Real Earnings Management (REM) is defined as “management actions that deviate
from normal business practices, undertaken with the primary objective of meeting
certain earnings thresholds” (Roychowdhury, 2006, p. 336). Analytically, REM imposes
real economic costs to the extent that normal (optimal) business practices maximize
firm value (Ewert and Wagenhofer, 2005; and Wang, 2006). Yet, prior research provides
limited evidence that REM has a negative impact on subsequent operating performance.
The objective of this paper is to assess the effect of REM on subsequent operating
performance. We extend prior research by developing new methods for estimating
abnormal expenditures, and by developing a more proactive method of identifying the
occurrence of REM.
This study is motivated by the conflict between current empirical research results
and the intuition of researchers and managers as well as the reaction of the financial markets. Ewert and Wagenhofer (2005, p. 1115) argue that REM “is costly and directly
reduces firm value.” Cohen et al. (2008, p. 759) state REM is “likely to be more costly
to shareholders” than accrual earnings management. The Graham et al. (2005, p. 40)
study indicates managers think all companies should use REM to manage earnings
as long as “the real sacrifices are not too large.”1 Furthermore, the market discounts
the REM component of earnings relative to unmanaged earnings (Hribar et al., 2006)
and reduces the premium of REM firms just meeting or beating analysts’ forecasts
(Lin et al., 2006). While all the aforementioned studies suggest REM negatively impacts
future operating performance, empirical evidence to-date does not fully support this
relation.
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