The Financial Reporting Environment, Reporting Discretion, and Earnings Management: US GAAP vs. IFRS. Mark Evans Indiana University

Transcription

1 The Financial Reporting Environment, Reporting Discretion, and Earnings Management: US GAAP vs. IFRS Mark Evans Indiana University Richard Houston University of Alabama Michael Peters Villanova University Jamie Pratt* Indiana University October 2012 * Corresponding author. Kelley School of Business, 1309 E. 10 th Street, Bloomington, Indiana 47405, jpratt@indiana.edu. We appreciate comments received from participants at the 2012 Midwest Summer Accounting Research Conference at the University of Minnesota and an Indiana University Brown Bag Workshop.

2 The Financial Reporting Environment, Reporting Discretion, and Earnings Management: US GAAP vs. IFRS ABSTRACT In this study we examine the effect of characteristics of the financial reporting environment on the level of financial reporting discretion perceived by managers and the likelihood and method of earnings management. We focus primarily on the effects of financial reporting standards (US GAAP vs. IFRS), while simultaneously considering other important characteristics of the reporting environment and how they interact with the standards firm domicile, firm ownership, audit quality, firm size, and the direction of the earnings adjustment. Using a web-based case completed by 615 experienced financial officers from the US, Europe and Asia, we find that financial officers under IFRS perceive higher levels of reporting discretion than those under U.S. GAAP, and the perception of higher levels of reporting discretion leads to both a greater likelihood of earnings management and a preference for the use of accruals over real methods. While we generate no evidence that IFRS, compared to U.S. GAAP, leads to a greater likelihood of earnings management, we do observe that U.S. firms under U.S. GAAP show a strong preference for real activities over accruals methods, while all other firms (U.S. firms under IFRS and non-u.s. firms) are either indifferent between the two methods or prefer accruals. We also find that firms adjusting earnings upward strongly prefer real activities, while firms adjusting earnings downward are either indifferent (US GAAP users) or prefer accruals (IFRS users). These findings contribute to research concerning whether differences in financial reporting environments are associated with differences in the perception of allowable reporting discretion, and the inclination to manage earnings via real activities or accruals. They also suggest that adopting IFRS in the US may have little effect on the overall level of earnings management, but instead may encourage firms to substitute accruals for real activities when managing earnings. Keywords: Accounting standards; earnings management; regulation JEL Codes: M40; M41; M48

3 I. INTRODUCTION In this study we examine the effect of characteristics of the financial reporting environment on the level of financial reporting discretion perceived by managers and the likelihood and method of earnings management. We focus primarily on the effects of financial reporting standards (US GAAP vs. IFRS), while simultaneously considering other important characteristics of the reporting environment and how they interact with the standards. These characteristics include firm domicile (US vs. non-us), firm ownership (public vs. private), audit quality (Big 4 vs. non-big 4), firm size, and the direction of the earnings adjustment (upward vs. downward). 1 We collected data using a web-based exercise completed by 615 experienced financial officers whose firms report under U.S. GAAP or IFRS and are domiciled in the U.S., Europe, or Asia. Participants completed a short case in which they were asked to assume that their firms were approaching year-end, and were provided with monetary values for both expected unmanaged earnings (the firm s best guess of what earnings would be if left unadjusted) and an important benchmark. We then asked participants whether in this situation their entities would use allowable reporting discretion to increase, decrease, or not adjust earnings and, if they thought their entities would adjust earnings, by how much. 2 We also asked participants to indicate which methods (real vs. accruals) their entities would use to adjust earnings as well as various questions about their entities (e.g., reporting system, auditors, size, ownership, and benchmarks) and themselves (e.g., age, experience, and certification). 1 The direction of the earnings adjustment is not a characteristic of the reporting environment per se, but we argue later that the regulatory pressures controlling upward earnings management are quite different from those controlling downward earnings management. 2 Allowable reporting discretion is defined as the level of reporting discretion that the financial officer believes can be exercised either through operating, investing, or financing decisions (real activities) or accounting choices (accruals) without violating generally accepted accounting principles. 2

4 We report four primary findings: (1) compared to financial officers under US GAAP, financial officers under IFRS perceived greater levels of allowable reporting discretion; (2) greater levels of perceived allowable reporting discretion were associated with a greater likelihood of earnings management and a preference for accruals methods over real activities; (3) financial officers from US firms under US GAAP indicated that their firms preferred real methods for earnings management, while non-us officers and those under IFRS (US and non- US firms) indicated that their firms were either indifferent between real and accruals methods or preferred accruals methods; and (4) compared to firms adjusting earnings upward, firms adjusting earnings downward relied more heavily on accruals vis-à-vis real methods. These results contribute to research concerning the effects of regulation on earnings management (Leuz, Nanda, Wysocki 2003; Lang, Raedy, and Wilson 2006) and the use of real vs. accruals methods (Ewert and Wagenhofer 2005), while identifying a possible consequence associated with the adoption of IFRS in the U.S. (DeFond 2010; Pownall and Schipper 1999). Our evidence suggests, for example, that adopting IFRS in the US would allow greater levels of reporting discretion, but would not necessarily lead to more earnings management. Instead, it may lead to differences in the methods used to manage earnings - more accruals and less real activities. A related implication for standard-setters is that simply tightening accounting standards may not lead to less earnings management; it may lead instead to less reliance on accruals and more reliance on real activities. We build on archival research that examines reporting discretion across different domiciles and the value relevance of earnings across different accounting standards. Leuz et al. (2003) and Lang et al. (2006), for example, show that firms located in highly regulated domiciles are less likely to engage in earnings management by accruals; other studies show U.S. GAAP 3

