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Accrual-basedandrealearningsmanagementactivitiesaroundseasonedequityofferingsDanielA.Cohen1,PaulZarowinNewYorkUniversity,SternSchoolofBusiness,NY10012-1118,USAarticleinfoArticlehistory:Received15January2008Receivedinrevisedform22December2009Accepted18January2010Availableonline2February2010JELClassification:G14G32M4M41Keywords:SeasonedequityofferingsEarningsmanagementAccountingchoicesAccountingAccrualsRealactivitiesabstractWeshowthatSEOfirmsengageinrealactivitiesmanipulation,andthedeclineinpost-SEOperformanceduetotherealactivitiesmanagementismoreseverethanthatduetoaccrualmanagement.Ourevidenceisimportant,becauseitshowsthatpost-SEOoperatingunderperformanceisdrivennotjustbyaccrualreversals,butalsoreflectstherealconsequencesofoperationaldecisionsmadetomanageearnings.Wealsoshowhowfirms’choicesofrealversusaccrual-basedearningsmanagementactivitiesaroundSEOsvarypredictablyasafunctionofthefirm’sabilitytouseaccrualmanagementandthecostsofdoingso.&2010ElsevierB.V.Allrightsreserved.1.IntroductionInthispaper,weexaminebothrealandaccrual-basedearningsmanagementactivitiesaroundseasonedequityofferings(SEOs).PriorresearchhasdocumentedthatSEOsareassociatedwithearningsmanagementandsubsequentdeclinesinoperatingperformance(e.g.,Rangan,1998;Teohetal.,1998;Shivakumar,2000;DuCharmeetal.,2004).Thesestudiesfocusedexclusivelyonaccrual-basedmanipulation,andtheyattributedthepost-SEOperformancedeclineprimarilytoaccrualreversals.Inadditiontoaccrualmanipulation,however,firmscanmanageearningsbyalteringrealactivities(e.g.,Gunny,2005;Roychowdhury,2006;Zang,2006).Thedistinctionisimportant,becausewhileaccrual-basedearningsmanagementactivitieshavenodirectcashflowconsequences,realactivitiesmanipulationsaffectcashflows.Werefertorealactivitiesmanipulationasactionsmanagerstakethatdeviatefromnormalbusinesspractices.2WecontributetotheliteraturebyshowingthatSEOfirmsengageinrealactivitiesmanipulationintheyearoftheSEO,andthedeclineinpost-SEOperformanceduetotherealactivitiesmanagementismoreseverethanthatduetoaccrualContentslistsavailableatScienceDirectjournalhomepage::10.1016/j.jacceco.2010.01.002Correspondingauthor.Tel.:þ2129980015.E-mailaddresses:dcohen@stern.nyu.edu(D.A.Cohen),pzarowin@stern.nyu.edu(P.Zarowin).1Tel.:þ2129980267.2ThisdefinitionisconsistentwithRoychowdhury(2006)whodefinesrealactivitiesmanipulationsas‘‘ymanagementactionsthatdeviatefromnormalbusinesspractices,undertakenwiththeprimaryobjectiveofmeetingcertainearningsthresholds.’’JournalofAccountingandEconomics50(2010)2–19management.Ourevidenceisimportant,becauseitshowsthatpreviouslydocumentedpost-SEOoperatingunder-performanceisdrivennotjustbyaccrualreversals,butalsoreflectstherealconsequencesofoperationaldecisionsmadetomanageearningsatthetimeoftheSEO.Recentresearchshowsincreasedappreciationfortheimportanceofunderstandinghowfirmsmanageearningsthroughrealactivitiesmanipulationinadditiontoaccrual-basedactivities(e.g.,Gunny,2005;Roychowdhury,2006;Zang,2006).Forexample,Roychowdhury(2006)findsevidencethatfirmsusemultiplerealearningsmanagementmethodsinordertomeetcertainfinancialreportingbenchmarkstoavoidreportingannuallosses.Inparticular,hisevidencesuggeststhatmanagersareprovidingpricediscountstotemporarilyboostsales,reducingdiscretionaryexpendituresinordertoimprovereportedmargins,andoverproducingtolowerthecostofgoodssold.Inarecentsurveyoftopexecutives,Grahametal.(2005)provideevidencesuggestingthatmanagerspreferrealearningsmanagementactivitiescomparedtoaccrual-basedearningsmanagement.Thisisthecasesincerealmanagementactivitiesarelesslikelytobescrutinizedbyauditorsandregulators,andthuspotentiallyhaveagreaterprobabilityofnotbeingdetected,althoughtheconsequencesofsuchactivitiescanbeeconomicallysignificanttothefirm.Moreover,consistentwiththeconjecturesmadebyGrahametal.(2005),Cohenetal.(2008)findthatmanagershaveshiftedawayfromaccrualtorealearningsmanagementinthepostSarbanes–OxleyAct(SOX)period.Thisevidenceimpliesthatinthepost-SOXperiodfollowinghighlypublicizedaccountingscandals,theneedtoavoiddetectionofaccrual-basedearningsmanagementisgreaterthaninpreviousperiods,inducingmanagerstoshiftfromaccrual-basedtorealearningsmanagementactivities.Despitetheincreasinginterestinandimportanceofrealearningsmanagementactivities,nostudytodatehasexaminedwhetherandhowfirmsengageinrealearningsmanagementaroundSEOs,andhowrealandaccrual-basedearningsmanagementinteractaroundtheseimportantcorporateevents.Wefillthisgapintheliterature.Tocaptureaccrual-basedearningsmanagementwefollowpriorstudiesthatusethecross-sectionalJones(1991)model(e.g.,DeFondandJiambalvo,1994;Subramanyam,1996).Tocapturerealearningsmanagement,wefollowRoychowdhury(2006)andestimateabnormallevelsofcashflowsfromoperations,discretionaryexpenses(advertising,R&D,andSG&A),andproductioncosts.Inaddition,wecombinethesethreemeasuresintotwocomprehensiveaggregatemetricsofrealearningsmanagement.Consistentwithpriorstudies(e.g.,Teohetal.,1998,Rangan,1998,amongoth