Stock liquidity and managerial short-termism
Introduction
Managerial short-termism, or the “desire to achieve a high stock price by inflating current earnings at the expense of long-term growth” (Stein, 1989), is a major issue of interest to academics, practitioners, and legislators. Jacobs, 1991, Porter, 1992 document that U.S. managers have been heavily criticized for their obsession with short-term performance and their myopic investment behavior. Indeed, Graham et al. (2005) report that 78% of executives would sacrifice long-term value to meet near-term earnings targets. In a similar vein, the Chartered Financial Analyst (CFA) Institute and the Business Roundtable Institute for Corporate Ethics emphasize that the excessive focus that corporate executives place on short-term earnings destroys long-term value for shareholders (Krehmeyer et al., 2006). In a more recent study, Dichev et al. (2013) report that, in any given period, 20% of firms manage earnings in an attempt to influence stock price and avoid adverse compensation and career concerns. These studies clearly highlight the importance of understanding the determinants of managerial short-termism, which is viewed as a first-order problem by academics and practitioners (Edmans, 2009).
Utilizing an earnings management setting, this paper examines how stock liquidity affects managerial short-termism. Prior research shows that managers resort to earnings management using their discretion in financial reporting and investment decisions to pursue short-run objectives, and that the long-term costs of such activities for shareholders are substantial (Bushee, 1998, Teoh and Wong, 2002, Aboody et al., 2005, Bhojraj and Libby, 2005, Graham et al., 2005, Roychowdhury, 2006, Francis et al., 2008, Karpoff et al., 2008, Cohen and Zarowin, 2010, de Jong et al., 2014). Building on these papers, we view earnings management as a natural setting to examine managerial short-termism, as it captures the essence of managerial myopic behavior, in the spirit of Stein, 1989, Graham et al., 2005.
Our research is timely, in light of intense debate over the impact of stock liquidity on managerial short-termism. One view is that higher stock liquidity increases capital market pressure on managers to focus on near-term results, thus enhancing managerial short-termism. This view is succinctly described by Bhide (1993, p. 31): “…stock liquidity discourages internal monitoring by reducing the costs of ‘exit’ of unhappy stockholders.” This view is echoed in a number of studies (Coffee, 1991, Porter, 1992, Fang et al., 2014).
Another view is that higher stock liquidity facilitates blockholder control over firm management, either by enhancing blockholder voice (Maug, 1998) or by amplifying blockholder threat of exit (Edmans, 2009, Edmans and Manso, 2011). This view suggests that higher stock liquidity encourages managers to undertake actions that boost long-term firm value, thus resulting in less managerial short-termism. Given the competing predictions and mixed empirical evidence, further investigation is warranted to determine whether stock liquidity encourages or impedes managerial short-termism.
To investigate the impact of stock liquidity on managerial short-termism as reflected in earnings management practices, we examine three distinct research questions. First, we investigate whether the intensity of earnings management is affected by the liquidity of firm stock. Using a large sample of U.S. firms for the period 1993–2010, we find that firms with liquid stocks engage in less accrual-based earnings management, as evidenced by lower discretionary accruals and higher accrual quality. We also find that firms with liquid stocks engage in less real earnings management, such as overproduction and opportunistic reduction of discretionary expenses. These results are robust to alternative measures of earnings management and stock liquidity, and hold after controlling for a range of factors identified in prior research as determinants of earnings management.
While establishing a negative association between stock liquidity and intensity of earnings management, our baseline results are subject to endogeneity concerns. In particular, Bhattacharya et al. (2013) show that poor earnings quality leads to lower liquidity. Further, Chung et al. (2010) show that firms with better governance have higher liquidity. Therefore, our baseline results could be an artifact of either reverse causality or an omitted correlated variable (e.g., some unobservable attribute of corporate governance). To address these important concerns, we utilize the 1997 minimum tick size change and the 2001 decimalization events as exogenous shocks to stock liquidity. The results confirm the causal effect of stock liquidity on the intensity of earnings management.
