Alternative Methods of Measuring Real Earnings Management in R&D and SG&A Expenses

In this study, we argue that Research and Development (R&D) (Selling, General, and Administrative expenses, SG&A) expenses are in response to various earning-related stimuli rather than intangible or tangible capital accumulation that classic investment-q theory advocates, and there is a specification error in [Gunny, KA (2010). The relation between earnings management using real activities manipulation and future performance: Evidence from meeting earnings benchmarks. Contemporary Accounting Research, 27(3), 855-888] suspected R&D (SG&A) real activity manipulation. Our finding indicates that among three Tobin’s Q measures, either standard Tobin’s Q used in finance (a firm’s market value over the physical capital) or total Tobin’s Q incorporated intangible capital into standard Tobin’s Q [Peters, RH and LA Taylor (2017). Intangible capital and the investment-q relation. Journal of Financial Economics, 123(2), 251–272] cannot better explain R&D (SG&A) expense than classic Tobin’s Q regarding slope coefficient level and R-squared value. Moreover, the specification of R&D- or SG&A-based real activity manipulation, i.e., deep cuts in R&D or SG&A, is significantly related to firms just meeting zero and last year’s earnings. These findings suggest managers may deeply cut R&D or SG&A expenses to avoid an earnings shortfall. Our results further indicate that deep SG&A cuts or deep R&D cuts are negatively associated with future operating performance, which is more pronounced in the post-Sarbanes–Oxley (SOX) period. The net effects of deep SG&D cuts (R&D cuts) on future operating performance are negative (positive) when the firms meet the earnings benchmarks and have deep SG&D cuts (R&D cuts), implying that deeper cuts in SG&A expenses in response to earning-related stimuli could reflect firm-level opportunistic behaviors but deeper cuts in SG&A expenses in response to earning-related stimuli do not. Finally, deep SG&A cuts or deep R&D cuts increase the persistent predictability of cash flows on future earnings. However, the net effects of deep SG&A cuts (R&D cuts) on persistent predictability of cash flows for future earnings are negative (positive) when the firms meet earnings benchmarks and have deep SG&D cuts (R&D cuts). Overall, our estimated results imply that deep SG&A cuts are an expected outcome of opportunistic real earnings management, but deep low R&D cuts are not.