How does the stock market respond to R&D cuts used to manage earnings?
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Prior research shows returns are positive when firms meet or beat analysts’ consensus forecasts but negative when firms miss. Past studies also show managers frequently cut R&D expenses in order to meet the consensus forecast. Despite these findings, there is limited evidence about how the market responds when firms beat the forecast by cutting R&D. This study shows the stock market penalizes firms that use R&D cuts to manage earnings and exacts a discount to the market reward if beating the forecast requires cutting R&D. The discount is only partial and firms are still better off doing so in the short run. Furthermore, this study shows the R&D cuts used to manage earnings are concentrated in specific industries and are likely temporary, as firms tend to increase R&D spending in the subsequent period. Investors appear to recognize these short-term cuts and treat them similar to accruals.