Make It Harder (but Not That Hard) for Companies to Lie about Earnings
- December 29, 2022
- CBR - Accounting
It has been more than two decades since the massive Enron, Tyco, and WorldCom accounting frauds spurred the US Congress to pass the Sarbanes-Oxley Act of 2002. The measure has improved financial reporting and reined in corporate malfeasance, partly by making top executives personally accountable for the misreporting of financial information.
But, even after the legislation, there remains a corporate incentive structure that can cause managers to act in ways that at times run counter to the interests of their shareholders, according to research by Boston University’s Stephen J. Terry, University of Michigan’s Toni M. Whited, and Chicago Booth’s Anastasia A. Zakolyukina. They find that it would be better for investors if fudging financial statements carried higher costs—up to a certain, optimal level.
Public companies in the United States, by law, have to disclose their financial statements prepared in accordance with standards such as generally accepted accounting principles (GAAP). Having companies publicly report some financial information is widely seen as good for investors and markets, but mandating the release of too much information may also harm them. (For more, see “Can too much disclosure hurt profits and innovation?”) At the same time, more disclosure generally makes it harder to manipulate earnings via violation of accounting standards.
Company managers, the researchers point out, are in a sense caught in the middle of conflicting requirements: to regularly share financial information, and meanwhile to ensure long-term growth in competitive markets. Practically speaking, to balance these requirements, they have some flexibility to manage the information that gets disclosed, either by manipulating earnings (they do this by lying or violating accounting standards, both of which are illegal) or by distorting investment decisions (which is legal and can be cast as a prudent business decision). For the latter, they might, say, spend less on research and development or on advertising in order to boost profits. They thus face a trade-off between manipulation and distortion.
“We aim to understand whether this trade-off is empirically important and to quantify the real effects of frictions that induce firms to substitute between making efficient investment choices and revealing accurate information,” the researchers write.
To do this, the researchers estimate the tightness of disclosure regulation, or the cost of lying and manipulating earnings numbers via the violation of accounting standards. When lying about earnings carries few penalties or is easy, disclosure regulation is deemed loose. When lying is difficult and high risk, disclosure regulation is tight.
It might seem that it would be best for investors if lying were completely eliminated, but that’s where the trade-off comes in: executives may then opt to distort earnings legally, which still makes the information released less useful, the researchers point out. “When you make one of the tools more costly, they’re going to use the other, and that has real consequences for firm value,” says Zakolyukina.
Two ways companies boost earnings
Research finds that when companies inflated their earnings, they manipulated book values upward and reduced investment.
Some earnings manipulation is caught, but much goes undetected. Recognizing that, the researchers constructed a model using data on publicly traded US companies from 1999 to 2015, before and after Sarbanes-Oxley was introduced. They tapped into data providers for information on financial restatements as a measure of detected misreporting. The data show a surge in restatements right after the law passed, peaking after a section on internal control disclosures went into effect in 2004.
The data also highlight the twin tasks of reporting and making long-term investments: when companies inflated their earnings by misreporting (which later resulted in financial restatements), they also slashed their investment in research and development or spending on advertising, the researchers find. In such events, investment declined 2 percent, bolstering earnings.
The role of disclosure regulation is, then, to strike the optimal balance. According to the researcher’s model, as the cost of earnings manipulation rises and lying becomes harder, outright earnings misreporting falls, as does the cost of capital (meaning it becomes cheaper for companies to invest and grow). Earnings informativeness rises, along with growth, firm value, and social welfare. But as regulation continues to tighten, managers intensify the distortion of their investment decisions. The cost of capital rises, and earnings informativeness, growth, firm value, and social welfare all fall.
This trade-off doesn’t exist in a vacuum, of course, as managers’ decisions are affected by factors that include compensation, among other things. Equity incentives encourage executives to make efficient long-term investment decisions, yet their contracts also often give them short-term incentives to hit earnings targets and to deliver smooth earnings.
If managers can get away with a little misinformation, they can preserve the benefits of efficient long-term investments—for shareholders, the economy and, ultimately, themselves—while achieving short-term compensation goals. But these competing incentives can also cause managers to make suboptimal decisions about investments as they attempt to manage short-term business performance, Terry, Whited, and Zakolyukina find.
When the researchers considered compensation structure, regulation, and other factors in their model, they find that the socially optimal level of disclosure regulation is higher than the current level. Companies, too, would benefit from more disclosure regulation, they argue—although the socially optimal level is higher than what’s best from the companies’ perspective.
But while more disclosure regulation would be good, too much of it would hurt. When they analyzed what would happen if disclosure requirements were so extreme as to shut down any earnings manipulation, they find that increased distortive investment would raise the cost of capital and lower company value by almost 6 percent. Alternatively, in the absence of any incentives to manipulate earnings or investments, the cost of capital would fall and the value of the business would rise by 2.4 percent, the analysis suggests.
The findings could be useful to federal lawmakers seeking to improve upon Sarbanes-Oxley, which the researchers note “has been criticized for forcing firms to substitute real earnings manipulation for manipulation based on the misreporting of accounting accruals.” It could also help corporate boards trying to bring managerial incentives in line, by quantifying just how much short-term incentives can end up damaging shareholder value.
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