The Determinants of Managerial Decisions to Cook the Books

Abstract:     
Using data from all 868 SEC and Department of Justice enforcement actions for financial misrepresentation from 1978 through June 30, 2007, we examine firm characteristics during the periods that the firms' financial statements are misrepresented. These characteristics can inform us about managers' apparent motives to misrepresent financial reports. Preliminary test results indicate that the incidence of financial misrepresentation increases with the market-to-book ratio, recent acquisitions and the use of operating leases, the sensitivity of managers' pay to changes in the stock price, and a CEO who also is board chair. This incidence decreases with the prior year's stock performance, board independence, the fraction of shares owned by independent board members, and the fraction of shares owned by institutions. Together, these results suggest that managers are more likely to cook the company books when their pay is sensitive to the company stock price, when oversight from the firm's internal governance or institutional monitors is poor, and when the firm has complicated accounting issues involving recent acquisitions and operating leases.

Keywords: Financial misrepresentation, fraud, compensation, incentives, governance, analyst forecasts, Securities and Exchange Commission

JEL Classification: G38, K22, K42, M41

working papers series