Financial Misreporting: Hiding in the Shadows or in Plain Sight?

It’s widely assumed that executives are less likely to inflate earnings at  high profile companies under a good deal of regulatory oversight. And yet it’s also widely known that managers in high profile companies have an incentive to overstate their company’s performance because of pressure from investors to meet or beat Wall Street estimates every quarter.

How should policymakers looking to curb accounting fraud reconcile these countervailing forces?

When it comes to embellishing corporate earnings, managers weigh the costs and benefits: mainly the probability and consequences of getting caught in an accounting scandal against the potential for a higher stock price. So, what keeps a manager honest? In our study, we argue that one key to the puzzle lies in the quality of the information environment surrounding the company.

To test our hypothesis, we used three primary measures to gauge the quality of the information available about the firm: the number of institutional investors that own the company’s stock, the number of analysts that follow the company, and the number of articles about the company that appeared in the mainstream media during the year.

Our dataset included more than 300 restatements resulting from fraud or an SEC investigation. These misrepresentations took place between 2004 and 2012—well after the Sarbanes-Oxley Act created the Public Company Accounting Oversight Board (PCAOB) to oversee auditors. Using a combination of modeling and regression analyses, we found that as the quality of the information environment improves, misreporting first increases, reaches an inflection point, and then decreases. Misreporting is greatest in a medium-quality environment and is least in both high- and low-quality environments.

When executives operate in low profile companies—meaning there’s not much information or media coverage about what the leadership team is doing and why—we found that they are not particularly inclined to exaggerate earnings. In this type of environment, the weight that investors place on earnings in valuing the company tends to be low, and so embellishing earnings is not that beneficial—no one is watching.

However, as the information environment improves and the profile of the firm rises, investors and analysts pay more attention to the firm’s earnings. The benefits of reporting embellished earnings grow, and managers become more inclined to misstate earnings. At a certain threshold—which equates to about 17 media articles per year and a dedicated analyst following of a little over six—executives become less likely to overstate performance. The company is so high profile that any further investor attention increases the cost of misstatement more than the benefits.

In other words, as a company garners investor interest, analyst coverage, and media attention, the probability of misstatement increases. The market is beginning to pay more attention to the company’s financials. However, once the company has established a sufficiently high profile—with greater interest from investors, analysts, and media—the probability of misstatement decreases. From a research perspective, what’s most interesting is that middle ground. It’s only when the firm has reached a certain level of prominence that a manager’s incentive to overstate performance decreases.

Policymakers have looked at ways to curtail misreporting for some time. And for good reason: Accounting fraud is incredibly costly. Multibillion-dollar financial accounting scandals—like the ones that befell Enron, Fannie Mae, and WorldCom in the early 2000s—are prime examples. But the fact is, regulation aimed at curbing accounting fraud can often have unintended consequences. For companies with little transparency, our findings suggest additional transparency increases the incentive for misreporting. However, for companies that are already very transparent, our finding suggest additional transparency decreases the incentives for misreporting. The association between transparency and misreporting is not necessarily negative. Consequently, regulations designed to increase transparency will not necessarily reduce accounting fraud.

This post comes to us from professors Delphine Samuels at MIT’s Sloan School of Management and Daniel J. Taylor and Robert E. Verrecchia at The Wharton School of the University of Pennsylvania. It is based on their recent paper, “Financial Misreporting: Hiding in the Shadows or in Plain Sight?,” available here.