Earnings Management and Participation in Accounting Standard-Setting

Earnings Management and Participation in Accounting Standard-Setting [The final version of this paper will appear in the Central European Journal of Operations Research (2014): forthcoming. It is available at www.springerlink.com.]

ROLAND KÖNIGSGRUBER Department of Accounting, Vrije Universiteit Amsterdam, Amsterdam [email protected], T +31/20/598-7142

STEFAN PALAN Institute of Banking & Finance, University of Innsbruck and Institute of Banking & Finance, Karl-Franzens-University Graz [email protected], T +43/512/507-7579, F +43/512/507-2846

ABSTRACT Recent economic and political science research suggests that the way public policy is set, and in particular the participation of those affected by it, impacts upon the outcome of the policy. Accounting standard setting has long offered such a possibility to participate via the due process approach followed by major standard setters. We review the literature on areas close to financial reporting and find arguments for why the possibility to participate in standard setting may have a positive effect on diminishing distortion of financial reporting. We also discuss reasons why such a compliance effect may be less pronounced in financial reporting. We conclude that the existence of this effect is an open question and conduct a lab experiment to examine whether the possibility to participate in accounting standard setting leads to reduced earnings management. Our results indicate that this is not the case. We interpret this result in light of recent evidence that enforcement and incentives are better predictors of accounting quality than financial reporting standards. Keywords: Accounting standard setting, participation, compliance, experimental research

Earnings Management and Participation in Accounting Standard-Setting ABSTRACT Recent economic and political science research suggests that the way public policy is set, and in particular the participation of those affected by it, impacts upon the outcome of the policy. Accounting standard setting has long offered such a possibility to participate via the due process approach followed by major standard setters. We review the literature on areas close to financial reporting and find arguments for why the possibility to participate in standard setting may have a positive effect on diminishing distortion of financial reporting. We also discuss reasons why such a compliance effect may be less pronounced in financial reporting. We conclude that the existence of this effect is an open question and conduct a lab experiment to examine whether the possibility to participate in accounting standard setting leads to reduced earnings management. Our results indicate that this is not the case. We interpret this result in light of recent evidence that enforcement and incentives are better predictors of accounting quality than financial reporting standards. Keywords: Accounting standard setting, participation, compliance, experimental research

1. Introduction In this paper we address the question of the impact of participation in accounting standard setting by reporting firms on financial reporting outcomes. In the last two decades, a number of studies from various subfields of economics and political science have shown that individuals tend to identify more with rules, and exhibit a higher degree of compliance with them, if they have the possibility to participate in the process in which these are set (e.g., Dal Bó et al. 2010, Pommerehne and WeckHannemann 1996). Economists argue that this effect is due to procedural utility, i.e. that people value not only outcomes but also the procedures leading to these outcomes, and show that this effect applies to a range of situations from public policy setting via lawsuits in court to organizational decision-making (Frey et al. 2004). While a number of studies have shown that procedural aspects and participation in rule setting matter in a wide range of circumstances (e.g., Bardhan 2000 on irrigation systems in India, and Grossman and Baldassarri 2012 on public goods provision in Uganda), no such study has been carried out in the field of accounting and financial reporting. Financial accounting possesses a number of attributes which suggest that similar effects may present. Accounting standard setting is characterized by a due process approach which allows for participation by the interested public. A number of enforcement mechanisms exist to ensure compliance, ranging from the obligation to subject financial statements to a detailed audit, to public en-

