The effect of management earnings forecast characteristics on cost of equity capital

This study uses a framework presented in Hirst, Koonce, and Venkataraman (2008) to assess how differences in management earnings forecast characteristics influence a firm's cost of equity capital. I find that less specific forecasts, pessimistic forecasts, and forecasts that predict a loss for the period are associated with higher cost of equity capital levels and more timely forecasts and forecasts with more information content are associated with lower cost of equity capital levels. Analysis interacting control variables and forecast antecedents with forecast characteristics indicates that the effects forecast characteristics have on cost of equity capital are either enhanced or moderated depending on firm beta, firm size, firm book-to-market ratios, analyst following, prior forecast bias, and earnings quality. The results highlight the importance of interacting key variables when interpreting the market effect of management earnings forecasts.     

The effects of analyst forecasts and earnings trends on perceptions of management forecast credibility

We examine whether analyst forecasts influence investors’ perceptions of the credibility of a good news management earnings forecast. We hypothesize that the effect of analyst forecasts will depend on whether the analyst forecast confirms management’s forecast and the extent to which management’s forecast is consistent with the prior earnings trend. Findings indicate that the positive effect of a confirming analyst forecast is greater when the management forecast is trend inconsistent than when it is trend consistent. The negative effect of a disconfirming analyst forecast does not differ based on management forecast trend consistency.     

Audit committee characteristics and financial statement comparability

Financial statement comparability enables weighing the similarities and differences in financial performance between firms. Prior studies mainly focus on the role of accounting standards in the production of comparability, but the role of economic agents has been largely overlooked. We find that a firm's audit committee size and financial expertise affect its financial statement comparability. Financial information tends to be more comparable among industry peers when audit committees are larger and more members have financial and accounting expertise. The effect of audit committee expertise on comparability is stronger for firms with less independent and smaller boards, for firms with non-Big 4 auditors and for firms with CEOs serving as the chairperson of the boards.     

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.     

Structuring financial statement analysis projects to enhance critical thinking skills development

This paper documents a method of structuring financial statement analysis projects to enhance the development of students’ critical thinking skills. The project is structured in a cooperative learning framework in which a student accesses financial statement information from the World Wide Web, performs a financial statement analysis, and then engages in an exercise with other students who have analyzed firms in the same industry. Both the individual and team phases of the project offer opportunities for students to develop several important critical thinking skills.     

Audit committee financial expertise and properties of analyst earnings forecasts

An important role of financial accounting information is to aid financial statement users in forming expectations about the firm's future earnings. Prior research finds that accounting financial expertise of the audit committee is associated with higher financial reporting quality. We extend this literature by examining the association between audit committee financial expertise and analysts' ability to anticipate future earnings. We find a significant association between accounting financial expertise on the audit committee and analyst earnings forecasts that are more accurate and less dispersed. In contrast, we do not find a significant association between non-accounting financial expertise (i.e., supervisory expertise) and forecast accuracy or forecast dispersion. These findings contribute to our understanding of the benefits of accounting expertise in audit committees by demonstrating an association between accounting financial expertise and improvements in analyst earnings forecasts.     

CEO's financial experience and earnings management

We study whether Chinese CEOs with financial experience engage in more earnings management or less earnings management than those without such experience. In doing so, we distinguish between accrual-based earnings management and real earnings management. Overall, we find that CEOs with financial experience tend to do less real earnings management, while we find no evidence that they do either more or less accrual-based earnings management. Our findings tend to confirm that CEOs with financial experience provide more precise earnings information and higher quality financial statements.     

Gender diversity and financial statement fraud

This study investigates the role of gender diversity in fraud commission and detection with a view to identifying whether companies with more female corporate leaders are less likely to be involved in financial statement fraud. Using a bivariate probit model, the role of female corporate leaders in financial statement fraud commission and detection is examined for Chinese listed companies from 2007 to 2018. The representation of female corporate leaders increases the likelihood of fraud detection, thus reducing firms’ propensity to engage in fraud. The finding confirms that women are risk averse and more committed to ethical practices than men in corporate leadership positions. Moreover, this impact of gender diversity is contingent upon the nature of ultimate controllers of listed companies: more female representation in top leadership roles can mitigate fraud commission or detect fraud effectively in non-state-owned enterprises, but not in state-owned enterprises. In addition, the recent anti-corruption campaign initiated by Chinese President Jinping Xi is a powerful form of public governance. Female corporate leaders play a more positive role in mitigating fraud commission and detecting fraud commission in the post-campaign period than in the pre-campaign period.     

