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Metrics details Abstract Firms often change their operating policy to meet a short-term financial reporting target. Accounting researchers call this opportunistic action real earnings management REM. Firms that pursue distinct competitive strategies also display different cost patterns than peers. However, the models that measure REM do not control for differences in competitive strategy.

The researcher would also find a spurious correlation between earnings management and a firm characteristic that varies with competitive strategy.

A cause or effect relationship with earnings management could be wrongfully inferred. I suggest improvements in measurement models to avoid misspecification. Introduction Graham et al. The literature has made considerable progress in measuring accrual manipulation, but REM estimation models remain rudimentary.

Footnote 1 Researchers continue to use the original models proposed by Roychowdhurydespite the problems identified in recent studies Siriviriyakul ; Cohen, et al. Consequently, researchers could erroneously infer REM if same-industry firms pursue different strategies.

I find that variations in competitive strategies within industries are large enough to cause incorrect inferences about the presence and extent of earnings management.

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Furthermore, competitive strategy is associated with commonly studied accounting and finance variables, such as capital structure, corporate governance, executive compensation, and disclosure policy. Researchers can therefore document spurious correlations between earnings management and strategy-driven firm characteristics. I suggest improvements in REM estimation models to address this problem.

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Roychowdhury proposes four models to measure REM, each focused on a different component of operating income. The third model considers positive abnormal production cost [cost of goods sold [ COGS plus changes in inventory] to be overproduction.

The fourth model regards abnormal cash flow from operations as a sign of earnings management. Footnote 3 Abnormal values for each of the four variables are obtained from linear regression models at the industry-year level and rely on two assumptions.

First, all firms in an industry have the same cost and cash flow patterns when they are not managing earnings. Second, sales revenue is the sole driver of costs and profitability in the normal course of business.

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Researchers then, depending on the model, deem as abnormal the most real earnings on the network portion of costs or cash flows that are unrelated to current or past sales.

I show that the two assumptions underlying the estimation models are systematically violated. The cost patterns and cash profitability of firms in a given industry could differ because firms are in different stages of their life cycles Miller and Friesen ; Dickinson or they adopt dissimilar business models at the time of their formation Stinchcombe Young firms invest more in intangibles to create product differentiation or cost advantage Porter Hence younger cohorts are more likely to pursue customer intimacy and product leadership strategies than older cohorts at the same stage of their life cycle Treacy and Wiersema Furthermore, older cohorts show higher levels of cash profitability than do younger cohorts, which typically incur losses.

So the old and new cohorts within industries differ in their cost and profitability patterns.

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The second assumption, that current or past sales is the sole driver of nonmanipulated costs and profitability, is systematically violated in three of the four REM models. Firms make cost decisions according to their competitive strategy.

For example, firms invest in innovation, strategy, market research, customer and social relationships, computerized data and software, brands, and human capital to reap long-term rewards Wernerfelt ; Peteraf ; Eisfeldt and Papanikolaou A discretionary cost model that is based solely on past revenues should therefore be misspecified, because it excludes major determinants of planned investments. In contrast, a production cost model would be well specified because COGS, the main component of production cost, is matched to current revenues by accounting convention.

Footnote 5 I find that the residuals from discretionary cost models the portion of costs that is unrelated to current revenues are large and strongly associated with future revenue growth.

Discretionary cost models thus measure REM with errors that reflect long-term investments.

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Furthermore, residuals display the same cohort patterns as the reported discretionary costs—they increase from the oldest to the youngest cohorts. Because regression residuals must add up to zero, the oldest cohorts show large negative residuals, while the youngest cohorts display large positive values. A researcher would conclude that the oldest cohorts opportunistically cut discretionary costs and the youngest cohorts overinvest in intangibles.

The production cost model is better specified than the discretionary cost model and yields smaller residuals, because COGS is highly matched to current revenues. Footnote 6 Also, the difference between the residuals of the youngest and the oldest cohorts is much smaller the most real earnings on the network the production cost model than for the discretionary cost models.

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Thus the youngest and the oldest cohorts show no significant difference in earnings management by overproduction but appear to significantly differ in earnings management by discretionary cost curtailment. This pattern is noteworthy because studies typically find significant earnings management using discretionary cost models but not with production cost models. Stated differently, the literature shows widespread earnings management using measures that are obtained the most real earnings on the network under-specified models.

But the same studies do not report significant results with measures of better-specified models. Furthermore, earlier studies typically find higher REM for large, low-growth, the most real earnings on the network highly profitable firms, which are the characteristics of older cohorts.

Footnote 7 In effect, those studies conclude that older cohorts manage earnings by cutting discretionary costs when the routine business practice of those firms may be to invest less in research and development and intangibles.

The above tests do not rule out the possibility that older cohorts manage binary options on olimp trade to a greater extent than do younger cohorts.

