Professional Documents
Culture Documents
George FOSTER*
This paper exammes methodological problems 111 mea\ur!ns the capital marhct ~rrjpxt of
accounting policy declslon\. Topics co\ercd include the dc\elopmcnt of hqpothe\c\ ah~~ut the
magnitude and timing of capital market Impacts, sample xlcction ~\rues in contt<,l 91oup
designs, and the confounding events problem. Reference IS made to capital marhct \tudle\ on a
varletj of accounting policy docwona. Emplrlcal e\ldence related to \tudx\ on the capital
market Impact of Srtl/twwn~ o/ Fir~uwl~/ :I( umrnifrg .S:~~d~rd\ ,VIJ. I Y I\ alw prewltcd
1. Introduction
*My thoughts In this arca haw been tlghtcncd through intcrxtion ulth R. Ball and E. Deakln.
Earlwr versions of this paper were presented at The llnlccrslty of Colorado (May lY7Y),
Stanford Unlverslty (July lY79) and Th e Unl\crsity of Oregon (October 197)). Helpful
comments were provided by G. Benston, N. Dopuch, T. Dyckman, N Gonedcs. R. Kaplan. (
Olsen. J. Patell. G. Rankine, K. Schipper, J. Stoeckenius. R. Watts and J. Zimmerman. This
research was sponsored by the Stanford Program In Professional Accounting. mayor
contributors to which are: Arthur Andersen Br Co.. Arthur Young 62 Co.. Coopers & Lybrand.
Deloltte. Haskins & Sells, Ernst & Whinney, Peat. ?Inrwick. Mitchell & Co.. and Prlcc
Waterhouse & Co.
Griffin (1979) provides an overvwx of these studies.
See Collins and Dent (1979). Dyckman and Smith (1979). Haborth et al. 11978) and Le\
(1979).
JAE B
30 G. Foster, Accounting policy decisions (2nd cupitul murkcr rewtrch
policy decision and a capital market impact. This paper will argue that (I)
the more interesting research task is testing explanations (theories) for an
association. and (2) having an explicit explanation (theory) of why a capital
market impact should occur can considerably facilitate the design of more
powerful empirical tests. I will expand on these arguments by discussing
three important aspects of research design in this area:
3Sw~crmga (1977) and Schwert (1978) hate pre\iously defused rcscarch problems aw~c~atcd
with measurmg the capital market impact of policy de&tons by the FASB. SEC and olhcr
regulatory bodies.
G. Foster. Accounting policy decision,\ mui ctrpitrtl market rr.wtrrc~k 31
p,=m-S,bfccov(R,t,)/a(R4)1 (2)
I
l+R,
(3)
%ee, for instance, statements quoted in Deloitte, Haskins and Sells. The Week In Reoiew on
January 27, 1978 (Depbtment of Energy), March 3, 1978 (Justice Department) and March 12.
1978 (Federal Trade Commission).
4, being the information set available to the capital market (including the
policy decision or a policy mandated disclosure).
The theoretical underpinning of this methodology is the two-parameter
asset pricing model - see eq. (1). This model is used to predict the behavior
of R,, in the absence of the accounting policy decision.
The theoretical underpinnings of research designs examining impacts on
cov(C,Q. [Ii. E(&), 4&,), R, or n(vM) are less apparent. For
example, currently we lack a detailed theory of the determination of thr
relative risks (/Ii) of individual securities. Although there is promising
analytical work on individual determinants of relative risk. there is no
empirically tractable model akin to the two-parameter model used in CAR
research designs. Short of developing such a model, a researcher has a
variety of options. One option is not to conduct any experiment on the
grounds that no theoretical model exists to predict the behavior of /Ii in the
absence of the policy decision. The second option is to adopt an assumption
about the behavior of /Ii in the absence of the policy decision, e.g., that it
would have remained stationary. A third option is to have a control group
design where the two groups are identical. except for the differential exposure
to the accounting policy decision. As will be noted in section 3, obtaining
two identical groups is a very difficult task. A similar dilemma faces
researchers testing for potential impacts on economy wide parameters. At
present, we do not have a fully articulated theory of the determinants of
E(I?,), cr(i?,), R, or (T(V~). There is limited guidance from the macro-
economic literature on what the behavior of these parameters would be in
the absence of the policy decision.
Given this limited theoretical underpinning for studies examining impacts
on cov(e. tW),. [I,, E(fi,), a(R,&,), Rf and a(pM), it is appropriate that
authors be very explicit about the assumptions underlying their research
designs and (where possible) attempt to provide evidence on their
reasonableness. Another useful approach is to examine the sensitivity of the
results to assumptions that either appear critical or have limited theoretical
or empirical support.
