Management Earnings Forecasts and Target Ratcheting: From the Perspective of Abnormal Accruals

Abstract

This paper analyzes earnings management for the current year and the revision of management earnings forecasts (MEF) for the next year. It reports that the ratchet effect can be observed at the managerial level. Principals, who do not hold as much comprehensive information on productivity as agents do, determine the future budget based on past performance. This tendency of target ratcheting may cause a ratchet effect, wherein agents reduce their effort to prevent future budgets from being revised upward. First, in the relationship with shareholder as the principal and manager as the agent, evidence that target ratcheting can be observed in MEF is presented. Next, the study assumes two managers with different unmanaged earnings forecasts for the next year in order to analyze abnormal accruals manipulated by them in the current year, and the MEF revision for the next year—one includes management who attains the current year’s MEF, but predicts earnings decline for the next year (TRANSIT), while the other attains the current year’s MEF, but predicts earnings increase the next year (PERSIS). Consistent with the ratchet effect, both TRANSIT and PERSIS reduce accruals in the current period. Finally, the relationship between abnormal accruals of the current year and the revision of MEF for the next year are analyzed. The results show that the ratchet effect is only observed in TRANSIT. These results suggest that the managerial difficulty of the consecutive earnigs increases is a necessary condition for the ratchet effect to be established.