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INTRODUCTION
In chapter two, the theoretical foundation for the formulation of accounting standards is reviewed. This includes an examination of the nature and purpose of accounting standards, together with various aspects of accounting regulation. Chapter three describes the South African accounting standard-setting process within the context of the international harmonisation of accounting standards. The reviews conducted in chapters two and three are considered necessary to provide the theoretical background to the study of South African corporate management’sattitude to the accounting standard-setting process and international harmonisation. In chapter four, an attempt is made to focus on the central theme of this study, namely corporate management’sattitude to the accounting standard-setting process. The international harmonisation of accounting standards must, for the purpose of this chapter, be viewed as an integral part of the accounting standard-setting process rather than an innovation distinct from the standard-setting process.
As investors are able to adjust accounting earnings to take into account changes in accounting policies that occurred in the preparation of financial statements (Ball & Brown 1968, Choi 1994 and Kelly 1983), relatively little new information is provided to them. The question to be posited therefore is: Why does corporate management expend resources in an attempt to influence the accounting standard-setting process? A number of academics, including Bowen, Lacey and Noreen (1981), Dhaliwal (1980), Hagerman and Zmijewski (1979), and Zmijewski and Hagerman (1981), have investigated what motivates corporate management to select a particular accounting policy from the available choices. These studies have incorporated the use of agency theory and other economic factors to identify the reasons why corporate management selects a particular accounting treatment from the available alternatives (for example capitalisation versus expensing) for similar events and transactions.
There is no disputing that corporate management is an active participant in the accounting standard-setting process, a fact with which both Watts and Zimmerman (1978: 113) and Moonitz (1974:64) concur. As is illustrated in chapter three, the reason the South African Institute of Chartered Accountants requests comments to an exposure draft, is to obtain reactions and attitudes of various parties, including corporate management, to a proposed accounting change. South African corporate management and other interested parties respond to these exposure drafts by submitting comment letters to the Accounting Practice Committee in an attempt to influence the outcome of the proposed accounting policy. However, Kelly (1982: 154) rather cynically observes that interest by bodies such as the Accounting Practices Committee with the opinions of interested parties is merely, « to at least appear concemed with undesirable consequences from enactment. » Unfortunately, as is illustrated in chapter six, South African corporate management, with a few individual exceptions, appears to be an unenthusiastic participant in this process.
In this chapter corporate management’srole in the setting of accounting standards is examined. The identification of factors that influence corporate management to respond, either positively or negatively, to a proposed change in accounting standards are reviewed. Included is a review of the sociological role played by corporate management in the accounting standard-setting process. In addition, certain prior research highlighting corporate management’sreaction to accounting standard changes likely to negatively impact on their wealth is described. As South African corporate management’sresponses to exposure draft 89, Revenue; exposure draft 90, Property, plant and equipment, exposure draft 91 , Net profit or Joss for the period, fundamental errors and changes in accounting policies; exposure draft 92, Borrowing costs; exposure draft 93, Construction contracts; and exposure draft 94, Inventories; are reviewed as individual case studies in chapter six, it is instructive to review prior research focusing on management’sreaction to accounting standard changes.
It is important to realise that this section does not purport to be a comprehensive review of all research that has as its focus corporate management and their reaction to accounting changes, but rather a selective overview of research to date. As prior research is primarily positive in nature, it is reasonable to expect that the criticisms of positive accounting research highlighted in chapter two could be considered applicable to these studies. This chapter however, aims at merely describing the research and its outcomes, rather than being a methodological critique of the studies reviewed.
THE ROLE PLAYED BY CORPORATE MANAGEMENT IN THE ACCOUNTING STANDAR~SETTING PROCESS
As is explained in chapter two under agency theory, corporate management acts as the agent for the principal, the supplier of equity capital (Jensen & Meckling 1976 and Watts & Zimmerman 1978 and 1986). One of the ways in which the principal monitors the potential conflict that arises as a direct consequence of the agents’and principals’goals not being congruent, is financial reporting. As accounting measures are used to enforce many of the contracts existing within a firm, agency theory can be used to explain the reaction of the contracting parties (agent and principal) to proposed or mandatory changes to accounting standards. This is especially relevant where these changes are likely to impact on corporate managements wealth.
