Financial reporting during gloomy days: Air pollution and real earnings management

Abstract

We investigate whether long-term exposure to polluted air affects a firm’s real earnings management (REM). Using a sample of U.S. listed firms and Visibility, a novel measure of air pollution, we find that firms whose managers and employees are exposed to polluted air are more likely to engage in short-term-oriented REM. However, these firms do not show significant differences in accrual-based earnings management (AEM). A one standard deviation decrease in Visibility is associated with a 24.3 percent increase in REM. Interestingly, this effect is disproportionately associated with the overproduction of inventory and cuts in discretionary expenses, rather than in the manipulation of sales prices or credit terms. The impact of polluted air on REM is more pronounced in firms with high analyst pressure, no credit rating, low institutional ownership, or poor corporate governance. The results suggest the existence of earnings-target-oriented managerial myopia among firms exposed to polluted air. Cognitive biases among managers and reduced employee productivity, both induced by air pollution, are potential channels through which polluted air triggers firms’ myopic earnings management behaviors.