Do Firms Manage Earnings to Mitigate Stock Undervaluation? Evidence from Firms’ Use of Accounting Discretion after Experiencing Mutual Fund Fire Sales

• In Event: Earnings Quality, Earnings Management, and Accruals

Abstract

This paper examines whether firms manage their reported earnings upwards in an attempt to correct stock undervaluation. Both accruals management and real activities manipulation are used to proxy for earnings management. Using mutual fund fire sales as an exogenous and negative shock to stock prices, I find that firms use both accruals and real activities managements to increase their earnings. In addition, consistent with prior research’s finding, I show that firms shift from accruals management to real activities management after the passage of the Sarbanes-Oxley Act (SOX). Furthermore, firms’ abnormal return in one-year after experiencing fire sales is positively related to several earnings management metrics, suggesting that firms’ earnings management helps stock price recovery. Finally, additional test reveals that earnings management activities concentrate in the fourth fiscal quarter.

Author

• Yun Ke, University of British Columbia