Incentives, Discretion, and Asset Valuation in Closed–End Mutual Funds

Abstract

This paper studies earnings management using 363 closed–end mutual fund firm–years of data. Closed–end fund assets consist of unrestricted and restricted securities, and realized and unrealized income. While unrestricted securities are not subject to earnings management, restricted security values are largely discretionary. Managerial valuation of restricted securities is modeled as contingent on unrestricted returns relative to a performance benchmark. Four unrestricted performance regions are identified. Known multi–period compensation incentives become the basis for hypothesizing earnings management behaviors in the regions in the form of restricted security valuation. Across several benchmarks, the results are consistent with multi–period maximization rather than simpler single–period compensation maximization or income smoothing. Funds with extreme unrestricted performance show relatively larger income–decreasing earnings management, and funds with slightly–below benchmark returns show relatively larger income–increasing earnings management than those slightly above. These results clarify the relationship between complex earnings management behavior and managerial incentives.