John M. McInnis

Making Sense of Cents: An Examination of Firms that Marginally Miss or Beat Analyst Forecasts

This paper examines the performance consequences of cutting discretionary expenditures and managing accruals to exceed analyst forecasts. We show that firms that just beat analyst forecasts with low quality earnings exhibit a short-term stock price benefit relative to firms that miss forecasts with high quality earnings. This trend, however, reverses over a 3-year horizon. Additionally, firms reducing discretionary expenditures to beat forecasts have significantly greater equity issuances and insider selling in the following year, consistent with managers understanding the myopic nature of their actions. Our results confirm survey evidence suggesting managers engage in myopic behavior to beat benchmarks. THERE IS GROWING EVIDENCE that managers are willing to sacrifice economic value to meet short-run earnings objectives. For example, Graham, Harvey, and Rajagopal (2005) report that a majority of managers would forgo a project with positive net present value (NPV) if the project would cause them to fall short of the current quarter consensus forecast. When asked what actions they might take in order to meet an earnings target, approximately 80% suggest they would decrease discretionary spending, including R&D and advertising expense. This survey evidence is consistent with other research on myopic behavior and real earnings management (e.g., Baber, Fairfield, and Haggard (1991), Bhojraj and Libby (2005), Roychowdhury (2006)). Jensen (2005) attributes this behavior in part to the agency costs of overvalued equity, noting that “when numbers are manipulated to tell the market what they want to hear . . . and when real operating decisions that would maximize value are compromised to meet market expectations, real long-term value is being destroyed” (p. 8). In this paper, we provide evidence on the shortand long-term price and profitability ∗Sanjeev Bhojraj is from the Johnson School of Management, Cornell University. Paul Hribar is from the Tippie College of Business, University of Iowa. Marc Picconi is from the Kelley School of Business, Indiana University. John McInnis is from the McCombs School of Business, University of Texas at Austin. The authors gratefully acknowledge the insightful comments and suggestions made by Cam Harvey (the editor), an associate editor, and an anonymous referee, as well as seminar participants at Cornell University, Columbia University, Duke 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. The authors thank Thomson Financial Services Inc. for providing earnings per share forecast data, available through the Institutional Brokers Estimate System (I/B/E/S). These data have been provided as part of a broad academic program to encourage earnings expectation research.

Interpretive Guidance and Financial Reporting Costs: Evidence from Audit Fees

We examine the effect of interpretive accounting guidance on a direct and observable cost of financial reporting: audit fees. Many contend that U.S. GAAP has too much interpretive guidance, making it complex and difficult to assimilate. This effect would lead to higher audit effort and higher fees. However, specific guidance could both lower litigation risk and increase audit efficiency by reducing the need for auditors to continually deliberate complicated accounting issues across engagements. These effects would lead to lower audit fees. Overall, using both levels and changes regressions, we find that interpretive accounting guidance is associated with higher audit fees. However, this effect is smallest for firms facing the highest ex-ante litigation risk. Finally, we examine whether increased audit fees persist and find that the audit fee effect disappears by the third year after the interpretive guidance becomes effective. Overall, we find no evidence that interpretive guidance decreases audit costs.

Explaining Rules-Based Characteristics in U.S. GAAP: Theories and Evidence

Despite debate on the desirability of rules-based standards, no studies provide evidence on why accounting standards take on rules-based characteristics. We identify and test five theories from prior research (litigation risk, constraining opportunism, complexity, transaction frequency, and age) that could explain why some U.S. accounting standards contain rules-based characteristics. Litigation risk and complexity are most consistently related to cross-sectional and time-series variation in rules-based characteristics. We find more limited evidence that frequent transactions, age, and desires by regulators to constrain opportunistic reporting are related to rules-based standards. We note, however, that our findings are necessarily descriptive because standards arise endogenously from market and political forces, limiting causal interpretation. Further, it is difficult to perfectly separate rules-based characteristics of the standard from both the complexity of the standard and the characteristics of the underlying transaction, including the complexity of the transaction.