Real Activities Manipulation Research Articles

Does voluntary CSR disclosure and CSR performance influence earnings management? Empirical evidence from China

We examine whether Chinese firms with better voluntary corporate social responsibility (CSR) disclosure and CSR performance engage in earnings management in their financial reporting. Our results show that Chinese firms with better voluntary CSR disclosure are more likely to engage in earnings management through discretionary accruals and less likely to engage in earnings management through real activities manipulation, while Chinese firms with better CSR performance are more likely to engage in earnings management through real activities manipulation and are less likely to engage in earnings management through discretionary accruals. Our evidence shows that consistent with opportunistic theory, the Chinese firms’ engagement in CSR practices is based on opportunistic incentives, and voluntary CSR disclosure and CSR performance are being used by these firms as window-dressing tools for earnings management that infringes on the benefits of firm stakeholders.

Short selling threat and real activity manipulation: Evidence from a natural experiment

In this paper, we investigate whether and how short selling threat affects real activity manipulation. Using a regulatory experiment (Regulation SHO) that removes short selling restrictions on randomly selected pilot firms, we find that real activity manipulation is significantly reduced for pilot firms in response to increased short selling threat during the experiment period. The reduction effect is stronger for pilot firms with a transparent financial reporting strategy, a high level of negative financial reporting sentiment, and bad news. Our finding confirms short sellers' monitoring effect on opportunistic behavior, even for real activity manipulation that is difficult to detect.

Does Options Trading Deter Real Activities Manipulation?

We examine whether and how options trading activity curtails real activities manipulation. Using a large sample of US firms that are suspected of earnings manipulation, we document that an active options trading market significantly reduces real activities manipulation. We confirm our findings by using 2SLS analyses and alternative research designs. Our findings are also robust to using alternative proxies for options trading activity. Further, we find that the deterring impact of options trading on real activities manipulation is more pronounced among firms with low institutional ownership, firms in highly competitive industries, and small and young firms. Overall, our findings show that an active options market discourages managers from engaging in real activities manipulation as informed options trading helps stock prices better reflect adverse consequences of real activities manipulation. Our findings highlight the benefits of the options market development in reducing value-destroying activities and thus provide policy, practice, and research implications.

Having the government as a client: Does this reduce earnings management of the firm?

Does government contracting translate to better earnings quality and less earnings management? In this study, we seek to answer this question. We find strong evidence that government suppliers strategically substitute accrual-based earnings management with real earnings management. Firms with government customers distinctively employ greater real activities manipulation than their industry peers, as proxied by abnormal discretionary expenditures, abnormal production costs, and total real activities manipulation while avoiding accrual manipulation. These findings are robust to a host of robustness checks including measurement errors, selection bias and endogeneity. Hence, our findings have implications for procurement policy as policymakers may underestimate the total earnings management activities of government suppliers.

The effect of the internal control regulation on reporting quality in China

This paper aims to investigate whether Chinese internal control regulation improves reporting quality. After the enactment of US Sarbanes–Oxley Act (SOX), China introduced a quasi-SOX practice (C-SOX). C-SOX stipulates that firms should disclose both management and audit reports on internal control and aims to help firms ensure reporting reliability. Previous studies provide solid evidence of the effectiveness of SOX, but the conclusion cannot simply be generalized to emerging markets. We employ a modified difference-in-difference approach regarding the special batched implementation schedule of C-SOX and observe earnings management during the reform, finding that accrual-based earnings quality is enhanced significantly after compliance with C-SOX without causing more real activity manipulation. Our results thus show that C-SOX has a positive effect on reporting quality and triggers no side-effects harming firms’ long-term value. Our findings suggest that the mandatory disclosure regime of C-SOX contributes to better corporate disclosure even with weak enforcement.

Do Abnormal IPO Audit Fees Signal IPO Audit Quality and Post-IPO Performance? A Principal-Agent Analysis Based on Evidence from China

ABSTRACTWe assess the unexplained information content of abnormal audit fees using a sample of initial public offering (IPO) audits in China. We find that abnormal IPO audit fees are positively associated with manipulation of pre-IPO real activities, suggesting lower audit quality for IPO financial statements. We further find that abnormal IPO audit fees are negatively associated with post-IPO financial performance. These results suggest a strong alignment of interests between the principal (pre-IPO shareholders), whose main interest is to gain listing status, and its agent (the auditor), who is willing to cooperate with the principal for extra economic rents (abnormal audit fees). Our findings that abnormal IPO audit fees are associated with lower audit quality and can help predict post-IPO financial performance have important implications for audit regulators, IPO market participants, and the applicability of agency theory in the context of IPO audits.JEL Classifications: M43; M49.

