Market Competition and Earnings Management

Abstract

We show that product market competition reduces agency problems by curtailing misleading earnings management and improving earnings informativeness. Using the Herfindahl-Hirschman Index from the Census of Manufacturers to proxy for product market competition, we find that firms in more competitive industries are less likely to engage in earnings management as measured by the absolute value of discretionary accruals and they are more likely to engage in earnings smoothing improving earnings informativeness about future cash flows. Earnings smoothing ratios are higher in competitive markets and the positive relation between current discretionary accruals and future changes in operating cash flows is stronger in such markets. Moreover, we find that firms in competitive industries have lower analysts' earnings forecast errors and lower dispersion of earnings forecasts, suggesting lower information asymmetry between managers and the market. Stock-price informativeness is also higher in more competitive markets. Furthermore, forced earnings restatements and security fraud lawsuits are less common in such markets. When firms engage in misleading upward earnings management, in a competitive market they are more harshly punished by the stock market when the market learns about the misleading management. We find that firms engaging in such management experience worse long-term stock performance in competitive markets. In addition, the negative market reaction to the announcements of forced earnings restatements is stronger in competitive markets. Overall, our findings suggest that product market competition is an effective mechanism improving the accuracy of financial reporting and reducing the information asymmetry between managers and the market. Moreover, product market competition achieves more accurate reporting without incurring substantial costs often associated with government regulations of financial reporting or corporate governance.