A heated debate exists as to whether discontinuities in earnings distributions are indicative of earnings management. While many studies attribute discontinuities in earnings distributions to earnings management, other studies argue that earnings discontinuities are artifacts of sample selection and research design. Overall, there is limited direct evidence of a connection between earnings discontinuities and earnings management. In this study, we provide direct evidence linking earnings management to earnings discontinuities for a sample of firms that settle securities class action lawsuits and restate earnings from the alleged GAAP violation period. We compare the distribution of restated (“unmanaged”) earnings to originally reported (“managed”) earnings. We find that discontinuities are not present in the distribution of analyst forecast errors and earnings changes using unmanaged earnings but are present using managed earnings. The discontinuity in the earnings level distribution is attenuated, but not eliminated, on an unmanaged basis. These shifts among our sample of firms are caused by earnings management and cannot be explained by sample selection or research design issues. Our findings are important because many studies use earnings discontinuities as a proxy for intentional earnings manipulations and we provide the first direct evidence of a link between these two phenomena.

Cash flows play an important role in the accounting and finance literature. They are a major component of earnings, serve as a benchmark for earnings and accruals, and are an input to firm valuation. Although accrual measurement has been extensively studied, research on cash flow measurement remains limited. We review cash flow proxies researchers use in prior literature and highlight the importance of (1) identifying and defining the cash flow construct of interest based on the underlying research question and other constructs of interest and (2) selecting a cash flow proxy that minimizes measurement error and maps well into its construct. We also examine the challenges researchers face in measuring cash flows and demonstrate how measurement choices can affect the magnitude of coefficient estimates and statistical inferences. Finally, our study provides a framework researchers can follow to strengthen the construct validity of cash flow proxies.

In recent years, many companies have emphasized adjusted-GAAP earnings numbers in their quarterly press releases. While managers use different names to describe these nonstandard earnings metrics, the financial press frequently refers to them as “pro forma” earnings. Managers and other advocates of pro forma reporting argue that these disclosures provide a clearer picture of companies' core earnings. On the other hand, regulators, policymakers, and the financial press often allege that managers' pro forma earnings disclosures are opportunistic attempts to mislead investors. Recent evidence suggests that while many pro forma earnings disclosures are altruistically motivated, some may represent managers' attempts to portray overly optimistic financial performance. If this is the case, then less wealthy, less sophisticated, individual investors are arguably the most at risk of being misled. Consequently, this study investigates who trades on pro forma earnings information. Our intraday investigation of transactions around earnings announcements containing pro forma earnings information reveals that less sophisticated investors' announcement-period abnormal trading is significantly positively associated with the magnitude and direction of the earnings surprise based on pro forma earnings. In contrast, we find no association between sophisticated investors' trading and manager-reported pro forma information. Overall, our analyses and numerous robustness tests suggest that the segment of the market that relies on pro forma earnings information is populated predominantly by less sophisticated individual investors. This evidence is particularly relevant to standard-setters and regulators given that Section 401(b) of the Sarbanes-Oxley Act of 2002 and subsequent SEC regulations are specifically designed to protect ordinary investors from misleading pro forma information.