2012Cambridge Business & Economics ConferenceISBN : 9780974211428
The management approach and managerial behaviour: the need for checks and balances
Simon J. Hoy*
Faculty of Business and Government
University of Canberra
ACT 2601 Australia
Phone: +612 6201 2680
Mark D. Hughes
Faculty of Business and Government
University of Canberra
ACT 2601 Australia
Phone: +612 6201 2695
* corresponding author
February 22, 2012
The management approach and managerial behaviour: the need for checks and balances
Abstract
The International Accounting Standards Board (IASB)and the Financial Accounting Standards Board (FASB) propose to radically redesign the presentation of general purpose financial reports and to mandate the use of the management approach, thereby increasing managerial discretion over the presentation of information in those reports. The Boards expect this approach will assist users’ capital allocation decisions as it will facilitate managers providing entity-specific information. However, the literature provides mixed evidence as to how managers may respond to the adoption of the proposal. One view suggests that managers may reduce information asymmetry between themselves and users through the provision of additional information. In contrast, another perspective in the literature suggests that managers may engage in impression management, to the disadvantage of users. This paper examines a number of streams of literature which are related to the use of managerial discretion in the presentation of information in general purpose financial reportss and finds considerable evidence of opportunistic managerial behaviour. The study argues there are substantial weaknesses in the major structures the Boards will rely on to protect users from opportunistic behaviour. Potential avenues for research arising from the proposed introduction of the management approach are also provided.
Keywords: Management approach; Management discretion; Financial statement presentation; General purpose financial reports.
June 27-28, 2012
Cambridge, UK 1
2012Cambridge Business & Economics ConferenceISBN : 9780974211428
The management approach and managerial behaviour: the need for checks and balances
1.0. Introduction
A fundamental tenet of the joint project on financial statement presentation is that the management approach becomes the cornerstone in the presentation of general purpose financial reports (GPFR).1 This requires management to classify “its assets and liabilities in the business section and in the financing section in a manner that best reflects the way the asset or liability is used within the entity” (IASB, 2008, para 2.27). The Boards argue this will increase the utility of GPFR, as managers will have the discretion to provide users with entity-specific information by showing how assets are intended to be used and liabilities discharged (IASB, 2008, para 2.39).
The Boards deserve support for adopting a principles-based system designed to enhance the utility of GPFR (Schipper, 2003; Kothari, Ramanna, & Skinner, 2009). The management approach has the potential to contribute to a reduction in the magnitude of information asymmetry between managers and users, leading to improved decision making by users (Holthausen, 1990; Berger & Hann, 2003; Ettredge, Kwan, Smith, & Stone, 2006; Merkl-Davies & Brennan, 2007)2. However,there is a risk that the Boards’ proposal may lead to an increase in information asymmetrydue to expanded opportunities to engage in impression management.
Impression management involves managers manipulating the image conveyed to users through GPFR with respect to the underlying economic performance of an organization (Healy & Wahlen, 1999; Clatworthy & Jones, 2001, Merkl-Davies & Brennan, 2007)3. It adopts the agency theory perspective that managers will choose a style of presentation and content in GPFR that is beneficial to them (Jensen & Meckling, 1976; Demski & Feltham, 1978; Merkl-Davies & Brennan, 2007; Beaudoin, Agoglia, & Tsakumis, 2009; Merkl-Davies, Brennan, & McLeay, 2010).Research indicates this poses risks to usersby negatively impacting their capital allocation decisions (e.g. McVay, 2006; Athanasakou, Strong, & Walker, 2009; Beaudoin et al., 2009; Libby & Seybert, 2009).
Despite the potential for increasedopportunistic managerialbehaviour, the proposal does not put forward any discussion of new, or revised, protection mechanisms for users. Instead, theBoards have stated they intend to rely on existing disclosure requirements such as IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.The proposal also increases the difficulty for auditors to provide statutory assurance, as they are expected to verify and affirmthat the classification of an entity’s assets and liabilities in GPFR reflects the way management views those items. The Boards have not however, indicated how auditors are expected to deal with this increased ambiguity. Whilst no standard or rule is perfect and any incorporated protection mechanisms may be circumvented, to develop a standard without adequate protection mechanisms provides mangers an unfettered ability to cast GPFR in a more favourable manner (Powers, Troubh, & Winkour, 2002; Valukas, 2010).
