A Simple Approach to Better Distinguish Real Earnings Manipulation from Strategy Changes
59 Pages Posted: 13 Jun 2016 Last revised: 15 Mar 2022
Date Written: April 16, 2020
Researchers typically infer real earnings management when a firm’s operating and investing activities differ from industry norms. A significant problem with classifying deviations from industry averages as earnings management is that companies can change their operating and investing decisions for strategic business reasons rather than to mislead stakeholders. We systematically evaluate existing measures and develop a comprehensive real activities measure to better capture earnings manipulation using principal components analysis. Our measure reflects (1) deviations from industry averages across multiple activities and (2) other signals of manipulation. This approach is promising because, although there are many sources of abnormal activities, manipulation is more likely the cause when managers engage in multiple income-increasing abnormal activities that coincide with other signals that indicate an elevated risk of manipulation. This simple approach results in a metric that associates negatively with future operating performance and earnings persistence, yields high-power tests, and captures manipulation reasonably well across most life-cycle stages. Importantly, this approach performs better than the standard real earnings management metrics across all dimensions. Also, because this innovation does not require a long time-series nor rely on future period realizations for classification, it can be useful in more research settings than other recent innovations in the literature.
Keywords: real earnings management, earnings management, financial reporting quality, Principal Components Analysis
Suggested Citation: Suggested Citation