Earnings Management among Firms during the Pre-SEC Era: A Benford's Law Analysis

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Abstract: This paper examines the existence of financial statement manipulation in the U.S. during a time period when many of the current motivations did not exist. The study looks for types of manipulations that would be motivated by the pre-SEC operating environment. To examine this issue, a sample of U.S. firms from the 1915 Moody's Analyses of Investments is divided into industrial firms, railroads, and utilities. The railroad and utility companies faced rate regulation during this time period, providing incentives to manipulate the financial reports so as to maximize the rate received. Industrial firms were not regulated. These companies wanted to attract investors, motivating manipulations to increase income and net assets. To determine if manipulations are occurring, a Benford's Law analysis is used. This analysis examines the frequency of numbers in certain positions within an amount to determine if the distribution of the numbers is similar to the pattern documented by Benford's Law. Some manipulations consistent with expectations are found.

Companies face incentives to choose accounting policies and estimates to achieve certain goals. Managers may want to smooth earnings, maximize earnings, or meet analysts' earnings forecasts. They may want to generate enough earnings to he able to issue dividends or to maintain their current or debt ratios to satisfy lending agreements. Earnings management is the process of choosing accounting alternatives to achieve desired accounting results. McKee [2005] stresses that earnings management uses legal methods as opposed to fraud. Managers may also engage in economic earnings management by making operating decisions designed to achieve desired accounting results.

Several authors have examined accounting policy choice to study earnings management. Many studies have focused on the choice of inventory cost-flow assumption [Morse and Richardson, 1983; Hunt, 1985; Johnson and Dhaliwal, 1988; Lindahl, 1989]. In general, these studies have found that companies choose the LIFO inventory cost-flow assumption if they face high inflation in the cost of inputs, and also if they have certain accounting characteristics such as a high current ratio, low debt ratio, and/or large amounts of unrestricted retained earnings. These characteristics allow firms to continue with contracts that rely on accounting measures while using LIFO to reduce taxable income.

Other studies have modeled the accrual process and used the results to estimate abnormal accruals. These studies have then used abnormal accruals to examine a number of issues related to earnings management [Rees et al., 1996; Cheng and Warfield, 2005; Peasnell et al., 2005; Morsfield and Tan, 2006; Pincus et al., 2007]

Another approach to examine earnings management is Benford's Law. Digits are not uniformly distributed in naturally occurring, unrestricted data. Instead, the first digit is much more likely to be small and much less likely to be large. For example, approximately 30% of the first digits will be one. This is thought to be due to the geometric growth of natural processes [Nigrini, 1999]. Manipulated data do not tend to follow Benford's Law. This occurs because people may overuse a favorite number, for example, or may tend to overuse large digits or the digit one in an attempt to overstate results. Benford's Law can then be used to detect fraud (Nigrini and Mittermaier, 1997; Carr, 2005; Cleary and Thibodeau, 2005; Johnson, 2005] or earnings management [Skousen et al., 2004; Guan et al., 2006, 2008; Jordan and Clark, 2011].

This study will examine the earnings management of U.S. company-reported data from the 1915 Moody's Analyses of Investments (Moody's) using a Benford's Law analysis. This time period is being chosen because it is before the Securities and Exchange Commission (SEC) was created so that U.S. government regulation of securities did not exist. This time period is also before the existence of promulgated U. …