Real Earnings Management Technique

570 inflows, but the cash inflow per sale, net of discounts, from these additional sales is lower as margins decline. The lower margins due to the price discounts causes production costs relative to sales to be abnormally high. Another way to boost sales volumes temporarily to increase earnings is to offer more lenient credit terms zero-percent financing at the end of fiscal year. These are essentially price discounts and lead to lower cash inflow over the life of the sales, as long as suppliers to the firm do not offer matching discounts on firm inputs. These sales management activities lead to lower current-period CFO and higher production costs than what is normal given the sales level.

2.3.2 Discretionary Expenditure Reductions

Discretionary expenditures are expenses for firms as they incurred period costs which management has control in deciding the amount of reported expenses, such as RD, advertising, and maintenance Roychowdhury, 2006. By its control, management can reduce reported expenses, and increase earnings. If managers reduce discretionary expenditures to meet earnings targets, they should exhibit unusually low discretionary expenses. In effect, lowers cash outflows, so that has a positive effect on abnormal operating cash flows in the current period, possibly at the risk of lower cash flows in the future.

2.3.3 Overproduction

According to Roychowdhury 2006, in favor of manage earnings upward, managers of manufacturing firms can produce more goods than necessary to meet expected demand. By higher production levels, fixed overhead costs are spread over a larger number of units, lowering fixed costs per unit. As long as the reduction in fixed costs per unit is not offset by any increase in marginal cost per unit, total cost per unit declines. This implies that reported COGS is lower, and the firm reports better operating margins. Nevertheless, the firm incurs production and holding costs on the over-produced items that are not recovered in the same period through sales. As a result, cash flows from operations are lower than normal given sales levels. Ceteris paribus, the 571 incremental marginal costs incurred in producing the additional inventories result in higher annual production costs relative to sales.

2.3.4 Timing the Assets Sales

According to Gunny β005, the timing of asset sales is a manager‘s choice, and since a gain is reported on the income statement at the time of the sale the difference between the net book value and the current market value, the timing of asset sales could be used as a way to manage reported earnings. Bartov 1993, in Gunny 2005 provides evidence consistent with managers selling fixed assets in order to avoid negative earnings growth and debt covenant violations. Herrmann, Inoue and Thomas 2003, in Gunny β005 investigate Japanese managers‘ use of income from the sale of assets to manage earnings. They find that firms increase decrease earnings through the sale of fixed assets and marketable securities when current operating income falls below above management‘s forecast of operating income.

2.4 Future Operating Performance

Net income are affected by operating decision and how a firm is financed. In analyzing operating performance of a firm, any effect of financing activities to earnings should be isolated. Financing activities, like dividend, interest income, and realizedunrealized gains should be separated from operating activities because financing performance can distort the operating performance Wild et al, 2003; in Hasyim, 2006. Operating income is calculated before financing expense, such as interest expense, is deducted. So that, operating income is a more suitable operating performance proxy than earnings. Furthermore, according to Pradhono 2004, cash flows are more valuable to assure firm performance in the future. Cash flows shows the results of operations which the fund has been received by the firm and also, charged by the cash expenses and the expenses has been paid by the firm Pradhono, 2004. Therefore, both operating income and cash flows are the best proxy to measure operating performance.

2.5 Prior Research

572 One of the prior research which examine real activities manipulation is research from Roychowdhury 2006 which examine the impact of earnings management through real activities manipulation on operating cash flows. Firms that reports low earnings is categorized as suspect firms, that is firms inclined of doing earnings management, because firms with low earnings tend to do earnings management by increasing earnings. The model used by Roychowdhury 2006 is Dechow, Kothari, and Watts 1998 model to estimate normal operating cash flows or expected operating cash flows. After estimating the normal operating cash flows, the deviation between actual and normal operating cash flows is calculated which be called abnormal operating cash flows. Roychowhury 2006 finds that real activities manipulation has impact on operating cash flows, that is firms doing real activities manipulation report abnormal operating cash flows compared to firms which is not detected of doing real activities manipulation. Prior research which examine real activities manipulation and future operating performance is Gunny‘s β005 research. Gunny β005 investigates the consequences of real activities manipulation on operating performance in future period. The result indicates that firms doing real activities manipulation will find earnings and operating cash flows decreasing significantly in future period. In her research, Gunny 2005 uses performance-matching approach which the performance of each firms inclined of doing real activities manipulation compared to firms inclined of not doing real activities manipulation compared firms in the same year. Research in Indonesia that examine real activities manipulation in relation to future performance were done by Rahman 2007 and Oktorina 2008. Rahman 2007 identifies real activities manipulation and accrual manipulation and also its impact on market and operating performance of IPO firms. The result shows that the motivation of earnings management when IPO is using discretionary accrual proxy, but not using real activities manipulation proxy. Oktorina β008 identifies the firm‘s tendency to execute real activities manipulation through cash flow and its impact to market performance. The result shows that firm tend to execute real activities manipulation through operating cash flowbut not through investing and financing cash flow. Moreover, the impact of real activities manipulation on