Ebook Accrual-Based and Real Earnings Management Activities around Seasoned Equity Offerings
In this paper, we examine both real and accrual-based earnings management activities around seasoned equity offerings (SEOs). While a number of papers have documented evidence in support of income-increasing earnings management activities around SEOs (e.g., Rangan 1998, Teoh et al. 1998, Shivakumar 2000, and DuCharme et al. 2000) they have studied accrual-based manipulation exclusively. Such accruals-based earnings management activities have no direct cash flows consequences. Our research objective is important, since firms might use multiple strategies to manage their reported earnings around SEOs, for example, through real activities manipulations that does affect cash flows. We refer to real activities manipulation as actions managers take that deviate from normal business practices.
Recently, there has been an increased appreciation for understanding and documenting how firms manage earnings thru real activities manipulation in addition to accrual-based activities (e.g., Gunny 2006, Roychowdhury 2006, and Zang 2006). For example, Roychowdhury (2006) finds evidence that firms use multiple real earnings management tools in order to meet certain financial reporting benchmarks to avoid reporting annual losses. In particular, his evidence suggests that managers are providing price discounts to temporarily boost sales, reducing discretionary expenditures in order to improve reported margins, and overproducing to lower the cost of goods sold.
In a recent survey of top executives, Graham et al. (2005) provide evidence suggesting that managers prefer real earnings management activities compared to accrual-based earnings management. This is the case since real management activities can be indistinguishable from optimal business decisions, and thus more difficult to detect, although the costs involved in such activities can be economically significant to the firm. Moreover, consistent with the conjectures made by Graham et al. (2005), Cohen et al. (2007) find that mangers have shifted away from accrual to real earnings management in the post Sarbanes-Oxley Act (SOX) period. This evidence implies that in the post-SOX period that followed highly publicized accounting scandals, the need to avoid detection of accrual-based earnings management is greater than in previous periods inducing managers to shift from accrual-based to real earnings management activities.
Despite the increasing interest in and importance of real earnings management activities, no study to date has examined whether and how firms engage in real earnings management around SEOs, and how real and accrual-based earnings management interact around these important corporate events. We fill this gap in the literature.
To capture accrual-based earnings management we use the modified cross sectional Jones model (Jones 1991) as described in Dechow et al. (1995). To capture real earnings management, we follow Roychowdhury (2006) and estimate abnormal levels of cash flows from operations, discretionary expenses (advertising, R&D, and SG&A), and production costs. In addition, we combine these three measures into a comprehensive aggregate measure of real earnings management.
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