The lack of robustprotection mechanisms in the proposal is a concern, as this absence can have significant adverse consequences for users. Examples include the losses suffered by investors through Enron’s use of special purpose vehicles, and the impact of the systemic risk introduced to the global financial system through rules which failed to protect users while allowing entities to enhance the image of their GPFR through various forms of off-balance sheet financing(Turner, 2009).
The objective of this paper isto evaluate the adequacy of mechanisms the Boards will rely on to protect users in the event the management approach is adopted. A review of the literature indicates managerial discretion in financial reporting is often used for opportunistic purposes. This would indicate a need for robust structures to reduce the potential negative impact on users of GPFR. However, the paperidentifies structural weaknesses in key elements of the protection mechanisms specified by the Boards.To gain insight into the adequacy of these safeguards, an appraisal is conducted of views expressed by a range of stakeholders that will interface with the Boards’ initiative.
The structure of the paper isas follows. Section 2 describes how the proposal expands the scope of the management approach andprovides a literature review focusing on the factors critical to the management approach, as well as a discussion on impression managementand itsimplications for the management approach. Section 3 provides an analysis of the protection mechanisms the Boards intend to use. Section 4 describes the methods utilized and provides details with respect to data collection and analysis. Section 5 examines the views of preparers, users, auditors, and standard setters in relation to the adequacy of protection mechanisms relied on by the Boards. Section 6 concludes by consideringimplications for GPFR and provides suggestions for further research.
2.0. Literature review and theoretical framework
2.1.The IASB(2008) proposal
The Boards maintain that the manner in which information is presented to users is of the “utmost importance” (IASB, 2008, para 1.9), and hence the proposal seeks to improve the utility of GPFR by highlighting and separating those revenues and expenses that are expected to persist into the future from those which are not. To achieve this objective, the Boardsproposeto increase the discretion given to managers in the presentation of information in GPFR bysubstantially expanding the management approach.This approach requires managers of reporting entities to classify assets and liabilities as being related to business activities (composed of operating and investing activities) or related to financing activities. For example, the operating section of the statement of financial position will be comprised of those assets and liabilities “that management views as related to the central purpose(s) for which the entity is in business” (IASB, 2008, para 2.32). Similarly, the investing section will contain assets and liabilities that are used to generate business income, but are considered by management to be “unrelated to the central purpose for which the entity is in business” (para 2.33).
The Boards expect the proposal will result in a cohesive set of GPFR, as they will show clearly the relation between items across financial statements. For example, changes in assets and liabilities classified in the business section will be reflected in the same section of the statement of comprehensive income (SCI) and in the business section of the statement of cash flows. Similarly, changes in financing assets and financing liabilities will be reflected in the financing section of the SCI and in the same section of the statement of cash flows. Figure 1 illustrates how these relations will be reflected in the proposed GPFR.
[Insert Figure 1 about here]
2.2.Management discretionincurrent standards
Accounting standards have traditionally provided management with a degree of discretion over the presentation of information in GPFR. More recently, standard setters have permittedmanagers to exercise increasedlevels of discretion with respect tohow this information is portrayed. For example, the classification of financial assets and financial liabilities at fair value through profit or loss is largely dependent on managerial choices in the expected use, measurement, and evaluation of these assets and liabilities (IFRS 9 Financial Instruments, IAS 39 Financial Instruments: Recognition and Management,SFAS 159 The Fair Value Option for Financial Assets and Financial Liabilities and Accounting Standard Update 2011-04 Fair Value Measurement (Topic 820) Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs ). Similarly, IAS 36Impairment of Assets (para 80(a))requires managers to exercise discretion by allocating goodwill to the cash generating unit that represents “the lowest level within the entity at which the goodwill is monitored for internal management purposes.”Furthermore, managers are to test whether goodwill has been impaired “at a level that reflects the way an entity manages its operations” (IAS 36, para 82).The management approach is also seen in SFAS 131 Disclosures about Segments of an Enterprise and Related Information (SFAS 131) and IFRS 8 Operating Segments (IFRS 8), as corporate management is required to disclose the bases on which it makes resource allocation decisions and evaluates the performance of operating segments.
