The effect of cash flow forecasts on accrual quality and benchmark beating

When analysts provide forecasts of both earnings and operating cash flow, they also implicitly provide a forecast of total operating accruals. We posit that this increases the transparency and the expected costs of accrual manipulations used to manage earnings. As a consequence, we predict and find that accrual quality improves and firms’ propensity to meet or beat earnings benchmarks declines following the provision of cash flow forecasts. We also predict and find that firms turn to other benchmark-beating mechanisms, such as real activities manipulation and earnings guidance in response to the provision of cash flow forecasts.     

The impact of abnormal real earnings management to meet earnings benchmarks on future operating performance

Motivated by agency conflicts of real earnings management (e.g., opportunistic and signalling perspectives), this study investigates the association between firms that manipulate their business operations to meet earnings benchmarks (i.e., zero earnings, last year's earnings) and subsequent operating performance. We examine the effects of the magnitude of real earnings management on firms' future performance for the period 2009 to 2015 for UK firms. Our analysis shows that the manipulation of operating activities such as sales, discretionary expenditures, and production costs to meet earnings benchmarks has a significantly positive consequence for firms' subsequent operating performance and signals firms' good future performance. We also find that firms that manipulate their operating activities in the absence of meeting earnings benchmarks experience a decline in their subsequent operating performance. The findings of this research lend support to our understanding of the process that management follows to evaluate costs and benefits of real earnings management.     

Firms' Voluntary Recognition of Stock-Based Compensation Expense

We investigate factors associated with firms' decisions in 2002 and early 2003 to recognize stock‐based compensation expense under Statement of Financial Accounting Standards (SFAS) No. 123. We find that the likelihood of SFAS 123 expense recognition is significantly related to the extent of the firm's participation in capital markets, the private incentives of top management and members of the board of directors, the level of information asymmetry, and political costs. Although recognizing firms have significantly smaller SFAS 123 expense, we find no significant incremental relation between recognition likelihood and SFAS 123 expense magnitude after controlling for other factors that we expect explain the recognition decision. We also find positive and significant announcement returns for earlier announcing firms, particularly those stating that increased earnings transparency motivates their decision.     

Accruals Management to Achieve Earnings Benchmarks: A Comparison of Pre-managed Profit and Loss Firms

Abstract:  This study examines whether firms with profits before accruals management are more likely than firms with losses before accruals management to meet or exceed earnings benchmarks when pre-managed earnings are below those benchmarks. We extend Brown (2001) by documenting that the differential propensity to achieve earnings benchmarks by profitable and nonprofitable firms results from differential accruals management behavior. We find that firms with profits before accruals management are more likely than firms with losses before accruals management to have pre-managed earnings below both analysts' forecasts and prior period earnings and reported earnings above these benchmarks.     

An analysis of the reasons for the asymmetries surrounding earnings benchmarks

Several studies report an asymmetry in the distribution of earnings around specified benchmarks. However, doubt has arisen over whether the observed ‘kink’ in the distribution of earnings is solely caused by earnings management. We use a ratio analysis approach to examine a range of specific accruals for evidence of earnings management. We find little evidence that firms immediately above the benchmark have abnormal receivables, inventories or provisions. However, they do increase cash‐from‐customers and reduce inventory. Thus, our results support the recent research that suggests that firms engage in real actions to meet earnings benchmarks.     

Corporate Life Cycle and Earnings Benchmarks

We examine whether and how corporate life cycle significantly influences meeting or beating earnings benchmarks (MBE). We find that corporate life cycle plays a significant role in a firm's meeting or beating earnings benchmarks behaviour. Developing strategies that fit into the stage of corporate life cycle is crucial for corporate success. MBE is an important financial goal that requires strategies. In this study, we examine whether and how corporate life cycle significantly influences MBE. Specifically, we focus on the incentives of MBE in growth and mature firms. We find that corporate life cycle significantly influences a firm's tendency to meet or beat zero earnings, prior earnings and analysts’ earnings forecasts. Based on logit regressions for the period from 1988 to 2008, the results indicate that growth firms are more likely to meet or beat all three earnings benchmarks. Overall, the results of this study indicate that a firm's MBE behaviour should be examined in the context of its life cycle stage.     

