DAVID F.

HAWKINS

Behavioral Implications of Generally Accepted Accounting Principles

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

can condition the decisions of managers as well as measure their performance. Unfortunately, this does not always lead to desirable results. A number of these principles have a built-in bias which motivates managers under certain circumstances to adopt them in preference to alternative principles that may better reflect the operating results and financial condition of their company. In addition, other generally accepted accounting principles may induce managers to adopt specific operating policies, even though these policies may not necessarily be the most appropriate.

to be the best interests of their stockholders anc society. The Accounting Principles Board and others wjo influence the definition of what constitutes acceptable corporate accounting principles must ask themselves in each case: What might this accounting principle or practice motivate managers to do in their own selfish interest? Could this possible action obscure actual managerial performance, give the illusion of performance where none exists, or lead to unsound economic actions? If the answer to any part of the second question is "Yes" and the probability that it will occur is reasonably high in even a few cases, then the use of the accounting practice should not be encouraged, unless it is obviously justified by clearly defined business circumstances. Such accounting practices should not be encouraged even though sound from the technical vievi^oint of accounting theorj^ Another important determinant of the strength, character, and prevalence of managerial response to any improvements in the behavioral aspect of financial accounting is the attitude of the "managers" of the system toward corporate reporting. The "managers" include the Securities and Exchange Gommission, the major stock exchanges, the ethics and professional practice committees of the American Institute of Gertified Public Accountants, the courts, and Gongress. If these manager groups follow a vigilant. 13

Need to Consider Behavioral Implications

The Accounting Principles Board and its predecessor, the Gommittee on Accounting, have reduced the number of behaviorally undesirable accounting principles, but some still persist. The goal of the accounting and management professions should be to eliminate these remaining objectionable practices and to create a set of generally accepted principles that will motivate managers to make sound economic and reporting decisions. If this is not possible, our corporate reporting system should at least not encourage managers to act against what appear W I N T E R / 1969 / VOL. XII / NO. 2

tough, aggressive program to root out and expose undesirable accounting practices, corporate managers and the accounting profession will be more inclined to respond to the desii-able biases in our accounting system rather than the undesii-able. Fortunately, this seems to be increasingly the case today. The continuing controversy over the appropriate handling of deferred taxes illustrates the need to consider the behavioral aspects of an accounting principles decision. Deferred tax accounting problems arise when a company uses different accounting methods for book and tax purposes, i.e., capitalizef! research and development expenses on its boohs and expenses them for tax purposes. The timing differences between the book and tax recognition of revenues and costs can lead to a deferral of tax payments. There are three different proposals for handling these tax deferrals in financial statements. The flow-through method would report the taxes di^e to the taxing authorities as the tax expense fjr book purposes. The comprehensive allocation approach bases the book tax expense upon the book profits before taxes. The difference between this tax expense and the taxes shown on the tax retun is carried as a deferred tax liability on the balarce sheet; irrespective of when it is anticipated, tie deferred taxes will fall due. The partial allocaton approach is a variation of the ffow-through method. It would include in the deferred tax liability calculation only those taxes which are thought by management to be actually payable in the near future plus the taxes due on the current tax return. In my opinion the Accounting Principles Board came to the correct decision on this issue when it decided on the comprehensive allocation method, but it did so on bookkeeping grounds. Neither the Board nor those who opposed its decision appear to recognize the behavioral aspects of the contending approaches proposed. There are some undesirable motivation implications associated with the partial allocation and fiowthrough methodsthe two approaches the Accounting Principles Board rejected. These stem from two facts: (1) the first-year profit boost inherent in the
David Hawkins is an Associate Professor of Business at Harvard University and an active consultant with Kenrrwre Management Associates, Inc. and Social Administration Research Institute, Inc. He was formerly the Executive Assistant to the Managing Director of Australian Carbon Black Pty. Ltd.

