Fuqua Insights Podcast: Should the U.S. End Quarterly Earnings Reports?

Intro  00:03
Welcome to Duke Fuqua insights, a Podcast where we explore faculty research and the actionable takeaways for business leaders at every level.

Scott Dyreng  00:15
Today, we're diving into a developing situation. President Trump is calling for an end to quarterly earnings reports, a decades old requirement that has shaped how companies communicate with investors and how investors evaluate companies. If this change happens, what would it mean for investors, for corporate leaders and for the economy? I'm Scott dyering, Senior Associate Dean for innovation at Fuqua School of Business, and I'm joined by Professor Rahul Vasishta to help us make sense of this debate, his research looks directly at how changes in reporting rules affect how companies invest, grow and compete. It's my pleasure to welcome my friend and colleague, Rahul today. Rahul, thanks for joining us.

Rahul Vashishtha  00:54
Thank you for having me, Scott on this podcast.

Scott Dyreng  00:57
So Rahul, let's start with the basics. Why does reporting frequency matter so much? And for listeners who aren't familiar with the typical rhythms of finance, what's at stake in how often companies report?

Rahul Vashishtha  01:13
I think that's a great question to start this conversation with. So let's drive straight into the crux of the matter over here, I would start by saying that capital markets tend to function the best when investors have an understanding and have the ability to monitor that their money is being used properly or not okay. And it is really this understanding, if you think about it, allows investors to allocate their capital to the most productive use. So it is a very, very fundamental function we are talking about, and this function is primarily performed by this periodic reporting of accounting performance, and this is where this debate about quarterly reporting comes into play. So you can see it's performing a pretty vital function in capital markets, okay? But by that, we should not automatically conclude that more information is going to be better, okay? Or perhaps we should not automatically conclude that we should think about even higher frequencies of reporting, perhaps monthly or weekly on a daily basis. Okay, there's a very fundamental trade off here that we need to think about as these developments unfold. Okay, so the big problem here is that most consequential big decisions we make in the corporate world, right? So for example, think of a big acquisition a firm has made, or perhaps a big R and D investment a firm has made into a technology that will fundamentally change the way a product or service is delivered, or perhaps a capital expenditure you are making in in a different country altogether, let's say China, and it would take years to develop them to market. So you can see, for most consequential decisions, the value created by them is not going to be apparent over the next quarter or so. It might be years, perhaps. So what happens is, when you increase the reporting frequency, you're basically triggering a premature evaluation of decisions which are best considered over much longer horizon. Okay. So then the problem is this, when managers start believing they're actually evaluated based on their quarterly earnings performance, what they will do is they will give you their quarterly number. Okay? When they actually think their bonuses depend upon it, their jobs depend upon it, they'll become reluctant to make good, long term decisions, which can hurt their quarterly earnings before.

Scott Dyreng  03:21
So, so what you're really saying is, when managers focus on those quarterly reports, they become too focused on the short term. Or sometimes people call this their myopic or myopia. So tell us a little bit about what managerial myopia looks like in practice, and maybe you can weave that into some research that you've done that looks at shifts from annual reporting to semiannual reporting and then to quarterly reporting.

Rahul Vashishtha  03:51
Yeah, I'm happy to talk about that. So in practice, when you think about myopic behavior, I would say it can take two forms, the one that is particularly detrimental and more relevant to this debate is this reluctant to make long term investments? Okay, think about you. Start cutting down on your R and D, perhaps, and it could be crucial for a long term survival. That would be the most detrimental form in which myopia manifests. In other ways it manifests is through manipulation of earnings, earnings management apps. That's another way you might see it. Now, what I've done in one of my papers, which I would say is most relevant to this debate, is it's very interesting. If you go back in time, in US financial markets, firms were not always required to report on a quarterly basis. Initially, when SEC started the system, they required firms to report only on an annual basis. They changed it to biannual frequency in 1955 and then eventually required them to report on a quarterly basis since 1970 so what we did in this very interesting study I have with my co author, Mohan venkatachalaman Arthur Kraft, is we examine well what happens to the quality of man. Managerial long term decisions, okay around these changes in reporting frequency, and what we find is striking, okay? What we find is managers drop their long term investments as they are forced to report their performance at high frequencies.

Scott Dyreng  05:16
How can you distinguish, as a researcher, between whether or not a company is reducing its investments, which seems like reducing a good thing, so probably a bad outcome, versus maybe they were just cutting waste, like wasteful spending. How can you determine that?

