Review of Accounting and Finance

Beating threshold targets with earnings management

Mary P. Mindak, Pradyot K. Sen, Jens Stephan,
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RAF
15,2
198
Received 8 April 2015
Revised 27 July 2015
14 October 2015
15 December 2015
Accepted 14 January 2016
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Review of Accounting and Finance
Vol. 15 No. 2, 2016
pp. 198-221
© Emerald Group Publishing Limited
1475-7702
DOI 10.1108/RAF-04-2015-0057
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1475-7702.htm
Beating threshold targets with
earnings management
Mary P. Mindak
School of Accountancy and MIS, DePaul University, Chicago,
Illinois, USA
Pradyot K. Sen
School of Business, University of Washington, Bothell, Bothell,
Washington, USA, and
Jens Stephan
Department of Accounting and Finance, Eastern Michigan University,
Ypsilanti, Michigan, USA
Abstract
Purpose – The purpose of this paper is to document at the firm-specific level whether firms manage
earnings up or down to barely miss or meet/beat three common earnings threshold targets, namely,
analysts’ forecasts (AFs), last year’s earnings and zero earnings, and whether the market rewards or
punishes up versus down earnings management.
Design/methodology/approach – The authors assign each firm to its most likely earnings target
using an algorithm that reflects management’s economic incentives to manage earnings. The authors
place reported (managed) earnings in standard width intervals surrounding the earnings target. Jacob
and Jorgensen’s (2007) proxy for unmanaged earnings is also placed into the intervals. Thus, a firm with
unmanaged earnings in the interval just below the target and reported earnings in the interval just
above the target would be deemed to have managed earnings up. The authors also document whether
the market rewarded or punished the earnings management strategy with three-day cumulative
abnormal returns.
Findings – The authors find that most firms which barely meet/beat their target did so by managing
earnings up. The market rewarded this earnings management strategy. The market did not, however,
reward firms that managed earnings down (i.e. created a cookie jar of reserves) to barely meet/beat their
target. Thus, the meet/beat premium does not apply to all firms. The authors’ explanation is that most
earnings targets are set by AFs; that these are usually the highest of the three targets; and that these are,
therefore, considered to be “good” firms by the market because they have the ability to find that extra
penny to meet/beat the target. Firms that were assigned to the last year’s earnings and/or zero earnings
thresholds are not as “good” because they usually do not target the highest threshold and must manage
earnings down, as they are more likely to have to reverse income-increasing accruals booked during
interim quarters.
Research limitations/implications – The primary limitation in this study is the algorithm used to
assign firms to their threshold target. It is ad hoc in nature, but relies on reasonable assumptions about
the management’s incentives to manage earnings.
Practical implications – This study has practical implications because investors and regulators can
adopt this methodology to identify potential candidates for earnings management that would allow
further insight into accounting and reporting practices. This methodology may also be useful to the
auditor who wants to understand the tendencies of a new client. It may also be a useful tool for framing
auditing hypotheses in a way that would be appropriate for clients who manage earnings.
 Originality/value – This paper documents for the first time at the firm-specific level the market Beating
reaction to upward versus downward earnings management designed to barely meet/beat the earnings
threshold. It also documents the frequency with which firms target the three earnings thresholds and
threshold
the frequency with which firms miss or meet/beat their threshold. targets
Keywords Earnings management, Earnings thresholds, Meet/beat premium
Paper type Research paper
199
1. Introduction
It is generally accepted that firms manage earnings to meet/beat earnings targets. The
sheer volume of academic research in the area attests to the popularity/importance of the
topic, for example, over 1,400 papers with “earnings management” in the abstract have
been published in scholarly journals in the past 10 years. Accounting researchers
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have investigated management’s choice of threshold target with mixed results. For
example, a survey of chief financial officers (CFO’s) by Graham et al. (2005) indicates
that avoiding earnings declines and reporting losses are the most important thresholds.
A large adverse market reaction to the failure to meet/beat expectations is the primary
incentive that induces managers to engage in these activities[1]. The conventional
wisdom is that firms manage earnings upward to barely meet or beat one of the three
targets, namely, analysts’ forecasts (AFs), last year’s earnings per share (LYEPS) and
zero earnings (DeGeorge et al., 1999)[2]. A corollary to this belief is that earnings may be
managed downward in good years so as to build “reserves” for an uncertain future.
In this paper, we examine the market reaction to earnings management with an
emphasis on two popular scenarios for firms that barely meet/beat their target earnings:
finding a penny to boost earnings above the threshold and understating earnings to
create a cookie jar reserve for the future. We use two key tools to identify individual
firms that manage earnings up versus down.
First, we develop a heuristic that assigns each firm’s annual earnings to a specific
threshold, that is, AF, LYEPS or zero earnings. We hypothesize that managers will pick
the highest achievable target as the threshold of choice. Second, we use a methodology
similar to that used by Jacob and Jorgensen (2007) (hereafter JJ) of using annualized
earnings cumulated from third quarter to third quarter as a proxy for unmanaged
annual earnings.
The combination of a firm-specific threshold, a proxy for unmanaged earnings and
reported earnings allows us to identify individual firms that manage earnings up or
down in the fourth quarter to barely meet/beat their target earnings[3]. Our main results
indicate that most firms manage earnings upward, while a minority manages earnings
downward (the remainder are classified as not having managed earnings). Furthermore,
the market appears to reward upward earnings management while punishing firms that
deliberately understate earnings. Our evidence, therefore, supports the hypothesis that
the market favorably views firms with the ability to “find an extra penny of earnings” to
barely meet/beat the target and does not appear to reward firms that understate
earnings in the hope of mitigating future uncertainties.
While the extant research has provided important insights, it has not been able to
throw light on the dynamics of earnings management, that is whether earnings at the
individual firm level were managed up or down and whether the market makes a
distinction between firms managing earnings up or down, and if so, for what reasons.
Accounting research has also documented the existence of a meet/beat premium. Its
 RAF persistence raises a concern that market may be oblivious to, or even condone earnings
15,2 management. We suggest a method for identifying firms managing earnings up versus
down and document that the meet/beat premium is driven primarily by firms
“managing up”, while the firms “managing down” do not seem to get the premium. The
evidence is consistent with the notion that the ability of “finding a penny” to manage up
is rewarded by the market, while the absence of a “penny” (perhaps due to excessive
200 earnings management in the past) is punished. Our methodology and findings raise
important questions regarding how the market may treat an apparent inefficient
practice to price protect itself. These questions are important because regulators and
market participants need to understand the self-monitoring and self-correcting
incentives, if any, administered by the market that may mitigate the tendency to manage
earnings.
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To investigate the dynamics of earnings management, it is necessary to adopt two

