R&D Expenditures and Earning Management PDF

The Journal of Economic Asymmetries 11 (2014) 104–119
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The Journal of Economic Asymmetries

www.elsevier.com/locate/jeca
R&D expenditures and earnings management: Evidence from

Eurozone countries in crisis
Panayiotis D. Tahinakis ∗,1
Department of Accounting and Finance, School of Business Administration, University of Macedonia, Egnatia str., 540-06 Thessaloniki, Greece
a r t i c l e i n f o a b s t r a c t
Article history: This paper aims to investigate whether a firm’s behaviour regarding earnings manipulation
Received 4 July 2014 through cuts in research and development (R&D) expenditures is affected by the crisis
Received in revised form 17 September in Eurozone countries. More specifically, this research focuses on understanding whether
2014
firms operating in an environment with distinct country characteristics and a single
Accepted 25 September 2014
Available online 18 October 2014
currency perceive earnings manipulation through R&D cuts as a means to avoid reporting
earnings losses or earnings decreases, and whether the existence of a recession can impact
Keywords: this behaviour. Our approach design is based on a modified Bushee (1998) methodological
R&D rationale introducing both the recession impact in the form of intercept variables and a
Earnings management series of control variables to ensure robustness. The sample used for the analysis consists of
Eurozone listed Eurozone firms for a period extending from 2005 to 2013. The findings are consistent
Crisis with previous literature regarding the existence of earnings manipulation through R&D
cuts. Moreover, the evidence provided suggests that Eurozone firms cut R&D to avoid
reporting earnings losses or decreases, even when operating in a recessive environment.
© 2014 Elsevier B.V. All rights reserved.
1. Introduction
The focal point of this paper lies in investigating whether the crisis in the Eurozone countries affected firms’ behaviour
regarding earnings manipulation through cuts of R&D expenditures, in order to avoid reporting earnings losses or earnings
decreases. It is undeniable that the immense earnings pressure that was created certainly acts as a temptation for senior
management to resort to earnings manipulation through accounting and operating decisions. A number of studies (Bushee,
1998; Baber, Fairfield, & Haggard, 1991; Demirag, 1998; Grinyer & Collison, 1998; Roychowdhury, 2006; Zarowin & Oswald,
2005; Osma, 2008; Osma & Young, 2009; Gunny, 2010; Seybert, 2010; Cazavan-Jeny, Jeanjean, & Joos, 2011) provide evidence
of corporate figures manipulation or questionable accounting treatment of real business activities and decisions. Many of
these studies conclude that firms seem to provide a distorted corporate image in order to make ends meet and to gain
short-term benefits in spite of the consequences.
In this context, the matter of R&D expense cuts as a means of earnings manipulation seems to have become an important
research topic rather recently, following the increased interest in validating the existence of R&D expenditures’ informative
* Tel.: +30 2310891564.

