Evidence on the Management of Earnings Components

Abstract

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.

Why Do Companies From Emerging Countries Manage Earnings?

“…This earnings management behavior will result in a high incidence of reported earnings that meet or slightly exceed market expectations (Plummer and Mest, 2001). In contrast, when a firm is regarded as a poor investment, it has little to gain from managing earnings up and has little to lose if it reports low earnings (i.e., the firm is already regarded as a poor investment).…”

“…In contrast, when a firm is regarded as a poor investment, it has little to gain from managing earnings up and has little to lose if it reports low earnings (i.e., the firm is already regarded as a poor investment). These poor-investment firms have incentives to decrease reported earnings and create accounting slack for the future (Plummer and Mest, 2001).…”

The Usefulness of Measures of Consistency of Discretionary Components of Accruals in the Detection of Earnings Management

“…They model separately the components of accruals and special items, and test the difference between the levels of discretionary components in the test firms versus some control firms. However, they use accruals data from the balance sheet and not from the cashflow statement 5 Plummer and Mest (2001). follow the methodology set by Burgstahler and Dichev (1997) to examine the distribution of different components of earnings for a sample of firms that they believe are managing earnings upwards.…”

“…Limited prior research that identifies EM in components of accruals further corroborates this manipulation behavior. For example, Plummer and Mest (2001) find that, in a sample of firms that they believe are managing earnings upwards, manipulation is achieved through managing both sales upwards and managing operating expenses downwards 3…”

Method‐Shifting in Aggressive Earnings Reporting: The Case of the US Software Industry's Response to New US Regulation

“…Kane (1977 and 1981), an authority in the field of banking, expressed the general belief that bank managers method‐shift to avoid or circumvent US banking regulation. Burgstahler and Dichev (1997), Plummer and Mest (2001) and Marquardt and Wiedman (2004) argue that managers’ choice of methods to improve reported earnings depends on the cost and benefit of manipulating alternative earnings components. The hypothesis of method‐shifting has empirical research support.…”