As noted above, early studies could not successfully discriminate between the noeffects hypothesis and the mechanistic hypothesis. This did not lead to the rejection of the no-effects hypothesis. Instead the results led the researchers to examine the methodological aspects of those studies and question the empirical validity of one important assumption (i.e., zero contracting costs) underlying the tests. This has led to a breakthrough in accounting research. It has long been held in economics that contracting costs are non-zero (Coase, 1937). Accounting researchers abandoned the assumption of zero transaction and information costs.
This breakthrough opened the door to possibilities for explanation and prediction of variation of accounting practice across firms. The major idea behind this literature is that the firm is a nexus of contracts and accounting methods constitute an integral part of this set of contracts. Accounting numbers are used to write, monitor, and enforce contracts. Viewed in this way, accounting can affect firm value via their impact on contracts. Accounting is no longer mere form as was assumed under the EMH and CAPM regime.5 The dropping of the assumption of zero contracting costs has shown that accounting methods have the potential to affect the cash flow to the contracting parties. It thus provides incentives to the contracting parties to influence accounting methods.
Though the above idea is general, early empirical studies of accounting choices investigated the impact of variables related to earnings-based bonus plans, debt, and the political process affecting the firm. Three major hypotheses tested are: (a) the bonus plan hypothesis, (b) the debt-equity hypothesis, and (c) political cost hypothesis. The bonus plan hypothesis states that firms with bonus plans choose accounting methods so as to increase current period earnings. The debt-equity hypothesis says that firms with higher debt-equity ratios choose accounting procedures so as to shift earnings from future periods to the current period. The political cost hypothesis says that large firms rather than small firms choose accounting methods so as to shift earnings from the current period to future periods. Size has been used as the proxy variable for political attention in early studies (e.g., W & Z, 1978). Underlying all these hypotheses is the assumption of nonzero contracting costs. Empirical evidence is Under the EMH and CAPM regime, accounting is mere form and does not affect cash flow except the switch to the LIFO inventory method that affects tax in the USA. generally consistent with these hypotheses (See W & Z, 1986: Chapter Eleven; Christie, 1990). Another stream of research examines the stock price effects of accounting changes- both mandated and voluntary (See W & Z 1986: Chapter Twelve).
After the initial studies of earnings management, empirical studies have investigated different hypotheses. For example, some have examined earnings management around specific events (e.g., management buyouts (DeAngelo, 1986), labor negotiation (Liberty and Zimmerman, 1986), proxy contests (DeAngelo, 1988), import relief investigation (Jones, 1991), non-routine executive changes (Pourciau, 1993), and initial public offerings (Teoh et al., 1998)). Still others have investigated the linkage between corporate governance characteristics and earnings management (e.g., impact of institutional ownership on R & D behaviour (Bushee, 1998), impact of independent directors and CEO stockholdings on earnings management (Reitenga and Tearney, 2003), impact of the then Big 6 auditors on discretionary accruals (Becker et al., 1998; Francis etal., 1999), impact of Big 6 auditor industry expertise on earnings management (Krishnan, 2003), association between auditors’ fees for audit and nonaudit services and earnings management (Frankel et al., 2003), impact of outside directors and audit committee on abnormal accruals (Peasnell etal., 2005), association between board of director characteristics and conservatism (Ahmed and Duellman, 2007)). Also recently, some studies have examined the rationale of accounting conservatism (Watts, 2003a, 2003b).
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