Earnings management: the role of the agency problem and corporate social responsibility

ABSTRACT: Recently, publicly-traded corporations have had to restate their earnings as a result of using various earnings management techniques. Prior research documents the many incentives managers have for engaging in earnings management, including short-term compensation-related incentives. While prior research has mostly focused on aggregate measures of earnings management at the consolidated financial statement level, this study examines the role of the agency problem (i.e., incentives and information asymmetry) on managers’ discretionary accrual decisions. In addition, this study investigates the role of the corporate environment on discretionary accrual decisions. Specifically, I conduct an experiment that examines the impact of the agency problem on business-unit managers’ expense-related accrual decisions as well as the role of corporate social responsibility in mitigating this earnings management. Consistent with agency theory, I find that business-unit managers act in their own self-interest when there is an agency problem by booking larger discretionary expense accruals in order to maximize their bonus potential. Further, managers act in the firm’s best interest when there is not an agency problem by booking smaller discretionary expense accruals in order to maximize the firm’s attractiveness for a pending IPO. More importantly, I find that a greater commitment to corporate social responsibility mitigates the impact of the agency problem. These results suggest that managers consider factors other than those associated with the agency problem when making discretionary accrual decisions.