The Economic Implications of Corporate Financial Reporting

1
The Economic Implications of Corporate Financial
Reporting
September 17, 2004 University of Southern
California

• John R. Graham
• Duke University, Durham, NC USA
• Campbell R. Harvey
• Duke University, Durham, NC USA
• National Bureau of Economic Research, Cambridge,
  MA USA
• Shiva Rajgopal
• University of Washington, Seattle, WA USA

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Graham/Harvey/Rajgopal Corporate Reporting
Background

• In 1995, Duke and Financial Executives
  International make a deal to conduct a quarterly
  CFO survey
• The deal allows for some special academic
  surveys outside of the quarterly survey that
  would use the FEI e-mail list

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Graham/Harvey/Rajgopal Corporate Reporting
Background

• 1. Graham and Harvey conduct a survey on capital
  structure and project evaluation
• Theory and Practice of Corporate Finance
  Evidence from the Field appears in JFE 2001
• 2. Brav, Graham, Harvey Michaely survey on
  dividend and repurchase policy
• Payout Policy in the 21st Century forthcoming
  in JFE 2001
• 3. Graham, Harvey and Rajgopal survey on
  corporate financial reporting

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Graham/Harvey/Rajgopal Corporate Reporting
Methodology

• General goals our research program
• To examine assumptions
• To learn what people say they believe
• To provide a complement to the usual research
  methods archival empirical work and theory

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Graham/Harvey/Rajgopal Corporate Reporting
Methodology

• Approach contrasts with Friedmans (1953) The
  Methodogy of Positive Economics
• Goals of positive science are predictive
• Dont reject theory based on unrealistic
  assumptions
• Also, rejects notion that all the predictions of
  a theory matter to its validity goal is narrow
  predictive success

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Graham/Harvey/Rajgopal Corporate Reporting
Methodology

• Alternative view, Daniel Hausman (1992)
• No good way to know what to try when a
  prediction fails or whether to employ a theory in
  a new application without judging its
  assumptions.

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Graham/Harvey/Rajgopal Corporate Reporting
Narrow goals

• Insight on following issues
• Importance of reported earnings and earnings
  benchmarks
• Are earnings managed? How? Why?
• Real versus accounting earnings management
• Does missing consensus indicate deeper problems?
• Consequences of missing earnings targets
• Importance of earnings paths
• Why make voluntary disclosures?

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Graham/Harvey/Rajgopal Corporate Reporting
Strengths and limitations

• Strengths
• Surveys enable us to ask decision-makers specific
  qualitative questions about motivations
• Less of a variable specification problem
• Complements large sample analyses
• A unique angle to confront theories with data
• Limitations
• Questions may be misunderstood
• Truthful responses?
• Non-response bias
• Friedman (1953)

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Graham/Harvey/Rajgopal Corporate Reporting
Comparison to archival empirical work

• Limitations to existing research include
• Earnings management and voluntary disclosure hard
  to measure
• Rank ordering among various motivations difficult
• Variable with least measurement error may
  dominate
• Same r.h.s. variables can proxy for different
  economic motivations (e.g., size)
• Often a narrow focus on one motivation

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Graham/Harvey/Rajgopal Corporate Reporting
Method

• Survey and Interview Design
• Draft survey instrument refereed by both
  finance and accounting researchers as well as
  experts in survey design
• Interviewed structured to adhere to best
  scientific practices of interviews, e.g. Sudman
  and Bradburn (1983)
• IRB certification for human subject research

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Graham/Harvey/Rajgopal Corporate Reporting
Sample

• 401 usable survey responses
• response rate of 10.4
• 25 response rate at a practitioner conference
• 8 response rate to Internet survey
• Interview 20 CFOs
• 40-90 minutes in length
• More give and take than in the survey
• Interviewed firms are much larger, more levered
  and more profitable than the average Compustat
  firm.
• Relative to Compustat firms
• Surveyed firms are larger, more levered, greater
  dividend-yield, fewer firms report negative
  earnings
• Similar B/M and positive P/E

