Discretionary Accounting Research Articles

Private Benefits Extraction and the Opposing Effects of Income Smoothing on Private Debt Contracts

We provide evidence that a prevalent discretionary accounting action, income smoothing, affects private debt contract design in a manner that is fundamentally distinct from the effects of other accounting attributes. In particular, lenders use their understanding of the threat of private benefits extraction in the contracting environment to infer whether observed discretionary smoothing is associated with higher or lower expected credit loss. Discretionary smoothing decreases cost of debt within low extraction threat environments, consistent with lenders viewing smoothing as revealing managers' private information about economic earnings in low threat settings. In contrast, discretionary smoothing increases cost of debt within environments where the ability of insiders to extract private benefits is less well controlled, consistent with lenders viewing smoothing as attempts to enable the extraction of private benefits in high threat settings. We also find evidence that these effects are more pronounced for firms with relatively high credit risk.

Accounting Slack and Banks’ Response to Proposed Fair Value Accounting for Loans

We investigate the determinants of banks’ responses to the United States Financial Accounting Standard Board’s 2010 Exposure Draft that proposes fair value measurement for most financial instruments. Over 85 percent of the 2,971 comment letters were received from banks, with most bank-affiliated letters addressing—and rejecting — one issue: fair value measurement of loans. Interestingly, banks’ resistance to fair value measurement occurred despite the fact that the Exposure Draft explicitly proposed continued reporting of amortized cost information on the face of the financial statements. By proposing that companies report both fair value and amortized cost measures for loans, the Exposure Draft should result in increased levels of loan-related information and improve financial reporting transparency. We propose that agency problems are an important motivating factor for responding banks because banks reaping more private benefits have less incentive to increase financial reporting transparency. Consistent with weak monitoring and risk-shifting on the part of responding banks, we find that our non-accounting-based proxies for contemporaneous agency problems are associated with a higher propensity for banks to submit comment letters. In addition, consistent with banks valuing slack available in current generally accepted accounting principles, we find that banks historically and opportunistically using loan-related accounting discretion are more likely to submit negative comment letters. The narrow scope of banks’ comments and our empirical findings suggest that banks’ responses to the Exposure Draft may be more driven by concerns over reduced availability of accounting slack and accompanying de facto regulatory forbearance than by the conceptual arguments they offered. Our results have implications for standard setters, who must navigate special interests as they attempt to promulgate high quality accounting standards, and for users of financial statements who must consider how political forces shape generally accepted accounting principles.

Discretionary accounting choices and the predictive ability of accruals with respect to future cash flows

Using a sample of restatement firms and a meet-or-beat model to classify firms as making discretionary accounting choices for opportunistic meet-or-beat (OP-MB) reasons, we show that originally reported earnings and accrual components are less predictive of future cash flows relative to the restated numbers. We find the opposite is true for firms classified as making discretionary accounting choices for non-OP-MB reasons. We consider a number of competing explanations for these latter results. Our findings are most consistent with the informational hypothesis, weakly consistent with conservative-motivated efficient contracting hypotheses, but inconsistent with opportunistic contracting and misapplication/errors of GAAP explanations.

Earnings management and auditor specialization in the post-sox era: An examination of the banking industry

This study examines the impact of auditor specialization on bank loan loss provisions for a large cross-section of US banks for the period 2002–2006. We find a positive relationship between earning (before provision) and loan loss provision, suggesting that bank managers use LLP to smooth earnings in the post-SOX period. However, this relationship is significantly moderated by audit industry expertise, providing strong evidence that industry specialization constrains income smoothing. In further analysis, we find some evidence that auditor specialization is more effective in reducing potentially incoming-increasing earnings management. Our results hold after controlling for self-selection bias and are robust to alternative measures of industry specialization. Overall, our findings support the conclusion that audit industry expertise plays an effective monitoring role in constraining management’s discretionary accounting choices.

