Why Do New Issues and High-Accrual Firms Underperform: The Role of Analysts' Credulity

Abstract

We find that analysts' forecast errors are predicted by past accounting accruals (adjustments to cash flows to obtain reported earnings) among both equity issuers and non-issuers. Analysts are more optimistic for the subsequent four years for issuers reporting higher issue-year accruals. The predictive power is greater for discretionary accruals than non-discretionary accruals, and is independent of the presence of an underwriting affiliation. Predicted forecast errors from accruals partially explain the long-term underperformance of new issuers. The predictability of forecast errors also for non-issuers with high accruals suggests that analysts' credulity about accruals management more generally contributes to market inefficiency.

JEL Classification: M41, G29