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Governmental Accounting and Financial Reporting in Transition: A Study of

Earnings Management under the Accrual and Consolidation Model
A Dissertation Submitted to the Graduate Faculty of George Mason
University in Partial Fulfillment of the Requirements for the Degree of Ph.D. in
Public Policy
By
Odd J. Stalebrink
Master of Science in Business Administration
Jonkdping International Business School, 1997
Bachelor of Science in Business Administration
Jonkdping International Business School, 1996
Chair: Professor Jonathan L. Gifford
Summer Semester, 2002

George Mason University
Fairfax, VA
UMI Number: 3055816
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Copyright 2002 Odd J. Stalebrink

All Rights Reserved
GOVERNMENTAL ACCOUNTING & FINANCIAL REPORTING IN

TRANSITION: A STUDY OF EARNINGS MANAGEMENT" UNDER THE
ACCRUAL & CONSOLIDATION MODEL
by
Odd J. Stalebrink
A Dissertation
Submitted to the
Graduate Faculty
of
in Partial Fulfillment of
the Requirements for the Degree
of
Ph.D. in Public Policy
Committee
Director
Department Chairperson
7l
Program Director
Dean, School of Public Policy
Summer Semester 2002

Fairfax, VA
DEDICATION
To Meghan
ACKNOWLEDGEMENTS
This dissertation benefited from the advice and help provided to me by a

number of people. In particular, I would like to acknowledge the help from my
committee members. First, I would like to acknowledge my advisor Dr. Jonathan
Gifford. Over the past five years I have had the pleasure to work with Dr. Gifford
on a number of projects. I have benefited widely from his academic creativity
and commitment to multi-disciplinary research. Working with Dr. Gifford has put a
significant imprint on my academic approach. Throughout my dissertation work, I
have been most impressed by his a strong commitment to bringing me towards
the completion of the dissertation. Without his great efforts, this dissertation
would not have been completed in the manner it was. Second, I would like to
acknowledge Dr. Roger Stough who generously provided financial support
throughout the research. The financial support allowed me to get involved in a
number of innovative research projects that ultimately laid the basis for my
choice of dissertation topic. Dr. Stough also provided valuable advise helping me
to address a number of methodological issues. Third, I would like to acknowledge
Dr. John Sacco whos innovative view of the recent governmental accounting
reforms allowed me to significantly improve the context and theory of the
dissertation. Dr. Sacco was also enormously useful in helping me shape the
basic questions of my dissertation. Finally, I would like to acknowledge Dr. Sue

McNeil who signed on as an external reader in the 11th hour. She provided a
number of last minute comments that significantly enhanced the quality of the
dissertation. In addition, I would like to acknowledge my appreciation for the help
provided by several faculty and staff at the School Public Policy. These include
Stephen Fuller, Kingsley Haynes, James Finkelstein, Kenneth Button, and John
Petersen.
TABLE OF CONTENTS
Page
ABSTRACT.......................................................................................................... IX
1
INTRODUCTION............................................................................................. 2
1.1
1.2
1.3
1.4
1.5
1.6
1.7
O b j e c t iv e ............................................................................................................................................................2
Pr o b lem A r e a ....................................................................................................................................................2
R esearch Q u e s t io n s ......................................................................................................................................... 8
Resea rch M e t h o d ..........................................................................................................................................8
Sig n if ic a n c e ...................................................................................................................................................... 9
R esearch Sc o p e ...............................................................................................................................................12
O u t l in e .............................................................................................................................................................. 13
BACKGROUND............................................................................................. 14
2.1
Go v e r n m e n t a l a c c o u n t in g & Rep o r tin g : F u n c t io n ...................................................................... 14

Financial Statements .............................................................................................................................. 14
2.1.1.1
The Balance Sheet............................................................................................................................... 15
2.1.1.2
The Operating Statement..................................................................................................................... 16
2.1.1.3
The Statement of Cash Flows..............................................................................................................18
2.1.2
Management's Discussion and Analysis Section ............................................................................... 19
2.1.3
Audit Opinion ......................................................................................................................................... 19
2.2
G o v e rn m e n ta l a c c o u n tin g a n d R ep o rtin g a n d a g e n c y C o s t s ................................................20
2.2.1 Arguments fo r the Accrual and Consolidation M odel ..................................................................... 23
2.3
Re l ia b il it y ..................................................................................................................................................... 26
2.3.1
How Is Reliability Compromised?........................................................................................................27
2.3.1. 1 Accounting Measurement Constraints and Reliability..........................................................................28
2.3.1.2 Accounting Discretion and Reliability...................................................................................................31
2.4
E a r n in g s M a n a g e m e n t .............................................................................................................................. 34
2.1.1
LITERATURE REVIEW.................................................................................36
3.1
3.2
E m p ir ic a l C o n t e x t ...................................................................................................................................... 36
Ea r n in g s M a n a g e m e n t w it h in C o m m e r c ia l E n t it ie s :E m p ir ic a l F in d in g s .............................. 39
3.2.1
A Summary o f The Studies ..................................................................................................................... 41
3.2.1.1 Income-Smoothing Studies....................................................................................................................42
3.2.1.2 Income-Increasing/Decreasing Studies................................................................................................. 43
3.3
E m p ir ic a l C o n t r ib u t io n : A n O l d M o d e l in a N e w C o n t e x t ............................................... 47
METHOD....................................................................................................... 50
4.1
4.2
a s s u m p t io n s ...................................................................................................................................................51
D e p en d en t V a r ia b l e s ..................................................................................................................................53
4.2.1
Asset Write-offs........................................................................................................................................ 55
4.2.1.1
Background............................................................................................................................................ 55
4.2.1.2 Write-offs and Earnings Management................................................................................................... 56
4.2.2
Capital Depreciation Practices ........................................................................................................... 58
4.2.3
Depreciation Choices and Earnings Management........................................................................... 60
4.2.4
Pension Obligations.....................................................................................................................61
4.2.4.1
4.2.4.2
4.2.4.3
4.2.5
4.3
4.4
Background...........................................................................................................................................61
Valuation of Total Pension Obligations and Annual Costs................................................................. 62
Pension Obligations and Earnings Management..................................................................................65
Contributions to Infrastructure Investments............................................................................... 65

T h r e e M o d e l s ..........................................................................
H y p o t h e s e s ...............................................................................
4.4.1
4.4.2
4.4.3
Financial Condition......................................................
Political Competition.....................................................
Scrutiny...........................................................................
67
67
68
72
73
5 DATA COLLECTION AND SAMPLE SELECTION.......................................78

5.1
D a t a Sp e c if ic s .............................................................................................................................................. 82
5.1.1
Dependent Variables.....................................................................................................................84
5.1.1.1
5 .1. 1.2
5.1.2
Asset Write-offs and Capital Depreciation Practices........................................................................... 84

Annual Cost Allocated to Meet Future Pension Obligations................................................................84
Independent Variables...................................................................................................................85
5.1.2.1
5 .1.2.2
5.1.2.3
5 .1.2.4
Big Bath Variables.............................................................................................................................86

Proxy for Political Competition............................................................................................................86
Scrutiny................................................................................................................................................. 88
Control Variables..................................................................................................................................89
6 DATA ANALYSIS.......................................................................................... 91
6.1
6.2
Su m m a r y of V a r ia b l e s ............................................................................................................................. 91
C u r v e F it t in g ............................................................................................................................................... 93
6.2.1
6.3
6.3.1
6.3.1.1
6.3.1.2
6.3.1.3
6.3.2
6.4
Outliers...........................................................................................................................................94
D a t a -Q u a l it y A n a l y s is ........................................................................................................................... 96
Heteroscedasticity.........................................................................................................................96
Heteroscedasticity Test of Aggregate Model....................................................................................... 98
Heteroscedasticity Test of Write-ofE'Depreciation Model.................................................................. 98
Heteroscedasticity Test of Pension Cost-Allocation Model................................................................ 98
Multicollinearity............................................................................................................................99
R eg ressio n R es ults a n d I n t e r p r e t a t io n .......................................................................................... 103
6.4.1
6.4.2
6.4.3
The Aggregate Discretion Model: Results and Analysis.......................................................... 104

Write-off/Depreciation Model: Results and Analysis............................................................... 106
Pension Cost-Allocation Model: Results and Analysis............................................................. 107
7 DISCUSSION AND CONCLUSIONS...........................................................110

7.1
7.2
Po l ic y I m p l ic a t io n s ................................................................................................................................ 111
F u t u r e R esea rch a n d C a v e a t s ........................................................................................................... 113
REFERENCES................................................................................................. 118
APPENDIX....................................................................................................... 128
LIST OF TABLES
Page
Table 1.1: Formal Differences between Governmental & Commercial Entities
Operating Environments.................................................................................7
Table 1.2: Illustration o f Users, Resources & Possible Action Alternatives
11
Table 2.1: Differences between the Conventional and the Accrual and
Consolidation Models....................................................................................24
Table 6.1: Summary o f Variables........................................................................93
Table 6.2 - Test of Tolerances in Aggregate Discretion M odel.........................100
Table 6.3 - Test of Tolerances in Write-off/Depreciation M odel........................100
Table 6.4 - Test of Tolerances in Pension Cost-Allocation Model.....................101
Table 6.5 - Correlation M atrix...........................................................................102
Table 6.6 - Regression Results in Aggregate Discretion Model........................105
Table 6.7 - Write-off/Depreciation Model Regression Results..........................107
Table 6.8: Pension Cost-Allocation Model Regression Results........................108
ix
LIST OF FIGURES
Figure 2.1: Trade-Off between Economic Relevance and Cost/Objectivity
Page
31
ABSTRACT
GOVERNMENTAL ACCOUNTING AND FINANCIAL REPORTING IN

TRANSITION: A STUDY OF EARNINGS MANAGEMENT UNDER THE
ACCRUAL AND CONSOLIDATION MODEL
Odd J. Stalebrink
George Mason University, 2002
Dissertation Director: Dr. Jonathan L. Gifford
Over the past two decades, widespread changes have taken place
internationally in governmental accounting and financial reporting. Most
important, public-sector entities have moved towards the adoption of the accrual
and
consolidation
model,
commonly
used
by
commercial
entities.
Conventionally, public-sector entities have accounted for and reported their

activities using the compliance and liquidity model (Sacco 1996). This
dissertation reports on the adoption of the accrual and consolidation model in the
public sector as it relates to earnings management. Earnings management
refers to the systematic use of reporting discretion to influence the manner by
which an entity is portrayed in its external financial reports. The objective of the
dissertation is to examine the extent and form by which public entities engage in
earnings management. The findings of the study indicate that earnings
management occurs within public-sector entities that are reporting using an

accrual and consolidation model. These findings are important for several
reasons. Most importantly, they inform about the success of using an accrual and
consolidation model to hold public entities accountable for their operations.
Earnings management compromises this success by reducing the overall quality
of the reported information. That is, it reduces the extent to which the information
purports what it is set out to purport (i.e., the reliability and relevance of financial
information is compromised). Because earnings management reduces the quality
of the reported financial information, the findings are also important for the
prospects of using financial accounting information as a tool for improving public
management. The study concludes that if the accrual and consolidation model is
to be effectively utilized within public-sector entities, it may be necessary to
further constrain reporting discretion.
1.1
INTRODUCTION
Objective
Over the past two decades, widespread changes have taken place
internationally in governmental accounting and financial reporting. Most

importantly, public-sector entities have moved toward the adoption of the accrual
and
consolidation
model,
commonly
used
by
commercial
entities.
Conventionally, public-sector entities have accounted for and reported their

activities using the compliance and liquidity model (Sacco 1996). This
dissertation reports on the adoption of the accrual and consolidation model in the
public sector as it relates to earnings management." Earnings management
refers to the systematic use of reporting discretion to influence the manner by
which an entity is portrayed in its external financial reports. The objective of the
dissertation is to examine the extent and form by which public entities engage in
earnings management.
1.2 Problem Area
Very little is known about earnings management as it relates to publicsector entities that have adopted the accrual and consolidation model. There are
two principal reasons for this. First, the limited number of studies that have
explored earnings management in the public sector have done so in the context
of the conventional compliance and liquidity model (for examples, see (United
States General Accounting Office 1985,United States General Accounting Office
1993)). This model provides for an entirely different set of eamings-management
opportunities than those available in the accrual and consolidation model.
Consequently, the evidence generated in these studies is not necessarily
applicable to the accrual and consolidation model.
The second reason derives from the difficulty of transferring evidence
generated in the context of commercial-sector entities to the public sector. A
significant number of studies provide insights to earnings management as it
relates to the accrual and consolidation model. Due to stark differences between
the two sectors operating environments, the transferability of the evidence is
questionable (for a listing of the major differences, see Table 1.1). Hence,
problem areas and challenges associated with the accrual and consolidation
model need to be re-examined in a public-sector context.
At least five contextual factors may be found that motivate a re-examination
of earnings management in the context of public-sector entities. First, earnings
management in the public sector may focus on cost minimization to a larger
degree than in the commercial sector. In the commercial sector, a number of
incentives are present that provide commercial entities with incentives to engage
in earnings management to maximize costs (Dopuch and Pincus 1988,Gramlich
1991,Wolfson 1993,Dhaliwal, Frankel, and Trezevant 1994,Cloyd, Pratt, and

Stock 1996). These include tax savings, reduction of the risk of additional
competitors entering the marketplace,
and
avoidance of governmental
regulations that may have adverse affects on the ability of an entity to retain its
earnings (e.g., price ceilings). (For a discussion of these factors, see Section
3.1.)
Second, earnings management in the public sector may be driven by
financial rewards to a much lesser extent than in the commercial sector. Among
other things, this may be attributed to (a) the lack of natural connection between
revenues and costs in the provision of public services and goods; (b) the
complexity of generating objective measures of the benefits provided through
public-service provision; and (c) the fact that public entities not only operate
under goals of economic efficiency, but also goals of equity, interest groups or
office retention. For these reasons, the implementation of compensation plans
similar to those used in the commercial sector is often infeasible in a publicsector operating environment.
Specifically, the implementation o f plans that
allow managers to share profits in excess of a target level that often is stated in
terms of accounting net income (or the rate of return on the book value of the
assets of the entity) (Holthausen and Leftwich 1983). Earnings management in
the public sector is more likely to be tied to elected officials wishes to gain or
extend positions of political power (Ingram and Copeland 1986).
Third, earnings management in the public sector may be driven by internal

demands only. Dye has reported that earnings management in the commercial
sector is driven by a combination of internal and external demands (Dye 1988).
More specifically, Dye reports that demands exist for both managers (internal
demands) and shareholders (external demands) to allow for or to engage in
earnings management. In his 1988 study, Dye finds that managers are likely to
smooth income across accounting periods using eamings-management
practices, if stable results reflect positively upon them. Similarly, Dye finds that
owners are willing to allow managers to smooth income if it improves their firm's
contractual terms with outsiders. However, since governments are not owned by
external shareholders (i.e., a similar ownership structure does not exist in the
public sector), earnings management in a public-sector context may be confined
to internal demands.
Fourth, the incentive structure in each respective sectors operating
environment may provide different incentives for managers to engage in earnings
management. For example, based on a property-rights framework, it may be
argued that, compared to commercial agents, agents of public-sector entities are
more easily able to engage in earnings management without such attempts being
revealed (Alchian and Demsetz 1972.Zimmerman 1977,Fama 1980,Stalebrink
2002). The property-rights framework states that stakeholders of public entities,
in aggregate, have fewer incentives to monitor the actions of their agents,
compared to commercial agents. This is often attributed to the lack of private-
property rights in the public sector (i.e., the limited amount of personal property
that is invested in public entities) (von Mises 1935,Vaughn 1980,Kirzner 1996).
By contrast, principals of commercial entities put their own private property at risk
in an entity. Consequently, they have larger incentives to monitor the action of
agents. Hence, on grounds that public-sector agents are monitored less intensely
than commercial-sector agents, reporting discretion is more likely to result in
earnings management in a public sector context (Stalebrink 2002).1
It is
important to note, however, that scholars are yet to agree on who is most likely to
manipulate earnings numbers. Those with a favorable view of the market see
self-interest as not being adequately contained in monopolistic governments.
1 Similarly, it may be argued that reporting discretion is more likely to translate to earnings management
in public-sector settings, on the grounds that public agents are not directly disciplined by efficient
markets (Zimmerman 1977,Fama 1980). However, it may be argued that public-sector agents are
disciplined as a result of the existence of government bonds, which are traded on capital markets.
However, there are two reasons the disciplinary effects of these are likely to be smaller than in the
commercial sector. First creditors and investors do not represent the only groups to which
governments are held accountable, as is the case in the commercial sector. Governments are also
accountable to constituents and legislative and oversight bodies. A second contributing factor is that
there is often no natural connection between the costs and the revenues that support the provision of
public goods. The lack of this connection reduces the ability of analysts to use a bottom-line measure
(i.e., profit) for evaluating the effectiveness of an entity over time and relative to other entities (for a
discussion see (Simon 1945,173-179,von Mises 1996,308-309)). For this reason it is more difficult to
monitor agents of governmental entities.
Those who have more faith in government than the so-called greed of the market
feel that earnings manipulations are more likely under market conditions.
Table 1.1: Formal Differences between Governmental A Commercial Entities Operating

