is presented in this subsection.
CONTENT OF DISCLOSURES AND DISCLOSURE INDEXES
One strand of this literature presents case studies on the content of the
disclosures of individual firms. These case studies typically are used to
support arguments about the inadequacies of existing disclosure practices
or to iUustrate the proposition that managers use the financial reporting
system to present themselves in the most favorable Ught. An early
example is the literature discussing the disclosure impUcations of the
Royal Mail case litigated in the U.K. in the 1930s.^^ Examples of single-
company analyses in the 1970s and 1980s are the Briloff critiques pub-
lished in Barron's.*^ The problems of generalizing from single instances
are many; for example, (i) the single instance may be idiosjoicratic, and
{ii) it is impossible to distinguish which of several possible causes best
explains a single instance. An obvious approach to reduce these prohlems
is to examine the disclosure practices of many firms. One style is to cite
selectively individual instances that are consistent with a specific hypoth-
esis (argument or value beUef). For instance, this style is used by Ripley
[1927], Briloff [1972; 1976], and Chambers [1973].'*^ The specific instances
cited by these authors are neither presented as the expUcit source of the
hypotheses discussed nor as the data by which the hypotheses are
confirmed.^ These studies typicaUy also do not leave an "audit trail" to
indicate how the cited instances were chosen; nor is information provided
about how representative they are of the population of aU companies
reporting information to outside parties.
Another strand of this literature contains surveys of company disclo-
sures in which details of sjunple selection axe given and in which statistics
pertaining to the whole seunple are presented. In many instances, these
surveys attempt to array the data with limited evaluative inferences. The
annual editions of Trends and Technigues (published since 1948) and
many of the current publications of accounting firms faU in this category.
Another use of survey evidence has been to document disclosure levels
under different "regulatory regimes," as in Benston [1969; 1973; 1976].
Note that with this style of analysis the reader who may disagree with
" For example. The Accountant (August 8, 1931 and March 5, 1932),
*" See Foster [1979, table 1] for citations to 11 Briloff articles published in the 1970s, A
more recent example is "Lost and Found" in Barron'a (July 6,1981),
'" For example, Ripley [1927, p, 208] argued that "shareholders are entitled to adequate
information" and noted the "existing impublicity of corporations." Briloff [1972, p. 306]
argued that "many of our publicly owned corporations fail their responsibility for f^ and
fair and prompt accountability,"
'*" For debate on this point, see the exchange between Anderson and Leftwich [1974] and
Chambers [1974],
Benston's inferences may stiU use the tables summarizing the disclosures
of firms.
A frequent use of evidence on the disclosures of firms is to make
inferences about disclosure adequacy. A heuristic framework of "more
disclosure is better" appears to guide many statements in this area. This
heuristic framework is most apparent in studies using disclosure indexes.
Cerf [1961], for instance, develops a system of points for the disclosure of
31 individual items and computed index scores for 527 U.S. companies.
One purpose of the study is to determine "the characteristics associated
with relatively superior disclosure to determine where educational and
other methods to improve disclosure should be concentrated" [1961, p.
19]. Superior disclosure is operationalized as a higher index score. A more
recent example is the Kahl and Belkaoui [1981] study on the disclosure
practices of 70 banks incorporated in 18 different countries. The authors
refer to the "superiority of U.S. banks" [1981, p. 193], because U.S. banks
have higher average disclosure index scores than the banks of the other
17 countries examined. Such an inference is the "more disclosure is
better" perspective taken to its extreme!^'
The Cerf [1961], Kahl and Belkaoui [1981], and similar studies examine
disclosure of many items. Other studies focus on specific areas such as
social responsibility disclosures or replacement cost disclosures. For
instance, KeUy-Newton [1980] conducts a content analysis of the com-
ments made by management in relation to the replacement cost disclo-
sures mandated by the SEC under ASR No. 190; the conclusion is that
"the attitudes communicated by management reveal that reservations
centered around the reUability and relevance of the disclosures" [1980, p.
318].
VARIABLES ASSOCIATED WITH DIFFERENTIAL CONTENT OF
DISCLOSURE
Articulated theories of firm disclosure decisions did not exist when

evidence was first reported in the literature about variables associated
with differences across firms in their disclosures. The variables examined
in early studies appear to have been those heuristicaUy suggested in the
Uterature (very broadly defined) or those found to be empiricaUy signifi-
cant when a specific set of disclosures was examined for their content.
For instance, Anton [1954, p. 622] reports that "one in every three large
companies presents funds statements to stockholders regularly," whereas
the comparable statistic for smaU companies is "one in twenty." Cerf
" The "more disclosure is better" perspective has a long tradition in the literature. An
early example is the Kaplan and Reaugh [1939] survey of the content of the 1930 and 1937
financial statements issued by 70 U.S, companies. The authors concluded that 'on vital
counte, investors are left conjecturingsales, cost of sales, depreciation, inventories and
surplus generally are so inadequately described that an investor does not have a minimum
of information upon which to form an intelligent opinion on buying or selling" [1939, p.
[1961] regresses disclosure index scores of 527 companies against three

independent variables"asset size, stockholder number and profitabil-
ity." One conclusion is that the 50 highest (lowest) scoring firms had, on
average, larger (smaUer) asset sizes than the whole sample. However, all
three "independent variables accounted for only a relatively minor pro-
portion of the total variation in the score" [1961, p, 33]. Similar studies
in the 1970s include Singhvi and Desai [1971], Buzby [1974], Barrett
[1976], BeUcaoui and Kahl [1978], and Firth [19796].
A subset of recent studies is conducted within the context of the
"stewardship" or "contract monitoring" paradigm for firms disclosing
information to shareholders. Leftwich, Watts, and Zimmerman [1981]
correlate variables such as firm size, stock exchange listing, and the
number of outside directors with the disclosure/nondisclosure of interim
reports by firms in 1948; the results do not strongly support the predic-
tions of the contract monitoring hypothesis. Chow [1982] correlates
"contract monitoring" related variables with the inclusion/noninclusion
of an auditor's statement in the 1926 annual reports of U.S. companies;
three variables (leverage, number of debt covenants using accounting
measures, and firm size) are reported to be significant in the direction
predicted by the stewardship-contract monitoring hypothesis.^^
TIMING OF CORPORATE DISCLOSURES

