The real business effects of quarterly reporting

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1 The real business effects of quarterly reporting Benedikt Link* Oliver Vogler Jürgen Ernstberger Ruhr-University Bochum April Preliminary and incomplete version - * Corresponding author. Friedenheimer Str. 19, D München, Germany, Tel , benedikt.link@rub.de

2 The real business effects of quarterly reporting ABSTRACT: This study examines the real business effects of mandatory quarterly reporting. Specifically, we examine whether a higher mandated interim disclosure frequency has an effect on managers tendency to use real activities manipulation. We find that in years in which a firm just meets past years' earnings or the zero earnings benchmark (suspect years) mandatory quarterly reporters exhibit higher real activities manipulation compared to semiannual reporters. We also find significant cross-sectional differences of this effect depending on the industry and capital market characteristics in which the firm is operating. Institutional differences, however, only play a minor role in determining the size of the effect. We interpret these findings as evidence for managerial myopia as a result of increased pressure to meet or beat earnings benchmarks due to mandated interim disclosure. Our study contributes to the literature on the real effects of disclosure regulation. Keywords: Mandatory disclosure, interim reporting, quarterly reporting, real business effects, real activities manipulation, management myopia Data Availability: Data are available from public sources identified in the paper - 1 -

3 The real business effects of quarterly reporting I) INTRODUCTION This study investigates the real business effects of mandatory quarterly reporting. Specifically, we test whether interim reporting frequency influences management decisions by inducing myopic behavior. We argue that shorter reporting cycles lead managers to deviate from normal operational practices because in their attempt to meeting or beating earnings benchmarks they are tempted to use more earnings management and activities manipulation than they otherwise would. This argument is in line with empirical evidence from a recent survey among executives in the U.S., where 80% of CFOs admit they would decrease discretionary spending (e.g., R&D) given the pressure to meet quarterly earnings targets. Almost 40% would even provide incentives for customers to buy more products in the current period by, e.g., increasing discount levels (Graham et al., 2005). The authors argue that managers are willing to sacrifice long term value in order not to fail meeting short term expectations of analysts and investors. There is also ample anecdotal evidence, which suggests that managers, when required to issue quarterly financial reports, are forced to make short-sighted business decisions to meet earnings targets, often at the expense of long-term value. The most prominent example is probably German car manufacturer Porsche, who s CEO refused to issue quarterly reports in 2003, claiming that it triggers short-sighted management decisions. 1 As indicated by the evidence presented, we are particularly interested in the real effects of interim disclosure regulation. In order to test empirically whether reporting frequency leads to a deviation from normal operational practices, we need to compare quarterly reporters with companies that report semi-annually. The European Union (EU) constitutes a unique regulatory setup to test for these differences between reporting frequency regimes because quarterly reporting is mandatory only in 6 countries and 2 stock market segments 1 This resulted in a delisting of the company from the German stock market index for mid-caps (M-DAX). Other prominent examples of companies returning to semi-annual reporting include BAA (world's leading airport operator) and BHP Billiton (global leader in resource industry)

4 of the EU-15 countries. 2 Each member state and stock market operator in the EU can decide upon the required frequency of financial reporting individually. Hence, quarterly reporting is one of the few regulatory differences that remain, after the EU in general has harmonized accounting standards (IFRS), disclosure and enforcement regulations for publicly listed firms since This makes it easier to isolate the impact of disclosure frequency. Other settings, notably the U.S., do not offer such a variation in the frequency of reporting and/or have greater cross-country differences to control for. In order to measure real business effects we rely on the previously established measures for real activities manipulation (RAM) defined as deviations from normal operational practices for the purpose of avoiding earnings surprises and other adverse effects such as, e.g., loss in reputation. Prior research (Dechow et al., 1998; Roychowdhury, 2006) uses cash flow from operations (ACFO), abnormal production cost (APROD), and abnormal discretionary expenses (ADISC) as measures of RAM. We propose a new consolidated RAM measure, as previous studies have only partially consolidated these individual RAM measures. For our empirical study we hand-collected the regulatory requirements on interim disclosure in the EU-15 countries based on an extensive review of documents from the EU, national regulatory authorities, stock exchanges, and from interviews with financial analysts and stock market operators. Using a sample of 7,372 firm-year observations from EU-15 countries, we apply a propensity score based matching procedure to account for endogeneity and a potential lack of comparability between quarterly and semi-annual reporters. Moreover, we use the suspect year concept introduced in prior research to ensure that we primarily analyze years in which the probability of RAM is high. We also control for determinants of accounting earnings management (AEM) in our regressions to take into account the interaction between RAM and AEM. 2 EU-15 refers to the 15 countries that were part of the EU before its enlargement in We focus on these countries as these are mature economies that have integrated capital markets and harmonized disclosure regulation for several years already. The 12 new member states are mostly transitory economies and therefore less comparable

