The Effect of Managers' Mix of Real and Accrual‐Based Earnings Management on Future Performance

ABSTRACT Prior research finds that firms use both accrual‐based earnings management (AEM) and real earnings management (REM) to manage financial reporting outcomes and that each practice influences firm performance. We extend this research by examining how managers’ choices regarding the mix of AEM and REM relate to future performance. We argue that the sequential nature of the two earnings management strategies constrains managers’ ability to obtain a mix of AEM and REM that minimizes the total cost of earnings management, leading to weaker future performance. Consistent with this argument, we find evidence of deviations from the mix of AEM that would be expected based only on their costs: (1) resulting in future earnings and cash flows that are lower than the firm's historical performance, and (2) being significantly negatively associated with future buy‐and‐hold abnormal returns. We find similar results using commonly used measures of earnings management and recently refined measures designed to capture opportunistic earnings manipulation. Our evidence indicates that deviations from the mix of AEM and REM expected based on their relative costs are costly to firms regardless of whether managers’ intent is to inform or to mislead financial statement users.