Maintaining a Reputation for Consistently Beating Earnings Expectations and the Slippery Slope to Earnings Manipulation

This paper investigates whether maintaining a reputation for consistently beating analysts' earnings expectations can motivate executives to move from “within GAAP” earnings management to “outside of GAAP” earnings manipulation. We analyze firms subject to SEC enforcement actions and find that these firms consistently beat analysts' quarterly earnings forecasts in the three years prior to the manipulation period and continue to do so by smaller “beats” during the manipulation period. We find that manipulating firms beat expectations around 86 percent of the time in the 12 quarters prior to the manipulation period (versus 75 percent for control firms) and that manipulation often ends with a miss in expectations. We document that executives of manipulating firms face strong stock market and CEO pressure to perform. Prior to the manipulation period, these firms have high analyst optimism, growing institutional interest, and high market valuations, along with powerful CEOs. Further, we find that maintaining a reputation for beating expectations is more important than CEO overconfidence and is incremental to CEO equity incentives for explaining manipulation. Our results suggest that pressure to maintain a reputation for beating analysts' expectations can encourage aggressive accounting and, ultimately, earnings manipulation.     

Determinants of Managerial Earnings Guidance Prior to Regulation Fair Disclosure and Bias in Analysts' Earnings Forecasts*

Prior to Regulation Fair Disclosure (“Reg FD”), some management privately guided analyst earnings estimates, often through detailed reviews of analysts' earnings models. In this paper I use proprietary survey data from the National Investor Relations Institute to identify firms that reviewed analysts' earnings models prior to Reg FD and those that did not. Under the maintained assumption that firms conducting reviews guided analysts' earnings forecasts, I document firm characteristics associated with the decision to provide private earnings guidance. Then I document the characteristics of “guided” versus “unguided” analyst earnings forecasts. Findings demonstrate an association between several firm characteristics and guidance practices: managers are more likely to review analyst earnings models when the firm's stock is highly followed by analysts and largely held by institutions, when the firm's market‐to‐book ratio is high, and its earnings are important to valuation but hard to predict because its business is complex. A comparison of guided and unguided quarterly forecasts indicates that guided analyst estimates are more accurate, but also more frequently pessimistic. An examination of analysts' annual earnings forecasts over the fiscal year does not distinguish between guidance and no‐guidance firms; both experience a “walk‐down” in annual estimates. To distinguish between guidance and no‐guidance firms, one must examine quarterly earnings news: unguided analysts walk down their annual estimates when the majority of the quarterly earnings news is negative; guided analysts walk down their annual estimates even though the majority of the quarterly earnings news is positive.     

Differences in Auditors' Materiality Assessments When Auditing Financial Statements and Sustainability Reports

With increased interest in voluntary sustainability reports from investors and other stakeholders, more companies are having these reports assured. The issue of what is considered material in these assurance engagements is important, and yet research on materiality has focused only on financial statement audits. This article reports the results of an experiment where auditors assess the materiality of audit differences in the same magnitude for both a financial audit and a sustainability (water) assurance engagement. Two factors, the risk of breaching a contract and community impact, are manipulated between‐subjects. We find that auditors assess the materiality of an audit difference significantly higher for a financial case than for a water case. This difference is significantly greater when there is no risk of breaching a contract than when there is a risk of breaching a contract. The risk of breaching a contract has a stronger effect on the difference in auditors' materiality assessments when there is no community impact than when there is a community impact. Overall our findings suggest that qualitative factors have a greater impact on sustainability (water) materiality assessments than on financial statement materiality assessments when an audit difference is between 5 percent and 10 percent of a relevant base. Understanding the factors that impact material judgments in sustainability reports is important as these factors affect the reliability of the reported disclosures.     

