Predicting Earnings Management

Topics - Equities Defensive

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Predicting Earnings Management

Working paper

This paper examines whether accounting information may be useful in predicting when corporate managers intentionally inflate reported earnings for their firms. We focus on a comprehensive sample (1971–2000) of firms that were forced to restate earnings, because forced restatements are an ideal way to examine earnings management.

Given the substantial costs of undertaking investigations, the Securities Exchange Commission is likely to only undertake investigations for firms where the probability of success for a restatement is fairly high. Therefore, it is reasonable to assume that earnings restatement firms can be characterized as firms who knowingly and intentionally engaged in earnings manipulation.

We find that explicit contracts could motivate corporate executives to manage their earnings, because there is evidence that restatement firms have higher leverage than non-restatement firms. We find more compelling evidence consistent with the argument that firms undertake aggressive accounting practices due to capital market pressures.

We show that restatement firms are on average high-growth firms, have more frequent external financing needs, and raise larger amounts of cash. Further, we find that firms forced to restate earnings have reported consistent positive earnings growth and small positive forecast errors in the quarters leading up to the alleged manipulation.

Together these findings suggest that these firms were under significant capital market pressures to engage in aggressive accounting practices to deliver earnings growth to satisfy market expectations.

Collectively, the evidence suggests that market participants can gain substantial value from a careful consideration of information in financial statements.