Management Earnings Forecasts:

A Review and Framework

Eric Hirst
Lisa Koonce
Shankar Venkataraman

Department of Accounting
McCombs School of Business
The University of Texas
Austin, TX 78712

Corresponding author:
Lisa Koonce
The University of Texas
Department of Accounting
McCombs School of Business
CBA 4M.202
Austin, TX 78712
(512) 471-5576 phone
(512) 471-3904 fax
Lisa.Koonce@mccombs.utexas.edu

January 11, 2008

We thank the Department of Accounting at The University of Texas for funding for this project,
and Steve Baginski, John Hassell, Greg Miller, Dave Ziebart (editor), and two anonymous
referees for helpful comments.

Electronic copy available at: http://ssrn.com/abstract=921583

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Management Earnings Forecasts:

A Review and Framework

SYNOPSIS

In this paper, we provide a framework in which to view management earnings forecasts.

Specifically, we categorize earnings forecasts as having three components—antecedents,
characteristics, and consequences—that roughly correspond to the timeline associated with an
earnings forecast. By evaluating management earnings forecast research within the context of
this framework, we render three conclusions. First, forecast characteristics appear to be the least
well-understood component of earnings forecasts—both in terms of theory and empirical
research—even though it is the component over which managers have the most control. Second,
much of the prior research focuses on how one forecast antecedent or characteristic influences
forecast consequences and does not study potential interactions among the three components.
Third, much of the prior research ignores the iterative nature of management earnings
forecasts—that is, forecast consequences of the current period influence antecedents and chosen
characteristics in subsequent periods. Implications for researchers as well as educators,
managers, investors, and regulators are provided.

Electronic copy available at: http://ssrn.com/abstract=921583

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INTRODUCTION

Management earnings forecasts are voluntary disclosures that provide information about

expected earnings for a particular firm. They represent one of the key voluntary disclosure

mechanisms by which managers establish or alter market earnings expectations, preempt

litigation concerns, and influence their reputation for transparent and accurate reporting.

Management earnings forecasts are influential as they have been shown to affect stock prices

(Pownall, et al. 1993), analysts’ forecasts (Baginski and Hassell 1990), and bid-ask spreads

(Coller and Yohn 1997). The purpose of this paper is twofold. First, we provide an organizing

framework in which to evaluate research on management earnings forecasts. This framework

characterizes forecasts from management as having three components—antecedents,

characteristics, and consequences. We organize a large number of studies on management

earnings forecasts within this framework.1 Second, we draw on this framework to identify areas

and topics where additional management earnings forecast research would be most productive.

This paper makes several contributions to the literature. First, although prior reviews of the

management earnings forecast literature exist (Cameron 1986; King, et al. 1990), they pre-date

important changes in the environment in which management earnings forecasts are produced and

consumed. For example, the passage of Reg. FD and the increased use of earnings benchmarks

have significantly influenced both the frequency and content of management earnings forecasts

(Bailey, et al. 2003; Brown and Caylor 2005). Because significant research has been conducted

since those prior reviews, an up-to-date evaluation of the literature is warranted. Second, by

viewing the forecasting process as involving three related components, we can more readily

organize the existing literature and glean the insights from that research. The decomposition of

the literature also enables us to identify where theory development and additional empirical

Electronic copy available at: http://ssrn.com/abstract=921583

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research are warranted. Given the importance of voluntary management earnings forecasts to the

functioning of capital markets (Healy and Palepu 2001), we believe that a re-evaluation of the

literature is in order.

The framework used herein is adapted from one developed by Wiedman (2000) who

characterizes both voluntary and mandatory disclosure as involving three components—

antecedents, characteristics, and consequences.2 We tailor her framework to the management

earnings forecast domain and identify the elements comprising the three components.

Specifically, antecedents are the environmental and firm-specific characteristics, such as the

legal setting and the incentives of firm managers, that influence the likelihood of a forecast being

issued. Forecast characteristics pertain to the choices that a manager makes relating to the

content of the forecast itself, such as its form, horizon, and level of detail. Consequences pertain

to the reactions to the forecast, such as stock price changes and analyst behavior. Not

surprisingly, these consequences are a function of antecedents and forecast characteristics.

Looking at the published research over the last several decades through the lens of this

framework yields three important implications for researchers in the management earnings

forecast area. First, gaining a better understanding of the choices that managers make once they

decide to issue an earnings forecast is an important direction for both theory development and

empirical research. Existing theories largely focus on why managers choose to issue a forecast

and the likely consequences of those decisions (e.g., Ajinkya and Gift 1984; Skinner 1994;

Stocken 2000; Verrecchia 2001). That is, they primarily address antecedents and the

consequences. Thus, opportunities exist for theory development on the choices that managers

make related to forecast characteristics. Because of fewer theories, it is perhaps no surprise that

relative to the vast literature on forecast antecedents and consequences, comparatively fewer
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studies examine how managers choose the characteristics of their earnings forecasts. The lack of

theory may explain why the research that has been conducted on forecast characteristics is fairly

recent in time (at least compared to research on forecast antecedents and consequences). To the

extent that forecast characteristics are examined in the literature, they are primarily treated as

exogenous variables (Baginski, et al. 2004). Given that managers have substantially greater

control over forecast characteristics than they do over forecast antecedents and consequences, it

is striking that the decisions managers make about such characteristics are comparatively less

well-understood (Choi, et al. 2006). For example, we know relatively little about why managers

decide to issue forecasts with external versus internal attributions, why they issue them in

conjunction with other disclosures, and the nature of the content of those other disclosures

(Baginski, et al. 2004, 17).

Second, our review of the literature highlights that the typical study focuses on the main

effect of one or more forecast antecedents or characteristics on forecast consequences. Because

main effect results are unlikely to hold under all conditions, we argue that researchers should

identify and test possible interactions among antecedents or characteristics. Given the large

number of studies looking at main effects, interaction tests will push forward our knowledge and

understanding of such forecasts (Libby, et al. 2002). Although such interaction tests have been

more prevalent in recent research (e.g., Rogers and Stocken 2005; Hutton, et al. 2003; Wang

2007), ample opportunities exist for further study. For example, managers with strong incentives

tied to the firm’s stock price (a forecast antecedent) are viewed as issuing self-serving forecasts

(Rogers and Stocken 2005). What is less clear-cut, however, is how other factors might

moderate the influence of these incentives. For example, does providing forecasts more
 5

frequently moderate the influence of incentives on how forecasts are viewed by market

participants?

Further, interaction tests are useful in reconciling conflicting findings in the literature.

Including a theoretically motivated conditioning, or moderator, variable often allows the

researcher to identify where the effect holds and where it does not (or where it holds in a

different way). For example, Baginski, et al. (1993) find that stock price reactions to earnings

forecasts are contingent on forecast form; point forecasts lead to greater stock price reactions

relative to range forecasts. In contrast, Pownall, et al. (1993) and Atiase, et al. (2005a) find no

variation in stock price reactions conditional on forecast form. One possible answer for these

mixed results may originate from Hirst, et al. (1999) who examine how prior forecast accuracy

may moderate the effects of forecast form. They experimentally show that only when prior

forecast accuracy is high do investors consider forecast form. When prior accuracy is low,

forecast form does not influence investor judgments. That is, prior accuracy is shown to be a

significant moderator variable. Careful consideration of other such interactions within and

among antecedents, characteristics, and consequences could help establish important boundary

conditions to main-effect results.

Third, our review reveals a multi-period aspect of management earnings forecasts, yet the

existing literature is not completely leveraging this feature (see Miller 2002 for an exception).

Forecast consequences from one period can later become forecast antecedents and may influence

subsequent choices about forecast characteristics. For example, accurate forecasts in prior

periods enhance a firm’s reputation for forecasting accuracy (a consequence), which, in turn

becomes an antecedent for a current period forecast. This antecedent, in turn, can significantly

influence whether managers issue subsequent forecasts and, if they do, the chosen characteristics
 6

of those forecasts as well as the market’s reaction to them. A challenge in leveraging this multi-

period feature is identifying the manner in which consequences from one period affect

antecedents and forecasts in subsequent periods. For example, a firm’s a reputation for accuracy

is normally built over an extended time and is generally not quickly changeable, while

remedying information asymmetries may occur more readily. Thus, recognizing the multi-

period and iterative nature of the forecasting process and identifying the manner over which

forecast consequences become antecedents are important to extend our understanding of the

impact of forecasts beyond immediate, one-time reactions. In sum, our paper has numerous

implications for those who conduct research on management earnings forecasts.

