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The Economic Implications of The Economic Implications of Corporate Financial ReportingCorporate Financial Reporting

John R. GrahamDuke University, Durham, NC USA

Campbell R. HarveyDuke University, Durham, NC USA

National Bureau of Economic Research, Cambridge, MA USA

Shiva RajgopalUniversity of Washington, Seattle, WA USA

October 2004Q-Group Fall Conference,

La Quinta Resort & Club

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Graham/Harvey/Rajgopal: Corporate Reporting

Background

1. Graham and Harvey conduct a survey on capital structure and project evaluation– “Theory and Practice of Corporate Finance: Evidence from

the Field” appears in JFE 2001

2. Brav, Graham, Harvey & Michaely survey on dividend and repurchase policy– “Payout Policy in the 21st Century” forthcoming in JFE

2004

3. Graham, Harvey and Rajgopal survey on corporate financial reporting

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Methodology

General goals our research program:

• To examine assumptions

• To learn what people say they believe

• To provide a complement to the usual research methods: archival empirical work and theory

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Methodology

Approach contrasts with Friedman’s (1953) “The Methodogy of Positive Economics”

• Goals of positive science are predictive• Don’t reject theory based on “unrealistic

assumptions”• Also, rejects notion that all the predictions of a

theory matter to its validity – goal is “narrow predictive success”

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Narrow goals

Insight on following issues:• Importance of reported earnings and earnings

benchmarks• Are earnings managed? How? Why?

– Real versus accounting earnings management– Does missing consensus indicate deeper problems?

• Consequences of missing earnings targets• Importance of earnings paths• Why make voluntary disclosures?

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Strengths and limitations Strengths:• Surveys enable us to ask decision-makers specific qualitative

questions about motivations• Less of a variable specification problem• Complements large sample analyses • A unique angle to confront theories with data

Limitations: • Questions may be misunderstood• Truthful responses?• Non-response bias • Friedman (1953)

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Method

Survey and Interview Design• Draft survey instrument “refereed” by both finance

and accounting researchers as well as experts in survey design

• Interviewed structured to adhere to best scientific practices of interviews, e.g. Sudman and Bradburn (1983)

• IRB certification for human subject research

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Sample

• 401 usable survey responses– response rate of 10.4%

• 25% response rate at a practitioner conference• 8% response rate to Internet survey

• Interview 20 CFOs– 40-90 minutes in length– More give and take than in the survey– Interviewed firms are much larger, more levered and more

profitable than the average Compustat firm.• Relative to Compustat firms

– Surveyed firms are larger, more levered, greater dividend-yield, fewer firms report negative earnings

– Similar B/M and positive P/E

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Sample

Firm characteristics (self reported)• Agency

– CEO age, tenure, education– Inside ownership

• Size– Revenues– Number of employees

• Growth opportunities– P/E– Growth in earnings

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Sample

Firm characteristics (self reported)• Free cash flow effects

– Profitability– Leverage

• Informational effects– Public/private– Which stock exchange

• Industry• Credit rating

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Sample

Firm characteristics (self reported)• Financial reporting practices

– Number of analysts

– Do they give “guidance”?

• Ticker symbol!

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Corporate Financial Reporting

Performance measurements (earnings, cash flows): Sec 3.1,Table 2

Voluntary disclosure

Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:

Why meet benchmarks?Sec 3.3, Table 4

What if miss benchmarks? Sec 3.4, Table 5

How to meet benchmarks: Sec 4.1, Table 6

Value sacrifice to meet benchmarks:Sec 4.2, Table 7

Why smooth earnings?Sec 5.1, Table 8

Value sacrifice for smooth earnings Sec 5.2, Table 9

Why disclose?Sec 6.1,Table 11

Why not disclose?Sec 6.2, Table 12

TimingSec 6.3

Table 13

Fig. 1 Flowchart depicting the outline of the paper

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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Motivation

DeGeorge, Patel, Zeckhauser, JB 1999

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0% 20% 40% 60% 80% 100%

Same quarter last year EPS

Analyst consensus EPS forecast

Reporting a profit (i.e. EPS >0)

Previous quarter EPS

Percent of respondents


Earnings benchmarks

Responses to the question: “How important are following earnings benchmarks?” based on a survey of 401 financial executives.

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Earnings benchmarks

Conditional: Consensus is relatively more important for• Firms with more analysts• Firms that give guidance• Large firms• More levered firms

[Table 3]

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

avoid violating debt-covenants

achieve desired credit rating

employees achieve bonuses

assures stakeholders business is stable

reduce stock price volatility convey future growth prospects to investors

external reputation of management

maintain or increase our stock price

build credibility with capital market

Percent agree or strongly agree


Why meet earnings benchmarks?

