investor's decision and management forecasting

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The effects of analyst forecasts and earnings trends onperceptions of management forecast credibility

Lisa M. Gaynora, Andrea S. Keltonb

aSchool of Accountancy, University of South Florida, Tampa, FL, USAbSchools of Business, Wake Forest University, Winston-Salem, NC, USA

Abstract

We examine whether analyst forecasts influence investors perceptions of the credi-

bility of a good news management earnings forecast. We hypothesize that the effectof analyst forecasts will depend on whether the analyst forecast confirms manage-

ments forecast and the extent to which managements forecast is consistent with

the prior earnings trend. Findings indicate that the positive effect of a confirming

analyst forecast is greater when the management forecast is trend inconsistent than

when it is trend consistent. The negative effect of a disconfirming analyst forecast

does not differ based on management forecast trend consistency.

Key words: Analyst forecast; Management earnings forecast; Disclosure credibi-

lity; Investor expectations

JEL classification: M41

doi: 10.1111/j.1467-629X.2012.00505.x

We thank Anna Cianci, Shana Clor-Proell, Sukari Farrington, Frank Hodge, Lisa Koo-nce, Molly Mercer, Norma Montague, Sundaresh Ramnath, Jane Thayer, Shankar Venk-ataraman, Julie Wayne, Ya-Wen Yang, Tina Zamora and particularly, Steven Cahan (theEditor) and two anonymous referees for helpful comments and suggestions. We alsoacknowledge comments provided by the reviewers and participants of the 2010 AAAAnnual Meeting, the 2009 ABO Research Conference, and the New England BehavioralAccounting Research Series. We would like to express our gratitude to Robin Dillon-Merill, Dawn Porter, and David Post for assistance in recruiting participants. Finally, we

thank Lee Kersting, Norma Montague and Nicole Siroonian for research assistance. Pro-fessor Kelton gratefully acknowledges financial support from the Wake Forest School ofBusiness.

Received 26 July 2011; accepted 14 June 2012 by Steven Cahan (Editor in Chief).

2012 The AuthorsAccounting and Finance 2012 AFAANZ

Accounting and Finance 54 (2014) 189210


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1. Introduction

Investors often use management earnings forecasts to make investment-related

judgments and decisions. However, investor reliance on management forecastsdepends on the credibility of the disclosure (Jennings, 1987; Mercer, 2004; Hirst

et al., 2007). Investors know that managers have incentives to release biased fore-

casts, and investors must often use other information to corroborate the infor-

mation contained in a management forecast (Huttonet al., 2003). One source of

information that investors may use to determine the credibility of a management

forecast is analyst forecasts (Mercer, 2004). While much prior accounting

research has investigated the independent effects of management forecasts (e.g.

Coller and Yohn, 1997) and analyst forecasts (e.g. Lys and Sohn, 1990), little

research has investigated investors combined use of both of these informationsources. Because it is common for investors to utilize multiple sources of infor-

mation in their judgments and decisions, we investigate these joint effects.

Because management forecasts are voluntary disclosures, managers incentives

for issuing forecasts and the credibility of the forecasts are important factors

affecting investors use of these forecasts (Healy and Palepu, 2001). Forecast

credibility is of particular concern when the forecast conveys good news1 because

managers have market incentives to provide good news (Ajinkya and Gift,

1984). Consequently, investors often question disclosures that are seemingly dri-

ven by managements incentives (Hodgeet al., 2006) and may require additional

information to judge the credibility of such disclosures. For example, results

from Huttonet al. (2003) suggest that investors only consider good news fore-

casts to be credible when management provides verifiable forward-looking dis-

closures that corroborate the forecast.2 Because the impact of management

forecasts on investors judgments depends on the perceived credibility of such

forecasts, understanding the factors that influence investor perceptions of the

credibility of management forecasts, especially good news forecasts, is important

(Hirst et al., 2007). Thus, the purpose of this study is to investigate how inves-

tors perceptions of the credibility3 of a management earnings forecast are jointly

1 Hutton et al. (2003) use good news to indicate a management forecast that is higherthan an analyst forecast. Hirst et al. (2007) use good news to indicate a managementforecast that exceeds prior years actual reported earnings. In our setting, a good newsforecast is consistent with that used by Hirst et al.(2007).

2 Huttonet al.(2003) also report that good news forecasts are more likely than bad newsforecasts to be supplemented with the additional disclosures, which suggests that manag-ers are aware of the credibility concerns associated with good news forecasts and makeefforts to increase the credibility of the good news disclosures.

3 Mercer (2004, p. 186) defines disclosure credibility as investors perceptions of the believ-ability of a particular disclosure and differentiates between disclosure credibility and man-agement credibility. Although management credibility may influence disclosure credibility(Mercer, 2004), our study focuses on disclosure credibility.

190 L. M. Gaynor, A. S. Kelton/Accounting and Finance 54 (2014) 189210



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influenced by whether the analyst earnings forecast corroborates managements

forecast and the consistency of a management earnings forecast with the prior

earnings trend. We specifically examine these effects under the good news fore-

cast scenario as these forecasts are deemed to be less credible.Analyst forecasts are useful to investors in investment-related judgments and

decisions (e.g. Hirstet al., 1995; Ackert et al., 1997). Analyst forecasts are often

released subsequent to managements forecasts and provide information to inves-

tors regarding management forecast credibility (Jennings, 1987). However, recent

financial scandals have led to questions related to the independence between

financial analysts and firm management and have highlighted the related

incentives of analysts to provide overly optimistic disclosures. For example, Feng

and McVay (2010) show that incentives to please management often result in

analysts issuing biased short-term earnings forecasts. Research suggests thatinvestors are aware of these incentives and, as a result, discount both negative

and positive information from analysts (Kothariet al., 2009). Thus, the nature

of the relationship between management and analysts and the effect of this rela-

tionship on investors use of analyst forecasts make this an interesting and

important area of research.

