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An Experimental Investigation of the Effect of Accounting Discretion on the Reporting of Smooth Increasing Earnings

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Value-maximizing managers smooth earnings to communicate their firm’s value to shareholders. When accounting discretion is available, opportunistic managers are able to mimic the earnings patterns reported by value-maximizing managers. This paper reports an experiment that investigates (1) whether a reduction in accounting discretion leads to a separation in earnings series reported by opportunistic and value-maximizing managers, and (2) whether a reduction in accounting discretion impedes the ability of value-maximizing managers to communicate smooth increasing earnings to shareholders when operational smoothing variables are available. The study shows that a reduction in accounting discretion brings about a separation between the two types of managers because low discretion levels affect the reporting ability of opportunistic managers but not that of value-maximizing managers. Value-maximizing managers alter their operational strategies to overcome restrictions in accounting discretion in order to achieve their reporting objective.
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An Experimental Investigation of the Effect of Accounting Discretion
on the Reporting of Smooth Increasing Earnings
Hwee C. Tan and Karim Jamal
University of Alberta
October 2003
Please address correspondence to:
Karim Jamal
School of Business
University of Alberta
Edmonton, Alberta
Canada T6G 2R6
Telephone: (780) 492-5829; Fax (780) 492-3325
e-mail: karim.jamal@ualberta.ca (Karim)
ht1@ualberta.ca (Hwee)

An Experimental Investigation of the Effect of Accounting Discretion
on the Reporting of Smooth Increasing Earnings
Abstract
Value-maximizing managers smooth earnings to communicate their firm’s value to
shareholders. When accounting discretion is available, opportunistic managers are able to mimic
the earnings patterns reported by value-maximizing managers. This paper reports an experiment
that investigates (1) whether a reduction in accounting discretion leads to a separation in earnings
series reported by opportunistic and value-maximizing managers, and (2) whether a reduction in
accounting discretion impedes the ability of value-maximizing managers to communicate smooth
increasing earnings to shareholders when operational smoothing variables are available. The
study shows that a reduction in accounting discretion brings about a separation between the two
types of managers because low discretion levels affect the reporting ability of opportunistic
managers but not that of value-maximizing managers. Value-maximizing managers alter their
operational strategies to overcome restrictions in accounting discretion in order to achieve their
reporting objective.
Key Words:
Accounting discretion, managerial foresight, income smoothing, operating
decisions.
Data Availability: Please contact the first author.

An Experimental Investigation of the Effect of Accounting Discretion
on Reporting of Smooth Increasing Earnings
I. INTRODUCTION
Accounting discretion allows managers to manage earnings for value-maximizing and
opportunistic reasons. A value-maximizing manager uses accounting discretion to communicate
private information about future earnings and their variability to shareholders (Demski 1998,
Trueman and Titman 1988, Chaney and Lewis 1995), while an opportunistic manager uses it to
misrepresent a firm’s performance in order to achieve personal objectives (Healy and Wahlen
1999). One way in which value-maximizing managers can demonstrate their superior knowledge
to shareholders is by reporting smooth increasing earnings (Chaney and Lewis 1995, Barth et al.
1999). However, when accounting standards allow for discretion, opportunistic managers can
similarly report smooth earnings, and this makes it difficult for investors to discern a firm’s value
from earnings patterns (Demski 1998). The availability of accounting discretion facilitates
opportunistic financial reporting in two ways. First, when accounting standards are flexible,
managers find it expedient to use accounting estimation instead of the more costly operational
variables to manage earnings (Nelson et al. 2002a). Second, the subjectivity in accounting
standards results in a greater willingness of auditors to accept non-conservative accounting
practices by managers (Nelson et al. 2002a, Hackenbrack and Nelson 1996). In order to ensure
that reported earnings series provide useful information to investors, Demski (1998), and Sankar
and Subramanyam (2001) suggest that accounting discretion be restricted. The first objective of
this study is to investigate whether a reduction in accounting discretion brings about a separation
in the earnings series reported by opportunistic and value-maximizing managers.
1

The second objective of the study is to investigate whether a reduction in accounting
discretion affects a value-maximizing manager’s ability to communicate with shareholders
through smooth increasing earnings when operational techniques are available. The availability
of discretion allows managers to make accounting choices appropriate to their businesses so that
reported earnings can convey information on economic earnings (Dye and Verrecchia 1995). A
reduction in discretion is predicted to lessen a manager’s ability to communicate with
shareholders (Healy and Wahlen 1999, Schipper 1989). Several studies (Nelson et al. 2002a,
Lambert 1984), however, show that both operational and accounting choices are employed in
earnings management. A recent study by Barton (2001) finds that managers make substitutions
between real and accounting variables when smoothing earnings. In addition, Nelson et al.
(2002a) observe a dependence between the flexibility in accounting standards and the type of
earnings management technique employed by managers. Managers tend to use operational
variables when standards are precise, and accounting variables when standards are imprecise. A
reduction in accounting discretion therefore need not necessarily prevent managers from
achieving their reporting target, if managers have other earnings management instruments at
their disposal.
This study complements archival research on earnings management by using an experimental
approach to examine the effect of a reduction in accounting discretion on the ability of managers
to manage earnings for value-maximizing and opportunistic reasons. The experimental approach
permits the manipulation of manager types and levels of accounting discretion in order to test
hypotheses regarding these variables. The influence of these two variables is difficult to discern
from reported earnings data (Fields et al. 2001).
2