5 earnings to be of higher quality than earnings determined using IFRS (Barth, Landsman, Lang, and Williams 2012); and still others show that US GAAP and IFRS lead to comparable levels of earnings quality (Gordon et al., 2010; Hughes and Sander 2008). This line of research examines earnings management via accruals, and we extend it by studying both real and accruals methods, allowing us to identify whether management reacts to different reporting environments by changing the likelihood of earnings management and/or changing the method of earnings management. In addition, these studies focus primarily on income-increasing adjustments. We examine both earnings-increasing and earnings-decreasing adjustments, and find that real activities are preferred when increasing earnings, while accruals methods are preferred when decreasing earnings. Our study also builds on existing research examining whether and how firms trade-off real and accruals methods in response to changes in the level of regulation (Cohen et al., 2008; Cohen and Zarowin 2010). This research focuses on U.S. firms under U.S. GAAP, and considers regulatory changes created by SOX (Cohen et al., 2008). We also examine whether and how firms tradeoff real and accruals methods in response to differences in the reporting environment, but we focus on the effects of IFRS vs. US GAAP, and simultaneously consider the main and interactive effects related to firm domicile, the direction of the earnings adjustment, firm ownership, quality of auditor, and firm size all of which represent important characteristics of the reporting environment faced by the firm. Hail et al. (2010a, 2010b) note that the effects of changes in accounting standards on earnings management may not be predictable due to the variety of factors contributing to the level of regulation faced by the firm. Our extension addresses this issue by simultaneously examining the effects of a number of reporting environment characteristics, and we find that they interact in determining the 4

6 likelihood and method of earnings management. US firms under US GAAP, for example, appear to prefer real activities, while all other firms (US firms under IFRS and non-us firms under both US GAAP and IFRS) are either indifferent between real activities and accruals or prefer accruals. We base our method of data collection on Graham, Harvey, and Rajgopal (2005) by asking experienced financial officers to complete a web-based exercise. We expand on Graham et al. (2005) by including firms in non-u.s. settings, firms that report using IFRS, and asking financial officers to respond to a case that includes manipulations of the setting designed to induce firms to adjust earnings upward in one condition and downward in another. These differences allow us to investigate whether many of the Graham et al. (2005) findings hold in settings not included in their study. For example, Graham et al. (2005) find that U.S. managers strongly prefer adjusting earnings via real activities over accruals. We replicate their results, but extend them by showing that this conclusion may be limited to U.S. firms operating under U.S. GAAP adjusting earnings upward. U.S. firms operating under IFRS, non-u.s. firms, and firms adjusting earnings downward all exhibited a lower preference for real activities and, in some cases, actually preferred accruals. Our approach to data collection also allows us to avoid certain weaknesses inherent in related archival studies. Dechow et al. (2010) notes, for example, that archival methods must rely on indirect measures of earnings management, making it difficult to separate measures of earnings management from measures of general performance. Key constructs such as unmanaged earnings and the benchmarks most important to the firm must be measured indirectly. DeFond (2010) argues further that this issue, a construct validity problem, may not 5

7 be resolvable with archival methods because actual performance measures are unobservable. 3 Ewert and Wagenhofer (2005, 1115) point out that archival research often ignores adjustments via real activities and that this exclusion likely affects the estimation of earnings management and may overestimate the impact of various institutional safeguards to control it. Our design circumvents these difficulties by clearly identifying unmanaged earnings, asking financial officers to consider benchmarks important to their firms, and eliciting direct measures of the direction, amount, and method of the earnings adjustments. 4 In the next section we expand on the related literature, followed by the development of the hypotheses. Subsequent sections describe the experimental design, results, and conclusions. II. LITERATURE REVIEW Earnings management occurs when management uses either its reporting discretion (accruals) or its influence over operating, investing, or financing decisions (real activities) to achieve a desired reporting outcome. The literature in this area is extensive and includes both archival and experimental methods (e.g., see Healy and Wahlen 1999; Fields et al. 2001; Libby and Seybert 2009). Three streams of research are particularly relevant to this study: (1) differences in reporting quality between U.S. GAAP and IFRS; (2) the use of real and accruals earnings management; and (3) the effects of principles vs. rules-based accounting. 3 Schipper (1989), Kasznik (1999), McNichols (2000), Dechow and Skinner (2000), Fields et al. (2001), Lev (2003), Schipper and Vincent (2003), Dechow et al. (2003), and Ayers et al. (2006) all discuss difficulties inherent in archival studies that attempt to infer various dimensions of reporting discretion and earnings management. Healy and Wahlen (1999) and Fields et al. (2001), for example, argue that an important limitation of archival studies is the difficulty of determining whether the measure of earnings management is attributable to operational or reporting decisions. 4 In the parlance of List (2011) and Harrison and List (2004), our study uses a framed field experiment, which mimics a lab experiment, except that it uses participants drawn from the market of interest (experienced financial officers) and conducts the study in the natural environment of the subject (participants make accounting and operating decisions in response to relevant expectations; List 2011, 4-5). 6

