I
EI.SEVIER
management,
and
Investment
opportunit:y
incentives*
A. Scott Keatinga.*,
Jerold
L. Zimmermanb
aGraduate School of Business, University of Chicago, 1101 Eo 58th Street, Chicago, 1£ 60637, USA
bWi//iam Eo Simon Graduate School of Business Administration, University of Rochester, Rochester,
NY 14627, USA
Received 29 March
1999; received in revised form 9 February 2000
Abstract
Contrary to previous studies, we find managers change depreciation policies in
predictable ways. We identify three dimensions of depreciation-policy changes:whether it
is a method change or an estimate revision; whether it is income-increasing or decreasing;
and whether it applies to new assets only or both new and existing assets. This
disaggregation leads to three findings: First, a 1981 tax law altered the frequency of
estimate revisions and method changes. Second, firms adopting i1Jlcome-increasing
method changes for all assetsexperience worse performance than those adopting such
changes only for new assets. Finally, non-income-increasing policy changes are associated with changesin investment opportunities. (g) 2000 Elsevier ScienceB.V. All rights
reserved.
JEL
classification:
Keywords:
M41;
Contracting;
H25
Taxes;
Depreciation;
Policy
choice
*Financial support was provided by the John M. Olin Foundation and the Bradley JPolicy
Research Center at the University of Rochester. We thank Ray Ball, Jim Brickl~y, John Core:,Dan
Gode, S.P. Kothari, Andy Leone, Clifford Smith, Ross Watts (the editor), an anonymous referl:e and
seminar participants at the University of Rochester for useful suggestionsand Michelle LOWTyfor
research assistance.
* Corresponding author. Tel.: + 1-773-834-4078;fax: + 1-773-702-0458.
E-mail
address:
scott.keating@gsb.uchicago.edu
(A.S.
Keating).
I
0165-4101/00/$-see front matter @ 2000 Elsevier Science B.V. All rights reserved.
PII: SOl 6 5 -4 1 O 1 ( 00) 0 00 04- 5
360
A.S. Keating,
J:L.
Zimmerman
/ Journal
of Accounting
and Economics
28 (2000)
359-389
Introduction
Accounting depreciation affects firms' financial statements that are frequently
used in contracts, disclosures to capital markets, internal decision-makin~~and
control, and tax computations. Previous researchers examined just one dimension of accounting depreciation policy -the choice between straight-line and
accelerated depreciation methods. We examine several dimensions: depreciation
methods, asset life and salvage value estimates, and whether changes in these
policies are applied only to new assetsor to both new and existing assets.We
find that depreciation-policy changes are associated with changes in thc~tax
treatment of depreciable assets,the firm's financial performance, and changes in
the firm's investment opportunities.
Previous researchers, notably Hagerman and Zmijewski (1979), Skinner
(1993) and Bowen et al. (1995), find cross-sectional associations between depreciation methods and size, leverage, risk, and R & D, among others. However,
these studies' explanatory power tends to be low. Holthausen (1981) and
Sweeney (1994) find at best weak evidence of associations between changes in
depreciation methods and hypothesized determinants of depreciation policies
such as debt covenants and investment opportunities. The rather weak nature of
these previous results is somewhat surprising since depreciation expense is one
of the larger accruals over which managers exercise discretion.
To increase the power of our tests, we study estimate revisions in addition to
method changes,and also whether theseestimate revisions or method changesare
applied to new assetsonly or instead to both new assetsand assetsalready in
service.We document that policy changesapplied to both new and existing assets
produce significantly larger earnings changesthan policy changesapplied only to
new assets.We exploit this fact, along with differences between method changes
and estimate revisions and differences between income-increasing, income..neutral, and income-decreasing changes,to document the following three findings:
1. A 1981 tax law changed the relative costs and benefits of estimate revisions
versus method changes. Prior to 1981, if a firm estimated longer lives and
higher salvage values (i.e. income-increasing estimates) for financial reporting
than for taxes, the IRS could challenge the company's estimates for tax
purposes and, if successful,increase the firm's tax liability. The 1981 tax law
removed this indirect link between financial and tax reporting by mandating
fixed depreciation schedulesfor taxes. Our evidence shows that the frequency
of income-increasing estimate revisions increased following the 1981 tax law
change, while the frequency of income-increasing method changes declined.
This suggests that managers were reluctant to make estimate revisions prior
to the 19811aw because such revisions might trigger higher taxes.
2. Firms making income-increasing method changes applied to both new and
existing assets experience worse financial performance in the two ~lears
A.S. Keating, J:L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
361
preceding the change than firms making income-increasing method changes
applied to new assetsonly. Poor financial performance adversely affects bond
covenants, earnings-based compensation, and the likelihood of executive
firings, and hence managers have incentives to change depreciation policies
to offset poor performance. Depreciation method changes applied to both
new and existing assetshave a larger earnings-impact than do method changes
applied to new assets only since GAAP requires the cumulative effect of
a retroactive method change be included in income in the year of the change.
We predict that firms making income-increasing method changesfor all ~Lssets
experience poorer performance than firms making income-increasing method
changes applied to new assetsonly. The evidence supports this hypothesis.
3. Non-income-increasing depreciation-policy changes are in response to
changes in investment opportunities. A firm's depreciation policies are part of
its optimal organizational design given the operating environment. When
operating environments change, optimal organizational design, including depreciation policies, likely change as well (Smith and Watts, 1992;Skinner, 1993;
Brickley et al., 1997). For example, a firm experiencing an increase in investment opportunities can adopt a less-accelerated depreciation schedule to
reduce the likelihood that managers forego positive NPV projects (Ball et al.,
1999).Consistent with this hypothesis, we find that firms making non-incomeincreasing depreciation-policy changesexperiencesignificant changesin investment opportunities relative to firms not making such changes.
As the above findings suggest, the process of disaggregating depreciationpolicy changes along their various dimensions allows us to draw stronger
inferences about the determinants of such changes. Managers have discretion
over all dimensions of accounting policies, not just whether or not to make
a change. The choices managers make over each of these dimensions depend on
their incentives. Thus, identifying the dimensions of a given accounting policy,
and changes to that policy, allows richer, more powerful tests of the determinants of these policy changes.
In Section 2, we describe the mechanics of depreciation-policy changes and
managers' incentives to change those policies. In Section 3, the NAARS
database is used to identify a sample of firms changing depreciation policies.
Section 4 then presents our findings. Section 5 summarizes the paper's central
points and discussesimplications for other studies of accounting method choice.
2. Depreciation rules and managers' incentives
At the time a fixed asset is placed in service, managers establish its depreciation schedule by choosing a depreciation method -typically straight-line or
accelerated -and estimating the asset's service life and salvage value. Once an
asset is in service, managers can either change the depreciation method or revise
362
A.S. Keating,
J:L. Zimmerman
/ Journal
of Accounting
and Economics
28 (2000)
359-389
the estimated service life or salvagevalue of the asset.APB 20 requires that firms
changing depreciation methods for assetsalready in service recalculate depreciation charges as if the new depreciation method had been used from the date the
asset was originally placed in service. Prior financial statements are not restated,
but the cumulative effect of the method change -the difference between what the
depreciation expenseswould have been using the new method and what they were
under the old method -must be included in earnings in the year of the method
change. Thus, method changescan have a large impact on earnings in the year of
the change. However, the magnitude of the effect of the method change depends
on, among other things, the growth rate of the firm's depreciable assetbase and
whether the method change applies only to new assets or to both new and
existing assets.As discussedbelow, the empirical evidence indicates that method
changes have on average a relatively small effect on depreciation expense and
earnings, partly because many method changes are applied only to new assets.
If managers revise life or salvage value estimates, there is no cumulative effect
of the change. The remaining depreciable amount (gross book value less accumulated depreciation) is depreciated using the revised estimate of the asset's
service life and/or the revised estimate of the asset's salvage value.
While APB 20 requires disclosure of both changes in depreciation methods
and revisions of depreciation estimates, the disclosure burden of the two types of
changes differs. In their opinion letters auditors must identify a change in
depreciation method as a change in accounting principles affecting the comparability of the financial statements to previous periods' financial statements.
Moreover, Statement of Auditing Standards No.58 requires auditors to evaluate a change in depreciation methods and to be satisfied that management's
reasons for adopting the new method are justified. Finally, the SEC requires
auditors to submit to the SEC 'preferability letters' stating that the auditor is
satisfied with management's justification for the depreciation method change.
