2012 Cambridge Business & Economics Conference
ISBN : 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
Simon.Hoy@canberra.edu.au
Phone: +61 2 6201 2680
Mark D. Hughes
Faculty of Business and Government
University of Canberra
ACT 2601 Australia
Mark.Hughes@canberra.edu.au
Phone: +61 2 6201 2695
* corresponding author
February 22, 2012
June 27-28, 2012
Cambridge, UK
2012 Cambridge Business & Economics Conference
ISBN : 9780974211428
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.
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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 asymmetry due 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
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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 users
by 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 increased opportunistic managerial behaviour, the proposal
does not put forward any discussion of new, or revised, protection mechanisms for users.
Instead, the Boards 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 affirm that 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 robust protection 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).
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The objective of this paper is to 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 paper identifies 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 is as follows. Section 2 describes how the proposal expands
the scope of the management approach and provides a literature review focusing on the
factors critical to the management approach, as well as a discussion on impression
management and its implications 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 considering implications for GPFR and provides suggestions for further
research.
2.0. Literature review and theoretical framework
2.1. The IASB (2008) proposal
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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 Boards propose to increase the discretion given to managers in the
presentation of information in GPFR by substantially 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]
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2.2. Management discretion in current standards
Accounting standards have traditionally provided management with a degree of discretion
over the presentation of information in GPFR. More recently, standard setters have permitted
managers to exercise increased levels of discretion with respect to how 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 201104 Fair Value Measurement (Topic 820) Amendments to Achieve Common Fair Value
Measurement and Disclosure Requirements in U.S. GAAP and IFRSs ). Similarly, IAS 36
Impairment 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 to
assess how managers are likely to exercise discretion in the way they report information.
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The Boards’ expectation that the proposal will reduce 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 to release 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 variable driving
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 managers and this pressure has led them to
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
increasing managements’ influence over the presentation of information in GPFR, as
evidence indicates users’ decision-making processes are significantly affected by the way
information is presented in those reports (Libby, Bloomfield, & Nelson, 2002;
Chambers, Linsmeier, Shakespeare, & Sougiannis, 2007; Libby & Seybert, 2009).
Further, research suggests impression management stratagems mislead naïve users as
well as professional 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).
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A review of the earnings management, classification shifting, pro forma, and segment
reporting literature 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 reason to 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 linked to 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
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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.5 There is long-standing evidence that managers use a variety of methods to
reclassify items in GPFR so 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
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information to users in a comparatively less regulated reporting environment.7
Advocates claim that pro forma earnings exclude one-time or unusual items from GAAP
earnings, thereby enabling management to provide incrementally 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 findings show
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.
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2.3.4. Segment reporting
The segment reporting standards, SFAS 131 and IFRS 8 are 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 that this rule improved the quality of segment reporting compared
to SFAS 14. For example, Berger and Hann (2003) and Hope et al. (2009) report
enhanced forecast accuracy under SFAS 131. This standard has also been credited with
increasing the transparency of segments, thereby reducing information asymmetry for
users (Ettredge et al., 2006; Berger & Hann, 2007; Botosan & Stanford, 2009).
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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 a regime which generally offered more discretion
than its successor. However, this is contrary to the situation facing users should the
Boards’ proposal be adopted.
Concern has been raised regarding difficulties in enforcing the way entities report
operating segments under IFRS 8. The European Securities and Markets Authority
(ESMA) (2011) notes managers have considerable latitude in determining how many
segments to report. More importantly, they claim that the disclosures in IFRS 8 do not
assist users to determine how subjective management was when deciding which
segments to aggregate or report separately (EMSA, 2011). This regulator also cites
evidence of entities manipulating the way the Chief Operating Decision Maker (CODM)
receives information, in order to circumvent the requirements of this rule.
Evidence relating to management’s motivation in disclosing or concealing segment
information is inconclusive. Managers may obscure this information in order to keep
proprietary information from potential competitors (Bens, Berger & Monahan, 2009).