Participation in Accounting Standard Setting

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forcement agencies such as the U.S. Securities and Exchange Commission. Since no study has yet investigated the existence of positive effects of procedural aspects in accounting standard setting on compliance, we build our argument by analogy. In section 2, we identify two areas that are arguably similar to financial reporting in important aspects: taxation and management accounting. We present evidence from these fields which suggests the possibility of the presence of the described effect. We also present arguments on why this effect may be less pronounced in financial reporting. Since there are strong arguments for both sides, we treat it as an open research question whether this effect is in fact important in financial reporting. For our purpose, it is therefore necessary to define compliance in a financial reporting context. An accounting system involves estimations and judgment and therefore is subject to both unintentional error and intentional bias, i.e., earnings management (Dechow et al. 2010). The amount of intentional bias therefore seems a natural candidate for an (inverse) measure of compliance. A well-accepted definition of earnings management considers it to consist of a purposeful intervention in the financial reporting process with the intent of obtaining some private gain (Schipper 1989). Since this definition centers on the unobservable notion of management intent, operationalization in empirical studies is difficult (Dechow and Skinner 2000). Accordingly, Dechow et al. (1995) conclude that the power of most tests to detect earnings management of economically plausible magnitudes is low. Survey studies on earnings management (e.g., Graham et al. 2005) run into similar problems, even under the strong assumption that interviewed managers answer honestly to questions on sensitive reporting behavior. Recent psychological research suggests that individuals tend to uphold a positive self-image by adjusting their beliefs as much as by adjusting their actions (e.g., Valdesolo and DeSteno 2007, Mazar et al. 2008). Given ambiguity about the best estimate inherent in many accounting questions, managers may easily convince themselves that they acted in the company’s best interest even though their actions fall under Schipper’s (1989) definition which rests on the intention of obtaining private gain as the motivating force. We therefore opt for an experimental study and design two laboratory experiments to address our research question. This allows us to construct a setting where there is an unambiguously correct measure, thereby avoiding the pitfalls of empirical studies. We interpret deviations of reported figures from that correct measure as earnings management and larger deviations as a larger amount of earnings management. Laboratory experiments offer researchers the additional advantage of putting more variation under their control and giving them the possibility to compare hypothetical institutional settings, whereas empirical studies are by necessity limited to examine regulation already existing. The usefulness of experimental research for public policy making has been discussed in a number of settings (e.g., Engel 2010, Normann and Ricciuti 2009). For a discussion in the context of accounting regulation see Kachelmeier and King (2002). General reviews of the use of experimental methods in accounting research are provided by Callahan et al. (2006), Luft and Shields (2009) and Sprinkle and Williamson (2007).

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In both of our experiments, participants are asked to present a simple situation in a financial report. We design the incentive structure such that they have incentives to misreport, since their payouts depend positively on the reported figure. We design two treatments. In the first, participants have to apply exogenously determined financial reporting rules. In the second, they discuss two alternative rules among themselves and choose the rule to be applied by majority vote. We hypothesize that, if a positive participation effect exists, it should manifests itself in less misreporting in the second treatment. We run two comparable sets of treatments using this manipulation. In the first experiment, we simulate an enforcement mechanism such that misreporting is detected with positive probability, causing the participant detected to have manipulated the report to forfeit his or her payout. In the second experiment, we have a similar enforcement mechanism. In addition, the payout of all participants in a group is reduced by the average manipulation of all group members (this mimics a situation where the recipients of the reports are assumed to discount individual reports by the “expected” amount misreported). This implies a negative externality of misreporting on other group members, reinforcing the moral aspect of manipulation. While control questions indicate that participants behave as predicted in a number of respects (e.g., those who indicate that financial considerations were relatively important in their reporting decision misreport more than others), we find no significant treatment differences in reporting. We consider this as evidence that the effect of participation in rule-setting identified in other policy areas does not play a comparable role in the field of accounting regulation. In our conclusion we discuss potential reasons for this finding and outline promising areas for future research. A potential objection to our approach is that we draw inferences on corporate behavior from the observed behavior of individuals. Of course the actions of corporations are hard to study in a laboratory setting. Experimental research in industrial organization has regularly resorted to using individuals who were instructed to act as if they were firms engaged in competition (e.g., Huck et al. 2001, 2002; Huck and Wallace 2002; Potters and Suetens 2013). In order to examine whether results gained from experiments with individuals carry over to a corporate setting, Raab and Schipper (2009) conduct an experiment with both individual actors and teams competing in a Cournot setting. They find that team-firms do not behave significantly differently from individual firms. Engel (2010) reviews the literature to address the question of whether experimental results obtained with individuals can be used to gain insight into corporate behavior. He concludes that while there is no simple yes or no to this question, collective and corporate actors in many respects suffer from the same biases as individuals. Laboratory experiments have also been used to draw inferences on regulatory and governmental behavior (e.g., Hamman et al. 2011).


