Curbing Earnings Management: Experimental Evidence on how Clawbacks Provisions and Board Monitoring Affect Managers’ use of Discretion

Abstract

Concerns about earnings management and financial reporting quality have lead regulators to propose rules that clawback incentive-based compensation from managers when there is a financial restatement. Earnings management (EM) could, in theory, be curbed by internal governance mechanisms (e.g., strong boards) or by external governance mechanisms (e.g., clawbacks and other rules). We experimentally examine the impact of mandated clawbacks on managers’ EM behavior, conditional on firms’ board type (strong versus weak) We posit that aggregate earnings management will not be affected by mandated clawbacks. When boards are weak, we predict that mandated clawbacks simply shift EM from accrual-based methods to real-activities manipulation. When boards are strong, we predict that clawbacks will have little impact on EM. Our results are consistent with these predictions and suggest that clawbacks, at best, do little to deter EM (when boards are strong) and, at worst, may have counter-productive effects (when boards are weak).

I. INTRODUCTION

An extensive literature in accounting documents earnings management (EM) by firms

(Healy and Wahlen 1999, Nelson et al. 2002, Dichev et al. 2013). Healy and Wahlen (1999)

posit that “earnings management occurs when managers use judgment in financial reporting and

in structuring transactions to alter financial reports (p.368).” By exercising judgment or

discretion both in terms of accounting estimates and in terms of operational decisions, managers

can slant reported accounting numbers in a direction of their choice. This discretion available to

managers can be constrained by external governance mechanisms such as regulatory rules that

make it costlier to engage in EM. Alternatively, they can be constrained by internal governance

mechanisms such as monitoring by boards. Even regulators do not unanimously agree that rules

are better than internal governance when it comes to constraining managerial discretion. For

example, SEC Commissioner Gallagher, in a dissenting note against the Dodd-Frank clawback

rules notes that the proposed rules reflect a view that “a corporate board is the enemy of the

shareholder, not to be trusted to do the right thing”, implying that boards could accomplish part

(if not all) of the objectives of clawback rules (Gallagher 2015). There has however been little

empirical evidence on the relative effectiveness of internal versus external governance

mechanisms in curtailing EM. In this paper, we address this gap by examining the relative

impact of rules (clawbacks) versus monitoring (strong boards) on EM.

The literature on EM distinguishes between two broad methods of managing earnings.

Following this literature, we refer to the use of accounting discretion to manage earnings as

accruals-based earnings management (AEM) and the use of operational discretion to influence

reported earnings numbers as real earnings management (REM). REM differs from AEM in two

key respects—REM usually has direct cash flow consequences, AEM does not. REM can affect

a firm’s competitive advantage, AEM typically does not. We refer to the aggregate earnings

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management using these two methods as total earnings management (TEM). Our study

experimentally examines how clawbacks versus boards influence managerial discretion and, in

turn, impact the various forms of EM.

Understanding the relative impact of clawbacks versus boards in curbing managerial

discretion is important for both theoretical and practical reasons. First, as noted earlier, empirical

evidence for the relative effectiveness of the two governance mechanisms on EM is limited.

Second, from a theoretical perspective, the tradeoff between REM and AEM represents an

important research area that remains largely unexamined (Libby et al. 2015). Although survey

evidence suggests that managers prefer REM to AEM (Graham et al. 2005), there is little

evidence in a controlled setting that speaks to the issue of whether managers trade-off AEM and

REM and how this tradeoff impacts TEM. Our experiment provides empirical evidence on how

managers make this tradeoff and its impact on TEM. Specifically, we argue that these two

governance mechanisms have varying influence on managers’ discretion resulting in differential

effects on AEM, REM, and TEM. Finally, from a policy perspective, regulators believe that

clawbacks, ultimately, improve financial reporting quality (SEC 2015).1 However, our

theoretical predictions, detailed below, suggest that while clawbacks may improve financial

reporting quality (by decreasing AEM), this improvement could come at the cost of increased

REM. Evidence on this claim should be of interest to regulators and other stakeholders in a firm

who may be concerned, not just about AEM, but also about the aggregate level of earnings

management—TEM—and how it can affect firm competitiveness in the long run.

We compare the impact of clawbacks versus strong board monitoring to a baseline

condition where there is no clawback and the board is weak. Relative to this baseline, we expect

1 The final rules proposed by the Securities and Exchange Commission requiring companies to adopt clawback provisions proposed under Dodd-Frank Act (2010) are titled: “Proposed Rules Designed to Improve Quality of Financial Reporting and Enhance Accountability Benefiting Investors” (emphases ours)

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that clawbacks will reduce AEM, but this decrease will be offset by a corresponding increase in

REM which is beyond the purview of regulators. Clawbacks create incentives to avoid AEM by

making it potentially costlier (only AEM could lead to restatements which, in turn, trigger

clawbacks), but they also create behavioral incentives that make REM more appealing.

We develop our arguments and hypotheses by drawing on motivated reasoning theory

which posits that people’s directional preferences can influence how they evaluate, recall, and

search for information. A manager who recognizes that AEM is a potentially costlier option

because of clawbacks could more actively seek out and rationalize REM. For example, a project

that was previously thought to be an indispensable part of the firm’s marketing strategy may now

seem to be a perfectly reasonable candidate for a cut (to meet an earnings benchmark). Because

of this substitution effect (from AEM to REM), collectively, we expect TEM to be unaffected by

clawbacks relative to the baseline condition.