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Graham/Harvey/Rajgopal Corporate Reporting
Sample

• Firm characteristics (self reported)
• Agency
• CEO age, tenure, education
• Inside ownership
• Size
• Revenues
• Number of employees
• Growth opportunities
• P/E
• Growth in earnings

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Graham/Harvey/Rajgopal Corporate Reporting
Sample

• Firm characteristics (self reported)
• Free cash flow effects
• Profitability
• Leverage
• Informational effects
• Public/private
• Which stock exchange
• Industry
• Credit rating

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Graham/Harvey/Rajgopal Corporate Reporting
Sample

• Firm characteristics (self reported)
• Financial reporting practices
• Number of analysts
• Do they give guidance?
• Ticker symbol!
• Demographic correlations in Table 1
• Note positive relation between whether you give
  guidance and number of analysts (Lang and
  Lundholm TAR 1996)

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Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
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Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
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Graham/Harvey/Rajgopal Corporate Reporting
Motivation
DeGeorge, Patel, Zeckhauser, JB 1999
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Graham/Harvey/Rajgopal Corporate Reporting EPS
focus
Fig. 2. Responses to the question Rank the
three most important measures report to
outsiders based on a survey of 401 financial
executives.
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Graham/Harvey/Rajgopal Corporate Reporting EPS
focus

• Conditional analysis
• Unprofitable and younger firms, earnings less
  important
• Cash flows more important when less guidance
• Private firms put more emphasis on cash flows
  than earnings (suggesting capital market
  motivations drive focus on earnings)
• Table 2

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Graham/Harvey/Rajgopal Corporate Reporting EPS
focus

• Interviews Why focus on earnings?
• Complex world need simple, comparable number
• EPS gets broadest coverage in media
• By focusing on one number, simplifies the
  analysts job
• Investment banks can assess the performance of
  analysts by looking at forecast and actual EPS

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Graham/Harvey/Rajgopal Corporate Reporting
Earnings benchmarks
Responses to the question How important are
following earnings benchmarks? based on a
survey of 401 financial executives.
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Graham/Harvey/Rajgopal Corporate Reporting
Earnings benchmarks

• Conditional Consensus is relatively more
  important for
• Firms with more analysts
• Firms that give guidance
• Large firms
• More levered firms
• Table 3

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Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
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Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?
Responses to the statement Meeting earnings
benchmarks helps based on a survey of 401
financial executives.
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Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?

• Stock price motivation
• Barth, Eliot and Finn (TAR 1999) firms with
  continuous growth in earnings priced at premium
• Skinner and Sloan (RAS 2002) growth firms missing
  benchmarks are severely punished
• 86 of CFOs say builds credibility
• 80 maintain or increase stock price

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Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?

• Stakeholder motivations
• Bowen, Ducharme and Shores (JAE 1995) by managing
  earnings, firms enhance reputation with
  stakeholders, such as customers, suppliers,
  creditors
• Conditional analysis shows this is important for
  small, tech, inside dominated, young and not
  profitable

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Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?

• Employee bonus
• Healy (JAE 1986) accounting discretion to
  maximize bonus
• Matsunaga and Part (TAR 2001) failure to make
  consensus leads to CEO pay cuts
• Survey evidence not significant
• Interviews suggest that internal targets more
  important for managers (stretch and budget
  greater than consensus)

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Graham/Harvey/Rajgopal Corporate Reporting Why
meet earnings benchmarks?

