Meet Earnings Benchmarks Research Articles

Understanding the 'Numbers Game'

We model the earnings management decision as the manager's tradeoff between the costs and the capital market benefits of meeting earnings benchmarks. We estimate the benefits and realized distribution of earnings using a regression discontinuity design, and use these estimates as inputs to our model. Estimated model parameters yield the percentage of manipulating firms, magnitude of manipulation, and noise in manipulated earnings. These estimates also provide sufficient statistics for evaluating various proxies for suspect firms. Finally, we use the Sarbanes-Oxley Act as an experimental setting and show that it succeeded in reducing earnings management by 36%, through an increase in costs. This occurred despite an increase in benefits, as the market rationally became less skeptical of firms just meeting benchmarks.

Social Desirability Bias and Earnings Management around the World

Abstract In this paper we test whether inter-country variation in individuals’ tendency to conform, as measured by the Lie (social desirability) scale used in the Eysenck Personality Questionnaire, can explain differences in the propensity to employ corporate earnings management around the world. Such a link is feasible, given that survey data suggest executives tend to be under severe pressure to meet earnings benchmarks, to which they often succumb by engaging in earnings management (to the detriment of the company’s long-term prospects). We hypothesize that in countries where the propensity to act in a socially desirable (outsider-satisfying) way is stronger, earnings management should be more prevalent. Research results support our hypothesis, and demonstrate the existence of a positive relationship between the prevalence of earnings management in a country and the mean score of individuals from that country on the Eysenck Lie scale, which further evidences that capital market pressure is a significant determinant of earnings management.

CFOs Gender and Real Earnings Management

Using accruals as a proxy for financial reporting quality, Peni and Vahamaa (2010) and Barua, Davidson, Rama, and Thiruvadi (2010) provide evidence that female Chief Financial Officers (CFOs) are more moral than male CFOs. Using 2,048 U.S. firm-year propensity score matching samples from 1997-2014, this stereotyped relationship is re-examined by empirically testing the likelihood of Real Earnings Management (REM) by female CFOs. Overall, the results show that female CFOs are, on average, 6% more likely to manipulate REM than male CFOs. One possible explanation for these results is that female CFOs face significant pressure (e.g., age, wage or diversity) and/or are motivated by earnings management incentives (e.g., avoiding reporting losses, meeting earnings benchmarks or beating analysts’ forecasts). The likelihood of REM by female CFOs is weakened after including pressure on female CFOs into the regression models. Surprisingly, the results suggest that female CFOs who beat analysts’ forecasts by more than one cent are less likely to manipulate REM. This latter result suggests that the documented association between female CFOs and REM might be triggered by poor firm performance. Further analysis suggests that while female CFOs are significantly associated with high firm performance, female CFOs who manipulate REM are significantly associated with low firm performance, especially cash flow from operations. This study contributes to prior literature on diversity, organizational behavior, and earnings management in several ways. It suggests that individual behaviors in organizations are more complex than they appear. Early childhood and heredity may not be valid structural determinants of organizational behavior.

How does earnings management influence investor’s perceptions of firm value? Survey evidence from financial analysts

Survey evidence shows CFOs to believe that earnings management can enhance investor valuation of their firms. This evidence raises the question of correspondence between the beliefs of CFOs and investors. Surveying financial analysts to gain insight into how earnings management influences investor perception of firm value, we find analysts’ and CFOs’ beliefs to be generally consistent. We find that analysts perceive meeting earnings benchmarks and smoothing earnings to enhance investor perception of firm value and all earnings management actions to reach a benchmark, save share repurchases, to be value destroying. CFOs, however, are reluctant to repurchase shares, preferring to use techniques viewed by analysts as value destroying (e.g., reductions in discretionary spending). Analysts’ inability to unravel such techniques perhaps explains CFOs’ preferences.

Tourist Flow and Earnings Benchmarks

This study examines the relationship between meeting earnings benchmarks and regional factors related to the hospitality industry. Our hypothesis assumes that the tourist flow in which a hotel is located influences the hotel’s performance, but it is not the same for all firms. Specifically, firms meeting earnings benchmarks, when it is documented that managers have strong incentives to engage in earnings management strategy, present a different relationship with regional tourist flow. The evidence suggests that regional tourist flow is associated with the corporate performance of firms but that there is an inflexion point for firms meeting earnings benchmarks.