E-mail address: tahi67@uom.gr.
1
The author would like to thank Negakis C.I. (University of Macedonia), Ladas A. (University of Macedonia), and Samarinas M. (University of Macedonia),
for their great help and comments during the preparation of this paper, as well as the Editor and the anonymous referees for their valuable remarks.
Furthermore, he would, also, like to thank the participants of the 12th Hellenic Finance and Accounting Association Annual Conference for their beneficial
suggestions.
http://dx.doi.org/10.1016/j.jeca.2014.09.002
1703-4949/© 2014 Elsevier B.V. All rights reserved.
P.D. Tahinakis / The Journal of Economic Asymmetries 11 (2014) 104–119 105
value (Sougiannis, 1994; Green, Stark, & Thomas, 1996; Lev & Sougiannis, 1996; Chan, Lakonishok, & Sougiannis, 2001;
Franzen & Radhakrishnan, 2009; Palmon & Yezegel, 2012). It is easy to assume that the potential of earnings manipulation
utilising value-relevant R&D expenses could seriously affect financial reality. This notion seems quite intriguing if taken in
a recessive-environment context. Therefore, it becomes quite an interesting endeavour to investigate whether firms under
the financial stress added by a poor economic environment, which was created by a recession, adopt real activities earnings
manipulation utilising R&D expenditure cuts to avoid reporting earnings losses or earnings decreases.
The reason for attributing such a gravity on the R&D expenses account, as an earnings manipulation tool, has to do
with its function in the accounting cycle. As an income statement account, R&D becomes the focal point of our analysis,
since it is subtracted as an expense from the fiscal year’s earnings and therefore its magnitude can have an immediate
effect on the level of earnings. This fact provides a firm’s management with the ability to potentially use it as a real
activities manipulation tool, making it quite difficult to detect the motivation behind such an act. Therefore, it is clear that
during a recession, the pressure for reporting earnings is even higher for every public firm, considering the overall business
environment.
Considering the aforementioned ideas, we attempt to investigate whether the crisis in the Eurozone countries affected
firms’ behaviour regarding earnings manipulation through cuts of R&D expenditures in order to avoid reporting earnings
losses or earnings decreases. Focusing on answering that question, we attempt to employ a methodology that tests the
hypothesis that managers reduce R&D expenditures (cut R&D) in order to avoid reporting losses. We utilise a rather modified
Bushee (1998) methodological rationale and attempt to introduce into the created model the impact of recession in the form
of an intercept variable and its interactions with the main variables in order to examine the European corporate reality
regarding R&D cuts. We employ a dataset of Eurozone public firms and study them for the period from 2005 to 2013. The
goal is to capture the firms’ behaviour regarding R&D expenditure cuts both during and before the Eurozone crisis.
We also introduce into our methodological rationale a series of intercept variables and their interactions with the main
variables in order to examine whether firms’ behaviour regarding R&D cuts during a recession is influenced by various
determinants such as R&D intensity. Furthermore, we employ a series of control variables in order to ensure robustness. We
employ a fixed-effects panel regression estimation utilising country, period and/or industry fixed effects.
It is clear that the adoption of International Financial Reporting Standards (IFRS) across the Eurozone provides the neces-
sary comparativeness to address the issue of R&D expense cuts for the European economic reality. The novelty in this study
lies in the examination of real activities earnings manipulation utilising R&D cuts in the context of recession. Answering our
research question can provide us with evidence about the behaviour in a recessive environment for firms that spend funds
on R&D and that follow this as a strategic choice for corporate growth and development. It will allow us to understand
whether a challenging economic environment created by recession can pressure firm management towards real activities
earnings manipulation or if it will force them to follow a more “righteous” path and to use R&D expenses as a means for
confronting severe economic turmoil.
The estimation-educed results are consistent with previous research. The findings suggest that there is evidence imply-
ing that Eurozone firms cut R&D expenditures to avoid reporting earnings losses or earnings decreases. Furthermore, this
behaviour seems to remain unaltered by the Eurozone crisis since management decides to manipulate earnings with R&D
in a recessive environment.
The remainder of the study is formulated as follows. Section 2 describes and analyses the literature on earnings manage-
ment and R&D expenditures. Section 3 elaborates on methodological issues and hypothesis development. Section 4 presents
and analyses the empirical results and the dataset, and finally, Section 5 provides the concluding remarks for this paper.
2. Literature review
A great number of studies have been recently added to the accounting literature concerning the pressure for earnings to
meet earnings goals. The research concerning this topic has repeatedly tried to answer a specific question regarding whether
management manipulates earnings through accounting and operating decisions.
Earnings management, through real activities and specifically through R&D expenses, constitutes a common subject for
a significant number of papers with similar results that have attempted to address the earnings management issue through
operating decisions. Of course, the earnings management phenomenon has been vigorously studied in its accrual-based
form (Healy, 1985; DeAngelo, 1986; Jones, 1991; Dechow & Sloan, 1991; Dechow, Sloan, & Sweeney, 1995; Kothari, Leone,
& Wasley, 2005). Perhaps this can be attributed to its detection being relatively easier. However, research associated with
the real activities manipulation of earnings with R&D are fewer in comparison, and the need for equal study is clear.
One of the studies that researched the possibility of a connection between R&D expenditures and earnings management
is that of Dechow and Sloan (1991). They examined the role of CEOs in R&D expenditure reduction. This approach was used
in order to investigate whether an R&D expenditure reduction, and therefore an earnings increase, would simultaneously
increase stock prices for the firms practising this policy. The results have shown that this kind of earnings manipulation
affects stock prices and, therefore, investors. Perry and Grinaker (1994), using the abnormal measures approach, compared
analysts’ estimations of earnings with actual earnings to try to confirm the existence of earnings management with R&D
expenses. Their results appear to be the same as those of Dechow and Sloan. Management manipulates earnings with the
use of R&D under the pressure of analysts’ estimations.
106 P.D. Tahinakis / The Journal of Economic Asymmetries 11 (2014) 104–119
Baber et al. (1991) have examined whether the administration of a company decides to manipulate earnings by reducing
R&D and to enhance the firm’s position regarding the previous financial year. This is the reason the sample is divided into
three groups. The idea behind this approach can be summarised in the thoughts of Burgstahler and Dichev (1997) on the
estimation of the earnings targets that an entity presents. According to their grouping, the first group consists of companies
that did not reach their earnings target, regardless of whether they have reduced R&D expenses or not. The third group
consists of companies that exceed the earnings target, regardless of whether or not they reduce R&D expenses, while the
second group includes companies that reach the target only if they reduce R&D expenditures. By using this classification,
they used these data to run a Logit regression. The results of the regression analysis have shown that companies utilise R&D
expenses for earnings management.
Relatively consistent with the aforementioned results is the research of Bushee (1998). He also used the methodology
of Baber et al. (1991), but he tried to expand the model that Baber et al. used in their regression analysis. He intro-
duced certain control variables, since the decrease of R&D expenses does not depend only on how far the earnings may
be from the target, but also on a number of other factors, such as the change of GDP or the change of the company
size. Thus, by eradicating the impact of other determinants, the cut of R&D expenses for earnings manipulations becomes
clearer.
Demirag (1998), Grinyer and Collison (1998) used United Kingdom (UK) data to address the same issue: whether there
is a possibility that R&D used in operational decisions can help to manipulate earnings. Again, the findings were consistent
with previous research: R&D is used for earnings management. Roychowdhury (2006), with his research, reached a sim-
ilar conclusion. Corporate entities with a low level of earnings have an unexpectedly small amount of expenses, such as
commercial expenditures or R&D expenses (discretionary expenses).
Zarowin and Oswald (2005), using UK data and the Bushee approach, found that both the companies that expense R&D
on their income statements and those that finally capitalise them use R&D cuts for earnings management. Osma (2008)
investigated Board independence and its relationship with earnings manipulation using R&D expenses. Osma addressed the
same question by using the Bushee methodology and reached the same conclusion. R&D expenses are used for earnings
manipulation under the pressure to meet earnings targets. Osma and Young (2009) investigated the same issue from the
investors’ point of view. They tried to understand whether the investors’ perception is consistent with previous research and
whether they believe that R&D expenses are used by the management to manipulate earnings. Their findings have shown
that investors believe in the utilisation of R&D by managers for earnings-management purposes, but this depends on the
seriousness with which each corporation treats investments for R&D.
Gunny (2010) examined the relation between earnings management using real activities manipulation and future per-
formance. More specifically, she investigated four types of real earnings manipulation, among which is cutting discretionary
R&D expenses in order to boost earnings. She checked different types of manipulation in order to see primarily if they are
associated with the effort to meet earnings targets, and secondly if they can be associated with a firm’s future performance.
Her results are similar to those of previous papers in terms of using R&D to inflate earnings and meet earnings targets.
Seybert (2010) investigated the association between real activities manipulation and capitalisation of R&D expenses. His
experimental approach researches the probability that capitalisation of R&D also means manipulation of R&D expenses.
Seybert found that because abandoning a capitalised R&D project leads to impairment, it can consequently result in dam-
aging a manager’s reputation. This, according to Seybert’s findings, is a reason for over-investing R&D in projects that lead
to capitalisation and, like under-investment of R&D to meet earnings targets, this practice can also lead to real activities
manipulation.
Cazavan-Jeny et al. (2011) focused on investigating the decision between capitalisation or expensing of R&D in the con-
text of French business reality. While they did not establish that management uses R&D capitalisation to manage earnings,
they seem to suggest that management is unable to truthfully convey information about future performance through its
decision to capitalise R&D.
3. Methodological issues
The focus of the methodological rationale followed, lies in investigating whether there is an association between R&D
expense cuts with real activities earnings manipulation and simultaneously addressing the issue in a recession context.
3.1. Establishing a methodological rationale
As mentioned above, the epicentre of our approach lies in understanding whether there is an association between R&D
expense cuts with real activities earnings manipulation. Therefore, an attempt is made to examine whether the Eurozone
countries cut R&D expenditures in order to avoid earnings losses or earnings decreases. This leads us to formulate our initial
set of hypotheses in order to assess the validity of such a question. These are presented as follows:
H 1a : Eurozone public firms cut R&D expenditures to avoid reporting earnings losses.
H 1b : Eurozone public firms cut R&D expenditures to avoid reporting earnings decreases.
We utilise and adjust for our research question the methodology of Baber et al. (1991), extended by Bushee (1998), and
introduce certain determinants that potentially affect firms that spend on R&D. The utilised methodological approach is
based on a grouping of the sample firms. This classification is created by using the earnings level before R&D expenditures,
or the change of earnings before R&D expenditures, as a basis for the attempted distinction. Hence, the variables created in
order to produce some useful basis for our analysis have to be compared with previous-year R&D expenses. A potential cut
to these expenditures from year to year could imply real activities earnings manipulation.
The classification into groupings of our sample firms’ spending in R&D is the first part of our approach following the
methodological rationale of Baber et al. (1991) and Bushee (1998). This will allow us to generate our main variables and
construct the model utilised for the detection of earnings manipulation to avoid reporting earnings losses or earnings
decreases. The sample is divided in order to find out whether firms manage earnings to avoid losses. The sample division
can be represented as follows:
Group C1
Negative earnings before R&D expenses (report
EBRDt < 0
losses anyway)
Group C2
Positive earnings before R&D expenses (report
0 < EBRDt < RDt −1
earnings only by cutting R&D)
Group C3
Positive earnings before R&D expenses (report
RDt −1 < EBRDt
earnings anyway)
For this classification, EBRDt represents earnings before R&D expenses, and RDt-1 represents the previous year’s R&D
expenses. The firms that are used for Group C1 are firms that are not performing well and who will report losses even
if they will not consider manipulating their R&D expenses. On the other hand, the firms of Group C3 will report earnings
without having to manipulate R&D expenses, even if they are at the same level as the previous year. It is implied that the
most interesting group of the three is Group C2. The firms that constitute this category will be able to show positive results
and avoid reporting earnings losses only by manipulating and cutting their R&D expenses.
The grouping created in order to investigate whether firms manage earnings to avoid earnings decreases is constructed
in a way that is similar to the classification of our sample, utilised in order to detect earnings losses.
Group B1
Change in earnings before R&D expenses is smaller
EBRDt < −RDt −1 than previous year’s R&D (report earnings
decreases anyway)
Group B2
Change in earnings before R&D expenses, is
negative but bigger than previous year’s R&D
−RDt −1 < EBRDt < 0
(report earnings decreases only by not cutting
R&D)
Group B3
Positive changes in earnings before R&D expenses
0 < EBRDt
(report earnings increases anyway)
The logic behind this grouping is similar to the case of investigating R&D cuts to avoid earnings losses. Here, EBRD
represents the change in earnings before R&D expenses. The firms that are used for Group B1 are firms that are not per-
forming well and who will report earnings decreases even if they will not consider manipulating their R&D expenses. The
firms of the B3 group are those that will report positive changes in earnings without having to manipulate R&D expenses. It
is implied once more that the most interesting group of the three is Group B2. The firms that constitute this category will
be able to show increases in earnings level only by manipulating and cutting their R&D expenses.
3.2. Constructing the benchmark
Utilising the aforementioned classification in order to examine the behaviour of our sample in relation to R&D cuts to
avoid losses and earnings decreases, we construct the following mathematical representations respectively:
CutRDi ,t = α0 + α1 C 1i ,t + α2 C 3i ,t + e i ,t
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + e i ,t
CutRDt represents the dependent variable of our main model, which depicts whether the firm cuts R&D expenditures for
year t if we compare it with year t − 1. It is constructed as the ratio of RDt −1 to RDt . C1i , t is a dummy variable that equals
1 if the firm belongs to Group C1 for year t, and 0 in any other case. The same is true for the dummy variable C3i , t , but
for Group C3. In the same fashion, B1i , t is a dummy variable that equals 1 if the firm belongs to Group B1 for year t, and
0 otherwise, while B3i , t is a dummy variable that takes the value of 1 if the firm belongs to group B3, and 0 in every other
case.
In the empirical application of the models, the coefficients for Groups C2 and B2 are proxied by the intercepts α0 and
b0 , respectively. In this way, the coefficients of Groups C1 and C3 and Groups B1 and B3 can be seen as the incremental
probabilities of Groups B1 and B3 and Groups C1 and C3, respectively. Keeping this in mind, a positive and statistically
significant intercept in both equation models provides an indication of a relation between Groups C2 and B2, respectively,
with cut R&D practices.
In a manner similar to Bushee (1998), we attempt to expand the initial model as depicted by the previous set of equa-
tions. Certain control variables are added to the base models, examining the behaviour of each group in relation to R&D
cuts to avoid losses and earnings decreases, thus allowing elimination of potential effects that these proxies might cre-
ate. In this way, any potential variability of the CutRD variable that is explained by the dummy variables, but not by the
control variables, is considered to be an indication of earnings manipulation. Hence, we formulate the below-mentioned
equations constructed to describe the case of earnings manipulation both for avoiding losses or earnings decreases in the
respective cases (Eqs. (3) and (4)). Therefore, for the case of cut R&D to avoid reporting earnings losses, the mathematical
representation is as follows:
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 SALGi ,t + a4 SIZEi ,t + a5 LEVERAGEi ,t