This study makes two contributions to the accounting literature. First, it provides
experimental evidence in support of the results in Demski (1998) and Sankar and Subramanyam
(2001), which demonstrate that a reduction in accounting discretion will lead to a separation in
the pattern of earnings reported by opportunistic and value-maximizing managers. Second, the
study provides evidence for the operational (hence, economic) effects of a reduction in
accounting discretion on the firm (Jamal et al. 2003a, Jamal et al. 2003b). When accounting
discretion is reduced, managers find it difficult to rely on accounting adjustments to offset the
variability in operating earnings. This induces them to reduce their investments in assets with
variable returns such as research and development (R&D) expenditures in order to achieve their
earnings target. This study also complements a growing area of research which examines factors
that influence a manager’s operating policies. Some of the factors that have been investigated
include the decision rules used by shareholders to price shares (Kanodia 1980), the presence of
institutional shareholders (Bushee 1998), and the form of compensation contracts (Demski and
Dye 1999).
The two objectives of the study are investigated by conducting an experiment in which
opportunistic and value-maximizing managers are given different levels of accounting discretion
to report smooth increasing earnings over time. The concept of foresight described in Demski
(1998) is used to characterize the value-maximizing and opportunistic managers. A value-
maximizing manager is one with high foresight while an opportunistic manager has limited
foresight. In Demski (1998), foresight refers to the knowledge about future earnings, which can
be acquired through a manager’s diligence. Managers communicate this knowledge to investors
by smoothing earnings over time.
3

The choice of income smoothing instead of other forms of earnings management is based on
theoretical results which show that both value-maximizing and opportunistic managers are
motivated to smooth earnings. Value-maximizing managers smooth earnings to improve asset
prices (Trueman and Titman 1988, Ronen and Sadan 1981), to lower cost of debt (Lambert
1984), and to signal managerial type (Chaney and Lewis 1995). Opportunistic managers would
also like to smooth earnings for the same purposes (Demski 1998, Sankar and Subramanyam
2001, Chaney and Lewis 1995). Specifically, the experiment described in this study requires
managers to report smooth increasing earnings. This requirement is consistent with a manager’s
objective of maximizing the value of the firm: Barth et al. (1999) and Francis et al. (2003)
demonstrate that firms that report smooth increasing earnings obtain a higher valuation for their
shares compared to firms without such patterns of earnings. Further, if managers were required
to smooth earnings only, without regard to the level of earnings, a manager who smoothed a
series of losses would be ranked equally with one who smoothed a series of positive earnings.
Using the reporting of smooth increasing earnings as an objective avoids this problem and
ensures that managers would undertake value-maximizing actions.
One hundred experienced financial managers from various industries participated in the
experiment. The experiment had a 2 × 3 (managerial foresight × accounting discretion) between-
subject design. High foresight participants were given decision aids that predict future economic
earnings, but low foresight participants were not given the information. The amount of
accounting discretion was manipulated by varying the percentage of economic earnings that
could be affected by accounting adjustments. The participants were allowed to use both
operational and accounting techniques in order to achieve their reporting objective. The
operational techniques available in the experiment relate to the selection of assets that have an
4

effect on cash flows of the firm, while accounting techniques relate to the timing of expense
recognition which has no cash flow effect (Nelson et al. 2002a, Sivakumar and Waymire 2003).
This study shows that a restriction in accounting discretion is effective in bringing about a
separation in the earnings series reported by low and high foresight managers. At low levels of
accounting discretion, low foresight managers are unable to report smooth increasing earnings.
In contrast, high foresight managers are not affected by a reduction in discretion: they alter their
operational strategies in response to the available level of accounting discretion in order to
achieve their reporting objective. When accounting discretion is low, high foresight managers
reduce their investments in assets with variable returns and increase their investments in short-
term assets with stable returns.
The remainder of the paper is organized as follows. Section II describes the hypotheses that
are tested in the experiment. Section III provides the theoretical background for the experiment
and the algorithms implemented in the computer program used for the experiment. Section IV
describes the experiment. Section V discusses the experimental results and Section VI
summarizes the conclusions of the study.
II. HYPOTHESIS DEVELOPMENT
It is difficult for managers to make direct disclosures of private information to shareholders in
view of the existence of proprietary costs of disclosure, institutional and legal constraints
(Schipper 1989). As a result, managers rely on financial reports to communicate with
shareholders (Healy and Palepu 2001). One form of communication seeks to present smooth
increasing earnings over time as an indication of a firm’s superior value (Chaney and Lewis
1995, Burgstahler and Dichev 1997). Recent studies by Barth et al. (1999), and Francis et al.
5

