Efectos Económicos

Economic Effects of Tightening Accounting Standards to Restrict Earnings Management
Author(s): Ralf Ewert and Alfred Wagenhofer

Source: The Accounting Review, Vol. 80, No. 4 (Oct., 2005), pp. 1101-1124
Published by: American Accounting Association
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THEACCOUNTING
REVIEW
Vol.80, No. 4
2005
pp. 1101-1124
Economic Effects of Tightening

Accounting Standards to Restrict
Earnings Management
Ralf Ewert
Goethe-UniversityFrankfurt
Alfred Wagenhofer
Universityof Graz
ABSTRACT:This paper examines the usual claim that tighter accounting standards
reduce earningsmanagementand providemorerelevantinformationto the capitalmar-
ket. We distinguish between accounting and real earnings management and assume
that a standard setter can only influence accounting earnings management by the
tightness of standards. In a rationalexpectations equilibriummodel, we find that earn-
ings qualityincreases withtighterstandards, but we identifyseveral consequences that
may outweigh this benefit. First,managers increase costly real earnings management
because the higher earnings quality increases the marginalbenefit of real earnings
management. Second, tighter standards can increase ratherthan decrease expected
accounting and total earnings management.Third,the expected total costs of earnings
management can also increase. We provideconditions for the occurrence of each of
these effects.
Keywords: accounting standards; earnings management; earnings quality;standard
setting.
I. INTRODUCTION
standard setterscommonlyperceiveearningsmanagement as undesirable
Accounting
andattemptto reducemanagement's discretionfor earningsmanagement by tight-
eningaccountingstandards.Forexample,in late2003 theInternational
Accounting
Standards
Boardeliminatedaccountingoptionsin severalstandards withwhatit calledan
"improvementsproject"(IASB 2003). Other to
ways tighten standardsare to limit the
of
impact judgmentby managers(andauditors),e.g., by requiringmeasurement withtrust-
but less
worthy, perhaps relevant, numbersand by providing more "bright-line"rulesor
Helpful commentsby the editor, two anonymousreviewers,Sunil Dutta, Ron Dye, JerryFeltham,Jan-Pieter
Krahnen,BarbaraPirchegger,Stefan Reichelstein,ChristianRiegler, Stefan Wielenberg,and participantsat the
AccountingWorkshopat the StuttgartInstituteof Managementand Technology,StanfordAccountingSummer
Camp,EAA AnnualCongressin Prague,EIASMWorkshopon AccountingandRegulationin Siena,andUniversity
of Fribourgare gratefullyacknowledged.
Editor'snote: This paperwas acceptedby MadhavRajal.
SubmittedOctober2003
AcceptedMay 2005
1101

1102 Ewert and Wagenhofer
detailedguidance.The discussionof principles-basedversusrules-basedstandardsis in line

with this reasoning.
As noted by several authors,including Schipper(2003), tighter accountingstandards
may lead to a substitutioneffect in that the reductionof accountingearningsmanagement
is met with increasedreal earningsmanagement,therebycounteractingthe standard-setter's
intention.In contrastto accountingearningsmanagement,real earningsmanagementcon-
sumes real resources.However,the sources and consequencesof such substitutioneffects
are seldom explicated. In this paper,we study the effects of tighter accountingstandards
in a capital marketsetting and consider the following questions:Do tighter standardsim-
prove earningsquality?Can tighteraccountingstandardsindeed reduce earningsmanage-
ment?How do they affect the cost of earningsmanagementin a capitalmarketequilibrium?
We distinguishbetweenaccountingandreal earningsmanagement;accountingearnings
managementincludesthe way accountingstandardsare appliedto recordgiven transactions
and events, whereas real earningsmanagementchanges the timing or structuringof real
transactions.Real earningsmanagementimplies that the managerdeviates from an other-
wise optimalplan of actions only to affect earnings,thus, imposing a real cost to the firm.
We argue that an accountingstandardsetter can tighten standardsto restrictthe discretion
for accountingearningsmanagement,but can do little to restrictreal earningsmanagement.
Our results confirmthat tighteraccountingstandardsstrictlyincreaseearningsquality,
as measuredby the variabilityof reportedearningsand the associationbetween reported
earningsand the marketprice reaction(value relevance).We deriveinsightsinto the change
in the level of earningsmanagementif accounting standardsare tightened.We establish
that real earnings managementstrictly increases because the tighter standardsinduce a
greatervalue relevance,which again increases the marginalbenefit of real earningsman-
agement. Next, we provide conditions for a decrease, but also conditions for an increase
in expectedaccountingearningsmanagementand expectedtotal earningsmanagementwith
tighter standards.This latter result obtains if expected accountingearnings management
was originally small; in that case, the increase in value relevance increases accounting
earningsmanagement.Thus, we provide an endogenousexplanationfor a substitutionof
accountingby real earningsmanagement,and we give conditionswhen it arises and when
it does not. Finally, we analyze the effect of tighteningaccountingstandardson the costs
of earnings managementin equilibrium,which include the manager'sdisutility and the
change in firm value due to earningsmanagement.Tighterstandardsstrictlydecreasefirm
value, but the total costs can either decrease or increase, depending on the changes in
accountingand real earningsmanagementinducedby the resultingearningsqualitychange.
An increase in expected total costs is more likely the more uncertainis the marketabout
the manager'searningsmanagementobjective.These resultsinclude severalconsequences
of tighterstandardsthat run counterto conventionalwisdom. Therefore,they are relevant
for standardsetting, which should be aware of these potentially harmfuleffects in the
developmentof standards,and for the design of empiricaltests of earningsmanagement
across accountingregimes.
Our paper builds on Fischer and Verrecchia (2000), who analyze rational expectations
equilibria with earnings management. We extend their model by distinguishing between
accounting and real earnings management and focus on the effects of varying accounting
standards. Sankar and Subramanyam (2001) study earnings management in a two-period
capital market setting. They use a utility function similar to ours and show that earnings
management may allow a manager to communicate value-relevant private information
TheAccountingReview,October2005

EconomicEffectsof TighteningAccountingStandardsto RestrictEarningsManagement 1103
throughthe earningsreport.Thus, earningsmanagementcan lead to increasedvalue rele-

vance and is valuable given appropriaterestrictionsby accounting principles. However,
Sankarand Subramanyam(2001) do not explicitly study standard-setting issues.'
Demski (2004) sketchesa model with substitutionbetweenaccountingandreal earnings
management.He assumes that tighter standardsreduce accountingearningsmanagement,
but lower the disutility of engaging in real earnings management.Tighteningstandards
directlyincreasesreal earningsmanagementand the related social cost. While the idea in
his paperis relatedto our paper,we find an endogenousexplanationfor the occurrenceof
a substitutioneffect.
Dye (2002) analyzes earningsmanagementin the form of binaryclassificationmanip-
ulations, which are costly to the managerand inferredby the rationalcapital marketpar-
ticipantsin a one-periodequilibriummodel. He is interestedin efficientaccountingstandard
setting, taking into accountthat the equilibriumoutcome deviatesfrom the "official"clas-
sification standard.Dye and Sridhar(2004) study relevance and reliabilityof accounting
informationandmodel the accountantas the gatekeeperto tradeoff these two characteristics
in a capital marketequilibrium.
Earningsmanagementhas also been studied in the context of agency models. These
models challenge the view that earningsmanagementis undesirableand identify situations
in which a principalwould want to provide reportingdiscretionto a manager.2A paper
that studies optimal standardsetting is by Liang (2004), who finds that some discretion
for earnings managementcan improve risk allocation in a two-period agency model.
Christensenet al. (2004) considera generalrenegotiationsetting and assumethat the man-
ager can bias reportedincome at a disutilityand that the principalcan controlthe disutility,
which is similarto our standard-setter's control variable.The findings of these papersare
similarin spiritto our main result that it can be preferableto loosen accountingstandards
and therebyincrease accountingearningsmanagement,althoughfor differentreasons.
The rest of the paperis organizedas follows: Section II sets out the model and describes
the assumptions.Section III derives and characterizeslinear reportingequilibria.Section
IV contains the main results for tighteningaccountingstandardson earningsquality,the
equilibriumearnings managementpolicies, and the total costs of earnings management.
Section V discusses some extensions, and Section VI concludes.
II. THE MODEL

