What Have We Learned About Earnings Management? Integrating Discontinuity Evidence

The accounting literature includes numerous examples of discontinuities at prominent benchmarks that are widely interpreted as evidence that earnings are managed to meet those benchmarks. However, there are a few examples where discontinuities do not exist, which are sometimes interpreted as inconsistent with earnings management. Alternative explanations for discontinuities have also been suggested. This paper reviews, evaluates, and integrates the available evidence and concludes that the theory that earnings are managed to meet benchmarks provides the simplest and most complete explanation for the body of discontinuity‐related evidence.     

Dividend Stickiness,Debt Covenants,and Earnings Management

Consistent with the notion that dividends are very sticky, Daniel, Denis, and Naveen ( 2008 ) report evidence that firms manage earnings upward when pre‐managed earnings are expected to fall short of dividend payments. However, we find that this evidence is not robust when controlling for firms' tendency to manage earnings upward to avoid reporting earnings declines; only firms with high leverage exhibit a statistically weak tendency to manage earnings to close deficits of pre‐managed earnings relative to dividends. We further report that the decision to cut dividends depends on whether reported earnings fall short of past dividends, but not on earnings management that eliminates a shortfall in pre‐managed earnings relative to dividend payments. Overall, our evidence suggests that firms that face dividend constraints are more likely to cut dividends than to manage earnings to avoid dividend cuts.     

Incremental Information Content of the Change in the Percent of Production Added to Inventory*

Abstract. Manufacturing firms can manipulate income by producing in excess of the quantity needed to meet current period demand, thereby allocating part of current period fixed manufacturing overhead costs from cost of goods sold to inventory. Because it is subject to manipulation, the component of earnings due to producing in excess of sales may be of lower quality than the remaining component of earnings. We investigate this possibility using a regression of security returns on unexpected income and an estimate of the change in percent of production added to inventory (CPAI). An analytical model indicates that CPAI determines the “earnings surprise” subject to manipulation by overproducing. Assuming the market recognizes this, the coefficient on CPAI should be negative because this low quality component must be deducted from the total “good news” conveyed by the change in reported earnings. Alternatively, CPAI may convey good or bad news to the market that is unrelated to the manipulation of current period earnings. Firms may increase the percent of production added to inventory in anticipation of high levels of future sales. In this case, the estimated coefficient on CPAI should be positive. Or, if the increase in the percent of production added to inventory reflects anticipation of a strike or an unexpected downturn in current sales, the estimated coefficient should be negative. Cross-sectional tests using a large sample of manufacturing firms indicate a significant positive relation between security returns and CPAI. This finding is consistent with market participants viewing CPAI as a leading indicator of firm performance. Although the results are most supportive of CPAI conveying good news, there is some evidence that CPAI is used by managers to smooth earnings and, for firms classified as smoothing earnings, there is weak evidence that the component of earnings related to CPAI is viewed by market participants to be of lower quality.     

Determinants of Managerial Earnings Guidance Prior to Regulation Fair Disclosure and Bias in Analysts' Earnings Forecasts*

Prior to Regulation Fair Disclosure (“Reg FD”), some management privately guided analyst earnings estimates, often through detailed reviews of analysts' earnings models. In this paper I use proprietary survey data from the National Investor Relations Institute to identify firms that reviewed analysts' earnings models prior to Reg FD and those that did not. Under the maintained assumption that firms conducting reviews guided analysts' earnings forecasts, I document firm characteristics associated with the decision to provide private earnings guidance. Then I document the characteristics of “guided” versus “unguided” analyst earnings forecasts. Findings demonstrate an association between several firm characteristics and guidance practices: managers are more likely to review analyst earnings models when the firm's stock is highly followed by analysts and largely held by institutions, when the firm's market‐to‐book ratio is high, and its earnings are important to valuation but hard to predict because its business is complex. A comparison of guided and unguided quarterly forecasts indicates that guided analyst estimates are more accurate, but also more frequently pessimistic. An examination of analysts' annual earnings forecasts over the fiscal year does not distinguish between guidance and no‐guidance firms; both experience a “walk‐down” in annual estimates. To distinguish between guidance and no‐guidance firms, one must examine quarterly earnings news: unguided analysts walk down their annual estimates when the majority of the quarterly earnings news is negative; guided analysts walk down their annual estimates even though the majority of the quarterly earnings news is positive.     