metrics. The first is to assign each firm-year earnings number to a particular earnings
threshold. These thresholds can be rank-ordered in six ways, for example, AF ⬎
LYEPS ⬎ zero. We hypothesize that the management’s inside information about
earnings prospects combined with market incentives will motivate them to manage
earnings to the highest achievable target. The second is to select a proxy for unmanaged
earnings. Motivated by JJ, we use annualized quarterly earnings ending with the third
quarter of the current year (EPSQ4t ⫺ 1 ⫹ EPSQ1t ⫹ EPSQ2t ⫹ EPSQ3t) as our proxy for
unmanaged earnings.
While there is no consensus on an adequate proxy for either metric[4], our proxies
allow us to make a first pass in identifying firm-specific up or down earnings
management and the (possibly) differential market response to such earnings
management. It is worth noting that alternative explanations to earnings management
include a firm having a good/bad fourth quarter and/or reversal of prior accruals made
during interim quarters. However, like prior work, we focus on firms that barely miss or
meet/beat their earnings target because these firms are acknowledged to be more likely
to manage earnings around the threshold than firms that miss the threshold by a wide
margin. In the remainder of the paper, we use “earnings management” to include all
three possibilities.
Like prior work, we find strong evidence that the market rewards firms for barely
meeting/beating their earnings threshold (three-day cumulative abnormal return
[CAR] ⫽ ⫹0.74 per cent), while punishing firms that barely miss their threshold
(three-day CAR ⫽ ⫺0.63 per cent). The majority of the firms (67.1 per cent) that barely
meet/beat their target managed earnings up. The market rewards these firms (three-day
CAR ⫽ ⫹1.00 per cent), but punishes similar firms that also meet/beat their target but
apparently manage earnings down (three-day CAR ⫽ ⫺0.33 per cent). We offer the
following explanation for how the market decides to reward or punish some firms that
meet/beat their target.
AFs dominate our sample, accounting for 81.9 per cent of all threshold assignments.
In contrast, LYEPS and zero earnings account for 11.5 and 6.6 per cent of all threshold
assignments, respectively. AFs also dominate the highest of the three targets,
accounting for 47.9 per cent of all threshold assignments, whereas the LYEPS and zero
earnings as the highest thresholds account for 3.1 and 0.5 per cent of all observations,
respectively. Finally, the fraction of firms that barely meet/beat the AF target by
managing up (down) is 71.6 per cent (11.1 per cent). The fraction of firms that barely
 meet/beat the LYEPS and zero targets by managing up (down) is 25.6 per cent (54.0 per Beating
cent). While the market cannot observe managing up or down, it can observe ex post threshold
(with error) the target chosen by the firm and views firms that choose a high target as
“good” firms and firms that choose low targets as “bad” firms. We believe this
targets
partitioning of firms demonstrates that not all firms that barely meet/beat their target
enjoy the meet/beat premium and reconciles this premium to the phenomenon of
earnings management. 201
The market reaction for firms that barely miss their target is uniformly negative
regardless of whether they manage earnings up or down. The plurality of firms in each
threshold appears to manage down, suggesting that these firms either could not find the
penny to meet/beat the target, experienced a bad fourth quarter or had to reverse prior
accruals due to overstating interim earnings.
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We use the proximity of reported earnings to the three observable thresholds to

assign firms to their unique threshold. Using the previous example of AF ⬎ LYEPS ⬎
zero (representing high, medium and low thresholds), if reported earnings are between
AF and LYEPS but are closer to AF, we would categorize that firm as having missed the
AF target. Alternatively, if reported earnings were closer to LYEPS, we would
categorize that firm as having beaten the LYEPS target. While the actual target chosen
by management is unobservable, firms that barely miss or meet/beat their target are
highly likely to be correctly categorized. Almost 62 per cent of our sample firms fall into
that category, giving significant credence to our threshold assignment method.
Our threshold assignment mechanism also results in a stable pattern, that is, the
frequency of AF, LYEPS and zero earnings thresholds fluctuated over only a narrow
range during the 1984 to 2010 period and was similar to that identified by Brown and
Caylor (2005). Furthermore, when we assign all observations to either the LYEPS or zero
thresholds, we find the familiar kink in the distribution documented by Burgstahler and
Dichev (1997).
Li (2010) examines the choice of earnings target through the lens of firm
characteristics, for example, firm size, growth and trading volume and AF accuracy and
dispersion. She finds that large firms, high-growth firms and high-trading volume firms
seek to avoid missing AFs while small firms, low-growth firms and low-trading volume
firms seek to avoid earnings declines and reporting losses. Furthermore, firms with high
AF accuracy and low forecast dispersion focus more on the AF threshold than earnings
declines and losses. There is also evidence that the relative importance of earnings
thresholds has changed over time, with AFs gaining prominence recently (Dechow et al.,
2003; Brown and Caylor, 2005)[5]. Though overall consistent with the aggregate
observed wisdom, our attempt is somewhat different in that we assign individual firms
to their most likely target threshold.
Like prior work, we create standard width intervals around the target (where
interval ⫺1 [⫹1] represents barely missing [meeting/beating] the target). With both
unmanaged earnings (EPSQ4t ⫺ 1 ⫹ EPSQ1t ⫹ EPSQ2t ⫹ EPSQ3t) and managed
(reported) earnings placed in the appropriate interval for the current year, we are able to
infer whether earnings were managed up or down. Thus, firms with unmanaged
earnings in interval ⫺1 that lands in interval ⫹1 would be deemed to have managed
earnings up to barely meet/beat the target. Likewise, firms with unmanaged earnings in
interval ⫹2 that lands in interval ⫹1 would be deemed to have managed earnings down
to barely meet/beat the target. We are, therefore, able to estimate the frequency of the
 RAF classic earnings management effort to “find a penny” to meet/beat the target and the
15,2 “cookie jar” effort to create a reserve for an uncertain future. We repeat the caveat that
firms could also be having a good/bad fourth quarter and/or reversing interim accruals,
but it is generally acknowledged that firms landing in intervals ⫺1 and ⫹1 are the most
likely candidates for being subject to earnings management.
The choice of a proxy for unmanaged earnings is equally difficult. JJ cumulated
202 consecutive quarterly earnings over annual periods ending with the first, second and
third quarters of the current year. The average of these annualized earnings is used as
the “benchmark” distribution of unmanaged earnings. This distribution is compared
with the distribution of current year annualized earnings ending in the fourth quarter.
Our adaptation of the JJ methodology defines unmanaged earnings as Q4t⫺1 to Q3t
earnings[6]. If reported earnings (Q1t to Q4t) are higher (lower) than unmanaged
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earnings, we designate it as upward (downward) earnings management. Arguments

