Academic journal article The Journal of Real Estate Research

Stock Market Information and REIT Earnings Management

Academic journal article The Journal of Real Estate Research

Stock Market Information and REIT Earnings Management

Article excerpt


This paper investigates the interaction between stock price movement and REIT earnings management. We examine whether information generated from stock price volatility influences managers' incentives to engage in earnings management. Consistent with the efficient markets hypothesis, we find that suspected earnings-management firms do not appear to be more mispriced than others. In addition, using idiosyncratic volatility as a measure of private information embedded in stock price, we find that negative real earnings management, which allows REITs to circumvent the mandatory dividend payout requirement, is associated with greater information embedded in REIT stock prices. The result implies that information contained in stock price volatility motivates REIT managers to more actively avoid regulatory costs.

The influence of stock investors on corporate decisions has stimulated considerable scrutiny in the corporate finance literature. Stock investors express their view of a firm's future prospects via stock trading. As one of the bonding and monitoring mechanisms described by Fama and Jensen (1983, p. 313), "stock prices are visible signals that summarize the implications of internal decisions for current and future net cash flows. This external monitoring exerts pressure to orient a corporation's decision process toward the interests of residual claimants." Consistent with the monitoring role of stock investors, many empirical studies document that stock prices react to corporate decisions (Jensen, 1986; Lang, Poulsen, and Stulz, 1995; and Yermack, 1996). In general, abnormal stock returns tend to be positive when decisions made by managers are aligned with shareholders' interest, and negative if otherwise.

In addition to the monitoring role of stock investors, recent studies also suggest that stock investors may have an information role. Private information regarding firm fundamental values is capitalized into stock prices via stock trading. This information, which might be previously unknown to managers, is revealed via stock trading patterns and can impact managerial decision-making. In other words, stock prices change in response to management decisions and from actively generated information. The monitoring and information roles of stock investors combine to promote corporate decisions that maximize shareholders' wealth.

While numerous studies show that investor trading activity impacts corporate decisions, the effects on earnings management have received limited attention.1 We fill this gap by focusing on the interaction between stock price movement and earnings management to resolve two questions: Are stock investors able to detect earnings management and understand its consequence? And, more importantly, how do changes in stock prices affect manager incentives to perform earnings management? Our research questions are important for a number of reasons. Studying the connection between stock price movement and earnings management poses a more rigorous test on the efficient market hypothesis. Unlike most other corporate decisions, such as investment and financing activities, earnings management decisions are not publicly announced. Thus, to discover earnings management, stock investors need to have substantial knowledge about accounting standards, tax rules, and the company's underlying business activities. Moreover, because earnings management often involves complicated inter-temporal tradeoffs, it is challenging to understand the implication of earnings managements on current and future firm performance. Thus, by studying earnings management, we test investor ability to synthesize and price information.

Investor ability to price earnings management impacts the incentives for management to engage in earnings manipulation. If earnings management is indiscernible to investors, then information asymmetries may arise and hinder efficient corporate decisions. For instance, the desire for higher share prices may push managers to sacrifice growth potential in order to boost current earnings. …

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