Jurnal Economic

This study examines discretionary accruals associated with firms’ reaching profitability after a series of quarterly losses. As firms approach profitability, we posit they will be characterized with less income increasing discretion given the reversing nature of accruals. We find results consistent with this expectation. The discretionary accrual behavior for firms that remain profitable contrasts to that of a control sample that does not remain profitable. In the quarters preceding a reported profit, firms that sustain profitability use significantly lower income increasing discretionary accruals. For these firms, we also find that past discretion relates inversely to future profitability. We interpret our results as evidence that discretionary accruals for persistent loss firms can serve as a leading indicator of the ability to sustain future profits.

Keywords: Earnings Management, Losses, Discretionary Accruals

1. Introduction
Reaching and sustaining profitability is a fundamental objective of every publicly traded firm. Many firms, however, experience prolonged periods of reported losses as market share is initially established, during periods of general economic decline, or later in their life cycles as market share recedes. Regardless of the underlying cause, significant costs exist for firms that remain in a loss state. Often management compensation contracts are based on reported profits (Bergstresser and Philippon [2006]), individual or firm reputation costs are incurred as losses
build (Klein and Marquardt [2006]), and asymmetric valuation consequences associated with reporting profits versus losses unarguably exist (Hayn [1995]; Brown [2001]; Skinner and Sloan [2002]; Ayers, Jiang, and Yeung [2006]).

Download pdf full text