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RAF
11,2 Bloated balance sheet, earnings
management, and forecast
guidance
120
Li-Chin Jennifer Ho
Department of Accounting, The University of Texas at Arlington,
Arlington, Texas, USA
Chao-Shin Liu
Department of Accounting, University of Notre Dame, Notre Dame,
Indiana, USA, and
Bo Ouyang
Department of Accounting, Pennsylvania State University Great Valley,
Malvern, Pennsylvania, USA

Review of Accounting and Finance
Vol. 11 No. 2, 2012
pp. 120-140
q Emerald Group Publishing Limited
1475-7702
DOI 10.1108/14757701211228183
Abstract
Purpose – Barton and Simko argue that the balance sheet information would serve as a constraint on
accrual-based earnings management. This paper aims to extend their argument by examining whether
the balance sheet constraint increases managers’ propensity to use either downward forecast guidance
or real earnings management as a substitute mechanism to avoid earnings surprises.
Design/methodology/approach – Following Barton and Simko, the paper uses the beginning
balance of net operating assets relative to sales as a proxy for the balance sheet constraint. The
argument is that because of the articulation between the income statement and the balance sheet,
previous accounting choices that increase earnings will also increase net assets and therefore the level
of net assets reflects the extent of previous accrual management. Models from Matsumoto and
Bartov et al. are used to measure forecast guidance. Following Rochowdhury and Cohen et al., a firm’s
abnormal level of production costs and discretionary expenditures are used as proxies of real earnings
management. The empirical analysis is conducted based on the 1996-2006 annual data for a sample of
nonfinancial, nonregulated firms.
Findings – The paper finds that firms with higher level of beginning net operating assets relative to
sales are more likely to guide analysts’ earnings forecasts downward, and more likely to engage in real
earnings management in terms of abnormal increases in production costs and abnormal reductions in
discretionary expenditures.
Research limitations/implications – Overall, the paper’s evidence suggests that managers turn to
real earnings management or downward forecast guidance as a substitute mechanism to avoid
negative earnings surprises when their ability to manipulate accruals upward is constrained by the
extent to which net assets are already overstated in the balance sheet.
Originality/value – This study adds to prior literature that examines how managers trade off
different mechanisms used to meet or beat analysts’ earnings expectations. It also contributes to the
extant literature by providing further insights on the role of balance sheet information in the process of
managing earnings and/or earnings surprises.
Keywords Real earnings management, Downward forecast guidance, Earnings surprise games,
Balance sheets, Earnings, Financial forecasting
Paper type Research paper
I. Introduction Bloated balance
Prior studies (Brown and Caylor, 2005; Matsumoto, 2002; Bartov et al., 2002; Brown, sheet
2001) suggest that managers strive to report earnings that exceed analysts’ forecasts.
Because negative earnings surprises are generally associated with adverse market
reactions and unfavorable assessments of managerial performance, firms often employ
strategies that minimize the likelihood of failing to meet analysts’ earnings forecasts.
Accounting literature has documented that firms may avoid negative earnings 121
surprises in different ways. One way is to use discretionary accruals to manipulate
earnings upward, which is known as accrual-based earnings management. A second
way refers to “real” earnings management where managers take real economic actions
to maintain accounting appearances. Examples include reducing discretionary
spending on research and development (R&D), advertising, and maintenance, as well
as reducing cost of goods sold by increasing production in the current period. Another
way for managers to meet or beat analysts’ earnings forecasts is to manage analysts’
expectations downward, which is known as downward forecast guidance.
Much of extant literature treats accrual-based earnings management, real earnings
management, and forecast guidance as complementary mechanisms managers use to
avoid negative earnings surprises (Bartov et al., 2002; Matsumoto, 2002; Barton and
Simko, 2002; Burgstahler and Eames, 2006). Brown and Pinello (2007), however, show
circumstances where upward accrual-based earnings management and downward
forecast guidance are substitutes in the process of meeting or beating analysts’ earnings
forecasts[1]. Zang (2007) documents that managers use real and accrual manipulations
as substitutes in managing earnings. Overall, their evidence suggests that managers
substitute either real earnings management, downward forecast guidance, or both for
upward accrual-based earnings management when the latter is constrained.
In this study, we consider a constraint of engaging in upward accrual-based earnings
management: financial reporting flexibility in prior accounting periods. Due to the
limited flexibility within Generally Accepted Accounting Principles (GAAP) and the
reversing nature of accrual accounting, managers’ ability to manipulate earnings
upward by reporting positive discretionary accruals in the current period is constrained
by accrual management in previous periods. We follow Barton and Simko’s (2002)
approach and use the balance sheet measure of previous accounting choices as a proxy
for the level of accrual management in previous periods. The rationale for this proxy is
that because of the articulation between the income statement and the balance sheet,
previous accounting choices that increase earnings will also increase net assets, but such
increases are limited by the necessity to conform to GAAP. Barton and Simko (2002)
predict that managers’ ability to optimistically bias earnings is inversely related to the
extent to which the balance sheet overstates net assets relative to a neutral application of
GAAP. Consistent with this prediction, they find that the likelihood of firms’ avoiding
negative earnings surprises declines with this balance sheet constraint on accrual-based
earnings management.
Extending their argument, we examine whether the balance sheet constraint affects
managers’ propensity to use either real earnings management or downward forecast
guidance as a substitute mechanism to avoid negative earnings surprises. Given the
relative difficulty of managing earnings upward if the balance sheet is already
bloated, managers are more likely to use real earnings management or forecast
guidance to achieve earnings surprise targets. Conversely, because the financial
RAF reporting flexibility is not so constrained when the net assets in the balance sheet are
11,2 not overstated, managers wishing to avoid negative earnings surprises in these
situations are more likely to use accrual-based earnings management, reducing the role
of real earnings management or forecast guidance. Drawing on this line of logic,
we hypothesize that:
H1. The likelihood of managing earnings upward by real activities manipulation
122 is positively related to the extent to which a firm’s balance sheet is already
bloated (i.e. net assets are already overstated in the balance sheet).
H2. The likelihood of using downward forecast guidance is positively related to
the extent to which a firm’s balance sheet is already bloated.
Based on 1996-2006 annual data for a sample of nonfinancial, nonregulated firms, we
find that firms with higher level of beginning net operating assets relative to sales are:
.
more likely to engage in real earnings management in terms of abnormal
increases in production costs and abnormal reductions in discretionary
expenditures; and
.
more likely to guide analysts’ earnings forecasts downward.

These results hold after we control for several variables that:

. affect managers’ incentives to engage in earnings management and/or forecast
guidance; and
.
capture other constraints of earnings management or forecast guidance.

