Real earnings management and cost of capital

This study investigates whether a firm’s cost of equity capital is influenced by the extent of a firm’s real activities management. Using a large sample of U.S. firms, we find that our proxy for the cost of capital is positively associated with the extent of earnings management through the real activities manipulation after controlling for the effect of the accrual-based earnings management. We also provide evidence suggesting that this positive association stems from managerial opportunism rather than from the measurement errors in our real earnings management proxies. The main findings are robust to a battery of sensitivity tests. Collectively, our results suggest that real earnings management activities exacerbate the information quality of earnings used by outside investors, and thus the market demands a higher risk premium for these activities, which is incremental to the risk premium for the accrual-based earnings management.     

Product market competition and earnings management: A firm‐level analysis

In this paper, we employ a firm‐level measure of product market competition constructed from the textual analysis of firms’ 10‐K filings to examine the relationship between managers’ perceived competition pressure and earnings management. We find that accounting irregularities and accrual‐based earnings management are positively related to product market competition. This finding is consistent with the notion that competition pressure increases managerial incentives to manage earnings, due to their career concerns. We also find that real earnings management is negatively related to product market competition. This finding suggests that real earnings management involves actions that decrease firms’ competitiveness and thus is costly for firms confronted with high competition pressure.     

Improving the measures of real earnings management

Firms often change their operating policy to meet a short-term financial reporting target. Accounting researchers call this opportunistic action real earnings management (REM). They measure REM by the difference between a firm’s costs and those reported by its industry peers. Firms that pursue distinct competitive strategies also display different cost patterns than peers. However, the models that measure REM do not control for differences in competitive strategy. Hence a researcher can misinterpret a cost difference that stems from a firm’s competitive strategy as REM. The researcher would also find a spurious correlation between earnings management and a firm characteristic that varies with competitive strategy. A cause or effect relationship with earnings management could be wrongfully inferred. I suggest improvements in measurement models to avoid misspecification.

     

Product market power and management’s action to avoid earnings disappointment

We investigate the empirical relationship between a firm’s product market power and its management’s action to use real-activity-based earnings management techniques to avoid earnings disappointment by meeting or beating earnings targets such as analysts’ earnings forecasts, positive earnings, or higher earnings relative to previous years. While there is a general consensus that product market competition in an industry affects management’s operating and financial decisions, and thus is an important intervening factor in a firm’s strategies for many economic situations (Nickell in J Political Econ 104:724–746, 1996; Porter in The competitive advantage of nations. Macmillan, London, 1990), the linkage between product market power, managerial incentives, and financial reporting quality has so far received little academic attention. Our analyses show that while the firms manage both accruals and real activities in varying degrees, the firms having greater product market power with the ability to differentiate their products to earn additional revenue, if necessary, are less inclined to engage in real-activity-based earnings management in certain suspect economic situations compared to the firms with less market power. We, however, do not find any significant relationship between product market power and accrual-based earnings management.     

Equilibrium earnings management and managerial compensation in a multiperiod agency setting

To investigate how the possibility of earnings manipulation affects managerial compensation contracts, we study a two-period agency setting in which a firm’s manager can engage in window-dressing activities to manipulate reported accounting earnings. Earnings manipulation boosts the reported earnings in one period at the expense of the reported earnings in the other period. We find that the optimal pay-performance sensitivity may increase and expected managerial compensation may decrease as the manager’s cost of earnings management decreases. When the manager is privately informed about the payoff of an investment project to the firm, we identify plausible conditions under which prohibiting earnings management can result in a less efficient investment decision for the firm and more rents for the manager.     

Managerial flexibility and the wealth effect of new product introductions

This paper examines whether investors recognize the value of managerial flexibilities, as proxied by real options, in their valuation of new product introductions. We define a firm’s real options portfolio as the difference between the firm’s market value and its assets in place. A firm’s strategic flexibilities are modeled as the ratio of its real option portfolio to its book value. Using a sample of new product introductions from 1998–2007, we find our real options measure is positively related to announcement period abnormal returns. This result holds after we control for other variables known to be correlated with the announcement effect in previous studies. Our result is robust to alternative measures of real options based on analysts’ earnings expectations and whether a firm has one or multiple segments. In summary, our results suggest that a firm’s perceived strategic and operating flexibilities are an important factor in the valuation of new products.     

Do Managers Always Know Better? The Relative Accuracy of Management and Analyst Forecasts

We examine the relative accuracy of management and analyst forecasts of annual EPS. We predict and find that analysts’ information advantage resides at the macroeconomic level. They provide more accurate earnings forecasts than management when a firm's fortunes move in concert with macroeconomic factors such as Gross Domestic Product and energy costs. In contrast, we predict and find that management's information advantage resides at the firm level. Their forecasts are more accurate than analysts’ when management's actions, which affect reported earnings, are difficult to anticipate by outsiders, such as when the firm's inventories are abnormally high or the firm has excess capacity or is experiencing a loss. Although analysts are commonly viewed as industry specialists, we fail to find evidence that analysts have an information advantage over managers at the industry level. The two have comparable abilities to forecast earnings for firms with revenues or earnings that are more synchronous with their industries.     

