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

Posted: 23 Feb 2020

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

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Date Written: January 28, 2020

Abstract

We examine how shareholders’ trust in managers is affected by the outcome of earnings management (inconsistent vs. consistent with shareholders’ interests) and the method of earnings management (accruals vs. real methods). Using a controlled experiment, we predict and find that trust is impaired when the outcome of earnings management suggests that managers have put their interests above shareholders’ interests and/or when the method of earnings management suggests that managers misreported the firm’s economic performance. We argue that shareholders assess managers putting their interests above shareholders’ interests as a signal of untrustworthiness because it involves a transfer of the firm’s resources away from shareholders to managers. We argue that shareholders also assess managers’ use of accruals to manage earnings as a signal of untrustworthiness because, in this instance, managers misreport the firm’s economic performance. Finally, we show that trust mediates the combined effects of the outcome of earnings management and the method of earnings management on investment decisions. Our study incrementally contributes to the literature by highlighting the adverse implications of managers’ use of accruals to manage earnings even when its outcome serves shareholders’ interests.

Keywords: earnings management, shareholders’ interests, accruals, trust, investment decisions

JEL Classification: M41

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? (January 28, 2020). Contemporary Accounting Research, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3535774

Max Hewitt (Contact Author)

University of Arizona - Eller College of Management ( email )

School of Accountancy
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United States
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Frank Douglas Hodge

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

Paccar Hall 540, Box 353200
Seattle, WA 98195-3200
United States
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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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