Listen to the podcast:
In a tweet on Aug. 17, U.S. President Donald Trump announced that he has asked the Securities and Exchange Commission (SEC) to study whether it makes sense for publicly held companies to publish half-yearly earnings reports instead of the current quarterly mode. That switch would allow companies “greater flexibility” and would save money, he argued.
Trump later told reporters that PepsiCo CEO Indra Nooyi suggested the switch. Nooyi, who is set to leave PepsiCo in October, told Reuters that her comments were made in a broader context — reorienting U.S. companies to have a longer-term view of their businesses and “to explore the harmonization of the European system and the U.S. system of financial reporting.”
According to experts at Wharton and Georgetown University, switching to semi-annual reporting could have significant downsides, including a greater temptation for companies to cover up missteps and an increased potential for insider trading.
At the same time, it is not entirely clear if shareholders would be worse off with half-yearly performance reports from companies with mechanisms in place for disclosure of material and price-sensitive information when it occurs, they pointed out.
According to Donald Langevoort, a law professor at the Georgetown University, the potential problems arising from a switch to a half-yearly reporting mode outweigh the benefits. Advocates of the switch point to the savings for companies in accounting, legal and other costs, and the latitude to focus on longer-term growth rather than to be dictated to by quarterly earnings expectations, he noted. “Both of those [benefits] can be criticized, and certainly moving simply from reporting four times a year to twice probably isn’t going to solve the short term-long term problem,” he said.
David Zaring, Wharton professor of legal studies and business ethics, agreed with Langevoort, but said the SEC should seriously consider Trump’s proposal given the substantial push for a change in reporting frequency. It is not clear if investors would really be worse off if they got information on the performance of a company only twice a year, he argued.
Langevoort and Zaring discussed the issue on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)
According to Wharton accounting professor Daniel Taylor, cost savings and the ability to plan long-term are not sufficient justification for making the switch to half-yearly reporting. “What isn’t being taken into account is investors’ need for access to timely information,” he said.
“If you get regular information, then you might be more inclined to trust the company, which should lower the cost of capital.” –David Zaring
But the pressure to report earnings every quarter also prompts companies to constantly manage their numbers to meet Wall Street expectations, with a “net result of distorting financial performance negatively, much in the way teaching students solely to perform well on a standardized test distorts their learning,” argued Tensie Whelan, a professor at NYU’s Stern School of Business, in an opinion piece. Moreover, the focus on quarterly results has given rise to “unprecedented share buybacks, which artificially boost stock prices, non-strategic cost-cutting, less investment in longer-term basic and applied research (versus product development), as well as an unhealthy pressure on labor costs.”
Even with a switch to a half-yearly mode, companies would have to continue keeping investors in the loop on important events or other information that could move stock prices, Zaring pointed out. For example, companies would still need to file 8-K reports with the SEC that alert investors to any “market-moving information.” They would also be required to comply with Regulation FD (Fair Disclosure) requirements where they have to make publicly available any price-sensitive information they may have passed on to stock analysts or other entities.
Langevoort was not so convinced those regulatory filing requirements would bring sufficient protection for shareholders if companies switched to half-yearly reports. “The idea that you’ve slowed down the cycle and [are not demanding] formal disclosure so often means more and more secrets are going to be floating around the company for a longer period of time, and that’s going to be tempting a lot of insider trading activity there.”
When companies report earnings semi-annually, investors have to rely on alternative information sources, Taylor noted. He pointed to a January 2018 paper that studied the phenomenon. By relying on alternative information sources, investors “may be overreacting, rather than under-reacting, to alternative sources of earnings news,” wrote the paper’s authors, Indiana University accounting professor Salman Arif, who is also a visiting professor at Wharton, and Emmanuel de George, a London Business School accounting professor.
Taylor considered the sanctity of specific intervals for performance reports. “Why semi-annual? Why not annual or bi-annual?” he asked. “[Trump’s] ‘proposal’ does not espouse any form of tradeoff. If we are simply interested in saving companies money on preparation and filing costs, why require disclosure at all? Clearly there is a tradeoff; investors need to have sufficient information [so] that they feel comfortable investing.”
The possibility of semi-annual reports encouraging insider trading “is a huge risk,” Taylor said. “The CEO might want less frequent reporting, but the company is owned by shareholders. Quarterly reporting allows shareholders to better monitor the manager, and puts him/her at less of an information advantage.” He noted that academic research has consistently shown that “more transparent and timely information reduces the benefits of private information, and reduces insider trading, specifically.”
“Quarterly reporting isn’t just releasing earnings per share,” Langevoort noted. “It’s [about] providing updated warnings to investors about new risks that have come about. The ‘management discussion and analysis’ [section in earnings reports] warn people where past performance may not be indicative of what’s coming in the future. If we shut all that in the dark, we’re losing a lot. On top of that, certainly, inside information will become more valuable the less frequently it’s released.”
The Trust Factor
According to Zaring, quarterly reports help build investors’ trust in company managements to a degree that half-yearly reports may not. Quarterly reports give shareholders more information quickly, especially if the company changes its business strategy, introduces new products or hires new executives. “If you get regular information, then you might be more inclined to trust the company, which should lower the cost of capital.”
“I worry that in removing quarterly reporting, U.S. capital markets will lose their premier status throughout the world as being the most fair and transparent.” –Daniel Taylor
At the same time, other factors have also helped build investor trust in the U.S., Zaring noted. For instance, the U.S. has required quarterly reporting by companies since the 1930s, and “we have incredibly deep and very liquid capital markets,” he said. “[Quarterly reports] are sworn to be true and are looked at by lawyers and accountants. … [They give] you the transparency you want to take the step of entrusting your money to somebody else.”
