Does Investor Sentiment Affect Earnings Management?

Abstract

I hypothesize and find that earnings management via accruals is driven partially by the prevailing market‐wide investor sentiment. Managers inflate earnings in periods of higher sentiment, but report more conservatively during periods of low sentiment. Moreover, the likelihood of income‐increasing earnings management to avoid negative earnings surprises is also positively associated with investor sentiment. These results are robust to: (i) controls for time‐varying firm characteristics such as growth, investment opportunity sets, future profitability, leverage and size; (ii) macroeconomic variables such as future inflation, GDP growth, and growth in industrial production; (iii) multiple proxies for investor sentiment; and (iv) discretionary revenues as alternative measure of earnings management. Cross‐sectional analyses reveal that firms whose stock returns co‐move more with investor sentiment are more (less) likely to manage earnings upward via abnormal accruals in quarters of higher (lower) sentiment. The findings of managers’ strategic use of abnormal accruals show the need for increased attention from boards of directors, auditors and regulators to heightened managerial incentives to overstate earnings and to report optimistic earnings numbers during periods of high investor sentiment.

The CDS market reaction to restatement announcements

“…Kaplanski and Levy (), Stambaugh, Yu, and Yuan (), and Mian and Sankaraguruswamy (), among others, find evidence consistent with these predictions in the stock market. Prior studies also examine the impact of such sentiment on accounting practices, such as management forecast disclosures (Bergman & Roychowdhury, ), pro forma earnings disclosures (Brown, Christensen, Elliott, & Mergenthaler, ), and earnings management (Simpson, ). I extend the literature by investigating the impact of market sentiment on the credit market's response to restatements.…”

“…Highly distressed firms are more sensitive to firm-specific news and tend to behave differently from other more healthy firms (Avramov, Chordia, Justova, & Phillipov, 2009, 2013. To test whether my results are attributed to a subset of highly distressed firms, I compare CDS returns of speculative-rated versus investment-grade firms surrounding restatement announcements.…”

Investor Sentiment and Earnings Management: Does Analysts’ Monitoring Matter?

“…(Brown & Cliff, 2004). As a consequence, optimism in the capital market encourages, in addition to investors' decision-making, the action of managers, such as: dividend payment (Baker & Wurgler, 2004), investment (Polk & Sapienza, 2009), changes in capital structure (Baker & Wurgler, 2002), and earnings management (Ali & Gurun, 2009;Simpson, 2013).…”

“…This study focuses on the decisions deriving from discretionary practices when reporting accounting earnings. Evidence indicates that managers are more conservative after pessimistic periods and less conservative after optimistic sentiment periods, which implies the use of earnings management in optimistic moments (Simpson, 2013).…”

Estimating accruals models in Europe: industry-based approaches versus a data-driven approach

“…Our data show that, if a researcher wishes to investigate the Italian capital market, which is the smallest in our study but one of the largest in the EU, they will estimate AAs for only 43% of the potentially available observations using the 2SICy approach. In response, either an industry classification wider than the two-digit SIC code is used to estimate the accruals models cross-sectionally (e.g., Athanasakou et al, 2009;Gore et al, 2007;Lapointe-Antunes, Cormier, Magnan, & Gay-Angers, 2006;Lehmann, 2016;Sáenz González & García-meca, 2014;Saleh & Ahmed, 2005;Simpson, 2013;Van Tendeloo & Vanstraelen, 2008) or alternative techniques are employed to identify AAs (e.g., Capalbo, Frino, Mollica, & Palumbo, 2014;DeFond & Park, 2001;Francis & Wang, 2008;Ittonen, Johnstone, & Myllymäki, 2015;Jansen, Ramnath, & Yohn, 2012;Zerni, Haapamäki, Järvinen, & Niemi, 2012).…”