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What Have We Learned About Earnings Management?

Integrating Discontinuity Evidence*

David Burgstahler
Julius A. Roller Professor of Accounting
University of Washington/Seattle

Elizabeth Chuk
University of Southern California

March 30, 2015

Abstract

The accounting literature includes numerous examples of discontinuities at prominent


benchmarks that are widely interpreted as evidence that earnings are managed to meet those
benchmarks. However, there are also a few examples where discontinuities do not exist, which
are sometimes interpreted as inconsistent with earnings management. There are also several
suggested alternative explanations for discontinuities. This paper reviews and integrates the
various elements of the body of discontinuity-related evidence.

JEL classification: G14, M40


Key Words: Earnings management, discontinuities
* We appreciate helpful comments and suggestions on earlier drafts from Ilia Dichev, Bill
Kinney, Terry Shevlin, Bob Trezevant, and two anonymous reviewers.

Electronic copy available at: http://ssrn.com/abstract=1866008


1. Introduction

A large body of evidence documents discontinuities in earnings distributions. This

evidence is widely, but not universally, interpreted as consistent with the theory that earnings are

managed to meet prominent benchmarks. This theory posits that when pre-managed earnings are

lower than but sufficiently close to a benchmark such that the cost of managing earnings to exceed

the benchmark is low, firms take actions that transform pre-managed earnings below the

benchmark into post-managed (i.e., reported) earnings at or above the benchmark. As a result, the

distribution of reported earnings includes fewer observations below, and more observations above,

the benchmark than does the distribution of pre-managed earnings.

Despite extensive discontinuity evidence consistent with the theory that earnings are

managed to meet benchmarks, there are also some papers that provide evidence that is seemingly

inconsistent with the theory, comprising two basic forms of evidence. First, some papers provide

evidence that seems to support alternative explanations for discontinuities. For example, Durtschi

and Easton (2005, 2009) argue that discontinuities in earnings distributions are due to artifacts

such as scaling, sample selection, and the systematic relation between earnings and price, while

Beaver, McNichols, and Nelson (2007) suggest that discontinuities are due to a combination of the

effects of income taxes and the non-discretionary special items component of earnings. Second,

there are several papers that fail to find evidence that discontinuities are related to other commonly

used proxies for earnings management, such as discretionary accruals.

The purpose of this paper is to integrate and reconcile the various discontinuity-related

results that have appeared in the literature. The theory that earnings are managed to meet

benchmarks implies that differences in costs and benefits of managing earnings (across

benchmarks, firm characteristics, or time) will result in different rates of earnings management

and therefore differences in discontinuities. In Section 2, we summarize discontinuity evidence in

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Electronic copy available at: http://ssrn.com/abstract=1866008


the existing literature and review the extent to which the body of evidence is consistent with the

theory that earnings are managed. In Section 3, we evaluate the extent to which alternative

theories can explain the body of discontinuity evidence. Finally, in Section 4 we present some

additional empirical evidence on determinants of differences in discontinuities. Section 5

concludes.

2. Theory and Characteristics of Discontinuity Evidence

Economic theory suggests that firms manage earnings to meet benchmarks when the

benefits exceed the costs. Burgstahler and Dichev (1997, hereafter BD) suggest the primary

benefits of managing earnings to meet a benchmark are improved terms of transactions with

stakeholders, such as lower wage and benefit demands from current and potential employees,

better terms from suppliers and creditors, and higher valuation by shareholders. The costs of

managing earnings include the cost of restructuring transactions (real earnings management) and

the cost of making accrual accounting choices (accrual-based earnings management) to increase

current earnings.

Discontinuities in earnings distributions at benchmarks are characterized by an unusually

large number of observations immediately above the benchmark and an unusually low number of

observations immediately below the benchmark. Next, we summarize existing discontinuity

evidence within a framework based on five key characteristics of discontinuity evidence that are

highly consistent with the theory of earnings management:

1. Pervasiveness
2. Evidence of a trough below the benchmark and a peak above the benchmark
3. Covariation with earnings management incentives
4. Existence in earnings measures that are widely used in stakeholder decisions
5. Non-existence in earnings measures that are not widely used in stakeholder decisions

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Electronic copy available at: http://ssrn.com/abstract=1866008


2.1 Pervasiveness

Discontinuities appear in distributions of a variety of earnings measures, including

earnings, changes in earnings, and earnings surprise (i.e., earnings less forecasts) at a variety of

benchmarks, in annual and in quarterly earnings, and in the US and other countries. There is

evidence of discontinuities in a variety of earnings measures including levels of earnings at the

profit/loss benchmark (Hayn, 1995; BD, 1997; Degeorge et al., 1999; Burgstahler 2014), earnings-

per-share at zero, at other prominent non-zero benchmarks such as multiples of 5 or 10 cents per

share, and in the third decimal digit (Thomas, 1989, Das and Zhang, 2003, Grundfest and

Malenko, 2009, Jorgensen, Lee, and Rock, 2014, Burgstahler and Chuk, forthcoming); earnings

changes at zero (BD, 1997; Degeorge et al., 1999; Beatty et al., 2002; Brown and Caylor, 2005;

Donelson et al., 2013); and earnings surprise at zero (Degeorge et al., 1999; Abarbanell and

Lehavy 2003; Brown and Caylor, 2005; Burgstahler and Eames, 2006; Donelson et al., 2013).