Is There a Trade-Off Between Accrual-Based and Real Earnings Management Activities in the Presence of (fe) Male Auditors?

Prior research suggests that the presence of high-quality auditors (i.e. proxied by audit firm characteristics) constrains accrual-based earnings management, but it inadvertently leads to higher real activities manipulation. We investigate whether such trade-off exists between accrual-based and real earnings management activities in the presence of female or male auditors. We use a sample of UK firms for the period 2009 to 2016 and find that firms audited by female auditors do not resort to a higher-level real activities manipulation when their ability to engage in accruals management is constrained. Overall, our results suggest that the benefits of hiring female auditors (i.e. less accrual-based earnings management) are overwhelmingly higher than the costs they might bring to the client firms (i.e. higher real activities manipulation).

Is there any association between real earnings management and crash risk of stock price during uncertainty? An evidence from family-owned firms in an emerging economy

This research work intends to analyze the association between real earnings manipulation and stock price crash. Further, we also analyze the spillover outcome of the crash as a result of applying real earnings management. It is hypothesized that there is a positive and statistically significant association between real activities manipulation and crash risk. It is also assumed that this spillover outcome is more noticeable during uncertainty. By applying data of family firms for the time period 2005–2018, empirical results provide the proof that real manipulation has a significant impact on stock crash for a developing economy like Pakistan among family-based companies. This research work also gives a statistical insight that spillover outcome is more notable for firms facing uncertainty. Our statistical estimations are in support of the assumed hypotheses of the study. This study has very significant and practical implications for academic researchers, standard setters, and investors.

Corporate social responsibility, enterprise risk management, and real earnings management: Evidence from managerial confidence

This paper examines the relationship between enterprise risk management (ERM) and corporate social responsibility (CSR) and how this relationship is affected by managerial confidence and real activities earnings management (REM). The findings show that firms with more effective ERM are more willing to engage in CSR behaviors. From the interaction terms of managerial confidence and ERM, we find that when firms with more confident CEOs who engage in real activities manipulation are higher, their CSR inputs are larger. The managerial confidence affects corporate policies, including reducing the effects of overall risk on CSR. We also find that confident CEOs with higher shareholdings have a stronger coherence to firms, and therefore, they are more likely to increase CSR activities to enhance firms’ reputation through REM.

Does Teacher-Turned Businessmen Curb Accrual-Based Earning Management and Real Activity Manipulation

ABSTRACT Using manually collected data in Chinese-listed firms from year 2008 to 2018, this paper studies that how does teacher-turned businessperson curb or improve accrual-based earning management and real activities manipulation. Results show that top management team (TMTs) with academic experience manage earning less through accruals and manipulating real operating activities. Further studies show that when firms with no-big4 auditors or less analysts tracking, TMTs with (out) foreign experience or political connection, the inhibition of academic experience on the earning management is more pronounced.

Financial Reporting in Family Firms: A Socio-Emotional Wealth Approach Toward Information Quality

The strategic choices of family firms are influenced by economic and non-economic reference points. We contend that the preservation of the affect-related values a family derives from its ownership position in a firm (i.e., socio-emotional wealth – SEW) affects financial reporting quality and earnings management strategies. Using the voluntary International Financial Reporting Standards (IFRS) adoption by Italian unlisted family firms as a natural laboratory setting, we found that the level of SEW endowment impacts on financial reporting quality. Furthermore, we observe that IFRS adoption is associated with less accrual but higher real activity manipulation for increasing levels of SEW endowment.

The Effect of Board of Director Composition and Audit Committee Expertise on The Real Earnings Management in Indonesia

The Objective of this research was to prove that the implementation of good corporate governance will have an effect on the real activities manipulation which was done by the management. The implementations of good governance used by this research are board of director composition and audit committee expertise. This research was conducted in Indonesia by using 306 firm years’ observations. The result of this research showed a different result from previous researches. This research showed that the implementation of good corporate governance in the form of board director composition and audit committee expertise do not impact the practice of real activities manipulation. Or, in other words some of the good corporate governance tool could not mitigate the real activities manipulation in the company.

