Accounting and Business Research

ISSN: 0001-4788 (Print) 2159-4260 (Online) Journal homepage: https://tandfonline.com/loi/rabr20

On the nonlinear relation between product market

competition and earnings quality

Ying Guo, Boochun Jung & Yanhua Sunny Yang

To cite this article: Ying Guo, Boochun Jung & Yanhua Sunny Yang (2019): On the nonlinear
relation between product market competition and earnings quality, Accounting and Business
Research, DOI: 10.1080/00014788.2019.1586515

To link to this article: https://doi.org/10.1080/00014788.2019.1586515

Published online: 25 Mar 2019.

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Accounting and Business Research, 2019
https://doi.org/10.1080/00014788.2019.1586515

On the nonlinear relation between product

market competition and earnings quality

YING GUOa, BOOCHUN JUNGb AND YANHUA SUNNY YANGc*

a
College of Business and Economics, California State University, Hayward, CA, USA; bShidler College
of Business, University of Hawaii at Manoa, Honolulu, HI, USA; cSchool of Business, University of
Connecticut, Storrs, CT, USA

The literature documents conflicting results regarding the influence of product market
competition on earnings quality. We extend this stream of literature by incorporating
competition’s effect on both the opportunities and the incentives to manage earnings. The
combination of both effects results in a nonlinear relation between product market
competition and earnings quality. At low competition levels, additional information
associated with one more rival helps reveal earnings irregularity and deter earnings
management to a larger extent than its effect on the incentives to manage earnings,
suggesting a positive relation between competition and earnings quality. At high
competition levels, the latter effect dominates the former. We thus predict a positive
(negative) relation between competition and earnings quality at low (high) competition
levels. Consistent with our hypothesis, we document an inverted U-shaped relation between
earnings quality and product market competition.
Keywords: Earnings quality; Competition; Non-linearity; Earnings restatement; Earnings
management
JEL Classification: M41

1. Introduction
We examine the influence of product market competition on earnings quality by allowing for non-
linearity in the relation.1 The literature mostly assumes a linear relation between product market
competition and earnings quality and documents mixed empirical evidence. Some studies docu-
ment a negative relation (Karuna et al. 2012, Markarian and Santaló 2014, Tinaikar and Xue
2009), while a similar number of studies find it positive (Balakrishnan and Cohen 2014,
Cheng et al. 2013, Laksmana and Yang 2014, Marciukaityte and Park 2009). These conflicting
results motivate us to consider nonlinearity in the impact of competition on earnings quality.

Paper accepted by Juan Manuel García Lara

*Corresponding author. Email: yanhua.yang@uconn.edu

© 2019 Informa UK Limited, trading as Taylor & Francis Group

2 Y. Guo et al.

Our hypothesis of a nonlinear relation draws on previous literature that suggests a two-fold
influence of competition on earnings management. On the one hand, as competition intensifies,
earnings management decreases because of higher costs and fewer opportunities to manage
earnings without being caught, more so for companies with better governance because
rivals provide informative benchmarks for the investors (Hart 1983, Nalebuff and Stiglitz
1983), making it more difficult to engage in earnings management and successfully hide it.
On the other hand, as competition intensifies, companies face higher pressure to deliver satis-
factory performance and higher liquidation risk (Schmidt 1997, Raith 2003, Gaspar and Massa
2006), which strengthens management’s incentives to raise investors’ perception of profit-
ability, especially for companies with inferior performance compared to their industry peers
(Markarian and Santaló 2014).
The marginal effects of competition on the incentives and opportunities of earnings manage-
ment vary with competition level. At low competition levels, the information provided by one
additional rival is presumably more revealing about a firm’s management effort and performance
than at high competition levels, while the performance pressure associated with one more rival is
likely to be low. We thus predict a positive relation between competition and earnings quality. At
high competition levels, the performance pressure and associated earnings management incen-
tives likely dominate the effect of competition on constraining opportunities to manage earnings.
We thus predict a negative relation between competition and earnings quality. Overall, we predict
that earnings quality initially increases with competition and then decreases after competition
reaches a certain level. We depict our predictions graphically in Figure 1 and mathematically
derive our predictions in the Appendix.

Incentives to manage earnings

Opportunities to manage earnings

Figure 1. Illustration of the predicted relation between product market competition and earnings quality.
Note: The figure shows how the opportunities to manage earnings decline with competition, and the incen-
tives to manage earnings increase with competition. When the marginal effect of the former is below the
marginal effect of the latter, the relation between earnings quality and product market competition flips.
Overall earnings management is the sum of earnings management driven by opportunities and incentives.
Earnings quality is negatively correlated with overall earnings management.
 Accounting and Business Research 3

We test the nonlinear relation with a sample of 52,332 USA firm-year observations for the
period of 1988–2015 from Compustat. Our primary measure of product market competition is
based on the Herfindahl-Hirschman industry concentration index. Following the literature
(Francis et al. 2005, Dechow and Dichev 2002), we operationalise our primary earnings quality
measure with the extent to which working capital accruals map into past, current, and future oper-
ating cash flows. We employ both a nonparametric approach and multivariate analyses (Aghion
et al. 2005) to test our hypothesis. For the nonparametric approach, we perform the spline smooth-
ing analysis, which selects polynomial functions that best describe the data rather than impose any
specific function (Poirier and Garber 1974). We find that earnings quality increases with competition
up to approximately the 40th percentile of competition and then decreases with it. For the regression
analyses, based on a quadratic model, we show that the coefficient on competition is significantly
positive and that the coefficient on the squared term of competition is significantly negative.
Overall, the results from both approaches support an inverted U-shaped relation between compe-
tition and earnings quality, especially for firms with lower performance or weaker governance.
We perform a battery of robustness tests. In the first set of additional analyses, we adopt
various alternative measures of earnings quality and competition to mitigate concerns that
measurement error or a single construct of competition drives the results. We consider five
alternative earnings quality measures: (i) the discretionary portion of earnings quality for each
firm-year (Francis et al. 2005); (ii) the frequency of irregularity-type earnings restatements for
each industry-year (Hennes et al. 2014); (iii) a firm-specific time-series measure developed by
Dechow and Dichev (2002); (iv) a composite proxy derived from four underlying measures of
earnings quality for each firm-year constructed by Beatty et al. (2010); and (v) absolute discre-
tionary accruals based on the modified Jones model (Kothari et al. 2005).
We employ six alternative competition measures. The first two reflect competition from existing
rivals, measured as the Herfindahl-Hirschman industry concentration index based on total assets and
the number of firms in the same industry (Li 2010). The next two are proxies for competition from
potential entrants, measured as weighted average property, plant, and equipment and weighted
average research and development expense, both at the industry level (Raith 2003). The last two
use industry-level profitability (Lerner 1934) and industry-level sales (Li 2010, Sutton 1991),
reflecting competition from both existing rivals and potential entrants. In addition, we measure
both earnings quality and competition at either the industry-year level or firm-year level. The non-
linear relation persists with four out of the five alternative earnings quality measures and four out of
the six alternative competition measures, suggesting that measurement error in an individual
measure or different construct underlying various measures is unlikely to drive the results.
In the second set of additional analyses, to simultaneously capture various aspects of earning
quality and competition, we develop their composite measures by averaging the annual ranks of
multiple measures. The results show that the relation is positive for approximately 27 percent
of our sample facing less competition and negative for the rest of the sample. Our third set of
additional analyses addresses the concern that competition and earnings quality are endogenously
determined. We utilise reduction in tariff rates as an exogenous shock to product market compe-
tition (Frésard 2010, Valta 2012) that does not directly affect financial reporting quality. The
results are consistent with our main results. Although we identify the two-fold influence of com-
petition on earnings management and confirm the robustness of the inverted U-shaped relation
between them, our study does not answer what specific factors cause such a relation.
This study contributes to the literature in two ways. First, by introducing nonlinearity to the
relation between competition and earnings quality, we improve the understanding of the influence
of competition on financial reporting.2 Second, previous studies document nonlinear relations
between competition and innovation (Aghion et al. 2005), inventory-holding decision (Olivares
and Cachon 2009), management effort (Green and Mayes 1991, Schmidt 1997), and disclosure
4 Y. Guo et al.

(Muino and Nunez-Nickel 2016). We extend the literature on the nonlinear effect of product
market competition on managerial activities and corporate behaviours by focusing on managers’
financial reporting decision.

