Financial reporting & performance: Should we believe pessimistic companies?
08/21/2024
3 min
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How do managers set performance aspiration levels and evaluate their firm’s performance?
This question is central to the behavioural theory of the firm, which has been a prominent paradigm in organizational science and strategic management for more than 50 years. According to this paradigm, feedback from comparison of an organization’s own financial performance against that of peer firms (i.e., peer-based performance comparison) affects management’s perceptions and, therefore, their future decisions. These decisions are often strategic in nature, such as, strategic positioning, corporate transactions, R&D investments, and new product introductions. An overlooked yet important decision that could be driven by such comparison relates to firms’ disclosure strategy. Related to that, a key attribute that we examine is the tone that managers adopt in their written communication with outside stakeholders.
Our study shows that managers adapt the tone of their qualitative disclosures contained in the annual report based on how they perceive their firm’s performance; with performance falling below or exceeding the pre-defined peer-based benchmark as unfavourable or favourable, respectively. More specifically, we find that disclosures of firms with performance falling below the peer-based benchmark (hereafter, underperforming firms) exhibit over-pessimism. On the contrary, for firms with performance exceeding this benchmark (hereafter, outperforming firms), disclosures exhibit over-optimism. Interestingly, the further performance falls below (exceeds) this benchmark, the greater the observed over-pessimism (over-optimism).
A question of strategy
This finding raises a natural question: would this over-pessimistic vs over-optimistic strategy be informative (or uninformative) about future firm performance? This is specifically pertinent to ‘market participants’ (such as, security analysts, investors, and market observers), who assess information disclosed by the firm based on its relevance for future performance.
We find that underperforming firms’ over-pessimistic reports are not indicative of lower future earnings (or operating cash flows), while outperforming firms’ over-optimistic disclosures do not predict future performance at all! Hence, our evidence suggests that managers do not aim to share their private information, but rather use these disclosures strategically. One may wonder why?
Our study examined whether managers strategically employ this over-pessimism to facilitate a revision in analyst forecast, downwards, to an achievable level. Security analysts represent a salient and sophisticated group of market participants who periodically issue earnings forecasts for investors. And, managers engage in influencing analyst expectations through disclosure choices to meet their earnings forecasts (Cotter, Tuna, and Wysocki 2006). By meeting analyst forecasts, managers can reap plenty of benefits, such as, higher remuneration, influencing outsiders’ perceptions about their ability etc.
We find that underperforming firms’ over-pessimism is indeed associated with a greater downward revision in analyst forecasts. Our results also show that, the further performance falls below the peer-based benchmark, the higher is the likelihood that underperforming firms eventually end up meeting the analyst forecast!
Our findings resonate with the argument that, in an unfavourable performance situation (e.g., not meeting performance targets), firms are likely to make self-serving decisions that aim at achievements in the short run. Prior evidence shows that managers take tangible and costly decisions, such as, investing more in R&D, to effectively counter unfavourable performance over the long run. In this context, our study provides new insights, by showing that managers use their disclosure strategy as an easier and less costly tool to manage outsiders’ perceptions, instead of directly adjusting their firm’s performance.
For this research, we used qualitative (or textual) disclosures contained in the annual filings of publicly listed US firms over the period from 1993 to 2013. We focus exclusively on earnings-related disclosures, because of two reasons: first, our measure of peer-based performance comparison is based on reported earnings (see below); and second, prior studies document the usefulness of earnings-related disclosures for market participants when forecasting future earnings.
Tone is defined as the difference in the frequency of positive and negative words occurring in the firms’ earnings-related disclosures divided by the total number of words in the annual filings. But, tone is comprised of two different components: a normal component that correlates with firm economic fundamentals, such as, risk, current performance as well as performance targets, complexity etc; and an abnormal component capturing managers’ strategic choice of tone. It is the latter component that is relevant for our analysis. For each year in our sample period, we consider ‘peer’ firms as those companies that belong to the same industry and have similar size (where size is measured as firm total assets). Finally, we use median earnings (and alternatively, operating cash flow) in the peer group as our measure of peer-based performance benchmark.
Overall, our study drew a link between two important notions that are of interest to different groups of stakeholders:
- Peer-based comparison, the assessment method that assists managers (in having a better understanding about the strength of their firm’s performance vis-a-vis competitors) and investors and analysts (in evaluating firms’ performance and making better sense of subsequent firm decisions); and
- Company disclosure strategies that can be used as a tool by managers to shape market perceptions about their firm’s prospects.
Our work is an example of how insights from the strategic management domain can enhance understanding of corporate decisions about disclosures geared towards market participants.
Oveis Madadian, Assistant Professor of Accounting, IÉSEG School of Management et Pratik Goel, Assistant Professor in Accounting, IÉSEG School of Management
This is an English version of the article originally published on The Conversation France.