Cross‐Firm Real Earnings Management

Our analysis is rooted in the notion that stockholders can learn about the fundamental value of any firm from observing the earnings reports of its rivals. We argue that such intraindustry information transfers, which have been broadly documented in the empirical literature, may motivate managers to alter stockholders’ beliefs about the value of their firm not only by manipulating their own earnings report but also by influencing the earnings reports of rival firms. Managers obviously do not have access to the accounting system of peer firms, but they can nevertheless influence the earnings reports of rival firms by distorting real transactions that relate to the product market competition. We demonstrate such managerial behavior, which we refer to as cross‐firm real earnings management, and explore its potential consequences and interrelation with the practice of accounting‐based earnings management within an industry setting with imperfect (nonproprietary) accounting information.     

Options trades,short sales and real earnings management

We study the link between measures of stock options’ volatility and firms’ real earnings management (RM). We hypothesise that RM causes uncertainty in the value of a firm’s common stock and, as a result, increases the volatility spread and skew of the firm’s options. Spread and skew proxy for investors’ uncertainty in the value of the options underlying a stock. Consistent with our hypothesis, we find an association between a firm’s use of RM, and the volatility spread and skew in the firm’s options, more precisely in its put options. We also study the link between short selling and the extent of RM but do not find a consistent relationship between the two.     

Risk-based forecasting and planning and management earnings forecasts

This study examines the association between a firm’s internal information environment and the accuracy of its externally disclosed management earnings forecasts. Internally, firms use forecasts to plan for uncertain futures. The risk management literature argues that integrating risk-related information into forecasts and plans can improve a firm’s ability to forecast financial outcomes. We investigate whether this internal information manifests itself in the accuracy of external earnings guidance. Using detailed survey data and publicly disclosed management earnings forecasts from a sample of publicly traded U.S. companies, we find that more sophisticated risk-based forecasting and planning processes are associated with smaller earnings forecast errors and narrower forecast widths. These associations hold across a variety of different planning horizons (ranging from annual budgeting to long-term strategic planning), providing empirical support for the theoretical link between internal information quality and the quality of external disclosures.     

Informal institutions and managers’ earnings management choices: Evidence from IFRS-adopting countries

In this study, we investigate the role of informal institutions (religiosity and culture) in determining managers’ choices of earnings management methods (accruals vs. real activities), after controlling for formal institutions (investor protection, enforcement quality and equity market development). Using an ethical perspective, we find that managers tend to choose an earnings management strategy that meets the prevailing social (informal) norms of the environment where the firm is headquartered. Specifically, our analysis shows that firms domiciled in countries with strong religious adherence and high-power-distance cultures prefer to manage their earnings ‘upwards’ through real activities rather than accruals. Overall, our results suggest that informal institutions determine managers’ earnings management choices at least as strongly as formal institutions do. It would therefore be misleading to analyze managers’ choices in managing earnings solely from the formal rules perspective without considering the role of informal constraints or vice versa.     

Earnings Management Surrounding CEO Turnover: Evidence from Korea

This article examines the empirical relation between chief executive officer (CEO) turnover and earnings management in Korea using a sample of 403 CEO turnovers and 806 non‐turnover control firms during the period 2001–2010. We classify CEO turnovers into four types depending on whether the departure of the outgoing CEO is peaceful or forced and whether the incoming CEO is promoted from within or recruited from outside the firm. We measure earnings management by both discretionary accruals and real activities management. We also control for the endogeneity of CEO turnover and a potential selection bias using 2SLS and Heckman's two‐stage approach. After controlling for corporate financial performance and governance structure, we find upward earnings management by the departing CEO only when the departure is forced and the new CEO is an insider. In this case, the new CEO also engages in downward earnings management using both discretionary accruals and real activities management. We also find some evidence that the new CEO recruited from outside the firm manages discretionary accruals upward following the peaceful departure of his predecessor. In all other types of CEO turnover, we do not find evidence of significant earnings management by either CEO.     

Mandatory IFRS adoption: the trade-off between accrual-based and real earnings management

This paper examines whether firms substituted real earnings management for accrual-based earnings management after the International Financial Reporting Standards (IFRS) became mandatory. Using a sample of 101,331 firm-year observations from 33 countries between 2000 and 2010, we show that IFRS adoption came with the unintended consequence of certain firms substituting real earnings management for accrual-based earnings management, especially among firms in countries with strict enforcement regimes. Furthermore, we document that the trade-off is confined to EU countries in which strong firm-level characteristics (i.e. the firm-level mechanism of control, the market’s level of scrutiny, and firm-specific incentives to provide transparency) are coupled with strong enforcement. We also show that IFRS had an effect in countries outside the EU, albeit at a different time. Overall, the results suggest that accounting regulators’ efforts to increase earnings quality might have had the unintended consequence of increasing real earnings management activities.     