Three tests negate this proposition. First, older cohorts are characterized by low growth and positive cash flows.

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Therefore they have the least incentive to mislead external capital providers, which is arguably the strongest motive for earnings management Dechow and Skinner Second, the serial correlation of REM proxies is as high as 0. Footnote 8 Third, the oldest cohorts continue to show the largest profits year after year. This pattern contradicts the proposition that the oldest cohorts continually manipulate their operations, because a prolonged deviation from the optimal business practice must be followed by reduction in profits.

They must have competed successfully against each other and the nonsurviving firms by following superior strategies, creating better products, or establishing more stable markets and customer bases, which now enables them to earn economic rents without having to invest as much in intangibles as younger cohorts Amit and Schoemaker ; Agarwal and Gort New players, in contrast, must spend higher amounts on innovation, strategy, advertising, customer relationships, and brands to build competitive advantages or to gain from recent technological advances Porter ; Shapiro and Varian These differences in competitive strategies of the oldest and youngest cohorts, in conjunction with the under-specification of REM estimation models, lead to the appearance that the oldest cohorts underinvest in intangible assets.

The main takeaway from the paper is that competitive strategy is an omitted variable in REM estimation models that should be included in the first-stage models. Footnote 10 The empirical proxies for competitive strategy are not available in financial reports, which is a major limitation of accounting Lev and Gu I propose a sequence of the most real earnings on the network steps based on the available financial statement variables.

Thus, in the first-stage estimation, I include the proxies for opportunity set, namely, size, past profitability, and growth Gunny Second, I assume that firms spend on intangibles to generate current revenues as well as to secure future benefits.

Hence I include future revenues in the estimation models.

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Researchers can avoid this error by using a cohort adjustment, based on the assumption that firms in similar life-cycle stage and with similar technological vintage experience similar economic shocks. Footnote 11 I subtract the costs of a similar-size firm belonging to the same industry cohort from the costs of a given firm to estimate its abnormal behavior.

I demonstrate that each sequential step mitigates the measurement errors in REM proxies and reduces the portion of costs considered manipulative. Mitigation with each step, however, differs across proxies. The steps I propose could change the inferences of studies, such as that of Kim and Park My paper makes three contributions to the literature. First, it adds to understanding of the earnings management phenomenon as measured by the current REM models.

My findings are consistent with the ideas of Dechow et al. Second, I propose enhancements in the estimation models to lower the competitive strategy-related measurement errors in earnings management proxies.

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The enhancements I propose should improve the reliability of future tests about earnings management. As such, my contribution is analogous to that of Dechow et al.

Nevertheless, I caution researchers against mechanically applying the corrective steps I propose.

Improving the measures of real earnings management

I show that the oldest and youngest cohorts in an industry often differ in their competitive strategies, leading to systematic differences in their strategy-related financial characteristics. Thus cohort adjustment must be applied to any industry-based measurement of suboptimal or manipulative behavior.

The rest of the paper is organized as follows. Section 2 describes the literature on real earnings management and explains the estimation models and measurement of variables. Section 3 examines the violations of the two assumptions underlying the Roychowdhury models.

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Sections 4 and 5 investigate whether model misspecifications can lead to incorrect inferences about the presence and the extent of real earnings management. Section 6 proposes a sequence of improvements in the models.

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Section 7 concludes. Prior research, description of models, and measurement of variables Healy and Wahlenp. Footnote 12 This idea is confirmed in the Graham et al. Roychowdhury proposes an innovative method to detect such opportunism.

He reasons that lower discretionary costs, compared with industry peers [identified by two-digit Standard Industrial Classification SIC code], could indicate the reduction of soft discretionary costs. He also posits that higher production costs, relative to peers, represent overproduction of goods. He further argues that manipulation of real activities affects operating cash flow, though the direction of the effect is ambiguous.

Many subsequent studies associate abnormal operating cash flow with REM, consistent with the idea that curtailment of discretionary costs increases operating cash flow. Roychowdhury models require two assumptions. First, in the normal course of business, all firms in a given industry need the same level of discretionary costs and production costs, and they generate the same levels of cash operating profits.

Introduction

All variables are scaled by total assets at the beginning of the year. Second, either current or past revenue is the sole determinant of optimal costs. He finds that regression residuals are associated with the frequency of meeting earnings benchmarks. Footnote 13 All variables are scaled by total assets at the beginning of the year AT. To determine overproduction, I follow Roychowdhury and estimate the following cross-sectional regression for each industry two-digit SIC code and year.

The residual estimated on a firm-year basis represents a manipulation of the production schedule. The more positive the residual, the higher the manipulation, assuming that firms increase their production levels to spread fixed costs over a larger number of units to show higher profit margins.

To determine curtailment of discretionary costs, the following cross-sectional models are estimated for each industry and year Roychowdhury