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I find evidence consistent with managers manipulating real activities to avoid reporting annual losses. Specifically, I find evidence suggesting price discounts to temporarily increase sales, overproduction to report lower cost of goods sold, and reduction of discretionary expenditures to improve reported margins. Cross-sectional analysis reveals that these activities are less prevalent in the presence of sophisticated investors. Other factors that influence real activities manipulation include industry membership, the stock of inventories and receivables, and incentives to meet zero earnings. There is also some, though less robust, evidence of real activities manipulation to meet annual analyst forecasts.

There is substantial evidence that executives engage in earnings management.1 One means of managing earnings is by manipulation of accruals with no direct cash flow consequences, hereafter referred to as accrual manipulation. Examples include under-provisioning for bad debt expenses and delaying asset write-offs. Managers also have incentives to manipulate real activities during the year to meet certain earnings targets. Real activities manipulation affects cash flows and in some cases, accruals. Much of the current research on earnings management focuses on detecting abnormal accruals. Studies that directly examine earnings management through real activities have concentrated mostly on investment activities, such as reductions in expenditures on research and development.2 My paper contributes to the literature on earnings management by presenting evidence on the management of operational activities, which has received little attention to date. Real activities manipulation is defined as management actions that deviate from normal business practices, undertaken with the primary objective of meeting certain earnings thresholds. The first objective of this paper is to develop empirical methods to detect real activities manipulation. I examine cash flow from operations (CFO), production costs, and discretionary expenses, variables that should capture the effect of real operations better than accruals. Next, I use these measures to detect real activities manipulation around the zero earnings threshold. I find evidence consistent with firms trying to avoid losses by offering price discounts to temporarily increase sales, engaging in overproduction to lower cost of goods sold (COGS), and reducing discretionary expenditures aggressively to improve margins. There is predictable cross-sectional variation in real activities manipulation to avoid losses. In particular, the presence of sophisticated investors restricts the extent of real activities manipulation. This suggests that even though these activities enable managers to meet short-run earnings targets, they are unlikely to increase long-run firm value. Industry membership, the stock of inventories and receivables, growth opportunities, and the presence of debt are other factors that affect variation in real activities manipulation. I develop several robustness tests to investigate if the evidence of abnormal real activities among firm-years reporting small annual profits reflect (a) earnings management to avoid losses, or (b) optimal responses to prevailing economic circumstances. The collective evidence from these robustness tests seems more consistent with the earnings management explanation. Finally, I document some evidence of real activities manipulation to meet/beat annual analyst forecasts. Since Hayn (1995) and Burgstahler and Dichev (1997) found evidence of the discontinuity in frequency of firm-years around zero earnings, academics have had limited success in documenting further evidence of earnings management to avoid losses.3 For example, Dechow et al. (2003) fail to find evidence that firms reporting small profits manage accruals to cross the zero threshold. This paper contributes to the literature by providing evidence consistent with firms relying on real activities manipulation to meet the zero threshold. The evidence in this paper is particularly pertinent in the light of recent papers [Durtschi and Easton (2005), Beaver et al. (2004)] that question whether the observed discontinuities in firm-year distribution around zero can be attributed to earnings management.4 Section 2 discusses the definition of real activities manipulation and previous research. In Section 3, I identify firms that are likely to engage in real activities manipulation and develop hypotheses on how they should differ from the rest of the sample. I also develop hypotheses on cross-sectional variation in real activities manipulation. In Section 4, I discuss my data and estimation models, and present descriptive statistics. Section 5 presents my results. Section 6 discusses the implications of the evidence in this paper, as well as areas for further research.

This paper complements the existing literature on earnings management in several ways. First, this study develops empirical methods to detect real activities manipulation in large samples. In prior literature on real activities manipulation, the focus has mostly been limited to the reduction of discretionary expenditures. Second, the paper documents evidence consistent with real activities manipulation around earnings thresholds commonly discussed in the literature, in particular, the zero threshold. Third, this paper provides insights into factors that affect the nature and extent of real activities manipulation. For example, I find a negative association between institutional ownership and real activities manipulation. If the abnormal real activities that managers undertake to avoid losses represent optimal responses to economic circumstances, it is difficult to explain why the presence of sophisticated investors restricts such activities. There also exists evidence that the presence of debt, the stock of inventories and receivables, and growth opportunities are positively associated with real activities manipulation. Finally, I also find evidence of real activities manipulation among firms trying to avoid negative annual forecast errors. A deeper analysis of cross-sectional variation in earnings management to meet forecasts is left for future analysis. A number of studies use the distribution of the frequency of firm-years to argue that executives manage earnings up to avoid reporting losses and missing forecasts. My paper provides additional evidence that firms reporting small positive profits and small positive forecast errors manage earnings through real activities. The results indicate that drawing inferences on earnings management by analyzing only accruals is probably inappropriate. This paper also raises several questions for future research. One important issue is how managers choose between real activities manipulation versus accrual manipulation when they have the flexibility to engage in both. Another area for further research is the timing of real activities manipulation. While they have to occur during the year, their intensity should increase toward the end of the year, as managers form more reliable expectations of pre-managed earnings for the year. Further, it would be interesting to investigate whether firms that engage in manipulation of real activities habitually engage in such practices. For example, do firms that accelerate the timing of sales in a bad year through price discounts have incentives to do the same the following year? A related issue is whether the stock market understands the current and future implications of real activities manipulation. Research on these issues should lead to a more complete understanding of the importance of meeting earnings targets, the extent of earnings management through real activities, and the long-term effects of real activities manipulation.