Illustration: Chris Sharp

The corporate finance and accounting scandals of the late 1990s and early 2000s—Enron, WorldCom, Tyco—still lay ahead when Carroll School of Management accounting professor Amy Hutton began exploring the roots of “earnings management,” the term of art for casting losses and profits in a better light than facts might allow. Initially skeptical of Hutton’s project, her academic peers have come to recognize her work as seminal.

In the mid-1990s, Hutton and fellow researchers Patricia Dechow and Richard Sloan, now professors at the University of California, Berkeley, Haas School of Business, studied 92 publicly held firms under investigation by the Securities and Exchange Commission (SEC) for allegedly manipulating earnings reports. They wanted to see whether the prevailing academic theory—that individual managers cooked the books to increase their own bonuses or meet banks’ expectations—held up.

The researchers scrutinized consumer complaints, securities market surveillance data, and whistleblower tips. They pored over annual reports and proxy statements to learn how the firms were managed and governed, tracked the companies’ stock performance, and combed industry reports.

What they determined—and documented with mathematical models—was that managers who fiddled with financial reports most often did so to attract outside investors and inflate the value of company stock. The research also showed a strong correlation between certain corporate governance structures and misrepresentation of earnings to shareholders and investors. Firms run by chief executive officers who were simultaneously chairmen of the board and often company founders; those with rubber-stamp boards; and companies that lacked independent auditing oversight were more inclined to recognize revenues prematurely, misrepresent expenses, and engage in other practices counter to generally accepted accounting principles, according to Hutton.

The research was controversial at the time, recalls Hutton, then an assistant professor at Harvard Business School, who came to Boston College from the Tuck School of Business at Dartmouth College in 2006. “We bucked the academic paradigm that markets are efficient, that companies employ the optimal corporate governance structure, and that the market responds to and incorporates information efficiently.” Indeed, research suggesting that individuals could game the capital markets and fool investors flew in the face of market efficiency theory, says Hutton. Several prestigious accounting journals rejected the study, titled “Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC,” before Contemporary Accounting Research, then a small Canadian academic quarterly, published the paper in 1996.

Hutton, Dechow, and Sloan, friends and collaborators since their University of Rochester graduate school days, persisted. They trained attention on potential conflicts of interest among investment bankers who underwrite stock offerings and securities analysts who make buy-and-sell recommendations.

The bursting of the dotcom bubble in 2000 raised public awareness—and suspicion—of Wall Street’s ways, and, in June 2001, a House Financial Services Committee Congressional review board invited Hutton to conduct a review of the Securities Industry Association’s “best practices for equity research.”

Six months later, Enron filed for bankruptcy, setting in motion a cascade of revelations that it had systematically manipulated reported earnings, bamboozled Wall Street investors and analysts (who were relentlessly bullish about Enron stocks), and bilked investors. Notably, Enron’s Kenneth Lay and WorldCom’s Bernie Ebbers were the founders and CEOs of their companies, and chairmen of compliant boards.

Hutton, Dechow, and Sloan were recognized for their research last summer, when the American Accounting Association bestowed its inaugural Distinguished Contribution to Accounting Literature Award on their 1996 paper. The association noted the “enduring impact” of their study, and pointed out that federal regulations consistent with their research were enacted.
The researchers have recently developed a more powerful model for detecting earnings management, and Hutton is now looking at compliance with the 2002 Sarbanes-Oxley Act, a sweeping reform of corporate disclosure and accountability.

“Managers still manipulate earnings, though the magnitudes that do it are smaller,” says Hutton. “We’re all a little wiser, a little more on top of things, and a little more sophisticated.”

Read more by Maureen Dezell