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U.K. managers' decisions and their perceptions of capital markets
U.K. Managers’ Decisions and Their Perceptions of Capital Markets
D.J. Collison J.R. Grinyer A. Russell
This article discusses andpresents some empirical evidence on a particular aspect of the “economic consequences” of accounting. It considers whether U.K. managers’ perceptions of the attitudes of the capital market to reported earnings are likely to influence defined spending decisions of publicly quoted companies. This issue should be of interest to standard setters, financial managers, investors, and most users offinancial statements. The fundamental hypothesis is that managers’ spending decisions are affected by their perceptions of the extent to which the capital markets rely on reported earnings when valuing shares. The importance of testing the above hypothesis stems from the possibility that the decisions of managers may, on occasions, be driven by their expectations of the market’s use of short-term prospective earnings, rather than by more fundamental economic factors. An analysis of the results from a large-scale postal questionnaire of U.K. finance directors is presented. The conclusions from the study support the stated fundamental hypothesis.
BACKGROUNDTOSTUDY This article considers the potential of published figures of accounting earnings to influence defined spending decisions of managers of U.K. quoted companies. Such managers typically operate in an environment in which there are significant asymmetries of information (see, e.g., Miller and Rock 1985; Myers and Majluf 1984; Healy and Palepu 1993). Consequently, their actions are not directly observable or controllable by shareholders. Unless controlled by a system of monitoring
D.J. Collison, J.R. Grinyer, and A. Russell l Department of Accountancy University of Dundee, Dundee DDl 4HN, United Kingdom. Journal of International Accounting & Taxation, 5( 1):39-52 Copyright 0 1996 by JAI Press, Inc. All rights of reproduction
and Business Finance,
ISSN: 1061-9518 in any form reserved.
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and reporting, managers in such circumstances could to a considerable extent pursue their personal interests at the expense of shareholders (see, e.g., Penno 1985; Watts and Zimmerman 1986; Bromwich 1992). Therefore, there appears to be a need for financial reports to monitor financial perf0rmance.t Jensen (1983) identifies that need and associates it with the long-standing concept of “stewardship.” One of the implications of the monitoring (accountability) role of financial statements is that the requirement to disclose specified financial information can influence managers’ economic decisions (Rappaport 1977; Prakash and Rappaport 1977). Managers who are monitored by financial statements are likely to be interested in achieving a satisfactory reported outcome in accounting terms. They, therefore, have a potential motivation to take actions that would assist the achievement of that outcome. Such a motivation is likely to be reinforced by considerations of personal remuneration in firms that reward senior management by reference to figures of reported earnings. It is possible for managers to influence the content of financial reports in two fundamentally different ways. First, they could use the flexibility in accounting rules to adopt those accounting policies which produce the desired reported outcome. Second, managers can vary their operational decisions involving real resources (see, e.g., Ronen and Sadan 1981). This article is concerned with the second type of potential influence. Accounting earnings seem widely to be regarded as a primary accounting indicator of performance (see, e.g., Hopper et al. 1992; Grinyer et al. 1991). Financially sophisticated managers are likely to be well aware of the ability to manipulate eamings per share and of the limitations of that measurement as a summary indicator of company performance. They may also be well aware that certain policies which in the short term lower the earnings per share figure, or its rate of growth, may be in the interest of long-run shareholders.2 Nonetheless, these managers are likely to be keenly interested in the view of their company currently taken by the capital market. Thus, their own perceptions of the importance that should be assigned to accounting earnings in the short-term, as a performance indicator, may be dominated by what they think is the emphasis placed on such earnings by the capital market. If they expect adverse consequences to follow the reporting of disappointing earnings, they are likely to make decisions that reduce the shortfall in such earnings below market expectations. This could often boost current earnings at the expense of long-term economic progress. Similar perceptions to those expressed above have been previously reported in the financial management literature (see, e.g., Copeland et al. 1991,73). Arguably, the interests of many existing shareholders depend not only on the cash flow consequences of operational decisions but also on the markets’ reaction to accounting earnings (see, e.g., Lemer and Rappaport 1968; Healy and Palepu 1993). Managers may, therefore, believe that emphasizing the latter at the expense of the former is not inconsistent with acting in shareholders’ interests, especially when the interests of existing short-term shareholders are distinguished from those of potential and of
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long-term shareholders.3 However, it would be preferable if managers did not feel pressure to compromise economically desirable actions in order to improve the appearance of the organization when it is viewed through the lens of accrual accounting based performance indicators. In this article, economically desirable actions are assumed to be those which increase the wealth of long-term shareholders. Conventional accrual accounting recognizes only realized profit, associated with the prudence concept. The latter concept results in many expenditures that are undertaken for the medium- to longer-term being written off against current income as revenue expenditure. Such expenditures include: outlays on research and development; the startup costs of new products and of new businesses (which can be very large); substantial training costs, such as occur on the introduction of new technology into an ongoing operation; and probably a large part of many outlays on advertising to establish the demand for products or services. Such outlays usually reduce the reported earnings for the period during which they are made, although that period is unlikely to receive all of the benefits which they produce. Indeed, in many cases the current period is credited with none of the cash inflows which will subsequently be derived from them. In contrast, a reduction in the level of expenditure previously incurred on these “revenue investments” will increase the earnings of the current period. Assuming that managements only undertake expenditure which they consider will be justified by future returns, such cuts in outlays will result in increases in current earnings at the expense of reductions in future earnings. Overall, the backward-looking and prudent nature of conventional accrual accounting means that it does not directly report the economic progress during the period in a long-term context. That observation does not necessarily mean that earnings figures are uninformative, nor that they are inappropriate for some purposes. Furthermore, the fact that earnings are based on adjusted and pro-rated cash flows means that under identifiable assumptions they can reveal information about sustainable operating cash flows generated by the business. Such information may be of assistance when forecasting future cash flows and, therefore, useful when valuing the business at the present time. Nevertheless, it seems reasonable to assert that heavy reliance on the reported earnings figures of a single period to monitor financial performance in an ongoing business is unwise. The figures of earnings need to be interpreted within the context of the financial statements as a whole, of the available information about the economy in general and the industry involved in particular, and of the longer term trend of accounting variables under the existing management.
