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Article Excerpt
After a particularly grim presentation by CEO Bill Gates and sales chief Steve Ballmer at an analysts' meeting two years ago, Goldman Sachs analyst Rick Sherlund ran into the pair outside and said, "Congratulations. You guys scared the hell out of people." Their response? "They gave each other a high five," Sherlund recalls. (Fox 1997)
I. INTRODUCTION
Recent articles in the business press suggest that managers of some firms place great importance on meeting or exceeding analysts' expectations, which they achieve either by using their discretion over reported earnings to meet expectations (earnings management) or by guiding analysts' earnings forecasts downward to improve their firms' chances of meeting or beating the forecast when earnings are announced (forecast guidance). Although the academic literature recognizes earnings management more commonly than forecast guidance as a mechanism for achieving specific reporting goals, the business press often refers to forecast guidance:
* A growth stock strategist states, "[m]anagement tries to be conservative in its earnings guidance because of how severely stocks are punished when earnings disappoint" (Ip 1997b).
* The head of quantitative research at Merrill Lynch observes, "Investor-relations people have been making sure the hurdle of expectations remains low so their companies can clear it easily" (McGee 1997).
* "As is the custom late in a quarter, companies have been jawboning analysts' estimates down to be sure the companies at least meet or exceed the consensus figure" (Bleakley 1997).
* "Companies increasingly are talking down their profit prospects to Wall Street analysts, thereby lowering expectations" (Vickers 1999).
Recent academic studies find evidence consistent with managers taking actions to avoid negative "bad news" earnings surprises (Payne and Robb 2000; Brown 2001; Burgstahler and Eames 2001). Moreover, Skinner and Sloan (2001) find that the stock market reaction to negative earnings surprises tends to be large and asymmetric, particularly for growth stocks, suggesting a high cost to missing analysts' expectations. These findings, as well as the anecdotes from the business press, suggest that managers perceive benefits from managing earnings or guiding forecasts to avoid negative earning surprises. In the case of earnings management, managers must implicitly believe that users either are unable to detect earnings manipulations or do not find it cost effective to do so. In the case of guiding forecasts, managers must believe that negative surprises at the earnings announcement are more costly than an initially lower forecast. Whether managers' perceptions are, in fact, true, the prior findings and anecdotal reports raise the following question: What factors influence managers to take actions to avoid negative earnings surprises? This study explores these incentives and the mechanisms, earnings management, and forecast guidance, through which managers achieve this goal.
I test a number of hypotheses about managers' incentives to avoid negative earnings surprises by examining the association between proxies for these incentives and the probability that the firm meets or beats analysts' forecasts at the earnings announcement. As predicted, the results suggest that firms with the following characteristics are more likely to meet or exceed analysts' expectations: (1) higher transient institutional ownership; (2) greater reliance on implicit claims with their stakeholders; and (3) greater value-relevance of earnings. These associations exist even after controlling for other factors associated with the probability of meeting or exceeding analysts' expectations, including the seasonal change in earnings, the growth in industrial production, firm size, and the magnitude of the initial forecast error.
I also examine the mechanisms managers use to avoid negative surprises. I measure abnormal accruals using the modified Jones model (Dechow et al. 1995). I also develop a measure of forecast guidance by modeling an expected forecast based on prior earnings changes and cumulative returns during the year, and then comparing this expected forecast to the consensus analyst forecast. If firms use their influence to keep expectations low, then I expect the published consensus forecast to be lower than the forecast produced by the model. I then examine the relation between firm characteristics and the probability (conditional on meeting analysts' expectations) of (1) managing earnings upward and (2) guiding forecasts downward. The results suggest that firms with higher transient institutional ownership are more likely both to manage earnings upward and to guide forecasts downward, and that firms with consistent patterns of prior losses appear less likely to engage in either behavior. Firms with a greater reliance on implicit claims with their stakeholders, and those in industries in which earnings are highly value-relevant, exhibit evidence of guiding forecasts downward but not of managing earnings upward, whereas high-growth firms appear to manage earnings upward but not guide forecasts downward. Overall, the results suggest that both mechanisms play a role in avoiding negative earnings surprises.
