Information Content of Earnings Management – Evidence from Managing Earnings to Exceed Thresholds

This paper examines whether managers signal firms’ future performance by managing earnings to exceed thresholds. Because managers’ reporting discretion is bounded by the accounting regulations, managing earnings to exceed current period’s thresholds reduces future earnings and therefore makes future earnings thresholds harder to reach. As a result, only firms with sufficient future earnings growth benefit from doing so. I test the signaling hypothesis in three steps. I first hypothesize that firms with a higher degree of information asymmetry between the management and investors are more likely to signal performance using earnings thresholds. Consistent with the hypothesis, I find that the discontinuities in earnings distributions around thresholds are significantly more salient for information-strained firms than for firms with lower degree of information asymmetry. The second step examines the credibility of the signal. I document that firms who marginally exceed the earnings thresholds demonstrate superior future accounting performance compared with firms just missing the thresholds, and this difference in future performance increases with the degree of information asymmetry firms face. The third step of my analysis studies the market’s reaction to firms’ beating or missing the thresholds. My empirical results suggest that the capital market recognizes the information content of the earnings management activities and rationally incorporates it in setting prices. I am indebted to members of my dissertation committee, Richard Frankel, Joseph Weber and especially S.P. Kothari (Chairman) for their continuous encouragement and guidance. I am also grateful for helpful comments from Bing Cao, Ying Li, Volkan Muslu, George Papadakis, Peter Wysocki, Jieying Zhang and seminar participants at Massachusetts Institute of Technology.