Management’s causal reasoning on performance and earnings management

We investigate the association between the intensity of causal reasoning on performance in a firm’s annual management commentary and its earnings management propensity. Anticipated earnings management concerns are argued to constitute a significant accountability predicament, bringing management to offer more intense causal reasoning in order to mitigate investors’ earnings management concerns. We use computer-intensive techniques to measure causal reasoning intensity as a generic disclosure quality in the management commentary of a large sample of US firms from 1999 to 2007. We find that accruals earnings management (signed discretionary accruals) is positively associated with causal reasoning intensity. The positive association holds for alternative specifications of accruals earnings management (an earnings management dummy model and an analyst expectations model) and in a change model. Our results are consistent with the assertion that firms strategically use causal reasoning on performance to establish appropriateness and cognitive legitimacy, increase perceived plausibility of reported performance and mitigate performance-related concerns of investors.