Examining the Importance of Achieving Last Year's Earnings Threshold: An Investor's Perception

Given the importance of earnings, it is no surprise that management has a vital interest in how they are reported or wanted to manage earnings. Dechow and Skinner (2000) recommend that researchers consider management’s capital market incentives to meet or beat simple earnings benchmarks, consisting of the following: (1) to avoid losses, that is, to report earnings that are above zero; (2) to avoid earnings decreases, that is, to make the earnings in the corresponding quarter of previous year; and (3) to avoid negative earnings surprises, that is, to report earnings that meet or beat expectations. The main purpose of this paper is investigating the importance of achieving last year’s earnings threshold. Research Question: Prior research provides evidence that meeting (or beating) the forecasted earnings results in a differential market response compared to missing the forecast (e.g., Sajadi, 1998; Khani, 2007). This paper extends prior research by examining whether there is a market effect for meeting or missing unexpected last year’s earnings thresholds while controlling the effects of meeting or missing the forecasted earnings. To devise a proper test to see whether the market prices last year earnings threshold, it is important to identify the point at which the market should assign value for meeting or missing the threshold. For the vast majority of firms, reporting earnings above or below earnings increase threshold is not a surprise to the market at the time of the earnings announcement. Accordingly, two instances in which a firm’s announced earnings involve unexpectedly meeting or missing an earnings increase threshold after taking into consideration the effect of management forecasts, 1) Unexpected increase: firms that were forecasted to have a decrease in earnings that report an increase in earnings (UINCR). 2) Unexpected decrease; firms that were forecasted to have an increase in earnings that report a decrease in earnings (UDECR). And four additional classifications for the expected thresholds consider: 1) Expected increase with positive earnings forecast errors; firms that were forecasted to have an increase in earnings that report an increase in earnings (EINCRFE+). For these firms actual earnings is greater than forecasted earnings. 2) Expected increase with negative earnings forecast errors; firms that were forecasted to have an increase in earnings that report an increase in earnings (EINCRFE-). For these firms forecasted earnings is greater than actual earnings. 3) Expected decrease with positive earnings forecast errors; firms that were forecasted to have a decrease in earnings that report a decrease in earnings (EDECRFE+). For these firms actual earnings is greater than forecasted earnings. 4) Expected decrease with negative earnings forecast errors; firms that were forecasted to have a decrease in earnings that report a decrease in earnings (EDECRFE-). For these firms forecasted earnings is greater than actual earnings. This paper examines whether there is an incremental effect for unexpectedly meeting the increase threshold for firms already reporting a positive forecast error (UINCR). This can be examined by comparing the estimated coefficients of UINCR firms with those of EINCRFE+ and EDECRFE+ firms. Evidence of an incremental threshold effect for meeting the increase threshold would be found if the intercept or slope coefficient of UINCR firms is incrementally greater than those of EINCRFE+ and EDECRFE+ firms. A similar analysis is performed for the other group (UDECR, EINCRFE-, EDECRFE-). For data analysis, panel data were used and a sample consisting of 75 companies listed in Tehran Stock Exchange during the years 2008 to 2011 were selected. Results showed earnings response coefficient (ERC) for UINCR firms is more positive than ERC for EDECRFE+ but less positive than ERC for EINCRFE+ firms. This result is not consistent with a market reward for meeting the earnings increase threshold. For missing the earnings increase threshold, the ERC for UDECR firms is greater than the ERC for EDECRFE− firms but less positive than ERC for EINCRFE− firms, respectively. Once again, the results do not provide any evidence of an incremental threshold effect. Discussion and The results show that last year’s earnings threshold as one of the reference points is not considered in the decisions of investors. In other words, this research doesn’t support market-based incentives as a driver of earnings management on capital markets.