Auditors not satisfied with management's justifications can express a qualified
opinion or, worse, an adverse opinion. These requirements likely reduce managers' incentives to change depreciation methods. By contrast auditors rarely
evaluate or offer opinions on depreciation estimates or revisions of estimates
and are not required to supply the SEC with any documentation concerning the
estimate revision (O'Reilly et al., 1998, pp. 22-22).1
1In a random sample of 20 depreciation method changes from our total sample (described in
Section 3) with a reported dollar effect of the change, 16 (80%) method changes had consistency
qualifications in their audit reports. In all 16 cases, the auditor concurred in the consistency
qualifications regarding the method change. In a random sample of 20 estimate revisions, only two
(10%) revisions contained consistencyexceptions;the other 18 had clean audit reports. In every case
where the auditor issued a consistency exception for a method change we found a preferability letter
filed with the 10-K. We did not find any preferability letters on file when there was an estimate
revision. Thus, depreciation method changes result in a higher frequency of consistency exceptions
and preferability letters than depreciation estimate revisions.
A.S. Keating, J.L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
363
Depreciation method changes and estimate revisions are substitutes in the
sensethat they provide managers with alternate ways of affecting the time series
of depreciation expense. Managers can control the magnitude of the change on
earnings for both method changes and estimate revisions by applying the
change either to all existing assets,some subset of existing assets,or new assets
only. However, for a given impact on earnings, method changes are likely more
costly because they require auditors to issue qualified audit report opinions and
SEC preferability letters.2 Thus, to achieve a given dollar change in depreciation
expense, earnings, or book values, managers are more likely to prefer estimate
revisions over method changes. As documented below, there is a greater incidence of estimate revisions than method changes, arguably due in part to the
greater disclosure conditions placed on method changes. However, if management wants to achieve large changes in income statement or balance sheet
numbers, method changes are the only way to accomplish this.
Prior findings support a variety of reasons for earnings management (Watts
and Zimmerman, 1986, 1990; Warner et al., 1988; Weisbach, 1988).A decline in
accounting performance (a) increases the likelihood of technical violation of
bond covenants, (b) lowers the expected payouts from executive compensation
plans linked to earnings, and (c) increases the likelihood of management turnover. Declining accounting performance creates incentives to adopt incomeincreasing accounting changes, including depreciation method changes and
estimate revisions. Managers seeking to offset large declines in accounting
earnings will be inclined to use depreciation method changes applied to both
new and existing assetsbecause such method changes have a larger impact on
earnings than those applied to new assets only. Thus, we predict and report
consistent evidence below that firms making income-increasing depreciation
method changes applied to both new and existing assetshave significantly worse
financial performance than those making income-increasing method changes for
new assets only.
Firms also change depreciation policy to better align managers' incentives
with those of shareholders whenever the firm's operating environment changes
(Skinner, 1993). In addition, firms change financial accounting depreciation
policies if those policies affect tax depreciation and also if tax laws are revised.
These internal incentive-based and tax-based motives for depreciation-policy
changes are discussed in greater detail in Section 4.
2 In a private conversation with an auditor, the auditor indicated that consistency exceptions and
preferability letters add to the time required for the engagement,but not significantly in most cases.
Choi and Jeter (1992) find that earnings response coefficients are lower after auditors issue both
'subject to' and consistency qualifications. One interpretation of these findings is that the market's
perception of earnings noise or earnings persistenceis altered by the qualification. If this is true, the
firm bears a cost from the consistency exception.
364
A.S. Keating,
J.L. Zimmerman
I Journal
of Accounting
and Economics
28 (2000)
359-389
3. Sample selection
The NAARS database contains annual reports for approximately 4000 companies each year. From 1972 through 1994,we identify firms changing depreciation methods or revising depreciation estimates by using a keyword search of
the annual report footnotes, locating all instances of the word 'depreciation' that
occur within 10 words of various combinations of words associated with
accounting policy changes (i.e. 'change', 'changed', 'revise', 'revised', 'method', or
'estimate'). We then examine the full text of each keyword instance to confirm
that the firm had in fact changed depreciation methods or revised depreciation
estimates. This search yields 252 instances of depreciation method changes and
394 instances of depreciation estimate revisions -a total of 646 changes-representing 0.28% of the NAARS firm-years -made by 531 different firms for the
period 1972 through 1994.3
As a test of the comprehensiveness of our sample, we compare our NAARS
sample to Compustat firms whose footnote codes indicate a change in depreciation policies. Compustat footnote code # 5 specifies whether a firm changed
depreciation policies. Additionally, Compustat footnote code # 15 specifies the
type of depreciation method used; thus we can detect depreciation method
changes by comparing a firm's current year's footnote code # 15 to its prior year
footnote code # 15. Four hundred and fifty eight firm-years (0.3% of all
Compustat firm-years between 1972 and 1993)have a footnote code # 5 indicating a change in depreciation policies, and 3364 firm-years (2.2%) have a change
in footnote code # 15 indicating a change in depreciation methods.4
Somewhat surprisingly, there is a less than perfect overlap between the
NAARS-listed firms we identify as making depreciation-related policy changes
and the firms identified in Compustat as making depreciation-related policy
changes. Of the 440 NAARS-listed firm-years we identify making depreciationrelated policy changes and which are also in Compustat, only 95 (22%) have
a Compustat footnote code # 5 indicating a change in depreciation-related
3 A matched control sample is not used because of the nature of NAARS. NAARS, an on-line
word-searchable database, contains large, primarily NYSE and AMEX firms (Mutchler and Shane,
1995).Companies included one year need not be included the next year. The result is a sample biased
towards larger, more successfulfirms. NAARS does not provide annually a list of firms in its files.
Therefore, there is no easy way to select a control sample without searching NAARS by company
name to determine if a firm is present. If a matched sample is drawn from Compustat, it is difficult to
find 'control' firms that are as large and as profitable as the NAARS firms.
4 Changes in footnote code # 15 overstate the frequency of method changes since a firm's
depreciation method footnote code in a given year can differ from its depreciation method footnote
code in the previous year for reasons other than changesin depreciation methods. For example, an
acquisition of a firm using the straight-Iine method by a firm using the accelerated method with
neither firm changing depreciation methods will result in a change in the combined firm's method
footnote.
A.S. Keating, J.L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
365
policies in the same year. Moreover, only 74 (42%) of the 175 NAARS-listed
firm-years changing depreciation methods and which are also listed in Compustat have a change in Compustat footnote code # 15 indicating a method change
in the same year. Hence, less than half of our NAARS-detected depreciationpolicy changes are identified in Compustat footnote codes.
We next examine the extent to which Compustat-coded policy changes are
discussed in the financial statements of NAARS-listed firms. Twenty firm-years
with Compustat-detected method changes and that are also listed in the
NAARS database were randomly selected.We search the NAARS-listed annual
report in the year of and prior to the date of the method change detected by
Compustat. Of these 20 firms, nine (45%) show no evidence in their annual
report of any change in depreciation methods, which thus must reasonably be
considered as coding errors by Compustat. The remaining 11 firms (55%)
appear to change methods since the method used in one year differs from that
used in the prior year. In all of these 11 cases,there is no discussion of the
method change in either the annual report or the auditor's letter. Of these 11
changes, only one is from a single method to a different single method, suggesting that the change was applied to all assets. In the absence of a complete
disposition of existing assets(depreciated under the old method) and acquisition
of all new assets(depreciated under the new method), we are at a loss to explain
how a firm changes depreciation method for all assetswithout noting the policy
change in its financial statement footnotes. The remaining ten changes were
either from a mix of methods to one single method or vice versa. These latter ten
changes could be due to mergers, assetdispositions, or method changes applied
to new assetsonly, hence not requiring mention in the financial statements. We
cannot explain why Compustat fails to detect depreciation-policy changes
accurately, but these findings suggest that researchersshould be cautious when
using Compustat footnote codes.
The higher frequency of method changesin the Compustat sample than in the
NAARS sample highlights the sample selection bias underlying our results.
