It’s always a huge day on Wall Street when a major company issues its annual earnings report. If it’s better than expected, share prices can skyrocket – perhaps creating a ripple effect throughout the markets. If worse than expected, prices – and expectations – can come crashing down. Just look at Cisco Systems, which undershot its 2000 earnings projections by mere cents, causing shockwaves throughout the tech sector.


But in a perfect world, earnings reports shouldn’t create such volatile reactions. That’s because they have been preceded by the company’s earnings forecast, initially released about 190 days before the end of the year. Of course, “perfect world” is the operative phrase here. That “perfect world” is one where you can take these earnings forecasts at face value. Unfortunately, according to Credibility of Management Forecasts, a new study by Wharton accounting professor Phillip Stocken and Wharton doctoral candidate Jonathan L. Rogers, that perfect world doesn’t exist, and investors know it.


Rogers and Stocken looked at management forecasts, analyst forecasts, earnings reports, stock price response to forecasts, market conditions and incentives for forecast manipulation in 600 companies across a cross-section of industries between 1996 and 2000. They picked this period because it represented the first five years after Congress’ 1995 enactment of the Private Securities Litigation Reform Act, which protected corporate managers from being sued over forward-looking statements made in good faith. Previously, such “safe harbor” provisions only applied to SEC filings.


Based on their study results, Rogers and Stocken concluded that managers face tremendous incentives to strategically manipulate their forecasts to achieve particular results in the marketplace. They also concluded that managers are more likely to act on these incentives if they think they won’t get caught. Finally, they determined that the market realizes this, and looks skeptically at forecasts that are higher than analysts’ expectations.


Stocken says this study raises real questions about the overall credibility of management forecasts, and reinforces the following points:


·         Investors must be cautious when responding to management forecasts

·         Managers need to develop reputations for truthful forecasting

·         Private market forces may not be enough to deter management from issuing self-serving forecasts.


“We found that [if management is] more likely to be exposed as having lied or biased their forecasts, they are less likely to manipulate their forecasts,” says Stocken. “Opponents of the 1995 legislation argued that [because of the difficulty of proving bad faith] it would provide firms with a ‘license to lie.’ Proponents, on the other hand, argued that private market forces would induce truthful reporting. What we find is that managers do strategically manipulate these forecasts … Our study suggests that maybe we need to think about the appropriateness of the safe harbor provisions that have been provided.”


Cynical Public?

One of the study’s main conclusions is that management does indeed have strong incentives to strategically manipulate their companies’ earnings forecast. For example, managers at financially distressed firms would likely feel compelled to give “good news” forecasts, meaning forecasts that exceed those given by analysts. This is almost purely a matter of self-preservation, Stocken says. If the firm has performed poorly, the manager wants to show the board that he’s executing a business plan that will turn things around. “If the manager were to issue a pessimistic forecast, he’d likely be fired, and the shareholders and board would be inclined to appoint new managers whom they believe can return the firm to financial health,” says Stocken.


But managers also have strong strategic incentives to offer bad news forecasts too, Stocken and Rogers found. Firms in concentrated industries with few players are generally more profitable than those in other industries, so they obviously want to scare potential competitors from entering their market. They do this by issuing forecasts grimmer than those issued by the analyst community.


“These [findings] are all common sense,” says Stocken. “But we had to establish that we could predict what the forecast errors would be and understand how the management goes about manipulating forecasts. We expected to find these results, but we didn’t know for sure when we started.”


Meanwhile, Stocken and Rogers discovered that the investing public does, indeed, take potential manipulation into account when they react to optimistic forecasts. For example, the public adjusts for the bias in good news forecasts by dampening its response. That’s because the market is skeptical about management’s motives in issuing such a positive forecast. “[The market] tries to assess the management’s incentive or amount of manipulation in the forecast and then removes the bias that it thinks the forecast contains.”


However, the public handles bad news forecasts a little differently. The market seems to take these forecasts at face value as if they are unbiased representations of management beliefs, says Stocken. This is the case, even though – according to the study – bad news forecasts are just as likely to be biased as good news forecasts. The market’s subsequent response, however, is consistent with it eventually identifying the bias in bad news forecasts and modifying its valuation of the firm in the appropriate direction. “This goes straight to behavioral notions of people,” says Stocken. “Perhaps they are saying, ‘Well, since they have issued bad news, management probably has been truthful, and so we will accept what they are saying,’ where in the case of good news the perception may be that management is trying to push up the stock price. There is a lot of academic work arguing that bad news is more credible than good news, though we believe it’s not well-founded. But we still agree that bad news is perceived as more credible.”


Although this goes beyond the scope of the report, Stocken also acknowledges that it may be even tougher to gauge the credibility of earnings forecasts in today’s economy than it was in the period covered by the study. One important conclusion the study reached is that management was less likely to manipulate if they thought they were likely to be exposed. And in the past, it was a little easier to judge. You could simply compare the forecasts to the subsequent earnings announcements. But in the wake of high-profile corporate accounting scandals like the one involving WorldCom, earnings announcements may no longer be taken at face value. “In the current environment, a number of firms have been misstating their earnings announcements,” he explains. “Therefore it becomes very difficult to assess the credibility of any voluntary disclosures made and upon which investors rely.”


Proving Bad Faith

The results of the study send important messages to investors, management and policymakers alike.


For investors, the message is not to take any management forecasts at face value, says Stocken. Since bad news forecasts are every bit as likely to be strategically manipulated as good-news forecasts, it’s crucial to view both of them skeptically. Look carefully for any incentives management may have in making their forecasts and assess what these incentives are, Stocken suggests. “If you look at much of the academic literature out there, you would think bad news is credible. But it’s not good for investors to think that way.”


For managers, the message is to try to overcome public skepticism by developing a reputation for forecasting truthfully. They can do this by helping investors evaluate the integrity of their forecast, reconciling the forecast to the earnings announcement that’s been examined by the firm’s auditors (assuming, of course, that the public believes earnings announcements can still be trusted). After all, a discrepancy doesn’t always mean management was dishonest in the forecast. Macroeconomic circumstances can change a lot in 190 days, as can competitive positions. If management can point to specific circumstances that explain, say, a 10-cent discrepancy in earnings, investors will probably accept that explanation.” “Investors might even be more inclined to [accept] subsequent forecasts if the manager has a history of reconciling forecasts,” says Stocken.


Finally, for policymakers, the study indicates that it may be time to re-examine the 1995 extension of safe-harbor provisions. One of the study’s most important conclusions is that managers are more tempted to manipulate forecasts if they are less likely to be exposed for it. With the 1995 legislation, they are less likely to be sued because a plaintiff is now required to prove that a forecast was made in bad faith, meaning made with actual knowledge that it was false or misleading. Simple reckless or incompetent forecasting is no longer enough to get a manager sued.


Bad faith is obviously an extremely tough case to prove, which is why critics of the legislation initially branded the law a “license to lie,” Stocken notes. The law’s proponents claimed that market forces – like impact on a manager’s reputation – would induce truthful forecasts. But Stocken says that the results of this study indicate that market forces may not be enough. “You have to be very careful about generalizing from this very small study that the law should be revisited or changed, because there are many forces at play,” he warns. “But you can certainly raise questions about this piece of legislation. It’s at least cause for debate.”