favoring this metric are as follows: firms have fewer incentives to manage earnings
during interim quarters, and if the earnings management was accomplished by
short-term accrual manipulations[7], the fourth-quarter accruals will have reversed
themselves[8] [9].
Our results suggest an explanation for how the market processes earnings
management. Specifically, we seek to explain why the meet/beat premium does not
apply universally. We find that firms that manage earnings down but still meet/beat
their threshold experience negative returns over the three days surrounding the
earnings announcement. Firms that manage earnings up experience large positive
returns. AF thresholds dominate our sample, are more often than not the highest
threshold and exhibit mostly upward earnings management. The market would classify
these firms as “good”. LYEPS and zero thresholds are less numerous, are more often
than not the medium or low threshold and exhibit mostly downward earnings
management (or more likely, experience a bad fourth quarter and/or have to reverse
interim accruals). The market would classify these firms as “bad”. If these
classifications are, on average, correct, then the “bad” firms would be the ones more
likely to be viewed as poor performers with the attendant negative stock market
reaction.
We make several contributions to the understanding of earnings management. First,
our paper is a unique attempt to identify the individual perpetrators of earnings
management as opposed to studying the phenomenon in aggregate. We develop an
algorithm for assigning firms to their “most likely” earnings target. Our empirical
design acknowledges and incorporates the existence of multiple thresholds, a concept
argued extensively in the literature. We verify that the pattern of allocation of the target
arrived at, by our method, is consistent with that of the overall phenomenon as
documented by Brown and Caylor (2005).
Second, using the JJ proxy for unmanaged earnings allows us to determine whether
individual firms managed earnings up or down in the fourth quarter. Because earnings
management is a continuous process intertwined with earnings measurement,
analyzing earnings outcomes alone cannot shine a light on the dynamic process that is
captured by our managing up or down determination. In spite of the general
acknowledgement of managing up or down, this phenomenon has not been documented
before, to the best of our knowledge.
 Third, identification of individual firms that managed earnings up or down also Beating
allows an examination of whether the market can “see through” earnings management threshold
and punish (reward) firms that manage earnings up (down) to meet/beat their target. We
recognize that our statements about earnings management are not absolute – the real
targets
fourth-quarter earnings could also account for such movement. However, as previously
stated, firms that barely meet/beat their target are generally considered the most likely
candidates for earnings management. 203
Finally, we document the changes in the distribution of annualized earnings through
successive earnings announcements and find that the mean of the distribution shifts up
over time (moving from the left of the threshold to the right of the threshold) and that the
variance decreases substantially over time with two-thirds of firm-year observations
ending up in intervals ⫺1 and ⫹1. This is conformation of earnings management as a
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dynamic process over an extended period of time and is consistent with arguments in
the literature that some of the fourth-quarter earnings management is a result of
reversing prior accruals.
The remainder of the paper proceeds as follows: Section 2 presents background;
Section 3 describes metric for earnings management; Section 4 explains the
determination of threshold assignment for each firm; Section 5 describes sample
selection; Section 6 explains research design; Section 7 presents discussion of results;
Section 8 describes robustness tests; and Section 9 provides concluding comments.

2. Earnings management
Das et al. (2009) cite three reasons why earnings management is primarily a
fourth-quarter phenomenon. First, managers have better information about how close to
the target they are after the third-quarter results have been posted, thus informing them
of the magnitude and direction required of earnings management to meet/beat the
target. Second, incentive compensation is typically tied to annual earnings with the
motivation to meet/beat the target. Third, capital markets probably view audited
earnings as more credible and, hence, more important, thereby contributing to the
incentives to manipulate the fourth-quarter earnings. Das et al. conclude that the
opportunity to manage interim rather than the fourth-quarter earnings may be higher,
but the incentives are probably lower.
Our adoption of the JJ methodology of earnings cumulated over the annualized period
ending in the third quarter leads to the calculation of the proxy for unmanaged earnings
as (EPSQ4t ⫺ 1 ⫹ EPSQ1t ⫹ EPSQ2t ⫹ EPSQ3t)[10]. This metric has two salient
characteristics: it captures a significant portion of current year results and to the extent
that the fourth-quarter accruals are reversed in the following quarter, it excludes
earnings management in the prior year. Current year reported earnings (EPSQ1t ⫹
EPSQ2t ⫹ EPSQ3t ⫹ EPSQ4t) and the proxy for unmanaged earnings are placed in their
appropriate intervals around the target. The difference between intervals (with and
without earnings management) allows us to infer whether a firm was likely to have
managed earnings up, down or did not manage earnings.
Note that Q1, Q2 and Q3 are common to both our proxy for unmanaged earnings and
annual fiscal year earnings, with the difference (interpreted as earnings management)
being equivalent to the change in the successive fourth-quarter earnings. Because the
prior year’s Q4 earnings may also have been managed, our metric may capture changes
in earnings management rather than absolute earnings management in the current year.
 RAF We address this issue empirically by testing a subset of firms that landed outside of
15,2 intervals ⫺1 and ⫹1 in the prior year, that is, firms are less likely to have managed
earnings because they did not barely miss or meet/beat their target. Results for this
subset are very similar to the results for the full sample of firms[11].
This is like the metric for managed earnings used by Das et al. (2009). They use
reversals in seasonal quarterly earnings as their indication of earnings management.
204 Specifically (using their NP characterization), if the change in the third-quarter earnings
is negative [EPSq3, t ⬍ EPSq3, t ⫺ 1 ¡ N] and the change in the fourth-quarter earnings is
positive [EPSq4, t ⬎ EPSq4, t ⫺ 1 ¡ P], then the sequence is NP and earnings management
may have taken place. The difference between our metric and the Das et al.’s metric is the
baseline; we use annualized earnings cumulated from third quarter to third quarter,
while they use only the change in the third-quarter earnings.
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3. Threshold assignments
We determine the relevant threshold on a firm-year basis. We assume for this exposition
that the three relevant thresholds are given in Table I.
Also, assume that the annualized fourth-quarter earnings are $0.68 per share.
Although AFs may be the most important threshold to meet/beat, we assign this firm to
the “last year’s earnings” threshold based on the presumption that the firm would
consider attaining $0.70 more likely than the $1.00 per share target and that $0.70 per
share is, therefore, the next most important goal to meet. This injects our judgment into
the research process, but we believe that more precise insights are possible. We apply
our rule for the threshold assignment to the above example as given in Table II.
Effectively, we pick the midpoint between thresholds as the cutoff for the assignment
to a threshold. We apply the same rule for any ranking of the thresholds. For example,
see Table III.
The following possible reported earnings (Q4 annualized EPS) would be assigned to
thresholds, as shown in Table IV.
This research design greatly improves the “signal-to-noise” ratio by classifying each
firm into a likely threshold. While our classifications are not perfect, we believe it is an

Table I.
Numerical examples AFs $1.00 per share
of earnings Last year’s earnings $0.70 per share
thresholds Zero earnings $0.00 per share

Table II.
Range of reported Reported Q4 annualized EPS Threshold
EPS and
management’s Q4 EPS ⱖ $0.85 AFs
assumed earnings $0.35 ⱕ Q4 EPS ⱕ $0.84 Last year’s earnings
threshold Q4 EPS ⱕ $0.34 Zero earnings

Table III.
Example of threshold AFs $1.00 per share
rankings from high Zero earnings $0.00 per share
to low Last year’s earnings $0.70 per share
 improvement over using only one threshold for all sample firms that results in all firms Beating
managing earnings (possibly to different thresholds) are assigned to an interval threshold
(possibly) far from their chosen earnings target.
targets

