Does a Disaggregated Earnings Forecast Enable Detection of Management’s Manipulation of Real Activities?

• In Event: Financial Reporting

Abstract

We investigate whether a disaggregated earnings forecast can enable investors to detect managers’ manipulation of real activities. Our experimental results suggest that when they are provided with disaggregated earnings forecasts, investors can infer the level of discretion management has over individual expense items that differ between forecast and the actual. Consequently, their investment decisions reflect a joint function of the realized income and the inferred discretion associated with the responsible expense item. In particular, when reported income exceeds the management forecast, investors downgrade firms that reduce R&D expenses when compared with firms whose income surplus is attributed to lower COS. On the other hand, investors react more positively to companies with an increase in R&D expense even though the reported income falls short of earnings forecast, when compared with companies whose income shortfall is attributable to an increase in COS. This study adds to the current literature on disaggregated earnings forecast and fills a gap in the existing earnings management literature by providing evidence of disaggregated forecast as a mechanism to detect management’s myopic behaviors. Moreover, contrary to the alleged market myopia, our findings suggest that individual investors may favor companies who sacrifice bottom line number for value-adding operational behaviors.

Authors

• Lei Dong, Washington State University

• Bernard Wong-On-Wing, Washington State University

• Gladie Lui, Lingnan University