• Career concerns
• External reputation very important
• This motivation was prominent in interviews.
  Executive labor market important. Failure to
  deliver on targets inhibits intra-industry
  mobility.
• Recent papers Farrell and Whidbee (JAE 2003)
  Feng (WP 2004) Francis, Huang, Rajgopal and
  Zhang (WP 2004)

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Graham/Harvey/Rajgopal Corporate Reporting
Consequences of missing benchmarks
Responses to the statement Failing to meet
benchmarks based on a survey of 401 financial
executives.
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Graham/Harvey/Rajgopal Corporate Reporting
Consequences of missing benchmarks

• Uncertainty
• Uncertainty about future prospects is thought to
  be priced

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Graham/Harvey/Rajgopal Corporate Reporting
Consequences of missing benchmarks

• Cockroach problem
• You have to start with the premise that everyone
  manages earnings
• If you cant come up with a few cents, there must
  be some previously unknown serious problems at
  the firm
• If you see one cockroach, you immediately assume
  there are hundreds behind the walls, even though
  you have no proof that this is the case

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Graham/Harvey/Rajgopal Corporate Reporting
Consequences of missing benchmarks

• Mitigation of negative reaction
• Explain miss is due to specific accounting
  accrual
• Miss quarterly but confirm annual guidance
• Nonfinancial indicators suggest good future
  performance
• Other factors
• Conference call becomes negative investors
  become defensive

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Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
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Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks
Near the end of the quarter, it looks like your
company might come in below the desired earnings
target. Within what is permitted by GAAP, which
of the following choices might your company make?
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Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks

• Real versus accounting actions
• 80 would reduce discretionary spending, RD,
  maintenance, advertising
• 55.3 would delay starting a new project even if
  it entailed a small sacrifice in value
• Not as much support for accounting actions

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Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks

• Real versus accounting actions
• Little research on real actions
• Dechow and Sloan (JAE 1991) Bartov (TAR 1993)
  Bushee (TAR 1998), RD or asset sales
• Mittelstaedt, Nichols, Regeir (TAR 1995) cut
  health care
• Penman and Zhang (TAR 2002) cutting investments
  in presence of conservative accounting
• Roychowdhury (WP 2003) over produce and sales
  discounts to meet targets

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Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks

• Real versus accounting actions
• Significantly more likely to say they are taking
  real rather than accounting actions
• In contrast, most of the work on earnings
  management has focused on accruals

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Graham/Harvey/Rajgopal Corporate Reporting
Actions taken to meet benchmarks

• Why real versus accounting actions?
• Aftermath of Enron-Worldcom along with S-Ox
• Any hint of accounting questions could have
  devastating effect on stock prices
• More willing to admit to real actions
• Auditors cant second guess real actions

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Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value
Hypothetical scenario Your companys cost of
capital is 12. Near the end of the quarter, a
new opportunity arises that offers a 16 internal
rate of return and the same risk as the firm. The
analyst consensus EPS estimate is 1.90. What is
the probability that your company will pursue
this project in each of the following scenarios?
Actual EPS if you do not pursue the project Actual EPS if you pursue the project The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row) The probability that the project will be pursued in this scenario is (check one box per row)
0 20 40 60 80 100
2.00 1.90
1.90 1.80
1.80 1.70
1.40 1.30
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Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value
Probability of accepting project
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Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value
Only 45 would take the project for sure even
if they are projected to meet consensus
Table 7
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Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value

• Reminiscent of Brav, Graham, Harvey and Michaely
• Sacrifice positive NPV projects before cutting
  dividends

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Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing long-term value
Repurchases Dividends
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Graham/Harvey/Rajgopal Corporate Reporting
Other insights on meeting benchmarks

• Interviews
• 18/20 interview mentioned trade off of short-run
  earnings and long-term optimal decisions
• Investment banks offer products that create
  accounting income with negative cash flow
  consequences

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Graham/Harvey/Rajgopal Corporate Reporting
Other insights on meeting benchmarks

• Guidance
• Goal of guidance is to meet or exceed consensus
  every quarter
• Analysts complicit in game of always meeting or
  exceeding
• Large positive surprises lead to ratchet-up
  effect
• Asymmetric

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Graham/Harvey/Rajgopal Corporate Reporting
Other insights on meeting benchmarks

• Break out of the game
• Why not declare that you will not play the
  earnings management game?