POTENTIALINFLUENCES An extensive literature discusses the potential influences of financial reporting on managers’ decisions; it will not be comprehensively reviewed here. That literature includes the Agency Theory literature that relates to monitoring (see, e.g.,
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Jensen 1983). The literature associated with contracts of remuneration is particularly pertinent (see Watts and Zimmerman 1986 for a review). One might reason that managers who are paid bonuses by reference to reported earnings will be motivated to take actions which maximize the value of their bonuses over time (see, e.g., Healy 1985). That suggests that managers’ decisions are likely to be affected by their impact on current reported earnings irrespective of the managers’ beliefs about the likely responses of the capital market to the earnings figures resulting from the decision. Such beliefs are, however, also likely to affect management behaviour. Concepts which suggest that this is the case have been advanced under the names of “information inductance” and “functional fixation.” Prakash and Rappaport (1977) identified an influence associated with the presentation of information which they referred to as “information inductance” or simply “inductance” (see also Rappaport 1977; Garrod 1987). This arises when the sender of information may be motivated to modify his or her actions in anticipation of the reaction which would otherwise arise from the recipient of that information. Inductance can affect decisions concerning presentation of information about economic events and decisions concerning economic events, or both. P&ash and Rappaport argued that inductance could result in economic consequences of material proportions.4 The potential inadequacies of current figures of earnings as indicators of longer term performance are discussed above. Acceptance of those arguments suggests that information inductance is more likely to result in uneconomic decisions (as defined above) if managers believe that the recipients of financial statements are “functionally fixated” on reported earnings. The notion of functional fixation (Ijiri et al. 1966) describes the lack of discrimination which individuals exhibit in reacting to certain familiar measures or symbols. For example, if the notion of a discrete figure of earnings dominates the thinking of a user of financial statements, he or she may not adequately recognize the significance of changing elements in the set of entries that underlie that figure. If managers think that investors are preoccupied with figures of, or figures directly derived from, reported earnings, they have an inducement to emphasize the consideration of such earnings in their decision analysis. A review of the literature (see, e.g., Jensen 1966; Abdel-Khalik and Keller 1979; Ashton 1976; Hand 1990; Harris and Ohlson 1990) relating to the functional fixation hypothesis (FFH) is given by Tiniq (1990). He considers whether stock prices are set by investors who are fixated on accounting measures and concludes that “it is fair to say that the FFH and its extensions to the price formation process in the stock market remain unresolved.” It appears at least possible that managers of large firms might reasonably believe that investors are functionally fixated. This article is concerned with the associations, if any, between reported eamings and management behaviour. As already indicated, the latter is likely to be influenced both by considerations of managerial remuneration and by managers’ beliefs about the reactions of the capital market to figures of reported earnings.
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Thus, the opinions of managers about capital market behaviour should be helpful in exploring the likelihood of information inductance. This perception is central to the empirical research described below. For example, rational managers who think that the market is functionally fixated on reported earnings could seek to meet the market’s expectations as they understand them. They could expect that a failure to do so would result in a reduction in share price which might impede their efforts to raise capital to fund future activities and could make them vulnerable to takeover. Information inductance might then follow-for example, management may then be tempted to forego expenditure that is subject to mandatory writeoff but which they would have incurred if it could have been capitalized.5 It follows that managers’ beliefs concerning the information which affects share prices on the capital market may influence their economic decision making. This article, therefore, considers managers’ perceptions of the reactions of share prices to information about eamings and not directly the adequacy of those prices. It follows that the analysis does not address the issue of the “efficiency” of the capital market. Thus, it avoids the use of that term and does not refer to its attendant rich literature.6 The above discussion suggests that managers’ decisions are likely to be affected by considerations of their impact on reported earnings. This may derive from the existence of managerial bonus schemes that are tied to earnings, from managers’ perceptions that the capital market places heavy emphasis on figures of earnings, or from a combination of these factors. Arguably, the use of earnings figures as a common basis for remunerating senior managers is itself an inductive response to perceptions of the market’s functional fixation on earnings. Even if that is the case, it is still possible to observe the information inductance effects if one can identify managers’ perceptions concerning the market’s response to specified changes in earnings. The above discussion suggests the fundamental hypothesis that: Hl:
The influence of reported earnings on managers’ spending decisions is in part a positive function of their perceptions of the extent to which the capital market relies on figures of reported earnings when valuing shares.
As the hypothesis is concerned with managers’ perceptions about the market, it is independent of the short-term impact of earnings figures on managerial remuneration. Hl cannot be tested directly on a basis that allows statistical analysis because it is not possible to observe management action for a large number of firms. It is, however, possible to ask managers how they believe management will act in certain circumstances. One can reason that managers’ beliefs about likely management responses reflect their observations of past actions. Therefore, the empirical study which is used to test the hypotheses proceeded by reference to managers’ perceptions. Perceptions sought related to: (1) the extent to which management believed that the capital market emphasizes figures of expected earnings for the
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current period rather than other information relating to the firm and its industry; and (2) anticipated effects of different scenarios of market expectations of earnings on management expenditure decisions.
