Product market competition and earnings management: A firm‐level analysis

• DOI: http://doi.org/10.1111/jbfa.12300
• Author: Li Zhang,Jianfei Sun,Guifeng Shi
• Published date: 01 May 2018
• Date: 01 May 2018

DOI: 10.1111/jbfa.12300

Product market competition and earnings

management: A firm-level analysis

Guifeng Shi1Jianfei Sun2Li Zhang3

1Accounting,Shanghai Jiao Tong University,

Shanghai,China

2Institutefor Social and Economic Research,

NanjingAudit University, Nanjing, Jiangsu, China

3Accountingand Finance, Thompson Rivers

University,Kamloops, British Columbia, Canada

Correspondence

LiZhang, Accounting and Finance, Thompson

RiversUniversity, Kamloops, British Columbia,

Canada.

Email:lizhang@tru.ca

Fundinginformation

TheHumanities and Social Sciences Foun-

dationof the Chinese Ministry of Education

(16YJA630045).

JELClassification: D6, G34, L1, M40, M41

Abstract

In this paper, we employ a firm-level measure of product market

competition constructed from the textual analysis of firms’ 10-K fil-

ings to examine the relationship between managers’ perceived com-

petition pressure and earnings management. We find that account-

ing irregularities and accrual-based earnings management are

positively related to product marketcompetition. This finding is con-

sistent with the notion that competition pressure increases man-

agerial incentives to manage earnings, due to their career concerns.

We also find that real earnings management is negatively related

to product market competition. This finding suggests that real earn-

ings management involves actions that decrease firms’ competitive-

ness and thus is costly for firms confronted with high competition

pressure.

KEYWORDS

accounting irregularities, career concerns, earnings management,

product market competition, real activities manipulation, textual

analysis

1INTRODUCTION

In the economic literature, intense competition can discipline managers to enhance firm value and improve social

efficiency.1Nevertheless,several recent studies find that competition can also induce managers to take excessiverisks

and engage in unethical behavior.In this paper, we employ a firm-levelcompetition measure to examine how managers’

perceived competition pressure affects their incentives to manage earnings.

Competition may have two opposing effects on managerial behavior. On the one hand, it can exert disciplinary

influences over managers and motivate them to make efforts by providing information on their peers’ performance

and/or through increasing the pressure from dismissal, firm liquidation, and takeovers (see Fama, 1980; Giroud &

Mueller, 2011; Grullon & Michaely, 2007; Holmstrom, 1999; Tang, 2017). On the other hand, competition pressure

can induce managers to manipulate financial results in order to mitigate the threats of dismissal, firm liquidation,

1The idea was recognized by Adam Smith in his The Wealthof Nations; he wrote “monopoly …is a great enemy to good management” (Smith, 1776). Similar

ideashave been acknowledged by Hicks (1935) and Caves (1980). In the past few decades, research formalized the idea and investigated the channels through

whichcompetition can affect managerial incentives (e.g. Aghion, Dewatripont, & Rey,1999; Balakrishnan & Cohen, 2013; Hart, 1983; Hermalin, 1992; Nalebuff

&Stiglitz, 1983; Scharfstein, 1988; Schmidt, 1997).

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2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2018;45:604–624.

SHI ET AL.605

and takeovers, or to improve their opportunities and conditions for financing (e.g. Bergstresser & Philippon, 2006;

Dechow,Sloan, & Sweeney, 1996; Markarian & Santalo, 2014; Morellec, Nikolov,& Zucchi, 2013; Teoh, Welch,& Wong,

1998a, b).2As investors value firms based on their ability to generate profits, managers can exertinfluence over mar-

ket valuation by managing earnings. Such behavior makes reported profits falsely reflect the firm's productivity and

can even damage the firm's long-term value. Thus, earnings management can lead to distorted investment decisions

and inefficient resource allocation in an economy.

Inthis paper, we employ a firm-level competition measure introduced in Li, Lundholm, and Minnis (2013), to examine

the relationship between firm competition pressure and earnings management. Existing studies generally use compe-

tition measures that reflect an industry's overall situation and ignore variations within the industry (e.g. Ali, Klasa, &

Yeung, 2014; Balakrishnan & Cohen, 2013; Cheng, Man, & Yi, 2013; Karuna, Subramanyam,& Tian, 2012; Markarian

& Santalo, 2014). Li et al. (2013), construct a firm-level competition measure from the textual analysis of firms’ 10-K

disclosures. This measure can capture managers’ perceivedcompetition pressure, thus allowing variations across firms

within each industry. It does not require an assumption on the classification of industries, and it incorporatescompe-

tition information from various dimensions and sources including foreign firms, private firms, and potential entrants.

This measure has several advantages over the industry-levelmeasures in the analysis of the effects that competition

has on firms’ earnings management. For example, the competition measure reflects managers’ perception, which can

be especially useful for the examination of the managers’ decisions on financial reporting and operations.More impor-

tantly, the employment of a firm-specific measure allows the examination of the relation between competition and

earnings management among comparable firms.3

In this paper, we predict that when firms are facing greater competition pressure, their managers have stronger

incentives to misstate earnings due to their career concerns. Further, we predict that real earnings management

decreases with competition pressure. Although firms can manage real activities to manipulate their reported earn-

ings like discretionary accruals, this real activities manipulation can be rather costly under intense competition pres-

sure. Real earnings management involvesreal operational and investment decisions, which may adversely affect firms’

competitiveness. For example, a firm can cut its advertising and research and development(R&D) expenses to boost

reported earnings temporarily. However, those expenses can be important investments to maintain or to expand the

firm's market share. Cutting those expenses can be destructiveif the firm's products may quickly become obsolete or

be easily substituted by those of its competitors. Therefore, costs of real earnings management increase with product

market competition and firms under great competition pressure maytend to avoid real activities manipulation.

In our empirical analysis, we find a positive relation between product market competition pressure and the like-

lihood of accounting misrepresentation. We observe that competition is positively related to the absolute value of

discretionary accruals. This observation is consistent with our prediction that when a firm is facing greater compe-

tition pressure, its managers have greater incentives to manage earnings. Further, firms under greater competition

pressure are more likely to engage in actions that are identified by the Securities and ExchangeCommission (SEC) to

be material violations of generally accepted accounting principles (GAAP) and are more likely to be sued by share-

holders. This observation indicates that the positive relation between competition and misrepresentation of finan-

cial reports is not completely driven by unintentional mistakes. We also observe a negativerelation between compe-

tition pressure and real activities manipulation. This observation is consistent with the prediction that competition

makes real earnings management so costly that firms under intense competition pressure tend to avoidreal activities

manipulation.

We notice that the positive relation between competition and accounting misrepresentation can also be explained

by the possibility that when firms perform poorly, managers have incentives to manage earnings and at the same

time, emphasize competition as the reason for poor firm performance. This alternative explanation may give rise to

2Inrecent studies, Lin, Officer, and Zhan (2013) and Lee and Liu (2013) use import tariff reductions as a natural experimentand find that earnings management

increaseswith the intensification of competition.

3In the existing empirical literature,earnings management is usually observed by comparing firms within the same industry, such as discretionary accruals

andreal earnings management. However, industry-level competition measures can only capture the relation between competition and earnings management

acrossindustries.