Investor reaction to earnings management
Purpose – The purpose of this paper is to investigate whether earnings management that surpasses a threshold is associated with market mispricing. Design/methodology/approach – The paper examines the level of discretionary current accruals (DCA) as a proxy for earnings quality. Operationally the threshold of earnings management is defined as the mean DCA, and it is assumed that highly managed firms (both income-decreasing and income-increasing) produce low-quality earnings information. It is postulated that such management may lead to mispricing errors by investors who make incorrect adjustments for lower earnings quality. Findings – The evidence suggests that investors possess idiosyncratic perceptions toward earnings management. Investors of income-decreasing firms tend to under-adjust for analyst optimism, while investors of income-increasing firms are inclined to over-adjust for analyst optimism. In addition, investors of both types of highly managed firms appear to under-adjust for earnings management. These investor characteristics result in a post-earnings announcement upward drift of cumulative abnormal returns (CARs) for income-decreasing firms and a downward drift for income-increasing firms. Practical implications – The findings strongly indicate that there is a significant mispricing at the earnings announcement date for the income-decreasing (P1) and income-increasing (P5) portfolios and the mispricing persists in the short run. Thus, it may be possible for investors to exploit the mispricing by holding a long position in P1 and a short position in P5. Originality/value – Prior studies concentrate on extreme cases of earnings management that are subject to securities and exchange commission (SEC) enforcement. In contrast to these studies, this paper focuses on the market reaction to earnings management, which may or may not lead to SEC enforcement actions.
Volume (Year): 36 (2010)
Issue (Month): 1 (January)
|Contact details of provider:|| Web page: http://www.emeraldinsight.com|
|Order Information:|| Postal: Emerald Group Publishing, Howard House, Wagon Lane, Bingley, BD16 1WA, UK|
Web: http://emeraldgrouppublishing.com/products/journals/journals.htm?id=mf Email:
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Degeorge, François & Patel, U & Zeckhauser, Richard, 1998.
"Earnings Management to Exceed Thresholds,"
CEPR Discussion Papers
1790, C.E.P.R. Discussion Papers.
- Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
- Beneish, Messod D., 1997. "Detecting GAAP violation: implications for assessing earnings management among firms with extreme financial performance," Journal of Accounting and Public Policy, Elsevier, vol. 16(3), pages 271-309.
- Richardson, Scott A. & Sloan, Richard G. & Soliman, Mark T. & Tuna, Irem, 2005. "Accrual reliability, earnings persistence and stock prices," Journal of Accounting and Economics, Elsevier, vol. 39(3), pages 437-485, September.
- Brown, Lawrence D. & Ngo Higgins, Huong, 2001. "Managing earnings surprises in the US versus 12 other countries," Journal of Accounting and Public Policy, Elsevier, vol. 20(4-5), pages 373-398.
- Dechow, Patricia M., 1994. "Accounting earnings and cash flows as measures of firm performance : The role of accounting accruals," Journal of Accounting and Economics, Elsevier, vol. 18(1), pages 3-42, July.
When requesting a correction, please mention this item's handle: RePEc:eme:mfipps:v:36:y:2010:i:1:p:44-56. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Louise Lister)
If references are entirely missing, you can add them using this form.