1. Clor‐Proell, S. M., & Maines, L. a. (2014)

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DOI: 10.1111/1475-679X.12053

Journal of Accounting Research Vol. 52 No. 3 June 2014

Printed in U.S.A.

The Impact of Recognition VersusDisclosure on Financial

Information: A Preparer’sPerspective

S H A N A M . C L O R - P R O E L L∗ A N D L A U R E E N A . M A I N E S†

Received 28 August 2013; accepted 27 February 2014

ABSTRACT

We investigate whether recognition on the face of the financial statements versus disclosure in the footnotes influences the amount that financial man-agers report for a contingent liability. Using an experiment with corporatecontrollers and chief financial officers, we find that financial managers inpublic companies expend more cognitive effort and exhibit less strategic biasunder recognition than disclosure. This difference appears to be associated

with capital market pressures experienced by public company managers as we find that both the cognitive effort and bias exhibited by private company

∗M.J. Neeley School of Business, Texas Christian University (TCU); † Kelley School of Busi-ness, Indiana University.

Accepted by Douglas Skinner. We thank Jason Brown, Andy Call, Tina Carpenter, RickCazier, Margaret Christ, Ted Christensen, Lisa Gaynor, Steve Glover, Max Hewitt, Pat Hop-kins, Lisa Koonce, Mark Nelson, Ray Pfeiffer, Chad Proell, Kathy Rupar, Casey Schwab, Geoff Sprinkle, Jane Thayer, Jeff Wilks, David Wood, Arnie Wright, Teri Yohn, Mark Zimbelman,an anonymous reviewer, and workshop participants at the following universities for helpfulcomments on prior versions of the paper: Arizona State, Brigham Young, Cornell, Georgia,Indiana, Northeastern, Texas Christian, South Florida, and Texas-Austin. We greatly appreci-ate the help of Diane Biagioni and Todd Stinson in creating the experimental instrument, andSpencer Anderson, Devon Erickson, Adam Esplin, Ken House, Tim Keune, and Gabby Wangfor research assistance. We thank the KPMG Professorship at the Kelley School of Business,

the M.J. Neeley School of Business, and the Wisconsin School of Business for their generousfinancial support. Finally, we thank the financial professionals who participated in the study.

671

Copyright C, University of Chicago on behalf of the Accounting Research Center, 2014


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672 S. M. CLOR -PROELL AND L. A . MAINES

managers are unaffected by placement. As a result, public company man-agers make higher liability estimates for recognized versus disclosed liabilities.Their liability estimates are similar to those of private company managers forrecognition but lower than private company managers’ estimates for disclo-

sure. Our results have implications for auditors and financial statement usersin evaluating recognized versus disclosed information for public and privatecompanies.

1. Introduction

We investigate whether placement of information on the face of the fi-nancial statements (recognition) versus in the footnotes (disclosure) influ-ences the amount financial managers in public and private companies re-port for a contingent liability. Understanding whether and how placement

influences the judgments and decisions of managers who prepare financialstatements is important because preparers establish the initial reliability of financial information.1 While research finds that auditors tolerate less mis-statement in recognized than disclosed information (Libby, Nelson, andHunton [2006]), it is unknown whether auditors’ actions serve to offset or exacerbate reliability differences in preaudit information. Thus, our re-search is important to auditors who attest to information reliability, as wellas to users, regulators, and standard setters who face consequences fromreliability differences remaining in audited financial information.

In addition to examining whether preparers’ estimates differ betweenrecognition and disclosure, we address two related issues associated withthese potential differences. First, we examine how differences in prepar-ers’ estimates arise. Specifically, we propose that differences between rec-ognized and disclosed amounts arise from two sources: (1) preparers’choice of approaches for arriving at reasonable ranges for the estimate,and (2) preparers’ choice of point estimates within those ranges. Drawingon Bernard and Schipper [1994], we hypothesize that capital market pres-sures from standard setters, investors, and auditors/regulators differentially affect preparers’ motivation to engage in effortful information processing

when making contingent liability estimates that are either recognized ordisclosed. Similarly, we expect that capital market pressures will also affect the extent to which preparers choose more justifiable estimates that are inthe middle of the range of possible outcomes, rather than biasing financial

1 Historically, the Financial Accounting Standards Board (FASB) has used the term reliabil-ity to describe information that is reasonably free from error and bias and faithfully represents

what it purports to represent (FASB [1980]). However, the FASB recently replaced the term re-liability with representational faithfulness to describe information that is complete, free fromerror, and neutral (FASB [2010]). Despite this change, the term reliability continues to ap-pear in the FASB Codification (e.g., FASB ASC 820, FASB [2013b]) and in recent accountingliterature (e.g., Kadous, Koonce, and Thayer [2012]). We use the term reliability throughout

the paper to refer to characteristics related to the 1980 definition, that is, information that isfree from error, unbiased, and faithfully represents what it purports to represent.


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THE IMPACT OF RECOGNITION VERSUS DISCLOSURE 673

information by choosing estimates toward the lower or upper end of therange. We leverage our comparative advantage as experimentalists to cap-ture information about preparers’ judgment process when making the ac-

counting estimate (Libby, Bloomfield, and Nelson [2002]) to provide in-sight on the mechanisms that lead to preparers’ estimates.Second, to provide further insight on capital market forces as the source

of differences in recognized versus disclosed estimates, we compare publiccompany managers’ judgments to identical judgments made by financialmanagers in private companies. We argue that private company preparersform a reasonable basis for comparison because they have the requisitelevel of expertise, but are less likely to be influenced by the capital mar-ket pressures that face public company preparers. Thus, we expect that private company preparers will be less likely to exhibit differences in theamount of cognitive effort and bias that they use when making recognized

versus disclosed estimates. We find it particularly interesting to examinedifferences between public and private company preparers as prior litera-ture in this area has examined differences in recognized, postaudit infor-mation, but has not examined whether differences exist in disclosed infor-mation, and/or in preaudit information (Givoly, Hayn, and Katz [2010],Hope, Thomas, and Vyas [2013]).

To examine these issues, we conduct an experiment with 113 experi-enced preparers (primarily controllers and chief financial officers (CFOs))using a 2× 2+ 1 between-subjects design. Preparers determine the amount of a contingent liability for costs associated with a chemical used in the

firm’s manufacturing process that appears to have had deleterious effectson employees’ health. For the 94 participants in the 2 (placement) × 2(company trading status) external financial reporting conditions, we ma-nipulate whether financial reporting standards require the estimate to bereported as an expense in the income statement and liability on the bal-ance sheet or only disclosed in the footnotes. Company trading status isa measured variable, with participants currently working for either publicor private companies. Finally, in the +1 internal reporting condition, 19participants provide their best estimate of the amount that the company

will have to pay related to the chemical for internal planning purposes

(i.e., not for financial reporting purposes). Thus, the +1 condition assessesparticipants’ beliefs about the ultimate resolution of the contingent liabil-ity and provides a benchmark for assessing managers’ external reportingestimates.

We use both self-reported and computer-tracked process data to exam-ine how differences in estimates arise. We find that public company man-agers use more effortful approaches for estimating recognized liabilitiesthan disclosed liabilities. In contrast, private company managers use simi-lar approaches regardless of whether the liability is recognized or disclosed.

We also find that public company managers are more likely to choose esti-

mates below the midpoint of their expected range for contingent liabil-ity payments when the estimate will be disclosed versus recognized. We


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observe no such difference for private company managers. Thus, our pro-cess results indicate that public company managers both choose more ef-fortful approaches and exhibit less strategic bias under recognition than

disclosure. In contrast, private company managers’ effort levels and amount of strategic bias are similar regardless of placement.Further, the results of a mediation analysis reveal that preparers’ effort

levels and extent of strategic bias affect the liability estimate that is reportedin the financial statements, with public company financial managers report-ing a higher amount when a contingent liability is recognized than whendisclosed and private company managers reporting a similar amount re-gardless of placement. Finally, we find that in the recognition conditionboth public and private company managers’ external financial reporting es-timates do not differ from the internal reporting group’s average estimateof future payments related to the contingent liability. In the disclosure con-dition, however, while private company managers’ external estimates donot differ from the internal estimate, public company managers’ externalestimates are significantly lower than the internal reporting estimate. Thus,

we conclude that preparers’ external reporting estimates are generally con-sistent with their beliefs about the ultimate resolution of the liability withthe exception of public company managers’ disclosed estimates. One possi-ble explanation for this result is that public company managers, who must disclose a contingent liability estimate, are more concerned about potentialscrutiny from the plaintiffs’ legal counsel than they are about scrutiny fromauditors and users. In contrast, public company managers who recognize a

contingent liability estimate must balance the scrutiny of attorneys against the greater scrutiny of auditors and users. Finally, private company man-agers would not have as much concern about scrutiny from the plaintiffs’legal counsel because their financial statements are not publicly available.

