Does Long-Term Earnings Guidance Mitigate Managerial Myopia? Andrew C. Call Arizona State University

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1 Does Long-Term Earnings Guidance Mitigate Managerial Myopia? Andrew C. Call Arizona State University Shuping Chen University of Texas at Austin Adam Esplin University of Alberta Bin Miao National University of Singapore October, 2014 Abstract: We address the policy debate on whether replacing short-term earnings guidance with long-term earnings guidance reduces managerial myopia through reductions in accruals and real earnings management and excess investment in fixed assets. We employ two event samples to capture long-term guidance: a hand-collected sample of firms that issue earnings-guidance for three to five years ahead and a sample that stops issuing quarterly guidance but continues to issue annual guidance. Using a propensity-score matched design, we find no evidence that long-term guidance firms manage earnings less or are more efficient in their investment decisions. Taken together, our evidence is inconsistent with the view that long-term guidance mitigates managerial myopia. Preliminary. Please do not circulate. Comments welcome. Corresponding author. We thank participants at 2014 BYU Research Conference, University of Texas at Austin brownbag workshop, and Utah State University workshop for helpful comments. All errors are our own.

2 Does Long-Term Earnings Guidance Mitigate Managerial Myopia? 1. Introduction Management frequently issues earnings guidance to communicate expectations of future earnings to the firm s stakeholders. 1 This guidance is usually short-term in nature forecasting earnings for the upcoming quarter. However, in recent years multiple investor groups and industry organizations argue that short-term guidance encourages managers to myopically focus on short-term results at the expense of long-term performance and investments (e.g., CFA Center for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics, 2006; The Aspen Institute, 2007; the Committee for Economic Development, 2007; and the Commission on the Regulation of U.S. Capital Markets in the 21 st Century 2007). These organizations encourage managers to cease giving short-term guidance and to instead issue longterm earnings guidance. These sentiments are echoed by prominent academic researchers (Fuller and Jensen 2010) and investors (e.g., Buffet 2000) alike. We examine whether firms engage in less earnings management and make better investment decisions, as evidenced in less excess investments, once they stop issuing short-term earnings guidance and/or if they issue long-term guidance. This investigation is important as it informs the policy debate on whether firms should replace short-term guidance with long-term guidance: if critics of short-term guidance are correct in their assertion that long-term guidance mitigates managerial myopia, replacing short-term guidance with long-term guidance should yield less earnings management and less over- or under-investment. To address our research question, we identify two samples of firms that issue long-term earnings guidance from 2000 to The first sample consists of 854 firm-year observations 1 We use management earnings forecasts, management earnings guidance, and management guidance interchangeably in this paper. 1

3 that issue long-term guidance of earnings three to five years ahead. We hand collect this sample through key-word searches of multiple data sources and refer to this sample as the LTMF sample. The second sample consists of firms that continue to issue annual earnings guidance after discontinuing the issuance of quarterly earnings guidance. We identify 609 firm-year observations using CIG/IBES guidance databases and call this sample our ANNMF sample. These firms behave as if they are heeding the call from practitioners to provide long-term annual guidance in lieu of quarterly guidance. 2 Our empirical investigation proceeds in three steps. To tackle the self-selection inherent in our setting, we first identify firm characteristics associated with the issuance of these longterm guidance. Using propensity-score matched (PSM) control samples constructed from our first-stage probit models, we then examine whether long-term guidance firms exhibit less accruals and real earnings management than their respective control firms, and whether longterm guidance firms exhibit less excess investment in fixed assets. We find that the LTMF sample firms that issue earnings guidance for 3-5 years ahead exhibits better stock and accounting performance, lower return volatility, a greater number of long-term forecasts issued by analysts, and longer investment horizon by institutional investors when compared to firms that do not issue this form of guidance. LTMF firms are also more likely to issue dividends. In contrast, firms that continue to issue annual guidance after stopping quarterly guidance (ANNMF firms) have experienced deteriorating performance, increasing uncertainty in their operating and information environment, a decrease in institutional investors 2 To more closely mirror critics recommendations, an ideal sample should consist of firms that issue only quarterly guidance but move to issuing only annual guidance or even longer-term guidance. However, over our sampling period, only 515 firms (5501 firm years) appear to issue only quarterly guidance, and of these firms, 35 firms (41 firm years) move from issuing only quarterly guidance to issuing only annual guidance. This is before requiring these observations to have the requisite data. This small sample makes it difficult to implement a meaningful research design. 2

4 holding horizons and fewer long-term growth forecasts issued by analysts when compared to firms that continue to issue quarterly earnings guidance. These findings are largely consistent with prior research investigating why firms cease guidance (Chen, Matsumoto, and Rajgopal 2011). Based on these determinants of long-term guidance, we construct propensity score matched (PSM) control samples for LTMF and ANNMF samples respectively. Our second step of empirical analysis compares the event samples with their PSM control samples on accruals and real earnings management. We use both signed and unsigned discretionary accruals derived from the Jones model (1989) and the Dichow-Dichev model (2002) adjusted for economic performance (Ball and Shivakumar 2006) and discretionary revenue (Stubben 2010) to capture accruals earnings management. We find no evidence that our two event samples exhibit differential accruals earnings management from their respective propensity-score matched control samples in either a univariate or a multivariate setting. Nor do we find evidence of differential real earnings management, proxied by abnormal operating cash flows, abnormal discretionary expenses, and abnormal production costs based on Roychowdury (2006). Lastly, using the McNichols and Stubben (2008) model of excess investment in fixed assets, we find no evidence of improved investment decisions for the two event samples. Thus, across six different measures of accruals earnings management (signed and unsigned), three different measures of real earnings management, and two different measures of excess investment (signed and unsigned), and using two different event samples to capture the concept of long-term guidance, we do not find evidence of differential earnings management or excess investment between long-term guidance and other firms. We provide no support for the 3

