What Have We Learned about Earnings Management? Correcting Disinformation about Discontinuities

• In Event: Methodologies in Earnings Management Research

Abstract

Earnings distributions commonly exhibit statistically significant discontinuities at prominent performance benchmarks. Discontinuities at zero earnings are widely interpreted as evidence of earnings management to avoid a loss, and discontinuities at zero earnings change or zero earnings surprise as evidence of management to avoid an earnings decrease or negative earnings surprise, respectively. In contrast, two recent papers by Durtschi and Easton (2005, 2009) assert that discontinuities are instead explained by some combination of prior researchers' choice(s) of sample selection and scaling as well as a systematic relation between the sign of earnings and market prices. Resolution of the conflicting interpretations of discontinuities is important because 1) it affects how investors, regulators, and scholars view earnings management and 2) it demonstrates the importance of a close linkage between theory and research design choices. In this paper, we evaluate the three alternative explanations proposed by Durtschi and Easton. We explain why Durtschi and Easton obtain their empirical results and show how their alternative explanations for discontinuities are inconsistent with the empirical evidence. Earnings management remains the only plausible explanation for the extensive body of evidence documenting discontinuities in earnings distributions.

Authors

• David Burgstahler, University of Washington

• Elizabeth Chuk, University of Southern California