Quarterly Earnings Patterns and Earnings Management.pdf

contemporary accounting research vol 26 no 3 fall 2009 pp 797 831 caaa doi 10 1506 car 26 3 7 quarterly earnings patterns and earnings management somnath das university of illinois at chicago pervin k shroff university of minnesota haiwen zhang the ohio state university 1 introduction empirical evidence suggests that fi rms manage earnings to avoid reporting losses or earnings decreases or to meet analysts expectations 1 if fi rms manage earnings to meet or beat a target number adjustments to earnings are likely to be made when the excess or shortfall from the target becomes known hence the timing of manipulation is likely to be a critical distinguishing feature that could provide a means to detect such target management behavior consistent with this view investment experts caution investors to watch out for late year surges in revenues and earnings which they regard as telltale signs of earnings manipulation articles in the business press dating back to the 1990s cite cases of technology companies reporting disproportionate increases in revenues and earnings in the fourth quar ter 2 in this paper we exploit the timing constraint on a fi rm s ability to manage to a target and examine whether the pattern of quarterly earnings can provide an indi cation of potential earnings management although anecdotal evidence of late year adjustments to earnings is ample large sample empirical evidence of the prevalence of this phenomenon and whether it in fact refl ects earnings management is relatively sparse dhaliwal gleason and mills 2004 fi nd that fi rms engage in last chance earnings manage ment by adjusting their effective tax rates from the third to the fourth quarters to meet or just beat annual earnings targets in relation to target management jacob and jorgensen 2007 and kerstein and rai 2007 examine distributions of earn ings measured over varying cumulation periods and fi nd evidence consistent with accepted by jeffrey callen an earlier version of this paper was presented at the 2007 contemporary accounting research conference generously supported by the canadian institute of chartered accountants we thank jeffrey callen associate editor two anonymous reviewers christine wiedman the car conference discussant mary ellen carter john dickhaut ranjan d mello peter easton stuart gillan dan givoly bob hagerman chandra kanodia jack kareken s maheswaran morton pincus bal radhakrishna judy rayburn douglas schroeder tom stober jaeyoung sung ram venkataraman terry warfi eld baohua xin and participants of seminars at suny buffalo university of minnesota george mason university university of cincinnati 2007 contemporary accounting research conference 1999 american accounting association national conference 1999 financial management association conference 2000 financial eco nomics and accounting conference and the securities and exchange commission offi ce of economic analysis for helpful discussions and comments 798contemporary accounting research car vol 26 no 3 fall 2009 earnings management efforts concentrated at the fi scal year end to meet or beat annual targets relying on prior anecdotal and empirical evidence of late year earnings management we examine fi rms that have experienced a reversal in the pattern of their quarterly earnings changes a fi rm performing poorly in interim quarters may attempt to increase earnings of the fourth quarter to achieve a desired level of annual earnings whereas a fi rm performing well in interim quarters may attempt to decrease earnings of the fourth quarter to build reserves for the future 3 specifi cally we hypothesize that a fi rm is more likely than others to have managed year end earnings upward if it reports bad news in interim quarters and good news in the fourth quarter on the other hand a fi rm is more likely than others to have managed year end earnings downward if it reports good news in interim quarters and bad news in the fourth the overarching objective of our study is to examine whether the pattern of quarterly earnings can potentially serve as an indicator of earnings management first we determine how prevalent the fourth quarter earnings reversal phenome non is in general second we test whether other indicators corroborate that this phenomenon refl ects earnings management behavior and assess the validity of competing explanations such as mean reversion of quarterly earnings or a change in the settling up of interim accruals in the fourth quarter third we examine whether investors perceive a fourth quarter reversal as a sign of earnings manage ment and undo the effect of the reversal when valuing a fi rm our focus on potential earnings management in the fourth quarter implicitly suggests that managers have greater incentives to manage annual rather than quar terly results in support of our assumption most accounting based performance measures used in bonus and compensation schemes are based on audited annual earnings rather than on unaudited quarterly earnings also if capital market partic ipants perceive audited annual earnings as more credible than interim earnings they may place a higher value on annual earnings providing managers with stronger incentives to manipulate annual earnings thus although managers may have greater opportunities to manipulate interim earnings because of the absence of an independent audit their incentives to manage earnings in interim quarters may be weaker the vast literature on earnings management relies on an accrual expectation model to estimate abnormal or discretionary accruals empirical studies typically identify a sample for which the direction of earnings management is predicted and then test whether the abnormal accruals of the sample suspected of earnings manage ment are higher or lower than some benchmark the inherent diffi culty in modeling accruals leads to model misspecifi cation and low power tests resulting in serious inference problems 4 thus there appears to