Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the Sec

Abstract

This study investigates firms subject to accounting enforcement actions by the Securities and Exchange Commission (SEC) for alleged violations of GAAP. We investigate: (i) the extent to which the alleged earnings manipulations can be explained by extant earnings management hypotheses; (ii) the relation between the earnings manipulations and weaknesses in the firms' internal governance structures; and (iii) the capital market consequences experienced by the firms when the alleged earnings manipulations are made public. We find that an important motivation for earnings manipulation is the desire to attract external financing at low cost. We show that this motivation remains significant after controlling for contracting motives proposed in the academic literature. We also find that firms manipulating earnings are: (i) more likely to have boards of directors dominated by management; (ii) more likely to have a CEO who simultaneously serves as Chairman of the Board; (iii) more likely to have a CEO who is also the firm's founder; (iv) less likely to have an audit committee; and (v) less likely to have an outside blockholder. Finally, we document that firms manipulating earnings experience significant increases in their costs of capital when the manipulations are made public.

JEL Classification: M41, G12, K22, G34