Preparing for the Next Business Downturn: How Managers Can Hedge against the Risks of Future Recessions
Kane, Gregory D., Brown, Robert M., Killough, Larry N., Review of Business
The periodic occurrence of declining levels of business activity, popularly referred to as recessions, are a fact of life in free markets. In the United States, the National Bureau of Economic Research has identified eight recessions that have occurred since 1950. Others have identified repetitious recessionary events as far back as the eighteenth century. Recessions have likewise occurred over the centuries in other countries. In view, therefore, of overwhelming evidence that business recessions continually reoccur, a reasonable expectation is that corporations should remain continually prepared for them. Instead, however, as each new recession unfolds, news reports are replete with announcements of emergency actions initiated by finns to respond to the "surprising" new decline in business activity. Such actions can be costly and disruptive to shareholders, creditors, employees and the business community in general. Two questions are addressed in this paper. (1) Are the costs of reactive policies triggered by recessions avoidable? (2) If they are avoidable, can accountants provide information helpful in assessing a firm's exposure to future recession related risk?
New evidence suggests that the information content of accounting data varies with the occurrence of business recessions and expansions. For example, Lev found that the apparent information content of certain accounting based signals, developed from those that analysts might use, varies across different levels of business activity.(1) Johnson found that the reaction of stock prices to unexpected earnings announcements seems to vary across the business cycle.(2)
Kane found that accounting based predictive information about future stock returns varies across periods of recession and expansion.(3) In addition, Kane found that accounting data have substantively more information content during periods of declining business activity than during periods of expansionary activity. These above findings suggest that accountants may be able to provide added information that should be useful to managers faced with the problem of managing a business during recessionary cycles.
Business Costs of a Typical Recession
What are the nature of costs associated with business recessions? What triggers the occurrence of these costs, are they measurable, and can they be prevented? To help us answer these questions, consider briefly the events that transpired in the last business recession which the National Bureau of Economic Research has now designated as occurring from August, 1990 through March, 1991. During this decline, real gross domestic product fell at an annual rate of only 1.02%, suggesting that the recession was quite mild by modern day standards. Nevertheless, when the cyclical downturn first became apparent, many large public corporations, as evidenced by reports in the news media, were apparently caught completely by surprise. As news of declining economic conditions and falling asset prices became available (particularly real estate and unsecured debt) many firms implemented emergency strategies designed to restore profitability and cash flow. Some of these measures included: cutting or eliminating dividend payouts; quickly reducing labor by using early retirement offers and layoffs; closing less efficient plants; downsizing; and discontinuance or sale of nonstrategic businesses.
In our view, the psychological effect of these visible policies was predictable. Consumer confidence dipped to low levels, thereby aggravating already declining spending patterns, particularly for durable goods. This "avalanche" effect triggered further operating losses for many firms, particularly those with high levels of operating leverage, as the further contraction in sales volume caused unit costs to soar. Firms then responded by cutting prices further in an effort to maintain operating volume. This activity proved suboptimal and resulted in further deflated prices for commodity outputs. …