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The remainder of this paper is organized as follows: Section 2 reviews the literature and derives hypotheses. Section 3 describes our experimental design. Section 4 presents the results and Section 5 concludes. 2. Literature Review and Hypothesis Development The question of the existence of a positive compliance effect of participation in accounting standard setting has not been addressed in existing studies. Recent research in economics and political science has shown that participation in rule-setting leads to positive effects on compliance in a number of different settings. However, this research has not yet provided conclusive answers to the question under what conditions and in what areas we should expect such effects. Whether they are present in financial reporting regulation is therefore an open question. We thus start by giving an overview of the institutional background of accounting standard setting and then present arguments why similar effects may or may not be present in financial reporting. 2.1. Institutional background The two globally most important accounting standard setters, the International Accounting Standards Board (IASB), whose standards are mandatory in the European Union as well as in numerous other countries, and the Financial Accounting Standards Board (FASB), which promulgates standards applicable in the United States, are organizationally very similar. Both apply a transparent and open process of setting standards (see IFRS Foundation 2013 for an overview of the IASB’s standard setting process. The FASB’s is similar). Each standard is developed following a due process procedure which involves public consultation in the form of, inter alia, public meetings and the collection and online publication of comment letters from the public. An extensive empirical literature investigates participation in and influence on the standard setting process. An interesting result of this line of research is that there is relatively little formal participation as measured by the number of comment letters adressed to the standard setter. While getting informed about a particular issue is probably prohibitively costly for individual investors, professionals in accounting arguably find the cost in terms of time for writing a comment letter to be relatively low. Nevertheless, participation has in the past not been widespread (see Tandy and Wilburn 1992 for the FASB; Larson 1997, 2007 and Jorissen et al. 2006 for the International Accounting Standards Board (IASB); Georgiou 2002, 2005 for the United Kingdom’s Accounting Standards Board). Based on a pure cost-benefit analysis, higher rates of participation would generally be expected (Sutton 1984). One reason which contributes to relatively low participation may be that firms find other channels to make their voices heard (Georgiou 2004). Nominally private sector standard setters still act in the shadow of public authorities who can withdraw their mandate (Horngren 1985, Königsgruber 2010). This opens the possibility for politi-

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cal lobbying for firms wishing to exert influence over the outcome over the standard setting process (Ramanna 2008, Johnston and Jones 2006). While writers in the field of financial reporting tend to be critical of what they consider political meddling (e.g., Armstrong 1977; Beresford 2001; Zeff 2002; Burlaud and Colasse 2011), political scientists tend to take a more benign view on such interventions, seeing them as a form of oversight (McCubbins and Schwartz 1984). Examining individual categories of respondents, accounting firms are well represented among those sending in comment letters to exposure drafts of new standards issued by a standard setter (Perry and Nölke 2005). More importantly for our study, preparers of financial statements are far better represented than users (Beresford 1993). In a recent study based on comment letters sent to the IASB, Jorissen et al. (2012) find that preparers and auditors react more strongly when accounting numbers are influenced by a proposed standard, while users tend to react relatively more strongly when the issue in question regards disclosures. For the purposes of our study it is important to stress again that despite the relative scarcity of comment letters sent to the standard setters during the due process procedure, preparers are relatively well represented. Our experiment focuses on this group, since we test whether “voice” (i.e., the possibility of having a say in the standard setting process) has a positive effect on compliance with a standard, and of course preparers of financial statements are the ones who make that decision.1 It is furthermore also conceivable that the relative scarcity of comment letters is indicative of a high overall level of satisfaction. When standard proposals are controversial, the number of comments received tends to be significantly higher than otherwise. In this sense, the possibility to participate appears to be more important than actual participation. 2.2. Evidence in favor of a positive compliance effect Traditional policy analysis is based on the assumption that individuals are maximizers of immediate gain and cannot commit to mutually beneficial courses of limiting one’s own current profit unless this is enforced by some external third party. However, more recently, economists have shown that procedural aspects in determining policy on public good provision and usage of common pool resources matter and 1

While beyond the scope of this study, it is worth noting that the lack of user participation is a matter of some concern to standard setters (Beresford 1993). Constituent participation is seen as essential to ensure the legitimacy of the standard setting process (Johnson and Solomons (1984); Schmidt (2002); Wallace (1990)). Durocher et al. (2004) use semi-structured interviews with users to obtain knowledge about their perceptions of the Canadian standard-setting process. Among other reasons, they mention a lack of knowledge about procedures as an impediment to participation. In an extension of this research, Durocher et al. (2007) develop a model based on legitimacy, valence, instrumentality and expectancy to explain user participation. They suggest that the standard setters could use their model to increase user participation.


