Earnings Management in Not-for-Profit Institutions: Evidence from Hospitals

This paper examines the incentives of CEOs in not-for-profit institutions to engage in earnings management. We predict and find that, with one exception, this different setting induces CEOs to engage in patterns of earnings management that are similar to those of their for-profit counterparts. This is noteworthy given that the structure of compensation and the objectives of not-for-profit organizations differ from for-profit firms. We examine the earnings management patterns of 744 not-for-profit hospitals (3,977 hospital-year observations) over an eight-year period from 1989-1996. The results suggest that similar to for-profit firms hospital CEOs 1) smooth earnings, 2) take a "big bath" with respect to discretionary accruals in the year of a CEO change, and 3) avoid small losses. Further, while not-for-profit CEOs avoid small losses, we find no evidence that CEOs manage earnings to avoid negative earnings changes, which is contrary to findings in the for-profit setting [Burgstahler and Dichev (1997)]. This is consistent with tax-exempt status restrictions implicitly limiting hospitals from reporting sustained patterns of profit growth. Overall, our results suggest that CEOs' reputation concerns, tax-exempt status restrictions, and debt costs drive earnings management decisions. Reputation appears to be a primary concern for CEOs in this industry because turnover is high and the frequency of earnings-based performance incentives is relatively small during the time period of our study.