Predicting earnings management: The case of earnings restatements

This paper examines the usefulness of accounting information in predicting earnings management. We investigate a comprehensive sample of firms from 1971-2000 that restated annual earnings. We find that firms restating earnings have high market expectations for future earnings growth and have higher levels of outstanding debt. We also find that a primary motivation for the earnings manipulation is the desire to attract external financing at a lower cost. Together, this suggests that capital market pressures are motivating companies to adopt aggressive accounting policies. Finally, we document that information in accruals, specifically, operating and investing accruals, are key indicators of the earnings manipulation that lead to the restatement. Collectively, the evidence suggests that market participants can gain substantial value from a careful consideration of information in financial statements.