This paragraph draws heavily on Ball (1972. 1979). See also Beaver (1979) for a related
discussion.
See, for instance, Hamada (1969), Lev (1974), and Rubmstem (1973). There IS also a large
body of empIrIcal work on fmancial variables associated with relative risk - see the studies
discussed in Foster (1978, ch. 9).
34 G. Fosfer, Accounting policy decisions and capirul market research
There is considerable dispute over the profitability of oil exploration activity - see Stone
(1978) for a detailed discussion and reference to existing evidence on this issue.
The above discussion relates only to the drop in oil exploration per se; the drop in oil
exploration may cause additional effects (e.g., those associated with management compensation
schemes) that need to be examined or controlled for in the experiment.
G. Foster, Accounting policy decisions and capital market research 35
(a) How the accounting policy decision affects the probability assessment of
a bond covenant violation. This assessment will be related to (i) how
much slack exists in the bond covenants prior to the mandated change,
and (ii) how the mandated change affects the reported numbers used in
defining the bond covenant restrictions.
(b) The renegotiation costs associated with violation; e.g., the likely penalties
a bank or other lender would impose on a borrower who defaults due to
a mandated accounting change.
(a) those without long-term debt or those with long-term debt not including
covenants written on financial statement variables, and
(b) those with long-term debt including covenants written on financial
statement variables.
(b-i) those that will not be placed into technical default by the accounting
change due to having protection clauses in their bond agreements (see
below), and
(b-ii) those that may be placed into technical default by the accounting
change.
The key feature of placing firms into the (a), (b-i) and (b-ii) categories, when
doing the security return analysis, is that the bond covenant argument is
See Benston (1978, pp. 3437), Collins-Dent (1979, p. 40), Dyckman and Smith (1979, p. 49)
and Lev (1979, pp. SoCr501). Studies on other accounting policy decisions also make reference
to bond covenant violations as an explanation for an adverse capital market impact, e.g., Dukes
(1978, p. 20). See Smith and Warner (1979) for detailed analysis of bond covenants and
Holthausen (1979) and Leftwich (1979) for analysis of them m capital market studies.
36 G. Fosrrr. Accounting policy decisions and capital murket research
explicitly factored into the research design (and is thus capable of being
rejected).
In deciding how many firms fall into the (a), (b-i) and (b-ii) categories, it is
important to examine the teims of bond covenants included in loan
agreements. Some firms may have long-term debt but fall into (a) due to the
covenants being written on (say) the net present value of oil reserves as
reported by an independent engineer (using cost of capital estimates outlined
in the loan agreement). For instance, Juniper Petroleum indicated in its 1977
Annual Report that the FC to SE change was not anticipated to have any
material effect on the Companys borrowing arrangements since most of the
Companys borrowings are related primarily to engineering projections of
revenues from its producing properties (p. F-12). Some firms may fall into
the (b-i) category. even though their bond covenants contain financial
statement restrictions. Firms can write covenants in an attempt to avoid
technical default due to a mandated accounting change. For example,
covenants can be written in terms of generally accepted accounting principles
as of the time the loan agreement is signed. Mestl Petroleum noted in its
1977 Annual Report that the change from FC to SE would not affect any of
the Companys debt/equity loan ratio requirements since such requirements
are based on accounting principles presently being followed (p. 38). A term
from Mr.su Prtro/rum.s private Eurodollar loan agreement is:
With this partitionmp, the confounding events problem would need to be addressed (see
section 4). It is likely that firms with a high probability of bond covenant violation due to a
mandated accounting change are not a random set. It would be important to control for the
other signals that the capital market was also receiving about the likelihood of default due to
(say) liquidity. manufacturing or marketing problems. These signals could range from releases by
the firm itself to competitors reporting significant market share gains and suppliers reporting
problems in payment collection.
Compare also the followng covenant: The Mortage Indenture provides that if the
dwounted present value of mor!aged estimated proved oil and gas reserves falls below 250
percent of the amount of secured indebtedness, m certam circumstances the time of payment of
xheduled sinkmg fund payments may be advanced and the amounts of such payments may be
Increased (Prospectus for Cumulative Preferred Stock of Houston Oi/ & Minrrds Corporation.