Firms choose not to disclose in their annual report footnotes depreciationpolicy changes (and hence are not in our NAARS-based study) for at least four
reasons. First, GAAP does not require firms to report the effect of an accounting
policy change unless the change has a material effect on earnings. Second, some
firms change depreciation policies -say from all straight-line to a mix of
accelerated and straight-line -due to mergers or acquisitions. Third, asset
acquisitions or dispositions may result in changes in depreciation methods. For
example, consider a firm using both the straight-line and units-of-production
methods. If it disposes of the assets being depreciated using the units-ofproduction method, then in the year following the disposition of those assetsit
reports using only the straight-line method. Fourth, a firm changing depreciation policies for new assets only, and not for assetsalready in service, will not
necessarily report the policy changes and their impact because the policy
366
A.S. Keating,
J:L. Zimmerman
/ Journal
of Accounting
and Economics
28 (2000)
359-389
changes do not affect earnings (except in the sensethat earnings might have been
different if the firm had applied the same policies to new assetsthat it applied to
assets already in service). Thus, our sample of depreciation-policy changes
consists of firms where the change is material and hence not representative of all
firms making such policy changes. However, this selection bias should increase
the power of our NAARS-based tests relative to a sample drawn using Compustat footnote codes.
We exclude firms taking fixed-asset write-downs, which is arguably another
type of depreciation policy, for two reasons. First, fixed-asset write-downs are
often not mentioned explicitly but rather included as part of restructurings or
plant shut-downs, and thus we are unable to use a keyword search of the
NAARS database to identify all, or even most, instances of fixed-asset writedowns. Second, many write-downs include write-downs of inventories, receivables, and other asset accounts in addition to depreciable assets,and thus it
is not possible to discern the dollar impact of the fixed-asset write-down alone.
4. Findings
In this section we report that depreciation changes are relatively rare events;
estimate revisions have a larger impact on earnings than do method changes;the
time series of the frequency of estimate revisions and method changes was
altered by a 1981 tax law change; firms making income-increasing method
changes applied to both new and existing assets experience worse financial
performance than firms making income-increasing method changes for new
assetsonly; and non-income-increasing changes applied only to new assetsare
associated with changes in firms' investment opportunities.
4.1.
Frequency
of depreciation
changes
Panel A ofTable 1 shows the distribution ofdepreciation-policy changes and
the time series of those changes. (We defer discussion of the time series to the
next sub-section.) NAARS-reported depreciation changes are relatively infrequent, occurring in only 0.71% of the firm-years (Column 3). If managers
exercise discretion over reported earnings, they do so infrequently. Panel B reports the frequency of income-increasing, income-neutral, and income-decreasing depreciation-policy changes. Income-increasing policy changes (Column 3)
are the most frequent in the sample, occurring in 0.35% of all NAARS firmyears followed by income-decreasing changes (0.27%) in Column 1 and incomeneutral changes (0.08%) in Column 2.
Panel A of Table 2 reports the incidences of firms making multiple changes.
Of the 531 firms in the sample, 444 (69%) make only one depreciation change in
the 23-year period, 69 firms (21%) make two changes, 12 (6%) make three
A.S. Keating, J.L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
367
changes and six (4% ) make four or more changes. Panels Band C of Table
2 report the incidences of firms making multiple changes of the same type. The
vast majority of firms (over 80% in both cases)make only one such change.
Only 20 of the 232 firms adopting new depreciation methods do so more than
once (Panel B). Forty three of the 338 firms revising depreciation estimates do so
more than once (Panel C). The low rate of repeated changes of one type suggests
that managers are not switching back and forth to manipulate earnings. The
numbers we report on repeat depreciation-policy changes are likely biased
downwards from the frequency of such changes in the population. This is again
becausethe NAARS sample does not consist of a constant set offirms acrosstime.
Table 3 reports the incidence offirms making more than one type of depreciation-related change. Again, the vast majority (93%) of firms makes only
one type of change. The remaining 7% change a method and revise an estimate.
Of the 39 firms making both changes,the mean (median) time between changes
is 2.07 (0) years. Tables 2 and 3 suggest that among those firms changing
depreciation policies, few exercise discretion over more than one depreciation
policy.
4.2. Time series of depreciation changes
Panel A of Table 1 shows the distribution of both method changes and
estimate revisions across time (Columns 1 and 2). The highest yearly incidence of
a depreciation method change in any year (Column 1) is 0.53% of the population (1972 and 1980), and the highest incidence of a depreciation estimate
revision (Column 2) is 1.05% (1994). Method changes decline in frequency over
the period 1972-1994, while estimate changes increase. However, the combined
frequency of both policy changes (Column 3) remains relatively constant over
time.5 Table 1, Panel B, reports the time series of the frequency of incomeincreasing, income-neutral, and income-decreasing depreciation-policy changes.
Income-decreasing (Column 1) and income-increasing (Column 3) policy
changes show no time trend, while income-neutral changes (Column 2) decline
in frequency over time.
As Panel A of Table 1 shows, the relatively constant frequency of depreciation-policy changes over time hides the fact that the frequency of method
changes has declined noticeably over the period, while the frequency of estimate
changes has increased. These time trends in frequencies suggest asystematic
change in the relative costs and/or benefits of method changes versus estimate
revisions. We next examine the effect of changes in the tax treatment of
5 Because the two policy compositions
vary over time and differ from each other, all financial data
used in this paper are restated to 1992 year-end dollars to control
effects of inflation.
for the possible confounding
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A.S. Keating, J.L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
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Table
A.S. Keating,
.JL. Zimmerman
/ Journal
of Accounting
and Economics
359-389
I
I
2
NAARS-listed
28 (2000)
firms
making
depreciation
method
changes
and/~r
estimate
revisions
in the period
1972-1994"
Number
of
changes
Panel A: Depreciation
Number
firms
of
Number of
changes made
method changes and depreciation estimate revisions
1
444
444
2
69
138
3
12
36
4
4
16
5
1
5
6
0
0
7
1
I
7
Total
%
of
firms
69
21
6
2
1
O
100
531
646
212
20
212
40
90
10
Total
232
252
100
Panel C: Estimate revisions
Number of
revisions
Number
firms
Number of
changes made
% of
firms
Panel B: Method changes
2
2
3
4
5
Total
of
295
295
87
34
68
10
6
18
2
2
8
1
1
5
0
338
394
100
aIn Panel A, 531 firms changed at least one depreciation policy. ,PanelsBand C indicate that 232
firms changed methods and 338 firms revised estimates, for a ~otal of 570 firms. The difference
between 531 and 570, namely 39 firms, is due to some firms maIqing more than one type of policy
change.
depreciation in 1981 on the relative frequency of depreciation method changes
and estimate revisions.
4.2.1. 1981 ta-xlaw changes
Prior to 1981 taxpayers were entitled, subject to IRS challenge, to set depreciation methods and make useful life and salvage value estimates for tax
purposes based on their experience and judgment of all facts and circumstances
of the asset being depreciated. However, firms using life and salvage value
estimates outside of the IRS-specified ranges risked having those estimates
A.S. Keating, J.L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
Table 3
NAARS-listed
firms making both a depreciation
period 1972-1994
.
method change and an estimate revision in thl
Combination
Number
Firms making method change only
Firms making estimate revision only
Firms making method change and estimate revision
193
299
39
Total
531
Time between changesof different types
Mean
Median
Maximum
Minimum
371
of firms
%
of total
firms
36
57
7
100
Years'
2.07
0
12
0
challenged by the IRS.6 One of the factors the IRS considered when evaluating
the appropriateness of a firm's depreciation life and salvage value estimates for
tax purposes was whether the firm used the same estimates for financial reporting purposes.7 Thus, for assetsplaced in service prior to 1981,financial reporting
depreciation estimates were not independent of tax depreciation estimates.
Taxpayers had incentives to estimate relatively short useful asset lives for
financial reporting to justify short estimated lives for tax purposes. Moreover,
managers likely were reluctant to make income-increasing estimate revisions for
financial reporting since such revisions might trigger similar revisions for tax
purposes and thus higher taxes. By contrast, the IRS did not challenge taxpayers' choices of depreciation methods, allowing managers to change book
depreciation methods without any potential tax consequences.Hence, prior to
1981,income-increasing estimate revisions were a potentially more costly substitute to method changes.
The Accelerated Cost Recovery System (ACRS) became law in 1981 and
applied to assets placed in service after 1980. Under ACRS and its successor
MACRS (Modified Accelerated Cost Recovery System), asset tax lives are
specified by law and not subject to taxpayer discretion.8 Thus, for assetsplaced
6 See, for example, The adoption of the asset depreciation range (ADR) system, US Treasury
Department Release,June 22, 1971, and Jones (1998, p. 13).
