An analysis of the positive effect of real earnings management on financial performance

Abstract

PurposeREM models infer abnormal levels of cashflow from operations (AbCFO), selling, general and admin (AbSGA) and production expenses (AbProd) are opportunistic, based on the supposition that engaging in real activities to meet current earnings targets (t) will negatively influence future performance (t+1). However, from a firm productivity perspective, cost reduction (via AbCFO, AbProd and AbSGA) is interpreted as an efficiency enhancing business strategy. This study therefore differentiates between (1) firms with ineffective management that have engaged in AbCFO, AbProd and AbSGA to achieve an optimal resource-cost mix to generate sales (REMF) and (2) firms with effective management that have not (OEF).Design/methodology/approachUsing a sample of Korean listed firms over the 2000–2016 sample period, the study utilizes data envelopment analysis to capture the capability of management to generate sales from resources that are directly under their control. The study then compares the incremental effect that managerial decision making can have on real earnings management (REM) and future firm performance (period t+1 to t+5).FindingsThe study makes two important contributions. First, consistent with the efficiency/productivity literature, but contrary to seminal REM studies, empirical results shows that AbCFO, AbProd and AbSGA improve firm performance in period t and t+1 (to t+5), demonstrating “REM” is not opportunistic by default. Second, OEF have higher financial performance compared to REMF, in periods t and t+1.Originality/valueThe study therefore invokes resource-based theory and data envelopment analysis to integrate managerial effectiveness (human capital) into REM modelling. The study therefore extends the basic REM residual model.