An investigation of earnings management to avoid losses and earnings decreases and the implementation of Prospects Theory to explain its motives

Accounting earnings are viewed as the premier information item provided in financial statements. Earnings are widely used as a key performance indicator of business success. Failure to meet or beat market expectations results in adverse consequences for the firm. Managers are, therefore, concerned about reporting an earnings number that meets or exceeds market expectations. Three research designs were commonly used in the earnings management literature: those based on aggregate accruals, those based on specific accruals and those based on the distribution of earnings (McNichols, 2000). As Burgstahler and Dichev (1997) suggest the earnings distribution approach investigates the statistical feature of earnings distribution to discover any abnormal patterns. These studies consider the behavior of earnings around a specific threshold to examine whether or not the frequency distribution of earnings above or below the threshold is smooth. In this paper, we use earnings distribution approach (EDA) to investigate whether firms manage reported earnings. This paper has focused on two earnings targets, namely (1) reporting profits, or ‘positive earnings’, (2) reporting results that improve upon last year’s performance. Our next question is related to the incentives of firms to manage earnings. We examine the capability of prospect theory to explain the motivation of this type of earnings management. If the preferences of the stakeholders are consistent with the prospect theory, then the manager has an incentive to report earnings that exceed the threshold, or the reference point, such as zero earnings levels or zero earnings changes, to obtain more rewards.
Research Hypotheses: Based on the theoretical literature and the conducted studies, research hypotheses were developed as follows:
Primary Hypotheses: 1- Earnings are managed to avoid losses.
2- Earnings are managed to avoid earnings decreases.
Secondary Hypotheses
1- In the case of earnings management to avoid losses, zero scaled earnings is the reference point corresponding to prospect theory
2- In the case of earnings management to avoid earnings decrease, zero scaled earnings change is the reference point corresponding to prospect theory
In this research, our data were obtained from the Iranian database of Tehran Stock Exchange (Rah Avard Novin). The sample was selected from the period 2009-2013. We investigate two earnings variables. One is earnings level and the other is earnings change. For the earnings level variable, we used 908 firm-year observations and for the earnings change variable, there are 917 firm-year observations. We used annual net earnings to measure first threshold, which is avoiding losses and annual net earnings changes to measure second threshold, which is avoiding earnings decreases. The earnings observations are drawn from a broad range of firm sizes and are therefore scaled. The earnings variable is scaled by beginning-of-the-year market value of common equity. We present two types of evidence to determine whether earnings management leads to avoiding earnings decreases and losses. First, we present graphical evidence in the form of histograms of the pooled cross-sectional empirical distributions of scaled earnings changes and levels of earnings. Second, we investigate the significance of any irregularities around the zero point via Burgstahler and Dichev statistical method.
The results of this research show that at a confidence level of 95%, earnings are managed to avoid losses. On the other words, we find that more firms than expected report small positive earnings in the Tehran Stock Exchange. However, there is no evidence to support that earnings are managed to avoid earnings decrease. Moreover, the findings show that the prospect theory can be used to explain the reasons and motives of earnings management to avoid losses.
Discussion and This paper provides compelling empirical evidence that earnings are managed to avoid losses. Earnings distributions show unexpectedly high frequencies of observations above the zero scaled earnings and unexpectedly low frequencies of observations below the zero scaled earnings. In addition, findings show that Kahneman and Tversky’s ‘prospect theory’ provide possible explanation for such behavior. From a psychological perspective, prospect theory postulates that decision-makers derive value from gains and losses with respect to a reference point, rather than from absolute levels of wealth. This captures the notion that losses are more displeasing than the equivalent gain. Thus, individuals derive the highest value when wealth moves from a loss to a gain relative to reference points. Firms above the earnings threshold are found to be risk averters while firms below the earnings threshold are found to be risk lovers. However, the study has several limitations. The earnings distribution approach does not capture the magnitude of earnings management. Furthermore, it does not specify the methods by which earnings are managed.