Regulatory (In)Attention and Earnings Management

Abstract

We examine the relation between regulatory attention and earnings management. We provide evidence that securities regulators provide most of their comment letters for new accounting standards in the first or second year of new standard effectiveness, consistent with regulators expending more regulatory resources on financial accounts altered by new accounting standards. We expect that firms anticipate where regulators spend regulatory resources and adjust financial reports accordingly to meet earnings expectations. We test this expectation surrounding a recent major accounting standard change for revenue recognition in the U.S. – ASU 2014-09. Consistent with this expectation, we find that firms that just meet or beat analysts’ consensus earnings expectations do so using expenses rather than revenues in the first years of the new revenue recognition standard’s effectiveness. We also find that discretionary revenue is lower for all sample firms and that research and development expenditure is lower for firms that just meet or beat analysts’ earnings expectations in sample years following ASU 2014-09. Finally, we find lower levels of discretionary spending for firms that just meet or beat analysts’ earnings expectations in the post-period vs. the pre-period, with strong evidence for firms that normally focus on revenue maximization. Our evidence suggests that firms understand regulatory resource constraints and manage their financial reports to achieve earnings objectives.

Keywords: securities regulation, revenue, discretion, spending, earnings management, attention

JEL Classification: G38, M41, M48