An explanation for earnings management : opportunistic or signaling?

Abstract

In a two-period and two-type framework, the market does not know a firm’s economic earnings creation ability, which could be high or low, but infers it by observing the firm’s accounting earnings. The firm liquidates some of its shares in the first period, and the rest in the second period. This paper provides a reason that a manager, no matter the firm’s type, may transfer some earnings from the second period and report high accounting earnings in the first period, ifthe first period’s economic income is low, because such action could have positive effects on the firm’s market value. We further argue that smoothing earnings is a signaling strategy for a high type firm, but an opportunistic behavior for a low type firm. In addition, we point out that the higher the liquidation needs in the first period, or the less information about the firm’s type the market has, then he more aggressive the manager may engage in earnings smoothing