• Selected
• Entire List

Abstract:
Prior research indicates that greater transparency in reporting formats facilitates the detection of earnings management. The current study hypothesizes and demonstrates that greater transparency in comprehensive income reporting also reduces the likelihood that managers will engage in earnings management in the area of increased transparency. In our experiment, 62 financial executives and chief executive officers decide which available-for-sale security to sell from a portfolio. We manipulate the transparency of comprehensive income reporting and the relationship of projected earnings to the consensus forecast in a 2 x 2 between-subjects design. When projected earnings are below (above) the consensus forecast, participants sell securities that increase (decrease) earnings. However, the rarely-used, more transparent format for reporting comprehensive income significantly reduces both income increasing and income decreasing earnings management. Participants in the less transparent setting indicate that earnings management attempts will not be obvious to readers, will improve stock prices, and have no effect on management's reputation for reporting integrity. Conversely, respondents in the more transparent condition suggest that earnings management will be obvious to readers, harmful to stock prices, and damaging to reporting reputation. Results of this study suggest that more transparent reporting requirements will reduce earnings management in the area of increased transparency or change the focus of earnings management to less visible methods.

financial reporting, transparency, earnings management, comprehensive income, SFAS 130

Abstract:
Prior research indicates that greater transparency in reporting formats facilitates the detection of earnings management (EM). The current study investigates whether greater transparency also reduces EM attempts. In our experiment, 62 financial executives and chief executive officers decide which available-for-sale security to sell from a portfolio. We manipulate the transparency of comprehensive income reporting and the relationship of projected earnings to the consensus forecast in a 2 x 2 between-subjects design. When projected earnings are below (above) the consensus forecast, participants sell securities that increase (decrease) earnings. However, the rarely-used, more transparent format for reporting comprehensive income dramatically reduces both income increasing and income decreasing EM. Participants indicate they believe EM in the less transparent setting will improve stock price and have no effect on their reputation for reporting integrity, whereas EM in the more transparent setting will damage both. Results of this study suggest that more transparent reporting requirements will reduce EM attempts or change the focus of EM attempts to less visible methods.

reporting transparency, earnings management, comprehensive income, SFAS 130

Abstract:
This paper uses recent experimental studies of financial accounting to illustrate our view of how such experiments can be conducted successfully. Rather than provide an exhaustive review of the literature, we focus on how particular examples illustrate successful use of experiments to determine how, when and (ultimately) why important features of financial accounting settings influence behavior. We first describe how changes in views of market efficiency, reliance on the experimentalist?s comparative advantage, new theories, and a focus on key institutional features have allowed researchers to overcome the criticisms of earlier financial accounting experiments. We then describe how specific streams of experimental financial accounting research have addressed questions about financial communication between managers, auditors, information intermediaries, and investors, and indicate how future research can extend those streams. We focus particularly on (1) how managers and auditors report information, (2) how users of financial information interpret those reports, (3) how individual decisions affect market behavior, and (4) how strategic interactions between information reporters and users can affect market outcomes. Our examples include and integrate experiments that fall into both the "behavioral" and "experimental economics" literatures in accounting. Finally, we discuss how experiments can be designed to be both effective and efficient.

Abstract:
This paper reports results of two experiments aimed at (1) assessing whether companies are less willing to record immaterial income decreasing audit differences when the adjustment causes the company to report earnings below the consensus analyst forecast and (2) determining whether implementation of proposed auditing standards aimed at this phenomenon will affect the willingness to record such audit differences. In the experiments, Big Five audit managers estimated the portion of an immaterial audit difference a client would choose to record in various circumstances. Our managers expected their clients not to record immaterial audit differences when such differences caused them to report earnings below the consensus forecast. This behavior was expected to be particularly prevalent when the misstatement amount was less objectively determined. Our results also suggest that the proposed auditing standards will be only minimally effective in promoting the recording of immaterial audit differences in general, and ineffective in reducing the use of unrecorded audit differences to meet the forecast. Even when the related error was objectively determined and the proposed auditing standards were in effect, no more than 30% of clients were expected to book an adjustment that would cause them to miss the forecast.