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can contribute to resolving such problems (Ostrom 1999; Ostrom et al. 1992). Truthful financial reporting has aspects which make it comparable to a public good: Firms in jurisdictions with more transparent financial reporting enjoy lower cost of equity capital and more liquid stock markets (Bhattacharya et al. 2003). If other firms deliver high quality financial reports to financial markets, there exist incentives for individual firms to free-ride on the trust thereby established and mislead users of these reports by means of reporting manipulation. This aspect probably explains why financial reporting is highly regulated, following the traditional economic paradigm. However, the effectiveness and necessity of this high level of regulation and enforcement is not uncontroversial. Leftwich (1980) for example argues that there is no market failure in financial reporting which governmental regulation could remedy. Importantly, researchers have found convincing empirical and experimental evidence for the conjecture that participation in rule-setting leads to lower tax evasion. Taxation is closely related to financial reporting. In many jurisdictions corporate tax accounts are based on individual company accounts. The largest tax advisory firms are also audit firms. Tax avoidance by corporations always also has an accounting aspect. We therefore expect that effects found in studies on tax morale may be present in the area of financial reporting as well. Pommerehne and Weck-Hannemann (1996) demonstrate that for a sample of Swiss cantons tax evasion is significantly lower when citizens have direct control over government budgets. Building on this finding, Feld and Frey (2002) and Feld and Frey (2007) show that taxpayers are willing to declare income honestly if the political process is perceived to be fair and legitimate. They explain tax morale as a function of an implicit tax contract between citizens and governments. Torgler (2005) uses survey data from the International Social Survey Programme and finds that direct democracy has a positive effect on tax morale. Similar results are presented by Kirchgässner (2007) and Torgler et al. (2008). Tax morale appears to be higher when people perceive tax authorities as procedurally fair and accountable (Bird et al. 2008, Hartner et al. 2008, Muehlbacher and Kirchler 2010, Murphy 2005, Murphy and Tyler 2008). This may be explained by people’s willingness to cooperate if they perceive others also cooperating (Frey and Torgler 2007). Tyran and Feld (2006) show in an experimental study that the possibility to vote on rules induces expectations of cooperation. Coglianese et al. (2004) cite a higher level of compliance as one potential advantage of self-regulation in the field of corporate governance, another area related to financial reporting. Dal Bó et al. (2010) use a laboratory experiment where subjects participate in several prisoner’s dilemma games and can choose a policy to encourage cooperation. They show that cooperation is significantly higher when the policy is chosen democratically by the subjects themselves than when it is imposed exogenously by the experimenter. Again such a situation is reminiscent of accounting standard setting. With both ex ante incentives to commit to high quality financial

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reporting and ex post incentives to manipulate reporting, the process of accounting standard setting is organized in a deliberately open manner, which gives ample opportunity for participation. Frey (1997) and Frey (1998) argue that constitutions should encourage direct citizen participation while at the same time being strict enough to deter exploitative behavior. Arguably, such a situation is implemented in accounting regulation, where those subject to the regulation can participate in standard-setting while public enforcement and private auditors serve to discourage manipulation. Another set of potentially relevant results comes from management accounting research. Empirical results in this field suggest a significant positive relation between employee participation in budgeting and employee performance (Brownell and McInnes 1986). In an experimental setting, Libby (2001) show that if the budget target is fair, the process leading to it has no effect on performance. With an unfair budget target, however, subjects’ mean performance is not significantly different from the one with a fair target if the budgeting process is perceived as fair. Libby (1999) finds significant performance improvements when using a combination of participation and explanation in the budgeting process. Tiller (1983) highlights subject’s perception of having exercised a choice as an important determinant of their commitment to budget achievement and performance. In a literature survey, Shields and Shields (1998) note that the studies reviewed generally believe employee motivation to be the reason of existence of participative budgeting practices. Evidently, management accounting and financial reporting are different in at least one important way: While firms are mostly free to design their management accounting system according to their desires, financial reporting is highly regulated. However, there are also important communalities. Academic training in either financial or management accounting typically also gives substantial consideration to the respective other subfield. Recently, financial accounting standard setters have furthermore started giving increased consideration to management accounting. For instance, International Financial Reporting Standard 8 Operating Segments, which was introduced in 2006, introduced the so-called management approach which means that operating segments for financial reporting purposes have to be defined in the same way in which management reporting is organized internally in the firm. While these results may not be directly applicable to financial reporting, they constitute another piece of evidence underlining important commonalities in the two settings. Summing up our argument, the first set of results presented above suggests that participation in public policy making leads to a greater degree of compliance with the policy. However, this has not yet been tested in an accounting context. The second set of results suggests a similar relationship in accounting, but stems from nonregulated internal accounting and has not been tested in an accounting regulation context. Taken together, the two sets of results argue in favor of the existence of a compliance-enhancing effect of participation in accounting standard setting.