Our paper also has implications for financial reporting educators, managers, investors, and

regulators. For those who teach financial reporting, our paper provides a succinct appraisal of

the scholarly literature on management forecasts. Most financial reporting textbooks focus on

mandatory financial reporting and provide little, if any, coverage on important voluntary

disclosures like management earnings forecasts. This focus is puzzling given the important role

of earnings forecasts in the operation of capital markets. Thus, we believe our paper will inform

these scholars/educators, thereby facilitating classroom coverage. Doing so will enable students

to understand, for example, why the stock market may react very little when the mandatory

earnings reports are released (i.e., the market already anticipates the news via management

earnings forecasts) or why managers may engage in manipulating earnings in response to

previous forecasts. This knowledge is not only helpful for financial reporting classes, but also

for auditing courses. By recognizing the expectations that managers create with their earnings

forecasts, auditing students (and even practitioners) should be improve their ability to identify

when certain accounting practices may be questionable.

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Managers can benefit from our paper by becoming more knowledgeable about scholarly

research findings regarding these forecasts. This information should improve their ability to

make informed decisions about whether and when to issue a forecast and what characteristics it

should possess. For example, from our review, managers can better appreciate the changes they

might make to their earnings forecasts to achieve immediate responses from market participants

and the changes that would not be quickly appreciated. As another example, managers also can

gain insight into the types of forecast characteristics that increase the credibility of good news

forecasts (i.e., verifiable information) and the types that do not (i.e., soft talk) (Hutton, et al.

(2003).

Investors should find our paper useful, because it draws attention to the full range of forecast

characteristics that managers can choose and the consequences that may occur. The distinct

characteristics of forecasts are important as not all choices that managers make are equally

relevant to investors. For example, a pre-commitment to disclosure may be viewed as a more-

powerful cue to the believability of a forecast than is its form. Our review also allows investors

to fully appreciate the various types of reactions that management earnings forecasts can

produce. While many investors might solely focus on the stock price reaction to a management

earnings forecast, our review highlights the important role of other reactions, such as manage-

ment’s reputation for clear and transparent disclosure. A better understanding, through the

framework, of the relations between antecedents, characteristics, and consequences also can

inform investors as they lobby firms to make changes in their disclosures.

Finally, our paper informs regulators who think about the quality, frequency, and

effectiveness of management earnings forecasts (House Committee on Financial Services, 2006).

Since 1973, when the Securities and Exchange Commission (SEC) lifted its prohibition against
 8

forward-looking information, the SEC and other regulators have been concerned with the

credibility of such information. Thus, they should be interested in our systematic review of the

management earnings forecast research literature, particularly where empirical findings have (or

have not) changed with new regulations. For example, we discuss research which shows that,

although Reg. FD does not decrease the amount of forward-looking information provided by

firms, it has apparently decreases the quality of such information (Bailey, et al. 2003; Irani and

Karamanou, 2003).

The rest of the paper is organized as follows. In the next section, we define management

earnings forecasts and provide an overview of our framework. In the following three sections,

we then summarize the major themes in the earnings forecast literature within the context of the

three components of our framework—namely, antecedents, characteristics, and consequences.

Our goal is not to provide an exhaustive survey of individual studies, but to identify broad

themes in the literature. In the penultimate section, we reflect on our review of the earnings

forecast research in light of our framework and identify areas and topics where additional

earnings forecast research would be most productive. The final section provides conclusions.

FRAMEWORK

King, et al. (1990) define management earnings forecasts as voluntary managerial

disclosures predicting earnings prior to the expected reporting date. The term earnings guidance

often is used synonymously with earnings forecasts, both in the popular press (Zuckerman 2005)

and in the academic literature (Atiase, et al. 2005a; Hutton 2005).3 Although earnings forecasts

are commonly issued well in advance of quarterly and annual earnings releases, they are some-

times provided after the accounting period has ended but before the earnings are announced.

These latter forecasts are typically referred to as earnings preannouncements.4 When manage-
 9

ment forecasts indicate substantial shortfall from expected earnings, they are commonly termed

earnings warnings (Kasznik and Lev 1995).

Figure 1 provides a pictorial representation of the antecedent, characteristics, and

consequences framework that we use to discuss management earnings forecasts. After providing

an overview of our framework, we then discuss each component of the framework in greater

detail.

---------------------------------------
Insert Figure 1 here
----------------------------------------
Because earnings forecasts are voluntary disclosures, the first question confronting managers

is whether or not to issue a forecast. The answer is shaped by a combination of the environment

faced by the firm and firm-specific characteristics. In our framework, we label these factors as

antecedents because they are precursors to the actual forecast decision. Having chosen to issue

an earnings forecast, the manager then faces a broad array of choices regarding the attributes of

that forecast. These choices involve, for example, the form of the forecast (e.g., point, range,

qualitative, etc.), the horizon (e.g., quarterly versus annual), and the information to accompany

the forecast (e.g., the presence or absence of attributions). We label these choices as forecast

characteristics because they are attributes associated with the forecast. The third component of

our framework, forecast consequences, captures events and reactions that occur after the forecast

is issued, such as the stock market reaction to the forecasted earnings information. Not

surprisingly, these consequences are a function of the antecedents and forecast characteristics.

For example, management forecasts lead to greater earnings forecast revisions by analysts when

they originate from firms with high prior forecast accuracy (Williams 1996).

Although our framework is organized chronologically—that is, consequences follow the

choice to issue a forecast with particular characteristics which, in turn, follow forecast
 10

antecedents—it is important to recognize that the framework is iterative. That is, forecast

consequences in one period become forecast antecedents in subsequent periods. For example,

Healy, et al. (1999) document that expanded disclosures result in increased institutional

ownership and analyst coverage. In other words, they view institutional ownership as a

consequence of disclosure, whereas Ajinkya, et al. (2005) argue that higher institutional

ownership leads to more frequent and more precise forecasts, implying that institutional

ownership is an antecedent. Reflecting the natural iterative aspect of the forecasting process,

some elements are listed under more than one component of our framework (see Figure 1).5

Forecast Antecedents

We define antecedents as factors that exist at the time the manager makes the decision to

issue a forecast. Indeed, antecedents influence whether the manager will issue a forecast and, as

explained later, can influence the manager’s choice of forecast characteristics and the forecast’s

consequences. As shown in Figure 1, we classify antecedents into two broad categories: (a)

forecast environment—that is, features of the legal and regulatory environment and features of

the analyst and investor environment, and (b) forecaster characteristics—that is, information

asymmetry, pre-commitment to disclosure, firm-specific litigation, managerial incentives, prior

forecasting behavior, and proprietary costs. Firms often have little or no control over certain

antecedents in the short term, although they can influence some of those antecedents in the

longer term. For example, a firm’s prior forecasting accuracy is an antecedent. A reputation for

accuracy is normally built over an extended time and is generally not quickly changeable.

We organize our discussion of antecedents as follows. We first separately discuss the two

components of the forecasting environment. Then, we discuss the forecaster characteristics.

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Forecast Environment

Legal and regulatory environment. Although management earnings forecasts are voluntary

disclosures, legal and regulatory environments can influence the type of forecasts that firms

make and the channels through which they are disseminated.6 Four significant changes in the

U.S. regulatory environment occurred over the last four decades. In 1973, the Securities and

Exchange Commission (SEC) allowed firms to include forward-looking information in their

regulatory filings. In 1979, the SEC provided safe harbor to firms issuing forecasts to shield

them from frivolous litigation related to forward-looking disclosures made in good faith. Then,

in 1996 the Private Securities Litigation Reform Act (PSLRA) extended the safe harbor so that

firms cannot be easily sued for forecasts that do not materialize. Finally, Regulation Fair

Disclosure (Reg. FD), passed in 2000, mandated that material information cannot be disclosed

selectively.7

The first three regulatory changes are largely aimed at encouraging companies to more freely

disclose forward-looking information (including earnings forecasts). These regulatory changes

are controversial. For example, the primary concern with the PSLRA is that companies might

issue self-serving, opportunistic forecasts with impunity given the expanded safe harbor.