While the accounting Uterature has long debated the issue of what
should be the periodicity of reporting, research on the timing of report
dissemination to extemal parties is a relatively recent phenomenon.^
One motivation for accounting researchers to become concerned with
timing issues was the rapid growth of capital market research in the late
1960s and 1970s. As a by-product of this research, descriptive statistics
pertaining to time lags between the fiscal year end and pubUc dissemi-
nation of earnings information are presented, for example by BaU and
Brown [1968, table 3].
Studies reporting variables correlated with differential timing of disclo-
sures aie primarily a post-1970 phenomenon. Researchers in this area
have not been able to access an articulated theory pertaining to corporate
decisions about the timing of information releases. They appear to have
reUed on heuristic notions suggested in the popular press or the academic
and Dhaliwal [1980] give stewardship as one rationale for a correlation

existing between firm size and the voluntary disclosure/nondisclosure of segment data hy
multiproduct firms. They report finding that "diversified firms which voluntarily disclosed
segmental sales and eamings data are significantly larger than the diversified firms which
did not voluntarily disclose such data" [1980, p, 561],
^ Concem with the information dissemination process was evidenced by the stock
exchanges, the SEC, and the legal profession (insider trading litigation) long before it
became a topic of mainstream accounting researchsee Loss [1961], An early detailed
questionnaire survey of "corporate news handling practices" is reported in Burson [1966];
this study, conducted by Burson Marsteller Associates, was stiid to be "probably the first
comprehensive portrait of corporate disclosure patterns" [1966, p, 39],
literature or an analysis of the institutional environment. Dyer and

McHugh [1975, p. 219] report that "corporate size was shown to account
for some of the variation" in AustraUan firm reporting lags and that firms
having June 30th financial year-ends "were generaUy, not as quick to
report as the non-June 30th companies." Whittred [1980a, p. 563] reports
that "the incidence of a qualified audit report delays the release of the
preliminary profit report" and that "the more serious the qualification,
the greater is the delay." While the documentation of such empirical
regularities can provide suhsequent researchers with valuahle clues, we
observe Uttle movement to date toward modeUng the timing of corporate
disclosures.
The most popular topic examined in this Uterature is whether there
are differential dissemination patterns associated with the release of
"good news" as opposed to "bad news." The basic research design is to
correlate differences in information dissemination with the coding of a
release as "good news" or "bad news." See, for instance, Pastena and
Ronen [1979], Davies and Whittred [1980], Garsombke [1981], and PateU
and Wolfson [1981]. Consistent results have not been produced across
the above and similar studies. The results have varied with the informa-
tion releases examined, the criterion used to classify a release as "good
news" as opposed to "bad news," and the time period used to measure
"delay in information dissemination." At present, there is Uttle of a
generalizable nature that has emerged from this Uterature.
RESPONSES TO INTERVIEWS OR QUESTIONNAIRES
A sizable Uterature reports the results of "interviews" with individual
participants in the corporate disclosure process. Reports of questionnaire
surveys with demand-side participants (security ansdysts, investors, bank-
ers, etc.) are most frequent. A common design is to ask respondents to
rank individual financial statement items on a scale of importance to
their decisions. For instance, Benjamin and Stanga [1977, p. 187] examine
the "perceived informational needs of two groups [bankers and financial
analysts]" by having them rank (on a scale of 0 to 4) 51 kinds of
information. Whether such studies provide reUable inferences about the
demands of individual participants is contingent (in part) upon how
severe the methodological problems with such research are perceived to
be. For instance, the setting is hypothetical, individuals' incentives to
misrepresent preferences are ignored, and no costs are associated with
the provision of the information." In one of the more extensive efforts to
" Typically, in these questionnaire studies, very little attempt is made to determine the
reasomng underlying the stated preferences of the respondents, Homgren [1955 p 575] is
one of the few efforts in this area-the concem is understanding the "security analysts'
MT,*""* "â^^'î **"*^ PôPoo^ price level adjustments to financial sUtements," Lees
[1981, p. 36] seeks reasons for security analysts not favoring "mandatory disclosure of
company prepared eamings forecaste," Note that analysts can have a vested interest in
opposmg extensions of company disclosures if these disclosures compete with products
bemg marketed by themselves, wuvi*
improve the reliabiUty of inferences from this line of research, Benston

and Krasney [1978a] examine the demand by life insurance investment
officers for 17 balance sheet and income statement items. They argue
that the investment officers "have practical experience with the alterna-
tive financial data, have uses for financial accounting information beyond
supporting a recommendation to buy or seU a share of stock at a given
market price, and bear some of the associated information production,
dissemination, and processing costs" [1978a, p. 3].^
There are fewer instances of studies of supply-side participants in the
corporate disclosure process. One approach is to examine single disclosure
decisions (e.g., the Shank and Calfee [1973] study of the 1972 forecast
disclosure decision of Fugua Industries). Another approach is to question
management about the factors it considers in a series of hjT)otheticaI
decisions, as in the Mautz and May [1978] study on the "competitive
disadvantage" rationale for management not pubUcly releasing informa-
tion about segment profit margins, names of customers, and forecasts of
income statement items. At present, research in this area is not guided
by models of firm disclosure decisions. This situation is not surprising
given the limited progress made in the theoretical Uterature on incorpo-
rating many of the institutional aspects that can be important in corporate
disclosure decisions.^
B. Accounting Method Choice