The Disposition of Audit‐Detected Misstatements: An Examination of Risk and Reward Factors and Aggregation Effects*

While professional standards indicate that auditors have the responsibility to both detect and report material errors, empirical evidence shows that auditors waive approximately 50 percent of material errors (Wright and Wright 1997). Unlike prior research that has examined factors that may affect auditors' decisions to waive single material misstatements, the current study examines auditors' propensity to waive proposed adjusting journal entries (henceforth PAJEs) that exceed materiality, either individually or in aggregate, under several different aggregation contexts. These contexts are represented in the form of different cases that vary in terms of the materiality and income direction of the individual and aggregate PAJEs. The current paper posits that auditors will be more likely to waive PAJEs in excess of materiality (i.e., make a “non‐GAAS” decision) when there is potential reward for doing so or when there is little litigation risk from doing so. The case decisions of 155 audit partners and managers indicate that they are not affected by potential reward (Client's Relative Fees), but are affected by potential risk (the Client's Financial Health, the PAJE's Subjectivity, and the PAJEs' Aggregate Directional Effect on Income). However, these factors are not equally influential across all aggregation contexts. Additionally, auditors are more likely to make non‐GAAS decisions when they are evaluating immaterial PAJEs that aggregate to a material level than when they are evaluating a single material PAJE.     

The Conservatism Principle and the Asymmetric Timeliness of Earnings: An Event‐Based Approach*

We test the asymmetric timeliness hypothesis by using information in extreme events as a measure of good/bad news. Our focus on extreme events is motivated by two arguments. First, the accounting concept of materiality in conjunction with litigation risk influences managers and auditors to make more conservative choices with respect to material events. Second, focusing on extreme shocks minimizes the probability that accounting slack may obscure the effect of asymmetric timeliness (Beaver and Ryan 2005). We identify individual events using short‐window extreme returns, since long‐window returns would aggregate the effect of multiple events and thus limit our ability to detect the asymmetry. Taken together, these features of our research design provide a more powerful test of asymmetric timeliness. Consistent with prior studies, we document that the correlation between bad news and concurrent earnings is significantly higher than that between good news and concurrent earnings. Our analysis of extreme events also enables us to document higher correlation of good news with earnings two or more quarters ahead. This is in contrast to prior studies that were unable to document asymmetry in the relation between returns and subsequent earnings in the opposite direction to that between returns and concurrent earnings. Our paper contributes to the growing literature on conservatism by modifying the Basu methodology to enhance the power of the test of asymmetric timeliness.     

Awareness of SEC Enforcement and Auditor Reporting Decisions

We find that non‐Big 4 audit offices with greater awareness of SEC enforcement are more likely to issue first‐time going‐concern reports to distressed clients; where SEC “awareness” is measured using (i) audit office proximity to SEC regional offices, and (ii) proximity to specific SEC enforcement actions against auditors. We also show that these non‐Big 4 audit offices issue more going‐concern opinions to clients who do not subsequently fail, indicating a conservative bias that reduces the informativeness of audit reports. This conservative reporting bias is also associated with higher audit fees and higher auditor switching rates. These findings are important because non‐Big 4 firms now audit 39 percent of SEC registrants and issue 88 percent of going‐concern audit reports. For Big 4 offices, we find some evidence that awareness of SEC enforcement may improve reporting accuracy by reducing Type II errors (failing to issue a going‐concern report to a company that fails), although the number of cases is small.     

The Incremental Informativeness of Stock Prices for Future Accounting Earnings*

This study extends previous research that documents a stock price reaction leading accounting earnings. The primary issue is that prior studies use a naive earnings expectation model (random walk) as the benchmark for the information content of lagged returns and do not adequately address the “incremental” information content of lagged returns. This study identifies and estimates firm-specific models of earnings to control directly for the autocorrelation in earnings. The explanatory power of lagged prices with respect to this earnings residual is investigated using both a multiple regression model of lagged returns and a multiple time-series vector autoregressive model. In-sample estimation of the models provides clear evidence that stock prices impound information about future earnings incremental to the information contained in historical earnings data. Holdout period analysis of the earnings forecasts from these lagged return models finds that both models outperform the naive seasonal random walk expectation, but neither model outperforms the more sophisticated Box-Jenkins forecasts. On an individual firm basis, earnings forecasts supplemented with the lagged return data tend to be less precise than the Box-Jenkins forecasts, but the price-based models demonstrate an ability to rank the earnings forecast errors from the time-series models. The analysis helps to characterize the limitations of lagged returns as a means of predicting future earnings innovations.     

