Are Regulators Effective at Unraveling Accounting Manipulation? Evidence from Public Utility Commissions

Prior research proposes that a monopolist with private information inflates its reported costs under rate regulation to extract an informational rent. Using a sample of U.S. electric utilities from 1990–2011, we first confirm an unexpected increase in operating expense during rate review periods, then decompose operating expense into its cash and accrual components, and find the cash component accounts for 89% of this increase. The observed pattern is consistent with some combination of real activities management and utility managers misrepresenting transitory expense shocks as permanent. We then focus on identifying regulators’ effectiveness at unraveling this manipulation and minimizing the rent. We estimate that, on average, regulators allow 17¢ out of every dollar of abnormal cash expense to be recovered in future annual revenue, a statistically significant amount. Next, we study the effects of regulators’ ability (proxied by experience) and motivation (proxied by whether they were elected) to unravel accounting manipulation. We find that whereas inexperienced and politically appointed regulators allow a significant portion of abnormal cash expense to be recovered (41¢ and 24¢ out of every dollar, respectively), experienced and elected regulators do not (although the difference between appointed and elected regulators is not statistically significant). Our findings suggest that regulators differ in their ability to identify manipulation—with experience enhancing this ability—and that, on average, state regulators effectively unravel most of the effect of accounting manipulation. This paper was accepted by Suraj Srinivasan, accounting.