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2.3. Arguments against a positive compliance effect A major argument against a substantial positive effect of participation in accounting standard setting on compliance is that accounting standards are but one aspect of accounting regulation and it is a priori unclear that it is even the most important one. Several recent studies have examined the importance of a variety of accounting institutions on reporting and capital market outcomes (e.g., Ball et al. 2000, Ball et al. 2003, Hail and Leuz 2006, Christensen et al. 2013). They tend to find that the strictness of enforcement and incentives are more important determinants of accounting outcomes than standards per se. Daske et al. (2008) find that capitalmarket benefits of IFRS adoption occur only in countries where legal enforcement is strong. Christensen (2012) concludes that standards per se have little effect on a firm’s information environment. Firms wishing to raise capital face obvious incentives to bond themselves to high quality financial reporting. A number of papers have argued that cross-listing in a jurisdiction with strict enforcement is one such means (Coffee 2002). Consistent with this hypothesis is the finding that cross-listing in the United States leads to capital market benefits, since it serves as a signal for better corporate governance. Empirical studies find that cross-listed firms are valued at a premium (Doidge 2004, Doidge et al. 2004, Stulz 1999). Furthermore, a cross-listing is associated with an improvement in firms’ earnings quality (Lang et al. 2003). If relevant outcomes are determined, as these references suggest, more by accounting enforcement than by accounting standards, then the incentives to participate in accounting standard setting are diminished and one would expect less positive effects from participation. Similarly, less positive effects would be expected if other reasons than the impact on financial reports dominate firms’ participation decision (i.e. the wish to evade transition costs, generate public relations effects, or imitate competitors).2 Furthermore, while recent research has found evidence that individuals derive benefits from “having their voice heard” (Frey et al. 2004, 2005, Ong et al. 2012) and that individuals feel committed to agreed rules even if these are not enforceable (Kessler and Leider 2012), it is unclear that these results carry over to organizations (Engel 2010). In the context of financial reporting regulation it is not necessarily the same persons who represent the organization in the standard setting process, i.e., write a comment letter, and those who ultimately make the actual accounting decisions. 2.4. Hypothesis Drawing from different strands of the literature, we conclude that the effects of participation in accounting standard setting on compliance with accounting standards are not clear-cut. Given that compliance effects of participation in rule-setting 2

We thank an anonymous referee for pointing this out.

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have been found both experimentally and empirically, we nevertheless hypothesize that such effects are also present in compliance with accounting rules. Defining compliance in accounting as an absence of manipulation, we thus formulate H:

Subjects who have the opportunity to choose an accounting rule themselves manipulate financial reporting less than those who have to comply with an exogenously set accounting rule.

3. Experimental Design At the beginning of an experimental session, subjects arrive and wait outside the laboratory. At the designated starting time, subjects are welcomed by the experimenter, draw cards with their computer numbers, are led into the lab and sit down at the workstation corresponding to the number on the card. They there find a printed set of the first part of the instructions (see online appendix A.1 for a translation of the instructions), which the experimenter then reads out loud, asking the subjects to read along. After answering any possible remaining questions individually, the experimenter then starts the main part of the experiment, which is implemented in zTree (Fischbacher 2007). After this is over, the experimenter starts a computerized questionnaire eliciting data on subject demographics and on their experiences and strategies in the experiment. Subjects who have finished filling in the questionnaire step outside the lab to wait until everybody else has also finished. Once this is the case, the experimenter asks subjects to step into the lab one at a time and pays them anonymously. Having outlined the procedures surrounding the experiment proper, we now return to describing the main phase of each experimental session. We investigate our hypothesis by means of four different treatments, which we implement in a betweensubjects design. We will start by describing the two treatments “Communication and Vote (CV)” and “no Communication, no Vote (nCnV)” and then continue with the follow-up treatments “Communication and Vote with Discounting (CVD)” and “no Communication, no Vote, Discounting (nCnVD)”. 3.1. Treatments CV and nCnV The first part of our experiment consists of two between subjects treatments: “Communication and Vote (CV)” and “no Communication, no Vote (nCnV)”. At the beginning of both treatments, subjects are informed that they play the role of an unspecified firm. Subjects play in randomly drawn groups of three. They learn that all firms in a group will be subject to the same reporting principle – either the prudence principle or fair value accounting. Once subjects have read the initial instructions, which include a short paragraph describing the two measurement principles, subjects in the CV treatment have the opportunity to discuss the rules with the two other group members in an electronic chat lasting for 10 minutes. After this chat, subjects in the CV treatment can vote for one of the two rules. The majority vote is