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Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
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Graham/Harvey/Rajgopal Corporate Reporting
Smoothing
96.9 and 20/20 interviews prefer smooth
earnings over more volatile holding cash flows
constant
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Graham/Harvey/Rajgopal Corporate Reporting
Smoothing
Responses to the question Do the following
factors contribute to your company preferring a
smooth earnings path?
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Graham/Harvey/Rajgopal Corporate Reporting
Smoothing

• Reasons
• Lowers risk increased predictability lower
  risk premium
• Clear from survey and interviews that CFOs
  believe that this risk is priced
• Possible link to literature on estimation error,
  disagreement in asset pricing, information risk
  premium, and behavioral literature on risk versus
  uncertainty

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Graham/Harvey/Rajgopal Corporate Reporting
Sacrificing value for smoothing
Responses to the question How large a sacrifice
in value would your firm make to avoid a bumpy
earnings path?
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Graham/Harvey/Rajgopal Corporate Reporting
Other insights on smoothing

• Interviews
• Volatile earnings will create trading incentives
  for speculators, hedge funds and legal vultures
• Volatile earnings mean that you will have a
  number of misses which CFOs want to avoid
• Smoothing example

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Graham/Harvey/Rajgopal Corporate Reporting
Marginal investor
Responses to the statement Rank the two most
important groups in terms of setting the stock
price for your company
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Graham/Harvey/Rajgopal Corporate Reporting
Marginal investor

• Price setters
• Institutional investors
• Analysts have important short-term impact
• Retail investors important because they are
  potential customers and are less likely to flip
  stock

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Graham/Harvey/Rajgopal Corporate Reporting
Marginal investor

• Critique of analysts, institutions
• Young, do not have sense of history
• Contagion bandwagon effect important given
  relative performance measurement
• Quantitative hedge funds issue sell signal if you
  miss irrespective of fundamental information
• CFOs believe idiosyncratic risk is priced

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Corporate Financial Reporting
Performance measurements (earnings, cash flows)
Sec 3.1,Table 2
Voluntary disclosure
Timing Sec 6.3 Table 13
Why disclose? Sec 6.1,Table 11
Earnings benchmarks Sec 3.2, Table 3
Earnings trends
Why not disclose? Sec 6.2, Table 12
Why meet benchmarks? Sec 3.3, Table 4
What if miss benchmarks? Sec 3.4, Table 5
Why smooth earnings? Sec 5.1, Table 8
How to meet benchmarks Sec 4.1, Table 6 Value
sacrifice to meet benchmarks Sec 4.2, Table 7
Value sacrifice for smooth earnings Sec 5.2,
Table 9
Fig. 1 Flowchart depicting the outline of the
paper
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Graham/Harvey/Rajgopal Corporate Reporting
Voluntary disclosure

• Types
• Conference calls, meetings, press releases, and
  disclosure of more than mandated information in
  regulatory filings
• Healy and Palepu (JAE 2001) say that motivations
  for voluntary disclosure important unresolved
  question for future research

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Graham/Harvey/Rajgopal Corporate Reporting
Voluntary disclosure

• Drivers
• Information asymmetry
• Increased analyst coverage
• Corporate control contest
• Stock compensation
• Management talent
• Limitations of mandatory disclosure

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Graham/Harvey/Rajgopal Corporate Reporting
Voluntary disclosure

• Contraints
• Litigation risk
• Proprietary costs
• Political costs
• Agency costs
• Setting a precedent that may be hard to maintain

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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure
Survey responses to the question Do these
statements describe your company's motives for
voluntarily communicating financial information?
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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Information asymmetry Information risk
• Diamond Verrecchia (1991) voluntary disclosure
  reduces asymmetry between informed and
  uninformed, increases liquidity.
• 81.9 agree only 4.3 disagree
• Related 56.2 agree that predictability of
  companys future prospects is enhanced

