The economic implications of corporate financial reporting☆
Introduction
We conduct a comprehensive survey that asks CFOs to describe their choices related to reporting accounting numbers and voluntary disclosure. Our objective is to address the following questions: Do managers care about earnings benchmarks or earnings trends and, if yes, which benchmarks are perceived to be important? What factors motivate firms to exercise discretion, and even sacrifice economic value, to manage reported earnings? How well do various academic theories explain earnings management and voluntary disclosure? We triangulate our answers to these questions with those from analytical and archival empirical research to enhance our understanding of these issues.
We investigate these questions using a combination of field interviews and a survey instrument. Using these methods allows us to address issues that traditional empirical work based on large archival data sources cannot. A combination of surveys and field interviews enables us to (i) get financial officers to rate the relative importance of extant academic theories about financial reporting policies; (ii) discover new patterns of behavior and new explanations for known patterns; and (iii) highlight stylized facts on issues that are relatively hard to document from archival data, such as earnings benchmarks, earnings guidance, and the identity of the marginal investor. Overall, our evidence provides a reference point describing where academic research and real-world financial reporting policies are consistent and where they appear to differ.1
Our results indicate that CFOs believe that earnings, not cash flows, are the key metric considered by outsiders. The two most important earnings benchmarks are quarterly earnings for the same quarter last year and the analyst consensus estimate. Meeting or exceeding benchmarks is very important. Managers describe a trade-off between the short-term need to “deliver earnings” and the long-term objective of making value-maximizing investment decisions. Executives believe that hitting earnings benchmarks builds credibility with the market and helps to maintain or increase their firm's stock price.
The severe stock market reactions to small EPS misses can be explained as evidence that the market believes that most firms can “find the money” to hit earnings targets. Not being able to find one or two cents to hit the target might be interpreted as evidence of hidden problems at the firm. Additionally, if the firm had previously guided analysts to the EPS target, then missing the target can indicate that a firm is managed poorly in the sense that it cannot accurately predict its own future. Both of these scenarios breed uncertainty about a firm's future prospects, which managers believe hurts stock valuation. Managers are willing to make small or moderate sacrifices in economic value to meet the earnings expectations of analysts and investors to avoid the severe market reaction for under-delivering. In contrast, they say that they are hesitant to employ within-GAAP accounting adjustments to hit earnings targets, perhaps as a consequence of the stigma attached to accounting fraud in the post-Enron environment.
An overwhelming majority of CFOs prefer smooth earnings (versus volatile earnings). Holding cash flows constant, volatile earnings are thought to be riskier than smooth earnings. Moreover, smooth earnings ease the analyst's task of predicting future earnings. Predictability of earnings is an over-arching concern among CFOs. The executives believe that less predictable earnings—as reflected in a missed earnings target or volatile earnings—command a risk premium in the market. A surprising 78% of the surveyed executives would give up economic value in exchange for smooth earnings.
Most executives feel they are making an appropriate choice when sacrificing economic value to smooth earnings or to hit a target. The turmoil that can result in equity and debt markets from a negative earnings surprise can be costly (at least in the short-run). Therefore, many executives feel that they are choosing the lesser evil by sacrificing long-term value to avoid short-term turmoil. In other words, given the reality of severe market (over-) reactions to earnings misses, the executives might be making the optimal choice in the existing equilibrium. CFOs argue that the system (i.e., financial market pressures and overreactions) encourages decisions that at times sacrifice long-term value to meet earnings targets. This logic echoes the evidence in the Brav et al. (2005) survey on corporate payout policy. They find that strong stock market reactions drive executives to avoid cutting dividends at all costs, even if this means bypassing positive NPV investments.
Companies voluntarily disclose information to facilitate “clarity and understanding” to investors. Executives believe that lack of clarity, or a reputation for not consistently providing precise and accurate information, can lead to under-pricing of a firm's stock. In short, disclosing reliable and precise information can reduce “information risk” about a company's stock, which in turn reduces the required return. Managerial concerns about revealing sensitive information to competitors and worries about starting disclosure precedents that are difficult to maintain (such as manager-provided earnings forecasts) constrain voluntary disclosure. In some cases, managers say that they release bad news earlier than good news in order to build credibility with the capital market and avoid potential lawsuits. At the same time, we find that poorly performing firms are more likely to delay bad news.
