The Effect of the Overvalued Stock Price on Financial Reporting Opacity
Asian Tax Journal Vol. 21 No. 4 (2020), pp. 103-150
Abstract
This paper examine the managerial response to equity overvaluation from the financial reporting quality perspective about one－ and two－year ahead accruals and real earnings management activities. In Jensen’s (2005) agency costs theory of overvalued equity, excessively high stock valuations induce managers to engage in earnings management with the purpose of sustaining upward trends in earnings and stock price in the short run but can destroy shareholder value in the long run. Empirical evidence supports Jensen’s proposition. For example, prior research find the positive association between equity overvaluation and subsequent income－increasing earnings management (Chi and Gupta 2009；Houmes and Skantz 2010；Badertscher 2011 etc.). On the contrary, Duong (2010) find evidence which is consistent with the signaling hypothesis suggesting that overvalued firms manage earnings downwards as signals to correct the market in long－term while trying to avoid an immediate correction in short－term. However, there is not yet any evidence of domestic research. Therefore, this study empirically examines the effect of overvaluation on earnings management behavior during the subsequent one－ and two－ year periods using data from KOSPI and KOSDAQ listed firms. For my empirical tests, final sample from fiscal years 2003 to 2019 of 21,879 firm－years. Three proxies for overvaluation are used in this paper. These are：PER, PBR, and abnormal－return－based overvaluation proxy measure (e.g., Rhodes－Kropf et al. 2005). My empirical results reveal the following. First, on average, I find that overvaluation is statistically related to income－deceasing earnings management (i.e., discretionary accruals as well as real earnings management) in the t＋1 or t＋2 years. Thus, this results implies that equity overvaluation will lead to subsequent income－deceasing earning management, which is consistent with Duong’s (2010) signaling hypothesis of overvalued equity. Second, I also find that earnings benchmark (i.e., loss aversion) beating firms with overvalued equity or increasing abnormal investment under the overvalued firms have positive discretionary accruals as well as real earnings management in the t＋1 or t＋2 years than other firms. These results is consistent with Jensen’s (2005) agency costs theory of overvalued equity. In sum, this study provides evidence, on average, inconsistent with Jensen’s (2005) agency costs theory, which predicts that equity overvaluation could induce managers to engage in income－increasing activities that prolong the inflated stock price in the short run, but can destroy shareholder value in the long run for firms listed on the Korean Stock Exchange’s settings. Rather I find evidence which is consistent with the signaling hypothesis suggesting that overvalued firms manage earnings downwards as signals to correct the market (Duong 2010). However, I also find that while market high valuation appears to be a strong motivation for managers of overvalued firms to beat earnings level benchmarks or increasing abnormal investment level have higher discretionary accruals and real earnings management than firms with less extreme valuations, which is consistent with Jensen’s (2005) agency costs hypothesis. Collectively, these results suggest overvalued equity status is indicative of future financial reporting quality. Thus, the findings of this study contributes to the literature on overvaluation and earnings management. Moreover, my results are still informative to regulators, investors, financial analysts, and policymakers who seek to better understand the role that sustained overvaluation plays in a manager’s accounting choice behaviors as well as financial reporting opacity.
Keywords
- Overvalued equity
- Discretionary accruals
- Real earnings management
- Financial reporting quality
- Loss aversion
- Abnormal investment
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