Are incentives for earnings management reflected in the ERC: Large sample evidence

In this study, I examine the effect of exposure to earnings management (EM) incentives on the earnings response coefficient (ERC). Drawing from several anecdotes and normative arguments about the implications of managers' incentives for investor perception, I predict and test that exposure to EM incentives is negatively associated with the ERC. I find that ERC is reliably lower for firms with elevated exposure to EM incentives, holding constant the effects of actual EM and other factors that affect the returns–earnings relation. Furthermore, the effect of the incentive exposure on cash flows as well as on total accruals is reliably negative. These results are robust across alternative price– and returns–earnings specifications, and are insensitive to the inclusion of other measures of earnings quality. Additional analysis shows that the effect of such incentives on the ERC is more pronounced at higher levels of institutional stock ownership. However, a certain class of institutional owners – transient institutions – are less sensitive to the implications of such incentives for earnings quality.