«Making Sense of Cents: An Examination of Firms That Marginally Miss or Beat Analyst Forecasts Sanjeev Bhojraj Paul Hribar Johnson Graduate School of ...»
Making Sense of Cents:
An Examination of Firms That Marginally Miss or Beat Analyst
Johnson Graduate School of Management
Cornell University, Ithaca, NY
Kelley School of Business
Indiana Univesity, Bloomington, IN
February 3, 2006
We thank Thomson Financial Services Inc. for providing earnings per share forecast data, available
through the Institutional Brokers Estimate System (I/B/E/S). The data have been provided as part of a broad academic program to encourage earnings expectation research. We gratefully acknowledge the insightful comments and suggestions made by Jeff Abarbanell, Marty Butler, Nick Dopuch, Charles Lee, Bob Libby, Bob Lipe, Jeff Payne, Scott Richardson, Siew Hong Teoh, Wayne Thomas, Charles Wasley, Ross Watts, Jerry Zimmerman, and seminar participants at Binghamton University, Cornell University, the University of Illinois, The University of Minnesota, The University of North Carolina, The University of Oklahoma, the University of Rochester, and Washington University in St. Louis.
Making Sense of Cents:
An Examination of Firms That Marginally Miss or Beat Analyst Forecasts Abstract This paper examines the short and long run performance implications of managing earnings to exceed market expectations. In particular, we examine the performance differences between two groups of firms: (1) firms that marginally exceed consensus forecasts but manage earnings upwards and (2) firms that miss consensus forecasts but do not manage earnings. We choose these two groups because they maximize the likelihood that earnings management activities undertaken by the firm would be able to move the firm from missing the earnings benchmark to beating it. In comparing the performance of these two groups, we find that using accruals or cutting discretionary expenditures to beat expectations results in a short-term positive impact on stock price, but adversely affects the firm in the long-term. We also examine whether managers behave as if they are cognizant of this trade-off and take actions to capitalize on the short-term positive performance impact of beating expectations through earnings management. We find that firms that manage earnings to exceed analyst expectations have significantly greater equity issuances and insider selling in the following year when compared with not only firms that missed expectations but also firms that beat expectations without managing earnings.
I. Introduction Recent work suggests that there is pressure on firms to avoid missing earnings forecasts, and that this pressure has intensified in recent years (e.g. Barth, Elliott, Finn 1999; Brown 2001;
Kasznik and McNichols 2002). Consequently, there is a growing body of evidence showing that a disproportionate number of firms meet or slightly beat analyst forecasts than would be expected by chance (Degeorge, Patel, Zeckhauser 1999; Payne and Robb 2000; Burgstahler and Eames 2002), and that the frequency with which firms exceed these forecasts has been increasing with time (Brown 2001). A recent survey by Graham, Harvey, and Rajgopal (2004) provides strong evidence that managers are willing to sacrifice economic value to meet short run earnings objectives. For example, they report that a majority of managers would forego a positive NPV project if it would cause them to fall short of the current quarter consensus forecast. In addition, Baber, Fairfield, and Haggar (1991) show that concerns regarding reported income affect expenditures on R&D, and Bhojraj and Libby (2004) find that managers faced with a stock issuance more often choose projects that they believe will maximize short-term earnings (and price) as opposed to total cash flows.
A related body of research investigates the reasons why managers are motivated to meet or beat expectations (see, for example, Bartov, Givoly, Hayn 2002; Kasznik and McNichols 2002; Skinner and Sloan 2002; Graham et al. 2004). One finding from this line of research is that there appears to be a valuation premium associated with meeting or beating analyst forecasts, i.e., firms that successfully meet or beat analyst forecasts earn higher returns than would be expected given the information contained in current earnings. A second explanation is provided by Skinner and Sloan (2002), who show that missing expectations even by a small amount can trigger a disproportionately large negative stock price response by the market, suggesting that firms will be motivated to take steps to avoid an ‘earnings torpedo.’ Finally, Graham et al. (2004) report that the most frequently cited reasons managers give for trying to beat benchmarks are to build credibility with the capital markets, to maintain or increase stock price, and to preserve managerial reputation. With respect to missing benchmarks, managers were most concerned that it created uncertainty about future prospects.
If, in fact, managers are willing to sacrifice future earnings, through accounting or cash flow-based earnings management, to meet short term earnings benchmarks, then there should be long term performance consequences associated with these choices. However, there is little empirical research that has documented the long-term implications of this behavior. In this paper, we address this issue by examining three research questions. First, do firms that indulge in myopic behavior enjoy short term benefits from managing earnings to exceed an earnings benchmark? Second, are there long run negative consequences associated with managing earnings to exceed benchmarks? Finally, do managers that act myopically to beat an earnings benchmark take actions to capitalize on this behavior?1 To examine these questions we focus primarily on two particular subsets of firms. One group consists of firms that marginally beat consensus forecasts (by one cent) and manage earnings upwards and the other group consists of firms that marginally miss consensus forecasts (by one cent) but do not manage earnings.2 We use accruals, R&D expense, and advertising While the term managerial myopia often reflects managerial opportunism that is detrimental to current shareholders, this need not be the case. In our study, we use the term myopia to reflect any activities that boost short run earnings at the expense of long run earnings (i.e. accruals and discretionary expenditures). For example, if a firm is planning on issuing equity, then increasing current earnings might benefit the current shareholders in that they will receive more cash for the shares that are issued. See Bhojraj and Libby (2005) for a more detailed discussion of this issue.
