Earnings Management Flexibility and Market Reactions to Earnings Announcements

Abstract

We examine investors’ use of balance sheet information to infer earnings management flexibility and the extent to which investors utilize that information to assess earnings quality. Investors face a level of uncertainty when firms meet or barely beat the consensus analyst forecast. Investors must assess the likelihood that the firm arrived at the reported numbers through earnings management. Firms with limited earnings management flexibility have less ability to manage earnings. We find evidence that the market uses this earnings management flexibility information to discern the firms that reach earnings benchmarks without having to resort to earnings management.