5 We find that mandatory quarterly reporters generally exhibit higher levels of RAM compared to semi-annual reporters, especially in suspect firm-years. We also document crosssectional differences depending on industry characteristics, such as short operating cycles and high competition, where the effect is most pronounced. While capital market characteristics are also important in determining the size of the effect, i.e., the effect is strongest when shareholders have a short investment horizon and the level of monitoring by analysts is low, institutional characteristics seem to play a minor role. Our findings suggest that mandated increased disclosure in form of interim reporting frequency is associated with indirect costs in terms of real activities manipulation. We conduct extensive additional analyses to test the robustness of our findings. In an additional analysis, we analyze the effect of the EU Transparency Directive (TD) introducing the requirement for semi-annual reporters to disclose additional quarterly financial information. Moreover, we rerun our main regressions using the individual RAM measures established by Roychowdhury (2006). Both tests corroborate our findings. Our study contributes to the literature in several ways. First, the findings contribute to the growing "real effects" literature by presenting evidence on real business implications of regulation. Roychowdhury (2006) shows that when companies are close to zero-earnings, they tend to deviate from normal operational practices by, e.g., price discounts and a reduction in discretionary expenses. Other studies have analyzed the real effects of accounting regulation recently in different contexts (e.g., Cohen et al., 2008; Gunny, 2010; Zang, 2010; Cohen and Zarowin, 2010). For example, Cohen et al. (2008) show that RAM has been used more extensively compared to accounting earnings management after the introduction of Sarbanes- Oxley. Cohen and Zarowin (2010) show that RAM is also used at the time of seasoned equity offerings. We contribute to this literature as the first study to present evidence on the "real" effects of interim reporting frequency. We also add to this literature by introducing a new aggregate RAM measure that consolidates all individual RAM measures and helps detecting RAM in general. Previous studies have only combined two of the three measures (e.g., Cohen - 4 -

6 and Zarowin, 2010). Second, we add to the literature by showing how these real effects depend on external characteristics, such as industry, capital market and institutional characteristics. We provide evidence of cross-sectional differences in the magnitude of disclosure frequency-induced real activities manipulation. Third, we add to the literature of mandatory reporting regulation by providing evidence on potential externalities of mandatory disclosure. The remainder of our paper is organized as follows. Section II discusses the related literature and states the hypotheses. Section III presents the methodology, sample and descriptive statistics. Section IV discusses the results of our empirical tests. Section V presents the results of additional and sensitivity analyses. Section 6 concludes. II) RELATED LITERATURE AND HYPOTHESIS DEVELOPMENT In 2003, the European Commission, the executive body of the European Union also in charge of proposing legislation changes to the European Parliament and the European Council, proposed to adopt a U.S.-like system of mandatory quarterly reporting for all listed companies in Europe in order to increase transparency towards investors and analysts. This triggered a discussion on the benefits and costs of increased disclosure frequency. Despite largely undisputed benefits of quarterly reporting (such as higher transparency and a reduction in asymmetric information), several countries (e.g., UK, Netherlands, Denmark and Austria) in Europe opposed the proposal. One of the main arguments was that mandated quarterly disclosure could induce myopic management behavior. The proposal was finally amended and today companies are not mandated to provide full quarterly reports by the EU. However, several national regulators and stock market operators do require quarterly financial reporting. This debate raises the question whether shorter reporting cycles influence real business decisions. We contribute to the discussion by investigating potential deviations from normal operational practices, i.e., a higher tendency towards real activities manipulation (RAM), as a reaction to an increase in mandatory reporting frequency

7 Economic effects of mandatory disclosure regulation The objective of disclosure regulation is to mitigate information asymmetries and the adverse selection problem between suppliers and users of capital and thus facilitate efficient capital allocation (e.g., Watts and Zimmerman, 1986). For instance, major benefits of disclosure include higher liquidity, lower cost of capital and higher firm valuation (e.g., Verrechia, 2001; Shleifer and Wolfenzon, 2002). Firm-specific costs include direct costs such as collecting, preparing and disseminating the respective reports as well as indirect costs such as the release of proprietary information to the market, which might benefit competitors (e.g., Butler et al., 2007). In the absence of disclosure regulation, firms voluntarily disclose information as long as the corresponding benefits exceed the costs. Besides these firmspecific costs, however, disclosure also has market-wide benefits and costs, which render a potential firm-specific disclosure equilibrium suboptimal. Previous literature finds that mandatory disclosure is particularly beneficial in the case of positive externalities, potential cost savings (e.g., through scale and standardization), stricter sanctions and sanction enforcement as well as costs from fraud and agency conflicts that could be mitigated by disclosure (Leuz and Wysocki, 2008) 3. However, mandatory disclosure can also have negative externalities such as unexpected interactions with other (disclosure) mechanisms or institutional features and it can ultimately also impact real decisions made, e.g., by managers (Beyer et al., 2010). While a variety of studies has investigated the firm-specific effects of voluntary disclosure (in particular the corresponding capital market effects), these studies cannot provide insights into the overall desirability, economic efficiency and potential negative externalities of regulating these disclosures (Leuz and Wysocki, 2008). Some studies have therefore compared voluntary and mandatory settings to test for potential differences caused by regulation. For instance, Butler et al. (2007) show that the timeliness of earnings in the 3 The authors provide an extensive review and framework of the existing literature on disclosure, its cost and benefits as well as corresponding economic consequences

