The Impact of Earnings Manipulation on the Science and Practice of Strategic Management
Gibbs, Ralph Anthony
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Strategic management research frequently seeks to explain variation in organizational performance using metrics such as accounting proﬁts scaled by ﬁrm assets (ROA). Essay 1 addresses a concern with such accrual-based accounting methods—perhaps best illustrated by a large discontinuity in the distribution of ROA around zero for U.S. public ﬁrms—that operational and accounting practices will artiﬁcially inﬂate/deﬂate accounting proﬁt. The essay establishes that such earnings management is common, introduces non-classical noise, and distorts our understanding of broad drivers of ﬁrm performance. It concludes with an analysis showing that an alternative performance measure, Cash Flows from Operations on Assets (OCFOA), oﬀers a robust vehicle for checking results using accounting proﬁts. Essay 2 addresses a core prediction of the behavioral theory of the ﬁrm—that a ﬁrm is more likely to engage in strategic change when its performance falls short of its aspirations. If a ﬁrm manipulates income to report above aspirations when otherwise it would have fallen short, this creates a theoretical tension—does the ﬁrm engage in strategic change or not? This study utilizes two instrumental variables for a ﬁrm’s capability to smooth earnings to analyze the linkage between earnings smoothing and strategic change. The results suggest that public ﬁrms actively smoothing earnings have a lower propensity to subsequently change the ﬁrm’s major resource allocations, and that avoiding reporting performance below aspirations is a mechanism through which this may occur.