Reexamine "Cookie Jar" and "Big Bath" Accounting Using the Backing-Out Method

Abstract

Prior research documents income-decreasing earnings management in the situation when true earnings exceed the targets by a substantial amount and in the situation when true earnings fall far below the targets and accounting reserves are not sufficient to reach the targets. These two situations are well known as cookie jar and big bath earnings management. True earnings are defined as pre-managed earnings (PMEs) and are measured as reported earnings minus adjusted discretionary accruals (DAs). However, the use of PMEs can induce a spurious association between earnings management and PMEs above or below the benchmarks, which are known as the backing-out problem (Lim & Lustgarten, 2002). This study reexamines the cookie jar and big bath type of earnings management and addresses in particular the issue of backing-out problem. By using an Australian sample of 3,326 observations covering all listed firms in the Australian Securities Exchange (ASX) for a period from 1999 to 2006, this study suggests that the finding of cookie jar accounting is not simply a consequence of the backing-out problem. The results show that an income-decreasing earnings management occurs when PMEs are well above the targets. This is consistent with the first argument of cookie jar accounting - Firms reduce current earnings in order to save some income for the future. However, the results do not support the big bath accounting theory.