Managers’ Incentives and Management Forecast Precision
University of Wisconsin-Madison
Our study examines whether managers manage forecast precision for self-interested purposes. We find that managers are more likely to release vague guidance for more negative news when they are about to make equity financing or to sell stocks on their personal accounts We also find that managers are more likely to manage forecast precision 1) when the litigation risk is low because risk of lawsuit and reputation loss can restrain their opportunistic behavior in forecast precision; 2) when their credibility is determined by their prior forecast accuracy because managers would be reluctant to hurt their credibility by issuing biased forecasts and would be more likely to take the precision strategy.
Keywords: Management Forecast; Managers’ Incentives; Forecast Precision
Please do not quote without permission
We thank Zhaoyang Gu, Jing Liu, James Ohlson, Jian Xue, Yue Li and conference participants at the Four-school Accounting Research Conference. We are responsible for all errors.
Management forecasts are important channels that managers use to convey their private information to investors and guide the market expectation (Hassell and Jennings 1986). In contrast to mandatory disclosures such as annual reports, management forecasts are voluntary. Managers have large discretion on whether, how, and what to disclose in the management forecasts. Prior research finds that management forecasts convey useful information (e.g., Pownall, et al. 1993; Baginski and Hassell 1990; Coller and Yohn 1997). Motivated by the usefulness of management forecasts, prior research also examines the determinants of management forecasts (e.g., Skinner 1994, 1997; Lang and Lundholm 2000; Cheng and Lo 2006). However, despite managers’ great discretion on the characteristics of management forecasts (e.g., precision and horizon) and the importance of such characteristics, how managers’ incentives affect the characteristics of management forecasts are not well
1understood (Hirst et al. 2008).
In this paper, we focus on one important characteristic of management forecast, forecast precision and examine how managerial incentive affects the choice of forecast precision. Forecast precision is one important characteristic that managers can determine when making forecasts. Of the population of management forecasts compiled by Thomas Financial, more than 80% of the quantitative forecasts are in the range format (i.e., a minimum and a maximum) and there is a large variation in forecast width. In addition to its large variation, forecast precision also has a significant impact on market reaction to management forecasts. Theoretical papers, such as Kim and Verrecchia (1991) and Subramanyam (1996), argue the magnitude of market’s response to a disclosure is positively related to its precision. Empirical studies, by examining stock returns and analyst revision, also report supportive evidence.
However, despite its variation and impact, the determinant of management forecast precision is not well-understood. This gap in the literature is particularly puzzling given how much discretion managers have in deciding the precision of such forecasts,
1 Hirst et.al. (2008) note that extant literature mainly focused on “why managers choose to issue a forecast and the likely consequences of those decisions”. They call for more research on managers’ choices on forecast characteristics.
2such as how large is the width of their forecasts. One might even argue that
managers have higher discretion in deciding whether to release a vague or precise forecast than whether to provide a forecast in the first place (Hirst et al. 2008). Managers cannot always intentionally withhold information; doing so will expose them to high litigation risk and great reputation loss. In fact, it is part of managers’
fiduciary duty to update or correct preexisting disclosures, including information disclosed in previous earnings announcements (Skinner 1994). Because of the short-horizon of management forecasts, managers also have little discretion in issuing biased forecasts, because investors can use the subsequent audited earnings report to evaluate the forecasted numbers. Therefore, we argue that managerial incentives can lead them to choose a forecast precision in their best interest, although the precision of managers’ private information is an important determinant as well. However, we do
want to stress that whether to provide a forecast has the first-order effect on market reaction, and choosing a desirable precision given the issuance of management forecast has the second-order effect.
We rely on prior research and identify two managerial incentives: equity issuance and insider trading. Prior research indicates that managers strategically use management
3forecasts to affect the market’s perception about a firm. For example, Lang and
Lundholm (2000) find that companies increase their disclosure activities before seasoned equity offerings, consistent with managers’ intent to increase stock prices and offering proceeds. Managers’ intent to increase stock price before seasonal equity offering is also underpinning the large literature on earnings management before SEO (e.g., Teoh, Welch and Wong 1998). The second managerial incentive is based on the literature on insider trading. A long-standing notion in the literature is that managers will employ their private information to sell shares when stock price is high and buy shares when stock price is low. Built on this, Cheng and Lo (2006) predict that managers will disclose bad news before buying shares and disclose good news before selling shares. While they do not find evidence consistent with the second prediction, they find that managers are more likely to disclose bad news before insiders buy shares on their personal accounts. These studies suggest that managers
2 Other characteristics include horizon, level of details, and supplemental information etc. 3 More detailed review of management forecasts literature can be found in Cameron (1986) and Hirst, Koonce and Venkataraman (2008).
disclose earnings forecasts strategically to influence market prices.
