Discretionary expenditures

3.1 Real Earnings Management
Firms sometimes deliberately control earnings so that the figures hit a target and give information users “untruthful
information”. Schipper (1989) defined ‘earnings management’ as a purposeful intervention in the external financial
reporting process, with the intent of obtaining some form of private gain. Healy and Wahlen (1999) note that
“earnings management occurs when managers use judgment in financial reporting and in structuring transactions to
alter financial reports to either mislead some stakeholders about the underlying economic performance of the
company, or to influence contractual outcomes that depend on reported accounting numbers”. In a review of the
literature, Dechow and Skinner (2000) note that accruals management involves within-GAAP choices that try to
“obscure” or “mask” true economic performance. They also indicate that methods such as acceleration of sales, and
delaying of research and development and maintenance expenditures, can be used for earnings management
purposes. Nelson et al. (2003) provide evidence how managers manage earnings based on the information obtained
from survey of 253 experienced auditors. They afford the proof of earnings management involving revenue
recognition, reserves and other accruals, and fixed asset impairment and amortization and so on.
Recently, real earnings management has become of interest to researchers. According to Graham et al.’s survey
(2005), managers prefer earnings management using manipulation activities including reduction of discretionary
expenditures or capital investments. Baber et al. (1991) and Bushee (1998) show that managers tend to reduce
research and development expenditures to hit their earnings targets. Baber et al. find that relative R&D spending is
correlated managers’ incentives to report positive or increasing income in the current period. Roychowdhury (2006)
finds evidence that managers manipulate real activities to avoid reporting annual losses. His findings also show that
managers use several real activities manipulation tools such as price discounts to temporarily increase sales,
overproduction to report lower cost of goods sold, and reduction of discretionary expenditures for the purpose of
improving reported margins.
Gunny (2005) finds that firms will use any one of the real earnings management strategies: reduction of R&D;
reduction of SG&A; timing of income recognition from the disposal of long-lived assets and investments; and
cutting prices to boost sales(and /or overproducing to decrease COGS expense). Also, he finds that real earnings
management negatively affects subsequent operating performance in terms of low future earnings and cash flows.