When Are Earnings Managed and Under What Constraints?

• In Event: Doctoral Student Faculty Interchange II

Abstract

The opportunities and incentives for managing earnings vary significantly between
interim reporting and annual reporting (AR). Less regulatory pressure and scrutiny from auditors
allows managers greater opportunities to successfully manage earnings to desired levels in interim
reporting than in AR. There are, however, greater incentives for managers to manage annual
earnings since most of the capital market considerations (equity incentives) and other contractual
incentives are tied to annual results. Testing the trade-offs to answer whether opportunities or
incentives to manage earnings prevail, I find that AR reduces the incidence of avoiding losses or
earnings decreases and income-increasing EM is less frequent in fourth quarter (a proxy for AR)
than in interim quarters. Results from multivariate analyses similarly indicate that firms are less
likely to avoid losses or earnings decreases in fourth quarter than in interim quarters. There is also
evidence that AR effectively limits both accrual-based EM and real activities manipulations that
are used to achieve the zero and prior-period earnings thresholds. Despite various alternative
specifications, the results remain robust and reveal a prominent feature of annual financial
reporting that can mitigate the impact of opportunistic manipulation of financial numbers–a
finding that has implications for policymakers and investors. The results also provide valuable
insight into the frequency of reporting as well as whether aligning interim reporting with AR will
improve the quality of reporting and transparency.

Author

• SM Mahamudal Islam, Florida International University