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Stock Return Dynamics Under Earnings Management

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  • Xiaotong Wang

Abstract

This paper explores how earnings management influences asset returns and return volatility via real economic activity. In the model, firms smooth earnings via the costly and economically suboptimal intertemporal transfer of assets and liabilities. As a result, the firm's stock return follows a process that conforms to an EGARCH-like statistical model. The key idea is that real earnings management generates an unobservable cost, and the market has to infer the underlying wealth of the firm from the smoothed reported earnings series. This framework may help explain why asset returns underreact to good news and overreact to bad news, while no news is always good news to the market. Empirical evidence that earnings innovations impact future return volatility, in line with the model's predictions, is found in the data.

Suggested Citation

  • Xiaotong Wang, 2005. "Stock Return Dynamics Under Earnings Management," Yale School of Management Working Papers amz2633, Yale School of Management, revised 01 Jul 2006.
    • Handle: RePEc:ysm:wpaper:amz2633
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    References listed on IDEAS

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