Constructive Obligations and Past Practice

Abstract

Accounting standards require companies to recognize liabilities when a pattern of past practice creates constructive obligations. We conduct two experiments to test whether, and under what circumstances, financial statement users believe that a company’s past practice gives rise to obligations. Although we find that financial statement users rely heavily on past practice to predict a company’s future activities, they do not believe that past practice alone is sufficient to obligate a company to continue the practice. There are, however, situations in which users believe past practice does create obligations, such as when a company’s employees rely on its past practice to make important decisions. Further, users believe that such obligations can arise from moral, and not necessarily legal, compulsion. This is important because it suggests that users view obligations as comprising a broader range of situations than would be encompassed by a strict legal standard for defining obligations. Our results present a nuanced picture of the role of past practice in creating obligations and provide input to standard setters as they consider how liabilities should be defined.