1 The Economic Implications of Corporate Financial Reporting John R. Graham Duke University, Durham, NC USA Campbell R. Harvey Duke University, Durham, NC USA National Bureau of Economic Research, Cambridge, MA USA Shiva Rajgopal University of Washington, Seattle, WA USA October 2004 Q-Group Fall Conference, La Quinta Resort & Club

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

3 Graham/Harvey/Rajgopal: Corporate Reporting 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

4 Graham/Harvey/Rajgopal: Corporate Reporting 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”

5 Graham/Harvey/Rajgopal: Corporate Reporting 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?

6 Graham/Harvey/Rajgopal: Corporate Reporting 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)

7 Graham/Harvey/Rajgopal: Corporate Reporting 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

8 Graham/Harvey/Rajgopal: Corporate Reporting 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

9 Graham/Harvey/Rajgopal: Corporate Reporting Sample Firm characteristics (self reported) Agency –CEO age, tenure, education –Inside ownership Size –Revenues –Number of employees Growth opportunities –P/E –Growth in earnings

10 Graham/Harvey/Rajgopal: Corporate Reporting Sample Firm characteristics (self reported) Free cash flow effects –Profitability –Leverage Informational effects –Public/private –Which stock exchange Industry Credit rating

11 Graham/Harvey/Rajgopal: Corporate Reporting Sample Firm characteristics (self reported) Financial reporting practices –Number of analysts –Do they give “guidance”? Ticker symbol!

12 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 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

13 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 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

14 Graham/Harvey/Rajgopal: Corporate Reporting Motivation DeGeorge, Patel, Zeckhauser, JB 1999

15 Graham/Harvey/Rajgopal: Corporate Reporting Earnings benchmarks Responses to the question: “How important are following earnings benchmarks?” based on a survey of 401 financial executives.

16 Graham/Harvey/Rajgopal: Corporate Reporting Earnings benchmarks Conditional: Consensus is relatively more important for Firms with more analysts Firms that give guidance Large firms More levered firms [Table 3]

17 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 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

18 Graham/Harvey/Rajgopal: Corporate Reporting Why meet earnings benchmarks? Responses to the statement: “Meeting earnings benchmarks helps …” based on a survey of 401 financial executives.

19 Graham/Harvey/Rajgopal: Corporate Reporting Why meet earnings benchmarks? Stock price motivation 86% of CFOs say “builds credibility” 80% maintain or increase stock price

20 Graham/Harvey/Rajgopal: Corporate Reporting Why meet earnings benchmarks? 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

21 Graham/Harvey/Rajgopal: Corporate Reporting Why meet earnings benchmarks? Employee bonus Survey evidence not significant Interviews suggest that internal targets more important for managers (“stretch” and “budget” greater than consensus)

22 Graham/Harvey/Rajgopal: Corporate Reporting Why meet earnings benchmarks? 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.

23 Graham/Harvey/Rajgopal: Corporate Reporting Consequences of missing benchmarks Responses to the statement: “Failing to meet benchmarks…” based on a survey of 401 financial executives.

24 Graham/Harvey/Rajgopal: Corporate Reporting Consequences of missing benchmarks Uncertainty Uncertainty about future prospects is thought to be priced

25 Graham/Harvey/Rajgopal: Corporate Reporting 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”

26 Graham/Harvey/Rajgopal: Corporate Reporting Consequences of missing benchmarks 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

27 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 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

28 Graham/Harvey/Rajgopal: Corporate Reporting Actions taken to meet benchmarks “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?”

29 Graham/Harvey/Rajgopal: Corporate Reporting 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”

30 Graham/Harvey/Rajgopal: Corporate Reporting Actions taken to meet benchmarks 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

31 Graham/Harvey/Rajgopal: Corporate Reporting Actions taken to meet benchmarks 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

32 Graham/Harvey/Rajgopal: Corporate Reporting Actions taken to meet benchmarks 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

33 Graham/Harvey/Rajgopal: Corporate Reporting 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 $1.80 $1.70 $1.40$1.30

34 Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing long-term value Probability of accepting project

35 Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing long-term value Only 45% would take the project for sure – even if they are projected to meet consensus [Table 7]

36 Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing long-term value Reminiscent of Brav, Graham, Harvey and Michaely Sacrifice positive NPV projects before cutting dividends

37 Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing long-term value Repurchases Dividends

38 Graham/Harvey/Rajgopal: Corporate Reporting 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

39 Graham/Harvey/Rajgopal: Corporate Reporting Other insights on meeting benchmarks 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

40 Graham/Harvey/Rajgopal: Corporate Reporting Other insights on meeting benchmarks Break out of the game Why not declare that you will not play the earnings management game?