Alternatively, managers may be motivated to shield information relating to inefficient
internal capital allocations from users (Hope & Thomas 2008; Bens, Berger &
Monahan, 2009). Hope and Thomas (2008) also find evidence of impression management
under SFAS 131, as managers’ obscure over-investment in international operations by
choosing not to report earnings by geographic segments.
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3.0. Protection mechanisms for users
The literature indicates managers react to pressure to meet benchmarks and so utilize a
range of impression management techniques. However, not all managers undertake
impression management, and it is unclear how users can identify those managers who
may engage in it from those who do not. Lougee and Marquardt (2004, p. 791)
crystallise this problem when they state “we cannot, on an ex ante basis, definitively
distinguish between firms’ motivations” in making particular disclosures. This
underscores the necessity for robust mechanisms to accompany any expansion in
managerial discretion so as to protect users.
3.1. Standards based protection mechanisms
3.1.1. FRS 3
The need for protection has been recognised by regulators in relation to previous
attempts to facilitate management communicating its view of an entity’s performance to
users. For example, the UK Financial Reporting Standard No. 3 Reporting Financial
Performance (FRS 3) was designed to facilitate managers communicating their
expectations of sustainable earnings to users through the reporting of managementadjusted EPS. This rule allowed management to exclude (include) items if it deemed
them to be transitory (non-transitory). Athanasakou, Strong, and Walker (2007) find
that the potential for opportunistic behaviour was limited as FRS 3 required
management to reconcile their alternative EPS calculations to the GAAP determined
figure and companies had to meet rigorous disclosure requirements designed to increase
transparency.
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Similarly, the FASB introduced Regulation G in 2003 requiring managers issuing nonGAAP earnings to reconcile them to comparable GAAP earnings (Bhattacharya, Black,
Christensen, & Mergenthaler, 2004; Bowen et al., 2005; Elliott, 2006; Kolev, Marquardt,
& McVay, 2008). Recent evidence documents that the implementation of Regulation G
effectively discouraged managers releasing non-GAAP earnings in their press releases
and in quarterly earnings announcements (Baik, Billings, & Morton, 2008; Kolev et al.,
2008).
The lack of a GAAP reference point as to what constitutes business or operating income
means it is not possible to determine a reconciling figure under the Boards’ proposal.
This may not be an issue at the aggregate level of total comprehensive income, as this
figure will not be affected by the way the sub-totals are composed. However, there is a
risk if management expect users to ascribe different levels of significance to the various
sub-totals such as business income and finance income. For example, Athanasakou et al.
(2009) indicate managers of larger organizations already behave in this manner by
shifting small core expenses to non-recurring items, which inflates core earnings to meet
target earnings. Given the lack of a reconciling figure, it is necessary to evaluate the
adequacy of other mechanisms to protect users.
3.1.2. IAS 8: Is it sufficiently robust?
The Boards recognise that managers may opportunistically reclassify elements in the
statement of financial position. Accordingly, the Discussion Paper (IASB 2008) mandates that
managers treat reclassifications as a change in accounting policy, leading to retrospective
disclosures under IAS 8. This requirement is reflected in paragraph 37 of the Staff Draft
(IASB 2010) which specifies entities “present an additional statement of financial position as
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at the beginning of the required comparative period if it applies an accounting principle
retrospectively, restates its financial statements or reclassifies items in its financial
statements.”
Given the potential impact on GPFR, the Boards’ reliance on IAS 8 to protect users
from opportunistic behaviour raises concern, primarily because this standard was not
designed to deal with pressures inherent in the proposal. Current GAAP limits the effect
on items within operating profit when reclassifying assets and liabilities (e.g.
discontinued operations). However, under the proposal, opportunistic reclassification is
likely to become more attractive as a way of meeting analysts’ forecasts, which is a
critical issue for managers (Graham et al., 2005; Athanasakou et al., 2009).
