Real Earnings Management around Stock Repurchases

Jimmy Downes Ph.D Student Spears School of Business Oklahoma State University Stillwater, Oklahoma 74078 [email protected]

Lauren Gorman Ph.D Student Spears School of Business Oklahoma State University Stillwater, Oklahoma 74078 [email protected]

Ramesh Rao Department of Finance 309 Business Building Spears School of Business Oklahoma State University Stillwater, OK 74078 [email protected]

August 2013

Real Earnings Management around Stock Repurchases

Abstract:

This study examines whether firms engage in income-decreasing real earnings management around stock repurchases that are made for non-signaling purposes. We focus our investigation on two methods of real earnings management: under-producing inventory and increasing discretionary expenditures. Our results suggest that firms engage in both of these activities prior to repurchasing their shares. This is consistent with firms attempting to mislead investors into under-valuing their stock, allowing them to repurchase their shares at a lower price. Additional analysis suggests that the income-decreasing real earnings management activities are concentrated in the subset of firms that are in strong financial health. Further evidence is provided by examining sets of firms that likely make repurchases for non-signally reasons. The evidence suggests that firms participate in more income-decreasing real earnings management when they have significant amounts of stock options outstanding, and to a lesser extent, when they are overvalued. Finally, we provide evidence that the firms that reduce income-increasing real earnings management experience positive abnormal returns during the period subsequent to the repurchase. We conclude that managers of firms that engage in stock repurchases for non- signaling purposes have incentives to depress their stock price prior to making the repurchase. Our results are important to investors and academics who are interested in the motivations of real earnings management.

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Real Earnings Management around Stock Repurchases

1. Introduction

This study examines whether firms engage in income-decreasing real earnings management around stock repurchases that are made for non-signaling purposes. Firms have the incentive to lower their share price prior to making a repurchase in order to reduce the price that they must pay to buy back shares. One way in which firms can accomplish this task is by managing their earnings downward in the period preceding the repurchase. 1 If investors are unaware that a firm’s reported income has been manipulated, then they will undervalue its stock.2 Consistent with this claim, the prior literature has found that firms engage in income- decreasing accruals-based earnings management in the period preceding stock repurchases

(Gong, Louis, and Sun 2008). However, given that real earnings management is more costly to firms than accruals-based earnings management in terms of its effects on future cash flows

(Cohen and Zarowin 2010; Gunny 2010) and that the prevalence of real earnings management

(accruals-based earnings management) has increased (decreased) since the passage of the

Sarbanes-Oxley Act of 2002 (SOX) (Cohen, Dey and Lys 2008), it is important to examine

1 Prior research documents the relation between unexpected earnings and unexpected returns is asymmetric. Specifically, investors penalize firms that miss earnings forecasts more so than they award firms that beat earnings forecasts (Skinner and Sloan 2002). As such, it is reasonable to assume a negative association between earnings decreases and stock returns. In this study, we use the term income-decreasing and a reduction in income-increasing activities synonymously. 2 Previous studies examining the use of income-increasing accruals-based earnings management around equity offerings find that these firms have lower subsequent stock returns compared to other firms (Teoh, Welch, and Wong 199a; Rangan 1998; Teoh, Welch, and Wong 1998b). The authors propose that this result is due to investors’ inability to fully understand that pre-issuance earnings have been managed upward. As a result, they overvalue issuing firms and are subsequently disappointed. In addition, Gong, Louis, and Sun (2008) find that firms using income-decreasing accruals-based earnings management prior to open-market stock repurchases have positive subsequent abnormal stock returns, suggesting that investors are surprised by the improvement in performance after the repurchase occurs. 2 whether firms engage in forms of real earnings management around non-signaling stock repurchases.

This study focuses on two specific types of income-decreasing real earnings management.3 The first method is under-producing inventory. By producing fewer inventories than are necessary to meet expected demand, fixed cost per unit increases, resulting in a higher cost of goods sold, and consequently, lower reported income. The second method considered is increased discretionary spending on research and development (R&D), advertising, and selling, general, and administrative (SG&A) expenses. Since these types of expenditures are generally expensed during the period in which they are incurred, increased spending leads to higher reported expenses, and thus, lower earnings. We predict that firms will engage in both of these real earnings management activities prior to making a stock repurchase.

We additionally examine cross-sectional differences among firms in order to identify which type of firms engage in more income-decreasing real earnings management preceding repurchases. The first cross-sectional test investigates the impact that financial health has on the association between real earnings management and stock repurchases. Prior research finds that firms in stronger financial health are more motivated to manipulate earnings by using real earnings management (Zang 2012). Consistent with the prior research, we expect that these firms have more resources to rely on and more opportunities to decrease production and increase discretionary spending prior to a stock repurchase. Accordingly, hypothesis two predicts that firms in strong financial health engage in more income-decreasing real earnings management prior to making a stock repurchase.

3 This study focuses on firms that participate in income-decreasing real earnings management given the incentives to do so preceding a stock repurchase. In contrast, the prior research mainly focuses on income-increasing real earnings management used to avoid earnings losses, earnings decreases, missing the analysts’ forecast, etc. (Roychowdhury 2006, Zang 2012, among others). 3

Next we examine two sets of firms that are likely to make stock repurchases for non- signaling reasons: firms that have significant outstanding stock options and firms that have overvalued equity. Kahle (2002) finds that the existence of stock options leads firms to make repurchases in order to have shares available to fund employee stock option plans. Since the repurchase is not primarily being used as a signaling device, we expect that these firms will want to accomplish the repurchase as cheaply as possible. Therefore, we predict that firms with greater stock option intensity will be more motivated to depress their stock price prior to making a stock repurchase, and accordingly, will participate in more downward real earnings management.

Finally, we examine the real earnings management behavior of firms that are overvalued.

A firm with overvalued equity has a high stock price, relative to its underlying value, and therefore, can achieve a larger reduction in the repurchase price than other firms. In contrast, firms with undervalued equity have little to gain from using real earnings management to lower their stock price because it is already relatively low. In addition, Ikenberry, Lakonishok, and

Vermaelen (1995) and Kahle (2002) find evidence consistent with undervalued firms making repurchasing for signaling purposes. Therefore, we predict that overvalued firms engage in more income-decreasing real earnings management prior to making a stock repurchase.

Real earnings management is empirically measured in a manner consistent with the prior literature (Roychowdhury 2006; Cohen and Zarowin 2010; Zang 2012). However, because we are interested in firms’ use of income-decreasing activities, our intuition runs opposite of previous studies that examine income-increasing activities. Using OLS regression, this study examines the association between under-produced inventory or increased amounts of discretionary spending and subsequent stock repurchases. The sample period investigated spans from 1988 to 2009. Consistent with Zang (2012), the analysis is performed using the Heckman

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(1979) two-stage procedure in order to correct for possible sample selection bias, given that firms are more likely to manage earnings in order to meet or beat various benchmarks.

This study finds three main results related to the association between real earnings management and stock repurchases. First, the results suggest that firms, on average, engage in income-decreasing real earnings management around stock repurchases. Specifically, firms produce fewer inventories and increase their discretionary spending in the period preceding the repurchase of their shares. Second, the use of both real earnings management methods is concentrated in the subset of firms that are in strong financial health. This suggests that only the set of firms that can afford to produce fewer inventories and spend more on discretionary expenditures are able to take advantage of the opportunity to manage earnings downward prior to a stock repurchase. Third, we find evidence suggesting that firms with greater stock option intensity, compared to firms with less stock option intensity, participate in more downward earnings management prior to a stock repurchase. We also find marginal evidence that firms with overvalued equity use more income-decreasing real earnings management prior to making a stock repurchase. We conclude that managers of firms that engage in stock repurchases for non- signaling purposes have incentives to depress their stock price prior to making the repurchase.

In additional analysis, we confirm our findings using quarterly data and find qualitatively similar results. Given that the stock price declines prior to the stock repurchase, we expect that those firms that depress their stock price the most will have the greatest amount of positive returns in the period subsequent to the repurchase. Accordingly, we examine firms’ abnormal returns in the period following the stock repurchase and find evidence that the firms that engage in the greatest amount of income-decreasing real earnings management experience the largest positive abnormal returns.

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This study makes several contributions to the accounting and finance literatures. First, it contributes to the earnings management literature by demonstrating that firms use income- decreasing real earnings management, as opposed to just accruals-based earnings management, surrounding stock repurchases. The prior literature has focused mainly on firms’ use of accrual- based earnings management prior to repurchasing its shares (Gong et al. 2008). However, given that real earnings management is more costly to firms in terms of future cash flows effects

(Cohen and Zarowin 2010) and that the prevalence of real earnings management has increased since the passage of SOX (Cohen et al. 2008), it is important to document that firms manage their earnings through real activities manipulation preceding stock repurchases. An additional contribution to the earnings management literature is the fact that we examine a setting where firms use income-decreasing real earnings management instead of income-increasing real earnings management. Prior research generally focuses on instances in which managers are motivated to increase earnings (Roychowdhury 2006). However, the results of our study suggest that there are certain settings (i.e. stock repurchases) where managers have greater motivation to decrease earnings through the use of real earnings management.

Second, this study indicates that one means through which firms are able to minimize their costs associated with stock repurchases is by taking deliberate, suboptimal actions that lead to a reduction in the repurchase price. Specifically, managers increase spending on discretionary expenditures and produce fewer inventories than are needed to meet expected demand for the purpose of reporting lower earnings, in the hope that the market will undervalue its shares. This, in turn, will result in a reduced repurchase price. It is important that investors as well as regulators know that firms are participating in these types of non-value enhancing behaviors around stock repurchases because they can have long-term effects on firm value.

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Finally, we show the tendency of firms to increase their use of real earnings management before a stock repurchase varies cross-sectionally. We find that the observed effect is larger for firms that are in strong financial health, those with greater stock options outstanding, and to a lesser extent, those with overvalued equity. This indicates the importance of considering managers’ motives for making firm decisions, such as stock repurchases, as well as identifying specific settings in which firms have a stronger motivation to engage in real earnings management.

The remainder of the paper is organized as follows. Section 2 describes the prior literature examining real earnings management and the management of earnings around corporate finance events. Section 3 develops our hypotheses. Section 4 describes our research design, and Section 5 presents our sample and the empirical results. Finally, Section 6 concludes.