method per se from the deferral of tax payments; (2) the accounting decision necessary to create the circumstances which give rise to tax deferral, such as the bookkeeping decision to use straight-line depreciation for public reporting purposes and some accelerated method for tax purposes. Thus, by simply adopting a bookkeeping change, profits can be improved by the cost difference between the two accounting treatments of depreciation plus the differential cost times the tax rate. This is potentially undesirable since it can encourage a manager to substitute the illusion of performance for the realities of performance. (See my article, "Controversial Accounting Changes," Harvard Business Review, March-April 1968.) In my opinion, this is enough reason to reject flow-through methods as acceptable accounting principles. In contrast, the comprehensive allocation approach to tax allocation has the desirable behavioral quality of encouraging and permitting management to make their tax and book accounting decisions independently of each other. Also, it reduces the strength of the incentive to make bookkeeping switches to create a timing difference between book and tax recognition of items. The comprehensive allocation method still permits a company to get the profit differential between, say, straight-hne and accelerated depreciation, but it eliminates the additional incentive of the profit differential times the tax rate gained under the flow-through methods. Side effects. The potentially undesirable motivational implications of the flow-through approaches to tax accounting extend to many accounting and tax decisions which can create timing differences between the recognition of revenues and costs for tax and book purposes. For example, the extra profit bonus flowing from applying flow-through methods biases managers toward the follovidng: Selling in an expanding sales situation on the installment basis rather than for cash. (An expanding company which accounts for installment sales on the accrual method for book purposes and the installment method for taxes could show greater current profits than a company either using the accrual method for both book and tax purposes or selling for cash.) Capitalizing dubious research and development and similar expenditures for book purposes and expensing them for tax reports. Recognizing profits on questionable long-term contracts on a percentage-of-compledon basis in stockholder reports and in tax returns on a completed contract basis. California Management Review

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 Including the earnings of marginal foreign subsidiaries in the accounts currently, but in tax returns when later remitted. In the case of the marginal firm these accounting inducements to improve profits may well work toward management's accepting some methods simply because they improve profits, regardless of tax deferral and underlying business considerations. The added profit bonus resulting from applying owthrough accounting to tax deferrals would make it harder to resist adopting these methods. Under these circumstances the potentially undesiiable behavioral aspects can interfere with the application of managerial judgment necessary to make financial reporting more meaningful, more responsible, and more responsive to the peculiar aspects of each business enterprise. A strong profession. It is conceivable that in particular instances the accounting methods cited above may most fairly reffect the actual circumstances. Eor instance, some expenditures for research activities may be just as good as an investment in bricks and mortar. In this case the research expenditures should be capitalized and written off over future accounting periods. However, the circumstances which might justify capitalization are not always clearly stated or clearly determinable in operational terms. Herein Hes the problem: Can those accounting methods with potentially undesirable motivational characteristics be eliminated from the list of generally accepted accounting principles without reducing the responsiveness of corporate reporting to the unique characteristics of each company? In my opinion, the answer to this question is "Yes." Certainly, the accounting profession must continue its work in reducing the inducements to adopt the obvious fiagrant misuse of accounting options. Also, the profession must, as it is, work to eliminate those practices not justifiable by different circumstances. Beyond these actions, the dilemma posed above points up: 1 / The need for an independent and knowledgeable public audit function with a strong commitment to "fairness" in corporate reporting and protecting third parties from accounting misrepresentations. 2 / A clearer definition of the circumstances under which alternative accounting practices are justifiable. Management control analogy. With one exception our corporate financial reporting systems perform operationally in a behavioral sense in our total

economy in a way somewhat analogous to the management control systems used internally by top corporate management to communicate with, understand, measure, and infiuence the actions of their operating unit managers. Because of this similarity, I believe that we can move toward a desirable behavioral set of accounting principles for public reporting practices by applying to our financial accounting recommendations and practices the same type of thinking which is applied to management control to influence behavior through the use of measurement devices. The financial reports to stockholders represent the information output of the public system to control managerial actions. In this case the contiol system is designed by the accounting profession to the extent it defines "generally accepted accounting principles," and by the managers themselves insofar as they make accounting policy decisions for individual companies within this framework. The principal operational difference between the motivational aspects of internal managerial control systems and our corporate reporting system lies in who sets the objectives the system is to achieve. Operationally, however, the desired results are the same: optimum use of resources with the system. In the case of managerial controls every manager within the system is an employee who is working toward specific goals that his superior has established with or without his participation. Also, resources within the company are allocated by a few managers at the top level of the company. In contrast, the reporting units in the corporate reporting system are independent of each other and act in their own self-interest. The resources of society are allocated between these units through a competitive free market capital allocation mechanism, the effectiveness of which rests in large measure on the reliability and relevance of the information in corporate financial reports. To the extent that accounting principles are used to consti'uct corporate financial statements, our society's resource allocation decisions rely in part on these principles. If these principles bias management toward unsound economic decisions or lead to financial reports which are misleading, then the effectiveness of society's resource allocations will be unnecessarily reduced. Even though those who establish accounting principles are not responsible for planning our eco-

