Relationship-specificity and real activities manipulation

Abstract

Purpose The purpose of this paper is to examine whether and how product market relationships are related to firms’ real activities manipulation (RAM), which refers to managers’ aggressive operating practices. Given the importance of suppliers’ relationship-specific investments to a firm’s competitiveness, the need for suppliers’ relationship-specific investments is expected to influence a firm’s RAM. Design/methodology/approach This paper adopts Nunn’s (2007) proxy for relationship-specificity and four proxies for RAM. It employs an ordinary least squares regression model to test whether a firm decreases RAM when it has greater need for supplier relationship-specific investments. It also uses an instrumental variable approach to address endogeneity and conducts cross-sectional analyses. Findings This study finds that, with the exception of RAM through sales manipulation, the importance of relationship-specific investments by suppliers is negatively associated with firms’ aggressive operating decisions. It also finds that the association between relationship-specificity and RAM is less pronounced for firms that have a greater market share but more pronounced for firms that are relatively young, consistent with the notion that a firm is more likely to be under pressure from its suppliers to reduce RAM when it has less competitive advantages. The results suggest that product market relationships play an important role in influencing managers’ aggressive operating decisions. Practical implications This study complements earlier work on earnings quality and has important implications for investors, regulators and other stakeholders who are concerned with corporate earnings quality. Originality/value This paper contributes to the literature on product market relationships and earnings quality and on financial reporting quality and investment efficiency.