This written assignment deliverable is a review of McNichols, M. F. and S. R. Stubben, 2008, “Does Earnings Management Affect Firms’ Investment Decisions?,” The Accounting Review 83 (6), 1571-1603.
I. Research question and its importance
Drawing on the literatures of resource allocation, earning management, and the effect of accounting information over investment decision, this article investigates whether manipulating earning leads to overinvestment in fixed asset. Despite extant works on earning management, most of the studies examine its antecedent (e.g., compensation incentive or fund raising) rather than outcome. Of the few works that concern outcome, they focus primarily on external stakeholders (e.g., investor and regulator). The authors argue, however, earning management does affect internal decision making, such as investment decision that is based on the expectation of growth and product demand. Distorted revenue and earning reports inevitably affect this expectation. Therefore, the authors postulate and show earning management indeed explain firm investment decision.
II. Method and findings
The observation consists of public companies from 1978 to 2002. The authors identify three groups of earning management firms: (1) those facing SEC investigation for irregularity, (2) those sued by shareholders, and (3) those restated their financial reports. Investment is measured from three years before to three years after the manipulation period, which is also three years. Given the skewed data structure, Spearman correlation is employed and Rank regression is adopted for the empirical analysis. Moreover, in the attempt to rule out alternative explanations such as inexpensive financing, pooling argument and masking poor results, the authors conduct several robustness checks. For one, they use discretionary revenue (i.e., residual of the main specification) as explanatory variable for earning management. For another, they match control firms by past growth and excess investment. For another, Granger causality was tested by one and two lags to rule out reverse causality. Ultimately, they show a positive association between earning management and excess investment, their proxy of suboptimal investment decision.
III. Limitation and future research
This article was written assuming naïve management who is unaware of earning distortion and makes investment decision accordingly. Yet, the authors either prove or disprove this proposition. Instead, they circumvent by stating that other stakeholders would step in and prevent suboptimal investment shall they were informed. Such argument resembles the Achilles’ heel for this well-structured paper. More elaboration is needed. In addition, the most valuable information (i.e., comparison with matched sample) was presented only at Table 6 in a way that all early presentations were biased or effortless. I would recommend the authors to omit Table 4 and 5, and move Table 2 and 3 to Appendix for brevity. Last but not least, recent research adopting more robust causal inference method can be a starting point for future extension.