Discussion of the balance sheet as an earnings management constraint.

I. INTRODUCTION

Barton and Simko (2002) (hereafter the paper) contribute to the earnings management literature by suggesting that earnings management is constrained by the fundamental characteristic of double entry accounting that links the balance sheet with the income statement: managerial judgments and estimates that increase earnings will also increase net assets, but such increases are limited by the necessity to recognize and measure net assets in conformity with GAAP. The paper's evidence is essentially consistent with the view that GAAP-imposed constraints on asset and liability measurements put upper limits on the extent to which managers can opportunistically increase reported earnings. Relative to prior earnings management research, which tends to focus on the income statement implications of managed earnings and the role of forces such as auditing and litigation outside of the accounting process to constrain earnings management, this paper is distinguished by its focus on the balance sheet and the role of accounting standards as constraints on earnings management.

The paper also contributes to the earnings management literature by offering an explanation for why some firms fall short of analysts' forecasted earnings by as little as one cent per share. Explaining this behavior is important because several recent papers find that investors impose large penalties on firms that just miss analysts' forecasts (Skinner and Sloan 2001; Dechow et al. 2000; Bartov et al. 2002; DeFond and Park 2002). While intuition suggests that managers should be able to exercise their reporting judgment to boost earnings by one cent per share, the paper identifies circumstances where this is not the case.

An additional contribution of the paper is that the study identifies a setting where market participants are likely to find balance sheet information useful in interpreting quarterly earnings announcements. The paper's findings suggest that information in balance sheets may help investors understand why managers miss forecasted earnings. Identifying a demand for financial information to assist investors in interpreting quarterly earnings at the earnings announcement date is consistent with recent research that finds increased disclosure of a variety of financial information concurrently with earnings announcements (Francis et al. 2002; Chen et al. 2002). Although this is not the authors' intent, the paper's findings imply that managers may provide these additional disclosures in response to investor demand for information to supplement quarterly earnings announcements.