An experimental investigation of the effect of accounting discretion on the reporting of smooth increasing earnings by managers

In order to maximise a firm's value, managers sometimes communicate their knowledge of the firm's future earnings or foresight by reporting smooth increasing earnings. Recent studies show that firms with such earnings patterns are valued highly by investors because these earnings patterns provide information about the permanence of future cash flows and earnings quality. Given this potential pricing benefit, managers with limited foresight may try to report smooth earnings patterns similar to those of foresight managers. The availability of accounting discretion is likely to make the task easier for these managers.; This thesis reports an experiment that investigates (1) whether a reduction in accounting discretion brings about a separation in the earnings patterns reported by high and low foresight managers, (2) whether the reduction affects a manager's ability to communicate with shareholders through smooth earnings when operational techniques are available, and (3) whether the length of smoothing period interacts with discretion and manager type to affect a manager's ability to report smooth earnings.; One hundred experienced financial managers from ten industries participated in the experiment, which had a 2 x 3 (foresight x accounting discretion) between-subject design. Participants are required to report smooth increasing earnings over time. Foresight was manipulated by giving more information about future earnings to high foresight managers and limited information to low foresight managers. Accounting discretion was manipulated by varying the percentage of operating earnings that could be affected by accounting adjustments. The results show that with high accounting discretion, low foresight managers are able to report smooth earnings similar to those of high foresight managers regardless of the length of smoothing period. A reduction in discretion results in a separation in the earnings series reported by both managers. High foresight managers continue to be able to smooth earnings despite the low discretion because they respond to the reduction in discretion by investing in assets with less variable earnings. Low foresight managers, in contrast, make less effective use of operational variables and are reliant on accounting adjustments to smooth earnings. Consequently, reducing discretion makes it difficult for them to smooth over time.