Our research is of interest to academics, auditors, and financial state-ment users. From an academic perspective, our research adds to the rel-atively sparse accounting literature on financial reporting practices associ-ated with preparers and preaudit information. In contrast to prior researchthat has held constant the amount of preaudit misstatement (Libby, Nelson,and Hunton [2006]), or has investigated the reliability of postaudit finan-

cial information (Davis-Friday, Liu, and Mittelstaedt [2004]), our researchexamines whether and how information location affects preaudit reliability.Thus, we answer calls for evidence concerning managements’ perspectiveon the reliability of disclosed information relative to recognized informa-tion (Libby and Emett [2014], Schipper [2007]).

Our findings also relate to the academic literature on the quality of finan-cial reporting in public versus private firms. Recent studies in this area tendto find that public firms have higher quality (recognized) earnings thanprivate firms (Burgstahler, Hail, and Leuz [2006], Hope, Thomas, and Vyas[2013]). While we do not examine all factors that could affect differential

financial reporting quality between public and private firms, our findingssuggest that public companies do not necessarily have higher quality disclosed information than private companies. In addition, our findings suggest


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that the impact of auditor scrutiny on preparers’ judgments and decisionsdiffers between public and private companies, and thus should differen-tially influence users’ reliance on audited information (Minnis [2011]).

Future research can further investigate the interactive effects of preparerand auditor judgments and decisions on the relative quality of financialinformation presented outside of the face of the financial statements forpublic versus private firms.

Finally, from a practical perspective, our research is useful to auditorsand financial statement users who are concerned about reliability of in-formation in the financial statements. Our findings support auditors’ andusers’ expectations for public companies that recognized numbers gener-ally are more reliable than disclosed numbers, and we document that thisdifference originates with preparers. Further, our results indicate that thesedifferences arise in part due to the level of effort that preparers use to assessrecognized versus disclosed information. For auditors, these results suggest that preparers may resist correction of recognized amounts more than dis-closed amounts in part because they have invested more effort in estimatingrecognized amounts. Thus, auditors should be aware that not all client resis-tance is necessarily motivated by a desire for biased reporting. For users, ourresults, in conjunction with those of Libby, Nelson, and Hunton [2006], in-dicate that the judgments of auditors and managers work in combination toproduce more reliable recognized amounts than disclosed amounts. Thus,users’ propensity to discount disclosed information relative to recognizedinformation appears reasonable given the current financial reporting envi-

ronment.The remainder of this paper is organized into four sections. The next

section provides background and develops the hypotheses, and section 3describes the experiment used to test these hypotheses. Section 4 presentsthe results, and section 5 provides a summary and discussion of theresults.

2. Background and Hypotheses

2.1 RESEARCH ON PLACEMENT AND FINANCIAL INFORMATION RELIABILITY Research on whether corporate financial managers differentiate between

recognition and disclosure when determining financial information is rel-atively sparse and is typically based on published financial statement num-bers rather than preparers’ preaudit numbers. These studies provide mixedevidence about the relative reliability of recognized versus disclosed infor-mation. For example, Wiedman and Wier [1999] find that firms’ uncon-solidated subsidiary debt increased when the FASB requirement switchedfrom disclosure to recognition, suggesting that firms were understatingthe previously disclosed amount. In contrast, research on stock-based com-

pensation documents that companies’ estimates for stock option com-pensation are more downwardly biased when recognized in the financialstatements than when disclosed in the footnotes (Johnston [2006],


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Standard Setters

Economic Differences(Greater Relevance or

Reliability of RecognizedInformation)

Financial Statement Users

Economic Differences GreaterWeighting

Processing Differences of Recognized Information

Auditors/Regulators

Economic Differences GreaterScrutiny of

Users’ Greater Weighting RecognizedInformation

Preparers

Level of Care forRecognized vs.Disclosed Information

Preparers

Strategic Bias forRecognized vs.Disclosed Information

Contracts/Regulations

Compensation ContractsDebt CovenantsIncome Taxes

Estimate

FIG. 1.—Capital market forces that affect preparers’ estimates. A + (–) sign indicates that aforce increases (decreases) level of care or strategic bias. The line thickness illustrates thestrength of a force, while a dotted line represents a force not considered in our experiment.

Choudhary [2011]). Overall, the scarcity of research in this area and mixedresults of the existing research suggest that further investigation of prepar-

ers’ treatment of recognized versus disclosed information is warranted. As defined by the FASB, information is reliable if it is free from error,

unbiased, and represents what it purports to represent (FASB [1980]). Weexamine two possible ways by which preparers influence the reliability of initial financial information. First, preparers affect reliability through theapproaches they use to arrive at financial amounts. By choosing a higherstandard of care in the approach used to arrive at financial information,preparers improve the ex ante expected reliability of that information be-cause a more careful approach decreases the probability that financial in-formation will contain errors. Second, for some financial information, such

as estimates, a given approach provides a range of numbers from which pre-parers must choose a point estimate to report in the financial statements.Preparers can influence the reliability of this point estimate by strategically choosing a number toward one end of the range, that is, “biasing” the infor-mation in one direction. Thus, both choice of an “approach level of care”and “strategic bias” influence the reliability of preparers’ financial informa-tion. To date, evidence on these two avenues tends to be either anecdotalor circumstantial (Schipper [2007]).

Drawing on Bernard and Schipper [1994], we argue that the level of care and strategic bias that preparers exhibit is determined primarily by

forces associated with a firm’s participation in the capital markets. Infigure 1, we describe the forces exerted by different participants in the


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capital markets—namely, standard setters, users, and auditors/regulators—and the pressures that they create for preparers.2

2.2 STANDARD SETTER , USER , AND AUDITOR VIEWS TOWARD RECOGNIZED VERSUS DISCLOSED INFORMATION

As shown in figure 1, the distinction between recognition and disclosureoriginates with standard setters because the FASB’s Conceptual Frameworksuggests a higher threshold for recognition than for disclosure. That is,Statement of Financial Accounting Concepts No. 5 specifies that informa-tion must be relevant and measured with sufficient reliability to be recog-nized in the financial statements (FASB [1984]). Information that fails tomeet these criteria is relegated to disclosure in the footnotes. Thus, stan-dard setters, at least implicitly, view recognized information as more usefulthan disclosed information because recognized information is presumably more relevant and/or reliable. The importance that standard setters as-cribe to recognized information creates the expectation that preparers willdemonstrate a higher level of care (represented with a plus sign in figure1) and less strategic bias (represented with a minus sign in figure 1) for rec-ognized information than for disclosed information. Importantly, standardsetters’ views toward recognition versus disclosure also have implicationsfor users and auditors/regulators. We discuss each group in turn.

Both the experimental and archival literatures find that users (investors)generally impound recognized information more strongly than disclosedinformation in their investment judgments and decisions (Davis-Friday, Liu,

and Mittelstaedt [2004], Fredrickson, Hodge, and Pratt [2006], Michels[2013]). As indicated in figure 1, and as articulated by Bernard and Schip-per [1994], there are at least two reasons why financial statement usersmight react differently to recognized and disclosed information. First, asa result of standard setters’ view toward recognition versus disclosure, usersmay rationally perceive that firms report the most important financial infor-mation on the face of the financial statements, that is, they believe that rec-ognized information in general is more relevant and reliable than disclosedinformation. This perspective suggests that economic differences betweenrecognized and disclosed numbers lead users to weight recognized infor-

mation more heavily than disclosed information.

2 Preparers’ recognition and disclosure judgments may also be determined by the use of fi-nancial statement information in contracts (e.g., compensation contracts, debt covenants) orregulatory reports (e.g., income tax reporting). However, contracting arrangements and regu-latory reports typically are tied to and influence recognized information only (e.g., reportinglower numbers for expenses in order to meet earnings benchmarks for bonuses). Overall, thedirection and level of the potential bias in recognized information is specific to the firm’s con-tractual and regulatory parameters, and is not the focus of our research. Thus, as discussed inmore detail in section 3, we minimize the effect of these forces in our experimental materials.