+ a6 TBQ i ,t + a7 GDP i ,t + a8 FCFC i ,t + a9 DISTANCEi ,t + a10 PCRDi ,t
+ a11 CCAPX i ,t + e i ,t (1)
For the case of cut R&D to avoid reporting earnings decreases, the mathematical representation is as follows:
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 SALGi ,t + b4 SIZEi ,t + b5 LEVERAGEi ,t

+ b6 TBQ i ,t + b7 GDP i ,t + b8 FCFC i ,t + b9 DISTANCEi ,t + b10 PCRDi ,t
+ b11 CCAPX i ,t + e i ,t (2)
This model representation following the Bushee (1998) approach incorporates, as mentioned previously, a series of control
variables. More specifically, SALG represents sales growth and is incorporated to capture firm growth as expressed by sales.
It is estimated as the annual change in sales accounts. The SIZE variable represents firm size and its calculation is based
on estimating the logarithm of market value of equity. The incorporation of this variable in the model is justified by the
assumption that firm size affects the decision for R&D investments. The LEVERAGE control variable is constructed as a
ratio of the long-term debt to total assets, reflecting the firm’s leverage, and is utilised in order to control for earnings
manipulation driven by increased debt exposure. Tobin’s Q (TBQ) is another proxy calculated as the ratio of the sum of
market value of equity, preferred stock, and long-term and short-term debt, divided by total assets. Following the Bushee
(1998) methodological rationale, we utilise TBQ for controlling for firms that present low costs of R&D cuts and small
benefits for investing in R&D.
The GDP variable represents GDP growth and is estimated as the annual change in real GDP. This variable will allow us
to capture the effect of economic development or deterioration in spending for R&D. Free cash flow change (FCFC) describes
the annual change in free cash flow. Reduction in free cash flow implies a potential need for financing that can perhaps
be achieved, as Bushee implies, by an earnings increase. The DISTANCE variable represents the distance from the earnings
goal set, and is constructed as the change in earnings before taxes and R&D divided by previous year’s R&D expenditures.
Moreover, the utilisation of PCRD is as a proxy depicting prior change in R&D and is calculated as the annual change
of prior-year R&D expenditures (R&Dt −1 ) from R&D expenditures the year before that (R&Dt −2 ). This variable controls for
intertemporal R&D investment, since according to Berger (1993) and Bushee (1998), increased R&D investments over time
mean that a potential increase in previous-year R&D expenditures equals a firm less eager to cut them at the present time,
and vice versa. Finally, the incorporation of capital expenditures change (CCAPX) is utilised in order to control for the lack
of investment funds and is calculated as the annual change in a firm’s capital expenditures.
3.3. Introducing recession to examine for R&D cuts as a means for earnings manipulation
For the next part of the analysis, we take under consideration the severe impact that the sovereign debt crisis had on
Eurozone countries. Keeping that in mind, the research’s focal point shifts towards a firm’s behaviour for earnings manip-
ulation with R&D cuts in a recessive environment. Some may argue that the pressure to avoid reporting earnings losses or
earnings decreases becomes even greater during a recession. Others might suggest that the cleansing effect that, on many
occasions, economic turmoil causes, pushes firms towards a more “honest” treatment of R&D expenditures that perhaps
can be translated in an attempt for corporate growth through innovation, created by increased research and development
investments.
Taking the aforementioned under consideration, we push our analysis one step further, attempting to introduce the
Eurozone crisis impact into our approach. We investigate whether a firm’s decision to cut R&D as a medium for earnings
management is affected by recession. Furthermore, we incorporate an R&D intensity factor that will allow us to explore
whether or not higher R&D investments during a recession constitute the profile of a company able and willing to cut R&D
in order to avoid earnings losses or decreases. We explore this notion by formulating the following hypotheses:
H 2a : Operating in a recessive environment affects R&D-intensive Eurozone firms’ behaviour in cutting R&D expenditures,
to avoid reporting earnings losses.
H 2b : Operating in a recessive environment affects R&D-intensive Eurozone firms’ behaviour in cutting R&D expenditures,
to avoid reporting earnings decreases.
In order to address the issue at hand and to investigate the recession’s impact on management’s behaviour towards R&D
cuts as means for earnings manipulation, we utilise our actual benchmark models and incorporate a recession effect. For
this reason, we construct two different variables that are introduced to Eqs. (1) and (2) in order to allow us to assess the
validity of our hypotheses.
More specifically, we incorporate the RECESSION variable, which represents the recession’s effect on economic activity
and allows us to examine our focal point in the context of recession. This is a dummy variable representing 1 when annual
real GDP is negative and 0 otherwise, thus allowing for a negative economic environment to be acknowledged in our
analysis.
This rationale is expressed by adding the RECESSION variable to Eqs. (1) and (2), thus creating Eq. (3) for expressing the
tactic of R&D cuts to avoid earnings losses, and Eq. (4) for R&D cuts to avoid earnings decreases.
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RECESSION i ,t + a4 SALGi ,t + a5 SIZEi ,t + a6 LEVERAGEi ,t

+ a7 TBQ i ,t + a8 GDP i ,t + a9 FCFC i ,t + a10 DISTANCEi ,t + a11 PCRDi ,t + a12 CCAPX i ,t + e i ,t (3)
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RECESSION i ,t + b4 SALGi ,t + b5 SIZEi ,t + b6 LEVERAGEi ,t
+ b7 TBQ i ,t + b8 GDP i ,t + b9 FCFC i ,t + b10 DISTANCEi ,t + b11 PCRDi ,t + b12 CCAPX i ,t + e i ,t (4)
Alternatively, we construct another dummy variable (CRISIS) that allows us to pinpoint the sovereign debt crisis of the
Eurozone and elaborate more on the crisis impact in real earnings manipulation. This dummy variable takes the value of 1
if the firm operates in a Eurozone country after 2010, and 0 otherwise. Therefore, the subsequent mathematical formulae
developed refer to R&D expenditure cuts for avoiding reporting earnings losses (Eq. (5)) and avoiding reporting earnings
decreases (Eq. (6)):
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 CRISISi ,t + a4 SALGi ,t + a5 SIZEi ,t + a6 LEVERAGEi ,t

+ a7 TBQ i ,t + a8 GDP i ,t + a9 FCFC i ,t + a10 DISTANCEi ,t + a11 PCRDi ,t + a12 CCAPX i ,t + e i ,t (5)
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 CRISISi ,t + b4 SALGi ,t + b5 SIZEi ,t + b6 LEVERAGEi ,t
+ b7 TBQ i ,t + b8 GDP i ,t + b9 FCFC i ,t + b10 DISTANCEi ,t + b11 PCRDi ,t + b12 CCAPX i ,t + e i ,t (6)
Moreover, we introduce the R&D intensity (RDI) variable in order to incorporate the effect that higher R&D investments
made by a firm might have on the behaviour of the management towards earnings manipulation by utilising R&D cuts. This
dummy variable is constructed in two stages. We calculate the ratio of annual R&D expenditures to the annual sales median.
Those sample firms with a ratio value bigger than the median take the value of 1, and 0 otherwise. Furthermore, we use the
interaction of R&D intensity (RDI) with the RECESSION and CRISIS dummy variables to capture the simultaneous impact on
firms that are both R&D-intensive and operating in a recessive environment, thus allowing us to get a more accurate view
of the C2 and B2 groups that have the aforementioned characteristics.
The mathematical representation of this notion is summarised by the following equations:
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RDIi ,t + a4 RECESSION i ,t + a5 (RDI ∗ RECESSION)i ,t