8 With regard to the first stream of literature, archival-based empirical research generally shows that firms in countries using IFRS tend to engage in more earnings management than firms in countries using U.S. GAAP. Barth et al. (2012) find that U.S. firms using U.S. GAAP exhibit higher levels of accounting quality than non-u.s. firms using IFRS. Alford et al. (1993), Land and Lang (2002), and Lang et al. (2003) generally show that U.S. firms using U.S. GAAP engage in less earnings management than non-u.s. firms, and Lang et al. (2003) show further that non-u.s. firms cross-listed in the U.S. practice less earnings management than non-u.s. firms not cross-listed in the U.S. In an attempt to separate the effects of differences in accounting standards from the effects of differences in jurisdictions, Lang et al. (2006) and Bradshaw and Miller (2008) compared measures of accounting quality of U.S. firms reporting under U.S. GAAP to that of non-us firms required to file SEC Form 20-F reconciliations. These studies either found or assumed that U.S. firms generally reported higher quality information, suggesting differences across countries in how accounting standards are applied. Overall, this research area suggests that earnings quality is greatest in U.S. firms operating under U.S. GAAP, followed by non-u.s. firms cross-listed on U.S. exchanges, and non-u.s. firms operating under either IFRS or local GAAP (Bradshaw and Miller 2008). 5 The second stream of research the use of real activities and accruals methods can be divided into two groups. The first group examines the relative preferences in general for real and accruals earnings management. Graham et al. (2005) examine a wide range of issues, including reporting discretion, and focus on U.S. managers, who primarily work for publicly-traded firms, operate under U.S. GAAP, and adjust earnings upward. They find that this group prefers real 5 In contrast, in a working paper, Ahmed, Neel, and Wang (2012) find that accounting quality decreases after mandatory adoption of IFRS across 20 countries. 7

9 activities over accruals methods. Nelson et al. (2002) surveyed auditors and asked them to recall client attempts to manage earnings. The auditors were more likely to recall clients use of accruals over real activities. The authors recognize, however, that real earnings management is unlikely to be a major concern for auditors because it involves no accounting manipulation. In a review of the behavioral research in this area, Libby and Seybert (2009) note that much evidence exists that management engages in both real and accruals methods, but none documents conditions under which each method is preferred. However, a recent archival paper (Zang 2012) identifies differential costs between real and accruals earnings management and provides evidence that based on these costs firms tradeoff the use of real and accruals methods. Another group of studies focuses on the use of real vs. accruals methods in response to changes in the regulatory environment. Several papers suggest that tighter reporting standards may cause firms to substitute real activities for accruals methods (Schipper 2003; Demski 2004; and Ewert and Wagenhofer 2005). Additional research provides archival-based empirical support for this form of substitution based on changes due to SOX regulations (Cohen et al. 2008) and in the presence of seasoned equity offerings (Cohen and Zarowin 2010). Two recent working papers address real and accruals earnings management in an international setting. Enomoto, Kimura, and Yamaguchi (2012) find that real activities are preferred over accruals methods in countries where investor protection is strong; and Ipino and Parbonetti (2011) find a decrease in accruals methods after mandatory IFRS adoption, but only in countries with strong legal enforcement. The third stream of research examines the impact of rules and principles-based accounting systems on the audit function and financial reporting discretion. Trompeter (1994), Hronsky and Houghton (2001), and Ng and Tan (2003), for example, show that auditors are 8

10 more likely to allow earnings management when transactions involve less precise accounting standards. Mayhew et al. (2001) suggest that earnings management via accruals methods is more likely under principles-based systems because it is easier to justify estimates to auditors when standards are less precise. Hackenbrack and Nelson (1996) find that auditors also use the imprecision in accounting standards to justify an accounting treatment consistent with their incentives. Kadous and Mercer (2012) show that jurors return fewer verdicts for violations of imprecise standards, and Backof, Bamber, and Carpenter (2011) find that under IFRS auditors are more likely to agree with management earnings adjustments via accruals methods. These findings generally support the argument that more discretionary, principles-based accounting systems impose lower regulatory costs, yielding more earnings management via accruals methods. 6 Our study contributes to the research summarized above by directly documenting the presumption that financial officers under IFRS perceive higher levels of allowable reporting discretion than financial officers under U.S. GAAP. We are also the first to provide evidence that adopting IFRS in the U.S. may not affect the overall likelihood of earnings management, but instead may affect the mix of earnings management methods used. That is, firms may substitute accruals for real activities when faced with the additional allowable reporting discretion introduced by IFRS, a more principles-based accounting system. We also show that the preference for accruals vs. real activities depends on an interaction between the system of financial standards and the domicile of the firm. US firms under US GAAP prefer adjusting earnings via real activities, while non-us firms and firms under IFRS (US and non-us) are either indifferent or prefer accruals methods. Finally, we introduce to the literature the finding 6 In contrast, in a working paper, Folsom, Hribar, Mergenthaler, and Peterson (2012) provide evidence that accounting quality as measured by informativeness, persistence, and predictive ability increases in more principles-based GAAP standards. 9

