Abstract
Using the comparative international accounting history approach advocated by Carnegie and Napier (2002), this study compares US and Italian earnings management (EM) literature published in the second half of the twentieth century and identifies the main similarities and differences in the research topics and methodologies. The historical comparison finds that although Italian and US contributions to EM literature grew in notably different contexts and research settings, they both recognized the issue of EM, agreed on its origins and shared some research topics. However, the two bodies of literature differed in respect of the research topics addressed and research methodologies adopted to analyse the EM issue. The discussion of these results provides also initial evidence of areas of potential contribution to the international debate on EM through cross-fertilization. The analysis demonstrates the fundamental role of comparative international accounting history in uncovering the potential contributions of national literatures to the development of accounting research at a genuinely international level. It also contributes to EM literature by bringing to international attention fifty years of Italian EM research that was previously unknown beyond Italian borders.
Introduction
In the last fifty years, earnings management (EM) research by US academics has come to play a dominant role in the EM field and is now considered the main reference internationally. However, research on EM has also developed in other contexts, such as Europe and emerging countries, where it was informed by similar or different theoretical frameworks and research methodologies, and, in addition, was written in languages other than English (Hopwood and Schreuder, 1984).
While non-native English speaking researchers are currently contributing to international EM literature with their EM studies in English, little is known about the non-English EM research they conducted in the past. However, the contents of these non-English contributions from the past may be unpacked, and their views, methodologies and topics analysed, to understand whether and how they differ from the leading US EM research. Hence, in this study, past national EM literatures are studied both from a historical and a comparative perspective through the Comparative International Accounting History (CIAH) model proposed by Carnegie and Napier (2002).
This study aims to compare US and Italian EM literature in the second half of the twentieth century and identify the main similarities and differences in the research topics and research methodologies developed in the two contexts.
The Italian and the US EM literatures published in the second half of the twentieth century are compared for two main reasons. First, similar to US scholars, Italian academics appeared to have a long tradition of EM studies throughout the twentieth century, but while past and present EM research from the US is well known internationally, EM research from Italy was confined to the country’s national borders and remained unknown at an international level (Lai et al., 2015). Second, Italy and the US represent contrasting financial and economic contexts in the second half of the twentieth century. Hence the EM research in both the countries can provide insights into EM in contexts that differ in terms of firm characteristics, capital market structures, accounting regulation, and roles for financial reporting.
To achieve the aims of the study, US and Italian EM literature from 1945 to 2000 is reviewed and subsequently compared, according to a readapted CIAH model that focuses on the research settings, the contextual conditions, the main research topics and the research approach which denoted US and Italian EM research in the second half of the twentieth century. The study sheds light on similarities and differences between US and Italian EM literature in the second half of the twentieth century. It also identifies signs of potential cross-fertilization between the Italian and US EM research.
With its results, the study contributes to both the comparative accounting history and the EM literature in several ways. As far as comparative accounting history is concerned, by implementing CIAH to compare different EM literatures, the study extends the implementation of CIAH beyond accounting practices to the accounting literature, and demonstrates its validity as a tool to widen international accounting research. With reference to EM literature, by identifying similarities and differences in research topics and methodologies between Italian and US EM literature, this study reveals the existence of alternative theories and methodologies in EM, which can foster new areas for international research on EM. Finally, the study contributes both to comparative accounting history and EM research by encouraging the implementation of historical comparisons to other national EM literatures, to further enhance the international debate on this topic and thereby potentially unearth new and valuable insights.
The remainder of the article is structured as follows. The next section discusses the analytical model, informed by the CIAH approach (Carnegie and Napier, 2002), and presents the aims of the study, together with a description of the literature review process. The third section develops the historical comparison of US and Italian EM literature from 1945 to 2000, according to the readapted CIAH model. The implications of the comparison are discussed in the fourth section, which is followed by concluding remarks.
Research methodology
Analytical model
The analytical model used for the conduct of the comparative study is informed by the CIAH model, which was first introduced by Carnegie and Napier in 2002. Although the comparative approach has found extensive use in the social sciences (Durkheim, 1982) and in accounting research as well, 1 comparison across time rather than just places was initially neglected due to the paucity of accounting history studies with an international perspective (Carnegie and Napier, 1996). However, in the 2000s, new studies analysing past international differences in the development of accounting practices began to emerge not only as a consequence of the call for CIAH by prominent academics in the field (Carnegie and Napier, 1996; Napier, 2006) but also thanks to the methodological contribution of a theoretical and practical framework to develop CIAH studies that was offered by Carnegie and Napier in 2002. The latter contribution, in particular, noted that CIAH offers an opportunity to “identify and explain similarities and differences between phenomena in different locations and cultures” (Carnegie and Napier, 2002: 691). Moreover, CIAH not only offers the potential to “identify either common or differentiating factors between countries” in the evolution of their accounting practices (Richardson and MacDonald, 2002: 69), but also provides new opportunities for non-native English speaking researchers to bring the contents and results of their national research to an international level (Giovannoni and Riccaboni, 2009: 341).
Reference to comparative accounting history is often made in accounting literature with different aims. For instance, the comparative approach was indicated as necessary in order to analyse the arrangements of accounting history in different research groups worldwide in the study of the accounting history scholarly community (Carnegie and Rodrigues, 2007: 445). The comparative historical approach also found application in the comparison of the evolution of cost accounting between France, Italy, Portugal and Spain (Carmona, 2007). Conversely, the historical evolution of cost accounting theory and practice solely in Italy was studied as a first step in the development of a historical comparison of cost accounting among European countries (Antonelli et al., 2009). In addition, CIAH informed the study of the historical evolution of corporate social responsibility reporting in comparison with financial reporting (Tschopp and Huefner, 2014: 1) and the auditing profession in France and the UK (Baker, 2014), both with the intention of understanding their past development to explain their current situation. Finally, the CIAH literature was also nurtured by comparative analysis regarding the historical evolution of different schools of thought in accounting. For instance, traditional and new accounting histories were compared from a historical point of view with reference to their content and approach (Gomes, 2008). The historical comparison supported also the identification of similarities and differences between the thought of the Italian Professor Aldo Amaduzzi and the positive accounting theory of the Rochester School (Melis, 2007), as well as the analysis of commonalities and differences between Austrian and Lombard-Venetian State accounting teaching from 1839 to 1931 (Gulluscio and Torrecchia, 2013).
