Investor reaction to earnings management

Abstract

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.

Citation

Kwag, S.(A). and Stephens, A.A. (2010), "Investor reaction to earnings management", Managerial Finance, Vol. 36 No. 1, pp. 44-56. https://doi.org/10.1108/03074351011006838