The choice between real and accounting earnings management

This study develops a theoretical model and presents empirical evidence on cross-sectional variation in managers' choice of accounting earnings management (AEM) and real earnings management (REM). AEM refers to managers' opportunistic use of the flexibility allowed under General Accepted Accounting Principles (GAAP) to change reported earnings without changing the underlying cash flows. REM refers to managers' opportunistic timing and structuring of operating, investing and financing transactions to affect reported earnings in a particular direction; it results in sub-optimal business consequences and imposes a real cost on the firm.;The study examines how AEM and REM are jointly affected by firms' growth prospects and managers' market-based compensation incentives. It first develops a model that describes how managers choose between AEM and REM in a capital market setting when they face both short-run and long-run incentives. The model, which provides a theoretical framework for analyzing the interactions between the manager's AEM and REM decisions and the capital market's pricing of the firm, yields several testable hypotheses. First, when the firm's growth prospects are favorable, the fine will boost current period earnings through AEM, but not REM. Second, when the sensitivity of the manager's compensation to stock price goes up, the firm will use AEM, but not REM, to inflate current period earnings. Third, when the market's pricing of earnings becomes higher, the manager will prefer AEM to REM in order to achieve short-term earnings objectives.;The study uses a sample of fines that barely meet or beat analysts' earnings forecasts to test these predictions. It focuses on managers' real manipulation of R&D expenditures to measure REM and Dechow et al.'s (2003) method of estimating managers' accrual manipulation to measure AEM. The univariate results indicate a strong positive (negative) relation between AEM (REM) and firm's growth prospects. They also indicate that REM (AEM) decreases (weakly increases) with the sensitivity of the manger's compensation to stock price. The multivariate analyses show that AEM (REM) increases (decreases) as the firm's growth prospects become better and the sensitivity of the manger's compensation to stock price becomes more pronounced. They also indicate that AEM increases but REM does not change significantly when the market's pricing of earnings becomes higher.