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DOI: 10.1111/j.1475-679X.2005.00174.x Journal of Accounting Research Vol. 43 No. 3 June 2005 Printed in U.S.A.

The Association between Outside Directors, Institutional Investors and the Properties of Management Earnings Forecasts
B I P I N A J I N K Y A , S A N J E E V B H O J R A J , AND PARTHA SENGUPTA Received 27 May 2003; accepted 20 September 2004

ABSTRACT

We investigate the relation of the board of directors and institutional ownership with the properties of management earnings forecasts. We nd that rms with more outside directors and greater institutional ownership are more likely to issue a forecast and are inclined to forecast more frequently. In addition, these forecasts tend to be more specic, accurate and less optimistically biased. These results are robust to changes specication, Granger causality tests, and simultaneous equation analyses. The results are similar in the pre and postRegulation Fair Disclosure (Reg FD) eras. Additional analysis suggests that concentrated institutional ownership is negatively associated with forecast properties. This association is less negative in the postReg FD environment, which is consistent with Reg FD reducing the ability of rms to privately communicate information to select audiences.

University of Florida; Cornell University; University of Maryland. We thank Kate Campbell, Charles Lee, Carol Marquardt, James Peters, and workshop participants at American University, University of Florida, Georgia State University, Texas Christian University, and the American Accounting Associations 2003 annual meeting at Hawaii and the 14th annual Financial Economics and Accounting Conference at Indiana University. We also thank Thompson Financial for generously providing us First Call analyst forecast and management forecast data through their Academic program. 343
Copyright
C

, University of Chicago on behalf of the Institute of Professional Accounting, 2005

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1. Introduction
The U.S. corporate world is dominated by publicly traded rms with widely dispersed ownership. Typically, shareholders designate rm managers to run the company with the goal of maximizing shareholder wealth. Because shareholders do not participate in day-to-day corporate activities, implicit or explicit governance mechanisms assist in monitoring management actions and protecting shareholder interests.1 In this article we examine the association between governance mechanisms and the extent and quality of voluntary disclosure. Specically, we examine the association of governance mechanisms (i.e., outside directors and institutional investors) with management earnings forecast occurrence, as well as with the specicity (i.e., precision), accuracy, and optimism of the issued forecasts. Prior work provides some evidence that the presence of outside directors reduces the likelihood of nancial fraud as well as earnings management (Dechow, Sloan, and Sweeney [1996], Beasley [1996], Klein [2002]).2 In addition to monitoring the quality of nancial information, outside directors can play a role in determining and monitoring a rms voluntary disclosure policy. Owing to their duciary duty toward shareholders, directors in general have a responsibility to ensure greater transparency when it is in the shareholders interests. Consistent with this responsibility, Osterland [2004] reported that several companies, including Burlington and Comcast, have established formal board-level committees to monitor corporate disclosure. Outside directors, by virtue of their position and presumed independence, are likely to possess greater incentives to ensure transparency when it is in the shareholders interests, as compared with other directors. To the extent that outside directors monitor disclosure policy and foster an environment of greater transparency, we expect to nd that rms with a larger proportion of these directors have a greater propensity to issue forecasts. We also expect the forecasts to be more specic, more accurate, and less optimistically biased. An alternative view is that outside directors may be ineffective, either because they have allegiance to company managers or because of fear of litigation (Mace [1986], Jensen [1993], National Investor Relations Institute (NIRI) [2002]). This view works against our nding a positive association between outside directors and forecast properties. Using a sample of managements earnings forecasts issued from 1997 to 2002, we nd results that are consistent with the governance role of outside directors. We nd that the probability of occurrence of management earnings forecasts and the frequency of such forecasts are positively associated with the percentage

1 See Shleifer and Vishny [1997] and Bushman and Smith [2001] for surveys of the corporate governance literature in nance and accounting. 2 Prior work examining the role of outside directors nds that outside directors also play an active role in monitoring corporate activities, such as replacing poorly performing CEOs (Weisbach [1988]) and protecting shareholder interests during takeover ghts (Shivdasani [1993]).

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of the board that consists of outsiders. The results also suggest that companies with a greater percentage of outside directors make more accurate and less optimistically biased earnings forecasts. However, we do not nd a signicant association between outside directors and the specicity of the forecasts issued, which could be attributable to the directors fear of greater litigation exposure that might result from more specic forecasts. Prior work examining the link between institutional investors and a rms information disclosure policy focuses on the association between analysts disclosure ratings and institutional ownership.3 Healy, Hutton, and Palepu [1999] nd that rms with sustained increases in disclosure (as proxied by analyst ratings) experience an increase in institutional ownership. Bushee and Noe [2000] nd an association between analysts disclosure ratings and institutional ownership using both levels and changes analysis. In this study we extend the prior research on institutional ownership by examining the association between institutional ownership and various properties of management forecasts. We focus on management earnings forecasts as a purer measure of voluntary disclosure of private information than analysts scores. Focusing on management forecasts also allows us to examine specic aspects of disclosure such as specicity and bias. Additional benets of focusing on management forecasts are a larger sample size and the ability to examine a more recent period, including the postRegulation Fair Disclosure (Reg FD) environment (analyst disclosure scores were discontinued in 1996). Given that corporate disclosures, especially earnings forecasts, are closely watched by institutions in addition to the constant investor probing of companies for their earnings outlook, we expect institutional ownership to be positively associated with a rms propensity to issue forecasts as well as the specicity and accuracy of forecasts issued, and negatively associated with managerial optimism. Consistent with our hypotheses, we nd that rms with higher institutional ownership are more likely to issue a management forecast. Over the six-year sample period, these rms also issue forecasts more frequently and the forecasts issued tend to be more specic (or precise). Using a subsample of point forecasts, we also nd that forecast accuracy (absolute forecast error) is positively (negatively) associated with institutional ownership, whereas forecast optimism bias is negatively associated with institutional ownership; that is, managers of rms with higher institutional ownership are more conservative in their forecasts. Prior research suggests that institutions are not a homogenous group and that their incentives are likely to be determined by ownership concentration

3 Other work examining the role of institutional investors focuses on whether these shareholders help protect investor interests in various contexts, including mergers and takeovers and management turnovers, and whether they help enhance rm performance and value (e.g., Denis and Serrano [1996], Jarrell and Poulsen [1987], Kang and Shivdasani [1995], Shivdasani [1993], Weisbach [1988]). Other research explores the effects of governance on CEO compensation (e.g., Core, Holthausen, and Larcker [1999]) and effects of governance on the cost of debt (Bhojraj and Sengupta [2003]).

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(e.g., percentage of companys common stock held by the ve largest institutional owners of the rm), which affects their ability to generate private information and benets (e.g., see Agrawal and Mandelker [1990], Porter [1992]). Testing the effect of such concentration (or blockholding), we nd that rms with concentrated institutional ownership, with their inherent ability to generate private information and benets, are less likely to promote voluntary disclosure. In this case we nd that rms are less likely to issue earnings forecasts, and the forecasts issued tend to be less specic. Hence, concentration of institutional ownership has an adverse effect on disclosure properties. We examine several alternative explanations for our ndings. For example, prior work exploring the effect of disclosure on institutional ownership (Healy, Hutton, and Palepu [1999], Bushee and Noe [2000]) suggests that institutions prefer to buy stock in rms that have superior disclosure or have experienced sustained disclosure increases. However, it seems reasonable that once institutions invest in a particular company they are likely to have added incentives to encourage further improvements in disclosure. This suggests that the link between institutional ownership and disclosure is likely to be endogenous. We carry out several tests examining this issue, including using changes specication and lead-lag (Granger causality) analysis, and controlling for endogeneity between the variables. The link between institutional ownership and forecast properties could also be driven by analyst following, which is shown in prior work to be related to both disclosure and institutional holding (see, for example, Lang and Lundholm [1996] and OBrien and Bhushan [1990]). Similarly, the results on board composition could be driven by underlying rm characteristics that are associated with both disclosure and board composition. We carry out several robustness tests to reduce the possibility that these potential alternative explanations are the source of our results. Although it is impossible to eliminate these explanations, the additional tests indicate an association between outside directors, institutional ownership, and forecast properties, thereby providing greater condence in interpreting the results. Our sample includes annual earnings forecasts issued from 1997 to 2002. In October 2000 a structural change occurred in the voluntary disclosure regulation, with the introduction of Reg FD, which prohibits rms from privately disclosing information to select audiences. Although this regulation has increased the number of forecasts issued (Hein, Subramanyam, and Zhang [2003], Bailey et al. [2003]), the question is whether outside directors and institutional ownership can explain cross-sectional variation in forecast issuances and their properties after Reg FD. We examine this issue as well as any effect that the structural shift might have had on the incentives of outside directors and institutional investors through a subperiod analysis. The results suggest no signicant differences in the association of the two governance proxies with forecast properties in the pre and postReg FD eras. However, the association between concentrated institutional ownership and the probability of forecast occurrence

