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How does competition affect real earnings management to meet or beat targets? Evidence from import tariff reductions

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Abstract

Targets provide incentives for earnings management, and a longstanding question is whether earnings management is undertaken opportunistically or to communicate private information about future firm value. To discriminate between these motivations, I follow analytical research showing that an increase in competition through a large decrease in tariffs disciplines managers and better aligns their interests with those of shareholders. Thus, if earnings management reflects managerial opportunism, then an increase in competition will decrease earnings management; and if it signals future performance expectations, then an increase in competition will increase earnings management. Consistent with earnings management indicating managerial opportunism, I show that an increase in competition decreases real earnings management to avoid reporting negative earnings or a negative change in earnings. In addition, by showing that the lessening of trade barriers through import tariff reductions reduces the use of real earnings management to meet or beat earnings targets, I provide evidence on the role of macroeconomic conditions as a determinant of earnings quality.

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Notes

  1. I use benchmarks, targets, and thresholds interchangeably.

  2. Vorst (2016) also finds that negative future performance consequences of RM are weakened when the firm meets earnings targets.

  3. Balakrishnan and Cohen (2014), Karuna et al. (2015), Lin et al. (2016) and Lee and Liu (2016) are examples of papers that adopt or consider this view.

  4. Results are qualitatively similar using the overproduction model from Roychowdhury (2006).

  5. To clarify, the purpose of the procedure is to decompose observed production costs into the fitted values (representing “normal” production costs) and the residuals (representing “abnormal” production costs). The procedure is not intended to partial out any variables in a Frisch–Waugh sense.

  6. http://faculty.som.yale.edu/peterschott/sub_international.htm.

  7. Including them does not qualitatively change the main results.

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Acknowledgements

This paper is based on my dissertation at Duke University. I am deeply indebted to my dissertation committee–Scott Dyreng, Per Olsson, Bill Mayew, and David Robinson–for their comments, guidance, and support. I thank the Editor, Anne P. Villamil; an anonymous referee; Dirk Black; Sergio Correia; Shane Dikolli; Frank Ecker; Zeqiong Huang; Song Ma; Katherine Schipper; Mani Sethuraman; Thomas Steffen, Rahul Vashishtha; Mohan Venkatachalam; Wei Wei; and seminar participants at Bentley University, North Dakota State University, and Oklahoma State University for questions and comments that have improved the paper. I also thank Peter Schott for providing the trade data used in this paper.

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  1. College of Business, North Dakota State University, 811 2nd Ave N., Fargo, ND, 58108, USA

    Alex Young

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Young, A. How does competition affect real earnings management to meet or beat targets? Evidence from import tariff reductions. Ann Finance 14, 331–342 (2018). https://doi.org/10.1007/s10436-017-0313-0

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