There is similar evidence using international data (Leuz, Nanda, and Wysocki, 2003; Haw et al.,

2005; Daske et al., 2006; Suda and Shuto, 2007). Evidence of discontinuities also exists for

performance measures other than earnings, such as debt covenant slack ratios (Dichev and

Skinner, 2002), current ratios (Dyreng, Mayew, and Schipper, 2012), and for reported hedge fund

returns (Bollen and Pool, 2009).1

2.2 Evidence of a trough below the benchmark and a peak above the benchmark

Discontinuities generally consist of both a trough below the benchmark and a peak above

the benchmark, consistent with the earnings management hypothesis that pre-managed earnings

below the benchmark are transformed into reported earnings above the benchmark. For examples

1
There is also evidence that choices about whether to take additional at-bats near the end of the season create
discontinuities in distributions of professional baseball batting averages and choices about whether to retake college
entrance exams create discontinuities in exam scores (Pope and Simonsohn, 2010)

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and discussion of distinctive trough and peak discontinuities, see BD; Das and Zhang, 2003;

Degeorge et al., 1999; Chen et al., 2010; and Jacob and Jorgensen, 2007. Also see Kerstein and

Rai 2007 and Dhaliwal, Gleason, and Mills 2004 for more direct evidence on actions that

transform pre-managed earnings below the benchmark into reported earnings above the

benchmark.

2.3 Covariation with earnings management incentives

Evidence that discontinuities co-vary with factors that affect the costs or expected benefits

of earnings management provides further support for the theory that discontinuities are due to

management of earnings to meet benchmarks. In settings where benefits are lower or costs are

higher, the proportion of observations where the benefits exceed the cost falls, and discontinuities

dissipate or vanish completely. For example, Burgstahler and Dichev (1997) provide evidence

that discontinuities in earnings levels (changes) are weaker among firms with a weaker record of

recent profitability (increases in profitability), consistent with the hypothesis that these firms

expect lower benefits or face higher costs of managing to meet benchmarks. Conversely,

discontinuities are stronger among firms with stronger incentives to manage earnings due to higher

benefits or lower costs. For example, Beatty, Ke, and Petroni (2002) hypothesize that public banks

have stronger incentives to report earnings increases than private banks and find corresponding

evidence of stronger discontinuities for public banks. Burgstahler and Chuk (forthcoming)

suggest that weaker evidence of discontinuities among smaller market capitalization firms and

among lower price per share firms is consistent with lower benefits and higher costs of earnings

management for those firms. Gilliam, Heflin, and Patterson (forthcoming) provide evidence that

suggests the costs of earnings management may have increased following passage of Sarbanes-

Oxley, resulting in much weaker evidence of discontinuities subsequent to Sarbanes-Oxley.

Finally, Li (2014) develops a model that predicts the strength of the discontinuity in earnings will

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be related to the autocorrelation of firms' earnings series and reports evidence consistent with the

differences predicted by the model.

2.4 Existence in earnings measures widely used in stakeholder decisions

Discontinuities appear in distributions of various forms of earnings that are widely-

reported and commonly used in stakeholder decisions, such as earnings before extraordinary

items, net income, or earnings per share (see, for example, BD, Das and Zhang 2003, Jacob and

Jorgensen 2007, Grundfest and Malenko 2009, Jorgensen, Lee, and Rock 2014, Burgstahler and

Chuk, forthcoming).

2.5 Non-existence in earnings measures not widely used in stakeholder decisions

Discontinuities do not appear in measures of earnings that are not widely-reported and used in

stakeholder decisions. For example, Jacob and Jorgensen (2007) show that there are highly

significant discontinuities in distributions of annual earnings while there are not discontinuities in

distributions of "pseudo annual earnings" measures constructed by adding earnings from four

adjacent quarters ending at interim quarter-ends. More recently, Jorgensen, Lee, and Rock (2014)

report evidence from a natural experiment created when the focal EPS measure was changed by

SFAS 128 and firms were required to report retroactively restated Diluted EPS measures. The

discontinuity at the zero benchmark appears in distributions of changes in 'as reported' Primary

EPS but not in changes in 'as restated' Diluted EPS, consistent with expectations if reported

earnings measures are managed to avoid small earnings decreases, whereas subsequently defined

and reported restated earnings measures are not managed.

Similarly, Dechow, Richardson, and Tuna 2003 Figure 6 shows that the distribution of

reported earnings contains a discontinuity while the distribution of their constructed "earnings

before discretionary accruals" does not. They also describe similar results for earnings before a

randomly generated variable with the same mean and variance as their measure of discretionary

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accruals. These results further support the theory that discontinuities are due to earnings

management because both earnings before discretionary accruals and earnings before randomly

generated noise are measures that are not widely used in stakeholders decisions so there is little

incentive to manage these measures to meet benchmarks. In Section 3.2 below, we provide some

additional examples showing that discontinuities do not occur in distributions of earnings

measures that are not widely used in stakeholder decisions, such as earnings before special items

or earnings before depreciation or earnings before research and development expense.

