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Three Essays on Corporate Pension Plans and Capital Market

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Three Essays on Corporate Pension Plans and Capital Market Powered By Docstoc
					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)
                                                      16

				
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