1979 Watts And Zimmerman

THE ACCOUNTING REVIEW Vol. LIV, No. 2 April 1979 The Demand for and Supply of Accounting Theories: The Market for Excuses Ross L. Watts and Jerold L. Zimmerman ABSTRACT: This paper addresses the questions of why accounting theories are predominantly normative and why no single theory is generally accepted. Accounting theories are analyzed as economic goods, produced in response to the demand for theories. The nature of the demand is examined, first in an unregulated, then in a regulated economy. Government regulation creates incentives for individuals to lobby on proposed accounting procedures, and accounting theories are useful justifications in the political lobbying. Further, government intervention produces a demand for a variety of theories, because each group affected by an accounting change demands a theory that supports its position. The diversity of positions prevents general agreement on a theory of accounting, and accounting theories are normative because they are used as excuses for political action (i.e., the political process creates a demand for theories which prescribe, rather than describe, the world). The implications of the authors’ theory for the changes in the accounting literature as a result of major changes in the institutional environment are compared with observed phenomena. I. INTRODUCTION The literature we commonly call financial accounting theory is predominantly prescriptive.1 Most writers are concerned with what the contents of published financial statements should be; that is, how firms should account. Yet, it is generally concluded that financial accounting theory has had little substantive, direct impact on accounting practice or policy 1 For example, see Canning [1929], Paton [1922], Edwards and Bell [1961], Sprouse and Moonitz [1962], Gordon [1964], Chambers [1966], and American Accounting Association [1966]. We would prefer to reserve the term “theory” for principles advanced to explain a set of phenomena, in particular for sets of hypotheses which have been confirmed. However, such a definition of theory would exclude much of the prescriptive literature and generate a semantic debate. To avoid that consequence, in this paper (unless qualified) we use the word “theory” as a generic term for the existing accounting literature. This research was supported by the Center for Research in Government Policy and Business, Graduate School of Management, University of Rochester. The authors wish to acknowledge the suggestions of Ray Ball, George Benston, Richard Brief, Nicholas Dopuch, Nicholas Gonedes, David Henderson, Robert Holthausen, Michael Jensen, Melvin Krasner, Richard Leftwich, Janice Maugire, William Mackie, Philip Meyers, Katherine Schipper, William Schwert, Clifford Smith, and Jerold Warner. We also acknowledge the suggestions received on an earlier version of this paper presented at the Stanford Summer Research Colloquium, August 2, 1977, and the comments of the anonymous reviewers. Ross L. Watts is Associate Professor and Jerold L. Zimmerman is Assistant Professor, both at the University of Rochester. Manuscript received October, 1977. Revisions received January and April, 1978. Accepted May, 1978. 273 274 The Accounting Review, April 1979 formulation despite half a century of research. Often the lack of impact is attributed to basic methodological weaknesses in the research. Or, the prescriptions offered are based on explicit or implicit objectives which frequently differ among writers.2 Not only are the researchers unable to agree on the objectives of financial statements, but they also disagree over the methods of deriving the prescriptions from the objectives.3 One characteristic common to the prescriptions and proposed accounting methodologies, however, is their failure to satisfy all practicing accountants and to be accepted generally by accounting standard-setting bodies. A committee of the American Accounting Association recently concluded that “a single universally accepted basic accounting theory does not exist at this time."4 The preceding observations lead us to pose the following question: What is the role of accounting theory in determining accounting practice? Our objective in the paper is to begin building a theory of the determinants of accounting theory. This theory is intended to be a positive theory, that is, a theory capable of explaining the factors determining the extant accounting literature, predicting how research will change as the underlying factors change, and explaining the role of theories in the determination of accounting standards.5 It is not normative or prescriptive.6 Other writers have examined the relationship between accounting theory and practice. For example, Zeff [1974, p. 177] examines the historical relationship and concludes: A study of the U.S. experience clearly shows that the academic literature has had remarkably little impact on the writings of practitioners and upon the accounting policies of the American Institute and the SEC. Too often, accounting theory is invoked more as a tactic to buttress one’s preconceived notions, rather than as a genuine arbiter of contending views (emphasis added). Horngren [1973, p. 61] goes further and suggests an explanation for accounting theory’s limited impact on the setting of accounting standards:7 My hypothesis is that the setting of accounting standards is as much a product of political actions as of flawless logic or empirical findings. Our theoretical theory is consistent with both Zeff’s and Horngren’s observations. It predicts that accounting theory will be used to “buttress preconceived notions” and further, it explains why. Our contribution to Zeff’s and Horngren’s ideas is to give them more structure so that we can make additional predictions about accounting theory. The source of that structure is economics. We view accounting theory as an economic good and 2 For example, Chambers [1966, Chapters 9-11] apparently adopts economic efficiency as an objective while the American Institute of Certified Public Accountants (AICPA) Study Group on the Objectives of Financial Statements [1973, p. 17] decided that “financial statements should meet the needs of those with the least ability to obtain information. . . .” 