Parents’ Use of Subsidiaries to “Push Down” Earnings Management: Evidence from Italy

We find evidence consistent with Italian nonlisted subsidiaries engaging in accrual and real earnings management, so that their listed parents can meet or beat benchmarks. Thus, the parent firm drives the earnings management of the subsidiaries. We identify parents that are more likely to have managed earnings as the ones that avoid a small loss or meet or beat analyst forecast by a few cents. Cross‐sectional analysis reveals that Big 4 auditors mitigate accrual earnings management at the subsidiary level and that family‐owned firms use earnings management through nonlisted subsidiaries mainly to avoid reporting losses. Finally, we find that parent firms communicate earnings management strategies to their subsidiaries using board proximity. Our evidence shows that business groups manage earnings differently from single firms, pushing earnings management down to subsidiaries. It also supports the monitoring role of Big 4 auditors in a business group setting and contributes to understanding financial reporting decisions in family‐owned firms.     

Maintaining a Reputation for Consistently Beating Earnings Expectations and the Slippery Slope to Earnings Manipulation

This paper investigates whether maintaining a reputation for consistently beating analysts' earnings expectations can motivate executives to move from “within GAAP” earnings management to “outside of GAAP” earnings manipulation. We analyze firms subject to SEC enforcement actions and find that these firms consistently beat analysts' quarterly earnings forecasts in the three years prior to the manipulation period and continue to do so by smaller “beats” during the manipulation period. We find that manipulating firms beat expectations around 86 percent of the time in the 12 quarters prior to the manipulation period (versus 75 percent for control firms) and that manipulation often ends with a miss in expectations. We document that executives of manipulating firms face strong stock market and CEO pressure to perform. Prior to the manipulation period, these firms have high analyst optimism, growing institutional interest, and high market valuations, along with powerful CEOs. Further, we find that maintaining a reputation for beating expectations is more important than CEO overconfidence and is incremental to CEO equity incentives for explaining manipulation. Our results suggest that pressure to maintain a reputation for beating analysts' expectations can encourage aggressive accounting and, ultimately, earnings manipulation.     

The Effect of Audit Quality on Earnings Management*

This study examines the relation between audit quality and earnings management. Consistent with prior research, we treat audit quality as a dichotomous variable and assume that Big Six auditors are of higher quality than non-Big Six auditors. Earnings management is captured by discretionary accruals that are estimated using a cross-sectional version of the Jones 1991 model. Prior literature suggests that auditors are more likely to object to management's accounting choices that increase earnings (as opposed to decrease earnings) and that auditors are more likely to be sued when they are associated with financial statements that overstate earnings (as compared to understate earnings). Therefore, we hypothesize that clients of non-Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accruals reported by clients of Big Six auditors. This hypothesis is supported by evidence from a sample of 10,379 Big Six and 2,179 non-Big Six firm years. Specifically, clients of non-Big Six auditors report discretionary accruals that are, on average, 1.5-2.1 percent of total assets higher than the discretionary accruals reported by clients of Big Six auditors. Also, consistent with earnings management, we find that the mean and median of the absolute value of discretionary accruals are greater for firms with non-Big Six auditors. This result also indicates that lower audit quality is associated with more “accounting flexibility”.     

Ownership Structure,Business Group Affiliation,Listing Status,and Earnings Management: Evidence from Korea*

Using a large sample of both publicly traded and privately held firms in South Korea (hereafter “Korea”), we investigate whether, and how, the deviation of controlling shareholders' control from ownership, business group affiliation, and listing status differentially affect the extent of earnings management. Our study yields three major findings. First, we find that as the control‐ownership disparity becomes larger, controlling shareholders tend to engage more in opportunistic earnings management to hide their behavior and avoid adverse consequences such as disciplinary action. The result of our full‐model regression reveals that an increase in the control‐ownership wedge by 1 percent leads to an increase in the magnitude of (unsigned) discretionary accruals by 1.3 percent of lagged total assets, ceteris paribus. Second, we find that for our full‐model regression, the magnitude of (unsigned) discretionary accruals is greater for group‐affiliated firms than for nonaffiliated firms by 0.8 percent of lagged total assets. This result suggests that business group affiliation provides controlling shareholders with more incentives and opportunities for earnings management. Finally, we find that for our full‐model regression, the magnitude of (unsigned) discretionary accruals is greater for publicly traded firms than for privately held firms by 1.2 percent of lagged total assets. This result supports the notion that stock markets create incentives for public firms to manage reported earnings to satisfy the expectations of various market participants that are often expressed in earnings numbers.     

