Fourth Quarter Reversals in Earnings Changes and Earnings Management

54 Pages Posted: 5 May 2002

See all articles by Somnath Das

Somnath Das

University of Illinois at Chicago

Pervin K. Shroff

University of Minnesota - Twin Cities - Carlson School of Management

Date Written: April 2002

Abstract

This paper investigates potential cases of earnings management by observing the pattern of quarterly earnings changes. We identify firms for which the sign of (seasonal) earnings changes observed in interim quarters reverses in the fourth quarter. We hypothesize that a firm performing poorly in interim quarters may attempt to increase earnings of the fourth quarter to achieve a desired annual earnings target, while a firm performing well in interim quarters may attempt to decrease earnings of the fourth quarter to build "reserves" for the future. Our results show that reversal of earnings changes in the fourth quarter is a common phenomenon and its occurrence is greater than would be expected by chance. Other indicators of earnings management, such as the size and direction of changes in fourth quarter accruals, reversals in subsequent earnings performance, and the use of special items in the income statement, suggest that firms with earnings reversals are more likely to have managed earnings than a control sample of nonreversal firms. Our results also indicate that the reversal firms may have debt-contracting and political costs-related incentives to manage earnings and a significant percentage of them may manage earnings to avoid reporting a decrease in annual earnings. Capital market participants and financial analysts both appear to attach lower credibility to earnings reported by the reversal samples. Our collective evidence leads us to suspect that fourth quarter reversals reflect earnings management behavior rather than some other phenomena, such as mean reversion of earnings or fourth quarter settling up.

JEL Classification: M41

Suggested Citation

Das, Somnath and Shroff, Pervin K., Fourth Quarter Reversals in Earnings Changes and Earnings Management (April 2002). Available at SSRN: https://ssrn.com/abstract=308441 or http://dx.doi.org/10.2139/ssrn.308441

Somnath Das

University of Illinois at Chicago ( email )

601 South Morgan Street
University Hall, Room 2303
Chicago, IL 60607
United States
312-996-4482 (Phone)
312-996-4520 (Fax)

Pervin K. Shroff (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-626-1570 (Fax)

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