We considertwo strategicplayers, a risk-neutralmanagerof a firm and a competitive,
risk-neutralcapitalmarket.A priori, the terminalvalue of the firmg is normallydistributed
with mean E[x] > 0 and variance0U. In orderto focus on earningsmanagementdecisions,
we do not explicitly considerthe underlyingproductiondecisions by the managerthatmay
affect g. In the first period the managerengages in earningsmanagementand reportspo-
tentially biased earnings, and the capital marketuses the reportedearningsto adjustthe
marketprice; in the second period the earningsmanagementeffect unwinds.The two pe-
riods are representativeof a multiperiodsettingin which the earningsmanagementstrategy
is independently selected in each period and reverses in one or more subsequent periods.
Otherpapersthatstudyearningsmanagementin rationalexpectationsequilibriaareKirschenheiter andMelumad

(2002), Fischerand Stocken(2004), and StockenandVerrecchia(2004). They do not considerstandardsetting.
2 See, e.g., Demski (1998), Duttaand Gigler (2002), andDemski et al. (2004).
The Accounting Review, October 2005

The Accounting System

The firm operatesan accountingsystem thatrecordstransactionsand events according
to a set of accountingstandardsin force, and producesthe base informationfor a periodic
financialreport.The base informationis summarizedby a signal in each period. The
y,
signals provide unbiasedinformationabout the (change in) terminalvalue X, i.e., Y, = X
+ t,, where the noise terms -, are normallydistributedwith mean 0 and varianceo2 and
independentfrom each other.
At the end of each periodt, the managerprivatelyobservesthe realizedearningssignal
y, and is obliged by a regulatorto issue a public accountingreportm, aboutearnings.The
report may deviate from the underlyingy, because the managercan engage in earnings
managementactivities described below. The capital marketobserves mt and adjusts the
marketprice to P,(m,),taking into accountthe potentialbias from y,.3
Earnings Management
We distinguishbetween two generic types of earningsmanagementactivities,account-
ing and real earnings management,where bA (bR) denotes the level of accounting(real)
earnings management.After observing yl, the manager chooses bA and bR to inflate or
deflate reportedearningsm, relativeto y1 in the following way:
= Yl + bA + bR. (1)
ml
Accounting earningsmanagementincludes the interpretationof accountingstandards

and their applicationto transactionsand events that have alreadyoccurred.Essentially,the
manager shifts some amount of accounting earnings from one period to the other. We
assume that clean surplusholds, so that reportedearningsin period two change by -bA.
In contrast,real earningsmanagementaffects the timing or structuringof transactions.
It occurs if the managerundertakestransactionsthat are inefficient from the firm's per-
spective, but generate a desired profit or loss in the currentperiod.4Thus, real earnings
managementimposes costs on the firm and changes firm value and second-periodearnings
by an amountover and above bR.We model these costs as a linearfunctionof real earnings
management,cbR, where c 0, and assume they are incurredin the second period. The
-
choice of the earningsmanagement activitiesin period one leads to the following reported
earningsby the managerin periodtwo:
m2 = Y2 - b - bR = (x + E2 - cbR) - bA - bR. (2)

-
Engaging in real earnings managementchanges the original terminal value to g
- cbR, and since 52 is an unbiasedsignal for the terminalvalue its value changes similarly.
Manager's Utility
In general,the manager'sinterestin earningsmanagementis drivenby numerousfac-
tors. We capturethese factors broadlyby assuming a utility function of the managerthat
3 In computingthe marketprice, we do not explicitlyconsiderthe manager'svariablecompensationassumingit

is small relativeto the marketprice effects.
4 In orderto be recordedin period 1, the transactionsmustoccurbeforethe end of the period(excludingconsid-
erationof transactionsinitiatedlaterbut antedated).If real earningsmanagementdependson y, (which is not
the case in equilibriumin this model), one would have to assumethat the managercan observeyi or closely
relatedinformationalreadybeforethe reportingdate.

depends on accountingearnings and marketprice."The manager'sinterestin accounting

reportsmay result, for example, from: an explicit accounting-basedbonus program,debt
covenants tied to accountingnumbers,the desire to document a positive performanceto
convince the marketabout the manager'scapabilities,or upcoming tenure decisions. The
interestin the firm'smarketprice may stem from:the manager'sintentionto sell shareshe
or she owns, an explicit stock-basedincentive contract,reducingthe threatof a takeover,
internalizingmarketreturnsas a measure of managerialperformance,the desire to raise
new capital, or simply the utility of managinga valuable firm ("empire building"). The
manager'stwo-periodutility is:
U = smi + pP1 + m2 - v(bA,bR), (3)
where s > 0 denotes the weight attachedon the accountingreportm, relativeto m2; p is
the weight on the marketprice P1 (or change in the marketprice); and v is the manager's
disutilityfrom engaging in earningsmanagement.
For simplicity,we do not include P2 into the manager'sutility function. What is key
for our results is that the managerhas some interest in the long-termeffects of earnings
managementin t = 1, which we capturethroughthe accountingreportm2 in the manager's
two-periodutility. We discuss potentialeffects of an inclusion of P2 in Section V.
The marketdoes not exactly know the manager'sinterestin earningsmanagement,but
holds beliefs of the factorsand their weights in the utility function.We model the market's
uncertaintyfollowing Fischer and Verrecchia(2000) and assume that the weight p on the
marketprice is a normallydistributedrandomvariablewith expected value E[pf]= p > 0
and variance r2;the distributionis independentof thatof the terminalvalue and the signals
Y,.Although we assume thatp is strictly positive, the realizedp can be negative, for ex-
ample, if the managerplans to repurchaseshares,receives stock options, or engages in a
managementbuyout. The managerobservesp before he or she makes the earningsman-
agement decision, whereas the capital marketonly knows the prior distributionof p and
prices the firmbased on its expectationof the manager'sincentivesto influencethe market
price. This uncertaintypreventsthe marketfrom perfectlyinferringthe manager'searnings
managementactivitiesin equilibrium.
The relative weight s on reported earnings is given and common knowledge, e.g.,
becauseinformationaboutthe managementcompensationpackageand/or the existingbond
covenantsis publicly available.In principle,there can also be uncertaintywith respect to
s; includingsuch additionaluncertaintywould only increasethe complexityof the analysis
without yielding additionalinsights. Time preferencescan be easily incorporatedby an
appropriatechoice of s, as can a more short-termor long-termorientation.Implicit in the
assumptionof the manager'sutility is that the underlyingincentive problemdoes not in-
teractwith the earningsmanagementdecisions.
The disutilityv is convex in both accountingand real earningsmanagement:
rb2 b2
= 2 + 2.
v(bA,bR) (4)
(4)
The parameterr is explained below. The disutility captures,for example, time and effort
needed to find and execute the appropriateactions as well as to negotiatewith the auditor,
5 Jiambalvo
(1996)discussesvariousincentives
forearnings
management.

