This paper develops a model in which firm managers maximize their own compensation by using accruals to manage reported earnings. The results of the model suggest that the form of the managerial compensation function and managerial time preferences may have an important influence on the relationship between accruals and latent earnings. Among the possible relationships suggested by the model are strategies we call Smooth Income, Occasional Big Bath, Live for Today, and Maximize Variability, each of which suggests a different reporting strategy pursued by managers. Most empirical tests of accruals are inconsistent with this and other theoretical models because they include a single earnings variable in a linear regression analysis. Instead, we document the reporting of accruals by two firms, Sunbeam and Citicorp, that is consistent with the “Live for Today” and “Occasional Big Bath” strategies.
JEL classification: G30, J33, M4
Key words: discretionary accruals, earnings management, executive compensation
The authors thank Sherley Wilson and Nichole Castater for research assistance and George Benston, Matej Blasko, Richard Bower, Mary Lea McAnally, Pam Peterson, Joe Sinkey, Steve Smith, and seminar participants at the University of South Carolina, Georgia State University, the University of Tennessee, and the Tenth Annual Conference on Financial Economics and Accounting for helpful comments. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility. This paper is preliminary and incomplete. Comments are welcome but please do not quote without permission.
Please address questions regarding content to Larry D. Wall, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303, 404-498-8937, firstname.lastname@example.org, or Timothy W. Koch, The Darla Moore School of Business, University of South Carolina, Columbia.
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