Can Companies Smooth-Talk Investors?

Investors Prove Wise at Judging Self-Serving Earnings Explanations

Investors have proven to be sophisticated enough to dismiss implausible explanations from companies of their quarterly earnings results, according to a new study.

For example, a utility company might attribute their lower earnings to “warm weather and higher propane products costs,” while an insurance company might explain a good quarter by touting its “continued efforts on cost containment and operational efficiencies.” Self-serving attributions such as these, which typically blame outside factors for negative developments and claim that their own internal initiatives led to positive results, are a traditional part of corporate earnings reports and press releases. But that doesn’t mean investors generally believe them.

According to a new study in The Accounting Review, a journal of the American Accounting Association, market response to self-serving attributions depends in large part on two key tests of plausibility—how badly the company’s industry peers are doing and what the study calls “commonality,” the extent to which market or industry forces drive a company’s earnings.

The difference proved to be dramatic when those two key tests were applied to the 94 companies in the study, which was conducted by Michael D. Kimbrough of the University of Maryland and Isabel Yanyan Wang of Michigan State University. Firms with average positive earnings surprises who made the highest-plausibility attributions had three-day above-market returns of 4.77 percent on average, whereas those that offered the lowest-plausibility reasons actually averaged a slight decline of 0.79 percent. Meanwhile, among firms with average negative surprises, those with the lowest-plausibility attributions sustained average declines of 5.11 percent, while those with the highest-probability excuses had declines of only 1.42 percent.

“Firms which provide defensive attributions to explain earnings disappointments experience less severe market penalties when 1) more of the their industry peers also release bad news, and 2) their earnings share higher commonality with industry- and market-level earnings,” said the paper. “On the other hand, firms that provide enhancing attributions to explain good earnings news reap greater market rewards when 1) more of their industry peers release bad news, and 2) their earnings shares lower commonality with industry- and market-level earnings.”

 “Collectively, our results suggest that investors neither completely ignore seemingly self-serving attributions nor accept them at face value, but use industry- and firm-specific information to assess their plausibility,” the professors added. “Further analyses reveal that investors’ use of industry peer performance and earnings commonality information appears justified because investors’ perceptions are consistent with the association between the plausibility measures and the ex post actual persistence of earnings surprises.”

In sum, “investors are somewhat sophisticated when interpreting these narrative disclosures,” Kimbrough and Wang wrote:

“Our findings ought to be of value to both investors and corporate leaders,” said Wang in a statement. “Hopefully it will disabuse those executives who are counting on the naiveté of investors to let them get away with empty words or phony excuses in their public communications. For investors, it provides standards they will need to meet to keep up with the investment community at large.”

“The tools needed to apply those standards are certainly available to institutional investors, even though determining commonality is probably beyond the reach of individual stock-pickers,” said Kimbrough. “Still, even they should have the means to stack up the claims of a given company against its industry peers, which can go a long way in assessing the plausibility of the firm's performance narrative.”

The study's findings are based on an analysis of press releases and earnings reports of 94 randomly chosen firms, a roughly equal mix of small, medium and large, over a seven-year period. Sufficient data was obtained for a total of 1,790 firm quarters, 1,023 of which featured self-serving attributions and 767 of which did not. The self-serving classification was assigned to quarters when companies attributed their success in meeting or beating consensus forecasts to internal factors, such as management strategies or introduction of new products, or blamed a negative earnings surprise on external factors, such as bad weather or rising costs or regulatory actions. Firm-years in the self-serving category featured at least one such attribution and an average of three to four in a given earnings press release.

The authors found a significant relationship between the plausibility of self-serving attributions, as determined by industry performance and commonality, and the market-adjusted cumulative return of firms' stocks in the three days centered on earnings announcements. In reaching that conclusion, they controlled for an array of factors likely to affect the market’s response to earnings announcements, including the size of companies, the volatility of their stock, and their book-to-market ratio.

What kind of companies are likely to issue suspect attributions? Preliminary evidence suggests, in the words of the study, “Firms which provide less plausible attributions are larger and have higher likelihood of insider trading around earnings announcements, higher analyst following, higher institutional ownership, higher return volatility, and lower book-to-market ratio. These findings imply that managers with insider trading incentives and those facing greater capital market scrutiny are more likely to offer seemingly self-serving attributions even if they lack plausibility, consistent with the ‘opportunistic behavior’ view of capital markets.”

This view, according to the paper, finds “that capital-market scrutiny combined with the linking of manager compensation with stock prices creates pressure for managers to prop up prices by biasing financial reporting. To the extent capital-market pressure is greater for firms with higher analyst following and/or institutional ownership, the ‘opportunistic behavior’ argument suggests that greater analyst following and/or institutional ownership may increase managers’ tendency to provide implausible attributions to either mitigate market reactions to negative earnings surprises or to increase market rewards to positive surprises.”

