Although recent studies provide convincing evidence that firms manage earnings to achieve certain reporting objectives, there is only limited evidence on what steps firms take to manage their earnings. This paper presents evidence as to which components firms use to manage bottom-line, reported earnings. Specifically, we identify a set of firms believed to be managing earnings upward; plot the empirical distributions of analysts' forecast errors for sales, operating expenses, nonoperating expenses, and depreciation expense; and then examine these distributions for discontinuities around zero. Results suggest that these firms managed earnings upward by managing sales upward and by managing operating expenses downward. There is no evidence to suggest that these firms managed nonoperating expenses or depreciation expense to affect earnings. We then identify firm characteristics (level of current assets, level of current liabilities, and operating margin percentage) that affect the likelihood that these firms used a specific component to manage earnings. Finally, we use a firm's stock recommendation to make predictions about its incentives to manage earnings. Our evidence suggests that firms rated buy (rated sell) manage earnings upward (downward) by managing sales, operating, and nonoperating expenses in predictable directions.
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