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i 73-11,608 ZEISEL, Gerald A., 1938- CHOICE OF ACCOUNTING PROCEDURES: WHEN CONFLICT EXISTS BETWEEN MANAGERS AND SHAREHOLDERS. The Ohio State University, Ph.D., 1972 Accounting! University Microfilms, A XEROX Company, A nn Arbor, Michigan THIS DISSERT AT) ON HAS BEEN MICROFILMED EXACTLY AS RECEIVED.
CHOICE OF ACCOUNTING PROCEDURES: WHEN CONFLICT EXISTS BETWEEN MANAGERS AND SHAREHOLDERS DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Gerald A. Zeisel, B.B.A., M.B.A, * * * * * The Ohio State University 1972 Approved by A dviser Faculty of Accounting
PLEASE NOTE: Some pages may have indistinct print. Filmed as received. University Microfilms, A Xerox Education Company
ACKNOWLEDGEMENTS Acknowledgements and thanks are due Professor Melvin N. Greenball, my committee chairman, and Professors Roger K. Harvey, Orace Johnson, and Curtis H. Stanley for their helpful suggestions and comments on this paper. i i
VITA March 6, 1938... Born - New York* New York 1959...B.B.A., C ity C o lle g e o f New Y ork, New Y ork, New York 1963...C.P.A., S ta te 6 f New York 1967...M.B.A., C ity U n iv e r s ity o f New Y ork, New York, New York 1959-1967... P u b lic A c co u n ta n t, Jaco b H. Diamond and Company, New York, New York 1967-1970... Teaching Associate, Department of Accounting, The Ohio State University, Columbus, Ohio 1970-1972... Assistant Professor, Department of Accounting, University of Massachusetts, Amherst, Massachusetts PUBLICATIONS Two a n a ly s e s in Income Theory and R ate of R e tu rn, e d ite d by J. L e s lie L iv in g s to n e and Thomas J. B urns, Columbus, O hio: C o lleg e o f A dm inist r a t i v e S cj e n c e, The Ohio S ta te U n iv e r s ity, 1971. ''Tow ards a G eneral Theory o f D e p r e c ia tio n," by F. K enneth W rig h t, pp. A3-51. "Incom e M odels, Book Y ie ld and R ate o f R e tu r n," by W illiam J. V a tte r, pp. 149-160. T hree a n a ly s e s in Management P la n n in g and C o n tr o l: M ath em atical M odels, e d ite d by John L e s lie L iv in g s to n e, New Y ork: M cgraw-hill Book Company, 1970. "On th e M athem atics of V a ria n ce A n a ly s is," by Zenon S. Z annetos (a n a ly z e d j o i n t l y w ith John L e s lie L iv in g s to n e ), pp. 153-157. "Im p ro v in g B reakeven A n a ly sis by L in e a r Programming T e c h n iq u e," by R o b ert K. J a e d ic k e, pp. 333-339. "A H e u r is tic Model f o r S ch ed u lin g L arge P r o je c ts w ith L im ited R e s o u rc e s," by Jerom e D. W ie st, pp. 515-521. "A ccounting f o r P en sio n P la n C o s ts," A ccounting Forum, S p rin g, 1965. i l l
FIELDS OF STUDY M ajor F ie ld : A cco u n tin g S tu d ie s in Management A cco u n tin g. C u r tis H. S ta n le y P r o f e s s o r s P au l E. F e r t l g and S tu d ie s in Q u a n tita tiv e A ccounting M odels. L iv in g s to n e P r o fe s s o r J. L e s lie S tu d ie s In A p p lied Econom ics. P r o fe s s o r R ich ard A. Tybout iv
TABLE OF CONTENTS Page ACKNOWLEDGEMENTS i i VITA 111 LIST OF TABLES v l l C h ap ter I. INTRODUCTION 1 I I. MANAGEMENT AND SHAREHOLDER DIVIDEND PREFERENCES 12 A rea o f P o t e n t i a l C o n f lic t A dvantages o f I n t e r n a l F in a n c in g from M anagerial V iew point S to c k h o ld e r P r e f e re n c e C oncerning D ividends C o n f lic t Between M an ag erial and S to c k h o ld e r P r e f e re n c e s in C e r ta in I n d u s t r i e s I I I. IMPLICATION OF MANAGEMENT AND SHAREHOLDER PREFERENCES ON MANAGEMENTS' ACCOUNTING POLICY DECISIONS... 29 S to c k h o ld e r E v a lu a tio n of F irm 's D ividend P o lic y IV. RESEARCH DESIGN - OPERATIONAL DEFINITION AND MEASUREMENT OF VARIABLES 36 S to c k h o ld e rs ' D ividend P r e f e re n c e V a ria b le M anagem ent's Payout P re fe re n c e V a ria b le V. RESEARCH DESIGN - SELECTION OF ACCOUNTING PROCEDURES TO BE INVESTIGATED, SAMPLE, AND STATISTICAL TEST... 54 S e le c tio n o f A ccounting P ro c e d u re s and Time P e rio d to be T ested S o u rces o f D ata C o n s tru c tio n o f Sample S t a t i s t i c a l T e st V I. R E S U L T S...75 I n d u s tr y C l a s s i f i c a t i o n T e s ts f o r A cco u n tin g P ro ced u res V II. SUMMARY AND CONCLUSIONS... 93 Summary L im ita tio n o f Study C o n clu sio n s v
Page APPENDIX A. 1964 ACCOUNTING CHOICES OF FIRMS IN FINAL SAMPLE...99 B. COMPUSTAT DEFINITION........ 105 BIBLIOGRAPHY... 107 v l
LIST OF TABLES Page The R e la tio n Between A ccounting F irm s and th e T reatm ent o f th e In v e stm en t C re d it - 1964 I n d u s t r i e s In c lu d e d in th e I n i t i a l Sample Sample C o n s tr u c tio n and E lim in a tio n I n d u s tr ie s Ranked by Mean SD o f Firm s in In d u s try R e s u lts ( f o r MP) o f th e T e st o f th e H y p o th e sis w ith R espect to th e In v e stm en t C r e d it D e c isio n R e s u lts ( f o r MP*) o f th e T e s t o f th e H y p o th esis w ith R espect to th e In v estm en t C r e d it D e c is io n Number o f Firm s - D i f f e r e n t i a t e d by P ayouts Above and Below t h e i r I n d u s tr y A verage - A dopting A lte r n a tiv e In v estm en t C r e d it Methods R e s u lts ( f o r MP) o f th e T e st o f th e H y p o th esis w ith R espect to th e In v estm en t C r e d it D e c isio n R e s u lts ( f o r MP) o f th e T e st o f th e H y p o th esis w ith R espect to th e In v estm en t C r e d it D e c is io n w ith o u t In c lu d in g High In v e n to ry Growth Firm s R e s u lts ( f o r MP) o f T e st I o f th e H y p o th esis w ith R espect to th e T reatm en t of E x tra o r d in a r y Item s R e s u lts ( f o r MP) o f T e st I I o f th e H y p o th esis w ith R espect to th e T reatm en t of E x tra o r d in a r y Item s R e s u lts ( f o r MP*) of T e st I o f th e H y p o th esis w ith R espect to th e T reatm en t of E x tra o r d in a r y Item s R e s u lts ( f o r MP*) o f T e st I I o f th e H y p o th e sis w ith R espect to th e T reatm en t o f E x tra o r d in a r y Item s R e s u lts ( f o r MP) o f th e T e st of th e H y p o th esis C oncernin g Funds S ta te m e n ts R e s u lts ( f o r MP*) o f th e T e st o f th e H y p o th esis Conc e rn in g Funds S ta te m e n ts 57 65 68 79 80 81 82 82 85 86 87 88 88 89 90 v i i
Table Page 16. R e s u lts ( f o r MP) o f th e T est o f th e H ypothesis C oncerning Funds S ta te n e n ts w ith o u t In c lu d in g High In v en to ry Growth Firms 91 v i i l
