Causes and Consequences of Disaggregating Earnings Guidance

Whether managers should provide earnings guidance, especially quarterly guidance, has been a hotly debated policy issue. Influential organizations have urged firms to stop providing earnings guidance to reduce earnings fixation and short‐termism in the capital markets. Little attention has been paid to an alternative proposal: instead of ceasing earnings guidance, companies could provide disaggregated earnings guidance. No archival evidence exists regarding the determinants of disaggregated earnings guidance and its effects on the firm and its information environment. We find that once managers provide guidance, the decision to disaggregate this guidance is primarily driven by demand‐and‐supply factors that exhibit little change from year to year rather than by strategic factors. We find more timely analyst forecast revisions (with no compromise of forecast accuracy), a greater magnitude of revisions, and a larger reduction in analyst disagreement for disaggregating firms than for non‐disaggregating firms. These findings suggest that disaggregation enriches a firm's information environment. We also find that disaggregation helps managers align analyst expectations with their own, but firms are punished by investors for providing multiple performance targets but missing them.     

Inside the “Black Box” of Sell‐Side Financial Analysts

Our objective is to penetrate the “black box” of sell‐side financial analysts by providing new insights into the inputs analysts use and the incentives they face. We survey 365 analysts and conduct 18 follow‐up interviews covering a wide range of topics, including the inputs to analysts’ earnings forecasts and stock recommendations, the value of their industry knowledge, the determinants of their compensation, the career benefits of Institutional Investor All‐Star status, and the factors they consider indicative of high‐quality earnings. One important finding is that private communication with management is a more useful input to analysts’ earnings forecasts and stock recommendations than their own primary research, recent earnings performance, and recent 10‐K and 10‐Q reports. Another notable finding is that issuing earnings forecasts and stock recommendations that are well below the consensus often leads to an increase in analysts’ credibility with their investing clients. We conduct cross‐sectional analyses that highlight the impact of analyst and brokerage characteristics on analysts’ inputs and incentives. Our findings are relevant to investors, managers, analysts, and academic researchers.     

A discussion of “Do managers use earnings guidance to influence street earnings exclusions?”

It is well known that both managers and analysts frequently define earnings by excluding various amounts from GAAP earnings. Christensen et al. (Rev Account Stud, 2011) make a prediction of causality whereby managers actively influence how analysts define earnings. They argue that the mechanism through which managers accomplish this is guidance of analysts’ earnings forecasts within a fiscal period. Using a large sample of firms actively followed by analysts, the authors examine whether the existence of earnings guidance is associated with higher levels of total exclusions in analysts’ definition of earnings. The study provides suggestive evidence that managers actively influence analysts’ definition of earnings that they forecast. However, the indirect nature of the research design calls for additional work to specifically link directed guidance of GAAP earnings exclusions to amounts actually excluded by analysts.     

Are more able managers good future tellers? Learning from Japan

Baik et al. (2011) find that high-ability managers in the U.S. are more likely to issue accurate management earnings forecasts. Focusing on Japan, where management earnings forecasts are effectively mandated, we extend the literature by exploring (1) whether the relationship between managerial ability and forecast accuracy is unique to the U.S. disclosure system, where management forecasts are voluntary, and (2) how high-ability managers increase their forecast accuracy. We find that managerial ability is negatively associated with forecast errors based on initial forecasts, suggesting that high-ability managers are more likely to issue accurate forecasts at the beginning of the fiscal year. We then show that high-ability managers are less likely to revise their initial earnings forecasts and less likely to use earnings management to improve the accuracy of their earnings forecasts. Our findings show that, while high-ability managers are more likely to issue accurate initial management forecasts, low-ability managers are more likely to revise their forecasts and conduct earnings management to reduce their forecast errors.     

