Evidence on Motivations for Downward Earnings Management

Abstract

We analyze a set of firms that restated earnings upward because of accounting irregularities and thus presumably had managed earnings downward. Our results are consistent with the restatement sample firms having managed earnings downward in their original financial statements to create cookie jar reserves, to depress share prices prior to corporate and insider stock purchases, and to minimize political costs. There is no evidence these firms managed earnings downward to reduce income taxes, which is consistent with tax-motivated downward earnings management being accomplished via real transactions that typically do not give rise to accounting irregularities. We estimate that taxable firms (i.e., profitable restatement sample firms without NOL carryforwards) left an average of 23 cents per dollar of pre-tax earnings management on the table by engaging in book-tax nonconforming downward earnings management. The forgone tax savings represent a lower bound on the incremental costs associated with real transactions management.

Keywords: Earnings management, restatements, book-tax differences, book-tax conformity

JEL Classification: M41, M43, H25, M49