...forecast and earnings predictability because there is evidence suggesting that deliberate earnings forecast optimism is not an effective mechanism for gaining access to managers' information (e.g., Eames et al. 2002; Matsumoto 2002). We document associations between earnings level and both forecast error and earnings predictability. These associations suggest that earnings level may be an important control variable when examining the association between forecast error and earnings predictability. When we control for the level of earnings we find no significant association between forecast error and earnings predictability. Thus, we find no evidence that analysts intentionally issue optimistically biased earnings forecasts.

Keywords: analyst earnings forecasts; forecast error; forecast bias; earnings predictability.

Data Availability: Data are commercially available from the sources identified in the text.

I. INTRODUCTION

Das et al. (1998) (hereafter DLS) examine the association between Value Line analysts' earnings forecasts and earnings predictability and find that as earnings become less predictable analysts' earnings forecasts become increasingly optimistic. To explain this pattern, DLS extend the management relations hypothesis (Francis and Philbrick 1993) (hereafter FP) to the earnings predictability context and argue that analysts intentionally bias their forecasts to curry favor with management in order to gain access to management's information. (1) DLS posit that as earnings become less predictable, analysts issue increasingly optimistic earnings forecasts because the potential gain in forecast accuracy from access to managers' nonpublic information is greater when earnings are less predictable. This intentional bias improves the overall accuracy of forecasts when the gain in accuracy through access to private information outweighs the loss in accuracy from the optimistic bias. DLS's evidence that analysts intentionally issue optimistically biased earnings forecasts is of interest to regulators (interested in establishing an environment where information is fairly and efficiently transferred to all investors), investors (as they interpret earnings forecast for their investment decisions), firms (as managers try to meet or beat the earnings forecast), and forecasting agencies (as they face the scrutiny of regulators and investors).

Contrary to DLS's theory, recent research suggests that issuing intentionally optimistic earnings forecasts is not an effective means for pleasing managers and improving access to their private information. Jorge and Rees (2000) present interview and survey evidence from Spain that managers more commonly respond to unfavorable analyst reports by providing more, rather than less, information. In addition, optimistic earnings forecasts result in negative earnings surprises, and related negative market reactions, while accurate and pessimistic forecasts have been linked with positive market responses (Bartov et al. 2002; Kinney et al. 2002; Kasznik and McNichols 2002; Lopez and Rees 2002; Skinner and Sloan 2001). Burgstahler and Eames (2002) present evidence that managers avoid negative earnings surprises by both managing earnings upward and analysts' forecasts downward--results inconsistent with a managerial preference for forecast optimism. Matsumoto (2002) argues that managers prefer pessimistic forecasts to avoid adverse market reactions to negative earnings surprises, and presents results consistent with this position.

FP and Kim and Lustgarten (1998) report evidence of greater earnings forecast optimism in association with less favorable recommendations, and reason that forecast optimism repairs the damage to the manager-analyst relationship invoked by unfavorable recommendations. However, Eames and Glover (2002) and Eames et al. (2002) further examine the association and conclude that FP's and Kim and Lustgarten's (1998) results likely stem from omitting the correlated variable--earnings level--from their analyses. Without including earnings level in their analyses, Eames and Glover (2002) and Eames et al. (2002) replicate the FP and Kim and Lustgarten (1998) results. However, when they control for earnings level they find no association between forecast optimism and recommendations for Value Line analysts (Eames and Glover 2002) and greater forecast optimism in association with more favorable recommendations for broker analysts (Eames et al. 2002). (2) These findings, combined with recent research indicating that issuing intentionally optimistic earnings forecasts is not an effective method to curry favor with management, lead us to explore whether the level of earnings is also an important control variable when considering the relation between analyst forecast errors and earnings predictability. Specifically, we investigate whether DLS's results are driven by their failure to consider the level of earnings in their analyses.

For earnings level to be an important control variable in examinations of the association between forecast error and earnings predictability, there must be associations between earnings level and both forecast error and earnings predictability. Numerous studies report an inverse relation between forecast error and the level of reported earnings (e.g., Brown 2001; Eames et al. 2002; Eames and Glover 2002; Hwang et al. 1996). The association reflects both earnings shocks due to unanticipated events and earnings management. Unexpected positive (negative) earnings shocks result in higher (lower) earnings and will generally be associated with more forecast pessimism (optimism) (Eames et al. 2001). Earnings baths are associated with low earnings and forecast optimism, while management to beat the forecast will lead to higher earnings and greater forecast pessimism (Abarbanell and Lehavy 2002).

In addition to the association between forecast error and earnings level, we document an association between earnings level and earnings predictability. We find earnings predictability is highest for earnings observations near the cross-sectional median level of earnings and that earnings predictability declines dramatically as earnings increasingly deviates from the median. With an association between forecast error and earnings level, and between earnings level and earnings predictability, we anticipate that earnings level will be an important control variable in examining the association between forecast error and earnings predictability.

We replicate DLS's results using analyses and data similar to theirs. However, plots of earnings predictability and the level of earnings reveal that the association between these two variables differs above and below median earnings. When we partition our sample at median earnings and further control for the level of earnings by including earnings as an independent variable, we find that neither subsample yields significant evidence of an association between forecast optimism and earnings predictability. (3) These findings suggest that DLS's results indicating intentional analyst bias are spurious and attributable to a failure to adequately consider earnings level controls in their analyses.

This study makes several important contributions to the existing literature examining earnings forecast errors. First, we provide evidence that earnings level is an important control variable to consider when examining the association between forecast error and earnings predictability. This finding, in combination with studies demonstrating that earnings is an important control variable when examining the association between forecast error and recommendations (e.g., Eames et al. 2002), suggests that research on earnings forecast error in other contexts should consider controlling for the level of earnings. Second, we demonstrate that forecast-error research that assumes linear relationships can be seriously flawed. A simple plot of the underlying data reveals that DLS's theory and findings do not generalize to at least half of the firms (i.e., those with earnings above the median). Third, we...

NOTE: All illustrations and photos have been removed from this article.



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