8 U.S. only significantly increased for voluntary adopters of quarterly reporting and not for mandatory adopters. A large range of studies focuses on the firm-specific, capital market and economic effects of all kinds of disclosure regulation as well as changes to this regulation. 4 The recent literature on the effect of the Sarbanes-Oxeley Act or the mandatory IFRS introduction are only two examples (e.g., Zhang, 2007; Chhaochharia and Grinstein, 2007; Cohen at al., 2008; Daske et al., 2008). We contribute to this literature by providing further insights into potential externalities of one particular type of mandatory disclosure, i.e., mandatory quarterly reporting Management myopia and earnings benchmarks Economic theory suggests several reasons for a myopic behavior of managers, which cannot directly be explained by Jensen s (1986) agency-theoretic view of the firm. Stein (1988) proposes a managerial myopia theory, which predicts myopic management behavior by focusing on short-term actions to inflate earnings and to increase the stock price assuming the prevalence of market imperfections. 5 The empirical literature documents myopic behavior of managers, especially under certain conditions like pending stock issuances (Bhojraj and Libby, 2005), IPOs (Teoh et al., 1998), employment concerns (Fudenberg and Tirole, 1995) or compensation issues (Hall and Murphy, 2003), as well as in the presence of institutional investors (Bushee, 1998). Graham et al. (2005) document myopic behavior of managers to meet expectations of analysts and investors when disclosing financial reports. A significant part of previous literature has relied on the concept of meeting or beating earnings benchmarks to identify years in which myopic behavior is highly likely, so-called suspect years (e.g., Roychowdhury, 2006; Gunny, 2010; Zang, 2010). 4 Leuz and Wysocki (2008) provide a comprehensive review of the existing literature. 5 Further important research on the prevalence and conditions of management myopia includes, e.g., Laffont and Tirole, 1987; Stein, 1989; De Long et al., 1990; Sloan, 1996; Bar-Gill and Bebchuk, 2003; Ellis,

9 We contribute to this literature by testing if myopic behavior proxied by real activities manipulation to meet earnings benchmarks is more prevalent if reporting frequency is higher. Interim disclosure frequency, earnings management and real business effects Managerial myopia can lead to earnings management when managers use judgment and discretion in financial reporting to mislead stakeholders about the underlying economic performance (Healy and Whalen, 1999). Managers have at least two options to achieve this: They can either use accounting based earnings management by accruals manipulation and classification shifting or they can use "real" earnings management defined as adapting their operational practices to influence financial performance. On the one hand, a variety of studies have shown that managers influence financial reporting through accounting discretion (commonly known as "earnings management") and classification shifting (e.g., Jones, 1991; Dechow and Dichev, 2002; Kothari et al., 2005; McVay, 2006; Fan et al., 2010). Some of these studies focus on reporting frequency and quarterly reports. Degeorge et al. (1999) propose a quarterly earnings threshold hierarchy, i.e. managers seek to avoid quarterly losses or quarterly earnings decreases more than meeting or beating financial analysts quarterly earnings forecasts. Brown and Caylor (2005) examine and find temporal changes in this hierarchy. Since the mid-1990s firms appear to focus more on avoiding quarterly earnings surprises due to the increased importance of analysts forecasts. Das et al. (2009) document that patterns in quarterly earnings changes reflect accounting earnings management behavior. Companies that perform poorly in interim quarters try to increase earnings in the last quarter to reach earnings benchmarks and vice versa (earnings reversals). On the other hand, a growing stream of literature also investigates managers' willingness to depart from normal operational practices ostensibly to achieve certain reporting goals. These practices include, for example, price discounts to increase short term revenues, production increases to reduce average cost per unit, and the reduction of discretionary - 8 -

10 expenses to boost short term profit (Roychowdhury, 2006). Previous research on real activities manipulation (RAM) focuses on opportunistic R&D expenditure reduction to meet earnings forecasts or avoid share price dilution (e.g., Bens et al., 2002; Dechow and Sloan, 1991). Other findings include the acceleration of sales and the delay of R&D and other discretionary expenses (e.g., Healy and Wahlen, 1999; Fudenberg and Tirole, 1995; Dichev and Skinner, 2002). Roychowdhury (2006) finds evidence for abnormal levels of cash flow from operations, production cost and discretionary expenses triggered by managers trying to avoid reporting losses. Using similar measures, Cohen et al. (2008) find that in the post- Sabanes-Oxley period, many firms switched from accrual-based to real activities manipulation methods. This is consistent with the model of Ewert and Wagenhofer (2005) who suggest that tighter accounting standards might increase the expected total cost of earnings management due to a switch from accounting to more costly real activities manipulation. Our study focuses on real activities manipulation rather than accounting earnings management, since we investigate the real business effects of mandatory disclosure, particularly of higher reporting frequency. By doing so, we add to the existing literature on externalities of mandatory disclosure beyond capital market effects to provide evidence about real effects of disclosure regulation (Leuz and Wysocki, 2008). Reporting frequency-induced real business effects Large-scale empirical studies investigating the real effects of mandatory disclosure, specifically reporting frequency, are sparse. In an experimental study with experienced financial managers, Bhojraj and Libby (2005) investigate the investment preferences of managers and find that only if capital market pressure is high, an increase in reporting frequency results in myopic management behavior. In a survey study among executives in the U.S., Graham et al. (2005) find that given the pressure to meet quarterly earnings targets, 80% - 9 -

