Understanding the 'Numbers Game'
51 Pages Posted: 18 Mar 2016 Last revised: 2 Jul 2016
Date Written: April 14, 2016
We model the earnings management decision as the manager's tradeoff between the costs and the capital market benefits of meeting earnings benchmarks. We estimate the benefits and realized distribution of earnings using a regression discontinuity design, and use these estimates as inputs to our model. Estimated model parameters yield the percentage of manipulating firms, magnitude of manipulation, and noise in manipulated earnings. These estimates also provide sufficient statistics for evaluating various proxies for "suspect" firms. Finally, we use the Sarbanes-Oxley Act as an experimental setting and show that it succeeded in reducing earnings management by 36%, through an increase in costs. This occurred despite an increase in benefits, as the market rationally became less skeptical of firms just meeting benchmarks.
Keywords: earnings management, managerial myopia, regression discontinuity, structural estimation, financial reporting
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