Our argument in favour of good earnings management is based on the blocked communication concept of Demski and Sappington (DS1; 1987). Frequently, agents obtain specialized information as part of their expertise, and this information can be prohibitively costly to communicate to the principal; that is, its communication is blocked. For example, it may be difficult for a physician to communicate to the patient exact details of an examination and diagnosis. Then, the physician’s act (e.g., operating on the patient) must stand in not only for the physician’s surgical skills but also for the information acquired during the diagnosis. DS1 showed that the presence of blocked communication can reduce the efficiency of agency contracts, since the agent may shirk on information acquisition and compensate by taking an act that, from the principal’s standpoint, is sub-optimal—the physician may simply sew up a badly cut hand on the basis of a cursory examination that fails to check for possible tendon or nerve damage, for example. If so, the principal has an incentive to try to eliminate or reduce the blocked communication.

There is a variety of ways to reduce blockage. Gu and Li (2007) reported an increased positive market reaction to disclosures of business strategy by high-tech firms when the disclosures are preceded by a credible gesture of confidence in the firm by management, namely insider stock purchases. Hirst, Koonce, and Venkataraman (2007) reported, based on an experimental study, that disaggregation of a good news forecast (i.e., forecasting sales and expenses as well as net income) increases its credibility. They argued that disclosure of line items reduces the ability of managers to use earnings management to attain the forecast, thereby offsetting investor suspicions that the forecast may be biased upward.

In our context, earnings management can also be a device to reduce blockage. To illustrate, suppose that a manager desires to communicate the firm’s expected long-run, persistent earnings potential. Assume that this amount is $1 million per annum. This earnings potential is complex inside information of the manager. If the manager simply announced it, the announcement would not be credible, since the market would find it prohibitively costly to verify. Suppose, however, that some low-persistence special item inflates earnings this period, such as a profit of $200,000 from the sale of a division. Suppose also that this item will increase current net income to $1,180,000, well above its sustainable level of $1 million. Rather than report a net income substantially higher than what is expected to persist in the long run, the manager decides to record a provision for restructuring of $180,000, thereby reducing current earnings to the $1 million the manager feels will persist.

This “unblocking” of the manager’s inside information by means of large discretionary accruals to produce a desired result has credibility. The market knows that a manager (except one with a very short decision horizon) would be foolish to report higher earnings than can be sustained. One reason is the oversight and enforcement provided by security commissions, and even the firm’s own audit committee. Of possibly greater importance to the manager, however, is that the inevitable reduction in future earnings would severely punish him/her through capital and labour market reaction. Notice that the market cannot unravel this earnings management, since it is based on inside information about sustainable earning power. However, the market can use the earnings management to infer what this inside information is. However, management typically has additional information about future performance, such as new firm strategies, planned restructurings, changes in firm characteristics, or changes in market conditions. While quite relevant, this information is likely to be sufficiently complex that its direct communication is blocked. Then, DS2 show that judicious choice and disclosure of discretionary accruals can reveal this information to investors.

References:

  • Scott, W. R. (2015). Financial Accounting Theory 7th Pearson Canada Inc. ISBN 978-0-13-298466-9
  • Google Image (2021).