3 Some writers (e.g., Chambers [1966]) make assumptions about the world without regard for empirical evidence and derive their prescriptions using those assumptions. Others (e.g., Gonedes and Dopuch [1974]) argue that prescriptions to achieve any given objective must be based on hypotheses which have been subjected to formal statistical tests and confirmed. 4 American Accounting Association, [1977, p. 1]. This report also reviews the major accounting theories. 5 The Committee on Concepts and Standards for External Reports, American Accounting Association [1977] examines many of these same questions, and the interested reader should refer to this committee report for an alternative explanation of these phenomena, specifically Chapter 4. 6 The terms “normative” and “prescriptive” are used interchangeably. See Mautz and Gray [1970] for an example of prescriptions to “improve” accounting research and hence its impact on practice. 7 See Sterling [1974, pp. 180-181] for Horngren’s response to Zeff’s initial remark. Watts and Zimmerman 275 examine the nature of the demand for and the supply of that good. Understanding why accounting theories are as they are requires a theory of the political process. We model that process as competition among individuals for the use of the coercive power of government to achieve wealth transfers. Because accounting procedures8 are one means of effecting such transfers, individuals competing in the political process demand theories which prescribe the accounting procedures conducive to their desired wealth transfers. Further, because individual interests differ, a variety of accounting prescriptions, hence a variety of accounting theories, is demanded on any one issue. We argue that it is this diversity of interests which prevents general agreement on accounting theory. While individuals want a theory which prescribes procedures conducive to their own interest, they do not want a normative theory which has their self-interest as its stated objective. The reason is that information is costly to obtain. Some voters will not obtain information on political issues personally. Those voters are not likely to support political actions which have as their stated objective the self-interest of others. The most useful theories for persuading uninformed voters are theories with stated objectives appealing to those voters, e.g., the “public interest.” As a result, individuals demand normative accounting theories which make prescriptions based on the “public interest.” In other words, the demand is for rationales or excuses. Because it arises from the political process, the demand for normative, “public interest”-oriented accounting theories depends on the extent of the government’s role in the economy. Section II analyzes the demand for financial accounting and accounting theory first in an unregulated economy, in which the only role of government is to enforce contracts, and then in a regulated economy. In Section III, we examine the nature of the supply of accounting theories. Because of the diverse demands for prescriptions, we expect to observe a variety of normative theories. Further, we expect theories to change over time as government intervention changes. In Section IV we examine the effect of government intervention on extant accounting theory during the last century. Section V summarizes the issues and presents our conclusions. II. THE DEMAND FOR ACCOUNTING THEORIES This section analyzes the demand for accounting theories in an unregulated economy (Part A) and the additional demands generated by government intervention (Part B). A. The Demand for Accounting Theories in an Unregulated Economy 1 Accounting in an Unregulated Economy. Audited corporate financial statements were voluntarily produced prior to government mandate.9 Watts [1977] concludes that the original promoters of corporations or, subsequently, corporate managers have incentives to contract to supply audited financial statements. Agreements to supply audited financial statements were included in articles of incorporation (or by-laws) and in private lending contracts between corporations 8 Accounting “procedures,” “techniques,” and “practices” are defined as any computational algorithm used or suggested in the preparation of financial accounting statements. “Accounting standards” are those “procedures” sanctioned or recommended by an “authoritative” body such as the AIP, FASB, SEC, ICC, etc. 9 Benston [1969a] reports that as of 1926 all firms listed on the New York Stock Exchange published a balance sheet, 55 percent disclosed sales, 45 percent disclosed cost of goods sold, 71 percent disclosed depreciation, 100 percent disclosed net income, and 82 percent were