How Scrutinizing Honest Managers Encourages Earnings Management

Research in finance and accounting consistently documents that a significant number of managers overstate reported earnings when true earnings miss a benchmark [1]. Managers face strong incentives to meet and beat important earnings thresholds, such as the analyst consensus forecast of a corporation’s next period future earnings per share (EPS), because capital markets react negatively to firms falling short of earnings expectations [2]. Hence, there is a widespread belief that managers “cook the books” in order to meet these benchmarks.

The accounting and corporate governance literature offers at least two ways to curb earnings management: carefully scrutinizing managers [3] and screening out manipulative personalities that are particularly prone to manage earnings [4]. In a recent study, we challenge these two approaches by examining a setting in which a conscientious manager’s true earnings meet a threshold exactly, the manager has no financial incentives to overstate earnings, but nevertheless succumbs to non-monetary reputational incentives to avoid meeting earnings thresholds, and misreports earnings to appear to others as truthful. Thus, we find that conscientious managers lie to appear truthful.

Our reasoning builds on the widespread belief that managers manipulate earnings to reach important thresholds. Investors and analysts are increasingly skeptical of earnings that just meet or barely beat forecasts [5]. A potential implication of this market skepticism is that managers are increasingly concerned about how the market will react to their reports. Research in psychology suggests that such image concerns arise when an outcome looks “too good to be true” [6]. Thus, it stands to reason that a manager concerned about how others view her or him (a conscientious manager), whose company has true earnings that meet an earnings benchmark exactly, might feel pressure to overstate her/his earnings to appear truthful.

We expect that the desire to be perceived as truthful is particularly strong when a manager is publicly scrutinized by investors, the media, or regulators. Public scrutiny increases managers’ awareness of others’ potentially skeptical perceptions. Importantly, public scrutiny is increasing in today’s market place with more media and regulatory attention on corporations, the new U.S. presidential administration’s likely change in SEC leadership, and greater access to managers through social media. One way to overcome image concerns is to simply report a more believable outcome. In other words, we propose that scrutinized managers alter their earnings reports because they want to appear truthful.

Additionally, certain types of managers may be more prone to image concerns than others. Managers who are generally conscientious and attuned to how others perceive them will be particularly affected by the pressure to be seen as honest. One measure of interpersonal awareness and empathy are the “Dark Triad” personality traits [7]. This construct captures a person’s level of psychopathy, narcissism, and Machiavellianism. Unlike prior research that links this construct to unethical behavior [4], we expect that these types of personalities better resist public scrutiny and take welfare-enhancing choices, regardless of the feelings and perceptions of others. Thus, managers who score low on the Dark Triad, the types we usually assume to be the “good actors,” are in turn more likely to manage earnings to avoid being seen as untruthful.

We test our predictions using an experiment in the tradition of experimental economics [8]. Student participants play several rounds of an economic reporting game designed such that their actions can be generalized to the roles of investors and managers, interacting over time. Each round, manager-participants privately observe earnings that either miss, meet, or beat market expectations. Investor-participants receive managers’ reports and accept or reject them. We repeatedly re-pair subjects with a different player each round. The payoffs are chosen such that they reflect managers’ incentives to overstate earnings that miss thresholds and to report instances of “beating” and “meeting” truthfully. That is, we create a setting in which managers have monetary incentives to report earnings that meet thresholds truthfully, but a nonmonetary incentive to overstate these earnings. To do this, we vary between subjects whether manager-participants in the game are visible and identifiable to other investor-participants before issuing their report. Finally, we measure participants’ Dark Triad personality.

The results of our study support the idea that earnings management decisions are driven by image concerns. In particular, we find that a significant proportion of managers report untruthfully when true earnings meet earnings expectations exactly. This type of unprofitable earnings management is most pronounced when they report under conditions that allow investors to scrutinize managers (e.g. when managers use social media). Consistent with the notion that image concerns motivate earnings management, we find the highest frequency of misreporting for individuals who score at the lower end of the Dark Triad scale. Further, we show that deviating from truthful reporting in this way increases their belief that investors will accept their earnings reports. Thus, we conclude that managers manipulate earnings because they want to be believed, and they even accept potential monetary losses for the perception of truthfulness.

With recent advances in technology, shareholders have an increased ability to publicly scrutinize and pressure managers for behavior that does not conform to their preferences [9]. Further, managers are facing increased shareholder activism and likely tightened regulatory oversight in upcoming years. Hence, managers are more aware than ever of different forms of public scrutiny. Our study documents a natural but unexplored consequence of these developments. Managers whose earnings meet thresholds exactly will misreport to appear truthful. In contrast to what conventional wisdom suggests, they manage earnings not only to meet thresholds but also to avoid them.

Our results are particularly intriguing as they primarily affect scrupulous managers that likely care about honesty, two factors that have traditionally been considered to be natural controls against earnings management. From a practical point of view, we suggest a cost benefit analysis when screening out managers based on their “dark” personality. There seem to be unintended costs to hiring “non-dark” personalities as executives and there might be good reasons why we still find prominent examples of narcissists, psychopaths, and Machiavellians in the corporate business world.

ENDNOTES

[1] Bird, A. Karolyi, S. A. and Ruchti, T. G. (2019). Understanding the “Numbers Game.” Journal of Accounting and Economics, 68 (2–3).

[2] Skinner, D. J. and Sloan, R. G. (2002). Earnings surprises, growth expectations, and stock returns or don’t let an earnings torpedo sink your portfolio. Review of Accounting Studies, 7 (2–3): 289–312.

[3] Jensen, M. C. and Meckling, W. H. (1976). Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3 (4): 305-360.

[4] Majors, T. M. (2016). The interaction of communicating measurement uncertainty and the dark triad on managers’ reporting decisions. Accounting Review, 91 (3): 973–992.

[5] Keung, E. Lin, Z. X. and Shih, M. (2010). Does the stock market see a zero or small positive earnings surprise as a red flag? Journal of Accounting Research, 48 (1): 105–136.

[6] Choshen-Hillel, S. Shaw, A. and Caruso, E. M. (2020). Lying to Appear Honest. Journal of Experimental Psychology: General, 149 (9): 1719–1735.

[7] Paulhus, D. L. and Williams, K. M. (2002). The Dark Triad of personality: Narcissism, Machiavellianism, and psychopathy. Journal of Research in Personality, 36 (6): 556–563.

[8] Smith, V. L. 1982. Microeconomic Systems as an Experimental Science. American Economic Review 72 (5): 923-955.

[9] Miller, G. S. and Skinner, D. J. (2015). The evolving disclosure landscape: How changes in technology, the media, and capital markets are affecting disclosure. Journal of Accounting Research, 53 (2): 221–239.

This post comes to us from Professor Jessen L. Hobson at the University of Illinois at Urbana-Champaign and Sebastian Stirnkorb, a PhD candidate at Erasmus University Rotterdam. It is based on their recent article, “Managing Earnings to Appear Truthful: The Effect of Public Scrutiny on Exactly Meeting a Threshold,” available here.

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