2. The Prior Literature

2.1 Real Earnings Management

For the purposes of this study, we follow Roychowdhury (2006) and define real earnings management as “departures from normal operational practices, motivated by managers’ desire to mislead at least some stakeholders into believing certain financial reporting goals have been met in the normal course of operations (page 337).” For example, managers could choose to reduce discretionary expenditures on R&D in the current period in order to decrease reported expenses, and accordingly, increase earnings. While it is possible that deviations from the normal level of operational activities are optimal given firms’ economic conditions, the definition above requires firms to deviate more than normal, for the purpose of meeting and/or beating earnings benchmarks, for their actions to be considered real earnings management.

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Survey evidence from Graham, Harvey, and Rajgopal (2005) suggests that managers behave in ways that are consistent with real earnings management. The authors report that approximately 80 percent of the 400 participating executives stated that they would decrease discretionary expenditures on R&D, advertising, and maintenance in order to meet an earnings benchmark. In addition, over 50 percent said that they would delay beginning a new project in order to meet an earnings target, even if it resulted in a small sacrifice in value. This suggests that managers take actions to increase earnings in the current period, potentially at the expense of the long-run value of the firm.4,5

Early archival studies confirming firms’ use of real earnings management primarily focused on investment activities, documenting that variations in firms’ R&D expenditures and asset sales are associated with meeting and/or beating various earnings benchmarks. Specifically,

Dechow and Sloan (1991) find executives spend less on R&D near the end of their tenure in order to increase short-term earnings, while Baber, Fairfield, and Haggard (1991) show firms reduce their spending on R&D expenditures in order to report positive or increasing income for the current period. In addition, Bartov (1993) demonstrates that firms with negative earnings changes report higher profits from the sale of long-lived assets and investments. Finally, it has been documented that institutional investors (Bushee 1998) and compensation committees

(Cheng 2004) mitigate firms’ willingness to reduce R&D expenditures in order to meet earnings targets.

4 Real earnings management activities can reduce the long-run value of a firm through their negative impact on future cash flows. For example, over-producing inventory will increase income for the current period by reducing the reported amount of cost of goods sold (by spreading fixed overhead costs over a greater number of units), but it will also lead to higher holding costs for the unsold units of inventory in future periods. 5 Prior research focuses on income-increasing real earnings management. Given the response to survey questions, it is also possible for managers to increase discretionary spending or reduce inventory production in order to decrease reported earnings. 8

More recent archival studies have expanded their scope and found evidence of real earnings management within firms’ various operational activities. For instance, Roychowdhury

(2006) finds firms offer price discounts to increase sales, reduce discretionary expenditures in

R&D, advertising, and SG&A to improve reported margins, and overproduce inventory to decrease cost of goods sold in order to manage earnings upward. Gunny (2010) confirms that firms reduce discretionary expenditures and manipulate sales in order to meet earnings benchmarks and shows that these firms have better future performance than those that do not participate in real earnings management and miss the earnings benchmark. Hence, evidence exists for firms’ use of real earnings management through a variety of operational activities.

The prevalence of real earnings management has been validated by comparing its use to another method of earnings management that has been widely studied in the prior literature, accruals-based earnings management.6 Specifically, Cohen et al. (2008) demonstrate that firms’ participation in real earnings management has increased, while their use of accruals-based earnings management has decreased, since the passage of SOX.7 In addition, Zang (2012) finds managers make a trade-off between the two earnings management methods based on their relative costs, while Baderstcher (2011) shows that firms’ choice between the two methods depends on the duration of overvaluation. The survey participants of Graham et al. (2005) also indicated that they prefer to manage earnings by taking real, as opposed to accounting, actions.

Thus, there is wide support for firms’ use of real earnings management as a tool to manage earnings.

2.2 Earnings Management around Corporate Finance Events

6 See Schipper (1989); Healy and Wahlen (1999); and Fields, Lyz, and Vincent (2001) for reviews of the accruals- based earnings management literature. 7 The authors propose that firms transitioned from using accruals-based earnings management to real earnings management because the later method is more difficult for auditors and regulators to detect. 9

The finance and accounting literatures contain extensive evidence of firms managing earnings upward around stock issuances.8 Both Teoh, Wong, and Rao (1998) and Teoh, Welch, and Wong (1998a) demonstrate that firms manage earnings through the use of income-increasing discretionary accruals prior to initial public offerings. Additionally, it has been found that firms use income-increasing discretionary accruals (Rangan 1998; Teoh, Welch, and Wong 1998b;

Shivakumar 2000) and real earnings management (Cohen and Zarowin 2010) to raise their stock price around seasoned equity offerings. With the exception of Shivakumar (2000) 9, the reasoning behind the earnings management decision is that if investors are unaware that a firm’s reported income number has been managed upward prior to the issuance, then they will overvalue its shares. This, in turn, will increase the firm’s proceeds from the stock issue.

In addition to the evidence indicating that managers use upward earnings management surrounding equity issuances, Gong et al. (2008) find that they use income-decreasing discretionary accruals around stock repurchases 10 . In this situation, managers’ objective is to reduce their firm’s stock price prior to a repurchase. Similarly to the scenario above, if investors are not aware that a firm has managed its reported earnings downward, then they will undervalue its shares, resulting in a lower repurchase price. Gong et al. (2008) reason that repurchasing stock at a lower price creates a transfer of wealth from the shareholders that are selling their shares to those that continue to hold stock in the firm. Managers benefit from this transfer as well, since their interests are more aligned with the remaining shareholders through their future

8 Managers have also been shown to use income-increasing discretionary accruals preceding stock-for-stock mergers (Erickson and Wang 1999; Louis 2004).

9 The author proposes that managing earnings before a seasoned equity offering is an issuer’s rational response because the market assumes this behavior once the offering has been announced and discounts the firms’ stock prices accordingly. 10 Managers also use income-decreasing discretionary accruals prior to announcing their intention of a management buyout (Perry and William 1994). The authors propose that shareholders may be willing to accept a lower buyout price if the firm appears to be less profitable. 10 compensation and equity interests in the firm. Therefore, the incentive exists for managers to take actions to reduce their firm’s stock price prior to making a repurchase.

The prior literature has illustrated that investors are unable to completely correct for the effects of earnings management on stock prices because they cannot directly observe managers’ actions and are uncertain about managers’ incentives (Louis 2004; Gong et al. 2008). In the case of stock repurchases, some managers use this action as a means of signaling favorable, private information to the market. If signaling is the intention behind a repurchasing decision, then it is less likely that managers will manage earnings downward prior to the repurchase. However, managers’ intentions are unobservable, which will cause investors to be uncertain as to whether a repurchase is being used as a signaling device or for a non-signaling purpose. Accordingly, they will be unable to fully adjust stock prices for the earnings management effect.

3. Hypothesis Development

3.1 Real Earnings Management and Stock Repurchases

As discussed in Section 2, managers repurchasing shares for a non-signaling purpose have an incentive to reduce their firm’s stock price prior to making the repurchase: the lower the value of the stock immediately preceding the repurchase, the less amount of cash that must be paid to repurchase their shares. One approach that firms can take to lower their stock price prior to a repurchase is to take actions to manage earnings downward. Since investors cannot observe management’s intent for the repurchase decision, they will be unable to fully correct the stock price for the earnings management effect, causing them to undervalue the firm’s stock. In support of this claim, Gong et al. (2008) show that firms use income-decreasing discretionary accruals around stock repurchases. However, another tool at their disposal is real earnings

11 management, which the prior literature has shown is a substitute to accruals-based earnings management, and in at least some cases, is managers’ preferred method of managing earnings

(Graham et al. 2005; Cohen et al. 2008; Baderstcher 2011; Zang 2012).

This study hypothesizes that firms use two specific methods of income-decreasing real earnings management before repurchasing their shares for a non-signaling purpose: under- producing inventory and increasing discretionary expenditures.11 Under the first method, firms choose to produce fewer inventories than is necessary to meet expected demand. The lower level of production results in fixed overhead costs being divided over a smaller number of units, increasing fixed costs per unit, and correspondingly, increasing the total cost per unit.12 This, in turn, increases the cost of goods sold, and results in a lower reported earnings number. If investors are unaware that a firm’s earnings appear low as a result of downward real earnings management, then they will reduce their value of its stock.13 Accordingly, if a firm aspires to depress its stock price prior to a repurchase, then we predict that it will under-produce its inventory. This is formally stated in the following hypothesis:

H1a : On average, firms under-produce their inventory in the period prior to a stock repurchase.

The second method of real earnings management that managers can use to lower their reported earnings number is increased discretionary spending on R&D, advertising, and SG&A.

These types of expenditures are generally expensed during the period in which they are incurred.

Therefore, increasing discretionary spending on these items will increase expenses for the current period, and consequently, decrease reported earnings. If investors are similarly unaware

11 Extensive support exists for the use of both of these methods of real earnings management by firms. Refer to the previous section for examples of studies that have found collaborating evidence. 12 This assumes that the increase in fixed cost per unit is not offset by a decrease in the marginal cost per unit. 13 Consistent with the results of the prior research discussed in footnote two, we assume that investors do not see through real earnings management prior to a stock repurchase. 12 of a firm’s use of this method of downward real earnings management, then they will likewise lower the value of its stock. Therefore, we predict that a firm will increase its discretionary expenditures if it aspires to reduce its stock price prior to a repurchase. This is formally stated in the following hypothesis:

H1b: On average, firms increase their discretionary expenditures in the period prior to a stock repurchase.

Real earnings management occurs when managers make departures from the optimal level of operating activities. However, they may want to avoid the use of income-decreasing real earnings management for several reasons. First, managers are pressured to report positive earnings, show positive changes in earnings, and meet analyst forecasts. Accordingly, they may be unwilling to take actions that retract from meeting these earnings benchmarks. Managers may also be hesitant because of the potential decline in long-run firm value resulting from the cash flow effects of real earnings management. Additionally, a loss of reputation in the job market may develop for managers that are known to manage earnings (Desai, Hogan, and Wilkins 2006).

Therefore, it may be possible that we find no association between real earnings management and subsequent stock repurchases. We expect, however, that the benefits of engaging in income- decreasing real earnings management around non-signaling stock repurchases will exceed these potential costs.

