Academic journal article Academy of Accounting and Financial Studies Journal

Earnings Manipulation to Achieve Cognitive Reference Points in Income

Academic journal article Academy of Accounting and Financial Studies Journal

Earnings Manipulation to Achieve Cognitive Reference Points in Income

Article excerpt

ABSTRACT

Thomas (1989) demonstrates that U.S. firms with positive earnings manipulate income by rounding up the second earnings digit to increase the first earnings digit by one, thereby reaching cognitive reference points in income. Companies with negative income manipulate earnings in the opposite direction. The current study replicates Thomas' (1989) twenty-year old research to ascertain if this type of earnings management continues today, particularly in light of the heightened scrutiny managers now face to present fair financial reporting. The results suggest that managers of negative earnings firms no longer engage in this manipulative behavior while managers of positive earnings firms continue to do so. In addition, for positive earnings firms, the findings indicate that the propensity to engage in this form of earnings management is related to specific company characteristics. Small firms appear to manage earnings to achieve cognitive reference points more intensively than large firms. Likewise, low-leverage companies exhibit this manipulative behavior more frequently than high-leverage firms, and less profitable firms engage in this activity more aggressively than companies enjoying high profit margins.

INTRODUCTION

Although no unique definition exists for earnings management, its primary attribute embodies the manipulation of the financial reporting process to create personal gain (Jackson & Pitman, 2001). Managers manipulate earnings for many reasons, and specific lines of research have developed around each form of earnings management. For example, earnings are manipulated to smooth income and, thereby, create the impression that a firm is low-risk to investors or creditors (Ronen & Sadan, 1981) or to meet analysts' earnings expectations, thus maintaining a steady growth in share price (Payne & Robb, 2000; Jordan & Clark, 2003). Earnings are typically manipulated upward but may be managed downward as firms take big hits to income in years when earnings are already depressed (Peek, 2004; Yoon & Miller, 2002). In addition, managers manipulate income to avoid reporting losses or decreases in earnings (Burgstahler & Dichev, 1997) or to enhance executive bonuses tied to income (Healy, 1985; Guidry et al., 1999).

A particular subset of earnings management research initiated by Carslaw (1988) examines the notion that firms manage earnings upward to reach cognitive reference points in income. Brenner and Brenner (1982) indicate that humans possess only a limited amount of memory and that memory is used to store the most relevant pieces of information about a price. As an example, in the price $496 more emphasis will be placed on the first digit (4), less on the second digit (9), and so forth. In remembering numbers, people tend to round down rather than up. For example, $496 would be rounded down to $490 or even to $400 rather than rounded up to the more logical $500.

Carslaw (1988) speculates that managers manipulate income to just above key cognitive reference points if the unmanaged earnings fall only slightly below the reference points. As an example, earnings of $891 million would be managed upward to an amount slightly above $900 million. As a result, financial statement users in their rounding would round down to $900 million rather than to $800 million. Carslaw (1988) and others demonstrate that this type of manipulative behavior exists as unusual digital patterns are observed in the second-from-the-left earnings position for firms with positive earnings (i.e., in particular, more zeros and fewer nines than expected appear in the second earnings position).

The current article extends this line of research by replicating it with recent data on U.S. companies to ascertain if earnings are still manipulated to achieve cognitive reference points in income despite the increased scrutiny managers now face to present fair financial reporting. …

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