519THE ACCOUNTING REVIEWVol. 79, No. 22004pp. 519–539Endogenous ExpectationsJoel S. DemskiUniversity of FloridaABSTRACT: I selectively survey the use of expectations in accounting research. Whileexpectations are central to modeling work and essential in empirical documentation,we tend to rely on largely exogenous expectations, as opposed to closing the analysiswith aggressive identification of information sources and an explicit equilibriumargument.I. INTRODUCTIONExpectations are the centerpiece of accrual accounting, and expectations about theseaccruals and their use are the centerpiece of accounting research. Yet in our teachingand in our research we typically employ reduced-form specification of the accountingprocess, coupled with transparent, largely exogenous expectation structures. The manner inwhich we estimate ‘‘abnormal accruals’’ or make use of analysts’ forecasts are cases inpoint, as are value relevance, audit judgment, compensation and earnings response studies,and FASB deliberations.This reliance on largely exogenous expectation structures, I think, needlessly limits thedepth and boundaries of our teaching and research. My purpose here is to document thisclaim, and to argue for a more inclusive approach to our scholarship, one that emphasizes‘‘micro foundations’’ and an equilibrium view of behavior.Accrual accounting, of course, is a formalized anticipatory statement of stocks andflows. For example, the noncash asset balances and the liability balances on a balance sheet,the various stocks of accruals, represent stocks of anticipated benefits and payments, justas the noncash components of income, the flows of various accruals, represent flows ofanticipated benefits and resource consumptions.These accruals, however, are surely not happenstance. Rather, they are estimates—estimates that can be interpreted as expectations as well as expectations that stem fromchoices: choice of accounting method as well as the decision to engage in the underlyingtransactions themselves. Consider, for example, the use of ‘‘mark to model’’ techniques toestimate the fair value of an unusual financial instrument. The firm chooses to employ theinstrument, and likewise enjoys considerable discretion in its temporal measurement. Re-latedly, the firm is free to adjust its transactions in anticipation of a regulatory event, suchas expanded fair value reporting of financial instruments or the demise of pooling. InPrepared for Presidential Lecture, American Accounting Association, August 5, 2003. Helpful comments by JohnChristensen, George Drymiotes, John Fellingham, Hans Frimor, David Larcker, David Sappington, Katherine Schip-per, Mary Stone, and seminar participants at Carnegie Mellon University and the University of Southern Denmarkare gratefully acknowledged.Editor’s note: The Executive Committee of the American Accounting Association has recommended the commis-sion of a series of Presidential Research Lectures, to be delivered at annual meetings of the Association. Toencourage broad dissemination, the Committee has requested that The Accounting Review publish this lecture givenat the 2001 American Accounting Association Annual Meeting in Atlanta, GA.520 DemskiThe Accounting Review, April 2004parallel fashion, the manner in which accounting measures are used is itself a choice: achoice to buy or sell, a choice to go forward with the new product proposal, or a choiceto allow management’s self-report to stand.This suggests our focus on understanding the nature and use of accounting measuresshould, ideally, be based on understanding how these choices are made, including the factthat coordinating forces, such as organizational architecture, market clearing, regulation,and education, are at work.1Yet, as noted, we tend to rely on reduced form, somewhat adhoc techniques instead of more directly on how the choices themselves are made. In anaudit judgment experiment, for example, we typically rely on psychology, to the exclusionof organizational and client interaction issues; in an earnings response experiment we typ-ically rely on the difference between reported and analysts’ forecasted earnings in identi-fying the substance of the information release, to the exclusion of other information or theorganizational context in which the forecasts are produced and archived.In emphasizing the underlying choices, my instinct is to rely on the context, forces,and behaviors involved, to emphasize the micro foundations or calculus of the choice set-ting, so to speak. Coupled with an equilibrium argument, we then have a picture of endog-enous expectations and choices.2I begin with a selective survey of the use of expectations in accounting practice, fol-lowed by a brief illustration of the expectations theme. From there I examine selectedexamples of accounting scholarship that highlight various expectations: earnings manage-ment studies, use of analyst forecasts, regulation assessment studies, audit judgment studies,compensation studies, cost measurement studies, and governance studies. The recurringtheme is a consistent pattern of reliance on exogenous expectations, of underinvestment inunderstanding and exploiting the underlying choices themselves; this leads to the conjecturethat if we broaden our analysis, broaden it to the point the underlying expectations areendogenous, we will then shed new light on these various phenomena. I emphasize mypoint is not a criticism of where we are, but an attempt to capitalize on what we haveaccomplished and move to a broadened, more integrated view of our subject matter, a taskthat depends on theoretical work, empirical work, and their interaction.II. REFLECTIONS ON CURRENT PRACTICEAs a prelude to my main theme, it is important to lay out several patterns in the practiceof accounting. To be sure, expectations are present, indeed widespread, in current practice.Consider the going concern concept, the auditor’s reliance on judgment-aided sampling,asset and income adjustments in the typical EVA威 implementation, the Bureau of EconomicAnalysis’s (BEA) income estimates, Standard & Poor’s core earnings project, and the ratioof cash to noncash assets for your favorite firm.Here we see, understandably, an imprecise notion of ‘‘looking forward’’ or ‘‘anticipat-ing,’’ as with the classic definition of an asset in terms of service potential. For example,the FASB’s (1985) Concepts Statement No. 6, paragraph 28