Brad Badertscher of Notre Dame presents some of the results from his dissertation in the November 2011 Accounting Review.
He considers an interesting driver of earnings management: overvaluation. He defines overvaluation as a high stock price/book value. Three findings:
- The longer the firm is overvalued, the more the earnings management.
- To manage earnings, managers tend to start with accruals management before they begin to use actual transactions. For example, managers might start with so-called “cookie-jar reserves,” and later on sell long-lived assets (or perhaps channel-stuff) to manage earnings.
- The longer the firm is overvalued, the more egregious the earnings management.
Warning: For readability’s sake, I am flagrantly oversimplifying Badertscher’s work.
Overvalued stocks are generally some of the riskiest. The earnings of these companies are often subject to all sorts of earnings management, and especially the most chutzpadik kinds – timing transactions to maximize profits. They are even riskier than we might naively think.
Badertscher’s results are consistent with anecdotal evidence. Stocks like Enron and Worldcom were monumentally overvalued before their frauds were discovered. Managers were under tremendous pressure to continue to manufacture earnings, real or otherwise.