+ a6 SALGi ,t + a7 SIZEi ,t + a8 LEVERAGEi ,t + a9 TBQ i ,t + a10 GDP i ,t + a11 FCFC i ,t
+ a12 DISTANCEi ,t + a13 PCRDi ,t + a14 CCAPX i ,t + e i ,t (7)
Eq. (7) depicts the relation of R&D cuts with the C1 group, demonstrated here by the intercept, thus allowing us to po-
tentially retrieve evidence of whether an R&D intensive firm operating in a recessive environment can cut R&D to avoid
reporting earnings losses.
Eq. (8) follows the same rationale, thus providing us with an estimation that can depict the probability of R&D cuts to
avoid earnings decreases.
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RDIi ,t + b4 RECESSION i ,t + b5 (RDI ∗ RECESSION)i ,t

+ b6 SALGi ,t + b7 SIZEi ,t + b8 LEVERAGEi ,t + b9 TBQ i ,t + b10 GDP i ,t + b11 FCFC i ,t
+ b12 DISTANCEi ,t + b13 PCRDi ,t + b14 CCAPX i ,t + e i ,t (8)
Eqs. (9) and (10) depict the relation of R&D cuts with the C1 group, demonstrated here by the intercept, thus allowing us
to potentially retrieve evidence of whether an R&D-intensive firm operating in a recessive environment, as described by the
CRISIS variable, can cut R&D to avoid reporting earnings losses (Eq. (9)) or earnings decreases (Eq. (10)).
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RDIi ,t + a4 CRISISi ,t + a5 (RDI ∗ CRISIS)i ,t
+ a6 SALGi ,t + a7 SIZEi ,t + a8 LEVERAGEi ,t + a9 TBQ i ,t + a10 GDP i ,t + a11 FCFC i ,t

CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RDIi ,t + b4 CRISISi ,t + b5 (RDI ∗ CRISIS)i ,t
+ b6 SALGi ,t + b7 SIZEi ,t + b8 LEVERAGEi ,t + b9 TBQ i ,t + b10 GDP i ,t + b11 FCFC i ,t

The goal of this multilevel analysis is, as mentioned, to capture whether R&D expenditure treatment by Eurozone companies
has a potential relationship to earnings manipulation. Apart from that, the focal point goes one step further in examining
the potential effect that the crisis in the Eurozone might have created, affecting in essence the behaviour of the listed firms
in the Eurozone countries regarding real activities earnings manipulation. It is interesting to see whether the added pressure
from the economic environment educes R&D cuts to avoid earnings losses or decreases.
4. Empirical findings
4.1. The sample
The present study uses a sample of listed firms from the eighteen Eurozone countries that are available from the COM-
PUSTAT Global database for the period 2005 to 2013. This results in a sample that contains a maximum of 2188 firms. Our
sample is decreased further since our methodological rationale implies utilising only firms investing in R&D, excluding, of
course, those that belong to the finance and assurance sector due to comparison difficulties. Furthermore, the construction
of certain variables, such as PCRD, forces us to use the years of 2005 and 2006 for their estimation, leaving us with a period
from 2007–2013.
Moreover, our sample is further reduced by deleting the upper and bottom 1.5% of the distribution of each variable in
order to avoid the effects of extreme observations. Our final sample consists of 1468 firm-year observations. Descriptive
statistics on the main variables are presented in Table 1.
This table displays graphically the characteristics of the variables used. It is evident that some relatively extreme high and
low values appear in our sample for our control variables, despite utilising some sample selection criteria. More specifically,
the CutRD, C1, C2, B1 and TBQ variables present a rather right-skewed distribution, whereas most values are concentrated
to the left, with some extreme values to the right. On the other hand, the C3, B3, GDP, FCFC, DISTANCE, PCRD, CCAPX and
CRISIS variables appear to be negatively skewed, presenting a rightward value concentration. The CutRD, C1, C2, C3, SALG,
TBQ, GDP, FCFC, DISTANCE, PCRD, and CCAPX variables represent a rather leptokurtic distribution in contrast with the B1
and LEVERAGE variables, which appear to be platykurtic.
All variables used for our analysis, except GDP and RECESSION, were available from the COMPUSTAT Global database. In
addition to COMPUSTAT’s CS Active file, we have also incorporated into our sample the CS Research file, consisting of firms
that have either ceased to exist, merged or delisted, in order to eradicate potential survivorship bias that the utilisation of
firms that lasted through time would create. The GDP and RECESSION variables were constructed using data retrieved from
Eurostat.
4.2. Some remarks
To examine for potential multicollinearity, the variables incorporated into our model were tested with Pearson’s correla-
tion test. The matrix created is depicted in Table 2.
As demonstrated in this table, a rather low probability of multicollinearity between variables seems to exist. Further-
more, for our analysis we implement a Fixed Effects Regression estimation. More specifically, Eqs. (1) and (2) are estimated
utilising Fixed Effects regression with cross-section and period-specific effects. For the estimation of Eqs. (3) to (10), only
cross-section fixed effects are preferred, since the incorporation of the RECESSION and CRISIS variables, which are time-
variant, do not allow us to introduce period-specific effects without multicollinearity issues. This method allows for the
fixed cross-section effects to pick up the effect of unobservable cross-section characteristics that are stable over time and
to present a correlation with explanatory variables. Furthermore, the incorporation of fixed-period effects provides us with
the ability to incorporate unobservable period characteristics in our estimation. Our choice of estimation is consistent with
the results of the F-test for joint significance that was implemented, a result in favour of the incorporation of fixed effects.
P.D. Tahinakis / The Journal of Economic Asymmetries 11 (2014) 104–119
Table 1
Descriptive statistics.
CutRD C1 C2 C3 B1 B2 B3 SALG SIZE LEVERAGE TBQ GDP FCFC DISTANCE PCRD CCAPX RECESSION RDI CRISIS
Mean 1.043 0.009 0.031 0.960 0.177 0.309 0.514 0.068 5.912 0.126 1.115 0.457 −0.033 −0.196 −0.002 0.081 0.307 0.472 0.686
Median 0.990 0.000 0.000 1.000 0.000 0.000 1.000 0.060 5.803 0.110 0.912 0.700 0.021 0.032 −0.001 0.091 0.000 0.000 1.000
Max. 3.842 1.000 1.000 1.000 1.000 1.000 1.000 0.951 9.580 0.600 6.007 10.000 5.656 78.781 1.540 1.952 1.000 1.000 1.000
Min. 0.205 0.000 0.000 0.000 0.000 0.000 0.000 −0.627 1.291 0.000 0.237 −17.700 −6.093 −134.6 −1.500 −1.984 0.000 0.000 0.000
Std. dev. 0.346 0.094 0.174 0.197 0.381 0.462 0.500 0.142 1.888 0.110 0.719 2.859 1.086 10.458 0.322 0.481 0.462 0.499 0.464
Note: The sample consists of 1.468 firm-year observations for the period 2005–2013. All data (except GDP, RECESSION and CRISIS variable) were available by COMPUSTAT Global and refer to firms listed in the
stock exchange markets of all the European Monetary Union Countries. GDP and RECESSION variables were retrieved by Eurostat. Our sample was further reduced by deleting the upper and bottom 1.5% of the
distribution of each variable in order to avoid the effects of extreme observations.
111
112
Table 2
Pearson’s correlation matrix.
CutRD C1 C2 C3 B1 B2 B3 SALG SIZE LEVERAGE TBQ GDP FCFC DISTANCE PCRD CCAPX RECESSION RDI CRISIS
CutRD 1.00
–
C1 −0.03 1.00
(0.2) –
C2 0.19 −0.02 1.00
(0.0) (0.5) –
C3 −0.15 −0.46 −0.88 1.00
P.D. Tahinakis / The Journal of Economic Asymmetries 11 (2014) 104–119

