The Effects of Business Strategy and Product Market Competition on Real Earnings Management

Author’s Contribution

LB: wrote the paper, collected the data, and performed the analysis; LL: conceived of the presented idea and designed the analysis; CR: contributed data and analysis tools and helped shape de manuscript.

Conflicts of interest

On behalf of all authors, the corresponding author states that there is no conflict of interest.

EDITOR-IN-CHIEF

Talles Vianna Brugni 0000-0002-9025-9440

ASSOCIATE EDITOR

Eduardo Flores 0000-0002-5284-5107

Panel A: Sample selection procedure
Description			Observations
Total number of firm-year observations from 1987 to 2020			255,918
Less: regulated industries (22 code) and financial industries (52-53 code) and missing 2-digit NAICS Codes values			(4,771)
Less: Observations without at least $1 million in net sales and total assets			(33,160)
Less: Observations with missing values for dependent and independent variables, including observations lost for estimating lagged variables.			(198,520)
Final sample			19,467
Panel B: Industry distribution
Code	Industry	# Observations	% Observations
72	Accommodation and Food Services	222	1.14%
56	Administrative and Support and Waste Management and Remediation Services	247	1.27%
71	Arts, Entertainment, and Recreation	31	0.16%
23	Construction	176	0.90%
61	Educational Services	61	0.31%
62	Health Care and Social Assistance	160	0.82%
51	Information	1,531	7.86%
31-33	Manufacturing	13,303	68.34%
21	Mining, Quarrying, and Oil and Gas Extraction	413	2.12%
54	Professional, Scientific, and Technical Services	1,735	8.91%
44-45	Retail Trade	1,004	5.16%
48-49	Transportation and Warehousing	177	0.91%
42	Wholesale Trade	407	2.09%
	TOTAL	19,467	100%

Variable	Description	Variable measurement
(1) Research and development to sales (RDS5)	Company’s propensity to seek for new products.	Average of research and development expenditures to net sales over the prior five years.
(2) Employees to sales (EMPS5)	Company’s ability to produce and distribute products and services efficiently.	Average of the number of employees to net sales over the prior five years.
(3) Employee fluctuations (σ(EMP5))	Company’s organizational stability.	Standard deviation of the total number of employees [EMP] over the prior five years.
(4) Change in total revenue (REV5)	Company’s historical growth or investment opportunities.	Average of one-year percentage change in net sales over the prior five years.
(5) Marketing to sales (SGA5)	Company’s focus on marketing investments.	Average of selling, general and administrative expenses to net sales over the prior five years.
(6) Capital intensity (CAP5)	Company’s commitment to technological efficiency and production.	Average of net property, plant and equipment scaled by total assets over the prior five years.

Panel A: Descriptive statistics
Variables	Full sample (n = 19.467)					Prospectors (STRATEGY range of 24-30) (n = 1.444)		Defenders (STRATEGY range of 6-12) (n = 1.756)
	Mean	Median	1st Quartile	3rd Quartile	Std. Dev.	Mean	Median	Mean	Median
REM	-0.052	0.004	-0.289	0.243	0.466	-0.326	-0.251	0.275	0.298
STRATEGY	17.750	18.000	15.000	21.000	3.904	25.046	25.000	10.886	11.000
HHI	-0.051	-0.026	-0.074	-0.020	0.054	-0.046	-0.026	-0.049	-0.026
CR4	-0.042	-0.020	-0.060	-0.012	0.054	-0.037	-0.020	-0.040	-0.019
HTI	-0.022	-0.009	-0.034	-0.007	0.023	-0.020	-0.009	-0.022	-0.009
ROA	-0.006	0.047	-0.012	0.089	0.216	-0.166	-0.045	0.019	0.045
LEV	0.501	0.483	0.300	0.638	0.298	0.462	0.406	0.564	0.522
SIZE	13.252	13.314	11.706	14.830	2.283	12.703	12.611	13.375	13.291
GROWTH	0.086	0.063	-0.028	0.166	0.270	0.265	0.178	0.023	0.023
Panel B: Correlation analysis
	1	2	3	4	5	6	7	8	9
1 REM	1.00
2 STRATEGY	-0.382	1.00
3 HHI	0.004	0.036	1.00
4 CR4	0.005	0.034	0.998	1.00
5 HTI	-0.010	0.057	0.895	0.876	1.00
6 ROA	-0.063	-0.211	0.047	0.047	0.014	1.00
7 LEV	0.107	-0.142	-0.049	-0.045	-0.057	-0.256	1.00
8 SIZE	0.106	-0.078	0.062	0.062	0.041	0.378	0.151	1.00
9 GROWTH	-0.155	0.215	-0.043	-0.043	-0.034	0.143	-0.061	0.038	1.00

