Asimultaneous examination of the effectes of reporting incentives of earning properties

A Simultaneous Examination of the Effects of Reporting Incentives on Earnings Properties Jana Raedy The University of North Carolina at Chapel Hill Wendy Wilson Southern Methodist University March 2012 Abstract This paper examines how multiple reporting incentives affect the ways that managers utilize discretion when reporting earnings In particular, this study directly addresses two financial reporting trade-offs that have received limited attention from the accounting literature: multiple reporting incentives and the endogenous determination of earnings characteristics Using a twostage least squares regression model, we provide a comprehensive analysis of the effects of reporting incentives arising from equity-based compensation, debtholders, equity stakeholders, tax, and labor unions on three different earnings characteristics in order to understand the implications of modeling determinants of accounting choice in a multi-incentive context We find that after considering the influence of multiple reporting incentives and the endogeneity inherent in the earnings process, the importance of individual reporting incentives varies considerably across different earnings characteristics, and is not always consistent with findings in prior literature JEL classification: M41 Keywords: reporting incentives; earnings management; discretionary accounting choices We thank Doug Hanna and seminar participants at Southern Methodist University for useful comments We also thank Mark Lang, Zining Li, Darius Miller, Karen Nelson, Tom Omer, Suzanne Paquette, Wayne Shaw, Greg Sommers, Johan Sulaeman, Michael Van Breda, Ram Venkataraman, and seminar participants at the 2009 Lone Star Accounting Conference for helpful comments on a previous version of this paper We thank Justin Hopkins for excellent research assistance I Introduction This paper examines how multiple reporting incentives affect characteristics of reported earnings in a simultaneous framework While there is a well-developed literature on the motivations for the use of accounting discretion, these studies primarily evaluate the relation between reporting incentives and properties of earnings by focusing on one incentive and one earnings property In their review of the accounting choice literature, Fields et al (2001) note that by concentrating on one incentive at a time, much of the literature misses the more interesting question of the interactions between, and trade-offs among, incentives (Fields et al 2001, 290) In this study, we draw on evidence from the literature on accounting choice that suggests that numerous reporting incentives affect characteristics of reported earnings simultaneously to provide a comprehensive analysis of how multiple incentives impact characteristics of reported earnings In general, papers analyzing the determinants of accounting choice focus on the relation between one incentive and one variable that measures a form of accounting discretion Under this approach, a conclusion is drawn that the incentive has an influence on the particular earnings characteristic if statistical significance between the two variables is found However, this empirical design can be problematic for two reasons First, it focuses on the effect of a single reporting incentive on reported earnings, which is not reasonable in the context of multiple reporting incentives Some studies (e.g., Beatty et al 2006) enhance the analysis of the primary incentive of interest by including control variables to account for one (or more) other plausible reporting incentives (i.e., those that could influence reported earnings in addition to the primary incentive) However, thorough consideration of the numerous incentives documented to affect characteristics of reported earnings has not been consistently applied in this area of research Consider research on incentives to report earnings that meet or beat analyst forecast targets as one example Evidence from this research shows that equity-based compensation incentives provide motivation for managers to report earnings that achieve forecast targets (Cheng and Warfield 2005, McVay et al 2006) In addition, evidence from studies in this area shows that managers have incentives to beat forecasts as a result of pressure from equity shareholders (Graham et al 2005), and that managers face disincentives to report earnings that achieve forecast targets when labor union demands are strong (Bova 2012) If the three incentives for reporting earnings that beat (or not beat) earnings forecasts are not modeled jointly, it is not clear which incentives dominate or whether a significant relation can be properly accredited to the modeled incentive(s) rather than to one(s) that is excluded from the model As Schipper and Vincent (2003) note, the existence of multiple, and often incongruent, incentives complicates interpretation of the results of research on accounting choice because it is not clear which incentives