A little over a year ago, I decided that my career goal was to become a business-school professor. I’ve been lucky enough to be admitted to several great business-school doctoral programs, and, this past week, I’ve been traveling to visit some of the schools. One common theme in my conversations with my fellow admits and the current grad students is that we have trouble explaining to outsiders what our research interests are and why they count as a part of a business-school PhD in subfields like marketing, or accounting, or management. The problem is that academe, as usual, has its own private semantics and, as usual, is not good at translating it to outsiders. This is hardly unique to business schools: Anymore, many dissertations in economics are what regular people might identify as mathematics, and many dissertations in political science are what regular people would identify as economics or game theory. So I thought I’d use what I learned and write a quick blog post about what business-school professors do, with a particular focus on what business-school accounting professors do, for the sake of curious and confused Googlers.
Most business school faculty and their associated doctoral programs are organized into several units, which usually include Management, Organizational Behavior, Accounting, Finance, Marketing, and maybe some others. But these names can miscommunicate what the faculty inside these units actually do. ‘Marketing’ professors and ‘marketing’ journals almost never actually study, say, whether 30-second or 60-second TV spots are more effective. Instead, ‘marketing’ journals have rigorous social science about human behavior and psychology which is at best tenuously attached to the things that firms’ marketing employees actually do. ‘Marketing’ professors may study things like the following: the microeconomic theory of ‘optimal auctions’ (how to design auctions such that bidders reveal their true prices—one application would be stopping oligopolistic government contractors from implicitly colluding); the psychological bases of trust and attachment (one application of which might be how learning how preferences and ideas ‘diffuse’ through populations); or even the neurological bases of attentiveness (which might have applications for education as much as for TV advertisements). So, long story short, when your friend tells you that they are becoming a marketing professor, you shouldn’t make fun of them for doing ‘soft’ cultural studies until you’ve actually read their specific research.
Similarly, ‘management’ professors never study how to schedule staff hours at a local retailer, but might study regional economics and why firms tend to cluster in certain geographies. And ‘organizational behavior’ professors don’t just study social psychology within the firm, but might also look at families, the military, or digital communities like online forums, or even computer models of evolving group behaviors. Even ‘finance’ tends to be broader and more abstract than outsiders expect. In other words, most business-school professors really just study subfields of economics (or in the case of organizational behavior, subfields of psychology), including topics that sometimes riff off of the associated business functions. But they do not, as their faculty unit names suggest, focus on very applied, vocational topics.
Now, some may criticize business academe for being so impractical, but the counterargument is that the private sector already gives private-sector researchers very strong incentives to research the more immediately practical questions, and so academe can add value by stepping back to more abstract questions, to shore up the clarity, precision, and theoretical basis of our ideas, in ways that may yield indirect benefits. The continued, outsized demand for expensive executive education courses, and business-school professors’ excellent consulting fees, are evidence that business practitioners see some benefit in the perspective that b-school theorists bring.
Let me go into more detail about the unit that I know the most about: What are the things that people in the ‘accounting’ units at business schools do? Well, to adapt a joke about economics, accounting research is what accounting researchers do, and accounting researchers are people who do accounting research. But one way of thinking about what counts as ‘accounting research’ in academe is that ‘accounting research’ is the subfield of economics that obliquely riffs off of the ‘accounting’ and ‘accountability’ functions within firms, just as marketing research obliquely riffs off of, but does not directly study, marketing functions.
‘Accounting’ refers to the financial information that firms produce (the legally required financial accounting in quarterly reports, as well as the managerial accounting used to make decisions internally, as well as more informal disclosures such as investor presentations and earnings calls). As such, it’s common to describe accounting research as a subfield of information economics. Research in this area includes the following: (A) The game theory of how firms decide what information to disclose given their conflicting goals of (i.) giving investors enough credible information so that they can get financing on good terms, (ii.) keeping trade and strategic secrets away from prospective competitors, and (iii.) not losing access to capital due to overreactions to short-term negative news—a complicated optimization problem; (B) The relationship between firms’ earnings numbers and their asset (stock and debt) valuations; (C) Assessing the performance of doctors in hospitals (given that it would be naïve to simply measure their patients’ outcomes, as this would reward doctors for choosing patients in less-dire straights); (D) How analysts assess municipalities’ finances and, thus, how city governments become cash constrained; (E) Corporate finance, e.g., how firms can issue more equity to raise cash for investments, without thereby signaling to investors that their shares are overvalued.
