Earnings Management to Avoid Losses and Earnings Decreases

This paper examines cross-sectional distributions of scaled annual earnings and earnings changes for all available observations on the annual industrial Compustat database for the years 1975-1993. The distributions are bell- shaped and relatively smooth except in the regions near zero. For both earnings and earnings change distributions there is a trough immediately to the left of zero and a peak immediately to the right of zero which is inconsistent with the overall shape of the remainder of the distribution i.e. the frequencies of small losses and small decreases in earnings are unusually low and the frequencies of small positive income and small increases in earnings are unusually high. We follow up on the distributional evidence that earnings are managed to avoid losses by defining five components of earnings: Cash flow from operations changes in working capital non-operating income special items and other accruals. The evidence suggests that the cash flow and change in working capital components play the primary role in earnings management in the vicinity of zero