Changes in Managers’ Forecasting Behavior and the Market’s Assessment of Forecast Credibility during Periods of Financial Misreporting

58 Pages Posted: 30 Aug 2011 Last revised: 30 Nov 2015

Stephen P. Baginski

University of Georgia - J.M. Tull School of Accounting

Sean T. McGuire

Texas A&M University - Department of Accounting

Nathan Y. Sharp

Texas A&M University - Department of Accounting

Brady J. Twedt

Indiana University - Kelley School of Business - Department of Accounting

Date Written: November 24, 2015

Abstract

The capital market benefits of high quality financial reporting create incentives for managers to signal the quality of their voluntary disclosure practices. Prior research focuses on the relations between observable measures of earnings quality and observable measures of voluntary disclosure quality. We examine the characteristics of management earnings forecasts during periods in which managers possess private (i.e., unobservable to the market) knowledge that they are engaging in financial misreporting (i.e., committing accounting fraud). Using a sample of Securities and Exchange Commission enforcement actions, we hypothesize and find that managers issue more bad news forecasts in periods of fraud relative to pre-fraud periods and control firms, consistent with the increased use of voluntary disclosure to manage expectations downward while violating constraints on earnings management. The fraud period forecasts are, when compared to fraudulent earnings observed by the market, less ex post biased and more accurate than pre-fraud period forecasts and thus give the appearance of higher quality voluntary disclosures. However, the fraud period forecasts are not less ex post biased or more accurate when accounting restatements later reveal true actual earnings. A consequence of the perceived increase in quality is greater bad news fraud-period forecast impact on prices relative to pre-fraud periods. Further, the enhanced price reactions do not deteriorate after the fraud is made public, suggesting that the public revelation does not taint investors’ assessment of the credibility of bad news management forecasts.

Keywords: Management Earnings Forecasts, Voluntary Disclosure, Fraud

JEL Classification: M40, M41, M45

Suggested Citation

Baginski, Stephen P. and McGuire, Sean T. and Sharp, Nathan Y. and Twedt, Brady J., Changes in Managers’ Forecasting Behavior and the Market’s Assessment of Forecast Credibility during Periods of Financial Misreporting (November 24, 2015). Kelley School of Business Research Paper No. 15-80. Available at SSRN: https://ssrn.com/abstract=1919291 or http://dx.doi.org/10.2139/ssrn.1919291

Stephen P. Baginski

University of Georgia - J.M. Tull School of Accounting ( email )

Athens, GA 30602
United States

Sean T. McGuire

Texas A&M University - Department of Accounting ( email )

430 Wehner
College Station, TX 77843-4353
United States

Nathan Y. Sharp (Contact Author)

Texas A&M University - Department of Accounting ( email )

4353 TAMU
College Station, TX 77843-4353
United States
979-845-0338 (Phone)

Brady J. Twedt

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States

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