Real Activities Earnings Management Surrounding Cash Flow Restatements

• In Event: Auditing/International Accounting/FAR/Forensic and Investigative Accounting

Abstract

We show that firms engage in real activities earnings management (REM) prior to a cash flow restatement (CFR), which is evidenced by a significant decline in REM post-CFR disclosure. We find evidence consistent with mangers using real activities manipulation prior to a CFR. We then test whether CFR firms trade-off between REM and accrual-based earnings management (AEM) surrounding CFRs. We do not find evidence that CFR firms substitute REM with AEM around CFR disclosures. We find CFR firms have significant overstated net assets, which suggests that CFR firms’ ability to use AEM may have been constrained. This may have contributed to their choice to engage in REM. Last, we find evidence that real economic consequences (i.e., subsequent operating performance) exist subsequent to a CFR. The implications of this study are (1) REM is less likely to be scrutinized by auditors and regulators, thereby having a lower probably of being detected; and (2) we provide some evidence that CFR firms that generally engage in REM are constrained from engaging in AEM.

Authors

• Shaokun (Carol) Yu, Northern Illinois University

• Dana Hollie, Louisiana State University, Baton Rouge