7 United States Treasury Revenue Procedure 62-21, 1962-2 CB 418.
8 For some types of assetsplaced in service after 1980,taxpayers can extend the recovery period
for an assetby opting out of the ACRS and MACRS and into the Alternative Depreciation System
(ADS). The ADS specifieslonger recovery periods for some (but nOt all) classesof assets,as well as
a less-accelerated depreciation schedule (150% declining balance rather than 200% declining
balance) for some asset classes.As with ACRS and MACRS, under ADS taxpayers can choose to
depreciate the asset straight-line over the recovery period in lieu of using the specified accelerated
schedule.
A.S. Keating, J:L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359- 389
in service after 1980, a firm's depreciation policies and estimates for non-tax
purposes have no effect on tax depreciation or the amount of taxes the firm pays
(unless this triggers the Alternative Minimum Tax introduced in 1986).The 1981
tax law had the effect of reducing the relative cost of income-increasing estimate
revisions versus income-increasing method changes. Assuming a constant demand for depreciation-related policy changes over the 1972-1994 period -as
evidenced by the relatively constant frequency of depreciation-policy changes
over the period (Table 1) -we predict more income-increasing estimate revisions
relative to method changes following the 1981 tax law.9 The incidence of
income-increasing estimate revisions in our sample increased from 0.16%
of firm-years in the 1972-1981 period to 0.29% in the 1982-94 period,
while the incidence of income-increasing method changes declined from
0.15% of firm-years prior to 1982 to 0.11% of firm-years after 1981 (not
tabulated). A chi-squared test rejects the independence of these frequencies at
the 1% level.
Note that a critical assumption underlying these conjectures is that the tax
laws prior to 1981 allowed the IRS to challenge taxpayers' tax depreciation
estimates if shorter life estimates and larger salvagevalue estimates were used for
tax purposes rather than for financial reporting purposes. We explore this
assumption in more detail later.
While the difference in the frequency of method changes and estimate
revisions between the 1972-1981 and the 1982-1994 periods are significant,
Table 1 reveals that the frequency of method changes declined more in 1984
than in 1982, and estimate revisions did not increase substantially until the
mid-1980s. However, these patterns are not inconsistent with our tax hypothesis. The 1981 tax law applied only to assetsplaced in service after 1980. Thus,
firms' incentives to change depreciation policies for assets placed in service
before 1981 did not change. Moreover, in the early years of the new tax depreciation regime, the income effect of a depreciation policy change applied only to
assetsplaced in service after 1980 would be relatively small- since the fraction of
the firm's asset base placed in service after 1980 was small. Thus, we would not
expect to observe changes in the relative frequency of method changes
and estimate revisions until the post-1980 fraction of a firm's assets became
significant, and this likely did not occur until several years after the tax law
change.
9 For the purposes of our tax law-related tests,we consider the year 1981 to be part of the pre-tax
law change period. Recall that the 1981 tax law applied only to new assets;assetsthat were already
in service continued to be depreciated under the old tax rules. A firm placing an assetin service in
1981would be unlikely to make an estimate revision or method changefor that assetin 1981.Hence,
any estimate revisions or method changes in 1981 can reasonably be expected to apply to assets
placed in service prior to 1981 and thus subject to pre-1981 tax laws. The first depreciation policy
changes applying to assetsplaced in service after 1980 occurred in 1982.
A.S. Keating, J:L. Zimmerman I Journal of Accounting and Economics 28 (2000) 359-389
4.2.2. The effect of marginal tax rates
We examine the relation between depreciation-policy changes and firms'
marginal tax rates as additional tests of the tax hypothesis.1° If firms were
reluctant to increase book life estimates of pre-1981 assets because of the
potential increased tax liability, then those firms with high marginal tax rates
-thereby facing a larger increase in tax liability from an IRS challenge -were
least likely to increase book estimates. By contrast, for all post-1980 assetsthere
were no tax consequencesof estimate revisions for financial reporting purposes,
so marginal tax rates likely did not affect firms' decisions to revise depreciation
estimates for assetsplaced in service after 1980. Also, firms with high marginal
tax rates have stronger incentives to reduce taxes than those with low marginal
tax rates, suggesting that pre-1982 high marginal tax rate firms were more likely
to adopt income-decreasing book estimate revisions to reduce taxes than pre1982 low marginal tax rate firms. Finally, over the entire 1972-1994 period, tax
and financial depreciation methods were independent, so a method change for
financial reporting purposes had no effect on tax liabilities. While marginal tax
rates likely affected firms' decisions to revise estimates in the pre-1982 period,
they did not affect their decisions to change methods in that period. Hence, we
make the following predictions. The marginal tax rates of pre-1982 incomeincreasing estimate revision firm-years are:
(i) lower than the marginal tax rates of post-1981 income-increasing estimate
revision firm-years;
(ii) lower than the marginal tax rates of pre-1982 income-decreasing estimates
revision firm-years; and
(iii) lower than the marginal tax rates of pre-1982 income-increasing method
change firm-years.
To test these predictions we use the Shevlin (1990) trichotomous method for
estimating marginal tax rates: Firm-years with positive net operating loss
carryforwards (Compustat item # 52) and zero taxes (Compustat item # 63) are
assigned a marginal tax rate of zero.ll Firm-years with zero net operating loss
carryforwards and positive taxes are assigned a marginal tax rate equal to one.
Firm-years with either positive net operating loss carryforwards and positive
taxes or zero net operating loss carryforwards and zero taxes are assigned
10Our thanks to the referee for suggesting these tests.
11Graham (1996a, b) develops a methodology for estimating marginal tax rates using a simulation, and makes his simulated marginal rates for firm years between 1980and 1995 available on the
internet at www.duke.edu/ , jgraham/taxform.html. Graham (1996b) shows that the Shevlin (1990)
trichotomous marginal tax rate estimates are highly correlated with Graham's simulated rates, and
are less costly to obtain. Since Graham only has simulated rates for 1'980-1995,and our sample
contains a considerable number offirm-years prior to 1980,we are unable to use Graham's rates to
test the robustness of our results.
A.S. Keating, J:L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
Table 4
Deviations from average Compustat marginal tax rates for firms making depreciation estimate
revisions and method changes,1971-1994.Marginal tax rate is 1 iffirm-year has positive taxes and
zero net operating loss carryforwards, 0 if the firm-year has zero taxes and positive net operating loss
carryforwards, and 0.5 if taxes are positive and net operating loss carryforwards are positive, or if
taxes are zero and net operating loss carryforwards are zero (Shevlin, 1990).Average Compustat
marginal tax rate based on marginal tax rates of all Compustat-listed firms with available data for
that year. Real property-intensive sub-sample (Panel B) consists of those firm-years whose ratio of
depreciable real property (Compustat items 155 and 73) to total property, plant and equipment (item
8) is in the upper two quintiles of the sample; equipment-intensive sub-sample (Panel C) consists of
those firm-years whose ratio of depreciable real property to property, plant, and equipment is in the
lower two quintiles of the sample.
Mean
deviation
from
avetage
marginal
tax rate
Median
deviation
from average
marginal
tax rate
Panel A: Entire sample
Pre-1982 income-increasing estimate revisions
Post-1981 income-increasing estimate revisions
Pre-1982 income-decreasing estimate revisions
Pre-1982 income-increasing method changes
-0.209
-0.114
-0.138
-0.017
-0.231
-0.117***
0.203
0.242
Panel B: Real property-intensive sub-sample
Pre-1982 income-increasing estimate revisions
Post-1981 income-increasing estimate revisions
Pre-1982 income-decreasing estimate revisions
Pre-1982 income-increasing method changes
-0.091
0.015
-0.226
-0.049
0.242
0.384
-0.228
0.281
Panel c: Equipment-intensivesub-sample
Pre-1982 income-increasing estimate revisions
Post-1981 income-increasing estimate revisions
Pre-1982 income-decreasing estimate revisions
Pre-1982 income-increasing method changes
-0.129
-0.069
-0.049
-0.073
0.251
-0.090*
0.241
0.251
N
41
111
42
25
8
14
2
24
6
11
24
*Significantly different from median marginal tax rate of pre-1982 income-increasing estimate
revisers at 10% level or better.
**Significantly different from median marginal tax rate of pre..1982income-increasing estimate
revisers at 5% level or better.