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is less negative in the postReg FD era, which is consistent with Reg FD reducing the ability of rms to privately communicate information to select audiences. Our results, linking institutional ownership and outside directors to voluntary disclosure, are interesting given the current scrutiny of corporate governance mechanisms and the state of the nancial reporting system. Governance mechanisms and the nancial reporting system have come under siege in the wake of a series of nancial scandals including Enron and WorldCom. These scandals have led to a greater focus on the need for stronger governance and more transparent disclosure. Our results suggest that the two are linkedstronger governance appears to be associated with more transparent disclosure. In a recent working paper, Karamanou and Vafeas [2004] also address the link between corporate governance and disclosure decisions. As in our study, they examine the effects of governance on the properties of management forecasts. They use a much smaller sample consisting of management forecasts issued by 275 Fortune 500 rms from 1995 to 1999 but they examine a broader set of governance variables including number of board meetings and measures of audit committee composition. Their ndings relating to the effect of institutional ownership and outside directors on the properties of management forecasts are generally similar to those we report here.4 The rest of the paper is organized as follows. Section 2 develops the main hypotheses, and section 3 outlines the method we adopt to test our hypotheses. The results are provided in section 4. Section 5 details the additional analyses and robustness checks, and section 6 summarizes and concludes the paper.

2. Outside Directors, Institutional Owners, and Earnings Forecast Properties


2.1
OUTSIDE DIRECTORS AND EARNINGS FORECAST PROPERTIES

Several prior studies document the favorable impact of outside directors on rm decisions aimed at enhancing shareholder wealth.5 Consistent with
4 The other governance variables Karamanou and Vafeas [2004] use generally turn out to be statistically insignicant in their regressions except for audit committee size, which seems to be negatively associated with the probability of issuing a forecast and the precision of the forecast. They also partition the forecasts into good news and bad news, and nd that the effect of governance is stronger for bad news disclosures and that precision decreases with governance only when bad news is conveyed. We, on the other hand, provide simultaneous analyses of the endogeneity between the characteristics of management forecasts and selected governance variables. We also analyze the effect of concentrated institutions on disclosure and use this variable as interacting with sample periods pre and postReg FD to examine the effect of FD on disclosure (see our later discussion). 5 Research shows that rms with outsider-dominated boards are more likely to participate in major restructuring events such as mergers, takeovers, and tender offers (Lin [1996]) and are more likely to remove poorly performing CEOs (Weisbach [1988]) and nominate outside

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these studies, Dechow, Sloan, and Sweeney [1996] and Beasley [1996] nd a negative association between outside directors and likelihood of nancial fraud. Similarly, Klein [2002] documents a negative relation between outside directors and earnings management. Finally, Sengupta [2004] documents that rms with more outside directors are more likely to release their quarterly earnings gures early. These studies suggest that the monitoring role of outside directors extends to the nancial reporting process. Prior work studying earnings forecasts suggests that managers acting in the best interests of the rm should enhance transparency by issuing more frequent, specic, and accurate forecasts (Skinner [1994], Kasznik and Lev [1995], Kim and Verrecchia [1991], Baginski, Conrad, and Hassell [1993], Williams [1996]).6 However, managers acting in their own self-interest could decide to disclose less than what is optimal for various reasons, including insider trading opportunities and reputational risks of erroneous forecasts. Outside directors can mitigate managerial self-interest and inuence the issuance and properties of earnings forecasts by directly reviewing the disclosure policy and earnings releases as well as by fostering an environment that encourages greater transparency. The NIRI [2002], in discussing issues related to earnings guidance and directors role in evaluating the guidance, nds that although the Sarbanes-Oxley Act does not expressly require the board to review earnings releases, several prominent securities lawyers say they advise their clients to do so. Along similar lines, Corporate Board Member magazine [2004] identies the evaluation of investor communications including quarterly teleconferences and press releases as a key role of directors. In addition, a New York Stock Exchange (NYSE) listing requirement is that the audit committee of the board discuss with management information that is presented in press releases, including earnings guidance. As an illustration, one of the key responsibilities and duties of the audit committee of the board of directors for Verizon is to review and discuss with management any proposed public release of earnings or guidance information (http://investor.verizon.com/corp gov/audit nance committee.html).7 The preceding discussion suggests that a greater proportion of outside

CEOs (Borokhovich, Parrino, and Trapani [1996]). Rosenstein and Wyatt [1990] document that shareholder wealth increases with the addition of outsiders to the board, and Cotter, Shivdasani, and Zenner [1997] provide evidence that outside directors enhance shareholder wealth during tender offers. 6 The willingness to enhance transparency, and therefore the optimal disclosure policy, is constrained by the costs of disclosure (including proprietary and litigation costs). 7 We contacted a few companies and directors to obtain further information and anecdotal evidence on this issue. Our sense is that board meetings occur regularly and earnings releases (including guidance) are discussed. In addition, board members are generally given copies of earnings releases ahead of time. One director we spoke to informed us that the audit committee discussed earnings announcements and guidance with the management. If the guidance is offmark, the board would hold the management accountable.

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directors (presumably more independent and effective members) should have a favorable effect on earnings forecast properties. However, an alternative view is that outside directors may be ineffective, either because they are appointed by, or have allegiance to, company managers or because the board culture discourages conict (Mace [1986], Jensen [1993]).8 The effectiveness of outside directors and the extent to which they represent shareholder interests could also be inuenced by the fear of litigation and reputation costs. For example, directors may not induce managers to disclose more precise forecasts for fear of personal litigation and reputation costs. To the extent that the directors own incentives affect their ability to act on behalf of the shareholders, it would bias our results against the hypothesis that outside directors would have a favorable effect on the properties of management forecasts. The following hypothesis summarizes our expectations. H1: Firms with a greater percentage of outside directors on their boards (a) are more likely to issue earnings forecasts, (b) issue forecasts more frequently, (c) are more likely to issue specic (precise) forecasts, (d) are more likely to issue accurate forecasts, and (e) are less likely to issue optimistic forecasts.

2.2

INSTITUTIONAL OWNERSHIP AND EARNINGS FORECAST PROPERTIES

Institutions desire and demand more disclosure. Disclosures, especially earnings forecasts, are closely watched by market participants.9 This can be found by listening in on conference calls, where institutions consistently probe the company for more specic, unbiased, and accurate information about future earnings. Brokerage houses regularly hold conferences where rms make presentations to institutional shareholders about the prospects of the company. Prior work (e.g., Healy, Hutton, and Palepu [1999], Bushee and Noe [2000]) suggests that institutions prefer to buy stocks in rms that have sustained disclosure enhancements. It seems reasonable that these institutions would continue to demand further augmentation of disclosure from the rms. A key precept of the International Corporate Governance Network, a group representing the interests of major institutional investors, corporations, and nancial intermediaries, is related to communications and reporting and states that corporations should disclose accurate, adequate, and timely [italics added] information . . . so as to allow investors to make informed decisions about the acquisition, ownership obligations and rights and sale of shares (Conference Board [2001, p. 10]).
8 Consistent with these arguments, Yermack [1996] and Bhagat and Black [1997] fail to document an association between the proportion of independent outside directors and rm performance. 9 A sell-side (brokerage house) analyst we spoke to stated that one of the key pieces of information the buy-side (including pension funds and asset management funds) investors consistently demand from her and the companies whose stock they own is information about near-term earnings.

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In a recent survey of more than 1,300 fund managers and nancial analysts aimed at identifying the best CFOs, Institutional Investor reports that companies, and CFOs, are being rewarded for delivering on promises. At Pzer, Shedlarzs ability to set rm nancial targets and then hit them has earned praise. Daley of P&G gets high marks for issuing earnings guidance early and often (Osterland [2004, p. 35]). Therefore, though institutions might not be able to directly oversee the activities of the manager (given that they are outsiders), they could elicit greater transparency by demanding more information from the rm. Given this disclosure-oriented focus of institutions and their constant probing of companies for their earnings outlook, we expect to see a positive association with a rms propensity to issue forecasts, the specicity and accuracy of forecasts issued, and a decrease in the managerial optimism bias of forecasts. Our expectations about the impact of institutional ownership on the properties of management forecasts can be summarized in the following hypothesis. H2: Firms with a greater percentage of institutional ownership (a) are more likely to issue earnings forecasts, (b) issue forecasts more frequently, (c) are more likely to issue specic (precise) forecasts, (d) are more likely to issue accurate forecasts, and (e) are less likely to issue optimistic forecasts.

