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.     

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.     

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.     

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.     

Market competition,earnings management,and persistence in accounting profitability around the world

We examine how cross-country differences in product, capital, and labor market competition, as well as earnings management affect mean reversion in accounting return on assets. Using a sample of 48,465 unique firms from 49 countries, we find that accounting returns mean revert faster in countries where there is more product and capital market competition, as predicted by economic theory. Country differences in labor market competition and earnings management are also related to mean reversion in accounting returns—but the relation varies with firm performance. Country labor competition increases mean reversion when unexpected returns are positive but slows it when unexpected returns are negative. Accounting returns in countries with higher earnings management mean revert more slowly for profitable firms and more rapidly for loss firms. Thus earnings management incentives to slow or speed up mean reversion in accounting returns are accentuated in countries where there is a high propensity for earnings management. Overall, these findings suggest that country factors explain mean reversion in accounting returns and are therefore relevant for firm valuation.     

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.     

Overvaluation and earnings management: Does the degree of overvaluation matter?

We examine whether the choice of earnings management strategies employed by managers of overvalued firms depends on the degree of market overvaluation. By distinguishing between substantially overvalued (SOV) and relatively overvalued (ROV) firms, we find that SOV firms significantly inflate earnings using both accruals-based and real earnings management. In contrast, managers of ROV firms do not engage in accruals-based earnings management and their firms’ accounts tend to report higher discretionary expenses. The reported higher discretionary expenses of ROV firms are comparable to the discretionary expenses of firms in the expanding stage of their business life cycle, a pattern consistent with ROV firms increasing discretionary expenses to finance growth and hence justify the high market valuation. Overall, we show that the existing evidence on income-increasing earnings management by overvalued firms is mainly driven by the pressure to sustain the high market valuation of firms that are substantially overvalued.     

External financing and earnings management: Evidence from international data

Corporate financing conditions in the external capital market are significantly affected by information asymmetry, while internal financing is not. Given that earnings information influences market perceptions regarding firms’ quality, firms relying on external financing should have incentives to manage earnings to improve their financing conditions. This study investigates the effect of corporate external financing behavior on earnings management. Using a sample comprising 75,790 observations of 12,874 firms in 43 countries, we find that accrual-based and real earnings management are positively associated with firms’ reliance on external financing. This positive relationship holds especially true for firms that rely on equity rather than debt financing. We argue that reliance on external financing (especially equity financing), which is subject to problems arising from information asymmetry, generates a motive for earnings management.     

Information Uncertainty,Earnings Management,and Long‐run Stock Performance Following Initial Public Offerings

We examine how information uncertainty surrounding IPO (initial public offering) firms influences earnings management and long‐run stock performance. For low‐information‐uncertainty issuers, at‐issue earnings’ management is positively related to subsequent unmanaged earnings and has no relationship to market reaction to earnings announcement and long‐run stock performance following the offering. For high‐information‐uncertainty issuers, however, at‐issue earnings’ management is unrelated to subsequent unmanaged earnings and negatively related to market reaction to earnings announcement and long‐run stock performance following the offer. The evidence suggests that, on average, managers in low‐information‐uncertainty firms tend to engage in earnings’ management for informative purposes, while managers in high‐information‐uncertainty firms engage in earnings’ management for opportunistic purposes.     

Economic growth potential creating a real put and the resulting valuation of the firm

What do innovative new firms in our dynamic economy do to the value of existing firms? Using Schumpeter’s creative destruction idea, we expand the valuation model to incorporate these dynamics. Our model shows that these dynamics should have a greater effect on smaller firms, those in closer to perfect product market competition and those with less financial market following, as they get less market feedback for warning of new competition. This additional consideration in valuation is named the “real put” as it is an optionagainst value. Simply stated, it is an amount subtracted from a firm’s market value of capitalized earnings, plus any growth potential (that might create destructive competition against other producers) to get its net value. Following Schumpeter, new entrepreneurs and larger firms that mimic existing entrepreneurs are the innovators of new products and services. They create the real put against value in their potential competitors. We empirically test this using Morningstar’s “moat” classification of firms. We find firms with “wider moats” meaning greater product market power have much lower delisting rates that indicate smaller puts against value being exercised. While we are not the first in finance to view Schumpeter’s ideas, this is the first paper to consider its direct effect on valuation.