Earnings Benchmarks Research Articles

Loss aversion and financial reporting: A possible explanation for the prevalence of discontinuities in reported earnings

We formalize the notion, first suggested by Burgstahler and Dichev (1997), that earnings discontinuities can be caused by reference dependence. We extend the signaling model by Guttman et al. (2006) to include loss-averse investors. The presence of loss aversion causes the separating equilibrium (without discontinuities in the distribution of reported earnings) to disappear, while the partially-pooling equilibrium (exhibiting discontinuities) may prevail. This implies that the presence of loss-averse investors will cause earnings discontinuities around reference points. The prime candidates for investors’ reference points are earnings benchmarks such as zero earnings, last year’s earnings and analyst forecasts. Our model provides an explanation for why earnings discontinuities appear around earnings benchmarks.

Earnings management and tone management: evidence from FTSE 350 companies

PurposeThis paper aims to examine whether firms meeting or just beating an earnings benchmark engage in tone management in earnings conference calls to complement earnings management in the UK context. It also investigates whether the audience tone in beating or just meeting earnings fails to predict future performance.Design/methodology/approachThis study was performed using a sample of non-financial UK firms listed in the FTSE 350 index over the period 2010–2015.FindingsThe findings show that firms that exercise more earnings management to meet or just beat earnings are positively associated with the abnormal tone during earnings conference calls. The outcomes also reveal that the audience’s tone of firms meeting or just beating an earnings benchmark fails to predict future performance. This confirms the effectiveness of the tone management in managing the perception of audience.Practical implicationsThis study highlights the need for increased accountability by firms on earnings conference call. It also supports academics and practitioners in understanding the management discretion used in reporting and communication during the earnings conference call. Overall, the results of this study are beneficial for regulators, policymakers and professionals, regarding confirming the need for the earnings conference calls to be regulated.Originality/valueTo the best of the authors’ knowledge, this is the first study that examines the association between earnings management and tone management in the UK earnings conference calls. It adds to the existing literature by examining the self-serving behaviour of managerial tone during earnings conference calls within a sitting in which meeting or just beating a benchmark is used. Unlike several studies that explain the behaviour of tone as a signalling strategy, this study reveals that the tendency of impression management behaviour can explain the tone management.

Internally generated intangible assets valuation: debate and literature review

This article contains a literature review around the issue of managerial discretion when deciding if and how much of an internally developed intangible asset’s development cost is to be capitalized. The interaction between earnings management and development cost capitalization is mentioned and the underlying factors, such as beating earnings benchmarks and meeting debt-covenants are discussed. In a nutshell, the trade-off between the additional informativeness offered to investors through signaling and the probability of managerial opportunistic behavior is debated. The results indicate that some degree of opportunism exists, intending mainly to beat analysts’ earnings forecasts. However, the market participants tend to identify such behaviors and thus adapt their equity price valuations. Also, the market value relevance varies depending on the entities’ origin, previous intangible project success or failure track record and intangible asset intensity.

Abnormal audit fees and audit quality: Australian evidence

We examine the association between abnormal audit fees and audit quality using Australian data. We find that audit quality, measured by auditors’ propensity to issue going concern opinions for financially distressed companies, discretionary accruals, and clients’ propensity to meet or beat earnings benchmarks, declines as positive abnormal audit fees increase in magnitude. Our findings support an economic bonding argument that positive abnormal audit fees reflect the extent of economic bonding between the auditor and the client. We also find that negative abnormal audit fees are negatively associated with the absolute value of discretionary accruals. Our findings suggest that academic researchers, practitioners, regulators, and others interested in assessing the effect of auditor remuneration on auditor independence and audit quality should be concerned with audit fees that are above a normal level rather than audit fees that are below a normal level of audit fees. JEL Classification: M42, M49

The spillover effect of shareholder activism: Evidence on firm reporting

This study examines the spillover effect of shareholder activism against target firms on financial reporting by non-target firms in portfolios held by the same activist shareholders. We find that firms that are not the target of institutional shareholders’ activism campaigns report more positive abnormal accruals. Cross-sectional tests indicate that the effect is more pronounced i) for firms that have more opportunities to engage in upward earnings management, or for firms with less effective alternative monitoring forces, and ii)when investors are more sensitive to good news. We also find that the effect is stronger when activist shareholders are more experienced, are waging more confrontational campaigns against target firms, and have larger holdings in non-target firms. We further find that non-target firms tend to report lower magnitude of asset write-downs, are more likely to restate financial statements and meet or beat earnings benchmarks, and exhibit a more optimistic tone in their 10-K/10-Q filings. Overall, our findings suggest that firms tend to window-dress their mandatory reporting to preempt possible shareholder activism against them.

