Abstract
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.
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Notes
The Private Securities Litigation Reform Act was passed in December 1995. The effectiveness of the Act in changing expected and management forecast behavior is not clear, at least for 1996. As noted by Baginski et al. (2002), several analyses indicate that, at least initially, the protections of the Act could be avoided by shifting the jurisdiction of the suit, and the evidence on the effectiveness of the Act is mixed. We leave 1996 forecasts in our sample to match the number of years in 1983–1986. However, we replicated all tests in this paper (not tabulated) with 1996 observations discarded. Our conclusions are identical.
For example, Lev and Zarowin (1999) document a decline in earnings relevance over a period ending in 1996. Francis and Schipper (1999) document a decline in earnings relevance over a period ending in 1994. Landsman and Maydew (2002) find an intertemporal increase in the value relevance of quarterly earnings announcements over a period ending in 1998. Francis et al. (2002a) document increases in the information content of analyst reports with a sample spanning 1986–1995. These studies form the basis for current thinking in the area.
Also, using a similar sample size to tests that reject the null of equal occurrence of external attributions, we fail to reject the null of equal occurrence of internal attributions (i.e., explanations for forecasted performance referring to management actions) across periods. Because Baginski et al. (2004) document pricing effects of external but not internal attributions, this result is also consistent with the idea that changes occur in the set of management forecast characteristics that are linked to higher quality forecasts.
Our DJNRS search keywords are: “expects earnings,” “expects net,” “expects income,” “expects losses,” “expects profits,” “expects results,” and three similar lists with first words “forecasts”, “predicts”, and “sees”. To be classified as a management forecast, the article had to describe an expectation about future earnings. If the language was past tense or present tense, the article was not coded as a forecast. The forecast also had to be attributed to a company official or to the firm. The number of forecasts discarded at each step of our sample selection process and the reason the forecast did not make the final sample can be found in Baginski et al. (1993, 2004).
Machine readable data bases from which management earnings forecasts can be drawn do not exist before 1993. Construction of large samples of 1980s forecasts is a labor-intensive process, especially when multiple qualitative dimensions of the forecasts such as attributions and other forecast language must be quantified. As a result, few studies using hand-gathered management earnings forecasts exist relative to the substantial number of studies which re-use machine-readable, existing samples coded on the COMPUSTAT and CRSP tapes. Our decision to use existing samples from 1983–1986 and 1993–1996 minimizes data collection costs. Further, it maximizes power if the change in information environment was gradual over the 1983–1996 period. We are unable to document what occurred in 1987–1992, however, which represents a potential limitation of our study.
The downturn in sample size appears temporary as it does not persist into 1997 and 1998 if we use the same sampling procedure. Smaller numbers of forecasts in the early 1990s might have stimulated the PSLRA legislation, the goal of which was to increase public disclosure. Anilowski et al. (2004) also report a substantial increase in management forecasts from the First Call database in 1997 and 1998 relative to 1995 and 1996.
External attributions are also issued with maximum type forecasts. However, forecast form is a management choice variable for which we do not wish to control. Nonetheless, we included an indicator variable for maximum type forecasts in an untabulated estimation of Eq. (2). It is significantly positive, as expected, but the conclusion about increased external attribution in the 1990s was unaffected.
As noted previously, when we discard 1996 forecasts, are results our unaffected. The lone exception is that discarding 1996 forecasts yields a much weaker significance level on the SHIFT coefficient in the results for the subsample not followed by financial analysts (p = 0.092). As a result, the SHIFT coefficient in the analyst followed subsample is larger than the SHIFT coefficient in the not followed sample, as expected, with a much higher reliability (p = 0.0025).
An exception is found in the annual management forecasts with no analyst coverage. The accuracy advantage of managers is higher in 1993–1996 relative to 1983–1986.
The rank transformation deals with nonlinearity in the relation between unexpected earnings and security returns induced by the likelihood that some unexpected earnings values in the tails are transitory. Rank transformations yield a conservative test of our hypotheses if improved management forecast quality extends beyond higher quality forecasts of current earnings to forecasts of more permanent earnings because rank transformation controls for such an effect. We also used raw unexpected earnings truncated at 100% of security price and found similar results, but slightly lower explanatory power.
Information environment changes for these non-followed firms unrelated to changes in, say, analyst coverage could have occurred over time. However, our price reaction tests indicate that any such changes are unrelated to management earnings forecast relevance for these firms.
Management earnings forecasts are highly dispersed in event time. Therefore, the potential dependency in regression residuals is minimized. An exception to this event time dispersion occurs because we treat two forecasts issued at the same time as two separate observations (unexpected earnings conveyed in the forecast and forecast form can be different for the two forecasts). The most prevalent case is a fourth quarter forecast and an annual forecast in the same article, which occurs approximately 10% of the time. Splitting the sample into annual forecasts and interim forecasts also serves as a robustness check with respect to this residual dependency.
Changing the deflator from price to earnings creates a new set of problems (e.g., negative earnings, outliers, distributional properties of unexpected earnings, etc.). We use various truncation schemes, windsorization, and ranking to make sure that our conclusions based on the alternative deflator are robust. We also took another approach to controlling for expected capitalization differences across firms in which we maintained the original price deflator for unexpected earnings and added an additional slope shift variable, the product of the leading earnings to price ratio and unexpected earnings conveyed in the management forecast (UEMF). The coefficient estimate on the variable was significantly negative, as expected, indicating that price response to the unexpected earnings is lower when capitalization rates are lower (i.e., earnings to prices is a smaller number) or insignificant. However, our conclusions on the shift variables in equation (6) were unaffected (results not tabulated).
Finally, Bradshaw (2003) provides a graph of the relation between EPS determined under GAAP and EPS as reported by I/B/E/S. These two variables closely align in 1983–1986, and they clearly diverge in 1993–1996. If post-1992 I/B/E/S analysts are forecasting and providing actuals based on what they believe are more value relevant numbers than provided by GAAP, then one would expect less measurement error in the expectation model post-1992. However, management forecasts issued post-1992 included rare references to special items, and it is not clear what earnings construct they are forecasting and whether that construct has changed over time. To test whether management forecasts have changed like analyst forecasts have over time, future research can consider whether pro forma earnings released by managers more closely align with management forecasts in more recent periods.
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Acknowledgements
We thank Stephen Taylor, Ben Ayers, Linda Bamber, Rick Morton, Bruce Billings, Allen Bathke, Bok Baik, Isabel Wang, Eli Bartov, Paul Zarowin, Joshua Livnat, Carol Marquardt, Stephen Ryan, Eric Yeung and workshop participants at Florida State University, the University of New South Wales, the University of Melbourne, the University of Georgia and NYU for their helpful comments on earlier versions of this paper. We gratefully acknowledge the contribution of I/B/E/S International Inc. for providing earnings per share forecast data. These data have been provided as part of a broad academic program to encourage earnings expectations research.
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Baginski, S.P., Hassell, J.M. & Kimbrough, M.D. Macro information environment change and the quality of management earnings forecasts. Rev Quant Finan Acc 31, 311–330 (2008). https://doi.org/10.1007/s11156-007-0070-7
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DOI: https://doi.org/10.1007/s11156-007-0070-7