1 The Economic Implications of Corporate Financial Reporting Campbell R. Harvey Duke University, Durham, NC USA National Bureau of Economic Research, Cambridge,

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

Campbell R. HarveyDuke University, Durham, NC USA

National Bureau of Economic Research, Cambridge, MA USA

Global Finance Conference 2005

27-29 June 2005, Trinity College Dublin, Ireland

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Corporate Financial Reporting

Based on research with:

John Graham and Shiva Rajgopal

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Graham/Harvey/Rajgopal: Corporate Reporting

Background

• In 1995, Duke and Financial Executives International make a deal to conduct a quarterly CFO survey

• The deal allows for some special ‘academic’ surveys outside of the quarterly survey that would use the FEI e-mail list

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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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Methodology

Alternative view, Daniel Hausman (1992)

• “No good way to know what to try when a prediction fails or whether to employ a theory in a new application without judging its assumptions.”

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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!

Demographic correlations in Table 1– Note positive relation between whether you give

guidance and number of analysts (Lang and Lundholm TAR 1996)

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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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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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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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Consequences of missing benchmarks

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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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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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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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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Conclusions

• Consensus earnings factors into decisions• Cash secondary to accounting earnings• 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

Other ideas

• 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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Future research

Other ideas

• Using the quarterly data– We have expected returns, individual volatility, direct

measures of overconfidence

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Future research

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Overconfidence:% of time realized returns fall outside 80% confidence range

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Overconfidence:% of time realized returns fall outside 80% confidence range

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Future research

Linking corporate attitudes to actions

• Link overconfidence to corporate actions• Measure optimism and link to corporate actions

Documents

1 The Economic Implications of Corporate Financial Reporting Campbell R. Harvey Duke University, Durham, NC USA National Bureau of Economic Research, Cambridge,