What Have We Learned About Earnings Management? Correcting Disinformation about Discontinuities*

Earnings distributions commonly exhibit statistically significant discontinuities at prominent performance benchmarks. Discontinuities at zero earnings are widely interpreted as evidence of earnings management to avoid a loss, and discontinuities at zero earnings change or zero earnings surprise as evidence of management to avoid an earnings decrease or negative earnings surprise, respectively. In contrast, two recent papers by Durtschi and Easton (2005, 2009, hereafter DE) assert that discontinuities are instead explained by some combination of prior researchers' choice(s) of sample selection and scaling as well as a systematic relation between the sign of earnings and market prices. Resolution of the conflicting interpretations of discontinuities is important because 1) it affects how investors, regulators, and scholars view earnings management and 2) it demonstrates the importance of a close linkage between theory and research design choices. We evaluate the three alternative explanations proposed by DE. We point out that DE provide no evidence that their explanations create discontinuities, but only evidence showing that their modified research designs eliminate discontinuities. We also demonstrate why the research designs used by DE eliminate evidence of discontinuities when alternative designs using the same data identify highly significant discontinuities. Finally, we outline the key characteristics of the extensive body of evidence documenting discontinuities in earnings distributions that are consistent with the theory that earnings are managed but are generally inconsistent with artifactual theories of discontinuities.