Understanding the “numbers game”

• Published in: Journal of accounting & economics 2019-11, Vol.68 (2-3), p.101242, Article 101242
• Main Authors: Bird, Andrew, Karolyi, Stephen A., Ruchti, Thomas G.
• Format: Article
• Language: English
• Subjects: Earnings management; Structural estimation
• ISSN: 0165-4101; 1879-1980
• DOI: 10.1016/j.jacceco.2019.101242

Two well-known stylized facts on earnings management are that the earnings surprise distribution has a discontinuity at zero, and that positive earnings surprises are associated with positive abnormal returns. We link these two facts in a model of the earnings management decision in which the manager trades off the capital market benefits of meeting earnings benchmarks against the costs of manipulation. We develop a new structural methodology to estimate the model and uncover the unobserved cost function. The estimated model parameters yield the percentage of manipulating firms, magnitude of manipulation, noise in manipulation, and sufficient statistics to evaluate proxies for identifying firms suspected of manipulation. Finally, we use the Sarbanes–Oxley Act as a policy experiment and find that by increasing costs, the Act reduced equilibrium earnings management by 36%. This reduction occurred despite an increase in benefits, consistent with the market rationally becoming less skeptical of firms that just meet benchmarks. •Capital markets reward firms that just meet earnings benchmarks, and the distribution of firms jumps at the benchmark.•We model the tradeoff between the observed capital market benefits and unobserved costs of manipulating to meet benchmarks.•Estimated parameters yield the percentage of manipulating firms, the magnitude of manipulation, and noise in manipulation.•The Sarbanes-Oxley Act reduced earnings management by 36% through an increase in costs.•This occurred despite an increase in benefits, as capital markets rationally became less skeptical of benchmark-beating.