Disclosure of internal control material weaknesses and optimism in analyst earnings forecasts

This paper investigates how analyst forecast optimism is associated with disclosures of internal control material weaknesses (ICMWs) and their remediation under Section 404 of the Sarbanes–Oxley Act (SOX). Drawing on agency theory, I hypothesize that analysts are likely to issue earnings forecasts that are more optimistic for firms with ICMW disclosures than for those without ICMW disclosures. Using a sample of 20,875 firm-year observations with 10-K (10-Q) reports from 2004 to 2018, I find a positive association between ICMW disclosures and analyst forecast optimism. This positive association is partially driven by investors’ inability to unravel analyst forecast bias and analysts’ intentions to curry favor with management for private information. In addition, analysts are found to issue less optimistic forecasts for firms with ICMW remediation disclosures compared with those without ICMW remediation disclosures. A series of propensity score matching and regression analyses are conducted to test the robustness of my inferences. Overall, the paper suggests that analysts have incentives to take the opportunity of firms disclosing ICMWs to bias their forecasts upward for self-interest. The findings have the potential to assist regulators in guiding analyst behavior and educating investors to unravel positive bias in analyst forecasts.     

The perceived credibility of forward-looking performance disclosures

We investigate the credibility of forward-looking performance disclosures (FLPDs) in the narrative sections of annual reports, as perceived by investors. Our proxy for these disclosures is an index of statements about future performance. We find that companies issue more FLPDs when raising debt or conveying bad news in the financial statements. In the presence of these managerial incentives, investor reliance on FLPDs increases with the quality of earnings reported in the audited financial statements. Our results suggest that firms derive a benefit in terms of higher credibility for their narrative disclosures from having a reputation for high quality earnings.     

Earnings Performance and Discretionary Disclosure

While the influence of earnings performance on disclosure is a fundamental issue in the disclosure literature, our understanding of this influence is limited. In this paper, I examine a comprehensive set of disclosures from a sample of firms experiencing an extended period of seasonally adjusted earnings increases. I study how these firms adjust disclosure in response to earnings increases, how disclosure changes as the period of strong earnings performance nears an end and how firms disclose during a subsequent period of earnings decline. I find an increase in disclosure during the period of increased earnings. This increase is pervasive across all types of disclosure and tends to be bundled with earnings announcements. The market responds positively to this disclosure. Firms continue to disclose at a high level as they approach earnings declines. However, they shift to disclosures that focus on the positive short-term results and do not discuss the impending decreases. While this behavior is systematic, the market does not appear to anticipate the subsequent earnings declines. Once the firms announce earnings declines, the magnitude of disclosure returns to the level provided prior to the increased earnings.     

Does the monitoring role of buyout houses improve discretionary accruals quality?

Using a sample of reverse leveraged buyout (‘reverse‐LBO’) firms, I find that discretionary accruals quality (AQ), the quality of accruals that are subject to management discretion, significantly improves from pre‐LBO to post‐reverse LBO. Moreover, buyout houses’ board seats and the length of firms’ stay‐in‐private periods are significant explanatory variables for the cross‐sectional variation in discretionary AQ for post‐reverse‐LBO firms. My findings suggest that the monitoring provided by private equity buyout houses improves discretionary AQ, consistent with the view of Jensen (1989a,b) that LBOs are a solution to inefficiencies that arise from agency problems.     

Does religiosity enhance the quality of management earnings forecasts?

This study investigates whether firms located in areas with higher levels of religiosity disclose higher-quality management earnings forecasts than do other firms. Using a US sample of 4,655 firm-year observations over the period 2001 to 2014, we find that firms headquartered in counties with higher proportions of religious adherents issue earnings forecasts that are less optimistically biased and that the effect of religiosity is concentrated in firms with weak monitoring mechanisms. We also find that religiosity mitigates pessimistic bias in management earnings forecasts, but only for those issued by firms operating in low litigation industries. This result suggests that when the litigation risk is high, both ethicality and risk aversion are at work and their competing effects likely offset each other. Additionally, we document that forecasts issued by firms in more religious areas trigger stronger stock price reactions than those issued by other firms and that the effect is limited to forecasts containing optimistic bias. Overall, our results show that religiosity enhances the quality of management earnings forecasts, but the effect varies based on different conditions.     