Given its flexible use in accounting literature, CIAH is considered to be a suitable model to inform the present analysis of the evolution of research on earnings management (EM) practices between 1945 and 2000 in two very different settings, the US and Italy. Therefore, this study aims to compare US and Italian EM literature in the second half of the twentieth century and identify the main similarities and differences in their research topics and methodologies.
To achieve its aims, the analysis takes the form of a parallel study that compares a phenomenon in different spaces and times. 2 Parallel studies require outlining the main factors to be observed in the comparison. Such factors are not fixed and can vary among the topics taken into consideration, but they need to be defined to give structure to the analysis (Carnegie and Napier, 2002). Therefore, in this study, which investigates research in accounting instead of accounting practices, we differentiated from the traditional CIAH model (Carnegie and Napier, 2002) and grouped the several aspects of the comparison into four factors that we considered more suitable for the specific topic of investigation (see Table 1).
Definition of the four factors used for CIAH of EM research.
Literature review
To collect the necessary primary sources for the historical comparison of EM research in Italy and the US, we performed an extensive review of the literature in both contexts. 3 Consistent with prominent literature, we consider EM in terms of “a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gains” (Schipper, 1989: 92). Therefore, we focused our attention on accrual EM, which occurs when managers use the room for judgement available in the preparation of the financial statement (for example, choice among different accounting treatments admitted for the same item, choice among different evaluation criteria or methods, estimation of future economic prospects) in order to alter reported earnings, both upwards and downwards (Healy and Wahlen, 1999).
Using proper search engines for the two contexts and the timeframe investigated (that is, ESSPER and OPAC for Italy; 4 EBSCO, Science Direct and JSTORE for the US), we searched for the following keywords in the title, abstract or keywords of the contributions: “earnings management”, “income smoothing”, “hidden reserves” and “stock watering”.
We collected publications regarding EM by Italian authors in the form of books, book chapters and journal articles. 5 More specifically, we searched the Italian equivalent of the keywords 6 in both the two accounting journals existing in the studied period: Rivista Italiana di Ragioneria e di Economia Aziendale (previously, Rivista Italiana di Ragioneria) and Rivista dei Dottori Commercialisti. Also, to cover the highest number of possible sources, we manually examined older books about Economia Aziendale as a general topic (for which a detailed content description is not available online) and searched for those chapters covering the EM issue. This process led us to the identification of 36 publications. 7
With reference to journal articles concerning EM published in US-based accounting journals, we focused our literature review on papers published in three top journals, namely The Accounting Review, Journal of Accounting Research, and Journal of Accounting and Economics. 8 As in previous authoritative reviews of the literature (for example, Dechow et al., 2010), we are confident that articles published in such prominent international accounting journals represent a good approximation of the main issues studied and methodologies used in the US context during the investigated period. By means of the methodology indicated above, we selected a total of 78 articles. 9
Finally, to depict the economic, cultural and regulatory context in which EM research developed for both countries, we collected several secondary sources regarding Italian and US economic history, education systems and academic research.
Comparative history of US and Italian EM literature
As described above, the comparison of EM literature in Italy and the US takes into consideration four major elements that characterized the development of EM literature in the two countries: the period, the context, the research topics and the research approach. Once the period under investigation is characterized in each country, the comparison covers two specific aspects to provide deeper knowledge about the fundamental differences between Italy and the US, particularly their accounting practices and regulation. Subsequently, the comparison proceeds with the analysis of the research topics and the research approach.
Period
We compared Italian and US EM literature in the second half of the twentieth century, from the end of the Second World War to 2000 (see Table 2). The decision to focus on this period had various motivations. The end of the Second World War signalled the beginning of the so-called “post-war economic boom”, followed by a period of growth stabilization in both the US and Italy, with financial markets developing quite rapidly and national boundaries being progressively breached in terms of international exchange of goods, services, capital and people (Crafts and Toniolo, 1996; Vatter and Walker, 1996). During this period, interest in the potential of economic and business sciences grew considerably (Whitley, 1986), as well as accounting education and the profession. The studied period ends in 2000, when the commitment to the harmonization process of accounting standards in Europe was endorsed in the 359/00/CEE Communication and introduced with Regulation 1606/2002. 10 Such an event represented a “turning point” for the accounting systems in force all around the European Union, while in Italy it was much more overwhelming due to revolutionary changes it brought to the existing, longstanding accounting tradition (Carmona and Trombetta, 2008).
Results summary of the comparison period.
During this period, the EM issue drew the attention of accounting researchers in both countries, which were characterized by very different research settings. Indeed, while US accounting research was subject to major changes in the 1970s under the pressure of educational and academic transformations (Whitley, 1988), Italian accounting research remained fastened to the very Italian dogma of Economia Aziendale throughout the whole period (Galassi and Mattessich, 2004; Mattessich, 2007).
In detail, US accounting research in the 1970s witnessed what was later recognized as an “empirical revolution”, which affected the way accounting research was conducted, as a consequence of the huge methodological changes imposed on the entire business education system (Whitley, 1986). Indeed, before the 1970s, the approach to accounting and financial research was similar to that pertaining to human sciences. Most of accounting research was narrative and descriptive, open to evaluation and based on general criteria; just a few researchers attempted to go beyond mere description of business activities or procedures or to judge the best prevailing practice (Phelps, 1947; Gordon and Howell, 1959). However, in the late 1950s both the Carnegie Corporation Report (Pierson, 1959) and the Ford Foundation Report (Gordon and Howell, 1959) revealed that business schools were seriously underrating the importance of research, devoting minimal time and few resources to it. Such reports called for a significant improvement in both business research and teaching towards a shift to more scientific methodologies. Focusing on research only, the Carnegie and Ford Foundations underlined the need for both more pure research and “more applied research at a high analytical level” (Gordon and Howell, 1959: 382). The latter type of research should incorporate more sophisticated methodologies as well as more standardized and formalized methods, such as those of natural sciences in formulating and testing hypotheses; indeed, “not until the data are embodied in principles or generalizations which can be said to ‘explain the facts’ can research attain general significance” (Pierson, 1959: 313). Finally, the Carnegie Corporation and Ford Foundation reports called for an improvement in the intellectual climate within business schools and closer relations with underlying disciplines such as psychology, behavioural sciences, mathematics, statistics, economics and engineering (Gordon and Howell, 1959; Pierson, 1959).
