Abstract
Motivated by recent practitioners’ concerns that short-term earnings guidance leads to managerial myopia, we investigate the impact of short-term earnings guidance on earnings management. Using a propensity-score matched control sample, we find strong and consistent evidence that the issuance of short-term quarterly earnings guidance is associated with less, rather than more, earnings management. We also find that regular guiders exhibit less earnings management than do less regular guiders. Our findings hold using both abnormal accruals and discretionary revenues to measure earnings management and after controlling for potential reverse causality concerns. Furthermore, in a setting where managers have particularly strong capital market incentives to manage earnings, we corroborate these findings by documenting that earnings guidance either has no impact on or mitigates earnings management. Overall, our evidence does not support the criticism from practitioners that short-term earnings guidance leads to more earnings management.
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Notes
As noted by Chen et al. (2011), surveys conducted by the National Investors Relations Institute suggest the number of firms providing quarterly guidance decreased from 75 % in 2003 to 27 % in 2007.
Accounting manipulations, when revealed, can lead to financial restatements that destroy shareholder value. For example, prior studies document significantly negative average abnormal returns and significant increases in cost of capital surrounding announcements of financial restatement (Palmrose et al. 2004; Hribar and Jenkins 2004).
We exclude forecasts made after the end of the fiscal period but before earnings are announced because these forecasts are usually considered pre-announcements of earnings. In untabulated sensitivity analyses, we include firms issuing earnings preannouncements, and our findings are qualitatively similar. Note that most firms that issue earnings preannouncements also issue quarterly guidance before the end of the quarter.
Managers have discretion in financial reporting and can use such discretion opportunistically for rent extraction or efficiently to maximize firm value. We adopt the opportunistic view of earnings management, consistent with Schipper (1989), who defines earnings management as “… a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain…,” and Healy and Wahlen (1999), who state that, “earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.”
While some critics of short-term earnings guidance are also concerned about the impact of guidance on earnings management through real activities, the focus of our paper is accrual-based earnings management. However, in untabulated analyses using annual measures of real activities management advanced by Roychowdhury (2006) (i.e., abnormal operating cash flows, abnormal production costs, and abnormal discretionary expenses), we find evidence that guiding firms exhibit less real activities manipulation than do non-guiding firms. In contrast, Cheng et al. (2008) examine the association between earnings guidance and real earnings manipulation and find firms that guide frequently invest significantly less in research and development than do firms that guide occasionally.
In an untabulated test, we compare firms that issue only long-term annual forecasts in the first three quarters of the current year (the same forecasts examined by Kasznik 1999) to a propensity-score matched control sample of firms that do not issue long-term annual guidance in the same year. We find no difference in absolute annual abnormal accruals or discretionary revenues, our two measures of earnings management, across these two samples. This finding further illustrates (a) that our findings cannot be inferred from Kasznik (1999), and vice versa, and (b) the fundamentally different incentives associated with long-term versus short-term guidance (Chen et al. 2011; Houston et al. 2010).
In a concurrent study, Acito (2011) examines whether quarterly earnings guidance is related to benchmark beating and accounting irregularities. He finds that both guiding and non-guiding firms manage earnings to beat earnings benchmarks and concludes that the level of earning management exhibited by both types of firms is similar. In addition, he finds no relation between the issuance of quarterly earnings guidance and the likelihood of accounting irregularities. Thus, his findings are also inconsistent with critics’ concerns that firms that issue quarterly earnings guidance exhibit more earnings management than do non-guiding firms.
The evidence in Choi et al. (2011) is also consistent with Houston et al. (2010) and Chen et al. (2011), who show that information transparency and disclosure quality deteriorate for firms that cease to issue quarterly earnings guidance. In contrast, Hu et al. (2012) find that, upon cessation of quarterly guidance, information asymmetry decreases more for firms that issued guidance in at least three quarters of the previous year than for firms that issued guidance in less than three quarters in the previous year.
To avoid considerably reducing the sample size, for firms that are not followed by any analysts, we set AC (analyst coverage) equal to zero and set DISP (forecast dispersion) equal to the sample mean.
