On the quality of financial statements in municipally owned entities: empirical evidence from Benford's Law

This dissertation consists of two essays examining the issue of earnings management in municipally owned entities (MOEs). The research provides empirical evidence on issues of increasing relevance for corporate financial reporting, especially for public sector entities. It does so by using Benford’s Law, a rarely used mathematical model in the accounting literature, to assess data quality and reliability. Each essay addresses mixed results produced by previous research, offering insights for researchers, practitioners, and regulators aiming to comprehend the incentives driving accounting data manipulation in entities controlled by local governments. The first essay examines the impact of local elections on financial reporting quality in entities controlled by local governments using a data science approach. By applying Benford’s Law to financial statements published by Italian municipally owned entities operating in utility industries, the research finds diffuse data anomalies around election seasons. This does not automatically mean that illegal manipulation or fraud was widespread in those periods, but it implies that (i) auditors need to pay particular attention to the quality of accounting data in those crucial periods and specific environments; and that (ii) voters and media have to be critical in assuming municipally owned entities’ indicators of financial performance as proxies of the administrative efficiency of incumbent politicians. This essay extends the sample size, breadth, and depth of prior studies by using an alternative, rarely used mathematical method and corroborates earlier empirical evidence by using a different theoretical reasoning. The second essay aims to examine how proportional appropriation systems affect the quality of financial reporting in entities controlled by local governments. It examines this issue using the setting of Italian municipally owned entities following the implementation of a new accounting regulation that limits the spending power of the participating municipality when the owned entity reports losses. The research applies Benford’s law on net income figures using the Chi-square and Z-tests on the adjusted version of the Mean Absolute Deviation (MAD) criterion to spot any sign of low data quality. The sample, which consists of 2,120 MOEs, covers the years 2010–2019 and is evenly divided into the periods pre- and post-policy introduction. Widespread data anomalies were detected following the introduction of the new regulation for MOEs controlled by local governments. Evidence is stronger for entities owned entirely by municipalities. The results suggest that the extent of data manipulation grows as the municipality’s ownership stake increases, consistent with the hypothesis that a decrease in spending power through the appropriation of financial resources affects earnings management practices in municipally controlled entities. This essay sheds light on government-based accounting policies by documenting empirical evidence of somewhat inefficient responses by those responsible for the preparation of financial statements on behalf of municipally owned entities, and, accordingly, insights are provided to help review these policies so as to forestall even indirectly detrimental repercussions on public services. This essay extends prior research in public-sector earnings management by being the first to test whether MOEs manipulate their earnings as a consequence of participating municipalities’ reduced spending capability. Understanding factors influencing earnings management practices driven by governments, other than political incentives, is still an open issue.