be a need to explore alternative approaches to detect earnings management if quarterly earnings reversals indeed refl ect earnings management behavior this approach can potentially provide us with an alternative detection tool examin ing earnings patterns of a fi rm over time avoids the specifi cation of expected or normal accruals this quarterly time series approach uses a fi rm as its own control and can be used to detect earnings management by any fi rm including those where quarterly earnings patterns and earnings management799 car vol 26 no 3 fall 2009 the motivation to manage is not obvious of course a limitation of this approach is that it is useful only in detecting cases where fi rms time the earnings management effort 5 we fi nd that reversals in fourth quarter earnings are a frequent occurrence in our sample our results show that 11 3 percent of the sample report negative to positive earnings changes np and 11 2 percent report positive to negative earnings changes pn from the interim to the fourth quarters we test whether the observed frequency of fourth quarter reversals is signifi cantly higher than expected we use a sequence of four quarters with randomly designated interim and fourth quarters and different sequences of four quarters ending in a quarter other than the fi scal fourth quarter as alternative benchmarks for the expected frequency of reversals on the basis of these benchmarks we fi nd that the occurrence of reversals in the fi scal fourth quarter is signifi cantly greater than would be expected by chance the examination of other indicators suggests that on average fourth quarter earnings reversals refl ect managers earnings management efforts we fi nd signifi cantly positive negative change in fourth quarter accruals discretionary accruals and special items and signifi cantly negative positive change in operating cash fl ows and effective tax rate for the np pn sample relative to the industry and performance matched control sample although the reversal samples appear to achieve their reported annual earnings mostly by adjusting accruals rather than operating cash fl ows cfo we fi nd that the np fi rms also cut their research and development r roy chowdhury 2006 an intriguing result that comes out of our analysis is that at least one fourth of the fi rms that report small increases in annual eps exhibit smoothing behavior and manage fourth quarter accruals downward to just beat the target this has implications for the interpretation of previous fi ndings for example dechow et al 2003 fi nd no signifi cant difference in the discretionary accruals of fi rms with small losses versus fi rms with small profi ts their fi nding leads them to question whether the observed kink in the earnings distribution at zero is truly driven by earnings management our results suggest that pooling fi rms that smooth earnings downward with fi rms that manage earnings upward can result in understated dis cretionary accruals for small profi t fi rms future research on fi rms meeting or beating earnings targets needs to adjust for the fact that a signifi cant proportion of these samples are not seeking to avoid losses or earnings decreases but in fact are smoothing earnings downward overall our paper contributes to the earnings management literature in gen eral and has specifi c implications for the target meeting or beating literature our fi ndings suggest that investors should view late year changes in general and fourth quarter earnings reversals in particular with caution on the basis of our evidence the fourth quarter reversal pattern can be used as a heuristic that triggers an inquiry into potential earnings management in conjunction with other indicators such as discretionary accruals or meeting or beating earnings targets the rest of the paper is organized as follows section 2 reviews related literature and describes our hypotheses section 3 discusses the data and sample selection empirical results are reported in section 4 followed by concluding remarks in section 5 2 literature review and hypotheses development reversals in earnings changes and earnings management empirical fi ndings suggest that managers engage in earnings management to avoid losses or earnings decreases hayn 1995 burgstahler and dichev 1997 6 if man agers wish to achieve an annual earnings target actions to manage to a target are likely to take place closer to the fi scal year end in an empirical study givoly and ronen 1981 fi nd that deviations of interim quarters earnings from their expecta tions are on average negatively correlated with deviations of fourth quarter earnings from their expectation these authors argue that this observed negative correlation occurs because managers make end of year adjustments to smooth annual income numbers dhaliwal et al 2004 provide more direct evidence suggesting that fi rms focus on a specifi c line item in the income statement to manage fourth quarter earnings to meet or beat annual earnings targets they suggest that because tax expense is the last account that is closed before earnings are announced it provides a fi nal opportunity for earnings management to achieve an annual earnings target quarterly earnings patterns and earnings management801 car vol 26 no 3 fall 2009 they fi nd that fi rms that just beat analysts expectations lower their projected annual effective tax rate from the third to the fourth quarter when absent the tax expense management they would have missed the target incentives to manage annual rather than interim quarters earnings may be stronger for several reasons most bonus and compensation plans based on accounting performance rely on audited annual results rather than unaudited quar terly results such remuneration schemes provide incentives for managers to manipulate fi scal year income to achieve preset targets in order to maximize their compensation the fi rm s standing in relation to these targets will likely be most clearly apparent in the fourth quarter thus