Make It Harder (but Not That Hard) for Companies to Lie about Earnings

Some earnings manipulation is caught, but much goes undetected. Recognizing that, the researchers constructed a model using data on publicly traded US companies from 1999 to 2015, before and after Sarbanes-Oxley was introduced. They tapped into data providers for information on financial restatements as a measure of detected misreporting. The data show a surge in restatements right after the law passed, peaking after a section on internal control disclosures went into effect in 2004.

The data also highlight the twin tasks of reporting and making long-term investments: when companies inflated their earnings by misreporting (which later resulted in financial restatements), they also slashed their investment in research and development or spending on advertising, the researchers find. In such events, investment declined 2 percent, bolstering earnings.

The role of disclosure regulation is, then, to strike the optimal balance. According to the researcher’s model, as the cost of earnings manipulation rises and lying becomes harder, outright earnings misreporting falls, as does the cost of capital (meaning it becomes cheaper for companies to invest and grow). Earnings informativeness rises, along with growth, firm value, and social welfare. But as regulation continues to tighten, managers intensify the distortion of their investment decisions. The cost of capital rises, and earnings informativeness, growth, firm value, and social welfare all fall.

This trade-off doesn’t exist in a vacuum, of course, as managers’ decisions are affected by factors that include compensation, among other things. Equity incentives encourage executives to make efficient long-term investment decisions, yet their contracts also often give them short-term incentives to hit earnings targets and to deliver smooth earnings.

If managers can get away with a little misinformation, they can preserve the benefits of efficient long-term investments—for shareholders, the economy and, ultimately, themselves—while achieving short-term compensation goals. But these competing incentives can also cause managers to make suboptimal decisions about investments as they attempt to manage short-term business performance, Terry, Whited, and Zakolyukina find.

When the researchers considered compensation structure, regulation, and other factors in their model, they find that the socially optimal level of disclosure regulation is higher than the current level. Companies, too, would benefit from more disclosure regulation, they argue—although the socially optimal level is higher than what’s best from the companies’ perspective.

But while more disclosure regulation would be good, too much of it would hurt. When they analyzed what would happen if disclosure requirements were so extreme as to shut down any earnings manipulation, they find that increased distortive investment would raise the cost of capital and lower company value by almost 6 percent. Alternatively, in the absence of any incentives to manipulate earnings or investments, the cost of capital would fall and the value of the business would rise by 2.4 percent, the analysis suggests.

The findings could be useful to federal lawmakers seeking to improve upon Sarbanes-Oxley, which the researchers note “has been criticized for forcing firms to substitute real earnings manipulation for manipulation based on the misreporting of accounting accruals.” It could also help corporate boards trying to bring managerial incentives in line, by quantifying just how much short-term incentives can end up damaging shareholder value.