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Do Corporations Manipulate Earnings to Meet or
Beat Analysts’ Expectations? Evidence from
Pension Assumption Changes
Yul W. Lee and T. Jeffrey Zhang
University of Rhode Island
AAA Conference
August 5, 2008
1
“Increasingly, I have become concerned that the
motivation to meet Wall Street earnings
expectations may be overriding common sense
business practices.”
– The “Numbers Game”, by Arthur Levitt, former
Chairman of SEC, a speech at NYU Centers for Law
and Business on September 28, 1998
2
Motivating Examples
• Verizon Communications (BeBchuk and Fried, 2004)
– Reported total earnings $389 million in 2001;
– $1.8 billion in pension income;
– But pension plan lost $3.1 billion. What’s the trick?
• Use the expected rate of return on pension assets (ERR) to estimate
pension income
• Increase ERR by 25 basis points from 9% in 2000 to 9.25% in 2001
– EPS beat analysts by $0.10
• IBM: plays the same trick with pension assumption
(Fortune, 2002)
• The SEC investigates whether firms tweak pension
assumptions to make themselves look better (The Wall
Street Journal on November 9, 2005)
3
DB Plans: An Interesting Test Ground for
Studying EM incentives
• Managers enjoy much discretion in setting the ERR
(expected vs. realized rate: SFAS 87)
• Pension plan assets are huge: small change of ERR
results in large impact
• Increasing ERR appears to be an effective EM tool (i.e.,
Verizon and IBM)
• Complicated pension accounting, hard to decipher (Jin,
Merton, Bodie, 2006).
4
How Can ERR Help Firms Increase Earnings?
• Calculation of Pension Expenses
Service cost (PV of pension benefits earned by employee over the last year)
+ Interest cost (Growth in PBO over the last year due to the passage of time)
+ Other costs (i.e., actuarial gain and pension amendment)
– Expected returns on plan assets (=ERR x FVPA)
= Net periodic pension cost (NPPC) (Reported on Income Statement)
• Impact of Changes in ERR on Firm Earnings
The Impact on
Expected Return on FVPA Net Periodic Pension Cost Earnings
ERR - Increase Increase Decrease Increase
ERR - Decrease Decrease Increase Decrease
5
Research Questions and Preview of Results (1)
• Do managers increase the ERR to meet or exceed
analysts’ expectations when the earnings would
otherwise have missed analyst consensus forecasts?
– Yes.
• What are the major benefits or potential costs in the
short-term, if any, associated with this EM activity?
– Positive short-term stock returns
– More likely to be subject to SEC enforcement actions;
greater likelihood of an unclean auditor’s opinion
6
Research Questions and Preview of Results (2)
• What are the long-run implications of such earnings
management activities?
– Stock returns and operating performance
significantly underperform control firms
• These findings suggest that corporate managers boost
current stock prices at the expense of long-term
growth prospects.
– Managerial myopia theory (Stein, 1988)
– Graham, Harvey, and Rajgopal (2004)
7
Data and Sample
• Accounting data: Compustat (1993 – 2005)
– ERR (date 336, available from fiscal year 1991)
• Stock return: CRSP
• Analyst earnings forecasts: IBES
– Unadjusted IBES summary file (Diether, Malloy,
Scherbina, 2002; Baber and Kang, 2002)
– Use median EPS as analyst consensus forecast
– 21,792 firm-year observation from 1993 to 2005
8
Frequency of Changes in ERR
Firm No.of % of Firms Average Firm No.of % of Firms Average Firm No.of Total
ERR Increasing Increase of ERR Decreasing Decrease of ERR % of Firms Firm
Year Increase ERR ERR (%) Decrease ERR ERR (%) Unchanged Unchanged Number
(1) (2) (3)=(2)/(10) (4) (5) (6)=(5)/(10) (7) (8) (9)=(8)/(10) (10)
1993 103 6.64% 0.655 195 12.56% -0.731 1,254 80.80% 1,552
1994 88 4.98% 0.715 380 21.52% -0.843 1,298 73.50% 1,766
1995 144 8.02% 0.742 291 16.20% -0.767 1,361 75.78% 1,796
1996 185 10.66% 0.734 150 8.65% -0.719 1,400 80.69% 1,735
1997 196 11.32% 0.68 140 8.08% -1.066 1,396 80.60% 1,732
1998 188 10.99% 0.73 129 7.54% -0.837 1,393 81.46% 1,710
