ABSTRACT We propose the standard neoclassical model of investment under uncertainty with short‐run adjustment frictions as a benchmark for earnings‐return patterns absent accounting influences. We show that our proposed benchmark generates a wide range of earnings‐return patterns documented in accounting research. Notably, our model generates a concave earnings‐return relation, similar to that of Basu [1997], and predicts that the earnings‐return concavity increases with the volatility of firms’ underlying shock processes and decreases with the level of firms’ investments. We find strong empirical support for these predictions. Overall, our evidence suggests that our proposed benchmark is useful for understanding the joint dynamics of variables of interest to accounting research (e.g., earnings, returns, investment, market‐to‐book) absent accounting influences, a necessary precondition for inferring the effects of accounting from these dynamics.

ABSTRACT We examine whether the design of a firm’s internal management accounting system is associated with GAAP earnings management. We exploit the fact that ASC 280 mandates a “management approach” requiring multisegment firms to disclose their segment earnings as defined internally by their management accounting system. We posit that the less these segment earnings are decoupled from GAAP earnings, the higher are the costs of earnings management because earnings management spills over to segment earnings and distorts information used for internal decision-making. Thus, we predict that firms with more decoupled segment earnings engage in more earnings management. Using a large sample of U.S. firms from 1998 to 2020, we find support for this prediction. We also find that the decision usefulness of segment earnings for segment investment purposes decreases as earnings management increases, with this association being more pronounced for firms with less decoupled segment earnings measures. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M41; G14.