Tom Mouck UNIVERSITY OF NEW MEXICO

THE REVOLUTION IN FINANCIAL REPORTING THEORY: A KUHNIAN INTERPRETATION

Abstract: A Kuhnian perspective is used to explain the transition in financial reporting theory from an “economic income perspective” to an “informational perspective” (a transition that Beaver refers to as a “revolution”), and to examine the subsequent development of the latter. The demise of the economic income perspective (represented by the normative a priorists) is attributed to the lack of a paradigm which could serve to identify research problems and provide methodological guidance. The success of the informational paradigm, on the other hand, is attributed to the fact that it was, in essence, a sub-paradigm of the broader and well-established market economics paradigm. The study concludes, however, with a discussion of two types of persistent anomalous findings (the first with respect to the EMH and the second with respect to the CAPM) that have the potential to generate a crisis for the informational paradigm.

The 1960s was a decade of turmoil in financial accounting theory and research. Post-1960s financial accounting research is radically different in method, theoretical content, and philo-sophical thrust than pre-1960s research. Wells [1976] has sug-gested that the turmoil signified the beginning of a Kuhnian revolution. Beaver [1989] characterizes the outcome as “an ac-counting revolution”; a revolution whereby an “economic in-come” approach was replaced by an “informational perspective” [Beaver, p. 18]. Although there is no indication that Beaver is using the term revolution in a Kuhnian sense, the implication is that the changes were internally generated, an overthrow that was initiated by developments in accounting theory. This paper offers a significantly different interpretation. A Kuhnian perspective is employed to argue that the new view of financial reporting theory described by Beaver can be seen as a “normal science” expansion of the economics paradigm.

This approach holds the potential of a new explanation for the failure of the normative a priori research movement and the success of the new informational research movement. The Kuhnian perspective also provides a unique vehicle for analyzing the potential significance of challenges to the validity of the efficient markets hypothesis (EMH) and the capital asset pricing model (CAPM) which have long served as cornerstones for the informational perspective. First, however, it will be useful to locate the present study within the context of existing Kuhnian analyses in the accounting literature.

KUHNIAN ANALYSIS OF ACCOUNTING THOUGHT

Cushing [1989] has provided an excellent review of Kuhnian references in the accounting literature and there is no need to repeat that process. This section, accordingly, shall be limited to locating the present study with respect to the more prominent and comprehensive applications of Kuhnian ideas that can, in turn, be related to the accounting debates of the 1960s and 1970s

In the mid-1970s, there were suggestions that accounting was in the midst of a Kuhnian crisis characterized by paradigm debate [Wells, 1976; The AAA’s Statement on Accounting Theory and Theory Acceptance, 1977]. Peasnell [1981] and Laughlin [1981] challenged the applicability of Kuhn’s ideas to accounting. Kuhn’s theory, according to Peasnell, applies only to sciences, and since accounting is not a science, Kuhnian analysis of accounting thought is inappropriate. Cushing, on the other hand, presents a case for the applicability of Kuhn’s ideas to intellectual disciplines other than the sciences. His analysis is more elaborate than previous studies and provides useful background for the present study.
With respect to accounting, Cushing argues that since the traditional concerns of accounting (making sense of the eco-nomic performance of business enterprises) share significant common ground with the concerns of science (making sense of reality), “Kuhn’s theories may be pertinent to an understanding of the historical evolution of the accounting discipline” [Cushing, p. 11]. He maintains that “the double-entry bookkeeping model has the features of an accounting paradigm, as that term is used by Kuhn, and that the historical evolution of accounting from approximately the Sixteenth century until about 1960 resembles the normal science of Kuhn’s theory” [p. 20].

The advent of governmental regulation of accounting practice and reporting in the Twentieth century led to a search for uniform accounting principles and resulted, according to Cushing, in the first stage of crisis for the double-entry para-digm. “The combination of government regulation and the commitment to uniformity has led to a buildup of unresolved accounting issues that perhaps more closely resemble the anomalies of Kuhn’s theory” [Cushing, p. 23].

A second stage of accounting’s crisis was triggered, Cushing suggests, when the search for a scientific foundation for financial accounting theory — a search which reached its most fervent pitch in the 1960s — produced instead a widespread conviction that “accounting was inherently arbitrary” [Cushing, p. 27]. The sense of crisis was further deepened by the growing conviction that even if a scientific theory of financial accounting could be found, it could never be implemented because of the extent to which the rule-making process had been politicized. “In essence, the further development of accounting thought along traditional lines was now irreconcilable with the ideals of science that accounting scholars had fervently embraced” [Cushing, p. 27]. Many academic accountants responded to this situation, Cushing argues, not by abandoning science, but by abandoning accounting. “Accounting scholars have committed themselves to science, but having come to realize that accounting has no scientifically valid paradigm to provide a basis for scientific research, have chosen to practice other sciences that do have such paradigms” [Cushing, p. 29].

This author agrees with Cushing that the 1960s ushered in a wholesale concern with scientific accounting research, but attributes this concern more to outside social, political, and technological factors than to crisis in a Kuhnian-type paradigm. Similarly, this author tends to share Peasnell’s skepticism about the applicability of Kuhn’s ideas to traditional (pre-1960s) accounting thought, but views the alternative proposals for scientific accounting practice which were put forth by the so-called normative a priori theorists of the 1960s as manifestations of pre-paradigm struggle. There is also agreement with Cushing’s view that, since the 1960s, there has been a wholesale abandonment (by academic accountants) of the traditional concerns of accounting and a corresponding wholesale acceptance of other disciplines (especially economics) which are considered to be scientific.
In short, the 1960s marked the beginning of the applicability of Kuhn’s ideas to accounting thought in correspondence with the development of widespread concern about being scientific. In the context of Kuhn’s ideas, the 1960s academic ac-counting literature was dominated by the search for a para-digm.

