A Diagnostic For Earnings Management Using Changes PDF

A Diagnostic for Earnings Management Using Changes
in Asset Turnover and Prot Margin*

IVO PH. JANSEN, Rutgers UniversityCamden
SUNDARESH RAMNATH, University of Miami
TERI LOMBARDI YOHN, Indiana University
1. Introduction
Identifying earnings management is important for nancial statement users to assess
current economic performance, to predict future protability, and to determine rm value.
However, it is often difcult and time-consuming to identify earnings management, especially in generic settings where an obvious incentive to manage earnings is absent. While
academic research has used numerous proxies for (or diagnostics of) earnings management, most recent studies use accruals models to decompose total accruals into a normal,
economics-driven component and an abnormal, earnings management component.1
McNichols (2000) points out, however, that there is limited theory about how accruals
should behave in the absence of discretion, and Fields, Lys, and Vincent (2001) argue that
the use of existing accruals models may lead to serious inference problems.
In DuPont analysis, a rms return on assets is decomposed into asset turnover (ATO,
the ratio of sales to net operating assets) and prot margin (PM, the ratio of operating
income to sales), and nancial statement analysis textbooks broadly advocate making this
decomposition when investigating protability and changes in protability (see, e.g.,
White, Sondhi, and Fried 2003; Palepu, Bernard, and Healy 2004; Penman 2007; Stickney,
Brown, and Wahlen 2004; Lundholm and Sloan 2004). In this study, we propose a simple
diagnostic of earnings management that relies on the widely held notion underlying
DuPont analysis that sales is a fundamental driver of a rms investment and income, and
that net operating assets on the balance sheet and net operating income on the income
statement should vary directly with sales. In other words, changes in ATO or PM warrant
further investigation in quality of earnings analyses. Moreover, we note that changes in
ATO and PM in opposite directions could signal earnings management. We base this observation on the articulation of the income statement and balance sheet, which ensures that
earnings management affects operating income and net operating assets in the same direction, and thus causes ATO and PM to move in opposite directions. For example, for a
given level of sales, if a rm manages earnings upward by understating bad debt expense,
both net income relative to sales and the net realizable value of accounts receivable relative
*
Accepted by K.R. Subramanyam. We thank Patricia Faireld for her contributions to the paper, as well as
Bill Baber, Walt Blacconiere, Bill Brown, Dave Burgstahler, Prem Jain, Chris Jones, Bin Ke, Jim Ohlson,
Scott Richardson, D. Shores, and seminar participants at George Washington University, Georgetown University, Michigan State University, University of Washington, Morgan State University, University of Minnesota, Rutgers UniversityCamden, Suffolk University, Loyola Marymount University, University of New
Hampshire, Villanova University, the Financial Economics and Accounting Conference, and the University
of Utah Winter Accounting Conference. We also thank Glass Lewis & Co. for the restatement data. Teri
Yohn acknowledges the generous support of the PricewaterhouseCoopers Fellowship.
1.
See, for example, Healy 1985; DeAngelo 1986; Jones 1991; Dechow, Richardson, and Tuna 2003; and
Kothari, Leone, and Wasley 2005.
Contemporary Accounting Research Vol. 29 No. 1 (Spring 2012) pp. 221251 CAAA
doi:10.1111/j.1911-3846.2011.01093.x
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Contemporary Accounting Research
to sales will be overstated. The increase in net income relative to sales will lead to an
increase in PM, while the increase in net accounts receivable relative to sales will lead to a
decrease in ATO. In general, upward earnings management causes PM to increase and
ATO to decrease, while downward earnings management causes PM to decrease and ATO
to increase.
We rely on this observation to argue that contemporaneous, directionally opposite
changes in a rms ATO and PM can serve as a signal of potential earnings management.
Specically, we propose and investigate the usefulness of contemporaneous increases in
PM and decreases in ATO as a diagnostic for upward earnings management, and of
contemporaneous decreases in PM and increases in ATO as a diagnostic for downward
earnings management.
The above relations between earnings management and ATO PM hold when the relation between net operating assets and sales is stable and when earnings are managed
through expenses. When earnings are managed through sales, the relations will hold if the
prot margin on the managed sales is greater than the prot margin on unmanaged sales
and if the asset turnover of the managed sales is less than the asset turnover of unmanaged
sales. The ATO PM diagnostic further assumes that a company has not changed its strategy and has constant growth rates in investment. A Type I error could occur if a company
changes its strategy or experiences unexpected growth. The ATO PM diagnostic also
assumes that a company does not manage earnings through cash ows. A Type II error
could occur if a rm manages earnings upward by delaying, for example, advertising or
research and development expenditures.
Because earnings management is not directly observable, we cannot perform direct
tests to validate the ATO PM earnings management diagnostic. Instead, we rely on prior
research which documents situations and outcomes indicative of earnings management
and show that the ATO PM diagnostic is associated with these earnings management
scenarios. We also suggest that directionally opposite changes in ATO and PM can be a
useful complement to abnormal accruals in detecting earnings management in academic
research. Therefore, in all tests, we compare the relative and incremental information
content of the ATO PM diagnostic to performance-adjusted abnormal accruals, a widely
accepted proxy for earnings management. (For recent studies that use abnormal accruals
see, e.g., Cohen, Dey, and Lys 2008; Gong, Louis, and Sun 2008; Zhao and Chen
2008.)2
Relying on prior research which suggests that rms manage earnings upward to meet
or beat analyst forecasts (e.g., Burgstahler and Eames 2006; Matsumoto 2002), we rst
examine the association between the ATO PM diagnostic and rms propensity to meet
or beat earnings expectations. We nd that the ATO PM diagnostic provides information about the likelihood of a rm meeting or beating expectations, even after controlling for performance-adjusted abnormal accruals. Moreover, we nd that the ATO PM
measure has signicantly greater discriminating ability than performance-adjusted abnormal accruals in identifying rms that meet or beat earnings expectations.
Second, we argue that when rms beat or miss earnings expectations by a wide margin, they are more likely to manage earnings downward (i.e., smooth earnings or take a
bath). We nd that the ATO PM diagnostic provides information about the likelihood
of a rm experiencing an extreme earnings surprise. Once again the ATO PM diagnostic
2.
We estimate performance-adjusted abnormal accruals using the abnormal accruals model from Dechow et
al. 2003 (259, model 3), augmented with protability as an independent variable to control for performance. All results reported in the paper are qualitatively similar if we omit the performance adjustment,
or if we estimate more basic versions of the abnormal accruals model.
CAR Vol. 29 No. 1 (Spring 2012)
A Diagnostic for Earnings Management
223
has signicantly greater discriminating ability than performance-adjusted abnormal accruals in identifying rms that report extreme earnings surprises.
Third, a growing body of research uses subsequent earnings restatements as an indicator of earnings management (Richardson, Tuna, and Wu 2002; Kedia 2003). We nd that
the ATO PM diagnostic provides information about the likelihood of a rm subsequently
restating earnings. In comparison, performance-adjusted abnormal accruals are unrelated
to future earnings restatements.
Finally, earnings management temporarily inates or deates earnings articially and
should therefore lead to a reversal in future protability (Penman 2007: 633). In addition,
failure of the stock market to see through the earnings management will lead to predictable
future returns (e.g., Xie 2001). We nd that both the ATO PM diagnostic and performanceadjusted abnormal accruals are useful, and incrementally informative, for identifying future
earnings reversals and future abnormal returns.
Based on these ndings, we conclude that contemporaneous, directionally opposite
changes in ATO and PM are informative about earnings management, even after controlling for performance-adjusted abnormal accruals, a widely accepted earnings management
proxy. In addition, the ATO PM diagnostic has signicantly greater discriminating ability
than performance-adjusted abnormal accruals in identifying rms that meet or beat expectations, report extreme earnings surprises, and subsequently restate earnings.
As a diagnostic of earnings management, the ATO PM measure has several appealing features. First, the measure relies on fundamental relations in the accounting model,
as opposed to estimated relations typically used in abnormal accruals models. Second,
ATO and PM are primary ratios in nancial statement analysis that are likely to be
investigated by many users of nancial statements, even when they are not explicitly
considering earnings management. In addition, unlike abnormal accruals measures which
require nancial statement data from a substantial time series or even an entire industry,
the ATO PM diagnostic can be computed for any rm using very few years of rm-level
data. In practical terms, our ndings suggest that nancial statement users will benet
from investigating the possibility that a rm has managed its earnings upward (downward) when there is a contemporaneous increase (decrease) in the rms PM and
decrease (increase) in its ATO. In short, we believe that the ATO PM diagnostic can be
used in academic and investment research as a (complementary) diagnostic of earnings
management.
The paper proceeds as follows. The next section provides the background and motivation for our earnings management diagnostic. In section 3, we discuss our sample, variable
measurement, and descriptive statistics. In section 4, we describe our analyses and report
our ndings. In section 5, we summarize and conclude the paper.
2. Background and motivation
Prior literature
Healy and Wahlen (1999) argue that earnings management occurs when managers use
judgment in nancial reporting to alter nancial reports to mislead stakeholders about the
underlying economic performance of the company. Dechow and Skinner (2000) argue that
earnings management could arise from accounting choices that are fraudulent or from
choices that are aggressive, but acceptable, uses of accounting discretion. Identifying both
forms of earnings management is important to investors for assessing rm value; however,
it is often difcult to do so, in part because many discretionary earnings components are
not separately observable. This task is further complicated when earnings management
occurs in the absence of an obvious incentive to manage earnings, such as preceding an
equity offering or a leveraged buyout. Thus, it is important for nancial statement users
224
and academic researchers to have diagnostics for earnings management that are informative even when no obvious incentive to manage income exists.
In quality of earnings analyses, one is generally concerned when growth in net operating assets exceeds growth in sales. Such a scenario could suggest that a company is
inappropriately recording costs on the balance sheet instead of the income statement.
The most popular proxy for earnings management abnormal accruals, estimated using
some version of the Jones 1991 model builds on this idea and adjusts total accruals
(i.e., growth in working capital less depreciation expense) for the amount of accruals
explained by changes in sales and property, plant, and equipment. There are several
variations of this model. For example, the modied Jones model (see Dechow, Sloan,
and Sweeney 1995) subtracts growth in accounts receivable from growth in sales when
calculating nondiscretionary accruals, to avoid the assumption, implicit in the Jones 1991
model, that earnings are not managed through sales. Dechow et al. (2003) further
enhance the model by including an estimation of the relation between the change in
receivables and the change in sales to avoid the assumption implicit in the modied
Jones model that the entire change in accounts receivable stems from revenue-based earnings management and by including prior total accruals. Kothari et al. (2005) suggest
that to isolate abnormal accruals researchers should control for rm performance in the
estimation model as well. Regardless of the specic model, the model parameters are generally estimated using annual, cross-sectional regressions within two-digit SIC codes, or
using time-series regressions by rm. The estimates are then used to calculate nondiscretionary accruals as the predicted value of total accruals, and the difference between total
accruals and nondiscretionary accruals is deemed discretionary and is used as a proxy for
managed earnings.
Bernard and Skinner (1996: 31617) argue that there are likely to be important omitted variables in explaining working capital accruals, and that any nonlinearity in the relation between growth in working capital and the explanatory variables will create
measurement error in estimating discretionary accruals. In addition, when the model is
estimated cross-sectionally in an industry, it is assumed that all rms in that industry have
the same strategy and relation between accruals and the explanatory variables. Alternatively, when the model is estimated by rm, one needs a sufcient estimation period to calculate the parameter estimates. Bernard and Skinner (1996) argue that the cross-sectional
estimates are very imprecise, even when estimated within two-digit industry codes, and
that the time-series estimates are even less precise. The abnormal accruals models, therefore, make signicant assumptions that may or may not hold. Moreover, the choice of
explanatory variables to capture the drivers of accruals is ad hoc, and the models lack
theoretical support.
Barton and Simko (2002) develop a measure of past earnings management that is
more grounded in the accounting model. They argue that rms that have aggressively
capitalized expenditures will have high net operating assets relative to sales and, therefore, rms with bloated balance sheets are more likely to have managed earnings upward
in the past. However, their metric assumes that all bloat in the balance sheet is due to
earnings management and does not consider other plausible reasons why some rms
may have a higher ratio of net operating assets to sales than others, such as differences
in strategy or protability. In addition, while the metric is potentially useful for identifying past earnings management, it is less useful for identifying earnings management in
the current period.
In short, existing proxies for earnings management build on the intuition that growth
in net operating assets should be accompanied by growth in sales. As discussed above,