We include contractual and regulatory forces in figure 1 only for the sake of completeness,

and represent the effects on preparers with dotted lines to signify the weak relationship in oursetting.


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Alternatively, there may be cognitive processing differences associated with recognized versus disclosed information. Financial statement usersmay experience cognitive overload in processing footnote information or

may simply find the varying formats of disclosed information more difficult to process and integrate than the more standardized format of the finan-cial statements.3 Regardless of whether users’ interpretation of recognized

versus disclosed information is driven by rational economic differencesand/or by processing difficulties, the fact that users generally place more

weight on recognized information than on disclosed information gives pre-parers not only the incentive to exhibit more care, but also the incentiveto exhibit greater strategic bias to make the firm look more favorable (asrepresented by the plus signs in figure 1).

As shown in figure 1, users’ greater weighting of recognized versus dis-closed information leads auditors and regulators to perceive recognized in-formation as more material than disclosed information because it has moreinfluence on users’ judgments. This perception, along with the direct influ-ence of standard setters’ perceptions of greater relevance and reliability forrecognized information, results in greater auditor and regulator scrutiny for recognized than for disclosed information, particularly in the post–Sarbanes-Oxley (SOX) era (Cohen, Dey, and Lys [2008]). Consistent withthis expectation, experimental evidence finds that auditors allow less er-ror in recognized than disclosed information (Libby, Nelson, and Hunton[2006]). Thus, due to auditor/regulator scrutiny, preparers are likely toexhibit both more care for recognized information (as represented by the

plus sign in figure 1) and less strategic bias (as represented by the minussign in figure 1).

2.3 RECOGNITION VERSUS DISCLOSURE AND PREPARERS’ PROCESSING

Bringing together the perspectives of standard setters, users, and audi-tors/regulators allows us to make predictions about public company pre-parers’ ultimate behavior regarding the level of care and strategic bias as-sociated with recognized and disclosed amounts. With respect to the levelof care, we expect that the views of standard setters, users, and auditors

will lead preparers to exhibit a higher standard of care (i.e., greater effort)

3 The literature in this area focuses on whether investors’ differential reaction to recognized versus disclosed information reflects differences in perceived reliability or user cognitive pro-cessing differences. For example, using inferences from subsequent event reporting, Michels[2013] concludes that differences in reactions to recognized versus disclosed information aredue to users failing to fully incorporate disclosed information into stock prices. In contrast,Frederickson, Hodge, and Pratt [2006] find that investors’ perceived reliability differs betweenrecognition and disclosure. Additionally, Bratten, Choudhary, and Schipper [2013] find that investors and creditors do not distinguish between recognition and disclosure for lease infor-mation with similar reliability. To date, the literature appears to suggest that both reliability and cognitive processing differences have a role in the differential weighting of recognized

versus disclosed information, but has not fully explored the circumstances under which oneor the other force will prevail.


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in their approach to determining recognized versus disclosed informationdue to both the greater perceived importance and greater scrutiny that recognized information receives relative to disclosed information. Again,

we represent this expectation in figure 1 with plus signs to indicate that thelevel of care will be greater for recognition than for disclosure, as formally stated in H1a below:

H1a: Public company preparers’ cognitive effort to arrive at a contin-gent liability estimate will be higher for recognition than for dis-closure.

With respect to the strategic bias that preparers exhibit, the greaterscrutiny that standard setters and auditors apply to recognized informa-tion makes it less likely that preparers will attempt to strategically bias rec-

ognized information relative to disclosed information. We represent thisexpectation with minus signs in figure 1. However, the fact that users placegreater weight on recognized information when making investment deci-sions suggests that preparers will have a greater incentive to strategically bias recognized information to make the firm look more favorable, as rep-resented by a plus sign in figure 1. To make a prediction about how pre-parers will resolve this conflict, we rely on recent research that suggeststhat in a post-SOX environment preparers are likely to be more concerned

with auditor and regulator scrutiny than with impressing investors (e.g.,Graham, Harvey, and Rajgopal [2005, p. 36], Cohen, Dey, and Lys [2008],

Agoglia, Doupnik, and Tsakumis [2011]). We express this in figure 1 by us-ing thicker arrows to connect auditors/regulators to preparers. Therefore,combining all forces together, we expect that preparers’ recognized esti-mates will exhibit less strategic bias than will their disclosed estimates, asstated in H1b:

H1b: Pubic company preparers’ contingent liability estimates will beless biased under recognition than disclosure.

If it is indeed the case that differences in the level of care and strategicbias that preparers exhibit for recognized versus disclosed information are

driven by participation in the capital markets, then we would expect that private company preparers would be less likely to exhibit these differences.To test our theory, we turn our attention to private company preparers as acomparison group.

2.4 COMPARING PUBLIC AND PRIVATE PREPARERS TO ASSESS EFFECTS OFCAPITAL MARKET FORCES

To provide further insight on capital market forces as the source of dif-ferences in recognized versus disclosed estimates for public companies, wepropose private company preparers as a useful comparison. Private com-

pany preparers possess a similar level of training and business/financial re-porting experience, but do not routinely confront stock market pressures


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in financial reporting. Limited prior research has considered how the ab-sence of capital market pressures will affect the level of care and strate-gic bias that private company preparers exhibit for recognized, postaudit

information.

4

In contrast, our research focuses on preaudit informationthat is both recognized and disclosed.Drawing on figure 1, we argue that the absence of capital market forces

will make private company preparers less sensitive to investors’ perspec-tives on financial information because private company investors typically have greater familiarity with the company and are less likely than publiccompany investors to make investment decisions based on external finan-cial reports. Thus, users’ greater emphasis on recognized information forpublic companies is less likely to impact private companies. In turn, thisimplies that auditors will have less reason to differentially scrutinize recog-nized information relative to disclosed information. Accordingly, we expect that private company preparers will be more likely to exhibit a more sim-ilar level of care for recognized and disclosed information and will haveless incentive to bias recognized information relative to disclosed informa-tion. Thus, we predict that any differences observed for public company preparers (the focus of H1a and H1b) will be weaker for private company preparers, as formally stated in H2a and H2b below:

H2a: The difference in cognitive effort to arrive at a recognized versusa disclosed contingent liability estimate will be greater for publiccompany preparers than for private company preparers.

H2b: The difference in strategic bias associated with a recognized ver-sus a disclosed contingent liability estimate will be greater forpublic company preparers than for private company preparers.

As shown in figure 1, the level of care and amount of strategic bias that preparers exhibit should affect the liability estimate that they ultimately report in the financial statements. Thus, for both public and private com-pany preparers, we expect that these variables will mediate the relationshipbetween placement (recognition vs. disclosure) and preparers’ liability es-timate. We state this formally in H3a and H3b below:

4 Prior literature has established the importance of various recognized metrics to preparers,but has not examined how preparers think about recognized information relative to disclosedinformation (Graham, Harvey, and Rajgopal [2005]). With respect to recognized information,researchers have established two perspectives on this issue. The “demand hypothesis” arguesthat private companies face fewer stakeholder demands and regulatory requirements to pro-

vide high-quality financial information to financial statement users than do public companies, which leads private company preparers to be less concerned with the level of care for rec-ognized information relative to public company preparers. Alternatively, the “opportunistichypothesis” argues that stakeholders’ reliance on financial information to make investment and other decisions gives public company preparers a stronger incentive to bias recognizedinformation in ways favorable to the company (Givoly, Hayn, and Katz [2010], Hope, Thomas,

and Vyas [2013]). We argue that placement of information affects the relative strength of thesetwo hypotheses.


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H3a: Preparers’ cognitive effort will mediate the effect of placement on their preaudit contingent liability estimates.

H3b: Preparers’ strategic bias will mediate the effect of placement on

their preaudit contingent liability estimates.