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nomic development, they must seek to reflect society's best interests and desiies in their actions related to accounting principles. This is a heavy responsibility, but it will do this more effectively if it is recognized that accounting principles can influence corporate and investor behavior. Like the typical management control system, our financial reporting system serves as a two-way communication device between management and society. Everyone recognizes that financial reports are a communication between management and their stockholders. The communication from society to management is less obvious and less clearly defined. This aspect of communication is achieved through the accounting principles that society sanctions in the form of generally accepted accounting practices. Consequently, if some of these principles encourage management to do things that are contrary to the current modes of thought in society, then society must share part of the blame. It is very difficult to define the current mode of thoughts as to what is acceptable corporate behavior. It is equally difficult to adjust accounting principles to changes in this standard. Thus, all too often our corporate financial reporting system is not as responsive to new attitudes as is, say, the typical management control system, where the commvmication from top management to operating managers is under the control of a few people who can readily determine what is acceptable behavior in their company. Nevertheless, as difficult as it is to make our system more responsive, the messages carried by accounting principles from society to management can be clearer and closer to today's modes of thought if the groups charged with responsibility for maintaining our corporate reporting system recognize the two-way communication potential in our system and use it to the best of their ability to communicate society's goals to management. A key element of any management control system is the standard against which aetual performance is measured. This relationship gives meaning to the control system. Experts in the field have long recognized that the measure of a manager's performance index can influence in a crude way the behavior of the managers subjected to the system. For example, if a manager of a foreign subsidiary in a country such as Brazil, with a continuously devaluating currency, is measured in terms of his net profit in local currency, he is not necessarily encour16

aged by this measure to protect the parent company's investment from devaluation. Devaluation has no direct effect on this particular measure of performance. On the other hand, if the manager's profit performance is measured in the dollar equivalent of his local profits after adjustments for devaluation gains or losses, he may be stimulated toward taking actions to reduce the devaluation erosion of the parent's investment. However, what specific actions the manager takes to reduce the effects of devaluation may in part be influenced by the particular technique used to translate the local currency statements into dollars. Some translation techniques encourage managers to shift their assets from monetary items to nonmonetary items. Other methods induce the manager to switch his assets from the current to the long-term category. Thus, the measure of performance may be the same for two managers, but the way it is determined may lead them toward making different decisions on how to protect their operations from devaluation losses. The performance standards of our corporate reporting system are established in a variety of ways: Managers can set these standards themselves by publicly predicting their company's future eamings-per-share results. Similarly, standards can be set by the public predictions of security analysts and others who advise investors. The actual or predicted results of competitors are often used as a standard against which actual performance is measured. Another standard used widely is the common expectation that a corporation should improve upon its last year's results. Erom these standards stockholders and potential investors pick the financial measures of performance they consider most relevant, which, despite its limitations, in most cases seems to be principally earnings-per-share. Despite the fact that the earnings-per-share performance measurement is a crude measure of performance it influences managerial behavior in two ways: In the way corporations are capitalized. In the accounting and economic decisions made along the v/ay in the creation and calculation of profits. The strength of the direction of a control system's motivational bias depends in large measure on the California Management Review

relationship of the manager's compensation to his performance measurement. The closer this relationship the more likely is the system to influence the behavior of the manager. The economic and psychic rewards received by managers for successfully meeting the earningsper-share measures of performance in our corporate reporting system are attractive. Modem managers understand this fact of life. Unfortunately, the pressures to meet these standards are sometimes so strong that some chief executive officers acting under the weight of an adverse business situation have stretched the credibility of their accounting reports to meet their stockholders' insatiable appetite for continually improved performance. It is these incentivesplus the pressures for producing successful performance together with the fact that managers are human beingsthat give meaning to the behavioral aspects of generally accepted accounting principles. It is reasonable to expect that managers acting in their self-interest will seek to meet their performance standards by whatever reasonable legitimate accounting methods are available to them. Hopefully, the accounting means they use will be in the best interests of society. This will be more likely to occur if corporate accounting policy decisions and corporate action are not complicated by the fact that available techniques used to measure and report performance have built-in biases toward the reporting of misleading results and the structuring of coi^orate decisions to justify the use of these methods.