5 belief held by many practitioners that long-term guidance reduces managerial focus on shortterm results and improves investment decisions. The evidence in this study informs the current debate on the merits of long-term guidance as a tool to reduce managerial fixation on short-term performance and to facilitate improved investment decisions. While some prominent practitioners argue that the issuance of long-term guidance mitigates managerial myopia, our results do not support this argument. We contribute to the growing literature motivated by the debate over the costs and benefits of short-term earnings guidance, and more broadly the costs and benefits of guidance in general. Chen, Matsumoto, and Rajgopal (2011) and Houston, Lev, and Tucker (2010) find that when firms cease earnings guidance, analyst earnings forecast accuracy declines and forecast dispersion increases, impairing the quality of information available to investors. 3 More recently, Call, Chen, Miao, and Tong (2014) find that firms issuing short-term quarterly guidance actually exhibit less, not more earnings management, and Chen, Huang, and Lao (2014) find that guidance firms report more future innovations than non-guidance firms, and that quarterly guidance has a positive incremental impact on future innovation over annual guidance. We extend this literature by evaluating the potential impact of one of the highly touted alternatives to short-term guidance, and find that long-term guidance has no discernable effect on earnings management activity or on investment decisions. 4 3 We note our research question is different from the research question investigated in Chen et al. (2011) and Houston et al. (2010): the prior two studies investigate the consequence of stopping guidance (both quarterly and annual earnings guidance), whereas our focus is on firms that (continue to) issue long-term guidance. Their event samples are firms that stop guidance, and our event samples are firms that continue to issue annual guidance/issue longer-term guidance. 4 Lao (2013) utilizes the Ohlson model and finds that investors place significantly higher weight on short-term earnings of quarterly guidance firms than on the corresponding earnings of non-guidance firms. We note, however, that Lao (2013) focuses on investor short-termism whereas our paper focuses on managerial short-termism. 4

6 Lastly, the issuance of long-term guidance of earnings three to five years ahead is itself an interesting disclosure choice that has received little attention in the academic literature. We provide the first evidence on such long-term guidance and the characteristics of firms issuing such guidance. Our evidence adds to the academic literature on firms voluntary disclosure behavior. We note one important caveat in interpreting our results: our two event samples, LTMF and ANNMF, are both small. This is because in practice only a small number of firms issue longer-term 3~5 year earnings guidance or stop quarterly guidance but continues with annual guidance. Thus, the null results in this paper could be due to lack of power. We do not preclude the possibility that once more firms start replacing short-term guidance with longer term guidance, a researcher may be able to document evidence that long-term guidance indeed mitigates managerial myopia. The rest of the paper is organized as follows. Section two reviews relevant literature and develops our empirical predictions. Section three describes our long-term guidance samples and selection of our control samples. Section four presents the research designs and discusses the respective test results. Section five concludes. 2. Background and empirical predictions In recent years, influential practitioners and academics have been critical of the practice of giving short-term earnings guidance. Critics allege that short-term earnings guidance fosters managers myopic behavior such as earnings management and encourages fixation on short-term earnings performance to the detriment of long-term performance and investments (Fuller and Jensen 2010). Even regulators and politicians weigh in on this debate. Former SEC Chairman 5

7 William H. Donaldson cited short-termism as a critical issue facing corporate leaders at the 2005 CFA Institute annual conference and called upon business leaders [to] manage business for long-term results (CFA Center for Financial Market Integrity 2006), and Al Gore, former U.S. vice president, called for companies to end this default practice and encourage a long-term view of the business rather than the current focus on quarterly results (Gore and Blood 2012). Multiple industry organizations similarly call for firms to issue long-term guidance in place of short-term guidance (CFA Center for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics, 2006; The Aspen Institute, 2008; the Committee for Economic Development, 2007; and the Commission on the Regulation of U.S. Capital Markets in the 21 st Century 2007). Beginning in September 2005, the CFA Center for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics co-sponsored a Symposium Series on Short-Termism. One of their key recommendations was to encourage corporate leaders, asset managers, institutional investors, and analysts to [e]nd the practice of providing quarterly guidance and to adopt guidance practices that reflect overall long-term goals and strategies. 5 Together with these two organizations, the U.S. Chamber of Commerce Center for Capital Market Competitiveness and Committee for Economic Development recommended that, companies focus their communications more on their long-term strategic plans, thereby leading and encouraging investors to do the same (The Aspen Institute 2008). 6 Another example comes from the Reports and Recommendations by the Commission on the Regulation of U.S. Capital Markets in the 21 st Century (March 2007): 5 Breaking the Short-Term Cycle: Discussions and Recommendations on How Corporate Leaders, Asset Managers, Investors, and Analysts Can Refocus on Long-Term Value. CFA Center for Financial Market Integrity/Business Roundtable Institute for Corporate Ethics, Operating and Investing for the Long-Term: Best Practices in Communications, Guidance and Incentive Structures to Create Value for the Long-Term, the Aspen Institute

