۱- Introduction

۲- Prior literature and hypothesis development

۳- Data and research design

۴- Empirical results

۵- Additional analyses and robustness tests

۶- Conclusion

References

Abstract

Accounting big baths are pervasive in practice. While big baths can improve the information environment and reduce information asymmetry, they can also degrade the information environment and obscure operating performance. In this study, we examine the role of management ethics. Specifically, we investigate whether managers’ truthfulness (or conversely, deceptiveness) affects how investors perceive big baths. Using linguistic analysis on earnings-conference calls to measure managerial deception and employing a difference-in-differences research design with propensity-score matching, we find that information asymmetry is significantly higher following big baths taken by deceptive CEOs, compared with big baths taken by less deceptive CEOs.

Introduction

How does a firm’s information environment change after accounting big baths? Prior literature provides evidence on both positive (Elliott & Shaw, 1988; Francis, Hanna, & Vincent, 1996; Haggard, Howe, & Lynch, 2015) and negative (Bens & Johnston, 2009; Kirschenheiter & Melumad, 2002; Kothari, Shu, and Wysocki 2009; Moore, 1973) consequences of big baths on the information environment. As managers have discretion regarding whether to incur a large write-off, and can decide the timing and amount of the write-off, management’s incentives are important in studying the effects of big baths. However, such incentives are unobservable. Investors may use managerial characteristics to infer management incentives. Among the most salient managerial characteristics in this setting is truthfulness; thus this study examines how truthfulness (or conversely, deceptiveness) affects investors’ perceptions of big baths. According to upper-echelons theory (Hambrick & Mason, 1984), the ethical attentiveness throughout the organization is instilled by its leaders (Patelli & Pedrini, 2015). A series of accounting fraud scandals over the last decades put leadership ethics at the forefront of the heated debate on financial-reporting truthfulness (Mihajlov & Miller, 2012; Tourish & Vatcha, 2005). Ethics is an intrinsic part of managers’ behavior (Solomon, 1992). As firms’ high-level decision makers, top managers are likely to follow a cognitive and rational approach that revolves around moral judgments about the issues when making ethical decisions, just as an individual making a choice when facing an ethical dilemma (Albert, Scott, and Turan 2015; Kohlberg, 1981; Reynolds, 2006; Vitell, Lumpkin, and Rawwas 1991; Weber, 1990). Big baths are managerial decisions that can be the result of managers’ ethical considerations of the firms’ welfare, or can be the result of managers’ incentives to maximize their personal utility. Being truthful or deceptive to investors and other stakeholders also indicates management’s ethical choice of how they view their responsibility to the firm’s stakeholders. On one hand, big baths can manifest themselves as exceptionally large negative discretionary accruals. On the other hand, big baths can consist of one-time, large write-offs, and may include restructuring charges, asset impairments, and litigation losses. These write-offs are generally reflected as “special items” in the financial statements. There are two ways to look at a big bath. If a company reports a loss that is larger than expectations, it could be the case that there are certain issues within the firm that warrant such actions and that managers are truthfully conveying such information to the capital market and other stakeholders. In line with that view, some analysts interpret big baths as managers’ positive response to existing problems (Elliott & Shaw, 1988). Big baths can also “clear the air” (Haggard et al., 2015). That is, by writing off assets when their carrying values are less than the market values, the reported values of the assets are realigned with their economic values. As a result, firm-level information asymmetry following a big bath should decrease.