The Spillover Effect of SEC Comment Letters on Qualitative Corporate Disclosure: Evidence from the Risk Factor Disclosure

In this study we use the recently mandated risk factor disclosure to examine the spillover effect of the Securities and Exchange Commission (SEC) review of qualitative corporate disclosure. We find that firms not receiving any comment letter (“No‐letter Firms”) modify their subsequent year's disclosures to a larger extent if the SEC has commented on the risk factor disclosure of (i) the industry leader, (ii) a close rival, or (iii) numerous industry peers. We refer to this effect as “spillover.” Further, we find that after SEC comments on the industry leader's disclosure, No‐letter Firms also provide more firm‐specific disclosures in the subsequent year. The increased disclosure specificity reduces these firms’ likelihood of receiving SEC risk disclosure comments on their new filings. Our evidence suggests an indirect effect of the SEC review of qualitative disclosure.     

The Relation between Analysts' Forecasts of Long‐Term Earnings Growth and Stock Price Performance Following Equity Offerings*

In this paper we evaluate the role of sell‐side analysts' long‐term earnings growth forecasts in the pricing of common equity offerings. We find that, in general, sell‐side analysts' long‐term growth forecasts are systematically overly optimistic around equity offerings and that analysts employed by the lead managers of the offerings make the most optimistic growth forecasts. In additional, we find a positive relation between the fees paid to the affiliated analysts' employers and the level of the affiliated analysts' growth forecasts. We also document that the post‐offering underperformance is most pronounced for firms with the highest growth forecasts made by affiliated analysts. Finally, we demonstrate that the post‐offering underperformance disappears once we control for the overoptimism in earnings growth expectations. Thus, the evidence presented in this paper is consistent with the “equity issue puzzle” arising from overly optimistic earnings growth expectations held at the time of the offerings.     

Discontinuities and Earnings Management: Evidence from Restatements Related to Securities Litigation*

A heated debate exists as to whether discontinuities in earnings distributions are indicative of earnings management. While many studies attribute discontinuities in earnings distributions to earnings management, other studies argue that earnings discontinuities are artifacts of sample selection and research design. Overall, there is limited direct evidence of a connection between earnings discontinuities and earnings management. In this study, we provide direct evidence linking earnings management to earnings discontinuities for a sample of firms that settle securities class action lawsuits and restate earnings from the alleged GAAP violation period. We compare the distribution of restated (“unmanaged”) earnings to originally reported (“managed”) earnings. We find that discontinuities are not present in the distribution of analyst forecast errors and earnings changes using unmanaged earnings but are present using managed earnings. The discontinuity in the earnings level distribution is attenuated, but not eliminated, on an unmanaged basis. These shifts among our sample of firms are caused by earnings management and cannot be explained by sample selection or research design issues. Our findings are important because many studies use earnings discontinuities as a proxy for intentional earnings manipulations and we provide the first direct evidence of a link between these two phenomena.     

Investors' Misweighting of Firm-Level Information and the Market's Expectations of Earnings

Prior studies use fundamental earnings forecasts to proxy for the market's expectations of earnings because analyst forecasts are biased and are available for only a subset of firms. We find that as a proxy for market expectations, fundamental forecasts contain systematic measurement errors analogous to those in analysts' biased forecasts. Therefore, these forecasts are not representative of investors' beliefs. The systematic measurement errors from using fundamental forecasts to proxy for market expectations occur because investors misweight the information in many firm-level variables when estimating future earnings, but fundamental forecasts are formed using the historically efficient weights on firm-level variables. Thus, we develop an alternative ex ante proxy for the market's expectations of future earnings (“the implied market forecast”) using the historical (and inefficient) weights, as reflected in stock returns, that the market places on firm-level variables. A trading strategy based on the implied market forecast error, which is measured as the difference between the implied market forecast and the fundamental forecast, generates excess returns of approximately 9 percent per year. These returns cannot be explained by investors' reliance on analysts' biased forecasts. Overall, our results reveal that market expectations differ from both fundamental forecasts and analysts' forecasts.     

