Do managers manage earnings to ‘just meet or beat’ analyst forecasts?

Abstract

This paper examines whether managers manage earnings to ‘just meet or beat’ analyst forecasts in Australia. Previous Australian studies on benchmark-beating have focused on loss avoidance and small earnings increases as benchmarks [Coulton, J., Taylor, S., & Taylor, S. (2005). Is ‘benchmark beating’ by Australian firms evidence of earnings management? Accounting and Finance, 45, 553–576; Holland, D., & Ramsay, A. (2003). Do Australian companies manage earnings to meet simple earnings benchmarks? Accounting and Finance, 43, 41–62]. This paper extends this earlier research on benchmark-beating in Australia by incorporating analyst forecast as an important benchmark. Using three different models of unexpected accruals as proxies for earnings management, this study did not find any significant difference between the mean and median unexpected accruals of the “‘just meet or beat” group as against the “just miss” group. Furthermore, for a long period of time (1997–2002), the proportion of Australian firms ‘just meeting or beating’ analyst forecasts benchmark increased, although such increase was not statistically significant.

Introduction

The purpose of this paper is to examine whether managers manage earnings to ‘just meet or beat’ analyst forecasts in Australia. Previous Australian research on ‘benchmark-beating’ used loss avoidance and small increases in earnings as the earnings benchmarks, but not analyst forecasts. For instance, Holland and Ramsay (2003) found that there were abnormally large (small) numbers of observations for the interval immediately above (below) zero for both scaled earnings levels and scaled earnings changes variables. But Holland and Ramsay (2003) did not examine whether managers manage earnings to achieve those benchmarks. Coulton, Taylor, & Taylor (2005) tested that premise but failed to discover any evidence of earnings management. They suggested, therefore, that discontinuity around zero does not necessarily indicate earnings management designed to meet or beat earnings targets. However, their use of the last year's earnings benchmark is questionable, since analysts have been shown to incorporate a broader set of information and to be timelier in their forecasts than time-series models (Ramnath, Rock, & Shane, 2008). The present paper fills this gap in earlier research on benchmark-beating in Australia, by incorporating analyst forecasts as an important benchmark.

Recent research suggests that meeting or beating analyst forecasts became the most significant benchmark for managers (Brown & Caylor, 2005). This could result from the markets’ increasing focus on just meeting analysts’ expectations (because these forecasts are becoming more accurate and precise) or from increases in the number of analysts and in the media attention paid to their forecasts. Bartov, Givoly, and Hayn (2002) found firms that ‘just meet or beat’ current analyst earnings expectations enjoyed a higher stock return. Similar results were reported by both Kasznik and McNichols (2002) and Lopez & Rees (2002). Failure to meet or beat forecasts was associated with significant adverse consequences. Matsunaga and Park (2001) found a significant negative incremental effect on the CEO's bonus where managers failed to meet quarterly earnings forecasts. Given the significant benefits (costs) associated with just meeting (failing to meet) analyst forecasts benchmark, managers are no longer passive in the earnings game. Rather, they are actively trying to win the game by altering reported earnings and/or influencing analyst expectations. Meeting benchmarks boosts management's credibility by meeting stakeholders’ expectations and avoiding costly litigation that could potentially be triggered by unfavorable earnings surprises (Bartov et al., 2002).

The evidence of earnings management to ‘just meet or beat’ analyst forecasts, comes primarily from the studies conducted in the United States of America (hereafter US). Whether this finding can also be generalized to the Australian reporting environment needs to be assessed in light of at least two questions, namely whether (a) investors value analyst forecasts as a gauge of managerial performance; and whether (b) just meeting or beating analyst forecasts results in a value premium for Australian companies. There is a dearth of evidence in the Australian context to answer these questions. The available evidence has investigated the factors associated with forecast accuracy and bias, but there is hardly any evidence on the information content of analyst forecasts error.

Brown, Clarke, How, and Lim (2002), using consensus forecast data from 1985 to 1998, found that analyst dividend forecasts were, on average, more accurate (and less biased) than their corresponding earnings forecasts. Brown, Taylor, and Walter (1999) reported that analyst forecast errors actually increased after the passage of the Corporations Law Reform Act 1994. Hope (2003), in an international study, found that strong enforcement regimes lead to higher forecast accuracy. He found that mean forecast accuracy was highest in Australia, although Australia ranked well below other common law countries in terms of enforcement mechanisms. Basu, Hwang, and Jan (1998), on the other hand, reported that the average forecast error is 1.53% higher in Australia than in the US. The findings from the present paper could provide indirect evidence of the value of analyst services in the Australian context. It is expected that managers will engage in costly earnings management to ‘meet or beat’ analyst forecasts only when they find it beneficial to do so.

Earnings management to ‘just meet or beat’ analyst forecasts is a phenomenon that is strongly shaped by the business reporting environment. Reporting environments in the US and Australia differ in some important respects, and the threat of litigation faced by corporate managers is an important attribute of such differences. In particular, consistent evidence of earnings management to ‘just meet or beat’ analyst forecasts in the US has been attributed to, among other factors, the excessive threat of litigation. In particular, high-tech stocks have been extremely vulnerable when they fall below analyst forecasts benchmark (Skinner & Sloan, 2002). However, the lack of legal class-action privileges, and the entitlement of successful defendants to cost recovery from the plaintiff (Taylor & Taylor, 2003), has discouraged investors from suing corporate managers in cases of poor firm performance in Australia.

Furthermore, analyst following of Australian companies has not been intensive. For the year 2004, forecast data for only 458 companies were available in the I/B/E/S, which represented a mere 30% of the total number of domestic listed companies.¹ Additionally, US-based research on ‘benchmark-beating’ has strongly established that stock option-based executive compensation schemes were among the most important determinants of managerial incentives to ‘just meet or beat’ analyst forecasts (Cheng & Warfield, 2005). The extent to which these findings also hold in Australia is not clear because of the lower analyst coverage of Australian companies and a lack of evidence on the usefulness of long-term incentive packages.

In an international context, O’Brien (1988) raised concerns about whether analysts’ ability to forecast earnings is important outside the US. She argued that financial statements in some countries are prepared to satisfy legal requirements, rather than to inform investors. However, in Australia this consideration is less relevant because of the separation of financial from tax reporting. Australia belongs to a common law tradition where investors rely on publicly disclosed accounting information to make investment decisions (Ball, Kothari, & Robin, 2000). Common law countries provide analysts with an incentive to engage in private information acquisition, because their service is demanded by the market. Also, the high level of company-specific disclosure in common law countries makes forecasting easier. These factors suggest that investors might use analyst forecasts to evaluate managerial performance. Furthermore, some recent class-action lawsuits made against corporations like AWB and Multiplex may encourage Australian investors to take legal actions against managers failing to meet or beat analyst forecasts. The contrasting perspectives on the value of analyst services in Australia outlined here, therefore, justify an empirical examination of whether mangers manage earnings to ‘just meet or beat’ analyst forecasts.

Using analyst forecasts data from the I/B/E/S for 1995 to 2004, and employing three different models of discretionary accruals (hereafter DACCR) measurement, this study failed to find any significant difference in DACCR levels between the “just meet or beat” and the “just miss” groups. Additional analysis revealed that there was no discernible increase in the managerial propensity to ‘just meet or beat’ analyst forecasts in Australia over the sample period. The paper proceeds as follows: the next section presents the background for the study and a brief description of the related literature. Section 3 explains the research design issues. Sample selection procedure is discussed in Section 4. Section 5 provides the substantive test results and Section 6 concludes.