***Significantly different from median marginal tax rate of pre-1982 income-increasing estimate
revisers at 1% level or better.
marginal tax rates equal to one-half. Hence,a firm-year's marginal tax rate can have
a value of zero, one-half, or one. To control for other factors affecting marginal
tax rates over time, we calculate a firm-year's marginal tax rate as the deviation
from the mean marginal tax rate for all Compustat-listed firms in that year.
Panel A of Table 4 reports the results of tests of differences in mean and
median marginal tax rates. The mean (median) marginal tax rate for pre-1982
A.S. Keating, J:L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
375
income-increasing estimate revisions is -0.209 ( -0.231), whereas the mean
(median) marginal tax rate for post-1981 income-increasing estimate revisions is
-0.114 ( -0.117). This difference of 0.095 (0.114) is in a direction consistent
with our predictions. Moreover, the difference in medians is significantly different from zero at the 1% level, although the difference in means is not. Also
consistent with our predictions, the mean and median marginal tax rates for
firms making pre-1982 income-decreasing estimate revisions ( -0.138 and 0.203
respectively) are higher than the comparable statistics for the pre-1982 incomeincreasing estimate revision sample, although neither difference is significantly
different from zero. Finally, the mean (median) marginal tax rate of pre-1982
firm-years with income-increasing methodchangesis -0.017 (0.242),higher, but
insignificantly so, than the mean (median) marginal tax rate for pre-1982
income-increasing estimate revisions. Overall, these tax rate-based tests are
directionally consistent with our hypothesis that the 1981 tax act affected the
relative frequencies of estimate revisions and method changes.
4.2.3. The CLADR system of tax depreciation
The previous tests assumed that book depreciation estimates for assets
placed in service before 1981 could be used by the IRS to challenge taxpayers'
tax depreciation estimates. However, a tax depreciation system known as the
Class Life Asset Depreciation Range system (CLADR) was available for assets
placed in service after 1970 and offered a depreciation 'safe haven' for taxpayers
adopting IRS-specified life ranges. The IRS would not challenge life estimates
within those ranges. For example, taxpayers could use a tax life of between
8 and 12 years for office equipment, regardless of their book life estimates
for office equipment, and be assured the IRS would not challenge the
tax life.
For firms using the CLADR system for most of their assets,book and tax
depreciation was largely uncoupled before 1981, and hence faced no higher
incentive to make income-increasing estimate revisions for pre-1981 assetsthan
for post-1980 assets. Indeed, if all firms adopted the CLADR system for all
assets,then we would predict no difference in the pattern of depreciation policy
changes pre-1982 and post-1981. However, a study by the IRS of 1975 corporate
tax returns (Internal Revenue Service, 1979) revealed that among the largest
corporate tax returns -sales greater than $100 million and representative of our
sample- only 31% of all returns included depreciation of at least one assetusing
the CLADR system. While it is possible that CLADR adoption increased
between 1975 and 1980,this IRS study suggeststhat all firms did not immediately embrace the system. Indeed, our findings suggestthat the CLADR system was
not widely adopted.
The existence of the CLADR system compromises the power of our tests
reported above. CLADR-adopting firms did not face the same change in book
depreciation incentives in 1981 as did non-CI-,ADR-adopting firms. To increase
376
A.S. Keating,
J.L. Zimmerman
/ Journal
of Accounting
and Economics
28 (2000)
359-389
power, we exploit the fact that the CLADR system was rarely used for depreciable real property (see, for example, Gravelle, 1980; Scholler et al., 1973).12
Firms with a high proportion of depreciable real property were likely to have
a relatively small fraction of their assetsdepreciated for tax purposes using the
CLADR system and hence were likely to experience an increase in incentives
after 1981 to make income-increasing estimate revisions. Firms with little
depreciable real property were likely to have a relatively large fraction of their
assetsdepreciated using the CLADR system and hence were unlikely to experience an increase in incentives to make income-increasing estimate revisions after
1981. We, therefore, predict a bigger increase in the frequency of incomeincreasing estimate revisions between the pre-1982 period and the post-1981
period among firms with a high proportion of depreciable real property than
among firms with a low proportion of depreciable real property.
We divide our sample into two groups: those with ratios of depreciable real
property to total property, plant and equipment in the fourth or fifth quintile
(the 'real property-intensive sub-sample') and those with ratios in the first or
second quintile (the 'equipment-intensive sub-sample').13 We predict the realproperty-intensive sub-sample to exhibit a significant increase in estimate revisions after 1981 relative to before 1982, and a significant decrease in method
changes over the same two periods. Among the real-property-intensive firmyears, there were nine income-increasing estimate revisions and 16 incomeincreasing method changes before 1982, and 30 income-increasing estimate
revisions and only nine income-increasing method changes after 1981.Thus, the
frequency of estimate revisions increased after 1981 while the frequency of
method changes decreased.A chi-squared test rejects the independence of these
frequencies at the 1% level. By contrast, among the equipment-intensive sample
both estimate revisions and method changes increase in frequency after 1981.
There were 15 income-increasing estimate revisions and seven income-increasing method changes before 1982, and 29 income-increasing estimate revisions
and ten income-increasing method changes after 1981.A chi-squared test fails to
reject the independence of these frequencies a1:even the 10% level. This is further
evidence that the change in the relative frequency of estimate changes and
method changes in the pre-1982 and post-1981 periods is due to changes in tax
depreciation rules.
We also repeat our marginal tax rate tests on the real-property-intensive and
equipment-intensive sub-samples. Since real-property-intensive firms are least
12Our thanks to the referee for pointing out the fact that the ADR system was generally not used
for depreciable real property and for suggesting a test exploiting this fact.
13We estimate a firm-year's real depreciable property as the sum of buildings (Compustat
items
155) and construction in progress (item 158). We use book values net of accumulated depreciation
because gross book values are not available on Compustat for firm-years earlier than 1984.
A.S. Keating, J:L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
377
likely to have adopted the CLADR system for assetsplaced in service between
1971 and 1980, we would expect to obtain stronger results from our marginal
tax rates tests using this sample. Conversely, we would expect to obtain weaker
or even opposite results from equipment-intensive firms which are most likely to
have adopted the CLADR system. These statistics and their significance levels
are reported in Panels Band C of Table 4. For the real-property-intensive firms,
the mean and median marginal tax rate of pre-1982 income-increasing estimate
revisions is lower than the mean and median of both post-1981 incomeincreasing estimate revisions and pre-1982 income-increasing method changes.
The mean and median marginal tax rates for pre-1982 income-decreasing
estimate revisions are lower than pre-1982 income-increasing estimate revisions
-inconsistent with our predictions -although the sample size is small (n = 2).
For the equipment-intensive firms the results are inconsistent. The mean but not
the median marginal tax rate of the pre-1982 income-increasing estimate revisions
is smaller than the marginal tax rates of the other three samples. The results in
Panels Band C of Table 4 are at least weakly consistent with our tax law change
hypothesis, although small sample sizes compromise the power of these tests.
4.2.4. Changes in disclosure requirements
We also investigated whether the observed trends in depreciation-policy
changes reported in Table 1 resulted from changes in disclosure requirements.
The history of disclosure requirements does not bear this out however. APB 20,
governing disclosure of changes in methods or estimates, went into effect in
1971, before the beginning of our sample period. Statement of Auditing Standards (SAS) No.58, governing the form of an auditor's discussion of a method
change, was considered by the AICPA beginning in 1985, adopted in 1988 and
became effective in 1989. The frequency of method changes declined noticeably
in 1984 and 1985, before SAS 58 was even under consideration. Moreover, SAS
58 simply changed the manner in which auditors discussed method changes in
their opinion letter, not the disclosure or non-disclosure of method changes.
Finally, the SEC requirement that auditors certify the preferability of newly
adopted methods was in force over this entire period. Hence, it appears unlikely
that the change in the relative frequency of method changes and estimate
revisions is due to a change in reporting or disclosure requirements.
4.3.
Three dimensions
of depreciation-policy
changes
Table 5 presents summary statistics on sales, assets, and the effect of the
depreciation-policy change for our sample.14 The median firm in our sample
14Note that our sample size declines from 646 firm-years in Tables 1-3 to 440 firm-years in Tables
4 and 5, reflecting the fact that not all NAARS-Iisted firms are also Compustat-listed.
