Earnings Management Dynamics and Deregulation: Case of the U.S. Airline Industry(WORKING PAPERS)

Abstract

This paper examines earnings management dynamics in the airline industry around the industry deregulation of 1978. The corporate-governance-dynamics hypothesis (Kole and Lehn, 1999) suggests that there exists a time lag of the internal corporate governance systems in adapting to new industry environments. Since industry deregulations expand managerial discretion rapidly whereas internal corporate governance systems are sluggish at adapting to the newly changed environment, the magnitude of earnings management is expected to increase in the post-deregulation period. As corporate governance structures become more effective in tempering highly discretionary managers and as capital markets learn more about how to design better management incentive systems, managers incentives and capacity to distort their earnings report will diminish. From the industry data, we find that the magnitude of discretionary accruals increased significantly in the post-deregulation period. Managers in the airline industry were also inclined to overstate their earnings after deregulation. The increased level of discretionary accruals of those airline companies, however, dwindled afterwards close to the level of the regulation period. Our findings support the predicted deregulation impact on earnings management dynamics.