Thursday, December 20, 2012

Shareholder rights and earnings management

Academics, like journalists, often seem surprised by the obvious. For example, it turns out that greater shareholder "rights" increases the propensity of corporate leaders to "manage" earnings:

Using a model recently developed by Dechow, Hutton, Kim and Sloan (2012), we document that when shareholder rights are stronger, managers are more likely to (1) manage earnings upward when meeting or slightly beating analyst expectations and (2) manage earnings downward when easily beating analyst expectations. Additional tests confirm that the propensity to manage accruals downward allows managers to reserve current accruals to meet expectations in future periods. Overall, the results are not consistent with the traditional expectation that shareholder rights serve a governance role by reducing discretionary reporting behavior. Given recent demands to enhance shareholder rights, our study highlights an interesting financial reporting consequence.
Uh, duh. Institutional investors, who are the only investors who have a meaningful impact on either the governance or the share price of most public corporations, get really irritated and grumpy when a company misses its numbers. Why? Because they expect both "Street" expectations and actual results to be, well, managed as well as possible within the boundaries of law and propriety. Any CFO who fails to consider the preferences of his most influential stockholders will not long be in a job. If governance reforms make institutional investors more powerful at the expense of the board -- and they have, especially since Dodd-Frank -- then executives are going to be even more responsive.

This is, of course, contrary to the hilarious notion popular among most journalists and professors that there is one particular "truth" in financial reporting, but that does not make it any less so.

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