Earnings Management? Alternative Explanations for Observed Discontinuities in the Frequency Distribution of Earnings, Earnings Changes, and Analyst Forecast Errors

Abstract:     
The discontinuities at zero in the frequency distributions of reported net income (deflated by beginning-of-period market capitalization), deflated change in net income, I/B/E/S "actual" earnings, and analysts' forecast errors are the most widely cited evidence of earnings management. We provide evidence consistent with alternative explanations for each of these discontinuities. We show that firms reporting small losses are priced significantly differently from firms that report small profits. An effect of this difference in pricing is that earnings to the left of zero are deflated by significantly different denominators than earnings to the right of zero inducing a discontinuity in the distributions of deflated net income and deflated changes in net income at zero. We also show that sample selection criteria may contribute to the discontinuity in these distributions as well as the discontinuity in I/B/E/S actual earnings. Finally, the presumption in the literature which focuses on the discontinuity at zero in the distribution of analysts' forecasts errors is that earnings are managed to meet or beat analysts' forecasts. We provide an alternative explanation: the discontinuity is caused by the fact that analysts' forecast errors tend to be much greater when the forecasts are optimistic than when they are pessimistic. This tendency leads to more small positive forecasts errors (pessimistic forecasts) than small negative forecast errors (optimistic forecasts).

Number of Pages in PDF File: 58

Keywords: Earnings management, thresholds, earnings discontinuity, scaling

JEL Classification: G14, G29, G30, H30, M41, M43

working papers series