4093131

Financial Reporting Transparency and Earnings Management
Author(s): James E. Hunton, Robert Libby and Cheri L. Mazza

Source: The Accounting Review, Vol. 81, No. 1 (Jan., 2006), pp. 135-157
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol. 81, No. 1
2006
pp. 135-157
Financial Reporting Transparency an

Earnings Management
James E. Hunton
Bentley College
Robert Libby
Cornell University
Cheri L. Mazza
Fordham University
ABSTRACT: Prior research indicates that greater transparency in reporting formats
facilitates the detection of earnings management. The current study hypothesizes and
demonstrates that greater transparency in comprehensive income reporting also reduces the likelihood that managers will engage in earnings management in the area of
increased transparency. In our experiment, 62 financial executives and chief executive
officers decide which available-for-sale security to sell from a portfolio. We manipulate
the transparency of comprehensive income reporting and the relationship of projected
earnings to the consensus forecast in a 2 x 2 between-subjects design. When projected earnings are below (above) the consensus forecast, participants sell securities
that increase (decrease) earnings. However, the rarely used, more transparent format
for reporting comprehensive income significantly reduces both income-increasing and
income-decreasing earnings management. Participants in the less transparent setting
indicate that earnings management attempts will not be obvious to readers, will improve stock prices, and have no effect on management's reputation for reporting integrity. Conversely, respondents in the more transparent condition suggest that earnings management will be obvious to readers, harmful to stock prices, and damaging
to reporting reputation. Results of this study suggest that more transparent reporting
requirements will reduce earnings management in the area of increased transparency
or change the focus of earnings management to less visible methods.
Keywords: financial reporting; transparency; earnings management; comprehensive income; SFAS No. 130.
The authors thank Rob Bloomfield, Jan Bouwens, Cheryl Dunn, Peter Easton, Eric Hirst, Lisa Koonce, Robert
Knechel, Linda McDaniel, Mark Nelson, Nick Seybert, Dan Stone, Eddy Vaassen, workshop participants at the
Financial Accounting Standards Board, Florida State University, Harvard University, Tilburg University, The University of Iowa, University of Kentucky, University of Maastricht, University of Tennessee, and participants at the
AAA Doctoral Consortium and the FARS Doctoral Consortium for their comments on earlier versions.
Editor's note: This paper was accepted by Jane Kennedy, Editor.

Submitted November 2004
Accepted August 2005
135
136 Hunton, Libby, and Mazza

I. INTRODUCTION
any studies of reporting transparency examine its effects on users' abili

earnings management. These studies generally report that more trans
closures (those that are easier to process) lead to greater detection o
management (e.g., Hirst and Hopkins 1998). Managers also often lobby for an
transparent disclosure formats (e.g., inclusion of expenses and liabilities in
market value changes in the statement of stockholders' equity). This suggests
believe there is a benefit derived from limiting some users' ability to detect
agement. Such a belief is consistent with the view of Fields et al. (2001)
managers likely would not engage in earnings management in the absence o
benefits, and such benefits require that at least some users of accounting inf
unable or unwilling to disentangle its effects. If easier detection of earnings
reduces its expected value, then greater reporting transparency should reduce
of earnings management attempts. We test whether managers' earnings manag
and underlying beliefs are consistent with this logic. By doing so, we ca
understand determinants of earnings management strategies, and facilitate p
evaluations of the costs and benefits of mandating increased transparency.'
Based in part on user group requests for clearer reporting of other com
income items, the Financial Accounting Standards Board issued Statement o
Accounting Standards No. 130 (SFAS No. 130, FASB 1997), Reporting Co
Income. The exposure draft leading to SFAS No. 130 (FASB 1996) required a
statement approach for the display of comprehensive income. However, in
preparer input, the FASB decided to also allow a less transparent display in t
of stockholders' equity. The large majority of companies currently choose t
parent display.2 The FASB and the International Accounting Standards Boar
reconsidering how to display comprehensive income (FASB 2005) with the o
improving transparency.
Recent research indicates that users are less likely to detect earnings mana
relevant information is disclosed in the less transparent statement of stockh
(e.g., Hirst and Hopkins 1998; Hirst et al. 2004). Contemporaneous research
that property casualty insurance firms with a history of selective sale of av
securities, choice of nonspecialist auditors, lower institutional ownership and
erage, and higher bid-ask spreads, were more likely to select the less transpa
in the statement of stockholders' equity in the first year of implementation
130 (Lee et al. 2005). This suggests that firms with a history of earnings man
weaker monitoring/corporate governance systems tend to choose the less tra
porting format. What remains unknown is (1) whether the more transparent repo
would reduce the likelihood that managers will engage in earnings manageme
of increased transparency, (2) if it does, why managers behave in such a m
whether the effects are symmetric for income-increasing and income-decrea
management. The answers to these questions provide a basis for predicting t
requiring more transparent comprehensive income reporting standards (e.g
and developing a more complete theory of earnings management and disclosu
See Arya et al. (2003) for a discussion of potential costs that can result from transparency improvement.
2 In a survey of 111 randomly selected firms from the Russell 2000 Index, Mazza and Porco (2004) find that 83
percent report comprehensive income in a statement of stockholders' equity, 3 percent use the one-statement
approach, and 14 percent use the two-statement approach.
The Accounting Review, January 2006
Financial Reporting Transparency and Earnings Management 137
We conduct an experiment where 59 financial executives and three chief executive

officers recommend the sale of an available-for-sale security to raise cash for a principl
payment. Using a between-subjects design, we vary the direction of management's incenti
to manage earnings (consensus analysts' forecasts either below or above management's
projection of earnings) and the transparency of the display of comprehensive income (th
less transparent statement of stockholders' equity or more transparent single statement
comprehensive income). When projected earnings are below the consensus forecast, parti
ipants increase current income by selling an available-for-sale security with an unrealize
gain. When projected earnings are above the consensus forecast, participants decrease cu
rent income by selling an available-for-sale security with an unrealized loss. Most impor
tantly, the more transparent format (the single statement of comprehensive income) dr
matically reduces, but does not eliminate, the prevalence of both types of earnin
management. In debriefing, participants indicate they believe that earnings manageme