CHAPTER I INTRODUCTION One o f th e m ajor c u r r e n t t h r u s t s o f a c c o u n tin g r e s e a r c h is co n cern ed w ith w h eth er th e employment o f a l t e r n a t i v e a c c o u n tin g p ro ced u res a f f e c t s th e d e c is io n s o r e x p e c ta tio n s o f th e u s e r s o f a c c o u n tin g r e p o r t s. Two com peting t h e o r ie s have been advanced to e x p la in th e e f f e c t o f a c c o u n tin g a l t e r n a t i v e s on r e p o r t u s e r s. One, th e " e f f i c i e n t m ark et" th e o r y,^ h o ld s t h a t th e s e c u r i t i e s m ark et i s e f f i c i e n t in th e se n se t h a t p r ic e s co m p le tely r e f l e c t a l l in fo rm a tio n p u b lic ly a v a i l a b l e. The im p lic a tio n o f th e th eo ry f o r f i n a n c i a l r e p o r tin g i s t h a t th e m arket i s n o t " fo o le d " by a l t e r n a t i v e r e p o r tin g m ethods b e c a u se in v e s t o r s w i l l a d ju s t f o r r e p o r tin g d i f f e r e n c e s. The o t h e r th e o ry h as been c a ll e d th e " n a iv e i n v e s t o r " th e o ry. 2 I t r e l i e s p r im a r i ly on th e c o n c e p t o f " f u n c tio n a l f i x a t i o n " a s p r e - s e n te d by I j i r i, J a e d ic k e, and K n ig h t. 3 They d e s c r ib e " f u n c tio n a l f i x a t i o n " to b e "b e h a v io r i n w hich th e p e rso n a t t a c h e s a m eaning to a t i t l e o r o b j e c t and i s u n a b le to s e e a l t e r n a t i v e m eanings o r u s e s. 4 ^F o r a rev iew o f th e t h e o r e t i c a l and e m p iric a l w ork r e l a t e d to th e th e o r y, se e E.F. Fama, " E f f i c i e n t C a p ita l M ark ets: A Review of Theory and E m p iric a l W ork," J o u rn a l o f F in a n c e, XXV (May, 19 7 0 ), pp. 383-417. 2 T.R. A rc h ib a ld, "S to c k M arket R e a c tio n to th e D e p re c ia tio n S w itc h -B a c k," A ccounting R eview, XLVII (Ja n u a ry, 19 7 2 ), p. 24. ^Y. I j i r i, R.K. J a e d ic k e, and K.E. K n ig h t, "The E f f e c ts o f Acc o u n tin g A l t e r n a t i v e s on Management D e c is io n s," In R ese arch in A ccountin g M easurem ent, e d ite d by R.K. J a e d ic k e, Y. I j i r i, 0. N ie lse n, (A m erican A cco u n tin g A s s o c ia tio n, 1 9 6 6 ), pp. 186-199. 4 I b i d., p. 194. 1
2 C o n se q u e n tly, th e " n a iv e in v e s to r " th e o ry im p lie s t h a t u s e r s r e ly v e ry h e a v ily on re p o rte d n e t income and do n o t ta k e in to c o n s id e r a tio n th e a l t e r n a t i v e m ethods t h a t, when u sed, produce d i f f e r e n t " n e t income" num bers. B e lie f i n th e n a iv e in v e s to r th eo ry by members o f th e f i n a n c i a l community is ev id en ced by th e fo llo w in g s ta te m e n ts from b u s in e s s j o u r n a ls :... th e an n u al n e t e a rn in g s f ig u r e ten d s to have a m a g ic al s i g n i f i c a n c e - n o t only fo r th e o rd in a ry in v e s to r, b u t f o r s e c u r i t y a n a ly s ts and even f o r a c q u is itio n -m in d e d managements.-* P eo p le te n d to demand... s im p lic ity, and th e s in g le, c o n v e n ie n tly packaged n e t e a rn in g s f ig u r e has alw ays seemed to f i l l th e b i l l p e r f e c t l y. Companies r e p o r t them fr e q u e n tly... and th e y c a r ry th e b le s s in g o f c e r t i f i e d p u b lic acc o u n ta n ts, so i t i s th a t re p o rte d e a rn in g s have become th e common d en o m in ato r of th e s to c k market.**... no one on W all S t r e e t i s making much o f an allo w an c e f o r th e way e a rn in g s a r e r e p o r te d. T his is s u r p r i s i n g s in c e th e m arket i s now su p p o se d ly dom inated by p r o f e s s i o n a l s.^ E m p iric al e v id e n c e r e l a t i n g to th e se com peting th e o r ie s has been m ixed and in c o n c lu s iv e. T hree s tu d ie s co n cern ed w ith th e r e l a t i o n s h i p betw een re p o r te d income and sto c k p r i c e s le n d su p p o rt to ^"What a r e E arn in g s? 99 (May 15, 1 9 6 7 ), p. 28. The Growing C r e d i b i l i t y G ap," F o rb es, 6 I b l d.. p. 29. p. 29. ^B. W ilaon, T w o -T h ird s' E x p o su re," B a rro n s, May 6, 1968,
g th e e f f i c i e n t m arket th e o ry. A ll th re e e x c lu s iv e ly u t i l i z e d firm s in th e e l e c t r i c u t i l i t y in d u s tr y. S in ce a c c o u n tin g a l t e r n a t i v e s a re l i k e l y to have r e a l ( r a t h e r th a n sim ply i l l u s o r y ) e f f e c t s in t h i s I n d u s try (b ecau se r e p o rte d ex p en ses a r e used by r e g u la to r y a g e n c ie s f o r r a t e s e t t i n g p u rp o se s) i t i s q u e s tio n a b le w h e th er e l e c t r i c u t i l i t y firm s a r e a good sam ple f o r t e s t i n g th e r e l a t i o n s h i p betw een a c c o u n tin g a l t e r n a t i v e s and s to c k p r i c e s. A nother stu d y u t i l i z i n g firm s in a r e g u la te d in d u s tr y ( a i r l i n e s ) produced r e s u l t s w hich w ere in c o n f l i c t w ith th o s e r e p o rte d above. Sumners d ev elo p ed a m easure of " a c c o u n tin g e f f i c i e n c y " and found t h a t he co u ld n o t c o n clu d e t h a t th e r e was a d i f f e r e n c e in th e " e f f ic ie n c y " o f any o f th e a c c o u n tin g a l t e r n a t i v e s in c lu d e d in h is i n v e s t i g a t i o n. He i n t e r p r e t e d t h i s fin d in g to im ply t h a t in v e s to r s w ere i n d i f f e r e n t to th e r e p o r tin g a l t e r n a t i v e s. O ther e v id en c e in su p p o rt o f th e n a iv e i n v e s t o r th e o ry can be o b ta in e d by s e l e c t i v e l y o b s e rv in g th e m ark et r e a c t i o n to th e announcem ent o f a change in a c c o u n tin g m ethods. On th e day th a t C a re e r Academy, In c. announced t h a t i t was ch an g in g th e m ethod by which i t re c o g n iz e d f r a n c h is e in come - o r i g i n a l l y th e f u l l incom e was re c o g n iz e d when th e c o n tr a c t g J.L. O 'D o n n e ll, " R e la tio n s h ip s Between R ep o rted E arn in g s and S tock P r ic e s in th e E l e c t r i c U t i l i t y I n d u s tr y," A ccounting Review, XL (Ja n u a ry, 1965), pp. 135-143; J.L. O 'D o n n ell, " F u r th e r O b se rv a tio n on R eported E a rn in g s and S to ck P r i c e s, " A ccounting R eview, X L III (J u ly, 1968), pp. 549-553; F.A. M lynarczyk, J r., "An E m p iric a l Study o f Acc o u n tin g M ethods and S tock P r i c e s, " E m p iric al R ese arch in A c co u n tin g : S e le c te d S tu d ie s 1969, Supplem ent to V ol. 7, J o u rn a l o f A ccounting R e se a rc h, pp. 63-8 1. Q E.L. Summers, " O b se rv a tio n o f E f f e c ts o f U sing A lte r n a t i v e Rep o r tin g P r a c t i c e s, " A ccounting Review, X L III (A p ril 19 6 8 ), pp. 257-265.
