Analyst Forecast Error:Analyst Forecast Error:Evidence from Restated Earnings and Analyst Evidence from Restated Earnings and Analyst

AffiliationAffiliation

Pei-Gin HsiehPei-Gin Hsieh

This StudyThis Study

Examines the issue of using forecast error Examines the issue of using forecast error as the benchmark for analyst performance.as the benchmark for analyst performance. Increased earnings restatements in recent Increased earnings restatements in recent

years.years. Significance of analyst conflict of interest Significance of analyst conflict of interest

issues.issues. What are the differences between the What are the differences between the

forecast error of affiliated vs. unaffiliated forecast error of affiliated vs. unaffiliated analysts for restatement firms vs. non-analysts for restatement firms vs. non-restatement firms?restatement firms?

Management Incentives-Management Incentives-Meet or Beat Analyst Meet or Beat Analyst

ForecastsForecasts Obtain rewards [Kasznik and McNichols Obtain rewards [Kasznik and McNichols

(2002), Chan et al. (2003), Dopuch et al. (2002), Chan et al. (2003), Dopuch et al. (2003)] and (2003)] and

avoid punishment [Skinner (1994), avoid punishment [Skinner (1994), Kasnick and Lev (1995), Chang (1991), Ip Kasnick and Lev (1995), Chang (1991), Ip (1998), Myers and Skinner (1999)] from (1998), Myers and Skinner (1999)] from investors via abnormal returns at the time investors via abnormal returns at the time of earnings announcements.of earnings announcements.

Management CompensationManagement Compensation

Management BehaviorManagement Behavior Manipulate reported earnings upward [GAO Manipulate reported earnings upward [GAO

(2002)].(2002)]. Guide street earnings (the bases of calculating Guide street earnings (the bases of calculating

analyst forecast error and earnings surprises) analyst forecast error and earnings surprises) upward [Abarbanell and Lehavy (2002), Ciccone upward [Abarbanell and Lehavy (2002), Ciccone (2002), Doyle and Soliman (2002)]. (2002), Doyle and Soliman (2002)].

Guide analyst forecasts downward [Matsumoto Guide analyst forecasts downward [Matsumoto (2002), Richardson et al. (1999), Chan et al. (2002), Richardson et al. (1999), Chan et al. (2003)]. (2003)].

Goal: Achieve small positive earnings surprises. Goal: Achieve small positive earnings surprises.

Consequences of GAAP Consequences of GAAP Earnings ManipulationEarnings Manipulation

Earnings restatements [GAO, 2002].Earnings restatements [GAO, 2002]. Class action lawsuits [Griffin, Class action lawsuits [Griffin,

Grundfest, Perino (2003)]. Grundfest, Perino (2003)]. Negative market reaction to both Negative market reaction to both

types of events [GAO (2002), types of events [GAO (2002), Richardson et al. (2002), Griffin, Richardson et al. (2002), Griffin, Grundfest, Perino (2003)].Grundfest, Perino (2003)].

Analyst Information Analyst Information Sources, Incentives, and Sources, Incentives, and

BehaviorBehavior Information sources: Information sources:

1. Private Information. 1. Private Information.

2. Management Guidance.2. Management Guidance. Incentives: Underwriting [Liu and Song Incentives: Underwriting [Liu and Song

(2001), Lin and McNichols (1998b), (2001), Lin and McNichols (1998b), DeChow, Hutton, and Sloan (2000)]DeChow, Hutton, and Sloan (2000)]

Behavior based on Incentives: Behavior based on Incentives:

Put more weight on management guidance.Put more weight on management guidance. Goal: Funding and commission. Goal: Funding and commission.

Analyst Forecast Error Analyst Forecast Error ResearchResearch

Analyst forecasts are slightly below earnings [Brown (1997, 1998, Analyst forecasts are slightly below earnings [Brown (1997, 1998, 2001), Bagnoli, Beneish, and Watts (1999), Richardson et al. (1999)] 2001), Bagnoli, Beneish, and Watts (1999), Richardson et al. (1999)] due to analyst conflict of interest issues [Chan, Karceski, Lakonishok due to analyst conflict of interest issues [Chan, Karceski, Lakonishok (2003)].(2003)].

