, Volume 36, Issue 4, pp 781-821
Date: 21 Apr 2010

Incentive to manipulate earnings and its connection to analysts’ forecasts, trading, and corporate governance

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We develop a model where insiders’ decision to manipulate earnings is linked both to their stake and to corporate governance. We show how earnings manipulation affects analysts’ forecasts and institutional trading. More precisely, whenever there is “excessive” earnings manipulation, we observe less optimistic analysts. Furthermore, institutions exhibit positive feedback trading behavior and appear to “front-run” analysts’ errors. Finally, companies with strong corporate governance are less prone to these phenomena, being able to avoid the detrimental effects of insiders’ incentives. We then provide strong empirical evidence to support our model.

This paper was previously circulated under the title “Ownership Structure and Analysts’ Forecasts”. We would like to thank Franklin Allen, Markus Brunnermeier, Harrison Hong, Andrew Metrick, David Musto, Áureo de Paula, Hélène Rey, Ailsa Röell, José Scheinkman and the participants in seminars at Wharton, UNC-Charlotte, Macalester College, Loyola U. Chicago, U. Central Florida and U. Washington for insightful comments and suggestions. The authors also acknowledge I/B/E/S for making the data on analyst forecasts available for use in this research project. All remaining errors are our own.
The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF or its policy.
The material discussed herein may not reflect the opinions of Cornerstone Research.