4 was signed* w h ile u nder th e new method incom e would o n ly be re c o g n iz e d when c a sh was c o lle c te d - th e p r ic e o f i t s common s to c k f e l l $12.75 to $24 a s h a r e. This o c c u r re d d e s p ite th e a s s e r t i o n by th e chairm an o f i t s b o a rd t h a t N othing h a s changed in th e o p e r a tio n o f o u r conpany o r in o u r f u tu r e o p p o r tu n i tie s in the f i e l d o f e d u c a tio n."^ In s ta n c e s l i k e t h i s p ro v id e s i g n i f i c a n t su p p o rt f o r th e "n a iv e in v e s t o r " th e o ry. In a d d itio n to th e re s e a rc h d is c u s s e d above, th r e e o th e r r e p o rte d s t u d i e s have been concerned w ith th e e f f e c t of a l t e r n a t i v e a c c o u n tin g m ethods on s to c k p r ic e s. However, th e r e s u l t s o f th e s e s tu d ie s w ere in c o n c lu s iv e and th e e m p ir ic a l fin d in g s o f each o f them co u ld be used to s u p p o rt e i t h e r th e o ry ev en though th e a u th o rs chose to i n t e r p r e t them in f a v o r o f one o r th e o t h e r. ^ I t sh o u ld be in d ic a te d th a t even i f f i n a n c i a l m a rk e ts a r e " e f f i c i e n t, " a c c o u n tin g a l t e r n a t i v e s may h av e an e f f e c t upon s to c k p r i c e s i f th e m ethods a d o p ted a r e n o t d is c lo s e d o r i f s u f f i c i e n t in fo rm a tio n i s n o t made p u b lic ly a v a i l a b l e to a d j u s t re p o rte d am ounts fo r d i f f e r e n t a c c o u n tin g m ethods. Hence, we s e e t h a t a lth o u g h th e e m p iric a l t e s t s o f th e com peting th e o r ie s have b e e n mixed and in c o n c lu s iv e, th e r e ^ T h e W all S t r e e t J o u r n a l, F e b ru a ry 2, 1970, p. 10. ^ N. J. G onedes, "The S ig n if ic a n c e o f S e le c te d A ccounting P ro c e d u re s: A S t a t i s t i c a l T e s t," E m p iric a l R esearch in A c c o u n tin g : S e l e c te d S tu d ie s 1969, Supplem ent to V ol. 7, J o u rn a l o f A ccounting R e s e a rc h, pp, 10-113; T.R. A rc h ib a ld, oj>. c i t., pp. 2 2-3 0 ; W.H. B eaver and R.E. Dukes, " in t e r p e r i o d Tax A l l o c a t io n, E a rn in g s E x p e c ta tio n s, and th e B eh av io r o f S e c u r ity P r i c e s, " A cco u n tin g R eview, XLV1I (A p ril 1 9 7 2 ), pp. 320-332.
5 I s c o n s id e r a b le s u p p o rt f o r th e p o s i t i o n t h a t a l t e r n a t i v e p ro c e d u re s do have a n e f f e c t. F u r th e r, th e f u r o r w ith in th e f i n a n c i a l conn u n ity and th e r e c e n t a c ti o n s o f th e AICPA (th e Wheat com m ittee stu d y and th e r e s u l t a n t e s ta b lis h m e n t o f th e F in a n c ia l A cco u n tin g S ta n d a rd s 12 Board) make i t o b v io u s t h a t a l a r g e segm ent of t h a t community bel i e v e s t h a t r e p o r tin g a l t e r n a t i v e s have an e f f e c t upon re p o r t u s e r s, and t h a t th e e x is ta n c e o f th e s e a l t e r n a t i v e s i s a m a tte r o f g r e a t conc e rn. The argum ent c o n c e rn in g r e p o r tin g a l t e r n a t i v e s and th e d e s i r a b i l i t y o f in c re a s e d c o m p a ra b ility betw een c o r p o r a te f i n a n c i a l r e p o r ts h a s ra g e d fo r a long tim e. 13 Some a rg u e f o r in c r e a s in g c o m p a ra b ility by s i g n i f i c a n t l y re d u c in g (o r even e lim in a tin g ) th e r e p o r tin g a l t e r n a t i v e s a v a i l a b l e to m anagem ent. Some s u g g e s tio n s in c lu d e (a) s p e c if y - 14 v in g c irc u m sta n c e s when a l t e r n a t i v e s can be a d o p te d, (b) h a v in g th e in d e p e n d e n t a u d ito r d e te rm in e th e a c c o u n tin g p r i n c i p l e s to be f o l l o w e d,^ o r (c ) h a v in g th e f e d e r a l governm ent, th ro u g h th e SEC, n o t s a n c tio n a l t e r n a t i v e s by d e s ig n a tin g o n ly one a c c e p ta b le m ethod w here a l t e r n a t i v e s 12 R eport o f th e Study on E sta b lish m e n t o f A ccounting P r i n c i p l e s, E s ta b lis h in g F in a n c ia l A ccounting S ta n d a rd s (New Y ork: Am erican I n s t i t u t e o f C e r t i f i e d P u b lic A c c o u n ta n ts, 19 7 2 ). 13 A p r e s e n ta tio n o f th e v a rio u s v ie w p o in ts a p p e a rs in th e v o l ume, "U n ifo rm ity in F in a n c ia l A c c o u n tin g," Law and C ontem porary P roblem s, XXX (Autumn, 1 9 6 5 ). 14 T.F. K e lle r, "U n ifo rm ity V ersus F l e x i b i l i t y : A Review o f th e R h e t o r ic," in " U n ifo rm ity in F in a n c ia l A c c o u n tin g," I b i d., p. 650. ^ C.E. Jo h n so n, "Management and A ccounting P r i n c i p l e s, " in "U nifo rm ity in F in a n c ia l A c c o u n tin g," I b i d., p. 703.