Corporate management’sreactions to proposed or enacted changes in accounting policies can best be understood by recognising that as part of its stewardship function, management is responsible for reporting the organisation’s financial position and results of operations. This is achieved by management selecting those accounting policies and disclosure levels necessary to ostensibly maximise the wealth of the company, after taking into account existing economic conditions.
To understand why corporate management reacts to a proposed or enacted accounting standard, it is necessary for the costs and benefits of the alternative accounting procedures to be assessed in terms of their cash flow implications. As Kelly (1983: 112) explains, « this involves identifying the points at which the selection of accounting methods and reactions to policy prescriptions occur. » Figure 4.1 illustrates how changes in economic events or accounting policies impact on financial reports, which in tum have cash flow implications.
Figure 4.1 illustrates that either a change in economic events, or a proposed or enacted change in accounting standards impact on financial reports by: (1) providing new/better financial information, {2) having a direct cash flow impact, (3) effecting debt agreements or, (4) resulting in political costs. Each of these changes has the potential to influence share prices, and as a result, corporate managements wealth. Kelly (1983: 112), argues that corporate management can react to a proposed change in accounting standards in one of three ways. Firstly, by lobbying policy makers to initiate a change in allowable procedures, or to•express support or opposition to a proposed or enacted accounting standard. Secondly, by making discretionary changes to mitigate the financial statement effect of the economic event or accounting standard. Finally, financing, production, or investment activities can be changed in an attempt to assuage the financial statement effect of the change in accounting standard.
To overcome the effect of economic events or proposed or mandatory changes to accounting standards, Kelly (1983: 112-114) suggests that corporate management make a number of decisions. Where mandatory accounting changes have occurred, for example, the expensing of research and development costs has been made mandatory, corporate management may make discretionary accounting changes. Examples of these includes extending the period used to amortise pension costs to reduce the negative impact that expensing research and development costs would have on earnings. Examples of economic events necessitating changes in financing, production or investment activities, include disinvesting in politically unstable countries, and the increased use of hedging transactions for foreign currency translations (Kelly 1983:114).
Alternatively, where corporate management opposes a particular accounting standard they can attempt to either circumvent the reporting requirements, subvert the standard, and/or discredit the policy maker (Kelly 1985:615). It would not be unreasonable to argue that for certain accounting standards (for example deferred taxation), corporate management in South Africa embarked on a process of circumventing the reporting requirements required by the accounting standard which effectively discredited the accounting standard-setting body. The only retaliation available to the South African Institute of Chartered Accountants was to propose to the Standing Advisory Committee on Company Law, that the Companies Act Act 61 of 1973, be revised, making compliance with statements of generally accepted accounting practice mandatory. The low level of compliance in South Africa with accounting standards highlighted in chapters two and three, as well as certain identified responses to the various deferred taxation exposure drafts (Samkin 1993), provides adequate justification for this stance.
Academics including Bowen eta/. (1981), Dhaliwal (1980), Hagerman and Zmijewski (1979), Watts and Zimmerman (1978 and 1986), Zmijewski and Hagerman (1981) and Zimmer (1986), have investigated the reasons why corporate management select a particular accounting alternative. In their seminal work, Watts and Zimmerman (1978: 113-116) identified factors which. they argue, influence corporate management’sattitude towards accounting standards. Based on the Watts and Zimmerman’s (1978: 114) assumption that management’s utility is a positive function of the expected compensation in Mure periods (or wealth) and a negative function of the dispersion of Mure compensation (or wealth), management would select wealth increasing accounting standards. The reason for this is that corporate management is typically compensated for performing their stewardship function by direct remuneration and incentive plans linked to both accounting earnings and share prices (Healy 1985, Murphy 1985, Ronen & Aharoni 1989, Smith & Watts 1982, and Watts & Zimmerman 1978).
