Can Stock Recommendations Predict Earnings Management and Analysts' Earnings Forecast Errors?

40 Pages Posted: 24 Jul 1999

See all articles by Jeffery S. Abarbanell

Jeffery S. Abarbanell

University of North Carolina (UNC) at Chapel Hill - Finance Area

Reuven Lehavy

University of Michigan, Stephen M. Ross School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: September 2002

Abstract

We investigate whether the direction and magnitude of earnings management by a firm is affected by analysts' current perception of its equity investment potential (i.e., its perceived ability to generate positive abnormal returns). We argue that firms whose investment potential is perceived to be high (low) by analysts have strong (weak) incentives to meet earnings expectations. Accordingly, firms whose investment potential is perceived to be high are expected to manage earnings towards expectations (to ratify analysts beliefs), whereas firms whose investment potential is perceived to be low are expected to manage earnings away from expectations (to create the greatest possible amount of accounting slack for the future). Relying on analysts' Buy, Hold and Sell recommendations as proxies for firms' perceived investment potential and analysts' earnings forecasts to measure earnings expectations, we find evidence that strongly supports these hypotheses. Specifically, we find that after being rated a Sell, firms engage more frequently in extreme income-decreasing earnings management than other firms, indicating strong incentives to take earnings baths to create accounting slack. This earnings management behavior is associated with extreme bad news earnings surprises. In contrast, after being rated a Buy, firms engage in more frequent (but not more extreme) income-increasing earnings management than other firms. This behavior is associated with a high incidence of reported earnings that meet or slightly exceed the target of analysts' earnings forecasts. Our findings provide evidence of widespread earnings management in response to equity market incentives. They also suggest that some portion of apparent "optimism" in analysts' forecasts previously documented may be attributable to actions taken by managers subsequent to the issuance of forecasts rather than incentives to bias forecasts often ascribed to analysts.

JEL Classification: G12, G14, G29, M41, M43

Suggested Citation

Abarbanell, Jeffery S. and Lehavy, Reuven, Can Stock Recommendations Predict Earnings Management and Analysts' Earnings Forecast Errors? (September 2002). Available at SSRN: https://ssrn.com/abstract=165814 or http://dx.doi.org/10.2139/ssrn.165814

Jeffery S. Abarbanell

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Reuven Lehavy (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI 48109
United States
734-763-1508 (Phone)
734-936-0282 (Fax)

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