6 c u r r e n tly e x i s t. ^ Those p ro p o n e n ts o f f l e x i b i l i t y o f c h o ice among a c c o u n tin g a l t e r n a t i v e s f o r management co n ten d t h a t s in c e econom ic s i t u a t i o n s and managements* p e r c e p tio n s o f th e s e s i t u a t i o n s d i f f e r, s p e c if y in g o n ly one p e r m is s ib le m ethod w i l l n o t in s u r e c o m p a ra b ility - d i f f e r e n t s i t u a tio n s r e q u ir e d i f f e r e n t a c c o u n tin g m ethods. Pow ell g iv e s an example o f two firm s in th e same in d u s tr y t h a t each buy a new f a c t o r y and becau se o f d i f f e r e n t management a t t i t u d e s tow ards th e f u tu r e u t i l i t y of th e in v e stm e n t, he a rg u e s t h a t each management sh o u ld p ro p e r ly adopt a d i f f e r e n t d e p r e c ia tio n method.he th e n goes on to s t a t e th a t a g r e a t many tim e s in p r a c t i c e th e e f f e c t o f m anagement a t t i t u d e, and o f o th e r c irc u m sta n c e s as w e ll, is n o t so e a s i l y i d e n t i f i a b l e and m e asu ra b le as in th e sim p le exam ple g iv e n. Thus, w h ile i t i s c l e a r t h a t c irc u m sta n c e s do v a ry and t h a t d i f f e r e n t c irc u m sta n c e s c a l l f o r d i f f e r e n t a c c o u n tin g tr e a tm e n ts, i t i s n o t c l e a r how one d is t i n g u i s h e s among c irc u m sta n c e s and ch o o ses among a c c o u n tin g tr e a tm e n ts. What i s a c i r cum stance in w hich a d e p a r tu r e from custom ary p r a c t i c e i s p e r m is s ib le? How much o f a d e p a r tu re i s t o le r a b le? I f th e c irc u m sta n c e i s a l e g a l re q u ire m e n t, su ch as a p r o v is io n o f th e incom e ta x law o r a re q u ire m e n t o f governm ental r e g u la to r y a u t h o r i t y, w hat is th e b e s t way to d e a l w ith i t? U n til th e s e q u e s tio n s and o th e r s l i k e them can be answ ered s a t i s f a c t o r i l y, i t seems im prudent to h o ld o u t th e hope t h a t v a r i a t i o n s in a c c o u n tin g tre a tm e n t can be g e a re d e x c lu s iv e ly o r la r g e ly to d i f fe re n c e s in c irc u m s ta n c e s. I t may be th a t in th e c o u rse o f tim e a co n sen su s w i l l be re a ch e d on th e s e m a tte r s, b u t i t i s d o u b tfu l t h a t t h i s w i l l come about i n th e ^ J. F. F o te n o s, "A cco u n tin g f o r B u sin ess C o m b in atio n s: A C r itiq u e o f APB O pinion Number 16,'* S ta n fo rd Law Review, 23 (J a n u a ry, 1971), pp. 330-348. 17W. P o w ell, " P u ttin g U n ifo rm ity i n F in a n c ia l A cco u n tin g I n to P e r s p e c t i v e," in "U n ifo rm ity i n F in a n c ia l A c co u n tin g," o p. c i t., p. 681.
7 *. 18 n e a r f u t u r e. To f u r t h e r d evelop th e c a se f o r r e t e n t i o n o f m a n a g e ria l d i s c r e t i o n in th e a p p l i c a t i o n o f a c c o u n tin g p ro c e d u re s, Pow ell i n d i c a t e s t h a t i n o u r dynam ic economy th e l a r g e number o f new b u s in e s s d e v e lo p - 19 m ents r e q u ir e s e x p e rim e n ta tio n w ith no v el r e p o r tin g tr e a tm e n ts. He h o ld s t h a t th e developm ent o f p ro p e r a c c o u n tin g m ethods r e q u ir e s th a t management have th e freedom to e x p e rim e n t. H ence, we se e P o w ell a rg u in g t h a t n o t o n ly m ust a l t e r n a t i v e a c c o u n tin g tre a tm e n ts be a v a i l a b le to be chosen by m anagement, b u t he does n o t even e n v is io n t h a t th e s p e c i f i c a t i o n o f c irc u m sta n c e s when a l t e r n a t i v e s can be ad o p ted i s a p r e s e n tly f e a s i b l e s o l u t i o n. He co n ten d s t h a t management m ust be f r e e to choose among a c c o u n tin g a l t e r n a t i v e s. Many who arg u e a g a in s t r e t a i n i n g m a n a g e ria l f l e x i b i l i t y in th e c h o ic e o f a c c o u n tin g m ethods c o n ten d t h a t even i f management c o u ld i d e n t i f y th e p ro p e r m ethod to u s e in a p a r t i c u l a r in s ta n c e, they do u b t w h eth er th e q u e s tio n o f w hich is th e p ro p e r m ethod would be cons id e r e d. These opp o n en ts o f m a n a g e ria l d i s c r e t i o n f e a r th a t th e 20 freedom to choose p e rm its th e i n tr o d u c tio n o f management b i a s. C h a rle s E. Jo h n so n, making r e f e r e n c e to a s p e c i a l d e c is io n when 18 I b i d. 19I b i d., p. 685. 20 E.S. H e n d rlk sen, A cco u n tin g T h eo ry, r e v is e d e d itio n (Homewood, I l l i n o i s : R ich ard D. Ir w in, I n c., 1 9 7 0 ), p. 110.
8 considering Che general area of management choice among accounting methods, has stated, "if you can imagine that, in wrestling with the choice of depreciation methods the minds of those involved in the decision were ever troubled by the question of which approach resulted in th e f a i r e r p r e s e n ta tio n o f perform ance, you have a more l i v e l y 21 im a g in a tio n th a n have I. " The argum ent - th a t d i f f e r e n t economic c irc u m sta n c e s, management a t t i t u d e s, and changing economic s i t u a t i o n s r e q u ir e d i f f e r e n t a cc o u n t in g methods (and e x p e rim e n ta tio n w ith new m ethods) and th a t management i s in the b e s t p o s itio n to d eterm in e th e a p p ro p ria te method - is i n e f f e c tiv e i f, in f a c t, management has used i t s d is c r e ti o n in th e p a s t in a b ia se d m anner. W hile th e c o n te n tio n of b ia s has fr e q u e n tly been made by th e opponents o f m an ag erial f l e x i b i l i t y in th e ch o ice among a cc o u n t ing a l t e r n a t i v e s, th e r e has been l i t t l e e m p iric a l e f f o r t devoted to th e q u e stio n. A ll o f th e re c e n t e m p iric a l work r e l a t e d to m an ag erial b ia s when s e le c tin g r e p o r tin g a l t e r n a t i v e s was i n i t i a t e d in o rd e r to t e s t the in come ''sm oothing" h y p o th e sis ( t h a t management d e s ir e s to m inim ize v a r i a tio n s in re p o rte d incom e). Some o f th e s tu d ie s co n sid e re d changes in a cco u n tin g p o lic y a s a means o f in v e s t ig a ti n g th e h y p o th e s is. While 21 C.E. Johnson, "M anagem ent's R ole In E x te rn a l A ccounting Mea su re m e n ts," in R esearch in A ccounting M easurem ent, e d ite d by R.K. J a e d ic k e, Y. I j i r i and 0. N ie lse n (American A ccounting A s s o c ia tio n, 1966), p. 91.