Consistent evidence of discontinuities for earnings measures widely used in stakeholder

decisions but not for earnings measures that are not used by stakeholders substantially narrows the

set of plausible explanations for discontinuities. This evidence is inconsistent with explanations

that apply to earnings measures irrespective of whether the measure is used by stakeholders. On

the other hand, this evidence is consistent with the theory that earnings measures used in

stakeholder decisions are managed to meet benchmarks.

2.6 Summary

The characteristics of the body of discontinuity evidence are consistent with the theory that

earnings are managed to meet benchmarks. In contrast, these characteristics are difficult to

reconcile with many potential alternative explanations for discontinuities. In particular, the

combination of characteristics in Sections 2.4 and 2.5 is inconsistent with any artifactual

explanation that does not specify why the artifact applies selectively only to earnings measures

that are widely used in stakeholder decisions.

3. Evaluation of alternative explanations for discontinuities

It is important for researchers to continue to explore the possibility that discontinuities in

earnings distributions might be explained by something other than earnings management.

However, in order to be considered a general explanation for discontinuities in earnings


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distributions, an alternative explanation should be consistent with all the characteristics of

discontinuity evidence outlined above, rather than with just one or two individual characteristics.

In this section, we evaluate the plausibility of several alternative explanations.

3.1 Durtschi and Easton (2005, 2009) alternative explanations

Durtschi and Easton (2005, 2009) report examples of distributions that do not contain

discontinuities and assert that their evidence shows that discontinuities are not due to earnings

management but instead are attributable to a combination of scaling, selection, and the relation

between earnings and price. As explained in the previous section, these explanations, and other

artifactual explanations that apply to both reported earnings and to alternative earnings measures

that are not widely used by stakeholders are not consistent with the fact that discontinuities do not

exist in distributions of earnings measures not used by stakeholders. Further, results in

Burgstahler and Chuk (forthcoming) show why the Durtschi and Easton distributions do not

contain discontinuities. The research designs used throughout Durtschi and Easton fail to account

for the substantial effect of size as a covariate and focus almost exclusively on observations for the

smallest firms. Burgstahler and Chuk (forthcoming) show how research designs that correct for

these flaws reveal highly significant discontinuities in unscaled earnings and in EPS. Thus,

scaling, selection, and the relation between earnings and price are not plausible alternative

explanations for discontinuities.

3.2 Beaver, McNichols, and Nelson (2007) special items explanation

Beaver, McNichols, and Nelson (2007, hereafter BMN) suggest that special items

contribute to the discontinuity in earnings based on the evidence in their Figure 3 that shows the

distribution of earnings before special items has a less pronounced discontinuity than the

distribution after special items, a result that at first seems to suggest that special items cause the

discontinuity. However, we demonstrate below that removing virtually any component of

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earnings to form "earnings before the component" eliminates the discontinuity at zero, as long as

(1) the modified earnings measure that results from removing the component is not widely used in

stakeholder decisions and (2) the removed component of earnings has non-trivial variability.2

To demonstrate how components of earnings may seem to play a special role in earnings

management, we construct measures of earnings before three components of earnings: 1) earnings

before special items, 2) earnings before research and development expense, and 3) earnings before

depreciation. Removing any of these components creates a new earnings measure that is not

widely used in stakeholder decisions.3

Figure 1 replicates and refines the findings in BMN by focusing on the subset of

observations for which the component is non-zero and non-missing. The significance of

discontinuities can be assessed by focusing on the standardized difference for either the interval

immediately below the benchmark (the left standardized difference) or the interval immediately

above the benchmark (the right standardized difference). For the sake of brevity, we discuss only

the left standardized difference (where more negative values indicate a more significant

discontinuity) in the text, but for completeness Table 1 reports both left and right standardized

differences.4 Panel A shows a clear and highly significant (standardized difference = -5.27)

2
A component of earnings with "non-trivial" variability is a component that is not simply constant, or nearly
constant, across observations. For example, for firms that do not have special items, special items are zero and have
trivial variability. For these firms, the distribution of earnings before special items is identical to the distribution of
earnings including special items, and the identical distributions both have a discontinuity.
3
An example of an earnings measure formed by removing a component that is widely used in stakeholder decisions
is Earnings before extraordinary items (EBEI). The importance of EBEI in stakeholder decisions is indicated by its
emphasis in the financial press, on the income statement, and in the computation of earnings per share before and after
extraordinary items. Distributions of both net income and earnings before extraordinary items contain discontinuities,
consistent with the hypothesis that both net income and EBEI are managed.
4
As discussed in more detail in Burgstahler and Chuk 2014, when discontinuities are the result of earnings
management where pre-managed earnings observations move only from the interval immediately below the
benchmark and are transformed into reported earnings only in the interval immediately above the benchmark, the left
and right standardized differences yield similar evaluations of significance. When observations are from primarily the
interval immediately below the benchmark but are transformed to a number of intervals above the benchmark, the left
standardized difference will provide the more powerful test. When observations are from a number of intervals below