The control variables include institutional ownership, value-relevance of earnings,

litigation risk, growth prospects, firm size, market share, and forecast environment
uncertainty. Overall, our evidence suggests that managers turn to real earnings
management or downward forecast guidance as a substitute mechanism to avoid
negative earnings surprises when their ability to manipulate accruals upward is
constrained by the extent to which net assets are already overstated in the balance sheet.
This paper makes three contributions. First, it adds to prior literature that examines
how managers trade off different mechanisms used to meet or beat analysts’ earnings
expectations. Consistent with Brown and Pinello (2007), our evidence suggests a
substitution of forecast guidance for accrual-based earnings management when the
latter is constrained. Our study, however, differs from theirs in two important respects.
First, we examine how GAAP-imposed constraints on balance sheet information put
limits on the extent to which managers can engage in upward accrual-based earnings
management. While Brown and Pinello (2007) investigate how outside forces in the
accounting process such as auditing constrain accrual-based earnings management, our
study focuses on the role of inherent characteristics of the accounting process (i.e. the
nature of the double-entry bookkeeping system and the reversing nature of accruals) as
constraints on earnings management. Second, Brown and Pinello (2007) only consider
the substitution effect between accrual-based earnings management and forecast
guidance. This study extends theirs by examining the possibility of using real earnings
management as an alternative mechanism to meet or beat earnings expectations.
Our study also contributes to the extant literature by providing further insights on the
role of balance sheet information in the process of managing earnings and/or
earnings surprises. Barton and Simko (2002) argue that net assets overstatements in the Bloated balance
balance sheet represent a constraint on upward accrual-based earnings management and sheet
find that the probability of meeting or beating analysts’ forecasts is negatively associated
with the extent to which the balance sheet is already bloated. Our study extends theirs by
examining the mechanisms used by managers to meet or beat analysts’ forecasts. Our
results indicate that, although the balance sheet constraint curbs managers’ ability to use
accruals to manage earnings upward, it increases managers’ propensity to use real 123
activities manipulation in managing earnings. In addition, the balance sheet constraint
appears to do little, if anything, to limit managerial attempts to engage in downward
forecast guidance in the process of avoiding negative earnings surprises.
Finally, our results complement those of Brown and Pinello (2007) and Cohen et al.
(2008) and suggest that reporting standards, internal monitoring mechanisms, or
accounting regulations that intend to mitigate earnings management and earnings
surprise games are unlikely to totally eliminate them because of the interactions among
accrual-based earnings management, real earnings management, and forecast guidance.
Investors and auditors should take this substitute effect into consideration in their
decision making process. It also implies that, when attempting to protect the integrity of
financial reporting and capital markets, regulators should fashion regulations that not
only increase the monitoring of accrual-based earnings management but also enhance
the scrutiny of real earnings management and forecast guidance by perhaps requiring
companies to provide better disclosures on such activities.
The remainder of the paper is organized as follows. Section II reviews relevant
literature and develops our hypotheses. Section III discusses the methodology.
Section IV describes data and sample. Results are presented in Section V, and
concluding remarks are in the final section.

II. Background and hypotheses development

Incentives and mechanisms for earnings surprise management earnings surprise
management
Managers have strong incentives to avoid negative earnings surprises because negative
market reactions are generally associated with negative earnings surprises (Brown,
2001). Research by Bartov et al. (2002) and Lopez and Rees (2001) indicates that firms that
meet or beat analysts’ forecasts experience a significantly higher return at the earnings
announcement date than those with negative earnings surprises. Kasznik and McNichols
(2002) also show that firms with positive earnings surprises experience significantly
higher earnings and market values over subsequent quarters. Moreover, Skinner and
Sloan (2002) document an asymmetric market reaction to earnings surprises – firms
reporting negative surprises suffer larger negative market response compared to the
positive market response associated with firms reporting positive surprises[2].
Firms can avoid negative earnings surprises by managing either earnings or
forecasts. Existing literature has identified two forms of earnings management:
accrual-based and real earnings management. Accrual-based earnings management
refers to the situation where firms manage earnings by using accounting estimates and
judgments (Schipper, 1989; Healy and Wahlen, 1999). Real earnings management, on
the other hand, occurs when managers take real economic actions such as reducing
R&D expenditures to manage earnings (Baber et al., 1991; Graham et al., 2005;
Roychowdhury, 2006; Cohen et al., 2008). An alternative mechanism used to avoid
RAF negative earnings surprises is forecast management, a process in which managers
11,2 guide analysts’ earnings expectations downward to improve the chances they can meet
or beat analysts’ forecasts (Bartov et al., 2002; Matsumoto, 2002).
Evidence from extant studies is consistent with managers use all three mechanisms
to avoid missing analysts’ expectations. Matsumoto (2002) find that firms with the
following characteristics are more likely to use either upward accrual-based earnings
124 management or downward forecast guidance in the process of meeting or beating
analysts’ expectations:
.
higher institutional ownership;
.
higher growth prospects;
.
greater value-relevance of earnings; and
.
greater reliance on implicit claims with their stakeholders.

Bartov et al. (2002) indicate that firms that engage in downward forecast guidance,
“even at the expense of an earlier dampening of those expectations, enjoy a higher
return than their peers that fail to do so”. Burgstahler and Eames (2006) examine the
distributions of annual earnings surprises and find that both upward accrual-based
earnings management and downward forecast management are employed by
managers to achieve zero or small positive earnings surprises.
Also, several studies have documented that managers use real activities
manipulation to meet earnings benchmarks. Baber et al. (1991) and Bushee (1998) find
evidence consistent with firms reducing R&D expenditures to manage earnings.
Roychowdhury (2006) documents that managers use not only R&D but also advertising,
selling, general and administrative (SG&A), or even production costs as earnings
management methods. Graham et al. (2005) report that more than half of surveyed
financial executives admit that they would decrease maintenance or advertising
expenditures or even delay positive NPV projects in order to avoid negative earnings
surprises. Cohen et al. (2008), using Roychowdhury (2006) methodology, document a rise
in real earnings management after the enactment of SOX.

Complement vs substitute nature of the earnings surprise management mechanisms

The majority of existing literature treats accrual-based earnings management,
real earnings management, and forecast guidance as complementary mechanisms used
by managers to meet earnings targets. Limited evidence has been provided regarding
how managers may use the three mechanisms as substitutes to avoid negative earnings
surprises. Brown and Pinello (2007) represent the first study to show circumstances
where managers trade off between upward accrual-based earnings management and
downward forecast guidance in meeting or beating analysts’ forecasts. In particular,
they find that, because the annual reporting process is subject to an independent audit
and more rigorous expense recognition rules, the likelihood of both upward
accrual-based earnings management and negative surprise avoidance is reduced in
the annual reporting process. However, managers’ propensity to use downward
expectations management increases in the annual reporting process. Their findings
suggest that managers use downward forecast guidance as an alternative way to meet or
beat analysts’ forecasts when their ability to manage accruals upward is constrained.
In a related vein, Zang (2007, p. 28) documents that managers use accrual and real
manipulations as substitutes in managing earnings. Using a sample of lawsuit firms, she Bloated balance
further finds that “accrual manipulation decreases and real manipulation increases after sheet
lawsuit filings, consistent with managers changing their earnings management
strategies in response to the increase in litigation risk and outside scrutiny”.

