Earnings management induced by cognitive reference points

Previous studies [Carslaw (1988), Thomas (1989) and Niskanen and Keloharju (2000)] have shown that companies’ managers tend to round up the first digits of reported earnings (i.e. for companies reporting profits). According to Carslaw (1988), this type of behaviour is inspired by the existence of the so-called “$ 1.99” phenomenon where a price of $ 1.99 is perceived as being abnormally lower than one of $ 2.00. In the current study, we try to determine whether managers of U.K. listed companies also engage in this type of ‘earnings rounding-up behaviour’. Analogous to the earlier studies, our study compares observed and expected (i.e. estimated using Benford’s Law) frequencies for the second-from-the-left digit in reported earnings. Our results suggest that managers of U.K. listed companies tend to round up reported pre-tax income, in a way that increases the first digit by one, when they are faced with a nine in the second-from-the-left position for this particular earnings measure. The major contribution of the current study is that it introduces discretionary accruals in this line of research. Discretionary accruals were estimated using both the Jones model (1991) and the modified Jones model as proposed by Dechow, Sloan and Sweeney (1995). Our results clearly suggest that discretionary accruals are used in order to round up reported earnings figures. Moreover, discretionary accruals enabled us to increase the power of the tests used in previous studies.