Real Earnings Management and Subsequent Operating Performance*

Abstract

Real earnings management (REM) is the manipulation of business activities to meet an earnings threshold. Despite concern that REM activities create real economic costs, research on the relation between REM and subsequent operating performance is inconclusive. We develop two firm-level methods of estimating abnormal discretionary expenditures and implement a more proactive method of identifying REM activity. Using firm-level estimates of abnormal expenditures, we find strong evidence that REM is negatively related to subsequent period return on assets and cash flows from operations. Our results suggest that the inconclusive results in prior research may be in part due to estimating abnormal expenditures using industry-level models.

Keywords: Real earnings management, discretionary expenditures, operating performance

JEL Classification: M41