3. Methodology
3.1
SAMPLE SELECTION AND DESCRIPTION

We obtain management earnings forecast data from the Corporate Investor Guidelines (CIG) database, maintained by First Call. The CIG database covers the period from mid-1994 to mid-2003 and has earnings as well as nonearnings forecasts made by companies before the ofcial release of reported earnings. It includes point forecasts, range forecasts, openended forecasts, and qualitative forecasts (such as comfortable with analyst expectations). First Call carries both annual and quarterly forecasts.10 In this study we report results based on annual earnings forecasts only. Separate analyses based on quarterly forecasts were also performed and these are discussed in section 5.6. Panel A of table 1 provides a summary of the screens applied to identify the primary management forecast sample

10 We performed a small-sample test of the comprehensiveness of the CIG database. We picked June 1997 and June 2000 for our test and compared the 182 and 211 forecasts appearing in the CIG database with those extracted from a search of the Factiva (formerly known as the Dow Jones News Retrieval) database. Keywords expects earnings, expects income, expects losses, expects prots, expects results, and three similar lists with rst words forecasts, predicts, and sees were used to identify forecasts from Factiva. These keywords are consistent with those used by Baginski, Hassell, and Kimbrough [2002]. The Factiva search turned up 53 and 84 forecasts made in June 1997 and June 2000, respectively, suggesting that the CIG database is a comprehensive source of management forecast information.

OUTSIDE DIRECTORS, INSTITUTIONAL INVESTORS, AND EARNINGS FORECASTS


TABLE 1 Sample Selection and Description Panel A: Sample-selection criteria All Forecasts Initial sample of all annual forecasts Less: Nonearnings forecasts Preannouncements Multiple forecasts for the same scal period Firms not followed by at least three analysts Forecasts not for 19972002 Governance data unavailable Compustat and other nancial data unavailable Usable annual forecastsa Number of different companies 24,406 (1,097) (1,544) (11,664) (4,244) (1,366) (815) (742) 2,934 1,467 Point Forecasts 5,825 (257) (501) (1,692) (1,091) (766) (231) (242) 1,045 695

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Panel B: Distribution of the frequency of earnings forecasts made by a rm during 19972002 1 2 3 4 5 or More Total Number of rmsb 267 183 142 120 541 1,253

Panel C: Distribution of the specicity of earnings forecasts made by rms during 19972002 Point Range Open Ended Other Total Number of forecastsc 873
a

1,272

551

68

2,764

For tests of occurrence, the forecasting samples were matched with all nonforecasting rms for which requisite data were available to compute the independent variables (4,811 rm-year observations), resulting in the combined sample of 7,745 observations. b Tests of forecast frequency could be performed based on a potential sample of 1,467 rms (from panel A, column 2). However, because forecast frequency from 1997 to 2002 was regressed on averages of the independent variables over the sample period, rms that did not have at least three years of data were dropped, resulting in the reduced sample of 1,253 observations. c Tests of forecast specicity could be performed based on a potential sample of 2,934 observations (forecasting sample in panel A). However, some observations were deleted because analyst following information just before the forecast was not available, resulting in a sample of 2,764 observations. Sample size information is provided at the bottom of each table reporting the regression results.

used in our tests. Initially, we selected all annual earnings forecasts made before the scal period-end (excluding pre-announcements) for 19972002.11 Year 2002 is the last complete year for which explanatory variable data were available. We ignored forecasts made before 1997 for two reasons. First, the number of usable forecasts is substantially lower for years before 1997. It is not clear whether this is solely because of the fewer forecasts made during this period or whether the data collection in the earlier years was less comprehensive. Second, for tests of the probability of forecast occurrence, we match the management forecast sample with all other (nonforecast) rms by scal period for which the requisite data could be obtained. Although the sample was restricted to six years in an effort to reduce problems of interdependence of observations that arise from pooling nancial data for the same rm over multiple years, the duration accommodated the pre and
11 We dene pre-announcements as management forecasts issued after the scal period end but before the actual earnings announcements.

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postReg FD periods. To reduce further problems of data interdependence, if a company made multiple forecasts during a scal period, we retained only the latest forecast.12 The sample of management earnings forecasts was then matched with First Call data on nancial analyst following. Companies that did not have valid ticker symbols or were not followed by at least three analysts were dropped.13 The observations that satised the preceding criteria were then matched with the specied governance data (institutional ownership and outside directors) collected from Compact Disclosure. This database provides information on stock ownership collected from Spectrum and information on ofcers and board of directors collected from proxy statements. The June CD-ROM for each of the years 1997 to 2002 was examined to obtain institutional ownership and outside directors information. The ownership data in these CD-ROMs represent holdings as of March 1 of each year. Every forecast observation was matched with the institutional ownership as of the period immediately preceding March. Thus, a forecast made in between March and December 2000 is matched with institutional ownership as of March 2000, whereas forecasts made in January or February 2000 were matched with institutional ownership as of March 1999. Data on ofcers and boards of directors were based on the latest available proxy statement included in the June CD-ROMs. Finally, some observations were lost because of lack of data for control variables (obtained mainly from Compustat). The nal sample comprises 2,934 annual management earnings forecasts (1,045 point forecasts).14 The control group of companies initially consisted of all rms for which First Call analyst forecast information was available for 1997 to 2002 and for which the company did not make a management earnings forecast. We deleted all rms with less than three analysts following the rm, missing Compustat data, and missing institutional ownership and outside directors data, resulting in a nal control sample of 4,811 observations. We avoid problems relating to outliers by winsorizing the variables at the 1% and 99% levels.
Analyses carried out after retaining the earliest of multiple forecasts yielded similar results. The analysts screen was necessary because one of the key control variables is the standard deviation of analysts forecasts. Analyses carried out without applying this screen yielded similar results (we replaced the standard deviation of analysts forecasts with the standard deviation of stock returns). 14 The actual number of observations used in the regressions varies. For tests of occurrence, the management forecast sample was matched with all other rms for which First Call, governance, and other nancial data were available, resulting in 7,745 observations (2,934 forecasting and 4,811 nonforecasting). For tests of frequency, the number of forecasts made by a company during 19972002 was matched with averages of all control variables calculated from 1997 to 2002. If a company did not have at least three years of data it was dropped, resulting in a sample of 1,253 observations (rms). Tests of forecast specicity were based on a sample of 2,764 forecasts (some of the original forecast sample rms were missing analyst following information before the earnings forecast). For tests of forecast error and bias, only point forecasts were used, resulting in a sample of 1,045 observations (for further clarication, see footnotes to table1).
13 12

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Panel B of table 1 shows the forecast frequency for the sample of 1,253 rms making annual forecasts from 1997 to 2002. The table reveals that 267 companies made only one forecast during the six-year period, whereas 541 rms made ve or more earnings forecasts over the period. Panel C of table 1 provides data on the specicity of the forecasts. The table shows that a large proportion of the forecasts are point and range forecasts.

3.2

RESEARCH DESIGN

3.2.1. Measures of Forecast Properties. To examine the association of institutional ownership and outside directors to voluntary disclosure, we focus on several aspects of management forecasts. Our primary measure is the probability of occurrence of forecasts, dened as: OCCUR = 1 if the rm issued an earnings forecast during the scal period, and 0 otherwise For tests of forecast occurrence, a rm that issues multiple forecasts and one that issues just a single forecast in the period are treated the same. Similarly, a rm might issue just one forecast in our sample period whereas others might be more consistent in their disclosure policy. Sporadic occurrence of forecasts could be attributed to managerial opportunism, as opposed to a consistent disclosure policy induced by governance. If effective governance is inducing disclosure, we should nd an association between the number of forecasts that a rm issued (in our sample period) and the governance variables. This would lend additional support to the results from the occurrence specication. To test this we dene the frequency, or total incidence of forecasts, as: FREQ = total number of forecasts issued by a rm in our sample period (19972002) To evaluate the effect of governance variables on the quality of earnings forecasts issued by management we focus on specicity, accuracy, and optimism (bias) of the forecasts: SPECIFIC = 3 if the rm issued a point forecast during a scal period, 2 if an interval forecast, 1 if an open-ended forecast, and 0 if a qualitative forecast ERROR = absolute value [(management forecast of earnings per share (EPS) actual EPS)/price at the beginning of the scal period]. Accuracy of forecasts is the inverse of ERROR .15
15 The actual earnings numbers, as well as the forecasts, are both derived from First Call to ensure consistency across the two numbers. The actual earnings number represents the actual per share numbers reported by the companies following a scal period-end. According to First Call, the actual values have been adjusted to exclude any unusual items that a majority of the contributing analysts deem nonoperating or nonrecurring. Similarly, the majority of analysts estimates on First Call are real time and come from broker notes or through electronic transmission and are adjusted to exclude any unusual items that a majority of the contributing