Of course, earnings management is not necessary for a firm to beat expectations. The sample of firms that beat by one cent includes (1) firms that would have missed but managed earnings through accruals or reductions in discretionary expenditures in order to beat, (2) firms that would have missed but guided analysts downward early in the quarter in order to beat by one cent, and (3) firms that did not have to take any overt actions in order to beat by one cent (i.e. they would have beaten by one penny or more without any earnings management or guidance). We expense to capture the discretion that firms have in meeting the consensus forecast.3 We choose these two particular subsamples because they maximize the likelihood that earnings management activities undertaken by the firm would be able to move the firm from missing the earnings benchmark to beating it.4 For example, a firm that beats by one cent but has a significant decrease in R&D or advertising expenditures or reports a significant amount of income increasing accruals likely would have missed expectations without these transactions. In contrast, a firm that misses by only one penny but continues investing in R&D or advertising and has conservative accruals likely could have beaten the benchmark had they cut these expenditures.
A comparison of these two groups of firms speaks directly to the economic consequences of the tradeoff that managers face when they manage earnings to exceed analyst forecasts. On the one hand, beating forecasts increases contemporaneous returns and a consecutive string of such positive surprises can increase the valuation premium that a firm receives (Kasznik and McNichols 2002), and avoid a potentially drastic reduction in stock price associated with missing a forecast (Skinner and Sloan 2002). On the other hand, cutting discretionary expenditures or managing accruals upward will induce a transitory component to earnings that increases the likelihood that future earnings will reverse, and future performance will suffer. While accruals will often reverse within one year, cutting discretionary expenditures is potentially even more are only interested in the first group of firms. To the extent that our partition captures firms of the second or third type, it will reduce the power of our tests.
We do not examine expectations management as a mechanism to exceed analyst forecasts. Although earnings guidance shifts the timing of the earnings surprise, they should not affect future profitability since no economic construct has changed (i.e. unlike accruals and discretionary expenditures, forecast guidance does not affect the earnings of the current period, and should not affect future earnings, ceteris paribus).
Prior research has examined the association between earnings surprises and accruals (e.g. Collins and Hribar 2000;
Defond and Park 2001) in the extreme earnings surprise groups. We do not examine these groups as it is unreasonable to expect that a firm in an extreme earnings surprise decile would be able to qualitatively alter their earnings surprise (i.e. move from negative earnings surprise to a positive earnings surprise) via any type of earnings management. Moreover, these studies have focused on the groups where the signals are in the same direction, whereas we are interested in the tradeoff between reporting a small positive earnings surprise and taking potentially myopic actions.
problematic because to the extent that these expenditures are positive NPV investments intended to generate long-term earnings, the persistence of earnings is reduced even further.5 The firms that miss expectations but report high quality earnings provide an interesting comparison group because they represent the other side of the tradeoff. In particular, it appears that these firms have financial statement characteristics that would allow them to exceed the benchmark, but for some reason have chosen not to do so. Thus, they are likely to have negative stock returns at the earnings announcement, but high quality earnings, which would reflect positively on their longterm prospects.
Our results show that in the short term, firms using accruals or discretionary expenditures to beat a forecast outperform firms that miss expectations but have high quality earnings. In the long run, however, these firms underperform the firms that missed expectations with high quality earnings. Examining the components separately, we find that accruals and R&D contribute to the superior performance of the firms that miss expectations, but that advertising expense either has no effect or works in the opposite direction. We also find that firms beating expectations with low quality earnings show a reduction in ROA at the one year horizon, followed by a flat ROA over the next two years, while firms that missed expectations with high quality earnings have a flat ROA in the first year and significantly positive increases in ROA in years 2 and 3.
After observing the patterns in future earnings and stock returns, we then examine whether managers take actions that reflect an understanding of the short and long run implications of beating expectations through earnings management. If, in fact, managers act myopically and sacrifice long-run earnings in order to meet a short-run earnings benchmark, then Stated differently, reductions in value generating discretionary expenditures will have two effects on earnings persistence. First, an increase in earnings generated by cutting these expenses will be less persistent (i.e. the increase cannot be permanent) because the expenditures are bounded at zero. Second, future earnings will be reduced because of the lost income associated with the investment in R&D or advertising.
we would expect their actions to reflect this tradeoff. Theoretical models such as Stein (1989) and Bar-Gill and Bebchuk (2003) suggest that firms that are planning to issue equity will be more likely to behave myopically or misreport corporate performance. Bar-Gill and Bebchuk (2003) also find that managerial selling will increase when managers misreport. Consistent with these models, our results show that firms that beat forecasts with low quality earnings are significantly more likely to issue equity in the following year and exhibit significantly greater insider selling. These results hold regardless of whether they are compared to the firms that miss forecasts with high quality earnings or to the firms that beat forecasts but with high quality earnings. This is finding suggests that managers are aware of the short and long term implications of beating forecasts with low quality earnings and take actions accordingly.
Our paper contributes to the literatures on benchmark beating and managerial myopia, and our findings are particularly germane in light of the Graham et al. (2004) survey, where managers report a willingness to forego positive NPV projects in order to meet consensus forecasts. Our results indicate that while there are short-term benefits to a strategy of beating expectations using earnings management, there are also adverse long-term effects. The results suggest that a long-term investor is likely to be better off investing in a firm that marginally misses expectations without managing earnings than investing in one that beat expectations through earnings management.
We also provide empirical evidence that managers of these firms appear to understand these tradeoffs, in that they are significantly more likely to take actions that capitalize on the short term price benefits associated with beating the benchmark. This evidence is consistent with the survey and experimental evidence that suggests managers are willing to take myopic actions to exceed earnings benchmarks.