This paper contributes to the literature in a number of ways. First, this study is among the first to recognize that managers may guide forecasts downward to avoid reporting negative earnings surprises. Prior studies have examined the effect of management's public forecasts on analysts' forecast revisions (Baginski and Hassell 1990; Williams 1996; Hansen and Noe 1999). However, using only management's public disclosures to investigate downward guidance does not capture the effects on analysts' forecasts of any guidance provided in informal, private conversations. (1) This paper examines forecast guidance by comparing actual forecasts to a measure of expected forecasts in an attempt to better capture any informal guidance managers provide to analysts. The perception that managers often provide informal guidance was at least partially responsible for the SEC's recent passage of Regulation Fair Disclosure (Reg FD). If firms rely on guidance to avoid negative earnings surprises, then the new disclosure rule may diminish a firm's ability to avoid such surprises. The results of this study (conducted prior to the passage of Reg FD) provide insights into the types of firms most likely to be hurt by any inability to provide guidance in this new regulatory environment.
Second, this paper provides further evidence on cross-sectional differences in incentives to avoid negative earnings surprises. Evidence on the incentives for managers to bias either reported earnings or analysts' forecasts (or both) could have implications for studies that test market reactions to earnings announcements. For example, if the market adjusts for perceived downward guidance in analysts' forecasts when forming its expectations, then associations between market reactions and forecast errors based on published forecasts may be diminished. (2)
Finally, this study contributes to the literature that investigates bias in analysts' forecasts. Earlier studies, which generally found an optimistic bias in analysts' forecasts, focused on incentives for analysts to bias their forecasts (Francis and Philbrick 1993; Lin and McNichols 1998). (3) In contrast to these studies, which implicitly assumed that managers prefer optimistic forecasts, this study directly explores the role managers' incentives play in guiding analysts' forecasts, and provides evidence consistent with anecdotal reports suggesting that some managers prefer lower forecasts to avoid negative surprises when the firm announces earnings.
In the next section, I discuss the related literature and provide descriptive evidence on the incentive to avoid negative earnings surprises. Section III explores possible incentives for managers to take actions to avoid negative surprises. Section IV describes the research design and provides descriptive statistics. Evidence of an association between the hypothesized incentives and avoiding negative surprises appears in Section V. In Section VI, I describe the approach employed to distinguish earnings management from forecast guidance and present evidence on the extent to which each mechanism is associated with the hypothesized incentives. Concluding remarks and suggestions for future research appear in Section VII.
II. BACKGROUND
Prior and Concurrent Research
Managers have strong incentives to avoid negative earnings surprises because such surprises generally lead to negative price revisions (Brown et al. 1987) and overall negative publicity for the firm. In addition, a recent study by Skinner and Sloan (2001) suggests that the market response to earnings surprises is asymmetric--the absolute magnitude of the price response to negative surprises significantly exceeds the price response to positive surprises, particularly for high-growth firms.
Evidence from recent empirical work is consistent with managers taking actions to avoid these negative earnings surprises. Burgstahler and Eames (2001) find in the distribution of analysts' forecast errors a larger-than-expected proportion (assuming a smooth distribution) of zero and small positive forecast errors. Brown's (2001) evidence of an overall increase in the percent of zero and positive forecast errors over time is consistent with managers taking actions to avoid negative earnings surprises (assuming the incentive to avoid negative earning surprises has increased over time). Richardson et al. (1999) also provide evidence of a temporal decline in the extent to which actual earnings fall short of analysts' expectations (i.e., analyst optimism).
Managers have two mechanisms for avoiding negative earnings surprises--they can manage earnings upward if unmanaged earnings fall short of expectations or they can guide analysts' expectations downward to avoid overly optimistic forecasts. Both mechanisms entail costs. Managing earnings is difficult because auditors and boards of directors scrutinize questionable accounting practices. Moreover, because accruals reverse in subsequent periods, managers are unlikely to be able to use abnormal accruals to continually increase earnings above expectations every period. Guiding analysts' forecasts downward requires revising current expectations downward if initial forecasts are too high, which could cause a negative stock price reaction at the forecast revision date. Guiding expectations early on to keep them at a "beatable" level is also costly to the extent that it leads to lower stock prices for an extended period of time. For either mechanism to be beneficial, the cost of a negative earnings surprise (e.g., negative stock price reactions or negative publicity for the firm at the earnings announcement date) must exceed the cost of managing earnings (e.g., reputation costs) or the cost of an initially lower forecast (e.g., lower initial stock prices). (4)
Evidence from prior and concurrent studies is consistent with managers managing earnings to avoid missing analysts' expectations. Payne and Robb (2000) find that firms with premanaged earnings below analysts' expectations have greater positive abnormal accruals. Burgstahler and Eames (2001) find that firm-years in the zero-forecast-error category exhibit more positive earnings management than firm-years in the adjacent categories. Both studies conclude that managers manipulate accruals to avoid negative earnings surprises, but neither explores cross-sectional differences in managers' incentives to avoid negative surprises.
