Abstract
We present a model to study the role of earnings management in explaining the properties of asset prices and stock market participation. We demonstrate that limited market participation can arise endogenously in the presence of earnings management. Our model generates novel predictions on how limited participation relates to the composition of investors and the policies of corporate governance and accounting standards. In addition, we show that investors’ uncertainty about the extent of earnings management can cause excess movements in stock prices relative to fluctuations in output. Our model also generates a positive association between the expected market returns and the degree of earnings management, and thus develops a risk-based explanation for the observed pattern documented in Hirshleifer, Hou, and Teoh (2007).
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