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RAF
14,1
64
Received 21 October 2012
Revised 22 July 2013
4 November 2013
Accepted 10 March 2014
Review of Accounting and Finance
Vol. 14 No. 1, 2015
pp. 64-80
© Emerald Group Publishing Limited
1475-7702
DOI 10.1108/RAF-10-2012-0111
Earnings smoothing around
open-market share repurchases
Hui Di
Department of Accounting and Finance, Indiana University – Purdue
University Fort Wayne, Fort Wayne, Indiana, USA, and
Dalia Marciukaityte
Department of Finance Insurance and Law, Illinois State University,
Normal, Illinois and Drexel University, Philadelphia, Pennsylvania, USA
Abstract
Purpose – The purpose of this paper is to examine whether firms engage in earnings decreasing
management before share repurchases to mislead investors or to smooth earnings and improve
earnings informativeness.
Design/methodology/approach – The authors examine discretionary accruals and cash flows
around open-market share repurchases. The primary discretionary accruals measure is industry- and
performance-adjusted discretionary current accruals estimated from cash-flow data.
Findings – Results show that, firms experience temporary increases in operating cash flows and
use negative discretionary accruals to smooth earnings before share repurchases. Firms with the
highest pre-repurchase cash flows use the lowest pre-repurchase discretionary accruals. Moreover,
pre-repurchase discretionary accruals reflect expectations about future operating cash flows. Firms
with the strongest deterioration in operating cash flows after repurchases use the lowest pre-repurchase
discretionary accruals. These findings suggest that repurchasing firms use earnings management to
increase smoothness and predictability of reported earnings rather than to mislead investors.
Originality/value – This paper provides an alternative explanation to the finding of negative
discretionary accruals before share repurchases. It adds to the literature on repurchases and earnings
smoothing by showing that firms use earnings management around share repurchases to smooth
earnings.
Keywords Share repurchases, Earnings smoothing, Discretionary accruals, Earnings management
Paper type Research paper
1. Introduction
A majority of chief financial officers (CFOs) in Graham et al.’s (2005) study express their
concern about reporting volatile earnings. These CFOs are willing to engage in earnings
management to smooth reported earnings even when such smoothing is costly.
Managers have incentives to report smoother earnings, as firms with smoother and
more predictable earnings have lower costs of equity capital (Francis et al., 2004). On the
other hand, some studies argue that firms use earnings management to mislead
investors (Gong et al., 2008).
Gong et al. (2008) find that firms engage in earnings decreasing management before
share repurchases and suggest that firms mislead selling shareholders to obtain lower
prices. However, Dittmar and Dittmar (2004) show that share repurchases are often used
to distribute temporary income. Since managers and investors prefer smoother earnings
(Graham et al., 2005; Francis et al., 2004), we suggest that firms may respond to this
temporary increase in income by engaging in downward earnings management to avoid Earnings
reporting high earnings that cannot be sustained. Thus, although reporting lower smoothing
earnings is likely to result in lower share prices, such reporting is not misleading in this around share
case. Instead, reporting temporarily high earnings would be misleading, as investors
would expect high reported earnings to continue. We examine whether misleading
repurchases
earnings management or earnings smoothing drive earnings management before share
repurchases. If firms engage in earnings smoothing, they should use negative 65
discretionary accruals when they expect a decline in future operating cash flows.
Such earnings management would not be misleading but instead would increase
earnings informativeness.
We provide support for the earnings smoothing hypothesis using a sample of 2,201
open-market share repurchases during 1989-2008. We find that discretionary accruals
decline before repurchases and recover after repurchases. Moreover, operating cash flows
exhibit the opposite pattern; operating cash flows increase before share repurchases and
decline afterwards. We find a negative cross-sectional relation between pre-repurchase
discretionary accruals and contemporaneous operating cash flows. The mean (median)
adjusted discretionary accruals decline from 4.43 per cent (3.15 per cent) in the lowest
cash-flow quintile to ⫺4.74 per cent (⫺4.57 per cent) in the highest cash-flow quintile, with
the difference significant at the 1 per cent level. We confirm these findings using multivariate
analyses controlling for firm characteristics.
We provide further support for the earnings smoothing hypothesis by showing that
managers avoid reporting temporary rather than permanent changes in operating
performance. We find a positive relation between pre-repurchase discretionary accruals
and post-repurchase changes in operating cash flows. When we form quintiles by the
changes in post-repurchase operating cash flows from the pre-repurchase year to the
third post-repurchase year, the mean (median) adjusted discretionary accruals increase
from ⫺5.44 per cent (⫺5.00 per cent) in the lowest quintile to 2.99 per cent (2.66 per cent)
in the highest quintile, with the difference significant at the 1 per cent level. We confirm
our findings using multivariate analyses controlling for firm characteristics.
To show the robustness of our findings, we confirm our findings separately for
firms with negative and positive pre-repurchase accruals. Moreover, we obtain very
similar results for repurchases made during 1989-1998 and 1999-2008, suggesting
the persistence of our findings.
Overall, our findings suggest that most managers use discretionary accruals before
share repurchases to obtain smoother and more predictable earnings. The positive
relation between pre-repurchase discretionary accruals and post-repurchase changes in
operating performance is inconsistent with misleading earnings management. An
important implication of our findings is that restricting managerial discretion in
earnings reporting could harm rather than benefit investors. Our study adds to a
number of recent studies (Subramanyam, 1996; Tucker and Zarowin, 2006) suggesting
that firms use discretionary accruals to obtain smoother and more predictable earnings.
We expand their findings by showing earnings smoothing around share repurchases.
The rest of the paper is organized as follows. In Section 2, we discuss why firms
smooth earnings around share repurchases. We present the sample description in
Section 3 and methodology in Section 4. We describe our findings about discretionary
accruals and earnings smoothing in Section 5. Section 6 concludes.
RAF 2. Earnings smoothing
14,1 Since share repurchases are often used to distribute temporary earnings (Dittmar and
Dittmar, 2004), share repurchases can be expected to coincide with or follow the periods
of temporary increases in earnings. Such temporary changes in earnings make earnings
more volatile. Beattie et al. (1994) show that firms are more likely to smooth earnings
when facing high earnings variability. Moreover, reporting a temporary increase in
66 earnings raises investor’s expectations about future earnings and leads to investor
disappointment when high earnings are not maintained. Managers try to avoid such
situations, as the market harshly punishes the firms that report lower than expected
earnings (Skinner and Sloan, 2002).
When managers smooth reported earnings by avoiding reporting temporary
changes in income, they reflect their inside knowledge about the firm and improve
the informativeness of earnings instead of misleading investors[1]. Differently from
opportunistic earnings management, earnings smoothing may benefit current
shareholders and potential investors by reducing information asymmetry between
the managers and investors. A number of studies (Subramanyam, 1996; Sankar and
Subramanyam, 2001; Chaney and Lewis, 1998; Tucker and Zarowin, 2006) suggest
that earnings smoothing benefits investors by improving earnings informativeness.
Subramanyam (1996) finds that discretionary accruals help to predict firms’ future cash
flows, nondiscretionary income, net income and dividends. High (low) discretionary accruals
are associated with future improvement (deterioration) in these performance measures.
Moreover, Subramanyam shows that such earnings management is pervasive. Sankar
and Subramanyam (2001) model the reporting of discretionary earnings when a
manager has private information about the firm. They show that allowing some
discretion in earnings reporting can improve the information content of reported
earnings, as this allows managers to smooth earnings. Tucker and Zarowin (2006)
confirm the hypothesis that smoothed earnings provide more information about future
earnings. The authors examine the information content of changes in stock prices for
firms with high and low levels of earnings smoothing and find that firms with high level
of earnings smoothing have changes in prices that are more informative about future
earnings. Thus, investors seem to be able to obtain more information from smoothed
earnings. These studies suggest that earnings smoothing allows managers to
communicate inside information about future performance.
Some studies of earnings management (Teoh et al., 1998a, 1998b; Chou et al., 2009)
give an impression that misleading and manipulative behavior is quite common among
managers. However, other studies do not support this notion. A number of studies
(Hribar and Collins, 2002; Armstrong et al., 2009) show that the evidence of misleading
earnings management before corporate events disappears once we correct for the known
measurement errors in the estimation of discretionary accruals. Similarly, the evidence
on other types of misleading signaling by managers suggests that only a small number
of managers are engaging in such behavior (Chan et al., 2010).
Gong et al. (2008) suggest that managers manipulate earnings before open-market
share repurchases to mislead investors and obtain lower repurchase prices. While Gong
et al. do not suggest or examine the earnings smoothing hypothesis, their findings do not
reject this hypothesis. They find negative discretionary abnormal accruals during the
quarter of repurchase announcement and the preceding quarter. This is expected if
repurchases are preceded by a temporary improvement in operating performance and
firm’s smooth earnings. Gong et al. find the negative relation between pre-repurchase Earnings
discretionary accruals and the percentage of the total shares repurchased. That is smoothing
expected if both the negative pre-repurchase discretionary accruals and repurchases are
driven by a temporary increase in cash flows. Firms with the largest cash flows will need
around share
the lowest accruals to smooth earnings, and they will have the largest repurchases. repurchases
Moreover, Gong et al. report a negative relation between pre-repurchase discretionary
abnormal accruals and post-repurchase stock performance. If not all firms smooth their 67
temporarily high earnings before the repurchases, the ones that do not smooth earnings
will report a decline in earnings after repurchases. As Skinner and Sloan (2002) show, a
decline in earnings is associated with negative market reaction. Thus, there may be a
negative relation between pre-repurchase discretionary accruals and post-repurchase
stock performance as long as not all firms engage in earnings smoothing to the same
degree.
We suggest earnings smoothing as an explanation of earnings management
around share repurchases. The earnings smoothing hypothesis predicts a decline in
discretionary accruals before repurchases and an increase afterwards, with the
opposite pattern for operating cash flows. Moreover, it predicts a negative
cross-sectional relation between pre-repurchase discretionary accruals and
contemporaneous changes in operating cash flows as well as a positive relation
between pre-repurchase discretionary accruals and post-repurchase changes in
operating cash flows. We test these predictions.