2.3. The exercise of managerial discretion in reporting choices
When evaluating the merits of expanding the management approach, it is necessary toassesshow managers are likely to exercise discretion in the way they report information. The Boards’expectation that the proposal willreduce information asymmetry is supported by model-based research which predicts managers will be motivated by reduced costs of capital (Lambert, Leuz & Verrecchia, 2007) to voluntarily increase disclosures (Healy & Palepu, 2001; Beyer, Cohen, Lys & Walther 2010).4 There is also some empirical support for the view that managers choose torelease incrementally decision-useful information(Holthausen, 1990; Lin Walker, 2000; Choi, Lin, Walker, & Young, 2007; Merkl-Davies & Brennan, 2007; Riedl & Srinivasan, 2010).
In contrast, other research suggests that the management approach may not contribute to a reduction of this asymmetry, as the proposal does not address a key variabledriving impression management, that is, meeting benchmarks (Bhojraj & Libby, 2005; Graham, Harvey, & Rajgopal,2005, 2006).Athanasakou et al. (2009 p. 3)argue that meeting analysts’ targets is a “fundamental” goal of managersand this pressure has ledthemto exercise discretion to bias users’ investment decisions. Accordingly, the prospect arises that some managers may view corporate reports as impression management vehicles to “strategically …. manipulate the perceptions and decisions of stakeholders” (Yuthas, Rogers, & Dillard, 2002, p.142). If this is the case, concerns may be raised about increasingmanagements’ influence over the presentation of information in GPFR, as evidence indicates users’ decision-making processes are significantly affected by the way information is presentedin those reports (Libby, Bloomfield, & Nelson, 2002; Chambers, Linsmeier, Shakespeare, & Sougiannis, 2007; Libby & Seybert, 2009). Further, research suggests impression management stratagems misleadnaïve users as well asprofessional users, such as analysts and bank lending officers (Harper, Mister, & Strawser, 1991; Hopkins, 1996; Hirst Hopkins, 1998; Hopkins, Houston, Peters, 2000; Hirst, Hopkins, & Wahlen, 2004).
A review of the earnings management, classification shifting, pro forma,and segment reportingliterature illustrates how managers exercise discretion in fields that relate directly to the Boards’ proposal. If the literature provides evidence that the risk of opportunistic managerial behaviour is low, there is no compelling reasonto design enhanced protection mechanisms for users. However, if the literature suggests that the risk of impression management is high, there is a need to examine the adequacy of the protection mechanisms proposed by the Boards.
2.3.1. Earnings management
Managers undertake impression management in a variety of ways, including accounting earnings management (Healy & Wahlen, 1999; Field, Lys, & Vincent, 2001). This occurs in areas such as the timing of accruals, manipulation of the cost base of assets acquired individually and in business combinations, the modification of depreciation schedules, revenue recognition, inventories, stock options, lease expenses, fair value estimates, and changes in accounting policies (Nelson, Elliott, & Tarpley, 2003; Libby & Seybert, 2009).
The pressure to meet benchmarks has also been linkedto real earnings management. In this case, managers exercise discretion relating to “real operating and investing activities that deviate from normal business practices, where the primary objective is to achieve certain reporting objectives” (Bartov & Cohen, 2008, p. 1). Bhojraj and Libby (2005) as well as Graham, Harvey, and Rajgopal (2005, 2006) find that managers would reject investing in positive NPV projects if the projects were likely to have a negative impact on their ability to meet benchmarks. Similarly, Dechow and Shakespeare (2009) find evidence that managers time the sale of securitized assets, and the amounts sold, to meet earnings targets.
2.3.2.Classification shifting
A key area of concern is whether managers are likely to opportunistically shift assets and liabilities between classifications in order to manipulate various subtotals of earnings.5There is long-standing evidence that managers use a variety of methods to reclassify items in GPFRso as to influence users’ perceptions of the quality of an entity’s earnings (e.g. Barnea, Roden, Sadan, 1976; Lin, Radhakrishnan, & Su, 2006).McVay (2006) finds that it is common for managers to deliberately misclassify core expenses as special items to meet analysts’ forecasts. She argues this misclassification is attractive to managers, as they believe that core earnings convey particular information content to users regarding the persistence of future earnings, compared to non-core earnings.Barua, Lin,and Sbaraglia (2010) report evidence of managers reclassifying core expenses into discontinued operations for the same purpose.