Johnson, et al. (2001) document that the PSLRA does not adversely affect the quality of

management earnings forecasts, at least for high-tech firms. In fact, they find that the accuracy

of earnings forecasts increases after the passage of the PSLRA.

Reg. FD raises concerns of a different nature. Before the passage of Reg. FD, managers

could privately provide earnings guidance to selected analysts. Prior research documents that

many managers used this private channel extensively (Ajinkya and Gift 1984; Hutton 2005).

Following Reg. FD, managers face a choice between public disclosure and no disclosure at all.
 12

Many, including regulators, fear that firms would choose the no-disclosure option because

guidance is voluntary. However, research reveals an increase in public earnings forecasts

following the passage of FD, suggesting that concerns about the information-chilling effect of

this regulation may have been misplaced (Bailey, et al. 2003; Heflin, et al. 2003). However,

Wang (2007) reports that the decision regarding the continuation of guidance after the passage of

Reg. FD depends on firm-specific characteristics. Specifically, those firms with lower

information asymmetry and higher proprietary information costs do, in fact, reduce or eliminate

their public disclosures subsequent to Reg. FD.

The research discussed above compares forecasting behavior before and after a new

regulation is enacted. In contrast, Baginski, et al. (2002) study the effect of the legal

environment on earnings forecast behavior by examining two legal regimes. Comparing the U.S.

and Canada, they argue that the business environment in the two countries is similar, but the U.S.

is more litigious (Baginski, et al., 2002, 28-29). Specifically, they compare forecasts issued by

Canadian versus U.S. managers and find that Canadian managers behave in a manner that

suggests less concern over litigation. Specifically, Canadian managers issue more forecasts in

general and, in particular, during periods of rising profits relative to their U.S. peers. Further,

they issue longer-term and more-precise forecasts than their U.S. counterparts. Finally,

Canadian managers are less likely to issue interim forecasts during periods of earnings decreases.

Investor and Analyst Behavior. Two other environmental factors also affect whether managers

issue forecasts, namely the behavior of investors and analysts. Research shows that investors

and analysts seek disclosure of forward-looking information, such as earnings forecasts, and they

tend to invest in and provide coverage of companies that have more forthcoming disclosure

policies (Ajinkya, et al. 2005; Healy, et al. 1999).

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Both institutional investment and analyst coverage have changed over time. Specifically,

institutional investors’ share of the U.S. stock market capitalization has expanded from under 30

percent in 1980 to over 50 percent in 2002 (Gompers and Metrick 2001; Gillan and Starks 2003).

Further, analyst coverage of companies has increased over time as well. Barber, et al. (2001,

2003) report that the number of firms followed by analysts rose from 1,841 in 1986 to 5,786 in

2001. Arguably because of these changes in institutional investment and in analyst coverage, the

number of firms providing public earnings guidance also has increased from approximately 10-

15 percent in the mid 1990’s to approximately 50 percent in 2004 (Anilowski, et al. 2007).

Forecaster Characteristics

Because the legal/regulatory and investor/analyst antecedents largely vary longitudinally,

they arguably impact U.S. firms similarly. For example, all public U.S. firms are subject to the

forces of Reg. FD in the same fashion. However, the other antecedent, forecaster characteristics,

exhibits significant cross-sectional variation because it refers to unique aspects of the forecasting

firm. We discuss a number of these important forecast antecedents next (see Figure 1).

Information Asymmetry. Many of the motivations managers have for issuing earnings

forecasts are congruent with those of shareholders. That is, the supply of and the demand for

forecasts is assumed to be largely driven by stock price considerations, with managers issuing

forecasts (and analysts and investors demanding them) to reduce the asymmetry in information

between managers and analysts and current or potential investors (Ajinkya and Gift 1984;

Verrecchia 2001). Lower information asymmetry is viewed as desirable because it is associated

with higher liquidity (Diamond and Verrecchia 1991) and lower cost of capital (Leuz and

Verrechia 2000).
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Prior research supports the idea that there is a relationship between information asymmetry

and firm behavior. Specifically, firms issuing management earnings forecasts are noted to have

higher information asymmetry (measured by bid-ask spreads prior to the forecast) compared to

firms that do not issue such forecasts (Coller and Yohn 1997). More importantly, this study

finds that the information asymmetry is reduced after the issuance of the forecasts, suggesting

their powerful influence. Interestingly, though, managers may not always desire to reduce

information asymmetry. For example, if lower information asymmetry leads to greater

monitoring (Shleifer and Vishny 1989), managers may not necessarily seek to voluntarily reduce

it.

Pre-commitment to Disclosure. Economic theory suggests that pre-commitment to continued

disclosure also reduces the information asymmetry component of a firm’s cost of capital (Leuz

and Verrecchia, 2000). Although managers can proffer their commitment to disclosure, they can

only credibly signal such commitment by providing disclosures more frequently (Botosan and

Harris 2000). Despite the apparent benefits of a commitment to disclosure, wide variation exists

in how frequently managers choose to issue forecasts. Some firms issue forecasts regularly

(either quarterly or annually) while others exhibit a sporadic pattern of forecasting.

Prior research captures this mix of empirical forecast frequencies. For a sample of 733

forecasts (548 firms) during the period 1979-1983, McNichols (1989) reports that approximately

half of her sample issues only one annual forecast over the sample period and only seven firms

issue forecasts in every year. Such results are consistent with a 1981 survey by the Conference

Board (cf. Ajinkya and Gift 1984), revealing that only 10 percent of New York Stock Exchange

(NYSE) firms issue public forecasts. Similar results exist for more-recent time periods.

Specifically, Rogers and Stocken (2005) report for a sample of 925 annual forecasts (595 firms)
 15

during the period 1995-2000, 63 percent of firms issue only one forecast in the time period and

only seven firms issue forecasts in every year (also see Tucker (2005) and Kasznik and Lev

(1995) for evidence on quarterly and fourth-quarter guidance, respectively). Because most of

these studies consider only point and range forecasts and exclude other forms of forecasts, it is

possible that these frequency levels are understated.8 Kile et al. (1998) capture these other types

of forecasts in their sample of NYSE firms for the year 1980 and they report a relatively high

forecast frequency of 64 percent.

Prior research documents several regularities associated with forecasting frequency.

Specifically, less-volatile firms issue forecasts more often than more-volatile firms (Waymire

1985), and firms with stronger corporate governance tend to issue more-frequent forecasts

(Ajinkya, et al. 2005). Further, the forecast frequency is associated with a firm’s performance.

Miller (2002) finds that guidance frequency increases during periods of rising earnings and falls

when the period of earnings increases ends. Finally, forecast frequency is associated with the

firm’s prior record of meeting analysts’ consensus earnings estimates. Firms that consistently

fail to meet analyst estimates stop providing forecasts. When they resume, their record of

meeting analysts’ estimates is improved (Houston, et al. 2007).

Firm-specific litigation risk. Firm-specific litigation risk appears to be another important

determinant of whether a firm issues a forecast. That is, managers often issue forecasts to pre-

empt earnings disclosures, particularly when they involve bad news, and to avoid subsequent

litigation and its cost (Skinner 1994, 1997). Extant research uses a variety of proxies to model

firm-specific litigation risk (Brown, et al. 2005; Rogers and Stocken 2005; Field, et al. 2005).

The variables commonly associated with increased litigation risk in these models are (a) firm

size, (b) variability of returns, (c) impending negative news that leads to a large drop in stock
 16

price, and (d) industry membership. These studies find that factors (a) through (c) are all

positively associated with litigation risk, and that firms in the high-tech industry are more prone

to lawsuits. Cao and Narayanamoorthy (2005) employ a different approach to measuring

litigation risk by using the directors and officers’ liability insurance premium as a measure of a

firm’s ex-ante litigation risk.