however, these proxies have several limitations. In this study, we propose a new diagnostic
for earnings management that builds on similar intuition, but exploits the accounting
225
model to gain insight into when changes in the ratio of sales to net operating assets that
is, changes in the asset turnover ratio are likely due to earnings management.3
Hypotheses
It is well accepted that sales is the fundamental driver of net operating income on the
income statement and net operating assets on the balance sheet. Indeed, most nancial
statement analysis textbooks advocate forecasting income statement and balance sheet line
items based on sales forecasts. For example, Penman (2007: 559) provides a framework
for forecasting and states that sales forecasting is the starting point. This intuition,
which also underlies the widely used DuPont analysis, is that there should be a stable relation between sales and both operating income on the income statement and net operating
assets on the balance sheet. These relations are captured by the ATO and PM ratios:
ATO = Sales Net operating assets;
PM = Operating income Sales.
We argue that ATO and PM should remain relatively constant in a stable operating
environment and that, in quality of earnings analysis, changes in ATO and or PM warrant
further investigation. We also argue that one should be particularly concerned when ATO
and PM change in opposite directions as this could signal earnings management. This is
based on the fact that the articulation of the income statement and balance sheet forces
earnings management to affect operating income and net operating assets in the same
direction. This is apparent from the denition of net operating assets:
Net operating assetst Net operating assetst1 DWorking capitalt
Depreciation expenset DLong-term net operating assetst
Net operating assetst1 Operating incomet
Cash from operationst DLong-term net operating assetst
Thus, assuming that earnings are not managed through cash ows (e.g., real earnings
management), any upward management of operating income will also overstate net
operating assets. Because operating income is the numerator of PM and net operating
assets is the denominator of ATO, upward earnings management increases PM and
decreases ATO, while downward earnings management decreases PM and increases ATO.
We therefore propose that directionally opposite changes in the PM and ATO ratios can
be used as a diagnostic for earnings management. We state our rst set of hypotheses as
follows:4
Hypothesis 1a. Contemporaneous increases in PM and decreases in ATO signal upward
Hypothesis 1b. Contemporaneous decreases in PM and increases in ATO signal downward earnings management.
3.
4.
McNichols (2000) suggests three methods to identify earnings management: (i) using aggregate accrual
models such as the Jones 1991 model, (ii) examining the behavior of specic accruals, and (iii) examining
the distribution of earnings after management. Our diagnostic is in the spirit of the aggregate accrual
models, in that the aim is to identify general earnings management. We do not examine specic accruals
because earnings management is likely to occur in accounts that may not be separately reported in the
nancial statement and footnotes. We use the distribution of realized earnings to test whether our diagnostic is informative about earnings management.
All hypotheses are stated in the alternative form.
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The ATO PM earnings management diagnostic is in the same spirit as abnormal accruals
models, in that it also attempts to identify discretionary growth on the balance sheet; however, the ATO PM diagnostic exploits the accounting model to produce additional insights
about earnings management over those obtained from abnormal accruals models. For
example, consider a rm that invests in current operating assets in anticipation of future
sales growth. In this case, abnormal accruals would likely be positive, even in the absence
of upward earnings management, because additional investments in working capital (i.e.,
additional accruals) would not necessarily be accompanied by current sales growth. The
ATO PM diagnostic, on the other hand, would not suggest upward earnings management
for this scenario, because even though ATO would decrease, investments in operating
assets in anticipation of future sales growth will not affect current PM. We therefore propose that directionally opposite changes in ATO and PM can be a useful complement to
abnormal accruals in detecting earnings management in academic research. This leads to
our second hypothesis:
Hypothesis 2. The ATO PM diagnostic provides incremental and greater relative
information content over abnormal accruals in identifying earnings management.
More insights into the ATO PM earnings management diagnostic
The argument made above, which underlies the ATO PM diagnostic, is that under fairly
general conditions upward earnings management increases PM and decreases ATO and
downward earnings management decreases PM and increases ATO. These relations hold
for (noncash) expense management when there is no change in business strategy and when
there is neutral accounting or aggressive conservative accounting with constant growth in
net operating assets.5 The relations do not hold for all revenue management cases, however, because the numerators and denominators of both ATO and PM would change. The
diagnostic will correctly classify (upward) earnings management if the revenue management causes PM to increase and ATO to decrease. In other words, the diagnostic will
correctly signal earnings management if: (i) the prot margin on the managed revenues is
greater than the prot margin on unmanaged revenue and (ii) the asset turnover of the
managed revenue is less than the unmanaged asset turnover. This rst condition is very
likely because prot margin on normal revenue will be reduced by both product and period costs, whereas managed revenue is likely accompanied by only additional product
costs, not additional period costs.
The second condition is less clear-cut. If the company does not accrue any expenses
related to the managed component of sales, the ATO of managed sales will be equal to
one because the numerator (sales) will equal the denominator (receivables). In our sample, 82 percent of the rm-year observations have ATO greater than one, which makes
it likely that, in the absence of related expenses being accrued, the second condition will
also generally be satised. However, sales management will most likely be accompanied
by some accrued expenses which will decrease net operating assets (e.g., decreases in
inventory, increases in payables) resulting in the ATO of managed sales being greater
than one. In these instances, the second condition may or may not be satised. Expenses
accrued on managed sales are not observable, and therefore we are unable to provide
empirical estimates of how frequently rms in our sample meet or do not meet the second condition. In short, the ATO PM diagnostic will identify most expense-based earnings management, but can only capture sales management in certain situations, which is
5.
See Penman 2007 (593603) and Rajan, Reichelstein, and Soliman 2007 for discussions of the interaction
between growth and accounting methods and their effects on nancial ratios.
227
a limitation of the diagnostic. As a result, the diagnostic is more prone to Type II errors
(failure to identify earnings management) than Type I errors (falsely agging earnings
management).
The ATO PM diagnostic assumes that a company has not changed its strategy and
has constant growth rates in investment. A Type I error could occur if a company changes
its strategy or experiences unexpected growth. For example, if a rm changes its strategy
from low-margin high-turnover to high-margin low-turnover, the ratios would most likely
move in opposite directions even in the absence of earnings management. Under this scenario, however, it is also likely that a rms abnormal accruals would be signicantly nonzero, because the change in strategy would probably be accompanied by signicant
accruals (i.e., a signicant change in working capital) that would be characterized by
accruals models as abnormal. In addition, it seems more reasonable to assume that a rm
will continue the same strategy over time than to assume that all rms in the same industry have the same strategy, which is the implicit assumption in cross-sectional estimates of
the Jones model.6
The ATO PM diagnostic also assumes that a company does not manage earnings
through cash ows. A Type II error could occur if a rm manages earnings upward by
delaying advertising or research and development expenditures. In this case, PM would
increase because of higher operating income, but ATO would be unaffected because of the
absence of an accrual on the balance sheet. Of course, given the latter, accruals models
would also likely fail to detect such earnings management.
3. Sample, variable denitions, and descriptive statistics
Sample
We obtain nancial statement data from the 2006 COMPUSTAT Annual Industrial, Full
Coverage, and Research tapes. Because funds from operations (COMPUSTAT data item
#110) which which we need to compute cash from operating activities in years before
1988 is not available prior to 1971, and because we need year-ahead data for several
variables, our sample spans the years 1971 through 2005 (we use the COMPUSTAT year
convention). The nancial statement variables we use in our study are available for
118,679 rm-year observations. We eliminate observations in which net operating assets
are negative in year t)1 or year t, because ATO is undened for negative net operating
assets (5,578 observations). We also eliminate all nancial rms from our analyses (SIC
60006999) because it is difcult to distinguish between operating and nancial activities
for these rms (2,931 of the remaining observations). After applying the above screens,
our primary sample consists of 110,170 rm-year observations.7 Missing stock returns
around the earnings announcement date of the rst scal quarter of the next year reduce
the sample size to 67,075 observations for our abnormal returns tests. When we intersect
the primary sample with nonmissing analyst forecast data from I B E S, the sample size
decreases to 46,522 observations. For the restatement analysis, the sample size decreases to
6.
7.
Consider, for example, Walmart and Macys, which are in the same four digit SIC code but have very different strategies. It seems more realistic to assume that each rm continues its strategy over time than to
assume that the rms have similar strategies (i.e., forcing the abnormal accruals model parameters to be
equal across all rms in the industry).
As a robustness test, we also ran the analyses after eliminating rms that were involved in any divestitures
and or mergers or acquisitions, because these transactions can cause the articulation between balance
sheet changes and the income statement to break down. Specically, we eliminated rm-year observations
in which a rm discontinued operations or was involved in a merger or acquisition (COMPUSTAT annual
footnote code #1) in year t)1, year t, or year t + 1. We also deleted rm-years with increases in goodwill
in year t)1, year t, or year t + 1. The results are qualitatively similar to those reported in the tables.
228
22,160 because we only have restatement data available for the 20002005 period. We
obtain our base sample of 2,319 restatements from Glass Lewis.8
Variable measurement
We provide a detailed description of the denition and measurement of all variables in
Table 1. We dene the change in PM (DPMt) and the change in ATO (DATOt) as follows:
DPMt operating incomet =salest operating incomet1 =salest1 ; and
DATOt salest =net operating assetst salest1 =net operating assetst1 :
We argue that a contemporaneous increase in PM and decrease in ATO signals potential upward earnings management, and that a contemporaneous decrease in PM and
increase in ATO signals potential downward earnings management. We dene two corresponding indicator variables that represent our diagnostic for earnings management:
EM_UP for upward earnings management and EM_DN for downward earnings management. They are dened as follows:
EM UPt one if DPMt >0; DATOt <0 and EM DNt1 6 1; and zero otherwise, and
EM DNt one if DPMt <0; DATOt >0; and EM UPt1 6 1; and zero otherwise.
We include the requirement that EM_DNt)1 1 and EM_UPt )1 1 in the denitions of EM_UPt and EM_DNt, respectively, to eliminate cases where the diagnostic is
likely to identify the reversal of earnings management. This is a potential shortcoming of
many diagnostics of earnings management, including abnormal accruals. For example, if a
rm understates bad debt expense to manage earnings upward in one period, but then is
forced to account for the shortfall by increasing bad debt expense in the next period, one
is likely to observe directionally opposite changes in ATO and PM in both periods, but of
opposite signs. The ATO PM diagnostic would identify the rst period increase in PM
and associated decrease in ATO as evidence of upward earnings management, and the second period reversal as suggestive of downward earnings management.9 Because we are
interested in identifying earnings management, not its reversal, we do not classify a rm as
having managed earnings up (down) in year t if the same rm was classied as having
managed earnings down (up) in year t)1.10
We estimate abnormal accruals using the performance-adjusted approach suggested by
Kothari et al. 2005. To mitigate specication problems with discretionary accruals for
rms experiencing extreme performance, Kothari et al. (2005) recommend the use of performance-matched discretionary accruals, where abnormal discretionary accruals are
dened relative to the discretionary accruals for a rm with similar performance. Performance-matched discretionary accruals, which by construction represent abnormal earnings management, not total earnings management, are useful for identifying rms
responding to specic and uniquely identiable earnings management incentives but are
not useful for identifying generic earnings management (Kothari et al. 2005: 171). Because
8.
9.
10.
Compiled by Glass Lewis & Co, this data set includes restatements led from 2003 to 2006, although the
affected period includes earlier years. Only restatements led to correct accounting errors as dened by
Accounting Principles Board Opinion No 20 are included. Accordingly, the data set excludes restatements
caused by changes in accounting principle, changes in estimates, adoption of new standards, changes in
the discussion of results, minor wording changes or typographical errors.
Note that abnormal accrual metrics will similarly misclassify the second period reversal as a negative
abnormal accrual.
Without this restriction, the number of EM_UP (EM_DN) observations would have been 31 percent (27
percent) higher. We also performed all the analyses in the paper after eliminating this constraint on the
denition of EM_UP and EM_DN. The results (untabulated) are similar to those reported in the tables.
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TABLE 1
Variable denitions
DPMt
DATOt
EM_UPt
EM_DNt
PABNACt
DRECt
PAB_UP
PAB_DN
SURP
EES
RESTATE
DN_RESTATEt
UP_RESTATEt
NO_RESTATEt
= change in PM = (operating incomet salest (COMPUSTAT data item #12);