Earnings Management Around Share Repurchases: A Note

This work examines a subset of the important area of earnings management. Specifically, it seeks to identify the extent of earnings management preceding self-tender offers for a sample of U.S. firms. Pre-repurchase total accruals and discretionary current accruals were found to be somewhat lower for a sample of self-tendering firms compared to a sample of industry- and performance-matched control firms. Weak evidence of post-buyback accruals reversal is also presented. The evidence is weakly consistent with the notion that share repurchases are employed by managers to exploit shareholders through earnings management.     

Accounting flexibility and managers’ forecast behavior prior to seasoned equity offerings

This study examines the effect of accounting flexibility on managers’ forecasting behavior prior to seasoned equity offerings (SEOs). Although SEO firms have a strong incentive to convey optimistic information to boost the pre-SEO stock price, they also face enhanced litigation risk arising from SEO-related regulations. Thus, I hypothesize that managers will release positive news through their forecasts (relative to the prevailing analyst consensus) prior to an SEO only if they have the accounting flexibility to manage subsequent reported earnings to meet or exceed their forecasts. I find that managers with greater accounting flexibility are more likely to issue a forecast prior to the SEO and that their forecasts are more likely to convey positive news and are more specific. Furthermore, I find no effect of accounting flexibility for non-SEO control firms or for non-SEO periods. My results suggest that when managers experience a tension between the incentive for voluntary disclosure and high litigation risk, accounting flexibility is an important factor that determines their forecasting behavior.     

The Role of Supplementary Statements with Management Earnings Forecasts

We investigate managers' decisions to supplement their firms' management earnings forecasts. We classify these supplementary disclosures as qualitative “soft talk” disclosures or verifiable forward‐looking statements. We find that managers provide soft talk disclosures with similar frequency for good and bad news forecasts but are more likely to supplement good news forecasts with verifiable forward‐looking statements. We examine the market response to these forecasts and find that bad news earnings forecasts are always informative but that good news forecasts are informative only when supplemented by verifiable forward‐looking statements, supporting our argument that these statements bolster the credibility of good news forecasts.     

Corporate social responsibility and earnings quality: Evidence from China

We examine the association between corporate social responsibility (CSR) and earnings quality using CSR ranking data from Rankins (RKS) and four measures of earnings quality. Using a sample of 2580 Chinese listed firms for fiscal years 2009–2015, with 14,807 firm-year observations, we find that CSR firms and those with higher CSR ratings are less likely to engage in earnings management than non-CSR firms and those with lower CSR ratings, and their earnings are more persistent and more accurately predict future cash flows from operations. State ownership and marketization moderate the relationship between CSR disclosures and earnings quality.     

Is it Free Cash Flow, Tax Savings, or Neither?An Empirical Confirmation of Two Leading Going-private Explanations:The Case of ReLBOs

Firms which 'go private' via a leveraged buyout (LBO) retain the option to 'go public' again, a process known as a reverse LBO transaction. This paper examines the rarer phenomenon of reLBOs; that is, the practice of going private via leveraged buyout, reobtaining public status through a new initial public offering, and then going private a second time. Among the several alternative hypotheses explaining LBOs, we focus on two prominent ones – free cash flow and tax savings – to explain reLBOs. With a sample of 21 reLBO firms, we find no empirical support for the free cash flow hypothesis but detect a significant relationship between the decision to go private for the second time and the tax savings potential of the firm.     

