Earnings Management Implications for further research

908 additional costs may incur. For example, temporary sales increase through price discounts, which is one of RM, will decrease cash flows eventually. It is because the increased sales volumes as a result of the discounts are likely to disappear when the firm increases the sales price in later periods. Also, another way to temporarily boost sales for increasing earnings is channel stuffing, which may increase accounts receivables. These kinds of sales management activities will lead to lower cash flows in current period given the normal sales levels. Another example for RM is overproduction. Firms may produce more than necessary in order to increase earnings. That is, when managers produce more units, they can spread the fixed overhead costs over a larger number of units, thus 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 will decline. This will decrease reported cost of goods soldCOGS, and the firm can report higher operating margins. However, the firm may still incur other production and holding costs, which will lead to higher annual production costs relative to sales and lower cash flows from operation given sales levels. Discretionary expenditures include RD, advertising expenses and SGA expenses. Managers can increase current period earnings by reducing such expenses. If managers reduce such discretionary expenditures, these will be lower given sales levels. Also if such expenditures have been paid in cash, it could lead to higher current period cash flows. The focus of this paper is to find whether RM and DM are performed simultaneously or sequentially in managing earnings. Also, we peruse to examine whether factors, which are known to influence DM, will affect managers RM. This study is important for two reasons. First, as mentioned by Fields, Lys and Vincent2001, examining only one earnings management techniques at one time cannot explain the overall effect of earnings management activities. In particular, If managers use RM and DM as a substitute, examining either type of management in 909 isolation cannot lead to definitive conclusions. Further managers are more likely to use RM or DM as substituteor combination. Second, factors deterring DM are more likely to lead to RM since this will be associated with managers accounting choices. This study will, first of all, test whether RM or DM are determined sequentiality or simultaneously. Also, we will define factors which influence RM or DM to test for whether managers decisions for DM affect RM decisions, and then we will test the association between these factors and RMor DM. In addition, this study will examine what will happen in quarterly bases. In general, DM doesnt affect cash flows directly. However, it is more likely restricted by the rigidity of accounting standards or interested parties who are affected by firms accounting results. Thus, we adopt Big4 as one of the major restricting factors for DM in our model. This is because prior literatures provide evidence that Big4 is able to restrict DMBecker, DeFond, Jiambalvo, and Subramanyam, 1998; Francis, Maydew, and Sparks, 1999 and Big4 are more strict in auditing than Non-Big4. Second factor for DM is leverage ratio. Managers DM may be constrained because interest parties may require more severe audit process for high leverage firms. Also, additional obvious costs associated with DM is that the abnormal accruals are mechanically reversed in the short-run, reducing earnings in the next period. That is, if managers ability to increase earnings upward in a current period is constrained by DM activities in previous periods. The last factor constraining DM is the probability to avoid reported losses. IF firms avoided reported losses through DM, they have to report losses in case that the reported earnings is corrected in the following auditing processes. In addition, for RM we identify such controlling variables. The first controlling variable is a modified version of Altmans K-scoreAltman 1996. We use Altmans K- score in our model because firms close to bankruptcy status are more sensitive to RM, which will affect cash flows. Second controlling variable is equipment volumedivided by sales. Manufacturing firms managers can decrease cost of sales 910 through over-production without incurring additional expenses. Third controlling variable is a firms sales ratio to the average sales of industry. The ratio represent the leading position of the firm in the industry, which firms is likely to be constrained by RM since pushing sales for boosting earnings may lead to a considerable level of accounting receivables. Thus, DM or RM may affected by such each proxies, DM are expected to have negativepositive relation with factors having positivenegative association with RM. In addition, some existing literatures analyzed RM and provided evidence that DM on based on the discretionary accruals was decreased with DM changed to RM based on real activity management.Cohen et al. 2008; Zang 2008 Korean companies are rely on DM to raise reported earnings or avoid losses in the first 3 quarters of a year and upward DM in the previous quarters tend to be reversed in the fourth quarter. However, there isnt any study testing how RM are performed in quarterly bases. We expect that managers are likely to refrain from using DM to raise earnings in the fourth quarter if they have used DM in the previous 3 quarters of a year. Thus, managers have incentive to report higher earnings in the first 3 previous quarters using DM, which dont accompany with costs. However, they may do relatively more RM in the last quarter since their ability for using DM is now constrained. Many earnings management studies have investigated DM in various ways, but only a few recent studies used RM. Moreover, this paper may be the first study testing a relation between DM and RM especially on quarterly bases. The remaining sections of this study are organized as follows. Section 2 presents the related literatures. Section 3 sets hypothesis, describes the empirical specification and sample. Section 4 presents the empirical results, and finally section 5 provides the conclusion of this study. 911

