The Misrepresentation of Earnings

23 Pages Posted: 9 Jan 2014 Last revised: 12 Aug 2015

Ilia D. Dichev

Emory University - Department of Accounting

John R. Graham

Duke University; National Bureau of Economic Research (NBER)

Campbell R. Harvey

Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER); Duke Innovation & Entrepreneurship Initiative

Shivaram Rajgopal

Columbia Business School

Date Written: August 10, 2015

Abstract

We ask nearly 400 CFOs about the definition and drivers of earnings quality, with a special emphasis on the prevalence and detection of earnings misrepresentation. CFOs believe that the hallmarks of earnings quality are sustainability, absence of one-time items, and backing by actual cash flows. Earnings quality is determined in about equal measure by controllable factors like internal controls and corporate governance, and non-controllable factors like industry membership and macroeconomic conditions. On earnings misrepresentation, CFOs believe that in any given period a remarkable 20% of firms intentionally distort earnings, even though they are adhering to generally accepted accounting principles. The economic magnitude of the misrepresentation is large, averaging about 10% of reported earnings. While most misrepresentation involves earnings overstatement, interestingly, one third of the firms that are misrepresenting performance are low-balling their earnings or reversing a prior intentional overstatement. Finally, CFOs provide a list of red flags that can be used to detect earnings misrepresentation.

Related paper:
"Earnings Quality: Evidence from the Field" http://ssrn.com/abstract=2103384

Teaching/Presentation Slides:
"A Guide to Earnings Quality" http://ssrn.com/abstract=2347428


Keywords: Earnings management, Earnings misrepresentation, Smooth earnings, Accruals, GAAP, Low-balling, Cookie jar reserves, Sustainable earnings, predictable earnings, real earnings management

JEL Classification: M40, M41, M42, M48, G32, G38

Suggested Citation

Dichev, Ilia D. and Graham, John R. and Harvey, Campbell R. and Rajgopal, Shivaram, The Misrepresentation of Earnings (August 10, 2015). Financial Analysts Journal, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2376408 or http://dx.doi.org/10.2139/ssrn.2376408

Ilia D. Dichev

Emory University - Department of Accounting ( email )

1300 Clifton Road
Atlanta, GA 30322-2722
United States

John Robert Graham

Duke University ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7857 (Phone)
919-660-8030 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Campbell R. Harvey (Contact Author)

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7768 (Phone)
919-660-8030 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Duke Innovation & Entrepreneurship Initiative ( email )

215 Morris St., Suite 300
Durham, NC 27701
United States

Shivaram Rajgopal

Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

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