Relation of Firm's IOS with Future Profitability and Earnings Persistence

This paper examines the effect of a firm's investment opportunity set (IOS) on future profitability and earnings persistence. Using the market to book value as a proxy for IOS, evidence has been obtained confirming the previous findings that IOS is positively related to future pre-tax earnings and earnings persistence. When adding earnings management as a new variable, the coefficient of interaction between future profitability and earnings management turns significantly (p<0.01) negative (-0.012, t= -2.34) and at the same time, the coefficient of interaction between earnings persistence and earnings management becomes insignificant (0.099, t=0.63) even at 10% level. This paper provides support for a hypothesis that with the presence of earnings management, the IOS is negatively related to future profitability and earnings persistence. The practical implication of this finding explains that a firm's value cannot be increased by earnings management regardless of the magnitude of IOS.