Question

How much discretion is there in the application of GAAP and is that good or bad?

Answer 1

Discretion is provided in GAAP to allow the fairest representation of a company’s operationsand financial position. Discretion also allows for earnings management.The problem is that wecannot see the actual motivation for the choices made, we cannot always distinguish fairrepresentation from earnings management.

Managers have a strong incentive to ensure that earnings expectations are met, particularly ifthey hold ESOs. If expectations are not met, the market will reason that if the manager could notfind enough earnings management to avoid the shortfall, the firm’s earnings outlook must bebleak or the firm is not well managed.*Rather than report a net income substantially higher than what is expected to persist in the longrun, managers will decide to report earnings that they feel could persist in the future. So there issometimes no use in reporting very high income.

investors anticipate the fact that management will manage upwards the earnings so they willadjust their valuation accordingly. If the firm reports unmanaged earnings, the investors will stillbelieve that the earnings have been managed (because it is expected to be), so they will concludethat the firm’s earnings are even lower then they actually are, which bid downs the price.

Managing earnings upwards decreases the Informativeness of net incomeabout managereffort.That is, knowing that the owner supports managing earnings upwards, the managerhas an incentive to shirk, but still receives high compensation.Higher quality disclosure helps investors to evaluate the financial statements, thereby reducingtheir susceptibility to behavioral biases and reducing managers’ incentive to exploit poorcorporate governance and market inefficiencies.

For example,clear reporting of revenuerecognition policies, and detailed descriptions of low-persistence items and major discretionaryaccruals such as write-downs and provisions, will bring bad earnings management into the open,reducing manager’s ability to manipulate and bias the financial statements for their ownadvantage.

Good

Earnings management is made possible by the fact that true net income does not exist.Furthermore, GAAP do not completely constrain managers’ choices of accounting policies andprocedures.Such choices are much more complex and challenging than simply selecting thosepolicies and procedures that best inform investors. Rather, manager’s accounting