11 that management s preference for real vs. accruals methods depends on the direction of the earnings adjustment income-increasing adjustments rely primarily on real activities; incomedecreasing adjustments rely primarily on accruals methods. III. THEORY AND HYPOTHESES The financial reporting environment imposes constraints on management s reporting discretion, and the effectiveness of these constraints is determined by two dimensions. The environment must first provide a means of identifying when a reporting violation has occurred and, in the event that a violation is identified, the environment must include a significant expected consequence to the violating firm. Leeway (or lack of guidance, monitoring, or enforcement) in either of these two dimensions increases the extent to which management perceives that it is allowed to use reporting discretion to achieve performance goals. Each firm faces a unique reporting environment, and level of allowable reporting discretion, determined by the characteristics of that environment. The set of reporting standards under which a firm operates (U.S. GAAP or IFRS) represents one important element because it provides a means for identifying when a reporting violation has occurred. Other important elements of the reporting environment include firm domicile, firm ownership, auditor quality, firm size, and even the direction of earnings adjustment because each influences the level of allowable reporting discretion by affecting either the means of identifying a reporting violation or the expected consequence. We assume that management has incentives to use reporting discretion to adjust earnings to achieve important benchmarks, and two kinds of discretion are available to do so: (1) discretion over reporting decisions and (2) discretion over operating, investing, and financing 10

12 decisions. Earnings management via accruals methods is the use of reporting discretion to achieve important benchmarks, and earnings management via real activities is the use of discretion over operating, investing, and/or financing decisions to achieve important benchmarks. Firm management can respond to different levels of allowable reporting discretion by changing its willingness to engage in earnings management and/or the mix of the methods used to do so. In environments where allowable reporting discretion is relatively high, management will be more willing to engage in earnings management and will prefer accruals over real activities because accruals are precise and can be delayed until the end of the reporting period. Adjustments via real activities must be implemented well in advance of year end, when uncertainty exists with respect to both the effect on reported earnings of the chosen strategy and the level of reported earnings if left unmanaged. Further, accruals do not directly disturb the firm s cash flows, while real activities typically do. In reporting environments where allowable reporting discretion is relatively low, management will practice earnings management less via accruals methods, relying more heavily on real activities. The additional reporting regulations designed to restrict reporting discretion force management to find a method other than accruals to achieve its reporting goals and encourage the structuring of transactions around the bright-line standards. Consequently, management will substitute real activities for accruals. 7 A consensus exists that IFRS is more principles-based than U.S. GAAP (SEC 2003; Dichev et al. 2012). Assuming that principles require greater use of management judgment than rules, we predict that management of firms under IFRS perceives greater levels of allowable 7 These arguments are largely based on predictions from the model established by Ewert and Wagenhofer (2005), and Zang (2012) used many of these same arguments. 11

13 reporting discretion than management of firms under US GAAP. In addition, consistent with the arguments articulated in this section, we predict that the likelihood of earnings management and the preference for accruals methods over real activities is increasing in the level of allowable reporting discretion perceived by management. H1: Management of firms operating under IFRS perceives higher levels of allowable reporting discretion than management of firms operating under U.S. GAAP. H2: Firms whose management perceives higher levels of allowable reporting discretion are more likely to adjust earnings to meet benchmarks and tend to rely more heavily on accruals methods and less heavily on real activities than firms whose management perceives lower levels of allowable reporting discretion. H1 predicts that IFRS allows more reporting discretion than US GAAP, while H2 predicts that higher levels of reporting discretion lead to a greater likelihood of earnings management and a preference for accruals methods over real activities. Consequently, we predict that, compared to US GAAP, IFRS will lead to a greater likelihood of earnings management and a preference for accruals over real activities. H3: Firms operating under IFRS are more likely to adjust earnings to meet benchmarks and rely more heavily on accruals and less heavily on real activities than firms operating under U.S. GAAP. IV. EXPERIMENTAL DESIGN Participants Participants consisted of 615 financial officers obtained from a business publication s (BP) research database, 191 (31 percent) of whom indicated that in the situation described in the 12

