Costs and benefits of managing earnings to meet an earnings target

Abstract

I examine both the incentives and the disincentives associated with managing earnings to meet a specific earnings target by looking at two related questions: What are the benefits that firms seek by managing earnings to meet an earnings target? What are the costs of managing earnings to meet an earnings target? I use a signaling perspective to describe the benefits that accrue to firms for meeting either of two earnings targets, i.e. zero EPS and the previous year's EPS. I argue that the achievement of an earnings target is a signal to the firm's stakeholders that their implicit claims with the firm are more likely to be fulfilled than if the firm had not met the earnings target. Four stakeholder groups (customers, employees, suppliers and short-term creditors) and five earnings management tools (bad debt expense, depreciation expense, pension expense, tax expense and special items) are considered. Net benefits from stakeholders are measured by abnormal returns, and the costs of managing earnings are measured in terms of the firm's "capacity" to manage earnings. I find evidence that meeting both earnings management targets simultaneously provides information to stakeholders, which they use in assessing the probability that their implicit claims will be fulfilled by the firm. I am unable to predict whether a firm meets an earnings target based on my proxies for a firm's dependence on stakeholders and its capacity to manage earnings.