through selective sale of available-for-sale securities disclosed in the less transparent sta
ment of stockholders' equity would improve stock price and not harm their reputation f
reporting integrity. Conversely, they indicate that earnings management disclosed in th
more transparent single statement of comprehensive income would harm both stock pri
and reporting reputation. These results suggest that more transparent reporting requirements
will reduce the likelihood of managers engaging in earnings management in areas of in

creased transparency or change the focus of earnings management attempts to less visib
methods.
This study provides direct causal evidence relevant to the effects of the FASB's current
proposal on comprehensive income reporting and other efforts to improve reporting trans-
parency. It is also responsive to Healy and Wahlen's (1999) and Libby et al.'s (2002)
suggestion that accounting research examine the characteristics of accounting regulation
that encourage or discourage earnings management. Further, when combined with the contemporaneous research by Lee et al. (2005), our study demonstrates the power of using
multiple methods to examine the same financial reporting issue (Maines 1995; McDaniel
and Hand 1996). Our experiment extends the findings of Lee et al. (2005) by allowing for
a direct causal inference relevant to the effects of the FASB's current proposal, isolates
income-increasing and income-decreasing earnings management, and provides insight into
managers' beliefs concerning stock price and reporting reputation effects that underlie their
earnings management decisions. Bolstering the external validity of our results, the complementary findings of Lee et al. (2005) suggest that identified effects in the current study
would likely not be swamped in the natural environment or offset by factors not included
in our experimental setting.
II. BACKGROUND AND HYPOTHESES
Managing Earnings through Selective Sale of Available-for-Sale Securities

Under the provisions of SFAS No. 115 (FASB 1993) and SFAS No. 130 (FAS
available-for-sale securities are reported at fair value on the balance sheet, and un
holding gains and losses on those securities are reported as part of other compre
income, which is added to net income to arrive at an all-inclusive income measure
as comprehensive income. When the holder sells the securities, they realize as p
earnings the gain or loss that occurred over the entire holding period. In that sam
in order to avoid double counting of gains and losses in comprehensive income r
over the entire holding period, other comprehensive income includes a reclassifica
justment opposite in sign from the gain or loss reported in earnings. Therefore, manag
138
can
Hunton,
Libby,
manipulate
for-sale
and
earnings,
securities.
Mazza
but
not
com
Several archival studies find that fin

by strategically timing the realization
Moyer 1990; Scholes et al. 1990; Beatty
sample of earnings management attem
Nelson et al. (2003) find a number of c
timed recognition of realized gains or
Transparency
and
Comprehensive
In
One of the perceived advantages of c

ease of extracting information on gain
directly in equity.3 For example, the A
(AIMR) urged the FASB to implement
create more transparency for the rep
securities. The AIMR supported the al
hensive income and furthermore supp
be reported in a performance stateme
sentation of comprehensive income in
thereby increasing investors' use of th
agreed to implement comprehensive i
inclusion of other comprehensive inco
comprehensive income as the bottom l
SFAS No. 130 permits three alternati
prehensive income in a statement of
proach or the two-statement approach.
a performance statement that display
latter, a company displays the traditi
comprehensive income that begins with
which presents comprehensive incom
thereby presenting unrealized gains an
changes in the balance sheet account a
We define more transparent financi
mation can be more easily extracted an
ics. In the context of comprehensive in
prominence given to items of other co
(FASB 1996, 1997). Placement of comp
considered to be more prominent, and
statement
of
stockholders'
equity.
performance-related financial informa

result in items of other comprehensive
strued as non-performance-related.
Hirst and Hopkins (1998) was the fir
reporting format affects users' extra
available-for-sale securities. Specifically
3 Prior to SFAS No. 130, preparers were reporti

losses on available-for-sale securities, and minim
as a separate component of equity.
The
Accounting
Review,
January
2006
gains and losses on available-for-sale securities in a statement of stockholders' equity,

than a separate statement of comprehensive income, diminishes analysts' ability to d
earnings management through selective sale. They conclude that, relative to the state
of stockholders' equity approach, the two-statement approach enhances analysts' abili
detect this type of earnings management activity. In addition, the two-statement app
increases analysts' acquisition of information related to comprehensive income and re
bias in their valuation judgments. The Hirst and Hopkins (1998) results suggest that a h
level of transparency is achieved when comprehensive income and its componen
displayed in a statement of comprehensive income rather than a statement of stockho

equity.
In a study focusing on fair value accounting for banks, Hirst et al. (2004) investigate
whether differences in the way in which commercial banks measure and report comprehensive income cause systematic variation in bank analysts' investment risk assessments
and valuation judgments. They find that the valuation judgments of analysts distinguish
between banks with different levels of risk only when fair value changes are measured
completely (full fair value accounting) and included in a separate comprehensive income
statement (as opposed to a statement of stockholders' equity). Thus, although bank analysts
are aware of the different interest rate risks assumed by high-risk and low-risk banks, clear
performance reporting of the financial implications of these risks increases the likelihood
that analysts will use the information in their investment-related judgments. Similarly,
Bloomfield et al. (2005) find that share prices in an experimental market are influenced
more by unrealized gains and losses when they are disclosed in the statement of comprehensive income format.
Maines and McDaniel (2000) use an experiment to examine whether alternative presentation formats affect different stages of nonprofessional investors' processing of comprehensive income information. They view more transparent disclosures as those that promote acquisition and proper interpretation or weighting of information. Their results
indicate that nonprofessionals acquire and appropriately evaluate the volatility of unrealized
gains reported as part of other comprehensive income, regardless of whether managers
display such information in a statement of stockholders' equity or in a separate statement
of comprehensive income. However, nonprofessional investors place significant weight on
their volatility assessments only when those unrealized gains are reported in a statement of
comprehensive income.4 Maines and McDaniel (2000) also suggest that statement placement, income labeling, net income linkage, and other disclosure features can increase reporting transparency. Taken together, these papers suggest that of the three alternative
reporting formats for comprehensive income allowed by SFAS No. 130, the statement of
stockholder's equity approach is less transparent than either of the performance statement
approaches.
Transparency and Earnings Management