The extent to which investors will rely on analyst forecasts will likely depend

on characteristics of managements forecast, and specifically whether manage-

ments forecast is consistent with their expectations. Absent additional informa-

tion, investors develop future earnings expectations based on a firms historical

reported earnings and use earnings trend as a benchmark to evaluate future per-

formance (Grahamet al., 2005; Koonce and Lipe, 2010). Investors are thus also

likely to evaluate an earnings forecast, specifically the credibility of the forecast,

based on the extent to which the forecast is consistent with the prior earnings

trend (Mercer, 2004).4 Research in psychology (Hastie, 1984) and accounting

(Earley, 2002; Ballou et al., 2004) suggests that investors may evaluate subse-

quent information (e.g. analyst forecasts) differently based on whether manage-

ments forecast is consistent with the prior earnings trend (hereafter, trend

consistency). Specifically, research shows that individuals expend more effort

processing information that is inconsistent with their expectations such that theirreliance on the information, and any subsequent information received, is more

extreme (Earley, 2002; Ballou et al., 2004; Clor-Proell, 2009). As such, we

posit that, when presented with analyst forecasts, changes to investors credi-

bility judgments and decisions will be greater when managements forecast is

4 Investors may use other information to form expectations (e.g. other management-pro-vided information); however, we chose to focus on the prior years earnings trend as itshould be perceived as relatively credible as such earnings would have been audited. Weutilize Mercer (2004, 192) who states, an earnings growth forecast of 10 percent is proba-bly less credible coming from a firm that reported three consecutive years of negativeearnings growth than one that reported three consecutive years of positive earningsgrowth.

L. M. Gaynor, A. S. Kelton/Accounting and Finance 54 (2014) 189210 191



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inconsistent with the prior earnings trend than when it is consistent with the

prior earnings trend.

We conduct an experiment that utilizes a 22 between-participants research

design. Across the four groups of participants, we vary the consistency of a goodnews management forecast with the prior earnings trends (trend consistent versus

trend inconsistent) and whether the analyst forecast confirms (or contradicts) man-

agements forecast. Study participants are Master of Business Administration

(MBA) students who are asked to assume the role of investors. Participants review

information regarding a potential investment opportunity, including earnings fore-

casts from the companys management and from analysts. To isolate the incremen-

tal effect of the analyst forecast on credibility judgments, we measure participants

perceptions of management forecast credibility, as well as their own estimates of

earnings per share (EPS), both prior to and after receiving the analyst forecast. Weutilize credibility and EPS change scores to examine the effect of the analyst fore-

cast on investor judgments. In all scenarios, managements forecast is a good news

forecast (i.e. the forecasted EPS is higher than the prior years reported EPS).

Ceteris paribus, we expect that analyst forecast confirmation and management

forecast consistency will jointly affect investors perceptions of management fore-

cast credibility. We predict that the positive effect of a confirming analyst fore-

cast will be moderated by management forecast consistency. Research shows

that investors often discount favourable analyst reports (Hirstet al., 1995); thus,

we expect investors, when given a confirming (i.e. favourable) analyst forecast,

to also consider management forecast consistency. Specifically, because of the

expectations violation caused by a trend inconsistent management forecast, we

predict that the positive effect of a confirming analyst forecast will be greater for

trend inconsistent forecasts than for trend consistent forecasts. Alternatively,

research suggests that investors consider negative information to be more rele-

vant to their investment decisions than positive information (Cianci and Falsetta,

2008; Coram, 2010) and bad news analyst forecasts are more useful to investors

than good news analyst forecasts (Frankelet al., 2006). Thus, we do not expect

investors negative reactions to a disconfirming analyst forecast to differ based

on management forecast consistency.Collectively, our results inform both research and practice. Our results confirm

findings from archival accounting research (e.g. Jennings, 1987), which suggest

that analyst forecasts provide information about management forecast credibil-

ity. However, our results show that the informativeness of analyst forecasts

about management forecast credibility depends on the agreement between the

forecasts and on the consistency of managements forecast with investors earn-

ings expectations. Extant research in accounting has focused mostly on under-

standing factors thatnegatively influence management credibility, and very few

studies examine factors that may improve the credibility of management earningsforecasts (Mercer, 2004). We show that a confirming analyst forecast can

improve investor perceptions of management forecast credibility, even when

managements forecast is inconsistent with investors expectations.




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On a practical level, our results provide information to managers on specific

factors that affect the credibility of their earnings forecasts, specifically those

forecasts that are perceived as inherently less credible (i.e. good news forecasts).

According to Hirstet al. (2008, p. 329), managers have to expend greater effortto make good news credible. We find that the damage to credibility from an

unexpected (i.e. trend inconsistent) management forecast can be offset by a

confirming analyst forecast. Thus, our results suggest that to increase forecast

credibility among investors, managers may have to expend additional effort

in convincing intermediaries, like financial analysts, that their information is

credible. Such efforts may be more rewarding in instances where the manage-

ment forecast contains a surprise element (i.e. deviates from expectations). This

finding is consistent with recent evidence that suggests managers use earnings

guidance to lead analysts towards beatable earnings targets (Cotteret al., 2006).However, our results also show that companies may be penalized, at least tempo-

rarily, if analyst forecasts are below their own forecasts.