3. Sample
To obtain the sample of open-market share repurchases, we start with all firm-years
included in Compustat and Center for Research in Security Prices (CRSP) during
1989-2008[2]. As small repurchases are not likely to be associated with significant
temporary increases in income, we limit our sample to 8,494 firm-years with the
percentage of common equity repurchased of at least 5 per cent[3]. Stephens and
Weisbach (1998) report that the median size of open-market repurchases is 5 per cent.
The estimation procedures for the percentage of common equity repurchased using
Compustat data and other variables are explained in Table I.
For a few firms, the estimated value of common equity repurchased using Compustat
data is significantly higher than the market value of equity at the beginning of the
repurchase year, suggesting a possibility of recording errors. Moreover, Banyi et al.
(2008) show that the measures of common equity repurchased sometimes provide
incorrect estimates of the repurchase size. To identify firm-years where the variable is
likely to be misreported, we estimate the percentage of common shares repurchased
using CRSP data. Similar to Stephens and Weisbach (1998), the measure is computed as
the sum of daily decreases in outstanding shares during each firm-year divided by the
outstanding shares at the beginning of the firm-year and adjusted for stock splits[4]. To
reduce the impact of recording errors, we exclude firm-years with the percentage of
common equity repurchased estimated from Compustat more than ten times higher than
the percentage of common shares repurchased estimated from CRSP. We also exclude
firm-years when the estimate from CRSP is not available. These restrictions limit our
sample to 5,169 firm-years.
Furthermore, we exclude regulated utilities (standard industrial classification [SIC]
codes 4,910-4949), depository institutions (SIC codes 6,000-6099) and holding or other
RAF Variables Definitions, compustat names and compustat item numbers
14,1
Adjusted discretionary Difference in discretionary current accruals of repurchasing firms and
current accruals industry- and performance-matched firms. Estimation is explained in
detail in Section 4
Discretionary current We estimate discretionary current accruals from cash-flow statements
68 accruals (Hribar and Collins, 2002). Estimation is explained in detail in Section 4
Firm size Logarithm of total assets (AT; 6)
Leverage (Long-term debt [DLTT; 9] ⫹ Debt in current liabilities [DLC; 34])/Total
assets
Market-to-book (Total assets ⫺ Common equity ⫹ Market value of equity)/Total assets
Percentage of common (The purchases of common and preferred stock [PRSTKC; 115] ⫹ The
equity repurchased decrease in preferred stock [PSTK; 130])/Market value of equity (from
CRSP) at the beginning of the repurchase fiscal year
Percentage of common The sum of daily decreases in outstanding shares during each firm-
shares repurchased year/The outstanding shares at the beginning of the firm-year
Table I. Operating cash flows Net cash flow from operating activities (OANCF; 308)
Variable definitions Return on assets Net income (NI; 172)/Lagged total assets