audited by a CPA. 276 The Accounting Review, April 1979 and creditors.10 These contracts increase the welfare of the promoter or manager (who is raising the new capital) because they reduce the agency costs11 which he bears. Agency costs arise because the manager's (the agent's) interests do not necessarily coincide with the interests of shareholders or bondholders (the principals). For example, the manager (if he owns shares) has incentives to convert assets of the corporation into dividends, thus leaving the bondholders with the "shell" of the corporation. Similarly, the manager has incentives to transfer wealth to himself at the expense of other shareholders and bondholders (e.g., via perquisites). Bondholders and shareholders anticipate the manager's behavior and appropriately discount the price of the bonds or shares at the time of issue. Hence, the promoter (or manager) of a new corporation receives less for the shares and bonds he sells than he would if he could guarantee that he would continue to act as he did while he owned the firm (i.e., when there were no outside shareholders or bondholders). This difference in the market value of the securities is part of the cost of an agency relationship, it is part of agency costs, and is borne by the promoter (or manager).12 Jensen and Meckling [1976, p. 308] call it the "residual loss." Because he bears the residual loss, the manager has incentives to make expenditures to guarantee that he will not take certain actions which harm the principal's interest or that he will compensate the principal if he does. These are "bonding" and "monitoring" expenditures and are additional elements of agency costs. Examples of such expenditures include contracting to restrict dividend payments and expenditures to monitor such dividend covenants. The final element of agency costs is the utility of the increase in perquisites, wealth transfers, etc., the manager receives because of his actions as an agent. An equilibrium occurs when the net costs of an agency relationship, the agency costs, are minimized by trading-off the decreases in the promoter's (or manager's) utility due to the residual loss, the monitoring and bonding expenditures, and the increased utility due to increased perquisites. The promoter or manager will write contracts for monitoring and bonding as long as the marginal benefits of those contracts (e.g., reduction of the residual loss) are greater than the marginal costs (e.g., the costs of contracting and the utility of any perquisites foregone). Moreover, since he bears the agency costs, the manager or promoter will try to write the contracts and perform the bonding or monitoring at minimum cost. In fact, the Jensen and Meckling analysis suggests that the equilibrium set of contractual devices is the one which minimizes the agency costs associated with the separation of management and control and with the conflict of interests associated with the different classes of investors. 10 In the period 1862–1900, many U.K. companies voluntarily adopted the optional articles included in Table A of the 1862 U.K. Companies Act. See Edey [1968], Edey and Panitpakdi [1956] and Watts [1977]. Examples of private contracts can be found today in any loan or bond indenture agreement. 11 Jensen and Meckling [1976, p. 308] define an agency relationship as "a contract under which one or more persons (the principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent." There are at least two agency relationships which cause corporate promoters and managers to bear agency costs. The first is the relationship between shareholders (the principals) and the manager (the agent) and the second is the relationship between the bondholders (the principals) and the manager (the agent). 12 See Jensen and Meckling [1976] for a formal proof that he bears this cost. Watts and Zimmerman 277 included bonding covenants in corporate articles and by-laws in the nineteenth century. Dividend covenants were voluntarily included in company charters as early as 1620.13 Watts's [1977] analysis of agency relationships suggests that the function of audited financial statements in an unregulated economy is to reduce agency costs. This theory predicts that accounting practices (i.e., the form, content, frequency, etc., of external reporting) would vary across corporations in an unregulated economy depending on the nature and magnitude of the agency costs. Agency costs, in turn, are, among other things, a function of the amount of corporate debt outstanding and of the relative share of equity owned by the manager.14 These variables affect the manager's incentive to take actions which conflict with the interests of shareholders and bondholders. Agency costs also vary with the costs of monitoring managers, which, in turn depend on the physical size, dispersion, and complexity of the firm. Further, the practices underlying financial statements will vary across firms because an accounting practice which minimizes agency costs in one industry may not minimize those costs in another. As an example of the association between agency costs and accounting procedures, consider management compensation schemes in the nineteenth century. Some management compensation schemes in the nineteenth century were included in corporate articles. Those schemes tied management compensation to the firms' "profits" [Matheson, 1893, pp. vii–viii] to reduce the divergence between the interests of the managers and shareholders.15 At that