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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Information asymmetry Information risk
• Interviews distinguish between information risk
  and inherent risk
• Believe that both command a risk premium
• Releasing bad news quickly can be beneficial in
  reducing information risk

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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Information asymmetry Reputation
• 92.1 agree with reputational benefit for
  transparent reporting (scores the highest)
• Interviews
• Correct investors misperceptions
• Create an environment of trust so strategic
  actions more easily taken in the future
• Trust may be important in gaining access to
  future capital

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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Information asymmetry Cost of capital
• While only 39.3 point to cost of capital, the
  information risk is linked to cost of capital
• P/E lift 42 is similar to the cost of capital
• Interviews
• A number mentioned reducing analysts
  disagreement and linked that to cost of capital

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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Information asymmetry Liquidity
• Motivation especially for small firms

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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Increased analyst coverage
• Bhushan (1989a,b) and Lang and Lundholm (1996)
• 50.8 agree
• More agreement with small and insider dominated
  firms

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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Stock price motivation
• 48.4 use disclosure to try to correct
  undervalued stock

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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Stock compensation
• Managers want to reduce contracting costs with
  employees where there is information asymmetry,
  otherwise employees will demand a risk premium
• No support, half disagree

69
Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Management talent signaling
• Trueman (1986)
• Little support but more support for small firms

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Graham/Harvey/Rajgopal Corporate Reporting
Motivations for voluntary disclosure

• Limitations of mandatory disclosures (new)
• 72.1 say that voluntary corrects gaps in
  mandatory
• Interviews
• Some mandatory confuse rather than enlighten
• Some of our own footnotes related to off-balance
  sheet items and securitizations are so complex,
  even I dont understand them.
• Quarterly mandatory disclosures lack timeliness
• Mandatory ignores intangibles

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Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure
Survey responses to the question Limiting voluntary communication of financial information helps
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Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure

• Precedent (new)
• The most popular response with 69.6 agreeing
• Most important for insider dominated firms
• Start a practice that you might want to abandon
  later

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Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure

• Litigation costs
• Threat of litigation makes managers disclose bad
  news quickly
• 46.4 agree especially important for young and
  tech

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Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure

• Proprietary costs
• Might jeopardize firms competitive position
• 58.8 agree
• More agreement with small firms and those with
  few analysts

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Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure

• Agency costs
• We know that career concerns and external
  reputation important for meeting benchmarks
• Information may be limited to reduce the chance
  of undue focus by stakeholders
• Not much support for this agency cost angle

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Graham/Harvey/Rajgopal Corporate Reporting
Constraints on voluntary disclosure

• Political costs
• Disclosure may be limited to avoid unwanted
  attention of regulators
• No support on average but this question, in
  particular, is difficult to interpret

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Graham/Harvey/Rajgopal Corporate Reporting
Good news versus bad news
Survey responses to the question Based on your
company's experience, is good news or bad news
released to the public faster?
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Graham/Harvey/Rajgopal Corporate Reporting
Good news versus bad news
Survey responses to the question Do the
following statements describe your company's
motives related to the timing of voluntary
disclosures?
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Graham/Harvey/Rajgopal Corporate Reporting
Conclusions

• Managers focused on earnings not cash flows
• Strong desire to meet benchmarks cockroach
  problem
• It is routine to sacrifice long-term value to
  meet these benchmarks
• Meeting benchmarks is important both for the
  firms stock price and managers reputation and
  mobility

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Graham/Harvey/Rajgopal Corporate Reporting
Conclusions

• Having predictable smooth earnings is thought to
  both reduce the cost of capital and enhance
  manager reputation
• Voluntary disclosure is an important tool in
  managers arsenal
• Disclosure can potentially reduce information
  risk and enhance a managers reputation

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Graham/Harvey/Rajgopal Corporate Reporting
Future research