dominate The second reason the “one incentive to one earnings characteristic” research design is problematic is because it assumes that when managers have incentives to report earnings with a particular attribute other impending goals with respect to reported earnings are fixed However, this is not accurate when reporting one earnings characteristic affects the likelihood that a secondary earnings characteristic will be realized For example, evidence from the literature suggests that equity-based compensation incentives affect reporting earnings that achieve forecast targets (Cheng and Warfield 2005, McVay et al 2006) and reporting smooth earnings (Cheng and Warfield 2005) However, managers’ use of discretion to report earnings that beat the forecast target will also affect whether reported earnings are smooth Empirical models of the determinants of earnings characteristics that treat earnings properties as exogenous are misspecified if decisions with respect to accounting discretion contemporaneously affect reported earnings For the most part, accounting research has not made widespread attempts to address how firms use accounting discretion in the presence of multiple objectives and how endogenous earnings characteristics collectively affect properties of reported earnings To this point, Dechow et al (2010, 390) highlight the need for accounting research to consider these reporting trade-offs faced by managers by making a call for future research to (1) examine how managers choose between competing objectives and (2) examine choices about the portfolio of accounting policies, specifically within the context of meeting multiple objectives The most thorough studies of the impact of several reporting incentives on earnings have been conducted in restricted settings with specialized incentive structures.1 Beatty et al (1995) use data from commercial banks to investigate how firms manipulate various bank loan-related accounts in order to achieve regulatory capital, tax, and earnings objectives, and Hunt et al (1996) examine how firms use several inventory-related accruals to manage accounting under LIFO to meet conflicting tax and financial reporting objectives.2 While these studies reinforce the importance of considering the multiple reporting trade-offs faced by managers, inferences from these studies are not applicable to the broader settings most commonly examined by research on the effects of reporting incentives due to the lack of generalizability Based on the framework for the usefulness of accounting information provided by Fields et al (2001), we analyze the effects of five specific stakeholders that have vested interests in The joint effect of multiple incentives on managers’ decisions has also been the subject of research that is indirectly related to reported earnings For example, Collins et al (1997) examine the joint effects of tax, regulatory, and other incentives on capital gain realizations by life insurers Qiang (2007) examines the significance of multiple explanations for accounting conservatism, which is similar to the approach in our paper of considering the existence of multiple reporting incentives simultaneously However, Qiang (2007) does not incorporate the endogenous nature of the earnings process or other accounting properties beyond evidence of conservatism reported earnings: managers with equity-based compensation and debtholders (for contracting purposes), equity shareholders (for asset pricing purposes), and tax authorities and labor unions (to influence information prepared for external parties) We utilize a panel dataset of over 3,000 firm-year observations comprised of data from the years 2000 to 2008 to analyze the relation between variables representing these reporting incentives and three different earnings properties that exhibit evidence of discretionary reporting: (1) meeting or beating analysts’ forecasts, (2) reporting smooth earnings, and (3) timely recognition of losses Our analysis incorporates multiple conjectures with respect to how specific reporting incentives influence characteristics of reported earnings Empirically, we use two-stage least squares (2SLS) regression models to take into account the fact that accounting decisions interactively affect earnings characteristics We find that after considering the influence of multiple simultaneous reporting incentives and the endogeneity inherent in the earnings process, the importance of individual incentives varies considerably across different earnings characteristics The results indicate dominance of one reporting incentive over others with respect to achieving forecast targets and reporting smooth earnings In particular, the evidence shows that incentives from equity-based compensation are stronger than incentives from equity shareholders and labor effects when discretion is used to achieve analyst forecast targets In addition, the evidence shows that reporting incentives from equity shareholders have a significant effect on reporting smooth earnings relative