The role of earnings management in equity valuation

Abstract

The intrinsic value of a firm’s equity is determined by the present value of future payoffs to equity-holders. Thus, to estimate equity value, one needs to identify and process a series of information that is relevant to the present value of expected future payoffs. Among the value-relevant information, earnings pertain to a summary measure of firm performance, and thus play a key role in the equity valuation. Nevertheless, it is not uncommon in practice that firm managers either intentionally or unintentionally misreport earnings, making valuation challenging for outsiders. This chapter aims to explore the role earnings management plays in equity valuation, and how market participants may detect and adjust for misreported earnings, if any, in their forecasts and valuation for a firm. The chapter is organized to comprise the following sections: (i) varied managerial incentives for earnings management; (ii) various tactics of earnings management via accruals manipulation; (iii) various tactics of earnings management via real activities manipulation; (iv) consequences and determinants of earnings management; (v) trade-off between accruals manipulation and real activities manipulation to manage earnings; (vi) how to discern and measure earnings management; (vii) introduction of various equity-valuation models; (viii) how to adjust for the effects of accruals-based and real earnings management in equity valuation.