Debates over alternative accounting methods have been a major part
of the accounting Uterature for most of the twentieth century. Table 2
classifies post-1969 empirical studies in this area into fovu- main categories:
(1) accounting alternatives and reported numbers, (2) accounting method
decisions (use or preference): statistics on and variables associated with
differential use, (3) accounting changes: statistics on and characteristics
of changing firms, and (4) accounting method choice and decision making
(excluding capital market and laboratory experiments). This subsection
discusses research in these foxur categories.
ACCOUNTING ALTERNATIVES AND REPORTED NUMBERS
From a historical perspective, the largest empirical Uterature in the
accounting method choice area examines how the reported numbers are
affected by the use of alternative methods. Consider the effect on the
"Ânother attempt to improve research designs in this area is Pankoff and Virgil
[1970], This study creates a laboratory muket setting in which analysts have to purchase
infonnation "at prices high enough to force some expression of preference from among the
available infonnation items" [1970, p, 2],
^ For instance, Bhattacharya and Ritter [1981] is one of the first papers in the signaling
literature to model issues that arise when a firm has superior information about its future
prospects but when a policy of full disclosure will provide valuable information to its
competitors. The paper illustrates how the disclosure decision of firms can be affected by
different responses by competitors to the information.
reported eamings number of using a general price-level-adjusted method

or a specific price-level-adjusted method. In each decade since at least
the 1920s, examples of such exercises can be found (e.g., Sweeney
[1936], Jones [1949], Baxter [1959], Rosenfield [1969], and Davidson and
Weil [1975a]). The typical style of conclusion is: "Inflation distorts all
financial statements... [GPLA] adjusted net income [in 1973] as a
percentage of reported net income ranges from 18 to 153 percent for the
[Dow Jones 30 Industrial stocks]" (Davidson and Weil [1975a, pp.
27-28]).
The research designs in the above-cited and numerous similar studies
impUcitly assume that the use of different accounting methods does not
affect the financing, investment, or production {FIP) decisions of a firm;
the issue is how different accounting methods numericaUy represent the
effects of these fixed FIP decisions.^^ While this assumption certainly
faciUtates a tractable set of mechanical adjustment techniques being
used, it is difficult to reconcile its vaUdity with the arguments offered by
these same authors for moving away from historical cost accounting
methods.
Generalizations based on studies in this area are difficult. Many studies
report results for a single year rather than a multiyear horizon, precluding
insight into how methods which increase (or decrease) reported income
in the first year affect the pattern of reported income in future years.
Moreover, studies in this area rarely work within the guidance of a model
that ex ante predicts the impact of using alternative accounting methods.
The few models that have been developed to faciUtate such predictions
have not been utiUzed in subsequent empirical research in this area. For
instance. Sunder [1976a, 19766] models how the use of fuU cost vis-a-vis
successful efforts accounting affects the reported eamings of oil explora-
tion companies; a key determinant of this effect is whether oil exploration
activity is expanding, in a steady state, or declining. At present, the
descriptive vaUdity of this model has not been tested. The Uterature in
this area typically has been purely empirical or purely analytic with Uttle
Unkage between the two strands.
ACCOUNTING METHOD DECISIONS (USE OR PREFERENCE)
One approach to examining the factors management considers in its
accounting method decisions is to study statements by management.
This can be done by private interview, by questionnaire, or by observing
pubUc statements by managers. Early examples of this approach include
Butters and Niland [1949] and Lindhe [1963]. Factors said to be impor-
tant include taxation savings, administrative complexity, expected effect
" A related strand of this literature aims to adjust the financial statement of all firms in
a sample to a uniform set of accounting methods. There is little recognition in these studies
of management having substantive reasons for choosing nonuniform sets of accounting
methods.
s
1*1
a
I
5
I
ll
O X
on the price of the company's stock, industry practice, management

compensation effects, restrictions on dividend distributions, and fear of
excess profits taxation. Archibald [1976] is a more recent example of this
research design. Results from a questionnaire returned by 15 companies
that switched from accelerated to straight line depreciation are reported:
"the preponderance of the answers related to the impact on net income"
[1976, p. 72].
While interviews with management (or statements by them) can iden-
tify possible factors that are important in accounting method decisions,
this research design is not without its limitations. One limitation arises
from our Umited understanding of the incentives of respondents to
communicate their knowledge honestly. For instance, there can he incen-
tives to disguise true motives, such as a desire to manipulate a manage-
ment compensation scheme or to minimize taxes.* A second limitation is
the potential for management to rationalize past decisions (especially
when questions relate to their motives).^^ Third, there is the problem of
deciding who in an organization (if any individual) makes a specific
disclosure decision; no single manager need be able to describe accurately
the actual management decision process. Fourth, the possibiUty of sig-
naling behavior makes the interpretation of pubUc statements ambiguous.
Firm submissions to regulatory bodies such as the FASB provide
another source of public statements by management. The Watts and
Zimmerman [1978] paper examining firm submissions on GPLA uses this
data source. This approach reduces several of the above problems, such
as those associated with ex post rationalization. However, other prohlems
can become more critical. For instance, there is the unresolved issue of
how firms see their submissions affecting the decisions of the regulatory
body; for example, is it via a voting mechanism in which case positive
submission costs when associated with the low likelihood of influencing
outcomes can result in there not being a one-to-one correspondence
between firms' interests and their submissions (see Downs [1957]). Watts
and Zimmerman appear to see the effects of firms' suhmission costs and
of negligible influences on voting outcome as determining only the sub-
mit/no-submit decision (only 35 unregulated firms in the U.S. made
GPLA submissions). Cost factors surely did not disappear for the 35
GPI/,<4-submitting managers. These comments also apply to other studies
examining firm submissions to the FASB, for example, the DhaUwal
[1982] analysis of firm submissions on accounting for interest cost.
'^ This honesty problem has not gone unnoticed. One response is to be cautious when
interpreting statements by management. For instance, Lindhe [1963, p, 145] notes: "changes
in profit-sharing rates [in compensation plans] sometimes were followed by a change in
depreciation policy. Since the motives of the decision-makers are in question, there is no
true way of resolving the cause of the action," KeUy-Newton [1980, p. 318] notes: "the
arguments offered by management,,, may differ from its true reasons and motivations."
'''^ Clendenin [1941] is an early example of an author attempting to go behind "accounting
model" based rationalizations for accounting method choice.
VARIABLES ASSOCIATED WITH DIFFERENTIAL ACCOUNTING