June 14, 1978. p. 6).
earnings before federal income tax. The Prospectus noted that a provision in
the agreement was that:
The discussion in sections 2.1 and 2.2 referred to a policy decisiorl. This
was a convenient simplification to allow other issues to be discussed. What
really occurs with many accounting issues is a policy process. All during this
process, information could be disseminating to the market. This information
could relate (i) to the policy decision itself. (ii) to the information firms will
release complying with a specific decision, or (iii) to the actions management
will take in response to a specific decision. As regards (iii). these management
Another agency cost vartable alluded to in several oil and gas studtes related to
management Incentive schemes. As with the bond covenant argument. it IS likely that more
powerful tests can be constructed if the actual management incentive schemes are examined. For
example, not all incentive schemes in the oil and gas industry would be directly affected by
SFAS No. 19. One such case is when the incentive scheme is based on revenues rather than
earnings: e.g., During the year ended April 30, 1977 the Company adopted an incentive
compensation plan for key management personnel under which these employees receive from the
Company an amount based upon a specified percentage of the gross revenues of selected
properties owned directly by the Company or through its public hmited partnerships (p. 45 of
December 22, 1977 Prospectus for Convertible Subordinated Debentures of Pufrick Prtroleum
COmpUfly).
40 G. Foster, Accounting policy decisions und capitol murket research
actions may occur prior to, at the time of, or subsequent to the policy
decision (or the subsequent release of a mandated disclosure).
The oil and gas dispute is again an excellent example of the difficulties that
may arise in designing empirical work. Appendix A.1 details some key events
in the evolution of this dispute in the 1975-78 period. There were at least 4
possible outcomes to this dispute from the outset:
In a forward looking capita1 market, the key factors are (i) the assessed
economic effects associated with each outcome and (ii) the assessed
conditional probability of each outcome. During the 1975-78 period, both
assessments could have been changing continually.
This rolling assessment perspective (both in terms of economic effects of
each outcome and the probability of each outcome) requires the researcher
to consider a variety of questions, e.g., when Moss first introduced the
Accounting Practices provision to the Energy Bill, what was the revision in
probability of the FASB adding the oil and gas topic to its agenda?, and
what was the probability of a SE decision by the FASB once the topic was
added to its agenda? As regards the latter question, the market could have
used a variety of cues to assess this conditional probability. For instance, the
Acc~~~~~itrg Prirlciplrs Board had earlier favored a version of SE. Moreover,
several earlier FASB Statements - e.g., SFAS No. 2 (Accounting for
Research and Development Costs) and SFAS No. 5 (Accounting for
Contingencies) -- appear more consistent with SE than with FC.
Note, however, that there is no requirement that the FASB follows a
consistent set of decisions. Political considerations, as well as consistency
with an agreed upon (or implied) set of asset, liability, revenue and expense
definitions, appear to be influences on the decisions of accounting policy
bodies ~ see Horngren (1973) and Moonitz (1974). Over time (e.g., at the
FASBs March-April 1977 Public Hearings) information about the set of
political forces operating on a specific policy issue could be revealed to the
market.
Given this rolling assessment perspective, a researcher must determine
which event (or set of events) is the critical one to examine. Several oil and
gas studies chose the Exposure Draft (ED) release date as the critical event;
this was the first time the FASB publicly announced its official support for
SE. Note, however, a finding that the ED had no statistically significant
capital market impact [as Dyckman and Smith (1979) concluded] is
consistent with many hypotheses, e.g.:
# 1 ~~ The probability of a pro SE Exposure Draft was close to 1 from the
time the item was added to the FASBs agenda.
#2 ~- The economic effects associated with SE being mandated were not
assessed to be large.
#3 ~~ The economic effects associated with SE being mandated were
assessed to be potentially large for those significantly affected by the
decision. but as yet there was not sufficient information on which
firms fell in this category.
#4 ~~ There was an effect, but contemporaneous events obscured it.
#5 There was an effect, but the chosen research methodology was
inappropriate or not powerful enough to detect it.
and Smith (1979, pp. 70-71) suggest this approach as one way to resolve the
differential findings of their study and those in Collins and Dent (1979). The
other things being equal proviso, however, may be a problem with the
August 31 decision as it involved the SEC not just reversing the FASBs SE
decision, but also imposing its own reserve recognition accounting
requirements.
It is likely that future accounting policy studies will include a more explicit
multiple event focus than is apparent in the existing literature. This focus
could include both (a) multiple events pertqining to one policy process by a
body like the FASB (e.g., addition to agenda, discussion memorandum,
public hearing, exposure draft, etc.), and (b) multiple events pertaining to
several policy processes on the one issue e.g., the October 22, 1971
announcement by the Accounting Principles Board that it had tentatively
concluded that the field was the appropriate cost center for oil and gas
companies and the July 19, 1977 release by the FASB that it favored SE
accounting. One advantage of examining events pertaining to several policy
processes on the one issue is a reduction in the time-period dependencies
that cloud the inferences drawn from a study that examines a single event in
which event time and real time is the same for all firms (see section 4). A
useful supplement to a multiple event study would be a detailed chronicle of
events pertaining to the issue examined. Appendix A.1 illustrates such a
chronicle for oil and gas deliberations in the 1975-78 period. By making the
chronicle reasonably comprehensive, event exclusion as well as event
inclusion choices would be apparent to the reader.