3.2 Cross-Sectional Variation in Real Earnings Management Hypotheses

In addition to determining whether firms, on average, increase their use of income- decreasing real earnings management prior to non-signaling stock repurchases, this study examines whether the association varies cross-sectionally. The first subset of firms that we consider includes those that are in strong financial health. Zang (2012) demonstrates that firms

13 with stronger financial health can participate in real earnings management at a lower cost compared to firms in weaker financial health. If a firm is financially strong, then it will have more resources to rely on and greater opportunities to participate in real earnings management activities. For instance, a financially healthy firm will have more resources available to allocate to increased discretionary expenditures, compared to other firms. In addition, financially stable firms are better able to absorb the financial hit of producing fewer inventories than are needed to meet expected demand than firms that are less financially stable. Accordingly, we predict that firms in strong financial health participate in more income-decreasing real earnings management in the period prior to a stock repurchase than the average firm. This is formally stated in the following hypotheses:

H2a : Firms in strong financial health under-produce their inventory in the period prior to a stock repurchase to a greater extent than the average firm.

H2b : Firms in strong financial health increase their discretionary expenditures in the period prior to a stock repurchase to a greater extent than the average firm.

The argument that is outlined above for why managers engage in income-decreasing real earnings management prior to stock repurchases assumes that the repurchase decision was made for non-signaling purposes 14 . If managers’ decision to repurchase shares is primarily driven by a desire to signal favorable, new information about the future value of the firm, then the price at which they buy back their shares may not be a principle concern. As such, we examine two sets of firms that are more likely to take their shares’ price into account when making a repurchase

14 Gong et al. (2008) compiles an extensive list of non-signaling reasons that managers conduct stock repurchases, including: the distribution of excess cash to shareholders (Brennan and Thakar 1990); the reduction of agency costs (Denis and Denis 1993; Grullon and Michaely 2004); the maximization of the value of employee stock options (Jolls 1998); the financing of employee stock option plans (Kahle 2000); a change toward a firm’s optimal financial leverage (Dittmar 2000); and the expropriation of creditors (Maxwell and Stephens 2003). 14 decision: firms with a significant amount of outstanding stock options and those with overvalued equity.

Accordingly, the third set of hypotheses examines the cross-sectional differences based on the amount of stock options outstanding. Kahle (2002) finds that the existence of stock options leads firms to make repurchases in order to have shares available to fund employee stock option plans. By combining stock repurchases with stock option exercises, firms are able to avoid diluting their basic earnings per share (EPS). Since the main purpose for the repurchase is to fund employee stock option plans, we expect that they will want to accomplish this as cheaply as possible. Therefore, we predict that firms with greater stock option intensity will be more motivated to depress their stock price prior to making a stock repurchase, and accordingly, will participate in more downward real earnings management. This discussion is formalized in the following hypotheses.

H3a: Firms with greater stock options outstanding under-produce their inventory prior to a stock repurchase to a greater extent than the average firm.

H3b : Firms with greater stock options outstanding increase their discretionary expenditures in the period prior to a stock repurchase to a greater extent than the average firm.

The final subset of firms consists of those that are overvalued. Jensen (2005) defines equity as being overvalued when “a firm’s stock price is higher than its underlying value (5).”

We predict that a firm with overvalued equity will be more likely to manage earnings downward prior to making a stock repurchase than an undervalued firm 15 . First, prior studies (Ikenberry et

15 The prior literature examining the earnings management behavior of overvalued firms has generally found that they engage in income-increasing earnings management (Efendi, Srivastava, and Swanson 2007; Chi and Gupta 2009; Badertscher 2011):. This is consistent with Jensen’s (2005) agency cost theory of overvalued equity, that firms manage earnings in an effort to sustain their overvaluation. We expect, however, that managers’ incentive to 15 al. 1995; Kahle 2002) find evidence consistent with undervalued firms making repurchases for signaling purposes. In addition, a firm with undervalued equity has little incentive to use real earnings management to lower its stock price prior to making a stock repurchase because it is already at a low level. In contrast, a firm with overvalued equity 16 has a high stock price, relative to its underlying value, and therefore, can achieve a larger reduction in the repurchase price by participating in income-decreasing real earnings management activities prior to making a stock repurchase. This is formally restated in the following hypotheses.

H4a: Firms that are overvalued based on the price-to-value ratio under-produce their inventory prior to a stock repurchase to a greater extent than the average firm.

H4b: Firms that are overvalued based on the price-to-value ratio increase their discretionary expenditures in the period prior to a stock repurchase to a greater extent than the average firm.

4. Research Design

4.1 Real Earnings Management

Real earnings management is measured similarly to Roychowdhury (2006), Cohen and

Zarowin (2010), and Zang (2012). Specifically, we examine two methods of real earnings management.17 The first method is reporting lower cost of goods sold through increased production. A firm can over-produce its inventory, which will result in a lower cost of goods sold,

lower the repurchase price of their shares will outweigh their motive to continue the upward trend in their stock price. 16 The determination of whether a firm is overvalued is based on its price-to-value ratio, which is estimated using the EBO residual income model of Edwards and Bell (1961) and Ohlson (1995). This is further discussed in the next section. 17 Consistent with Zang (2012), we do not examine abnormal cash flows from operations, because, as discussed in Roychowdhury (2006), real earnings management impacts this in different directions and the net effect is ambiguous. For example, price discounts, channel stuffing, and over-production all decrease cash flows from operations, while cutting discretionary expenditures increases them. 16 and thus, increase current period income. The second method is to decrease discretionary expenses, including R&D, advertising, and SG&A expenses. If managers choose to decrease these expenditures, then they will consequently increase current period earnings. Given that the purpose of the study is to examine firms’ income-decreasing , rather than income-increasing , activities, the intuition will run opposite of the prior literature. That is, we expect firms to decrease production and increase discretionary expenses, both of which are income-decreasing activities. Following Roychowdhury (2006), we use equations (1) and (2) to estimate normal levels of production and discretionary expenses.

∆ ∆ , = + + + + (1) , , , , ,

, = + + (2) , , ,

where Assets are total assets, and Sales are annual sales revenues. PROD are production costs, defined as the sum of costs of goods sold and the change in inventory during the year. Abnormal production costs ( REM_PRODUCTION ) are estimated as the deviations from the predicted values from equation (1). The higher (lower) the residual, the larger (smaller) the amount of inventory over-production, and the greater (smaller) the increase in reported earnings. DISX are discretionary expenses during the year, defined as the sum of R&D, advertising, and SG&A expenses. Abnormal discretionary expenses (REM_DISC_SPEND ) are estimated as the deviations from the predicted values from equation (2). The residuals from equation (2) are multiplied by negative one, so that the greater (smaller) the residual, the more income-increasing

(decreasing) real earnings management occurs through discretionary expenditures. Both estimation equations (equations (1) and (2)) are estimated by industry-year combinations for all industry-year combinations with at least eight observations (Cohen and Zarowin 2010), which

17 allows the estimated coefficients to vary over time and across industries, reflecting the changes in macroeconomic conditions. We define industries by the two-digit SIC code.

4.2 Real Earnings Management and Stock Repurchases

The purpose of the study is to determine whether or not managers of firms participate in income-decreasing real earnings management before an upcoming share repurchase. As such, we model real earnings management as a function of share repurchases in the subsequent period along with control variables identified in the prior literature (Zang 2012).

Yit = α0 + α1 Repurchase t+1 + α2 Disc_Accruals t + α3 Market_Share t-1 + α4 Zscore t-1 + α5 AnaCov t-1 + α6 MTR t + α7 Big4 t + α8 SOX t + α9 NOA t-1 + α10 Cycle t-1 + α11 ROA t + α12 Assets t + α13 MTB t + α14 Earn t + α15 IMR t + Year Fixed Effects + εt (3)

where variables are defined as follows:

Y = takes one of the real earnings management values estimated from equations (1)

and (2), REM_PRODUCTION or REM_DISC_SPEND .

Repurchase = takes the value of one if the increase in treasury stock scaled by the prior year

market value of equity is positive, and set to zero otherwise. If treasury stock is

zero in both years of the balance sheet, we assume the retirement method is

used and measure from the statement of cash flows: stock purchases, minus

stock issuances, scaled by the prior year market value of equity. For the

purposes of our study, we are interested in net stock repurchases. Therefore,

we follow Skinner (2008) to measure net repurchases.

Disc_Accruals = the absolute value of discretionary accruals. 18

Market_Share = is the percentage of the company’s sales to the total sales of its industry at the

18 Discretionary accruals are measured as the residuals from the following Jones (1991) model (estimated by year and industry):

Total_Accruals = ρ1(1/Assets) + ρ2(ΔSales/Assets) + ρ3(PPE/Assets) + ε

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beginning of year t, where industry is defined based on three-digit SIC codes,

consistent with Zang (2012).

Zscore = following Altman (1968, 2000), is equal to 0.3(NI t/Asset t) + 1.0(Sales t/Asset t)

+ 1.4(Retained Earningst/Asset t) + 1.2(Working Capital t/Asset t) + 0.6([Stock

Price x Shares Outstanding t]/Total Liabilities t).

AnaCov = the log of the number of analysts covering firm i.

MTR = the marginal tax rate developed and provided by Professor John Graham 19 .

Big4 = set equal to one if the firm is audited by one of the Big N auditors, and set

equal to zero otherwise.

SOX = set equal to one if the year is after 2002 and set equal to zero otherwise.

NOA = an indicator variable that equals one if the net operating assets (i.e.,

shareholders’ equity, less cash and marketable securities, plus total debt) at

the beginning of the year divided by lagged sales is above the median of the

corresponding industry-year, and zero otherwise.

Cycle = the days receivable plus the days inventory less the days payable at the

beginning of the year

ROA = the firm’s return on assets

Assets = the industry-adjusted log value of total assets

MTB = the firm’s market-to-book ratio

Earn = the earnings before extraordinary items, minus discretionary accruals and

production costs, plus discretionary expenditures.

IMR = the inverse Mills ratio calculated from the Heckman (1979) first stage probit

model, in order to control for potential sample selection bias, as discussed

19 See Graham 1996a, 1996b, Graham and Mills (2008), and http://faculty.fuqua.duke.edu/~ jgraham/. 19

below.

We estimate equation (3) by including year fixed effects and clustering standard errors at the firm-level in order to control for heteroscedasticity and auto correlation of the error terms

(Peterson 2009; Gow et al. 2010). A negative and significant α1 is consistent with our first set of hypotheses (H1a and H1b), that firms reduce income-increasing real earnings management in anticipation of a stock repurchase in the subsequent year.