Managing earnings risk under SFAS 133/IAS 39: the case of cash flow hedges

Whereas empirical studies suggest that firm hedging is influenced by accounting standards such as SFAS 133 and IAS 39, the nature of earnings risk management remains a puzzle. I develop a model that shows how non-financial firms that prefer predictable earnings jointly optimize their hedging strategy and the choice between fair-value and hedge accounting. I also examine the implications of these decisions for earnings predictability under SFAS 133/IAS 39. In this model, which has two accounting periods, earnings uncertainty arises from economic shocks and accounting mismatches. The specific influence of accounting mismatches is isolated with two benchmarks, one for firm hedging (cash flow hedging) and another for an accounting system that fully complies with the matching principle. In this forward-looking analysis, most firms significantly decrease the hedging of long-term earnings when faced with persistent price dynamics. Under non-persistent price dynamics, the levels of long-term earnings hedging are only slightly reduced. Therefore, the influence of accounting mismatches on firm hedging is highly dependent on the economic environment in which a firm operates, which suggests that the potential influence of accounting on firm hedging may be difficult to identify in archival studies. The analysis also offers a forward-looking perspective on the changing properties of earnings since the late 1970s that supplements the existing body of archival accounting studies. For example, under persistent price dynamics, forward-looking short-term earnings volatility may increase tenfold or more for cash flow hedging under fair-value accounting compared with a perfectly matched accounting system.     

Why do pro forma and Street earnings not reflect changes in GAAP? Evidence from SFAS 123R

This study examines how key market participants??managers and analysts??responded to SFAS 123R??s controversial requirement that firms recognize stock-based compensation expense. Despite mandated recognition of the expense, some firms?? managers exclude it from pro forma earnings and some firms?? analysts exclude it from Street earnings. We find evidence consistent with managers opportunistically excluding the expense to increase earnings, smooth earnings, and meet earnings benchmarks but no evidence that these exclusions result in an earnings measure that better predicts future firm performance. In contrast, we find that analysts exclude the expense from earnings forecasts when exclusion increases earnings?? predictive ability for future performance and that opportunism generally does not explain exclusion by analysts incremental to exclusion by managers. Thus our findings indicate that opportunism is the primary explanation for exclusion of the expense from pro forma earnings and predictive ability is the primary explanation for exclusion from Street earnings. Our findings suggest the controversy surrounding the recognition of stock-based compensation expense may be attributable to cross-sectional variation in the relevance of the expense for equity valuation, as well as to differing incentives of market participants.     

Shifting corporate culture: executive stock ownership plan adoptions and incentives to meet or just beat analysts’ expectations

This paper investigates whether adoptions of executive stock ownership plans coincide with decreased incentives to meet or just beat analysts’ near-term EPS forecasts. Firms often assert that ownership plans focus executives on long-term performance. I find that the impact of these adoptions on meeting or just beating analysts’ EPS forecasts differs depending on whether the plan binds the CEO to reach ownership targets by a specified date. In particular, I find that firms that adopt plans requiring an increase in CEO ownership exhibit a lower propensity to meet or just beat earnings forecasts following plan adoptions. In contrast, firms that adopt plans that require no increase exhibit no change in the propensity to meet or just beat. The results suggest that firms use binding ownership plans to shift executives’ focus from near-term earnings benchmarks to long-term value creation.     

Detecting overproduction: Evidence from inventory write-down

We use inventory write-downs to differentiate opportunistic and non-opportunistic overproduction measures. We posit that non-opportunistic overproduction is positively associated with future write-downs because overproduction generally leads to excess inventory, while opportunistic overproduction (to inflate earnings) is negatively associated with write-downs because write-downs decrease earnings. We find that change-based proxies (deviations from past behaviour) are positively associated with the likelihood of future write-downs, whereas residual-based proxies (deviations from industry norms) are negatively associated with this likelihood, suggesting that the former (latter) primarily capture non-opportunistic (opportunistic) overproduction. Our study highlights the importance of using appropriate overproduction measures for each research setting.     

Conditional conservatism and the limits to earnings management

We examine the impact of conditional conservatism on earnings management. Our findings support the view that conditional conservatism reduces accruals-based earnings management but also triggers a trade-off between accruals and real earnings management. In our main tests we use the passage of SFAS 121 as a plausibly exogenous regulatory change that increased the level of conditional conservatism but did not materially affect earnings management. We find that, after the regulation, treated firms reduce accruals-based earnings management and increase real earnings management, and are less likely to be marginal or habitual beaters of earnings benchmarks. Given the crucial role of earnings for firm valuation and analysis, and that conditionally conservative accounting choices are observable, our results should be of wide interest for investment professionals.     

