Evidence for the Existence of Downward Real-Activity Earnings Management
Bill Francis, Iftekhar Hasan, Lingxiang Li
Journal of Accounting, Auditing and Finance,
Nr. 2,
2016
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.
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Abnormal Real Operations, Real Earnings Management, and Subsequent Crashes in Stock Prices
Bill Francis, Iftekhar Hasan, Lingxiang Li
Review of Quantitative Finance and Accounting,
Nr. 2,
2016
Abstract
We study the impact of firms’ abnormal business operations on their future crash risk in stock prices. Computed based on real earnings management (REM) models, firms’ deviation in real operations (DROs) from industry norms is shown to be positively associated with their future crash risk. This association is incremental to that between discretionary accruals (DAs) and crash risk found by prior studies. Moreover, after Sarbanes–Oxley Act (SOX) of 2002, DRO’s predictive power for crash risk strengthens substantially, while DA’s predictive power essentially dissipates. These results are consistent with the prior finding that managers shift from accrual earnings management to REM after SOX. We further develop a suspect-firm approach to capture firms’ use of DRO for REM purposes. This analysis shows that REM-firms experience a significant increase in crash risk in the following year. These findings suggest that the impact of DRO on crash risk is at least partially through REM.
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