Does Stock Liquidity Affect Accrual‐based Earnings Management?

• Author: Kelly Huang,Brent Lao,Gregory McPhee
• Date: 01 March 2017
• DOI: http://doi.org/10.1111/jbfa.12236
• Published date: 01 March 2017

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 44(3) & (4), 417–447, March/April 2017, 0306-686X

doi: 10.1111/jbfa.12236

Does Stock Liquidity Affect Accrual-based

Earnings Management?

Kelly Huang, Brent Lao and Gregory McPhee∗

Abstract: This study investigates the effects of stock liquidity on earnings management. While

prior research finds that liquidity has mixed effects on corporate governance, our baseline

regression results show that an increase in stock liquidity is associated with an increase in

discretionary accruals and revenues. To establish causality, we use two quasi-natural experiments

that exploit exogenous increases in stock liquidity resulting from regulatory changes to

the minimum tick size. The results of our difference-in-differences approach indicate that

stock liquidity increases accrual-based earnings management. Additional analysis suggests that

liquidity affects earnings management by magnifying the effects of takeover pressure and equity

compensation.

Keywords: stock liquidity, earnings management, corporate governance, managerial myopia

1. INTRODUCTION

Prior research provides mixed evidence of how stock liquidity, a market microstructure

characteristic, affects managers’ focus on short-term performance. While greater stock

liquidity can discourage managers from excessively focusing on short-term perfor-

mance by increasing shareholder monitoring and threat of exit, it can also motivate

myopic behavior due to greater hostile takeover pressure and equity compensation

(e.g., Porter, 1992; Edmans, 2009). We investigate these contrasting perspectives with

respect to accrual-based earnings management since accrual manipulation is often

motivated by managers’ incentives to inflate short-term earnings and this manipulation

can lead to misallocated firm resources and reduced firm value (Palmrose et al., 2004;

McNichols and Stubben, 2008).

Stock liquidity, despite being viewed as a desirable policy objective for US equity

markets (Bhide, 1993), can motivate managers to focus on short-term performance

to the detriment of long-term value creation. One way that liquidity can motivate

such behavior is by better concealing large block trades that increase the likelihood

∗All the authors are from Florida International University, Miami, Florida. We are grateful for the helpful

comments and suggestions from an anonymous referee, the Editor (Peter Pope), Vivian Fang, Qiang Kang,

Eric Rapley, workshop participants at Florida International University, and conference participants at the

2015 American Accounting Association annual meeting and 2016 JBFA Capital Markets Conference. (Paper

received August 2015, revised revision accepted December 2016).

Address for correspondence: Kelly Huang, School of Accounting, Florida International University, 11200

SW 8th Street, Miami, FL 33199.

e-mail: huangx@fiu.edu

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of hostile takeovers and compel managers to take actions to prevent temporary stock

undervaluation (Stein, 1988; Kyle and Vila, 1991). Liquidity can also lead to a short-

term performance focus because it is associated with an increased use of equity

compensation (Jayaraman and Milbourn, 2012). While this effect can be characterized

as evidence of optimal contracting, due to greater impounding of private information

for performance measurement purposes (Holmstrom and Tirole, 1993; Jayaraman

and Milbourn, 2012), it can also be viewed as creating incentives for managers to

manipulate short-term earnings in order to increase private trading profits (Murphy,

2003; Cheng and Warfield, 2005).1

Although liquidity can induce an excessive focus on short-term performance, it

is empirically unclear whether this focus will lead to greater accrual-based earnings

management. Liquidity may constrain accrual manipulation by promoting greater

direct and indirect monitoring by blockholders since liquidity increases blockholder

building and threat of exit by reducing investor transaction costs (Admati and Pflei-

derer, 2009; Edmans, 2009; Edmans and Manso, 2011). In addition, increased liquidity

has been associated with behaviors that are consistent with real earnings management,

e.g., lower innovation (Fang et al., 2014). Managers engaging in harder-to-detect

real earnings management may not be sufficiently motivated to concurrently use

riskier accrual-based earnings management since liquidity is associated with greater

monitoring (e.g., Zang, 2012; Chan et al., 2014).

We examine these two contrasting perspectives by drawing on the liquidity and

governance literature, which provides a theoretical basis for characterizing accrual-

based earnings management as a consequence of stock liquidity (Fang et al., 2014).

While the viewpoint of this stream of research differs from that of research that

describes accounting quality as a determinant of stock liquidity (Chung et al., 2009),

the two points of view are not mutually exclusive. The accounting quality and

liquidity research identifies a firm’s information environment as one endogenous

determinant of liquidity (Diamond and Verrecchia, 1991; Charoenwong et al., 2014).

In contrast, the liquidity and governance literature focuses on the average effect of

stock liquidity, which is determined by a combination of endogenous determinants

as well as exogenous determinants such as the risk preferences of noise traders,

the exchange/index where a stock is listed/included, trade execution technology,

and market regulations on tick sizes (e.g., Fang et al., 2009; Edmans et al., 2013).

Consistent with the liquidity and governance literature, our study, through empirical

design, controls for endogenous liquidity and establishes the causal direction between

stock liquidity and accrual-based earnings management by using exogenous liquidity

shocks.

We begin our analysis by estimating ordinary least squares regressions using a

broad sample from the years 1993–2013. Following prior studies (e.g., Fang et al.,

2014; Dechow et al., 1995), we use the relative effective bid-ask spread to measure

stock liquidity and signed discretionary accruals to measure earnings management.

We find that change in stock liquidity is positively associated with change in accrual-

based earnings management. These results are robust to controlling for a compre-

hensive list of time-varying determinants of earnings management and firm fixed

1 Greater liquidity is also likely to exacerbate opportunistic trading by managers since it camouflages

managers’ private trading activities in the same way that liquidity provides greater concealment for hostile

takeover attempts.

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