Along with the empirical revolution, since the late 1960s accounting research was affected by the growing establishment of the positive accounting theory (PAT), which aims to explain and predict accounting practices by testing hypotheses through the statistical analysis of accounting data (Watts and Zimmerman, 1978; Whitley, 1988). In this aspect, it differs from the normative approach in accounting research, which, conversely, seeks to derive and prescribe “optimal” accounting practices.
Therefore, in the 1970s, accounting research incorporated more and more extensive use of quantitative analysis of standard data by researchers. Considering the firm as basically a nexus of contracts, researchers tested hypotheses of dual-dimensional interactions between the principal and agents in constant environmental conditions, sometimes neglecting the dynamic nature of a firm as an institution (Chandar and Miranti, 2005). To satisfy the need for more “scientific” skills in accounting research, the study of mathematics and modern statistics was introduced – also thanks to the financial support provided by large American foundations (for example the already mentioned Carnegie and Ford ones) – and emphasized in doctoral programmes, thus fostering the use of statistical methods in PhD dissertations and academic research (Gordon and Howell, 1959; Pierson, 1959).
Conversely, the second half of the twentieth century corresponded to a generally stable period in Italian accounting research and education. In these years, Italian accounting academics remained loyal to the paradigm of Economia Aziendale, as proposed by Gino Zappa (1920–29, 1926–27, 1957). According to this theory, “accounting was seen as investigating the structure and economic life of the ‘azienda’ (firm)” (Galassi and Mattessich, 2004: 65–66) in order to enhance the firm’s efficiency. Therefore, by means of its quantitative calculations, accounting was strongly interrelated and linked with organization and management theories (Zappa, 1920–29; Onida, 1951; Giannessi, 1954; Amaduzzi, 1957; Masini, 1957; Cattaneo, 1966; Ferrero, 1968). 11 Within this field of study, the research methodology was generally narrative and descriptive, intended to provide critical perspectives and interpretative judgement of different accounting topics by means of a deductive approach (Zambon, 2002). Moreover, it should be noted that education, as well as research trading and funding, were considered “purely national concerns”; indeed, in Italy, financial assistance for research came from the Ministry of Education and the National Council of Research (CNR – Consiglio Nazionale delle Ricerche) and only marginally from private institutions and companies (Galassi, 1984). Like research training and funding, the “research and professional journals which existed were primarily nationally oriented and, if only for reasons of language, had quite narrowly circumscribed national readerships” (Hopwood and Schreuder, 1984: 1).
The period is considered suitable for historical comparison because in this timeframe the two countries faced very different dynamics in their accounting research but developed an interest in the same research subject (see Table 2). Therefore, such prima facie similarity deserves a deeper investigation.
Context
The settings in which the Italian and the American EM literature developed are rather different and need to be taken into account to the extent they could have affected EM research in the two countries (Hopwood, 1983). Therefore, the contextual conditions in which Italian and American EM research grew in the second half of the twentieth century need to be compared to enhance a deeper understanding of the two contexts, especially the less known Italian setting (see Table 3).
Summary of the contexts comparison.
For the aims of this study, among several contextual factors, we focused on three main aspects that might have influenced the origins and the views of EM, which were then mirrored in the EM research of the two countries. Hence, the firms’ and capital markets’ characteristics, the accounting regulation and the role of financial reporting in the two countries were compared.
Characteristics of firms and capital markets
In the second half of the twentieth century, the majority of US firms were large, widely held public companies in which ownership was separated from control, generating the well-known agency problem (Jensen and Meckling, 1976 ; LaPorta et al., 1999; Previts and Merino, 1998). More than 9,000 companies were listed at the end of 1990s, providing evidence that capital markets played a central role in the development of public companies, which gathered capital by the dispersion of ownership among several small and private investors (Barca, 1995; LaPorta et al., 1999). In such a market-based system, investors’ protection policies were developed to provide information – especially of a financial kind – to shareholders deprived of control over the company (Goldstein and Nicoletti, 1995).
Conversely, the vast majority of Italian firms were small and medium-sized private firms (SMEs) 12 and usually family owned (Corbetta and Montemerlo, 1999), 13 with the exception of a small portion of large, public companies, characterized by concentrated ownership, generally in the hands of a single family as well (Zattoni, 1999). In this situation, there was general correspondence between ownership and control in Italian companies, for both private SMEs and public companies (Leoni, 2013; Cannari et al., 1994). Moreover, the ownership concentration gave the unique shareholder, or the coalition of major shareholders, the power to appoint and remove the managers and to exercise stringent controls on their work (Goldstein and Nicoletti, 1995).
In contrast to the US, Italian capital markets were underdeveloped because of the large presence of private SMEs and the need for public corporations’ owners to maintain control over the firm (Shleifer and Vishny, 1997; Zattoni, 1999). Looking at the size of the main Italian stock exchange, we found that the number of listed companies varied from around 130 to 160 from the 1960s to mid-1980s and around 200–240 from the late 1980s to 2000 (Borsa Italiana, 2001). In 1974, the Italian government tried to tackle the minimal appeal of capital markets by creating a special type of share that excluded any voting right and granted only dividends. This was intended to encourage more corporations to go public while enabling their owners to retain control over the firm (Zingales, 1994). This policy actually improved the Italian Stock Exchange’s attractiveness and increased the presence of small and institutional investors in Italian listed firms’ capital, but it did not affect their ownership, which remained coupled to control. Indeed, in the Italian context “the stock market has never been a major source of capital. Characteristically, listings have been relatively few in number and are associated with very large companies (e.g., in 1995 the top 8 groups accounted for over 70% of the market capitalisation)” (Zambon, 2002: 26). Moreover, Italian companies traditionally relied on short-term borrowings as the major source of debt financing and were subject to inadequate disclosure requirements and insufficient protection for minority shareholders (Goldstein and Nicoletti, 1995) (see Table 3).