RESEARCH
METHOD
The empirical research was conducted as follows: first, to identify senior finance managers’ opinions concerning the importance of current earnings to (a) the process of share price formation and (b) management’s expenditure decisions; and second, to test for an association between the opinions identified in (a) and (b), which, if positive, would support the hypothesis. Data for the investigation were obtained from the responses to a questionnaire (the relevant sections of which are reproduced in the Appendices) distributed to the finance directors of The (U.K.) Times 1000 (1990) companies in May 1991. The survey, therefore, covered many of the largest firms in the United Kingdom. There were 246 responses, resulting in a response rate of 24.6%. Only part of the questionnaire is used in this study. The questionnaire sought responses to statements about the market’s valuation process. These are shown as Ml and M2 in Table A.1 in the Appendix. Questions also sought managers’ responses to statements concerning management decisions on expenditure on “revenue investments”7 (research and development, advertising, and training) and acquisitions of other companies. Table A.2 in the Appendix shows these 17 decision-related statements, grouped under headings D 1 to D6. The analysis in this article depends only on associations between responses. Nevertheless, the descriptive statistics are provided in the appendices as background information. Respondents were invited to check one of five boxes, giving a Likert scale ranging from (1) “strongly agree” to (5) “strongly disagree.” This scale enabled descriptive statistics to be prepared and assisted with the ensuing analysis, while maintaining a standard format for the responses to each statement. In addition, questions and codes were devised to enable industry and size classifications to be made and to identify the status of the person responding, while maintaining total anonymity of the reporting company. Thus, followup mailing to nonrespondents could not be done. Nevertheless, the researchers believed that anonymity was desirable because of the possibility that some finance managers might be deterred from responding if their firm’s identity were to be disclosed or, if they responded, might be inhibited in the responses they provided. Another potential limitation to the generalizability of the results arises because of the nature of questionnaire-based research. Thus, throughout the process of developing the questionnaire, there was a recurring conflict between the need for brevity and the desire to avoid ambiguity. There was a need for brevity in order to encourage a high response rate. A short question often poses fewer problems of interpretation for the respondent than a
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longer, more heavily qualified, one. However, the adoption of such questions can produce statements which rely on the individual interpretation of the respondents, resulting in potential ambiguity. Efforts were made to minimize this limitation by pretesting the questionnaire on academic colleagues and by pilot testing as discussed below. Two tests were made to check for nonrespondent bias. First, responses were classified by both industry and firm size; no nonrespondent biases were identified by reference to those classes. Second, the responses of “quick” and “slow” respondents were compared, but no statistically discernable differences in patterns of responses were found. An aspect of the questionnaire which deserves special mention is the perspective which respondents were asked to adopt. They were asked to respond to hypothetical statements concerning quoted companies in general. Had they been asked to respond to the statements as they applied to their own companies and their own decisions, it was thought likely that in many instances, some of the statements would have been inappropriate for their particular circumstances. That might have resulted in a lower response rate and/or have required the deletion of statements which were not applicable to all companies. The questionnaire derived from the preliminary work was developed and tested in a pilot study, which involved interviewing the finance directors of nine companies quoted on the London Stock Exchange. Each director was asked whether the statements used were clear and unambiguous. One question which required additional explanation by the researchers was removed. The interviewees considered that all of the remaining questions would be readily understood by similar respondents. Many of the directors volunteered their opinions about the shortterm valuation practices of the capital market and how it affected their financial decisions. All of them accepted that the perspective outlined in the previous paragraph was a reasonable one. A number of interviewees indicated that their responses to the questionnaire were made with reference to their firms’ normal practices in communicating with the capital markets. It was widely accepted that top management could effectively communicate with the market to explain special circumstances whenever management considered such action to be desirable. The questionnaire did not specify the information assumed to be available to the market because the researchers wished to explore likely management responses to accounting variables. Responses were likely to be influenced by managers’ beliefs about the information set available to the market. In that event, it was considered best to leave respondents to answer by reference to their personal perceptions of the sources and quality of information flowing to the market. All questionnaires face a potential problem of response bias. Clearly, at worst the findings of the survey are indicative only of the characteristics of the part of the population that responded. At best, they could be representative of the population as a whole; there are no special factors in this study which suggest that such a sit-
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uation is not the case. Readers must decide for themselves whether they wish to assign a wider or narrower interpretation to the findings. The analysis can, strictly speaking, only be claimed to be exploring the opinions of the group of finance managers who responded.8 Even allowing for such a caveat, the number of firms whose managers did respond represents a substantial, and therefore economically significant, proportion of the largest companies in the United Kingdom.
ANALYSIS
OF RESPONSES
Finance managers may agree that the capital market values shares primarily on the basis of the current year’s prospective earnings (Statement Ml) and yet may hold very different views about the adequacy of the market’s process for valuing shares. Those members of this group who have confidence in the capital market’s process presumably think that the figure of short-term accounting earnings is a good surrogate for the economic variables that underlie the longer-term worth of a share. Those members of the group who believe that accounting earnings are a very limited depiction of economic variables in the future would presumably regard such a basis for valuation as being myopic. Statement M2 sought managers views about the extent to which the market is aware of the business opportunities available to specific companies. The market would only be aware of such opportunities if participants had invested in the acquisition of information, which investment would be irrational if the information obtained was not considered to be relevant to their investment decisions. Consequently, M2 implies that the market values shares by reference to a broader set of data than figures of reported earnings alone. Respondents could agree with Statement Ml without believing that the share price was determined exclusively by reference to reported earnings. One might, however, anticipate that the responses to the statement reflected the beliefs of managers concerning the level of emphasis placed by the market on earnings. Logically, managers who believe that the market is aware of the investment and commercial opportunities available to specific companies will be inclined to place less emphasis than otherwise on earnings in their responses to Ml, because they believe that the market uses non-earnings information. It is, therefore, possible to confirm the appropriateness of Ml as an indication of expectations of “the extent to which the capital market relies on figures of reported earnings when valuing shares,” by examining whether there is a significant negative correlation between responses to Statements Ml and M2. Table 1 shows the correlation between the responses using Kendall’s Tau for a one-tailed distribution. It can be seen that the responses are, as expected, negatively correlated with a significance level of 1%. This can be taken as support for a contention that the responses to Ml reflect respondents’ expectations of the extent to which the capital market relies on figures of reported earnings when valuing shares.
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TABLE 1 Sign and Significance Level of Correlation Between Ml and M2 Presumed Sign
Actual Sign
Significance Level Category
**
Nores:
Signijkance Level
Kendall’s Tau Correlation Coefficient
n
-0.1908
244
0.000
** Denotes significant at -C 1%. (-_) Denotes negative correlation. n = Sample size.
Most of the statements shown in Table A.2 concern managers’ operating decisions in the areas of expenditure on: “revenue investments,” investments in innovative projects, and takeovers. By studying associations between responses to Statement Ml and these statements concerning managers’ decisions, we can investigate Hl . As indicated in the discussion above, it is not possible to test the hypothesis directly. Instead, the test has to be formulated in terms of management expectations. Furthermore, the decisions which can be investigated by reference to the data base available to this study are limited to the identified categories of expenditure. It is, therefore, necessary to reformulate Hl in an empirically testable form. This can be expressed as (HIE): TABLE 2 Signs and Significance of Correlations with Ml
Statement
Presumed Sign
Actual Sign
Signijkance Level Category
Dla Dlb Dlc D2a D2b D2c D3a D3b D4 D5a D5b D5c D5d D6a D6b D6c D6d
+ + + + + + + + + + + + + + + + +
+ + + + + + + + + + + + + + + + +
** ** ** * ** ** * ** ** ** ** * ** ** ** * **
No/r.r: * Denotes significant at < WC. ** Denotes significant n = Sample size.
at < 1%.
Significance Level 0.007 0.006 0.008 0.041 0.005 0.002 0.047 0.006 0.000 0.002 0.005 0.03 1 0.006 0.003 0.000 0.041 0.003
Kendall’s Tau Correlation Coeficient
n
0.1388 0.1397 0.1338 0.0977 0.1435 0.1637 0.0934 0.1409 0.2313 0.1614 0.1467 0.1059 0.1421 0.1550 0.2089 0.0979 0.1554
241 243 241 242 243 241 241 241 243 237 235 237 235 242 241 242 241
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HlE: Managers’ perceptions of the extent to which managerial spending decisions are influenced by considerations of reported earnings are positively associated with their perceptions of the extent to which the capital market relies on prospective earnings for the current period when valuing shares.
