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What motivates a firm to manipulate earnings?

A strong CEO and an increase in institutional shareholding both play a role in the likelihood of earnings manipulation, linked to beating analyst forecasts, says study co-authored at Cambridge Judge Business School.

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The power of a company’s CEO plays a role in the likelihood of earnings manipulation linked to consistently beating analyst forecasts, says a new study co-authored at Cambridge Judge Business School based on US companies over a 25-year period.

Other factors that boost the likelihood of such manipulation include an increasing stake by institutional investors and high long-term growth expectations by sell side analysts that create pressure to continue beating ever-higher expectations.

“Our results suggest that when an executive team with a powerful CEO has a reputation for consistently beating expectations is faced with a situation where they have utilised much of their accounting flexibility and have market pressure to perform, they are more likely to go down the ‘slippery slope’ and engage in earnings manipulation,” the study says.

The study is based on US companies that manipulated earnings between 1985 and 2010 as indicated by Accounting and Auditing Enforcement Releases (AAER) by the SEC. Earnings manipulation as outlined in AAER proceedings includes boosting revenues with fictitious transactions, and hiding expenses.

The study found that continuing a trend of consistently beating analyst expectations was an “important motivation” for firms to move from “within GAAP” (Generally Accepted Accounting Standards) to “outside of GAAP” earnings manipulation – and the research documents that these firms are more likely to have consistently beaten expectations both during the manipulation period and during the previous three years.

The authors then analysed key motivations for such “beat”-linked behaviour.

“We found that escalating pressure to meet increasing market expectations plays a role in manipulating earnings, and this leads many executives to move outside of GAAP to meet these higher expectations.” says co-author Patricia Dechow of the Marshall School of Business at University of Southern California. “We found that manipulating firms have high long-term growth expectations, growing institutional investment, high market values relative to fundamentals, and are strongly recommended by analysts.”

Co-author Jenny Chu, University Lecturer in Accounting at Cambridge Judge Business School added: “We also found that pressure from within the organisation such as CEO power and accounting flexibility at the firm level influences the likelihood of manipulation.”

While CEO power was found to be a clear factor in the likelihood of companies manipulating earnings, the evidence was weaker for CEO overconfidence. The study measured CEO power on three variables: the ratio of cash-based compensation compared to the second highest-paid executive; the prevalence of independent directors as a percentage of all members of the board; and whether the CEO is also the firm’s chairman of the board.

The study – “A reputation for beating analysts’ expectations and the slippery slope to earnings manipulation” – was co-authored by Dr Jenny Chu of Cambridge Judge Business School, Professor Patricia Dechow of the University of Southern California, Dr Kai Wai Hui of the University of Hong Kong, and Dr Annika Yu Wang of the University of Houston.

The research was launched with the hypothesis that, like athletes focused on competitive events, executives can become so focused on earnings forecasts that they “lose sight of the big picture and do ‘whatever it takes’ to meet their goals.”

This sort of “tunnel vision”, the study says, creates an escalating problem in which executives initially manage earnings within GAAP to meet targets, but then use “increasingly aggressive accounting techniques” that move outside of GAAP as expectations continue to rise. Overall, the study suggests that maintaining a reputation for meeting or beating analysts’ expectations can encourage aggressive accounting and, ultimately, earnings manipulation.