Corporate executives pay considerable attention to secondary market prices and they have strong incentives to maintain or increase the level of their firms’ stock prices. The accounting literature has long recognized that managers can make strategic financial reporting or disclosure choices to influence stock prices. A large body of empirical research examines whether and how corporate disclosures affect stock prices. The literature, however, provides little directional evidence on whether the behavior of stock prices has a causal effect on managerial strategic disclosure decisions. The difficulty in establishing causality stems largely from the endogenous nature of stock prices. In the paper, Short Selling Pressure, Stock Price Behavior, and Management Forecast Precision: Evidence from a Natural Experiment, which is forthcoming in Journal of Accounting Research, we use a randomized experiment, the Regulation SHO pilot program, to examine the causal effect of stock price behavior on managers’ voluntary disclosure choices.
Posts Tagged ‘Forecasting’
An initial public offering (IPO) is a major event in the life of any firm. But what does an IPO imply for the industry’s future? In our paper, An IPO’s Impact on Rival Firms, which was recently made publicly available on SSRN, we take a structural approach that allows different industries to progress in different ways post IPO. If one is forced to make a sweeping generalization, then this paper finds an IPO augurs in an era of reduced profits and greater consumer mobility within an industry. Unlike a static model, a structural model’s parameters produce implications about magnitudes rather than just signs. This permits one to assess whether the estimates are economically “reasonable in a straightforward manner.”
In Osram Sylvania Inc. v. Townsend Ventures, LLC, the Delaware Court of Chancery (VC Parsons) declined to dismiss claims by Osram Sylvania Inc. that, in connection with OSI’s purchase of stock of Encelium Holdings, Inc. from the company’s other stockholders (the “Sellers”), Encelium’s failure to meet sales forecasts and manipulation of financial results by the Sellers amounted to a material adverse effect (“MAE”). The decision was issued in the context of post-closing indemnity claims asserted by OSI against the Sellers and not a disputed closing condition.
OSI, a stockholder of Encelium, agreed to purchase the remaining capital stock of Encelium not held by OSI pursuant to a stock purchase agreement executed on the last day of the third quarter of 2011. The $47 million purchase price was agreed based on Encelium’s forecasted sales of $4 million for the third quarter of 2011, as well as Sellers’ representations concerning Encelium’s financial condition, operating results, income, revenue and expenses. Following the closing of the transaction in October 2011, OSI learned that Encelium’s third quarter results were approximately half of its forecast and alleged that Encelium and the Sellers knew about these sales results, but failed to disclose them at closing in violation of a provision in the agreement requiring them to disclose facts that amount to an MAE. OSI also alleged other misconduct by Encelium and the Sellers, including, among other things, that they had manipulated Encelium’s second quarter results to make its business appear more profitable.
In considering the Sellers’ motion to dismiss OSI’s contract and tort-based claims, the court held that:
In our paper, Managerial Incentives and Management Forecast Precision, forthcoming in The Accounting Review, we focus on one important characteristic of management forecasts—forecast precision—and examine how managerial incentives affect the choice of forecast precision. We choose to focus on forecast precision (or specificity, as it is sometimes referred to in the literature) for two reasons. First, precision is one of the most important forecast characteristics over which managers have a great deal of discretion. Managers can issue qualitative or quantitative forecasts, and the latter may take the form of point forecasts, range forecasts, or open-ended forecasts. More than 80% of the quantitative forecasts compiled by Thomas Financial are in the range format (i.e., estimates with explicit upper and lower bounds), and there is a large degree of variation in forecast width (i.e., the difference between the upper and lower bounds). One might even argue that managers have greater discretion over the precision of their earnings forecasts than over whether to provide forecasts in the first place (Hirst et al. 2008). Managers cannot always withhold information because it is part of their fiduciary duty to update and correct previous disclosures. Furthermore, withholding information can lead to considerable litigation risks and can cause great damage to a manager’s reputation (Skinner 1994). Second, forecast precision has a significant effect on market reactions to management forecasts. A number of theoretical papers, such as Kim and Verrecchia (1991) and Subramanyam (1996), argue that the magnitude of the market reaction to a disclosure is positively related to its precision, and empirical studies examining the impact of management forecast precision on stock returns and analyst forecast revisions provide support for this argument (e.g., Baginski et al. 1993; Baginski et al. 2007).
