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    Deakin - Rational Economic Behaviour and Lobbying On Accountig Issues

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    Rational Economic Behavior and Lobbying on Accounting Issues: Evidence from the Oil and Gas Industry Edward B. Deakin The Accounting Review, Vol. 64, No. 1. (Jan., 1989), pp. 137-151. Stable URL: http://links,jstor.org/sieisici=0001-4826% 28 198901 % 296434 1%3C 137%3AREBALO%3E2.0,CO%3B2-1 The Accounting Review is currently published by American Accounting Association. ‘Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at hhup:/www.jstororg/about/terms.huml. JSTOR’s Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at hup:/www jstor-org/journals/aaasoc. uml Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the sereen or printed page of such transmission, JSTOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor.org. hupulwww jstor.org/ ‘Sat Sep 2 08:55:02 2006 Rational Economic Behavior and Lobbying on Accounting Issues: Evidence from the Oil and Gas Industry Edward B. Deakin ABSTRACT: A substantial accounting research literature seeks to explain the existence of ‘alternative accounting methods and management's willingness to expend efforts lobbying to ‘defend alternate methods. This paper investigates the association between management lobbying on accounting for oil and gas producing activities and the effect that the method ‘may have on firm cash flows and on accounting numbers that are restricted by the terms of firm contracts. Full cost companies that lobbied at different stages of the deliberations on oil ‘and gas accounting are compared with those that did not. The models and their classificatory ‘success rates were statistically significant. Also, the models developed at each stage of the rule-making process provided statistically significant predictions for the other stages. This ‘suggests that the contract and cash flow effects were stable predictors of lobbying by managers. HE question of why firms choose certain accounting practices has been of interest to accounting re- searchers and practitioners for some time (see Gordon [1964] for an early study in this area). Recent work suggests that accounting policy choices may be viewed as economic decisions made by managers coincident with investment and production decisions [Zmijewski and Hagerman, 1981]. One approach to in- creasing our understanding of these ac- counting policy decisions is the system- atic study of the lobbying activities of managers affected by an accounting change (Watts and Zimmerman, 1978]. Watts and Zimmerman suggest that man- agement compensation, information pro- duction costs, regulation, taxes, and 137 political costs are factors that influence a manager’s decision to lobby on account- ing issues. The empirical part of their study surveyed the lobbying positions taken by company representatives who made submissions to the FASB regard- ing its February 1974 Exposure Draft, Particular thanks ate due to Robert Freeman, ‘Mayper, Paul Newman, Jerry Salamon, and two anony ‘mous reviewers for their helpful comments on earlier ‘tats of this pape Edward B. Deakin is Institute Chair Professor of Accounting at University of North Texas. ‘Manuscript received December 1985. Revisions reclved August 1986, May 1987, February 1988, May 1988, and July 1988. Accepted August 1988. 138 “Reporting the Effects of General Price- Level Changes in Financial Statements.”” They interpreted the results of their study as being consistent with their theoretical ‘conjectures, However, Christenson [1983] ques- tioned Watts and Zimmerman’s interpre- tation of their evidence and can perhaps be interpreted as suggesting that more controlled studies are necessary for fur- thering our understanding of accounting policy choices. Along these lines, McKee et al. (1984) reevaluated Watts and Zim- merman’s data on an extended sample and found less support for the influence of the posited factors on lobbying be- havior than reported previously. In addi- tion, the issue studied by Watts and Zim- merman—the FASB’s price-level project —was related to supplemental disclo- sures rather than the primary financial statements that form the reference point for the accounting-based variables that are included in firm contracts and which can affect cash flows. Hence, the ques- tion of what factors influence managers when they (1) choose from alternative accounting techniques, and (2) engage in costly lobbying on accounting issues re- mains open. A logical avenue for further investiga- tion of the theory would be to test it on an issue that involves primary financial statements and is simple enough that the number of factors that have the potential to influence this decision is small. An issue that allows a focus on contracting cost variables (defined as costs related to debt, management compensation, and regulation) alone avoids certain comp! cations due to possible interactions with tax effect and political consequence vari ables. Also, an accounting issue that af- fects the firms in only one industry tends to limit the number of potential con- founding effects that can influence the decision to lobby compared to a broader ‘The Accounting Review, January 1989 issue which affects firms in several in- dustries. The lobbying activity by full cost oil and gas companies over several attempts to eliminate the full cost accounting ‘method is an issue that has these charac- teristics. Since all full cost companies that lobbied favored the full cost meth- od, a test of firm lobbying positions would not be meaningful since their then current method would be a perfect pre- dictor of lobbying position. Instead, the issue investigated is why some firms using the full cost method lobbied and others did not. In essence, the study is a measure of factors which correlate with the intensity of management's perceived importance of its accounting method. This paper presents the results of de- veloping explanatory