11 of the responding managers would decrease discretionary spending (e.g. R&D). Almost 40% would even provide incentives for customers to buy more products in the current quarter. Gigler et al. (2009) examine the impact of more frequent mandatory reporting in the presence of multiple market imperfections. They assume that managers cannot disclose credibly whether they are investing in short-term or long-term project. While the short-term project generates stochastically higher cash-flows in the early periods and lower cash-flows in the later periods, the long-term project overall has a higher net present value. In such a setting, more frequent financial reports lead to more efficient market prices (i.e., prices better reflect the firm's underlying cash flows), but also induces managers to engage in short-term projects which overall may not be socially desirable. They conclude that more frequent disclosure could be associated with a trade-off between higher price efficiency and lower economic efficiency, because the more frequent disclosure regimes can change the business activities they report about and thus can have strategic consequences. This evidence suggests that managerial myopia is a consequence of a higher disclosure frequency, in particular when capital market pressures are present. We contribute to the literature on the real effects of mandatory disclosure regulation in arguing that mandatory quarterly reporting leads managers to deviate from normal operation practices. In line with previous research, we measure real activities manipulation of managers in suspect years, i.e., when firms meet or beat earnings forecasts. We conjecture that a higher frequency of reporting is associated with higher RAM for several reasons: First, the main difference between semi-annual and quarterly reporting is the number of times a company releases full financial statements to the market. This increase in frequency leads to an increase in the number of potential earnings benchmarks that a company is expected to meet. 6 Following previous research (Roychowdhury, 2006; Gunny, 2010; Zang, 2010), managers use real activities manipulation to meet earnings benchmarks. Due to the 6 In line with Gunny (2010), we define earnings benchmarks as meeting or beating zero earnings as well as last period earnings. Quarterly reporters therefore have 8 (4x2) potential interim benchmarks and 2 yearly benchmarks, whereas semi-annual reporters only have 4 (2x2) interim benchmarks and 2 yearly benchmarks

12 increased number of earnings benchmarks, we expect firms to more heavily use RAM. Alternatively, one could also argue that since quarterly reporters only have to reach half of the semi-annual benchmark managers only have to use half of the level of RAM. However, RAM does not reverse automatically, at least not quickly, so the effect might be escalating the more often it is used in shorter successive time windows. For example, assume that a manager uses abnormal sales discounts in one period to meet a certain earnings benchmark. The market will probably adapt to the new price level quickly and it will be hard to restore the original price in the next period. In order to reach the target in the next period, the manager might have to reduce the price further or at least keep it at the lower level. The longer time horizon of semi-annual reporters should help in returning to normal operational practices and potentially also in restoring the price level in this example. 7 Second, a higher reporting frequency can create additional pressure due to more timely enforcement of contractual arrangements (e.g., performance-based compensation of managers, credit contracts). Penalties for missing performance targets or breaching debt covenants might therefore play an important role in triggering myopic decision making of managers of quarterly reporters. If we assume that performance is randomly distributed and missing a contractual arrangement only once will lead to sanction, then quarterly reporters incur a higher risk of missing at least one such benchmark because contracts are enforced four times instead of twice a year. This effect should be reinforced by the shorter time window to compensate for potential deline in performance during the period. Consequently, managers of quarterly reporters are likely to use disproportionally more RAM compared to semi-annual reporters. Third, quarterly reporters are supposedly subject to a higher level of capital market pressure because firms that report more frequently are potentially more attractive to investors 7 Another example of an escalating effect of RAM would be an increase in production with the intention to reduce average COGS: In the next period, one could either decrease production (which would be an economic reversal of RAM) at the cost of increasing average COGS. However, managers might be tempted/have to reduce the price of the units in stock to increase sales while keeping production constant which would further increase RAM

