Abstract

Prior studies investigate the determinants and consequences of real earnings management (REM) as a function of firm-specific characteristics. In this study, we examine how managerial ability relates to the use of REM and future firm performance. We find that higher-ability managers engage in less REM. Furthermore, we find that managers with superior ability reduce the negative impact of REM on future firm performance. This is consistent with prior studies, which link higher-ability managers to better management of firm resources and more positive outcomes.

Introduction

This study examines the role of managerial ability in real earnings management (REM). REM is manager’s purposeful action that deviates from the optimal business practice to alter reported earnings in a particular direction (Roychowdhury, 2006). Prior studies (e.g., Cohen & Zarowin, 2010; Zang, 2012) focus on firm-level characteristics (e.g., the relative costs and constraints of REM and accrual-based earnings management) that lead to manager’s choice of REM. However, in addition to firm-level characteristics, executive characteristics may affect the use of REM. Our study investigates the relation between managerial ability and the use of REM. Furthermore, prior studies (e.g. Bhojraj, Hribar, Picconi, & McInnis, 2009; Cohen & Zarowin, 2010) suggest that REM is a value-destroying activity and has a negative impact on future firm performance. Our study sheds new light on the role of managerial ability in the relation between REM and future firm performance.