The effect of real earnings management on the persistence and informativeness of earnings

Abstract

Abstract: This study investigates the effect of real earnings management on two important aspects of earnings quality: earnings persistence and its informativeness about future cash flows. I focus on real earnings management through the abnormal reduction in discretionary expenditures and investigate how this type of real earnings management affects earnings quality. Examining a large sample over a period of four decades, I find that the extent of real earnings management is negatively related to earnings persistence, and this effect is achieved largely through the negative effect of real earnings management on cash flows rather than on accruals. The less persistent current earnings as a result of real earnings management exhibit a weakened ability to predict future cash flows, suggesting a decreased informativeness of current earnings about future cash flows. Moreover, I find that the negative effect of the abnormal reduction in discretionary expenses on earnings persistence and its association with future cash flows from operations is more pronounced in the post-SOX period. Overall, the results suggest that real earnings management through the abnormal reduction in discretionary expenses is associated with deteriorated earnings quality.