13 with shorter investment horizons due to the more timely information updates and the increased level of transparency associated with more frequent disclosure. If the group of short-term oriented shareholders is relatively large, investor myopia might induce myopic management behavior if management acts in the best interests of its average shareholders. 8 Taken together, these arguments suggest that a higher reporting frequency induces myopic management behavior. Following previous studies, we use RAM measures as proxies for testing the following hypothesis: H1: Mandatory quarterly reporting is associated with higher real activities manipulation (RAM) compared to semi-annual reporting. Cross-sectional differences of frequency-induced real activities manipulation Prior theoretical work (Stein, 1989; Bar-Gill and Bebchuk, 2003) suggests that the degree of myopic behavior will be influenced by the extent to which managers care about short-term price relative to long-term value. We identify several incentives and monitoring mechanisms arising from institutional differences, capital market differences and industry differences that can exacerbate or mitigate the impact of quarterly reporting on RAM. At the institutional level, we hypothesize that so-called insider economies (i.e., weaker securities regulation, weaker investor protection and lower securities regulation enforcement) exhibit a stronger effect than outsider economies due to an overall lower level of institutional quality resulting in higher RAM (Leuz, 2010). Similarly, we expect the effect to decrease in the level of overall regulatory enforcement (Kaufmann et al., 2010), because of the role of enforcement in monitoring the compliance of rules and in mitigating manipulations (Leuz et al., 2003). 8 The spiral of silence theory for financial markets proposed by Aspara et al. (2008) even predicts managerial myopia when the majority of financial analysts and (institutional) investors is not short-term oriented. The theory assumes that financial market participants could fear disadvantages from behaving according to a long-term orientation when they perceive short-term orientation as the dominant orientation and a larger proportion of market participants could shift to behave myopic. This effect is reinforced by a herding behavior, by short-term evaluations of investment managers and analysts and by potentially biased reports of the mass media. Quarterly reporting can act as a catalyst in this dynamic and self-reinforcing process, because it provokes mass media reports about short-term performance changes and a short-term evaluation of managerial performance by internal and external stakeholders. As a result short-term orientation could become the predominant orientation and could trigger managerial myopia even when the majority of financial market participants is not short-term oriented

14 Capital market differences might have an effect on the results. The shareholder horizon is likely to be a strong determinant of management decision horizon. A higher share of shortterm oriented investors correspondingly induces managers to behave myopically creating an additional incentive for higher RAM. In addition, the number of financial analysts following a firm should reduce the reporting frequency-induced RAM because of their external monitoring function (Yu, 2008). 9 Finally, on the industry level, we expect that shorter operating cycles lead to increased managerial myopia because of a smaller time window to compensate for a decline in performance and because investors of firms with short operating cycles generally tend to value short-term information more heavily (Zang, 2010). We also conjecture that reporting frequency-induced RAM increases in industry competition because firms have to use RAM more heavily due to higher peer pressure. We correspondingly predict: H2: Reporting frequency-induced RAM is higher in weak institutional environments, for firms with more short-term oriented investors and a lower number of analysts that monitor managers as well as in industries with shorter operating cylces and higher competition III) METHODOLOGY, DATA, AND DESCRIPTIVE STATISTICS Regulatory background We exploit the institutional setting of the European Union to test our hypotheses. Europe has a high level of harmonization with respect to financial disclosure and reporting regulation. 10 One of the few choices left to the individual member states is to whether or not the national regulators mandate quarterly financial reporting. In this setting, it is therefore 9 An alternative view would be that a higher number of analysts creates additional pressure on managers to meet targets. These competing hypotheses concerning the role of financial analysts is examined by Yu (2008). Following his results, we conjecture a monitoring function of analysts and predict that the number of analysts decreases the magnitude of reporting frequency-induced RAM. 10 All publicly-traded companies have to report according to IFRS. Capital markets are highly integrated and there is a common supervisory body next to the national regulators

15 easier to isolate the effect of different reporting frequency regimes than in comparable international studies. Table 1 gives an overview about the specific requirements in each EU-15 country, which we compiled from an extensive review of documents from the EU, national regulatory authorities, stock exchanges, and from interviews with financial analysts and stock market operators in the respective countries. In Finland, Greece, Italy, Portugal, and Spain, the regulatory authorities require listed firms to publish full quarterly financial reports. In Sweden, the stock market operator on both regulated stock markets requires full quarterly financial reports for all companies. In Austria and Germany, companies listed in specific stock market segments ("Prime Market" in Austria and "Prime Standard" in Germany) are also obliged to publish full quarterly reports. The remaining seven countries (Belgium, Denmark, France, Great Britain, Ireland, Luxembourg, The Netherlands) do not mandate full quarterly reports or quarterly earnings announcements. We classify companies into semi-annual reporters and quarterly reporters based on the corresponding Datastream item WC05200 ("earnings reporting frequency"). 11 [place Table 1 here] Measuring real business effects To test for real business effects of interim reporting frequency, we develop a consolidated real activities manipulation measure. We use the model from Dechow et al. (1998), further refined by Roychowdhury (2006) to calculate specific components of RAM, i.e., abnormal cash flow from operations (ACFO), abnormal production costs (APROD) and abnormal discretionary expenses (ADISC). We derive normal levels of the corresponding measures based on industry-year regression similar to Roychowdhury (2006). The corresponding residuals of these regressions represent the abnormal level of the measures. 11 We perform sensitivity checks on the validity of the Datastream item. Changing the definition of quarterly reporters to those companies for which quarterly net earnings are actually available in Datastream does not affect our results