5

Recall that the FASB identifies three elements of reliable information:freedom from error, unbiasedness, and representing what it purports torepresent. We use preparers’ cognitive effort and level of strategic bias asproxy measures for the first two elements. In our context, the third ele-ment corresponds to the extent to which the liability estimate in the finan-cial statements reflects the ultimate cash outflow associated with the liabil-ity. The preceding discussion suggests that preparers’ liability estimates aremost likely to correspond to their beliefs about the ultimate cash outflow

when the estimate is recognized rather than disclosed. Further, we argue

that any potential difference will be smaller for private company preparersthan for public company preparers. Thus, our final hypothesis addressesthis third element of reliability and predicts that the difference betweenpreparers’ estimates and their expectation of the ultimate settlement of the liability will be smaller for recognition than for disclosure, and that differences between recognition and disclosure will be smaller for privatecompany preparers, as stated in H4 below:

H4: Preparers’ contingent liability estimates will be more closely asso-ciated with their beliefs about the ultimate liability settlement un-

der recognition than under disclosure, and this difference will besmaller for private company preparers than for public company preparers.

In summary, we expect that public company preparers’ participation inthe stock market will affect the level of care and the amount of bias that they exhibit when estimating financial information, with the level of carebeing greater (H1a) and the amount of strategic bias being smaller (H1b)for recognized information than for disclosed information. We also expect that removing concerns about capital market pressures creates a bench-mark to assess the effect of these pressures, with private company prepar-

ers exhibiting smaller effort- and bias-related differences under recogni-tion versus disclosure than do public company preparers (H2a and H2b).Further, we expect that preparers’ effort and bias will mediate their lia-bility estimates (H3a and H3b). Finally, we expect that preparers’ liability estimates will be more closely aligned with their beliefs about the ultimatecash outflow if recognized than if disclosed and that this difference will be

5 Note, however, that the relation hypothesized in H3b may be somewhat mechanical as any type of bias will have a direct impact on preparers’ estimates. We alleviate this direct impact in

our tests of H3b by using an indicator variable rather than a parametric variable to measurebias.


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more pronounced for public company preparers than for private company preparers (H4).

3. Method 3.1 PARTICIPANTS

We recruit participants for our experiment in two ways. First, we ran-domly select from alumni databases 670 practitioners with job titles that identify them as either CFOs or controllers. Second, we randomly select from the Capital IQ database 600 practitioners with job titles that identify them as controllers. Practitioners are contacted via email or U.S. mail andasked to participate in a Web-based experiment. In exchange for partic-ipation, we donate $10 to a not-for-profit on their behalf. A total of 113

practitioners (9%) participate in the experiment.6

Participants are 47 yearsold on average, have an average of 24 years of business experience, and arepredominately male (82%). Sixty-nine percent hold a Certified Public Ac-countant license, and 83% list their job title as CFO and/or controller. Onehundred four participants (92%) indicate having experience with makingaccounting estimates and accounting for contingent liabilities.7

3.2 DESIGN

Our experiment has a 2 × 2 + 1 between-subjects design.8 The 2 × 2portion of the design is set in an external financial reporting context and

allows us to test our first three hypotheses. Participants in the 2 (company trading status) × 2 (placement) portion of the experiment are identifiedas currently being associated with a public or private company (a measured

variable), and are randomly assigned to one of the two experimental con-ditions for placement of the contingent liability (a manipulated variable).In the recognition (disclosure) condition, participants are told that the rel-evant accounting standard requires recognition (disclosure) of contingent liabilities that have a moderate likelihood of being incurred and can bereasonably estimated. The +1 portion of the design is set in an internal

6 Our response rate of 9% is similar to rates reported by surveys of financial executives,including Graham, Harvey, and Rajgopal [2005] with a response rate of 10.4%.

7 The descriptive statistics for our participants are similar to those reported by prior researchthat examines the judgments of experienced financial managers. For example, Bhojraj andLibby [2005] report that their participants had 16 years of business experience and 59% wereCPAs. Similarly, Hunton, Libby, and Mazza [2006] report that their participants had 23 yearsof business experience and 50% were CPAs.

8 We also manipulated the attainability of analysts’ forecasts on a between-subjects basis.However, this manipulation was not a significant predictor of any of our dependent measures,except for a marginally significant main effect on preparers’ liability estimates ( F 1,86 = 3.26, p = 0.07). Moreover, this variable did not interact with other manipulated or measured variablesin any of our analyses (all F 1,86 < 0.63, all p > 0.43). Finally, fully crossing this variable with

our other independent variables does not affect any of the inferences that we draw from ouranalyses. Therefore, we do not discuss it further.


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reporting context in which there is no mention of relevant accounting stan-dards. This condition provides a measure of preparers’ beliefs about the ul-timate cash outflow associated with the liability estimate, thereby allowing

us to test H4.3.3 MATERIALS AND PROCEDURE

The experiment is administered via a Web-based instrument. The taskrequires participants to evaluate information about XYZ Corporation, a fic-tional public company in the electronic manufacturing services (EMS) in-dustry.9 The company has recently become aware of a situation that may result in a contingent liability for potential costs associated with the use of a chemical in the firm’s manufacturing process. Participants in the 2 × 2portion of the design assume the role of controller and estimate an amount associated with the contingent liability for financial reporting purposes.Participants in the +1 portion of the design assume the role of corporatetreasurer and provide, for internal planning purposes, their best estimateof the amount that the company will ultimately have to pay in connection

with the liability.The first part of the instrument provides participants with background in-

formation for XYZ Corporation and financial information, which includesabbreviated balance sheets, income statements, and cash flow statements.

All financial information is constructed based on a composite of three ac-tual firms in the EMS industry. Participants in the 2 × 2 portion also receiveinformation about executive compensation for the company’s officers, and

information about analyst coverage and estimates.10 Next, all participantsreceive information about the circumstances that have given rise to the pos-sible contingent liability. Specifically, they are informed that XYZ Corpora-tion has been using a chemical, CNX, in its manufacturing process, whichhas potentially deleterious health effects. Some employees have been diag-nosed with conditions, such as bronchitis, pneumonia, pulmonary edema

9 Note that the company in question is a publicly traded company. We test the effects of pub-lic versus private companies by identifying the type of company with which our participantsare associated, rather than by varying the type of company in the experimental materials. Con-sistent with discussion in Libby, Bloomfield, and Nelson [2002], we believe that professionalparticipants come to the experiment with experience in their particular professional settingthat is the primary determinant of how they approach the task. We are interested in the effect of this experience in light of our manipulated variable.

10 Both public and private company participants may consider contracting or regulatory ar-rangements when completing the task. Thus, we designed characteristics of the company tominimize the potential effects of these considerations on participants’ estimates. The amount of long-term liabilities was minimal (4.7% of assets), suggesting that contracting issues relatedto debt covenants were not likely to be material. In addition, while compensation was basedin part on bonuses related to financial information, no specific details were provided in thematerials about the exact nature or parameters of the compensation contracts. Finally, incometax (regulatory) issues are not relevant because any deduction related to the contingent liabil-

ity would be based on eventual cash outflows related to legal settlements, not on the estimatedamounts in the financial statements.


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(inflammation), and pulmonary fibrosis (scarring). Employees have re-quired long-term therapy, have been unable to return to work, and havefiled claims and lawsuits for damages.

Following the contingent liability information, participants in the 2 ×

2 portion are provided with the relevant accounting guidance, whichincludes the placement manipulation, shown in the appendix. We makethree design choices with respect to the relevant accounting guidance. First,

we inform participants that they should adhere to the financial reportingstandard described in the case even if it does not conform to the guidancethat they are familiar with in their daily lives. Second, consistent with priorresearch in accounting, we create a fictitious accounting standard that isclose, but not identical, to current accounting guidance governing con-tingent liabilities to ensure the scenario is familiar to participants but not one for which they possess an “automatic” response (e.g., Cuccia, Hacken-brack, and Nelson [1995]). Third, the accounting guidance in the case issilent with respect to the amount that should be accrued or disclosed whenthere are a range of possible outcomes (i.e., FIN 14 guidance, FASB [1976],now included in ASC 450, FASB [2013a]). This abstraction from current ac-counting standards is a critical design choice, which allows us to examinehow managers will strategically bias financial information when allowed todo so. To the extent that our participants are familiar with FIN 14 guidance,this biases against our ability to observe treatment effects.