1106 Ewertand Wagenhofer
psychic costs of biasing accountingearnings,and individualregulatoryand litigationrisks.6

We assume that the disutility incurredby the manageris additive in the two types of
earningsmanagement.Therefore,thereis no directinteractionbetweenthem.The convexity
capturesthe fact that it becomes increasinglycumbersomefor the managerto find more
opportunitiesfor either type of earningsmanagement.
Tightness of Accounting Standards
The parameterr in Equation(4) reflects the effect of tighter accountingstandardsin
our model. We formalize tighteningaccountingstandardsby increasingr, where r 1.7
Tighter standardsmake it more costly for the manager to achieve a desirable level - of
accountingearningsmanagement.8
This formalizationcapturesthe notion that, from a standard-settingperspective,a key
difference between accounting and real earnings managementlies in the fact that it is
generallymuch moredifficultto restrictreal earningsmanagementthanaccountingearnings
management.Real earnings managementis often indistinguishablefrom other economic
transactionsundertakenby the firm; it may even generate cash flows and, then, avoid
measurementissues completely.For example, the sale of inventoryor assets at a bargain
price is recognized in income, whateverthe motivationfor this sale has been. It is easier
for a standardsetter to tighten accountingstandardsthat reduce management'sdiscretion
for accountingearningsmanagement,takingas given the economic transactionsand events
over the reportingperiod.
In practice, the distinctionbetween accountingand real earnings managementis not
always clear. Examples are leases, recognitionand derecognitionof financialinstruments,
and variable interest entities, which involve a great deal of structuredtransactionswith
economic effects. While we use accounting and real earnings managementas a typical
It capturesa situation
distinction,our formalizationis open to a more generalinterpretation.
in which there are two sets of earningsmanagementopportunities,and the standardsetter
considersrestrictingone set. Our interpretationhas the advantagethat we can examine the
role of real costs incurredby one set of earningsmanagementactivities.
Figure 1 summarizesthe sequence of events.
III. EQUILIBRIUM
A reportingequilibriumconsists of an earningsreportand a marketprice reactionwith
the following properties.The managerselects bA and bR to maximize his or her expected
utility given the realizedweight p of the marketprice in the utility function,knowledgeof
y, and real cost c, and the conjecture(indicatedby a caret)of the marketprice reactionon
the reportedearnings,
Pl(ml):
rb2 b2
b*, bb E arg max sm1 + pp1(m1) + E[m2] A R (5)
bA,bR 2 2
In general,the manager'soptimalearningsmanagementactivities,bl(yl, p) and

b*(yl,
p), depend on the realized signal y, and weight p, which are privateinformationof the
6 See Marquardt and Wiedman (2004) for a description of the cost of different instruments of earnings
management.
There are other instruments that increase r besides the tightening of accounting standards. For example, the
Sarbanes-Oxley Act of 2002 requires the CEO and CFO to certify the financial statements of the firm, thus,
increasing their private risk of litigation.
8 An alternative, but qualitatively similar, formulation of the effect of tighter standards would be that they reduce
the effect of the bias in reported earnings, m = yi + bA/r + bR with r 1.
-

FIGURE 1
Sequence of Events
I I I I I I
Manager Realcost Manager Marketprice Manager Manager
observesthe c is publicly chooses adjuststo P1 observes reportsm2
weightp on observed earnings accounting
marketprice management earningsy2
and accounting (bA,bR)and
earningsy, reportsmi
manager.The capitalmarketadjuststhe marketprice of the firmunderrationalconjectures

bA
and bR regardingthe choice functions of the manager.The price Pl(mlhb, hR) equals
the expected terminal value of the firm conditional upon the manager'sreport and the
conjecturedreportingstrategy.In equilibrium,the conjecturesmust equal the actual func-
tions, i.e., b*(yl, p) = bA(yl, ip) b*(yI, p) = bR(Yl, p), and PB = P,. Our first result
establishesthat any equilibriummust involve some form of earningsmanagement.
Lemma 1: Every equilibriumwith a differentiableand nonconstantprice function P,

involves earningsmanagementby the manager(i.e., b*, b* 4 0 with prob-
ability one).
All proofs are in the Appendix.
Lemma 1 rules out equilibriawith no earningsmanagementfor arbitrarydifferentiable

conjecturesabout the marketprice, given the accountingreportis not simply ignored by
the capital marketparticipants.Furtherinsights into equilibriaare obtainedby imposing
some structureon the form of the conjecturesof earningsmanagementand the price re-
action. We restrict attentionto linear equilibriain which the pricing function Pl(ml) is
linear in mi:
P1 = at + 3m. (6)
The manageruses the conjectures& and and maximizes his or her expected utility
over bA and bR:
rb2 b2
s(y1 + bA + bR) + E[y21Y1]- bA - bR + p( +
+ bA + bR))
2 22'
2A
(7)
where Y2 alreadyincludes the real cost cbR of earningsmanagement.The first-ordercon-
ditions with respect to bA and bR yield:
aU
s - 1 + pp - rb* = 0,
abaa
3U
s - 1 - c + p - b* =0.
abR -

These two equationsdo not depend on y1 and, hence, the optimal levels of earnings
managementactivities, b* and b*, are independentof the accountingearningsy1. Let As
s - 1 be the differencein the (relative)weights in the two periods and R = (1 + r)/r.
The following propositionestablishesexistence and the characteristicsof linear equilibria.
Proposition 1:
(i) There exists a linearequilibriumin which the managerchooses the
accountingand real earningsmanagementpolicies:
1
bA*= (As+ pp)'-r
(8)
b* = As + pp - c
and the marketprice of the firm adjustslinearlyin m, with strictly

positive weight 13on the earningsreport,where P is implicitly de-
fined by:
(2 - CP2Rr2
2P+x E(-+ r2R2
U2
p(9)
(ii) If c2a2 > 3(a2 + U2), there exist up to two additionalequilibria

with p < 0.
In equilibrium,the sign of accountingearningsmanagementis determinedby the sign

of (As + pp). As capturesthe direct compensationeffects of shifting reportedearnings
between the two periods. A positive As favors aggressive earnings managementbecause
the benefit from early reportingof earningson compensationin periodone is greaterthan
the correspondingcost in period two. The second term, pp, results from the effect of
earningsmanagementon the equilibriummarketprice.
Real earningsmanagementalso dependson (As + pp), but the managerfactorsin the
effect of the real cost c in the second period on his or her expectedutility.The cost c > 0
curbs an incentive for aggressivereal earningsmanagement.Further,-c is the beneficial
effect of real decision makingper unit of bRand (As + pp) capturesthe actualreal earnings
management,i.e., the bias due to reportingincentives.To see this, suppose there were no
earningsmanagement.The (benevolent)managermaximizes the expected terminalvalue
net of (the monetaryequivalentof) his or her personaldisutility:
b2
E[x] - cbR 2
R
by choosing b1 = -c.
The marketadjuststhe marketprice with a rate of P of the earningsreportm,. [ is
based on the revision of the expected terminalvalue conditionalon ml, u + oa), if
there were no earnings management,and additionalterms that correct for+/(ox
the expected
earningsmanagement.The equilibriumP in Equation(9) is lower than the [3 that would
emerge without earnings management,as the numeratordecreases and the denominator
increases,ceterisparibus.The more uncertainthe marketis aboutthe manager'spropensity