14 case their firm would adjust earnings. 8 Table 1 reports descriptive statistics grouped by U.S. GAAP and IFRS firms, and Table 2 reports descriptive statistics grouped by participants not choosing to adjust earnings and participants choosing to adjust earnings. Panel A of Table 1 shows that 294 participants (48 percent) worked for U.S. firms and 321 (52 percent) worked for non-u.s. firms (about evenly split between Europe and Asia). 9 Both groups were dominated by senior financial officers (almost 65 percent were CFOs, VPs or Directors of Finance). Participants from both groups tended to be in their low to mid-forties; predominantly male (over 83 percent); have a professional accounting certification (almost 70 percent); and highly experienced (about 20 years). [Insert Tables 1 and 2 here] Panel B of Table 1 shows that the firms varied from less than $100 million in sales (32 percent) to over $1 billion (21 percent); the reporting entity of about 61 percent was the firm as a whole; over 76 percent were audited by a Big 4 auditor; and (not tabulated) manufacturing was the industry most highly represented, followed by wholesale/retail, financial institutions, and technology. Participants from the IFRS firms were younger (42 years vs. 44 years) and less experienced (18 years vs. 21 years); and the IFRS firms tended to be smaller (46 percent with <$100 million in sales vs. 24 percent for U.S. GAAP firms). Approximately 51 percent of the firms were publicly-traded. 8 This percentage is similar to results in Burgstahler and Dichev (1997), who estimate the frequency with which firms use EM to avoid earnings decreases at 8-12 percent and to avoid losses at percent, and Dichev et al. (2012), who find that CFOs believe about 20% of firms manage earnings in any given period. 9 European participants mostly were Northern European, with more than half from France, Germany, Spain, and the United Kingdom (other countries represented include Belgium, Denmark, Finland, Ireland, Switzerland, and Sweden). The data was collected after the mandatory adoption of IFRS by the European Union in About 80 percent of the Asian participants were from Hong Kong, India, the Philippines, and Singapore (other countries represented include China, Indonesia, Japan, and Malaysia). Most countries represented are in Leuz et al. s (2010) analysis of reporting quality across domiciles; approximately 70 percent of the non-u.s. countries have environments that Leuz et al. classify into weaker regulatory clusters than that of the U.S. 13

15 Table 2 reveals no significant differences between participants who indicated that their firms would adjust earnings and those who did not, except that those in the adjust earnings sample were more (less) likely to be managers of profit centers (firms as a whole); and those who chose to adjust earnings had less experience (18.3 years vs years). Sensitivity tests reported later in the paper indicate that the differences identified above did not influence the results. Procedure The experimental task involved a short case in which participants were asked to assume that their firm was approaching year end, and they were provided with monetary values for both expected unmanaged earnings and an important benchmark. We then asked participants whether their entities would use allowable reporting discretion to increase or decrease earnings and, if so, by how much. We also asked participants what methods (real and accruals) their entities would use to adjust earnings, as well as various questions about their entity (e.g., reporting system, auditors, size, ownership, important benchmarks) and themselves (i.e., demographics). The case was designed to be completed on a web-based tool that allows researchers to design studies and collect data. The case was extensively pilot-tested with current and former financial officers, other academics, and representatives from the BP. We obtained participants using an request sent by the BP. The request mentioned that we were investigating legitimate tactics (operational and accounting) that companies use to influence reported earnings. Participants were asked to click on a URL link to participate in the study and were told that, if they participated, they would be eligible to receive one of four $250 American Express gift cards. The message described the study as a confidential survey, and the request reiterated that their identity would remain confidential. If respondents clicked on the link, they 14

16 were directed to the case. 10 They saw the first page of a case titled A Case for Financial Officers, and were told that the case consists of about 20 questions. A sample copy of the first page of the case appears in Appendix A, which included a brief description of the situation facing the financial officer. The data used in this study is a subset of data gathered for other research purposes. 11 In total, requests in the U.S. were sent to 11,200 financial officers from two distribution lists. The first included 1,200 financial officers who agreed to respond to a given number of annual requests from the BP to respond to surveys. Based on feedback from the BP, we expected a percent response rate from this group; we received 150 total responses, representing a 12.5 percent response rate. An additional 10,000 requests were sent to the BP s general distribution list, for which the BP estimated a one percent response rate. We received 217 responses, a 2.2 percent response rate. These response rates compare to recent rates reported in the accounting literature; for example, Nelson et al. (2002) report a response rate of 16 percent in their survey of auditors from one Big 5 accounting firm, and Graham et al. (2005) report a response rate of 8.4 percent in their survey of CFOs. In Europe (Asia), 6,262 (6,000) requests were sent and we received 240 (324) responses, representing a 3.8 (5.4) percent response rate; in both cases, these response rates were consistent with what BP representatives predicted. Variable Measures Reporting System. The reporting system (U.S. GAAP vs. IFRS) was measured by asking the financial officers to respond to a question that asked: Which set of financial reporting 10 We sent separate requests, each with its own URL link related to each of the versions of the case, to an equal number of financial officers for each URL in each geographic region (U.S., Europe, and Asia). 11 The case instrument contained twelve scenarios created by three variables: (1) expected unmanaged earnings was either above, equal to, or below the relevant benchmark; (2) dispersion around expected unmanaged earnings was either wide or narrow; and (3) the period of time prior to year-end was either one week or one month. The third variable was varied only within the U.S. sample. These variables appear in the tests associated with the likelihood of adjusting earnings reported later, but they are not the focus of this study and do not influence the results. 15