METHOD USE
Many studies examining variables associated with the accounting
methods used are best viewed as exercises in "descriptive statistics."
Butters and Niland [1949, p. 61], for instance, report finding a "systematic
and pronounced tendency for the use of LIFO to be concentrated among
large companies." It appears that the authors observe this association as
an "empirical regularity" during their research. Sorter et al. [1964 p. 188]
report a "relationship between depreciation poUcy and the magnitude of
the debt/asset ratios." Deakin [1979] examines the profiles of nonmajor
oil firms. The conclusion is that fuU cost firms differed significantly from
successful efforts firms on three of seven variables examinedthe fuU
cost firms are "newer, more highly leveraged and spend more on capital
expenditures per revenue dollar than do those in the successful efforts
group" [1979, p. 729].
Attempts to provide a theoretical underpinning to the variables ex-
amined in correlation- or classification-based research designs are of
recent vintage. The stewardship-contract monitoring h5T}othesis under-
Ues most of these attempts. Watts and Zimmerman [1978] use a discrim-
inant analysis approach with six independent variables to predict firm
submissions on GPLA to the FASB. Although the total discriminant
function is reported to be statisticaUy significant, it is difficult to interpret
this significance since the authors examine several combinations of the
independent variables but do not employ a holdout sample. They report
that one variable (firm size) "explains over half the explained variance in
voting behavior" [1978, p. 131].
The Watts and Zimmerman [1978] paper has played an important role
in generating much subsequent research. The same basic methodology
has also been appUed to explaining accoimting methods use by firms.
Hagerman and Zmijewski [1979, p. 141] use "probit analysis to determine
if size, risk, capital intensity, concentration and the existence of incentive
compensation plans affect the choice of accounting principles." Four
accounting altematives are independently examined (depreciation, inven-
tory, investment tax credit, and pension cost amortization); a consistent
set of variahles is not found to be significant across each of the four
altematives examined. Bowen, Noreen, and Lacey [1981, p. 151], in
similar spirit, use both univariate and multivariate tests to exaniine
"economic factors potentiaUy influencing firms' decisions to expense or
capitalize.. .interest costs associated with capital expenditures." Of three
sets of variables examined (firm size, management compensation, and
violation of debt covenant), only the last is reported to be significant for
the whole sample.^
Bowen, Noreen, and U c e y [1981] report that three debt-covenant-related ratios

(dividends paid/unrestricted eamings, interest coverage, and net tangible assets/funded
long-term debt) are significantly different for the interest capitalizers vis-a-vis the interest
In an interesting extension of their 1979 paper, Zmijewski and Hager-

man [1981] group firms into five categories according to the hypothesized
joint effect of the four accounting methods on reported income. The
authors conclude that their "test provides strong evidence consistent
with the positive theory of accounting standard setting/choice,. .the
results indicated that size, the existence of a profit-sharing plan, degree
of concentration and debt to total assets ratio aU influence the accounting
strategy of a firm" [1981, p. 129,147]. The basis for this conclusion is the
assumption that a firm has an equal probabiUty of being in any of the
five income categories. A different conclusion emerges if one uses the
benchmark of assuming a firm wiU always be in the most common
category for their sample. Note that this benchmark ignores all infor-
mation about the six stewardship variables. The authors report that their
model does not predict any differently from this benchmark model at
even the 20-percent significance *
ACCOUNTING METHOD CHANGES
The accounting change Uterature includes several strands. One strand
presents statistics on the number of firms making specific accounting
changes (e.g., Frishkoff [19706]). Another strand reports variables asso-
ciated with accounting change firms. The choice of variables exeunined in
many of these studies has been heuristic. In a representative study,
Bremser [1975, p. 572] concludes: "This study of the reported EPS of a
sample of 80 firms reporting discretionary accounting changes during
1965 to 1970 has shown that these companies exhibited a poorer pattern
or trend of EPS than a random sample of companies with no reported
accounting changes during the same period. The changers also reported
significantly lower returns on their common stockholders' investments
during the period." Other variables examined in similar exercises include
change of management, firm size, and industry membership.
One area where models are available to guide researchers in the choice
of variables is in the LIFO inventory valuation area. Biddle [1980],
working within the framework of accounting method choice based on
taxation pajnuent minimization, examines whether the future period
inventory holding characteristics of firms changing to LIFO differ firom
those of firms not choosing to switch to LIFO. He concludes that "as
implied by a one-period model which considers LIFO-FIFO tax incen-
tives in optimal inventory order quantity decisions, the empirical results
expensers. In inferring that this result supports a debt covenant violation effect the authors
do not analyze the actual bond covenants of the firms in their sample, Tliey appear to
assume that the same set of specific covenant restrictions applies equally to interest
capitalizers and interest expensers and hence any difference in the three financial ratios
between the two groups represents a difference in closeness of the actual ratios to their
covenant restrictions,
" The authors also report that (using equal probability benchmarks) their model is "only
significant for large firms and those in highly concentrated industries" [1981, p. 148],
suggest that the managers of firms that adopted LIFO chose to hold
larger inventories than their control group counterparts" [1980, p. 273].
Future empirical (and theoretical) work in this area faces the difficult
chaUenge of recognizing interactions among the accounting method
choice, taxation, and financing-investment-production decisions of
finns.^
ACCOUNTING METHOD CHOICE AND DECISION MAKING
A very sizable Uterature examines how the choice of accounting method
may affect decisions made by investors, creditors, and management.
Much of this Uterature is outside the domain of this paper (see Lev and
Ohlson [1982] on capital market studies and Swieringa and Weick [1982]
on lahoratory studies). Quasi-experimental studies examining the associ-
ation between accounting policy decisions and management decisions
have been conducted on many accounting method topics, for example:
SFAS No. 2 (Accounting for Research and Development Costs)Dukes,
Dyckman, and EUiott [1980] and Horwitz and Kolodny [1980], and SFAS
No. 13 (Accounting for Leases)Ahdel-khalik [1981].
The major focus in these and many similar studies is documenting the
existence of an effect (if it exists) rather than probing explanations for
any effects that are observed. This focus reduces the abiUty to generalize
from the results of individusd studies in this area. Detailed discussion of
methodological issues in this area is reported in the proceedings of the
1980 University of Chicago conference on Studies on Economic Conse-
guences of Financial and Managerial Accounting: Effects on Corporate
Incentives and Decisions (see especiaUy the comments of BaU, MarshEdl,
and Wolfson and the repUes hy Dukes, Dyckman, and ElUott and Horwitz
and Kolodny).
C. Time-Series Analysis
The Uterature on the time-series properties of financial statement
numbers is predominantly a post-1960 phenomenon. Table 3 classifies
empirical studies into three main categories: (1) time-series modeling of
annual and interim data, (2) aggregation issues in time-series analysis,
and (3) smoothing, eamings management, and time-series analysis. Re-
search in each category is discussed below.**
^ When using any model to guide empirical research, it is important to recognize that
observing results not consistent with the model can say as much about the ability of the
model to capture the economic context managers face as about the rationality of manage-
ment. This observation is important when interpreting Biddle's [1980, p, 273] statement
that "many firms have voluntarily paid tens of millions of dollars in additional income taxes
by continuing to use FIFO rather than switching to LIFO,"
^ See Cohen and Halperin [1980] and Gonedes [1980] for discussion,
*" Surveys of this literature include Abdel-khalik [1980], Lorek, Kee, and Vass [1981],
and Hopwood and McKeown [1981a].
TIME-SERIES MODELING OF ANNUAL AND INTERIM FINANCIAL

