Competition and Earnings Management

We examine the relation between industry product market competition and the extent of earnings management. We use several determinants of competition (product substitutability, market size, and entry costs), and use accruals’ based measures as well as the incidence of accounting irregularities (AAERs and restatements) to proxy for the extent of earnings management. Cross-sectional tests suggest a significant positive relation between the levels of competition and earnings management in an industry. We provide confirmatory evidence of this positive relation by showing that an exogenous increase in competition, via deregulation in the telecommunications industry and tariff reductions due to the North American Free Trade Agreement (NAFTA), results in a significant abnormal increase in earnings management levels. We add to the nascent literature that documents perverse effects of competition.