The literature has clearly established that corporate decisions can be driven by market value. When equity is overvalued, companies are more likely to make more investments (Baker, Stein, and Wurgler, 2003; Polk and Sapienza, 2009; Stein, 1996), conduct more mergers and acquisitions (e.g., Dong et al., 2006; Rhodes-Kropf, Robinson, and Viswanathan, 2005; Shleifer and Vishny, 2003), offer more securities and pay more dividends (Baker and Wurgler, 2000, 2002, 2004), and use more accruals (Chi and Gupta, 2009). In addition, many of these researchers also show that these decisions are followed by lower stock returns, suggesting that they are not beneficial to investors.
In fact, Jensen (2005) argued that the agency costs of overvalued equity set into motion a series of value-destroying forces that can undermine core firm value. Although the literature widely agrees on the problem, the solution remains an open question. That is, researchers have yet to fully address whether any existing monitoring mechanisms can deter managers' value-destruction behaviors. To investigate this question, we examine the relation between overvaluation and earnings management decisions.
Earnings management is an important component of corporate decision making. Supporting Volcker’s (2002) claim, Graham, Harvey, and Rajgopal (2005) find that executives manage earnings to meet outsiders’ expectations of future earnings. Anecdotal evidence (e.g., Enron) also suggests that companies inflate their earnings when the market expectation becomes excessive. However, certain monitoring mechanisms can prevent managers from inflating the earnings. Therefore, we investigate the relation among degree of monitoring, market overvaluation, and earnings management. We consider two hypotheses regarding the impact of overvaluation on earnings management: the market pressure hypothesis and the monitoring hypothesis.
The market pressure hypothesis, drawn from Jensen’s (2005) agency theory of overvalued equity, suggests that when investors irrationally overvalue a firm, they anticipate a growth rate of cash flows higher than what the firm can realistically achieve. As a consequence, managers may engage in earnings management to generate earnings reports that satisfy these investors as well as justify the firm’s overvalued market price. Therefore, under the market pressure hypothesis, the extent of earnings management is expected to be higher for firms with higher overvaluations.
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Monitoring Mechanism, Overvaluation, and Earnings Management