Earnings management to avoid earnings boosts

PurposeThe purpose of this study is to investigate whether earnings boosts before the year end trigger earnings management. It examines whether firms that substantially outperformed their last year earnings during the first three quarters push their earnings down to avoid reporting earnings boosts.Design/methodology/approachRegression analysis is used to compare earnings management of firms with earnings boosts and other firms.FindingsThe results indicate that firms outperforming their last year results by the end of the third quarter manipulate their earnings downwards by means of real activities manipulation, while they do not indicate income-decreasing accruals management. It is also found that consistent with the prominent shift from accruals management to real activities manipulation, accruals management is less costly which justifies why it is used for downward manipulation.Research limitations/implicationsThe results are limited to one single earnings benchmark i.e. last year earnings. Further research may individually or collectively examine other benchmarks including analysts' forecasts.Practical implicationsThe findings suggest that users should be more vigilant of firms exceeding their last year interim results, as they could be involved in downward earnings management.Originality/valueThis study documents earnings management in a new setting where earnings boosts before the year end trigger downward manipulation of real activities.

How does real earnings management respond to the 2007-2008 financial crisis?

PurposeThis paper aims to investigate the dynamics of repurchase-based earnings management vis-à-vis other real activities manipulations during the 2007–2008 financial crisis.Design/methodology/approachThis paper adopts a Probit model to regress alternate real earnings management (REM) methods on a dummy variable indicating whether a firm falls in the crisis event window or not, during our 15-year sample period. This paper also detects switches made by suspected firms from repurchasing to other REM tools such as reducing discretionary expenditures.FindingsThis paper provides solid evidence indicating that firms suspected of earnings management have the tendency to decrease accretive share repurchases after the onset of the crisis. Conversely, the above pattern is neither observed in non-suspect firms nor over non-crisis periods. A further investigation documents that firms that switch REM during crisis can be characterized by less cash holding, smaller size, more severe liquidity shortage and/or tighter financial constraint.Originality/valueThis paper contributes to the literature on understanding the respective and interactive implications of both share repurchases and global financial crisis on firms’ REM activities.

Heterogeneity in CSR activities: is CSR investment monotonically associated with earnings quality?

ABSTRACT Extant studies have investigated the relation between corporate social responsibility (CSR) endeavours and earnings quality based on monotonic models, showing mixed and inconclusive empirical evidence. By identifying heterogeneity in CSR investments, we extend prior literature to explore the potentially nonmonotonic nature of this relation. Specifically, we classify firms into two sub-groups, entities underinvesting and overinvesting in CSR activities, in which the levels of CSR investments are lower and higher than the theoretically optimal point respectively. Our empirical results show that the level of CSR underinvestment is positively associated with the magnitude of both accrual-based earnings management (AEM) and real earnings management (REM) and, hence, negatively related to earnings quality. For firms overinvesting in CSR activities, we do not find a significant relation between CSR overinvestment and AEM. The empirical analyses for real activities manipulation exhibit inconsistent results throughout our four REM proxies. However, the mixed evidence for firms with CSR overinvestment cannot fully exclude the possibility that overinvesting in CSR activities has a significant impact on future financial reporting quality. Varying incentives for CSR overinvestment in different firms could drive the inconsistent results. The positive effect of CSR overinvestment by some firms may offset the negative effect brought about by other entities, making the overall effect minor and unnoticeable. Our empirical results, together with some other CSR-related research, emphasise the need for more transparent reporting regarding the detailed nature, aim, and strategy of relevant CSR investments to help investing communities and other constituents better understand the incentives behind CSR activities.