Abstract:
We review recent behavioral studies of the effects of regulation on earnings management and accounting choice. Our review examines the impact of financial reporting, auditing, and other corporate governance regulations on the beliefs and choices of managers, auditors and corporate directors. Behavioral studies contribute to the broader literature by shedding light on potential unintended consequences and overall efficacy of proposed regulations, revealing the roles of specific actors and the motives behind reporting choices, and demonstrating what determines managers' preferences for different earnings management methods (both real and accruals based). We also discuss areas that have received less attention that provide promising avenues for future behavioral research involving regulation, earnings management, and accounting choice.

earnings management, accounting choice, financial reporting, regulation, corporate governance, auditing

Abstract:
We review recent behavioral studies of the effects of regulation on earnings management and accounting choice. Our review examines the impact of financial reporting, auditing, and other corporate governance regulations on the beliefs and choices of managers, auditors, and corporate directors. Behavioral studies contribute to the broader literature by shedding light on potential unintended consequences and overall efficacy of proposed regulations, revealing the roles of specific actors and the motives behind reporting choices, and demonstrating what determines managers' preferences for different earnings management methods (both real and accruals based). We also discuss areas that have received less attention that provide promising avenues for future behavioral research involving regulation, earnings management, and accounting choice.

earnings management, accounting choice, financial reporting, regulation, corporate governance, auditing

Abstract:
Recent research indicates that managers minimize the probability of a negative earnings surprise at the actual earnings announcement date, in part, by issuing earnings preannouncements that understate positive earnings news and overstate negative news. However, there is little evidence of the effects of this strategy on actions by investors and their agents. We conduct an experiment to investigate experienced analysts' reactions to preannouncements that either understate, accurately state, or overstate the magnitude of either positive or negative earnings news. As predicted, firms with positive total news receive the highest revised forecasts of future earnings when the preannouncement understates the magnitude of the positive news. Negative total news firms receive the highest revised forecasts when the preannouncement overstates the magnitude of the negative news. This suggests a possible benefit to preannouncement strategies that avoid negative actual earnings surprises, holding constant the total earnings surprise. Our results also provide insights into analysts' beliefs about the preannouncing firms that employ these strategies.

Abstract:
This paper shows that whether laboratory markets over- or under-react to information is influenced by two factors: the reliability of investors' information and the portfolio formation rule used to identify price anomalies. Consistent with research in psychology, prices tend to over-react to unreliable information and under-react to highly reliable information, because investors' confidence in their information is moderated toward a central level. Forming portfolios on the basis of price changes tends to yield larger apparent overreactions than forming portfolios on the basis of information that is independent of market price, because market prices include mean-reverting random errors (in addition to systematic price errors due to moderated confidence). These results can help empirical researchers develop specific alternative hypotheses to market efficiency, by helping them predict ex ante whether a given research study is likely to reveal over- or underreactions.

Abstract:
This paper uses a laboratory experiment to show that investors systematically over-rely on firms' previous performance levels: when previous performance is high (low), prices are too high (low). This error creates two types of anomalies. Too much reliance on previous levels gives the appearance that investors under-react to changes in performance from that level. Prices therefore remain too low (high) after large increases (decreases) in performance, similar to the post-earnings-announcement drift anomaly. Too much reliance on previous levels also gives the appearance that investors overestimate the degree to which extreme performance in prior periods leads to extreme performance in the target period. Prices therefore remain too high (low) after persistently strong (weak) performance, similar to the long-term over-reaction anomaly. The results therefore suggest that these two anomalies may be caused by a single behavioral effect.