16 The intuition behind real activities manipulation and its calculation has been well established in previous literature. We have compiled explanations and formulas for the generation of ACFO, APROD and ADISC in Appendix 1. A substantial amount of studies has validated, consolidated and refined the measures (e.g., Zang, 2010; Cohen et al., 2008; Gunny, 2010, Cohen and Zarowin, 2010). We establish a new consolidated RAM measure, because previous studies have only partially consolidated the individual RAM components. In order to derive our consolidated RAM measure (TOTALRAM), we rely on the previously identified RAM components, i.e., sales manipulation, overproduction and a reduction in discretionary expenses. TOTALRAM is defined as the sum of all individual RAM components: TOTALRAM = RAM ( Salesmanip) + APROD + ADISC (1) where all variables are defined in Appendix 2. While APROD and ADISC can be calculated directly and are not affected by other RAM activities, sales manipulation needs to be calculated via ACFO, which consolidates the effect of sales manipulation, overproduction and a reduction in discretionary expenses. In line with Roychowdhury (2006), ACFO is defined as follows: ACFO = RAM ( Salesmanip) + APROD ADISC where all variables are defined in Appendix 2. As established by Roychowdhury (2006), excessive discounts or more lenient credit terms and increases in COGS or inventory increase ACFO. As opposed to that, a reduction in discretionary expenses increases cash flows such that ACFO is biased downwards by ADISC. RAM(Salesmanip) can therefore be rewritten as follows: RAM ( Salesmanip) = ACFO APROD + ADISC (2) where all variables are defined in Appendix 2. In order to calculate TOTALRAM, we combine equation (1) and (2): TotalRAM = ACFO + 2*( ADISC) (3)

17 where all variables are defined in Appendix 2. While previous research has combined two of the three individual measures presented by Roychowdhury (2006),e.g., Cohen and Zarowin (2010), this is the first paper that consolidates all individual RAM activities into one measure. We use TOTALRAM throughout the paper for our main analyses. As additional sensitivity analysis, we also use the individual RAM measures to validate our results and determine the individual effect of each of the manipulation activities. We always calculate RAM on an annual level as it is commonly done in the literature. In addition, interim financial data other than sales and net income is not available on Datastream. We rely on the yearly RAM measure to identify differences between the two interim reporting frequency regimes. This should however not impede the robustness of our findings for two reasons: First, as opposed to accounting earnings management, there is no automatic reversal of RAM. For instance, a price discount that is granted in any given quarter is not necessarily off-set by a price increase in the following quarter.. We argue that once a manager has started to ride the tiger, it is comparatively hard to get back to normal operational practices, in particular if reporting cylces are short. Second, as is described below, by using suspect year definitions based on meeting or beating interim reporting targets, we are able to distinguish between interim and yearly RAM effects. Therefore, the effect should also be measurable on a yearly basis. Research design We perform extensive analyses to validate our findings. First, we use a propensity based score matching procedure to mitigate endogeneity concerns. Second, we employ the suspect year concept introduced in prior research to ensure that we primarily analyze years in which the probability of RAM is high. Third, we employ two fundamentally different regression analyses to reduce concerns on correlated omitted variable bias

18 Matching procedure As described above, our sample consists of both, countries that mandate quarterly reporting and countries that leave the choice of the interim reporting frequency to the individual companies. Quarterly reporters that voluntarily opt to do so by definition self-select into the group of quarterly reporters. These might be firms with a set of particular characteristics, which raises endogeneity concerns. We therefore exclude all voluntary quarterly reporters from the sample. However, even in mandatory reporting environments, there might be firms that would opt to report voluntarily anyways. Our study investigates the effects of mandatory quarterly reporting so if these companies had adopted the same reporting frequency without regulation, they are unaffected and including them in the sample might bias our results. We therefore intend to create a group of pure mandatory reporters, those that would presumably not report quarterly if they did not have to. We therefore use a probit model to determine the characteristics of the voluntary quarterly reporters to eliminate similar firms from our sample of mandatory reporters. We assume that firms with the following characteristics are more likely to adopt quarterly reporting voluntarily, which we estimated based on a probit model: Pr obit( voladopt) = α + α SIZE + α LEV + α DIV + α CLHELD + α FORSALES + α DELFORSALES + α OPCYC + α HERF + α INDSIZE + α TOPIND + α ANFOL + α INDEX α13lagroa + Fixedeffects + ε where all variables are defined in Appendix After plugging the characteristics of our mandatory firms into the probit model, we identify firm-years in the mandatory sample that have a hypothetical probability of voluntarily adopting quarterly reporting in excess of 50%. We exclude these from the sample. After this initial matching, our sample should consist of firms that report semi-annually and pure mandatory reporters, i.e., those that would (most probably) report semi-annually in a voluntary environment. One potential challenge of the setting we are using in the first set of analyses are structural differences in the characteristics of different companies across different countries