378
A.S. Keating,
J.L. Zimmerman
/ Journal
of Accountj'ng
and Economics
28 (2000)
359-389
Table 5
Descriptive statistics on 440 firm-years of changes in depreciation methods and/or revisions of
depreciation estimates. (Dollar figures are price level adjusted to 1992 dollars and reported in
millions.)
Medians
(1)
(2)
Method
(n =
changes
Estimate
(3)
revisions
Entire
sample
175)
(n = 265)
(n = 440)
Sales
271
Net income
7.4
Assets
226
Impact of change on net income"
0.296*
Income impact as % of net incomeb
6**
Impact of change as % of assets"
0.3**
251
5.2
284
0.802*
14**
0.5**
270
5.~\
270
o.~;00
11
o.~.
aAs reported by firms in their annual reports or 10 Ks.
bAbsolute value of impact of change/absolute value of net income.
cAbsolute value of Impact of change/assets.
* Median of the first series is significantly
or better.
**Median
or better.
of the first series is significantly
smaller than the median of the second series at 10% level
smaller than the median of the second series at 5% level
(Column 3) experiences a $500,000 increase in earnings as a result of the
depreciation-policy change, representing 11% of income and 0.5% of assets.
While method changers (Column 1) do not differ significantly from estimate
revisers (Column 2) in terms of sales, earnings, or assets, the dollar effect of
method changes, as well as the earnings and asset impact of those changes, are
significantly smaller than comparable statistics for estimate revisers. As discussed above and demonstrated in Table 6, the impact of method changes is
smaller than that of estimate revisions because many method changes are
applied to new assets only.
Table 6 divides the sample along three dimensions: the type of change
(method change versus estimate revision), the direction of the change (incomeincreasing, income-neutral and income-decreasing), and the way in which the
change is applied (to new assetonly or to both new and existing assets).Table 6,
Panel A (Column 4) indicates that, of 175 method changes, 102 (58%) are
applied to both new and existing assets,while 73 (42%) are applied only to assets
placed in service on or after the adoption of the new depreciation method. The
earnings impacts of these two types of method changes differ significantly.
Income-increasing method change applied to both new and existing assets
increases median earnings by $3.9 million, or 23% of earnings (Column 1), while
A.S. Keating, J.L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
379
income-increasing method change applied only to new assetsincreases median
earnings by $600,000 (6%).
In Table 6 Panel B (Column 4), 258 of the 265 estimate revisions are for
both new and existing assets. Only ten of the 258 have an immaterial effect
Table 6
Income effects of depreciation method changes and estimate revisions broken down by (a) type of
change (method change or estimate revision), (b) the directional effect of the change on net income
(income-increasing, income-neutral or income-decreasing),and (c) how the change is applied (to new
assetsonly or to both new and existing assets).Sample I::onsistsof 440 depreciation-policy changes
made by NAARS-Iisted firms between 1972 and 1994 for which Compustat data is available.
(3)
Income
increasing
(2)
Income
neutral
changes
changes
changes
(1)
Income
(4)
decreasing
Total
Panel A: Method changes
Change applies to
both new and
existing assets
Median dollar impact
on earnings (millions)
$3.9
$0.0
Median percentage
impact on earnings
23%
0%
Median percentage
impact on assets
Change applies to
new assetsonly
Total
1.3%
0%
N
66
22
Median dollar impact
on earnings (millions)
$0.6
$0.0
-$14.
$0.7
56%
2.3%
14
15%
0.8%
102
$0.
-$0.2
Median percentage
impact on earnings
6%
0%
7%
3%
Median percentage
impact on assets
0.3%
0%
0.2%
0.1%
N
41
25
Median dollar impact
on earnings (millions)
$1.6
$0.0
Median percentage
impact on earnings
14%
0%
Median percentage
impact on assets
N
0.6%
107
7
-$6.5
$0.3
12%
0%
47
73
1%
21
6%
0.2%
175
380
A.S. Keating,
J:L. Zimmerman
/ Journal
of Accounting
and Economics
28 (2000)
359-
Table 6 (continued)
(3)
Income
increasing
(2)
Income
neutral
changes
changes
changes
(1)
Income
(4)
decreasing
Total
Panel B: Estimate revisions
Change applies to
both new and
existing assets
Median dollar impact
on earnings (millions)
$2.0
$0.0
Median percentage
impact on earnings
16%
0%
Median percentage
impact on assets
N
Change applies to
new assetsonly
Median dollar impact
on earnings (millions)
Median percentage
impact on earnings
Total
0.5%
190
15%
16%
$0.0
58
-$10.5
8%
0.3%
0.5%
N
3
2
2
Median dollar impact
on earnings (millions)
$1.9
$0.0
Median percentage
impact on earnings
15%
0%
193
258
8%
0%
N
0.5%
0%
0.3%
0.5%
15%
$0.0
Median percentage
impact on assets
Median percentage
impact on assets
$0.9
0.7%
0%
10
$0.1
-$1.7
0%
12
-$1.7
15%
0.6%
60
$0.8
14%
0.5%
265
(Column 2).15The 190 income-increasing revisions (Column 1) have roughly the
same absolute dollar and absolute percentage impact ($2.0 million and 16%) as
the 58 income-decreasing revisions in Column 3 ( -$1.7 million and 16%). The
earnings impact of income-increasing method changes for new and existing
assets is almost twice as large ($3.9 million) as the earnings impact of incomeincreasing estimate revisions for new and existing assets($2.0 million). Although
not reported in Table 6,88% of the estimate revisions are revisions of estimated
lives, 7% are revisions of estimated salvage values, and 5% are revisions ofboth
useful lives and salvage values.
1SFirms are not required to disclose that the estimated useful life or salvage value of new assets
differs from that of assetsalready in service.As a result, we would expect the majority of disclosed
estimate revisions to apply to both new and existing assets.
A.S. Keating, JL. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
381
Overall, Table 6 shows that method changes generate smaller average dollar
and percentage earnings changes than estimate revisions because managers
frequently elect to apply method changes to new assetsonly, and then to only
a subset of their assets.Only 80 (66 income-increasing plus 14 income-decreasing) of the 175 method changes in Panel A apply to both new and existing assets
and have a material effect on income. Estimate revisions, by contrast, are almost
always applied to both new and existing assetsand produce material earnings
effects in 248 (190 income-increasing plus 58 income-decreasing) of the 265
estimate revisions.
4.4.
Test of responses to declining
performance
We predict that declines in accounting performance create incentives to
adopt income-increasing method changes that have a material impact on
earnings. To test for earnings management. by poorly performing firms, we
examine two groups of income-increasing depreciation-policy changes:
(a) income-increasing method changes for both new and existing assets; and
(b) income-increasing method changes applied only to new assets. From
Table 6 we know that group (a) experiences the greater earnings increase
from the change, while group (b) experiences the lesser earnings impact. We
therefore predict that the group applying the method changes to both new and
existing assets is likely to exhibit worse financial performance relative to
the group applying the method changes only to new assets. Notice that
neither the ROA, leverage nor current ratio variable we use in our tests is
adjusted for the effect of the depreciation change, and hence the tests are biased
against finding the predicted relations.
Table 7 presents data on ROA (income before extraordinary items divided by
total assets),leverage (Iong-term debt to total assets),and current ratio (current
assetsto current liabilities) for both groups of income-increasing depreciationpolicy changers. We examine the current ratio because debt covenants often
contain minimum working capital provisions and depreciation-policy changes
can affect working capital through inventory values.
The sample sizes are smaller in Table 7 than in Table 6 because we
require that each firm has Compustat data in years t -2, t -1, t, and
t + 1, where t is the year of the policy change. In the year of the policy change,
firms making income-increasing method changes for both new and existing
assets (Column 1 in Table 7 Panel A) have a significantly lower ROA (0.019)
and higher leverage (0.280) than firms changing methods only for new
assets (0.054 and 0.171, respectively) (Column 2). Moreover, in Panel B
sales and ROA decline more, and leverage increases more from year t- 1 to
year t for firms changing methods for new and existing assets than for
firms changing only for new assets. These findings are consistent with our
predictions.
382
A.S. Keating,
J.L. Zimmerman
/ Journal
of Accounting
and Economics
28 (2000)
359-389
Table 7
Year-to-year levels and changes in summary statistics for firms making (a) income-increasing
depreciation method changes for new and existing assets,and (b) income-increasing depreciation
method changes for new assets only. (Dollar figures are price level adjusted to 1992 dollars and
reported in millions.)
