Earnings Management and Stock Market Reaction

Introduction

The main objective of this chapter is to analyze whether earnings management practices developed by managers are fully detected or not by market participants, relying on stock market reaction.

To understand the relevance of studying earnings management researchers may begin by recalling some extreme events where companies allegedly developed actions with the main purpose of misleading investors, Desai (2005), Zang (2012) and Agrawal & Cooper (2015). This is the case of a number of corporate financial scandals occurring over the first decade of the 21st century. Such corporate scandals uncover a hidden reality in a number of publicly held firms which misreported earnings to capital markets and they had a widespread negative and long-lasting impact on the real economy and on the financial sector. For example, in 2000 Xerox revealed that it had overstated profits by $1.4 billion over a 4-year period. Diverse rules used to report earnings to capital markets and to fiscal authorities allowed Enron to engage in transactions designed to report financial accounting benefits immediately, while the corresponding income tax benefits would only occur into the future, Desai (2005).

What is puzzling in those scandals is how it was possible for the companies to get into such a dramatic situation despite the obligation to disclose financial information under the scrutiny of audit firms, financial analysts, international rating agencies and regulatory institutions. From the above evidence, sometimes reported earnings may not reflect the true performance of the firm, therefore to study the quality of earnings is fundamental. Leuz et al. (2003) argue that managers have incentives to misrepresent firm performance through earnings management due to the conflict of interest between insiders and outsiders.

The methodology used to develop this study is essentially based on a literature review. In more general terms, the problematic of earnings management can be analysed within theoretical frameworks such as the agency theory and the stakeholder theory. Stakeholder theory tends to be more extensive than the agency theory by viewing cash flows of a firm as a pie divided among stakeholders, as dividends to shareholders, taxes to governments, and bonuses to managers and perhaps employees, Ball et al. (2000). Both discretionary accounting choices and deliberate managerial strategies can be used to exploit information asymmetries and differences in stakeholder power, Roberts & Mahoney (2004). Such earnings management practices may be explained for example by managers’ incentives to engage in income-increasing earnings because of the links between their reputation and reported earnings.

In prior literature the fundamental role of earnings relies on their use both for contracting purposes or to make investment decisions, Schipper & Vincent (2003). In the case of the contracting perspective, compensation contracts and debt agreements are usually based on accounting earnings. In the case of investment decisions, earnings are the basis for predicting future cash-flows and for risk assessment. In line with the above arguments, Francis et al. (2004) refer that earnings are a premier source of firm-specific information and that investors rely on earnings more than any other summary measure of performance, such as dividends, cash flows and EBITDA.

Once earnings are important, sometimes managers may have incentives to exercise discretion when preparing financial statements. In the case of the formal contracting perspective incentives result, for example, when managers pursue some target numbers that are specified in formal contracts, Healy & Wahlen (1999). Concerning the decision making perspective, which relates to implicit contracts between the firm and stakeholders, managers may be motivated to overstate or understate earnings relative to the normal level of discretion anticipated by stakeholders.