2. Literature review and hypothesis development

2.1. Literature review
The literature has long recognised different effects of product market competition on management’s
incentives and opportunities to manipulate earnings. On the opportunity aspect, one stream of lit-
erature (Hart 1983, Holmstrom 1982, Nalebuff and Stiglitz 1983) analytically demonstrates that
competition increases information about an agent’s effort and reduces management slack. This
increase in information could occur when firms share some common cost components (Hart
1983) or when productivity shocks and managerial abilities are correlated (Nickell 1996). Cost
and performance reported by competitors thus provide informative benchmarks for investors,
which discipline the management in their effort and activity. Specifically, Hart (1983) shows that
more competition reduces management slack.3 The informational effect of competition could simi-
larly reveal earnings irregularities and deter earnings management. In other words, higher compe-
tition leads to fewer opportunities to manage earnings without being caught.
Related to the incentives of earnings management, previous literature documents incentives
arising from reaching performance targets set by compensation contracts (Nelson et al. 2002),
increasing media and market coverage (Hendricks and Singhal 1996), avoiding debt covenant vio-
lations (Dechow et al. 1996), or hiding inefficiency associated with managerial slacks. These
incentives could exist even when competition is weak. In addition, managers could manipulate
earnings to lower investors’ perceptions of risk or to boost stock valuation for the use of stock
in future acquisitions and employee compensation (Graham et al. 2005, Shleifer 2004), to avoid
the threat of liquidation (Schmidt 1997) and to increase the assessment of customers, suppliers,
and employees regarding a firm’s ability to fulfil its implied commitment (Bowen et al. 1995).
Because product market competition lowers profits and increases liquidation risk (Schmidt
1997, Raith 2003, Gaspar and Massa 2006), management facing higher competition presumably
has stronger incentives to manage earnings in order to boost perceptions of various stakeholders.
This argument suggests a negative relation between competition and earnings quality.

2.2. Hypothesis development

Empirical evidence on the relation between competition and earnings quality is mixed, with some
studies finding it positive (Balakrishnan and Cohen 2014, Cheng et al. 2013, Laksmana and Yang
2014, Marciukaityte and Park 2009) and other studies finding it negative (Karuna et al. 2012,
Markarian and Santaló 2014, Tinaikar and Xue 2009). Related to, but different from the literature,
we consider the marginal influence of competition on (1) constraining the opportunities to manage
earnings and (2) strengthening the incentives to manage earnings simultaneously, and introduce
nonlinearity to the relation.
At the lowest competition levels, there is not much information from rivals that provides bench-
marks for the management’s effort and performance. Thus, the management has ample opportu-
nities to manage earnings and enjoy high level of slacks. As discussed in last section, the use of
earnings in contracts with various stakeholders or operating inefficiency from managerial slacks
could motivate earnings management. When competition intensifies (e.g. due to more rivals), we
expect more information available for evaluating management effort and performance, and
reduced profits and increased liquidation risk. The increased information constrains earnings
 Accounting and Business Research 5

management, and reduced profit motivates earnings management to boost stakeholders’ perception
of performance. In addition, we expect a greater increase in earnings management constraint at
lower competition levels than at higher competition levels. This rationale is similar to the
finding by Hong and Kacperczyk (2010) that analyst coverage decline leads to a significant increase
in analyst forecast optimism, with the increase being more pronounced for firms followed by fewer
analysts, where analysts face less competition. On the other hand, the marginal increase in earnings
management incentives is either stable or becomes larger with competition. Thus, at low (high)
competition levels, the marginal constraint on earnings management associated with competition
increase is stronger (weaker) than the marginal increase in incentives, suggesting a negative (posi-
tive) relation between competition and earnings management. The above discussion suggests an
inverted U-shaped relation between competition and earnings quality.
In Figure 1, we depict how the two influences of competition collectively lead to a nonlinear
relation with earnings quality as we predict. In the Appendix, we explicitly illustrate the two influ-
ences of competition on earnings management by adopting specific functional forms and math-
ematically deriving the variation in earnings management tendencies with competition. In sum,
we predict that below (above) a certain level of competition earnings quality improves
(worsens) with competition because the influence of competition on constraining the opportu-
nities to manage earnings dominates (is dominated by) its influence on strengthening incentives
to manage earnings, as hypothesised below.4

Hypothesis: The relation between earnings quality and competition is positive when competition is
relatively low and becomes negative when competition is more intense.

In addition, we expect competition to (1) constrain the opportunities to manage earnings more
tightly when corporate governance is stronger and (2) induce stronger incentives to manage earn-
ings when a company’s performance is relatively low within the industry. We separately examine
these predictions after the main tests.

3. Research design and variable definition

We use equation (1) below to test our hypothesis.

AQ FLOSit =b0 + b1 COMP SALEit + b2 COMP SALEit2 + b3 SIZEit + b4 MTBit + b5 LEVit

+b6 CFOit + b7 STD SALESit + b8 STD CFOit + b9 OPRCYCLEit
+b10 NEG EARNit + Industry fixed effect + 1it
(1)

where the subscripts refer to firm i in year t and

AQ_FLOS = earnings quality measure per Francis et al. (2005). It equals the standard devi-
ation of firm-level residuals over the past five years from estimating the model below for each
industry-year with at least 20 observations: TCAi,t = σ0 + σ1CFOi,t−1 + σ2CFOi,t + σ3CFOi,t+1 +
σ4ΔRevenuei,t + σ5PPEi,t + εi,t, where TCA is total current accruals; CFO is cash flow from oper-
ations; ΔRevenue is change in revenue; and PPE is the amount of property, plant and equipment.
All variables are scaled by average assets. It is multiplied by −1 such that a higher value indicates
better accounting quality.
COMP_SALE

= competition measure based on the Herfindahl-Hirschman Index, measured as
1 − Ni=1 x2i , where xi is the market share of sales for firm i within the same industry. A higher
value of COMP_SALE indicates higher competition.5
6 Y. Guo et al.

SIZE = the logarithm of total assets.

CFO = cash flow from operations scaled by the average of total assets at the beginning and
end of each year.
MTB = the ratio of market value to book value of total assets. Market value of total assets is
measured as book value of debt (total assets minus book value of common equity and deferred
taxes) plus market value of common equity (the product of the number of common shares out-
standing and the closing stock price at fiscal yearend).
LEV = long-term debt scaled by total assets.
STD_SALES = standard deviation of sales scaled by the average of total assets at the begin-
ning and end of each year during the previous 10 years.6
STD_CFO = standard deviation of CFO during the previous 10 years.
OPRCYCLE = operating cycle, measured as the logarithm of the sum of days to collect
accounts receivable and days to sell inventory.
NEG_EARN = proportion of years reporting losses during the past 10 years.
To account for the nonlinearity between competition and earnings quality, we specify a
quadratic model that includes both product market competition (COMP_SALE) and its
squared term (COMP_SALE2). Equation (1) includes control variables per previous studies
(Francis et al. 2005, Chaney et al. 2011). Consistent with Francis et al. (2005) and Dechow
and Dichev (2002), we expect negative coefficients on cash flow volatility (STD_CFO), sales
volatility (STD_SALES), operating cycle (OPRCYCLE) and the proportion of loss years
(NEG_EARN) and a positive coefficient on firm size (SIZE). We further add cash flow from
operations (CFO), market-to-book ratio (MTB) and leverage (LEV) to account for the effects
of performance, growth, and leverage on earnings quality. Finally, equation (1) includes industry
fixed effects to control for the variation of earnings quality across industries. All standard errors
are adjusted for firm and year clustering to mitigate the potential autocorrelation problem.

4. Sample, descriptive statistics and empirical results

4.1. Sample
Our initial sample consists of all USA firm-years between 1988 (the first year data on cash flow
from operations are available) and 2016 from the Compustat. To avoid possible differences in the
results driven by sample differences, we use the same sample for the main analyses and most
robustness tests. For this purpose, we require data availability for all variables in our main
regression and the alternative measures of earnings quality and competition based on the Compu-
stat data.7 Because our main earnings quality measure requires cash flow from operations for one
future year, our final sample ends in 2015, consisting of 52,332 firm-years.

4.2. Descriptive statistics

Table 1 presents descriptive statistics of our main variables. In this table and all subsequent tables,
we winsorize all the continuous variables at the 1% and 99% levels to mitigate the effects of out-
liers on our results. The mean (median) value of earnings quality measure, AQ_FLOS, is −0.071
(−0.052), similar to that reported in the literature (e.g. Biddle et al. 2009). The mean (median) of
competition measure, COMP_SALE, is 0.842 (0.886), with a standard deviation of 0.145. The
large standard deviation of COMP_SALE relative to its mean value suggests that our sample
has a large range of variation in competition, thus a powerful setting for testing the hypothesised
nonlinear relation.
 Accounting and Business Research 7

Table 1. Descriptive statistics.

