![]() We find these measures are often misspecified with Type I error rates that deviate from the nominal significance level of the test, especially in samples of firms with extreme performance or firm characteristics. We provide such evidence by documenting the Type I error rates and power of the test of the REM measures commonly used in the literature. ![]() Yet, there is no systematic evidence on the statistical properties of commonly used REM measures. Tests using measures of abnormal REM hinge critically on the measurement of normal real activities. These results challenge the view that SFAS 151 inadvertently encouraged overproduction.Įn To test hypotheses about earnings management, many studies investigate managers' manipulation of real activities (real earnings management, REM). Consistent with expectations, we find a lower propensity to use overproduction to meet benchmarks following SFAS 151. Therefore, we posit that management's propensity to use overproduction to meet earnings benchmarks should decrease after the adoption of SFAS 151. Because periods of underproduction often follow periods of overproduction, and because SFAS 151's emphasis on the subjective determination of normal capacity can erroneously categorize overproducing firms as underproducers in subsequent years, we posit that SFAS 151 makes overproduction less desirable than before. 151 (SFAS 151) limited the fixed costs that can be capitalized to inventory in periods of low production, thereby introducing a penalty for underproduction by requiring firms to expense unallocated overhead in the current period. Additionally, Statement of Financial Accounting Standards No. Prior research finds that managers engage in inventory overproduction to inflate current earnings despite the fact that overproduction is associated with significant economic costs. High-ability managers’ intentional smoothing is also associated with increased voluntary (but not forced) executive turnover, consistent with high-ability managers being motivated, at least in part, by how the capital market consequences of smoothing are expected to benefit shareholders, thereby bolstering their reputation. We do not, however, find evidence that high-ability managers who smooth are more likely to have engaged in informed trading or are more likely to consume perquisites. We find that (a) high-ability managers are significantly more likely to engage in intentional smoothing, (b) their intentional smoothing is associated with improved future operating performance, and (c) their intentional smoothing is more prevalent when the smoothing either benefits shareholders, the manager, or both. Although prior studies provide evidence that high-ability managers report higher quality earnings, the literature does not indicate whether this behavior is common because of (or happens in spite of) high-ability managers’ intentional smoothing activities. We investigate if high-ability managers are more likely to intentionally smooth earnings, a form of earnings management, and when they are more likely to do so.
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