This paper examines the development of positive accounting theory (PAT) and compares it with three standard accounts of science: Popper (1959), Kuhn (1996), and Lakatos (1970).
PAT has been one of the most influential accounting research programs during the last four decades. One important reason which Watts & Zimmerman (1986) have used to popularize and legitimize their approach is that their view of accounting theory is the same as that used in science. Thus, it is important to examine how far accounting has been successful in imitating natural science and how the development of PAT compares with the three standard accounts of science. This paper shows that accounting could not emulate the success of natural science. Further, the methodological positions of PAT conform to none of the standard accounts of science. Rather, PAT contains elements of all three. Finally, this paper identifies some methodological gaps in PAT. Keywords: Positive Accounting Theory, Philosophy of Science, Methodological Controversies
Acknowledgements
I would like to thank two anonymous reviewers of the journal for their helpful comments. Earlier versions of this paper benefited from comments from Lee Parker of the University of South Australia, Keith Hooper of Auckland University of Technology, Divesh Sharma of Kennesaw State University, and Santi Narayan Ghosh of the University of Dhaka.
Introduction
This paper examines the development of positive accounting theory (PAT) and compares it with three standard accounts of science. There is some confusion about what PAT is. If the definition of accounting theory (i.e., accounting theory seeks to explain and predict accounting and auditing practice) given in Watts and Zimmerman’s 1986 book is taken to mean PAT, studies of accounting choices and auditing practices constitute PAT. At the same time, they also seek to explain the economics-based empirical literature in accounting and they describe, in addition to accounting choice studies, capital market-based accounting research. They point out that Ball and Brown (1968) initially popularized positive research in accounting, suggesting that PAT includes both capital market-based accounting research and research in accounting choices. This paper takes PAT to include both research programs. This usage is consistent with Watts and Zimmerman’s (1986) assertion that when they use the term “positive” to differentiate it from “prescriptive” theory.
The Term Paper on Watts And Zimmerman Accounting Pat Theory
... the light of hindsight. Critical theory and the popularity of PAT. Positive Accounting Theory has been the predominant research paradigm of the 1980's ... that their basis is more of rhetoric than science and that for two researchers who spend so ... 1992), 'The Rhetoric of Science and the Rhetoric of Revolt in the Story of Positive Accounting Theory', Accounting, Auditing and Accountability Journal, ...
Positive Accounting Theory and Science
PAT has been one of the most influential accounting research programs during the last four decades. It has spawned a great deal of empirical research on the association between accounting numbers and stock prices and returns, and determinants of accounting choices by management. It has spawned a number of accounting journals, among which the Journal of Accounting and Economics is the most prominent. Brinn, Jones, and Pendlebury (1996), in a survey of UK academics’ perceptions of journal quality, found that the top four accounting journals are the following: Journal of Accounting and Economics, Journal of Accounting Research, the Accounting Review, and Accounting, Organizations and Society. Articles published in the top three journals are predominantly in the positive tradition. The sheer number of articles in these two paradigms published in major accounting journals and the dominance of PAT in PhD programs in US and other universities testify to the dominant position of PAT. Thus, judged by the number of research articles, the number and dominance of the journals it spawned, and the dominance of PAT in doctoral programs, PAT has been immensely influential.
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The aim of this essay is to compare and contrast the social theories of science as proposed by Merton, Barnes and Feyerabend; and to determine if these theories support the suggestion that science is part of Weber's rationalisation process. In order to achieve this aim, Weber's account of formal rationalisation will be summarised. Additionally, Weber's paradigm case, the structure of modern ...
Before the emergence of PAT, normative accounting research had been the dominant research tradition in accounting. Normative accounting theorists had been preoccupied with developing accounting principles1. The primary concern of these researchers had been recognition and measurement issues in accounting. Typical accounting questions asked and answered by normative accounting theorists include whether to recognize changes in market prices if the entity is not a party to the transaction, what basis (e.g., historical cost, market value, etc.) to use in preparing financial statements, etc. (Chambers, 1966; Ijiri, 1975; Littleton, 1953; MacNeal, 1939; Paton & Littleton, 1940).
In contrast with normative accounting theory which deals with “should” type questions, PAT deals with “is” type questions. Instead of asking which measurement basis to use in accounting, PAT asked, for example, whether accounting information is useful to the stock market, which accounting measurement basis management actually uses, and why.
