Accrual-Based/Real Earnings Management Activities

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Introduction

Earnings management tends to involve two main constituencies, which are the real activities management and accruals management. As a result, those types of management influence the approaches that are used to investigate the different types of earnings manipulation. However, to obtain the comprehensive and exhaustive picture of the practices that the executives are using to manage the companies’ earnings, it is important to build research about both aspects.

Accrual-related earnings management usually involves seasoned equity offerings. Nevertheless, given the fact that another way to manage earnings is to alter the real financial activities, the data concerning the executives’ equity offerings and equity rates should be analyzed alongside them. The accrual-based manipulations do not relate directly to any of the cash flow activities, and therefore, they can be accompanied by the real activities manipulations to stabilize the financial reporting. The main implication is that the managers would be able to make the earnings seem smoother in their reports and to provide judgment about the future earnings and the level of cash flow (Schipper 92).

However, the issue is that after the seasoned equity offerings (SEO) accompanied by earnings management with real activities manipulations, the managers refuse the performance followed by SEO because such type of earnings management turns out to have more severe consequences than the accruals-related manipulations.

Hypothesis development and empirical methodology

Even though accrual-based earnings management takes place in many areas of accounting and is widely studied, to smooth the earnings the most common practice for the majority of the managers involves real activities manipulation (Graham Harvey and Rajgopal 4). The reasons for using this path can be attributed to several factors. Firstly, reliance solely on accruals management has substantial risks. However, the second reason is that the manipulation involving the real activities threatens a lesser level of scrutiny and legal consequences. Thus, it is likely that those two types of earnings management often accompany each other.

Another consistent tendency among the results of different studies is that meeting of the earnings benchmarks is often related to the earnings management and equity offerings. Thus, the earnings manipulations, in such case, define the benefits of the executives through the SEOs. Variations in research and development and other expenditures, as well as asset sales, can be associated with the managers’ attempts to meet the analysts’ forecasts. Therefore, the hypothesis is that the companies issuing the SEOs are more likely to produce evidence of earnings management. Their performance, under such circumstances, depends on the extent of both types of earnings management.

Evidence on real and accrual earnings management

The correlations between real activities manipulation and accruals-based actions have many implications. For example, according to Roychowdhury (2006), the companies involved in the real activities manipulation, that after controlling for sales levels, show either unusually low cash flow or the unexpectedly low discretionary expenses (Roychowdhury 341). Furthermore, such measures, as a rule, result in unusually production costs that are higher than in the previous fiscal periods. For that reason, companies with higher financial liabilities show higher production costs.

The larger the company is, the more likely it is to be involved in smoothing earnings because there are a bigger number of the sources of profits, variations of expenditures, including research and development, and cash flows (Tucker and Zarowin 252).

However, the managers themselves classify discretion of the earnings in their financial reports as either garbling or the means of protecting the sensitive and private information that can only be accessed by the insiders of the company (Healy and Palepu 406). However, there are different associations between the types of managed accruals and financial consequences. Thus, the study by Cohen and Zarowin (2010) shows that there is only a negative correlation between the discretionary accruals and abnormal cash flows (Cohen and Zarowin 9).

Determinants of earnings management for SEO firms and post-SEO operating performance

There are first-stage and second-stage models that explain the motivations and incentives of the earnings management amongst the SEO companies. According to the first-stage model, the decision of the company’s executive to apply the earnings management does not strongly correlate with the type of management that is used. Therefore, it is only the circumstance and conveniences that define the accruals and the real activities that are managed.

However, in the second-stage model, it is revealed that the real activities management is preferable since the managed accruals are more likely to be discovered. Therefore, there is a likelihood that accrual-based management, at the post-SEO operation performance will be revealed, and the managers will be punished.

Conclusion

The real activities manipulation and accrual-based earnings management have a similar motivation. The main difference is in the likelihood of litigation. Real financial actions have more severe legal consequences, but most of the managers prefer them because accrual-based management is more expected to be discovered among the SEO firms.

Works Cited

Cohen, Daniel, and Paul Zarowin. “Accrual-based and Real Earnings Management Activities Around Seasoned Equity Offerings.” Journal of Accounting and Economics 50.1 (2010): 2-19. Print.

Graham, John, Campbell Harvey, and Shiva Rajgopal. “The Economic Implications of Corporate Financial Reporting.” Journal of Accounting and Economics 40.1 (2005): 3-73. Print.

Healy, Paul, and Krishna Palepu. “Information Asymmetry, Corporate Disclosure, and the Capital Markets: A Review of the Empirical Disclosure Literature.” Journal of Accounting and Economics 31.1 (2001): 405-440. Print.

Roychowdhury, Sugata. “Earnings Management through Real Activities Manipulation.” Journal of Accounting and Economics 42.3 (2006): 335-370. Print.

Schipper, Katherine. “Commentary on Earnings Management.” Accounting Horizons 3.4 (1989): 91-102. Print.

Tucker, Jennifer, and Paul Zarowin. “Does Income Smoothing Improve Earnings Informativeness?” The Accounting Review 81.1 (2006): 251-270. Print.

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