Capital Market Efficiency and Managerial Discretion over Accounting Choices: Evidence from the Relation between Stock Liquidity and Accrual-based Earnings Management

Abstract

We reason that stock liquidity, due to its enhancing effect on price efficiency, dampens accrual-based earnings management (AEM) by making it difficult for managers to use AEM to move stock price and by making stock price revealing about the value-destroying consequence of AEM. Consistent with our reasoning, we document three major findings: (a) stock liquidity has a causal dampening effect on AEM; (b) the higher stock liquidity, the weaker the relation between discretionary accruals and mis-valuation and the more informative stock price about future earnings; and (c) the greater the value-destroying consequence of AEM, the stronger the dampening effect of stock liquidity on AEM. Our findings affirm the view that when facing a more efficient stock market managers exert less discretion over accounting choices.