This paper examines the effects of economic policy uncertainty (EPU) on earnings management, accrual-based (accrual-based earnings management (AEM)) and real activities manipulation (real earnings management (REM)), in the euro area.
Using a sample of firms listed in stock exchanges of eight euro area countries and studying how earnings management motives are formed during EPU, we perform a fixed-effects panel regression. As EPU proxy, we use the index of Baker et al. (2016), while widely applied models are employed to estimate earnings management. Our sample spans the period from 2002 to 2022. Endogeneity concerns are also addressed.
We find evidence of negative association between EPU, AEM and REM through abnormal levels of production and positive with sales manipulation. Moreover, we show that industry classification affects this relationship, as during these times firms operating in politically sensitive industries increase upward AEM and REM through reduction of discretionary expenditures. Finally, considering the impact of corporate governance on earnings management, we show that large board size contributes to income-increasing AEM.
The limitation of the Baker et al. (2016) index in terms of country availability restricts the generalizability of our results to the entire euro area. Thus, future studies could create a respective index for the euro area countries that were not included and examine the robustness of our results. Moreover, the understudied subject of the impact of other corporate governance parameters on the relationship between EPU and earnings management could be also further examined.
Our results provide key insights primarily for investors and secondarily for auditors, policymakers and corporate governance regulators.
According to authors’ knowledge, this is the first study to investigate the effects of EPU on earnings management focusing exclusively in the euro area. Moreover, we examine the effects of EPU on REM by exploring the reasons and the motives to conduct each one of its methods. Finally, we add to the corporate governance literature by investigating the impact of board size on earnings management during periods of EPU.