When benchmarked against the existing literature, we believe that our evidence offers four key insights. First, accounting earnings matter more to managers than cash flows for financial reporting purposes, which contrasts with the emphasis on cash flows found in the finance literature. This might indicate that earnings have more information content about firm value than do cash flows. Alternatively, it might indicate that managers inappropriately focus on earnings instead of cash flows. Second, managers are interested in meeting or beating earnings benchmarks primarily to influence stock prices and their own welfare via career concerns and external reputation, and less so in response to incentives related to debt covenants, credit ratings, political visibility, and employee bonuses that have traditionally been the focus of academic work (e.g., Watts and Zimmerman, 1978, Watts and Zimmerman, 1990). Third, holding cash flows constant, managers care a lot about smooth earnings paths. This concern has been somewhat under-emphasized in the academic literature (see Ronen and Sadan, 1981 for an early reference on smoothing). Finally, managers are willing to sacrifice economic value to manage financial reporting perceptions. It is difficult for archival empirical research to convincingly document such behavior.
Our work is related to, but in important ways differs from and adds to, three other survey papers. Nelson et al., 2002, Nelson et al., 2003 survey one audit firm to learn about company attempts to manage earnings that were detected by the auditors. Hodge (2003) seeks to assess the earnings quality perceptions of small investors. The key difference between our work and prior research is that we find direct evidence of managers’ willingness to give up real economic value to manage financial reporting outcomes.2 Our research differs from prior survey work in four other ways. First, rather than rely on third-party perceptions of what motivates CFOs’ financial-reporting decisions, we survey and interview the decision-makers directly. A potential disadvantage of our approach is that executives may be unwilling to admit to undesirable behavior, especially if agency issues are important. However, given that executives admit to sacrificing economic value to achieve reporting objectives, unwillingness to admit to undesirable behavior does not appear to be a major problem in our study. Moreover, an advantage of directly asking the CFOs is that they presumably have the best information about the circumstances surrounding their decisions.3 Second, the scope of our survey is broader, in that we cover both earnings management and voluntary disclosure practices. Third, we sample a large cross-section of firms. Fourth, we analyze survey responses conditional on firm characteristics. We examine the relation between the executives’ response and firm size, P/E ratio, leverage, credit rating, insider stock ownership, industry, CEO age, and the education of the CEO. By examining conditional responses, we attempt to shed light on the implications of various disclosure and earnings management theories related to firm heterogeneity in size, risk, investment opportunities, informational asymmetry, analyst coverage, level of guidance, and management incentives.
Several other broad themes emerge from our analysis. Corporate executives pay a lot of attention to stock prices, personal and company reputation, and predictability. Agency concerns, such as internal and external job prospects, lead executives to focus on personal reputation to deliver earnings and run a stable firm. Stock market valuation, especially related to earnings predictability, causes an executive to be concerned about her company's reputation for delivering reliable earnings and disclosing transparent information. Earnings are thought to be unpredictable if they are volatile or if the firm under-performs earnings benchmarks, and unpredictability leads to low stock returns. A poor reputation for delivering transparent and reliable information can increase the information risk of a firm, also hurting stock performance. Executives believe that the market sometimes misinterprets or overreacts to earnings and disclosure announcements; therefore, they work hard to meet market expectations so as not to raise investor suspicions or doubts about their firms’ underlying strength.
Fig. 1 summarizes the organization of the paper. The two main topics of interest are performance measurements and voluntary disclosure. Section 3.1 presents evidence that earnings, not cash flows, are perceived by CFOs to be the most important performance measure reported to outsiders. The remainder of Section 3 explores the relative importance of various earnings benchmarks and provides data on the motivations for meeting earnings benchmarks. Section 4 focuses on actions taken by managers to meet benchmarks, including sacrificing economic value. Section 5 discusses the economic motivations for smoothing earnings paths, as well as the perceived identity of the marginal investor. Section 6 investigates the economic motivations that drive managers’ decisions to voluntarily disclose information, and the timing of voluntary disclosures. The last section offers some concluding remarks.