If the precision of management forecasts has an impact on stock price and the above managerial incentives exist, we would expect to observe an association between forecast precision and managerial incentives. The direction of the association depends on the nature of the news and the incentives. Prior research indicates that managers prefer a higher stock price before SEO. Thus, for good news disclosed before SEO, we predict it to be of higher precision and for bad news disclosed before SEO, we predict it to be of lower precision, because prior research indicates that less precise forecasts have a smaller market impact. Since in general bad news have lower precision than good news forecasts (Skinner 1994), we test the prediction separately for good news forecasts and bad news forecasts. That is, we test whether precision increases (decreases) with the magnitude of the good (bad) news. We have the same prediction for insider sales and the opposite prediction for insider purchase because managers benefit from higher stock price for sales and from lower stock price for purchases.
To test our hypotheses, we examine a sample of 7,466 management earnings forecasts issued during the 1999-2006 period. Using the negative of forecasts width to measure forecast precision, we confirm that good (bad) forecasts are more (less) precise, as documented in prior research (Choi et al. 2009). The evidence is consistent with notion that managers strategically decide forecast precision so as to increase (or decrease) market’s reaction to good (or bad) news. For bad news issued
before SEO, we find that managers are more likely to release vague guidance for more negative news. We do not find that the precision level is correlated with the magnitude of the news for good news forecasts issued before SEO. Similarly, we find that for bad news issued before insider sales, the precision decreases with the magnitude of the news and we do not find results for good news released before insider sales. For management forecasts disclosed before insider purchases, we find that the precision is decreasing with the magnitude of the good news and we do not find significant results for bad news forecasts.
These results are consistent with our predictions. Managers issue less precise bad news before equity issuance and insider sales to reduce the blow of bad news to stock
prices, and they issue less precise good news to reduce the positive impact of good news on stock price before insider purchases. We do not find results good news disclosed before equity issuance and insider sales or bad news disclosed before insider purchases.
Managers’ opportunistic behaviors are not without any cost. They are subject to litigation risk and reputation loss once their manipulation is detected. We argue that litigation risk can moderate their opportunistic behavior in forecast precision. To test this prediction, we split the sample into low-litigation group and high-litigation group, and then replicate the analysis for each group. We find that the results documented above are largely driven by the low litigation group. We do not find consistent results for the high litigation group except that bad news disclosed before insider sales are less precise. Following similar procedures, we find that managers are more likely to manage forecast precision when their credibility is determined by their prior forecast accuracy because managers would be reluctant to hurt their credibility by issuing biased forecasts and would be more likely to take the precision strategy.
Our paper contributes to the literature in several important ways. First, our paper extends the voluntary disclosure literature by providing evidence that managers strategically determine forecast precision in their earnings guidance. The theoretical model in Hughes and Pae (2004) suggest managers’ tendency for playing the precision game. Our study provides empirical evidence supportive for their argument.
Second, we indentify managers’ trading incentives, either on behalf of firms or on their personal accounts, can drive them to play the precision game. Previous studies have found that managers tend to manage the market’s perception by their earnings guidance. However, these studies mainly focus on whether to disclose information, or whether the disclosed information is biased. Our study proposes another strategy that managers could take in their forecast decision. By managing the precision of forecast news, managers could affect market reaction to disclosure and gain from the temporary mispricing.
Hirst et al. (2008) suggests that forecast characteristics are the most controllable yet the least studied component of management forecasts and calls for future research on this direction. Previous studies primarily focus on such forecast characteristics as stand-alone vs. bundled or disaggregation vs. aggregation or others, that managers might employ to serve specific purposes. To the best of our knowledge, no previous studies have built up a link between managers’ incentives and forecast precision. Our paper contributes to the literature by identifying managers’ opportunistic behavior in forecast precision.