Responses to the statement: “Meeting earnings benchmarks helps …” based on a survey of 401 financial executives.

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Stock price motivation• 86% of CFOs say “builds credibility”• 80% maintain or increase stock price

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Stakeholder motivations• Firms enhance reputation with stakeholders, such as

customers, suppliers, creditors• Conditional analysis shows this is important for

small, tech, inside dominated, young and not profitable

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Employee bonus• Survey evidence not significant• Interviews suggest that internal targets more

important for managers (“stretch” and “budget” greater than consensus)

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Career concerns• External reputation very important• This motivation was prominent in interviews.

Executive labor market important. Failure to deliver on targets inhibits intra-industry mobility.

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0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

increases the possibility of lawsuits

outsiders might think firm lacks flexibility

increases scrutiny of all aspects of earnings releases

have to spend time explaining why we missed

outsiders think there are previously unknown problems

creates uncertainty about our future prospects


Consequences of missing benchmarks

Responses to the statement: “Failing to meet benchmarks…” based on a survey of 401 financial executives.

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Uncertainty• Uncertainty about future prospects is thought to be

priced

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Cockroach problem• “You have to start with the premise that everyone

manages earnings”• If you can’t come up with a few cents, there must be

some previously unknown serious problems at the firm

• “If you see one cockroach, you immediately assume there are hundreds behind the walls, even though you have no proof that this is the case”

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Mitigation of negative reaction• Explain miss is due to specific accounting accrual• Miss quarterly but confirm annual guidance• Nonfinancial indicators suggest good future

performance

Other factors• Conference call becomes negative; investors become

defensive

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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Actions taken to meet benchmarks0% 20% 40% 60% 80% 100%

Decrease discretionary spending (e.g. R&D,advertising, maintenance, etc.)

Delay starting a new project even if this entails asmall sacrifice in value

Book revenues now rather than next quarter (ifjustified in either quarter)

Provide incentives for customers to buy moreproduct this quarter

Draw down on reserves previously set aside

Postpone taking an accounting charge

Sell investments or assets to recognize gains thisquarter

Repurchase common shares

Alter accounting assumptions (e.g. allowances,pensions etc.)

“Near the end of the quarter, it looks like your company might come in below the desired earnings target. Within what is permitted by GAAP, which of the following choices might your company make?”

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Actions taken to meet benchmarks

Real versus accounting actions• 80% would reduce discretionary spending, R&D,

maintenance, advertising• 55.3% would delay starting a new project even if it

entailed a small sacrifice in value• Not as much support for “accounting actions”

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Real versus accounting actions• Little research on real actions

– Dechow and Sloan (JAE 1991); Bartov (TAR 1993); Bushee (TAR 1998), R&D or asset sales

– Roychowdhury (WP 2003) over produce and sales discounts to meet targets

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Real versus accounting actions• Significantly more likely to say they are taking real

rather than accounting actions• In contrast, most of the work on “earnings

management” has focused on accruals

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Why real versus accounting actions?• Aftermath of Enron-Worldcom along with S-Ox• Any hint of accounting questions could have

devastating effect on stock prices• More willing to admit to real actions• Auditors can’t second guess real actions

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Sacrificing long-term value

Hypothetical scenario: Your company’s cost of capital is 12%. Near the end of the quarter, a new opportunity arises that offers a 16% internal rate of return and the same risk as the firm. The analyst consensus EPS estimate is $1.90. What is the probability that your company will pursue this project in each of the following scenarios?

Actual EPS if you do not pursue the project

Actual EPS if you pursue the project

The probability that the project will be pursued in this scenario is …

(check one box per row)

0% 20% 40% 60% 80% 100%

$2.00 $1.90

$1.90 $1.80

$1.80 $1.70

$1.40 $1.30

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Sacrificing long-term value 0% 20% 40% 60% 80% 100%

If you take project, youwill exactly hit consensus

earnings

If you take project, youwill miss consensusearnings by $0.10



Probability of accepting project

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Only 45% would take the project for sure – even if they are projected to meet consensus

EPS if you do not pursue

EPS if you

pursue

Average probability of

pursuing 0% 20% 40% 60% 80% 100%

$2.00 $1.90 4% 4% 5% 10% 32% 45%$1.90 $1.80 10% 14% 10% 20% 28% 18%$1.80 $1.70 14% 12% 13% 21% 22% 17%$1.40 $1.30 20% 13% 12% 15% 20% 19%