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automatically implemented and becomes the rule subjects have to follow in the remainder of the experiment. Subjects are informed of the number of votes cast for each of the two rules and which rule they will have to follow. In the nCnV treatment, subjects are neither allowed to discuss the rules, nor can they vote for them. They are informed that the standard setter has chosen a rule without consulting them. Before this choice is revealed to them, subjects are asked to state which rule they would prefer if they had the choice. After answering this unincentivized question, subjects are informed about the standard setter’s choice, which is independent of their stated preferences (there is no deception in our experiment). Using the dichotomy of the prudence principle and fair value accounting in our experiment provides a major advantage. Schematically speaking, the prudence principle and fair value accounting are distinguished by how they treat upward movements in value. A decline in value of assets has to be recognized identically under both principles. This allows us to create a setting where the situation in the second part of the experiment is identical, independent of what principle was chosen in the first part. This in turn enables us to directly compare results and focus on whether the accounting principle was chosen or imposed, without having to distinguish which accounting principle was chosen or imposed. Subjects in both treatments then learn that their firm has an outstanding claim amounting to 7 mio. Euros which may be subject to impairment.3 They are furthermore informed that they will be asked to report the value of this claim and that they will have the choice to report it correctly or to overreport the claim’s value. Their bonus (which they can get in addition to the show-up fee of 5 EUR) equals 2 EUR times the reported value of this claim. In case that they overreport the claim value, however, there is a risk of detection with a probability of 0.1 , where is the reported and the actual value of the claim, in million Euros. In other words, for every million Euros that subjects overreport their firm’s income, the probability of detection increases by 10 percentage points. (This mechanism is designed to mimic the real-world uncertainty surrounding the outcome of enforcement actions by modeling a higher probability of an intervention by accounting authorities the more the firm’s financial report deviates from an internal estimate.) If a subject is found to be overreporting their firm’s income, it loses its entire payoff from the experiment (including the show-up fee). Note again that this reporting situation was specifically chosen such that there is no difference in the correct report between groups which have to apply the prudence principle and ones which are subject to fair value accounting. After having been informed about the consequences of overreporting their claim value, subjects learn that an internal analysis has found the value of their firm’s 3

An example for such a claim would be receivables from goods and services.

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claim to be 0, i.e. that the claim has to be completely written down. Subjects are then asked to state what value 0,1, … ,7 they want to report for their firm’s claim. Their payoff function expressed in EUR is: 5

2 0

if no discovery of overreporting, if overreporting discovered.

(1)

Since the probability of discovery increases by 10 percentage points in each million of value reported in excess of the true value of zero, the expected payoff as a function of thus is: E

5

1

2

0

5

The first derivative of equation (2) with regard to d

1.5

d

1.5

0.2

(2)

yields:

0.4

(3)

Setting equation (3) equal to 0 and testing for a maximum shows that this function peaks at 3.75, or including the integer condition at 4. By comparing subjects’ actual behavior to this benchmark prediction for rational, risk-neutral subjects, the payoff function allows us to identify undermanipulation and overmanipulation. The former may for example be induced by a preference for honesty or an aversion to risk, while the latter could be interpreted as a sign of insufficient subject sophistication or bounded rationality. 3.2. Treatments CVD and nCnVD The second part of the experiment was again made up of two between subjects treatments: “Communication and Vote with Discounting (CVD)” and “no Communication, no Vote, Discounting (nCnVD)”. They are identical to CV and nCnV, respectively, in a number of characteristics, starting with the entire procedures concerning the choice of the applicable accounting rule (chat; voting; wording of instructions except for one minor detail). They differ in the initial (10 instead of 7 mio. Euros) and actual value of the firm’s claim (4 instead of 0 mio. Euros) and in that subjects are informed that the other firms’ claims have the same actual value as their own. The main difference between the two treatment pairs, however, is that “the market” discounts subjects’ reports by the group’s average overreported value, and that subjects’ payment is determined by the market’s valuation of their firm’s claim, with a payoff of EUR 2.5 per million of the market’s valuation of their claim. Subjects’ payoff as a function of their own ( ) and others’ ( ) reported values expressed in EUR is: , 2.5

∑ 0

4

if no discovery of overreporting, if overreporting discovered,

(4)


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where , , 1,2,3 index the subjects. Since the probability of discovery again increases by 10 percentage points in each million of value reported in excess of the true value 4, the expected payoff thus is: ,

E

1

The derivative with regard to ,

d d

∑

2.5

4

(5)

is: ∑

4

(6)

