Product market power, industry structure, and corporate earnings management Sudip Datta a,⇑ , Mai Iskandar-Datta a , Vivek Singh b a Department of Finance, School of Business Administration, Wayne State University, 5201 Cass Avenue, Detroit, MI 48202, United States b Department of Finance and Accounting, College of Business, University of Michigan-Dearborn, Dearborn, MI 48126, United States article info Article history: Received 25 July 2012 Accepted 22 March 2013 Available online xxxx JEL classification: G30 L11 M4 M41 Keywords: Product market power Industry structure and competition Earnings management Discretionary accruals management abstract This is the first study to establish a link between product market power of firms and the degree of earn- ings management. We hypothesize and document a significant and robust association between (a) a firm’s product market pricing power and its degree of earnings management, and (b) industry competi- tiveness and the degree of earnings management in the industry. Our study reveals that firms with infe- rior product market pricing power engage in greater discretionary earnings accruals, adding a new dimension to our understanding of the transparency and informativeness of firms’ financial statements. These findings are mirrored at the industry level where we document that more competitive industries are associated with greater earnings manipulation. The empirical evidence has direct implication on the informativeness and earnings quality of firms based on their product market power and competitiveness. Ó 2013 Elsevier B.V. All rights reserved. 1. Introduction The idea that competitive pressure is an important determinant of managerial decision-making has received empirical support in the literature. A number of studies establish that a firm’s product market environment influences its investments, financing, cash distributions, corporate governance, analysts’ earnings forecasts, and hedging decisions (see e.g., Akdogu and MacKay, 2012; Datta et al., 2011; Haushalter et al., 2006; Grullon and Michaely, 2007; Fama, 1980). Yet, how product market power impacts the strategic decision to manage a firm’s reported earnings is an issue that has largely been overlooked. A central issue in earnings management research is to identify which firms have a propensity to engage in earnings manipulation. Much of the literature on earnings man- agement delves into the degree to which firms are able to ‘‘game’’ the capital markets through earnings manipulation. However, we know very little about firm attributes that drive earnings manage- ment. In fact, Healy and Wahlen (1999) state ‘‘These studies point to the value of further research to explain how business factors drive accruals.’’ In this study we argue that a firm’s pricing power has the poten- tial to influence the degree of earnings management for a number of reasons. First, pricing power can serve as a cushioning mecha- nism that affords the firm the ability to pass on any cost shocks to the customers, reducing cash flow fluctuations, and thereby diminishing the need to manipulate earnings. Second, in light of the fact that the market punishes firms when they fail to meet earnings expectations, one can argue that firms under weak pricing power are more likely to manipulate earnings to meet market expectation. Another motivation for earnings manipulation is to strategically limit and obfuscate the information available to rivals in an attempt to maintain a competitive advantage. Therefore, firms facing greater competitive pressures may be motivated to manage earnings to limit information available to their rivals. Till date, the potentially important link between product market pric- ing power of firms and earnings management remains unexplored. The primary focus of this study is to address whether product mar- ket power influences the degree of earnings manipulation by cor- porate managers. Specifically, we seek to answer the following questions: Is there a link between product market pricing power and the transparency 0378-4266/$ - see front matter Ó 2013 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.jbankfin.2013.03.012 ⇑ Corresponding author. Address: Department of Finance – Prentis 216, School of Business Administration, Wayne State University, 5201 Cass Avenue, Detroit, MI 48202, United States. Tel.: +1 313 577 0408; fax: +1 313 577 0058. E-mail addresses: sdatta@wayne.edu (S. Datta), mdatta@wayne.edu (M. Iskan- dar-Datta), vatsmala@umich.edu (V. Singh). Journal of Banking & Finance xxx (2013) xxx–xxx Contents lists available at SciVerse ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf Please cite this article in press as: Datta, S., et al. Product market power, industry structure, and corporate earnings management. J. Bank Finance (2013), http://dx.doi.org/10.1016/j.jbankfin.2013.03.012