Inflation expectations and earnings management in the euro area: evidence from business and consumer surveys

Abstract

This paper aims to examine the associations between inflation expectations and earnings management, accrual-based and real activities manipulation, using a sample of firms listed and incorporated in euro area countries. Drawing on survey-based measures of inflation expectations, along with the models developed by Kothari et al. (2005) and Roychowdhury (2006) to estimate accrual and real earnings management, and a sample spanning from 2005Q1 – the year when most euro area countries adopted IFRS – to 2023Q4, the authors perform fixed-effects regressions. The authors find that higher firms’ inflation expectations are associated with greater accrual-based earnings management and real earnings management through overproduction, whereas sales manipulation exhibits a negative association. In addition, in recessionary periods, when there is a broad decline in economic activity, these relationships become more pronounced, with upward accrual-based earnings management and real earnings management through sales manipulation being particularly evident. Finally, when the effective lower bound (ELB) is binding, the positive relation between earnings management and inflation expectations generally weakens. Replicating the analysis using consumers’ inflation expectations as the primary explanatory variable, the authors further find that downward accrual-based earnings management and overproduction are more prominent during recessions, whereas firms appear to rely on sales manipulation when the ELB is being approached. To the best of the authors’ knowledge, this is the first study to investigate the associations between inflation expectations and earnings management. The results of this study may have implications mainly for investors, auditors and central banks.