Still, given the hazards of implausible attributions, as revealed by the new study, why would managers make them? It’s a matter of what they believe, Wang and Kimbrough wrote. “If managers believe there is a chance that investors might be persuaded by their implausible seemingly self-serving attributions, they are more likely to offer them even if ex post it turns out that investors can see through them.”

This article is by Michael Cohn in Accounting Today. The study, “Are Seemingly Self-Serving Attributions in Earnings Press Releases Plausible? Empirical Evidence,” appears in the March/April issue of The Accounting Review, published six times a year by the American Accounting Association.

More on Less Complexity in Financial Reporting

Want simpler financial reporting? If you believe the SEC’s public statements, reduction in complexity may be on the way.

Edith Orenstein has posted the following in the FEI Financial Reporting Blog. Here is her full post:

One recent development at the SEC that ties into FASB’s “combating complexity” goal cited further above, is that noted by SEC Chairman Mary Jo White concurrent December 20, 2013 issuance of the SEC staff report, Report on Review of Disclosure Requirements in Regulation S-K. The report was conducted by the SEC as requested by Congress under the JOBS Act.

Importantly, as noted in the SEC's press release, White stated:

“This report [on Reg S-K] provides a framework for disclosure reform. As a next step, I have directed the staff to develop specific recommendations for updating the rules that dictate what a company must disclose in its filings. We will seek input from companies about how we can make our disclosure rules work better for them and will solicit the views of investors about what type of information they want and how it can best be presented. The ultimate objective is for the Commission to improve the disclosure regime for both companies and investors.”

Keith Higgins, Director of the SEC’s Division of Corporation Finance stated:

“Updating our rules is only one step – albeit an important one – in improving company disclosures. For their part, companies should examine how they can improve the quality and effectiveness of their disclosures and how our rules can be improved to facilitate clear and effective communications to investors. Better disclosure benefits everyone in the marketplace, and we plan to work with companies and investors to achieve this common goal.”

The press release also noted that:

“The SEC’s Office of the Chief Accountant will coordinate with the Financial Accounting Standards Board to identify ways to improve the effectiveness of disclosures in corporate financial statements and to minimize duplication with other existing disclosure requirements.”

Chairman White led up to this initiative in remarks given at the NACD’s annual conference in November, 2013, as we noted in this post, SEC’s White Calls for ‘A Meaningful Review of Disclosure Requirements.’ 

Commissioner Dan Gallagher also focused on the need for disclosure reform in a speech at the 2nd Annual Institute for Corporate Counsel on December 6, 2013, excerpted below:

“We can’t foster capital formation in fair and efficient capital markets through private investment unless the critically important information about public companies is routinely and reliably made available to investors. We need to take seriously however, the question whether there can be too much disclosure. Justice Louis Brandeis famously stated that sunshine is the best disinfectant. As my friend and former colleague Troy Paredes pointed out some years ago, though, it is possible to create conditions in which investors are 'blinded by the light.' That is to say that from an investor's standpoint, excessive illumination by too much disclosure can have the same effect as obfuscation - it becomes difficult or impossible to discern what really matters ...”

“I often hear from investors that disclosure documents are lengthy, turgid, and internally repetitive. In their present state, they are, in other words, not efficient mechanisms for transmitting the most critically important information to investors — especially not to ordinary, individual investors. They are not the sort of documents most people are likely to read, even if doing so is in their financial self-interest. For that reason, today’s disclosure documents raise questions of what their purpose actually is and whether they are meeting it.”

“Here, it seems to me, we must acknowledge a dilemma. The good we have done in shaping a detailed disclosure regime to assist and protect investors has, in fact, led to some potential but, I submit, avoidable harm. Corporate disclosure filings didn’t naturally evolve into their present convoluted state. Rather, the rules that require periodic corporate reporting and the detailed instructions that implement them, as well as the staff interpretations and guidance that supplement those rules and instructions, have been the principal forces shaping modern corporate disclosure filings.”

“But other, external forces have played a role as well, most notably the risk of litigation -- much of it absolutely frivolous and solely for the benefit of plaintiffs’ lawyers, not investors. The failure to disclose anticipatorily is often enough to prompt a shareholder lawsuit based on the assertion of a material omission. It is rational, in other words, for those who prepare corporate disclosure documents to prepare for the worst, thus perversely prioritizing the need to avoid the penalties that accompany claims of insufficient disclosure, it seems, over rendering the required disclosure in a manner intelligible to the average investor. In sum, the Commission has cause for self-examination where the question of the utility and lucidity of corporate disclosures arises.”