Managerial compensation, explains Smith and Watts (1982:140-144), is a function of both current and future compensation. This includes salary, incentive remuneration such as cash bonuses, share or share option schemes, perquisites or non-pecuniary rewards, and enhancements to the value of managerial human capital. Corporate management is therefore motivated to select that permutation of accounting policies likely to maximise their income through increasing share prices and cash incentive bonuses. As Watts and Zimmerman (1978: 114) explain, factors influencing corporate management’s attitude towards choice of accounting standard are those that affect both:
forms of compensation indirectly through i) taxes, ii) regulatory procedures if the firm is regulated, iii) political costs, iv) information production costs, and directly via v) management compensation plans. The first four factors increase managerial wealth by increasing the cash flows and, hence, share price. The last factor can increase managerial wealth by altering the terms of the incentive compensation.
The obvious implication of corporate management’swealth maximising function is that, based on their own self-interest, they will participate in the standard-setting process by lobbying the standard-setting body, provided the costs of lobbying does not exceed that which would be incurred by changing financing, production or investment activities. Obviously, it is less costly for a firm to lobby the accounting standard-setting body to amend a proposed standard, than for the firm to change its financing, production or investment activities. Kelly (1983:114) explains the rationale behind this as follows:
Offsetting these costs, and providing the incentives for management’s choices and reactions, are benefits in terms of the effect of alternative accounting policies on management’s wealth. These benefits are influenced by the probability of success of the various reactions. Thus lobbying, while less costly, may be less effective in mitigating the impact of an accounting change on a financial statement.
Factors Influencing corporate management’s attitude towards accounting
standards
Changes in accounting policies not only influence the cash flows of a finn, but also impact on Mure taxation policies, regulatory action, political, and bookkeeping costs. In reacting to a proposed change in accounting standards, corporate management must not only take into account the immediate impact on the finn’scash flow, but also any potential cash flow effects that will occur as a result of the change.
Factors identified as influencing corporate management’sattitude towards accounting standards have been developed into a number of hypotheses. These are described as: (1) taxation hypothesis, (2) costs of regulation hypothesis, (3) political costs hypothesis, (4) infonnation production costs hypothesis and, (5) management compensation hypothesis. In addition, academics including Dhaliwal (1980 and 1982), Holthausen and Leftwich (1983), and Kelly (1983), identify the existence of monitoring contracts as an additional factor that influences corporate managers attitude towards accounting standards.
Taxation hypothesis
Although financial statements prepared for taxation purposes and those prepared for other external users differ, an indirect relationship exists between these two sources of financial infonnation. Both Watts and Zimmennan (1978: 114-115) and Kelly (1983: 124) argue that the use of a particular accounting procedure makes it more likely that revenue authorities will adopt that practice than had it not been used. Watts and Zimmerman (1978: 115) explain this as follows: « To the extent that management expects a proposed financial accounting procedure to influence future tax laws, their lobbying behaviour is affected by the Mure tax law effects. »
Measuring this aspect of political costs explains Kelly (1983:124), requires the finn’s exposure to the taxation effects of a particular policy to be specified. For example, the taxation impact of expensing research and development costs would be greater for companies with significant research and development activities.
Costs of regulation hypothesis
Certain public utilities (Watts & Zimmerman 1978:115 and Kelly 1983: 125), base their rate-setting formulas on accounting detennined costs. A proposed accounting standard that reduces reported income would find support on the grounds that management of the utility could lobby for rates increases. Whether a rates increase is granted, depends on consumer and other groups opposed to the increase, being able to exert the necessary political pressure to prevent it.
Political costs hypothesis
Kelly (1982:156 and 1983:118), in concurring with Watts and Zimmerman (1978 and 1986), explains that costs to the firm from political events have several sources. Accounting disclosure is often used by third parties in their dealings with the firm. These include union contracts, government regulations in the form of price controls, taxation policy, and public surveillance which includes antitrust activities. Political costs occurring as a direct result from reactions of various parties to the firm’saccounting disclosures have potential cash flow implications. Higher profits increase the likelihood of incurring political costs from antitrust action, union demands, price controls, and increased taxes. Where these circumstances exist, corporate management is likely to oppose any accounting standard increasing income. These situations can be avoided however by the use of appropriate income decreasing accounting procedures.
