Management by the Numbers: A Formal Approach to Deriving Informational and Distributional Properties of 'Un-managed' Earnings

Forthcoming in Journal of Accounting Research

Kenan Institute of Private Enterprise Research Paper No. 18-33

52 Pages Posted: 7 Nov 2018

See all articles by Thomas Hemmer

Thomas Hemmer

Rice University - Jesse H. Jones Graduate School of Business

Eva Labro

Kenan-Flagler Business School University of North Carolina

Date Written: October 9, 2018

Abstract

We explore the theoretical relation between earnings and market returns as well as the properties of earnings frequency distributions under the assumption that managers use unbiased accounting information to sequentially decide on real options their firms have and report generated earnings truthfully, with the market pricing the firm based on those reported earnings. We generate benchmarks against which empirically observed earnings-returns relations and aggregate earnings distributions can be evaluated. This parsimonious model shows a coherent set of results: reported losses are less persistent than reported gains, decision making diminishes the S-shaped market response to earnings and earnings relate to returns asymmetrically in the way documented by Basu (1997). Furthermore, the implied frequency distribution of aggregate earnings is neither symmetric nor necessarily single-peaked. Instead, it may exhibit a kink at zero and look similar to the plots reported by Burgstahler and Dichev (1997). However, within our model, none of these phenomena are due to reporting noise, bias or some undesirable strategic managerial behavior. They are the natural consequences of using past earnings as the basis for value increasing managerial decision making that in turn generates the future earnings on which future decisions will be based.

Keywords: Information for Decision Making, Decision Usefulness, Precision, Bias, Persistence, Earnings Management, Earnings Discontinuity

JEL Classification: M40, M41, D80, G14

Suggested Citation

Hemmer, Thomas and Labro, Eva, Management by the Numbers: A Formal Approach to Deriving Informational and Distributional Properties of 'Un-managed' Earnings (October 9, 2018). Forthcoming in Journal of Accounting Research, Kenan Institute of Private Enterprise Research Paper No. 18-33, Available at SSRN: https://ssrn.com/abstract=3263584

Thomas Hemmer

Rice University - Jesse H. Jones Graduate School of Business ( email )

6100 South Main Street
P.O. Box 1892
Houston, TX 77005-1892
United States

Eva Labro (Contact Author)

Kenan-Flagler Business School University of North Carolina ( email )

McColl Building
Chapel Hill, NC 27599-3490
United States
(919) 962-5747 (Phone)

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