Environments
Nature
Public agencies
Commercial Companies
Formation
Established by citizenry through

constitutional and charter
process
Render not-for-profit services to
citizens
Formed by entrepreneurs
Operating motives
Dependence on
legislative authorities
Receive authority to act from

legislative authorities
Responsibility to
citizens/owners
Demonstrate good stewardship

with financial resources provided
and entrusted to them by
citizenry
Taxes levied on citizenry
Source of revenue
Render services to maximize

the owners profit and repay
investors
Regulatory rather than
proprietary public-authority
involvement
Demonstrating good
stewardship with financial
resources to senior debt- and
equity-security owners
Sales
Finally, public officials often operate under a shorter decision-making

horizon than do managers of commercial entities. Public officials are generally
elected in two- to four-year intervals. This relatively short-term decision-making
horizon may affect an entitys choice of accounting practices. This may be
illustrated in the case of capital depreciation methods (i.e., straight-line versus
accelerated depreciation) when the objective is to minimize costs. Under a short
term decision-making horizon the use of straight-line depreciation may lead to a
lower reported cost and income smoothing because it does not put a heavy
weight on the write-off amount at the beginning of an assets life. Conversely,
under a longer term decision horizon the same practice may be chosen.
However, the rationale for arriving at the choice may be different. It may be
based on inflationary pressures' most heavily affecting straight line-depreciation.
If the goal were to minimize costs, writing off more at a later time would then be
beneficial. Hence, the decision-making horizon may affect the assumptions that
underlie a particular accounting choice.
1.3 Research Questions
This dissertation recognizes the limited knowledge that exists about
earnings management in the context of public-sector entities that have adopted
the accrual and consolidation model. To provide for further knowledge in this
area the dissertation examines two specific research questions. They are as
follows:
How does earnings management reveal itself within public-sector entities that
have adopted an accrual and consolidation model (i.e., the form it takes)?
To what extent does earnings management occur within public-sector entities

that have adopted an accrual and consolidation model?
1.4 Research Method

The method used to examine the above research questions is similar to the
method used in empirical studies of earnings management within commercialsector entities. Regression models are used to test for the relationship between
certain conditions in an entitys operating environment that may drive earnings

management and select accounting practices that provide material opportunities
for earnings management. The regression models developed are centered on the
study of earnings management as it relates to isolated opportunities for earnings
management. Hence, those accounting practices that provide opportunities for
earnings management are treated as dependent variables in the models.
Conditions hypothesized to drive earnings management include (a) financial
condition, (b) public scrutiny, and (c) political competition (i.e., the independent
variables).
1.5 Significance
A study on earnings management is significant for at least three reasons.
First, it is significant because earnings management reduces the effectiveness by
which external financial reports are able to serve their primary purpose: to
provide an entitys stakeholders (i.e., its principals) with information that allows
them to effectively monitor the activities of those to whom they have delegated
(both directly and indirectly) decision-making authority (i.e., the agents).2
Earnings management reduces this effectiveness because it compromises the
extent reported accounting information purport what it is set out to purport (i.e., it
compromises the reliability of the financial information).
2 If this is achieved, financial reports facilitate informed decision-making concerning resources that
principals have at stake in the entity.
Table 1.2, below, identifies the primary principals of public-sector entities

and their potential uses of financial accounting information. They are:
Creditors: Creditors use governmental accounting information to allocate

financial resources among different investment alternatives.
Legislative and oversight bodies: Legislative and oversight bodies use

financial
accounting
information
to
monitor
the
actions of
public
administrators/managers on behalf of constituents, and as a basis for

appropriation decisions.
Constituents: the provision of governmental accounting information to

constituents has, in democratic societies, often been motivated by a belief
that these have a right to know, and to receive openly declared facts that
may lead to a public debate by the citizens and their elected representatives
(Governmental Accounting Standards Board (GASB) 1987, ii).n Thus,
governmental accounting information is viewed as a source that allows
constituents to participate in the democratic process. Actions resulting from
such participation may include lobbying, voting, and in extreme cases,
Tieboutian location shifts (Tiebout 1956).
The second reason a study of earnings management is significant is that it
informs accounting standard-setting authorities about the need to further

constrain available reporting discretion. A number of studies in the commercial
accounting literature provide insights to this need (Johnson 1966,Benway
10
1985,Mims
1986,Berton
and
Miller
1986,Smith
and
Lipin
1994,Grover
1992,Linden 1990,Strong and Meyer 1987,Berton and Miller 1986,Zucca and

Campbell 1992,Francis, Hanna, and Vincent 1996,Elliot and Shaw 1988,Rees,
Gill, and Gore 1996). For reasons explained above, however, insights to this
need in the context of public-sector entities that have adopted the accrual and
consolidation model are limited.
Table 1.2: Illustration of Users, Resources & Possible Action Alternatives
User Group
Resource to be allocated
Possible actions
Constituents
Representatives/ elected
officials
Cast vote or move from area
Creditors/investors
Financial resources
Invest/not invest
Legislative and oversight

bodies
Appropriations
Appropriate/not appropriate
Finally, a study on earnings management is significant because it provide

insight to the so-called positive accounting theory on accounting choice that was
started by Watts and Zimmerman in the 1970s (Watts and Zimmerman
1978,Watts and Zimmerman 1986). This theory is underdeveloped as it relates
to public-sector entities. A study of earnings management in a public-sector
setting contributes to this theory by providing further insights to the role of
institutional factors in accounting choice. Watts and Zimmerman (1986) were
skeptical about business-type reforms succeeding in government because of
market pressures and the dominance of monopolistic control over external
reporting. However, they did not anticipate the emergence of global capital
11
markets or the reach of these markets into the power of the sovereign over
selecting financial reporting systems.3
1.6 Research Scope
The data used in the dissertation were collected in the context of Swedish
municipalities. Despite this geographical limitation, the dissertation seeks to
generalize beyond the case of Swedish municipalities to include countries that
have undertaken similar reforms. Good examples are the United States, the
United Kingdom, Spain, Iceland, Australia, New Zealand, and Canada. The
public-sector accounting reforms in these countries have been driven by
motivations similar to those experienced in Sweden. In essence, they have been
instituted in response to more broad-based public-management reforms, driven
by beliefs that public entities operate more effectively under an institutional
structure that emphasizes transparency and allows them to more freely adapt to
the specific circumstances under which they operate (i.e., a let managers
3 In a public-sector context the accrual and consolidation model has been superimposed on states
seeking to preserve their sovereignty. For years, academics and many reformers felt that economic
efficiency models (with their use of business-oriented accrual, consolidation and more recently fairvalue accounting) would work well in government, notwithstanding the monopolistic features of
government The accrual and consolidation models focus on economic efficiency was a power unto
itself. Unfortunately, those advocates of the independent power of business-oriented bottom-line
models did not incorporate the influence of global capital markets on the positive impact on economic
efficiency models on transparency.
12
manage" philosophy) (for a discussion, see (Kettl 1997,Senge 1990,Gifford and

Stalebrink 2001)). The past two decades governmental accounting reforms have
been instituted to counterbalance this expanded managerial flexibility.
The scope of the dissertation is also limited to the examination of eamingsmanagement opportunities that arise in the accounting-measurement process.
Moreover, consideration is not given to eamings-management opportunities that
exist outside the model examined.
1.7
Outline
Following the introductory chapter, the second chapter introduces
governmental accounting and financial reporting and relates it to earnings

management. The third chapter provides a literature review. The fourth chapter
introduces the research approach. The fifth chapter describes the data and the
sample selection. The sixth chapter describes the procedure used to analyze the
results generated. A final chapter summarizes and offers a discussion of the
implications that the results of this dissertation ought to have for govemmentalaccounting policy. The findings are also discussed in the context of a number of
the above-mentioned countries that have adopted an accrual and consolidation
model.
2.1
BACKGROUND
Governmental Accounting & Reporting: Function

In most democratic societies, governments are required to prepare periodic
external financial reports and make these available for public scrutiny. In theory,
these reports are often considered to be the single and most important source of
information available to the public in determining the extent to which
governments are fiscally responsible. Consequently, external financial reports
can play a central role in achieving public transparency.
External financial reports foster public transparency by providing at least
three components of information. These are (a) financial statements; (b) a
managements discussion and analysis section; and (c) an audit opinion.4 A
discussion of these components is provided below.
2.1.1 Financial Statements
The financial statements are the focal point of an entitys external financial
report. They seek to provide an objective overview of the entitys financial
4 Increasingly performance indicators are also added to provide quantitative and qualitative insights to
service efforts and accomplishments.
13
14
activities. The overview is provided either at an entity-wide level (referred to as

consolidated financial reporting) or at a fund/project level (i.e., fund accounting).
At the consolidated level, three types of financial statements are generally
included in external financial reports: the balance sheet, the operating statement
(similar to or also called the income statement and the statement of activities),
and the statement of cash flows. Similar financial reports can also be given at the
fund or project level.
2.1.1.1 The Balance Sheet
The balance sheet presents a snapshot of an entitys resources (assets)
and the claims on those resources (liabilities) as of a specific time. The asset
portion of the balance sheet reports the effects of the entitys investment
decisions, and the liability portion reports the effects of the entitys past financing
decisions. The balance sheet derives its name from the fact that it illustrates a
balance between the entitys assets and liabilities. Overall, it should provide a
picture of the entitys ability to meet short- and long-term debt.
The balance sheet recognizes the following four categories of assets
(Stickney 1996):
Current Assets: Assets that entities expect to consume within a year.
Capital Assets (Property, Plant, and Equipment (PP&E)): Tangible assets that
an entity uses in its operations over a period that exceeds one year.
Investments: Assets allocated into the equity of other entities.
15
Intangibles:
Non-physical assets that represent a resource to the entity.
Examples include goodwill and patents.

The liability portion of the balance sheet generally represents an entitys
obligations to make
payments of cash, goods, or services in a reasonably
definite future time for benefits or services received in the past (Stickney 1996,
10-11). Most commonly, liabilities are monetary and require payments of fixed
amounts of cash.
2.1.1.2 The Operating Statement
The operating statement provides information about the operating
performance of an entity during a particular accounting period, usually a fiscal
year. In business, as a measure of operating performance, the revenues reflect
the services rendered by the entity, and the expenses indicate the efforts
required or expended (Stickney 1996,14). In government, revenue raised has no
necessary relationship to who receives the services (Reed and Swain 1997, 21).
Moreover, in government the focus of the operating statement is on whether
sufficient revenues have been raised to cover annual costs incurred from
operations during an accounting period (Sacco 1996). As a measure of operating
performance, cost expended to generate public services therefore needs to be
related to some public-service outcome measure.
Of fundamental importance to the operating statements ability to provide a
measure of an entitys operating performance is the accounting method (or basis)
16
used to determine when transactions are recognized in the operating statement.

By definition, the accrual and consolidation model uses the accrual basis method
of accounting for recognizing these. Under this method, transactions are counted
at the time they happen regardless of when the money is received or paid (Martin
and West 2003).
Implicit in accrual accounting is its attempts to recognize economicresource flows, rather than cash or financial flows (as a result, accrual
accounting is sometimes referred to as resource-based accounting (Perrin
1998)). This means that it gives recognition to the
inter-generational
characteristics of financial transactions. Using accounting terminology, this is

often referred to as a total measurement focus (Sacco 1996). The recognition of
the inter-generational characteristics of financial transactions is exemplified in the
case of capital assets. The life-length of these assets spans, by definition,
beyond the current accounting period. Under accrual accounting the value of
these assets is, therefore, depreciated annually, based on their estimated
productive life-length. That is, an expense amount is attributed to the assets
annually to reflect partial consumption of the overall value of the asset (i.e.,
depreciation).
The compliance and liquidity model uses the second principal method for
recognizing income and expenses - the cash-based method of accounting - in
which income is recognized only when cash is received or paid out. In contrast to
accrual accounting, the cash-based method of accounting only recognizes the
17
effects that financial transactions have on the current accounting period. Using
accounting terminology, this is referred to as a current measurement focus.
It should be noted that a third method of accounting exists - the modified
accrual basis of accounting. This method represents an in-between alternative to
the cash and the accrual accounting basis. In essence, it allows the entity to
recognize certain transactions on a cash basis and others on an accrual basis.
Because the modified accrual accounting basis is losing some of its prominence,
this dissertation is centered on contrasting cash and accrual accounting. For a
discussion of the use of this method in the public sector, see (Zimmerman
1977)).
2 .1.1.3 The Statement o f Cash Flows
The statement of cash flows reports for a period of time the net cash flow
(inflow vs. outflow) that results from an entitys operating, investing, and financing
activities (Stickney 1996). The statement of cash flows may be viewed as a
supplementary statement to the operating statement in cases where it is
prepared using the accrual basis method of accounting.
As previously
mentioned, accounting on an accrual basis does not necessarily coincide with

cash flows, as is the case under the cash-based method of accounting. Often,
cash expenditures precede the recognition of expenses and cash receipts occur
after the recognition of revenue, leaving entities vulnerable to cash shortages if
poorly managed (Stickney 1996).
As a result, the statement of cash flows
18
supplements the operating statement by providing users with information about

the ability of an entity to pay suppliers, employees, and other creditors.
The statement of cash flows identifies the following three types of cash
flows (Stickney 1996,19-20):
Operating: Cash flows associated with the selling of goods and the provision
of services.
Investing: Cash flows
associated with non-current assets, particularly
property, plant, and equipment.

Financing: Cash flows
generated from short- and long-term borrowing
(including the issuance of capital stock) to finance an entitys activities.

2.1.2 Managements Discussion and Analysis Section
The discussion and
analysis section of a financial report provides
management with an opportunity to discuss the annual results reported in the

financial statements and to reveal future plans and strategies. This part of the
financial report reflects management's subjective opinions about the entitys
operations and activities, and should therefore be read with reservation.
2.1.3 Audit Opinion
The audit opinion asserts the extent to which the information reported in the
financial statements provides a truthful reflection of the entitys financial activities
in all-important respects. Or using accounting terminology, it asserts that the
19
financial statements are accurate in all material respects. The audit opinion is
generally rendered by private accounting firms, and may take any of the following
four forms (Kell and Boynton 1992, 724-726):
An unqualified audit opinion. Provides assurance that an entitys statements

present fairly, in all material respects, the financial position of the entity as of
a particular date, and that the results of the entitys operations and its cash
flows conform with generally accepted accounting principles (GAAP).
A qualified audit opinion. States that except for the effects of the matters to
which the qualification relates, the financial statements present fairly, in all
material respects, the financial position of the entity as of a particular date,
and that the results of the entitys operations and its cash flows conform with
GAAP.
An adverse audit opinion. States that the financial statements do not present
fairly the financial position of the entity as of a particular date, and that the
results of the entitys operations and its cash flows do not conform with
GAAP.
A disclaimer of audit opinion. States that the auditor does not express an
opinion on the financial statements.
2.2
Governmental A ccounting and Reporting and Agency Costs

Governmental
accounting
and
reporting
and
the
subsequent
transparency they provide through the external financial reports are ultimately
20
aimed at reducing agency costs.5 Agency costs are those costs imposed to
ensure that principals (i.e., stakeholders) get their wishes fulfilled when they
delegate decision-making authority to agents (Smith 1991). Agency costs are
imposed because the delegation of decision-making authority creates a situation
in which principals cannot be assured that agents are acting according to their
wishes (i.e., because of the information asymmetry that follows from the
delegation of decision-making authority).
Two kinds of agency costs are affected by the provision o f external financial
reports monitoring expenditures and residual losses (Jensen and Meckling
1976). Monitoring expenditures are defined as those expenditures that are
imposed by a principal to control an agents activities. Residual losses are
defined as those losses that are imposed on a principal as a result of a disparity
between decisions taken by an agent and those that would coincide with the
wishes of the principal (for additional discussion of agency costs, see
(Zimmerman 1977,Ingram 1983,Gordon and Hamer 1983,Ingram 1984,Baber
and Pradyot 1984,Stiglitz 1991,Munro 1991)).
In theory, external financial reports contribute to the reduction o f these
types of agency costs by providing principals with information that allows them to
5 Although financial accounting information represents an important source of information for
stakeholders, it is by itself unable to entirely remove the information asymmetry between principals and
agents. This is true even if it is assumed that the financial reports fully purport what they are set out to
purport.
21
cost-effectively monitor the activities of those to which they have delegated

decision-making authority (i.e., the agents), both directly and indirectly. In the
public sector this has traditionally been assumed to be achieved most effectively
through the provision of information that allows principals to assess the extent to
which public agents comply with the budgetary mandate sanctioned by the
legislative process (Zimmerman 1977,Ingram 1984). The compliance and
liquidity model is generally regarded as providing such information most
effectively. By requiring (a) the preparation of separate sets of financial
statements for each budgetary purpose (i.e., fund-accounting), and (b)
recognition of resource flows based on the receipt or payment of cash (i.e.,
cash-based accounting),
it
allows principals to
trace
public entities
expenditures at a program level.

Over the past two decades, however, public-management reforms have
challenged the traditional assumption made about the information needs of
principals to governmental entities. These reforms have been aimed at
transforming public-sector organizations to operate more like businesses. This
means that governments should be cost-efficient, as small as possible in relation
to their tasks, competitive, and dedicated to pleasing the customer (Box 1999).
Correspondingly, it has been assumed that the users of governmental financial
reports also place a high value on information that allows them to hold public
entities accountable based on measures of operational performance (i.e.,
operational accountability).
With
its focus on
budget compliance, the
22
conventional governmental accounting and reporting model has been regarded

as insufficient in meeting these information needs (International Federation of
Accountants (IFAC) 1997). The accrual and consolidation model therefore is
increasingly seen as a viable option for more effectively meeting the information
needs of principals of public-sector entities. The large number of countries that
have moved towards adopting the model in the public sector over the past 15
years exemplifies this.
2.2.1 Arguments for the Accrual and Consolidation Model
The accrual and consolidation model has been argued, for two reasons, to
be superior to the conventional governmental accounting and reporting model in
providing information that allows users to hold public entities accountable based
on measures of operational performance (i.e., operational accountability). The
first is that it requires recognition of revenues and expenditures on an accrual
basis. Compared to cash-based accounting, accrual accounting is argued to
provide for a more accurate matching of the real costs involved in public-service
provision, due to the considerations it gives to the inter-generational
characteristics of financial transactions (i.e., inter-generational equity) (Kwon
1989).
The second reason is that it requires only one set of financial statements for
the entire entity (i.e., consolidated financial statements). The conventional
government accounting and reporting model requires a separate set o f financial
23
statements for each budget appropriation/fund (i.e., fund accounting).

