The Economic Implications of Corporate Financial Reporting

Abstract

Forum on Corporate Finance and the University of Washington for comments. Finally, we thank the financial executives who generously allowed us to interview them or who took time to fill out the survey. We acknowledge financial support from the John W. Hartman Center at

Earnings Guidance and Managerial Myopia

“…When managers overweight current market value vis-à-vis future market value, they are unwilling to wait until the temporary mispricing (if any) based on short-term performance is corrected and hence unwilling to adopt a long-term perspective. Managers can be motivated to overweight current stock price because of poorly designed equity incentives (Hall and Murphy [2003], Rappaport [2005]), takeover threats (Stein [1988]), need to raise capital (Bhojraj and Libby [2005], Teoh et al [1998]) or employment concerns (Fundenberg and Tirole [1995], Graham et al [2005]). Second, the capital markets should misprice current earnings without regard to its underlying economics or managers should believe that they do.…”

“…Markets can incorrectly price current earnings if investors have a short-term focus (Ellis [2004]) or misinterpret the persistence of earnings components (e.g., Sloan [1996]). Also, managerial myopia can result even when the capital markets are efficient as long as managers believe the markets can be fooled (Stein [1989]), which they do (e.g., Graham et al [2005]). Alternatively, myopic managerial behavior can also arise when managerial compensation function directly emphasizes short-term earnings performance, such as meeting earnings targets.…”

“…First, earnings guidance induces investors to place too much emphasis on meeting or beating earnings targets, resulting in extreme price drops when firms fail to meet targets (Skinner and Sloan [2002]). Second, managers may face loss of reputation and credibility if they are unable to deliver on their forecasts (Graham et al [2005]). The pressure to meet short-term earnings targets in turn precipitates actions that destroy long-term shareholder value creation, such as reduction in R&D spending or cancellation of marketing campaigns, when otherwise the firm is in danger of not being able to meet its forecast.…”

“…For example, managers at Coca-Cola believe that discontinuing quarterly earnings guidance will help the company focus on long-term objectives, such as expanding its business into new markets, without having to worry about meeting short-term earnings targets (McKay and Brown [2002]). For similar reasons, CFOs interviewed by Graham et al [2005] also deplore the culture of providing quarterly earnings guidance and subsequently having to meet these targets.…”

“…In a recent survey by Graham, et al [2005], managers describe the trade-off between the short-term need to "deliver earnings" and the long-term objective of making value-maximizing investment decisions.…”