Saturday, June 9, 2012

Evaluating the Relationship Between Earnings Management And Financial Bubbles

[Authors: Wei Xu, New Jersey Institute of Technology; Michael Ehrlich, New Jersey Institute of Technology]

When Supreme Court Justice Potter Stewart was confronted with the challenge of ruling on an 1964 obscenity case, he conceded that an objective definition of pornography was hard to produce, but “I know it when I see it”. Economists and academicians have treated financial bubbles the same way for most of recent history. Charles Kindleberger and Robert Aliber in their seminal work, Manias, Panics, and Crashes: a History of Financial Crises (1978) defined a bubble as “an upward price movement over an extended range that then implodes” (p.16) 

While the Kindleberger definition relies on price movements that accelerate unsustainably to identify financial bubbles, this definition ignores traditional pricing theory that suggests prices are based on the present value of expected future cash flows, also known as intrinsic value. An alternative definition suggests that a financial bubble exists when the price of an asset exceeds its intrinsic value as determined by market fundamentals. However, financial bubbles seem to have relatively long lives and the market fundamentals that determine equilibrium pricing are unobservable.