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discontinuity in the distribution of earnings after special items (i.e., reported earnings) while Panel

B shows no significant discontinuity in the distribution of the constructed measure, earnings

before special items (standardized difference = 0.00). The discontinuity in the distribution of

reported earnings is consistent with the theory that reported earnings are managed to meet the zero

benchmark. The lack of a discontinuity in the distribution of earnings before special items is

consistent with the conjecture that earnings before special items (which is neither widely reported

nor widely used in stakeholders decisions) is not managed to meet the zero benchmark.5

For two other components of earnings with non-trivial variability, research and

development expense and depreciation expense, we find similar results. For the subset of firms

with nonzero and non-missing research and development expense, Figure 2 Panel A shows a

significant discontinuity in the distribution of reported net income (standardized difference =

-8.22). In contrast, Panel B shows no significant discontinuity in the distribution of earnings

before research and development expense (standardized difference = .49). Similarly, for the

subpopulation of firms with nonzero and non-missing depreciation, Figure 3 Panel A shows a

significant discontinuity in the distribution of reported net income (standardized difference =

the benchmark but are transformed primarily to the interval immediately above the benchmark, the right standardized
difference will provide the more powerful test. We have no reason to believe that any one of these specific conditions
applies generally to our results so the text refers only to left standardized differences while Table 1 reports both left
and right standardized differences.
5
Panels A and B refine the special items results in BMN by concentrating only on the subset of observations where
special items are non-zero. For observations where special items are zero or missing, earnings before and after special
items are identical by definition. Although they are not reported here to save space, distributions for the
subpopulations where each component is zero or missing and therefore has no effect on reported earnings have
significant discontinuities, consistent with the hypothesis that reported earnings are managed to meet the zero
benchmark. These facts explain the effect of including observations in the analysis where the component is zero or
missing. For example, when observations where special items are zero or missing are pooled with observations in
Panel A, the two distributions being pooled both contain significant discontinuities and the resulting pooled
distribution of reported earnings has a highly significant discontinuity at zero (corresponding to BMN Figure 2 Panel
A where the standardized difference is 9.07). When observations where special items are zero or missing are pooled
with observations in Panel B, only one of the two distributions being pooled contains a significant discontinuity and
the resulting pooled distribution of earnings before special items has a much less significant discontinuity at zero
(corresponding to BMN Figure 3 Panel A where the standardized difference is 3.23).

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-10.46) while Panel B shows no significant discontinuity in the distribution of earnings before

depreciation expense (standardized difference = -.78).

Thus, evidence that removing a component of earnings eliminates the discontinuity in

earnings distributions is not evidence of a unique role for that component, but rather evidence that

the component plays a role similar to other non-trivial components of earnings. Further, the lack

of a discontinuity in distributions of earnings before special items, earnings before R&D, and

earnings before depreciation is consistent with the conjecture that these constructed measures are

not managed to meet the zero benchmark.6 These results provide additional evidence inconsistent

with any alternative explanation for discontinuities unless the alternative explanation applies only

to reported earnings and not to any of these constructed measures.

3.3 BMN tax explanation

A second alternative explanation proposed in BMN is that discontinuities surrounding the

zero benchmark are due to much lower tax rates for negative earnings than for positive earnings,

so that positive earnings are pulled toward zero by taxes more than are negative earnings. While

this explanation could in concept play some role, there are two important reasons to believe the

role of differential effective tax rates in explaining the body of discontinuity evidence is extremely

limited.

First, the differential tax rate explanation is limited strictly to discontinuities where the tax

rate for earnings immediately above the benchmark is substantially higher than the tax rate

immediately below the benchmark. This condition potentially holds for the benchmark at zero in

6
Dechow, Richardson, and Tuna (2003) provide a related result in their Figures 6(a) and 6(b), where they report that
subtracting a random noise variable with non-trivial variability from reported earnings results in a transformed
earnings measure ("earnings before random noise") that does not have a discontinuity. Obviously, this does not
indicate that randomly generated noise plays a role in earnings management, but rather that firms do not manage
earnings before random noise.

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earnings levels (see BMN Figure 2 Panel B) but there is no evidence that it holds for other

benchmarks. For example, there is no reason to believe that tax rates are markedly higher for

increases in earnings than for decreases in earnings or for positive earnings surprises than for

negative earnings surprises or for EPS above versus below each multiple of $.05 or $.10 per

share.7 Therefore, the BMN tax explanation does not apply to any of the discontinuities

documented in the literature other than the discontinuity at zero earnings levels.

Second, even for the benchmark at zero in earnings levels, the assumption that differences

in tax rates account for discontinuities in earnings distributions requires further examination.

From a theoretical perspective, effective tax rates, defined consistent with BMN as the ratio of tax

expense to pretax income, depend not only on the level of pretax income for the current year, but

also on the actual and expected origination and reversal of temporary book-tax differences as well

as on permanent differences.8 While BMN Figure 2 Panel B shows a higher effective tax rate for

positive pre-tax earnings than negative pretax earnings on average, effective tax rates are not

simply a function of the level of pre-tax earnings. Instead, effective tax rates and pretax earnings

are jointly determined, so that distributions of reported earnings differ across effective tax rates.

