When earnings fall short of targets or don’t achieve a desired strategic goal, managers often engage in earnings management. These manipulations can either take place during the fiscal year – one survey found 80 per cent of Chief Financial Officers had decreased R&D, advertising and maintenance expenditures to deliver earnings – or they can occur after the fiscal year, by manipulating the accounting methods or estimates used.

A study by Amy Zang has identified the conditions under which managers use each of these practices and shown that managers trade off them depending on the cost to them. She also found that if a suspect firm engages in a low-level of one type of earnings management, chances are it will increase engagement in the other.

“Looking at how managers trade off real activities manipulation [during the fiscal year] and accrual-based earnings management [after the year] is important for two reasons,” she said.

“First, studying only one earnings management technique at a time cannot explain the overall effect of earnings management activities.”

“Second, we can shed light on the economic implications of accounting choices – that is, whether the costs that managers bear for manipulating accruals affect their decisions about real activities manipulation. This has implications for whether such measures as enhancing scrutiny by the Securities and Exchange Commission or reducing accounting flexibility in accounting rules might increase the levels of real activities manipulation engaged in by firms.”

Prof. Zang looked at 6,680 firm-year observations for 1987-2008 for firms suspected of engaging in earnings management due to just beating or meeting the prior year’s earnings, zero earnings and analyst consensus forecast.

Firms were more likely to use real activities manipulation if their accounting practice was constrained by heightened regulatory scrutiny (such as the Sarbanes-Oxley Act), they had prior periods of accrual manipulation or they had shorter operating cycles.

Firms were more likely to use accrual-based earnings management if they were less competitive in their industries, had a less-healthy financial condition, had a higher level of scrutiny from institutional investors, and faced higher marginal tax rates.

However, they did not limit themselves to one type of earnings management. The time restriction on real activities manipulation left an opening for managers to substitute the two strategies and Prof. Zang found that this indeed happened. When the outcome of real activities manipulation was too high, they decreased accrual-based earnings management, and when it was too low they increased it.
The lessons from the research are twofold. For researchers, it suggests that focusing on accrual-based earnings management alone does not fully explain earnings management activities.

“For regulators, the research implies that increasing scrutiny or constraints over accounting discretion doesn’t eliminate earnings management activities altogether, but only changes managers’ preference for different earnings management strategies, some of which, such as real activities manipulation, can be more costly for investors,” she said.