Voluntary disclosure practices by foreign firms cross-listed in the United States

This is one of the first large-scale studies to examine the voluntary disclosure practices of foreign firms cross-listed in the United States. We proxy for voluntary disclosure using three attributes of firms’ management earnings guidance: (1) the likelihood of issuance; (2) the frequency of earnings guidance; and (3) a guidance quality measure. After first establishing that market participants view these firms’ disclosures as credible and economically important (i.e., the disclosures are negatively related to analyst forecast errors and the implied cost of equity capital), we compare cross-listed firms’ disclosure practices with comparable US firms and explore variations in disclosure practices among cross-listed firms. We find that cross-listed firms issue less frequent and lower quality management earnings guidance than comparable US firms. We further show that the gap between US and cross-listed firms widened after passage of Regulation FD, a regulation which induced greater public disclosure of firm-specific information. Focusing on the sample of cross-listing firms, we show that firms from common-law countries disclose more than firms from code-law countries. Finally, our results indicate that cross-listed firms that do not list on an organized US exchange provide more frequent and higher quality disclosure than those that do list on organized exchanges.     

Voluntary disclosure and the cost of equity capital: Evidence from management earnings forecasts

This paper examines the directional effects of management earnings forecasts on the cost of equity capital. We find that forecasters of bad news experience a significant increase in the cost of equity capital in the month after their disclosure. Conversely, the cost of equity capital for good news forecasters does not change significantly in the same period. We also indicate that the magnitude of changes in the cost of capital for good news forecasters is significantly lower than that for bad news forecasters and non-forecasters, which suggests that investors may view good news forecasts less credible. Finally, we show that the effect of the subsequent earnings announcement on the cost of equity capital is preempted by the management forecasts for bad news firms, and that the combined effects of the management earnings forecasts and the earnings announcement are not significant for both good news and bad news forecasters. Our paper contributes to the literature by adding evidence on directional effects of voluntary disclosures and on long-term economic consequences of management earnings forecasts.     

Efficiency Gains in Unsuccessful Management Buyouts

This article uses a sample of 120 unsuccessful management buyouts (MBOs) to test whether operational improvements following successful MBOs are a result of organizational changes or private information. The findings are consistent with the organizational changes hypothesis. Firms with an unsuccessful MBO had no increase in operating performance following the buyout attempt. In addition, the cumulative abnormal stock return from before the attempted buyout until two years after the attempt is insignificantly different from 0 percent. I also find that management turnover following an unsuccessful MBO is significantly higher than normal.     

Terrorism activities and long-term annual management forecasts

We study the effects of terrorist attacks on firms’ long-term annual management earnings forecasts bias. We find that the managers of firms located closer to the epicenters of attacks are more likely to issue optimistic long-term annual earnings forecasts relative to the managers of a control group of unaffected firms. The exposure effect is stronger for more severe terrorist events, and firms with more uncertain fundamentals and less geographic diversification. In addition, we document that managers’ forecast optimism intensifies for firms with stronger negative stock market reaction to the terrorist event, for CEOs with higher ability and for companies that are more likely to issue equity or engage in acquisitions following the terrorist event. Overall, our results are consistent with the idea that long-term annual earnings forecasts are used by managers to counterbalance the short-term pessimistic response to terrorist attacks.     

Why Do Managers Explain Their Earnings Forecasts?

Managers often explain their earnings forecasts by linking forecasted performance to their internal actions and the actions of parties external to the firm. These attributions potentially aid investors in the interpretation of management forecasts by confirming known relationships between attributions and profitability or by identifying additional causes that investors should consider when forecasting earnings. We investigate why managers choose to provide attributions with their forecasts and whether the attributions are related to security price reactions to management earnings forecasts. Using a sample of 951 management earnings forecasts issued from 1993 to 1996, we find that attributions are more likely for larger firms, less likely for firms in regulated industries, less likely for forecasts issued over longer horizons, more likely for bad news forecasts, and more likely for forecasts that are maximum type. Furthermore, attributions are associated with greater absolute price reactions to management forecasts, more negative price reactions to management forecasts (forecast news held constant), and a greater price reaction per dollar of unexpected earnings. Our findings hold after control for the aforementioned determinants of attributions and after control for other firm‐ and forecast‐specific variables that are often associated with security prices.     

