The Predictable Cost of Earnings Manipulation

Although financial reporting fraud generates considerable losses, we find that investors do not fully exploit publicly available information relevant for detecting fraud. We show that firms with a high probability of overstated earnings have lower future earnings, less persistent income-increasing accruals, and lower future returns. The trading strategy based on the probability of manipulation ranks subsumes the relation between accruals and future performance and yields a hedge return of 13.9%, mostly arising from the short position. Although this suggests a limits-to-arbitrage explanation, we show that institutional investors actually increase their holdings in firms with a high probability of manipulation, and that hedge returns remain large for firms with market capitalization in excess of $1 billion. Thus, the returns concentrated on the short side of the strategy appear to arise not from asymmetric arbitrage costs, but from asymmetric errors in the expectations of (even sophisticated) market participants