Product Market Competition, Information and Earnings Management

Abstract

We study the effect of product market competition on the incentives to engage in earnings manipulation and we find that they crucially depend on the level of visibility of firm real activity in the marketplace. If investors can perfectly observe real firm output and sales, then CEOs are forced to act in the marketplace in a consistent manner with the earnings they are reporting. We show in a simple model how this is too expensive in more competitive markets and therefore competition should reduce rather than increase earnings manipulation. On the contrary, if investors and analysts cannot observe firm real output in the marketplace we show how manipulating earnings might be particularly rewarding in more competitive markets since the boost in market value of good news is especially important. Using a large panel dataset, we report empirical evidence that systematically and consistently points out to a positive effect of product market competition on the level of earnings management. This has been found with three different proxies of market competition, three alternate specifications of the “Jones” earnings management model, earnings quality measures and with different econometric techniques that alleviate endogeneity concerns including firm fixed effects and controls of firm corporate governance.