Incentives and Penalties Related to Earnings Overstatements that Violate GAAP

Abstract

This paper investigates the incentives and the penalties related to earnings overstatements primarily in firms that are subject to accounting enforcement actions by the Securities and Exchange Commission (SEC). I find (1) that managers in treatment firms are more likely to sell their holdings and exercise stock appreciation rights in the period when earnings are overstated than are managers in control firms, and (2) that the sales occur at inflated prices. I do not find evidence that earnings overstatement in these firms is motivated by concerns about debt covenant violations or the cost of external financing. The evidence suggests that the monitoring of managers' trading behavior can be informative about the likelihood of earnings overstatement. Many economists believe that insider trading is an efficient method of compensating managers for their efforts. These economists argue that reputation losses would preclude managers from making profitable trades before periods of poor corporate performance. Consequently, this paper also investigates the employment and monetary penalties imposed on managers after the earnings overstatement is publicly discovered. This evidence reveals that (1) managers' employment losses subsequent to discovery are similar in firms that do and do not overstate earnings and (2) that the SEC is not likely to impose trading sanctions on managers in firms with earnings overstatement unless the managers sell their own shares as part of a firm security offering. The evidence suggests that neither employment or SEC-imposed monetary losses are effective in preventing the managers in these firms with extreme earnings overstatements from selling their stake in their firms in the face of declining performance.