Real earnings management practices for meeting earnings benchmarks: Indian evidence

Abstract

This study examines whether managers of Indian companies engage in earnings-increasing real earnings management practices, i.e., overproduction and reduction in discretionary expenses, viz., research and development (R&D) expenses and selling, general, and administrative (SG&A) expenses, to meet two important earnings benchmarks, i.e., avoiding losses and sustaining last year’s earnings. It further examines reduction made in three components of SG&A expenses, viz., marketing (MRK) expenses, welfare and training (W&T) expenses, and other general and administrative (OG&A) expenses, with respect to the same. This study analyses large samples from panel data of Indian companies listed on National Stock Exchange of India during the period 2000 to 2016. The analysis is based on the production cost model of Roychowdhury (J Account Econ 42(3):335–370, 2006), the R&D expense model of Gunny (Contemp Account Res 27(3):855–888, 2010), the SG&A expense models of Roychowdhury (2006), Cohen and Zarowin (J Account Econ 50(1):2–19, 2010), Gunny (2010), and Badertscher (Account Rev 86(5):1491–1518, 2011). Additionally, the study based its analysis on modified estimation models recently developed by Srivastava (Rev Account Stud 24:1277–1316, 2019) of production cost and discretionary expenses. The modified estimation models of Srivastava (2019) provide control for firm’s strategy which is an important determinant of firm’s investing decisions, especially for discretionary expenses. Consistent with Srivastava (2019), the modified estimation models exhibit substantially higher explanatory power for SG&A expenses and its components in comparison with other models. The results indicate that managers are likely to overproduce to avoid losses and to sustain last year’s earnings. This insight, however, is not supported when control is provided for firm’s strategy. Managers do not reduce spending on R&D expenses to meet earnings benchmarks. They do reduce spending on SG&A expenses for the same, which again, however, is not supported after controlling for firm’s strategy. The results pertaining to components of SG&A expenses suggest that managers reduce spending on all of its three components, i.e., MRK expenses, W&T expenses, and OG&A expenses, to avoid losses. The evidence of reduction in spending on the latter two components for the same is reinforced when control for firm’s strategy is taken into consideration. To sustain last year’s earnings, managers appear to reduce spending only on W&T expenses. This evidence, however, is not supported after controlling for firm’s strategy. Overall, the findings indicate that managers in India are more likely to manage W&T expenses to show earnings in line with desired benchmark level.