THE “SCIENTIFIC TURN” AND THE SEARCH FOR A PARADIGM

On all fronts, the 1960s were, in the words of Dyckman and Zeff, “a pivotal decade” for accounting research: “In the literature of accounting research, the 1960s was the Decade of Awakening” [Dyckman and Zeff, p. 233]. A unique congruence of social, political and technological developments had produced a shared commitment to the pursuit of scientific research in accounting. By the mid-1970s, however, it was obvious that the “decade of awakening” had produced nothing remotely resembling a consensus view of financial accounting and reporting theory. In fact, a study commissioned by the American Accounting Association concluded that, “a multiplicity of theories has been — and continues to be — proposed” [AAA, 1977, p. 1]. The AAA committee further characterized the current theoretical debate as “virtually endless argumentation and inability to resolve issues that are raised” [AAA, 1977, p. 1]. In Kuhnian terms, the committee suggested that accounting theorists were involved in paradigm competition [p. 43].

The AAA’s study, published under the title Statement on Accounting Theory and Theory Acceptance (SATTA), classified the diverse perspectives on accounting theory into three categories: “classical approaches to theory development” [p. 5]; “the decision usefulness approach” [p. 10]; and “information economics” [p. 21]. SATTA’s classification scheme, however, is deficient on two counts. In the first place, it does not differentiate the pre-19608 theorists from the science-oriented theorists of the 1960s. Secondly, it lumps empirical capital markets researchers such as Gonedes, Beaver, Ball and Brown together with normative, apriorists such as Chambers and Sterling in the “decision usefulness” category. As Peasnell points out, this categorization is at odds with other classifications in the accounting literature. He (Peasnell) charges that “the committee’s classification seems to border at times on the artificial” [p. 70]. This charge is further borne out by the fact that Beaver, in 1981, presented very cogently the interrelationship of information economics theory and empirical capital markets research: schools of thought which the AAA committee had treated as separate “paradigms”.

This brings up another problem with the AAA’s SATTA; a problem with respect to the committee’s use of Kuhnian termi-nology. SATTA included an argument that, “[t]here are a num-ber of people offering different paradigms” [p. 45], thus suggesting that Kuhn’s description of paradigm competition was applicable to the (then) current state of accounting theory. As Peasnell has pointed out, however, this is indicative of a misunderstanding of Kuhn’s theory. A given way of looking at the world, including theoretical orientation, becomes paradigmatic after it has found a certain level of acceptance. Theories may be offered by individual theorists, but paradigms are not put forth by individuals. The perspective suggested by an individual may eventually become paradigmatic, but it is not paradigmatic at the time it is put forth. Such considerations led Peasnell to pose the following question: “Do the variety of accounting theory approaches identified by the committee really constitute competing paradigms (or pre-paradigm ‘schools of thought’, for that matter)?” [p. 69]. The present study argues that, with respect to the various normative apriorists, the 1960s and early 1970s cannot be appropriately characterized by Kuhn’s notion of paradigm competition.

Kuhn [1970b] points out that the discourse of philosophy, as well as many of the social sciences, is characterized by “claims, counter-claims, and debates over fundamentals” [p. 6]. According to Kuhn, debate over fundamentals was also characteristic of many fields that subsequently developed into sciences:

. . . there are many fields — I shall call them proto-sciences — in which practice does generate testable conclusions but which nonetheless resemble philosophy and the arts rather than the established sciences in their developmental patterns. I think, for example, of fields like chemistry and electricity before the mid-eighteenth century, of the study of heredity and phylogeny before the mid-nineteenth, or of many of the social sciences today. In these fields . . . incessant criticism and continual striving for a fresh start are primary forces . . . [Kuhn, 1970c, p. 244]

It is the contention here that the debates among the normative apriorists of the 1960s and early 1970s can be much more aptly characterized as pre-paradigm debate [Kuhn, 1970a, p. 160], or alternatively as proto-science debate, than as paradigm competition.

With respect to the situation faced by the information economics and the capital market researchers, however, the AAA committee erred in a different direction. After noting that, in the absence of an accepted body of thought, each theorist must “provide his own foundation for the field” [AAA, 1977, p. 43], the committee asserts that, “Theorizing from efficient markets research has proceeded in a similar vein” [p- 43]. With respect to the informational perspective (information economics and capital markets research), the contrary was actually the case. Instead, accounting theorists in the informational perspective were, in fact, “jumping onto the bandwagon” of a very solidly established paradigm — the economics paradigm.

Thus, with respect to Kuhnian thought, accounting in the 1960s and early 1970s was the site of two distinct, yet interacting, Kuhnian processes. From the perspective of the traditional concerns of accounting, i.e., concern with the measurement of economic performance of business enterprises, the efforts of theorists such as Chambers, Edwards and Bell, Mattessich, and Sterling (so-called normative apriorists are viewed as pre—paradigm debate. The normative apriorists were attempting to establish a solid scientific foundation for the pursuit of the traditional concerns of accounting.

At the same time, another Kuhnian process was in opera-tion. From the perspective of economics (a discipline which can be considered to be appropriately characterized as a full-fledged scientific paradigm), the “normal science” process appropriately includes attempts to expand the explanatory power of the paradigm. During the 1960s theoretical developments such as the EMH and the CAPM held the promise of extending the explanatory power of the basic economics paradigm to encompass first business finance, and subsequently, financial accounting, while developments in information economics served to locate the emerging new perspective on financial reporting theory within the broader theoretical framework of economic thought.