Watts and Zimmerman (1978: 115) explain that governments are able to mandate wealth transfers between various groups, with the corporate sector especially vulnerable to redistributions of this nature. They provide the following explanation for this position:
Certain groups of voters have an incentive to lobby for the nationalization, expropriation, break-up or regulation of an industry or corporation. This in turn provides an incentive for elected officials to propose such actions. To counter these potential government intrusions, corporations employ a number of devices, such as social responsibility campaigns in the media, government lobbying and selection of accounting procedures to minimise reported earnings (Watts & Zimmerman 1978:115).
Four economic variables that can be used as proxies for political costs are identified by Hagerman and Zmijewski (1979:142-145), Holthausen and Leftwich (1983:95), and Watts and Zimmerman (1986:251-252). These include size, risk, capital intensity and concentration.
(a) Size
In an attempt to reduce attention that may be focused upon them, large corporations have an incentive to select accounting standards that either reduce or postpone net income. Empirical studies by Bowen eta/. (1981 ), Daley and Vigeland (1983), Dhaliwal, Salamon and Smith (1982), Hagerman and Zmijewski (1979), Watts and Zimmerman (1978), and Zmijewski and Hagerman (1981), focus on the hypothesised relationship between firm size and the income effect of accounting policies.
(b) Risk
Hagerman and Zmijewski (1979: 143) with Kelly (1983) concurring, hypothesise that in an equilibrium situation, the expected return a firm can expect on capital invested is positively related to systematic risk. Firms with higher systematic risk can expect higher accounting returns.
Unless adjustments are made for risk, these firms will appear to make excessive profits and face the threat of negative wealth transfers. Furthermore, high risk firms also have a high variability of accounting earnings which, under certain circumstances, appear abnormal. In order to reduce the potential of incurring political costs, these firms select income reducing accounting procedures. Hagerman and Zmijewski (1979:143) explain this as follows: « The beta of accounting earnings should serve as a reasonable proxy for variability of accounting earnings, since systematic risk is a large component of total risk, so we expect higher risk firms to choose income deflating alternatives. »
(c) Capital intensity
Capital intensive firms, argue Hagerman and Zmijewski (1979:143), do not use the opportunity cost of capital in the calculation of net income. This results in capital intensive firms appearing more profitable than a labour intensive firms. Capital intensive firms subject to political costs, have an incentive to select accounting techniques that reduce reported income.
(d) Goncentravon
Concentration refers to the degree of competition within a particular industry. Hagerman and Zmijewski (1979: 144) provide two reasons why excessive accounting profits increase the competition faced by a firm. The first is antitrust or other legislative action aimed at increasing competition. The second is the entry of new firms into the market reducing excessive profits which results in a portion of corporate management’sexplicit or implicit earnings being forfeited. Hagerman and Zmijewski (1979: 145) with Watts and Zimmerman (1978: 115-116 and 1986:252) concurring, argue that because of the greater probability of incurring political costs, firms that are large, risky, capital intensive or have monopoly rents, have an incentive to select income reducing accounting techniques. Costs incurred in avoiding political events lead to share price movements which impact on the value of management’sshareholding and human capital. The political costs that arise through regulation or taxation occur, suggests Kelly (1983:124-125), because politicians and other regulators are unaware of the impact of accounting changes when making decisions. One of the reasons why politicians and regulators fail to make these adjustments is their perception that no benefits will accrue to them. However, a more likely scenario is the lack of ability on the part of politicians and regulators to make the adjustments.
It is submitted that the potential threat associated with the political cost hypothesis has been recognised by South African corporate management. The pre and post 1994 unbundling of a number of South African corporations provides testimony to this. By unbundling these corporations, corporate management has sought to avoid both political regulation and negative wealth transfers associated with what has been perceived in some quarters as excessive profits. In addition, potential costs in the form of increased wage demands are also avoided. In South Africa, the mining, banking and insurance industries are especially susceptible to pressure attributable to the political cost hypothesis.
Information production costs hypothesis
Changes in accounting procedures argues Watts and Zimmerman (1978:116), are not costless to firms. Information production or bookkeeping costs are incurred when changes in accounting standards are promulgated, or additional disclosure is mandated. However Bowen et a/. (1981: 156) have argued that for certain accounting changes, the resultant increased information production costs are relatively inconsequential.