9 n o t f in d in g s i g n i f i c a n t su p p o rt fo r th e h y p o th e s is, th e s e s t u d i e s have d i s c l o s e d a s tro n g ten d en cy fo r a c c o u n tin g p o lic y changes to r e s u l t in 22 h ig h e r re p o rte d incom e. I f th e problem i s sim p ly one o f management b ia s when changing m ethods, th e problem c a n be m inim ized by r e s t r i c t i o n s on m anagem ent's d i s c r e t i o n to change, as th e A ccounting P r i n c i p le s 23 Board h a s a tte m p te d in O pinion 20. However, i f u n d e rly in g b ia s in th e i n i t i a l c h o ice o f m ethods i s, in f a c t, a s i g n i f i c a n t problem, th e n much m ore d r a s t i c a c t i o n would be r e q u ir e d ( e. g., s p e c if y in g circum s ta n c e s which j u s t i f y e v ery a l t e r n a t i v e a c c o u n tin g m ethod, o r e lim in a t in g a l t e r n a t i v e s c o m p le te ly, o r h a v in g someone o th e r th a n management d e c id in g which a l t e r n a t i v e i s a p p r o p r i a t e ). In o rd e r to d is c e r n w h eth er su ch f a r re a c h in g a c t i o n is r e q u ir e d, s t u d i e s co n cern ed w ith th e e x i s t en ce o f m a n ag e ria l b ia s in th e i n i t i a l c h o ic e among a c c o u n tin g a l t e r n a t i v e s m ust be c o n s id e re d. Smoothing h y p o th e s is s tu d ie s u t i l i z i n g a c c o u n tin g p o lic y adopt i o n s ( r a t h e r th a n ch an g es) as th e means o f i n v e s t i g a t i o n have produced m ixed r e s u l t s. Some o f th e s tu d ie s found no s i g n i f i c a n t e v id e n c e to 22 See B.E. C u sh in g, "An E m p iric a l Study of Changes in A ccounting P o l i c y," Jo u rn a l o f A cco u n tin g R e se a rc h, 7 (Autumn, 1969), pp. 196-203; P. F r is h k o f f, "Some R ecen t Trends in A cco u n tin g C h an g es," J o u rn a l o f A c co u n tin g R ese arch, 8 (S p rin g, 1970), p p. 141-144; and G.E. W hite, " D is c r e tio n a r y A cco u n tin g D e c isio n s and Income N o rm a liz a tio n," J o u rn a l o f A cco u n tin g R e se a rc h, 8 (Autumn, 1 9 7 0 ), pp. 260-273. 23 A ccounting P r i n c i p l e s Board o f th e Am erican I n s t i t u t e o f C ert i f i e d P u b lic A c c o u n ta n ts, O pinion No. 20, "A ccounting C h an g es," ( J u ly, 1 9 7 1 ).
10 24 su p p o rt th e h y p o th e s is, w h ile a n o th e r d is c lo s e d only m oderate su p - 25 26 p o rt and one d is c lo s e d s i g n i f i c a n t s u p p o rt. I t sh o u ld be noted th a t in two o f th e s e s tu d ie s (one th a t d is c lo s e d no su p p o rt fo r th e h y p o th e s is and th e one th a t d is c lo s e d s i g n i f i c a n t su p p o rt) m anagem ent's c h o ic e among a l t e r n a t i v e methods was n o t c o n sid e re d, b u t sm oothing was In v e s tig a te d w ith re s p e c t to a c e r ta in s e t o f p ro ced u res f o r firm s th a t ad o p ted th e s e p ro c e d u re s. F u rth e r, in th e stu d y th a t produced s i g n i f i c a n t s u p p o rt, sm oothing was l i k e l y due to r e a l t r a n s a c tio n s, fo r exam ple, e x p e n d itu re s fo r re s e a rc h and developm ent, r a th e r th an to manag em e n t's choosing among a l t e r n a t i v e a cc o u n tin g p ro c e d u re s. In a d d itio n to th e s tu d ie s r e f e r r e d to above, two r e l a t e d I n v e s tig a tio n s co n cern in g th e a l t e r n a t i v e methods o f a cc o u n tin g fo r b u sin e ss com binations unco v ered no ev id en ce o f sm oothing b u t d is c lo s e d th a t th e "p u rch ase" v e rs u s " p o o lin g - o f - in te r e s t" ch o ice app eared to be a f f e c te d by manage- 27 m e n t's d e s ir e to maximize re p o rte d income in t h i s s p e c ia l case. 24 M.J. Gordon, B.N. H orw itz and P.T. M eyers, "A ccounting M easurem ents and Normal Growth o f th e F irm," in R esearch in A ccounting M easurem ent, o p. c i t., pp. 221-231; and R.M. Copeland and R.D. L ic a s tr o, "A N ote on Income Sm oothing," A ccounting Review, X LIII (J u ly, 1968), pp. 540-545; N. Dopuch and D.F. D rake, "The E ffe c t o f A lte r n a tiv e A ccounting R ules f o r N onsubsidiary In v e s tm e n ts," E m p irical R esearch in A cco u n tin g : S e le c te d S tu d ie s 1966, Supplement to V ol. 5. Jo u rn a l o f A ccounting Res e a r c h, pp. 192-219. 25 R.M. B a r e f ie ld and E.E. Comisky, "The Smoothing H ypothesis: An A lte r n a tiv e T e s t," A ccounting Review, XLVII (A p ril 1972), pp. 291-298. 26 P.E. D ascher and R.E. Malcom, "A Note on Income Smoothing in th e C hem ical I n d u s tr y," J o u rn a l o f A ccounting R esearch, 8 (Autumn, 1970), pp. 253-259. 27 R.M. Copeland and J.F. Wojdak, "Income M an ip u latio n and th e P u r c h a se -P o o lin g C h o ice," J o u rn a l o f A ccounting R esearch, 7 (Autumn 1969), pp. 188-195; and J. Gagnon, "The P u rch a se-p o o lin g C hoice: Some E m piric a l E v id en ce," J o u rn a l of A ccounting R esearch, 9 (S p rin g 1971), pp. 52-72.
11 G iven th e n a tu re o f th e f in d in g s d is c u s s e d above, th e e x is te n c e o f management b ia s tow ards income sm oothing when ch o o sin g among a c c o u n tin g a l t e r n a t i v e s Is s t i l l in d o u b t. A d d itio n a l r e s e a r c h r e g a rd in g sm oothing i s needed. F u r th e r, w ith r e s p e c t to th e g e n e r a l a r e a o f management b ia s when i n i t i a l l y s e l e c t i n g a c c o u n tin g p ro ced u res* r e s e a rc h beyond th e income sm oothing realm i s r e q u ir e d. F or th e new ly e s ta b lis h e d F in a n c ia l A ccounting S ta n d a rd s Board to make in fo rm ed d e c is io n s c o n c e rn in g th e c r u c i a l to p ic o f a c c o u n tin g a l t e r n a t i v e s ( c r u c i a l b ecau se o f th e s i g n i f i c a n t changes su g g e ste d by th e o p p o n e n ts o f m an ag erial f l e x i b i l i t y ) e m p iric a l r e s e a rc h m ust be conducted in to a number o f p o t e n t i a l a re a s o f b ia s in o rd e r to d is c e r n th e e x te n t o f th e problem. The r e s e a r c h d e s c rib e d in t h i s p a p e r is one such e f f o r t. I t I n v e s t i g a t e s w h eth er management b ia s in cho o sin g a c c o u n tin g p ro c e d u re s e x i s t s in a p a r t i c u l a r in s ta n c e w here th e r e i s c o n f l i c t betw een m an ag ers' and s h a r e h o ld e r s ' i n t e r e s t s. The p ap er is o rg a n iz e d i n th e fo llo w in g m anner. In C h ap ter I I we c o n s id e r th e v a rio u s f a c t o r s t h a t m ig h t a f f e c t management and s h a re h o ld e r d iv id e n d p ay o u t p r e f e r e n c e s. We co n clu d e th a t t h e i r p re f e r e n c e s a r e c o n s i s t e n t in c e r t a i n in s ta n c e s and in conf l i c t in o t h e r s. The im p lic a tio n o f t h e i r payout p r e f e r e n c e s on m anagem ents' a c c o u n tin g p o lic y d e c is io n s is c o n s id e re d in C h ap ter I I I and a t e s t a b l e h y p o th e sis i s d e r iv e d. R esearch m ethodology i s d is c u s s e d in C h a p te rs IV and V and th e r e s u l t s o f th e r e s e a rc h a r e p re s e n te d In C h ap ter V I. C h apter V II i s d e v o ted to a summary and c o n c lu s io n s.