In sum, accounting in the 1960s and early 1970s is viewed as the site of competition between the normative apriorists (who were engaged in pre-paradigm debate with each other) and the proponents of the newly formed financial economics paradigm (an economics sub-paradigm which was engaged in normal science expansionary efforts). The remainder of this paper presents: a Kuhnian interpretation of competition between the normative apriorists and proponents of the financial economics paradigm; an overview of the subsequent normal science-type development of the “informational perspective” of financial re-porting theory; and an exploration (in terms of Kuhnian crisis theory) of the significance of challenges to the EMH and the CAPM.

THE FAILURE OF THE NORMATIVE A PRIORI RESEARCH MOVEMENT

It has been noted that the decade of the 1960s witnessed tremendous pressures for “scientific” accounting research. But the 1960s also saw a major increase in the pressure for more research. The American Assembly of Collegiate Schools of Business (the primary accrediting organization for academic schools of business in the U.S.) instituted the doctorate as the terminal degree for academic accountants in 1967 and began placing greater and greater emphasis on research productivity in the accreditation process. This emphasis, together with the social and political pressures noted earlier, resulted in a major push for more accounting research that was also scientific.

However, research never happens in isolation from a net-work of beliefs, attitudes and theories. This was one of the most salient features of Kuhn’s exposition of normal scientific practice: “. . . in the absence of at least some implicit body of intertwined theoretical and methodological belief that permits selection, evaluation, and criticism … it must be supplied, perhaps by a current metaphysic, by another science, or by personal and historical accident” [Kuhn, 1970a, pp. 16-17]. From a Kuhnian perspective the body of intertwined theoretical and methodological belief provided by a paradigm is what gives researchers the confidence that their work will find acceptance. With respect to the situation faced by new PhDs in accounting in the 1960s, a research paradigm was needed to provide confidence that their research would “pay off’, that it would lead to success and recognition in the form of tenure.

This sort of consideration is a major reason that “normal science . . . [is] firmly based upon one or more past scientific achievements, achievements that some particular scientific community acknowledges for a time as supplying the foundation for its further practice” [Kuhn, 1970a, p. 10]. More precisely, “When the individual scientist can take a paradigm for granted, he need no longer, in his major works, attempts to build his field anew, starting from first principles and justifying the use of each concept introduced” [Kuhn, 1970a, pp. 19-20]. An accepted paradigm ends “the constant reiteration of fundamentals” [Kuhn, 1970a, p. 18]; it provides “confidence that they [are] on the right track . . . [and encourages] scientists to undertake more precise, esoteric, and consuming sorts of work” [Kuhn, 1970a, p. 18].

According to the AAA’s SATTA, the normative apriorists of the 1960s were not operating from any generally accepted paradigm. Various theoretical perspectives were put forth by individual researchers, but no single perspective found widespread acceptance. The most notable proposals tended to disagree on one or more fundamental issues. The situation is stated quite succinctly by Mattessich in his personal account of the “golden age” of a priori research: “It is characteristic of my approach that in contrast to others (e.g. to Alexander who used present values, Edwards and Bell who stressed replacement values, Chambers who championed exit market values, Ijiri who defended acquisition cost values), I introduced a general valuation assumption, thus tolerating all specific valuation hypotheses . ..” [Mattessich, 1984, p. 34].

Mutual criticism among the leading apriorists was also highly visible. Perhaps the most notable example was the ex-change between Chambers and Mattessich. Chambers published a critical review of Mattessich’s Accounting and Analytical Methods (AAM) in the Journal of Accounting Research [1966b] suggesting, according to Gaffikin, that “the work suffers from being ‘forced’ to fit methodological requirements at the expense of more fundamental, substantive analysis” [Gaffikin, 1988, p. 21]. Mattessich has subsequently referred to Chambers’ review as a “wholesale rejection” of his work [Mattessich, 1984, p. 32]. With respect to Chambers’ Accounting, Evaluation and Economic Behavior, Mattessich has asserted that, “Chambers started from a preconceived, and to my mind, dogmatic objective” [Mattessich, 1984, p. 33].

Mattessich was also involved in another notable exchange, this one with Sterling. Mattessich had published a critical re-view of Sterling’s The Theory of the Measurement of Enterprise Income in Abacus in 1971. Sterling’s reply, the following year, concluded that Mattessich had criticized his (Sterling’s) book for:

1. not taking an approach (teleological) that it in fact took;
2. not considering three users (creditors and stockholders, taxing authorities, and managers) that it in factconsidered;
3. not drawing a conclusion (different-incomes-for-dif-ferent-purposes) that was identical to its statement of the problem;
4. placing boundaries (to serve only stockholders) on the theory of accounting that it did not place;
5. drawing a conclusion (exclusive market values) that it did not draw; and
6. not being a general theory of accounting when it was explicitly stated to be (and entitled) a theory of income measurement. [Sterling, 1972, p. 101]

Sterling closed his reply with the assertion that Mattessich’s critique was “amorphous” and “without foundation” [p. 101].

In such an environment, in which even the theoretical leaders cannot seem to gain any substantial degree of acceptance, and at times display open contempt for each other’s work, is it any wonder that young new PhDs under pressure to publish would tend to look for a safer, more promising research perspective? Mattessich attributes the “reorientation of many young scholars, away from the a priori approach, towards empirical research” [1984, p. 36] to a “reaction of the dialectical process of academic fashion . . .” [1984, p. 35]. From a Kuhnian perspective, however, a different explanation is compelling. That explanation is that many young accounting academics tended to gravitate toward a budding new research paradigm which provided clear-cut research problems and examples of acceptable research methods. Many young new PhDs tended to gravitate toward a new accounting research paradigm which can be considered to be a sub-paradigm of economics.

