Do "Firms Lean Against the Wind"? Earnings Management and Stock Market Returns

We investigate whether firms “lean against the wind”, i.e., manage earnings upward to offset aggregate (market wide) undervaluation, by examining how firm-specific measures of earnings management correlate with aggregate market conditions. Leaning against the wind has been proposed by prior research as a behavioral explanation for a negative contemporaneous relation and a positive predictive relation between aggregate accruals (both total and discretionary) and aggregate market returns. We find no empirical evidence to support the “lean against the wind” hypothesis. In particular, when the overall market return is negative, only firms whose own return is negative have positive discretionary accruals; if firms were to lean against the wind, all firms should have positive discretionary accruals in down markets. Moreover, the tendency of firms to manage earnings upward to beat benchmarks is positively related to marketwide conditions, implying that firms lean toward the wind. Importantly, since growth may explain the relation between aggregate accruals and returns but has been omitted from standard accruals models, we also adjust our discretionary accruals measures for growth and our results are robust to this specification. Since earnings management in response to aggregate market fluctuations does not appear to explain the relation between aggregate accruals and aggregate returns, our results suggest a fundamentals-based explanation.