Group A: 0, x 0,
(4)
Group B: 0, 0,
The firms self select into the control (SE) and experimental (FC)
groups. Characteristics that relate to this self selection provide potential
explanatory hypotheses for any resulting statistically significant results
that may be found. (pp. 51-52)
Yet, these authors did not discuss what these characteristics might be, let
alone examine if the control and experimental groups exhibited significant
differences in these characteristics. One approach in this context is to
conduct a firm profile analysis of the control and experimental groups in
which the statistical significance of financial and other differences between
the two groups is tested.
How a researcher reacts to any differences in the financial profiles of the
The FASB Research Report Dyckmnn (1979) did present SOme descrlptlvc data on
FC and SE firms (pp. 57;60). However. this data H;,S not used to probe the se\enty of the self-
selection problem. Dyckman noted that III his lnltial report to the FASB, he attempted to
control for firm size and security market Ilsting. See Deakin (1979) for evidence on financial and
other differences betwecn FC and SE firms.
control and experimental groups will depend on (1) the theory underlying his
research as to why a capital market impact should occur, and (2) the model
underlying his research as to the determinants of capital asset prices. In some
cases, the theory underlying the research may explicitly entail choosing firms
which have different financial profiles. Consider a theory which predicts that
an accounting policy decision will differentially affect the control and
experimental groups due to differential political costs. If the magnitude of
political cost is highly dependent on firm size ~~ see Watts and Zimmerman
(1978, p. 115) then the control group and experimental groups should be
chosen so as to exhibit size differences. Use of a paired-firm sample selection
technique where the pairing was on firm size in this case would not yield a
sample that would probe the political cost explanation: by construction, the
firm sizes (and the associated political costs) of the two groups would be
approximately the same.
In an ideal empirical study, the profiles of the control and experimental
groups would be identical except for (I) those differences related to the
explanation for an impact that is being tested. and (2) those differences
explicitly controlled for with the chosen asset pricing model [e.g., relative
risk differences when eq. (1) is used]. In most empirical studies, this ideal
case is not likely to occur.* In this situation, the researcher faces the difficult
decision of deciding when to stop controlling for firm profile differences. It is
my position that the researcher should concentrate on controlling for firm
profile differences associated with
(i) alternative theories as to why the accounting policy decision will ha\e a
capital market impact, and
(ii) alternative models as to how capital asset prices are determined.
This problem ih now well recognired in the flnanclai dlstrc~ predlction literature where
many of the early studies paired firms so that the industry mcmbcr\hlp and sue profiles for the
failed and non-failed ftrm groups would be the same. This palrIng, howevzr, meant that variablea
relating to industry or sve would not discriminate between the failed and non-falled firms in the
chosen samples. Yet. there is considerable evidence that both Industry membershlp and si7c are
Important determinants of firm failure see Foster (1978, p. 476 and pp. 478 479).
In the case of some mandatory accounting disclosures. the criterion for disclosure It\clf
may be a significant dlscrlminatmg variable. The SECs mandated replaccrnent cost dlsclohureb
under ASK No. 190 illustrates this case. The companies required to make these disclosures were
put&c companies with inventories and property, plant and equipment exceeding $100 mllllon
AND exceedmg lo:,, of total assets. A firm profile analysrs, between disclosing and non-
disclosing firms, using these variables would likely not yield any new Insights; by conatructlon,
the two groups are different. To argue that these differences do not damage the lntcrnal valldlty
of a pre-test post-test control group design, one would need to argue that these \ariablcb (and
those closely correlated with them, e.g.. market capitahration) do not affect security returns. In
this regard, It IS interesting to note that Banz (1979) reports a negative relatlonship exlsted
between the total market value of the common stock of a firm and the mean return of the shares
in the 1936-75 period ._. the difference in returns between the smallest firms and the
remaining ones is, on acerage, about 0.4 percent per month (pp. I. 18).
As an example of (i), suppose the explanation being tested for SF.*l.S No.
IY having a negative impact on FC company stock prices rests on a decline
in exploration activity. An alternati1.e explanation for a decline in the stock
prices of FC companies is bond covenant violation costs (see section 2.2). In
this case, the internal validity of a test probing the exploration activity
explanation would be increased if the control and expertmental groups were
constructed so that they did not syxtetnatically differ as regards bond
covenant violation costs.
