Alternative Methods of Measuring Real Earnings Management in R&D and SG&A Expenses

Wen-Ju Liao (), Cheng-Few Lee () and Hao-Chang Sung
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Wen-Ju Liao: Newhuadu Business School of Minjiang University, No. 200, Xiyuangong Rd., Shangjie Town, Minhou County, Fuzhou City, Fujian Province 350108, P. R. China
Cheng-Few Lee: Rutgers Business School, Rutgers, The State University of New Jersey, Room 5188, 100 Rockefeller Road, Piscataway, NJ 08854, USA
Hao-Chang Sung: Department of Business Administration, National Chung Cheng University, No. 168, Sec. 1, University Rd., Minhsiung Township, Chiayi County 621301, Taiwan

Review of Pacific Basin Financial Markets and Policies (RPBFMP), 2024, vol. 27, issue 03, 1-45

Abstract: In this study, we argue that Research and Development (R&D) (Selling, General, and Administrative expenses, SG&A) expenses are in response to various earning-related stimuli rather than intangible or tangible capital accumulation that classic investment-q theory advocates, and there is a specification error in [Gunny, KA (2010). The relation between earnings management using real activities manipulation and future performance: Evidence from meeting earnings benchmarks. Contemporary Accounting Research, 27(3), 855-888] suspected R&D (SG&A) real activity manipulation. Our finding indicates that among three Tobin’s Q measures, either standard Tobin’s Q used in finance (a firm’s market value over the physical capital) or total Tobin’s Q incorporated intangible capital into standard Tobin’s Q [Peters, RH and LA Taylor (2017). Intangible capital and the investment-q relation. Journal of Financial Economics, 123(2), 251–272] cannot better explain R&D (SG&A) expense than classic Tobin’s Q regarding slope coefficient level and R-squared value. Moreover, the specification of R&D- or SG&A-based real activity manipulation, i.e., deep cuts in R&D or SG&A, is significantly related to firms just meeting zero and last year’s earnings. These findings suggest managers may deeply cut R&D or SG&A expenses to avoid an earnings shortfall. Our results further indicate that deep SG&A cuts or deep R&D cuts are negatively associated with future operating performance, which is more pronounced in the post-Sarbanes–Oxley (SOX) period. The net effects of deep SG&D cuts (R&D cuts) on future operating performance are negative (positive) when the firms meet the earnings benchmarks and have deep SG&D cuts (R&D cuts), implying that deeper cuts in SG&A expenses in response to earning-related stimuli could reflect firm-level opportunistic behaviors but deeper cuts in SG&A expenses in response to earning-related stimuli do not. Finally, deep SG&A cuts or deep R&D cuts increase the persistent predictability of cash flows on future earnings. However, the net effects of deep SG&A cuts (R&D cuts) on persistent predictability of cash flows for future earnings are negative (positive) when the firms meet earnings benchmarks and have deep SG&D cuts (R&D cuts). Overall, our estimated results imply that deep SG&A cuts are an expected outcome of opportunistic real earnings management, but deep low R&D cuts are not.

Keywords: Earnings benchmark; real earnings management; real activity models; Sarbanes–Oxley; Tobin’s Q measures (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1142/S021909152450019X

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