Variables Mean Std. Dev. Median 25% 75%
AQ_FLOS −0.0707 0.0625 −0.0516 −0.0846 −0.0322
COMP_SALE 0.8421 0.1448 0.8863 0.8016 0.9400
SIZE 5.0799 2.3276 5.0794 3.3943 6.7494
TOTAL ASSETS 1567.74 4571.03 160.685 29.795 853.5115
MTB 2.1293 2.3711 1.4340 1.0648 2.1827
LEV 0.1706 0.2048 0.1109 0.0017 0.2648
CFO 0.0233 0.3663 0.0782 0.0062 0.1349
STD_CFO 0.1176 0.1392 0.0753 0.0464 0.1282
STD_SALES 0.2986 0.2528 0.2255 0.1363 0.3682
OPRCYCLE 4.6944 0.7592 4.7803 4.3188 5.1674
NEG_EARN 0.3231 0.3197 0.2000 0.0000 0.5000
Note: The sample includes 52,332 USA firm-years from 1988 to 2015.
AQ_FLOS = Our primary measure of earnings quality. It equals the standard deviation of firm-level residuals over the past
five years from estimating the model below for each industry-year with at least 20 observations:
TCAi,t = σ0 + σ1CFOi,t−1 + σ2CFOi,t + σ3CFOi,t+1 + σ4ΔRevenuei,t + σ5PPEi,t + εi,t, where TCA is total current accruals
measured as firm i’s change in current assets, subtracting change in current liabilities and change in cash, and adding
change in debt in current liabilities. CFO is cash flow from operations; ΔRevenue is change in revenue; and PPE is the
amount of property, plant and equipment. All variables are scaled by average assets. It is multiplied by −1 such that a
higher value indicates better accounting quality.
COMP_SALEit = Our
primary measure of product market competition. It is based on the Herfindahl-Hirschman Index,
measured as 1 − Ni=1 x2i , where xi is the market share of sales for firm i among all firms within the same industry. A
higher value of COMP_SALE indicates less concentrated industries, or more competition among firms in the same
industry.
SIZE = the logarithm of total assets.
MTB = the ratio of market-to-book value of assets. Market value of total assets measured as book value of debt plus market
value of common equity (the product of the number of common shares outstanding and the closing stock price at fiscal
year-end). Book value of debt equals total assets minus book value of common equity and deferred taxes.
LEV = long-term debt scaled by total assets.
CFO = cash flow from operations scaled by the average of total assets.
STD_SALES = the standard deviation of sales scaled by the average of total assets, from years t−10 to t−1. At least five
non-missing observations are required.
STD_CFO = the standard deviation of cash flow from operations scaled by the average of total assets, from years t−10 to t
−1. At least five non-missing observations are required.
OPRCYCLE = operating cycle, measured as the logarithm of the sum of the firm’s days of accounts receivable and days of
inventory.
NEG_EARN = the proportion of loss years during the past 10 years.

Table 2 contains correlations among the main variables. COMP_SALE is negatively correlated
with AQ_FLOS, suggesting that more intense competition is associated with worse earnings
quality. However, this result does not account for control variables and a possible nonlinearity
between competition and earnings quality. Turning to other variables, earnings quality is signifi-
cantly correlated with all of them. Below, we further examine the relation between COMP_SALE
and AQ_FLOS with both a nonparametric approach and regressions.

4.3. Results based on the nonparametric approach

To explore the relation between earnings quality and competition without imposing a specific
functional restriction, we use a nonparametric regression to interpolate the data. This procedure
enables us to uncover the underlying structure in the data that might otherwise be missed from
following a parametric approach. Specifically, similar to Aghion et al. (2005), we use a cubic
smoothing spline analysis, which regresses earnings quality on nonlinear continuous functions
of competition that have continuous second derivatives. The spline procedure focuses on two
 8
Table 2. Pearson correlation coefficients among the main variables.
COMP_SALE SIZE MTB LEV CFO STD_CFO STD_SALES OPRCYCLE NEG_EARN
AQ_FLOS −0.108 0.475 −0.393 0.013 0.353 −0.527 −0.334 −0.068 −0.462
COMP_SALE 1 −0.095 0.106 −0.043 −0.073 0.125 0.048 −0.052 0.185

Y. Guo et al.
SIZE 1 −0.295 0.16 0.312 −0.477 −0.315 −0.091 −0.52
MTB 1 0.011 −0.490 0.511 0.155 −0.011 0.346
LEV 1 −0.072 −0.025 −0.028 −0.135 0.046
CFO 1 −0.468 −0.117 −0.064 −0.374
STD_CFO 1 0.387 0.011 0.533
STD_SALES 1 −0.154 0.227
OPRCYCLE 1 0.001
NEG_EARN 1
Note: The sample includes 52,332 USA firm-years from 1988 to 2015. Except the italicised numbers, all correlation coefficients are significant at a p-value of 1% or beyond. All variables
are defined in Table 1.
 Accounting and Business Research 9

items: the squared distance of the fitted value of earnings quality based on the nonlinear function
of competition from the actual value of earnings quality; and a penalty for the curvature in the
function (i.e. the lack of smoothness). The function that minimises the combination of the two
items is selected. The fitted value of earnings quality from this procedure, labelled as the
spline function of competition, sheds light on the underlying relation between competition and
earnings quality.
As shown in Panel A of Figure 2 and consistent with our prediction depicted in Figure 1, the
relation between product market competition and earnings quality exhibits an inverted U-shape.
The relation between AQ_FLOS and COMP_SALE is positive until COMP_SALE reaches 0.85,
or the 40th percentile of our firm-year observations, and then turns negative. Since the inverted U-
shape can be explained by a quadratic function, these results also support our use of equation (1)
to test our hypothesis.8 To provide a more intuitive understanding of the non-linear relation
between competition and earnings quality, we follow the same procedures as for Panel A and
depict the relation between the number of firms (as another proxy for competition) and earnings
quality for six randomly selected industries. Panel B of Figure 2 shows an inverted U-shape in all
six individual industries as well.

4.4. Results based on regression analyses

The nonparametric analysis does not account for the effect of confounding factors on the
relation. Equation (1) mitigates this concern. Per the results in Table 3, the coefficient on
COMP_SALE is positive and the coefficient on COMP_SALE2 is negative, both highly signifi-
cant (p-values < 0.001). The results indicate (1) that higher product market competition
enhances earnings quality at a relatively low level of competition and (2) that as the product
market competition becomes more intense, earnings quality worsens. The results are consistent
with the nonparametric regression results in Figure 2 and further support our hypothesis.9
Turning to control variables, we find that firms with larger size, lower leverage, higher cash
flows, lower market-to-book ratio, lower volatility of operating cash flows, lower volatility of
sales, shorter operating cycle, and fewer loss incidences tend to have better earnings quality,
generally consistent with previous studies (Francis et al. 2005, Chaney et al. 2011). The adjusted
R-squared of 40% suggests that the independent variables in model (1) explain a large extent of
the variation in earnings quality.10

4.5. Variation of the relation between competition and accounting quality with relative
performance and corporate governance
We further examine how the relation between competition and earnings quality varies with
within-industry relative performance and corporate governance, as discussed in our hypothesis
development. We expand equation (1) with an indicator for above-median performance or gov-
ernance within the same industry-year and its interactions with all control variables. We
measure performance as pre-managed net income (net income minus discretionary accruals)
divided by total assets at the beginning of the year (Markarian and Santaló 2014). Discretionary
accruals are estimated from the modified Jones model (Dechow et al. 1995). The results presented
in the first two columns of Panel B of Table 3 show that coefficients on the interactions are oppo-
site to those on the main competition terms, confirming that the non-linear relation between com-
petition and earnings quality is more pronounced among underperformers in terms of both slopes
and the turning points.
10 Y. Guo et al.

Figure 2. The relation between product market competition and earnings quality based on the Spline
approximation. Panel A: The relation between COMP_SALE and earnings quality in the entire sample.
Panel B: The relation between COMP_#FIRM and earnings quality in various industries. Note: The
Spline approximation is a nonparametric regression that regresses earnings quality on various functions of
competition. The selection of the function of competition is based on two factors: the squared distance of
the fitted value of earnings quality from the actual value of earnings quality; and a penalty for the curvature
in the function (i.e. the lack of smoothness). The function that minimises the combination of the two items is
selected. Panel A presents the fitted value of earnings quality from this procedure for the total sample based
on COMP_SALE and AQ_FLOS. Panel B presents the relations between the number of firms in the industry-
year and AQ_FLOS for randomly selected six industries from Fama-French 48 industry classifications.
 Accounting and Business Research 11

Figure 2 Continued

We proxy for governance with the number of analysts following a firm and institutional ownership.
The results in columns (3) to (6) of Panel B suggest that the inverted U-shaped relation is more pro-
nounced among firms with weaker governance, consistent with our argument in Section 2.

5. Sensitivity analyses and additional tests

This section gauges the robustness of our primary results to alternative measures of earnings
quality and competition and the treatment of the potential endogeneity issue. Dechow et al.
(2010) review various proxies for earnings quality and note that the proxies do not seem to
be substitutes of each other, and none is superior in all settings, suggesting that different
measures of earnings quality may reflect different constructs. Similarly, as Karuna (2007) and
Li (2010) point out, competition can have multiple dimensions. Thus, we also employ
various alternative measures of product market competition. The robustness of the results to
alternative measures supports the generalizability of the results to different aspects of earnings
quality and competition.

