Accounting Expert: Executive Networks Can Lead to Earnings Manipulation

Publicly traded companies manipulate their financial documents more often when their officers and directors have well-connected social circles, Assistant Professor Ming Taylor (Ming Fang) of NJIT's Martin Tuchman School of Management found, earning her the Best Paper of 2022 award from British Accounting Journal.

Taylor, with assistance from colleagues at Rensselaer Polytechnic Institute, Fordham University and Hong Kong Polytechnic University, found a proveable overlap between the profiles of nearly 200,000 business executives using 17 years of data from relationship mapping firm BoardEx — such as where they worked, went to college, made charitable donations, and joined country clubs — overlaid on data about companies that spin their quarterly stock reports.

Insiders use the term earnings management for the gamut of tricks accounting that can make a company appear to have made more money or to have a smoother, less risky chart over time. Officially, it's "the practice of distorting the true financial performance of the company," according to the U.S. Securities and Exchange Commission.

"There are many ways to change those numbers. Some are legal, some are illegal. Sometimes they backfire and get caught by the SEC," Taylor explained. Experts like her sometimes call it earnings manipulation, as it's often a red flag leading to SEC investigations of companies like AT&T, IBM and the ill-fated Enron.

"We find that firms with more external connections are more aggressive in managing earnings through both accruals and real activities. Our baseline regressions show that a one-standard-deviation increase in social network centrality is associated with a 4.8% increase in discretionary accruals and a 5.0% increase in real earnings management," Taylor stated in the article, External social networks and earnings management, published in March 2022.

"If you are central in the network, you have an information and resources advantage. You know more of these tricks from all of your friends and you also have more resources to implement these tricks. For example, you have good connections with the bank and a good reputation from the stock market, so you can borrow money to cover up."

"Many congratulations to Prof. Ming Fang and her co-authors on winning the British Accounting Review’s annual best paper award. [Their] findings enhance our understanding of the role of social ties in corporate reporting and have both academic and policy implications," BAR co-editors Wen Hou and Jason Xiao said.

On receiving her award from the prestigious journal, "I'm pretty happy about all the work that is now being recognized," Taylor said. "You could call it an open secret. Every company does something. Some are benign, some are extreme."

"Our study has both academic and practical implications. From the academic perspective, given the significant impact of external social networks on earnings management, we suggest that future studies on both accrual and real activity-based earnings management should consider external social networks as a standard control. From the practical perspective, we believe that evidence from this study can help U.S. regulators and investors better understand and detect firms’ aggressive reporting behaviors in light of social networks," Taylor wrote in the paper.

Taylor said the next stage of her research examines the connections between earnings management and tax avoidance.