Product market competition and earnings management: A firm‐level analysis

In this paper, we employ a firm‐level measure of product market competition constructed from the textual analysis of firms’ 10‐K filings to examine the relationship between managers’ perceived competition pressure and earnings management. We find that accounting irregularities and accrual‐based earnings management are positively related to product market competition. This finding is consistent with the notion that competition pressure increases managerial incentives to manage earnings, due to their career concerns. We also find that real earnings management is negatively related to product market competition. This finding suggests that real earnings management involves actions that decrease firms’ competitiveness and thus is costly for firms confronted with high competition pressure.     

Earnings quality and the heterogeneous relation between earnings and stock returns

We adopt a heterogeneous regime switching method to examine the informativeness of accounting earnings for stock returns. We identify two distinct time-series regimes in terms of the relation between earnings and returns. In the low volatility regime (typical of bull markets), earnings are moderately informative for stock returns. But in high volatility market conditions (typical of financial crisis), earnings are strongly related to returns. Our evidence suggests that earnings are more informative to investors when uncertainty and risk is high which is consistent with the idea that during market downturns investors rely more on fundamental information about the firm. Next, we identify groups of firms that follow similar regime dynamics. We find that the importance of accounting earnings for returns in each of the market regimes varies across firms: certain firms spend more time in a regime where their earnings are highly relevant to returns, and other firms spend more time in a regime where earnings are moderately relevant to returns. We also show that firms with poorer accrual quality have a greater probability of belonging to the high volatility regime.     

An analysis of earnings management by European private firms

This paper addresses the questions of whether private firms in eight European countries engage in earnings management, and if so, whether tax incentives affect such practices. To measure earnings management, we analyze the earnings distributions of private firms and compare these distributions with those of public firms in the same countries. The empirical evidence suggests that in absence of capital market pressures, firms still have incentives to manage earnings, as we find that private firms avoid reporting small losses. We further find that private firms in some countries where tax regulation strongly influences financial accounting do not avoid reporting small losses. We attribute this finding to tax incentives reducing firms’ benefits of (upward) earnings management. Finally, our results suggest that some types of earnings management are due to capital market pressures and are specific to public firms since we do not find evidence that private firms avoid earnings decreases.     

Cross‐Firm Real Earnings Management

Our analysis is rooted in the notion that stockholders can learn about the fundamental value of any firm from observing the earnings reports of its rivals. We argue that such intraindustry information transfers, which have been broadly documented in the empirical literature, may motivate managers to alter stockholders’ beliefs about the value of their firm not only by manipulating their own earnings report but also by influencing the earnings reports of rival firms. Managers obviously do not have access to the accounting system of peer firms, but they can nevertheless influence the earnings reports of rival firms by distorting real transactions that relate to the product market competition. We demonstrate such managerial behavior, which we refer to as cross‐firm real earnings management, and explore its potential consequences and interrelation with the practice of accounting‐based earnings management within an industry setting with imperfect (nonproprietary) accounting information.     

Information content of credit ratings in pricing of future earnings

This paper examines whether credit ratings convey information about the firm’s future earnings to the capital markets. Using the future earnings response coefficient methodology, we find that the current stock returns of rated firms reflect more future earnings than do the stock returns of non-rated firms. We also find that the market reflect more future earnings in current returns for higher-rated firms. In addition, we present evidence that returns impound future earnings to a greater extent after a ratings initiation or upgrade. We empirically eliminate the possibility that our findings are driven by earnings smoothing, market liquidity or omitted default risk factors associated with ratings. Our results are robust to controlling for potential omitted variables, endogeneity bias, loss versus profit firms, and serial correlation of error terms. Overall, the evidence suggests that credit ratings help disseminate private information to reduce information uncertainty about the firm’s future profitability among market participants.     

