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Quarterly Earnings Patterns and Earnings Management*

Somnath Das · Pervin K. Shroff · Haiwen Zhang

156 citations0/0 files storedContemporary Accounting Research

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Auditing, Earnings Management, Governance Accounting and Organizational Management Corporate Governance and Financial Management

Abstract

This paper investigates whether the pattern of quarterly earnings changes provides a signal of earnings management. We identify firms for which the sign of (seasonal) earnings changes observed in interim quarters reverses in the fourth quarter. We hypothesize that a firm performing poorly in interim quarters may attempt to increase earnings of the fourth quarter to achieve a desired annual earnings target, while a firm performing well in interim quarters may attempt to decrease earnings of the fourth quarter to build reserves for the future. Our results show that reversal of earnings changes in the fourth quarter is a common phenomenon and its occurrence is greater than would be expected by chance. Other indicators of earnings management, such as the size and direction of discretionary accruals, reversals in subsequent accruals, the use of special items in the income statement, and adjustment of R&D spending, suggest that firms with earnings reversals are more likely to have managed earnings than industry and performance matched control firms. The capital market appears to attach lower credibility to earnings reported by the reversal samples. Our collective evidence leads us to suspect that fourth-quarter reversals on average reflect earnings management behavior. We recommend that analysts use earnings reversals as a heuristic to detect potential cases of earnings management in conjunction with other indicators, such as the magnitude of discretionary accruals. We further find that firms in the reversal samples significantly overlap with the sample of firms reporting small profits and small EPS increases. These results provide an interesting insight - that at least one-fourth of the sample of firms that meet or just beat earnings targets are attempting to smooth annual earnings by managing earnings downward in the fourth quarter.

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References

2008Estimating Standard Errors in Finance Panel Data Sets: Comparing Approaches 1991Earnings Management During Import Relief Investigations 2005Performance matched discretionary accrual measures 1995Detecting Earnings Management.2003Earnings Management through Real Activities Manipulation 1999A Review of the Earnings Management Literature and Its Implications for Standard Setting 1997Earnings management to avoid earnings decreases and losses 1985The effect of bonus schemes on accounting decisions

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