The effect of Regulation FD on the properties of management earnings forecasts

We investigate Regulation FD’s (FD) effect on management earnings forecast properties. We posit FD’s prohibition on private manager-analyst communication reduces (increases) optimism (pessimism) in management earnings forecasts. Prior to FD, managers could avoid publicly retracting prior optimistic forecasts by privately communicating with analysts, who could lower investor expectations with a new analyst forecast. After FD, managers with optimistic forecasts must either publicly admit their optimism by issuing a new management forecast or they must negatively surprise investors at the earnings announcement. Further, FD forces managers to use public forecasts instead of private communications to establish beatable expectations. Our evidence suggests FD reduced optimism in management forecasts. This reduction in optimistic bias is not offset by an increase in pessimistic bias. Consistent with this, we further find post-FD improvements in forecast accuracy and informativeness. We find no such changes around several potentially confounding events or for foreign firms surrounding FD. Overall, our evidence suggests FD improved firms’ forecast properties (less bias, greater accuracy, and greater informativeness).     

Serial Correlation in Management Earnings Forecast Errors

We examine whether management earnings forecast errors exhibit serial correlation and how analysts understand the serial correlation property of management forecast errors (MFEs). MFEs should not exhibit serial correlation if managers efficiently process information in prior forecast errors and truthfully convey their earnings expectations through management forecasts. However, for long‐horizon management forecasts of annual earnings, we find significantly positive serial correlation in MFEs, and sample self‐selection does not seem to drive this phenomenon. Further analyses suggest that managers’ unintentional information processing bias contributes to this positive serial correlation. Analysts anticipate the intertemporal persistence of MFEs but underestimate the persistence level when reacting to management forecasts. Our findings have implications for market participants who rely on management forecasts to form earnings expectations, and also shed light on the efficiency of managerial decision making.     

Does the Precision of News Affect Market Underreaction? Evidence from Returns Following Two Classes of Profit Warnings

We evaluate whether the market reacts rationally to profit warnings by testing for subsequent abnormal returns. Warnings fall into two classes: those that include a new earnings forecast, and those that offer only the guidance that earnings will be below current expectations. We find significant negative abnormal returns in the first three months following both types of warning. There is also evidence that underreaction is more pronounced when the disclosure is less precise. Abnormal returns are significantly more negative following disclosures that offer only qualitative guidance than when a new earnings forecast is included.     

Analyst forecast,accounting conservatism and the related valuation implications

This study investigates whether financial analysts incorporate accounting conservatism into their earnings forecasts and whether it is more difficult for them to forecast earnings for less conservative firms, and then examines the impact of the findings on the return predictability of the value‐to‐price (V/P) ratio. After controlling for the other factors affecting forecast accuracy, such as earnings predictability and information uncertainty, I find that analysts incorporate accounting conservatism into their earnings forecasts and that forecasting earnings is more difficult for less conservative firms. Consequently, the return predictability of the V/P ratio is stronger for more conservative firms, and previously reported return predictability of the V/P ratio is an average across firms with differing levels of conservatism.     

The Effect of Issuing Biased Earnings Forecasts on Analysts' Access to Management and Survival

This study offers evidence on the earnings forecast bias analysts use to please firm management and the associated benefits they obtain from issuing such biased forecasts in the years prior to Regulation Fair Disclosure. Analysts who issue initial optimistic earnings forecasts followed by pessimistic earnings forecasts before the earnings announcement produce more accurate earnings forecasts and are less likely to be fired by their employers. The effect of such biased earnings forecasts on forecast accuracy and firing is stronger for analysts who follow firms with heavy insider selling and hard‐to‐predict earnings. The above results hold regardless of whether a brokerage firm has investment banking business or not. These results are consistent with the hypothesis that analysts use biased earnings forecasts to curry favor with firm management in order to obtain better access to management's private information.     

Earnings Management Constraints and Classification Shifting

Prior literature has investigated three forms of earnings management: real earnings management (REM), accruals earnings management (AEM) and classification shifting. Managers make trade‐off decisions among these methods based on the costs, constraints and timing of each strategy. This study investigates whether managers use classification shifting when their ability to use other forms of earnings management is constrained. We find that when REM is constrained by poor financial condition, high levels of institutional ownership and low industry market share, managers are more likely to use classification shifting. Further, we find that when AEM is constrained by low accounting system flexibility and the provision of a cash flow forecast, managers are more likely to use classification shifting. In addition, when we limit our sample to firms that are most likely to have manipulated earnings, we continue to find support for constraints of both REM and AEM leading to higher levels of classification shifting. We also find support for the hypothesis that the timing of each earnings management strategy influences managers’ trade‐off decision. Our results indicate that managers use classification shifting as substitute form of earnings management for both AEM and REM.     

