Research Magazine 2022

The Joint Effect of Justification and Uncertainty on Real Earnings Management Hong Qu, Lucy F. Ackert, Dana R. Hermanson, and Velina K. Popova

Coles Working Paper Series SPRING22-01, March 2022

Overview Real earnings management (REM) is a common way of misleading investors by altering transactions to meet financial reporting goals. The growth of REM is of significant concern because REM is not easily detected or curbed. Some have pointed to greater management disclosure as a way to mitigate the risk of REM. We conduct an experiment to examine the effects of management justification (some participants are asked to justify their project decision to the owners) and uncertainty (greater or lesser uncertainty about future project outcomes) on participants’ REM-type behavior. While some may expect management justification to reduce REM, we find that the opportunity to justify an operating decision actually has the effect of increasing REM-type decisions when there is greater uncertainty about future project outcomes. In essence, it appears that some managers leverage greater uncertainty to make disclosures to the owners that make the managers look like they are protecting the owners, when they are simply maximizing their own payoffs. Overall, the results suggest that management justification may not be an effective way to reduce REM, especially if uncertainty is high.

38 | Working Papers

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