THE ECONOMICS PARADIGM AND THE RISE OF MARKET-BASED ACCOUNTING RESEARCH

In contrast to the debates which dominate pre-science, the practice of normal science is characterized by the lack of debate over fundamentals. In fact, normal science is what Kuhn terms paradigm-based research, where the term paradigm, in the broad sense “stands for the entire constellation of beliefs, values, techniques, and so on shared by the members of a given community” [Kuhn, 1970a, p. 175]. According to Kuhn, the ac-cepted framework provided by a paradigm serves as a founda-tion for the articulation of problems that must be solved if the range of explanatory power is to be extended: “… normal-scientific research is directed to the articulation of those phenomena and theories that the paradigm already supplies” [1970a, p. 24]. As indicated earlier, “. . . in the absence of at least some implicit body of intertwined theoretical and methodological belief that permits selection, evaluation, and criticism … it must be supplied, perhaps by a current metaphysic, by another science, or by personal and historical accident” [Kuhn, 1970a, pp. 16-17]. This provides a major clue to the success of the informational perspective in financial reporting theory.

Three related theoretical developments in the 1950s and 1960s — the efficient markets hypothesis (EMH), the capital assets pricing model (CAPM), and modern portfolio theory (MPT) — had served to transform business finance into financial economics [Whitley, 1986]; they all three extended the “rationality assumption” and the “basic maximizing model” of economics to securities price research. These developments, in conjunction with the theoretical framework of information economics, created the opportunity for accounting researchers who were trained in economics to import the constructs and methods of economics into financial accounting research.

The spectacular “scientific” developments in finance in the 1960s were followed closely by academic accountants (espe-cially at the University of Chicago) who were anxious to find a theoretical foundation for the development of “scientific” re-search in accounting. The University of Chicago began its an-nual Conference on Empirical Accounting Research in 1966 with the leadership and participation of academics trained in the theory and methodology of financial economics.

In 1967, Ball and Brown presented their paper (“An Empirical Evaluation of Accounting Income Numbers”) at the conference; a paper that would later be recognized as having a formative influence on the emerging new research paradigm. Brown, in his recently published reflections on the paper, attributes their (Ball and Brown’s) success to their Chicago-style training in economics and finance. Brown notes that he had already studied the accounting classics at the University of New South Wales before going to Chicago for graduate study in 1963. “So on my arrival at Chicago I was exempted from all accounting courses other than the doctoral seminar … I was, however, programmed into a full complement of courses in Chicago-style economics and finance” [p. 203]. The strong empirical impetus in finance research at Chicago was supported by the data base made available by the University’s Center of Research into Security Prices, and scholars such as Merton Miller and Eugene Fama provided the intellectual leadership. “It did not take long”, Brown notes, “for me to be completely seduced by the sheer vitality of the Chicago finance group which, at that time, was rapidly developing lines of research fundamentally at odds with much of the accounting literature to which I had been exposed” [Brown, p. 203]. Developments in finance, however, were closely related to the spirit of Chicago economics which, as Brown implies, provided the theoretical underpinning of the entire financial economics paradigm.

The second part to this ‘formative’ story is the role of Chicago’s Economics Department. I and many of my doctoral program classmates chose Economics as our basic discipline . . . We then trotted off to the Econom-ics Department where we inevitably were schooled in applied microeconomics and given a heavy dose of so-called positive economics, often taught by Milton Friedman himself. The empirical mindset was so dominant in the 1960s that it influenced almost all of the doctoral students’ choices of research topics for a generation or more. [Brown, p. 203]

In any case, the publication of Ball and Brown’s article in 1968 provided the real breakthrough for the aspiring new ac-counting research movement. Watts and Zimmerman [1986, p. 5] cite this article as the one having the biggest impact on the evolution of securities price research in accounting. This was borne out by an earlier report by Dyckman and Zeff of an informal survey of their research-oriented colleagues regarding the most important contributions to accounting literature between 1960 and 1980. Their survey resulted in 56 votes for articles published in The Journal of Accounting Research (JAR) versus 44 for articles published in the Accounting Review, but fully one-half of the votes for JAR were votes for the 1968 Ball and Brown article [Dyckman and Zeff, p. 254]. It was an article that “stirred widespread interest in efficient markets research in accounting” [Dyckman and Zeff, p. 242].

The Ball and Brown study was essentially an extension of the financial economics paradigm. Using the CAPM as a tool for relating accounting numbers to securities prices, they investigated the relationship between unexpected earnings and abnormal rates of return for 261 New York Stock Exchange firms during the nine years from 1957 to 1965. The results, interpreted in light of the efficient markets hypothesis, indicated that stock price changes do reflect earnings changes, but that most of the change in stock prices occurs prior to the report of annual earnings.

The Ball and Brown article was so different from tradi-tional accounting literature that “it was rejected [by the Ac-counting Review] on the reviewer’s contention that ‘it was not an Accounting manuscript'” [Dyckman and Zeff, p. 242]. From a Kuhnian perspective, it is not surprising that a study that was so radically different from the traditional approach to accounting research should become the exemplary study for future research. The “scientific achievements” that become the exemplars for a new paradigm must be “sufficiently unprecedented to attract an enduring group of adherents away from competing modes of scientific activity” [Kuhn, 1970a, p. 10]. From a Kuhnian perspective, the Ball and Brown study can be seen as a demonstration of how accounting researchers could harness the productive potential of the financial economics paradigm. For the growing number of young accounting academics who were under pressure to publish “scientific” research, the prospect of having an intellectual foundation (a paradigm) with established respectability must have been quite compelling; especially when compared with the tumultuous pre-paradigm debate among the normative apriorists.