19 In order to account for this, we use a second propensity based score matching to ensure that industry and size of the firms is comparable. Based on this analysis, we further exclude firmyear observations that do not have a comparable counterpart in the other reporting frequency regime. To further address concerns about country differences, all of our regressions include country fixed effects as well as standard errors clustered by country (Christensen et al., 2010). Moreover, our measures are constructed such that industry and year fixed effects are also accounted for. Suspect years Previous research has extensively used the suspect year concept to identify years in which increased RAM is more likely than in others. This is important as it reduces potential measurement bias. While some studies investigate activities manipulation around seasoned equity offerings (e.g., Cohen and Zarowin, 2010), most studies have relied on years in which firms meet or beat earnings benchmarks (e.g., Roychowdhury, 2006; Zang, 2010; Gunny, 2010). We follow Gunny (2010) and define suspect years as firm-year observations that just meet of beat past years' earnings or the zero earnings benchmark. We define observations as suspect years if either of the two following conditions holds: Firm-years in which a company s net income before extraordinary items as percentage of lagged total assets is between 0 and 1% or firm-years in which delta net income as percentage of lagged total assets is between 0 and 1% as suspect years (SUSPECT_Y; Gunny, 2010). In the RAM literature, activities manipulation is usually calculated based on annual figures similar to suspect years. Given our research question, however, we are also interested in meeting or beating earnings benchmarks of interim reports. This gives us the opportunity to disentangle potential RAM drivers more appropriately than just comparing annual suspect years with annual RAM levels. Specifically, we are interested in firm-years where quarterly reporters and semi-annual reporters only meet or beat interim earnings benchmarks and

20 explicitly not the yearly benchmark. 12 We calculate quarterly and semi-annul earnings benchmarks by using only a forth and half of the above range, respectively. We therefore define two more types of suspect years: First, firm-years in which quarterly reporters meet or beat benchmarks in 2 successive quarters in the same half-year as well as semi-annual reporters meeting or beating the first or second half year target (SUSPECT_2Q, basic interim suspect year). This suspect year definition provides the basis for an important test: It allows us to compare quarterly reporters RAM level when they meet two successive quarterly benchmarks in the same half-year to semi-annual reporters meeting or beating one benchmark over the same period. Second, to make our analysis even more robust, we compare firm-years in which quarterly reporters meet or beat only one quarterly benchmark to semi-annual reporters that meet or beat one half-year benchmark (SUSPECT_1Q, strict interim suspect year). Both of the interim tests are particularly interesting because they allow us to compare quarterly and semi-annual reporters RAM activities directly: Finding that quarterly reporters exhibit higher RAM in SUSPECT_2Q or SUSPECT_1Q firm-years, would indicate that RAM for quarterly reporters is much higher for quarterly reporters even when comparable benchmarks (or even lower benchmarks for quarterly reporters in the case of SUSPECT_1Q) are met. All suspect year definitions are summarized in Appendix 1 and descriptive statistics are provided in Table 3. Regression setup In order to test our first hypothesis, we run extensive cross-sectional analyses to compare quarterly and semi-annual reporters RAM in different suspect years. We therefore run the following regression: Controls + Fixedeffects + TOTALRAM = α + α SUSPECTX + QR + QR * SUSPECTX + ε 0 1 where all variables are defined in Appendix 2. (4) 12 For instance, a firm can very well meet or beat several interim benchmarks, without meeting or beating the yearly benchmark and vice versa

21 We use a wide of control variables to account for potential differences in company characteristics. These include several measures of accounting earnings management, a potential substitute of RAM, which might bias our results if it is not controlled for (e.g., Zang, 2010; Gunny, 2010). As our main explanatory variable (QR) varies on country level, we use country fixed effects and standard errors clustered by country to account for country differences similar to Christensen et al. (2010). As TOTALRAM is measured by industryyear, fixed industry and year effects are also be accounted for. Despite including a variety of fixed effects, we cannot completely rule out potential correlated omitted variable bias. In section 5, we therefore make an additional test using a pre-treatment/post-treatment setup of a disclosure shock that primarily affected semi-annual reporters (the Transparency Directive) To validate our first hypothesis, we also combine the different suspect year definitions in one equation in order to separate the RAM effects of meeting or beating yearly and interim earnings benchmarks. We run the following regression: TOTALRAM = α + α SUSPECT _ Y + α SUSPECT _ XQ + α QR + α QR * SUSPECT _ Y + α QR * SUSPECT _ XQ Controls + Fixedeffects + ε 3 4 (5) where all variables are defined in Appendix 2 and SUSPECT_XQ represents both, SUSPECT_2Q as well as SUSPECT_1Q. If SUSPECT_2Q and SUSPECT_1Q are found to be significant next SUSPECT_Y in explaining TOTALRAM, this can be interpreted as additional evidence for the importance of interim earnings benchmarks in explaining overall RAM levels and thereby differences in RAM levels across different interim reporting frequency regimes. In order to test our second hypothesis, we examine whether in how our results depend on institutional, capital market and industry characteristics. This analysis is particularly important for at least two reasons. First, if the results differ in particular settings, this reduces concerns about omitted variables driving the results. Second, it is important to better understand the supporting factors and conditions of real effects of disclosure frequency,

