Investor sentiment and earnings management: Evidence from Korea

Abstract

This paper examines whether earnings management varies with sentiment in the stock market. While many studies have focused on firm characteristics related to earnings management, this paper sheds light on the effect of aggregate investor sentiment on earnings management. The author identifies earnings management based on a firm's tendency to meet or beat earnings thresholds (e.g., analyst forecasts, last period's number, and zero earnings). Investor sentiment is measured by two alternative proxies: an index based on sentiment proxies suggested in recent work (Baker and Wurgler, 2007) and the level of the stock market (Conrad, Cornell and Landsman, 2002). Using a sample of firms listed on Korean Securities Market between 2003 and 2011, this study finds that a tendency of firms to meet or beat three earnings targets is negatively related to investor sentiment. This suggests that firms are more likely to engage in upward earnings management to meet analyst forecasts, to sustain recent performance, or to report positive profits during pessimistic sentiment periods than during optimistic periods. These findings may be of interest to investors and regulators, as these demonstrate that firms tend to inflate earnings to a greater extent in order to boost their stock prices during bad economic times. © Sorah Park, 2015.