Do Firms Time Changes in Accounting Estimates to Manage Earnings?†

ABSTRACTPrior earnings management research often focuses on specific accounts or on estimations of discretionary accruals but provides only limited insight into the methods firms actually use to manage earnings. In order to begin exploration of some of the operational details regarding how earnings are managed, we investigate whether firms time their decisions to make changes in accounting estimates (CAEs) in consideration of their earnings benchmarks. Using CAE data across all accounts from 2006 to 2018, we find that 28.1% of income‐increasing CAEs are implemented in quarters where pre‐CAE earnings are below a forecasted earnings benchmark but inclusion of the CAE effectively allows the firm to meet the benchmark. We find that income‐increasing CAEs are more likely implemented when a firm's pre‐CAE earnings are further below the benchmark. We also find that firms are more likely to implement income‐decreasing CAEs under two scenarios: (i) when pre‐CAE earnings are relatively high, as a way either to smooth earnings or to “bury bad news,” and (ii) when pre‐CAE earnings are already low, as a way to take a financial “big bath” and position the firm for positive future earnings. In addition, we present evidence that firms using CAEs to achieve an earnings benchmark face financial consequences in terms of poorer immediate stock price performance and subsequent return on assets. Our conclusions hold after performing several additional analyses, including consideration of other discretionary options, addressing endogeneity concerns, and conducting falsification tests. In sum, we contribute to the earnings management literature by presenting consistent evidence that firms appear to time CAEs to meet earnings benchmarks or achieve other reporting objectives.

Earnings management through financing activities: Evidence from early debt extinguishments

AbstractWe investigate whether early debt extinguishments, a financing activity, are used to manage earnings after the introduction of SFAS No. 145 in 2002. This standard changes the reporting rules of gains and losses from early debt extinguishments, which are now included in income from continuing operations. This shift in reporting rules provides firms with a potential opportunity to manage income from continuing operations, which is valued more by investors than below the line items. We hypothesize and find that gains from early debt extinguishments are positively associated with the magnitude of shortfall from earnings benchmarks and the propensity to meet or beat earnings benchmarks after the adoption of SFAS 145. Thus, our findings suggest unintended consequences of the SFAS No. 145, which may have implications for policy makers.

Overseeing the External Audit Function: Evidence from Audit Committees' Reported Activities

SUMMARYRecently, in response to calls for more transparency, many firms have begun reporting the activities undertaken by their audit committees in overseeing the work of the external auditor. We use a composite measure of audit committees' reported oversight activities for a sample of S&P 1500 firms and examine the extent to which these reported activities are associated with audit quality. We find that when firms' audit committees report exerting strong oversight, they have higher audit quality as proxied by audit fees, discretionary accruals, the likelihood of meeting or beating earnings benchmarks, and restatements. We also find that the market reacts positively to reports indicating strong oversight, consistent with perceptions of higher audit quality. This study extends prior literature on audit committees by introducing a new comprehensive measure of audit committees' reported oversight activities and sheds light on how these activities map into audit quality.JEL Classifications: M41; M42; G18.

Corporate social responsibility and non-GAAP reporting

ABSTRACT This study examines the relationship between a firm’s corporate social responsibility (CSR) performance and non-GAAP earnings disclosure. I find that firms with good CSR performance (i.e. CSR firms) are more likely to disclose non-GAAP earnings than firms with poor CSR performance (i.e. non-CSR firms). More importantly, I find that CSR firms provide more informative non-GAAP earnings than non-CSR firms. Furthermore, CSR firms’ decisions to disclose non-GAAP earnings are less affected by the incentives to meet earnings benchmarks or constraints on other earnings management tools. These findings are consistent with the notion that CSR firms communicate with stakeholders about their sustainable earnings through non-GAAP reporting.

Does shared tenure between audit committee chair and engagement partner affect audit outcomes? Evidence from the UK

Social psychology literature suggests that shared working experience between individuals affects the way in which they communicate, interact and exchange information. Given that the relationship between audit committee (AC) and engagement partner (EP) involves extensive interactions and information sharing with the aim to protect the integrity of financial statements, this study examines whether the co-tenure relationship between the person who leads the AC (audit committee chair (ACC)) and EP affects audit outcomes. Using 234 UK non-financial companies, we find that longer co-tenure between ACC and EP improves accruals quality and reduces the propensity to meet or beat the earnings benchmark. Moreover, we do not find a significant relationship between ACC–EP shared tenure and audit fees, alleviating the concern that ACC–EP shared tenure could lead to collusion or inappropriate favoritism towards the EP regarding audit fees. Our findings offer a valuable contribution to the literature, practice, and regulators.

