«Campbell R. Harvey, Duke University, Durham, NC 27708 National Bureau of Economic Research, Cambridge, MA 02138 Shiva Rajgopal, University of ...»
Value Destruction and Financial Reporting Decisions
John R. Graham
Duke University, Durham, NC 27708
National Bureau of Economic Research, Cambridge, MA 02138
Campbell R. Harvey,
Duke University, Durham, NC 27708
National Bureau of Economic Research, Cambridge, MA 02138
University of Washington, Seattle, WA 1
We recently conducted a comprehensive survey that analyzes how senior financial executives
make decisions related to performance measurement and voluntary disclosure. In particular, we ask CFOs what earnings benchmarks they care about and which factors motivate executives to exercise discretion, and even sacrifice economic value, to deliver earnings. These issues are crucially linked to stock market performance. Much of the media attention is focused on a small number of high profile firms that have engaged in earnings fraud. Our results show that the destruction of shareholder value through legal means is pervasive, if not a routine way of doing business. Indeed, we assert that the amount of value destroyed by firms striving to hit earnings targets exceeds the value lost in these high profile fraud cases.
Keywords: Earnings management, earnings smoothing, consensus earnings, meeting benchmarks, value destruction, agency problems, real earnings management, unexpected earnings, earnings surprise, net present value JEL classification: G14, G30, G32, M41, M42, G38 September 6, 2006. This paper is an augmented version of “The Economic Implications of Corporate Financial Reporting” in the Journal of Accounting and Economics (2005). We have added additional interviews of CFOs and present results that are not contained in our earlier work.
INTRODUCTIONBased on a survey of 401 senior financial executives and in-depth interviews with an additional 22 executives, we document a willingness to routinely sacrifice shareholder value to meet earnings expectations or to smooth reported earnings. While much previous research has focused on the use of accounting for earnings management, such as accrual decisions, we provide new evidence of the widespread use of ‘real’ earnings management. Real earnings management, which might include deferring a valuable project or slashing research and development expenditures, is almost always value decreasing.
The survey, administered in the fall of 2003, contained 10 questions, most with subsections, and explored both earnings management and voluntary disclosures in some depth. In addition, from the fall of 2003 to early 2005, we interviewed 22 CFOs, which added depth to our understanding of corporate decision-making. Our results indicate that CFOs believe that earnings, not cash flows, are the key metric watched by investors and other outsiders. The two most important earnings benchmarks are quarterly earnings for the same quarter last year and the analyst consensus estimate. CFOs believe that hitting earnings benchmarks is very important because such actions build credibility with the market and help to maintain or increase their firm’s stock price in the short run. To avoid the severe market reaction for under-delivering, CFOs are willing to sacrifice long-term economic value (such as delaying a valuable project) to meet the earnings expectations of analysts and investors. In contrast, executives say that they are hesitant to employ legal, within-GAAP (General Accepted Accounting Practices) accounting adjustments to hit earnings targets, perhaps as a consequence of the stigma attached to accounting fraud in the post-Enron environment.
Not surprisingly, almost all CFOs prefer smooth earnings (versus volatile earnings), holding cash flows constant. The executives believe that less predictable earnings – as reflected in a missed earnings target or volatile earnings – command a risk premium in the market. A surprising 78% of the surveyed executives would destroy economic value in exchange for smooth earnings.
CFOs argue that the system (that is, financial market pressures and overreactions) encourages decisions that at times destroy long-term value to meet earnings targets.
We also explore how the malaise of excessive short-termism can be fixed. We argue that a greater emphasis on principles versus rules based accounting standards, reduction in quarterly earnings guidance, disclosure of how accrual estimates are settled ex post, focus on integrity in financial reporting process, a proactive Board of Directors which changes the balance of between short-term and long-term goals, and a more active role for institutional investors can mitigate the myopic emphasis on quarterly earnings measures.
In the next section, we briefly discuss the design of the survey (with more details provided in the Appendix). Then, we review our findings, first on earnings management and then on voluntary disclosure decisions.
SURVEY TECHNIQUES AND SAMPLE CHARACTERISTICSThe most important aspect of survey research is designing a survey instrument that asks clear and relevant questions. We took several steps to achieve this goal. We developed an initial survey instrument and solicited feedback from academic researchers, CFOs, and marketing research experts to minimize biases induced by the questionnaire and to maximize the response rate. After extensively beta-testing the survey, we made several changes to the wording of some questions on the draft survey. The final survey contained 12 questions, and the paper version was five pages long.2 We e-mailed the survey to 3,174 members of an organization of financial executives. We also contacted executives attending CFO forums at two universities and administered a paper version of the survey at a conference of financial executives conducted on November 17 and 18, 2003 in New York City. Our overall response rate of 10.4% falls close to those reported by several recent surveys of financial executives.3 The companies from which we receive responses range from small (15.1% of the sample firms have sales of less than $100 million) to very large (25.6% have sales of at least $5 billion). Approximately 8% of the firms did not have any analyst coverage, while 16.7% are covered by at least 16 analysts. We also collect information about CEOs (implicitly assuming that the executives that we survey act as agents for the CEOs). Relative to the average public firm in the U.S. (proxied by firms on the Compustat database), the firms in our sample are fairly large and profitable.