for the marketprice, measuredby an increasingU2, the less is the price reaction on the
earningsreport.The numeratorof Equation(9) includes a term that also depends on the
real cost c, which capturesthe fact that the capitalmarketinfers from the reportedearnings
m, informationaboutp and uses it to updateits expectationsof the change in firm value
due to the cost of real earningsmanagement.
The Propositionstates that there always exists an equilibriumwith strictlypositive 1,
but there may be additionalequilibriawith strictly negative p if c2oU2 > 3(U2 + U2). A
negative 3 implies that the marketprice decreases in the earnings report.This counter-
intuitive finding is due to the fact that the earnings report not only informs the market
about the terminalvalue, but also about the incentive weight p. If the marketassociates a
favorableearningsreportwith large values for p, then it expects large real earningsman-
agementand, consequently,a great reductionin firm value. The higher the incentive vari-
ance ., the more is the earningsreportdrivenby the incentiveparameterp, thus making
it more likely thatthe condition 2 3(U(o2+ C2) is fulfilled.In what follows, we confine
attentionto the equilibriumwithc2Op2
a positive P and assume
c2r2 < 3(u2 + o1).
IV. EFFECTS OF TIGHTER ACCOUNTING STANDARDS
In this section, we examine the effects of tighter standards(i.e., increasing r) on the
qualityof reportedearnings,the level of earningsmanagement,and the totalcost of earnings
management.The subsequentresults analogouslyapply for loosening standards.
Standardsetters are interestedin the averageeffects of a policy change. Similarly,the
empiricalliteraturefocuses on averageearningsmanagement.Therefore,much of the fol-
lowing analysis is in terms of expected earningsmanagement,that is, we state the effects
from an ex ante perspectivewith respect to the sensitivityp of the manager'sutility on
marketprice.
Quality of Reported Earnings

Earnings quality has generatedconsiderableinterest in the empirical literature.For
example, Franciset al. (2004) discuss seven attributesof (reported)earnings.In this model,
we examine two earningsqualityattributes,value relevanceand earningsvariability.9Value
relevanceis typicallymeasuredby the associationbetweenreportedearningsandthe change
in marketprices, i.e., 3 in our model. Earningsvariability(or efficiency) is often measured
by the standarddeviationor the varianceof earnings.Proposition2 providesthe results.
Proposition 2: Tighteraccountingstandardsimply a higher value relevance P and a

lower variancevar(iz,) of reportedearnings.
Proposition2 confirmsthattighterstandardsreduce the noise in reportedearningsand

make them more value-relevantand less variablein equilibrium.-0Assumingthe objective
of a standardsetter is to improve the quality of reportedearnings,tighteningaccounting
standardsunambiguouslyachieves this objective.While Proposition2 is intuitive,it is not
straightforward because of the interaction between the changing incentives for earnings
management and the quality of earnings. The following discussion examines these effects
in more detail.
9 FischerandStocken(2004) use the expectedvalueof the squareof the differencebetweenunbiasedandmanaged

earningsas a measureof earningsquality.
1o Fischerand Verrecchia(2000) obtaina similarresultin theirmodel withoutreal earningsmanagement.

Level of Earnings Management

An increase of r has a direct effect on accountingearningsmanagement;it becomes
more costly in termsof the disutilityfor the managerto achieve a certainlevel of earnings
management.Tighteningstandardshas no directeffect on real earningsmanagement.How-
ever, thereis anothereffect on accountingandreal earningsmanagement,which stems from
the change in earningsquality.We consider these effects for a manager,who is expected
to have an incentivefor aggressiveearningsmanagement,i.e., As + p3 > 0.11 In this case,
expected accountingearningsmanagementis strictlypositive, as is expected real earnings
managementif it is measuredagainstthe benchmarkof b+ = -c.
Proposition 3: Tighteraccountingstandardsimply:
(i) Expectedreal earningsmanagementstrictlyincreases.
(ii) If As ? 0, then expected accounting earnings managementand
expected total earningsmanagementstrictlydecrease.
(iii) For any As < 0 there exist 81, 82 > 0 such that for 86 < p < 82
expectedaccountingearningsmanagementandexpectedtotalearn-
ings managementstrictlyincrease.
Part(i) establishesthatexpectedreal earningsmanagementstrictlyincreasesfor tighter

accountingstandards.The increase in the value relevanceP (Proposition2) increases the
marginalbenefit of real earningsmanagementand, in turn,the managerengages in more
real earningsmanagementin equilibrium.
Part (ii) confirmsan intuitiveresult if As 2 0: Tighteningstandardsstrictly decreases
expected accounting earnings managementbecause it increases the manager's disutility
from accountingearningsmanagementand lowers his or her incentive to engage in such
activities.However,the increasein value relevanceruns counterto this effect and increases
the benefit from accounting earnings management.It turns out that, in equilibrium,the
direct (disutility)effect dominatesthe effect from the increasedvalue relevance.Parts (i)
and (ii) togetherestablishthat thereis an endogenoussubstitutionbetween accountingand
real earningsmanagementthat arises from the marketreaction alone; there are no direct
interdependenciesbetween the two types of earningsmanagement.Moreover,the increase
in real earningsmanagementonly partiallysubstitutesfor the reductionin accountingearn-
ings managementbecause, in equilibrium,expected total earningsmanagementstrictlyde-
creases in r.
Part (iii) of the Propositionshows that these intuitiveresults need not hold any more
if As < 0, and it recordsconditionsfor which expected accountingearningsmanagement
strictlyincreases.Since real earningsmanagementalways increases,expectedtotal earnings
managementincreases, as well, and the substitutioneffect vanishes. This result obtains if
the benefit from accounting earnings managementdue to the increased value relevance
exceeds the increasein disutility.This is morelikely to occurfor lower expectedaccounting
earnings management, which eventually leads to the necessary condition As < 0.
The proof is constructive and gives explicit expressions for the lower and upper bounds
on p such that expected earnings management increases for arbitrarily chosen As < 0. The
lower bound 86 is determined by the situation in which the manager's expected earnings
management incentives just cancel, i.e., As + = 0. While the value relevance
8•,P3(r)
"
A similar analysis can be performed for conservative earnings management. The focus on aggressive earnings
management is meant to better describe current practice on average and to avoid too many case distinctions in
the presentation of the results.

p > 0 is endogenous(and clearly depends on r), it does not depend on As and p. Fixing
an arbitraryr - 1 as a startingpoint for tightening standards,p is fully determinedby
exogenous variables.In this case, expected accountingearningsmanagementis zero, since
taking expectationsin Equation(8) for p = 81 and rearrangingyields:
= As + pp(r)= As + 681(r).
rE[bj*] (10)
The right-handside of Equation(10) capturesthe averagemarginalbenefitof increasing
bA (which equals 0 at p = 81), and the left-hand side includes the average marginaldis-
utility.12At p = 6,, tighteningaccountingstandardshas a second-ordereffect on the man-
ager's averagemarginaldisutility but a positive first-ordereffect on the averagemarginal
benefit because of the increase in value relevance. Consequently,the equilibriumwith
tighterstandardsinduces a higherlevel of expected accountingearningsmanagement.Due
to continuity,there is a set of values for p with an upper bound 82 for which this result
still holds while at the same time preservingthe (assumed)incentives for aggressive ac-
countingearningsmanagementon average,i.e., As + p1p> 0.
Although the result is theoreticallyappealing,its empiricalrelevanceis perhapsless
significantbecause it arises only in situationsin which earningsmanagementincentives,
on average,are not pronouncedand, consequently,averageearningsmanagementis small.
Empiricalstudies usually try to single out observationsin which strong earningsmanage-
ment incentives are hypothesized.Then tighter standardswould appearto result in less
earningsmanagement.
Given the possibility of an increasein expected earningsmanagementfor tighterstan-
dards,it is worthrevisitingthe result in Proposition2 that the qualityof reportedearnings
increases in r for any As, p-, and variancelevels. The key driverof this result is not the
level of expected earningsmanagement(which is influencedby As andp) but the decrease
in the varianceof earningsmanagement.Expectedtotal earningsmanagementis:
E[bF + b*] = E[AsR + f3PR - c]
and the varianceis:
var(b* + b*) =
p2R202
which strictly decreasesfor tighteraccountingstandards.Thus, earningsquality improves

due to the reductionof the noise in reportedearnings.Given rationalexpectationsof the
market,a shift in the level of earningsmanagementcan eventuallybe backedout in equi-
libriumby simply adjustingthe pricing constant;thus, it has no impact on the sensitivity
of the price with respect to earnings.
Costs of Earnings Management

