Overvaluation and Earnings Management

37 Pages Posted: 25 Mar 2008 Last revised: 27 Jul 2010

See all articles by J. Daniel Chi

J. Daniel Chi

University of Nevada, Las Vegas (UNLV) - Department of Finance

Manu Gupta

Virginia Commonwealth University (VCU) - Department of Finance, Insurance & Real Estate

Date Written: April 29, 2009

Abstract

Consistent with Jensen’s (2005) agency-costs-of-overvalued-equity prediction, we find that overvaluation is statistically and economically related to subsequent income-increasing earnings management. This relation is robust to a series of tests that address potential endogeneity concerns, including omitted variable bias and reverse causality. The agency costs of overvalued equity are substantial. Overvaluation-induced income-increasing earnings management is negatively related to future abnormal stock returns and operating performance, and this negative relation becomes more pronounced as prior overvaluation intensifies. Among the most overvalued firms, those with high discretionary accruals underperform those with low discretionary accruals during the following year by 11.88% as measured by the three-factor alphas, and by 12.87 percentage points as measured by industry-adjusted unmanaged EBITDA-to-assets ratio.

Keywords: overvaluation, earnings management, agency costs, overvalued equity, discretionary accruals

JEL Classification: G14, G34, M41, M43

Suggested Citation

Chi, Jianxin Daniel and Gupta, Manu, Overvaluation and Earnings Management (April 29, 2009). Journal of Banking and Finance, Vol. 33, No. 9, pp. 1652-1663, September 2009 , Available at SSRN: https://ssrn.com/abstract=1030359

Jianxin Daniel Chi (Contact Author)

University of Nevada, Las Vegas (UNLV) - Department of Finance ( email )

4505 S. Maryland Parkway
Box 456008
Las Vegas, NV 89154-6008
United States

HOME PAGE: http://www.unlv.edu/people/jianxin-chi

Manu Gupta

Virginia Commonwealth University (VCU) - Department of Finance, Insurance & Real Estate ( email )

Richmond, VA 23284
United States

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