Earnings Management and Capital Market Misallocation

This study seeks to find evidence of misallocation of invested capital caused by opportunistic earnings management. Investors, if unable to detect the direction and magnitude of the managed portion of reported earnings, may tend to over-value firms practicing income-increasing earnings management and under-value firms practicing income-decreasing earnings management. I test this possibility by measuring future abnormal returns from a trading rule based on the magnitude of earnings management. Using five separate and distinct methodologies, I find consistent evidence of significant positive abnormal trading returns from a hedge portfolio based on the magnitude of earnings management. These results represent evidence of significant mis-pricing associated with opportunistic earnings management