Economic Policy Uncertainty and Earnings Management: Does Institutional Governance Matter

Abstract

This study examines the relationship between economic policy uncertainty, earnings management, and the interacting role of institutional governance using a sample of 27,598 firms from 22 countries over 2014-2021. We found that as economic policy becomes more uncertain, companies are more likely to engage in accrual-based earning management and reduce real earnings management. This suggests that managers use an accruals approach to smooth earnings or meet specific financial targets during uncertain economic times as accruals-based earnings management can be managed easily according to the financial year. More importantly, we find stronger institutional governance can mitigate the effect of economic policy uncertainty on accruals-based earnings management but not real earnings management, but when we control for the complementary effects between accruals-based earnings management and real earnings management, the past economic policy uncertainty effect, as well as the lagged accruals-based earnings management and real earnings management effects, the institutional governance interaction terms become significant for most cases. We also find the positive effect of economic policy uncertainty is stronger for accruals-based earnings management in developed markets while the negative effect of economic policy uncertainty on real earnings management remains prominence in emerging markets.

Keywords: Economic policy uncertainty, Accrual-based earning management, Real earnings management, Institutional governance