When Are Execs Most Likely to Inflate Earnings?
Earnings management tends to occur not when a company is getting little or a lot of attention, but rather when it's in the middle of those extremes.
It’s widely assumed that executives are less likely to inflate their earnings when they work at high-profile companies that operate under a good deal of regulatory oversight.
And yet it’s also widely known that executives at such companies face tremendous pressure from investors to meet or beat Wall Street estimates every quarter. That provides an incentive to overstate company performance — what’s known as earnings management.
How should policymakers looking to curb accounting fraud reconcile these countervailing forces? New research by Delphine Samuels, an assistant professor at the MIT Sloan School of Management, sheds light on the question.
“When it comes to embellishing corporate earnings, managers weigh the costs and benefits — mainly the probability and consequences of getting caught in an accounting scandal against the potential for a higher stock price,” says Samuels.
“And since many managers’ salaries and bonuses are based on performance measures, such as earnings, [embellishing earnings] can often translate into better compensation.”
She adds, “We wanted to discover the point at which the cost of getting caught outweighs the benefit of inflating earnings.”
Samuels and her colleagues, Daniel J. Taylor and Robert E. Verrecchia of the University of Pennsylvania’s Wharton School, argue that the key to the puzzle lies in the “quality of the information environment” surrounding a company.
The team used three measures to gauge the quality of the information available about the firm. They looked at the number of institutional investors that owned the company’s stock, the number of industry analysts that followed the company, and the number of articles about the company that appeared in mainstream media over the course of a year.
For the study, the researchers examined a dataset of more than 300 restatements resulting from fraud or an SEC investigation. These intentional misrepresentations took place between 2004 and 2012 — well after the introduction of the Public Company Accounting Oversight Board, the agency created by the Sarbanes-Oxley law to oversee auditors.
Using a combination of modeling and regression analyses, the team found that as the quality of the information environment improves, misreporting first increases, reaches an inflection point, and then decreases. Consequently, earnings management is greatest in a medium-quality environment and is lowest in both high- and low-quality environments.
“When executives operate in closed corporate environments — meaning there’s not much information or media coverage about what the leadership team is doing and why — we found that they are not particularly inclined to exaggerate earnings,” says Samuels. “In [that] type of environment, the weight that investors place on earnings in valuing the company also tends to be low, and so exaggerating earnings is not that beneficial.”
The advantages of earnings management grow as investor interest, analyst coverage, and media attention increase. Managers then become more inclined to misstate earnings.
But at a certain threshold — which Samuels says equates to about 17 media articles per year and just over 6 dedicated analysts — executives become less likely to overstate performance.
“What’s most interesting is that middle ground,” she says. “It’s only when the company has reached a certain level of interest that a manager’s incentive to overstate performance decreases — likely because the cost of getting caught is much higher.”
The study may have important implications for policymakers.
“Our findings suggest that regulations designed to improve transparency and provide more information can sometimes have unintended adverse consequences,” says Samuels.