Capital Ideas Blog

Manipulation or misreporting? When we're too quick to cry fraud

By Francine McKenna
June 07, 2013

From: Blog

Accounting and finance researchers are more media savvy than in the past. Professors used to just quietly badger the Securities and Exchange Commission when they discovered some interesting data. That’s what the University of Iowa’s Erik Lie of stock option backdating infamy did until a Wall Street Journal reporter picked up on his work and made him a star, as well as a favorite of plaintiff lawyers and prosecutors. These days, professors and research get mentioned in mass media even before a paper is published in traditional academic journals. (It can take 5-7 years for peer review and publication in prestigious journals.) The objective is to be on CNBC, to be quoted in the Wall Street Journal and the New York Times

That’s the kind of buzz a Duke University quarterly survey of CFO sentiment gets. An Emory and Duke University joint survey last year of CFO views on earnings quality was also extremely popular with mainstream media. That research reported approximately 20 percent of companies manage earnings and that manipulation has an average impact of about 10 percent on reported earnings per share.
Ray Ball, an accounting professor at Chicago Booth, is slightly skeptical. Ball wrote a short essay in February, “Accounting Informs Investors and Earnings Management is Rife: Two Questionable Beliefs.” His remarks are directed at academic researchers such as the Emory and Duke professors. He chides his academic colleagues for promoting the apparently widely held belief that “earnings management” is rampant:

“A powerful cocktail of authors’ strong priors, strong ethical and moral views, limited knowledge of the determinants of accruals in the absence of manipulation, and willingness to ignore correlated omitted variables in order to report a result, seems to have fostered a research culture that tolerates grossly inadequate research designs and publishes blatantly false positives.”

It’s not that accounting manipulation and earnings management doesn't occur. Ball agrees that it does and that executives have gone to jail as a result. His beef is with the exaggeration of the size and frequency of “discretionary” manipulation and that none of the researchers who do these kinds of papers and surveys report specific individuals and companies to regulators (as Lie did). He also wonders how academics can so quickly and easily identify pervasive manipulation even though internal auditors, external auditors, whistleblowers, boards, analysts, short sellers, trial lawyers, press, and regulators who have huge incentives to identify anomalies and substantially greater access to non-public information do not.

Ball thinks it would be much more useful for researchers to accept the selection bias and focus on deep analyses of proven cases of accounting manipulation and fraud. He cites a recent paper by Sarah L. Center Zechman, a Chicago Booth colleague, and Catherine M. Schrand of the University of Pennsylvania, “Executive Overconfidence and the Slippery Slope to Financial Misreporting.” Zechman’s paper provides a detailed analysis of 49 firms subject to SEC Accounting and Auditing Enforcement Releases (AAERs) in the 1990s and 2000s. (One disadvantage of the paper is the age of its data. It would be great if this research could be updated to post-Sarbanes-Oxley enforcement orders.) Zechman found that only 25 percent of the misstatements (13 of the 49) cited by the AAERs suggest a degree of criminal intent by executives that would support a legal claim of fraud per SEC Rule 10b-5. The majority of the AAERs do not suggest the same degree of “scienter,” or fraudulent intent, and are reviewed by the researchers as “misreporting.”

Zechman’s conclusion about the difference between “fraud” firms and “misreporting” firms: The “fraud” firms initially misstate earnings in a year with particularly poor performance and then continue to misstate even after the decline in performance has leveled off and performance improves. “Misreporting” firms initially misstate earnings in a year of poor performance and then go down a “slippery slope,” increasing misstatements in growing amounts as performance continues to decline.

“Misreporting” cases begin with an “optimistically biased, but not necessarily intentional, misstatement.” When optimistic performance expectations are not realized, an executive makes the willful decision to intentionally misreport or “manage” earnings.

Based on the enforcement actions taken by the SEC, it appears the agency expects board chairs, CEOs, CFOs, and managers with financial expertise to detect significant misstatements. The orchestrators are less likely to be CPAs or auditors, which suggests that the accountant does not direct the fraud, but his participation is necessary to achieve it. CEOs and CFOs are most often mentioned in the AAERs as the ones who orchestrated the fraud (73 executives), participated in the fraud (23), or were reckless in not knowing about the fraud (7). They are high level executives (board chairs, CEOs or CFOs), CPAs, and executives with audit experience.

What’s important here is that whether it’s “fraud” or only “misreporting,” SEC sanctions are very likely and criminal charges are quite possible. Providing knowledge that can help prevent both can be a worthy goal of future academic research.