Abstract:
We examine whether managers behave myopically in response to increased capital market pressures and whether the prevalence of myopia is affected by a change from semiannual to quarterly external reporting. In our experiments, experienced financial managers choose between projects where a conflict exists between near-term earnings and total cash flow. In response to a pending stock issuance, they choose projects that they believe will maximize short-term earnings (and price) as opposed to total cash flows. However, counter to common arguments in past and recent debates over mandatory disclosure frequency, the myopic behavior is increased or reduced by increasing the frequency of required disclosure, depending on the earnings patterns of the projects involved and whether the firm is likely to issue stock. Our study provides insights into managers' beliefs about stock market pressures, mandatory reporting, and the availability of alternative communications channels, and contributes to literature on managerial myopia and earnings management, as well as current debates over disclosure frequency.

managerial myopia, financial reporting, disclosure frequency, experimental studies

Abstract:
In response to recommendations by the AICPA Special Committee on Financial Reporting and the Association for Investment Management and Research, the FASB has recently invited comment regarding the question ?Given [efficient] markets, would any disservice be done to the interests of individual investors by allowing professional investors access to more extensive information?? (AICPA, 1996, p 22). Research in psychology (e.g., Griffin & Tversky, 1992) suggests that less-informed investors may suffer from overconfidence and trade too aggressively given their information. This paper reports two experiments designed to address these issues. In both experiments, security values are determined by the price/book ratios of actual firms, ?more-informed? investors observe three value-relevant financial ratios derived from Value-Line reports, and ?less-informed? investors observe only one of those signals. Experiment 1 provides evidence from a pencil-and-paper task that less-informed investors are overconfident relative to their more-informed counterparts, and that this relative overconfidence is reduced by alerting investors to the extent of their informational disadvantage. Trading behavior follows the same pattern as confidence assessments. Experiment 2 provides evidence from laboratory markets that, even after market prices have stabilized after many rounds of trading, less-informed investors systematically transfer wealth to more-informed investors as a result of biased prices and overly aggressive trading, but that alerting less-informed investors to the extent of their informational disadvantage eliminates these welfare losses. The results of both experiments thus suggest that providing information to only professional investors could harm the welfare of less-informed investors if less-informed investors are not aware of the extent of their informational disadvantage.

Abstract:
We examine whether information in footnotes might lack reliability because auditors permit more misstatement in disclosed as opposed to recognized amounts. In both a stock-compensation and leasing setting, audit partners require greater correction of misstatements in recognized amounts than in equivalent disclosed amounts. Debriefing questions indicate that the partners make these decisions knowingly, even though they face greater client resistance to correcting recognized amounts, because they view recognized amounts as more material. Partners also spend more time on correction decisions for recognized information. While prior literature suggests that amounts are often relegated to footnotes because they are less reliable, our results suggest that the actual choice to disclose versus recognize can also reduce information reliability. These results have implications for the interpretation of prior research on the reliability of recognized and disclosed numbers, for financial-accounting standard setters who may want to consider the reliability effects of their recognition versus disclosure decisions, and for auditing standard setters who may wish to clarify auditors' responsibilities for preventing misstatements in disclosed amounts.

recognition, disclosure, reliability, stock options, leases, auditing

Abstract:
We conduct two experiments which demonstrate that the effect of earnings preannouncement bias on analyst forecasts depends on the form of the preannouncement and that the effect of preannouncement form does not become evident until the release of the actual earnings announcement. Preannouncement form (point, narrow range, wide range) has no effect on forecasts made immediately after the preannouncement. However, after the actual earnings announcement, the effect of preannouncement bias on analysts' reforecasts is magnified by a narrow range and reduced by a wide range, compared to a point estimate. These results suggest that treating range preannouncements and forecasts as equivalent to point estimates equal to the mean of the range, assuming that ranges of varying widths will trigger similar responses, and failing to consider behavioral effects after the release of actual earnings may paint an incomplete picture of how preannouncements and other forecasts affect analysts and investors.

preannouncements, earnings guidance, management forecasts, point estimate, range estimate, analyst forecasts