Thus, PAT represents a major shift in accounting research paradigm. One important comparison to which Watts and Zimmerman (1986) have appealed to legitimize and promote PAT is the sameness of their view of theory and that in science. They have cited various philosophy of science authors to assert that their view of theory is the same as that in science and to justify their method; and to discredit, to a certain extent, normative theory. Thus, given that PAT has been of interest to accounting theorists for around four decades, it is important to examine how far PAT has been successful in imitating natural sciences and what the limits have been. It is also important to revisit the methodological positions of PAT. It would be interesting to see how the development pattern of PAT compares with accounts of science to which Watts and Zimmerman appealed to legitimize and promote their theory. This is because such a comparison will enhance our understanding of how PAT progressed and what methodological gaps remain. PAT has been subject to various criticisms since its emergence.
For example, Chambers (1993) called the advocates of PAT a PA cult. Sterling (1990) criticized PAT on the ground that it restricted itself to the positive study of accounting practice and accounting practitioners and hinders accounting progress by neglecting the need for the assessment of accounting practice. Sterling (1990) further assessed its potential accomplishment as being nil. Whittington (1987) criticized PAT for its methodological intolerance and asserted that normative accounting theory had a legitimate place in accounting. Neu (1997) provided a largely negative appraisal of PAT. Sue (1997) said that PAT narrowed the researchers’ focus. Hall (1997), on the other hand, disagreed with Sterling’s (1990) assessment that the potential contribution of PAT was nil. Deegan (1997) examined how PAT had ignited emotions among academics. It attracted many academics and alienated some at the same time. Milne (2002) judged PAT’s attempt to explain an entity’s social disclosures as failure. However, not many articles compared the development of PAT with different accounts of science in spite of the fact that Watts and Zimmerman appealed to science as a way of promoting their theory. Mouck (1990) is the notable exception.
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He likened PAT to the Lakatosian research program. Others (e.g., Christenson, 1983; Sterling, 1990) criticized PAT for not following the methodological dictates of Popper. However, none of these papers have attempted to compare the development pattern of PAT with Popper (1959), Kuhn (1996), and Lakatos (1970).
This paper attempts to do this. This paper focuses mainly on Watts and Zimmerman’s 1986 book and the empirical accounting literature of accounting choices and capital market-based accounting research. The empirical accounting literature is surveyed to determine how it has developed during the last four decades.
Positive Accounting Theory and Science
This paper discusses three interrelated methodological issues: (a) how PAT progressed over time, (b) the role of counterevidence/anomalies in PAT, and (c) how a theory is to be chosen from among competing theories. These three issues are chosen because, as mentioned above, Popper (1959), Kuhn (1996), and Lakatos (1970) do not give the same account of these issues as they apply to science. The rest of this paper is structured as follows: The next section provides a brief sketch of the development of positive accounting theory, and this sketch serves as the basis for discussion in Sections 3-7. Section 3 discusses the contribution of PAT to accounting practice and Section 4 examines the difficulties of PAT. Sections 5-7 compare the developmental pattern with three standard accounts of the development of science. The last section contains conclusions.
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Development of PAT2
PAT started with examining some assumptions underlying normative accounting prescriptions during the 1960s. Two sets of empirical studies3 were conducted. One set of studies (e.g., Ball & Brown, 1968; Beaver, 1968; Foster, 1977; Beaver, Clarke, & Wright, 1979; Beaver, Lambert, & Morse, 1980; Grant, 1980; McNichols & Manegold, 1983) examined the association between accounting earnings numbers and stock prices. Results indicated that earnings numbers reflected factors (e.g., cash flow and risk) relevant to stock valuation. This, according to Watts and Zimmerman (1986), undermined the claim in normative accounting literature that accounting earnings numbers were meaningless because they were computed using multiple valuation bases. The second set of studies (e.g., Kaplan & Roll, 1972; Sunder, 1973, 1975; Ricks, 1982; Biddle & Lindahl, 1982) attempted to discriminate between two competing hypotheses: the no-effects hypothesis and the mechanistic hypothesis.4 Evidence in these studies is mixed and could not successfully discriminate between the competing hypotheses.