As Hirst et al. (2004) note, managers' frequent lobbying efforts for the option to employ
less transparent reporting formats provides indirect evidence that they believe that the costs
and benefits of earnings management are affected by disclosure transparency. Maines and
McDaniel (2000) analyzed the 281 comment letters received by the FASB on their exposure
4 Biddle and Choi (2002) support the need to weight comprehensive income elements in valuation decisions. They
find that comprehensive income is more relevant for share returns than traditional net income, and that securities
gains and losses provide the greatest incremental value-relevance among the other comprehensive income
components.
140
Hunton,
Libby,
and
Mazza
draft, and 90 percent supported disclo

in the statement of stockholders' equ
lobbied for the option of note disclos
and operating lease liabilities as well
each case, the FASB's initial decision r
transparent
option
was
later
allowed
as
choose the less transparent option whe

of companies display comprehensive
disclose employee stock option compe
from operating activities using the in
This behavior suggests that manager
parent disclosures. Such a belief is co
Hirst et al. (2003) that companies wil
management is easier to detect, and t
likely would not engage in earnings m
such benefits require that at least som
willing to disentangle the effects of
recent theories developed by Bloomfi
that
markets
directly
correct
on
will
react
setting
less
to
where
informat
all
inform
interpretation.5
Bloomfield (2002) develops the "inco

rium outcomes in noisy rational expe
model, all traders have the same amo
trading
keeps
prices
from
fully
revealin
mation to make their trading gains e

rium, facts that are more costly to ex
interest and are less completely reve
directly focus on "choices between se
including choices of information loca
ment
for
recognition).
In
their
model,
is less easily extracted being absorbe

attentive investors also causes them
their
limited
greater
attention.
capacity)
are
All
investors
unable
to
are
fully
demonstrate how the market will differ

ing information that differ in the atten
Both theories suggest that easier det

proved transparency should reduce the
described by Bloomfield (2002) and H
more to managed earnings than to un
ings requires additional effort. If ma
requiring greater reporting transparen
management attempts in the area of
5 As Fields et al. (2001) note, accounting choice m

influences parties other than owners, or infl
Bhojraj and Libby (2005) and Graham et al. (for
based on contracts or parties other than owner
The
Accounting
Review,
January
2006
Maines and McDaniel's (2000) emphasis that more transparent disclosures are tho
promote acquisition and proper interpretation of information.
The most relevant archival research related to this prediction is Lee et al.
contemporaneous study of the initial comprehensive income reporting decisions of

traded property-liability insurers. Following prior studies, they identify firms as
history of selective sale of available-for-sale securities (they call these firms cherry
if there is a significant negative correlation between realized available-for-sale security
and losses and net income before extraordinary items and realized gains and loss
find that firms classified as having a history of selective sale (cherry-picking),
nonspecialist auditors, lower institutional ownership and analyst coverage, and hig
ask spreads were more likely to select the less transparent display in the statem
stockholders' equity in the first year of implementation of SFAS No. 130.
While the Lee et al. (2005) study indicates that firms identified as earnings ma
are more likely to select the less transparent disclosure, the extent to which th
transparent reporting format would reduce managers' propensity to engage in earnings
agement remains unknown. Furthermore, use of the correlational measure of ea

management does not allow for distinguishing between income-increasing and in
decreasing earnings management, or assessing managers' beliefs that underlie their
management choices. Our study focuses on these issues.6
Hypotheses
Archival, experimental, and survey studies conclude that firms manage earnings to meet
or exceed analysts' forecasts (e.g., Degeorge et al. 1999; Burgstahler and Eames 2003;
Brown 2001; Libby and Kinney 2000; Nelson et al. 2002). Depending on the circumstances,
managers can have an incentive to manage earnings up or down. For example, the government case against a former HealthSouth CEO contends that "he picked a desired earningsper-share number each quarter that met or exceeded Wall Street expectations and then
instructed his finance executives to inflate the company's financial results accordingly"
(Mollenkamp 2003). In other cases, managers have managed earnings downward in some
periods (e.g., Freddie Mac).
In our study, participants are required to select one of five available-for-sale securities
to sell, any one of which would result in the firm meeting its liquidity needs. Absent other
incentives or penalties, it would be optimal for the participants to choose the security that
would carry the additional benefit of meeting the analysts' consensus forecast. Thus, an
underlying assumption in our study is that participants will recommend the sale of the
security that moves projected earnings toward the consensus forecast. As noted above, prior
studies of selective sale of available-for-sale securities cannot distinguish between incomeincreasing and income-decreasing earnings management. Accordingly, we set the direction
of managers' earnings management incentives by manipulating whether projected earnings
are below or above analysts' consensus forecast, and then test separately whether increasing
the transparency of reporting for the financial statement items in question will decrease the
prevalence of both income-increasing and income-decreasing earnings management. Based

on the literature and theory discussed in the prior section, we anticipate the following:
6 Additionally, Lee et al. (2005, 29) note, "Another limitation of our study is that we consider only one highly
regulated industry that uniquely has a fairly significant percentage of firms reporting comprehensive income on
a performance statement. The increased prevalence of performance reporting may be due to the nature of
property-liability insurers' investment portfolios."
142
Hunton,
Libby,
and
Mazza
Hla: More transparent disclosure o

dency to recommend selling ava
come when projected earnings
Hlb: More transparent disclosure o

dency to recommend selling av
income when projected earning
These hypothesized effects would

analyst consensus forecast. Results
transparency will reduce the preva
III. RESEARCH METHOD
In our experiment, experienced financial managers select an available-for-s