investment offices (SIC codes 6,700-6799). We also restrict the sample to ordinary
common shares with CRSP share codes of 10 and 11. Because we examine repurchasing
firms for the three years before to three years after the repurchase year, we require that
repurchase years for the same firm be at least three years apart. When the same firm is
included more than once in any four-year period, we include only the earliest firm-year
(2,708 firm-years).
The repurchase sample identified from Compustat includes open-market repurchases as
well as fixed-price tender offers and Dutch auctions. To limit our sample to open-market
share repurchases, we identify the announcements of open-market repurchases from the
Securities Data Company (SDC) database. Stephens and Weisbach (1998) show that
about 82 per cent of open-market repurchase programs are completed within three
years. Thus, we search the SDC for the announcements of open-market repurchases
during the repurchase year and the three years before the repurchase year. Furthermore,
since our study focuses on earnings management before repurchases, we require the
availability of adjusted discretionary current accruals (ADCA) for the year before the
repurchase year. Our final sample includes 2,201 firm-years with substantial
open-market share repurchases. The event year (Year 0) is the repurchase year.
We present the descriptive statistics for our sample of open-market share
repurchases in Table II. Panel A of Table II reports the calendar distribution of the 2,201
repurchases from 1989 to 2008. The highest concentration of repurchases is in 1999, with
10.27 per cent of the sample repurchases. Panel B depicts the distribution of repurchases
across the two-digit SIC codes. At least 5 per cent of repurchasing firms are in each of the
following industries: business services, electronic and other electric equipment,
instruments and related products, industrial machinery and equipment, and chemicals
and allied products.
Panel C of Table II provides select characteristics of repurchasing firms. The
definitions of all the variables used in the paper are presented in Table I. To reduce the
effect of recording errors and outliers, all variables are winsorized at the top and bottom
1 per cent. Repurchasing firms in our sample tend to be large firms with the mean
 No. of Per cent of No. of Per cent of
Earnings
Year events events (%) Year events events (%) smoothing
around share
Panel A: Calendar distribution
1989 98 4.45 1999 226 10.27 repurchases
1990 105 4.77 2000 161 7.31
1991 57 2.59 2001 90 4.09
1992 32 1.45 2002 60 2.73
69
1993 45 2.04 2003 97 4.41
1994 98 4.45 2004 105 4.77
1995 116 5.27 2005 124 5.63
1996 95 4.32 2006 163 7.41
1997 143 6.50 2007 149 6.77
1998 171 7.77 2008 66 3.00

Industry SIC code No. of events Per cent of events (%)

Panel B: Industry distribution

Business services 73 259 11.77
Electronic and other electric equipment 36 187 8.50
Instruments and related products 38 148 6.72
Industrial machinery and equipment 35 144 6.54
Chemicals and allied products 28 122 5.54
Insurance carriers 63 101 4.59
Food and kindred products 20 75 3.41
Eating and drinking places 58 72 3.27
Wholesale trade – durable goods 50 67 3.04
Transportation equipment 37 63 2.86
Other 963 43.75

Lower Upper
Mean Median quartile quartile

Panel C: Select characteristics of repurchasing firms

Total assets, $M 4,393 394 89 1,791
Leverage 0.19 0.14 0.02 0.28
Market-to-book 1.63 1.38 1.05 1.90
Percentage of common equity repurchased (%) 10.19 7.66 6.03 10.98
Percentage of common shares repurchased (%) 8.66 5.70 3.05 9.62