In contrast, strong boards, by definition, make managers more accountable and prior

research shows that accountability attenuates motivated reasoning (Crowley and Zentall 2013,

Lerner and Tetlock 1999). Managers are more likely to be held accountable both for accounting

estimates (AEM) and operational choices (REM). Consequently, we expect monitoring by strong

boards to reduce both AEM and REM such that TEM will be lower relative to our baseline

condition.

We test our predictions experimentally. We believe that an experiment is particularly

appropriate to address our research question for several reasons. First, the biggest challenge

facing archival studies testing for earnings management is specifying what earnings would be

under the null hypothesis—that is, what would unmanaged earnings look like (Jacob and

Jorgensen 2007). An experimental setting allows us to address this challenge directly with a

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control / baseline condition which differs from our treatment conditions in only one respect (the

presence of clawbacks or monitoring by strong boards). Second, it is difficult to ascertain in

archival studies whether reductions in operational expenses are a function of changed business

conditions or a consequence of EM motivations. Holding constant all other factors except our

treatment of interest allows us to draw stronger causal inferences related to EM. Third, unlike

archival studies that are limited to examining the effects of existing regulatory regimes, an

experimental setting allows us to study the potential impact of a proposed regulatory regime (the

Dodd-Frank clawback provisions) for which archival data are unavailable (Kachelmeier and

King 2002, Libby et al. 2015).

We test our predictions experimentally using a 2 × 2 between-participants design. Our

two manipulations are clawbacks (present versus absent) and board strength (strong versus

weak). Across conditions, executive-MBA participants in the role of a CEO for a hypothetical

firm are told that their firm is significantly short of analysts’ earnings estimates for the upcoming

quarter—missing this benchmark could negatively affect the firm’s stock price, lead to

downgrades by analysts, and result in lost bonuses across the organization. The CEO can choose

to cut selling, general and administrative expenses (SG&A) in the current quarter to ensure that

the firm meets or exceed analysts’ earnings estimates.

The firm can cut SG&A by doing one or more of the following: (a) decrease the accrual

for warranty expense (AEM) or (b) postpone advertising expenses in the last quarter and reduce

current year expenses (REM) or (c) choose not to interfere in the financial reporting process.

Choices (a) and (b) are not mutually exclusive. That is, participants can choose some

combination of (a) and (b). Importantly, a dollar reduction in the warranty expense has exactly

the same impact on reported earnings per share (EPS) as a dollar reduction in advertising

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expense. The dollar amounts cut from warranty expense, advertising expense, and the aggregate

cut in SG&A represent the dependent variables used to test our predictions relating to AEM,

REM, and TEM respectively.

In our baseline condition, there is no threat of clawback and monitoring by the board is

weak (the board has rubber-stamped CEO decisions in the past). In the clawback condition, we

tell participants that if they choose to manage accruals, there is a high probability of restatement

and they will be forced to return any bonus in the event of a restatement. In the (strong) board

condition, participants are told that the board has overruled the CEO’s proposals on four

occasions in the last three years on grounds of violating shareholder interests.2 All other

information is held constant across conditions.

Our results are broadly consistent with our predictions. Relative to our baseline condition,

clawbacks do not significantly impact TEM. We find that clawbacks reduce AEM, but they also

increase REM, as predicted. In contrast, monitoring by strong boards significantly reduces AEM,

REM, and TEM. We thus find that monitoring by strong boards may be a better mechanism to

curtail TEM. We also find some evidence of motivated reasoning. Managers who shift from

AEM to REM (under clawbacks) believe that their long-run competitive advantage will remain

intact even though their short-run competitive advantage will suffer, suggesting a biased

interpretation of the outcomes of REM.

Our study contributes to the literature on earnings management. First, we find that externally

mandated clawbacks reduce financial misstatements but that this reduction comes at the cost of

increased REM. While other studies (Chan et al, 2015) have found similar evidence for the

substitution effect of clawbacks, our study differs from them in important ways. First, Chan et al.

2 Our fourth condition where there is both a clawback and a strong board allows us to test the incremental effect of clawbacks over boards in our specific context. Because we do not have a specific prediction related to this condition, a detailed discussion of this condition is deferred to later sections.

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study voluntary clawbacks adopted by firms whereas we study mandatory clawbacks proposed

by regulators. Even if voluntary clawbacks reduce restatements, Denis (2014) provides

compelling reasons why it is not certain that externally mandated clawbacks will yield a similar

result. Second, our evidence related to the substitution of AEM with REM comes from a

controlled experimental setting allowing us to make stronger causal inferences about precisely

what is driving this substitution. Third, our study proposes and finds that this substitution effect

can be mitigated by an internal governance mechanism—strong boards—while also mitigating

TEM.

Results of our study also clarify survey evidence suggesting that managers prefer REM to

AEM (Graham et al. 2005) by showing that this preference depends on the strength of firms’

internal governance mechanisms. In that sense, our evidence suggests that managerial discretion,

which underlies most of EM, is malleable, but firms’ internal governance mechanisms can

provide a check on the extent of this malleability. Our results suggest that policy makers who

view restatements as the most egregious symptom of EM may, indeed, be able to curtail

restatements with clawbacks, but at the cost of REM, which could damage firms’ long-term

competitiveness.

The rest of the paper is organized as follows. Section 2 outlines our theory and hypotheses.

