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Fudged or Managed? Fan Probes Earnings Reports

With all of the attention focused in recent years on the Enron and WorldCom debacles, it should come as no surprise to anyone that companies sometimes fudge their earning figures. Qintao (pronounced “chin-tao”) Fan, assistant professor of accounting, has looked at such activity, known somewhat euphemistically as “earnings management,” particularly in cases where firms prepare for IPOs. She explores whether companies are indeed trying to pull the wool over investors' eyes by reporting inflated earnings figures, and whether such inflation renders accounting reports totally meaningless or serves a useful purpose.

Fan, a freshly minted graduate of Stanford University 's doctoral program in accounting, has found that, surprisingly, earnings management can effectively differentiate firms with higher earnings potential from those with lower potential in the eyes of investors.

Accounting reports can be manipulated only to a certain extent, Fan maintains, because inflating figures is ultimately costly to any firm. “If you report a high earnings figure now, you are essentially borrowing against your future,” she explains. “Subsequent reports will have to be lower because eventually your total reported earnings have to equal your total cash flows. This can potentially trigger litigation and an increase in the cost of capital.”

Lower-potential firms will overstate their earnings during the IPO process to make themselves appear on par with higher-potential firms. Higher-potential firms will follow suit in part to separate themselves from the lower tier, overstating their earnings at a level that's prohibitively costly for a lower-tier firm to mimic.

Firms can also demonstrate their value to investors by strategically combining earnings inflation with another “signal” – such as retaining a certain degree of ownership in the company. Data on IPO firms from 1987 to 1997 confirm that investors do pick up on signals such as earnings inflation and ownership retention in valuing an IPO firm.

Fan's most recent research examines the capital market implications of fair value accounting versus historical cost accounting, and how effective contracts can be designed to best motivate managers. She came to the United States from China in 1996, after completing a BA in international economics at Renmin University in Beijing.

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Qintao Fan

Qintao Fan
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