(2003) provide evidence that firms with a pattern of smooth increasing earnings have higher
valuations than those without such patterns.
Demski (1998) explains that patterns of earnings have information content for investors
because only managers with high foresight are able to report smooth earnings. High foresight
managers have a greater understanding of their operations, which improves their knowledge
about future earnings. Consequently, high foresight managers are able to combine inputs in a
manner that generates smooth earnings. Low foresight managers, in contrast, lack the knowledge
about future earnings to help them achieve a smooth increasing earnings stream. The availability
of high levels of accounting discretion, however, may compensate for a lack of foresight, and
allows low foresight managers to report earnings patterns that are similar to those of high
foresight managers (Demski 1998, Sankar and Subramanyam 2001). When this happens,
investors cannot rely on earnings patterns produced by firms to infer managerial types. Demski
(1998) and Sankar and Subramanyam (2001) suggest that an environment of limited accounting
flexibility is important for ensuring that earnings reports can be used to distinguish value-
maximizing managers from opportunistic ones. Given that value-maximizing managers in this
study are characterized by high foresight managers, and opportunistic managers are characterized
by low foresight managers, the hypotheses in this section are framed in terms of the foresight of
the manager. The first hypothesis (in alternative form) is:
H1: A reduction in accounting discretion brings about a separation in the earnings series
reported by high and low foresight managers.
For a reduction in accounting discretion to be an effective separating mechanism, it has to
prevent opportunistic reporting of earnings by low foresight managers, but at the same time
allow high foresight managers to continue reporting smooth increasing earnings. Healy and
6

Wahlen (1999) argue that managers need accounting discretion in order to report earnings that
reflect economic earnings. A reduction in accounting discretion is therefore predicted to affect
the reporting ability of high foresight managers negatively because managers cannot make
accounting choices that are appropriate to their businesses. Dye and Verrecchia (1995) provide
similar theoretical arguments. An assumption in Healy and Wahlen (1999) and Dye and
Verrecchia (1995) is that managers rely only on accounting discretion in order to achieve their
earnings target. However, both operational and accounting techniques can be used by managers
for earnings management (Nelson et al. 2002a, Ronen and Sadan 1981). Hence, a reduction in
accounting discretion may not affect a manager’s ability to report smooth increasing earnings
when alternative smoothing techniques are available.
Recent studies show that managers view accounting adjustments and operational variables as
substitutes when managing earnings (Barton 2001), and that the use of operational variables in
earnings management is related to the flexibility in accounting standards (Nelson et al. 2002a). In
Barton (2001), managers view financial instruments that have cash flow effects and accounting
accruals as substitutes in their earnings management process. Firms with a large derivative
portfolio tend to have lower levels of discretionary accruals compared to firms with small
derivative portfolios. Nelson et al. (2002a) further document a dependence between the precision
of accounting standards and the type of earnings management techniques. In their survey of
auditors, earnings management attempts fall into two categories: structured and unstructured.
Structured attempts are defined to include contract modification, and the manipulation of
operations. Unstructured attempts refer to the manipulation of accounting estimation. Structured
and unstructured attempts, respectively, therefore correspond to operational and accounting
smoothing techniques in this study. Nelson et al. find that an auditor’s acceptance of a manager’s
7

earnings management attempt depends on how the attempt is structured with respect to the
precision of the affected GAAP. When accounting standards are precise, auditors generally
accept actions by managers to structure transactions in a way that avoids an infringement of
accounting rules. However, when accounting standards are less precise, auditors prefer managers
not to structure transactions. Accordingly, Nelson et al. find that there are more instances of
structured earnings management attempts when standards are precise than when they are
imprecise.
The results in Barton (2001) and Nelson et al. (2002a) suggest that managers can alter their
operational strategies in response to the level of accounting discretion in order to achieve their
reporting objective. When accounting discretion is reduced, managers may invest less in assets
with variable returns (e.g. R&D), and more in assets with stable returns, in order to reduce their
need for accounting adjustments. In contrast, when a high level of accounting discretion is
available, managers may be more risk-seeking in their investment decisions because they can
offset any operational variability with accounting adjustments.
The use of operational variables in earnings management, however, requires knowledge about
a firm’s operations and an understanding of future earnings. Nelson et al. (2002a) note that
auditors and experts are sometimes used to assist managers in this form of earnings management.
They find that only 13% of earnings management attempts relate to operational variables,
presumably because of the cost and effort involved in such activities. In this study, managers
with high foresight understand their operations better, which provides them with a greater
capacity to use operational variables for smoothing earnings than low foresight managers
(Demski 1998). When accounting discretion is reduced, high foresight managers are likely to
organize their investments in a way that reduces their exposure to the variability in earnings.
8

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