Causes and Consequences of Aggressive Financial Reporting Policies

Abstract:     
This paper investigates the motivations for managers' decisions to overstate earnings and examines the consequences of such decisions. We examine firms subject to enforcement actions by the Securities and Exchange Commission for having violated the financial reporting requirements of the securities laws. In addition to considering the traditional bonus and debt hypotheses as motivations for earnings management, we also investigate the hypothesis that earnings management is systematically related to firms' demands for external financing. We argue that by employing aggressive accounting policies, firms temporarily inflate their market values and temporarily reduce their costs of capital. Thus, managers of firms with high current demands for external financing have incentives to increase reported earnings. Further, we argue that aggressive reporting is more likely to occur in firms with poor governance structures. The empirical evidence supports our predictions. Relative to a matched control sample, aggressive reporters are in greater need of external financing and have poor governance structures. They have fewer outsiders on their boards of directors; are more likely to have their chief executive officers be chairmen of their boards; are less likely to have audit committees; and are less likely to have large outside blockholders. We also investigate the consequences of aggressive reporting. When management are identified as aggressive reporters, their firms' stock prices fall and they face less liquid markets for their securities and higher costs of capital.

JEL Classification: G14, G3, M4

working papers series