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Earnings Management and Future Corporate Investment

This paper examines whether earnings management through accounting manipulation has an impact on subsequent corporate investments. Using a measure of earnings management based on the work of Kothari, Leone, and Wasley (2005), I find that investment level in firms with the most aggressive accounting practices is higher and is less sensitive to internal cash flows, whereas investment in firms with the least aggressive accounting practices is more sensitive to internal cash flows. Furthermore, earnings management induces investment inefficiency in the future. The findings suggest that financial reporting has an impact on real investment patterns and efficiency. This paper also provides cross-sectional evidence that corporate investments respond to the market assessment even when it differs from the managerial own assessment of the fundamentals.