where operating incomet = salest (#12) (cost of goods sold (#41) + selling,
general and administrative expenses (#189) + depreciation and amortization
expense (#14))t;
= change in ATO = (salest (COMPUSTAT data item #12) net operating assetst)
(salest)1 net operating assetst)1); where net operating assetst = net assetst
(#216) net nancial assetst; and net nancial assetst = cash and short term
investments (#1) interest-bearing liabilitiest (#34 + #9).
= 1 if DPMt > 0, DATOt < 0, and EM_DNt)1 1, and 0 otherwise.
= 1 if DPMt < 0, and DATOt > 0, and EM_UPt)1 1, and 0 otherwise.
= performance adjusted abnormal accruals = the tted residual from the following model:
TACt TAt)1 = a1(1 TAt)1) + a2((1 + k)(DREVt )DRECt) TAt)1)
+ a3(PPEt TAt)1) + a4(TACt)1 TAt)1) + a5(RNOAt TAt)1)
+ et,
where:
TACt
= income before extraordinary itemst (#18) cash from operations (CFO)t;
TAt)1
= total assetst)1 (#6),
DREVt
= changes in salest (#12),
DRECt
= change in receivablest (#2);
PPEt
= gross property, plant, and equipmentt (#7);
RNOAt
= return on net operating assets;
CFOt
= net cash ow from operating activities (#308) in 1988 and
thereafter;
CFOt
= funds from operationst (#110) change in current assetst (#4)
+ change in cash and short-term investmentst (#1) + change
in current liabilitiest (#5) change in short term debtt (#34)
prior to 1988;
where all variables above are deated by total assetst)1 (#6); and k = the
slope 1 coefcient from the following model:
= b0 + kDREVt + u.
= 1 if PABNAC is positive, and 0 otherwise;
= 1 if PABNAC is negative, and 0 otherwise.
= actual earnings less the median analyst forecast of earnings closest to the earnings announcement date. MBE = 1 if SURP is between 0 and 2 cents, and 0
otherwise;
= 1 if SURP is in the top or bottom decile of SURP, and 0 otherwise;
= the difference (in $ millions) between restated and the originally reported operating income for year t;
= 1 if the rm subsequently restates its operating earnings down for year t, and 0
otherwise;
= 1 if the rm subsequently restates its operating earnings up for year t, and 0
otherwise;
= 1 if the rm does not subsequently restated its operating earnings for year t,
and 0 otherwise;
(The table is continued on the next page.)
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TABLE 1 (Continued)
ABRETt+1
IRNOAt
MTBt
MVEt
RNOAt
DRNOAt
NOAt
DNOAt
= the size-adjusted cumulative abnormal return over the three-day period centered on
next years rst scal quarter earnings announcement;
= average of RNOAt for the 2-digit SIC code to which the rm belongs (excluding the
rm);
= the market-to-book ratio dened as the ratio of the rms market value of equity
(#25 * #199) divided by its book value (#60) at the end of the scal year;
= the rms market value of equity (#25 * #199);
= return on net operating assets = operating incomet average net operating assetst;
where average net operating assetst = (net operating assetst + net operating
assetst)1) 2;
= change in return on net operating assets = RNOAt RNOAt)1;
= net operating assetst salest; and
= change in net operating assets = (net operating assetst net operating assets
t)1) net operating assetst)1.
our diagnostic is intended to ag all potential earnings management, we do not use performance-matched abnormal accruals in our analyses, but instead use the alternative
approach suggested in Kothari et al. 2005, in which rm performance is included in the
accruals estimation.
Accordingly, we add the rms return on net operating assets (RNOA) for the current
period to the enhanced version of the Jones 1991 model suggested in Dechow et al. 2003
(259, model 3) and estimate abnormal accruals.11 Specically, we estimate performanceadjusted abnormal accruals (PABNACt) as the tted residual from the following model:12

TACt
1
1 kDREVt DRECt1
PPEt
a1
a2
a3
TAt1
TAt1
TAt1
TAt1

TACt1
RNOAt
a4
a5
et
TAt1
TAt1
where:
TACt
TAt)1
DREVt
DRECt
PPEt
RNOAt
CFOt
k
DRECt
11.
12.
= income before extraordinary itemst cash from operations (CFO)t;

