Stock Return Dynamics under Earnings Management

Xiaotong Wang and Heng-Fu Zou ()
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Xiaotong Wang: Penn State University

No 331, CEMA Working Papers from China Economics and Management Academy, Central University of Finance and Economics

Abstract: This paper explores how earnings management influences asset returns and return volatility via real economic activity. In the model, firms smooth earnings via the costly and economically suboptimal intertemporal transfer of assets and liabilities. As a result, the firm's stock return follows a process that conforms to an EGARCH-like statistical model. The key idea is that real earnings management generates an unobservable cost, and the market has to infer the underlying wealth of the firm from the smoothed reported earn-ings series. This framework may help explain why asset returns underreact to good news and overreact to bad news, while no news is always good news to the market. Empirical evidence that earnings innovations impact future return volatility, in line with the model's predictions, is found in the data.

Pages: 36 pages
Date: 2008-03-23
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Persistent link: https://EconPapers.repec.org/RePEc:cuf:wpaper:331

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