Earnings Management? Erroneous Inferences Based on Earnings Frequency Distributions

A vast literature following Hayn [1995] and Burgstahler and Dichev [1997] attributed the so-called "discontinuities" in earnings distributions around zero to earnings management. Despite recent evidence that these discontinuities are likely caused by other factors, researchers and teachers continue to point to the shapes of these distributions as evidence of earnings management. We provide three sets of further evidence that these discontinuities are likely caused by factors other than earnings management: (1) we provide, as an example, a detailed analysis of the severe effects of sample selection in a recent study; this study erroneously concludes that the shape of an earnings distribution is evidence of earnings management, (2) we provide a simple explanation for the shape of the earnings distribution that is most often cited as evidence of earnings management; the relation between earnings and prices differs with the magnitude and the sign of earnings, and (3) we provide further examples that support the main point of our paper; evidence beyond the mere shape of a distribution must be brought to bear before researchers can draw conclusions regarding the presence/absence of earnings management.     

Two factors affecting an auditor's ability to integrate audit evidence*

Abstract. This study is an examination of auditors' ability to integrate audit evidence. Integration is defined here as identification of the meaningful relationships that exist between separate pieces of information. Failure to integrate is defined as failure to identify such relationships. Auditor subjects at four levels of experience simulated a supervisor's review of audit workpapers; the workpapers contained eight target contradictory pairs of evidence. The nature of the evidence was manipulated so that the contradicting and contradicted pieces in each pair were either in the same or different audit tests, and either used repeated wording or did not. Integration was counted when subjects wrote review notes indicating that the evidence covered by the contradictory documentation needed to be reconsidered. Failure to integrate was counted when subjects failed to point out any problem with the contradictory evidence. The results indicate that experienced auditors integrated significantly more often than inexperienced auditors. It was expected that this superior performance would carry over to contradictory items that were not proximate when encountered and that were not semantically similar. Contrary to expectations, experienced as well as inexperienced subjects failed to integrate more often when the contradictory items were in different audit tests or did not repeat wording. Some implications of these results for the design of decision aids and future research are discussed. Résumé. L'auteur examine la capacité des vérificateurs d'intégrer l'information probante. L'intégration est définie comme étant la capacité de déterminer les relations significatives qui existent entre différents éléments d'information. L'incapacité d'intégrer est définie, elle, comme étant l'impossibilité de déterminer ces relations. Les vérificateurs qui ont participé à l'étude possédaient quatre niveaux d'expérience; ils ont simulé l'examen par le chef d'équipe des feuilles de travail d'un dossier de vérification. Ces feuilles de travail contenaient huit parties cibles d'informations probantes contradictoires. La nature de l'information probante a été manipulée de telle sorte que l'information contradictoire et l'information contredite de chaque paire étaient issues soit des mêmes sondages de vérification, soit de sondages différents. Les cas d'intégration dénombrés correspondaient à la situation où les sujets indiquaient dans leurs notes de révision que l'information probante touchée par la documentation contradictoire devait être réexaminée. Les cas de non-intégration dénombrés correspondaient à la situation où les sujets ne parvenaient pas à cerner un problème quelconque à partir de l'information probante contradictoire. Les résultats indiquent que les cas d'intégration sont beaucoup plus fréquents chez les vérificateurs expérimentés que chez les vérificateurs inexpérimentés. On aurait pu s'attendre à ce que cette performance supérieure se transpose aux éléments contradictoires dont l'occurrence était éloignée et qui ne se ressemblaient pas sur le plan sémantique. Or, constatation inattendue, ni les sujets expérimentés ni les sujets inexpérimentés ne sont parvenus à intégrer plus fréquemment l'information lorsque les éléments contradictoires étaient issus de sondages de vérification différents ou que leur formulation était différente. L'auteur élabore sur les conséquences de ces résultats pour la conception d'aides à la décision et l'orientation des recherches à venir.     

The role of source availability in inference verification*

Abstract. Accountants who presume that documentation of observations will be available whenever needed may not process information thoroughly enough to internalize it. If they rely on access to documentation, they may later fail to recognize the need to refer to that documentation, and may then overlook important pieces of information. As a result, they may be less effective when asked to evaluate inferences than accountants who rely on more careful initial processing. This paper reports experiment results that indicate that accountants may make more accurate tests of inferences when they rely on their memories than when they rely on free access to source materials. Résumé. Les experts-comptables qui supposent que les pièces justificatives relatives aux observations seront à leur disposition dès qu'ils en auront besoin risquent de ne pas traiter l'information de façon suffisamment approfondie pour en garder souvenance. S'ils comptent sur l'accès aux pièces justificatives, il se peut qu'ils ne reconnaissent pas, le moment venu, la nécessité de se reporter à ces pièces justificatives et qu'ils négligent ainsi des éléments d'information importants. Par conséquent, ils risquent d'être moins efficaces, si on leur demande d'évaluer des inductions, que les experts-comptables qui s'appuient sur un traitement initial de l'information plus rigoureux. Les auteurs livrent les résultats d'une experience qui révèle que les experts-comptables peuvent parvenir à des sondages plus précis des inductions lorsqu'ils comptent sur leur mémoire que lorsqu'ils s'appuient sur le libre accès aux pièces justificatives.     

Earnings Management? The Shapes of the Frequency Distributions of Earnings Metrics Are Not Evidence Ipso Facto

We provide evidence that the shapes (particularly around zero) of the frequency distributions of earnings metrics examined in the extant earnings management literature are affected by (1) deflation (using, for example, price or market capitalization), (2) sample selection criteria that lead to differential inclusion/exclusion of observations to the left of zero versus observations to the right of zero (implicit in studies focusing on firms followed by I/B/E/S and explicit in studies partitioning on a variable differing between loss observations and profit observations), (3) differences between the characteristics of observations to the left of zero and observations to the right of zero (such as market pricing and analyst optimism/pessimism), or (4) a combination of these factors. Since the shapes of the frequency distributions of earnings metrics at zero are likely due to one of the above effects, we conclude that the shapes cannot be used as ipso facto evidence of earnings management.     

Credit: the consumer perspective

The U.K. has seen a considerable expansion in the use of credit during the 1980s. Although the majority of consumers are able to manage their use of credit there are many whose borrowing leads to hardship. There are various ways in which the availability of credit can be controlled but there is a high degree of reluctance to do so, both on the part of government and the credit card companies. A mechanism for assessing credit worthiness and a properly resourced system for assisting those who experience difficulties through using credit is needed. The social and economic consequences for consumers of the overuse of credit cannot be underestimated.