STATEMENT DATA
A major research thrust in this area aims to characterize statisticaUy
the time-series properties of financial statement numhers. Researchers in
these studies have taken the reported numbers as a given and have
examined which of several statistical models (for example, an autoregres-
sive or a moving average model) is the most descriptively valid. Initial
research concentrates on drawing inferences based on mean or median
results for broad samples of firms, for example. Little [1962], Lintner and
Glauber [1967], and BaU and Watts [1972]. The statistical tools used
include autocorrelation functions and forecast metrics such as mean
ahsolute error and mean square error. A consistent conclusion emerges
from much of the early work, that is: "the evidence of independence in
detrended income changes is compelling.. .measured accounting income
is a submartingale or some very similar process" (BaU and Watts [1972,
p. 680]).
By the early 1970s, computer-usable algorithms for univariate Box-
Jenkins time-series analysis were availahle and were actively utilized to
analyze statisticaUy the time series of individued firms. For instance.
Watts and Leftwich [1977, p. 269] model the annual earnings series and
conclude that the assumption of a random walk or a random walk with
drift is "stiU a good description of the process generating annual eamings
in general and for individual firms." It is only recently that evidence
suggesting this conclusion may not be descriptively valid for aU firms has
heen presented. For instance. Brooks and Buckmaster [1980] report that
for extreme eamings change firms systematic pattems in detrended
earnings changes are detectable: "it appears that either a decrease or
large relative increase in income (shock) signifies the likely starting point
for a moving average or mean reverting tjê process (disturbance) that
lasts for one to several periods before reverting to a form of martingale
process" [1980, p. 451].^
These and many simileu- exercises are statistical in their orientation.
Although discussions of economic and other explanations for observed
statistical pattems are sometimes provided, typicaUy these discussions
are included in either the introduction or the conclusion of the paper
rather than being factored into the research design. Two explanations for
the observed statistical pattems that have received attention in the
empirical Uterature are: (i) Accounting-method-based explanation. Bea-
ver [1970, p. 69] presents an argument that "accounting measurement
rules permit, and in many cases, dictate that unexpected components in
eamings be averaged over several subsequent periods." Using both actual
data and simulated data, the results are interpreted to be consistent with
"See also Beaver, Lambert, and Morse [1980] and Freeman, Ohlson, and Penman
[1982],
these explanations. Apart from an extension by Lookabill [1976], very

little empirical research has been done in this area, (ii) Industrial-
organization-based explanation. Several early time-series studies pre-
sent industrial organization notions such as barriers to entry, "market
power," etc., as one rationale for expecting a random-walk model not to
be descriptive.^ It is only recently that studies have appeared that
examine empiricaUy these rationales (e.g.. Lev [1977] and van Breda
[1981]). Neither study provides strong evidence that barriers to entry or
concentration ratios are important variables in explaining differences
across finns in their time-series properties of annual eamings. At present,
our knowledge as to why certain statistical properties are found for the
annual earnings series of firms is very meager indeed.
The growth of research into the time-series properties of interim data
was associated with the increasing utilization of univariate Box-Jenkins
tools in the 1970s, as in Foster [1977] and Griffin [1977]. In general, these
and similar studies report evidence of two systematic pattems in interim
data, a seasonal component and an adjacent quarter-to-quarter compo-
nent. The best representation of the second component is an unresolved
issue (see Brown and Rozeff [1979] for discussion). At this stage, the
Uterature probing accounting method, industrial organization, or other
economic-based explanations for the above two systematic patterns in
interim data is virtuaUy nonexistent.
By the mid 1970s, computer-usable algorithms for multivariate Box-
Jenkins research were available. Applications to annual and interim data
include Hopwood [19806] and Hopwood and McKeown [19816]. The
results to date have reaffirmed conclusions drawn from previous studies
that examine accounting "index models" (for example. Brown and BaU
[1967], Gonedes [1573], Magee [1974], and Foster [1978]). These conclu-
sions include (i) the importance of an economy-wide eamings factor in
the time-series behavior of individual firms, and (ii) related to (i), the
correlation across firms in their earnings forecast errors when forecasts
are made from univariate time-series models.
A topic that heis generated Uttle empirical work is the effect of alter-
native accounting methods on the time-series properties of accounting
numbers. Dopuch and Watts [1972] examine this issue using univariate
Box-Jenkins analysis in the context of materiaUty decisions by auditors.
Gonedes and Dopuch [1979] also discuss the topic in the broader context
of how the use of alternative accounting methods can affect inferences
drawn from research on industrial organization and macroeconomic
^ For example: "Apart from the risk characteristics of any company's operations and
financing, surely the most fundamental of these fundamentals were prospects for growth in
eamings and dividends Our markets were zooming and the real rockets were the
Polaroids and Xeroxes with the fastest growth records. The fast growth companies were
ones with distinctive products, aggressive managements, and many of the attributes asso-
ciated with (products) market power,,,, Exceptions to purely competitive static models
were not regarded as merely random nor strictly transient" (lintner and Glauber [1967, p.
2]).
modeling. The topic area is relatively unexplored, in part (we suspect)