Corporate social responsibility and classification shifting

This study examines the relation between corporate social responsibility (CSR) and firm behavior to misclassify core expenses as special items in the income statement to inflate core earnings (i.e., classification shifting). We find that firms with good CSR performance (high-CSR firms) are less likely to engage in classification shifting than firms with poor CSR performance (low-CSR firms). We also find that high-CSR firms engage in less classification shifting even when they have greater incentives to meet earnings benchmarks. Overall, our results are consistent with the notion that socially responsible firms behave ethically in financial reporting.

Do auditors react to real earnings management?

Prior research has documented an association between audit effort and real earnings management [REM]. Specifically, audit report lags have been shown to be positively associated with REM. We investigate the auditor and firm characteristics underlying this association. Our results indicate that overall, REM is associated with longer abnormal audit report lags [ARLs]. We find, however, that this association is driven largely by non-accelerated filers. This result holds for both suspect firms (those firms just meeting earnings benchmarks) and non-suspect firms, for specialist as well as non-specialist auditors, and for profit as well as loss firms. Together our results indicate that when auditors are not constrained by the time pressure of accelerated filing, encountering REM is associated with greater audit effort. Our results may indicate, however, that with respect to accelerated filers, abnormal ARLs may be an imperfect proxy for additional effort. These results have implications for both future research and for the impact of accelerated filing deadlines on audit quality.

MANDATORY JOINT AUDIT AND AUDIT QUALITY IN THE CONTEXT OF THE EUROPEAN BLUE CHIPS

This study investigates audit quality under joint and single audit regimes with a sample of large European firms. Both, the economic relevance of these companies, and the fact that the impact of joint audit on audit quality should be stronger when the audited company is a blue-chip firm motivate the study. If mandatory joint audit were positively associated with audit quality, French firms, under mandatory joint audit since 1966, should present higher audit quality compared to their European peers. The results do not indicate this to be the case. Specifically, similar levels of discretionary accruals are observed for French and other European firms. Furthermore, for the first time in the literature, evidence is reported indicating that French firms may even present lower audit quality than their European peers, when audit quality is measured by the likelihood of just beating earnings benchmarks. These results are expected to inform the ongoing debate in several countries about joint audits.

Analyst Revenue Forecasts and Firm Revenue Misstatements

Earnings and revenue are ranked as the two most important performance measures reported to outsiders. However, prior literature primarily focuses on management’s incentives and willingness to manipulate earnings to meet earnings benchmarks. Increasingly, analysts are releasing forecasts of financial items in addition to aggregate earnings, with revenue forecasts being the most common. We posit that management may be under similar pressure to meet revenue forecasts given their impact on firm value. As such, we examine whether analyst revenue forecasts aggravate revenue misstatements. We find that revenue misstatements are positively associated with revenue forecasts and the association is more pronounced when beating revenue forecasts is more important. We also show that several characteristics of revenue forecasts aggravate management pressure and thus the likelihood of revenue misstatements. Further analyses suggest that firms use accruals management rather than real earnings management to inflate reported revenue. Our findings may be useful to academics, investors, and regulators in examining the relationship between analyst revenue forecasts and firms’ financial reporting behavior.

Earnings Benchmarks and Enterprises’ Expenditure Manipulation：Evidence from Advertising Expenditures

