Earnings Management Among Firms During the Pre-Sec Era: A Benford's Law Analysis‪.‬

Abstract: This paper examines the existence of financial statement manipulation in the U.S. during a time period when many of the current motivations did not exist. The study looks for types of manipulations that would be motivated by the pre-SEC operating environment. To examine this issue, a sample of U.S. firms from the 1915 Moody's Analyses of Investments is divided into industrial firms, railroads, and utilities. The railroad and utility companies faced rate regulation during this time period, providing incentives to manipulate the financial reports so as to maximize the rate received. Industrial firms were not regulated. These companies wanted to attract investors, motivating manipulations to increase income and net assets. To determine if manipulations are occurring, a Benford's Law analysis is used. This analysis examines the frequency of numbers in certain positions within an amount to determine if the distribution of the numbers is similar to the pattern documented by Benford's Law. Some manipulations consistent with expectations are found. Companies face incentives to choose accounting policies and estimates to achieve certain goals. Managers may want to smooth earnings, maximize earnings, or meet analysts' earnings forecasts. They may want to generate enough earnings to he able to issue dividends or to maintain their current or debt ratios to satisfy lending agreements. Earnings management is the process of choosing accounting alternatives to achieve desired accounting results. McKee [2005] stresses that earnings management uses legal methods as opposed to fraud. Managers may also engage in economic earnings management by making operating decisions designed to achieve desired accounting results.