The associated
null hypothesis
(HIEN) would have exactly
the same wording
except that the words “are positively associated” would be replaced by “are not positively associated.” As indicated in the discussion above, Statement Ml can be considered to reflect the emphasis placed by the market on figures of current earnings. The responses to that statement are, therefore, taken as a basis for testing Hl, empirically. Correlations of Ml with Statements Dl to D6 are shown in Table 2. In all cases, the signs are as predicted ex ante and the correlations are statistically significant, indeed most of them are significant at the < 1% level. This is clear evidence for the rejection of the null hypothesis, Hl,,. The results, therefore, support the alternative hypothesis, Hl,. That, in turn, is supportive of the fundamental hypothesis, Hl.
CONCLUSIONS
This article has established and tested the fundamental Hl:
hypothesis:
The influence of reported earnings on managers’ spending decisions is in part a positive function of their perceptions of the extent to which the capital market relies on figures of reported earnings when valuing shares.
Evidence from correlating the responses to different statements in a large scale postal questionnaire was strongly supportive of the hypothesis. It appears that managers’ perceptions that the capital market places heavy emphasis on reported earnings could lead them to emphasize the short-run, to the detriment of the longer-term, progress of their businesses. The evidence of the study underlines the potential importance of managers’ perceptions of the market’s earning expectations as influences on management action.
Acknowledgment: The authors thank the Institute of Chartered Accountants in England and Wales for funding the empirical work which is reported in this article.
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NOTES 1.
2.
3.
4.
5. 6.
I.
8.
Shareholders and other investors in aggregate can act to discipline managers. This might be achieved by: (1) selling shares to other individuals, resulting in reduction in share prices with consequential financing implications; (2) selling shares to other companies in takeovers; or (3) acting directly to remove managers or influence their remuneration if the shareholders involved have very substantial holdings. In all cases, senior managers may find that their personal interests are adversely affected. It is accepted that there are many other participants in the firm who have valid claims for the recognition of their interests. This analysis proceeds, however, using the conventional assumption that managers should seek primarily to serve shareholders’ interests. If the market does not always see through accounting earnings manipulation, existing shareholders could profit at the expense of future shareholders if share prices were temporarily raised above their fundamental value by reason of manipulated figures of reported earnings. Prakash and Rappaport also claim that accountants had not “concerned themselves greatly” with the economic consequences of inductance. Such a view is consistent with the standard setters’ commitment to “decision usefulness” as a guiding principle (see, e.g., FASB 1978; ASB 1991). It is worth emphasizing that the recognition of such an effect does not necedsarily imply any assumption as to which course of action management should have taken. There is, however, an assumption in the analysis that managers who believe that the market does not discern the economic realities which underlie accounting figures will also believe that market prices do not systematically take account of those realities. ASB (1991) defined this term as: “material categories of expenses which have been charged to the profit and loss account of a period having been incurred wholly or partly in order to enhance future profitability. . .” Approximately 60% of the respondents to the postal questionnaire used the title “finance
director.” APPENDIX TABLE A.1
Responses to Statements Ml-M2 Percent In Each Category
Agree
Neither Agree Nor Diqpe
Disagree
Strongly Disagree
Meun”
Standard Deviation
10.2
56.2
12.7
19.3
1.6
2.46
0.97
0.8
33.2
26.6
35.7
3.1
3.08
0.93
Strongly Agree
Statement M 1 The capital market values companies primarily by reference to the current year’s prospective earnings Statement M2 The capital market is aware of the investment and commercial opportunities available to specific companies Notes:
“Means are based on a scale of 1 to 5 where strongly agree = 1,soa neutral response = 3. As indicated above, the descriptive statistics are.provided for background information. The analysis focuses exclusively on correlations.
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TABLE A.2 Responses to Statements Dl-D6 .~~__ Percent In Each Cateaotv
Statement
Statement
Statement
DI Top management will not accept proposals for increasing expenditure m the following separate categories if it results in a significant fall in profits from the previous year: a. Research and development b. Advertising c. Training D2 Top management will not accept proposals for increasing expenditure in the following separate categories if it results in a significant shortfall in earnings growth below capital mar ket expectations: a. Research and development b. Advertising c. Training D3 Top management will not undertake a product development project if it results: a. In a significant fall in profits from the previou\ year b. In a significant shortfall in earnings growth below capital market expectations
9.5 15.2 IS.7
39.7 56.1 48.8
16.5 14.8 16.1
33.s 13.5 18.2
0.8 0.4 I.2
2.76 2.28 2.40
I .os 0.90 I .oo
9.5 13.3
39.7 57.6 51.5
16.5 16.5 17.8
33.5 13.6 17.0
0.8 0.4 0.4
2.70 2.33 2.40
0.99 0.87 0.93
9.1
34.7
21.1
33.5
I .6
2.84
I.03
6.2
43.2
21.1
29.5
0
2.74
0.95
28.7
6. I
2.74
I.17
I I.9
Statement
D4 Top management’s
I I.5
44.3
Statement
D5 If the market’s expectations of reported earnings for the current period would not otherwise be met. top management could bc expected to reduce significantly planned expenditure on: a. Research b. Product development c. Advertising d. Training
3.x 3.4 IO.5 5.9
30.4 28. I 53.6 48.1
30.4 29.8 22.4 X.4
32.9 37.0 13.1 19.6
2.5 I .7 0.4 0
3.00 3.06 2.39 2.60
0.94 O.Y3 0.86 0.87
D6 Outlays on the following are likely to bc higher when the firm cxpecrs reported earnings to exceed significantly the capital market’s expectation: a. Research b. Product dcvelopmcnt c. Advertising d. Training
4.1 7.1 5.4 4.1
52.5 54.3 43.8 49.0
25.2 20.3 31.4 28.6
18.2 18.3 19.4 18.3
0 0 0 0
2.57 2.so 2.65 2.61
0.83 0.87 0.85 0.83
Statement
N~r.\c
decl\ions on whether or not to take ovel another company would bc influenced by the accounting treatment of goodwill
See notes to Table A.
I.
Y.4
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Tin&, Seha M. 1990. A perspective on the stock market’s fixation on accounting numbers. The Accounting Review (October): 78 I-796. Watts, Ross L., and Jerold L. Zimmerman. 1986. Positive Accounting Theory. Englewood Cliffs, NJ: Prentice Hall International Editions.
