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The balance sheet accumulates the effects of previous accounting choices, so the level of net assets partly reflects the extent of previous earnings management. We predict that managers' ability to optimistically bias earnings decreases with the extent to which the balance sheet overstates net assets relative to a neutral application of GAAP. To test this prediction, we examine the likelihood of reporting various earnings surprises for 3,649 firms during 1993–1999. Consistent with our prediction, we find that the likelihood of reporting larger positive or smaller negative earnings surprises decreases with our proxy for overstated net asset values.

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and the Southeast Summer Accounting Research Conference are appreciated. We also thank Tina Duchaine of PhRMA for valuable assistance with the PhRMA survey data. We would like to acknowledge the generous research support of the D u k e College of Management and the Goizueta Business School. Finally, we would like to thank the participants of the 2002 JAAFKF'MG conference and, in particular, Philip Joos, for their helpful comments. 163 164 JOURNAL OF ACCOUNTING, AUDITING & FINANCE 1. This result is consistent with a number of studies that find a positive relation between market value and research and development costs across a variety of industries (e.g., Bowen and Shores [2OOOl; Chambers, Jennings, and Thompson [1998]; Lev and Sougiannis [1996]; Shortridge [2000]). Note also that consistent with Hand (2001), although net income before research and development costs provides no explanatory power, we find that book value and research and development costs explain about 68% of the variation in market value, suggesting that financial variables have significant explanatory power.

This paper examines the conditions under which the market responds to disclosures of significant increases in short selling, and whether proxies for earnings expectations and alternative information sources help explain this response. Our sample is based on firms that experience abnormal short interest increases (“short spikes”) during 1989–1998. We find that the mean abnormal return around short spike announcements is significantly more negative for firms with low analyst following, consistent with short sellers providing perceived value when there are limited alternative sources of guidance available. For firms with high analyst following we find the market response is dependent on earnings levels, consistent with investors viewing a short interest increase as providing information about the sustainability of earnings. Additional analyses reveal that these inferences are not affected by measures of firms' earnings quality or by the relative size of the short spike. We infer from our analyses that the information content of short interest disclosures is conditional on both the firms' existing information environment and expectations of future performance as conveyed by prior earnings. This inference is consistent with short sellers' role as information intermediaries covering the lower tail of earnings expectations.