This study investigates whether or not managers select assumptions used to account for postretirement benefits enabling them to manage annual earnings, thereby increasing the likelihood of achieving earnings benchmarks. We believe the assumptions used to account for postretirement benefit costs can be used as an earnings management tool because: (i) the accounting rules allow managers great flexibility in setting the assumptions; (ii) the complexity of the accounting rules and related disclosures make it difficult for outside users to identify changes in assumptions and their economic effects; and (iii) the liability is long-term in nature enabling small changes in assumptions to have a large impact on financial statements. Our sample consists of 116 firms with six years of hand-collected data from postretirement benefit plan disclosures included in annual reports from 2002 to 2007. We find firms reporting health care inflation rates below the sample median in year t - 1 have an increased likelihood of achieving earnings benchmarks in year t consistent with managers using long term accruals such as postretirement benefits to manage earnings in subsequent years. We also find firms with the highest positive abnormal accruals in year t - 1 have selected health care inflation rates that are significantly below the sample median for year t - 1. These results are consistent with management anticipating the reversal of current accruals in the future and planning for the use of long-term accruals, increasing their flexibility of achieving earnings benchmarks. Our results imply that the quality of investor reporting could be improved by revising current postretirement accounting rules by taking away the flexibility allowed management in selecting health care inflation rates.
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