Like lemmings that follow the leaders off the cliff, many companies follow their peers in earnings management, according to a new study.
There are caveats to that, of course, which we’ll get to. But the authors of Evidence of Contagion in Earnings Management, which will be published next month in the American Accounting Association’s The Accounting Review journal, make the case that their study is “the first to document that peer firms begin managing earnings after an earnings restatement is announced by target firms in their industry or in their metropolitan statistical area.”
Co-author Kevin Koh, assistant accounting professor at Nanyang Technological University in Singapore, offers this example: Healthcare provider America Service Group Inc. restated earnings after revealing it manipulated almost $2.5 million during a five-year period. Within almost three months after the restatement, three other healthcare companies were managing their earnings according to start dates in their subsequent restatements – Metropolitan Health Network Services, Hooper Holmes Inc., and AMN Healthcare Services Inc.
“Of course, where just a few firms are involved, the link may be coincidental,” Koh said in a written statement. “But for our sample as a whole, consisting of thousands of firms, the chance that the public contagion we have documented was just a coincidence is extremely slim.”
Koh and co-authors Simi Kedia, professor of finance and economics at Rutgers University Business School in New Jersey, and Shivaram Rajgopal, professor of accounting and auditing at Columbia University Business School in New York, examined 2,376 restatements issued from 1997 to 2008. So that the study’s focus was on substantial restatements, which would be more likely imitated, the authors included only restatements involving inflated net income.
Rajgopal indicated that the restatements apparently serve as an education for peers.
“A pattern we saw frequently was for peer firms to follow the lead of announcement companies in what they misreported and how they misreported it,” he said. “Thus, if an announcing firm misstates revenues, peers commonly do the same – and so on with other ploys, whether they involve expense accounts or inventory or something else. In a sense, restatements serve as handbooks of trickery.”
About those caveats mentioned earlier: The study indicates that the “contagion” is absent when the company that has restated faces class-action lawsuits or US Securities and Exchange Commission discipline, which suggests that enforcement actually is a deterrent. During 2003 to 2005, the contagion stopped – and the study suggests that was due to enforcement related to the Sarbanes-Oxley (SOX) Act. But the misconduct resumes from 2006 to 2008, “perhaps because the sting associated with SOX has worn off,” according to the study.
The authors also indicate that there is an average of 2.6 years between the beginning of misrepresentation and its public disclosure. When earnings management begins during this period, it’s likely because of economic pressures or insider knowledge, they write. That private information could be gleaned from a common lax auditor’s office or a common board member, they add.