4.3 Correction for Potential Sample Bias

Consistent with Zang (2012) and Cohen and Zarowin (2010), we control for potential sample selection bias, given that firm-years with earnings at or just above various benchmarks were likely managed in order to meet these important targets. Accordingly, we define earnings management suspects as firm-years with earnings just meeting or beating the prior year’s earnings, zero earnings, and analyst consensus forecast. To address the fact that using a non- random sample can create a potential omitted-variable problem, we conduct the Heckman (1979) two-stage procedure to correct for the potential sample selection bias. In the first stage, we estimate a selection model using all the sample firms and obtain the inverse Mills ratio. In the second stage, we include the inverse Mills ratio in equation (3) to control for the potential sample selection bias. The following probit model is used in the first-stage estimation procedure:

Prob[ Suspect t = 1] = Probit( δ0 + δ1 HabBeat t + δ2 SharesIssued t+1 + δ3 AnalystFollowing t + δ4 MTB t-1 + δ5 LogShares t + δ6 ROA t + Year Fixed Effects + εt) (4)

where variables are defined as follows:

Suspect = set equal to one if a firm just meets/beats one of the earnings benchmarks

discussed above, and zero otherwise.

HabBeat = the number of times the firm has met/beaten the analysts’ consensus

20

forecast in the past four quarters.

SharesIssued = set equal to one if the firm issues equity in the next year, and zero otherwise.

AnalystFollowing = the log of the number of analysts following the firm.

MTB = the firm’s market-to-book ratio

LogShares = the log of the number of shares outstanding

ROA = net income divided by average total assets

4.4 Cross-Sectional Variation in Real Earnings Management

After examining the average effect of real earnings management changes in the year prior to a net stock repurchase, we examine whether the association varies cross-sectionally.

Specifically, we examine whether firms that are in strong financial health, have significant stock options outstanding, and are over-valued engage in more income-decreasing earnings management. To test these cross-sectional hypotheses, we modify equation (3) as follows:

Yit = α 0 + α1 Repurchase t+1 + α 2 XSEC t*Repurchase t+1 + α 3 XSEC t + α 4 Disc_Accruals t + α 5 Market_Share t-1 + α 6 Zscore t-1 + α 7 AnaCov t-1 + α 8 MTR t + α 9 Big4 t + α 10 SOX t + α 11 NOA t-1 + α 12 Cycle t-1 + α 13 ROA t + α 14 Assets t + α 15 MTB t + α 16 Earn t + α 17 IMR t + Year Fixed Effects + εt (5)

where all variables are defined the same as above except for XSEC .

When testing the financial health hypotheses (H2a and H2b), XSEC takes the value of one when the firm’s z-score is above the industry-year median, and zero otherwise

(ZSCORE_HIGH ). As was previously discussed, we expect firms in greater financial health to have more resources to rely on and more opportunities to decrease production and increase discretionary spending (income-decreasing activities). As such, we predict that the increase in downward real earnings management activities prior to a repurchase will be concentrated in the

21 subset of firms in strong financial health. Accordingly, we expect α 2 to be significantly less than zero.

The third set of hypotheses examines the strength of the relation between real earnings management and repurchases for firms with differing amounts of stock options outstanding (H3a and H3b). We measure stock options outstanding as the ratio of options outstanding to total shares outstanding. When the firm has an options-to-shares outstanding ratio above the industry- year median, the variable XSEC takes a value of one and is set equal to zero otherwise

(OPT_INTENSITY) . Firms with stock options outstanding are motivated to make a repurchase in order to have shares available to fund their employee stock option programs without diluting their basic EPS. We expect that these firms will want to accomplish this task as cheaply as possible, suggesting that they have a greater motivation to reduce the cost of the stock repurchase.

Compared to the average firm, we predict that the relation between real earnings management and stock repurchases will be more negative for the firms with greater stock options outstanding, implying that α 2 will be significantly less than zero.

When testing the valuation hypotheses (H4a and H4b), XSEC takes the value of one when the firm’s price-to-value ratio is greater than the year-median and zero otherwise

(OVERVALUED ). Following Frankel and Lee (1998), the price-to-value ratio is estimated using the EBO residual income model of Edwards and Bell (1961) and Ohlson (1995). Specifically, equation (6) is used to estimate a firm’s fundamental value:

(FROE t-re) (FROE t+1 -re) (FROE t+2 -re) Vt = Bt + Bt + 2 Bt+1 + 2 Bt2 (6) (1+ re) (1+ re) (1+ re) re where B is book value and FROE is the future return on equity derived from I/B/E/S consensus earnings-per-share estimates. The cost of capital, re, is based on discount rates derived from the

Fama and French (1993) three-factor risk model. When a firm is overvalued, the price of the 22 security is greater than the fundamental value. Accordingly, a firm that wants to repurchase its shares for a non-signaling purpose can achieve a larger reduction in the repurchase price by participating in real earnings management if it is overvalued. Compared to the average firm, we expect firms with greater price-to-value ratios will participate in more income-decreasing real earnings management prior to a stock repurchase, suggesting that α 2 will be significantly less than zero. We estimate equation (5) six times. Specifically, we estimate equation (5) for each type of real earnings management activity ( REM_PRODUCTION and REM_DISC_SPEND ), and for each cross-sectional test (financial health, stock options outstanding, and valuation).

5. Results

5.1 Sample Selection

The sample is formed from both Compustat and I/B/E/S and ranges over the period 1988-

2009. The sample starts in 1988 because we use cash flow from operations reported on the cash flow statements (with one lag), which first became available in 1987. Additionally, the sample ends in 2009 because we require two years of lead variables for the real earnings management variables estimated in equations (1) and (2). We restrict our sample to firms with the necessary financial data from Compustat and non-zero analyst coverage from I/B/E/S and require there to be at least eight observations for each industry-year combination. We also restrict our sample to firms that do not regularly repurchase their stock. For example, if a firm regularly repurchases stock, similarly to making regular dividend payments, then it would not be able to continually depress its stock price by participating in income-decreasing real earnings management. This would eventually lead to a degradation of firm profits. Therefore, we exclude firms that repurchase stock in two consecutive years. This isolates the year before a one-time stock

23 repurchase. 20 We include all firms in our sample, whether or not they participate in repurchases.

In untabulated results, we delete those firms that do not participate in stock repurchases during our sample period and obtain qualitatively similar results to those reported in the tables.

Table 1 reports the descriptive statistics for our stock repurchases sample. Panel A provides summary information on all variables used in the regressions as well as additional descriptive measures. The sample is large ( MarketValue µ=2,928), generates a sizable amount of sales ( Sales µ=2,876), and is followed by an average of nine analysts ( AnaCov µ=9.239). The means of our variables of interest, REM_PRODUCTION and REM_DISC_SPEND are -0.0244 and 0.0420, respectively. This suggests that the average firm under-produces its inventory and over-spends on its discretionary expenditures. In addition, twenty-five percent of the sample participates in a one-time stock repurchase (Repurchase µ=0.2476). Panel B shows the distribution of the sample over time. The sample is evenly spread out, with none of the years being over-represented. 21 Finally, panel C reports the frequency of the sample by industry. We follow Cohen and Zarowin’s (2010) industry classification based on the two-digit SIC code.

Major industries include chemical products, computer equipment, electronic equipment, and electric, gas, and sanitary systems.

Table 2 presents the correlation matrix, which includes the correlations for all variables used to estimate equation (3). The variable of interest, Repurchase , is significantly and negatively related to our measure of real earnings management via over-production

(REM_PRODUCTION) , which indicates that the lagged values of real earnings management for over-production estimates are negatively correlated with future repurchases. The correlation

20 Firms that repurchase stock every other year are included in the sample. 21 We also estimate our regressions by eliminating the year 1988 given the small sample size. The results are qualitatively similar to the results reported in the paper. We also include year fixed effects as independent variables in all of our regressions. 24 between the second measure of real earnings management, REM_DISC_SPEND , and

Repurchase is negative, but not significant. Overall, the set of univariate analysis that we performed confirms our first set of hypotheses and suggests that managers reduce their level of income-increasing real earnings management in the three periods before a stock repurchase.22

Given that univariate evidence does not control for contemporaneous factors on the relation between repurchases and real earnings management, we next examine the multivariate regressions.

5.2 Testing the Association between Real Earnings Management and Subsequent Repurchases

Table 3 presents the estimated coefficients from equation (3) used to test our first set of hypotheses. Panel A and B present results where the dependent variable is REM_PRODUCTION and REM_DISC_SPEND, respectively. The coefficient of interest, α1, is the coefficient on the variable Repurchase in both panels. This coefficient is negative and significant for the regressions using REM_PRODUCTION (α1= -0.0220, t-statistic : -5.48) and REM_DISC_SPEND

(α1= -0.0103, t-statistic : -2.29). Consistent with H1a and H1b, the results suggest that managers reduce their income-increasing real earnings management in the period directly preceding stock repurchases. Specifically, managers decrease the firm’s over-production and increase discretionary spending in the period prior to a stock repurchase.

5.3 Cross-Sectional Tests Based on Financial Health, Stock Options Outstanding, and Valuation

Table 4 presents the estimated coefficients from equation (5) used to test our financial health hypotheses (H2a and H2b). Panel A and B present results where the dependent variable is

REM_PRODUCTION and REM_DISC_SPEND , respectively. The coefficient of interest, α2, is negative and significant in both Panel A ( α2= -0.0324, t-statistic = -4.23) and Panel B ( α2= -

22 We also examine the correlation table for instances of multicollinearity and conclude that it is not an issue. In additional analyses, we examine the variance inflation factors (VIFs) for the regressions, None of the VIFs are greater than 5.0. 25

0.0204, t-statistic = -2.31). In addition, the main effect ( α1) in both regressions is not significantly different from zero. These results suggest that the negative relation between real earnings management and repurchases is concentrated in the set of firms that are in stronger financial health. This is expected given that it is costlier to increase discretionary spending and reduce production below expected demand when a firm is nearer to bankruptcy. Therefore, only those firms that are in a strong financial position are willing to take these suboptimal actions. These results are consistent with our hypotheses, and we interpret them as indicating that firms in strong financial health can afford to produce less inventory and spend more on discretionary expenditures in order to decrease earnings in the period before a stock repurchase.

Table 5 presents the estimated coefficients from equation (5) used to test H3a and H3b.

Panel A and panel B present the estimated coefficients for REM_PRODUCTION and

REM_DISC_SPEND , respectively. The coefficient of interest is α2, which is the coefficient associated with the interaction between OPT_INTENSITY and REPURCHASE . This coefficient estimate represents the incremental impact of the negative relation between real earnings management and repurchases for firms that have an above-average amount of stock options outstanding. In both instances of real earnings management, we find that firms tend to reduce income-increasing real earnings management when they have greater stock options outstanding.