The remainder of this paper is organized as follows. In the next section, we

provide the theoretical background and present the motivation for our hypothe-

ses. In the third section, we discuss the research method used in the study, and in

the fourth section, we present and discuss the results. We provide concluding

remarks in the final section.

2. Theory and hypothesis

Jennings (1987) provides evidence that analyst forecasts made subsequent to

the release of a management earnings forecast provide information about the

credibility of the management forecast. Subsequent studies in accounting use

analyst forecast revisions as a proxy for management earnings forecast credibility

(e.g. Koch, 2005). These studies presume that analyst forecasts represent market

expectations and, therefore, analyst forecast revisions proxy for investors assess-

ment of the credibility of managements forecast (i.e. the bigger the deviation of

the analyst forecast from managements forecast, the lower the perceived credi-

bility of managements forecast). While this presumption may be true, otherresearch finds that investors expectations may differ from analyst expectations

and that investors (mentally) adjust analyst forecasts to incorporate other infor-

mation. For example, Hirst et al. (1995) find that investors incorporate both

characteristics of the analyst (e.g. their relationship with management) and of

the analyst report (e.g. the favourability of the news conveyed) in their judg-

ments. In general, they find that investors place less weight on analyst reports

that are from analysts with ties to management (i.e. less credible).5 Results from

5 Hirst et al. (1995) do not specifically measure their participants credibility judgmentsbut instead measure the mean stock performance ratings of stocks based on their manipu-lated variables.




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Ackertet al.(1997) and Pinello (2008) suggest that investors use analyst forecasts

for investment-related decisions, but that investors recognize and adjust analyst

forecasts to reduce the effects of perceived forecast bias. Thus, while research

shows that investors impound analyst information into their judgments and deci-sions, their use of analyst forecasts depends on other factors. In this study, we

examine the interactive effects of two such factors: analyst forecast confirmation

and management forecast trend consistency.

Collectively, both archival and behavioural accounting research indicates that

analyst forecasts are informative to investors (e.g. Hirst et al., 1995; Ackert

et al., 1997), and we expect that investors will utilize analyst forecasts to assess

the credibility of management earnings forecasts. Specifically, we expect that an

analyst forecast that confirms (does not confirm) a management forecast will be

perceived as positive (negative) information and will thus positively (negatively)affect investors perceptions of management forecast credibility.

Investors reliance on analyst forecasts will also depend to some extent on

whether the management forecast is consistent with the prior earnings trend

(i.e. is consistent with investor expectations).6 Expectations violations theory

predicts that information that is inconsistent with or deviates from expecta-

tions will cause individuals to expend more effort in processing the informa-

tion (Hastie, 1984). In general, individuals engage in deeper cognitive

processing in an attempt to discover the cause of the unexpected information

(i.e. causal reasoning; Hastie, 1984). Information that is inconsistent with

expectations is also more salient (Erdfelder and Bredenkamp, 1998) and

therefore has a greater influence on judgments (Fiske and Taylor, 1991).

Information that is inconsistent with expectations is also often considered to

be of lower quality (Koehler, 1993). While such findings are robust in psy-

chology research (Stangor and McMillan, 1992), they are also found in

accounting settings. For example, Earley (2002) examines the effect of consis-

tent and inconsistent information on auditors judgments related to the rea-

sonableness of a clients real estate valuation. She predicts and finds that

when initial information is consistent with auditors expectations, auditors

process subsequent information less deeply, which in turn leads to decreasedjudgment quality. In addition, Ballou et al. (2004) find that auditors are less

likely to consider relevant subsequent information when a clients strategic

position is consistent with industry norms (i.e. their expectations). Clor-Proell

(2009) examines whether financial statement users judgments of a firms

accounting choice (i.e. recognition versus disclosure) are influenced by the

6 Prior research shows that managements reporting reputation (i.e. prior forecast accu-racy) is an important factor influencing investor judgments of management forecasts (Wil-liams, 1996; Hirst et al., 1999). In this study, we control for managements forecastingreputation by informing participants that the company has been consistently recognizedfor its high financial reporting quality by the Chartered Financial Analyst Institute. Thisdesign choice should bias against finding results.




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extent to which the firms choice matches their expectations. Her findings

show that users judgments of management credibility and investment deci-

sions are more extreme when the actual accounting choice does not match

expectations. In addition, Clor-Proell (2009) finds that users are more apt toseek out additional information when their expectations are violated.7 In

sum, the above research provides evidence that expectations violations invoke

additional processing, influence task outcomes (Earley, 2002; Ballou et al.,

2004) and credibility judgments (Clor-Proell, 2009) and affect individuals

search for additional information (Clor-Proell, 2009).

The effect of an expectations violation (i.e. a trend inconsistent manage-

ment forecast) should be most prevalent when individuals engage in sequen-

tial information processing such as when investors view various pieces of

information in evaluating a companys forecast. During sequential informa-tion processing, an individual develops an initial belief and then revises it to

account for subsequent information. The magnitude of revision often depends

on the extent to which new information deviates from prior beliefs (Hogarth

and Einhorn, 1992). In addition, the causal reasoning processes that are

evoked by inconsistent (sequential) information are most evident in settings

in which it is natural or adaptive to consider the motives, intentions or cir-

cumstances of the provider of the information (Hastie, 1984), as is the case

in forming credibility perceptions.