	Dependent variable: Real Earnings Management
	(1)	(2)	(3)	(4)	(5)	(6)	(7)
STRATEGY	-0.050^***	-0.050^***	-0.050^***	-0.050^***	-0.212^***	-0.209^***	-0.209^***
	(0.002)	(0.002)	(0.002)	(0.002)	(0.011)	(0.010)	(0.011)
HHI		-0.104			-0.149
		(0.259)			(0.268)
CR4			-0.103			-0.150
			(0.251)			(0.260)
HTI				-0.065			-0.203
				(0.820)			(0.842)
STRATEGY*HHI					-0.399^***
					(0.141)
STRATEGY^*CR4						-0.413^***
						(0.142)
STRATEGY^*HTI							-0.740^***
							(0.347)
SIZE	0.034^***	0.034^***	0.034^***	0.034^***	0.034^***	0.034^***	0.034^***
	(0.005)	(0.005)	(0.005)	(0.005)	(0.005)	(0.005)	(0.005)
LEV	-0.053	-0.053	-0.053	-0.053	-0.055	-0.054	-0.055
	(0.037)	(0. 037)	(0.037)	(0.037)	(0.037)	(0.037)	(0.037)
ROA	-0.502^***	-0.503^***	-0.503^***	-0.502^***	-0.502^***	-0.501^***	-0.504^***
	(0.051)	(0.051)	(0.051)	(0.051)	(0.051)	(0.051)	(0.051)
GROWTH	-0.067^***	-0.067^***	-0.067^***	-0.067^***	-0.069^***	-0.069^***	-0.067^***
	(0.020)	(0.020)	(0.020)	(0.020)	(0.020)	(0.020)	(0.020)
Industry FE	Yes	Yes	Yes	Yes	Yes	Yes	Yes
Year FE	Yes	Yes	Yes	Yes	Yes	Yes	Yes
Observations	19,467	19,467	19,467	19,467	19,467	19,467	19,467
Adjusted R2	0.206	0.206	0.206	0.206	0.208	0.208	0.207

	Dependent variable: Real Earnings Management
	(1)	(2)	(3)	(4)
PROSPECTORS	-0.651^*** (0.035)	-0.769^*** (0.044)	-0.751^*** (0.041)	-0.743^*** (0.045)
HHI		0.958^* (0.534)
CR4			0.968^* (0.527)
HTI				1.865 (1.562)
PROSPECTORS^* HHI		-2.567^*** (0.522)
PROSPECTORS^* CR4			-2.675^*** (0.523)
PROSPECTORS^* HTI				-4.406^*** (1.299)
SIZE	0.030^*** (0.008)	0.025^*** (0.008)	0.025^*** (0.008)	0.027^*** (0.008)
LEV	-0.017 (0.048)	-0.016 (0.045)	-0.016 (0.045)	-0.020 (0.047)
ROA	-0.432^*** (0.074)	-0.436^*** (0.072)	-0.435^*** (0.072)	-0.439^*** (0.073)
GROWTH	-0.060^* (0.031)	-0.068^** (0.031)	-0.069^** (0.031)	-0.060^* (0.031)
Industry FE	Yes	Yes	Yes	Yes
Year FE	Yes	Yes	Yes	Yes
Observations	3,200	3,200	3,200	3,200
Adjusted R2	0.381	0.393	0.394	0.388

	Dependent variable: Accurals Management
	(1)	(2)	(3)	(4)	(5)	(6)	(7)
STRATEGY	0.003^*** (0.000)	0.003^*** (0.000)	0.003^*** (0.000)	0.003^*** (0.000)	0.012^*** (0.002)	0.012^*** (0.002)	0.013^*** (0.002)
HHI		0.044 (0.035)			0.049 (0.035)
CR4			0.040 (0.034)			0.045 (0.034)
HTI				0.003 (0.101)			0.039 (0.101)
STRATEGY ^*HHI					0.036 (0.022)
STRATEGY ^*CR4						0.035 (0.022)
STRATEGY ^*HTI							0.112^*** (0.041)
SIZE	-0.010^*** (0.001)	-0.010^*** (0.001)	-0.010^*** (0.001)	-0.010^*** (0.001)	-0.010^*** (0.001)	-0.010^*** (0.001)	-0.010^*** (0.001)
LEV	0.039^*** (0.008)	0.039^*** (0.008)	0.039^*** (0.008)	0.039^*** (0.008)	0.039^*** (0.008)	0.039^*** (0.008)	0.039^*** (0.008)
ROA	-0.089^*** (0.014)	-0.089^*** (0.014)	-0.089^*** (0.014)	-0.089^*** (0.014)	-0.089^*** (0.014)	-0.089^*** (0.014)	-0.089^*** (0.014)
GROWTH	0.044^*** (0.007)	0.044^*** (0.007)	0.044^*** (0.007)	0.044^*** (0.007)	0.045^*** (0.007)	0.045^*** (0.007)	0.044^*** (0.007)
Industry FE	Yes	Yes	Yes	Yes	Yes	Yes	Yes
Year FE	Yes	Yes	Yes	Yes	Yes	Yes	Yes
Observations	20,509	20,509	20,509	20,509	20,509	20,509	20,509
Adjusted R2	0.166	0.166	0.166	0.166	0.166	0.166	0.166