IAS 8 (para 16(a)) specifies that “transactions, other events, or conditions that differ in
substance from those previously occurring” do not qualify as a change in accounting
policy. This provision allows managers substantial scope to structure transactions that
result in reclassifications without triggering the disclosure requirements. For example,
accounts receivable would normally be classified as an operating asset. However, if
management offers extended terms on some of its receivables, it is unclear whether these
receivables would differ in substance from others. This ambiguity could allow managers
to selectively classify riskier receivables in the financing section, rather than the
operating section without having to disclose this. Managers may be attracted by such a
reclassification, as any associated doubtful debts expense would also be confined to the
financing section of the SCI, leading to inflated operating and business profit. The issue
of classifying receivables is non-trivial, as standard setters have been unable to reach
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agreement on this matter (Statement of Financial Accounting Standards No. 95
Statement of Cash Flows).
Companies could also reclassify assets and liabilities without triggering IAS 8
disclosures by simply “disposing” of the items to an obliging counterparty, such as a
merchant bank or other intermediary, reacquire and classify the “new” items as desired.
Rules such as IAS 18 Revenue may prevent the recognition of income from this
“disposal”. However, this is not a significant disincentive, as the objective is to reclassify
items, in order to place future income, expenses and cash flows in desired parts of the
SCI and the cash flow statement, rather than to generate income per se from the
disposal of assets or liabilities.
Another example of the limitations inherent in IAS 8 relates to the method of funding
assets. The IASB proposal suggests that finance leases would be classified as operating
liabilities, whereas bank loans would be classified as financing liabilities. It is unlikely
that IAS 8 disclosures would apply if managers change the way they finance the
acquisition of assets.
The Discussion Paper (IASB 2008) and the subsequent Staff Draft (IASB 2010) provide
another mechanism for managers to opportunistically reclassify assets and liabilities
without involving
external
parties,
thereby
circumventing
IAS
8
disclosure
requirements. Paragraph 68 of the Staff Draft (IASB 2010) states “An entity with more
than one reportable segment shall classify items in its financial statements into the
sections, categories and subcategory that reflect the functions of the items in its
reportable segments (as defined in IFRS 8).”8 Paragraphs 69 and 70 of the Staff Draft
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(IASB 2010) illustrate how this would operate in the case of an entity with three
reporting segments and shows that if an asset is classified in the operating section in one
segment, while another segment classifies similar items in the financing section, then the
consolidated GPFR will follow the classifications used by the segments and will present
this type of item in both the financing and operating sections. Depending on the types of
assets and liabilities involved, it would be a simple matter to arrange transfers between
segments. These transfers are unlikely to be disclosed under IAS 8, as there are no
requirements for entities to disclose internal transfers of assets and liabilities. Indeed,
the requirements of consolidation accounting to eliminate any gains or losses on these
transactions would make these reclassifications nearly impossible for users to detect.
3.2. Auditor based protection mechanisms
The exercise of increased managerial discretion may add a further degree of complexity
for auditors and auditing. Auditors provide a critical role to capital markets through the
delivery of statutory assurance to users of GPFR. However, the value of this assurance
varies with audit quality (Becker, DeFond, Jiambalvo, & Subramanyam, 1998; Francis,
2004). Myers, Myers, and Omer (2003) propose that when audit quality is high, auditors
constrain the presumably self-serving choices that management would like to make in
the presentation of GPFR. Although auditors are regarded as the gatekeepers of
securities markets, Ghosh and Moon (2005) indicate that the frequency of accounting
irregularities has led many to question auditor independence. Two issues arise in the
context of audit quality that are relevant to this study.
First, audit quality is subject to a range of behavioural and structural factors which may
motivate auditors to acquiesce to client perspectives and hence impair audit quality. An
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extensive body of research identifies a range of behavioural factors that can result in
auditors deferring to clients (Koch & Wüstemann, 2009). An important factor is the
“intense pressure” (Segovia, Arnold, & Sutton, 2009, p68) auditors are subjected to by
clients seeking to exploit opportunities to undertake aggressive earnings management
(Levitt, 1998). In addition, there is evidence that auditors are exposed to unconscious
self-serving bias, which can cause them to interpret information in ways that comply
with clients’ wishes (Hackenbrack & Nelson, 1996; Lerner & Tetlock, 1999; Bazerman,
Loewenstein, & Moore, 2002). Auditors have also been found to form relations with
clients and may identify with their needs more than those of the investors they are
supposed to be serving (Bazerman, Loewenstein & Moore, 2002).
