Earnings Management to Exceed Thresholds Summary

Earnings Management to Exceed Thresholds

Earnings are important information for investment decisions.
Analysts, investors, senior executives, and boards of directors consider earnings the most important item in financial reports.
In the medium to long term (1-10 years), returns to equities are overwhelmingly explained by cumulative earnings.
Executives have strong incentives to manage earnings due to monitoring by investors, directors, customers, and suppliers.
The article introduces the concept of behavioral thresholds for earnings management.
A model shows how thresholds induce specific types of earnings management.
Empirical explorations identify earnings management to exceed three thresholds:
- Report positive profits.
- Sustain recent performance.
- Meet analysts’ expectations.
The positive profits threshold is predominant.
The future performance of firms boosting earnings just across a threshold is poorer than that of control group firms.

Earnings are an important explanatory factor for short-term equity returns.
Rewards for senior executives (employment decisions and compensation) depend on earnings.
Executives have considerable discretion in determining the earnings figure.
Within GAAP, executives have flexibility in:
- Choosing inventory methods.
- Allowance for bad debt.
- Expensing of research and development.
- Recognition of sales not yet shipped.
- Estimation of pension liabilities.
- Capitalization of leases and marketing expenses.
- Delay in maintenance expenditures.
Executives can defer expenses or boost revenues (e.g., by cutting prices).
Executives have both the incentive and ability to manage earnings.
The popular press frequently describes companies as engaged in earnings management (manipulation).

Earnings Management (EM) is defined as the strategic exercise of managerial discretion in influencing the earnings figure reported to external audiences.
It is accomplished principally by timing reported or actual economic events to shift income between periods.
The article sketches a model predicting how executives strategically influence earnings figures.
- It examines historical data to confirm these patterns.
The model incorporates behavioral propensities and interactions among executives, investors, directors, and earnings analysts.
The goal is to identify EM patterns that generate specific discontinuities and distortions in the distribution of observed earnings.
The study does not determine which components of earnings or supplementary disclosures are adjusted.
It doesn’t distinguish empirically between “direct” EM (strategic timing of investment) and “misreporting” (discretionary accounting).

Three thresholds that drive EM are identified:
- Reporting positive profits (e.g., 1 penny a share).
- Sustaining recent performance.
- Meeting analysts’ earnings projections.
Performance relative to each benchmark is assessed by examining quarterly earnings reports in its neighborhood.
A big jump in density at the benchmark demonstrates its importance.
Burgstahler and Dichev (1997) examine the management of earnings to meet the first two thresholds, identifying the “misreporting” mechanisms that permit earnings to be moved from negative to positive ranges.
The article considers direct EM (lowering prices to boost sales) in addition to misreporting, providing an optimizing model and analyzing the consequences for future earnings.
It explores EM as the executive’s response to steep rewards that depend on meeting a bright threshold.
Finally, it looks at the hierarchy among the thresholds.

Earnings management arises from the game of information disclosure between executives and outsiders.
Investors base decisions on information from analysts and published earnings announcements.
To bolster investor interest, executives manage earnings, despite the real earnings sacrifice.
Other parties (boards of directors, analysts, accountants) participate, but their choices are exogenous to the analysis.
Boards' actions are known to executives, and pay packages are structured to account for distorting possibilities.
Finding evidence of management is thus more significant.
Executives may distort earnings reports in a self-serving manner, imposing an agency loss.
Full alignment of incentives is unlikely due to the executive's shorter time horizon.
Stock options help extend the time horizon for executives.
Compensation is linked to earnings and stock price performance.
Executives manage earnings upward to avoid termination or lost bonuses.
When bonuses are near maximum, there is an incentive to shift earnings forward.
Executives may be reluctant to report large gains because performance targets will be ratcheted up.
Poor earnings may also be shifted to the future.