Section 3 describes our experiment designed to test our hypotheses. Section 4 describes the

results and section 5 concludes with implications.

II. BACKGROUND AND THEORY

EARNINGS MANAGEMENT AND MANAGERIAL DISCRETION

Anecdotal and empirical evidence suggests that firm managers face considerable pressure

to meet external earnings benchmarks—specifically, analysts’ earnings estimates (Levitt 1998,

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Kasznik and McNichols 2002, Brown and Caylor 2005, Graham et al. 2005). A large body of

research provides evidence that firms manage earnings around this benchmark (see Healy and

Wahlen 1999 and Dichev et al. 2013 for surveys of the earnings management literature).

Importantly, while markets appear to reward (punish) firms that meet/exceed (miss) this

benchmark, markets do not appear to clearly distinguish between firms based on how this

benchmark is met. The stock-price premium that accrues to firms that meet/exceed the

benchmark through earnings management is only marginally different from the premium that

accrues to firms that meet/exceed the benchmark without managing earnings (Bartov et al.

2002). In addition to firm-level benefits, there are individual benefits to managers to meet

earnings benchmarks. Performance-related bonuses are often linked to meeting earning

benchmarks (Armstrong et al. 2017). There is thus a clear incentive for managers to meet earning

benchmarks by managing earnings.

Managers facing a shortfall between their “unmanaged” earnings and analysts’ earnings

estimates can bridge the gap by using the discretion available to them from two broad sources.

The inherent discretion available in GAAP provides managers some latitude to report an income

number consistent with their preferences.3 For example, managers could use accounting

discretion and accrue a lower-than-usual allowance for bad and doubtful accounts, leading to an

income-increasing accrual. A second source of managerial discretion comes from operational

decisions. For example, managers can defer an R&D project to a subsequent accounting period,

again, leading to an increase in reported income for the current period, but this time not due to an

accrual. Following prior literature (e.g., Roychowdhury 2006), we refer to the use of accounting

discretion to manage earnings as accruals-based earnings management (AEM) and the use of

3 The discretion available under GAAP to manage accruals, however, is (a) not unlimited (Barton and Simko 2002) (b) does not always have to be income-increasing (Wahlen, Baginski & Bradshaw 2010) and (c) does not necessarily have to be against shareholder interest (Arya et al. provide a signaling story).

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operational discretion to influence reported earnings numbers as real earnings management

(REM).

However, both forms of earnings management rely on managerial discretion. The role of

discretion is important because its presence suggests that explicit rules will not be able to

eliminate gamesmanship from managers attempting to achieve their preferred financial reporting

objectives. In addition, this inherent discretion can leave the decisions of even well-intended

managers open to bias, as explained later.

CORPORATE GOVERNANCE AND MANAGERIAL DISCRETION

Although definitions of corporate governance vary widely (Brickley and Zimmerman

2010), much of corporate governance is concerned with the constraints that managers place on

themselves or that investors place on managers to constrain managers from using their discretion

against the interest of investors (Shleifer and Vishny 1997). More specifically, corporate

governance can be viewed as “[a] collection of control mechanisms … to prevent or dissuade

potentially self-interested managers from engaging in activities detrimental to the welfare of

shareholders and stakeholders” (Larcker and Tayan 2011). These mechanisms that seek to

control managers’ discretion can be imposed by regulators or by a firm’s board of directors. We

examine two specific mechanisms that curtail managerial discretion and aim to deter earnings

management.

Externally mandated clawbacks are regulatory provisions that require managers to return

their incentive-based compensation if a firm restates its financial statements and it is determined

that managers were not entitled to the incentive-compensation based on the restated financials.

Clawbacks were mandated as part of the Sarbanes-Oxley Act (2002), but the scope of clawbacks

has expanded considerably under the provisions of the Dodd-Frank Act (2010). Mandatory

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clawbacks are triggered only when firms restate their financial statements. Prior research

suggests that earnings management is a leading cause of financial restatements (Ettredge et al.

2010, Richardson et al. 2002). The implicit regulatory presumption behind clawbacks is that they

will deter managers from managing earnings and, thus, curtail restatements.4

A second mechanism for constraining managerial discretion is a strong board.

Empirically, Hazarika et al. (2012) provide evidence that strong boards act proactively to

discipline managers’ accrual manipulations well before the earnings management leads to a

restatement. Anecdotal evidence suggests that strong boards are also likely to constrain

operational decisions of a CEO that could destroy shareholder value. For instance, in 2001, Coca

Cola’s board turned down the CEO’s proposal to acquire Quaker Oats on the grounds that it

diluted shareholder interests (Mckay and Deogun, 2000). In 2009, General Motor’s board over-

ruled the CEO’s proposal to sell Opel forcing the CEO to resign (Vlasik, 2009). The knowledge

that strong boards could overrule their proposals could deter / constrain CEOs from exercising

their accounting or operational discretion.

The key difference between externally mandated clawbacks and boards when it comes to

constraining earnings management is that rules focus only on one source of discretion—

accounting discretion—leaving managers’ operational discretion unchecked. Boards, on the

other hand, can constrain both accounting and operational discretion (particularly when the board

believes that the discretion is likely against shareholder interests) and, can, in theory be far more

effective. Regulators and governance theorists seem to agree. For instance, Arthur Levitt, the

former commissioner of the SEC, in his “numbers game” speech, which focused largely on

4 See, for instance, comments from the SEC commissioners (emphases ours). Commissioner Aguilar (2015) stated that “the existence of a clawback policy should, among other things, incentivize executives to create a culture of compliance that results in accurate reporting of financial performance. The end result is that, hopefully, fewer financial statements will be required to be restated.” SEC Chair White stated that “the proposed rules would result in increased accountability and greater focus on the quality of financial reporting, which will benefit investors and the markets.”