Earnings Management through Transaction Structuring: Contingent Convertible Debt and Diluted Earnings per Share

In this article we examine whether firms structure their convertible bond transactions to manage diluted earnings per share (EPS). We find that the likelihood of firms issuing contingent convertible bonds (COCOs), which are often excluded from diluted EPS calculations under Statement of Financial Accounting Standard (SFAS) 128, is significantly associated with the reduction that would occur in diluted EPS if the bonds were traditionally structured. We also document that firms' use of EPS‐based compensation contracts significantly affects the likelihood of COCO issuance and find weak evidence that reputation costs, measured using earnings restatement data, play a role in the structuring decision. These results are robust to controlling for alternative motivations for issuing COCOs, including tax and dilution arguments. In addition, an examination of announcement returns reveals that investors view the net benefits and costs of COCOs as offsetting one another. Our results contribute to the literature on earnings management, diluted EPS, financial reporting costs, and financial innovation.     

The use of advertising activities to meet earnings benchmarks: evidence from monthly data

Using a unique database of monthly media advertising spending, we examine whether managers engage in real earnings management to meet quarterly financial reporting benchmarks. We extend prior literature by (1) separately analyzing advertising activities, allowing us to explore the possibility that managers could reduce or boost advertising to meet benchmarks; (2) analyzing actual activities as opposed to inferring them from reported expenses, which are also subject to accrual choices; (3) investigating the timing, within a quarter, of altered advertising spending; and (4) examining quarterly earnings benchmarks. We find that managers, on average, reduce advertising spending to avoid losses and earnings decreases. However, we also report that firms in the late stages of their life cycle increase advertising to meet earnings benchmarks. Finally, we find some evidence that firms increase advertising in the third month of a fiscal quarter and in the fourth quarter to beat prior year’s earnings.     

Creating a Bigger Bath Using the Deferred Tax Valuation Allowance

Abstract:  The provisions of SFAS No. 109 allow US companies to make an earnings big bath even bigger through the establishment of a deferred tax valuation allowance. At the time a firm recognizes a non-cash charge, it also recognizes a deferred tax asset to represent the future tax benefits of the charge. Recognition of the deferred tax asset partially mitigates the negative earnings impact of the special charge. However, if the firm does not expect to have sufficient future taxable income to utilize the future tax benefits of the charge, SFAS No. 109 requires the firm to establish a deferred tax valuation allowance, effectively eliminating the recognized deferred tax asset. Thus, the establishment of the valuation allowance amplifies the negative earnings impact of the non-cash charge. We use a valuation allowance prediction model to identify firms that create a larger-than-expected valuation allowance; these firms may be creating a large valuation allowance as a reserve to be used to manage earnings in a subsequent period. We find that the vast majority of these larger-than-expected valuation allowances apparently reflect informed management pessimism about the future in that these firms actually do have poorer operating performance in subsequent periods. We do not find any evidence that subsequent reversals of valuation allowances are used to turn a loss into a profit. However, we do find a very small number of firms that appear to have used a valuation allowance reversal to meet or beat the mean analyst forecast.     

Institutional investor type,earnings management and benchmark beaters

This paper classifies institutional investors into transient or long-term by their investment horizons to examine the association between institutional investor type and firms’ discretionary earnings management strategies in two mutually exclusive settings – firms that (do not) use accruals to meet/beat earnings targets. The results support the view that long-term institutional investors constrain accruals management among firms that manage earnings to meet/beat earnings benchmarks. This suggests long-term institutional investors can mitigate aggressive earnings management among these firms. Transient institutional ownership is not systematically associated with aggressive earnings management and is evident only among firms that manage earnings to meet/beat their earnings benchmarks. This indicates transient institution-associated managerial myopia may not be as prevalent as posited by critics. This study highlights the importance of explicitly considering the type of institutional investor and the specific setting when investigating the association between institutional ownership and corporate earnings management.     

