Real earnings management and idiosyncratic return volatility

Abstract

PurposeHigher real earnings management (REM) reduces financial reporting quality and increases the uncertainty of future cash flows and profitability among investors. This study asserts that REM-induced noise increases idiosyncratic return volatility (IVOL), aims to examine the association between REM and IVOL and further investigates whether information asymmetry, firm life cycle and economic policy uncertainty (EPU) moderate the association between REM and IVOL.Design/methodology/approachThe authors use 94,445 firm-year observations from the US over 1987 to 2019 and test this study’s hypotheses using ordinary least square regressions with robust standard errors clustered by firm. The authors use change analysis, two-stage models and the impact threshold of the confounding variable analysis to address endogeneity.FindingsThe authors find that REM increases IVOL. This positive association is more pronounced for firms with more information asymmetry, for firms in the mature stage of the life cycle, compared with their growth-stage counterparts; and during periods of high EPU.Originality/valueExtant research suggests that accrual manipulation increases IVOL. However, the shift from accrual manipulation to REM and the managerial preference towards REM suggests that it is important to explore the impact of REM on IVOL. Thus, the authors enhance the understanding of the impact of earnings management on IVOL by documenting that REM-induced noise increases IVOL. The authors further extend the limited research on the consequences of REM and report an adverse consequence.