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Prospect Theory and Earnings Manipulation: Examination of the Non-Uniform Relationship between Earnings Manipulation and Stock Returns Using Quantile Regression

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Abstract

Using the prospect theory as a research framework, this paper makes contributions by demonstrating that managerial risk preference and stock return may influence a firm’s earnings manipulation behavior. Specifically, this study argues that corporate executives may develop risk-averting (risk-seeking) attitudes because of high and positive (low and negative) stock returns. Under this scenario, managers may decide to actively manage the reported earnings in order to preserve gain (gamble on loss) on stock returns. On the other hand, firm executives may not actively manipulate their reported incomes when experiencing average and close-to-zero stock returns. Using quantile regression method to examine the relation between earnings manipulation and stock returns, this study finds that there is a significantly positive (negative) relation between earnings manipulation and stock returns at the high (low) stock returns quantiles. As predicated, such relation is not significant at the middle range of stock returns. To ensure the findings reported in this study are robust, we conduct several tests. In conclusion, we offer policy implications to regulators.

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  • Leon Li & Nen-Chen Richard Hwang, 2017. "Prospect Theory and Earnings Manipulation: Examination of the Non-Uniform Relationship between Earnings Manipulation and Stock Returns Using Quantile Regression," Working Papers in Economics 17/25, University of Waikato.
    • Handle: RePEc:wai:econwp:17/25
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    More about this item

    Keywords

    prospect theory; quantile regression; earnings manipulation; stock return; discretionary accruals;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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