Real Operating Activities Research Articles

Earnings Management Behavior of Firms with Financial Constraints: Focusing on Firms that Issue Redeemable Convertible Preferred Stocks

Purpose: T his study aim s to e xplore t he e ffect of f inancial c onstraints o n earnings m anagement by f ocusing on firms that issue redeemable convertible preferred stocks (RCPS). RCPS are considered a financing option primarily used by firms that have investment opportunities but face difficulties in raising funds with a low cost of capital. Therefore, the issuance of RCPS can be an effective indicator to identify firms with financial constraints. Design/methodology/approach: This study employs a sample of 12,406 firm-year observations of listed companies in the Korean stock market from 2011 to 2018. The study conducts multiple regression analyses to investigate the level of earnings management of RCPS-issuing firms with respect to that of non-issuing firms. In this analysis, the earnings management is proxied by discretionary accruals and real operational activities. Findings: This study shows that RCPS-issuing firms have a higher level of discretionary accruals than non-issuing firms. Meanwhile, there is no significant difference in the level of real activities management between RCPS-issuing and non-issuing firms. These findings imply that firms with financial constraints engage in aggressive earnings management through discretionary accruals rather than real operational activities. Research limitations/implications: This study provides compelling evidence that financially constrained firms strategically use discretionary accruals to signal positive prospects for external capital suppliers, allowing them to raise the capital necessary for investment. It is also confirmed that financially constrained firms do not depend on real activities management, which sacrifices cash flows and firm value in the long run. Originality/value: T his is t he f irst s tudy t o test t he l ink between f inancial c onstraints a nd e arnings m anagement by analyzing RCPS-issuing firms that conform to the definition of financial constraints. This approach can alleviate the risk of errors in the classification of firms and the endogeneity problems accompanied by estimating financially constrained firms with firm characteristics, such as dividend payout ratio, cash flows, size, age, or a combined index of these variables.

Is Earnings Management Related to Labor Productivity Gap? Evidence from the USA

Using a standard partial adjustment model and US firms, we study the relationship between managers’ failure to achieve target labor productivity and their tendency to manage earnings. To overcome the endogeneity problem, we employ an instrumental variable technique based on negative investment growth and find that managers, experiencing a labor productivity gap, tend to manage earnings by manipulating discretionary accruals and real operating activities. Additional analysis suggests that elements of personal value maximization biases drive the estimated effect of the labor productivity gap. Our results are robust considering variation and alternative measures of statistical sensitivity. The positive association between the labor productivity gap and earnings management is also consistent with the opportunistic financial reporting hypothesis and impression management theory.

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.

The Impact of Managerial Ability on the Relation between Real Earnings Management and Future Firm’s Performance: Applied Study

This study aims to investigate the managerial ability of executives’ managers’ role on mitigating the negative impact of real earnings management on future firm’s performance. The researcher operationalizes managerial ability by using a measure developed by Demerjian, Lev, and McVay (2012). This measure captures managers’ ability to efficiently convert firm resources into sales revenue relative to their industry peers. In other words, higher-ability managers are more likely to generate more sales revenue for a given set of resources compared to lower-ability managers. The researcher follows Roychowdhury (2006) and Kothari et al. (2016) to calculate abnormal sales, abnormal production costs, and abnormal discretionary expenses. To capture the total effects of three REM methods an aggregate REM that is a proxy for real earnings activities was used. Following Gunny (2010) and Huang & Sun (2017) future performance proxies are ROA and operating cash flows to total assets (CFO) for the next three years each year. Using a panel sample of 605 firm-year observations from 2005 to 2015. The study concluded that there is a positive significant relationship between the managerial ability of managers and earnings management through manipulating of real operational activities.

The effect of investor sentiment on the means of earnings management

Prior research has shown that a firm’s tendency to meet or beat earning targets is greater during bad economic times than good times. The paper extends this line of research by investigating which means of earnings management is used in different states of economy. A sample of non-financial companies listed on Korea Securities Market from 2003 to 2011 is used for empirical tests. The findings of this study are summarized as follows. The magnitude of discretionary accruals is negatively related to investment sentiment, indicating that firms tend to use positive discretionary accruals to manipulate reported income upward when the sentiment is pessimistic. However, the real activity based earnings management is not significantly associated with the state of economy. Collectively, this study contributes to behavioral finance and accounting literature by suggesting that managers use discretionary portion of accruals, but do not change their real operating activities, in order to meet or beat earnings targets in economic downturn.