Specifically, in Panel A, the coefficient is negative and significant ( α2 = -0.0363, t-statistic =-

3.25), suggesting that firms with a greater amount of stock options reduce their income- increasing real earnings management more, compared to the average firm. We also note that the main effect, REPURCHASE , remains negative and significant ( α1 = -0.0146, t-statistic =-2.47).

In Table 6, Panel B, we find consistent evidence with H4b. Specifically, as firms’ stock option intensity increases, so does management’s motivation to reduce income-increasing

26 discretionary spending real earnings management. The coefficient associated with the interaction between REPURCHASE and OPT_INTENSITY is negative and significant ( α2 = -0.0330, t- statistic =-2.28). Contrary to the relation between production real earnings management and repurchases, the main effect in panel B is not significant ( α1 = -0.0034, t-statistic = -0.52), suggesting that the negative relation between repurchases and discretionary spending real earnings management only exists in the subset of firms that have a high amount of stock options outstanding.

Finally, Table 6 presents the estimated coefficients from equation (5) used to test our valuation hypotheses (H4a and H4b). We hypothesize that the negative relation between real earnings management and repurchases will be stronger for firms that are overvalued. Similarly to previous tables, the dependent variable is REM_PRODUCTION and REM_DISC_SPEND in

Panel A and Panel B, respectively. The coefficient of interest is α2, which is associated with the interaction between Repurchase and OverValued . In both panels, α2 is negative as expected, but only significant at the 10 percent level. In panel A and panel B, the coefficient is -0.0123 ( t- statistic = -1.56) and -0.0136 ( t-statistic = -1.47), respectively. These results suggest that the valuation of a firm is considered when deciding how much to reduce income-increasing real earnings management in the period prior to a stock repurchase. However, valuation may not be as strong of a factor as the financial health of a company or the degree of stock options outstanding when deciding to reduce income-increasing real earnings management in the period prior to a stock repurchase. Managers of overvalued firms may be hesitant to use more income- decreasing real earnings management because it works against their goal of sustaining overvaluation. Additionally, the main effect of the relation between real earnings management

27 and repurchases remains significant and negative. We interpret this evidence as weak support for

H4a and H4b.

In summary, we find that, on average, firms reduce income-increasing real earnings management in the period prior to making a net stock repurchase. Specifically, we find that firms over-produce their inventory to a lesser extent and have more discretionary spending in the period prior to stock repurchases. We also show that the income-decreasing real earnings management activities are concentrated in the subset of firms that are in strong financial health.

Further evidence is provided by examining sets of firms that likely make repurchases for non- signally reasons. Specifically, the negative relation between real earnings management and repurchases increases for firms with greater stock options outstanding. Finally, the evidence suggests that when firms are overvalued, they participate in income-decreasing real earnings management to a greater extent. We conclude that managers of firms that engage in stock repurchases for non-signaling purposes have incentives to depress their stock price prior to making the repurchase.

5.4 Additional Analysis

5.4.1 Future Returns Analysis

To further confirm our findings that managers reduce income-increasing real earnings management in the period prior to a stock repurchase, we examine post-repurchase stock returns.

Gong et al. (2008) find that post-repurchase stock returns are greater for those firms that reduce income-increasing accruals management prior to an open-market repurchase. Similarly to their argument, we expect firms that participate in the most income-decreasing real earnings management prior to a stock repurchase to have the greatest stock returns following the open- market repurchase. Given that the pre-repurchase earnings figure will be deflated as a result of

28 the change in real earnings management, earnings growth following the stock repurchase should be greater than the market expects. This is also consistent with Louis (2004), who argues that post-event abnormal returns will be associated with pre-event earnings management when investors are unable to observe managers’ actions.

We measure abnormal returns using the Fama and French (1993) three factor risk model.

Specifically, we form monthly portfolios of firms that participated in a repurchase during the prior year and calculate the average excess returns of the monthly portfolio over the risk-free rate.

We then estimate a regression of the monthly portfolio average excess return on the time series of the market excess return, the small-minus-big factor, and the high-minus-low book-to-market factor. The estimated intercept represents the average abnormal return. We then form quintiles of firms based on the levels of REM_PRODUCTION and REM_DISX_SPEND in the year prior to the repurchase and compare the abnormal returns for these portfolios.

Table 7 reports the post-stock repurchase abnormal returns for the portfolios based on the level of real earnings management. In Panel A, the portfolios are based on

REM_PRODUCTION where quintile one (five) represents those firms with the smallest (largest) reduction in income-increasing real earnings management. The difference between the first

(0.2075 percent) and fifth (0.4712 percent) quintiles is 0.2637 percent and is significant at the one percent level. This suggests that firms that reduce their income-increasing real earnings management in the period prior to a stock repurchase have greater abnormal returns in the period subsequent to the stock repurchase. 23 Panel B reports the abnormal returns based on quintile portfolios of REM_DISX_SPEND. Consistent with Panel A, quintile five (0.5163 percent) has the greatest abnormal returns, where as quintile one (0.2700 percent) has the lowest abnormal

23 We note that the abnormal return for quintile four is greater than the abnormal return for quintile five. In unreported analysis, this difference is not significant at conventional levels. 29 returns. The difference is 0.2463 percent and is significant at the one percent level. These results are consistent with our main findings and provide evidence that firms that use downward real earnings management prior to a stock repurchase experience positive abnormal stock returns in the period subsequent to the repurchase.

5.4.2 Quarterly Data

It is possible that the main findings are attributable to the use of annual data and that the results are driven by other factors that we did not control for. As such, we perform the same analysis based on quarterly data 24 . Table 8 presents the results from estimating our regressions on a quarterly basis. Each panel of Table 8 represents one of the four sets of hypotheses (i.e. on average, financial health, stock options, and valuation). For brevity, only the variables of interest are presented. Overall, the results are consistent with the main findings. Therefore, we only discuss the notable differences.

First, in column (4) of Panel B, the coefficient associated with the interaction between

OPT_INTENSE and REPURCHASE is not significantly different from zero. In contrast, we found using annual data that firms with a large amount of stock options outstanding increase their discretionary expenditures in order to deflate earnings in the period prior to a repurchase more than the average firm. The difference can be attributed to the time period over which discretionary expenditures and repurchases occur. It is probable that the decision to increase discretionary spending spans over a longer time period than a quarter and that the associated repurchases are drawn out over multiple quarters as well. This is consistent with Lie (2005), who shows that repurchases occur over multiple quarters following the announcement of the buyback.

24 All variables are the same, except that they are calculated using quarterly data. 30

The second notable difference occurs in Panel D, column (2), where we find marginal significance for the association between production real earnings management and repurchases for firms that are overvalued. This result is consistent with our expectation that compared to the average firm, overvalued firms have more incentive to reduce their stock price and, therefore, participate in more income-decreasing real earnings management prior to a stock repurchase.

With the exception of these differences, the results using quarterly data are largely consistent with those from the main analysis, adding confidence that our findings are not simply the product of our methodological choices.

6. Conclusion

In this study, we examine whether firms participate in income-decreasing real earnings management prior to making a stock repurchase for a non-signaling purpose. If investors are unaware that a firm’s reported income has been managed downward, then the stock price will drop, allowing the firm to repurchase its shares at a lower price. The results are consistent with this explanation. Specifically, we find that firms increase their spending on discretionary expenditures and under-produce their inventory prior to making a stock repurchase.

We additionally examine whether the relation between real earnings management and repurchases is influenced by the financial health of the firm and find that the use of downward real earnings management is concentrated in the subset of firms that are in strong financial health.

This suggests that only the set of firms that can afford to produce fewer inventories than are needed to meet expected demand and spend more on discretionary expenditures are able to take advantage of the opportunities to manage earnings downward prior to a stock repurchase. We also examine two sets of firms that are likely to make stock repurchases for non-signaling

31 reasons: firms with overvalued equity and significant stock options outstanding. We find that firms that are overvalued are more likely to participate in downward real earnings management, either by increasing their spending on discretionary expenditures or under-producing their inventory prior to a stock repurchase. Additionally, the negative relation between real earnings management and repurchases becomes more negative for those firms that have greater stock options outstanding.

Our findings highlight the importance of considering the occurrence of real earnings management, rather than focusing solely on accruals-based earnings management, around significant corporate events. Our results also emphasize the need to consider managers’ motives for making firm decisions, such as their motivation for making a stock repurchase. The results should be informative to investors as well as regulators because they demonstrate the significance of income-decreasing real earnings management activities around stock repurchases for non-signaling reasons. Although we identify three situations in which managers manage pre- repurchase earnings downward to a greater extent, namely for firms with strong financial health, those that are overvalued, and those with significant stock options outstanding, it would be beneficial for future research to examine other settings in which this effect may be concentrated.

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Table 1 - Descriptive Statistics Panel A: Summary Statistics Variable N Mean Std Q1 Median Q3 REM_PRODUCTION 14,089 -0.0244 0.2105 -0.1234 -0.0140 0.0718 REM_DISC_SPEND 14,089 0.0420 0.2433 -0.0476 0.0454 0.1630 DISC_ACCRUALS 14,089 0.0170 0.1205 -0.0257 0.0159 0.0654 MARKETVALUE 14,089 2,927.95 14,344.52 178.35 529.58 1,617.43 ASSETS 14,089 3,390.29 10,388.71 232.46 678.38 2,256.65 SALES 14,089 2,875.91 9,290.57 226.52 652.65 2,146.80 REPURCHASE 14,089 0.2476 0.4317 0.0000 0.0000 0.0000 ANACOV 14,089 9.2390 7.4035 4.0000 7.0000 13.0000 MARKET_SHARE 14,089 0.1262 0.2230 0.0047 0.0277 0.1274 ZSCORE 14,089 7.5232 361.5688 1.7356 2.8181 4.4953 MTR 14,089 0.2019 0.1555 0.0135 0.2844 0.3500 BIG4 14,089 0.9380 0.2412 1.0000 1.0000 1.0000 SOX 14,089 0.3865 0.4870 0.0000 0.0000 1.0000 NOA 14,089 0.5018 0.5000 0.0000 1.0000 1.0000 CYCLE 14,083 77.29 351.52 29.52 65.52 111.61 ROA 14,089 0.0177 0.1525 0.0063 0.0417 0.0774 MTB 14,089 3.1240 52.4030 1.3507 2.0083 3.2211 PRICE_VALUE 8,953 1.6778 8.4811 -0.4280 0.9032 2.9329 OPT_PCT 12,652 0.0225 0.0241 0.0066 0.0159 0.0310 EARN 14,089 -1,332.87 6,042.34 -862.22 -192.70 -14.37 (continued on next page)

