Earnings Management: Real Activities Manipulation

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Table of Contents

Introduction
Earnings management, real activities manipulation, and existing literature
Hypotheses development, data, and methodology
Results
Conclusion
Works Cited

Introduction

The researchers of the accounting standards today obtain more and more evidence that it became a part of the common practice for the executives to be involved in the earnings management activities. Two major aspects need specification in terms of the mechanisms of earnings management. Firstly, income management can take place on different levels. It can be represented either by the real financial manipulations with the money or by the financial actions that only take place in the reports. The latter include discretionary actions and misrepresentation of financial information. Another important aspect is to recognize the motivation behind earnings management, the particular incentives that are typical for a certain type of management, both involving the real activities manipulation and introducing discretionary information.

The performance of the managers is partially evaluated based on the positive profit of the company. Therefore, out of the consideration for the job security and personal benefits, the managers discrete some information in the financial reports presented to the external audience.

Also, executives often have incentives to manipulate real financial activities. In that case, the manipulation would involve the operations with the cash flows and some particular accruals, depending on the managers’ benefits and the purpose of the earnings management (Roychowdhury 336). The aim of the real manipulation is always to avoid the earnings decrease. However, there might be some objective restrictions and constraints to such manipulations, including the financial agents, such as the investors and shareholders, and the governmental regulations (Kothari and Sloan 150).

Earnings management, real activities manipulation, and existing literature

Avoiding losses is the main cross-sectional incentive of the real activities manipulation in earnings management. The most problematic issue with such type of income manipulation is the fact that real activities manipulation can only show sustainable results in achieving the short-run goals of the company. However, with the long-run objectives, such type of earnings management can substantially distort the understanding of the real financial performance of the company (Graham, Harvey, and Rajgopal 19).

There are some differences in the definition of the notion of real activities manipulation. Given the fact that the earnings management occurs when the financial judgment of the manager is involved in the reporting (Schipper 96), it is important to underline that the objective of the earnings management is to create a certain impression amongst the investors or other audience (Healy 98).

However, the problem is to define which precise methods of financial reporting that include judgment to consider the earnings management practice (Healy and Wahlen 369). According to Roychowdhury (2006), the real activities manipulation can be classified as the type of earnings management if they involve “departures from normal operational practices, motivated by managers’ desire to mislead at least some stakeholders” (Roychowdhury 337).

Hypotheses development, data, and methodology

The methodology used for establishing the mechanisms of the real activities manipulations relies on analyzing the various discretionary procedures, in which the companies with the forecasts of decreasing future performance are involved. The main data that needs to be investigated came from the analysis of the discretionary expenses and production costs of such companies. Most of the discretionary expenses commonly involved “advertising expenses, research and development expenses, and selling, general and administrative expenses” (Roychowdhury 339).

The discrete nature of those expenses creates the impression of the reduced expenditure. On the other hand, the sales manipulations, such as abnormal operational practices in shipments and accounts receivable, artificially boost the cash flow and create the impression of the positive profit in the short-run.

Therefore, the main hypothesis is that 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). In their turn, those measures result in unusually high production costs, which demonstrate to be higher than in the previous fiscal periods. Therefore, companies with higher financial liabilities show higher unusual production costs.

Results

The main measure of defining the company’s potential for the earnings management involving the real activities manipulations is the comparison of the suspect interval with other earnings intervals in the vicinity of the zero benchmarks, the cross-sectional variation in real activities manipulation, the performance matching coefficients, and alternated earnings thresholds to the annual analyst forecasts. Both too optimistic and too pessimistic forecasts of the analysts give the incentives for the increase in the earnings management. The main correlation is that the degree of increase of the production costs, a decrease in the discretionary accruals and cash flows in the correlation to the gap between the current earnings and the anticipations of the analysts.

Conclusion

In conclusion, the empirical methods of recognition of the earnings management that involves the manipulation of the real activities are not restricted to defining the reduction of the discretionary expenditures in the large samples. Other means of finding out that manipulation took place are the traces of the unexpectedly high liabilities together with the low cash flow, and the abnormally high production costs.

Works Cited

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

Healy, Paul M. “The Effect of Bonus Schemes on Accounting Decisions.” Journal of Accounting and Economics 7.1 (1985): 85-107. Print.

Healy, Paul M., and James M. Wahlen. “A Review of the Earnings Management Literature and Its Implications for Standard Setting.” Accounting Horizons 13.4 (1999): 365-383. Print.

Kothari, Stephen P., and Richard G. Sloan. “Information in Prices about Future Earnings: Implications for Earnings Response Coefficients.” Journal of Accounting and Economics 15.2 (1992): 143-171. 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.

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