Earnings Co-Movements and Earnings Manipulation in Different Economic States

• In Event: Earnings Management

Abstract

Using a sample of SEC enforcement actions, we show a marked decline in the co-movement
of earnings with market level earnings for firms that clearly manipulated their financial statements. This is consistent with a number of theories that predict firms will be more likely to manipulate financial reports when investors learn less about their earnings from other firms. Using the F-score from Dechow, Ge, Larson, and Sloan (2011) as a proxy for earnings management, we expand our analysis to a more general setting and find co-movements are capable of explaining variation in the probability of earnings management. Furthermore, we find evidence that the probability of manipulation and the importance of earnings co-movements in determining that probability increase as the state of the economy improves. This means earnings management is more prevalent during expansions relative to recessions, which is consistent with the findings from the finance literature that asset correlations are higher on the downside than the upside. The results on earnings co-movements are in addition to returns based measures of co-movements including betas, downside betas, and a measure of sensitivity to market sentiment thus indicating accounting based measures of co-movements have an important relationship with earnings management.

Authors

• Andrew Jackson, University of New South Wales

• Brian Rountree, Rice University