Earnings management using asset sales:

  1. 1. Introduction
    There is a considerable literature on U.S. companies’ earnings management through discretionary accruals and real
    earnings management. We extend this literature to the international setting and also include the effects of corporate
    tax on earnings management decisions. Specifically, we examine discretionary spending for research and
    development (R&D), selling and administrative expenses (SG&A), and advertising. We find that US based models
    of earnings management work reasonably well in the Canadian setting as well, and except for the influence of taxes,
    work reasonably well for Hong Kong, Japanese, Korean, and Taiwanese firms as well.
    For U.S. and Canadian firms, we find that firms with larger potential tax benefits are more likely to manage taxes
    through real expenditures management. Since these discretionary deductions have income-reducing expenses for
    financial reporting purposes, the results suggest that income taxes have a strong incentive effect in these two
    countries. In contrast, taxes appear to have no influence on Asia firms’ discretionary expenditures. The results may
    have policy implications for other countries as well.
    2. Discretionary Real Expenditures
    Consider a situation where management decides whether to make additional discretionary real expenditures (DRE)
    in research and development (R&D) selling, general, and administrative expenses (SG&A), and advertising in
    period t. The decision is a function of the marginal return to such expenditures, or R (DRE), tax status (T) in t, cash
    flow constraints (CF), and financial reporting costs (FRC) of potentially missing earnings targets. Financial
    reporting costs are assumed to be increasing in DRE, or f(DREt). Financial reporting costs are also a function of
    discretionary accruals made first;