Rahul Vashishtha  05:32
That's a great question to ask Scott, and this is the part where we had to spend a ton of effort in the paper to rule out that possible and very logical alternative interpretation. So I would say there are two findings in the paper which suggest to me that this is myopic cut in investments as opposed to cutting down on wasteful expenditures. Okay, so finally, number one, we find that these cuts in investments are also accompanied by decreases in productivity and deterioration in financial performance. So firms asset turnover goes down. Their return on asset goes down, their sales growth goes down, okay, if these firms were simply cutting down on wasteful investments, well, you would expect some improvement in financial performance. That's not what we see. We see exactly the opposite.

Scott Dyreng  06:19
You have this research that shows when reporting frequency increases managerial myopia causes them to make kind of worse decisions. It supporters of ending quarterly earnings would buy into that and say that it would reduce costs and free managers from short-term pressures. But the critics of ending quarterly earnings would say that this is going to mean less transparency for investors, and that seems like a very real trade off. So what's How do you see that trade off?

Rahul Vashishtha  06:55
Based on my own research and thinking about this topic for a while, for a while, here is where I am with respect to this trade off. Okay, I would say, based on my research in the paper that just described in a few other related papers, I feel pretty confident that if we were to move away from a quarterly reporting system, one thing that's gonna happen is the quality of your long term thinking and decision making is gonna Okay. I just feel very confident about that. But what we need to do is still think very hard about well, what are the potential downsides? And like you said, there are two. What are some possibilities? One is perhaps the liquidity of the stock market suffers. The other natural concern is it would be harder for investors to monitor managers on a timely basis, and your concerns is maybe they can get away with some poor choices during that time frame. Okay? Now that said, I also want to highlight that I'm yet to run into convincing academic evidence which supports the concerns, okay? And then when I combine this with some casual observations, so for example, when you move out of us, look at some other jurisdictions Europe, perhaps they have been on a biannual reporting frequency basis for a long time. And I don't think the world has ended over there firms to seem to be running fine without any apparent dysfunctional behavior, at the very least. The other example I can point out is the way private firms run. Okay, barely any information available, yet, research actually suggests the quality of investment decisions tends to be higher in private firms. So when I put it all together, I would say it's a worthy experiment, and they're likely to be positive effects.

Scott Dyreng  08:38
And in Europe, as you mentioned, the reporting frequency is less frequent. And yet, stock markets in Europe function and investors can still make decisions. So not only are the managers making investment decisions for their companies, but the market participants who want to invest in companies seem to have enough information to make those choices absolutely whether or not quarterly reporting changes, and we move something to like a semi annual reporting as opposed to quarterly reporting. Managing short term pressures for long term value creation is critical in any business. So what practical steps can leaders or investors take to encourage long term value creation.

Rahul Vashishtha  09:24
I do think there are some things within our control, and there is variation across firms in how effectively they do these things to contain myopic pressures. A few simple things comes to my mind. Number one in the list for me would be, I think there are great benefits to be had if you can cultivate a long term stock ownership base. It's easier said than done, but if you could do it, I can see two big advantages here. One is, you don't really have to worry about somebody selling the next quarter just before your performance went down a little. The other advantage that comes with that is it's your long. Term investors who would be willing to dedicate the time and resources that is necessary to truly understand your long term prospect. Okay, it's not a trivial thing to do. Not anybody can do it. It does require some investment, and I don't think as somebody who's going to hold the stock for one month is really going to do it. Okay, so that's number one in a focus on cultivating a long term stock ownership base. The second thing I really want to emphasize pertains to communications. I think it's important to emphasize, when talking to investors, your long term strategy, your long term performance, where do you see the firm going, in addition to your short term financial numbers? So sure talk about your earnings performance as well. But on top of them, give them good perspective into where do you think the firm is really going? Okay, if you can give them that understanding, even if your quarterly earnings are down, perhaps you're not going to suffer the consequence, and it should alleviate the myopic pressure. So communications super important. The third thing I would highlight is a judicious design of executive incentive. So okay, the idea is you should not have incentive plans that maximize your incentives to boost your short term valuation. That's asking for myopic behavior. So some thought on that dimension, I think can go a long way as well.

Scott Dyreng  11:12
Yeah, and I like what you're saying on this compensation dimension, and I do think it's probably worth pointing out that the thing we're talking about here relates to public reporting, and there's nothing that would prevent a company from using more frequent reporting internally for compensation purposes or other evaluation purposes, because the law pertains to their external reports, not necessarily to their internal reports.

Rahul Vashishtha  11:40
It's an important clarification to make Scott, I 100% agree.

Scott Dyreng  11:44
Well, Rahul, thank you so much for joining, and it's really fun to talk about your research which is so applicable in today's world.

Rahul Vashishtha 11:50
Okay, my pleasure, Scott, thank you for having me on this podcast.

Outro  11:59
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