Beating Threshold Targets with Earnings Management

Purpose - The purpose of this paper is to document at the firm specific level (1) whether firms manage earnings up or down to barely miss or meet/beat three common earnings threshold targets: analysts' forecasts, last year's earnings, and zero earnings, and (2) whether the market rewards or punishes up vs. down earnings management. Design/methodology/approach - We assign each firm to its most likely earnings target using an algorithm that reflects management’s economic incentives to manage earnings. We place reported (managed) earnings in standard width intervals surrounding the earnings target. The Jacob & Jorgensen (2007) proxy for unmanaged earnings is also placed into the intervals. Thus, a firm with unmanaged earnings in the interval just below the target and reported earnings in the interval just above the target, would be deemed to have managed earnings up. We also document whether the market rewarded or punished the earnings management strategy with three-day CAR’s. Findings - We find that most firms which barely meet/beat their target did so by managing earnings up. The market rewarded this earnings management strategy. The market did not, however, reward firms that managed earnings down (i.e., created a cookie jar of reserves) to barely meet/beat their target. Thus, the meet/beat premium does not apply to all firms. Our explanation is that most earnings targets are set by analysts’ forecasts, that these are usually the highest of the three targets, and that these are, therefore, considered to be “good” firms by the market because they have the ability to find that extra penny to meet/beat the target. Firms that were assigned to last year’s earnings and/or zero earnings thresholds, are not as “good” because they usually do not target the highest threshold and must manage earnings down because they are more likely to have to reverse income increasing accruals booked during interim quarters. Research limitations/implications - The primary limitation in our study is the algorithm used to assign firms to their threshold target. It is ad hoc in nature, but relies on reasonable assumptions about management’s incentives to manage earnings. Practical implications - Our study has practical implications because investors and regulators can adopt this methodology to identify potential candidates for earnings management that would allow further insight into accounting and reporting practices. This methodology may also be useful to the auditor who wants to understand the tendencies a new client. It may also be a useful tool for framing auditing hypotheses in a way that would be appropriate for clients who manage earnings. Originality/value - This paper documents for the first time at the firm specific level the market reaction to upward vs. downward earnings management designed to barely meet/beat the earnings threshold. It also documents the frequency with which firms target the three earnings thresholds and the frequency with which firms miss or meet/beat their threshold.