Accounting Discretion in Goodwill Impairments: UK Evidence

This study examines managers’ use of discretion in determining goodwill impairment losses following the mandatory adoption of IFRS 3 “Business Combinations,” and whether this discretion reflects opportunistic reporting by managers or the provision of their private information. Although IFRS 3 was issued to improve the accounting treatment for goodwill and provide users with more useful and value-relevant information regarding the underlying economic value of goodwill, it has been criticized on the grounds of the managerial discretion inherent in impairment testing. Therefore, ex-ante, it is unclear how the impairment-only approach has affected the reporting of goodwill impairment losses. After controlling for economic factors, empirical results reveal that managers are exercising discretion in the reporting of goodwill impairments following the adoption of IFRS 3. Specifically, goodwill impairments are more likely to be associated with recent CEO changes, income smoothing and “big bath” reporting behaviors. However, the results also indicate that goodwill impairments are strongly associated with effective governance mechanisms suggesting that managers are more likely to be exercising their accounting discretion to convey their private information about the underlying performance of the firm rather than acting opportunistically. These inferences are robust to various modeling specifications and variable definitions, suggesting that IFRS 3 has provided managers with a framework to reliably convey their private information about future cash flows consistent with the IASB's objectives in developing the impairment standard.

Takeovers And Incentives For Earnings Management: An Empirical Analysis

This study tests the hypothesis that managers of firms that are targets of takeovers systematically increase reported earnings in the quarters immediately preceding and following initiation of the takeover attempt. Using both a modified version of the Jones method and the DeAngelo method, discretionary accounting accruals are examined for a sample of 100 firms that were targets of tender offers between 1985 and 1989, inclusive, and for a control group of nontargets. Results for the quarter ended prior to initiation support the hypothesis. Additional tests performed on the sub-samples of hostile and friendly takeover targets indicate that the results obtained for the sample as a whole are primarily due to the hostile takeover targets. No evidence of earnings management is found in the quarter ended subsequent to initiation.

On the mechanics of deformation and stability of the beam with a nanocoating

In this study, the mechanics of deformation (under the tension) and the stability of an elastic beam with a nanocoating under an axial compression are investigated. The behavior of the construction is modeled by the two-layered beam. The basic relations of the first layer, that is, an elastic beam gives in the framework of Hook’s law and the basic relations of the second layer, that is, the coating is carried out taking into account discreteness of the nanomaterial. First, the strain–stress relations of the elastic beam with nanocoating under axial tensile load are obtained. Then, stability equations of layered beam consisting of two elastic layers and elastic beam with the nanocoating subjected to a uniform axial compression are obtained, respectively. The dimensionless critical axial load parameter, that is, the ratio of the critical axial load of elastic beam with nanocoating to the critical axial load of layered beam consisting of two elastic layers is found. Finally, carrying out some computations, effects of the characteristics of a nanocoating on the values of the dimensionless critical axial load parameter have been studied.

Efficient algorithms for optimal control of quantum dynamics: the Krotov method unencumbered

Efficient algorithms are of fundamental importance for the discovery of optimal control designs for coherent control of quantum processes. One important class of algorithms is sequential update algorithms, generally attributed to Krotov. Although widely and often successfully used, the associated theory is often involved and leaves many crucial questions unanswered, from the monotonicity and convergence of the algorithm to discretization effects, leading to the introduction of ad hoc penalty terms and suboptimal update schemes detrimental to the performance of the algorithm. We present a general framework for sequential update algorithms including specific prescriptions for efficient update rules with inexpensive dynamic search length control, taking into account discretization effects and eliminating the need for ad hoc penalty terms. The latter, despite being necessary for regularizing the problem in the limit of infinite time resolution, i.e. the continuum limit, are shown to be undesirable and unnecessary in the practically relevant case of finite time resolution. Numerical examples show that the ideas underlying many of these results extend even beyond what can be rigorously proved.