• Last survey instrument!
• We are thinking of administering the identical
  survey before it is published to non-management
  members of Boards of Directors.
• Also
• Detection of Financial Earnings Management
• Detection of Real Earnings Management
• We have the tickers for 107 firms many of which
  admit to both financial and real earnings
  management

82
Payout Policy in the 21st Century
Alon Brav Duke University, Durham, NC USA John
R. Graham Duke University, Durham, NC
USA Campbell R. Harvey Duke University, Durham,
NC USA National Bureau of Economic Research,
Cambridge, MA USA Roni Michaely Cornell
University, Ithaca, NY USA IDC, Israel
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Brav/Graham/Harvey/Michaely Payout Policy
Introduction

• In 1956, John Lintner laid the foundation for the
  modern understanding of dividend policy
• He conducted detailed interviews with 28
  companies
• His research helped set the agenda for
  theoretical and empirical research on dividend
  policy
• Much has changed in the last 50 years.
• Possibly different payout policy goals
• Repurchases
• More insights from theory that may help direct
  the spotlight in the right direction
• We revisit this path-breaking study at the
  beginning of the 21st century

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Brav/Graham/Harvey/Michaely Payout Policy
Introduction

• We survey 384 financial executives with an
  instrument that focuses on both dividends and
  repurchases
• 256 public, 128 private
• Most presented results are based on the public
  firms
• We conduct one-on-one interviews with 23 CFOs or
  Treasurers of prominent corporations
• Interviews last between 40 minutes and two hours

85
Brav/Graham/Harvey/Michaely Payout Policy
Methodology

• Survey and Interview Design
• Draft survey instrument refereed by both
  finance researchers and experts in survey design
• Interviewed structured to adhere to best
  scientific practices of interviews, e.g. Sudman
  and Bradburn (1983)

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Brav/Graham/Harvey/Michaely Payout Policy
Methodology

• Survey Delivery
• Survey CFOs, Treasurers, Finance VPs
• Primarily members of Financial Executives
  International
• Two 500 random winners
• Three surveys
• FEI CFO Forum (April 23, 2002, Co. Springs CO)
• Dave Ikenberry NFCF (May 1, 2002, Houston TX)
• Mass emailing to 2200 FEI members
• Overall 16 response rate

87
Brav/Graham/Harvey/Michaely Payout Policy How
are payout decisions made?

• Goals of Treasury department
• Fund investment
• MM
• Liquidity and possible contingencies
• Payout decisions are second-order
• Except...
• DO NOT CUT DIVIDENDS ranks equal to or above all
  of these items

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Brav/Graham/Harvey/Michaely Payout Policy
Payout vs. Investment Decisions
Repurchases Dividends
89
Brav/Graham/Harvey/Michaely Payout Policy
Dividends vs. Repurchases (Fig. 2)
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Brav/Graham/Harvey/Michaely Payout Policy
Complements or Substitutes?

• Level of dividend fixed
• Substitute repurchases for change in dividends
• One way substitution
• Would use even more repurchases if they were free
  of constraint of dividend history

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Brav/Graham/Harvey/Michaely Payout Policy
Lintner (1956)

• Three main points
• Target payout ratio (dividend/earnings)
• Dividend policy set conservatively
• partial adjustment to target payout
• smooth through time
• sticky (history important)
• Level given, focus on changes
• tied to long-run sustainable earnings
• do not increase now if you might have to cut
  later
• No repurchases

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Brav/Graham/Harvey/Michaely Payout Policy
Compare to Lintner (1956)

• Dividend policy still conservative?
• Yes
• Perceived big penalty for cut, small reward for
  increase
• So, smooth, to avoid future cuts
• Path dependence of dividend policy
• BUT
• stealth dividend cut if possible
• holding dividend constant OK