Under the background of the new economic era, great changes have taken place in the business environment faced by enterprises. The business model of enterprises is changing from the “product-centered” model to the “customer-centered” model. In this trend, brand capital has become an essential factor for enterprises to form core competitiveness. As a long-term investment in brand, with the transformation of enterprise business model, the importance of advertising expenditures in enterprise brand building and value promotion is becoming increasingly prominent. Advertising expenditures are generally the research topic in the field of marketing. This paper extends it to the research field of accounting and corporate finance, trying to take advertising expenditures as the research object, uncover the “black box” of enterprise expense manipulation, and explore the enterprise expense manipulation behavior under different earnings benchmarks（avoiding a loss, avoiding an earnings decline, meeting analysts’ earnings forecasts）. And on this basis, we further explore the cross-sectional differences of advertising expenditure manipulation between different enterprises. The results show that enterprises will try to achieve the goal of avoiding a loss by cutting advertising expenditures. However, there is no evidence on enterprises’ advertising expenditure manipulation under the goal of avoiding an earnings decline or meeting analysts’ earnings forecasts. The above conclusions remain unchanged under various robustness tests. Further, the research on the cross-sectional differences of advertising expenditure manipulation to avoid a loss shows that advertising expenditure manipulation is more significant in enterprises with higher advertising expenditure intensity, shorter listing time, analyst tracking and lower tax rate. This paper not only makes a preliminary study on advertising expenditure manipulation in China’s capital market, explores whether advertising expenditures will be used as a means of earnings management under a variety of earnings benchmarks, enriches the academic literature in the field of expenditure manipulation in earnings management, and is helpful to understand the relationship between earnings benchmarks and expenditure manipulation; but also makes a thorough study on the cross-sectional differences of advertising expenditure manipulation under earnings benchmarks, which is helpful to reveal the mechanism behind the expenditure manipulation behavior, and has reference value and enlightenment significance to the subsequent scholars’ research in related fields. In addition, the conclusions of this paper can not only enlighten the participants and regulators of capital market in policy, but also have reference value to understand the relationship between earnings benchmarks and expenditure manipulation in practice.

The Relationship between Earnings Benchmarks and Earnings Management across the Stages of a Listed Egyptian Firm’s Life Cycle

The Relationship between Earnings Benchmarks and Earnings Management across the Stages of a Listed Egyptian Firm’s Life Cycle

Short-Termism Spillovers from the Financial Industry

Abstract To meet short-term benchmarks, lenders may alter their monitoring behavior, providing a channel for short-termism to spill over to their borrowers. We find that short-termist lenders are significantly more likely to enforce covenant breaches. This behavior is pronounced when performance benchmarks are precise or salient, and when managers have high pay-performance sensitivity, but not when they face strong shareholder governance. Affected borrowers are more likely to switch lenders, pay higher spreads on renegotiated loans, and reduce investment. Our findings suggest that bank managers trade off relationship capital for income-boosting fees and term changes from covenant enforcement to meet earnings benchmarks.

Real earnings management through syndicated lending

I examine whether banks manage syndicated loan originations to achieve financial reporting goals. Using a large sample of loans and relying on a within-quarter analysis, I find that publicly traded banks that narrowly beat earnings benchmarks initiate more loans in the last month of the fiscal quarter to book origination fees. Relative to otherwise similar loans, these loans are associated with front-end fees that are 4.2% higher but have credit spreads that are 3.3% lower, resulting in a net price discount of 2.5%. The findings are stronger for bigger banks, for lenders that are funding-constrained, and for banks whose managers’ pay is more sensitive to stock performance. Further, these loans underperform in terms of future defaults and rating downgrades. Finally, I find that while the hypothesized earnings management helps banks raise capital in the short term, it is costly in the longer term, as it is associated with lower capital and profitability ratios. Overall, I provide model-free evidence on banks’ real earnings management and the costs of this behavior.

Financial Distress, Earnings Benchmark and Earnings Management Practices

Prior research exhibits contradictory evidence on earnings management practices, both accrual and real, undertaken by the firms in state of financial distress. This study uniquely examines the issue in the presence of earnings-increasing earnings management motivation- meeting earnings benchmark of avoiding losses. For examining the issue, this study analyzes large panel data of Indian public companies for the period 2000–2016. The findings indicate prevalence of earnings-decreasing real earnings management practices, that is, decrease in overproduction and increase in spending on discretionary expenses, in financially distressed firms despite there being motivation to increase earnings to avoid losses. No evidence of accrual earnings management practices has been observed in such firms.

What's my target? Individual analyst forecasts and last-chance earnings management

Kirk, Reppenhagen, and Tucker (2014) find that investors use individual analyst forecasts as additional earnings benchmarks. We investigate whether executives manage earnings to beat these individual benchmarks. Using year-end effective tax rate (ETR) manipulation as our setting, we find that firms decrease ETRs from 3rd to 4th quarter to meet or beat a greater percentage of individual forecasts. We also find some evidence that firms use incremental ETR changes to meet forecasts by key analysts. After controlling for the distance to the nearest forecast, our evidence shows that firms are more likely to beat an incremental forecast with a decrease in ETR compared to missing an incremental forecast with an increase in ETR. Our study highlights the strategic nature of earnings management by providing evidence that managers consider individual forecasts to calibrate earnings management decisions.