Faced with decreasing government payments and subsidies and intense market competition, hospitals had to resort to other cost cutting measures to increase their earnings to expand operations, or merely avoid financial insolvency. Given the argument that hospital managers are evaluated in part on their ability to a non-financial objective (e.g., quality of care) subject to a zero-profit constraint, hospital managers who want to avoid a loss are willing to cut costs when revenues decrease and to limit the cost increases when revenues increase. To do so, they often use an accounting technique, earnings management, which enables managers to improve their ability to cope with uncertainties in revenue and competition.
Earnings management occurs when hospital financial executives use judgment in financial accounting and in structuring transactions to alter financial reports to meet external benchmarks or to assure that they will have working capital on their accounting statements temporarily. It is regarded as inappropriate when a misallocation of economic resources arises from managerial opportunism or when non-compliance with accounting regulations is camouflaged.
This paper uses the financial statements of all hospitals that filed Medicare Cost Reports between 1997 and 2010 to examine the strategic financial reporting choice in the hospital industry. It attempts to answer the question: "Is earnings management commonplace or relatively infrequent among U.S. hospitals?" Overall, hospitals in most states, especially during the recent financial crisis in 2008 and 2009, adopted a negative discretionary accruals strategy that is to book a negative accrual to bring down the net income when actual earnings are above target in the hope of being able to reverse the accrual in a subsequent year when actual earnings are below target.
der1 [at] columbia [dot] edu