Market competition, earnings management, and persistence in accounting profitability around the world

Paul Healy,Gwen Yu,George Serafeim,Suraj Srinivasan

doi:10.1007/s11142-014-9277-8

Abstract

We examine how cross-country differences in product, capital, and labor market competition, as well as earnings management affect mean reversion in accounting return on assets. Using a sample of 48,465 unique firms from 49 countries, we find that accounting returns mean revert faster in countries where there is more product and capital market competition, as predicted by economic theory. Country differences in labor market competition and earnings management are also related to mean reversion in accounting returns—but the relation varies with firm performance. Country labor competition increases mean reversion when unexpected returns are positive but slows it when unexpected returns are negative. Accounting returns in countries with higher earnings management mean revert more slowly for profitable firms and more rapidly for loss firms. Thus earnings management incentives to slow or speed up mean reversion in accounting returns are accentuated in countries where there is a high propensity for earnings management. Overall, these findings suggest that country factors explain mean reversion in accounting returns and are therefore relevant for firm valuation.

Highlights

This paper tests whether mean reversion in corporate profitability varies systematically across countries
We document that country-level factors such as product, labor, and capital market competition and earnings management are associated with the rate of mean reversion of corporate accounting returns and are relevant inputs to forecasts of firms’ future performance
Columns (1) and (2) show that the interactive coefficients on the country competition variables are negative and significant, implying that increased product and capital market competition increase the rate of mean reversion

Summary

Introduction

This paper tests whether mean reversion in corporate profitability varies systematically across countries. Our analysis uses firm-year-level data to examine how country measures of product and factor market competition and earnings management affect mean reversion in ROA. We document that country-level factors such as product, labor, and capital market competition and earnings management are associated with the rate of mean reversion of corporate accounting returns and are relevant inputs to forecasts of firms’ future performance. Managers of firms with losses and abnormally low returns face capital market pressures to use their reporting judgment to demonstrate a turnaround in their firm’s performance, accelerating mean reversion These earnings management effects are expected to be stronger for firms that operate in countries with higher earnings management propensity. (4) The interaction term directly tests our main prediction that mean reversion of accounting profits varies systematically with country variables representing product and factor market competition and earnings management (CVAR). The highest univariate correlation between any of the competition variables is for capital and labor market (0.432), and the lowest correlation is for product and capital market competition (0.350)

Results

Additional Tests

Conclusion