Notes: The sample includes 2,201 firm-years with open-market repurchases of at least 5% of common
equity during 1989 to 2008. We exclude (1) firm-years with the percentage of common equity
repurchased estimated from Compustat more than 10 times larger than the percentage of common
shares repurchased estimated from CRSP; (2) regulated utilities (SIC codes 4910-4949), depository
institutions (SIC codes 6000-6099), and holding or other investment offices (SIC codes 6700-6799); (3)
repurchases with share codes other than 10 or 11; (4) firms with missing adjusted discretionary accruals
during the pre-repurchase year. When the same firm is included more than once in any four-year period,
we include only the earliest firm-year. Panel A reports the distribution of events by year, Panel B reports
the distribution of events across two-digit standard industrial classification (SIC) codes, and Panel C
presents select characteristics of repurchasing firms. Descriptions of all variables are in Table I. Table II.
Variables are winsorized at the top 1% and the bottom 1% Sample description
RAF (median) total assets of $4,393M ($394M), similar to those in Grullon and Michaely’s
14,1 (2004) sample of repurchasing firms. Repurchasing firms have moderate leverage and
market-to-book values.
Panel C of Table II also shows that during the repurchase year, the mean (median)
percentage of common equity repurchased as estimated from Compustat is 10.19 per
cent (7.66 per cent). The mean (median) percentage of common shares repurchased as
70 estimated from CRSP is 8.66 per cent (5.70 per cent).

4. Methodology
As it is easier for firms to manage current rather than long-term discretionary accruals
to reach the desired earnings during a particular year (Guenther, 1994; Teoh et al.,
1998a), we examine current accruals. Hribar and Collins (2002) show that estimating
discretionary accruals using balance-sheet data leads to spurious evidence of earnings
management around mergers and acquisitions, discontinued operations and foreign
currency conversions. Following their suggestions, we estimate current accruals from
cash-flow statements.
To enhance the reliability of discretionary accruals measures, we examine the
current accruals estimated relative to those of firms matched by the two-digit SIC code
and returns on assets during the pre-repurchase year (Kothari et al., 2005). To create this
industry- and performance-matched sample, we require each two-digit SIC group to
have at least ten firms. Repurchasing firms are excluded from the matched sample for
the three years before to the three years after the repurchase year. As we require the
availability of discretionary current accruals (DCA) during the pre-repurchase year for
repurchasing firms, we apply the same requirement for the matched firms.
To estimate current accruals (CA) for firm j at time t, we use a formula similar to the
one in Hribar and Collins (2002) while excluding depreciation expenses[5]:

CAj,t ⫽ ⫺ ( RECCHj,t ⫹ INVCHj,t ⫹ APALCHj,t ⫹ TXACHj,t ⫹ AOLOCHj,t ) (1)

where RECCH is the decrease (increase) in accounts receivable (Compustat Item 302),
INVCH is the decrease (increase) in inventory (Item 303), APALCH is the increase
(decrease) in accounts payable (Item 304), TXACH is the increase (decrease) in taxes
payable (Item 305) and AOLOCH is the net change in other current assets (Item 307).
Throughout the paper, we use mnemonic names in the Compustat database to represent
all Compustat variables in equations. We winsorize all variables at the top and bottom
1 per cent to reduce the effect of recording errors and outliers.
To obtain non-discretionary accruals, we study all firm-years during our sample
period, excluding repurchasing firms for the three years before to the three years after
the repurchase year. Each year, for each two-digit SIC code, we estimate the following
OLS regression[6]:

CAj,t /ATj,t⫺1 ⫽ ␣0 ⫹ ␣1( 1/ATj,t⫺1 ) ⫹ ␣2( ⌬SALEj,t /ATj,t⫺1 ) ⫹ ␧j,t (2)

where AT is total assets (Item 6) and SALE is net sales (Item 12). We use the estimated
coefficients from equation (2) to obtain non-discretionary current accruals (NDCA) for
firm i in year t:

NDCAi,t ⫽ ␣ˆ 0 ⫹ ␣ˆ 1( 1/ATi,t⫺1 ) ⫹ ␣ˆ 2(( ⌬SALEi,t ⫹ RECCHi,t ) /ATi,t⫺1 ) (3)

We estimate DCA for firm i in year t: Earnings
smoothing
DCAi,t ⫽ CAi,t /ATi,t⫺1 ⫺ NDCAi,t (4) around share
ADCA are the difference between the DCA of a repurchasing firm and those of an repurchases
industry- and performance-matched firm.
71
5. Discretionary accruals and earnings smoothing
5.1 Discretionary accruals and operating cash flows around share repurchases
Gong et al. (2008) report negative discretionary accruals before the announcements of
share repurchases and suggest that firms use discretionary accruals to mislead the
market about the firm value and reduce the repurchase price. We examine an alternative
explanation for earnings management around share repurchases, earnings smoothing.
We start with examining the discretionary accruals for the three years before to the three
years after the actual repurchases. Panel A of Table III shows that discretionary
accruals decline during the pre-repurchase year (significant at the 1 per cent level) and
remain negative during the pre-repurchase year (mean ⫽ ⫺0.62 per cent; median ⫽
⫺0.54 per cent) and the repurchase year (mean ⫽ ⫺0.48 per cent; median ⫽ ⫺0.29 per

Fiscal year ⫺3 ⫺2 ⫺1 0 1 2 3

Panel A. Discretionary current accruals normalized by lagged total assets

Adjusted discretionary current accruals
Mean (%) ⫺0.46* 0.10 ⫺0.62*** ⫺0.48** 0.12 ⫺0.29 0.18
Median (%) ⫺0.52* ⫺0.02 ⫺0.54*** ⫺0.29* 0.07 ⫺0.36 ⫺0.16
N 1,469 1,793 2,201 1,997 1,700 1,368 1,081
Annual changes in adjusted discretionary current accruals
Mean (%) 0.33 ⫺0.81*** 0.05 0.64** ⫺0.46 0.40
Median (%) 0.52 ⫺0.72*** 0.03 0.04 ⫺0.07 ⫺0.24
N 1,460 1,793 1,997 1,676 1,350 1,071
Panel B. Operating cash flows normalized by lagged total assets
Operating cash flows
Mean (%) 10.84*** 10.94*** 11.11*** 11.09*** 10.45*** 10.18*** 10.12***
Median (%) 10.27*** 10.37*** 10.83*** 10.95*** 10.19*** 9.97*** 9.74***
N 1,793 1,993 2,201 2,200 2,069 1,799 1,523
Annual changes in operating cash flows
Mean (%) 0.24 0.58** 0.07 ⫺0.76*** ⫺0.37* ⫺0.35
Median (%) 0.18 0.29*** ⫺0.25 ⫺0.35*** ⫺0.25 ⫺0.24
N 1,792 1,993 2,200 2,069 1,798 1,522

