Real earnings management and stock returns: moderating role of cross-sectional effects

Abstract

PurposeThe study aims at investigating the impact of real earnings management (REM) on the cross-sectional stock return after considering the moderating role of market effect, size effect, value effect and momentum effect.Design/methodology/approachThe study uses weekly and monthly data of 3,085 Bombay Stock Exchange listed stocks spanning over twenty years, from January 2000 to December 2019. REM is measured through metrics developed by Roychowdhury (2006), namely, abnormal levels of operating cash flows, production costs and discretionary expenditure. The study employs univariate and bivariate portfolio-level analysis.FindingsThe findings deduced from the empirical results demonstrate that investors perceive downward REM as an element of risk; hence, they discount the stock prices at a higher rate. On the contrary, results show that investors positively perceive upward REM; hence, they hold the stocks even at a lower rate of return. This anomaly is found to be robust for all kinds of considered moderations.Practical implicationsThe findings have important managerial implications as investors are found to assign different weights to different forms of REM, depending upon the perception regarding the magnitude of risk involved in different forms. Managers can accommodate this information during their short- and long-term corporate planning.Originality/valueFirst, the study is among the earlier attempts to examine the association between REM and stock returns by considering the moderating role of cross-sectional effects. Second, the study considers the direction and endogenous nature of REM while investigating the issue.

Determinants of earnings management: The study of Nigerian nonfinancial companies

“…The result fails to support S. Sayari et al (2013, 51), who found a significantly positive relationship between stock returns and earnings management. The results were all but supportive of the earlier studies that had shown stock returns were negatively significantly related to earnings management (Bansal et al, 2021;Chi & Gupta, 2009). The negative insignificant result is probably indicative of the fact that the stock exchange is unable to reflect earnings management practice (Al Omush et al, 2019, 20).…”

“…M. Bansal, A. Ali and B. Choudhary (2021) investigated the real bearing of earnings management on the cross-sectional stock return of the weekly and monthly data of 3,085 firms of the Bombay Stock Exchange from January 2000-December 2019 and showed that investors discounted the stock price when they perceived low-quality real earnings management.…”

Betting against real earnings management

“…For instance, Kim and Sohn (2013) find that REM negatively affects the cost of equity capital because investors demand a higher risk premium for REM stocks. In the same vein, under the Indian institutional settings, Bansal et al (2021) find that investors perceive REM as an element of risk, hence demanding a higher premium. Khurana et al (2018) document that REM increases the likelihood of stock price crashes because managers keep poor-performing projects through REM for their self-interests.…”

The Effect of Intellectual Capital, Dividend Policy, Tobin's Q, and Inflation on Stock Return with Profitability as Intervening variable on Consumer Goods Companies in Indonesia Stock Exchange

“…In addition, if a company's fundamental performance is solid, then when the company wants to get additional funds from the Right Issue, it can sell its shares at a higher price than the previous IPO. Stock return is a reward from the investment process (Bodie et al, 2010), which consists of two components, namely, (1) return on cash flow from a percentage that measures cash flow in the percentage of related share prices such as purchase price and market price, and (2) Capital Gain, namely transaction profits obtained from the difference between the selling price and the purchase price (Bansal et al, 2021). Stock return is the return that shareholders obtain from the stock investment (Widyakto et al, 2021).…”