Hypotheses 125
As indicated in prior research (Matsumoto, 2002; Brown and Pinello, 2007; Zang, 2007),
both upward earnings management and downward forecast guidance entail costs.
Upward accrual-based earnings management is constrained by the flexibility within
GAAP and the scrutiny from auditors, investors and regulators. The main cost of doing
real earnings management is the sacrifice in shareholder value due to the departure from
optimal business decisions. Finally, guiding analysts’ forecast downward could cause a
negative stock price reaction at the forecast revision date. Both Brown and Pinello (2007)
and Zang (2007) predict that if costs of using one mechanism increase, the likelihood of
using alternative mechanisms is likely to increase in the process of achieving earnings
targets[3].
Barton and Simko (2002) argue that the balance sheet information would serve as an
earnings management constraint. Although managers are allowed to make judgments
and estimates in reporting their firms’ performance under GAAP, they do not have
unlimited discretion in doing so. In particular, because of the reversing nature of
accrual accounting, managers’ ability to manipulate earnings upward in the current
period is constrained by the amount of earnings optimism in prior periods. Also,
“because the balance sheet accumulates the effects of previous accounting choices, the
level of net operating assets partly reflects the extent of previous earnings
management” (p. 1). Following this argument, Barton and Simko (2002) predict that
managers’ ability to optimistically bias earnings (and therefore to report higher
amount of earnings surprises) by managing accruals upward in the current period is
constrained by the extent to which net assets are already overstated in the balance
sheet. Their empirical evidence is consistent with this prediction.
In this paper, we consider the degree of net asset overstatement in the balance sheet
as a constraint on upward accrual-based earnings management and examine how
managers trade off alternative mechanisms to avoid negative earnings surprises.
Although the balance sheet constraint curbs managers’ ability to use discretionary
accruals to manage earnings upward, it does not affect their ability to manage
analysts’ expectations downward or engage in real earnings management. If managers
trade off one mechanism for another, they are more likely to trade off upward
accrual-based earnings management in favor of either downward forecast guidance or
real activities manipulation when the degree of net asset overstatement is higher. Thus,
we test the following two hypotheses, stated in alternative form:
H1. The likelihood of guiding analysts’ forecasts downward is positively
related to the extent to which net assets are already overstated in the balance
sheet.
H2. The likelihood of using real activities manipulation to manage earnings
upward is positively related to the extent to which net assets are already
overstated in the balance sheet.
RAF III. Research methodology
11,2 Measure of net asset overstatement
Following Barton and Simko (2002), we use the beginning balance of net operating
assets relative to sales (NOA) as a proxy for the optimistic bias in the prior periods’
accounting choices. Net operating assets are defined as shareholders’ equity minus
cash and marketable securities, plus total debt.
126
Measure of forecast guidance
We use two models to compute a measure of forecast guidance, one based on
Matsumoto (2002) and the other based on Bartov et al. (2002).
Measure based on Matsumoto (2002). Following Matsumoto (2002), the annual
change in earnings for each firm i in industry j during year t is modeled as a function of
the prior year’s change in earnings and returns cumulated over the current year:
 
DEPSijt DEPSijt21
¼ ajt þ b1jt þ b2jt ðCRETijt Þ þ 1ijt ð1Þ
Pijt21 Pijt22

where:
DEPSijt ¼ earnings per share for firm i in two-digit SIC code j in year t, less
earnings per share for the same firm in year t 2 1, as reported in
I/B/E/S.
Pijt ¼ price per share for firm i in two-digit SIC code j at the end of year t, as
reported by annual COMPUSTAT (adjusted for stock splits).
CRETijt ¼ cumulative daily excess returns for firm i in two-digit SIC code j in year
t obtained from CRSP. Returns are cumulated from three days after the
year t 2 1 earnings announcement to 20 days before the year t
earnings announcement.
For each firm-year, we estimate model (1) cross-sectionally for each industry classified
by its two-digit SIC code. We also require at least ten companies in a particular
industry group for model inclusion. The parameter estimates from the prior firm-year
are used to determine the expected change in earnings per share (E[DEPS]):
   
DEPSijt21
E½DEPSijt
¼ ajt21 þ b1jt21 þ b2jt21 ðCRETijt Þ £ Pijt21 ð2Þ
Pijt22
The expected change in EPS is added to the earnings from the prior year to obtain an
estimate of the expected forecast of the current year’s earnings (i.e. E(FORE)). To
measure whether analysts’ earnings forecasts are guided downward, we compare the
actual forecast (i.e. the most recent forecast) prior to the yearly earnings announcement
date (i.e. FORE) and expected forecast, E(FORE). Similar to Matsumoto (2002),
a dichotomous variable DOWN is defined by comparing FORE and E(FORE) as follows:
.
DOWN ¼ 1 if FORE , E [FORE], indicating that actual forecast is less than the
estimated forecast, consistent with downward forecast guidance.
.
DOWN ¼ 0 if FORE . ¼ E [FORE], indicating that actual forecast is greater than
or equal to the estimated forecast, inconsistent with downward forecast guidance.
Bartov et al. (2002) model. Following Bartov et al. (2002), a firm-year observation is Bloated balance
characterized as having downward forecast guidance (i.e. DOWN ¼ 1) when:
sheet
. current actual earnings are less than the first forecast;
.
the last forecast is less than the first (i.e. earliest) forecast; and
.
current actual earnings are greater than or equal to the last (i.e. latest) forecast.
Otherwise, DOWN is 0.
127
To be included in this test, firm-year observations are required to satisfy the
following criteria:
.
at least two individual earnings forecasts (not necessarily by the same analyst)
that are at least 20 trading days apart exist for the year;
.
the release date of the first forecast is at least three trading days after the release
of the previous year’s earnings; and
.
the release date of the last forecast precedes the earnings release date of the
current year by at least three days.

Measure of real earnings management

Following Roychowdhury (2006) and Cohen et al. (2008), we use a firm’s abnormal level
of production costs and discretionary expenditures as proxies of real earnings
management. Specifically, we model the normal level of production costs and
discretionary expenditures as:
     
PRODijt 1 SALESijt DSALESijt
¼ ajt þ b1jt þ b2jt
Aijt21 Aijt21 Aijt21 Aijt21
  ð3Þ
DSALESijt21
þ b3jt þ 1ijt
Aijt21
   
DISEXPijt 1 SALESijt21
¼ ajt þ b1jt þ 1ijt ð4Þ
Aijt21 Aijt21 Aijt21
where:
PRODijt ¼ production costs for firm i in the two-digit SIC code j in year t. It is
defined as the sum of cost of goods sold and the change in
inventories.
Aijt2 1 ¼ total assets for firm i in the two-digit SIC code j in year t 2 1.
SALESijt ¼ sales revenues for firm i in the two-digit SIC code j in year t.
DSALESijt ¼ change in sales revenue for firm i in the two-digit SIC code j in year t.
DISEXPijt ¼ discretionary expenditures for firm i in the two-digit SIC code j in
year t, defined as the sum of advertising expenses, R&D expenses,
and SG&A.
For each firm-year, we estimate the cross-sectional regressions of both models (3) and
(4) for each two-digit SIC code and require that at least ten firms in a particular
industry for model estimation. The abnormal production costs and abnormal
RAF discretionary expenditures are computed as the difference between the actual values
11,2 and the normal levels estimated from models (3) and (4). Two dichotomous variables,
REAL1 and REAL2, are created as follows.
We assign a value of one to REAL1 if the firm’s actual production costs is greater
than the normal level predicted from equation (3), suggesting that the firm has engaged
in real earnings management by reporting lower cost of goods sold through increased
128 production. REAL1 is assigned a value of zero otherwise.
The value of REAL2 is equal to one if the firm’s discretionary expenditures are
lower than the normal level predicted from equation (4), suggesting that the firm has
engaged in real earnings management by reducing advertising, R&D and SG&A
expenses. The value of REAL2 is zero otherwise.

