Temporality and Evidence of Earnings Management in Fraud Companies

Abstract

Companies manage earnings for a variety of reasons. One method managers use to manipulate earnings in order to meet expectations is discretionary accruals. Fraud and discretionary accruals has been studied in the past but confined in very specific contexts. The purpose of this study is to broaden the generalizability of these studies by addressing two significant issues. First, literature provides ample evidence that companies who managed earnings illegally resulting in fraud, did so using discretionary accruals. However, do all companies that commit fraud resulting in financial restatements, also display behavior consistent with earnings management? The second issue addressed is that of temporality. Is there a pattern to the use of discretionary accruals in the years leading to fraud? In other words is earnings management present for just the fraud period or for further periods leading up to the fraud? Using a sample of AAERs issued by the SEC is used as a proxy for fraud, the results show that earnings management is commonly used in firms who commit accounting fraud broadly not just those using earnings management as the primary vehicle. The results further show that the earnings management extends to more than one year prior to the fraud.