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    Earnings Management During Import Relief Investigations Jennifer J. Jones Journal of Accounting Research, Vol. 29, No. 2 (Autumn, 1991), 193-228. Stable URL: httpflinksjstor.orgsici?sici=0121-8456%28 199 123%2020%3A2%9C 1933 AEMDIRIZ3E2.0.CO%SB21 Journal of Accounting Research is currently published by The Instcute of Professional Accounting, Graduate Schoo! of Business, University of Chicago. Your use of the ISTOR archive indicates your acceptance of [STOR's Terms and Conditions of Use, available at tlp//ewvejstororglabouttenms.html. ISTOR's Terms and Conditions of Use provides, in pat, chat unless you fave obtained pcior permission, you may not dowaload an cnt isus of @ journal or multiple copies of articles, and you may use content inthe ISTOR archive only for your personal, non-commercial uss. Please contact the publisher cegarding any further use of this work. Publisher contact information may be obtained at bup:orww stor org/joummals/grad-uchicago.hen, Each copy of any part of a JSTOR transi printed page of such transtnission. ion must contain the same copyright notice that appears on the screen or ISTOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding ISTOR, please contact jstor-info@jstor.org. hup:thewwwjstor.orgy ‘Tue Ape 27 09:28:20 2004 Journ Accounting Reseach Ua ese Rae Preedint Sh Earnings Management During Import Relief Investigations JENNIFER J. JONES* 1. Introduction ‘This study tests whether firms that would benefit from import relief (eg., tariff increases and quota reductions) attempt to decrease earnings through earnings management during import relief investigations hy the United States International Trade Commission (ITC). The import relief determination made by the ITC is based on several factors that. are specified in the federal trade acts, including the profitability of the industry. Explicit use of accounting numbers in import relief regulation provides incentives for managers to manage earnings in order (o inerease the likelihood of obtaining import relief and/or increase the amount of relief granted While studies of earnings management typically examine situations in which all contracting parties have incentives to “perfectly” monitor adjust} accounting numbers for such manipulation, import relief inves- tigations provide a specific motive for earnings management that is not 7 University of Chicago. 1am especially indebted to my dissertation enrrnicee, Sohn, Bound, Michael Bradley (cochairman), Michael Maher (cochairman), and Thorsae Siaber for thele asistance and to others wha have provided helpul comments, notably an anonymous refers, Victor Bernard, Deen Crawford, Linda DeAngelo, Bruce Ikawa, William Kinnes, Richard Leftwich, Robert Tipe, Petae Wileon, David Wright, and workshop Dertcipants at Camnegie-Mallon University, Northwestern University, Ohio Seate Unver- sity, University of Arizona, University of Chicago, Univesity of fowa, University of North Carolina, University of Rochester, Waskizgton University, and Wharton Sehodl. Lam also indebted to Rienard Lauloe from the United States [ntemational Trade Commission (TC) for his help in obtaining information about the import relief investigation process at the ITC. This paper as bacn funded by tho Instiata of Profesional Accounting at the University of Chicago and dissertation fellowships thom the Arthsr Andersen & Co, Foundation and the University of Michigan Dyistea Pune. 130 (Canpitht, Joornal of Acousting Rass 1201 194 JOURNAL OF ACCOUNTING RESEARCH, AUTUMN 1991 provided in other earnings management studies, Import relief is a wealth transfer from a group of diffuse losers (consumers) to a group of concen- trated winners (all other contracting parties of domestic producers re- ceiving import relief)" I argue that consumers do not monitor earnings management as effectively as lasers examined in other studies because the loss to each consumer is smaller, and their interests more diverse, than for the contracting parties examined in these studies.* Regulators have less incentive to adjust for managers’ earnings manipulations since their ultimate payoff for such adjustment is less direct than in other situations previously studied (eg., union contract negotiations). Fur- thermore, interviews of ITC regulators indicate that the ITC does not adjust financial data for accounting procedures used or for accrual decisions made by firms. ‘This study documents the use of accounting numbers in a federal government program as a basis for wealth transfers (.e., import relief An estimate of the discretionary component of total actuals is used as the measure of earnings management, rather than the discretionary component of a single accrual {as used in McNichols and Wilson 11988). The discretionary component of total accruals is more appropri- ate in this context because the ITC is interested in earnings before taxes, which includes the effects of all accrual accounts, and, as such, managers are likely to use several accruals to reduce reported earnings. Firm- specific expectations models are developed to estimate normal (nondis- cretionary) accruals. The expectations models control for the effects of ‘economie conditions on the level of accruals. T eonduct a cross-sectional analysis to test whether estimated discretionary accruals (i.e. residuals from the estimated expectations models) tend to be income-decreasing during the import relief investigation period. 