Employee Movements from Audit Firms to Audit Clients

Regulators have expressed concerns about the “revolving door” between auditors and clients, whereby audit employees move directly from audit firms to audit clients (i.e., “direct alumni hires”). Regulators are concerned that these direct hires could compromise audit quality, partly because these employees could have previously audited their hiring company's financial statements. In contrast, we examine accounting and finance executives who move indirectly from audit firms to audit clients and who could not have previously audited the hiring company's financial statements (i.e., “indirect alumni hires”). We show that indirect hires occur more often than the direct hires that have concerned regulators. We predict and find that both direct and indirect alumni hires are associated with lower rates of executive turnover and audit firm turnover. However, there is no evidence that the reduced rates of executive turnover are explained by managerial entrenchment or that these hires are associated with lower audit quality. Overall, our findings suggest that direct and indirect employee movements from audit firms to audit clients are beneficial to executives, audit clients, and audit firms because they reduce the incidence of costly turnover.     

A Re-Examination of Financial Analysts' Differential Earnings Forecast Accuracy*

Abstract. This research re-examines whether there are differences in the forecast accuracy of financial analysts through a comparison of their annual earnings per share forecasts. The comparison of analyst forecast accuracy is made on both an ex post (within sample) and an ex ante (out of sample) basis. Early examinations of this issue by Richards (1976), Brown and Rozeff (1980), O'Brien (1987), Coggin and Hunter (1989), O'Brien (1990), and Butler and Lang (1991) were ex post and suggest the absence of analysts who can provide relatively more accurate forecasts over multiple years. Contrary to the results of prior research and consistent with the belief in the popular press, we document that differences do exist in financial analysts' ex post forecast accuracy. We show that the previous studies failed to find differences in forecast accuracy due to inadequate (or no) control for differences in the recency of forecasts issued by the analysts. It has been well documented in the literature that forecast recency is positively related to forecast accuracy (Crichfield, Dyckman, and Lakonishok 1978; O'Brien 1988; Brown 1991). Thus, failure to control for forecast recency may reduce the power of tests, making it difficult to reject the null hypothesis of no differences in forecast accuracy even if they do exist. In our analysis, we control for the differences in recency of analysts' forecasts using two different approaches. First, we use an estimated generalized least squares estimation procedure that captures the recency-induced effects in the residuals of the model. Second, we use a matched-pair design whereby we measure the relative forecast accuracy of an analyst by comparing his/her forecast error to the forecast error of another randomly selected analyst making forecasts for the same firm in the same year on or around the same date. Using both approaches, we find that differential forecast accuracy does exist amongst analysts, especially in samples with minimum forecast horizons of five and 60 trading days. We show that these differences are not attributable to differences in the forecast issuance frequency of the financial analysts. In sum, after controlling for firm, year, forecast recency, and forecast issuance frequency of individual analysts, the analyst effect persists. To validate our findings, we examine whether the differences in the forecast accuracy of financial analysts persist in holdout periods. Analysts were assigned a “superior” (“inferior”) status for a firm-year in the estimation sample using percentile rankings on the distribution of absolute forecast errors for that firm-year. We use estimation samples of one- to four-year duration, and consider two different definitions of analyst forecast superiority. Analysts were classified as firm-specific “superior” if they maintained a “superior” status in every year of the estimation sample. Furthermore, they were classified as industry-specific “superior” if they were deemed firm-specific “superior” with respect to at least two firms and firm-specific “inferior” with respect to no firm in that industry. Using either definition, we find that analysts classified as “superior” in estimation samples generally remain superior in holdout periods. In contrast, we find that analysts identified as “inferior” in estimation samples do not remain inferior in holdout periods. Our results suggest that some analysts' earnings forecasts should be weighted higher than others when formulating composite earnings expectations. This suggestion is predicated on the assumption that capital markets distinguish between analysts who are ex ante superior, and that they utilize this information when formulating stock prices. Our study provides an ex ante framework for identifying those analysts who appear to be superior. When constructing weighted forecasts, a one-year estimation period should be used because we obtain the strongest results of persistence in this case.     

