This study explores the relationship between competition in product markets and managerial incentives to distort earnings. A large amount of voluminous literature in economics provides theoretical guidance on how market competition can mitigate agency problems (Hart, 1983; Meyer and Vickers, 1995; Schmidt, 1997) or sometimes exacerbate agency problems (Schfarstein, 1988; Martin, 1993; Horn, Lang and Lundgren, 1994). Empirical researchers have relied on some of these theoretical predictions to motivate their analyses on the effects of competition on managerial effort and thereby a firm’s productivity and operating efficiency (Nickell, 1996; Graham, Kaplan and Sibley, 1983). Given that the demand for financial reporting arises from agency conflicts between outside stakeholders and insiders (Healy and Palepu, 2001), the impact of competition on agency problems (even though an ambiguous one) leads us to motivate and predict some relationship between competition in product markets and financial reporting practices.
Because agency problems can distort financial reporting, this study examines those aspects of financial reporting that may be induced by managerial incentives to distort true economic performance by managing reported income. We therefore rely on three earnings management measures as proposed in Leuz, Nanda and Wysocki (2003) which have been motivated in their study from managerial inclination to distort economic performance with a motive to concealing or extracting private benefits. These measures encompass both earnings smoothing in excess of what may be considered “normal” and earnings discretion i.e. managerial tendency to overstate reported earnings or achieve certain earnings targets.
Existing theories that directly correlate product market competition to our specific attributes of financial reporting (e.g. earnings smoothing) are scarce (Ronen and Yaari, 2008). Thus, this study is intended to guide future theoretical work. We explore various potential connections in exploring the role of product market competition in affecting earnings management practices that may be motivated by manager’s incentives to extract private benefits, where private benefits relate to the ability of insiders to redirect or steal corporate resources. The ability to steal or divert corporate resources is also a function of the strength of the legal regime in which a firm operates. For instance, private benefit opportunities in the United States are at low levels, given its relatively strong investor protection environment (Dyck and Zingales, 2004). We therefore conduct this study in an international context where sufficient variation in laws and enforcement exists to strengthen our ability to empirically detect private benefit opportunities.
The theoretical idea of product market competition is in essence, not a static one. For example Raith (2003) shows that market structure is endogenously determined by free entry and exit in the industry. This implies that changes in the nature of competition lead to changes in the equilibrium market structure. Competition is therefore a dynamic and complex concept and relying solely on say, market structure or industry concentration to proxy for competition (as has much of the prior research) can lead to misleading interpretations of the underlying economic relationships (Demsetz, 1973). Furthermore, capturing this dynamism through simple cross-sectional regressions is an additional challenge. An implicit assumption as encompassed in a cross-sectional regression is that most industries across countries have achieved their equilibrium levels of competition and the empirical analysis serves to test this implication for earnings management practices.
To mitigate some of these concerns, we employ changes regression specifications in addition to levels regressions. If an increase in competition is interpreted as an exogenous shock to an industry, then we can obtain more unbiased effects of competition on firms’ financial reporting. We also employ two different measures of competition – competition from foreign suppliers and industry-level price-cost margins. To the extent that some industries may defy uni-dimensional labels of competition (Karuna, 2006), we attempt to arrive at a more collective view of the relationship between product markets competition and earnings management. The competition data is obtained from two databases compiled by the OECD and the United Nations Industrial Development Organization (UNIDO), both of which include annual industry-level measures of output, inputs, labor and international trade within each country. It includes data for both public and private firms and thus may be considered more accurate than those constructed from aggregates of publicly reported firms.
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PDF Ebook Product Market Competition and Earnings Management: Some International Evidence