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BIAS = [(management forecast of EPS actual EPS)/price at the beginning of the scal period]. If BIAS > 0, the earnings forecast is optimistically biased. 3.2.2. Measures of Corporate Governance. To determine the association between the voluntary information disclosure environment and corporate governance, we specify two widely used measures of corporate governancethe proportion of the board consisting of outsiders and the proportion of aggregate institutional ownership: OUTDIR = percentage of the board of directors that are not also ofcers of the rm16 INST = percentage of the companys aggregate common stock held by institutions 3.2.3. Control Variables. Based on prior research, we selected several additional independent variables to control for other possible determinants of the properties of management forecasts: LMVAL = log of the market value of a rms common equity at the beginning of the scal period. The prior literature provides evidence supporting the positive association between rm size and management earnings forecasts (e.g., Kasznik and Lev [1995]). AUDIT = 1 if the company is audited by one of the Big 5 auditors, and 0 otherwise. Auditor reputation could also be a factor in disclosure decisions. Thus, prior research indicates that rms using Big 5 auditors tend to have better disclosure (Lang and Lundholm [1993]). NUMEST = number of analysts following the rm. Prior research (Lang and Lundholm [1993, 1996]) documents a positive association between corporate disclosure quality and the number of analysts following a rm. LITIGATE = 1 for all rms in the biotechnology (28332836 and 8731 8734), computers (35703577 and 73707374), electronics (36003674), and retail (52005961) industries, and
analysts deem nonoperating or nonrecurring. We called First Call to discuss this issue and were told that in the event of an outlier analyst forecast or perceived nonconformity of an analyst with the construct of the majority of analysts, an editor contacts the outlier analyst to determine whether it is just a difference of opinion or difference in construct, and the editor takes corrective action accordingly. To the extent that management guidance is intended to inuence analysts forecasts and market expectations, it would seem reasonable that managers are forecasting the same construct as analysts (and First Call actuals). However, it is possible in some cases that the construct that managers are forecasting and that is captured on First Call is different from the analysts forecasts and actual earnings construct. Unless this difference is systematically correlated with our explanatory variables of interest (INST and OUTDIR ), it should not bias our results. 16 We also use the number of outside directors as an alternative proxy for this variable. This yielded results that are similar to those reported with OUTDIR .

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MKBK =

LOSS =

HORIZON =

SURPRISE = DISPFOR =

NEWS =

0 otherwise (based on Francis, Philbrick, and Schipper [1994]). Furthermore, Jones and Weingram [1996] nd that market capitalization and equity beta are both determinants of litigation risk. We use both these measures as controls in our analyses. ratio of market value to book value of common equity at the beginning of the scal period. We use MKBK as a proxy for proprietary costs (Bamber and Cheon [1998]). In keeping with Bamber and Cheon [1998], we also use sales concentration as an alternative proxy to measure proprietary costs. The results based on this second proxy (not reported) were similar to those using MKBK . 1 if the rm reported losses in the current period, and 0 otherwise. Prior research suggests that earnings are less value relevant for loss-making rms (Hayn [1995]) and that meeting or beating nancial analyst expectations is less important for these rms (Degeorge, Patel, and Zeckhauser [1999]). Brown [2001] documents substantial differences between the analyst forecast errors of loss and prot rms. Analysts have greater problems forecasting earnings for loss rms. It is therefore likely that managements ability to forecast earnings would be similarly circumscribed for rms making losses. number of days between the forecast date and the scal period-end date. Prior work uses this measure to proxy for greater earnings uncertainty and the unobservable precision of managers beliefs (Baginski and Hassell [1997]). absolute value [(management forecast of EPS median analyst forecast of EPS)/price at the beginning of the scal period] standard deviation of analysts forecasts divided by the median forecast. This variable captures the interanalyst uncertainty in the earnings prospects of a rm (Ajinkya and Gift [1984], Brown, Foster, and Noreen [1985], Swaminathan [1991]). Analogously, management would also likely nd it more difcult to forecast earnings when the value of this variable is higher and could face greater litigation exposure. 1 if the current-period EPS is greater than or equal to the previous-period EPS, and 0 otherwise. Baginski, Hassell, and Kimbrough [2002] nd that the sign of random-walk differences in earnings is negatively associated with forecast occurrence. Bhojraj [2002] suggests that a reason for this negative association is that management is likely to issue a forecast in this case (i.e., if NEWS = 0) to prevent unfavorable litigation.

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EARNVOL = standard deviation of quarterly earnings over 12 quarters ending in the current scal year, divided by median asset value for the period. Waymire [1985] nds an association between a rms earnings volatility and the frequency of management earnings forecasts. Kross, Lewellen, and Ro [1994] use a similar measure called stability, dened as the standard deviation of return on equity. BETA = equity beta for the scal period. This variable represents the proxy for market risk (Bushee and Noe [2000]). FD = 1 if the observation is related to the postReg FD period (after October 2000), and 0 otherwise. Hein, Subramanyam, and Zhang [2003] and Bailey et al. [2003] nd that the number of forecast issuances has increased after Reg FD. The variables DISPFOR , EARNVOL , and BETA (and to a limited extent LOSS ) capture different and possibly overlapping dimensions of uncertainty; hence, the respective coefcients of these variables may not all be statistically signicant. The appendix provides a complete listing of all variable denitions. 3.2.4. Regression Specications. The specications of the various regressions are as follows: OCCUR = 0 + 1 OUTDIR + 2 INST + 3 LMVAL + 4 AUDIT + 5 NUMEST + 6 DISPFOR + 7 LITIGATE + 8 MKBK + 9 LOSS + 10 NEWS + 11 EARNVOL + 12 BETA + 13 FD (1) FREQ = 0 + 1 OUTDIR + 2 INST + 3 LMVAL + 4 AUDIT + 5 NUMEST + 6 DISPFOR + 7 LITIGATE + 8 MKBK + 9 LOSS + 10 NEWS + 11 EARNVOL + 12 BETA SPECIFIC = 0 + 1 OUTDIR + 2 INST + 3 LMVAL + 4 AUDIT + 5 NUMEST + 6 DISPFOR + 7 LITIGATE + 8 MKBK + 9 LOSS + 10 NEWS + 11 EARNVOL + 12 BETA + 13 FD +14 HORIZON ERROR = 0 + 1 OUTDIR + 2 INST + 3 LMVAL + 4 AUDIT + 5 NUMEST + 6 DISPFOR + 7 LITIGATE + 8 MKBK + 9 LOSS + 11 EARNVOL + 12 BETA + 15 SURPRISE (4) (3) (2)

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BIAS = 0 + 1 OUTDIR + 2 INST + 3 LMVAL + 4 AUDIT + 5 NUMEST + 6 DISPFOR + 7 LITIGATE + 8 MKBK + 9 LOSS + 11 EARNVOL + 12 BETA + 15 SURPRISE (5)

Because the dependent variable, OCCUR , is a binary variable, we estimate equation (1) with a probit model. For the dependent variable, SPECIFICITY , which has four ordinal values, we use an ordered probit model on equation (3). We use an ordinary least squares (OLS) model to estimate equations (2), (4), and (5). For tests of occurrence, NUMEST and DISPFOR were calculated based on the last analyst forecast data available before the scal year-end. For the other four dependent variables, NUMEST and DISPFOR were calculated based on the latest data available before the management forecast date.

4. Results
Summary descriptive statistics for selected variables are provided in panels A and B of table 2. Panel A provides summary statistics for variables based on 2,934 annual forecast observations. Summary statistics for ERROR , BIAS , HORIZON , and SURPRISE are based on the sample of 1,045 observations used for tests of forecast accuracy and bias. Panel B of table 2 also provides summary statistics of the key variables for the control (nonforecasting) group. Forecasting rms tend to be larger, with a median market value of equity of about $1.43 billion compared with approximately $805 million for the nonforecasting sample. Median institutional ownership is about 64% for the forecast sample and about 54% for the nonforecast sample. The median number of analysts following the rm is eight for the forecast sample and six for the nonforecasters. Table 3 presents results of our basic analysis examining the link between our governance measures and forecast occurrence, frequency, and specicity. Column 3 shows that the probability of occurrence of a management earnings forecast is, as expected, positively associated with the two governance variables, OUTDIR and INST , and the respective coefcients are statistically signicant at the .01 level. Several of the control variables in this regression are in the expected direction and signicant (including LMVAL , NUMEST , LOSS , and BETA). Consistent with Miller and Piotroski [2000], we nd that LITIGATE has a positive and signicant effect on forecast occurrence. The coefcient on FD is positive and highly signicant, which is consistent with prior work (Hein, Subramanyam, and Zhang [2003], Bailey et al. [2003]) that shows an increase in the level of forecast activity after the introduction of Reg FD. Hein, Subramanyam, and Zhang [2003] argue that previously private information releases might be substituted for public disclosures after Reg FD. Column 4 of table 3 provides regression results of tests of the effect of our governance measures on the frequency of earnings forecasts. The results

