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Noting that the downward revisions of corporate profit estimates for the 1998-2000 period are among the largest such revisions in forty years, economists Charles P. Himmelberg, James M. Mahoney, April Bang, and Brian Chernoff conclude that the dominant cause was an unexpected surge in the exercise of stock options. Since conclusive data on these options became available only significantly after the fact, the initial profit estimates did not capture the full expense associated with the options. The authors also determine that firms’ inflated statements of profit, particularly in some industries, made a downward revision necessary, although this factor played a more limited role.
Examining data from the Bureau of Economic Analysis (BEA), the authors find that several different preliminary sources are used for first-round estimates before other, more comprehensive sources become available, leading to a series of revisions during the next two years. Thus, as of July 2002, the cumulative downward revisions for corporate profits of the years 1998, 1999, and 2000 totaled 11.0 percent, 9.3 percent, and 8.9 percent, respectively. The Fed economists note that initial overstatements of profits can potentially lead to the misallocation of capital because such information is used to shape fundamental business decisions about expenditures on fixed capital or research and development. This information also influences lenders’ decisions in the debt markets and investors’ decisions in the equity markets.
The exercise of stock options, which grew in popularity in the second half of the 1990s, is not reported by companies in their regular quarterly reports, but rather is reported by companies with a considerable lag, generally on an annual basis. Because of this lag, the BEA must first estimate the expense associated with stock option exercises and then revise the original estimate when the companies report the actual stock option exercise expense.
The authors conclude that reform efforts to increase timeliness and accuracy of information relevant to corporate profits should be useful to investors and business decision makers.
Charles P. Himmelberg and James M. Mahoney are senior economists, and April Bang and Brian Chernoff assistant economists, in the Capital Markets Function of the Research and Market Analysis Group of the Federal Reserve Bank of New York.