Recent Progress
During the last five years the Accounting Principles Board has made a number of significant decisions which have influenced the motivational bias of generally accepted accounting principles. Unconsolidated subsidiaries. Opinion No. lO's amendment to Accounting Research Bulletin No. 51 reduced the motivational bias inherent in the old principles governing consolidation. These principles presented a strong inducement for companies to establish unconsohdated subsidiaries whose principal business activity was leasing property or facilities to their parents. This often led to an inadequate and unfair presentation of the consolidated financial position of the total enterprise. Significant assets and WINTER / 1969 / VOL. XII / NO. 2

liabilities were excluded from the consolidated statements. Subsequent to Opinion No. 10 such subsidiaries must be consolidated. Thus, the strength of accounting inducement to establish this particular type of subsidiary was reduced. Extraordinary income and losses. Prior to Opinion No. 9 the accounting principles related to writing off extraordinary losses provided strong incentives for corporations to defer facing up to potential write-offs of costs, such as goodwill, bad debts, etc. and then write them off against retained earnings, rather than income. Opinion No. 9 reversed this situation. Henceforth, the general presumption is that net income will reflect all items of profit and loss recognized during the period, except for those rare items which were actually adjustments to prior period income calculations. Now tlie accounting motivation tends to bias corporations away from capitalizing costs which may some day have to be written off against revenues, but do not have any offsetting related income. However, should a corporation build up large potential write-offs on its balance sheet, the effect of Opinion No. 9 may be to make the company more reluctant than ever before to write tbese costs off the balance sheet. In most cases these costs now would have to be charged against income. The option of a "painless" write-off against retained earnings is no longer available. Common stock eqviivalents. Opinions No. 9 and 15 reduced the incentive for managers to issue convertible securities, particularly those which at the time of their issuance are the equivalent of common stock. Previously, the potential dilution from such securities was not included in the eamings-per-share calculation. This encouraged corporations to issue convertible securities to acquire other companies and for new financing. Beginning in late 1968, however, the Securities and Exchange Commission stated that the actual eamings-per-share calculation of corporations in its jurisdiction had to include all classes of common stock outstanding, all outstanding securities ^vith participating dividend rights with common stock, and all securities deriving a major portion of their value from the conversion rights or common stock characteristics. This accounting change reduced one advantage of convertible securities as a financial device to the extent that they might now dilute primary and fully diluted earnings per share. 17

Retroactive poolings. Prior to Opinion No. 10 the business combinations consummated during or shortly after the close of the accounting period but before the financial statements of the continuing business were issued to stockholders, were includable on a pooling-of-interest basis in the results at the close of the accounting period. There was no requirement for disclosing the results of operations and the fiscal condition of the acquiring company before effecting the combination. The stockholder could not distinguish that part of reported earnings which related to operations and that part which related to acquisitions. This accounting practice was a strong inducement to some managers to acquire companies in order to reach previously announced projected earnings levels. Opinion No. 10 did not remove the accounting incentive for such acquisitions, but it did reduce the strength of the inducement. Opinion No. 10 recommended: "In order to show the effect of poolings upon their earnings trends, companies may wish to provide reconciliations of amounts of revenues previously reported with those currently presented." The effectiveness of such disclosure admonitions upon corporate behavior has yet to be fully tested. The assumption is, however, that this disclosure requirement will contribute to more responsible managerial behavior in merger decisions. Each of these changes sponsored by the Accounting Principles Board reduced the opportunity for managers to improve or hide profits through accounting manipulations. While the Board was not able to remove the conditions which led to managers adopting these practices for nonoperating reasons, it did eliminate or reduce the strength of the potentially undesirable accounting inducements inherent in these reporting practices.