Abstract:
We examine whether analysts' incentives to maintain good relationships with management contribute to the optimistic/pessimistic within-period time trend in analysts' forecasts, controlling for management guidance, access to information, forecast revision likelihood, prior accuracy, experience, employer size, and other potential omitted variables. In our experiments, 81 experienced sell-side analysts from two brokerage firms predict earnings based on historical information and management guidance. Analysts' forecasts exhibit an optimistic/pessimistic pattern across the two timing conditions (early and late in the quarter), and the effect is significantly stronger when the analysts have a good relationship with management than when their only incentive is to be accurate. Debriefing results indicate that analysts are aware of this pattern of forecasts, and believe that this benefits their future relationships with management and with brokerage clients. The analysts most frequently cite favored conference call participation and information access when describing benefits from maintaining good relationships with management. Our results suggest that the optimistic/pessimistic pattern in forecasts is in part a conscious response to relationship incentives, that information access is perceived to be a major benefit of management relationships, and that recent regulatory changes may have lessened but have not eliminated this conflict of interests source.

Financial Analysts, Earnings Forecasts, Optimistic, Pessimistic, Forecast Bias

Abstract:
Prior research indicates that analysts do not fully adjust for the general downward bias in earnings guidance issued by management. We report the results of two experiments designed to investigate how guidance track record and analysts' incentives jointly explain the extent to which analysts adjust for guidance bias. Our results suggest that analysts with accuracy incentives adjust for management's track record of downwardly-biased guidance when the bias is relatively small (one cent), but those with relationship incentives do not. Furthermore, the difference in adjustment is larger when the bias track record is inconsistent than when it is consistent. Also, when guidance bias is larger (two cents) relative to smaller (one cent), analysts with relationship incentives partially adjust, as they appear to strike a balance between accuracy and their desire to please management. These findings hold implications for investors, regulators, and the interpretation of prior research.

management earnings guidance, track record, incentives, analyst forecasts

Abstract:
Prior research indicates that analysts do not fully adjust for the general downward bias in earnings guidance issued by management. We report the results of three experiments designed to investigate how cognitive factors, incentive effects and their interaction help to explain this phenomenon. Our results suggest that analysts do not adjust for the general tendency of companies to issue downwardly-biased guidance, but they do adjust after they learn about a firm's specific bias pattern over time. The degree of adjustment, however, depends on the interactive effects of analysts' incentives, and the consistency and magnitude of bias revealed by a company's guidance track record. Analysts with accuracy incentives adjust for management's track record of downwardly-biased guidance, but those with relationship incentives do not. Furthermore, the difference in adjustment between analysts with relationship and accuracy incentives is larger when the bias track record is inconsistent than when it is consistent. Also, when guidance bias is larger (two cents) relative to smaller (one cent), analysts with relationship incentives only partially adjust, as they appear to strike a balance between accuracy and their desire to please management. These findings have implications for investors, regulators, and the interpretation of prior research.

management earnings guidance, track record, incentives, analyst forecasts

Abstract:
In this paper we examine whether firms exhibit patterns in managerial guidance properties that are consistent with learning and whether market reactions to guidance change in recognition of learning by firms. We conduct analyses of (1) differences in guidance properties and market response across frequent and occasional guiders (using the full sample and a matched sample) and (2) the evolution of guidance properties and reactions to guidance over time for frequent guiders. We find that frequent guiders are less optimistically biased, more accurate, and issue guidance with a tighter range earlier in the period. They also issue guidance that conveys good news while occasional guiders are more likely to convey bad news. Analysts and markets react more to guidance by experienced guiders, after controlling for the amount of news, suggestive of a premium for guidance experience. This differential reaction is asymmetric, with the experience premium being greater for bad news as compared with good news. The same general pattern of results is in evidence when we compare guidance properties and market reactions over time for the frequent guiders. This ensures that at least some of the documented cross-sectional differences are the result of learning.

