The purpose of this paper is to add an important new dimension to the earnings management literature by establishing a link between idiosyncratic risk and the degree of accrual management.
Based on a comprehensive sample of 44,599 firm-year observations during the period spanning 1987-2009, the study offers robust empirical evidence of the importance of firm-specific idiosyncratic volatility as a determinant of earnings manipulation. The authors use standard measures of earnings management and idiosyncratic volatility. The authors test the hypotheses with robust econometrics techniques.
The authors document a strong positive relationship between idiosyncratic risk and accruals management. Further, the authors find a positive association between residual volatility and discretionary accruals whether accruals are income inflationary or income deflationary. The findings are robust to alternate idiosyncratic risk proxies and variables associated with earnings management.
Overall, the knowledge derived from this study provides additional tools to assess the degree of earnings management by firms, and hence the quality of the financial reporting. Thus the findings will enable standard setters, financial market regulators, analysts, and investors to make more informed legislative, regulatory, resource allocation, and investment decisions.
