Managers set the tone: Equity incentives and the tone of earnings press releases☆
Introduction
The use of performance-based executive compensation schemes has increased significantly in the last decade. Although these compensation schemes are clearly intended to align managers’ and shareholders’ incentives, there is ample empirical evidence that stock-based compensation contracts increase managers’ incentives to manipulate earnings numbers in accounting statements (see e.g., Burns and Kedia, 2006, Bergstresser and Philippon, 2006, Ke, 2003, Yermack, 1997, Gaver et al., 1995).1 However, it remains an open question whether equity-based incentives also influence managers’ reporting behaviour of qualitative financial information, and in particular the tone of the earnings press releases.
Since quantitative information provides investors with an incomplete picture of a firm’s economic performance, the analysis of the narrative disclosure in earnings press releases is of utmost importance. Prior research shows that the tone of earnings press releases – measured as the spread in the proportion of positive and negative words – provides a signal regarding managers’ future earnings expectations to the market, explaining why the market tends to react positively to the tone in a short window around the earnings announcement date (Davis et al., 2012, Davis and Tama-Sweet, 2012, Henry, 2008). In the same way as managers may manipulate earnings numbers to maximize their compensation package, this evidence suggests that managers can opportunistically influence stock prices by inflating the tone of their narrative disclosures to increase their compensation. Moreover, words are more elastic than numbers in conveying an impression. Whereas quantitative disclosures are subject to GAAP enforced by independent auditors or the SEC monitoring of periodic filings, the key feature of earnings press releases is that they are unregulated voluntary disclosures, giving the management almost full discretion on what information to disclose to investors.2 Such disclosures are thus harder to regulate or to litigate against and offer managers an opportunity to more subtly manipulate market participants’ perceptions of future firm performance.
Based on a sample of 26,000 earnings press releases written by managers of the S&P 1500 firms between 2004 and 2011, we first investigate whether highly incentivized managers – those whose wealth is tied to the firm’s share price – inflate the tone of words in earnings press releases. We find that, irrespective of the library used to measure the tone, incentivized managers appear to use positive words more aggressively in press releases and that this effect cannot be explained by differences in past performance, information asymmetry, industry or time fixed effects. In addition to showing that the propensity for tone inflation is higher for managers whose wealth is more tied to the stock price, we also show that managers whose portfolio value increases when the stock return volatility increases have a lower tendency to inflate the tone of the earnings press release. We thus conclude that measures of tone in earnings press releases do not simply reflect the economic events of the firm but also managers’ incentives to increase the value of their stock and option portfolio.
The critical question is how investors react to this incentive for tone inflation. We examine this question by studying the effect of the equity incentives on the impact of abnormal tone on the immediate and delayed stock price reaction following the earnings announcement. We find that the immediate stock price reaction remains a positive function of the abnormal tone in the earnings press release, but that the marginal price effect of abnormal tone decreases as managers’ equity incentives increase. We interpret this result as evidence that investors can (partially) see through the tone inflation in the earnings press release, and therefore discount the information signal in the abnormal tone for the presence of managers’ opportunistic motives. Consistent with Huang et al. (2014), we find that, at high levels of equity incentives for tone inflation, the delayed impact of abnormal tone on the return in the 60-day window starting two days after the announcement, can even become negative.
The bottom line of our analysis is that equity-based compensation induces managers to engage more in self-service disclosure practices and that investors anticipate this by reducing the influence of the tone in the earnings press release on the firm valuation for firms where the managerial compensation is strongly dependent on the value of the stock price. These results contribute to the compensation literature by providing further evidence on compensation-related opportunistic behavior. While stock-based compensation can provide positive incentive alignment effects, compensation contracts should reflect the consequences of tone inflation practices arising from these equity incentives.
The rest of the paper is organized as follows. In Section 2, we discuss prior literature on managers’ compensation and earnings management. In Section 3, we describe the data and the variables used. Section 4 describes our results. Finally, Section 5 concludes and suggests directions for further research.
Section snippets
Literature review and hypothesis development
We extend the prior literature by investigating the impact of the stock price sensitivity of managerial equity incentives on the information transmission from managers to investors through earnings press releases.
Sample and variable description
We now describe the longitudinal sample of quarterly earnings press releases and define the tone, equity-incentive and control variables used in our tests. Table 1 provides a synthesis of the main variables.
Results
Do equity-incentives lead to tone inflation and how does the presence of equity incentives influence the market reaction to the abnormal tone in the earnings press release? These are the two critical issues that we investigate.
In Section 4.1, we evaluate executives’ tone inflation and test the relation between managers’ equity incentives and the tone in earnings press releases across the S&P 1500 firms between 2004 and 2011. We find that both the sensitivity of the manager’s wealth to changes
Conclusion
Managers whose compensation depends on the firm’s stock price wear two hats while writing an earnings press release. On the one hand, as the shareholders’ agent, their goal is the reduction of information asymmetries. In this case, one could expect managers to disclose a credible signal regarding their future-earnings expectations. On the other hand, as an investor, they may opportunistically use these voluntary disclosures to influence investors’ expectations of future earnings and maximize
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This research was carried out thanks to financial support in the form of a grant from the Dutch Science Foundation and the Hercules Foundation (Project No. AKUL/11/02). We thank Robert Chirinko, Angela Davis, Dalia Marciukaityte, Lalitha Naveen, the Editor and two anonymous referees for helpful comments and suggestions, as well as the participants of the seminar organized at the Katholieke Universiteit Leuven, the IFABS 2014 conference in Lisbon and the 2015 meeting of the Southwestern Finance Association in Houston, Texas.