Cross‐Firm Real Earnings Management

• Author: ETI EINHORN,NISAN LANGBERG,TSAHI VERSANO
• Published date: 01 June 2018
• DOI: http://doi.org/10.1111/1475-679X.12188
• Date: 01 June 2018

DOI: 10.1111/1475-679X.12188

Journal of Accounting Research

Vol. 56 No. 3 June 2018

Printed in U.S.A.

Cross-Firm Real Earnings

Management

ETI EINHORN,

∗NISAN LANGBERG,

∗,†AND TSAHI VERSANO

∗

Received 30 December 2015; accepted 13 September 2017

ABSTRACT

Our analysis is rooted in the notion that stockholders can learn about the

fundamental value of any firm from observing the earnings reports of its ri-

vals. We argue that such intraindustry information transfers, which have been

broadly documented in the empirical literature, may motivate managers to

alter stockholders’ beliefs about the value of their firm not only by manipu-

lating their own earnings report but also by influencing the earnings reports

of rival firms. Managers obviously do not have access to the accounting sys-

tem of peer firms, but they can nevertheless influence the earnings reports

of rival firms by distorting real transactions that relate to the product mar-

ket competition. We demonstrate such managerial behavior, which we refer

to as cross-firm real earnings management, and explore its potential con-

sequences and interrelation with the practice of accounting-based earnings

management within an industry setting with imperfect (nonproprietary) ac-

counting information.

∗Tel AvivUniversity; †University of Houston.

Accepted by Haresh Sapra. We appreciate the insightful comments and constructive sug-

gestions of an anonymous referee. We also thank Pingyang Gao, Michael Kopel, Jack Stecher,

Shyam Sunder, Brett Trueman, Alfred Wagenhofer,Amir Ziv, and participants in the 2015 Eu-

ropean Accounting Association annual congress at Glasgow, the 2015 Tel Aviv International

Conference in Accounting, and seminars at the University of Graz and the Hebrew University

of Jerusalem for helpful remarks. This research was supported by the Israel Science Founda-

tion (grant no. 1758/16), by the Coller Foundation (grant no. 061201549), and by the Henry

Crown Institute of Business Research in Israel.

883

Copyright C, University of Chicago on behalf of the Accounting Research Center,2017

884 E.EINHORN,N.LANGBERG,AND T.VERSANO

JEL codes: D82; M41; M43

Keywords: accounting; financial reporting; earnings management; real

earnings management; nonproprietary information; product market com-

petition; managerial myopia

1. Introduction

Our study is rooted in the observation that stockholders can learn about

the fundamental value of any firm from observing the earnings announce-

ments of other firms that operate in the same industry. For instance, favor-

able earnings announcements of a certain firm may allude to a reduction

in the market share of its rivals or may alternatively reflect some industry-

wide shock, such as an increase in the consumer demand or a decrease in

the input prices, which is likely to affect all firms in the industry favorably.

There is ample empirical evidence documenting that stock prices indeed

reflect such intraindustry information transfers (e.g., Foster [1981], Han,

Wild, and Ramesh [1989], Han and Wild [1990], Freeman and Tse [1992],

Lang and Lundholm [1996], Ramnath [2002], Thomas and Zhang [2007],

Kim, Lacina, and Park [2008]). Therefore, managers may influence stock-

holders’ beliefs regarding the value of their firm not only by managing

their own earnings report but also by influencing the earnings reports of

rival firms. Managers obviously do not have access to the accounting sys-

tem of peer firms, but they can nevertheless influence the economic profits

of rival firms, and thereby also their earnings reports, by distorting real

transactions within their product market. So, while the target of earnings

management is conventionally perceived in the literature as the account-

ing report of managers’ own firm (e.g., Dye [1988], Stein [1989], Arya,

Glover, and Sunder [1998], Fischer and Verrecchia [2000], Kirschenheiter

and Melumad [2002], Demski [2004], Fischer and Stocken [2004], Ewert

and Wagenhofer [2005], Guttman, Kadan, and Kandel [2006], Amir, Ein-

horn, and Kama [2014], Heinle and Verrecchia [2016]), we draw attention

to another practice of earnings management, which aims to influence the

reported earnings of other firms.1We refer to this practice as “cross-firm

real earnings management.”

We demonstrate the potential for the practice of cross-firm real earn-

ings management to exist and study its consequences within a Cournot

competition game between two firms that operate in the same product

market and whose stocks are publicly traded in the same capital mar-

ket. For simplicity, we model the two firms in a symmetric way. Managers

in this game are myopic in the sense that, in addition to their inter-

est in the fundamental value of their firm, which will become commonly

known only in the long run, they also care about the firm’s stock price as

1See Ewert and Wagenhofer [2012] for a recent survey of the earnings management litera-

ture.