Earnings Management to Avoid Earnings Decreases and Losses

Anecdotal evidence and recent research suggest there are incentives to avoid earnings decreases and losses. This paper provides systematic evidence that firms increase reported earnings to achieve these goals. Specifically, using all available observations on the annual industrial and research Compustat database for the years 1976-1994, cross-sectional distributions of scaled annual earnings changes and earnings are bell-shaped and fairly smooth except in the regions near zero. For both earnings changes and levels distributions, there is a trough immediately to the left of zero and a peak immediately to the right of zero which are inconsistent with the overall shape of the remainder of the distribution, i.e., the frequencies of small decreases in earnings and small losses are unusually low and the frequencies of small increases in earnings and small positive income are unusually high. Exploring the methods of earnings management, we find evidence that two components of earnings, cash flow from operations and changes in working capital, are used to achieve the manipulation of earnings. Finally, we present two theories about the motivation for avoidance of earnings decreases and losses. We find that the main results of this paper are consistent with both prospect theory and managerial opportunistic behavior motivated by stakeholder use of earnings-related heuristics.