17 standards does your firm use? Response choices included (1) Generally Accepted Accounting Principles (U.S. GAAP); (2) International Financial Reporting Standards (IFRS); (3) Both U.S. GAAP and IFRS; or (4) Other. 12 Reporting Discretion. We measured the level of allowable reporting discretion perceived by the financial officers by asking them to indicate the extent to which their reporting entityt could use allowable reporting discretion to adjust earnings without violating generally accepted accounting principles. They chose one of the following: Very little discretion (<1 percent of reported earnings); little discretion (1%- 2% of reported earnings); some discretion (3% - 5% of reported earnings); Significant discretion (6% - 10% of reported earnings); or a great deal of discretion (>10% of reported earnings). Likelihood of Adjusting Earnings. We asked participants to indicate without violating GAAP, how would your reporting entity use allowable discretion to influence reported earnings. This discretion could take the form of non-accounting decisions (e.g., operating, investing, financing) or accounting choices (e.g., accounting estimates, assumptions, and/or methods). Participants responded by choosing increase earnings, decrease earnings, or would not change earnings. The likelihood of adjusting earnings for a given group was determined by dividing the number of participants in the group choosing to increase or decrease earnings by the total number of group participants. 12 Ninety one of the 615 participants were from firms that reported using both U.S. GAAP and IFRS (29 U.S. and 62 non-u.s.). We classified the U.S. participants, who indicated that they use both U.S. GAAP and IFRS, as IFRS users based on the assumption that they are subsidiaries of parent companies located outside the U.S. We classified the non-u.s. participants, who indicated they use both U.S. GAAP and IFRS, as U.S. GAAP users based on the assumption that they are subsidiaries of parent companies located within the U.S. Consistent with this assumption, participants, who reported using both U.S. GAAP and IFRS, are significantly more likely to be a cost or profit center than those who report using either U.S. GAAP or IFRS (p < 0.01). Further, comparing the U.S. GAAP and IFRS users (n = 91) to the U.S. GAAP or IFRS users (n = 524) showed no other significant response differences. In tests reported later, we also exclude these participants, focusing only on US/US GAAP firms and non-us/ifrs firms. Results are similar to those reported from our main tests. 16

18 Method of Adjusting Earnings. We measured the relative preference for real activities vs. accruals by asking the financial officers to respond to the following question: How would your reporting entity rely on the two forms of discretion to attain the increase (or decrease) indicated in Question A1? (11-point scale ranging from 1 = operating, investing, financing only to 11 = accounting choices only). 13 Other Important Characteristics of the Reporting Environment In this section we discuss five firm-specific variables that may determine the level of allowable discretion in the reporting environment (firm domicile, direction of earnings adjustment, firm ownership, audit quality, and firm size). They are treated as control variables in most of the tests reported later (Schipper 2005; Hail et al. 2010a). 14 Firm Domicile: U.S. vs. Non-U.S. Much of the accounting literature concerned with cross-national earnings management differences is based on the belief that the investor protection environment is more effective in the U.S. than in non-u.s. settings (e.g., Leuz et al. 2010). A long-standing tradition of conservative accounting exists in non-u.s. settings, and in some cases regulators actually have encouraged earnings understatements (Joos and Lang 1994; Lamb et al. 1998; Garcia-Lara and Mora 2004). It appears, in general, that the cultural and business environment operating in non-u.s. settings allows management more reporting discretion than is allowed in the U.S. These arguments suggest that non-u.s. auditors are less concerned with 13 Respondents answered this question immediately after indicating the likelihoods that they would use in this situation a series of specific real and accrual methods. The answers to the questions related to the specific methods provided a validity check for the primary question used in the analysis. That is, those indicating a preference for real activities tended to attach greater likelihoods to the individual questions related to real methods, while those indicating a preference for accruals tended to attach greater likelihoods to the individual questions related to accruals methods. Additional analysis of these specific methods is provided later in the paper in Table Schipper (2005) recommends including regulatory environment factors as control variables, specifically arguing that domicile and ownership should be controlled for when evaluating reporting consequences between reporting regimes. 17