“And in that process we cannot ignore the impact of excessive and frivolous litigation.”

“Here, we come to a fundamental fork in the road. Should we jump in with both feet to begin a comprehensive review and possible overhal of SEC-imposed disclosure requirements under the securities laws, or should we take a more targeted approach, favoring smaller steps towards our ultimate reforming goals? Ordinarily, I would argue for a comprehensive approach to the solution of almost any problem. Where securities regulation is concerned, we often find that actions we take in one area have unforeseen and unintended effects in others.”

“However, disclosure reform may be the exception. Although I've publicly called on multiple occasions for a holistic, comprehensive review of market structure issues, I believe, on balance, that with disclosure reform it is better to start addressing discrete issues now rather than risk spending years preparing an offensive so massive that it may never be launched. On this point, I was very pleased to see the recent remarks by Chair White (citing NACD speech). I hope and expect that, under her stewardship, the Commission will begin to make real headway on disclosure reform. I am genuinely enthusiastic about the prospect of solving some of the real-world problems that have become obvious to all who focus on this area. In short, it’s time to get practical and time to get started.”

Inquiring minds may ask: why have I not put “disclosure reform” as the highest priority item for 2014 as relates to the SEC, instead of “Enforcement”? Well, it’s not just because “Disclosure Reform” is two words, and “Enforcement” is one. I truly believe that with so much messaging from the highest levels of the SEC of a “get tough” attitude that we will see some illustrations of that attitude. We have seen that messaging from the Chairman, the Director of Enforcement, and in speeches from the Office of the Chief Accountant, and although preparers and auditors may prefer to see “disclosure reform” I believe that is a longer term project, and that in the shorter term, specifically 2014, attention should be paid to dotting the I’s and crossing the t’s as well as the big picture, substance over form, etc. with an eye toward Enforcement.

Slimming Down Disclosures: SEC Speaks Out

A targeted, step-by-step approach is the best way for the SEC to review and overhaul its financial disclosure requirements under securities laws, SEC Commissioner Daniel Gallagher said Monday.

In a speech at the Forum for Corporate Directors in California, Gallagher said he hopes the SEC can “make real headway” in its initiative to reduce unnecessary disclosures. And he said a piece-by-piece approach is preferable to addressing the issue in a comprehensive fashion.

“I would prefer to address discrete issues now rather than risk spending years preparing an offensive so massive that it may never be launched,” Gallagher said.

In December, SEC Chairman Mary Jo White instructed the commission’s staff to develop recommendations for updating what companies should be required to disclose in public filings. Gallagher said it’s time to get started on disclosure reform even though the SEC has yet to complete about 60 rules mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203.

Here are some of the issues Gallagher said the SEC may need to focus on:

Layering disclosures. This would mean making key information easily available in a standardized format, while making additional details available elsewhere. Gallagher said material information, such as a company’s financial statements, could be treated differently from information that he said is not material, such as the Dodd-Frank pay-ratio disclosures the SEC is developing.

Streamlining Form 8-K disclosures. “Does each of the categories of information now required to be disclosed on Form 8-K really require almost immediate disclosure when a change occurs?” Gallagher asked.

Location, location. Authoritative guidance can be provided, Gallagher said, about where issuers must disclose or need not disclose particular types of information, enabling analysts and others to easily find the information or identify its absence.

Streamlining proxy and registration statements. Permitting some required financial information to be included in an appendix to the proxy would aid investors and preparers, Gallagher said. He also said it could be helpful if the SEC permits forward incorporation by reference in Form S-1 registration statements. This could simplify the registration process by allowing reference to previous forms.

The potential of technology. Gallagher suggested testing a standardized system that would require one-time online disclosure of basic corporate information, mandating that it be updated as necessary with changes tracked. “We have not come anywhere close to realizing the potential technology holds for improving our disclosure system,” Gallagher said.

Improving guidance. SEC disclosure guidance could be more reliable and authoritative if significant guidance was issued only with the explicit endorsement of the commission, rather than as staff guidance, Gallagher said.

Opposing politically driven disclosures. The SEC’s newly required conflict minerals disclosures were cited by Gallagher as an example of “ill-advised anomalies” that should not be the realm of an independent, bipartisan agency.

“From an investor’s standpoint, excessive illumination by too much disclosure can have the same effect as inundation and obfuscation—it becomes difficult or impossible to discern what really matters,” Gallagher said.

By Ken Tysiac a Journal of Accountancy senior editor.