This consideration (the pressure to publish) leads to Kuhn’s second characteristic of exemplary “scientific achievements” — they must be “sufficiently open-ended to leave all sorts of problems for the redefined group of practitioners to resolve” [Kuhn, 1970a, p. 10]. If there was nothing left to be done, no unsolved problems or nagging questions, researchers would have to look for different areas in which to practice their skills of inquiry. The “success of a paradigm”, Kuhn points out, “. . . is at the start largely a promise of success discoverable in selected and still incomplete examples” [1970a, pp. 23-24]. When paradigms cease to be problematic (as very few have), they cease “to yield research problems at all and . . . become tools for engineering” [Kuhn, 1970a, p. 79].

The Ball and Brown [1968] article was a success in the sense suggested by Kuhn. It held the promise of successfully extending the financial economics paradigm to accounting. Ball and Brown established that, within the financial economics paradigm, accounting earnings are empirically related to stock prices, but they studied only a limited set of accounting earnings (annual) and established only a gross relationship between earnings and stock prices. Left unanswered were such questions as the following. Could their results be duplicated for other sets of accounting earnings (such as quarterly earnings)? To what extent does the market anticipate changes in earnings? To what extent do accounting earnings announcements convey information to market participants? Are investors misled by earnings changes that result solely from changes in accounting procedures? The Ball and Brown article stimulated a number of studies aimed at answering such questions. As Watts and Zimmerman pointed out, “A reasonable characterization of the objective of the economics-based empirical literature that evolved in the 10 years following Ball and Brown (1968) … is that it sought to investigate the implications of the EMH and the CAPM for the role of accounting numbers in supplying information to the capital markets for valuation purposes” [pp. 15-16].

MARKET-BASED ACCOUNTING RESEARCH AS NORMAL SCIENCE

Most of the empirical work stimulated by Ball and Brown fits Kuhn’s characterization of normal science; it was work aimed at articulating and fleshing out the financial economics paradigm with respect to accounting numbers. It consisted mainly of “mopping-up operations” which could be classified into Kuhn’s three categories of normal scientific problems — “determination of significant fact, matching of facts with theory, and articulation of theory . . .” [Kuhn, 1970a, p. 34].

By demonstrating that a certain class of facts is “particu-larly revealing of the nature of things . . . the paradigm has made them worth determining both with more precision and in a larger variety of situations” [Kuhn, 1970a, p. 25]. Much normal scientific research, accordingly, aims at more clearly delin-

eating the boundaries of this “class of facts”. Such work can be demonstrated quite clearly with respect to the extension of the financial economics paradigm to financial reporting theory. Whereas Ball and Brown had demonstrated the relationship between annual earnings and stock prices for NYSE firms, an obvious approach for further research was to determine whether the same relationship existed for other securities. As Watts and Zimmerman note, “The Ball and Brown study has been replicated for annual earnings announcements by firms traded in U.S. markets other than the NYSE … It also has been replicated for annual earnings announcements for firms traded in other countries” [p. 47]. Other “mopping-up” work by researchers in the new accounting paradigm established that the class of significant facts included the relationship between interim earnings and securities prices.

A second category of normal scientific problems arises as a result of difficulties involved in matching theory with factual observations. “Improving that agreement or finding new areas in which agreement can be demonstrated at all presents a constant challenge to the skill and imagination of the experimentalist and observer” [Kuhn, 1970a, p. 26]. In the natural sciences, for instance, special equipment must be developed to measure results that are not observable to the naked eye, and the use of such special equipment usually requires theoretical justification and adaptation. This type of problem was very pointed for researchers in the new accounting paradigm. The underlying theory of financial economics specified a certain relationship between expected future cash flows and securities prices. Accounting researchers, on the other hand, were primarily concerned with the relationship between earnings and securities prices; and in any case, expectations about the future are not directly observable. The development of the new accounting paradigm, therefore, left much scope for work regarding the fit between fact and theory.

Ball and Brown assumed that accounting earnings could be used as a surrogate for cash flows, thus allowing them to use the CAPM to make predictions about the response of securities prices to earnings announcements. Due to the fact that expectations are not directly observable, Ball and Brown chose to proceed as follows: “. . . we construct two alternative models of what the market expects income to be and then investigate the market’s reactions when its expectations prove false” [p. 161].

They further used market models to differentiate the market response in terms of normal versus abnormal rates of return. In short, the actually observed data was compared with theoretical models which were, in turn, (theoretically) linked with the un-derlying theories of financial economics. Such investigative procedures obviously left considerable scope for further mopping-up work aimed at improving the fit between fact and theory. And indeed, many of the studies stimulated by Ball and Brown experimented with alternative models for measuring market expectations and abnormal returns.

Finally, the third type of normal scientific problem noted by Kuhn can be illustrated with respect to the new accounting paradigm; that is, “work undertaken to articulate the paradigm theory, resolving some of its residual ambiguities and permitting the solution of problems to which it had previously only drawn attention” [Kuhn, 1970a, p. 27]. As noted earlier, the Ball and Brown study established that securities price changes are related to accounting earnings changes, but it also found that much of the price changes occur prior to the annual earnings announcements. This gave rise to what was perhaps the most interesting question for subsequent researchers seeking further articulation of the basic theory — how much information con-tent do accounting earnings actually convey? Ball and Brown concluded that annual earnings announcements do contain use-ful information, but that only 10-15 percent of the potential information is conveyed in the month of announcement. The limitations of their study raised a number of questions about the validity of their conclusions with respect to information content of earnings announcements, and especially with respect to the role played by interim announcements. Many subsequent studies which addressed these issues can be viewed as attempts to refine and further articulate the paradigm theory.

