| This study investigates the appropriateness of using measures of earnings management as proxies for earnings quality. Even though many recent studies subscribe to the notion that earnings management impairs earnings quality, one school of thought in accounting believes that firms can enhance the predictive ability of earnings via earnings management (i.e., "beneficial" earnings management). Since predictive ability with respect to future earnings is central to firm valuation, it is not clear that earnings management can always be viewed as affecting earnings quality adversely. Therefore, this analysis examines the association between earnings management and the predictive ability of earnings components. The results suggest that firms engaging in consistently high levels of earnings management (High EM firms) are not necessarily behaving in a manner detrimental to shareholders (i.e., "opportunistic" earnings management). In particular, for a subset of these High EM firms, earnings management even enhances predictive ability. Thus, if predictive ability is also an important dimension of earnings quality, it is important to take into account the impact of earnings management on predictive ability of earnings components. Also, market tests reveal a strongly positive reaction to accrual information when firms appear to be practicing beneficial earnings management. In contrast, the market reacts far less favorably to firms behaving in a relatively opportunistic manner. In sum, the study sheds new light on systematic differences in firm characteristics and documents differences in market reaction between firms engaging in beneficial earnings management and those engaging in opportunistic behavior. |
