Journal of Accountmg and Econormcs 5 (1983) 77-117. North-Holland zyxwvutsrqponmlkjihgfedcbaZYX THE ECONOMIC CONSEQUkNCES OF ACCOUNTING CHOICE Implications of Costly Contracting and Monitoring* Robert W. HOLTHAUSEN and Richard W. LEFTWICH Unioersrty of Chicago, Chxago, IL 60637, USA Received October 1982, final version received June 1983 In this paper, we review research mto the economic consequences of voluntary and mandatory choices of accountmg techmques and standards We discuss how the predictlons of extant economic consequence theories are dnven by contracting and momtormg costs associated with management compensation contracts, bond covenants, regulation, and/or pohtlcal vlslbdlty We review empirical tests of economic consequence theones, categonze those tests, and discuss their strengths and weaknesses. The empincal tests reveal two systematic associations with accountmg choice: sm, a proxy for pohtlcal visiblhty, and leverage, a proxy for contracting and momtonng costs of lending agreements. Interpretation of the results is difficult, due to general hmitatlons of the tests. We conclude by suggestmg some dlrectlons for future research, based on our analysis of the potential payoffs associated with different types of emplrical tests. 1. Introduction In this paper, we review research into the economic consequences of voluntary and mandatory choices of accounting techniques and standards. Accounting choices have economic consequences if changes in the rules used to calculate accounting numbers alter the distribution of firms’ cash flows, or the wealth of parties who use those numbers for contracting or decision making.’ Predictions of extant theories of economic consequences are driven by contracting and monitoring costs associated with firms contractual agreements, such as management compensation contracts and lending agreements, and with firms’ political visibility. Contracting and monitoring *An earlier version of this paper was presented at the Amencan Accountmg Assonatlon Convention in San Diego m August 1982. We appreciate the comments of the discussants of that paper, Bob Magee and Ross Watts. In addition, Rick Antle, Dan Collms, Nick Dopuch, John Elliott, George Foster, Michael Jensen, Bob Kaplan, Jerry Zimmerman, an anonymous referee, and the participants of the accounting workshop at Cornell Umverslty provided helpful comments on that version of the paper We gratefully acknowledge the financial support of the Institute of Professional Accountmg, and the Center for Research m Secunty Prices at the Umverslty of Chlcago ‘See Watts (1977) and Watts and Zimmerman (1978) for theones which explam the link between firms, cash flows and reported accounting income numbers We synthesize those theories below. The theories are commonly referred to as ‘posltlve theones’, but we descnbe them as econonuc consequence theories. The theones are posltlve, as opposed to normative, but that IS not then dlstmguishmg feature. Much research m accountmg 1s positive. Only a subset of that research mvestlgates the economic consequences of accounting choice. 0165-4101/83/$3.00 0 1983, Elsevler Science Pubhshers B.V. (North-Holland)