Research on the use of financial statement information for forecasting profitability

Research on the use of financial statement information for forecasting profitability has two objectives: (i) to generate improved forecasts of profitability and accurate estimates of firm value; and (ii) to identify market inefficiencies with respect to financial statement information. For these areas of research, this article describes the evolution, provides examples and shares implications of the research. It also discusses opportunities for future research. The article highlights that financial statement analysis research has slowly evolved and has received limited attention from academics. The article argues that there are vast opportunities for impactful research on fundamental analysis and market inefficiencies.     

Management earnings forecasts and bank loan contracting

We find that firms tend to issue management earnings forecasts and convey good news before bank loan initiation. Issuing firms enjoy more favorable contracting terms and attract more lenders. Management forecasts issuance within a nine‐month period prior to the loan activating quarter can lower the subsequent loan spread by 14.06 basis points. Moreover, firms with larger management forecast errors are charged harsher contracting terms and attract fewer lenders. Our study suggests that firms strategically issue management earnings forecasts before entering into debt contracts and lenders incorporate the information contained in management earnings forecasts into bank loan contracting.     

Economic policy uncertainty and financial statement comparability

We examine the implications of economic policy uncertainty (EPU) for financial statement comparability. We posit that the increased difficulty of estimating future cash flows and the increased opportunity for earnings management with increased EPU reduce the quality of earnings and its comparability. Consistent with this reasoning, we find a negative relation between earnings comparability and lagged EPU. Further, the association between EPU and comparability is more negative for firms that have poorer accruals quality and higher earnings volatility. We do not find that accounting policy choice is systematically related to the association between EPU and comparability. These results suggest that cross-sectional differences in accounting estimates rather than accounting policies influence the relation between EPU and comparability.     

Transitory earnings components and the two faces of non‐generally accepted accounting principles earnings

Non‐generally accepted accounting principles (non‐GAAP) earnings reporting has been linked with both informative and strategic incentives. We seek to disentangle these conflicting effects by examining the association between non‐GAAP earnings disclosure and transitory items in GAAP earnings, conditional on managers' reporting incentives. We report evidence of a statistically and economically significant asymmetric relation between disclosure propensity and transitory items in GAAP earnings conditional on both the sign and magnitude of the GAAP earnings surprise. Our findings suggest that non‐GAAP earnings disclosures tend to be driven by a desire for informative (strategic) reporting when GAAP earnings beat (undershoot) market expectations.     

Business and financial information integration and voluntary management earnings forecasts

In this study, the impact of business and financial information integration (BFII) on the voluntary management earnings forecasts (VMEFs) of listed firms in China between 2008 and 2018 is investigated. Drawing on litigation cost and ability signaling theories, we find that the adoption of BFII encourages top managers to disclose VMEFs. BFII firms are identified through the textual analysis of management discussion and analysis (MD&A) reports, and the empirical results indicate that BFII firms have a higher probability and frequency of issuing VMEFs than non-BFII firms. The results remain robust after we identify causality by applying a propensity score matching and difference-in-differences (PSM-DID) test and use an alternate measure of BFII. Further tests show that BFII firms issue more accurate VMEFs and are able to issue them at an earlier stage. We also find that the positive relationship between BFII and VMEFs is weakened if the media expresses concern about the uncertainty of BFII adoption.     

Model-based earnings forecasts vs. financial analysts' earnings forecasts

Existing accounting-based forecasting models of earnings either do not fully consider information that is contained in stock prices or use an ad hoc specification that is not based on rigorous valuation theory. In this paper, we develop an earnings forecasting model built on the theoretical linkages between future earnings and stock prices as well as a number of accounting fundamental variables. We find that our model-based forecasts of earnings are in general less biased and more accurate than both existing model-based forecasts and analysts' consensus forecasts, at both shorter and longer horizons. We also show that the accuracy of both model-based forecasts and financial analysts' forecasts depend on firm-specific characteristics such as firm size and industry membership.     

Business Cycle and Management Earnings Forecasts

This study examines the effects of the economic cycle on the properties of management earnings forecasts. Although a large volume of accounting literature examines the determinants of managerial earnings forecasts, the properties of such forecasts, and the response of market participants to earnings forecasts (Cameron 1986; King et al., 1990; Hirst et al., 2008), research on management earnings forecasting incentivized by macro‐economic factors has received scant empirical investigation. We use the National Bureau of Economic Research economic cycle definition to operationalize economic recession, and consider some commonly used management earnings forecast characteristics, including forecast likelihood, forecast frequency, forecast error, forecast pessimism, and forecast precision. We find that the likelihood of providing management earnings forecasts and frequency of forecasts increases during economic recession. We also find that economic recession is positively associated with forecast error, but negatively associated with forecast precision. Our findings suggest macro‐economic factors as an important determinant of management earnings forecasts properties.     

