Evidence on the Tradeoff between Real Manipulation and Accrual Manipulation

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; that is, the firm first makes necessary discretionary accruals (which have no tax
www.ccsenet.org/ibr International Business Research Vol. 4, No. 2; April 2011
258 ISSN 1913-9004 E-ISSN 1913-9012
effects in general) to exceed earnings target, there is little cost to making an income-decreasing discretionary accrual.
After the firm makes the discretionary accrual decision, the firm decides on discretionary real expenditures.
The manager maximizes profit π by solving spending on DRE in year t:
Max π = max [R(DREt )(1-Tt) – f(DREt)] (1)
s.t. CF ≥ DREt
Solving first order conditions, and rearranging:
∂π/∂DRE = R(1-Tt )/ f. (2)
Thus, DRE is an increasing function of R and T, a decreasing function of f, and subject to cash flow considerations.
In our data, we cannot observe R, and assume it is constant across firms and time. However, we can proxy for
financial reporting costs as follows:
Prediction 1: Ceteris paribus, firms’ discretionary expenditures are lower when larger income-increasing
discretionary accruals have been made.
We can proxy for cash flow considerations by proposing that growth firms can afford to make more discretionary
expenditures, as follows:
Prediction 2: Ceteris paribus, firms’ real earnings management through increased expenditures in years when the
firm has increased sales and increased cash flows from operations.
Additionally, following from (2):
Prediction 3: Ceteris paribus, firms’ real earnings management through increased expenditures is higher when
marginal tax rates are higher.
Of course, in the international setting, marginal rates vary by country. For example, we would expect the tax effects
to higher in the U.S. with a 35% marginal rate, than in Hong Kong which has a 15% rate (on average).
There is a growing literature on real earnings management through discretionary expenditures, in the absence of tax
considerations. The next section discusses that literature.