To ensure that our matching procedure is valid, we calculate the average difference in the predicted probability of guidance issuance between guidance firms and the matched control firms that do not issue guidance. This average difference is very small and is not statistically significant using a t test. We therefore conclude that our matching procedure is effective.
Dechow and Dichev (2002) provide a theoretically sound abnormal accrual model that is widely used to capture earnings management. However, we do not use the Dechow–Dichev model because we focus on the impact of short-term earnings guidance on quarterly earnings management, and the Dechow–Dichev model does not lend itself to quarterly estimation.
In Eq. (2), even though MF is measured using the same window as the dependent variable, EM, there is a lead-lag relation between the measures of forecast guidance (i.e., MF_ISSUE and MF_REG) and the abnormal accrual/discretionary revenue proxies (ABAC and ABREV).
We control for the level of operating cash flows in the estimation of abnormal accruals (ABAC), consistent with the approach in Ball and Shivakumar (2006). However, Hribar and Nichols (2007) suggest that the level of operating cash flows can be included again as a control variable in subsequent empirical models with unsigned abnormal accruals as the dependent variable. As a robustness check, we further control for the level of operating cash flows in Eq. (1). We find similar results (untabulated) in all our primary tests, and our inferences remain unchanged.
For expositional ease, in our regression analyses, we multiply the quarterly earnings management proxies (ABAC and ABREV) by 100 (see “Appendix 1”). The mean of the quarterly abnormal accrual proxy (ABAC = 2.59 or 10.36 % on an annual basis) reported in Table 1 is comparable to those reported in prior studies using annual abnormal accruals. For example, Hribar and Nichols (2007) report means of absolute annual abnormal accruals between 10.1 and 13.0 % based on the Jones (1991) model.
In terms of economic significance, firms that issue short-term guidance exhibit, on average, between 4.3 % (ABAC) and 6.1 % (ABREV) less earnings management than do firms that do not issue short-term guidance. Furthermore, firms that regularly issue short-term guidance (MF_REG = 4) exhibit between 10.9 % (ABAC) and 14.5 % (ABREV) less earnings management than do non-guiding firms.
Francis, Nanda, and Olsson (2008) capture voluntary disclosure quality through a self-constructed index based on 2001 annual reports and 10-K filings for 677 firms and find that higher earnings quality drives the quality of disclosure in firms’ mandatory filings. However, unlike Lennox and Park (2006); Francis et al. (2008) do not find any relation between management earnings forecast frequency and their earnings quality metric.
For parsimony and expositional purposes, we do not tabulate the coefficients and t statistics for the control variables in all subsequent tables.
We do not perform a corresponding analysis on the signed regularity of earnings guidance because UPMF, MIDMF, and DOWNMF are already defined based on the direction of every management forecast that the firm issues during the year.
These results do not suggest meeting or beating is not an appropriate proxy for earnings management in other research settings. Rather, because our primary independent variable (earnings guidance) is associated with meeting or beating for reasons other than managerial manipulation of earnings, it is not a reliable proxy for earnings management in this setting.
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Acknowledgments
We thank Patricia Dechow (editor) and two anonymous reviewers for their comments and guidance. In addition, we thank Bruce Billings, Rebecca Hann, Frank Heflin, John Jiang (discussant at the 21st Annual Conference on Financial Economics and Accounting, University of Maryland), Steve Kachelmeier, Bill Kinney, Ramgopal Venkataraman (discussant at the 2011 FARS Midyear Conference), and workshop participants at Georgetown University, Florida State University, Hong Kong University of Science and Technology, and the University of Rochester, and brownbag participants at the University of Texas at Austin for helpful comments. All errors are our own.
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Call, A.C., Chen, S., Miao, B. et al. Short-term earnings guidance and accrual-based earnings management. Rev Account Stud 19, 955–987 (2014). https://doi.org/10.1007/s11142-013-9270-7
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DOI: https://doi.org/10.1007/s11142-013-9270-7