Academic journal article International Management Review

A Study of the Impact of Equity Overvaluation on Earnings Management: Iranian Overview

Academic journal article International Management Review

A Study of the Impact of Equity Overvaluation on Earnings Management: Iranian Overview

Article excerpt

[Abstract] Researchers indicate that if the market value of the stock in a firm exceeds its true value, this overvaluation affects the managerial behaviors and corporation actions. Thus, for investigating the impact of equity overvaluation on consequent, income-increasing earnings management financial data of 60 listed companies were collected from Tehran Stock Exchange during 2006-2010. Consequently, regression analysis for testing correlation regressions was employed. Results of the study indicate that equity overvaluation had a positive and significant relationship with subsequent income-increasing earnings management. The results indicate that firm's management tended to support valuation errors to access the benefits of a rising stock price through discretionary accrual's manipulation, when stock would become overvalued by market.

[Keywords] overvalued equity; earnings management; discretionary accruals; valuation errors

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Accounting regulations allow managers to affect financial reports by selecting accepted procedures. This policy helps manage reported earnings and better reflect firms' economic position. Selecting policies to transfer present expenses to future expenses and forthcoming revenues to present revenues have been gathered together, which makes it difficult to attain objectives in the future periods, Schaller and Chirinko (2007) illustrate some effects of misevaluation on investment, such as investors become excited about particular firms. In their excitement, they bid up the prices of these firms. Overvalued shares lower the perceived cost of equity capital. If managers act on this lower-perceived cost, they will issue new shares, lower the discount rate used in evaluating investment projects, and increase investment spending. Moreover, Benish and Nicholas (2009) believe firms that meet overvalued equity have a likelihood of financial statement fraud, high sales growth, low operating cash flows, and a recent history of acquisition and stock issuance. Thus, managers gradually are forced to select policies that are more aggressive and maintain them in the process. However, these policies could lead to fraud eventually (Jensen, 2005). In the current study, with regard to importance of impacts of overvaluation on firm's future value and severe volatilities, the impact of equity overvaluation on earning's management is tested in firms listed in the Tehran stock exchange.

The finance literature has widely documented that overvaluation intensifies income-increasing earning's management activities (i.e., higher discretionary accruals). It has an economic impact: onestandard-deviation increase in total valuation error generates a fifteen percent standard-deviation increase in discretionary accruals. Additionally, the agency costs of overvalued equity are substantial. Overvaluation-induced, income-increasing earnings management is negatively related to future abnormal stock returns and operating performance, and this negative relation becomes more pronounced as overvaluation intensifies. Among the most overvalued firms, those with high discretionary accruals underperform those with low discretionary accruals during the following year (Chi & Gupta 2009). In contrast, undervalued firms are not expected to actively under-report accruals, (i.e., manage earnings) downwards. In fact, under-valued firms might also attempt to manage earnings upward to correct the misevaluation. Therefore, such firms are unlikely to be concentrated in the low accrual deciles of the population of firms; instead, they might be dispersed across various accrual deciles of firms. Hence, the low accrual deciles' portfolios' future stock-price performance is expected to be normal. This prediction differs from that of the investor-fixation hypothesis for the accrual anomaly (Kothari et al., 2005).

Marciukaityte and Varma (2007) argue that substantial overvaluation of equity pressures managers to manipulate earnings, and when investors learn about earning's restatements by overvalued firms, they reevaluate the firms to correct not only for pre-misstatement overvaluation, but also for the loss. …

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