The Evolution of Earnings Management and Firm Valuation: A Cross-Country Analysis

Abstract

We investigate the determinants of earnings management and its implications for firm value for more than 24,000 firms in 43 countries for the 1990-2003 period. We find that firm characteristics explain at least as much of the variation in earnings management as country characteristics, and that firm characteristics become relatively more important at the turn of the 20th century. Investment opportunities, dependence on external finance, ownership dispersion, cash holdings, and greater visibility and access to global financial markets tend to decrease earnings management, as firms adopt more rigorous standards when they can benefit the most from them. We find a link between earnings management and firm valuation: a move from the 75th to the 25th percentile of earnings management is associated with an increase in Tobin's Q of 16%. The negative relation between earnings management and firm valuation is found to be particularly strong at the turn of the 20th century and for firms with strong investment opportunities and need of external finance.

Keywords: Earnings management, investment opportunities, financial markets, firm valuation

JEL Classification: G34, G38, F36