Management's Earnings Justification and Earnings Management under Different Institutional Regimes

• Author: Walter Aerts,Ann Tarca,Peng Cheng
• Date: 01 January 2013
• DOI: http://doi.org/10.1111/corg.12014
• Published date: 01 January 2013

Management’s Earnings Justif‌ication and

Earnings Management under Different

Institutional Regimes

Walter Aerts*, Peng Cheng, and Ann Tarca

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines whether accruals earnings management is associated with managers’

explanations of performance provided in narrative reports accompanying the f‌inancialstatements in an international setting

that covers voluntary and mandatory institutional environments for management commentary (MC) reporting. Differences

in institutional environment are theorized as having a profound impact on the relative adequacy of different explanation

types in mitigating earnings management concerns.

Research Findings/Insights: Based on 162 companies from four countries (the United Kingdom, Australia, the United

States, and Canada), the study reports a close alignment of the use of earnings explanations and the strength and direction

of accruals management. The results indicatethat explanation type signif‌icantly affects the associationbetween performance

explanations and accruals management and that this effect becomes more pronounced in a mandatory institutional regime

where expected regulatory and litigation costs are higher.

Theoretical/Academic Implications: The results indicate that the mandatory setting for narrative reporting (United States

and Canada) affects the type of explanation perceived by managers to be more effective in mitigating potential concerns

about earnings management. In a mandatory setting, the more costly causal explanations are more likely to be used by

companies that are engaged in upwards earnings management.

Practitioner/Policy Implications: Regulators have debated about how to promote useful disclosure in management com-

mentary reports. They have pointed to the need for more meaningful causal explanations. Our f‌indings are relevant to the

debate as they show that more scrutiny via a mandatory reporting regime (with associated higher expected litigation and

regulatory costs) is a setting that encourages provision of these more costly causality-based explanations when preparers

have incentives to ensure the adequacy of their explanations.

Keywords: Corporate Governance, Earnings Management Justif‌ication, Management Commentary, Performance Expla-

nations, Reporting Environments

INTRODUCTION

This study focuses on the association between a compa-

ny’s accruals management and its use of performance

explanations in the management commentary (MC) reports

that commonly accompany the corporate f‌inancial state-

ments. Such reports are variously known as MD&A reports

in the US and Canada, and Operating and Financial Review

(OFR) in the UK. Weinvestigate whether such an association

can be established, whether the relationshipis contingent on

the type of explanation offered and whether the institutional

setting with regard to MC affects the strength of the asso-

ciation. Our sample relates to two pairs of countries: the US

and Canada compared to the UK and Australia. All have a

similar strong capital market orientation, but the pairs have

marked differences in MC reporting requirements (volun-

tary versus mandatory regime) and institutional reporting

scrutiny, which affect expected regulatory and litigation

costs associated with public f‌inancial reporting.

MC reporting has become an integral part of the account-

ability mechanisms embedded in the institutional environ-

ment of public companies. Accountability mechanisms are

key to corporate governance processes. Like disclosure stan-

dards, independent audits, audit committee arrangements

*Address for correspondence: WalterAerts, Department of Accounting and Finance,

Antwerp University,Faculty of Applied Economics, 13 Prinsstraat,B-2000 Antwerpen,

Belgium. Tel: 32 32654110; Fax: 32 3265 4064; E-mail: walter.aerts@ua.ac.be

93

Corporate Governance: An International Review, 2013, 21(1): 93–115

© 2013 Blackwell Publishing Ltd

doi:10.1111/corg.12014

and related corporate governance mechanisms, MC is an

instrument to keep companies answerable and responsible

for past behavior (Aerts & Tarca, 2010; Brown, Beekes, &

Verhoeven, 2011). As an accountability mechanism, MC

involves a systematic review of a company’s actions and

decisions by external entities, linked to rewards and sanc-

tions (Frink & Ferris, 1998). Accountability predicaments

and properties of institutional context will affect the promi-

nence and relative importance of specif‌ic benef‌its and sanc-

tions and can be expected to affect the way companies

respond to accountability pressures.

Performance explanations provided in MC may be a key

instrument in companies’ response strategies. Explanations

are important as they expose rationality and appropriate-

ness (Gowler & Legge, 1983). Argumentation and related

explanation helps to build cognitive legitimacy by connect-

ing prior experiences, events, goals, and outcomes and

making them comprehensible and sensible. Performance

explanations tend to delineate and cognitively circumscribe

performance features which are deemed to be key in judging

the reasonableness and appropriateness of prior behavior.