Participants are instructed to assume that any insurance coverage relatedto the potential liability will be accounted for separately. Participants in

the 2 × 2 portion also receive information about the company’s materiality threshold ($4.5 million). All participants then receive additional informa-tion about the estimated number of affected employees and are provided

with three approaches that can be used to estimate the liability. Participantsaccess each approach by clicking on a link, which brings up a textbox. Par-ticipants must close the textbox before continuing with the instrument, al-lowing us to track the amount of time that participants spend viewing eachapproach.

The approaches increase in the effort required to calculate the min-imum and maximum for the range of potential costs associated with

consequences of the chemical. Specifically, Approach One requires par-ticipants to perform two multiplications; Approach Two requires six mul-tiplications and two additions with each addition involving three numbers;

Approach Three requires 18 multiplications and 2 additions with each ad-dition involving nine numbers. See the appendix for a description of thethree approaches.

The three approaches also result in different estimates for ranges of possible costs. Approach One provides an estimate range from approxi-mately $858,600–$14,166,900, Approach Two has an approximate rangeof $3,847,000–$15,315,000, and Approach Three provides a range of

$6,709,000–$15,291,500. The midpoint of the range increases with the ef-fort required ($7,512,750, $9,581,000, and $11,000,250 for low, medium,


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and high effort, respectively). Moreover, the range decreases as the ef-fort associated with the approach increases ($13,308,300, $11,468,000,and $8,582,500 for low, medium, and high effort, respectively), suggest-

ing greater precision of the estimate. Thus, Approach Three appeared themost valid in that it used the most disaggregated information to arrive at anestimate.11

After accessing the approaches and completing their calculations, par-ticipants respond to the questions that elicit the dependent variables andare able to scroll through all information provided thus far. After submit-ting this section of the instrument, all participants are directed to a secondquestion set and are not allowed to return to this portion of the experi-ment. The second question set contains manipulation check questions, de-briefing questions, and demographic questions. Submitting this section of the instrument completes the experiment.

3.4 DEPENDENT VARIABLES

We use three dependent variables to test our hypotheses. The first de-pendent variable is participants’ estimate for the contingent liability. Partic-ipants in the 2 × 2 portion are asked the following, “Given the contingent liability information and accounting guidance stated in the case, please es-timate the amount of the contingent liability that XYZ Co. should accrue[disclose ] in the 20x4 balance sheet [ footnotes ] in connection with the useof CNX.” Participants in the +1 portion are asked, “Given the contingent liability information, please provide your best estimate of the amount thecompany will have to pay related to CNX.”

The second dependent variable, designed to capture the effort that par-ticipants bring to the task, is based on participants’ response to the follow-ing, “Please explain how you arrived at your liability estimate in the first question above. Please indicate how, if at all, you incorporated the threeapproaches described above.” As described more fully in section 4, all re-sponses are coded by two independent coders to form a measure of prepar-ers’ effort.

The third dependent variable is a measure of the bias associated withparticipants’ contingent liability estimate. After providing their estimate,

participants are asked to provide a 90% confidence interval for the actualamount that the company will have to pay for the liability. To determine

whether participants’ estimates for the contingent liability are biased, we

11 The experienced accountants that we consulted in developing the experimental materi-als suggested that, while all approaches seem acceptable, the face validity of the approachesincreases with their complexity. Moreover, as part of a post-experimental questionnaire, wealso asked a subset of our participants (those from the Capital IQ database) to rank the threemethods in terms of perceived reliability. Their ranking mirrored the effort associated withthe approach, with the high-effort Approach Three ranked first, the medium-effort Approach

Two ranked second, and the low-effort Approach One ranked third in perceived reliability.


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compare each participant’s liability estimate to the midpoint of his/herconfidence interval. If the liability estimate is less than (equal to) [greaterthan] the midpoint, then the bias measure takes a value of –1 (0) [+1].

If a participant’s estimate is equal to the midpoint of his/her confidenceinterval, then we argue that the estimate is unbiased. If, however, partici-pants choose an estimate that is either greater or less than the midpoint of their range for the eventual costs that the company will incur to resolve theliability, then we argue that the estimate is biased.

We acknowledge two weaknesses of the bias dependent variable. First, deviations from the midpoint of the range may simply reflect that participantshave a nonuniform probability distribution for values within the range.Thus, these deviations may not be intentional bias. Second, we acknowl-edge that a participant who chooses to report a biased point estimate may also choose to report a confidence interval that is similarly biased. However,it is important to note that if the point estimate and the confidence inter-

val are both biased in the same direction, then our bias measure is morelikely to take a value of zero, which would suggest no bias even in circum-stances in which bias exists. Thus, we view our bias measure as providing aconservative test of the bias associated with preparers’ estimates.

4. Results

4.1 MANIPULATION CHECK

Of the 94 participants in the 2 × 2 external financial reporting condi-tions, 85% (94%) of participants in the recognition (disclosure) conditionscorrectly indicated that the accounting guidance in the case requires con-tingent liabilities with a moderate likelihood of being incurred to be ac-crued in the balance sheet (disclosed in the footnotes). We find that com-pany trading status does not have either a main or interactive effect on theplacement manipulation check (all F 1,87 < 0.86, all p > 0.35), indicatingthat both groups of participants responded similarly to the manipulation.Further, there were no main or interactive effects associated with partic-ipants’ interpretation of the term “moderate likelihood” used in the ac-

counting guidance (all F 1,80 < 0.39, all p > 0.53), indicating that all partici-pants interpreted the threshold necessary for recognition (disclosure) in asimilar manner. Thus, we deem the placement manipulation to be success-ful. Further, excluding the participants who failed the placement manip-ulation check question does not affect the results. Therefore, all analysesinclude these participants.

4.2 HYPOTHESIS TESTS

We examine how preparers influence the reliability of preaudit estimatesby assessing the level of care and the amount of strategic bias that preparers

bring to the task when estimating a contingent liability. Further, we exam-ine how the resulting estimate compares to preparers’ beliefs about the


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ultimate cash outflow associated with the liability. We structure our hypoth-esis tests by first examining the hypotheses that relate to preparers’ levelof care, then examining the hypotheses that relate to the amount of strate-

gic bias, and finally examining the hypothesis that compares the liability estimate to preparers’ beliefs about future cash outflows for the liability.

4.2.1. Examining Preparers’ Level of Care. H1a, H2a, and H3a all relate tothe level of care that preparers exhibit with respect to financial informa-tion. H1a predicts that public company preparers will expend greater cog-nitive effort when estimating recognized amounts than when estimatingdisclosed amounts. To test this hypothesis, we examine the process data col-lected in the experiment. Specifically, participants were asked to describethe process they used to make their judgment and to describe how they incorporated the three approaches shown in the appendix. As discussed in

section 3, the approaches require an increasing amount of effort to imple-ment, and therefore serve as a measure of cognitive effort.

Participants’ open-ended responses were separately coded by an authorand a research assistant, both blind to condition. Responses were coded ona zero-to-three scale, with higher numbers indicating that the participant used a more effortful judgment approach. That is, responses were coded as“zero” for participants who did not use any of the approaches when makingtheir judgments. For participants who used one or more of the approaches

when making their judgments, responses were coded as “one” if the most ef-fortful approach stated in the response was Approach One, coded as “two”

if the most effortful approach stated in the response was Approach Two,and coded as “three” if the most effortful approach stated in the response

was Approach Three. Scores assigned by each coder were highly correlated(r 90 = 0.87, p < 0.01) and all disagreements between coders were resolvedby a separate author, also blind to condition, to create a consensus pro-cess code for each participant. Inferences are identical if based on eithercoder’s individual codes.

We report the descriptive statistics associated with the consensus pro-cess code in table 1, panel A.12 We test H1a by examining the simple ef-fect of placement on the public company managers’ process codes. As

reported in table 1, panel C, we find that the average consensus processcode is significantly greater under recognition (2.65) than under disclo-sure (2.00) ( F 1,88 = 5.46, p = 0.02).

13 This pattern of results is consistent with H1a, indicating that public company preparers expend more cognitiveeffort when estimating recognized amounts than when estimating disclosedamounts.

12 This analysis is based on 92 of the 94 participants because two participants had responsesthat were incomplete.

13 Throughout the paper, we report least square means that adjust for unbalanced cell sizes.

The degrees of freedom vary for different tests due to a few participants not responding to allquestions. All p -values reported in the paper are two-tailed for the sake of consistency.


