The Relation Between Earnings Management Using Real Activities Manipulation and Future Performance: Evidence from Meeting Earnings Benchmarks*

Abstract

Earnings management can be classified into two categories: accruals management and real activities manipulation (RM). Accruals management involves within generally accepted accounting principles (GAAP) accounting choices that try to ‘‘obscure’’ or ‘‘mask’’ true economic performance (Dechow and Skinner 2000). RM occurs when managers undertake actions that change the timing or structuring of an operation, investment, and ⁄or financing transaction in an effort to influence the output of the accounting system. Schipper (1989, 92) includes RM in her definition of earnings management and describes earnings management as ‘‘a purposeful intervention in the external financial reporting process, with the intention of obtaining some private gain...[a] minor extension of this definition would encompass ‘real’ earnings management, accomplished by timing investment or financing decision to alter reported earnings or some subset of it.’’ This paper examines the extent to which RM is associated with firms just meeting earnings benchmarks. Then, I examine the extent to which RM affects subsequent operating performance. Accruals management is not accomplished by changing the underlying operating activities of the firm, but through the choice of accounting methods used to represent those activities. In contrast, RM involves changing the firm’s underlying operations in an effort to boost current-period earnings. Both types of earnings management involve managers’ attempts to increase ⁄decrease earnings; however, one type affects operations and the