1 The Economic Implications of Corporate Financial Reporting Campbell R. Harvey Duke University, Durham, NC USA National Bureau of Economic Research, Cambridge, MA USA Global Finance Conference June 2005, Trinity College Dublin, Ireland

2 Corporate Financial Reporting Based on research with: John Graham and Shiva Rajgopal

3 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 list

4 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

5 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

6 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”

7 Graham/Harvey/Rajgopal: Corporate Reporting 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.”

8 Graham/Harvey/Rajgopal: Corporate Reporting Corporate Financial Reporting 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?

9 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)

10 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

11 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

12 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

13 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

14 Graham/Harvey/Rajgopal: Corporate Reporting 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)

15 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

16 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

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

18 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

19 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.

20 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.

21 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”

22 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

23 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?”

24 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

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

26 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]

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

28 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

29 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

30 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?

31 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

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

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

34 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

35 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?”

36 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

37 Graham/Harvey/Rajgopal: Corporate Reporting 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

38 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

39 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

40 Future research Other ideas Using the quarterly data –We have expected returns, individual volatility, direct measures of overconfidence

41 Future research One-year expected excess return

42 Future research 10-year expected excess return

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

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

45 Future research Linking corporate attitudes to actions Link overconfidence to corporate actions Measure optimism and link to corporate actions