Do stock markets acceptably reflect earnings manipulation? Analysis of Indian manufacturing firms

Abstract

Understanding the quality of a firm’s earnings is essential to developing confidence in its financial reports and making appropriate investment decisions. Generally, a high focus on a firm’s bottom line leads investors to overlook important information contained in financial accruals. Rising accruals along with a rise in earnings may indicate a poor quality of firm’s earnings. The current study is among the few of its kind in India to evaluate the earnings quality of firms. Taking a sample of 1123 firms from manufacturing sector, the first part of our study determines the persistence and mean reversion effect in firms’ earnings to understand whether these are transitory in nature or not. Further, the study divides the earnings into accruals and cash flow components in order to bring out their relative significance in driving future earnings. The second part of our study calculates Benish M-score for the sample companies and draws a comparison on earnings quality on its basis. Finally, we calculate excess buy and hold abnormal returns of size-based portfolios of M-score flagged and unflagged companies to conclude about the differential impact of high- and low-quality earnings on excess returns of stocks.