4. Sample selection
Sample firms must have eight consecutive quarters of required information. The firms 205
must also have data to calculate annualized fourth-quarter AFs and LYEPS threshold
data. We also restrict our sample so that only firm observations with unique thresholds
exist. For example, if a firm observation has their LYEPS data equal to the zero-profit
thresholds, then we eliminate that firm-year observation. As shown in Table V, these
restrictions leave us with 34,822 firm-year observations during 1984 to 2010.
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Tables VI and VII show descriptive statistics of our sample versus the Compustat
universe. Because we include additional data requirements to obtain asset, net income,
revenue and market valuation data, we lose 131 observations of the 34,822 to obtain our
data for Table VI. We find that the firms in our sample are significantly larger than other
firms in the Compustat universe. This is to be expected as we place restrictions on our
sample to have multiple quarters of data, institutional brokers’ estimate system (IBES)
analyst information and stock market return data.
There are 69 separate industries represented in our sample with 5,866 unique firms
that make up the 34,822 firm-year observations. Table VII provides information on the
top industries represented in our sample of 5,866 unique firm observations. About 32 per
cent of our sample is made up of firms in the depository institutions, business services
and chemicals and allied products industries.

Reported Q4 annualized EPS Threshold

Table IV.
Q4 EPS ⱖ $0.50 AFs Assignment of
$⫺0.35 ⱕ Q4 EPS ⱕ $0.49 Zero earnings reported earnings in
Q4 EPS ⱕ $⫺0.34 Last year’s earnings Table I to thresholds

No. of
Description observations

Firm observations with the annualized fourth-quarter earnings 127,980

from 1984 through 2010
Eliminate firm observations where the LYEPS data threshold 15,703
is missing
Eliminate firm observations where the annualized fourth- 76,479
quarter AFs threshold is missing
Eliminate firm observations that have the annualized fourth- 31
quarter forecast or the LYEPS threshold equal to zero
Eliminate firm observations where the annualized fourth- 58
quarter AF equals LYEPS threshold
Eliminate firm observations missing CAR data from CRSP 887 Table V.
Total final firm observations 34,822 Sample selection
 RAF Firm characteristic statistics
15,2 Sample firms (N ⫽ 34,691) Compustat firms (N ⫽ 102,392)
Variable Mean Median SD Mean Median SD Mean difference

Assets 9,264 1,018 60,035 4,961 107 60,645 4,303.4***

Net income 212 27 1,375 63 1 904 148.4***
206 Revenues 3,318 546 12,885 1,248 51 7,237 2,069.8***
MVAL 4,464 735 17,445 1,390 66 10,017 3,073.5***

Notes: This table provides descriptive statistics for the main size variables (*** denotes significance
Table VI. at the 99% level); Assets ⫽ Compustat data item AT; Net income ⫽ Compustat data item NI;
Descriptive statistics Revenues ⫽ Compustat data item SALE; MVAL ⫽ Compustat data items CSHO ⫻ PRCC_F
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2-Digit SIC code Description Frequency (%)

60 Depository institutions 745 12.7

73 Business services 624 10.6
28 Chemicals and allied products 508 8.7
36 Electronic and other electrical equipment 326 5.6
38 Measuring, analyzing and controlling instruments 293 5.0
35 Industrial and commercial machinery and computer 261 4.4
equipment
63 Insurance carriers 257 4.4
13 Oil and gas extraction 246 4.2
48 Communications 237 4.0
49 Electric, gas and sanitary services 213 3.6
67 Holding and other investment offices 208 3.5
80 Health services 114 1.9
87 Engineering, accounting, research, management and 111 1.9
related services
Table VII. Other 1,723 29.4
Industry data Total 5,866 100.0

Our sample observations cover the period from 1984 to 2010. Table VIII shows that 61
per cent of our sample observations are for 2000-2010, 31 per cent are for 1990-1999 and
8 per cent for 1984-1989.

5. Research design
Our research design entails calculating annual threshold assignment measures,
annualized earnings and earnings surprise measures. The relevant earnings threshold
(we use target and threshold interchangeably) is defined at the individual firm level and
can be AF, LYEPS or zero earnings. Each firm is assigned a threshold each year by its
proximity to the pre-managed earnings. The following information provides description
of the variables used to calculate our threshold measures. Our sample is restricted to
include only firms in our sample that have a December fiscal year-end.
 Year Frequency (%)
Beating
threshold
1984 314 0.90 targets
1985 334 0.96
1986 424 1.22
1987 409 1.17
1988 543 1.56
1989 666 1.91
207
1990 715 2.05
1991 752 2.16
1992 788 2.26
1993 930 2.67
1994 1,000 2.87
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1995 1,221 3.51

1996 1,252 3.60
1997 1,340 3.85
1998 1,428 4.10
1999 1,443 4.14
2000 744 2.14
2001 1,511 4.34
2002 1,644 4.72
2003 1,810 5.20
2004 1,927 5.53
2005 2,046 5.88
2006 2,216 6.36
2007 2,331 6.69
2008 2,447 7.03
2009 2,312 6.64
2010 2,275 6.53
Total 34,822 100.00
Table VIII.
Note: Underline signifies that the number below is the sum of the column above Yearly data

Threshold calculations
As discussed earlier, each firm is assigned to its individual threshold. The three
potential thresholds that a firm could be targeting in the fourth quarter of year t are as
follows (we use commonly used notation for earnings with the subscripts identifying the
fiscal quarter and the year):
(1) Fourth-quarter AF threshold:

AF ⫹ EPSq1,t ⫹ EPSq2,t ⫹ EPSq3,t ⫹ meanIBESestq4,t

(2) LYEPS threshold:

LYEPS ⫽ EPSq1,t⫺1 ⫹ EPSq2,t⫺1 ⫹ EPSq3,t⫺1 ⫹ EPSq4,t⫺1

(3) Zero EPS threshold: EPS ⫽ 0

 RAF Thus, the AF threshold is a combination of actual interim earnings plus the mean
15,2 fourth-quarter AF (meanIBESestq4,t). The mean AF was restricted to forecasts made
between the third- and fourth-quarter EPS announcement dates.

Managed and unmanaged earnings

The annualized earnings used in various parts of our study are defined as follows:
208
Q1EPS ⫽ EPSQ2,t⫺1 ⫹ EPSQ3,t⫺1 ⫹ EPSQ4,t⫺1 ⫹ EPSQ1,t

Q2EPS ⫽ EPSQ3,t⫺1 ⫹ EPSQ4,t⫺1 ⫹ EPSQ1,t ⫹ EPSQ2,t

Q3EPS ⫽ EPSQ4,t⫺1 ⫹ EPSQ1,t ⫹ EPSQ2,t ⫹ EPSQ3,t

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Q4EPS ⫽ EPSQ1,t ⫹ EPSQ2,t ⫹ EPSQ3,t ⫹ EPSQ4,t

Q3 annualized EPS represents our proxy for “unmanaged” earnings, while Q4

annualized EPS represents “managed” or reported earnings (hereafter Q3EPS and
Q4EPS). Following JJ, we create 64 intervals surrounding the threshold from ⫺0.155 to
⫹0.155, numbered from ⫺32 to ⫹32 excluding zero. Managed and unmanaged earnings
(scaled by price) are then assigned the appropriate intervals, and the change in interval
for Q3EPS to Q4EPS represents earnings management. Therefore, a firm with Q3EPS in
interval ⫺1 whose Q4EPS lands in interval ⫹1 is deemed to have managed earnings up.
Similarly, a firm with Q3EPS in interval ⫹2 whose Q4EPS lands in interval ⫹1 is
deemed to have managed earnings down (we also use the terms up and down “moves” in
the remainder of the paper).