Consolidated reporting has therefore been argued to provide for a more
comprehensive picture of an entitys operations. Consolidated reporting, it has
also been argued, provides users with a format with which they are more familiar
(Gaffney 1986,Brorstrom 1998). (Table 2.1 below, summarizes the principal
differences between the conventional government accounting model and the
accrual and consolidation model).
[Table 2.1: Differences between the Conventional and the Accrual and Consolidation
WFZHF.
Conventional Model
Accrual and Consolidation Model
Accounting Basis
Cash
Accrual
Measurement
Focus
Consolidation Level
Current (annual)
Total (inter-generational)
Fund-by-fund
Entity-wide
In opposition to these arguments, it has been said that the consolidated

format results in too much information loss due to the high level of aggregation at
which the financial data are presented (Herzlinger and Sherman 1980,Jones, et
al. 1985). It has also been argued that government operations are too diversified
to benefit from consolidation. Only entities in which overall economic activity is
the focus of users' tasks, it has been argued, benefit from consolidated financial
statements (American Accounting Association 1965,Ortman 1975,Patton 1978).
In regard to the superiority of the model in matching the cost of public-service
24
provision, concerns have been raised about the difficulty of accurately assigning
costs to public goods. These arguments find their roots in a century-long debate
about the merits of using the accrual and consolidation model in the public sector
(see,
(Hylton
1957,White
1975,Davidson,
et
al.
1977,Zimmerman
1977,Herzlinger and Sherman 1980,Brorstrom 1998)).

At this time, public-management reforms continue to provide strong support
for the use of the accrual and consolidation model in the public sector. The
assumption that principals of public entities place a high value on information that
allows them to assess operational performance is also getting continued support.
The move towards an accrual and consolidation model for accounting and
reporting in the public sector is therefore likely to continue, at least in the near
term (for a discussion, see (Sacco 2000)).
It should also be noted that the adoption of the accrual and consolidation
model is being driven by the belief that it will have a favorable impact on the
credit-quality ratings of public entities.6 Over the past two decades, favorable
credit-quality ratings have become increasingly important for public sector
entities, due to an increasing gap between available public funding and funds
6 For a fee, public entities may receive such ratings from credit-quality rating agencies, such as
Moodys, Fitch and Standard & Poors. Credit-quality ratings are used extensively in the investment
community as a surrogate measure for the riskiness of bonds (Kaplan and Urwitz 1979). They are
therefore an important determinant of an entitys ability to obtain external capital from capital markets at
low costs (i.e., the interest rate).
25
needed to properly meet public service obligations.7 For many public entities,
favorable credit-quality ratings may, therefore, have significant effects on their
long-term capital cost structure.8 Compared to the conventional governmental
accounting and reporting model, the accrual and consolidation model is viewed
by the major quality-rating agencies as providing a more reliable source of
information for assessing entities' credit quality (Finden 2001).
2.3 Reliability
While it is important to ascertain that users of external financial reports
receive the type of information they demand, it is also important that the
information that is being provided purports what it is set out to purport. That is,
that the information generated is reliable. If the reliability o f the information
provided in the financial reports is compromised, the reports will be a less
effective tool for reducing agency costs (both monitoring expenditures and the
residual losses). Several examples illustrate this:
7 A case in point is found in one of the largest public service expenditures categories - public surface
transportation services. In 1995, the U.S. Department of Transportation (DOT) reported that $49.9
billion in highway and bridge capital investment was needed in 1994 just to maintain 1993 conditions
and performance of the nation's highways. Additionally, they estimated that $68.2 billion in highway
investment was needed to provide a higher quality of service justified by direct benefits to highway
users (U.S. Department of Transportation October 27,1995). Total public spending on capital
improvements to highways and bridges was approximately $39 billion in 1993.
26
Cases in which principals suspect that financial reports suffer from a low
degree of reliability. In these cases, principals may either use alternative
sources of information to monitor the actions of their agents or simply
recognize the reduced reliability without compensating for it by collecting
additional information. The first scenario results in increased monitoring of
expenditures, in the form of costs associated with the collection of the
additional information. The second scenario increases the risk that residual
losses occur because the reduced reliability of financial accounting
information reduces the ability of principals to monitor the activities of their
agents.
Cases in which principals are unaware and/or uncritical of the fact that the
reliability has been compromised. In these cases, principals may act under
the perception that their capacity to monitor agents is greater than it actually
is. This potentially flawed perception can lead to residual losses if it causes
the principals to make sub-optimal decisions in protecting their resources.
2.3.1 How Is Reliability Compromised?

Within the realms of a particular accounting model (i.e., consistent with its
practices), the reliability of the information generated is compromised in two
principal ways. First, through constraints imposed on existing accounting
8 Bond yields have consistently been reported to correlate strongly with bond ratings, with high-rated
bonds selling at substantially lower yields than low-rated bonds (Hickman 1958).
27
measurement methods to fully purport what they are set out to purport. And
second, through the reporting discretion that a particular model provides in the
accounting process. A more detailed discussion of these two ways is provided
below.
2.3.1.1 Accounting Measurement Constraints and Reliability
Under the conventional governmental accounting and reporting model, the
constraints imposed on existing accounting-measurement methods to fully
purport what they are set out to purport are quite limited. The reason for this, of
course, derives from the fact that the purpose of this model is centered on
providing information about the extent to which agents have used appropriated
cash in compliance with legal mandates (i.e., a budget-compiiance focus). As
indicated above, the use of the cash-based method of accounting is by definition
able to provide such information.
The objective set out by the accrual and consolidation model is much more
complicated. The objective of this model is to purport/reflect underlying economic
conditions. At least three constraints may be found that reduce its ability to
achieve this objective. The first is the inability of existing accountingmeasurement methods to fully account for the dynamics of the environment in
which entities operate. Comprehensive explanations of this inability may be
derived from Hayeks writings on economic calculation and the problem of
knowledge (Hayek 1948a,Hayek 1948b,Hayek 1948c). In these writings, Hayek
28
dismisses the ability to fully account for the dynamics involved in economic
calculation on grounds that the required data are not readily available.
Knowledge, according to Hayek, provides the data from which the economic
calculus starts, and it is largely dispersed over time and place (i.e. private
knowledge that depends on particular circumstances). Hayek writes ...the
knowledge of the circumstances of which we must make use [to calculate] never
exist in concentrated or integrated form but solely as the dispersed bits of
incomplete and frequently contradictory knowledge which all the separate
individuals possess (Hayek 1948d, 77). The real problem then, according to
Hayek, is that the data from which the economic calculus starts are never for the
whole society given to a single mind which could work out the implications and
can never be so given (Hayek 1948d, 77). Thus, in Hayeks view the problem of
calculation is rooted in the notion that knowledge cannot be fully captured by a
single mind or model (in his writings, Hayek make a distinction between scientific
knowledge and knowledge of particular circumstances).9
The second constraint is an objectivity constraint. Accounting information
seeks objectivity, which in practice means that accounting transactions need to
9 In addition, to his knowledge argument, Hayek also argued that economic calculation was
constrained by the nature and the amount of concrete information required if ...a numerical solution is
to be attempted and the magnitude of the task which this numerical solution must involve to fully reflect
underlying economic conditions (Hayek 1948b, 153). In fact, Hayek argued that to fully reflect these
29
be verifiable. This need for verifiable information significantly reduces the number
of approaches available for accounting measurement. More sophisticated
approaches often require subjective judgments or calculation procedures that are
difficult to verify.
Finally, accounting measurement needs to be cost-effective. To seek more
accurate accounting measurement requires additional data collection and
analysis, which incurs additional costs. The accuracy of a particular accounting
number therefore tends to be inversely related to the extent that it is able to
reflect the underlying economic conditions.
The interaction of the three constraints is illustrated in Figure 2.1, below
(adapted from (Stalebrink and Gifford 2000)). As can be seen, increased
economic relevance is often associated with higher costs (i.e., a rightward
movement in Figure 2.1). In asset valuation, for example, invoice cost is the
most objective measure for cost information but perhaps the least economically
relevant, whereas the net present value of future benefit streams is often
regarded as the most economically relevant measure, but its estimation is open
to numerous subjective influences (appropriate discount rate, benefit valuation,
etc.) (the example is taken from (Stalebrink and Gifford 2000)).
(assuming it is possible) the amount of information needed would exceed the power of algebraic
analysis (Hayek 1948c).
30
Objectivity
Economic Relevance/Cost
[Figure 2.1: Trade-Off between Economic Relevance and Cost/Objectivit^
2.3.1.2 Accounting Discretion and Reliability

The second way that the reliability of financial reports is compromised is
through the reporting discretion that is inherent in financial reports.
This
discretion is often significant and introduces subjective choices into the

accounting process. An obvious example is the preparation of the management
discussion and analysis section of the financial report, where management
subjectively reports on the entitys activities with few restrictions.
There is also significant discretion inherent in the two above-mentioned
accounting and reporting models. In the conventional government accounting
and reporting model, this discretion has often been attributed to the opportunities
that the cash-based system provides the reporting entity to lim e the recognition
of revenues and expenses in the financial system (United States General
31
Accounting Office 1985,United States General Accounting Office 1993,Copley, et

al. 1997). For example, an entity may affect financial results simply by delaying
payments into a future accounting period.
By contrast, the reporting discretion in the accrual and consolidation model
has primarily been attributed to the discretion that this model allows in the
accounting-measurement process (Johnson 1966). Specifically, the reporting
entity is provided with a number of available accounting-measurement choices
and is, according to good accounting practice, expected to choose the method
that best reflects the underlying economic values.
The rationale behind providing entities with measurement discretion is often
attributed to the belief that the reporting entities themselves are most familiar with
the particular circumstances in which they operate. As a result, they are best
equipped to measure financial transactions. Hence, by allowing measurement
discretion in accounting measurement, it is believed that knowledge may be
incorporated more effectively into financial reports, thereby improving the extent
to which the reported financial data reflect underlying economic values (Johnson
1966,Wilson 2002).
Examples of measurement discretion inherent in the accrual and
consolidation model include:
32
1. capital depreciation choices, in which a choice is allowed between the

accelerated versus the straight-line depreciation method (Dhaliwal, Salamon,
and Smith 1982,Penno and Simon 1986);
2. inventory valuation choices, in which a choice is allowed between the LIFO
(last-in first-out) versus the FIFO (first-in first-out) method (Penno and Simon
1986);
3. choices that concern the treatment of investment tax credits, in which entities
may choose between the deferral versus the flow-through method (Penno
and Simon 1986); and
4. discretionary asset write-off choices, in which entities are given discretion to
adjust (i.e., write-off) for reductions in capital asset values that have resulted
from unforeseen events (discretionary asset write-offs often include inventory;
goodwill; property, plant, and equipment (PP&E); and restructuring charges)
(Francis, Hanna, and Vincent 1996).
2.3.1.2.1 Accounting Discretion and Reliability: The Human Factor

Reporting discretion compromises the reliability of financial data, to the
extent that it results in sub-optimal accounting choices. Such choices may result
from a number of factors that are inherent in subjective decision-making (for a
comprehensive account of these, see (Arkes and Hammond 1986). These
include:
33
Unawareness or Ignorance. Changes may have occurred in an entity's

operating circumstances that may validate a change in accounting practice. If
management is unaware of these changes a sub-optimal accounting choice
may result. Or worse, the entity may not have sufficiently qualified personnel
to handle the accounting process (i.e., unawareness of available accounting
choices and procedures).
Past Practice. A particular accounting choice may simply be the result of past
practice. For example, the choice of LIFO as the inventory valuation method
may be used on grounds that it has been used in the past, regardless of the
entity's operating circumstances.
Opportunistic Behavior. Accounting choices may also be exercised based on

opportunistic behavior. That is, an accounting choice is made as a means of
gaining an advantage. Opportunistic behavior in this regard may be defined
as accounting choices made to influence reported financial results as a
means of positively influencing the perceived performance of the entity. The
underlying incentive for such behavior has been attributed to an entitys
wishes to impress external stakeholders by means of its reported earnings
(Dye 1988).
2.4
Earnings Management
As indicated in the introductory chapter, this dissertation is focused on the
influence of the last of the above three human factors." That is, the opportunistic
34
use of financial reporting discretion to influence the manner by which an entity is

portrayed in its external financial reports. Moreover, it is limited to the study of
earnings management as it relates to the accounting-measurement discretion
inherent in the accrual and consolidation model.
Opportunities
for
earnings
management
under the
accrual
and
consolidation model arise primarily from the reporting discretion that it provides in
the accounting-measurement process (Johnson 1966). Specifically, the reporting
entity is provided with a number of available accounting-measurement methods
in determining the size of its revenues and expenses. As previously explained,
the entity is expected, according to good accounting practice, to choose the
method that best reflects 'its underlying economic conditions. The next chapter
provides a literature review of existing studies that have examined the extent to
which this discretion is exercised opportunistically.
3.1
LITERATURE REVIEW
Empirical Context
As indicated in Section 1.2, empirical interest in earnings management has
mainly been centered on commercial entities. The existing studies have been
stimulated by a combination of factors. These include:
1. Anecdotal evidence reported in the popular press that managers of
commercial firms exercise reporting discretion opportunistically (Benway
1985,Mims 1986,Berton and Miller 1986,Smith and Lipin 1994,Grover
1992,Linden 1990,Strong and Meyer 1987,Berton and Miller 1986,Zucca and
Campbell 1992). The most significant of these cases include the Kreuger
debacle in the 1930s (see (Glete 1975,Flesher and Flesher 1986) and the
recent downfall of the Enron Corporation.
2. A peak in the magnitude and number of asset write-downs and write-offs by
commercial firms during the mid-1980s (see (Strong and Meyer 1987,Berton
and Miller 1986,Zucca and Campbell 1992,Francis, Hanna, and Vincent
1996)).
36
3. Concern about the need to further constrain the discretion inherent in the
accrual and consolidation model to prevent earnings management (Berton
and Miller 1986,Elliot and Shaw 1988,Francis, Hanna, and Vincent 1996).10
The resulting empirical evidence may be classified into three categories.
First, there is a category of studies attempting to document why managers might
rationally want to smooth their firms income (referred to as income-smoothing"
studies) (Hepworth 1953,Beid!eman 1973,Lambert 1984,Trueman and Titman
1988,Dye 1988). The second category examines the extent to which tax
considerations affect firms financial accounting choices (Dopuch and Pincus
1988,Gramlich 1991,Dhaliwal, Frankel, and Trezevant 1994,Cloyd, Pratt, and
Stock 1996)). A final category examines existing incentives for managers to use
income-increasing and income-decreasing accounting practices in their non-tax
financial statements (Bowen, Noreen, and Lacey 1981,Dhaliwal, Salamon, and
Smith 1982,Penno and Simon 1986,Strong and Meyer 1987,Elliot and Shaw
1988,Francis, Hanna, and Vincent 1996,Rees, Gill, and Gore 1996).
10 In practice, the response to these concerns has been limited. The only effort to constrain reporting
discretion in the corporate-styfe accounting and reporting model that was found as part of this literature
review was FASB's issuance of SFAS No. 121: Accounting for the Impairment o f Long Lived Assets
and for a Long Lived Assets to be Disposed Of in 1995 (Financial Accounting Standards Board (FASB)
March 1995). This standard was intended to reduce managements discretion over the timing and
amount of asset write-downs. However, due to the absence of quoted prices for many firm specific
assets, SFAS was viewed to have a very limited effect on managers discretion over the timing and
amount of asset write-downs (Rees, Gill, and Gore 1996).
37
All three of these categories of studies have generally used a similar

research approach. Regression models have been used to test for the
relationship between proxies for opportunistic behavior and select accounting
choices that provide opportunities for earnings manipulation. Hence, the studies
have equated earnings management with opportunistic behavior. Moreover, the
regression
models developed are centered on the study of earnings
management as it relates to isolated opportunities for it. Hence, the dependent

variables in the models are represented by those accounting choices that provide
opportunities for earnings management.
The most commonly examined opportunities for earnings management
have included:
Capital depreciation choices, by which a choice is allowed between the

accelerated versus the straight-line depreciation method (Barefield and
Comisky 1971,Dhaliwal, Salamon, and Smith 1982,Penno and Simon 1986);
Inventory valuation choices, by which a choice is allowed between the LIFO

(last-in first-out) versus the FIFO (first-in first-out) method (Sunder
1973,Penno and Simon 1986,Dhaliwal, Frankel, and Trezevant 1994);
Choices that concern the treatment of investment tax credits, by which

entities may choose between the deferral versus the flow-through method
(Penno and Simon 1986);
38
Pension accounting choices, in which entities are given significant discretion

in determining the size of their annual pension costs (i.e., the annual amounts
that entities are required to put aside to meet their future pension payment
obligations); and
Asset write-off choices, in which entities are given discretion in adjusting for
reductions (i.e., writing-off) in capital asset values that have resulted from
unforeseen events (common asset write-offs include accounts receivable,
inventory, goodwill, property, plant and equipment) (Francis, Hanna, and
Vincent 1996).
3.2 Earnings Management within Commercial Entities: Empirical Findings

In the context of commercial entities, studies on earnings management
have often indicated that earnings management occurs when accounting choices
have economic consequences for the entity or for individuals within the entity.
Factors identified to drive earnings management include (Hagerman and
Zmijewski 1979,Bowen, Noreen, and Lacey 1981,Holthausen and Leftwich
1983,Strong and Meyer 1987):
Tax savings: In the commercial sector, entities may avoid taxes by minimizing
reported earnings. Incentives therefore exist for commercial entities to
engage in earnings management to maximize costs (Oopuch and Pincus
1988,Gramlich
1991,Wolfeon
1993,Dhaliwal,
Frankel,
and
1994,Cloyd, Pratt, and Stock 1996).
Trezevant
39
Incentive plans: Managers of commercial entities are often allowed to share

profits in excess of some target level, stated in terms of accounting income, or
a rate of return on the book value of the assets of the firm (i.e., managementcompensation plans) (Holthausen and Leftwich 1983). When such plans are
in effect, economic incentives exist for managers to engage in earnings
management to inflate reported earnings.
Earning ceilings: Earning ceilings are imposed on some industries to prevent

firms from taking advantage of too strong a market position (e.g., utilities
companies are often subject to rate-of-retum regulations). These ceilings are
often based on reported book values that, if exceeded, result in adjustments
in the prices of the specific service provided (Holthausen and Leftwich 1983).
Incentives therefore exist for firms that are exposed to earning ceilings to
minimize their earnings, by means of eamings-management practices. These
incentives are particularly great when an entity runs the risk of exceeding the
ceiling. It should also be noted that industries or firms that are not yet subject
to price ceilings have incentives to reduce their earnings by engaging in
earnings management. This allows them to preserve a low degree of political
visibility, which reduces their risk of becoming subject to future government
regulations (Holthausen and Leftwich 1983).
Credit ratings: Firms may be argued to have incentives to engage in earnings

management to inflate their earnings to enhance credit ratings (Kaplan and
40
Urwitz 1979,Ingram, Brooks, and Copeland 1983,Cluff and Famham

