The context of earnings management and its ability to predict future stock returns

Abstract

This paper constructs a signal-based composite index, namely ESCORE, which captures the context of earnings management. Specifically, ESCORE aggregates 15 individual signals related to both accrual and real earnings management based on prior relevant literature. After establishing that ESCORE is capable of capturing the context in which earnings management is more likely to occur, the study finds that low ESCORE firms outperform those with high ESCORE by an average of 1.37% per month after controlling for risk loadings on the market, size, book-to-market and momentum factors up to one year after portfolio formation in the UK. This finding implies that investors tend to ignore the observable context of earnings management. In addition, with ESCORE model, investors do not need to estimate the magnitude of earnings management, rather it is sufficient to look at the surrounding context to differentiate between low and high earnings management firms. Finally, when tested using the US data, most of the main results of the study appear to hold.

Earnings quality and firm valuation: evidence from several European countries

“…As Dechow et al (2010, p. 344) mention, scholars have used numerous proxies such as “ persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness and external indicators such as restatements and SEC enforcement releases. ” These attributes of EQ have been rigorously studied with regard to the consequences of governance at micro and macro level (namely, as corporate governance and country-level governance) (Agnes Cheng et al , 2007; Chiang et al , 2017; Gaio and Raposo, 2014; Harymawan and Nowland, 2016; Jiang et al , 2008; Islam et al , 2022; Lobanova et al , 2019; Machuga and Teitel, 2009; Rezaee and Safarzadeh, 2023; Salehi et al , 2018; Salehi et al , 2020; Seifzadeh et al , 2021; Thesing and Velte, 2021), International Financial Reporting Standards (IFRS) adoption (Ho et al , 2015; Houqe et al , 2012, 2016; Ismail et al , 2013; Kabir et al , 2010; Krishnan and Zhang, 2019; Liu and Sun, 2015; Sun et al , 2011), audit quality (Chen et al , 2018; Huang et al , 2016; Lambert et al , 2017; Lennox et al , 2016), organizational outcome (Charitou et al , 2011; Elsiddig Ahmed, 2020; Elzahaby, 2021; Fonou-Dombeu et al , 2022; Francis et al , 2008; Gaio and Raposo, 2011; Ma and Ma, 2017; Mensah and Onumah, 2023; Moardi et al , 2020; Nguyen et al , 2022; Saleh et al , 2020), and CSR (Bozzolan et al , 2015; Brahem et al , 2022; Choi et al , 2013; Dang and Pham, 2022; Jacobsen, 2013; Kim et al , 2012; Mohmed et al , 2019; Muttakin et al , 2015; Rezaee et al , 2020).…”