'The methodology developed in this study extends the methodology used in other earnings manage- ment studies; specifically, time-series models are developed to estimate total nondiscretionary accruals and enoss-sectional tests of the earnings management hypothesis are applied. The results of these tests are con- sistent with the hypothesis that managers decrease earnings through earnings management during import relief investigations. This evidence " Exninples of other contracting parties are management, shareholders, debtholders, nd ‘employoes. It should be noted that the long-run effacte of import relief are not wall understood. It maybe the eae that the chart-tatm cous to eonquoers (he, Wealth transfers ‘due impart ie?) ae offset. in the long-run by benefit rom a stronger domestic indir. "For example, employees ring union cantaace negotiations (Liberty ana Zitmexman 1986), shareholéers in setting management compessation eal [1986], shareholders in ‘management buyouts (DeAngelo (19A6)}, and shareholders in proxy contests (DeAngelo (18. Ag | discus ater, the ITC has bean organized in auch a way 28 to minimie the effoct of voters on the ITC's actions; therefore, the ITC may have less incentive to adjust than regulators in situations in which voters have a more diet influence. In either case, the payoff to regulators for adjusting for managers’ opportunistic sceaurting choices is lesa Airect than i ig for other contracting partios such as dobsholder end stockholders. EARNINGS MANAGEMENT DURING INVESTIGATIONS 195 is of particular importance in the light of the current interest in import, protection. ‘The next section provides institutional background for import relief determinations. Section 3 develops the hypothesis to be tested. Section 4 contains the sample selection procedures and deseriptive statistics, Section & reports the results of the empirical. tests. The lest section provides conclusions. 2. Role of Accounting Numbers in Foreign Trade Regulation Foreign trade regulation provides avenues for granting import relief through tariffs, quotas, marketing agreements, and/or federal adjustment, assistance. In most cases, an increase in impart protection results in a ‘wealth transfer from domestic consumers, domestic importers, and for eign suppliers to domestic producers of the protected good. Agents in the domestic producers’ nexus of contracts, such as employees, stockholders, debtholders, and suppliers, cannot be hurt directly by the import protec: tion and instead may benefit.’ Managers of firms that. would benefit from. increased import protection have incentives to take actions to increase the likelihood of obtaining such protection and/or increase the amount of protection granted. ‘The ways in which managers can increase the expected value of the import relief depend on the factors considered by the regulators when making import relief decisions. In the remainder of this section, I review these factors. 2.L STATUTORY PROVISIONS OF THE FORBIGN TRADE ACTS ‘The major statutory provisions of the foreign trade acts that relate to import relief are summarized in Appendix A. The first three statutes, which pertain to general escape clause, countervailing duty, and anti- ‘dumping investigations, are the primary focus of this study. Title VII of the Taritf Act of 1930 was designed to protect domestic industzies from imports that are sold at less than fair value (antidumping) or are benefiting from foreign subsidies (countervailing duty), The general ‘escape clause investigations are hased on section 201 of the Trade Act of 1974, which was designed to aid domestic industries that are seriously injured by inereased imports. Section 201 is based on article XTX of the General Agreement. on ‘Tariffs and Trade (GATT), which permits a country to “escape” (hence the teri “escape clause”) temporarily from its obligations under the GATT when inercased imports of @ specific product are causing or threatening to cause serious injury to domestic producers of a like or directly competitive product. ITC investigations conducted under section 201 provide a basis for the president. to invoke article XIX of the GATT. “xcept ta the extent thatthe contracting parties are also consumers. 