for sale to raise cash for a principle payment on debt. The consensus analysts
comprehensive income report format are varied in a 2 x 2 between-subjects d
Participants
Our experimental approach is most similar to Cloyd et al. (1996), who study the effects
of managers' incentives at public versus private firms on the importance of tax and book
conformance; Kennedy et al. (1998), who study the effects of managers' incentives on
alternative liability disclosures; and Bhojraj and Libby (2005), who study the effects of
capital market incentives and reporting frequency on managers' investment decisions. As
Libby et al. (2002) discuss, these studies, as well as the current study, use experienced
managers as participants because their goal is to "peer into the minds" of experienced
managers to determine what they have learned in the field about the costs and benefits of
financial reporting decisions.
The study participants are attendees at six corporate training sessions offered by a
professional consulting firm. The 62 participants include 59 financial managers and three
CEOs representing 17 public companies. We present demographic data on Table 1.
Task
The task is designed to achieve three goals. First, the portfolio is designed such that
sale of available-for-sale securities can be as easily used to manage earnings up or down.
Second, the choice context is designed such that the sale is a costless operational decision;
that is, it neither requires a trade-off between reporting goals and cash flows nor involves
an unethical or illegal decision. Third, the information necessary for detection of selective
sales is available in all disclosure formats, but differs in transparency as demonstrated in
prior research.
The case materials ask participants to assume that they work for a public company
followed by analysts and places them in the situation next described. It is December 15,
7 Several arguments have been made in the literature suggesting a plausible finding of no effect of transparency
on earnings management. In efficient capital markets, changes in transparency such as those discussed above
should have no effect on share price because at least some investors have access to the information. As a
consequence, they should have no effect on earnings management behavior. Similarly, if managers believe that
there is no cost to earnings management, and there is any chance of a possible benefit, then rational managers
would manage earnings equally under all levels of transparency. Only if managers believe that costs and benefits
of earnings management vary by levels of transparency would a requirement to use a more transparent comprehensive reporting format be expected to change earnings management behavior. Additionally, research examining
the relationship between disclosure quality and earnings management offers mixed results, as one study indicates
a positive relationship (Shaw 2003), while another suggests a negative association (Lobo and Zhou 2001).
TABLE 1
Demographic Data
Numbera Percent
Participants employed by public companies 62 100

Professional certifications held by participants:
Certified public accountant (CPA) 31 50

Certified management accountant (CMA) 7 11
Certified financial analyst (CFA) 7 11
Certified internal auditor (CIA) 4 6
Compensation schemes of employer companies:
Straight salary 17 27
Salary plus bonus based on an income-related measure 23 37
Salary plus a bonus based on the company's stock price 22 36
Meanb (S.D.)
Average business experience 22.50 (6.44) years

Average accounting/finance experience 20.69 (7.83) years
Personal wealth invested in employer company stock 31.53 (23.62) percent
Average total assets of employer companies $92,124.56 (220,975.29) million
Average annual sales of employer companies $10,200.76 (15,622.24) million
a Based on Chi-square testing, neither professional certification nor compensation schemes are significantly
different (p > .10) across treatment conditions.
b Based on ANOVA testing, response means are not significantly different (p > .10) across treatment cond
2002 and the company needs to sell equity securities in order to raise $80 million f
December 20 principle payment on debt. Each participant is provided with informa
about five equity securities comprising the available-for-sale securities portfolio (see
2, Panel A). Each security has a current market value of $80 million. Sale of th
alternative available-for-sale securities A through E will produce a realized $20 mill

loss, $10 million loss, no gain or loss, $10 million gain, and $20 million gain, respectiv
Beginning with income from operations, Table 2, Panel B summarizes the financial st
ment effects of the sale of each of the five securities.
Participants next learn that (1) the company projects earnings of $1,000 million before
considering the effects of the security sales, (2) the information provided ignores income
taxes, (3) they are to assume no tax consequences associated with the sale of any security,
and (4) for simplicity, relevant balance sheets and cash flow statements are not included in
the case materials.8 The participants then read the analysts' consensus forecast for the
company's 2002 earnings and recommend which security they would sell if the situation
arose at their company. We also ask participants to indicate which security the senior
executives in their company would prefer to sell and which security sale would result in
the highest stock price for their company.
As part of the basis for their recommendations, participants also receive five two-page
sets of pro forma financial statements, including a performance statement, statement of
stockholders' equity, and an available-for-sale securities note reflecting the expected effects
of sale of each of the five securities. We provide each set of financial statements on two
8 The participants are not given any information indicating differential expected future returns for the five
securities.
144
Hunton,
Libby,
and
Mazza
TABLE 2
Security Sale Recommendation

Panel A: Choice of Available-for-Sale Securities to Sell
Portfolio of Available-for-Sale Securitiesa
Co. A Co. B Co. C Co. D Co. E
Market
Cost
value
$80
100
$80
90
$80
80
$80
70
$80
60
Unrealized gain (loss) $(20) $(10) $0 $10 $20

Panel B: Effect of Security Sale Recommendation
Security Sale Recommen

Co. A Co. B Co. C Co. D Co. E
Income from operations $1,000 $1,000 $1,000 $1,000 $1,000

Realized gain (loss) from security sales (20) (10) 0 10 20
Net earnings $980 $990 $1,000 $1,010 $1,020
Other comprehensive income:
Reclassification adjustment for (gain) loss
realized in earnings 20 10 0 (10) (20)