Management Guidance Pre‐ and Post‐Restatement

We examine whether the quality of restating firms’ management guidance differs in periods before and after restatement announcements. While characteristics of restating firms and the consequences of restatement have been a central topic in accounting and auditing research, the quality of management guidance around restatements is less well understood. We consider two competing characterizations of the link between management forecast accuracy and bias and restatement (an event that tends to signal poor financial controls): “Forecast–Opportunism Explanation” and “Forecast–Ability Explanation”. Under the Forecast–Opportunism Explanation, pre‐restatement weaknesses in financial controls enable managers to manipulate earnings toward forecasts and to meet or exceed opportunistically biased forecasts, and the post‐restatement strengthening of financial controls constrains opportunistic behavior. Under the Forecast–Ability Explanation, pre‐restatement weaknesses in financial controls impede managers’ ability to issue accurate forecasts, and post‐restatement improvements remove impediments so that the accuracy of forecasts improves; forecast bias remains unaffected. Evidence indicates that before a restatement, restating firms’ forecasts are more accurate and relatively more downwardly biased than control firms’ forecasts. Post‐restatement, restating firms have less accurate and less downwardly biased management guidance. Our overall results are consistent with the Forecast–Opportunism Explanation.     

How Disaggregation Enhances the Credibility of Management Earnings Forecasts

An important problem facing managers is how to enhance the credibility, or believability, of their earnings forecasts. In this paper, we experimentally test whether a characteristic of a management earnings forecast—namely, whether it is disaggregated—can affect its credibility. We also test whether disaggregation moderates the relation between managerial incentives and forecast credibility. Disaggregated forecasts include an earnings forecast as well as forecasts of other key line items comprising that earnings forecast. Our results indicate that disaggregated forecasts are judged to be more credible than aggregated ones and that disaggregation works to counteract the effect of high incentives. We also develop and test an original model that explains how disaggregation positively impacts three factors that, in turn, influence forecast credibility: perceived precision of management's beliefs, perceived clarity of the forecast, and perceived financial reporting quality. We show that forecast disaggregation works to remedy incentive problems only via its effect on perceived financial reporting quality. Overall, our study adds to our understanding of how managers can credibly communicate their expectations about the future to market participants.     

The accuracy of earnings forecasts in IPO prospectuses on the Kuala Lumpur Stock Exchange

This paper examines the accuracy of earnings forecasts made by managers of Malaysian initial public offerings (IPOs) during the period 1984–1995. It is a mandatory requirement for Malaysian IPOs to furnish earnings forecasts together with the opinions thereon of the auditors and the lead underwriter in their prospectuses. Their accuracy is measured by forecast errors, absolute forecast errors, squared forecast errors and standardised forecast errors. The results suggest that, on average, managers under-forecast earnings by 33.37%. A comparison with the naive no change model in earnings suggests that 96 out of 122 companies outperform this model. A number of company specific characteristics (size, age, forecast interval, gearing, proportion of shares retained by owners, auditor reputation and industry) are tested. The results reveal that both the age and industry classification of the company are statistically significant, and that management earnings forecasts are particularly inaccurate where firms experience a decline in earnings. Key words: accuracy of prospectus earnings forecasts, initial public offerings, accounting in Malaysia.     

Flu Fallout: Information Production Constraints and Corporate Disclosure

Using influenza epidemic data, we examine how constraints on corporate information production affect disclosure policies. We find that firms in areas with higher flu activity are less likely to issue short-run earnings forecasts and more likely to issue long-run earnings forecasts. These results are more pronounced when the information production process is more complex, when managers face a greater reputational loss for issuing low-quality short-run forecasts, and when firms’ costs of switching the forecast horizon are lower. Further analysis implies that the effect of flu activity on these forecast issuance decisions is not driven by firm performance or information uncertainty. Our results suggest that managers do not simply avoid issuing forecasts in response to information production constraints. Instead, they shift the forecast horizon from short-run to long-run, appearing to balance the costs of issuing low-quality forecasts with those of not issuing forecasts at all.     

