Performance-Expectation Ratcheting and Earnings Management

This study finds that asymmetric performance-expectation ratcheting is prevalent across publicly traded firms. Asymmetric ratcheting occurs when a favorable performance variance (i.e., positive unexpected performance) in the prior year leads to a greater absolute change in the current year's performance expectation than does an unfavorable performance variance of the same magnitude. This paper shows that such ratcheting affects managers' earnings management decisions. Specifically, when a firm performs well in interim quarters (the first three fiscal quarters), managers facing intensive ratcheting attempt to decrease the reported earnings of the fourth quarter to build more "reserves and rein in the increase of expectations for the future, compared to managers under little or no ratcheting. When underlying performance exceeds current performance expectations, managers under intensive ratcheting engage in income-decreasing accruals and real activities manipulation (i.e., sales manipulation, changes in discretionary expenses including R&D and SG&A, and underproduction). In addition, managers facing intensive ratcheting prefer to use discretionary accruals to manage earnings downward when there is a transitory earnings increase.