Earnings Management to Avoid Losses with Positive, Negative, Large and Small Discretionary Accruals

Most work studying earnings management has conjectured that firms with otherwise negative incomes use their accounting discretion to increase their reported incomes with positive discretionary accruals to just barely meet their zero earnings levels and have implemented research designs that treat all suspect EM firms as engaging in only this behavior. For example, Dechow et al. (2003) study whether small-loss firms using income-increasing discretionary accruals to report small profits explains the kink in the earnings distribution around the zero earnings level, but do not find support for that proposition. They conclude that one possible explanation (of several) is “that the earnings management story is more complex than the one we test.” Explaining, examining and documenting that more complex story is the contribution of our paper; the story that EM consists of positive, negative, large, and small exercises of discretionary accounting.

Income Smoothing Using Reserve Accounts By Japanese Companies

<p class="MsoBodyText3" style="line-height: normal; margin: 0in 34.2pt 0pt 0.5in;"><span style="font-family: Times New Roman;"><span style="font-size: 10pt; mso-bidi-font-style: italic;">This paper </span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">examines</span><span style="font-size: 10pt; mso-bidi-font-style: italic;"> </span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">income-smoothing </span><span style="font-size: 10pt; mso-bidi-font-style: italic;">by Japanese firms using several reserve accounts. </span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">Previous</span><span style="font-size: 10pt; mso-bidi-font-style: italic;"> studies investigate</span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">d</span><span style="font-size: 10pt; mso-bidi-font-style: italic;"> the incentives for Japanese managers to smooth income using sales of assets</span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">, discretionary </span><span style="font-size: 10pt; mso-bidi-font-style: italic;">accounting accruals </span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">or </span><span style="font-size: 10pt; mso-bidi-font-style: italic;">depreciation charges under different operating environments</span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">.</span><span style="font-size: 10pt; mso-bidi-font-style: italic;"> </span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">Discretion</span><span style="font-size: 10pt; mso-bidi-font-style: italic;"> </span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">in</span><span style="font-size: 10pt; mso-bidi-font-style: italic;"> reserve accounts </span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">as a means of income-smoothing, however, </span><span style="font-size: 10pt; mso-bidi-font-style: italic;">has not yet been investigated</span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">.</span><span style="font-size: 10pt; mso-bidi-font-style: italic;"> </span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;">Understanding Japanese </span><span style="font-size: 10pt; mso-bidi-font-style: italic;">managers’ earnings management</span><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;"> via reserve accounts is particularly interesting because of the unique legal environment for reserve accounts. We find that income-smoothing via reserve accounts is associated with size, tax, capital intensity, operating deviations, leverage, earnings variability, and securities offerings. When we partition the sample to take into account the substantial structural changes in Japan in 1990, the effects of several variables appear to be different over the two periods</span><span style="font-size: 10pt; mso-bidi-font-style: italic;">.</span></span><strong><span style="font-size: 10pt; mso-fareast-font-family: Batang; mso-bidi-font-style: italic; mso-fareast-language: KO;"></span></strong></p>

Valuation and Underpricing of Initial Public Offerings: Role of Discretionary Accounting Accruals

This study examines the role of pre-IPO discretionary accruals in the valuation and underpricing of IPOs. We find that the underwriter offer price is unaffected whereas the market closing price is positively associated with the levels of pre-IPO discretionary accruals for issuers with aggressively reported earnings. We also find that this relative over-valuation of managed earnings by the markets explains a portion of the initial return that is not explained by other known determinants. For issuers with conservatively reported pre-IPO earnings, there is no relation between discretionary accruals and the offer price or the market price, and that the discretionary accruals do not explain any IPO underpricing. Our subsequent analysis shows that lower stock retention appears to be a screen and a signal of entrepreneurs’ credibility to the markets. There seems to be a higher degree of earnings scrutiny by both the markets and the underwriters for IPOs with low insider retention. However, markets tend to assign higher weight to aggressively reported earnings of issuers with higher insider retention, presumably because of perceived incentive alignment. Underwriters, with relatively lesser information asymmetry than the markets, tend to see through the distortions caused by earnings manipulations in the valuation of IPOs, regardless of the levels of issuers’ stock retention.

