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Review of Quantitative Finance and Accounting

, Volume 46, Issue 2, pp 217–260 | Cite as

Abnormal real operations, real earnings management, and subsequent crashes in stock prices

  • Bill Francis
  • Iftekhar HasanEmail author
  • Lingxiang LiEmail author
Original Research

Abstract

We study the impact of firms’ abnormal business operations on their future crash risk in stock prices. Computed based on real earnings management (REM) models, firms’ deviation in real operations (DROs) from industry norms is shown to be positively associated with their future crash risk. This association is incremental to that between discretionary accruals (DAs) and crash risk found by prior studies. Moreover, after Sarbanes–Oxley Act (SOX) of 2002, DRO’s predictive power for crash risk strengthens substantially, while DA’s predictive power essentially dissipates. These results are consistent with the prior finding that managers shift from accrual earnings management to REM after SOX. We further develop a suspect-firm approach to capture firms’ use of DRO for REM purposes. This analysis shows that REM-firms experience a significant increase in crash risk in the following year. These findings suggest that the impact of DRO on crash risk is at least partially through REM.

Keywords

Crash risk Deviation in real operations Earnings management Real earnings management Sarbanes–Oxley 

JEL Classification

D89 G19 M10 M41 

Notes

Acknowledgments

We are thankful to the discussants and participants at the concurrent sessions at the 2012 AAA annual meeting in D.C. and 2012 FMA annual meeting in Atlanta, GA. Usual caveats apply. This research has begun as Chapter 2 of Lingxiang Li’s dissertation submitted in partial fulfillment of the requirements for a Ph.D. at Rensselaer Polytechnic Institute.

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Copyright information

© Springer Science+Business Media New York 2014

Authors and Affiliations

  1. 1.Lally School of ManagementRensselaer Polytechnic InstituteTroyUSA
  2. 2.School of BusinessFordham UniversityNew YorkUSA
  3. 3.Bank of FinlandHelsinkiFinland
  4. 4.School of BusinessState University of New York-Old WestburyOld WestburyUSA

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