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.     

The impact of product market competition on earnings quality

The objective of this paper is to examine the impact of product market competition on earnings quality. Based on a sample from the US manufacturing sector for the period 1996–2005, we find consistent evidence showing a positive relation between product market competition and earnings quality. Additional tests also confirm a positive relation between product market competition and the precision of public and private information held by investors and analysts. We also provide evidence that firms competing in concentrated and heterogeneous industries are associated with a number of earnings attributes and information quality not shared by those competing in concentrated but homogeneous industries. These findings are consistent with the intuition that firms enjoying a monopolistic advantage tend to avoid the attention of their competitors and politicians by creating a more opaque information environment.     

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.     

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.     

Distress Risk,Growth and Earnings Quality

We extend and complement prior work by investigating the earnings quality of firms with different financial health characteristics and growth prospects. By using three alternative measures of default likelihood and two alternative measures of growth options, without being limited to a specific event, we provide a more comprehensive setup for analysing the earnings characteristics of the universe of firms than examining distressed firms with persistent losses, dividend reductions or bankruptcy‐filings. Our dataset consists of 15,049 healthy U.S. firms over the period 1990–2004. Results show that the relation between earnings quality and financial health is not monotonic. Distressed firms have a low level of earnings timeliness for bad news and a high level for good news, and manage earnings toward a positive target more frequently than healthy firms. On the other hand, healthy firms have a high level of earnings timeliness for bad news. Growth aspects play an important role in a firm's ability to manage earnings. In contrast to the findings of prior studies, growth firms have greater earnings timeliness for bad news, whereas value firms manage earnings toward a positive target more frequently than growth firms.     

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.     

Corporate governance and earnings management in the Chinese listed companies: A tunneling perspective

This paper examines the relation between earnings management and corporate governance in China by introducing a tunneling perspective. We document systematic differences in earnings management across the universe of China's listed companies during 1999–2005, and empirically demonstrate that firms with higher corporate governance levels have lower levels of earnings management. We study two China-specific situations, in which the listed firms have strong incentives to manage earnings in order to meet certain return on equity (ROE) thresholds, and earnings management has been shown to be the most conspicuous. We identify tunneling evidence for each. Our empirical findings, although not being able to completely exclude other explanations, strongly suggest that agency conflicts between controlling shareholders and minority investors account for a significant portion of earnings management in China's listed firms.     

Economic Relations Among Earnings Quality Measures

Empirical studies on earnings quality use various measures that capture particular dimensions of earnings quality. This paper provides a theoretical foundation to evaluate and compare several common earnings quality measures: value relevance; persistence; predictability; smoothness; and discretionary accruals. We use a rational expectations framework in which a manager has market price, earnings, and smoothing incentives and can bias earnings reports. Taking the information content of reported earnings as a natural benchmark, we determine how variations of management incentives, operating risk, and accounting noise affect earnings quality and examine whether the different measures point in the same or in the opposite direction. We find that value relevance and persistence are measures that are closely aligned with each other and with our benchmark, followed by predictability and smoothness. Discretionary accruals measures are less aligned because they are based on the level of accruals, which confounds their information content. Our results also support the notion that smoother earnings and higher discretionary accruals are associated with greater earnings quality.     

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.     

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.     

IFRS and U.S. GAAP: Assessing the impact of reporting incentives on firm restatements in foreign and U.S. markets

This study examines the impact of reporting incentives on firm restatements in foreign and U.S. markets. We investigate whether financial reporting, using International Financial Reporting Standards (IFRS) results in quality disclosures, given differences in institutional and market forces. This study examines the quality of financial statements prepared in accordance with IFRS and U.S. GAAP by concentrating on firm restatements as a measure of earnings management. Our results indicate that there is no significant difference in the value of restatements due to differences in accounting standards when the rule of law is high in the international market. Furthermore, firms with better law enforcement and higher traditions of law and order, tend to have smaller restatement amounts or less earnings manipulation. This study contributes to the literature by providing evidence of the quality of financial information prepared under IFRS and its dependency on the institutional factors and market forces of a country.     

