Abstract

۱٫ Introduction

۲٫ Hypothesis development

۳٫ Data and methodology

۴٫ Empirical result

۵٫ Conclusions

CRediT authorship contribution statement

Acknowledgements

References

Abstract

     By utilizing listed firms inand China from 2014 to 2018, this paper investigates how air pollution affects firms’ accrual earnings management. Empirical results show that higher air pollution promotes a firm’s earnings management. Next, we conduct a series of robustness checks, including a random discontinuity design regression and an instrumental variable regression; and confirm the causal effect of air pollution on companies’ earnings manipulation behaviors. Our results indicate that air pollution affects earnings management by lowering labor productivity and strengthening executives’ negative sentiments. In the additional analysis, air pollution transfers firms’ real earnings management to accrual earnings management. Finally, we found that the positive effect of air pollution on earnings management is more pronounced in firms in low polluting industries and non-state-owned firms. In summary, our study not only enriches the literature on how the external natural environment reshapes firms’ behaviors but also contributes to the literature on the determinants of firms’ earnings management. Our research could also provide policy implications for developing countries to balance the relationship between environmental protection and economic development

Introduction

     In most developing countries, rapid economic development and industrialization are associated with environmental pollution, especially air pollution. According to the 2018 Environmental Performance Index Report, which was constructed by Yale University and Columbia University, China’s environmental performance ranks 120th out of 180 countries, and 20% of the deaths in China are associated with air pollution. In addition to physical health, air pollution could also reshape human sentiment and decisions (Qin and Zhu, 2018; Roback, 1982) and affect firms’ behaviors (Shen et al., 2020; Tan et al., 2021; Wang et al., 2021a; Wang et al., 2021b; Zhang et al., 2021). Our paper intends to examine the impact of air pollution on firms’ accruals earnings management.

     Air pollution might reshape a firm’s earnings management in two ways. First, air pollution is detrimental to labor productivity and increases operating costs (Chang et al., 2016; Graff Zivin and Neidell, 2012; Zhu et al., 2022). The existing literature shows that air pollution lowers employees’ cognitive capacity and psychological concentration, finally resulting in lower productivity (Graff Zivin and Neidell, 2012; Heyes et al., 2016) and reducing firms’ total factor productivity (Li et al., 2020). On the other hand, air pollution might affect managerial sentiment and finally change firms’ earnings management. Previous studies show that air pollution could reshape investors’ and funds managers’ sentiment, thereby altering their risk preferences and lowering investment returns and volatility (Ding et al., 2021; Lepori, 2016; Wu et al., 2018). Besides, air pollution could also impact managerial sentiment and ultimately promote a firm’s investment in social responsibility. Combining these analyses together, air pollution could reshape labor productivity and managerial sentiment and finally affect a firm’s earnings management. Yao and Liu (2020) analyze the uncertainty of air quality and confirm that stronger uncertainty regarding air quality could promote a firm’s downside earnings management. However, it is still unclear how air quality affects firms’ earnings manipulation. Our studies enrich the research on the economic consequences of air quality and extend the external determinants of earnings management.

Conclusions

     By utilizing the data on public companies in China from 2014 to 2018, we investigate the causal relationship between air pollution and accrual earnings management. Our results show that firms engage in more earnings management when air pollution is stronger. This result is robust to alternative measurements for earnings management and air pollution and the random discontinuity design. Moreover, air pollution affects earnings manipulation by affecting managerial sentiment and labor productivity. This is reflected by the impact of air pollution being stronger in firms with higher labor productivity and lower negative managerial sentiments. In addition, we find that firms are more likely to positively manipulate earnings when air pollution is high. Then, we show that real earnings management is reduced by air pollution, indicating that earnings management is transferred. Finally, the relationship between air pollution and earnings manipulation is weaker in firms in polluting industries and state-owned firms.