Measuring Real Activity Management
Daniel A. Cohen
University of Texas at Dallas - Naveen Jindal School of Management
University of Illinois at Chicago
Charles E. Wasley
University of Rochester - Simon Business School
Ohio State University (OSU) - Fisher College of Business
July 28, 2014
Much recent research focuses on earnings management via the manipulation of real activities (real earnings management, REM). While tests of REM hinge critically on the measurement of abnormal real activities there is no systematic evidence on the properties of commonly-used REM measures or the statistical tests based on them. We provide such evidence by documenting which REM measures lead to well-specified hypothesis tests and which do not. We find that the traditional REM measures used (to date) in the literature are severely mis-specified in that their Type I error rates differ significantly from nominal significance levels. We analyze alternative REM measures based on performance matching and find that while performance-matched REM measures are not well-specified in each and every setting (no REM measure is), the weight of the evidence suggests that across a wide variety of settings they will provide better-specified tests than the traditional REM measures. To concretely demonstrate the importance of our findings for actual accounting research, we reexamine the widely-cited result that managers manipulate real activities to avoid reporting losses. We document that inferences are sensitive to how REM is measured. Specifically, we find that prior published results suggesting that managers manipulate real activities to avoid reporting losses become insignificant when performance-matched REM measures are used. Such evidence highlights the importance of using performance-matched REM measures when testing managers’ real activities manipulation.
Number of Pages in PDF File: 53
Keywords: Real activity management, real earnings management, earnings management, real activity models, test specification, meet or beat, earnings benchmarks, model specification
JEL Classification: M41, C12, C15, M42
Date posted: March 24, 2011 ; Last revised: July 29, 2014
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