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T A B L E 1

Process Data

Panel A: Process code descriptive statistics: Least square mean [median] (standard deviation)

Placement ConditionRecognition Disclosure

Public company participants 2.65 2.00[3.00] [3.00](0.80) (1.24)n = 26 n = 18

Private company participants 2.67 2.48[3.00] [3.00](0.58) (0.98)n = 21 n = 27

Panel B: Conventional ANOVA and results of planned contrast

Source df MS F -Statistic p -ValuePlacement 1 3.94 4.73 0.03Trading status 1 1.37 1.64 0.20Placement × trading status 1 1.23 1.48 0.23Error 88 0.83Planned contrast (H2a) 1 5.51 6.61 0.01Residual 2 0.08 0.09 0.91

Panel C: Simple effects tests

p -ValueConditions Compared df F -Statistic (Two-Tailed)

Recognition versus disclosure for public participants (H1a) 1 5.46 0.02

Recognition versus disclosure for private participants 1 0.49 0.49Public versus private participants under recognition 1 0.00 0.96Public versus private participants under disclosure 1 3.01 0.09

Panel D: Percentage of time spent on each judgment approach

Public Company Private Company Participants Participants

Recognition Disclosure Recognition Disclosure

Percentage of time spent on Approach One

19.55% = 23.81% 23.68% > 16.42%

Percentage of time spent on Approach Two

21.86% < 30.00% 31.66% = 33.52%

Percentage of time spent on Approach Three

58.59% > 46.18% 44.66% = 50.06%

Participants described the process they used to estimate a dollar amount for a contingent liability that was either to be recognized (recognition condition) or disclosed (disclosure condition) in the financialstatements. Participants were employed by either a publicly traded or privately held company. Participants’self-described process was coded by two coders that were blind to treatment condition and then differences were resolved to create a consensus process code. Responses were coded on a zero-to-three scale and highernumbers indicate a more effortful judgment process. Panel A reports the descriptive statistics. Panel Breports the conventional analysis of variance and the results of the planned contrast. Panel C presentsthe simple effects tests. Panel D reports the percentage of time that participants spent on each judgment approach provided in the case, as tracked by the computer software used to administer the experiment. Approach One requires the least effort to implement and Approach Three requires the most effort toimplement.


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H2a predicts that public company preparers will exhibit greater differ-ences in cognitive effort between recognition and disclosure than will pri-

vate company preparers. The weights embedded in the traditional ANOVA

interaction, however, differ from the weights inherent in our hypothesizedinteraction, suggesting that a contrast test is more appropriate (Bucklessand Ravenscroft [1990]). Using the approach recommended by Bucklessand Ravenscroft [1990], we derive contrast weights of +2 (recognition-private), +2 (recognition-public), +1 (disclosure-private), –5 (disclosure-public). These weights reflect our expectation that differences in cognitiveeffort will be greater for public company preparers (+2 vs. –5) than forprivate company preparers (+2 vs. +1).

Table 1, panel B presents the contrast test. We find that our hypothesizedinteraction is significant ( F 1,88 = 6.61, p = 0.01).

14 Examining the remain-ing simple effects tests reported in table 1, panel C, we find that the privatecompany preparers use a similar judgment process regardless of whetherthey are in the recognition or disclosure condition ( F 1,88 = 0.49, p = 0.49).Further, we find that there is not a significant difference between publicand private company preparers’ judgment process in the recognition con-dition ( F 1,88 = 0.00, p = 0.96). In contrast, we find that there is a marginally significant difference between public and private company preparers’ judg-ment process in the disclosure condition ( F 1,88 = 3.01, p = 0.09). Theseresults are consistent with H2a.15

H3a predicts that preparers’ effort levels will mediate their preaudit es-timates of the contingent liability. To test H3a, we use a four-step proce-

dure that examines the links shown in figure 2 for the consensus processcode as a mediator of the liability estimate (Baron and Kenny [1986],Kenny, Kashy, and Bolger [1998]). The first step in this procedure re-quires that we establish a significant relationship between our indepen-dent variables and participants’ liability estimates. Using the same contrast

weights that we used to test H2a, we find that this relationship is significant

14 Our results are robust to alternative contrast weights, including weights that predict no difference between recognition and disclosure for private company managers. For exam-ple, alternative weights of +1 (recognition-private), +1 (recognition-public), +1 (disclosure-private), −3 (disclosure-public) yield a significant interaction ( F 1,88 = 6.26, p = 0.01). Sim-ilarly, weights of +2 (recognition-private), +2 (recognition-public), −1 (disclosure-private),−3 (disclosure-public) yield a significant interaction ( F 1,88 = 6.35, p = 0.01). Further, we ex-amine the residual between-group variance that is not captured by the planned contrast, and

we find that it is insignificant ( F 2,88 = 0.09, p = 0.91). This indicates that the specified contrast weights are a good fit for the data.

15 To shed light on whether the differences in preparers’ effort levels were intentional, ourpost-experimental questionnaire included a within-participants question about how effort lev-els would be affected by recognition versus disclosure. We find that responses to this questiondid not differ for the public and private company participants ( F 1,89 = 0.44, p = 0.51), withboth groups indicating that they expected to exert slightly more effort under recognition thanunder disclosure. This result is consistent with the direction of the relative mean process codes

for recognition versus disclosure for both public and private company participants in table 1,panel A.


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Placement x

Trading Status

Contrast

Contingent

Liability Estimate

Judgment Process

(Process Code)

Link 1

F 1,90 = 8.56, p < 0.01

Link 4

(with mediator)

F 1,87 = 2.72, p = 0.10

Link 2

F 1,88 = 6.61, p = 0.01Link 3

F 1,90 = 34.82, p < 0.01

FIG. 2.—Mediation analysis with cognitive effort as mediator. This figure depicts the mediationanalyses conducted as a test of H3a using a four-step procedure (Baron and Kenny [1986],Kenny, Kashy, and Bolger [1998]). The analyses estimate the direct path from the indepen-dent variable to the dependent variable (link 1) and the indirect path from the independent variable to the dependent variable via the mediator (links 2 and 3). Finally, the analyses esti-mate the effect of the independent variable on the dependent variable in the presence of themediator (link 4). This figure shows that the effects of placement and trading status on par-ticipants’ contingent liability estimate are mediated by participants’ self-reported judgment process (process code).

( F 1,90 = 8.56, p < 0.01; link 1). As reported in connection with our tests

of H2a, the placement by trading status interaction significantly predictspreparers’ consensus process codes ( F 1,88 = 6.61, p = 0.01; link 2). Next, we find that participants’ process codes significantly predict their liability estimates ( F 1,90 = 34.82, p < 0.01; link 3). Finally, we find that the effect of placement and trading status on participants’ liability estimates is insignifi-cant ( F 1,87 = 2.72, p = 0.10) in the presence of the process code, and that the process code remains significant ( F 1,87 = 28.01, p < 0.01; link 4). Thus,consistent with H3a, we conclude that participants’ self-described judgment process mediates their contingent liability estimates.

4.2.2. Examining Preparers’ Strategic Bias. H1b, H2b, and H3b all relate

to the amount of strategic bias that preparers exhibit with respect to fi-nancial information. H1b predicts that public company preparers’ liability estimates will be less biased under recognition than disclosure. To test thishypothesis, we examine the simple effect of placement on our measure of bias for public company managers. Recall that our bias measure takes a

value of –1 (0) [+1] if a participant’s liability estimate is less than (equalto) [greater than] the midpoint of the participant’s range. The means re-ported in table 2, panel A reveal that public company managers’ disclosedliability estimates are downwardly biased relative to their recognized esti-mates (−0.58 vs. 0.08). As reported in table 2, panel C, we find that this

difference is significant ( F 1,90 = 6.83, p = 0.01). Again, this pattern of


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T A B L E 2

Bias Measure

Panel A: Bias descriptive statistics: Least square mean [median] (standard deviation)

Placement ConditionRecognition Disclosure

Public company participants 0.08 −0.58[0.00] [−1.00](0.89) (0.61)n = 26 n = 19

Private company participants −0.32 0.04[−0.50] [0.00](0.78) (0.94)n = 22 n = 27


Source df MS F -Statistic p -ValuePlacement 1 0.52 0.75 0.39Trading status 1 0.28 0.41 0.53Placement × trading status 1 5.89 8.52 < 0.01Error 90 0.69Planned contrast (H2b) 1 3.55 5.14 0.03Residual 2 1.42 2.06 0.13

Panel C: Simple effects tests

p -ValueConditions compared df F -Statistic (Two-Tailed)

Recognition versus disclosure for public participants (H1b) 1 6.83 0.01

Recognition versus disclosure for private participants 1 2.21 0.14Public versus private participants under recognition 1 2.69 0.10Public versus private participants under disclosure 1 6.12 0.02

Participants provided a dollar estimate for a contingent liability that was either to be recognized (recog-nition condition) or disclosed (disclosure condition) in the financial statements, as well as a 90% confi-dence interval for the ultimate payout. We construct a three-level bias measure by comparing participants’liability estimate to the midpoint of their confidence interval. A liability estimate that is less than (equal to)[greater than] the participant’s midpoint is coded as –1 (0) [+1]. Participants were employed by either apublicly traded or privately held company. Panel A reports the descriptive statistics. Panel B presents theconventional analysis of variance and the results of the planned contrast. Panel C presents the simple effectstests.

results is consistent with H1b, suggesting that public company preparers’recognized estimates are less biased than their disclosed estimates.