The role of discretionary pension accruals in earnings management

PurposeManagers of defined-benefit (DB) firms have considerable discretion in deriving pension costs and flexibility in cash contributions to pension plans. Pension accruals occur when cash contributions differ from pension costs. The manipulable nature of pension costs and cash contributions allows managers of DB firms to manipulate pension accruals to achieve their desired earnings. We study whether DB firms with earnings management attributes (referred to as suspect DB firms) used more discretionary pension accruals (DPA) than non-suspect DB firms, especially after the passage of Sarbanes-Oxley (SOX).Design/methodology/approachThe authors develop an aggregate measure of DPA to capture overall earnings management in pension accounting. They then employ a multivariate regression model to study whether the suspect DB firms engage in more DPA than non-suspect firms and to assess the impact of SOX on DPA for all DB firms and for suspect DB firms.FindingsThe authors find evidence that suspect firms inflate DPA to achieve their earnings goals and also that all DB firms and the suspect firms use more DPA in the post-SOX era compared to the pre-SOX period. In contrast, they observe no significant difference in real activities earnings management (REM) between suspect and non-suspect firms. In addition, neither the entire sample of DB firms nor the suspect firms display a significant change in REM after SOX.Research limitations/implicationsThe samples in the study are limited to firms with defined pension plans; thus, the findings cannot be generalized to all firms. In addition, as in other empirical studies relying on models to estimate earnings management proxies, this study inherits estimation errors from Jones and Roychowdhury's models. Consequently, the impact of these estimation errors cannot be ruled out.Practical implicationsThe empirical findings of the study appear that instead of deterring DB firms from engaging in pension accruals earnings management, enacting the stringent anti-fraud SOX prompts these firms to rely more on accrual-based discretionary pension rather than switch to real activities manipulation to manage earnings.Originality/valueWhile many prior studies focus on the impact of managing individual pension assumptions on earnings, the authors study overall earnings management in pension accounting by developing a model to derive an aggregate measure of pension earnings management.

How Do Reporting Frequency and Analyst Perceptions of Real Activities Manipulation (RAM) Influence Managers' RAM Behavior?

ABSTRACT Real Activities Manipulation (RAM) is an earnings management technique that is increasingly being used by managers. RAM is a purposeful action by managers to manipulate earnings by altering operations, finances, and investments. In this study, we investigate the effects of reporting frequency and the knowledge that financial analysts view RAM negatively on the likelihood of management engaging in RAM. Based on the results of an online experiment with 73 experienced managers and MBA students, we find that more frequent financial reporting significantly reduces managers' likelihood to engage in sales-related RAM when they are also informed that analysts view RAM negatively. As a result, the combination of more frequent reporting and the knowledge that analysts view RAM negatively, taken together, may assist in deterring managers' engagement in sales-related RAM.

Financial reporting in family firms: a socioemotional wealth approach toward information quality

ABSTRACT The strategic choices of family firms are influenced by economic and noneconomic reference points. We contend that the preservation of the affect-related values a family derives from its ownership position in a firm (that is, socioemotional wealth [SEW]) affects financial reporting quality and earnings management strategies. Using the voluntary International Financial Reporting Standards (IFRS) adoption by Italian unlisted family firms as a natural laboratory setting, we found that the level of SEW endowment impacts on financial reporting quality. Furthermore, we observe that IFRS adoption is associated with less accrual, but higher real activity manipulation for increasing levels of SEW endowment.

Influence of geographic distribution on real activities manipulation within consolidated companies: Evidence from Japan

With the globalization of companies, distances between parent companies and their subsidiaries have increased and the locations of subsidiaries have become more diversified. These changes have had various effects on corporate real activities, depending on information asymmetry, transport costs, and the economic environment. We investigate the impact of the geographic distribution of companies on real activities manipulation (RM) within Japanese companies. The results show that (1) as the distance between a parent company and its subsidiaries increases, the subsidiaries’ RM decreases; (2) as the proportion of subsidiaries in Organisation for Economic Cooperation and Development countries increases, the subsidiaries’ RM decreases; and (3) part of the subsidiaries’ RM reduced by geographic distribution is replaced by the parent company’s RM. Additional tests comparing RM with accrual-based manipulation (AM) show that subsidiaries’ AM increases with the distance from the parent company. This result suggests that the parent–subsidiary distance and locations of subsidiaries influence accounting information.

Target Firm Earnings Management, Acquisition Premium, and Shareholder Gains

Using a sample of U.S. domestic deals from 1990 to 2016, we find that bidders adjust the amount of premium paid in mergers and acquisitions (M&As) based on the levels of earnings management at target firms. However, the way a firm manipulates earnings upward matters: earnings management via real activities manipulation is more detrimental than discretionary accruals. As a result, target firms that engage in real earnings management receive lower premiums in M&As, while accruals management has no effect on premiums. Correspondingly, we find that the targets’ M&A announcement-period cumulative abnormal returns are inversely related to their level of real earnings management, while the returns are not related to accruals management. Further analyses confirm that target shareholders’ wealth is not only driven by undervaluation, expected synergy, and managerial hubris, but also reflects bidders’ perception of the target firms’ earnings quality based on real earnings management.