Empirical Tests of Budget Ratcheting and its Effect on Managers' Discretionary Accrual Choices

Posted: 22 Oct 2001

See all articles by Andrew J. Leone

Andrew J. Leone

University of Miami

Steve Rock

University of Colorado at Boulder - Department of Accounting

Multiple version iconThere are 2 versions of this paper

Abstract

In this paper, we investigate whether budgets ratchet. Using business-unit data from a large multinational corporation, we find evidence consistent with ratcheting where favorable budget variances result in performance budget increases that are larger than decreases associated with unfavorable variances of the same magnitude. We argue that under ratcheting, the cost of reporting positive transitory earnings surprises outweigh the short-term benefits of the current-period bonus. Consequently, we hypothesize that managers make income-decreasing discretionary accruals to offset transitory earnings surprises beyond the level expected under fixed budgets. Using a proxy for transitory earnings surprise, we find evidence consistent with this hypothesis.

Keywords: Performance budgets; Ratchet principle; Ratchet effect; Bonus plans; Earnings management

JEL Classification: M40, M43, M46, J33

Suggested Citation

Leone, Andrew J. and Rock, Steven Karl, Empirical Tests of Budget Ratcheting and its Effect on Managers' Discretionary Accrual Choices. Journal of Accounting & Economics, Vol. 33, No. 1, February 2002. Available at SSRN: https://ssrn.com/abstract=283777

Andrew J. Leone (Contact Author)

University of Miami ( email )

School of Business
Coral Gables, FL 33146
United States
305-284-3101 (Phone)

HOME PAGE: http://sbaleone.bus.miami.edu

Steven Karl Rock

University of Colorado at Boulder - Department of Accounting ( email )

419 UCB
Boulder, CO 80309-0419
United States
303-735-5009 (Phone)
303-492-5962 (Fax)

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