(0.0) (0.0) (0.0) –
B1 0.07 0.19 0.04 −0.12 1.00
(0.0) (0.0) (0.1) (0.0) –
B2 0.13 −0.05 0.13 −0.10 −0.31 1.00
(0.0) (0.1) (0.0) (0.0) (0.0) –
B3 −0.17 −0.10 −0.15 0.18 −0.48 −0.69 1.00
(0.0) (0.0) (0.0) (0.0) (0.0) (0.0) –
SALG 0.09 −0.09 −0.05 0.08 −0.18 −0.12 0.25 1.00
(0.0) (0.0) (0.1) (0.0) (0.0) (0.0) (0.0) –
SIZE −0.05 −0.08 −0.06 0.09 −0.03 0.01 0.01 0.04 1.00
(0.0) (0.0) (0.0) (0.0) (0.2) (0.6) (0.6) (0.2) –
LEVERAGE −0.03 0.10 0.04 −0.09 0.08 −0.03 −0.03 −0.04 0.21 1.00
(0.3) (0.0) (0.1) (0.0) (0.0) (0.2) (0.2) (0.2) (0.0) –
TBQ 0.01 −0.05 −0.04 0.06 −0.10 0.01 0.06 0.19 0.24 −0.15 1.00
(0.6) (0.1) (0.1) (0.0) (0.0) (0.6) (0.0) (0.0) (0.0) (0.0) –
GDP 0.02 −0.09 −0.02 0.06 −0.12 −0.04 0.13 0.29 −0.02 −0.05 0.00 1.00
(0.4) (0.0) (0.5) (0.0) (0.0) (0.1) (0.0) (0.0) (0.5) (0.0) (1.0) –
FCFC 0.06 −0.13 −0.13 0.18 −0.31 −0.18 0.40 0.24 0.01 0.01 0.05 0.01 1.00
(0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.6) (0.6) (0.1) (0.6) –
DISTANCE −0.08 −0.12 −0.01 0.07 −0.35 −0.01 0.28 0.14 0.03 0.05 0.04 0.06 0.20 1.00
(0.0) (0.0) (0.7) (0.0) (0.0) (0.7) (0.0) (0.0) (0.3) (0.0) (0.1) (0.0) (0.0) –
PCRD 0.13 −0.06 0.06 −0.03 −0.10 0.09 −0.01 −0.08 0.01 0.02 −0.08 0.00 0.01 0.02 1.00
(0.0) (0.0) (0.0) (0.3) (0.0) (0.0) (0.8) (0.0) (0.6) (0.5) (0.0) (0.9) (0.8) (0.4) –
CCAPX −0.02 −0.07 −0.06 0.08 −0.12 −0.03 0.12 0.39 0.03 0.01 0.06 0.23 -0.16 0.08 −0.06 1.00
(0.5) (0.0) (0.0) (0.0) (0.0) (0.2) (0.0) (0.0) (0.3) (0.7) (0.0) (0.0) (0.0) (0.0) (0.0) –
RECESSION −0.02 0.08 0.02 −0.06 0.11 0.01 −0.10 −0.22 0.04 0.08 0.02 −0.77 0.03 0.00 −0.01 −0.20 1.00
(0.4) (0.0) (0.4) (0.0) (0.0) (0.6) (0.0) (0.0) (0.1) (0.0) (0.4) (0.0) (0.3) (0.9) (0.8) (0.0) –
RDI −0.02 0.00 0.04 −0.04 −0.18 0.15 0.00 0.07 −0.59 −0.29 0.15 0.04 0.00 0.03 −0.01 0.03 −0.08 1.00
(0.4) (0.9) (0.1) (0.2) (0.0) (0.0) (0.9) (0.0) (0.0) (0.0) (0.0) (0.1) (0.9) (0.2) (0.8) (0.3) (0.0) –
CRISIS −0.01 −0.09 −0.03 0.07 −0.10 −0.04 0.11 0.12 −0.01 0.01 0.05 0.27 0.05 0.04 −0.02 0.12 −0.28 0.01 1.00
(0.7) (0.0) (0.3) (0.0) (0.0) (0.1) (0.0) (0.0) (0.7) (0.8) (0.0) (0.0) (0.1) (0.1) (0.5) (0.0) (0.0) (0.7) –
Note: Numbers in brackets represent p-value. The sample consists of 1.468 firm-year observations for the period 2005–2013. All data (except GDP, RECESSION and CRISIS variable) were available by COMPUSTAT
Global and refer to firms listed in the stock exchange markets of all the European Monetary Union Countries. GDP and RECESSION variables were retrieved by Eurostat. Our sample was further reduced by deleting
the upper and bottom 1.5% of the distribution of each variable in order to avoid the effects of extreme observations.
Table 3
Fixed effects regression estimation for Eqs. (1) and (2) – (2007–2013).
Eq. (1) Eq. (2)

Variable Coef. Prob. Variable Coef. Prob.
intercept 1.4586 0.0000 intercept 1.1134 0.0000
C1 −0.7057 0.0000 B1 −0.0104 0.7648
C3 −0.4444 0.0000 B3 −0.1683 0.0000
SALG 0.1783 0.0432 SALG 0.1680 0.0521
SIZE 0.0000 1.0000 SIZE −0.0009 0.9816
LEVERAGE 0.0811 0.7045 LEVERAGE −0.0617 0.7712
TBQ −0.0039 0.9287 TBQ 0.0169 0.6832
GDP 0.0053 0.4004 GDP 0.0054 0.3864
FCFC 0.0129 0.1981 FCFC 0.0411 0.0001
DISTANCE −0.0002 0.8921 DISTANCE 0.0021 0.0804
PCRD 0.3492 0.0000 PCRD 0.3568 0.0000
CCAPX −0.0194 0.3898 CCAPX 0.0007 0.9727
N 1468 N 1468
Adjusted R-squared 0.305307 Adjusted R-squared 0.301152
Effects specification
Cross-section fixed (dummy variables)
Period fixed (dummy variables)
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 SALGi ,t + a4 SIZEi ,t + a5 LEVERAGEi ,t + a6 TBQ i ,t + a7 GDP i ,t + a8 FCFC i ,t
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 SALGi ,t + b4 SIZEi ,t + b5 LEVERAGEi ,t + b6 TBQ i ,t + b7 GDP i ,t + b8 FCFC i ,t

∗∗∗ p < 0.01, ∗∗ p < 0.05, ∗ p
< 0.1.
Note: The sample consists of 1.468 firm-year observations for the period 2005–2013. All data (except GDP, RECESSION and CRISIS variable) were available
by COMPUSTAT Global and refer to firms listed in the stock exchange markets of all the European Monetary Union Countries. GDP RECESSION and CRISIS
variable was retrieved by Eurostat. Our sample was further reduced by deleting the upper and bottom 1.5% of the distribution of each variable in order to
avoid the effects of extreme observations.
For variable specification see Appendix A.
4.3. Empirical results for the benchmark models
The initial results focusing on the estimation of Eqs. (1) and (2) allow us to review the results of our benchmark models,
taking under consideration, of course, the increased significance that both the C1 and B1 groups (as expressed by the inter-
cepts a0 and b0 ) have for our analysis. Table 3 depicts the outcomes of the regression-estimated results with cross-section
and period-fixed effects.
As demonstrated by Table 3, a positive statistical association between cuts in R&D expenditures and firms in Groups C2
and B2 seems to exist. This relationship can be interpreted as an indication of the presence of earnings management
practices to avoid reporting both losses and earnings decreases. Furthermore, both the C1 and the C3 groupings represent a
negative and statistically significant relationship with R&D cuts, implying that in both of these groups there is little incentive
for earnings manipulation utilising R&D. The same sign applies for the coefficient of the B1 and B3 groupings but only B3
seems to be statistically significant, implying that sample firms from this group represent a negative relationship with R&D
cuts as means for earnings manipulation.
The inclusion in both equations of certain control variables provides an additional dimension to this analysis. Certain
proxies depicted in Table 3 appear to be significant, thus implying that they capture other aspects of the changes in the
dependent variable that are not captured by the C1, B1, C3 and B3 variables. Specifically, the PCRD variable appears to be
significant in both Eq. (1) and Eq. (2), demonstrating a positive relationship with R&D cuts and deviating from the findings
of Bushee (1998). The same applies for the FCFC variable in Eq. (2). The rest of the proxies appear to be insignificant in our
analysis.
The results seem to allow us to not reject the H1a and H1b hypotheses formulated, since our analysis outcomes present
some evidence that public firms cut R&D expenditures to avoid reporting earnings losses and earnings decreases.
4.4. Empirical results incorporating a recession factor
Moving our focal point towards the examination of whether recession affects a firm’s behaviour regarding earnings
manipulation with R&D cuts, we estimate three different sets of equations. Firstly, we put under the scope the case of
firms operating in a recessive environment and try to examine whether these stressful economic conditions force corporate
management to decrease R&D investments to avoid reporting earnings losses or earnings decreases. The results of estimating
Table 4
Eq. (3) Eq. (4)