196 JENNIFER J, JONES ‘The antidumping, countervailing duty, and general escape clause stat- tutes require the ITC to make a favorahle injury decision before import. relief ean be granted.* In the case of countervailing duty and antidumping ceases, once the ITC has determined that an industry is being injured by imports, the Department of Commerce determines the increase in tariffs necessary to offset the dumping margin or foreign subsidy. If the ITC rules favorably in general escape clause investigations, a recommendation is made by the ITC to the president ta grant the industry some specified type of impart relief. The president has 60 days to make his import relief decision, If the president does not grant any import relief or grants relief that differs from that recommended by the ITC, Congress can override the president's decision and aecept the ITC's recommendation by abtain- ing an affirmative vote in each House within 99 daya after the president's decision. In each of these three (ypes of investigations, the JTC must find that the industry has been injured before import relief can be granted, The federal trade acte specify the factors to be considered when making import relief decisions. In the case of general escape clause investigations, the Trade Act of 1974 states that in determining injury: the Commission shall take into aceaust all economic factors which it considers ‘relevant, including (but not limited to)— (A) with respact ta serious injury, the significant idling of productive cilities im the indusizy, the inability af ¢ significant number of firms to oporaie at reasonable level of profit, and significant uzemployment or undeterployment within the industry, {B) with respect to threat of serious injury, a decline in ales, @ higher and growing, Inventory, «nd a dawnward trend in production, profits, wages, or exsployment (or increasing undoremployment) in the domestic industry concerned... (89 USC 2261(b)(2). [Emphasis adcod.) The factors to be considered in antidumping and countervailing duty investigations are as follows: (0) actual and potential decline im output, sales, market share, peafite, productivity, return an investments, and utilization of capacity, (2) factors affecting domestic prices, and 2) actual and potential negative effecte on cash flaw,’ inventaries, employment, ‘wages, growth, ability to rite capital, and investment (Trade Ageesments Act of 1979, section 771 (19 USC 1677(7}).(Exmphasis added.) Since injury determinations specifically call for the use of accounting numbers (L., profits, sales, and inventories) in foreign trade regulation, ‘the remainder of this paper addresses the three types of investigations that require such determinations. The PPC is responsible for making all injury decisions under the foreign trade statutes. The deCinition of cash flows uted by the ITC is izcame before tax plus depreciation copense EARNINGS MANAGEMENT DURING INVESTIGATIONS 197 2.2 USE OF ACCOUNTING NUMBERS BY THE ITC ‘The use of accounting numbers by the IC is not only specified in the trade acts but is also apparent in other ways, A review of 50 petitions” filed with the ITC for import relief investigations reveals that: most. petitioners cite the poor financial condition of the domestic producers as an indication of the industry's need for import protection. In an article regarding the copper industry's petition for import relief, the Wall Street Journal states that “the eleven copper producers that filed the complaint cited a $623 million loss last year” (Wall Street Journal (January 27, 1984], p. 45). Another indication of the I'TC's use of accounting numbers is reflected in the public version of its staff reports,‘ which include a section devoted to industry financial performance. An analysis of the income statement through net operating profit (or loss) before taxes for the industry is always presented. The commissioners’ injury opinions, which are included in the ITC staff reports, always include a discussion of the financial performance of the industry. All commissioners and commissioners’ aides that I interviewed agreed that the financial condi. tion of the industry is 4 key factor considered in injury determinations. ‘The use of accounting numbers by the ITC provides an incentive for managers to manage earnings in order to increase the appatent injury to the firm and, thereby, the industry." Staff members at: the ITC indieated that the footwear industry was @ prime candidate for inclusion in this study. Their reasoning was as "In the case of general etcape clause investigations, “a petition for eligibility for impart reli for the purpose of faclitating orderly adjustmont to import competitian may be fled with the Intemational Trade Commission ... by an entity, including trade association, fir, certified or recognized union, or group of workers which is representative of