Earnings management in the aftermath of the zero-earnings discontinuity disappearance

Purpose: The purpose of this paper is to investigate earnings management by firms reporting a small profit or a small loss after the recent evidence that the discontinuity around zero earnings has disappeared.

Design/methodology/approach: Using a large sample of US firms for the period 2002-2011, regression analysis and earnings distribution approach are employed to examine the earnings management of small profit and small loss firms in terms of both accruals management and real activities manipulation.

Findings: The results suggest that both small profit and small loss firms are engaged in upward manipulation of accruals and real activities. This implies that failure to document a difference between firms to the right and left of zero by prior studies is not due to small profit firms not managing earnings, but rather this is more attributable to loss firms engaging in upward manipulation. Furthermore, it is indicated that the discontinuity around the distribution of earnings change has also recently disappeared as firms reporting a small earnings decrease demonstrate similar earnings management behavior to those reporting a small earnings increase.

Research limitations/implications: This study is subject to the measurement error which is a common limitation in the earnings management literature.
Practical implications: The results suggest that the users should be aware that, in addition to firms that meet benchmarks by a slight margin, firms narrowly missing benchmarks are also involved in earnings management.

Originality/value: This study shows that the disappearance of the discontinuity around zero earnings and zero change in earnings should not be interpreted as a sign of no earnings management. It also explains how earnings management could have contributed to the disappearance of the discontinuities in earnings distribution.