5.1. Alternative measures of earnings quality

We employ five alternative proxies that capture different dimensions of earnings quality.11 The
first alternative measure is the discretionary portion of our primary earnings quality measure
 12
Table 3. The relation between competition and earnings quality.
Panel A: The relation between competition and earnings quality for the entire sample
Dependent Variable = AQ_FLOS Coeff. t-value

Intercept −0.0792*** −16.74

COMP_SALE 0.0619*** 8.05
COMP_SALE2 −0.0500*** −8.33
SIZE 0.0052*** 42.35
MTB −0.0033*** −16.26
LEV −0.0109*** −7.22
CFO 0.0094*** 5.37
STD_CFO −0.0907*** −22.58
STD_SALES −0.0340*** −24.76
OPRCYCLE −0.0060*** −11.61
−0.0269*** −26.27

Y. Guo et al.
NEG_EARN
Industry fixed effects Yes
Firm and year clustering Yes
Adj. R2 40.49%
N 52332
Panel B: The effect of performance and governance on the relation between competition and earnings quality
Dependent Variable = AQ_FLOS
(1) (2) (3) (4) (5) (6)
Coeff. t-value Coeff. t-value Coeff. t-value
INDICATOR = HIGHER_PERF HIGHER_AF HIGHER_INST
COMP_SALE 0.1611*** 7.11 0.0394*** 3.01 0.0710*** 5.19
COMP_SALE2 −0.1266*** −8.16 −0.0336*** −3.42 −0.0604*** −5.97
INDICATOR 0.0344*** 3.19 0.0059 0.94 0.0098 1.54
COMP_SALE*INDICATOR −0.1134*** −4.18 −0.0330** −2.27 −0.0660*** −4.35
COMP_SALE2*INDICATOR 0.0973*** 5.33 0.0312*** 2.87 0.0597*** 5.35
Intercept and control variables Yes Yes Yes
Control variables*INDICATOR Yes Yes Yes
Industry fixed effects Yes Yes Yes
Industry and year clustering Yes Yes Yes
Adj. R2 40.34% 29.46% 34.28%
N 49,371 46,221 45,874
Note: Panel A presents the results of estimating the following regression based USA firm-years from 1988 to 2015:

AQ FLOSit =b0 + b1 COMP SALEit + b2 COMP SALEit2 + b3 SIZEit + b4 MTBit + b5 LEVit + b6 CFOit
+b7 STD SALESit + b8 STD CFOit + b9 OPRCYCLEit + b10 NEG EARNit (1)
+Industry fixed effects + 1it

For Columns (1) and (2) in Panel B, HIGHER_PERF = 1 when pre-managed net income divided by total assets at the beginning of year is above the industry-year median, and 0
otherwise. Pre-managed net income equals income minus discretionary accruals, which are estimated from the modified Jones model (Dechow et al. 1995): Total Accrualit/Assetsit−1
= β0 + β1(1/Assetsit−1) + β2(ΔRevenueit – ΔAccounts Receivableit) /Assetsit−1 + β3PPEit/Assetsit−1 + β4ROAit + εit. Total Accrual is earnings before extraordinary items minus cash flow
from operations; CFO is cash flow from operations; ΔRevenue is annual change in revenue; ΔAccounts Receivable is annual change in accounts receivable; PPE is the amount of

Accounting and Business Research

property, plant and equipment; and ROA is net income divided by total assets at the beginning of the year.
For Columns (3) and (4) in Panel B, HIGHER_AF = 1 when the number of analysts following the firm-year is above the industry-year median, and 0 otherwise.
For Columns (5) and (6) in Panel B, HIGHER_INST = 1 when institutional ownership for the firm-year is above the industry-year median, and 0 otherwise.
The smaller number of observations in Panel B than that in Panel A is due to requirement of additional data to measure performance, analyst following and institutional ownership. All
other variables are defined in Table 1.

13
14 Y. Guo et al.

(AQ_FLOS_RES). Our hypothesis development suggests that earnings quality is determined by

the financial reporting choice of managers in response to product market competition. Thus,
we expect AQ_FLOS_RES to drive the relation between AQ_FLOS and competition. Following
Francis et al. (2005), we use model (2) below to estimate AQ_FLOS_RES for each industry-year
with at least 20 observations.

AQ FLOSit =s0 + s1 SIZEit + s2 STD CFOit + s3 STD SALESit

(2)
+s4 OPRCYCLEit + s5 NEG EARNit + 1it

All variables are as defined previously. We calculate AQ_FLOS_RES as the residual value from
estimating model (2) for each firm-year, multiplied by −1.
Our second alternative measure, AQ_DD, is estimated from model (3) based on firm-specific
time series (Dechow and Dichev 2002).

TCAi,t = s0 + s1 CFOi,t−1 + s2 CFOi,t + s3 CFOi,t+1 + 1i,t (3)

AQ_DD equals the standard deviation of the firm-level residuals over the past ten years multiplied
by −1.
The third alternative measure, AQ_BLW, follows Beatty et al. (2010). We measure AQ_BLW
as the average of four individual measures that capture different dimensions of earnings quality.
All four measures are estimated from firm-specific time series regressions over the past ten
years.12 The first individual measure equals the decile rank of the adjusted R-squared from esti-
mating equation (3). The second and third individual measures proxy for earnings persistence
and predictability, estimated from the regression of one-year-ahead earnings on current period
earnings. They equal the decile rank of the coefficient on current period earnings and the
decile rank of the adjusted R-squared, respectively. The fourth individual measure proxies for
the ability of earnings to predict future cash flows. It equals the decile rank of the adjusted
R-squared from regressing one-year-ahead operating cash flows on current period earnings.
The fourth alternative measure AQ_MJ is based on the modified Jones model (Kothari et al.
2005) below. AQ_MJ is the absolute value of residual from estimating model (4) for each indus-
try-year, multiplied by −1.

Total Accrualit /Assetsit−1 = b0 + b1 (1/Assetsit−1 )

+ b2 (DRevenueit –DAccounts Receivableit )/Assetsit−1
+ b3 PPEit /Assetsit−1 + b4 ROAit + 1it (4)

Our last alternative earnings quality measure is the negative of the industry-level frequency of
restatements, –FREQ_Restatement, measured as the number of irregularity-type restatements
divided by the number of firms within the same industry in a given year. Hennes et al. (2008)
classify restatements as irregularity-type if ‘fraud’ or ‘irregularity’ is used in the discussion of
the restatement or a restatement is under the investigation from an independent third-party,
such as the SEC or the Department of Justice. We obtain the restatement information from
Hennes et al. (2008) for the period between January 1997 and June 2006.13 For this measure,
the sample is reduced to 22,680 firm-year observations.
As displayed in Panel A of Table 4, AQ_FLOS is highly correlated with three of the five
alternative measures. No other two measures have a correlation above 0.5, suggesting that they
are not substitutes of each other. We re-estimate regression (1) after replacing AQ_FLOS with
Table 4. Robustness tests based on alternative measures of earnings quality.
Panel A: Pearson correlation coefficients among the measures of earnings quality
AQ_FLOS_RES AQ_DD AQ_BLW AQ_MJ −FREQ_Restatement
AQ_FLOS 0.783 0.662 0.124 0.538 0.102
AQ_FLOS_RES 1 0.266 0.101 0.341 0.043
AQ_DD 1 0.134 0.436 0.073
AQ_BLW 1 0.033 0.023
AQ_MJ 0.045
−FREQ_Restatement 1

Accounting and Business Research

Panels B through F: Estimation results based on alternative measures
Panel B: Panel C: Panel D: Panel E: Panel F
AQ_FLOS_RES AQ_DD AQ_BLW AQ_MJ −FREQ_Restatement
Dependent variable = Coeff. t-value Coeff. t-value Coeff. t-value Coeff. t-value Coeff. t-value
COMP_SALE 0.0574*** 3.78 0.0255*** 4.10 0.7549** 2.32 −0.0308 −1.23 0.0321*** 5.05
COMP_SALE2 −0.0459*** −3.80 −0.0187*** −3.88 −0.7640*** −3.10 0.0073 0.42 −0.0403*** −7.79
Intercept and control variables Yes Yes Yes Yes Yes
Industry fixed effects Yes Yes Yes Yes Yes
Firm and year clustering Yes Yes Yes Yes Yes
Adj. R2 4.15% 55.06% 9.81% 24.64% 15.73%

(Continued )

15
Table 4. Continued.

16
Panels B through F: Estimation results based on alternative measures
Panel B: Panel C: Panel D: Panel E: Panel F
AQ_FLOS_RES AQ_DD AQ_BLW AQ_MJ −FREQ_Restatement
Dependent variable = Coeff. t-value Coeff. t-value Coeff. t-value Coeff. t-value Coeff. t-value
N 52,332 52,332 52,332 49,375 22,680
Note: Panel A presents correlation coefficients among various measures of earning quality. Panels A through D are based on 52,332 USA firm-year observations from 1988 to 2015. Panel
E is based on 49,375 firm-years from 1988 to 2015. Panel F is based on 22,680 firm-years from 1997 to 2006. All correlation coefficients are significant at a p-value of 1% or beyond.
Other panels present results of estimating the following regression:

AQmeasureit =b0 + b1 COMP SALEit + b2 COMP SALEit2 + b3 SIZEit + b4 MTBit + b5 LEVit + b6 CFOit
+b7 STD SALESit + b8 STD CFOit + b9 OPRCYCLEit + b10 NEG EARNit + Year fixed effects (1)
+Industry fixed effects + 1it

