Session 3: Basic Cost Terms and Concepts

Article: Earnings management through real activities manipulation, Sugata Roychowdhury (2006)

The research paper “Earnings management through real activities manipulation” by Sugata Roychowdhury analyses evidence on real activities manipulation in corporate earnings management to meet operational targets. Roychowdhury presents “abnormal real activities” in operations management by examine cash flows from operation (CFO), production costs and discretionary expenses. My paper will focus on how the evidence of real activities manipulation presented in the research paper is related to the concepts of opportunity and period costs.

To identify how accounting and operational decision making is related to opportunity costs in earnings management, I oppose present period cost to future period costs in my paper. As accrual accounting is based on the revenue recognition principle manipulating real activities during the present year is often used to influence short-run earnings targets to avoid annual losses without realizing the opportunity costs of a decrease in long-run firm value. Managers engage in accrual manipulation by reason of attaching high values to abnormal accruals in their evaluation of opportunity costs. Short-term activities, i.e. altering financial reports to meet annual analyst forecasts, earn higher recognition than long-term upcoming costs by misleading stakeholders or influence contractual outcomes. Graham et al.’s survey (2005) confirms in consistency with the research paper that financial executives have a high willingness to pay meeting those earnings targets, even though there is high probability to reduce firm value in future periods by real activities manipulation. Misvaluation of opportunity costs for potential decreasing firm value by actions taken in current periods to increase annual earnings can