Based on the above, when managements forecast is inconsistent with

expectations, we expect that investors will consider it less credible and

expend more effort processing additional (subsequent) information (Hastie,

1984). Thus, investors will rely more on analyst forecasts when the forecast

is trend inconsistent than when it is trend consistent. However, we expect

that this effect will be most pronounced in the confirming analyst forecast

condition.

Prior research suggests that positive information from analysts often

lacks credibility. For example, Hirst et al. (1995) find that investors

discount favourable analyst reports and view unfavourable reports as

unexpected. Additionally, archival accounting research shows that themarket reacts more strongly to negative (versus positive) analyst forecasts

(Frankel et al., 2006), suggesting that bad news analyst forecasts are more

useful to investors. Consistent with these findings, we expect investors to

discount good news (confirming) analyst forecasts and to consider other

factors, such as management forecast consistency, in their judgments.

Owing to the expectations violation caused by the trend inconsistent

management forecast, we expect the positive effect of a confirming analyst

7 Clor-Proell (2009) measures participants propensity to search for additional informa-tion but does not assess actual search behaviour. This study extends findings from Clor-Proell (2009) by examining the effect of expectations violations on investors actual use ofadditional information.




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forecast to differ between management forecast consistency conditions.

Alternatively, given investors tendency to react more to negative news,

we expect investors to place more weight on the disconfirming analyst

forecast and thus do not expect investors reliance on the disconfirminganalyst forecast to differ between management forecast consistency condi-

tions. Formally stated:

H1: The positive effect of a confirming analyst forecast on investor perceptions of the credi-

bility of a good news management earnings forecast will be greater for trend inconsistent

forecasts than for trend consistent forecasts.

H2: The negative effect of a disconfirming analyst forecast on investor perceptions of the

credibility of a good news management earnings forecast will not differ for trend inconsistent

and trend consistent forecasts.

We expect results of this study to confirm findings from prior research that ana-

lyst forecasts are informative to investors and are used to assess management

forecast credibility (e.g. Hirst et al., 1995; Ackert et al., 1997). Because these

findings are well documented in the research, we make no formal hypotheses

although they are discussed in the results.

3. Method

3.1. Design

To test our hypotheses, we conduct an experiment using a 2 2 between-par-

ticipants design. The first factor relates to the relationship between the analysts

earnings forecast and the management earnings forecast. Specifically, the analyst

forecast either confirms or disconfirms managements forecast. The second

factor, management forecast consistency, relates to whether the management

earnings forecast is consistent with the firms prior earnings trend. In the trend

inconsistent (consistent) condition, the company has experienced a steady

decrease (increase) in EPS over the past 3 years. In all conditions, managements

forecast is the same ($0.81) and is greater than the most recent years reportedEPS ($0.71 in all conditions) (i.e. good news) and is thus either trend consistent

or trend inconsistent.

3.2. Participants

One hundred and forty MBA students from the United States participated

in the study as proxies for nonprofessional investors.8 Prior experimental

financial accounting research often uses MBA students to proxy for nonpro-

8 There were 142 participants in our initial pool; however, two participants did notcomplete the instrument and were omitted from our analyses.




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fessional investors (e.g. Maines and McDaniel, 2000; Hodge et al., 2004).

According to Elliott et al. (2007), MBA students are reasonable proxies for

nonprofessional investors for experimental tasks that are relatively low in inte-

grative complexity.9

Our experimental task is similar to those classified by El-liott et al. (2007) as exhibiting relatively low integrative complexity; thus,

MBA students are appropriate participants for our task. Approximately

88 per cent of participants reported having personal investing experience aver-

aging 4.8 years. Approximately 94 per cent of participants reported experience

conducting financial statement analysis. On average, students reported having

taken 2.4 (2.1) graduate-level accounting (finance) courses.10

3.3. Procedures

Participants were instructed to assume the role of a potential investor

in ProMed Corp, a hypothetical company that develops, manufactures and

markets surgical products. Participants were provided with instructions for

completing the case, general company background and management

information,11 and the companys actual reported EPS for the past 3 years.

Actual EPS for the past 3 years revealed either a downward (trend inconsis-

tent) or an upward (trend consistent) trend with the most current years EPS

held constant across all conditions. All participants then received ProMeds

9 Elliott et al. (2007, p. 140141) define integrative complexity as the complexity ofconnections involved in making a judgment or decision.

10 When included as a covariate, we noted no significant effects of any of our experiencemeasures in our results. Results excluding those participants without financial statementanalysis experience and with no previous graduate accounting and finance courses arequalitatively similar to those reported in the paper.

11 Management credibility (Mercer, 2004) and managements incentives (Hodge et al.,2006) affect disclosure credibility. Our instrument indicated that ProMeds manage-

ment has enjoyed a good reputation in the industry. Additionally, participants wereinformed that company officers do not receive performance-based compensation andthat ProMed has been consistently recognized by the CFA Institute for high-qualityfinancial reporting. We measured participants perceptions of ProMed managementscompetency at providing financial disclosures (competency) and ProMed manage-ments trustworthiness (trustworthy) (Mercer, 2005). Management forecast consistencydid not affect competency (p = 0.98) or trustworthy perceptions (p = 0.33). How-ever, participants in the confirming analyst forecast condition perceived ProMedsmanagement as significantly more competent and significantly more trustworthy(both p < 0.01) than those in the disconfirming analyst forecast condition. Resultsincluding competent and trustworthy as covariates are qualitatively similar and, assuch, are not included in the analyses as reported in this paper. Participants alsoassessed the likelihood that ProMed will file for bankruptcy in the next year and thelikelihood that ProMeds management has incentives to overstate estimates of futureearnings and meet analyst forecasts. As expected, these measures did not differacross treatment conditions and are not reported.