1984,Ederington 1985,Loviscek and Crowley 1990).
Competition (Hagerman and Zmijewski 1979): Earnings management may

also be geared to reducing the risk of new competitors entering an industry or
a particular market segment.
An entity that reports excessive earnings
signals to potential competitors that there is room for additional market

players. Hence, by reducing its earnings through earnings management an
entity may act to influence the competitive nature of the industry, and thereby
its own potentials for making profits.
3.2.1 A Summary of The Studies
Among the studies reviewed in this dissertation, the most convincing
support for earnings management has been generated in studies that have
examined income-smoothing.11 These studies provide unanimous support for the
thesis that firms opportunistically exercise reporting discretion to manage
reported results.
In regard to the remaining categories of studies, three of four
income-increasing studies and one of three income-decreasing studies provide

partial support for the thesis that firms opportunistically exercise reporting
discretion. It should be noted, however, that the reported effects in the studies
41
tend to be quite small. This section provides a summary of 12 studies that

provided the basis for the empirical context of this dissertation.
3.2.1.1 Income-Smoothing Studies
As indicated above, a number of empirical studies have consistently
documented that income-smoothing does occur (see, (Hepworth 1953,Beidleman
1973)). However, questions have been raised about the ability of these studies
to demonstrate the extent to which income-smoothing actually may be attributed
to earnings management. Three of the more recent income-smoothing studies
provide some insight into this issue. First, Lambert provides evidence in support
of the hypothesis that risk-averse managers who are precluded from borrowing
and lending in capital markets exercise income-smoothing in response to
contracts that provide the agent with monetary compensation for generating
stable income streams. The paper uses agency theory to construct an economic
model of the stockholder-manager relationship (Lambert 1984).
Lamberts findings are supported by a 1988 study by Dye. Using an
overlapping generations model, Dye illustrates that income-smoothing occurs
as a result of one shareholder generations attempt to impress the next
generation with the firms past performance (Dye 1988).
11 Strong evidence of earnings management may also be found in studies that examine the extent to
which tax considerations affect firms' financial accounting choices (See section 3.1). However, because
42
A third study by Trueman and Titman (Trueman and Titman 1988) extends
Lambert and Dye's finding by providing evidence that incentives also exist for
managers to smooth income independently of risk aversion or access to capital
markets.
3.2.1.2 Income-Increasing/Decreasing Studies
The studies that examine existing incentives for managers to use
accounting practices that either increase or decrease reported income have been
the most frequent set of studies in the area. To date, at least four incomeincreasing studies and three income-decreasing studies may be found in the
literature that empirically examine earnings management. These are summarized
below, starting with the income-increasing studies.
Strong and Meyer, 1987 (income-increasing): Strong and Meyer (Strong and
Meyer 1987) provide evidence that write-down decisions are associated with
changes in senior management and with poor past performance. The authors
conclude that write-offs are used to manage earnings but that the effect is
limited. They find stronger support for the hypothesis that write-offs are used to
signal to investors that management has taken action to eliminate those assets
generating little on no return. That is, that management uses the existing write
off discretion in attempts to reflect true asset values. It should be noted that this
tax incentives are unique to commercial entities, this category of studies was excluded from the
empirical context of this dissertation.
43
conclusion may be challenged on grounds that prior management may have

opportunistically postponed write-offs to hide even more severe losses.
Penno and Simon, 1986 (income-increasing): Penno and Simon (Penno and
Simon 1986) test the hypothesis that private firms are less likely to choose
income-increasing accounting alternatives for reporting purposes than are public
firms. Three types of discretionary accounting choices are tested: (1) accelerated
versus straight-line depreciation; (2) LIFO versus other cost-flow assumptions for
inventory; and (3) the deferral versus flow-through methods for the investment
tax credit. In the study it is assumed that accelerated depreciation, the LIFO
inventory method, and the deferral method of accounting for the investment tax
credit reflect the income-decreasing alternative for each accounting choice. The
empirical results indicate that private firms are significantly more likely to use
accelerated depreciation and LIFO than are public firms.
There was no
significant difference for the investment tax credit. Hence, partial support was
provided for the hypothesis tested in the study.
Dhaliwal, et al. 1982 (income-increasing): Dhaliwal, et als study (Dhaliwal,
Salamon, and Smith 1982) tests the hypothesis that there is no difference in the
accounting methods of management and owner-controlled firms. The foundation
for this hypothesis is grounded in Famas theory that managers of managementcontrolled firms bear the full cost of failing to maximize firm value and, thus,
would be reluctant to elect accounting methods that did not maximize the firms
value (Fama 1980). The evidence generated in the study contrasts their
44
hypothesis. They indicate that management-controlled firms are more likely than
owner-controlled firms to adopt accounting methods that result in increased or
early reported earnings. In the study, accounting discretion is represented by
firms choices of depreciation methods. Straight-line depreciation (as opposed
the accelerated depreciation) is assumed to represent the accounting choice that
leads to higher reported earnings. While the findings are statistically significant,
the reported effects are relatively small.
Bowen, et al. 1981 (income-increasing): Bowen, et als study (Bowen, Noreen,
and Lacey 1981) investigates the effect that management-compensation
agreements tied to reported earnings have on a firm's decision to capitalize or
expense interest associated with capital expenditures. Capitalizing interest
typically results in a short-term increase in reported profits. It is therefore
assumed in the study that incentives exist for managers to capitalize interest
when it is in their interest to inflate earnings. Their findings indicate that the
frequency of explicit management-compensation packages was not greater for
the interest capitalization group. Bowen, et als study supports the theory
developed by Fama (Fama 1980) that managers in commercial entities limit their
opportunistic behavior in making accounting-measurement choices because of
efficient markets.
Francis, et al., 1996 (income-decreasing): Francis, et al.s study (Francis,
Hanna, and Vincent 1996) explores whether discretionary asset write-offs are
explained by incentives for managers to manipulate earnings or are driven by
45
managerial attempts to reflect declines in the values of assets (write-offs

considered include inventory; goodwill; property, plant, and equipment (PP&E);
and restructuring charges). A regression model is developed based on proxies
for factors associated with (a) management incentives to take write-offs, and (b)
impairment of asset values. Proxies for the former include recent changes in
management and the current years earning performance. The second set of
proxies includes firms' past stock-price performances; industry-adjusted book-tomarket ratios; mean changes in firms' own book-to-market ratios over the five
years preceding the write-off year; and mean changes in firms' return on assets
(ROA), also .over the five years preceding the write-off year. The results indicate
that write-offs are explained both by management incentives and by the
impairment of asset values. The only exception to these results is that incentives
were found to play no or little role in determining inventory and PP&E.
Rees, et al., 1996 (income-decreasing): Rees, et als study (Rees, Gill, and
Gore 1996) seeks to determine whether reporting discretion associated with the
recognition of permanent asset impairments is used opportunistically by
management to manage earnings or to provide value-relevant signals to
investors. The evidence indicates that abnormal accruals in the year of asset
write-downs are significantly negative, suggesting that management act
opportunistically to improve future years reported earnings. Additional analysis
performed in the paper, however, reveals that the abnormal accruals in the write
down year remain in subsequent years, suggesting that the firms have
46
experienced a permanent shift in their accrual balances during the write-down

year. Hence, the study supports the notion that managers exercise discretion to
provide value-relevant signals to investors rather than for personal gain.
Elliot and Shaw, 1988 (income-decreasing): Elliot and Shaws study (Elliot and
Shaw 1988) examines the behavior of 240 firms that reported discretionary write
offs from 1982 to 1985. The study indicates that firms disclosing large
discretionary write-offs are systematically larger than other firms in their industry.
They are also more heavily leveraged. The evidence also indicates that firms
with large write-offs substantially underperform in their industries in the years
preceding the write-offs and in the write-off year (in terms of return on assets and
return on equity). Hence, the evidence supports the hypothesis that write-offs
are exercised by management in an attempt to reflect the loss in value or
productivity of assets, and therefore, not opportunistically.
3.3 Empirical Contribution: An Old Model in a New Context
The adoption by public-sector entities of the accrual and consolidation
model represents the use of an old and established model in a new context.
Historically, it has almost exclusively been used for the purpose of accounting
and reporting in commercial-sector entities (see (White 1975,Zimmerman
47
1977,Remis 1982)).12 The empirical contribution of this dissertation arises from

the fact that no studies have yet examined earnings management of publicsector entities in this new context. As indicated earlier, studies of earnings
management in the context of public-sector entities have been limited to the
context of the conventional compliance and liquidity model (for examples, see
(United
States
General Accounting
Office
1985,United
States
General
Accounting Office 1993)). This model provides for an entirely different set of
eamings-management opportunities than those inherent in the accrual and
consolidation model. Specifically, opportunities for earnings management under
the accrual and consolidation model arise primarily from the reporting discretion
that it provides in the accounting-measurement process (Johnson 1966). By
contrast, opportunities for earnings management under the conventional
governmental accounting and reporting model arise from the opportunities it
provides a reporting entity to time" the recognition of revenues and expenses
(United
States
General Accounting
Office
1985,United
States
General
12 The corporate-style accounting and reporting model may be traced as far back as to 1494 and
Luca Pacioirs explanations of the methodology involved in double-entry bookkeeping (Patioli 1458).
Littleton explains that double-entry bookkeeping provided an important stimulus to the development of
accrual accounting (also referred to as resource" accounting) and reporting by providing an efficient
mechanism for evaluating an entitys credit worthiness (Littleton 1933/1981). Furthermore, in the 19m
century the emergence of accounting standard-setting authorities contributed to the development of
uniform accounting practices in many industrialized countries. At this time, the corporate-style
accounting and reporting model as we know it has been used for well over 200 hundred years.
48
Accounting Office 1993,Copley, et al. 1997). The accrual and consolidation

model makes it much more difficult for entities to opportunistically time'' the
recognition of revenues and expenses because it focuses on the measurement
of economic resources and obligations (not just financial resources and short
term obligations) and changes in those resources and obligations (Copley, et al.
1997). In addition, conventional governmental accounting practices allow
governments, in many cases, to arbitrarily choose between full and modified
accrual accounting practices (for a problem discussion, see (Zimmerman 1977)).
They could also, in many cases, place long-term assets off the balance sheet.
METHOD
The method used to examine the above research questions is similar to the
method used in empirical studies of earnings management within commercialsector entities. Regression models are used to test for the relationship between
certain conditions in an entity's operating environment that may drive earnings
management and select accounting practices that provide material opportunities
for earnings management. The regression models developed are centered on the
study of earnings management as it relates to isolated opportunities it. Hence,
those accounting practices that provide opportunities for earnings management
are treated as dependent variables in the models. Conditions hypothesized to
drive earnings management include (a) financial condition, (b) public scrutiny,
and (c) political competition (i.e., the independent variables).
This chapter provides a more detailed overview of the methodology used in
the dissertation. Specifically, it (a) introduces the major assumptions made in the
study; (b) identifies the specific eamings-management opportunities examined in
the study and describes the process by which they were selected; and (c)
specifies the hypotheses that were tested.
49
50
4.1 Assumptions
Three basic assumptions are made in the study about the form and extent
to which earnings management occurs within public-sector entities that have
adopted an accrual and consolidation model.
The first is that earnings
management is tied primarily to elected officials' wishes to gain or extend

positions of political power rather than by financial rewards (Ingram and
Copeland 1986). This assumption is derived partly from the difficulty of
implementing monetary compensation plans in the public sector for the reasons
explained in Section 3.1.
It is also partly derived from the notion that public
agents are attracted to public service to pursue a public-service agenda rather

than for monetary reasons.
The second assumption is that earnings management in the public sector is
driven by internal demands. As explained in Section 2.1, governments are not
owned by external shareholders, and the citizenry lacks both the ability and the
incentives to allow for earnings management (i.e., external demands for earnings
management).
The final and perhaps most important assumption is that earnings
management is revealed through attempts to minimize costs. The following
contextual factors support this assumption:
(a) Source of revenue. As illustrated in Table 1.1 above, the principal source of
revenue for public entities is derived from taxes levied on the citizenry. These
51
revenues vary directly with tax rates determined by the legislature and the
well-being of the economy. From an eamings-management perspective,
public entities are therefore able to exercise very little influence on the
revenue side (i.e., the measurement discretion is limited on the revenue side).
(b) The changing nature of how financial success is defined within public entities.
As public-sector entities are trying to operate more like businesses, the
elimination of deficits as a financial objective is growing in importance. A case
in point is Sweden. Since 1999, Sweden has required its municipalities to
present an operating statement in which revenues at a minimum exceed
expenditures, i.e., reflect a surplus (Government Proposition 1996/1997:52).13
Earnings management targeted at cost minimization enhances the ability of
public entities to comply with these changing financial objectives.
(c) Lack of incentives for cost-maximizing eamings-management practices. The
incentives to engage in cost-maximizing eamings-management practices in
the public sector are limited. As explained in Section 1.2, these are largely
confined to the operating environment of commercial entities, where a
number of such incentives are present. Again, these include tax savings; a
reduction of the risk of additional competitors entering the marketplace; and
to avoid governmental regulations that may have adverse affects on the
ability of an entity to retain its earnings (e.g., price ceilings).
52
(d) Financial stress. Over the past two decades, public agencies have been
exposed to continuous budget cuts while simultaneously being expected to
do more with less. This has placed enormous strains on their ability to meet
budget requirements, let alone to generate surpluses. To improve an already
strained financial situation, it may therefore be argued that earnings
management is more likely to focus on cost minimization as opposed to
alternative earnings management objectives such as income-smoothing.
4.2 Dependent Variables
As indicated above, the dependent variables in the regression models
developed in the dissertation are represented by those discretionary accounting
choices that provide entities with eamings-management opportunities. The
selection procedure of these was based partly on previous evidence generated in
the commercial sector accounting literature and partly on conversations with
practitioners and experts.
The conversations held with the practitioners consisted of face-to-face
conversations, telephone and email correspondence with municipal financial
managers, and officers of localities in Sweden, New Zealand, and Australia (see
appendix for a listing of these).
13This requirement is argued to play an important symbolic role as it assists in avoiding the risk of
idealizing zero as a net income (Brorstrom 1998).
53
The conversations and correspondence were targeted at revealing

material" accounting categories that are important to consider when analyzing
reported results.
That is, accounting categories that may have a significant
impact on an entitys reported results. Direct discussion about earnings

management was avoided to reduce the risk of inhibiting a constructive dialogue,
which may result if it is implied that certain accounting practices are being used
to manage earnings. Correspondence was also held with experts who had been
involved
in
governmental
accounting
standards-setting
processes
and
implementation efforts of the accrual and consolidation model in a public-sector

context (see.appendix for a listing of these).
The following discretionary opportunities were highlighted in the dialogue
with practitioners and experts:
Asset write-offs:
Capital depreciation practices;
Changes in foreign currency:
Contributions to infrastructure investments; and
Accounting for pension obligations.

Of the above five categories, all but changes in foreign currency provide
opportunities for engaging in earnings management. A description of the

remaining four and their link to earnings management is provided below.
54
4.2.1 Asset Write-offs

4.2.1.1 Background
According to good accounting practice, a write-off amount is to be assigned
when an asset has been determined to be impaired." That is, when its book
value exceeds some measure of its fair value (Zucca and Campbell 1992).
Formally, this impairment is recognized in the financial records by decreasing the
book value of the asset in the balance sheet and by debiting an operatingstatement expense account.
According to generally accepted accounting
practices, the asset should in most cases be written down to the amount that
represents the remaining economic value.
The accounting literature identifies three categories of asset write-offs
(Zucca and Campbell 1992). First are write-offs of current assets that have lost
part of or their entire value. The general rule is that entities need to examine their
current assets periodically and adjust them (i.e., write off) to the lower of
replacement cost or market value. Examples of current assets that need to be
examined periodically for potential write-offs include accounts receivable that are
deemed non-collectible; changes in the value of inventories; and changes in the
value of marketable securities.
The second category of write-offs is for long-term assets for which disposal
has been contemplated (Zucca and Campbell 1992). An example of this is assets
that are being sold as part of a discontinued operation. Commonly, it is required
55
that these assets be written off when their book value exceeds their liquidation
value.
The final category of write-offs is often referred to as discretionary write
offs. These are write-offs of long-term assets for which the entity has made no
decision ... to dispose [of] the asset in question, but has come to the conclusion
(based on their own decision model) that the asset is impaired.
It plans to
continue to use and depreciate the asset and do not indicate any current intent to
sell the asset (Zucca and Campbell 1992)." Conditions that may motivate this
category of write-offs include (Strong 1986,Strong and Meyer 1987):
A change in the manner or extent to which the asset is used;
Physical damage;
Sudden and significant technological developments;
A decline in the need for the service provided by the asset;
A decision to halt construction of an asset before it is complete or in usable or

saleable condition; or
A change in the law or environment affecting the extent to which the asset
can be used.
4.2.1.2 Write-offs and Earnings Management

Accounting for asset impairments is often not specifically prescribed.
Generally accepted accounting principles (GAAP) often provide guidance to
56
entities with regard to making these write-off decisions at a very general level.
Common GAAP rules for write-offs include the following (Ministry of Finance
2002).
Assets must be written down if it is possible to objectively measure a

reduction in their value.
Assets must be reduced when it can no longer contribute to the entitys ability
to provide services at the level previously anticipated.
Assets must be written off if there is a total loss in their value.
Assets are to be written off in instances when they are destroyed, stolen, or
lost.
An asset that is written down or written off must be charged to an

appropriation in the period where the decreased value was determined.
Asset write-off amounts are not to be reversed.