= total assetst)1,;
= changes in salest;
= change in receivablest;
= gross property, plant and equipmentt;
= return on net operating assets;
= net cash ow from operating activities (for rm-years from 1988);
= funds from operationst change in current assetst + change in cash and
short-term investmentst + change in current liabilitiest change in short
term debtt (for rm-years prior to 1988); and
= the slope coefcient from the following model:
= b0 + kDREVt + u.
Dechow et al. (2003) also modify the Jones model by including forward-looking sales growth. We do not
use this variation because our purpose is to identify earnings management using current, not future, nancial statement information. In addition, Dechow and Dichev (2002) suggest an alternative model that captures earnings quality over an extended time period. We do not examine this measure because our focus is
on short-horizon earnings management behavior, not long-run earnings quality.
We suppress rm subscripts.
231
Following DeFond and Jiambalvo 1994, Subramanyam 1996, and Xie 2001, we
estimate the model in cross-section, for each two-digit SIC code and year combination.13
While PABNAC is a continuous measure in our primary analyses, we also examine an
indicator variable, PAB_UP (PAB_DN), which equals one if PABNAC is positive (negative), and zero otherwise, as indicators of upward (downward) earnings management.
We examine ve variables that are intended to capture the consequences of earnings
management, or earnings management outcomes, to determine if the ATO PM diagnostic is predictive of these outcomes. Specically, we examine if the diagnostic is useful in
identifying rms that meet or just beat analyst forecasts (MBE), report extreme earnings
surprises (EES), subsequently restate earnings upward (UP_RESTATE) or downward
(DN_RESTATE), experience a reversal in year-ahead protability (DRNOAt+1) or produce predictable year-ahead abnormal returns (ABRETt+1). We dene the variables as
follows:
MBE
= one if SURP is greater than or equal to zero and less than $0.02, and
zero otherwise;
where
SURP
= actual earnings per share less the consensus median analyst forecast
of earnings per share closest to the earnings announcement date;14
EES
= one if SURP is in the top or bottom decile of SURP, and zero otherwise;
DN_RESTATEt = one if the rm subsequently restates its operating earnings down for
year t, and zero otherwise;
UP_RESTATEt = one if the rm subsequently restates its operating earnings up for year
t, and zero otherwise;
DRNOAt
= RNOAt+1 RNOAt; and
ABRETt+1
= the size-adjusted cumulative abnormal return over the three-day period centered on next years rst scal quarter earnings announcement.
We dene control variables as follows:15
IRNOAt
= average RNOAt for two-digit SIC code to which the rm belongs
(excluding rm);
MVE
= market value of equity;
MTB
= MVE book value of equity at the end of the scal year;
RNOAt
= operating incomet average net operating assetst;
DRNOAt
= RNOAt RNOAt)1;
NOAt
= net operating assetst salest;16 and
DNOAt
= (NOAt NOAt)1) NOAt)1.
13.
14.
15.
16.
Consistent with these studies, we require at least six observations for a given combination to be included
in the sample. We also performed the analyses using the Jones model and the modied Jones model to calculate abnormal accruals. The results (untabulated) using these alternative abnormal accrual models are
similar to those reported in the tables.
We also dened MBE as analyst forecast errors greater than or equal to zero but less than $0.01. The
results are similar to those reported in the tables.
Note that we use ending net operating assets in computing ATO as well as for the change in net operating
assets so as to better capture earnings management that occurs at the end of the year. On the other hand,
we compute return on net operating assets using average net operating assets in the denominator because
the variable is included to control for the overall protability of the company for the year. Redening
RNOA using ending net operating assets in the denominator does not alter our conclusions.
We use the term NOA to describe this variable to be consistent with Barton and Simko 2002 but note that
since net operating assets is scaled by sales, the ratio reects the inverse of the ATO ratio. Excluding this
variable from the analyses does not alter our conclusions.
232
Descriptive statistics
Table 2 presents descriptive statistics, sample correlations, and univariate analyses. All
variables are winsorized at the 1st and 99th percentiles to mitigate the inuence of outliers.
The descriptive statistics in panel A suggest that the ATO PM diagnostic identies potential upward earnings management in 14.8 percent of the sample observations and downward earnings management in 17.3 percent of the sample observations. EM_UP and
TABLE 2
Descriptive statistics
Panel A: Descriptive statisticsa
Variable
EM_UPt
EM_DNt
PABNACt
PAB_UPt
DPMt
DATOt
IRNOAt
MTBt
MVEt
RNOAt
DRNOAt
NOAt
DNOAt
MBEt
EESt
DN_RESTATEt
UP_RESTATEt
DRNOAt+1
ABRETt+1
Mean
Std Dev
25%
Median
75%
0.148
0.173
)0.008
0.495
0.005
0.052
)0.038
2.38
969.28
0.000
)0.008
0.795
0.207
0.243
0.200
0.016
0.011
)0.018
0.006
0.355
0.378
0.386
0.499
0.275
1.369
0.092
3.41
3291.29
0.508
0.316
1.083
0.658
0.429
0.399
0.126
0.105
0.352
0.093
0.000
0.000
)0.071
0.000
)0.027
)0.225
)0.080
0.87
14.33
)0.030
)0.070
0.333
)0.056
0.000
0.000
0.000
0.000
)0.070
)0.034
0.000
0.000
)0.002
0.000
0.000
0.023
)0.022
1.55
67.16
0.095
)0.002
0.510
0.071
0.000
0.000
0.000
0.000
)0.002
0.000
0.000
0.000
0.065
1.000
0.025
0.265
0.034
2.78
388.33
0.194
0.056
0.796
0.259
0.000
0.000
0.000
0.000
0.055
0.039
Panel B: Sample Pearson correlations

Variable
DPMt DATOt IRNOAt MTBt MVEt RNOAt DRNOAt NOAt DNOAt PABNACt EM_UPt EM_DNt
DPMt
1.00
DATOt
IRNOAt
MTBt
MVEt
RNOAt
DRNOAt
NOAt
DNOAt
PABNACt
EM_UPt
EM_DNt
0.08
1.00
)0.01 0.08 0.00

)0.01 )0.01 )0.01
1.00 )0.17 )0.12
1.00 0.22
1.00
0.01
0.48 )0.02 0.06
)0.11
0.05 )0.07 )0.56
0.30 )0.02 )0.14 )0.07
0.01 0.11 )0.03 0.15
0.10
0.02 0.01 )0.01
1.00
0.24 )0.10 0.02
1.00 0.03 0.14
1.00 0.15
1.00
0.10
)0.08
)0.05
0.03
)0.03
0.01
0.07
)0.01
0.14
1.00
0.10
)0.22
0.01
0.09
0.03
0.10
0.16
)0.10
0.25
0.09
1.00
)0.15
0.20
0.00
)0.07
)0.03
)0.08
)0.18
)0.05
)0.20
)0.09
)0.19
1.00
233
TABLE 2 (Continued)
Panel C: EM_UP, EM_DN, and PAB_UP by industry
Industry by rst digit of SIC code
0
1
2
3
4
5
7
8
9
Agriculture and shing

Extraction and construction
Commodity production
Manufacturing
Utilities and transportation
Wholesale and retail
Business services and entertainment
Health and other services
Public administration
EM_UP
EM_DN
PAB_UP
338
8,583
19,812
42,815
5,949
15,696
12,128
3,853
996
14%
13%
15%
14%
15%
17%
16%
17%
12%
17%
16%
18%
16%
18%
19%
18%
19%
19%
44%
44%
46%
50%
49%
50%
55%
54%
5%
Panel D: EM_UP, EM_DN, and PAB_UP by year

Year
EM_UP
EM_DN
PAB_UP
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
1,929
1,894
1,908
1,991
2,215
2,913
2,767
2,697
2,589
2,510
2,548
2,673
2,788
2,953
3,020
3,031
2,665
3,003
3,283
3,318
3,404
3,507
3,596
3,791
3,935
4,096
4,453
4,390
4,137
12%
12%
14%
12%
9%
12%
15%
17%
13%
11%
13%
11%
16%
15%
14%
16%
15%
12%
14%
14%
13%
14%
17%
18%
19%
19%
21%
19%
18%
20%
18%
15%
20%
18%
17%
17%
17%
19%
21%
18%
17%
13%
14%
19%
17%
16%
21%
19%
21%
20%
18%
17%
14%
15%
15%
14%
14%
15%
50%
50%
50%
50%
48%
49%
51%
49%
50%
51%
47%
44%
45%
52%
47%
48%
45%
50%
45%
46%
46%
46%
49%
49%
50%
52%
49%
50%
58%
234
TABLE 2 (Continued)
Year
EM_UP
EM_DN
PAB_UP
2000
2001
2002
2003
2004
2005
4,109
4,018
3,832
3,715
3,573
2,932
14%
9%
14%
15%
16%
15%
19%
23%
17%
19%
16%
18%
58%
46%
60%
53%
52%
47%
Notes:
a
ABRETt+1 includes 67,075 observations; MBE EES includes 46,522 observations; RESTATE
includes 22,160 observations; all other variables include 110,170 observations.
indicates that the correlation coefcient estimate is not signicantly different from zero at the
10 percent level (two-tailed). All remaining correlation coefcient estimates are signicantly
different from zero at the 10 percent level (two-tailed).
EM_DN thus identify approximately 32 percent of rms as having managed earnings,