93
Brav/Graham/Harvey/Michaely Payout Policy
Payout Decisions Still Made Conservatively? vs.
Lintner (1956)
Repurchases No, flexible Dividends Yes, still
conservative
94
Brav/Graham/Harvey/Michaely Payout Policy
Conservatively increase payout? Similar to
Lintner (1956)?
Repurchases Dividends
95
Brav/Graham/Harvey/Michaely Payout Policy
Payout ratio still target? vs. Lintner (1956)
96
Brav/Graham/Harvey/Michaely Payout Policy
Payout ratio still target? vs. Lintner (1956)
97
Brav/Graham/Harvey/Michaely Payout Policy
Payout ratio still target? vs. Lintner (1956)

• Extension of Fama-Babiak (1968), Choe (1990)
• The SOA and TP .
• Both SOA and TP have declined through time using
  both matching sample to our survey and broader
  Compustat sample

98
Brav/Graham/Harvey/Michaely Payout Policy
Summary vs. Lintner (1956)

• Dividend policy still very conservative
• Modern cash cows live in (close to) Lintner world
• Repurchase policy is not (i.e., it is more
  flexible)
• Payout ratio no longer target
• Targets very flexible
• Repurchases now very important

99
Brav/Graham/Harvey/Michaely Payout Policy
Miller and Modigliani (1961)

• Payout Policy irrelevant if capital markets
  perfect
• Imperfections that could explain payout policy
• Taxes
• Managerial agency conflict
• Information/signaling
• Other factors (EPS, float, credit ratings, etc)
• Clienteles could result from imperfections

100
Brav/Graham/Harvey/Michaely Payout Policy A.
Taxes

• Theory At least for individual investors,
  dividends are taxed move heavily than capital
  gains.
• Therefore
• Firms should consider investors taxation when
  deciding about payout policy
• Relative taxation should affect the amount of
  dividends they pay

101
Brav/Graham/Harvey/Michaely Payout Policy A.
Taxes

• Interviews repurchases are efficient way to
  return capital
• taxes (2nd order) important
• Surveys modest support

Repurchases Dividends
102
Brav/Graham/Harvey/Michaely Payout Policy B.
Clienteles

• Investors that pay (relatively) more taxes on
  dividends should hold stocks that pay out through
  repurchases.
• Translation Individual investors should have an
  aversion to dividend paying stocks. By
  implications, institutions should be more
  attracted to such stocks.
• Prudent man
• Institutions as monitors

103
Brav/Graham/Harvey/Michaely Payout Policy B.
Clienteles

• Retail investors
• Prefer dividends, in spite of tax disadvantage
• Firms like because loyal
• Institutions
• If anything, prefer repurchases
• Some can not invest in zero dividend stocks
• 42 say pay dividends because of prudent man
  rules
• Tax advantage not an issue to institutions
• Firms like because they have the money

104
Brav/Graham/Harvey/Michaely Payout Policy B.
Clienteles

• Companies do not think that dividends attract
  institutions more so than do repurchases
• Companies do not use dividends or repurchases
  attract institutions to monitor
• Inconsistent with Allen, Bernardo, and Welch
  (2000) idea that firms use dividends to attract
  institutional investors

Repurchases Dividends
105
Brav/Graham/Harvey/Michaely Payout Policy C.
Agency Stories

• Firms pay dividends to impose discipline on
  managers

106
Brav/Graham/Harvey/Michaely Payout Policy C
Free Cash Flow

• Interviews some say money can burn hole in
  pocket
• But payout not the way to fix the problem
• Surveys (1) no support in general, (2)
  repurchases work as well as dividends but (3)
  Cash cows are much more likely to pay more
  reluctant to cut more likely to keep dividend
  growth as earnings growth

Repurchases Dividends
107
Brav/Graham/Harvey/Michaely Payout Policy D.
Asymmetric Information

• Conveying information
• Costly self-imposed actionSignaling
• Adverse selection
• Do informed investors benefit from repurchase
  programs, at expense of uninformed?
• Stock undervaluation