Due to the subjective nature of these rules, significant discretion remains for
the entity in determining (a) under what circumstances write-offs are required; (b)
the size of the write-off amount; and (c) in which accounting period they should
be included. Therefore, write-offs provide an entity with significant opportunities
to engage in earnings management. Specifically, write-offs may be used to
manage earnings in two ways. First, earnings may be managed by postponing or
prematurely writing down an impaired asset. The postponement of a write-down
57
or write-off shifts a current expense (i.e., the write-off amount) to a future

accounting period and thereby contributes to higher profits. Conversely, a
premature write-down reduces the reported profit during a particular accounting
period. It reduces profits by an amount in excess of that which would have been
reported if the accounting-measurement discretion had been used fairly.
The second method by which write-offs might be used to manage earnings
is by making overly conservative (i.e., assigning an asset value below market) or
overly aggressive market valuations (i.e., assigning an asset value above
market) of assets considered for write-offs. This opportunity arises because the
determination of what represents a fair value is left to the discretion of the
reporting entity. Overly aggressive valuations of assets contribute to higher
profits because they reduce the write-off amount (i.e., the amount expensed).
Conversely, overly conservative valuations reduce profits because they increase
the write-off amount. Assessments of these market values tend to be particularly
subjective in the public sector due to the lack of secondary markets for public
goods.
4.2.2 Capital Depreciation Practices
Capital depreciation refers to the loss in economic value of an asset that is
associated with the aging of a capital asset, holding time constant (see, (Hulten
and Wykoff 1981,Fraumeni 1995,Hulten and Wykoff 1996), or, more specifically,
the reduction in the assets economic value resulting from wear and tear.
58
Depreciation needs to be distinguished from obsolescence. Obsolescence is a

decrease in the value of an asset because of the emergence of a new asset that
is more productive, efficient, and suitable for production (Fraumeni 1995).
Hence, obsolescence does not assume constant time, and thereby allow for
technological change. Rather than being categorized as depreciation costs, costs
incurred as a result of obsolescence fall under the category of discretionary write
offs, discussed above.
The accrual and consolidation model commonly allows for a choice
between two methods in accounting for the depreciation costs o f capital assets:
the straight-line and the accelerated depreciation method. Both of these
depreciation methods are based upon established standards o f the productive
life length of different capital asset categories. These life-length estimates are
used as a basis for annual depreciation charges assigned. The straight-line
depreciation method allocates equal depreciation charges across the life length
of the capital asset. The accelerated depreciation method allocates a relatively
larger fraction of the depreciation costs in the early years of a capital asset's life
and a smaller fraction in the later years. Comparatively, therefore, the straightline depreciation method results in lower depreciation costs in the early
depreciation years.
59
4.2.3 Depreciation Choices and Earnings Management

The accounting for depreciation costs provides discretion in two principal
ways. First, by choosing a particular depreciation method, an entity is able to
influence the size of the annual depreciation charges. As explained above, the
straight-line depreciation method results in lower depreciation costs in the early
depreciation years, and the accelerated method results in lower depreciation
costs in the later depreciation years. The commercial sectors accounting
literature has usually regarded the straight-line method to be the cost-minimizing
method (Barefield and Comisky 1971,Dhaliwal, Salamon, and Smith 1982,Penno
and Simon 1986). However, a sufficient condition for this to hold true is non
decreasing investments in fixed assets (Penno and Simon 1986). Given the past
two decades reduction in government expenditures, this assumption may not
hold true in a public-sector context.
However, by selecting a particular
accounting method for capital asset acquired during the current accounting
period, the discretion inherent in the accounting for depreciation costs may still
be used for eamings-management purposes. In addition, shifts in depreciation
methods used for capital assets that are already being depreciated provide
opportunities for earnings management. It is important to note, however, that
there are barriers that might prevent such shifts, as they have to be accompanied
with a plausible explanation attached in the financial report that is subject to the
approval of impartial auditors.
60
Second, some discretion also exists in determining the number of years

upon which the annual depreciation charges are based, given that firm
accounting rules have yet to be established for a particular category of capital
assets (in cases where the move towards the accrual and consolidation model is
still in the transition phase, these standards tend to be underdeveloped). Hence,
by choosing a longer depreciation term, the annual depreciation charges may be
spread across a longer time frame, thereby reducing annual depreciation costs.
4.2.4 Pension Obligations
4.2.4.1 Background
Pension obligations represent obligations to pay employees for benefits that
will accrue in the future. Over the past three decades, the inclusion of information
about these obligations in financial statements has grown in importance
(Dankner, et al. 1981). There are several reasons for this. The most important
include changes in the economic environment (for example, higher inflation and
interest rates), and significant increases in the amounts of pension assets and
obligations (Financial Accounting Standards Board (FASB) 1985). Due to these
changed circumstances, the traditional methods for pension accounting have
been exposed to growing criticism; they fail to recognize pension-related
obligations in the financial statements. Specifically, pensions have traditionally
been accounted for using two methods: terminal funding and the pay-as-you-go
method (Dankner, et al. 1981). Neither of these methods gives any recognition
61
to pension costs until employees actually retire. Under the terminal funding
method, a fund is established at the date of an employees retirement that is
actuarially equivalent to all payments expected to be made to the retiree under
the pension plan. Under the pay-as-you-go method, costs are recognized at the
time benefits are actually paid to the retired employee.14
With the transition to the accrual and consolidation model, public entities
are being required to account for pensions on principles that are more consistent
with the accrual basis of accounting. Specifically, they are being required to fund
pension obligations as each employee works out the service period involved. The
annual amount allocated to fund future payment obligations is commonly
recognized as an expense in the entitys operating statement (Brorstrom 1997).
Public entities are also being required to report their total outstanding pension
obligations in their balance sheets.
4.2.4.2 Valuation of Total Pension Obligations and Annual Costs
The determination of total outstanding pension obligations and the annual
amounts (i.e., expenses) to be allocated to meet future pension obligations are
based on some form of actuarial valuation. Actuarial valuation may formally be
defined as ... the process by which an actuary estimates the present value of
14 Under terminal funding, pension costs are not recognized until the date of the employees retirement
(Dankner, et al. 1981). At that time, a fund is established that is actuarially equivalent to ail payments
62
benefits to be paid under a pension plan and calculate the amount of the
employer contributions or accounting charges for pension costs (American
Institute of Certified Public Accountants (AICPA) 1968,105).
As implied by the definition, the employer needs to estimate the total
outstanding pension obligation. These estimations are based on some formula
that ultimately is aimed at determining the net present value (NPV) of the
projected benefit obligation. The specific measure is the difference between the
present value of the projected benefit obligation and the present value of the fund
assets available to pay benefits (Bryan 1997). However, because pension
benefits are defined in terms of uncertain future variables, the calculation of
these estimations (both the periodic pension expenses and pension liabilities)
requires the reporting entity to make a number of assumptions. The most
common of these include assumptions about the following (see, (Dankner, et al.
1981, 33-35,Gopalakrishnan and Sugrue 1995)):
Mortality rates: Pension benefits are generally paid only to employees who
have reached retirement. It is unlikely that all employees reach retirement
age, and there is also uncertainty about the actual number of years that
employees who have reached retirement will be collecting pension benefits.
Consequently,
when
the
projected
benefit
obligation
is
calculated,
assumptions need to be made with regard to mortality rates.
expected to be made to the retiree under the pension plan. Under the pay-as-you-go method, costs
63
Employee turnover Depending on the benefits plan, assumptions are

sometimes made about employee-tumover rates. This is necessary when
termination of employment before retirement age reduces or eliminates
pension benefits that would otherwise accrue.
Salary scales: If the pension plan is keyed to salary rates, then assumptions
need to be made with regard to the salary progression.
Interest-rate: The funds set aside to fulfill the pension obligations generate
investment incomes. Assumptions need to be made about the annual rate of
return generated by these funds. Recognition of future fund income is called
discounting for interest (Dankner, et al. 1981, 34)." For public-sector entities,
law sometimes establishes this discount rate. However, it is more common
that it be established based on some measure of the opportunity cost of
capital. That is, the cost of using capital for a certain purpose measured by
the benefit given up by not using them in their best alternative use.
Once the NPV has been established, the annual expense amount needs to
be determined. That is, the annual amount set aside to assure that the future
pension obligations are met. In determining this amount, two types of cost
methods are commonly accepted GAAP (Dankner, et al. 1981). First, the
accrued benefit-cost method, in which costs are assigned based on the principle
that pension benefits are earned as employees provide their services. A common
are recognized at the time benefits are paid to the retired employee.
64
example is when an employee gets assigned the right to retrieve a certain

amount of future pension benefits for each year of employment. The second
allocation method is the projected benefit-cost method, in which costs are
allocated to each year of service until an estimated normal retirement age has
been reached for the employee. The former of these cost-allocation methods
results in lower costs in the earlier plan years and larger cost in the later plan
years. This is due to the impact that the time-value of money has on the amount
allocated (i.e., the more years, the larger the effect of the discount rate).
4.2.4.3 Pension Obligations and Earnings Management
Both the assumptions that underlie the valuation of an entitys total pensioncost obligation and the selection of the cost-allocation method are made at the
discretion of the reporting entity. This discretion has been illustrated to have
significant potential for influencing an entitys reported earnings (Trowbridge and
Farr 1977).
Specifically, by making assumptions that result in a lower total
estimated pension obligation and by choosing the cost-allocation method that

results in the lowest cost, an entity may reduce its costs and thereby improve its
reported earnings (or vice versa).
4.2.5 Contributions to Infrastructure Investments
Contributions to infrastructure investments include contributions to be used
for investments in infrastructure by a company outside the realm of the
65
municipality.15 Contributions to infrastructure investments were revealed to be

material entries only in the accounting system used by Swedish municipalities.
Hence, these entries should be considered unique to Swedish municipalities.
Contributions to infrastructure investments provide opportunities for
earnings management in that they provide an entity with a choice as to the
amount of the contribution. The size of the contribution is equal to a reduction in
profits. It should be noted that these contributions are sunken costs.
Consequently, they are only useful from an eamings-management perspective if
it is beneficial for a manager to permanently reduce profits.16 For this reason,
they were not considered in the study to be a material eamings-management
opportunity. In sum, the dependent variables that were identified to provide public
entities with material eamings-management opportunities are:
(a) Write-offs;
(b) Capital depreciation charges; and
(c) Annual cost allocations to meet future pension obligations.
15 The motivation behind these contributions is to support the local or regional economy with
infrastructure investments that are considered not to occur otherwise.
16 This may be the case, for example, when a shift in management has occurred and incoming
managers want to show consecutive improvements in financial results. This is easier to achieve with a
low profit during the first year. The poor results may be attributed to poor previous management and
restructuring charges (Francis, Hanna, and Vincent 1996).
66
4.3
Three Models
To test for the propensity of the public sector to use the above-identified
material eamings-management opportunities to manage its earnings, three

models were developed. The first model considers the combined opportunities
provided by asset write-offs, capital depreciation practices, and pension costs.
This model is referred to as the aggregate discretion model." Specifically, it
examines the relationship between the aggregate discretion provided by the
above opportunities and conditions in an entitys operating environment that are
hypothesized to drive earnings management.
The second and third models use the same explanatory variables as the
aggregate model, but examine these in relation to particular accounting
practices.
Specifically, the second model considers them in relation to the
opportunities provided in the accounting for pension costs. And the second
model considers them in relation to the combined opportunities provided by asset
write-offs and capital depreciation practices. The combined treatment is a result
of a lack of disaggregated data on asset write-offs and capital depreciation
practices. In the remainder of the dissertation the latter two models are referred
to as the write-off/depreciation model and the pension cost allocation model.
4.4
Hypotheses
As explained above, the explanatory variables in the dissertation consist of
conditions in an entitys operating environment that may drive earnings
67
management. The accounting literature suggests a number of such conditions

that might be applied to a public-sector context. Some of these may be derived
from studies on earnings management in commercial-sector entities (see (Watts
and Zimmerman 1978,Hagerman and Zmijewski 1979,Bowen, Noreen, and
Lacey 1981,Holthausen and Leftwich 1983,Strong and Meyer 1987)). Others
may be derived directly from the literature, aimed at explaining the association
between economic factors and the evolution and adoption of accounting
practices in the public sector (see (Zimmerman 1977,Baber and Pradyot
1984,Ingram 1984)). In this study, four conditions build the foundation for the
hypotheses .developed in the study. These include financial condition, political
competition, and scrutiny.
4.4.1 Financial Condition
It may be argued that earnings management is an important tool for public
entities to influence their popular approval (for a discussion, see (Ingram and
Copeland 1986)).17 As explained above, financial accounting information
represents the most comprehensive source of information for holding public
entities accountable. In theory, it provides stakeholders with information that
allows them to assess the extent to which entities are fiscally responsible. By
using eamings-management practices that paint a favorable picture of their
17 In democratic societies, popular approval is a prerequisite for serving the public (Reed and Swain
1997,5). Public entities that serve the public poorly will ultimately be replaced. Conversely, public
entities that serve the public well are more likely to preserve or extend their positions of political power.
68
operations, public entities, it therefore can be argued, may positively affect their
popular approval (Ingram and Copeland 1986).
Financial accounting information is likely to reflect most positively (or least
negatively) on public entities, in cases where the operating statement indicates a
small surplus. Such a result provides assurance of the ability of public entities to
keep costs in line with their revenues (Gosling 1992, 130,United States General
Accounting Office 1985,United States General Accounting Office 1993). This
signals that the entity is behaving in a fiscally responsible manner. A surplus that
is too large can easily become a target of criticism. Gosling explains that
detractors can point to large surpluses as evidence of political irresponsibility
and accuse policy makers of excessive taxation (Gosling
1992, 139).
Conversely, deficits call into question the managerial competence of the entity.
The first hypothesis in this dissertation explores whether an entitys financial
condition influences its propensity to engage in earnings management. In the
dissertation, financial condition refers to the ability of the entity to balance its cost
with its revenues.
Specifically, it is hypothesized that big bath" accounting
practices are used by public entities to enhance their prospects of reporting

balanced results. Big bath accounting practices are often described as dumping
additional costs on already poor results (Berton and Miller 1986). Anecdotal and
empirical findings in the context of commercial-sector entities provide dear
indications that negative earnings (i.e., losses) are viewed as an opportunity to
69
dump additional costs (Berton and Miller 1986,Linden 1990,Grover 1992).18The

rationale for this behavior is founded in the notion that the marginal effect of
additional losses on stakeholders perceptions (of the ability of an entity to
conduct its operations) diminishes with the size of the losses. Concentrating
losses to one accounting period may therefore be argued to have positive overall
effects on stakeholders' perceptions because this sets the stage for future
accounting periods (i.e., a form of income-smoothing").
In this dissertation, big bath" practices are expected to occur when entities
are experiencing excessive deficits as well as when they are experiencing
excessive surpluses. Hence, a symmetric big bath theory is developed and
tested.
The motivation for using big bath practices in the latter case is argued to
arise from the unique financial objectives of public-sector entities. As indicated
above, the financial objectives of public-sector entities are focused primarily on
keeping costs in line with revenues. By definition, therefore, excessive surpluses
do not necessarily affect popular approval positively. It may, therefore, be
beneficial for public entities to dump costs during accounting periods when
excessive surpluses arise, thereby setting the stage for cost minimization in
accounting periods when there is a greater likelihood of meeting the financial
objectives (i.e., when the divergence between cost and revenues is smaller and a
18 According to good accounting practice, these costs may more appropriately be allocated to future
accounting periods.
70
balanced result is within reach). Consequently, in this dissertation excessive

deficits and excessive surpluses are expected to be positively associated with
the size of write-offs, depreciation expenses, and annual costs allocated to meet
future pension obligations. That is, a U-shaped, or second-order, relationship is
expected between reported results and costs associated with the above identified
eamings-management opportunities. Explicitly stated, the first hypothesis is as
follows:
H1: Excessive deficits and surpluses are positively related to the size of write
offs, depreciation expenses, and annual costs allocated to meet future pension
obligations.'
It is important to note that the above hypothesis assumes that financial

information reaches the citizenry and is being read. Traditionally this assumption
has been questionable. However, the adoption of the accrual and consolidation
model has been argued to significantly enhance the potential for governmental
accounting information to reach the citizenry (see (Copley, et al. 1997)). This
has attributed to its more familiar format and its ability to generate more value
relevant signals to users (see Section 2.2.1). The accrual and consolidation
model is also argued to economize more effectively with information provided.
The conventional governmental accounting and reporting model has been
argued to provide too much and too segmented information to allow for intelligent
analysis (Herzlinger and Sherman 1980). Hence, with the reduction of this
71
information barrier, a stronger argument may be made that governmental

accounting information, at least partly, influences constituents perceptions of the
ability of public entities to conduct their operations.19
4.4.2 Political Competition
Political competition refers to the strength of the opposition expected in
future elections (Baber and Pradyot 1984). A strong opposition increases the
probability of political administrative change.
That is, the probability that an
elected official, a majority party, or coalition is replaced.
In the case of
mandates, political competition increases the relative importance of single

mandates. The most extreme example of this, of course, is when close elections
result in an evenly divided number of mandates among governing parties. In this
situation, a single mandate often plays a critical role in the political process.
Because political competition increases the
probability of political
administrative change, it increases those costs imposed on public entities that

are associated with a failure to satisfy constituents (e.g., political costs) (Baber
and Pradyot 1984). Given that a public entitys reported financial results influence
the publics perception of its ability to fulfill its obligations, the reported results will
play a relatively more important role in politically competitive environments.
19 Governmental accounting information generally reaches the citizenry indirectly through monitoring
agents, such as citizen groups or the media. It may also reach them through the ability of individual
citizens to derive decision-useful information on their own, albeit this is more unlikely (Brenner 1971).
72
From an eamings-management perspective, political competition may therefore

be argued to drive public entities propensity to engage in earnings management.
Hence, in this study it is expected that public entities that are exposed to political
competition are more likely to inflate their earnings by means of eamingsmanagement practices than are those exposed to less political competition.
Explicitly stated, the second hypothesis is as follows:
H2: Political competition is positively related to the size of write-offs, depreciation
expenses, and annual costs allocated to meet future pension obligations.
4.4.3 Scrutiny
As explained in the introductory chapter, in theory, it may be that public
information about governments is exposed to less scrutiny than similar
information released about commercial entities. Public agents are therefore able
to more easily engage in earnings management without such attempts being
revealed. Again, this argument is based on the notion that stakeholders in public
entities have fewer incentives than their counterparts in the commercial sector to
monitor agents, due to the lack of private property rights (i.e., the limited amount
of personal property that is invested in public entities) (von Mises 1935,Vaughn
1980,Kirzner 1996).
In the commercial sector, a large body of empirical evidence supports the
above theory (Fama
and
MacBeth
1973,Black,
Jensen,
and
Scholes
73
1972,Stalebrink 1997). Formally the theory is referred to as the efficient markets

