Can XBRL Help Reduce Earnings Management and Stock Price Volatility?

Written by Bob Schneider     Posted on May 8, 2010

A few days ago, Jeff Henson of the XBRL USA blog published a highly useful post on the pluses and minuses of the data standard. Listing the disadvantages, he writes:

XBRL facilitates near real-time disclosure. The potential to quickly report information in automated ways is a double edged sword. On the one hand, near real-time disclosure improves transparency and sharing of information for a variety of beneficial purposes. On the other hand, near real-time disclosure may emphasize short-term results at the expense of long-term objectives. Some argue that financial information shared in a real-time way may cause undue volatility in stock prices and impulsive decisions by investors, suppliers, customers and business managers.

A few years ago, the audit chiefs of the big accounting firms published a paper that offered their vision of the future of financial reporting. In discussing a new paradigm of real-time reporting that includes nonfinancial indicators, they offer a different view than the one Jeff describes:

Finally, and perhaps counter-intuitively, more frequently reported information may reverse some or much of the “short-termism” about which corporate managers and others have long complained. Once investors have almost real-time access to financial and other information about companies, forecasting “quarterly” profit numbers will no longer be relevant, while forecasts of daily or weekly profits will be pointless. As a result, by having more frequent information, investors and their companies may begin looking over longer time horizons. The disclosure of more useful, non-financial forward-looking information should reinforce this outcome, along with continued compensation reforms by public companies themselves that reward long-term performance.

Note the “perhaps counter-intuitively” in the first sentence. American companies have long been accused of “short-termism,” which includes a focus on managing earnings to meet quarterly targets (and hence analyst expectations) at the expense of long-term goals and the overall good of the firm. If, as some have argued, reporting quarterly is an important reason for the “short-termism” of American managers compared with their counterparts in Europe (who still typically report semi-annually), won’t continuous reporting merely exacerbate this tendency?

It is conceivable that reporting a continuous stream of information will give some managers the perspective of day traders, and they will give all their energies to polishing whatever bit of data will next be made public.

But it seems much more likely that, as the audit chiefs imply, the sheer futility of this exercise will make managers unconcerned about individual data releases. Because investors are being constantly updated on company performance, quarterly reports won’t be the headline events they are today, and they will contain far fewer upside or downside surprises. Managing quarterly earnings will be not only less necessary but more difficult: reporting stellar net income will raise suspicion if you’ve been giving the market mediocre numbers on a host of indicators for the past twelve weeks.

This new world of financial reporting was envisioned in a CFO.com article Back to the Future: What the SEC should really do about earnings management that was published more than ten years ago, before the first international XBRL conference:

…There are those who say the only way to stop earnings management is to render the quarterly earnings release obsolete. In fact, these forward-thinking accounting experts argue that most current rules and reporting practices have outlived their usefulness, especially with the emergence of new knowledge-based industries. They contend that layering on new guidelines and new disclosures only further encumbers a system whose artificiality encourages earnings management… Instead, they envisage something completely different -- a real-time financial reporting system in which analysts and investors have continuous, networked access to a wealth of disaggregated corporate data.

What about the charge that continuous reporting will increase the volatility in stock prices, which occurs when new, relevant information is released to markets that surprises investors? Here’s what KPMG partner Bob Elliott said about volatility in the CFO.com article I cited earlier:

To the extent that you disclose more corporate information on a more-frequent basis, it seems to me that uninformed volatility would be reduced. You'd still have volatility when exogenous events occur that change the real value of the company, but you'd have less volatility from lack of information or misinformation in the marketplace.

It does seem possible to me that continuous reporting could increase intraday volatility slightly, as some trading becomes geared toward that particular day’s release. But as Mr. Elliott expresses, the substantial volatility often associated with quarterly reports would decline significantly. 

Quarterly reporting for US companies has been around for many decades, and it is part and parcel of the investing environment. But there is nothing sacrosanct about it, and if new technology makes better alternatives feasible, they should be adopted. That XBRL can be the facilitator for this new era of financial reporting should be counted among its advantages, not one of its minuses.