Firms’ Real Earnings Management and Subsequent Stock Price Crash Risk

Abstract

Using a large sample of U.S. firms for the period from 1994 to 2009, we find that firms’ prior real earnings management (RM) is positively associated with their stock price crash. These results are robust to firm-fixed effects analysis, different crash likelihood measurements, and suspect-firm analysis. On the other hand, RM does not show any predicting power on positive jumps, which supports the argument that insiders use real activities to hide bad but not good information. We find that the predicting power of RM on crash risks after SOX 2002 is much stronger, with the marginal impact being nearly three times as it is in pre-SOX period. By contrast, and consistent with the finding by Hutton et al. (2009), the marginal impact of accrual-based earnings management on crash risks drops by about half after SOX.