\frac{{P R O D}_{i t}}{A_{i t - 1}} = \propto_{0} + \propto_{1} \frac{1}{A_{i t - 1}} {+ \propto}_{2} \frac{S_{i t}}{A_{i t - 1}} + \propto_{3} \frac{∆ S_{i t}}{A_{i t - 1}} + \propto_{4} \frac{∆ S_{i t - 1}}{A_{i t - 1}} + ε_{i t}

\frac{{C F O}_{i t}}{A_{i t - 1}} = \propto_{0} + \propto_{1} \frac{1}{A_{i t - 1}} {+ \propto}_{2} \frac{S_{i t}}{A_{i t - 1}} + \propto_{3} \frac{∆ S_{i t}}{A_{i t - 1}} + ε_{i t}

{R E M}_{i, t} = β_{0} + β_{1} {S T R A T E G Y}_{i, t} + β_{2} {R O A}_{i, t} + β_{3} {L E V}_{i, t} + β_{4} {S I Z E}_{i, t} + β_{5} {G R O W T H}_{i, t} + {I n d u s t r y D u m m y}_{i, t} + {Y e a r D u m m y}_{i, t} + ε_{i, t}

{R E M}_{i, t} = β_{0} + β_{1} {S T R A T E G Y}_{i, t} + β_{2} {M a r k e t c o m p e t i t i o n}_{i, t} + β_{3} {R O A}_{i, t} + β_{4} {L E V}_{i, t} + β_{5} {S I Z E}_{i, t} + β_{6} {G R O W T H}_{i, t} + {I n d u s t r y D u m m y}_{i, t} + {Y e a r D u m m y}_{i, t} + ε_{i, t}

{R E M}_{i, t} = β_{0} + β_{1} {S T R A T E G Y}_{i, t} + β_{2} {M a r k e t c o m p e t i t i o n}_{i, t} + β_{3} {S T R A T E G Y}_{i, t} * M a r k e t {c o m p e t i t i o n}_{i, t} + β_{4} {R O A}_{i, t} + β_{5} {L E V}_{i, t} + β_{6} {S I Z E}_{i, t} + β_{6} {G R O W T H}_{i, t} + {I n d u s t r y D u m m y}_{i, t} + {Y e a r D u m m y}_{i, t} + ε_{i, t}

Variable Definitions
Dimension	Variable	Definition
Dependent variable	Real earnings management	The value of real earnings management was calculated by the sum of APROD, ACFO, and ADISX: where APROD is the level of abnormal production costs, ACFO is the level of abnormal cash flows from operations, and ADISX is the level of abnormal discretionary expenses. ACFO and ADISX were multipled by -1.
Independent variables	STRATEGY	Each variable presented at Table 2 was measured per firm-year based on the rolling prior five-year average, except the variable σ(EMP5) that considers the standard deviation of the number of employees over the prior five years. In sequence, each of the six variables was ranked into quintiles per industry (two-digit NAICS code) and year. The observations in the highest quintiles were given a score of 5, while the ones in the lowest quintiles were given a score of 1 (except capital intensity which was reversed-scored, meaning that observations in the lowest (highest) quintile were given a score of 5 (1)). Within each firm-year, the scores were summed over the six measures, such that the maximum score that a firm could receive is 30 (prospector-type) and a minimum score of 6 (defender-type). Therefore, the discrete STRATEGY score ranges along a continuum in value from 6 to 30 with defender- and prospector-type companies closer to the endpoints
	HHI	The HHI was calculated as $H H I = \sum_{i = 1}^{N} ω^{2}$ , where ω is market share for firm i measured by its sales divided by total industry sales, and N is the number of firms per year-industry.
	CR4	The concentration ratio was calculated as $C R 4 = \sum_{i = 1}^{N = 4} ω^{2}$ , only the largest four firms in the industry were considered.
	HTI	Hall Tideman index (HTI) was calculated as $H T I = 1 / (2 \sum_{i = 1}^{N} (k * ω) - 1)$ , where k represents firm rank according to market share.
Control variables	ROA	The return on assets was calculate through the ratio of net income before extraordinary items of year t to total assets of year t.
	LEV	Leverage was calculated through the ratio of total liabilities of year t to total assets of year t.
	SIZE	Firm size was calculated by the natural logarithm of total assets of year t.
	GROWTH	Growth was calculated by dividing the difference between net sales of period t and net sales of t-1 by the net sales of t-1.

[1] luiza.dazzi@gmail.com

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The Effects of Business Strategy and Product Market Competition on Real Earnings Management

Abstract