Earnings Breaks and Earnings Management

Abstract

This paper examines the role of earnings management for firms that report at least three consecutive years of annual earnings increases (hereafter earnings string firms). Specifically, I examine how levels of earnings management change as earnings string firms approach the end of their earnings string patterns. My results show that earnings string firms engage in income-increasing earnings management consistent with an attempt to stretch these earnings string patterns. I also examine whether the cumulative effect of income-increasing earnings management activities during the earnings string period reduces the ability of these firms to continue reporting earnings increases. I do not find evidence to suggest that earnings string firms, on average, break their earnings string patterns because they ran out of accounting flexibility. However, there are two instances which the accumulated effect of income-increasing earnings management increases the likelihood of ending the earnings string. The two instances relate to firms which repeatedly engage in income-increasing earnings management throughout the earnings string period, and firms whose pre-managed earnings decline in the last year of the earnings string period. Finally, I show that firms that resume a subsequent series of reporting at least three consecutive years of annual earnings increases, on average, exhibit similar earnings management behavior. That is, these firms also increasingly resort to income-increasing earnings management toward the end of their second (or third) earnings strings.