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The Relation between Earnings Management Using Real Activities Manipulation and Future Performance: Evidence from Meeting Earnings Benchmarks

40 Pages Posted: 13 Oct 2005 Last revised: 2 Feb 2012

Katherine Gunny

University of Colorado at Denver

Date Written: July 23, 2009

Abstract

This paper examines the consequences of real activities manipulation. Using financial statement data, I identify firms that appear to engage in any of the following real activities manipulation (RM): reducing R&D to increase income, reducing SG&A to increase income, timing of income recognition from the disposal of long-lived assets and investments, and cutting prices to boost sales in the current period and/or overproducing to decrease COGS expense. I then examine whether RM is associated with firms just meeting two earnings benchmarks (zero and last year’s earnings). The results indicate that real activities manipulation of R&D, SG&A, and production are positively associated with firms just meeting these earnings benchmarks. Next, I examine the extent to which real activities manipulation affects subsequent performance. A negative association between just meeting earnings benchmarks by using RM and subsequent performance supports prior research suggesting managers opportunistically use earnings management to the detriment of shareholders (i.e., managerial opportunism). A positive association is consistent with managers using operational discretion to attain benefits that allow better future performance or to signal future firm value. I find that firm-years reflecting RM to just meet earnings benchmarks have higher subsequent firm performance (compared to firm-years that do not engage in RM and miss or just meet the earnings benchmarks). In this setting, using RM to influence the output of the accounting system is not opportunistic, but consistent with managers attaining benefits that allow better future performance or signaling.

Keywords: real earnings management, earnings management, accounting flexibility, return on assets, cash flow management

JEL Classification: M41, M43

Suggested Citation

Gunny, Katherine, The Relation between Earnings Management Using Real Activities Manipulation and Future Performance: Evidence from Meeting Earnings Benchmarks (July 23, 2009). Available at SSRN: https://ssrn.com/abstract=816025 or http://dx.doi.org/10.2139/ssrn.816025

Katherine Gunny (Contact Author)

University of Colorado at Denver ( email )

Box 173364
1250 14th Street
Denver, CO 80217
United States

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