Investor Sentiment, Managerial Manipulation, and Stock Returns

The degree of earnings manipulation has been shown to be positively associated with stock returns at the aggregate level but negatively so in the cross- section. We examine, both theoretically and empirically, the role of investor sentiment in accounting for such relations. We find that these patterns are primarily driven by high-sentiment periods. Embedding investor sentiment into a game-theoretic model of earnings manipulation with a continuum of firms delivers consistent predictions. Our analysis highlights the importance of increased scrutiny of corporate reporting during market booms, when manipulation is widespread and adds fuel to price exuberance.