which is in contrast to PABNAC which, by construction, identies all rms as having
managed earnings either up or down. The distributions of the control variables are consistent with prior research (e.g., Faireld and Yohn 2001). The descriptive statistics on the
earnings management outcome variables suggest that 24.3 percent of the observations meet
or beat analyst expectations (MBE) while, by construction, 20 percent of the observations
are classied as extreme earnings surprises (EES). Consistent with restatements being an
unusual event, only 1.6 (1.1) percent of the observations experiences downward (upward)
restatements of reported earnings. The mean year-ahead change in return on net operating
assets is )1.8 percent and size-adjusted abnormal returns around the earnings announcement date of the rst scal quarter of the subsequent year are 0.60 percent.
Panel B of Table 2 reports Pearson correlation coefcients between the explanatory
variables used in the study. Consistent with information overlap in both diagnostics, there
is a signicant positive correlation of 0.09 between EM_UP and PABNAC and a signicant negative correlation of )0.09 between EM_DN and PABNAC. EM_UP and EM_DN
are signicantly correlated with most of the control variables. None of the correlations
exceed 30 percent, however, suggesting that EM_UP and EM_DN capture a substantial
amount of unique information relative to the other variables. All reported correlations are
sufciently low to mitigate concerns about multicollinearity when estimating multivariate
models.
In panel C of Table 2, we report the percentage of observations with EM_UP,
EM_DN and PAB_UP (the observations for which PABNAC is positive) by industry.17
We dene industries by the rst digit of the rms primary SIC code. We note that there is
some variation in the frequency of EM_UP and EM_DN across industries. Although we
do not perform formal tests for differences across industries, we include industry xed
effects in all of our tests to control for industry clustering.
In panel D of Table 2, we report the percentage of observations with EM_UP,
EM_DN, and PAB_UP by year. We note that the frequency of EM_DN observations is
greater than that of EM_UP in 24 of the 35 years. The years in which EM_DN is less
frequent are concentrated in the period 1993 through 1999 when the EM_UP percentage is
17.
We do not report PAB_DN because the abnormal accruals model classies all observations as either managing earnings up or down, and therefore, PAB_DN = 1 ) PAB_UP.
235
markedly higher relative to other years. It is possible that rms were under greater pressure to manage earnings up during the bull market of the late 1990s. Alternatively, the
surge in EM_UP observations may be related to the rise of Internet and high-growth rms
during this period. We also note that the EM_UP percentage drops markedly and the
EM_DN percentage increases in 2000 and 2001, likely due to rms reporting conservatively subsequent to the accounting scandals that surfaced during this period. We also note
that the PAB_UP percentage is greater than 50 percent in only nine of the 35 years suggesting that, similar to the ATO PM diagnostic, PABNAC is more often negative than
positive. However, in contrast to the ATO PM diagnostic, the PAB_UP percentage tends
to be greater than 50 percent in the later years of the sample.
4. Results
We present and discuss our results in two sections. First, we present contingency tables to
provide insight into the univariate relations between EM_UP, EM_DN, PAB_UP,
PAB_DN, and the earnings management outcome variables. Next, we present results from
multivariate analyses that investigate the relation between the earnings management outcome variables and the ATO PM diagnostic.
Univariate analyses and ndings
Panel A in Table 3 shows the relation between EM_UP and PAB_UP, and between
EM_DN and PAB_DN. In the rst contingency table, we report the percentage of observations for which EM_UP is equal to zero or one and PAB_UP is equal to zero or one.
When PAB_UP is equal to zero, EM_UP is equal to zero in 89.8 percent of observations
and equal to one in 10.2 percent of observations. When PAB_UP is equal to one, EM_UP
is equal to zero in 80.6 percent of observations and equal to one in 19.4 percent of observations. This suggests that the ATO PM diagnostic ags upward earnings management
almost twice as often when PABNAC is positive than when it is negative (19.4 percent vs.
10.2 percent). Similarly in the EM_DN and PAB_DN contingency table in panel A, the
ATO PM diagnostic ags downward earnings management almost twice as often when
PABNAC is negative than when it is positive (22.6 percent vs. 11.9 percent). A test of proportions shows that these ratios are highly signicant, which indicates that EM_UP ags
upward earnings management much more often when PABNAC is positive than when it is
negative, and that EM_DN ags downward earnings management much more often when
PABNAC is negative than when it is positive.
Panel B in Table 3 shows the relation between EM_UP, PAB_UP, and rms that meet
or beat expectations (MBE). We nd that PAB_UP correctly ags more of the meet or
beat observations than EM_UP (51.2 percent versus 21.3 percent); however, PAB_UP also
incorrectly ags more of the non-MBE observations than EM_UP as having managed
earnings (48.9 percent versus 14.7 percent). This is not surprising because there are more
PAB_UP than EM_UP observations with a value of one. To make a more meaningful
comparison between the two diagnostics, we rely on the following observation: if a diagnostic is useful in identifying a particular event, we expect the diagnostic to ag the event
more often when the event occurs (= 1) than when the event does not occur (= 0). In
other words, the ratio of proportions, the former proportion over the latter proportion,
should be signicantly greater than one. The ratio of proportions for PAB_UP is 1.05
(51.2 percent over 48.9 percent), which is signicantly greater than one (Z-statistic = 4.08;
p-value < 0.001) based on a test of proportions (Hildebrand, Ott, and Gray 2005). The
corresponding ratio for EM_UP is 1.45 (21.3 percent over 14.7 percent), which is also signicantly greater than one (Z-statistic = 15.48; p < 0.001). Thus, both diagnostics are
useful for identifying MBE, but EM_UP appears to be more discriminating than PAB_UP
based on a comparison of the two ratios. It is also evident from the contingency tables
236
TABLE 3
Contingency tablesa
Panel A: The association between EM_UP and PAB_UP and between EM_DN and PAB_DN
EM_UP
PAB_UP
0
1
EM_DN
89.8%
80.6%
10.2%
19.4%
55,351
54,819
Ratio of proportions
Z-statistic
p-value
PAB_DN
1.90
43.16
<0.001
0
1
88.1%
77.4%
11.9%
22.6%
54,819
55,351
Z-statistic
p-value
1.90
47.59
<0.001
Panel B: The association between EM_UP, PAB_UP, and rms meeting or beating expectations
(MBE)
EM_UP
MBE
0
1
PAB_UP
85.3%
78.7%
14.7%
21.3%
Z-statistic
p-value
51.1%
48.8%
48.9%
51.2%
N
35,236
11,286
1.45
15.48
<0.001
MBE
0
1
Z-statistic of difference
p-value
35,236
11,286
1.05
4.08
<0.001
Panel C: The association between EM_DN, PAB_DN, and rms reporting extreme earnings surprises (EES)
PAB_DN
EM_DN
EES
0
1
84.6%
78.5%
15.4%
21.5%
Z-statistic
p-value
50.5%
45.4%
49.5%
54.6%
N
37,250
9,272
1.40
13.12
<0.001
EES
0
1
Z-statistic
p-value
37,250
9,272
1.10
8.76
<0.001
Panel D: The association between EM_UP, PAB_UP, and rms subsequently restating earnings
downward (DN_RESTATE)
EM_UP
RESTATE_DN
0
1
PAB_UP
86.2%
83.7%
13.8%
16.3%
21,805
355
RESTATE_DN
0
1
47.2%
44.5%
52.8%
55.5%
21,805
355
237
TABLE 3 (Continued)
EM_DN
0
PAB_DN
1
Ratio of
proportions
Z-statistic
p-value
N
1.18
1.31
<0.20
Ratio of
proportions
Z-statistic
p-value
N
1.05
1.01
<0.32
Panel E: The association between EM_DN, PAB_DN, and rms subsequently restating earnings
upward (UP_RESTATE)
EM_DN
RESTATE_UP
0
1
Z-statistic
p-value
PAB_DN
81.5%
70.7%
18.5%
29.3%
21,911
249
1.58
3.73
<0.001
RESTATE_UP
0
1
52.9%
51.0%
47.1%
49.0%
21,911
249
Z-statistic
p-value
1.04
0.58
<0.57
Notes:
a
The ratio of proportions equals the percentage of observations when the earnings management diagnostic ags earnings management correctly versus incorrectly (i.e., the percentage
in the bottom right cell divided by the percentage in the top right cell.) The Z-statistic tests
whether this ratio is signicantly greater than one (see Hildebrand et al. 2005). See Table 1
for variable denitions.
that PAB_UP is more prone to Type I errors (agging observations as having managed
earnings when they have not), while EM_UP is more prone to Type II errors (not identifying rms that may have managed earnings). Indeed, all panels in this table conrm the
higher propensity for Type I errors for the PABNAC diagnostic, and for Type II errors
for the ATO PM diagnostic.18
Panel C in Table 3 shows the relation between EM_DN, PAB_DN, and rms that
have extreme earnings surprises (EES). As discussed earlier, rms with EES are more
likely to manage earnings down; consequently, we expect PAB_DN and EM_DN to be
more frequently equal to one for EES rms than for other rms. The contingency tables
conrm our expectation: the ratio of proportions where EM_DN is equal to one when
EES is equal to one, compared to when EES is equal to zero, is 1.40 (Z-statistic = 13.12;
p < 0.0001). This indicates that EM_DN ags downward earnings management much
more frequently when a rm reports extreme earnings surprises than when it does not.
Similarly, the corresponding ratio of proportions for PAB_DN equals 1.10 (Z-statistic = 8.76; p < 0.001), conrming the usefulness of PABNAC for identifying rms with
extreme earnings surprises as well. The evidence is consistent with the ability of PAB_DN
and EM_DN to identify possible downward earnings management.
18.
The ATO PM diagnostic has a lower error rate (Type I and Type II combined) than PABNAC in all of
our tests. However, the superiority of a particular diagnostic will depend on the (user-specic) relative cost
of Type I and Type II errors.
238
Finally, panels D and E in Table 3 provide similar details with respect to downward and
upward earnings restatements. The proportion of observations classied as having managed
earnings up is not signicantly higher for either EM_UP or PAB_UP when rms restate
earnings downward as opposed to when they do not. In other words, neither EM_UP nor
PAB_UP appears to discriminate between rms that may have initially managed earnings
up from rms that do not manage earnings. When rms subsequently restate earnings up,
on the other hand, EM_DN is signicantly more likely to ag these observations as having
initially managed earnings down (ratio = 1.58; Z-statistic = 3.73; p < 0.001). However,
the proportion of rms that PAB_DN identies as having managed earnings down is not signicantly higher when rms subsequently restate earnings up than when they do not.
Taken together, Table 3 provides preliminary evidence of the usefulness of the
ATO PM diagnostic for identifying earnings management associated with rms meeting
or beating analyst forecasts, reporting extreme earnings surprises, and subsequently restating earnings upward. In addition, it appears that the ATO PM diagnostic is at least as
reliable in identifying earnings management as PABNAC. We next investigate the relative
and incremental information content of the two diagnostics in multivariate analyses, where
we also control for other variables known to be related to the earnings management outcome variables.
Multivariate analyses and ndings
Meet or beat expectations
Prior research (e.g., Burgstahler and Eames 2006; Matsumoto 2002; Moehrle 2002; Cheng
and Wareld 2005) provides evidence that rms manage earnings upward to avoid missing
analyst forecasts of earnings. This suggests that rms that meet or just beat analyst forecasts are more (less) likely to have managed their earnings upward (downward) than other
rms. We therefore predict that EM_UP (EM_DN) is positively (negatively) associated
with the incidence of rms meeting or just beating analyst forecasts.19
Descriptive statistics for analyst forecast errors (SURP), EM_UP, EM_DN and
PABNAC by MBE are reported in panel A of Table 4. We note that 11,286 rm-years
meet or just beat the analyst forecast. We nd a mean EM_UP of 21.34 percent for MBE
rms compared to a mean of only 14.69 percent for all other rms. This difference is statistically signicant at the one percent level. Our results also show a mean EM_DN of
13.61 percent for MBE rms compared to a mean of 17.52 percent for all other rms. This
difference is also signicant at the one percent level. These univariate results are consistent
with EM_UP and EM_DN identifying rms that meet or just beat analyst forecasts. Panel
A also provides evidence that PABNAC is signicantly higher for MBE rm-years relative
to non-MBE rm-years.
In panel B of Table 4, we use multivariate analyses to evaluate the ability of EM_UP
and EM_DN to identify rms that meet or just beat analyst forecasts. Specically, we run
logistic regressions with MBE as the dependent variable and EM_UP, EM_DN, and
PABNAC as the primary explanatory variables.20 We also include industry RNOA
(IRNOAt), market to book ratio (MTBt),21 and market value of equity (MVEt) as control
19.
20.
21.
Barton and Simko (2002) point out that the pressure to meet analyst forecasts appears to be a relatively
recent phenomenon and that I B E S changed the formulae to calculate actual earnings per share in
1993. Given this, we also performed the analysis after excluding observations prior to 1993. The results
are similar to those reported in the tables.
It is possible that rm-years in which the rm missed the analyst forecast by a large amount reect signicant economic changes, which could confound our analyses. Therefore, we repeated the tests including
only those rm-year observations with earnings surprises between )$0.02 and +$0.02. The results are similar to those reported in the tables.
We repeated all the multivariate tests after including the price to earnings ratio and sales growth as additional control variables. The results are similar to those reported.
11,286
0.0063
0.0051
0.2134
0.1361
0.0120
0.0021
35,236
)0.1108
)0.0100
0.1469
0.1752
0.0007
)0.0018
All other rms
48.793***
71.79***
15.48***
)10.29***
3.52***
4.08***
Test of difference
MVE
DATO
0.0560***
0.0001*** )0.0365***
(258.66)
(106.29)
(16.81)
0.0526***
0.0001*** )0.0021
(225.86)
(98.95)
(0.05)
0.0525***
0.0001*** )0.0016
(225.41)
(99.22)
(0.03)
0.0468***
0.0001***
0.0344***
(158.79)
(48.94)
(8.30)
MTB
RNOA
0.2583***
(28.74)
0.1592***
(10.57)
0.1560***
(10.05)
0.2505***
0.67808***
(13.79)
(431.59)
DPM
)0.0044
(0.01)
DRNOA
DNOA
)0.0295*
0.0754***
(3.08)
(12.20)
NOA
0.0266
(0.46)
0.0073
(0.03)
0.0588
(2.25)
PABNAC
EM_DN
0.3354*** )0.1834***
(127.39)
(31.15)
0.3345*** )0.1825***
(126.47)
(30.79)
0.2701*** )0.1330***
(78.39)
(16.04)
EM_UP
8.33%
6.57%
6.57%
6.03%
Pseudo R2
Test of difference presents a t-statistic (Z-statistic) from a t-test (Wilcoxon signed rank test) of difference in means (medians). bModels are estimated using
44,237 rm-year observations, controlling for xed effects by year and industry (two-digit SIC code). v2 statistics are reported in parentheses. See Table 1
for variable denitions. ***, ** and * indicate that value is signicantly different from zero at the 1, 5, and 10 percent level, respectively (two-tailed).
Notes:
1.3244***
(29.42)
1.2586***
(25.60)
1.2717***
(26.99)
0.5606**
(5.09)
IRNOA
MBEt c0 c1 IRNOAt c2 MTBt c3 MVEt c4 DATOt c5 DPMt c6 RNOAt c7 DRNOAt c8 NOAt c9 DNOAt c10 PABNACt c11 EM UPt c12 EM DNt nt1
Panel B: Multivariate analysis of the association between EM_UP, EM_DN, and MBEb
# observations
Mean SURP
Median SURP
Mean EM_UP
Mean EM_DN
Mean PABNAC
Median PABNAC
MBE
Panel A: Characteristics of MBE rms relative to other rmsa
TABLE 4
Association between EM_UP, EM_DN, and meeting or just beating expectations (MBE)

