Advantageous Comparison and Rationalization of Earnings Management

• Published date: 01 September 2014
• Date: 01 September 2014
• DOI: http://doi.org/10.1111/1475-679X.12054
• Author: TIMOTHY J. BROWN

DOI: 10.1111/1475-679X.12054

Journal of Accounting Research

Vol. 52 No. 4 September 2014

Printed in U.S.A.

Advantageous Comparison and

Rationalization of Earnings

Management

TIMOTHY J. BROWN

∗

Received 9 August 2012; accepted 24 February 2014

ABSTRACT

This paper proposes that psychological factors can change managers’ be-

liefs about earnings management when they choose to engage in it. I show

that, under certain circumstances, engaging in a small amount of earnings

management alters a manager’s beliefs about the appropriateness of the act,

which may increase the likelihood of further earnings management. Specif-

ically, I predict and find in two experiments that participants who initially

choose to manage earnings are motivated to rationalize their behavior. Par-

ticipants who are exposed to an egregious example of earnings management

(commonly the focus of enforcement actions and press reports) have the op-

portunity to rationalize their behavior through a mechanism called “advan-

tageous comparison,” where participants compare their behavior against the

egregious example and conclude that what they did was relatively innocuous

and appropriate. My analysis also indicates that presenting participants with

an example of earnings management that is similar to the initial decision they

made mitigates advantageous comparison. These results have implications for

∗The University of Illinois at Urbana-Champaign.

Accepted by Phillip Berger. I sincerely thank the members of my dissertation committee at

Cornell University for their invaluable support: Robert Libby (chair), Mark Nelson, J. Edward

Russo, and Steven Schwager. I also thank Robert Bloomfield, Scott Asay, Kristina Rennekamp,

Eldar Makysmov, Mark Peecher, and workshop participants at the University of Kentucky, the

University of Alberta, the University of Florida, Indiana University, the University of Notre

Dame, the University of South Carolina, the University of Illinois, the University of Arizona,

and the Georgia Institute of Technology for helpfulcomments.

849

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

850 T.BROWN

academics interested in how earnings management, and perhaps fraud, can

accrete over time and for regulators and practitioners who are interested in

preventing it.

1. Introduction

There is a great deal of interest in earnings management in both the ac-

counting literature (see Healy and Palepu [2001] and Healy and Wahlen

[1999] for comprehensive reviews) and the popular press (Creswell [2002],

Giroux [2003], Fontevecchia [2013]). The Securities and Exchange Com-

mission (SEC) shares this concern, highlighting the idea of a “numbers

game” that managers play to meet benchmarks and mislead investors

(Levitt [1998]). The SEC publishes Accounting and Auditing Enforcement

Releases (AAERs) in part to highlight how it detects and punishes egre-

gious examples of earnings management (Pitt and Shapiro [1990]). How-

ever, these AAERs may have an unintended effect. In this study, I examine

how highlighting egregious examples of earnings management in AAERs

might affect those who have already made a decision to engage in a less

egregious form of earnings management. I propose that managers who

are motivated to rationalize their earnings management behavior will view

AAERs as a comparison point rather than a warning. These individuals will

compare their past behavior against an egregious example and conclude

that their behavior was actually relatively innocuous and appropriate. In

this way, AAERs might encourage rationalization, rather than prevent earn-

ings management.

Understanding how managers might rationalize earnings management

using egregious examples in AAERs is an important topic. The SEC has a

unique role in the U.S. capital markets, providing guidance for complex

accounting issues (Taub [2009]) and safeguarding investors from fraud-

ulent reporting. The SEC sets out to provide high profile, visible exam-

ples of its enforcement activities to increase the agency’s profile (Pitt and

Shapiro [1990]), and often publicizes very egregious examples of earnings

management to achieve this goal (Defond and Smith [1991]). For exam-

ple, the SEC published an AAER related to PACCAR Incorporated in 2013,

discussing how the company inappropriately aggregated different business

segments to conceal a $474 million loss from investors (SEC [2013]). Even

though egregious examples of earnings management highlighted in AAERs

should highlight the penalties associated with that type of behavior, they

could be used as an opportunity to rationalize previous earnings manage-

ment behavior. This runs against the intentions of the SEC and could actu-

ally encourage future earnings management.

I use psychology theory to derive this prediction. When managers make

a choice to manage earnings, theory predicts it will produce a motivation

to rationalize their behavior. Managing earnings creates a conflict in the

mind of a managers, between the desire to meet a performance bench-

mark and the desire to think of themselves as an “honest person” (Mazar,