to insignificant effects from equity-based compensation and labor union incentives Evidence from our test of the determinants of timely loss recognition reveals a different pattern in that we find that multiple stakeholder incentives have a significant influence In particular, we find that timely loss recognition is increasing in the importance of debtholders and labor unions, which is consistent with the contracting explanation for conservatism (Watts 2003) We conduct additional tests to gain an understanding of whether consideration of multiple incentives or endogeneity affects the inferences from our analyses When the endogenous nature of the earnings process is relaxed and the earnings characteristics of achieving forecast targets and reporting smooth earnings are modeled in an OLS (or logit, in the case of forecast targets) regression on multiple incentives, we find significance for additional reporting incentives These results are notable because individual incentives that have been found to be significant determinants of earnings characteristics in one-to-one analyses (e.g., labor union incentives affect the propensity of managers to report earnings that achieve forecast targets) are not found to have a significant effect once we control for the endogeneity of the earnings characteristics Our paper makes several contributions to the literature on incentives for accounting choice First, our study makes a comprehensive attempt to understand how managers balance financial reporting trade-offs in the presence of multiple incentives We find that taking account of multiple reporting motivations, as well as the endogenous nature of the earnings process, leads to different inferences than have been obtained in prior research when the reporting trade-offs faced by managers have been not been modeled comprehensively Understanding management’s incentives is important in understanding the ways in which managers choose to engage in earnings management (Dechow and Skinner, 2000), and our consideration of the effects of multiple motivations in a simultaneous framework fills a noted gap in the literature (Fields et al 2001, Dechow et al 2010) Second, results from our study provide implications for related research on incentives for earnings management Evidence from this study demonstrates that consideration of multiple incentives in a simultaneous framework has implications for understanding the significance of determinants of earnings characteristics that are indicative of accounting discretion Collectively, the results from this study show that without studying the comprehensive effects of multiple reporting incentives shown to be significant by existing research, our understanding of the significance of incentives for reporting earnings with particular earnings properties, and thus the potentially conflicting trade-offs involved in discussions related to earnings management, remains incomplete The rest of the paper proceeds as follows The next section develops the background for the reporting incentives and earnings properties we use in the paper, and the third section presents the research design The fourth section discusses the data and sample, the fifth section presents the results and the final section concludes II Reporting Incentives and Earnings Properties Our study is based on the premise that multiple reporting incentives influence management’s use of discretionary accounting choices Therefore, we identify variables that represent incentives that are likely to influence managers in their financial reporting choices as well as variables that represent various earnings properties Because a large number of variables fall within the broad categories of ‘reporting incentives’ and ‘earnings properties’, we reference comprehensive review papers on accounting choice and earnings quality for assistance in identifying the particular measures that are best-suited for our analysis We derive our categorization of reporting incentives from Fields et al (2001), where the determinants of accounting choice arise from the effects of reported earnings on (1) contracts, (2) asset prices, and (3) information prepared for external parties As described in their review paper, Fields et al (2001) note that in the absence of complete and perfect markets (Modigliani and Miller 1958) accounting choices have decision-making usefulness for information users, which results in accounting information being useful for contracting purposes (to overcome agency costs), for asset pricing (to overcome information asymmetries), and in order to influence external parties (by imposing positive externalities) Using these three determinants of accounting choice as a framework, Fields et al (2001) further identify specific stakeholders within each area to whom reporting incentives should matter Fields et al (2001) suggest that the reporting preferences of the following parties affect accounting choice: managers with equity-based compensation and debtholders (for contracting purposes), equity