6. Discussion of results
Thresholds
Table IX, shows the number/fraction of earnings surprises assigned to individual
thresholds. There are a total of 34,822 earnings surprises. AFs are the predominant
threshold accounting for 81.9 per cent (28,533 observations) of the sample[12]. LYEPS

AF LYEPS Zero Total

High/beat 10,836 31.1% 687 2.0% 109 0.3% 11,632 33.4%

High/miss 5,838 16.8% 397 1.1% 65 0.2% 6,300 18.1%
Total 16,674 47.9% 1,084 3.1% 174 0.5% 17,932 51.5%
Med/beat 3,408 9.8% 1,017 2.9% 251 0.7% 4,676 13.4%
Med/miss 4,921 14.1% 1,121 3.3% 257 0.7% 6,299 18.1%
Total 8,329 23.9% 2,138 6.2% 508 1.4% 10,975 31.5%
Low/beat 983 2.8% 265 0.8% 622 1.8% 1,870 5.4%
Low/miss 2,547 7.3% 495 1.4% 1,003 2.9% 4,045 11.6%
Table IX. Total 3,530 10.1% 760 2.2% 1,625 4.7% 5,915 17.0%
Threshold Total/beat 15,227 43.7% 1,969 5.7% 982 2.8% 18,178 52.2%
frequencies: Total/miss 13,306 38.2% 2,013 5.8% 1,325 3.8% 16,644 47.8%
frequency of Total 28,533 81.9% 3,982 11.5% 2,307 6.6% 34,822 100.0%
observations in each
threshold group Note: Underline signifies that the number below is the sum of the column above
 and zero account for 11.5 per cent (3,982 observations) and 6.6 per cent (2,307 Beating
observations) of the sample. Overall, 52.2 per cent (47.8 per cent) of the sample reflects threshold
earnings beating (missing) the threshold. Of interest is the fact that regardless of which
threshold a firm is assigned to, if it is the highest threshold, the beat/miss ratio is almost
targets
2 to 1, while if it is the lowest threshold, the beat/miss ratio is 1 to 2.
Table X shows that common financial statement items are similar in magnitude for
firms assigned to the AF and LYEPS thresholds. Firms assigned to the zero thresholds 209
have losses, on average, and smaller revenues and lower market value than the other
two groups. This is consistent with the Durtschi and Easton critiques of the kinks in the
distribution method for identifying earnings management. However, as will be shown
later, inclusion or exclusion of these firms in the analysis does not change the inferences
that we reach about earnings management.
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Managing earnings up and down

Figure 1(a) shows the number of firms for all three thresholds landing in intervals ⫺5
to ⫹5. The firms in these ten intervals account for about 76 per cent of all observations.
It is quite apparent that a vast majority of firms (56.4 per cent) barely miss or meet/beat
their target. Most of the firms in interval ⫹1 managed earnings up (alternatively, they
could have had good fourth quarters or reversed downward accruals made in interim
quarters). Conversely, firms that barely miss their target are about evenly split between
managing earnings up or down.
Figure 1(b), which focuses only on the AF threshold, is virtually the same as Figure
1(a), primarily due to the fact that AFs represent the vast majority of firm-year
observations. Figures 1(c) and 1(d), representing the LYEPS and zero thresholds,

Target N Assets ($) Income ($) Revenue ($) MVAL ($)

AF 28,435 9,127 230 3,318 4,575

LYEPS 3,961 9,761 242 3,568 4,739
Zero 2,295 10,112 65 2,885 2,608

Notes: The number of observations is not the same as in Panel A because of missing Computstat data.
Variable definitions: AF ⫽ analysts’ forecasts target ⫽ EPSq1,t ⫹ EPSq2,t ⫹ EPSq3,t ⫹
mean IBESestq4,t, where mean IBESestq4,t ⫽ mean analyst fourth quarter forecast; LYEPS ⫽ last year’s
EPS target ⫽ EPSq1,t⫺1 ⫹ EPSq2,t⫺1 ⫹ EPSq3,t⫺1 ⫹ EPSq4,t⫺1; Zero ⫽ zero earnings target ⫽ 0; First
category of placement– each firm’s thresholds are placed into order based upon their calculated value
from high to low. Then, the actual annualized earnings per share (eps) are compared to the thresholds.
High ⫽ a firm’s observation is placed into the high category if their actual annualized earnings per share
in year t is greater than the other two thresholds and greater than the midpoint between the high and
med thresholds; Med ⫽ a firm’s observation is placed into the med category if their actual annualized
earnings is less than the midpoint between the high and med threshold and greater than the midpoint
between the low and med threshold; Low ⫽ a firm’s observation is placed into the low category if their Table X.
actual annualized earnings is less than the midpoint between the low and med category Second Threshold
category of placement– once a firm observation is found to be in the high, med or low threshold group, frequencies:
then the actual annualized earnings per share is determined to meet or beat the designated threshold; descriptive statistics
Beat ⫽ if the actual annualized earnings per share is greater than or equal to the designated threshold, (mean values) of
then it is placed into the beat category; Miss ⫽ if the actual annualized earnings per share is less than firms for each
the designated threshold, then it is placed into the miss category threshold target
 RAF
15,2

210
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Figure 1.
Number of firms that
moved up, down or
stayed the same from
Q3 to land in their Q4
interval
 respectively, are qualitatively similar to the AF threshold, but with some exceptions. For Beating
example, the frequency of upward earnings management is sharply reduced compared threshold
to the AF threshold. This is consistent with the empirical evidence that the AF threshold
is usually the highest of the three thresholds and, therefore, represents “good” firms that
targets
can find the extra penny to beat the earnings target. In fact, the zero threshold reflects
primarily downward earnings management (or bad fourth quarters or reversal of
interim accruals). This feature of earnings management is not apparent in the traditional 211
kinks in the distribution approach.
A question heretofore unaddressed by research is whether the market can “see
through” earnings management and distinguish between the “cookie jar” behavior and
upward earnings management to just meet/beat their target. Table XI provides evidence
about three-day CARs (CARs beginning one day before and ending one day after the
earnings release) for firms landing in intervals ⫺1 and ⫹1. The average three-day CAR
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for all sample firms in intervals ⫺1 and ⫹1 is ⫹0.17 per cent. Furthermore, conventional
wisdom is confirmed insofar as firms that barely miss their target earnings
experience ⫺0.63 per cent CAR, while those that barely meet/beat their target
experience ⫹0.74 per cent CAR. The difference, ⫹1.37 per cent, is highly significant.
Accounting researchers have speculated that managers who expect to beat their
target by a sufficient margin may deliberately manage earnings down to create reserves
for an uncertain future. In our sample, we found that only 14.2 per cent of the firms that
barely meet/beat their target reported lower earnings than unmanaged earnings. This
suggests that the frequency of the “cookie jar” strategy is not very large.

