11 Financial Accounting 5: Earnings management (FAR5)
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ItemThe Impact of Social Capital on Abnormal Accruals( 2021)In this essay, I explore the influence of social capital on the market consequences of reporting abnormal accruals. I find that as social capital increases, the market value for reporting excess cash decreases, as does the market value of reporting abnormal accruals. I find that abnormal accruals are priced lower as social capital increases, and that the cost of equity capital is higher when firms that have high social capital report abnormal accruals. Taken together, these results suggest that when managers do not conform to expected social norms, the market imposes more severe consequences.
ItemDoes fair value accounting affect how banks convey information about future performance? Evidence from SFAS 115( 2021)Studies find that banks manage earnings with realized gains and losses on investment securities (RGL) to signal changes in future operating performance. We do not find evidence of this relation using a current sample after the enactment of Statement of Financial Accounting Standard 115 (SFAS 115). We hypothesize that SFAS 115’s fair value requirement caused managers to stop signaling with RGL by increasing the transparency of RGL earnings management. Our tests indicate a significant reduction in the association between RGL and future earnings changes after SFAS 115, suggesting that the standard reduced RGL signaling. Consistent with a loss of valuable information, we find that the reduction in RGL signaling after SFAS 115 is associated with lower quality analyst forecasts, and that banks that previously relied on RGL signaling experienced an increase in information asymmetry after SFAS 115. Collectively, these findings suggest that SFAS 115 reduced earnings management with RGL, as the FASB intended, but may have reduced the informativeness of financial reporting at banks that had used asset sales to signal.
ItemCriminal employees and financial reporting( 2021)The literature provides mounting evidence that top managers are associated with financial reporting outcomes. In this paper, I predict and find that traits of rank-and-file employees explain these outcomes. Controlling for the CEO’s criminal record, firms with more employees with criminal records (relative to other firms) have higher discretionary accruals when they raise new finance, report earnings that are less informative about future earnings and cash flows, and have lower accruals quality. I find some, although less robust, evidence that these firms are less likely to recognize timely losses. My results suggest that employees, incremental to top managers, are associated with firm outcomes.
ItemThe Cost of Fraud Prediction Errors( 2021)We compare seven fraud prediction models with a cost-based measure that nets the benefits of correctly anticipating instances of fraud (true positives), against the costs borne by incorrectly flagging non-fraud firms (false positives). Our cost-based measure supplements traditional comparison metrics and is estimated separately for auditors, investors, and regulators. We find that the higher true positive rates in recent models come at the cost of higher false positive rates, and that even the best models trade off false to true positives at rates exceeding 100:1. Indeed, the high number of false positives makes all seven models considered too costly for auditors to implement, even when we consider extreme subsamples in which a priori the likelihood of misreporting is greater. For investors, M-Score and, when used at higher cut-offs the F-Score, are the only models providing a net benefit; the other models are only economically viable when applied to extreme subsamples of misreporting risk. For regulators, several models are economically viable as false positive costs are limited by the number of investigations they can initiate, and by the relatively low market value loss a ‘falsely accused’ firm would bear in denials of requests under the Freedom of information Act (FOIA). Our results are similar irrespective of whether we consider fraud or two alternative restatement samples.
ItemManagers’ rank & file employee coordination costs and real activities manipulation( 2021)We predict that managers’ rank & file employee coordination costs constrain decentralized real activities manipulation (RAM). We test this prediction using 99 state adoptions of wrongful dismissal laws (WDLs) between 1967 and 2004. WDLs increase managers’ rank & file employee coordination costs because WDLs strengthen rank & file employees’ motive and ability to resist manager pressure to engage in myopic activities. We find decentralized RAM declines when managers’ rank & file employee coordination costs increase. In contrast, coordination costs neither affect centralized RAM nor accrual-based earnings management, both of which are less likely to require rank & file employee coordination. Corroborating tests demonstrate that the effect of coordination costs on decentralized RAM varies predictably in event-time, with firms’ earnings management incentives, and across states and WDL subtypes. Our primary inference is that managers’ rank & file employee coordination costs constrain decentralized forms of earnings management.