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(continued from previous page) Panel B: Distribution by Year Panel C: Distribution by Industry Year Freq. % Industry SIC Code Freq % 1988 70 0.50% Oil and gas 13, 29 730 5.18% 1989 504 3.58% Food products 20 310 2.20% 1990 505 3.58% Paper and paperproducts 24-27 683 4.85% 1991 599 4.25% Chemical products 28 1,204 8.55% 1992 653 4.63% Manufacturing 30-34 865 6.14% 1993 686 4.87% Computer equipmentandservices 35, 73 2,291 16.26% 1994 590 4.19% Electronic equipment 36 1,353 9.60% 1995 587 4.17% Transportation 37, 39, 40-42, 44, 45 1,056 7.50% 1996 565 4.01% Scientific instruments 38 1,025 7.28% 1997 749 5.32% Communications 48 401 2.85% 1998 715 5.07% Electric, gas,and sanitaryservices 49 1,094 7.76% 1999 682 4.84% Durable goods 50 339 2.41% 2000 754 5.35% Retail 53, 54, 56, 57, 59 864 6.13% 2001 499 3.54% Eating and drinking establishments 58 225 1.60% 2002 486 3.45% Entertainment services 70, 78, 79 193 1.37% 2003 500 3.55% Health 80 185 1.31% 2004 895 6.35% Others 1,271 9.02% 2005 738 5.24% Total 14,089 2006 698 4.95% 2007 690 4.90% 2008 930 6.60% 2009 994 7.06% 14,089 Table 1 presents descriptive statistics on the sample. Panel A includes descriptive statistics on all variables used in regression analysis. Panel B includes the distribution by year. Panel C includes distribution by industry based on Cohen et al. (2010), two-digit SIC codes. Variables are defined as follows: REM_PRODUCTION are the residuals from equation (1) used to estimate normal production levels. REM_DISC_SPEND are residuals from equation (2) used to estimate normal levels of discretionary expenses. DISC_ACCRUALS are the discretionary accruals estimated as the residuals from the modified Jones (1991) model, MARKETVALUE is price times the number of shares outstanding, ASSETS is total assets, SALES is total sales, REPURCHASE is an indicator equal to one if the firm has net repurchases during the year and zero otherwise, ANACOV is the number of analysts covering the firm, MARKET_SHARE is is the percentage of the company’s sales to the total sales of its industry at the beginning of year t, where industry is defined based on three-digit SIC codes, ZSCORE is equal to 0.3(NI/Asset) + 1.0(Sales/Asset) + 1.4(Retained Earnings/Asset) + 1.2(Working Capital/Asset) + 0.6([Stock Price x Shares Outstanding]/Total Liabilities), MTR is the marginal tax rate developed and provided by Professor John Graham, BIG4 is set equal to one if the firm is audited by a Big N auditor and zero otherwise, SOX is set equal to one if the year is after 2002 and zero otherwise, NOA an indicator variable that equals 1 if the net operating assets (i.e., shareholders’ equity less cash and marketable securities and plus total debt) at the beginning of the year divided by lagged sales is above the median of the corresponding industry-year, and 0 otherwise, CYCLE is the days receivable plus the days inventory less the days payable at the beginning of the year, ROA is return on assets, PRICE_VALUE is the ratio of price-to-value where value is estimes using the Frankel and Lee (1998) methodology, OPT_PCT is the number of total options outstanding divided by total shares outstanding, MTB is the market-to-book ratio, EARN is the earnings before extraordinary items, minus discretionary accruals and production costs, plus discretionary expenditures.

38

Table 2 - Correlation M atrix REM_ PRODUCTION REM_ DISC_SPEND REPURCHASE DISC_ ACCRUALS MARKET_ SHARE ZSCORE ANACOV MTR BIG4 SOX NOA CYCLE ROA ASSETS_ REG MTB REM_ 0.5839 1 DIS C _S PEND <.0001 REPURC HAS E -0.0631 -0.0013 1 <.0001 0.8821 DIS C _ -0.0087 0.1522 -0.0016 1 AC C RUALS 0.3024 <.0001 0.8508 MARKET_ 0.0625 0.0270 0.0347 -0.0285 1 S H ARE <.0001 0.0013 <.0001 0.0007 ZS C O RE 0.0703 -0.0118 -0.0050 0.0125 -0.0069 1 <.0001 0.1612 0.5525 0.1375 0.4132 ANAC O V -0.0529 0.0069 0.0597 -0.0489 0.1497 -0.0135 1 <.0001 0.4135 <.0001 <.0001 <.0001 0.1092 MTR -0.0457 0.0252 0.0566 0.0217 0.1036 0.0043 0.0872 1 <.0001 0.0028 <.0001 0.0099 <.0001 0.6143 <.0001 B IG 4 0.0164 -0.0007 0.0065 -0.0242 0.0578 0.0015 0.1738 0.0257 1 0.0511 0.9374 0.4418 0.0041 <.0001 0.861 <.0001 0.0023 S O X -0.0017 0.1336 0.0062 0.0924 -0.1097 0.0114 -0.1639 -0.1703 -0.1391 1 0.8431 <.0001 0.4623 <.0001 <.0001 0.1759 <.0001 <.0001 <.0001 NO A -0.0436 0.0777 -0.0128 -0.0212 -0.0061 -0.0089 0.1414 -0.0377 0.0107 -0.0063 1 <.0001 <.0001 0.1286 0.0118 0.4661 0.2901 <.0001 <.0001 0.2039 0.4551 C YC LE 0.0024 0.0122 -0.0126 0.0164 -0.0046 -0.0016 -0.0102 -0.00 18 0.0083 0.0050 0.0263 1 0.7733 0.1486 0.1341 0.052 0.5869 0.8521 0.2268 0.8315 0.326 0.555 0.0018 RO A -0.1929 0.0698 0.1193 0.3191 0.0892 -0.0645 0.1152 0.2686 0.0176 -0.1111 -0.0720 -0.0761 1 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 0.0367 <.0001 <.0001 <.0001 AS S ETS _ 0.0542 0.1913 0.0729 0.0035 0.3285 -0.0179 0.6434 0.0870 0.2064 -0.0699 0.1801 -0.0042 0.1898 1 REG <.0001 <.0001 <.0001 0.6811 <.0001 0.0332 <.0001 <.0001 <.0001 <.0001 <.0001 0.6227 <.0001 MTB -0.0193 -0.0054 -0.0019 0.0068 -0.0013 0.0005 0.0117 -0.00 66 0.0101 0.0092 -0.0074 0.0001 0.0098 0.0030 1 0.0221 0.5192 0.8265 0.4167 0.8772 0.956 0.1663 0.436 0.229 0.2769 0.3782 0.9932 0.2455 0.7202 EARN -0.1459 -0.0747 -0.0154 0.0009 -0.1797 0.0029 -0.1712 0.00 77 -0.0465 -0.0516 0.0440 0.0161 -0.0082 -0.2632 0.0053 <.0001 <.0001 0.0685 0.9152 <.0001 0.7277 <.0001 0.3603 <.0001 <.0001 <.0001 0.0565 0.332 <.0001 0.5265 39 (continued on next page)

(continued from previous page) Table 2 presents the correlation matrix for variabl es used in the regression analysis. P-values are pr esented underneat the correlations in italics. Vari ables are defined as follows: REM_PRODUCTION are the residuals from equation (1) used to estimate normal production levels. REM_DISC _SPEND are residuals from equation (2) used to esti mate normal levels of discretionary expenses. DISC_ACCRUALS are the discr etionary accruals estimated as the residuals from t he modified Jones (1991) model, MARKETVALUE is pric e times the number of shares outstanding, ASSETS is total assets, SALES i s total sales, REPURCHASE is an indicator equal to one if the firm has net repurchases during the year and zero otherwise, ANACOV is the number of analysts covering the firm, MARKET_SH ARE is the percentage of the company’s sales to the total sales of its industry at the beginning of ye ar t, where industry is defined based on three-digit SIC codes, ZSCORE is equal to 0.3(NI/Asset) + 1.0(Sales/Asset) + 1.4(Retained Ear nings/Asset) + 1.2(Working Capital/Asset) + 0.6([St ock Price x Shares Outstanding]/Total Liabilities), MTR is the margina l tax rate developed and provided by Professor John Graham, BIG4 is set equal to one if the firm is au dited by a Big N auditor and zero otherwise, SOX is set equal to one if the year is a fter 2002 and zero otherwise, NOA an indicator vari able that equals 1 if the net operating assets (i.e ., shareholders’ equity less cash and marketable securities and plus total debt) at the b eginning of the year divided by lagged sales is abo ve the median of the corresponding industry-year, a nd 0 otherwise, CYCLE is the days receivable plus the days inventory less the days pa yable at the beginning of the year, ROA is return o n assets, PRICE_VALUE is the ratio of price-to-valu e where value is estimes using the Frankel and Lee (1998) methodology, OPT_PCT is the number of total options outstanding divided by tota l shares outstanding, MTB is the market-to-book rat io, EARN is the earnings before extraordinary items, minus discretionary acc ruals and production costs, plus discretionary expe nditures.

