Earnings Management Literature Review

568 achieve some specific reported earnings objectives ‖. Gunny 2005 asserts that earnings management can be classified into three categories, such as fraudulent accounting, accruals management, and real earnings management. Fraudulent accounting involves accounting choices that violate GAAP. Accruals management involves within- GAAP choices that try to ―obscure‖ or ―mask‖ true economic performance Dechow and Skinner, 2000; in Gunny, 2005. Real earnings management occurs when managers undertake actions that deviate from the first best practice to increase reported earnings Gunny, 2005. Fraudulent accounting and accruals management are not accomplished by changing the underlying economic activities of the firm but through the choice of accounting methods used to represent those underlying activities. In contrast, real earnin gs management involves changing the firm‘s underlying operations in an effort to boost current period earnings. Examples of real earnings management are cutting prices toward the end of the year in an effort to accelerate sales from the next fiscal year into the current year, delaying desirable investment, and selling fixed assets to affect gains and losses.

2.2 Real Activities Manipulation

Roychowdhury 2006 defines real activities manipulation as departures from normal operational practices, motivated b y managers‘ desire to mislead at least some stakeholders into believing certain financial reporting goals have been met in the normal course of operations. These departures do not necessarily contribute to firm value even though they enable managers to meet reporting goals. Consistent to the definition by Roychowdhury 2006, Graham, Harvey, dan Rajgopal 2005 suggest that manager will manipulate their real activities to accomplish earnings target, eventhough these will decrease firm value in the long run. Graham, Harvey, dan Rajgopal‘s β005 survey finds that a financial executives attach a high importance to meeting earnings targets such as zero earnings, previous period‘s earnings, and analyst forecasts, and b they are willing to manipulate real activities to meet these targets, even though the manipulation potentially reduces firm value. 569 Real activities manipulation can reduce firm value because actions taken in the current period to increase earnings can have a negative effect on cash flows in future periods. For example, aggressive price discounts to increase sales volumes and meet some short-term earnings target can lead customers to expect such discounts in future periods as well. This can imply lower margins on future sales. Overproduction generates excess inventories that have to be sold in subsequent periods and imposes greater inventory holding costs on the company.

2.3 Real Earnings Management Technique

According to Roychowdhury 2006, there are three ways for management in doing real earnings manipulation: sales manipulation through increased price discounts or more lenient credit term, reduction of discretionary expenditures, and overproduction. Gunny 2005 adds one more way which allows manager to manipulate, that is timing the sale of fixed assets to report gains so that recognition of gain on asset sales can increase the reported earnings amount. Production costs are defined as the sum of COGS and change in inventory during the period. By using production costs variable instead of COGS, as one of real activities manipulation indicator, eliminates the possibilities of accrual manipulation in reporting lower COGS by delaying write-offs of obsolete inventory. This accrual manipulation effect does not impact production costs, so that production costs primarily reflect the effects of real activities. Moreover, the LIFOFIFO cost flow assumption affects reported COGS, but not production costs, due to offsetting effects on COGS and inventory change.

2.3.1 Sales Manipulation

Roychowdhury 2006 defines sales manipulation as managers‘ attempts to temporarily increase sales during the year by offering price discounts or more lenient credit terms. Jackson and Wilcox 2000, in Xu, Taylor, dan Dugan 2007 finds that manager grant sales price reductions in the fourth quarter to avoid reporting losses and decreases in earnings and sales. The increased sales volumes as a result of the discounts causes higher cash