Firm Life Cycle and Real-Activity Based Earnings Management

Abstract

We examine real-activity based earnings management, i.e., cuts in discretionary spending to report small profits, across introductory, growth and mature stage firms. We use the cash flow components to classify a firm’s life cycle. We predict and find that firms in the mature stage, on average cut discretionary spending to report small profits; but firms in the introductory and growth stages do not. We examine future performance and document the following: (a) firms in all stages that report small profits and have small cuts in discretionary spending exhibit better short-term performance; (b) firms in the mature stage that report large profits and have large cuts in discretionary spending exhibit worse future performance; and (c) firms in the introductory and growth stages that have small and large cuts in discretionary spending and report large profits exhibit better future performance. Collectively, this shows the importance of considering firm’s life cycle when examining real-activity based earnings management and its consequences.