Sometimes, companies might just decide to walk that extra mile to earn investor trust, irrespective of what regulators may want. The U.K. mandated quarterly reporting in 2007, but returned to the half-yearly format in 2014, and Europe followed suit. As it turned out, companies in the U.K. and Europe continued to put out quarterly reports, egged on by investors, analysts and portfolio managers, Langevoort said. However, it is not clear if U.S. companies would be similarly encouraged to continue with quarterly reports if they are no longer required to do so, said Zaring.
Zaring noted that while there have been calls to move from mandated disclosures to a system of voluntary reporting by companies, that may not be the best idea. Standardized reporting requirements by the SEC make investors more comfortable, he said.
Taylor noted that academic research has consistently shown that the U.S. capital markets are among “the most liquid and safest in the world,” and the requirement of quarterly reporting strengthens that position. “I worry that in removing quarterly reporting, U.S. capital markets will lose their premier status throughout the world as being the most fair and transparent.”
Academic research also shows that semi-annual reporting results in “greater information asymmetry,” said Taylor. “Investors have less information, and consequently are more hesitant to trade – reducing liquidity and opening the door for corporate malfeasance.”
The Case for Long-term Planning
The big argument corporate executives make in favor of half-yearly reporting is that it allows them the bandwidth they need to plan long term. They don’t want to be shackled by the pressure to demonstrate growth in each successive quarter, since many promising long-term projects inherently have ups and downs along the way.
Jamie Dimon, chairman and CEO of JPMorgan Chase, and Warren Buffett, billionaire investor and chairman of Berkshire Hathaway, have argued that while they do not advocate the removal of quarterly reporting, they do think that the practice of companies issuing quarterly earnings forecasts is bad for the economy. “In our experience, quarterly earnings guidance often leads to an unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability,” they wrote in a Wall Street Journal opinion piece in June.
Zaring said executives may also be worried about the legal liabilities they may expose themselves to as they sign off on performance reports each quarter. Firms also view the paperwork and compliance costs involved in earnings releases as an additional heavy burden, he noted.
Both Zaring and Langevoort didn’t see much merit in the argument that half-yearly reports allow for better long-term planning at companies. “If you still have to report how everything’s going in six months, I’m not sure that that’s going to let you plan for 10 years down the road,” Zaring said. Added Langevoort: “When you hear company executives talk about the long term, they’re talking about at least a three- to five-year time horizon. Three months versus six months is irrelevant to that question.”
Taylor dismissed the argument of long-term performance planning as “just cheap talk.” Here again, he noted, academic research has found that “companies are less forthcoming with short-term guidance when they are performing poorly, not because of some altruistic focus on the long term.”
Managers have ample opportunity to explain to shareholders that they might be sacrificing short-term performance for the sake of long-term success, Taylor pointed out. “The market rewards this behavior — it doesn’t punish it. Think of the early days of Facebook, Amazon and Tesla. Investors flocked to those companies even though, at the time, the short-term performance was abysmal. Investors realized the long-term potential of these companies and drove stock prices up, even though short-term performance was poor.”
“When you hear company executives talk about the long term, they’re talking about at least a three- to five-year time horizon. Three months versus six months is irrelevant to that question.” –Donald Langevoort
The Likely Road Ahead
It isn’t clear if the switch to a half-yearly reporting mode is high on the agenda of the Trump administration. “I suspect the President … decided to tweet without giving much exploration to the issue,” said Langevoort. At the very least, the SEC would study the possibility, he added. “President Trump was just channeling what a lot of people in both politics and the business community want to see happen,” he said. Zaring added that for some time now, “corporate executives have complained quite bitterly about quarterly reports.”
If the switch does become law and companies are freed from the quarterly requirement, it would certainly mean a “cultural change” for Wall Street analysts, investors and companies, said Zaring. Even the SEC might find itself with more resources and time to seriously pursue enforcement and monitoring, he added.
Without the pressure of quarterly reporting, more privately held businesses might also want to go public, said Zaring. He noted that SEC chairman Jay Clayton has said that he would like more companies to go public. “Maybe at the margin, some companies would be more likely to take on the burden of reporting if they knew it would only come around two times a year.”
Langevoort said Congress and the SEC have been considering a proposal for the last six to seven years to allow smaller or newer companies – “companies that are not the established Pepsis and Apples” – to take advantage of a slower reporting cycle. They could transition to the quarterly reporting format when they become bigger over time, he added.
How do investors feel about the proposed switch to half-yearly reports? “The average retail investor doesn’t care that much, whether it’s quarterly reporting, semi-annual or annual,” said Langevoort. “This is about how prices become and stay honest, and that’s the work of the big boys on Wall Street.” He noted that sophisticated investors carefully study the 10-Q (quarterly) and 10-K (annual) reports that companies put out. Also, savvy investors these days use algorithmic trading to instantaneously process earnings announcements into trade orders. “By the time information finds its way into the hands of those of us who go into the average category, prices have already adjusted to what’s been announced.”
The debate on quarterly reporting seems one-sided, with members of Congress and corporate CEOs complaining about it, Zaring said. Sophisticated investors like hedge funds and big money managers like Fidelity have thus far stayed on the sidelines, he pointed out. “I rarely see their sort of full-throated defenses of the quarterly reporting system.” He expected more of a public debate on the subject, especially over social media. “I am looking forward to lots of fun tweeting about it.”