The above sets of studies have used the Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM) as their underlying foundation. Furthermore, it was assumed that contracting costs5 were zero. Overall, these studies raised doubts about the empirical descriptiveness of the following assumptions underlying normative prescriptions during the 1960s: (a) There is only one source of information about a company, (b) earnings numbers are useless because they were not prepared according to a single basis, and (c) it is possible to mislead the stock market by manipulating the earnings number through accounting choices. Information content studies reveal that these assumptions are unlikely to be descriptive of the real world. The EMH implies that there is competition for information. There are alternative sources of information about the firm such as information releases by management and interviews of corporate personnel by analysts.
The Essay on Accounting for Financial Management Answers
However, the firm’s net cash flow is also quite important, especially if one distrusts management and thinks the accounting statements might be misleading. 7-2a. WorldCom understated costs. This had the effect of increasing its reported profits and its net worth. Also, since assets were not reduced by the correct amounts, reported assets were too high. This caused the reported debt ratio ( ...
The observed association between unexpected earnings and abnormal rate of return reveals that the earnings number reflects factors relevant to the valuation of stock despite not being calculated on a single basis. Furthermore, the believers in EMH and CAPM argued that it is not possible to systematically mislead the market by accounting changes. The market differentiates between accounting changes having cash flow effects and changes with no cash flow effects. Thus, the mechanistic hypothesis was unlikely to be descriptive of the real world. As noted above, early studies could not successfully discriminate between the no-effects hypothesis and the mechanistic hypothesis. This did not lead to the rejection of the no-effects hypothesis. Instead the results led the researchers to examine the methodological aspects of those studies and question the empirical validity of one important assumption (i.e., zero contracting costs) underlying the tests. This has led to a breakthrough in accounting research.
It has long been held in economics that contracting costs are non-zero (Coase, 1937).
Accounting researchers have abandoned the assumption of zero transaction and information costs. This breakthrough opened the door to possibilities for explanation and prediction of variation of accounting practice across firms. The major idea behind this literature is that the firm is a nexus of contracts, and accounting methods constitute an integral part of this set of contracts (Sunder, 1997).
Accounting numbers are used to write, monitor, and enforce contracts (Sunder, 1997).
Viewed in this way, accounting can affect firm value via their impact on contracts. Accounting is no longer mere form as was assumed under the EMH and CAPM regime6. The dropping of the assumption of zero contracting costs has shown that accounting methods have the potential to affect the cash flow to the contracting parties. It thus provides incentives to the contracting parties to influence accounting methods.
Positive Accounting Theory and Science
Though the above idea is general, early empirical studies of accounting choices investigated the impact of variables related to earnings-based bonus plans, debt, and the political process affecting the firm. Three major hypotheses tested are as follows: (a) the bonus plan hypothesis, (b) the debt-equity hypothesis, and (c) political cost hypothesis (Watts & Zimmerman, 1986).
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The bonus plan hypothesis states that firms with bonus plans choose accounting methods so as to increase current period earnings. The debt-equity hypothesis says that firms with higher debt-equity ratios choose accounting procedures so as to shift earnings from future periods to the current period. The political cost hypothesis says that large firms rather than small firms choose accounting methods so as to shift earnings from the current period to future periods. Size has been used as the proxy variable for political attention in early studies (e.g., Watts & Zimmerman, 1986).
Underlying all these hypotheses is the assumption of non-zero contracting costs (Watts & Zimmerman, 1986).
Empirical evidence is generally consistent with these hypotheses (Watts & Zimmerman, 1986, chapter 11; Christie, 1990).
Another stream of research examines the stock price effects of accounting changes – both mandated and voluntary (Watts & Zimmerman, 1986, chapter 12).
The initial studies of earnings management have been expanded to investigate earnings management in different situations. For example, research has examined earnings management around specific events (e.g., management buyouts, DeAngelo, 1986; labor negotiation, Liberty & Zimmerman, 1986; proxy contests, DeAngelo, 1988; import relief investigation, Jones, 1991; non-routine executive changes, Pourciau, 1993; and initial public offerings, Teoh, Wong, & Rao, 1998).