The remainder of the paper proceeds as follows. Section 2 discusses related literatures on management forecasts and develops our hypotheses. Section 3 describes our empirical design and the results of empirical tests. Section 4 reports the analysis for market reaction and forecast precision. The final section concludes the paper.
2. Related literature and hypotheses development
Managers have information advantages over outside investors about firm values. Besides mandatory reporting required by the regulators, managers provide voluntary disclosure as well to reduce information asymmetry, to guide market perception, and to reduce the cost of capital. Management earnings forecast is the most common type of voluntary disclosure (Hirst et.al. 2008). The literature finds that management forecast is an informative guidance that has significant impact on the capital markets (e.g., Baginski and Hassell 1990; Matsumoto 2002; Pownall, et al. 1993; Rogers and
Since management forecasts are voluntary, managers have large discretion on whether to make the disclosure, when to make the disclosure, and what are the contents and form of the disclosure. The extant literature indicates that managers would exploit their discretion on management forecasts for self-serving purposes. For example, Nagar et al. (2003) argue that equity-based compensation drives managers to issue more frequent forecasts to avoid equity mispricing that could adversely impact their wealth. Rogers and Stocken (2005) find that managers have incentives to time their
4 Rogers and Stocken (2005) finds the credibility of management forecasts varies with their incentives and the market ability to detect misrepresentation.
bad news forecasts to take advantage of a lower purchase price.
Different incentives lead to various disclosure strategies. Previous research primarily focuses on the likelihood, the frequency, and the bias of forecasts. Matsumoto (2002) find that managers use earnings guidance to guide down analysts’ expectation, so as to reduce the frequency of negative surprise and the associated adverse market reaction. Frankel et al. (1995) and Lang and Lundholm (2000) find that firms increase the frequency of disclosure and issue more favorable news prior to raising external capital. Cheng and Lo (2006) demonstrate that managers disclose more bad news before they buy stocks on their personal accounts. Brockman et al. (2008) find that the frequency and magnitude of bad news (good news) disclosure are higher (lower) before share repurchase, presumably to deflate stock prices so that firms can buy back shares at a lower price. The evidence overall indicates that the frequency of management forecasts is determined by managers’ incentives. Managers could temporarily affect the market response via their voluntary guidance
5and benefit from doing so.
Although managers have the opportunity to exploit their discretion over earnings guidance, investors can use the subsequent audited earnings report and information from other sources to evaluate management forecast. If managers are believed to have withheld information or have issued biased forecasts, investors may sue managers and their reputation might be damaged. Therefore, managers could strategically make the disclosure less verifiable but still able to stimulate specific market response. Managing forecast precision is a feasible choice.
Managers can choose their forecast precision. They can issue point estimate, range estimate, or qualitative estimates. And for range forecasts, they can choose how large the range between the minimum and maximum estimates is. The literature suggests that forecast precision affects market reaction to earnings guidance. Theoretical models by Kim and Verrecchia (1994) and Subramanyam (1996) show that information with higher precision leads to larger market reaction. Baginski et al. (1993) indicates that the degree of market response to management forecasts varies
5 The extent of market response may depend on the ability that the market detects the misrepresentation. (see Rogers and Stocken 2005).
with forecast form, and point forecasts lead to greater responses relative to range
6forecasts. If this is the case, managers can strategically choose forecast precision so as to affect market reaction for self-interested purposes. Hughes and Pae (2004) shows that the entrepreneur discloses only high (low) precision information, for estimates above (below) the prior expectation of the asset value. That is, entrepreneurs choose high precision for good news to increase stock prices and low precision for bad news to reduce the blow to stock prices.
When firms are about to sell stocks, they have incentive to increase stock prices because firm can receive more proceeds if stock prices are higher. Managers can affect stock prices through earnings management (Teoh, Welch and Wong 1998), as well as through voluntary disclosures. Consistent with this argument, Lang and Lundholm (2000) find that issuing companies dramatically increase their disclosure activities before seasoned equity offerings. They also find that firms which abnormally increase their disclosure activities before equity offering experience positive returns in that period, and negative returns after equity issuance. The evidence suggests managers use voluntary disclosure to inflate prices. Richardson, Teoh and Wysocki (2004) indicate that firms that are net issuer of equity are more likely guide analysts’ expectation downward to beatable targets. However, the
literature also reports conflicting evidence. For example, Frankel, McNichols and Wilson (1995) find that management forecasts are not optimistic prior to equity issuance, probably due to the potential reputation loss.
