Changes In Discretionary Accruals Research Articles

Earnings smoothing and CEO cash bonus compensation: the role of mandatory derivatives disclosure policy

Motivated by intense controversy over mandatory derivative instruments disclosure required by the Statement of Financial Accounting Standard No. 133 (SFAS 133), this study is to examine whether the sensitivity of CEOs compensation to earnings smoothing changes following the adoption of SFAS 133. Moreover, the study investigates whether the sensitivity of CEOs compensation to earnings smoothing after the implementation of SFAS 133 varies with the level of market volatility. Using the correlation between the changes in discretionary accruals and the changes in pre-discretionary income as a measure of earnings smoothing and dollar value of a bonus earned by the CEOs during the year as a measure of CEOs compensation, the empirical evidence reveals that while earnings smoothing and CEOs compensation are positively related, the positive relation is stronger after the adoption of SFAS 133. The study also finds that the positive association between earnings smoothing and CEOs compensation after the adoption of SFAS 133 is larger when the market volatility is higher. This study provides direct evidence on the impact of the adoption of SFAS 133 on the sensitivity of CEO compensation to earnings smoothing and sheds light on current literature on the effects of accounting regulations, earnings smoothing, and compensation plan. Moreover, this study helps standard setters to better understand the trade-off between transparency and compensation plans.

Recent Auditor Downgrade Activity and Changes in Clients' Discretionary Accruals

SUMMARYThis study examines whether recent auditor downgrade activity is associated with subsequent changes in clients' discretionary accruals. The market for audit services has undergone dramatic change in recent years, resulting in a substantial increase in the number of clients realigning to smaller auditors. This shift in the audit market raises concern about the potential adverse effects of clients moving away from larger, and perhaps more effective, auditors. Consistent with this concern, our analysis of auditor switches occurring between 2003 and 2005 indicates that downgrade clients reported a significant increase in signed discretionary accruals over the two years following the switch. In contrast, we find no significant change in discretionary accruals for a control sample of lateral switches. However, between-sample comparisons fail to provide consistent evidence that the two groups reported accrual changes differently following the auditor switch.Data Availability: Data are available from the public sources identified in the text.

Compensation Committees' Treatment of Earnings Components in CEOs' Terminal Years

ABSTRACT Compensation committees face special difficulties when setting pay in the last years of a CEO's tenure. For example, incentives to manipulate earnings for the purpose of enhancing earnings-based compensation are greater in CEOs' terminal years. We predict that compensation committees are aware of these incentives and adjust the relative weights placed on earnings components in the cash compensation function to mitigate the problem. Consistent with our prediction, we find that in CEOs' terminal years, positive changes in discretionary accruals receive significantly less weight than other income components in determining cash compensation. This provides new evidence that not all gains flow through to compensation. We also find that in non-terminal years, managers' compensation is partially shielded from the negative effects of selling, general, and administrative expenditures (SG&A), but this effect reverses in the terminal period, consistent with the compensation committee discouraging investment in legacy assets by outgoing CEOs. Overall, our findings suggest that compensation committees treat components of earnings differently when setting pay in the terminal period. JEL Classifications: M41; J33.

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.

The Impact of Corporate Governance on Discretionary Accrual Changes Around the Sarbanes-Oxley Act*

Previous research such as Cohen, Dey and Lys (2005) and Lobo and Zhou (2006) document that there is a decrease in discretionary accruals following the Sarbanes-Oxley Act (hereafter SOX). More specifically, Cohen et al. (2005) document that firms' management of accounting earnings increased steadily from 1987 until the passage of the Sarbanes Oxley Act (SOX) in 2002, with a significant increase in the two years before SOX when major scandals occurred, and a significant decline after passage of SOX. Lobo and Zhou (2006) find that firms report lower discretionary accruals after SOX than in the period preceding SOX and firms incorporate losses more quickly into their earnings in the post-SOX period. In this paper we posit that corporate governance plays an important role in the behavior of discretionary accruals. We present evidence that firms with stronger corporate governance engage in less earnings management in the post-SOX period. More importantly, firms with stronger governance experience a lower reduction in discretionary accruals in the post-SOX period. This study provides further evidence of the impact of corporate governance on managers' discretionary accounting decisions. More importantly this study shows that the decrease in discretionary accruals behavior in the post-SOX period is not homogeneous across sample firms; it is inversely related to the quality of corporate governance.