C1 −0.6935 0.0000 B1 −0.0024 0.9450
C3 −0.4489 0.0000 B3 −0.1665 0.0000
RECESSION −0.0155 0.6344 RECESSION −0.0082 0.8010
SALG 0.1554 0.0701 SALG 0.1550 0.0661
SIZE 0.0043 0.8952 SIZE 0.0001 0.9980
TBQ −0.0024 0.9530 TBQ 0.0175 0.6590
GDP 0.0006 0.9102 GDP 0.0034 0.5056
FCFC 0.0131 0.1867 FCFC 0.0416 0.0001
PCRD 0.3514 0.0000 PCRD 0.3597 0.0000
CCAPX −0.0199 0.3744 CCAPX 0.0011 0.9618
N 1468 N 1468
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RECESSION i ,t + a4 SALGi ,t + a5 SIZEi ,t + a6 LEVERAGEi ,t + a7 TBQ i ,t
+ a8 GDP i ,t + a9 FCFC i ,t + a10 DISTANCEi ,t + a11 PCRDi ,t + a12 CCAPX i ,t + e i ,t (3)
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RECESSION i ,t + b4 SALGi ,t + b5 SIZEi ,t + b6 LEVERAGEi ,t + b7 TBQ i ,t
+ b8 GDP i ,t + b9 FCFC i ,t + b10 DISTANCEi ,t + b11 PCRDi ,t + b12 CCAPX i ,t + e i ,t (4)

∗∗∗ p < 0.01, ∗∗ p < 0.05, ∗ p
< 0.1.
Eqs. (3) and (4) allow us to review this new perspective once more, taking under consideration the increased significance
of both the C1 and the B1 groups (as expressed by the intercepts a0 and b0 ). Table 4 depicts the results of our regression
analysis estimated with cross-section specific effects.
Table 4 depicts similar results with Table 3, demonstrating a positive statistical association between cuts in R&D expen-
ditures and firms in Groups C2 and B2. This positive and statistically significant sign of the intercept can be interpreted as
an indication of the presence of earnings management practices to avoid reporting both losses and earnings decreases. Both
the C1 and the C3 groupings present a negative and statistically significant relationship with R&D cuts, implying that in
both of these groups there is little incentive for earnings manipulation utilising R&D. As for Eq. (4), only Group B3 seems
to be statistically significant, a fact that can perhaps be interpreted as a negative relationship with R&D cuts that appear to
play the role of the medium for earnings manipulation.
The RECESSION variable that is constructed to introduce the recession effect in our analysis does not seem to bear any
significance for either Eq. (3) or Eq. (4). RECESSION is incorporated to capture any slowing effects in the economy that
may have incremental effects on R&D expenses. Nevertheless, the coefficient of this variable seems to remain statistically
insignificant, depicting the lack of any real relationship with R&D cuts and the failure to improve the estimation as depicted
by the Adjusted R 2 change. Even the coefficients of the C1 and B1 groups, respectively, demonstrate no significant changes
in either equation. Specifically, a minor increase from 1.45 to 1.44 in Eq. (3) is depicted and a small decrease to 1.109 from
1.11 is presented in the case of Eq. (4). These findings present some evidence that a firm’s behaviour toward cutting R&D as
a medium for earnings manipulation does not seem to be affected by the fact that firms operate in a recessive environment.
Moreover, in both equations, the specific proxies depicted in Table 4 appear to be significant, thus controlling for changes
in the dependent variable that are not captured by the C1, B1, C3 and B3 variables. For Eqs. (3) and (4), the PCRD variable
appears to be significant but a positive relation with R&D cuts seems to exist. Sales growth (SALG) is another proxy that
seems to be statistically significant in both equations ((3) and (4)), but once more, this control raises questions because
of its positive sign. The FCFC and DISTANCE variables in Eq. (4) appear to relate positively with R&D cuts, capturing the
changes in the dependent variable that cannot be controlled by B1 and B3. The rest of the proxies appear to be insignificant
in our analysis-estimated results.
The incorporation of a different variable to measure the impact of the recession on a firm’s behaviour regarding earnings
manipulation with R&D cuts does not seem to produce any different results in the estimation of Eqs. (5) and (6) as depicted
by Table 5. We incorporate the CRISIS variable to our initial set of equations, namely (1) and (2), and follow the same
Table 5
Eq. (5) Eq. (6)

C1 −0.6994 0.0000 B1 −0.0041 0.9066
C3 −0.4465 0.0000 B3 −0.1669 0.0000
CRISIS −0.0189 0.4879 CRISIS −0.0150 0.5767
SALG 0.1534 0.0741 SALG 0.1525 0.0710
SIZE 0.0207 0.5984 SIZE 0.0128 0.7412
TBQ −0.0117 0.7851 TBQ 0.0106 0.7978
GDP 0.0033 0.3877 GDP 0.0051 0.1801
FCFC 0.0128 0.1940 FCFC 0.0416 0.0001
PCRD 0.3511 0.0000 PCRD 0.3592 0.0000
CCAPX −0.0192 0.3909 CCAPX 0.0017 0.9382
N 1468 N 1468
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 CRISISi ,t + a4 SALGi ,t + a5 SIZEi ,t + a6 LEVERAGEi ,t + a7 TBQ i ,t
+ a8 GDP i ,t + a9 FCFC i ,t + a10 DISTANCEi ,t + a11 PCRDi ,t + a12 CCAPX i ,t + e i ,t (5)
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 CRISISi ,t + b4 SALGi ,t + b5 SIZEi ,t + b6 LEVERAGEi ,t + b7 TBQ i ,t
+ b8 GDP i ,t + b9 FCFC i ,t + b10 DISTANCEi ,t + b11 PCRDi ,t + b12 CCAPX i ,t + e i ,t (6)

∗∗∗ p < 0.01, ∗∗ p < 0.05, ∗ p
< 0.1.
rationale. The results of this estimation depict a statistically significant and positive relationship of R&D cuts in both the C1
and the B1 groups, as expressed by the intercepts a0 and b0 . Table 5 depicts the results of our regression analysis estimated
with cross-section specific effects.
Once more, our estimation-educed outcomes are indicative of earnings management practices to avoid reporting both
losses and earnings decreases. One finding that seems to persist is that the incorporation of another dummy variable in-
corporating the crisis does not appear to affect a firm’s decision to cut R&D. The Eurozone sovereign debt crisis presents
no real impact. This finding is also supported by the rather unchanged intercepts in both equations and the rather similar
Adjusted R 2 between Eqs. (1) and (5) as well as between (2) with (6). Furthermore, both the C1 and the C3 groupings
represent a negative and statistically significant relationship with R&D cuts, implying that in both of these groups there is
little incentive for earnings manipulation utilising R&D. As for Eq. (6), only B3 seems to be statistically significant, a fact
that can perhaps be interpreted as a negative relationship with R&D cuts that appears to play the role of the medium for
earnings manipulation.
The estimations of Eqs. (5) and (6) also present a statistical significance for certain proxies depicted in Table 5. The PCRD
variable appears to be positively related to R&D cuts, bearing a rather high statistical significance. Sales growth (SALG)
seems to be statistically significant once more in both Eqs. ((5) and (6)), with an estimated positive sign. As in the case
of Eq. (4), the FCFC and DISTANCE variables in Eq. (6) appear to relate positively with R&D cuts, capturing the changes in
the dependent variable that cannot be controlled by B1 and B3. The rest of the proxies appear to be insignificant in our
analysis-estimated results.
The estimation outcomes for Eqs. (7) to (10) present some interesting results. The two sets of estimation outcomes are
presented in Tables 6 and 7 and are rather similar. In both sets of models, we kept the RECESSION and CRISIS variables,
respectively, and introduced into our analysis the RDI variable.
More specifically, we used Eqs. (3) and (4) and incorporated both the R&D intensity variable (RDI) and its interaction
with RECESSION (R&D ∗ RECESSION) in order to capture the slowing effects in the economy that might have incremental
effects on R&D expenses made by R&D-intensive firms. Hence, we have created Eqs. (7) and (8) to allow the examination of
R&D cuts made to avoid reporting both earnings losses and earnings decreases.
It is clear from the results presented in Table 6 that there is a positive statistical association between cuts in R&D
expenditures and firms in Groups C2 and B2. This positive and statistically significant sign of the intercept can be interpreted
as an indication of the presence of earnings management practices to avoid reporting both losses and earnings decreases.
Table 6
Eq. (7) Eq. (8)

