The Effect of Income-Increasing Earnings Management on Analysts' Stock Recommendations in Overvalued Firms

• In Event: SESSION 3D: Financial Analysts and Forecasts

Abstract

As a consequence of financial analysts’ joint role as information intermediaries and firm monitors, we investigate how analysts’ stock recommendations are affected by opportunistic earnings management in overvalued firms. We find strong evidence of a negative association between analysts’ stock recommendations and opportunistic corporate earnings management in overvalued firms. However, we only find partial support for our hypothesis that the negative association is more pronounced as the cost of the earnings management mechanism used to manage earnings increases. Further, we find evidence of a negative association between analysts’ stock recommendations and opportunistic earnings management as the length of consecutive years of firm overvaluation increases.

The main implications of our findings are that analysts consider earnings management and use fundamental valuation models when forming their stock recommendations in overvalued firms. In addition, our results provide evidence that analysts’ stock recommendations are consistent with strategies based on residual income models for overvalued firms.

Authors

• Jomo Sankara, Illinois State University

• Terrance R Skantz, University of Texas-Arlington