Probability that the project will be pursued: (Percent of respondents indicating)

[Table 7]

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Reminiscent of Brav, Graham, Harvey and Michaely• Sacrifice positive NPV projects before cutting

dividends

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0% 10% 20% 30% 40% 50% 60% 70% 80%

Percent of CFO's who rate choice as +1 or +2 (on scale of -2 to +2)

6j: M&A strategy

7j: M&A strategy

6h: Good alternative investments

7h: Good alternative investments

3a: Investment decision made 1st

4a: Investment decision made 1st

3e: Fund externally, rather than cut

4e: Fund externally, rather than cut

Repurchases Dividends

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Other insights on meeting benchmarks

Interviews• 18/20 interview mentioned trade off of short-run

earnings and long-term optimal decisions• Investment banks offer products that create

accounting income with negative cash flow consequences

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Guidance• Goal of guidance is to meet or exceed consensus

every quarter• Analysts complicit in game of always meeting or

exceeding• Large positive surprises lead to “ratchet-up effect”• Asymmetric

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Break out of the game• Why not declare that you will not play the earnings

management game?

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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Smoothing

96.9% and 20/20 interviews prefer smooth earnings over more volatile holding cash flows constant

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Smoothing 0% 20% 40% 60% 80% 100%

Is perceived as less risky by investors

Makes it easier for analysts/investors to predictfuture earnings

Assures customers/suppliers that business is stable

Reduces the return that investors demand (i.e.smaller risk premium)

Promotes a reputation for transparent and accuratereporting

Conveys higher future growth prospects

Achieves or preserves a desired credit rating

Clarifies true economic performance

Increases bonus payments

Responses to the question: “Do the following factors contribute to your company preferring a smooth earnings path?”

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Smoothing

Reasons• Lowers “risk”; increased predictability; lower “risk”

premium• Clear from survey and interviews that CFOs believe

that this risk is priced• Possible link to literature on: estimation error,

disagreement in asset pricing, information risk premium, and behavioral literature on risk versus uncertainty

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Sacrificing value for smoothing 0% 20% 40% 60% 80% 100%

None

Small sacrifice

Moderate sacrifice

Large sacrifice

Responses to the question: “How large a sacrifice in value would your firm make to avoid a bumpy earnings path?”

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Other insights on smoothing

Interviews• Volatile earnings will create trading incentives for

speculators, hedge funds and legal vultures• Volatile earnings mean that you will have a number

of misses – which CFOs want to avoid

Smoothing example

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53%36%

7% 2%2%

Institutions

Analysts

Individuals

Rating Agencies

Hedge Funds


Marginal investor

Responses to the statement: “Rank the two most important groups in terms of setting the stock price for your company”

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Marginal investor

Price setters• Institutional investors• Analysts have important short-term impact• Retail investors important because they are potential

customers and are less likely to flip stock

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Marginal investor

Critique of analysts, institutions• Young, do not have sense of history• Contagion: bandwagon effect important given

relative performance measurement• Quantitative hedge funds issue sell signal if you miss

–irrespective of fundamental information

CFOs believe idiosyncratic risk is priced

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Earnings benchmarks

Sec 3.2, Table 3

Earnings trends:









TimingSec 6.3

Table 13


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Types• Conference calls, meetings, press releases, and

disclosure of more than mandated information in regulatory filings

• Healy and Palepu (2001) say that motivations for voluntary disclosure “important unresolved question for future research”

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Drivers• Information asymmetry• Increased analyst coverage• Corporate control contest• Stock compensation• Management talent• Limitations of mandatory disclosure

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Contraints• Litigation risk• Proprietary costs• Political costs• Agency costs• Setting a precedent that may be hard to maintain

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Motivations for voluntary disclosure0% 20% 40% 60% 80% 100%

promotes a reputation for transparent/accurate reporting

reduces the “information risk” that investors assign toour stock

provides important information to investors that is notincluded in mandatory financial disclosures

increases the predictability of our company’s futureprospects

attracts more financial analysts to follow our stock

corrects an under-valued stock price

increases the overall liquidity of our stock

increases our P/E ratio

reveals to outsiders the skill level of our managers

reduces our cost of capital

reduces the risk premium employees demand forholding stock granted as compensation

Survey responses to the question: Do these statements describe your company's motives for voluntarily communicating financial information?

