Applied Finance and Accounting Vol. 1, No. 1, February 2015 ISSN 2374-2410 E-ISSN 2374-2429 Published by Redfame Publishing URL: http://afa.redfame.com 47 Firm Performance and Business Cycles: Implications for Managerial Accountability Fabio Yoshio Suguri Motoki 1 & Carlos Enrique Carrasco Gutierrez 2 1 Universidade Federal do Espirito Santo – UFES, Brazil. 2 Universidade Catolica de Brasilia – UCB, Brazil. Correspondence: Fabio Yoshio Suguri Motoki, Universidade Federal do Espirito Santo – UFES, Brazil. Received: December 10, 2014 Accepted: December 31, 2014 Available online: January 26, 2015 doi:10.11114/afa.v1i1.647 URL: http://dx.doi.org/10.11114/afa.v1i1.647 Abstract This study explores the relationship between firm performance and business cycles. These cycles are deviations from the trend of an economy-wide variable, in our case, GDP. Using a sample of Brazilian listed firms and accounting measures of performance, we find a generally positive contemporaneous relationship between the cycle and firm performance. Results also indicate that different industries show distinct relationships. This research presents a novel approach by linking firm performance from several industries to business cycles, indicating that managerial effort may be less determinant of firm performance than what is generally accepted. Our findings have potential implications for the design of more efficient compensation packages and to the study of managerial self-attributed performance. Keywords: firm performance, business cycles, accountability, compensation, self-attribution 1. Introduction This is an exploratory study on the relationship between firm performance and business cycles. Business cycles are also known as economic cycles: they are the deviations from the trend of an economy-wide variable, such as total output (GDP) (Kydland & Prescott, 1982; Long & Plosser, 1983). Although macroeconomic studies document a co-movement between business cycles variables (aggregate-level macroeconomic variables), little is known about firm performance during the ups and downs of the cycles. Understanding how firm performance is tied to the cycles has potential implications for the development of fair and efficient compensation packages for executives. Understanding this relationship is also relevant to sophisticated investors, who can discern more precisely how much of the performance is due to managers and how much is due to market conditions. Our sample comprises Brazilian firms that traded in São Paulo Stock Exchange (Bovespa) from 1995 to 2005, and we use ROA and ROE as measures of firm performance. Results indicate that, in general, firms’ performance and the business cycle exhibit a contemporaneous positive relation (procyclicality). There is also some persistence, with a positive relationship between firms’ performance and the lagged cycle. When we break down by industry, results vary. Management of companies & enterprises and Construction industries show no consistent relation. Retail trade, Utilities, and Manufacturing show strong procyclicality and some persistence. Information and Transportation & warehousing show some contemporaneous and lagged procyclicality, although generally marginal. There is also leading countercyclicality from Utilities, Manufacturing, Information, and Transportation & warehousing industries, indicating that when there is a future inversion of the cycle, their firms do not anticipate the turn. Our evidence corroborates the predictions of Long & Plosser (1983), that industries tend to move together in a procyclical pattern. However, our results are new in the sense that they do not measure aggregate activity levels, but firms’ performance. Results indicate that executives may just surf the wave during booms– and get overcompensated – but cannot do much during depressions – ending up undercompensated. A better understanding of the limits of managerial ability to influence outcomes may help designing compensation packages that better link pay to managerial effort. We have indication that firm performance and the macroeconomic environment are tightly linked, and that management effort may play a lesser role than what is currently believed. Boards and compensation committees should be aware of this in order to design fair and effective compensation packages. Furthermore, a more meaningful link between performance and compensation, e.g., controlling the measurement of performance for the macroeconomic environment, could help preventing executives’ engagement in earnings management.