Microsoft Word 2007 ichrie conference Proceedings Final-Final 06-06-07. doc

 
2007 Annual International CHRIE Conference & Exposition 
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assets. Overall, his results indicate that firms are much more likely to manipulate earnings when receivables are 
increasing, gross margins are declining, asset quality is decreasing, sales are increasing and accruals are also 
increasing. 
Investors tend to highly focus on earnings (Sloan, 1996) and they appear to be unable to distinguish 
between two components of earnings: accruals versus the cash flows. Cash flows are less subject to management 
distortion than net income (earnings) (Bernstein, 1993). Sloan (1996) confirms the proposition that the cash flow 
component of earnings has a higher level of persistence. In other words, current earnings are more likely to continue 
if they are primarily attributable to cash flow than accruals. Accordingly, Sloan finds firms with high levels of 
accruals experience negative future abnormal stock returns.
The literature suggests that unidentified EM firms enjoy benefits such as low costs of capital and fewer 
risks, while identified firms suffer a great loss in stock price and a higher cost of capital. The EM hypothesis may 
help gain perspective on the relationship between EM and market return. That is, managers may opportunistically 
use accruals to inflate the earnings number for high accruals firms (Chan et al, 2004). These firms tend to have a 
better firm performance in the short-term. Since accruals are accounting adjustments to cash flow and should sum to 
zero over the life of the firm, upward accruals will lead to downward accruals afterwards. Therefore, current 
accruals have a negative impact on future earnings. If the EM strategy of a firm is made public, the market will 
immediately react to news and the stock price will decline significantly. The investors are not fooled by EM and the 
market is efficient enough to make the adjustment.
Beneish (1999 b) documents that stock prices will plunge 20 % on average when EM is discovered. Teoh, 
Welch, and Wong (1998) find a negative relation between pre-issue discretionary accruals and post-issue earnings 
and stock return. Rangan (1998) finds that discretionary accruals are higher during the pre-offering period and are 
reversed in the year following the offers. Chan et al (2004) quantify the size of the negative effect of current EM on 
future earnings. The results showed that an upward accrual today by $1 will bring about $0.046, $0.096, and $0.128 
in average future earnings in the following year, year three and year five, respectively. The findings further support 
the results in Sloan (1996) that stocks with high EM under-perform stocks with low EM for the following years.
Collectively, these studies provide empirical evidence of the inverse relationship between EM and the subsequent 
earnings and return performance.
It is a generally accepted notion that earnings manipulation takes place. The problem of course, is that this 
cannot be generalized across firms in all industries across all periods of time. Given the existing literature on EM, 
we propose to construct variables used by Beneish (1999a) as a way to determine if restaurant firms that manipulate 
earnings are punished with a decrease in stock price.