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earnings management, opined: “[t]his (earnings management) is a financial community problem.

It can't be solved by a government mandate: it demands a financial community response.” In a

similar vein, Jensen (1993) posits that “[t]he legal/political/regulatory system is far too blunt an

instrument to handle the problems of wasteful managerial behavior effectively.”5

Empirical evidence about the relative effects of these two sources of constraints on

managerial discretion is scarce.6 Most of the research has focused on the examining the relative

presence (absence) of the different types of earnings management without any particular focus of

rules versus monitoring constraints on managerial discretion. In addition, one criticism of the

empirical archival literature on EM is that any earnings management identified may be a result of

an omitted variable or could be capturing behavior other than intentional manipulation (Gunny

2010, Ball 2013). We, therefore, use an experimental setting that allows us to partly overcome

these criticisms by holding constant managerial incentives and the underlying economics of the

firm constant and ask the question: How do mandated clawbacks and boards influence

managerial discretion when managers face pressure to meet an external earnings benchmark? We

present our predictions in the next section.

CLAWBACKS AND MANAGERIAL DISCRETION

Our baseline case is where managers’ discretion is unconstrained, either by mandated

clawbacks or by strong boards. In this scenario, we expect managers to use both the accounting

and operational discretion that is available to them to fully meet any shortfall between

unmanaged earnings and the analysts’ consensus estimates. That is, we expect managers to

5 Also see Jensen (1986): “the external takeover market serves as a court of last resort that plays an important role in …….protecting shareholders when the corporation's internal controls and board-level control mechanisms are slow, clumsy, or defunct.”6 “[t]here is also a lack of literature examining interactions among accounting choices and how they are affected by context and the regulatory environment. The tradeoff between real and accruals earnings management represents one such broad category. Very few papers (including archival papers) over the last decade have examined this issue.” (Libby et al. 2015 p. 35)

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engage in both AEM and REM such that they can meet the earnings benchmark. 7 This,

presumably, is the scenario that regulators are most concerned about. We expect however that

imposing a mandatory clawback will not significantly affect TEM relative to this baseline

condition. We argue that this occurs because mandatory clawbacks reduce manager’s propensity

to engage in AEM, but increase their propensity to engage in REM— in other words, a

substitution effect occurs—for two reasons.

The first reason for this substitution is strategic. AEM (particularly if it is aggressive)

increases the likelihood of restatements (Ettredge et al. 2010, Richardson et al. 2002).

Restatements trigger clawbacks and it is reasonable to expect managers to decrease AEM if it

increases the likelihood of subsequent restatement and, therefore, clawback. REM, on the other

hand, is relatively immune to regulatory scrutiny and managers have wide latitude when it comes

to discretionary spending decisions. Prior research shows that managers tradeoff AEM and REM

(Zang 2012, Bradeschter 2011). Therefore, if AEM becomes costly, it is likely that managers

will switch to REM for purely strategic reasons.

A second reason draws on research in psychology examining how people’s directional

goals influence how they evaluate, recall, and search for information. In our setting, a manager

facing a potential shortfall from analysts’ earnings estimates has a clear directional preference to

reduce expenses (either accruals or actual) in order to meet/exceed analysts’ earnings estimates.

This preference is likely to bias the way that manager evaluates information and the subsequent

judgments he makes—a psychological process known as motivated reasoning (Kunda 1990,

Epley and Gilovich 2016). Once the manager recognizes that AEM is a potentially costlier

7 We are agnostic about whether managers will utilize AEM or REM more in this baseline scenario. Although survey evidence suggests that managers have a distinct preference for REM (Graham et al), there is a large literature documenting that managers engage in accruals manipulation . Our predictions do not depend on the relative extent of AEM and REM, but if managers rely exclusively (or even largely) on REM in the baseline scenario, it would work against our ability to find support for our hypotheses.

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option because of clawbacks, the manager may more actively seek out and rationalize REM. A

project that was previously thought to be an indispensable part of the firm’s fourth-quarter

marketing strategy may now seem to be a reasonable candidate for a cut. Importantly, motivated

reasoning may allow the manager to conclude that delaying the project to the next quarter may

not really impede the firm’s long-term competitive advantage. The inherent uncertainty of

operational outcomes allows managers to more easily engage in motivated reasoning and leads to

the same substitution effect from AEM to REM described earlier. Hribar et al. (2017) show that

bank’s loan-loss provisions (accruals) are influenced both by strategic discretion and

unintentional errors (based on sentiment), further supporting our expectation that both processes

can simultaneously (and additively) impact the substitution effect that we expect. Formally

stated:

H1a: Mandated clawbacks will not impact TEM relative to our baseline condition.H1b: Mandated clawbacks will reduce AEM relative to our baseline condition.H1c: Mandated clawbacks will increase REM relative to our baseline condition.

BOARDS AND MANAGERIAL DISCRETION

We turn next to the impact of strong boards relative to our baseline case where managers’

discretion is unconstrained, either by mandated clawbacks or by boards. In contrast to clawbacks,

we expect that strong boards will lead to a decrease in both AEM and REM relative to our

baseline condition. In other words, we do not expect a substitution effect. Consequently, we

expect a reduction in TEM when boards are strong relative to our baseline condition.

