High-level managers rely heavily on subordinates to collect, analyze, and summarize information.

Prior research has shown that financial statement users (hereafter users) consider the consistency between management’s reporting incentives and management’s disclosures (hereafter incentive consistency) when assessing the credibility of the disclosures (Hirst, Koonce, & Simko, 1995). In this study we investigate how the level of discretion in the reporting environment and management’s reporting reputation influence the importance of incentive consistency in explaining the credibility of management disclosures. Consistent with prior accounting and finance research, we assume that managers possess private information about the true economic identity of the transactions and events represented in the financial statements, and we define credibility as the extent to which users perceive that management’s disclosures represent management’s unbiased beliefs about the true nature of the transactions and events.1

Hirst et al. (1995) find that users view incentive-consistent information as less credible than incentive-inconsistent information. We show that this result holds in our setting and then extend it by arguing that the strength of the link between incentive consistency and the perceived credibility of a firm’s disclosures depends upon both the level of discretion in the reporting environment and management’s reporting reputation. The link is weaker in mandated reporting environments and for managers with good reporting reputations because in both cases users tend to believe the disclosures, discounting the importance of whether they are incentive consistent. We argue that in mandated environments, users rely less on incentive consistency because in such environments management structures transactions in advance to achieve desired disclosure treatment and ex post has limited ability to bias the disclosure. We argue that users rely less on incentive consistency when determining the credibility of disclosures provided by managers with good reporting reputations because users realize that such managers have more to lose by misreporting.

We test our arguments in an experiment where users assess the credibility of a firm’s choice to classify a hybrid security as a liability or equity.2 Our experimental firm has a debt/equity ratio above the industry average and is approaching technical violation of debt covenants, providing management an incentive to classify the hybrid as equity.3 We manipulate three variables: (1) classification is either inconsistent with management’s reporting incentives (liability) or consistent with management’s reporting incentives (equity); (2) classification is either discretionary or mandated by accounting standards, and (3) management’s reporting reputation is either good or poor. Consistent with Hirst et al. (1995), we predict that users consider incentive-inconsistent classifications to be more credible than incentive-consistent classifications. We extend Hirst et al. (1995) by predicting that the incentive consistency of management’s classification choice will interact with both the level of discretion in the reporting environment and management’s reporting reputation. Specifically, the incentive consistency of management’s classification choice will have a smaller effect on user credibility assessments in the mandated reporting environment and when management has a good reporting reputation. The results support the predictions.

In general, the results demonstrate that users consider information helpful in assessing management’s reporting incentives (e.g., industry benchmarks) when evaluating the credibility of management’s classification choices. The results further demonstrate that the extent to which users rely on such information depends on two factors: the level of discretion in the reporting environment and management’s reporting reputation. As the level of discretion decreases or management’s reporting reputation improves, users tend to reduce their reliance on the information helpful in assessing management’s reporting incentives when assessing the credibility of management’s classification; incentive consistency becomes less important.

These findings have implications for both accounting standard-setters, who can influence the level of discretion in the reporting environment, and management, who can influence its reporting reputation. Accounting standard-setters are continually faced with the difficult question of how much discretion to allow in the financial reporting environment. For example, the recent debate over principles-based vs. rules-based accounting standards (Schipper, 2003) exemplifies the tension inherent in allowing additional financial reporting discretion.4 Credibility is an important component of information usefulness (Hutton et al., 2003, Williams, 1996), and research examining how the level of reporting discretion affects user judgments can help users and standard setters better understand the ramifications of mandating vs. allowing classification discretion.5 Yet, current research does not provide unambiguous evidence concerning whether users perceive mandated or discretionary classifications as more credible. Mandated accounting treatment makes non-fraudulent strategic reporting more difficult, but also limits management’s ability to reveal private information. Allowing managers reporting discretion, on the other hand, facilitates honest revelation of private information, but increases the likelihood of self-serving strategic reporting. To date, no research has addressed how the level of discretion in the reporting environment affects the credibility of management’s classification choices, even though credibility is a central element of decision usefulness, the primary criterion for accounting information in the FASB’s Statement of Financial Accounting Concepts No. 1.

Our findings suggest that neither discretionary nor mandated reporting environments provide uniformly more credible accounting information. In mandated reporting environments, users appear to de-emphasize information helpful in assessing management’s reporting incentives, discounting a key variable in determining credibility, which leads to neither high nor low levels of perceived credibility. In discretionary settings, on the other hand, users rely heavily on information helpful in assessing management’s reporting incentives, leading to high levels of perceived credibility for incentive-inconsistent classification and low levels of perceived credibility for incentive-consistent classification.

