There’s no smoke without fire: Does the context of earnings management predict the existence of earnings management and future stock returns?

This paper constructs a signal-based composite index, namely ESCORE, which captures the context of earnings management. Specifically, ESCORE aggregates 15 individual signals related to earnings management based on prior relevant literature. After establishing that ESCORE is capable of capturing the context in which earnings management is more likely to occur, the study finds that low ESCORE firms outperform those with high ESCORE by 1.37% per month after controlling for risk loadings on the market, size, book-to-market and momentum factors up to one year after portfolio formation in the UK. This finding implies that investors tend to ignore the observable context of earnings management. When tested using the US data, most of the main results appear to hold.