| This paper examines the consequences of four types of real earnings management. Using financial statement data, I identify firms that engage in any of the following real earnings management activities: (1) myopically investing in R&D to increase income, (2) myopically investing in SG&A to increase income, (3) timing of income recognition from the disposal of long-lived assets and investments, and (4) cutting prices to boost sales in the current period and/or overproducing to decrease COGS expense. Then, I explicitly examine (i) the extent to which real earnings management affects subsequent operating performance (as measured by both earnings and cash flows), and (ii) whether market participants (investors and analysts) expect the subsequent decline in performance.; The empirical results are consistent with all four types of real earnings management (RM) activities having a significantly negative impact on future operating performance. Additionally, it appears that investors recognize the future earnings implications of myopic investment in SG&A and cutting prices and/or overproducing to increase current period income. The results are inconsistent with investors recognizing the future earnings implications of myopic investment in R&D and the strategic timing of asset sales. The results are consistent with analysts recognizing the future earnings implications of all four types of real earnings management.; Given the extensive evidence on the existence of RM, this study examines the extent to which RM affects subsequent operating performance. By definition, RM negatively impacts future firm performance because the manager is willing to sacrifice future cash flows for current period income. However, the extent to which various RM activities impact future operating performance has not been addressed in prior literature. Using a matched sample of firms that did not engage in RM, I find that four types of RM are associated with significantly lower future earnings and cash flows after controlling for size, performance, level of accruals and industry.; Since the empirical results that all four types of real earnings management activities negatively affects future operating performance, my second set of tests examines whether investors and analysts recognize the consequences of RM. The results indicate that investors recognize the future earnings implications of myopic investment in SG&A and cutting prices and/or overproducing to increase current period income. However, the results are inconsistent with investors recognizing the future earnings implications of myopic investment in R&D and the strategic timing of asset sales. Analysts' expectations, as reflected in forecasts of earnings, appear to recognize the future earnings implications of all four types of RM. |
