Does Earnings Guidance Invite Earnings Management?

Abstract

In the wake of Enron-era scandals, practitioners warn that earnings guidance invites earnings management as executives scramble to achieve previously announced targets. Concurrent academic studies show that company executives manage earnings to achieve benchmark targets. This study attempts to connect these two bodies of work by developing a model of earnings management behavior. Hypothesis testing uses structural equation modeling of responses to a survey completed by 344 financial executives. The primary finding is that general guidance activities appear to constrain earnings management. However, earnings per share guidance given in the context of an active investor relations program is associated with a higher propensity to structure business transactions to manage reported income.