Notes: Panel A reports industry- and performance-adjusted discretionary current accruals estimated Table III.
from cash-flow statements before and after the share repurchase year (Year 0) and annual changes in Discretionary
this variable. Panel B reports operating cash flows before and after the share repurchase year and accruals and
annual changes in this variable. Descriptions of all variables are in Table I. Variables are winsorized at operating cash flows
the top 1% and the bottom 1%. We use t-tests for the means and Wilcoxon sign-rank tests for the around share
medians; *** , ** , and * indicate statistical significance at the 1, 5, and 10% levels (two-tail tests) repurchases
RAF cent). During the three post-repurchase years, discretionary accruals are not
14,1 significantly different from zero.
If repurchases are driven by temporary increases in operating cash flows, we should
observe an increase in operating cash flows before the repurchase year and/or during the
repurchase year and a decline afterwards. The findings in Panel B of Table III confirm
this hypothesis. Operating cash flows normalized by lagged total assets increase during
72 the pre-repurchase year (mean ⫽ 0.58 per cent; median ⫽ 0.29 per cent) and decline
during the first post-repurchase year (mean ⫽ ⫺0.76 per cent; median ⫽ ⫺0.35 per cent).
Both changes are statistically significant at the 5 per cent or higher level. The patterns
of discretionary accruals and operating cash flows around share repurchases are
consistent with earnings smoothing.

5.2 Pre-repurchase discretionary accruals and contemporaneous operating cash flows

To keep the earnings smooth, firms should use negative (positive) discretionary
accruals when their operating cash flows are especially high (low). The findings in
Table IV confirm these expectations. In Panels A through D of Table IV, we examine the
mean and median ADCA and their annual changes by operating cash-flow quintiles.
Panel A of Table IV examines quintiles by operating cash flow normalized by lagged
total assets. The mean (median) ADCA decline from 4.43 per cent (3.15 per cent) in the
lowest quintile to ⫺4.74 per cent (⫺4.57 per cent) in the highest quintile; the differences
in means and medians are significant at the 1 per cent level. These differences across
quintiles are highly significant economically and statistically.
Panel B of Table IV examines quintiles by the changes in operating cash flows
normalized by lagged total assets. Here, we find that the mean (median) annual change
in adjusted discretionary accruals declines from 7.26 per cent (7.12 per cent) in the lowest
quintile to ⫺9.00 per cent (⫺8.97 per cent) in the highest quintile, with the differences
significant at the 1 per cent level. Panels C and D of Table IV use industry- and
performance-adjusted operating cash flows rather than raw operating cash flows. The
findings remain essentially the same, supporting the earnings smoothing hypothesis.
We confirm the negative relation between pre-repurchase year discretionary accruals
and contemporaneous operating cash flows in Panel E of Table IV using OLS regression
analyses. Following Daniel et al. (2008), we control for the lagged values of the firm size,
leverage and market-to-book. Model 1 tests the relation between discretionary accruals
and normalized operating cash flows, while Model 2 tests the relation between the
annual change in discretionary accruals and the annual change in normalized operating
cash flows. In Models 3 and 4, we use industry- and performance-adjusted operating
cash flows rather than raw operating cash flows. All four models confirm negative
relations between discretionary accruals and contemporaneous operating cash flows,
significant at the 1 per cent level[7]. Overall, our results suggest that firms reduce their
discretionary accruals to cancel the increase in operating cash flows during the
pre-repurchase year, consistent with the earnings smoothing hypothesis.

5.3 Pre-repurchase discretionary accruals and post-repurchase changes in operating

cash flows
If firms use discretionary accruals before share repurchases to avoid reporting
temporary rather than permanent increases in operating cash flows, there should be a
positive relation between pre-repurchase discretionary accruals and post-repurchase
Variables Q1 (%) Q2 (%) Q3 (%) Q4 (%) Q5 (%) Q5 – Q1 (%)
Earnings
smoothing
Panel A: Quintiles by operating cash flows around share
ADCA, mean 4.43*** 0.48 ⫺1.26*** ⫺2.00*** ⫺4.74*** ⫺9.17***
ADCA, median 3.15*** 0.66 ⫺1.05*** ⫺1.78*** ⫺4.57*** ⫺7.72*** repurchases
Panel B: Quintiles by the changes in operating cash flows
⌬ADCA, mean 7.26*** 1.10** ⫺0.71 ⫺2.40*** ⫺9.00*** ⫺16.26*** 73
⌬ADCA, median 7.12*** 1.10*** ⫺0.41 ⫺2.01*** ⫺8.97*** ⫺16.09***
Panel C: Quintiles by adjusted operating cash flows
ADCA, mean 8.95*** 2.26*** ⫺0.27 ⫺3.82*** ⫺10.19*** ⫺19.14***
ADCA, median 8.03*** 2.04*** ⫺0.46** ⫺4.14*** ⫺10.99*** ⫺19.02***
Panel D: Quintiles by the changes in adjusted operating cash flows
⌬ADCA, mean 11.16*** 3.21*** ⫺0.91** ⫺4.54*** ⫺12.85*** ⫺24.01***
⌬ADCA, median 10.86*** 2.90*** ⫺0.58** ⫺4.04*** ⫺13.36*** ⫺24.22***

