DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY?

CHAPTER 6 FIRMS AND PRODUCTION FIRMS’ GOAL
DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY?
SAMPLE CRITERIA FOR EVALUATING AUDIT FIRMS’ PROPOSALS 1 PAST




The Economic Costs of Earnings Management on Equity Liquidity in the Period of Corporate Financial Reporting Crisis


Do firms earnings management practices affect their equity liquidity?


Huimin Chunga,

Her-Jiun Sheub,

Juo-Lien Wangb*


a Graduate Institute of Finance, National Chiao Tung University, Taiwan

b Department of Management Science, National Chiao Tung University, Taiwan



Do firms earnings management practices affect their equity liquidity?



Abstract: This study sets out to investigate the relationship between earnings management and equity liquidity, positing that as incentives arise for the manipulation of firm performance through earnings management (due, in part, to a conflict of interest between firms’ insiders and outsiders), a higher degree of earnings management may signal greater adverse selection costs. If the manipulation of earnings reveals aggressive accounting practices, liquidity providers may tend to widen the bid-ask spreads so as to protect themselves. The empirical results indicate that companies with a higher degree of earnings management incur lower equity liquidity.

JEL class: G01; G10; G30; M40.

Keywords: Equity Liquidity; Adverse selection costs; Earnings management.


  1. INTRODUCTION

In order to express firm performance more properly, accounting standards permit discretion when applying accounting methods to report financial statements. However, when this discretion is intentionally used to manage a company’s reported results, this is known as ‘earnings management’ (hereafter EM). There are of course various motives behind earnings management; and indeed, there are many circumstances in which managers may conduct aggressive earnings management for their own private benefits. For example, Bergstresser and Philippon (2006) have shown that stock-based compensation induces executives to engage in earnings management by which they may benefit at the expense of shareholders. Leuz et al. (2003) examine the differences in EM from a cross-county perspective, arguing that much of the difference is due to attempts by insiders to conceal the firm actual performance from outsiders, and protect their private benefits.

This paper investigates the effect of EM on equity liquidity, positing that companies with higher levels of EM will incur higher liquidity costs. Aggressive EM indicates a lower quality of corporate accounting information1, which may well lead to an increase in the proportion of informed traders in the firm’s equity, along with a corresponding decline in the willingness of uninformed traders (liquidity traders) to trade in such equities. Furthermore, since evidence shows that managers may conduct aggressive earnings management for their own private benefits, liquidity traders recognize that there are adverse selection costs involved in earnings management, with such costs having been clearly demonstrated by the corporate accounting scandals. Although sophisticated market makers can sense earnings management performed by managers and calculate discretionary accruals based upon reported financial information, they are uncertain about how much private information the insiders have and how much the manipulated earnings is. Since those companies with high earnings management will incur higher asymmetric information costs, thereby increasing the probability of trading against informed traders, the uninformed liquidity providers will incur relatively higher costs; they will therefore offer wider bid-ask spreads, whereupon the information asymmetry gets higher.

In periods of corporate financial reporting crises, managerial agency costs are particularly severe for those firms with high discretionary accruals; as are the information asymmetry costs2. This study aims to investigate the relationship between EM and equity liquidity during the recent financial reporting crisis period and the period after the Sarbanes-Oxley (SOX) Act promulgated. The results suggest that aggressive EM increases information asymmetry and the effects of EM on the equity liquidity may appear to have been more severe after the promulgation of the SOX Act.

  1. DATA SOURCE AND VARIABLE DEFINITION

We identify an initial sample of non-financial firms included in the Russell 3000 index. Firm numbers must be higher than six in any given industry for the cross-sectional estimation of the EM. The necessary related data on COMPUSTAT must be available to estimate the measures of EM and the financial variables. The trading characteristic variables are obtained from CRSP. Similar to Huang and Stoll (1996), we select those stocks with an average price grater than $1.00 and with four or more average daily trades. The two sub-sample periods run from October to December 2001 and October to December 2002, periods corresponding with the Enron crisis period and promulgating the SOX Act. This study obtains the intraday data from the TAQ database and deletes all trades and quotes that are out of time sequence. We also omit irregular quotes following the data screening method in Chung (2006): (i) where either the bid or the ask price is equal to, or less than, zero; (ii) where either the bid or the ask depth is equal to, or less than, zero; and (iii) where either the price or volume is equal to, or less than, zero.