The Influence of Strong Shareholders on Earnings Management

Presumably, shareholder rights aim to better align the actions of managers with the interests of shareholders; however, it is not clear from prior research whether such alignment mitigates or exacerbates managers’ propensity to manage earnings. We document that when shareholder rights are stronger, managers are more likely to manage earnings upward to meet analyst expectations or last year’s EPS. The greater propensity of firms with strong shareholder rights to manage earnings to meet earnings benchmarks is not consistent with the traditional expectation that shareholder rights serve as a governance mechanism to reduce what could be opportunistic reporting behavior. We further highlight the unique impact of shareholder rights for our sample by demonstrating that other traditional governance mechanisms (audit quality, institutional ownership, and board’s financial expertise) have the expected effect of reducing earnings management. Given recent demands to enhance shareholder rights, our study highlights an interesting and perhaps unexpected financial reporting consequence.

Why do pro forma and Street earnings not reflect changes in GAAP? Evidence from SFAS 123R

This study examines how key market participants—managers and analysts—responded to SFAS 123R’s controversial requirement that firms recognize stock-based compensation expense. Despite mandated recognition of the expense, some firms’ managers exclude it from pro forma earnings and some firms’ analysts exclude it from Street earnings. We find evidence consistent with managers opportunistically excluding the expense to increase earnings, smooth earnings, and meet earnings benchmarks but no evidence that these exclusions result in an earnings measure that better predicts future firm performance. In contrast, we find that analysts exclude the expense from earnings forecasts when exclusion increases earnings’ predictive ability for future performance and that opportunism generally does not explain exclusion by analysts incremental to exclusion by managers. Thus our findings indicate that opportunism is the primary explanation for exclusion of the expense from pro forma earnings and predictive ability is the primary explanation for exclusion from Street earnings. Our findings suggest the controversy surrounding the recognition of stock-based compensation expense may be attributable to cross-sectional variation in the relevance of the expense for equity valuation, as well as to differing incentives of market participants.

How Does Earnings Management Influence Investors’ Perceptions of Firm Value? Survey Evidence from Financial Analysts

Survey evidence shows CFOs to believe that earnings management can enhance investor valuation of their firms. This evidence raises the question of correspondence between the beliefs of CFOs and investors. Surveying financial analysts to gain insight into how earnings management influences investor perception of firm value, we find analysts’ and CFOs’ beliefs to be generally consistent. We find that analysts perceive meeting earnings benchmarks and smoothing earnings to enhance investor perception of firm value, and all earnings management actions to reach a benchmark, save share repurchases, to be value destroying. CFOs, however, are reluctant to repurchase shares, preferring to use techniques viewed by analysts as value destroying (e.g., reductions in discretionary spending). Analysts’ inability to unravel such techniques perhaps explains CFOs’ preferences.

Earnings Benchmarks en las empresas hoteleras internacionalizadas

This paper focuses on earnings management around earnings benchmarks (avoiding losses and earnings decreases hypothesis) in international firms and non international firms belonging to the Spanish hotel industry. First, frequency histograms are used to determine the existence of a discontinuity in earnings in both segments. Second, the use of discretionary accruals as a tool to meet earnings benchmarks is analysed in international and non international firms. Empirical evidence shows that international and non international firms meet earnings benchmarks. It is also noted different behaviour between international and non international firms.

Why Do Pro Forma and Street Earnings Not Reflect Changes in GAAP? Evidence from SFAS 123R

This study examines how key market participants — managers and analysts — responded to SFAS 123R’s controversial requirement that firms recognize stock-based compensation expense. Despite mandated recognition of the expense, some firms’ managers exclude it from pro forma earnings and some firms’ analysts exclude it from Street earnings. We find evidence consistent with managers opportunistically excluding the expense to increase earnings, smooth earnings, and meet earnings benchmarks, but no evidence that such exclusion results in an earnings measure that better predicts future firm performance. In contrast, we find that analysts exclude the expense from earnings forecasts when the exclusion increases earnings’ predictive ability for future performance, and opportunism generally does not explain exclusion by analysts incremental to exclusion by managers. Thus, our findings indicate that opportunism is the primary explanation for exclusion of the expense from pro forma earnings and predictive ability is the primary explanation for exclusion from Street earnings. Our findings suggest the controversy surrounding the recognition of stock-based compensation expense may be attributable to cross-sectional variation in the relevance of the expense for equity valuation, as well as to differing incentives of market participants.

