Is Earnings Management Really Rampant? Evidence from a Structural Model

Abstract

We derive a measure of earnings management cost and the associated equilibrium level of earnings management from the cross-sectional properties of earnings and prices. This approach enables us to separate economic shocks from reporting discretion by modeling the economic trade-off faced by management. The trade-off can be easily estimated from a closed-form likelihood function. Overall, the estimates suggest that earnings management is modest, consistent with the conjecture in Ball (2013) that earnings management is not as rampant as what prior research would suggest. Consistent with prior studies, the measure suggests more earnings management during seasoned equity offerings, for smaller and growing firms, as well as in industries with more irregularities.

Keywords: earnings management; structural estimation; financial accounting; reporting; signalling; bias.

JEL Classification: D83; G14; M4