Do managers manipulate gross profits? Role of product market competition

Gross profits being a part of the sustainable profits of the firm are monitored by investors and analysts. This study examines whether managers manipulate gross profits by misclassifying costs of goods sold as other operating expenses. The paper also tests whether the level of competition in the product market intensifies such misclassification, as managers in more competitive industries face declining margins, more capital market pressures, and are more concerned about their careers. Using data from the United States, the paper presents evidence that managers do engage in such misclassification and the firms in more competitive industries are more likely to do so. The study thus sheds light on an earnings management tool that is used to manipulate an important performance indicator, and also shows the adverse effects of product market competition.