Overvaluation and its Effect on Management's Choice of Alternative Earnings Management Mechanisms

Abstract:     
In this study I test and extend several conjectures in Jensen's (2005) agency theory of overvalued equity. Specifically, I provide evidence on how varying degrees of overvalued equity affect managers' choice of alternative methods of managing earnings. I find compelling evidence that managers of firms that are more highly overvalued not only exhibit greater evidence of prior exploitation of within-GAAP earnings management relative to less overvalued firms, but also are more likely to be restricted in their ability to engage in further within-GAAP earnings management. Moreover, I find that highly overvalued firms are more likely to engage in more egregious forms of non-GAAP earnings management relative to less overvalued firms. Furthermore, I find that the choices management makes reflect an interaction between the relative degree of overvaluation and the relative costs of alternative earnings management mechanisms. The findings in this study provide evidence that overvaluation motivates managers to engage in a wide variety of earnings management choices in an effort to sustain their firms overvalued stock price.

Keywords: earnings management, restatements, overvaluation

JEL Classifications: M41, M43, G12, G14

Working Paper Series