CHAPTER II MANAGEMENT AND SHAREHOLDER DIVIDEND PREFERENCES Area o f P o te n tia l C o n f lic t The s e p a ra tio n o f ow nership from management in the la rg e American c o rp o ra tio n i s a phenomenon w hich has been e v id e n t fo r many y e a r s. Awareness o f th e p a r t i t i o n and i t s p o te n tia l im p lic a tio n s were i n i t i a l l y su g g e ste d by B e rle and Means in 1932.* R e c e n tly, th e tre n d tow ard 2 in c re a s e d s e p a ra tio n was e m p iric a lly In v e s tig a te d and confirm ed. With management having c o n tr o l o f a s s e t s and being s e p a ra te d from th e le g a l ow ners, th e s e owners become a p a rt o f th e e x te r n a l environm ent w ith w hich th e managers m ust d e a l. A ll o f th is has s i g n i f i c a n t im p lic a tio n s co n cern in g m anagem ent's r e l a t i o n s h i p w ith i t s s to c k h o ld e rs. L et us c o n s id e r the e f f e c t t h i s has on one o f m anagem ent's d e c is io n s in i t s d e a lin g s w ith i t s s to c k h o ld e rs - i t s d iv id en d p o lic y. A dvantage of I n te r n a l F in an cin g from M anagerial V iew point Assuming Independence o f In v estm en t and F in an cin g D ecisio n s I f c a p i t a l b u d g e tin g d e c is io n s a re made in d e p en d e n tly o f fin a n c in g d e c is io n s, th en, fo r a fix e d amount o f re q u ire d fu n d s, management must *A.A. B erle and G.C. Means, The Modern C o rp o ra tio n and P r iv a te P ro p e rty (New York: The M acm illan Company, 1932). 2 R.J. L a m e r, "O w nership and C o n tro l in th e 200 L a rg e st N onfinanc i a l C o rp o ra tio n s, 1929 and 1963," American Economic Review, LVI (Septem ber, 1966), pp. 777-787. 12
13 choose betw een i n t e r n a l fin a n c in g ( r e ta in e d e a rn in g s p lu s ex p en ses w hich do n o t r e q u ir e th e u t i l i z a t i o n o f fu n d s) and e x te r n a l f in a n c in g ( s a le o f a d d i t i o n a l s to c k, bonds, and lo n g -te rm lo a n s ). I n s ig h t in to m a n a g e ria l p re fe re n c e w ith r e s p e c t to t h i s c h o ic e can be g a in e d by exam ining some o f th e l i t e r a t u r e r e l a t i n g to th e b e h a v io r a l th e o ry o f o r g a n i z a t i o n s. 3 C y e rt and March su g g e s t t h a t one o f th e m ost s i g n i f i c a n t p ro b lems c o n fro n tin g th e management o f any o r g a n iz a tio n i s th e n e c e s s ity to d e a l w ith u n c e r ta in t y. S u b s t a n t i a l m a n a g e ria l e f f o r t i s d e v o ted to e lim in a tin g o r m in im izin g as much u n c ei *>inty a s p o s s i b l e. Thompson c o n c e iv e s " o f complex o r g a n iz a tio n s a s open sy ste m s, hence in d e te rm in a te and fa c e d w ith u n c e r t a i n t y, b u t a t th e same tim e as s u b je c t to c r i - 4 t e r i a o f r a t i o n a l i t y and hence n e e d in g d e te rm in a te n e s s and c e r t a i n t y. " One o f th e m ajor s o u rc e s o f u n c e r ta in ty a r i s e s from m anagem ent's dependence upon an u n c o n tr o lla b le e n v iro n m en t. Thompson o b s e rv e s th a t " i f b o th r e s o u r c e - a c q u i s i t i o n and o u tp u t- d is p o s a l problem s - w hich a r e i n p a r t c o n tr o lle d by e n v iro n m e n ta l e lem en ts and hence to a d e g re e unc e r t a i n o r p ro b le m a tic - can be removed from th e te c h n i c a l c o r e, th e l o g i c can b e b ro u g h t c l o s e r to c lo s u r e, and th e r a t i o n a l i t y in c re a s e d." '* 3 R.M. C y ert and J.G. M arch, A B e h a v io ra l Theory o f th e F irm, (Englewood C l i f f s, New J e r s e y : P r e n t i c e - H a l l, I n c., 1 9 6 3 ). 4 J.D. Thompson, O rg a n iz a tio n s in A c tio n (New Y ork: M cg raw -H ill, I n c., 1 9 6 7 ), p. 10. 5I b i d., pp. 1 1-1 2.
14 T his le a d s him to th e p r o p o s itio n t h a t "u n d er norms o f r a t i o n a l i t y, o r g a n iz a tio n s se e k to s e a l o f f t h e i r c o re te c h n o lo g ie s from en v iro n m e n ta l i n f l u e n c e s. These n o rm a tiv e a s s e r t i o n s a r e v e ry r e le v a n t to m anagem ent s fin a n c in g d e c is io n. One o f Lhe re s o u r c e s which management a c q u ir e s from i t s en v ironm ent i s th e funds r e q u ir e d to fin a n c e i t s o p e r a tio n s. I f management makes no a tte m p t to m in im ize i t s r e l i a n c e upon e x te r n a l fin a n c e m a rk e ts, th e n i t is s u b je c t to th e u n c e r t a i n t i e s of an uncont r o l l a b l e e n v iro n m e n ta l e lem en t. Thompson a ls o i n d i c a t e s th a t "dependence [upon e x te r n a l s o u rc e s] in tr o d u c e s c o n s t r a i n t s o r c o n tin g e n c ie s." 7 F o r exam ple, bonds o r o th e r lo n g -te rm lo a n s may r e q u ir e in d e n tu re a g r e e m ents w hich r e s t r i c t m anagem ent's a c t i v i t i e s in th e f u t u r e o r i f f i n a n c in g becomes d i f f i c u l t to o b ta in, c o r p o r a te p la n s may have to be a l t e r e d. F u r th e r, r e s o r t i n g to e x te r n a l so u rc e s r e s u l t s in m anagem ent's perfo rm an ce b e in g s u b je c t to rev iew by in c re a s e d num bers, and b e ca u se o f th e dep en d en t r e l a t i o n s h i p, management i s u nder p r e s s u r e to s a t i s f y t h i s rev iew. These u n c e r t a i n t i e s and c o n s t r a i n t s can be re d u ced by managem e n t's m in im izin g i t s r e lia n c e upon e x te r n a l fin a n c in g s o u rc e s. I t can acco m p lish t h i s by in c re a s e d u t i l i z a t i o n o f i n t e r n a l so u rc e s - by r e ta i n i n g c o rp o ra te e a rn in g s r a th e r th a n d i s t r i b u t i n g them to s h a r e h o ld e r s. Thom pson's th e o ry s u g g e s ts t h a t t h i s i s th e a l t e r n a t i v e th a t w i l l be 6 I b i d., p. 19, 7I b i d., p. 32.
