1 Do Corporations Manipulate Earnings to Meet or Beat Analysts Expectations? Evidence from Pension Assumption Changes Yul W. Lee and T. Jeffrey Zhang University of Rhode Island AAA Conference August 5, 2008

2 Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. – The Numbers Game, by Arthur Levitt, former Chairman of SEC, a speech at NYU Centers for Law and Business on September 28, 1998

3 Motivating Examples Verizon Communications (BeBchuk and Fried, 2004) –Reported total earnings $389 million in 2001; –$1.8 billion in pension income; –But pension plan lost $3.1 billion. Whats the trick? Use the expected rate of return on pension assets (ERR) to estimate pension income Increase ERR by 25 basis points from 9% in 2000 to 9.25% in 2001 –EPS beat analysts by $0.10 IBM: plays the same trick with pension assumption (Fortune, 2002) The SEC investigates whether firms tweak pension assumptions to make themselves look better (The Wall Street Journal on November 9, 2005)

4 DB Plans: An Interesting Test Ground for Studying EM incentives Managers enjoy much discretion in setting the ERR (expected vs. realized rate: SFAS 87) Pension plan assets are huge: small change of ERR results in large impact Increasing ERR appears to be an effective EM tool (i.e., Verizon and IBM) Complicated pension accounting, hard to decipher (Jin, Merton, Bodie, 2006).

5 How Can ERR Help Firms Increase Earnings? Calculation of Pension Expenses Service cost (PV of pension benefits earned by employee over the last year) + Interest cost (Growth in PBO over the last year due to the passage of time) +Other costs (i.e., actuarial gain and pension amendment) –Expected returns on plan assets (=ERR x FVPA) =Net periodic pension cost (NPPC) ( Reported on Income Statement ) Impact of Changes in ERR on Firm Earnings

6 Research Questions and Preview of Results (1) Do managers increase the ERR to meet or exceed analysts expectations when the earnings would otherwise have missed analyst consensus forecasts? –Yes. What are the major benefits or potential costs in the short-term, if any, associated with this EM activity? –Positive short-term stock returns –More likely to be subject to SEC enforcement actions; greater likelihood of an unclean auditors opinion

7 Research Questions and Preview of Results (2) What are the long-run implications of such earnings management activities? –Stock returns and operating performance significantly underperform control firms These findings suggest that corporate managers boost current stock prices at the expense of long-term growth prospects. –Managerial myopia theory (Stein, 1988) –Graham, Harvey, and Rajgopal (2004)

Data and Sample Accounting data: Compustat (1993 – 2005) –ERR (date 336, available from fiscal year 1991) Stock return: CRSP Analyst earnings forecasts: IBES –Unadjusted IBES summary file (Diether, Malloy, Scherbina, 2002; Baber and Kang, 2002) –Use median EPS as analyst consensus forecast –21,792 firm-year observation from 1993 to

9 Frequency of Changes in ERR

10 Empirical Results Pseudo-EPS: Eliminating the effect of changes in the ERR from the I/B/E/S actual annual EPS Use a dummy variable, pseudoMiss to indicate whether the pseudo-EPS misses or beats analysts expectations: pseudoMiss = 1 if MissAmt < 0 (pseudo-EPS < analysts median forecasted EPS) pseudoMiss = 0 if MissAmt >= 0 (pseudo-EPS >=analysts median forecasted EPS)

11 Regression of ERR Incentives When Pseudo-EPS Misses Analysts Expectations

12 Short-Term Stock Returns and Trading Volumes Surrounding Earnings Announcement

13 Long-Run Operating Performance for the ERR- Increase Firms

14 Long-Run Buy-and-Hold Abnormal Stock Returns (BHAR) for ERR-Increase Firms

15 Estimate of EM Magnitude

16 Conclusions Managers increase the ERR to boost earnings to meet or exceed analysts expectations. Such earnings management incentive tends to be stronger when the earnings would have slightly missed analyst forecasts. These ERR-increase firms earn positive short-term stock returns; but the long-run stock returns and operating performance of the ERR-increase firms significantly underperform the control firms. These findings suggest that corporate managers boost current stock prices at the expense of long-term growth prospects (e.g., Stein, 1988; Graham, Harvey, and Rajgopal, 2004)