To measure equity liquidity, we first use the variable PSP which is averaged percentage spread for each security from October to December 2001 or from October to December 2002. PSPi is calculated as:

DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY? = mean of DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY? (1)

where ait and bit are the intraday ask and bid prices at time t for security i.

The bid-ask spread is modeled theoretically as arising from three sources, order-processing, asymmetric information, and inventory holding costs due to risk aversion (McInish and Van Ness, 2002). The asymmetric information component compensates the market maker for losses incurred on trades against informed traders. We next investigate the impact of EM on the asymmetric information component of the bid-ask spread. This study uses the method adopted by George et al. (1991) (hereafter GKN approach) since McInish and Van Ness (2002) document that GKN approach strongly supports the hypotheses that asymmetric information component is positively related to risk information. In the work of McInish and Van Ness (2002), they also provide similar evidence for Madhavan et al. (1997) (hereafter MRR approach) asymmetric information components, so we adopt MRR approach as our robust test. For the purpose of brevity, since the results are quite similar to the results of GKN approach, they are not reported here.

We next adopt modified-Jones model (Jones, 1991) to measure abnormal accruals. Dechow et al. (1995) suggest that this model is extremely powerful in detecting sales-based manipulations. The parameters of the following cross-sectional OLS regression model are estimated:

DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY? (2)

where Accrualsi,t refers to the current accruals for firm i in year t, measured as the change in non-cash current assets minus the change in non-debt current liabilities and depreciation expenses; ∆SALES i,t is the change in sales for firm i in year t; and TAi,t-1 is the book value of total assets for firm i from the previous year. The regression equation is deflated by TAi,t-1 in order to reduce heteroskedasticity. The regression coefficient is estimated for each industry. Following Dechow et al. (1995), the non-discretionary accruals (NDA) for each sample firm are estimated as follows3:

DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY? (3)

where DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY? and DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY? are OLS estimates for the regression parameters in Eq. (2) and ∆TR i,t is the change in trade receivables, subtracted to allow for the possibility of credit sales management by the company. The discretionary accrual (DA) is then the remaining portion of the accruals:

DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY? . (4)

Accruals reverse over time, managing earnings upward and downward are hypothesized to be earnings management. Following Leuz et al. (2003), our hypothesis does not rely on the direction of the discretionary accruals, but rather on the magnitude; thus, earnings management (EM) measures are based upon the absolute value of DA.

  1. METHODOLOGY

We investigate the following regression model in order to control for the factors that might be important in determining the spreads (Stoll, 1978; 2000; Van Ness et al., 2002):

DO FIRMS’ EARNINGS MANAGEMENT PRACTICES AFFECT THEIR EQUITY LIQUIDITY? (5)

where PSP is the average of the percentage spread for equity i of the given period; EM is the measure of earnings management; SDRET is the standard deviation of daily stock returns for the sample period; LNTV is the natural log of the average daily trading dollar volume for the sample period; LNCLP represents the natural log of the average closing stock price for the sample period; LNTR is the natural log of the average daily total number of trades for the sample period; LNMV is the natural log of the market value of the firm at the end of the sample period; and DEXCH is the dummy variable which is equal to 1 if the company is listed on the NASDAQ, otherwise 0. To disclose financial information timely, firms have to announce interim financial report and any unscheduled material events or corporate changes deemed of importance to investors during the accounting year. Accordingly, although market makers do not have explicit financial reports of firms and any public information on abnormal discretionary accruals during our sample period, they may use interim financial information to conclude the degree of EM.

When information asymmetry is high, shareholders do not have sufficient resources to monitor managers’ actions; thus, EM might occur. Richardson (2000) shows that the information asymmetric costs (bid-ask spread) could affect EM. Hence, simultaneity may well exist between EM and the liquidity of a firm, we conduct a simultaneous equation model and estimate Eq. (5) by the three stage least squared (3SLS)4, which follows prior studies (Dechow et al., 1996; Richardson, 2000; Lee et al., 2006) and uses firm leverage (LEV), quarterly operating cash flow volatility (CFVAR), firm size (LTA), market-to-book ratio (MB), return on assets (ROA), and revenue growth (GROWTH) as the instrumental variables. Finally, in order to investigate the impact of EM on the adverse selection components of the equity bid-ask spread, we also test the relation between EM and the information asymmetry component by GKN approach.

