Earnings Management and the Reconstitution of the Russell Indexes

Abstract

Past studies have shown that firms moving from the Russell 1000 to the Russell 2000 exhibit positive cumulative abnormal returns (CARs), referred to as the addition effect while firms that move up to the Russell 1000 display negative CARs, or the deletion effect. We hypothesize that firms moving down to and remaining in the Russell 2000 engage in negative earnings management. Results show that firms moving to the Russell 2000 utilize negative earnings management but that does not necessarily lead to positive CARs. In contrast, firms remaining in the Russell 2000 Index with negative earnings management exhibit significant positive CARs.