8 All public companies should eliminate the practice of providing quarterly earnings guidance and that companies should instead provide shareholders and Wall Street with meaningful additional information on their long-term business strategies. The underlying assumption to these calls for long-term guidance is that a switch from short-term to long-term guidance would mitigate managers focus on short-term results. For example, a recent report by McKinsey & Company argues that long-term guidance can shift their [managers ] focus away from short-term performance and toward the drivers of long-term company health as well as their long-term goals. 7 We empirically investigate the assumption that long-term earnings guidance reduces managerial myopia. Specifically, we investigate whether managers engage in less earnings management after issuing long-term guidance. We also examine whether the investment efficiency improves for firms that issue long-term guidance. If the assumption by investor and industry groups is valid, we expect managers of firms that issue long-term guidance to exhibit less earnings management and to make better investment decisions. We summarize these as testable empirical predictions below: P1: Long-term earnings guidance mitigates earnings management. P2: Long-term earnings guidance improves investment decisions. Most recommendations from investor and practitioner groups do not explicitly define the horizon of long-term guidance. However, most criticisms of short-term guidance are focused on the issuance of quarterly guidance. We therefore define long-term earnings guidance alternatively as (a) management forecasts of earnings with a horizon of three to five years ahead, or (b) management guidance for annual earnings. These empirical definitions are in line with practitioners implicit proposals. For example, a report issued by the Committee for Economic Development states: Medium-term indicators might point toward the likelihood the company 7 The Misguided Practice of Earnings Guidance, McKinsey & Company publications, March

9 could maintain performance over one to five years. ( Built to Last, 2006). The first definition also coincides with the definition I/B/E/S employs for long-term analysts growth forecasts. 8 We recognize that firms issuing long-term earnings guidance may differ systematically from firms that do not. Since these differentiating factors may also be associated with incentives to manage earnings or investment decisions, we compare firms that issue long-term guidance to propensity score matched control samples that exhibit similar characteristics but that do not exhibit the same guidance behavior. We discuss our sampling process below. 3. Long-Term Guidance Samples and Control Samples for Determinant Tests An ideal sample to address the policy debate is a sample of firms that truly replace shortterm (such as quarterly) guidance with long-term (such as annual) guidance. In other words, an ideal sample consists of firms that were issuing only quarterly guidance before and start issuing only annual or even longer term guidance. However, such a sample is extremely small: using CIG/IBES guidance data base, we find that only 35 firms (41 firm-years) satisfy the sampling criteria of issuing only annual after issuing only quarterly forecasts over the period of Thus, we identify two samples of firms that issue long-term earnings guidance that most closely mirror the call from practitioners which also have reasonable sample sizes for our empirical analysis. The first sample, the LTMF sample, consists of firms that issue guidance of earnings for three to five years ahead. We use a series of keyword searches for mentions of long- 8 The Thomson Reuters (I/B/E/S) (2009) Methodology for Estimates manual states The long term growth rate represents an expected annual increase in operating earnings over the company s next full business cycle. These forecasts refer to a period between three and five years and are expressed as a percentage. 8

10 term guidance in the business press over the period January 1, 2000 to December 31, Our search for long-term forecasts encompasses the Dow-Jones News Service, the Wall Street Journal, PR News Wire, Business News Wire, and conference call transcripts via the Fair Disclosure database. We read over 8,000 articles retrieved using the key word search to identify our sample of long-term earnings guidance. This process yields a total of 275 unique firms and 854 firm-year observations with long-term forecasts of earnings that are three-to-five years ahead from 2000 to The control sample pool for the LTMF event sample consists of all CIG/IBES guidance firms that do not issue 3~5 year earnings guidance. Thus, the LTMF event firms issue 3~5 year guidance whereas the control firms have never issued any 3~5 year earnings guidance. 10 Our second sample, the ANNMF sample, consists of firms that stop issuing quarterly guidance while continue to issue annual guidance. We use the CIG/IBES databases to identify these firms from 2000 to Specifically, we set an indicator variable, ANNMF, equal to one for firms that issue at least one annual forecast without issuing any quarterly guidance for four consecutive quarters (post period), after having issued at least 3 quarterly forecasts in the 9 The search terms we use include variations of the following string to accommodate different databases: (management or manager or CEO or chief executive* or CFO or chief finance* or company or firm) and ((anticipates or expect* or predict* or forecast* or see* or project* or put* or estimate) near10 (five year near3 earn*) or (three year near3 earn*) or (long term near3 earn*) or (five year near3 eps) or (three year near3 eps) or (long term near3 eps)). We start our search in 2000 to mitigate errors in the measurement of earnings guidance that are not captured by the Company Issued Guidance (CIG) database prior to Regulation FD. We further augment our sample by identifying 78 long-term forecasts captured by the CIG database and 6 long-term forecasts identified by I/B/E/S. To ensure the completeness of our search, one author and one research assistant conducted independent searches using various combinations of the search strings using the same data sources. 10 Again, a more ideal LTMF sample should be firms that are not subject to short-term guidance pressure, namely, LTMF firms that do not issue quarterly earnings guidance. Imposing this data restriction leads to sample attrition of more than 56%, resulting in a sample size of 371 observations. Given that our data requirement to perform subsequent tests on earnings management and excess investments will lead to further data attrition, and Type II error is a challenge in our setting, we choose to start with the larger sample of 854 observations. 9