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TABLE 2 Descriptive Statistics

Variables Mean Panel A: Forecasting group ERROR a 0.022 0.018 BIAS a HORIZON a 173.881 0.007 SURPRISE a INST 60.977 INST5 24.534 INSTCONS 0.023 OUTDIR 71.633 MVAL b 8.612 AUDITOR 0.759 NUMEST 9.685 DISPFOR 0.004 LITIGATE 0.307 MKBK 4.202 LOSS 0.123 NEWS 0.478 EVARNVOL 0.034 BETA 1.047 DE 0.490 YIELD 0.010 LIQUID 0.148 Panel B: Control groupc MVAL b 4.291 INST 50.413 OUTDIR 68.535 MKBK 3.871 NUMEST 7.568

Std. Dev. 0.067 0.068 112.364 0.017 21.859 10.354 0.032 19.803 28.095 0.428 6.097 0.069 0.461 5.108 0.329 0.500 0.084 0.699 0.382 0.015 0.843 14.788 25.837 21.690 5.219 5.005

Median 0.003 0.000 161.000 0.001 64.100 23.861 0.018 76.923 1.425 1.000 8.000 0.001 0.000 2.714 0.000 0.000 0.014 0.913 0.451 0.001 0.098 0.805 53.580 73.684 2.400 6.000

25% 0.001 0.001 70.000 0.000 47.400 17.422 0.010 66.667 0.534 1.000 5.000 0.000 0.000 1.714 0.000 0.000 0.008 0.595 0.103 0.000 0.347 0.303 31.510 60.000 1.564 4.000

75% 0.017 0.015 263.000 0.004 77.200 30.943 0.029 84.615 5.020 1.000 13.000 0.002 1.000 4.686 0.000 1.000 0.030 1.342 0.914 0.015 0.660 2.645 70.750 83.333 4.083 10.000

Variables are dened in the appendix. a Summary statistics for ERROR , BIAS , HORIZON , and SURPRISE are based on the sample of 1,045 point forecasts; summary statistics for the other variables are based on the sample of 2,934 annual earnings forecasts. b MVAL represents market value of common equity in $ billions. In regressions, log of market value of common equity (in $ millions) is used. c The summary statistics for the control sample were calculated based on the sample of 4,811 observations that were matched with the annual forecast data for tests of occurrence.

indicate that the coefcient on OUTDIR is positive and signicant at the .05 level. The coefcient on INST is also positive and signicant (one sided p -value < .05). Thus, it appears that rms with effective governance mechanisms in place are likely to have more frequent earnings forecast disclosures. Fewer of the control variables are signicant in explaining FREQ compared with OCCUR . NUMEST and LITIGATE cease to be signicant in explaining forecast frequency. However, the results suggest that rms with greater volatility (proxied by EARNVOL ) are likely to issue forecasts less frequently. Next, we evaluate another important property of the dependent variable, that is, how specic (or precise) the disclosure is provided that disclosure (management forecast) occurs. Column 5 of table 3 summarizes the results

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TABLE 3 Regression Results of the Effects of Outside Directors and Institutional Ownership on the Probability of Occurrence of Annual Earnings Forecasts, Frequency, and Specicity Predicted Sign ? + + + + + ? + Forecast Occurrence Forecast Frequency Forecast Specicity (OCCUR ) (FREQ ) (SPECIFIC ) 1.5804 2.7708 2.0473 (15.226) (2.684) (12.899) 0.0030 0.0164 0.0006 (4.048) (1.680) (0.572) 0.0085 0.0130 0.0039 (1.963) (4.022) (12.937) 0.0466 0.9197 0.0329 (3.642) (6.458) (1.829) 0.0328 0.2610 0.1111 (0.930) (0.851) (2.207) 0.0203 0.0493 0.0066 (5.641) (1.068) (1.259) 0.0335 0.1592 0.2106 (0.201) (0.737) (0.553) 0.1906 0.0605 0.0605 (4.948) (0.190) (1.183) 0.0050 0.0128 0.0043 (1.506) (0.346) (1.025) 0.4195 1.2942 0.1994 (2.814) (3.052) (9.387) 0.0213 1.8266 0.0172 (0.687) (3.037) (0.395) (0.0920) 2.0710 0.0173 (0.878) (2.115) (0.872) 0.1505 1.1278 0.0449 (4.321) (1.369) (5.829) 0.0004 (2.538) 0.5887 0.1251 (17.883) (2.674) 4,607.12 3,109.79 0.20 7,745 1,253 2,764

359

Intercept OUTDIR INST LMVAL AUDIT NUMEST DISPFOR LITIGATE MKBK LOSS NEWS EARNVOL BETA HORIZON FD

Log likelihood Adjusted R 2 No. of observations

Variables are dened in the appendix. Whites [1980] heteroskedasticity-adjusted t -values are provided in parentheses below each coefcient. , , and indicate signicance at the 10%, 5%, and 1% levels, respectively (one-tailed test, except for the intercept and LITIGATE ).

of the ordered probit regression. INST is positively associated with the specicity of earnings forecasts (signicant at the .01 level). Outside directors, however, do not seem to inuence the specicity of forecasts. The coefcient is negative, although not statistically signicant. This nding could be attributable to the personal incentives (discussed earlier), including fear of litigation, constraining the outside directors willingness to facilitate more specic disclosure. Although outside directors might be willing to facilitate forecast issuance, they might leave the specicity of the forecast to the discretion of the manager. Among the control variables, the result relating to

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LOSS is particularly interesting. The evidence from the last three columns suggests that a manager is less likely to have issued a forecast when the rm reports a loss. Another provocative nding is that although forecast occurrence has increased after Reg FD (column 3), specicity is reduced (column 5). Thus the coefcient for FD is negative and signicant at the .01 level in column 5. Although this nding may be explained in various ways, we posit the following hypothesis. When the forecast environment changed after Reg FD (and the nancial analyst channel was shut off), rms for which the costbenet ratio of disclosure was marginally unfavorable before Reg FD might be willing to forecast earnings publicly for the rst time provided they could do so with less specicity and thereby reduce the costs of disclosure. This may suggest why after Reg FD, the specicity would be reduced even though occurrence has increased.17 Results of tests of the association of corporate governance with the accuracy of management earnings forecasts are presented in table 4 (dependent variable used is ERROR , inverse of accuracy). Outside directors (OUTDIR ) are, as expected, positively (negatively) associated with forecast accuracy (ERROR ), with the coefcient statistically signicant at the .01 level. The coefcient on INST is also positively related to accuracy and statistically signicant at the .01 level. This nding is in accordance with institutions consistently probing rms for more accurate information. Among the control variables, HORIZON , DISPFOR , EARNVOL , and SURPRISE are inuential when the dependent variable is management forecast ERROR . A longer HORIZON measure (i.e., earlier management forecast relative to scal year-end date) suggests a greater forecast error. DISPFOR , which measures interanalyst earnings forecast uncertainty, is positively associated with management forecast ERROR . Table 4 also summarizes the regression results of the association of the governance variables with the ex post bias in management earnings forecasts. A positive value of BIAS suggests that managers are optimistic in their forecasts. The table shows that the coefcients for OUTDIR and INST are negative, as expected, and signicant at conventional levels. This is consistent with the view that a greater proportion of outside directors and larger institutional ownership are associated with more conservative (as opposed to optimistic) forecasts. The coefcients of the control variables HORIZON , EARNVOL , and SURPRISE are statistically signicant in expected directions.18

17 We conducted additional analysis to check whether our conjecture is valid. We tabulated specicity for two groups of rms: (1) those that forecast only in the postReg FD period and did not forecast in the preReg FD period, and (2) those that disclosed both in the pre and postReg FD period. The rst group had lower specicity, consistent with our argument. The difference in specicity between the two groups is statistically signicant at p -value < .05. 18 We also carried out our analysis using a dichotomous variable OPTIM , where OPTIM = 1 if the forecast was optimistically biased, and 0 otherwise. The results are similar to the BIAS ndings. Also, FD is omitted in the ERROR and BIAS regressions. Hein, Subramanyam, and

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TABLE 4 Regression Results of the Effect of Outside Directors and Institutional Ownership on the Error and Bias in Managements Annual Earnings Forecasts Forecast Accuracy Forecast Bias Predicted Sign (Dependent Var. = ERROR ) (Dependent Var. = BIAS ) Intercept ? 0.0340 0.0299 (2.085) (1.798) OUTDIR 0.0002 0.0002 (2.331) (1.835) INST 0.0003 0.0003 (2.183) (2.348) HORIZON + 0.0001 0.0001 (6.006) (5.286) LMVAL 0.0014 0.0018 (1.109) (1.352) AUDIT 0.0013 0.0028 (0.298) (0.600) NUMEST 0.0000 0.0000 (0.116) (0.052) DISPFOR + 1.3500 0.6284 (2.588) (1.132) LITIGATE ? 0.0006 0.0022 (0.125) (0.447) MKBK + 0.0006 0.0005 (2.089) (1.649) LOSS + 0.0059 0.0032 (0.640) (0.338) EARNVOL + 0.1564 0.1351 (2.086) (1.834) BETA + 0.0021 0.0011 (0.658) (0.321) SURPRISE + 0.9010 0.9882 (4.093) (4.426) Adjusted R 2 0.16 0.13 No. of observations 1,045 1,045
Variables are dened in the appendix. Whites [1980] heteroskedasticity-adjusted t -values are provided in parentheses below each coefcient. , , and indicate signicance at the 10%, 5%, and 1% levels, respectively (one-tailed test, except for the intercept and LITIGATE ).