19 identifying reporting violations, and that the expected consequences are lower. Domicile was determined directly from the respondent s location, as separate requests were sent to addresses in the U.S., Europe, and Asia. Direction of Earnings Adjustment: Upward vs. Downward. Using discretion to adjust earnings upward normally involves situations in which expected unmanaged earnings is below the benchmark, and management is considering whether to increase earnings to avoid failing to achieve the benchmark. Using discretion to adjust earnings downward normally involves a situation where expected unmanaged earnings is above the benchmark, and management is considering whether to decrease earnings to reduce the amount by which reported earnings exceeds the benchmark. The cost to management of reporting earnings below the benchmark is much higher than the cost of reporting earnings above the benchmark because underperformance carries greater negative consequences for management than over-performance (Beyer 2008; Healy and Wahlen 1999). The cost of losing one s job, failing to receive a bonus, and/or missing an analysts forecast, for example, are typically higher and more immediate than the costs associated with setting a higher standard for next year s performance. These differential costs suggest that management has a stronger incentive to adjust earnings upward in a weak year than to adjust earnings downward in a strong year. With this in mind, auditors are more alert to and concerned with upward earnings adjustments. Similarly, Barron et al. (2001) find that auditors are more likely to allow understatements than overstatements, arguing that the auditor s litigation exposure is higher for undiscovered overstatements. Finally, conservatism is an important accounting measurement principle, which may encourage auditors to more readily tolerate downward adjustments to earnings. 18

20 Together, these arguments suggest that the likelihood of identifying and acting on potential reporting violations when management is adjusting earnings downward is lower than when management is adjusting earnings upward. The direction of the earnings adjustment was determined by noting whether management chose to increase or decrease earnings. 15 Firm Ownership: Public vs. Private. Reporting regulations in the publicly-owned environment allow less reporting discretion than in the privately-owned regulatory environment because auditor monitoring is more thorough, SEC enforcement laws exist, and the threat and expected consequences of litigation for both the auditor and management are larger. More thorough auditor monitoring increases the likelihood of identifying reporting violations, and SEC enforcement laws and litigation can lead to large negative consequences. The financial officers indicated whether their firm was privately or publicly owned. Audit Quality: Big 4 vs. Non-Big 4. The Big 4/non-Big 4 classification is often used as a measure of audit quality, based on the premise that the additional resources available to Big 4 firms and their additional litigation and reputation exposure encourage stronger monitoring and oversight of management s reporting behavior. Big 4 auditors, therefore, are expected to allow less reporting discretion than non-big 4 auditors (Chi, Lisic, and Pevzner 2011). The financial officers indicated whether their firm was audited by a Big 4 or non-big 4 firm. Firm Size. Managers in small firms are accountable for less capital owned by fewer capital providers than are managers in large firms. Auditor monitoring is less thorough for small firms because auditor litigation exposure is lower, thereby decreasing the likelihood of 15 Recall that the instrument included different scenarios of firm performance by the placement of the benchmark relative to expected unmanaged reported earnings: strong (unmanaged earnings > benchmark); average (unmanaged earnings = benchmark); and poor (unmanaged earnings < benchmark). We assumed that firms would adjust earnings toward the benchmark; consequently, we expected specific scenarios to induce upward and downward earnings adjustments. Of the 191 participants who chose to adjust earnings, 156 (82 percent) adjusted earnings toward the benchmark. Adjusting earnings away from the benchmark, however, was not considered unreasonable. Reasonable explanations for adjusting earnings away from the benchmark include taking a bath in the poor firm performance condition, and maximizing a bonus in the strong firm performance condition. 19

21 identifying and acting on reporting violations. The potential negative consequences for adjusting earnings reported by small firms are less than in large firms because small-firm managers are accountable to fewer capital providers for less capital. We measured firm size by asking the financial officers to place their entities in one of the following categories based on annual sales: <$100 million, $100 - $499 million, $500 million - $999 million, and >$1 billion. Additional Questions 16 Because we used the responses of financial officer as proxies for firm-level reporting behavior, we assessed the extent to which each officer was involved in the firm s discretionary reporting decisions. Specifically, we asked participants to indicate To what extent can financial officers at your level influence the [earnings adjustment indicated earlier in the case]? (1 = No influence and 11 = Significant influence ). The overall mean response of 8.24 (s.d. = 2.08) significantly exceeds the scale midpoint (6.0), allowing us to conclude that the participants are involved with their entities discretionary reporting decisions. We also asked several additional questions about issues that may relate to discretionary reporting, including (1) how discretionary accounting adjustments in a given period influence the entity s ability to use such discretion in future periods; (2) what is the likelihood that external auditors would notice their discretionary adjustments; (3) if the external auditor noticed, what is the likelihood that the auditor would raise questions about them; (4) how accurately can your reporting entity predict reported earnings for the year; and (5) what is the importance of meeting various benchmarks (e.g., analyst earnings forecasts, budgeted earnings, prior year s earnings). Few meaningful differences emerged between the U.S. GAAP and IFRS groups on these questions. For both groups, over 84 percent believed that reported annual earnings could be 16 Appendix B includes summary statistics for responses to additional questions in graphical and/or tabular format. 20

