The torpedo effect: Myth or reality?

Jeff L. Payne; Wayne B. Thomas

doi:10.1177/0148558X11401216

The torpedo effect: Myth or reality?

Jeff L. Payne, Wayne B. Thomas

Accountancy

Research output: Contribution to journal › Article › peer-review

14 Scopus citations

Abstract

General evidence indicates that managers manage earnings at three common earnings thresholds: analyst forecasts, prior period earnings, and zero earnings. We examine one market-based motivation suggested for this behavior. If managers perceive the market penalty for barely missing an earnings threshold to be disproportionately high (i.e., a torpedo effect), they may use discretion to manage earnings upward to meet the earnings threshold. This market-based incentive would explain the evidence in favor of earnings management at earnings thresholds. To test the existence of a torpedo effect, we employ a comprehensive model that measures the market's reaction to reported earnings that barely miss earnings thresholds. This model controls for the level of unexpected earnings and several other firm characteristics known to affect the relation between returns and earnings. Overall, we conclude that there is little evidence of a torpedo effect. This conclusion holds for both low-growth and high-growth firms and is unaffected by the firm's history of meeting the threshold. Our paper dispels some commonly held beliefs about the market's response to earnings thresholds.

Original language	English
Pages (from-to)	255-278
Number of pages	24
Journal	Journal of Accounting, Auditing and Finance
Volume	26
Issue number	2
DOIs	https://doi.org/10.1177/0148558X11401216
State	Published - Apr 2011

Bibliographical note

Funding Information:
We are grateful for comments received on earlier versions of this manuscript from Ted Christensen, James Conover, Brooke Elliott, Doug Hanna, Chris Hogan, Bob Lipe, Jody Magliolo, Elizabeth Plummer, K. K. Raman, K. Sivaramakrishnan, Greg Sommers, Kay Stice, Scott Whisenant, G. Lee Willinger, Mark Zimbleman, and workshop participants at University of Arkansas, Brigham Young University, Emory University, University of Houston, University of North Texas, University of Oklahoma, and Southern Methodist University. Professor Payne acknowledges funding from the Von Allmen School of Accountancy at the University of Kentucky and KPMG.

Keywords

Earnings Management
Earnings Thresholds
Market Reaction
Torpedo Effect

ASJC Scopus subject areas

Accounting
Finance
Economics, Econometrics and Finance (miscellaneous)

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10.1177/0148558X11401216

Cite this

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title = "The torpedo effect: Myth or reality?",

abstract = "General evidence indicates that managers manage earnings at three common earnings thresholds: analyst forecasts, prior period earnings, and zero earnings. We examine one market-based motivation suggested for this behavior. If managers perceive the market penalty for barely missing an earnings threshold to be disproportionately high (i.e., a torpedo effect), they may use discretion to manage earnings upward to meet the earnings threshold. This market-based incentive would explain the evidence in favor of earnings management at earnings thresholds. To test the existence of a torpedo effect, we employ a comprehensive model that measures the market's reaction to reported earnings that barely miss earnings thresholds. This model controls for the level of unexpected earnings and several other firm characteristics known to affect the relation between returns and earnings. Overall, we conclude that there is little evidence of a torpedo effect. This conclusion holds for both low-growth and high-growth firms and is unaffected by the firm's history of meeting the threshold. Our paper dispels some commonly held beliefs about the market's response to earnings thresholds.",

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note = "Funding Information: We are grateful for comments received on earlier versions of this manuscript from Ted Christensen, James Conover, Brooke Elliott, Doug Hanna, Chris Hogan, Bob Lipe, Jody Magliolo, Elizabeth Plummer, K. K. Raman, K. Sivaramakrishnan, Greg Sommers, Kay Stice, Scott Whisenant, G. Lee Willinger, Mark Zimbleman, and workshop participants at University of Arkansas, Brigham Young University, Emory University, University of Houston, University of North Texas, University of Oklahoma, and Southern Methodist University. Professor Payne acknowledges funding from the Von Allmen School of Accountancy at the University of Kentucky and KPMG. ",

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AU - Thomas, Wayne B.

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N2 - General evidence indicates that managers manage earnings at three common earnings thresholds: analyst forecasts, prior period earnings, and zero earnings. We examine one market-based motivation suggested for this behavior. If managers perceive the market penalty for barely missing an earnings threshold to be disproportionately high (i.e., a torpedo effect), they may use discretion to manage earnings upward to meet the earnings threshold. This market-based incentive would explain the evidence in favor of earnings management at earnings thresholds. To test the existence of a torpedo effect, we employ a comprehensive model that measures the market's reaction to reported earnings that barely miss earnings thresholds. This model controls for the level of unexpected earnings and several other firm characteristics known to affect the relation between returns and earnings. Overall, we conclude that there is little evidence of a torpedo effect. This conclusion holds for both low-growth and high-growth firms and is unaffected by the firm's history of meeting the threshold. Our paper dispels some commonly held beliefs about the market's response to earnings thresholds.

AB - General evidence indicates that managers manage earnings at three common earnings thresholds: analyst forecasts, prior period earnings, and zero earnings. We examine one market-based motivation suggested for this behavior. If managers perceive the market penalty for barely missing an earnings threshold to be disproportionately high (i.e., a torpedo effect), they may use discretion to manage earnings upward to meet the earnings threshold. This market-based incentive would explain the evidence in favor of earnings management at earnings thresholds. To test the existence of a torpedo effect, we employ a comprehensive model that measures the market's reaction to reported earnings that barely miss earnings thresholds. This model controls for the level of unexpected earnings and several other firm characteristics known to affect the relation between returns and earnings. Overall, we conclude that there is little evidence of a torpedo effect. This conclusion holds for both low-growth and high-growth firms and is unaffected by the firm's history of meeting the threshold. Our paper dispels some commonly held beliefs about the market's response to earnings thresholds.

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The torpedo effect: Myth or reality?

Abstract

Bibliographical note

Keywords

ASJC Scopus subject areas

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