11 previous four quarters (pre period). 11 Figure 1 presents the timeline used in this design. These firms are heeding practitioners calls to favor long-term guidance and to discontinue the practice of issuing quarterly forecasts. This sampling procedure leads to 370 unique firms and 609 firmyear observations from 2001 to 2012 that stopped giving quarterly earnings guidance but continue to issue annual guidance. The control sample pool for the ANNMF event sample consists of CIG/IBES guidance firms that have issued at least 6 quarterly forecasts in two consecutive 8-quarter period, namely at least three quarterly forecasts in each four-quarter interval. In other words, the ANNMF event sample issues annual guidance but does not issue quarterly guidance in the post period, whereas the control sample issues quarterly guidance in both the pre and post period. Note we exclude from our control samples firms that do not appear on CIG/IBES guidance database and therefore have not issued any guidance for two reasons. First, the debate that motivates our study is whether long-term guidance mitigates the short-termism associated with managers short-term guidance. As such, firms that issue no guidance are less relevant to this debate. Second, a large body of literature has documented that firms issuing earnings guidance differ systematically from those not issuing guidance (see Beyer, Cohen, Lys and Walther 2010 for a literature review). Limiting the analysis to firms that have issued guidance holds these differences constant and allows us to draw cleaner inferences. Panel A of Table 1 presents descriptive statistics on the frequency of long-term guidance, before imposing data restrictions. The issuance of 3~5 year earnings guidance (LTMF=1) is relatively consistent through our sample period, with a peak of 81 in 2007 and a low of 34 in 11 We use the CIG database to identify the ANNMF observations for years as the Thomson Reuter s IBES guidance database does not start its coverage of management issued guidance until For , we use the combination of CIG and IBES databases to identify ANNMF observations for years

12 The incidence of firms stopping quarterly guidance while issuing annual guidance (ANNMF=1) reaches a peak in 2006, and has tapered off in the years since. 13 It is important to note that, overall, the number of firms issuing LTMF 275 firms - and the number of firms stopping quarterly but continuing with annual guidance (ANNMF firms) 370 unique firms - are small compared to the total number of firms that appear in CIG/IBES guidance database. In addition, 154 out of the 370 firms in ANNMF sample restart issuing quarterly earnings guidance after a four-quarter period of issuing no quarterly guidance. Thus, despite the fact that many prominent investors and important industry groups urge firms to replace short-term guidance with longer term guidance, in practice not so many firms have heeded to such call for longer term guidance or have done so consistently. Panel B of Table 1 shows some industry clustering of long-term guidance, with the LTMF observations being clustered in the Shops, Consumer Non-Durables, and Money industries, and the ANNMF observations being clustered in the Shops and Business Equipment industries. In our subsequent tests investigating the impact of long-term guidance, we require that the PSM control observations to come from the same year and industry of the event observations, and we also include industry and year fixed effects in our empirical models investigating earnings management and investments in fixed assets. 4. Research Design and Empirical Results 4.1 What determines long-term earnings guidance? Research design 12 We report only 10 LTMF observations in 2013 because we ended our search in December 2012, and some of the firms that issued long-term guidance in 2012 have a 2013 fiscal year-end. 13 Note even though our sampling period for ANNMF observations starts in 2000 and ends in 2013, our ANNMF starts in 2001 and ends in 2012 because we require 8 consecutive of quarters to identify these observations. 11

13 Our first objective is to identify factors that differentiate firms issuing long-term 3~5 year earnings guidance (LTMF sample) from other guidance firms, and factors that lead firms to stop issuing quarterly guidance while continuing to issue annual guidance (ANNMF sample). We compare LTMF firms to guidance firms that do not issue 3~5 year guidance (LTMF=0), and ANNMF firms to those that continue to issue quarterly guidance (ANNMF=0), as described in the previous section. This comparison is important as the factors affecting firms voluntary disclosure behavior can conceivably also impact firms earnings management behavior and investment decisions. Addressing this question mitigates the endogeneity concern that selfselection contributes to the observed earnings management or investment behavior. This investigation allows us to construct propensity score matched control samples for each of our event samples in our subsequent investigation of the impact of these practices on managerial myopia. The issuance of long-term 3~5 year earnings forecasts (LTMF) is a distinctly different phenomenon from the much more prevalent practice of issuing quarterly or annual earnings guidance. It is conceivable that firms can only issue longer-term forecasts when they are better able to forecast the future with confidence. This reasoning and our review of the disclosure literature (e.g., Healy and Palepu 2001; Beyer, Collins, Lys, and Walther 2010) lead to the following conjectures: firms are more likely to issue LTMF if they (1) have solid performance (2) have more stable operating and information environment, (3) face greater demand for longterm information from long-term investors. We also conjecture that firms (4) undergoing restructuring and mergers and acquisitions are less able to issue LTMF, as such changes make it more difficult for managers to predict long term. On the other hand, (5) managers who are historically better at forecasting are in a better position to give LTMF. Finally, our reading of the 12

