Improving the Measures of Real Earnings Management

Abstract

Firms often change their operating policy to meet a short-term financial reporting target. Accounting researchers call such an 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 their industry 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 distinct 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 when none exists. I suggest improvements in measurement models to avoid misspecification.

Keywords: Competitive strategy; Intra-industry homogeneity; Real activity manipulation; Intangible investments

JEL Classification: M13, M41, M43, C12, C13, G32