Hierarchy of earnings thresholds based on discretionary accruals

Abstract

Prior studies identify hierarchies of earnings thresholds based on distributions of earnings (e.g., Degeorge et al., 1999) and survey opinions of CFOs (Graham, Harvey, & Rajgopal, 2005). We complement extant literature by investigating a threshold hierarchy in the context of accounting discretion exercised by managers. We examine the relative extent of discretionary accruals used to achieve three earnings thresholds—avoiding losses, avoiding earnings declines, and avoiding negative earnings surprises. Our empirical findings suggest that managers are likely to use the largest amount of discretionary accruals to avoid earnings declines, and the least amount of discretionary accruals to avoid negative earnings surprises. Thus, this study identifies the hierarchy of the earnings thresholds based on accounting discretion used in financial reporting. We also find that the hierarchy remains stable over the last two decades during our sample period. Then, we provide several explanations for why managers are likely to exercise more accounting discretion to avoid earnings declines. These explanations include earnings smoothing, reduction of stock returns volatility, and signaling of future growth potential. Overall, this study provides new insights into accruals management behavior.

Introduction

Managers often exercise considerable discretion over accruals in financial reporting to achieve pre-set earnings thresholds. Prior studies (e.g., Beneish, 1998; Healy & Wahlen, 1999) underscore the importance of understanding the motives and extent of accruals management. This study empirically measures the relative extent of discretionary accruals used in achieving three earnings thresholds—avoiding losses, avoiding earnings declines, and avoiding negative earnings surprises. Thus, a hierarchy of earnings thresholds emerges based on the extent of discretionary accruals. While prior studies also identify the hierarchy of earnings thresholds based on the distributions of earnings (Burgstahler & Dichev, 1997; Dechow, Richardson, & Tuna, 2003; Degeorge, Patel, & Zeckhauser, 1999), capital market rewards (Brown & Caylor, 2005), and survey opinions (Graham, Harvey, & Rajgopal, 2005), we focus on discretionary accruals that reflect managerial action to achieve these earnings thresholds.¹ We also explore factors that explain the hierarchy identified based on the relative use of discretionary accruals to achieve earnings thresholds.

Investigating the relative extent of discretionary accruals used to achieve earnings thresholds is particularly interesting and important for several reasons. First, accruals management is the main accounting mechanism employed by managers to achieve earnings thresholds. A large volume of research in earnings management literature suggests that managers rely on discretionary accruals to achieve earnings thresholds (Burgstahler & Eames, 2006; Matsumoto, 2002; Payne & Robb, 2000).² Moreover, academic researchers, policy makers, standard setters, and regulators have routinely expressed concerns about earnings management based on accruals.³ Second, identifying the hierarchy based on managerial discretion in financial reporting could potentially provide further insights into the relative extent of accruals management for achieving these thresholds, which may help regulators and auditors in their enforcement processes (Healy & Wahlen, 1999). Third, extant literature documents explanations for achieving earnings thresholds. Firms are rewarded (penalized) by the capital market for achieving (missing) those thresholds (Barth, Elliott, & Finn, 1999; Bartov, Givoly, & Hayn, 2002; Brown & Caylor, 2005; Graham et al., 2005; Kasznik & McNichols, 2002; Lopez & Rees, 2002). Graham et al. (2005) also offer other explanations for achieving earnings thresholds such as smoothing earnings, reducing stock price volatility, signaling about growth prospects, attaining desired credit rating, maintaining external reputation of management, and earning bonuses. For example, 96.9% of survey respondents in Graham et al. (2005) suggest that they prefer smooth earnings. Complementing prior studies, we provide explanations that are consistent with the hierarchy based on the relative extent of discretionary accruals used to achieve earnings thresholds.

To address our research questions, we use firm years between 1990 and 2012, which cover most of the sample periods of the prior studies that examine the hierarchy of earnings thresholds. We follow the research design by Brown and Caylor (2005) to identify eight mutually exclusive and collectively exhaustive categories of achieving or missing the three earnings thresholds. We then regress discretionary accruals on the eight category indicator variables after controlling for other factors that affect discretionary accruals.^4,5 This approach estimates the average amount of discretionary accruals used to achieve each earnings threshold, which, in turn, enables us to rank the three earnings thresholds based on the relative use of discretionary accruals. By relying on the regressions with the indicator variables of the eight mutually exclusive and collectively exhaustive categories of achieving/missing each earnings threshold, we also overcome the shortcoming of investigating one earnings threshold conditional on only one other earnings threshold (not the other two earnings thresholds at the same time).⁶

Empirical results show that discretionary accruals are consistently higher for avoiding earnings declines than for the other two earnings thresholds since the mid-1990s. These findings suggest that managers exercise more discretion over financial reporting to avoid earnings declines (i.e., smoothing earnings) than the other two earnings thresholds. Our results also suggest that managers use the least amount of discretionary accruals to avoid negative earnings surprises throughout the sample period. While we do not interpret these results as indicative of the relative importance of earnings thresholds to managers, we show the relative extent of discretionary accruals employed in achieving those thresholds. These results may also imply that managers rely on other mechanisms such as earnings guidance (i.e., expectations management), to avoid negative earnings surprises. By contrast, managerial discretion over financial reporting appears to be the main means of avoiding earnings declines. Unlike prior studies (e.g., Brown & Caylor, 2005; Dechow et al., 2003), we do not find evidence of any temporal shift in the hierarchy of earnings thresholds based on discretionary accruals. Our findings suggest that the hierarchy of the three earnings thresholds with respect to discretionary accruals used in financial reporting consistently maintains the following order: (1) avoiding earnings declines, (2) avoiding losses, and (3) avoiding negative earnings surprises. We also provide several explanations for the hierarchy that emerges from our analyses. First, we find that high historical earnings volatility is significantly associated with the incremental use of discretionary accruals to avoid earnings declines. Second, we observe that firms with high prior stock returns volatility are likely to use more discretionary accruals to avoid earnings declines. Third, managers of firms with high growth potentials are inclined to exercise more discretion over financial reporting to avoid earnings declines.⁷ These findings are consistent with the notion that managers rely more on discretionary accruals to avoid earnings declines when they try to smooth earnings and convey future growth prospects to investors. Our results are robust to several sensitivity checks.

The findings in this study contribute to extant literature in several ways. First, we complement prior studies that examine the hierarchy of the three earnings thresholds based on earnings distributions (Dechow et al., 2003; Degeorge et al., 1999), capital market valuation (Brown & Caylor, 2005), and survey opinions (Graham et al., 2005) by identifying the hierarchy based on managerial discretion in financial reporting (i.e., discretionary accruals). To the best of our knowledge, this is the first study that examines the hierarchy of earnings thresholds based on discretionary accruals. Second, this study provides new insights into earnings management behavior for achieving earnings thresholds. We show that avoiding earnings declines receives the highest priority in using discretionary accruals. Along with prior archival findings, our results imply that managers rely more on other means (e.g., earnings guidance) to achieve other earnings thresholds. Third, our results indirectly suggest that firms that avoid earnings declines should be monitored closely when potential earnings management in financial reporting is investigated. Finally, several explanations are offered for achieving earnings thresholds based on the discretionary accruals that managers employ, which are consistent with the hierarchy of earnings thresholds reported in this study.

This study is organized as follows. Section 2 summarizes prior research and develops research questions. Section 3 describes the research design process. Section 4 explains the sample selection procedure and data requirements. Section 5 presents the empirical findings about the hierarchy of earnings thresholds based on discretionary accruals. Section 6 provides explanations for the hierarchy documented in this study. Section 7 discusses robustness checks. Section 8 concludes this study.