In brief, managers are documented to release biased forecasts when they are about to issue equity, but the concern of reputation loss might deter them from doing this. Hence, managers would take the strategy of managing forecast precision before raising external fund, purported to manage share prices upward while avoid the potential reputation loss. The above argument is summarized as the following hypothesis:
Hypothesis 1a: The relationship between forecast precision and forecast news is
6 Other studies (such as Pownall et al. 1993) however find insignificant relationship between market response and forecast form.
stronger when firms are about to raise external fund.
When managers trade shares on their personal accounts, they have the incentive to maximize trading profits by utilizing their information advantage. Noe (1999) finds that managers sell more shares after good news than after bad news, and buy more after bad news than after good news, suggesting managers’ intention to selecting the
timing of their trades. Building on Noe’s finding, Cheng and Lo (2006) argue that
managers change the frequency of voluntary disclosure before insider trading. They hypothesize that managers who plan to sell shares will disclose good news or defer bad news, and managers who plan to buy shares will disclose bad news or defer good news. However, insider trading has been under scrutiny by the regulators. The“disclose or abstain” rule requires that anyone in possession of material nonpublic information should either disclose it to the public before trading or abstain from trading. Consistent with managers’ incentives to affect the stock price before insider trading, Cheng and Lo (2006) find that managers are more likely to disclose bad news before buying shares, but they find that managers do not change the frequency of voluntary disclosure before insider sales, consistent with the litigation argument. However, given the disclosure of news, managers can increase trading profits by choosing forecast precision to influence market response to the disclosure. The benefit of selling shares is higher when stock price is higher; thus we expect that managers are more likely to be vague (precise) for bad (good) news when they are about to sell stocks, while they would be more likely to release vague (precise) for good (bad) news when they are about to buy stocks. The hypothesis is summarized as follows:
Hypothesis 1b: The relationship between forecast precision and forecast news is stronger when managers are about to sell stocks on their personal accounts.
Hypothesis 1c: The relationship between forecast precision and forecast news is weaker when managers are about to buy stocks on their personal accounts.
When making decisions on whether to manipulating forecast precision, managers have to consider their cost and benefit function. By strategically disclosing vague or precise information before equity financing and insider trading, managers can increase their trading profits by influencing market response to their desired direction. However, this strategy is not without any cost. If detected, opportunistic behaviors for self-interests are subject to litigation risk and reputation loss. The higher risk involved, the less likely managers would play precision game. We argue that risk of lawsuit can serve as a monitoring mechanism and work against managers’ intention to
manage forecast precision in order to increase trading profits. The hypothesis is formalized as:
Hypothesis 2: Managers are more likely to play precision game when they are
exposed to lower litigation risk.
Manager’s Perceived Forecast Reliability
Investors do not always distinguish between forecasts with various forecast precision. Prior studies report mixed results on the relation between forecast form and stock returns. For example, Baginski et al. (1993) report that the more precise the forecast, the stronger the relation between unexpected earnings and expected returns. In contrast, Pownall et al. (1993) find no effects on stock returns from forecast form. Hirst et al. (1999) proposes investors’ judgment as an explanation for the mixed
finding. They argue that forecast precision standalone does not necessarily affect investor judgment on future earnings, rather, it matters when investors perceive the information source as reliable. Their evidence shows that stock returns varies with forecast precision more substantially when managers used to release accurate earnings guidance. Given that managers’ motivation in manipulating forecast precision is to increase their trading profits, they would take this strategy when their manipulation is able to produce the desired influence on stock prices. Hence, we argue that managers would be more likely to play precision game for self-interested purposes, when the market perceives their forecasts as reliable and then would determine their response through forecast precision. The hypothesis is summarized as:
Hypothesis 3: Managers are more likely to play precision game when investors tend to perceive their forecasts as reliable.