Innovation Focused Strategy and Earnings Management
This study examines two research questions. First, it investigates the extent to which firms with an innovation-focused strategy engage in earnings management. Earnings management is the manipulation of profits or income to meet a specific target or earnings threshold. The study examines two earnings management methods: accrual-based and real activity-based (e.g., reduction in research and development (R&D) spending). Extant research provides several theories regarding why innovative firms might be more likely to manage earnings. Innovative firms are in need of large pools of capital to support new research projects (Choi and Ahn 2010), thus pressuring management to manipulate earnings in order to receive desired funding from investors (Fuller and Jensen 2010). Additionally, innovative firms are more likely to experience severe price reactions if they do not meet earnings expectations (Skinner and Sloan 2002). The study uses the methodology described in Murphy (2001) and Cohen et al. (2006) to examine the relationship between firms with an innovation focused strategy and earnings management. Results suggest that more innovative firms manage earnings using accounting accruals more than less innovative firms. Still, more innovative firms are less likely to use real activities to manage earnings than less innovative firms since myopic management often leads to poor future performance (Mizik 2010). Second, the study examines the relationship between firm innovation strategy and earnings informativeness. Earnings informativeness is defined as the usefulness of earnings in determining market returns and value. Signaling theory suggests that firms send information or signals to the market regarding their future performance (Hao and Yao 2010). While earnings are important signals of firm value, innovative firms may transmit other information that is more indicative of firm value, such as new technology, to the market.. Using the models in Warfield et al. (1995), Francis and Schipper (1999), and Jung and Kwon (2002), I measure the informativeness of earnings by examining the effect of earnings on returns, and the effect of book value and earnings on stock price. While findings indicate that earnings of more innovative firms are less informative than less innovative firms, the results regarding the informativeness of book value and earnings on stock price are not conclusive.
Accounting, earnings management, innovation, earnings informativeness, strategy
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