Management's Earnings Justification and Earnings Management under Different Institutional Regimes

Manuscript Type Empirical Research Question/Issue This study examines whether accruals earnings management is associated with managers' explanations of performance provided in narrative reports accompanying the financial statements in an international setting that covers voluntary and mandatory institutional environments for management commentary (MC) reporting. Differences in institutional environment are theorized as having a profound impact on the relative adequacy of different explanation types in mitigating earnings management concerns. Research Findings/Insights Based on 162 companies from four countries (the United Kingdom, Australia, the United States, and Canada), the study reports a close alignment of the use of earnings explanations and the strength and direction of accruals management. The results indicate that explanation type significantly affects the association between performance explanations and accruals management and that this effect becomes more pronounced in a mandatory institutional regime where expected regulatory and litigation costs are higher. Theoretical/Academic Implications The results indicate that the mandatory setting for narrative reporting (United States and Canada) affects the type of explanation perceived by managers to be more effective in mitigating potential concerns about earnings management. In a mandatory setting, the more costly causal explanations are more likely to be used by companies that are engaged in upwards earnings management. Practitioner/Policy Implications Regulators have debated about how to promote useful disclosure in management commentary reports. They have pointed to the need for more meaningful causal explanations. Our findings are relevant to the debate as they show that more scrutiny via a mandatory reporting regime (with associated higher expected litigation and regulatory costs) is a setting that encourages provision of these more costly causality-based explanations when preparers have incentives to ensure the adequacy of their explanations.