Y. Guo et al.
AQ measure takes one of the four measures defined below.
AQ_FLOS_RES = The discretionary portion of AQ_FLOS, measured as the residual from estimating the following model (2): AQ_FLOSit = σ0 + σ1SIZEit + σ2STD_CFOit +
σ3STD_SALESit + σ4OPRCYCLEit + σ5NEG_EARNit + εit (2). All the variables in model (2) are defined as in Table 1.
AQ_DD = earnings quality measure based on following the time series model (3) developed by Dechow and Dichev (2002): TCAi,t = σ0 + σ1CFOi,t−1 + σ2CFOi,t + σ3CFOi,t + 1 + εi,t (3),
where, TCA is total current accruals and CFO is cash flow from operations. We first measure the standard deviation of residuals estimated from model (3) for the same firm over the
previous ten years. Then, the standard deviation is multiplied by −1 such that a larger value of AQ_DD indicates better earnings quality.
AQ_BLW = the average of four individual measures that capture different dimensions of earnings quality (Beatty et al. 2010), multiplied by −1 such that a larger value indicates better
earnings quality. All four measures are estimated from the firm-specific time series regressions over the past ten years. The first individual measure equals the decile rank of the adjusted R-
squared from estimating regression (3) above. The second and third individual measures proxy for earnings persistence and predictability, respectively. They are estimated from the
regression of one-year-ahead earnings on current period earnings. The second measure equals the decile rank of the coefficient on current period earnings, and the third measure
equals the decile rank of the adjusted R-squared. The fourth individual measure proxies for the ability of earnings to predict future cash flows, measured as the decile rank of the
adjusted R-squared from regressing one-year-ahead operating cash flows on current period earnings.
AQ_MJ = The absolute amount of residual from estimating equation (4) below for each industry-year.
Total Accrualit/Assetsit−1 = β0 + β1(1/Assetsit−1) + β2(ΔRevenueit – ΔAccounts Receivableit)/Assetsit−1 + β3PPEit/Assetsit−1 + β4ROAit + εit (4)
Total Accrual is earnings before extraordinary items minus cash flow from operations; CFO is cash flow from operations; ΔRevenue is annual change in revenue; ΔAccounts Receivable is
annual change in accounts receivable; PPE is the amount of property, plant and equipment; and ROA is net income divided by assets at the beginning of the year.
−FREQ_Restatement = (−1)*the number of irregularity-type restatements divided by the number of firms within the same industry. According to Hennes et al. (2008), restatements are
classified as irregular if ‘fraud’ or ‘irregularity’ is used in the discussion of the restatement, or a restatement is under the investigation from an independent third-party, the Securities and
Exchange Commission, or the Department of Justice. Industry is defined based on the 3-digit SIC code.
All other variables are defined in Table 1.
 Accounting and Business Research 17

each alternative measure. The results presented in Panels B through F show that our inferences
about an inverted U-shaped relation between earnings quality and competition apply to all the
alternative measures except AQ_MJ. For example, in Panel B, where we use AQ_FLOS_RES,
the coefficient on COMP_SALE (COMP_SALE2) is significantly positive (negative).14 In Panel
F, when we use the frequency of irregularity-type of restatements, the coefficient on COMP_SALE
(COMP_SALE2) is 0.032 (−0.040) and remains significant.15

5.2. Alternative measures of product market competition

We categorise alternative competition measures as (1) competition among existing rivals, (2)
competition from potential entrants, (3) and other types of competition.

5.2.1. Two alternative measures of competition among existing rivals

The first alternative measure of product market competition, COMP_ASSET, is measured the
same as COMP_SALE except that total assets rather than sales are used to compute the Herfin-
dahl-Hirschman Index (Hou and Robinson 2006). We measure the second alternative measure,
COMP_#FIRM, as one minus the inverse of the number of firms within the same industry (see
Li 2010).

5.2.2. Two alternative measures of competition from potential entrants

We calculate two alternative measures of competition from potential entrants, COMP_PPE and
COMP_R&D, both of which indicate industry level entry cost. COMP_PPE equals the negative
of the logarithm of the weighted average of property, plant, and equipment for all firms within the
same industry year. The weight is each firm’s sales divided by total sales for its industry. We view
an industry with a larger amount of property, plant, and equipment as having a higher set-up cost
for potential competitors to enter and thus less competition from potential entrants (Sutton 1991,
Karuna 2007). The other measure, COMP_R&D, is computed the same as COMP_PPE except
that the amount of R&D replaces the amount of property, plant, and equipment.16 For both
measures, a larger value indicates stronger competition.

5.2.3. Two other measures of competition: industry profitability and market size
Li (2010) suggests that industry-level profitability (COMP_ROA) and market size
(COMP_MKTSIZE) could represent competition from both existing rivals and potential entrants. We
calculate COMP_ROA as 1 minus the industry level return on assets (ROA), which equals total net
income divided by total assets for the industry so that higher COMP_ROA indicates more competition.
Higher profitability could reflect both less price competition among existing competitors (Nevo 2001)
and more competition from potential entrants through attracting more companies to enter the market,
which suggests a negative correlation between competition among existing competitors and that
from a potential entrant. We compute COMP_MKTSIZE as the negative of the natural logarithm of
aggregate industry sales scaled by the maximum value among the sample. The scaling transforms
COMP_MKTSIZE to a range close to other competition measures and eases the comparison among
the results based on different competition measures. COMP_MKTSIZE could proxy for both compe-
tition among existing competitors and that from potential entrants (Li 2010). For the former, to the
extent that market size is positively correlated with the number of firms, a larger market size indicates
stronger competition. For the latter, it could indicate either stronger customer demand and thus attract
potential competitors to the industry, resulting in greater competition (Sutton 1991), or a higher entry
18 Y. Guo et al.

barrier due to usually heavy investment in fixed assets or technology associated with industries with
large sales (Li 2010) and thus weaker competition from potential rivals.

5.2.4. Results based on the six alternative measures of competition

Panel A of Table 5 presents the correlation coefficients among all the competition measures. We
observe positive correlations among the three measures for competition from existing rivals,
COMP_SALE, COMP_ASSET, and COMP_#FIRM, between the two measures of competition
from potential entrants, COMP_R&D and COMP_PPE, and negative correlations between the
two sets of measures. Both COMP_ROA and COMP_MKTSIZE are negatively (positively) cor-
related with the proxies for competition from existing rivals (potential entrants), implying their
dual roles in the two dimensions of competition. The signs of the correlations among the compe-
tition measures are mostly consistent with the literature (Karuna 2007, Li 2010).
We estimate model (1) after replacing COMP_SALE with each of the six alternative measures
of competition. Panels B through G of Table 5 present the results. With the exceptions of
COMP_MKTSIZE and COMP_PPE, results based on the alternative proxies for competition
are consistent with those in Table 3.17 Regarding the insignificant results for COMP_PPE, we
interpret them as indicating that our hypothesised relation between earnings quality and compe-
tition applies less to competition from potential entrants than to competition among incumbents.
Insignificant results based on COMP_MKTSIZE could be a reflection of various distinct dimen-
sions of competition, as explained above.18

5.3. Analyses based on composite measures of earnings quality and competition

In this section, we create composite measures of earnings quality and competition to more fully
capture their various dimensions. For the composite measure of earnings quality, ALL_AQ, we
rank the main and four alternative earnings quality measures in Table 4 in deciles and take the
average. We exclude earnings restatement frequency from the composite measure since its
inclusion significantly reduces the sample size. To compute the composite measure of compe-
tition, ALL_COMP, we take the average of the decile ranks of the main and all alternative
measures of competition in Table 5. We then re-estimate model (1) with the two composite
measures. Our sample size is reduced to 45,622 firm-year observations due to data requirements
for AQ_MJ and COMP_R&D. The results reported in Panel A of Table 6 show that we continue to
document an inverted U-shaped relation between the composite measures of earnings quality and
competition.

5.4. Analyses based on industry-year measures

In this section, we replace all firm-year level variables in model (1) with their respective industry-
year means and estimate it at the industry level. Panel B of Table 6 presents the estimation results
based on 3,032 industry-year observations. The results confirm our main inference about the non-
linear relation between competition and earnings quality, mitigating the concern that industry
effect, rather than competition, drives the results.

5.5. Analysis based on tariff rates

Since our proxies for competition so far are based only on public firms available in the Compustat,
we also employ two alternative measures to incorporate competition from non-public firms. The
Table 5. Robustness tests based on alternative measures of competition.