In general, research shows that litigation risk does influence the decision to issue forecasts.

Specifically, Cao and Narayanamoorthy (2005) find that when faced with high ex-ante litigation

risk, managers with bad news are more likely to issue earnings guidance. Managers with good

news, however, are not more likely to issue earnings guidance, regardless of ex-ante litigation

risk. Brown, et al. (2005) find that higher litigation risk is associated with more forecasts by

both good-news and bad-news firms. After controlling for litigation risk, however, they find that

bad-news firms are significantly more likely to issue a forecast relative to good-news firms. That

finding is consistent with Kasznik and Lev (1995) who also find that bad-news firms are signifi-

cantly more likely to issue warnings relative to good-news firms.

Managerial Incentives. As noted earlier, managers often are motivated to issue earnings

forecasts to reduce the information asymmetry that exists between them and analysts and

investors. However, at times, managers issue forecasts for reasons that are consistent with only

their own self-interests or incentives. Different levels of managerial incentives, such as equity-

based compensation, exist across firms and time. Specifically, equity-based compensation

accounted for less than 20 percent of CEO compensation in 1980 but increased to nearly 50

percent in 1994 (Hall and Liebman 1998) and grew even further, to nearly 60 percent by 2003

(Bebchuk and Grinstein 2005).

 17

Research suggests that these incentives influence managers’ forecasting behaviors.

Specifically, Nagar, et al. (2003) argue that managers with greater levels of equity-based

compensation issue more frequent forecasts to avoid equity mispricing that could adversely

impact their wealth. They also argue that equity-based incentives encourage not just good-news,

but also bad-news disclosures, because silence (i.e., no forecasts) is likely to be interpreted

negatively. Consistent with their hypothesis, they find that the frequency of management

earnings forecasts is positively related to the proportion of chief executive officer compensation

affected by stock price as well as the absolute value of shares held by that individual. In a

similar vein, prior research documents that the quantity of earnings forecasts increases

significantly around equity offerings (Ruland, et al. 1990; Marquardt and Wiedman 1998).

Although one might conclude that managers with equity-based compensation will always

issue forecasts in an attempt to boost their firm’s stock price, Aboody and Kasznik (2000)

identify situations where incentives may lead to forecasts that depress the firm’s stock price.

Specifically, they report that managers issue bad-news earnings forecasts around stock option

award periods to temporarily depress stock prices and take advantage of a lower strike price on

managers’ option grants. In a similar vein, Cheng and Lo (2006) and Rogers and Stocken (2005)

find that insider trading is related to unfavorable management forecasts. Both studies suggest

that managers have incentives to time their bad news forecasts to take advantage of a lower

purchase price. In sum, these studies show that firm-specific managerial incentives play an

important role in the decision to issue earnings forecasts.

Prior Forecasting Behavior. Firms’ prior forecasting behavior, namely their historical forecast

accuracy and their historic behavior regarding meeting and/or beating benchmarks, also is shown

to influence the decision to forecast. Accuracy is defined as the forecast’s deviation from the
 18

actual earnings realization. Recent survey evidence by Graham, et al. (2005) confirm that

managers issue voluntary disclosures, including earnings forecasts, to develop and maintain a

reputation for accurate and transparent reporting (also see Skinner 1994; Stocken 2000; Healy

and Palepu 2001). Indeed, research shows that prior forecast accuracy affects the credibility, or

believability, of current forecasts (Williams, 1996; Hutton and Stocken 2007), suggesting that

the decision to forecast may be influenced by the firm’s prior accuracy.

Regarding the firm’s historic behavior regarding meeting and/or beating benchmarks, both

anecdotal evidence and research confirm that since the mid-1990’s, managers are now largely

concerned with meeting or beating analysts’ consensus earnings forecasts (Dechow, et al. 2003;

Brown and Caylor 2005). Prior to the mid-1990’s, managers appeared to care more about prior-

period earnings benchmarks or avoiding losses (DeGeorge, et al. 1999). Research shows the

important role that the analysts’ consensus forecast now plays in firm behavior. Specifically,

firms that do not meet analysts’ forecasts temporarily stop issuing management earnings

forecasts, but later resume when their ability to meet analysts’ forecasts improves (Houston, et

al. 2007). Along related lines, Cheng, et al. (2005) find that regular forecasters meet or beat

analysts’ forecasts more frequently compared to less-regular forecasters.

Proprietary Costs. Although there are benefits to disclosing management earnings forecasts,

there also are costs. Economic theory suggests that proprietary costs are an important deterrent

to full voluntary disclosure, including management earnings forecasts (Verrecchia 1983). That

is, a firm may want to keep private either the content or the timing of its disclosure for competi-

tive reasons. For example, Wang (2007) finds that R&D expenditures scaled by total assets (as a

proxy for proprietary costs) negatively impacts the decision to issue public earnings forecasts.

That is, firms with high proprietary costs replace private earnings guidance with non-disclosure
 19

following the passage of Reg. FD (instead of replacing it with public guidance, which is the

stated intent of the legislation). Additionally, proprietary costs appear to influence attributes of

the forecast (Rogers and Stocken 2005; Bamber and Cheon 1998). Other research by Ajinkya, et

al. (2005), however, finds no relationship between proprietary costs and a firm’s decision to

issue a forecast. They use market-to-book ratio and sales concentration as surrogates for

proprietary costs.

In sum, the decision to issue a forecast is influenced by pre-existing conditions or

antecedents. Some antecedents are external to the firm (legal, regulatory, investor, and analyst

environment) while others are internal and firm-specific (forecaster characteristics). Both factors

influence the decision to issue a forecast in the current period (as well as the characteristics of

that forecast). With some exceptions, these antecedents are not easily changed in the short-term.

That is, while managers can disclose more forward-looking information to remedy information

asymmetry problems, it is more difficult to quickly change their prior forecasting accuracy. In

the next section, we describe attributes of the forecast over which managers have greater

control—that is, we discuss forecast characteristics.

Forecast Characteristics

Forecast characteristics are properties or attributes of the earnings forecast per se. They

differ from forecast antecedents in at least one important respect—namely, managers have

greater discretion over forecast characteristics (particularly in the short-term). For example,

managers can choose whether to issue a point or a range forecast, and they also can choose the

level of detail that accompanies a forecast. Perhaps not surprisingly, prior research documents

substantial variation in forecast characteristics (King, et al. 1990).

 20

We organize our review by the various forecast characteristics. Specifically, we separately

discuss earnings forecast news, forecast accuracy and bias, forecast form, attributions

accompanying forecasts, stand-alone versus bundled forecasts, forecast disaggregation, and

forecast horizon and timeliness. See Figure 1 for a listing of these characteristics.

Earnings Forecast News

Although managers do not entirely control the news that their forecasts convey, they

effectively can create such control via their current-period decisions about whether or not to

issue an earnings forecast and the earnings number to forecast. The news conveyed by a forecast

falls into one of three categories. Good-news forecasts exceed market expectations, bad-news

forecasts fall short of these expectations, and confirming forecasts corroborate those expecta-

tions. In many cases, researchers use analysts’ consensus earnings estimates as a proxy for

market earnings expectations. However, other proxies exist. For example, Penman (1980) uses

a time-series model of earnings to proxy for the market earnings expectation. Yet other research

infers the market’s expectation from the sign and magnitude of stock price response to new

information (e.g., Basu, 1997).

Research shows a changing trend over time in terms of management earnings forecast news.