providing managers with the strongest incentive to manage earnings in the fourth quarter furthermore audited annual earnings may have higher valuation implications if investors attach greater credibility to them relative to interim earnings providing managers with stronger incentives to manipulate annual earnings 7 prior empirical studies provide indirect evidence consistent with managers having stronger incentives to manage earnings at the fi scal year end several of these studies examine the market response to earnings announcements for a broad cross section of fi rms and infer whether fi rms manage earnings differentially across interim and fourth quarters for example kross and schroeder 1989 and salamon and stober 1994 fi nd that the market s reaction to an earnings surprise is lower in the fourth quarter relative to interim quarters both studies attribute their fi ndings to earnings management at the fi scal year end or to the settling up of interim accruals in the fourth quarter other empirical studies examine properties of earnings distributions and draw inferences about potential earnings management in the fourth quarter jeter and shivakumar 1999 examine squared abnormal accruals of interim versus fourth quarters and fi nd that the evidence of potential earnings management is greater in the fourth quarter than in interim quarters also the fi ndings of degeorge patel and zeckhauser 1999 suggest that the special saliency of annual reports creates additional incentives to manipulate earnings to cross an annual threshold relative to quarterly thresholds as refl ected by the variation in fourth quarter earnings similarly jacob and jorgensen 2007 show that managers attempts to avoid losses earnings decreases refl ected by the discontinuity in the distributions of fi scal year earnings earnings changes at zero are not observable in annual periods ending in each of the fi rst three fi scal quarters of a year unlike prior studies we do not infer that earnings management occurs on average in the general population of fi rms in contrast we rely on these studies fi ndings which suggest that earnings management is more likely to occur at fi scal year end and examine the pattern of quarterly earnings to identify potential earn ings managers who may have timed their efforts to manage annual earnings in the fourth quarter to corroborate that our identifi ed sample fi rms are in fact managing earnings we examine these fi rms on a number of dimensions that have been offered by prior research as indicators of earnings management we identify two samples of fi rms that exhibit fourth quarter earnings rever sals a negative earnings change in at least two interim quarters as well as the 802contemporary accounting research car vol 26 no 3 fall 2009 combined interim quarters and positive earnings change in the fourth quarter np and b positive earnings change in at least two interim quarters as well as the com bined interim quarters and negative earnings change in the fourth quarter pn 8 change in earnings is measured relative to earnings of the same quarter of the pre vious year that is quarterly earnings are adjusted for seasonal effects on one hand fi rms with poor performance until the fourth quarter may boost their fourth quarter earnings upward to achieve the annual earnings target for example by early booking of sales underestimating expenses or postponing r meyers meyers and skinner 2007 special items are expenses losses or income items that are either nonrecurring or unusual in nature and are reported as a separate line item in the operating section of the income statement if the np pn fi rms are managing fourth quarter earnings upward downward there is a greater likelihood that these fi rms report higher positive negative special items in the fourth quarter relative to the matched control fi rms inconsistent results would imply that either the reversal fi rms did not manage fourth quarter earnings or used income statement items other than special items to manage earnings research and development r dechow and sloan 1991 bushee 1998 if np fi rms are managing fourth quarter earnings upward it is possible that they do so partly by cutting their r 11 3 percent 11 2 percent of the sample report negative positive earnings changes in interim quarters and positive negative in the fourth quarter the sample distributions are generally consistent across years a substantially higher percentage of observations are in the np sample than in the pn sample in 1991 a recession year when cyclical economic activity reached a trough 15 4 percent versus 9 6 percent and a substantially higher percentage of observations are in the pn sample than in the np sample in 1988 and 2000 years in which economic growth reached a peak 1988 14 percent versus 11 8 percent 2000 13 2 percent versus 10 1 percent 15 although one would expect some poor performers in recessionary times to manage fourth quarter earnings upward to avoid losses or meet previous year targets that some high performers would strategically manage earnings downward in times of economic growth is quite intriguing if fourth quarter earnings reversals indeed refl ect managers deliberate attempts to manage annual earnings the frequency of these reversals should be signifi cantly higher than expected however specifying what this frequency would be under the null hypothesis that is in the absence of earnings management is a chal lenge we construct three different benchmarks for expected frequency of reversals to test whether the observed frequency is higher than expected first we randomly 806contemporary accounting research car vol 26 no 3 fall 2009 table 1 distribution of fourth quarter earnings reversals panel a year wise distribution of reversals 19882 178 11 7513 96 19892 22412 9012 37 19902 33112 2312 05 19912 465 15 389 57 19922 69711 7511 53 19932 98411 6012 06 19943 2879 8312 47 19953 74111 4112 24 19964 13511 1011 58 19974 5519 7112 15 19984 83110 1212 61 19995 23813 369 87 20005