361

The results in tables 3 and 4 are consistent with the argument that outside directors foster an environment of greater disclosure transparency. Outside directors are associated with a greater likelihood of earnings forecasts and greater frequency of earnings forecasts as well as more accurate and conservative forecasts. Institutional ownership is similarly associated with disclosure quality. Firms with high institutional ownership are not only more likely to issue a forecast but tend to forecast more frequently, and the forecasts are more specic, accurate, and conservatively biased. Although we
Zhang [2003] nd that, for analysts earnings forecasts, there is no change in accuracy or bias after Reg FD. We had initially included FD , but because of insignicant results, we decided to exclude this variable in table 4.

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view the improvements in disclosure as arising primarily from the demand pressure generated by institutional investors, to the extent the disclosures are in the interests of all shareholders, we see an indirect governance role from institutional investors.

5. Additional Analyses and Robustness Checks


5.1
ENDOGENEITY BETWEEN INSTITUTIONAL OWNERSHIP AND DISCLOSURE

The positive association between institutional ownership and disclosure can be explained in two ways. Healy, Hutton, and Palepu [1999] and Bushee and Noe [2000] suggest that institutions prefer to buy stock in rms that have superior disclosure. However, institutions also have incentives to encourage greater disclosures from companies in which they choose to invest. This suggests that the link between institutional ownership and disclosure is likely to be endogenous. Although ownership decisions could be inuenced by a rms disclosure policy, it is also reasonable that a rms disclosure policy is inuenced by its institutional ownership. Thus, disclosure could lead to future institutional ownership, which in turn could lead to future disclosure, and so on. We examine this endogenous link between our governance variables and the propensity to disclose by adopting (1) a Granger-type leadlag approach and (2) a simultaneous equation analysis. The specication of the lead-lag regression is as follows: OCCUR = 0 + 1 OCCURL + 2 OUTDIR + 3 INST + 4 LMVAL + 5 AUDIT + 6 NUMEST + 7 DISPFOR + 8 LITIGATE + 9 MKBK + 10 LOSS + 11 NEWS + 12 EARNVOL + 13 BETA + 14 FD , where: OCCURL = OCCUR lagged one period. In this specication, INST lags the dependent variable OCCUR . OCCURL in turn lags INST , such that the time sequence is OCCURL INST OCCUR . The purpose of this specication is to isolate the incremental explanatory power of INST on future disclosure after controlling for the potential effect of prior disclosure on INST .19 We also estimate a simultaneous equations system of the form: OCCUR = 0 + 1 OUTDIR + 2 INST + 3 LMVAL + 4 AUDIT + 5 NUMEST + 6 DISPFOR + 7 LITIGATE + 8 MKBK + 9 LOSS + 10 NEWS + 11 EARNVOL + 12 BETA + 13 FD , (7a)
19 See Hamilton [1994, pp. 30405] for a description of econometric tests for Granger causality.

(6)

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INST = 0 + 1 OCCUR + 2 LMVAL + 3 AUDIT + 4 NUMEST + 5 LITIGATE + 6 MKBK + 7 LOSS + 8 NEWS + 9 BETA + 10 DE + 11 YIELD + 12 LIQUIDITY + 13 SNP . (7b)

Control variables for equation (7b) are drawn from prior work, including OBrien and Bhushan [1990], Bushee and Noe [2000], and Bushee [2001]. Control variables not dened earlier and used in equation (7b) are as follows: DE = ratio of long-term debt to stockholders equity. This variable controls for the possibly negative relationship between institutional ownership and leverage. YIELD = dividend yield for the scal period. This variable captures the effect of performance based on which institutions might make ownership decisions. LIQUIDITY = log(trading volume/shares outstanding). This controls for an institutions preference for more liquid stocks. SNP = 1 if the company is part of the S&P 500, and 0 otherwise. This variable captures preference for S&P 500 stocks. If institutional ownership induces disclosure, the coefcient for INST in equation (7a) should be positive. The estimation of the system of equations was performed by rst regressing each endogenous variable on all exogenous variables (instruments). In the second stage, equations (7a) and (7b) were separately estimated with the right-side endogenous variable replaced by its tted value from the rst-stage regression.20 In the preceding specications, the disclosure variable equals 1 if the rm issued a forecast in a given period, and 0 otherwise. Our approach is analogous to two-stage least squares, but not identical, because one of the equations requires a probit analysis. Column 3 of table 5 provides results of governance effects after controlling for past forecast occurrence. The coefcient of OCCURL is positive and statistically signicant at the .01 level, suggesting that past disclosure is a good indicator of future disclosure. However, as we posited, INST continues to provide signicant explanatory power, suggesting that institutional ownership is associated with future disclosure after controlling for the correlation between institutional ownership and past disclosure. The Granger test comparing the restricted and unrestricted sum of squares residuals rejected the null hypothesis of INST = 0 at p -value < .001. Columns 4 and 5 of table 5 provide results of the simultaneous regression analysis. Consistent with prior work, we nd that institutional ownership is inuenced by disclosure practices (column 5, equation (7b)). More important, and consistent with our expectations of an endogenous relationship,
20 See Maddala [1983, p. 244] for a discussion of this issue. Because OCCUR is a binary variable, (7a) was estimated using probit both in the rst and second stages.

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TABLE 5 Granger Causality and Simultaneous Determination of Forecast Occurrence and Institutional Ownership Two-Stage Least Squares Estimation with INST Endogenous (OCCUR ) 2.176 (18.714) (INST ) 50.5859 (29.397) 3.4573 (3.876)

Predicted Sign Intercept OCCUR OCCURL OUTDIR INST LMVAL AUDIT NUMEST DISPFOR LITIGATE MKBK LOSS NEWS EARNVOL BETA FD DE YIELD LIQUIDITY SNP Log likelihood Adjusted R 2 ? + + + + + + + ? + + +

Occurrence Regression with Lagged Occurrence 1.452 (13.436) 1.193 (30.939) 0.002 (2.821) 0.006 (9.115) 0.017 (1.271) 0.033 (0.890) 0.015 (3.774) 0.152 (0.630) 0.188 (4.730) 0.007 (1.979) 0.389 (8.261) 0.005 (0.160) 0.157 (0.828) 0.116 (4.263) 0.468 (13.279)

0.002 (3.218) 0.022 (15.810) 0.056 (4.289) 0.009 (0.249) 0.007 (1.966) 0.314 (1.957) 0.174 (4.495) 0.008 (2.275) 0.324 (7.008) 0.008 (0.248) 0.382 (2.027) 0.181 (6.857) 0.515 (15.296)

1.9234 (6.681) 2.1461 (3.929) 0.0662 (1.084) 3.2361 (5.048) 0.3983 (7.770) 4.9714 (6.679) 1.8963 (4.046) 6.9689 (10.914) 2.3118 (3.029) 119.5646 (2.741) 12.8980 (30.198) 1.2141 (1.590) 0.32

5,090.60

4,561.73

Regressions are based on a sample of 7,745 observations. Variables are dened in the appendix. Whites [1980] heteroskedasticity-adjusted t -values are provided in parentheses below each coefcient. , , and indicate signicance at the 10%, 5%, and 1% levels, respectively (one-tailed test, except for the intercept and LITIGATE ).

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we nd that institutional ownership continues to be associated with occurrence of forecasts (column 4, equation (7a)) and is statistically signicant at the .01 level in this simultaneous equations setting. Outside directorship also continues to be a signicant factor in explaining forecast occurrence. Among the control variables, LMVAL , NUMEST , LITIGATE , LOSS , BETA, and FD are consistently effective in explaining forecast occurrence.

