Introduction:
Provide an overview of the article’s main purpose and main argument. Basically, in this section you respond to the following question,
What is the article’s background and purpose?
Summary paragraph:
Briefly reviews the article’s key points (summary). Basically, in this section you respond to the following question,
What is/are the main idea/s (objective, research method and findings) that the article is communicating?
Critical examination paragraphs:
Evaluate the articles strengths and weaknesses. Basically, in this section you will be responding to the following questions,
How convincing or persuasive is/are the research findings provided in the article?
Whether the research findings are supported through explication of evidence.
Avoid composing a critique that solely addresses the article’s strengths.
Conclusion:
Presents your conclusions on the article’s overall usefulness. You should address the extent to which the findings of the article help the academics including the management accounting students and practitioners to understand the applicability of the management accounting techniques and concepts presented in the article.
untitled JOURNAL OF MANAGEMENT ACCOUNTING RESEARCH American Accounting Association Vol. 31, No. 3 DOI: 10.2308/jmar-52371 Fall 2019 pp. 41–63 How the Interplay between Financial and Nonfinancial Measures Affects Management Forecasting Behavior Joseph F. Brazel North Carolina State University Bradley E. Lail Baylor University ABSTRACT: This study examines how the interplay between financial and nonfinancial measures (NFMs) affects management forecasting behavior. Building on the knowledge that NFMs are typically aligned with actual earnings and are likely incorporated into earnings forecasts, we investigate if the level of divergence between changes in NFMs and contemporaneous changes in earnings influences management forecasting behavior. We hand collect company-specific NFMs disclosed in 10-K filings and describe how a greater divergence between NFMs and earnings (i.e., NFM changes substantially outpacing earnings growth, or vice versa) is associated with greater uncertainty about the underlying business. As such, in more divergent settings, we observe that management is less likely to issue guidance. Consistent with our theory, for managers that do provide guidance in more divergent settings, management forecast errors increase. Last, we provide evidence that external stakeholders can use the level of divergence to predict future management forecasting behavior. JEL Classifications: G14; M40; M41. Data Availability: The data used in this study are publicly available from the sources indicated in the text. Keywords: earnings guidance; forecast errors; management forecasts; nonfinancial measures. I. INTRODUCTION T his study examines how the interplay between financial and nonfinancial measures (NFMs) affects management forecasting behavior. Consistent with Brazel, Jones, and Zimbelman (2009) and Dechow, Ge, Larson, and Sloan (2011), we use the term nonfinancial measures (NFMs) to represent quantitative, capacity/performance-related measures that are expected to have a positive contemporaneous relation with growth in revenues and/or earnings. Building on the knowledge that NFMs are typically aligned with actual earnings and likely incorporated into earnings forecasts (e.g., Baginski, Hassell, and Kimbrough 2004; Curtis, Lundholm, and McVay 2014), we investigate how changes in both NFMs and contemporaneous earnings affect management forecasting behavior. The level of divergence between changes in NFMs and changes in contemporaneous earnings represents incremental information about the firm’s investment choices/performance (e.g., increasing employee headcount, number of stores, facility size) that are not recognized in the firm’s earnings. As the level of divergence increases, NFM changes substantially outpace actual earnings changes (or vice versa), and management may need to provide additional clarity to investors to reduce external uncertainty. Alternatively, for managers internal to the company, divergence between NFMs and earnings could also lead to higher internal uncertainty about the underlying business and a reluctance to issue an earnings forecast. We therefore investigate if We thank Shane S. Dikolli (editor), two anonymous reviewers, Michael Crawley, Michelle Hanlon, Blake Hetrick, Kathleen Linn, Gregory Martin, Bill Mayew, Don Pagach, Wayne Thomas, Jim Wahlen, Beverly Walther, seminar participants at North Carolina State University and The University of Oklahoma, and participants at the 2013 AAA Annual Meeting for many valuable comments. We appreciate the research assistance of Madison Bell, Addison Collins, and Dylan Johnson. Editor’s note: Accepted by Shane S. Dikolli, under the Senior Editorship of Karen L. Sedatole. Submitted: March 2017 Accepted: January 2019 Published Online: January 2019 41 a greater divergence influences whether management chooses to provide earnings guidance. For managers that do choose to forecast under divergent conditions, we also determine whether forecast accuracy suffers. As such, the objective of this study is to empirically examine if the level of divergence between NFMs and earnings influences management forecasting behavior.1 Companies disclose quantitative NFMs related to performance or capacity (e.g., number of patents or customers) along with financial statements in 10-K filings (Brazel et al. 2009). NFMs reported in the Management Discussion and Analysis section of the 10-K should reveal information about the company’s strategy, its current and future performance, and its ability to meet future accounting outcomes such as analysts’ forecasts (SEC 1989). For example, retailers disclose the number of stores they operate, manufacturers discuss production capacity, and service providers offer the number of customers served. In instances where a clear link exists between NFMs and financial performance, managers and analysts may build revenue and earnings models using NFMs to develop both internal and external forecasts (Koller, Goedhart, and Wessels 2005; Curtis et al. 2014). A primary objective of financial accounting is to record, classify, and summarize economic events to provide financial information for decision making (Bell, Peecher, and Solomon 2005; FASB 2010, } OB2; Arens, Elder, and Beasley 2010). Companies disclose NFMs that reflect key aspects of company performance/capacity and measure economic activity (Francis, Schipper, and Vincent 2003; Schultz, Bierstaker, and O’Donnell 2010). Prior research suggests a relatively consistent (versus divergent) relation between investments and divestments in NFMs and contemporaneous