models of lobbying behavior of full cost firms at three differ- ent stages associated with deliberations on oil and gas accounting. The models are used to predict lobbying on the same events from which the model was devel- oped as well as to cross-predict lobbying on the other two events. Tue On anp Gas AccounTiNG DEBATE AND FACTORS AFFECTING MANAGEMENT Action on SFAS No. 19 Under the Energy Policy and Conser- vation Act of 1975, the FASB was dele- gated the responsibility to develop a uni- form accounting method in the oil and gas industry. The FASB issued a Discus- sion Memorandum (DM) in December 1975. In June 1977, the FASB issued an Exposure Draft (ED) of its proposed standard, In December 1977, the FASB issued SFAS No. 19 which, among other things, eliminated the full cost account ig method that had been used by many industry members [FASB, 1977]. The FASB’s decision was appealed to the SEC in March 1978. There were, there- fore, three different events which gave Deakin tise to lobbying: (1) issuance of the DM; (2) issuance of the ED; and (3) the SEC appeal. Fall cost companies lobbied at all three stages in the rule-making process, ‘Twenty-seven full cost companies lob- bied in favor of their method of account- ing in response to the DM. Fifty-one lobbied in response to the ED. In the aftermath of the issuance of SFAS No. 19, 50 full cost companies participated in the appeal to the SEC to overturn the FASB standard. The lobbying companies themselves stated that, the factors that affected their decision to lobby on this issue included: (i) the expected impact on cost of capital and access to capital markets, (2) the potential of the proposed elimination of the full cost method to affect account- ing income-based management incentive contracts, (3) the perceived effect on future drilling activity, and (4) the effect on rate-regulation [U.S. Securities and Exchange Commission, 1978]. Previous discussions of management lobbying behavior suggest that manage- ment will lobby if the expected benefits of lobbying exceed the costs of lobbying [Kelly, 1983]. Lobbying is always costly since, among other costs, it requires the use of management time to appear be- fore rule-making bodies or to prepare statements for such rule-making bodies. Consequently, lobbying will only occur if management believes that it can affect the probability that a rule will be enacted or repealed." For the issue investigated in this paper, the benefits from lobby- ing arise in the form of the avoidance of costs associated with the mandated change in accounting method. Following the earlier studies on ac- counting method choice and lobbying behavior, this study assumes that for analytical purposes the cost of lobbying is fixed, but that the benefits from lobby- 139 ing will vary across firms. Firms that would incur high costs because of the mandated accounting change are more likely to lobby than firms that would in- cur only small costs. The costs examined here are those related to management in- centive plans, debt contracts, regulation, and the level of oil and gas exploration ‘expenditures by a company. For reasons discussed below, the influences of taxes, political costs, ‘and ownership control that have been suggested as important in other contexts do not seem important here. Historically, income taxes for oil and gas exploration activity (as well as for other natural resources) are computed on a different basis than these funda- mental financial accounting rules. Hence, the proposed accounting change would have no direct tax consequences. More- over, full cost companies tend to be the smaller producers and smaller companies have traditionally received preferential tax treatment.? Therefore, the affected subset will tend not to experience adverse tax consequences as a result of their use of the full cost method. * Alternatively, management may believeitcancausea ‘modification to the rule that wil reduce the adverse ef- fects. Theanalysisof management's incentives under this scenarios the same, Note that tis assumed hee tht the fulleostissueis not one for which firms would perceiveit totheiradvantage to misrepresent their ue feelings. The income and equity effects from the elimination of full ‘cost were probably too lage for managers to consider Tong run strategic issues, See Amershi etal 1982] for tlaboration on stratepie considerations in the lobbying + For example, smaller companies re permitted 10 de- uct inanatble driling costs as incurred [Internal Reve- ‘nue Code Section 291]. Larger companies mustcapitalize these costs. Certain smaller companies may stil wsestat- ‘tory depletion, that snot available to larger companies Ilnternat Revenue Code Sexton 613A]. Smaller compa les were subject to preferential tax rates under the ‘Windfall Profit Tax Act of 198D [Internal Revenue Code Section 4983). Smaller companies are ened to certain ‘exemptions under that Act that ae not avalabe larget ‘Companies [Code Section 4994). The royalty owner's ex- tmption i also limited to smaller companies (Code Sec- ton 643. 140 ‘The structure of the oil and gas indus- try tends to shield full cost companies from the types of political pressures faced by the major companies. The in- dustry is generally considered to consist of 20 to 24 “major” companies [Deakin and Porter, 1978] as well as a number of smaller “independent”” companies. Major companies are traditionally singled out for legislative action.’ Only three of the majors employ the full cost accounting method. Two of these companies have most of their ex- ploration activities located outside of the U.S. and the remaining one is predom- inantly an interstate pipeline company whose exploration accounting is pre- scribed by Federal Power Commission Order 440-A requiring full cost account- ing. Thus, the political cost factor is not perceived relevant to the lobbying deci- sions of firms for the accounting issue ex- amined in this paper. The level of management ownership has been suggested as a variable that may be associated with the lobbying positions taken by firms [Kelly, 1983]. However, Deakin [1980] showed that full cost com- panies tend to have low levels of manage- ment ownership. Thus, this variable’s effect is minimized in thisindustry subset. MEASUREMENT ISSUES AND VARIABLE DEFINITIONS In an empirical test on lobbying activ- ity data cannot be obtained directly about the expected benefits of lobbying because the factors that are considered in making these decisions are private. Hence, it is necessary to find operational measures of unobservable motivating factors. As noted above, the four identi- fied factors believed significant in this accounting context are: (1) debt cove- nant costs, (2) management incentive compensation effects, (3) the size of The Accounting Review, January 1989 operations subject to the accounting change, and (4) regulation. A discussion Of the operational measures of each fac- tor follows. Debt Covenant Costs Earlier studies suggest that the impact of an accounting change on capital costs (including access to capital markets) is related to the existence of loan agree- ments that impose restrict agement’s actions if certain variables denominated in terms of accounting con- structs breach specified limits. If the Joan agreements for full cost companies contain restrictions in terms of a net in- come or equity number, then the pro- posed accounting standard, because it reduces net income or equity, could bring the company closer to violation of its contractual constraints (Leftwich, 1981]. Companies that have higher debt relative to equity are assumed to be closer to the limits imposed by such loan agreements, Hence, the relative debt-equity position of a company within its industry is as- sumed correlated with the capital cost factor. It has been suggested [Dhaliwal, 1980; Holthausen, 1981; and Leftwich, 1981] that renegotiation of debt covenants is more costly for public debt than for pri- vately held debt. The change in contract terms because of the change in account- ing may be waived by a private lender. 2 The Energy Policy and Conservation Act of 1975 provided that an enerey data base be developed wins ac- Courting information on the largest companies. At the time, Congressional hearings were begun that souht 0 quire divestiure of integrated oil company operations. ‘Thisdivestture would only have affected the larger com- panies. The Tax Act of 1984 that repealed certain bene Ws ofthe foreign tex credit was almed at larger inte ated ll producers. Recently, larger producers have been subjot fo adverse tax effests related to foreigh in tanatbledriling costs 1986 Tax Act]- As noted in foot ‘ote 2 above larger integrated producers have also been Subject to diferemial tax treatment Deakin However, the trustee of a public debt issue may be under greater pressure to uphold the contract terms even though they are based on an accounting rule that was changed in a manner beyond the control of or unforeseen by either the debtor or creditor. At the time this ac- counting rule was in process, interest costs were rising dramatically. Lenders, therefore, had an incentive to force rene- gotiation when possible in order to ob- tain higher interest rates as part of the agreement to waive contract violations. This fact would tend to increase the cost of all debt subject to renegotiation. Pub- licly held debt, however, would be more likely to be subject to such renegotiation because the trustees would be under more pressure to force renegotiation to obtain the higher rates. The impact of debt covenant effects on the cost of and access to capital may be viewed as a function of (1) the exis- tence of debt covenants based on equity or income numbers,* (2) the closeness of the company to its debt limits as reflected by its relative debt/equity ratio, and (3) whether the company’s debt is publicly or privately held. Although a direct com- putation of these costs for the affected ‘companies is not possible, it is reason- able to assume that the capital costs associated with an accounting method change will rise with the presence of these factors. The more of these factors present, the more likely a company would be to incur costs and, by exten- sion, the greater would be the expected value of such costs. The capital cost effect is measured by a variable which reflects the existence of accounting-based debt limits, higher than average debt ratios, and the existence of public debt. A value of one was assigned for each factor present, with a “capital cost” score ranging from a possible value of zero (no accounting-based_restric- M41 ns, below average debt, no public debt) to a value of three (all these ele- ments present). Thus, we assume that the capital cost factor will be positively cor- related with the presence of each of these items. The use of such a “scoring” rule to construct a variable combines the fac- tors believed to affect capital costs into a single variable. Since the scoring rule is ad hoc, several alternative approaches were tried, including the use of each vari able as independent predictors. The re- sults were not sensitive to alternative for- mulations.* Management Incentive Compensation The sensitivity of management to ac- counting income numbers may be en- hanced if management’s compensation is, at least in part, based on an incen- tive compensation plan that is based on accounting income. Jensen and Meckling [1976] suggest it may be in management’s interest to increase ac- counting income through bookkeeping “Although it may be arpued that companies with no accountng-based numbers in their debt contract would not experience increased deb-related costs, thechange in accountng method could alec even those companies by ‘making it more costly for them to raise capital in the Tuture. This poine was addressed during the U.S. Secuk- ties and Exchange Commission hearings in 1978. * alternative models included one where each of the

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