management earnings forecasts, earnings guidance, learning, guidance frequency

Abstract:
We examine whether information in footnotes might lack reliability because auditors permit more misstatement in disclosed as opposed to recognized amounts. In both stock-compensation and lease settings, audit partners require greater correction of misstatements in recognized amounts than in equivalent disclosed amounts. Debriefing questions indicate that the partners make these decisions knowingly, even though they expect greater client resistance to correcting recognized amounts, because they view recognized amounts as more material. Partners also spend more time on correction decisions for recognized information. While prior literature suggests that amounts are often relegated to footnotes because they are less reliable, our results suggest that the actual choice to disclose versus recognize can also reduce information reliability. These results have implications for the interpretation of prior research on the reliability of recognized and disclosed numbers, for financial-accounting standard setters who may want to consider the reliability effects of their recognition versus disclosure decisions, and for auditing standard setters who may wish to clarify auditors' responsibilities for preventing misstatements in disclosed amounts.

recognition, disclosure, reliability, auditing, audit adjustments, materiality, stock options, leases

Abstract:
This study examines how the form of managements' earnings guidance (point, narrow range, wide range) affects analysts' earnings forecasts. Results from two experiments demonstrate that: (1) guidance form has no effect on analysts' forecasts made immediately after the guidance; and (2) after the actual earnings announcement, guidance form and the relationship of the earnings guidance to actual earnings (guidance error) interact in their effect on analysts' forecasts. After the actual earnings announcement, guidance error leads to higher (lower) analysts' forecasts for firms with downwardly (upwardly) biased guidance; this effect of guidance error is magnified by a narrow range and reduced by a wide range, compared to a point estimate. These results suggest that treating the mean of the range endpoints as equivalent to a point estimate and failing to consider effects after the release of actual earnings may paint an incomplete picture of how management guidance affects analysts and investors. It also offers useful information to managers who issue earnings guidance, and presents a challenge to the psychology literature regarding the effects of information precision on judgment and decision making.

preannouncements, earnings guidance, management forecasts, point estimate, range estimate, analyst forecasts

Abstract:
We investigate analysts? reactions to qualitative warnings of adverse earnings, and attempt to reconcile analysts? more negative forecast revisions, as documented in previous research, and the apparently conflicting anecdotal evidence that suggests more positive responses to firms that warn. We conjecture that the inconsistency arises because warnings cause analysts to revise their earnings forecasts sequentially in response to two related signals (the warning and the earnings announcement). However, their responses to retrospective questions about the effects of warnings are the result of a simultaneous response to both signals. In our experiment, 28 financial analysts predicted future years? earnings in one of three conditions. Consistent with the anecdotal evidence suggesting that analysts evaluate warnings positively, analysts who simultaneously evaluated a warning and a later earnings announcement (the Simultaneous warning condition) forecasted higher future earnings than analysts who received no warning (the No Warning condition). However, analysts who first revised their forecasts based on the warning and then made a second revision based on the later earnings announcement (our Sequential warning condition) forecasted much lower future earnings than those in the Simultaneous warning condition, and slightly lower future earnings than in the No warning condition. This suggests that the act of sequential processing contributes to analysts more negative forecasts documented in previous archival research. Taken together, these results suggest that the positive impact of analysts' stated beliefs about firms that warn (as reflected in their responses to reporters? retrospective questions) are more than offset by the effects of sequentially processing a warning followed by an earnings announcement.

Abstract:
Prior research provides evidence that auditors encounter difficulty in applying the error frequencies they have experienced to judgments of the probability that an audit objective is violated given a particular transaction cycle. This may occur because of a mismatch between the organization of the judgment task (in which transaction cycle is the more important organizing dimension) and the organization of auditors' knowledge (in which audit objective is the more important organizing dimension). We performed an experiment to test the effectiveness of two decision aids in counteracting this difficulty: (1) a checklist-style decision aid which facilitates knowledge retrieval and (2) a decomposition-and-mechanical-aggregation decision aid which facilitates both knowledge retrieval and aggregation. Our results indicate that the checklist aid improved the degree to which auditors' judgments reflected their experienced frequencies to a small degree, but that the mechanical-aggregation aid improved auditors' judgments to a great extent, completely counteracting the effect of the mismatch in dimension importance between task organization and knowledge organization.