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earnings forecast and were asked to make several judgments regarding the

forecast and to provide their own EPS forecast. Next, participants were pro-

vided with the mean analyst earnings forecast from Thomson First Call,

depending on the experimental condition. Participants in the confirming (dis-

confirming) analyst forecast condition were given an analyst forecast equal to

(less than) managements forecast.12 Participants then made several judgments

regarding the information, provided a revised EPS forecast and completed thepost-experimental questionnaire. Figure 1 provides a description of the experi-

mental procedures.

Three most recentyears audited EPS

(Oldest to Most Current)

$0.61 $0.66 $0.71

Managementearningsforecastreleased

$0.81

Analystforecastreleased

(Confirming )

$0.81


(Disconfirming)

$0.71

Participantprovides revised

credibilityperception and

expected actualEPS


credibilityperception andexpected actual

EPS



EPS



EPS

Participantprovides initial


EPS

Three most recentyears audited EPS

(Oldest to Most Current)

$0.79 $0.75 $0.71

Managementearningsforecastreleased

$0.81


(Confirming)

$0.81

Trend inconsistent management forecast

Trend consistent management forecast


(Disconfirming)

$0.71

Participantprovides initial


EPS

Figure 1 Experimental procedures.

12 Investors reliance upon information from analysts depends on characteristics of theanalyst and the information, such as whether the report is favourable or unfavourable(Hirst et al., 1995). Participants were informed that Thomson First Call has a reputationfor high-quality forecasts and no mention was made about analyst revisions or any initialforecasts (i.e. analyst forecasts that may have been made prior to managements forecast).We measured participants perceptions of analyst forecast credibility using an 11-pointscale anchored by (0) not at all credible and (10) extremely credible. Analyst forecastcredibility is significantly different between analyst forecast confirmation conditions(p < 0.01). Interestingly, participants perceived the analyst as more (less) credible whenthe analyst confirmed (did not confirm) managements forecast (means = 6.36 vs. 5.12).




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The experiment was conducted in two settings. Sixty-six per cent of partici-

pants completed the experiment during scheduled class time using hard-copy

materials. Thirty-four per cent of participants completed the experiment at their

convenience on the Internet. The materials used in both settings were identicalexcept for the method in which they were obtained (hard-copy versus web

based). Analysis of the dependent measures indicates no significant differences

owing to experimental setting.13

3.4. Dependent variable

Our primary dependent variable is participants perceptions of management

earnings forecast credibility which we measure at two points in time: (i) after par-

ticipants receive managements forecast (initial measure) and (ii) after partici-pants receive the analyst earnings forecast (revised measure). We ask

participants to assess both the credibility and the believability of managements

forecast using 11-point scales anchored at (0) not at all credible (believable) and

(10) extremely credible (believable). We average these two measures into one

credibility score for further analysis (Hirstet al., 2007).14 To assess the incremen-

tal effect of the analyst forecast on management forecast credibility, we construct

a credibility change score calculated as the participants revised measure minus

his/her initial measure. As we are interested in both the direction and the magni-

tude of participants reactions to the analyst forecast, we use both the change

score and the absolute value of the change score in our analyses.

4. Results

4.1. Manipulation checks

To assess the effectiveness of the analyst forecast confirmation manipulation,

we asked participants whether ProMeds forecast was greater than, less than or

equal to the analyst forecast. One hundred and twenty-seven (90.7 per cent) par-

ticipants correctly identified the relationship. For the management forecast con-sistency manipulation, we asked participants to indicate ProMeds prior years

earnings trend. One hundred and thirty-three (95 per cent) participants correctly

identified the earnings trend.15

13 Prior research suggests that research conducted online and in a laboratory setting pro-vides similar results (Alexander et al., 2006).

14 The initial (revised) measures of believability and credibility are significantly correlated

with a Pearson correlation = 0.818, p < 0.01 (0.926, p < 0.01). Additionally, Cron-bachs alpha for the initial (revised) items is 0.899 (0.962).

15 Results excluding participants that did not correctly respond to either question arequalitatively similar to those reported in the paper.




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Additionally, we asked participants to indicate on an 11-point scale, after

receiving prior years reported earnings but prior to receiving managements

forecast and the analyst forecast, whether they believed the next years EPS

would be much less (scale value = )

5), no different (scale value = 0) ormuch greater (scale value = +5) than last years EPS. Participants in the

trend consistent condition indicated significantly different expectations for Pro-

Meds future EPS (t = 14.20, p < 0.01, one-tailed) than participants in the

trend inconsistent condition, and expectations were directionally consistent with

our manipulation (means = 1.94 vs. )1.53). Participants also reported the extent

to which they agreed that ProMeds earnings forecast was consistent with their

expectations using an 11-point scale anchored by ()5) strongly disagree and

(5) strongly agree. Responses were significantly different between the management

forecast consistency conditions (means =)

0.56 vs.)

1.45, t = 2.45, p < 0.01,one-tailed). These items provide additional support for our manipulations.

