Earnings Management and Economic Conditions

Abstract

We examine whether economic conditions are associated with firms' earnings management decisions as well as the strength of incentives to manage earnings. We expect economic conditions affect both the benefits and costs of engaging in earnings management, and thus, potentially explain time-series variation in earnings management. We find incomeincreasing earnings management activities are negatively associated with real GDP growth, especially during periods when economic conditions are worsening (i.e., declining economic growth rates). Our counter-cyclical earnings management results are robust to using multiple measures of earnings management and economic conditions. In addition, we find earnings management incentives related to earnings smoothing, equity financing, market reactions to earnings surprises, and CEO turnover vary with economic conditions in ways that are consistent with how earnings management varies with economic conditions. Overall, firms' earnings management activities vary counter-cyclically with economic growth, as do their internal and external incentives to manage earnings.

Keywords: earnings management, economic conditions, earnings response coefficients, CEO turnover risk, business cycle, equity issuance