The impact of IFRS adoption on management of bad debt expense and real operational activities: evidence from South Korea

This study examines whether the adoption of International Financial Reporting Standards in Korea affects earnings management behavior by focusing on the allowance for doubtful accounts. Adopting IFRS implies a change in approach whereby firms are required to build up an allowance only for incurred losses. Using a sample of 3817 firm-year observations of Korean listed companies covering 2000–2014, I find evidence that the discretionary portion of the allowance is decreased and that the opportunistic management of bad debt expense to meet crucial earnings targets is mitigated after the adoption of IFRS. Further, I find partial evidence that a shift from accrual-based to real earnings management may occur when the management of a specific accrual account is constrained by the adoption of IFRS.

Do managers manipulate earnings to influence credit rating agencies’ decisions?

PurposeThis study aims to investigate whether firms engage in earnings management behavior that attempts to manipulate Credit Rating Agency (CRA) perceptions during the Watchlist process and, if so, whether earnings management behavior appears to influence CRAs’ decisions.Design/methodology/approachTo measure earnings management activities, this paper computes accrual-based and real earnings management measures in the year or in the quarter immediately before the Watchlist resolutions for all negative and positive Watchlist firms. To examine the association between the levels of earnings management and Watchlist resolutions, a logit model is applied to the data obtained from a sample of Watchlist firms.FindingsSome evidence suggests that managers in Watchlist firms manage earnings in attempts to gain favorable Watchlist treatment. The findings are consistent with the Graham et al.’s (2005) survey evidence, which shows that one of the primary reasons for earnings management is to gain (or preserve) a desirable rating. In addition, CRAs appear to be misled by these attempts during the negative Watchlist process period.Research limitations/implicationsThe findings support SEC’s (2011, 2013a, 2013b) rules to reduce its reliance on credit ratings and the recent regulation reforms concerning the competition in the rating industry [the Credit Rating Agency Reform Act (2006)], and concerning conflicts of interest of CRAs among others [Dodd–Frank Wall Street Reform and Consumer Protection Act (2010)].Originality/valueWhile many studies examine whether managers use discretionary accruals as a tool to manage earnings to obtain favorable ratings, those studies do not consider manipulation of real operating activities to manage earnings and CRA perceptions.

Consequences for Future Return with Earnings Management through Real Operating Activities

ABSTRACT This article analyzes earnings management through real operating activities by firms in the Brazilian capital market. This way of manipulating outcomes takes place when managers make suboptimal decisions in terms of timing and volume of operating activities. This study tests the hypothesis that firms engaged in earnings management through real operating activities might have a negative impact on future returns. Our analysis is restricted to nonfinancial firms listed on the Brazilian Securities, Commodities, and Futures Exchange (BM&FBOVESPA) with annual data made available by the Economatica(r) for the years from 1989 to 2012. Empirical tests involving regression on panel data and estimation of future firm returns and outcomes indicate a negative impact on return on assets (ROA) related to manipulation through real operating activities. This finding is useful for several stakeholders. It demonstrates that manipulation through real operating activities takes place in the Brazilian capital market, suggesting that earnings management extends beyond discretionary accounting choices in this country. The main contribution is demonstrating a negative relation between earnings management by using real operating activities and future returns. This finding is relevant for investors, particularly for the purposes of comparison and valuation of securities.

Earnings Management and Fraudulent Financial Reporting: The Malaysian Story

Earnings management research has a long and rich history. The agency conflict, incentives, rationalization, opportunity plus having the capability among the managers to manipulate the financial statements lead them to commit fraud. The loopholes in the standards or the deviation from real operational activities promote this situation to prolong. In relation to this issue, this study examines the earnings management behavior among fraud firms in Malaysia. Further, this study examines the relationship between accruals earnings management as a proxy variable for discretionary accruals and real earnings management as the proxy variable for discretionary cash flow. Sample of 57 alleged fraud firms was selected based on the fraudulent financial reporting offences announced in Bursa Malaysia website. The sample data are collected from public firms which committed fraud from 2001 to 2013. This study found a significant negative relationship between accruals earnings management and real earnings management among the fraud firms in Malaysia suggesting that these firms aggressively manage earnings downwards or upwards essentially to avoid regulators scrutiny apart from aiming to achieve personal incentives. The study significantly finds evidence that fraud firms manage earnings on a sequential basis between accruals earnings management and real earnings management prior to fraud year. The findings indicate that firms opt for real earnings management and make full use of its distinguished features of not easily traceable to continue managing earnings immediately subsequent to fraud year. This study may assist regulators, auditors, and policymakers to curb earnings management patterns that have high likelihood of becoming part of fraud antecedent.

