Why Do CEOS of Publicly Traded Firms Prefer Reporting Small Increases in Earnings and Long Duration of Consecutive Earnings Increases?

Abstract

Previous studies document that publicly traded firms report more small increases in earnings than small decreases in earnings and long strings of consecutive earnings increases. Although the two earnings properties have been partially attributed to earnings management, there is little consensus on why CEOs of publicly traded firms have incentives to do so. Using a sample of publicly traded firms from the EXECOMP database during 1992-98, the objective of this study is to analyze the determinants of the two properties of accounting earnings. Specifically, this study considers both direct CEO compensation incentives (i.e., bonus and equity incentives) and other earnings management incentives, including book-to-market ratio (a proxy for value vs. growth stock), financial leverage, and analyst following. Probit regression results indicate that the probability of reporting a small increase in earnings is increasing in CEO equity-based compensation incentives and decreasing in a firm's book-to-market ratio. Regression results from the event history analysis determine that the duration of consecutive earnings increases is increasing in both CEO bonus incentive and equity incentives but decreasing in a firm's book-to-market ratio. In addition, the event history analysis suggests that, as the duration of consecutive earnings increases becomes longer, firms with low book-to-market ratios (growth stocks) have a stronger incentive to report continuous increases in earnings than firms with high book-to-market ratios (value stocks). Interestingly, firms with high analyst following and high leverage are less likely to report either small increases in earnings or long duration of consecutive earnings increases. The above conclusions were obtained after controlling for changes in operating cash flows, changes in nondiscretionary accruals, and other control variables. The results in the paper contribute to our understanding of the determinants of accounting earnings for publicly traded firms.

JEL Classification: M41, M43, J33, G29