1. September 28, 2004 University of Chicago 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

2. Graham/Harvey/Rajgopal: Corporate ReportingBackground • 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 e-mail list

3. Graham/Harvey/Rajgopal: Corporate ReportingBackground 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 2001 2. Brav, Graham, Harvey & Michaely survey on dividend and repurchase policy • “Payout Policy in the 21st Century” forthcoming in JFE 2004 3. Graham, Harvey and Rajgopal survey on corporate financial reporting

4. Graham/Harvey/Rajgopal: Corporate ReportingMethodology 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

5. Graham/Harvey/Rajgopal: Corporate ReportingMethodology 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”

6. Graham/Harvey/Rajgopal: Corporate ReportingMethodology 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.”

7. Graham/Harvey/Rajgopal: Corporate ReportingNarrow 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?

8. Graham/Harvey/Rajgopal: Corporate ReportingStrengths 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)

9. Graham/Harvey/Rajgopal: Corporate ReportingComparison to archival empirical work Limitations to existing research include • Earnings management and voluntary disclosure hard to measure • Rank ordering among various motivations difficult • Variable with least measurement error may dominate • Same r.h.s. variables can proxy for different economic motivations (e.g., size) • Often a narrow focus on one motivation

10. Graham/Harvey/Rajgopal: Corporate ReportingMethod 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 ReportingSample • 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 ReportingSample 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 ReportingSample 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 ReportingSample 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 Timing Sec 6.3 Table 13 Why disclose? Sec 6.1,Table 11 Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why not disclose? Sec 6.2, Table 12 Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 Why smooth earnings? Sec 5.1, Table 8 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Value sacrifice for smooth earnings Sec 5.2, Table 9 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 Timing Sec 6.3 Table 13 Why disclose? Sec 6.1,Table 11 Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why not disclose? Sec 6.2, Table 12 Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 Why smooth earnings? Sec 5.1, Table 8 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Value sacrifice for smooth earnings Sec 5.2, Table 9 Fig. 1 Flowchart depicting the outline of the paper

17. Graham/Harvey/Rajgopal: Corporate ReportingMotivation DeGeorge, Patel, Zeckhauser, JB 1999

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

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

20. Corporate Financial Reporting Performance measurements (earnings, cash flows): Sec 3.1,Table 2 Voluntary disclosure Timing Sec 6.3 Table 13 Why disclose? Sec 6.1,Table 11 Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why not disclose? Sec 6.2, Table 12 Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 Why smooth earnings? Sec 5.1, Table 8 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Value sacrifice for smooth earnings Sec 5.2, Table 9 Fig. 1 Flowchart depicting the outline of the paper

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

22. Graham/Harvey/Rajgopal: Corporate ReportingWhy meet earnings benchmarks? Stock price motivation • 86% of CFOs say “builds credibility” • 80% maintain or increase stock price

23. Graham/Harvey/Rajgopal: Corporate ReportingWhy 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

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

25. Graham/Harvey/Rajgopal: Corporate ReportingWhy 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.

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

27. Graham/Harvey/Rajgopal: Corporate ReportingConsequences of missing benchmarks Uncertainty • Uncertainty about future prospects is thought to be priced

28. Graham/Harvey/Rajgopal: Corporate ReportingConsequences 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”

29. Graham/Harvey/Rajgopal: Corporate ReportingConsequences 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

30. Corporate Financial Reporting Performance measurements (earnings, cash flows): Sec 3.1,Table 2 Voluntary disclosure Timing Sec 6.3 Table 13 Why disclose? Sec 6.1,Table 11 Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why not disclose? Sec 6.2, Table 12 Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 Why smooth earnings? Sec 5.1, Table 8 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Value sacrifice for smooth earnings Sec 5.2, Table 9 Fig. 1 Flowchart depicting the outline of the paper

31. Graham/Harvey/Rajgopal: Corporate ReportingActions 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?”

32. Graham/Harvey/Rajgopal: Corporate ReportingActions 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”

33. Graham/Harvey/Rajgopal: Corporate ReportingActions 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

34. Graham/Harvey/Rajgopal: Corporate ReportingActions 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

35. Graham/Harvey/Rajgopal: Corporate ReportingActions 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

36. Graham/Harvey/Rajgopal: Corporate ReportingSacrificing 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?

37. Graham/Harvey/Rajgopal: Corporate ReportingSacrificing long-term value Probability of accepting project

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

39. Graham/Harvey/Rajgopal: Corporate ReportingSacrificing long-term value Reminiscent of Brav, Graham, Harvey and Michaely • Sacrifice positive NPV projects before cutting dividends

40. Graham/Harvey/Rajgopal: Corporate ReportingSacrificing long-term value Repurchases Dividends

41. Graham/Harvey/Rajgopal: Corporate ReportingOther 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

42. Graham/Harvey/Rajgopal: Corporate ReportingOther 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

43. Graham/Harvey/Rajgopal: Corporate ReportingOther insights on meeting benchmarks Break out of the game • Why not declare that you will not play the earnings management game?

44. Corporate Financial Reporting Performance measurements (earnings, cash flows): Sec 3.1,Table 2 Voluntary disclosure Timing Sec 6.3 Table 13 Why disclose? Sec 6.1,Table 11 Earnings benchmarks Sec 3.2, Table 3 Earnings trends: Why not disclose? Sec 6.2, Table 12 Why meet benchmarks? Sec 3.3, Table 4 What if miss benchmarks? Sec 3.4, Table 5 Why smooth earnings? Sec 5.1, Table 8 How to meet benchmarks: Sec 4.1, Table 6 Value sacrifice to meet benchmarks: Sec 4.2, Table 7 Value sacrifice for smooth earnings Sec 5.2, Table 9 Fig. 1 Flowchart depicting the outline of the paper

45. Graham/Harvey/Rajgopal: Corporate ReportingSmoothing 96.9% and 20/20 interviews prefer smooth earnings over more volatile holding cash flows constant

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

47. Graham/Harvey/Rajgopal: Corporate ReportingSmoothing 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

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

49. Graham/Harvey/Rajgopal: Corporate ReportingOther 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

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