time "profits" were effectively operating cash flows, since accrual accounting was not used. [Litherland, 1968, pp. 171–172]. However, a cash flow "profit" index is susceptible to short-run manager manipulation. The manager can reduce repairs and maintenance expenditures and increase cash flows and "profits,"16 which would increase the manager's compensation.17 In addition, reduced maintenance increases the ability of the corporation to pay current dividends. Such dividends could reduce the value of the creditors' claims and increase the shareholders' wealth.18 To reduce these agency costs of equity and debt, several contractual devices were used to decrease the likelihood that managers and shareholders would run down the value of the capital stock. i) Dividends were restricted to a fixed proportion of profits, thereby creating a buffer.19 ii) Reserve funds of fixed amounts had to be maintained if dividends were to be paid.20 iii) Fixed assets were treated as merchandise accounts with changes in value (usually not called depreci- 13 See Kehl [1941, p. 4]. 14 Agency costs are also a function of the tastes of managers for non-pecuniary income, the extent of managerial competition, the degree to which the capital markets and the legal system are able to reduce agency costs, etc. See Jensen and Meckling [1976, pp. 328-330]. 15 The terms "shareholders" and "stockholders" are used interchangeably. 16 See Matheson [1893, p. 5] for a report that managers did in fact adopt this tactic in the nineteenth century. 17 See Matheson [1893, p. vii] for a statement that managers did in fact resist depreciation charges because of the effect on their compensation. 18 See Smith [1976, p. 42]. Also, we find labor managed firms in socialist countries faced with the same agency problem. Labor has less incentive to maintain physical capital than an owner-manager. Jensen and Meckling [1977]. 19 For example, the General Bank of India had a provision in its charter limiting dividends to not more than one of (net) cash profits [DuBois, 1933, p. 365]. 20 The Phoenix Insurance Company, 1781, required a reserve fund of £2,000 before any dividends could be paid. Ibid. 278 The Accounting Review, April 1979 ation) closed to profits prior to dividend distributions.21 In the latter procedure, depreciation was treated as a valuation technique which had to be estimated only in profitable years, since dividends were paid only in these years. A typical company charter requiring depreciation is: The directors shall, before recommending any dividend, set aside out of the profits of the company, but subject to the sanction of the company in general meeting, such sum as they think proper as a reserve fund for maintenance, repairs, depreciation and renewals.22 The court interpreted this article and the term "proper reserve" as a mechanism to account for declines in the capital stock.23 Thus, the existence of a depreciation covenant (and hence the presence of depreciation in the financial statement) or other restrictions on dividends was a function of the amount of fixed assets and the nature and magnitude of the agency costs of debt. Capital market participants contract to supply capital. Managers and owners seeking capital have incentives to enter into contracts which limit the agency costs they incur. But these contracts must then be monitored and enforced since managers have incentives to circumvent the contracts. For example, the promoter or manager of a corporation may contract to restrict dividends to, or base management compensation on, profits after a deduction for depreciation because such a covenant enables him to sell bonds and shares at a higher price. However, after the contract is written the manager has incentives to minimize that depreciation charge, thereby leading to increased profits (and potentially increased management compensation) and dividends which transfer wealth from bondholders to shareholders (including management). Thus, contracts will reduce agency costs only if they include provisions for monitoring. Since audited financial statements are useful devices to monitor these voluntary agreements between owners and managers, these statements serve a useful role in the capital markets and owner-managers will agree to provide them in advance. 2. The Function of Accounting Theories The preceding analysis suggests that accounting theories will serve three overlapping functions in an unregulated economy. i) Pedagogic demand. Accounting procedures are devised in order to reduce agency costs of contracts. Since these costs vary across firms, accounting procedures will vary, giving rise to diversity of techniques, formats, etc.24 However, diversity in accounting procedures increases the difficulty of teaching the 21 See Littleton [1933, pp. 223–227]. 22 Dent v. London Tramways Company, 1880, in Brief [1976, p. 193]. 