The market’s use of supplier earnings information to value customers

In this paper we examine whether the quarterly earnings announcements of supplier firms contain information about their customer’s earnings. Our evidence suggests that they do. Specifically, we find evidence consistent with the market impounding supplier firm earnings information into the stock prices of the firm’s customers. This is consistent with the market using the supplier’s earnings to help assess the customer firm’s future cash flows and/or uncertainty of those cash flows. We also find that the quality of the earnings influences the magnitude of the customer firm’s stock price reaction. The customer’s stock price reaction is increasing in the revenue growth reported by the supplier and the past persistence of the supplier’s earnings. Additional tests reveal that the market reaction is amplified when the customer firm is more dependent on the supplier. Finally, we find that the relative bargaining power of the customer influences the market reaction to supplier earnings. While prior research has documented that the market uses industry peer earnings and customer earnings in pricing a firm’s stock, this is the first study to provide evidence on the market’s use of supplier earnings information.     

Firm diversification and earnings management strategies: European evidence

This paper investigates whether corporate diversification, both international and industrial, provides a favourable environment for earnings management. We find that international diversification is associated with greater manipulation of accruals and sales but with lower manipulation of production costs. Industrial diversification is associated with lower levels of all three earnings management strategies. We find strong evidence that the combination of industrial and international diversification increases real activity manipulation but has no effect on accrual manipulation. Moreover, we find that in the presence of firm complexity linked to higher levels of earnings management, the recommendations of financial analysts are more likely to be on the sell side and vice versa. Our results provide useful insights to investors by highlighting the impact of corporate diversification on earnings management and, thus, the accurate estimation of firm value.     

An empirical study of voluntary transfer pricing disclosures in China

This paper empirically investigates the factors that affect the management’s voluntary disclosures of the transfer pricing details of related-party transactions. Using Chinese data from 2004 and 2005, we hypothesize and find that firms that make voluntary disclosures of the pricing methods of related-party transactions are negatively associated with (i) a higher level of earnings management (as captured by abnormal related-party transactions) and (ii) its underlying incentives (as captured by the management’s performance-linked bonuses and the firm’s incentives to achieve earnings targets); further, they are positively associated with (i) a higher percentage of independent directors and (ii) a higher percentage of government ownership. Overall, our findings suggest that earnings management and its incentives, board composition, and ownership structure significantly influence the voluntary disclosure decisions of managers.     

Boards,takeover protection,and real earnings management

We investigate the effect of board governance and takeover protection on real earnings management. Four types of real earnings management are considered: sales manipulation, overproduction, the abnormal reduction of research and development (R&D) expenses, and the abnormal reduction of other discretionary expenditures. Using panel data from US public firms in the post-Sarbanes–Oxley Act period, we find that the level of real earnings management (sales manipulation, abnormal declines in R&D expenses, and other discretionary expenses) increases with better board governance and decreases with higher takeover protection. These two governance factors generally have no significant effect on overproduction. We further find that firms substitute accrual-based earnings management with sales manipulation and abnormal cuts in discretionary expenses, and the substitution effect is more pronounced in firms with stronger board governance. Overall, our findings indicate that the level of real earnings management is higher when a firm is faced with tough board monitoring, and that takeover protection may reduce managerial incentives for real earnings management.     

Stock market listing status and real earnings management

This study analyzes real earnings management among privately held versus publicly listed firms. Our first finding is that public firms engage in more earnings management through operating activities. When a clear incentive to manage earnings in a specific direction is present we continue to find that public firms manage their earnings more than private firms. We reason that capital market pressure and ownership characteristics drive our results. Additional analyses reveal that public firms employ more real earnings management as a proportion of the total earnings management strategy. Furthermore, we find that mitigating factors of real earnings management have stronger impact in public firms. This study contributes to literature on non-accrual earnings management and to the broader understanding about the private vis-à-vis public firm reporting and operating behavior. Finally, we contribute by identifying an important societal cost of stock market listing, which is the increase in potentially value-destroying real earnings management.     

Does the executive labor market discipline? Labor market incentives and earnings management

This paper investigates the role of outside options in the executive labor market on earnings management decisions. To proxy for executives’ outside options, we use the number of times other firms cite the executive’s firm as a compensation peer. We find that executives with more citations conduct less earnings management. Exploiting the 2006 SEC requirement for compensation peer disclosure as a quasi-natural shock to executives’ awareness of outside options, we show that the executives who should be more responsive to outside options significantly reduce earnings management. Cross-sectional tests support a labor market discipline channel of outside options. Finally, we exploit state-level recognition of Inevitable Disclosure Doctrine and enforcement of non-compete agreements as cross-sectional restrictions on labor mobility and show that the impact of peer citations on reducing earnings management is stronger when there are fewer restrictions on mobility.     

Conditional conservatism and the limits to earnings management

We examine the impact of conditional conservatism on earnings management. Our findings support the view that conditional conservatism reduces accruals-based earnings management but also triggers a trade-off between accruals and real earnings management. In our main tests we use the passage of SFAS 121 as a plausibly exogenous regulatory change that increased the level of conditional conservatism but did not materially affect earnings management. We find that, after the regulation, treated firms reduce accruals-based earnings management and increase real earnings management, and are less likely to be marginal or habitual beaters of earnings benchmarks. Given the crucial role of earnings for firm valuation and analysis, and that conditionally conservative accounting choices are observable, our results should be of wide interest for investment professionals.