5.2

CHANGES SPECIFICATION

To examine the robustness of our results, we perform additional analysis examining the association between changes in institutional ownership and outside directors and changes in the number of earnings forecasts issued by a company over a scal year. The specication is as follows: FREQ = 0 + 1 OUTDIR + 2 INST + 3 LMVAL + 4 AUDIT + 5 NUMEST + 6 DISPFOR + 7 LITIGATE + 8 MKBK + 9 LOSS + 10 NEWS + 11 EARNVOL + 12 BETA. (8)

We include both annual and quarterly forecasts for the analysis to increase the power of our tests for the changes specication. All other variables are as dened earlier, and the changes are measured annually. The change in the number of forecasts issued (FREQ ) is measured for the period after the change in institutional ownership and outside directors. The results of this analysis are provided in table 6. The coefcient on the change in outside directors is positive and statistically signicant at the .10 level, which indicates that rms that increase their outside directorships have a subsequent increase in disclosure. The coefcient on the change in institutional ownership is also positive and signicant (p -value < .01). Among the control variables, changes in AUDIT and NUMEST seem to explain the change in forecast frequency.21

5.3

CONCENTRATED INSTITUTIONAL OWNERSHIP AND THE EFFECT OF REG FD

The analysis thus far is based on the argument that institutional owners, on average (or in the aggregate), act as outsiders relative to management. However, prior work nds that under certain circumstances institutions behave like insiders. Specically, these studies nd that when ownership in a rm is concentrated in the hands of a few institutions, these institutions are likely to have an undue inuence over management, whereby they secure self-serving benets that are detrimental to other capital providers (other

21 Table 6 considers all observations of changes. We performed an alternate regression where we eliminated observations with no change in the dependent variable, and the results still held (improved marginally).

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TABLE 6 Regression Results of the Effects of Changes in Outside Directors and Institutional Ownership on Changes in the Number of Managements Earnings Forecasts Predicted Sign ? + + + + + ? + Change in the Number of Forecasts (All Changes) 0.0815 (7.654) 0.0007 (1.433) 0.0017 (3.714) 0.1853 (8.510) 0.1431 (2.905) 0.0399 (9.422) 0.0405 (0.561) 0.1372 (1.242) 0.0013 (2.109) 0.0060 (0.199) 0.0108 (0.714) 0.0085 (0.041) 0.0950 (3.237) 6,571 0.04

Intercept OUTDIR INST LMVAL AUDIT NUMEST DISPFOR LITIGATE MKBK LOSS NEWS EARNVOL BETA No. of observations Adjusted R 2

The dependent variable represents the change in the number of earnings forecasts made by the rm during a scal year (change is calculated as the difference over two consecutive scal periods). All other variables are as dened in the appendix except that each variable represents changes over two consecutive scal years. Whites [1980] heteroskedasticity-adjusted t -values are provided in parentheses below each coefcient. , , and indicate signicance at the 10%, 5%, and 1% levels, respectively (one-tailed test, except for the intercept and LITIGATE ).

shareholders and bondholders).22 These concentrated (or blockholder) institutions often have better access to private information (Porter [1992]) and consequently may not press the rms for public disclosures. Some may actively prefer fewer forecasts or forecasts of lower quality, thereby giving them an advantage relative to the market. Effectively, concentrated ownership can be seen as analogous to insiders. In such a case, voluntary public
22 This is called the private benets hypothesis . Consistent with this argument, Bhojraj and Sengupta [2003] nd that bond yields (ratings) are negatively (positively) associated with institutional ownership but positively (negatively) associated with ownership concentration. See Barclay and Holderness [1992] for a discussion of the private benets and the shared benets hypotheses. Other studies examining the benets of large blockholders include Huddart [1993] and Maug [1998].

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disclosure may suffer and thus would lessen the quality of management forecasts. We choose two alternate proxies for concentrated ownership vis-` a-vis institutional incentives:23 INST5 = percentage of companys common stock held by the ve largest institutional owners of the rm INSTCONS = Herndahl index of institutional ownership concentration, measured as:
N i =1

shares held by institution i total shares outstanding

The argument that concentrated institutions may discourage frequent disclosures rests on the assumption that these institutions have access to private information from the rms. In October 2000, Reg FD was introduced, which prohibited rms from privately disclosing information to select audiences. The regulation was intended to level the playing eld among individuals, analysts, and institutional investors through enhanced and simultaneous public disclosure of information. If Reg FD indeed increased the cost of private information transfer from rms to favored audiences, which includes large and concentrated institutional owners, we would expect concentrated institutional ownership to have a less negative or dampening effect on disclosure (or zero effect if Reg FD was completely effective) in the post Reg FD period. We examine this issue by including an additional explanatory variable that interacts the concentrated institutional ownership variable with the FD variable. Table 7 provides the results of including FD (a dummy variable that equals 1 for the postReg FD years 2001 and 2002, and 0 otherwise), INST5 or INSTCONS , and the interaction of either of these two concentrated institutional ownership measures with FD in our occurrence regressions. Several observations can be made from the results. First, the coefcients for INST5 and INSTCONS both turn out to be negative and statistically signicant at the .01 level as expected, suggesting that the probability of issuing a forecast is lower when institutional ownership is highly concentrated (similar results were obtained when we performed the regressions without the interaction terms).24 The interaction terms INST5 FD and INSTCONS FD , however,
23 Similar variables are used in the prior literature (e.g., Brickley, Lease, and Smith [1988], Agrawal and Mandelker [1990], Baysinger, Kosnik, and Turk [1991]). Bushee [1998] and Bushee and Noe [2000] devise a compound partition that combines private benets and investment horizons whereby institutions are separated into three classes: dedicated, quasi-indexers, and transient. As an alternative to our two measures, we conducted a separate analysis using Bushees three-way classication. The results of this separate analysis (not reported) showed that rms with a larger fraction of shares held by dedicated institutions were less likely to issue earnings forecasts. This is consistent with the results we report based on our measures of institutional ownership concentration. 24 Similar results are found for the specicity (SPECIFIC ) regression (i.e., higher institutional concentration leads to forecasts of lower precision). However, the concentrated institutional ownership variables are not signicant in explaining forecast error (ERROR ) and bias (BIAS ).

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TABLE 7 Regression Results of the Effect of the Nature of Institutional Ownership on the Probability of Occurrence of an Earnings Forecast and the Differential Impact of Such Ownership in the Pre and PostRegulation Fair Disclosure Periods Intercept OUTDIR INST INST5 INSTCONS INST5 FD INSTCONS FD LMVAL AUDIT NUMEST DISPFOR LITIGATE MKBK LOSS NEWS EARNVOL BETA FD Log likelihood No. of observations Predicted Sign ? + + + + + + + ? + Model 1 1.3655 (11.786) 0.0030 (3.981) 0.0122 (11.943) 0.0117 (4.759) 0.0041 (1.461) 0.0290 (2.150) 0.0343 (0.973) 0.0190 (5.245) 0.0416 (0.251) 0.1880 (4.873) 0.0051 (1.529) 0.4011 (8.794) 0.0180 (0.577) 0.1596 (0.846) 0.1565 (5.949) 0.4894 (6.448) 4,596.66 7,745 Model 2 1.5640 (14.998) 0.0030 (3.997) 0.0098 (14.190) 2.5722 (6.812) 0.9921 (1.531) 0.0442 (3.424) 0.0364 (1.032) 0.0190 (5.260) 0.0332 (0.199) 0.1868 (4.846) 0.0050 (1.509) 0.4100 (9.026) 0.0189 (0.604) 0.1603 (0.855) 0.1553 (5.912) 0.5669 (15.452) 4,598.07 7,745

Variables are dened in the appendix. Whites [1980] heteroskedasticity-adjusted t -values are provided in parentheses below each coefcient. , , and indicate signicance at the 10%, 5%, and 1% levels, respectively (one-tailed test, except for the intercept and LITIGATE ).

turn out to be positive and statistically signicant at the .1 level, indicating that the effect of the concentrated institutional ownership is less negative in
A possible explanation for this latter result is that once the decision to disclose is made, the concentrated institutional owners may not want the information to be biased or erroneous for litigation reasons.

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the postReg FD period than in the preReg FD period. Additional tests reveal that in the postReg FD environment, the marginal impact of concentrated ownership remains negative and signicant (p -value = .01). These results suggest that Reg FD has been partially effective in reducing private information communication, although institutions seem to continue deriving private information benets, even in the postReg FD era. This is consistent with an Institutional Investor [2001] survey of approximately 1,600 CFOs that nds that although almost 57% of CFOs had private conversations with analysts in the preReg FD environment, only 37% continue to do so in the postReg FD environment. We carry out additional analysis to explore differences in the association between institutional ownership, outside directors, and forecasts disclosure. Untabulated results indicate that there is no signicant shift in coefcient values of INST and OUTDIR across the two regimes.

