Wealth Destruction Effects of Annual Management Forecasts

• In Event: Voluntary Disclosure - Determinants and Effects

Abstract

I find robust evidence that managers engage in myopic underinvestment to meet earnings targets set through annual guidance. For identification, I employ two-stage least squares (2SLS) approach that exploits the staggered state adoption of Inevitable Disclosure Doctrine (IDD), which makes it harder for key employees possessing trade secrets to switch to close rivals. In the first stage, I show that IDD leads to a significant increase in annual guidance issuance because it (i) improves earnings predictability as uncertainty about earnings process diminishes, and (ii) lowers proprietary cost of disclosure as employee rent extraction threat declines. In the second stage, I use IDD as an instrument for annual earnings guidance and find that an increase in annual guidance results in significant decreases in SGA expenses, R&D expenditures and capital expenditures. These adverse real effects lead to a gradual decline in firm growth and innovation as well as shareholder value loss. To sharpen causal inferences, I show that the cross-sectional variations in myopic underinvestment predictably follow the cross-sectional variations in annual guidance. More importantly, falsification analyses reveal that whereas IDD adversely affects investments when firms issue guidance, it encourages more investments––consistent with key employee retention and trade secret protection benefiting firms––when the guidance channel is shut down. Overall, my findings suggest that annual earnings guidance exacerbates managerial short-termism.

Author

• Mahfuz Chy, University of Toronto - Rotman School of Management