Real earnings management’s effects on performance in firms reaching the loss avoidance threshold: indian evidence after controlling for variations in firm’s competitive strategy

Abstract

This study investigates the managerial intent—whether opportunistic or signaling—behind real earnings management (REM) actions taken to meet the loss avoidance threshold by examining their impact on future performance, whether negative or positive. The focus is on the impact of REM through overproduction, as well as selling, general, and administrative expenses (SGAX), both in aggregate and individually, on return on assets (ROA) and cash flow from operations (CFO). Additionally, the study delves into the impact of three components of SGAX, namely marketing expenses (MRKX), welfare and training expenses (WTX), and other general and administrative expenses (OGAX)—separately. To estimate REM proxies, this research utilizes Srivastava’s (2019) models, which account for variation in a firm’s competitive strategy. It applies panel regression analysis on observations from a sample frame consisting of 1444 non-financial enterprises spanning from 2005 to 2019. The findings reveal that firms motivated to meet the loss avoidance threshold and exhibiting REM, particularly through SGAX, experience a negative ROA in later years. The study observes similar implications for MRKX and OGAX. Furthermore, firms engaging in REM through OGAX witnessed unfavorable CFO implications. The study does not observe any impact of REM through overproduction and WTX on future performance. The robustness tests corroborate these findings, and additionally indicate that SGAX and WTX-focused REM negatively impact CFO, while overproduction-focused REM adversely impacts ROA. The results suggest that manager exercise REM opportunistically to avoid losses, highlighting the need for regulatory intervention to address the threshold mentality among Indian firms.