2. Related literature

Managers can use various means for earnings management. Specifically, they can use both discretionary accruals and real activities. Existing literatures provide evidence that managers use discretionary accruals more frequently in managing earnings. DeFond •Jiambalvo1994와 Sweeney1994 studied the accounting choices and earnings management for firms violating debt covenants. DeFond•Jiambalvo1994 indicated that managers used discretionary accruals to increase reported earnings in preventing a debt contract violation. Sweeney1994 also found an evidence that firms were increasing cashflows and earnings to prevent debt contracts violation. Guenther1994 suggested that managers were manipulating earnings by using discretionary accruals to cut down the corporation tax when tax rates are increasing. Subramanyam1996 examined if stock market could price discretionary accruals. He provided evidence on pervasive income smoothing, which improves the persistence and predictability of reported earnings. He also indicated that discretionary accruals help in predicting future profitability and dividend changes. In addition, Schipper1991 asserted that managers have incentives managing earnings using discretionary accruals when they wanted to low earnings. Existing literatures suggested that mangers have used more discretionary accruals for earnings management. However, there are a few studies using real activity as a tool for earnings management. Presently, studies based on RM have shown that mangers may use acceleration of sales or increase production level as a tool for RM methods available to mangers. Shipper 1991, Healy and Wahlen 1999, Dechow and Skinner 2000, Thomas and Zhang 2002, Roychowdhury 2006 In fact, mangers are likely to manage earnings by delaying or maintaining discretionary expenditures. That is, they could decrease discretionary expenditures 912 to meet earnings target or to increase reported earnings.Baber et al. 1991, Bushee 1998, Dechow and Sloan 1991 Kasznik1999 also provide evidence that research and development costsRD or advertising expenditures are abnormally lower in the firms whose real earnings is lower than their voluntarily disclosed earnings Specifically, Roychowdhury2006 is to develop empirical method to detect real activity management. Also, this paper examine cash flow from operationsCFO, production costs, and discretionary expenses, variables that should capture the effect of real operations better than accruals. Next, this study use these measures to detect real activities management around the zero earnings threshold. He find evidence consistent with firms trying to avoid losses by offering price discounts to temporarily increase sales, engaging in overproduction to lower cost of goods soldCOGS, and reducing discretionary expenditures aggressively to improve margins. Zang2007 study whether managers use real and accrual manipulations as substitutes in managing earnings, and study the order that managers make these decisions. Zang2007 find that managers determine real manipulation before accrual manipulation. This paper use an empirical model that captures the sequentiality of real and accrual manipulations to test the tradeoffs between the two. The results of the broad sample tests are consistent with managers using real and accrual manipulations as substitutes. However, in a small sample test examining firms subject to securities class action lawsuits, Zang2007 examine whether real and accrual manipulations change over time with changes in litigation risk. Cohen et al.2008 document that accrual-based earnings management increased steadily from 1987 until the passage of the Sarbanes-Oxley ActSOX in 2002, followed by a significant decline after the passage of SOX. Conversely, the level of real earnings management activities declined prior to SOX and increased significantly after the passage of SOX, suggesting that firms switched from accrual- based to real earnings management methods after the passage of SOX. They find that firms that just achieved important earnings benchmarks used less accruals and