H2b predicts that public company preparers will exhibit greater differ-ences in strategic bias between recognition and disclosure than will pri-

vate company preparers. As was the case with H2a above, we use con-trast weights of +2 (recognition-private), +2 (recognition-public), +1(disclosure-private), −5 (disclosure-public) to test this hypothesis. Again,these weights reflect our expectation that differences in strategic bias willbe greater for public company preparers (+2 vs. −5) than for private com-pany preparers (+2 vs. +1).


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Table 2, panel B presents the contrast test. We find that our hypothesizedinteraction is significant ( F 1,90 = 5.14, p = 0.03).

16 Examining the remain-ing simple effects tests reported in table 2, panel C, we find that the bias

measure for private company preparers’ does not differ between recogni-tion and disclosure ( F 1,90 = 2.21, p = 0.14). Further, comparing the biasmeasure for public company preparers to that of private company prepar-ers, we find that there is not a significant difference between public andprivate company preparers in the recognition condition ( F 1,90 = 2.69, p = 0.10). However, in the disclosure condition public company preparersexhibit a significant downward bias when compared to private company preparers ( F 1,90 = 6.12, p = 0.02). Thus, we find a pattern of results that isconsistent with H2b.

H3b predicts that preparers’ strategic bias will mediate their preaudit estimates of the contingent liability. To test H3b, we again use a four-stepprocedure that examines the links shown in figure 3 for the bias measure asa mediator of the liability estimate (Baron and Kenny [1986], Kenny, Kashy,and Bolger [1998]). As was the case with our test of H3a, we find that link1 is significant ( F 1,90 = 8.56, p < 0.01). As reported in connection withour tests of H2b, the placement by trading status interaction significantly predicts preparers’ bias measure ( F 1,90 = 5.14, p = 0.03; link 2). Next, wefind that participants’ bias measure significantly predicts their liability es-timates ( F 1,92 = 48.73, p < 0.01; link 3). Finally, we find that the effects of placement and trading status on participants’ liability estimates are less sig-nificant ( F 1,89 = 3.67, p = 0.06) in the presence of the bias measure, and

that the bias measure remains significant ( F 1,89 = 44.00, p


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Placement x

Trading Status

Contrast

Contingent

Liability Estimate

Bias

Measure

Link 1

F 1,90 = 8.56, p < 0.01

Link 4

(with mediator)

F 1,89 = 3.67, p = 0.06

Link 2

F 1,90 = 5.14, p = 0.03

Link 3

F 1,92 = 48.73, p < 0.01

FIG. 3.—Mediation analysis with strategic bias as mediator. This figure depicts the mediationanalyses conducted using a four-step procedure (Baron and Kenny [1986], Kenny, Kashy, and

Bolger [1998]). The analyses estimate the direct path from the independent variable to thedependent variable (link 1) and the indirect path from the independent variable to the de-pendent variable via the mediator (links 2 and 3). Finally, the analyses estimate the effect of the independent variable on the dependent variable in the presence of the mediator (link 4).This figure shows that the effects of placement and trading status on participants’ contingent liability estimate are partially mediated by participants’ strategic bias.

than under disclosure, and that this difference will be smaller for privatecompany preparers than for public company preparers. To assess partici-pants’ beliefs about the ultimate liability, we asked 19 participants in the +1internal reporting condition to provide their best estimate of the amount

that the company will ultimately have to pay in connection with the liability.Participants in this condition provided a mean estimate of $9,321,308 forthe contingent liability (untabulated).

To test H4, we subtract the mean in the internal reporting condition fromthe responses of participants in the 2 × 2 external reporting conditions.Table 3, panel A shows the descriptive statistics associated with both prepar-ers’ liability estimates and the distance of these estimates from the averageresponse in the internal reporting condition. We expect the pattern of dif-ferences between preparers’ external estimates and beliefs to follow thesame pattern as we expected for preparers’ effort and bias measures. Thus,

we test H4 using the same contrast weights that we used to test H2a andH2b—i.e, weights of +2 (recognition-private), +2 (recognition-public), +1(disclosure-private), –5 (disclosure-public). As shown in table 3, panel B,

we find that this contrast is significant ( F 1,90 = 8.56, p < 0.01) and that theresidual is not significant ( F 2,90 = 0.09, p = 0.92).

18,19

18 Our results are robust alternative contrast weights of +1 (recognition-private), +1(recognition-public), +1 (disclosure-private), −3 (disclosure-public) ( F 1,90 = 8.64, p < 0.01),and alternative contrast weights of +2 (recognition-private), +2 (recognition-public), −1(disclosure-private),−3 (disclosure-public) ( F 1,90 = 6.45, p = 0.01).

19 As an alternative approach to testing H4, we conduct a series of t -tests that compare eachof the external liability estimates to the internal reporting estimate. We find that only the


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T A B L E 3

Contingent Liability Estimates

Panel A: Descriptive statistics: Least square mean [median] (standard deviation)

Distance from InternalExternal Reporting Estimate Reporting Estimate

Placement Condition Placement Condition

Recognition Disclosure Recognition Disclosure

Public company participants $8,232,191 $5,205,624 −$1,089,117 −$4,115,684[$9,473,000] [$7,500,000] [$151,692] [−$1,821,308]($4,144,765) ($4,568,828) ($4,144,765) ($4,568,828)

n = 26 n = 19 n = 26 n = 19Private company participants $8,706,995 $8,322,280 −$614,313 −$999,028

[$9,800,000] [$10,000,000] [$478,692] [$678,692]($4,028,186) ($4,312,118) ($4,028,186) ($4,312,118)

n = 22 n = 27 n = 22 n = 27


Source df MS F -Statistic p -Value

Placement 1 6.70 3.70 0.06Trading status 1 7.43 4.10 0.05Placement × trading status 1 4.02 2.22 0.14Error 90 0.18Planned contrast (H4) 1 1.55 8.56 0.46).


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4.3.2. Evidence Regarding Conservatism in Preparers’ Estimates. We assert that private company preparers are a useful benchmark for assessing theeffects of capital market pressures on preparers’ liability estimates, and

we find that private company preparers recognize directionally higher li-ability estimates than do their public company counterparts. While table 3suggests that private company preparers’ estimates are more reliable thanthose of public company preparers because they are directionally closerto estimates of ultimate cash outflows, it may be the case that the privatecompany preparers recognized higher liability estimates out of a desire tobe more conservative rather than to report a more reliable number. Thus,

we conduct an additional analysis to look for evidence of conservatism inpreparers’ estimates. Our analysis focuses on unconditional conservatism,defined in the literature as recognizing the highest value for liabilities (e.g.,Ball and Shivakumar [2005]). We do not address conditional conservatism,defined as recognizing losses sooner than gains (e.g., Ball and Shivakumar[2005]), because we examine only loss recognition.

If participants are exhibiting unconditional conservatism in their recog-nized numbers, we would expect their liability estimates to be above themidpoint of their confidence interval for the ultimate cash outflow, that is, their bias measure should equal 1 as measured in table 2. Thus, we ex-amine whether the private company participants are more likely to have abias measure of 1 than are the public company participants. Looking just at recognized estimates, we find that 18% (4/22) of private company pre-parers report a liability greater than their confidence interval midpoint,

compared to 42% (11/26) of public company preparers. Although this dif-ference is not statistically significant (χ21,48 = 3.23, p = 0.20), it is in thedirection of private company preparers being less conservative than publiccompany preparers. Thus, our unconditional conservatism test provides noevidence that private company preparers desire to be more conservative intheir judgments than do the public company preparers.

