Earnings Management Through Real Activities Manipulation

Abstract

I find evidence consistent with managers manipulating real activities to avoid reporting annual losses: price discounts to temporarily increase sales, overproduction to report lower cost of goods sold, and reduction of discretionary expenditures to improve reported margins among firms reporting small annual profits. Cross-sectional analysis reveals that these activities are less prevalent in the presence of sophisticated investors, suggesting that the activities do not contribute to long-run value. Other factors that influence the extent of real activities manipulation include industry membership, the stock of inventories and receivables, and finally, incentives to meet zero earnings, including the presence of debt and growth opportunities. There is also some, though less robust, evidence of real activities manipulation to meet annual analyst forecasts.

Keywords: Real activities manipulation, small profits, earnings management, cash flow from operations, cash flow manipulation, real activities, real manipulation

JEL Classification: M1, M4, M41, M43