As an example of (ii). consider the use of the two parameter asset prtctng
tnodel in an empirical study. This model ha> been criticired and re-
formulated by several authors. For instance. Brcnnan ( 1973) and
Litzenberger and Ratnaswamy (1979) ha\,e deribcd asset pricing models
including both /I, and dividend yield. Based on an analysis of all securities on
the CRSP monthly security price tape for 1936 to 1977. the latter papet-
concluded there is a strong positive relationship betv,eeun before tax expected
returns and dividend yields of common stock (p. 190). These theoretical
models and empirical results suggest the inclusion of a dividend yield
variable in a firm profile analysis. If dividend yield IS a determinant of
security returns and the two groups in the cxpcrimcnt differ in terms of
dividend yield. an observed difference bet\\ccn O1 and 0, could be due to
this variable rather than due to the differential application of I.
To illustrate firm profile analysis. the following financial \ariablch were
calculated from the 1976 Annual Reports or IOKs of the firms included in
each of the 4 SF.AS :Vo. 10 studies:
l Gross revenues
. Market \,alue of common shares outstanding at fiscal year-end
A Mann-Whitney U-test [see Hollander and Wolfe (1973)] was used to test
46 G. Fosfrr, Accounling policy duckrota cmd cccpifctl mrtrkel resrctrch
Table 2
Successful-efforts
Full-cost firms firma %-statlhtlc
-~ for
Mean Median Mean Median Mann Whitney
Dyckmun Smith
Gross revenues* 153.868 29,013 153,677 27,639 0.400
Market captaliration 117,823 58.698 176.004 57,469 0.334
Debt/Equity 0.49 I 0.333 0.350 0.166 I .4Y9
Interest exp./Revenues 0.066 0.050 0.030 0.022 4.0YOh
Dividend yield 0.013 0.000 0.0 I I 0.003 1.361
Collins DWII
c;foss rcvcnues X5-1 I I 20,638 208.974 33,321 0.X82
Market capltahzatmn 106,085 52,001 162,585 56,344 0.015
Debt/Equity 0.444 0.332 0.4x3 0.3 19 0.167
Interest exp./Rcvenues 0.072 0.056 0.035 0.022 2.72?h
Dividend yield 0.00x 0.000 0.014 0.000 0.76 I
SEC fluwrrh (I rrl.
Grws revenues 505,970 5 I.694 6, I 76,455 724.1 15 4.431sh
Market caplthatlon 215,236 x7.450 2.760.32) 741,140 4.73Xh
Dcbtxqulty 0.650 0.432 0.3x4 0.250 .360h
Interest exp./Revenues 0.063 0.044 0.020 0.012 5.143h
Dividend yield O.OIX 0.000 0.027 0.076 3.X5Yh
Lcr,
Cirov revenues 536.34X Y5.554 4.x 17.244 900.645 3.2XOh
Market capltaliation 274.444 87.450 2.273.773 537.695 4.05?
Dcbt/Equay 0.723 0.4 I6 0.341 0.213 3.03?
Interest cxp.. Revenues 0.064 0.040 0 075 0.0 12 4.441
Dlvldcnd yteld 0.024 0.007 0.026 0.026 2.27Yb
In $000~.
497:
*. Ntrturi4l Grrs Tr~frlsrni.s.siorz ~~ establishments engaged in the
transmission and.or storage of natural gas for sale.
hY I,) 7, ,
Y <, -- /I
3) I,, I I ,, I I ,, 33(,,
65 )(, 20 (, h,, Y /,
2.5 I,, 62 <I 5 ,, x II
JY ,, I 2 I IO,, --7I) /,
26 ,, 47 I:: h,. 21 I,,
as those in Le\ (1979) and the SEC study. may cause a problem if there are
industry wide events occurring simultaneously with the accounting po!icq
decision see Fertuck (1975) for c\,idence of differential security bcha~ior 01
SIC defined industries. In the next section, one means of testing for the
significance of SLICK industry wide (and other) events is discussed.
One means of probing the internal validity of the two sample research
designs used in security market policy studies is to examine the security
returns of the two groups in non-treatment (non-accounting policy decision)
periods. Note that this internal validity check is inherent in the analysis of
0, and 0, in the pre-test/post-test control group design. Given the
discussion in section 2.3 about the continuous nature of the information
revision process with accounting policy decisions, however, it is important
that the non-treatment period be appropriately interpreted. In the oil and
gas dispute, this period should be prior to the time when Congressman Moss
first added the Accounting Practicea pro\ Ision to the Energy Bill. i.e., prior
to July 8, 1975. Thus, for instance, \&ith 111~Collins Dent (1979) sample, one
could examine the return differences for the July 22 to March 17 periods in
1973 74 and 1974 75. The assumption underlying their experiment is that
after using the same sample deletion procedures for 1973 74 and 1974 75
that were applied to 1977 78 (e.g., for takeovers), the returns of the two
groups should not be statistically significantly different in 1973~-74 and
1974 75.
