Camouflaged Earnings Management

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday January 26, 2011 at 9:14 am
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Editor’s Note: The following post comes to us from Itay Kama, Assistant Professor of Accounting at Tel Aviv University and Nahum Melumad, Professor of Accounting and Business Law at Columbia University.

In the paper, Camouflaged Earnings Management, which was recently made publicly available on SSRN, we argue that cash management (in particular one that converts accruals into cash or vice versa) may reduce the transparency of possible earnings management. In recent years, there has been increased scrutiny of financial reporting and greater analysts and investors attention to indicators of potential earnings management, in particular, to cash and accruals relative to earnings and revenues. We assert that, in response, firms have increased their focus on cash management aimed at aligning these variables, which has resulted in camouflaged earnings management.

Analytically, we develop indicators of camouflaged earnings management and use them empirically to test whether the alignment of cash and earnings has intensified following the legislation of the Sarbanes-Oxley Act (SOX). The empirical results are all in line with, and reinforce, our assertion.

The main contributions of our study are as follows. We propose that on top of switching from accrual-based to real earnings management in response to SOX (as suggested by the extant literature), firms continued to engage in earnings management but have also attempted to camouflage the earnings management through cash management. We develop new proxies for accruals-conversion cash management that we use to test our assertion. An important implication of our study is that a comprehensive investigation of earnings management (and not necessarily one with respect to SOX) should consider the possibility of camouflaged earnings management through cash management. Ignoring this option may amount to the omission of an important correlated variable, and thus could result in misleading inferences.

The full paper is available for download here.

 

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