Earnings management has become a wide practice for US firms. Healy (1985), Perry and Williams (1994), and DeFond and Jiambalvo (1994) are examples of empirical research suggesting that earnings management is common among firms.
However, most studies in the literature focus on the relation between earnings management and stock returns. Pervious studies also have some analytical models showing that the relation between earnings management and equity liquidity. This relation still lack of empirical work to investigate it. This paper fills this gap by examining the relation between earnings management and equity liquidity.
Investors and managers are very concern about firm’s reported earnings.
Financial news that a firm has raised earnings expectations, this event can immediately send it stock price raise. Therefore, investors can get return from it.
Managers are interested in maintaining growth in earnings because their bonuses are often tied to their firm’s profits. The focus on reported earnings is so intense that is has been suggested that the market fixates on firm’s earnings management.
What is earnings management? According to Healy and Wahlen (1999), they define “earnings management occurs when manages use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers”. The issue of earnings management is more and more important by the recent spate of corporate accounting scandals. Managers have incentive to be aggressive in applying accounting rule so as not to disappoint investors. The Securities and Exchange Commission (2003) cites hundreds of cases where managers have used accounting
accruals to bloat their firm’s profits. For example, Enron, Worldcom and Xerox have inflated reported earnings to create a false impression of high-profile firms.
What are the incentives of managers to manipulate reported earnings?
Shivakumar (1996) and Rangan (1998) indicate that management faces the incentive to manage earnings upwards around a seasoned equity offering to maximize the offer price for its shares of stock. They provide evidence of earnings management around seasoned equity offerings. Leuz et al. (2003) argue that the incentive to misrepresent firm performance through earnings management is a conflict of interest between insiders and outsiders. They report that insiders are like controlling owners or managers that can use their control rights get benefits to themselves and at the expense of other stakeholders. For example, insider can use their discretionary current accruals to create reserves for future periods by understating earnings in years of good performance, in others word, effectively making reported earnings less than the firm’s true economic performance. Insider also can use discretionary current accruals to overstate earnings and conceal loss earnings realizations. So insiders will acquire private control benefits through earnings management. However, insiders also have incentives to hide their private control benefits from earnings management. The reason is that these private control benefits were be found, the outsiders will take disciplinary action against them (Zingales,1994 ; Shleifer and Vishny, 1997).
Liquidity is usually defined as the ability that an asset can be trade quickly with the least cost of searching counterpart and the least price concession. Stoll (2000) indicates that immediate sales are usually made at the bid price, and immediate purchase are usually made at ask price. On the one hand, the spread is the price concession needed for an immediate transaction to liquidity demanders; on the other hand, it is the revenue earned by liquidity suppliers such as market makers or dealers.
Thus, the quoted bid-ask spread is often used as a measure of market liquidity.
According to Akerlof (1970), he has pointed out the adverse effects information asymmetries have on the functioning of markets. Information asymmetry is thought to promote unwillingness to trade and increase the cost of capital as investors price protect against potential losses from trading with better informed market participants (Bhattacharya and Spiegel 1991). Lev (1988) argues that observable measures of market liquidity can be used to identify the perceived level of information asymmetry facing participants in equity markets. Bid-ask spreads are one such measure of equity liquidity that has been used extensively in previous research as a measure of information asymmetry between insiders and outsiders. This paper follows pervious studies, I use bid-ask spreads proxy for equity liquidity.
Richardson (2000) reported that when information asymmetry is high, stakeholders may don’t have the necessary information to penetrate manipulation earnings. Richardson also mentions other possible explanation is that the high level of information asymmetry is evidence of shareholders without sufficient resources, incentives, or access to relevant information to monitor manager’s action. So it may increase the practice of earnings management. Anyway, Richardson provides the evidences which the magnitude of information asymmetry affects the magnitude of earnings management practiced by firm managers.
This paper not only extends previous Richardson empirical work but also hypothesizes that the magnitude of earnings management affects the magnitude of equity liquidity. When the magnitude of earnings management is high, I expect the information asymmetry between insiders and outsiders is high. It was implied low equity liquidity and large spread. On the other hand, as insiders can easy manipulate reported earnings; the high level of information asymmetry must exist in between insiders and outsiders. Another possible explanation is that the outsiders detect manager manipulate reported earnings, they would unwilling to trade this firm’s stock
in equity market. Market will punish the firms which manipulate reported earnings through market mechanism, at the same time, the equity liquidity is low.
The result of this paper is a significant positive relation between earnings managements and liquidity in equity market. In the ordinary least squares (OLS) estimation, the results show that earnings management and equity liquidity exhibit a significantly positive association as predicted by our hypothesis. It shows the earnings management affects the liquidity in equity market. Similar results are obtained if all the other control variables are used as instruments in the three-stage least squares (3SLS) estimation. Our empirical results not only consist with Richardson’s (2000) empirical result but also provide a comprehensive empirical work to discuss the relationship between earnings management and information asymmetry on equity liquidity.
The empirical findings are subject to several limitations. First, earnings management is difficult to measure, especially as it manifests itself in different forms.
I attempt to capture earnings management activities by using the most popular accrual model (Jones Model). Second, some studies report that bonus and board composition are determinants of the earnings management activities. Management may have incentive to manipulate reported earnings to maximize their bonuses over time. Many studies document evidence consistent with the manipulation of reported earnings caused by bonus-maximizing incentives (Healy (1985), Holthausen et al. (1995), and Gaver at al. (1995)). Competition in the outside directors’ labor market, as discussed by Fama and Jensen (1983), suggests that outside directors may have an incentive to monitor earnings management. Consistent with this view, Dechow et al. (1996) and Beasley (1996) provide US evidence that outside board members are effective in constraining earnings frauds. In this paper, our control variables of earnings management ignore these two variables.
Because our database lack of these two variables and they are difficult to measure.
Moreover, the existence of complementarities raises concerns about endogeneity bias. I attempt to address these concerns with two-stage least squares (2SLS) and three-stage least squares (3SLS) estimation. However, I acknowledge that the endogeneity bias may still exist in two-stage least squares (2SLS). Finally, this endogeneity problem has been controlled by using three-stage least squares (3SLS) estimation. The remainder of this paper is organized as follows. Section 2 discusses the relevant literature. Section 3 describes the method used to measure equity liquidity and earnings management. Section 4 describes the data and the research methodology.
Section 5 shows the empirical results. Section 6 concludes the paper.