Incremental Information Content of the Change in the Percent of Production Added to Inventory*

Abstract. Manufacturing firms can manipulate income by producing in excess of the quantity needed to meet current period demand, thereby allocating part of current period fixed manufacturing overhead costs from cost of goods sold to inventory. Because it is subject to manipulation, the component of earnings due to producing in excess of sales may be of lower quality than the remaining component of earnings. We investigate this possibility using a regression of security returns on unexpected income and an estimate of the change in percent of production added to inventory (CPAI). An analytical model indicates that CPAI determines the “earnings surprise” subject to manipulation by overproducing. Assuming the market recognizes this, the coefficient on CPAI should be negative because this low quality component must be deducted from the total “good news” conveyed by the change in reported earnings. Alternatively, CPAI may convey good or bad news to the market that is unrelated to the manipulation of current period earnings. Firms may increase the percent of production added to inventory in anticipation of high levels of future sales. In this case, the estimated coefficient on CPAI should be positive. Or, if the increase in the percent of production added to inventory reflects anticipation of a strike or an unexpected downturn in current sales, the estimated coefficient should be negative. Cross-sectional tests using a large sample of manufacturing firms indicate a significant positive relation between security returns and CPAI. This finding is consistent with market participants viewing CPAI as a leading indicator of firm performance. Although the results are most supportive of CPAI conveying good news, there is some evidence that CPAI is used by managers to smooth earnings and, for firms classified as smoothing earnings, there is weak evidence that the component of earnings related to CPAI is viewed by market participants to be of lower quality.     

Evidence that Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings: An Experimental Markets Approach*

Abstract. Analysts have been found to underweight the innovation in the most recent quarterly earnings when forecasting next-quarter earnings, and these expectations have been posited as an explanation for post-earnings-announcement drift. This study uses an experimental asset market to examine whether similar errors in forecasting quarterly earnings are made by student-subjects. We examine two aspects of their behavior: (1) do subjects underestimate the autocorrelation in quarterly earnings when forming earnings expectations? and (2) are asset prices consistent with a subject's underestimation of the autocorrelation in quarterly earnings? We observe subject errors in forecasts that underweight extreme innovations in the most recent quarterly earnings by approximately 40 percent. The prices in the experimental markets also fail to reflect fully the most recent innovation in quarterly earnings. We are able to predict the sign of the incorrect pricing, from the mean initial earnings predictions of the subjects, in 74 percent of the 135 markets. These forecast errors observed in this study are consistent with forecast errors observed for analysts, and this consistency suggests that errors in analysts' forecasts may be at least partially attributable to the use of judgmental heuristics.     

Option Trading,Price Discovery,and Earnings News Dissemination*

Abstract. Option market activity increases by more than 10 percent in the four days before quarterly earnings announcements. We show that the direction of this preannouncement trading foreshadows subsequent earnings news. Specifically, we find option traders initiate a greater proportion of long (short) positions immediately before “good” (“bad”) earnings news. Midquote returns to active-side option trades are positive during nonannouncement periods and are significantly higher immediately prior to earnings announcements. Bid-ask spreads for options widen during the announcement period, but traders do not gravitate toward high delta contracts. Collectively, the evidence shows option traders participate generally in price discovery (the incorporation of private information in price), and more specifically in the dissemination of earnings news.     

Misclassifying Core Expenses as Special Items: Cost of Goods Sold or Selling,General, and Administrative Expenses?

Prior studies of classification shifting in the income statement conclude that managers misclassify core expenses as special items to inflate reported core earnings (McVay 2006; Fan, Barua, Cready, and Thomas 2010). These studies do not distinguish between the core expense components—cost of goods sold (COGS) and selling, general, and administrative expenses (SGA). This study models COGS and SGA separately, and investigates managers’ misclassification of COGS versus SGA to meet different profitability benchmarks. We find that COGS (but not SGA) misclassification is associated with just beating the benchmark of gross margin four quarters earlier. In comparison, both COGS and SGA misclassification are associated with just beating the benchmarks of zero core earnings, prior‐year core earnings, and analyst earnings forecasts in the fourth fiscal quarter. We also investigate real activities management (RAM) of COGS and SGA to meet benchmarks, and find that managers engage in RAM of COGS to achieve the gross margin benchmark, but not core earnings benchmarks. We demonstrate that unexpected SGA contains a significant misclassification effect distinct from RAM, suggesting that future RAM research should consider controlling for expense misclassification. Overall, our study extends prior literature on both classification shifting and RAM.     

