Incentives and Penalties Related to Earnings Overstatements that Violate GAAP

Abstract

This paper investigates the incentives and the penalties related to earnings overstatements primarily in firms that are subject to accounting enforcement actions by the Securities and Exchange Commission (SEC). I find (1) that managers in treatment firms are more likely to sell their holdings and exercise stock appreciation rights in the period when earnings are overstated than are managers in control firms, and (2) that the sales occur at inflated prices. I do not find evidence that earnings overstatement in these firms is motivated by concerns about debt covenant violations or the cost of external financing. The evidence suggests that the monitoring of managers' trading behavior can be informative about the likelihood of earnings overstatement. Many economists believe that insider trading is an efficient method of compensating managers for their efforts. These economists argue that reputation losses would preclude managers from making profitable trades before periods of poor corporate performance. Consequently, this paper also investigates the employment and monetary penalties imposed on managers after the earnings overstatement is publicly discovered. This evidence reveals that (1) managers' employment losses subsequent to discovery are similar in firms that do and do not overstate earnings and (2) that the SEC is not likely to impose trading sanctions on managers in firms with earnings overstatement unless the managers sell their own shares as part of a firm security offering. The evidence suggests that neither employment or SEC-imposed monetary losses are effective in preventing the managers in these firms with extreme earnings overstatements from selling their stake in their firms in the face of declining performance.

Private Information, Earnings Manipulations, and Executive Stock-Option Exercises

“…On the one hand, studies have shown that insiders are better informed and earn abnormal returns (see, e.g., Jaffe 1974, Seyhun 1998, as well as that they sell on foreknowledge of forthcoming earnings declines as long as two years before the decline is reported (Ke, Huddart and Petroni 2003). Furthermore, Beneish (1999) shows that managers of firms with inflated earnings are more likely to sell their holdings and exercise stock appreciation rights than managers in control firms. Beneish and Vargus (2002) find evidence consistent with insiders trading on their knowledge of factors associated with accrual persistence, while Beneish, Press, and Vargus (2003) document that upwards earnings management occurs in firms facing higher than expected costs of default, and that insider selling and debt-covenant incentives co-exist and are complementary.…”

The role of information and financial reporting in corporate governance and debt contracting

“…(We later discuss similar studies in the context of director turnover.) Early research by Beneish (1999) and Agrawal, Jaffe, and Karpoff (1999) generally failed to find an increase in turnover frequency following accounting irregularities, specifically GAAP violations and the revelation of corporate fraud, respectively. In a more recent study, Desai, Hogan, and Wilkins (2006) examine the frequency of managerial turnover following accounting restatements.…”

Financial Statement Fraud: A Case Examination Using Beneish Model and Ratio Analysis

“…Auditors can use Bonefish's ratios to help carry out the AIS 240 requirements to perform audits to be reasonably assured that financial statements are free from material misstatement. In the other hand, investigators brought in to investigate a suspected fraud can use this tool to help focus the investigation [7]. Numbers from different reporting period of the income statement and the balance sheet produce results that red flag the problem.…”