Although a number of studies explore managers' incentives to manage reported earnings to meet various reporting goals, few studies have considered the incentives for managers to lower expectations to avoid negative earnings surprises. In their sample of firms that preannounce earnings, Softer et al. (2000) find that the market considers the majority of preannouncements bad news, but the majority of earnings announcements positive or neutral--suggesting that some firms preannounce bad news, but then reveal positive surprises at the earnings announcement. However, using only the firm's public disclosures to investigate managers' guidance of analysts does not capture the effects of any guidance managers provide privately to analysts. Burgstahler and Eames (2001) find the revision of forecasts from the beginning to the end of the year is more negative for firm-years in the zero-forecast-error category than in adjacent categories, suggesting that managers guide forecasts downward when doing so will allow them to meet analysts' exact expectations. While the evidence from these studies is consistent with downward forecast guidance, neither study explores cross-sectional differences in the propensity to engage in guidance.
This paper contributes to this emerging literature by exploring cross-sectional differences in the propensity to avoid negative earnings surprises. In addition, I investigate the cross-sectional differences in two mechanisms managers likely use to avoid earnings disappointments: earnings management and forecast guidance. Finally, I employ a new technique to investigate forecast guidance.
Descriptive Evidence of the Incentive to Avoid Negative Surprises
The majority of financial press accounts of managers' downward guidance have appeared in the last few years; therefore, the proportion of quarters with positive earnings surprises is likely to have increased in recent years. Using Zacks earnings surprise file, I compute the percentage of firm-quarters where actual reported earnings ([E.sup.REP]) meets or exceeds the consensus forecast outstanding at the earnings announcement ([F.sup.EA]) for each year from 1985 to 1997. (5) Table 1 reports the results of this analysis. Similar to the findings in Brown (2001) and Richardson et al. (1999), both of which are based on data from I/B/E/S, the percentage of quarters in which earnings met or exceeded analysts' expectations has increased over time (Spearman rank correlation = 0.90, p < 0.001), consistent with growing emphasis on avoiding negative earnings surprises. (6)
The increase is unlikely to be due to analysts underestimating the effect of positive macroeconomic events on firm profits. Table 1 shows that there is no significant trend over time in the percent of quarters with increases in earnings per share before extraordinary items (quarterly Compustat data item no. 8) from the same quarter in the previous year (i.e., the seasonal change in earnings). Thus, the tendency to meet or exceed analysts' consensus forecasts does not appear to result from a general increase in earnings performance that analysts failed to anticipate. Figure 1 plots the trend in these two percentages, which appear to move together in the first half of the sample period. From approximately 1991 onward, however, the percent of quarters that meet or exceed analysts' expectations has increased steadily, whereas the percent of quarters with increases in earnings has not.
[FIGURE 1 OMITTED]
The foregoing evidence is consistent with anecdotal reports suggesting managers take actions to avoid negative earnings surprises, particularly in recent years. In the next section I discuss firm characteristics that are likely associated with the incentive to meet or exceed analysts' forecasts.
III. HYPOTHESIS DEVELOPMENT
Institutional Ownership
A manager is likely concerned that a negative earnings surprise will lead to significantly lower stock prices and adversely affect his or her performance evaluation. Puffer and Weintrop (1991), for example, find that the probability of CEO turnover increases with the shortfall of actual earnings from analysts' expectations. To the extent institutional investors overemphasize near-term profits (Porter 1992; Business Week 1987), managers of firms with higher institutional ownership likely perceive greater costs to missing analysts' forecasts. Frequently cited reasons for institutional investors' focus on current earnings include pressure for near-term portfolio performance; difficulty in analyzing...
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