Differential market reaction

Furthermore, for firms landing in interval ⫹1, the three-day CAR for those that
managed earnings up is 1.00 per cent, while those that managed earnings down (created
a cookie jar) experienced a ⫺0.33 per cent return[13]. It would appear that the market
views favorably those “good” firms that are able to find that last cent of earnings to
reach their target but either do not recognize the benefit of creating a reserve for the
future or do not reward it on seeing it[14].
We also note that more firms move down (37.0 per cent) in interval ⫺1 than move up
(29.4 per cent) in the same interval. Because it is almost inconceivable that a firm would
deliberately manage earnings downward with discretionary accruals to barely miss
their target, this probably reflects either firms honestly reporting a bad fourth quarter or
firms making downward adjustments in the fourth quarter because interim quarters
were overstated. We believe this suggests that firms may also be managing earnings
during interim quarters.
Figures 2(a) to (d) trace the evolution from Q1 to Q4 of the distribution of reported
earnings relative to the target. Two patterns are particularly interesting. First, the
highest frequency intervals move from ⫺2 (Q1) to ⫺1 (Q2 and Q3) to ⫹1 (Q4). Firms are
clearly moving up over time to meet/beat the earnings target. Second, the variance of the
distribution is decreasing over time as the vast majority of firm-year observations land
in intervals ⫺1 and ⫹1.

7. Robustness tests
While we perform several robustness checks on the analysis, one is of particular
importance. Durtschi and Easton (2005, 2009) argue that scaling and selection bias can
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15,2

212
RAF

earnings
Table XI.

management
Market reaction to
Earnings Movement Three-day CAR
interval Down Same Up Total Down Same Up All

Int ⫺1 3,317 (37.0%) 3,013 (33.6%) 2,631 (29.4%) 8,961 (100.0%) ⫺0.61%*** ⫺0.96%*** ⫺0.26%* ⫺0.63%***
Int ⫹1 1,778 (14.2%) 2,337 (18.7%) 8,380 (67.1%) 12,495 (100.0%) ⫺0.33%* 0.62%*** 1.00%*** 0.74%***
Total 5,095 5,350 11,011 21,456
Mean three-day CAR difference ⫺0.28% ⫺1.58%*** ⫺1.27%*** ⫺1.37%***

Notes: This table provides the number and percentage of observations for firms that managed earnings up, down or did not manage earnings. The table
includes only intervals ⫺1 and ⫹1. The three-day CARs are provided for each interval and each designated earnings management activity. ( * , ** and ***
denote statistical significance at the 90%, 95% and 99% levels, respectively.) Down movement ⫽ A firm observation that was in a lower earnings surprise
interval in the fourth quarter than in the third quarter; Same movement ⫽ A firm observation that remains in the same earnings surprise interval from the
third quarter to the fourth quarter; Up movement ⫽ A firm observation that is in a higher earnings surprise interval in the fourth quarter than in the third
quarter; Int ⫺1 ⫽ Interval ⫺1, where the earnings surprise calculation is greater than or equal to ⫺0.005 and less than 0. Also, see Section 4 for more details
on the earnings surprise calculations; Int ⫹1 ⫽ Interval ⫹1, where the earnings surprise calculation is greater than or equal to 0 and less than 0.005
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% Observaons for Q1
40%

35% % Observaons for Q2

30% 40%
35%
25%
30%
20% 25%
15% 20%
15%
10%
10%
5% 5%
0% 0%

–5 –4 –3 –2 –1 1 2 3 4 5 –5 –4 –3 –2 –1 1 2 3 4 5

Interval Interval

(a) (b)
% Observaons for Q3 % Observaons for Q4
40% 40%
35% 35%
30% 30%
25% 25%
20% 20%
15% 15%
10% 10%
5% 5%
0% 0%
–5 –4 –3 –2 –1 1 2 3 4 5
–5 –4 –3 –2 –1 1 2 3 4 5
Interval Interval
(c) (d)
Notes: (a to d) These graphs indicate the percentage of reported earnings that fell in intervals −5 to +5 in interim quarters; the
distribution of earnings converges toward interval −1 and +1 over time and interval +1 does not dominate until the fourth
quarter; interval construction is described in Section 6; the total span of intervals ranges from −32 to +32. On average, 76 per
cent of observations fall in intervals −5 to +5 for Q1 to Q4

Figure 2.
213
targets
threshold
Beating

interim quarters
thresholds during
earnings for all
Fraction of reported
 RAF account for the discontinuities in the distribution of earnings around the zero thresholds.
15,2 They provide evidence that the price per share is significantly lower for firms
experiencing a small loss than for firms experiencing a small profit, thereby driving net
income scaled by price further away from the threshold for firms that barely miss their
target relative to firms that barely beat their target. Furthermore, selection bias arises
because a larger fraction of loss firms do not have beginning of year prices available on
214 Computstat, thereby reducing the number of observations to the left of zero earnings.
The zero threshold comprises only 6.6 per cent of our sample. We address Durtschi
and Easton’s concerns by excluding these observations from the analysis in our
robustness tests and find that inferences about earnings management do not change.
Firms belonging to the zero thresholds do, however, behave differently. The
predominant movement for intervals ⫺1 and ⫹1 is down compared to up for firms
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assigned to the two other thresholds. This suggests that firms experiencing a small gain
or loss are particularly prone to having bad fourth quarters or having to reverse the
upward earnings management activities that occurred during interim quarters.
As stated previously, our metric for earnings managements is the difference between
annualized earnings cumulated through Q4 versus Q3. Because Q3, Q2 and Q1 are
common to both annualized earnings, the difference between Q4t and Q4t ⫺ 1 earnings
represents our earnings management metric. However, Q4t ⫺ 1 earnings may also have
been managed, and we may, therefore, be capturing the change in earnings management
from one year to the next instead of the earnings management in the current year.
Figure 3(a) addresses this issue by focusing on the subset of firms that landed in
intervals ⫺1 or ⫹1 in the current year (more likely to have managed earnings), but were
in other intervals in the prior year (less likely to have managed earnings). This should be
a cleaner proxy for unmanaged earnings in the current year. Figure 3(a) indicates that
this subset of firms is qualitatively similar to all firms and, in particular, to the AF
subset in terms of up versus down earnings management and the frequency with which
firms barely miss or meet/beat the threshold.
It is also possible for two (or even three) thresholds to be very close to each other
which would make it more difficult to assign a specific threshold to a firm. Figure 3(b)
presents the data excluding firms where another threshold is within $0.02 of the
assigned threshold. This subset of firms is also qualitatively similar to the main data set
and suggests that the choice of threshold in the more ambiguous cases did not distort
our inferences about earnings management.