  1. EMPIRICAL RESULTS

The 3SLS regression results of Eq. (5) are provided in Table 1. The positive relationship between EM and percentage spread (PSP) exists for both pre- and post-SOX Act. The coefficients of DEXCH are significantly positive, indicating a significant difference in the percentage bid-ask spreads between the two market structures, as in Van Ness et al. (2002). The regression results for EM are presented in Panel B. EM is positively related to percentage spread (PSP) at less than the 0.01 level. Table 1 also presents the results of the effects of EM on the GKN approach asymmetric information (IA) component of percentage spread. The coefficient of EM is significantly positive at the 0.05 level, indicating that firms with a high EM will incur higher equity liquidity costs due to the higher degree of asymmetric information that may be perceived by market makers.

<Table 1 is inserted about here>

In general, we find that the spreads amongst those companies with higher EM are wider after controlling for cross sectional differences. The results support our argument that EM provides a signal of aggressive accounting practices with the intention of the managers being to obtain certain private benefits, and the rational response of liquidity providers being to widen the bid-ask spreads so as to afford themselves some measure of price-protection.

To test if the effect of EM on equity liquidity is changed after the implementation of the SOX Act, Table 2 presents the 3SLS regression results for pooling the data of 2001 and 2002. Dummy variable d1 is equal to 1 for the post-SOX period data to control for the potential difference due to the 2002 sample. Two regression models are presented respectively in Table 2. The first model assumes there is no structural change in the control variables; the second one assumes these variables have structural change for the post-SOX period. The results show that for both models the estimated coefficients on the “EM × d1” variable are significantly positive. That provides some evidence that the effect of EM on equity trading costs is higher for the post-SOX period.

<Table 2 is inserted about here>

  1. CONCLUSIONS

This study posits that aggressive EM signals greater managerial agency costs and greater asymmetric information costs; liquidity providers will incur relatively higher costs and will therefore offer higher bid-ask spreads. Our empirical results support this hypothesis, and show a positive simultaneous relationship between EM and equity trading costs. The evidence also indicates that there might be an increase in the adverse selection costs of EM for the post-SOX period.

ACKNOWLEDGEMENT

The authors would like to acknowledge the financial support from the National Science Council of Taiwan.

Table 1 3SLS regression results of the simultaneous equation model a


October-December 2001

October-December 2002

Panel A

PSP

IA

PSP

IA

Intercept

0.010

***

0.007

***

0.007

***

0.006

***

EM

0.024

***

0.009

**

0.076

***

0.017

**

SDRET

0.101

***

0.038

***

0.068

***

0.028

***

LNTV

-0.001

*

-0.001

*

0.001


-0.001

*

LNCLP

-0.002

***

-0.001

***

-0.002

***

-0.001

***

LNTR

-0.003

***

-0.001

***

-0.003

***

-0.001

***

LNMV

0.001

***

0.001

***

0.001

***

0.001

***

DEXCH

0.005

***

-0.001

**

0.005

***

0.001

***

Panel B b









Intercept

-0.002


0.018


0.024

***

0.024

**

PSP

2.203

***



1.849

***



IA



3.575

***



4.279

***

LEV

-0.029

***

-0.033

***

-0.019

***

-0.017

*

CFVAR

0.002

*

0.003

**

0.001


0.001

**

LTA

0.008

***

0.005

***

0.003

***

0.003

**

(Table 1 continued)

MB

0.003

***

0.003

***

0.003

***

0.003

***

ROA(%)

-0.001

***

-0.001

***

-0.001

***

-0.001

***

GROWTH

0.001


-0.002


0.009

**

0.012

**

No. of Obs. 999

921

1,059

1,005

a The dependent variable in the first equation is the average percentage spread (PSP) or the information asymmetry component of percentage spread (IA) for the sample period. The dependent variable in the second equation is the absolute value of the discretionary accruals (EM). *** indicates significance at the 1% level; ** indicates significance at the 5% level; and * indicates significance at the 10% level.

b LEV is the debt to total asset ratio at the end of the sample period; CFVAR represents the standard deviation of quarterly operating cash flows over the 12 quarters before the sample periods and divided by the average quarterly operating cash flows over the period; LTA represents the natural log of total assets at the end of the sample periods; MB is the market to book ratio at the end of the sample periods; ROA is the return on assets for the given year; and GROWTH is the growth rate in net revenue.