5.4

FIRM CHARACTERISTICS AND OUTSIDE DIRECTORS

One possible explanation for the results relating to OUTDIR is that the proportion of outside directors is related to underlying rm characteristics, which could also be related to disclosure. However, there is little prior work relating rm characteristics to board composition. Denis and Sarin [1999] nd that the proportion of outside directors is related to the size of rm, size of the board, and the industry median ratio of market to book value. We therefore carry out a two-stage analysis where we initially regress OUTDIR on these characteristics. The error term from this regression represents the portion of OUTDIR not explained by the rm characteristics identied in the prior literature. In the second stage, we regress OCCUR on the error term from the rst-stage regression and control variables. Untabulated results from this analysis nd that the error term is signicant in explaining OCCUR , suggesting that OUTDIR continues to be signicant after controlling for known underlying rm characteristics that affect OUTDIR . It is also possible that the proportion of outside directors is the result of greater investor oversight that is also the source of greater disclosure. To examine this possibility, we carry out a simultaneous equation analysis with a system of three equations where OCCUR , INST , and OUTDIR are endogenous.25 We include several variables that proxy for investor oversight in the OUTDIR regression, including analyst following, industry dummy, size, and institutional ownership. OUTDIR continues to be signicant in explaining OCCUR in this specication. Although this suggests that outside directors are associated with disclosure beyond that accounted for by proxies of investor oversight, we cannot rule out this alternative explanation.

25 See the excellent survey paper on boards of directors and endogeneity by Hermalin and Weisbach [2003].

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5.5

ENDOGENEITY BETWEEN INST AND NUMEST

OBrien and Bhushan [1990] document a simultaneous relationship between INST and NUMEST . It is therefore possible that the results for INST could be due to the underlying inuence of NUMEST on INST . We attempt to control for this possibility in two ways. First, we carry out a simultaneous equation analysis with a system of three equations where OCCUR , INST , and NUMEST are endogenous. INST continues to be a signicant explanatory variable of OCCUR in this specication. Second, we carry out a twostage analysis similar to the previous OUTDIR analysis. In the rst stage we regress INST on NUMEST and other control variables. In the second stage we regress OCCUR on the error term from the rst regression and on control variables. The error term is signicant in explaining OCCUR , suggesting that INST continues to be signicant after controlling for the effect of NUMEST .

5.6

ANALYSES USING QUARTERLY FORECASTS

The analyses and results so far are based on annual forecasts. Separate analyses are also carried out using a sample of quarterly forecasts. Untabulated results nd that our corporate governance variables continue to be signicant in their association with forecast occurrence and frequency. These results continue to hold after carrying out the simultaneous equation analysis and other robustness checks detailed in the previous subsections. As with the annual forecasts, institutional ownership is also signicant in explaining the specicity of management forecasts. Furthermore, institutional ownership is positively associated with more accurate and more conservative forecasts. However, unlike the annual forecast sample results, outside directors are not signicant in explaining forecast error and bias. The results of the quarterly analyses are subject to the following limitation. Our analysis is carried out using annual governance measures. To the extent that quarterly changes in governance variables inuence quarterly disclosure, the power of our tests would be compromised. The quarterly error and bias regressions tend to have lower power (compared with those based on annual forecasts reported in table 4), with some control variables turning insignicant in these regressions. This could be attributable to a structural difference in the error and bias of quarterly and annual forecasts that might merit separate investigation.

5.7

OTHER ROBUSTNESS CHECKS

We carry out additional analyses using the number of outside directors as an alternate proxy for outside directorship. The results are qualitatively similar to those using the proportion of outside directors. Finally, we carry out a simultaneous equation analysis with a system of four regressions where OCCUR , INST , OUTDIR , and NUMEST are the endogenous variables. INST and OUTDIR continue to be signicantly associated with OCCUR .

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Regression diagnostics revealed that multicollinearity was not a severe problem in the individual regressions because the condition numbers in the regressions did not exceed 50 (see Belsley, Kuh, and Welsch [1980]). We identied a few inuential observations in our samples and examined the robustness of our results to these inuential observations by eliminating the inuential observations. The results are essentially unchanged.

6. Summary and Conclusions


The focus of this study is to investigate the relation between a set of governance mechanisms and voluntary disclosure, surrogated by the properties of management earnings forecasts. Specically, we examine the association between governance proxies (outside directors and institutional investors) and the occurrence, frequency, specicity (i.e., precision), accuracy, and bias of earnings forecasts disclosed by rm managers. Using a sample spanning from 1997 to 2002, we nd that institutional ownership and the proportion of outside directors are favorably associated with the likelihood of forecast occurrence and frequency of forecast issuance. The evidence also indicates that the forecasts issued are more specic and accurate. In addition, governance mechanisms are negatively associated with managerial optimism; that is, rms with greater institutional ownership and percentage of outside directors are likely to issue less optimistically biased (or more conservative) forecasts. Subsample analysis indicates that the coefcients on outside directors and institutional ownership are not signicantly different in the pre and postReg FD eras. Additional analysis suggests that concentrated institutional ownership is negatively associated with forecast properties. The association is less negative in the postReg FD environment, which is consistent with Reg FD reducing the ability of rms to privately communicate information to select audiences. This nding is also consistent with survey data that document a reduction, but not elimination, of private communication between CFOs and analysts in the postReg FD era. This article contributes to the literature on discretionary disclosure and on corporate governance. We nd that the monitoring mechanisms are related to the extent and quality of discretionary information a manager discloses. These results are interesting given the current scrutiny of corporate governance mechanisms and the state of the nancial reporting system. Recent nancial bankruptcies have led to a greater focus on the need for stronger governance and more transparent disclosure. Our results suggest that the two are linked and that promoting stronger governance could also promote more transparent disclosure. This article also contributes to the literature on the effectiveness of governance variables by focusing on a rm attributeinformation disclosure environmentthat is novel to the literature.

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APPENDIX Variable Denitions


OCCUR = 1 if the rm made an earnings forecast during a scal period, and 0 otherwise OCCURL = 1 if the rm made an earnings forecast during scal period t1, and 0 otherwise FREQ = number of management forecasts made by a rm from 1997 to 2000 SPECIFIC = 3 if the company made a point forecast, 2 for a closedinterval forecast, 1 for an open-interval forecast, and 0 for other kinds of forecasts ERROR = absolute value [managements forecasted EPS actual EPS]/price at the beginning of the scal period BIAS = [managements forecasted EPS actual EPS]/price at the beginning of the scal period INST = percentage of common shares held by institutions INSTCONS = Herndahl index of concentration of institutional ownership measured as:
N i =1

shares held by institution i total shares outstanding

OUTDIR = percentage of the board of directors who are not ofcers of the rm HORIZON = number of days between the forecast date and the scal period end date SURPRISE = absolute value [managements forecasted EPS median analysts forecasted EPS]/price at the beginning of the scal period LMVAL = natural log of the market value of a rms common equity (in $ millions) at the beginning of the scal period AUDIT = 1 if the auditor is one of the Big 5 (previously Big 8) auditors, and 0 otherwise NUMEST = number of analysts following the rm. For tests of occurrence and frequency, this is based on the last-available analyst forecast information in First Call before scal periodend. For tests of specicity, accuracy, and bias, this is based on the last-available analyst forecast information in First Call before the management forecast. DISPFOR = standard deviation of analyst forecasts divided by median forecast. For tests of occurrence and frequency, this is based on the last-available analyst forecast information in First Call before scal period-end. For tests of specicity, accuracy, and bias, this is based on the last-available analyst forecast information in First Call before the management forecast.

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LITIGATE = 1 if the rm belongs to the biotechnology (SIC codes 28332836), R&D services (87318734), programming (73717379), computers (35703577), electronics (3600 3674), or retailing (52005961) industry, and 0 otherwise MKBK = market value of equity divided by the book value of equity at the beginning of the scal period LOSS = 1 if the rm reported losses in the current period, and 0 otherwise NEWS = 1 if the current-period EPS is greater than or equal to the previous-period EPS, and 0 otherwise EARNVOL = standard deviation of quarterly earnings before extraordinary items for the 12 quarters before the current scal year, divided by median assets over the 12 quarters DE = long-term debt/total stockholders equity at the beginning of the scal period YIELD = dividend yield for the scal period BETA = equity beta for the scal year LIQUIDITY = log(trading volume/shares outstanding) for the scal year SNP = 1 if the company was part of the S&P 500, and 0 otherwise FD = 1 if the observation is related to the postRegulation Fair Disclosure period (after October 2000), and 0 otherwise
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