Firm Life Cycle and Real-Activity Based Earnings Management

Abstract

We examine real-activity based earnings management, i.e., cuts in discretionary spending to report small profits, across introductory, growth and mature stage firms. We use the cash flow components to classify a firm’s life cycle. We predict and find that firms in the mature stage, on average, cut discretionary spending to report small profits; but firms in the introductory and growth stages do not. We also show the importance of considering the different earnings bins in the research design. Our study shows the importance of considering firm’s life cycle and calibrating suspect firms appropriately when examining real-activity based earnings management.

Keywords: Small profit, Large profit, Small losses, Small cuts, Large cuts