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

This paper examines the consequences of real activities manipulation (RM). Using financial statement data, I identify firms that appear to engage in any of the following RM: reducing research and development (R&D) to increase income; reducing selling, general, and administrative (SG&A) expenses to increase income; timing of income recognition from the disposal of long-lived assets and investments; and cutting prices to boost sales in the current period and/or overproducing to decrease cost of goods sold expense. I then examine whether RM is associated with firms just meeting two earnings benchmarks (zero and last year's earnings). The results indicate that RM of R&D, SG&A, and production are positively associated with firms just meeting these earnings benchmarks. Next, I examine the extent to which RM affects subsequent performance. A negative association between just meeting earnings benchmarks by using RM and subsequent performance supports prior research suggesting managers opportunistically use earnings management to the detriment of shareholders (i.e., managerial opportunism). A positive association is consistent with managers using operational discretion to attain benefits that allow better future performance or to signal future firm value. I find that firm-years reflecting RM to just meet earnings benchmarks have higher subsequent firm performance (compared to firm-years that do not engage in RM and miss or just meet the earnings benchmarks). In this setting, using RM to influence the output of the accounting system is not opportunistic, but consistent with managers attaining benefits that allow better future performance or signaling.