Using Kuhn’s terminology, then, much of the accounting research stimulated by Ball and Brown can be aptly character-ized as Kuhnian “puzzle-solving”. The paradigm both generates (acceptable) research problems and supplies criteria for accept-able solutions, in much the same way that game-type puzzles specify problems and stipulate the rules for solving them. Thus, when engaged with a normal research problem, the sci-entist must premise current theory as the rules of his game. His object is to solve a puzzle . . . and current theory is required to define that puzzle and to guarantee that, given sufficient brilliance, it can be solved. [Kuhn, 1970b, pp. 4-5]

Kuhn employs the puzzle metaphor to emphasize that normal science research is not carried out as a test of the paradigm theory. Quite the contrary, it is the skill of the researcher that is at risk: “I use the term ‘puzzle’ in order to emphasize that the difficulties which ordinarily confront even the very best scien-tists are, like crossword puzzles or chess puzzles, challenges only to his ingenuity. He is in difficulty, not current theory” [Kuhn, 1970b, p. 5, n. 1].

The upshot of this is that the puzzle-solving activity of the normal science researcher is frequently aimed at establishing predictable or unsurprising results. Consider, for instance, the studies which applied Ball and Brown’s methods to stock mar-kets other than the NYSE. It surely was no surprise to find, as Watts and Zimmerman note, that “The replications suggest that the results are not unique to the NYSE” [p. 47]. Or consider the research on interim earnings, when Ball and Brown provided evidence that most of the price adjustments related to earnings changes took place prior to the month of annual earnings announcements, the obvious explanation was that most of the information reported was not new. It had previously been reported in interim announcements. So, it was no surprise when Foster [1977] reported a study using quarterly earnings which found evidence “consistent with the hypothesis that quarterly earnings convey information to the capital markets” [Watts and Zimmerman, p. 51]. Such examples are consistent with Kuhn’s contention that normal science does not “aim to produce major novelties” [1970a, p. 35].

This raises questions about why so much accounting re-search effort and so much journal space has been devoted to issues that are merely “mopping-up” or “puzzle-solving” issues. The answers Kuhn suggests are as follows. In a general sense, such studies increase the paradigm’s claim to legitimacy by in-creasing the scope and precision of its application [Kuhn, 1970a, p. 36]. As for the motivation of the individual researcher, personal satisfaction and professional recognition are associated with demonstrations of ingenuity in “puzzle-solving.”

Bringing a normal research problem to a conclusion is achieving the anticipated in a new way, and it requires the solution of all sorts of complex instrumental, conceptual and mathematical puzzles. The man who sue-

Mouck: The “Revolution” in Financial Reporting Theory 49
ceeds proves himself an expert puzzle-solver, and the challenge of the puzzle is an important part of what drives him on. [Kuhn, 1970a, p. 36]

ANOMALY AND THE DEVELOPMENT OF POSITIVE ACCOUNTING THEORY

The foregoing discussion is not intended to imply that nor-mal science proceeds in a perfectly straight line with no unex-pected turns or new directions. “Normal science does not aim at novelties of fact or theory . . . New and unsuspected phenomena are . . . repeatedly uncovered by scientific research, and radical new theories have again and again been invented by scientists” [Kuhn, 1970a, p. 52]. Indeed, anomalies — findings that seem contradictory to the paradigm theory — are ever present. They provide many of the puzzles that drive the normal scientific researcher. If solutions prove to be too elusive the paradigm theory may be adjusted to incorporate the anomaly. One of the most visible extensions of the dominant financial reporting paradigm can be attributed to the process of dealing with anomalous observations, such as the development of positive accounting theory.

Watts and Zimmerman note that “by the mid-1970s ac-counting researchers had observed . . . whole industries chang-ing from one method of accounting to another at one point in time (e.g., the switch by the steel industry from accelerated de-preciation to straight line in 1968)” [p. 6]. Such observations seemed consistent with the view that the stock market can be misled by earnings changes that result solely from changes in accounting procedures; a view that was widely held in the 1960s. However, as Watts and Zimmerman point out, this view contradicts the EMH which implies that the stock market will not be misled by such changes [p. 108]. From the perspective of financial economics, these observations represented anomalies.

These anomalous observations were dealt with by positive accounting theorists by adjusting the paradigm theory. Early research within the paradigm had applied the EMH with the assumption of no information or transaction costs. The anoma-lous observations of entire industries making costly changes in accounting procedures “led some researchers to drop the zero information and transaction assumptions . . .” [Watts and Zimmerman, pp. 109-110]. This created an opening for introducing the contracting theory that had developed from the “property rights” version of economic theory. With the addition of sophisticated contracting models the paradigm theory was modified to provide answers to the following question: “If an accounting change that does not affect taxes is costly and has no other effect on firm value, why do managers make those changes?” [Watts and Zimmerman, p. 173]. A very simplified version of the answer proposed by positive accounting theorists can be gleaned from the following examples.