Real and Accrual-Based Earnings Management: Can A Qualified Auditor Detect It?

This study examines whether management of public companies in Indonesia engage real earnings management to meet earnings benchmarks. This paper documents evidence consistent with firms committing real earnings management around earnings threshold for poor performing firms. Manager opportunistically utilize price discounts to temporarily increase sales, overproduction to report lower cost of goods sold, and reduction of discretionary expenditures to improve reported margins. Consistent with the conjecture of Roychowdhury (2006) and Cohen & Zarowin (2010) auditors find it more difficult to detect real earnings management than accrual-based earnings management. The results of this study indicate that drawing inferences about earnings management by analyzing only accrual manipulation is inappropriate. This study contributes to the accounting literature by presenting evidence on the real earnings management, which has received relatively little attention to date.

The Market Pricing of Special Items that are Included Versus Excluded From 'Street' Earnings

We re-investigate the market pricing of special items, with particular emphasis on how managers “frame” them via their inclusion or exclusion from “street” earnings. When managers include the special items in “street” earnings (i.e., “street” = GAAP), the market overprices them, believing the special items to be more persistent than they actually are. As a result, there is a negative relationship between the special items and future stock returns in the following year. However, when managers exclude special items from “street” earnings (i.e., “street” ≠ GAAP), the market recognizes their transitory characteristic and the relationship between special items and returns is insignificant in the following year. We also demonstrate that the decision to include (exclude) special items with (from) “street” earnings is associated with whether inclusion or exclusion of special items a) increases earnings numbers, b) smoothes the earnings series, or c) helps managers to meet earnings benchmarks.

The Relation Between Earnings Management Using Real Activities Manipulation and Future Performance: Evidence from Meeting Earnings Benchmarks*

Earnings management can be classified into two categories: accruals management and real activities manipulation (RM). Accruals management involves within generally accepted accounting principles (GAAP) accounting choices that try to ‘‘obscure’’ or ‘‘mask’’ true economic performance (Dechow and Skinner 2000). RM occurs when managers undertake actions that change the timing or structuring of an operation, investment, and ⁄or financing transaction in an effort to influence the output of the accounting system. Schipper (1989, 92) includes RM in her definition of earnings management and describes earnings management as ‘‘a purposeful intervention in the external financial reporting process, with the intention of obtaining some private gain...[a] minor extension of this definition would encompass ‘real’ earnings management, accomplished by timing investment or financing decision to alter reported earnings or some subset of it.’’ This paper examines the extent to which RM is associated with firms just meeting earnings benchmarks. Then, I examine the extent to which RM affects subsequent operating performance. Accruals management is not accomplished by changing the underlying operating activities of the firm, but through the choice of accounting methods used to represent those activities. In contrast, RM involves changing the firm’s underlying operations in an effort to boost current-period earnings. Both types of earnings management involve managers’ attempts to increase ⁄decrease earnings; however, one type affects operations and the

An analysis of the reasons for the asymmetries surrounding earnings benchmarks

Several studies report an asymmetry in the distribution of earnings around specified benchmarks. However, doubt has arisen over whether the observed ‘kink’ in the distribution of earnings is solely caused by earnings management. We use a ratio analysis approach to examine a range of specific accruals for evidence of earnings management. We find little evidence that firms immediately above the benchmark have abnormal receivables, inventories or provisions. However, they do increase cash-from-customers and reduce inventory. Thus, our results support the recent research that suggests that firms engage in real actions to meet earnings benchmarks.

Information Versus Strategic Reporting: Determinants of the Disclosure of Pro Forma Earnings by Large German Corporations

This paper investigates the determinants of firms’ decisions to disclose ‘pro forma’ earnings, voluntarily performance metrics, in a largely unregulated setting, the German capital market. For a sample of earnings releases published by large German firms, we address the role of informative and strategic motives for the disclosure of such voluntary performance metrics, and investigate effects of first-time IFRS adoption. Results indicate that incentives to meet earnings benchmarks play a significant role in the decision to disclose pro forma earnings and are positively associated with relative reporting emphasis assigned to these metrics. On the other hand, we find no evidence that firms use pro forma earnings to compensate for low quality of reported GAAP earnings. Consistent with an informative endeavor, voluntary adopters of IFRS are significantly less likely to use pro forma earnings disclosures and to assign reporting emphasis than mandatory adopters. Taken together, these results suggest that regulatory concern may be warranted, and point out the need for further capital markets based studies.