Control variables
In testing our hypotheses, we control for variables that:
.
affect managers’ incentives to engage in earnings management and/or forecast
guidance; and
.
capture other constraints of earnings management or forecast guidance.

We discuss them in turn.

Institutional ownership. Matsumoto (2002) finds that firms with higher institutional
ownership are more likely to engage in upward earnings management and downward
forecast guidance to avoid negative earnings surprises, a finding consistent with the
view that institutional investors often overemphasize near-term profits. However, there
is also evidence that institutional investors play a monitoring role in curbing the degree
of upward earnings manipulations. For example, Bushee (1998) finds that firms with
higher institutional ownership are less likely to reduce R&D spending to avoid
earnings decreases. Given the mixed findings, we do not predict the sign of
institutional ownership in our empirical tests. We control for this factor in our analysis
using INST, the percentage of total shares owned by institutions, as reported in the
Spectrum database.
Growth prospects. Skinner and Sloan (2002) document evidence that firms with
high-growth opportunities suffer larger asymmetric market reactions to negative
earnings surprises, suggesting that managers of high-growth firms have stronger
incentives to avoid negative earnings surprises. Consistent with this notion, Matsumoto
(2002) finds that high-growth firms are more likely to manage earnings upward and
guide analysts’ forecasts downward to meet market expectations. Brown and Pinello
(2007), however, document a negative association between a firm’s growth prospects
and its likelihood of doing upward earnings management and downward forecast
guidance. We use LTG, the market-to-book ratio, to proxy for a firm’s growth prospects.
Litigation risk. We control litigation risk because prior research (Matsumoto, 2002)
argues that firms facing greater litigation risk are more likely to take actions to avoid
negative earnings surprises. Indeed, Matsumoto (2002) documents a significant and
positive association between a firm’s litigation risk and its propensity to meet/beat
analysts’ forecasts; she, however, fails to find any significant relation between
litigation risk and firms’ propensity to engage in either earnings management or
forecast guidance. Zang (2007) finds that litigation risk is negatively associated with
the magnitude of accrual-based earnings management, a finding consistent with
the interpretation that firms with higher litigation risk are subject to more scrutiny Bloated balance
from auditors and regulators and therefore their ability to manipulate earnings using sheet
accruals is more constrained.
Following Francis et al. (1994), Matsumoto (2002) and Zang (2007), we control for
litigation risk by identifying firms in the industries classified as litigious: SIC codes
2833-2836 (biotechnology), 3570-3577 and 7370-7374 (computers), 3600-3674
(electronics), and 5200-5961 (retailing). A dummy variable, LIT, is included in our 129
analysis with a value of one if the firm is in the litigious industry and zero otherwise.
Value-relevance of earnings. Firms with low value-relevance of earnings are less
concerned with failing to meet analysts’ expectations because shareholders of such
firms likely react less strongly to negative earnings surprises (Matsumoto, 2002). Prior
studies (Hayn, 1995; Collins et al., 1997) document a lower association between returns
and earnings for loss firms. Degeorge et al. (1999) also suggest that managers of loss
firms are less likely to take actions to meet the earnings surprise threshold. Using a
lagged measure of consistent losses in prior years as a proxy for value-relevance of
earnings, Matsumoto (2002) finds a significantly negative relation between the
measure and the tendency to:
.
avoid negative earnings surprises;
.
manage earnings upward; and
.
guide forecasts downward.
Following her approach, we use a dummy variable, LOSS, to indicate whether a firm
reports consistent losses before extraordinary items in each of the last two years in
order to control this factor.
In addition, Matsumoto (2002) uses an industry-specific R 2 from a regression of
12-month returns on earnings to capture industry-specific differences in the
value-relevance of earnings[4]. Following her approach, we also employ this variable,
EARNRET, to measure the value-relevance of earnings.
Firm size. As a proxy for investor interest, firm size is also included as a control
variable in the analysis[5]. It has been shown that the analysts’ forecasts of larger firms
are less optimistically biased (Brown, 1997; Das et al., 1998). Matsumoto (2002) shows
that larger firms are more likely to meet or beat analysts’ earnings forecasts. Brown
and Pinello (2007) argue that the less optimistically biased analysts’ forecasts for larger
firms make it easier for their managers to avoid negative earnings surprises without
using earnings management. Consistent with this view, they find that larger firms are
less likely to engage in upward earnings management. We measure firm size (SIZE) by
using the log of the market value of equity.
Forecasting uncertainty. Following Matsumoto (2002) and Brown and Pinello (2007),
we control for uncertainty in the forecasting environment because managers facing
greater uncertainty may have more difficulty in managing earnings or guiding
forecasts to avoid negative surprises. The variable, FE, is included and computed as
the absolute value of the current year’s actual EPS minus the earliest forecast, scaled by
closing price at the end of the prior year.
In testing the relation between the extent of net assets overstatement and real
activities manipulation, we also consider two additional control variables. Following
Zang (2007), we use market share (MS) to control for firms’ leadership position
in the market. The argument is that “managers in market leader firms may perceive
RAF real earnings management as less costly since the erosion to their firms’ competitive
11,2 advantage is relatively small” (p. 17). MS is measured as the percentage of the firm’s
sales to the total sales of its industry (defined by using the three-digit SIC codes). Zang
(2007) further suggests that a firm’s cost structure may have an impact on its tendency
to use abnormal production costs for real earnings management. Specifically, firms
with higher operating leverage (i.e. higher fixed cost component in the cost structure)
130 are more likely to engage in overproduction than firms with lower operating leverage.
We follow her approach and include the fixed cost component, FC, in the analysis of
abnormal production costs. FC is measured using property, plant, and equipment
divided by sales.