Table 2 3SLS regression results of the simultaneous equation model on EM and the percentage spread for the two sub-sample periods a

Variables

Model 1

Model 2

Panel A

Coefficient


t-value

Coefficient


t-value

Intercept

0.008

***

13.49

0.009

***

12.04

EM

0.037

***

5.96

0.027

***

3.56

SDRET

0.085

***

12.26

0.108

***

10.12

LNTV

-0.001


-0.91

-0.001


-1.44

LNCLP

-0.002

***

-14.86

-0.002

***

-10.64

LNTR

-0.003

***

-16.17

-0.003

***

-10.45

LNMV

0.001

***

10.29

0.001

***

7.77

DEXCH

0.005

***

24.08

0.005

***

16.23

EM × d1

0.012

***

4.07

0.029

*

1.80

SDRET × d1




-0.040

***

-2.58

LNTV × d1




0.001


0.81

LNCLP × d1




-0.001


-0.61

LNTR × d1




-0.001


-0.88

LNMV × d1




-0.001


-0.21

DEXCH × d1




0.001


0.08

(Table 2 continued)

Panel B







Intercept

0.009


1.23

0.010


1.34

PSP

2.262

***

6.25

1.962

***

5.06

LEV

-0.026

***

-3.21

-0.025

***

-3.10

CFVAR

0.001


1.45

0.001


1.54

LTA

0.006

***

6.51

0.006

***

6.53

MB

0.003

***

6.17

0.003

***

6.29

ROA(%)

-0.001

***

-8.45

-0.001

***

-8.43

GROWTH

-0.001


-0.04

-0.001


-0.15

PSP × d1

-0.213


-0.57

0.157


0.34

LEV × d1

0.004


0.36

0.002


0.21

CFVAR × d1

0.001


0.04

-0.001


-0.02

LTA × d1

-0.001

**

-2.42

-0.002

**

-2.45

MB × d1

0.001


1.34

0.001


0.83

ROA(%) × d1

0.001

***

4.57

0.001

**

4.28

GROWTH × d1

0.012

*

1.87

0.011

*

1.76

a The dependent variable in the first equation is the average percentage spread (PSP). The dependent variable in the second equation is the proxy of earnings management (EM). The number of observations is 2,058.

REFERENCES

Bergstresser, D., Phillippon, T., 2006. CEO incentives and earnings management. Journal of Financial Economics 80, 511-529.

Chung, H., 2006. Investor protection and the liquidity of cross-listed securities: Evidence from the ADR market. Journal of Banking and Finance 30, 1485-1505.

Cohen, D.A., Dey, A., Lys, T.Z., 2008. Real and accrual-based earnings management in the pre- and post-Sarbanes Oxley periods. The Accounting Review 83, 757-787.

Dechow, P., Dichev, I., 2002. The quality of accruals and earnings management: The role of accruals estimation errors. The Accounting Review 77, 35-59.

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George, T.J., Kaul, G., Nimalendran, M., 1991. Estimation of the bid-ask spread and its components: A new approach. Review of Financial Studies 4, 623-656.

Huang R.D., Stoll, H.R., 1996. Dealer versus auction markets: A paired comparison of execution costs on the NASDAQ and the NYSE. Journal of Financial Economics 41, 313-357.

Jain, P.K., Kim, J.-C., Rezaee, Z., 2008. The Sarbanes-Oxley Act of 2002 and market liquidity. Financial Review 43, 361-382.

Jones, J., 1991. Earnings management during import relief periods. Journal of Accounting Research 29, 193-228.

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McInish, T.H., Van Ness, B.F., 2002. An intraday examination of the components of the bid-ask spread. Financial Review 37, 507-524.

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* Address for correspondence: Juo-Lien Wang, Tel: +886-3-5712121 ext.57126; Fax: +886-3-5713796; e-mail: lotus@cute.edu.tw.


1 The evidence provided by and Dechow and Dichev (2002) shows that high accrual levels signify low quality and less persistent earnings.

2 Cohen et al. (2008) suggest that there is a significant increase in firms management of their accounting earnings during the period prior to the SOX Act. Jain et al. (2008) also find that the reported financial scandals have led to a higher adverse selection component for spreads, and a decline in investor confidence.

3 In Eq. (2), the average adj-R2 for all industries is 36.53% (34.15%) in 2001 (2002).

4 One shortcoming of simultaneous equation is that market makers and liquidity traders do not seem to have the EM information available for the current year exactly. For robustness, we also verify that our results hold if the EM for the previous year is used in the estimation of Eq. (5) by two stage least squares regression model (2SLS), and get similar results.

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