The effect of capital market pressures on the association between R&D spending and CEO option compensation

We examine the effect of capital market pressures for meeting earnings benchmarks on the relationship between R&D spending and CEO option compensation. We consider a particular scenario when firms face small earnings declines but could opportunistically reduce R&D spending to increase reported earnings. We find that firms with income reporting concerns punish their CEOs with lower option compensation when R&D spending increases but reported earnings decreases. Further, for firms with income reporting concerns, we find that the penalty for increasing R&D is greater when the firms frequently miss quarterly earnings benchmarks in the year. Overall, our findings suggest that the adverse consequence on CEO options encourages short-run compensation-motivated actions to eliminate or postpone R&D projects with positive net present values.

The use of advertising activities to meet earnings benchmarks: evidence from monthly data

Using a unique database of monthly media advertising spending, we examine whether managers engage in real earnings management to meet quarterly financial reporting benchmarks. We extend prior literature by (1) separately analyzing advertising activities, allowing us to explore the possibility that managers could reduce or boost advertising to meet benchmarks; (2) analyzing actual activities as opposed to inferring them from reported expenses, which are also subject to accrual choices; (3) investigating the timing, within a quarter, of altered advertising spending; and (4) examining quarterly earnings benchmarks. We find that managers, on average, reduce advertising spending to avoid losses and earnings decreases. However, we also report that firms in the late stages of their life cycle increase advertising to meet earnings benchmarks. Finally, we find some evidence that firms increase advertising in the third month of a fiscal quarter and in the fourth quarter to beat prior year’s earnings.

The Use of Advertising Activities to Meet Earnings Benchmarks: Evidence from Monthly Data

Using a unique database of monthly advertising spending in media outlets, we examine whether managers engage in real earnings management to meet quarterly financial reporting benchmarks. We extend prior literature by: (1) separately analyzing advertising activities, allowing us to explore novel issues such as the possibility that managers could either reduce or boost advertising to meet an earnings benchmark; (2) analyzing actual activities as opposed to inferring them from reported expenses, which are also subject to accrual choices; (3) investigating the timing, within a fiscal quarter, of altered advertising spending; and (4) examining quarterly as opposed to annual earnings benchmarks. Overall, we find that managers reduce their advertising spending to avoid losses and avoid earnings decreases. However, we also provide evidence that firms in the late stages of their life cycle choose to increase advertising to meet earnings benchmarks. Finally, we find some evidence that firms increase their advertising activities in the third month of a fiscal quarter and in the fourth quarter to meet or beat prior year’s earnings.

Stock Options, R&D, and the R&D Tax Credit

Two separate streams of research find evidence that firms decrease R&D spending to meet earnings benchmarks and that the R&D tax credit increases R&D spending. However, these studies do not consider stock option exercises by R&D employees that likely influence R&D spending decisions because they increase R&D tax credits without reducing reported earnings. This study extends both areas of research by incorporating R&D tax credits from stock option exercises into the R&D spending decision. We find evidence that firms reduce R&D spending by 0.46 percent of total assets to avoid earnings decreases, but R&D tax credits generated by stock option exercises offset this decrease by 16 percent on average and up to 42 percent for a fully taxable firm. The results of this study suggest that the tax benefits of R&D-related stock option exercises are important considerations in studies that investigate myopic R&D investment and in studies that investigate the effect of the R&D tax credit on R&D spending.

An Analysis of the Reasons for the Asymmetries Surrounding Earnings Benchmarks

Several studies report an asymmetry in the distribution of earnings around specified benchmarks. However, doubt has arisen over whether the observed ‘kink’ in the distribution of earnings is solely caused by earnings management. We use a ratio analysis approach to examine a range of specific accruals for evidence of earnings management. We find little evidence that firms immediately above the benchmark have abnormal receivables, inventories or provisions. However, they do increase cash-from-customers and reduce inventory. Thus, our results support the recent research that suggests that firms engage in real actions to meet earnings benchmarks.