Empirical models examining H1 and H2

The following logistic regression models are used to test the two hypotheses:

Prob ðDOWN ¼ 1Þ ¼ A0 þ A1 NOA þ A2 INST þ A3 LTG þ A4 LIT

þ A5 LOSS þ A6 EARNRET þ A7 FE þ A8 SIZE ð5Þ
þ A9j INDUSTRY þ A10j YEAR

ProbðREAL1 ¼ 1Þ ¼ B0 þ B1 NOA þ B2 INST þ B3 LTG þ B4 LIT

þ B5 LOSS þ B6 EARNRET þ B7 FE þ B8 SIZE ð6Þ
þ B9 MS þ B10 FC þ B11j INDUSTRY þ B12j YEAR

ProbðREAL2 ¼ 1Þ ¼ C0 þ C1 NOA þ C2 INST þ C3 LTG þ C4 LIT

þ C5 LOSS þ C6 EARNRET þ C7 FE þ C8 SIZE ð7Þ
þ C9 MS þ C10j INDUSTRY þ C11j YEAR
DOWN equals one if the actual forecast is less than the estimated forecast, consistent
with downward forecast guidance. DOWN equals zero otherwise. REAL1 equals one if
the actual production cost is greater than the normal level, an indicator that real
earnings management occurs by reporting lower cost of goods sold through increased
production. The value of REAL1 is zero otherwise. REAL2 equals one if the
discretionary expenditures are lower than the normal level, suggesting that the firm
engages in real earnings management by reducing advertising, R&D and SG&A
expenses. The value of REAL2 is zero otherwise. INDUSTRY is a control for
industry effects based on two-digit SIC codes and YEAR is a control for calendar year.
All other explanatory variables are as defined previously.

IV. Sample selection and descriptive statistics

Our sample consists of all firm-years spanning the 11-year period, 1996-2006. Because
firms in regulated industries are likely to have different incentives than those in
non-regulated industries, we exclude utilities and financial services firms (two-digit
SIC codes 49 and 60-67). We also focus on firms with December 31 fiscal year end to
facilitate certain parts of data analysis. Our analyses require data from the IBES,
Compustat, Spectrum, and CRSP databases. For H1, the final sample includes
11,431 (12,293) firm-year observations based on the Matsumoto (2002)
(Bartov et al., 2002) model. For H2, the final sample consists of 7,053 firm-year
observations in the production cost regression and 9,559 firm-year observations in the Bloated balance
discretionary expenditures regression. sheet
Descriptive statistics on the dependent and explanatory variables are presented in
Table I. Mean DOWN indicates that approximately 53 percent of firm-year
observations are associated with a negative unexpected forecast, an indication of
downward forecast guidance[6]. Mean REAL1 indicates that upward earnings
management by lowering cost of goods sold through overproduction occurs in 131
Variable Mean SD Median 25% 75%

DOWN 0.527 0.499 1.000 0.000 1.000

REAL1 0.486 0.499 0.000 0.000 1.000
REAL2 0.610 0.488 1.000 0.000 1.000
NOA 5.084 5.226 3.497 2.389 5.479
INST 0.570 0.253 0.602 0.381 0.774
LTG 3.262 3.447 2.421 1.532 3.891
LIT 0.264 0.441 0.000 0.000 1.000
LOSS 0.132 0.338 0.000 0.000 0.000
EARNRET 5.026 2.712 5.000 3.000 7.000
SIZE 6.614 1.788 6.471 5.347 7.712
FE 0.026 0.116 0.006 0.002 0.022
MS 0.141 0.277 0.021 0.004 0.152
FC 0.854 1.836 0.430 0.251 0.767
Notes: DOWN equals one if the actual forecast is less than the estimated forecast, in this case,
managers are suspected of managing forecasts downward, DOWN equals zero otherwise; the numbers
reported in this table are based on the Matsumoto (2002) model; REAL1 is equal to one if the actual
production cost is greater than the normal level predicted from equation (1), in this case, managers are
suspected of engaging in real earnings management by reporting lower cost of goods sold through
increased production, the value of REAL1 is zero otherwise; REAL2 is equal to1 if the actual
discretionary expenditures are lower than the normal level predicted from equation (2), in this case,
managers are suspected of engaging in real earnings management by reducing advertising, R&D and
SG&A expenses, the value of REAL2 is zero otherwise; NOA proxies for the optimistic bias in prior
periods’ accounting choices and equals the beginning balance of net operating assets relative to sales,
net operating assets are defined as shareholders’ equity minus cash and marketable securities, plus
total debt, INST is the percentage of a firm’s total shares owned by institutional investors, as reported
in the Spectrum database; LTG proxies for the firm’s growth prospects and is equal to market value of
equity divided by book value of equity as of the end of the current year; LIT is a dummy variable with
the value of 1 if the firm is in the litigious industry and 0 otherwise, the following industries are
classified as litigious: SIC codes 2833-2836 (biotechnology), 3570-3577 and 7370-7374 (computers),
3600-3674 (electronics), and 5200-5961 (retailing); LOSS is a dummy variable with the value of 1 if the
firm reports consistent losses before extraordinary items in each of the last two years and 0 otherwise;
EARNRET is the measure of value-relevance of earnings; specifically, we regress excess daily returns
(cumulated from three days after the year t 2 1 earnings announcement to three days after the year t
earnings announcement) on the change in earnings per share from year t 2 1 to year t, scaled by price
per share at the end of year, t 2 1; we run regressions by year for each four-digit SIC code and use the
yearly decile rank of the industry’s R 2 as the value of EARNRET; SIZE is the logarithm value of
the firm’s market value of equity; FE is a proxy for the firm’s forecasting uncertainty and equals the
absolute value of the difference between the current year’s actual EPS and the earliest analyst forecast,
scaled by price at the end of the prior year; MS is a proxy for the firm’s leadership position in the
industry; it is computed as the percentage of the firm’s sales to the total sales of its industry (defined by
using the three-digit SIC codes); FS is the fixed cost component in the firm’s cost structure; it is Table I.
measured as the total value of property, plant, and equipment divided by sales Descriptive statistics
RAF the 48 percent of firm-year observations. Mean REAL2 indicates that upward earnings
11,2 management by reducing R&D, advertising, and SG&A spending occurs in the
61 percent of firm-year observations.
Table I also shows that the mean and median NOA is 5.084 and 3.497, respectively.
Nearly 27 percent of the firm-years in the sample are from firms in high-litigation-risk
industries. Relatively a small portion of the firm-years in the sample (13 percent) have a
132 consistent history of prior losses. In addition, the average firm has a logarithm market
value of equity (SIZE) of $6.61 and is associated with a 57 percent institutional ownership
(INST) and market-to-book ratio (LTG) of 3.262. Finally, the mean market share (MS) for
the sample firms is 0.141 and the mean ratio of PPE to sales (FC) is 0.854[7].
Table II presents a correlation matrix of all independent variables to assess the
degree of multicollinearity within the regressions (5) through (7). As shown, while the
overwhelming majority of correlations are statistically significant, the magnitudes of
many of them are not particularly large. We also conduct collinearity diagnostics using
variance inflation factors. The analysis indicates that all variance inflation factors are
less than 10, suggesting collinearity is not a serious concern.

