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. The purpose of this study is to detect manipulation of real activities to meet earnings targets. I analyze cash flow from operations (CFO), production costs and discretionary expenses. Using a simple model 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 trying to increase reported annual earnings beyond zero by giving price discounts to boost sales temporarily and by overproduction. I also find evidence suggesting that some of these firms reduce discretionary expenses to report higher margins. Further analysis in the paper yields interesting insights into cross-sectional variation in the nature and extent of real activities management. I am grateful for the guidance and many helpful suggestions I have received from Ross Watts, Jerry Zimmerman and Andy Leone. Ths paper has also benefited from helpful comments and suggestions by Liz Demers, Joanna Wu, Charles Wasley, Jim Brickley, Ludger Hentschel, S.P. Kothari, Joe Weber, Shailendra Pandit , Hema Roychowdhury and Lance Young. All errors in the paper are mine.