Industry valuation driven earnings management

This paper investigates whether industry valuation impacts firms’ earnings management decisions. Existing accounting literature assumes that industry valuation has a constant impact on this decision. We argue that a higher industry valuation increases the perceived benefits of earnings management at a time when the negative consequences associated with accrual reversal and the probability of detection are believed to be lower. Using a sample of quarterly data of U.S. firms from 1985 to 2005, we find that the four-quarter lagged industry valuation has a positive relationship with industry aggregate (current) discretionary accruals. More specific, one standard deviation increase in the aggregate industry valuation is associated with a significant increase of 2.4 cents in quarterly earnings per share. Our results are robust after controlling for several factors, including bubble years, size, leverage and performance.