V. Results
Test of H1 (forecast guidance hypothesis)
Our first hypothesis predicts that the likelihood of engaging in downward forecast
guidance is positively related to the extent to which the balance sheet is already
bloated. The prediction is based on the argument that when the balance sheet
constraint curbs the managers’ ability to manipulate accruals, managers are likely to
respond by using downward forecast guidance to meet earnings expectations[8].
\Table III shows the results of testing H1 based on the Matsumoto (2002) model. We
first present the results for the full sample where we test the relation between NOA and
downward forecast guidance regardless of whether the firm achieves the earnings
surprise threshold (i.e. meeting or beating analysts’ forecasts). As predicted, the coefficient
on NOA for the full sample is positive and significant ( p , 0.01), suggesting that firms
with higher amount of NOA are more likely to guide analysts’ forecasts downward.
Table III also displays the results for the restricted sample where we test the
relation between NOA and downward forecast guidance by limiting our sample to
observations with nonnegative earnings surprises (i.e. firms that either meet or beat
analysts’ forecasts). Similar to the results of full sample, the coefficient on NOA is
positive and significant ( p , 0.01), indicating that managers make increased use of the
less constrained forecast guidance mechanism to avoid negative earnings surprises
when the balance sheet constraint reduces their ability to engage in accrual-based
earnings management.
In addition, Table III shows that, for both the full and restricted samples, LTG is
negatively related to the tendency to engage in downward forecast guidance, a finding
consistent with Brown and Pinello (2007). In line with Matsumoto (2002), LOSS is
negative and SIZE is positive. Both coefficients are significant at the 1 percent level.
The findings support the arguments that:
.
firms with consistent prior losses are less likely to manage analysts’ expectations
because such firms are associated with lower value-relevance of earnings; and
.
larger firms are more likely to engage in downward forecast guidance because
their analysts’ forecasts contain less optimistic bias.
 NOA INST LTG LIT LOSS EARNRET FE SIZE FC MS

NOA 2 0.041 * * * 2 0.053 * * * 2 0.103 * * * 0.261 * * * 2 0.084 * * * 0.038 * * * 0.046 * * * 0.557 * * * 2 0.092 * * *
INST 0.046 * * * 0.031 * * * 2 0.066 * * * 2 0.227 * * * 0.083 * * * 2 0.098 * * * 0.421 * * * 2 0.080 * * * 0.210 * * *
LTG 20.115 * * * 0.074 * * * 0.095 * * * 0.054 * * * 2 0.102 * * * 2 0.086 * * * 0.258 * * * 2 0.021 * 0.001
LIT 20.151 * * * 2 0.064 * * * 0.098 * * * 0.052 * * * 2 0.103 * * * 2 0.018 * 2 0.050 * * * 2 0.090 * * * 2 0.242 * * *
LOSS 0.175 * * * 2 0.224 * * * 0.023 * * 0.052 * * * 2 0.185 * * * 0.110 * * * 2 0.255 * * * 0.209 * * * 2 0.199 * * *
EARNRET 20.075 * * * 0.086 * * * 2 0.114 * * * 2 0.092 * * * 2 0.188 * * * 0.006 0.063 * * * 2 0.042 * * * 0.210 * * *
FE 0.012 2 0.302 * * * 2 0.314 * * * 2 0.034 * * * 0.194 * * * 2 0.009 2 0.146 * * * 0.057 * * * 2 0.074 * * *
SIZE 0.184 * * * 0.468 * * * 0.353 * * * 2 0.068 * * * 2 0.267 * * * 0.069 * * * 2 0.392 * * * 2 0.057 * * * 0.485 * * *
FC 0.548 * * * 2 0.056 * * * 2 0.055 * * * 2 0.177 * * * 0.235 * * * 2 0.036 * * * 0.112 * * * 0.083 * * * 2 0.071 * * *
MS 0.001 0.341 * * * 2 0.028 * * 2 0.380 * * * 2 0.396 * * * 0.300 * * * 2 0.215 * * * 0.597 * * * 0.009
Notes: Significant at: *10, * *5 and * * *1 percent levels for a two-tailed test; the Pearson (Spearman) correlations are above (below) the diagonal
Bloated balance
sheet

independent variables
Correlations among
133

Table II.
RAF Variable Predicted Sign Full sample (n ¼ 11,431) Restricted sample (n ¼ 7,651)
11,2
Intercept ^ 0.468 * * * 0.547 * * *
NOA þ 0.017 * * * 0.017 * * *
INST ^ 2 0.089 20.138
LTG ^ 2 0.024 * * * 20.025 * * *
134 LIT ^ 2 0.008 20.046
LOSS – 2 0.848 * * * 20.786 * * *
EARNRET þ 2 0.015 * 20.010
FE – 1.466 * * * 0.584
SIZE ^ 0.054 * * * 0.049 * * *
Wald x 2 1071.632 * * * 753.875 * * *
Notes: Significant at: *10, * *5 and * * *1 percent levels for a two-tailed test:
ProbðDOWN ¼ 1Þ ¼ A0 þ A1 NOA þ A2 INST þ A3 LTG þ A4 LIT þ A5 LOSS þ A6 EARNRET
þ A7 FE þ A8 SIZE þ A9j INDUSTRY þ A10j YEAR
for the “full sample”, we test the elation between NOA and downward forecast guidance regardless of
Table III. whether the firm achieves the earnings surprise threshold (i.e. meeting or beating analysts’ forecasts);
Logistic analysis of the for the restricted sample, we test the relation between NOA and downward forecast guidance by
probability of downward limiting our sample to observations with nonnegative earnings surprises (i.e. firms that either meet or
forecast guidance, NOA, beat analysts’ forecasts)
and control variables Source: Based on Matsumoto (2002) model

Contrary to Matsumoto (2002), however, we find that FE is positively related to the

tendency to use downward forecast guidance. The result is significant at the 1 percent
level for the full sample but it turns insignificant for the restricted sample. Finally,
the sign on EARNRET is negative and significant at the 10 percent level for the full
sample and it turns insignificant for the restricted sample[9].
As mentioned earlier, we also measure downward forecast guidance using the model
employed by Bartov et al. (2002). The results are reported in Table IV. As shown, the
results based on the Bartov et al. (2002) model are somewhat weaker than those based on
the Matsumoto (2002) model. Specifically, the positive relation between NOA and
downward forecast guidance is not significant for the full sample. However, we find a
significant and positive association ( p ¼ 0.05) between NOA and downward forecast
guidance for the restricted sample, indicating that firms are more likely to use
downward forecast guidance to avoid negative earnings surprises when their ability to
manipulate income-increasing accruals is constrained by the extent to which the balance
sheet is already bloated.