From an empirical perspective, we can obtain a better understanding of the role of effective tax

rates by stratifying the population based on the effective tax rate. Further, stratification holds the

tax rate approximately constant within each stratified segment. Because there is (approximately)

no difference between how positive versus negative pre-tax earnings observations are pulled

toward zero within each stratified segment, effective tax rates cannot explain discontinuities in the

distribution of earnings within the segment.

7
Carslaw 1988, Thomas 1989, Dechow et al 2003, Grundfest and Malenko 2009, and Burgstahler and Chuk
(forthcoming) provide evidence of management to benchmarks defined by multiples of $.05 or $.10 per share.
8
For a more extensive discussion of the determinants of effective tax rates, see Dyreng, Hanlon, and Maydew (2008),
especially Section III.

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Figure 4 Panels A to D show distributions of earnings for segments of the population

where each stratum has a constrained range of positive effective tax rates.9 Panel A includes all

observations with effective tax rates greater than 0 and less than or equal to 15%, while Panels B,

C, and D show observations with effective tax rates greater than 15% and less than or equal to

30%, greater than 30% and less than or equal to 45%, and greater than 45%, respectively. The

majority of the observations, approximately 56% of the total observations in the four panels, are in

Panel C for tax rates between 30% and 45%. This distribution includes a significant discontinuity

with a distinct trough below and peak above the benchmark (standardized difference = -6.96).

Panels B (effective rates between 15% and 30%) and A (effective rates between 0% and 15%)

account for the next two largest proportions of observations, 21% and 13 %, respectively, and both

show significant discontinuities (standardized differences of -4.78 and -6.00, respectively) with a

distinct trough below the zero benchmark. Panel D accounts for the smallest proportion of

observations, approximately 10%, but also shows significantly more observations above the

benchmark (standardized difference = -4.72).

The four segments of the population plotted in Figure 4 account for 72% of the distribution

of market-value scaled earnings. Because the omitted segments where effective tax rates are less

than or equal to zero account for only 28% of the distribution and do not contain discontinuities,

the four plotted segments account for essentially all of the discontinuity in the scaled earnings

distribution. Within each of these segments where the effective tax rate is held approximately

9
Figure 4.2 excludes observations with negative or zero tax rates, which are commonly omitted in research on tax
rates (see, for example, Dyreng, Hanlon, and Maydew 2008). These omitted observations constitute a relatively small
proportion of the total observations in the overall distribution of earnings (about 28%). More importantly, these
observations do not contribute to the discontinuity in the overall distribution, as there are more observations below the
zero benchmark than above for both these segments of the population. The distribution for the negative effective tax
rate observations has a mode below the zero benchmark and the distribution for the zero effective tax rate
observations is bimodal, with one mode at moderately negative earnings and a smaller mode at moderately positive
earnings.

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constant, differences in effective tax rates for positive versus negative earnings cannot explain the

discontinuities. Thus, a careful examination of the joint determination of effective tax rates and

reported earnings reveals that differences in the tax rates that apply to positive versus negative

earnings do not explain the discontinuity in earnings levels.

3.4 Managing accruals to meet benchmarks

There is an essentially unlimited list of real operating, financing, and investing decisions

(such as actions to encourage customers to accelerate purchases or decisions to defer expenditures

or actions to motivate employees to exert extra effort to meet the benchmark) and accrual

decisions (such as accounting decisions that transfer future income to the present) that can be used

to manage earnings (McVay 2006, Roychowdhury 2006). While the body of evidence of

discontinuities at benchmarks is highly consistent with the theory that firms take actions that

transform pre-managed earnings below the benchmark into reported earnings above the

benchmark, discontinuity evidence cannot identify exactly what actions were taken. Further, there

is no reason to believe that an observed discontinuity at any given benchmark is uniquely, or even

predominantly, attributable to a single type of earnings management action. Instead, it is probable

that different observations have been transformed by different earnings management actions. In

fact, in many cases, each individual observation is likely to have been transformed by more than

one earnings management action.10

Several papers suggest that discontinuities are not explained primarily by abnormal

accruals. Dechow, Richardson, and Tuna (2003, hereafter DRT) report that they cannot confirm

that the discontinuity in earnings is driven primarily by discretionary accruals and note that

discontinuities may also be attributable to real economic decisions. Ayers, Jiang, and Yeung

10
The Harnischfeger Corporation case illustrates how an individual earnings observation can be influenced by
multiple real and accrual decisions.

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(2006, hereafter AJY) are unable to document a unique positive association between discretionary

accruals and beating earnings benchmarks, as the same positive association extends to other points

of the earnings distributions that do not represent benchmarks. AJY conclude that their results are

not sufficient to conclude that discretionary accruals account for earnings management for

earnings levels and earnings changes.

The findings in DRT and AJY reinforce the idea that earnings management actions include

broad sets of both real economic decisions and accrual decisions and that reported earnings are

affected by different actions drawn from these broad sets. Further, significant specification issues

for discretionary accrual models further complicate attempts to determine whether accrual

decisions are important explanators of instances of earnings management. Therefore, the lack of

evidence confirming that earnings management is due primarily to discretionary accrual choices

does not contradict the theory that earnings are managed to meet benchmarks.