D.J. Collison J.R. Grinyer A. Russell
This article discusses andpresents some empirical evidence on a particular aspect of the “economic consequences” of accounting. It considers whether U.K. managers’ perceptions of the attitudes of the capital market to reported earnings are likely to influence defined spending decisions of publicly quoted companies. This issue should be of interest to standard setters, financial managers, investors, and most users offinancial statements. The fundamental hypothesis is that managers’ spending decisions are affected by their perceptions of the extent to which the capital markets rely on reported earnings when valuing shares. The importance of testing the above hypothesis stems from the possibility that the decisions of managers may, on occasions, be driven by their expectations of the market’s use of short-term prospective earnings, rather than by more fundamental economic factors. An analysis of the results from a large-scale postal questionnaire of U.K. finance directors is presented. The conclusions from the study support the stated fundamental hypothesis.
BACKGROUNDTOSTUDY This article considers the potential of published figures of accounting earnings to influence defined spending decisions of managers of U.K. quoted companies. Such managers typically operate in an environment in which there are significant asymmetries of information (see, e.g., Miller and Rock 1985; Myers and Majluf 1984; Healy and Palepu 1993). Consequently, their actions are not directly observable or controllable by shareholders. Unless controlled by a system of monitoring
D.J. Collison, J.R. Grinyer, and A. Russell l Department of Accountancy University of Dundee, Dundee DDl 4HN, United Kingdom. Journal of International Accounting & Taxation, 5( 1):39-52 Copyright 0 1996 by JAI Press, Inc. All rights of reproduction
and Business Finance,
ISSN: 1061-9518 in any form reserved.
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and reporting, managers in such circumstances could to a considerable extent pursue their personal interests at the expense of shareholders (see, e.g., Penno 1985; Watts and Zimmerman 1986; Bromwich 1992). Therefore, there appears to be a need for financial reports to monitor financial perf0rmance.t Jensen (1983) identifies that need and associates it with the long-standing concept of “stewardship.” One of the implications of the monitoring (accountability) role of financial statements is that the requirement to disclose specified financial information can influence managers’ economic decisions (Rappaport 1977; Prakash and Rappaport 1977). Managers who are monitored by financial statements are likely to be interested in achieving a satisfactory reported outcome in accounting terms. They, therefore, have a potential motivation to take actions that would assist the achievement of that outcome. Such a motivation is likely to be reinforced by considerations of personal remuneration in firms that reward senior management by reference to figures of reported earnings. It is possible for managers to influence the content of financial reports in two fundamentally different ways. First, they could use the flexibility in accounting rules to adopt those accounting policies which produce the desired reported outcome. Second, managers can vary their operational decisions involving real resources (see, e.g., Ronen and Sadan 1981). This article is concerned with the second type of potential influence. Accounting earnings seem widely to be regarded as a primary accounting indicator of performance (see, e.g., Hopper et al. 1992; Grinyer et al. 1991). Financially sophisticated managers are likely to be well aware of the ability to manipulate eamings per share and of the limitations of that measurement as a summary indicator of company performance. They may also be well aware that certain policies which in the short term lower the earnings per share figure, or its rate of growth, may be in the interest of long-run shareholders.2 Nonetheless, these managers are likely to be keenly interested in the view of their company currently taken by the capital market. Thus, their own perceptions of the importance that should be assigned to accounting earnings in the short-term, as a performance indicator, may be dominated by what they think is the emphasis placed on such earnings by the capital market. If they expect adverse consequences to follow the reporting of disappointing earnings, they are likely to make decisions that reduce the shortfall in such earnings below market expectations. This could often boost current earnings at the expense of long-term economic progress. Similar perceptions to those expressed above have been previously reported in the financial management literature (see, e.g., Copeland et al. 1991,73). Arguably, the interests of many existing shareholders depend not only on the cash flow consequences of operational decisions but also on the markets’ reaction to accounting earnings (see, e.g., Lemer and Rappaport 1968; Healy and Palepu 1993). Managers may, therefore, believe that emphasizing the latter at the expense of the former is not inconsistent with acting in shareholders’ interests, especially when the interests of existing short-term shareholders are distinguished from those of potential and of
U.K. Managers’ Decisions and Their Perceptions of Capital Markets
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long-term shareholders.3 However, it would be preferable if managers did not feel pressure to compromise economically desirable actions in order to improve the appearance of the organization when it is viewed through the lens of accrual accounting based performance indicators. In this article, economically desirable actions are assumed to be those which increase the wealth of long-term shareholders. Conventional accrual accounting recognizes only realized profit, associated with the prudence concept. The latter concept results in many expenditures that are undertaken for the medium- to longer-term being written off against current income as revenue expenditure. Such expenditures include: outlays on research and development; the startup costs of new products and of new businesses (which can be very large); substantial training costs, such as occur on the introduction of new technology into an ongoing operation; and probably a large part of many outlays on advertising to establish the demand for products or services. Such outlays usually reduce the reported earnings for the period during which they are made, although that period is unlikely to receive all of the benefits which they produce. Indeed, in many cases the current period is credited with none of the cash inflows which will subsequently be derived from them. In contrast, a reduction in the level of expenditure previously incurred on these “revenue investments” will increase the earnings of the current period. Assuming that managements only undertake expenditure which they consider will be justified by future returns, such cuts in outlays will result in increases in current earnings at the expense of reductions in future earnings. Overall, the backward-looking and prudent nature of conventional accrual accounting means that it does not directly report the economic progress during the period in a long-term context. That observation does not necessarily mean that earnings figures are uninformative, nor that they are inappropriate for some purposes. Furthermore, the fact that earnings are based on adjusted and pro-rated cash flows means that under identifiable assumptions they can reveal information about sustainable operating cash flows generated by the business. Such information may be of assistance when forecasting future cash flows and, therefore, useful when valuing the business at the present time. Nevertheless, it seems reasonable to assert that heavy reliance on the reported earnings figures of a single period to monitor financial performance in an ongoing business is unwise. The figures of earnings need to be interpreted within the context of the financial statements as a whole, of the available information about the economy in general and the industry involved in particular, and of the longer term trend of accounting variables under the existing management.
