This essay investigates innovative Small and Medium Entities’ earnings management strategies and the related economic consequences. This type of firm is characterized by the presence of high information asymmetry due to the uncertainty and complexity surrounding their activities, leaving managers room for discretionary choices which are difficult to detect, raising the issue of moral hazard. At the same time, regulators are debating on the adequate level of regulation for this type of firm which should protect investors without stifling innovation. Based on SMEs listed on AIM London, a stock market for firms of smaller size, over the 1995-2014 period, I show that the innovative SMEs engage less intensively in accrual earnings management than non-innovative SMEs, and that they prefer to manage their earnings mainly through real activities. Looking at the economic consequences, the decision to focus on real earnings management is performed focusing the resources towards the investment in R&D in the subsequent years, leading to stable performance, whereas accrual earnings management appears detrimental to future performance. I further examine the role of external monitoring on accounting quality, comparing innovative SMEs listed on stock exchanges with different regulatory requirements, i.e., AIM London and Nasdaq. I document that stricter rules significantly reduce only the level of accrual earnings management, but not that of real earnings management. By providing a comprehensive representation of SMEs’ strategies to manipulate earnings, this paper contributes to the literature on SMEs’ financial reporting quality and on the impact of regulation on accounting quality.
Key-Words: Earning Management, innovation, regulation, AIM London