4.2. Hypothesis tests

Table 1 presents descriptive statistics for participants initial and revised credi-

bility judgments and credibility change scores. Participants initial credibility

assessments are significantly greater in the trend consistent condition than in

the trend inconsistent condition (means = 5.72 vs. 5.00, t = 2.37, p < 0.01,

one-tailed), suggesting that management forecast consistency affects the credibil-

ity of management forecasts. Credibility change scores in all conditions are sig-

nificantly different from zero (allp < 0.01), indicating that participants revised

their initial credibility perceptions to incorporate the analyst forecast. A confirm-

ing analyst forecast has a significantly positive effect on management forecast

credibility (mean = +1.16,p < 0.01), and a disconfirming analyst forecast has

a significantly negative effect on management forecast credibility (mean =

)1.45, p < 0.01). These results confirm that investors believe that analyst fore-

casts are useful for assessing management forecast credibility.

Panel A of Table 2 presents results from an ANOVA on the credibility

change scores,16 and Figure 2 provides a graphical summary of the results.Taken together, H1 and H2 predict an ordinal interaction between analyst

forecast confirmation and management forecast consistency. The first contrast

presented in Panel B of Table 2 is a comprehensive test of our predictions.

Consistent with prior research on the negativity bias (Ito et al., 1998), we

expect participants credibility change scores to be greater in the disconfirming

analyst forecast conditions than in the confirming analyst forecast conditions.

As predicted in H1, we also expect a confirming analyst forecast to affect

credibility change scores more when the management forecast is trend inconsis-

16 Nonparametric analysis provides qualitatively similar results (KruskalWallischi-square test = 71.613, p < 0.01).




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tent compared to trend consistent.17 As predicted in H2, we do not expect the

effect of a disconfirming analyst forecast to differ between management fore-

cast consistency conditions. The overall contrast is significant (t = 1.346,

p = 0.090) providing support for the predicted pattern described above.

Simple effect tests show that the positive effect of a confirming analyst forecast

Table 1

Descriptive statistics

Management forecast credibility judgments*,

Mean (median) [standard deviation]

Management forecast consistency

Analyst forecast Trend Trend

Confirmation Consistent Inconsistent Overall

Confirming analyst

forecast

Initial measure 5.99 (6.00) [1.71] 4.95 (5.00) [1.78] 5.47 (5.50) [1.81]

Revised measure 6.89 (7.00) [1.59] 6.39 (6.50) [1.77] 6.63 (7.00) [1.69]

Change score +0.88 (1.00) [1.29] +1.44 (1.00) [2.00] +1.16 (1.00) [1.69]n = 38 n = 37 n = 75

Disconfirming analyst

forecast

Initial measure 5.43 (5.00) [2.19] 5.07 (5.00) [1.42] 5.25 (5.00) [1.86]

Revised measure 3.97 (4.00) [2.00] 3.61 (3.00) [1.34] 3.80 (4.00) [1.71]

Change score )1.46 ()1.00) [1.55] )1.45 ()1.50) [1.33] )1.45 ()1.00) [1.44]

n = 34 n = 31 n = 65

Overall

Initial measure 5.72 (5.50) [1.96] 5.00 (5.00) [1.62]

Revised measure 5.50 (5.75) [2.30] 5.13 (5.00) [2.11]

Change score )

0.22 (0.00) [1.83] +0.13 (0.00) [2.25]n = 72 n = 68

*Trend consistent (inconsistent) management forecasts are good news management forecasts

made in situations where the prior earnings trend is increasing (decreasing) and thus are consis-

tent (inconsistent) with the prior trend. Confirming (disconfirming) analyst forecasts are analyst

forecasts that are equal to (less than) the management forecast. Participants assessed the credi-

bility and believability of managements forecast using 11-point scales anchored by (0) not at all

credible (believable) and (10) extremely credible (believable). We average these two measures

into one score, which we refer to as credibility. Participants assessed credibility at two points in

time after receiving managements forecast (initial measure) and after receiving the analyst

earnings forecast (revised measure). The change score is computed as the revised measure minusthe initial measure.

17 Contrast weights were assigned as follows: )3 for the confirming analyst forecast/trendconsistent condition, )1 for the confirming analyst forecast/trend inconsistent conditionand +2 for both disconfirming analyst forecast conditions.




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Table 2

Hypothesis tests

Panel A: Results of analysis of variance for credibility change scores

Source df SS MSE F p-value

Corrected model 3 243.88 81.29 32.71


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is greater for trend inconsistent forecasts than for trend consistent forecasts

(means +1.44 vs. +0.88, p = 0.076). The negative effect of a disconfirming

analyst forecast is not significantly different between management forecast

consistency conditions (means )

1.45 vs. )

1.46, p = 0.991). These results areconsistent with our hypotheses.

4.3. Additional analysis of credibility perceptions

We also analyse participants revised credibility measures to gain additional

insight into the effects of analyst forecasts on management forecast credibility.

As previously mentioned, ceteris paribus, investors perceive trend consistent

forecasts as more credible than trend inconsistent forecasts. However, descriptive

statistics presented in Table 1 suggest that an analyst forecast may mitigate thisfinding. Specifically, we find that a trend inconsistent forecast that has been con-

firmed by an analyst is significantly more credible than a trend consistent fore-

cast that has been disconfirmed by an analyst (means 6.39 vs. 3.97,p < 0.01).

Interestingly, participants perceive a trend inconsistent forecast to be just as cred-

ible as a trend consistent forecast when the forecast is confirmed by an analyst

(means 6.39 vs. 6.89, p = 0.11). These findings suggest that investors rely more

on information from analysts than characteristics of the management forecast

(i.e. management forecast consistency) when assessing management forecast

credibility.