POTENTIALINFLUENCES An extensive literature discusses the potential influences of financial reporting on managers’ decisions; it will not be comprehensively reviewed here. That literature includes the Agency Theory literature that relates to monitoring (see, e.g.,
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Jensen 1983). The literature associated with contracts of remuneration is particularly pertinent (see Watts and Zimmerman 1986 for a review). One might reason that managers who are paid bonuses by reference to reported earnings will be motivated to take actions which maximize the value of their bonuses over time (see, e.g., Healy 1985). That suggests that managers’ decisions are likely to be affected by their impact on current reported earnings irrespective of the managers’ beliefs about the likely responses of the capital market to the earnings figures resulting from the decision. Such beliefs are, however, also likely to affect management behaviour. Concepts which suggest that this is the case have been advanced under the names of “information inductance” and “functional fixation.” Prakash and Rappaport (1977) identified an influence associated with the presentation of information which they referred to as “information inductance” or simply “inductance” (see also Rappaport 1977; Garrod 1987). This arises when the sender of information may be motivated to modify his or her actions in anticipation of the reaction which would otherwise arise from the recipient of that information. Inductance can affect decisions concerning presentation of information about economic events and decisions concerning economic events, or both. P&ash and Rappaport argued that inductance could result in economic consequences of material proportions.4 The potential inadequacies of current figures of earnings as indicators of longer term performance are discussed above. Acceptance of those arguments suggests that information inductance is more likely to result in uneconomic decisions (as defined above) if managers believe that the recipients of financial statements are “functionally fixated” on reported earnings. The notion of functional fixation (Ijiri et al. 1966) describes the lack of discrimination which individuals exhibit in reacting to certain familiar measures or symbols. For example, if the notion of a discrete figure of earnings dominates the thinking of a user of financial statements, he or she may not adequately recognize the significance of changing elements in the set of entries that underlie that figure. If managers think that investors are preoccupied with figures of, or figures directly derived from, reported earnings, they have an inducement to emphasize the consideration of such earnings in their decision analysis. A review of the literature (see, e.g., Jensen 1966; Abdel-Khalik and Keller 1979; Ashton 1976; Hand 1990; Harris and Ohlson 1990) relating to the functional fixation hypothesis (FFH) is given by Tiniq (1990). He considers whether stock prices are set by investors who are fixated on accounting measures and concludes that “it is fair to say that the FFH and its extensions to the price formation process in the stock market remain unresolved.” It appears at least possible that managers of large firms might reasonably believe that investors are functionally fixated. This article is concerned with the associations, if any, between reported eamings and management behaviour. As already indicated, the latter is likely to be influenced both by considerations of managerial remuneration and by managers’ beliefs about the reactions of the capital market to figures of reported earnings.
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Thus, the opinions of managers about capital market behaviour should be helpful in exploring the likelihood of information inductance. This perception is central to the empirical research described below. For example, rational managers who think that the market is functionally fixated on reported earnings could seek to meet the market’s expectations as they understand them. They could expect that a failure to do so would result in a reduction in share price which might impede their efforts to raise capital to fund future activities and could make them vulnerable to takeover. Information inductance might then follow-for example, management may then be tempted to forego expenditure that is subject to mandatory writeoff but which they would have incurred if it could have been capitalized.5 It follows that managers’ beliefs concerning the information which affects share prices on the capital market may influence their economic decision making. This article, therefore, considers managers’ perceptions of the reactions of share prices to information about eamings and not directly the adequacy of those prices. It follows that the analysis does not address the issue of the “efficiency” of the capital market. Thus, it avoids the use of that term and does not refer to its attendant rich literature.6 The above discussion suggests that managers’ decisions are likely to be affected by considerations of their impact on reported earnings. This may derive from the existence of managerial bonus schemes that are tied to earnings, from managers’ perceptions that the capital market places heavy emphasis on figures of earnings, or from a combination of these factors. Arguably, the use of earnings figures as a common basis for remunerating senior managers is itself an inductive response to perceptions of the market’s functional fixation on earnings. Even if that is the case, it is still possible to observe the information inductance effects if one can identify managers’ perceptions concerning the market’s response to specified changes in earnings. The above discussion suggests the fundamental hypothesis that: Hl:
The influence of reported earnings on managers’ spending decisions is in part a positive function of their perceptions of the extent to which the capital market relies on figures of reported earnings when valuing shares.
As the hypothesis is concerned with managers’ perceptions about the market, it is independent of the short-term impact of earnings figures on managerial remuneration. Hl cannot be tested directly on a basis that allows statistical analysis because it is not possible to observe management action for a large number of firms. It is, however, possible to ask managers how they believe management will act in certain circumstances. One can reason that managers’ beliefs about likely management responses reflect their observations of past actions. Therefore, the empirical study which is used to test the hypotheses proceeded by reference to managers’ perceptions. Perceptions sought related to: (1) the extent to which management believed that the capital market emphasizes figures of expected earnings for the
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current period rather than other information relating to the firm and its industry; and (2) anticipated effects of different scenarios of market expectations of earnings on management expenditure decisions.
RESEARCH
METHOD
The empirical research was conducted as follows: first, to identify senior finance managers’ opinions concerning the importance of current earnings to (a) the process of share price formation and (b) management’s expenditure decisions; and second, to test for an association between the opinions identified in (a) and (b), which, if positive, would support the hypothesis. Data for the investigation were obtained from the responses to a questionnaire (the relevant sections of which are reproduced in the Appendices) distributed to the finance directors of The (U.K.) Times 1000 (1990) companies in May 1991. The survey, therefore, covered many of the largest firms in the United Kingdom. There were 246 responses, resulting in a response rate of 24.6%. Only part of the questionnaire is used in this study. The questionnaire sought responses to statements about the market’s valuation process. These are shown as Ml and M2 in Table A.1 in the Appendix. Questions also sought managers’ responses to statements concerning management decisions on expenditure on “revenue investments”7 (research and development, advertising, and training) and acquisitions of other companies. Table A.2 in the Appendix shows these 17 decision-related statements, grouped under headings D 1 to D6. The analysis in this article depends only on associations between responses. Nevertheless, the descriptive statistics are provided in the appendices as background information. Respondents were invited to check one of five boxes, giving a Likert scale ranging from (1) “strongly agree” to (5) “strongly disagree.” This scale enabled descriptive statistics to be prepared and assisted with the ensuing analysis, while maintaining a standard format for the responses to each statement. In addition, questions and codes were devised to enable industry and size classifications to be made and to identify the status of the person responding, while maintaining total anonymity of the reporting company. Thus, followup mailing to nonrespondents could not be done. Nevertheless, the researchers believed that anonymity was desirable because of the possibility that some finance managers might be deterred from responding if their firm’s identity were to be disclosed or, if they responded, might be inhibited in the responses they provided. Another potential limitation to the generalizability of the results arises because of the nature of questionnaire-based research. Thus, throughout the process of developing the questionnaire, there was a recurring conflict between the need for brevity and the desire to avoid ambiguity. There was a need for brevity in order to encourage a high response rate. A short question often poses fewer problems of interpretation for the respondent than a