22 predicted within five percent approximately one month prior to year end, and both groups believed that using reporting discretion in the current period would have a moderate effect (approximately 6.42 on an 11-point scale) on using discretion in future years. In general, both groups believed that it was moderately unlikely (5.63 on an 11-point scale) that the external auditor would notice their discretionary earnings adjustments, and neither group believed that the external auditor was especially likely to raise questions about their adjustment in the event that the auditor noticed them (6.11 on an 11-point scale). The importance of the various benchmarks were largely the same across the two groups (budgeted earnings was considered most important, followed by prior year s earnings and employee bonus threshold), but the financial officers under U.S. GAAP attributed greater importance to debt covenants. 17 Also, these results reveal that managers in our sample believe beating benchmarks is important, in general, with 94% rating at least one benchmark at 5 (out of 7) in terms of importance. In addition, 80% rate at least one benchmark at 6, and almost half rate at least one benchmark at 7, or extremely important. V. RESULTS Univariate Tests Univariate Pearson correlations among the primary variables are presented in Table 3. Panel A reports results for the full sample. Most of the correlations are consistent with expectations, and while many are significant, the size of the coefficients are not large enough to present multicollinearity issues in the tests reported later in the paper. Specifically, firms perceiving more reporting discretion are more likely to adjust earnings (ρ = 0.183), use IFRS (ρ = ), reside outside the U.S. (ρ = ), be smaller and privately owned (ρ = and - 17 This result is consistent with Dichev et al. s (2012) finding that inside pressure to meet benchmarks is a significant factor in CFOs earnings management decisions. 21

23 0.103, respectively), and be audited by non-big 4 firms (ρ = ). In addition, firms under U.S. GAAP tend to be larger (ρ = 0.166), and larger firms tend to be public (ρ = 0.327) and audited by Big 4 auditors (ρ = 0.277). One somewhat surprising finding is that the inclination to adjust earnings does not relate to the reporting system (ρ = ) that is, firms under IFRS were neither more nor less likely to adjust earnings compared to firms under U.S. GAAP. Panel B reports univariate correlation results for the sample of firms that indicated an earnings adjustment. Results are generally consistent with Panel A and, as expected, the preference for accruals (vis-à-vis real activities) is positively associated with higher levels of perceived discretion (ρ = 0.156), and is higher for firms using IFRS (ρ = ), non-u.s. firms (ρ = ), and firms adjusting earnings downward (ρ = ). 18 [Insert Table 3 here] Hypotheses Tests The tests of the hypotheses are contained in Tables 4, 5, and 6. Table 4 (Panel A) reports the frequencies of the responses to the question asking respondents to indicate the level of allowable discretionary influence over reported earnings, for all respondents and broken down by US GAAP and IFRS. Both a Chi-square test (Chi-square = 10.83, p < 0.05) and a t-test comparing the means across U.S. GAAP and IFRS (t = 3.21, p < 0.01) are significant, indicating financial officers under IFRS perceive more reporting discretion than do financial officers under U.S. GAAP. [Insert Table 4 here] Panel B of Table 4 reports results of multivariate analyses (via ordered logistic regression) in which the dependent variable was a coding of 1 (very little discretion) 5 (a great 18 The direction of the earnings adjustment is not correlated with any of the other variables. This result validates the random assignment of firm performance scenarios discussed in footnotes 15 and

24 deal of discretion), and the variable of interest is the reporting system (GAAP). 19 We also control for other regulatory factors, including domicile (U.S.), firm ownership (Public), audit quality (Big 4), and firm size (Size). We first test whether the reporting system is associated with perceived discretion excluding control variables other than size. These results show that financial officers under IFRS perceive more reporting discretion than those under U.S. GAAP (coefficient = , onetailed p-value = 0.004). Column 2 includes all control variables expected to affect the level of perceived discretion. The coefficient for the reporting system (GAAP) remains negative and significant (coefficient = , one-tailed p-value =0.002). The only significant control variable is Big 4 (coefficient = , two-tailed p-value = 0.015), indicating that firms with Big 4 auditors perceive less reporting discretion than firms with non-big 4 auditors. All tests support H1 - financial officers using IFRS perceive more discretionary influence over reported earnings than those using U.S. GAAP. 20 [Insert Table 5 here] Table 5 reports the effects of the level of perceived allowable reporting discretion (Discretion) and reporting system (GAAP) on the likelihood of adjusting earnings. In Panel A, we first report evidence consistent with Table 2, showing that the reporting system and the likelihood of adjusting earnings are unrelated (Chi-Square = 0.258, p-value = 0.611). In Panel B, we control for firm size (Size), domicile (US), audit quality (Big 4), ownership (Public), the direction of the earnings adjustment (Increase), timing, and uncertainty in unmanaged earnings An OLS regression was also used and produced substantively the same results. 20 In unreported tests, we included interactions among GAAP and control variables. None of these interactions was significant and we, therefore, exclude from our reported results. 21 Recall that we introduced three scenarios to participants: performance (high, average, low), timing, (one month vs. one week), and uncertainty in unmanaged earnings (high vs. low). The performance manipulation was used to induce upward and downward earnings adjustments and therefore correlates highly with the direction of the earnings adjustment. 23