Does the Balance Sheet Prevent Managers from Hiding Bad News? Evidence from Firm-Specific Crash Risk

Abstract

I examine whether the balance sheet serves as a binding control mechanism that prevents managers from withholding bad news from outside investors. I predict that firms with bloated balance sheets are more likely to suffer stock price crashes. I use net operating assets scaled by total assets (NOA) as my proxy for balance sheet bloat; I use three measures of residual returns distribution to capture firm-specific crash risk: extreme negative outliers below the mean weekly returns (CRASH), negative skewness (NCSKEW), and down-to-up asymmetric volatility (DUVOL). While beginning NOA is negatively associated with next period CRASH, I find a positive relation between beginning NOA and NCSKEW as well as DUVOL before the Sarbanes-Oxley Act (SOX). NOA’s predicative power has largely dissipated since the passage of SOX. This finding is consistent with that in Cohen et al. [2008] that managers substitute away from accounting manipulation in response to the heightened outside monitoring in the post-SOX world.