Does Real Activities Management Influence Earnings Quality and Stock Returns in Emerging Markets? Evidence from Korea

ABSTRACT

We explore the association between real earnings management and the persistence of earnings and cash flows, respectively. Further, we investigate the effect of real earnings management on the relation between current stock returns and future earnings. Using 15,826 firm-year observations listed in the Korean stock market from 2000 to 2015, we find that real earnings management is negatively associated with the persistence of earnings. We also find that real earnings management restricts the persistence of cash flows. Lastly, we find that real earnings management prevents the market from assessing firms’ future earnings reflected in the current stock prices.

KEY WORDS:

• Cash flow persistence
• earnings persistence
• earnings quality
• future earnings response coefficient
• real earnings management

JEL CLASSIFICATION:

• G10
• M40

Correction Statement

Data availability: Data used in the study are available from public sources.

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

1. For instance, The Conceptual Framework for Financial Reporting (IASB 2010) reports the importance of predictive value of earnings as follows: “If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent. Relevant financial information is capable of making a difference in the decisions made by users. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both (paragraphs QC4, QC6, and QC7).”

2. The mean value of the dominant shareholders’ ownership in our sample is 40.62%.

3. Among the papers in the literature, Zhang (2006) and Meini and Siregar (2014) are the most closely related to our study. Zhang (2006) finds that abnormal cash flows are less persistent than normal cash flows. Meini and Siregar (2014) expect the negative relation between REM and earnings persistence, but they do not find such results. The main difference between our study and the previous two studies is that we explore the relationship between REM and earnings persistence with more elaborate measures developed by Roychowdhury (2006). Also, we further extend the literature by investigating the effect of REM on future earnings response coefficients.

4. The situation is common in the industry requiring advanced technology, such as smart phones.

5. Consistent with this argument, Kim and Sohn (2013) provide evidence that investors demand a higher risk premium for firms that engage in real earnings management, increasing the uncertainty of future cash flows.

6. See pp. 339–340 on Roychowdhury (2006) for more details.

7. Taxes and dues, depreciation, rent, and insurance expenses are excluded because these are less subject to managerial discretion (Kwak and Choi 2011).

8. Since 1999, Korea has included Statement of Cash Flows in financial statements. As our study uses cash flow information, the beginning year is 2000. We exclude the transition year 1999 to avoid the potential contamination of data.

9. The FSS is an integrated supervisory authority in Korea. It conducts supervision of banks, nonbank financial companies, financial investment services providers, and insurance companies. In addition, the FSS performs capital market supervision, consumer protection, and other supervision and enforcement activities (http://english.fss.or.kr/fss/eng/wpge/eng121.jsp).

10. We examine the relationship between REM and AEM in more detail in the “3.3. Additional tests” section.

11. We follow Angrist and Pischke (2009) for the interpretation of interactions terms.

12. In Panel B, variable of TACC*REM is significant when we use RM2 as a dependent variable. Although we have no ex ante prediction on this variable, one possible interpretation is that this result may occur in the case where REM has a complimentary relation with AEM (Choi et al. 2011). We additionally provide a positive relation between REM and AEM in additional test. Nevertheless, we do not discuss further because investigating the relation between real and accrual-based earnings management is beyond the scope of this paper.

Additional information

Funding

This work was supported by a grant from KyungHee University in 2018 (KHU-20180927).