The Effect of Tax-Exempt Status and Regulatory Scrutiny on Managers\u27 Portfolios of Earnings Management Strategies in Hospitals

The purpose of this paper is to examine the influence of hospitals\u27 tax-exempt status and the recent increase in regulatory scrutiny related to the renewal of the tax exemption on the accrual-based and real activities earnings manipulations exhibited by the U.S. hospital industry. I find that taxable hospitals (for-profit hospitals) engage in more earnings management than annually tax-exempted hospitals (not-for-profit hospitals) which, in turn, engage in more earnings management than permanently exempted hospitals (government hospitals). However, the magnitude of the manipulation of patient services costs, a specific real activity earnings management strategy, is the lowest in not-for-profit hospitals. Considering that a significant portion of these activities (e.g. patient care service costs provided as charity) are monitored by federal, state and local government agencies to evaluate the renewal of the not-for-profit hospital\u27s tax-exempt status, these findings suggest that regulatory scrutiny is associated with the low level of manipulations. I also find that all hospital managers behave as if accrual-based earnings management and real activities earnings management are substitutes--greater levels of one type of earnings management are associated with reduced levels of the other. The findings of this study suggest that state additional oversight and the new IRS regulations established in 2009 may provide not-for-profit hospitals with added incentives to switch from real activities manipulations to accrual-based earnings management, and thus require additional scrutiny of their accrual accounting