«Christa H.S. Bouwman* Case Western Reserve University and Wharton Financial Institutions Center August 2012 This paper empirically examines how CEO ...»
Managerial Optimism and Earnings Smoothing
Christa H.S. Bouwman*
Case Western Reserve University and
Wharton Financial Institutions Center
This paper empirically examines how CEO optimism affects earnings smoothing and earnings
surprises. It is documented that optimistic managers smooth earnings more than rational
managers and are associated with smaller (in absolute value) earnings surprises. A possible
theoretical explanation is offered for these results based on a combination of the “torpedo effect,” the innate behavior of optimists, and the risk of litigation / prosecution for misreporting earnings.
* Contact details: Weatherhead School of Management, Case Western Reserve University, 10900 Euclid Avenue, 362 PBL, Cleveland, OH 44106. Tel.: 216-368-3688. Fax: 216-368-6249. Email: email@example.com.
Keywords: Smoothing; Earnings Surprise; Earnings Management; Behavioral JEL Classification: M41, M43, D80.
I thank Mo Khan and Doug Skinner for helpful comments, and Brian Hall for providing data.
1. Introduction A well-known stylized fact in the literature is that managers engage in earnings smoothing: they report earnings that are sometimes higher than economic earnings and sometimes lower (see, e.g., Beidleman, 1973; Lev and Kunitzky, 1974; Ronen and Sadan, 1981, Hand, 1989; Barth, Elliott, and Finn, 1999; Goel and Thakor, 2003; Leuz, Nanda, and Wysocki, 2003; Lang, Raedy, and Wilson, 2006; and Myers, Myers, and Skinner, 2007). Recent survey evidence provides further confirmation that managers actively smooth earnings, as evidenced by a quote from an interviewed CFO: “businesses are much more volatile than what their earnings numbers would suggest” (Graham, Harvey, and Rajgopal, 2005).1 However, the degree of earnings smoothing varies in the cross-section of firms. This has led to research that has uncovered several factors that help explain cross-sectional variations in earnings smoothing.
Numerous papers have tried to explain differences in the degree of earnings smoothing across firms. While earlier contributions tended to focus on firm-specific attributes, more recent papers have analyzed attributes of decision makers. For example, Healy (1985) and Bergstresser and Phillipon (2006) examine the impact of executive compensation on earnings smoothing.
Klein (2002) and Bowen, Rajgopal and Venkatachalam (2008) focus on the characteristics of boards of directors to understand the issue. Ge, Matsumoto and Zhang (2008) link CEO personal characteristics (e.g. age and education) to earnings smoothing. Managerial beliefs could matter as well. For example, recent evidence indicates that managerial optimism, where optimism is defined as an upward bias in beliefs about future outcomes, does affect a wide range of corporate and individual decisions.2 Notable accounting applications include Hribar and Yang (2010), who The popular press tends to view accounting discretion, including earnings smoothing, as a device used by selfinterested rent-seeking managers to manipulate earnings. See, for example, the following quote from Fortune (1997): “If Microsoft is the archetype of a hugely successful company trying to tone its earnings down so people don't get their expectations too high, Boston Chicken bespeaks an altogether different and more common phenomenon. It is a business that isn't successful yet but has used accounting to help convince investors that it already is, or at least will be soon.” The academic literature is divided on the question whether managers use accounting discretion, including earnings smoothing, to efficiently maximize shareholder value (e.g., Ronen and Sadan, 1981; and Chaney and Lewis, 1995) or to opportunistically make themselves better off at the expense of shareholders (e.g., Warfield, Wild, and Wild, 1995). Papers that attempt to disentangle whether efficiency or managerial opportunism drives accounting discretion include Christie and Zimmerman (1994) and Bowen, Rajgopal, and Venkatachalam (2008). See also Dechow and Skinner (2000) for a discussion of the practitioners and academic viewpoints on why firms smooth earnings.
In a non-accounting context, these decisions include credit policies (Manove and Padilla, 1999); financial intermediary existence (Coval and Thakor, 2005), investment choices and acquisition decisions (Malmendier and Tate, 2005, 2008), dividend policy and capital structure (Ben-David, Graham and Harvey, 2007), portfolio holdings and the choice to remarry after divorce (Puri and Robinson, 2007), and CEO succession within firms (Goel and Thakor, 2008).
find that overconfident/optimistic managers are more likely to issue overly optimistic earnings forecasts and are more likely to have earnings that miss such forecasts; and Schrand and Zechman (forthcoming), who find that CEOs of firms which misstated earnings tend to be overly optimistic about their firms’ performance and may follow initially unintentional misstatements with intentional misstatements if optimistic expectations are not realized.
Continuing in the tradition of this literature, in this paper, I empirically address the question: how does managerial optimism affect earnings smoothing? It is natural to ask this question since smoothing is affected significantly by expectations about future earnings, and optimism affects such expectations. Stated differently, we would expect optimism to affect earnings smoothing because the intertemporal adding-up constraint implies that smoothing involves making tradeoffs between how much to report in the current period and how much to report in the future, and such tradeoffs depend on managerial beliefs about future events.
Nonetheless, while it is intuitively straightforward that optimism would affect earnings smoothing and that optimistic managers would issue inflated earnings forecasts, it is less apparent whether they would smooth earnings more or less than rational managers. I therefore empirically address the smoothing question but will also offer a potential theoretical explanation for my findings.
