Earnings Management to Achieve the Peer Performance Benchmark

Abstract

Other than three extensively researched earnings thresholds, avoiding earnings declines, avoiding negative earnings and avoiding negative earnings surprises (Burgstahler and Dichev 1997; Degeorge, Patel, and Zeckhauser 1999), peer performance is an additional threshold that is often mentioned in news reports, compensation contracts and analysts’ reports, while largely ignored in the academic research. Thus, I examine whether firms manage earnings to achieve peer performance. First, I examine accruals-based earnings management to achieve peer performance. The empirical results show that firms exhibit more income-increasing accruals management in the current year under the following situations: 1) when firms’ prior year performance is below that of their peer group; 2) when firms’ average performance over the prior two years is below that of its peer group; 3) when firms’ expected performance is below its peer group’s expected performance. In addition, firms with cumulative performance that is lower than that of its peer group through the first three quarters of the fiscal year exhibit more upward accruals management in the fourth quarter. Second, I investigate real activities manipulation to achieve peer performance. The empirical results show that that firms exhibit more income-increasing real activities manipulation in the current year under the following situations: 1) when firms’ prior year performance is below that of their peer group; 2) when firms’ average performance over the prior two years is below that of its peer group. Third, firms that are under pressure to achieve peer performance benchmarks tend to restate financial statements in subsequent years. Specifically, firms under the following four situations are more likely to restate current earnings in the future: 1) firm’s prior year performance is below that of its peer group; 2) firm’s average performance over the prior two years is below that of its peer group; 3) firm’s expected performance is below that of its peer group; and 4) firm’s cumulative performance for the first three fiscal quarters is below that of its peer group. The influence of peer performance on earnings management behavior implies that relative performance evaluation can induce income-increasing earnings management and subsequent restatements.