due to the difficulty of obtaining extended time-series observations relat-
ing to alternative accounting methods for the same firm.
AGGREGATION ISSUES IN TIME-SERIES ANALYSIS
The reported earnings number is an aggregated number in two dimen-
sions. One dimension is temporal: annual earnings are an aggregate of
four individual quarterly earnings with each quarter in tum being an
aggregate of three individual monthly eamings, etc. Several issues have
been addressed from this temporal dimension. One research thrust ex-
amines the improvement in forecasting annual eamings from incorporat-
ing the first quarter's eamings, second quarter's eamings, etc., as in
Coates [1972] and Lorek [1979]. This issue has been addressed almost
exclusively at an empirical level with Umited analysis of the conditions
under which improvement in forecasting would (or would not) be ex-
pected.^^ One temporal issue raised, but as yet not examined at an
empirical level, is the impUcations of different time-series models of
monthly (quarterly) data for the time-series model that would character-
ize quarterly (annual) data. Brewer [1973] and Cogger [1981] provide
some interesting analytical results in this area. Consider the result that
"if [quarterly] data are mean reverting, annual wiU be mean reverting"
(Cogger [1981, p. 292]). If one tentatively inferred that quarterly eamings
behaved as a mean-reverting process, one could cross-vaUdate this sample
inference by aggregating the quarterly data to annual data and examining
if the annual data behaved in the predicted manner, that is, as a mean-
reverting process. Although such results do not add to our economic
understanding of why time series behave in a specific way, they can
improve the reUabiUty of the inferences drawn about their statistical
properties."
Reported eamings are also an aggregate of time-equivalent subseries
such as sales and cost of goods sold. A variant of this perspective views
the eamings series of a multiactivity firm as an aggregate of the earnings
series of the individual activities. Research in this eu-ea has compared
forecasts based on time-series modeUng of the more disaggregated series
to forecasts based on modeling the aggregated series. Kinney [1971] and
ColUns [1976] conclude that disaggregate LOB data improved forecasting
while Silhan [1982] reports Uttle evidence of forecast improvement.
Interesting additions to this Uterature include the Ang [1979], Barnea
and Lakonishok [1980], and Hopwood, Newhold, and Silhan [1982] pa-
pers. These papers structure their empirical analysis around analytical
results that specify conditions under which analysis of disaggregated data
would improve forecasting performance. This style of analysis provides
insight into why specific results are obtained in the empirical work.
*' For one exception, see Barnea, Dyckman, and Magee [1972],
^ See Hopwood, McKeown, and Newbold [1982] for research on intertemporal disaggre-
gation.
214 R. BALL AND G, FOSTER
SMOOTHING AND OTHER EARNINGS MANAGEMENT ACTIVITIES

Statements that management "manages" the eamings numbers re-
ported to extemal parties have been part of the accounting Uterature for
many years. At one level, these statements are hardly newsworthy.
Management makes decisions about the Unes of business the firm oper-
ates, its financing options, and its production activities; aU these decisions
affect the eamings numbers reported to extemal parties. At another level,
the "earnings management" statements are more newsworthy; the asser-
tion in part of the Uterature is that management "manipulates" the
reported numbers. A pejorative connotation is apparent in this part of
the Uterature as weU as parts of the closely related "income smoothing"
Uterature.''" Although the literature in this area is very sizable, it is both
uneven and highly fragmented.^^ For instance, there is Uttle agreement
on the underlying motivations for "eamings management" or "income
smoothing" activities. Consider some of the motivations suggested in the
Uterature: Taxation Related"The most compelling motivation for in-
come smoothing is the existence of tax levies, based upon income"
(Hepworth [1953, p. 33]). Labor Negotiations"The absence of peaks
and valleys in the eamings record of an enterprise may do much to
maintain continuing satisfactory industrial relations" (Hepworth [1953,
p. 33]). Maximization of Management Welfare"The achievement of
the management goals is dependent in part on the satisfaction of stock-
holders with the corporation's performance... stockholder satisfaction
with a corporation increases with the average rate of growth in the
corporation's income and the stabiUty of its income... management
should, within the limits of its power, i.e., the latitude aUowed by
accounting rules, (1) smooth reported income, and (2) smooth the rate of
growth in income" (Gordon [1964, pp. 261-62]). Signaling"Income
smoothing could be designed to convey information relevant for the
prediction of future eamings. If we assume management has some knowl-
edge about the firm's future eamings, the smoothing of ordinary income
with extraordinary items could be undertaken to produce an income
number that can be used to predict future eamings efficiently" (Bamea,
Ronen, and Sadan [1976, p. 110]).
Empirical studies typicaUy have not factored any of the above moti-
vations into their sample selection and other research methods. The
result is very limited insights from empirical research into which of the
above motivations is important. Motivations for "eiimings management"
or "income smoothing" typicaUy are discussed (if at all) in the introduc-
tion or conclusion of papers in this research area.
"" See, for instance, discussions of the Royal Mail case in Brooks [1933].
^^ For example: "Some of the most common and most pervasive manipulative practices
in accounting are designed to affect the presentation of eamings trends The income-
smoothing process is a rather sophisticated and insidious device" (Bernstein [1978, p, 229-
30]).
^' A detailed discussion of this literature is in Ronen and Sadan [1981],
The main development in the empirical studies in this area is an

