Do sin firms engage in real activities manipulation to meet earnings benchmarks?
DOI | https://doi.org/10.1108/IJAIM-09-2019-0110 |
Date | 02 March 2020 |
Published date | 02 March 2020 |
Pages | 535-551 |
Author | Suzanne M. Ogilby,Xinmei Xie,Yan Xiong,Jin Zhang |
Subject Matter | Accounting & Finance,Accounting/accountancy,Accounting methods/systems |
Do sin firms engage in real
activities manipulation to meet
earnings benchmarks?
Suzanne M. Ogilby
College of Business Administration, California State University Sacramento,
Sacramento, California, USA
Xinmei Xie
College of Business Administration, California State University Stanislaus,
Turlock, California, USA, and
Yan Xiong and Jin Zhang
College of Business Administration, California State University Sacramento,
Sacramento, California, USA
Abstract
Purpose –Recent literaturesuggests that sin firms (firms in tobacco, gamblingand alcohol industries) have
lower institutional ownership, fewer analysts following, higher abnormal returns and higher financial
reporting quality. This study aims to investigate empirically how sin firms engage in real activities
manipulation(RAM) to meet earnings benchmarks in comparison to non-sinfirms.
Design/methodology/approach –The authors examine two types of RAM, namely, Cutting
discretionary expenditures including research and development (R&D), SG&A and advertising to boost
earnings. Extending deep discount or lenient credit terms to boost sales and/or overproducing to decrease
COGS to increase grossprofit. Consistent with Roychowdhury (2006), the authors use abnormaldiscretionary
expenditures as the proxy for expenditure reduction manipulation and abnormal production costs as the
proxy for COGS manipulation.
Findings –The results for theabnormal discretionary expense model suggestthat sin firms do not engage
in RAM of advertising, R&D, SG&A expense to just meet earnings benchmarks. The results for the
production costs model suggest that sin firms do not engage in COGS manipulation to just meet earnings
benchmarks. The results are robust aftercontrolling accrual-based earnings management (AEM). Overall, in
this setting, these results suggest that managers of sin firms engage less in RAM to meet earnings
benchmarks.
Originality/value –The findings are of interest to investors, auditors, regulators and academics with
respect to financialstatement analysis and earnings quality.
Keywords Earnings management, Accrual-based earnings management (AEM),
Real activities manipulation (RAM), Sin firms
Paper type Research paper
1. Introduction
Social norms play a role in shaping both economic behavior and market outcomes. In
general, socially responsible investors favor corporate practices that promote
environmental, consumer protection and human rights, and avoid businesses involved in
alcohol, tobacco, gambling, weaponsor the military (Social Investment Forum,2011). Firms
that engage in activities related to tobacco, gambling and alcohol, also known as sin firms,
Real activities
manipulation
535
Received18 September 2019
Revised7 January 2020
Accepted23 January 2020
InternationalJournal of
Accounting& Information
Management
Vol.28 No. 3, 2020
pp. 535-551
© Emerald Publishing Limited
1834-7649
DOI 10.1108/IJAIM-09-2019-0110
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1834-7649.htm
have specific economic behavior and market outcomes consistent with social responsibility
perspectives.
Hong and Kacperczyk (2009) find that institutional investors hold fewer sin stocks and
financial analysts provide less coverage of sin stocks than comparable stocks. Their
findings are consistent withthe notion that such stocks are neglected by an important group
of capital market participants. Kim and Venkatachalam (2011) find that sin firms have
better earnings quality relative to non-sin firms. Specifically, sin firms report accruals with
better future cash flow predictive value andrecognize losses in a timelier fashion relative to
non-sin firms. They conclude that the neglected effect by market participants is not
attributable to financial reporting factors. Zhang (2012) examines the relationship between
discretionary accruals and whether a firm is a sin firm and finds that the magnitude of
absolute discretionaryaccruals is smaller and less positive for sin firms as compared to non-
sin firms. These results imply that sin firms are less likely to engage in income-increasing
earnings management.
Earnings management can be classified into two categories: accrual earnings
management (AEM) and real activities manipulation (RAM). AEM occurs when managers
make generally accepted accounting principles (GAAP) accounting choices that try to
“obscure”or “mask”true economic performance (Dechow and Skinner, 2000;Gunny, 2010).
RAM occurs when managers undertake actions that change the timing orstructuring of an
operation, investment and or financingtransaction in an effort to influence the output of the
accounting system(Gunny, 2010). RAM is more difficult for investors to detect than AEM.
In this paper, we investigate whether sin firms engage in RAM to manage earnings. We
examine two types of RAM:
(1) reducing discretionary expenditures of R&D, SG&A and advertising to boost
earnings; and
(2) extending deep discount or lenient credit terms to boost sales and or
overproducing to decrease COGS to increase gross profit.
Consistent with Roychowdhury (2006), we use abnormal discretionary expenditures as one
proxy for expenditure reduction manipulationand abnormal production costs as one proxy
for sales manipulation and or COGS manipulation. We use the Roychowdhury (2006)
method to estimate abnormaldiscretionary expenditures and abnormal production costs.
The results for the abnormal discretionaryexpenditure model suggest that sin firms do
not engage in RAM of advertising, R&Dor SG&A expense to just meet zero and past year’s
earnings benchmarks. The results for the productioncosts model suggest that sin firms do
not engage in sales manipulation and or COGS manipulation to just meet zero and past
year’s earnings. The results are robust after controlling for AEM. Overall, in this setting,
these results suggest that managers of sin firms engage less in RAM to meet earnings
benchmarks than managersin non-sin firms.
Our study contributes to the literature in two ways. First, this study sheds light on the
enigma that sin stocks outperform the market. Our findings suggestthat sin firms provide
high-quality financial reports although they are rather ignored by investors due to social
norm concerns. Previousstudies primarily focused on the use of AEM.This study is the first
to examine RAM in sin firms. Second, the results suggestthat managers of sin firms engage
less in RAM to meet earnings benchmarks. The findings help improve auditors’
understanding of the sin firm industry in terms of risk detection and the assessment of
earnings quality. The findings also provide similar insight for analysts’and investors’
ability to analyze financial statements and make investment decisions for firms in both sin
IJAIM
28,3
536
To continue reading
Request your trial