22 e.g., to derive potential policy implications. We test hypothesis H2 using 6 different institutional, capital market and industry factors. Institutional factors include enforcement (low=1) as defined by Kaufmann (2010), general regulatory differences based on country clusters defined by Leuz (2010) 13. Capital market differences include shareholder horizon proxied by stock turnover (Polk and Sapienza, 2008; high=1) and abnormal number of analyst following (low=1) 14 Industry differences include operating cycle (short=1) and industry competition (high=1) measured using the Herfindahl index. Each of the cross-sectional variables is split into two groups depending on its position below or above the median. We use the following regression to test the hypothesis: TOTALRAM = α1 SUSPECT _ Y * QR * CROSS1 + α 2SUSPECT _ Y * QR * CROSS 0 + Controls + Fixedeffects + where all variables are defined in Appendix 2. ε (6) We compare QR in suspect years between the two groups. In addition to a large range of controls including several controls for the level of accounting earnings management, we include country fixed effects to again account for country differences within the two groups. Control variables We use a wide range of controls to mitigate omitted variable concerns and to account for other known RAM drivers. The controls can be classified broadly into four categories: Company characteristics, capital market effects, industry characteristics and the level of accounting earnings management. First, we include a range of company characteristics to further improve comparability, although the matching procedure as well as the elimination of cross-listed shares should already substantially reduce potential bias from structural differences between the companies. SIZE (natural logarithm of total assets) is included because bigger firms supposedly have 13 We split the 5 country clusters in table 4 (Leuz, 2010) into 2 groups, cluster ( outsider economies) as well as cluster ( insider economies ). No countries from cluster 5 are included in our sample. 14 Based on regressing of analyst following on size, book-to-market, market share and common shares outstanding by industry-year

23 more RAM, for instance because of their high visibility and the increased importance of meeting benchmarks. Firms with higher short term LEV (leverage, i.e., current liabilities divided by lagged total assets) are expected to have more RAM because meeting and beating earnings benchmarks is particularly important for these firms to get refinancing or not to breach debt covenants (Roychowdhury, 2006). For NI (net income divided by lagged total assets), we expect a negative effect because firms with higher net income are less likely to engage in RAM. CLHELD (closely held shares, i.e., shares held by shares held by officers, directors and their immediate families, shares held in trust, shares of the company held by any other corporation, shares held by pension/benefit plans and shares held by individuals who hold 5% or more of the outstanding shares) is included to account for differences in governance that might explain the level of RAM. We expect RAM to be negatively correlated to the amount of shares closely held. Second, capital market controls include SHARES (common shares outstanding) to account for the capital market orientation of firms. A greater number of shares can imply higher RAM as more activity is needed to achieve a given per share earnings target. Alternatively, it can discourage managers to use RAM because a given target is more difficult to reach. (Cohen and Zarowin, 2010). We also include ANFOL (natural logarithm of one plus analyst following) because financial analysts are amongst the most important recipients of interim and annual financial statements. Analysts can fill one of two roles: They can either have a monitoring function similar to effect of CLHELD, which reduces average RAM levels (Yu, 2008). Alternatively, they can exercise pressure on firms and thereby force managers to use more RAM. We follow Yu (2008) and expect the monitoring function to preponderate. Third, industry characteristics include MKTSHARE (market share which equals company sales divided by total industry sales) where firms with higher market share to have lower RAM because competition is lower so the pressure to meet or beat earnings benchmarks is lower. Zang (2010) argues that for firms with higher market share, RAM is comparatively less costly, so we are agnostic about the sign. In addition, we include an

24 indicator variable for LITIND (high litigation industries). The effect could be either positive or negative because firms could potentially be sued for missing earnings targets or for excessively using RAM, if detected. We also include OPCYC (a firms operating cycle measured as average receivables over the last two years divided by sales plus average inventory over the last two years to COGS; Biddle et al., 2009). We expect it to be negative because a longer operating cycle leaves more flexibility to use accounting earnings management due to smaller accrual accounts and a shorter period for accruals to reverse and therefore requires less RAM (Zang, 2010). Fourth, we account for a potential trade-off between accounting earnings management and RAM which is an important determinant of the RAM level (e.g., Ewert and Wagenfofer, 2005). Building upon previous research (Barton and Simko, 2002; Zang, 2010; Cohen and Zarowin, 2010), we include NOA (net operating assets, i.e., shareholders equity less cash and marketable securities plus total debt at the beginning of the year, divided by lagged total assets). This is a proxy of firm s balance sheet constraint to use accounting earnings management based upon its previous accounting choices. We expect a higher value of NOA to be positively correlated with RAM, as firms are willing to use more RAM if they are constrained in their opportunity to use accounting earnings management. We also include BIG4, i.e., an indicator variable that is one if the firm s auditor is a BIG4 auditor. (Zang, 2010; Cohen and Zarowin, 2010). We are agnostic about the sign because BIG4 can either force the company to reduce accounting earnings management and thereby have a positive effect on RAM. Alternatively, BIG4 could also have a negative effect on overall earnings management (accounting and RAM) due to higher level and quality of monitoring of earnings management activities. Sample selection We collect a sample of all shares covered by Datastream/Worldscope and I/B/E/S in EU-15 countries between January 2005 and December 2009, also including shares that were

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