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Motivations for voluntary disclosure

Information asymmetry: Information risk• Diamond Verrecchia (1991) voluntary disclosure

reduces asymmetry between informed and uninformed, increases liquidity.– 81.9% agree – only 4.3% disagree– Related 56.2% agree that predictability of company’s

future prospects is enhanced

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Information asymmetry: Information risk• Interviews distinguish between “information risk”

and “inherent risk”• Believe that both command a risk premium• Releasing bad news quickly can be beneficial in

reducing information risk

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Information asymmetry: Reputation• 92.1% agree with reputational benefit for transparent

reporting (scores the highest)• Interviews:

– Correct investors misperceptions– Create an environment of trust so strategic actions more

easily taken in the future– Trust may be important in gaining access to future capital

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Information asymmetry: Cost of capital• While only 39.3% point to cost of capital, the

information risk is linked to cost of capital• P/E lift 42% might be similar to the cost of capital• Interviews:

– A number mentioned “reducing analysts disagreement” and linked that to cost of capital

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Information asymmetry: Liquidity• Motivation especially for small firms

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Increased analyst coverage:• Bhushan (1989a,b) and Lang and Lundholm (1996)• 50.8% agree• More agreement with small and insider dominated

firms

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Stock price motivation:• 48.4% use disclosure to try to correct undervalued

stock

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Stock compensation:• Managers want to reduce contracting costs with

employees where there is information asymmetry, otherwise employees will demand a risk premium

• No support, half disagree

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Management talent signaling:• Trueman (1986)• More support for small firms plus other questions

suggest that this is important

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Limitations of mandatory disclosures (new):• 72.1% say that voluntary corrects gaps in mandatory• Interviews:

– Some mandatory “confuse rather than enlighten”– “Some of our own footnotes related to off-balance sheet

items and securitizations are so complex, even I don’t understand them.”

– Quarterly mandatory disclosures lack timeliness– Mandatory ignores intangibles

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Constraints on voluntary disclosure 0% 20% 40% 60% 80% 100%

avoid setting a disclosure precedent that may bedifficult to continue

avoid giving away “company secrets” or otherwiseharming our competitive position

avoid possible lawsuits if future results don’t matchforward-looking disclosures

avoid potential follow-up questions aboutunimportant items

avoid attracting unwanted scrutiny by regulators

avoid attracting unwanted scrutiny by stockholdersand bondholders

Survey responses to the question: Limiting voluntary communication of financial information helps…

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Constraints on voluntary disclosure

Precedent (new)• The most popular response with 69.6% agreeing• Most important for insider dominated firms• Start a practice that you might want to abandon later

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Litigation costs• Threat of litigation makes managers disclose bad

news quickly• 46.4% agree; especially important for young and tech

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Proprietary costs• Might jeopardize firm’s competitive position• 58.8% agree• More agreement with small firms and those with few

analysts

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Agency costs• We know that career concerns and external

reputation important for meeting benchmarks• Information may be limited to reduce the chance of

undue focus by stakeholders• Not much support – for this agency cost angle

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Political costs• Disclosure may be limited to avoid unwanted

attention of regulators• No support on average – but this question, in

particular, is difficult to interpret

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Good news versus bad news

Bad news fasterNo differenceGood news faster

Survey responses to the question: Based on your company's experience, is good news or bad news released to the public faster?

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Good news versus bad news 0% 20% 40% 60% 80% 100%

Disclosing bad news faster enhances our reputationfor transparent and accurate reporting

Disclosing bad news faster reduces our risk ofpotential lawsuits

Good news is released faster because bad newstakes longer to analyze and interpret

Good news is released faster because we try topackage bad news with other disclosures which

can result in a coordination delay

Survey responses to the question: Do the following statements describe your company's motives related to the timing of voluntary disclosures?

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Conclusions

• Consensus earnings factors into decisions• Strong desire to meet benchmarks – cockroach

problem• It is routine to sacrifice long-term value to meet these

benchmarks• Meeting benchmarks is important both for the firm’s

stock price and managers reputation and mobility• Agents optimizing over short-term horizon

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Conclusions

• Having predictable smooth earnings is thought to both reduce the cost of capital and enhance manager reputation

• Voluntary disclosure is an important tool in manager’s arsenal

• Disclosure can potentially reduce information risk and enhance a manager’s reputation

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Future research

Last survey instrument!

• We are thinking of administering the identical survey before it is published to non-management members of Boards of Directors.

Also…• “Detection of Financial Earnings Management”• “Detection of Real Earnings Management”We have the tickers for 107 firms many of which admit to both

financial and real earnings management

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