Do Shareholders Assess Managers’ Use of Accruals to Manage Earnings as a Negative Signal of Trustworthiness Even When its Outcome Serves Shareholders’ Interests?

54 Pages Posted: 6 Apr 2013 Last revised: 27 Feb 2019

See all articles by Max Hewitt

Max Hewitt

University of Arizona - Eller College of Management

Frank D. Hodge

University of Washington - Michael G. Foster School of Business

Jamie H. Pratt

Indiana University - Kelley School of Business - Department of Accounting

Date Written: February 23, 2019

Abstract

Using a controlled experiment, we examine how shareholders’ trust in managers is influenced by the interaction of (1) the outcome of earnings management (i.e., inconsistent or consistent with shareholders’ interests), and (2) the method of earnings management (i.e., accruals or real methods). We predict and find that the method of earnings management only affects trust—and ultimately investment decisions—when the outcome of earnings management is consistent with shareholders’ interests. In this situation, we predict that managers’ use of accruals—relative to real methods—to manage earnings is more likely to impair trust because it involves dishonest reporting. Our findings are consistent with this explanation and are opposite to the effect of the method of earnings management on cash flows in our setting. Conversely, we find that trust and cash flows are both adversely affected when the outcome of earnings management is inconsistent with shareholders’ interests. Our study contributes to the literature by highlighting when the method of earnings management provides shareholders with a distinct signal concerning managers’ trustworthiness.

Keywords: earnings management; accruals vs. real methods; trust; investment decisions

JEL Classification: M41, M52

Suggested Citation

Hewitt, Max and Hodge, Frank Douglas and Pratt, James H., Do Shareholders Assess Managers’ Use of Accruals to Manage Earnings as a Negative Signal of Trustworthiness Even When its Outcome Serves Shareholders’ Interests? (February 23, 2019). Available at SSRN: https://ssrn.com/abstract=2245204 or http://dx.doi.org/10.2139/ssrn.2245204

Max Hewitt

University of Arizona - Eller College of Management ( email )

School of Accountancy
1130 E. Helen Street
Tucson, AZ 85721
United States
(520) 621-4805 (Phone)

Frank Douglas Hodge (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Paccar Hall 540, Box 353200
Seattle, WA 98195-3200
United States
206-616-8598 (Phone)
206-685-9392 (Fax)

James H. Pratt

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States
812-855-2657 (Phone)
812-855-8679 (Fax)

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