Defying Gravity: Costly Signaling to Mislead or to Inform?

49 Pages Posted: 6 Nov 2013 Last revised: 12 May 2014

See all articles by Messod D. Beneish

Messod D. Beneish

Indiana University - Kelley School of Business - Department of Accounting

Vedran Capkun

HEC Paris - Accounting and Management Control Department

Martin S. Fridson

Lehmann, Livian, Fridson Advisors LLC

Date Written: January 23, 2013

Abstract

While it is generally maintained that earnings management can occur to inform as well as to mislead, evidence that earnings management informs has been scarce, and evidence that credibility increases with signal costliness inexistent. We provide evidence that firms use discretion over financial reporting and real activities to report higher earnings on lower sales from continuing operations. Although these firms defy gravity artificially, we show that the upwards earnings management informs rather than misleads investors. We find that firms that defy gravity (1) report higher future earnings and cash flows, (2) earn higher one-year-ahead abnormal returns, (3) have a positive market reaction to the defying gravity earnings announcement, and (4) their CEOs are more likely to be net buyers in the year preceding the defying gravity event. We also show that the upwards earnings management signal is more credible when it is more costly to achieve: Defying gravity firms perform better when they bear the opportunity loss of not taking a big bath in times of crisis — years where poorer performance can be blamed on economy-wide shocks, and when they have fewer degrees of freedom to report higher earnings.

Keywords: Earnings Management, Signaling, Informativeness, Opportunism, Credibility

JEL Classification: G14, G17, M4

Suggested Citation

Beneish, Messod Daniel and Capkun, Vedran and Fridson, Martin S., Defying Gravity: Costly Signaling to Mislead or to Inform? (January 23, 2013). HEC Paris Research Paper No. ACC-2013-1024. Available at SSRN: https://ssrn.com/abstract=2349780 or http://dx.doi.org/10.2139/ssrn.2349780

Messod Daniel Beneish (Contact Author)

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States
812-855-2628 (Phone)
812-855-4985 (Fax)

Vedran Capkun

HEC Paris - Accounting and Management Control Department ( email )

Jouy-en-Josas Cedex
France

Martin S. Fridson

Lehmann, Livian, Fridson Advisors LLC ( email )

136 E 57th Street
Suite 501
New York, NY 10022
United States

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