Accounting regulation
As a common law country, the US had a different history of accounting regulation than Italy, which is a civil law country. In particular, initial US accounting principles were the result of the “explication, standardisation and codification of financial accounting practices” (Burchell et al., 1980: 7) made by professional accounting bodies and fostered by the Securities and Exchange Commission (SEC). The first attempt to create a set of accounting principles dates back to 1936, when the American Accounting Association (AAA) issued the statement Examination of Financial Statements by Independent Public Accountants. This contained 20 accounting standards with general applicability to published financial reports and the statement was subsequently modified four times through to 1957 (Cox, 1959). 14 Although towards the end of the 1950s both the AAA and the American Institute of Certified Public Accountants (AICPA) started to recommend the creation of an Accounting Principles Board devoted to the development of a set of authoritative and coordinated accounting principles (Cox, 1959), the Financial Accounting Standards Board (FASB) was not founded until 1973. 15 As the full-time independent body in charge of the definition of accounting objectives and for tackling the entire hierarchy of accounting theory, including its qualitative characteristics, types of information and its users, and basic accounting concepts (Zeff, 1999), it issued more than fifty accounting standards in only 10 years of activity. The FASB based many of its statements on the results and opinions of practitioners and academics. As a consequence, in the US, accounting practices, as interpreted by professionals and academics, informed the constitution or reformation of accounting regulations.
In contrast, the accounting rules in Italy, as well as in other civil law countries of continental Europe, were a direct outcome of the actions and intervention of the State and took the form of rules more than principles (Burchell et al., 1980: 7). In Italy, there was a long tradition of civil law codes providing minimal accounting rules that were then interpreted by practitioners and academics (Coda and Frattini, 1980) .
Starting in 1942, in Italy the Civil Code regulated the preparation and provision of financial reporting and replaced the Code of Commerce (1882), which was based on French Commercial Law and lacked detailed accounting rules and prescriptions. 16 The 1942 Civil Code rendered Italian accounting regulation more detailed in terms of general principles, presentation and evaluation requirements. At this stage, the minimum content and format of the balance sheet were regulated, and the historical cost principle was adopted, but significant room for discretion in the application of year-end evaluation criteria was still available to managers (Di Pietra et al., 2001; Zambon, 2002). The regulations became more stringent after the subsequent reform of the Code in 1974, with the standardization of the format and minimal content for the income statement and detailed prescriptions for evaluation criteria (Galassi, 1984; Zambon, 2002).
Italian accounting regulation was established by State initiative and then integrated, interpreted and used in day-to-day accounting practices by professionals and academics, whose work was also institutionalized in a formal national standard setter in 1975 with the foundation of Consiglio Nazionale dei Dottori Commercialisti (CNDC – National Council of the Most Authoritative Professional Body), which started issuing national accounting principles in 1977. During the 1980s, such principles were recognized as the reference point for Italian listed companies by the newly created Commissione Nazionale per le Società e la Borsa (CONSOB – National Commission for Companies and the Stock Exchange). 17
Finally, in the 1990s Italian accounting regulation was affected by major changes, in this case mainly due to the implementation of several Directives issued by the European Commission 18 (EC) and devoted to favouring the harmonization of financial reporting throughout the European Union (EU) by means of the provision of common general accounting principles, formats and evaluation criteria for both the individual and consolidated financial statements of any type of industrial, commercial and financial company (see Table 3).
Although the interpretation and practical application of the new rules were often influenced by the extant Italian accounting traditions, 19 “the wide scope and importance of these changes seem largely self-evident. In a few years virtually all the previous regulations dealing with the technical and professional aspects of accounting were swept away and replaced” (Zambon, 2002: 134). The Anglo-Saxon “true and fair view” formula became the core object by which the overall financial reporting system was informed, departures from the new classification and evaluation criteria to comply with the “true and fair view” provision became compulsory, and the notes to the annual accounts became an integral part of the legal concept of financial statements. These are some examples of the changes brought by the EC Directives, which, in the end, “may be considered revolutionary because they touched upon the very core of the manner in which accounting is practised and organised in Italy” (Zambon, 2002: 156; Zambon and Saccon, 1993). 20
Role of financial reporting
Having considered the differences between the US and Italy with reference to their firms’ characteristics, capital market structure, and accounting regulation, it is not surprising that the two countries also differed in the roles attributed to financial reporting.
Indeed, the large presence of widely held corporations in the US and the consequent separation between ownership and control (Jensen and Meckling, 1976; Fama, 1980) fostered the need for a solution to the agency problem. In this context, financial reporting and information in general came to be considered fundamental tools to enhance the control of dispersed owners over managers. Therefore, as the primary users of financial reporting, shareholders and investors relied on financial information to make their investment decisions and exert their control over management. This role of financial reporting was clearly underlined by the AAA in 1966 in its Statement of Basic Accounting Theory, where decision usefulness was recognized as a relevant characteristic of financial reporting, and accounting was defined as “the process of identifying, measuring, and communicating economic information to permit informed judgment and decisions by users of the information” (AAA, 1966: 1). 21 Accordingly, at the beginning of its activity, the FASB agreed that “financial reporting should provide information to help present and potential investors and creditors and other users in assessing amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans” (FASB, 1978, Concept Statement 1, par. 37). As a consequence, on one hand, fair and true information was a requirement of financial reporting to assist investors’ decisions, but, on the other hand, managers could take advantage of the investors’ reliance on financial reporting by providing deceitful financial information. 22 In the same period, US regulations regarding financial statement preparation and audits increased with the foundation of the Financial Accounting Standards Board (FASB) in 1973 and the issuance of the first 15 Statements on Audit Standards between 1972 and 1976. 23
Conversely, in Italy, in consideration of the concentrated ownership of Italian public companies in addition to the marginal role of small investors, the 1942 Civil Code relegated the financial statement to the role of a compulsory document for taxation purposes rather than an informative tool for external disclosure purposes (Amaduzzi, 1957; Ardemani, 1986). Indeed, it was only in the mid-1970s that the Civil Code was reformed to remove its deficiencies by providing more stringent and detailed rules for the preparation of financial statements (see Table 3). Moreover, in 1974, compulsory external auditing for listed companies was introduced to guarantee “(i) the regularity of the company’s book keeping, and the correctness of the representation of administrative facts in the accounting records, and (ii) the correspondence of the company and group financial statements with the results of the account books, as well as their conformity to legal rules” (Zambon, 2002: 148). This change, in addition to the increased attractiveness of capital markets due to the introduction of new financial instruments, stressed the quality of the information conveyed by the Italian companies’ financial statements (Capaldo, 1975, 1981; Coda and Frattini, 1980; Mattessich, 2007), and it enabled a new interpretation of the role of financial reporting by professionals and academics. Financial statements began to be viewed as a tool to disclose financial data to several categories of stakeholders and not solely as a mandatory document for taxation purposes (Capaldo, 1975; Cassandro, 1978; Colombo, 1987; Cattaneo and Manzonetto, 1997; Savioli, 1999).