hypothesis (EMH) (Bodie, Kane, and Marcus 1996, 3). Under the EMH, scrutiny
is viewed as being imposed on agents by capital markets. In relation to earnings
management, these markets would be viewed under the EMH as an important
factor in disciplining agents (i.e., constraining them) to not exercise reporting
discretion opportunistically (Zimmerman 1977,Fama 1980,Sta!ebrink 2002). The
underlying logic is that in a competitive financial environment, investors have the
ability to see through agents attempts to manipulate earnings (Holthausen and
Leftwich 1983). Successful eamings-management strategies therefore selfdestruct, and the benefits of engaging in earnings management become
doubtful (Kaplan and Roll 1972,Bodie, Kane, and Marcus 1996, 3).
The EMH operates at different levels of strength. At its strongest level, the
EMH suggest that all influences of earnings management are discounted for by
analysts because they are able to see through and anticipate all possible
eamings-management attempts. In its weaker versions, the EMH suggests a
partial ability among analysts to see through and these attempts. In relation to
earnings management, a likely result of the weaker versions of the EMH is that
analysts not only discount earnings manipulation (albeit more arbitrarily than in
the strong version), but also seek out alternative and more reliable sources. Both
of these reactions reduce the effectiveness of the intended outcome of earnings
management, thus reducing the incentives for entities to engage in earnings
management.
74
Despite their limited private property rights, public entities are by no means
exempt from scrutiny. The disciplinary effects that are argued to arise from
capital markets may be argued to arise in a public-sector context, as well, albeit
on a smaller scale. In this dissertation, it is argued that this scrutiny is directly
related to individual public entities relative dependency on external capital. Using
the same logic as in the above the argument, it can be stated that the disciplinary
effects imposed by capital markets are expected to be less effective when public
entities have a low level of dependency on external capital. Consequently, it is
expected that the propensity of public entities to engage in earnings
management is positively related to their relative dependence on external capital.
Over the past two decades, this argument has become particularly strong as the
gap between available public funds and the funds needed to properly meet
public-service obligations have grown. To close this gap, public entities have
become increasingly dependent on raising capital on publicly traded bond
markets. Correspondingly, the scrutiny imposed by capital markets on public
entities has grown in intensity. Explicitly stated, the third hypothesis of the
dissertation is as follows:
H3: Public entities relative dependency on external capital is positively related to
the size of write-offs, depreciation expenses, and annual costs allocated to meet
future pension obligations
75
Similar to the above argument, it may also be argued that constituents

discipline prevents public-sector agents from engaging in earnings management
by gathering information as a means of staying involved in the political process.
Again, the EMH suggests that this occurs through the ability of analysts to
discount the effects of earnings manipulation or partially discard the usefulness
of the information (i.e., turn to alternative information sources). In a public-sector
setting, it may be unrealistic to expect that individual citizens systematically
analyze financial information as a means of staying involved in the political
process. For individual constituents the benefits of obtaining accounting
information as a means of monitoring public agents are often small because the
possibility of successful individual action, either through voting or lobbying, is
remote (for a discussion, see (Gaffney 1986)). A rational individual will only
invest the time and money in obtaining and processing information when the
benefits of doing so outweigh the costs. Based on this logic, constituents would
not scrutinize public entities based upon publicly available financial information
due to the unfavorable cost-benefit ratio.
However, as Gaffney pointed out, once constituents organize the costbenefit incentives of obtaining and processing governmental accountinginformation changes, organizations increase the possibility for successful action
(also see, (Downs 1957,Gaffney 1986). A more realistic scenario, therefore, is
that constituents discipline public entities indirectly though information filtered to
76
them by organized groups. Examples of such groups include citizen groups and
the media.
An additional argument that further strengthens the argument that the
constituency may
discipline public agents, arises from the emergence of
political costs associated with earnings management. If revealed, earnings

management may compromise the trust and goodwill of an entity, and thereby
its popular approval. Therefore, it may be argued that public entities may have a
lower propensity to engage in these practices in high-scrutiny environments on
the grounds that earnings management is more likely to be revealed. Hence, not
only may scrutiny compromise the effects of earnings management it may also
affect political costs. Given this, the fourth hypothesis of the dissertation is as
follows:
H4: Scrutiny imposed on public entities by the citizenry is positively related to the
size of write-offs, depreciation expenses, and annual costs allocated to meet
future pension obligations
DATA COLLECTION AND SAMPLE SELECTION
Two principal data sources may be used to examine earnings management

in the context of public-sector entities that have adopted an accrual and
consolidation model. First, it may be examined with data collected from financial
statements generated prior to the past two decades reforms. Conventionally,
governments have been required to report on their proprietary activities (i.e.,
business-type activities) using enterprise funds." Similar to the accrual and
consolidation model, these funds generally require entities to account for their
revenues and expenses on an accrual basis. Many of the eamings-management
opportunities that exist in the accrual and consolidation model are therefore also
present in the accounting for proprietary activities and, thus, make them a
potential source for an eamings-management study.
The advantage of using data collected from financial statements generated
prior to the reforms is the availability of the data. Governments have accounted
for and reported publicly their proprietary activities on an accrual basis for
decades (see (White 1975)). A major disadvantage of using this data, however,
is that it is difficult to isolate those eamings-management opportunities that arise
in the accounting for proprietary activities from those that arise in the accounting
77
78
for government-type activities. The former uses the accrual basis of accounting,
and the latter the cash basis of accounting. As mentioned above, these two
bases provide for a different set of eamings-management opportunities.20
An alternative and more reliable source of data are financial reports
generated by public-sector entities that have already established accounting
practices based on the accrual and consolidation model. These include New
Zealand, Australia, the United Kingdom, Spain, Iceland, Sweden and Canada.
However, the provision of reliable financial data from these countries generated
under the accrual and consolidation model is limited. The most important reason
for this is that the majority of the above-mentioned countries are yet to fully
implement the accrual and consolidation model.
That is, they are still in a
20 The accrual basis provides eamings-management opportunities through the discretion it allows in the
accounting-measurement process. By contrast opportunities for earnings management under cashbased accounting primarily arise from the opportunities it provides entities to timethe recognition of
revenues and expenses (i.e., discretion in determining which accounting period a particular revenue or
expense is to affect (see, (United States General Accounting Office 1985,United States General
Accounting Office 1993,Copley, et al. 1997)). The accrual basis makes it much more difficult for entities
to opportunistically time" the recognition of revenues and expenses. Copley, et al. attributes this to the
fact that accrual accounting focuses on the measurement of economic resources and obligations (not
just financial resources and short-term obligations), and changes in those resources and obligations
(Copley, et al. 1997). Conventional governmental accounting practices also allow governments, in
many cases, to arbitrarily choose between full and modified accrual accounting practices (for a problem
discussion, see (Zimmerman 1977)) and gives them a lot of latitude in placing long-term assets off
balance sheet"
79
transition phase. The limited availability of public financial data makes studies
based on data collected from financial reports generated by public-sector entities
that have already established accounting practices based on the accrual and
consolidation even more rare.
An exception is found in the publication of financial data for Swedish
municipalities. The Swedish municipalities started their transition to the accrual
and consolidation model in 1986, based on recommendations issued by The
Swedish Association for Local Authorities and the Federation of Swedish County
Councils (Brorstrom 1998). At this time, the majority of Swedish municipalities
account for their activities using the accrual and consolidation model. Statistiska
Centralbyran
(SCB), the principal statistical authority in Sweden (see,
www.scb.se). has made available in standardized form municipal financial data

generated under the accrual and consolidation model for fiscal 1998, 1999 and
2000.21 Data for 2001 is yet to be published. While the available data is not
comprehensive enough to allow for time-series analysis, it provides a good basis
for a cross-sectional study.
In addition to the availability of financial data, the Swedish case is
interesting for three additional reasons. First, SCB provides a number of
additional data sources that may be used to reflect those factors that are
hypothesized in the dissertation to drive earnings management.
80
Second, the case of Swedish municipalities provides a situation in which

financial reports are made highly accessible for public scrutiny.
Swedish
municipalities are by law required to publish their financial reports online. They
also need to be available free of charge in hard-copy format directly from the
individual municipalities.
Finally, the Swedish case is likely to serve as a good basis for drawing
conclusions beyond Swedish municipalities. The Swedish case holds a number
of characteristics similar to other countries that have adopted or are adopting the
accrual and consolidation model in the public sector. These include:
Reform rationale. As mentioned in the introductory chapter, the accounting

reforms in Sweden have been instituted to complement and counterbalance
expanded managerial flexibility within public-sector entities that have resulted
from extensive public-management reforms. This has also been the case in
the accounting reforms undertaken in Spain, New Zealand, Australia, the
United Kingdom and Canada (see (Kettl 1997,Senge 1990,Gifford and
Stalebrink 2001)).
Financial condition. Swedish municipalities have been struggling financially

due to significant reductions and reallocations of state tax monies. Because
of significant policy changes in 1995, Swedish municipalities saw a cut in
21 Local governmental accounting in Sweden is performed under an almost identical accounting and
reporting model to the one used in the commercial sector.
81
contribution from the state of 8 billion Swedish Kronor (SEK), at the same
time a larger fraction of the monies were allocated to larger urban areas. The
budget cuts took effect in 1996 and represented approximately 2% of the total
Swedish municipal expenditures (Brorstrom 1997, 56). Similar events have
also occurred internationally; at the same time taxpayers have made it clear
that general tax increases are not acceptable (Gosling 1992,130)
Financial objective. Swedish municipalities represent a case in point of the

changing nature of how financial success is defined within public entities.
That is, a larger emphasis placed on eliminating deficits. Starting in 1999,
Sweden requires its municipalities to present an operating statement in which
revenues at a minimum exceed expenditures, i.e., a profit (Government
Proposition 1996/1997:52). As mentioned in Section 4.1, this definition is also
changing internationally.
5.1
Data Specifics22
The data used in the study consist of pooled data for fiscal 1998, 1999, and
2000, published by SCB. In all three fiscal years, the municipal financial data
include all the 288 Swedish municipalities.
Consequently, the raw data set
consists of 864 observations.
22 The information provided in this section was collected from the data-description document
published on SCB's website (www.scb.se).
82
SCB collects the financial data with an electronic survey in MS Excel

format. Municipalities are required to respond to the survey. To assure data
accuracy, the survey has preprinted data and auditing controls.
A common
auditing control is the use of key financial ratios to identify large discrepancies
across accounting periods. If such discrepancies are found the municipalities are
required to attach a commentary. SCB also follows up with most of the
municipalities to get supplementary information. The final database includes the
following three types of information for each municipality :
1. Information on the major account categories in each municipalitys balance
sheet;
2. Information on the major account categories in each municipality's operating

statement; and
3. A number of key financial ratios.
The financial data for the account categories in the balance sheet and the
operating statement are available both on a per-capita basis and in total
numbers. For example, data on tax revenues collected by a particular
municipality are available either as a measure of its total tax revenues or as a
measure of its total tax revenues divided by each municipalitys population.
No information was available with regard to audit opinions. Information on
audit opinions is important to consider because it indicates how well
municipalities conform to generally accepted accounting principles. Data on audit
83
opinions, therefore, affect our ability to assess the reliability of the data. In lieu of
such data, a sample of 25 municipal financial statements was collected to get a
general indication of the extent to which Swedish municipalities pass their audits.
Among the collected financial statements, all had passed with an Uunqualifiedn
audit opinion.
The influence of the lack of data on auditing opinions on the
overall data quality was, therefore, determined to be small.

5.1.1 Dependent Variables
5.1.1.1 Asset Write-offs and Capital Depreciation Practices
The data on the size of the individual municipalities asset write-offs and
capital depreciation practices were collected directly from the information that
SCB collects from the municipalities operating statements. As mentioned above,
the data on the size of permanent discretionary write-offs and depreciation
charges were only available as a combined measure. To allow for comparability
across municipalities, the combined data on these were collected on a per capita
basis.
5.1.1.2 Annual Cost Allocated to Meet Future Pension Obligations
As explained above, annual pension expenses are largely determined
based on (a) the choice of the cost-allocation method used and (b) the
assumptions that underlie the determination of the NPV of the total outstanding
pension obligation. Swedish municipalities are not given a choice as to the cost-
84
allocation method. GAAP require them to allocate annual costs to meet future
pension obligations based on the accrued benefit-cost method (Brorstrom,
Eriksson, and Haglund 2001, 58). That is, costs are assigned as pension benefits
are earned.
Consequently, no discretion is provided to the individual
municipalities in regard to the choice of cost-allocation method. However,

significant reporting discretion remains for Swedish municipalities in determining
the size of the annual pension expenses. Significant latitude is given to them in
establishing the assumptions that underlie the calculation of the NPV of the total
outstanding pension obligation.
The data on the size of the total estimated pension cost obligations were
gathered directly from the information that SCB collects from the municipalities
operating statements. Again, to allow for comparability across municipalities,
they were reported on a per capita basis.
5.1.2 Independent Variables
A number of proxies were identified for the above- cited drivers of earnings
management. Control variables and proxies that may be related to the identified
eamings-management opportunities were also identified. These were included in
the final models to control for existing differences among the municipalities. A
description of the proxies used to test the above hypotheses is provided below.
85
5.1.2.1 Big Bath Variables

As explained above, excessive deficits and excessive surpluses are
expected to be positively associated with big bath accounting practices. Or,
more specifically, excessive deficits and surpluses are expected to be positively
related to the size of write-offs, depreciation expenses, and annual costs
allocated to meet future pension obligations. Hence, a U-shaped" or curvilinear
relationship is assumed to exist between reported results and the size of write
offs, depreciation expenses, and annual costs allocated to meet future pension
obligations.
Per capita data on financial results of operations (i.e., surpluses or deficits)
were collected to test for this relationship. The data were gathered directly from
the information that SCB collects from the municipalities operating statements.
5.1.2.2 Proxy for Political Competition
Party competition was used as a proxy for political competition.
In the
political science literature, party competition refers to the closeness of the

outcome of elections (Stigler). In the context of Swedish municipalities, party
competition is likely to be a close proxy for political competition. The principal
reason for this is the relative importance that individual political parties play in the
political process in Sweden (including the municipal level). The political power
within Swedish municipalities subsists almost exclusively on the number of
political mandates that a particular party is awarded in the Town Assembly
86
(Stadsfuilmaktige). The allocation of these mandates is determined directly by

the percentage of votes that a party receives in an election. Moreover, the ability
of voters to participate in the political process through votes is essentially limited
to party voting. The system provides very limited opportunities for voting on
individual candidates.23
To develop a proxy for political competition, it is important to recognize that
the Swedish political system often operates as a coalition party system.
In
essence, it consists of two possible coalitions, represented by the two left-wing

parties on the one side and the four right-wing parties on the other. Party
competition in this study was measured based on the relative competition that
exists between these two coalitions.
Party competition, as developed in the literature of political science, is
usually defined based on the fulfillment of two basic conditions (see (Pfeiffer
1957,Hofferbert 1964,Stigler)):
The average share of votes of the losing party is not much less than 50
percent; and
The parties do not have long runs of electoral success or failure.

