135
THE ACCOUNTING REVIEW
Vol. 81, No. 1
2006
pp. 135–157
Financial Reporting Transparency and
Earnings Management
James E. Hunton
Bentley College
Robert Libby
Cornell University
Cheri L. Mazza
Fordham University
ABSTRACT: Prior research indicates that greater transparency in reporting formats
facilitates the detection of earnings management. The current study hypothesizes and
demonstrates that greater transparency in comprehensive income reporting also re-
duces the likelihood that managers will engage in earnings management in the area of
increased transparency. In our experiment, 62 financial executives and chief executive
officers decide which available-for-sale security to sell from a portfolio. We manipulate
the transparency of comprehensive income reporting and the relationship of projected
earnings to the consensus forecast in a 2
2 between-subjects design. When pro-
jected earnings are below (above) the consensus forecast, participants sell securities
that increase (decrease) earnings. However, the rarely used, more transparent format
for reporting comprehensive income significantly reduces both income-increasing and
income-decreasing earnings management. Participants in the less transparent setting
indicate that earnings management attempts will not be obvious to readers, will im-
prove stock prices, and have no effect on management’s reputation for reporting in-
tegrity. Conversely, respondents in the more transparent condition suggest that earn-
ings management will be obvious to readers, harmful to stock prices, and damaging
to reporting reputation. Results of this study suggest that more transparent reporting
requirements will reduce earnings management in the area of increased transparency
or change the focus of earnings management to less visible methods.
Keywords: financial reporting; transparency; earnings management; comprehensive in-
come; SFAS No. 130.
The authors thank Rob Bloomfield, Jan Bouwens, Cheryl Dunn, Peter Easton, Eric Hirst, Lisa Koonce, Robert
Knechel, Linda McDaniel, Mark Nelson, Nick Seybert, Dan Stone, Eddy Vaassen, workshop participants at the
Financial Accounting Standards Board, Florida State University, Harvard University, Tilburg University, The Uni-
versity of Iowa, University of Kentucky, University of Maastricht, University of Tennessee, and participants at the
AAA Doctoral Consortium and the FARS Doctoral Consortium for their comments on earlier versions.
Editor’s note: This paper was accepted by Jane Kennedy, Editor.
Submitted November 2004
Accepted August 2005

136 Hunton, Libby, and Mazza
The Accounting Review, January 2006
I. INTRODUCTION
Many studies of reporting transparency examine its effects on users’ ability to detectearnings management. These studies generally report that more transparent dis-closures (those that are easier to process) lead to greater detection of earnings
management (e.g., Hirst and Hopkins 1998). Managers also often lobby for and choose less
transparent disclosure formats (e.g., inclusion of expenses and liabilities in the notes and
market value changes in the statement of stockholders’ equity). This suggests that managers
believe there is a benefit derived from limiting some users’ ability to detect earnings man-
agement. Such a belief is consistent with the view of Fields et al. (2001) that rational
managers likely would not engage in earnings management in the absence of expected
benefits, and such benefits require that at least some users of accounting information be
unable or unwilling to disentangle its effects. If easier detection of earnings management
reduces its expected value, then greater reporting transparency should reduce the prevalence
of earnings management attempts. We test whether managers’ earnings management choices
and underlying beliefs are consistent with this logic. By doing so, we can more fully
understand determinants of earnings management strategies, and facilitate policy makers’
evaluations of the costs and benefits of mandating increased transparency.1
Based in part on user group requests for clearer reporting of other comprehensive
income items, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 130 (SFAS No. 130, FASB 1997), Reporting Comprehensive
Income. The exposure draft leading to SFAS No. 130 (FASB 1996) required a performance
statement approach for the display of comprehensive income. However, in response to
preparer input, the FASB decided to also allow a less transparent display in the statement
of stockholders’ equity. The large majority of companies currently choose the less trans-
parent display.2 The FASB and the International Accounting Standards Board (IASB) are
reconsidering how to display comprehensive income (FASB 2005) with the objective of
improving transparency.
Recent research indicates that users are less likely to detect earnings management when
relevant information is disclosed in the less transparent statement of stockholders’ equity
(e.g., Hirst and Hopkins 1998; Hirst et al. 2004). Contemporaneous research also indicates
that property casualty insurance firms with a history of selective sale of available-for-sale
securities, choice of nonspecialist auditors, lower institutional ownership and analyst cov-
erage, and higher bid-ask spreads, were more likely to select the less transparent display
in the statement of stockholders’ equity in the first year of implementation of SFAS No.
130 (Lee et al. 2005). This suggests that firms with a history of earnings management and
weaker monitoring/corporate governance systems tend to choose the less transparent re-
porting format. What remains unknown is (1) whether the more transparent reporting format
would reduce the likelihood that managers will engage in earnings management in the area
of increased transparency, (2) if it does, why managers behave in such a manner, and (3)
whether the effects are symmetric for income-increasing and income-decreasing earnings
management. The answers to these questions provide a basis for predicting the effects of
requiring more transparent comprehensive income reporting standards (e.g., FASB 2005),
and developing a more complete theory of earnings management and disclosure policy.
1 See Arya et al. (2003) for a discussion of potential costs that can result from transparency improvement.
2 In a survey of 111 randomly selected firms from the Russell 2000 Index, Mazza and Porco (2004) find that 83
percent report comprehensive income in a statement of stockholders’ equity, 3 percent use the one-statement
approach, and 14 percent use the two-statement approach.