Overvaluation and earnings management: does the degree of overvaluation matters?

We examine whether the choice of earnings management strategies employed by managers of overvalued firms depends on the degree of market overvaluation. By distinguishing between substantially overvalued and relatively overvalued firms, we find that substantially overvalued firms significantly inflate earnings using both accruals-based and real earnings management. In contrast, managers of relatively overvalued firms do not engage in accruals-based earnings management and their firms’ accounts tend to report higher discretionary expenses. The reported higher discretionary expenses of relatively overvalued firms are comparable to the discretionary expenses of firms in the expanding stage of their business life cycle, a pattern consistent with relatively overvalued firms increasing discretionary expenses to finance growth and hence justify the high market valuation. Overall, we show that the existing evidence on income-increasing earnings management by overvalued firms is mainly driven by the pressure to sustain the high market valuation of firms that are substantially overvalued.