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

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

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