14 press releases to identify LTMFs shows that (6) firms issuing dividends are more likely to provide longer term information, perhaps to assure investors of the sustainability of dividends. We use stock returns in the previous twelve months (RET -12 ) and the return on assets in the prior year (ROA) to proxy for performance, daily stock return volatility (STD RET ) for the prior year and the number of long-term analyst forecasts (LTAF) in year t-1 to proxy for operating and information environment uncertainty, respectively, and the negative of the average turnover rate of institutional investors (CHURN) in year t-1 to proxy for demand for information from longterm investors. 14 We use an indicator variable equal to one if the firm either had a restructuring event or a merger in year t-1 (ResMA), and capture managers ability to forecast earnings using a measure of the precision of prior management earnings guidance (PRECISE), where point estimates are considered more precise than range estimates, and range estimates are considered more precise than qualitative forecasts. We capture dividend issuance using an indicator variable DIV coded as one for firms issuing at least two quarterly dividends in year t-1. Detailed definitions of all proxies are tabulated in the Appendix. We estimate the following probit regression for our LTMF sample: Prob (LTMF=1) it = RET it ROA it STD RET it LTAF it CHURN it ResMA it PRECISE it DIV it-1 it (1a) Prior research has investigated why firms stop giving quarterly earnings guidance. For example, Chen et al. (2011) and Houston et al. (2010) find that firms stop when performance declines and uncertainty increases. Though these studies focus on the stopping decision rather than the continuation of annual guidance, they nevertheless provide a starting point for our first 14 Specifically, we use the average turnover rate of institutional investors (CHURN) following Gaspar, Massa and Matos (2005) to capture investment horizon. Higher CHURN rate indicates lower investment horizon. For ease of interpretation we multiple CHURN by negative one, thus we can interpret high CHURN to indicate longer investment horizon. 13

15 investigation. 15 Thus, we conjecture that, compared to control firms that continue to issue quarterly guidance, ANNMF firms experience decreasing stock and accounting performance and increasing uncertainty. We use buy-and-hold return for the past 12 months (RET -12 ) and the change in return on assets from year t-1 to year t ( ROA) to proxy for performance change, and year-over-year change in daily stock return volatility ( STD RET ) to capture increases in uncertainty in the operating environment and the change in the number of IBS analysts issuing long-term 3~5 year earnings forecasts ( LTAF) to capture changes in uncertainty in the information environment. With greater information uncertainty analysts are less able to forecast far into the future. Prior research also finds some evidence that firms stop quarterly guidance when facing investors with longer holding horizons, thus we include CHURN to capture this change in demand for information. Positive CHURN indicates increases in investment horizon of institutional investors and negative CHURN indicates decreases in investment horizons. Detailed definitions for all variables are offered in the Appendix. We estimate the following probit model: Prob(ANNMF=1) it = RET it ROA it + 3 STD RET it + 4 LTAF it + 5 CHURN it + it (1b) 16 The changes specification captures the changes in disclosure behavior of ANNMF firms: these firms change from giving quarterly and annual guidance to only giving annual guidance. 15 We first replicate the Chen et al. (2011) results using their sampling period. Note the Chen et al. (2011) sample is substantially different from our sample, as their research focus is on the stopping of quarterly guidance, not the continuation of annual guidance. Thus, their event sample, the stopper sample, consists of firms that stop giving both annual and quarterly earnings guidance these firms stop appearing in the CIG database in four adjacent quarters after having appeared at least three quarters in the previous adjacent quarters. In addition, their sampling period is 2002 to 2003, whereas our sampling period is much longer covering Houston et al. (2010) has similar sampling procedure as Chen et al. (2011) and their sample period is from Q12002 to Q12005, substantially shorter than our sampling period. 16 We employ this parsimonious model in order to maximize matching on each of the individual factors and also to avoid further data attrition, while noting that results do not change if we augment Equation (1a) with more variables such as analyst forecast dispersion or replacing ROA with a measure based on the frequency of firms meeting or beating analyst forecasts, which is more data-demanding. 14