Setting equation (6) equal to 0, this yields the peak of the expected payoff function ∑ for 6 4 . In other words, given the vector of possible average reports by the other group members of: 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10 , the optimal report vector for a subject aiming to maximize her own payment without consideration of her fellow group members’ payments is: 6 6.25 6.5 6.75 7 7.25 7.5 7.75 8 8.25 8.5 8.75 9 . Since this payoff function is considerably more complex than the one for the treatments without discounting, we took two measures to ensure subjects’ understanding of the consequences of their choices. First, subjects had to correctly solve four control questions after having being informed about the decision situation and about how their payment would be calculated. Second, we provided subjects with a “flight simulator” on their decision screens, which allowed them to simulate the consequences both for themselves and their group members, of different reported values for themselves for different hypothetical reports by the other two group members. A screenshot is provided in Fig. 1.

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Fig. 1


Decision screen, discounting treatments

Example decision screen in treatments CVD and nCnVD. Text printed in red (grey in greyscale printouts) is a translation of the German original which was not visible in the experiment.

This payoff function again allows us to compare subjects’ behavior to a benchmark prediction for rational subjects and to identify under- and overmanipulation. 3.3. General Notes Our four treatments taken together constitute a 2x2 full factorial design where we vary whether subjects participate in the accounting standard setting process and whether the market discounts the reported company values by the average overstatement. The former is clearly motivated by our research question. The latter was introduced as an alternative approach after treatments CV and nCnV failed to uncover the hypothesized effect. In the discounting treatments, a subject’s reporting choice affects the payoffs to her fellow group members. Specifically, manipulation by one subject, while potentially increasing this subject’s payoff, at the same time creates negative external effects for her fellow group members. Assume that there are subjects who carry the potential to modify their behavior in response to the


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standard setting process in our subject pool.4 Given this assumption, we conjectured that this response would be strengthened (or made more likely) when we increased the salience of the social impact of subjects’ decisions. It is for this reason that we introduced the discounting treatments. 4. Results The experiments were conducted at the Karl-Franzens-University Graz, employing a total of 89 female and 72 male subjects with an average age of 23.7 years. Recruiting was accomplished through ORSEE (Greiner 2004), from a subject pool consisting mainly of business and economics students. 129 subjects had prior (but unrelated) experimental experience, 98 were currently enrolled in a bachelor’s program, 60 in a master’s program and the remaining 3 were PhD students. Furthermore, 16.15% of our subjects are accounting majors.5 Sessions took an average of 38 minutes excluding subject payment, and individual subjects’ earnings ranged from 0 to EUR 21.70, with a mean of EUR 7.14.

4

If this assumption is not fulfilled, there is no treatment which could detect an effect of the design of the standard setting process.

5 The transferability to a professional context of research results gained by using students as experimental subjects has been discussed in the literature. A number of recent articles argue that student subjects are an attractive and cost-effective option, yielding results which in the majority of cases do not differ from those obtainable from experiments using professional subjects. Fréchette (2011) for example conducts a survey of studies which compare student and professional subject pools, finding that experiments using these yield the same conclusions in 69% of the studies he surveys (where he finds differences, students are closer to theoretical predictions in 75% of all cases). Druckman and Kam (2011) make a strong logical and statistical argument for why generalizing from political science experiments using student subject pools is in most cases unproblematic. Finally, Gächter (2010) argues for the use of student subject pools unless the research objective is specifically to compare different subject pools.

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Participation in Accounting Standard Setting Table 1 Session overview

This table lists summary data on experimental sessions.

Treatment Subjects Female

1 1 12 6

3 2 13 5

4 1 12 7

5 2 14 7

6 7 8 9 1 1 2 3 9 12 5 6a 6 4 5 2

10 3 6 4

11 4 9 4

12 3 6 6

13 4 12 10

14 4 15 9

15 3 15 6

16 3 15 8

Treatments: 1=CV, 2=nCnV, 3=CVD, 4=nCnVD. In session 2, subjects received the wrong instructions. This session is therefore excluded. a Due to a software error, only the report and earnings data of the first subject in each group to make a decision was saved in session 9. The available data from this session is nonetheless included in the analysis, since these subjects’ decisions were unaffected by this error.

