Management fraud and earnings management: Fraud versus GAAP as a means to increase reported income

When management is faced with the need to report increased earnings, possible responses range from issuing fraudulently overstated financial statements to adopting more aggressive accounting methods (Jiambalvo 1996). This dissertation examines benefits that may prompt management to choose fraud rather than legitimate earnings management methods. To test the hypotheses, a sample of 60 firms that increased income via fraud is compared to a sample of 178 firms from the same industries as the fraud firms, but these “GAAP” firms chose to increase earnings via a legitimate change in an accounting method. ^ Findings of the study were that fraud caused a significantly larger increase in income than GAAP changes did, and that fraud was significantly more likely to increase gross profit. The fraud firms also had significantly fewer opportunities to make income-increasing GAAP changes, although this was not significant in the logit analysis. Contrary to expectations, the GAAP changes made by fraud firms in the preceding three years were neither more numerous nor more income-increasing than the GAAP changes made by the GAAP firms. ^ This is the first study to compare fraud versus legitimate means of achieving increases in reported earnings. The results have theoretical as well as practical implications. For example, an issue important to earnings management theory concerns whether firms choose fraud to avoid the disclosure required for a GAAP change. At the time of the fraud, 25 of the 60 fraud firms had an income-increasing GAAP option available to them, but none of these options were capable of producing a particularly large income effect. This may suggest that effect size is at least as important as avoidance of disclosure. Another interesting result is the fact that, when an alternative GAAP method existed, both fraud firms and GAAP firms used the most aggressive alternative about 80% of the time. However, for reasons that are not clear, alternatives were not as likely to exist for fraud firms, so they bad fewer income-increasing opportunities overall. Further research is needed to resolve these issues and expand our understanding of management\u27s use of fraud in the financial statements.