The next analysis examines the effect of tighter standardson the expected costs of
earningsmanagement.To motivatethe cost analysis, notice that the reportingequilibrium
leads to a kind of second-bestsituationcomparedto a situationwithout earningsmanage-
ment. Suppose the managercould crediblyprecommitto avoid earningsmanagement,and
the capital market would believe that. Without earnings managementthe quality of the
12 The same argumentholds for the earningsmanagementcomponentof b*.

financialreportwould attainits maximumin this setting, 13= /( + or2).Moreover,the

managerwould not incur disutilityof accountingearningsmanagement.The real activities
would be chosen to maximize firm value net of the disutility, i.e., b, = -c, which is
essentiallya first-bestadaptationof firmvalue to the currentmarketconditions,represented
by c. The net increasein firm value then is:
(b) - c2
- =
cb
R -2 = c2
2 2
However,the manageris unableto crediblyprecommitto such a behavior.A standard

settercannotsubstitutefor a commitmentbecause tighteningaccountingstandardscan only
reduceaccountingearningsmanagementbut not real earningsmanagement.This discussion
suggests the change in the costs of earningsmanagementto the partiesin equilibriumas a
measureof the economic effects of tighteningstandards.
We define the expected total costs due to earnings managementas the sum of (the
monetaryequivalentof) the expectedmanager'sdisutilityand the expectedreal cost of real
earningsmanagement:
E[TC] = E[v(b*, b*)] + E[cb*] + -.2

C2
(11)
The first term is the expected disutility,and the second and the thirdtermscapturethe
real cost. The thirdterm, c2/2, correctsthe cost for the beneficial effect of the manager's
adjustment(b' = -c). Since this term is constant,it does not affect the following results.
Althoughit is generallydifficultto combinedifferentperson'sutilities,we add the monetary
equivalentof the manager'sutility and the change in firm value because, in the end, both
are costs to the firm (directlyor by compensatingthe manager).
The next propositionprovidesconditionsunderwhich the expectedtotalcosts can either
decreaseor increase.
Proposition 4: Tighteraccountingstandardsimply:
(i) If c > 0, then the value of the firm strictlydecreases.
(ii) If eitherUo or U is sufficientlylarge, then the expectedtotal costs
decrease.
(iii) If a 2 is sufficientlylarge relativeto (r2 + 72), then for any >
0 there exist 8~ < 0 and 682> 0 such that for 861 As _ 62 the
expected total costs increase. If As _ 0, then a sufficientlylarge
relative to (U?2+ U 2) is also necessaryfor expected total costs
rpincrease.
to
The value of the firm directlydependson the level of expected real earningsmanage-
ment because of the cost c associated with it. Since expected real earningsmanagement
increasesfor tighteraccountingstandards(as shown in Proposition3 (i)), firmvalue strictly
decreases.
Proposition4 (ii) states sufficientconditionsfor a strict decreasein the expected total
costs. They requireeither a highly uncertainterminalvalue or a highly noisy accounting
system. A high varianceU2 relative to the accountingrisk a2 implies that the accounting
report is very informativeand leads to a value relevance that approachesP = 1. Then,
tighteningaccountingstandardsdoes not materiallyaffect the value relevance and, hence,

Economic Effects of Tightening Accounting Standards to Restrict Earnings Management 1113
the substitutioneffect is negligible. As a consequence, tightening standardsreduces the

expectedtotal costs. A similarline of argumentapplies for high accountingrisk a' relative
to :2. Although a high ar reduces the value relevance,it also reduces the marginalvalue
relevanceof tighterstandardsto a value close to zero. Again, the value relevancedoes not
change much due to tighterstandardsand expected total costs decrease.
Proposition4 (iii) gives necessaryand sufficientconditionsfor an increasein expected
total costs even thoughexpectedearningsmanagementreduces.The criticalparameterhere
is the market'suncertaintyur2aboutthe weightp for the marketpriceeffect in the manager's
utility function. The Propositionstates that for sufficientlyhigh Ur there always exists a
non-emptyset of parameters,which leads to an increase in the expected total costs. The
reason is that the marginalvalue relevanced3/dr is relativelyhigh, which induces a strong
increase in real earningsmanagementand, therefore,leads to an increase in the expected
total costs of earningsmanagement.'3
V. DISCUSSION AND EXTENSIONS

Our analysis of the effects of tighteningaccountingstandardsassumes no exogenous
interactionbetween accountingandreal earningsmanagement.Ourresultthatreal earnings
managementincreaseswith tighteraccountingstandardsis a subtle consequenceof higher
value relevanceof reportedearnings,which increasesthe marginalbenefitof earningsman-
agement.A substitutionof accountingearningsmanagementby real earningsmanagement
arises endogenously(or does not arise under certainconditions).It is, of course, possible
to model a direct interactionbetween accountingand real earningsmanagement.One as-
sumptionwould be that the managerwants to meet or beat a target,such as an earnings
forecast.For simplicity,assume the manageruses earningsmanagementto achieve a target
earningslevel Mr,given some signal yl. Increasingthe disutility (decreasingthe effective-
ness) of accountingearningsmanagementby tighteningstandardschangesthe optimalmix
of accountingand real earnings managementand leads to a substitutioneffect. Another
assumptionwould be that the manager'smarginaldisutilityof engaging in earningsman-
agement depends on the level of both earnings managementactivities. An example is a
disutilityof v(bA, bR) = rb2 + 2kbAbR+ b2 with k E (0, 1). k -- 0 approachesthe disutility
we use in our model, whereas k -* 1 treats accounting and real earnings management
activitiesequally (an interpretationcould be thatthe managerincursdisutilityfrom the time
devoted to the searchand implementationof earningsmanagementof either type).
There is empiricalevidence of a substitutioneffect. For example, Barton(2001) finds
thatfinancialderivativesareused as a substitutefor accountingearningsmanagement.Black
et al. (1998) comparethe use of asset sales in countriesthatdifferwith respectto the option
of revaluing noncurrentassets. While upward asset revaluationsare not allowed in the
United States, they are an available option in the United Kingdom, Australia,and New
Zealand. They find that the use of asset sales to smooth income is less pronouncedin
countriesthat allow revaluations.It is not clear from these papers what the source of the
substitutioneffect is.
We show in Proposition4 (i) thattighteraccountingstandardsstrictlyreducefirmvalue
if c > 0. However,we note that our model abstractsfrom othereffects thatmay affect firm
value. For example,the decreasein the variabilityof reportedearningsmay benefitinvestors
13 Fischerand Verrecchia(2000) derive a relatedresultin their model withoutreal earningsmanagement.They

show that for sufficientuncertaintyaboutthe manager'sincentiveshis or her utility can increaseif earnings
managementis available.We consideronly costs of earningsmanagementand, therefore,our resultis driven
by the substitutioneffect.

