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Understanding the 'Numbers Game'

51 Pages Posted: 18 Mar 2016 Last revised: 2 Jul 2016

Andrew Bird

Carnegie Mellon University - Tepper School of Business

Stephen A. Karolyi

Carnegie Mellon University - Tepper School of Business

Thomas G. Ruchti

Carnegie Mellon University - Tepper School of Business

Date Written: April 14, 2016

Abstract

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

Suggested Citation

Bird, Andrew and Karolyi, Stephen A. and Ruchti, Thomas G., Understanding the 'Numbers Game' (April 14, 2016). Available at SSRN: https://ssrn.com/abstract=2748220

Andrew Bird (Contact Author)

Carnegie Mellon University - Tepper School of Business ( email )

Pittsburgh, PA 15213-3890
United States

Stephen A. Karolyi

Carnegie Mellon University - Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
4122682909 (Phone)

Thomas G. Ruchti

Carnegie Mellon University - Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

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