Still other studies have investigated the linkage between corporate governance characteristics and earnings management (e.g., impact of institutional ownership on R & D behavior, Bushee, 1998; impact of independent directors and CEO stockholdings on earnings management, Reitenga & Tearney, 2003; impact of the then Big 6 auditors on discretionary accruals, Becker, et al, 1998; Francis, Maydew, & Sparks, 1999; impact of Big 6 auditor industry expertise on earnings management, Krishnan, 2003; association between auditors’ fees for audit and nonaudit services and earnings management, Frankel, Johnson, & Nelson, 2002; impact of outside directors and audit committee on abnormal accruals, Peasnell, Pope, & Young, 2005; association between board of director characteristics and conservatism, Ahmed & Duellman, 2007).
Also, some studies have examined the rationale of accounting conservatism (Watts, 2003a, 2003b).
On the other hand, the capital market-based accounting research has expanded to investigate the value relevance of accounting numbers.
This branch of capital market-based accounting research is motivated by standard-setting considerations (Barth, Beaver, & Landsman, 2001).
For example, capital market-based studies have examined whether fair value is value-relevant in different settings (American Accounting Association Financial Accounting Standards Committee, 2005; Barth, Beaver, & Landsman, 1996, 2001; Barth & Clinch, 1998; Landsman, 2007; Eccher, Ramesh, & Thiagarajan, 1996).
More recently, empirical research has examined the value relevance of accounting numbers reported under different sets of Generally Accepted Accounting Principles (e.g., German GAAP, International Financial Reporting Standards, and US GAAP; Clarkson et al, 2009; Hung & Subramanyam, 2007; Morais & Curto, 2009).
PAT and Accounting Practice
PAT has enhanced the understanding of various accounting phenomena and issues. For example, it has yielded important insights into the linkage between accounting numbers and stock returns and management’s financial reporting incentives. Despite this, its contribution to accounting practice has been very limited. Accounting practice has evolved over hundreds of years through the interplay of a myriad of factors (Edwards, 1989) and the process of change in accounting practice has been slow. Findings of positive accounting research, however, have informed debates on important accounting issues. For example, positive accounting research has helped shape the recent fair value debate (Barth et al., 2001; Holthausen & Watts, 2001).
The fair value debate centers on whether fair value should be mandated as a measurement attribute in financial statements. The debate on market value is actually very old (Chambers, 1966; Ijiri, 1975; Littleton, 1953; MacNeal, 1939; Paton & Littleton, 1940).
Empirical evidence, however, now exists on the pros and cons of fair value measurement. For example, the value relevance literature has documented that fair value of assets is value relevant in some settings (American Accounting Association Financial Accounting Standards Committee, 2005; Landsman, 2007).
On the other hand, such accounting sources argued that fair value is a soft measure especially when it is measured by reference to models and it is easy to manipulate fair value estimates. The PAT literature documents that management manages reported earnings to serve its purpose (Watts & Zimmerman, 1986).
More recently, studies document that management manipulates fair value estimates. For example, Benston (2006) provided evidence on fairly extensive use of fair value by Enron and argued that misuse of fair value by management contributed to its demise. Byrne, Clacher, Hillier, & Hodgson (2008) have reported substantial variations in assumptions – discount rate, wage growth, expected return on equity, discount rate spread and equity return spread – used in fair value accounting for pensions in the UK. They have further suggested that the variations in assumptions are related not to economic fundamentals but to management’s motives to inflate income from pension scheme assets. Similarly, the PAT literature has informed the intangible assets debate, which centers on whether internally generated intangibles should be recognized in financial statements.
The value relevance literature has suggested that disclosure of intangibles in financial statements is value relevant. These findings have served as the basis for the proposal that the current accounting for intangibles be changed (see, for example, Lev & Zarowin, 1999; Lev, 2001).
Further, results in PAT have suggested situations in which management is likely to manage earnings. For example, earnings are managed when management’s bonus depends on reported earnings (Healy, 1985), when firms are about to violate debt covenants (Duke & Hunt, 1990; Press & Weintrop, 1990), when current year’s earnings is likely to fall short of certain benchmarks (e.g., last year’s earnings, avoiding loss, and securities analysts’ forecasts; e.g., Burgstahler & Dichev, 1997), when companies issue shares (Teoh et al., 1998), when there are changes in management (Pourciau, 1993).