Liu and Song (2001) find that affiliated (via lead underwriting Liu and Song (2001) find that affiliated (via lead underwriting relationships) analysts of internet companies are more pessimistic relationships) analysts of internet companies are more pessimistic than unaffiliated analysts before the burst of internet bubble in 2000. than unaffiliated analysts before the burst of internet bubble in 2000. The former provided pessimistic forecasts, while the later provided The former provided pessimistic forecasts, while the later provided optimistic forecasts. However, both types of analysts provide optimistic forecasts. However, both types of analysts provide pessimistic forecasts after the bubble burst.pessimistic forecasts after the bubble burst.

Hansen and Sarin (1996) find insignificant difference between the Hansen and Sarin (1996) find insignificant difference between the forecast error of affiliated (via SEOs) vs. unaffiliated analysts.forecast error of affiliated (via SEOs) vs. unaffiliated analysts.

DeChow, Hutton, and Sloan (2000), Lin and McNichols (1998a) find DeChow, Hutton, and Sloan (2000), Lin and McNichols (1998a) find that analysts’ long-term earnings forecasts are more optimistic for that analysts’ long-term earnings forecasts are more optimistic for stocks their employers underwrite. stocks their employers underwrite.

Zhang (2004) find that analyst forecast optimism hurts analysts’ Zhang (2004) find that analyst forecast optimism hurts analysts’ career outcome rather than helps it. career outcome rather than helps it.

Bajari and Krainer (2004) find that analysts are influenced more by Bajari and Krainer (2004) find that analysts are influenced more by market performance and peer pressure than by investment banking market performance and peer pressure than by investment banking incentives.incentives.

This StudyThis Study ManagersManagers

Manipulate GAAP [GAO (2002)] and Street Earnings Manipulate GAAP [GAO (2002)] and Street Earnings [Abarbanell and Lehavy (2002), Ciccone (2002), [Abarbanell and Lehavy (2002), Ciccone (2002), Doyle and Soliman (2002)] Upward.Doyle and Soliman (2002)] Upward.

Guide Analyst Forecasts Downward [Matsumoto Guide Analyst Forecasts Downward [Matsumoto (2002), Richardson et al. (1999), Chan et al. (2003)].(2002), Richardson et al. (1999), Chan et al. (2003)].

Compensation Incentives [Healy (1985)].Compensation Incentives [Healy (1985)]. Analysts Analysts

Follow Management Guidance [Matsumoto (2002)].Follow Management Guidance [Matsumoto (2002)]. Underwriting Incentives [Lin and McNichols Underwriting Incentives [Lin and McNichols

(1998b), DeChow, Hutton, and Sloan (2000), Liu and (1998b), DeChow, Hutton, and Sloan (2000), Liu and Song (2001)], although prior studies have Song (2001)], although prior studies have inconsistent conclusions.inconsistent conclusions.

Model for Analyst Model for Analyst ForecastsForecasts

Analyst forecast = a*management Analyst forecast = a*management guidance + (1-a)*private information guidance + (1-a)*private information

a = f (analysts’ company related a = f (analysts’ company related incentives).incentives).

Unanswered Research Unanswered Research Questions Questions

How do forecast errors differ when using How do forecast errors differ when using street earnings versus final earnings (i.e. street earnings versus final earnings (i.e. restated earnings for restatement firms, restated earnings for restatement firms, reported earnings for non-restatement firms) reported earnings for non-restatement firms) as the basis?as the basis?

How do forecast errors differ between How do forecast errors differ between restatement firms versus non-restatement restatement firms versus non-restatement firms?firms?

How do forecast errors of affiliated analysts How do forecast errors of affiliated analysts differ from those of unaffiliated analysts?differ from those of unaffiliated analysts?

How do forecast errors of the above How do forecast errors of the above combinations differ?combinations differ?

Definition of EarningsDefinition of Earnings

Street Earnings: continuing operating Street Earnings: continuing operating annual earningsannual earnings

GAAP (reported, restated, final) GAAP (reported, restated, final) Earnings: earnings per share before Earnings: earnings per share before extraordinary items.extraordinary items.

Final Earnings: reported earnings for Final Earnings: reported earnings for non-restatement firms; restated non-restatement firms; restated earnings for restatement firmsearnings for restatement firms

Definition of Forecasts and Definition of Forecasts and AnalystsAnalysts

The last forecast before each annual The last forecast before each annual earnings announcement [Bernhardt earnings announcement [Bernhardt and Campello (2002), Brown and and Campello (2002), Brown and Kim (1991)].Kim (1991)].