Staggered boards, accounting discretion and firm value

Motivated by agency theory, this study investigates how staggered boards influence accounting discretion. The results indicate that staggered boards do affect accounting discretion. In fact, the impact of staggered boards on accounting discretion is substantially larger (about seven times stronger) than the effect of all other corporate governance provisions combined. Firms with a staggered board exercise less income inflating accounting discretion. Further evidence reveals that accounting discretion has a benign effect on subsequent firm value. Yet, the presence of staggered boards reduces significantly the favourable effect of accounting discretion on subsequent firm performance. The evidence is robust to a large number of control variables including other governance provisions. The evidence is in line with the notion that staggered boards improve managers’ job security, reduce managerial myopia, and thus induce managers to exercise less short-term transitory accounting discretion.

Accounting Responses to Hedge-Fund Activism

We examine changes in firms’ discretionary accounting accruals around the commencement of activism by hedge funds. We argue that hedge funds have the potential to provide increased monitoring of earnings management behavior and we predict and find empirically that average discretionary accruals decrease around the commencement of hedge fund activism. We find in both univariate and multivariate tests that discretionary accruals decline significantly after commencement of hedge fund activism, suggesting activist hedge funds do provide at least some incremental monitoring of accounting and reporting in addition to their focus on the governance, operations and financing of target firms. However, we find no cross-sectional relationship between changes in earnings management and analyst following, institutional ownership or other factors, suggesting that the accounting improvements are not conditional on these factors but are instead a general benefit resulting from the intervention of activist hedge funds.

Discretionary Accounting Choices and the Predictive Ability of Accruals with Respect to Future Cash Flows

Using a sample of restatement firms and a meet-or-beat model to classify firms as making discretionary accounting choices for opportunistic meet-or-beat (OP-MB) reasons, we show that originally reported earnings and accrual components are less predictive of future cash flows relative to the restated numbers. We find the opposite is true for firms classified as making discretionary accounting choices for non-OP-MB reasons. We consider a number of competing explanations for these latter results. Our findings are most consistent with the informational hypothesis, weakly consistent with conservative-motivated efficient contracting choices, but inconsistent with opportunistic contracting and misapplication/errors of GAAP explanations.

Have IFRS Affected Earnings Management in the European Union?

There has recently been considerable discussion of those features of IFRS that are likely to help improve financial reporting in the European Union. However, certain issues may also have a negative impact on the quality of information. This paper focuses on the effect of IFRS on earnings management. Its main purpose is to examine whether the adoption of IFRS in the European Union has increased or decreased the scope for discretionary accounting practices by comparing discretionary accruals in the periods preceding and immediately after the regulatory change. Another objective is to determine which firms' features and country factors may explain the accounting discretion observed before and after IFRS. We consider a sample of non-financial firms listed on 11 EU stock markets. The results obtained show that earnings management has intensified since the adoption of IFRS in Europe, as discretionary accruals have increased in the period following implementation. The variables explaining accounting discretion are the same before and after IFRS (business size, leverage, investor protection and legal enforcement). These results suggest that variations in earnings management might be due to some room for manipulation under international standards when compared with local standards.

Staggered Boards, Accounting Discretion, and Firm Value

Motivated by agency theory, this study investigates how staggered boards influence accounting discretion. The results indicate that staggered boards do affect accounting discretion. In fact, the impact of staggered boards on accounting discretion is substantially larger (about seven times stronger) than the effect of all other corporate governance provisions combined. Firms with a staggered board exercise less income-inflating accounting discretion. Further evidence reveals that accounting discretion has a benign effect on subsequent firm value. Yet, the presence of staggered boards reduces significantly the favorable effect of accounting discretion on subsequent firm performance. The evidence is robust to a large number of control variables including other governance provisions. The evidence is in line with the notion that staggered boards improve managers’ job security, reduce managerial myopia, and thus induce managers to exercise less short-term transitory accounting discretion.