ant industry” (Trade Act of 1974, 19 USC 2251(a)(1). Investigations ean also be instiated by the president, the Special Representative for Trede Negotations, Congeess or the ITC. In the case of antidumping and eountervelling duty invastgations, petitions can be fled by & dornestc producer, of wholesa‘er, union or group of workers, o & trade association (see the ‘Trace Agreements Act of 1979, 24 USC 3083(0)(C-F), "The staff report is peepared by the snvestigntive ataff at the TTC for use by the ‘commissioners in-making injury determinations. The report includes @ wide range of information including 4 ciseassion of the product, domestic producers, foreign producees, level of imports, and all the economie factor speifed in the trade statutes tae considered in injury doterminstions euch as production, capacity ullizaton, financial performance, product prices, and other eacses af injary. ‘Tve public version of the staff report alsa Includes the final opinioas ofthe commissioners " Ineerviaws were concicted in December 1956 with Commissioners Seeley G. Lodwice and Alfied B. Bake and staf aides Kenneth Novak (ade to Commissioner Lodwick) and Fan Blur (ade to Coremissioner David E, Rob). ‘Management discussion and analysis sections in annual reports and 10-Ks may also atiect the expected value of the import Feliet For example, the staff report for one investigation late the reasons for the firms’ poor financial performance during the past three years as described is the firms’ annual reports and 10-Ks (Investigation Number TA- ‘201-32 Pabliction no, 905, p.A:44), 198 JENNIFER J. JONES follows, The footwear industry originally petitioned for an import relief investigation in 1984. Later that year, the ITC ruled that the footwear industry was not being injured. One reason for this finding was the fact that the footwear industry was relatively profitable in the most recent. periods. The petitioners later took their ease to their congressional representatives, The federal trade statutes specify that, in the case of general escape clause investigations, one year must elapse between the ITC's recommendation to the president and commencement of another general escape clause investigation unless there is good cause to forego the required waiting period (Trade Act of 1974, 19 USC 2251(e))."" The Senate Committee on Finance issued a resolution stating that they believed circumstances had changed since the ITC’s recommendation to the president in 1984; therefore, they requested that the ITC institute a second investigation. ITC Chairwoman Stern found in the second inves tigation (1985) that “while the data in the previous investigation showed that producers of the majority of domestic production were experiencing strong profits, our most recent data show otherwise” (United States International Trade Commission, Publication no. 1717, p. 19). The sudden and dramatic drop in profitability of the footwear industry led some staff members at the ITC to wonder if managers of these firms had taken steps deliberately to decrease reported earnings during the secand. investigation period. IT'C staff members do not believe that the footwear industry is the only case in which managers may have deliberately reduced profits during import relief investigations; instead, they helieve that it denicts an obvious case in which deliberate reduction of profits is, a possibility. Managers have greater incentives to make income-decreasing account- ing choices if they believe that the regulators do not. completely adjust for these choices. Neither the public nor the regulators are necossarily thought to be “fooled” hy the accounting numbers reported by domestic producers. Instead, the regulatars may be “captured” or may simply not. regard “undoing” the reported numbers to be cost. effective. On the ‘The waiting period differs if the industry ia granted impart relief by the president 05 4 result of the earlier investigation. A general escape clmisé investigation exncat be Undertaken unless tuo years have elapsed since the last day on which impart relief was provided (Trade Agreement of 1874, (9 USC 22586). ie should be noted that in 1916 ehe ITC (chen called the United Staten Taritt Commission) was established as a nonpartisan information-gathering agency. Mozy of the early advocates of the tariff eommission hati hoped to ‘take the tanff out of politic’ by ‘xtablishing& nampartisan agoney to analyze the impact of various tariff alrctures (els (1976). But as Dobson also notes, his was an impeasibe task fo an issue ae emotional ac foreign wade regulation, Over the past 70 years, Congres has attempted to insulate the TTC from politics by limiting the Vrms of the six commissioners (who are presidential sppointass) to ane nine-year appoistinent, limiting the nomber of commissioners fon ‘ech political party to thre, anc stagporng the terme