Test of H2 (real earnings management hypothesis)

Tables V and VI show the results for H2. In the production cost regression (Table V),
the coefficient on NOA for the full sample is positive and significant ( p , 0.01),
suggesting that the likelihood of managing earnings upward by increasing production
(therefore lowering cost of goods sold) is positively associated with the extent to which
net assets are already overstated on the balance sheet. The results are similar for the
restricted sample. The evidence supports H2 and is consistent with a substitution
effect between the accrual-based and real earnings management.
 Bloated balance
Variable Predicted sign Full sample (n ¼ 12,293) Restricted sample (n ¼ 8,216)
sheet
Intercept ^ 2 1.056 * * * 20.135
NOA þ 0.002 0.012 * *
INST ^ 0.100 0.129
LTG ^ 2 0.019 * * * 20.017 * * *
LIT ^ 0.071 0.008 135
LOSS 2 2 0.372 * * * 20.382 * * *
EARNRET þ 2 0.016 * 20.018 *
FE 2 2 1.021 * * * 21.558 * * *
SIZE ^ 0.053 * * * 0.008
Wald x 2 982.790 * * * 1057.915 * * *
Notes: Significant at: *10, * *5 and * * *1 percent levels for a two-tailed test:
ProbðDOWN ¼ 1Þ ¼ A0 þ A1 NOA þ A2 INST þ A3 LTG þ A4 LIT þ A5 LOSS þ A6 EARNRET
þ A7 FE þ A8 SIZE þ A9j INDUSTRY þ A10j YEAR
for the “full sample”, we test the relation between NOA and downward forecast guidance regardless of
whether the firm achieves the earnings surprise threshold (i.e. meeting or beating analysts’ forecasts); Table IV.
for the restricted sample, we test the relation between NOA and downward forecast guidance by Logistic analysis of the
limiting our sample to observations with nonnegative earnings surprises (i.e. firms that either meet or probability of downward
beat analysts’ forecasts) forecast guidance, NOA,
Source: Based on Bartov et al. (2002) model and control variables

Variable Predicted sign Full sample (n ¼ 7,053) Restricted sample (n ¼ 4,735)

Intercept ^ 20.328 * 20.393

NOA þ 0.037 * * * 0.036 * * *
INST ^ 0.142 0.225
LTG ^ 20.065 * * * 20.078 * * *
LIT ^ 21.132 * * * 21.046 * * *
LOSS 2 0.603 * * * 0.724 * * *
EARNRET þ 0.086 * * * 0.092 * * *
FE 2 1.794 * * * 1.098
SIZE ^ 20.079 * * * 20.052 * *
MS þ 0.130 * * * 0.105 * * *
FC þ 0.021 20.011
Wald x 2 617.776 * * * 392.824 * * *
Notes: Significant at: *10, * *5 and * * *1 percent levels for a two-tailed test:
ProbðREAL1 ¼ 1Þ ¼ B0 þ B1 NOA þ B2 INST þ B3 LTG þ B4 LIT þ B5 LOSS þ B6 EARNRET
þ B7 FE þ B8 SIZE þ B9 MS þ B10 FC þ B11j INDUSTRY þ B12j YEAR Table V.
Logistic analysis of the
for the “full sample”, we test the relation between NOA and abnormal production costs regardless of probability of reporting
whether the firm achieves the earnings surprise threshold (i.e. meeting or beating analysts’ forecasts); lower cost of goods sold
for the restricted sample, we test the relation between NOA and abnormal production costs by limiting through increased
our sample to observations with nonnegative earnings surprises (i.e. firms that either meet or beat production, NOA, and
analysts’ forecasts) control variables
RAF
Variable Predicted sign Full sample (n ¼ 9,559) Restricted sample (n ¼ 6,452)
11,2
Intercept ^ 20.572 * * * 20.657 * * *
NOA þ 0.052 * * * 0.112 * * *
INST ^ 0.526 * * * 0.655 * * *
LTG ^ 20.784 * * * 20.144 * * *
136 LIT ^ 21.171 * * * 21.156 * * *
LOSS 2 20.833 * * * 20.921 * * *
EARNRET þ 0.059 * * * 0.064 * * *
FE 2 20.099 0.139
SIZE ^ 0.240 * * * 0.191 * * *
MS þ 0.003 0.145
Wald x 2 1064.830 * * * 777.112 * * *
Notes: Significant at: *10, * *5 and * * *1 percent levels for a two-tailed test:
ProbðREAL2 ¼ 1Þ ¼ C0 þ C1 NOA þ C2 INST þ C3 LTG þ C4 LIT þ C5 LOSS þ C6 EARNRET
þ C7 FE þ C8 SIZE þ C9 MS þ C10j INDUSTRY þ C11j YEAR
Table VI.
Logistic analysis of the for the “full sample”, we test the relation between NOA and discretionary expenditures regardless of
probability of reducing whether the firm achieves the earnings surprise threshold (i.e. meeting or beating analysts’ forecasts);
discretionary for the restricted sample, we test the relation between NOA and discretionary expenditures by limiting
expenditures, NOA, our sample to observations with nonnegative earnings surprises (i.e. firms that either meet or beat
and control variables analysts’ forecasts)

The results in Table VI are also consistent with H2. Specifically, the coefficient on
NOA is significantly positive for both full and restricted samples, indicating that firms
with higher NOA are more likely to engage in real earnings management by reducing
the discretionary expenditures in R&D, advertising and SG&A. Taken together, the
results in Tables V and VI suggest that although the balance sheet constraint can
mitigate accrual-based earnings management, managers in these situations react by
increasing real earnings management.
With respect to control variables, Table V indicates that the likelihood of engaging in
real earnings management by increasing production is significantly higher for firms
with:
.
consistent losses in prior years (LOSS);
.
higher value-relevance of earnings (EARNRET);
.
higher uncertainty in forecasting environment (FE); and
.
higher market share (MS).

The likelihood, however, is significantly and negatively associated with litigation risk
(LIT), growth prospect (LTG), and firm size (SIZE).
The results in Table VI show that firms with higher litigation risk, consistent losses
in prior years, and higher growth prospect are less likely to reduce discretionary
spending for managing earnings upward. On the other hand, firms with higher
institutional ownership, larger size, and higher value-relevance of earnings are more
likely to use discretionary spending as an earnings management tool. Finally, there is
no evidence that firms with higher market share has higher tendency to engage in real
earnings management via curbing discretionary spending.
VI. Concluding remarks Bloated balance
In this paper, we examine the role of the balance sheet as a constraint on accrual-based sheet
earnings management and its impact on the trade offs between accrual-based earnings
management, real earnings management, and forecast guidance in managing earnings
surprises. Prior research by Barton and Simko (2002) suggests that GAAP-imposed
constraints on accounting choices put upper limits on the extent to which managers can
engage in upward accrual-based earnings management. In particular, they argue that 137
managers’ accounting choices reflected in earnings are also reflected in net asset values,
and such choices are constrained because all asset and liability measurements must be in
conformity with GAAP. Thus, managers’ ability to optimistically bias earnings in
the current period is a declining function of earnings optimism in the previous period.
Consistent with their prediction, they find that firms with larger amount of overstated
net asset values are less likely to meet or beat analysts’ earnings forecasts.
Our study extends Barton and Simko (2002) by examining how the balance sheet
constraint affects the mechanisms used by managers to avoid negative earnings
surprises. Although the balance sheet constraint curbs managers’ ability to use
discretionary accruals to manage earnings upward, it does not affect their ability to
engage in real earnings management or downward forecast guidance. If managers
trade off one mechanism for another, they are likely to trade off upward accrual-based
earnings management in favor of either real activities manipulation or downward
forecast guidance when the degree of net asset overstatement is higher.
Based on 1996-2006 annual data for a sample of nonfinancial, nonregulated
firms, we find that firms with higher level of beginning net operating assets relative to
sales are:
.
more likely to engage in real activities manipulation through slashing
discretionary spending and increasing production; and
.
more likely to guide analysts’ earnings forecasts downward.