In this study the definition of party competition was slightly modified.
Specifically, it was measured by the relative closeness of the outcome of

23 It should be noted that individuals might express their preferences for individual candidates on the
ballots, but the expression of these has no formal political implication.
87
elections in percentage units. This closeness was calculated by dividing the

difference between the total number of votes received by each respective
coalition (expressed as an absolute number), with the total number of votes
received by both coalitions. Hence, higher values of the proxy indicate a lower
degree of political competition, and vice versa. The data were derived from
SCB's census on localities.
5.1.2.3 Scrutiny
5.1.2.3.1 Proxy for Debt-Dependency (External Capital)

SCB does not provide data on the total amount of debt that Swedish
municipalities have acquired from external capital markets. However, SCB
provides sufficient information to calculate municipalities long-term debt-to-asset
ratio (i.e., long-term debt/total assets). This ratio indicates municipalities relative
debt-dependency and may therefore be argued to serve as a reasonable proxy
for municipalities dependency on [external] capital.
The data used to calculate the long-term debt-to-asset ratio were collected
from the municipal balance sheets data published by SCB.
5.1.2.3.2 Proxy for Political Involvement

Voting participation was used as a proxy for political involvement. Voting
participation is assumed to indicate the extent to which constituents in a
particular locality are involved in the political process. A high degree of voting
88
participation in a particular constituency is assumed to indicate a higher degree

of scrutiny of the financial information provided by the municipality, and vice
versa.
The data on voting participation were collected directly from SCBs
census on localities.
5.1.2.4 Control Variables
Five additional variables were included in the models to control for
differences among municipalities that may influence the dependent variables but
that do not necessarily explain earnings management. They are:
Long-term assets/per capita: To control for the influence that an entitys long
term asset base has on write-offs and capital depreciation. An entity with a
high degree of long-term assets will naturally have higher reported write-off
and depreciation costs.
Short-term assets/per capita: To control for the influence that an entitys

short-term asset base has on write-offs. An entity with a high degree of these
will naturally have higher reported write-offs.
Size of municipality: To explore whether municipalities relative size

influences the dependent variables. For example, it may be argued that the
accounting
and
financial
management
function
within
larger
size
municipalities maintains a higher degree of sophistication than do smaller

municipalities. Smaller municipalities in Sweden often have a very limited
number of employees assigned to oversee the financial accounting and
89
reporting function, while larger municipalities often possess large departments

to handle them. These differences may be argued to affect both the ability
and the extent to which earnings management occurs within a particular
municipality. The proxy used to control for the size of municipalities in the
study is represented by total revenue. The data for this proxy were collected
from per capita data on total revenues reported in the various municipalities'
operating statements.
YEAR2000: To control for differences across fiscal years (i.e., between 1998,
1999, and 2000).
YEAR1999: To control for differences across fiscal years (i.e., between 1998,
1999, and 2000).
DATA ANALYSIS
The data analysis of each of the three models developed was performed
using a three-step process. The first step was aimed at determining the type of
linearity exhibited by the variables included in the models (i.e., curve fitting).
The linearity was determined by graphing the independent variables against their
respective dependent variables. The second step consisted of an analysis of the
quality of the data used to test the models. Tests were made for multicollinearity
and heteroscedasticity. The final step was to generate and interpret the results.
This chapter provides a more detailed description of these three analytical steps.
Before these analytical steps are described, however, a summary of the
variables is provided.
6.1
Summary of Variables
As indicated in Table 6.1, the models are made up of 13 variables. The
majority of these variables are expressed in Swedish Crown (SKR) per capita.
These are:
Ingasst = Long-term assets
shrtasst - Short-term assets
90
91
Addpens = Annual cost allocated to meet future pension obligations
Writeoff= Annual asset write-offs and capital depreciation
Result = financial results of operations
totdiscr = total discretion (Addpens+Writeoff)

The remainder of the variables includes:
Votepart = Voter participation, expressed as the percentage of eligible voters

that participated in the most recent election.
Policomp = political competition, expressed as the relative closeness of the

outcome of elections in percentage units.
TOTALREV = Total revenue collected by individual municipalities through

taxes and operations.
Resultsq = the square of financial results of operations per capita.
Debtrat = Debt-to-total-asset ratio.
YEAR2000 - Dummy variable for fiscal year 2000.
YEAR1999 = Dummy variable for fiscal year 1999 (1998 is used as the
reference year).
92
Table 6.1: Summary o f Variables

Variable
Ingasst
shrtasst
Addpens
Writeoff
result
votepart
policomp
TOTALREV
totdiscr
resultsq
debtrat
YEAR2000
YEAR1999
Obs
Mean
833
833
833
833
833
833
833
833
833
833
833
833
833
25026.79
5815.184
1006.136
1530.259
-62.08163
.7307706
.2037796
1001723
2536.395
5109013
.2 44 3 7 9 3
.3 22 9 2 9 2
.334934
I
I
;
I
i
I
I
I
I
!
!
Std.
Dev.
8 26 9. 88
4299.895
563.8415
567.1426
2260.817
.0 645676
.14 86745
2016645
862. 07 24
1 . 83e+ 07
.1850462
.4678768
.4 722509
Min
Max
5375
599
73
406
-9069
.4 4 87 0 3 9
.0 00 19 85
75 5 32
887
4
.0001104
0
0
77216
46100
3435
9091
15227
.8446275
.7804747
2 . 82e+07
11038
2 . 32e+08
.9010306
1
1
6.2 Curve Fitting

Regression analysis assumes linear relationships between variables. The
most commonly applied criterion for regression analysis is the ordinary least
square (OLS). Regression analysis based on OLS exhibits the following two
advantages (Wonnacott and Wonnacott 1987, 31):
It [OLS] squares the models errors and thereby overcomes the sign problem.
This makes the algebra that OLS produces very manageable.
It [OLS] generates the most efficient estimator of c* and o. That is, the
regression line is specified through OLS as minimum variance (i.e., least
squares), when it is assumed that the estimators are unbiased.
To the extent that real-world phenomena do not behave in a linear manner,
conventional OLS regression analysis tends to underestimate the relationships
93
(Garson 2002). The problem of nonlinear relationships may be avoided by

transforming them into linear relationships. Statistical analysis allows for
transformations of a number of linear relationships, including logarithmic,
exponential, and polynomial relationships. OLS provides more accurate
estimates of the relationship examined if the appropriate relationship is identified.
The exercise of identifying the appropriate curve is often referred to as
curve fitting. In this study, the curve-fitting exercise was conducted by graphing
each of the independent variables identified against their respective dependent
variables. Based on the resulting graphs, it was determined that the variables in
the models generally behaved in a linear manner. An exception was the big
bath hypothesis. A u,J-shaped" or polynomial relationship was expected to exist
between reported results and the size of write-offs, depreciation expenses, and
annual costs allocated to meet future pension obligations.. This relationship
became even more evident when reported results were graphed against the
aggregate discretionary costs (i.e., write-offs, depreciation expenses, and annual
costs allocated to meet future pension obligations). Hence, the graph provided
support for the hypothesis stated in Section 4.4.1.
6.2.1 Outliers
Graphing each of the independent variables against their respective
dependent variables also allowed for the identification of potential outliers. If
large in magnitude and number, these may severely bias the OLS estimates. In
94
the data set used as part of this dissertation, 29 outliers were identified and
dropped from the data set. They were as follows:
The municipality of Stockholm's annual data from fiscal 1999 and 2000 (3
observations): Stockholm is by far the largest municipality in Sweden. Its total
revenues amount to 28,000,000,000 SEK. Based on total revenues, this
makes it almost twice the size of the second-largest municipality Gothenburg - and 28 times larger than the average Swedish municipality.
The municipality of Oskarshamns annual data from fiscal 1999 (1

observation): In its 1999 financial report Oskarshamn reported a result before
adjustment for write-off had been made of 34,468 SEK per capita.
This
amount was more than double the amount of the next-highest result reported
by a municipality. The average reported earnings were negative 99 SEK per
capita. The high earnings were a result of extraordinary revenues from the
municipalitys sale of 3.5 millions shares of Sydkraft (i.e., an isolated
occurrence) (Joakim Malmdal 2002). Sydkraft is one of Swedens biggest
utility companies, and the shares were sold as part of an ongoing privatization
of public utilities.
The municipality ofJokkmoks annual data from fiscal 2000 (1 observation): In

its 2000 financial report Jokkmok reported a total write-off of 9,091 SEK per
capita (calculated based on the municipalitys total population). This amount
was more than double the amount of the next-largest write-off reported by a
95
municipality. The average size of write-offs among the municipalities included

in the final sample was 1,569 SEK per capita.
Observations in which municipalities had reported 0 SEK in long-term debt

(18 observations) and observations in which the reported annual allocation of
pension cost were 0 (6 observations). These results were regarded as errors
in the data set
6.3 Data-Quality Analysis

After considering the linearity of the variables in the models, as well as the
existence of outliers, the quality of the collected data was examined. Specifically,
the presence of heteroscedasticity and multicollinearity in the data set was
examined.
6.3.1 Heteroscedasticity
Heteroscedasticity is a term that describes the extent to which residuals are
systematically dispersed throughout the range of the estimated dependent
variable. Put another way, heteroscedasticity is present when the error terms
exhibit systematic patterns, rather than being randomly dispersed. OLS
estimators cannot be justified in the presence of heteroscedasticity (Berry 1993,
81,Garson 2002). Consequently, the presence of heteroscedasticity needs to be
determined.
96
The statistical software24 used as part of the study allows for testing of
heteroscedasticity. The test is based on the null hypothesis that the variance is
constant (i.e., not homogeneous). When the probability is large (i.e., the pvalues), the
null
hypothesis of constant variance is accepted.
When
heteroscedasticity is present, the software allows for regression with robust

standard errors, using the Huber-White sandwich estimators (UCLA 2002). With
the robust option, the point estimates of the coefficients are exactly the same as
in ordinary OLS, but the standard errors take into account issues concerning
heterogeneity and lack of normality. As a result, regression with robust standard
errors is able to control for the influence of heteroscedasticity on the results.
Coefficients are not affected by the robust regression. The only change that
occurs is in the standard errors and the t-tests (UCLA 2002).
As indicated from the results below, the test for heteroscedasticity in the
three models generates p-values that are smaller than the chi2-value.
The
aggregate and the write-off/depreciation models generate p-values well below

the chi2-va!ue. The pension cost model generates more balanced values.
However, the p-value is still smaller than the chi2- value. Thus, the null
hypothesis is rejected in all models, and the alternative hypothesis that the
variance is constant is accepted. Hence, heteroscedasticity is present in all three
models. Regression with robust standard errors must therefore be used.
24 STATA: Version 7.
6.3.1.1 Heteroscedasticity Test of Aggregate Model

Cook-Weisberg tests for heteroscedasticity using fitted values of totdiscr
(i.e., dependent variable in the aggregate discretion model).
Ho: Constant variance
chi2(1)
= 117.17
Prob > chi2
= 0.0000
6.3.1.2 Heteroscedasticity Test of Write-off/Depreciation Model

Cook-Weisberg tests for heteroscedasticity using fitted values of writeoff
(i.e., dependent variable in the write-off/depreciation model).
chi2(1)
= 478.44
Prob > chi2
= 0.0000
6.3.1.3 Heteroscedasticity Test of Pension Cost-Allocation Model

Cook-Weisberg tests for heteroscedasticity using fitted values of addPens
(i.e., dependent variable in pension cost-allocation model).
chi2(1)
7.86
Prob > chi2
0.0051
98
6.3.2 Multicollinearity
Multicollinearity is the intercorrelation of independent variables (Garson
2002). The absence of multicollinearity is essential to a multiple regression model
because it reduces a researchers ability to determine which of the interrelated
independent variables really explains the variation in the dependent variable. The
statistical software used in the study allows for a test of multicollinearity
(bivariate) through a test of tolerances (1A/IF values).25 A rule of thumb is that a
VIF in excess of 0.20, or a tolerance of 0.05 or less, suggests that further
investigation may be necessary (Garson 2002).
As can be seen from the results presented in the tables below, there is no
evidence of multicollinearity. The variance factors (VIF) are well below 20, and
the tolerances above 0.05. Hence, no further action is necessary to adjust the
data or the models for multicollinearity (e.g., dropping variables, factoring, etc.).
99
Table 6.2 - Test of Tolerances in Aggregate Discretion Model

Variable
VIF
Y E A R 20 00
YEAR1999
shrt as st
d eb tr at
TOTALREV
lngasst
v o t e pa rt
policomp
resultsq
I
I
I
I
|
I
I
I
I
1.34
1.32
1.20
1.13
1.06
1.06
1.04
1.02
1.01
M ea n V I F
1.13
1/VIF
0 .743738
0.755674
0 .834151
0.8 8 87 52
0.945328
0.94 57 52
0 .960561
0. 98 46 11
0. 98 52 85
Table 6.3 - Test o f Tolerances in Write-off/Depreciation Model

Variable
VIF
YE AR 20 00
Y E A R 199 9
sh rtasst
de btrat
TOTALREV
lngasst
v o t e pa rt
policomp
resultsq
I
I
1
1
|
1
1
I
1
1.34
1.32
1.20
1.13
1.06
1.06
1.04
1.02
1.01
Mean V I F
1.13
1/VIF
0. 743738
0.755674
0 .834151
0 .888752
0.945328
0. 945752
0. 960561
0. 984611
0. 985285
25 Garson describes tolerance as follows: Tolerance is 1 -R 2for the regression of the independent
variable on all the other independents, ignoring the dependent. There will be as many tolerance
coefficients as there are independents. The higher the interconelation of the independents, the more
the tolerance will approach zero. As a rule of thumb, if tolerance is less than .20, a problem with
multicollinearity is indicated. When tolerance is dose to 0 there is high multicollinearity of that variable
with other independents and the b and beta coefficients will be unstable. The more the multicollinearity,
the lower the tolerance, the more the standard error of the regression coefficients. Tolerance is part of
the denominator in the formula for calculating the confidence limits on the b (partial regression)
coefficient (Garson 2002).
100
Table 6.4 - Test o f Tolerances in Pension Cost-Allocation Model

Variable
VIF
YEAR2000
YEAR1999
shrtasst
debtrat
TOTALREV
lngasst
votepart
policomp
resultsq
|
|
I
I
I
I
I
I
I
1.34
1.32
1.20
1.13
1.06
1.06
1.04
1.02
1.01
M e a n VIF
1.13
1/VIF
0.743738
0 . 7 5 56 7 4
0.834151
0.888752
0.945328
0.945752
0.960561
0.984611
0.985285
A correlation matrix was also developed to examine collinearity among the

independent variables. The advantage of using a correlation matrix is that it
allows for more direct identification of correlation between independent variables.
As can be seen below, three interrelationships between variables stand out in the
matrix. First, a correlation of 0.6229 between writeoff and lngasst is reported. As
explained in Section 5.1.2.4, this correlation was anticipated due to the influence
that an entitys long-term asset base has on write-offs and capital depreciation.
Again, an entity with a high degree of capital assets will naturally have higher
reported write-off and depreciation costs. Second, a correlation of 0.5218
between totdiscr and lngasst is reported. This correlation was also anticipated
because totdiscr account for writeoff. Consequently, the influence that an entitys
long-term asset base has on write-offs and capital depreciation is re-reflected in
this relationship. Finally, a correlation of -0.4901 is reported between YEAR2000
101
and YEAR1999, indicating that differences exist across years in the pooled data
set.
Besides the above-highlighted correlations, the correlations between
variables tend to be low. From an interpretive perspective, a rule of thumb is that
correlations below 0.7 do not significantly affect regression results. Hence, the
correlations reported in the correlation matrix support the conclusion drawn
above (i.e., based on the tolerance test performed) that no significant collinearity
exists between the independent variables in the study.
Table 6.5 - Correlation Matrix
Writeoff
W r iteoff
Addpens
totdiscr
lngasst
shrtasst
T O TALREV
votepart
p o licomp
YEAR2000
YEAR1999
debtrat
resultsq
result
Addpens
totdiscr
1.0000
0.7606
0.1712
-0.0632
0.0245
0.0078
0.0334
-0.3359
0.6061
0.1309
0.0325
-0.1737
0.5218
0.0569
-0.0689
0.0567
0.0054
-0.1536
0.4048
0.1089
0.0443
-0.1978
1.0000
0.1620
0.7638
0.6229
0.1494
-0.1292
0.0784
-0.0250
0.1004
0.0128
0.0355
0.0350
-0.1279
1.0000
policomp YEAR2000 YEAR1999

policomp
YEAR2000
YEAR1999
debtrat
resultsq
result
lngasst shrtasst TO T A L R E V votepart
1.0 0 0 0
1.0000
0.2098
-0.0738
-0.0811
0.1288
-0.0407
-0.2546
0.0799
0.1846
1.Q000
0.0732
-0.0620
0.0279
-0.0021
-0.0409
0.0280
0.0912
debtrat resultsq
result
0.1132
0.0441
0.0899
-0.0016
0.0435
0.0030
0.1230
-0.0338
-0.1135
1.0000
0.0047
0.0024
-0.0033
-0.0826
-0.0451
-0.0442
1. 0000
0.0026
-0.0009
-0.0526
0.0064
-0.0239
1.0000
-0.4901
0.0129
0.0181
0.0773
1.0000
0.0103
0.0442
-0.0777
1.0 0 0 0
0.0098
-0.2515
1.0000
0.4696
1.0000
102
6.4
Regression Results and Interpretation

The final step in the analytical process was to interpret the results
generated in the three models. As explained above, the results were generated
from a pooled data set consisting of fiscal 1998, 1999, and 2000. Pooling the
data allowed for a cross-sectional analysis based on 833 observations (after
dropping municipalities that had provided incomplete information to SCB or that
were characterized as outliers (see above)).
Dummy variables were also
included in the model to highlight systematic differences among the fiscal years
that made up the sample.
Overall, the three models provide strong indications that earnings
management occurs within public-sector entities that have adopted an accrual
and consolidation model. One of the four hypotheses, the big bath hypothesis,
generates statistically significant values with correct signs in all models. That is,
the hypothesis that public entities systematically dump costs when they report
excessive deficits or surpluses is supported. Support is also generated in both of
the disaggregated models for the scrutiny hypothesis. Specifically, votepart is
statistically significant with the correct sign in the write-off/depreciation model,
and debtrat is statistically significant with the correct sign in the pension costallocation model.
The lack of significance for debtrat in the aggregate and the write
off/depreciation model may be attributed to the role played by the inclusion of the
long-term asset in these two models. The correlation matrix in Table 6.5indicates
103
a strong correlation among lngasst, write-off, and totdiscr. lngasst is excluded in

the pension cost-allocation model and may, therefore, be argued to be a more
reliable model for assessing the effect that scrutiny imposed by capital markets
has on the propensity of public entities to engage in earnings management. The
political competition hypothesis is the only hypothesis that is not supported by the
models. Policomp is statistically insignificant in all three models.
The remainder of this section provides a more detailed description of the
results generated in each of the three models, starting with the aggregate
discretion model.
6.4.1 The Aggregate Discretion Model: Results and Analysis
The variables included in the aggregate discretion model explain more than
46 percent of the variation in the dependent variable (R-squared = 0.4687). The
model provides partial indications that earnings management occurs within
public-sector entities that have adopted an accrual and consolidation model. It
generates statistically significant results for the big bath hypothesis at the 99%
confidence level. As indicated above, the big bath" hypothesis is tested using
polynomial regression. Polynomial regression results from the transformation of a
U-shaped regression and is used for meeting the assumptions of OLS.
This
type of regression includes as predictors ... both an independent variable and its
square (and possibly higher powers if necessary)." (Hamilton 2000, 149) In the
104
regression models developed as part of this dissertation this is reflected through

the variables result and resultsq.
Among the remaining variables, lngasst and YEAR1999 are statistically
significant at the 100% confidence level. As expected, lngasst is positively
related to totdiscr. The beta value indicates that for every SEK increase in long
term assets, discretionary costs increase by a little more than 0.49 SKR.
Table 6.6 - Regression Results in Aggregate Discretion Modej
Regression with robust standard errors
I
totdiscr I
lngasst
shrtasst
TOTALREV
votepart
policomp
YEAR2000
YEAR1999
debtrat
resultsq
result
_cons
I
I
|
I
I
I
I
I
I
I
I
Coef.
.0519325
.0118803
-.0000395
312.8862
8.159766
48.15989
730.258
62.63499
5.65e-06
-.0635144
668.6499
Robust
Std. Err.
.0039679
.0068381
.0000245
369.5476
134.5956
54.53444
44.69251
136.2992
1.76e-06
.0156258
325.0384
Number of obs
F( 10,
822)
Prob > F
=
R-squared
=
Root MSE
=
t
13.088
1.737
-1.616
0.847
0.061
0.883
16.340
0.460
3.215
-4.065
2.057
P> 111
0.000
0.083
0.107
0.397
0.952
0.377
0.000
0.646
0.001
0.000
0.040
833
63.52
0.0000
0.4687
632.19
Beta
.4981899**
.0592574
-.092476
.0234346
.0014072
.0261381
.4000418*
.0134448
.1199417**
-.1665688**
* = Significant, with incorrect sign or where no theory has been developed to support
either sign
** = Significant carrying a correct sign.
The significance of YEAR1999 is more difficult to interpret. In principle, it

