The Impact of Alternative Forms of Earnings Management on the Returns-Earnings Relation
27 Pages Posted: 2 Feb 1999
Date Written: February 1999
This paper examines the impact of the management of reported earnings on the returns-earnings relationship. Two alternative types of earnings management behavior are modeled: myopic earnings management and income smoothing.
In each setting, the manager of a firm privately observes the realized earnings of the firm and issues earnings reports, which may be biased relative to realized earnings. Under myopic earnings management (MEM), the manager has a short term planning horizon and always biases reported earnings upwards by the maximum amount possible. Under income smoothing (IS), on the other hand, the manager has a longer term planning horizon and thus trades off current gains against possible future gains. In this setting the manager underreports when realized earnings are high and over-reports when realized earnings are low.
The returns-earnings relationships are characterized under the two type of earnings management setting, and are shown to differ both in average slope and shape. The slope of the returns-earnings relationship, or its earnings response coefficient (ERC) under MEM is, on average, lower than if the earnings report was not managed (UR). Under IS, on the other hand, the ERC is higher, on average, than under UR. Further, under MEM the returns-earnings relationship is convex for positive earnings surprises and concave for negative earnings surprises. In contrast, under IS the returns-earnings relationship is concave for positive earnings surprises and convex for negative earnings surprises.
The above characterization of the returns-earnings relationship under IS is consistent with (and provides an alternative explanation for) the S-shape documented in prior empirical studies. However, the returns-earnings relationship characterized under MEM has a lower average slope and a different shape. Thus, the results in this paper highlight the importance of conditioning any specification of the returns-earnings relationship on the type of earnings management in existence. Furthermore, this paper provides explicit non-linear functional forms for the returns-earnings relationship under each type of earnings management.
JEL Classification: M41, M43, D82, G12, G14
Suggested Citation: Suggested Citation