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    Management Credibility and Investment Risk: An Experimental...
    research summary posted December 1, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 09.0 Auditor Judgment, 09.13 Recognition vs. Disclosure 
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    Title:
    Management Credibility and Investment Risk: An Experimental Investigation of Lease Accounting Alternatives
    Practical Implications:

    The research helps identify conditions under which financial statement users are more likely to detect accounting and disclosure choices that are seemingly intended to misrepresent firms’ financial positions.  The evidence indicates that participants in the experiment do not naturally adjust for financial statement impact. These participants perceive a deficiency in management credibility only when they understand both the financial statement impact of an incentive-consistent accounting choice and believe that management has not been forthcoming about that choice.  The research suggests that investors make credibility judgments based on the forthcomingness of corporate disclosure as well as on what they understand about managers’ choices from the broader information environment.

    For more information on this study, please contact Susan Krische.

    Citation:

    Krische, S. D., P. R. Sanders, and S. D. Smith.  2014.  Management credibility and investment risk: An experimental investigation of lease accounting alternatives.  Behavioral Research in Accounting 26 (1): 109-130.

    Keywords:
    lease transaction structuring; recognition and disclosure; reconciliation; management credibility.
    Purpose of the Study:

    What are the conditions necessary for an investor to question managers’ choices as attempts to misrepresent their firms’ financial positions? This paper examines how users’ understanding of the financial statement impact of accounting alternatives and the disclosure choices management has made jointly influences users’ assessments of management credibility and investment risk.

    The authors place the research in the context of bright-line lease accounting standards and reporting decisions because lease structuring to achieve operating lease treatment is among the most prevalent strategies for off-balance sheet financing, while academic research has produced mixed evidence on whether and how market participants detect and respond to managers’ efforts to obfuscate those obligations. The authors expect that users will perceive lower management credibility only when they understand that management has made an accounting decision for strategic financial reporting purposes and that management has not been forthcoming about that decision in its disclosures.

    Design/Method/ Approach:

    The research requires careful control of users’ understanding of the financial statement impact of management’s reporting choices. Participants in the experiment were therefore students in a junior-level management accounting course at a large public university, who were asked to evaluate a company’s financial information and provide several judgments including management credibility and investment risk. The financial information varies in three ways: (1) whether the lease obligations are recognized or disclosed; (2) whether a supplemental reconciliation to lease capitalization is presented; and (3) whether the source of the reconciliation is internal or external. Data from the experiment was collected in 2006.

    Findings:
    • When the firm merely discloses lease obligations vs. recognizing (capitalizing) them, participants:
      • assess lower investment risk, but
      • do not perceive lower management credibility. 
    • When an externally sourced supplemental reconciliation of lease accounting treatments is provided, participants:
      • assess higher investment risk, and
      • perceive lower management credibility.
    • The authors find that participants’ assessments of management credibility mediate the difference in investment risk judgments caused by the reconciliation source.
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Management Integrity, Recognition vs. Disclosure