Managerial Empire Building and Firm Disclosure

This study tests the agency cost hypothesis in the context of geographic earnings disclosures. The agency cost hypothesis predicts that managers, when not monitored by shareholders, make self‐maximizing decisions that may not necessarily be in the best interest of shareholders. These decisions include aggressively growing the firm, which reduces profitability and destroys firm value. Geographic earnings disclosures provide an interesting context to examine this issue. Beginning with Statement of Financial Accounting Standards No. 131 (SFAS 131), most U.S. multinational firms are no longer required to disclose earnings by geographic area (e.g., net income in Mexico or net income in East Asia). Such nondisclosure potentially reduces the ability of shareholders to monitor managers' decisions related to foreign operations. Using a sample of U.S. multinationals with substantial foreign operations, we find that nondisclosing firms, relative to firms that continue to disclose geographic earnings, experience greater expansion of foreign sales, produce lower foreign profit margins, and have lower firm value in the post–SFAS 131 period. Our conclusions are strengthened by the fact that these differences do not exist in the pre–SFAS 131 period and do not relate to domestic operations. We find differences in the predicted direction only for foreign operations and only after adoption of SFAS 131. Our results are robust to the inclusion of an extensive set of control variables related to alternative corporate governance mechanisms, operating performance, and the firm's information environment. Overall, the results are consistent with the agency cost hypothesis and the important role of financial disclosures in monitoring managers.     

Asset Disposal as a Method of Real Earnings Management: Evidence from the UK

We examine asset sales as a method of real earnings management around the benchmarks of loss avoidance and last year's earnings. Evidence is reported of asset sales to boost or reduce earnings near the benchmark of last year's earnings. For the zero earnings benchmark our results are moderated by the opening balance of accruals: only firms with high levels of accruals use asset sales to boost earnings to avoid a loss and only firms with low levels of accruals use asset sales as part of a big bath. We suggest that firms with high accrual balances find it difficult to use additional income-increasing accruals but find it more convenient to write off accruals rather than sell assets to artificially reduce earnings. International Financial Reporting Standards (IFRS) are associated with reduced use of asset sales for gains and especially with reduced asset sales for losses. We ascribe this to IFRS introducing additional judgement and estimation in relation to the valuation of both long-lived and current assets on a recurring basis.     

The effect of SFAS 131 on the stock market’s ability to predict industry‐wide and firm‐specific components of future earnings

This study examines the impact of SFAS 131 on the extent to which stock prices incorporate industry‐wide and firm‐specific components of future earnings. By decomposing earnings into industry‐wide and firm‐specific components, this paper finds that the firms that aggregated segments under the old rule experience significant acceleration in the incorporation of future earnings into current stock prices upon adoption of SFAS 131. However, the acceleration of future earnings is mostly driven by the improved incorporation of industry‐wide components of future earnings, which indicates the market’s ability to predict firm‐specific components is not significantly changed. Supplemental analysis suggests that the reduced geographic earnings information is one possible reason for lack of improvement in incorporating firm‐specific earnings into price.     

The impact of SFAS No. 141 on earnings predictability of merging firms: Evidence from the initial year of implementation

This study examines the impact of SFAS 141 on earnings predictability of merging firms. I expect a relative improvement in analysts’ earnings forecast accuracy for merging firms versus non-merging peers after SFAS 141 adoption. I restrict the post-SFAS 141 sample to the initial year of SFAS 141 implementation. This research design disentangles effects of SFAS No. 141 from those of SFAS No. 142. The evidence from analysis of 48 pairs of merging and matched non-merging firms is consistent with expectations and confirms the increase in earnings predictability for merging firms versus their non-merging peers post-SFAS 141. Results of additional tests suggest that earnings predictability improvement more likely follows from extended disclosure requirements and the other changes in the Purchase Method (“better purchase” issue) than from the elimination of Poolings-of-Interest (“purchase vs. pooling” issue).     

Competitive harm and geographic area disclosure under SFAS 131

Prior research documents considerable diversity in the amount of detail provided by companies in complying with the foreign country disclosure requirements of SFAS 131. We posit that the potential competitive harm associated with country specific disclosures provides an incentive for management to avoid making these disclosures. Specifically, we hypothesize that firms with higher potential competitive harm costs will provide less detailed geographic area disclosures. Our results show that, as expected, firms exposed to greater competitive harm costs provide less detailed country specific revenue disclosures. This study helps to explain the diversity in practice with respect to the level of detail provided by companies in their geographic area disclosures under SFAS 131. In addition, it adds to the literature examining the impact of potential competitive harm on disclosures made by U.S. firms, by extending the line of research to geographic area disclosures.