if they use earnings to provide incentives to risk-aversemanagers.Moreover,the model

assumes risk-neutralvaluation in the capital marketand does not include the effects of
higher value relevancefor portfoliodecisions of risk-averseinvestorsand risk premiums.
While the focus of our analysis is on the effects of tighteraccountingstandards,there
are otherregulatoryactions that can be studiedin our framework.One aspect is the quality
of the accountingsystem, representedby the noise '2it generates.To producebetter in-
formationabouta firm'sfinancialposition,a standardsettermight seek to develop standards
that reduce such noise. Since p monotonouslydecreases in a', the relevance of the ac-
countingreportsindeed increasesfor lower u . However,Proposition1 also revealsthat an
increase in p increases earningsmanagementin equilibrium,so reducingCr leads to in-
creased expected accounting and real earnings management.Hence, a better accounting
system imposes a cost in terms of a change in managementbehavior.In addition,lower
noise TI2may affect total expected costs if standardsare tightened subsequently,since it
becomes more probablethat the case of Proposition4 (iii) obtains.
Anotheraspect concernsthe market'suncertaintyaboutthe manager'sincentive struc-
ture. Suppose a standardsetter increases the disclosure requirementsregardingthe com-
ponents of managers'compensationpackages. Ex ante, such informationreduces the un-
certainty over p by lowering a'. A lower incentive risk reduces the variabilityof the
earnings report, and if the expected value p remains unaffected,it implies higher value
relevancep and increasesearningsquality.However,this comes at a cost because a higher
p increasesexpected accountingand real earningsmanagementand induces a reductionin
firm value. Again, the behaviorof total expectedcosts by subsequentlytightenedstandards
may change, but now in the opposite directioncomparedto a reductionof Ua.
We defined the manager'sutility function (3) in terms of the accountingreports,m,
and m2, and the price P1, but not P2. Inclusionof P2 can have differenteffects depending
on the manager'sand the capital market'sinformationendowments.For example, if the
utility function depends on P2 but not on m2 the results are qualitativelyunchangedas m2
and P2 are linearlydependentin the linear equilibrium.An alternativespecificationmay be
thatp5is the relativeweight of P, and P2 (as is s for accountingearnings),so that:
U = sm1 + pPI + 2 + P2 - v(bA, bR).
With linearconjectures,P2 = tM2+ ~ + 2. Then, similarto the situationwithout

P2, the uncertaintyregardingp affects only the utility and pricing terms in t = 1 and the
optimal policies for the managerare analogousto, but more cumbersomethan, those de-
scribedin Equation(8), which leaves most of our resultsqualitativelyintact.Alternatively,
if p1also affects the second-periodutility:
U = smi + pP1 + m2 + pP2 - v(bA, bR),
then the marketlearns aboutp from both periods'reportedearnings,which is anticipated

by the managerin his or her earningsmanagementdecision. Anotherpossible specification
would be to assume a second-periodweightP2 on P2, which is knownby the manageronly
at the beginning of the second period. Such assumptionswould lead to more involved
solutionsthan those shown above and make it more difficultto derive the effects of tighter
standards.
VI. CONCLUSIONS
This papercontributesto understandingthe implicationsof tighteningaccountingstan-
dardson the quality of informationin the capitalmarket,the level of expected accounting

and real earningsmanagement,and the expected cost of earningsmanagement.It provides

a numberof results that challenge conventionalwisdom. Tighteraccountingstandardsin-
crease earningsquality,measuredby the variabilityof reportedearningsand by the asso-
ciation between reportedearningsand marketprice reactions.Because of that,the marginal
benefitof earningsmanagementincreasesandmanagersincreasereal earningsmanagement,
which is costly and directly reduces firm value. While tighter standardsmake accounting
earnings managementless effective, they do not always reduce earnings managementin
equilibrium.Indeed,we stateconditionsunderwhich expectedaccountingandtotalearnings
managementincrease for tighterstandards.Moreover,the expected total costs of earnings
management(the real costs and the manager'sdisutility of engaging in earningsmanage-
ment) can increase even if expected earnings managementreduces. Therefore,the inter-
vention of a standardsetter is not unconditionallypreferred,even though earnings man-
agement incurs a dead-weight loss. Standardsetters should consider these potentially
unintendedconsequencesin the developmentof standardsand empiricalresearchersmight
wish to control for the potentiallyambiguousrelationships.
While these results suggest a link between accountingand real earningsmanagement
activities caused by the change in the earnings quality, most empirical studies consider
either accountingor real earningsmanagement.Ignoringreal earnings managementmay
have an effect on the estimationof (accounting)earningsmanagement,because most dis-
cretionaryaccrualsmodels use variableswhose values may be affected by real earnings
management.Further,studies that ignore real earningsmanagementmay overestimatethe
impact of variousinstitutionalsafeguardsto control earningsmanagement.However,cap-
turing the level of real earnings managementempirically is difficult because it is often
indistinguishablefrom normalactivities.One possibility might be to measurethe potential
for accountingearningsmanagement,e.g., by a proxy for the overstatementof net assets
in the balance sheet (Bartonand Simko 2002), and infer the incentives for real earnings
management.
The results of the analysis rely on several assumptions.One assumptionis that the
basic firm value and the manager'sobjective function are given exogenously. In a more
comprehensivemodel, the manager'sproductivedecisions, incentives for effort, and earn-
ings managementactivities could be integrated.Such a setting may provide insights into
interactionsof earningsmanagementand the design of managerialcompensation.However,
our analysis is an importantfirst step in such a more general setting: finding an optimal
contractrequiresanticipationof the contingenteffects contractshave in the second stage.
Recent researchcasts doubt on the descriptivevalidity of the assumptionthat the in-
vestorsfully understandthe reportingsituationand are able to inferthe equilibriumearnings
managementpolicies. For example, investorsmay be inattentiveand naively take the re-
ported earnings at face value (functionalfixation).'4Different representationsof investor
behaviormay affect the equilibriumstrategiesand the resultingcosts and benefitsof earn-
ings management.Finally, the model structurecould be used to address other forms of
accounting regulation, such as changes in the precision of accounting information(for
which we present some preliminary analysis) or the inclusion of supplemental disclosures
if accounting standards are tightened. Our focus on the interaction between accounting and
real earnings management should be viewed as one element of such analyses.
14 See, e.g., Hirshleiferet al. (2002) and Kirschenheiter

and Melumad(2002).

APPENDIX
Proof of Lemma 1
Assume an arbitrarydifferentiablepricing function, The managermaximizes
P1(ml). rb2 b2
b*, b* E arg max s(y1 + bA + + pp(m) + E[y2y,] - bA - b - b2
bA,bR bR) 2b
The necessaryfirst-orderconditionsfor a maximumare:
au dP am *
-=s-l+p rb*=0
A
abA dm, abA
au di am
=bs-1-c+p db*=0 R
abR dmi abR
where = 1 for i = A, R. An equilibriumwith b* = 0 and b* = 0 requires:

abi
dP 1-s l+c-s
dmi p p
This conditioncan only hold for c = 0. If s * 1, the value of the derivativeis completely
determinedby the randomvariablep, so the equationcan hold only by coincidence. Al-
ternatively,assume c = 0 and s = 1, then dP/dml = 0 and the price function must be
constantin mi, which contradictsthe assumptionof the Lemma. U
Proof of Proposition 1
Part(i): The optimalearningsmanagementpolicies in (8) are linear in p:
8A ? XP A=; )+
b•• r
b*= R = AS-
pR C;, = ).
Then, for any y, the earningsreportm, is also linear in p:
miY
= 1 =
Yl +
?A R+ 6 + (X + )p*
Investorsrevise the marketprice P, using the conjecturesof the earningsmanagement

activities bA = A + AXpand bR = 8R + $p. The marketprice is the expected gross
Pl(ml)i.e.:
terminalvalue less the expected real cost of earningsmanagement,
Pl(ml) = E[xlm1]- E[cbRIml],
where:

