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

Abstract

This research investigated the singular and combined effects of firm-level business strategy (BS) and industry-level market competition (MC) on real activities-based earnings management (REM). A composite strategy score based on Miles and Snow’s framework was used to empirically assess BS, while MC was measured through three distinct metrics, and REM was calculated based on Roychowdhury’s (2006) models of abnormal level of production, sales, and discretionary expenditures. Archival data from United Stated (U.S.) non-financial public listed firms in the period 1987-2020 was analyzed using Ordinary Least Squares (OLS) regressions, controlled for industry and year fixed effects. Findings suggested that firms following an innovation-oriented prospector strategy are associated with lower levels of REM than firms following an efficiency-oriented defender strategy. While MC alone did not have a significant effect on REM, the combined effect of BS and MC reveals that prospectors in more competitive markets engage less in REM activities, which confirms the relevance of competition in the relationship between BS and REM. This research contributes to earnings management literature by documenting that REM practices are affected not only by internal choices of resource allocation in accordance with a business strategy, but also by exogenous determinants of market competition.