shareholders (for asset pricing purposes), and tax authorities and labor unions (to influence external parties) We incorporate these five stakeholder interests in our paper and examine whether their reporting incentives are determinants of the ways in which managers utilize discretion to report earnings.3 We derive our categorization of earnings properties from the proxies for earnings quality identified by Dechow et al (2010) in their review of the earnings quality literature Dechow et al (2010) summarize the large number of variables used in accounting research to represent the notion of earnings quality, which they admit is a somewhat elusively-defined construct that is not consistently applied in the literature As we are not interested in ‘earnings quality’ per se, but rather are focused on earnings outcomes that are more indicative of discretionary accounting Accounting information is also useful for regulatory purposes and evidence from accounting research shows that regulatory incentives influence discretionary accounting choice in specific contexts (e.g., Beatty et al 1995) We not incorporate regulatory incentives in our framework because the types of firms subject to regulatory scrutiny (e.g., financial services firms, banks, utilities) have been intentionally omitted from our sample because of their unique reporting incentives In addition, as noted by Armstrong et al (2010), it is likely that other groups have an interest in a firm’s financial reports beyond the five stakeholders that we consider in our paper (e.g., customers, suppliers, etc.) We incorporate these five stakeholders in order to follow the theoretical development of Fields et al (2001), for comparison with inferences from prior research, and because of data availability choices, we narrow the attributes identified by Dechow et al (2010) to three earnings properties that suggest the use of accounting discretion: meeting analysts’ forecasts, smooth earnings, and timely loss recognition.4 While no empirical proxy for discretion is perfect because management’s choices are not directly observed, each of these earnings characteristics represents a reporting outcome that incorporates management’s use of accounting judgment Our analysis incorporates the fact that managers are faced with two distinct trade-offs when reporting earnings First, trade-offs exist to the extent that multiple, and potentially conflicting, incentives simultaneously dictate preferences for different earnings characteristics Overall, managers must evaluate the importance of reporting to provide value to traditional investor stakeholders (e.g., equity investors, debtholders) relative to other investor stakeholders (e.g., managers with equity-based compensation) versus reporting to satisfy noninvesting stakeholders (e.g., labor union members, tax authorities) Considering the simple example of the incentives of two stakeholder parties (equity shareholders and labor union members), Tirole (2001) describes that when investors have greater influence managers place higher priority on emphasizing capital value, and when labor has greater influence managers place higher priority over employee welfare relative to equity value enhancement To the extent that reporting preferences of the two parties are different, managers face trade-offs in considering the dominance of one versus the other Incorporating the effects of more than two stakeholder groups further complicates consideration of trade-offs arising from incentives for financial reporting Another earnings quality measure identified by Dechow et al (2010) that is indicative of accounting discretion is discretionary accruals However, we not include the use of discretionary accruals as one of our earnings properties because the use of discretionary accruals is a mechanism by which managers achieve desired earnings outcomes as opposed to the earnings outcome itself Notwithstanding potentially conflicting incentives, trade-offs also exist when managers must evaluate how to use discretion from a technical perspective since achieving one earnings objective affects the ability to report earnings with an alternative desirable characteristic For example, due to the endogenous nature of the earnings process, it would likely be impossible for a manager to report smooth earnings, earnings which beat analysts’ forecasts, and earnings that incorporate losses on a timely basis at the same time When faced with the option of how to utilize accounting discretion, managers must prioritize the effect of such discretion on desirable earnings characteristics, knowing that the decision affects other earnings characteristics as well We describe the incentives for financial reporting that are expected to affect each earnings characteristic below In particular, we rely on predicted relations between incentives and earnings characteristics as prescribed by existing theory and/or evidence from empirical research A summary of the predictions is reported in Table 1.5 Forecast targets Accounting research