4. Evidence on determinants of the strength of discontinuities

If earnings management explains the discontinuities documented in prior studies, then

economic theory predicts that the strength of each discontinuity depends on the relative benefits

versus costs of earnings management in a particular setting. In this section, we consider examples

of determinants of the costs and benefits of managing earnings to meet various benchmarks (e.g.,

zero earnings, prior-year earnings, and analyst forecasts). Specifically, we provide cross-sectional

evidence on the strength of discontinuities based on industry regulation, managerial incentives

related to firm growth, and analyst following. Our sample consists of all firm-years on Compustat

with non-missing required data items during the years 1990 to 2013. For the figures using analyst-

based earnings surprises and analyst following partitions, we also require corresponding data from

IBES.

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4.1 Regulated Industries

Empirical evidence has typically excluded regulated firms out of concern that these firms

might face different incentives.11 In this section, we discuss incentives and examine the associated

discontinuities for various types of regulated firms. We begin by constructing a sample

comprising firms in regulated industries that are typically deleted in earnings management studies:

firms with SIC codes between 4400 and 5000 and between 6000 and 6500. We then partition the

regulated industries into subsets based on incentives created by regulation: (1) rate-regulated firms

with SIC codes 4600 to 4699 and 4900 to 4999, (2) banks with SIC codes 6000 to 6299 and

insurance companies with SIC codes 6300 to 6499, and (3) all others with SIC codes 4400 to 4599

and 4700 to 4899.

First, we examine rate-regulated firms, which are subject to government regulation on the

supply and pricing of goods and services sold. In rate-regulated industries, there is typically little

or no competition, such that customers generally have no alternative to the rate-regulated entity, so

regulators seek to ensure that the rate-regulated entity earns no more than a fair and reasonable

rate of return. For this reason, rate-regulated firms have incentives to report lower earnings in

order to make the case to regulators for higher rates. Thus, rate-regulation provides incentives to

reduce reported earnings, and these incentives counteract incentives to increase earnings to meet

benchmarks. Figure 5 Panel A shows the distribution of earnings levels for the rate-regulated

firms. The lack of discontinuity in this distribution (standardized difference =-0.4963) is

consistent with the conjecture that incentives to report lower earnings counteract incentives to

meet the zero benchmark for rate-regulated firms.

11
For example, BD eliminated regulated firms that might have "conflicting incentives to report lower earnings or
decreases in earnings" to regulators and also eliminated financial institutions where "incentives to avoid earnings
decreases or losses might be linked to regulatory oversight." An example of research that focused specifically on
regulated firms is Beatty et al (2002), discussed further below.

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Second, we examine banks, subject to multiple regulatory requirements designed to ensure

capital adequacy and reduce the probability of bank failures, and insurance companies, also

subject to regulation to maintain solvency and liquidity. The incentives created by capital

regulation are similar to the incentives for earnings management, in that both types of incentives

encourage managers to report higher earnings. Thus, the incentives created by capital regulation

do not counteract the earnings management incentives so we expect to find evidence that banks

and insurance companies manage earnings to meet benchmarks. For example, Beatty et al. (2002)

report evidence that public banks have incentives to report earnings increases, and that these

incentives are substantially stronger than those for private banks; their findings illustrate that

banks have incentives to manage earnings that are similar to those of non-banks. Figure 5 Panel B

shows the distribution of earnings levels for our sample of banks and insurance companies. The

distribution shows a clear discontinuity at zero (standardized difference =-3.5767), consistent with

Beatty et al. (2002) and suggesting that the additional regulatory incentives faced by banks and

insurance companies do not counteract the incentives to meet the zero earnings benchmark.

Finally, for completeness, we examine the earnings distribution for the remaining regulated

industries, which include transportation (SIC codes 4400 to 4599) and television and radio

broadcast (SIC codes 4700 to 4899). The regulatory requirements for the transportation industry

largely relate to safety requirements, and the regulatory requirements for television and radio

broadcast largely relate to censorship and the decency of content. There is no reason to believe

these regulatory requirements create incentives that counteract the incentives to manage earnings

to meet benchmarks. Therefore, we expect to find discontinuities for this segment of regulated

industries and, as expected, Figure 5 Panel C shows a significant discontinuity for these regulated

industries (standardized difference =-2.9039).

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Cross-sectional differences in discontinuities for the regulated industries that are typically

omitted in tests of earnings management to meet benchmarks are consistent with the theory that

earnings are managed to meet benchmarks.

4.2 Earnings Management and Growth

Higher expected growth firms are likely to be penalized more for failing to report earnings

that reinforce perceptions of continuing growth (Skinner and Sloan 1999, Das and Zhang 2003).

Das and Zhang (2003) report evidence that higher growth firms are more likely to report earnings

where the third decimal digit is such that earnings round up rather than down. The strength of

incentives for high growth firms to meet benchmarks is likely to depend on how directly the

earnings measure is related to growth. Because positive growth is closely related to positive

change in earnings, we expect stronger evidence of discontinuities for higher growth firms in

distributions of earnings changes. On the other hand, positive growth is less directly related to

earnings levels. In fact, it is not uncommon for high growth firms to have negative earnings.