15 c h o sen. However, he i s a l s o aw are t h a t w h ile " b u f f e r in g of an u n ste a d y environm ent o b v io u s ly b r in g s c o n s id e ra b le a d v a n ta g e s to th e te c h n i c a l 8 c o re,... i t does so w ith c o s ts to th e o r g a n i z a t i o n." The c o s t o f m in im izin g d iv id e n d s p a id o u t to s h a r e h o ld e rs r e s u l t s from in c u r r in g th e w ra th o f th e s h a r e h o ld e rs i f th e y a r e n o t s a t i s f i e d w ith th e f i r m s d iv id e n d p o lic y. Management, th e r e f o r e, w i l l m inim ize d iv id e n d p ay o u t to th e e x te n t i t can w ith o u t c a u sin g e x c e s s iv e s to c k h o ld e r d i s s a t i s f a c ti o n. Assuming In v estm en t D e c isio n i s D ependent Upon D ividend D e c isio n In th e p re v io u s s e c tio n, i t was assum ed t h a t in v e stm en t d e c is io n s w ere in d e p en d e n t o f d iv id e n d p o lic y. However, p o s s ib ly b ecau se o f mana g e r i a l r e lu c ta n c e to r e s o r t to e x te r n a l c a p i t a l m ark ets o r f o r o th e r re a s o n s, th e r e h as been some e v id e n c e th a t th e r e i s a t r a d e - o f f betw een 9 cash d iv id e n d s and In v e stm e n t o u tla y s. In th o s e in s ta n c e s w here th e t r a d e - o f f e x i s t s, management m ust choose betw een (a ) r e t a i n i n g funds d e riv e d i n t e r n a l l y in o rd e r to in v e s t in a d d i t i o n a l c a p i t a l equipm ent, and (b) r e lin q u is h in g th e fu n d s to t h e i r s h a r e h o ld e rs in th e form o f cash d iv id e n d s. Much o f th e r e c e n t l i t e r a t u r e r e l a t i n g to m a n a g e ria l o b je c t iv e s 8 I b i d., pp. 20-2 1. 9 P.J. Dhrymes and M. K urz, " In v e stm e n t, D ividend and E x te rn a l Finance B eh av io r o f F irm s," C o n feren ce on In v e stm en t B ehavior (New York: N a tio n a l Bureau o f Economic R e se a rc h, June 1 0-1 2, 1965).
16 r e f e r s to p erfo rm an ce g o a ls such a s s a le s m ax im iz atio n, s h a r e o f th e m a rk e t, and grow th r a t e In a s s e t s o r s a l e s. ^ A ll o f th e s e o b je c t iv e s r e q u ir e a d d i t i o n a l in v e s tm e n ts. I f th e r e i s a t r a d e - o f f betw een d i v i dends and in v e stm e n t e x p e n d itu re s and i f m anagem ent's o b je c t iv e s r e q u ir e v e ry la r g e c a p i t a l o u tla y s, th e n i t i s to m anagem ent's a d v a n ta g e to m inim ize i t s d iv id e n d p a y o u t. We a r e le d to th e same c o n c lu s io n s a s in th e p r i o r s e c tio n, t h a t management w i l l m inim ize d iv id e n d p a y o u t to th e e x te n t i t can w ith o u t c a u sin g e x c e s s iv e s to c k h o ld e r d i s s a t i s f a c t i o n. R e lu c ta n c e to Reduce D iv id en d s In a d e t a i l e d stu d y o f c o r p o r a te d iv id e n d p o lic y, L in tn e r id e n t i f i e d a g r e a t r e lu c ta n c e on th e p a r t of management to re d u ce d iv id e n d s below w hat was p a id in th e p re v io u s y e a r." ^ Management w ish es to av o id s i t u a t i o n s w here d iv id e n d s m ust be red u ced b e c a u se " s to c k h o ld e r re a c ti o n s in such s i t u a t i o n s have been s u f f i c i e n t l y v ig o ro u s and e f f e c t i v e in enough com panies t h a t th e f e a r o f such a r e a c t i o n i s an e f f e c t i v e 'b u r r u n d er th e saddle* to a l l m anagem ents, in c lu d in g th o se w hich have 12 n e v er b een in such d i f f i c u l t y th e m s e lv e s." C o n se q u e n tly, i f management ^ F o r exam ple, se e W.J. Baumol, B u sin e ss B e h a v io r, V alue and G row th, R ev ised E d itio n (New York: H a rc o u rt, B race & W orld, I n c., 19 6 7 ). ^ J. L in tn e r, " D is t r ib u tio n o f Incomes o f C o rp o ra tio n s Among D iv id e n d s, R e ta in e d E a rn in g s, and T a x e s," A m erican Economic R eview, XLVI (May, 1956), pp. 97-113. 1 2 I b i d., p. 1 0 1.
17 i s r e l u c t a n t to red u ce d iv id e n d s, th e n In y e a rs when th e amount o f In t e r n a l l y g e n e ra te d fu n d s d e c lin e s, a l l (o r a m ajor p a r t ) o f th e d e c lin e w i l l be b o rn e by th e management group (a r e d u c tio n In funds r e t a i n e d ). I f d iv id e n d payout i s h ig h, then a s l i g h t d e c lin e in I n t e r n a l l y g e n e r a te d funds can e lim in a te a s i g n i f i c a n t p o r ti o n o f m anagem ent's s h a r e o f th e s e fu n d s - th e re b y c a u s in g management to p la c e g r e a te r r e l i a n c e on e x te r n a l c a p i t a l m ark ets a n d /o r to c u r t a i l in v e stm en t a c t i v i t i e s. To c u sh io n I t s e l f a g a in s t such a c o n tin g e n c y, i t I s to m anagem ent's advanta g e to m inim ize th e amount o f d iv id e n d s d is b u r s e d. R e la te d L i t e r a t u r e The p re v io u s d is c u s s io n has a tte m p te d to r e l a t e some o f th e norma t i v e and e m p iric a l f in d in g s in econom ics and o r g a n iz a ti o n a l th e o ry to m anagem ent's d iv id e n d d e c is io n. T h is ap p ro a ch h as been ta k e n by o t h e r s. W alter s t a t e s th a t " b a s ic to o u r th in k in g i s th e Image o f a r a t i o n a l and s e l f - i n t e r e s t - s e e k i n g management o p e r a tin g in an u n c e r ta in w o rld." He goes on to say t h a t i t w ould be " s u r p r i s i n g i f management d id n o t ta k e a c c o u n t o f i t s own p re f e r e n c e s ( u n le s s fo rc e d to do o th e rw is e by th e p r e s s u r e o f c ir c u m s ta n c e s )." 13 However, W alter made no rig o r o u s a tte m p t to co n firm h i s s ta te m e n ts. The m ost com prehensive stu d y o f m a n a g e ria l d i s c r e t i o n in th e 13 J.E. W alter, D iv id en d P o lic y and E n te r p r is e V a lu a tio n (B elm ont, C a l if o r n ia : W adsworth P u b lis h in g Company, I n c., 1967), p. 19.
