When to show your hand: Competition and financial reporting

Accounting professionals face challenges when they decide how conservative to be in reporting a public company’s financial results. New research by Assistant Professor Shawn X. Huang shows that the degree of conservatism in these accounting decisions likely depends on the stiffness of competition in an industry and on a company’s position within its industry.

Imagine playing a high-stakes game of poker. At the table are your competitors, eager to see who holds good cards and who is ready to fold. You look at your hand and consider: Which cards do I play, and when?

If your stack of chips is much higher than anyone else’s, you might not care. But if your stack looks no bigger than the others’, and you want to stay in the game, then you’d better have a strategy.

Financial accounting might not have the drama of made-for-TV card tournaments, but accounting professionals can face similar challenges when they decide how conservative to be in reporting a public company’s financial results. New research by Assistant Professor Shawn X. Huang shows that the degree of conservatism in these accounting decisions likely depends on the stiffness of competition in an industry and on a company’s position within its industry.

The research, in essence, sheds light on when the various players in a game will show their financial cards.

Huang, assistant professor in the School of Accountancy at W. P. Carey School of Business, has researched the links between industry competition, companies’ positions in an industry, and public companies’ approach to reporting financial results.

Huang and co-authors Dan Dhaliwal of the University of Arizona and Inder Khurana, and Raynolde Pereira of the University of Missouri-Columbia examined an approach that accountants call “conditional conservatism.” Companies that use conditional conservatism choose to announce their losses, write-downs and other bad news quickly, but they prefer to act more slowly with good news — verifying a gain, for example, before announcing it. Using conditional conservatism can benefit a company’s position in the market, and Generally Accepted Accounting Principles provide companies with this bit of flexibility.

But what makes companies choose or reject conditional conservatism? Proponents of a “political costs” view think big industry leaders would want to err on the conservative side and report losses quickly, in hopes of avoiding deregulation or antitrust actions. Proponents of a “governance” view think managers of companies in highly competitive industries would not bother with reporting conservatively, focusing instead on improving efficiency and monitoring performance.

Where there’s competition, there’s strategy

Huang and his co-authors took a “strategic” view: That competition in an industry could be a significant factor in a company’s decision to report conservatively.

They reasoned that, like in the poker game, players’ strategies in relation to their competitors affect their decisions of what to reveal and when to reveal it. In the strategic view, a firm looks at its competitive position when choosing whether to go the conservative route. Quickly reporting losses, for example, could make potential entrants think an industry isn’t as lucrative as they’d hoped. Timely reporting of losses also could make existing rivals think the market for an industry’s products is weak, thus discouraging them from cranking up production.

“Sometimes there are potential competitors, so you are trying to … scare them so they won’t be able to enter the market,” Huang said. “Sometimes you want to give some bad news so that when your competitors see it, they’re afraid that ‘If I produce too many products, I will not be able to sell them.’ Once they reduce their production, you will be in a good position in the market.”

Previous researchers developed a model measuring companies’ use of conservatism in reporting their financial results. Another model measures the degree of competition in an industry. Huang and his fellow researchers put the two concepts together. They used one database of earnings reports from public companies covering 187 industry groups and the years 1975 to 2005, and to reflect competition among public and private companies, they used a second database including private companies. They excluded companies in the financial and utilities industries, which were regulated throughout the period.

Huang’s team then examined the various ways that conservatism in reporting and competition in an industry might interact.

Conservative approach, competition linked

They found that on average, firms reported losses more quickly than they reported gains. They also found that companies facing stiff competition, both from existing rivals and from potential entrants in their industry, were more likely to use conditional conservatism in their accounting than companies in industries with little competition. Adding to the evidence that competition and conservative reporting are linked, they found that smaller firms tended to be more conservative in their reporting than bigger firms.

The governance view, which assumes competition would reduce conservative reporting, didn’t hold up in the findings.

“We think the main reason is that when managers are making decisions, they always look at the competitors,” Huang said. “Managers probably say, for the gains, ‘I want to make sure it is very firm, and then I’ll release it to the market.’ For the losses, they say, ‘Let’s just disclose it, because that will be treated as bad signals to the competitors, so potential entrants don’t want to enter the market, and existing rivals will keep their production low.’’’

The researchers also wanted to look at whether industry leaders — those with greater market shares — were more or less likely to use conservatism. The research confirmed that leaders were less likely than followers to report results conservatively, indicating that leaders’ market positions are so strong that they don’t care much about how potential entrants or existing rivals will respond to their news. The political-costs view, which assumes leaders report conservatively to avoid legal actions, didn’t hold up in these findings.

Followers, though, were more likely than leaders to report conservatively. After all, they are the ones who face greater threats. They care about other players nipping at their heels, even as the big-dog leaders run comfortably ahead of the pack.

Which comes first?

There still remained the chicken-and-egg question: Does competition lead to conservatism, or does conservatism give rise to competition? To sort that out, the researchers looked for events that would spark competition. One set of events they found was deregulation of the airline, telecommunications and transportation industries in the 1970s and 1980s, and the second was variations in antitrust actions from 1964 to 2006. After deregulation and during periods of high antitrust case filings, they figured, competition in an industry would increase.

In the deregulation scenario, the researchers compared the three industries before and after deregulation, and they compared those industries to ones not subject to deregulation during that era. The team found that after competition increased, companies in the subject industries became more conservative in their accounting. Companies outside the deregulated industries, however, made no significant changes.

Because those findings were just for those three industries, the researchers looked at antitrust actions affecting a wide range of industries over time. They found that companies, especially the leaders in an industry, became more conservative during periods of more intense antitrust actions.

“When there are lots of antitrust cases and enforcement of regulations, firms in those industries should feel more pressure from the government,” Huang said, “so that will affect their decisions as well.”

Together, the researchers say, the deregulation and antitrust scenarios showed that as industries became more competitive, companies became more conservative in their financial reporting.

Huang notes that the research looked at earnings reports, which are historical. He suspects the strategic view would hold for other financial reports, though more research would be needed on whether competition leads companies to be conservative in their forward-looking reports, such as earnings forecasts.

The bottom line

Huang advises stakeholders analyzing financial reports to put them in the context of a company’s competitive position. Specifically:

• For managers and chief financial officers: Think strategically about your company and its position in its industry. Using conditional conservatism and recognizing losses more quickly than gains is provided for under GAAP. “You’re just using your flexibility to release the information which will benefit your own position in the market,” Huang said.
• For industry leaders and followers: Leaders probably don’t need to worry about the kind of information going to or coming from followers, because leaders already are in a good position in their industry. Followers, however, should be cautious when they see competitors reporting losses. “You never know if the information they gave is just for a strategic reason,” Huang said, “or if there is something really happening in the firm.”
• For investors: Know a company’s competitive position in its industry. If it is a follower and it releases bad news, consider that the news might not be as bad as it seems. Especially if the loss is small, the company might be disclosing a loss to scare its competitors.