Equities

Why Are Earnings Kinky? An Examination of the Earnings Management Explanation

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Why Are Earnings Kinky? An Examination of the Earnings Management Explanation

An empirical regularity documented by Hayn (1995) is that there is a ‘‘kink’’ in the earnings distribution: too few firms report small losses and too many firms report small profits. Burgstahler and Dichev (1997a) build on Hayn by showing a kink in both the earnings change and the earnings level distributions and suggesting the cause of the kink is earnings management.

We investigate whether the boosting of discretionary accruals explains the ‘‘kink’’ in the earnings distribution identified by Hayn and Burgstahler and Dichev. The ‘‘earnings management to avoid a loss’’ explanation for the kink predicts that firms with small (premanaged) losses boost earnings to report a profit.

This results in fewer firms than expected in the small-loss group and more firms than expected in the small-profit group. One implication of this story is that small-profit firms will have higher discretionary accruals than small-loss firms. In addition, the earnings management explanation is directional: small-loss firms manage earnings up to report a small profit. Therefore, another implication is that after removing from the earnings distribution firms that have positive discretionary accruals, one should see the kink decline.

Our results testing these implications are not compelling. We find that small-profit and small-loss firms have similar levels of discretionary accruals and both have similar proportions of positive discretionary accrual firms. In addition, the kink increases when we examine the distribution of earnings for negative discretionary accrual firms.

One explanation for our lack of results is that earnings management explains the kink but our tests lack power.

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Review of Accounting Studies

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