Earnings Overstatement Research Articles

Materiality Uncertainty and Earnings Misstatement

The concept of materiality provides a basis for auditors to ignore small misstatements, but the definition of small in this context is ambiguous. The issue of materiality-standard-setting has been raised recently by Arthur Levitt, former chairman of the Security and Exchange Commission. We examine how materiality uncertainty affects the auditor's evaluation of audit evidence and a manager's choice of earnings overstatement in a strategic auditing model where earnings misstatements also include unintentional system error. We find that when the expected cost of accepting financial statements that are materially misstated, which we refer to as an audit failure, is relatively large, an increase in materiality uncertainty results in a more conservative auditor evaluation of the audit evidence and a decrease in the amount of intentional overstatement. Alternatively, if the auditor's expected cost of extending audit procedures is relatively high, then an increase in materiality uncertainty results in a less conservative auditor evaluation of the audit evidence and an increase in the manager's earnings overstatement. The auditor also becomes increasingly conservative as the report increases when the information system is sufficiently noisy. Finally, when the expected cost of audit failure is large, the equilibrium audit risk can increase or decrease in materiality uncertainty despite the corresponding increase in auditor conservatism and decrease in intentional overstatement. Audit risk is the average probability of audit failure across all possible evidence outcomes.

How Much Will Firms Pay for Earnings That Do Not Exist? Evidence of Taxes Paid on Allegedly Fraudulent Earnings

This paper examines the extent, if any, to which firms pay additional income taxes on allegedly fraudulent earnings. Our sample consists of firms that restated their financial statements in conjunction with SEC allegations of accounting fraud during the years 1996 to 2002. By examining firms that were accused of fraud by the SEC we obtain a relatively clean sample of earnings overstatements and avoid having to rely on models of earnings management. By further focusing on restatements, we are able to estimate how much income tax was paid on the overstated earnings. The estimates in this paper represent the most direct evidence to date that firms are willing to sacrifice substantial cash to inflate their accounting earnings. Our detailed analysis of a sample of firms admitting to large earnings overstatements indicates that the mean firm sacrificed eleven cents in additional income taxes per dollar of inflated pre-tax earnings. In aggregate, the firms in our sample paid $320 million in taxes on overstated earnings of about $3.36 billion. These results illustrate the stark trade-off faced by firms and managers contemplating earnings manipulation - the choice between (non-cash) accounting earnings and (cash) taxes.

Do Firms Mislead Investors by Overstating Earnings Before Seasoned Equity Offerings?

Rangan (1998) and Teoh, et al. (1998) argue the failure on part of investors to identify pre-offering earnings management as a cause for the post-offering stock underperformance. This paper re-examines their hypothesis. Like Rangan and Teoh et al., I find evidence of earnings overstatements by issuers, but show their conclusions on investor naivete to be influenced by skewness in long-run returns data. Far from being naive, investors appear to infer earnings management and rationally undo its effects at offering announcements. The paper shows this to be consistent with an extension of the Myers-Majluf model, which endogenizes asymmetric information between managers and investors around equity offerings. I conclude that earnings management by issuers may not be intended to mislead investors, but may merely reflect their rational response to anticipated market behavior at offering announcements.

Does Mandated Audit Communication Reduce Opportunistic Corrections to Manage Earnings to Forecasts?

This paper reports two experiments in which Big 5 audit managers estimate reported (audited) earnings conditional on analysts' consensus forecast, auditing standards, and auditor discovery of a quantitatively immaterial earnings overstatement. We find that auditors judge overstatement correction less likely if it would cause a missed forecast, even for objectively measured misstatements. This behavior is consistent with SEC Chairman Levitt's concerns about opportunistic corrections to manage earnings to forecasts. Also, SAS No. 89's mandated representations and communications do not increase corrections that would cause a missed forecast, indicating that the Auditing Standards Board has limited ability to reduce opportunistic corrections through such regulations.

Incentives and Penalties Related to Earnings Overstatements that Violate GAAP

This paper investigates the incentives and the penalties related to earnings overstatements primarily in firms that are subject to accounting enforcement actions by the Securities and Exchange Commission (SEC). I find (1) that managers in treatment firms are more likely to sell their holdings and exercise stock appreciation rights in the period when earnings are overstated than are managers in control firms, and (2) that the sales occur at inflated prices. I do not find evidence that earnings overstatement in these firms is motivated by concerns about debt covenant violations or the cost of external financing. The evidence suggests that the monitoring of managers' trading behavior can be informative about the likelihood of earnings overstatement. Many economists believe that insider trading is an efficient method of compensating managers for their efforts. These economists argue that reputation losses would preclude managers from making profitable trades before periods of poor corporate performance. Consequently, this paper also investigates the employment and monetary penalties imposed on managers after the earnings overstatement is publicly discovered. This evidence reveals that (1) managers' employment losses subsequent to discovery are similar in firms that do and do not overstate earnings and (2) that the SEC is not likely to impose trading sanctions on managers in firms with earnings overstatement unless the managers sell their own shares as part of a firm security offering. The evidence suggests that neither employment or SEC-imposed monetary losses are effective in preventing the managers in these firms with extreme earnings overstatements from selling their stake in their firms in the face of declining performance.

Overstated Quarterly Earnings and Analysts' Earnings Forecast Revisions*

ABSTRACTA primary purpose of accounting is to provide information for decision makers. Accounting misstatements may have a detrimental effect on decision making. The Securities and Exchange Commission (SEC) identifies earnings overstatements as being particularly troublesome to users, as indicated by SEC Accounting and Auditing Enforcement Releases' emphasis on earnings' overstatement errors. This research investigates how security analysts' forecast revisions are affected by accounting earnings overstatement errors, which become known only after the analysts released their revised annual earnings forecasts. The paper investigates the clarifying role that additional information plays in analysts' revisions. The results show that analysts draw significantly different conclusions from earnings containing (unknown) overstatement errors than from accurately reported earnings. In essence, the analysts identify some of the overstatement, at least on average, by making an adjustment that effectively ignores 21 percent of the overstatement error.

Is Railroad Working Capital Overstated?

IN THE PAST TWO YEARS THE overstatement of railroad earnings arising from five-year amortization of defense facilities has been an increasing topic of discussion in railroad analytical and accounting circles. Under the regulations of the Interstate Commerce Commission, the nation's carriers are allowed to take advantage of the income tax savings arising from this amortization, but are not allowed to include these charges in operating expenses. The resulting overstatement of net income is substantial with estimated savings of $187 million in 1955, amounting to 21% of estimated net income of $875 million. (In 1954, tax savings of $150 million were 22% of net income of $674 million for Class 1 roads.)