interprets earnings that either just meet or exceed forecasted earnings by a small amount as potentially having been manipulated (Degeorge et al 1999) Matsumoto (2002), Ayers et al (2006) and Burgstahler and Eames (2006) provide evidence that firms utilize either earnings management, expectations management, or a combination of the two to meet or beat forecast targets While this evidence supports the idea that achieving forecast targets is a documented goal of financial reporting, several different motivations have been brought forth to explain target-achieving behavior We not make conjectures about the association between certain pairs of reporting incentives and earnings characteristics when there is a lack of support for a systematic relation from either theoretical or empirical research Thus, we directly examine fewer 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Effects of Reporting Incentives on Characteristics of Earnings _ Characteristics of Earnings Reporting Incentive Achieving Forecast Targets Smooth Earnings Equity-based compensation Increasing Increasing Increasing Debtholders Equity shareholders Increasing Increasing Increasing Increasing Taxes Labor Unions Timely Loss Recognition Decreasing Increasing 33 Increasing TABLE Sample Characteristics _ Panel A: Sample attrition # obs Compustat observations from 2000-2008 28,462 Observation not included because: Missing data necessary to calculate earnings characteristics (12,985) Missing data necessary to calculate reporting incentives (11,841) Missing data necessary to calculate control variables (277) Final Sample 3,359 Panel B: Number of observations by year Year # obs % obs 2000 2001 2002 2003 2004 2005 2006 2007 2008 44 281 251 307 368 435 545 610 518 1.31% 8.37% 7.47% 9.14% 10.96% 12.95% 16.23% 18.16% 15.42% Total 3,359 34 TABLE (continued) Sample Characteristics _ Panel C: Number of observations by industry Industry # obs % obs Mean LABOR Agriculture Arts, entertainment & recreation Durable goods manufacturing Educational services Healthcare & social assistance Information Management-related services Mining Nondurable goods manufacturing Other services Retail trade Scientific & technical services Transportation & warehousing Wholesale trade 143 1,262 15 66 235 84 198 550 10 327 181 145 140 0.09% 4.26% 37.57% 0.45% 1.96% 7.00% 2.50% 5.89% 16.37% 0.30% 9.74% 5.38% 4.31% 4.17% 0.006 0.042 0.045 0.168 0.173 0.011 0.102 0.012 0.048 0.023 0.050 0.011 0.117 0.029 Total 3,359 35 0.042 TABLE Descriptive Statistics _ Panel A: Variables used in regression analyses Variable Mean Median Q1 Q3 0.126 0.468 0.018 0.000 0.655 0.026 0.000 0.150 -0.011 0.000 0.894 0.065 0.259 0.069 0.591 0.204 0.042 0.194 0.020 0.618 0.299 0.022 0.099 0.000 0.458 0.026 0.008 0.367 0.115 0.754 0.350 0.055 1,829 1.113 0.043 0.054 0.157 211,096 0.711 9.385 0.530 1,205 1.093 0.000 0.063 0.000 35,852 0.727 8.000 0.386 523 1.010 0.000 0.026 0.000 6,056 0.600 5.000 0.230 3,240 1.190 0.000 0.107 0.000 256,634 0.833 13.00 0.672 Earnings Characteristics: POSFE CF_ACC C_SCORE Incentives: INCENT_RATIO DEBT EQUITY TAX LABOR Control variables: SIZE GROWTH LITRISK ROA LOSS SALES_VAR OUTSIDEPCT NUMEST FORDISP Variable definitions are provided in the appendix The number of firm-year observations for all variables is 3,359 36 TABLE (continued) Descriptive Statistics _ Panel B: Pearson Correlation Matrix of Incentive and Earnings Characteristics Variables INCENT_RATIO DEBT EQUITY INCENT_RATIO 1.00 DEBT -0.15 (.001) 1.00 EQUITY 0.13 (.001) -0.52 (.001) 1.00 TAX TAX 0.14 (.001) -0.05 (.01) 0.10 (.001) 1.00 LABOR POSFE CF_ACC C_SCORE Variable definitions are provided in the appendix The number of firm-year observations for all variables is 3,359 37 LABOR -0.06 (.001) 0.15 (.001) -0.19 (.001) 0.11 (.001) 1.00 POSFE 0.08 (.001) -0.05 (.01) 0.06 (.001) 04 (.02) -0.01 (.74) 1.00 CF_ACC 0.01 (.59) 0.09 (.001) -0.10 (.001) 12 (.001) 0.07 (.001) 0.03 (.06) 1.00 C_SCORE 0.36 (.001) -0.18 (.001) 0.43 (.001) 19 (.001) -0.13 (.001) 0.07 (.001) -0.00 (.98) 1.00 TABLE Determinants of Achieving Forecast Targets _ POSFE = a1 + a2 INCENT_RATIO + a3 EQUITY + a4 LABOR + a SIZE + a6 GROWTH + a7 LITRISK + a8 ROA + a9 LOSS + a10 NUMEST + a11 FORDISP + ∑ a FITTED_EARN_MEASURE + e Predicted sign Coefficient (p-value) Intercept ? 