Does the Balance Sheet Prevent Managers from Hiding Bad News? Evidence from Firm-Specific Crash Risk
53 Pages Posted: 4 Oct 2014
Date Written: April 30, 2012
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.  that managers substitute away from accounting manipulation in response to the heightened outside monitoring in the post-SOX world.
Keywords: stock price crash, SOX, net operating assets, bad news, earnings management
JEL Classification: M41
Suggested Citation: Suggested Citation