16 We note that because the ANNMF sample is characterized by firms that change their guidance behavior, as such we employ a changes model (1b) to generate propensity scores, while we use a levels model in equation (1a) in an effort to differentiate firms that either issue or do not issue long-term guidance of 3~5 year ahead earnings Results of determinants tests In Panel A of Table 2 we report univariate statistics for the independent variables included in our prediction models, separately for the two event samples and their respective control samples used in the probit regressions. Tests of difference in means and medians reveal that LTMF firms have higher returns and ROA, lower return volatility, and more analysts issuing long-term forecasts, are twice as likely to grant dividends and have institutional investors with longer horizons. However, inconsistent with our predictions, these firms have more incidences of restructuring and M&A activities and lower prior management forecast precision at the univariate level. In contrast, ANNMF firms have experienced decreasing returns and ROA, increasing return volatility and bigger drops in the number of analyst long-term forecasts. ANNMF firms also exhibit an increase in institutional investors horizon, though the increase is smaller than that of control firms. Panel B of Table 2 presents our probit estimation results. The results are largely consistent with the univariate results, with the exception that ResMA and PRECISE are not significant in the LTMF regression. In addition, contrary to our prediction and prior research, the coefficient on CHURN is negative, suggesting ANNMF firms have experienced a relative decrease in investor holding horizons. It is possible that these firms stop issuing quarterly but 17 We do not include year or industry fixed effects in equations (1a) or (1b), as in our subsequent propensity score matching procedure we require the matched firm to come from the same year and industry as the event firm. 15

17 continue to issue annual guidance in an effort to win back more long-term investors, instead of responding to the demand of current investors. 18 In Panel C of Table 2 we tabulate the companion of the matching variables after we generate one-one-one matches for each observation in our two event samples. The matched observations are from the same year and industry and have the closest propensity scores to the event observations. Panel C shows that our matches are largely successful, with the exception of LTAF for the LTMF matched sample and RET -12 for the ANNMF matched sample. 4.2 Do managers engage in less earnings management after the issuance of long-term guidance? Research design To investigate the potential impact of long-term guidance on managerial myopia, we examine whether the long-term guidance firms differ in the extent to which they engage in accrual-based and real earnings management. We compare the firms in our LTMF and ANNMF samples to PSM control firms based on equations (1a) and (1b) generated above. We use three proxies to capture the extent of accrual-based earnings management: abnormal accruals from the Jones model (1991) (ABAC) and from the Dechow-Dichev model (2002) (ABDD), both modified per Ball and Shivakumar (2006), and abnormal revenues based on Stubben (2006, 2010) (ABREV). Detailed definitions of these variables are offered in the Appendix. We estimate the following regression: EM it = α + β 1 ANNMF/LTMF it-1 + β 2 LEV it-1 + β 3 BTM it-1 + β 4 OPCYCLE it-1 + β 5 CAPINT it-1 + β 6 ROA i + β 7 SIZE it-1 + β 8 INST it-1 + β 9 σ(cfo) it-1 + β 10 σ(earn) it ΣIND + ΣYEAR + ε it (2a) EM is one of the three abnormal accruals proxies (ABAC, ABDD, or ABREV) discussed above 18 Note alternative measures of accounting performance (the frequency of meeting or beating analyst forecasts) and uncertainty (analyst forecast dispersion) yield the same results. 16

18 and outlined in the Appendix. Larger absolute values of these measures indicate more earnings management. LTMF/ANNMF is an indicator variable set to one for LTMF/ANNMF =1 observations, and set to zero for PSM control observations. Our control variables in Eq. (2a) are drawn from Call et al. (2014) which investigates the impact of quarterly guidance issuance and frequency on the extent of accruals earnings management. We include the ratio of debt to equity (LEV) to control for the effects of leverage on earnings management (DeFond and Jiambalvo 1994; Barton and Waymire 2004). We control for growth using the book-to-market ratio (BTM) as Skinner and Sloan (2002) find growth firms have stronger incentives to manage earnings because the market penalizes growth firms for negative earnings surprises. We include several variables to control for firms underlying business fundamentals, such as the length of the operating cycle (OPCYCLE) and capital intensity (CAPINT), as both have been shown to affect reported accruals (Dechow and Dichev 2002; Cohen 2008). We also control for firm performance (ROA), firm size using the natural log of sales (SIZE), and percentage of institutional ownership (INST). We address the concerns of correlated omitted variables raised in Hribar and Nichols (2007) by including both the standard deviation of operating cash flows ( (CFO)) and the standard deviation of earnings ( (EARN)) to control for the volatility of the firm s operating environment. Finally, we include industry dummies (IND) in Eq. (2a) based on Fama and French s 12 industry groupings. We also include year dummies (YEAR) to mitigate concerns over cross-sectional dependence (i.e., earnings management for firm i is correlated with earnings management of firm j in a given year). We cluster our standard errors by firm to address time-series in the residuals (Petersen 2009). Detailed definitions of all variables are provided in the Appendix While the extant literature has relied on a variety of empirical measures of earnings management (e.g., meetingor-beating benchmarks, earnings restatements, accounting frauds, etc.), we believe abnormal accruals and 17

