Abstract

     We provide a systematic literature review of the determinants and consequences of real earnings management (REM) in an international context. We provide a theoretical framework for REM, the development of REM measures, and review the determinants of REM, categorising these into financial reporting, auditing, governance and controls, capital market incentives, and regulatory determinants. We then review the empirical literature on the consequences of REM. We provide some suggestions for future research on measurement issues related to REM, and on filling gaps in the empirical research investigating its determinants and consequences.

Introduction

     We provide a systematic review of the determinants and consequences of real earnings management (hereafter REM) in an international context. Earnings management research has dominated the accounting research landscape for about three decades. Researchers initially investigated the determinants of accruals earnings management (hereafter AEM) following the seminal paper of Jones (1991). However, after the passage of the Sarbanes Oxley Act (hereafter SOX) of 2002, research on the determinants and consequences of REM proliferated.

     REM is defined as ‘departures from normal operational practices, motivated by managers’ desire to mislead at least some stakeholders into believing certain financial reporting goals have been met in the normal course of operations’ (Roychowdhury, 2006, p. 337). Examples of REM include, but are not limited to, overproduction designed to decrease the cost of goods sold and the cutting of R&D investment to boost current-period earnings. Managers are increasingly using REM, particularly in the post-SOX period, owing to the greater possibility of AEM being detected by auditors and regulatory authorities (Cohen et al., 2008).1 In a survey of 401 chief financial officers (CFOs) in the US, Graham et al. (2005), reveal that ‘۸۰% of survey participants report that they would decrease discretionary spending on R&D, advertising, and maintenance to meet an earnings target. More than half (55.3%) state that they would delay starting a new project to meet an earnings target, even if such a delay entailed a small sacrifice in value’ (p. 32).2 This increased use of REM has, consequently, expanded academic research on the determinants and consequences of REM. In this paper, we use REM and real activities manipulation interchangeably.

Conclusion

     The current study is a timely review of the body of knowledge of REM, based on the papers published from 2006 to 2021. Since the passage of SOX in 2002, research on the determinants of REM has proliferated, owing primarily to a shift from more easily detectable AEM to difficult-to-scrutinise REM actions. We surveyed and synthesised the REM literature with respect to the measurement, determinants and consequences of REM. Our review suggests that the existing REM literature has made little effort to adopt suggestions aimed at improving the measurement models of REM originally proposed by Roychowdhury (2006). Second, the passage of the SOX, as well as IFRS internationally, motivated managers to engage more in REM than in AEM. Capital market incentives arising from IPOs, SEOs and acquisition activities also appear to drive firms’ REM behaviour. A vast body of literature has examined the relation between REM and various factors related to corporate governance and controls. Some such factors include corporate boards, TMT characteristics, incentive compensation structures, external ownership structure, market competition, and country-level political, economic, legal and cultural characteristics. However, the evidence on the relation between corporate governance and REM remains mixed. Third, studies that examined the consequences of REM are fewer in number than the ones that examined the determinants of REM and, importantly, also provide inconclusive evidence.