Early studies report that earnings forecasts predominantly conveyed good news (Penman 1980;

Waymire 1984). Studies based on samples from the early 1980’s to the mid-1990’s suggest a

different trend. Both McNichols (1989) and Hutton, et al. (2003) find that good-news forecasts

and bad-news forecasts are equally likely. More recently, for a sample of 9,381 annual earnings

forecasts between 1996-2003, Hutton and Stocken (2007) find that good-news forecasts

constitute 37 percent of their sample, confirming-news forecasts are about 17 percent, and bad-

news forecasts account for 46 percent. For large earnings surprises, Kasznik and Lev (1995)
 21

find that managers from bad-news firms are twice as likely as good-news firms to provide

earnings forecasts.9

In terms of factors associated with forecasts with different types of news, research has shown

that bad-news forecasts are positively associated with analyst optimism and inversely associated

with equity issuance (Cotter, et al. 2006). Bad-news forecasts are positively associated with firm

size, size of the surprise, and firm-specific litigation risk (Kasznik and Lev 1995). Good-news

forecasts, on the other hand, are systematically associated only with firm size. Further,

pessimistic forecasts are issued by firms in concentrated industries (a proxy for proprietary costs)

more than they are by firms in less concentrated industries, presumably to deter new entrants

(Rogers and Stocken 2005).

Accuracy versus Bias

Once the decision to issue a forecast has been made, managers can strive to achieve accurate

forecasts or they can strategically forecast to achieve a desired result. Turning first to forecast

accuracy (defined as closeness to actual earnings), research shows substantial variation in

managers’ forecast accuracy. For example, Hassell and Jennings (1986) report that for the time

period 1979-1982, forecast errors range from 0 to 242 percent with a mean (median) error rate of

15 percent (6.5 percent).10 Research also shows managers’ quarterly forecasts are more accurate

compared to their annual forecasts. Specifically, managers meet their annual forecasts

approximately 6 percent of the time (Kasznik 1999; Hribar and Yang 2006) whereas they meet

their quarterly forecasts approximately 45 percent of the time (Chen 2004).

Studies identify additional variables associated with forecast accuracy. For example,

managers who face lower accounting flexibility and those who are subject to exogenous shocks
 22

are less likely to issue accurate forecasts (Chen 2004; Kasznik 1999). Further, managers with

less forecasting experience are shown to be less-accurate forecasters (Chen 2004).

In terms of strategic forecasting behavior, the systematic tendency to forecast in a particular

direction apparently depends on the time period in question. Early research finds a

preponderance of negative forecast errors, suggesting that forecasts are optimistically biased

during the 1970-1980 time period in which the samples for these studies are drawn (Basi, et al.

1976; Penman 1980). Studies between 1980 and the mid-1990’s find no discernible bias in

forecasts (McNichols 1989; Johnson, et al. 2001). A sample from a more-recent time period

(i.e., 1994-2003), in contrast, shows a steadily increasing pessimistic bias in quarterly manage-

ment earnings forecasts (Chen 2004). In the last year of her sample, Chen shows that actual

earnings exceeded forecasts 44 percent of the time, suggesting that quarterly earnings forecasts

are pessimistically biased.

The recent trend in forecast pessimism is often explained as the result of management’s

desire to use their earnings forecasts as a device to walk-down market earnings expectations

(Matsumoto 2002; Cotter, et al. 2006; Bergman and Roychowdhury 2007). As noted earlier,

managers intentionally issue pessimistic forecasts that, in turn, cause market participants to

revise downward their expectations. Although this behavior creates bad-news earnings forecasts

from management, it later creates an easier benchmark to meet or beat when actual earnings are

released. Bergman and Roychowdhury (2007) find that this bias depends on forecast horizon.

Specifically, for long-horizon analysts’ forecasts that are optimistic, firms are disinclined to

walk-down earnings estimates. In contrast, for short-horizon forecasts that are optimistic,

managers tend to walk-down analyst forecasts towards realized earnings. Therefore, it is not

surprising that annual earnings forecasts (usually long horizon) are optimistically biased (Rogers
 23

and Stocken 2005, Choi and Ziebart 2004), whereas quarterly forecast (usually short horizon) are

pessimistically biased.

Finally, research suggests additional factors associated with forecast bias. Specifically,

those managers who appear to be overconfident issue optimistically-biased forecasts (Hribar and

Yang 2006). In addition, firms with superior corporate governance provide more accurate and

less biased forecasts (Ajinkya, et al. 2005; Karamanou and Vafeas 2005). Firms issuing earnings

forecasts around equity offerings are optimistically biased (Lang and Lundholm 2000),

reiterating the role of incentives in understanding managers’ forecasting behavior. Finally,

Rogers and Stocken (2005) find that managers issue misleading earnings forecasts when it is

difficult to detect bias, but not otherwise.

Forecast Form

Managers can issue earnings forecasts in either qualitative or quantitative forms. Qualitative

forecasts are non-numerical (i.e., earnings will be higher next quarter), while quantitative

forecasts can occur as numerical point, range, minimum, or maximum estimates. Baginski, et al.

(1993) report that point and range forecasts account for less than 20 percent of their sample

drawn from the 1983-1986 time period. More-recent studies indicate that approximately 50

percent of forecasts sampled from 1993-1997 are point and range forecasts (Hutton, et al. 2003;

Baginski, et al. 2004). Regardless of the time period studied, these results imply that other types

of forecasts—qualitative and open-ended—account for a non-trivial percentage of forecasts.

Yet, the typical archival study focuses on point and range forecasts, perhaps due to their more-

straightforward interpretation for measuring accuracy and bias (Lev and Penman 1990; Rogers

and Stocken 2005; Atiase, et al. 2005a). Whereas measures of forecast accuracy and bias can be
 24

computed from range forecasts by using the midpoint of the range, there is no widely-accepted

way to measure bias or accuracy for a qualitative or open-ended forecast.

Researchers suggest that forecast form captures the precision of managers’ beliefs about the

future (King, et al 1990). More precise (i.e., point) forecasts are generally perceived to reflect

greater managerial certainty relative to less-precise (i.e., range) forecasts (Hughes and Pae 2004).

Factors that are positively associated with precise forecasts include managerial overconfidence

(Hribar and Yang 2006), superior corporate governance (Ajinkya, et al. 2005; Karamanou and

Vafeas 2005), and analyst following (Baginski and Hassell 1997). Moreover, research has

established that earnings forecasts made in the presence of analysts tend to be more precise

relative to press releases, possibly because of the immediacy and the directness of the potential

scrutiny from analysts (Bamber and Cheon 1998). Factors that are negatively associated with

forecast precision include firm size, return volatility, proprietary costs, exposure to legal liability,

and the length of the forecast horizon (Baginski and Hassell 1997; Baginski, et al. 2002; Bamber

and Cheon 1998). Finally, negative news is associated with less precise forecasts than is positive

news (Choi, et al. 2006).

Attributions Accompanying Forecasts

Although recognition that forecasts do not occur in isolation is not new (Waymire 1984), the

information accompanying forecasts is only recently subject to scholarly inquiry. For a sample

of 961 forecasts during 1993-1996, Baginski, et al. (2004) find that nearly three out of four

forecasts were accompanied by attributions, or causes, explaining their forecasts. They also

report that bad-news forecasts, maximum forecasts, and shorter-horizon forecasts are more likely

to be accompanied by these attributions. They also note that large firms are more likely to

provide attributions whereas firms in regulated industries are less likely to do so.
 25

Along similar lines, Hutton, et al. (2003) evaluate a sample of 278 forecasts for the period

1993-1997 and find that two in three firms supplemented their forecasts with verifiable forward-

looking information. Acknowledging that the information accompanying forecasts might be

value-relevant in its own right and may amplify (or diminish) the value of the forecast represents

an important departure from prior studies that typically evaluate the numerical forecast per se

and ignore the accompanying information.

Stand-alone Versus Bundled Forecasts

Earnings forecasts are often bundled with earnings announcements or with other corporate

announcements. In a sample of 658 forecasts for the period 1993-97, Hutton, et al. (2003) find

that 195 forecasts are made concurrently with earnings announcements. In a sample of 263

annual earnings forecasts for the period 1978-82, Han and Wild (1991) find that 162 are stand-

alone earnings forecasts whereas 101 earnings forecasts are accompanied by revenue forecasts.

Atiase, et al. (2005a) report that firms that provide guidance bundled with earnings announce-

ments have more favorable earnings guidance, are larger, and have higher book-to-market ratios

compared to firms that provide stand-alone guidance.