‘Accountability’ refers to the allocation of decision and control rights within the firm, as well as how the individuals/groups who have been allocated those responsibilities are subsequently assessed and rewarded (‘held accountable’). Research in this area includes the following: (A) Corporate governance—everything about how the owners (shareholders) of firms control the management—including the role and effects of activist investors and the characteristics of successful directors; (B) Executive compensation and pay/incentive packages more broadly; (C) Mergers and acquisitions, which are fundamentally just changes in control/accountability; (D) White collar crime and corporate scandals; and (E) Corporate finance, e.g., how debt holders and equity owners fight over the riskiness of the firm’s capital structure, or how private-equity owners use debt-financing as a way to ‘discipline’ their businesses into running tight ships.
At business schools, courses on valuation, mergers and acquisitions, ethics, and corporate governance are taught by ‘accounting’ faculty. For better or worse, ‘accounting’ professors and research have nothing to do with what ordinary people think of when they hear the word ‘accounting.’ And most accounting professors have never done a single debit/credit T-account in their entire lives, nor does the PhD curriculum include a single such class—just as most marketing professors have never made a TV commercial. Some might criticize business academe for being so impractical, but there’s (again) an argument that people can become CPAs through vocational classes and textbooks and taking the CPA exam (usually well before they go to business school), and b-school professors can add more value by fleshing out the broader economic theory of corporate information and controls.
So, what is the value-add of business-schools’ accounting research? What does it have that isn’t already being done in regular college economics departments? Well, I actually think there’s a different answer for every individual topic I listed above, but let me focus on the biggest question in accounting research, and the topic that launched the field—financial valuation. Now, according to basic financial theory, a financial asset (like a stock) is simply a vehicle for transforming cash today into cash tomorrow. Therefore, valuing a financial asset (that is, deciding how much cash today it is worth) is simply a question of projecting how much cash it will return to you in the future, and discounting each future cash flow by a number that ‘translates’ tomorrow’s money into today’s terms—that is, the interest rate—and adding them all up. You can think of the interest rate as the extent to which we humans prefer money today to money a year from now, or, alternatively, as the rate of return of completely risk-free alternative investments such as Treasuries. Additionally, given that the world is uncertain, you also have to think about the probability distributions of those future cash flows, as well as how worried you are about losing how much of your wealth—that is, risk and risk preferences. So financial theory says that only three things matter in valuing assets—and thus, by extension, in setting prices, which are the basis of everything else in the economy—(i.) cash, (ii.) interest, and (iii.) risk.
Given this, firms’ accounting numbers, as opposed to simple cash receipts, ought to be irrelevant. This is because audited accounting financial statements (such as those that you see in companies’ annual reports) hinge on artificial, man-made, abstract concepts that have nothing to do with underlying cash flows, including accruals, amortization and depreciation. Under U.S. GAAP, if you acquired another company at a premium, you had to depreciate this ‘goodwill’ over the following years, recognizing a portion of that goodwill as an ‘expense’ in each, even if the acquisition had gone well and the acquired firm had actually increased in its true value. Under U.S. GAAP, you may have had to depreciate the expense of a building even if it was in fine condition and located in an area that had become more popular such that it’s true value had only increased. GAAP earnings incorporate these fake expenses that don’t actually exist; thus, they are deceptive about what actually matters, namely cash.
As such, the thinking by the 1960s was that accounting information was just a kind of weird relic of a past when people weren’t thinking clearly about economics and finance. While accounting information might have a legal function, in preventing managers from deceiving the public, it did not have an economic/financial function in setting prices and valuations and efficiently allocating capital—in the modern world, it should be useless to sophisticated practitioners.
The paper that launched the field of academic accounting research, An Empirical Evaluation of Accounting Income Numbers (Ball and Brown 1968), however, found that in practice what should be true was pretty much the opposite of the truth. Ball and Brown found—and it has remained the case since—that the best predictors of the value of stocks, their future returns and performance, was accounting earnings numbers.
