| Asymmetric ratcheting means that 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 study finds that asymmetric performance-expectation ratcheting is prevalent across publicly traded firms. It also finds that the extent of performance-expectation ratcheting is positively associated with the strength of external governance (i.e., shareholder rights). This paper also shows that such ratcheting affects earnings management decisions. Specifically, when a firm performs well in interim quarters (i.e., 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, when there is a temporary earnings increase, managers facing intensive ratcheting tend to use real activities to manage earnings downward. The results are robust after controlling for various factors. |