0.117 (0.435) INCENT_RATIO + 0.137*** (0.010) EQUITY + 0.073 (0.280) LABOR – -0.018 (0.449) SIZE + 0.000 (0.137) GROWTH + 0.078*** (0.016) LITRISK + -0.022 (0.511) ROA + 0.098 (0.377) LOSS – -0.029 (0.398) NUMEST + 0.001 (0.600) FORDISP – -0.180*** (0.001) Fitted earnings properties included R-squared N Yes 2.4% 3,359 All variables are defined in the appendix P-values for the reporting incentive variables are one-tailed and are twotailed for the control variables ***, **, * indicates significance at 0.01, 0.05, 0.10 levels, respectively 38 TABLE Determinants of Smooth Earnings _ CF_ACC = a1 + a2 INCENT_RATIO + a3 EQUITY + a4 LABOR + a5 SIZE + a6 GROWTH + a7ROA + 8 SALES_VAR + a9 OUTSIDEPCT + ∑ a FITTED_EARN_MEASURE + e Predicted sign Coefficient (p-value) Intercept ? -0.480 (0.110) INCENT_RATIO + 0.072 (0.316) EQUITY + 0.415* (0.071) LABOR + -0.690 (0.930) SIZE + 0.000*** (0.001) GROWTH + -0.048 (0.659) ROA + 0.820*** (0.006) SALES_VAR – -0.000*** (0.001) OUTSIDEPCT + 0.146 (0.369) Fitted earnings properties included R-squared N Yes 2.1% 3,359 All variables are defined in the appendix P-values for the reporting incentive variables are one-tailed and are twotailed for the control variables ***, **, * indicates significance at 0.01, 0.05, 0.10 levels, respectively 39 TABLE Determinants of Timely Loss Recognition _ C_SCORE = a1 + a2 DEBT + a3 EQUITY + a4 TAX + a LABOR + a6 SIZE + a7 GROWTH + 8 LITRISK + a9 ROA + a10OUTSIDEPCT + ∑ a FITTED_EARN_MEASURE + e Predicted sign Coefficient (p-value) Intercept ? -0.080*** (0.001) DEBT – -0.044*** (0.004) EQUITY – 0.085 (0.999) TAX – 0.013 (0.931) LABOR – -0.092*** (0.001) SIZE + 0.000*** (0.001) GROWTH + 0.004 (0.508) LITRISK – 0.003 (0.597) ROA – 0.095*** (0.001) OUTSIDEPCT – -0.000 (0.978) Fitted earnings properties included R-squared N Yes 23.2% 3,359 All variables are defined in the appendix P-values for the reporting incentive variables are one-tailed and two-tailed for the control variables ***, **, * indicates significance at 0.01, 0.05, 0.10 levels, respectively 40 TABLE Importance of Trade-offs: Simultaneity vs Endogeneity Predicted sign Our model Model with simultaneity only Model with endogeneity only Panel A: Achieving Forecast Targets INCENT_RATIO + 0.137*** (0.010) 0.836*** (0.001) 0.111*** (0.001) EQUITY + 0.073 (0.280) 0.469* (0.065) 0.145 (0.974) LABOR – -0.018 (0.449) -0.052 (0.481) 0.086 (0.761) INCENT_RATIO + 0.072 (0.316) 0.026 (0.274) -0.070 (0.731) EQUITY + 0.415* (0.071) -0.249 (0.999) 0.252 (0.113) LABOR + -0.690 (0.930) 0.238* (0.083) -0.459 (0.867) Panel B: Smooth Earnings Panel C: Timely Loss Recognition DEBT – -0.044*** (0.004) -0.069*** (0.001) -0.093*** (0.001) EQUITY – 0.085 (0.999) 0.106 (0.999) 0.096 (0.999) TAX – 0.013 (0.931) 0.010 (0.993) 0.025 (0.922) LABOR – -0.092*** (0.001) -0.096*** (0.001) -0.123*** (0.004) All variables are defined in the appendix Coefficients on the primary independent variables in each regression are reported with one-tailed p-values reported in parentheses below the coefficient The column labeled “Our model” refers to the regression coefficients from equation (results reported in tables 4, 5, and 6) that incorporate both endogeneity (2SLS research design) and simultaneity (multiple reporting incentives) The column labeled “Model with simultaneity only” refers to regression coefficients from an OLS (or logit) regression of each earnings measure on the relevant (multiple) reporting incentives plus control variables The column labeled “Model with endogeneity only” refers to regression coefficients from equation (2SLS), where each reporting incentive is modeled separately ***, **, * indicates significance at 0.01, 0.05, 0.10 levels, respectively 41 APPENDIX Variables Used in Regression Analyses _ Earnings properties: Variable POSFE CF_ACC C_SCORE Description (data sources) An indicator variable equal to one if the difference between actual earnings and the median analyst forecast, scaled by price, is between and 0.01 and zero otherwise (I/B/E/S, CRSP) The Pearson correlation between operating cash flows and operating accruals, both scaled by total assets and measured over a five-year rolling window (Compustat) The raw value of CF_ACC is multiplied by -1 so that a larger value of CF_ACC indicates smoother earnings The firm-year timely loss recognition coefficient calculated according to the methodology introduced by Khan and Watts (2009), which uses a modified version of the Basu (1997) model measured with cross-sectional estimation by year (Compustat, CRSP) The raw value of C_SCORE is multiplied by -1 so that a larger value of C_SCORE indicates less timely recognition of losses Reporting incentives: Variable INCENT_RATIO DEBT EQUITY TAX LABOR Description (data sources) The share of the CEO’s total compensation that would result from a onepercentage point increase in the equity value of the firm, based on the methodology outlined by Core and Guay (2002) (Execucomp, Compustat, CRSP) The ratio of the sum of notes and bonds payable to the sum of the book value of liabilities and the market value of shareholder’s equity (Compustat) The ratio of the market value of equity shares owned by outsiders (market value of equity * (1-insider percentage)) to the sum of the book value of liabilities and the market value of shareholder’s equity (Corporate Library, Compustat) The marginal tax rate, calculated using the simulation methodology of Graham (1996) (John Graham’s website) The product of the number of employees and the industry unionization rate (Compustat, Union Membership and Coverage Database) Control variables: Variable SIZE GROWTH LITRISK Description (data sources) Total sales (Compustat) The ratio of the book value of equity to the market value of equity (Compustat) Industry-based measure of