Research topics
Comparison of the research topics covered by EM literature in the two countries revealed that American and Italian researchers focused on common topics with reference to EM techniques, incentives and consequences (see Table 4).
Summary of research topics comparison.
In terms of the techniques used to manage earnings, both American and Italian researchers recognized that the room for discretion and the accounting alternatives provided in the preparation of financial statement created the opportunity to manipulate earnings, and they both investigated similar phenomena such as the realization of EM practices (Copeland, 1968; Copeland and Licastro, 1968; White, 1970; Amaduzzi, 1949a; Onida, 1951; DiToro and Ianniello, 1996).
For instance, the stock watering phenomenon 24 was found to be of interest in both settings. In the US, the issue was investigated within the public utilities industry (Bonbright, 1945; Lindley, 1960; Key, 1997), as well as in connection with treasury share purchases (Buttimer, 1960) and stock dividends (Tucker, 1985). Overall, the issuance and distribution of watered stocks (that is, new stocks without receipt of consideration from the shareholders) was identified as a dangerous practice to the detriment of the shareholders themselves and the financial market in general. In Italy, attention was more focused on the overvaluation of assets and/or the undervaluation of liabilities, which were condemned because they could lead to the overestimation of the resources actually invested (Damato, 1953).
Moreover, the discretional use of reserves was studied as another technique to manage earnings in both countries. In particular, US researchers analysed reserves accounting to manage earnings (Hepworth, 1953; Devine, 1963) and described it as a “crude and arbitrary technique” (Hepworth, 1953: 38). Similarly, Italian authors noted the dangerous managerial practices of hiding earnings reserves to avoid taxes and reduce share value, leading to falsification of the actual performance of the company (Cassandro, 1946; Cavalieri, 1983). It has to be noted that, in the Italian context, authors distinguished hidden reserves from implicit reserves generated by a very strict use of conservatism, which was considered a proper practice to preserve the company’s profitability and the share capital for the benefit of shareholders and creditors (Cassandro, 1946; Amaduzzi, 1949a ; Onida, 1951; Accetta, 1970; Maiello, 1973; Azzini, 1975).
To the same extent, the use of depreciation, deferred charges, and accruals in general were indicated both by American and Italian authors as the main tools to manipulate earnings. In the US, the following accounting items and techniques were investigated as the major tools to manipulate earnings: the depreciation of intangible and tangible assets (Hepworth, 1953; Archibald, 1967; Elliott and Shaw, 1988; Francis et al., 1996; Rees et al., 1996; Keating and Zimmerman, 2000); deferred charges and provisions (Hepworth, 1953; DeAngelo, 1988; McNichols and Wilson, 1988; Mensah et al., 1994; Ahmed et al., 1999); extraordinary item adjustments, pension costs, sales and advertisement expenses and R&D costs (Dascher and Malcom, 1970; Beidleman, 1973; Moore, 1973); changes in evaluation criteria (Cushing, 1969; Moses, 1987; Elliott and Philbrick, 1990; Balsam et al., 1995; Hand and Skantz, 1998); asset revaluation (Dean, 1954); and the adoption-timing of new accounting standards (Amir and Livnat, 1996). Finally, from a more calculative perspective, American researchers also studied the dynamics of accruals as possible tools to manage earnings; indeed, as values based on estimates that shift or adjust the recognition of cash flow to determine earnings, accruals are subject to discretion and so can provide opportunities for EM. Therefore, some researchers proposed different models to address methodological issues in detecting EM practices and distinguish between discretionary and non-discretionary accruals (Jones, 1991; Dechow et al., 1995; Kang and Sivaramakrishnan, 1995; Guay et al., 1996; Dechow et al., 1998; DeFond and Subramanyam, 1998; Hirst and Hopkins, 1998).
Italian authors also noted similar techniques. In particular, depreciation, amortization and provisions for future expenses were described as related to earnings manipulation (Onida, 1974; Di Toro and Ianniello, 1996; Oricchio, 1999), as well as specific accounting choices (Viganò, 1973; Bruni 1975; Cavalieri, 1983), over- or underestimation of discretional accounting values (Frattini, 1988), cost capitalization (Oricchio, 1999), and accounts receivable (Coronella, 1997) 25 .
In terms of incentives to manage earnings, both US and Italian researchers identified income smoothing – that is, the practice of earnings stabilization over financial years – as the main motivator. Indeed, the US literature described income smoothing as the main motivator of EM because earnings become less volatile (Gordon, 1964; Copeland, 1968), thus making them more predictable by both investors and analysts (Brown, 1983) but less representative of the actual performance of the company (Newman, 1988; Trueman and Titman, 1988). Similarly, Italian authors identified income smoothing as a motivation to manage earnings, but they attributed a different meaning to it. Income smoothing was considered useful to counterbalance the simultaneous need to assign an adequate remuneration to shareholders and safeguard the company as a going concern, which required the capability to generate positive earnings in subsequent years (Amaduzzi, 1949b; Ardemani, 1986). Furthermore, income smoothing was viewed more as a conservative motivation than a deceiving one as far as the long-term profitability of the company was concerned (Cassandro, 1946; Onida, 1951; Coda and Frattini, 1980). Accordingly, in the Italian setting, stringent conservatism was another important motivation associated with income smoothing, especially to justify the use of implicit reserves to offset years of good performance with years of poor ones (Onida, 1974). Conversely, such a motivation was not particularly considered in the American EM literature, even if some studies discussed the income smoothing motivation as not always a negative or dangerous practice (Beidleman, 1973; Collins and Kothari, 1989; Easton and Zmijewski, 1989; Collins et al., 1994).