increfising recognition of the many ways management can affect the
reported eamings series, for example, via transactions with suppUers and
creditors, via decisions regarding discretionary expenditure items Uke
research and development and exploration budgets, via the accounting
methods adopted, and via the classification of expenditures as ordinary
or extraordinary. There has not been a similar development in analjrtical
models or research designs to handle this increasing recognition of the
very complex environment empirical researchers face in this area. Despite
the Umited progress to date, interest in the design of more reUable
research designs is considerahle, in part due to the development of the
"stewardship-contract monitoring" paradigm in which confUcts between
management and other parties are explicitly recognized.
D. Financial Distress Analysis

Relative to the corporate disclosure and accounting method choice
topic areas, the Uterature on financial distress prediction has appeared in
a broader set of pubUcation outlets, for example, in banking, economics,
and finance journals as weU as accounting journals. Empirical studies in
this area are classified in table 4 into three areas: (1) distress prediction
modeling, (2) accounting altematives and distress prediction modeling,
and (3) appUcations of distress prediction models. Studies in these three
areas are discussed below.
DISTRESS PREDICTION MODELING

One major research thrust in this area has been to seek empiricaUy
validated characteristics that distinguish financiaUy distressed from non-
distressed firms. Both univariate (e.g.. Beaver [1966]) and multivariate
(e.g., Altman [1968] and Ohlson [1980]) studies have been conducted. A
typical conclusion is: "it was possible to identify four basic factors as
being statisticaUy significant.. .these are (i) the size of the company; {ii)
a measure(s) of the financial structure; {iii) a measure(s) of performance;
(iv) a measure(s) of current liquidity" (Ohlson [1980, p. 110]).
Most studies in this area are exercises in descriptive statistics, in part
due to the absence of an articulated economic theory of financial distress.
Ohlson [1980, pp. 109, 111] is refreshingly frank on this point:
This paper presents some empirical resvilts of a study predicting corporate failure as
evidenced by the event of bankruptcy One might ask a basic and possibly embarrassing
question: Why forecast bankruptcy? This is a difficult question, and no answer or justifi-
cation is given here Most of the analysis should simply be viewed as descriptive
statisticswhich, may, to some extent, include estimated prediction error-rates and no
"theories" of bankruptcy or usefulness of financial ratios are tested.
This ahsence of an economic underpinning to the research surfaces in

many areas. For instance, Uttle attention has been given to discussing
what "financial distress" means. Although a "long-term severe cash flow
o>
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1975]
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problem"-based definition appears impUcit in much of this literature,

empirical studies typicaUy have used hankruptcy as the operational
criterion for a distressed firm. This criterion ignores the many other
options a firm has if it faces "long-term cash flow problems." For example,
(i) it could redefine its objectives or severely reduce its scale of operations
by a divestiture, or {ii) it could liquidate aU its assets and distribute the
proceeds, or {iii) it could seek a merger partner. The choice of indepen-
dent variables to examine in a multivariate model is another area where
the lack of an economic underpinning to the research is apparent. One
approach has been to use those variables suggested in the Uterature or
those found significant in prior studies. Another approach has been to
consider a large set of independent variables initiaUy and then employ a
data reduction approach like factor analysis or stepwise discriminant
analysis.
Most attempts to use models to guide empirical research on distress
prediction have drawn on the statistical or mathematical Uteratures
rather than the economics Uterature. For instance, Wilcox [1973] and
Vinso [1979] use variants of the gambler's ruin statistical model to
structure their experiments. More recently, the mathematics-Uterature-
based "catastrophe theory" approach has been advanced by Ho and
Saunders [1980] and Scapens, Ryan, and Fletcher [1981]. Schipper's
[1977] analysis of financial distress of private universities is one of the
few expUcit attempts to integrate economic modeUng into the empirical
analysis.
Relative to the three other topic areas examined in this appendix, there
has been considerable debate on many technical issues that arise in
empirical research in distress analysis, for example, Joy and ToUefson
[1975]"On the Financial AppUcations of Discriminant Analysis" (see
also the exchanges between these authors and {i) Altman and Eisenbeis
and {ii) Scott in the March 1978 issue of the Journal of Financial and
Quantitative Analysis), Eisenbeis [1977]"Pitfalls in the AppUcation of
Discriminant Analysis in Business, Finance and Economics," and Pinches
[1980]"Factors Influencing Classification Results from Multiple Dis-
criminant Analysis." Issues discussed include factors related to (a) vari-
able choice or sample selection (such as multivariate normaUty and
treatment of missing variables), (6) classification decisions (such as error
rates and costs of misclassification), and (c) inference drawing (such as
interpreting the significance of individual variahles). In addition, Scott's
[1981] review paper and the Altman et al. [1981] book contain discussion
of empirical research issues. Individual empirical studies also show con-
siderable concem with improving the research designs in this area; for
example, Altman, Haldeman, and Narayanan [1977] include analysis of
the effect of using Unear vs. quadratic discriminant analysis, of using
different costs of misclassifying ohservations, and a comparison of a 1968
discriminant function with one based on more recent data.
DISTRESS PREDICTION MODELING AND ACCOUNTING

