This paper investigates the association between firms' engagement in real activities manipulation (hereafter REM) on future firm performance in an international setting, and whether the association is conditional upon country-level institutional factor. Our inquiry is motivated by a paucity of research on the consequences of REM in an international setting. Using a large sample over the period of 2001 to 2015, we find that current-period REM is positively associated with future performance: a finding that is consistent with Gunny (2010) in the US. Importantly, we find that the positive performance effect is driven by firms operating in countries with strong institutional environments. Finally, we find that future operating performance improves when REM is undertaken by firms in strong institutional environments only during a non-economic crisis period, but not during an economic crisis period. The paper adds to the existing REM literature by showing a non-monotonic effect of REM on future performance that is conditional on the strength of a country's institution. We also contribute to the accounting information and crisis literature by documenting a time-variant effect of REM on future performance.
This paper investigates the association between firms' engagement in real activities manipulation (hereafter REM) on future firm performance in an international setting, and whether the association, if any, is conditional upon country-level institutional factors. A sizable volume of academic research has shown that managers manipulate reported earnings by changing accounting methods or estimates (also known as accrual–based earnings management, hereafter AEM) (Dechow, Ge, & Schrand, 2010). However, the opportunistic reporting behaviour of firms is not limited to AEM alone. To boost short-term reported earnings artificially, managers also manipulate the timing or structure of real operations. Increasingly, recent REM studies in the US explore the mechanisms of REM (Roychowdhury, 2006); managerial trade-offs between REM and AEM (e.g., Cohen, Dey, & Lys, 2008; Zang, 2012); and the consequences of REM for firm operating performance (e.g., Ewert & Wagenhofer, 2005; Gunny, 2010). A recent stream of research has started to investigate the determinants of REM in an international setting, incorporating legal regimes and country-level investor protections as likely determinants of the degree of REM activities, as well the extent to which REM substitutes for AEM (Braam, Nandy, Weitzel, & Lodh, 2015; Choi, Choi, Kim, & Sohn, 2012; Enomoto, Kimura, & Yamaguchi, 2015; Ipino & Parbonetti, 2017). However, the consequence of REM for future performance internationally has remained unexplored, and this is the focus of our study. Competing hypotheses exist regarding the association between REM and future firm performance. On one hand, engagement in REM can impact firms' long-term productivity and performance adversely, because these practices deviate from normal business operations, alter firm's future cash flow patterns, and may hamper innovation (Roychowdhury, 2006). For instance, cutting R&D expenditure, a major means of REM, boosts earnings temporarily but harms the firm's long term competitiveness and is detrimental to its performance in the long run. On the other hand, firms may conduct REM strategically to avoid both immediate loss and failure to reach the current period's earnings targets, thereby signalling the firm's potential for better performance in the future. Thus, REM can be associated with relatively better subsequent performance (Gunny, 2010). Using US data, Gunny (2010) finds evidence consistent with this hypothesis. Zhao, Chen, Zhang, and Davis (2012) find that, although abnormal real activities in general are associated with a weaker future performance, abnormal real activities intended to just meet earnings targets are associated with a higher future performance.