Abstract

۱٫ Introduction

۲٫ Conceptual background and literature review

۳٫ Hypotheses formulation

۴٫ Methods

۵٫ Results

۶٫ Conclusions

Acknowledgements

References

Abstract

     We examine an unexplored side of management control systems (MCS): their links with real earnings management. We propose that interactive use of MCS supports management in identifying, evaluating, selecting, and implementing real actions that conceptually would be classified as real earnings management (REM). Interactive MCS use is predicted to enhance managerial REM actions that retain the focus of the organization on its strategic objectives, leading to higher future performance. We test our research model empirically with survey and archival data. The results support our predictions. Finally, we explore the role of other levers of control.

Introduction

     We examine the links between the interactive use of management control systems (MCS) and real earnings management (REM).1 REM refers to real actions taken to manage earnings that alter the timing and structure of investment, operating, and financing transactions (Schipper, 1989; Vorst, 2016). Examples of these actions include reducing R&D and advertising expenditures, offering aggressive credit terms, selling assets, overproducing, or repurchasing stock (e.g., Bushee, 1998; Graham et al., 2005; Roychowdhury, 2006; Ali and Zhang, 2015). Prior work provides mounting evidence that managers take REM actions to meet earnings targets.

     The financial accounting literature has devoted significant attention to earnings management, and generally views such practices as having adverse consequences (Dechow et al., 2010), but a growing body of research documents both benefits of REM and cases where REM can be value destroying.2 Gunny (2010) finds that firms that engage in REM to just meet earnings targets have relatively better subsequent performance than firms that do not engage in REM and miss or just meet their earnings targets. These findings are challenged by Bhojraj et al. (2009), who finds lower long-term market performance for firms that use REM to meet their earnings targets. Against this backdrop of mixed findings on the consequences of REM actions, a question arises as to the role of MCS in supporting managers in making decisions and taking these actions. In this paper, we examine whether the interactive use of MCS supports management in (i) taking real actions to meet earnings targets and that conceptually would be classified as REM, and (ii) making REM more successful in terms of improved organizational performance.

Conclusions

     We provide novel insights on the links between MCS and earnings management through the lens of the Levers of Control (LOC) framework (Simons, 1995). In doing so, we conceptualize the interactive use of MCS as a mechanism that spurns managerial search, discovery, and implementation of action plans to correct deviations from critical values of earnings. Our evidence indicates that using the interactive lever involves the organization in the development of action plans to achieve strategic objectives, leading to REM practices that ultimately improve firm performance, relative to firms that engage in REM actions without activating the interactive lever. Prior work examines the drivers of earnings management (e.g., Liu and Lu, 2007; Ali and Zhang, 2015; Kim et al., 2016; Liu, 2016), but does not focus on how managers use MCS to achieve benchmarks and, particularly how interactive use influences REM.

     A key assumption in our framework is that MCS use helps balance the needs for long-term investments, innovation, and constraints (Tuomela, 2005). To this end, we conceptualize MCS in terms of the LOC framework, since it pays special attention to the interplay of the different control mechanisms and to patterns of attention in managing organizational benchmarks (Mundy, 2010; Kruis et al., 2016). We examine a novel side of interactive use of MCS, looking at its links with REM. This sheds light on how control systems shape financial reporting and, consequently, have organizational consequences, via firm strategy or investment. Unlike prior research which generally uses archival data, we show evidence on how, through the lens of the LOC framework, managers mobilize their control systems in the search for solutions, deriving in earnings management.