U.K. Managers’ Decisions and Their Perceptions of Capital Markets
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longer, more heavily qualified, one. However, the adoption of such questions can produce statements which rely on the individual interpretation of the respondents, resulting in potential ambiguity. Efforts were made to minimize this limitation by pretesting the questionnaire on academic colleagues and by pilot testing as discussed below. Two tests were made to check for nonrespondent bias. First, responses were classified by both industry and firm size; no nonrespondent biases were identified by reference to those classes. Second, the responses of “quick” and “slow” respondents were compared, but no statistically discernable differences in patterns of responses were found. An aspect of the questionnaire which deserves special mention is the perspective which respondents were asked to adopt. They were asked to respond to hypothetical statements concerning quoted companies in general. Had they been asked to respond to the statements as they applied to their own companies and their own decisions, it was thought likely that in many instances, some of the statements would have been inappropriate for their particular circumstances. That might have resulted in a lower response rate and/or have required the deletion of statements which were not applicable to all companies. The questionnaire derived from the preliminary work was developed and tested in a pilot study, which involved interviewing the finance directors of nine companies quoted on the London Stock Exchange. Each director was asked whether the statements used were clear and unambiguous. One question which required additional explanation by the researchers was removed. The interviewees considered that all of the remaining questions would be readily understood by similar respondents. Many of the directors volunteered their opinions about the shortterm valuation practices of the capital market and how it affected their financial decisions. All of them accepted that the perspective outlined in the previous paragraph was a reasonable one. A number of interviewees indicated that their responses to the questionnaire were made with reference to their firms’ normal practices in communicating with the capital markets. It was widely accepted that top management could effectively communicate with the market to explain special circumstances whenever management considered such action to be desirable. The questionnaire did not specify the information assumed to be available to the market because the researchers wished to explore likely management responses to accounting variables. Responses were likely to be influenced by managers’ beliefs about the information set available to the market. In that event, it was considered best to leave respondents to answer by reference to their personal perceptions of the sources and quality of information flowing to the market. All questionnaires face a potential problem of response bias. Clearly, at worst the findings of the survey are indicative only of the characteristics of the part of the population that responded. At best, they could be representative of the population as a whole; there are no special factors in this study which suggest that such a sit-
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uation is not the case. Readers must decide for themselves whether they wish to assign a wider or narrower interpretation to the findings. The analysis can, strictly speaking, only be claimed to be exploring the opinions of the group of finance managers who responded.8 Even allowing for such a caveat, the number of firms whose managers did respond represents a substantial, and therefore economically significant, proportion of the largest companies in the United Kingdom.
ANALYSIS
OF RESPONSES
Finance managers may agree that the capital market values shares primarily on the basis of the current year’s prospective earnings (Statement Ml) and yet may hold very different views about the adequacy of the market’s process for valuing shares. Those members of this group who have confidence in the capital market’s process presumably think that the figure of short-term accounting earnings is a good surrogate for the economic variables that underlie the longer-term worth of a share. Those members of the group who believe that accounting earnings are a very limited depiction of economic variables in the future would presumably regard such a basis for valuation as being myopic. Statement M2 sought managers views about the extent to which the market is aware of the business opportunities available to specific companies. The market would only be aware of such opportunities if participants had invested in the acquisition of information, which investment would be irrational if the information obtained was not considered to be relevant to their investment decisions. Consequently, M2 implies that the market values shares by reference to a broader set of data than figures of reported earnings alone. Respondents could agree with Statement Ml without believing that the share price was determined exclusively by reference to reported earnings. One might, however, anticipate that the responses to the statement reflected the beliefs of managers concerning the level of emphasis placed by the market on earnings. Logically, managers who believe that the market is aware of the investment and commercial opportunities available to specific companies will be inclined to place less emphasis than otherwise on earnings in their responses to Ml, because they believe that the market uses non-earnings information. It is, therefore, possible to confirm the appropriateness of Ml as an indication of expectations of “the extent to which the capital market relies on figures of reported earnings when valuing shares,” by examining whether there is a significant negative correlation between responses to Statements Ml and M2. Table 1 shows the correlation between the responses using Kendall’s Tau for a one-tailed distribution. It can be seen that the responses are, as expected, negatively correlated with a significance level of 1%. This can be taken as support for a contention that the responses to Ml reflect respondents’ expectations of the extent to which the capital market relies on figures of reported earnings when valuing shares.
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U.K. Managers’ Decisions and Their Perceptions of Capital Markets
TABLE 1 Sign and Significance Level of Correlation Between Ml and M2 Presumed Sign
Actual Sign
Significance Level Category
**
Nores:
Signijkance Level
Kendall’s Tau Correlation Coefficient
n
-0.1908
244
0.000
** Denotes significant at -C 1%. (-_) Denotes negative correlation. n = Sample size.
Most of the statements shown in Table A.2 concern managers’ operating decisions in the areas of expenditure on: “revenue investments,” investments in innovative projects, and takeovers. By studying associations between responses to Statement Ml and these statements concerning managers’ decisions, we can investigate Hl . As indicated in the discussion above, it is not possible to test the hypothesis directly. Instead, the test has to be formulated in terms of management expectations. Furthermore, the decisions which can be investigated by reference to the data base available to this study are limited to the identified categories of expenditure. It is, therefore, necessary to reformulate Hl in an empirically testable form. This can be expressed as (HIE): TABLE 2 Signs and Significance of Correlations with Ml
Statement
Presumed Sign
Actual Sign
Signijkance Level Category
Dla Dlb Dlc D2a D2b D2c D3a D3b D4 D5a D5b D5c D5d D6a D6b D6c D6d
+ + + + + + + + + + + + + + + + +
+ + + + + + + + + + + + + + + + +
** ** ** * ** ** * ** ** ** ** * ** ** ** * **
No/r.r: * Denotes significant at < WC. ** Denotes significant n = Sample size.
at < 1%.
Significance Level 0.007 0.006 0.008 0.041 0.005 0.002 0.047 0.006 0.000 0.002 0.005 0.03 1 0.006 0.003 0.000 0.041 0.003
Kendall’s Tau Correlation Coeficient
n
0.1388 0.1397 0.1338 0.0977 0.1435 0.1637 0.0934 0.1409 0.2313 0.1614 0.1467 0.1059 0.1421 0.1550 0.2089 0.0979 0.1554
241 243 241 242 243 241 241 241 243 237 235 237 235 242 241 242 241
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HlE: Managers’ perceptions of the extent to which managerial spending decisions are influenced by considerations of reported earnings are positively associated with their perceptions of the extent to which the capital market relies on prospective earnings for the current period when valuing shares.