Comprehensive income $1,000 $1,000 $1,000 $1,000 $1,000
Unrealized gain (loss) remaining in available-
for-sale portfolio $20 $10 $0 $(10) $(20)
a Dollar values are stated in millions.
separate pages. Following the normal order in annual reports, the first page includes the
performance statement and the second page includes the statement of stockholders' equity
and the financial statement note. The Appendix displays excerpts from the experimental
materials.
Design
We vary whether the consensus forecast is above or below projected earnings and the
transparency of the comprehensive income reporting in a 2 x 2 between-subjects design.
We hold the projected earnings before the security sale constant at $1,000 million and vary
the analysts' consensus forecast at $1,010 million ($10 million above projected earnings)
and $990 million ($10 million below projected earnings). Participants with a consensus
forecast of $1,010 million have an incentive to engage in current income-increasing earnings
management, and could meet or exceed the forecast by selling Security D ($10 million
gain) or Security E ($20 million gain), respectively. In the $990 condition, participants have
an incentive to engage in current income-decreasing earnings management, and could meet
the consensus forecast by selling Security B ($10 million loss) or beat the consensus forecast by selling Security C ($0 gain/loss), Security D ($10 million gain), or Security E ($20
million gain).
We vary the transparency of the comprehensive income reporting at two levels that
reflect the most and least transparent options allowable by SFAS No. 130. In the Statement
of Comprehensive Income (SCI) condition, the format displays net earnings and other
comprehensive income in a single performance statement with comprehensive income as
the bottom line. In the Statement of Stockholders' Equity (SSE) condition, the form
displays other comprehensive income and total comprehensive income in the statemen
stockholders' equity, while the performance statement includes net earnings as its bo
line (see the Appendix for an illustration of both conditions). For all participants, the
item of other comprehensive income is a reclassification adjustment for the realized (
loss on the security sale, which is displayed clearly on the face of the financial statem
in which comprehensive income is reported (in either the SCI or SSE).
Procedure
The training takes place at conference room locations in six different cities across
U.S. At each session, participants represent more than one company. The subject matte
the training involves compliance with Sections 302 and 404 of the Sarbanes-Oxley Ac
2002. The same trainer holds each of the six sessions and each session lasts four hours.
The trainer is unaware of the study hypotheses.9

Before each session, the trainer informs the researchers of the number of expected
participants. The researchers then provide the trainer with a stack of portfolio folders, each
containing two envelopes. The first envelope contains the consent form and experimental
materials, and the second envelope includes the manipulation check and debriefing questions. Within the stack of portfolio folders, we place the four treatment conditions in random
order.
At the end of each training day, the trainer asks the participants if they would volunteer
to participate in a research study that would take about 20 minutes to complete. All participants in each session agree. The trainer passes out the portfolio folders from the top to
the bottom of the stack, and asks the participants to remove the materials from the first
envelope (marked Envelope #1) and complete the assignment. Prior to responding to the
manipulation check and other debriefing items, participants place and seal all materials
back into the first envelope and open the second envelope (marked Envelope #2). Hence,
they cannot look back at the case materials to answer the manipulation check and other
debriefing questions or change their answers to the security sale questions after becoming
aware of the nature of the debriefing questions. Once participants complete the manipulation
check and debriefing questions, they seal these materials back into the second envelope
and place both envelopes into the portfolio folder. The trainer ensures that participants do
not communicate with each other during the study, requests that the participants place the
materials back into and seal the envelopes, collects the portfolio folders, and mails them
back to the researchers.
IV. RESULTS
Manipulation Checks
In the post-experiment debriefing questionnaire, we ask participants to record

alysts' consensus earnings forecast and comprehensive income reporting format p
in the case. All participants correctly indicate their randomly assigned forecast and
conditions, suggesting that they understand the manipulations. In the debriefing q
naire, we also ask several questions to ascertain participants' understanding of the
ments of SFAS No. 115 and SFAS No. 130. All participants correctly report that un
holding gains and losses on available-for-sale securities should be included as part o
9 One of the researchers observes the first experimental session to ensure that the trainer understan
administer the materials. One of the researchers also attends the fourth session, again to ensure that t
is properly administering the materials.
146
Hunton,
Libby,
and
Mazza
comprehensive income. In addition, al

an available-for-sale security, the amo
difference between selling price and
to which they agree with the followi
No. 115 provide an opportunity to sel
to achieve desired income statement
The mean (standard deviation) respon
participants are aware of earnings m
ANOVA testing indicates no significan
> .30 for all). Based on the responses
manipulations successful.
Hypothesis
The
Tests
dependent
variable
for
the
hyp
of the recommended security (Secu

Security C = $1,000, Security D = $
choice of Security A or Security B is

Alternatively, a choice of Security
increasing strategy. Finally, a choice
reports frequencies of security sale c
(Panel A) and $1,010 condition (Panel
for the net earnings resulting from t
We test our hypotheses using an AN
the recommended sale as the depende
consensus forecast ($1,010 and $990)
5 (Panel A), the main effect of repor
effect of consensus forecast is signifi
(p = .000).0o
As discussed previously, an underlying assumption in our study is that participants will

recommend the sale of the security that moves projected earnings toward the consensus
forecast. Consistent with that assumption, when projected earnings ($1,000) are below the
consensus forecast ($1,010), the mean reported income of $1,009.35 million indicates an
income-increasing strategy. Alternatively, when projected earnings are above the consensus
forecast ($990), the mean reported income of $994.19 million suggests an incomedecreasing strategy. The mean reported income in the $1,010 (t = 7.66, one-sided p
= .000) and $990 (t = -6.45, one-sided p = .001) consensus forecast conditions were
significantly different from $1,000.
Hypothesis la (Hypothesis lb) predicts that more transparent disclosure of comprehensive income will reduce managers' tendency to recommend the sale of available-forsale securities that increase (decrease) current income when projected earnings are below
(above) analysts' consensus forecast. That is, when an analysts' consensus forecast is different from the company's projected earnings, participants' choice of security sale will be
influenced by comprehensive income reporting format such that the more transparent format
(SCI) will mitigate earnings management attempts as compared to the less transparent
o10 Dependent variable responses are not significantly different (p > .10) across the following background variables:
professional certification (CPA, CMA, CFA, CIA, Other), compensation scheme, years of business experience,
years of finance/accounting experience, percent of personal wealth invested in employer company, total assets,
annual sales, company number (1 through 17), or training session (1 through 6).
TABLE 3
Participants' Security Sale Recommendation Frequencies
Security Recommended and Net Earnings Resulting from Sale of

