Earnings Management? Erroneous Inferences Based on Earnings Frequency Distributions

Authors


  • We thank Brad Badertscher, Ray Ball, Miao Bin, Jeff Burks, Donal Byard, Vincent Chen, Carol Dee, Rosemary Fullerton, Alon Kalay, Christian Leuz, Carol Marquardt, Fred Mittelstaedt, Mike Morris, Joe Piotroski, Rachna Prakash, Ram Ramanan, Arnt Verriest, students in Ray Ball's Accounting Ph.D. class at the University of Chicago, workshop participants at the 2009 CARE conference, Baruch College, College of William and Mary, DePaul University, Katholieke Universitiet Leuven, Loyola University of Chicago, National University of Singapore, University of Notre Dame, Utah State University, and the Ball and Brown tribute conference, University of New South Wales for helpful comments on an earlier draft of this paper, and students in the 2007 Limperg Institute “Advanced Capital Markets” class organized by Jan Bouwens at Tilburg University for helpful discussions during the early stages of this work.

ABSTRACT

A vast literature following Hayn [1995] and Burgstahler and Dichev [1997] attributed the so-called “discontinuities” in earnings distributions around zero to earnings management. Despite recent evidence that these discontinuities are likely caused by other factors, researchers and teachers continue to point to the shapes of these distributions as evidence of earnings management. We provide three sets of further evidence that these discontinuities are likely caused by factors other than earnings management: (1) we provide, as an example, a detailed analysis of the severe effects of sample selection in a recent study; this study erroneously concludes that the shape of an earnings distribution is evidence of earnings management, (2) we provide a simple explanation for the shape of the earnings distribution that is most often cited as evidence of earnings management; the relation between earnings and prices differs with the magnitude and the sign of earnings, and (3) we provide further examples that support the main point of our paper; evidence beyond the mere shape of a distribution must be brought to bear before researchers can draw conclusions regarding the presence/absence of earnings management.

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