239
240
variables because prior research (e.g., Koh, Matsumoto, and Rajgopal 2008; Barton and
Simko 2002) shows that these variables are informative for identifying rms that meet or
just beat expectations.22 We further include the change in asset turnover (DATOt) and the
change in prot margin (DPMt) as control variables to test whether EM_UP and EM_DN
provide incremental information over these fundamental ratios on which the diagnostic is
based. Finally, we include xed effects dummy variables by year and two-digit SIC code
to control for cross-sectional and time-series correlation in the errors.
In the rst model in panel B, we include the control variables and PABNAC. We nd
that rms with higher IRNOA, higher MTB, and higher MVE are more likely to meet or
just beat analyst forecasts than other rms. These results are consistent with prior research
(e.g., Barton and Simko 2002). The signicant positive coefcient on DPM and signicant
negative coefcient on DATO are consistent with the notion that rms that manage
earnings upward experience increases in PM and decreases in ATO. We also note that
PABNAC is not signicant at the 10 percent level, suggesting that abnormal accruals do
not provide incremental information in identifying rms that are more likely to meet or
beat analyst forecasts.
In the second model, we include the control variables and EM_UP and EM_DN. We
document a positive and signicant coefcient on EM_UP and a negative and signicant
coefcient on EM_DN (both at the 1 percent level). The results suggest that the ATO PM
diagnostic for earnings management is successful in identifying rm-years that meet or just
beat analyst forecasts. We also note that the pseudo R2 is higher for the EM_UP EM_DN
model than for the PABNAC model. We formally compare the relative predictive power
of models 1 and 2 by comparing the area under the Receiver Operating Characteristic
(ROC) curves for the two models (DeLong, DeLong, and Clarke-Pearson 1988). We nd
(untabulated) that the area under the ROC curve for the PABNAC model is 0.6377 compared to 0.6415 for the ATO PM diagnostic model, and the difference is signicant at less
than the one percent level (v2 = 15.08). Consistent with the univariate ndings in the contingency tables presented in Table 3, this evidence conrms that, compared to the PABNAC model, the multivariate ATO PM model better discriminates between rms that
meet or just beat expectations versus rms that do not.
In the third model, we include PABNAC and EM_UP and EM_DN to assess whether
EM_UP and EM_DN provide incremental information over this widely used proxy for
earnings management. We nd that both EM_UP and EM_DN are still highly signicant
with the expected signs, whereas the coefcient on PABNAC is not signicant at conventional levels. The odds ratio for EM_UP in this specication is 1.40, which indicates
that, after controlling for the effect of other variables, the odds of meeting or just beating
analyst forecasts are 40 percent higher for observations where EM_UP ags earnings management than when it does not. In the nal model, we follow Barton and Simko 2002 and
include the current return on net operating assets (RNOAt), current change in return on
net operating assets (DRNOAt), current net operating assets (NOAt), and the current
change in net operating assets (DNOAt) as additional control variables, to determine if
EM_UP and EM_DN provide incremental information over these nancial statement
ratios. Again, we nd an insignicant coefcient on PABNAC and a signicant positive
(negative) coefcient on EM_UP (EM_DN). The results suggest, therefore, that the
22.
We note that prior research (e.g., Barton and Simko 2002) has included additional control variables, such
as the rms litigation risk, whether the rm previously met or beat analyst forecasts, and auditor type, in
the analysis of rms that meet or beat analyst forecasts. We do not include these variables as our interest
is not in developing a comprehensive model to predict rms that meet or beat analyst forecasts but rather
to determine the nancial statement variables that are useful in predicting whether a rm meets or beats
analyst forecasts (i.e., managed earnings).
241
ATO PM diagnostic is useful for identifying rms that meet or beat expectations while
PABNAC has no association with rms that meet or just beat expectations.23
Extreme earnings surprises
In the previous section, we based our analyses on the notion that rms manage earnings
upward to meet or just beat analyst forecasts. In this section, we argue that rms that miss
or beat the analyst forecast by a large amount are more likely to have managed earnings
downward. That is, rms with surprisingly low earnings have an incentive to take a bath,
while rms with surprisingly high earnings have an incentive to save earnings for the
future (i.e., create cookie-jar reserves). Further, given that they have already missed (or
beaten) expectations by a wide margin, these rms are unlikely to manage earnings
upward. We therefore predict that EM_DN (EM_UP) is positively (negatively) associated
with the incidence of extreme earnings surprises (EES).
Results of this test are reported in Table 5. We rst sort all earnings surprises into
deciles and then label the observations in the top and bottom deciles as extreme earnings
surprises (EES). Panel A provides descriptive statistics. The mean (median) absolute earnings surprise in the extreme deciles is $6.82 ($0.40).24 The mean (median) absolute earnings
surprise for the remaining deciles is $0.05 ($0.02). The mean EM_UP is 11.56 percent for
EES rms compared to a mean of 17.48 percent for other rms. On the other hand, the
mean EM_DN is 21.46 percent for EES rms compared to a mean of 15.35 percent for all
other rms. The mean and median PABNAC are also signicantly lower for EES rms relative to the other rms.
In panel B of Table 5, we estimate logistic regressions with the indicator variable EES
as the dependent variable. As in the previous analysis, we include EM_UP, EM_DN, control variables, PABNAC, and year and industry xed effects. We expect a positive (negative) coefcient on EM_DN (EM_UP) because rms are more (less) likely to have
managed earnings downward (upward) when they miss or beat analyst forecasts by a large
amount.
The rst model includes the control variables and PABNAC. The coefcient signs of
the control variables are as expected, and have the opposite association with EES compared to MBE. Consistent with PABNAC being useful for identifying earnings management, we nd a signicantly negative coefcient on PABNAC. In the second model, we
nd a signicantly positive (negative) coefcient on EM_DN (EM_UP), suggesting that
the ATO PM diagnostic provides information for identifying rms with EES, consistent
with our expectation. The pseudo R2 is 4.77 percent for the PABNAC model compared
to a pseudo R2 of 5.25 percent for the EM_UP EM_DN model, providing evidence that
the ATO PM diagnostic provides more information for EES than PABNAC. Consistent
with this, we nd (untabulated) that the area under the ROC curve is larger for the
ATO PM model (0.6335) than for the PABNAC model (0.6305), and the difference is signicant at less than the ve percent level (v2 = 5.75). Moreover, when we include all
three variables, EM_UP, EM_DN and PABNAC (model 3), we nd that the ATO PM
diagnostic is incrementally informative to PABNAC. The (untabulated) odds ratio of 1.30
for EM_DN in this specication suggests that after controlling for the effect of other
variables, the odds of a rm having EES is 30 percent higher when EM_DN equals one.
23.
24.
We also estimated all regression models in this paper with the indicator PAB_UP in place of the continuous variable PABNAC, as well as with indicator variables (for observations above and below the median)
instead of continuous variables for each of the explanatory variables. The (untabulated) results are similar
to those reported in the tables.
We do not scale the earnings surprise by price because it is difcult to argue that investors assess the surprise relative to price. In addition, Cheong and Thomas (2009) show that the magnitude of earnings surprises do not seem to vary with scale.