The results from this first investigation reveal that higher stock liquidity results in less earnings management. This finding leads us to the second of our three research questions: what is the governance channel that drives the negative impact of stock liquidity on earnings management observed in our sample? We consider two major channels: (i) governance by voice (or intervention), and (ii) governance by exit.1 We find that the effect of stock liquidity on earnings management is stronger for firms with higher levels of managerial pay-for-performance sensitivity. This finding provides support for the threat-of-exit channel, as the threat of exit is amplified when manager wealth is closely tied to stock price. Since we find no effect from the level of shareholder rights on the stock liquidity-earnings management relation, we conclude that governance by intervention is not the channel through which stock liquidity affects earnings management.
The results for our first two research questions highlight the role of stock liquidity as an important determinant of intensity of earnings management, yet generate little evidence on how the information content of earnings management varies across firms with high versus low levels of stock liquidity. While the overall weight of the empirical evidence is consistent with earnings management being driven by managerial opportunistic motives, several studies suggest that managers may also manage earnings to convey information about future prospects of the firm to investors (Gul et al., 2003, Gunny, 2010). Thus, if stock liquidity enhances monitoring, it should affect not only the intensity but also the information content of earnings management.
To distinguish between opportunistic and information production motives of earnings management, we observe that opportunistic earnings management makes firm financial disclosure more opaque, giving rise to information risk, in contrast to earnings management driven by information production motives. In turn, information risk results in higher firm cost of capital (Aboody et al., 2005, Francis et al., 2008, Kim and Qi, 2010, Ng, 2011, Kim and Sohn, 2013). This leads us to the third of our three research questions: how does the association between the intensity of earnings management and firm cost of capital vary across firms with high versus low levels of stock liquidity? We posit that if stock liquidity discourages opportunistic motives for earnings management, then the association between the earnings management proxies and firm cost of capital should be weaker for firms with higher levels of stock liquidity. Consistent with our prediction, we document a positive and significant association between earnings management proxies and firm cost of capital for low-liquidity firms, but not for high-liquidity firms. These results further support our conclusion that higher stock liquidity reduces the extent of earnings manipulation, thus mitigating managerial short-termism.
Our paper makes several contributions to the literature. First, we contribute to the rapidly growing stream of research examining the effects of stock liquidity on managerial short-termism (Bharath et al., 2013, Edmans et al., 2013, Fang et al., 2014). These studies provide mixed evidence as to whether stock liquidity exacerbates or mitigates managerial short-termism. We document that higher stock liquidity results in less earnings management, suggesting that stock liquidity discourages managerial short-termism.
Our second contribution is to the literature that examines the determinants of earnings management. Our paper documents that higher stock liquidity results in less earnings management, thus establishing an important link between market conditions for a firm’s stock and earnings management practices. Our results should be of interest to legislators, as prior research shows that liquidity can be altered through market regulations (Fang et al., 2009, Bharath et al., 2013). Specifically, our findings suggest that regulations aimed at improving market liquidity are also expected to have a beneficial effect on both the quality of financial reporting and real investment decisions, by discouraging accrual-based and real earnings management practices.
Our third contribution is to the research on the consequences of earnings management. Prior studies document a positive association between the intensity of earnings management and firm cost of capital, consistent with the notion of earnings management making the firm information environment more opaque (Aboody et al., 2005, Francis et al., 2008, Kim and Qi, 2010, Kim and Sohn, 2013). Our findings suggest that such an effect is concentrated in the subsample of low-liquidity firms, thus highlighting the role of stock liquidity as an important moderator of the relation between the opacity of the firm information environment and firm cost of capital.
Our study is also related to recent research that examines the linkages between stock liquidity and the quality of corporate disclosure.2 Prior studies in this stream of research emphasize the role of stock liquidity as the channel through which information quality affects firm valuation, thus positing information quality as a determinant of stock liquidity (Lang and Maffett, 2011, Ng, 2011, Bhattacharya et al., 2013). Little is known, however, about whether stock liquidity itself impacts the quality of corporate disclosure. We attempt to fill the void by examining the effect of stock liquidity on corporate earnings management practices.