As mentioned in the design section, we aimed to investigate the effect of letting subjects participate in the choice of an accounting standard, without intending for the outcome of this choice to bias our results. For this reason, we presented the two standards neutrally and without portraying any as advantageous. We find that subjects’ choice (or their indication of preference) overall is remarkably well balanced, with 75 (86) subjects indicating a preference for the prudence principle (fair value accounting). When looking at individual treatments, however, Pearson’s -test reveals a significant difference between subjects’ preferences in CV and in nCnV – 56% prefer the prudence principle in CV vs. only 31% in nCnV, for a p-value of 0.035 –, while there is no such difference between CVD and nCnVD (the corresponding percentages are 63% and 58%, respectively, with a p-value of 0.699). Overall, the treatments allowing subjects to communicate and vote yield a weakly significantly lower proportion of subjects who express a preference for the prudence principle (46%) than the treatments where subjects are not allowed to communicate and can only indicate their preference but not actually vote for a standard (59%, p-value=0.089). Although this indicates a weak treatment effect on subjects’ accounting standard preferences, it does not interfere with our research objective, which builds on the effect of communicating and voting per se and is orthogonal to the standard chosen.6

6

Note that the pairwise correlation between dummy variables for a subject preferring the prudence principle and majoring in accounting is 0.064, p-value=0.421.


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Table 2 Summary statistics This table lists summary statistics on the four treatments. Mean reported value1 Mean decision time (secs) Mean session length (mins) a

CV 2.067 (29.5a) 256.96 36

nCnV 1.688 (24.1a) 278.25 23

CVD 5.568 (26.1a) 623.05 46

nCnVD 5.194 (19.9a) 573.75 37

Percentage value of the report when the range of possible reports is rescaled to [0…1].

The first row in Table 2 lists the mean project values reported in the four treatments. The first impression already reveals that subjects on average overreport their claims’ true values. At the same time, they report significantly less than the risk-neutral optimum of 4 in treatments nCnV and CV, and than the lowest possible optimum of 6, given any possible expectations about the other group members’ reports, in treatments nCnVD and CVD (both in t-tests and in one-sample Kolmogorov-Smirnov tests all p-values are 0.000). As noted in section 3, reasons for this behavior may be e.g. a preference for honesty, other-regarding preferences, or an aversion to risk. For better comparison, we rescale the range of possible reports to [0…1] for all treatments and list the mean report as a percentage of the maximum possible report in the treatment in parentheses.7 The data show that there is no tendency for subjects to report lower values in the treatments in which they are allowed to communicate about, and vote on, the accounting standard (CV and CVD) than in the respective treatments where they are allowed to do neither (nCnV and nCnVD). The effect in fact goes in the opposite direction, with the mean report in the treatments with communication and vote, CV and CVD, equaling 29.5% and 26.1% of the maximum possible report, respectively, and in the treatments where subjects cannot influence the standard setter’s decision, nCnV and nCnVD, equaling 24.1% and 19.9%, respectively. However, none of the differences in reports between the treatments are significant. This finding is corroborated by Fig. 2, which displays histograms of subjects’ project value reports in the four treatments. There are no visible material differences between the comparable treatments without and those with discussion and vote.

7

In treatments CV and nCnV, the subject can report values from the set {0, 1, … , 7}, such that a report of e.g. 5 would be converted to 5 / 7 = 71.4%. In treatments CVD and nCnVD, subjects can report values from the set {4, 5, … , 10}, such that a report of 5 would be converted to (5 - 4) / (10 - 4) = 16.7%.

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Fig. 2

Reported values, by treatment

Histograms of subjects’ reported project values, by treatment.

The pairwise correlation between a dummy variable for the time taken by a subject in its reporting decision and the value reported is 0.600, p-value=0.000 (the mean decision time for each treatment is listed in Table 2). This is in line with the literature on lying, which finds that lying requires cognitive resources and therefore takes longer than truth-telling (e.g. Walczyk et al. 2003). Table 3 Regression analysis This table lists the results of different OLS regression analyses of factors influencing subjects’ report when the range of possible reports is rescaled to [0…1]. Regressors CV

Baseline 0.088 (0.266)

Discounting 0.084 (0.068)*

-0.025 (0.121) -0.018 (0.420) 0.082 (0.000)*** -0.032 (0.156) -0.022 (0.677) 0.201 (0.087)* 0.38 0.33 77

-0.007 (0.706) -0.007 (0.656) 0.075 (0.000)*** -0.040 (0.037)** 0.201 (0.013)** 0.112 (0.252) 0.29 0.23 80

D EthicalConcerns SatisfactionVote PayoffMaximization PayoffSalience AccountingMajor Constant R2 Adjusted R2 N

Pooled 0.074 (0.053)* -0.052 (0.129) -0.015 (0.238) -0.010 (0.389) 0.084 (0.000)*** -0.037 (0.012)** 0.053 (0.248) 0.169 (0.025)** 0.30 0.27 157

* p