CEOs tend to boost forecast for final year

Less regulatory scrutiny is motivation, UA study says

A recent University of Arkansas study suggests many chief executive officers paint a brighter picture of their company’s financial future in the year before they retire than the one they see in the rear-view mirror once they’ve left.

UA assistant accounting professor Cory Cassell and two former colleagues in the Sam M. Walton College of Business examined data on the careers of hundreds of CEOs and found the executives talked more about their company’s earnings in their final year at the corporate helm - and tended to be more optimistic - than in the years leading up to the year they retire.

“Basically what we’re showing is that incentives for CEOs change as they progress in their career and particularly change right at the end,” Cassell said. “Some of the mechanisms that are usually in place to kind of discipline them … go away.

“For retiring CEOs, they can issue a forecast about the next year’s earnings and they will have left office before the actual earnings are announced,” he said.

Their motive, the study suggests, is that there is less regulatory scrutiny around stock trades a chief exec makes post-departure. Cassell and his bunch recommended a longer requirement for post-retirement securities filings related to transactions.

“[They do it] to inflate stock prices during the year leading up to their retirement,” Cassell said. “Our work suggests that managers use opportunistic earnings forecasts to manipulate analysts’ and investors’ perceptions, presumably in an effort to maximize the value of their stock holdings as they approach retirement.”

It’s common sense, said Randy Koontz, first vice president of investments at Pinnacle Wealth Management of Raymond James & Associates Inc. in Rogers.

Today, management isn’t as forthcoming as it once was about giving forward guidance - information that a company provides as an indication or estimate of its future earnings. And the guidance it does provide is usually muted, Koontz said.

“They know they’re not going to have to deal with the more optimistic view they give,” he said of the CEOs. “If I’m a CEO and my optimistic views don’t pan out, then it’s going to be up to the one who follows me to deal with it.”

Brian Gilmartin, portfolio manager at Trinity Asset Management in Chicago, agrees.

“If I’m a CEO and I know that I’m going to be retiring in the next couple of years, sure, obviously I want the stock price to go up,” Gilmartin said.

Even so, such changes in behavior could easily be explained, Gilmartin said.

Cassell conducted the study with Shawn X. Huang and Juan Manuel Sanchez, who now teach at Arizona State University and Texas Tech University, respectively. Their research was published in the November issue of The Accounting Review, the journal of the American Accounting Association. They conducted their query with a team of graduate students over 2011-2012.

No full names of CEOs were in the study.

Some factors taken into consideration when crunching the data: the percentage of independent board members, whether the CEO retains a position on the board of directors after retirement, whether the incoming CEO is hired internally, and whether the retiring CEO’s retirement is announced early. Those aspects have a significant effect on some, but not all, of the forecast characteristics in the predicted direction, Cassell and his colleagues wrote in the study.

As managers get closer to retirement, their incentive structure typically changes, Cassell said. So can their behavior.

Outgoing leaders have less incentive to invest company dollars on research and development or capital expenditures because the payoff for those kinds of projects won’t be realized until farther into the future.

The study’s findings could be particularly helpful to governing boards and regulators, who wish to implement incentive mechanisms that mitigate such conflicts or potentially unethical behavior.

“With knowledge that this type of activity goes on, then they might do a more stringent job of monitoring the forecasts that go out when the CEO is close to retirement,” Cassell said.

The findings can also benefit market investors and analysts who rely on information from management earnings forecasts. The CEOs final-year forecasts can be misleading.

Cassell, along with Huang and Sanchez (both of whom taught at UA through completion of the study), examined CEO turnovers from 1997 to 2009 as documented by ExecuComp, a comprehensive database that tracks executive compensation in the S&P 1000 index of firms.

From that data, they pulled two sample groups for their study: a list of 272 CEO retirements that included quantitative forecast information to construct measures of forecast news and bias. Tests using forecast issuance and frequency were performed using a larger sample of CEO retirements, 862, because qualitative forecasts could be used in those tests, Cassell said.

Business, Pages 73 on 03/02/2014

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