Do Firms Undo the Effects of Earnings Management on Segment Earnings?

• In Event: Earnings Management

Abstract

Under SFAS 131, firms must disclose segment earnings as used for internal decision-making. These earnings can differ from GAAP earnings. We examine one reason why: Firms have an incentive to undo the effects of earnings management on segment earnings to avoid distortions of information they use for internal decision-making. Using a large sample of segment reports of U.S. firms, we find that the contemporaneous relation between consolidated GAAP earnings and the reconciliation difference is positive and stronger for abnormal accruals than for other earnings components. We also find that firms with systematically more decoupled internal performance measures manage earnings more because the cost of induced inefficient decisions is lower. For these firms, GAAP earnings are less informative, and internal investment decisions are less sensitive to internal segment earnings. Overall, our results are consistent with firms attempting to shield internal performance measures from their own earnings management.

Authors

• Christian Gross, KELAG

• Alfred Wagenhofer, University of Graz

• David Windisch, University of Graz