Enron Scandal and Earnings Management Hoje Jo Santa Clara University April 2003

Enron Scandal: Crony capitalism? Clifford Baxtor, vice chairman made $22 million from stock option since Oct. ‘98 and suicided eventually. Jeff Skilling, CEO, made more than $112 million (about W1,344euk) Andy Fastow, CFO, made more than $30 million. Top management together cashed out more than $1 billion. Kristona Mordaunt, controller, invested $6,000 in Enron and made more than $1 million within a few weeks. What happed to Employees’ pension funds? (wiped out).

Enron’s 10-year Stock Price

What is Earnings Management? Healy and Wahlen (1999) definition: Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.

Corporate Examples of Earnings Management AOL Time Warner Enron Merck Quest Communications WorldCom Xerox Merrill Lynch and Wall Street And many others

Simplified Example of Manipulation Consider two identical firms with identical true earnings of $100 and assume a discount rate of 10% to compute the firm value in year -1. So, market value of two firm at year -1 is $1,000. Firm A report report true earnings of $100 in year 0 and year 1. Investor value the firm at $1,000 and the returns of 0% in both years. Manipulation: Firm B engages in earnings manipulation and report earnings of $110 in year 0. So, investors value the firm at $1,100. But firm B is unable to maintain the earnings adjustment and report earnings of $90 in year 1, leading investors to value the firm at $900. As a consequence, firm B’s return is 10% during the earnings manipulation and negative 18.18% [( )/1100] in the year following the earnings manipulation.

Data The sample firms contain all firms with necessary data from CRSP and Compustat from 1980 to A firm must have at least two adjacent years of Compustat data to calculate discretionary accruals. We also require three years of subsequent and one year of prior CRSP returns. Overall, 37,285 firm years (about 2,071 firms per year on average) of data remain. Monthly time series of factor returns are from Fama and French.

Results The analysis show that high discretionary current accruals (DCA) predict low future returns but are associated with high returns during earnings management. Most of the high returns are realized in the first 12 to 24 month following firm’s earnings management.

Results (Cont’d) Low accrual firms outperform high accrual firms over a subsequent 12-month period. The average stock in the lowest accrual group outperforms the average stock in the highest accrual group by about 14.3% over the subsequent three years.

Return reversal for lowest and highest DCA groups

Return trend for four portfolios

Interpretation Investors penalize firms that do not inflate their earnings using DCA during the period of earnings management. After the earnings manipulation becomes obvious and true earnings are revealed, the returns reverse.

Summary High DCA firms outperform low DCA firms during the earnings management. High DCA firms under-perform low DCA firms over the following three years and, in particular, over the following year. DCA exhibits negative autocorrelation.