(1)
Income-increasing
change for both
existing assets
(n = 61)
method
new and
(2)
Income-increasing
method change for
new assets only
(n = 38)
Panel A: Levels in the year of the policy change (medians)
Sales
Net income
Assets
ROA a
233
1.3
259
0.019*
Leverageb
Current ratio"
Depreciation expense
as % of net incomed
as % of assets"
Impact of change on net incomef
Income impact as % of net incomeg
Income impact as % of assetsh
0.280*
1.930
16.1
100%
4.7%
4.3*
24%*
1.3%*
442
10.3
209
0.054*
0.171*
2.148
10.7
91%
5.2%
0.72*
6%*
0.3%*
-0.003
-0.024t*
-0.008
0.044
0.039*
-0.007
-0.072
-0.330t
-0.097
0.122
-0.011
-0.202
-0.009t
-0.033t*
-0.006
-0.001
-0.005*
-0.011
0.011
0.009t*
-0.006
-0.012
-0.013*
-0.008
t-1
-0.061 t
t+
-0.043
-0.146t
0.070
-0.008
0.017
Panel B: Year-to-year changes
Sales
t-l
t+l
Earnings
t-l
t+
ROAa
tt
t+l
Leverageb
t-l
t+1
Current
ratio'
aROA = income before extraordinary
items (Compustat
item 18)/total assets (Compustat
item 6).
bLeverage = long-term debt (Compustat item 9)/total assets (Compustat item 6).
cCurrent ratio = current assets (Compustat item 4)/current liabilities (Compustat item 5).
dDepreciation expense/absolute value of net income.
eDepreciation expense/assets.
f As reported by firms in their annual reports or 10 Ks.
gAbsolute value of impact of change/absolute
hAbsolute value of impact of change/assets.
tSignificantly
*Significantly
value of net income.
different from zero at 5% level or better.
different from the other sub-sample at 5% level or better.
A.S. Keating, J:L. Zimmerman I Journal of Accounting and Economics 28 (2000) 359-389
383
As an additional test of these associations, we estimate logit and probit
regressions (untabulated). The dependent variable is one if the firm makes an
income-increasing method change for new and existing assets (Column 1 in
Table 7) and zero if the income-increasing method change is for new assetsonly
(Column 2). The independent variables include ROA, leverage, and the current
ratio, and changes in these variables, in the year of the depreciation-policy
change. Results are consistent with those reported in Table 7. The chi-squared
statistic for this regression is significant at the O.Ollevel; ROA, leverage, and the
change in ROA have significant coefficients of the predicted signs.
The evidence from Table 7 is consistent with firms adopting income-increasing methods for new and existing assets to offset poor performance. Firms
adopting income-increasing methods only for new assets appear to do so for
reasons other than poor performance.
4.5.
Tests of changes in investment
opportunities
This section tests whether changes in firms' depreciation policies are associated with changes in their investment opportunities. In response to changes in
their environment, firms change their investment strategies through entering or
exiting markets, introducing or deleting products, or building or disposing of
plants. These new strategies often require a realignment offirms' decision rights
assignments, performance measurement systems, and compensation schemes
{Brickley et. al., 1997). Realigning performance measures often require
changing accounting policies. Thus, accounting policies likely change when
overall organization design changes. We conjecture that, and test whether,
non-income-increasing depreciation-policy changes are associated with
changes in firms' investment opportunities. We conduct two sets of tests:
a directional test and non-directional test. In the directional test, we have no
theory as to the direction of changes made in the investment opportunity set of
firms adopting non-income-increasing policy changes. However, we assume
that firms making these policy changes all experience increases or decreasesin
their investment opportunities in the same direction. That is, our maintained
hypothesis is that all non-income-increasing policy change firms adjust their
investment activity in the same direction; lacking a more complete theory,
however, we have no prediction as to the direction of the change. Hence, we
conduct two-tailed tests.
In the non-directional tests we drop the maintained hypothesis that the
investment opportunity changes precipitating non-income-increasing depreciation-policy changes are in the same direction. We examine whether the variance
of the change in investment opportunities increases surrounding depreciationpolicy changes. Suppose that in response to some exogenous shock one firm
increases its ratio of property, plant, and equipment {PPE) to assets-a measure
of investment opportunities -from 30% in year t- 1 to 35% in year t, while
384
A.S. Keating,
JL.
Zimmerman
/ Journal
of Accounting
and Economics
28 (2000)
359-389
another firm decreasesits ratio ofPPE to assetsfrom 35% in year t -1 to 30%
in year t. The median level of PPE to assets has not changed. Moreover, the
median change in PPE to assetsis zero. However, the variance of the change in
PPE to assetsis non-zero and varies with the magnitude of the changes.We thus
examine the standard deviations of the changesin variables as an additional test
of an association between depreciation-policy changes and investment opportunity changes.
In both the directional and non-directional tests we compare a treatment group
consisting of firms making income-decreasing or income-neutral ('non-incomeincreasing') method changesor estimate revisions only for new assetsto a matched control group. The treatment firms are unlikely changing depreciation policies
due to poor financial performance becausethe changes do not increase income.
The fact that these changes are applied to new assetsonly suggeststhat they are
not done for earnings management reasons, since the impact of the changes on
earnings is relatively small. We conjecture these firms are likely changing for
non-earnings management reasons, such as to re-align internal and external
contracting incentives due to new investment opportunities facing the firm.
We construct our control sample as follows: For each treatment firm (i.e.
a firm making a non-income-increasing depreciation.policy change), we identify
all Compustat-listed firms (other than the treatment firm being matched) with
PPE.to-assets, capital expenditures.to-sales, and market-to-book ratios within
0.1 standard deviation of the comparable ratio of the treatment firm two years
prior to the treatment firm's depreciation-policy change (Holthausen and Larcker, 1996; Barber and Lyon, 1996). For example, consider a treatment firm
making a depreciation-policy change in 1988 whose PPE.to-assets, capital
expenditures-to-sales and market-to-book ratios in 1986 (2 years prior to the
1988 policy change) are 0.4, 0.05, and 1.2, respectively. Assume the standard
deviations of PPE-to-assets, capital expenditures-to.sales, and market-to-book
for all Compustat firms in 1986 are 1.0,0.04, and 3.0, respectively. We include in
our control sample all Compustat firms with available data for 1988 whose 1986
PPE.to-assets ratio is in the range 0.3-0.5, capital expenditures-to-sales ratio is
in the range 0.046-0.054, and market-to-book ratio is in the range 0.9-1.5.
Ideally, we would like to exclude from our control group those firms making
non-income-increasing depreciation-policy changes. However, as noted above,
the Compustat footnote codes are at best imperfect indicators of depreciationpolicy changes. Moreover, these footnote codes do not indicate the incomeimpact of the change. We exclude from our control group any firm that has
either a footnote code # 15 indicating a depreciation.policy change, or a change
in footnote code # 5 between years t -1 and t indicating a change in methods
from straight.line to accelerated (a non-income-increasing method change).
While this selection procedure reduces the likelihood that the control sample
contains firms making depreciation-policy changes, it does not eliminate that
possibility altogether.
A.S. Keating, J:L. Zimmerman I Journal of Accounting and Economics 28 (2000) 359-389
385
Table 8
Year-to-year levels and changes in summary statistics for (a) firms choosing income-decreasing or
income-neutral ('non-income-decreasing')
depreciation method changes or estimate revisions for
new assets only ('treatment' firms) and (b) a set of 'control' firms matched to treatment firms based on
PPE/total
assets, CapEx/sales, and market-to-book
two years prior to the depreciation-policy
change (t -2). (Dollar figures are price level adjusted to 1992 dollars and reported in millions.)
,
Treatment firms
(n on-income- increasing
changes for new assets only)
(n = 37)
Control firms
(n = 1108)
Panel A: Levels (medians)
Sales
Net income
Assets
ROAa
240
9.3
161
0.061*
0.147
0.301
0.047*
2.280
1.16
5.4
53%
3.5%
0.0
0%
0%
Leverageb
PPE/total assets
CapEx/Sales
Current ratioC
Market-to-book
ratio
Depreciation expense
As % of net incomed
As % of assets"
Impact of change on net incomer
Income impact as % of net incomeg
Income impact as % of assetsb
229
4.5
140
0.043*
0.179
0.264
0.033*
2.156
1.01
5.3
67%
3.7%
Panel B: Year-to-year changes
PPE/total assets
t-l
t+1
CapEx/Sales
t-l
t+l
Median
Standard
deviation
Median
change
of change
change
0.004
0.014t*
-0.002
0.001
0.006t*
-0.003
0.033°
0.001
0.000*
-0.004t
0.041
0.110°
0.001
-0.001 *
0.018
0.083°
0.000
0.106
Standard
deviation
of change
0.050
0.050
0.063°
2.040
1.991
0.098°
&ROA = income before extraordinary items (Compustat item 1&)/total assets (Compustat item 6).
bLeverage = long-term debt (Compustat item 9)/total assets (Cfmpustat item 6).
