Earnings Management Proxies: Prudent Business Decisions or Earnings Manipulation?

Abstract

Researchers and practitioners often use the term “earnings management” to mean different things. In particular, earnings management proxies are often designed to capture a particular construct, but used by subsequent researchers for different (and often incongruous) purposes. We focus on the distinct construct of “earnings manipulation” and assess the extent to which commonly used earnings management proxies (which are designed to represent varying constructs) actually capture earnings manipulation. We argue that current-period earnings manipulation should lead to declining future operating performance when accruals reverse or the implications of real earnings management are realized. Although many studies use this logic, prior research does not provide a systematic investigation of the relation between commonly used earnings management measures and future performance. We find that three earnings management measures are negatively associated with firms’ future operating performance (earnings and cash flows), indicating that they likely reflect the construct of earnings manipulation. However, we find that four common earnings management proxies are actually positively associated with firms’ future operating performance. Thus, these four commonly used measures do not appear to reflect earnings manipulation, but instead may capture prudent business decisions or earnings smoothing. In supplemental analyses, we also examine stock price performance, restatements, and analysts’ forecast errors and find similar results, suggesting that our inferences are very robust.