Transitory earnings components and the two faces of non‐generally accepted accounting principles earnings

Non‐generally accepted accounting principles (non‐GAAP) earnings reporting has been linked with both informative and strategic incentives. We seek to disentangle these conflicting effects by examining the association between non‐GAAP earnings disclosure and transitory items in GAAP earnings, conditional on managers' reporting incentives. We report evidence of a statistically and economically significant asymmetric relation between disclosure propensity and transitory items in GAAP earnings conditional on both the sign and magnitude of the GAAP earnings surprise. Our findings suggest that non‐GAAP earnings disclosures tend to be driven by a desire for informative (strategic) reporting when GAAP earnings beat (undershoot) market expectations.     

Product Market Competition,Managerial Incentives and Firm Valuation

This paper contributes to the very small empirical literature on the effects of competition on managerial incentive schemes. Based on a theoretical model that incorporates both strategic interaction between firms and a principal agent relationship, we analyse the relationship between product market competition, incentive schemes and firm valuation. The model predicts a nonlinear relationship between the intensity of product market competition and the strength of managerial incentives. We test the implications of our model empirically based on a unique and hand‐collected dataset comprising over 600 observations on 200 Swiss firms over the 2002–2005 period. Our results suggest that, consistent with the implications of our model, the relation between product market competition and managerial intensive schemes is convex indicating that above a certain level of intensity in product market competition, the marginal effect of competition on the strength of the incentive schemes increases in the level of competition. Moreover, competition is associated with lower firm values. These results are robust to accounting for a potential endogeneity of managerial incentives and firm value in a simultaneous equations framework.     

The influence of accounting enforcement on earnings quality of banks: Implications of bank regulation and the global financial crisis

We study the effects of country-level accounting enforcement on earnings quality of banks and whether bank regulation substitutes or complements the effect of accounting enforcement on bank earnings quality. We also examine whether the influence of accounting enforcement on bank earnings quality changed after the global financial crisis. Using a sample of listed banks from 40 countries between 2001 and 2014, and abnormal loan loss provisions (ALLP) as our main proxy for earnings quality, we document a consistent and strong association between accounting enforcement and bank earnings quality. More specifically, an increase in accounting enforcement decreases the level of ALLP and decreases the propensity to manage earnings to avoid losses. Furthermore, we provide empirical evidence that bank regulation complements the effect of accounting enforcement on bank earnings quality. Finally, unlike in the pre-crisis period, we find a positive association between accounting enforcement and income-decreasing ALLP in the post-crisis period, which indicates that stronger accounting enforcement is associated with more conservative earnings and higher loan loss reserves. Overall, our results indicate that accounting enforcement reduces opportunistic earnings management.     

Why Do Canadian Firms Cross‐list? The Flip Side of the Issue

We investigate the relation between managerial incentives and the decision to cross‐list by comparing Canadian firms cross‐listed on US stock exchanges to industry‐ and size‐matched control firms. After controlling for firm and ownership structure characteristics, we find a positive association between substantial holdings of vested options held by CEOs prior to cross‐listing and the decision to cross‐list. Further, firms managed by CEOs with substantial holdings of vested options exhibit positive announcement returns and negative post‐announcement long‐run returns. CEOs of cross‐listed firms seem to take advantage of the aforementioned market behaviour, because they abnormally exercise vested options and sell the proceeds during the year of listing only when their firms underperform during the subsequent year. In addition, there is a positive relation between substantial holdings of vested options and discretionary accruals during the year of listing, consistent with the view that CEOs manage earnings to keep stock prices at high levels. Overall, these results have significant implications for the cross‐listing literature, suggesting an association between cross‐listing and CEO incentives to maximize CEO private benefits.     