Theory suggests that Chief Executive Officers (CEOs) with short horizons with their firm have weaker incentives to act in the best interest of shareholders (Smith and Watts 1982). To date, research examining the “horizon problem” focuses on whether CEOs adopt myopic investment and accounting policies in their final years in office (e.g., Dechow and Sloan 1991; Davidson et al. 2007; Kalyta 2009; Antia et al. 2010). In our paper, Forecasting Without Consequence? Evidence on the Properties of Retiring CEOs’ Forecasts of Future Earnings, forthcoming in The Accounting Review, we extend this line of research by investigating whether retiring CEOs are more likely to engage in opportunistic forecasting behavior in their terminal year relative to other years during their tenure with the firm. Specifically, we contrast the properties (issuance, frequency, news, and bias) of earnings forecasts issued by retiring CEOs during pre-terminal years (where the CEO will be in office when the associated earnings are realized) with forecasts issued by retiring CEOs during their terminal year (where the CEO will no longer be in office when the associated earnings are realized). We also examine circumstances in which opportunistic terminal-year forecasting behavior is likely to be more or less pronounced.
Our predictions are based on several incentives that arise (or increase) during retiring CEOs’ terminal year with their firm. Specifically, relative to CEOs who will continue with their firm, retiring CEOs face strong incentives to engage in opportunistic terminal-year forecasting behavior in an attempt to inflate stock prices during the period leading up to their retirement. Deliberately misleading forecasts can be used to influence stock prices. Consistent with this argument, prior work shows that managers use voluntary disclosures opportunistically to influence stock prices (Noe 1999; Aboody and Kasznik 2000; Cheng and Lo 2006; Hamm et al. 2012) and that managers use opportunistic earnings forecasts to manipulate analysts’ (Cotter et al. 2006) and investors’ perceptions (Cheng and Lo 2006; Hamm et al. 2012) in an effort to maximize the value of their stock-based compensation (Aboody and Kasznik 2000). Moreover, because SEC trading rules related to CEOs’ post-retirement security transactions are less stringent than those in effect during their tenure with the firm, post-retirement transactions can be made before the earnings associated with the opportunistic forecast are realized and with reduced regulatory scrutiny.
In our paper, Bias and Efficiency: A Comparison of Analyst Forecasts and Management Forecasts, we compare the forecast characteristics of analyst forecasts and management forecasts. Frequently, analysts and managers provide similar type of information to investors, namely forecasts. Since managers and analysts have different incentives and different information sets, we empirically test whether those differences are manifested in their forecast characteristics. Specifically, we compare the bias, a systematic deviation of management and analyst EPS forecasts from the actual realized EPS, and efficiency, the ability of managers and analysts to incorporate prior publicly available information in their forecasts.
When comparing management forecasts and analyst forecasts, it is important to consider the implications of the difference in incentives and information available to analysts and managers. Since prior literature documents an optimistic bias in analyst forecasts, we expect that, given management incentives and cognitive biases, management forecasts will be at least as biased as analyst forecasts. In addition, since companies’ managers are exposed to private information, we expect management forecasts to better incorporate prior available information.
We find several striking results. First, we find that prior stock returns do not predict management forecast errors while they predict analyst forecast errors. Furthermore, while we find an optimistic bias in a broad sample of both management forecasts and analyst forecasts, the optimistic bias in analyst forecasts disappears in months in which management forecasts are issued. The bias is still apparent for these firms when managers do not provide forecasts.