40

Table 3 - Multivariate Analysis Yit = α1 + α2 Repurchase t+1 + α2 Disc_Accruals t + α3 MarketShare t-1 + α4 Zscore t-1 + α5

Anacov t-1 + α6 MTR t + α7 Big4 + α8 SOX t + α9 NOA t-1 + α10 Cycle t-1 + α11 ROA t + α12

Assets_Reg t + α13 MTB t + α14 Earn t + α15 IMR t + εt Panel A: Dependent Variable= Panel B: Dependent Variable = REM_PRODUCTION REM_DISC_SPEND Variable Estimate Variable Estimate Intercept 0.0724 *** Intercept 0.1855 *** (3.52) (7.56) REPURCHASE -0.0220 *** REPURCHASE -0.0103 ** (-5.48) (-2.29) DISC_ACCRUALS 0.1188 *** DISC_ACCRUALS 0.2500 *** (3.31) (5.55) MARKET_SHARE 0.0139 MARKET_SHARE -0.0451 *** (0.81) (-2.55) ZSCORE 0.0000 *** ZSCORE 0.0000 *** (29.07) (-6.63) ANACOV -0.0496 *** ANACOV -0.0567 *** (-9.09) (-8.95) MTR 0.0041 MTR 0.0487 ** (0.22) (2.41) BIG4 0.0016 BIG4 -0.0207 (0.11) (-1.19) SOX 0.0037 SOX -0.0242 ** (0.38) (-2.13) NOA -0.0253 *** NOA 0.0249 *** (-4.15) (3.87) CYCLE 0.0000 ** CYCLE 0.0000 (-1.86) (0.78) ROA -0.3243 *** ROA 0.0057 (-11.59) (0.17) ASSETS_REG 0.0258 *** ASSETS_REG 0.0510 *** (7.48) (13.64) MTB -0.0001 MTB 0.0000 (-1.14) (-0.57) EARN 0.0000 *** EARN 0.0000 (-3.42) (-1.43) IMR 0.0044 ** IMR 0.0015 (1.88) (0.37)

Year Indicators Yes Yes Adj. R-Squared 0.0981 0.1075 N 14,089 14,089

(continued on next page)

(continued from previous page) Table 3 presents the coefficient estimates from equation (3). All multivariate regressions are estimated with year fixed effects. Standard errors are clustered at the firm-level. **, *** represent significance at the .05 and .01 p-value level, one-tailed tests. Variables are defined as follows: REM_PRODUCTION are the residuals from equation (1) used to estimate normal production levels. REM_DISC_SPEND are residuals from equation (2) used to estimate normal levels of discretionary expenses. DISC_ACCRUALS are the discretionary accruals estimated as the residuals from the modified Jones (1991) model, MARKETVALUE is price times the number of shares outstanding, ASSETS is total assets, SALES is total sales, REPURCHASE is an indicator equal to one if the firm has net repurchases during the year and zero otherwise, ANACOV is the number of analysts covering the firm, MARKET_SHARE is the percentage of the company’s sales to the total sales of its industry at the beginning of year t, where industry is defined based on three-digit SIC codes, ZSCORE is equal to 0.3(NI/Asset) + 1.0(Sales/Asset) + 1.4(Retained Earnings/Asset) + 1.2(Working Capital/Asset) + 0.6([Stock Price x Shares Outstanding]/Total Liabilities), MTR is the marginal tax rate developed and provided by Professor John Graham, BIG4 is set equal to one if the firm is audited by a Big N auditor and zero otherwise, SOX is set equal to one if the year is after 2002 and zero otherwise, NOA an indicator variable that equals 1 if the net operating assets (i.e., shareholders’ equity less cash and marketable securities and plus total debt) at the beginning of the year divided by lagged sales is above the median of the corresponding industry-year, and 0 otherwise, CYCLE is the days receivable plus the days inventory less the days payable at the beginning of the year, ROA is return on assets, PRICE_VALUE is the ratio of price-to-value where value is estimes using the Frankel and Lee (1998) methodology, OPT_PCT is the number of total options outstanding divided by total shares outstanding, MTB is the market-to- book ratio, EARN is the earnings before extraordinary items, minus discretionary accruals and production costs, plus discretionary expenditures.

42 Table 4 - Multivariate Analysis - Financial Health

Yit = α1 + α2 Repurchase t+1 + α2 ZSCORE_HIGH t*Repurchase t+1 + α3 ZSCORE t + α4 Disc_Accruals t + α5

MarketShare t-1 + α6 Zscore t-1 + α7 Anacov t-1 + α8 MTR t + α9 Big4 + α10 SOX t + α11 NOA t-1 + α12 Cycle t-1 +

α13 ROA t + α14 Assets_Reg t + α15 MTB t + α16 Earn t + α17 IMR t + εt Panel A: Dependent Variable= Panel B: Dependent Variable = REM_PRODUCTION REM_DISC_SPEND Variable Estimate Variable Estimate Intercept 0.0724 *** Intercept 0.1862 (3.54) (7.58) REPURCHASE -0.0056 REPURCHASE 0.0001 (-1.15) (0.02) ZSCORE_HIGH*REPURCHASE -0.0324 *** ZSCORE_HIGH*REPURCHASE -0.0204 *** (-4.23) (-2.31) ZSCORE_HIGH -0.0098 ZSCORE_HIGH -0.0095 (-1.60) (-1.40) DISC_ACCRUALS 0.1175 *** DISC_ACCRUALS 0.2489 (3.28) (5.56) MARKET_SHARE 0.0126 MARKET_SHARE -0.0461 (0.74) (-2.61) ZSCORE 0.0000 *** ZSCORE 0.0000 *** (32.29) (-6.79) ANACOV -0.0468 *** ANACOV -0.0544 (-8.48) (-8.46) MTR 0.0083 MTR 0.0522 ** (0.45) (2.59) BIG4 0.0012 BIG4 -0.0210 (0.09) (-1.20) SOX 0.0042 SOX -0.0238 *** (0.43) (-2.09) NOA -0.0290 *** NOA 0.0219 *** (-4.80) (3.39) CYCLE 0.0000 ** CYCLE 0.0000 (-1.88) (0.80) ROA -0.3168 *** ROA 0.0116 *** (-11.40) (-0.34) ASSETS_REG 0.0236 *** ASSETS_REG 0.0492 ** (6.68) (13.00) MTB -0.0001 MTB 0.0000 (-1.15) (-0.58) EARN 0.0000 *** EARN 0.0000 (-3.49) (-1.48) IMR 0.0045 ** IMR 0.0015 (1.93) (0.39)

Year Indicators Yes Yes Adj. R-Squared 0.1008 0.1086 N 14,089 14,089 (continued on next page)

43 (continued from previous page) Table 4 presents the coefficient estimates from equation (4). All multivariate regressions are estimated with year fixed effects. Standard errors are clustered at the firm-level. **, *** represent significance at the .05 and .01 p-value level, one-tailed tests. Panel A estimates the equation when the dependent variable is equal to REM_PRODUCTION. Panel B estimates the equation when the dependent variable is equal to REM_DISC_SPEND. Variables are defined as follows: REM_PRODUCTION are the residuals from equation (1) used to estimate normal production levels. REM_DISC_SPEND are residuals from equation (2) used to estimate normal levels of discretionary expenses. ZSCORE_HIGH is set equal to one if the firm's ZSCORE is greater than the year-median and set equal to zero otherwise. DISC_ACCRUALS are the discretionary accruals estimated as the residuals from the modified Jones (1991) model, MARKETVALUE is price times the number of shares outstanding, ASSETS is total assets, SALES is total sales, REPURCHASE is an indicator equal to one if the firm has net repurchases during the year and zero otherwise, ANACOV is the number of analysts covering the firm, MARKET_SHARE is the percentage of the company’s sales to the total sales of its industry at the beginning of year t, where industry is defined based on three-digit SIC codes, ZSCORE is equal to 0.3(NI/Asset) + 1.0(Sales/Asset) + 1.4(Retained Earnings/Asset) + 1.2(Working Capital/Asset) + 0.6([Stock Price x Shares Outstanding]/Total Liabilities), MTR is the marginal tax rate developed and provided by Professor John Graham, BIG4 is set equal to one if the firm is audited by a Big N auditor and zero otherwise, SOX is set equal to one if the year is after 2002 and zero otherwise, NOA an indicator variable that equals 1 if the net operating assets (i.e., shareholders’ equity less cash and marketable securities and plus total debt) at the beginning of the year divided by lagged sales is above the median of the corresponding industry-year, and 0 otherwise, CYCLE is the days receivable plus the days inventory less the days payable at the beginning of the year, ROA is return on assets, PRICE_VALUE is the ratio of price-to-value where value is estimes using the Frankel and Lee (1998) methodology, OPT_PCT is the number of total options outstanding divided by total shares outstanding, MTB is the market-to-book ratio, EARN is the earnings before extraordinary items, minus discretionary accruals and production costs, plus discretionary expenditures. IMR is the inverse mills ratio.

44 Table 5 - Multivariate Analysis - Stock Options

Yit = α1 + α2 Repurchase t+1 + α2 Opt_Intensity t*Repurchase t+1 + α3 Disc_Accruals t + α4 MarketShare t-1 +

α5 Zscore t-1 + α6 Anacov t-1 + α7 MTR t + α8 Big4 + α9 SOX t + α10 NOA t-1 + α11 Cycle t-1 +

α12 ROA t + α13 Assets_Reg t + α14 MTB t + α15 Earn t + α16 IMR t + εt

Panel A: Dependent Variable= Panel B: Dependent Variable = REM_PRODUCTION REM_DISC_SPEND Variable Estimate Variable Estimate Intercept 0.0717 *** Intercept 0.1857 *** (2.52) (5.75) REPURCHASE -0.0146 *** REPURCHASE -0.0034 (-2.47) (-0.52) OPT_INTENSITY*REPURCHASE -0.0363 *** OPT_INTENSITY*REPURCHASE -0.0330 ** (-3.25) (-2.28) DISC_ACCRUALS 0.2004 *** DISC_ACCRUALS 0.2770 *** (5.52) (5.97) MARKET_SHARE 0.0300 MARKET_SHARE -0.0473 *** (1.40) (-2.16) ZSCORE -0.0030 *** ZSCORE 0.0007 (-3.26) (1.48) ANACOV -0.0476 *** ANACOV -0.0626 *** (-6.83) (-8.02) MTR 0.0158 MTR 0.0357 (0.70) (1.43) BIG4 0.0099 BIG4 -0.0205 (0.44) (-0.81) SOX -0.0013 SOX -0.0151 (-0.14) (-1.54) NOA -0.0219 *** NOA 0.0236 *** (-2.98) (3.02) CYCLE 0.0000 ** CYCLE 0.0000 (-1.62) (0.07) ROA -0.4281 *** ROA -0.1152 *** (-10.14) (-2.76) ASSETS_REG 0.0194 *** ASSETS_REG 0.0538 *** (4.54) (11.36) MTB -0.0001 MTB 0.0000 (-1.11) (-0.50) EARN -0.0001 *** EARN 0.0000 (-2.63) (-1.27) IMR 0.0117 ** IMR 0.0033 (4.17) (0.85) (continued on next page)