Earnings attributes and investor-protection: International evidence

This study explores the effects of investor-protection on reported earnings quality assessed on the basis of four accounting-based earnings attributes (accruals quality, earnings persistence, earnings predictability, and earnings smoothness). We test the hypothesis that favorable values of each earnings attribute (considered individually) occur in countries whose institutional characteristics provide relatively strong investor-protection. The results based on K-means cluster analysis of institutional characteristics are mixed. Earnings smoothness is less prevalent in strong investor-protection countries, as hypothesized. However both accruals quality and earnings predictability are better in countries whose institutional characteristics are relatively weak. No association is found between investor-protection and earnings persistence, except that countries with low ownership concentration appear to have high earnings persistence. The results based on regression analysis are consistent with those based on the cluster analysis. These results imply that conclusions about the impact of institutional characteristics on earnings quality depend on how earnings quality is measured.     

The impact of audit quality on real and accrual earnings management around IPOs

We examine the relation between audit quality and the earnings management activities of IPO firms. The impact of high quality auditors on real earnings management has been researched in a number of settings e.g. SEOs. However, to date, there has been no work on the effect of high quality auditors on real activities-based manipulation around IPOs. We examine UK IPOs between 1998 and 2008 and find evidence that high quality auditors constrain the use of real activities manipulation that occurs via the management of discretionary expenses. We also find evidence, consistent with prior research, that high quality auditors constrain the manipulation of discretionary accruals. Crucially, we find IPO firms audited by high quality auditors undertake sales-based manipulation in order to manage earnings upward at the end of the IPO year. The presence of high quality auditors is not, therefore, sufficient to constrain all forms of earnings management.     

Real earnings management and the properties of analysts' forecasts

Prior literature generally finds analysts are able to identify and process complex financial information. However, research suggests that in certain settings, analysts struggle to fully incorporate into their forecasts all available information. We examine analysts' forecast properties in the face of a specific type of complex financial information: real earnings management (REM). First, we investigate the relation between measures of REM and analysts' forecast properties. We find REM measures are associated with greater forecast error and dispersion in the following year. However, REM measures, by definition, capture abnormal operating results, and thus include both firms engaging in manipulative REM as well as firms experiencing firm-specific economic shocks. Thus, we conduct cross-sectional tests of analysts' forecasts for firms with and without incentives to manipulate earnings. We find that firms with low incentives to engage in earnings management (i.e., firms most likely experiencing firm-specific economic shocks) generate the strongest positive relation between REM measures and the following year's analysts' forecast properties, suggesting analysts more fully incorporate the earnings implications of firms with high incentives (i.e., firms most likely engaging in manipulative REM). Our results are consistent across numerous REM proxies and indicators of earnings management incentives.     

China-US trade dispute investigations and corporate earnings management strategy

This paper studies Chinese firms’ earnings management strategy in response to the trade dispute investigations initiated by the U.S. from 2001 to 2018. This topic is important given the increasingly severe international trade environment and the significant influence of macro economy on financial reporting. We find that firms affected by the U.S.-initiated trade dispute investigations engage in more upward earnings management. Additionally, the result is more pronounced in firms with a more negative market reaction around the announcement of the investigations. Cross-sectional tests provide evidence that the positive relation is stronger among firms whose U.S. operating revenue and management ownership is high, firms in provinces with weak investor protection, and firms that performed well one year after initiation of the investigations. Moreover, investors react positively to the earnings management by the affected firms. Our results are robust to a variety of sensitivity checks. Overall, our findings suggest that companies will manage their earnings upward to mitigate the negative impacts of the U.S.-initiated trade dispute investigations.     

Product Market Competition,Information and Earnings Management

We study theoretically the effect of product market competition on the incentives to engage in earnings manipulation, and we show how manipulating earnings is particularly rewarding in more competitive markets since the boost in market value of reporting good earnings is especially important. Using a panel dataset of about 70,000 observations spanning the period 1989–2011, we document that the competitive environment is an important determinant of Jones type discretionary accruals and it also affects real earnings management. In additional analysis, we find that the effect of competition on earnings manipulation is particularly important for companies that seem to be underperforming their competitors and that the competition‐earnings management linkage is moderated by the degree of information visibility at the industry level.