8. Concluding comments
This paper contributes to the earnings management literature by attempting to identify
specific firms that manage earnings up or down as opposed to studying an aggregate
phenomenon. We use two key tools to accomplish this objective. First, we develop a
heuristic that assigns each firm’s annual earnings to a specific threshold, for example,
AFs, last year’s earnings or zero earnings. We hypothesize that managers will pick the
highest achievable target as the threshold of choice. Second, we use a methodology
similar to that used by JJ of using annualized earnings cumulated from third quarter to
third quarter as a proxy for unmanaged annual earnings. The combination of a specific
threshold, a proxy for unmanaged earnings and reported earnings allows us to identify
specific firms that manage earnings up or down in the fourth quarter.
 Q3 to Q4 Moves With Prior Year's Earnings Unmanaged Beating
2,500
threshold
targets
2,000
Number of Firms

1,500
215
1,000

500
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0
Int –5 Int –4 Int –3 Int –2 Int –1 Int +1 Int +2 Int +3 Int +4 Int +5
DOWN SAME UP
(a)
Q3 to Q4 Moves With Thresholds More Than $0.02 Apart
12,000

10,000
Number of Firms

8,000

6,000

4,000

2,000

0
Int –5 Int –4 Int –3 Int –2 Int –1 Int +1 Int +2 Int +3 Int +4 Int +5
DOWN SAME UP
(b) Figure 3.
Robustness tests
Notes: Variable definitions: interval calculations for Figures (a) to (b) are described in Section 5; designed to confirm
down = the observation is in a lower-numbered interval in Q4 than it was in Q3; same = the the threshold
observation is in the same interval in Q4 as it was in Q3; up = the observation is in a assignment
higher-numbered interval in Q4 than it was in Q3 methodology

Our study has practical implications because investors and regulators can adopt this
methodology to identify potential candidates for earnings management that would
allow further insight into accounting and reporting practices. This methodology may
also be useful to the auditor who wants to understand the earnings management
tendencies of a new client. It may also be a tool for framing auditing hypotheses in a way
that would be appropriate for clients who manage earnings.
Our threshold assignment mechanism and proxy for unmanaged earnings allow
us to make three important contributions to the earnings management literature.
 RAF First, we document the frequency with which firms manage earnings up or down to
15,2 barely meet/beat their earnings thresholds. Second, we document that the market
rewards “good” firms that are able to find the extra penny to meet/beat their
earnings threshold. Third, we document that the market either does not see or
chooses to reward firms that deliberately understate earnings to barely meet/beat
expectations.
216 We focus on firms that barely miss or meet/beat their target earnings because they
are more likely to have used earnings management tools. Consistent with conventional
wisdom, most firms that meet/beat their target do so by managing earnings up. Of the
firms that barely meet/beat their target, 67.1 per cent managed earnings upward, while
only 14.2 per cent managed earnings downward. This suggests only weak evidence in
favor of the hypothesis that managers will “cookie jar” earnings to create reserves for
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future years.
Furthermore, the market appears to reward upward earnings management in this
context (three-day CAR ⫽ ⫹1.00 per cent) while punishing firms that deliberately
understate earnings by downward management (three-day CAR ⫽ ⫺0.33 per cent). Our
evidence, therefore, supports the hypotheses that the market favorably views firms with
the ability to “find an extra penny of earnings” to barely meet/beat the target.
However, a surprisingly large fraction of firms that barely miss their target (37.0 per
cent) apparently managed earnings down in the fourth quarter. Alternative
explanations are clearly needed and include those firms that had a bad fourth quarter,
and/or they had managed earnings up too far in the interim quarters, and thereby lack
ability to manage up in the fourth quarter. We find evidence for the latter explanation
insofar as the distribution of earnings becomes tighter around the target as each quarter
progresses. Given that such “cookie jar” activity is not rewarded by the market, on
average, our alternative explanation seems more plausible. If so, this interpretation runs
counter to the conventional wisdom of the market participants that creating “cookie jar”
may be a good thing. Furthermore, we document that regardless of managing up or
down, the market reaction for firms that barely miss (meet/beat) their earnings target is
negative (positive). This supports our argument that the market rewards flexibility with
which targets can be met.
Finally, we find two interesting features of the change in the distribution of
annualized earnings from the first to the fourth quarters. There is a distinct shift from
missing the target toward meeting/beating the target. There is also a distinct
convergence toward the target, that is, the variance around the target decreases as time
passes. This finding offers additional insights into the dynamics of earnings
management, insights that cannot be observed through the aggregate analysis of the
phenomenon. Such observation opens up many avenues of future research using our
methodology.

