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This study examines the relationship between a firm’s market value and earnings management in the Italian financial market. Change in total accruals is used as a proxy for earnings management and change in the market to book ratio is used as a proxy for a firm’s market value. In contrast to the United States, Italy is a code-law and insider system country. The financial accounting system is characterized by a close overlap with tax accounting systems, which allows me to study the relationship with a different perspective than is possible with U.S. data. Moreover, I imply change in total accruals to measure earnings management. To my knowledge, there are no studies utilising this methodology in this type of institutional setting. The results of my study show that an increase in a firm’s market value is associated with income-increasing earnings management and a decrease in a firm’s market value is associated with income-decreasing earnings management. In line with U.S. evidence, my findings empirically validate Jensen’s prediction (Jensen, 2005) of the overvalued company also in the Italian financial market. The positive relationship between a decrease in a firm’s market value and income-decreasing earnings management is consistent with Badertscher (2011) study.

Do managers engage in earnings management to support firm’s market valuation?