A Catering Theory of Earnings Management

Abstract:     
We propose that earnings management is driven by the prevailing investor demand for earnings surprises. Managers cater to investors by inflating earnings in periods when investors react optimistically to positive earnings surprises relative to negative earnings surprises and report more conservatively when investors react pessimistically to earnings news. Using aggregate market-level data, we find that the propensity to use income-increasing abnormal accruals is higher (lower) in quarters when proxies for investors' response to positive earnings surprises relative to negative earnings surprises is higher (lower). Further analysis suggests that investor sentiment might at least partly account for the relation between abnormal accruals and investors' earnings optimism.

Number of Pages in PDF File: 58

Keywords: earnings management, sentiment, earnings optimism, aggregate-level earnings, abnormal accruals

JEL Classification: M41, M43, G12

working papers series