Discontinuities and Earnings Management: Evidence from Restatements Related to Securities Litigation


  • Accepted by Jere Francis. We thank Jere Francis (Editor), two anonymous referees, Dave Burgstahler, Jeff Burks, Shuping Chen, Daniel W. Collins, Peter Easton, Dan Givoly, Cristi Gleason, Michelle Hanlon, Ross Jennings, W. Bruce Johnson, Bill Kinney, Theodore Sougiannis, and Ryan Wilson; and workshop participants at The University of Iowa, The University of Texas at Austin, the 2010 American Accounting Association Annual Meeting, and the 2010 American Accounting Association FARS Midyear Meeting for their comments. We thank Isaac Griesbaum for excellent research assistance.


A heated debate exists as to whether discontinuities in earnings distributions are indicative of earnings management. While many studies attribute discontinuities in earnings distributions to earnings management, other studies argue that earnings discontinuities are artifacts of sample selection and research design. Overall, there is limited direct evidence of a connection between earnings discontinuities and earnings management. In this study, we provide direct evidence linking earnings management to earnings discontinuities for a sample of firms that settle securities class action lawsuits and restate earnings from the alleged GAAP violation period. We compare the distribution of restated (“unmanaged”) earnings to originally reported (“managed”) earnings. We find that discontinuities are not present in the distribution of analyst forecast errors and earnings changes using unmanaged earnings but are present using managed earnings. The discontinuity in the earnings level distribution is attenuated, but not eliminated, on an unmanaged basis. These shifts among our sample of firms are caused by earnings management and cannot be explained by sample selection or research design issues. Our findings are important because many studies use earnings discontinuities as a proxy for intentional earnings manipulations and we provide the first direct evidence of a link between these two phenomena.