Notes
1. DeAngelo et al. (1996), for example, document a ⫺14 per cent stock market reaction for firms
that experience an earnings decline after several consecutive years of earnings increases.
Barth et al. (1999) find higher P/E multiples after firms demonstrate several consecutive
years of earning increases. Bartov et al. (2002) show that firms that meet/beat their earnings
benchmarks perform better the following year than firms that miss their benchmark. Kasznik
 and McNichols (2002) find that future earnings are higher for firms that meet/beat their Beating
benchmark than for those that miss their benchmark. threshold
2. Graham et al. (2005) surveyed and interviewed over 400 financial executives about their targets
earnings reporting strategy. When asked what benchmarks were important, respondents
agreed or strongly agreed that beating the following earnings targets were important: same
quarter last year (85 per cent); AFs (74 per cent); zero earnings (65 per cent); and last quarter’s
earnings (54 per cent). The CFOs strongly believe that the ability to deliver earnings and hit 217
benchmarks is important to “build credibility with the capital market” and “maintain or
increase stock price”. They also believe that meeting/beating benchmarks enhances their
reputation with customers, suppliers and creditors. Compensation (e.g., management
bonuses) was considered a second-order effect. The top two consequences of a failure to meet
earnings targets were “an increase in uncertainty about future prospects” and “a perception
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among outsiders that there are deep, previously unknown problems at the firm”. Thus,
financial executives appear to be very concerned about not raising doubts among investors
about the underlying viability of the firm and are willing to find the “earnings” to meet/beat
expectations. Also, refer to Matsumoto (2002) for more anecdotal evidence. Other research
largely mirrors the results of the Graham et al. survey. Academic research documents that
managers try to avoid bad news earnings surprises (Payne and Robb, 2000; Brown, 2001;
Burgstahler and Eames, 2006). Jiang (2008) examines whether firms that meet/beat their
earnings targets have a lower cost of debt capital. The data indicate that such firms have
better one-year-ahead credit ratings and smaller initial bond yield spreads.
3. We understand that the efficacy of the results are dependent on the heuristic for identifying
the firm-specific threshold and the proxy for unmanaged earnings. Selecting the highest
achievable threshold seems compatible with economic incentives faced by management and
the JJ methodology is well established (34 citations in the accounting literature).
4. It is important to note that selection of threshold ought to be an integral part of detecting
earnings management. One of the main tools for detecting earnings management (besides the
use of the concept of “abnormal accrual”) relies on kinks in the distribution of reported
earnings around benchmarks. This work was pioneered by Hayn (1995) and Burgstahler and
Dichev (1997) who found that the frequency of observations was smaller than expected just to
the left (negative) of zero earnings and last period’s earnings and higher than expected just to
the right (positive) of those thresholds. They interpreted this discontinuity as evidence of
earnings management. Other researchers have subsequently used this technology to study
earnings management under a variety of contexts (Beatty et al., 2002; Leuz et al., 2003).
DeGeorge et al. (1999) use AFs as the threshold and report similar discontinuities. The
problem with this proxy for the earnings target is that AFs are the peak of the distribution
which makes it more difficult to estimate the expected frequency of observations just below
the peak. One way is to assume that the distribution is symmetrical, but there is no a priori
reason why this should be so. Also, such methodology begs the question of why a sample of
all firms should distribute the same characteristics, when different firms may be adopting
different thresholds.
5. Managers have (at least) three tools at their disposal to manipulate earnings: discretionary
accruals, real operating expenses and influencing the expectations themselves. Accounting
researchers have examined aggregate discretionary accrual models that are based on the
cross-sectional regression model proposed by Jones (1991), where the residual is interpreted as
the discretionary accrual (Burgstahler and Dichev, 1997; Dechow and Dichev, 2002;
 RAF McNichols, 2002; and others). The resulting estimates of discretionary accruals are typically
15,2 biased, have low power and do not provide information about the specific components of
earnings that are being managed. Other researchers have examined specific accruals, such as
allowance for bad debts, provisions for loan losses in the banking industry and income tax
expenses (McNichols and Wilson, 1988; Beaver et al., 1989; Phillips et al., 2003).
Roychowdhury (2006) reports evidence that firms manage real activities such as price
218 discounts to increase sales, overproduction to reduce cost of goods sold and reductions in
discretionary expenditures to achieve earnings targets. Athanasakou et al. (2011) find that the
market does not reward UK firms that achieve expectations by manipulating the guidance
given to analysts. Overall, this research is consistent with CFOs responses to Graham et al.
(2005)’s survey on these topics. However, the empirical research has not been able to identify
which firms actually manage earnings and when. Other research has explored the flexibility
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of accrual manipulation (Hiu, 2012), and has extended literature on balance sheet constraints
(Li-Chin, 2012).
6. Such modification avoids the “weighting” problem as commented on by Easton and Durtschi
(2009). See also note 10.
7. The wide prevalence of the abnormal accruals model to identify earnings management lends
credence to the assumption that earnings management is done primarily through accruals
(Jones, 1991; Dechow, 1994; Badertscher et al., 2012). Other research has shown that
management also manipulates real operating activities to achieve earnings management
(Roychowdhury, 2006).
8. Durtschi and Easton (2009) criticize the JJ method by stating that cumulating quarterly
earnings over different fiscal years is inappropriate due to: the integral method of accounting,
i.e., each quarterly statement is an installment in only one fiscal year; annual expenses are
allocated to quarters within a fiscal year and are “settled up” in the fourth quarter to actual
expenses; and the allocations across quarters can be different for different fiscal years. Given
that JJ method requires a weighted average of different quarterly earnings, the critique has
somewhat more merit. Our method limits these concerns because it involves no weighting,
and it extends the economic reality by just one quarter. If the earnings process is relatively
stable and earnings management is done primarily through discretionary accruals,
annualized earnings ending in other quarters, particularly Q3, should be an attractive
benchmark for unmanaged earnings.
9. It is true that not all firms characterized like this will have used accruals to manage earnings.
Some firms may have had a good fourth quarter with real earnings that caused them to
meet/beat the target. However, it is generally acknowledged that a sample of firms that barely
misses or meets/beats its target is likely to contain a disproportionate number of earnings
managers.
10. JJ use the average of annualized earnings cumulated over the first, second and third fiscal
quarters to proxy for unmanaged earnings. Durtschi and Easton point out that this is not a
simple average as certain quarters (Q1,t and Q4,t⫺1) are included three times while other
quarters (Q3,t and Q2,t⫺1) are included only once.
11. We also address the issue by testing alternative metrics for unmanaged earnings. Specifically,
we use current year (Q2 ⫹ Q3) ⫻ 2 earnings and (Q1 ⫹ Q2 ⫹ Q3) ⫻ 4/3 earnings as proxies
for unmanaged earnings. The market reaction (three-day CAR) in intervals ⫺1 and ⫹1 for
firms that manage earnings down, same or up are very close to those reported in Table XI. We
 note that all proxies are imperfect, for example, (Q2 ⫹ Q3) ⫻ 2 avoids the earnings Beating
management impact of using Q4 but ignores the seasonality. Similarly, (Q1 ⫹ Q2 ⫹ Q3) ⫻ 4/3 threshold
also avoids the Q4 impact but is subject to possible reversal of prior Q4 accruals. The fact that
the market response is similar for several different proxies for unmanaged earnings at
targets
minimum suggests that our results are not particularly sensitive to the way we define the
unmanaged earnings (results are available on request).
12. We also examine the percentage of thresholds represented by AFs year-by-year and find that 219
it is very steady around 81.9 per cent (the standard deviation is 2.1 per cent). The exception is
2008 when the fraction of AF thresholds plummets to 69.8 per cent, while the fraction of zero
thresholds jumps to 15.4 per cent. This, of course, corresponds to the effects of the recent
recession.
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13. We eliminated firm-year observations prior to 1990 and found no significant differences from
the results shown in Table XI.
14. The mean difference for interval ⫹1 comparing the movement up to the movement down
group is ⫺1.34 per cent. This difference is significant at the 1 per cent level.

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About the authors

Mary P. Mindak is an Assistant Professor at DePaul University. She graduated from Miami
University with a BS in Accountancy in 1999 and a Masters of Accountancy in 2000. She attended
the University of Cincinnati and achieved her PhD in 2009. She has published papers in Issues in
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Accounting Education, Managerial Auditing Journal, Research in Accounting Regulation, Journal

of Accounting Ethics and Public Policy, CMA Magazine and The CPA Journal. Professor Mindak
is working on various research projects in the areas of audit risk, bankruptcy, earnings
management and corporate environmental responsibility.
Pradyot K. Sen is a Professor at the University of Washington, Bothell. He received PhD at
Columbia in 1985. He has published papers in the Journal of Accounting Research, Accounting
Review, Management Science, Academy of Management Journal, Journal of Accounting Auditing
and Finance, Journal of Business Finance and Accounting, etc. His current area of work is
corporate governance, fundamental valuation and understanding of information asymmetry and
its application in accounting and auditing.
Jens Stephan is a Professor at Eastern Michigan University. His research interests are in the
capital markets area where he has investigated questions of interest to accounting and finance
researchers. He has also published papers in professional journals targeted for practitioners and
educators. Furthermore, he earned his PhD from Cornell University in 1985, teaches financial and
managerial accounting and has delivered executive education programs to organizations in the
USA and in abroad. Jens Stephan is the corresponding author and can be contacted at:
jens.stephan@emich.edu

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