Introduction
Companies can manipulate earnings in different ways and for different reasons. Whether the goal is to boost earnings or for any other reason, the action has consequences. This paper summarizes an article by Dechow, Sloan, and Sweeney on the causes and consequences of earnings manipulation.
Summary
The proper functioning of an organization requires control and monitoring. Corporate governance comprises one of the ways of controlling and enhancing the monitoring of organizational operations (Caldwell and Karri 251). At its heart is the need to mitigate or enact conflict of interest control and prevention mechanisms among stakeholders. The mitigation of conflicts of interests is mostly accomplished through the enactment of various customs, laws, processes, policies, and institutions, which influence how organizations are controlled. SEC rules and regulations comprise one of the systems deployed in the US to mitigate accounting fraudulent activities such as the misrepresentation of financial statements or inadequate disclosure. Indeed, Dechow, Sloan, and Sweeney assert that earnings manipulation violates the SEC Act of 1934.
Dechow, Sloan, and Sweeney studied organizations that were subjected to enforcement by the SEC in the violation of GAAP standards. Their goal was to identify the causes and consequences of manipulation of earnings in companies. Dechow, Sloan, and Sweeney sought to study “the extent to which extant earnings management hypotheses could explain the alleged earnings manipulations” (1). Secondly, the authors established the relationship between the weaknesses of firms’ governance structures and earnings manipulation.
They also noted that when allegations of manipulation of earnings were made public, firms experienced severe consequences in terms of performance of capital markets. Their research assumes that SEC does not erroneously identify a firm that overstates its earnings. However, such an assumption does not invalidate their research findings since SEC investigates in a lengthy manner to establish that a firm has manipulated its earnings both intentionally and knowingly before an action is taken against it.
SEC takes actions against all firms that violate financial reporting rules as established in the SEC Act of 1934. Through various Accounting and Auditing Enforcement Release (AAER) articles, SEC publishes its actions against firms that violate the Act (6). The researchers only investigated firms reflected in AAERs from 1982 to 1992 whose actions were taken by calling Section 13(a) of the 1934 SEC Act. A sample of 92 firms was examined.
Dechow, Sloan, and Sweeney assert that the motivation to manipulate earrings emanates from the appetite for acquiring low-cost external financing. The motivation is significant even on “controlling for contracting motives proposed in the academic literature” (Dechow, Sloan, and Sweeney 1). For example, Kellogg and Kellogg assert that companies manipulate their earnings to attract investors to purchase their stocks, bonds, or raise stock value for the current owners (56).
The National Association of Certified Fraud Examiners concurs that firms manipulate financial statements to entice people to invest via the selling of stocks (19). Dechow, Sloan, and Sweeney also observe that firms manipulate earnings to run away from debt agreements. Their study finds no evidence for manipulation of earnings to acquire bonuses based on the earnings or sale of stocks at heightened prices.
For effective operation of an organization, monitoring and control procedures are necessary. Corporate governance comprises one of the ways of controlling and enhancing the monitoring of organizational operations (Abdulla and Page11). Hence, failed or poor governance structures may encourage firms to engage in the mishandling of earnings. Dechow, Sloan, and Sweeney assert that poor or pathetic governance structures reduce the management’s supervision ability. Therefore, such structures are catalysts for the manipulation of earnings (Dechow, Sloan, and Sweeney 30). Firms that are likely to manipulate their earnings have CEO serving as the chair of their boards. Many of such business leaders are organizations’ founders who lack efficient auditing committee and/or board of directors (Dechow, Sloan, and Sweeney 1). Hence, governance structures can be enhanced by electing independent persons to serve on the board of directors and in the positions of company chairpersons.
Dechow, Sloan, and Sweeney’s research shows that firms that engage in overstating their earnings suffer from increased costs of their capital after SEC reveals such manipulations. Hence, even though a firm may enjoy low capital costs after manipulating its financial statements, such benefits are short-term (Kellogg and Kellogg 22). One major weakness of the study is that Dechow, Sloan, and Sweeney only analyzed spectacular cases of earnings manipulation.
This situation has the limitation of attracting generalization of their research findings. All firms strive to increase their capital while enjoying low costs (Jones 194). Any wishes to increase outdoor monetary aid constitute an important inspiration for engaging in earnings exploitation. Therefore, such malpractice is economically significant, despite the way it has received little academic scrutiny.
Conclusion
In the discourse of corporate governance, accountability ensures that managers are responsible to the board. The board needs to exercise the utmost responsibility to the shareholders. In the conceptualization of cases of earnings manipulation, as discussed by Dechow, Sloan, and Sweeney, an immense requirement should be placed on firms to foster and portray a high level of integrity when conducting their business. While the motivation to participate in earnings manipulation may be attractive or economically significant as it increases capital at low costs, its long-term effects upon disclosure of the malpractice by SEC is costly.
Works Cited
Abdulla, Azizah, and Michael Page. Corporate Governance and Corporate Performance: UK FTSE 350 Companies, Scotland, The Institute of Chartered Accountants of Scotland, 2009. Print.
Caldwell, Cam, and Rachael Karri. “Organizational Governance and Ethical Systems: A Covenantal Approach to Building Trust.” Journal of Business Ethics 58.1 (2005): pp 249-259. Print.
Dechow, Patricia, Richard Sloan, and Army Sweeney. “Causes and consequences of earnings manipulation: an analysis of firms subject to enforcement actions by SEC.” Contemporary Accounting Research 13.1 (1996): 1-36. Print.
Jones, Jenifer. “Earnings Management During Import Relief Investigations.” Journal of Accounting Research 29.2 (1991): 193-228. Print.
Kellogg, Irving, and Loren Kellogg. Fraud Window Dressing and Negligence In Financial Statements: Commercial Law Series, New York, NY: McGraw-Hill, 1991. Print.
The National Association of Certified Fraud Examiners. What Every Accountant Should Now About Fraud, New York, NY: NASBA, 1993. Print.