Do Companies Adjust Revenue in Response to Investor Behavior?

Research suggests a correlation between market sensitivity to financial results and reported revenue in the following quarter.
David McCannMay 17, 2017
Do Companies Adjust Revenue in Response to Investor Behavior?

A new study offers fresh evidence that companies may manipulate their financial results in response to investor behavior.

The American Accounting Association research, which studied 6,836 public companies over a period of more than 16 years, measured the market’s sensitivity to quarterly revenue and earnings results.

For each company in each quarter, the study calculated two metrics to reflect such sensitivity: revenue response coefficient (RRC) and earnings response coefficient (ERC). RRC represents the degree to which stocks rise and fall in response to the disparity between analysts’ revenue forecasts and actual performance, and ERC represents the same with regard to earnings.

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The study showed that in quarters immediately following those when RRC was above the median for all studied companies, 16% of firms reported revenue that barely met or slightly exceeded analysts’ forecasts. In contrast, only 9% of firms did the same following quarters of below-median RRC.

The pattern was strikingly reversed when it came to ERC. Following quarters of low ERC, 15% of the companies reported revenue that barely met or slightly exceeded analysts’ revenue forecasts. Only 11.5% did so following quarters of high ERC.

In other words, it appears that when investors react to revenue announcements, revenue in the following quarter is more likely to align with analysts’ revenue forecasts than is the case when investors react to earnings announcements.

“Clearly, corporate managers are attuned to what investors are looking for in their companies’ reports and to the weight investors assign to revenues as distinct from earnings,” says Rong Zhao, an assistant accounting professor at the University of Calgary, who performed the research. “And to a considerable degree, the revenues they report reflect this.”

She adds, “Given the fact that company financial results conform as conveniently as they do to what investors are looking for, one also has to wonder about the extent of accounting manipulation in bringing this about. … The unusually high frequency of small positive revenue surprises … suggests that firms attempt to cross the thresholds of revenue forecasted by analysts.”

The correlation was evident in all sectors studied: health care, technology, consumer, manufacturing, and a fifth category labeled as “miscellaneous other” sectors. But in the health care and technology sectors, the stock market’s sensitivity to reported revenues was almost double that of the other sectors.

Thus, notes Zhao, if a high-tech or drug company just meets or slightly beats analysts’ revenue benchmarks, there may be less to that achievement than meets the eye, as such companies have a heightened incentive to manage their accounting with precisely that goal in mind.

A similar motivation is also at work, the findings suggest, for companies at relatively early stages of development. Defining firms’ life cycles on the basis of three factors — dividend payout, sales growth, and age — Zhao found that the positive association with RRC and meeting revenue benchmarks is stronger for less-developed firms.

Commenting on the balance between earnings and revenue in terms of investor priority, she comments that “for what it’s worth, I think the general emphasis of the market now is back to growing revenue after several years of focusing on cost reduction during the financial crisis.”

The study, “Revenue Benchmark-Beating and the Sector-Level Investor Pricing of Revenue and Earnings,” is in the June issue of Accounting Horizons, published quarterly by the American Accounting Association.