of the commissioners. The overall ‘ffeetiveness of there rebrctions ic mot central ta this study, but it eppears a though pallies kave aot been completely eliminated fror the ITC. EARNINGS MANAGEMENT DURING INVBSTIGATIONS 199 ‘other hand, voters may realize that they could personally benefit from ‘opposing special interest groups (i.e, domestic producers seeking import relief), but this personal gain might not exceed the costs of information search, lobbying, and forming coalitions. As stated by Peltzman (1976, p. 212}, “producer protection represents the dominance of a small group with a large per capita stake over the large group (consumers) with moze diffused interests.” In summary, while regulators might not adjust the accounting numbers for various reesons, consumers would nat be able to form effective coalitions to oppose this practice because the potential benefit to each consumes is too small, and their interests too diverse, to ake such opposition cost effective Peltzman [1976] also argues that regulators will not exclusively serve tone economic interest (e.g, domestic producers) but will instead help the groups that provide the greatest amount of personal gain to the regulator. Thus, not all domestic industries seeking import relief can be expected to obtain the desired relief. If all domestic producers are granted relief, there may be less incentive for them to increase the apparent injury to the industry."*In a subsequent section, a description of the sample sed in this paper is presented which is consistent with Peltzman’s theory that the regulators (i., the ITC) will not exclusively serve one economic interest (that of domestic producers). 2.8 ITC SOURCES OF FINANCIAL INFORMATION ‘The ITC obtains its financial information from the domestic producers! audited financial statements, 10-Ks, and responses to an ITC question- naire called the Producer's Questionnaire, The financial information collected in the Producer's Questionnaire is similar to that reported in firms’ annual reports, but it is disaggregated by product line and/or establishment."* Appendix B contains a summary of the data requested in the Producer's Questionnaire. A company official is required to affirm that the questionnaire is complete and correct to the best of his/her Knowledge and beliefs. Domestic producers are required under law to provide the requested data and subpoenas can be used to obtain the information if the producers fail to comply. The ITC attempts to obtain information from all domestic producers unless there are a very large number of small producers, in which case the ITC requests information from a subset of the stwall producers. The ITC agareyates the data provided by the producers into industry totals, "Domestic producers may all have incentives to increase tne apparect injury to the {industry in order to provide az “excaea” for the TTC to recommend impart tlie Als, if ‘the incugay granted import relief appears ta be injured, it may reduce tho risk of retaliation 1a foreign governments establishment is defined by the [TC a8 “each f product is produced, including auxiliary fasties ‘ar nat physically separate fram) ‘a sample Producer's Question lity in the United Staves in which rated in conjuction with (whether th production fadliuas” This dafincion was taken from provided by the ITC. 200 JENNIFER 1. JONES ‘The Trade Act of 1979 provides for the verification of information submitied to the ITC by domestic producers. he Act provides that: “ the administering authority shall verify all information relied upon in making a final determination in an investigation. ... If the administering authority is unable to verify the accuracy of the information submitted, it shall use the hest information available to it as the basia for its determination ..." (Trade Act of 1979, section 776 (19 USC 167e)). ‘The following details of the verification process used by the ITC were obtained from interviews with members of the investigative staff of the ITC.© The ITC does not verify any information in the audited financial statements or 10-Ks, nor do they make any adjustments to these data. Verification of the submitted data is restricted to the product line and/ or establishment data provided in the Producer's Questionnaire, Most of the verification process is aimed at determining whether the cost allo- cation methods used were appropriate and consistently applied. The ITC. does not attempt to adjust the financial data for accounting procedures, used or for accrual decisions made by the firms’ managers. 