The news media are an important source of information for the U.S. capital markets, especially when drawing attention to questionable behavior of corporate executives. Coverage can, however, pressure companies into making dubious financial decisions like emphasizing short-term earnings over long-term value. In our recent article, we explore the effect of media coverage on earnings management to shed light on the media’s role in the U.S. capital markets.

Earnings management is the use of accounting techniques to produce financial reports that misstate a firm’s business performance and financial position. There are two main mechanisms through which managers manipulate earnings: accrual-based and real earnings management. Accrual-based earnings management is conducted through changing the accounting methods or estimates used when presenting a given transaction in the financial statements. Because accrual-based earnings management makes firm financial reporting more opaque and less reliable, it increases the risk that the market will receive false information.

Real earnings management refers to managers’ use of business practices to manipulate earnings. It can include an opportunistic reduction of discretionary spending (e.g., research and development, advertising, and maintenance), delay in starting a new project, overproduction, and acceleration of sales. Because real earnings management changes firm operations, its negative effect on long-term firm value is even more severe than that of accrual-based earnings management.

Managers are agents of shareholders (they manage the firm for shareholders in exchange for compensation), so they have incentives to manipulate earnings for their own benefit. Managers may, for example, manipulate earnings higher to inflate stock prices and increase the value of their stock and option compensation. However, such manipulation usually comes at the expense of long-term firm value and thus hurts shareholders. For example, earnings management could reduce the quality of firm financial disclosure, which increases a firm’s cost of issuing external capital. Because earnings management is common and skews the information the markets receive, it is important to examine whether the media play a role in earnings management.

On the one hand, the media may serve as an external monitor of managerial opportunism, which would reduce earnings management. If managers manipulate earnings, they risk having their activities detected and disclosed by the media, resulting in negative consequences such as lower stock prices and increased litigation risk. Anticipating this, managers may engage in less opportunistic earnings management activities.

On the other hand, the media may impose short-term performance pressure on managers, leading them to manipulate earnings. A news release announcing bad earnings could send a company’s stock price plummeting. Considering this, managers may have extra incentives to manipulate earnings when media coverage is high. Therefore, whether media coverage curbs or amplifies firm earnings management is an empirical question.

To answer it, we count the number of news articles about a given firm each year. We then examine whether firms with high media coverage engage in more or less earnings management. Using a large sample of U.S. public firms for the period 2000-2014, we find strong evidence that media coverage reduces both accrual-based and real earnings management. The findings are consistent with the argument that the media serve as an external monitor to reduce managerial opportunism in earnings management.

Further, we find that earnings-related news coverage is more effective at curbing accrual-based earnings management, and product and service-related news coverage is more effective at curbing real earnings management. This suggests that news articles with different focuses have monitoring effects on different aspects of firm operation. We also find that the effect of media coverage on earnings management is more pronounced for firms with lower audit quality or weaker internal corporate governance. These findings suggest that the media’s role as an external monitor is strengthened when other monitoring mechanisms fail, implying that the media can to an extent substitute for weak corporate governance.

Our article adds new empirical evidence to the debate about the role of the media in the U.S. capital markets. We show that media coverage has real consequences for the market by curbing managers’ earnings management. Our article also suggests that the media in general serve as an external monitor on managers and make financial reporting more transparent.

This post comes to us from Yangyang Chen, C.S. Agnes Cheng, and Jingran Zhao, who are professors at Hong Kong Polytechnic University, and Shuo Li, who is a PhD candidate at the university. It is based on their recent paper, “The Monitoring Role of the Media: Evidence from Earnings Management,” available here.