19 To capture real earnings management, we employ the three proxies advanced in Roychowdury (2006): abnormal operating cash flows (DISCFO), abnormal discretionary expenses (DISEXP), and abnormal production costs (DISPROD). Lower values of DISCFO and DISEXP and higher value of DISPROD indicate greater extent of real earnings management (Roychowdury 2006). Lower DISCFO and DISEXP can stem from managers effort to increase earnings through excessive price discount to generate revenue and excessive cutting of discretionary expenses to reduce expense. Higher DISPROD can result from overproduction in order to lower COGS. Detailed estimations of these measures are provided in the Appendix. We estimate the following regression to investigate whether firms issuing long-term forecasts are engaged in less real activities management than their PSM control firms: REALEM it = α + β 1 ANNMF/LTMF it-1 + β 2 PMBAF it-1 + β 3 STK_ISSUE it-1 + β 4 LOGNAF it-1 + β 5 BTM it-1 + β 6 LOGSHROUT it-1 + β 7 LOGMV it-1 + β 8 ROA it-1 + ΣIND + ΣYEAR + ε it (2b) REALEM is one of the above three proxies (DISCFO, DISEXP, or DISPROD) for earnings management through real activities. Our control variables are drawn from Cohen and Zarowin (2010) and Zang (2012). PMBAF is firms percentage of meeting or beating consensus analyst forecasts in the past 8 quarters. Habitual beaters of market expectations have a greater likelihood of achieving this through real activities manipulations. STK_ISSUE is an indicator variable for equity issuance as prior research finds that firms issuing stock are more likely resort to real manipulations of earnings. Firms with more analyst following (LOGNAF) and growth firms (BTM) are under greater pressure to manage earnings, and a greater number of shares outstanding (LOGSHROUT) requires more earnings management to achieve a given earnings per discretionary revenues best capture managers use of accounting discretion to manage earnings. In particular, critics are concerned with accounting shenanigans. Since these concerns are focused on managerial discretion over earnings, rather than on outcomes that potentially follow (e.g., meeting-or-beating benchmarks, restatements, fraud), we assess accruals earnings management by measuring the extent of managerial intervention in the earnings process. 18

20 share target. We also include controls for firm size (LOGMV) and performance (ROA), as well as industry and year fixed effects in Eq. (2b) Accrual-based earnings management test results We report the results of our accrual-based earnings management tests in Table 3 (absolute values of accruals) and Table 4 (signed accruals). Univariate statistics in Panel A of Table 3 reveal no significant difference in accrualbased earnings management proxies between LTMF firms and their PSM control firms. Similarly, none of the three accruals earnings management proxies are different between ANNMF firms and their PSM controls. Our multivariate regressions reported in Panel B reveal similar results. Ceteris paribus, there is no significant difference in accrual-based earnings management between our two event samples and their respective PSM control samples, using any one of our three proxies (ABAC, ABDD, or ABREV). The results on ANNMF event sample in Panel B is based on a cross-sectional design comparing the magnitude of accruals after the event quarter 1. Since ANNMF firms have changed their guidance behavior, in Panel C of Table 3 we employ a difference-in-difference design to further examine if ANNMF firms differ from control firms in the extent of their changes in accruals earnings management. We define a dummy variable POST coded as one for the one year after cessation of quarterly guidance and zero for the year before, and interact POST with ANNMF. The results in Panel C show that there is no difference in the extent of accruals earnings management in the year before between event and PSM control samples. In the POST period, ABDD for event firms is marginally higher than control firms (firm-clustered t=1.82), whereas neither ABAC no ABREV are different between event and control firms. 19

21 The results in Table 4, based on signed accruals, yield similar inference. At the univariate level LTMF firms exhibit higher ABDD but lower discretionary revenues ABREV (Panel A), and in the regression in Panel B these differences persist. The opposite signs on the two accruals earnings management measures, however, make it difficult to conclude that LTMF firms manage earnings less than PSM controls. The signed accruals results based on ANNMF sample show that ANNMF firms exhibit lower discretionary accruals (3 out of 6 differences are significant, Panel A), however the difference disappears once we control for other factors that can affect the dependent variable (Panel B), though ANNMF firms show slightly lower ABAC in the DiD design (significant at 10% level) in Panel C. Taken together, the results in Table 3 and Table 4 fail to yield consistent evidence that our two long-term guidance event samples differ in discretionary accruals and discretionary revenues from their respectively PSM control samples. We interpret our results as inconsistent with the assumption that replacing short-term guidance with long-term guidance mitigates accrual-based earnings management Real earnings management test results We report the results of our real earnings management tests in Table 5. In the univariate results presented in Panel A, we find that LTMF firms exhibit lower abnormal discretionary expenses than their PSM controls at a univariate level, while neither DISCFO nor DISPROD are different between the two samples. The ANNMF firms exhibit lower abnormal cash flows (DISCFO) but higher abnormal discretionary expense (DISEXP) than their PSM control sample. Note that real earnings management would indicate higher abnormal cash flows and lower abnormal discretionary expense, if firms are trying to manage earnings upward to meet forecasts as alleged by critics. 20

22 The results in a multivariate setting (Panel B) when controlling for other determinants of real earnings management show that, ceteris paribus, there is no significant difference in real earnings management (DISCFO, DISEXP, or DISPROD) proxies between the LTMF sample and the PSM control sample. In addition, ANNMF firms exhibit higher, not lower, abnormal discretionary expenses. This result is opposite to firms increasing earnings through aggressive price discount or cutting discretionary expenses such as R&D. Similar to our investigation of the accruals earnings management behavior for ANNMF firms, we further employ a difference-in-difference design to examine the possibility that ANNMF firms exhibit greater decrease in the extent of real earnings management than control firms. We report these estimation results in Panel C of Table 5. The dummy variable POST is defined the same as in Panel C of Tables 3 and 4. The results show no difference between ANNMF observations and controls in the extent of real earnings management either before or after the event quarter. Taken together, these findings are inconsistent with practitioners assumption that longterm guidance mitigates managerial myopia by limiting real earnings management Do managers make more efficient investment decisions following long-term guidance issuance? Research design To investigate whether firms make more efficient investment decisions following the issuance of long-term guidance, we use the models developed in McNichols and Stubben (2008) to capture excess investment. We calculate excess investment ( XINVT ) for a seven-year period centered on the event year (Year 0), which is defined as the year when the firm stops giving quarterly but continues with annual guidance (ANNMF sample), or the year the firm issues 3~5 21