Our findings suggest that by improving its reporting reputation management can reduce the extent to which users rely on information helpful in assessing its reporting incentives when determining the credibility of its disclosures. This result identifies a potential benefit associated with a good reporting reputation; that is, it reduces the influence on users of information over which management has little control. A good reporting reputation, for example, may encourage users to rely less on uncontrollable external information, like industry benchmarks, to assess whether management’s disclosures are truthful. To the extent that management wants users to focus on its disclosures, instead of outside information, good reporting reputations may be valuable.

Our findings also contribute to the literature concerning the formation and value of reporting reputations; these studies have shown that firms develop systematically different reporting reputations (Lang and Lundholm, 1993, Lang and Lundholm, 1996), investors adjust prices to management’s reporting tactics (King, 1996), and good reporting reputations are associated with lower costs of capital (Healy et al., 1999, Welker, 1995) and higher stock prices (Healy et al., 1999). Our findings suggest that the credibility benefits associated with possessing a good reporting reputation vary according to the situation. They appear to be greatest when management’s reporting choice is consistent with its reporting incentives. Users judged the credibility of classifications provided by managers with good reporting reputations to be higher only in the case where the hybrid was classified as equity.

We investigate hybrid securities because they are a popular form of corporate financing and their balance-sheet classification has long-been a matter of management’s judgment. In addition, classification is an important feature of financial reporting. For example, research suggests that firms are willing to incur costs to manage the classification of hybrid securities (Engle, Erickson, & Maydew, 1999), short vs. long-term liabilities (Gramlich, McAnally, & Thomas, 2001), and operating vs. non-operating expenses (Rapaccioli & Schiff, 1991). Prior research has also shown that balance sheet classification of hybrid securities is an important output of the accounting function, affecting the judgments of professional analysts (Hopkins, 1996). We conduct our analysis in an experimental setting because for any given reporting issue, mandated and discretionary reporting settings do not exist simultaneously in naturally occurring settings, and it would be extremely difficult to find equivalent firms using different accounting choices that reflect incentive-consistent and incentive-inconsistent signals.

The remainder of the paper is organized into four sections. We develop the hypotheses in Section “Theory and hypotheses”. We then describe the laboratory experiment in Section “Experiment”, report the results in Section “Results”, and conclude with a discussion of our findings in Section “Discussion”.

Theory and hypotheses

Birnbaum and Stegner (1979) define credibility in terms of perceptions of source expertise and source bias. In our experimental setting we hold source expertise constant by having all information originate from the same source (management), and focus on user perceptions of management’s reporting bias. As perceived management bias increases, we expect the perceived credibility of management’s disclosures to decrease (Eagly et al., 1978, Frost, 1997, Koch, 1999).

Psychology research on attribution

Experiment

One hundred and ninety graduate business students from a large state university participated in the experiment. On average, participants had completed four accounting and three finance courses.

Manipulation and other checks

We manipulated three variables: hybrid classification (liability/equity), reporting environment (mandated/discretionary), and financial reporting reputation (good/poor). Ninety percent of the participants correctly indicated whether Bransford’s management had a choice in classifying the newly-issued hybrid securities as liabilities or equity; 83% correctly indicated Bransford’s financial disclosure reputation as described in the FAF excerpt; and 93% correctly indicated whether Bransford

Discussion

In a laboratory setting where a firm has an incentive to classify hybrid securities as equity because its debt/equity ratio is well above the industry average, we show that the perceived credibility of management’s classification choice depends on whether the classification is consistent or inconsistent with management’s reporting incentives. Users viewed incentive-inconsistent (liability) classification as more credible than incentive-consistent (equity) classification. We show further that

Acknowledgements

We are grateful to Bob Bowen, Kathryn Kadous, Lisa Koonce, Dawn Matsumoto, Terry Shevlin, D. Shores, two anonymous reviewers, and the participants of the 2001 University of British Columbia, Oregon, and Washington (UBCOW) Conference, and research workshops at Indiana University, University of Kentucky, University at St. Gallen (Switzerland), and the University of Texas (Austin) for helpful comments on earlier versions of the paper. Frank Hodge acknowledges support of the William R. Gregory

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