Among US studies of EM for income smoothing purposes, a number of explanatory variables were tested, such as ownership structure, firm size and the divergence of actual earnings from expectations (Koch, 1981; Moses, 1987), as well as the timing of adoption of new accounting principles to favour earning smoothness (Amir and Livnat, 1996) and other peculiar accounting “gimmicks” (Copeland and Licastro, 1968; Weil, 1980; Warfield and Linsmeier, 1992). A small stream of US EM literature tested the “big bath” hypothesis (that is, a one-time charge is taken against income to show higher net income in future years) (Amir and Livnat, 1996), as well as the earnings overstatement hypothesis (Beneish, 1999).
In addition to income smoothing motivation, American and Italian EM research differed in other possible motivations, especially after the “empirical revolution” in the US. Indeed, Italian researchers denoted tax avoidance as a possible motivation for EM, especially in consideration of the taxation purposes attributed to financial reporting in Italy (Damato, 1957; Bruni, 1975; Coda and Frattini, 1980). Conversely, American researchers focused on loss avoidance as a reason for EM because managers prefer to communicate small positive or zero earnings to investors and capital markets rather than losses; thus, EM might help to achieve such aims (Carslaw, 1988; Thomas, 1989; Burghstaler and Dichev, 1997).
In American EM research, other motivations were also examined that were not discussed in Italian research. In particular, a large part of EM literature in the 1980s and 1990s studied capital market incentives for EM, such as stock prices (Brown and Ball, 1967; Ball and Brown, 1968; Beaver, 1968; Mlynarczyk, 1969; Ball, 1972), initial public offerings (DeAngelo, 1986; Aharony et al., 2000), management buyouts (Perry and Williams, 1994), and mergers (Erickson and Wang, 1999). Another notable research stream is related to contractual motivations for EM, such as covenant violation (DeFond and Jiambalvo, 1994; Dhaliwal et al., 1994; Sweeney, 1994), executive compensation (Beidleman, 1973; Healy, 1985; Moses, 1987; McNichols and Wilson, 1988; Gaver et al., 1995; Holthausen et al., 1995; Evans and Sridhar, 1996; Guidry et al., 1999), maintenance of job security (DeFond and Park, 1997), management turnover (Moore, 1973), shareholders’ interests (Dye, 1988), and taxation (Boynton et al., 1992; Dhaliwal et al., 1994; Maydew, 1997; Mills, 1998). Moreover, some literature investigated income decreasing practices in the US oil industry in specific circumstances, such as incoming corporate tax rate reductions (Guenther, 1994), litigation events with potentially large damage awards (Hall and Stammerjohan, 1997), and the 1990 Persian Gulf Crisis (Han and Wang, 1998).
Finally, with reference to EM consequences for financial information quality and users, American and Italian research showed more differences than similarities. In particular, the impacts reported in US EM literature were generally negative throughout the whole period, notwithstanding the “empirical revolution”. Accordingly, earnings management practices could cause a reduction in the objectivity of periodic income determination (Hepworth, 1953), reduction in the decision usefulness of financial information for users (Brown, 1983), and lower stock valuations (Beaver and Engel, 1996). A distinction has to be made with reference to the stabilization of earnings as a consequence of EM. In this case, as noted previously, some American researchers echoed Italian researchers and agreed on the conservative effect of income smoothing, which could foster earnings predictability and persistence, both considered good qualities of earnings (Beidleman, 1973; Collins and Kothari, 1989; Easton and Zmijewski, 1989; Collins et al., 1994).
Conversely, the main EM effect noted by Italian researchers, especially up to the 1970s, was on the firm as a going concern through income stabilization and maintenance of share capital . Only after the 1970s and legislative reforms of the content of the financial statement did new reflections appear in Italian EM research regarding the possible negative impacts of EM on the external disclosure of the firms (Capaldo, 1975, 1981; Colombo, 1987; Cattaneo and Manzonetto, 1997; Savioli, 1999). In particular, concerns grew about the possible deceiving effects of EM on shareholders, stakeholders and financial markets in general (Viganò, 1973) and the alteration of the fair and true representation that financial reporting was supposed to provide (Bruni, 1975; Cavalieri, 1983), not to mention the risk of fraud (Prosperi, 1999a, 1999b) (see Table 4).
Research approach
To complete the comparison of American and Italian EM literature, we compared the research methodologies adopted by academics in the two countries and found that the initial similar approach to EM research diverged into a brand new approach in the US, while it remained the same in Italy (see Table 5). In particular, in the first part of the period under investigation, the approach to EM research was very similar in the US and Italy, while after the 1970s and the so-called “empirical revolution” in the US we observed a major redirection in the EM literature towards a completely different methodological approach compared to the Italian EM literature, which remained stuck in its traditional approach. 26
Summary of the research approach comparison.
Accordingly, until the 1970s both American and Italian EM research showed a similar qualitative approach to investigation, with broad and interpretative discussions of the origins of the EM issue, its motivation and its consequences. American researchers initially debated the issue on a very descriptive and narrative basis with normative aims by means of illustrative case studies to provide critical perspectives (Hepworth, 1953; Gordon, 1960) and descriptive statistics to compare specific accounting practices (Dean, 1954; O’Donnell, 1968; Cushing, 1969). In Italy, researchers performed their investigations on EM in a similar way. They usually adopted a narrative approach and focused on critical aspects of the issue following a deductive methodology to support their thesis (Mattessich, 2007; Viganò and Mattessich, 2007; Godfrey et al., 2010). As opposed to US researchers and according to the comprehensive paradigm of Economia Aziendale, they aimed to offer the big picture of their own interpretation of the firm, encompassing organization, management and accounting theories, instead of focusing on very specific subjects. Therefore, their contributions on the EM issue can be found in the form of chapters in monographs in which many aspects of the dynamics of the firm were investigated (Onida, 1951; Masini, 1957, 1958, 1970; Cattaneo, 1966; Ferrero, 1968).
