Critique: Stock and Earnings Management Essay

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Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC
PATRICIA M. DECHOW, RICHARD G. SLOAN and AMY P. SWEENEY

Summary:
The objective in this paper was to investigate the motives for and consequences of earnings manipulation in a sample of firms targeted by the SEC for allegedly overstating earnings. The paper examined the need for external financing which had received a small amount of attention in previous earning management literatures. This paper also discussed management incentive to manipulate which should be checked on by an internal governance structure. This paper also examined the stock price reaction and changes in bid-ask spreads caused by aggressive reporting. Several tables were presented to help illustrate the study. This paper investigated the following issues. First, the extent to which the alleged earnings manipulations could be explained by extant earnings management hypotheses. Second, the relation between earnings manipulations and weaknesses was in firms' internal governance structures. Third, the capital market consequences experienced by firms when the alleged earnings manipulations are made public. The findings in this paper indicated that important motivations for earnings manipulation were the desire to raise external financing at low cost and to avoid debt covenant restrictions. Moreover, this paper did not find systematic evidence that managers are manipulating earnings to obtain a larger earnings-based bonus. Managers did not appear to be manipulating in order to sell their stockholdings at inflated prices. The firms manipulated earnings are more likely to have boards of directors dominated by management, more likely to have a Chief Executive Officer who simultaneously serve as Chairman of the Board and also the firm’s founder and less likely to have an audit committee. At the end, the firms manipulated earnings experience significant increases in their costs of capital when the manipulations are made public.
Critiques:
This paper was a very complete research. It investigated not only the motivation but also consequences including stock price reaction, changes in bid-ask spreads, analysts’ followings and so on. In my point of view, this paper had a comprehensive analysis and a great contribution to the earnings management literatures. Prior research assumed that the ability to manipulate was a constant variable across firms. Nevertheless, this paper considered the management’s incentives to manipulate by an effective internal governance structure. It had governance structure factor that limited the ability of managers to manipulate earnings. Moreover, this paper investigated
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