The Bright Side of Earnings Management

Abstract

This paper demonstrates the usefulness of earnings management in correcting stock underpricing. We find that underpricing, measured using mutual fund fire sales or the 2003 trading scandal as a shock, increases the likelihood of firms meeting or marginally beating analyst forecasts. Firms beat earnings targets by cutting R&D as well as making income-increasing reporting choices, but lean towards R&D reduction if reporting manipulation becomes costly. While both types of manipulation accelerate price reversal after fire sales, firms cutting R&D underperform those using accruals in the long-run. These results suggest that reporting discretion can sometimes be desirable to avoid real consequences.

Keywords: Earnings Management, Real Manipulation, Reporting Manipulation, Mutual Funds, Fire Sales, Fire Purchases, Sarbanes-Oxley Act of 2002, Mutual Fund Trading Scandal of 2003

JEL Classification: G01, G11, G23, G34, M41