The pressure to meet external benchmarks does not disappear when firms have strong

boards, but strong boards provide an important constraint to motivated reasoning—

accountability. Crowley and Zentall (2013) argue that the most efficient way to attenuate

motivated reasoning seems to be accountability. They argue that having to justify one’s actions

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to an audience can make people anticipate potential counter-arguments and impose greater

discipline on the arguments they generate. Consequently, they may change their mind—often,

though not always, for the better (Lerner & Tetlock 1999). Empirical evidence suggests that

strong boards deter attempts at AEM (Hazarika et al. 2012), but evidence that strong boards

constrain managers’ REM attempts is scarce. Prior research shows that even subtle cues that one

is under scrutiny can have large effects on behavior in real-world contexts (Bateson et al. 2006,

Burnham and Hare 2007). Therefore, we predict that even the expectation that one will be held

accountable can substantially attenuate motivated reasoning. Formally:

H2a: Strong boards will reduce TEM relative to our baseline condition.H2b: Strong boards will reduce AEM relative to our baseline condition.H2c: Strong boards will reduce REM relative to our baseline condition.

III. EXPERIMENT

PARTICIPANTS

Participants in our experiment are 127 students from an executive MBA program from a

top-ranked MBA program in the south-eastern U.S. On average, our participants have 14 years

of work experience and are 37 years old. This provides us some assurance that our participants

are likely to understand the incentive-structures for senior managers of publicly-traded firms

which is important, given our research question and our experimental context. Given our

participant pool, we do not expect that monetary incentives for participation will induce them to

exert additional effort on the experimental task. Consistent with other studies that employ a

comparable participant pool and examine questions related to earnings management (Clor Proell

and Maines 2014, Rose et al. 2014), we do not pay our participants for their participation.

PROCEDURE & SETTING

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Participants in our experiment assume the role of a CEO of a hypothetical firm—Zeta.

They first see summarized financial statement data for three years for this firm. These data

suggest that Zeta’s recent financial performance has been strong. They are told that Zeta has met

or exceeded analysts’ EPS expectations in the past three years. Next, they are told that, for the

upcoming year, Zeta expects to fall short of analysts’ consensus EPS estimate. The principal

decision that participants make is how to deal with this shortfall. As we describe in greater detail

below, the choice(s) that participants make to address this shortfall represent(s) our primary

dependent variable. Before proceeding to the choices available to them to help them with their

decision, participants are told that if Zeta misses analysts’ earnings estimates, Zeta’s stock price

could decline, Zeta’s stock could be downgraded and employee bonuses across the board would

not be paid.8

Participants are told that the analysts’ consensus earnings estimates for Zeta is $1.80 for

the year whereas internal estimates show that the company is on track to report only an EPS of

$1.65—that is, a significant shortfall. They are further informed that all options to increase

earnings to meet or exceed the analysts’ consensus have been exhausted except for reducing two

line items from selling, general & administrative expenses (SG&A). The two line items are (1)

reducing the accrual for warranty expense (the AEM option) and (2) postponing some

advertising expenses slated for Q4 of the current year (the REM option).9

Participants are told that both line items can be cut (up to $ 2 million each) to make up

8 We believe that the pressure to meet earnings benchmarks represents a key setting where earnings management pressures come to the fore. Anecdotal and survey evidence suggests that managers are keenly aware of the importance of meeting or exceeding analysts’ consensus (Graham et al. 2005). Several papers document the importance of meeting or beating analysts’ earnings expectations (MBE) and also the negative consequences of having a string of MBE interrupted (Burgstahler and Dichev 1997, Cheng and Warfield 2005). We remind participants of some of the adverse consequences associated with missing analysts’ estimates. Arguably, this reminder could encourage more participants to manage earnings than they would without the reminder, but this reminder is provided to participants across experimental treatment conditions. 9 The experimental materials do not use the term “earnings management” nor do they use the terms “real” or “accrual-based” earnings management to avoid predisposing the participants in favor of an option.

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the 15 cent ($ 1.5 million) shortfall between internal projections and analysts’ earnings

expectations. However, we wanted our participants to recognize that cutting either expense (or

both) may neither be necessary nor sufficient to meet analysts’ consensus estimates.

Accordingly, participants are reminded that if there are no cuts, they are highly unlikely to meet

analysts’ estimates (but the possibility is not ruled out). Similarly, they are reminded that if they

cut $2 million in expenses, they are highly likely (but not certain) to meet analysts’ expectations.

Further, participants are reminded that a one dollar cut in advertising expenses and an equivalent

cut in warranty accrual would have exactly the same impact on EPS. However, reducing the

warranty accrual could lead to a restatement—postponing advertising expenses carries no

restatement risk. Following these reminders, the two independent variables are introduced.

INDEPENDENT VARIABLES

Participants are told that there are two additional factors they need to consider before

making their final decision—oversight by the board of directors and by regulators. These are our

two independent variables. They correspond to board type (strong versus weak) and the

mandated clawback (present versus absent). We do not use the terms “strong” board, “weak”

board, or “clawbacks” in the experiment for obvious reasons. Participants in both the strong and

the weak board conditions are told that the board has broad powers to discipline the CEO and

review the CEO’s decisions to assess whether these decisions have been in the interest of Zeta’s

shareholders. In the strong board condition, participants are told that, in the past three years,

Zeta’s board has overturned the CEO’s decision on four separate occasions. In contrast,

participants in the weak board condition are told that, in the past three years, Zeta’s board has

unanimously agreed with all CEO decisions.