However, this finding is challenged by capital market research indicating that audit
quality and earnings quality can increase with audit tenure (Myers et al., 2003; Ghosh
and Moon, 2005). Structural factors such as the increasingly competitive market for
audit services may result in auditors supporting client-preferred reporting methods
(Moreno and Bhattacharjee, 2003). Research also indicates auditors are less likely to
withstand management pressure if the client is large or financially attractive, even if this
results in material misstatements that may expose auditors to litigation (Nelson, Elliott,
& Tarpley, 2002; Kadous, Kennedy, & Peecher, 2003; Moreno & Bhattacharjee, 2003;
Carcello & Nagy, 2004).
The second issue relating to audit quality that is of particular relevance to the Boards’
proposal focuses on the nature (rules or principles based) of specific standards, as this has
been found to impact auditors’ propensity to defer to client demand. Gibbins, Salterio and
Webb (2001) and Moreno and Bhattacharjee (2003) report that experienced auditors find it
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hard to resist client pressure when dealing with incomplete or unclear standards or when
accounting precedents are mixed. These findings are supported by research which indicates
that the likelihood of experienced auditors deferring to management’s preferences in relation
to unstructured transactions increases when dealing with imprecise accounting rules (Nelson,
Elliot, & Tarpley, 2002; Nelson, 2005). Gibbins et al. (2001) also find in their study of audit
partners that unambiguous standards increase auditors’ power in client negotiations. Becker et
al. (1998, p. 1) suggest that lower audit quality is associated with increased “accounting
flexibility.”
However, the literature sounds a note of caution with respect to unambiguous standards as
they can also result in unintended consequences if preparers structure transactions to meet the
requirements of a rules-based standard. Segovia, Arnold and Sutton (2009) find that auditors
will allow more aggressive reporting when accounting standards are rules-based rather than
principles-based, as they facilitate clients justifying the appropriateness of their accounting
treatment. Similarly, Nelson et al. (2002) find auditors are more likely to defer to clients when
dealing with structured transactions and rules-based accounting standards.
The literature suggests it is important to protect the capacity of auditors to successfully
challenge the assertions of management in relation to the various subtotals identified in the
Boards’ proposal, such as operating and business income. However, the inherent subjectivity
of the management approach raises questions regarding the ability of auditors to affirm that
these subtotals reflect how management views the relevant assets and liabilities. In dealing
with something as nebulous as management intention, it is important to ensure auditors are
equipped with mechanisms to ensure they do not inappropriately defer to management.
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Hence, this gives rise to the question of whether stakeholders expect the expansion in
managerial discretion under the Boards’ proposal is accompanied by adequate protection
mechanisms. This gives rise to the following research question.
Research question: Do stakeholders expect that the expansion in managerial discretion under
the Boards’ proposal is accompanied by adequate protection mechanisms?
4.0. Method
Data for this study were obtained from submissions sought by the Boards in response to
the Discussion Paper. In total, 229 comment letters were received from individuals,
companies, professional bodies and audit firms from countries including the UK, USA,
Australia, Germany, Canada, Sweden, Japan, Ireland, Hong Kong (SAR), France, and
Switzerland.
Sampling of the submissions was conducted in two stages. At stage one, 23 comment
letters were selected on the basis of respondents’ size and influence at the global level,
reflecting a range of standard setters, users, auditors and preparers. These are listed in
part A of table 1. Stage two involved selecting a random sample of a further 27
submissions to provide an overall sample size of 50 comment letters. The decision was
made to cease sampling at this number as no new comments or points of view were made
by the final five respondents in the sample. The randomly sampled submissions are
listed in part B of table 1.
The comment letters were manually analyzed to ascertain respondents’ views as to the
adequacy of protection mechanisms relating to note disclosures, the primary protection
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mechanism relied on by the Boards, and the impact of the proposal on the ability of
auditors to provide statutory assurance. Following Walker and Robinson (1993), no
attempt is made to consider the submissions as an overall vote of approval or rejection
of the Boards’ proposal. Rather, the analysis of the submissions was restricted to the
specific issue of the adequacy of protection mechanisms.