Section snippets
Surveys versus archival research
Most large-sample archival analyses provide statistical power and cross-sectional variation. However, these studies can suffer from several weaknesses related to variable specification and the inability to ask qualitative questions. First, large sample analyses cannot always speak to the relative importance of competing hypotheses for a phenomenon because the explanatory variable with the least measurement error might dominate in a regression analysis. Second, developing good empirical proxies
EPS focus
CFOs state that earnings are the most important financial metric to external constituents (Table 2, panel A, row 1 and Fig. 2). One hundred fifty nine of the respondents rank earnings as the number one metric, relative to 36 top ranks each for revenues and cash flows from operations. This finding could reflect superior informational content in earnings over the other metrics.6
Mix between accounting and real actions
The literature has long recognized that managers can take accounting actions or real economic actions to meet earnings benchmarks. Table 6 and Fig. 5 summarize our analysis comparing these two types of actions. We find strong evidence that managers take real economic actions to maintain accounting appearances. In particular, 80% of survey participants report that they would decrease discretionary spending on R&D, advertising, and maintenance (Table 6, row 1) to meet an earnings target.14
Preference for smooth earnings paths, keeping cash flows constant
We ask CFOs whether they prefer smooth or bumpy earnings paths, keeping cash flows constant. An overwhelming 96.9% of the survey respondents indicate that they prefer a smooth earnings path. Such strong enthusiasm among managers for smooth earnings is perhaps not reflected in the academic literature.26
Voluntary disclosure decisions
Voluntary disclosure policies are integral to the earnings reporting process. Voluntary disclosures take various forms: press releases (especially for new product introductions and awards), investor and analyst meetings, conference calls, monthly newsletters, field visits with existing and potential institutional investors, and disclosure beyond that mandated in regulatory filings, such as in the 10-Q or 10-Ks (e.g., adding an extra line in financial statements to separate core from non-core
Summary and conclusions
This paper reports financial executives’ opinions and motives for earnings management and voluntary disclosure. Our interview and survey evidence contributes in four different dimensions. First, we establish some stylized facts about financial reporting. Second, executives rate the descriptive validity of academic theories about why managers make voluntary disclosures or manage reported earnings numbers. Third, the interviews and surveys suggest new explanations for several phenomena that have
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Cited by (0)
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We thank the following people for suggestions about survey and interview design: Sid Balachandran, Phil Berger, Robert Bowen, Larry Brown, Shuping Chen, Hemang Desai, Julie Edell Britton, Gavan Fitzsimons, Michelle Hanlon, Frank Hodge, Jim Jiambalvo, Bruce Johnson, Jane Kennedy, Lisa Koonce, S.P. Kothari, Mark Leary, Baruch Lev, Bob Libby, John Lynch, John Martin, Dawn Matsumoto, Ed Maydew, Jeff Mitchell, Mort Pincus, Jim Porteba, Avri Ravid, Brian Turner, Terry Shevlin, Doug Skinner, K.R. Subramanyam, and especially Mark Nelson. We have also benefited from useful discussions with Michael Jensen. A special thanks to Chris Allen, Cheryl de Mesa Graziano, Dave Ikenberry, Jim Jiambalvo and Jennifer Koski, who helped us administer the survey and arrange some interviews. Mark Leary provided excellent research support, Andrew Frankel provided editorial assistance, Dorian Smith provided graphics assistance, and Tara Bowens and Anne Higgs provided data entry support. We thank Charles Lee (the referee), Doug Skinner (the editor), as well as Larry Brown, Brian Bushee, Rob Bloomfield, Frank Gigler, Chandra Kanodia, S.P. Kothari, Bob Libby, Maureen McNichols, Krishna Palepu, Gary Previts, Josh Ronen, L. Shivakumar and seminar participants at the 2005 ASSA annual conference, AAA annual conference, Case Western University, CFO Forum at University of Washington, University of Chicago, Duke University, 2004 FEA conference at USC, Harvard University, the Forum on Corporate Finance, University of Minnesota, Q group, University of Southern California, University of Washington and Yale University for comments. Finally, we thank the financial executives who generously allowed us to interview them or who took time to fill out the survey. We acknowledge financial support from the John W. Hartman Center at Duke University and the University of Washington.