Bloated balance sheet, earnings management, and forecast guidance

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. 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. 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. 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. 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.