Accountability predicaments tend to trigger more intense

explanatory behavior (Bloomf‌ield, 2008; Merkl-Davies &

Brennan, 2007; Tetlock, 1985).

Outsiders’ concerns of potential earnings management

may constitute such a predicament. Earnings management

involvesmanagerial behavior whereby a company’searnings

are deliberately manipulated in order to achieve particular

f‌inancial outcomes. The objective may be to change outsider

perception of the company’s economic position and perfor-

mance and/or affect contractual outcomes that use reported

earnings as a reference. Prior research suggests that earnings

management is not without costs, especially not in a high

scrutiny environment thatfacilitates the detection of earnings

management (Dechow, Sloan, & Sweeney, 1996; Graham,

Harvey, & Rajgopal, 2005; Leuz, Nanda, & Wysocki, 2003). In

this respect, performance explanations may be used in a

remedial mode after earnings management occurs, to defend

reported earnings and thus mitigate performance manipula-

tion concerns and reduce the likelihood of related reputation

costs.

We follow Aerts (1994), Hooghiemstra (2003), and Aerts

and Tarca (2010) in identifying two kinds of explanation

in MC reports, namely “technical-accounting” explanations

and causality-based explanations. Technical-accounting ex-

planations refer to explanations of accounting effects

framed in f‌inancial accounting language (Aerts, 1994). For

example, management may explain a rise in the company’s

prof‌it margin by relating it to an increase in revenue or a

decrease of particular categories of operating expenses.

Causality-based explanations, on the other hand, refer to

statements in which performance outcomes are linked to

internal or external events, actions or decisions which

are identif‌ied as underlying sources for performance.

Causality-based explanations include, for example, perfor-

mance explanations in terms of the company’s strategy and

underlying business model, and explanations of how indus-

try and general economic forces affected business out-

comes. Both types of explanation may be appropriate from

a pragmatic point of view, as they conform to generally

expected patterns of reasoning, but we argue that their

adequacy to alleviate earnings management concerns may

be signif‌icantly different.

We analyse the content of the MC reports of 162 public

companies from f‌ive industry sectors: retail, food process-

ing, building materials, pharmaceuticals, and biotechnology.

We identify the amount and type of explanations offered for

earnings-related outcomes. Our main focus is to compare

explanatory content differences between companies from

the North American institutional environment with those

from the two other common law countries and how differ-

ences in institutional regime (voluntary versus mandatory

reporting system and related expected regulatory and liti-

gation costs) affect explanatorybehavior. We predict that the

association between earnings management and perfor-

mance explanations will be stronger for causal explanations

than for technical-accounting explanations and that the

North American institutional environment strengthens the

tendency to use more (causal) earnings explanations in con-

junction with stronger earnings management.

Our results are generallyconsistent with predicted effects,

but they are strongly contingent on the direction of earnings

management. Our f‌indings indicate that stronger upward

accruals management is related to the use of more earnings

explanations, predominantly of the causal type. This pattern

is, however, signif‌icantly stronger for North American com-

panies than those from the UK and Australia. These results

suggest that causal explanations, which tend to be more

costly than technical-accounting explanations, are seen as

more adequate in mitigating upward earnings management

concerns in a high scrutiny environment. Companies exhib-

iting stronger downward earnings management provide

fewer causal and more accounting explanations, suggesting

that downward accruals earnings management is of less

concern as an accountability predicament. This is consistent

with companies experiencing an asymmetric loss function

with regard to earnings management. Our results are not

materially affected when we control for a potentially endog-

enous relationship between accruals management and

explanatory activity on earnings-related outcomes. This sug-

gests a direct relationship between the use of explanationon

earnings and accruals earnings management.

THEORETICAL DEVELOPMENT

Earnings Management and the Need for

Justif‌ication of Earnings

Earnings management is generally taken to mislead

outsiders’ perceptions of the f‌inancial performance of the

company, to the benef‌it of insiders. Managers might also use

earnings management to make f‌inancial reports more infor-

mative for outsiders, with accounting choices or estimates

being signals of a company’s f‌inancial performance. Man-

agement’s motives for earnings management are, however,

not transparent from reported numbers, so both manipula-

tive and communicative (i.e., signaling managers’ private

information) earnings management are likely to feed ex ante

uncertainty of users with regard to earnings management

consequences. In this regard, Louis and Robinson (2005)

argue that when companies use accruals to signal private

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Volume 21 Number 1 January 2013 © 2013 Blackwell Publishing Ltd