Quarterly Earnings Patterns and Earnings Management

This paper investigates whether the pattern of quarterly earnings changes can provide an indication of earnings management. We identify firms for which the sign of (seasonal) earnings changes observed in interim quarters reverses in the fourth quarter. We hypothesize that a firm performing poorly in interim quarters may attempt to increase earnings of the fourth quarter to achieve a desired annual earnings target, while a firm performing well in interim quarters may attempt to decrease earnings of the fourth quarter to build "reserves" for the future. Our results show that reversals of earnings changes in the fourth quarter occur more frequently than would be expected by chance. Other indicators of earnings management, such as the size and direction of discretionary accruals, reversal of subsequent accruals, use of special items in the income statement, and adjustment of R&D spending and effective tax rate, suggest that firms with earnings reversals are more likely to have managed earnings than industry-and performance-matched control firms. From our results, the capital market appears to attach lower credibility to earnings reported by the reversal samples. We further find that a significant percentage of firms reporting small profits and small increases in EPS also exhibit fourth-quarter earnings reversals. This finding provides an interesting insight - that at least one-fourth of the sample of firms that meets or just beats earnings targets are attempting to smooth annual earnings by managing earnings downward in the fourth quarter.