By capturing expectations about declining patterns of future business performance, earnings decline risk (EDR) contains information about each firm's risk. Firms with a high risk of profit decline are more likely to face negative business performance in the future and are more affected by macroeconomic conditions.
INTRODUCTION
Since earnings management mainly consists of two parts: accrual earnings management and real activity manipulation, each type of earnings management is analyzed separately to examine its association with EDR. Companies with a higher EDR therefore also have incentives to focus more on real profits.
PRIOR LITERATURE
Earnings Downside Risk
Following the lower partial moment framework of Stone (1973) and Fishburn (1977), EDR shows the expectation of the company's future downward operating performance. This paper will thus examine the connection between the company's downward fundamental risk and the company's commitment to earnings management.
Earnings Management
For example, the widely used types of earnings management, accrual-based earnings management (AEM) and real earnings management (REM), have been extensively examined. Since accrual quality is closely related to accrual-based earnings management, the link between EDR and earnings management seems logical. Because of the trade-off between accrual-based earnings management and real earnings management, the relationship between EDR and REM may be the opposite of the relationship between EDR and AEM.
In particular, firms with high downside earnings risk are likely to manage their real profits through overproduction of inventories, but not through overproduction. The firms in this sample with high EDR are more likely to engage in accrual earnings management. The result also indicates that smaller and older companies are more likely to adopt accrual-based earnings management.
To further test the analysis of H2b, the cost associated with accrual-based earnings management is added. This study examines the relationship between firm earnings downside risk and accrual-based and real earnings management. The measurement of EDR shows a significant and positive correlation with accrual-based earnings management and manipulation of real activities through inventory overproduction.
For regulators, the company's past earnings downside risk can be useful in examining the company's earnings management behavior.
HYPOTHESES DEVELOPMENT
EDR and Accrual-based Earnings Management
In fact, EDR provides distinctive information not captured by other measures of earnings characteristics (Konchitchki et al. 2016). A finding that EDR reflects the expectation of future downward operating performance is consistent with a firm's incentive to manipulate earnings to avoid losses.
EDR and Real Earnings Management
When companies experience poor operating performance, they are more likely to report poor profits, even lower than what analysts have forecast, and thus more likely to keep their profits in check. Several studies present systematic evidence of firms' motivation to report earnings increases to meet their benchmarks (e.g., DeAngelo et al. 1996; Hayn, 1995) and of those firms that expect future downward activity. Finally, REM and AEM even have different effects on companies, as REM, unlike AEM, can have a negative impact.
Since real earnings management is practiced under the same motivation of accrual-based earnings management, to avoid reporting potential losses, higher EDR may result in more real management activities. Because discretionary expenses are expensed immediately, rather than capitalized, managers can easily adjust their spending on R&D, advertising, and SG&A to achieve certain earnings management goals (Xu et al., 2007). According to Baber et al. 1991), firms cut their R&D expenditures to maintain an increase in their profits, regardless of the firm's overall investment opportunities.
DATA AND RESEARCH DESIGN
Data and Sample Selection
Measurement
ROA is annual revenue scaled by total assets and SALE is the ratio of total revenue to total assets. SIZE is company size, measured as the natural logarithm of the market value of shares, and LEVERAGE is the leverage ratio, calculated as long-term and short-term debt divided by total assets. STD_ROA is the standard deviation of ROA estimated over the last four years, as available.
When the trailing loss indicator variable is the dependent variable, the probit estimation method is used, and OLS regression is used for the margin measures of trailing performance. 𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠𝑡 is the profit before extraordinary items and discontinued operations, less the cash flows from operations stated in the statement of cash flows in year t, and 𝑃𝑃𝐸𝑡 is gross tangible fixed assets. The first is measured by the abnormal level of production costs, and the second by the abnormal level of discretionary spending.
Empirical Models
Roychowdhury (2006) suggests that firm-specific growth opportunities and firm size can explain significant variation in earnings management. To isolate the effect of EDR on earnings management, industry-adjusted ROA (ADJ_ROA) is included in the regressions. To further address the problem of omitted correlated variables, leverage (LEV) and a proxy variable for the incidence of an equity offering during the following fiscal year (EO) are included to control for incentives related to leverage and equity offerings for earnings . management (e.g., Teoh et al. 1998; Kim and Park 2005).
To ensure that the estimated relationships between EDR and earnings management are not biased or inconsistent due to the possible omission of company fundamentals or risk variables, cash, CASH; intensity of capital investment, INVEST_CAPX;. One thing to note is that the EDR measure is from year t-1, while the earnings management proxies, the dependent variables, are from year t. Because EDR contains information about the expectation of future downside operating performance, the realized downside operating performance of the future based on the forecast in year t-1 will be associated with the earnings management of the future in year t.