One potential benefit that non-treatment period security return analysis
can provide is insight into the significance of the confounding events problem
(see section 4) for the treatment period. Suppose that systematic differences
between the FC and SE firms in Collins Dent (1979) were observed in the
1973 74 and 1974- 75 periods. Further analysis of the information releases
for these firms and their security returns may reveal that exploration
announcements explain a substantial portion of these 1973~74 and 1974- 75
return differences. By (i) explicitly controlling for these exploration
announcements in the research design and documenting no additional
significant 1973 -74 and 1974 75 return differences, and (ii) then applying the
same research design to the 1977 78 period, ones confidence that any
observed 1977 78 return differences are due to the accounting policy decision
rather than confounding events would be increased.
0 0 2 0 1
2 1 1 0 1
1 4 18 12 24
9 14 7 5 5
0 0 2 0 0
35 49 41 18 37
G. Foster. Accounting policy decisims and cupitul nwrkrt resrorch 51
Alternative (b) has the attractive feature of assuming the market attempts
to adjust reported accounting numbers for accounting method differences ~
an assumption consistent with the available evidence. One limitation of (b),
however. is that we have very little evidence as to the accuracy of
alternative approximating techniques. For instance, Sunder (1976) did not
apply his approximating formulas to any company. while Seidler (1977)
illustrated his technique for only one company (Mesrr Petroleum).
Alternative (c) implicitly assumes perfect foresight by investors. One factor in
determining the reasonableness of this assumption would be the richness of
the information set available to the market at the date of the policy decision.
See Beaver and Dukes (1973), Foster (1975), Dukes (1976) and Foster (1977a).
Seldler (1977) estimated that Mew Petrolrums 1976 earmngs would be reduced
approxlma!ely 58 ; by a FC to SE change. In its 1977 Annual Report, Mesa estimated that
adoption of the SE version outlined in the Exposure Draft to SFAS No. 1Y would have red?lced
1976 reported net income by 20:,, to 40,, (p. 38).
For an illustration of an attempt to test the accuracy of an approximating technique see
Fabozzi and Shiffrm (1979). This study examined the consistency of 1976 replacement cost
estimates by Falkenstein and Well (1977) with the numbers 17 pharmaceutical companies
subsequently reported in their 1976 10Ks. They reported that the distribotable income estimate
developed from the [lOK] exceeded the income estimated usmg the F-W methodology. The
distributable income dlffered from that obtained from the lo-KS by between 2 percent to 24
percent (p. 167).
Some problems in this area are well illustrated by the replacement cost
disclosures under ASR No. 290. Currently we lack an articulated theory of
how specific accounting measurement rules are linked to the pricing of
capital assets. Attempts to partition replacement cost disclosing firms
according to the materiality of the impact will thus, of necessity, appear
rather arbitrary. A variety of partitions could be adopted e.g.,
Any observed results will be a joint test of (i) the disclosures under ASR No.
100 having a capital market impact, and (ii) the partition chosen reflecting
real differences perceived by the capital market.
Most existing studies of the market impact of mandated disclosures test for
the existence of an effect as opposed to testing an explanation for an
observed effect. The partitions employed in these studies (and the variables
used in these partitions) often have limited theoretical underpinning. In this
context, it is important that researchers adopt internal validity controls to
increase the probability that any positive effects reported are population
effects rather than sample specific effects. In concept, the problems in this
area are similar to those in interpreting studies using financial ratios to
predict financial distress, e.g., in both there is a lack of an articulated theory
to guide the researcher on which variables to include (and exclude). Some of
the internal validity controls now accepted in the financial distress prediction
literature could well be adopted in studies on newly mandated income
disclosures e.g.. at the start of the research, select a hold-out sample to
validate that any positive results found on the first sample are not specific to
only that sample.
~(UtJXtJ/,
l hu, Jorw\ :YLw.Y, k~triertJ/ co\ crs items in 71~ Wrll Strut Joirrrirrl.
BLJI.IYUIS. quotes from se\en major stoch markets. plus selected items from
T/w Ne\\, York Tires. and
l nitJ/ogIJJfi~rnztJf ior1 Rrtric2rtJ/ St)uic,ce details the reports firms file with
the SEC e.g.. XKs. IOKs and Proxy Statements.
Alternutice #I. Retain all firms in the sample and partition the firms into
various event combination categories. Thus, if one had a sample that
included the Exposure Draft (ED), and/or a dividend announcement and/or
an earnings announcement one could classify firms into the following
categories :
(i) ED only,
(ii) ED plus earnings.
(iii) ED plus dividends,
(iv) ED plus earnings and dividends.
