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Earnings Manipulation and the Cost of Capital


  • Accepted by Haresh Sapra. I would like to thank Ray Ball, Martin Dierker, Simon Gervais, Ohad Kadan, Peter Pope, Paul Povel, as well as seminar participants at the European School of Management and Technology, the University of Chicago, the University of North Carolina, the 2007 EFA Meetings, and the 2012 JAR Conference for comments on an early draft.


The widespread use of accounting information by investors and financial analysts to help value stocks creates an incentive for managers to manipulate earnings in an attempt to influence short-term stock price performance. This paper examines the role of earnings management in affecting a firm's cost of capital. Using an agency model with multiple firms whose cash flows are correlated, we demonstrate that the extent of earnings manipulation varies across the business cycle. Depending on a firm's earnings profile, it can have stronger incentives to overstate its performance in good times or in bad times. Because of this dependence on the state of the economy, earnings manipulation can influence a firm's cost of capital despite the forces of diversification.