14 la r g e firm was co n d u cted by tfillia m s o n. He was co ncerned w ith th e e n t i r e a re a o f m a n ag e ria l d i s c r e t i o n and n o t J u s t w ith i t s e f f e c t on th e d iv id e n d d e c is io n. However, one o f h is e m p iric a l t e s t s r e l a t e d to t h i s d e c is io n. E m p iric a l C o n firm atio n In an a tte m p t to g e t a m easure o f c o rp o ra te m anagem ent s a t t i t u d e tow ards o u ts id e I n f lu e n c e, W illiam son used I n t e r n a l r e p r e s e n ta tio n on th e board o f d i r e c t o r s as a s u rro g a te fo r t h i s a t t i t u d e. "As th e p ro p o r ti o n a l r e p r e s e n ta tio n o f management on th e board I n c r e a s e s, i t i s assum ed t h a t s to c k h o ld e r i n t e r e s t s tend to be s u b o rd in a te d to m an ag erial o b j e c t i v e s. One o f th e t e s t s he perform ed was to com pare th e r e l a tio n s h ip betw een e a r n in g s - r e t e n t i o n p o lic y and co m p o sitio n o f th e b o a rd. I f management p r e f e r s to m inim ize d iv id e n d p a y o u t, th e n one would ex p ect t h a t " th e e a r n in g s - r e t e n t i o n r a t i o be d i r e c t l y r e l a t e d to th e co m p o sitio n o f th e b o a rd. T his fo llo w s s in c e r e ta in e d e a rn in g s a r e a s o u rc e o f d i s c r e t i o n and a h ig h i n t e r n a l r e p r e s e n ta tio n p ro v id e s th e o p p o rtu n ity f o r management to s h i f t th e d iv id e n d p o lic y to i t s a d v a n ta g e. 14 O.E. W illiam son, The Economics of D is c r e tio n a r y B e h a v io r: Manag e r i a l O b je c tiv e s in a_ Theory of th e Firm (Englewood C l i f f s, New J e r sey : P r e n t i c e - h a l l, I n c., 1 964); p a r t i a l l y rep ro d u ced as "M anagerial D is c r e tio n and B u sin ess B e h a v io r," Am erican Economic Review, L I I I (Decem ber, 19 6 3 ), pp. 1032-1057. ^ I b l d., A m erican Economic Review, p. 1047.
To e lim in a te in d u s tr y e f f e c t s, W illiam son ch o se two firm s (th e two l a r g e s t a s m easured by 1957 s a l e s ) from each o f tw e n ty - s ix m ajor" I n d u s t r i e s. For each p a i r of fir m s, he compared th e e a r n i n g s - r e t e n tio n r a t i o to th e c o m p o sitio n o f th e b o ard r a t i o in th r e e d i f f e r e n t y e a rs (1953, 1957, 1 9 6 1 ). I f th e r e w ere no m a n a g e ria l p r e f e r e n c e f o r low d iv id e n d s, th e n one w ould ex p ec t to f in d h ig h r e t e n t i o n r e l a t e d to high m a n a g e ria l r e p r e s e n t a t i o n f i f t y p e r c e n t o f th e tim e. However, f o r th e 77 o b s e r v a tio n s ( th e r e w ere o n ly 25 in 1953), t h i s r e l a t i o n s h i p was p r e s e n t 62 p e rc e n t of th e tim e. (T h is i s s i g n i f i c a n t a t th e two p e r c e n t l e v e l ). W illia m s o n 's d a ta s u p p o rt th e h y p o th e sis o f m a n a g e ria l p r e f e r e n c e f o r low d iv id e n d p a y o u t. S to c k h o ld e r P re fe re n c e C oncerning D iv id en d s How l e t us d i r e c t o u r a t t e n t i o n to th e s to c k h o ld e r. How does th e m a n a g e ria l p r e f e r e n c e to m inim ize d iv id e n d payout r e l a t e to s to c k h o ld e r d e s ir e s? I s a low d iv id e n d p a y o u t p o lic y c o n s i s t e n t w ith s to c k h o ld e r p r e f e r e n c e o r i n c o n f l i c t w ith i t? Would th e s to c k h o ld e r p re f e r d e c re a se d c u r r e n t d iv id e n d s in exchange f o r In c re a s e d s h a r e v a lu e s a n d /o r h ig h e r d iv id e n d s i n l a t e r p e rio d s? To answ er th e s e q u e s tio n s, we m ust exam ine th e v a rio u s f a c t o r s w hich m ight a f f e c t s to c k h o ld e r p re f e r e n c e s. They a re : 1. D i f f e r e n t i a l ta x tre a tm e n t o f d iv id e n d s and c a p i t a l g a in s ; 2. U n c e rta in ty - e f f e c t o f p o stp o n in g d iv id e n d on r a t e o f r e t u r n r e q u ire d by s h a r e h o ld e r s ;
20 3. D i f f e r e n t i a l t r a n s a c t i o n c o s t s, to fir m, o f i n t e r n a l and e x te r n a l fin a n c in g ; 4. R e la tio n s h ip betw een r a t e o f r e t u r n firm can e a rn and r a t e o f r e tu r n s to c k h o ld e r can e a rn. D i f f e r e n t i a l Tax T reatm ent o f D iv id en d s and C a p i ta l G ains I f a l l o r a p a r t o f a c o r p o r a t i o n 's e a rn in g s a re r e t a i n e d, one w ould e x p e c t, c e t e r i s p a r ib u s, th e v a lu e o f th e s to c k to be h ig h e r th a n i t would be i f th e s e e a rn in g s w ere p a id o u t. S in ce th e s h a r e h o ld e r r e c e iv e s re m u n e ra tio n f o r h is in v e stm e n t in th e form o f d iv id e n d s and changes in s h a re v a lu e s, s to c k h o ld e r p r e f e r e n c e as to th e form o f r e m u n eratio n w i l l be a f f e c t e d by th e Income ta x la w s. D iv id en d s a re ta x ed as o r d in a r y Income w h ile g a in s r e a l i z e d on th e s a l e o f a s e c u r i ty h e ld fo r a t l e a s t s i x m onths a r e tax ed a t p r e f e r e n t i a l r a t e s. Cons e q u e n tly, th e d i f f e r e n t i a l ta x tre a tm e n t w i l l cau se th e s to c k h o ld e r to p r e f e r lo n g -te rm c a p i t a l g a in s to d iv id e n d s. However, th e m o tiv a tio n a l in f lu e n c e o f th e d i f f e r e n t i a l ta x tre a tm e n t on s to c k h o ld e r d e c is io n s is n o t c l e a r. For exam ple, one re c e n t s tu d y found l i t t l e e v id e n c e o f o p en ly e x p re sse d ta x c o n s c io u s n e ss on th e p a r t o f h ig h -in co m e i n d i v i d u a l s. ^ Only 17 p e r c e n t o f th e h ig h -in co m e in d iv id u a ls q u e s tio n e d s t a t e d t h a t th ey p r e f e r r e d grow th a to c k s (h ig h grow th r a t e in c a p i t a l v a lu e ) to Income s to c k s b e c a u se o f ^ J. N. M organ, R, B arlow, and H.E. B ra z e r, "A Survey o f I n v e s t ment Management and Working B eh av io r Among H igh-incom e I n d i v i d u a l s, " A m erican Economic Review, LV (May, 1965), pp. 252-264.