Forecast Disaggregation

Earnings forecasts vary in levels of disaggregation. That is, managers can issue a forecast of

only the bottom-line earnings number. Alternatively, they can issue earnings forecasts along

with forecasts of other key line items in the income statement (i.e., revenues, cost of goods sold,

etc.). Lansford, et al. (2007) find that nearly one in three S&P 500 companies that provide

annual earnings forecasts also provides disaggregated forecasts. These data are consistent with

Hirst et al. (2007) who review an ad hoc sample of 172 earnings forecasts for the year 2005 and
 26

find that, although most forecasts (71 percent) are of earnings, or earnings and revenues, a

substantial number of forecasts (29 percent) include multiple income-statement lines.

In general, prior empirical research does not identify either the circumstances under which

disaggregated forecasts are provided or the characteristics of firms that provide such forecasts.

An exception is Tucker et al. (2007) who find that the likelihood of issuing components of

earnings guidance is associated with good news earnings guidance, favorable forthcoming sales

performance, low value relevance of earnings, high institutional ownership, and high analyst

following. They conclude that forecast disaggregation is primarily associated with enhancing the

credibility of good news earnings guidance and responding to the demand for additional

disclosures.

Forecast Horizon and Timeliness

Managers can choose the time horizon over which they provide their forecasts. Typically,

managers provide quarterly or annual earnings forecasts. Recent evidence suggests that a

growing number of companies appear to be moving away from quarterly to annual guidance.

Specifically, in a survey of 654 of its members, the National Investor Relations Institute (NIRI

2006) reported that the percentage of companies providing annual guidance increased from 61 to

82 percent while the percentage of companies providing quarterly guidance declined from 61 to

52 percent. This change in behavior may be the result of market participants (CFA Institute

2006) and researchers (Fuller and Jensen 2002) expressing concerns over managers using their

forecasts to strategically manage the analysts’ consensus forecasts. They argue that such

behavior represents a game, particularly when it is done on a quarterly basis. Reflecting this

concern, they call for eliminating quarterly earnings guidance altogether.

 27

A related forecast characteristic is forecast timeliness which refers to the difference in time

between the forecast and the actual earnings realization. More-timely forecasts are issued further

in advance of actual earnings than are less-timely forecasts. Waymire (1985) studies timeliness

and finds that companies with more volatile earnings are likely to forecast later in the year.

Baginski, et al. (2002) argue that the more litigious environment in the U.S. leads U.S. managers

to issue shorter-term forecasts than Canadian managers.

In sum, once the decision to issue a forecast is made, managers have many choices as to the

characteristics of these forecasts. Most of these characteristics are controllable by the manager,

particularly in the short term. In the next section, we describe consequences associated with

firms issuing management earnings forecasts.

Forecast Consequences

Forecast consequences refer to the outcomes associated with the issuance of a forecast. As

we note previously, forecasts are issued for a variety of reasons (e.g., reduction of litigation risk,

reduction of information asymmetry) and produce a variety of related consequences. We

organize our discussion in this section around those consequences as shown in Figure 1—

namely, stock market reaction, information asymmetry/cost of capital, earnings management,

litigation risk, analyst and investor behavior, and reputation for accuracy and transparency.

Stock Market Reaction

Managers often issue earnings forecasts to correct information asymmetry problems and,

thus, influence their firm’s stock price (e.g., Nagar, et al. 2003). The idea that earnings forecasts

are value relevant was not always obvious, however. Indeed, early research questions whether a

forecast from management (i.e., a subjective and unaudited projection of future events) would be

relied upon by market participants. Studies from the 1970’s and early 1980’s find that manage-
 28

ment earnings forecasts indeed have information content as they influence stock prices (Patell

1976; Penman 1980).

Having established that management earnings forecasts are value relevant, subsequent

research examines whether forecaster and forecast characteristics affect the informativeness, or

the stock-price impact, of forecasts. Regarding forecaster characteristics, Hutton and Stocken

(2007) examine the effect of firm forecasting reputation on investors’ reactions to management

earnings forecasts. They construct a measure of forecasting reputation that reflects prior forecast

accuracy and frequency. They find that investors are more responsive (i.e., stock price reacts

more promptly) to managers’ good news forecasts when a firm has built a forecasting reputation.

Researchers also conjecture that markets may react differently to good-news versus bad-news

forecasts. Whereas bad-news forecasts are considered to be inherently informative, good-news

forecasts are considered informative only when accompanied by verifiable forward-looking

information (Hutton, et al. 2003) or if they come from managers who have been accurate in the

past (Ng, et al. 2006). Holding constant the absolute amount of news, markets appear to react

significantly more negatively to bad news compared to an equivalent amount of good news,

suggesting that bad news is inherently credible whereas managers have to expend greater effort

to make good news credible.11

The form and time horizon of the forecast is another characteristic that appears to influence

how stock markets react to the forecast, although the evidence on this point is mixed. Baginski,

et al. (1993) report that point forecasts are more informative relative to other (less precise) types

of forecasts, but Pownall, et al. (1993) and Atiase, et al. (2005a) find no difference in stock-price

reaction conditional on the form of the forecast. Additionally, Pownall, et al. (1993) also find

that interim forecasts are significantly more informative relative to annual forecasts.
 29

The manner in which the stock market reacts also depends on the type of additional

information accompanying management earnings forecasts. Although stand-alone forecasts are

more informative relative to forecasts bundled with earnings announcements (Atiase, et al.

2005a), stand-alone forecasts are not more informative than those containing attributions, or

detailed explanations (Baginski, et al. 2004). Similarly, forecasts accompanied by verifiable

forward-looking information are seen as more informative (Hutton, et al. 2003). The market

reaction to attributions and verifiable information accompanying forecasts, however, is not

unconditional. For example, external attributions (i.e., management targets a cause external to

the company in explaining their forecast) are generally viewed as informative whereas internal

attributions (i.e., management targets themselves as the cause) are not informative (Baginski, et

al. 2004). In a similar vein, verifiable forward-looking information enhances the informative-

ness of good-news forecasts, but not that of bad-news forecasts (Hutton, et al. 2003).

Information Asymmetry / Cost of Capital

Economic theory predicts that voluntary disclosures (and particularly those that suggest a

commitment to disclosure) reduce information asymmetry (Diamond and Verrecchia 1991; Leuz

and Verrecchia 2000). This reduction in information asymmetry, in turn, leads to a lower cost of

capital. One of the few studies that directly examine the cost-of-capital consequences of issuing

management forecasts is Coller and Yohn (1997). They document a reduction in bid-ask spreads

(a proxy for information asymmetry) as a consequence of providing management earnings

forecasts. Other studies provide indirect evidence on the connection between forecast issuance

and cost of capital. For example, consistent with the idea that issuing earnings forecasts

favorably impacts the terms at which a firm may be able to raise capital, prior research
 30

documents that more frequent forecasters also access capital markets more often (Frankel and

McNichols 1995).

Earnings Management

Managers cannot directly influence how much their stock price or cost of capital will change

in response to their earnings forecasts. However, they can influence the news that they

ultimately report. It is precisely this control over the subsequent earnings number that causes

many to express concerns that managers who provide earnings forecasts may later engage in

questionable practices (i.e., earnings management) or suboptimal behavior (i.e., forgoing

potentially profitable projects) to meet their self-imposed earnings targets (Fuller and Jensen

2002).

Research suggests that these concerns are valid. Specifically, evidence indicates that

managers use positive discretionary accruals to revise earnings upward to meet their own

forecasts (Kasznik 1999). Concerns that managers who provide earnings forecasts may engage

in myopic, or short-sighted, albeit legitimate business actions also has support. For instance,

Cheng, et al. (2005) find that more-regular forecasters invest significantly less in research and

development (R&D) relative to less-regular forecasters. They also find that more-regular

forecasters’ long-term earnings growth rates are significantly lower than that of less-regular

forecasters.

Although their research does not examine manager behavior (but does examine investor

perceptions of management behavior), Hirst, et al. (2007) find that investors believe that

financial reporting quality is higher when managers provide disaggregated forecasts. The idea

behind this behavior is consistent with an analytical model by Dutta and Gigler (2002) who show
 31

that managers are less likely to manage earnings when they constrain themselves in terms of

opportunities for subsequent earnings management.