After the 1970s and the “empirical revolution”, in the US context, EM research started to provide evidence of EM motivations and impact by means of statistical hypotheses tested using the new “scientific” research approach. The first studies adopting this new approach aimed to establish whether EM was affected by specific factors, such as stock prices (Ball and Brown, 1968; Beaver, 1986) or income smoothing motivation (Copeland, 1968). After these initial empirical studies, investigations based on statistical models to detect EM phenomena started to proliferate in the US context, becoming the preferred approach for this subject, with rare exceptions. In detail, statistical models were applied in EM research to search for causal relations between several possible motivations and EM, such as income smoothing (Copeland, 1968; Beidleman, 1973; Brown, 1983; Collins and Kothari, 1989; Easton and Zmijewski, 1989; Collins et al., 1994), capital market incentives (DeAngelo, 1986), and contractual motivations (DeFond and Jiambalvo, 1994). The same quantitative approach was applied to provide empirical evidence that EM was related to specific consequences, such as a reduction in decision usefulness (Brown, 1983) and reduction in stock valuation (Beaver and Engel, 1996). Furthermore, statistics and mathematics provided US accounting researchers with models and techniques to measure the manipulated earnings and make estimates of the abnormal use of discretion in determining earnings in large samples of firms based on financial data. By applying statistical models to the dynamic of accruals, researchers were able to determine whether companies were manipulating earnings within the room for discretion provided by accounting regulation (Jones, 1991; Dechow et al., 1995).
In contrast, no empirical revolution occurred in Italian EM research, due to the firm loyalty to the Economia Aziendale methodological tradition shown by Italian accounting academics. As outlined in the research-setting comparison, Italian researchers maintained Economia Aziendale as an undisputed point of reference even after the 1970s, when researchers still conducted their investigations according to the traditional narrative approach of this solely Italian paradigm. They still considered EM to be a subtopic within the Economia Aziendale debate and neglected agency theory in their EM studies. Italian researchers continued to approach the EM issue from a critical perspective, providing opinions and interpretation about the techniques, motivations and impacts of this phenomenon. The manipulation of earnings was interpreted within the context of a firm’s accounting practices, instead of within the problem of information asymmetry, maintaining a narrative and descriptive approach. Attention was also paid to the need to improve the ability of the financial statements to report the actual income generated by the firm (Poli, 1971, 1975; Provasoli, 1974; Bruni, 1975; Amodeo, 1976; Coda and Frattini, 1980; Coronella, 1997). Such an approach can be easily related to the role exerted by Italian professors in the accounting field; indeed, they frequently serve as consultants both to professional organizations and private companies (Galassi, 1984).
Only in rare cases did investigations elaborate firms’ financial data to study EM and detect income smoothing and present descriptive statistics, but they never performed statistical elaborations to demonstrate causal relations between any motivations or impacts and EM (Frattini, 1988; Oricchio, 1999) (see Table 5).
Discussion of the comparison
This historical comparison sheds light on the similarities and differences in EM research in Italy and the US from 1945 to 2000 in terms of research topics and methodologies, taking into consideration the contexts in which these fields of literature developed.
By detecting the commonalities, the comparison highlighted that the same problem of earnings manipulation came up in both contexts, even though accounting regulation and financial reporting aims were vastly different throughout the timeframe investigated. By detecting the differences, the comparison identified elements of US EM literature that could contribute to the widening of Italian EM literature, as well as those elements of Italian EM literature that could foster alternative perspectives in US EM literature. Indeed, the historical comparison allowed the identification of several potential areas of cross-fertilization between the two research streams to contribute to the development of the international debate about EM.
Regarding the commonalities, although the US and Italy had very different contexts with specific reference to firms’ and financial markets’ characteristics, accounting regulation and the role of financial reporting, both US and Italian researchers recognized the issue of EM, agreed that the origin of this phenomenon is the use of the discretion allowed by accounting rules and principles, and shared some research topics. Therefore, the use of discretion in financial statement preparation to achieve opportunistic aims is inevitable, no matter the context. Indeed, some EM techniques, derived from the use of discretion, were recognized in both contexts, especially stock watering and discretional modification of reserves, as well as depreciation, deferred charges and accruals, in addition to specific accounting choices and cost capitalization.
While some reflections on the problematic aspects of EM were similar in the two sets of literature, other aspects were rather different as a result of diverse research settings and contextual conditions. In particular, dissimilarities were found in the interpretation of EM, the variety of EM research topics, and the approach to studying EM. However, one benefit of these differences is the identification of potential areas of cross-fertilization between US and Italian literature.
With reference to the interpretation of EM practices, until the 1970s EM practices were generally not condemned by Italian researchers, but there was a general concern about the negative effects of EM on financial information in US EM literature throughout the studied period. As far as share capital preservation and maintaining a going concern were concerned, Italian academics regarded EM practices as acceptable to achieve such ends. Actually, the close proprietorship that characterized Italian firms and the marginal importance of capital markets allowed conservatism to prevail over the informativeness of financial results. Only after the increased appeal of capital markets and the reinforcement of accounting regulations in the 1970s in Italy did the usefulness of financial statements for investors grow in importance, and EM practices as a whole came to be regarded as misleading and detrimental to investors by Italian researchers, a stance more in line with US researchers.
Furthermore, the income smoothing motivation, which at first glance appeared to be a common topic between the two sets of literature, was interpreted differently by US and Italian researchers. According to the general interpretation of EM, US researchers regarded income smoothing as a mechanism to make earnings less volatile but also less representative of the actual performance of the company, thus misleading investors. Conversely, Italian academics depicted such motivation as tolerable if aimed to assign adequate remuneration to shareholders without damaging the prospects of the company as a going concern, even if after the 1970s the risk of investors being deceived by misleading information became a major concern when debating income smoothing motivations.
These different positions in the two sets of literature, as well as the change in the view of Italian researchers, demonstrated the potential effects of contextual conditions in informing the interpretation of EM practices in addition to the absence of a universal understanding of the EM phenomenon. Consequently, such different views could foster alternative considerations in the international debate on EM, and US researchers in particular could benefit from the different interpretations supported by Italian researchers to nurture their debate about earnings smoothing, which is described as having questionable tolerability in the US EM literature.
In regard to research topics, the US literature was found to have more variety in topics than Italian literature because it covered a wider set of EM motivations and consequences. Loss avoidance, capital market incentives and contractual motivations were not discussed by Italian researchers, who therefore could benefit from US literature and enlarge the number of investigated EM motivations and consequences to verify their influence in the Italian context.
Finally, with reference to the research approach, the comparison showed that until the 1970s, both US and Italian researchers approached the EM issue from a qualitative perspective. They described the origin of the phenomenon and its possible realizations as well as the motivations for earnings manipulation and the potential consequences. No empirical investigations were conducted nor were statistical models used to detect EM practices.