We then provide information on the regulatory oversight conditions. Participants in the

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mandated clawback condition are told that if Zeta restates their past financial statements, the

SEC requires that any bonus based on past inaccurate financial statements will have to be

returned. In contrast, participants in the no clawback condition are told that there is no SEC

regulatory policy governing CEO bonus; even if a firm has to restate past financial statements,

there is no SEC requirement to return the original bonus. Following these manipulations,

participants are asked to decide how much they would cut from their SG&A expenses, which

represents our dependent variable, discussed in greater detail next.

DEPENDENT VARIABLES AND OTHER QUESTIONS

Participants are told to assume that it is sufficiently early in the fourth quarter such that

they have enough time to effect reductions of either warranty accruals or advertisement expense

(or both). Participants are first asked to indicate in their proposal to the board by how much they

would cut SG&A, in aggregate. Participants were told previously that both warranty accruals and

advertisement expense fall under the broad head of SG&A. Next, we ask participants to

disaggregate this amount (assuming it was non-zero) between the warranty accrual and the

advertisement expense. Again, participants are reminded that they can cut one or both of these

items, or choose not to cut either. The only constraint imposed is that the sum of the two cuts

should add up to the amount they specified in response to the first question. Participants’

response to the first question (the total cut to SG&A) represents our measure of total earnings

management and their responses to the warranty accrual and the advertisement expense questions

represent our measure of AEM and REM respectively.

Following their responses to our dependent variables, participants indicate whether their

choice was consistent with shareholder value maximization and how they believe their choice

will affect Zeta’s competitive position and stock price, both in the short and in the long run.

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Next, participants answer two questions to confirm that they understood the manipulations as we

intended. Finally, participants answer a question not directly related to Zeta. The first question

asks them to indicate the extent to which they think that company boards are more important in

ensuring that companies do not misreport their financials compared to external regulators like the

SEC. Before participants are dismissed, we obtain demographic information to check whether

any of their responses vary systematically based on demographic variables.

IV. RESULTS

MANIPULATION CHECKS

To check that participants understood our manipulations as intended, we ask participants

two questions. For the board strength manipulation, we asked participants to rate the extent to

which they thought that Zeta’s board was likely to challenge their decisions. As expected,

participants in the strong (weak) board condition indicated that the board was more (less) likely

to challenge their decisions (Likelihoodstrong = 4.10 > Likelihoodweak = 2.97, t=3.46, p = .001). For

the clawback manipulation, participants provided a true / false response to the following

question: “If Zeta is required to restate their financial statements, SEC regulations require that

you will have to return your bonus if the restated financials made you ineligible for the bonus.”

One hundred eleven of the 122 participants answered this question correctly, suggesting that

most participants understood our manipulations as intended.10 While our reported analyses are

based on all responses, our inferences remain the same if we exclude participants who failed

manipulation checks.

HYPOTHESES TESTS

10 Five participants decomposed their total earnings management (TEM) inaccurately into the AEM and the REM components. That is, their AEM and REM does not add up to the TEM. We drop these participants. Therefore, our sample comes down from 127 to 122 participants.

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Our main prediction is that mandated clawbacks will not significantly affect total

earnings management (TEM), but monitoring by a strong board will. Table I presents descriptive

statistics for all our treatment conditions. Figure I graphically presents the results for our

baseline condition and the two primary treatment conditions—clawbacks and strong boards.

Both Table I and figure I suggest that our main prediction is supported. Table II presents formal

tests of our hypotheses.

Recall that managers’ cuts to warranty expense and to advertising expense represent our

proxy for AEM and REM respectively and the aggregate represents our proxy for TEM. H1a

predicts that mandated clawbacks will not impact TEM relative to our baseline condition. Our

results are consistent with this prediction (TEMbaseline = 1.69 versus TEMclawback = 1.55, t = .903, p

= 0.370). Further, as predicted by H1b, we find that clawbacks lead to a significant decline in

AEM (AEMbaseline = 0.72 versus AEMclawback = 0.28, t = 3.780, p < 0.001). Finally, as predicted by

H1c, we find that clawbacks increase REM (REMbaseline = 0.97 versus REMclawback = 1.27, t = -

2.023, p = 0.024). Overall, we find strong support for the substitution effect we predict in H1—

the decrease in AEM following mandated clawbacks is offset by a corresponding increase in

REM.

H2a predicts that strong boards will reduce TEM relative to our baseline condition.

Results are consistent with this prediction (TEMbaseline = 1.69 versus TEMboards = 1.30, t = 2.589, p

= 0.012). As predicted by H2b and H2c, we find that strong boards reduce both AEM and REM

relative to our baseline (AEMbaseline = 0.72 versus AEMboards = 0.52, t = 1.842, p = 0.035 and

REMbaseline = 0.97 versus REMclawback = 0.78, t = 1.571, p = 0.061). Overall, we find that strong

boards reduce earnings management across the board.

