Disclosure Quality and Earnings Management

Abstract

This study examines the relationship between disclosure quality and earnings management. Corporate disclosure and earnings management are both subject to managers' discretion; therefore, managers are likely to consider their interaction when exercising managerial discretion. This study employs a simultaneous equations model to test the hypothesis that disclosure quality and earnings management are negatively related. It uses ratings published by the Association for Investment Management and Research to measure corporate disclosure, and discretionary accruals from the modified Jones model to measure earnings management. Consistent with theoretical predictions, the empirical analysis indicates that there is a statistically significant negative relationship between corporate disclosure and earnings management. Firms that disclose less tend to engage more in earnings management and vice versa. This result holds even after controlling for the effects of potentially confounding variables, and for all three components of corporate disclosure: annual disclosure, quarterly disclosure, and investor relations disclosure. By documenting a consistent negative relationship between corporate disclosure and earnings management, the study provides evidence on how management uses the flexibility afforded it under current minimum disclosure requirements to exercise discretion in reporting earnings. This has implications for the interpretation of and information conveyed by reported accounting earnings. It also provides support for the SEC's approach to attenuating earnings management by requiring more informative corporate disclosure.