Incentives to Manage Earnings to Avoid Earnings Decreases and Losses: Evidence from Quarterly Earnings

Abstract

This paper develops a model which shows how higher marginal benefits of earnings management in the vicinity of zero can lead to avoidance of earnings decreases and losses like that reported in Burgstahler and Dichev (1997) for annual earnings. In addition, two types of related empirical evidence are presented. First, for quarterly earnings where incentives and costs of earnings management are expected to differ, cross-sectional distributions of reported earnings show evidence of earnings management to avoid earnings decreases (both relative to the immediately preceding quarter and relative to the corresponding fiscal quarter in the previous year, though evidence of the latter is stronger) and to avoid losses (both for individual quarters and for cumulative year-to-date earnings). Second, evidence is presented consistent with the key assumption of the model that the marginal benefit of earnings management is higher in the vicinity of zero. Specifically, it is shown that the net probability of equity and debt rating improvements (the probability of ratings upgrades less the probability of rating downgrades) increases in the vicinity of zero changes and zero levels of earnings.

JEL Classification: M41, M43, L14, C89