Does air pollution affect earnings management? Evidence from China

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 •Firms in areas with strong air pollution intends to conduct more accrual earnings management•Air pollution promotes earnings management by impeding firm’s labor productivity•Air pollution facilitates earnings manipulation by lowering managers’ sentiments•The effect of air pollution on earnings management is stronger in low-polluting industries•The enhancing effect of air pollution on earnings manipulation is more substantial in non-state-owned enterprises