Earnings management through real activities manipulation by firms that publish short-term profit plans

Abstract

Accounting information published by a firm's manager is used for investment and debt contracts, which, in turn, affects subsequent funding and executive compensation. Thus, managers have an incentive to manipulate the profit, and they perform earnings management as a legitimate means. Managers also manipulate the profit toward the profit benchmark, which usually includes earnings forecasts and short-term profit plans. Earnings forecasts are based on managers' or analysts' expectations about the company's overall growth. Short-term profit plans are based on first-year, medium-term management. It appears that there is a relationship between these two aspects since they are generally announced simultaneously. The purpose of this study is twofold. First, it examines the relationship between short-term profit plans and first-quarter earnings forecasts. Second, it clarifies whether firm managers create short-term profit plans or first-quarter earnings forecasts by real activities manipulation. The findings show that in the firms that do not announce short-term profit plans, they conduct earnings forecasts through real activities manipulation. Conversely, in the firms that announce short-term profit plans, the managers do not conduct real activities manipulation. For the reasons stated above, in firms that do not announce short-term profit plans, managers might establish internal short-term profit plans that differ from external earnings forecasts.