3. Hypothesis Development 2.1 EARNINGS MANAGEMENT HYPOTHESIS ‘The ITC's use of reported earnings in injury determinations provides ‘an incentive for managers to make accounting choices that increase the apparent injury of the firm. By doing so, managers may increase the probahility of obtaining the desired import zelief and/or inerease the amount of relief granted; therefore, the link between accounting numbers and injury determinations may result in managers’ accounting choices, having economic consequences (.., wealth transfers from consumers to domestic producers due to import relief). This incentive leads to the following hypothesis EARNINGS MANAGEMENT HYPOTHESIS: Managers of domestic producers that would benefit from import protection make accounting choices that reduce reported earings during ITC investigation periods ‘8 compared to noninvestigation periods. SLL. Conflicting Incentives. An assumption underlying this hypothesis, is that the import relief incentive to decrease reported earnings is greater than other incentives the managers have to increase reported earnings Prior research in other contexts (see n. 2) indicates that managers face other economic consequences of their accounting choices that motivate ‘them to make income increasing rather than income-decreasing account ing choices—for example, debt covenants and management compensation Interviews were conducted in December 1986 with Richard Lalor, supervicr of the Finaucial Analysis and Accounting Division of che Office af svestigatione, Chand Metta, ‘ccountant, and Dan Deve, investigatsr FARNINGS MANAGEMENT DURING INVESTIGATIONS — 201 plans." By increasing reported earnings, managers can reduce the restric tiveness of the debt covenants and increase their own compensation ‘through higher bonuses. Debtholders would benefit by tolerating managers’ income-deereasing accounting choices during import relief investigations, even if it requires, them to waive or amend covenants that are violated," since the financial performance of the firm can be expected to improve if import relief is granted. Managers would also benefit from ohtaining import relief if the fotare earnings of the firm are higher than without the relief and higher earnings result in higher bonus payments. Thus, during import relief investigations managers have less incentive to increase reported earnings than they would at other times because it is in the best intereste of all contracting parties (except consumers) for the firm to obtain the desired import protection. 3.12, Free-Rider Problem. The fact that all domestic producers within an industry stand to benefit if import relief is granted results in a free- rider problem. As a result, managers of firms within an industey may not have equal incentives to manage earnings during import relief investi- gations. The ITC evalustes the overall resulte of the industry but does not require that all firms be injured in order to recommend import relief; therefore, the managers of some domestie producers may decide that the resulta of their operations will not alter the ITC's ultimate decision and, consequently, they may not manage earnings during import relief inves- tigations, Of caurse, if large number of managers adopted this attitude, then, asa group, they could potentially affect the ITC's ultimate decision. Also, some firms may not decrease reported earnings during import relief investigations because their management compensation and/or debt cov- nant incentives to manage earnings upward override the import reliet incentive In order to address the free-rider problem, a supplemental test of the earnings management hypothesis restricts the sample to firms that petitioned for import relief. The petitioners bear the costs, thouight to be quite substantial in many cases, of supporting their claims of injury before the ITC, Thus, petitioners may have greater incentives than other domestic producers in the industry to maximize the probability of ab- taining import relief and, as a result, petitioners may have greater incentives to manage earnings during import relief investigations, 3.13. Investigation Types. The type of import relief investigation may “*Byidance presented in Healy (1985) indiostes Uhat ransgemont compansation alans donot motivate manegers to rake strictly income increasing woxounting c>oies but instead ‘tho accounting ehoiees depend onthe relation fhe earnings number (before Cres choles) ‘ta any upper of lower limite specified in che plas " Asoo, Incorporated isan example of « dameatic producer that obtained debt covenant amendments when the eavenants were violated during an ITC import relief investigation tf the copper industry (Asaren, Incorporated, £084 Annual Repar’. 202 JENNIFER J, JONES. also affect managers’ incentives to manage earnings during import relief investigations. Antidumping and countervailing duty cases are instituted when there is evidence that. unfair trade practices exist, whereas general escape clause cases are instituted when there is no such evidence. Man- agers may have greater incentives to manage earnings in general escape

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