Current Areas of Concern

There are still a number of accounting practices which have undesirable behavioral characteristics since they can condition managerial decisions in such a way that the resulting measurement of performance is misleading. The major areas of current concern are the treatment of poolings-of-interest, leases, unconsolidated financial subsidiaries, and investment tax credits. In each of these cases there is a need to tighten current accounting practices so as to reduce the temptation for managers to gear their

operating or reporting decisions to take advantage of the profit or balance sheet improvements inherent in the relevant accounting options. Pooling of interests. An important feature of the prolonged trend of corporate mergers and acquisitions is the "pooling-of-interest" accoiHiting practice. Originally, this treatment was reserved for the merger through an exchange of equity stocks of two companies of comparable size. The sales and profits of the two companies were added together and presented as though they had always been one company. Similarly, the assets, liabilities, and retained earnings were combined and the remaining capital accounts adjusted to bring the totals of the left- and right-hand sides of the new balance sheet into equilibrium and to refiect the new stock issued. Before the mid-1950's the relative size of the acquired company tended to be an important criteria in determining how to account for the acquisition. As often as not this meant acquisitions of smaller companies by larger ones for either cash or stock were usually treated as a purchase. In these cases the sales, expenses, and profits of the acquired company were added to the income statement of the acquiring company only as earned from the date of acquisition. Usually the assets of the acquired company were added to tliose of the acquiring company at their book or fair market value. Any excess of purchase price over the net asset value of the acquisition was listed as goodwill among the acquirer's assets. The purchase treatment was unpopular with a number of managers, and, in general, it did not encourage them to actively seek acquisitions of smaller companies. Managers were reluctant to show large amounts of goodwill on their balance sheet, even though there was no requirement to write this intangible asset off against earnings or retained earnings, except if there was a permanent decline in the profitability of the acquired business. Also, they were reluctant to attribute some of this goodwill to the assets they had acquired. This would have raised their annual depreciation costs and lowered profits. Beginning about ten years ago the pooling treatment was slowly expanded to cover more and more mergers until today nearly every acquisition involving a taxfree exchange of stock is treated as a pooling-of-interest. Now bigger companies can acquire smaller ones without being burdened with the troublesome goodwill item. California Management Review

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Thus, an accounting consideration changed from a disincentive to an incentive to merge. In fact, much of the merger movement can be attributed to this development. It made it possible for some companies with high price / earnings ratios to grow faster and easier through acquisitions than through operations. The power of the pooling incentive is increased significantly when one considers the disincentive inherent in the accounting presumption that the costs of such programs as research and development and new product development and marketing are written off as incurred. If these costs are heavy this could have a depressing effect on profits since the revenues from such activities are usually relatively small in the early years of the program. Thanks to the pooling treatment a company can avoid this situation by acquiring new products and research know-how through a merger. The development costs can be avoided and the risks can be less. Off-the-balance-sheet financing. A significant factor in the growth of leasing companies is the current accounting practice which does not require lessees to capitalize future rental payments and list them as a liabiHty on the balance sheet. This fact has encouraged corporations to enter into leasing arrangements rather than acquire assets through debt. The result is a more attractive debt-equity ratio, even though in most leasing situations it is hard to see how the substance of the lease contract and the intentions of the parties differ from those associated with a normal debt agreement. Consequently, the accounting treatment of leases has a built-in bias toward leasing. The debt equivalent of the lease is kept off the balance sheet Another so-called "off-the-balance-sheet" financing device encouraged by accounting is the creation of financial subsidiaries to handle the debt financing of credit sales. These subsidiaries do not necessarily have to be consolidated with their parent company in reports to the public. Consequently if the financial subsidiary is not consolidated, the debt held by the finance company is not included in the debt-equity ratio of the parent, even though in some cases it is the general credit of the parent that guarantees the debt In my opinion, the exclusion of many of these financial subsidiaries from the parent company statement can lead to misleading parent company statements. Investment tax credit. The flow-through accounting treatment of the investment tax credit which WINTER / 1969 / VOL. XII / NO. 2

