Earnings Management and Stock Market Reaction

Abstract

This chapter aims to analyze if and the extent to which earnings management activities are detected by market participants. For that purpose, this chapter reviews prior literature on stock market reaction to earnings management and earnings quality. A main conclusion obtained with this approach is that stock market participants are to some extent misled by earnings management activities consistent with those activities making the firm's information environment more opaque, thus increasing the difficulty for investors to interpret financial statements. Both the theoretical and empirical contributions provided in such works are relevant given the potential negative consequences of earnings management for stakeholders, firms, and even for the entire economy. In addition, it must be emphasized that accounting regulation is fundamental to balance the trade-off between more informative financial statements and reducing the level of managers' opportunistic choices.