Managers In Public Firms Use Earnings To Influence Short-Run Stock Prices
The results of a recent study authored by a Penn State accounting professor could prove useful for the Securities and Exchange Commission (SEC) in its ongoing battle against earnings management.
UNIVERSITY PARK, PA-The results of a recent study authored
by a Penn State accounting professor could prove useful for the Securities
and Exchange Commission (SEC) in its ongoing battle against earnings management.
"My study found that the high frequency of small earnings increases
and long strings of consecutive earnings increases reported by publicly
traded firms are due to managerial incentives to use earnings to influence
short-run stock prices," says Bin Ke, assistant professor of accounting
in Penn State's Smeal College of Business.
His study -- "Why Do CEOs of Publicly Traded Firms Prefer Reporting Small Earnings Increases and Long Strings of Consecutive Earning Increases?" - is believed to be the first study to examine multiple competing explanations for the high frequency of small earnings increases and long duration of consecutive earnings increases in publicly traded firms. The paper was presented at the 2001 American Accounting Association Annual meeting in Atlanta, GA.
Ke explains that previous researchers have documented two salient properties of accounting earnings reported by publicly traded firms: 1) Small earnings increases are reported more often than small earnings decreases; 2) strings of consecutive earnings increases are longer in public firms than in private firms.
"Previous research also shows that the two earnings properties are partially due to earnings management. The objective of this study was to investigate why CEOs of public firms prefer reporting the two earnings properties," says Ke. "The results indicate that publicly traded firms whose stock prices are very sensitive to earnings changes (i.e., growth stocks), and whose CEOs' holdings of exercisable stock option and stock are very sensitive to stock prices (i.e., high equity incentives immediately available for sale), are more likely to report the two earnings properties."
This study's findings are very timely, notes Ke. Since a significant portion of their compensation is tied to stock returns, CEOs are concerned about stock prices and whether stock prices are sensitive to small earnings increases and the duration of consecutive earnings increases. In addition to attempting to influence stock prices, CEOs may manage earnings to avoid disappointing financial analysts or to avoid violating debt covenants.
Ke points out that former SEC Chairman Arthur Levitt accused management, financial analysts, and independent auditors for the increased earnings management in recent years, but there is little direct evidence to substantiate his claims.
"The evidence in this study should help the SEC to allocate more of its limited enforcement resources to firms where earnings management is most widespread (i.e., high growth firms with high CEO equity incentives immediately available for sale). The research findings should also help capital market investors better interpret the quality of reported earnings by using the observable firm characteristics documented in the study," says Ke.
Ke used a sample of publicly traded firms from the EXECUCOMP database during 1992-1998 to assess the importance of various economic determinants of the two earnings properties. He used probit regression to examine the determinants of small earnings increases and event history analysis to analyze the determinants of the duration of consecutive earnings increases. The economic determinants Ke considered included CEO bonus and equity compensation incentives, the sensitivity of stock prices to earnings surprises, analysts' pressure and debt covenant constraints.
Both probit and event history analyses indicate that after controlling
for normal earnings changes, the probability of small earnings increases
and the duration of consecutive earnings increases are higher for firms
with lower book-to-market ratios (i.e., growth firms), and higher CEO
equity incentives immediately available for sale. However, there is no
evidence that the probability of small earnings increases and the duration
of consecutive earnings increases are higher for firms with higher CEO
bonus incentive, analysts following and financial leverage. In addition,
the book-to-market ratio is the most important determinant of the two
earnings properties, followed by CEO equity incentives immediately available
for sale.