Auditing standards require the auditor to identify and assess risks of material misstatements in financial statements (e.g., International Auditing and Assurance Standards Board [IAASB], 2009).
These findings may help the auditor identify situations of possible earnings manipulation.
Difficulties of PAT
In pursuing accounting research in the mould of science, PAT has faced two difficulties. First, there is a long-running debate on whether the methodology of the natural sciences is appropriate for social sciences. Durkheim (1964) believed that the methodology of natural sciences can be used to study social phenomena. He treated social phenomena as things and argued that they be treated as things. Thus, they can be studied objectively as external things. On the other hand, Lessnoff (1974) believed that the model of physical sciences is not appropriate for social sciences in several aspects. He argued that to see an event as a human action, it is necessary to interpret empirically observable behavior in terms of mental categories. It is the subjective aspect of behavior, not its physical aspect, which provides meaning to an action. Consistent with the view of Lessnoff (1974), both Whitley (1988) and Mouck (1990) argued against the reliance of accounting researchers on the philosophy of natural science. One major question that PAT researchers seek to answer is why managers make accounting choices as they do. According to intentionalism, the explanation must be couched in terms of the mental processes of the agent (i.e., the manager, Fay, 1996).
The explanation must be couched in terms of beliefs and reasons that weighed in the mind of the manager at the time of making accounting choices. The validity of explanation does not depend on the regularity of the particular accounting choice behavior in the same situations by the agent himself or herself and others (Lessnoff, 1974).
This is because the human being does not always resort to the same action in the same situation. Two persons can take two different actions in the same situation and the same action in different situations. The methodological position of PAT researchers is similar to the behaviorist position. The idea is that mental processes can be defined in terms of observable behavior. This methodological position underlies earnings management research. For example, when empirical research finds that managers tend to shift income from future periods to the current period when the conditions in the debt covenant reach their limit, the assumption is that the tightness of the conditions caused the current period incomeincreasing accounting choices (Duke & Hunt 1990; Press & Weintrop, 1990).
Watts and Zimmerman (1986) emphasize large sample and statistical methods. However, using large sample and statistical methods cannot fully resolve the problem raised by Fay (1996) and Lessnoff (1974).
For example, earnings management research has relied on separating discretionary accruals from non-discretionary accruals and designed various regression models to estimate non-discretionary accruals.
The predicted magnitude of accruals from the models has been treated as non-discretionary accruals and the error term from those regression models has been interpreted as discretionary and, hence, opportunistic (Ball & Shivakumar, 2006).
The validity of the interpretation of the error term as discretionary and opportunistic depends on the assumption that the relationship between accruals and model variables is mechanistic, which is untenable. Accounting standards (e.g., International Accounting Standards Board [IASB], 2009) recognize that management uses its judgments and estimations in the accounting process. Second, the generalizability of PAT hypotheses is limited by accounting environments and time. For example, the three widely tested hypotheses of earnings management (i.e., the bonus plan hypothesis, debt-equity hypothesis, and the political cost hypothesis) have particular institutional environmental backgrounds and may not be equally valid in all cultures (Sunder, 1999; Sawabe & Yamaji, 1999).
Ali and Hwang (2000) found that value relevance of earnings and book value of equity depended on country-specific factors. More recent research has found that earnings quality depends on institutional factors such as ownership structure, tax-book conformity, importance of the stock market in the country’s economy, rule of law, etc. (Ball, Robin, & Wu, 2003; Soderstrom & Sun, 2007).
Begley and Freedman (2004) found that the role of accounting numbers in public debt contracts changed during the 1975-2000 period. The frequency of accounting-based restrictions on dividends and borrowings declined significantly from the 1975-1979 sample to 1999-2000. Thus, in contrast with natural science, the generalizability of PAT is limited by institutional environments and time.
PAT: Normal Science or Extraordinary Science?
According to Popper (1959), science as practiced by scientists is extraordinary in nature in that scientists constantly attempt to refute theory. On the other hand, Kuhn’s (1996) position was that normal science constitutes most of the scientific activity of the scientific community. It is to be noted that Popper (1970) acknowledged the existence of normal science. However, his attitude towards normal science was strikingly different from Kuhn’s. While Kuhn viewed normal science as essential to scientific progress, Popper considered the uncritical attitude of normal scientists unfortunate. The brief sketch of the development of PAT drawn in section 2 seems to suggest that what Kuhn (1996) called normal science characterizes the development of PAT in important aspects.
