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Metrics details Abstract Firms often change their operating policy to meet a short-term financial reporting target. Accounting researchers call this opportunistic action real earnings management REM. Firms that pursue distinct competitive strategies also display different cost patterns than peers.
However, the models that measure REM do not control for differences in competitive strategy. The researcher would also find a spurious correlation between earnings management and a firm characteristic that varies with competitive strategy. A cause or effect relationship with earnings management could be wrongfully inferred. I suggest improvements in measurement models to avoid misspecification.
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Introduction Graham et al. The literature has made considerable progress in measuring accrual manipulation, but REM estimation models remain rudimentary. Footnote 1 Researchers continue to use the original models proposed by Roychowdhurydespite the problems identified in recent studies Siriviriyakul ; Cohen, et al.
Consequently, researchers could erroneously infer REM if same-industry firms pursue different strategies. I find that variations in competitive strategies within industries are large enough to cause incorrect inferences staircase option video the presence and extent of earnings management.
Furthermore, competitive strategy is associated with commonly studied accounting and finance variables, such as capital structure, corporate governance, executive compensation, and disclosure policy.
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Researchers can therefore document spurious correlations between earnings management and strategy-driven firm characteristics. I suggest improvements in REM estimation models to address this problem. Roychowdhury proposes four models to measure REM, each focused on a different component of operating income. The third model considers positive abnormal production cost [cost of goods sold [ COGS plus changes in inventory] to be overproduction.
The fourth model regards abnormal cash flow from operations as a sign of earnings management. Footnote 3 Abnormal values for each of the four variables are obtained from linear regression models at the industry-year level and rely on two assumptions. First, all firms in an industry have the same cost and cash flow patterns when they are not managing earnings.
Second, sales revenue is the sole driver of costs and profitability in the normal course of business. Researchers then, depending on the model, deem as abnormal the portion of costs or cash flows that are the most real earnings on the network to current or past sales. I show that the two assumptions underlying the estimation models are systematically violated.
The cost patterns and cash profitability of firms in a given industry could differ because firms are in different stages of their life cycles Miller and Friesen ; Dickinson or they adopt dissimilar business models at the time of their formation Stinchcombe Young firms invest more in intangibles to create product differentiation or cost advantage Porter Hence younger cohorts are more likely to pursue customer intimacy and product leadership strategies than older cohorts at the same stage of their life cycle Treacy and Wiersema Furthermore, older cohorts show higher levels of cash profitability than do younger cohorts, which typically incur losses.
So the old and new cohorts within industries differ in their cost and profitability patterns.
The second assumption, that current or past sales is the sole driver of nonmanipulated costs and profitability, is systematically violated in three of the four REM models. Firms make cost decisions according to their competitive strategy. For example, firms invest in innovation, strategy, market research, customer and social relationships, computerized data and software, brands, and human capital to reap long-term rewards Wernerfelt ; Peteraf ; Eisfeldt and Papanikolaou A discretionary cost model that is based solely on the most real earnings on the network revenues should therefore be misspecified, because it excludes major determinants of planned investments.
In contrast, a production cost model would be well specified because COGS, the main component of production cost, is matched to current revenues by accounting convention. Footnote 5 I find that the residuals from discretionary cost models the portion of costs that is unrelated to current revenues are large and strongly associated with future revenue growth.
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Discretionary cost models thus measure REM with errors that reflect long-term investments. Furthermore, residuals display the same cohort patterns as the reported discretionary costs—they increase from the oldest to the youngest cohorts.
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Because regression residuals must add up to zero, the oldest cohorts show large negative residuals, while the youngest cohorts display large positive values. A researcher would conclude that the oldest cohorts opportunistically cut discretionary costs and the youngest cohorts overinvest in intangibles.
Improving the measures of real earnings management
The production cost model is better specified than the discretionary cost model and yields smaller residuals, because COGS is highly matched to current revenues. Footnote 6 Also, the difference between the residuals of the youngest and the oldest cohorts is much smaller for the production cost model than for the discretionary cost models. Thus the youngest and the oldest cohorts show no significant difference in earnings management by overproduction but appear to significantly differ in earnings management by discretionary cost curtailment.
This pattern is noteworthy because studies typically find significant earnings management using discretionary cost models but not with production cost models. Stated differently, the literature shows widespread earnings management using measures that are obtained from under-specified models.
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But the same studies do not report significant results with measures of better-specified models. Furthermore, earlier studies typically find higher REM for large, low-growth, and highly profitable firms, which are the characteristics of older cohorts.
Footnote 7 In effect, those studies conclude that older cohorts manage earnings by cutting discretionary costs when the routine business practice of those firms may be to invest less in research and development and intangibles.
The above tests do not rule out the possibility that older cohorts manage earnings to a greater extent than do younger cohorts.