One could strengthen this design by taking three additional sets of firms not
predicted to be affected by the ED in the same time period:
A coding scheme that categorizes the information releases of firms into fourteen basic
categories is available from the author.
55
One could then do an analysis of variance and test the main effect and
interaction effects of the three separate treatments (ED, earnings and
dividends).
An interesting by-product of this design \vould be insight into the strength
of the ED effect relative to the effect induced by other signals. This design
also has the advantage of controlling for one problem that often arises in
joint signal studies, i.e., attributing information content to individual signals
when the set of signals examined is non-orthogonal. This design, however, ib
generally feasible only when there is a large population and or a small
number of confounding events to cxaminc.
Allerr~rrire #?. Delete firms experiencing other events in the time period
from the sample. Deleting firms is generally feasible only if the time period
examined is short or if the event is of a non-recurring kind. For instance.
Lev (1979) deleted 7 firms from his SFilS No. 19 sample as they had
announced earnings, dividends or stock dividends during the critical period
surrounding the publication of the Exposure Draft; July 13, 1977 to July 22,
1977 (p. 491). Systematic adoption of this criterion to studies using 6 or X
month critical periods. however. would virtually eliminate all companies from
the sample. Collins Dent (1979) adopted this alternative for a set of firms
that may have been affected by a *major oil discovery in the West Pembina
(p. 13) region of Alberta. Canada.
ilItr,.rltrlilc #3. Retain all firms in the sample, but delete an appropriate
time period for each announcement. Assume one was examining the market
reaction to disclosures associated with SF.4S No. X for a sample of IO0 firms
30 days either side -of the announcement date. For one firm there was an
announcement of the divestiture of a Mexican subsidiary. If one assumed this
announcement was impounded within 1 day of the announcement. one
would only delete the - IX and - 17 days for this firm. Dyckman~~Smith
(1979) adopted this alternative for annual (but not interim) earnings
announcements and several takeover announcements.
This alternative has the advantage of retaining more observations in the
study vis-2-vis the deletion approach in Alternative #3. One potential
problem, however, is the assumption that the announcement deleted is
unrelated to the treatment effect. Yet, the divestitute may have been induced
24In order to remove the effect of annual earnings announcements. the 5 weekly returns
centered on the announcement week are not used The deasion IO omlt 5 weeks is arbitrary
and on the generous side [Dyckman- Smith (1979, p. 54)].
by the effect that volatility in the Mexican U.S. exchange rate would have,
under SFAS No. H, on the reported EPS of the U.S. parent company.
Ignoring these interactions between information events could result in an
underestimate of the capital market impact of the SFAS No. 8 disclosures.
(This problem also exists with Alternative #2 outlined earlier.) Another
problem is choosing the time period to delete. If the confounding event
announcement is assumed to be impounded in a short time period, then
presumably the same short time period should be used to examine the
impoundment of the accounting policy decision (as the time period chosen
becomes shorter, Alternative # 3 approaches Alternative # 2).
ilIrcrrrc/rirr #4. Retain all firms in the sample, explicitly estimate the
capital market effect of other events and subtract this estimate from the
observed return for the sample. The major problem with, this alternative is
that our research tools for estimating the magnitude of the capital market
impact of major classes of events at the firm level are not very refined.
Indeed, it is only for a subset (e.g., earnings and dividends) of the many
signals firms release to the market that detailed empirical evidence of theit
effect exists. Nevertheless, some variant of Alternative #4 may be useful in a
research design. Beaver, Clarke and Wright (1979) have reported that the
security market effect of an earnings announcement is most marked for
significantly large positive and large negative earnings changes. This result
suggests that a policy of deleting only those firms with earnings (say) IO,,
different from expected may represent a more appropriate trade-off between
sample size and minimizing the effect of confounding events than the
Alternative #2 policy of deleting all firms with earnings announcements in
the critical period.
While Alternative #4 may appear to be the least attractive of the above
alternatives, in some isolated cases a researcher may have little option but to
adopt it if he wishes to conduct an empirical study that includes controls for
confounding events. One such case is where a policy decision or SEC
judgment affects only one firm. (One area where Alternative #4 is being
applied currently is in legal testimony submitted in lob-5 insider trading
cases.)
Altrrrlutire #5. Retain all firms in the sample and assume that the net
effect of other events is minimal. Ball (1979) argues that this assumption was
a reasonable one for the Ball and Brown (1968) earnings announcement study.
