2.2. Literature Review
Earnings management occurs when managers use accounting methods or arrange transactions to change financial reports to mislead some stakeholders′ about the underlying economic performance of the company or to influence contracts based on reported earnings [
9]. According to Healy and Wahlen [
9], motivations behind higher absolute levels of earnings management include meeting capital markets expectations, contracting incentives, and avoiding political costs.
Meeting capital markets expectations is the first factor that motivates the earning management. There is a positive correlation between corporate accounting earnings and stock prices, and higher reported earnings can lead to relatively higher stock prices [
10,
11]. Equity financing is an important motivation for corporate earnings management [
12,
13]. In the process of an initial public offering, additional issues, and rights issues, the managers have a strong incentive to increase earnings and convey false information to investors and other users of financial information [
14,
15,
16]. Some studies have found that when the frequency of slight declines and losses in earnings is abnormally low while the frequency of slight gains and gains in earnings is abnormally high, it proves that managers will also conduct earnings management for the purpose of avoiding a decline in earnings and avoiding losses under the transaction cost theory and prospect theory [
17,
18]. Other evidences suggest that when the firms fail to meet the analyst′s target, the market value of the firm will be lost, and the manager will experience a reduced salary or even be terminated. When the firms cannot cater to investor sentiment, investors may sell stocks to cause the firms′ stock price to fall. For those reasons, managers try to meet the expectations of the outside by overstating earnings [
19,
20].
The second factor that causes the earning management is contracting incentive. When accounting data is used to monitor contracts between listed firms and related stakeholders, contract motivations are generated, which mainly include management compensation contracts and debt contracts. Based on the principal–agent relationship, managers will manipulate accounting earnings to maximize their compensation and bonus for their own benefit [
21,
22]. Managers will also carry out earnings management for increasing job security. Before the change of executives, senior executives who were temporarily dismissed tended to manipulate profits and increase reported earnings to maintain personal interests or reputation; after the change of executives, succession executives often reduce profits through negative earnings management and attribute the responsibility to their predecessors so that their performance can be improved [
23,
24,
25]. Meanwhile, earnings overstatement is greater in the early than in the later years of a CEO′s service [
26]. In addition, those companies that violate or are likely to violate the debt contract will make accounting choices to increase revenue to reduce or evade the restrictions of the debt contract [
27].
The third factor that leads to earning management is political cost. Political costs are the potential wealth transfer that firms face because of industry regulation, tax barriers, and other political activities. Existing literature shows that firms will manage earnings to reduce the net cost of potential regulatory outcomes under the uncertainty of changing regulation and external environment. Cahan et al. took the new environmental regulations issued by the U.S. Congress as a research event, and found that firms in a relevant industry would reduce the level of earnings management [
28]. Based on the policy of Australian government to levy income tax on the gold mining industry, Monem found that firms in the gold mining industry would reduce earnings in the period of government policy formulation and review to avoid being imposed more income tax [
29]. Ramanna and Roychowdhury examined the discretionary accrual choices of outsourcing firms with links to U.S. congressional candidates during the 2004 elections through the political cost hypothesis [
30]. Godsell et al. examined earnings management by E.U. firms that initiated an antidumping investigation, revealing that earnings management increases when accounting data directly affect the magnitude of the tariffs imposed in the trade investigation [
31]. An increase in policy risk implies an increase in the opaqueness of the information environment and in the expected volatility of future operating profitability [
32]. Yung and Root used the Baker, Bloom, and Davis index (BBD) to investigate the association between policy uncertainty and earnings management; the results show that firms will manage reporting earnings when policy uncertainty is high [
33].
In general, earnings management is not only a common financial means for managers to achieve financial goals, but also an effective plan for firms to cope with adverse situations [
34]. In the framework of earnings management motivation, scholars have studied the impact of corporate-level governance factors on earnings management, such as equity structure, equity incentives, personal characteristics of executives, board of directors, board of supervisors, external auditing, institutional investor shareholding, corporate reputation, and other corporate governance factors. At the same time, it also pays attention to the impact of the external governance environment such as macroeconomic fluctuations, accounting system reform, investor protection level, legal governance level, tax policy, government intervention, media supervision, and other factors. However, factors causing changes in the political costs do not include air quality uncertainty. Environmental uncertainty refers to the fluctuation and unpredictability caused by factors such as consumers, suppliers, competitors, and regulators [
35]. Environmental uncertainty increases the volatility of a company′s earnings. In other words, greater environmental uncertainty is associated with a higher degree of earnings management [
6]. Since the air quality is becoming increasingly more important, the air quality uncertainty has been a factor affecting the environmental uncertainty. According to the concept of environmental uncertainty, we define fluctuations in the external air quality as air quality uncertainty. Some studies have concerned the smog′s effect (delegated as the PM2.5 burst incident) on earning management via political costs [
5]. However, this study does not explore the air quality effect on earning management directly and does not include air quality uncertainty. We select the Action Plan as the institutional background and study the relation between air quality uncertainty and earning management.
2.3. Hypothesis Development
The air quality uncertainty, as a macro change of the external environment, affects firms′ activities through political costs. Political costs are the potential wealth transfer that firms face because of industry regulation, tax barriers, and other political activities. It makes firms subject to strict government supervision, which is significantly related to accounting data. When the air quality uncertainty increases to reduce or avoid political costs, firms may implement earnings management using accounting procedures or accounting options to reduce the expected value of the wealth transfer. On the one hand, if the regional air quality uncertainty is increasing and the overall trend is decreasing, local governments will use various resources to improve the environmental quality under the pressure of the superior environmental target responsibility system. Local governments tend to adopt stricter environmental regulations for the firms within its jurisdiction, such as strengthening law enforcement and supervision and increasing environmental regulation or environmental protection investment. The source of these funds is firms. Local governments transfer resources using related party transactions [
36] and raising taxes [
37]. To respond to the strict regulation, firms′ managers tend to hide their true performance and reduce their attractiveness with earnings management. By lowering firms′ profits, firms show a worse image to increase sympathy from local governments. Some firms may even get subsidies from the government with those measures [
38]. On the other hand, if the regional air quality uncertainty is increasing and the overall trend is also increasing, local governments tend to balance environmental performance and economic development. Firms tend to choose downward earnings management to keep a low profit level if the government pursues stable regional air quality and strictly regulates firms. If the government tends to pursue GDP (gross domestic product) growth, managers would engage in performance-oriented earnings management and managers might overestimate profits in response to government and market incentives. In summary, we propose that firms tend to improve their degree of earnings management when the regional air quality uncertainty increases. Therefore, we propose the following hypothesis:
There is a positive relationship between the regional air quality uncertainty and the degree of firms’ earnings management.