Consequences of real earnings management on subsequent operating performance

ABSTRACT I examine whether a reversal of an abnormal cut in discretionary investments is associated with the degree to which the cut is reflective of real earnings management (REM) and whether and how it predicts future operating performance. I define a reversal as occurring when a firm cuts discretionary investments to a below-expected level in one period and reverts back to at least the expected level of investment during the next period. Unlike accrual earnings management, REM involves deliberately altering the operations of the firm to influence reported accounting numbers. To the extent that such interventions diverge from optimality, they can expose the firm to real economic costs. I find that a reversal of an abnormal cut in discretionary investments in the year after the cut has taken place is indicative of REM. I further find that, on average, reversing cuts are associated with lower future operating performance, but that such results vary significantly depending on the various incentives to engage in REM, as well as other factors that affect its associated costs and benefits. These findings are of interest to investors, regulators, and academics with respect to the identification and consequences of REM.

Download Full-text

Analysis of incentive effects of managers’ bonuses on real activities manipulation relevant to future operating performance

Management Decision ◽

10.1108/md-04-2014-0172 ◽

2015 ◽

Vol 53 (2) ◽

pp. 432-450 ◽

Cited By ~ 4

Author(s):

Mahdi Moradi ◽

Mahdi Salehi ◽

Mohammad Zamanirad

Keyword(s):

Earnings Management ◽

Design Methodology ◽

Compositional Data ◽

Operating Performance ◽

Negative Relationship ◽

Real Earnings Management ◽

Negative Effects ◽

Content Type ◽

Future Performance ◽

The Relationship

Purpose – The purpose of this paper is to analyze the effect of managers’ incentive bonuses on both accrual and real earnings management. Design/methodology/approach – First, the authors investigate the relationship between managers’ bonuses and both accrual earnings management (measured by a modified Jones model) and real earnings management (measured by Roychowdhury proxies). Next, the authors examine whether management has any preferences for earnings management methods to enhance its bonuses. Finally, the authors investigate the possible effects of earnings management on future operating performance. The sample consists of compositional data in the period from 2006 to 2012. Findings – The authors find a negative relationship between real earnings management and managers’ bonuses and detect that managers prefer to use accrual earnings management to earn more bonuses. The results also show that real earnings management will reduce a firm’s performance in future periods, and on the other hand that increasing managers’ bonuses links to improvement of the firm’s future performance. The results suggest that managers are typically aware of the negative effects of real earnings management on the firm’s future performance and thus prefer to improve the firm’s performance in securing their bonuses when their ability to manage accruals is constrained. Originality/value – The implications of this paper provide further evidence on how managers’ bonuses affect their discretion in using accrual and real earnings management. This finding is important to investors and regulators.

Download Full-text