Understanding earnings quality - MIT Sloan School of Management

past service costs). Zmijewski and Hagerman (1981) document that larger firms are more likely to
choose a set of accounting policies that in the aggregate are income-decreasing, suggesting that
while size does not explain individual choice very well, it explains the firm’s overall strategy.
Bowen, Noreen, and Lacey (1981) find support for the political visibility hypothesis in the oil
industry (i.e., large firms avoid using the interest costs capitalization method), but contradictory
results in other industries. Moreover, Zimmer (1986) finds that larger firms capitalize interest in
Australia, which is inconsistent with the political cost argument. Moses (1987) finds that firm size
and market share (marginally) are associated with accounting method changes specifically to smooth
(as opposed to decrease) earnings.
Overall, in some specific settings, size is likely to be an important indicator of the type of
visibility that increases expected political costs. However, in other settings, the political costs may
be most severe for firms in a targeted industry (Han and Wang, 1998) or for young firms (Beneish,
1999). While there is fairly compelling evidence that political pressure can create incentives for
earnings management (Section 5.6), and size is often used as a proxy for pressure, the leap to an
association between firm size and any dimension of EQ would be inappropriate. Firm size could
proxy for factors other than political visibility such as information environment, capital market
pressure, or financial resources. For example, several studies hypothesize fixed costs associated
with maintaining adequate internal control procedures, and hence predict a positive relation between
firm size and internal control quality. 48 These studies show that small firms are more likely to have
internal control deficiencies and are more likely to correct previously reported earnings (Kinney
and McDaniel, 1989; Ge and McVay, 2005; Doyle, et al., 2007a; Ashbaugh-Skaife et al., 2007).
48 Ball and Foster (1982) also make this point. One argument they make for not using size as a proxy for political costs
is that the cost of compliance may be fixed, such that small firms that bear the greatest cost.
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