Litigation Risk

Researchers posit that managers’ pre-emptive earnings disclosures, particularly when they

involve bad news, are aimed at avoiding litigation or at least minimizing the cost of subsequent

litigation. Specifically, Skinner (1994) argues that pre-emptive forecasts that convey impending

bad news reduce the subsequent potential for litigation, ceteris paribus, implying that bad-news

firms are better off issuing earnings warnings. However, Francis, et al. (1994) find no evidence

suggesting either that pre-emptive earnings forecasts deter subsequent litigation or that the

absence of such forecasts increases the likelihood of litigation. Surprisingly, they report that pre-

emptive guidance increases the likelihood of subsequent litigation. Their findings cast doubt on

the value of earnings guidance as a tool to minimize litigation risk. Field, et al. (2005) find that

pre-emptive bad-news forecasts are useful in deterring certain types of lawsuits. Further, their

results rule out the possibility that pre-emptive forecasts might actually trigger (instead of deter)

litigation.

Analyst and Investor Behavior

Many studies find that analysts update their forecasts in response to firms’ earnings forecasts

(Waymire 1986; Jennings 1987). Indeed, recent evidence suggests that approximately 60 percent

of analysts revise their forecasts within five days of management guidance (Cotter, et al. 2006),

suggesting the important role of management forecasts in the current stock market environment.

In earlier time periods, analysts often took up to four weeks to revise their forecasts (Jennings

1987). Even management forecasts that are confirmatory alter the dispersion of analysts’

forecasts without altering the mean consensus forecast (Clement, et al. 2003), indicating that
 32

analysts respond to management forecasts. Not surprisingly, Graham, et al. (2005) report that

the number of analysts covering a firm is higher for firms that provide more earnings forecasts

(also see Wang, 2007).

Research also shows that analyst behavior is influenced by certain forecast characteristics.

For example, Libby, et al. (2006) experimentally show that analysts’ earnings estimates are not

differentially influenced by forecast form (point versus range) immediately after the

announcement of a forecast (also see Hirst, et al. 1999). After earnings are reported, however,

forecast accuracy (a forecast antecedent) interacts with forecast form (a forecast characteristic) to

determine analysts’ revised earnings estimates.

Economic models predict that increased disclosures by firms, including management

earnings forecasts, will be associated with increased investment in the firm’s stock (Kim and

Verrecchia 1994; Diamond and Verrecchia 1991). Consistent with this prediction, Healy, et al.

(1999) document that sustained increases in earnings forecasts (among other disclosures) leads to

increased institutional ownership. However, not all institutional ownership is positively

associated with forthcoming corporate disclosure. Evidence reported by Bushee and Noe (2000)

suggests that transient institutions and quasi-indexers respond positively to expanded disclosures

whereas dedicated investors’ (institutions that have large, stable holdings in a small number of

firms) stock ownership is not related to expanded disclosures. 12

Reputation for Accuracy and Transparency

Over 90 percent of managers surveyed by Graham, et al. (2005) indicate that developing a

reputation for accurate and transparent reporting is a key factor motivating their voluntary

disclosures, including earnings forecasts. This idea is not new, having been previously

documented by other researchers (Skinner 1994; Stocken 2000; Healy and Palepu 2001). This
 33

focus on accurate forecasts appears well-founded as studies indicate that forecast accuracy

affects how analysts react to a forecast. As noted earlier, Hutton and Stocken (2007) report that

the median stock price reaction to good news is larger for firms with a reputation for providing

accurate (and frequent) forecasts than for firms without this reputation. Other researchers also

find similar results. Specifically, after controlling for the magnitude of the surprise in the

management earnings forecast, analysts revise their forecasts more for firms with high prior

forecasting accuracy, again showing that a reputation for forecasting accuracy is important

(Williams 1996; Atiase, et al. 2005b). Finally, research shows that managers’ forecasts tend to

be more accurate when they are issued in a venue where they expect immediate scrutiny, such as

a press conference or in a meeting with analysts (Bamber and Cheon 1998).

Interestingly, other research suggests that managers’ efforts to be viewed as transparent in

their disclosures may be misplaced. If one interprets an early warning of bad news to be a

transparent disclosure, then the results of Kasznik and Lev (1995) suggest that companies who

are transparent in their disclosures fare worse than those who are not transparent. Specifically,

they show that companies that warn ahead of bad news are worse off than those who do not

warn. A recent study by Tucker (2007) shows that the Kasznik and Lev conclusion appears to

hold for short-windows, though it goes away for long-windows after controlling for news

content. Libby and Tan (1999) experimentally demonstrate that this short-window result occurs

because a warning and a subsequent bad earnings outcome are two instances of bad news,

thereby causing analysts to consider the bad news twice. A recent experimental study by Mercer

(2005) may offer insight into one reason why firms warn about bad news in the short-term.

Specifically, she shows that being forthcoming about bad news causes investors to judge

management as credible.
 34

In sum, management earnings forecasts are associated with important capital-market

consequences, such as stock price and cost of capital changes. Not surprisingly, these conse-

quences are a function of the antecedents and forecast characteristics. For example, management

forecasts lead to greater earnings forecast revisions by analysts when they originate from firms

with high prior forecast accuracy (Williams 1996).

SUMMARY OF FRAMEWORK AND REVIEW

The framework and selective review of the literature suggest three important conclusions for

future research. First, when we look at the literature through the lens of our framework, we find

that there is relatively less theory regarding how managers choose forecast characteristics as

compared to a manager’s decision to issue a forecast and the expected consequences of doing so.

That is, existing theories generally address antecedents and consequences (e.g., Ajinkya and Gift

1984; Skinner 1994; Stocken 2000; Verrecchia 2001). These theories do not speak to many of

the choices that a manager faces once the decision to issue a forecast has been made. For

example, when managers with high incentives (perhaps due to compensation plans tied to stock

price) issue management earnings forecasts, they also must consider the characteristics

associated with those forecasts. That is, should they forecast just earnings or also other line-

items on the income statement? Should the forecasts also include explanations as to why the

forecasts are plausible? We believe that great potential exists for theory refinement and/or

development to address management’s choice of forecast characteristics.

Perhaps because of this relative lack of theory, there is less research on the determinants of

forecast characteristics. That is, much of the research in this area has documented the types of

forecast characteristics that exist (with less focus on the determinants of those characteristics) or

has treated forecast characteristics as exogenous variables. The latter research documents how
 35

forecast characteristics influence the market consequences associated with an earnings forecast.

Because of this, we know relatively less about how managers choose forecast characteristics than

we know about other aspects of management earnings forecasts. Stated differently, much of the

existing research focuses on the links between antecedents and consequences as well as

characteristics and consequences. The relationship between antecedents and characteristics (i.e.,

how characteristics are chosen) is studied less frequently.

Second, our review of the literature highlights that the modal study focuses on the main

effects of forecast antecedents or characteristics on forecast consequences. We argue that

significant advances in the literature will derive from the study of interactions as some of the

main effect results are unlikely to hold under all conditions. Although such interaction tests have

been more prevalent in recent research (e.g., Rogers and Stocken 2005; Hutton, et al. 2003;

Wang 2007), ample opportunities exist for further study. For example, the empirical variation in

a firm’s incentives to manage earnings (a forecast antecedent) influences the market’s reaction to

a forecast. What is less clear-cut, however, is how other factors might moderate the influence of

incentives—in particular, characteristics associated with the forecast. Can explicit choices of a

manager mitigate or exacerbate the effects associated with less-controllable factors, such as

antecedents? For example, Hirst, et al. (2007) experimentally show that managers with

substantial incentives to issue self-serving forecasts can mitigate investor skepticism by issuing

detailed, disaggregated forecasts that pre-commit managers to a specific path via which they will

achieve their earnings target. In other words, managerial incentives (a forecast antecedent)

interact with disaggregation (a forecast characteristic) to determine firm valuation (a forecast

consequence).
 36

Such interaction tests need not be limited to forecast antecedents and characteristics—they

could be between two (or more) forecast antecedents, characteristics, or consequences. For

example, Rogers and Stocken (2005) find that managers’ likelihood of issuing self-serving

forecasts (a forecast antecedent) is moderated by investors’ ability to detect such

misrepresentation (a forecast consequence). They report that managers are less likely to engage

in self-serving behavior (i.e., issue more optimistic forecasts before disposing of stock and more

pessimistic forecasts before acquiring stock or options) when investors can more easily detect

misrepresentation.

