The Balance Sheet as an Earnings Management Constraint

The balance sheet accumulates the effects of previous accounting choices, so the level of net assets partly reflects the extent of previous earnings management. We predict that managers' ability to optimistically bias earnings decreases with the extent to which the balance sheet overstates net assets relative to a neutral application of GAAP. To test this prediction, we examine the likelihood of reporting various earnings surprises for 3,649 firms during 1993-1999. Consistent with our prediction, we find that the likelihood of reporting larger positive or smaller negative earnings surprises decreases with our proxy for overstated net asset values.