This is the first study to establish a link between product market power of firms and the degree of earnings management. We hypothesize and document a significant and robust association between (a) a firm's product market pricing power and its degree of earnings management, and (b) industry competitiveness and the degree of earnings management in the industry. Our study reveals that firms with inferior product market pricing power engage in greater discretionary earnings accruals, adding a new dimension to our understanding of the transparency and quality of firms' financial statements. These findings are mirrored at the industry level where we document that more competitive industries are associated with greater earnings manipulation. The empirical evidence has direct implication on the informativeness and earnings quality of firms based on their product market power and competitiveness.
JEL classification: G30; L11; M4; M41Keywords: Product market power; industry structure and competition; earnings management; discretionary accruals management.
Purpose
The purpose of this paper is to add an important new dimension to the earnings management literature by establishing a link between idiosyncratic risk and the degree of accrual management.
Design/methodology/approach
Based on a comprehensive sample of 44,599 firm-year observations during the period spanning 1987-2009, the study offers robust empirical evidence of the importance of firm-specific idiosyncratic volatility as a determinant of earnings manipulation. The authors use standard measures of earnings management and idiosyncratic volatility. The authors test the hypotheses with robust econometrics techniques.
Findings
The authors document a strong positive relationship between idiosyncratic risk and accruals management. Further, the authors find a positive association between residual volatility and discretionary accruals whether accruals are income inflationary or income deflationary. The findings are robust to alternate idiosyncratic risk proxies and variables associated with earnings management.
Originality/value
Overall, the knowledge derived from this study provides additional tools to assess the degree of earnings management by firms, and hence the quality of the financial reporting. Thus the findings will enable standard setters, financial market regulators, analysts, and investors to make more informed legislative, regulatory, resource allocation, and investment decisions.
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