Issuance of subsidiary stock as an earnings management strategy

Abstract

Arthur Levitt, chairman of the Securities and Exchange Commission, expressed concern that the pervasiveness of earnings management in American corporate financial statements threatens the integrity of financial reporting. Levitt referred to the "cookie jar" phenomenon wherein U.S. firms have earmarked opportunities to "find gains" when earnings are less than anticipated. The academic research literature includes a large number of studies on earnings management strategies. One relatively unexplored strategy is the use of stock issuances by subsidiaries to generate gains under the provisions of SEC Staff Accounting Bulletin No. 51. Based upon a sample of 125 observations of this accounting choice over the period 1985 through 1997, our study provides compelling evidence that recognition of gains on the issuance of subsidiary stock coincides with periods when earnings fail to meet expectations (as measured by analysts' forecasts), and that the recognition of these gains in the income statement is effective in achieving earnings expectations. Further, the amounts of these gains are large relative to pre-gain net income.