Before we discuss the results, we would like to point out that like all other survey research, our results represent CFO beliefs not actions. The two may not coincide. It is also possible that executives make (close to) optimal decisions without knowing it or articulating it in language used by economists designing survey questions. We, of course, worked to minimize these concerns when designing the survey.
The survey is posted at http://faculty.fuqua.duke.edu/~jgraham/finrep/survey.htm.
Examples include 12% response rate by Trahan and Gitman (1995) and 9% by Graham and Harvey (2001).
SHORT TERM FOCUS ON REPORTED EARNINGSThe Importance of Earnings Financial professionals and some equity analysts emphasize cash flows as driving value, while many accountants argue that earnings are a better measure of firm value. We asked CFOs
to rank order the perceived importance to outside stakeholders of several competing metrics:
earnings, pro-forma earnings, revenues, operating cash flows, free cash flows and EVA. Earnings are king. CFOs picked earnings as the overwhelming favorite (Fig. 1). Nearly two-thirds of the respondents rank earnings as the number one metric, relative to fewer than 22% choosing revenues and cash flows from operations. This finding could reflect superior informational content in earnings over the other metrics. Alternatively, it could reflect myopic managerial concern about earnings.
Fig. 1. Based on the responses to the question: “Rank the three most important measures reported to outsiders” based on a survey of 401 financial executives. We report the distribution of the #1 rating.
Additional analysis reveals that unprofitable and younger firms rank earnings as relatively less important. Cash flows are relatively more important in younger firms and when less earnings guidance is given. Interestingly, private firms place more emphasis on cash flow from operations than do public firms, suggesting perhaps that capital market motivations drive the focus on earnings. Unprofitable firms, firms with young CEOs, and firms with high earnings guidance and analyst coverage emphasize pro-forma earnings.
How do we explain the overwhelming importance of reported earnings? 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. The market appears to believe that earnings per share (EPS) satisfies these criteria. Moreover, the EPS metric gets the broadest distribution and coverage by the media. Further, 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. Finally, ex post evaluation of a firm’s progress is often based on whether a company hits the consensus EPS or beats the same quarter last year. Investment banks can also assess analysts’ performance by evaluating how closely they predict the firm’s reported EPS.
Earnings benchmarks We dig deeper to determine which earnings benchmark is most important. Of the four benchmarks we proposed, 85.1% of CFOs viewed earnings same quarter last year as the most important benchmark, followed by analyst consensus estimate (73.5%), reporting a profit (65.2%), and previous quarter EPS.
We would have thought that analyst consensus estimate would come out to be more important; and in the interviews the CFOs told us that missing the consensus number leads to the largest stock price reaction. Moreover, conditional on firms having substantial analyst coverage, and among firms that provide substantial guidance, we find that the consensus earnings number is as important as the four quarters lagged number. Interviewed CFOs note that the first item in a press release is often a comparison of current quarter earnings with four quarters lagged quarterly earnings. The next item mentioned is often the analyst consensus estimate for the quarter.
Interviewed CFOs also mention that while analysts’ forecasts can be guided by management, last year’s quarterly earnings number is a benchmark that is harder, if not impossible, to manage after the 10-Q has been filed with the SEC.
Meeting earnings benchmarks The financial press is replete with cases in which a firm misses an earnings benchmark (such as the analysts consensus estimate) by a cent per share and gets its stock price hammered. Thus, CFOs are likely to have strong incentives to meet or beat earnings benchmarks. We asked CFOs specific questions about such incentives. The results, shown in Fig. 2, strongly suggest that the dominant reasons to meet or beat earnings benchmarks relate to stock prices. An overwhelming 86.3% of the survey participants believe that meeting benchmarks builds credibility with the capital market. More than 80% agree that meeting benchmarks helps maintain or increase the firm’s stock price. Consistent with these results, managers believe that meeting benchmarks conveys future growth prospects to investors.
More than three-fourths of the survey respondents agree or strongly agree that a manager’s concern about her external reputation, and external job prospects, helps explain the desire to hit the earnings benchmark. 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. According to one executive, “I miss the target, I’m out of a job.”
Apart from stock price and career concern motivations, a statistically significant majority of the respondents want to meet or beat earnings benchmarks to enhance their reputation with stakeholders, such as customers, suppliers and creditors, and hence get better terms of trade.
Somewhat surprisingly, maintaining employee bonuses and lowering the expected cost of debt are relatively unimportant motivations to meet or beat earnings benchmarks. This is in contrast to the disproportionate academic attention devoted to bonuses and debt as important motivations to manage accounting earnings (e.g., Watts and Zimmerman 1990).
Failure to meet earnings benchmarks We explicitly ask CFOs about the consequences of failing to deliver expected earnings. Fig.
3 summarizes the results. The top two consequences of a failure to meet earnings benchmarks are an increase in the uncertainty about future prospects (80.7%) and a perception among outsiders that there are deep, previously unknown problems at the firm (60%). The importance of these concerns increases with the degree of earnings guidance.
Creates uncertainty about our future prospects Outsiders think there are previously unknown problems
Fig. 3. Responses to the question: “Failing to meet benchmarks…” based on a survey of 401 financial executives.