COMP_ASSET COMP_#FIRM COMP_ROA COMP_MKTSIZE COMP_PPE COMP_R&D

Panel A: Pearson correlation coefficients among the measures of product market competition

COMP_SALE 0.954 0.785 −0.061 −0.635 −0.187 −0.256

COMP_ASSET 1 0.746 −0.049 −0.590 −0.136 −0.213
COMP_#FIRM 1 −0.070 −0.630 −0.321 −0.327
COMP_ROA 1 0.245 0.242 0.247
COMP_MKTSIZE 1 0.742 0.545
COMP_PPE 1 0.530
Panels B through G: regression results based on alternative measures of competition

COMP Panel B: Panel C: Panel D: Panel E: Panel F: Panel G:

Accounting and Business Research

(=Alternative COMP_ASSET COMP_#FIRM COMP_PPE COMP_R&D COMP_ROA COMP_MKTSIZE
competition
measure) Coeff. t-value Coeff. t-value Coeff. t-value Coeff. t-value Coeff. t-value Coeff. t-value

COMP 0.0527*** 7.56 0.2916*** 5.24 0.0003 0.15 0.0006*** 5.83 0.4826*** 5.93 −0.0319 −1.25
COMP2 −0.0447*** −8.03 −0.1757*** −5.33 0.0000 −0.10 −0.0001*** −5.24 −0.2553*** −6.15 −0.0311* −1.92
Intercept and Yes Yes Yes Yes Yes Yes
control
variables
Industry fixed Yes Yes Yes Yes Yes Yes
effects
Firm and year Yes Yes Yes Yes Yes Yes
clustering
Adj. R2 40.50% 40.46% 40.43% 40.53% 40.50% 40.48%
N 52,332 52,332 52,332 47,786 52,332 52,332

Note: Panel A presents correlation coefficients among various measures of competition. All are based on 52,332 USA firm-years from 1988 to 2015 except COMP_R&D, which is based
on 47,786 observations. All correlation coefficients are significant at a p-value of 1% or beyond. Other panels present the results of estimating the following equation:

AQ FLOSit =b0 + b1 COMPit + b2 COMPit2 + b3 SIZEit + b4 MTBit + b5 LEVit + b6 CFOit

+b7 STD SALESit + b8 STD CFOit + b9 OPRCYCLEit + b10 NEG EARNit
+Industry fixed effects + 1it ,

where COMP is measured in one of the six ways defined as follows: COMP_ASSET = defined the same as COMP_SALE except that total assets are used instead of sales; COMP_#FIRM
= 1− 1/the number of firms with the same three-digit SIC code; COMP_ROA = 1− industry level (categorised by the three-digit SIC codes) return on assets, calculated as aggregate
industry net income divided by aggregate industry total assets; COMP_MKTSIZE = (−1)*the logarithm of aggregate industry sales scaled by the maximum value of the whole
population; COMP_PPE = (−1)*logarithm of the weighted average of property, plant, and equipment for all firms within the same industry-year. The weight is each firm’s sales
divided by total sales for the industry; COMP_R&D = (−1)*logarithm of the weighted average of research and development expense for all firms within the same industry year. The

19
weight is each firm’s sales divided by total sales for the industry. All other variables are defined in Table 1.
 20
Table 6. Additional robustness tests based on alternative specifications of earnings quality and competition, and different data aggregation.
Panel C: Industry-
year analysis of the Panel D: Firm-year analysis of the
Panel A: Firm-year analysis based on relation between relation between AQ_FLOS and
composite measures of earnings quality Panel B: Industry-year analysis of the relation between AQ_FLOS_MEAN COMP_LLM (firm-year level
(ALL_AQ) and competition (ALL_COMP) AQ_FLOS_MEAN and COMP_SALE and COMP_TR competition measure)
Coeff. t-value Coeff. t-value Coeff. t-value Coeff. t-value
Intercept 3.9402*** 30.38 Intercept −0.0312*** −3.92 −0.7848*** −3.15 Intercept −0.0431*** −8.62
ALL_COMP 0.2793*** 6.6 COMP_SALE (or 0.0357*** 2.87 1.7346*** 3.17 COMP_LLM 0.0300*** 2.95

Y. Guo et al.
COMP_TR)
ALL_COMP −0.0365*** −8.05 COMP_SALE2 (or −0.0319*** −3.20 −0.9451*** −3.17 COMP_LLM2 −0.0688** −2.43
COMP_TR2)
SIZE 0.1830*** 43.77 SIZE_MEAN 0.0029*** 5.93 0.0033*** 4.92 SIZE 0.0038*** 21.64
MTB −0.0117*** −2.93 MTB_MEAN −0.0024*** −2.89 −0.0044*** −3.77 MTB −0.0011*** −3.29
LEV −0.3813*** −9.73 LEV_MEAN 0.0063 1.29 0.0043 0.60 LEV −0.0068*** −3.71
CFO 0.0637** 2.4 CFO_MEAN 0.0081 1.09 0.0045 0.40 CFO 0.0226*** 5.50
STD_CFO −0.2026** −2.58 STD_CFO_MEAN −0.1188*** −6.53 0.0264 0.82 STD_CFO −0.0642*** −9.91
STD_SALES −0.8658*** −23.92 STD_SALES_MEAN −0.0321*** −7.72 −0.0396*** −4.48 STD_SALES −0.0338*** −18.28
OPRCYCLE −0.2038*** −14.59 OPRCYCLE_MEAN −0.0049*** −4.77 −0.0121*** −5.93 OPRCYCLE −0.0082*** −11.92
NEG_EARN −1.0678*** −32.84 NEG_EARN_MEAN −0.0343*** −7.57 −0.0505*** −5.83 NEG_EARN −0.0141*** −9.40
Year clustering Yes Yes Yes Yes
Industry fixed Yes No No Yes
effect
Firm clustering Yes Industry clustering Yes Yes Firm clustering Yes
Adj. R2 (%) 26.66 Adj. R2 36.23 35.93 Adj. R2 22.96
N 45,662 N 3,032 1,114 N 17624
Note: Panel A presents the results of estimating the following equation for 45,662 USA firm-year observations from 1988 to 2015:

ALL AQit =b0 + b1 ALL COMPit + b2 ALL COMPit2 + b3 SIZEit + b4 MTBit + b5 LEVit
+b6 CFOit + b7 STD SALESit + b8 STD CFOit + b9 OPRCYCLEit + b10 NEG EARNit
+Industry fixed effects + 1it ,

where, ALL_AQ and ALL_COMP are composite measures of earnings quality and competition, respectively. For ALL_AQ, we rank the five earnings quality measures (AQ_FLOS,

Accounting and Business Research

AQ_FLOS_RES, AQ_DD, AQ_MJ, and AQ_BLW) in deciles and compute the average of the ranked values. To compute ALL_COMP, we apply similar procedures to the following
competition variables: COMP_SALE, COMP_ASSET, COMP_#FIRM, COMP_PPE, COMP_R&D, COMP_ROA, and COMP_MKTSIZE. Because the requirement of earnings
restatement frequency significantly reduces the sample size, we exclude it from the computation of the composite earning quality measure.
Panels B and C present the results of estimating the following equation. The results in Panel B (Panel C) are based on 3,032 (1,114) industry-year observations from 1989 to 2005:

AQ FLOS MEANit =b0 + b1 COMP SALEit (or COMP TRit ) + b2 COMP SALEit2 (or COMP TR2it )
+b3 SIZE MEANit + b4 MTB MEANit + b5 LEV MEANit + b6 CFO MEANit
+b7 STD SALES MEANit + b8 STD CFO MEANit + b9 OPRCYCLE MEANit
+b10 NEG EARN MEANit + 1it

Where, COMP_TR = 1 − tariff rate for industry-years with tariff rate available from 1989 to 2005. Tariff rate is computed as duties collected by USA Customs divided by the Free-on-
Board value of imports. A higher value indicates more intense competition.
Panel D presents the results of estimating the following equation for 17,624 firm-year observations from 1995 to 2009:

AQ FLOSit =b0 + b1 COMP LLMit + b2 COMP LLMit2 + b3 SIZEit + b4 MTBit

+b5 LEVit + b6 CFOit + b7 STD SALESit + b8 STD CFOit + b9 OPRCYCLEit
+b10 NEG EARNit + Industry fixed effects + 1it

Where,
COMP_LLM = firm-level estimate of competition developed by Li et al. (2013). It is measured as the number of words related to ‘competition’ divided by the number of total words in a
firm’s 10-K filing. It is scaled by the maximum value among the sample.
All other variables are defined in Table 1. For panels B and C the industry mean for each corresponding variable is used.

21
22 Y. Guo et al.

first one is based on tariff rates, as described below. The other one is based on managers’ per-
ceived competition and described in the next section.
We use import tariff rates compiled by Schott (2008), available for 1,115 industry-years from
1989 to 2005.19 The literature argues that a reduction in import tariff rates facilitates the pen-
etration of foreign rivals into local markets and increases competition. Previous studies document
that more intense competition associated with tariff rate reduction results in increased cost of debt
(Valta 2012) and decreased capital expenditures (Frésard and Valta 2014). We measure
COMP_TR as 1 minus tariff rate so that a higher value indicates more intense competition.
Through squeezing profitability and market share of domestic firms, foreign firms that enjoy
low tariff rates strengthen domestic firms’ incentives to manage earnings. On the other hand,
to the extent that their financial information is not publicly available or is prepared under a stan-
dard not comparable to USA GAAP, foreign firms provide no or weak constraints on domestic
firms’ earnings management opportunities.
We estimate equation (1) after replacing COMP_SALE with COMP_TR and replacing other
independent variables with industry-year means. As shown in Panel C of Table 6, the coefficient
on COMP_TR (COMP_TR2) is significantly positive (negative), again consistent with our main
results in Table 3. Consistent with our discussion above that such competition from foreign
firms due to the reduction in tariff rates mainly provides incentives to manage earnings, the
turning point is at the 14th percentile of the sample (or at a value of 0.9177), which is much
lower than our main results based on COMP_SALE.