5.0. Results
A number of respondents identify structural weaknesses of the management approach which
could be expected to negatively impact users, unless accompanied by robust protection
mechanisms. For example, The Investors Technical Advisory Committee (ITAC) of the
FASB states that their primary concern with the management approach is its unbounded
subjectivity, “and the lack of any economic underpinnings or other rigorous criteria to restrain
the generous interpretation of the concept (and changes in the interpretation) from period to
period.” The American Accounting Association (AAA) indicates the proposal provides the
“opportunistic manager greater opportunity to manipulate the perceptions of investors.”
Similarly, the Financial Accounting Commission of the European Federation of Financial
Analysts’ Societies (EFFAS), ITAC, Deloitte, the Audit Commission, and the AAA take the
view that subjectivity can lead to gaming by managers opportunistically categorizing an item
as an operating asset in one year and as an investment asset in the next year. EFFAS
emphasise “there is a risk that undesired results in a year are classified outside the operating
category similar to the experience of ten to fifteen years ago when companies classified items
as extraordinary in the income statement.”
The subjective nature of the management approach caused a number of commentators to
question how stakeholders would be able to evaluate something as nebulous as management
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intention. The Risk Management Association (RMA) summarizes these concerns by arguing
that the management approach “provides too much latitude without guaranteeing sufficiently
detailed disclosure and offers the opportunity for vast inconsistencies among similarly
situated companies with markedly different financial statements being the result.”
The only protection mechanism specifically identified by the Boards in the proposal and the
Exposure Draft is retrospective note disclosure of changes in accounting policy. The
adequacy of this mechanism is questioned by a number of respondents. For example, KPMG
illustrate it is not difficult to reclassify assets without triggering the disclosure requirements
of IAS 8. Moreover, EFFAS, argue that “additional disclosure cannot compensate for
potential misleading in the primary financial statements. We believe that arguments stating
that additional disclosure in the notes provides users with information to understand the
classification methodology and the reasons for changes from year to year is not convincing.”
ITAC suggests that there is a substantial gap between what these disclosures are supposed to
do and what they actually achieve, commenting that “experience has shown, mandating full
disclosure and realizing it in practice are rather different matters.”
Contrary to this view, other respondents suggest that the proposal contains adequate
safeguards. The AASB, Ernst & Young, Peyto Energy Trust, Roche, CFA Institute Centre for
Financial Market Integrity (CFA) and Nestlé, argue that changes in classification will be
treated as a change in accounting policy, triggering adequate note disclosures. For example,
The European Federation of Insurers and Reinsurers (CEA) commented that “each entity will
explain in the accounting policies ... this disclosure should be a suitable safeguard to avoid
arbitrary classification by management.”
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A number of stakeholders express concern about the ability of auditors to provide
assurance. For example, the International Corporate Governance Network (ICGN)
identifies a threat to users as “management and auditors often interpret the
management approach as giving management the final say on classification and
aggregation. As management performance is evaluated based on financial statement
information, management may sometimes have incentives to hide information useful to
investors.” This is a serious claim as it implies auditors have a restricted ability to
challenge management’s assertions in this area and management has a strong incentive
to attempt to dominate the auditors. This is supported by research showing that
managers are particularly sensitive to market expectations (Graham et al., 2005; Black
& Christensen, 2009) and behave in a variety of ways to protect their own interests.
The Audit Commission, Deloitte & Touche LLP, CPA Australia, the Basel Committee
on Banking Supervision, and the Financial Accounting and Reporting Special Interest
Group of the British Accounting Association expect that the expansion of the
management approach will lead to increased difficulty in verification of managerial
assertions. In discussing the allocation of shared services within entities, Financial
Executives International reaches a similar conclusion and indicates that auditability
“beyond testing mathematical accuracy of the allocation tools would be essentially
nonexistent.”