23 year ahead earnings guidance (LTMF sample). McNichols and Stubben (2008) propose two models, a short model and a long model, to derive expected investment, and excess investment is the residuals from these models. The McNichols and Stubben (2008) models of expected investment are as follows: Short Model: INVT it = a + β 1 Q it-1 + β 2 CF it-1 + e it, (3a) Long Model: INVT it = a + β 1 Q it-1 + β 2 Q_QRT2 it-1 + β 3 Q_QRT3 it-1 +β 4 Q_QRT4 it-1 +β 5 CF it-1 +β 6 GROWTH it-1 + β 7 INVT it-1 + e it, (3b) INVT is investment in capital expenditure taken from the cash flow statements. Detailed variable definitions are offered in the Appendix. We estimate the above two models cross-sectionally each year by industry, with at least 20 observations for each industry-year. We interpret the absolute values of the residuals as excess investment. We then compare the excess investment thus derived across both the event (ANNMF or LTMF) and the PSM control samples for the seven-year window. We also compare the signed values of XINT to gauge the extent of over- or under-investment. We focus our discussion of the results using the long model, and note that, with a few exceptions, the conclusions are largely the same when using the short model. In untabulated analysis we also compare the simple industry-adjusted means of XINVT for the event and control samples and we note that the inference remains the same. The focus of our attention is the years beginning with Year 0. For the LTMF sample year 0 is defined as the first year in the sampling period when the firm issues LTMF. For the ANNMF sample year 0 is defined as the year the firm stops issuing quarterly guidance. Recall we require the PSM control observations to come from the same industry and year in the matching process, thus all the control observations have a pseudo event year year 0 too. As reported in Table 6, we find limited evidence of differential subsequent excess investment between firms that issue long-term guidance and matched control firms. For the 22

24 LTMF sample comparison in Panel A, we only find a significant difference in Year 2 and a very marginal difference in year 0, when LTMF firms exhibit less excess investments than their PSM control firms. For the ANNMF sample comparison in Panel B, we only find a significant difference in Year 3, where ANNMF exhibit less excess investment than their PSM control sample. Table 7 tabulates the results based on signed values of XINT, thus we can interpret positive values as over investment and negative values as under investment. Using the long model, we find no difference in the extent of under- or over-investment between our two event samples and their respective controls in any of the 7 years presented. Collectively, while there is some evidence of lower excess investment for the LTMF firms in Panel A of Table 6, the findings are marginal. Thus, we conclude that our evidence does not support the view that long-term guidance firms generate less under or over- investment. 5. Conclusion Management guidance, in particular shorter-term earnings guidance, has come under considerable scrutiny from many investor and industry organizations in recent years (e.g., CFA Center for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics, 2006; The Aspen Institute, 2007; the Committee for Economic Development, 2007; and the Commission on the Regulation of U.S. Capital Markets in the 21 st Century 2007). The primary criticism of earnings guidance practice is that short-term guidance fosters managerial myopia and negatively impacts long-term value creation. These organizations frequently encourage managers to cease giving short-term guidance and to instead issue long-term earnings guidance. An 23

25 important untested belief of these advocacies is that long-term guidance can mitigate managerial myopia. Using a propensity score matched design, we test whether this underlying assumption holds by examining the impact of long-term guidance on 1) the extent of accruals earnings management and real earnings management, and on 2) the extent of excess investment. As there is no clear definition of what constitutes long-term guidance, we construct two samples that most closely approximate the concept of long-term guidance in practice: the first sample of firms, the LTMF sample, has issued guidance for earnings 3~5 years ahead. We hand collect this sample using key-word searchers over multiple databases over and identify 275 unique firms and 854 firm-year observations. The second sample of firms, the ANNMF sample, ceases giving quarterly guidance but continues to issue annual guidance. We obtain this sample using machine-readable data from CIG/IBES guidance databases and identify 370 firms with 609 firm-year observations from Note that despite repeated calls from practitioner groups and prominent academics for firms to replace short-term guidance with long-term guidance, the number of firms doing so over a 12-year period is small compared to the population of firms issuing guidance (3,279 unique firms). To investigate the impact of long-term guidance issuance on earnings management and investment decisions, we first estimate probit regressions to capture the determinants of longterm guidance by comparing 1) LTMF firms with CIG/IBES guidance firms that do not issue 3~5 year ahead earnings guidance, and 2) ANNMF firms with CIG/IBES guidance firms that continue to issue quarterly guidance. We find LTMF firms have better performance, lower uncertainty, more long-term analyst growth forecasts, and their institutional owners have longer investment horizons. These firms are 24