Study: Moderate Scrutiny Most Likely to Produce Inflated Earnings Statements, Versus High or Low

Chris Gaetano
Published Date:
Jun 7, 2018

A recent study has found that there is a Goldilocks zone for earnings management risk, with executives most likely to overstate performance when there is a moderate amount of external scrutiny, versus high or low levels, according to The study, which came from the MIT Sloan School of Management, looked at a data set of more than 300 restatements resulting from fraud or an SEC investigation between 2004 and 2012, and evaluated what the researchers called their "information environment." The more there were institutional investors owning company stock, industry analysts following the company and articles about the company in the mainstream media over a year, the better the information environment. 

Using regression analysis, the study found that as information quality improves, restatements increase, until reaching an apex point and then decreasing from that point on. The researchers believe this has to do with incentives. In low-information environments, there's little incentive to massage the numbers because, bluntly, not enough people care. But as the information environment improves and more attention is put on the company, executives have more reason to manipulate figures because there's more riding on public perceptions of the firm's performance. However, as scrutiny further increases, the risk of getting caught gets too high, and so the risk of restatements starts to decrease. 

The researchers pegged the specific threshold at which the risk of getting caught outweighs the incentive to manipulate the numbers at 17 media articles and just over 6 dedicated analyses. 

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