.Current ratio = current assets (Compustat item 4)/current liabilities (Compustat item 5).
dDepreciation expense/absolute value of net income.
.Depreciation
expense/assets.
f As reported by firms in their annual reports or 10 Ks.
gAbsolute value of impact of change/absolute
hAbsolute value of impact of change/assets.
i
value of net incotne.
*Significantly
different from the other sub-sample at 5% level or better (2-tailed test).
tSignificantly different from zero at 5% level or better (2-tailed test).
"Standard deviation is significantly different from the previous year's standard deviation at the 5%
level or better (2-tailed test).
386
A.S. Keating,
J.L. Zimmerman
/ Journal
of Accounting
and Economics
28 (2000)
359-389
Using these procedures we identify 1108 control nrms, or 29.9 control firms
per treatment firm. We do not require each treatment firm-year to have
at least one control sample firm-year (i.e. for some treatment firms this
matching process will not yield any 'matched' control firms) and we do not
preclude a control firm-year from being included more than once in the
control sample.
Table 8 presents data on the investment opportunities. Descriptive data about
levels of variables such as sales and ROA are provided in Panel A. In Panel B,
using changes in investment opportunity proxies, we test whether firms adopting non-income-increasing depreciation changes for new assets only are
likely to increase or decreaseinvesting activity. In Table 8 Panel A, firms making
non-income-increasing changes only for new assetsare significantly healthier in
the year of the change than control firms. While they do not differ significantly
in terms of sales, earnings, or assets, the non-income-increasing sample has
significantly higher ROA (0.061) and capital expenditures to sales (0.047) than
the control sample (0.043 and 0.033).
In Panel B of Table 8, we present evidence regarding changes in investment
opportunity variables. The median-based tests in Panel B assume that all firms
adopting non-income-increasing changes for new assetsonly will change PPE
or capital expenditures in the same direction. The non-income-increasing group
has a significant increase in PPE to total assets(0.014) and capital expenditures
to sales(0.006) in the year of the depreciation-policy change (year t). By contrast,
control firms do not experience a significant change in plant and equipment
(0.000) and capital expenditures (0.001) in year t.
Panel B of Table 8 also reports the standard deviation of changes in PPE to
total assets and capital expenditures to sales for the treatment and control
sample. We use these standard deviations as the basis for the non-directional
tests described above. For the non-income-increasing group the standard deviation of the changes in plant and equipment as a fraction of total assetsincreases
more than four-fold (from 0.018 to 0.083), and the standard deviation of the
changes in capital expenditures more than doubles (from 0.041 to 0.110), from
year t -1 to year t. These results contrast with the control firms not making
a depreciation-policy change, where the standard deviation of the change in
PPE/assets and CapEx/sales variables does not change significantly from year
t -1 to year t. The differences in standard deviations are statistically significant
between the treatment and control groups in year t.
Overall, these results suggestthat non-income-increasing depreciation-policy
changes adopted by firms for new assets only are associated with changes in
their investment opportunities. Moreover, the directional tests showing an
association between increases in investment opportunities and non-incomeincreasing depreciation-policy changes suggestthat firms experiencing increases
in investment opportunities shorten estimated asset lives, decrease estimated
salvage values, or adopt more accelerated depreciation schedules.
A.S. Keating, J:L. Zimmerman / Journal of Accounting and Economics 28 (2000) 359-389
387
To test for any confounding tax effects in the pr~-1981 period, we redo our
analysis restricting the samples used in Tables 7 and 8 to depreciation-policy
changes after 1983, i.e. two years after the adoption of federal tax laws making
financial reporting depreciation choices largely independent of tax considerations. Our inferences do not change.
5. Conclusions
The extant accounting literature (e.g.,Hagerman and Zmijewski, 1979, Skinner, 1993, Bowen et al., 1995) documents statistically significant cross-sectional
associations between depreciation method and firm size, leverage, risk, investment opportunity set, and bonus plans, among other variables. However, these
tests' explanatory power is low. Moreover, attempts to explain changes in
depreciation methods have not proven very fruitful (see, for example, Holthausen, 1981; Sweeney, 1994). Thus, we do not have compelling theories to
explain why firms choose the depreciation methods they do or why managers
change one of the largest accruals under their control: depreciation. Unlike the
previous literature, we examine whether two depreciation accounting policy
changes -one being changes in depreciation methods the other being revisions
of useful lives and salvage values of depreciable assets-are responsesto changes
in the tax code, measures taken to offset poor performance, or reactions to
changes in the firm's investment opportunities.
We find that these policy changes are relatively infrequent events among
NAARS-listed firms, occurring in less than 1% of firm-years. Changing depreciation policies does not appear to be a frequently used earnings management
tool.
While the frequency of depreciation-policy changesin aggregate has remained
constant over time, the frequency of method changes has declined and estimate
revisions have increased. These shifts in frequencies of policy changes over time
are consistent with a 1981 tax law that uncoupled useful life and salvage
value estimates for financial reporting purposes from tax liabilities. In particular, following the 1981 tax revision there is a significant increase in the frequency
of estimate revisions, while there is a significant decline in the frequency of
method changes. This finding suggests that prior to 1981, while firms were
allowed to keep separate books for tax and financial reporting, financial reporting estimates of useful lives and salvage values could affect tax liability.
The median absolute value of depreciation method changes on income is
small, only 6% of the absolute value of earnings. By contrast, the median
absolute value of the impact of estimate revisions is 13% of the absolute value of
earnings. The smaller impact of method changes is due to managers electing
42% of the time to change methods only for new assets,while retaining extant
methods for assetsalready in service. Moreover, when managers elect to apply
388 A.S. Keating, J.L. Zimmerman / Journal of Accounting and Eeonomics 28 (2000) 359-389
the method change to both new and existing assets,in about 20% of these cases
the change is only applied to one class of assets(such as buildings) yielding an
immaterial effect on earnings.
When managers elect to make an income-increasing method change for both
new and existing assets,the earnings effect is larger than for estimate revisions.
Moreover, firms adopting such changes have the worst financial performance
and the highest leverage. This evidence is consistent with earnings management
to avoid debt covenant violations, to increase executive compensation, and/or
to reduce the likelihood of executive turnover.
Firms electing non-income-increasing depreciation-policy changeshave a larger change in their investment opportunity sets than firms not making these
changes. These firms are performing well and furthermore are increasing the
ratio of property, plant, and equipment to assets and capital expenditures to
sales in the same year as the depreciation-policy change.
We conclude that depreciation-policy changes are made for a variety of
reasons. Book depreciation estimate revisions prior to a 1981 tax law change
appear to have been done to reduce the firm's tax liability. Income-increasing
changes applied to both new and existing assets,which produce large changes in
earnings, are likely adopted to boost earnings for debt covenant and compensations reasons or to reduce the likelihood of executive dismissal. Non-incomeincreasing depreciation-policy changes, meanwhile, appear to be in response to
changes in firms' investment opportunity sets.
Our findings have implications for research examining other accounting
policy changes. The discretion afforded managers over such changes is more
subtle than simply the 'change' versus 'do not change' decision. For example,
a manager electing to change depreciation methods can choose (a) whether the
change will be income-increasing -say by switching from the accelerated
method to the straight-line method -or income-decreasing say shortening
estimated lives; (b) whether to apply the change only to assetsacquired after the
adoption of anew depreciation-policy, or to existing assets as well; and
(c) whether to apply the new method to all types of assetsin all sub-units or to
onlya sub-set of assets -say, equipment but not buildings -and a sub-set of
business units. Managers' choices along each of these dimensions are associated
with their incentives. We find evidence of depreciation-policy changes being
correlated with tax law changes, poor performance, and changes in investment
opportunities only after we identify the sub-set of policy changes most likely to
be associated with each incentive. Studies of other accounting policy changes
will likely benefit from similar disaggregation.
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