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  • Management of Earnings through the Manipulation of Real Activities That Affect Cash Flow from Operations

    Sugata Roychowdhury∗

    Sloan School of Management MIT

    This Version: October 20, 2003 Abstract Most of the current research on earnings management focuses on the detection of abnormal

    accruals. The purpose of this study is to detect manipulation of real activities to meet earnings

    targets. I analyze cash flow from operations (CFO), production costs and discretionary expenses.

    Using a simple model to determine the normal levels of these variables, I detect abnormally low

    CFO and abnormally high production costs for companies that report small positive profits at the

    annual level. The evidence is consistent with firms trying to increase reported annual earnings

    beyond zero by giving price discounts to boost sales temporarily and by overproduction. I also

    find evidence suggesting that some of these firms reduce discretionary expenses to report higher

    margins. Further analysis in the paper yields interesting insights into cross-sectional variation in

    the nature and extent of real activities management.

    ∗I am grateful for the guidance and many helpful suggestions I have received from Ross Watts, Jerry Zimmerman and Andy Leone. Ths paper has also benefited from helpful comments and suggestions by Liz Demers, Joanna Wu, Charles Wasley, Jim Brickley, Ludger Hentschel, S.P. Kothari, Joe Weber, Shailendra Pandit , Hema Roychowdhury and Lance Young. All errors in the paper are mine.

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    1. Introduction

    There is substantial evidence that executives engage in earnings management.1

    Incentives to manage earnings arise from contractual agreements, capital market

    considerations and regulatory concerns. One way executives can manage earnings is by

    manipulation of accruals with no direct cash flow consequences (pure accrual manipulation).

    Examples of pure accrual manipulation include under-provisioning for bad debt expenses,

    delaying of asset write-offs and opportunistic selection of accounting methods. Pure accrual

    manipulation is a convenient form of earnings management because it has no direct cash flow

    implications and can be done after the year-end when managers are better informed about

    pre-managed earnings. However, managers also have incentives, discussed in detail in the

    next section, to manipulate real activities during the year with the specific objective of

    meeting certain earnings targets. Real activity manipulation affects both cash flows and

    accruals.

    Much of the current research on earnings management has focused on the detection

    of abnormal levels of accruals, estimated using models that cannot distinguish between the

    effects of pure accrual manipulation and real activities manipulation. Studies that directly

    examine earnings management through real activities have concentrated mostly on

    investment activities.2

    My paper contributes to the literature on earnings management by presenting

    evidence on the management of operational activities, something that has received scant

    attention so far. Instead of examining only accruals, I focus on variables that should be

    relatively free of the effects of pure accrual manipulation. Specifically, I concentrate on cash

    flow from operations (CFO), production costs and discretionary expenses. Using a simple

    model (presented in Dechow, Kothari and Watts 1998) to estimate the normal levels of these

    variables, I detect abnormally low CFO and abnormally high production costs for companies

    that report small positive profits at the annual level. The evidence is consistent with firms

    increasing reported earnings beyond zero by giving price discounts to temporarily boost sales

    and by overproduction. I also find evidence suggesting that some of these firms reduce

    discretionary expenses to report better margins. The results do not appear to be driven by

    1 Healy (1985), Guidry, Leone and Rock (1999). Defond and Jiambalvo (1994), Teo, Welch and Wong (1998) and Kasznik (1999) are a few example of studies that provide evidence on earnings management. Kothari (2001), Fields, Lys and Vincent (2001) and Healy and Wahlen (1999) provide a survey of the literature on earnings management and accrual manipulation. 2 These studies are discussed in greater detail in the next section.

  • 3

    optimal managerial responses to adverse economic conditions. They are robust to controls for

    performance, including non-linear controls.

    My empirical results have the following implications. First, evidence that managers

    manipulate both accruals and real activities suggests that the degree of manipulation detected

    by analyzing accruals only probably understates earnings management. Abnormal real

    activities may or may not have accrual effects. Second, the results imply that researchers

    should be cautious about using ex-post cash flows as a measure of the true economic

    performance of firms. For example, Givoly and Hayn (2000) assert that the ratio of cash flow

    from operations to assets is unaffected by accrual accounting and hence is a measure of the

    firm’s economic performance. Barth, Cram and Nelson (2001) use the ability of current

    earnings, current accruals and current cash flows to predict expected future cash flows as a

    way of determining the quality of various components of current earnings. Their proxy for

    future expected cash flows is realized cash flows. These studies assume that cash flows are

    free from manipulation. But manipulation of real activities affects cash flows and as a result,

    realized cash flows are as likely to reflect management incentives as accruals.

    My findings offer interesting questions for future research. For example, what is the

    relative magnitude of earnings management via accruals alone versus real activities? Does

    the manipulation of real activities in any given period give rise to predictable patterns in

    accruals and cash flows in subsequent periods?

    One caveat is in order at this point. At various places in this paper, I use the words

    ‘real activities manipulation’ and ‘pure accrual manipulation’ to refer to activities that appear

    to be motivated solely by the desire to meet earnings targets and are not a reflection of

    normal business practices. However, since I do not attempt to quantify the benefits that arise

    to investors from meeting earnings targets, I cannot conclude that these activities are sub-

    optimal or firm-value-decreasing.

    The rest of the paper is organized as follows. Section 2 contains a discussion on the

    incentives of firm managers to manipulate real activities. I also discuss prior academic and

    anecdotal evidence on the earnings management through real activities. In Section 3, I

    consider three specific kinds of real activities manipulation: management of sales,

    overproduction and reduction of discretionary expenses. I develop hypotheses based on the

    effects of these activities on cash flow from operations (CFO) and production costs for a

    given sales level. Section 4 discusses my data requirements and methods used to estimate

    normal levels of CFO, production costs, etc. In Section 4, I also discuss my selection of firms

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    reporting small profits and present descriptive statistics for the firms in my sample. I present

    the main results of this paper in Section 5. I also develop and test hypotheses on the cross-

    sectional variation of real activities manipulation. Section 5 concludes with sensitivity

    analyses and robustness checks. Section 6 summarizes the main results of the paper,

    discusses their implications, and identifies areas for further research.

    2. Motivation behind real activities manipulation and prior evidence

    In this section I first discuss why executives have incentives to use methods other than pure

    accrual manipulation to manage earnings. Following this discussion is a summary of extant

    literature on the management of real activities.

    2.1 Motivation behind manipulation of real activities

    An important issue in considering the incentives behind manipulation of real

    activities is the timing of earnings management. In contrast to accrual management, any

    manipulation of real activities has to occur during the course of the year. Managers have the

    scope to engage in pure accrual manipulation after the year-end (and before the earnings

    announcement), after pre-managed earnings are observed.

    Consider the case where firm managers believe that annual earnings will fall below

    zero unless they undertake actions that deviate from normal practice. To avoid reporting

    losses, one option is to wait until year-end and use pure accrual manipulation to cover the

    shortfall between pre-managed earnings and zero.3 This strategy entails the risk that the

    realized shortfall at year-end is larger than the discretionary accruals that can be reported

    with pure accrual manipulation, as a result of which reported earnings will fall below zero.

    Pure accrual manipulation is limited by GAAP and also by any accrual manageme

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