Window-dressing of financial reports: Evidence from financial firms

Abstract

Using Benford’s law, this study documents pervasive evidence that managers of U.S. financial firms tend to engage in earnings manipulative activities of rounding earnings numbers to achieve key reference points. Consistent to prior studies, we find that the first digit is often emphasized by management in window-dressing the earnings numbers. More importantly, we find that key reference points are not limited to the first digit. The second, third, fourth, or even fifth digits are sometimes used as the reference points of rounding earnings. Our empirical results further show that the incentives of rounding earnings numbers are negatively associated with the distance of pre-rounded earnings to the reference point. Specifically, the greater the magnitude of the distance of pre-rounded earnings to the key reference point, the less likely management chooses to round earnings to achieve that point. The findings of the study have significant implications to the corporate control mechanisms of firms, especially to the roles of external auditors and the audit committees