Earnings seasonality,management earnings forecasts and stock returns

We examine whether management earnings forecasts (MEFs) help reduce the stock return seasonality associated with earnings seasonality around earnings announcements (EAs) in Chinese A-share markets. We find that firms in historically low earnings seasons outperform firms in high earnings seasons by 2.1% around MEFs. Firms in low earnings seasons also have higher trading volume and return volatility than their counterparts around EAs and MEFs. MEFs significantly reduce the ability of historical seasonal earnings rankings to negatively predict announcement returns, volume and volatility around EAs. The reduction effects are stronger when MEFs are voluntary or made closer to EAs. The evidence suggests that MEFs facilitate the correction of investors’ tendency to extrapolate earnings seasonality and its resulted stock mispricing.     

Analyst reputation and management earnings forecasts

Prior studies show that analysts with high reputation are influential in the market. This paper examines whether managers consider analyst reputation in shaping their voluntary disclosure strategy. Using Institutional Investor magazine’s All-American (AA) rankings as a proxy for analyst reputation, we find that the coverage of AA analysts is positively associated with the likelihood of quarterly management earnings forecasts (MEFs). We also find that AA analysts’ forecast optimism is more positively associated with the likelihood of MEFs than non-AA analysts’ forecast optimism when the firm is covered by AA analysts. Analyses based on AA analyst coverage changes and AA status changes confirm the relation between analyst reputation and MEFs. We further find that analyst reputation influences other MEF properties, such as forecast news, bias, and revisions, and that our results are robust to alternative measures of analyst reputation. Further analyses show that market reactions at quarterly earnings announcements are more positive (negative) when firms meet/beat (miss) AA analysts’ forecasts than when firms meet/beat (miss) non-AA analysts’ forecasts. Collectively, our findings suggest that managers strategically provide voluntary forecasts by taking into account the reputation of individual analysts following their firms.     

The effect of financial leverage on real and accrual-based earnings management

Past research has documented a substitution effect between real earnings management (RM) and accrual-based earnings management (AM), depending on relative costs. This study contributes to this research by examining whether levels of (and changes in) financial leverage have an impact on this empirically documented trade-off. We hypothesise that in the presence of high leverage, firms that engage in earnings manipulation tactics will exhibit a preference for RM due to a lower possibility – and subsequent costs – of getting caught. We show that leverage levels and increases positively and significantly affect upward RM, with no significant effect on income-increasing AM, while our findings point towards a complementarity effect between unexpected levels of RM and AM for firms with very high leverage levels and changes. This is interpreted as an indication that high leverage could attract heavy outsider scrutiny, making it necessary for firms to use both forms of earnings management in order to achieve earnings targets. Furthermore, we document that equity investors exhibit a significantly stronger penalising reaction to AM vs. RM, indicating that leverage-induced RM is not as easily detectable by market participants as debt-induced AM, despite the fact that the former could imply deviation from optimal business practices.     

The relation between earnings management and financial statement fraud

This paper provides new evidence on the characteristics of firms that commit financial statement fraud. We examine how previous earnings management impacts the likelihood that a firm will commit financial statement fraud and in doing so develop three new fraud predictors. Using a sample of 54 fraud and 54 non-fraud firms, we find that fraud firms are more likely to have managed earnings in prior years and that earnings management in prior years is associated with a higher likelihood that firms that meet or beat analyst forecasts or that inflate revenue are committing fraud. We further find that fraud firms are more likely to meet or beat analyst forecasts and inflate revenue than non-fraud firms are even when there is no evidence of prior earnings management. This paper contributes to the fraud detection literature and the earnings management literature, and can help practitioners and regulators develop better fraud detection models.     

Analyst revenue forecast reporting and the quality of revenues and expenses

We decompose earnings quality into revenue and expense quality and examine their associations with analyst propensity to supplement their earnings forecasts with revenue forecasts. Analysts report more revenue forecasts to I/B/E/S when expense quality is low to compensate for the low accuracy of their earnings estimates, which has a positive association with expense quality. Expense quality is unassociated with revenue forecast accuracy, thus revenue forecasts become increasingly useful for valuing firms when expense quality is low. Analysts report fewer revenue forecasts when revenue quality is low because both earnings and revenue forecast accuracy decline as revenue quality deteriorates. To control for endogeneity, we use firm‐fixed effects to control for unobserved time‐invariant heterogeneity across firms, instrumental variables regressions and regression in changes.