Equities

Predicting Earnings Management

Topics - Equities Defensive

${ numberSection } ${ text }
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.

AQR Capital Management, LLC, (“AQR”) provide links to third-party websites only as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by us of any content or information contained within or accessible from the linked sites. If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which AQR.com has no control. In no event will AQR be responsible for any information or content within the linked sites or your use of the linked sites.

 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

 

Hypothetical performance results have many inherent limitations, some of which, but not all, are described herein. Hypothetical performance results are presented for illustrative purposes only.

 

Diversification does not eliminate the risk of experiencing investment loss.

 

Certain publications may have been written prior to the author being an employee of AQR.

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.