Earnings management to avoid earnings decreases and losses

This paper provides evidence that firms manage reported earnings to avoid earnings decreases and losses. Specifically, in cross-sectional distributions of earnings changes and earnings, we find unusually low frequencies of small decreases in earnings and small losses and unusually high frequencies of small increases in earnings and small positive income. We find evidence that two components of earnings, cash flow from operations and changes in working capital, are used to achieve increases in earnings. We present two theories, based on stakeholder use of information-processing heuristics and prospect theory, about the motivation for avoidance of earnings decreases and losses. (C) 1997 Elsevier Science B.V. All rights reserved.