In the paper, Mandatory Financial Reporting Environment and Voluntary Disclosure: Evidence from Mandatory IFRS Adoption, which was recently made publicly available on SSRN, we investigate the interaction between mandatory financial reporting environment and voluntary disclosure by employing the mandatory adoption of International Financial Reporting Standards (IFRS) in 2005 as an exogenous increase to mandatory reporting to examine changes in firms’ voluntary disclosure practices. To measure voluntary disclosure, we focus on a discretionary action, namely the extent to which managers provide earnings forecasts, the most prominent performance measure that a firm supplies to investors. Ex-ante, it is unclear how the increase in reporting quality following the mandatory adoption of IFRS could influence management forecasts. On the one hand, mandatory financial reporting and voluntary disclosure can be complements, wherein the former produces verifiable information that improves the credibility of the latter and therefore encourages managers to issue more forecasts, i.e. the confirmatory role of mandatory reporting.
Prior studies document improved reporting quality following IFRS adoption, evidenced by earnings with lower manipulation and higher value relevance, timeliness, and information content. Therefore, given the evidence that IFRS improves the verifiability of earnings, the complementary view suggests that the mandatory adoption of IFRS should increase management forecasts. On the other hand, mandatory financial reporting and voluntary disclosure could also be substitutes, as private information that was previously conveyed through voluntary disclosure is now directly reflected in mandatory financial reports. Since IFRS produces more timely and value-relevant earnings numbers, the substitution effect predicts that the increased quality of financial reporting may reduce the demand for supplementary information from investors to predict future earnings. Therefore, IFRS adoption may also lead to fewer management forecasts.
In the paper, Capital Market Consequences of Managers’ Voluntary Disclosure Styles, which is forthcoming in the Journal of Accounting and Economics, I examine the capital market consequences of managers establishing an individual disclosure style. While both neoclassical economic and agency theories suggest that managers’ individual preferences should not have an effect on corporate outcomes, several recent academic studies find that managers have styles of their own that they carry from one firm to the other. Anecdotal evidence also suggests that manager credibility matters to financial analysts, who penalize CEOs and CFOs that fail to effectively manage expectations. To the extent that these manager-specific “styles” affect investors’ perceptions of the manager’s overall reputation and credibility, investors should take this into consideration when responding to managers’ disclosure decisions.
In July 2005, the Securities and Exchange Commission (SEC) announced the enactment of the Securities Offering Reform (Reform), which, among other things, relaxes restrictions—known as ‘gun jumping’ provisions—on firms’ forward-looking disclosures prior to public equity offerings. The SEC argues that in recent years, the information environment has become much richer through marked improvements in mandated disclosure quality and both broader and timelier dissemination of information, rendering gun jumping provisions “unnecessary and outdated,” as these rules restrict valuable information flow to investors around a highly important corporate event (SEC ). However, opponents of the Reform argue that the restrictions are meant to protect investors from managers conditioning the market (i.e., hyping the stock price) before incentive-rich corporate events such as equity offerings, and the relaxation of these restrictions will increase market conditioning.
In our paper, The Changing Information Environment and Disclosure De-regulation: Evidence from the 2005 Securities Offering Reform, which was recently made publicly available on SSRN, we examine the impact of the Reform on management forecasting behavior before equity offerings. To provide a broader context in which to evaluate this impact, we also investigate the effect of the recently improved information environment on market conditioning. Thus, this paper is comprised of three main analyses. First, using the enactment of SOX in 2002 as the shift in the information environment, we examine whether managers generally attempt to mislead the market using forecast announcements in the pre-SOX period. Using a difference in differences design, we find that there is a statistically significant increase in the propensity and magnitude of good news disclosures by SEO firms via management forecasts in the period before the SEO, as compared to those of non-SEO firms in the same industry and of similar size, growth, and performance. Moreover, we observe a negative association between the pre-SEO good news disclosure activity and long-term abnormal returns following the SEO. This suggests that in the less rich information environment pre-SOX, managers use forecast announcements to hype the stock price in the months prior to equity offerings.