Academic journal article Accounting Horizons

Are Unmanaged Earnings Always Better for Shareholders?

Academic journal article Accounting Horizons

Are Unmanaged Earnings Always Better for Shareholders?

Article excerpt

SYNOPSIS: The push for increased transparency in financial reporting and corporate governance serves shareholders only up to a point. The problem of assessing the value of transparency to shareholders is subtle because both the level and pattern of earnings can convey information. Even when earnings management conceals information, it can be beneficial to shareholders. Distinguishing between ex ante and ex post efficiency underscores the advantages of achieving a balance between transparency and privacy in corporations.

INTRODUCTION

Alack of transparency in financial reports has often been cited as a weakness of capital markets. Numerous revelations of financial reporting shenanigans by publicly held firms have attracted intense political and media attention, of which Enron and WorldCom are two striking examples. Capital markets are alarmed at such news. The scandals in 2002 have attracted the attention of the securities regulators, accounting standard setters, Congress, and even the President to corporate earnings management.

These guardians of shareholder interests can be too zealous, even for the good of their wards. The push for increased transparency in financial reporting and corporate governance serves the shareholders only up to a point. Beyond that, managerial inhibitions induced by a lack of privacy can damage the interests of shareholders. In other words, increasing transparency without limits does not necessarily improve corporate governance. As an extreme example, installing monitoring cameras in offices may inhibit, not motivate, better performance.

Medical research revealed that cholesterol is not just an artery-hardening villain; it serves a complex and essential physiological function in our bodies. Similarly, accounting research shows that income manipulation is not an unmitigated evil; within limits, it promotes efficient decisions. Our argument, admittedly controversial, is worth airing: earnings management and managerial discretion are intricately linked to serve multiple functions. Accounting reform that ignores these interconnections could do more harm than good.

That earnings management reduces transparency is a simplistic idea. A fundamental feature of decentralized organizations is the dispersal of information across people. Different people know different things and nobody knows everything. In such an environment, a managed earnings stream can convey more information than an unmanaged earnings stream. A smooth car ride is not only comfortable, but it also reassures the passenger about the driver's expertise. The remainder of the paper elaborates on these ideas.

SELFLESS MANAGER

A simple story of income manipulation is that the manager owes the best possible estimate of permanent income of the firm to its shareholders (Fukui 1998). Permanent income is the periodic income the shareholders can expect in perpetuity; capitalizing this income stream yields the value of the firm. If the permanent income is $10 per year and 12 percent is the appropriate discount rate, then the value of the firm is $10/0.12 = $83.33.

Actual income of the firm varies from year to year due to transient shocks as well as accounting effects. With their access to more information, managers can isolate the transient from permanent changes better than the shareholders can. If, for example, the permanent income of the firm remains $10 but a transient factor causes its income in a given period to be $11, then the shareholders, being less well-informed, may capitalize $11 to arrive at a value of $11/0.12 = $91.67, an error of $8.33 or 10 percent. If, on the other hand, the increase in income to $11 were permanent, and the less well-informed shareholders interpreted it to be transient, then they would continue to value the firm at $83.33 instead of $91.67; again committing an error of $8.33 in valuation.

Managers could be asked to report permanent changes in income separately from transient changes to help investors reduce errors in valuation. …

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