Overvaluation and Earnings Management

Abstract

Consistent with Jensen’s (2005) agency-costs-of-overvalued-equity prediction, we find that overvaluation is statistically and economically related to subsequent income-increasing earnings management. This relation is robust to a series of tests that address potential endogeneity concerns, including omitted variable bias and reverse causality. The agency costs of overvalued equity are substantial. Overvaluation-induced income-increasing earnings management is negatively related to future abnormal stock returns and operating performance, and this negative relation becomes more pronounced as prior overvaluation intensifies. Among the most overvalued firms, those with high discretionary accruals underperform those with low discretionary accruals during the following year by 11.88% as measured by the three-factor alphas, and by 12.87 percentage points as measured by industry-adjusted unmanaged EBITDA-to-assets ratio.

Keywords: overvaluation, earnings management, agency costs, overvalued equity, discretionary accruals

JEL Classification: G14, G34, M41, M43