An empirical analysis of analyst reaction to the extent and direction of earnings management

Revelations of massive accounting frauds involving large corporations over the past several years catalyzed public criticism of the failure of financial experts to warn of accounting irregularities and imminent bankruptcies. This study aims to explore analyst reaction to earnings management. We show that analysts detect earnings management, and in cases of material earnings management, accounting fundamentals become less value- relevant for stock pricing. While analyst reliance on extensively managed accounting information has decreased dramatically, the levels of their recommendations and target prices do not seem to be directly affected by the extent of earnings management. On the other hand, analysts appear to react to the direction of earnings management. This reaction is expressed in lower target prices issued to income-increasing firms and in lower incentive to cover these firms.