The Annual Earnings Distribution's Characteristics in Small Cumulative Profits Firms at the End of the Third Quarter －Focused on the Income Smoothing－
Asian Tax Journal Vol. 12 No. 1 (2011), pp. 229-264
Abstract
Prior research examines whether firms manage earnings to meet or beat certain benchmarks (e.g., profitability, earnings increases, and analysts’ forecasts). Building on the results of Burgstahler and Dichev (1997) show that there is a large discontinuity, or kink, in the annual earnings distribution around zero. Degeorge et al. (1999) find similar evidence using quarterly earnings distributions. Also, prior research examines whether manage earnings the fourth quarter earnings to use the last chance to meet or beat certain benchmarks. Specifically, prior research examines whether firms that unmanaged earnings are small loss of the cumulative earnings distribution at the end of the first three quarters report small profits annual earnings to avoid negative earnings surprises by managing the fourth quarter earnings (Kerstein and Rai 2007 ; Park and Jeon 2010). Whereas, we investigates whether firms with small cumulative profits at the beginning of the fourth-quarter manage fourth quarter earnings to income smoothing. We argue that such firms are the most likely not to manage earnings upward or downward, still at the stay. One particular manifestation of earnings management is smoothing or managing reported earnings to achieve a certain earnings targets across accounting periods. Tucker and Zarowin (2006) report that the changes in the current stock prices of higher smoothing firms contain more information about these firms’ future earnings than do the changes in the current stock prices of lower smoothing firms. Taken collectively this study support the notion that income smoothing represents an efficient vehicle for managers to reveal private information. We then test whether firms shift abnormally within the fourth-quarter earnings distribution to achieve annual profits corresponding to the smallest profit level considered. Further, we extend the earnings distribution approach to identifying earnings management by examining changes to the earnings distribution, not just the earnings distribution itself, and also extends Kerstein and Rai (2007). Our logistic regression results provide strong evidence that firms with the smallest cumulative profits (small profits level at the end of the third-quarter, unmanaged earnings are small profits more than prior year earnings at the end of the third-quarter, and unmanaged earnings are small beating profits more than analyst’s forecasts at the september) also report the smallest annual profits at an abnormally high rate in order to income smoothing. That is, for the benefit of the firms contains more private information about their future earnings. Overall, our results show that compared to a control group (large cumulative profits or small cumulative losses at the first three quarter), a high proportion of firms with small cumulative profits at the beginning of the fourthquarter report small annual profits rather than large annual profits or small annual losses. Therefore, our study contributes to the earnings management literature.
Keywords
- small profit
- cumulative earnings through the first three quarters
- annual earnings
- earnings distribution
- income smoothing
- avoiding losses and earnings declines
- meeting analyst's earnings forecasts
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