5.6. Analysis based on managers’ perceived competition

Managers’ perceived competition (COMP_LLM) is measured for each firm-year and developed
by Li et al. (2013), available for the period of 1995–2009.20 It equals the frequency of references
to competition divided by the total number of words in a firm’s 10-K filing. A larger value indi-
cates management’s perception of higher competition. We scale it with the maximum among the
sample so that its value is comparable to other competition measures. The results in Panel D of
Table 6 based on the sample of 17,624 firm-years continue to support an inverted U-shaped
relation between earnings quality and competition.21 Overall, the results in this section further
mitigate concerns about the construct validity of competition measure.22

5.7. Discussion of our results and economic significance

Overall, we find an inverted U-shaped relation exists for most competition measures. However,
we observe a large variation in the turning points with different measures of competition,
especially between proxies for competition among existing rivals and those for competition
from potential entrants. For example, per Table 3, the turning point for COMP_SALE is at
0.619 (= 0.0619/(0.050 × 2)), or the 8th percentile of our sample firm-years and the 27th percen-
tile of the industry-years. When COMP_R&D is used in Table 5, the inflection is around the 92nd
percentile of our sample firm-years and the 83th percentile of the industry-years. This variation is
also consistent with our argument that the combination of the influence of competition on oppor-
tunities and incentives to manage earnings explains the nonlinearity in the relation between com-
petition and earnings quality. Compared to competition from potential entrants, competition
among existing rivals creates stronger incentives to manage earnings upward and thus a wider
range of competition being negatively correlated with earnings quality. In contrast, when
facing potential competitors, management may engage in upward earnings management less
aggressively or even manage earnings downward to deter potential entrants, consistent with a
 Accounting and Business Research 23

positive relation between earnings quality and competition from potential entrants for the majority
of the sample.
The turning point based on COMP_ROA is at 45% of our sample firm-years (and 33% of our
sample industry-years), which is between that for competition among existing rivals and that for
competition from potential entrants. This finding is consistent with our early argument that
COMP_ROA may reflect both types of competition. The relatively higher turning points for
COMP_R&D and COMP_ROA than those for competition among existing rivals suggest that
when entry barriers and/or industry profitability shrinks to a larger extent (i.e. at their highest com-
petition level), fierce competition can create earnings management incentives that are stronger
than its constraints on earnings manipulation.
Finally, due to various dimensions of competition, we also assess the economic significance of
our results based on the composite measure, ALL_COMP. The results reported in Table 6 show
that the turning point based on ALL_COMP is at approximately the 27th percentile of competition
among the firm-years.23

Table 7. Treatment of endogeneity: the relation between tariff rate reduction and change in earnings quality.
ΔAQ_FLOS_MEANt + 1
Dependent variable =
Coeff. t-value
Intercept 0.0315** 2.62
ΔCOMPETE_TR 54.7682** 2.09
COMPETE_TR · ΔCOMPETE_TR −55.6683* −1.91
ΔSIZE_MEAN −0.0283 −0.92
ΔMTB_MEAN 0.0337 1.32
ΔLEV_MEAN 0.2402 1.10
ΔCFO_MEAN 0.2829* 1.73
ΔSTD_CFO_MEAN −0.5817 −0.84
ΔSTD_SALES_MEAN −0.3043 −1.59
ΔOPRCYCLE_MEAN 0.0303 0.30
ΔNEG_EARN_MEAN −0.2062 −0.87
Year clustering Yes
Industry clustering Yes
Adj. R2 2.33%
N 954
Note: This table presents the results of estimating the following regression for 954 industry-years with annual tariff rate
change from 1989 to 2005:

DAQ FLOS MEANi,t+1 =b0 + b1 DCOMP TRit + b2 COMP TRit · DCOMP TRit
+b3 DSIZE MEANit + b4 DMTB EMANit + b5 DLEV MEANit
+b6 DCFO MEANit b7 DSTD SALES MEANit + b8 DSTD CFO MEANit
+b9 DOPRCYCLE MEANit + b10 DNEG EARN MEANit + 1it

Where:
ΔAQ_FLOS_MEANi,t+1 = (AQ_FLOS_MEANi,t+1 − AQ_FLOS_MEANit) / AQ_FLOS_MEANit.
COMP_TR = 1− tariff rate for industry-years with tariff rate available from 1989 to 2005. Tariff rate is computed as duties
collected by USA Customs divided by the Free-on-Board value of imports. A higher value indicates more intense
competition.
ΔCOMP_TR = − (tariff ratet − tariff ratet−1) / (1−tariff ratet−1).
All other variables are defined in Table 1. This table uses the annual change in the industry mean of each variable. For
example, ΔSIZE_MEANit equals the annual change in the industry-mean of firm assets.
24 Y. Guo et al.

5.8. Addressing the endogeneity issue

To address the concern that earnings quality and competition are endogenously determined, we
identify a setting where competition change is exogenous. Following the literature (Frésard
2010, Frésard and Valta 2014, Valta 2012), we use import tariff rate reduction as an exogenous
shock for competition increase. Specifically, we estimate the following model (5) to examine
the impact of tariff rate reduction on earnings quality change:24

DAQ FLOS MEANi,t+1 =b0 + b1 DCOMP TRit + b2 COMP TRit · DCOMP TRit
+b3 DSIZE MEANit + b4 DMTB MEANit + b5 DLEV MEANit
+b6 CFO MEANit + b7 DSTD SALES MEANit + b8 DSTD CFO MEANit
+b9 DOPRCYCLE MEANit + b10 DNEG EARN MEANit + 1it
(5)

where
ΔAQ_FLOS_MEANi,t + 1 = (AQ_FLOS_MEANi,t + 1 – AQ_FLOS_MEANit)/AQ_FLOS_MEANit;
COMP_TR = 1 – tariff ratet; ΔCOMP_TR = – (tariff ratet – tariff ratet−1).
From an inverted U-shaped relation between earnings quality and competition, we expect a
positive (negative) relation between change in competition and change in earnings quality
when competition is low (intense). Thus, we expect a positive β1 and a negative β2. Other vari-
ables are as defined in model (1) except that the change in the industry-year mean is used (Balak-
rishnan and Cohen 2014). For example, ΔSIZE_MEANit is defined as the annual change in the
industry-year mean of total assets.25 The results in Table 7 show a significantly positive β1 and
a significantly negative β2. The results support our expectation of an inverted U-shaped relation
between accounting quality and competition and also corroborate the results in Table 3 and further
mitigate endogeneity concerns.

6. Conclusion
The literature documents conflicting results regarding the relation between product market com-
petition and earnings quality (Karuna et al. 2012, Markarian and Santaló 2014, Tinaikar and Xue
2009, Balakrishnan and Cohen 2014, Laksmana and Yang 2014). We revisit this relation by
allowing for a nonlinear influence of competition on earnings management. Drawing on the lit-
erature that examines the effect of rivals on the information environment and profit prospect,
we hypothesise and show an inverted U-shaped relation between competition and earnings
quality. The results are robust to a battery of alternative measures of earnings quality and
product market competition, as well as the treatment of potential endogeneity problems.
However, this paper does not explicitly examine causal factors for the inverted U-shaped relation,
which we leave to future research.
The results in this paper have two novel implications for the literature. First, since the relation
between product market competition and earnings quality is nonlinear, the overall relation (that
does not consider nonlinearity) could be positive or negative, depending on whether the positive
relation or the negative relation dominates in the sample examined. Second, we find that the
turning point for the nonlinear relation between competition and earnings quality varies widely
among the different dimensions of competition, such as competition among existing rivals, com-
petition from potential entrants, and management perception of competition.
 Accounting and Business Research 25

Acknowledgements
We thank the editor, two anonymous reviewers, Taesik Ahn, Bok Baik, Bjorn Jorgensen, Qianqiu Liu, Willie
Reddic (discussant), Ghon Rhee, Jaeyong Shin, David Wang, and workshop participants at Seoul National
University, the University of Connecticut, the University of Hawaii at Manoa, and 2014 Northeast AAA
meeting (Best paper award winner) for their helpful suggestions and comments.

Disclosure statement
No potential conflict of interest was reported by the authors.

Data availability
All data used in this study are publicly available from the sources identified in the text.

