Empirical Tests of Budget Ratcheting and its Effect on Managers' Discretionary Accrual Choices

Abstract

In this paper, we consider the maintained assumption in previous earnings-management research that budgets are static through time (fixed-target assumption) versus the common belief in practice that budgets ratchet. Using business-unit data from a large multinational corporation, we find evidence consistent with ratcheting, where favorable budget variances result in performance budget increases that are larger than decreases associated with unfavorable variances of the same magnitude. We then demonstrate that managerse bonus-maximizing discretionary accrual decisions differ when they perceive that budgets ratchet rather than remain fixed. On average, bonus-maximizing discretionary accruals are lower assuming ratcheting budgets. Finally, we find that proxies for discretionary accruals are better explained by bonus-maximizing behavior conditioned on ratcheting budgets than by bonus-maximizing behavior conditioned on fixed budgets. Collectively, these results suggest that including the dynamic nature of budgets in models of bonus maximization is likely to improve the power of tests of the relation between earnings-based bonus compensation and earnings management.

JEL Classification: M40, M43, M46, J33