Earnings management in the pre-IPO process: Biases and predictors

We analyze a sample of 3,293 IPOs from 29 countries to investigate the firm, industry, and country characteristics related to earnings management during the IPO process. We find that IPO firms tend to have significantly positive discretionary accruals (DCA) both prior to and after the IPO, suggesting that IPO firms tend to engage in pre-IPO earnings management. However, we also find that using a proxy for earnings management in the IPO year may lead to biased conclusions concerning pre-IPO earnings management. Firms that are more likely to need access to capital markets in the future (firms with high leverage, and firms backed by a venture capitalist) are less likely to engage in pre-IPO earnings management. Firms operating in countries with a superior rule of law are also less likely to engage in earnings management. Lastly, we find that firms may engage in pre-IPO earnings management in part to avoid returning to the capital markets to raise more funds (capital market staging). This result is robust to possible endogeneity bias stemming from management self-selection.     

Product market competition and earnings management: Evidence from discretionary accruals and real activity manipulation

We examine the association between product market competition and earnings management activities. We use the Herfindahl-Hirschman Index (HHI), a widely used measure for market concentration, as a proxy for product market competition. We examine two forms of earnings management: accrual-based and real activity-based. Our results are mixed, but generally suggest that both income-increasing accrual manipulation and real activity-based manipulation are more prevalent among firms in low competition industries than those in high competition industries. Our findings are robust to various measures of earnings management, alternative measures of product market competitions, and different subsamples. We further explore the reasons why firms in low competition industries are more inclined to manage earnings and find that the market consequences of missing important earnings targets are more severe among firms in low competition industries than those in high competition industries.     

Accounting-based downside risk,cost of capital,and the macroeconomy

We hypothesize that earnings downside risk, capturing the expectation for future downward operating performance, contains distinct information about firm risk and varies with cost of capital in the cross section of firms. Consistent with the validity of the earnings downside risk measure, we find that, relative to low earnings downside risk firms, high earnings downside risk firms experience more negative operating performance over the subsequent period, are more sensitive to downward macroeconomic states, and are more strongly linked to earnings attributes and other risk-related measures from prior research. In line with our prediction, we also find that earnings downside risk explains variation in firms’ cost of capital, and that this link between earnings downside risk and cost of capital is incremental to several earnings attributes, accounting and risk factor betas, return downside risk, default risk, earnings volatility, and firm fundamentals. Overall, this study contributes to accounting research by demonstrating the key valuation and risk assessment roles of earnings downside risk derived from firms’ financial statements, also shedding new light on the link between accounting and the macroeconomy.     

The relationship between returns and unexpected earnings: A global analysis by accounting regimes

Numerous studies have documented a long-term association between earnings and returns. Surprisingly, few attempts have been made to internationally examine market reactions to earnings releases over return windows less than 12 months. This paper globally explores the market reaction to unexpected earnings defined by both the change in earnings per share (EPS) and analyst forecast errors (AFE) using a 1-month return window. First, the existence of the earnings-returns relationship is examined using a sample of firms from 32 countries grouped into accounting regimes. Accounting regimes represent groups of countries that exhibit similarities in accounting standards, stock market characteristics, corporate governance mechanisms, and economic conditions. Thus, similar reactions to earnings are expected within regimes. Next, the incremental information content of analyst forecasts, a proxy for investors’ earnings expectations, is examined. Finally, changes in the structure of the earnings-returns relationship over time are investigated. Results support the existence of a relationship between earnings and returns in all accounting regimes. In addition, analyst forecast errors appear to be incorporated into earnings expectations in most developed countries. Finally, evidence suggests that the significance and explanatory power in the earnings-returns relationship has increased in recent years.     

The effect of accounting firm mergers on international markets for accounting services

The purpose of this paper is to examine the effect of the accounting firm mergers on competition in the market for accounting services. This paper investigates accounting firm concentration both before and after the accounting firm mergers in ten countries. Large firms were found to dominate the market before the mergers and this dominance was extended further following the mergers, particularly in the European market. When the performance of large and small firms was compared, large firms were found to be significantly superior both before and after the merger in some European countries, possibly indicating reduced competition. Performance of large and small firms did not significantly differ in several other countries, suggesting that high levels of concentration do not necessarily mean low levels of competition.     