4.4. Additional analysis of EPS estimates

The capital market consequences of forecast credibility are well documented in

the accounting literature (e.g. Jennings, 1987; Coller and Yohn, 1997). Hirst

et al. (2007) show that investor perceptions of forecast credibility are positively

related to estimated price-earnings multiples, that is, investors assess a value pre-

mium for firms with more credible earnings forecasts. Similarly, in our setting,

we expect participants to provide higher EPS estimates when the management

forecast is trend consistent and when the credibility of the management forecastis strengthened by a confirming analyst forecast. Therefore, while not our main

dependent variable, we also examine the effects of analyst forecast confirmation

and management forecast consistency on investors EPS judgments.

Participants provided EPS estimates after receiving ProMeds forecast (initial

EPS) and after receiving the analyst forecast (revised EPS). Panel A of Table 3

presents descriptive statistics for participants initial and revised EPS estimates

and the change scores (revised minus the initial EPS estimate). Interestingly, the

initial EPS estimates of participants in both management forecast consistency

conditions are significantly less than managements forecasted EPS (0.81 in allconditions) (p < 0.01) but significantly greater than the most recent years

reported EPS (0.71 in all conditions) (p < 0.01). Thus, participants in this study

appear to discount managements estimate when determining their own EPS esti-




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Table 3

Additional analysis

Panel A: Descriptive statistics for earnings per share estimates

Mean (median) [standard deviation]

Management forecast consistency

Analyst forecast

confirmation

Trend

Consistent

Trend

Inconsistent

Overall

Confirming analyst forecast

Initial measure 0.776 (0.780) [0.026] 0.756 (0.760) [0.039] 0.766 (0.770) [0.035]

Revised measure 0.787 (0.790) [0.023] 0.779 (0.790) [0.034] 0.783 (0.790) [0.029]

Change score +0.011 (+0.010) [0.019] +0.023 (+0.020) [0.029] +0.017 (+0.010) [0.025]

n = 38 n = 37 n = 75Disconfirming analyst forecast

Initial measure 0.768 (0.780) [0.038] 0.760 (0.760) [0.032] 0.764 (0.760) [0.036]

Revised measure 0.754 (0.750) [0.035] 0.745 (0.750) [0.029] 0.749 (0.750) [0.032]

Change score )0.015 ()0.020) [0.038] )0.016 ()0.020) [0.029] )0.015 ()0.100) [0.034]

n = 34 n = 31 n = 65

Overall

Initial measure 0.772 (0.780) [0.032] 0.758 (0.760) [0.036]

Revised measure 0.771 (0.775) [0.034] 0.764 (0.760) [0.036]

Change score )0.001 (0.000) [0.032] +0.005 (0.000) [0.035]

n = 72 n = 68

Panel B: Results of analysis of variance of earnings per share change scores

Source df SS MS F p-value

Corrected model 3 0.038 0.013 14.860


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mate but still provide a good news/optimistic EPS estimate, even when manage-

ments forecast lacks credibility (i.e. is trend inconsistent).

Earnings per share change scores in all conditions are all significantly different

from zero (all p < 0.01), indicating that participants revised their initial EPSestimates to incorporate the analyst forecast. In Panel B of Table 3, we present

results from an ANOVA of participants EPS change scores, and Figure 3

provides a graphical summary of the results. Consistent with our primary results

for credibility, the overall contrast presented in Panel C of Table 3 is significant

(t = 2.570, p = 0.006). Simple effect tests show that the positive effect of a con-

firming analyst forecast on EPS estimates is greater for a trend inconsistent forecast

than for a trend consistent forecast (means +0.023 vs. +0.011,p = 0.019). The

negative effect of a disconfirming analyst forecast does not differ between manage-

ment forecast consistency conditions (means)

0.016 vs.)

0.015,p = 0.926).Similar to Hirst et al. (2007) and Clor-Proell (2009), we examine whether

investor perceptions of management forecast credibility mediate the effect of ana-

lyst forecast confirmation on investors revised EPS estimates. The following

must exist to demonstrate mediation: (i) a significant analyst forecast confirma-

tion effect on EPS estimates; (ii) a significant analyst forecast confirmation effect

on credibility judgments; and (iii) a significant effect of credibility judgments on

EPS estimates when analyst forecast confirmation is included in the analysis

(Barron and Kenny, 1986). Untabulated analyses indicate that analyst forecast

confirmation significantly affects both revised EPS estimates (F= 42.326,

p < 0.01) and revised credibility judgments (F= 96.666, p < 0.01), meeting

the first two criteria above. To complete the mediation test, we conduct an

ANCOVA with revised EPS estimates as the dependent variable and analyst

+0.011

0.015

+0.023

0.016

Confirming analyst

forecast

Disconfirming analyst

forecast

Trend consistent

Trend inconsistent

Figure 3 Earnings per share change scores.




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forecast confirmation as the independent variable and include participants

revised credibility judgments as a covariate. Participants revised credibility

judgments are significant (F= 63.295,p < 0.01); however, analyst forecast con-

firmation is no longer significant (F= 1.085, p = 0.299). Thus, participantscredibility judgments appear to fully mediate the effect of analyst forecast confir-

mation on EPS estimates.