permits a company to recognize the full income benefit of the credit in the year it is granted leads to a misleading statement of current profits. This profit-enhancing potential of the credit biases management toward purchasing assets, although like the examples cited above it is not the only factor in the decision. The strength of the influence of the accounting treatment on the investment decision would be reduced if investment tax credits had to be accounted for by the deferral method which spreads the credit's profit improvement influence over the economic life of the asset. This handling of the credit relates profit recognition more closely to the use of assets in operations which adds to the company and society's capital and makes profits less of a derivative of accounting treatment and capital outlays. Protection through disclosure. It is possible that tlie potentially undesirable behavioral implications of the foregoing cases may be diminished by the disclosure requirements relating to them. This would be true if security analysts and stockholders fully understood the accoimting practices involved and explicitly made adjustments for the influence of accounting on corporate profits and actions in their evaluations. The enthusiasm of the public and the investment communit)' for conglomerate company stocks whose managements have molded their actions in large part to take advantage of accounting profit enhancers would seem to indicate that this is not the case. If this is so, disclosure is not necessarily an adequate safeguard for investors or an adequate motivator for improved reporting. The existence of an accounting principle with potential behavioral implications is seldom enough alone to encourage management to adopt a principle for reporting purposes. Certain nonaccounting facts, when combined with the reporting opportunities inherent in the accounting practice, activate the motivational biases of the accounting principle. One basic condition is the existence of a general operating need. For example, managers are not likely to lease a new building simply because of the accounting treatment of leases. The need for a building has to be there first. However, the "offthe-balance-sheet" financing aspect of the lease treatment may well induce a manager to lease the needed building, rather than purchasing it through regular mortgage financing. Of course, other factors beside the accounting consideration may lead the managers to decide to lease or not lease. 19

There are a variety of other circumstances which may give added strength to the undesirable behavioral bias of some accounting principles. These include the case where a corporation fails to reach its "earnings-per-share" standard through operations. The opportunity to increase profits through accounting devices is present. It takes a strongminded management to resist the temptation inherent in these methods, especially when the competition is adopting these practices to boost profits. Another common circumstance is a company seeking, for one reason or another, to project a particular financial image. A common example of this phenomena is the company that seeks a growth image. The "pooling-of-interest" accounting encoin:ages this to be done through acquisition for the reasons outlined above. A second illustration is the company which seeks to project a high return on capital image. The accounting treatment of unconsolidated subsidiaries encourages companies with this goal to establish unconsolidated financial subsidiaries. The equity method allows management to include the profits of financial subsidiaries in the consolidated statement, but not the assets or liabilities. In summary, within the accounting practice the direction of any bias is clear. However, the strength of this bias depends on the attendant circumstances. Internal control. A number of companies have recognized the motivational implications of specific generally accepted accounting practices and have explicitly made decisions for behavioral reasons to use or not use these principles to calculate the internal measures of perfonnance through which the actions of managers are controlled in part. Some of these companies use these principles for internal statement purposes, but oppose their use for reports to stockholders. The reverse is true of others. Here are four illusti-ations: 1 / Very few corporations show capitalized leases on their public statements, yet a great number of them require divisional managers to capitalize leases on their divisional statements. Why? Top management recognizes that managers can improve their retuin on total assets by leasing rather than buying new plant equipment. The leased assets never enter into the investment base whereas the purchased assets do. As noted earlier, this can encourage excessive leasing in some situations. Also, comparing divisional performance can be more difficult when some divisions lease and others buy assets. To facilitate comparison, some companies require all divisions leasing assets to capitalize the leases and 20

then depreciate the offsetting asset like any ordinary purchased assets. This puts all divisions on the same basis. 2 / Few companies permit divisional managers to capitalize research and development, principally because this "tends to let them off the hook." If they were permitted to capitalize research and development the managers might be less inclined not to terminate projects with poor prospects of success because their costs could be kept out of the income statement. Yet, in the case of external reporting it is often those companies who are in trouble and whose research projects are the most dubious that try to capitalize these costs. 3 / For somewhat similar motivational reasons a number of companies use accelerated depreciation for internal purposes. The early heavy depreciation charges tend to make managers more careful about making investments with marginal prospects. On the other hand, some of these same companies use straight-line depreciation in public reports. 4 / Apparently, few companies give divisions credit for investment tax credits flowing from their investments. Their reason is that it might encourage divisions to make investments primarily to get the credit. Yet, a number of these same corporations report the credit for public purposes by the flow-through methods, which gives them the fuU credit in the year they acquired the asset. Examples such as the above raise the disturbing question: If an accounting method is not a useful measure of performance for internal purposes because: (1) it motivates managers to follow operating policies not desired by the company; (2) it provides top management with a misleading measure of performance; or (3) it fails to reflect the company's prospects, then why would tlie same considerations not govern the selection of the method for reporting these same facts to stockholders? The presumption is that the internal and external application of generally accepted accounting principles should be the same. In both cases the underlying purpose is the sameto measure performance and to motivate managers to operate in such a way as to achieve the company's goals. The challenge to those who create generally accepted accounting principles is to develop a set of principles that are both behaviorally and technically sound. They should be behaviorally sound in that they Inhibit managers from taking undesirable operating actions to justify the adoption of an accounting alternative. Inhibit the adoption of accounting practices hy corporations which create the illusion of performance. California Management Revieto