ADDITIONAL ANALYSES

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Our primary hypotheses (H1 and H2) compare how managers tradeoff AEM and REM in

three of our four treatment conditions. We also examine a fourth condition where boards are

strong and mandated clawbacks are in place to check whether there is any incremental effect of

clawbacks when boards are strong. In our setting, we do not find an incremental effect of

clawbacks on TEM (TEMboards = 1.30 versus TEMclawbacks & boards = 1.23, t = 0.421, p = 0.675). We

also find no incremental effect of clawbacks on AEM and REM (untabulated, both p values >

0.60), suggesting that, at least in our setting, clawbacks do little to alter TEM, either alone or in

concert with boards.

Table III presents the results of a conventional ANOVA for completeness. Our first

ANOVA with AEM as the dependent variable, clawback and board as independent variables

shows a clawback × board interaction effect (F = 6.898, p < .001). This interaction is consistent

with our primary result that mandated clawbacks decrease AEM and this decrease is steeper for

firms whose boards are weak than for firms whose boards are strong. That is, we find a

substitution between AEM and REM due to clawbacks, but not for firms with strong boards.

Next, an ANOVA with REM as the dependent variable also shows a significant clawback ×

board interaction effect (F = 3.322, p = .071). This interaction suggests that REM increases

significantly after clawbacks and this increase is steeper for firms with weak boards than for

firms with strong boards—the flip side of the substitution effect. Finally, an ANOVA with TEM

as the dependent variable shows a main effect for boards (F = 9.478, p = 0.003), consistent with

our main results. That is, strong boards curb TEM whereas clawbacks do not.

PROCESS MEASURES

Participants across treatment conditions believe that they are acting in the interest of

shareholder value maximization. On an 8-point scale ranging from 0 to 7 with higher values

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indicating greater congruence with shareholder value maximization, participants across

conditions average 5.19, which is significantly above the midpoint (t = 13.7, p < 0.001). An

ANOVA by treatment condition reveals no significant difference in participants’ perceptions

across conditions that their decisions are consistent with shareholder value maximization (F =

0.807, p =.492).

However, participants in the clawback condition who shift from AEM to REM relative to

the baseline condition, on average, appear to recognize that this shift comes at some cost to

competitive advantage. On an 8-point scale (0 (7) indicating a negative (positive) impact on

competitive advantage), participants in the clawback condition, on average, rate that their cuts

could impact competitive advantage in the short-run more negatively than participants in the

baseline condition (3.269 vs. 4.074, t = -2.373, p = .021, 2-tailed). However, when the same

participants rate the long-run implications of their cuts on competitive advantage, this differential

assessment goes away (4.481 vs. 4.500, t = -.045, p = 0.964, 2-tailed). We interpret this result as

evidence of motivated reasoning―participants in the clawback condition appear to be

rationalizing that although the cuts to advertising expenses might affect their short-run

competitive advantage, these cuts will not affect the firm’s competitive advantage in the long-

run.

To better understand participants’ perceptions about how their decisions affect the firm in

the long run, we average their responses to two questions―how their total cuts affect the firm’s

stock price and competitive advantage in the long-run.11 We label this measure long-term impact

(LTI). A regression (untabulated) with LTI as the dependent variable, total earnings management

(TEM), board strength (BOARD), and the interaction term (TEM × BOARD) as independent 11 The Cronbach’s Alpha for these two measures is 0.86 suggesting that the two questions capture the same underlying construct. A factor analysis of participants’ responses to the post-experimental questions also reveal two clear factors―one denoting the long-run and the other denoting the short-run. Using the factor scores on the long-run factor as the dependent variable in the regression yields similar inferences.

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variables reveals a significant TEM × BOARD interaction (p=0.03, one-tailed). Participants in

the weak board condition believe that TEM is positively associated with LTI whereas

participants in the strong board conditions believe that TEM is negatively associated with LTI.

We interpret this result as evidence consistent with our theory that strong boards constrain

motivated reasoning to some extent because participants’ views about the long-term impact of

their cuts appears to vary contingent on board strength.

We also run a regression with LTI as the dependent variable, total earnings management

(TEM), the likelihood of meeting / beating analysts’ benchmark (MB)12 and the interaction term

(TEM × MB) as independent variables. Again, the interaction term is significant―participants

who are likely (or highly likely) to meet the analysts’ earnings benchmark based on their cuts

believe that TEM is positively associated with LTI. In contrast, participants who are less likely to

meet the analysts’ benchmark believe that TEM is negatively associated with LTI. Again, this

result provides indirect evidence of motivated reasoning. Participants’ beliefs about the long-

term impact of their cuts should not depend on whether they meet or miss analysts’ benchmarks,

yet they do.

5. CONCLUSION

This study experimentally examines the relative impact of mandated clawbacks and

strong boards on managers’ earnings management behavior. We find that strong boards can

reduce TEM by reducing both AEM and REM relative to a baseline condition. Clawbacks,

however, do not appear to significantly impact TEM. Managers reduce AEM following

clawbacks, but this reduction in AEM in AEM is accompanied by a corresponding increase in

REM.

12 MB is an indicator variable that can assume one of two values―cuts below $1.5 million are coded as 1 (they are less likely to meet analysts’ benchmarks); cuts above $1.5 million are coded 0 (they are likely or highly likely to meet analysts’ benchmarks).

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Our results suggest that mandated clawbacks are unnecessary at best and may have

counter-productive effects, at worst. When boards are strong, clawbacks do little to deter EM.

