This paper evaluates alternative accrual-based models for detecting earnings management. The evaluation compares the specification and power of commonly used test statistics across the measures of discretionary accruals generated by the models and provides the following major insights. First, all of the models appear well specified when applied to a random sample of firm-years. Second, the models all generate tests of low power for earnings management of economically plausible magnitudes (e.g., one to five percent of total assets). Third, all models reject the null hypothesis of no earnings management at rates exceeding the specified test-levels when applied to samples of firms with extreme financial performance. This result highlights the importance of controlling for financial performance when investigating earnings management stimuli that are correlated with financial performance. Finally, a modified version of the model developed by Jones (1991) exhibits the most power in detecting earnings management.

https://www.jstor.org/stable/pdfplus/248303.pdf

Detecting earnings management

. This study investigates firms subject to accounting enforcement actions by the Securities and Exchange Commission for alleged violations of Generally Accepted Accounting Principles. We investigate: (i) the extent to which the alleged earnings manipulations can be explained by extant earnings management hypotheses; (ii) the relation between earnings manipulations and weaknesses in firms' internal governance structures; and (iii) the capital market consequences experienced by firms when the alleged earnings manipulations are made public. We find that an important motivation for earnings manipulation is the desire to attract external financing at low cost. We show that this motivation remains significant after controlling for contracting motives proposed in the academic literature. We also find that firms manipulating earnings are: (i) more likely to have boards of directors dominated by management; (ii) more likely to have a Chief Executive Officer who simultaneously serves as Chairman of the Board; (iii) more likely to have a Chief Executive Officer who is also the firm's founder, (iv) less likely to have an audit committee; and (v) less likely to have an outside blockholder. Finally, we document that firms manipulating earnings experience significant increases in their costs of capital when the manipulations are made public.

Resume. Les auteurs analysent les entreprises assujetties aux mesures d'execution prises par la Securities and Exchange Commission dans les cas de presomption de transgression des principes comptables generalement reconnus. Ils s'interessent aux aspects suivants de la question: i) la mesure dans laquelle les presomptions de manipulations des benefices peuvent etre expliquees par les hypotheses existantes de gestion des benefices; ii) la relation entre les manipulations de benefices et les faiblesses des structures de regie interne des entreprises; et iii) la reaction du marche financier a l'endroit des entreprises au sujet desquelles les presomptions de manipulation des benefices sont rendues publiques. Les auteurs constatent qu'un incitatif majeur a la manipulation des benefices est le desir d'obtenir du financement externe a moindre cout. Ils demontrent que cet incitatif demeure important meme apres le controle des motifs contractuels que mettent de l'avant les travaux theoriques. Ils constatent egalement que les entreprises qui manipulent les benefices sont: i) davantage susceptibles d'avoir des conseils d'administration domines par la direction; ii) davantage susceptibles d'avoir un chef de la direction qui joue simultanement le role de president du conseil; iii) davantage susceptibles d'avoir un chef de la direction qui est egalement le fondateur de l'entreprise; iv) moins susceptibles d'avoir un comite de verification; et v) moins susceptibles d'avoir un bloc de titres detenus par un actionnaire exterieur. Enfin, les auteurs etablissent le fait que le cout du capital, pour les entreprises qui manipulent les benefices, enregistre des hausses appreciables lorsque ces manipulations sont rendues publiques.

/pdf/causes-and-consequences-of-earnings-manipulation-an-analysis-356ezw8q95.pdf

Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC*

This study empirically tests the prediction that the inclusion of larger proportions of outside members on the board of directors significantly reduces the likelihood of financial statement fraud. Results from logit regression analysis of 75 fraud and 75 no-fraud firms indicate that no- fraud firms have boards with significantly higher percentages of outside members than fraud firms. Results are not sensitive to the definition of outside directors used, given that no-fraud firms have significantly higher percentages of both "grey" and "independent" directors than fraud firms. Interestingly, the presence of an audit committee does not significantly affect the likelihood of financial statement fraud. Additionally, as outside director ownership in the firm and outside director tenure on the board increase and as the number of outside directorships in other firms held by outside directors decreases, the likelihood of financial statement fraud decreases.

An Empirical Analysis of the Relation between Board of Director Composition and Financial Statement Fraud

https://isiarticles.com/bundles/Article/pre/pdf/14778.pdf

The market pricing of accruals quality

Researchers have used various measures as indications of "earnings quality" including persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases. For each measure, we discuss causes of variation in the measure as well as consequences. We reach no single conclusion on what earnings quality is because "quality" is contingent on the decision context. We also point out that the "quality" of earnings is a function of the firm's fundamental performance. The contribution of a firm's fundamental performance to its earnings quality is suggested as one area for future work.

/pdf/understanding-earnings-quality-a-review-of-the-proxies-their-1r9rjtuq8l.pdf

Understanding Earnings Quality: A Review of the Proxies, Their Determinants and Their Consequences

This paper explores three questions related to the SEC's accounting enforcement program: (1) what types of accounting and auditing problems motivate enforcement actions, (2) what are the consequences of investigations on targets' financial statements, managers, and auditors, and (3) how do investors and other market agents view the SEC's actions? The SEC enforcement program, which consists of investigations and subsequent injunctive actions or administrative proceedings against offending registrants and auditors, is designed "to concentrate on particular problem areas and to anticipate emerging problems" (SEC [1989, p. 1]). The potential for SEC enforcement actions provides incentives for corporate officers and independent CPAs to avoid unacceptable practices whose "effective prosecution is

The Financial and Market Effects of the SEC's Accounting and Auditing Enforcement Releases

This study extends the scope of timing research to China's emerging capital market by examining the effects of audit opinions and earnings surprises on the timeliness of annual earnings announcements, after controlling for firm size, the presence of losses, financial distress, auditor switches, and changes in the Chinese regulatory environment. Based on a sample of listed Chinese firms for 1995–1999, we observe that both audit opinions and earnings surprises have significant effects, as reported in Bamber et al. (1993). We also find a significant effect attributable to the magnitude of negative earnings surprises as shown by Begley and Fischer (1998). In addition, we document a significant interaction effect between audit opinions and earnings surprises. Positive earnings surprises with modified audit opinions are announced significantly later than unqualified negative earnings surprises.

Kyungjoo Park

Papers

The Financial and Market Effects of the SEC's Accounting and Auditing Enforcement Releases

Audit Qualification and Timing of Earnings Announcements: Evidence from China