Recommended Security
Co.
Co.
Co.
Co.
Co.
Report Format $980 $990 $1,000 $1,010 $1,020

Panel A: Participants Receiving Consensus Forecast of $990
SSE
SCI
(n
(n
=
=
Total
16)
15)
0
Panel
SSE
SCI
0
0
14
2
4
11
18
B:
13
0
0
0
Particip
(n=
16)
0
0
0
10
(n
=
15)
0
0
8
7
Total
0
0
17
6
0
6
TABLE 4
Net Earnings Resulting from Sale of Recommended Security

Mean (Standard Deviation)
CI Reporting Formata
Main Effect of
Consensus
$990
Forecastb
991.25
SSE
SCI
997.33
Forecast
994.19
(3.42) (4.58) (5.02)

$1,010 1,013.75 1,004.67 1,009.35
(5.00) (5.16) (6.80)
Main Effect of Format 1,002.50 1,001.00
(12.181) (6.07)
Security Resulting
Selected Earnings
Co. A = $980
Co. B = $990
Co. C = $1,000
Co. D = $1,010
Co. E = $1,020
a In the SSE condition, comprehensive income is reported within the statement of stockhold
SCI condition, comprehensive income is reported in one statement, labeled "statement of
comprehensive income." In the SSE (SCI) condition, the statement of stockholders' equit
separate page from the statement of earnings (statement of earnings and comprehensive in
b The analysts' consensus forecast for the company's earnings reflect earnings before the ef
sale. In one condition, the forecast is $990 million; in the other condition, the forecast i
both conditions, unmanaged earnings are $1,000 million.

148
Hunton,
Libby,
and
Mazza
TABLE 5
ANOVA Analysis
Panel A: Tests of Between-Participants Effects
Source SS d.f. MSE F-Statistic p-value
Reporting Format (RF) 34.84 1 34.84 1.66 .203
Consensus Forecast (CF) 3445.27 1 3445.27 164.24 .000

RF
CF
Error
Panel
890.43
1216.67
B:
58
890.43
42.45
.000
20.98
Hypotheses
Tests
(one-sid
t-statistic p-value
Hla: SCI x 1,010 ($1,004.67) < SSE x 1,010 ($1,013.75) -4.98 .000
Hlb: SCI x 990 ($997.33) > SSE x 990 ($991.25) 4.21 .000
Panel C: Additional Tests (one-sided t-tests)
SCI x 1,010 mean ($1,004.67) > $1,000 (No EM)a 3.50 .004
SCI x 990 mean ($997.33) < $1,000 (No EM)a -2.26 .041
SSE $1,010 - SSE $990 > SCI $1,010 - SCI $990 6.52 .000b
SSE $1,010 - SCI $1,010 > SSE $990 - SCI $990 1.29 .101
aA $1,000 value reflects no earnings management (EM) attempt.

b This contrast is equivalent to the interaction term in the ANOVA.
format (SSE). The hypotheses, therefore, predict a significant in

independent variables. Table 5 (Panel A) indicates a significant
reporting format and consensus forecast. This interaction is equ
the difference in mean reported income between the $1,010 and
in the SSE condition than the SCI condition (SSE $1,010

- SCI $990; t = 6.52, one-sided p = .000). Figure 1 illustrates the
We separately test H1a and HIb, for income-increasing and in

management as shown on Table 5, Panel B. We find that the m
format (SCI) significantly dampens managers' tendency to incr
projected earnings are below analysts' consensus forecast (H
= .000), and decrease current income when projected earnings ar
t = 4.21, one-sided p = .000).
We also test whether any income-increasing and income-decr

ment remains in the more transparent SCI conditions (see Tabl
whether the mean reported income resulting from the $1,010 S
significantly greater than $1,000, and the mean reported incom
SCI condition ($997.33) is significantly less than $1,000. Both of
(t = 3.50, one-sided p = .004; t = -2.26, one-sided p = .041; r
that while the more transparent SCI condition does indeed dam
income-increasing and income-decreasing earnings managemen
management persists nevertheless.
Finally, we test whether the difference in reported income betw
in the $1,010 condition where income-increasing earnings mana
FIGURE 1
Mean Net Earnings Resulting from Sale of Recommended Security

1,020
1,015
,A
1,010
tn 1,005
S1,000
, 995
990
985
980
$990
(Below
Presale
Consensus Forecast
--A-- SSE Format -- SCI Format
greater than the change in the $990 condition where income-decreasing earnin
ment was in evidence (SSE $1,010 - SCI $1,010 > SSE $990 - SCI $990), a
a result that is not significant at conventional levels (t = 1.29, one-sided p =
analysis does not suggest a significant asymmetry in the effects of transparency o
increasing and income-decreasing earnings management. In summary, the expe

sults support Hla and Hlb, and indicate that the likelihood of earnings mana
tempts decreases as transparency increases.
Debriefing Analyses
As noted earlier, we also ask participants to indicate (1) which security se

tives in their company would prefer to sell, and (2) which security would re
highest stock price for their company. There are no significant differences in
sale recommended by the participants and the security they thought senior executi
sell, and the security they thought would result in the highest stock price. Fur
responses to debriefing questions, all participants indicate that it is very impor

to maintain or improve stock price and reputation for reporting integrity. Th
suggest that participants believe that increases in transparency of reporting d
benefits to their company and its shareholders resulting from selective sales
for-sale securities.
To further investigate the participants' beliefs that underlie their choices, w
to assume that a company used the same comprehensive income format as in th

(either SCI or SSE), and answer three questions:
1. How obvious would it be to statement readers that a company was using

such as realized gains/losses from available-for-sale securities to manage
(1 = Not very; 9 = Very)
150
Hunton,
Libby,
and
Mazza
2. If a company used techniques s

securities to manage earnings, w
price? (1 = Strong negative; 9 =
3. If a company used techniques s
securities to manage earnings, w
porting integrity? (1 = Strong n
Table 6 reports participants' mean r