It has to be noted that this similar approach resulted from different research settings in the two countries. As highlighted in the comparison, before the “empirical revolution”, accounting academics in the US approached EM research (and accounting research in general) as consultants for practitioners and had to provide comment and critique on accounting practices. Therefore, they adopted methodologies that were traditionally employed by human sciences, and this caused extensive use of a deductive approach, interpretative and critical studies, as well as descriptions of case studies. Furthermore, US academics generally publish their research in the form of articles in accounting journals, whilst monographs and books are regarded mainly as teaching tools.
Conversely, as highlighted in the comparison between US and Italian research methodologies, the narrative and interpretative approach used by Italian academics responded to the need fostered by the Economia Aziendale paradigm to study accounting by embracing all aspects of a firm’s life. Italian accounting research used to be broader as opposed to more specialized in nature, encompassing several accounting topics, among which EM was studied as a problem generated more by a firm’s accounting practices, than by agency problems. To fulfil the need for broad research on firms’ accounting practices, Italian researchers used to critically observe and interpret various accounting issues with narrative and descriptive analysis or case studies. Because this approach to research was fostered by loyalty to Economia Aziendale, which persisted throughout the studied period, it is not surprising that as long as Italian academics continued to be tied to this paradigm, they maintained a qualitative approach to EM research (and accounting research in general) and were not affected by the US “empirical revolution”. In Italian EM literature, no shifts towards an empirical approach emerged after the 1970s, whilst in US EM studies a major methodological turnaround occurred, with progressive abandonment of qualitative methodologies in favour of statistical and mathematical ones, as indicated by the comparative analysis of the research settings and the research approaches.
The narrow settings required by statistical methodologies, the tension for measurement improvements, and the interest in dual-dimensional interactions fostered consideration of the firm as basically a nexus of contracts rather than a dynamic institution that changes over time – as instead suggested by Economia Aziendale – and should be studied from a broader perspective. Again, to a further extent, the comparison provided initial evidence of potential areas of cross-fertilization between the two sets of literature. Italian researchers could benefit from a deeper knowledge of EM research in the US to make up for the delay in developing empirical methodologies, while US researchers could recover the past interpretative approach in EM studies and regain a broader view of the EM issue.
In brief, the comparison shed light on the similarities and the differences between the dominating EM literature published by US academics and a national EM literature only known in the Italian context. By achieving this aim, it has been demonstrated that even very different contexts can reveal common interests in specific accounting issues, but the way in which academics debate such issues in each context can widen the international debate through the consideration of diverse settings and alternative theories. To a further extent, it also provided initial evidence of potential areas of cross-fertilization between the two literatures, which can contribute to the development of future comparative research on this topic. Moreover, the CIAH model, readapted for the aims of this study, proved to be suitable not only to compare the EM literature that developed in two different contexts over time but also to provide insights that could foster international debate on this topic. To such ends, the CIAH model might be a valuable tool to inform future comparisons of EM literature in other settings, as well as to perform new historical comparisons of research in other accounting topics.
Conclusions
The historical comparison presented has shed light on similarities and differences between US and Italian EM literature in the second half of the twentieth century, utilizing the CIAH model as the basis of exploring different accounting literatures, rather than different accounting practices.
The study found that although accounting regulation and financial reporting aims were vastly different throughout the timeframe investigated, both Italian and US scholars recognized the same problem of earnings manipulation, identified the use of discretion as the foundation of the phenomenon, and agreed on particular EM techniques, like income smoothing. However, as a result of the diverse research settings and contextual conditions, Italian and US scholars attributed different interpretations to EM, demonstrating the absence of a universal understanding of the EM phenomenon. The different scholars also differed in their research methodologies, which in the US originated from a research revolution, while in Italy they remained largely subordinate to a strong loyalty to a national research paradigm. Finally, EM research topics studied in the US were more varied than in Italy.
This study contributes to both the comparative accounting history and the EM literature in different ways. With regards to comparative accounting history, by implementing CIAH to compare different EM literatures instead of accounting practices, the study widens the use of CIAH to accounting literature beyond accounting practices. It thereby provides an additional tool to extend and support international accounting research. With reference to EM literature, this study reveals the existence of alternative theories and methodologies in EM literature pertaining to different contexts and, to a further extent, it found signs of potential cross-fertilization between US and Italian literature. Finally, the study contributes both to comparative accounting history and EM research by encouraging the implementation of historical comparisons to other national EM literatures to further enhance the international debate on this topic.
We recognize that some limitations affect our study. The choice made to collect the Italian studies on EM is subject to an inevitable bias, especially with respect to the gathering of Economia Aziendale books. Additionally, we limited the search for US contributions to only three journals, while many studies are published in other US-based accounting journals. However, our purpose was to compare the main features of Italian and US EM literature and not to provide a comprehensive literature review of EM studies in the two countries. Finally, although the choice of the period under investigation is broadly justified, it is still based on inescapable subjectivity. At the same time, this article provides insights into future research informed by the CIAH model. Future research might carry out parallel studies on the development of other fields of research, or look for cross-fertilization opportunities among national accounting literatures in topics other than EM. Finally, new comparisons on the diffusion of specific accounting topics or research methodologies in different contexts might investigate the forces driving such changes.
Footnotes
Acknowledgements
The authors gratefully acknowledge the two anonymous reviewers for their insightful comments and the editors of Accounting History, Garry Carnegie and Brian West for their encouragement to improve this study. A hearty “thank you” to Alessandro Lai and Lee Parker for their valuable advice and encouragement. The article, in its earlier version, also benefited from the feedback provided by the attendees at the seventh Accounting History International Conference held in Seville in September 2013 and at the 2013 AIDEA Conference held in Lecce in September 2013. While the article is the result of a joint effort from the authors, the individual contributions are the following: Giulia Leoni wrote ‘Introduction’, ‘Analytical model’, ‘Context’, ‘Discussion’, and ‘Conclusions’; Cristina Florio wrote ‘Literature review’, ‘Period’, ‘Research topics’, and ‘Research Approach’.
Funding
This research received no specific grant from any funding agency in the public, commercial or not-for-profit sectors.