Therefore, there is less reason to expect growth-related differences in discontinuities in

distributions of earnings levels.

To provide evidence regarding these conjectures, we define high growth versus low growth

firms by partitioning our sample into terciles based on growth, where the top (bottom) tercile

represents the high (low) growth firms. In order to avoid the possibility of a mechanical relation

between our measure of growth and current-year results, our proxy for growth in year t is the one-

year rate of revenue growth from the prior year, defined as (Revenuet1 Revenuet2) / Revenuet2.

We compare the strength of discontinuities for high versus low growth firms for both earnings

levels and changes distributions.

Figure 6 Panels A and B show distributions of earnings levels for high versus low growth

firms, respectively. The strength of the discontinuity in earnings levels for the high growth firms

Page 17
in Panel A (standardized difference = -6.91) is not markedly different than that for the low growth

firms (standardized difference = -5.74) in Panel B. The results provide no evidence to support the

conjecture that incentives to meet the zero benchmark in earnings levels are stronger for higher

growth firms.

Figure 7 Panels A and B show a corresponding analysis for earnings changes for high

growth and low growth firms. Panel A shows a significant discontinuity (standardized difference

= -2.30) in the distribution of earnings changes for high growth firms. In contrast, Panel B does

not show a significant discontinuity (standardized difference = -.89) for firms in the bottom tercile.

These findings are consistent with the conjecture that high growth firms have stronger incentives

to meet the zero earnings change benchmark, more directly reinforcing perceptions of continued

growth by beating prior-year earnings.

The results in Figures 6 and 7 show growth-related differences in the strength of

discontinuities in changes in earnings but not in earnings levels. These results are consistent with

stronger incentives for higher growth firms to meet the prior-year earnings benchmark, perhaps

because this benchmark is more directly related to perceptions of continuing growth than the zero

benchmark in earnings levels.

4.3 Earnings Management and Analyst Following

Incentives for earnings management may also be related to the information environment.

In higher quality information environments, there may be weaker incentives to manage earnings to

meet simple heuristic benchmarks, such as zero earnings. Analyst following is positively related

to the quality of the information environment, as analysts typically are sophisticated processors of

earnings information and analysts may also choose to more often follow firms that have a higher

quality information environment (Healy and Palepu 2001). Therefore, we proxy for quality of the

information environment by partitioning based on the number of analyst following the firm. We

Page 18
define low-analyst-following firms as those with fewer than four analysts and define high-analyst-

following firms as those with greater than four analysts, where four is the median number of

analyst following in our sample.

Figure 8 Panels A and B show the distributions of earnings levels for firms on IBES with

low and high analyst following, respectively. The discontinuity for firms with high analyst

following in Panel B is less prominent (standardized difference = -3.25) than that for firms with

low analyst following in Panel A (standardized difference = -6.34).12 This finding is consistent

with the idea that a higher quality information environment reduces incentives to manage earnings

to meet the simple heuristic benchmark of zero earnings.

Next, we perform a similar analysis using analyst-based earnings surprises. While the

findings for earnings levels suggest there are weaker incentives to meet the simple heuristic

benchmark of zero earnings for firms in information environments with higher analyst following,

the prediction for analyst forecasts is less straightforward. On one hand, the consensus analyst

forecast is also a simple heuristic benchmark, so a higher-quality information environment would

reduce the incentives to meet the simple heuristic benchmark of the analyst consensus estimate.

On the other hand, greater analyst coverage may increase the importance of the consensus analyst

forecast as a benchmark, so a larger number of analysts forecasting earnings for the firm creates

stronger incentives to manage earnings to meet analyst forecasts. For these reasons, the predicted

strength of discontinuities in analyst-based earnings surprises for high versus low growth firms is

unclear.

12
In untabulated results, we further partition the sample into groups based on the following ranges of analyst
following: 1, 2 to 3, 4 to 5, 6 to 10, and 11 and above. The pattern of results for this finer partitioning also supports
the idea that the discontinuity at the zero benchmark becomes weaker for firms with larger analyst following.

Page 19
Figure 9 Panels A and B show distributions of price-scaled earnings surprises for low and

high analyst following, respectively. In contrast to the results on earnings levels in Figure 8, the

discontinuity for firms with high analyst following in Figure 9 Panel B is more prominent

(standardized difference = -43.26) than for firms with low analyst following in Panel A

(standardized difference = -28.33). This finding is consistent with the idea that there are stronger

incentives to manage earnings to meet the consensus analyst forecasts for firms that are followed

by more analysts.13

5. Conclusion

The extensive body of discontinuity evidence is consistent with the theory that earnings are

managed to meet prominent benchmarks. Discontinuity evidence is pervasive in that

discontinuities occur for a variety of earnings variables (earnings levels, earnings changes, and

earnings surprises) using a variety of scalers (market value, book value, revenue, or total assets)

and in unscaled earnings and unscaled earnings per share. The form of the distributional

discontinuities is consistent with the predicted transformation of pre-managed observations

immediately below the benchmark into post-managed observations immediately above the

benchmark. Also, the strength of discontinuities covaries with the strength of incentives to

manage earnings. Finally, discontinuities exist for earnings measures widely used by stakeholders

but do not exist for other earnings measures that are not used by stakeholders.