23 “Take the case of a warehouse: suppose that a house keeper, having a new warehouse, should find at the end of the year that he had no occasion to expend money in repairs, but thought that, by reason of the usual wear and tear of the warehouse, it was 1,000£ worse than it was at the beginning of the year, he would set aside 1,000£ for a repair or renewal or depreciation fund, before he estimated any profits; because, although that sum is not required to be paid in that year, it is still the sum of money which is lost; so to say, out of capital, and which must be replaced.” Ibid. 24 Prior to the creation of the Securities and Exchange Commission (SEC) in 1934, much variation existed in accounting procedures. See Blough [1937, p. 7]. In an unregulated economy, the market itself regulates the amount of diversity of accounting procedures. There are economies associated with using existing practices and terminology. If the firm adopts previously unknown accounting practices, then the users of the statements (i.e., creditors monitoring shareholders and shareholders monitoring management) will incur costs in learning the new accounting procedures. If creditors or shareholders have alternative uses of their capital (i.e., capital markets are competitive by the costs of the new procedures are ultimately borne by the shareholders and managers. Hence, new procedures (and increased diversity) will be implemented only if their added benefits offset the added costs they impose. practice of accounting. Consequently, accounting teachers develop pedagogic devices (rules-of-thumb) to assist learning and to structure the variation found in practice. Theorists examine existing systems of accounts and summarize differences and similarities. These descriptions of practice highlight the tendencies of firms with particular attributes to follow certain accounting procedures. Nineteenth century accounting texts and articles indicate that accounting theorists recognized the diversity of practice and attempted to distill general tendencies from the diversity. For example: No fixed rules, or rates of depreciation can be established for general use, because not only do trades and processes of manufacture differ, but numerous secondary circumstances have to be considered in determining the proper course. It may, however, be possible to lay down some general principles which will always apply, or which, at any rate, may with advantage be held in view in deciding particular cases. [Matheson, 1893, p.1] Similarly, Dicksee and Tillyard's [1906] treatise describes current accounting practice for goodwill and the relevant court cases. Based on this description, the authors “enunciate general business principles and explain their practical application” [Dicksee and Tillyard, 1906, p. vii]. ii) Information Demand. In an unregulated economy there is a demand for writers to do more than just describe variations in accounting practice. There is a demand for predictions of the effects of accounting procedures on both the manager’s and auditor’s welfare via exposure to law suits. The auditor contracts with the shareholders (and creditors) to monitor management, and he is legally liable if he fails to report breaches of covenants in the corporation’s articles or by-laws.25 Furthermore, the demand for a given auditor’s services is a function of the auditor’s efficiency in monitoring management.26 Hence, the auditor again has an incentive to understand how management’s choice of accounting procedures affects agency costs. Auditors would value information in the form of theories predicting how agency costs vary with accounting procedures. In particular, auditors would like to know how managers’ actions and hence agency costs would be affected by alternative accounting procedures. iii) Justification Demand. Early accounting textbooks warned that managers would use accounting to serve their own interests at the expense of shareholders. The second edition of Matheson [1893] contains examples of such warnings. Matheson provides illustrations of how managers can take advantage of deficiencies in the definition of depreciation, repairs, and maintenance charges to increase “profits” and their own compensation at the expense of shareholders and/or bondholders. For example, on page 5 he writes: The temptation to treat a Profit the Surplus of Income over Expenditure, without sufficient allowance for Depreciation, appears to be often irresistible. Thus, in the case of a Tramway undertaking in its first years of working, a dividend may be possible only by writing off little or nothing from the capital value of the cars, the harness, and the horses. This, of course, cannot last without the intro- 25 See the Leeds Estate Building Company case in Edwards [1986b, p. 148]. 26 Share prices are unbiased estimates of the extent to which the auditor monitors management and reduces agency costs (see Fama [1970] and Gomes and Dopuch [1974] for a review of the evidence on market efficiency). The larger the reduction in agency costs effected by an auditor (and not the auditor’s fees), the higher the value of the corporation’s shares and bonds and, ceteris paribus, the greater the demand for that auditor’s services. If the market observes the auditor failing to monitor management, it will adjust downwards the share price of all firms who engage this auditor (to the extent to which the auditor does not reduce agency costs), and this will reduce the demand for his services. the temptation to treat a Profit the Surplus of Income over Expenditure, without sufficient allowance for Depreciation, appears to be often irresistible. Thus, in the case of a Tramway undertaking in its first years of working, a dividend may be possible only by writing off little or nothing from the capital value of the cars, the harness, and the horses. This, of course, cannot last without the introduction of new capital, but in undertakings long established there may yet be epochs of fictitious profits due to various causes. For instance there may be neglect of repairs, which, when the necessity for them becomes evident, will