Participants indicate that earning
sale securities would be much mor
transparent SSE format conditions
TABLE 6
Debriefing Analysis
Panel A: How Obvious Would It Be to Statement Readers that a Company was Using
Techniques Such as Realized Gains/Losses from Available-for-Sale Securities to
Manage Earnings?
CI Reporting Format
Consensus
Forecast
$990
2.44
$1,010
3.56
(1
Tests
Source
SS
of
d.f.
MSE
SSE
SCI
8.33
8.40
Not
ver
Between-P
F-Statistic
p-value

RF
CF
Error
4.34
32.81
58
4.34
7.66
.008
0.57
Panel B: If a Company Used

Sale Securities to Manage
Stock Price?
CI Reporting Format
Consensus
Forecast
$990
5.62
$1,010
(1
Tests
6.56
=
of
SSE
SCI
2.00
2.00
Strong
ne
Between-P

RF
CF
Error
3.40
31.64
58
3.40
6.23
.015
0.55
(continued
The
Accounting
Review,
Janua

TABLE 6 (Continued)
Panel C: If a Company Used Techniques Such as Realized Gains/Losses from Available-forSale Securities to Manage Earnings, What Would be the Effect on Its Reputation for
Reporting Integrity?
Consensus
Forecast
CI Reporting Format
SSEa SCIb
$990
3.94
1.93
$1,010
4.12
1.73
(1
Tests
of
Strong
neg
Between-Par

RF * CF 0.58 1 0.58 1.64 .205
Error
a
Mean
20.55
58
(standard
0.35
deviation)
4.03
(.047
scale (t-statistic = 0.72, p-value = .35

b Mean (standard deviation) = 1.83 (.07
(t = 4.76, p-value = .001).
to have a positive effect on st

more transparent SCI conditio
effect on reporting reputation
cantly different (p = .355) from
conditions (mean response of 1
of the scale. The significant int
and p = .015, respectively) also
increasing than income-decrea
managers believe that more tra
crease the costs of earnings ma
V. DISCUSSION
In an experiment involving 62 professional financial managers and CEO

the extent to which financial reporting transparency affects current incom
income-decreasing earnings management attempts. We find that when fin
consensus forecasts are above (below) management's projected earnings, stud
recommend an income-increasing (-decreasing) earnings management strat
observe that increased reporting transparency significantly dampens but do
earnings management attempts. These findings are consistent with manage
earnings management in less transparent disclosure regimes will improve st
not harm reputation for reporting integrity, while earnings management in mo
disclosure regimes will harm both stock price and reputation for reporting i
results suggest that requiring more transparent financial reporting will reduce e
agement attempts in the areas of increased transparency or shift such attem

lesser transparency.
152
Hunton,
Libby,
and
Mazza
Our study contributes to ongoing re

parency, and comprehensive income re
nation of managers of nonfinancial p
through the sale of available-for-sale
Hopkins (1998) study, and a finding
Second, we provide systematic evidenc
ings management in response to the an
report the joint effect of both types
first direct evidence of earnings mana
trast,
prior
studies
(e.g.,
Libby
and
reports of manager behavior. Fourth,

financial reporting transparency on e
and others study the impact that alte
have on the detection of earnings ma
methods of display have a similar imp
combined with Lee et al.'s (2005) find
reporting
transparency
and
earnings
ma
that a requirement of more transpar

earnings management of this type, an
parent domains.
The results of our study lend suppo
tion
for
improving
the
transparency
of
management to meet Wall Street earn

report comprehensive income in a sta
format allowed by SFAS No. 130), resu
makers, such as the IASB and FASB, a
comprehensive income. In a major ag
porting of financial performance an
required to report comprehensive in
similar to our single statement of SC
changes
would affect the transparency o

of this form of earnings management
We acknowledge certain limitations
with a complete set of financial statem
statement nor highlight other incentive
beating analysts' forecasts. For exam
quences, even though Cloyd et al. (199
tax consequences as well as financial
limiting the financial information in
consequences, and designing other sim
from a participant resource perspectiv
We offer participants only one earn
sensus forecast) and ask them to assu
sell a security out of the available-for
have various incentives and ways to m
suggests that managers do manage ear
"
At
The
this
time,
the
Accounting
FASB
has
Review,
not
released
January
an
2006
we suggest that requiring participants to raise cash by selling an available-for-sale

is a reasonable setting for examining transparency effects.
Our study does not directly test which of the determinants of transparency (e.
ment placement, income labeling, net income linkage) identified by Maines and
(2000) have the greatest effect on managers' earnings management decisions. Suc
could be the focus of future research. Additionally, Hodge et al. (2004) suggest tha
facilitating technology such as XBRL (eXtensible Business Reporting Language) i
the transparency of firms' financial statement information. They assert that se
facilitating technology could affect managers' financial reporting choices because
tates comparisons across companies in such a way that differing choices become
transparent to users. Such possibilities could also be the focus of future research.
APPENDIX
Excerpts of Materials Provided to Participants

Experimental Task:
Assume that you work for a public company followed by analysts. It is De

2002, and your company needs to sell equity securities in order to raise $80 m
principle on debt that is due on December 20, 2002.
Your company owns equity securities in five different companies classified

for-sale under FASB Statement No. 115. As of today (December 15), the secu
have the following cost and market value:
($ in millions) Co. A Co. B Co. C Co. D Co. E
Market Value (total proceeds) $80 $80 $80 $80 $80

Cost
100
90
80
70
60
Unrealized Gain (Loss) $(20) $(10) $0 $10 $20
You have been asked to make a recommendation about w

raise the $80 million cash that is needed to pay debt princ
When making your recommendation, consider the followi
(1) Your company projects its earnings before considering

to be $1,000 million.
(2) For simplicity, the information provided ignores incom

assume that there are no tax consequences associated wi
(3) For simplicity, the balance sheets and cash flow state
attached materials.
Attached to these instructions are five sets of pro forma financial statements representing
the effects of the sale of each alternative security. Please examine and compare each set
carefully. Then make your recommendation as you would if this situation arose in your
company.
Please answer the following questions considering that:

Analysts' consensus forecast for your company's 2002 earnings is $1,010 [$990] million.
154
Hunton,
For
Senior
Co.
Co.
my
SSE
and
company,
Co.
Co.
Co.
Co.
Co.
Co.
Co.
Condition:
Mazza
recommend
D
in
that the
one):
B
Co.
executives
* I believe
of (circle
Co.
Libby,
Co.
my
company
Co.
highest
Co.
Co.
Example
stock
of
Fina
Page 1: Statement of Earnings
For the Three Months Ended December 31, 2002
Net
Sales
$6,000
Less: Cost of goods sold 3,800
Gross
profit
2,200
Selling, general and administrative expenses 1,200
Income from operations 1,000
Other gains (losses) (20)
Net
earnings
$980
Page 2: Statement of Stockholders' Equity

Accumulated
Other Total
Common Retained Compreh

Stock Earnings Income (Loss) Equity
Balance at September 30, 2002 $14,500 7,200 0 $21,700

Net
earnings
Other
980
980
comprehensive
Unrealized
available-for-sale securities
Current
gains
period
incom
(losses)
Reclassification adjustment
for (gains) losses
recognized in earnings 20
Net unrealized gain (loss) 20 20

Total comprehensive income 1,000
Balance at December 31, 2002 $14,500 8,180 20 $22,700
Notes to the Financial Statements
December 31, 2002
NOTE 1: INVESTMENT SECURITIES
The fair value and cost of available-for-sale securities as of December 31, 20

September 30, 2002 are shown below.
December 31, 2002 September 30, 2002

Fair
value
Cost
Unrealized
SCI
$320
300
gain
Condition:
$400
400
(loss)
$20
Example
$0
of
Financial
Page 1: Statement of Earnings and Comprehensive Income

Net
Sales
$6,000
Less:
Cost
of
goods
sold
3,800
Gross
profit
2,200
Selling, general and administrative expenses 1,200
Income from operations 1,000
Other gains (losses) (20)
Net
earnings
980
Other
comprehensive
i
Unrealized
gains
(losse
Current period $0
Reclassification adjustment for (gains) losses recognized in 20
earnings
Net
unrealized
Comprehensive
gain
(loss)
income
20
$1,000
Page 2: Statement of Stockholders' Equity

Accumulated
Other Total
Common Retained Comprehensive Stockholders'

Stock Earnings Income (Loss) Equity
Balance at September 30, 2002 $14,500 7,200 0 $21,700
Net earnings 980 980
Other comprehensive income 20 20
Balance at December 31, 2002 $14,500 8,180 20 $22,700
Notes to the Financial Statements
December 31, 2002
NOTE 1: INVESTMENT SECURITIES
The fair value and cost of available-for-sale securities as of December 31, 2

September 30, 2002 are shown below.
December 31, 2002 September 30, 2002
Fair
value
Cost
Unrealized
$320
300
gain
$400
400
(loss)
$20
The
$0
Accounting
Rev
156
Hunton,
Libby,
and
Mazza
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Financial Reporting Transparency and Earnings Management

Author(s): James E. Hunton, Robert Libby and Cheri L. Mazza

THE ACCOUNTING REVIEW

Vol. 81, No. 1

Financial Reporting Transparency an

Editor's note: This paper was accepted by Jane Kennedy, Editor.

Accepted August 2005

136 Hunton, Libby, and Mazza

any studies of reporting transparency examine its effects on users' abili

The Accounting Review, January 2006

Financial Reporting Transparency and Earnings Management 137

We conduct an experiment where 59 financial executives and three chief executive

management. In debriefing, participants indicate they believe that earnings manageme

will reduce the likelihood of managers engaging in earnings management in areas of in

Managing Earnings through Selective Sale of Available-for-Sale Securities

The Accounting Review, January 2006

Several archival studies find that fin

One of the perceived advantages of c

performance-related financial informa

3 Prior to SFAS No. 130, preparers were reporti

Financial Reporting Transparency and Earnings Management 139

gains and losses on available-for-sale securities in a statement of stockholders' equity,

level of transparency is achieved when comprehensive income and its componen

displayed in a statement of comprehensive income rather than a statement of stockho

Transparency and Earnings Management

The Accounting Review, January 2006

draft, and 90 percent supported disclo

choose the less transparent option whe

Bloomfield (2002) develops the "inco

mation to make their trading gains e

is less easily extracted being absorbe

demonstrate how the market will differ

Both theories suggest that easier det

5 As Fields et al. (2001) note, accounting choice m

Financial Reporting Transparency and Earnings Management 141

contemporaneous study of the initial comprehensive income reporting decisions of

if there is a significant negative correlation between realized available-for-sale security

transparent reporting format would reduce managers' propensity to engage in earnings

agement remains unknown. Furthermore, use of the correlational measure of ea

prevalence of both income-increasing and income-decreasing earnings management. Based

property-liability insurers' investment portfolios."

The Accounting Review, January 2006

Hla: More transparent disclosure o

Hlb: More transparent disclosure o

These hypothesized effects would

In our experiment, experienced financial managers select an available-for-s

The Accounting Review, January 2006

Financial Reporting Transparency and Earnings Management 143

Participants employed by public companies 62 100

Certified public accountant (CPA) 31 50

Compensation schemes of employer companies:

Average business experience 22.50 (6.44) years

alternative available-for-sale securities A through E will produce a realized $20 mill

ment effects of the sale of each of the five securities.

The Accounting Review, January 2006

Security Sale Recommendation

Co. A Co. B Co. C Co. D Co. E

Unrealized gain (loss) $(20) $(10) $0 $10 $20

Security Sale Recommen

Income from operations $1,000 $1,000 $1,000 $1,000 $1,000

realized in earnings 20 10 0 (10) (20)

for-sale portfolio $20 $10 $0 $(10) $(20)

a Dollar values are stated in millions.

Financial Reporting Transparency and Earnings Management 145