Penny-Wise and Pound-Foolish: Does Striving to Meet Earnings Expectations by Manipulating Real Activities Undermine Product Quality?

Abstract

We examine whether managers’ activities in striving to reach earnings targets affect their firms’ product quality. We find that firms suspected of manipulating real activities in trying to meet earnings benchmarks exhibit a higher likelihood and frequency of product recalls. Other evidence implies that high earnings pressure induces managers to manipulate real activities, resulting in more product quality failures. In cross-sectional results consistent with expectations, we find that the impact of exploiting real activities to attain earnings benchmarks on product recalls intensifies for firms whose managers have stronger incentives to manage earnings and subsides for firms subject to greater customer power and firms with more growth opportunities. Additional analysis shows that suspected benchmark targeting also raises the severity of product recalls.

Keywords: product quality, product recalls, earnings expectations, real activities management

JEL Classification: G10, L15, M40, M41