Earnings management when firms face mandatory contributions

Purpose - In this paper, we aim to answer two questions. First, whether firms manipulate reported earnings via pension assumptions when facing mandatory contributions. Second, whether firms alter their earnings management behavior when the Financial Accounting Standard Board (FASB) mandates disclosure of pension asset composition and a description of investment strategy under SFAS 132R. Design/methodology/approach - Our basic approach is to run linear regressions of firm-year assumed returns on the log of pension sensitivity measures, controlling for current and lagged actual returns from pension assets, fiscal year dummies and industry dummies. The larger the pension sensitivity ratios, the stronger the effects from inflatedERRson reported earnings. We confirm the early results that the regression slopes are positive and highly significant. We construct an indicator variableDMCto capture the mandatory contributions firms face and another indicator variableD132Rto capture the effect of SFAS 132R.DMCtakes the value of one for fiscal years during which an acquisition takes place and zero otherwise.D132Rtakes the value of one for fiscal years after December 15, 2003 and zero otherwise. Findings - Our sample covers the period from June 1992 to December 2017. Our key results are as follows. The estimated coefficient (t-statistic) onDMCis 0.308 (6.87). Firms facing mandatory contributions tend to setERRsat an average 0.308% higher. The estimated coefficient (t-statistic) onD132Ris −2.190 (−13.70). The new disclosure requirement under SFAS 132R constrains all firms to setERRsat an average 2.190% lower. The estimate (t-statistic) on the interactive termDMA×D132Ris −0.237 (−3.29). When mandatory contributions happen during the post-SFAS 132R period, firms tend to setERRsat 0.237% lower than they would do otherwise in the pre-SFAS 132R period. Originality/value - When firms face mandatory contributions, typically firm experience negative stock market returns. We examine whether managers manage earnings to mitigate such negative impact. We find that firms inflate assumed returns on pension assets to boost their reported earnings when facing mandatory contributions. We also find that managers alter earnings management behavior, in the case of mandatory contributions, following the introduction of new pension disclosure standards under SFAS 132R that become effective on December 15, 2003. Under the new SFAS 132R requirement, firms need to disclose asset allocation and describe investment strategies. This imposes restrictions on managers' discretion in makingERRassumptions, since now the composition of pension assets is a key determinant of the assumed expected rate of return on pension assets. Firms need to justify theirERRswith their asset allocations.