If managers agree with the IASB proposition that users will ascribe more significance to income and expenses in the operating section of the SCI than those in the financing section, they may respond by reclassifying relevant assets and liabilities. This classification shifting would not change total profit for the year, but will affect the amount of core earnings reported by entities.6
2.3.3.Pro forma reporting
Research into the use of pro forma reporting relates directly to the Boards’ proposal as this literature gives insights into how managers exercise discretion when presenting information to users in a comparatively less regulated reporting environment.7Advocatesclaim that pro forma earnings exclude one-time or unusual items from GAAP earnings, therebyenabling management to provideincrementally valuable information, compared to that delivered through GAAP (Brown Sivakumar, 2003; Bowen, Davis, & Matsumoto, 2005; Elliott, 2006; Black & Christensen, 2009). For example Choi, Lin, Walker, and Young (2007) find that the majority of managers in their sample acted to reduce information asymmetry by reporting pro forma earnings that had more persistence than comparable GAAP-based figures and those produced by analysts.
In contrast,critics argue that managers seek to manipulate users’ perceptions of a firm’s performance by emphasizing pro forma figures which meet strategic earnings benchmarks that could not be met under GAAP (Doyle, Lundholm, & Soliman, 2003; Andersson Hellman, 2007; Black Christensen, 2009). A number of findingsshow that pro forma earnings are usually greater than those derived under GAAP, as managers generally exclude expenses in the calculation of their adjusted earnings metric (Lougee Marquardt, 2004; Bowen et al., 2005; Marques, 2006; Black & Christensen, 2009). Perhaps of greater concern is evidence that pro forma earnings figures do not just exclude transitory items. For example,Bhattacharya, Black, Christensen, and Larson(2003, p. 287) argue that “routine expenses are the most common types of pro forma adjustments” resulting in higher income figures.Similarly, Black and Christensen (2009) find that the majority of companies which met analysts’ forecasts in their pro forma statements did so by excluding recurring expenses.Choi, Lin, Walker,and Young (2007) also note that approximately ten percent of companies in their sample displayed opportunistic behaviour in the construction of pro forma figures.
2.3.4. Segment reporting
The segment reporting standards, SFAS 131 and IFRS 8are relevant to the Boards’ proposal as they explicitly adopt the management approach when reporting on segments in GPFR. Literature on how managers have reacted to these rules may shed light on how they could be expected to exercise discretion if the management approach is more widely adopted.
In 1976 the FASB released SFAS 14 Financial Reporting for Segments of a Business Enterprise. Briefly, this standard required entities to make segment disclosures according to their lines of business. However, this rule attracted “severe criticism from various user groups” (Hope, Kang, Thomas, & Vasvar, 2009, p. 423) as entities often aggregated different lines of business into one segment (Piotroski, 2003), reducing the utility of segment disclosures for users. In response to this pressure, the FASB released SFAS 131 which requires reporting entities to use the management approach when presenting information on segments in GPFR. In 2006 the IASB released IFRS 8, which is consistent with SFAS 131 (IFRS 8, IN3).
A number of studies focusing on the impact of the management approach, in the context of SFAS 131, indicate thatthis rule improved the quality of segment reporting compared to SFAS 14. For example, Berger and Hann (2003) and Hope et al. (2009) reportenhanced forecast accuracy under SFAS 131.This standardhas also been credited with increasing thetransparency of segments, thereby reducing information asymmetry for users (Ettredge et al., 2006; Berger & Hann, 2007;Botosan & Stanford, 2009).
However, it is necessary to put these findings into context, as SFAS 131 replaced a rule which was heavily criticized for allowing “managers undue discretion...in determining their segment definitions” (Botosan & Stanford, 2009, p. 1). In other words, these studies examine the impact of moving from aregime which generally offered more discretion than its successor. However, this is contrary to the situation facing usersshould the Boards’ proposal be adopted.