Rounding up performance measures in German firms : Earnings cosmetics or earnings management on a larger scale?

Abstract

Since stakeholders tend to fall prey to the left-digit bias when processing the information from financial statements, managers have an incentive to report performance measures that meet those thresholds that investors regard as critical. If the actually realized performance metric falls below these thresholds, managers might use accounting discretion to round up the reported number. This behavior is objectionable only if rounding involves large-scale earnings management, but not in cases of insignificant “earnings cosmetics”. Using Benford’s Law, we document rounding in German firms for both the unscaled net income and the earnings per share, but not for the revenues, the operating income, and the cash flow from operations. In subsequent analyses, we show that firms round only one of these earnings numbers (but not both). Moreover, we use the introduction of the Euro to show that round earnings numbers are likely the result of management’s deliberate actions. However, the difference between the pre-managed and the reported earnings is unobservable. Thus, we investigate whether the prevalence of rounding up depends on several earnings and auditor characteristics. If rounding up is “cosmetic”, it should occur independently of these characteristics. In contrast, if firms use earnings management on a larger scale, it might not be possible to simultaneously round up and achieve other earnings management objectives. Moreover, auditors providing higher quality should only prevent large-scale earnings management. Our evidence is in line with substantial earnings management because we find that only firms with specific levels of the earnings and auditor characteristics round up.