These results hold after we control for several variables that:

.
affect managers’ incentives to engage in earnings management and/or forecast
guidance; and
.
capture other constraints of earnings management or forecast guidance.

Overall, our findings suggest that managers use either real earnings management or
downward forecast guidance as an alternative way to avoid negative earnings
surprises when their ability to manipulate accruals is constrained by the extent to
which net assets are already overstated in the balance sheet.

Acknowledgements
The authors appreciate the valuable comments provided by the seminar participants at
the University of Texas at Arlington and 2010 American Accounting Association
Annual Meeting. The authors also gratefully acknowledge Thomson Financial for
providing earnings per share forecast data, available through the Institutional Brokers
Estimate System (I/B/E/S) as part of a broad academic program to encourage earnings
expectation research.
RAF Notes
11,2 1. In particular, they find that, relative to interim reporting, annual reporting reduces the
incidence of both income-increasing accrual-based earnings management and negative
earnings surprises avoidance, but raises the incidence of downward earnings
forecast guidance. This finding is consistent with the view that managers’ ability to
engage in upward accrual-based earnings management is more constrained in annual than
in interim periods because “the annual reporting process is more rigorous than the interim
138 reporting process by allowing for less discretion over expense recognition and requiring an
independent audit” (p. 953).
2. In addition to the capital market incentive, managers are also concerned with the reputational
effects of failing to meet earnings expectations. For example, according to Graham et al. (2005),
about 60 percent (75 percent) of the survey respondents indicated that maintaining firm (their
own) reputation is another important incentive to achieve earnings targets.
3. As we consider the substitute relation among the three mechanisms, one possible scenario is
that a firm is likely to first engage in upward accrual-based earnings management because it
is able to fly below the GAAP radar and not draw undue attention to itself from its auditors,
investors and regulators. If earnings surprises could still not be avoided, the mechanism of
engaging in activities that guide analysts’ to lower their forecasts might be employed next.
Finally, if this mechanism fails to eliminate a negative earnings surprise completely, the most
costly method of real earnings management might be considered as a last resort. We thank
the reviewer for pointing out this to us.
4. Specifically, we regress excess daily returns (cumulated from three days after the year t 2 1
earnings announcement to three days after the year t earnings announcement) on the change
in earnings per share from year t 2 1 to year t, scaled by price per share at the end of year
t 2 1. We run regressions by year for each four-digit SIC code and use the yearly decile rank
of the industry’s R 2 as the second proxy for value-relevance (EARNRET).
5. We also use the number of analysts following as the proxy for investor interest. The results
are essentially the same as those based on firm size.
6. The result is based on the Matsumoto (2002) model. When the Bartov et al. (2002) model is
used, only 37.64 percent of the observations are characterized as downward guidance. This
finding is consistent with Brown and Higgins (2005) and shows that the Bartov et al. (2002)
model is more restrictive as it classifies fewer observations as downward guidance than the
Matsumoto (2002) model.
7. As a preliminary analysis, we test whether DOWN, REAL1, REAL2 are generally an
increasing function of NOA. To this end, we partition all sample observations into five
portfolios with firms in quintile 1 having the lowest NOA and firms in quintile 5 having
the highest NOA. The results indicate that, although the increase is not monotonic, we see
the general pattern that the probability of using downward forecast guidance and real
activities manipulation increases from the bottom to the top quintile of NOA. For each
measure, we perform a t-test to examine the difference between the top and bottom quintiles
and find that all the differences are significant at the 1 percent level.
8. An important assumption behind our hypothesis development is that NOA effectively proxies
for the constraint role of balance sheet in curbing accrual-based earnings management. To
check the validity of this assumption, we test whether NOA is negatively associated with the
accrual-based earnings management in the current period. To this end, we estimate abnormal
accruals using the modified Jones model described in Dechow et al. (1995). Based on
10,193 firm-year observations over the 1996-2006 period, we find that NOA is significantly and
negatively correlated with the amount of abnormal accruals (the level of significance is
1 percent in both Pearson and Spearman correlation tests). We also partition all sample
 observations into five portfolios with firms in quintile 1 having the lowest NOA and firms in Bloated balance
quintile 5 having the highest NOA. Our analysis indicates that the average value of abnormal
accruals for quintile 1 is 0.011 and that is 2 0.004 for quintile 5. A t-test indicates that abnormal sheet
accruals in the top quintile (i.e. quintile 5) of NOA are lower than those for firms in the bottom
quintile (i.e. quintile 1) of NOA at the 2 percent significance level. This result provides further
support for the argument that NOA captures the optimism in the prior-period accounting
choices and therefore reduces managers’ ability to manipulate accruals in the current period.
9. We also perform the logistic regression analysis to test whether NOA affects firms’
139
propensity to meet or beat analysts’ earnings forecasts. Specifically, we use the regression
model (5) with the dependent variable, MEET, being equal to one if earnings surprises are
non-negative and zero otherwise. Consistent with Barton and Simko (2002), we find that
firms with higher NOA are less likely to meet or beat analysts’ expectations.

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Further reading
Dechow, P., Richardson, S. and Tuna, I. (2003), “Why are earnings kinky? An examination of the
earnings management explanation”, Review of Accounting Studies, Vol. 8, pp. 355-84.

About the authors

Li-Chin Jennifer Ho is a Professor of Accounting at the University of Texas at Arlington. She earned
her PhD degree from the University of Texas at Austin. Professor Ho has published articles in The
Accounting Review, Financial Review, Review of Quantitative Finance and Accounting, Journal of
International Financial Management and Accounting, and many other journals. Currently, she
mainly teaches cost/managerial accounting and capital market research seminars.
Li-Chin Jennifer Ho is the corresponding author and can be contacted at: lichinho@uta.edu
Chao-Shin Liu is an Associate Professor of Accountancy at the University of Notre Dame.
He earned his PhD degree from the University of Illinois. Professor Liu has published articles in
The Accounting Review, Journal of Accounting Research, Contemporary Accounting Research,
Review of Accounting Studies, the FASB Research Supplement and other accounting and finance
journals. Currently, he mainly teaches corporate financial reporting.
Bo Ouyang is an Assistant Professor of Accounting at Pennsylvania State University Great
Valley. He earned his PhD degree from the University of Texas at Arlington. His research
interests include corporate governance and auditing. He teaches financial accounting and
financial statement analysis courses.

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