Understanding earnings quality - MIT Sloan School of Management

the definition of fraud in SAS No. 99. In some cases, however, the SEC alleges that managers were
negligent (i.e., “reckless in not knowing” of the misstatement).
Because the AAER sample includes cases of egregious and intentional misstatements (i.e.,
earnings management), it is likely to have a lower Type I error rate than samples identified using
other methods such as abnormal accruals models. One issue of concern, however, is the potential for
selection bias related to how the SEC identifies the misstating firms. Given a constrained budget,
the SEC may not pursue cases that involve ambiguity and that it does not expect to win. The SEC
states that it will scrutinize firms that restate earnings because the firm has already admitted to
making a mistake. The SEC also states that it is concerned with market impact because their role is
to protect investors. Therefore, they scrutinize firms with large market capitalizations as well as IPO
firms and firms raising public debt or equity.
Determinants of AAERs
Managerial compensation: Dechow et al. (1996) and Beneish (1999) do not find an association
between the existence of an earnings-based bonus plan and the likelihood of accounting
manipulations. Johnson, Ryan, and Tian (2009) find that AAER managers face stronger incentives
from unrestricted stocks than those of control firms, however, Erickson, Hanlon, and Maydew
(2006) and Armstrong, Jagolinzer, and Larcker (2009) do not find a positive association between
stock-based incentive compensation and the likelihood of accounting fraud. Dechow et al. (1996) do
not find abnormally higher stock sale activities for the officers and directors of the AAER firms
during the manipulation years, but two subsequent studies find that insiders of fraud firms tend to
engage in more stock sales during the manipulation period (Summers and Sweeney, 1998; Beneish,
1999).
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