Abstract
We argue that managers’ choice to manage earnings depends on the trade-off in the present value of expected future net benefits associated with that choice. Specifically, we examine if discount rates are associated with the likelihood that managers engage in earnings management to meet or beat various earnings targets. We find that discount rates are positively associated with income-increasing earnings management. This means that managers increase both accrual-based and real earnings management when discount rates are higher. However, the economic magnitude of this association is relatively moderate.
1. Introduction
This paper examines whether managers’ decisions to engage in income-increasing earnings management are sensitive to discount rates. Rational managers are expected to pursue and favor strategies that maximize their own gains, even at the expense of other stakeholders (Jensen & Meckling, 1976). Financial reporting provides one way to serve self-interests, particularly when information asymmetry exists between users and providers of the reports. Managers can take accounting or real economic actions to manage short-term performance and, consequently, serve self-interests e.g. by triggering earnings-based performance compensation (Gaver, Gaver, & Austin, 1995; Healy, 1985; Holthausen, Larcker, & Sloan, 1995; Watts & Zimmerman, 1986) to meet capital market expectations (Eames, 1998) or prior to IPOs (Teoh, Welch, & Wong, 1998).
8. Conclusion
We examine the association between discount rates and income-increasing earnings management. We expect that higher discount rates reduce the present value of managing earnings less than the present value of not managing earnings. Consequently, this increases the likelihood of earnings management either through accruals or real operating activities. In certain incentive settings, we find positive and significant associations between the proxy for managers’ discount rates and income-increasing earnings management. The increase in earnings management is prevalent both for accrual-based earnings management and real earnings management. Specifically, our estimations suggest that a one percentage-point increase in the discount rate is associated with an economically moderate increase of about 0.14 percentage-points of total assets through accrual-based earnings management and 0.23 percentage-points of total assets through real earnings management.