reflects some structural change that has occurred across the fiscal years
included in the sample. To determine exactly what has caused this change is
difficult. An array of possible explanations may be found at both the micro and
105
macro levels. Examples include changes in accounting rules and changes in the
productivity of the overall economy.
6.4.2 Write-off/Depreciation Model: Results and Analysis
The write-off/depreciation model explains more than 45 percent of the
variation in the dependent variable (R-squared = 0.4503). The findings provide
strong indications that earnings management occurs within public-sector entities
that have adopted an accrual and consolidation model. As can be seen below,
both the big bath and scrutiny hypotheses find support in the results generated
in the model. The result and resultsq variables are statistically significant at the
98% and 97% confidence levels. Votepart is statistically significant at the 95%
confidence level. As explained, the lack of significance for debtrat may be
attributed to the role played by the inclusion of the long-term asset variable.
Hence, votepart may be argued to serve as a more reliable measure of scrutiny
in this particular model. The beta value of votepart indicates that for every
percentage increase in voting participation, write-offs increase by a little more
than 0.04 SKR.
Similar to the aggregate model, lngasst is statistically significant at the
100% confidence level. The beta value indicates that for every SEK increase in
long-term assets, discretionary costs increase by a little more than 0.60 SKR. In
contrast to the aggregate model, however, YEAR2000 is statistically significant at
the 99% confidence level, while YEAR1999 is statistically insignificant.
An
106
additional difference is that short-term assets come through statistically

significant in the write-off/depreciation model. This variable is significant at the
99% confidence level. The beta value indicates that for every SEK increase in
short-term assets, discretionary costs increase by a little more than 0.11 SKR.
Table 6.7 - Write-off/Depreciation Model Regression Results
I
Write-off I
lngasst
shrtasst
TOTALREV
votepart
policomp
YEAR2000
YEAR1999
debtrat
resultsq
result
_cons
I
I
I
!
I
I
I
I
I
l
!
Coef.
.0415344
.0145332
-.0000506
353.2854
-126.9992
117.914
57.87264
-161.8036
3.48e-06
-.0330923
186.9137
Robust
Std. Err.
.0031482
.0052181
.0000223
178.7352
77.61544
34.02991
30.40345
94.34244
1.61e-06
.0136654
196.6761
Number of obs
F( 10,
822)
Prob > F
R-squared
Root MSE
t
13.193
2.785
-2.266
1.977
-1.636
3.465
1.903
-1.715
2.158
-2.422
0.950
=
=
=
=
=
P>ltl
0.000
0.005
0.024
0.048
0.102
0.001
0.057
0.087
0.031
0.016
0.342
833
27.26
0.0000
0.4503
423.06
Beta
.6056398**
.1101864**
-.1798917*
.0402206**
-.0332924*
.0972758
.0481897
-.052793
.1123069**
-.1319167**
* = Significant, with incorrect sign or where no theory has been developed to suj
either sign.
* = Significant carrying a correct sign.
6.4.3 Pension Cost-Allocation Model: Results and Analysis

The pension cost-allocation model also provides strong indications that
earnings management occurs within public-sector entities. This model has a
slightly lower explanatory power, compared to the write-off/depreciation model. It
explains 40.15 percent of the variation in the dependent variable (i.e., R-square =
0.4015). Similar to the aggregate and the write-ofF/depreciation models, it
107
provides statistically significant results in support of the symmetric big bath

theory. The model also generates statistically significant results supporting the
hypothesis that capital markets discipline public entities in cases where they are
dependent on raising capital from these markets. Debtrat is reported to be
statistically significant at the 99% confidence level. The strong significance of
debtrat is of particular interest in the pension cost-allocation model, as it allows
for the regression without having to control for the individual entitys asset base
(i.e., Ingasset and shrtasst). The beta value of debtrat indicates that a 1percentage increase in total debt/total assets results in a 9.5 percent increase in
added pension costs allocated to future pension obligations.
Similar to the aggregate model, YEAR1999 is statistically significant in the
pension cost-allocation model. The variable is significant at the 100% confidence
level.
Table 6.8: Pension Cost-Allocation Model Regression Results
Addpens
I
I
Coef.
Robust
Std. Err
TOTALREV
votepart
policomp
YEAR2000
YEAR1999
debtrat
resultsq
result
_cons
I
I
I
I
I
I
I
I
I
.0000121
99.55941
143.T963
-62.21345
675.8736
289.6224
2.19e-06
-.0343836
601.5888
7.19e-06
303.3775
107.0308
40.69399
29.66054
88.35398
1.05e-06
.0098308
225.4064
Number of obs
F( 8,
824)
=
Prob > F
R-squared
=
=
Root MSE
t
1.678
0.328
1.344
-1.529
22.787
3.278
2.100
-3.498
2.669
P>ltl
0.094
0.743
0.179
0.127
0.000
0.001
0.036
0.000
0.008
833
90.48
0.0000
0.4015
438.30
Beta
.0431412
.0114009
.0379164
-.0516248
.5660845*
.0950507**
.0712577**
-.1378666**
* = Significant, with incorrect sign or where no theory has been developed to support
either sign.
108
'* = Significant, carrying a correct sign.
In conclusion, the above models provide strong support for the hypothesis
that public entities' propensity to engage in earnings management is related to a
number of conditions in their operating environment.
In this dissertation, the
following conditions were identified:
Scrutiny imposed by the public and by capital markets; and
excessive financial operating results, both on the surplus and deficit side (i.e.,
polynomial big-bath accounting practices)
No support was provided for the hypothesis that political competition affects
public entities propensity to engage in earnings management.
DISCUSSION AND CONCLUSIONS
This study has reported on the application of an accrual and consolidation

model in the public sector as it relates to earnings management. In brief, three
models were developed to test for the propensity by which public-sector entities
use [material] discretion provided in accounting measurement to manage their
earnings. The first model examined the relationship between conditions
hypothesized to drive earnings management and the aggregate discretion
discretion provided through accounting practices associated with (a) asset write
offs, (b) capital depreciation, and (c) pension-cost accounting. The conditions
hypothesized to drive earnings management included (a) financial condition, (b)
scrutiny, and (c) political competition (i.e., the independent variables).
The second and third models used the same independent variables as the
aggregate model but examined these in relation to individual accounting
practices.
Specifically, the second model considered them in relation to the
opportunities provided in the accounting for pension costs. The third model
considered them in relation to the combined discretion provided in the accounting
for asset write-offs and capital depreciation practices. The combined treatment
109
110
was a result of a lack of disaggregated data on asset write-offs and capital

depreciation practices.
Overall, the three models provided strong indications that public-sector
entities do use accounting-measurement discretion to manage their eamings.
One of the four hypotheses the symmetric big-bath hypothesis generated
statistical significance with correct signs in all three models. This hypothesis
states that public entities systematically dump costs when they report excessive
deficits or surpluses as a means of smoothing their income. Support was also
found for the scrutiny hypothesis in both of the disaggregated models. The
scrutiny hypothesis states that public entities are less likely to engage in eamings
management in environments where they are exposed to a high degree of
scrutiny by the citizenry and capital markets (i.e., they are disciplined" by these).
The only hypothesis that was not supported by the models was the hypothesis
that political competition drives eamings management. The proxy for political
competition (i.e., policomp) was statistically insignificant in all three models.
7.1
Policy Implications
The above findings are important for several reasons. Most important, they
inform about the success of using the accrual and consolidation model as a
means of holding public entities accountable for their operations. Eamings
management compromises this success by reducing the overall quality of the
reported information. That is, it reduces the extent to which the information
Ill
purports what it is set out to purport (i.e., the reliability o f the financial
information).
The major conclusion that follows from the findings is that the success of
the accrual and consolidation model in public-sector settings is partially
contingent upon the discretion allowed in the accounting-measurement process.
From an accounting policy-making perspective, the findings signal that the
existing accounting-measurement discretion needs to be further constrained if
the usefulness of the accrual and consolidation model is to be enhanced in
public-sector settings. A possible drawback of such an action, however, is that it
would reduce the ability of entities to adjust for changes in accounting values.
Assuming that public entities are able to adjust accurately for value changes in
accounting data, a reduction in discretion may harm the relevance of the
accounting information. An additional issue that accounting policy-makers need
to address, therefore, is the trade-off between the positive and the negative
effects of allowing for discretion. That is, enhanced economic relevance of
accounting data, due to the ability of entities to adjust accounting data to reflect
changes in underlying economic values, or distortion to the accounting data as a
result of earnings management. Preliminary theoretical research indicates that
the latter of the two will be most influential on the quality of the accounting
information (Stalebrink 2002).
The findings are also relevant for assessing the applicability of the accrual
and consolidation model for purposes of internal management.
An important
112
motivating factor for the implementation of the model has been its potential
contribution to improve public management. In its purest version, the accrual
and consolidation models usefulness will be compromised by the influence of
earnings management practices in a similar manner to the case of external
accountability. However, it is important to note that the experiences with the
accrual and consolidation model as managerial tool in the commercial sector
indicate the development of internal rules and regulations for how the internal
accounting system is to be developed.
The findings of this dissertation are
limited to one aspect that needs to be considered in the development of internal

accounting systems (i.e., the provision of discretion).
7.2 Future Research and Caveats
This dissertation
represents the first effort at exploring earnings
management in the context of public-sector entities that have adopted an accrual

and consolidation model. Naturally, a number of issues validate the need for
further research on the topic. For example, additional factors may be found that
explain earnings management in a public-sector setting or that interfere with the
hypotheses developed herein.
An extension of the models developed in the
dissertation may, therefore, be suggested as a future venue for research. At

least one such venue of research may be identified. It concerns the relationship
between financial condition and earnings management.
This dissertation
explored this issue in relation to big bath accounting practices. Further insights
may be gained by exploring the relationship between earnings management and
113
credit ratings. A strong argument may be made that the process by which creditquality rating agencies determine their ratings provides incentives for public
entities to engage in earnings management. The logic behind this argument is
based on the fact that an entity's financial statements often serve as an important
source of information for determining credit-quality ratings (Reed and Swain
1997).26 Studies have indicated that this source of data alone may explain as
much as two-thirds of an entitys final credit rating (Kaplan and Urwitz
1979,Ingram, Brooks, and Copeland 1983,Cluff and Famham 1984,Ederington
1985,Loviscek and Crowley 1990)).27 Credit-quality ratings are used extensively
in the investment community as a surrogate measure for the riskiness of bonds
(Kaplan and Urwitz 1979). They are, therefore, an important determinant of the
ability of public entities to obtain external capital from capital markets at low costs
(i.e., the interest rate).28 Hence, by managing its earnings an entity may enhance
26 In turn, the most important information derived from these includes measures of an entitys capital
structure, earnings stability, balance-sheet leverage, earnings coverage of interest, and profitability
(Reed and Swain 1997,26)
27 In practice, the quest for favorable credit-quality ratings has been an important argument for the
adoption of the corporate-style accounting and reporting model in the public sector. Compared to the
conventional governmental accounting and reporting model, the corporate-style accounting and
reporting model is viewed by the major quality-rating agencies to provide for a more reliable source of
information of these measures.
28 Bond yields have consistently been reported to correlate strongly with bond ratings, with high-rated
bonds selling at substantially lower yields than low-rated bonds (Hickman 1958).
114
its likelihood of obtaining a higher quality rating. Consequently, the relationship

between earnings management and credit ratings assigned to public-sector
entities may offer a promising venue of research, particularly as the dependency
and willingness of public entities to raise capital in capital markets continues to
increase.
There are also some caveats that need to be addressed in relation to the
findings of the dissertation. First, due to a lack of time-series data, this study was
confined to cross-sectional analysis of earnings management. A limitation with
this is that it is unable to capture the effect that the previous years eamingsmanagement decisions have on current eamings-management decisions. As
more data become available, a follow-up study based on time-series analysis
would be able to provide insights to this issue.
A second caveat concerns the scope of the study. The data used in the
dissertation were collected in the context of Swedish municipalities. However, as
explained in Section 1.4, despite this geographical limitation the findings should
be useful beyond the case of Swedish municipalities to include countries that
have undertaken similar reforms. As explained in Section 4.1, these countries
include the United Kingdom, Spain, Iceland, Australia, New Zealand, and
Canada. Public-sector accounting reforms in these countries have been driven
by motivations similar to those in Sweden. An additional factor that is likely to
further enhance the ability to generalize beyond the case of Swedish
municipalities is the unitary characteristics that these entities hold.
They hold
115
significant powers in the determination of the allocation of resources (i.e., the

expenditure side), as well how funds are raised (i.e., the revenue side). From an
earnings management perspective, the unitary characteristic is significant
because it reinforces the relationship between force and action. In the
dissertation, this relationship is perhaps best depicted by the influence that an
entitys dependence on external capital has on its propensity to engage in
earnings management. In conclusion, the findings may therefore also be
applicable in a U.S. context, where State and local governments holds strong
unitary characteristics.
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APPENDIX
Experts
John Petersen
Fairfax, VA
Anders Nilsson
Svenska Kommunforbundet
Sektionen for ekonomistyming
Stockholm, Sweden
Bjom Brorstrom
University of Gothenburg, Sweden
Paul Copley
University of Georgia
Athens, GA
Finance Officers
Ian Zierk
Finance Coordinator
City of Greater Geelong
Victoria, Australia
Tony Henningsson
Redovisningschef
Kommunstyrelsen
Helsingborg, Sweden
Birgitta Hammar
Redovisningschef
Linkdpings kommun
Elisabet Ohrman
Jonkopings kommun
Jonkoping, Sweden
Marianne Jonsson
Stadskontoret, ekonomiavdelningen
Malmo, Sweden
Graeme Gard
City of Warmambool
Victoria, Australia
Kerne Jordan
Group Accountant
Melbourne City Council
Australia
Paul Hultberg, Planeringschef
Eksjo Kommun, Sweden
Joakim Malmdal
Ekonomiavdelningen
Oskarshamns kommun
Sweden
CURRICULUM VITAE
Odd J. Stalebrink is a Swedish citizen and a permanent resident of the

United States. He holds bachelors and masters degrees in business
administration from Jonkoping International Business School, Jonkdping,
Sweden. His academic publication and presentation record have focused on the
effects of recent public financial management reforms on governance and public
management, with a particular emphasis on the management of public
transportation assets. He has been actively involved in various activities relating
to Transportation Asset Management, an emerging and innovative approach for
managing the existing transportation infrastructure stock. Transportation Asset
Management is closely related to his interest in current public financial
management reforms. He has been a frequent attendee and participant of
taskforce meetings, workshops, and conferences on Transportation Asset
Management.

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INFORMATION TO USERS

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ProQuest Information and Learning

Governmental Accounting and Financial Reporting in Transition: A Study of

Chair: Professor Jonathan L. Gifford

Summer Semester, 2002

UMI Number: 3055816

ProQuest Information and Learning Company

Copyright 2002 Odd J. Stalebrink

GOVERNMENTAL ACCOUNTING & FINANCIAL REPORTING IN

Dean, School of Public Policy

Summer Semester 2002

This dissertation benefited from the advice and help provided to me by a

basic questions of my dissertation. Finally, I would like to acknowledge Dr. Sue

Go v e r n m e n t a l a c c o u n t in g & Rep o r tin g : F u n c t io n ...................................................................... 14

Contributions to Infrastructure Investments............................................................................... 65

5 DATA COLLECTION AND SAMPLE SELECTION.......................................78

Asset Write-offs and Capital Depreciation Practices........................................................................... 84

Big Bath Variables.............................................................................................................................86

R eg ressio n R es ults a n d I n t e r p r e t a t io n .......................................................................................... 103

The Aggregate Discretion Model: Results and Analysis.......................................................... 104

7 DISCUSSION AND CONCLUSIONS...........................................................110

Figure 2.1: Trade-Off between Economic Relevance and Cost/Objectivity

GOVERNMENTAL ACCOUNTING AND FINANCIAL REPORTING IN

Conventionally, public-sector entities have accounted for and reported their

management occurs within public-sector entities that are reporting using an

internationally in governmental accounting and financial reporting. Most

Conventionally, public-sector entities have accounted for and reported their

1991,Wolfson 1993,Dhaliwal, Frankel, and Trezevant 1994,Cloyd, Pratt, and

Specifically, the implementation o f plans that

Third, earnings management in the public sector may be driven by internal

Table 1.1: Formal Differences between Governmental A Commercial Entities Operating

Established by citizenry through

Receive authority to act from

Demonstrate good stewardship

Render services to maximize

Finally, public officials often operate under a shorter decision-making

To what extent does earnings management occur within public-sector entities

1.4 Research Method

certain conditions in an entitys operating environment that may drive earnings

Table 1.2, below, identifies the primary principals of public-sector entities

Creditors: Creditors use governmental accounting information to allocate

Legislative and oversight bodies: Legislative and oversight bodies use

administrators/managers on behalf of constituents, and as a basis for

Constituents: the provision of governmental accounting information to

informs accounting standard-setting authorities about the need to further

1992,Linden 1990,Strong and Meyer 1987,Berton and Miller 1986,Zucca and

Cast vote or move from area

Legislative and oversight

Finally, a study on earnings management is significant because it provide

manage" philosophy) (for a discussion, see (Kettl 1997,Senge 1990,Gifford and

governmental accounting and financial reporting and relates it to earnings

Governmental Accounting & Reporting: Function

activities. The overview is provided either at an entity-wide level (referred to as

Current Assets: Assets that entities expect to consume within a year.

Investments: Assets allocated into the equity of other entities.

Non-physical assets that represent a resource to the entity.

Examples include goodwill and patents.

payments of cash, goods, or services in a reasonably