Evidence for the Existence of Downward Real-Activity Earnings Management

Abstract

Prior studies of real-activity earnings management (REM) focus on earnings-inflating abnormal activities. We seek to establish the existence of downward REM by investigating several corporate events in which managers have incentives to temporarily deflate market valuations. Specifically, we focus on, and find downward REM before, share repurchases, management buyouts (MBOs), and CEO option awards. Large-sample evidence of downward REM is also found in our general analysis of earnings smoothing. Downward REM becomes much smaller or nonexistent when there is a lack of managerial incentives in those events, such as non-carry-through repurchases, incomplete MBOs, and unexpected option awards. Following the research design of Zang, we find that various REM and accrual-based earnings management (AEM) cost factors consistently influence the magnitude of downward REM and AEM around the three corporate events.

Earnings Smoothing as Information Signaling or Garbling: A Review of Literature

“…Therefore, when the accumulated bad news bubble burst, stock price crash as a result of investors' negative reaction. Francis et al (2016) also find that firms engage in downward real earnings management to garble information. Managers manage earnings downward immediately before share repurchases, management buyouts and CEO option awards to lower the stock prices, for their private benefits.…”

“…Only very few studies measure earnings smoothing using real smoothing, such as Dhole et al (2016), Francis et al (2016), Huang et al (2009) and Khurana et al (2017). Therefore, this section is contributed to the studies that examine real smoothing activities while the rest of the paper i.e.…”

“…Following Hepworth's (1953) note that firms with smooth earnings signal stable corporate management to the shareholders and creditors, the study on corporate earnings smoothing has evolved ever since. Until recently, scholars have been trying to prove the existence of earnings smoothing activities (Beidleman, 1973;Boterenbrood, 2014;Khalil & Simon, 2014), figuring how (Atik, 2009;Francis et al, 2016) and when (Gassen et al, 2006;Gill de Albornoz & Alcarria, 2003) managers smooth earnings, characterizing earnings smoothing firms Bouwman, 2014;Z. Huang & Xue, 2016;Safdar & Yan, 2016;Silhan, 2014), and most importantly understanding the motivation (Goel & Thakor, 2003;Lambert, 1984;Trueman & Titman, 1988) and consequences (Houcine, 2017;Shubita, 2015;Tucker & Zarowin, 2006) of such behavior.…”

The Influence of a Company’s Ownership Structure on Upward Real Earnings Management

“…The links between accounting (accrual) earnings management and ownership structure have been analyzed in many outstanding studies described in the next section, including [3,[15][16][17][18][19][20][21][22][23][24][25]. Research on the relationship between the magnitude of real earnings management and the ownership structure of companies has been much more limited and has not necessarily focused on ownership concentration and managerial ownership, including that of [26][27][28][29][30][31][32][33]. Hsu and Wen [34] analyzed only the linear correlation between the percentage of insider shareholdings and the magnitude of real earnings management.…”

“…Prior studies mostly document the role of managerial ownership in the processes of accounting (accrual) earnings management; therefore, we contribute to [3,[20][21][22]29], but in our study, it is viewed through the lens of real earnings management. The next element of the contribution to the subject literature is the examination of the impact of the degree of ownership concentration in actions monitoring the activity of the enterprise, thereby expanding the research of [26][27][28] in providing evidence that the association between the magnitude of total upward real earnings management and shareholder concentration is U-shaped. The next aspect of the contribution of the study to the knowledge consists of the expanded description of the factors influencing upward real earnings management, in relation to the ownership structure of the enterprise [9,34].…”