The Relationship between Product Market Competition and Corporate Earnings Quality

Abstract

This paper empirically analyzes the relationship between product market competition and earnings quality of firms listed on the Korea Exchange from 1999 to 2015. The proxy variable for product market competition is the industrial concentration measured by the Herfindahl -Hirschman index, while industry homogeneity on the other hand is measured using the partial correlation coefficients among firms’ common stock returns within the industry. Earnings quality is estimated using the Dechow, Sloan and Sweeney (1995) model, the Dechow, Kothari and Watts (1998) CFO model, the Kothari, Leone and Wasley (2005) ROA-performance -matched-discretionary-accrual model, and their aggregate measure. The empirical results are as follows. First, product market competition has positive and significant effects on earnings quality, implying that firms from more competitive industries are associated with a higher level of earnings quality. Second, the earnings of firms operating in concentrated and homogeneous industries are associated with a lower level of earnings quality than are those of firms operating in concentrated and heterogeneous industries. This result suggest that firms facing less competition tend to create a more opaque information environment to protect their competitive advantage. These findings imply that product market competition may be recognized as a new mechanism which has a significant effect on earnings quality in the Korean capital market.