When boards are weak, clawbacks deter AEM, but substitute them with REM which could,

arguably, be more destructive to a firm. Policy makers who seek to curtail restatements may

indeed be able to do so with clawbacks, but the tradeoff in the form of increased REM could be

costly. Our results suggest that the regulatory emphasis on restatements as a means to reduce EM

may be misplaced. Instead, measures to strengthen boards may be more effective in curtailing

TEM thereby enhancing financial reporting quality.

Our experiment is subject to limitations. First, we use a very specific type of AEM

(warranty accruals) and REM (cutting advertising expense). Although these are representative

contexts in which EM has been studied, it is important to verify that our findings hold for

alternative contexts of AEM and REM. Second, governance theorists argue that externally

imposed sanctions can crowd out internal mechanisms for ensuring desirable behavior. Although

our experiment cannot speak to this important point, it is worth examining whether mandatory

clawbacks that curtail board discretion eventually end up weakening boards as feared by some

regulators (Gallagher 2015).

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Figure I

Figure I graphically presents the impact of clawbacks and boards on AEM, REM, and TEM in three conditions. The numbers represent the proposed cuts to SG&A (in $ millions: see Table I for details). In the baseline condition, the boards are weak and there is no mandated clawback. The clawback condition is identical to the baseline condition except that clawbacks are mandatory for restatements. The strong board condition is identical to the baseline condition except that boards are strong.

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TABLE I

Descriptive Statistics ($ millions)

ACCRUAL EARNINGS MANAGEMENT, REAL EARNINGS MANAGEMENT & TOTAL EARNINGS MANAGEMENT

Mean Judgments (Standard Deviation)

Board Strength

Mandated Clawback Strong Weak

Row

Means

Present0.51 (0.50)0.72 (0.57)1.23 (0.78)

n=32

0.28 (0.40)1.27 (0.67)1.55 (0.68)

n=26

0.41 (0.47)0.97 (0.67)1.37 (0.75)

n=58

Absent0.52 (0.38) 0.78 (0.47) 1.30 (0.64)

n=30

0.72 (0.49)0.97 (0.49)1.69 (0.56)

n=34

0.63 (0.45) 0.88 (0.48) 1.51 (0.63)

n=64

Column

Means

0.51 (0.44)0.75 (0.52)1.26 (0.71)

n=62

0.53 (0.50) 1.10 (0.58)1.63 (0.61)

n=60

Experimental participants in the role of a CEO indicate in their proposal to the board how much they would cut selling, general, and administrative (SG&A) expenses in the last quarter to increase the likelihood of meeting or exceeding analysts’ earnings estimates. The proposed cut in SG&A (in $ millions) represents our measure of Total Earnings Management (TEM).

Participants further indicate how much of this proposed cut in SG&A would come from warranty expense and from advertising expense. The proposed reduction in warranty expense constitutes our measure of Accrual Earnings Management (AEM). The proposed reduction in advertising expense constitutes our measure of Real Earnings Management (REM).

We manipulate two factors—board strength (strong versus weak) and mandated clawbacks (present versus absent) resulting in four treatment conditions.

This table presents descriptive statistics for participants’ proposed cuts to SG&A. The first row represents our measure of AEM, the second our measure of REM, and the third row represents TEM.

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TABLE II: PLANNED COMPARISONS

PANEL A: Baseline versus Clawback condition

Test statistic

p-value

H1a Mandated clawbacks will not impact TEM relative to our baseline condition t = 0.903 0.370H1b Mandated clawbacks will reduce AEM relative to our baseline condition t = 3.780 < .001H1c Mandated clawbacks will increase REM relative to our baseline condition t = -

2.2030.024

PANEL B: Baseline versus Strong Boards condition

Test statistic

p-value

H2a Strong boards will reduce TEM relative to our baseline condition t = 2.589 0.012H2b Strong boards will reduce AEM relative to our baseline condition t = 1.842 0.035H2c Strong boards will reduce REM relative to our baseline condition t = 1.571 0.061

This table presents the planned comparisons between conditions that test our primary hypotheses. Details of the conditions are provided in Table I and Figure I. All p-values are one tailed (except for the p value testing H1a).

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TABLE III: CONVENTIONAL ANOVAS

Panel A: Analysis of Variance: Accruals Earnings Management (AEM)

Source Sum of Squares

d.f. Mean Square

s

F-Statistic p-value

Clawback 1.576 1 1.576 7.834 0.006

Board 0.004 1 0.004 0.019 0.892

Clawback × Board 1.387 1 1.387 6.898 0.010

Error 23.732 118 0.201

Panel B: Analysis of Variance: Real Earnings Management (REM)

Source Sum of Squares

d.f. Mean Square

s

F-Statistic p-value

Clawback 0.419 1 0.419 1.415 0.237

Board 4.058 1 4.058 13.711 0.000

Clawback × Board 0.983 1 0.983 3.322 0.071

Error 34.921 118 0.439

Panel C: Analysis of Variance: Total Earnings Management (TEM)

Source Sum of Squares

d.f. Mean Square

s

F-Statistic p-value

Clawback 0.370 1 0.340 0.827 0.365

Board 3.815 1 3.815 8.531 0.004

Clawback × Board 0.035 1 0.035 0.078 0.781

Error 52.763 118 0.447

Panel A presents the results of an ANOVA with board strength and mandated clawbacks as the independent variables and the dollar amount of AEM as the dependent variable. Panels B & C present the results of an

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ANOVA with the same independent variables, but with REM and TEM as the dependent variable respectively. All p-values are two tailed.

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