To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance

In recent years, quarterly earnings guidance has been harshly criticized for inducing “managerial short‐termism” and other ills. Managers are, therefore, urged by influential institutions to cease guidance. We examine empirically the causes of such guidance cessation and find that poor operating performance — decreased earnings, missing analyst forecasts, and lower anticipated profitability — is the major reason firms stop quarterly guidance. After guidance cessation, we do not find an appreciable increase in long‐term investment once managers free themselves from investors’ myopia. Contrary to the claim that firms would provide more alternative, forward‐looking disclosures in lieu of the guidance, we find that such disclosures are curtailed. We also find a deterioration in the information environment of guidance stoppers in the form of increased analyst forecast errors and forecast dispersion and a decrease in analyst coverage. Taken together, our evidence indicates that guidance stoppers are primarily troubled firms and stopping guidance does not benefit either the stoppers or their investors.     

Unexpected SEC Resource Constraints and Comment Letter Quality

We investigate whether reviews of transactional filings by the SEC unexpectedly constrain SEC resources, leading to lower quality comment letters for periodic reports. The Sarbanes-Oxley Act requires the SEC to review periodic reports (e.g., 10-Ks) at least once every three years. However, the SEC also reviews transactional filings (e.g., initial public offerings and acquisitions), which are unpredictable and often occur in waves. We find comment letters for periodic reports are of lower quality (in terms of outputs, inputs, and firm responses) during periods of abnormally high transactional filings. We also find that comment letters issued during periods of abnormally high versus low transactional filings are associated with increased information asymmetry and lower earnings response coefficients in the quarter after the resolution of the comment letter. Overall, our results suggest that unexpected resource constraints affect the quality of SEC oversight of periodic reports.     

Financial Statement Complexity and Meeting Analysts’ Expectations

We examine whether firms with greater financial statement complexity are more likely to meet or beat analysts’ earnings expectations. We proxy for financial statement complexity using the firm's industry and year adjusted accounting policy disclosure length. Firms with more complex financial statements are more likely to just beat expectations than just miss expectations. Firms with complex financial statements appear to use expectations management to beat expectations, but do not use earnings management. Corroborating these findings, we find analysts rely more on management guidance for more complex firms. Firms with complex financial statements are also more likely to have analysts exclude items from actual “street earnings,” but tests suggest this strategy is not specifically used by complex firms to beat expectations. The effect we document is specific to analyst forecasts and not to other alternative benchmarks.     

Auditor Conservatism,Asymmetric Monitoring,and Earnings Management*

In this paper, we investigate whether, and how, audit effectiveness differentiation between Big 6 and non‐Big 6 auditors is influenced by a conflict or convergence of reporting incentives faced by corporate managers and external auditors. In so doing, we incorporate into our analysis the possibility that managers self‐select both external auditors and discretionary accruals, using the two stage “treatment effects” model. Our results show that only when managers have incentives to prefer income‐increasing accrual choices are Big 6 auditors more effective than non‐Big 6 auditors in deterring/monitoring opportunistic earnings management. Contrary to conventional wisdom, we find Big 6 auditors are less effective than non‐Big 6 auditors when both managers and auditors have incentives to prefer income‐decreasing accrual choices and thus no conflict of reporting incentives exists between the two parties. The above findings are robust to different proxies for opportunistic earnings management and different proxies for the direction of earnings management incentives.     

An Approach to Adjusting Analysts' Consensus Forecasts for Selection Bias*

Many recent empirical studies have concluded that analysts' earnings forecasts are optimistic on average. In this paper, we attempt to undo the effect of one potential source of optimistic bias in analysts' earnings forecasts. Assuming forecasts come from a truncated normal distribution, we estimate the “true” population mean using maximum likelihood. We find that our estimates of earnings are more accurate and less biased than standard measures of sample mean and median. However, we do not find a closer relationship between excess market returns and forecast errors from our maximum likelihood estimate than from the sample mean. This may suggest that the market does not fully incorporate analysts' incentives in generating expectations about future earnings.