Similarly, ITAC states the management approach is “unobservable and unauditable”
and indicates it knows of many “companies whose sections and categories are unstable
and inconsistent over time, appear not to be based on any clearly discernible economic
drivers, and are apparently a product of the experience, interests, or even desired
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lifestyle of a particular manager at a particular time rather than any essential
characteristic of the business or the underlying economics driving the value creation in
the business.” These comments are particularly relevant in the light of paragraphs 68-70
of the Staff Draft (IASB, 2010), which requires entities to follow the classifications used
by their reporting segments. Transfers of assets and liabilities between these segments
could facilitate reclassifications without triggering IAS 8 disclosures. The ITAC
comments suggest that auditors would not be able to require disclosure of these events,
or unwind the impact of them in the various sections of the statement of comprehensive
income.
6.0. Conclusions and suggestions for further research
This paper examines how managers may be expected to behave following an expansion
of the management approach in the presentation of information in GPFR. While there is
some evidence to suggest this proposal may lead to improved capital allocation decisions
by users, another view suggests that managers will use this substantial increase in
discretion to manipulate the way information is presented for their own advantage. This
could lead to a result which is not aligned with the Boards’ stated intention of improving
the quality of GPFR and gives rise to concerns regarding the adequacy of mechanisms to
protect users.
The paper suggests that the Boards need to focus on developing adequate mechanisms to
protect users, as the only mechanism specifically identified by the Boards, retrospective
note disclosure under a rule such as IAS 8, is unsatisfactory due to design issues and the
changed environment it will be required to operate in. Further, there is considerable
concern regarding the ability of auditors to carry out their assurance tasks adequately
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and the proposal does not contain any provisions which would facilitate the auditors’
tasks. While it is true that no standard or rule is perfect and any incorporated
protection mechanisms may be circumvented, to design a standard without adequate
protection mechanisms exposes users to unacceptable risks.
The Boards’ proposal has generated a number of research opportunities. The limitations of
IAS 8 suggest that a more rigorous governance framework needs to be in place before the
management approach is implemented. The literature indicates specific rules, such as FRS 3
and Regulation G, have constrained managers from engaging in impression management
when reporting non-GAAP figures. However, the Boards’ proposal is markedly different to
these rules, as there are no benchmarks to reconcile to. Thus, research is required to develop a
robust framework that will further protect users if the proposal to expand the management
approach is implemented. A significant aspect of this research could be to identify the
protocols auditors require to provide assurance to users. Research is needed to identify
structures for inclusion in the governance framework that reduce the attractiveness of
impression management to managers. There is also a need to examine whether a single
governance framework is feasible, or whether there is a need for national versions of this
framework to address different cultural and political environments.
The proposition that the management approach be the cornerstone of financial reporting has
far-reaching implications. Matters of importance to users, particularly the establishment of an
adequate protection mechanism and the assurance issue, require further consideration and
analysis if the IASB is to achieve its goal of increasing the decision usefulness of GPFR.
However, the recent global financial crisis provides evidence of the risks that standard setters
face when attempting to enhance the decision usefulness of information. Although the
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Boards’ objective of increasing the utility of GPFR is laudable, much work remains to be
done to ensure this goal is achieved.
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Footnotes
1.
This project is conducted by the International Accounting Standards Board (IASB) and the Financial
Accounting Standards Board (FASB) (hereafter the Boards). To date this has resulted in the release of a
Discussion Paper (IASB 2008) and a Staff Draft (IASB 2010). These are issued by the IASB but reflect the
views of both Boards.
2.
Information asymmetry is an underlying assumption of agency theory, and arises when one party has more
information than another party with respect to some matter (Chia, 1995). The greater the difference in the
level of information held by one party over another, the greater is the level of information asymmetry
(Baiman & Evans, 1983).
3.
Beattie and Jones (2008) categorize considerable research, such as that addressing earnings management, as
falling under the impression management heading. Impression management is not necessarily restricted to
financial information. Cho, Roberts, and Patten (2010, p. 431) report that management frequently prefers
environmental disclosures over those of a financial nature as the former “can be deliberately tailored to
manage users’ impressions.”
4.