The associated
null hypothesis
(HIEN) would have exactly
the same wording
except that the words “are positively associated” would be replaced by “are not positively associated.” As indicated in the discussion above, Statement Ml can be considered to reflect the emphasis placed by the market on figures of current earnings. The responses to that statement are, therefore, taken as a basis for testing Hl, empirically. Correlations of Ml with Statements Dl to D6 are shown in Table 2. In all cases, the signs are as predicted ex ante and the correlations are statistically significant, indeed most of them are significant at the < 1% level. This is clear evidence for the rejection of the null hypothesis, Hl,,. The results, therefore, support the alternative hypothesis, Hl,. That, in turn, is supportive of the fundamental hypothesis, Hl.
CONCLUSIONS
This article has established and tested the fundamental Hl:
hypothesis:
The influence of reported earnings on managers’ spending decisions is in part a positive function of their perceptions of the extent to which the capital market relies on figures of reported earnings when valuing shares.
Evidence from correlating the responses to different statements in a large scale postal questionnaire was strongly supportive of the hypothesis. It appears that managers’ perceptions that the capital market places heavy emphasis on reported earnings could lead them to emphasize the short-run, to the detriment of the longer-term, progress of their businesses. The evidence of the study underlines the potential importance of managers’ perceptions of the market’s earning expectations as influences on management action.
Acknowledgment: The authors thank the Institute of Chartered Accountants in England and Wales for funding the empirical work which is reported in this article.
U.K. Managers ’ Decisions and Their Perceptions of Capital Markets
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NOTES 1.
2.
3.
4.
5. 6.
I.
8.
Shareholders and other investors in aggregate can act to discipline managers. This might be achieved by: (1) selling shares to other individuals, resulting in reduction in share prices with consequential financing implications; (2) selling shares to other companies in takeovers; or (3) acting directly to remove managers or influence their remuneration if the shareholders involved have very substantial holdings. In all cases, senior managers may find that their personal interests are adversely affected. It is accepted that there are many other participants in the firm who have valid claims for the recognition of their interests. This analysis proceeds, however, using the conventional assumption that managers should seek primarily to serve shareholders’ interests. If the market does not always see through accounting earnings manipulation, existing shareholders could profit at the expense of future shareholders if share prices were temporarily raised above their fundamental value by reason of manipulated figures of reported earnings. Prakash and Rappaport also claim that accountants had not “concerned themselves greatly” with the economic consequences of inductance. Such a view is consistent with the standard setters’ commitment to “decision usefulness” as a guiding principle (see, e.g., FASB 1978; ASB 1991). It is worth emphasizing that the recognition of such an effect does not necedsarily imply any assumption as to which course of action management should have taken. There is, however, an assumption in the analysis that managers who believe that the market does not discern the economic realities which underlie accounting figures will also believe that market prices do not systematically take account of those realities. ASB (1991) defined this term as: “material categories of expenses which have been charged to the profit and loss account of a period having been incurred wholly or partly in order to enhance future profitability. . .” Approximately 60% of the respondents to the postal questionnaire used the title “finance
director.” APPENDIX TABLE A.1
Responses to Statements Ml-M2 Percent In Each Category
Agree
Neither Agree Nor Diqpe
Disagree
Strongly Disagree
Meun”
Standard Deviation
10.2
56.2
12.7
19.3
1.6
2.46
0.97
0.8
33.2
26.6
35.7
3.1
3.08
0.93
Strongly Agree
Statement M 1 The capital market values companies primarily by reference to the current year’s prospective earnings Statement M2 The capital market is aware of the investment and commercial opportunities available to specific companies Notes:
“Means are based on a scale of 1 to 5 where strongly agree = 1,soa neutral response = 3. As indicated above, the descriptive statistics are.provided for background information. The analysis focuses exclusively on correlations.
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TABLE A.2 Responses to Statements Dl-D6 .~~__ Percent In Each Cateaotv
Statement
Statement
Statement
DI Top management will not accept proposals for increasing expenditure m the following separate categories if it results in a significant fall in profits from the previous year: a. Research and development b. Advertising c. Training D2 Top management will not accept proposals for increasing expenditure in the following separate categories if it results in a significant shortfall in earnings growth below capital mar ket expectations: a. Research and development b. Advertising c. Training D3 Top management will not undertake a product development project if it results: a. In a significant fall in profits from the previou\ year b. In a significant shortfall in earnings growth below capital market expectations
9.5 15.2 IS.7
39.7 56.1 48.8
16.5 14.8 16.1
33.s 13.5 18.2
0.8 0.4 I.2
2.76 2.28 2.40
I .os 0.90 I .oo
9.5 13.3
39.7 57.6 51.5
16.5 16.5 17.8
33.5 13.6 17.0
0.8 0.4 0.4
2.70 2.33 2.40
0.99 0.87 0.93
9.1
34.7
21.1
33.5
I .6
2.84
I.03
6.2
43.2
21.1
29.5
0
2.74
0.95
28.7
6. I
2.74
I.17
I I.9
Statement
D4 Top management’s
I I.5
44.3
Statement
D5 If the market’s expectations of reported earnings for the current period would not otherwise be met. top management could bc expected to reduce significantly planned expenditure on: a. Research b. Product development c. Advertising d. Training
3.x 3.4 IO.5 5.9
30.4 28. I 53.6 48.1
30.4 29.8 22.4 X.4
32.9 37.0 13.1 19.6
2.5 I .7 0.4 0
3.00 3.06 2.39 2.60
0.94 O.Y3 0.86 0.87
D6 Outlays on the following are likely to bc higher when the firm cxpecrs reported earnings to exceed significantly the capital market’s expectation: a. Research b. Product dcvelopmcnt c. Advertising d. Training
4.1 7.1 5.4 4.1
52.5 54.3 43.8 49.0
25.2 20.3 31.4 28.6
18.2 18.3 19.4 18.3
0 0 0 0
2.57 2.so 2.65 2.61
0.83 0.87 0.85 0.83
Statement
N~r.\c
decl\ions on whether or not to take ovel another company would bc influenced by the accounting treatment of goodwill
See notes to Table A.
I.
Y.4
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Tin&, Seha M. 1990. A perspective on the stock market’s fixation on accounting numbers. The Accounting Review (October): 78 I-796. Watts, Ross L., and Jerold L. Zimmerman. 1986. Positive Accounting Theory. Englewood Cliffs, NJ: Prentice Hall International Editions.