The sample comprised 2349 observations - 9 yearly observations for 261
firms from a broad cross-section of industries. Each observation was centered
on the annual earnings announcement of a firm and these were then
averaged across firms and over time. As firms differ in the month of annual
earnings announcement, the event time chosen each year for each firm was
not the same (i.e., event time F real time eken for a single year).5 Moreover.
the models used to classify firms into good and bad news categories meant
that the composition of the firms in each category changed each year. Thus.
the research design had considerable internal validity controls to minimiLe
time period effects and industry effects. The Beaver (1968) study of annual
earnings announcements (715 observations= 143 firms over 5 years) and the
Foster (1977) study of quarterly earnings announcements (3580 obser\ atinns
=69 firms over 51 quarters) also had many similar strong internal validit)
controls.
It is unlikely that the same set of reasoning can be applied to accounting
policy decision studies. Consider the SILAS No. 1Y studies. In these studies
there was no time period diversification: event time was real time for e!er!
firm. Moreover, the samples were constrained to be industry specific by the
nature of the FASB standard examined. Finally, the maximum number 01
observations included in any study was 113. Under these conditions, to
assume without a detailed analysis of the information releases of firms. that
the other events problem is minimal appears optimistic in the extreme. [The
SEC study Haworth et al. (1978) apparently made this assumption as
no statements are made about controls for other events affecting the 71 firms
analyzed.]
5. Conclusion
Note, however. that due to a comblnatlon of restrlctlon to December 31 firms. the u\e of
monthly data and the heavy clustering of earnings announcement\ 111 February and March.
there was less divcr~ificatwn in the Ball and Brown (196X) design 111this respect VIS-~-\I\ more
recent studies using dally data
design will appear simplistic. However, the alternative approach of letting
the data tell it as it is is less likely to yield a rich and reliable set of research
findings.
Relative to several other areas of capital market research (e.g., studies on
the information content of earnings announcements), I believe the reliability
of inferences drawn from most existing capital market studies on effects of
accounting policy decisions to be low. Most policy decision studies have had
limited industry diversification in their sample, limited time period
diversification and limited controls for other information releases. In this
paper, a variety of suggestions have been made to improve the internal
validity of existing research designs. These suggestions involve the researcher
conducting much more extensive analysis of financial reports, debt
agreements, industry newsletters, etc., than has been done in prior studies.
However, it is believed that the inclusion of this additional work will
considerably improve the reliability of inferences drawn from studies in this
area of capital market research.
b chrtrr~~~ 24. 1075 Department of Energy holds tubltc Hcar~ng (in part)
to assc~ the cffcct of .Sk.1S :\o. IY on the ability of oil and gas cornpanics to
raise capital and on oil and gas explor:ttion and de\,clopmcnt acti\ tty.
,2lrrrc./t 2Y 31. .April 3 I trrd .Apvi/ II 14. 1078 SEC l~olds Public Hcartngs
in Washington. D.C.. and HcJubton.
.-lfrglrl 31. 1Y7S SEC issues Release on Adoption of Rcquircments IOI
k-inancial Accounting and Reporting Practices for Oil and Gas Producing
Acti\,tties. Overt-ules SK1 5 :lo. IY and ~I~IIOIIIICCS its rcscr\,c recognition
accounting requirements. Rclcase is dated August 21. but IS reported in T/IV
ltirll iSfro~,fJo~rrr~trl on August 30. 1978.
There were four major studies on the stock market reaction to the EASBs
Exposure Draft (ED) and the related SFAS No. 19 pronouncements. The
FASB sponsored a study by Dyckman and Smith (1979). This study
examined a 21 week period surrounding the ED. The conclusion was that
there was evidence of a relative negative impact on the returns of full-cost
securities [but that] the strength of the results, when coupled with
methodological issues, mitigate against concluding that the alleged
substantial market effects exist (p. 45). The full-cost lobby (using the name of
The Committee to Permit Small Producers to Compete in Energy
Exploration) sponsored the Collins and Dent (1979) study. The 35 week
period beginning the week following the issuance of the Exposure Draft (p.
23) was used as the test period. The conclusion was that the annualized risk-
adjusted returns [were] ~ 58.2 (, for full-cost firms and -29.1 ,i for
successful efforts firms a [statistically significant] difference of nearly 30,,
(p. 25). A third study was conducted at the SEC Research Division by
Haworth. Matthews and Tuck (1978). Using the four weeks starting with the
issuance of the ED. they reported an initial adverse impact on the trading
prices of full-cost companies. However, the evidence indicates a subsequent
relative price recovery for the affected group of companies (p. 27). An
independently sponsored research study was conducted by Lev (1979). The
period analyzed was seven trading days, starting two days prior to the
Exposure Draft rclcasc. The conclusion was that for FC firms, on aberage,
the cumulative market adjusted price decrease during the announcement
period was about 4.5 percent and significantly affected about 20 percent of
the sampled firms (p. 500).
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