Do Firms Specifically Manage Gross Margin Ratio? Evidence from Analyzing Losers’ Earnings Management Decisions

Earnings management can target specific components of earnings. Evidence suggests that the gross margin ratio (GMR) is more value relevant than other earnings components, especially for firms that miss earnings forecasts (losers), and that firms have some discretion managing cost of goods sold. To the extent that losers intend to cast their financial information in a favorable light without incurring the costs associated with managing earnings from missing to meeting/beating forecasts, the incremental value relevance and discretion create a natural incentive to manage GMR. Using a sample of firms whose earnings and GMR are both forecasted by analysts, I provide evidence suggesting that losers inflate GMR. I also show that the probability of firms missing earnings forecasts and resorting to managing GMR increases in the detection risk and litigation costs associated with managing earnings from missing to meeting/beating forecasts as well as the benefits expected from managing GMR. Finally, I show that losers with better future performance use more production management and discretionary accruals to manage GMR, whereas such an association is not found in firms meeting/beating earnings forecasts (winners).