x S cov(.k, ri1)
+ A
E[ilm] = (m -8B
o var(ritl)
2
07 + o + ( + 0 2
r
^-)2' +
and:
E[cbRlml] = (R + )
c" EL[/lml]).
The revised expectationof p is:
- ri)
E[Plm+]= + cov(pf, -
c (ml -8B-p +
var(ri1) bA
2
+ () + 0
P
(+
o2?
xI
+ . 2
1 x 8B
++x + (+ ?
Combining these equations shows that is indeed linear in ml, i.e., =
o
+ 3m1,with: P,(ml) Pl(ml)
2 (A1)
2x + + (X+ 4))2u
x - C(R + ) - + A R+ ( ))i). (A2)
In equilibrium,the conjecturesof the marketand of the managermust be met, i.e.:
8A
,=, = R = ,
a = &, 3 = 13.
The terms in (Al) and (A2) solely dependon parametersthat are commonknowledge.
What remainsto be shown is the existence of values that satisfy these equations.
First, the manager'spolicy must maximize his or her expected utility. The first-order
conditionsare derivedin the text. The second-orderconditionsare:
a2U a
ab2 =
ab2 (As + pp - rb*) = -r < 0
abA
a2U a
- c + pp - b*) = -1 < 0
abab(AS
abR
ObR
a2Ua2 U a2u 2=
r>0
abAabR abAabR/

z2U = 0. Therefore,the
because the cross-derivativeis earningsmanagementactivities
abAabR
constitutea maximum(since r ? 1) and they are unique for a given 3.
Second, P as defined (Al) in must be a solution. Substituting X = X = 4 = 3
=, r
and R -(1 + r)/r, P is implicitly defined by:
2 + p2cR2 +
Z(p) 33RR 2 )+
?(p(U - 0.
+2=
A third-degreepolynomialhas up to three real roots. Since c - 0, Descartes'rule of
signs implies that Z(P) = 0 has exactly one positive real solution. This P lies between 0
and + 2() < 1 because Z = <O for p= 0; Z > for p = I/(ux () +
r2I/(r2'
< 1; moreover,Z(3) strictlyincreases-Cx for P > 0.
Part(ii): The othertwo solutionsto Z(3) = 0-should they exist in real numbers-are
necessarily negative. Since Z(0) = -U2 < 0, such roots do not exist if Z(3) increases
monotonically in P for the entire real line. Since Z(P) - -oo if P -, -oc, a necessary and
sufficientconditionfor the existence of negativereal roots of Z(P) = 0 is that Z(3) attains
a maximumfor some 3m< 0 such that Z(P3m)> 0. A necessaryconditionfor a maximum
is given by the first-ordercondition:
2
dZ(3m) 3132
r )x
r +
23mc
r
r
+ 2 (
I) 0.
dp
This quadraticequationhas two real roots if the following conditionholds:
r 2 - 12( ? +U2 I)
4c2 +1r r x
)+02(g2
which is equivalentto:
1 c2 2
2 +.2
3 x0pP
If this inequality holds, Z(3) = 0 has two local extremes, P,,2 < ,,ml
< O0,where P,,m
is a local minimumand Pm2 constitutesa local maximum.If = 0 then P,,m2 is the
Z(3m2)
only negative real root for Z(P) = 0. If Z(,,m2) > 0, then there exist two negativereal roots
for Z(3) = 0. 1
( is implicitlydefinedin p3R2o2 + p((U + 2) - 02
= 0. The total derivative
is: 2cR02
dp +
> 0
2p3Ror +2C0)22
+ 2p3cRr2 2
dr r2(3p2R222
p
+ )
+p • 2 _
I2
dR 1
for p > 0 and using the fact that- = - < 0.
dr r2

2 +
The varianceof the earningsreportm, is = p2R2 2. Assume to the
var(r~i)
contrarythat the variance does not decrease for greaterr. Fix two values with r2 > r1.
Then, 12> P, and R2 < R1. A non-decreasingvariance0-2+implies:
2 * P2R2
(P2R2)2 ([1R1)2 1R1.
-
Since 12 >> 1, it follows that P2R2 > p2R1. But then:
=P
2
0 P2<
x 1c+3R2 r22p
-2c
xx1R+pR
lI 1 I
which is a contradiction.Hence, var(h13)= 2 + 12R2a2 decreasesin r.

+
Cr M
Part (i): Expected real earnings management is E[b*] = As - c + p1p. The total
derivativeis:
dE[b*] _ dp > 0.
dr Pr dr
=dr
Part (ii): Expected total earnings management is E[b*] = -c + (As + pp) R. The
total derivativeis: .
dE[b*] + dR dp
dr (As P dr dr
dR (As + 2
2 +
+ p13) - p3dR 203R2
21- + 1•2c
dr (As + P) - p ?32
3p2R2T 2 +
2pcRU2
02cR
+ C
Pp + (Y2
dR [ 232R2 + pcR
+ - -
<0
dr + 23pcR-2+
p p
( x
+ I)
33p2RR20-
for As ? 0 and p > 0. Finally, E[b*] = E[b*] + E[b], dE[dE[b

bj] > 0, and dE[b*] b*] 0
dr dr
dE[by]
< 0.
establishdEb*]
dr
Part(iii): Expectedaccountingearningsmanagementis:
1
= (As + p3) . -r
E[b*z]
and the total derivativewith respect to r is:
1 As + p
dE[b]dr r + P (A3)d
dr r r drJ
(A3)
>0

Note that for any r 2 1, the values for p and dpl/dr are completely determined by
exogenous variables and are independent of p and of As. Further,p and As are independent
of each other. Let As < 0, fix an r 2 1 and choose p equal to:
As
8 = > 0.
0.
Inserting 61 gives:
dE[b Ip = 81] 1 (As + 83) dp3 d

dr r r dr _1r dr
and, because of continuity,the derivativeremains positive for an interval around68. In

particular,for any r 1 and As < 0 there are values for p such that As + pp > 0 is
-
"small" and the derivativeis still strictlypositive untilp approachesan upperbound of:
As
p < 82 d
dp
P-r
dr
82 > 81 follows from:
+ 2
0<r dp = r * 2p3RU2
R 2C
dr r2(3p2R2o +p 23cRcr2+ 2 U2)
•
2p2RU2 2+
fcr2
r(3P2R2a2 + 2pcRr2 + + o)
xr
for all r 1 and, hence, R > 1.
As shown in Part (i), expected real earnings management always increases in r. There-
fore, if expected accounting earnings management increases in r, so does expected total
earnings management. U
Part (i): The expected terminal value is:
E[x~]- cE[b*] = E[?] - c * (As + pP3- c) = E[?] + c2 - c (As + pp),

?
which is strictly decreasing in r because p strictly increases in r (Proposition 2).

