Earnings Management Strategies for Meeting or Beating Expectations
Posted: 16 Nov 2020
Date Written: May 12, 2011
In this study, we dispel several popular notions regarding the meeting or beating expectations/thresholds (MBE) phenomenon that permeates the research design of many empirical papers. First, MBE is not unequivocally associated with aggressive earnings management. Second, MBE does not necessarily obfuscate the truth. Third, MBE may be consistent with the well-documented reporting strategy of smoothing. Specifically, we characterize the reporting strategy of firms that engage in MBE in a two-period game. Some firms value MBE in the first period more than in the second (short-run firms), and other firms are less concerned with missing a threshold in the first period but must meet or beat expectations in the second (long-run firms). The analysis yields additional insights: we also show that MBE, by a small amount, is driven by the demand for a truth-revealing report, since the extremely small margin is designed to vary with the truth. In addition, MBE explains the richness of the menu of reporting strategies (“taking a bath,” “cookie-jar reserve,” and marginal threshold beating). Moreover, MBE is good news when the firm is a long-run MBE firm because it signals that the firm will also meet or beat expectations in the future. Finally, MBE has a favorable economic effect, as it induces boards of directors to incentivize managers to expend more effort.
Keywords: Meeting or Beating a threshold, Earnings management, Repeated principal-agent contract, Smoothing, Taking a bath, Cookie-jar reserve
JEL Classification: M41, M49, G39, D81, D82
Suggested Citation: Suggested Citation