The Economic Implications of Corporate Financial Reporting
This is a really cool paper on the factors that drive decision making on performance measurement and voluntary disclosure.
Excerpts
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.
...
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.
...
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... A surprising 78% of the surveyed executives would give up economic value in exchange for smooth earnings.
...
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 (that is, financial market pressures and overreactions) encourages decisions that at times sacrifice long-term value to meet earnings targets.
...
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.
...
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.
...
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.
Importance of Reported Earnings
CFOs state that earnings are the most important financial metric to external constituents ... 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.
...
The interviews highlight four explanations for the focus on EPS. First, the world is complex and the number of available financial metrics is enormous. Investors need a simple metric that summarizes corporate performance, that is easy to understand, and is relatively comparable across companies. EPS satisfies these criteria. Second, the EPS metric gets the broadest distribution and coverage by the media. Third, by focusing on one number, the analyst’s task of predicting future value is made somewhat easier. The analyst assimilates all the available information and summarizes it in one number: EPS. Fourth, analysts evaluate a firm’s progress based on whether a company hits consensus EPS. Investment banks can also assess analysts’ performance by evaluating how closely they predict the firm’s reported EPS.
Earnings Benchmark
The survey evidence reported in Table 3 indicates that all four metrics are important: (i) same quarter last year (85.1% agree or strongly agree that this metric is important); (ii) analyst consensus estimate (73.5%); (iii) reporting a profit (65.2%); and (iv) previous quarter EPS (54.2%).
Stock price driven motication
The survey evidence is strongly consistent with the importance of stock price motivations to meet or beat earnings benchmarks. An overwhelming 86.3% of the survey participants believe that meeting benchmarks builds credibility with the capital market
Stakeholder motivations
Bowen, Ducharme and Shores (1995) and Burgstahler and Dichev (1997) state that by managing earnings, firms are able to enhance their reputation with stakeholders, such as customers, suppliers and creditors, and hence get better terms of trade. A statistically significant majority of the respondents agree with the stakeholder story (Table 4, row 6). Conditional analyses show that the stakeholder motivation is
especially important for firms that are small, in the technology industry, dominated by insiders, young, and not profitable. Perhaps suppliers and customers need more reassurances about the firm’s future in such companies.
Employee Bonuses
Consistent with the survey evidence, interviewed CFOs view the compensation motivation as a second-order factor, at best, for exercising accounting discretion. They tell us that companies often have internal earnings targets (for the purpose of determining whether the executive earns a bonus) that exceed the external consensus target... Furthermore, several interviewed CFOs indicate that bonuses are a function of an internal “stretch goal,” which exceeds the internal “budget EPS,” which in turn exceeds the analyst consensus estimates.
Career Concerns
The interviews confirm that the desire to hit the earnings target appears to be driven less by short-run compensation motivations than by career concerns. Most CFOs feel that their inability to hit the earnings target is seen by the executive labor market as a “managerial failure.” Repeatedly failing to meet earnings benchmarks can inhibit the upward or intra-industry mobility of the CFO or CEO because the manager is seen either as an incompetent executive or a poor forecaster.
Consequences of failure to meet earnings benchmarks
Several CFOs argue that, “you have to start with the premise that every company manages earnings.”...The common belief is that a well-run and stable firm should be able to “produce the dollars” necessary to hit the earnings target, even in a year that is otherwise somewhat down...As one CFO put it, “if you see one cockroach, you immediately assume that there are hundreds behind the walls, even though you may have no proof that this is the case.” Corporations therefore have great incentive to avoid the “cockroach” of missing an earnings benchmark.
Excerpts
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.
...
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.
...
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... A surprising 78% of the surveyed executives would give up economic value in exchange for smooth earnings.
...
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 (that is, financial market pressures and overreactions) encourages decisions that at times sacrifice long-term value to meet earnings targets.
...
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.
...
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.
...
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.
Importance of Reported Earnings
CFOs state that earnings are the most important financial metric to external constituents ... 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.
...
The interviews highlight four explanations for the focus on EPS. First, the world is complex and the number of available financial metrics is enormous. Investors need a simple metric that summarizes corporate performance, that is easy to understand, and is relatively comparable across companies. EPS satisfies these criteria. Second, the EPS metric gets the broadest distribution and coverage by the media. Third, by focusing on one number, the analyst’s task of predicting future value is made somewhat easier. The analyst assimilates all the available information and summarizes it in one number: EPS. Fourth, analysts evaluate a firm’s progress based on whether a company hits consensus EPS. Investment banks can also assess analysts’ performance by evaluating how closely they predict the firm’s reported EPS.
Earnings Benchmark
The survey evidence reported in Table 3 indicates that all four metrics are important: (i) same quarter last year (85.1% agree or strongly agree that this metric is important); (ii) analyst consensus estimate (73.5%); (iii) reporting a profit (65.2%); and (iv) previous quarter EPS (54.2%).
Stock price driven motication
The survey evidence is strongly consistent with the importance of stock price motivations to meet or beat earnings benchmarks. An overwhelming 86.3% of the survey participants believe that meeting benchmarks builds credibility with the capital market
Stakeholder motivations
Bowen, Ducharme and Shores (1995) and Burgstahler and Dichev (1997) state that by managing earnings, firms are able to enhance their reputation with stakeholders, such as customers, suppliers and creditors, and hence get better terms of trade. A statistically significant majority of the respondents agree with the stakeholder story (Table 4, row 6). Conditional analyses show that the stakeholder motivation is
especially important for firms that are small, in the technology industry, dominated by insiders, young, and not profitable. Perhaps suppliers and customers need more reassurances about the firm’s future in such companies.
Employee Bonuses
Consistent with the survey evidence, interviewed CFOs view the compensation motivation as a second-order factor, at best, for exercising accounting discretion. They tell us that companies often have internal earnings targets (for the purpose of determining whether the executive earns a bonus) that exceed the external consensus target... Furthermore, several interviewed CFOs indicate that bonuses are a function of an internal “stretch goal,” which exceeds the internal “budget EPS,” which in turn exceeds the analyst consensus estimates.
Career Concerns
The interviews confirm that the desire to hit the earnings target appears to be driven less by short-run compensation motivations than by career concerns. Most CFOs feel that their inability to hit the earnings target is seen by the executive labor market as a “managerial failure.” Repeatedly failing to meet earnings benchmarks can inhibit the upward or intra-industry mobility of the CFO or CEO because the manager is seen either as an incompetent executive or a poor forecaster.
Consequences of failure to meet earnings benchmarks
Several CFOs argue that, “you have to start with the premise that every company manages earnings.”...The common belief is that a well-run and stable firm should be able to “produce the dollars” necessary to hit the earnings target, even in a year that is otherwise somewhat down...As one CFO put it, “if you see one cockroach, you immediately assume that there are hundreds behind the walls, even though you may have no proof that this is the case.” Corporations therefore have great incentive to avoid the “cockroach” of missing an earnings benchmark.
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