Business cycle, accounting behavior and earnings management

Essay 1: Business cycle and accounting behavior. This paper investigates the influence of the business cycle on firm-level accounting measures. We focus on four measures of performance (sales growth, changes in profit margin, income before extraordinary items, and net income) and one measure of investment (total asset growth) to examine how they co-move with the business cycle. The study finds that all five accounting variables are positively associated with real GDP growth, but they exhibit greater sensitivity to economic conditions during recessions than expansions. There are systematic differences in accounting sensitivity to the business cycle that can be explained by industry- and firm-specific characteristics. For cyclical industries, the influence of the business cycle exists on all five accounting measures, whereas for non-cyclical industries the influence exists only on sales and investments but not on the three profit measures. Further analysis shows that accounting sensitivity to the business cycle decreases with firm size, earnings-to-price ratio, and increases with historical earnings volatility. In addition, we observe that the accounting sensitivity to the business cycle is the convex function of leverage (U-shape), and the concave function of concentration ratio (inverted U-shape). Book-to-market prices ratio also affects accounting sensitivity, but the effect is more complex.; Essay 2: Business cycle and earnings management. The study finds that earnings management in magnitude varies from quarter to quarter but the variation is predictable from real economic activity, that is, the magnitude of earnings management in aggregate is smaller during expansions than during recessions, and exhibits a nonlinear U-shape relationship with real GDP growth (earnings management decreases with real GDP growth up to a certain point, after which it increases with real GDP growth). We further find that the earnings management sensitivities of small-sized, low-EP and volatile firms to the business cycle are stronger than their respective counterparts. In addition, we also observe the directions of earnings management are associated with specific firm characteristics, more specifically, small-sized, low-EP and volatile firms tend to take less earnings management in the bad times, but large-sized, high-EP and stable firms are inclined to take more earnings management in such periods, relative to the other periods of business cycle. The results suggest policy makers and regulators should be more vigilant toward the integrity of financial reporting under certain economic circumstances and specific firm groups.