The empirical tests use measures of earnings smoothing but also of earnings surprises measured relative to analyst forecasts. The reason is that smoother earnings are more easily predictable for analysts (e.g., Skinner and Sloan, 2002) and may therefore be associated with fewer or smaller earnings surprises.3 Specifically, the empirical tests regress measures of earnings smoothing and earnings surprises on managerial optimism proxies and a set of control variables which includes firm size, market-to-book, and leverage, as well as variables that represent controls for operational differences, agency problems, asymmetric information, corporate governance, CEO stock and option ownership, systematic risk, and year and industry fixed effects. CEO stock and option ownership are controlled for because smoothing may be higher at firms with CEOs whose compensation is more sensitive to their firms’ stock prices (see Bergstresser and Philippon, 2006). Industry fixed effects are included is to address potential concerns that optimists may self-select to work in certain industries.
Note that the definition of earnings surprises used here is different from Hribar and Yang’s (2011): they focus on surprises relative to earnings guidance by management. They do not examine how such guidance affects expectations of analysts or earnings surprises relative to those expectations.
The optimism proxies used were developed by Malmendier and Tate (2005, 2008). Their proxies are based on the assumption that an (over)optimistic manager systematically overestimates the outcomes of her own firm’s projects, thereby delaying the exercise of her options. While they refer to their measures as overconfidence measures, they also acknowledge that the literature typically associates overconfidence with overestimation of a signal’s variance (e.g., Goel and Thakor, 2008), while overestimation of the mean of a signal (as their measures do) is referred to as (over)optimism (e.g., Manove and Padilla, 1999; Van den Steen, 2004;
Coval and Thakor, 2005; and Puri and Robinson, 2007).4 Following Baker, Ruback and Wurgler (2007), Jin and Kothari (2008), Page (2008), and Hackbarth (2009), I therefore refer to their proxies as measures of managerial optimism.5 The initial sample used for my tests is the same sample of 477 large U.S. corporations used by Malmendier and Tate (2005, 2008).
I have two main findings. First, firms with optimistic CEOs smooth earnings more than firms with rational managers. Second, optimistic managers are just as likely as rational managers to show positive or negative earnings surprises, but the surprises of the optimists are smaller in absolute value. Smaller earnings surprises seem consistent with greater smoothing, but may seem at odds with the finding by Hribar and Yang (2011) who find that optimistic managers are more likely to miss forecasts. Recall, however, that they measure earnings surprises relative to management’s own forecasts, whereas I measure them relative to analyst forecasts.
I perform several robustness tests and additional analyses to more deeply understand the main results. First, one potential concern is that CEOs who are classified as optimists – on the basis of delayed executive stock option exercise – are not truly optimists. They could simply be rational CEOs who have favorable inside information about future firm performance that makes them delay their option exercises until this information becomes public. Alternatively, they may work at firms with lower unsystematic risk which makes them more willing to hold on to their options longer. Yet another possibility is that the stock price volatility of their firms is lower, Following the literature on self-serving attribution, Malmendier and Tate (2005, 2008) use the term “overconfidence” to refer to an upward bias in the manager’s assessment of future outcomes that are firm-specific and potentially attributable to the manager’s own skill. They view this as being different from optimism related to a general overestimation of all outcomes, including those outside the CEO’s control, such as the level of the stock market.
In contrast, Hribar and Yang (2011) use the term overconfident, indicating that: “For consistency with prior research, we use the term ‘overconfident’ to describe our construct of interest, despite the fact that the empirical measure we use is actually a relative measure of confidence.” inducing them to hold on to their options longer. If any of these alternative explanations were to hold, the documented results would be due to factors other than managerial optimism.
Robustness checks reveal, however, that these alternative explanations do not drive the results.
Second, I examine whether optimistic managers smooth earnings more, not because they overestimate future earnings, but because their firms happen to have more volatile cash flows, and hence have a greater need to smooth earnings. The empirical evidence does not support this alternative explanation for the findings.
Third, I investigate whether the earnings surprise results are driven by my choice of a particular cutoff to define big and small surprises. Using alternative cutoffs, however, I obtain similar results. Also, to gain a deeper understanding of the earnings surprise results, I investigate whether these results are driven by large negative, small negative, large positive and/or small positive surprises.
Having established that optimistic managers smooth more and are associated with smaller earnings surprises than rational managers, I offer a possible theoretical explanation for these findings, based on a combination of three ingredients: the torpedo effect, the behavior of optimists relative to rational managers, and the risk of litigation / prosecution for earnings misreporting. Here, I briefly summarize the argument. The torpedo effect induces all managers to smooth more – they over-report in bad states and under-report in good states. Optimistic managers over-report more than rational managers in bad states, effectively “borrowing” more earnings from the future, because they are more bullish about having sufficiently high future earnings to “pay” for this borrowing. This reduces earnings the optimist can report in the good state. Moreover, even ignoring this adding-up-constraint effect, the ability of optimists to deliver positive earnings surprises in good states is lower than that of rational managers because the higher level of (expected) baseline earnings leaves them with less room to report higher-thanexpected earnings. This intuition delivers both greater smoothing of reported earnings relative to true cash flows as well as smaller earnings surprises relative to analyst expectations for optimists than for rational managers.
Admittedly, other explanations for why optimists smooth more and show smaller earnings surprises may exist. I leave that as an interesting topic for future research. Also, all my robustness checks notwithstanding, it should be recognized that any empirical measure of earnings smoothing is imperfect, so the results should be viewed in light of that caveat.
The remainder of the paper is organized as follows. Section 2 describes the related literature. Section 3 explains the empirical approach, discusses the variables, describes the data and provides descriptive statistics. Empirical results are presented in Section 4. Section 5 addresses robustness issues and performs additional tests. Section 6 provides a potential theoretical explanation for the findings. Section 7 summarizes and concludes.
2. Related Literature This paper is related to papers on: why managers prefer to report smooth earnings, the empirical detection of earnings smoothing, and factors that lead to smoothing differences across firms.
This section discusses these three strands and indicates the intended contribution of this paper.