9,272
6.8192
0.4000
0.1156
0.2146
)0.0124
)0.0099
37,250
0.0478
0.0200
0.1748
0.1535
0.0074
0.0008
Other rms
3.55***
107.62***
)15.34***
13.12***
)5.51***
)8.75***
Test of difference
)0.0735***
(221.50)
)0.0687***
(195.58)
)0.0683***
(193.36)
)0.0633***
(171.90)
)1.6405***
(40.78)
)1.5310***
(35.79)
)1.6053***
(39.01)
)0.5615**
(4.52)
DATO
DPM
RNOA
)0.0001***
0.1000*** )0.3344***
(79.19)
(103.56)
(37.82)
)0 .0001***
0.0682*** )0.2297***
(74.99)
(44.23)
(17.69)
)0.0001***
0.0652*** )0.2087***
(75.70)
(40.18)
(14.56)
)0.0001***
)0.0121
)0.0604
)0.7126***
(31.49)
(0.94)
(1.26)
(770.04)
MVE
)0.0640
(1.83)
DRNOA
DNOA
0.0911*** )0.1845***
(41.99)
(50.90)
NOA
)0.1654***
(14.83)
)0.1387***
(9.90)
)0.1970***
(21.24)
PABNAC
EM_DN
)0.3060***
0.2696***
(67.63)
(75.12)
)0.3014***
0.2642***
(65.56)
(71.97)
)0.2176***
0.2216***
(32.86)
(48.63)
EM_UP
8.22%
5.30%
5.25%
4.77%
Pseudo R2
Test of difference presents the t-statistic (Z-statistic) from a t-test (Wilcoxon signed rank test) of difference in means (medians).
|SURP| is the absolute value of SURP.
c
Models are estimated using 44,237 rm-year observations, controlling for xed effects by year and two-digit SIC code. v2 statistics are reported in parentheses.
See Table 1 for variable denitions.
*** **
, and * indicate that value is signicantly different from zero at the 1, 5 and 10 percent level, respectively (two-tailed).
Notes:
MTB
IRNOA
EESt c0 c1 IRNOAt c2 MTBt c3 MVEt c4 DATOt c5 DPMt c6 RNOAt c7 DRNOAt c8 NOAt c9 DNOAt c10 PABNACt c11 EM UPt c12 EM DNt nt1
Panel B: Multivariate analysis of the association between EM_UP, EM_DN, and EESc
# observations
Mean |SURP|b
Median |SURP|
Mean EM_UP
Mean EM_DN
Mean PABNAC
Median PABNAC
EES
Panel A: Characteristics of EES rms relative to other rmsa
TABLE 5
Association between EM_UP, EM_DN, and extreme earnings surprises (EES)
242
243
In the nal model, when additional nancial statement ratios are included in the regression, we continue to nd that EM_UP and EM_DN provide incremental information
content for EES.
Restatements
Dechow and Skinner (2000) note that earnings management can occur through accounting
choices that are acceptable within U.S. generally accepted accounting principles (GAAP)
or through accounting choices that violate U.S. GAAP. The previous analyses on MBE
and EES likely capture earnings management that falls within the acceptable use of discretion available in U.S. GAAP. In order to test whether EM_UP and EM_DN are informative about earnings management that violates U.S. GAAP, we examine whether EM_UP
and EM_DN are predictive of earnings restatements.
We argue that rms that subsequently restate their earnings downward (upward) are
more likely to have initially managed their earnings up (down). We therefore expect
EM_UP to be more (less) frequent in a sample of rms that subsequently restate their
earnings downward (upward). Similarly, we expect EM_DN to be more (less) frequent in
a sample of rms that restate their earnings upward (downward). We control for all
previously identied variables including year and industry-xed effects and examine
the association between the ATO PM diagnostic and the probability of subsequent
restatements.
We obtain restatement announcements from the Glass Lewis database and then determine the income effect of the restatements by comparing originally reported and restated
numbers in the COMPUSTAT Point-in-Time database. We sum the quarterly data over
the scal year for both the originally reported and the restated numbers and identify
restatements as observations where the originally reported operating income25 differs from
the restated income in the periods around the restatement ling.26 The nal sample
includes 604 rm-year observations involving operating income restatements (355 downward and 249 upward) and 21,556 nonrestatement rm-year observations from 2000
through 2005.
We report the restatement analysis results in Table 6. The descriptive statistics in panel
A show that the mean (median) downward restatement is $90.52 million ($2.4 million),
whereas the mean (median) upward restatement is $97.22 million ($1.44 million). We nd,
consistent with expectations, that the mean EM_UP is signicantly higher (t-statistic of
2.30) for rm-year observations that resulted in a downward restatement than in an
upward restatement, and mean EM_DN is signicantly higher in the upward restatement
sample than the downward restatement sample (t-statistic of )3.02). We do not nd a similar, signicant difference for PABNAC. We also nd that EM_UP (EM_DN) is signicantly lower (higher) for UP_RESTATE rms relative to rms that do not subsequently
restate earnings (t-statistics of )1.96 and 3.72, respectively). We document a similar mean
difference for PABNAC. Finally, we do not nd signicant differences in EM_UP,
EM_DN or PABNAC, in comparing DN_RESTATE rms relative to rms that do not
restate earnings (NO_RESTATE).
In panel B, we report results of logistic regression analyses with DN_RESTATE,
which is set equal to one (zero) if the rm subsequently restates (does not restate) earnings
25.
26.
Consistent with the rest of the paper, we dene operating income as sales (cost of goods sold + selling,
general and administrative expenses + depreciation and amortization expense).
The Point-in-Time database provides nancial information as originally reported in the announcement
month as well as for each month thereafter. We identify the impact of restatements by capturing changes
in the nancial variables reported within four months surrounding the month of the restatement ling.
This methodology was used to ensure that we capture the effect of the restatement of interest rather than
the effect of other events that led to restatements.
355
)90.52
)2.40
0.1634
0.1859
0.0197
0.0119
249
97.22
1.44
0.1004
0.2932
)0.0444
0.0025
UP_RESTATE
21,556
0.00
0.00
0.1380
0.1852
0.0095
0.0076
NO_RESTATE
4.70***
20.94***
2.30**
)3.02***
1.64
1.20
DN_RESTATE vs.
UP_RESTATE
3.84***
)120.96***
1.28
0.03
0.41
0.43
DN_RESTATE vs.
NO_RESTATE
Test of differences
3.02***
112.83***
)1.96*
3.72***
)1.77*
)1.08
UP_RESTATE vs.
NO_RESTATE
MTB
)0.0102
(0.39)
)0.0115
(0.49)
)0.0116
(0.50)
IRNOA
)0.0441
(0.00)
)0.1740
(0.01)
)0.1545
(0.01)
0.0000
(0.13)
0.0000
(0.11)
0.0000
(0.11)
MVE
0.0183
(0.33)
0.0325
(0.97)
0.0325
(0.98)
DATO
)0.4450**
(5.39)
)0.4909**
(6.34)
)0.4940**
(6.38)
DPM
RNOA
DRNOA
NOA
DNOA
0.1783
(1.26)
0.1770
(1.24)
EM_UP
)0.1098
(0.55)
)0.1088
(0.54)
EM_DN
10.22%
10.22%
10.16%
Pseudo R2
0.0234
(0.04)
0.0335
(0.08)
PABNAC
DN RESTATEt c0 c1 IRNOAt c2 MTBt c3 MVEt c4 DATOt c5 DPMt c6 RNOAt c7 DRNOAt c8 NOAt c9 DNOAt c10 PABNACt c11 EM UPt
c12 EM DNt nt
Panel B: Multivariate analysis of the association between EM_UP, EM_DN and DN_RESTATEb
# of observations
Mean RESTATE ($ millions)
Median RESTATE ($ millions)
Mean EM_UP
Mean EM_DN
Mean PABNAC
Median PABNAC
DN_RESTATE
Panel A: Characteristics of DN_RESTATE and UP_RESTATE rms relative to other rmsa
TABLE 6
Association between EM_UP, EM_DN, and restatements of operating income
244
)0.0161
(0.88)
)0.2798
(0.02)
0.0000
(0.01)
MVE
0.0953**
(6.06)
DATO
)0.5233**
(4.22)
DPM
0.3742***
(9.02)
RNOA
)0.2962
(2.27)
DRNOA
)0.0164
(0.07)
NOA
0.2031**
(5.18)
DNOA
0.0274
(0.05)
PABNAC
0.1353
(0.70)
EM_UP
)0.0975
(0.42)
EM_DN
10.64%
Pseudo R2
0.0076
(0.18)
0.0113
(0.39)
0.0119
(0.44)
0.0132
(0.50)
3.5931
(2.40)
4.0816*
(3.15)
3.7852
(2.66)
3.5755
(2.34)
DATO
0.0175
(0.21)
)0.0225
(0.30)
)0.0229
(0.58)
)0.0374
(0.49)
MVE
)0.0000*
(3.29)
)0.0000*
(2.98)
)0.0000*
(3.05)
)0.0000**
(4.07)
)0.6389***
(8.34)
)0.5109**
(4.97)
)0.4852**
(4.44)
)0.7891**
(6.23)
DPM
0.3082**
(4.04)
RNOA
0.1628
(0.42)
DRNOA
)0.0617
(0.63)
NOA
)0.1230
(0.72)
DNOA
)0.1942
(1.76)
)0.1873
(1.60)
)0.2187
(2.26)
PABNAC
)0.2396
(1.12)
)0.2291
(1.03)
)0.2300
(1.00)
EM_UP
0.5335***
(12.34)
0.5267***
(12.01)
0.5196***
(11.46)
EM_DN
11.63%
11.32%
11.26%
10.79%
Pseudo R2
Test of difference presents the t-statistic (Z-statistic) from a t-test (Wilcoxon signed rank test) of difference in means (medians).
Models are estimated using 22,160 rm-year observations, controlling for xed effects by year and industry (two-digit SIC code). v2 statistics are
reported in parentheses. See Table 1 for variable denitions.
*** **
, and * indicate that the value is signicantly different from zero at the 1, 5, and 10 percent level, respectively (two-tailed).
Notes:
MTB
IRNOA
c12 EM DNt nt
UP RESTATEt c0 c1 IRNOAt c2 MTBt c3 MVEt c4 DATOt c5 DPMt c6 RNOAt c7 DRNOAt c8 NOAt c9 DNOAt c10 PABNACt c11 EM UPt
Panel C: Multivariate analysis of the association between EM_UP, EM_DN and UP_RESTATEb
MTB
IRNOA
TABLE 6 (Continued)

