Climate change regulation compliance and earnings management

PurposeThis study investigates how firms responded to the compliance costs imposed by the US Nitrogen Oxides Budget Trading Program (NBP), a regulatory initiative aimed at reducing climate-related air pollution. Specifically, it examines whether affected firms used real and/or accrual-based earnings management to offset the adverse effects on financial reporting.Design/methodology/approachUsing a difference-in-differences regression framework, the authors compare manufacturing firms headquartered in 11 NBP-compliant states with those in noncompliant states. The authors test for changes in earnings management behavior using ordinary least squares, Propensity Score Matching and the Generalized Method of Moments (GMM), ensuring robustness across methods.FindingsResults show that the NBP led to significant increases in real earnings management, particularly through inventory overproduction and reductions in discretionary expenditures (Selling, General and Administrative Expenses and Research and Development Expenses). The impact on accrual-based earnings management was limited.Practical implicationsThis study highlights that even well-designed environmental regulations can have unintended financial reporting consequences, as firms seek to preserve short-term profitability. Policymakers should account for such behavioral responses when designing compliance regimes.Originality/valueThis study makes a unique contribution to the literature on climate policy and earnings quality by demonstrating how compliance costs from environmental regulation prompt strategic financial reporting responses. It also contributes to understanding the substitution between real and accrual-based earnings management.