Financial Statement Complexity and Meeting Analysts’ Expectations

We examine whether firms with greater financial statement complexity are more likely to meet or beat analysts’ earnings expectations. We proxy for financial statement complexity using the firm's industry and year adjusted accounting policy disclosure length. Firms with more complex financial statements are more likely to just beat expectations than just miss expectations. Firms with complex financial statements appear to use expectations management to beat expectations, but do not use earnings management. Corroborating these findings, we find analysts rely more on management guidance for more complex firms. Firms with complex financial statements are also more likely to have analysts exclude items from actual “street earnings,” but tests suggest this strategy is not specifically used by complex firms to beat expectations. The effect we document is specific to analyst forecasts and not to other alternative benchmarks.     

投资者是否被上市公司的盈余管理行为所误导?——来自配股融资的证据

为了获得配股资格和提高配股价格，上市公司具有通过调整异常应计利润来提升报告盈余的强烈动机。本文使用横截面修正的Jones模型研究了配股公司盈余管理的时间序列分布特征．并分析了异常应计利润与配股后运营业绩和股票长期收益的关系。研究结果表明，配股公司在配股前3个年度和配股当年都具有较高的异常应计利润，而配股后运营业绩和股票长期收益趋于下降，异常应计利润与配股后的股票长期收益具有显著的负相关关系。投资者由于没有能够及时“看穿”配股公司的盈余管理行为而暂时高估了股票价值，从而被上市公司的盈余管理行为所误导。     

Last‐Chance Earnings Management: Using the Tax Expense to Meet Analysts' Forecasts*

We assert that the tax expense is a powerful context in which to study earnings management, because it is one of the last accounts closed prior to earnings announcements. Although many pre‐tax accruals must be posted in the year‐end general ledger, managers estimate and negotiate tax expense with their auditors immediately prior to earnings announcements. We hypothesize that changes from third‐ to fourth‐quarter effective tax rates (ETRs) are negatively related to whether and how much a firm's earnings absent tax expense management miss analysts' consensus forecast, a proxy for target earnings. We measure earnings absent tax expense management as actual pre‐tax earnings adjusted for the annual ETR reported at the third quarter. We provide robust evidence that firms lower their projected ETRs when they miss the consensus forecast, which is consistent with firms decreasing their tax expense if non‐tax sources of earnings management are insufficient to achieve targets. We also find that firms that exceed earnings targets increase their ETR, but this effect is less significant. By studying the tax expense in total, rather than narrow components of deferred tax expense, our results provide general evidence that reported taxes are used to manage earnings.     

An Approach to Adjusting Analysts' Consensus Forecasts for Selection Bias*

Many recent empirical studies have concluded that analysts' earnings forecasts are optimistic on average. In this paper, we attempt to undo the effect of one potential source of optimistic bias in analysts' earnings forecasts. Assuming forecasts come from a truncated normal distribution, we estimate the “true” population mean using maximum likelihood. We find that our estimates of earnings are more accurate and less biased than standard measures of sample mean and median. However, we do not find a closer relationship between excess market returns and forecast errors from our maximum likelihood estimate than from the sample mean. This may suggest that the market does not fully incorporate analysts' incentives in generating expectations about future earnings.     

Are Investors Misled by “Pro Forma” Earnings?*

This paper uses stock market data to investigate the popular claim that investors are misled by the “pro forma” earnings numbers conspicuously featured in the press releases of some U.S. firms. We first document the frequency and magnitude of pro forma earnings in press releases issued during June through August 2000, and describe the 433 firms that engaged in this financial disclosure strategy. Our test period predates public expressions of concern by trade associations and regulators that pro forma earnings may mislead investors and the subsequent issuance of guidelines and rules on the disclosure of pro forma earnings numbers. We use two complementary approaches to determine whether the share prices that investors assign to pro forma firms are systematically higher than the prices assigned to other firms. Our market‐multiples tests for differences in price levels find some evidence suggesting that pro forma firms may be priced higher than firms that do not use the disclosure strategy. This apparent overpricing is not, however, related to the pro forma earnings numbers themselves. Our narrow‐window stock returns tests reveal no evidence of a stock return premium for pro forma firms at the quarterly earnings announcement date. Collectively, the results cast doubt on the notion that investors are, on average, misled by pro forma earnings disclosures despite the widespread concern expressed in the financial press and by regulators.     

