Evidence on Contagion in Earnings Management

Abstract

In this paper, we examine the importance of contagion in earnings management, proxied by 2,376 earnings restatements announced during the years 1997-2008. Controlling for industry and firm-level characteristics, we find that firms are more likely to begin managing earnings after the public announcement of a restatement by another firm in their industry or in their geographical neighborhood. Such contagion in earnings management is absent when the restating firm is subject to SEC enforcement or a class action lawsuit, pointing to the deterrent effects of enforcement activity. Contagion among peers is observed in the same account as the one restated by the target firm. Moreover, contagion is more likely to occur when (i) larger and hence more visible target firms restate; or (ii) when the target firm’s restatement is less severe; (iii) when the target firm’s restatement is prominently disclosed via a press release. Contagion in earnings management stops during the years 2003-2005, possibly due to the rigorous enforcement associated with developments surrounding the Sarbanes-Oxley (SOX) Act. However, it reappears in the 2006-2008 period presumably because the sting of SOX related enforcement has worn off. Our results are unlikely to be attributable to (i) industry wide payoffs to earnings management; or (ii) mechanical time trends in earnings management. Our findings suggest that a peer firm’s decision to manage earnings is not made in isolation. Rather, the decision seems to incorporate the nature of the restatement, the target firm announcing the restatement and the reaction of the regulators and litigators to the target firm’s announcement.