C1 −0.6857 0.0000 B1 −0.0065 0.8489
C3 −0.4477 0.0000 B3 −0.1627 0.0000
RDI −0.3710 0.0000 RDI −0.3591 0.0000
RECESSION −0.0112 0.7615 RECESSION −0.0153 0.6763
RDI ∗ RECESSION −0.0070 0.8686 RDI ∗ RECESSION 0.0195 0.6450
SALG 0.1558 0.0659 SALG 0.1516 0.0688
SIZE −0.0174 0.5926 SIZE −0.0187 0.5615
TBQ 0.0221 0.5886 TBQ 0.0373 0.3436
GDP 0.0005 0.9239 GDP 0.0033 0.5047
FCFC 0.0127 0.1922 FCFC 0.0400 0.0001
DISTANCE 0.0000 0.9879 DISTANCE 0.0023 0.0564
PCRD 0.3621 0.0000 PCRD 0.3699 0.0000
CCAPX −0.0113 0.6085 CCAPX 0.0085 0.7010
N 1468 N 1468
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RDIi ,t + a4 RECESSION i ,t + a5 (RDI ∗ RECESSION)i ,t + a6 SALGi ,t + a7 SIZEi ,t
+ a8 LEVERAGEi ,t + a9 TBQ i ,t + a10 GDP i ,t + a11 FCFC i ,t + a12 DISTANCEi ,t + a13 PCRDi ,t + a14 CCAPX i ,t + e i ,t (7)
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RDIi ,t + b4 RECESSION i ,t + b5 (RDI ∗ RECESSION )i ,t + b6 SALGi ,t + b7 SIZEi ,t
+ b8 LEVERAGEi ,t + b9 TBQ i ,t + b10 GDP i ,t + b11 FCFC i ,t + b12 DISTANCEi ,t + b13 PCRDi ,t + b14 CCAPX i ,t + e i ,t (8)
∗∗∗ p < 0.01, ∗∗ p < 0.05, ∗ p < 0.1.
There is also a strong negative relationship between C1, C3 and B3 with R&D cuts, thus validating the notion that only firms
in the C2 and B2 groups have a real incentive for real activities earnings manipulation through R&D cuts.
What draws the most attention is the result depicting a significant negative relationship of R&D intensity (RDI) with R&D
cuts. It seems that this variable captures the effects that above-average R&D investments create in the decision for earnings
manipulation utilising R&D. In both cases, namely to avoid reporting earnings losses or earnings decreases, the findings
seem to be consistent. Furthermore, the introduction of the RECESSION variable seems to have no effect, appearing to be
once more insignificant. The results also depict as statistically significant an increased number of proxies, compared with
the previous estimations. Table 6 demonstrates an improvement of the empirical estimation with an increased Adjusted R 2 ,
equal to 32% and 31% in the respective cases (from 30% and 30% in previous estimations).
As mentioned earlier, similar findings are demonstrated in Table 7. Once more, we use Eqs. (3) and (4), and incorporate
both the R&D intensity variable (RDI) and its interaction with CRISIS (R&D ∗ CRISIS) in order to capture the slowing effects
in the economy due to the Eurozone sovereign debt crisis and its impact on cutting R&D investments made by R&D-intensive
firms. Hence, we have created Eqs. (9) and (10) to allow the examination of R&D cuts made to avoid reporting both earnings
losses and earnings decreases.
Again, the results depict a significant negative relation of R&D intensity (RDI) with R&D cuts. It seems that this variable
captures the effects that above-average R&D investments create in the decision for earnings manipulation utilising R&D. In
both cases, namely to avoid reporting earnings losses or earnings decreases, the findings seem to be consistent. Furthermore,
the introduction of the CRISIS variable seems to have no effect, appearing to be once more insignificant.
The results presented in Table 7 depict a positive statistical association between cuts in R&D expenditures and firms
in Groups C2 and B2. This positive and statistically significant sign of the intercept persists throughout our estimation
and indicates the presence of earnings management practices to avoid reporting both losses and earnings decreases. The
statistically significant negative relationship between C1, C3 and B3 with R&D cuts also persists here and is consistent with
previous findings.
It is evident from the results acquired by Tables 4 to 7 that recession does not seem to affect a firm’s behaviour towards
utilising R&D cuts to manipulate earnings. Both the H2a and the H2b hypotheses seem to be rejected by the fact that
Table 7
Eq. (9) Eq. (10)

C1 −0.6896 0.0000 B1 −0.0105 0.7604
C3 −0.4454 0.0000 B3 −0.1624 0.0000
RDI −0.4108 0.0000 RDI −0.3866 0.0000
CRISIS −0.0441 0.1720 CRISIS −0.0380 0.2388
RDI ∗ CRISIS 0.0470 0.2521 RDI ∗ CRISIS 0.0402 0.3232
SALG 0.1575 0.0630 SALG 0.1548 0.0639
SIZE 0.0013 0.9732 SIZE −0.0042 0.9131
TBQ 0.0110 0.7949 TBQ 0.0297 0.4662
GDP 0.0030 0.4238 GDP 0.0048 0.1987
FCFC 0.0124 0.2043 FCFC 0.0396 0.0001
DISTANCE 0.0001 0.9611 DISTANCE 0.0023 0.0565
PCRD 0.3609 0.0000 PCRD 0.3681 0.0000
CCAPX −0.0120 0.5880 CCAPX 0.0073 0.7426
N 1468 N 1468
CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RDIi ,t + a4 CRISISi ,t + a5 (RDI ∗ CRISIS)i ,t + a6 SALGi ,t + a7 SIZEi ,t
+ a8 LEVERAGEi ,t + a9 TBQ i ,t + a10 GDP i ,t + a11 FCFC i ,t + a12 DISTANCEi ,t + a13 PCRDi ,t + a14 CCAPX i ,t + e i ,t (9)
CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RDIi ,t + b4 CRISISi ,t + b5 (RDI ∗ CRISIS)i ,t + b6 SALGi ,t + b7 SIZEi ,t
+ b8 LEVERAGEi ,t + b9 TBQ i ,t + b10 GDP i ,t + b11 FCFC i ,t + b12 DISTANCEi ,t + b13 PCRDi ,t + b14 CCAPX i ,t + e i ,t (10)
∗∗∗ p < 0.01, ∗∗ p < 0.05, ∗ p < 0.1.
management continues to manipulate earnings with R&D cuts, even in a recessive environment, in order to avoid reporting
losses or earnings decreases.
5. Summary and conclusions
The focal point of this paper lies in whether the Eurozone crisis affected firms’ behaviour regarding earnings manipu-
lation through cuts of R&D expenditures in order to avoid reporting earnings losses or earnings decreases. Using a dataset
of public Eurozone firms investing in R&D for the period 2007–2013, we provide some evidence of earnings management
to avoid losses and earnings decreases by means of manipulating the level of R&D expenditures. Furthermore, the analysis’
outcomes suggest that this behaviour is persistent during a recession where the financial stress added by the poor economic
environment seems to act as a motive for earnings manipulation rather than a disincentive.
Specifically, the methodology of Baber et al. (1991) and Bushee (1998) is utilised in order to create a benchmark for our
analysis. We incorporate into the aforementioned model the ratio of previous-year to present-year R&D and utilise it as a
dependent variable in order to measure for R&D cuts. A classification is introduced into the analysis to categorise the firms
according to their potential to cut R&D to avoid either earnings losses or earnings decreases. The classification is divided
into three distinct groups, two of which have no real incentive to cut R&D for earnings manipulation and one in which the
expected earnings outcome will come only after earnings manipulation. This applies for both cases (manipulation to avoid
earnings losses and earnings decreases). The variables created depict exactly that, and we estimate the generated models,
incorporating into them a series of proxies to control for other aspects of the changes in the dependent variable that cannot
be controlled by the main independent variables of our models. Moreover, we introduce into our estimation the impact of
an economic environment in turmoil to examine whether a firm’s behaviour will change regarding R&D cuts as means of
earnings manipulation. Hence, we incorporate two variables for recession and R&D intensity to produce results regarding
our research question.
Our estimation-educed results allow us to not reject our initial hypotheses, since firms seem to manipulate earnings
through R&D cuts to avoid earnings losses or earnings decreases. However, our second set of hypotheses seems to be
rejected. Despite the utilisation of different recession variables, we cannot confirm that the earnings manipulation tactic
through R&D cuts changes in a recessive environment. Firms continue to cut R&D during economic turmoil to avoid re-
porting earnings losses or earnings decreases. This finding is somewhat expected, since it is only natural to assume that
economic pressure educed in a recessive environment will only add to the existing pressure that corporate management
seems to be under in order to make ends meet and to ensure the optimum level of financing through the stock market.
The aforementioned research outcomes provide a rather new perspective. The examination of earnings-manipulation
phenomena in a recessive environment through R&D expenditure cuts introduces two parallel views in this investigation.
It allows referring to the issue at hand by examining a set of countries with distinct financial characteristics but a com-
mon currency, and also allows the examination of corporate behaviour towards earnings manipulation with R&D cuts due
to the impact of the Eurozone crisis. The evidence provided, suggesting that Eurozone firms cut R&D to avoid reporting
earnings losses or decreases even when operating during a recession, extends the existing research regarding earnings ma-
nipulation with R&D cuts, putting into perspective firms’ behaviour during a crisis for a set of countries comprising, despite
their differences, a monetary union. Furthermore, this study provides support for the argument concerning the need for a
stricter regulatory framework, regarding R&D expenses especially when taking under consideration the challenges raised by
a recessive environment.
This study main limitation concerns the rather mediocre size of the utilised dataset. It is self evident that the creation
of a sample comprised solely of firms investing in R&D for this analysis, is an one way street, but it is certain that the
existence of a very large dataset would reinforce the arguments made, to a greater extent. Obviously, future research could
consider extending the analytical framework of this study by introducing the analysis of firm’s behaviour, for the post crisis
period. This could provide the ability to broaden the perspective and allow the examination of whether various changes
on the institutional and professional framework affected certain firm’s tactic to use R&D cuts as a means for earnings
manipulation.
Appendix A
In order to provide a more coherent representation of the variables utilised, we provide their definition, as well as their
method of measurement, in Table 8:
Table 8
Variable definitions.
Variable definition Variable name Variable measurement