Notes
1. We define earnings quality as the ability of earnings to measure a firm’s financial performance (e.g.
Statement of Accounting Concepts No. 1, Dechow and Dichev 2002; Dechow et al. 2010). We
measure it in multiple ways developed in the literature, including the extent to which working
capital accruals map into cash flows (Francis et al. 2005) and earnings restatement frequency
(Hennes et al. 2014).
2. Our study does not completely rule out other alternative explanations for the conflicting results in the
literature. For example, the different results could be due to selections of different sample firms,
periods, or proxies for earnings quality and competition. Thus, when feasible, we hold a constant
sample for different proxies for earnings quality and competition. We also replicate two studies and
still document the nonlinear relation in their empirical settings (see Section 4).
3. Hart’s model assumes that management does not value income above a certain level. Once manage-
ment utility strictly increases with income, Scharfstein (1988) shows that competition actually
increases management slack.
4. Our hypothesis development and the model derivation in the Appendix make two implicit assump-
tions. First, at the lowest level of competition, managers still have incentives to manage earnings
due to, e.g. incentives to hide inefficiency or meet thresholds specified in various contracts with sta-
keholders, such as compensation contracts or debt contracts. Second, fierce competition does not elim-
inate opportunities to manipulate earnings. Thus, our empirical analyses serve as joint tests of these
assumptions and our hypothesis.
5. We also measure competition for year t−5 and year t−3 such that competition (partially) lags the
accounting quality proxy. Untabulated results based on these measures are qualitatively similar to
those in Table 3. For firms with multiple segments, we also recompute COMP_SALE as the weighted
average of competition in all the industries in which the firms operate (Markarian and Santaló 2014).
The weight for each industry is sales in the industry as a percentage of the firm’s total sales based on
Compustat Segment data. Untabulated results based on this measure are qualitatively similar to those
in Table 3.
6. At least five non-missing observations are required for STD_SALES, STD_CFO and NEG_EARN.
7. We also relax the requirement of a constant sample and use the maximum number of observations for
the main test and the robustness tests. Our main results and inferences are mostly robust to this change.
8. When we instead use the number of firms within each industry to proxy for competition, the graph
exhibits an inverted U-shape (not reported) similar to Panel A of Figure 2.
9. Without the squared term of competition in equation (1), the estimated coefficient on competition is
significantly negative, consistent with univariate correlation.
10. To assess the generalizability of the nonlinear relation we document, we replicate Balakrishnan and
Cohen (2014) and Karuna et al. (2012) and further allow for nonlinearity in their settings. We
select these two papers due to their opposite results and their selection of a wide range of firm
years and industries. We confirm their respective results when not considering nonlinearity. More
importantly, we document nonlinearity between competition and earnings quality based on their
samples. Results are available upon request.
26 Y. Guo et al.

11. We choose to examine each of the proxies separately for two reasons. First, using individual measures
facilitates comparison of results in this paper with those in other studies. Second, we can gauge the
robustness of the results to alternative measures of earnings quality and thus mitigate concerns
about measurement error driving the results. For the same reasons, in the next subsection, we
employ individual competition proxies. In section 5.3, we further construct composite measures of
earnings quality and competition and document robust results based on the composite measures.
12. For the estimation of both AQ_DD and AQ_BLW for each firm-year, we require at least eight years’ data.
13. This dataset was obtained from Andy Leone’s website at https://sbaleone.bus.miami.edu. It could also
be collected from the GAO dataset (www.gao.gov) after eliminating multiple announcements of the
same restatement and additional restatements by the same firm and after correcting data errors.
14. In untabulated tests, where we examine the estimated innate portion of earnings quality, the coefficient
on COMP_SALE (COMP_SALE2) is −0.002 (0.001) with a t-value of −1.24 (1.14). Taken together,
these results imply that earnings quality at management’s discretion drives the results in Table 3.
15. In untabulated results, we also document an inverted U-shaped relation between competition and earn-
ings smoothness, which is measured as the ratio of standard deviation of assets-scaled earnings before
extraordinary items to the standard deviation of assets-scaled cash flow from operations (Leuz, Nanda,
and Wysocki 2003).
16. Firm years with missing R&D expenses in the Compustat are set to zero. If none of the firms in an
industry report R&D expenses, we exclude the industry from the analysis. Thus, the sample for this
analysis is reduced from 52,332 to 47,786 firm-year observations.
17. We also use the natural logarithm of the number of firms within each industry and find that the results
(untabulated) are consistent with those in Panel C of Table 5.
18. We also include COMP_SALE, COMP_R&D, COMP_ROA, and COMP_MKTSIZE and their squared
terms simultaneously in model (1) to analyze the relations between earnings quality and different types
of competition. The coefficients on each competition measure and its squared term have similar mag-
nitude to those in Tables 3 and 5, suggesting that competition among existing rivals and competition
from potential entrants are distinct from each other.
19. The tariff data is available from Schott’s webpage at http://faculty.som.yale.edu/peterschott/sub_
international.htm and from the NBER website at http://www.nber.org/. Tariff is computed as duties col-
lected by U.S. Customs divided by the Free-on-Board value of imports. The original U.S. import data
in Schott (2008) are provided by Feenstra (1996), Feenstra et al. (2002), and the U.S. Customs Service.
20. We retrieve the data from http://webuser.bus.umich.edu/feng/.
21. Li et al. (2013) find that COMP_LLM reflects aspects of competition distinct from other measures. In
untabulated results, we find that in general, COMP_LLM is significantly positively correlated with the
other competition measures except an insignificant correlation with COMP_MKTSIZE and a negative
correlation with COMP_R&D. The absolute magnitude of all correlation coefficients is at or below
0.111.
22. In untabulated results, we use the Herfindahl-Hirschman Index provided by the U.S. Census Bureau for
only the manufacturing sector and do not find a significant relation between competition and earnings
quality (see also Ali, Klasa, and Yeung 2009). We find that the competition measure based on the
census data is more highly correlated with competition from potential entrants (correlation coefficient
is above 0.26) than competition among existing rivals (correlation coefficient is below 0.10), and has
low standard deviation (0.05 versus 0.14 for COMP_SALE) due possibly to it being collected once
every five years. The former property suggests a weak relation with earnings quality, as documented
in Table 5, and the latter suggests the lower power of this measure.
23. One caveat of the composite competition is that we assign equal weight to each individual measure
when their economic effects may vary. Nonetheless, we believe that these results provide a reasonable
estimate of the economic significance of our findings.
24. We derive model (5) from model (1). Taking the derivative of earnings quality on competition from
regression (1) yields dAQ_FLOS = β1·dCOMP_SALE + 2β2·COMP_SALE·dCOMP_SALE. We then
replace the earnings quality variable with its industry mean and competition variable with the tariff rate.
25. For consistency with our main tests, we also measure the control variables at firm-year levels and docu-
ment results consistent with Table 7. As described in Section 5.4, our main results are also robust to
measuring control variables at industry-year level or firm-year level.
26. Note that in (a), we assume under-performing firms have stronger incentives to manage earnings, likely
upward (see Markarian and Santaló 2014). However, our hypothesis of a nonlinear relation does not
depend on this assumption and holds for both upward and downward earnings management. In Section
4.5, we further explore the interaction of relative performance with competition. In addition, we
 Accounting and Business Research 27

assume a linear relation between incentives and competition in (a). To the extent that the effect of com-
petition on performance and liquidity risk is larger when competition is fiercer, the relation can be
convex (e.g. I + COMP2/P). Imposing this nonlinear relation leads to a similar inference.

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Appendix
To explicitly illustrate the two influences of competition on earnings management, we adopt specific func-
tional forms to demonstrate how they can lead to a nonlinear relation between competition and earnings man-
agement. In equation (a) below, we assume that earnings management incentives are negatively correlated
with performance and positively correlated with competition (COMP).26

(a) Incentives = I + COMP/P

where I > 0 and represents the level of earnings management incentives such as those related
to compensation or debt covenants or hiding operating inefficiency from managerial slacks when
there is no competition. P represents relative performance within an industry. We normalise
COMP to range from 0 (no competition) to 1 (highest competition).
The opportunities to manage earnings decrease with competition due to the informational
effect of competition, which leads to equation (b):

(b) Opportunities = O − a·ln(1 + COMP)

where O indicates the maximum opportunities available when there is no competition, which
can be a function of earnings management constraint due to the earnings management of previous
years (Barton and Simko 2002), and a is a positive scalar. We assume O is greater than a·ln(2), i.e.
competition does not eliminate earnings management opportunities. The relation in (b) reflects a
larger marginal effect on opportunities at a lower level of competition. For example, when an
industry has two companies, information provided by one additional rival is presumably more
revealing about a firm’s management effort and performance than when the industry already
has fifty competitors. The relation is also consistent with the finding by Hong and Kacperczyk
(2010) that competition among analysts constrains analyst forecast bias to a larger extent when
firms are followed by fewer analysts, where analysts face less competition.
Based on (a), the marginal change in earnings management incentives for each unit change of
competition is dIncentives/dCOMP = 1/P. Based on (b), the marginal change in opportunities
for each unit change of competition is dOpportunities/dCOMP = −(a/(1 + COMP)). Thus,
the net marginal effect of competition change on earnings management tendency is summarised
in (c) below:

(c) 1/P − (a/(1 + COMP)).

Thus, when 1/P − (a/(1 + COMP) . 0, i.e. 1 + COMP > aP, earnings management ten-
dency increases with competition, and thus, earnings quality worsens as competition increases.
In contrast, when 1 + COMP is below aP, earnings management tendency decreases with compe-
tition, and thus, earnings quality improves as competition increases. By definition, earnings
quality decreases with earnings management, as in earnings quality = quality absent earnings
management – earnings management. The above discussion predicts an inverted U-shaped
relation between competition and earnings quality.