earnings changes. For example, Brazel et al. (2009) observe that the average difference between changes in employees and changes in contemporaneous revenue is only 4 percent.2 When a company’s NFM changes substantially outpace its actual earnings changes (or vice versa), the company is exhibiting a more divergent relation. In these settings, the impact of NFM changes on earnings growth is less clear, and investor concerns about the validity of the financial results or the operational efficiency of the company could arise (Brazel et al. 2009). To reduce external uncertainty, managers could be incentivized to voluntarily release earnings forecasts during the course of the year to signal to investors how changes in the company’s NFMs will ultimately be reflected in earnings (Trueman 1986). Conversely, prior research suggests that management is accustomed to experiencing similar growth rates between NFMs and earnings (e.g., Brazel et al. 2009). Thus, in more divergent settings, management faces an atypical relation between NFMs and earnings and uncertainties may arise among managers about the underlying business. Heightened internal uncertainty could reduce the likelihood that management releases a forecast. We test these competing arguments by examining the relation between the level of NFM/earnings divergence and the likelihood that management issues an earnings forecast. Regardless of management’s incentives or abilities to compile information into a forecast, forecasts made under more uncertain conditions are likely to be less accurate (e.g., Dorantes, Li, Peters, and Richardson 2013). Thus, we investigate if management forecast errors are larger under more divergent conditions. To examine our hypotheses, we hand collect numerous company-specific, year-end NFM disclosures from 10-K filings across many industries. We then examine how the level of divergence between NFMs and contemporaneous earnings affects the forecasting behavior of managers. For our sample of firms, we measure the level of divergence with the variable DIFF, which is the difference between a company’s change in actual earnings and its median change in actual NFMs for the same year. We observe that as the absolute value of DIFF increases (i.e., less typical conditions where investment choices are not recognized in the firm’s earnings), managers are less likely to issue forecasts. As noted previously, divergence between NFMs and earnings is likely associated with uncertainty among management of the company. Consistent with this notion, when management provides earnings guidance under more divergent/uncertain conditions, we find that forecast errors increase. Prior studies examining inconsistencies between financial and nonfinancial measures have either examined small sample sizes due to the labor-intensive hand collection of NFMs (Brazel et al. 2009) or employed only one type of NFM (e.g., employee headcount; Dechow et al. [2011]). We contribute to the NFM literature by collecting numerous company-specific NFM disclosures across a variety of industries and develop a standardized measure of how a firm’s investment choices are and are not recognized in the firm’s earnings (i.e., how NFMs and earnings diverge). By doing so, we extend the NFM literature to the forecast setting by examining management forecasting behavior under divergent conditions. We demonstrate that managers are hesitant to issue guidance in the divergent setting, consistent with the notion that divergence between NFMs and earnings is indicative of uncertainty among company management about the underlying business. Despite the incentive for managers to issue a forecast in divergent settings to appease investor concerns, we observe that management uncertainty overwhelms this incentive. Also, our results for forecast accuracy show that those who use 1 We operationalize ‘‘management forecasting behavior’’ separately as the likelihood of management issuing a forecast and forecast error. 2 While Brazel et al. (2009) provide small-sample (n ¼ 50) evidence in support of the assumption that NFMs and earning changes are positively correlated (or aligned), we illustrate in Figure 1 that as the divergence between actual earnings changes and contemporaneous NFM changes increases, the number of companies exhibiting such a relation decreases. Further, Table 3 illustrates that the mean difference between changes in actual earnings and changes in NFMs (DIFF) for our sample is only –1.76 percent. Last, the first regression of Table 9 shows that actual changes in NFMs are positively associated with actual changes in reported earnings (%CHANGE_EPS). Thus, while we rely on the assumption that NFMs and actual earnings are typically aligned, we also provide empirical evidence in support of this notion. 42 Brazel and Lail Journal of Management Accounting Research Volume 31, Number 3, 2019 management forecasts should be cautious of forecasts issued under divergent conditions.3 Last, in additional analyses we determine that the level of NFM/earnings divergence can be used by stakeholders as an early indicator of whether management will issue forecasts in the next fiscal year and whether those forecasts will be accurate. The remainder of our paper is organized as follows: Section II discusses the related literature and develops hypotheses; we then describe our research method in Section III and the results of our empirical tests in Section IV; Section V concludes. II. MOTIVATION AND DEVELOPMENT OF HYPOTHESES NFM disclosures are gaining recognition for their importance to financial statement users and those that regulate financial reporting (Black, Christensen, Kiosse, and Steffen 2015). For example, popular press coverage of the IPO filing by Facebook was directed at both the company’s financial performance (e.g., sales growth) and its related NFMs (e.g., number of active users, employees, click-through rate) (e.g., Raice 2012). Recent articles concerning Google LLC and Netflix, Inc. discuss ‘‘revenue per click’’ and compare revenue and subscriber growth, respectively (Nikas 2017; Hufford 2017). While regulators and investors want to ensure that these NFMs directly relate to company performance, companies claim that knowledge of these NFMs is essential to understanding the business.4 Traditional NFMs such as the number of retail stores, production space, and employee headcount can be viewed as surrogate measures of economic activity (Brazel et al. 2009). Most studies examining the relation between NFMs and financial performance have demonstrated that NFMs are useful in predicting future (versus contemporaneous) financial performance. These studies have also typically examined only one industry or a specific type of NFM. For