Affiliated analysts: Analysts whose Affiliated analysts: Analysts whose employers are underwriters of IPOs employers are underwriters of IPOs or SEOs of covered firms within a 6 or SEOs of covered firms within a 6 year window around earnings year window around earnings announcements.announcements.

Hypotheses 1Hypotheses 1 H1a: Street earnings are greater than reported H1a: Street earnings are greater than reported

earnings.earnings. H1b: Street earnings are greater than reported H1b: Street earnings are greater than reported

earnings for restatement firms.earnings for restatement firms. H1c: The difference between street earnings H1c: The difference between street earnings

and reported earnings is greater for restatement and reported earnings is greater for restatement firms than for non-restatement firms.firms than for non-restatement firms.

H1d: The difference between street earnings H1d: The difference between street earnings and final earnings is greater than the difference and final earnings is greater than the difference between reported earnings and final earnings between reported earnings and final earnings for restatement firms.for restatement firms.

Summary of Sub-Summary of Sub-Hypotheses 2 & 3Hypotheses 2 & 3

I/B/E/S Actuals Final Earnings HE2a ERRORAR<ERRORUR HE3a ERRORAR>ERRORUR

HE2b ERRORAN<ERRORUN HE3b ERRORAN>ERRORUN

HE2c ERRORAR>ERRORAN HE3c ERRORAR>ERRORAN

HE2d ERRORUR>ERRORUN HE3d ERRORUR>ERRORUN

Data SourcesData Sources

Institutional Brokers Estimates Institutional Brokers Estimates System (I/B/E/S)System (I/B/E/S)

Compustat Compustat Center for Research in Security Center for Research in Security

Prices (CRSP) Prices (CRSP) GAO-03-395R, EDGAR, Lexis-Nexis GAO-03-395R, EDGAR, Lexis-Nexis

Newswire Newswire SDC SDC

Time PeriodTime Period

Earnings restated: 1997-mid 2002.Earnings restated: 1997-mid 2002. Misstated and restated earnings: Misstated and restated earnings:

1992-2001.1992-2001. Reported earnings, street earnings, Reported earnings, street earnings,

analyst forecasts: 1992-2001.analyst forecasts: 1992-2001.

Data AnalysesData Analyses

Supplemental Analyses Supplemental Analyses Based on the Same Framework Based on the Same Framework

for H1-H3for H1-H3 Magnitude and Direction of Street Earnings Magnitude and Direction of Street Earnings

Guidance relative to reported earnings and Guidance relative to reported earnings and final earnings final earnings

-Restatement Firms vs. Non-Restatement -Restatement Firms vs. Non-Restatement FirmsFirms

Forecast Bias using street earnings, final Forecast Bias using street earnings, final earnings as the basesearnings as the bases

-Affiliated vs. Unaffiliated Analysts of -Affiliated vs. Unaffiliated Analysts of

Restatement Firms vs. Non-Restatement Restatement Firms vs. Non-Restatement FirmsFirms

SummarySummary Managers of restatement firms manipulate Street Managers of restatement firms manipulate Street

Earnings upwards from GAAP Earnings. However, Earnings upwards from GAAP Earnings. However, this is not so for non-restatement firms.this is not so for non-restatement firms.

For non-restatement firms, there is no difference For non-restatement firms, there is no difference between the forecast error and forecast bias of between the forecast error and forecast bias of affiliated and those of unaffiliated analysts. Hence, affiliated and those of unaffiliated analysts. Hence, there is no evidence of conflict of interest issues for there is no evidence of conflict of interest issues for these firms.these firms.

For restatement firms, both affiliated and For restatement firms, both affiliated and unaffiliated analysts are unable to warn investors unaffiliated analysts are unable to warn investors about the existence of earnings manipulation. about the existence of earnings manipulation.

Affiliated analysts of restatement firms issue Affiliated analysts of restatement firms issue forecasts that are greater than Street Earnings. forecasts that are greater than Street Earnings. Although the cause for this evidence is unknown, it Although the cause for this evidence is unknown, it is not due to conflict of interest issues.is not due to conflict of interest issues.

Implications and Implications and ContributionsContributions

There is no need for concern There is no need for concern regarding analyst conflict of interest regarding analyst conflict of interest issue.issue.

Academics and Regulators need to Academics and Regulators need to help investors identify firms that help investors identify firms that manipulate earnings.manipulate earnings.

Regulators need to provide cost Regulators need to provide cost effective ways to solve the effective ways to solve the “restatement firms” problems.“restatement firms” problems.