Earnings management, business cycle, and product market competition

Using annual data from non-financial listed companies in China between 2001 and 2011, this paper empirically examines the degree and key mechanism of upwards earnings management by companies under cyclical fluctuations of the macro-economy. We find that: firstly, upwards earnings management is significantly and positively correlated with the growth rate of the macro-economy, indicating a relatively strong pro-cyclical effect; secondly, the pro-cyclical effect of upwards earnings management will be more significant if the management expects corporate profit to be lower than the average profit for the industry; thirdly, the pro-cyclical effect of upwards earnings management will be more significant if the company faces greater pressure from product market competition. Further tests reveal that the greater the incentive for management, the greater the financing restrictions, and the more sensitive the industry is to the economic cyclical fluctuations, then the more significant is the pro-cyclical effect of upwards earnings management. The results demonstrate that the key mechanism of upwards earnings management during the economic boom is the expected profit based on the difference between the previous year’s expected firm’s profit and that year’s average profit for the industry, as well as the pressure of product market competition. Thus, the combination of the macro-economic state and the degree of product market competition will play an important role in understanding earnings management behaviour.