There are two contemporaneous, but independently executed, studies related to this paper. Dou et al. (2015) test governance by exit channel in the context of financial reporting quality. Similar to our study, these authors show that as exit threat increases, firms demonstrate higher financial reporting quality. Our study differs from Dou et al. (2015) in the following ways. First, these authors focus solely on the threat-of-exit channel, whereas prior research shows that monitoring may occur through both intervention and exit channels (e.g., Edmans et al., 2013). In contrast, we explore both intervention and exit channels as potential mechanisms for the documented effect of stock liquidity on earnings management. The second key difference is that we study the role of stock liquidity in the relation between earnings management and firm cost of capital. In so doing, we address an important concern raised by Dechow et al. (2010), who argue that focusing on only one aspect (i.e., either determinants or consequences of earnings management), gives an incomplete picture.
Fang et al. (2015) show that the prospect of short-selling curbs earnings management and improves price efficiency, identifying short-sale constraints as a significant determinant of earnings management. Our study differs from Fang et al. (2015) in the following ways. First, Fang et al. (2015) focus on trading (in their case, the prospect of short-selling) as a mechanism that mitigates earnings management. In contrast, we explore both intervention and exit as potential channels through which liquidity reduces earnings management. Second, their focus is solely accruals-based earnings management, while we study the impact of stock liquidity on both accruals-based and real earnings management activities. This is an important distinction, as Zang (2012) shows that managers may substitute both types of earnings management. Third, Fang et al. (2015) focus solely on the intensity of earnings management, while we examine the impact of stock liquidity on both the intensity of earnings management and its implications for firm cost of capital.
The remainder of this paper proceeds as follows. In Section 2, we discuss related literature and develop our hypotheses. Section 3 describes the data and variables. In Section 4, we examine the impact of stock liquidity on earnings management. Robustness tests are presented and discussed in Section 5. In Section 6, we explore potential channels through which stock liquidity impacts earnings management. In Section 7, we examine the effect of stock liquidity on the earnings management–firm cost of capital relation. Section 8 sets forth our conclusions.
Section snippets
Earnings management: a brief overview
This section briefly reviews the basic types of earnings management identified in prior research and summarizes the implications of earnings management for long-run firm value. Healy and Wahlen (1999) state that “earnings management occurs when managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on
Data
We obtain our data from multiple sources. Firm financial information is obtained from Compustat and stock returns from CRSP. Our main measure of stock liquidity is the relative effective spread, calculated using intra-day data from the Trade and Quote database. This measure originated in Vanderbilt University’s Financial Markets Research Centre (FMRC).
Accrual-based earnings management
This section examines the relation between stock liquidity and accrual-based earnings management. The baseline regression specification is as follows:
The dependent variable is ACCR, which is discretionary accruals, and the explanatory variable of interest is LIQ, which is the measure of stock liquidity. Control variables are
Economic significance
To facilitate economic interpretation of our results, we rank each explanatory variable (except for the dummy variables) for each year, and then partition the resulting ranks into deciles labeled from 1 (lowest decile) to 10 (highest decile). Next, we regress discretionary accruals and each of the two real earnings management indices on the decile rankings of explanatory variables.
The results are presented in Panel A of Table 4. For the sake of brevity, we report only the coefficients of stock
Governance channel of stock liquidity: threat of exit versus intervention
Our results suggest that higher stock liquidity results in less earnings management. As discussed above, such an effect can be motivated based on either the threat of blockholder exit or blockholder intervention mechanisms. To examine which of the two mechanisms drives the liquidity effect observed in our sample, we conduct two analyses.
First, we examine the effect of managerial pay-for-performance sensitivity on the stock liquidity–earnings management relation. The disciplining effect of the
Stock liquidity, earnings management, and firm cost of capital
The results documented in the preceding sections show that firms with higher stock liquidity have lower discretionary accruals and lower real earnings management indices, suggesting that stock liquidity is an important determinant of the intensity of earnings management. Yet, these findings provide little evidence as to whether and how stock liquidity impacts the information content of earnings management; that is, whether stock liquidity impacts the association between the extent of earnings
Conclusion
This paper examines the effect of stock liquidity on managerial short-termism. Utilizing earnings management as a proxy for managerial short-termism, we address three important research questions. First, we examine the effect of stock liquidity on the intensity of earnings management. Second, we identify the potential channel through which stock liquidity affects earnings management. Third, we examine the consequences of earnings management for firm cost of capital, and how the effect of
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