Labor protection,information disclosure and analyst forecasts: Evidence from China’s Labor Contract Law

Labor protection increases employees’ stability and strengthens their monitoring role, improving firms’ information environment and increasing analysts’ earnings forecast accuracy. Using the implementation of China’s Labor Contract Law as a quasi-natural experiment, we find that labor protection significantly improves analyst forecasts. This positive impact is stronger when agency problems are weaker, board independence is greater, corporate reputation is better and industry competition is more intense. Enhanced labor protection significantly reduces firms’ business risk and accrual-based earnings management, decreases stock price synchronicity and increases market pricing efficiency. Our findings of significant impacts of China’s Labor Contract Law on analysts’ forecasting behaviors offer important guidance for promoting the development of the Chinese capital market and policy making in labor protection.     

Transparency,Liquidity, and Valuation: International Evidence on When Transparency Matters Most

We examine the relation between firm‐level transparency, stock market liquidity, and valuation across countries, focusing on whether the relation varies with a firm's characteristics and economic environment. We document lower transaction costs and greater liquidity (as measured by lower bid‐ask spreads and fewer zero‐return days) for firms with greater transparency (as measured by less evidence of earnings management, better accounting standards, higher quality auditors, more analyst following, and more accurate analyst forecasts). The relation between transparency and liquidity is more pronounced in periods of high volatility, when investor protection, disclosure requirements, and media penetration are poor, and when ownership is more concentrated, suggesting that firm‐level transparency matters more when overall investor uncertainty is greater. Increased liquidity is associated with lower implied cost of capital and with higher valuation as measured by Tobin's Q. Finally, a mediation analysis suggests that liquidity is a significant channel through which transparency affects firm valuation and equity cost of capital.     

Earnings Quality Based on Corporate Investment Decisions

In this paper, I examine a new approach for measuring earnings quality, defined as the closeness of reported earnings to “permanent earnings,” based on firm decisions with regard to capital and labor investments. Specifically, I measure earnings quality as the contemporaneous association between changes in the levels of capital and labor investment and the change in reported earnings. This approach follows the reasoning that (1) firms make investment decisions based on the net present value (NPV) of investment projects and (2) reported earnings with higher quality should more closely associate with real investment decisions. I find that measures of earnings quality based on managerial labor and capital decisions correlate positively with earnings persistence and have incremental explanatory power relative to earnings‐quality measures used in the accounting literature. Furthermore, investment‐based earnings‐quality measures are less informative when managers tend to overinvest.     

Real Options, Product Market Competition, and Asset Returns

We study how competition in the product market affects the link between firms' real investment decisions and their asset return dynamics. In our model, assets in place and growth options have different sensitivities to market wide uncertainty. The strategic behavior of market participants influences the relative importance of these components of firm value. We show that the relationship between the degree of competition and assets' expected rates of return varies with product market demand. When demand is low, firms in more competitive industries earn higher returns, whereas when demand is high firms in more concentrated industries earn higher returns.     

The effect of trade secrets protection on disclosure of forward-looking financial information

Using the recognition of the Inevitable Disclosure Doctrine (IDD) by US state courts as an exogenous shock to the risk of losing trade secrets, this study examines the effects of trade secrets on disclosure of forward-looking financial information. We find that management earnings forecast frequency and forecast horizon increases after the US state where a firm is headquartered starts to recognize IDD. We also find that the effect of IDD recognition on management forecasts is more pronounced for firms that have larger market shares, higher product market competition, more intensive R&D, shorter distance to their industry rivals, and more employees who possess knowledge of the firms’ trade secrets.     