We summarize the discontinuity literature using a framework that identifies five key

characteristics of the body of empirical evidence:

1. Pervasiveness
2. Evidence of a trough below the benchmark and a peak above the benchmark

13
In Figure 9, the peak of the distribution occurs at the benchmark which raises issues of interpretation. For a
discussion of these issues, see footnote 9 in Burgstahler and Chuk, forthcoming, Page 375 in Dechow et al. (2003), or
Page 381 in Jacob and Jorgensen (2007).

Page 20
3. Covariation with earnings management incentives
4. Existence in earnings measures that are widely used in stakeholder decisions
5. Non-existence in earnings measures that are not widely used in stakeholder decisions

Many potential alternative explanations for discontinuities are inconsistent with one or more of the

characteristics. For example, the BMN tax rate explanation applies only to benchmarks where

there are higher tax rates above versus below the benchmark and is therefore limited to

discontinuities in earnings levels at the zero benchmark. Because there is no evidence that tax

rates are different above versus below benchmarks for earnings changes, earnings surprise, or at

non-zero benchmarks, differences in tax rates cannot explain any of these discontinuities and also

cannot explain the trough below the benchmark and the peak above the benchmark.14

We recommend that future researchers evaluate alternative explanations for discontinuities

on the basis of their ability to explain these five characteristics. It is difficult to account for the

key characteristics of the evidence, especially the fourth and fifth characteristics, using any theory

based on artifacts since the artifact must simultaneously apply to reported earnings yet not apply to

modified earnings measures that are not widely used in stakeholder decisions. Among the

possible explanations that have thus far been developed in the literature, the theory that earnings

are managed to meet benchmarks provides the most simple and complete explanation for the entire

body of evidence of discontinuities in earnings distributions.

14
Although we attempt to focus on major issues in interpreting the body of discontinuity evidence, there are still
important technical issues to be addressed, such as development of more powerful and more valid tests for the
significance of discontinuities that appear at the peak of an earnings distribution. The standardized difference statistic
used in this paper relies on the assumption of local linearity. However, the standardized difference statistic might not
be appropriate when local curvature is high, such as at the peak of a leptokurtic distribution like scaled earnings
(Frecka and Hopwood, 1983; Basu and Markov, 2004).

Page 21
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Page 24
Table 1
Standardized Difference Statistics

Figure Description Left Std Diff Right Std Diff

Figure 1 Panel A Earnings after special items, scaled by beginning MVE -5.2748 5.3824
Figure 1 Panel B Earnings before special items, scaled by beginning MVE 0.0000 0.7899
Figure 2 Panel A Earnings after R&D expense, scaled by beginning MVE -8.2171 5.5910
Figure 2 Panel B Earnings before R&D expense, scaled by beginning MVE 0.4953 0.4608
Figure 3 Panel A Earnings after depreciation expense, scaled by beginning MVE -10.4562 7.5707
Figure 3 Panel B Earnings before depreciation expense, scaled by beginning MVE -0.7800 -1.0979
Figure 4 Panel A Earnings scaled by beginning MVE for firms with ETRs in (0%, 15%] -6.0003 1.1890
Figure 4 Panel B Earnings scaled by beginning MVE for firms with ETRs in (15%, 30%] -4.7778 0.5906
Figure 4 Panel C Earnings scaled by beginning MVE for firms with ETRs in (30%, 45%] -6.9608 -0.2132
Figure 4 Panel D Earnings scaled by beginning MVE for firms with ETRs > 45% -4.7242 9.9452
Figure 5 Panel A Earnings scaled by beginning MVE for rate-regulated firms -0.4963 -0.1374
Figure 5 Panel B Earnings scaled by beginning MVE for banks and insurance companies -3.5767 1.4594
Figure 5 Panel C Earnings scaled by beginning MVE for other regulated firms -2.9039 2.1732
Figure 6 Panel A Earnings scaled by beginning MVE for high growth firms -6.9092 4.1137
Figure 6 Panel B Earnings scaled by beginning MVE for low growth firms -5.7368 4.6586
Figure 7 Panel A Change in earnings scaled by beginning MVE for high growth firms -2.3033 2.0881
Figure 7 Panel B Change in earnings scaled by beginning MVE for low growth firms -0.8874 2.1888
Figure 8 Panel A Earnings scaled by beginning MVE for firms with low analyst following -6.3426 3.9899
Figure 8 Panel B Earnings scaled by beginning MVE for firms with high analyst following -3.2516 1.3168
Figure 9 Panel A Earnings surprise scaled by beginning price for firms with low analyst following -28.3341 35.7218
Figure 9 Panel B Earnings surprise scaled by beginning price for firms with high analyst following -43.2644 74.0358

Notes: The standardized differences are computed following Burgstahler and Dichev (1997).
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