5. Discussion

In this paper, we investigate whether financial managers from publicly

traded and privately held companies differentiate between recognition anddisclosure when estimating a contingent liability. Drawing on Bernard andSchipper [1994], we argue that participation in the stock market createspressures for public company managers that can affect the relative relia-bility of their recognized and disclosed estimates via both the level of careand the amount of strategic bias that they exhibit. Thus, we draw on privatecompany preparers, who do not face stock market pressures, to provide acomparison group against which we can assess the judgments of the publiccompany managers. Specifically, we compare both groups in terms of thecognitive effort, and the amount of bias that they bring to the estimation

task. Further, we investigate how the resulting estimate compares to that provided by preparers tasked with estimating the ultimate cash outflow for


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internal reporting purposes (our proxy for preparers’ beliefs about the ul-timate resolution of the liability).

Our results indicate that public company managers generally exhibit less

cognitive effort and more bias for disclosure than for recognition. We findthat these differences are smaller for private company managers. Further, we find that both preparers’ level of care and amount of bias affect theirpreaudit liability estimates. In addition, comparing preparers’ estimates tothose provided by preparers in an internal reporting setting reveals that public company managers exhibit a downward bias in their disclosed es-timates, but not in their recognized estimates. In contrast, private com-pany managers do not exhibit a bias in either their disclosed or their rec-ognized estimates. Additional analyses support our level of care results by documenting that computer-tracked process data are consistent with partic-ipants’ self-reported judgment process. Further, examining preparers’ rec-ognized estimates, we find no evidence to support the notion that higherestimates result from a desire to be more conservative, lending credence tothe idea that these estimates are, in fact, more reliable.

Our findings add to the relatively sparse literature on preparers’ judg-ments and decisions (Bhojraj and Libby [2005], Hunton, Libby, and Mazza[2006]). Stock market pressures play a primary role in both the amount of cognitive effort that preparers are willing to devote to the reportingtask, and the extent to which preparers are willing to bias their financialestimates, thereby leading to the differential reliability of preparers’ rec-ognized and disclosed estimates. For public company managers, our re-

sults support users’ assumption that recognized numbers are more reliablethan disclosed numbers. This result, along with those of Libby, Nelson, andHunton [2006], also indicates that decisions of managers and auditors workin conjunction to lead to greater reliability of recognized versus disclosednumbers. Thus, it is particularly important for auditing regulators to clarify auditors’ responsibilities with respect to disclosed information.

We believe that our results provide some interesting avenues for futureresearch. For example, additional research opportunities emerge whencontrasting our results with other studies on recognition/disclosure. First,our study involved estimating an item that is likely to eventually be recog-

nized in income. That is, even in the disclosure condition, preparers may have been conscious that the amount would eventually be recognized asan expense. We believe that this design choice increases the tension in ourtests and biases away from us finding results. However, it also means that our study differs from prior studies on recognition versus disclosure that examined stock-based compensation, in which the disclosure choice hadno implications for future expenses. Thus, future research could examinehow the bias and decreased effort that we observed in our disclosure setting

would be affected if the required disclosure was not expected to affect net income in the future.

Second, we assessed the reliability of preparers’ estimates using threemetrics that we believe capture the FASB’s conceptual definition of


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reliability as information that is free from error, unbiased, and repre-sents what it purports to represent. Namely, we captured preparers’ effort,amount of bias, and underlying beliefs about the contingent liability. How-

ever, we also note that reliability is a difficult and elusive concept to mea-sure (Maines and Wahlen [2006]). Thus, future research could consideradditional ways in which our metrics, or other metrics, could be refined tobetter examine the reliability of preparers’ estimates.

Third, we examined preparers’ estimates under conditions of mandated,rather than voluntary, recognition versus disclosure. We believe that this isan important design choice that helps us avoid self-selection issues and isconsistent with most “real-world” settings in which an actual choice betweenrecognition and disclosure is unlikely (Schipper [2007]). That being said,future research could examine questions such as how the choice to make adisclosure, for example, affects the care with which preparers attend to thetask. Namely, preparers who choose to disclose information may dedicatemore effort to the task than preparers who are required to disclose infor-mation. In short, we leave it to further research to examine these and otherfactors that may affect preparers’ recognition and disclosure decisions.

APPENDIX

Excerpts from Experimental Instrument

ACCOUNTING GUIDANCE

Based on the information above, you think that there is a moderatelikelihood that a liability has been incurred. You also consulted withthe company’s attorneys, who agreed with your assessment that thereis a moderate likelihood that a liability has been incurred. You havesought guidance from financial accounting standards about the appropri-ate accounting treatment for this potential liability. You have found thefollowing:

Financial accounting standards require the accrual of a liability on thebalance sheet (disclosure of a liability in the footnotes but no accrual in the balance sheet ) if it is moderately likely that a liability has been incurred at the date

of the financial statements and the amount of the loss can be reasonably estimated.

APPROACH INFORMATION

The vice president of manufacturing has conducted a comprehensive review of the manufacturing process and has estimated that roughly 2% of the 7,942 manufacturing employees work directly with CNX and potentially have been affected by their exposure.

There are a number of possible approaches that can be used to estimatethe liability. You have identified three approaches: the first approach esti-

mates the liability based on the expected average claim, the second esti-mates claims by potential size, and the third estimates claims by potential


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size and geographical region. The links below provide the details associated with each approach.

Approach One . Details: This approach estimates the liability based on the

size of the average potential claim.Implementation: Implementing the approach requires multiplying the

estimated average claim by number of potentially affected employees. Re-call that the total number of potentially affected employees is 7,942× 2%=159.

Additional information: The average claim per manufacturing employeeis estimated to be between $5,400 and $89,100.

Approach Two . Details: This approach estimates the liability based on thesize of potential claims and the proportion of affected employees that areexpected to have claims of a given size.

Implementation: Implementing the approach requires determining thenumber of potentially affected employees that could have small, medium,and large claims. Then it requires multiplying the number of potentially affected employees by the corresponding claim size. Recall that the totalnumber of potentially affected employees is 7,942 × 2% = 159.

Additional information:Small potential claims:

$1,000–$5,000 per employee87 potentially affected employees

Mid-sized potential claims:


Large potential claims:


Approach Three . Details: This approach estimates the liability based onthe size of potential claims and the proportion of affected employees that are expected to have claims of a given size. It also takes into account thegeographic region in which the affected employees are located and theeffect that this will have on the possible payouts.

Implementation: Implementing the approach requires determining thenumber of potentially affected employees in each geographic region that could have small, medium, and large claims. Then it requires multiplyingthe number of potentially affected employees by the corresponding claimsize. Recall that the total number of potentially affected employees is 7,942

× 2% = 159. Additional information:


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United Statesand Europe Asia Mexico

Small potential claims:

Cost per employee $1,000–$5,000 $1,200–$4,500 $2,000–$5,000Number of affected

employees39 15 33

Mid-sized potential claims:


employees37 11 8

Large potential claims:


employees10 4 2

REFERENCES

A GOGLIA , C. P.; T. S. DOUPNIK ; AND G. T. TSAKUMIS. “Principles-Based Versus Rules-Based Ac-counting Standards: The Influence of Standard Precision and Audit Committee Strengthon Financial Reporting Decisions.” The Accounting Review 86 (2011): 747–67.

B ALL, R., AND L. SHIVAKUMAR . “Earnings Quality in UK Private Firms: Comparative Loss Recog-nition Timeliness.” Journal of Accounting and Economics 39 (2005): 83–128.

B ARON, R., AND D. K ENNY . “The Moderator-Mediator Variable Distinction in Social Psychologi-cal Research: Conceptual, Strategic, and Statistical Considerations.” Journal of Personality and

Social Psychology 51 (1986): 1173–82.BERNARD, V., AND K. SCHIPPER . “Recognition and Disclosure in Financial Reporting.” Workingpaper, University of Michigan, 1994.

BHOJRAJ, S., AND R. LIBBY . “Capital

Documents

1. Clor‐Proell, S. M., & Maines, L. a. (2014)