ADCA ⌬ADCA ADCA ⌬ADCA

Model 1 Model 2 Model 3 Model 4

Panel E: Regression analyses

Operating cash flows ⫺0.3571***
(⫺17.77)
Change in operating cash flows ⫺0.5452***
(⫺19.80)
Adjusted operating cash flows ⫺0.5112***
(⫺40.75)
Change in adjusted operating cash flows ⫺0.5445***
(⫺37.07)
Firm size 0.0009 0.0003 ⫺0.0002 0.0006
(0.89) (0.25) (⫺0.28) (0.52)
Leverage ⫺0.0022 0.0225 0.0057 0.0297**
(⫺0.19) (1.45) (0.62) (2.32)
Market-to-book 0.0171*** ⫺0.0003 0.0071*** ⫺0.0024
(8.19) (⫺0.10) (4.45) (⫺1.07)
Constant ⫺0.0028 ⫺0.0105 ⫺0.0107* ⫺0.0110
(⫺0.38) (⫺1.07) (⫺1.86) (⫺1.34)
Observations 2,079 1,784 2,079 1,775
Adjusted R2 0.1334 0.1801 0.4455 0.4355

Notes: Panels A through D report the mean and median industry- and performance-adjusted
discretionary current accruals (ADCA) in pre-repurchase year (Year 1) and annual changes in this
variable (⌬ADCA) by quintiles. In Panel A, quintiles are by the pre-repurchase operating cash flows
normalized by lagged total assets, and in Panel B, by annual changes in this variable. Panels C and D are Table IV.
similar to Panels A and B, however, here we examine industry- and performance-adjusted operating Pre-repurchase
cash flows. Panel E presents OLS regression analyses of the relations examined in Panels A through D. discretionary
Descriptions of all variables are in Table I. Variables are winsorized at the top 1% and the bottom 1%. accruals and
t-statistics are reported in parentheses; *** , ** , and * indicate statistical significance at the 1, 5 and contemporaneous
10% levels (two-tail tests) operating cash flows
RAF changes in operating cash flows[8]. To obtain smoother earnings, only firms that expect
14,1 deterioration in operating performance in the future should use negative discretionary
accruals before repurchases. The findings in Table V confirm these arguments. There is
a strong positive relation between the pre-repurchase discretionary accruals and
post-repurchase changes in operating cash flows. Panel A of Table V examines quintiles
by the changes in normalized operating cash flows from the pre-repurchase year to the
74 third post-repurchase year. The mean (median) pre-repurchase discretionary accruals
increase from ⫺5.44 per cent (⫺5.00 per cent) for the lowest quintile to 2.99 per cent (2.66

Variables Q1 (%) Q2 (%) Q3 (%) Q4 (%) Q5 (%) Q5 – Q1 (%)

Panel A: Quintiles by the changes in operating cash flows

ADCA, Mean ⫺5.44*** ⫺1.65*** ⫺0.39 0.48 2.99*** 8.43***
ADCA, median ⫺5.00*** ⫺1.51*** ⫺0.34 1.04 2.66*** 7.66***
⌬ADCA, mean ⫺5.98*** ⫺1.52* ⫺0.36 0.80 2.13** 8.11***
⌬ADCA, median ⫺4.52*** ⫺1.41* ⫺0.26 0.18 1.87** 6.39***
Panel B: Quintiles by the changes in adjusted operating cash flows
ADCA, mean ⫺7.38*** ⫺3.08*** ⫺0.68 1.86*** 6.18*** 13.56***
ADCA, median ⫺7.65*** ⫺2.54*** ⫺0.16 1.58*** 5.37*** 13.02***
⌬ADCA, mean ⫺7.02*** ⫺3.32*** ⫺0.41 0.98 4.84*** 11.86***
⌬ADCA, median ⫺6.68*** ⫺2.79*** ⫺1.01 0.69 4.35*** 11.03***

ADCA ⌬ADCA ADCA ⌬ADCA

Model 1 Model 2 Model 3 Model 4

Panel C: Regression analyses

Post-repurchase change in operating cash flows 0.2486*** 0.2604***
(11.77) (8.23)
Post-repurchase change in adjusted operating 0.2503*** 0.2333***
cash flows (16.79) (10.01)
Firm size 0.0007 0.0016 ⫺0.0005 0.0025
(0.56) (0.88) (⫺0.39) (1.25)
Leverage ⫺0.0057 0.0087 0.0233 0.0238
(⫺0.40) (0.41) (1.54) (1.03)
Market-to-book 0.0066** 0.0042 0.0052* 0.0044
(2.56) (1.14) (1.96) (1.10)
Constant ⫺0.0219** ⫺0.0259** ⫺0.0177* ⫺0.0367***
(⫺2.47) (⫺1.99) (⫺1.95) (⫺2.62)
Observations 1,435 1,211 1,072 912
Adjusted R2 0.089 0.0520 0.2118 0.1021

