Corporate Earnings: Facts and Fiction

I nvestors’ conŽ dence in the quality and integrity of corporate Ž nancial reports has been seriously shaken of late. The ever-increasing procession of headlines about fraudulent earnings, in ated asset values and understated liabilities reported by erstwhile leading companies—the likes of Enron, Tyco, WorldCom, Xerox and a host of lesser household names, all audited by major accounting Ž rms—suggests systematic deŽ ciencies in the accounting standards and governance systems that generate Ž nancial information of public companies, not to mention in the regulatory systems overseeing them. Both aggregate data and cross-sectional research conŽ rm the anecdotal evidence that the correspondence to reality of reported earnings deteriorated throughout the 1990s. For example, the gap between aggregate earnings and taxable corporate income, which abstracts according to Internal Revenue Service rules from most estimates and provisions often used to manipulate earnings, has been continuously widening throughout the 1990s (Desai, 2002). Also increasing during the 1990s was the gap between earnings and the corporate proŽ ts reported in the national income and product accounts, which are based on Ž rms’ taxable income adjusted for current values of inventory and depreciation. While part of the difference between earnings and taxable income is probably due to increasing corporate sophistication of tax management, manipulation of earnings played a major role in the widening gap (Lev and Nissim, 2002a). Firm-speciŽc data corroborate the increasing vulnerability of earnings to manipulation. The number of earnings restatements by public companies, often in the wake of admitted reporting improprieties, has skyrocketed in the last three to four years (Wu, 2002). Also, the frequency of Ž rms beating analysts’ forecasts of