involve a heavy outlay for renewals; or it may arise from actual fraud in postponing expenditure, so as to show larger profits, which will raise the value of shares for stock-jobbing purposes. There are railways where the dividend income and the corresponding value of the shares have fluctuated considerably, not according to alterations in the real earnings, but according to alternate neglect and attention in regard to plant. Accounting texts (and theories) which detail how managers seek to manipulate profits and the consequent effects of those manipulations on shareholders and bondholders not only improve the auditor’s ability to monitor such behavior, but also provide the auditor with ready-made arguments to use against such practices in discussions with management. It is clear that Matheson’s work fulfilled this role. William Jackson, a member of the Council of the Institute of Chartered Accountants in England and Wales, stated that he used Matheson’s book in that fashion: To those who honestly and from conviction treat the subject on the only sound basis, it may seem superfluous to urge due consideration of the arguments so convincingly set out in these pages; but Auditors, and especially those who have to deal with joint-stock or other concerns where the remuneration of the management is made wholly or partly dependent upon declared Profits, know in what varied forms resistance to an adequate Charge against profits for Depreciation is presented. The fallacies underlying these objections present themselves again and again with the modifications caused by the lack of apprehension in some, or the ingenuity of others. Mr. Matheson’s work provides the Auditor with true antidotes to these fallacies, and it has been in past times used by the writer with satisfactory effect, where his own less-reasoned arguments have failed to convince. He therefore recommends it afresh to the notice and for the support, where necessary, of members of his own profession, and of those who, untrained in the practice of Auditing, are confronted with unfamiliar and specious pretenses for avoiding the unwelcome charge against Profits [Matheson, 1893, pp, vii-viii] (emphasis added). B. The Demand for Accounting Theories in a Regulated Economy This section extends the previous analysis of the demand for theories to include the effects of government. We assume that private citizens, bureaucrats, and politicians have incentives to employ the powers of the state to make themselves better off and to coalesce for that purpose. One way by which coalitions of individuals are made better off is by legislation that redistributes (i.e., confiscates) wealth. 1. Accounting and the Political Process Farm subsidies, tariffs, welfare, social security, even regulatory commissions27 are examples of special interest legislation which transfer wealth. The business sector is both the source (via taxes, antitrust, affirmative action, etc.) and the recipient of many of these wealth transfers (via tax credits, tariffs, subsidies, etc.). Financial accounting statements perform a central role in these wealth transfers and are affected both directly and indirectly by the political process. The Securities and Exchange Commission (SEC) regulates the contents of financial statements directly (upward asset revaluations are not allowed, statements of changes in financial position must be prepared, etc.). The Federal Revenue Acts also affect the contents of financial statements directly (e.g., LIFO). In addi- tion, regulatory commissions (e.g., state public utility boards, various banking and insurance commissions, the Interstate Commerce Commission, the Federal Trade Commission) often affect the contents of financial statements. Besides these more direct effects, there are indirect effects. Government commissions often use the contents of financial statements in the regulatory process (rate setting, antitrust, etc.). Further, Congress often bases legislative actions on these statements.28 This, in turn, provides management with incentives to select accounting procedures which either reduce the costs they bear or increase the benefits they receive as a result of the actions of government regulators and legislators.29 Since public utilities have incentives to propose accounting procedures for rate making purposes which increase the market value of the firm, their arguments are assisted if accounting standard-setting bodies such as the Financial Accounting Standards Board (FASB) mandate the same accounting procedures for financial reporting.30 Consequently, managers of utilities and other regulated industries (e.g., insurance, bank and transportation) lobby on accounting standards not only with the regulatory commissions but also with the Accounting Principles Board (APB) and the FASB. Moonitz [1974 a and b] and Horngren [1973 and 1977] document instances of regulated firms seeking or opposing accounting procedures which affect the value of the firm via direct and indirect wealth transfers. Examples of other firms lobbying on accounting standards exist. Most of the major U.S. oil companies made submissions regarding the FASB’s Discussion Memorandum on General Price Level Adjustments [Watts and Zimmerman, 1978]. 2. The Effect of Government Intervention on the Demand for Accounting Theories The rules and regulations which result from government regulation of business increase the pedagogic and information demands for accounting theories. Even beginning accounting textbooks report the income tax requirements of LIFO, depreciation, etc. Practitioners demand detailed texts explaining SEC requirements (e.g., Rappaport [1972]), tax codes, and other government regulations. The justification demand for theories also expands with regulation. The political process in the U.S. is characterized as an advocacy proceeding. Proponents and opponents of special interest legislation (or petitioners before regulatory and administrative committees) must give arguments for the positions they advocate. If these positions include changes in accounting procedures, accounting theories which serve as justifications (i.e., excuses) are useful. These advocacy positions (including theories) will tend to be based on contentions that the political action is in the public interest.31 28 The reported profits of U.S. oil companies during the Arab oil embargo were used to justify bills to break up these large firms. 29 See Watts and Zimmerman [1978] for a test of this proposition. Also, see Prakash and Rappaport [1977] for further discussion of these feedback effects. 30 The Interstate Commerce Commission based its decision to allow tax deferral accounting on APB Opinion No. 11. See Interstate Commerce Commission, Accounting for Federal Income Taxes, 318 I.C.C. 803. 31 Other writers have also recognized the tendency for advocates to use public interest arguments. For example, Peltzman [1976, pp.64-65] concludes that the accounting profession has increased its economic power via control over entry “through legislation justified as protecting the public interest” (p.64). “In most cases, public rather than professional interest was cited as the primary reason for the legislation]” (p.65) (emphasis added). The Accounting Review, April 1979 Copyright © 2001 All Rights Reserved 282 that everyone is made better off, that most are made better off and no one is harmed, or that the action is “fair,” since those contentions are likely to generate less opposition than arguments based on self-interest. Often, those public interest arguments rely upon the notion that the unregulated market solution is inefficient. The typical argument is that there is a market failure which can only be remedied by government intervention. Politicians and bureaucrats charged with the responsibility for promoting the general welfare demand public interest testimony not only to inform them of the trade-offs but also for use in justifying their actions to the press and their constituencies. Consequently, when politicians support (or oppose) legislation, they tend to adopt the public interest arguments advanced by the special interests who promote (oppose) the legislation. i) Examples of Public Interest or Market Failure Justifications. The reported objective of the Securities Exchange Act of 1934 and of required disclosure is stated by Mundheim [1964, p. 647]: The theory of the Securities Act is that if investors are provided with sufficient information to permit them to make a reasoned decision concerning the investment merits of securities offered to them, investor interests can be adequately protected without unduly restricting the ability of business ventures to raise capital. This objective stresses economic efficiency. The statement suggests that required disclosure can increase investors’ welfare at virtually zero cost (i.e., that there is a market failure). Examples of “public interest” justifications of accounting procedures are observed in rate-setting hearings for public utilities. For example, Public Systems, an organization that represents municipalities and rural electrification agencies, applied for a hearing on the Federal Power Commission’s (FPC) Order 530 which allowed the use of income tax allocation in setting rates.2 Order 530 increases the cash flow of electric utilities “at the expense of customers using electricity” and hence harms the interests of Public Systems. But, Public Systems did not argue that it is in its self-interest to oppose Order 530. Instead it argued that “normalization [income tax allocation] represents an inefficient means of subsidizing the public utility industry” [U.S. Congress, Senate, 1976, p. 683] (emphasis added). Bureaucrats also use public interest arguments to justify their actions.3 For example, the former SEC Chief Accountant, John Burton, a bureaucrat, justified the disclosure regulations imposed during his term in office by arguing: In a broad sense we hope [that disclosure regulations] will contribute to a more efficient capital market.... The way in which we hope that will be achieved is first by giving investors more confidence that they are getting the whole story and second by encouraging the development of better tools of analysis and more responsibility on the part of the professional analyst to understand what’s going on. We think that by giving them better data we can encourage them in the direction of doing a better job, thus leading, we hope, to more effective [sic] capital markets [Burton, 1975, p. 21]. Government regulation creates a demand for normative accounting theories employing public interest arguments, that is, for theories purporting to demonstrate that certain accounting procedures should be used because they lead to better decisions by investors, more efficient capital markets, etc. Further, the demand 32 U.S. Congress, Senate [1976, p. 59]. “Metcalf Staff Report.” 30 McGraw [1975, p. 162]. Also, see U.S. Securities and Exchange Commission [1945, pp. 1-10].