1999 173 10.83% 0.597 167 10.46% -0.827 1,257 78.71% 1,597
2000 185 11.82% 0.8 166 10.61% -0.714 1,214 77.57% 1,565
2001 206 13.48% 0.647 121 7.92% -0.788 1,201 78.60% 1,528
2002 145 8.84% 0.673 201 12.25% -0.606 1,295 78.92% 1,641
2003 73 4.46% 0.881 637 38.89% -0.779 928 56.65% 1,638
2004 72 3.99% 0.852 777 43.09% -0.725 954 52.91% 1,803
2005 106 6.36% 0.6 460 27.61% -0.551 1,100 66.03% 1,666
1993-2005 1,864 8.58% 0.716 3,814 17.55% -0.766 16,051 73.87% 21,729
9
Empirical Results
Pseudo-EPS: Eliminating the effect of changes in the ERR from the I/B/E/S
actual annual EPS
ERR FVPA 0.65
pseudo EPS I / B / E / S Actual Annual EPS
Common Shares Used to Calculate EPS
pseudo EPS I / B / E / S Analyst Median Forecasted EPS
MissAmt
Absolute Value of Analyst Median Forecasted EPS
Use a dummy variable, pseudoMiss to indicate whether the pseudo-EPS
misses or beats analysts’ expectations:
pseudoMiss = 1 if MissAmt < 0 (pseudo-EPS < analysts’ median forecasted EPS)
pseudoMiss = 0 if MissAmt >= 0 (pseudo-EPS >=analysts’ median forecasted EPS)
10
Regression of ERR Incentives When Pseudo-EPS
Misses Analysts’ Expectations
11
Short-Term Stock Returns and Trading Volumes
Surrounding Earnings Announcement
1.00% 90.00%
0.80% 85.00%
0.60% 80.00%
Cumulative Abnormal Returns
Mean Adjusted Volumes
75.00%
0.40%
70.00%
0.20%
65.00%
0.00%
60.00%
-20 -15 -10 -5 0 5 10 15 20
-0.20%
55.00%
-0.40% 50.00%
-0.60% 45.00%
-0.80% 40.00%
Trading Day Relative to EAD of the ERR-Increase Firms [-20, +20]
12
Long-Run Operating Performance for the ERR-
Increase Firms
Year IBER/Sales (%) IBER/Assets (%) IBER/Equity (%) Earnings Growth (%)
ERR-Increase (Median) – ERR-Decrease (Median)
-5 1.36 0.33 0.61 1.03
-4 1.29 0.40 0.68 3.63
-3 1.40 0.38 0.78 4.42
-2 -1.96 -0.37 -1.10 -8.17
-1 -1.89 -0.64 -1.05 -3.23
0 -0.88 -0.27 -0.99 -1.86
1 -1.48 -0.09 -0.26 -1.56
2 -0.79 -0.05 -0.24 -2.09
3 -0.74 -0.70 -1.46 -4.80
4 -0.78 -0.10 -1.54 -2.40
5 -1.67 -0.35 -0.37 -0.84
ERR-Increase (Median) – ERR-Maintain (Median)
-5 1.02 0.37 0.53 1.01
-4 0.56 0.34 0.50 1.66
-3 -0.63 -0.27 -0.47 -1.55
-2 -1.12 -0.26 -0.67 -1.68
-1 -1.27 -0.31 -0.66 -3.10
0 -0.93 -0.08 -0.80 -3.19
1 -0.83 -0.02 -0.39 -1.06
2 -0.48 -0.26 -0.48 -1.01
3 -0.39 0.04 -0.44 -1.43
4 -1.05 0.19 -0.11 -2.35
5 -1.03 -0.43 -0.05 -0.64
13
Long-Run Buy-and-Hold Abnormal Stock
Returns (BHAR) for ERR-Increase Firms
0%
Buy-and-Hold Abnormal Returns
0 6 12 18 24 30 36 42 48 54 60
-5%
-10%
(BHAR)
-15%
-20%
-25%
Months Relative to Date of Increases in ERR
ERR-Increase Firms BHAR using Size-M atched ERR-M aintain Firm as Control Firm
ERR-Increase Firms BHAR using Size-Industry-M atched ERR-M aintain Firm as Control Firm
ERR-Increase Firms BHAR using Size-BM -M atched ERR-M aintain Firm as Control Firm
14
Estimate of EM Magnitude
Total Managed EPS Inflated/Analyst
Earnings EPS Inflated ($) Consensus EPS
Year ($ mil.) Mean Median Mean Median
1993 177.05 0.052 0.022 21.67% 4.83%
1994 91.01 0.040 0.013 12.62% 3.81%
1995 202.27 0.034 0.008 9.68% 3.08%
1996 252.77 0.044 0.012 13.60% 3.34%
1997 362.20 0.035 0.015 11.81% 3.55%
1998 569.53 0.039 0.013 13.25% 3.21%
1999 305.70 0.024 0.010 7.15% 2.69%
2000 886.75 0.054 0.012 15.06% 2.68%
2001 670.47 0.030 0.016 10.78% 3.45%
2002 359.05 0.020 0.007 6.12% 1.84%
2003 104.71 0.022 0.009 7.68% 2.99%
2004 49.95 0.009 0.003 4.55% 1.12%
2005 136.64 0.012 0.003 3.49% 0.80%
Average 320.62
(Total) (4168.09) 0.032 0.011 10.57% 2.88%
15
Conclusions
• Managers increase the ERR to boost earnings to meet
or exceed analysts’ expectations. Such earnings
management incentive tends to be stronger when the
earnings would have slightly missed analyst forecasts.
• These ERR-increase firms earn positive short-term
stock returns; but the long-run stock returns and
operating performance of the ERR-increase firms
significantly underperform the control firms.
• These findings suggest that corporate managers boost
current stock prices at the expense of long-term growth
prospects (e.g., Stein, 1988; Graham, Harvey, and
Rajgopal, 2004)
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