Abstract
This paper constructs a signal-based composite index, namely ESCORE, which captures the context of earnings management. Specifically, ESCORE aggregates 15 individual signals related to both accrual and real earnings management based on prior relevant literature. After establishing that ESCORE is capable of capturing the context in which earnings management is more likely to occur, the study finds that low ESCORE firms outperform those with high ESCORE by an average of 1.37% per month after controlling for risk loadings on the market, size, book-to-market and momentum factors up to one year after portfolio formation in the UK. This finding implies that investors tend to ignore the observable context of earnings management. In addition, with ESCORE model, investors do not need to estimate the magnitude of earnings management, rather it is sufficient to look at the surrounding context to differentiate between low and high earnings management firms. Finally, when tested using the US data, most of the main results of the study appear to hold.
Highlights
Prior literature shows that stock markets overprice total and/or discretionary accrual component of earnings
We find that firms which are required to restate their annual accounts by the Financial Reporting Review Panel (FRRP ) have higher ESCORE in the year to which the restatement is related
This study demonstrates that an index, named as ESCORE which accumulates 15 individual financial-statement-based signals, can capture the context of earnings management and reliably predict future stock returns
Summary
Prior literature shows that stock markets overprice total and/or discretionary accrual component of earnings (see, for example, Sloan 1996; Teoh et al 1998a, b; Xie 2001; Desai et al 2004; Iqbal et al 2009; Iqbal and Strong 2010; Wu et al 2010; Simlai 2021). Accruals, especially the discretionary component over which managers have the discretion to manipulate, are widely used as a proxy for earnings management. The mispricing of accruals could be attributable to investors failing to fully reflect on the ‘true’ earnings that a manager knows but does not truthfully reveal to the market. The market might not observe the actual earnings manipulation, but they could sense the existence of such manipulation if the general context surrounding the firm is susceptible. Since it is hard for managers to conceal the general context surrounding their firms, if investors are still ‘fooled’ by earnings management, they must have underreacted to the information contained in the context. This paper develops an empirical proxy for the context of earnings management and empirically tests the hypothesis that markets underreact to that context
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