Further examination of participants revised EPS estimates shows that consis-

tent with Pinello (2008), participants in this study discounted information from

analysts when determining their own EPS estimate. As previously mentioned,

participants in the confirming analyst forecast/trend consistent condition were

informed that both management and analysts forecasted the same EPS (0.81).

However, these participants provided a mean final EPS estimate that was

significantly less than that which was provided by management and analysts(mean = 0.787,t =)6.264,p < 0.01).

5. Conclusions

Management forecast credibility is an important topic as management fore-

casts are not useful to investors unless they are credible. As managers have incen-

tives to voluntarily disclose good news, forecast credibility is of particular

concern for good news earnings forecasts and investors often require additional

information to confirm good news forecasts in order to perceive the forecast as

credible (Hutton et al., 2003). Analyst forecasts provide useful information to

market participants making investment-related decisions. Prior research (e.g.

Jennings, 1987) suggests that analyst forecasts represent market expectations

and, accordingly, provide information regarding the credibility of management

earnings forecast. However, research has not examined investors joint use of

analyst forecasts and the prior earnings trend in determining the credibility of

managements forecasts (Mercer, 2004).

In this study, we provide experimental findings on the effects of analyst fore-

cast confirmation and management forecast trend consistency on investor per-

ceptions of management forecast credibility. Our results show that informationfrom analysts can act as either a substitute for or a complement to information

from management, depending on the situation. In the presence of a confirming

analyst forecast, investors credibility judgments depend on whether manage-

ments forecast is consistent with expectations (i.e. complements). However, in

the presence of a disconfirming analyst forecast, investors rely primarily on infor-

mation from analysts and do not consider characteristics of managements fore-

cast in their credibility judgments (i.e. substitutes).

Our results are important to both research and practice. Consistent with prior

research that shows investors use analyst forecasts to evaluate actual firm perfor-mance (e.g. Bartov et al., 2002), our results suggest that investors also use ana-

lyst forecasts to evaluate firms earnings forecasts and, specifically, the credibility

of those forecasts. Recent research suggests that analyst forecasts suffer from




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credibility concerns because of a perceived lack of independence between ana-

lysts and management and analysts incentives to please management (Kothari

et al., 2009). Results from our study suggest that despite these concerns, inves-

tors still perceive analyst forecasts as useful information.This study also provides information on the role that analyst forecasts play in

investors judgment and decision-making. Archival research in accounting often

uses analyst forecast revisions as a proxy for the credibility of management earn-

ings forecasts and shows that the market reacts to analyst forecast revisions (e.g.

Koch, 2005); yet little research to date has shown the situations and circum-

stances under which this relationship holds. Hirstet al. (2008) discuss the need

within the management earnings forecast literature for interaction tests that spe-

cifically identify and examine potential moderating variables. Specifically, they

state that such tests should help researchers understand the conditions in whichspecific effects may or may not hold. This study answers such calls by examining

the interactive effects between characteristics of management and analyst fore-

casts. Our results show that the effect of a confirming analyst forecast on man-

agement forecast credibility depends on whether managements forecast is

consistent with the prior earnings trend and investor expectations. When inves-

tors receive a disconfirming analyst forecast, the analyst forecast appears to be a

substitute for managements forecast in their judgments of management forecast

credibility.

Our results provide information to managers on how to improve the credibility

of their earnings forecasts, specifically those forecasts that are inherently less

credible (i.e. good news forecasts). Our results show that the credibility losses

experienced by an unexpected (i.e. trend inconsistent) management forecast can

be eliminated by a confirming analyst forecast. Recent evidence suggests that

managers use earnings guidance to steer analysts down towards beatable earn-

ings targets (Cotteret al., 2006). However, because we find that companies may

be penalized if an analyst forecast is below their own forecast, management

should be cautious in providing such guidance.

From a regulatory perspective, our results also provide information regarding

investors use of analyst earnings forecasts. Recent research suggests that therelationship between management and analysts provides incentives for analysts

to issue biased forecasts (Libby et al., 2008; McEwen et al., 2008). Although

investors often adjust for the perceived bias in analyst forecasts when making

EPS predictions (Ackert et al., 1997; Pinello, 2008), our results suggest that

investors rely upon analyst forecasts (and often more so than managements pre-

dictions) to determine management forecast credibility. Given the economic con-

sequences of forecast credibility (e.g. Jennings, 1987; Hirst et al., 2007) and

evidence of the negative consequences of management and analyst relationships

(Libby et al., 2008), regulators should be interested in the role of analyst fore-casts on investor perceptions of the credibility of good news management earn-

ings forecasts.




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As with all studies, this study is not without limitations. First, we use MBA

students as surrogates for investors. Although our participants report having

investing experience, we do not know whether our results would generalize to

different populations of investors. Second, we limit the amount of informationparticipants received making this experimental setting less complex but poten-

tially reducing the generalizability of this study. Future research could examine

the effect of other information (e.g. audited financial statements, MD&A) on

investors use of analyst forecasts.

Our findings suggest several areas for future research. Although findings from

Hodge et al. (2006) suggest that good reporting reputation may mitigate

concerns about management forecast credibility, we do not know to what extent

managements reporting reputation (controlled for in our experimental design)

influenced this result. Future research could examine potential interactive effectsbetween management forecast consistency and reporting reputation and other

characteristics of management earnings forecasts (e.g. timeliness, accuracy). In

addition, our results suggest that in some circumstances, an analyst forecast is a

substitute for managements forecast. Future research could examine other

information available to investors and how investors use this information rela-

tive to analyst forecasts and management forecasts when making investment-

related judgments.

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