Stock market reactions to R&D cuts used to manage earnings

Prior research shows that stock returns are positive when firms meet or beat analysts' consensus earnings forecasts but negative when they miss. Past studies also show that managers frequently cut research and development (R&D) expenses in order to meet the consensus forecast. This study shows that the stock market penalizes this behavior and exacts a discount to the market reward if beating the forecast requires cutting R&D. However, it is only a partial discount and firms are still better off managing R&D expenditures in the short run. This study also shows that the reductions in R&D are likely temporary, as firms tend to increase R&D spending in the subsequent periods. Investors appear to recognize these short-term cuts and treat them similarly to accruals.