New Research Findings about Overvaluation and Earnings Management

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:

  1. The longer the firm is overvalued, the more the earnings management.
  2. 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.
  3. 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.

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About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.

4 comments

  1. There is so much pressure in todays society, especially with all of the competition provided by our capitalistic system that earnings managers or manipulators, whichever you prefer, feel the urgency to channel stuff or do other things in order to make their stock price appear high. It seems to be a vicious cycle: managers begin by i.e. channel stuffing and so their accounts receivable goes up; however when buyers begin to return the inventory managers are then forced to manipulate the numbers even more fraudulently because the high amount of returns would run the stock price down, leading managers along a downward spiral of fraud. This post makes a very good point.

  2. Once a company's stock becomes overvalued, management is going to want to keep the stock price as high as they can. Especially when their bonuses are linked to stock price. This incentive creates a lot of motivation for managers to manipulate numbers and even commit fraud. Some people are greedy and once they get a taste of the kind of money they make with an overvalued company, they will do anything to keep it that way. This only hurts the average investor in the long run because fraud will eventually surface and the overvalued company stock will tank. I completely agree with the paper.

  3. It's a catch-22. If high-level executives get paid huge salaries, regardless of performance, then they have no real incentive to make the business grow. If they get paid based on performance, then that will give them the incentive to manipulate earnings and thus, overvalue stocks. I remember hearing in multiple of my business classes that one of the solutions to this dilemma was to pay executives with stocks mostly. The problem with that idea is that it gives managers even more incentive to overvalue stocks. Therefore, I honestly don't see a solution.I guess a "possible fix" would be to pass a law with timing restrictions. In other words, managers must wait at least x days to sells their stock. Managers, on the other hand, could argue that it is not fair, and they have the right to reap the benefits of their company's earnings – as long as they are legit earnings.

  4. I think that there is a lot of pressure in big public companies to manipulate earnings to meet stock price projections made by analysts. Top management at these companies feel that they must dabble in earnings management tactics in order to meet the bottom line and appease investors. The issue with this is that they might not even be in bad shape, but once you start to manipulate earnings it becomes a constant game of catch up. This is especially true of companies experiencing lower earnings due to economic or industry conditions that may not turn around anytime soon. When you manipulate earnings one year, unless there is a turnaround in the future, management will feel the pressure to continue to manipulate earnings in the future. When this happens, a lot of companies pass the fine line between opportunistic earnings management and fraud. Various accrual tactics are used such as shady capitalization practices, taking a “big bath”, relying on reserves in years of desperation, etc. It seems like a huge commonality in companies that resort to excessive earnings management and overvaluation are companies that have history of success and feel that they must have similar financials as previous years. Brad Badertscher ‘s three findings seem to be common sense. Just like any employee fraud, the fraudster starts off by just stealing a little from their firm, and as the time passes and they realize they can get away with more, and they take greater risks. Earnings management and overvaluation appear to have the same trend – management keeps taking greater risks and they continue to manipulate more and more.

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