It should be noted that the assumed inverse relationship between disclosure and cost of capital has been
challenged recently on the basis that this is a diversifiable risk and so should not be priced by capital
markets (Hughes, Liu & Liu (2007). In addition, Clinch and Verrecchia (2011) suggest that in cases where a
negative shock causes a company to voluntarily increase disclosure, the cost of capital may rise, as the
increased disclosure is not enough to fully offset the initial shock.
5.
For example, if a manager wanted to increase operating income, he or she may reclassify certain assets into
or out of the operating section in the statement of financial position.
6.
In the context of the Boards’ proposal, core earnings would refer to either operating or business earnings.
7.
This paper is confined to a discussion of the literature which has analysed pro forma releases produced by
management of reporting entities, and does not consider the street earnings literature.
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8.
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This echoes paragraphs 2.27 and 2.40 of the Discussion Paper.
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June 27-28, 2012
Cambridge, UK
34
2012 Cambridge Business & Economics Conference
ISBN : 9780974211428
Figure 1: Proposed GPFR relations
Source: IASB (2008, p. 15)
June 27-28, 2012
Cambridge, UK
35
2012 Cambridge Business & Economics Conference
ISBN : 9780974211428
Table 1: Comment letter providers
___________________________________________________________________________
Letter Number
Respondent
Date of Comment
Letter
Submission
___________________________________________________________________________
_________________________
Part A
29
Accounting Standards Board of South Africa
30 March 2009
80A
Accounting Standards Board Canada
7
April 2009
133
American Accounting Association
14
April 2009
130
Audit Commission
12
March 2009
212
Australian Accounting Standards Board
29 April 2009
45
British Accounting Association
undated
213
Confederation of British Industry
April 2009
151
International Corporate Governance Network
14 April 2009
195
CPA Australia
14
April 2009
63
Deloitte & Touche LLP
10
April 2009
99
Ernst Young Global Limited
9
April 2009
184
European Federation of Financial Analysts’ Societies
14 April 2009
41
German Accounting Standards Board
7 April 2009
194
Institute of Chartered Accountants in England and Wales
20 April 2009
23
Institute of Management Accountants
26 March 2009
25
Intel
27 March
2009
151
International Corporate Governance Network
14 April 2009
206
International Organization of Securities Commissions
28 April 2009
226
Investors Technical Advisory Committee
1 July 2009
114
KPMG IFRG Limited
14 April
2009
182
Nestle S.A.
14 April
2009
June 27-28, 2012
Cambridge, UK
36
2012 Cambridge Business & Economics Conference
43
Risk Management Association
October 2008
36
Roche Group
2009
Part B
81
April 2009
162
April 2009
27
March 2009
216
173
April 2009
108
April 2009
46
April 2009
207
2009
117
2009
18
March 2009
153
2009
54
April 2009
9A
9B
37
2009
171
2009
100
April 2009
90
April 2009
72
April 2009
180
April 2009
64
April 2009
June 27-28, 2012
Cambridge, UK
ISBN : 9780974211428
16
3
April
American Council of Life Insurers
14
Association of British Insurers
14
Australasian Council of Auditors-General
31
Austrian Financial Reporting and Auditing Committee
undated
Basel Committee on Banking Supervision
14
British Bankers’ Association
14
BusinessEurope
7
CEA
28
April
CFA Institute
14
April
Daniel Tinkelmann
EnCana Corporation
12
14
E.On AG
Financial Executives International
(Committee on Corporate Reporting)
14 April 2009
Financial Executives International
(Committee on Private Companies Standards)
21 April 2009
Group of 100
Husky Energy
April
9
6
April
14
April
Nippon Keidanren
14
P.A. Pieterse van Wijck
13
Peyto Energy Trust
13
Securities Commission
16
Telephone and Data Systems Inc
10
37
2012 Cambridge Business & Economics Conference
189
April 2009
198
225
2009
126
The Actuarial Profession
The Danish Accounting Standards Committee/
The Swedish Financial Reporting Board
April 2009
The Hundred Group
The Institute of Certified Public Accountants in Ireland
14 April 2009
135
Torben Thomsen
April 2009
144
US Bancorp
2009
June 27-28, 2012
Cambridge, UK
ISBN : 9780974211428
20
16
16
June
15
April
38