For firm’s with restrictive debt contracts that tie dividend payments to the level of reported earnings, a change in account-ing procedures that causes an increase in earnings can cause a change in the cash flows to various contracting parties. This led to the formulation of the “debt/equity hypothesis” which Watts and Zimmerman state as follows: “Ceteris paribus, the larger a firm’s debt/equity ratio, the more likely the firm’s manager is to select accounting procedures that shift reported earnings from future periods to the current period” [p. 216]. Similarly, for firm’s with contracts that tie management compensation to the level of reported earnings, management may have some incentive to change accounting procedures. Consideration of various compensation contracts thus led to the formulation of the “bonus plan hypothesis” which Watts and Zimmerman formulate as follows: “Ceteris paribus, managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period” [p. 208]. Finally, for firms concerned about attracting regulatory attention with the reporting of large earnings, there may be an incentive to change accounting methods to reduce reported earnings. This consideration led to the formulation of another testable hypothesis that has been dubbed the “size hypothesis” — “Ceteris paribus, the larger the firm, the more likely the man-ager is to choose accounting procedures that defer reported earnings from current to future periods” [Watts and Zimmer-man, p. 235].

In summary, the anomalies encountered by the economics-based empirical research paradigm were dealt with by adopting various changes in the theoretical framework. What emerged was a dramatic new extension of the informational view of financial reporting theory; an extension that explains previously anomalous changes in accounting procedures by attributing them to the existence of contracting, information, and political costs.

ANOMALY AND CRISIS: IS THE INFORMATIONAL PARADIGM IN DANGER?

Anomaly, on the other hand, can generate a crisis. If solu-tions prove to be elusive and the theory cannot be adjusted — because the contradiction is too destructive of the paradigm theory — then the paradigm may be thrown into a “crisis” which, in the extreme case, may make it susceptible to a scientific “revolution” and replacement by an alternative paradigm. To generate a crisis, an anomaly must be seen as “more than just another puzzle of normal science . . .” [Kuhn, 1970a, p. 82]. This could be the case for an anomaly that “clearly call[s] into question explicit and fundamental generalizations of the paradigm . . .” [Kuhn, 1970a, p. 82]. The informational paradigm has encountered two types of anomalous findings that clearly hold the potential for generating a crisis — findings that call into question the validity of the EMH and the CAPM. The crisis potential of such anomalies can be gleaned from a brief overview of the paradigm.

The informational paradigm can be described as a coherent program for financial accounting research which seeks to de-scribe the role of accounting information in the operation of capital markets. Capital markets are presumed to provide for the efficient allocation of resources. Modern portfolio theory is presumed to describe the way rational investors make decisions which optimize lifetime consumption possibilities. The CAPM is presumed to describe the efficient allocation of risk in capital asset pricing. The EMH presumes that securities markets function to eliminate economic profits with respect to information. Within this theoretical context, the linkage between accounting information and capital market theories has been succinctly described by Lev and Ohlson [1982] as follows:

The link provided by capital market theories connects the accounting information system to its function in capital markets. Information has a dual role in these markets. First, it aids in establishing a set of equilib-rium security prices that affects the allocation of ‘real’ resources and the productive decisions implemented by firms. Second, it enables individuals to exchange claims to present and future consumption across different states, thereby attaining both preferred patterns of lifetime consumption and the sharing of societal risks. This explicit conceptualization of the role of information in capital markets appears to provide the elusive operational framework for the systematic analysis of alternative accounting information systems. The out-come of the economic system, as a function of the in-formation system, can now be analyzed, [p. 252]

In short, the EMH and the CAPM provide linkages between information, securities prices, and expected utility in a way that allows for a coherent financial reporting theory that is an integral part of a broader theory of market economics. “Such integration pointed to a well-specified and operational agenda for financial accounting research” [Lev and Ohlson, p. 252]. If the validity of the EMH and/or the CAPM is rejected, then the integral relationship between financial reporting theory and the theory of market economics is called into question. From this perspective, there is good reason to suspect that the informational perspective may be entering a state of crisis.

With respect to the EMH, researchers have long been aware of anomalous findings. In 1978, the Journal of Financial Economics published a special issue dealing with findings anomalous to the EMH. In an editorial introduction to that issue, Jensen states succinctly the need for special consideration of the anomalous findings.

I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis . . . Yet, in a manner remarkably similar to that described by Thomas Kuhn in his book, The Structure of Scientific Revolutions, we seem to be entering a stage where widely scattered and as yet incohesive evidence is arising which seems to be inconsistent with the theory. As better data become available (e.g., daily stock price data) and as our econometric sophistication increases, we are beginning to find inconsistencies that our cruder data and techniques missed in the past. It is evidence which we will not be able to ignore. [Jensen, p. 95]

Jensen expressed optimism that future research would ex-plain the anomalies without sacrificing the underlying theory of market efficiency [p. 100]. Over a decade later, however, Brown commented with respect to market efficiency that, “There are so many ‘anomalies’ around nowadays that I sometimes wonder if there are more anomalies than instances of efficiency” [p. 215]. Nevertheless, Brown asserts his allegiance to market efficiency in no uncertain terms: “… I am afraid my Chicago training has left me too skeptical to believe that competitive capital markets could remain so obviously inefficient for so long” [p. 216].

The increasingly widespread awareness of findings anomalous to the EMH, however, are not being ignored or pushed aside with mere reiterations of belief in market efficiency. A recent issue of The Accounting Review, for example, published a series of articles dealing with the functional fixation hypothesis (FFH) which is directly contradictory to the EMH. Whereas the EMH assumes that investors are sophisticated enough to sort out the effects of reported accounting numbers and rationally assess future cash flow potentials, the FFH assumes that investors are fixated on accounting numbers “and, therefore, fail to unscramble the true cash flow implications of accounting data” [Hand, p. 740]. The article by Hand (which was one of two articles awarded the AAAs Competitive Manuscript Award for 1989), reported evidence which was inconsistent with the EMH, but consistent with a modified version of the FFH. In another study, Harris and Ohlson reported results (based on the application of trading rules to oil and gas firms) which supported neither the EMH nor the FFH. In a discussion of these papers, Tinic concluded that, “The studies by Hand and Harris and Ohlson are useful first steps in developing alternative testable hypotheses to the EMH. They offer thought-provoking illustrations of the type of problems that should be included in the agenda for future research” [p. 795].