41 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 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

42 Graham/Harvey/Rajgopal: Corporate Reporting Smoothing 96.9% and 20/20 interviews prefer smooth earnings over more volatile holding cash flows constant

43 Graham/Harvey/Rajgopal: Corporate Reporting Smoothing Responses to the question: “Do the following factors contribute to your company preferring a smooth earnings path?”

44 Graham/Harvey/Rajgopal: Corporate Reporting 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

45 Graham/Harvey/Rajgopal: Corporate Reporting Sacrificing value for smoothing Responses to the question: “How large a sacrifice in value would your firm make to avoid a bumpy earnings path?”

46 Graham/Harvey/Rajgopal: Corporate Reporting 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

47 Graham/Harvey/Rajgopal: Corporate Reporting Marginal investor Responses to the statement: “Rank the two most important groups in terms of setting the stock price for your company”

48 Graham/Harvey/Rajgopal: Corporate Reporting 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

49 Graham/Harvey/Rajgopal: Corporate Reporting 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

50 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 Timing Sec 6.3 Table 13 Fig. 1 Flowchart depicting the outline of the paper

51 Graham/Harvey/Rajgopal: Corporate Reporting Voluntary disclosure 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”

52 Graham/Harvey/Rajgopal: Corporate Reporting Voluntary disclosure Drivers Information asymmetry Increased analyst coverage Corporate control contest Stock compensation Management talent Limitations of mandatory disclosure

53 Graham/Harvey/Rajgopal: Corporate Reporting Voluntary disclosure Contraints Litigation risk Proprietary costs Political costs Agency costs Setting a precedent that may be hard to maintain

54 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure Survey responses to the question: Do these statements describe your company's motives for voluntarily communicating financial information?

55 Graham/Harvey/Rajgopal: Corporate Reporting 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

56 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure 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

57 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure 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

58 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure 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

59 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure Information asymmetry: Liquidity Motivation especially for small firms

60 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure Increased analyst coverage: Bhushan (1989a,b) and Lang and Lundholm (1996) 50.8% agree More agreement with small and insider dominated firms

61 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure Stock price motivation: 48.4% use disclosure to try to correct undervalued stock

62 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure 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

63 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure Management talent signaling: Trueman (1986) More support for small firms plus other questions suggest that this is important

64 Graham/Harvey/Rajgopal: Corporate Reporting Motivations for voluntary disclosure 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

65 Graham/Harvey/Rajgopal: Corporate Reporting Constraints on voluntary disclosure Survey responses to the question: Limiting voluntary communication of financial information helps…

66 Graham/Harvey/Rajgopal: Corporate Reporting 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

67 Graham/Harvey/Rajgopal: Corporate Reporting Constraints on voluntary disclosure Litigation costs Threat of litigation makes managers disclose bad news quickly 46.4% agree; especially important for young and tech

68 Graham/Harvey/Rajgopal: Corporate Reporting Constraints on voluntary disclosure Proprietary costs Might jeopardize firm’s competitive position 58.8% agree More agreement with small firms and those with few analysts

69 Graham/Harvey/Rajgopal: Corporate Reporting Constraints on voluntary disclosure 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

70 Graham/Harvey/Rajgopal: Corporate Reporting Constraints on voluntary disclosure 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

71 Graham/Harvey/Rajgopal: Corporate Reporting Good news versus bad news Survey responses to the question: Based on your company's experience, is good news or bad news released to the public faster?

72 Graham/Harvey/Rajgopal: Corporate Reporting Good news versus bad news Survey responses to the question: Do the following statements describe your company's motives related to the timing of voluntary disclosures?

73 Graham/Harvey/Rajgopal: Corporate Reporting 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

74 Graham/Harvey/Rajgopal: Corporate Reporting 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

75 Graham/Harvey/Rajgopal: Corporate Reporting 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