Ex ante expectations and ex post assessment of the nature and extent of earnings management in the MBE setting

Ex ante expectations and ex post assessment of the nature and extent of earnings management in the MBE setting

There are two main objectives of this research. First, this research investigates whether the relationship between the extent of earnings management and the abnormal return of firms that meet or beat earnings expectations (MBE) is moderated by the nature of the earnings management (opportunistic or informative). Second, this research investigates whether a belief revision process exists regarding the pricing of discretionary accruals. Specifically, this research examines whether the abnormal return is a function of the markets’ ex ante expectation of the extent of earnings management at the earnings announcement date, and ex post assessment of the extent assessment of earnings management during the financial statement analysis period.
In relation to the first objective, the results reveal that the extent of earnings management has a negative (positive) relationship with the abnormal return when earnings management is likely opportunistic (informative). The discount (reward) to meeting or beating expectations is more significant when earnings management is more clearly opportunistic (informative). In addition, the market is shown to penalize firms more for the use of opportunistic earnings management than it rewards firms for the use of informative earnings management.
In relation to the second objective, the results reveal that the abnormal return is a function of the prior quarter discretionary accruals at the earnings announcement date and the current quarter discretionary accruals during the financial statement analysis period. Taken together, these results support a belief revision process occurring from the earnings announcement date to the financial statement analysis period as equity valuations change from being a function of prior quarter discretionary accruals to current quarter discretionary accruals. This is consistent with past literature that suggests that investors require time to
price earnings management into the abnormal return (Balsam, Bartov & Marquardt 2002; DeFond & Park 2001; Gavious 2007).
This research makes several contributions to the literature. Unlike past studies, this research does not assume that all firms that meet or beat expectations by one cent employ an opportunistic earnings management strategy. Rather, this research contributes to literature by testing whether the market differentiates between opportunistic and informative earnings management when awarding an abnormal return to firms that MBE.
A second contribution is in relation to the research design. This is the first known study to use an interaction variable to capture the non-linear relationship between the nature and extent of earnings management and the abnormal return. Utilizing a variable for the nature of earnings management, and examining the non-linear relationship between the nature and extent of earnings management contributes to the literature by offering a more robust test of the market pricing mechanism of earnings management.
A third contribution is the introduction of gross margin into the MBE setting. Anecdotal evidence clearly indicates that gross margin is a key metric; however, academic literature has yet to corroborate this assertion. These results suggest that gross margin is a key metric that is relied upon by the market when determining an abnormal return for firms that MBE. The fourth contribution, which is of significance to practice, is the introduction of a composite model that provides insight into whether a firm’s earnings management is likely to be opportunistic or informative. This model has potential applications for investors as a tool to make investment decisions and avoid inefficient allocations of capital. The fifth contribution is the insight regarding the timing by which discretionary accruals are reflected in equity valuations. The impact of the extent of earnings management is shown to be revised from the earnings announcement date to the financial statement analysis period.