Functional fixation clearly represents an anomaly with re-spect to the informational paradigm; an anomaly that calls into question one of the cornerstones of the informational perspec-tive (the EMH). If enough researchers become convinced that investors are functionally fixated, it could generate a crisis for the paradigm.

When … an anomaly comes to seem more than just another puzzle of normal science, the transition to cri-sis and to extraordinary science has begun. The anomaly itself now comes to be more generally recog-nized as such by the profession. More and more atten-tion is devoted to it by more and more of the field’s most eminent men. [Kuhn, 1970a p. 82]
While there is no indication that the FFH is widely accepted at this time, the prominent display of a series of FFH articles in one of the leading academic accounting journals indicates how seriously functional fixation is taken by some highly respected academics. If the concern increases, it will trigger more and more research that is characteristic of extraordinary science rather than normal science.

As indicated above, anomalous findings with respect to the CAPM also have the potential to generate crisis for the informational paradigm. In 1982, Lev and Ohlson noted that, “Disenchantment with the CAPM is widespread on both conceptual and empirical grounds” [p. 287]. The grounds for disenchantment continued to grow during the 1980s. In a new study of the CAPM, Fama and French [1992] discuss several studies published in the 1980s which reported evidence that average returns on stocks may be related to market size, leverage, book-to-market equity, and/or earnings-price ratios. Since the CAPM purports to explain the variability of returns solely on the basis of market beta’s, the evidence reported by these various studies is clearly anomalous with respect to the CAPM.

The new study by Fama and French, however, appears to be much more damaging to the validity of the CAPM than the previous studies. They (Fama and French) sought to evaluate the joint roles of the above mentioned variables (including beta) with respect to average returns. Their study included non-financial stocks traded on the NYSE, AMEX, and NASDAQ and covered the years 1963-1990. Their abstract conveys the results succinctly:

Two easily measured variables, size and book-to-mar-ket equity, combine to capture the cross-sectional variation in average stock returns associated with market [beta], size, leverage, book-to-market equity and earnings-price ratios. Moreover, when the tests allow for variation in [beta] that is unrelated to size, the relation between market [beta] and average return is flat, even when [beta] is the only explanatory variable. [Fama and French, 1992, p. 427]

In short, market beta’s, according Fama and French, are not related to average returns; market beta’s have no explanatory power with respect to systematic risk.
So, what are the implications of these findings for the informational paradigm of financial reporting theory? First, as noted above, the CAPM has served the role of connecting accounting information to the efficient functioning of a market economy. A quote from Markowitz will highlight the importance of the CAPM in this regard: “My work on portfolio theory considers how an optimizing investor would behave, whereas the work by Sharpe and Lintner on the Capital Asset Pricing Model … is concerned with economic equilibrium assuming all investors optimize in the particular manner I proposed” [1991, p. 469]. In short, if the CAPM is not valid, then the rationality of capital asset pricing may be in doubt. At the very least, if the CAPM is rejected, then another theory of rational asset pricing is called for, and a new theory of asset pricing opens space for paradigm debate.

Second, if the findings of Fama and French gain widespread acceptance, then the validity of many of the classic articles in the informational paradigm are placed in doubt because of the widespread reliance, directly or indirectly, on the CAPM in estimating abnormal returns or in controlling for systematic risk. In any case, the Fama and French study holds the potential for a very substantial blurring of the paradigm, and in Kuhn’s words, “All crises begin with the blurring of a paradigm and the consequent loosening of the rules for normal research” 11970a, p. 84].

CONCLUSIONS

The decade of the 1960s has been widely recognized as a watershed decade in accounting thought. Most notably, it was the decade which initiated the transition from the “economic income perspective” to the “informational perspective” in finan-cial reporting theory. Kuhnian analysis yields some unique in-sights into both the transition itself and the subsequent develop-ment of the informational perspective.

One of the major conclusions of the present study is that the informational perspective predominated precisely because it provided the support of a widely accepted paradigm, while the proponents of the “economic income perspective” could not offer paradigm support. The informational perspective, as an extension of the financial economics paradigm, provided researchers with well-defined normal science problems together with exemplars that served as guides regarding acceptable research methods, while the economic income theorists (the so-called normative apriorists) could offer neither a generally accepted theoretical perspective, nor exemplars for the pursuit of research problems.

As with the development of any scientific paradigm, the informational paradigm has encountered anomalous evidence, most of which could be ignored, explained away, or incorpo-rated into the paradigm by theoretical adjustments. The infor-mational paradigm has also encountered more troublesome anomalies that hold the potential of throwing the paradigm into a Kuhnian-type crisis. Perhaps the most notable anomalous findings are those reported in a dramatic new study by Fama and French; a study which flatly contradicts the validity of the CAPM and the explanatory power of market beta’s. Because the EMH and the CAPM have served as cornerstones for so many of the classic studies in the informational paradigm, the spreading awareness of challenges to their validity are prompting more and more attention. There is reason to believe that increasingly widespread attention to the persistence of such fundamental anomalies is beginning to blur the paradigm and loosen the rules for normal science research, thus creating intellectual space for the consideration of alternative paradigms.

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