Firm’s perception of economic policy uncertainty and earnings management practices: cross-sectional analysis in US context

PurposeThis study aims to examine the relationship between economic policy uncertainty (EPU) and earnings management practices. Specifically, this study explores how a firm’s perception of economic policy uncertainty (FPU) shapes reporting decisions, including earnings management.Design/methodology/approachBased on a sample of US firms over the period 2001–2020, the authors use a new proxy of EPU at the firm level based on textual analysis of conference call transcripts.FindingsThe results show that firm’s perception of economic policy uncertainty (FPU) is negatively associated with accruals earnings management (AEM), suggesting that under conditions of heightened uncertainty, managers have incentive to improve transparency and reduce discretionary accruals to reassure investors and reduce perceived risk. Moreover, this study finds that firms with high agency costs are even more likely to reduce AEM during periods of elevated policy uncertainty. Under such conditions, managerial discretion is constrained, possibly due to increased monitoring or reputational concerns. Robustness tests also reveal that firms may engage in both accrual-based and real earnings management (REM) simultaneously, and that the observed accrual effects are not mechanically driven by structural operational changes, but rather reflect managerial reporting behavior. Cross-sectional analyses further show that firms with greater external capital dependence, rapid sales growth and higher exposure to uncertainty are more likely to engage in AEM, highlighting the role of firm-specific incentives. Interestingly, the results suggest that local political orientation (e.g. Democratic, Republican or swing states) does not significantly influence the effect of FPU on earnings management. Perceived uncertainty within the firm is more important than external political alignment.Practical implicationsThis study has direct implications for market participants, firms and regulators. Understanding the nuanced relationship between firm policy uncertainty and earnings management can help investors and analysts recognize the propensity for earnings management in uncertain economic environments, especially among firms with significant agency costs and external capital requirements. This study also underscores the importance of robust corporate governance and monitoring mechanisms, particularly in firms with high free cash flow and uncertainty. Implementing stringent oversight can mitigate the propensity for managers to engage in REM, thereby protecting shareholder interests and preserving firm value. Finally, regulators and auditors need to be vigilant about earnings management. Enhanced due diligence, robust auditing standards and transparent disclosure practices are essential to ensure the integrity of financial reporting during periods of uncertainty.Originality/valueThis study focuses on the mechanism of firm-specific perception of policy uncertainty. This firm-level perspective provides a better understanding of how EPU influences corporate earnings management and allows to capture the heterogeneity in perceived uncertainty at the firm level.