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    Revenue Manipulation and Restatements by Loss Firms
    research summary posted April 16, 2012 by The Auditing Section, last edited May 25, 2012, tagged 06.06 Earnings Management, 14.0 Corporate Matters, 14.01 Earnings Management, 14.05 Earnings Targets and Management Behavior 
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    Title:
    Revenue Manipulation and Restatements by Loss Firms
    Practical Implications:

    This study’s results provide auditors and regulators with another potential indicator of managerial incentives to manipulate reported revenues (i.e., continued losses or negative cash flows) and how managers might achieve this result.  The authors demonstrate that this manipulation incentive applies across the general spectrum of firms and is not limited to young or internet-based businesses.

    Citation:

    Callen, J., S.W.G. Robb, D. Segal 2008. Revenue Manipulation and Restatements by Loss Firms. Auditing: A Journal of Practice & Theory 27 (2): 1-29.

    Keywords:
    revenue manipulation; earnings management; auditing; restatements
    Purpose of the Study:

    Regulating entities (such as the SEC and FASB) and auditors recognize managers have incentives to manipulate revenue accounts to achieve certain financial statement-related goals and perceptions with analysts and investors.  Although management can also manipulate earnings and financial data using expense-related accounts, accounting violation investigations by the SEC, FBI, and U.S. Attorney General’s office suggest that management is more likely to manipulate results using revenue-related items.  Survey evidence indicates management’s use of revenue items to increase earnings is more common, and studies show that firms have capital market incentives to provide positive revenue surprises.  Academic studies examining SEC enforcement actions support this perception.  Studies also indicate that individual firm characteristics could lead to a greater tendency to manipulate revenue-related line items.  For instance, studies suggest that young firms and internet-related businesses are more likely to manipulate earnings using revenue accounts.

    One reason why firms are more likely to manipulate revenue-related accounts is that firms with repeated losses or negative cash flows cannot be valued accurately using traditional valuation models such as the discounted cash flow and discounted residual earnings models.  In these cases, analysts use other models and ratios, such as the price-to-sales ratio, to value the firm.  Manipulating revenues in these situations help management project positive expectations concerning future growth and induce higher market capitalization.

    Although prior studies and enforcement actions suggest that firms, in particular young and/or internet-based firms, are more likely to manipulate revenues, the purpose of this study is to examine a broad spectrum of firms to determine whether repeated losses and anticipated future losses are an indicator of firms’ likelihood to manipulate revenues in violation of GAAP.

    Design/Method/ Approach:

    The authors use restatement data on U.S. publicly-traded firms for the years 1992-2005 to examine the relationship between revenue misstatements and past and expected future loss or negative operating cash flows.

    Findings:
    • Consistent with prior research, revenues appear relevant to the market valuation of loss and negative cash flow firms, but earnings and operating cash flows do not.
    • The authors find a positive association between the number of anticipated loss years and a firm’s accounts receivables, even after controlling for the firm’s credit policy.
    • The authors find a positive association between the number of actual and anticipated loss years and the probability of a firm manipulating revenue.
    • The authors find that the probability of revenue manipulation is positively related to the level of a firm’s accounts receivable balance.
    Category:
    Corporate Matters
    Sub-category:
    Earnings Management, Earnings Management, Earnings Targets & Management Behavior
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