R&D Cut CutRD CutRDt is a ratio of previous year R&D divided by this year R&D
(R&Dt-1/R&Dt).
Negative Earnings before R&D expenses (report losses C1 C 1i ,t is a dummy variable that equals 1 if the firm belongs to
anyway) Group C1, for year t and 0 in any other case.
Positive Earnings before R&D expenses (report earnings only C2 Proxied by intercept α0 (in all equations)
by cutting R&D)
Positive Earnings before R&D expenses (report earnings C3 C 3i ,t is a dummy variable that equals 1 if the firm belongs to
anyway) Group C3, for year t and 0 in any other case.
Change in Earnings before R&D expenses is smaller than B1 B1i ,t is a dummy variable that equals 1 if the firm belongs to
previous years R&D (report earnings decreases anyway) Group B1, for year t and 0 in any other case.
Change in Earnings before R&D expenses is negative but B2 Proxied by intercept b0 (in all equations)
bigger than previous years R&D (report earnings
decreases only by not cutting R&D)
Positive Changes in Earnings before R&D expenses (report B3 B 3i ,t is a dummy variable that equals 1 if the firm belongs to
earnings increases anyway) Group B3, for year t and 0 in any other case.
Sales growth SALG Annual change in sales account
Firm size SIZE Logarithm of market value of equity
Leverage LEVERAGE Ratio of the long term debt to total assets
Tobin’s Q TBQ Ratio of the sum of market value of equity, preferred stock, long
term and short term debt divided by total assets
GDP growth GDP Annual change in real GDP
Free cash flow change FCFC Annual change in free cash flow
Distance from earnings goal DISTANCE Change in earnings before taxes and R&D divided by previous year
R&D expenditures
Prior change in R&D PCRD Annual change of prior year R&D expenditures (R&D t −1 ), from
R&D expenditures the year before that (R&D t −2 )
Capital Expenditures CCAPX Capital Expenditures available by COMPUSTAT Global database
Recession’s effect in economic activity RECESSION A dummy variable representing 1 when annual real GDP is
negative and zero otherwise
Eurozone sovereign debt crisis index CRISIS A dummy variable takes the value of 1 if the firm operates in a
Eurozone country after 2010 and zero otherwise
R&D intensity RDI A dummy variable taking the value of 1 if the median ratio of
annual R&D expenditures to annual sales is bigger than the firms
ratio of annual R&D expenditures to annual sales and zero
otherwise
Table 8 (Continued.)
Variable definition Variable name Variable measurement

R&D intensive firms in a recessive environment RDI ∗ RECESSION RDI and RECESSION variable product
R&D intensive firms operating during the sovereign debt RDI ∗ CRISIS RDI and CRISIS variable product
crisis
Notes: All variables, except GDP, RECESSION and CRISIS, were available by COMPUSTAT Global and refer to firms listed in the stock exchange markets of all
the Eurozone countries. GDP and RECESSION were constructed, using data retrieved by Eurostat.
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The Journal of Economic Asymmetries 11 (2014) 104–119

Contents lists available at ScienceDirect

The Journal of Economic Asymmetries

R&D expenditures and earnings management: Evidence from

* Tel.: +30 2310891564.

3.1. Establishing a methodological rationale

3.2. Constructing the benchmark

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 SALGi ,t + a4 SIZEi ,t + a5 LEVERAGEi ,t

CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 SALGi ,t + b4 SIZEi ,t + b5 LEVERAGEi ,t

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RECESSION i ,t + a4 SALGi ,t + a5 SIZEi ,t + a6 LEVERAGEi ,t

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 CRISISi ,t + a4 SALGi ,t + a5 SIZEi ,t + a6 LEVERAGEi ,t

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RDIi ,t + a4 RECESSION i ,t + a5 (RDI ∗ RECESSION)i ,t

CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RDIi ,t + b4 RECESSION i ,t + b5 (RDI ∗ RECESSION)i ,t

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RDIi ,t + a4 CRISISi ,t + a5 (RDI ∗ CRISIS)i ,t

+ a6 SALGi ,t + a7 SIZEi ,t + a8 LEVERAGEi ,t + a9 TBQ i ,t + a10 GDP i ,t + a11 FCFC i ,t

CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RDIi ,t + b4 CRISISi ,t + b5 (RDI ∗ CRISIS)i ,t

+ b6 SALGi ,t + b7 SIZEi ,t + b8 LEVERAGEi ,t + b9 TBQ i ,t + b10 GDP i ,t + b11 FCFC i ,t

4.1. The sample

4.2. Some remarks

P.D. Tahinakis / The Journal of Economic Asymmetries 11 (2014) 104–119

Eq. (1) Eq. (2)

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 SALGi ,t + a4 SIZEi ,t + a5 LEVERAGEi ,t + a6 TBQ i ,t + a7 GDP i ,t + a8 FCFC i ,t

+ a9 DISTANCEi ,t + a10 PCRDi ,t + a11 CCAPX i ,t + e i ,t (1)

CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 SALGi ,t + b4 SIZEi ,t + b5 LEVERAGEi ,t + b6 TBQ i ,t + b7 GDP i ,t + b8 FCFC i ,t

+ b9 DISTANCEi ,t + b10 PCRDi ,t + b11 CCAPX i ,t + e i ,t (2)

4.3. Empirical results for the benchmark models

4.4. Empirical results incorporating a recession factor

Eq. (3) Eq. (4)

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RECESSION i ,t + a4 SALGi ,t + a5 SIZEi ,t + a6 LEVERAGEi ,t + a7 TBQ i ,t

+ a8 GDP i ,t + a9 FCFC i ,t + a10 DISTANCEi ,t + a11 PCRDi ,t + a12 CCAPX i ,t + e i ,t (3)

CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RECESSION i ,t + b4 SALGi ,t + b5 SIZEi ,t + b6 LEVERAGEi ,t + b7 TBQ i ,t

+ b8 GDP i ,t + b9 FCFC i ,t + b10 DISTANCEi ,t + b11 PCRDi ,t + b12 CCAPX i ,t + e i ,t (4)

Eq. (5) Eq. (6)

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 CRISISi ,t + a4 SALGi ,t + a5 SIZEi ,t + a6 LEVERAGEi ,t + a7 TBQ i ,t

+ a8 GDP i ,t + a9 FCFC i ,t + a10 DISTANCEi ,t + a11 PCRDi ,t + a12 CCAPX i ,t + e i ,t (5)

CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 CRISISi ,t + b4 SALGi ,t + b5 SIZEi ,t + b6 LEVERAGEi ,t + b7 TBQ i ,t

+ b8 GDP i ,t + b9 FCFC i ,t + b10 DISTANCEi ,t + b11 PCRDi ,t + b12 CCAPX i ,t + e i ,t (6)

Eq. (7) Eq. (8)

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RDIi ,t + a4 RECESSION i ,t + a5 (RDI ∗ RECESSION)i ,t + a6 SALGi ,t + a7 SIZEi ,t

CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RDIi ,t + b4 RECESSION i ,t + b5 (RDI ∗ RECESSION )i ,t + b6 SALGi ,t + b7 SIZEi ,t

Eq. (9) Eq. (10)

CutRDi ,t = a0 + a1 C 1i ,t + a2 C 3i ,t + a3 RDIi ,t + a4 CRISISi ,t + a5 (RDI ∗ CRISIS)i ,t + a6 SALGi ,t + a7 SIZEi ,t

CutRDi ,t = b0 + b1 B1i ,t + b2 B3i ,t + b3 RDIi ,t + b4 CRISISi ,t + b5 (RDI ∗ CRISIS)i ,t + b6 SALGi ,t + b7 SIZEi ,t

5. Summary and conclusions

Variable deﬁnition Variable name Variable measurement

Variable deﬁnition Variable name Variable measurement

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