Question:
It has been suggested that not all accounting choices are made by management in the best interest of fair
and consistent financial reporting.
Required:
What motivations can you think of for management’s choice of accounting methods?
Answer:
It would be nice to think that management makes all accounting choices in the best interest of fair
and consistent financial reporting. Unfortunately, other motives influence the choices among accounting
methods and whether to change methods. It has been suggested that the effect of choices on management
compensation, on existing debt agreements, and on union negotiations each can affect management’s
selection of accounting methods.1 For instance, research has suggested that managers of companies with
bonus plans are more likely to choose accounting methods that maximize their bonuses (often those that
increase net income).2 Other research has indicated that the existence and nature of debt agreements and
other aspects of a firm’s capital structure can influence accounting choices. 3 Whether a company is
forbidden from paying dividends if retained earnings fall below a certain level, for example, can affect the
choice of accounting methods.
Choices made are not always those that tend to increase income. As you will learn in Chapter 8,
many companies use the LIFO inventory method because it reduces income and therefore reduces the
amount of income taxes that must be paid currently. Also, some very large and visible companies might
1
Watts, R.L., and J.L. Zimmerman, “Towards a Positive Theory of the Determination of Accounting Standards,”
The Accounting Review, January 1978, and “Positive Accounting Theory: A Ten Year Perspective,” The
Accounting Review, January 1990.
2
For example, see Healy, P.M., “The Effect of Bonus Schemes on Accounting Decisions,” Journal of Accounting
and Economics, April 1985, and Dhaliwal, D., G. Salamon, and E. Smith, “The Effect of Owner Versus
Management Control on the Choice of Accounting Methods,” Journal of Accounting and Economics, July 1982.
3
Bowen, R.M., E.W. Noreen, and J.M. Lacy, “Determinants of the Corporate Decision to Capitalize Interest,”
Journal of Accounting and Economics,” August 1981.
It has been suggested that not all accounting choices are made by management in the best interest of fair
and consistent financial reporting.
Required:
What motivations can you think of for management’s choice of accounting methods?
Answer:
It would be nice to think that management makes all accounting choices in the best interest of fair
and consistent financial reporting. Unfortunately, other motives influence the choices among accounting
methods and whether to change methods. It has been suggested that the effect of choices on management
compensation, on existing debt agreements, and on union negotiations each can affect management’s
selection of accounting methods.1 For instance, research has suggested that managers of companies with
bonus plans are more likely to choose accounting methods that maximize their bonuses (often those that
increase net income).2 Other research has indicated that the existence and nature of debt agreements and
other aspects of a firm’s capital structure can influence accounting choices. 3 Whether a company is
forbidden from paying dividends if retained earnings fall below a certain level, for example, can affect the
choice of accounting methods.
Choices made are not always those that tend to increase income. As you will learn in Chapter 8,
many companies use the LIFO inventory method because it reduces income and therefore reduces the
amount of income taxes that must be paid currently. Also, some very large and visible companies might
1
Watts, R.L., and J.L. Zimmerman, “Towards a Positive Theory of the Determination of Accounting Standards,”
The Accounting Review, January 1978, and “Positive Accounting Theory: A Ten Year Perspective,” The
Accounting Review, January 1990.
2
For example, see Healy, P.M., “The Effect of Bonus Schemes on Accounting Decisions,” Journal of Accounting
and Economics, April 1985, and Dhaliwal, D., G. Salamon, and E. Smith, “The Effect of Owner Versus
Management Control on the Choice of Accounting Methods,” Journal of Accounting and Economics, July 1982.
3
Bowen, R.M., E.W. Noreen, and J.M. Lacy, “Determinants of the Corporate Decision to Capitalize Interest,”
Journal of Accounting and Economics,” August 1981.