Investor sentiment and management earnings forecast bias

This study investigates whether investor sentiment is associated with behavioral bias in managers’ annual earnings forecasts that are generally issued early in the year when uncertainty is relatively high. I provide evidence that management earnings forecast optimism increases with investor sentiment. Furthermore, I find that managers’ annual earnings forecasts are more pessimistic during low‐sentiment periods than during normal‐sentiment periods. Since managers lack incentives to further deflate stock prices during a low‐sentiment period, this evidence indicates that sentiment‐related management earnings forecast bias is likely to be unintentional. In addition, I find that the relationship between management earnings forecast bias and investor sentiment is stronger for firms with higher uncertainty, consistent with investor sentiment having a greater influence on management earnings forecasts when uncertainty is higher.     

Macro information environment change and the quality of management earnings forecasts

The 1990s were characterized by substantial increases in the performance of and investor reliance on financial analysts. Because managers possess superior private information and issue forecasts to align investors’ expectations with their own, we predict that managers increased the quality of their earnings forecasts during the 1990s in order to keep pace with the improved forward-looking information provided by financial analysts, upon which investors increasingly relied. Using a sample of 2,437 management earnings forecasts, we document an increase in management earnings forecast precision, management earnings forecast accuracy, and managers’ tendency to explain earnings forecasts in 1993–1996 relative to 1983–1986. Given that these forecast characteristics are linked to greater informativeness and credibility, we also document that the information content of management earnings forecasts, as measured by the strength of share price responses to forecast news, increased in 1993–1996 relative to 1983–1986. As expected, the increased information content of management forecasts primarily occurred for firms covered by financial analysts.

An Examination of the Differential Impact of Regulation FD on Analysts' Forecast Accuracy

Regulation fair disclosure (FD) requires companies to publicly disseminate information, effectively preventing the selective pre‐earnings announcement guidance to analysts common in the past. We investigate the effects of Regulation FD's reducing information disparity across analysts on their forecast accuracy. Proxies for private information, including brokerage size and analyst company‐specific experience, lose their explanatory power for analysts' relative accuracy after Regulation FD. Analyst forecast accuracy declines overall, but analysts that are relatively less accurate (more accurate) before Regulation FD improve (deteriorate) after implementation. Our findings are consistent with selective guidance partially explaining variation in the forecasting accuracy of analysts before Regulation FD.     

The Effects of Guidance Frequency and Guidance Goal on Managerial Decisions

We conduct an experiment to examine the effects of guidance frequency (frequent vs. infrequent) and guidance goal (accuracy vs. meet/beat vs. truthful) on managers’ operating decisions. We find that frequent guiders sacrifice total earnings for quarterly earnings predictability irrespective of their guidance goals. Furthermore, when guidance is infrequent, guiders with accuracy goals opt for quarterly earnings predictability over total earnings more often than do guiders with either meet/beat goals or truthful goals. These findings have implications for regulators and investors in terms of the unintended consequences of requesting frequent earnings guidance. Further, while managers may perceive that accuracy goals can help their firms establish forecasting and reporting reputations, we show that accuracy goals may result in dysfunctional internal managerial decisions, particularly when guidance is issued infrequently.     

Analysts’ earnings forecasts: coexistence and dynamics of overconfidence and strategic incentives

This paper formulates a two-stage model to capture the decision process of financial analysts when issuing earnings forecasts. Our model extends the model of Chen and Jiang [(2005). Analysts’ weighting of private and public information. Review of Financial Studies, 19 (1), 319–355], by allowing for a distortion of forecasts independent of whether an analyst has private information. Using quarterly earnings forecasts, we provide empirical evidence on the coexistence of overconfidence and strategic incentives. Financial analysts overweight their private information and at the same time strategically inflate their forecast.     

Nonearnings Corporate Guidance

We examine nonearnings related disclosure and find that many firms voluntarily provided guidance on capital expenditure (CAPEX) and provided strategic plan disclosure (SPD) before recent proposals to increase nonearnings information disclosure. Furthermore, we find that firms with high long‐term institutional ownership tend to provide both earnings and CAPEX guidance; that turnaround firms tend to provide SPD in lieu of earnings guidance; and growth firms tend to provide earnings guidance without SPD. Our results suggest that unconstrained firms make optimal disclosure decisions and that corporate guidance behaviors might not have contributed to earnings fixation and myopia in capital markets.