Third, our framework highlights the multi-period aspect of management earnings forecasts.

Interestingly, though, existing studies generally do not capture this feature in their research

designs. For example, many of the benefits attributed to the issuance of earnings forecasts are

based on short-window event studies that measure the impact of an earnings forecast

immediately after the issuance of a forecast. Studies that track the impact of an earnings forecast

both immediately following the earnings forecast and at a later time (e.g., after the earnings

release) are less common.

Intertemporal studies are important because many forecast consequences from one period

become forecast antecedents in subsequent periods. For example, an accurate forecast in the

current period lays the foundation for an enhanced reputation for accuracy in subsequent periods.

This antecedent, in turn, can influence how managers behave in subsequent periods—that is,

whether they issue forecasts and the characteristics of those forecasts. For example, Hutton and

Stocken (2007) construct a measure of forecasting reputation that reflects prior forecast accuracy

and frequency. They report that investors are more responsive (a consequence) to management

forecasts news when a firm has built a reporting reputation (an antecedent). In the experimental
 37

domain, Mercer (2005) shows that the short-term credibility benefits of issuing a forecast in light

of bad news (a forecast consequence and characteristic) are actually reversed in the long run.

That is, forthcomingness about bad news does not influence investors’ judgments about the

credibility of management after a longer time period has passed. Similarly, Libby, et al. (2006)

show that in the short-term, forecast form (a forecast characteristic) does not impact analysts’

earnings forecasts (a forecast consequence). However, once earnings are released, forecast

accuracy (a forecast antecedent) interacts with forecast form to determine analysts’ revised

earnings forecasts. Although these studies are in the minority of the extant research on

management earnings forecasts, all three make a strong case for considering the multi-period

nature of such forecasts. A challenge in leveraging this multi-period feature is identifying the

manner in which consequences from one period affect antecedents and forecasts in subsequent

periods.

CONCLUSION

In this paper, we adapt a framework originally proposed by Wiedman (2000) to review the

literature on management earnings forecasts. This framework categorizes the literature into three

components—antecedents, characteristics, and consequences—that roughly correspond to the

timeline associated with an earnings forecast. Antecedents refer to the pre-existing

environmental and firm-specific characteristics that influence the decision to issue a forecast.

Forecast characteristics refer to specific features of the forecast, chosen by managers, following

the decision to forecast. Forecast consequences refer to the outcomes resulting from forecasting.

Three important conclusions emerge through the lens of this framework. First, of all the

components of our framework, managers’ choice of forecast characteristics appears to be the

least well-understood (both in terms of theory and research) even though it is the component
 38

over which managers have the most control. Second, our review highlights that the modal study

focuses on the main effect of one or more forecast antecedents or characteristics on forecast

consequences. The study of interactions between and among forecast antecedents, characteris-

tics, and consequences appears to be a fruitful area for further work. Third, the multi-period

nature of management earnings research presents a number of opportunities for future research.
 39

ENDNOTES

1
By intention, we do not survey every paper on the topic of management earnings forecasts.
Our goal is to describe a sufficient number of studies within the context of our framework to be
able to legitimately render our conclusions.
2
We use different component labels than Wiedman (2000) who uses the terms environment,
attributes, and impact.
3
Earnings guidance represents any manager-provided information that guides outsiders in their
assessment of a firm’s future earnings, both directly and indirectly (Miller 2002). Thus, earnings
guidance might include, but need not be limited to, earnings forecasts. For instance, a firm’s
comments on its prospects in a new product market might be construed as indirect earnings
guidance. All references to earnings guidance in this paper refer to earnings forecasts only.
4
Even though preannouncements are technically earnings forecasts, most of the literature treats
them as early earnings announcements rather than late earnings forecasts. Accordingly, we do
not discuss preannouncements in this paper.
5
In theory, all elements under characteristics and consequences could be listed under
antecedents. That is, historical stock market reaction (a consequence) to a firm’s forecasts could
be an antecedent. The historical choices that a firm makes about forecast form (a characteristic)
could be viewed as an antecedent. Although we do not list all of these items under the
antecedents component, the reader is encouraged to think about whether and how other
characteristics and consequences might be profitably viewed as antecedents.
6
We focus on the U.S. environment. However, the framework could be expanded to cover
cross-border issues in other legal and regulatory regimes (see Baginski, et al. 2002).
7
Although the SEC does not provide a bright line definition of what constitutes material
information, recent enforcement actions indicate that even a discussion confirming a prior
forecast could be construed as material information (SEC v. Flowserve Corporation, 2005).
8
Two additional reasons exist regarding why forecast frequency may be understated. First, the
primary source of management earnings forecast data—the Corporate Investor Guidelines
database maintained by First Call—appears to be incomplete prior to 1998 (Lansford, et al.
2007; Anilowski, et al. 2007), thus understating the total number of forecasts. Note, though, that
Ajinkya, et al. (2005) and Choi and Ziebart (2004) both provide evidence that the Corporate
Investor Guidelines database is a more-complete source of management forecasts than
Factiva/Dow Jones News Retrieval System. Second, prior to Reg. FD companies could (and did)
engage in selective guidance. This selective guidance would not be reflected in public sources,
thereby understating forecast frequency.
 40

9
Kasznik and Lev (1995) define a large earnings surprise as one where the magnitude of the
earnings surprise exceeds one percent of the stock price.
10
Hirst, et al. (1999, 105) confirm these results with data for the period 1993-97. They find
mean (median) forecast error rates of 10.5 percent (3.5 percent) using a sample of 2,170
forecasts.
11
Kothari, et al. (2005) argue that this asymmetric market reaction may not be driven by news
content per se (good versus bad). They maintain that good news tends to be leaked out much
earlier than bad news. Therefore, stock prices already impound a substantial portion of the good
news. In contrast, bad news tends to be more of a surprise and markets react (more) negatively
because of the surprise element and not because of the news valence (good versus bad).
12
A growing experimental literature has examined how non-professional investors react to
management earnings forecasts. Han and Tan (2007), for example, experimentally show that
non-professional investors react differently to different types of range forecasts. That is, non-
professional investors’ revisions of forecasted earnings differ depending on whether
management’s range forecast has explicitly stated upper and lower bounds (i.e., earnings will be
between $1.00 and $1.10) or it has implicit upper and lower bounds (i.e., earnings will be within
5 cents of $1.05). Their results have implications for how managers disclose range forecasts, as
they suggest that investor reaction depends on this factor.
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 49

Figure 1: A Framework For Analyzing Management Earnings Forecasts

Decision to issue
forecast
FORECAST FORECAST FORECAST
ANTECEDENTS CHARACTERISTICS CONSEQUENCES

Forecast Forecaster
Environment Characteristics

• Legal and Regulatory • Information Asymmetry
Environment Pre-commitment to
• Analyst and Investor Disclosure
Environment • Firm-specific Litigation
Risk
• Managerial Incentives
• Prior Forecasting Behavior
• Proprietary Costs
• Earnings Forecast News
• Accuracy versus Bias
• Forecast Form
• Attributions Accompanying Forecasts
• Stand-alone vs. Bundled Forecasts
• Forecast Disaggregation
• Forecast Horizon and Timeliness
• Stock Market Reaction
• Information Asymmetry / Cost of
Capital
• Earnings Management
• Litigation Risk
• Analyst and Investor Behavior
• Reputation for Accuracy and
Transparency

This figure represents the various components in the forecasting process. Each component contains several elements. The forecasting
process is represented chronologically, but the bi-directional arrows indicate the iterative nature of the process.