45 (continued from previous page) Year Indicators Yes Yes Adj. R-Squared 0.1283 0.1272 N 12,652 12,652 Table 5 presents the coefficient estimates from equation (4). All multivariate regressions are estimated with year fixed effects. Standard errors are clustered at the firm-level. **, *** represent significance at the .05 and .01 p-value level, one-tailed tests. Panel A estimates the equation when the dependent variable is equal to REM_PRODUCTION. Panel B estimates the equation when the dependent variable is equal to REM_DISC_SPEND. Variables are defined as follows: REM_PRODUCTION are the residuals from equation (1) used to estimate normal production levels. REM_DISC_SPEND are residuals from equation (2) used to estimate normal levels of discretionary expenses. OPT_INTENSITY is set equal to one when the total options outstanding divided by shares outstadning is greater than the year-median and set equal to zero otherwise. DISC_ACCRUALS are the discretionary accruals estimated as the residuals from the modified Jones (1991) model, MARKETVALUE is price times the number of shares outstanding, ASSETS is total assets, SALES is total sales, REPURCHASE is an indicator equal to one if the firm has net repurchases during the year and zero otherwise, ANACOV is the number of analysts covering the firm, MARKET_SHARE is the percentage of the company’s sales to the total sales of its industry at the beginning of year t, where industry is defined based on three-digit SIC codes, ZSCORE is equal to 0.3(NI/Asset) + 1.0(Sales/Asset) + 1.4(Retained Earnings/Asset) + 1.2(Working Capital/Asset) + 0.6([Stock Price x Shares Outstanding]/Total Liabilities), MTR is the marginal tax rate developed and provided by Professor John Graham, BIG4 is set equal to one if the firm is audited by a Big N auditor and zero otherwise, SOX is set equal to one if the year is after 2002 and zero otherwise, NOA an indicator variable that equals 1 if the net operating assets (i.e., shareholders’ equity less cash and marketable securities and plus total debt) at the beginning of the year divided by lagged sales is above the median of the corresponding industry-year, and 0 otherwise, CYCLE is the days receivable plus the days inventory less the days payable at the beginning of the year, ROA is return on assets, PRICE_VALUE is the ratio of price-to-value where value is estimes using the Frankel and Lee (1998) methodology, OPT_PCT is the number of total options outstanding divided by total shares outstanding, MTB is the market-to-book ratio, EARN is the earnings before extraordinary items, minus discretionary accruals and production costs, plus discretionary expenditures. IMR is the inverse mills ratio.

46 Table 6 - Multivariate Analysis - Valuation

Yit = α1 + α2 Repurchase t+1 + α2 OverValued t*Repurchase t+1 + α3 Disc_Accruals t + α4 MarketShare t-1 + α5

Zscore t-1 + α6 Anacov t-1 + α7 MTR t + α8 Big4 + α9 SOX t + α10 NOA t-1 + α11 Cycle t-1 + α12 ROA t + α13

Assets_Reg t + α14 MTB t + α15 Earn t + α16 IMR t + εt Panel A: Dependent Variable= Panel B: Dependent Variable = REM_PRODUCTION REM_DISC_SPEND Variable Estimate Variable Estimate Intercept 0.0830 *** Intercept 0.2015 *** (4.41) (8.91) REPURCHASE -0.0224 *** REPURCHASE -0.0092 ** (-4.82) (-1.76) OVERVALUED*REPURCHASE -0.0123 OVERVALUED*REPURCHASE -0.0136 (-1.56) (-1.47) DISC_ACCRUALS 0.1196 *** DISC_ACCRUALS 0.2469 *** (3.76) (5.95) MARKET_SHARE 0.0145 MARKET_SHARE -0.0512 *** (0.80) (-2.79) ZSCORE 0.0000 *** ZSCORE 0.0000 *** (21.96) (-7.51) ANACOV -0.0544 *** ANACOV -0.0634 *** (-10.18) (-10.00) MTR 0.0138 MTR 0.0478 *** (0.75) (2.33) BIG4 -0.0005 BIG4 -0.0237 (-0.04) (-1.47) SOX -0.0015 SOX -0.0276 *** (-0.18) (-2.93) NOA -0.0196 *** NOA 0.0284 *** (-3.26) (4.35) CYCLE 0.0000 ** CYCLE 0.0000 (-1.82) (0.70) ROA -0.3498 *** ROA -0.0123 (-12.49) (-0.37) ASSETS_REG 0.0259 *** ASSETS_REG 0.0531 *** (7.59) (13.76) MTB -0.0001 MTB 0.0000 (-1.19) (-0.71) EARN 0.0000 *** EARN 0.0000 (-2.78) (-1.58) IMR 0.0048 ** IMR 0.0015 (2.10) (0.43) (continued on next page)

47 (continued from previous page) Year Indicators Yes Yes Adj. R-Squared 0.1007 0.1115 N 8,953 8,953 Table 6 presents the coefficient estimates from equation (4). All multivariate regressions are estimated with year fixed effects. Standard errors are clustered at the firm-level. **, *** represent significance at the .05 and .01 p-value level, one-tailed tests. Panel A estimates the equation when the dependent variable is equal to REM_PRODUCTION. Panel B estimates the equation when the dependent variable is equal to REM_DISC_SPEND. Variables are defined as follows: REM_PRODUCTION are the residuals from equation (1) used to estimate normal production levels. REM_DISC_SPEND are residuals from equation (2) used to estimate normal levels of discretionary expenses. OVERVALUED is equal to one if the price-to-value ratio is greater than the year-median and zero otherwise. DISC_ACCRUALS are the discretionary accruals estimated as the residuals from the modified Jones (1991) model, MARKETVALUE is price times the number of shares outstanding, ASSETS is total assets, SALES is total sales, REPURCHASE is an indicator equal to one if the firm has net repurchases during the year and zero otherwise, ANACOV is the number of analysts covering the firm, MARKET_SHARE is the percentage of the company’s sales to the total sales of its industry at the beginning of year t, where industry is defined based on three-digit SIC codes, ZSCORE is equal to 0.3(NI/Asset) + 1.0(Sales/Asset) + 1.4(Retained Earnings/Asset) + 1.2(Working Capital/Asset) + 0.6([Stock Price x Shares Outstanding]/Total Liabilities), MTR is the marginal tax rate developed and provided by Professor John Graham, BIG4 is set equal to one if the firm is audited by a Big N auditor and zero otherwise, SOX is set equal to one if the year is after 2002 and zero otherwise, NOA an indicator variable that equals 1 if the net operating assets (i.e., shareholders’ equity less cash and marketable securities and plus total debt) at the beginning of the year divided by lagged sales is above the median of the corresponding industry-year, and 0 otherwise, CYCLE is the days receivable plus the days inventory less the days payable at the beginning of the year, ROA is return on assets, PRICE_VALUE is the ratio of price-to-value where value is estimes using the Frankel and Lee (1998) methodology, OPT_PCT is the number of total options outstanding divided by total shares outstanding, MTB is the market-to-book ratio, EARN is the earnings before extraordinary items, minus discretionary accruals and production costs, plus discretionary expenditures. IMR is the inverse mills ratio.

48 Table 7 - Post-Repurchase Returns Panel A: REM_PRODUCTION Panel B: REM_DISX_SPEND Portfolios Portfolios Abnormal Abnormal Quintile Return Quintile Return 5 0.4712 5 0.5163 4 0.5058 4 0.4221 3 0.3146 3 0.3924 2 0.2972 2 0.3667 1 0.2075 1 0.2700

5-1 0.2637 *** 5-1 0.2463 *** N 14,089 14,089 Table 7 reports the post-repurchase abnormal stock returns for the sample of firms sorted by quintiles of REM_PRODUCTION (Panel A) and REM_DISX_SPEND (Panel B). Abnormal stock returns are calculated using the Fama and French (1993) three factor risk model. The quintiles of REM_PRODUCTION and REM_DISX_SPEND are based on the level of real earnings management in the year prior to the stock repurchase. The abnormal returns are estimated for the time period subsequent to the stock repurchase year. *** represents significance at the 1 percent level.

49 Table 8 - Multivariate Analysis using Quarterly Data Panel A: Multivariate Analysis on Average REM_PRODUCTION REM_DISC_SPEND Variable Estimate Variable Estimate Intercept 0.0146 *** Intercept 0.0508 *** (3.42) (9.42) REPURCHASE -0.0034 *** REPURCHASE -0.0017 * (-3.64) (-1.55)

Controls Included Included Year Indicators Yes Yes Quarter Indicators Yes Yes Adj. R-Squared 0.0799 0.0991 N 53,118 53,118 Panel B: Multivariate Analysis based on Financial Health REM_PRODUCTION REM_DISC_SPEND Variable Estimate Variable Estimate Intercept 0.0207 *** Intercept 0.0584 *** (4.87) (11.10) REPURCHASE -0.0010 REPURCHASE 0.0013 (-0.86) (0.99) ZSCORE_HIGH*REPURCHASE -0.0042 *** ZSCORE_HIGH*REPURCHASE -0.0057 *** (-2.41) (-2.84)

Controls Included Included Year Indicators Yes Yes Quarter Indicators Yes Yes Adj. R-Squared 0.0888 0.1005 N 53,118 53,118 Panel C: Multivariate Analysis based on Stock Option Intensity REM_PRODUCTION REM_DISC_SPEND Variable Estimate Variable Estimate Intercept 0.0125 *** Intercept 0.0440 *** (2.45) (7.07) REPURCHASE -0.0060 *** REPURCHASE -0.0020 ** (-4.63) (-1.66) OPT_INTENSE*REPURCHASE -0.0034 ** OPT_INTENSE*REPURCHASE -0.0018 (-1.76) (-0.42)

Controls Included Included Year Indicators Yes Yes Quarter Indicators Yes Yes Adj. R-Squared 0.0954 0.1135 N 47,806 47,806

50 Panel D: Multivariate Analysis based on Valuation REM_PRODUCTION REM_DISC_SPEND Variable Estimate Variable Estimate Intercept 0.0149 *** Intercept 0.0508 *** (3.47) (9.42) REPURCHASE -0.0031 *** REPURCHASE -0.0016 * (-3.27) (-1.49) OVERVALUED*REPURCHASE -0.0040 ** OVERVALUED*REPURCHASE -0.0027 (-1.67) (-0.52)

Controls Included Included Year Indicators Yes Yes Quarter Indicators Yes Yes Adj. R-Squared 0.0804 0.0992 N 22,657 22,657 Table 8 reports the estimated coefficients for only the variables of interest using quartly data. Panel A reports the estimated coefficients on average. Panel B reports the estimated coefficients including the ZSCORE test. Panel C reports the estimated coefficients including the stock option intensity test. Panel D reports the estimated coefficients including the valuation tests. All multivariate regressions are estimated with year fixed effects and quarter fixed effects. Standard errors are clustered at the firm-level. *, **, *** represent significance at the .10, .05 and .01 p-value level, one-tailed tests. Variables are defined as follows: REM_PRODUCTION are the residuals from equation (1) used to estimate normal production levels. REM_DISC_SPEND are residuals from equation (2) used to estimate normal levels of discretionary expenses, REPURCHASE is an indicator equal to one if the firm has net repurchases during the year and zero otherwise.

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