Comment on: Monitoring Mechanism, Overvaluation, and Earnings Management

1. Comment on: Monitoring Mechanism, Overvaluation, and Earnings Management Pei-Gi Shu

2. Summary: Hypotheses: • Market Pressure Hypothesis: in order to satisfy investors’ anticipation on growth, managers of overvalued firms tend to inflate earnings. • Prediction: the extent of overvaluation is positively correlated with the extent of earnings management.

3. Summary: (cont.) Hypotheses: • Monitoring Hypothesis: Effective monitoring from external intermediaries (e.g. analyst coverage, S&P 1500) or internal governance mechanisms (large size) could offset or partially ameliorate the market pressure on earnings management. • Prediction: the extent of overvaluation is independent from the extent of earnings management for well-monitored firms.

4. Summary: (cont.) Empirical Findings: • No statistical relation between the degree of overvaluation and earnings management for highly monitored firms (large, S&P 1500, analysts covered firms). This is consistent with the monitoring hypothesis

5. Summary: (cont.) • A strongly positive relation between market valuation and future accruals for non-S&P or non-IRRC firms with poor operating performance and with a high degree of equity dependence. This is consistent with the market pressure hypothesis.

6. Comments and Suggestions • The possible endogeneity between overvaluation and earnings management. For example, firms that engaged in high level of earnings management are overvalued. Accruals that are used in propping up earnings will be reversed in the following period. The market pressure for further propping earnings is offset by the reverse of earnings, resulting in a flat relation between market pressure and earnings management. →Possible remedial approaches include (1) inclusion of lag accruals in the regression model, (2) investigating the difference-in-difference relation, and (3) finding a suitable instrument variable

7. Comments and Suggestions (cont.) • Find a possible approach to isolate the impact of monitoring and market pressure. For example, tracing along the history of the sampling firms that changed their monitoring status in the sampling period, would firms engage in less earnings management after being monitored (being included in S&P 1500 and/or covered by analysts) than they did before being monitored?

8. Comments and Suggestions (cont.) • If earnings management is related to agency problem and therefore manager’s incentives (e.g. Efendi et al., 2007; Chava and Purnanandam, 2010, JFE), including manager’s portfolio and his risk exposure (e.g. delta and vega) in firm might include managerial incentive in affecting earnings management other than market pressure and monitoring status.

9. Comments and Suggestions (cont.) • Table 2, the differences of accruals between non-controlled and ROA-controlled firms in the highest M/V groups are significant in the sense that all the accruals estimated from different models are significantly positive in the non-controlled group and then become negative in the ROA-controlled group. This implies that the firms that are moderately overvalued (quartile 2 and 3) are associated with a higher level of accruals than firms being highly overestimated (highest M/V quartile). This is inconsistent with the finding from panel B of Table 3 and from Table 6 where ROA is positively correlated with the level of discretionary accruals.

10. Comments and Suggestions (cont.)

11. Comments and Suggestions (cont.) • The definition of AcCF,t = (OCFt– NIt) / Assetst-1 is more intuitive than AcCF,t = (NIt -OCFt ) / Assetst-1 • P. 21, inconsistence between the content and table 5. “Within the highest KZ index quartile, the average accruals are 0.0099 for the highest M/V quartile and -0.0049 for the lowest M/V quartile. The difference of 0.0148 is significant at the 0.01 level.”

12. Comments and Suggestions (cont.)

13. Comments and Suggestions (cont.) • Table 6: why not include lagged DD discretionary accruals instead of MJA as a control variable in that the dependent variable is DD discretionary accruals? • Table 9: Is this table for non-S&P 1500 firms?