Product market power and management’s action to avoid earnings disappointment

We investigate the empirical relationship between a firm’s product market power and its management’s action to use real-activity-based earnings management techniques to avoid earnings disappointment by meeting or beating earnings targets such as analysts’ earnings forecasts, positive earnings, or higher earnings relative to previous years. While there is a general consensus that product market competition in an industry affects management’s operating and financial decisions, and thus is an important intervening factor in a firm’s strategies for many economic situations (Nickell in J Political Econ 104:724–746, 1996; Porter in The competitive advantage of nations. Macmillan, London, 1990), the linkage between product market power, managerial incentives, and financial reporting quality has so far received little academic attention. Our analyses show that while the firms manage both accruals and real activities in varying degrees, the firms having greater product market power with the ability to differentiate their products to earn additional revenue, if necessary, are less inclined to engage in real-activity-based earnings management in certain suspect economic situations compared to the firms with less market power. We, however, do not find any significant relationship between product market power and accrual-based earnings management.     

Product market power,industry structure,and corporate earnings management

This is the first study to establish a link between product market power of firms and the degree of earnings management. We hypothesize and document a significant and robust association between (a) a firm’s product market pricing power and its degree of earnings management, and (b) industry competitiveness and the degree of earnings management in the industry. Our study reveals that firms with inferior product market pricing power engage in greater discretionary earnings accruals, adding a new dimension to our understanding of the transparency and informativeness of firms’ financial statements. These findings are mirrored at the industry level where we document that more competitive industries are associated with greater earnings manipulation. The empirical evidence has direct implication on the informativeness and earnings quality of firms based on their product market power and competitiveness.     

Corporate managerial ability,earnings smoothing,and acquisitions

This paper examines whether high-ability managers’ earnings smoothing is motivated by the need to mitigate the adverse effects of heightened information asymmetry triggered by mergers and acquisitions (M&As) on managers’ reputation capital (job loss) and firm value. We document that acquirers led by high-ability managers engage in more pre-acquisition earnings smoothing and experience more significant announcement abnormal returns and operating performance in post-M&A periods than their low-ability counterparts. This result is consistent with the theory of managerial response to asymmetric information, amplified by M&As, where high-ability managers use earnings smoothing as a signaling device to ensure that the market quickly discovers their superior abilities, to increase acquirers’ future growth prospects and avoid the adverse effects of information asymmetry on managers’ job security and career prospects in a competitive executive labor market.     

Do firms that wish to be acquired manage their earnings? Evidence from major European countries

In this paper, we examine whether findings on downward accrual-based earnings management for firms publicly ‘seeking a buyer’ from the US can be extrapolated outside of the US context, given that past research has indicated that the function of the Merger and Acquisition (M&A) markets is highly dependent on the degree of competition in a country. We test for the existence of earnings management (EM) around such events for firms listed in the largest European stock exchanges between 2000 and 2009, and get evidence that downward earnings management around ‘seeking buyer’ announcements more strongly holds for the country with the most competitive market for corporate control in our sample, that is the UK. We consider this finding indicative of the fact that a competitive M&A environment may induce earnings management-prone behavior. We further testify significantly positive abnormal returns around ‘seeking buyer’ announcements for firms from the UK, but limited such evidence for the other countries, a finding we also attribute to differences in competition and uneven split of benefits among bidders and targets in M&A markets. Finally, we find that EM positively affects abnormal returns around ‘seeking buyer’ announcements, indicating that market participants tend to compensate for upward EM, regardless of the degree of competition of the M&A market of a country.     

Stock market listing status and real earnings management

This study analyzes real earnings management among privately held versus publicly listed firms. Our first finding is that public firms engage in more earnings management through operating activities. When a clear incentive to manage earnings in a specific direction is present we continue to find that public firms manage their earnings more than private firms. We reason that capital market pressure and ownership characteristics drive our results. Additional analyses reveal that public firms employ more real earnings management as a proportion of the total earnings management strategy. Furthermore, we find that mitigating factors of real earnings management have stronger impact in public firms. This study contributes to literature on non-accrual earnings management and to the broader understanding about the private vis-à-vis public firm reporting and operating behavior. Finally, we contribute by identifying an important societal cost of stock market listing, which is the increase in potentially value-destroying real earnings management.