ReviewofAccountingStudies,3,7–34(1998)8ARYA,GLOVERANDSUNDER

Nevertheless,theRPisindirectlyusefulinstudyingearningsmanagement.WecanlooktoviolationsoftheRP’sassumptionstoclassifyearningsmanagementstories.Thesecondcontributionofourpaperistobringouttheinterrelationshipsamongvariousearningsmanagementstories.SincemultiplesimultaneousviolationsoftheassumptionsoftheRPareplausible,anysingleexplanationofearningsmanagement(includingourown)isunlikelytobetheexplanationofthephenomenon.Twoofthebetterknownformsofearningsmanagementare“smoothing”and“bigbath.”Forexample,inestimatingtheirbaddebtallowance,companiesmightbetemptedtoprovideagenerousallowanceingoodyearsandskimpinleanyearsinordertosmooththestreamofreportedearnings.3Incontrast,thebigbathhypothesissuggeststhatmanagersundertake

incomedecreasingdiscretionaryaccrualsinleanyears.Perhapsmanagersbelievethatoneverypoorperformancereportisnotasharmfulasseveralmediocreperformancereports.Ithasbeensuggestedthatbigbathsoftenoccurundertheguiseofrestructuringcharges(see,forexample,ElliottandShaw(1988))andmaycoincidewithtopmanagementtransition.Thepastthirtyyearshaveseenanintensiveefforttotrytodocumenttheexistenceandnatureofearningsmanagementinfielddataandtobuildformalmodelsinwhichman-agementofearningsarisesendogenouslyasaconsequenceofrationalchoicemadebyutility-maximizingeconomicagents.Datagatheredfromfinancialreportsofcorporationshavebeenscrutinizedforfingerprintsofopportunisticmanagerialmanipulationwithonlymixedresults(see,forexample,Archibald(1967),Bartov(1993),Copeland(1968),Cush-ing(1969),DeAngelo(1986),DeAngelo,DeAngelo,andSkinner(1994),Dechow,Sloan,andSweeney(1995),Gordan,Horwitz,andMeyers(1966),Healy(1985),LibertyandZim-merman(1986),LysandSivaramakrishnan(1988),McNicholsandWilson(1988),RonenandSadan(1981)).4Someofthereasonsgivenfortheweakandinconsistentempiricalresultsare:(1)useofunreliableempiricalsurrogatesformanagedandunmanagedportionsofearnings,(2)thefocusofmostempiricalstudiesononeaccountinginstrumentofearningsmanagementatatime,(3)anarrowinterpretationofearningsmanagement,and(4)managers’incentivestocovertheirtracks(Sunder,1997,pp.74–78).Ourpapersuggeststwomore:(5)ownersmayhaveincentivestomakeiteasyformanagerstohideinformationand(6)twoormoreindependentconditionsthatinduceearningsmanagementmayexistsimultaneously,causingstudiesthatfocusonasingleconditiontoyieldnoisyresults.Ourlimitedcommitmentexplanationforearningsmanagementisbasedontheideaof“at-will”employmentcontracts.Theirimplementationdependsentirelyonthewillingnessofthepartiestocontinuetosubjectthemselvestotheirterms.Eachemploymentcontractisbetweenanownerandamanager.Weassumetheownercannotcommittoapolicyregardingfiring/retentiondecisions.Also,themanagercannotcommittostayingwiththefirm.Thisisconsistentwithobservedemploymentcontractswhichoftenspecifybroadtermsandobjectives,butrarelyspecifytheexactcircumstancesunderwhichtheemployeecanquitorbedismissed(MilgromandRoberts,1992,p.330;Sunder,1997,p.40).Therearebenefitsandcostsassociatedwithdismissingamanager.Thebenefitstotheownerarethat(1)thethreatofdismissalforbadoutcomesprovidesthemanagerwithincentivestoreducetheprobabilityofbadoutcomesthroughhisactions,and(2)dismissalallowstheownertoreplaceamanagerwhoisknowntohaveperformedpoorlywithanotherEARNINGSMANAGEMENT9fromthepoolofcandidateswhoseexpectedproductivityisgreater.Becausetheownercannotcommittothedismissaldecision,shewillfirethemanagerwheneveritisinherownexpostbestinterest.Fromanexanteperspectivethiscanresultinthemanagerbeingfiredtoooftenandthecostofthefiringoptionreducingthewelfareoftheowner.5,6Wecomparetheowner’spayoffunderasystemofunmanagedearnings(theownerherselfdirectlyandcostlesslyobservesearnings)toherpayoffunderasystemofmanagedearnings(earningsreportsprovidedbythemanagerthatmayormaynotbetruthful).Apropositionestablishesconditionsunderwhichtheownerprefersmanagedearningstounmanagedearnings.Themanagermanipulatesearningstoretainhisjobforaslongaspossible,andtheownerfindsthecoarseninganddelayofinformationthatoccursunderearningsmanipulationbeneficialasadevicethateffectivelycommitshertomakingfiringdecisionsthatarebetterfromanexanteperspective.7Wealsopresentanexampleinwhichmanagedearningsarecomparedtootherbench-marks.Theintentistohighlighttheparticularwayinwhichearningsmanagementcoarsensanddelaysinformation.Earningsmanagementleadstoatime-additiveaggregationofper-formancemeasures,whichpreventstheownerfromlearningthefirm’sperformanceintheshortrunbutallowshertodetectpersistentlypoorperformance.8FudenbergandTirole(1995)presentastorycloselyrelatedtoours.Intheirmodel(andours)themanagermanipulatesearningsinordertoavoid(delay)dismissal.However,intheFudenbergandTirolesetting,theownerprefersunmanagedearnings(ifavailable)tomanagedearnings.Thisisbecause,intheirsetting,themanagerdoesnotsupplyaproductiveinputandthemanager’scompensationisnotmodeled.Thebenefittotheownerofbeingabletofirethemanageristhepossibilityofremovinganunproductivemanager;thereisnodiscipliningbenefittofiringandnocosttofiring.9Shadesofourstorycanalsobefoundinbusinesspress.First,managerssometimesfindearningsmanagementusefulasawayoflimitingownerintervention.Forexample,Germanexecutiveshavebeendescribedasviewingsecretreservesasusefulinkeeping“gimlet-eyedshareholders[from]callingtheshots”(TheWallStreetJournal,1998).Thetraditional(German)viewhasbeenthattheirreportingstandards,whichallowforsuchhiddenreserves,encouragemanagerstofocusonthelong-runratherthantheshort-runperformanceoftheircompanies.Second,placingsomeboundsonownerinterventionisdesirableforthecompanyasawhole,andfortheownersthemselves.AnarticleinExecutiveExcellence(1997)describesoneoftheboard’srolesasthatofprovidingautonomy:“Boardsmustgiveorganizationmemberstheautonomytodotheirjobs.”Thepresumptionhereisthat,withoutacertaindegreeofautonomy,managementisnotabletoperformatitsbest.Ourstorylinksthesetwoviewsandaddsatimingperspective.Earningsmanagementisasubstitutefortheownerscommittingexantetoresistanytemptationtheymighthavetointerveneexpost.Thisexantecommitmentisusefulinattractingandmotivatingmanagers.Inourmodel,theownerintervenesthroughherdecisiontoretainorreplacethemanager.Alternatively,theboardmayrespondtothefirm’sshort-termpoorperformanceby“backseatdriving”withrespecttodecisionsnormallylefttotheCEO.Byallowingforearningsmanagement,theboardgivestheCEOmoreroomtoworkthingsout.InSection2.5ofthepaperwepresentanumericalexamplethatillustratestheroleearningsmanagementcanhaveinpreventingsuchownerintervention.Intheexample,ownerinterventionrenders