Notes: Panel A reports the mean and median industry- and performance-adjusted discretionary
current accruals (ADCA) and annual changes in this variable (⌬ADCA) for quintiles by the changes in
Table V. operating cash flows normalized by lagged total assets. Both ADCA and annual changes in this variable
Pre-repurchase are estimated during the year before repurchases. Changes in operating cash flows are estimated from
discretionary the pre-repurchase year to the third post-repurchase year. Panel B is similar to Panel A, however, here
accruals and post- we examine industry- and performance-adjusted operating cash flows. Panel C presents OLS regression
repurchase changes analyses of the relations examined in Panels A and B. Descriptions of all variables are in Table I.
in operating cash Variables are winsorized at the top 1% and the bottom 1%. t-statistics are reported in
flows parentheses; *** , ** , and * indicate statistical significance at the 1, 5 and 10% levels (two-tail tests)
per cent) for the highest quintile, with the difference significant at the 1 per cent level. Earnings
The differences are highly significant both statistically and economically. Moreover, we smoothing
find that the mean (median) change in pre-repurchase discretionary accruals increases
from ⫺5.98 per cent (⫺4.52 per cent) for the lowest quintile to 2.13 per cent (1.87 per cent)
around share
for the highest quintile, the difference significant at the 1 per cent level. Panel B of repurchases
Table V examines industry- and performance-adjusted operating cash flows rather than
raw operating cash flows. The differences in discretionary accruals between the highest 75
and the lowest quintiles are even higher here. Thus, repurchasing firms seem to use
discretionary accruals to avoid reporting temporary improvements in operating
performance measures before share repurchases.
In Panel C of Table V, we study the relations between pre-repurchase
discretionary accruals and post-repurchase changes in operating cash flows using
OLS regression analyses. We use the same control variables as in Table IV.
Regression analyses support our earlier findings. The relation between
pre-repurchase discretionary accruals and post-repurchase changes in operating
cash flows are positive and significant at the 1 per cent level in all four models.
Assuming that actual future cash flows proxy for managers’ expectations, our
findings suggest that managers use negative discretionary accruals before
repurchases when they expect a deterioration in future operating cash flows
performance. These findings support the earnings smoothing hypothesis.
To show the robustness of our findings, we examine situations where firms are more
likely to engage in misleading earnings management. As firms have incentives to reduce
repurchase prices, the negative discretionary accruals are more likely to be misleading
before share repurchases than the positive discretionary accruals. Thus, we examine
separately firms with negative and positive pre-repurchase-adjusted discretionary
accruals. Table VI shows the same tests as in Panel C of Table V for the two subsamples.
We find that the positive relation between pre-repurchase discretionary accruals and
post-repurchase changes in operating cash flows is similar for both subsamples. These
results suggest that even when firms use negative discretionary accruals, they manage
temporary fluctuations in operating cash flows.
To provide additional evidence about the robustness of our findings, we examine
separately earlier (1989-1998) and later (1999-2008) periods in our sample. The
regulations regarding earnings management become more stringent and severe during
our sample period (Karpoff and Lott, 1993; Alexander, 1999; Lobo and Zhou, 2006).
Responding to regulations, firms may avoid engaging in misleading earnings
management in the later period, strengthening the positive relation between
pre-repurchase discretionary accruals and post-repurchase changes in operating cash
flows. On the other hand, stricter regulations may discourage firms from engaging in
any kind of earnings management, weakening this relation. Table VII reports the same
tests as in Panel C of Table V for the two subperiods. We find that the positive relation
between pre-repurchase discretionary accruals and post-repurchase changes in
operating cash flows is similar for both subperiods. Thus, our findings are persistent
throughout our sample period.

6. Conclusions
We examine DCA and operating cash flows for a sample of 2,201 open-market share
repurchases during 1989-2008. We find that discretionary accruals decline during the
RAF ADCA ⌬ADCA ADCA ⌬ADCA
14,1 Variables Model 1 Model 2 Model 3 Model 4

Panel A: Subsample with negative discretionary accruals

Post-repurchase change in operating cash flows 0.1134*** 0.1476***
(6.06) (3.75)
76 Post-repurchase change in adjusted operating 0.1259*** 0.0790**
cash flows (8.56) (2.46)
Control variables Yes Yes Yes Yes
Observations 772 643 566 482
Adjusted R2 0.082 0.034 0.165 0.034
Panel B: Subsample with positive discretionary accruals
Post-repurchase change in operating cash flows 0.0895*** 0.1282***
(3.83) (2.94)
Post-repurchase change in adjusted operating 0.0865*** 0.1533***
cash flows (4.93) (4.64)
Control variables Yes Yes Yes Yes
Observations 663 568 506 430
Adjusted R2 0.063 0.016 0.093 0.043

Notes: The table reports OLS regression analysis using the same models as in Panel C of Table V for
the subsamples of firms with negative (Panel A) and positive (Panel B) industry- and
Table VI. performance-adjusted discretionary current accruals (ADCA). We also examine annual changes in this
Subsamples with variable (⌬ADCA). Both ADCA and ⌬ADCA are estimated during the year before repurchases.
negative and positive Changes in operating cash flows are estimated from the pre-repurchase year to the third
pre-repurchase post-repurchase year. Descriptions of all variables are in Table I. Variables are winsorized at the top 1%
discretionary and the bottom 1%. t-statistics are reported in parentheses; *** and ** indicate statistical significance
accruals at the 1% and 5% levels (two-tail tests)

pre-repurchase year, while contemporaneous operating cash flows improve. Moreover,

