Gaap Consistency Requirements, Reporting Discretion and Private Information Communication Through Earnings
Posted: 4 Aug 1997
Date Written: June 1997
This paper examines the role of GAAP in the communication of private information through earnings. GAAP allows managerial discretion in accounting choice subject to certain restrictions. Accordingly, we address two related questions: (1) Does reporting discretion improve or impair the communication of value relevant information to the market through earnings? (2) What is the effect of GAAP restrictions, in particular the consistency requirement, on earnings management and the information content of earnings?We analyze a two period model of pure exchange, where a risk averse market maker prices a firm based on mandatory earnings reports released by a risk averse manager at the end of each period. The manager privately observes the "true" earnings realization each period and a signal regarding future earnings in the first period. The managers' compensation depends on both reported earnings and stock price and she is allowed to manage (bias) her earnings report subject to the GAAP consistence constraint, which mandates that a specified proportion of the bias be reversed in the next period.When the proportion of reversal exceeds some threshold, the GAAP constraint becomes binding and results in an interior solution to the manger's problem: we call this the "Discretion with GAAP" regime. In this regime, the manager incorporates her estimate of future earnings in her earnings report. As a consequence, reported earnings is more informative than "true" earnings and thus the market attaches a higher weight to reported earnings than in a truth-telling equilibrium. When the reversal proportion is below the threshold the GAAP constraint is non-binding; we call this the "Discretion without GAAP" regime. In this regime the earnings report is uninformative for vuluation purposes.Our results reveal that reporting discretion is not necessarily detrimental to the information content of earnings, nor is it unequivocally superior to a regime that prohibits discretion. However, a regime that allows limited discretion is superior to ones that force truthful reporting or allow unrestricted discretion. Therefore, our results highlight the importance of BOTH allowing discretion and restricting the allowed discretion via formal mechanisms to improve the information content of earnings -- if no discretion is allowed the manger is unable to communicate additional private information and if too much discretion is allowed the manager biases earnings to the point of rendering it uninformative.
JEL Classification: M41, M44, K22, D82
Suggested Citation: Suggested Citation