litigation risk following methodology of Francis et al (1994) that is an indicator variable equal to one for firms in the following industries: biotechnology (SIC codes 2833-2836 and 8731-8734), computers (SIC codes 3570-3577 and 7370-7374), electronics (SIC codes 3600-3674), and retailing (SIC codes 5200-5961) (Compustat) 42 Control variables (continued): Variable ROA LOSS SALES_VAR OUTSIDEPCT NUMEST FORDISP Description (data sources) The ratio of net income to beginning of year total assets (Compustat) An indicator variable equal to one if net income is less than zero and is zero otherwise (Compustat) The standard deviation of sales, measured over a five-year rolling window (Compustat) The percentage of outsider board members (Corporate Library) The number of analyst forecasts made during the year (I/B/E/S) The standard deviation of mean annual estimates of forecasted earnings, measured over a five-year rolling window (I/B/E/S) 43 [...]... the sum of the book value of liabilities and the market value of equity Equity shareholders are represented by EQUITY, defined as the ratio of the market value of common shares which are not closely held to the sum of the book value of liabilities and the market value of equity Tax incentives (TAX) are measured by the simulated marginal tax rate as estimated by Graham (1996), where the importance of. .. description of each control variable used in this analysis In the second stage, we incorporate the fitted values of the earnings properties from the first-stage regressions as instrumental variables Each of the second-stage regression models takes the following general form, where each of the non-fitted earnings measures is regressed on the relevant reporting incentives, fitted earnings properties, ... as to whether certain reporting characteristics enhance or diminish the informativeness of earnings (e.g., the informativeness of reporting smooth earnings as examined by Dichev and Tang (2009) and Leuz et al (2003)) The purpose of our paper is to examine the relation between particular characteristics of earnings and reporting incentives provided by a firm’s stakeholders, regardless of whether a managers... is to further our understanding of the effects of multiple reporting incentives on the ways that managers utilize discretion when reporting earnings 25 Importantly, we conduct our empirical analysis in a way that takes into consideration the endogenous nature of earnings characteristics as well as the trade-offs between a comprehensive set of financial reporting incentives When considering earnings... meet reporting objectives After taking into consideration the simultaneity of the decision-making process underlying reported earnings, if the reporting incentives of the firm’s stakeholder groups influence management’s use of accounting discretion then the sign and significance levels of the coefficients on stakeholder variables should be consistent with our expectations However, if the trade-offs... table 7 reports results from tests of the determinants of timely loss recognition The inferences from our main analysis remain unaltered after separately removing the consideration of multiple incentives and the endogenous nature of the earnings process The evidence is consistent with the contracting explanation for conservatism across all variants of the analysis, though the coefficients on EQUITY and... expectations, the results do not indicate that equity-based compensation and labor incentives have a significant influence on reporting smooth earnings In supplemental tests reported later in the paper, we investigate whether incorporation of simultaneous reporting incentives or the endogenous nature of the earnings process in our research design is affecting our results Several of the coefficients on the control... determinants of accounting choice has not incorporated a comprehensive analysis of how managers make discretionary accounting choices within the context of meeting multiple objectives, our paper contributes to this stream of research by examining the impact of such trade-offs We find that after considering the trade-offs faced by managers due to the endogenous nature of the earnings process and the influence of. .. a firm-year measure We omit the firm and year subscripts for simplicity 11 Actual earnings and the median forecast are collected from the I/B/E/S adjusted annual summary file 14 cross-sectional basis by year All three of the earnings properties are calculated such that a higher value of the variable is indicative of a greater degree of discretionary reporting Reporting incentives are represented by... between reporting incentives and earnings attributes after considering the endogenous nature of the earnings process Table 4 reports results on the determinants of achieving analyst forecasts As shown in table 4, only one of the coefficients for the three stakeholder variables is significant in the predicted direction Consistent with our predictions, the propensity of firms to report earnings which meet