The effect of earnings management constraints on financial reporting decisions
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This study extends recent research by Barton and Simko (2002) by examining whether earnings management constraints embedded within generally accepted accounting principles (GAAP) affect financial reporting outcomes beyond whether firms meet or beat earnings benchmarks. Specifically, this study tests whether earnings management constraints increase the likelihood that management will record an accounting write-off and whether this association depends on the amount by which earnings fall short of the benchmark. Using a sample of 51,581 firm-year observations for 5,739 firms during the years 1976-2000, this study regresses the likelihood of accounting write-offs on the extent to which managers face earnings management constraints relative to meeting an earnings benchmark, the amount by which earnings fall short of this benchmark, the interaction between these measures, and control variables. Consistent with expectations, this study finds a positive association between the extent of earnings management constraints in the current period and managers’ accounting write-off decisions. The results also show that the marginal effect of earnings management constraints on the write-off is inversely related to the amount of the benchmark shortfall. This evidence suggests that managers are more likely to record a write-off when earnings management constraints limit their ability to avoid reporting earnings that just slightly miss the benchmark, thus providing a second possible explanation for the disproportionately low observed frequencies of firms reporting small losses reported by Burgstahler and Dichev (1997).