According to him, normal science involved detailed efforts to articulate the paradigm with the aim of improving the match between it and nature. He argued that a paradigm would always be sufficiently imprecise and open-ended to leave plenty of that kind of work to be done. Kuhn depicted normal science as a puzzle-solving activity governed by the rules of the paradigm. The puzzles are of both a theoretical and experimental nature. Kuhn (1996) asserted that normal scientists must be uncritical of the paradigm in which they work. It is only by being so that they can concentrate their efforts on the detailed articulation of the paradigm and to perform esoteric work necessary to probe nature in depth. PAT has defined the legitimate problems and methods for the researchers. The problems that concern the positive researchers are the following: Why does management choose certain accounting methods, not others?
Why does management switch from one accounting method to another? What incentives and constraints does management face in making accounting choices? Do accounting earnings contain information for stock pricing? These questions have occupied the positive accounting researchers for the last four decades. Watts and Zimmerman (1978) propagated the idea that management’s incentives determined their lobbying position on an accounting standard. Later researchers expanded this idea and developed many hypotheses linking management’s incentives and his or her accounting choice behavior. Since 1978, PAT researchers have engaged themselves in the expansion and articulation of this theory. Two examples illustrate the above point. The first one is the measurement of the dependent variable (i.e., accounting choice by management) in studies of earnings management. Early researchers (e.g., Deakin, 1979; Hagerman & Zmijewski, 1979; Dhaliwal, 1980) investigated the choice of a single accounting procedure (e.g., depreciation methods, inventory costing methods) at a time. This led to the
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Positive Accounting Theory and Science
criticism that managers manipulate earnings numbers not through a single accounting procedure but through a number of accounting procedures that are available to management. Zmijewski and Hagerman (1981) improved upon previous studies by investigating a portfolio of accounting procedures. Healy (1985) went further and used accounting accruals as the dependent variable to capture the effects of a host of discretionary decisions – both accounting and real – by management. While accruals provide a summary measure of managerial discretion and are possibly an improvement over previous studies, it suffers from certain shortcomings (Kaplan, 1985).
Healy (1985) uses total accruals as a proxy for discretionary accruals. Researchers (e.g., Kaplan, 1985; McNichols & Wilson, 1988) have asked whether total accruals are all discretionary in nature. This then engages positive researchers to design better models of discretionary accruals. DeAngelo (1986), Dechow & Dichev (2002), Dechow & Sloan (1991), Dechow, Sloan, & Sweeney (1995), Jones (1991), Kothari, Leone, & Wasley (2005), and Teoh et al. (1998) have developed different models of discretionary accruals. Secondly, as mentioned earlier, the three most tested hypotheses are the bonus plan hypothesis, the debt-equity hypothesis, and the size hypothesis. Early studies used crude proxies of variables representing managerial bonus, debt covenant constraint, and political cost. However, as time passed, researchers refined both theory and the variables. For example, early researchers used a dummy variable to represent the existence of bonus plan to test the bonus plan hypothesis. Later researchers (e.g., Healy, 1985) examined the details of bonus plan and generated hypotheses linking bonus plan details and direction of earnings management. Similar efforts are extant (e.g., Duke & Hunt 1990; Press & Weintrop 1990) in articulating the debt-equity hypothesis. Furthermore, early researchers (e.g., Watts & Zimmerman, 1978) used size as a proxy for political cost. This was
criticized on the ground that size might be a proxy for variables other than political cost (Watts & Zimmerman, 1990).
Later studies examined managers’ accounting choice behavior in response to situations that reflect firms’ sensitivity to specific political situations. Jones (1991) investigated the accounting choice behavior of managers of domestic producers that would benefit from import protection. The above examples illustrate (a) how one study built on previous studies and (b) how PAT defines the particular questions addressed. These examples also illustrate that while PAT researchers have been committed to the basic framework for investigating accounting choices (i.e., management incentives explain accounting choices), they have been critical within that framework. Thus, they have made constructive criticisms of colleagues’ works and engaged themselves to developing better models.