The Hangover Effects of Real Earnings Management: Patterns of Real Earnings Management and Subsequent Performance

Using a new supermarket scanner data set for multiple product categories, this paper shows a relation between subsequent firm performance (in terms of earnings and stock prices) and retail prices. In a period of economic slowdown, these effects are different for price changes which are made at a firm's fiscal year-end than at other times of the year consistent with year-end price changes being associated with earnings management behavior. Further, these effects vary depending on how severe prior-year price changes were as well as the price elasticity of demand for each individual product. Prior research shows that firms use a variety of real actions to increase short-term earnings. However, the effects on subsequent firm performance are less well studied. This is due, in part, to the possibility that the firm may be able to repeat the earnings management behavior in successive periods making it especially hard to detect subsequent weak performance. The economic conditions involving an increase in many input prices and general slowdown in demand during 2008 suggest that firms which have engaged in real earnings management behavior in the past may be less able to successfully repeat these actions in this period and may therefore report less positive earnings than those firms not engaging in the same practices. As such, it is more likely that subsequent poor performance will be observed for firms managing their earnings in 2008 than in periods of steady economic growth. This paper considers firms which use price changes as a method of affecting reported earnings and how these alleged earnings management behaviors affect their performance in subsequent periods.