Real Earnings Management in UK Private and Public Firms

This paper analyses real earnings management among private versus public firms. Using accounting data of British firms, we find that public firms overall engage in more earnings management through real operating activities. Furthermore, when clear incentives to manage earnings in a specific direction are present, such as to beat earnings targets, we also find that public firms manage their earnings in the expected direction more than private firms. Additional tests reveal that higher analyst coverage may mitigate the level of abnormal operating behaviour in certain settings while quality auditing is not a limiting factor. We also find that high managerial ownership among private firms is associated with less real earnings management. Our study contributes to the emerging literature on non-accrual earnings management and to the broader understanding about the private vis-a-vis public firm reporting and operating behaviour.

Earnings Management and Ownership Structure

Abstract Earnings management research has a long and rich history. The agency conflict, incentives, rationalization, opportunity plus having the capability among the managers to manipulate the financial statement lead them to commit fraud. The loopholes in the standards or the deviation from real operational activities promote this situation to prolong. According to the agency theory, separation of ownership and control gives rise to manager's incentives to select and apply accounting estimates and techniques that can increase their own wealth. This issue has become more important in recent years as more firms are listed on stock exchanges as public firms. In this review, we emphasize studies that advance the managerial understanding of the earnings management and agency theory. This paper aims at reviewing on some major conducted research from various countries, examining relationships between ownership structure (and its subsets) and earnings management. The results of the paper further extend the literatures in understanding the determination of the influences of ownership structure and earnings management.

Earnings management through real activities choices of firms near the investment–speculative grade borderline

We examine whether manufacturing firms manage earnings through real activities for credit rating concerns. By using Standard & Poor’s Rating Service (S&P) credit rating data between 1989 and 2009, we find that manufacturing firms in the rating categories near the investment–speculative borderline, that is, BBB and BB ratings, choose the most aggressive income-increasing real operating activities. The credit rating agency does not appear to discount the managed portion of earnings if it is managed through real activities. Our results suggest that the investment–speculative-grade borderline created by the explicit use of this dichotomy in various regulations and practices is an important threshold that influences management’s real earnings management decisions.

Is Earnings Quality Associated with Corporate Social Responsibility?

ABSTRACT This study examines whether socially responsible firms behave differently from other firms in their financial reporting. Specifically, we question whether firms that exhibit corporate social responsibility (CSR) also behave in a responsible manner to constrain earnings management, thereby delivering more transparent and reliable financial information to investors as compared to firms that do not meet the same social criteria. We find that socially responsible firms are less likely (1) to manage earnings through discretionary accruals, (2) to manipulate real operating activities, and (3) to be the subject of SEC investigations, as evidenced by Accounting and Auditing Enforcement Releases against top executives. Our results are robust to (1) controlling for various incentives for CSR and earnings management, (2) considering various CSR dimensions and components, and (3) using alternative proxies for CSR and accruals quality. To the extent that we control for the potential effects of reputation and financial performance, our findings suggest that ethical concerns are likely to drive managers to produce high-quality financial reports. Data Availability: Data used in this study are available from public sources identified in the study.

Trends in Earnings Volatility, Earnings Quality and Idiosyncratic Return Volatility: Managerial Opportunism or Economic Activity

We establish a link between earnings volatility and earnings quality, and show that both earnings volatility and earnings quality contribute to the trend in idiosyncratic return volatility. We examine the trend in earnings volatility and its components during the period 1978-2006 and find that both cash flow volatility and accruals volatility have been increasing and that the contemporaneous correlation between cash flow and accruals has become less negative. The key driver for the deteriorating earnings quality measure is the less negative contemporaneous correlation between cash flow and accruals. We view cash flow volatility as reflecting the uncertainty in firms' real operating activities, accruals volatility as reflecting firms' absolute financial reporting uncertainty, and the cash flow-accruals correlation as reflecting firms' relative degree of earnings management. We find that both the marginal contribution and overall contribution of the cash flow volatility trend to the earnings volatility trend dominate those of accrual volatility and those of correlation. The cash flow volatility trend is positively associated with the idiosyncratic return volatility trend, reflecting the impacts of firms' economic operations. On the financial reporting side, the return volatility trend is positively associated with the earnings quality trend yet negatively associated with the accrual volatility trend. Collectively, the trends in earnings volatility and its components and the trend in earnings quality help explain the documented increasing idiosyncratic stock return volatility. In sum, this paper contributes to the literature in a number of ways. First, we identify the drivers for the trend in earnings volatility. While a few papers have separately identified the trend either in earnings or cash flow volatilities, this paper brings these strands of literature together. Our main finding is that cash flow volatility is the primary but not the only driver for earnings volatility. We also document the role of management opportunism in contributing to the earnings volatility trend. Second, we find that earnings quality, financial reporting volatility, and cash flow volatility coexist in explaining idiosyncratic stock return volatility. Our results highlight the roles of both operating volatility (economic forces) and financial reporting quality (managerial opportunism) in explaining earnings volatility and idiosyncratic return volatility, with economic forces dominating managerial opportunism.