245
246
downward, as the dependent variable. As explained earlier, we assume that rms that
subsequently restate earnings down must have initially managed earnings up for that year.
The only control variable that is consistently signicant in all variations of the logistic
regression is DPM which has a negative coefcient. This suggests that rms with decreasing prot margins are more likely to subsequently restate earnings downward, which is
consistent with poorly performing rms attempting to manage earnings upward. The rst
model also shows that the coefcient on PABNAC is positive but not signicant. In the
second model, we nd that EM_UP (EM_DN) is positively (negatively) related to
DN_RESTATE, but the coefcients are not signicant at conventional levels. The results
suggest, somewhat surprisingly but consistent with our ndings from the univariate
analysis, that neither PABNAC nor the ATO PM diagnostic is useful in identifying rms
with subsequent downward restatements. The lack of association between the earnings
management proxies and the binary restatement variable may in part be due to earnings
restatement being a noisy partition of rms that manage or do not manage earnings. Specically, some of the NO_RESTATE observations may in fact have managed earnings up,
but managed to go undetected during our sample period.
In panel C, we report results of logistic regression analyses with UP_RESTATE as the
dependent variable. With respect to the control variables, MVE has a signicantly negative
coefcient, suggesting that smaller rms are more likely to subsequently restate earnings
upward. In addition, the coefcient on DPM is signicantly negative, which is consistent
with poorly performing rms managing earnings down (i.e., big bath). The negative relation between DPM and both DN_RESTATE and UP_RESTATE suggests that rms with
increasing protability are less likely to subsequently restate earnings upward or downward. The rst model further shows that the coefcient on PABNAC is negative but not
signicant at conventional levels. In the second model, we nd that the coefcient on
EM_UP is also negative but not signicant at conventional levels. However, EM_DN is
positively related to the probability that rms subsequently restate upward and highly signicant (p < 0.001). The pseudo R2 for the ATO PM model (11.26 percent) is higher than
that of the PABNAC model (10.79 percent) suggesting that the ATO PM diagnostic has
greater explanatory power for rms that subsequently restate earnings upward. A formal
test (untabulated) of the area under the ROC curve for the two logistic models conrms
that the ATO PM model better discriminates UP_RESTATE rms from rms that do not
subsequently restate earnings upwards (v2 = 3.93; p < 0.05). In the third model, where
we include PABNAC, EM_UP and EM_DN, the coefcient on EM_DN continues to be
signicantly positive. The (untabulated) odds ratio of 1.69 for EM_DN in this specication
suggests that after controlling for other variables, the probability of upward restatement is
about 69 percent higher for rms that are classied as EM_DN than when they are not.
Overall, both EM_UP and EM_DN are associated with restatements in the expected direction, although the effect is much stronger for subsequent upward restatements. We nd no
signicant association between earnings restatements and PABNAC.
Future performance
Penman (2007: 634) states that if a rm manipulates earnings upward (downward), future
protability should fall (rise) as the income contribution from earnings management in the
current period reverses. Consistent with this, Dechow et al. (2003) use future reversals in
protability and stock returns as measures of earnings management. Relying on these
observations, we predict that rms with EM_UP (EM_DN) will report lower (higher)
year-ahead changes in performance than other rms. To test our prediction, we use regression analysis with the year-ahead change in return on net operating assets (DRNOAt+1)
and year-ahead abnormal returns (ABRETt+1) as dependent variables. We expect a negative coefcient on EM_UP and a positive coefcient on EM_DN. We include the following
247
control variables that have been identied in previous research (e.g., Faireld and Yohn
2001) to predict year-ahead performance: RNOA, DRNOA, NOA, DNOA, DATO, and
DPM.27
We examine the information content of EM_UP and EM_DN for explaining yearahead DRNOA in panel A of Table 7. In the rst model, we include the control variables
as well as PABNAC. The results for the control variables are consistent with mean reversion in RNOA (Freeman, Ohlson, and Penman 1982; Faireld, Sweeney, and Yohn 1996),
positive serial correlation in DRNOA (Faireld and Yohn 2001), rms with bloated balance sheets (NOA) being more likely to have engaged in upward earnings management in
prior years (Barton and Simko 2002), and DATO being informative about future protability changes (Faireld and Yohn 2001). We nd a signicant negative coefcient on
PABNAC, which suggests that PABNAC identies earnings components that will likely
reverse in the next year, and is consistent with reversal in abnormal accruals documented
in prior research (Dechow et al. 2003).
In the second model, we include the control variables and EM_UP and EM_DN
(without PABNAC). Consistent with our predictions, we document a signicant negative
coefcient on EM_UP and a signicant positive coefcient on EM_DN. Our ndings suggest, therefore, that the ATO PM diagnostic is successful in identifying protability reversals. We note, however, that the adjusted R2 for the PABNAC model is 4.08 percent while
the adjusted R2 for the EM_UP EM_DN model is 4.05 percent, indicating that PABNAC
has greater relative information content than the ATO PM diagnostic for explaining yearahead DRNOA.28 Finally, in the third model, we include EM_UP, EM_DN and PABNAC,
and nd that the coefcients on all variables remain signicant. These results suggest that
the ATO PM diagnostic has incremental information content relative to PABNAC for
identifying future earnings reversals.
In panel B, we estimate the same three models as in panel A, except that we use as the
dependent variable the size-adjusted abnormal return for the three-day window surrounding the subsequent rst quarter earnings announcement (ABRETt+1). With respect to the
control variables, we nd that the coefcient estimates on RNOA, NOA, DNOA and
DATO are signicantly different from zero, suggesting that the market does not correctly
price the information in these variables. We nd a signicant negative coefcient on
PABNAC, which is consistent with prior research (Xie 2001) and with the notion that the
stock market overprices abnormal accruals. Consistent with our predictions, we also nd a
signicant negative coefcient on EM_UP and a signicant positive coefcient on
EM_DN. These results suggest that EM_UP and EM_DN predict year-ahead abnormal
returns. We note that the PABNAC model yields an adjusted R2 of 0.44 percent while the
EM_UP EM_DN model yields an adjusted R2 of 0.39 percent, indicating that PABNAC
has greater relative information content than the ATO PM diagnostic for explaining
year-ahead returns.29 Finally, in the third model, we nd that the ATO PM diagnostic has
incremental information content relative to PABNAC for identifying future abnormal
returns. Overall, the ATO PM diagnostic identies future protability reversals as well as
27.
28.
29.
We also ran the analyses excluding NOA from the model, since NOA is dened as net operating assets
scaled by sales and is, therefore, the inverse of ATO. The conclusions regarding the relative and incremental information content of PABNAC and EM_UP and EM_DN are unchanged when NOA is excluded
from the model.
A Vuong 1989 test (untabulated) conrms the greater explanatory power of the PABNAC model over the
EM_UP EM_DN model. The Vuong statistic for comparison of these two models is 16.79, which is significant at the 1 percent level.
A Vuong 1989 test (untabulated) conrms the greater explanatory power of the PABNAC model over the
EM_UP/EM_DN model. The Vuong statistic for a comparison of these two models is 13.41, which is signicant at the 1 percent level.
248
TABLE 7
Association between EM_UP and EM_DN and future protability and returnsa
Panel A: Multivariate analysis of the association between EM_UP, EM_DN and year
DRNOAt1 c0 c1 RNOAt c2 DRNOAt c3 NOAt c4 DNOAt c5 DATOt c6 DPMt c7 PABNACt
c8 EM UPt c9 EM DNt nt1
RNOA
DRNOA
DNOA
NOA
DATO
DPM
PABNAC
EM_UP
EM_DN Adj.R2
)0.1381*** 0.0132** )0.0034*** )0.0031 0.0039*** )0.0001 )0.0359***

4.08%
()61.07) (3.37)
()3.03)
()1.56) (4.21)
()0.33) ()8.95)
)0.1374*** 0.0156*** )0.0034*** )0.0025 0.0035*** )0.0018
)0.0167*** 0.0086*** 4.05%
()60.66) (3.94)
()2.97)
()1.29) (3.78)
()0.40)
()5.40)
(2.97)
)0.1782*** 0.0160*** )0.0034*** )0.0014 0.0030*** 0.0000 )0.0346*** )0.0159*** 0.0076*** 4.11%
()60.59) (4.06)
()3.05)
()0.74) (3.23)
(0.09) ()8.63)
()5.13)
(2.61)
Panel B: Multivariate analysis of the association between EM_UP, EM_DN and year-ahead returns
ABRETt1 c0 c1 RNOAt c2 DRNOAt c3 NOAt c4 DNOAt c5 DATOt c6 DPMt c7 PABNACt
c8 EM UPt c9 EM DNt nt1
RNOA
DRNOA NOA
DNOA
DATO
DPM
PABNAC EM_UP
EM_DN Adj.R2
0.0021*** )0.0025* )0.0016*** )0.0021*** 0.0021*** )0.0025 )0.0096***

0.44%
(2.61)
()1.79) ()3.46)
()3.06)
(6.05)
()1.42) ()7.00)
0.0022*** )0.0019 )0.0015*** )0.0020*** 0.0020*** )0.0027
)0.0022** 0.0034*** 0.39%
(2.80)
()1.39) ()3.33)
()2.94)
(5.72)
()1.48)
()2.10)
(3.40)
0.0023*** )0.0019 )0.0016*** )0.0018*** 0.0019*** )0.0019 )0.0093*** )0.0020** 0.0032*** 0.46%
(2.87)
()1.34) ()3.42)
()2.58)
(5.34)
()1.07) ()6.79)
()1.99)
(3.14)
Notes:
a
DRNOAt+1 (ABRETt+1) models are estimated using pooled regressions, on 110,170 (67,075)
rm-year observations, controlling for xed effects by year and industry (two-digit SIC
code). t-statistics are reported in parentheses. See Table 1 for variable denitions ***, **
and * indicate coefcients signicantly different from zero at the 1, 5, and 10 percent level,
respectively (two-tailed).
future abnormal stock returns, two commonly documented consequences of earnings

management.
Additional analyses
Controlling for the effect of contemporaneous sales on net operating assets and operating
income is crucial in the computation of the ATO PM diagnostic we propose. To ensure
that contemporaneous sales is not merely acting as a deator, we repeat all the analyses
reported in the paper after computing ATO and PM with two alternative variables
lagged sales and market value of equity in place of contemporaneous sales. We nd
that the ATO PM diagnostic derived with these alternative deators is not associated with
the earnings management scenarios we examine in the paper (results not tabulated).
We also note that changes in ATO and PM could be driven by a change in rm performance. However, if changes in ATO and PM are driven by rm performance, then they
249
are likely to move in the same direction. For example, if a rm has an increase in sales,
ATO will likely go up because sales is in its numerator, and PM will likely go up because,
in the presence of period costs, an additional dollar of sales increases the ratio of operating income to sales. We nd, indeed, that rms with a signicant increase in sales (dened
as rms in the top quintile of sales growth), experience an increase in ATO 65 percent of
the time and an increase in PM 67 percent of the time, and that rms with a signicant
decrease in sales (dened as rms in the bottom quintile of sales growth), experience a
decrease in ATO 64 percent of the time and a decrease in PM 69 percent of the time. As
more general evidence that ATO and PM tend to move in the same direction, we document a positive Spearman correlation between changes in these ratios of 0.203. Also, when
ATO increases, PM increases 59 percent of the time, and when ATO decreases, PM
decreases 58 percent of the time. We argue, therefore, that changes in ATO and PM in the
same direction are more likely to be due to changes in rm performance, while changes in
ATO and PM in opposite directions are less frequent and are more likely to be due to
5. Summary and conclusions
In this study, we propose a new diagnostic for earnings management based on directional
changes in rms prot margin and asset turnover ratios. Consistent with expectations, we
nd that contemporaneous increases in PM and decreases in ATO signal upward earnings
management, and that contemporaneous decreases in PM and increases in ATO signal
downward earnings management. We draw this conclusion based on evidence that rms
with contemporaneous increases (decreases) in PM and decreases (increases) in ATO: (i)
are more (less) likely to meet or just beat analyst forecasts, (ii) are less (more) likely to
have extreme earnings surprises, (iii) are more likely to subsequently restate earnings
downward (upward), and (iv) experience lower (higher) year-ahead rm performance. In
each of our analyses, we document that the ATO PM diagnostic provides incremental
information over performance-adjusted abnormal accruals. Except for year-ahead performance, where the abnormal accruals diagnostic is superior, we also show that in all other
earnings management scenarios the relative explanatory power of the ATO PM diagnostic
is signicantly higher than that of performance adjusted abnormal accruals. Our study
documents a new, useful diagnostic for earnings management that is grounded in the
accounting model, relies on popular accounting ratios, is easy to compute with fewer data
requirements, and is informative about earnings management even when there is no obvious incentive for a rm to manage its income. The results should, therefore, benet academic researchers as well as educators and practitioners of nancial statement analysis.
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CAR Vol. 29 No. 1 (Spring 2012)