Discussion of the Balance Sheet as an Earnings Management Constraint - Vol. 77 Supplement 2002

Aug 31, 2026

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The discussion evaluates earnings management research centered on a balance sheet constraint created by double-entry accounting and GAAP measurement requirements. It explains how managers’ income-increasing judgments can be limited when net assets must be recognized and measured in conformity with GAAP. The analysis also addresses why firms may miss analysts’ forecasts by small amounts, and why investors may find balance sheet information useful when interpreting quarterly earnings announcements.

LanguageEnglish

CategoryResearch & Report

FormatPDF

Pages5

Reading Time13 min

AccessFree to download

Introduction

Double-entry accounting and GAAP constraints

Explaining small forecast misses

Investor use of balance sheet information

Incentive-based empirical testing

Empirical Measures of Balance-Sheet-Based Earnings Management Constraints

Definition vs. the empirical measures

THE ACCOUNTING REVIEW Vol. 77 Supplement 2002 pp. 29–33 DISCUSSION OF The Balance Sheet as an Earnings Management Constraint Mark L. DeFond University of Southern California 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. 30 The Accounting Review, 2002 Supplement Finally, the paper’s approach to investigating earnings management follows suggestions in recent articles that review and critique prior earnings management research. Speciﬁcally, the paper’s primary analysis examines evidence of earnings management conditioned on managerial incentives to achieve capital market-based earnings targets, as opposed to accounting-based earnings targets. Dechow and Skinner (2000) and Healy and Wahlen (1999), among others, argue that tests of earnings management should be based on capital market incentives because managers are likely to be more strongly motivated by market incentives than by accounting-based incentives. This motivation is likely to be particularly strong during the period the paper analyzes (1993–1999) because of the emphasis on stockbased rewards to managers over this period (Dechow and Skinner 2000) . Overall, the authors address an interesting question, perform a careful analysis, and ﬁnd some intuitive relations that add to the earnings management literature. Like all research, however, the paper has limitations. Sections II through IV of this discussion focus on problems of empirically capturing

FAQs

How does double-entry accounting connect the balance sheet to earnings management constraints?

Raising reported earnings through judgments increases net assets as well, but those net asset effects must be measured and recognized in conformity with GAAP. GAAP-imposed measurement limits therefore constrain how far managers can opportunistically increase reported earnings.

Why might firms miss analysts’ forecasted earnings by as little as one cent per share?

The discussion highlights circumstances where managers cannot boost earnings by small increments because balance-sheet-based constraints restrict the extent of opportunistic reporting, even when intuition suggests that judgment could be used to reach targets.

How are balance sheet disclosures useful during quarterly earnings announcements?

The findings imply that balance sheet information can help investors interpret why managers miss forecasted earnings. This demand aligns with evidence of increased disclosure around earnings announcement dates, suggesting managers may add disclosures to supplement that information.

Aug 31, 2026

Upload by Oliver