Discretionary Accrual Changes Following the Sarbanes-Oxley Act

We examine changes in discretionary accruals following the Sarbanes-Oxley Act (SOX). SOX imposes considerably greater potential penalties on CEO/CFOs who engage in financial wrongdoing; therefore, risk averse managers are likely to report lower earnings by reducing discretionary accruals following SOX. Our results indicate that (1) Canadian firms subject to SOX report lower discretionary accruals in the post-SOX period; (2) there is no regulatory spillover effect of SOX on Canadian firms not under the jurisdiction of SOX; (3) the impact of SOX on firms' conservative reporting through discretionary accruals in the post-SOX period is not homogeneous; it is more pronounced for firms that were aggressive in the pre-SOX period.

Does Hiring a New CFO Change Things? An Investigation of Changes in Discretionary Accruals

The recent spate of fraudulent financial reporting in the U.S. has drawn attention to the fact that the Chief Financial Officer (CFO) has a substantial amount of control over a firm's reported financial results. This paper examines the changes in discretionary accruals surrounding the appointment of a new CFO. Using a sample of 712 companies that appointed a new CFO in the period 1994 to 2000, we find that discretionary accruals decreased significantly following the appointment of a new CFO. Our tests indicate that this reduction is significantly greater for our group of CFO-hiring firms than for a control group of non-hiring firms, and that the changes are not driven by a concurrent appointment of a new Chief Executive Officer (CEO). We also find that our results are largely driven by firms that hire a new CFO from outside the company. Our study extends earlier research by providing empirical evidence that individuals in CFO positions wield significant influence over the firm's reported financial results and that a firm's discretionary accruals are significantly reduced surrounding the appointment of a new CFO.

Does Hiring a New CFO Change Things? An Investigation of Changes in Discretionary Accruals

Does Hiring a New CFO Change Things? An Investigation of Changes in Discretionary Accruals

Discretionary Accrual Changes Following the Sarbanes-Oxley Act: Evidence from Canadian Companies

We examine changes in discretionary accruals following the Sarbanes-Oxley Act (SOX). SOX imposes considerably greater potential penalties on CEO/CFOs; therefore, risk averse managers are likely to be more conservative in their financial reporting and report lower discretionary accruals following SOX. We find that Canadian firms that are listed on both Canadian and US exchanges and are subject to SOX report lower discretionary accruals following SOX than they did in the period immediately preceding SOX. To increase the validity of our findings, we perform a similar comparison on a matched sample of Canadian firms that are listed only on Canadian exchanges. Our results indicate that (1) Canadian firms subject to SOX report lower discretionary accruals and incorporate losses more quickly than gains in the period after SOX; (2) there is no regulatory spillover effect of SOX on Canadian firms not under the jurisdiction of SOX; (3) the impact of SOX on firms' conservative reporting through discretionary accruals is not homogeneous; it is more pronounced for firms that were aggressive in the pre-SOX period.

Cash Compensation and Earnings' Components Around CEO Turnover: Does the Compensation Committee See Over the Horizon?

Managers in their terminal years have an incentive to manipulate earnings to enhance earnings based bonuses. We examine this horizon problem by considering the role of the compensation committee in setting terminal-year compensation. We predict that compensation committees are aware of the horizon problem and intervene when setting pay in terminal years. We find that the relation between cash compensation changes and discretionary accruals changes is significantly reduced. This finding is similar for both positive and negative discretionary accrual changes. Our findings suggest that compensation committees do not act naively when setting CEO compensation in the terminal year.