Bridge over ocean
24 July 2018 CFA Institute Journal Review

Real Earnings Management, Institutional Environment, and Future Operating Performance: An International Study (Digest Summary)

  1. Michal Szudejko, CFA

Examining the effect of real earnings management on a company’s future performance, the authors find that the stronger the institutional environment, the higher the probability that the relationship is positive. This phenomenon is especially pronounced in non-crisis periods.

How Is This Research Useful to Practitioners?

According to the authors, their research is the first to focus on the future performance effects of real earnings management (REM) in an international setting. Moreover, they document the varying effects of REM on performance during periods of economic boom and crisis, respectively.

Company managers use REM to achieve a desired earnings level. REM activities deviate from the normal way of doing business and may affect a company’s future economic performance in a positive or negative manner. One way to conduct REM is to alter the level of discretionary expenditures—typically, R&D and S&A expenses. Other examples are overproduction, provision of substantial price reductions to boost sales, a buildup of stock levels, and a sale of fixed assets. REM activities are an “alternative” to accrual-based earnings management (AEM)—that is, altering earnings by changing accounting methods or estimates.

The authors determine that REM generally affects the future performance of a company in a positive manner. This positive performance is driven by companies that operate in markets with a strong institutional environment—for example, the United States, Japan, Australia, and Germany. The effect of REM on future performance is either negative or insignificant in markets with a weak institutional environment—for example, India and Indonesia. The observed relationship is stronger in non-crisis periods.

The study’s outcomes should interest regulators, auditors, and investors. The observed positive coexistence of REM and future performance is soothing. One should still remember that the positive relationship is directly related to the strength of the regulator.

How Did the Authors Conduct This Research?

The authors use 158,587 firm-year observations from 29 markets over the period 2001–2015. They retrieve financial data from the Wharton Compustat Global database. Data on GDP growth come from the World Bank and World Economic Outlook databases provided by the International Monetary Fund.

The authors test two hypotheses: (1) that REM affects future performance, conditional on the market-level institutional environment, and (2) that the moderating effect of institutional strength on the REM–future performance relationship differs between crisis and non-crisis periods.

The authors assess how selected REM measures affect a company’s future performance. The first measure is abnormal cash flow from operations. The authors assume that REM might have an ambiguous effect on cash flow. Some REM activities might result in an abnormal increase, whereas others might cause cash flow to decrease unexpectedly. Other measures used are abnormal production costs and abnormal discretionary expenses. Increasing production costs may result in a lower average fixed cost per unit and then become a cause for higher earnings. Nevertheless, total costs can increase because of increased volume. Year-end cash flow and profitability can thus decrease. Decreasing discretionary expenses will boost current-period earnings and cash flow.

The model is supplemented with variables that mimic the strength of the institutional environment. The explained variables are a future return on assets and future cash flow from operations.

The authors run a regression analysis for the entire sample. Next, they group the markets according to how strong the institutional environment is and rerun the regression separately for each group. They also test different sample parts to verify the results’ validity. For instance, they perform a separate test for markets with a large number of observations, exclude China from the sample, and perform the regression only on non-manufacturing firms.

Abstractor’s Viewpoint

It is apparent that REM constitutes potentially fraudulent behavior. Moreover, one-off, short-term REM decisions to improve performance can have very long-term consequences for a company and thus require further scrutiny from those responsible for corporate governance. REM actions take place at the operational level. The decision to alter performance in a “real” manner is difficult to trace back to its source. Hence, it is also difficult to prove the fraudulent nature of the given activity. As a matter of fact, such decisions can be made with a strong conviction of acting in the very best interests of a company and its investors. Hence, REM, compared with AEM, constitutes a far greater challenge for those responsible for corporate governance.

I assess the contribution of the research as positive. It touches on important matters and sheds light on the direction of future research. It seems that REM activities constitute a challenge for regulatory bodies and auditors. Only if these two market players are strong and engaged can the potentially adverse effect of REM be mitigated.

We’re using cookies, but you can turn them off in Privacy Settings.  Otherwise, you are agreeing to our use of cookies.  Accepting cookies does not mean that we are collecting personal data. Learn more in our Privacy Policy.