ALTERNATIVES
Many of the above-cited studies report that financial-statement-based
variables of distressed firms behave differently from those of nondis-
tressed firms. A natural extension is to ask if the results in these studies
are sensitive to the use of alternative accounting methods. The accounting
altematives examined include: capitalization of lease dataElam [1975,
p. 41] reports that the "addition of capitalized lease data to a firm's
financial statements" does not "increase the power of affected financial
ratios for predicting firm bankruptcy"; general price level adjustments-
Norton and Smith [1979, p. 72] report that GPLA "data were shown to
be consistently neither more nor less accurate than historical data for
predictions of bankruptcy." Ketz [1978a, p. 284] reports a different
conclusion although significance tests were not provided to support his
inference that "the results of this study have tended to support the
position of greater utiUty of the general price-level adjustments."
It is interesting to note that each of the ahove three cited papers has
been subjected to extensive criticism on methodological grounds.^'^ The
existence of these critical reviews is consistent with our prior observation
that the level of debate over research methods and research inferences in
this topic area is higher than in the other three topic areas examined.
APPLICATION OF DISTRESS PREDICTION MODELS
One of the motivations for the large number of empirical studies in this
area appears to be a relatively direct Unk between the research outputs
(e.g., predictions about financial distress) and decisions made in a variety
of practical decision contexts: commercial loan decisions (e.g., Altman
[1980], monitoring the solvency of banks (e.g., Dince and Fortson [1972]
and Sinkey [1977], and monitoring the solvency of insurance companies
(e.g.. Pinches and Trieschmann [1974; 1977]).
In such decision contexts, pragmatic justifications for undertaking
research are Ukely to be encountered. For instance, the absence of
economic theory notwithstanding, a technique such as discriminant anal-
ysis can be a cost-effective data reduction tool to a loan officer, an FDIC
official, or a state insurance commissioner. Discriminant-analysis-based
models have the potential to provide improvements in several areas over
existing procedures used in such contexts; for example, (i) they can
process information quicker and at a lower cost than do individual loan
officers or bank examiners, {ii) they can process information in a more
consistent manner, and {iii) they can faciUtate decisions about loss
functions being made at more senior levels of management.
"Elam [1975] by Altman [1976], Norton and Smith [1979] by Solomon and Beck
[1980], and Ketz [1978a] by Bildersee [1978] and PateU [1978], The Bildersee [1978] and
PateU [1978] criticisms occurred as a consequence of the conference format in which Ketz
[1978] appeared. The Altman [1976] and Solomon and Beck [1980] criticisms were individ-
ually submitted to The Accounting Review,
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Journal of Accounting Research

Vol, 20 Supplement 1982

Corporate Financial Reporting: A

is not simply to describe or categorize research methods, for two reasons

statements comprise a major part of the data base in the empirical

a methodological evaluation of current research and to provide some

//. Empirical Research in Accounting

accounting researchers and the empirical literature in accounting face a

///. The Genesis of Empirical Research Ideas

accounting profession at the time. Indeed, in some cases, the research is

at a very early stage of development. It is not surprising that inferences

3. AVAILABILITY OF THEORY TO GUIDE THE EMPIRICAL

Advances of a theoretical kind can be an important motivation for

literature reviewed in this paper. Indeed, a frequent observation through-

5. AVAILABILITY OF ECONOMETRIC OR STATISTICAL TECHNIQUES

feature of the papers reviewed in Appendix A is how different trade-offs

IV. Importance of Methodological Awareness in

View. This view posits that an important factor in accounting method

data would include the financial statements of other "comparable"

designs between (say) a single-period/single-issue perspective and a mul-

person world, the attendant complexities greatly increase" (Baiman [1975,

the experiment so that two otherwise identical worlds are compared

and divestitures hy I.T.T. It is unreasonable to expect Box and Jenkins

5. SUMMARY: DEVELOPING METHODOLOGICAL AWARENESS

V. The Validity of Experiments

corporate financial reporting studies, considerable benefit is to be ex-

variance (nonfailed firms), though they might not distinguish high-vari-

Based on our review of the studies discussed in Appendix A, we observe

^ Indeed, Watts and Zimmerman [1978, p, 127] recognize industry membership as a

approach to the operationalizing of a major construct in the theory. This

results could be occurring because of the severe construct validity issues

acts of individuals or of aggregate processes such as markets. For instance,

attributes of (i) the information content of earnings research designs and

In this context, subsequent researchers can make a useful contribution

limit the generalizahility of the results of any specific time-series study is

theory. In this case, it is inevitable that internal and construct validity

VI. Tests Against Competing Hypotheses

VII. The Maturity of Existing Research Paradigms

map into the institutional domain in which corporate financial statements

finns entering an industry is positively related to the accounting profit of

VII. Concluding Comments

vaUdity is a more important concern than intemal validity and construct

Articulated theories of firm disclosure decisions did not exist when

[1961] regresses disclosure index scores of 527 companies against three

TIMING OF CORPORATE DISCLOSURES

and Dhaliwal [1980] give stewardship as one rationale for a correlation

literature or an analysis of the institutional environment. Dyer and

improve the reliabiUty of inferences from this line of research, Benston

B. Accounting Method Choice

reported eamings number of using a general price-level-adjusted method

on the price of the company's stock, industry practice, management

VARIABLES ASSOCIATED WITH DIFFERENTIAL ACCOUNTING

Bowen, Noreen, and U c e y [1981] report that three debt-covenant-related ratios

In an interesting extension of their 1979 paper, Zmijewski and Hager-

TIME-SERIES MODELING OF ANNUAL AND INTERIM FINANCIAL

these explanations. Apart from an extension by Lookabill [1976], very

modeling. The topic area is relatively unexplored, in part (we suspect)

SMOOTHING AND OTHER EARNINGS MANAGEMENT ACTIVITIES

The main development in the empirical studies in this area is an

D. Financial Distress Analysis

DISTRESS PREDICTION MODELING

This ahsence of an economic underpinning to the research surfaces in

r-^ OS i_i 2 S <?

problem"-based definition appears impUcit in much of this literature,