after repurchases, discretionary accruals recover while operating cash flows decline. We
find a negative cross-sectional relation between the pre-repurchase year discretionary
accruals and contemporaneous operating cash flows. Firms seem to use current accruals
to avoid reporting improvements in operating performance measures before share
repurchases.
To establish that firms react to temporary rather than permanent improvements in
operating cash flows, we show a positive relation between pre-repurchase discretionary
accruals and post-repurchase changes in operating cash flows. Overall, our findings
suggest that firms smooth their earnings before share repurchases. Such earnings
management allows firms to reveal information about future performance, reducing
uncertainty to investors.
Recently, we hear many calls to regulate firms more strictly and as a result
regulations keep growing. Our findings suggest that strict regulations can restrict the
channel of communication between managers and investors. Even earnings
management before share repurchases, an event where misleading could benefit a firm
in a short run, improves earnings informativeness rather than misleads investors. A
number of studies (Subramanyam, 1996; Sankar and Subramanyam, 2001; Chaney and
Lewis, 1998; Tucker and Zarowin, 2006) suggest that earnings smoothing benefits
 ADCA ⌬ADCA ADCA ⌬ADCA
Earnings
Variables Model 1 Model 2 Model 3 Model 4 smoothing
around share
Panel A: Repurchases made during 1989-1998
Post-repurchase change in operating cash flows 0.2374*** 0.2421*** repurchases
(8.41) (5.34)
Post-repurchase change in adjusted operating 0.2698*** 0.2357***
cash flows (13.58) (7.00)
77
Control variables Yes Yes Yes Yes
Observations 745 583 559 441
Adjusted R2 0.105 0.053 0.266 0.122
Panel B: Repurchases made during 1999-2008
Post-repurchase change in operating cash flows 0.2555*** 0.2751***
(8.01) (6.21)
Post-repurchase change in adjusted operating 0.2203*** 0.2203***
cash flows (9.74) (6.80)
Control variables Yes Yes Yes Yes
Observations 690 628 513 471
Adjusted R2 0.081 0.054 0.155 0.091

Notes: The table reports OLS regression analysis using the same models as in Panel C of Table V for the
subsamples of firms making repurchases during 1989-1998 and 1999-2008. We examine industry- and
performance-adjusted discretionary current accruals (ADCA) and annual changes in this variable (⌬ADCA). Table VII.
Both ADCA and ⌬ADCA are estimated during the year before repurchases. Changes in operating cash flows Subsamples with
are estimated from the pre-repurchase year to the third post-repurchase year. Descriptions of all variables are repurchases made
in Table I. Variables are winsorized at the top 1% and the bottom 1%. t-statistics are reported in before and after the
parentheses; *** indicates statistical significance at the 1% levels (two-tail tests) end of 1998

investors by improving earnings informativeness. Strict regulations make it harder for

firms to communicate the information about future expectations to investors, making
the markets less efficient. Moreover, developing, enforcing and complying with
regulations uses resources. Instead, we could use these resources to produce goods and
services that people want to buy.

Notes
1. By earnings smoothing, we mean long-term earnings smoothing which improves the
informativeness of reported earnings. Short-term earnings smoothing where a firm
experiencing a permanent decline in operating cash flows uses earnings management to avoid
reporting a decline in earnings does not smooth earnings in a long-run. Such short-term
earnings smoothing is an example of opportunistic earnings management.
2. Data necessary to estimate discretionary accruals from cash-flow statements are not available
before 1988.
3. We also examine a sample with the 1 per cent restriction. As expected, the evidence of the
decline in discretionary accruals in Year 1 is weaker here. However, the negative relation
between pre-repurchase discretionary accruals and contemporaneous operating cash flows as
well as the positive relation between pre-repurchase discretionary accruals and
RAF post-repurchase changes on operating cash flows remain significant at the 1 per cent level.
14,1 Thus, our main findings remain qualitatively the same.
4. Unlike Stephens and Weisbach (1998), we use daily decreases instead of monthly decreases in
shares. For most firms, the results are the same whether using daily or monthly data.
However, some firms have more than one change in the number of shares per month, leading
to more precise estimates of repurchased shares using daily data.
78
5. Other studies (Teoh et al., 1998a, 1998b) also exclude depreciation from their measure of
current accruals.
6. Following Kothari et al.’s (2005) suggestion, we include the constant to mitigate statistical
problems associated with the estimation of the model.
7. We replicate our main findings (regression analyses in Tables IV and V) using quarterly
discretionary total accruals estimated from balance sheet data following the methodology in
Gong et al. (2008). While the statistical significance is lower when using quarterly data, all the
coefficients of interest remain significant at the 5 per cent or higher level.
8. Gong et al. (2008) also examine the relation between pre-repurchase discretionary accruals
and post-repurchase operating performance. However, their measure of operating
performance is return on assets, which includes discretionary accruals. Most accrual
management is done by shifting accruals from one period to another. Thus, if a firm uses
negative accruals before and during repurchases, it is likely to have more positive
discretionary accruals afterwards. This can create a mechanical negative relation between
pre-repurchase discretionary accruals and post-repurchase discretionary accruals or returns
on assets. As we want to focus on actual operating performance rather than what is achieved
by earnings management, we focus on operating cash flows.

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About the authors

Hui Di is an Assistant Professor of Finance at Indiana University – Purdue University Fort
Wayne. She earned her DBA degree from Louisiana Tech University. Her research interest is in
the area of corporate finance and taxes. Her research has been published in both finance and
accounting journals such as Managerial Finance, Advances in Accounting and Academy of
Accounting and Financial Studies Journal.
RAF Dalia Marciukaityte earned her PhD from Drexel University and is currently an Assistant
Professor of Finance at Illinois State University. Her research interests include earnings
14,1 management, security issues and repurchases, capital structure, behavioral finance, corporate
governance and impact of market characteristics on financial decisions. She has published in
journals, including Journal of Corporate Finance, Journal of Financial Research, Financial Review,
Financial Analysts Journal, Journal of Business Research and Journal of Behavioral Research.
Dalia Marciukaityte is the corresponding author and can be contacted at: dmarciu@ilstu.edu
80

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