108
Brav/Graham/Harvey/Michaely Payout Policy D
Do payout decisions convey information?

• Interviews Yes, punctuation mark at end of
  sentence
• Need to be consistent with other forms of
  communication
• Repurchases convey as much as dividends
• Surveys Yes, convey info in general

Repurchases Dividends
109
Brav/Graham/Harvey/Michaely Payout Policy
Information Signaling
Repurchases Dividends
110
Brav/Graham/Harvey/Michaely Payout Policy D.
Information Signaling

• Surveys
• No supporting evidence
• Scores are even lower for growth/risky firms
• 39 (16) say keep div (repurchase) policy of
  peers
• Interviews
• Spent hours on this issue
• Generally try to group selves with peers (not
  separate)
• No evidence of
• increasing dividend to show market that firm is
  strong
• viewing dividend as self-imposed cost
• Avoiding dividend cut
• Possibly a signal (costly for bad firms, separate
  from bad)
• Cuts are rare cant explain dividend policy for
  most firms
• Does not explain why firms pay dividends in the
  first place

111
Brav/Graham/Harvey/Michaely Payout Policy D.
Information Stock Price

• Interviews Would like to buy when price low, but
  
• often want to maintain liquidity at this time
• do not want credit rating downgrade
• So, its a conditional objective
• Surveys repurchases, stock good investment

Repurchases Dividends
112
Brav/Graham/Harvey/Michaely Payout Policy E.
Other factors EPS

• Interviews managers are concerned about EPS
• Some think its automatic that repurchases
  increase EPS
• Other believe that it depends on alternative use
  of funds
• Surveys EPS important

Repurchase questions
113
Brav/Graham/Harvey/Michaely Payout Policy E.
Other factors Float and credit ratings

• Interviews Float very important
• Execs think they need to have a large number of
  shareholders
• Interviews credit rating important
• Hoard cash to improve rating
• Especially for financial firms or firms with
  financial divisions

Repurchases Dividends
114
Brav/Graham/Harvey/Michaely Payout Policy
Initiate with repurchases or dividends?
115
Brav/Graham/Harvey/Michaely Payout Policy Why
initiate payout?
Repurchases Dividends
116
Brav/Graham/Harvey/Michaely Payout Policy
Conclusions

• Payout policy is not first-order important (MM)
• Repurchases decided de novo
• Dividends level very important
• Managers prefer repurchases over dividends
  because they are more flexible.
• Not because of taxes.

117
Brav/Graham/Harvey/Michaely Payout Policy
Conclusions

• According to managers, payout
• convey information
• NOT being used as a costly signal
• NOT being used to attract institutions
• Managers do not use dividends over repurchases to
  attract institutions
• Institutions do not push for more dividends

118
Brav/Graham/Harvey/Michaely Payout Policy
Conclusions

• Managers of cash cows believe more strongly that
• Dividends should be stable
• Keeping dividend growth rate with earnings growth
• But all managers reject the notion that they need
  dividends so that they will not spend cash
  unwisely.

119










Brav/Graham/Harvey/Michaely Payout Policy Rules
of the Game How payout policies are determined

• Make investment plans first
• Take care of cash/liquidity needs
• BUT, remember, level of dividends fixed
• Only reduce dividends in extraordinary
  circumstances
• Severe penalty for cutting dividend because the
  market believes that cuts precede bad news
• So, dont ever cut dividends
• unless you have an amazing investment opportunity
• smaller penalty if competitors cut
• Think very carefully before initiating dividends

120










Brav/Graham/Harvey/Michaely Payout Policy Rules
of the Game

• Desire to maintain the level of dividend at any
  cost consistent with findings in Graham, Harvey
  and Rajgopal, 2004, The Economic Implications
  of Corporate Financial Reporting
• Here managers desire to hit consensus EPS at any
  cost
• 55 would knowingly sacrifice value (not pursue a
  very positive NPV project) if it would cause the
  firm to miss next quarters target!
• 78 would knowingly sacrifice value to smooth
  earnings