Managing News Coverage around Initial Public Offerings

We examine opportunistic behavior of initial public offering (IPO) firms in Taiwan where they are required to disclose their own earnings forecasts and are unrestricted in releasing news around the offerings. We find that prior to the offerings, IPO firms tend to report higher earnings, disclose inflated earnings forecasts, and manage more good news. News management, however, emerges as the most predominant factor in aftermarket stock prices. In particular, IPO firms have a strong preference for releasing good news related to strategy/policy that may simply provide a vision of a firm's future. Furthermore, the news releases are often forward-looking when they are positive about the firms but tend to be realized when they are negative. IPO firms also tend to engage in more window dressing activities before a larger sale of IPO shares from existing shareholders or a larger decline in insiders' holdings. Our analysis shows that managerial optimism cannot fully account for their behavior .     

Detailed management earnings forecasts: do analysts listen?

We provide archival evidence on how a particular type of supplementary information affects the credibility of management earnings forecasts. Managers often provide detailed forecasts of specific income statement line items to shed light on how they plan to achieve their bottom-line earnings targets. We assess the effect of this forecast disaggregation on the credibility of management earnings forecasts. Based on a relatively large hand-collected sample of 900 management earnings forecasts, we find that disaggregation increases analysts’ sensitivity to the news in managers’ earnings guidance, suggesting that analysts find the guidance more credible. More importantly, we identify several factors that influence this relation. First, disaggregation plays a more important role when earnings are otherwise more difficult to forecast. Second, disaggregation is more important after Regulation Fair Disclosure prohibited selective disclosure, especially for firms that were more affected because they had previously provided more private guidance. Finally, in contrast to common assertions in the prior literature, we find that, in more recent years, disaggregation matters more for guidance that conveys bad news. Managers as well as researchers should be interested in evidence suggesting that financial analysts find disaggregation especially helpful in contexts where managers’ credibility is particularly important.     

Bringing the Future Forward: The Effect of Disclosure on the Returns-Earnings Relation

This paper studies how firm disclosure activity affects the relation between current annual stock returns, contemporaneous annual earnings and future earnings. Our results show that firms with relatively more informative disclosures "bring the future forward" so that current returns reflect more future earnings news. We also find that changes in disclosure activity are positively related to changes in the importance of future earnings news for current returns. These results suggest that a firm's disclosure activity reveals credible, relevant information not in current earnings, and that this information is incorporated into the current stock price.     

Processing Fluency and Investors’ Reactions to Disclosure Readability

The SEC's emphasis on the use of plain English is designed to make disclosures more readable and more informative. Using an experiment, I find that more readable disclosures lead to stronger reactions from small investors, so that changes in valuation judgments are more positive when news is good and more negative when news is bad. Drawing on research in psychology to explain this result, I predict and find that processing fluency from a more readable disclosure acts as a subconscious heuristic cue and increases investors’ beliefs that they can rely on the disclosure. Although I do not find that more readable disclosures directly increase perceptions of management credibility, I do find evidence of an indirect effect operating through feelings of processing fluency. In supplemental analyses, I find that investors who receive more readable disclosures revise their valuation judgments to be less extreme when they are explicitly made aware of the potential for variation in readability. I discuss potential explanations for these revised valuation judgments.     

Causal disclosures on earnings and earnings management in an IPO setting

We examine the association of earnings management and narrative impression management as reflected in properties of causal explanations of reported earnings in the prospectus of Chinese IPO firms. Anticipated earnings management concerns are argued to be a significant incentive for causal disclosures on earnings in order to rationalize and legitimize earnings outcomes. We find evidence of close alignment of a firm’s earnings management propensity and its use of tactical causal disclosures. Stronger earnings management is associated with more intense assertive causal disclosure. On the other hand, firms exhibiting stronger earnings management tend to avoid the use of explicit defensive causal disclosure tactics. These findings are consistent with the strong background expectations of managerial agency and control that pervade an IPO setting. Our evidence holds after controlling for endogeneity within the context of an opportunistic disclosure position.