| This study presents an empirical examination of whether financially distressed firms use the flexibility of pension actuarial assumptions by SFAS No. 87, Employers' Accounting for Pension, as a tool of earnings management. By looking into the three pension estimates required under SFAS No. 87, the discount rate, the expected rate of return on plan assets, and the salary progression rate, it investigates whether firms that would benefit from the flexibility of SFAS No. 87 in an attempt to portray better earnings.;Two common explanations for earnings manipulation are examined: the earnings smoothing hypothesis and the hypotheses of SFAS No. 87 pension actuarial assumptions. The solution for detecting earnings-smoothing is a system of four simultaneous equations. By using three-stage-least-squares (3SLS), this study demonstrates that taking account of simultaneity is important for three of the seven modeled incentives, namely, discount rate, expected rate of return on plan assets, and salary progression rate. All three behave as if they are used to manipulate pension costs, and discretion in each of these incentives depends on the levels of the other two. In contrast, the remaining four incentives, namely, bonus plan, debt covenant, cash flow, and funding status incentives, appear to be determined independently of the other incentives.;For a sample of 587 firm-year observations over the period of 1988--2002, the results suggest that all three are jointly used to manage earnings. Controlling for other incentives, the results indicate that the three pension actuarial assumptions are jointly related to change in earnings per share and parameter estimates suggest that discount rate and expected rate of return on plan assets are used to manage earnings, and salary progression rate is used, perhaps secondarily, to offset the total pension costs in financially distressed companies. These three assumptions are also related to the funding status, which provide another incentive for cash short companies to reduce pension costs.;This research differs from previous earnings management studies in that it considers a single accrual, the standard of SFAS No. 87, rather than a collection of accruals to determine earnings management. This paper contributes to the literature focusing on these trade-offs in financially distressed companies and allows three pension actuarial assumptions to be determined simultaneously. |