Option Trading,Price Discovery,and Earnings News Dissemination*

Abstract. Option market activity increases by more than 10 percent in the four days before quarterly earnings announcements. We show that the direction of this preannouncement trading foreshadows subsequent earnings news. Specifically, we find option traders initiate a greater proportion of long (short) positions immediately before “good” (“bad”) earnings news. Midquote returns to active-side option trades are positive during nonannouncement periods and are significantly higher immediately prior to earnings announcements. Bid-ask spreads for options widen during the announcement period, but traders do not gravitate toward high delta contracts. Collectively, the evidence shows option traders participate generally in price discovery (the incorporation of private information in price), and more specifically in the dissemination of earnings news.     

Ex Ante Severance Agreements and Earnings Management

This research studies whether severance agreements may reduce fraudulent earnings management, and whether severance pay mitigates executives’ career concerns. In a sample of large U.S. firms, those with higher severance pay are less likely to be subject to accounting and auditing enforcement releases (AAERs) by the U.S. Securities and Exchange Commission (SEC). Among S&P 500 firms in the post‐SOX period with premanaged earnings below analyst forecasts, firms with higher severance pay are less likely to meet/beat the analyst forecast using abnormal accruals. Overall, these results suggest that fear of losing a lucrative severance package, and/or the insurance offered by such a package curbs earnings management.     

Earnings Management in Response to the Introduction of the Australian Gold Tax*

Earnings from gold mining in Australia remained tax‐exempt for almost seven decades until January 1, 1991. In the early 1980s, rapid economic prosperity induced by escalated gold prices brought the Australian gold‐mining industry under intense political scrutiny. Using a variant of the modified Jones model, this paper provides evidence of significant downward earnings management by Australian gold‐mining firms, which is consistent with their attempts to mitigate political costs during the period from June 1985 to May 1988. In contrast, test of earnings management over a similar period in a control sample of Canadian gold‐mining firms produced insignificant results. Further, empirical results are robust to several sensitivity tests performed. During the period from June 1988 to December 1990, the Australian firms were found to have engaged in economic earnings management. This is consistent with the sample firms' incentive of maximizing economic earnings immediately prior to the introduction of income tax on gold mining. The findings of this study help to understand the impact of earnings management on the efficient resource allocation in an economy. They also contribute toward understanding the linkage between regulation of accounting for special purposes and general‐purpose financial reporting.     

JIT Adoption: The Effects of LIFO Reserves and Financial Reporting and Tax Incentives*

Using matched samples of JIT adopters and nonadopters, we examine the association of JIT adoption with firms' financial reporting and tax incentives, earnings‐management histories, and LIFO reserve levels. We find evidence that adoption decisions are influenced by the interaction of firms' LIFO reserves with their income smoothing, debt covenant, and tax incentives. We also find that adoption is less likely for firms historically engaging in high degrees of earnings management, particularly when such firms have no substantial LIFO reserves. Our study extends earlier research demonstrating a relation between inventory valuation method and year‐end inventory transactions, and documents a relation between earnings‐management incentives and a fundamental supply‐chain design choice.     

The Relation Between Earnings Management and Non‐GAAP Reporting

Managers have a variety of tools at their disposal to influence stakeholder perceptions. Earnings management and the strategic reporting of non‐GAAP earnings are just two of the available menu choices. We explore how real earnings management and accruals management influence the probability that a company will disclose a non‐GAAP adjusted earnings metric in its earnings press release and the likelihood that it will do so aggressively. We first investigate situations where managers already meet analysts’ expectations either based on strong operating performance or after employing real and accruals management. We find that when solid operating performance alone allows firms to meet expectations, managers do not employ earnings management or non‐GAAP reporting. However, when managers meet expectations using real and accruals management, they are significantly less likely to report a non‐GAAP earnings metric. Next, we explore scenarios where companies fall short of expectations. We find that when they just miss expectations after managing GAAP earnings, they are significantly more likely to employ non‐GAAP reporting, suggesting that the timing and relatively costless nature of non‐GAAP reporting allows managers to appear to meet expectations on a non‐GAAP basis when managed GAAP earnings fall short. Moreover, we find that companies are more likely to report non‐GAAP earnings (and to do so aggressively) when (i) they are unable to use real or accruals earnings management, (ii) are constrained by prior‐period accruals management, and (iii) their operating performance is poor. Taken together, our results are consistent with a substitute relation between non‐GAAP reporting and both real and accruals management.