The traditional approach to defining generally accepted accounting principles has focused principally on technical considerations. Typically, this has been done well. The time has come, however, to pay greater attention to the possible impact of accounting practices on people's actions. If this is also done well, financial accounting will do a better job of communicating the financial facts of a business situation, rather than the illusion of performance. Some accountants and regulatory agencies would go further than I suggest. These people argue that financial reports should be reports on management, not reports by management. They seem to believe it is both desirable and feasible that some all-wise body construct a set of accounting principles for business that will make the financial statements of corporations more accurate and more comparable as well as motivate managers to make sound economic decisions. These are desirable goals. However, the degree to which this can be achieved by some super-accounting body is limited. Our management control experience in the smaller environment of a single firm indicates that the use of financial controls can be a usefulbut somewhat imperfect crude tool for motivating managers. Also, within the confines of the single firm it is very difficult to de-

sign a uniform system of reporting for all of the economic subunits which produce meaningful results. Despite my reservations about how far we can go in using our financial reporting system to encourage managers to report fairly and make sound economic decisions, I nevertheless believe we should seek to improve the behavioral aspects of the system. In order to do this we must know more about the behavioral aspects of generally accepted accounting principles in a business climate. More research is needed in this area, particularly as it relates to the motivational relationship between external reporting and the internal management control system. Until such research is available we wiU have to rely on the many studies in management control for our direction. One important conclusion of these studies that we could well work with now is that control systems with behavioral attributes which allow and encourage responsible management by self-control, rather than command through inflexible rules, are the most appropriate in times of change within complex business environments. Such an approach is needed today for our financial accounting system if we are to encourage positive managerial operating and reporting responses.

REPRINTS Reprints of articles appearing in this issue of the California Management Review as well as previous issues are available. The following is a partial listing of reprints available from prior issues. 1. Andrews, Robert B. and Thomas E. Vollmann, "Uniproduct: A Pedagogical Device", Vol. X, No. 2, 1967. 2. Buckley, John W., "Management Services and Management Audits by Professional Accountants", Vol. IX, No. 1, 1966. 3. Bugental Daphne E., Robert Tannenbaum, and H. Kenneth Bobele, "Self Concealment and Self-Disclosure in Two Croup Contexts", Vol. XI, No. 2, 1968. 4 Chames A. W. W. Cooper, J. K. Devoe, and D. B. Learner, "DEMON: A Management Model for Marketing New Products". Vol. XI, No. 1, 1968. 5 Cramer Joe J. Jr., and Thomas Iwand, "Financial Reporting for Conglomerates: An Economic Analysis", Vol. XI, No. 3, 1969. 6. Fenn, Margaret and Ceorge Head, "Upward Communication: The Subordinates Viewpoint", Vol. VII, No. 4, 1965. 7. Fox, William M., "When Human Relations May Succeed and the Company Fail", Vol. VIII, No. 3, 1966. 8. Hillier, Frederick S. and David V. Heebink, "Evaluating Risky Capital Investments", Vol. VIII, No. 2, 1965. 9. Kotler, Philip, "The Competitive Marketing Simulator-A New Management Tool", Vol. VII, No. 3, 1965. 10. Lawler, Edward E. Ill, "The Mythology of Management Compensation", Vol. IX, No. 1, 1966. 11. Miles, Raymond E. and Roger C. Vergin, "Behavioral Properties of Variance Controls", Vol. VIII, No. 3, 1966. 12. Myers, M. Scott, "Evei-y Employee a Manager", Vol. X, No. 3, 1968. 13. 01m, Kenneth W., "A System for Measuring Office Work Performance", Vol. II, No. 2, 1960. 14. Renshaw. Edward F., "The Theory of Financial Leverage and Conglomerate Mergers", Vol. XI, No. 1, 1968. 15. Schoonmaker, Alan N., "Individualism in Management", Vol. XI, No. 2,1968. 1 4 5 99 100-299 300 or more To order, use the order card found inside back cover. reprints 1.00 each reprints .50 each reprints .40 each reprints .30 each

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