EMPIRICAL RESULTS
Descriptive Statistics and Univariate Analyses
To further address the problem of correlated omitted variables, leverage (LEV) and an indicator variable for the occurrence of an equity offering in the following fiscal year (EO) are included to control for the leverage and equity offering related incentives for earnings management (e.g. Teoh et al. 1998;. To ensure that the estimated EDR earnings management relationships are not biased or inconsistent due to the potential omission of firm fundamental characteristics or risk variables, cash holdings, CASH; capital investment intensity, INVEST_CAPX; .. operating opportunities, OO are included in the regressions.. FIRM_AGE is also included as financial reporting behavior may change as the firm matures and different . development stages of the firm may influence accordingly. One thing to note is that the target for EDR is from year t-1 when earnings management proxies, the dependent variables, are from year t. Since EDR contains information about the expectation of future downward operating performance, the realized downward operating performance for the future from prediction of year t-1 will be associated with the future earnings management of year t. Ⅴ. EMPIRICAL RESULTS 5.1.
Descriptive statistics and univariate analyses. percent, two-digit SIC code 73), followed by electronic and other electrical equipment (12.51 percent, two-digit SIC code 36) and industrial machinery and computer equipment (9.49 percent, two-digit SIC code 35). The measurement of EDR shows similar values to those reported by Konchitchki et al. 3 The values are even more similar when the sample period of the observations coincides with that of Konchitchki et al.
Validity Analyses
EDR and Earnings Management (AEM and REM)
Even if the management of discretionary expenses is performed under the similar incentive for accrual-based earnings management, to avoid losses, firms in this sample with high EDR are less likely to choose earnings management by reducing discretionary expenses. This adds to the second perspective that EDR and REM are positively related, as EDR and AEM do, since engagement in AEM and REM share the same motivation. Yet, unlike the result of AEM regression, firms with high R&D intensity are less likely to engage.
In sum, EDR is significantly associated with real earnings management, and the results in Table 5 provide evidence consistent with all three hypotheses. Consistent with the positive relationship between reverse accrual quality and EDR, the results show positive relationship between AEM and EDR, but the result is different for real earnings management. An interesting finding shows that the relationship between EDR and REM depends on the technique used to manipulate.
Further Analyses
Again, all test statistics and significance levels are based on the standard errors adjusted by a two-dimensional clustering at the firm and year level. This suggests that firms with high EDR and Tobin's Q values are even less likely to engage in the manipulation of discretionary R&D and S&D. The positive relationship between EDR and 𝑅𝑀𝑃𝑅𝑂𝐷 suggests that firms with high earnings downside risk are motivated to engage in overproduction of.
Based on the trade-off between AEM and REM, I hypothesize that high EDR companies will engage in inventory overproduction when accrual-based earnings management is more difficult to practice. Therefore, the predicted sign of the interaction term, 𝐸𝐷𝑅𝑡−1∗ 𝑁𝑂𝐴𝑡−1, is positive, as firms with high EDR and limited flexibility within their accounting system tend to opt for real earnings management. The untabulated result of the F-test on the sum of the coefficients of 𝐸𝐷𝑅𝑡−1 alone and the interaction term, 𝐸𝐷𝑅𝑡−1∗ 𝑁𝑂𝐴𝑡−1, shows significance even at the 1 percent level, with an F-value of 49 ,10.
CONCLUSION
For researchers, the conflicting relationship between EDR and two different real earnings managements suggests that the two manipulations should be treated separately to fully understand the management of real activities. Accounting earnings and cash flows as measures of firm performance – The role of accounting accruals. The relationship between earnings management using the manipulation of real activities and future performance: Evidence from meeting earnings benchmarks*.
IB) to the total income (Compustat: SALES) of company i in the financial year t 𝑁𝐼𝑀 The ratio between the annual net income (Compustat: NI) and the total turnover. 𝑂𝑃𝑀 The ratio between annual operating income after depreciation (Compustat: . OIADP) and total income (Compustat: SALES) for company i in financial year t. 𝐶𝐴𝑆𝐻 The ratio between cash and cash equivalents in relation to total assets 𝑅𝑂𝐴 The ratio between income before extraordinary items and total assets.
AD_IND_INT Advertising intensity for industry with two-digit SIC code for year 𝑂𝑂 Ratio of tangible fixed assets to total assets. This table reports the Pearson correlations of EDR, earnings management proxies, and other selected variables from the main models.
