Market Expected Uncertainty and Firms’ Time－Varying Earnings Management

[Purpose]This study examines the effect of market expected uncertainty on corporate earnings management. Prior studies have provided evidence that uncertainty－averse investors take on a pessimistic bias and place a disproportionately large market penalty on firms failing to meet the market’s earnings expectation. In this study, we expect that firms announcing negative earnings surprises following a sudden increase in uncertainty conduct more income－increasing earnings management in order to relieve investors’ concerns and solve some market undervaluation. [Methodology]We use a sample of 64,729 U. S. firm－quarter observations for the period from 2002 to 2016. For the measurement of uncertainty, we use the change in the market volatility index(VIX) provided by the CBOE. Firms’ earnings management incentives are captured by the discretionary accruals(DA) calculated using the modified Jones model. [Findings]We find that firms that announce negative earnings surprises following a sudden increase in uncertainty increase the extent of earnings management in the following period. We also find that the extent of earnings management by firms that missed the earnings benchmark is increasing with the magnitude of the uncertainty shocks experienced around the earnings announcement date. The results of this study provide consistent evidence of managers’ time－varying market－driven earnings management incentives. [Implications]Most prior papers examining managerial behavior have focused on the effects of firm－level or managerial－level characteristics, whereas we focus on effects of macro－environment. We suggest future studies to search for other effects that market uncertainty might have on corporate managerial behavior, such as cash holdings, various types of investment, or corporate governance.