Managerial Discretion and Firm Fundamentals

Abstract

We hypothesize and provide evidence that the economic consequences of managerial accounting discretion vary systematically with volatility in firm fundamentals. Unlike common approaches in the literature that identify managerial discretion as orthogonal to business volatility, we use a model structure that identifies both types of variation in earnings attributes and allows for a correlation structure between the two. Our results show that in the eyes of three types of capital market participants, investors, financial analysts and regulators, managerial discretion is overall viewed as enhancing information uncertainty, but the effect is attenuated with volatility in firm fundamentals. Our findings suggest that broad samples may exhibit different types of managerial discretion and that volatility in firm fundamentals is key in identifying accounting choices that reduce information uncertainty.