Quarterly Earnings Patterns and Earnings Management

51 Pages Posted: 26 Apr 2007

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

Haiwen Zhang

University of Minnesota

Date Written: April 2007

Abstract

This paper investigates whether the pattern of quarterly earnings changes provides a signal of earnings management. 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 discretionary accruals, reversals in subsequent accruals, the use of special items in the income statement, and adjustment of R&D spending, suggest that firms with earnings reversals are more likely to have managed earnings than industry and performance matched control firms. The capital market appears to attach lower credibility to earnings reported by the reversal samples. Our collective evidence leads us to suspect that fourth-quarter reversals on average reflect earnings management behavior. We recommend that analysts use earnings reversals as a heuristic to detect potential cases of earnings management in conjunction with other indicators, such as the magnitude of discretionary accruals. We further find that firms in the reversal samples significantly overlap with the sample of firms reporting small profits and small EPS increases. These results provide an interesting insight - that at least one-fourth of the sample of firms that meet or just beat earnings targets are attempting to smooth annual earnings by managing earnings downward in the fourth quarter.

JEL Classification: M41, M43, G12, G29

Suggested Citation

Das, Somnath and Shroff, Pervin K. and Zhang, Haiwen, Quarterly Earnings Patterns and Earnings Management (April 2007). Available at SSRN: https://ssrn.com/abstract=982642 or http://dx.doi.org/10.2139/ssrn.982642

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)

Haiwen Zhang

University of Minnesota ( email )

3-122 Carlson School of Management
321-19th Avenue South
Minneapolis, MN 55455
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
881
Abstract Views
3,881
rank
25,638
PlumX Metrics