Credibility of annual management earnings forecasts: theory and evidence
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Abstract
Much of accounting research is predicated on the fact that the capital markets operate well because disclosures of annual earnings are verified. It is generally observed, however, that market responses to the unverified management forecasts may be as strong as responses to similar l verified information disclosures. This dissertation is concerned with the credibility of such unverified information. Three hypotheses are investigated in the study. The data includes managements' annual earnings forecasts gathered from the 1986 to 1992 editions of the Wall Street Journal.
The first hypothesis concerns the timing of the disclosure of the forecasts by management. It is tested by comparing liquidity and leverage ratios at the event date to prior same-firm ratios. Evidence is found that supports the conclusion that the firm is preparing the market for a possible capital offering.
The second hypothesis concerns the asymmetry of information between the firm and investors. This asymmetry affects the stock market reaction. It is tested using OLS regressions with the market reaction as the dependent variable and various asymmetry surrogates as independent variables. Evidence is found that supports the conclusion that as more investors follow the firm, there is less new information associated with the management forecast disclosure. Further, as fewer investors follow the firm, there is a lower tendency to disclose forecasts.
The third hypothesis concerns the ability of the firm to provide credible communication. It is tested using OLS regressions with the market reaction as the dependent variable and various proprietary information surrogates as independent variables. Weak support is found for the conclusion that those firms releasing proprietary information through the forecast disclosure provide more credible communication. The support is restricted to the negative forecasts. For positive forecasts, it may be that reputation is most important to investor response.