Detecting Cosmetic Earnings Management Using Benford's Law

Charles E. Jordan, DBA, CPA, and Stanley J. Clark, PhD, CPA

Earnings management represents deliberate actions by managers to bring about desired financial outcomes. It occurs for several reasons, such as ensuring that earnings meet analysts' expectations so that share price continues a steady growth rate or avoiding debt covenant violations. According to Marilyn Fischer and Kenneth Rosenzweig, earnings management may be classified into two broad categories: those involving changes in accounting methods and those relating to operating decisions (“Attitudes of Students and Accounting Practitioners Concerning the Ethical Acceptability of Earnings Management,” Journal of Business Ethics, vol. 14, no. 4, 1995, pp. 433–444). An example of changing accounting methods would be extending the useful life of a depreciable asset, thus increasing reported income; an example of an operating decision would be shifting scheduled maintenance procedures from the current period into the next period. Some argue that the former type of earnings management is bad or unethical, while the latter type might be considered good or ethical because it results from managers acting wisely on behalf of shareholders (e.g., shifting maintenance expenditures into the next period allows the company to reach analysts' earnings expectations for the current period).