Management of earnings through the manipulation of real activities that affect cash flow from operations

Most of the current research on earnings management focuses on the detection of abnormal accruals. Earnings management may be accomplished through accruals alone and/or real activities. There has been no attempt to distinguish whether abnormal accruals are the result of pure accrual manipulation with no cash flow effects, or the result of real activities manipulation, which affects both cash flows and accruals.; The purpose of this study is to detect manipulation of real activities by focusing on variables that should be relatively free of the effects of pure accrual manipulation. Specifically, I concentrate on cash flow from operations (CFO), production costs and discretionary expenses. Using a simple model (presented in Dechow, Kothari and Watts, 1998) to determine the normal levels of these variables, I detect abnormally low CFO and abnormally high production costs for companies that report small positive profits at the annual level.; The evidence is consistent with firms avoiding losses by giving price discounts to temporarily increase sales and by overproduction to reduce cost of goods sold (COGS). I also find evidence suggesting these firms reduce discretionary expenses to report higher margins. Further analysis on cross-sectional variation in the nature and extent of real activities management reveals the following: firms with a traditionally low level of current assets are more aggressive at offering discounts and reducing discretionary expenses to increase total earnings. Manufacturing firms are more likely to engage in activities that result in abnormally high production costs relative to sales, where production costs are defined as the sum of COGS and change in inventory. Firms with outstanding debt are more aggressive at reducing discretionary expenses to meet the zero earnings target. Additionally, firms appear to be managing real activities to a greater extent if they have a higher proportion of current liabilities.