Part (ii): Expected total costs of earnings management as defined in (11) are:
C2
E[TC] = E[v(b*, b*) + cb*] + -
++ E[(b*)2] + C2
rE[(b*A)2]
2
++ 2
cE[b2] 2
where:

2
rE[(b*)2] - (As + pp)2 +2
f(E[b*]2 + var(b*))
2 2 2r
2 =2
(As + pp - c)2 +2
1 2
E[(b*)2]
2 =
2 (E[b*]2+ var(b*)) 2
cE[b*] = c(As + pp - c).
Collecting terms and simplifying,the expected total costs are:
E[TC]= RTC]
2 ((As+ pp)2+ P
Differentiatingtotally with respect to r results in:
dE[TC] dp dR
SR [(As + pp)p + p ] d+.1 + + 32c21]. (A4)
dr dr 2 dr [(As pp)2
InsertingdR/dr = -1/r2 into (A4) and rearranginggives:
dr
dE[TC]dr 2r dr - As
2r21 ((As+p )'[p2Rr2--.
d p (A5)
+d--(-22Rr2.
To prove the sufficientconditionsfor decreasingexpected total costs assume Ua --+

then p -+ 1 and dpldr - 0. (A5) yields:
lim dE[TC] 1
l
cr"o dr
-
2r2 (-(As + )2- ) < 0.
If - 00
0, then p - 0 and dpldr - 0, implying:
dE[TC] 1
lim~ = < 0.
dr 2r (As)2
--2
(iii): Inspectionof (A5)
Part
Part (i i): Inspection of (A5) reveals that if:
2Rr2 d
dr p> 0 (A6)
holds at a given r 1, then for each p > 0 it is always possible to find appropriatevalues
-
As ? 0 such that (A5) is still positive (recall that P does not depend on As, hence, the
choice of As has no impact on the left-handside of (A6)). If As < 0 and (A6) holds, then
(A5) is certainly positive as long as As + pp - 0, implying As > -pp = 81. From
Proposition2:

dp _ 2p33RU2+ 32cU2
dr r2(3p2R20
d r (3 p
2 + 22p3cR2 + 0 2 + u2)1).I p
Therefore,(A6) becomes:
+
2Rr
2
dp2Rr2
( 4p32R22 p
2p3cRU2 P
dr fp 3p2R2 2 + 2I I+ +
= [3" 13
-
+ 2p3cR02 (3P32R2p2
p
3 R
drp-
4p2R2C2 S+ 2p3cR-
0-x + 2p3cR +2 +
+2\)
[3"3p(2R2c22 ++ 23cR(R2+ +
+,
(+
p =R2(p2UU- +
-( 2
+
3p2R2
r2 2pcRo 2 (T2+ (
Since [ > 0, this expression is positive if and only if R2p > + 2. Next we
2-2
show that P2u increases in ;2. therefore,there exist above some0-2lower bound that
satisfy this condition.The derivativeis: •,
d(u.d
p2o ))
2
.(2 P
dp+ 2
der d(T
P P
Since dcR<
2 have[
2e
0 we v
do 3P32R222+pcRo
+ +
pO
2p2R2 + 2pcR
202" ddp2 2
d( 22 1(2
3p2R2 + 2p3cR+ /x2
-p
d(p2u )
Therefore,d 2x > 0. Hence,givenr 1 for anya 2 and T2 the inequality:
Pn e
R22 2 2+ 2
can be satisfiedby sufficientlylargeup, implying that:
2 r2 > 0
dr
-R
is also satisfied.Since p > 0, there exist As 0 that satisfy:
-
As 2 R r2[3)
< 82 p . .
All values of As with 81 ? As < 82 imply a positive derivativeof the expected total
costs (A5). This proves the sufficiency part of Proposition4 (iii). If (A6) is nonpositive
and As ? 0, inspectionof (A5) revealsthat expectedtotal costs cannotincreasewith tighter
standards.This proves the necessity of sufficientlylarge r2 for As 0.
_

Economic Effects of Tightening Accounting Standards to Restrict Earnings Management 1123
Finally, because we restrict our analysis to equilibria with positive 3, we show existence
of appropriate values for Ur such that the condition 2? 3(aU + r2) in Proposition 1
(ii) for the existence of additional <
equilibria with P c2x is not fulfilled. This requirement
0
an bound
gives birUIV 1HrrV upper VVUIU for
I VP r2:
2 3(0u + (T)
P C2
or, equivalently,R22 P 32
2 P2
3R< 2 22. An appropriatechoiceof must satisfy:
< ?
.A aproprie chice of -p
+ I 2
+ < R222 < p2
3R2(2
( x c2 <
(- 2.
p2
For r --, +oo, we have R --+ 1, hence, the left-hand side converges to a maximum of
C2/3. Since 32 > 0 in any equilibrium, there always exist values c - 0 such that this
condition holds for any r > 1. M
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Economic Effects of Tightening Accounting Standards to Restrict Earnings Management

Author(s): Ralf Ewert and Alfred Wagenhofer

This content downloaded from 131.152.63.135 on Tue, 2 Apr 2013 05:02:43 AM

Economic Effects of Tightening

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detailedguidance.The discussionof principles-basedversusrules-basedstandardsis in line

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throughthe earningsreport.Thus, earningsmanagementcan lead to increasedvalue rele-

II. THE MODEL

Otherpapersthatstudyearningsmanagementin rationalexpectationsequilibriaareKirschenheiter andMelumad

The Accounting Review, October 2005

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The Accounting System

Accounting earningsmanagementincludes the interpretationof accountingstandards

m2 = Y2 - b - bR = (x + E2 - cbR) - bA - bR. (2)

3 In computingthe marketprice, we do not explicitlyconsiderthe manager'svariablecompensationassumingit

The Accounting Review, October 2005

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depends on accountingearnings and marketprice."The manager'sinterestin accounting

U = smi + pP1 + m2 - v(bA,bR), (3)

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psychic costs of biasing accountingearnings,and individualregulatoryand litigationrisks.6

In general,the manager'soptimalearningsmanagementactivities,bl(yl, p) and

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manager.The capitalmarketadjuststhe marketprice of the firmunderrationalconjectures

Lemma 1: Every equilibriumwith a differentiableand nonconstantprice function P,

Lemma 1 rules out equilibriawith no earningsmanagementfor arbitrarydifferentiable

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and the marketprice of the firm adjustslinearlyin m, with strictly

(ii) If c2a2 > 3(a2 + U2), there exist up to two additionalequilibria

In equilibrium,the sign of accountingearningsmanagementis determinedby the sign

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Quality of Reported Earnings

Proposition 2: Tighteraccountingstandardsimply a higher value relevance P and a

Proposition2 confirmsthattighterstandardsreduce the noise in reportedearningsand

9 FischerandStocken(2004) use the expectedvalueof the squareof the differencebetweenunbiasedandmanaged

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Level of Earnings Management

Part(i) establishesthatexpectedreal earningsmanagementstrictlyincreasesfor tighter

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E[bF + b*] = E[AsR + f3PR - c]

and the varianceis:

which strictly decreasesfor tighteraccountingstandards.Thus, earningsquality improves

Costs of Earnings Management

12 The same argumentholds for the earningsmanagementcomponentof b*.

The Accounting Review, October 2005

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financialreportwould attainits maximumin this setting, 13= /( + or2).Moreover,the

However,the manageris unableto crediblyprecommitto such a behavior.A standard

E[TC] = E[v(b*, b*)] + E[cb*] + -.2

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the substitutioneffect is negligible. As a consequence, tightening standardsreduces the

V. DISCUSSION AND EXTENSIONS

13 Fischerand Verrecchia(2000) derive a relatedresultin their model withoutreal earningsmanagement.They

The Accounting Review, October 2005

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if they use earnings to provide incentives to risk-aversemanagers.Moreover,the model

U = sm1 + pPI + 2 + P2 - v(bA, bR).

With linearconjectures,P2 = tM2+ ~ + 2. Then, similarto the situationwithout

U = smi + pP1 + m2 + pP2 - v(bA, bR),

then the marketlearns aboutp from both periods'reportedearnings,which is anticipated

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E[TC] = E[v(b, b)] + E[cb*] + -.2

for As ? 0 and p > 0. Finally, E[b] = E[b] + E[b], dE[dE[b

E[x~]- cE[b] = E[?] - c (As + pP3- c) = E[?] + c2 - c (As + pp),