Corporate diversification and accrual and real earnings management: a non-linear relationship

Purpose – This study aims to examine the non-linear relationship between corporate diversification and real and accrual earnings management, using a sample of 5,659 US firm-year observations for 1,221 firms covering the period from 2001 to 2012.

Design/methodology/approach – The authors employ various techniques and regressions to test the hypotheses. Following prior research, several proxies have been used to measure diversification, accrual earnings management, and real earnings management.

Findings – The study produces several important findings. First, the study provides evidence that diversified firms engage in real and accrual earnings management to manage their reported earnings upwards. These results are consistent with recent research (e.g., Farooqi et al. 2014; Jirapon et al., 2008) that finds that diversified firms engage in earnings manipulation. Second, and most importantly, the study contributes to the literature by providing the first evidence on a non-linear relationship between corporate diversification and earnings management. Specifically, the study provides evidence that diversified firms engage in accrual (real) earnings management, but this engagement is associated with level of diversification in a non-linear U shaped (inverted U shaped) relationship.

Research limitations/implication – Like all other studies, the current study has some limitations. The study was conducted only on the largest firms in the US that have market capitalization of more than $10 million; hence the findings may not be generalizable to small publicly traded firms. Further, the findings may not be generalizable to other markets given the unique characteristics of US markets such as the presence of very sophisticated investors.

Practical implications – This study provides some important implications for US regulators to revise their regulations to prevent diversified firms from using earnings management to manipulate reported earnings.

Originality/value – This study is the first in the US to examine the non-linear relationship between corporate diversification and earnings management. The study focuses on one of the most active, most attractive, and largest capital markets throughout the world, that of the US. Also, this study is one of the few studies that examine whether diversified firms use real activities manipulation to manage their reported earnings.