Earnings management and investor protection: an international comparison

http://public.kenan-flagler.unc.edu/faculty/bushmanr/bushman-smith.pdf

Financial accounting information and corporate governance

Deception is part of many economic interactions. Business people, politicians, diplomats, lawyers, and students in the experimental laboratory who make use of private information do not always do so honestly. This observation indicates that behavior often rejects the moral approach to deception. As St. Augustine wrote, “To me, however, it seems certain that every lie is a sin. . . ” (St. Augustine, 421). Later, philosophers like Immanuel Kant (1787) again adopted this uncompromising moral stance when arguing against lying. At the other extreme, economic theory is built on the assumption of “homo economicus,” a figure who acts selfishly and is unconcerned about the well-being of others. An implication of this assumption is that lies will be told whenever it is beneficial for the liar, regardless of their effect on the other party. Another implication is that there is no negative outcome associated with lying per se. This assumption is very useful in many economic models. Consider contract theory, where it is assumed that without an explicit contract, neither side will fulfill its respective obligations. For example, George Akerlof’s (1970) paper on asymmetric information and the market for lemons assumes that sellers of used cars will always lie if it is in their benefit to do so. In the mechanism design literature (e.g., Bengt Holmstrom, 1979), the standard assumption is that people will tell the truth only if this is incentive-compatible given material outcomes. In the literature on tax evasion, the choice of whether to avoid paying taxes is considered a decision under uncertainty; cost is treated as a product of the probability of being caught and the cost of punishment, whereas benefit is simply the money saved by avoiding payment. However, there is no cost associated with the very act of lying (Michael Alingham and Agnar Sandmo, 1972). Another example is the game theoretic treatment of “cheap talk” (Crawford and Joel Sobel, 1982). An intermediate approach is taken by utilitarian philosophers (e.g., Jeremy Bentham, 1789). Utilitarianism prescribes that, when choosing whether to lie, one should weigh benefits against harm, and happiness against unhappiness. As Martin Luther stated, “What harm would it do, if a man told a good strong lie for the sake of the good and for the Christian church. . . a lie out of necessity, a useful lie, a helpful lie, such lies would not be against God, he would accept them.” Similarly to the economic theory approach, this type of calculation implies that lies, apart from their resultant harm and benefit, are in themselves neutral. A lie and a truthful statement that achieve the same monetary payoffs (for both sides) are considered * Graduate School of Business, University of Chicago, 5807 South Woodlawn Avenue, Chicago, IL 60637 (e-mail: uri.gneezy.gsb.uchicago.edu). I thank Douglas Bernheim and two anonymous reviewers for insightful comments that considerably improved the paper. I also thank Andreas Blume, Gary Charness, Rachel Croson, Martin Dufwenberg, Georg Kirchsteiger, David Levine, Muriel Niederle, Yuval Rottenstreich, Maurice Schweitzer, Richard Thaler, George Wu, and seminar participants at numerous universities for their comments and suggestions. Ira Leybman provided valuable help in running the experiment. I became interested in deception when my father was terminally ill and his physicians created in him a belief that they considered to be untrue. I dedicate this paper to his memory. 1 Important deviations from this assumption in economic modeling are found in Kenneth Arrow’s (1972) discussion of trust, Gary Becker’s (1976) modeling of altruistic preferences, and Akerlof’s (1982) study of the fair-wage hypothesis. For a general discussion, see Becker (1993): “The economic approach I refer to does not assume that individuals are motivated solely by selfishness or material gain. It is a method of analysis, not an assumption about particular motivations. Along with others, I have tried to pry economists away from narrow assumptions about self-interest. Behavior is driven by a much richer set of values and preferences” (p. 385). 2 Note that this does not mean that a completely selfish person will always lie. There may be strategic reasons not to lie. For example, see the David Kreps and Robert Wilson (1982) discussion of reputation and imperfect information; see also Vincent P. Crawford (2003). 3 Cited by his secretary, in a letter in Max Lenz, ed., Briefwechsel Landgraf Phillips des Grossmuthigen von Hessen mit Bucer, Vol. 1.

Deception: The Role of Consequences

In this paper, I provide two theories about why management might withhold information which is not proprietary, together with an analysis of the consequences of altering various assumptions underlying these theories. Proprietary information is considered here as any information whose disclosure potentially alters a firm's future earnings gross of senior management's compensation.' Even if a manager's private information is proprietary, shareholders may benefit occasionally from having this information disclosed (see Verrecchia [1983] and Dye [1984a]), although obvious explanations exist for the rarity of such disclosures. However, it is commonly believed that managers possess information about the firms they run, such as annual earnings' forecasts, whose release would affect the prices of their firms, but not the distribution of their firms' future

Disclosure of Nonproprietary Information

We define higher audit quality as greater assurance of high financial reporting quality. Researchers use many proxies for audit quality, with little guidance on choosing among them. We provide a framework for systematically evaluating their unique strengths and weaknesses. Because it is inextricably intertwined with financial reporting quality, audit quality also depends on firms’ innate characteristics and financial reporting systems. Our review of the models commonly used to disentangle these constructs suggests the need for better conceptual guidance. Finally, we urge more research on the role of auditor and client competency in driving audit quality.

A Review of Archival Auditing Research

Employees often acquire local (private) information in the process of discharging their delegated duties. An informational asymmetry exists whenever information is known to employees but not to the firm's owners. Informational asymmetries can create a control problem for the owners if the employees use private information to make decisions consistent with their own self-interests but not consistent with the interests of the owners. The owners may try to reduce this control problem by installing management control systems which mitigate this asymmetry. One such particular procedure is participative budgeting, wherein an employee (who possesses private information) communicates some or all of this information to a superior who, in turn, uses this information in setting the budget (and associated performance standards) by which that employee is evaluated. Controversy currently exists about whether such communication is strictly valuable. In this study, I develop reasonable conditions under which communication can be strictly valuable in an economic organization. The development is provided in section 3. A related and even more fundamental economic controversy is the issue of whether strict gains can occur when asymmetries are intentionally created in economic organizations. In managerial accounting, such an event would correspond to providing an employee private access to a

Asymmetry of Pre-Decision Information and Managerial Accounting

We use a linear contracting framework to study how the relation between performance measures used in an agent's incentive contract and the agent's private predecision information affects the value of delegating decision rights to the agent. The analysis relies on the idea that available performance measures are often imperfect representations of the economic consequences of managerial actions and decisions, and this, along with gaming possibilities provided to the agent by access to private predecision information, may overwhelm any benefits associated with delegation. Our analytical framework allows us to derive intuitive conditions under which delegation does and does not have value, and to provide new insights into the linkage between imperfections in performance measurement and agency costs.

Private Predecision Information, Performance Measure Congruity, and the Value of Delegation*

Accounting Choices: Public Versus Private Firms

Accounting, Principal-Agent Theory, and Self-Interested Behavior

The audited estimates of future events in financial reports contain uncertainty which is partly subject to managerial discretion. However, because firms do not routinely report the precision of their estimates (nor, for that matter, do they currently have a credible means of doing so), outside parties may be unsure about how the estimates should be interpreted. 1 This paper models a scenario in which management privately commits to a precision level at the beginning of the reporting period, immediately after the realization of a public signal which is informative about the firm's market value. For any given level of precision, the financial

Mark Penno

Papers

Asymmetry of Pre-Decision Information and Managerial Accounting

Private Predecision Information, Performance Measure Congruity, and the Value of Delegation*

Accounting Choices: Public Versus Private Firms

Accounting, Principal-Agent Theory, and Self-Interested Behavior

Unobservable Precision Choices in Financial Reporting