Now, nobody doubts that what fundamentally matters is future cash flows—it remains the case that financial assets exist to turn cash today into cash tomorrow. The thing is, it’s really hard to project cash flows, and so any cash-flow based model will be “garbage in, garbage out,” and it turns out that accounting numbers, including their fake accrual expenses, actually do surprisingly well at valuing companies. In other words the major insights that launched the field were (1) the structure and presentation of information matter (not just cash flows, interest rates, and risk) in setting prices, even in the most sophisticated markets, and (2) the artifices and the heuristics of the traditional practice of accounting embody a practical intelligence that modern, sophisticated analysts can rarely improve upon using pure cash-flow projections. Sophisticated analysts and investors still overwhelmingly rely on accounting numbers such as net income and free cash flow in pricing companies’ shares today.
Why might this be the case? Let me draw a parallel to heuristics in the evolutionary use of the term. We could metaphorically think of our genes as fundamentally ‘wanting’ to survive and reproduce, given that survival and reproduction are what have selected and passed down these genes over billions of years. But that doesn’t mean that the genes that influence our brains tell us “survive and reproduce,” and then let us figure out the rest. Instead, our genes give us a set of desires which happen to have maximized our chances of survival and reproduction in our evolutionary history, but which we do not read as such. In other words, they achieve their goal obliquely by giving us desires such as, “pursue status, don’t make other people angry, eat and stay warm, win the favor of attractive healthy people of reproductive age, and beware sudden movements at night.” These desires are heuristic goals in that they are not the goal itself (from our genes’ perspectives), but rather are rules-of-thumb that tended to produce evolutionary ‘success’ better than orienting us toward the goal itself would.
In the same vein, every investor’s goal in buying a financial asset is to transform cash today into cash tomorrow, but s/he’s more likely to achieve that goal by focusing on accounting-numbers heuristics, rather than by trying to make an incredibly complicated and uncertain cash-flow projection. This is arguably the case because accounting standards have been produced by a historical, evolutionary process, of small adjustments and changes being made as-needed, at the suggestion of experienced practitioners. As such, accounting standards embody a lot of historical intelligence that’s hard to reproduce in a single quantitative model. In this vein, accounting numbers do not represent the truth about a firm, but, rather, the best simplification of the truth that we imperfect humans can work with.
And that, in short, is why valuation has come to be part of what business-school academe calls ‘accounting,’ while most people would call it finance.
While empirical asset pricing has been the single biggest strain of accounting research over the past forty years, there are many others. And all of the topics of research I listed above have been improved by accounting academics’ focus on the economics of information and control.
Academic accounting research is usually seen as a subfield of economics, but I would argue that business-school accounting professors have some advantages over economists in many of the areas they study. First, accounting academics tend to have more ‘institutional knowledge’ about corporate law, about contracts, about the internal mechanics of firms and their transactions, and about the things that go into the numbers that we statistically analyze. A pure economist and an accounting academic could both prove the Modigliani-Miller theorem (that equity and debt financing are equally costly to firms in equilibrium absent tax biases), but the accounting academic is more likely to know what debt covenants are, or how interest payments are taxed, and how these things affect financing decision in reality. Second, business-school professors tend to engage with experienced students and real-world practitioners, through MBA, exec-ed, and consulting. As such, they tend to be a little bit closer to the ‘practice’ end, along the spectrum from pure theory to pure practice. They’re at a point in that spectrum that I like. (Personally, I think that ‘pure’ economics has already given us enough models of consumer utility-maximization in worlds with preferences defined by set theory and perfect information, etc.—and that there’s more value-add in using the major insights of economic theory in more realistic settings. But I certainly could be wrong and I do respect my pure-economist friends who have a preference for more abstraction.) That may be why you’re more likely to read about the kind of research that comes out of business-schools than about the kind that comes out of pure economics departments in the New York Times.
So the TL;DR version of this blog post is that business-school professors do some of the most exciting and interesting social-science research around today, while still being able to engage with the real world and enjoy very strong career options. Pretty much the only downside is that it sounds less sexy, and more vocational and applied, to say at cocktail parties that you are a PhD in Management or Marketing, instead of Economics or Neuroscience. It’s a smart career move for young researchers to get over that social anxiety quickly!