Earnings Manipulation, Manager's Compensation and Reputation Concerns

This paper analyzes the effects of managerial compensation and reputation concerns on earnings manipulation. I develop a model of earnings reporting in which a privately informed manager trades-off incentives to manipulate earnings which increases his compensation against incentives to be honest which improves his reputation. In equilibrium the manager manipulates earnings, but not enough to make reports uninformative. He lies with positive probability when underlying earnings are low, and he reports the truth when underlying earnings are high. Earnings manipulation is stronger when the manager is closer to retirement. Manipulation is independent of the sensitivity of the manager's compensation to reported earnings. Finally, earnings manipulation and accounting discretion have a bell-shaped relation: increasing discretion when it is low, leads to more earnings manipulation, and vice-versa. These results are robust to different compensation schemes and the inclusion of an accruals' constraint.

Auditor conservatism following audit failures

PurposeThe purpose of this paper is to examine the effects of audit failure on Big 4 audit firm monitoring activities. The paper analyzes changes in discretionary accruals (DAs) among clients of firms implicated in audit failure events and examines whether these DAs decline in the period following the event.Design/methodology/approachThe paper uses archival data and regression analyses to test whether DAs for clients of implicated audit firms decline in the period following the audit failure as compared to clients of other Big 4 firms. Audit failures are identified during the years 1996‐2004 based on significant lawsuit settlements. The paper focuses on an office‐level analysis to control for audit quality differences which may vary across firm geographic locations as suggested by recent research.FindingsEmpirical results indicate that auditor response to audit failure has changed over time. Auditors implicated in audit failure events occurring in the post‐Enron and Sarbanes‐Oxley period enforce more conservative accounting choices in the year following the event. Specifically, clients of the implicated firm's office report a significant decline in discretionary accounting accruals relative to clients of other auditors in the same city location. However, a significant change in client discretionary accounting accruals is not found following audit failures that occurred prior to 2001, the year of the Enron bankruptcy.Originality/valueThe results of this paper extend the knowledge of the effects of litigation pressure on audit quality. Additionally, this paper helps address the question of how large‐scale audit failures witnessed at the beginning of the century have impacted audit firm conservatism.

Corporate Debt Financing and Earnings Quality

Abstract: Our study establishes linkages between two extensively researched areas, debt financing and the quality of earnings. Debt can have a ‘positive influence’on earnings quality because managers are likely to use their accounting discretion to provide private information about the firms’ future prospects to lower financing costs. For high debt, it can also have a ‘negative influence’ on earnings quality as managers use accruals aggressively to manage earnings to avoid covenant violations. Using accruals quality as a proxy for earnings quality, we document a non‐monotonic (curvilinear) relation between debt and earnings quality. The relationship is positive at low levels of debt and negative at high debt levels with an inflection point around 41%. Our results suggest that firms that rely heavily on debt financing might be willing to bear higher costs of borrowing from lower earnings quality because the benefits from avoiding potential debt covenant violations exceed the higher borrowing costs.

Perbedaan Persepsi Etis Mahasiswa Akuntansi terhadap Praktik Earnings Management

This study investigates whether gender influences accounting students' perceptions of earnings management. Earnings management is the practice of making discretionary accounting choices or timing operating decisions to move reported earnings toward a desired goal. In this research, earning management has 4 four indicators: type of manipulation, direction of manipulation, materiality, and intention. Prior research reveals wide disagreement among both students and business executives regarding the ethical acceptability of earnings management. Male and female accounting students from Surabaya were evaluated using thirteen items that indicate and describe earnings management practices. No differences were detected between the responses of the male and female students or between the working and non-working students. The result shows that the practice of earnings management is perceived similarly in all groups of students studied.