Management compensation hypothesis
It is corporate management’sprincipal/agent relationship with owners, explains Hagerman and Zmijewski (1979:145-146) with Holthausen and Leftwich (1983:84), Kelly (1982:155 and 1983:116), and Watts and Zimmerman (1986:204-210) concurring, that gives rise to compensation agreements linking compensation schemes and bonus plans to accounting earnings and share prices. Recognising that management, acting in their own self interest may not necessarily make decisions that are principal optimal, these compensation agreements represent bonding and monitoring arrangements aimed at reducing corporate management’s tendency to appropriate non-pecuniary benefits. This potential conflict of interest between managers and shareholders is reduced by offering management various incentive compensation schemes, including bonus plans dependent upon accounting earnings, and stock option plans, which have the effect of making managers shareholders.
Proposed changes to accounting standards effect either the financial position, financial result or cash flow of a firm. Where a proposed accounting standard is likely to have a direct cash flow effect, for example by increasing taxation or bookkeeping costs, the value of the firm changes which results in the revision of return distributions. As share prices are a function of the cash flow distributions expected to be generated by a firm, these proposed changes may affect a firm’s equity markets (Kelly-Newton 1980:29). Where a portion of corporate management’swealth is derived as a direct result of its ownership of the firm’sshares, the existence of share options schemes, or share appreciation rights, management will be understandably concerned about the effect that changes in the firm’sdisclosure policies may have on share prices, especially as Murphy (1985:40) explains, « firm performance as measured by the shareholder’s realised return, is strongly and positively related to managerial remuneration. » As stated earlier, it is this potential loss of wealth that provides corporate management with the incentive to react to policy issues. Furthermore as is illustrated in figure 4.1 , changes to the firm’sshare price also affect the value of management’shuman capital in the managerial market. This factor is, however, of more concern to professional managers rather than owner managers.
Monitoring and bonding contracts
In the context of the firm, monitoring and bonding agreements exist to ensure that managers act in the best interest of the principal and reduce the manager’stendency to appropriate non-pecuniary benefits. These agreements include formal audits of the accounting records, control systems, budget restrictions, explicit bonding against malfeasance, and limits on the decision-making power of the manager.
Where a firm has extensive borrowings, these are often matched with various restrictions in the form of debt covenants on the firm’sactivities. These debt covenants often contain certain limitations. These include, limiting dividend payments, restricting redemptions, requiring the firm to maintain a minimum amount of working capital, or maintaining a particular current ratio. Daley and Vigeland (1983: 196) provide illustrations of typical leverage and dividend distribution restrictions. These include, limits on long-term debt/total assets and limits on interest cover ratios, while restricting to a maximum available pool from which they may be paid. Restrictions of this nature all affect the operating decisions of corporate management.
Financial statements used to monitor debt covenants are usually based on statements of generally accepted accounting practice. The existence of a debt covenant which, if violated, places the firm in technical default of the loan thereby resulting in the debt’s maturity or renegotiation, influences management’s attitude to a proposed standard. Where a firm is in default of a debt covenant, this represents a cost to the firm which will impact on its share price. Where a proposed standard results in negative consequences to a firm’sfinancial statements by either (1) reducing net income, (2) decreasing the book value of equity, (3) increasing the debt/equity ratio, (4) causing a deterioration in the relationship between interest expense and capital, (5) causing a deterioration in the relationship between interest expense and income or,
(6) reducing retained earnings available for dividends, management will oppose the proposal (Bowen eta/. 1981, Daley & Vigeland 1983, Dhaliwal1980, and Zmijewski & Hagerman 1981) as it will have an adverse impact on the value of management’s shareholding, and human capital.
CHAPTER FOUR CORPORATE MANAGEMENT AND THE ACCOUNTING STANDARD-SETTING PROCESS
4.1 INTRODUCTION
4.2 THE ROLE PLAYED BY CORPORATE MANAGEMENT IN THE ACCOUNTING STANDARD-SETTING PROCESS
4.3 PRIOR RESEARCH FOCUSING ON CORPORATE MANAGEMENT’SROLE IN THE ACCOUNTING STANDARD-SETTING PROCESS
4.4 CONCLUSION
