Earnings Management and Corporate Investment Decisions

Abstract

We investigate the relationship between earnings management and the efficiency of corporate investment decisions. Using discretionary accruals to measure intertemporal transfers of earnings, we show that earnings management exhibits a concave relationship with the investment sensitivity to investment opportunities as measured by Tobin's Q. We find that the association is concentrated among high Q firms. The effect is present among well governed firms, suggesting that better governed firms manage accruals strategically. The concave relationship suggests that the marginal impact of earnings management on investment efficiency decreases with the amount of earnings management. Using cases of misreporting, we document that excessive earnings management does not improve investment efficiency. Taken together, these results support the view that a moderate amount of earnings management helps improve corporate investment decisions while an excessive amount undoes the benefit of earnings management.

Keywords: Corporate Investment Decisions, Earnings Management