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From The Ivory Tower Part 1

After posting in an article on MLPs that "earnings projection accuracy" matters - and that metric is an input into my Required Rate of Return assessment, I followed that up with data on REITs and their earnings forecasts. I provided evidence that analyst forecasts echo company provided guidance.

The feedback on those articles was "off the mark" (it focused on minor points and not the major points) or lacking. The few "on the mark" or on topic postings contained opinions that I found to be just plain wrong. But that was more of a gut reaction than a mental reaction. As a result, I went searching for information from the academics.

What follows are my notes for those info gathering activities. The info is in presented in the order of when it was found during my search.

Does Quarterly Earnings Guidance Increase or Reduce Earnings Management?

Multivariate tests reveal that guiding firms recognize large abnormal accruals to beat their own guidance, but not to beat analyst forecasts, whereas non-guiding firms do recognize large abnormal accruals to beat analyst forecasts.

Overall, guiding firms and non-guiding firms use similar levels of abnormal accruals to beat benchmarks. Guidance may reduce earnings management because firms can use it as a tool to lower analyst expectations and make these targets easier to achieve.

Without guidance, managers have limited influence over expectations of analysts and investors. Survey evidence reports that managing these expectations is a commonly cited reason for firms issuing guidance (Graham, Harvey, Rajgopal 2005; Kueppers, Sandford, and Thompson 2009) and other studies have shown managers can influence analyst expectations through guidance (Baik and Jiang 2006; Cotter, Tuna, and Wysocki 2006). If managers feel compelled to meet analyst and market expectations even when these expectations are unrealistic, an absence of guidance may actually lead to more earnings management.

Providing quarterly guidance, it is argued, contributes to analyst and investor myopia by focusing them on short-term earnings (Committee for Economic Development 2007). Managers then respond to the market's short-term focus by taking actions to achieve earnings targets that may destroy long-term firm value. Consistent with these concerns, Cheng, Subramanyam, and Zhang (2007) find that firms issuing frequent quarterly guidance have lower investment in R&D and are more likely to cut R&D to achieve analyst forecasts. These frequent guidance firms also have lower future earnings growth relative to firms that infrequently or never provide quarterly guidance.

Proponents claim, however, that guidance is an important source of market information. This view is well supported by academic literature. First, earnings guidance explains a large portion of the variation in stock returns (Ball and Shivakumar 2008; Beyer, Cohen, Lys, and Walther 2009). More than 15 percent of the variation in quarterly stock returns occurs around guidance announcements, compared to less than three percent for earnings announcements and about six percent for analyst forecasts (Beyer, Cohen, Lys and Walther 2009). Second, earnings guidance can lower information asymmetry (Ajinkya and Gift 1984; Coller and Yohn 1997), which leads to lower information gathering costs (Diamond 1985) and lower cost of capital (Lambert, Leuz, and Verrecchia 2007).

Kasznik (1999) uses a sample of firms providing annual guidance between 1987 and 1991 to show that firms missing their guidance numbers have larger abnormal accruals compared to firms meeting their guidance. This evidence implies firms manipulate earnings upward to minimize the gap when their earnings fall short of guidance. Hribar and Yang (2010), however, show that firms meeting or beating their annual guidance have larger abnormal accruals compared to firms missing their guidance, consistent with firms using accruals to achieve their own forecasts. Other work (Hu and Jiang 2008) provides evidence that more frequent quarterly guidance is associated with a greater absolute value of abnormal accruals for a sample of firms that chose to stop providing earnings guidance.

Citations in this paper (or more stuff to check out):

B. Ajinkya, and M.J. Gift. 1984. Corporate Managers' Earnings Forecasts and Symmetrical Adjustments of Market Expectations. Journal of Accounting Research 22

R. Ball and L. Shivakumar. 2008. How much new information is there in earnings? Journal of Accounting and Economics 46

M. Coller and T. Yohn. 1997. Management Forecasts and Information Asymmetry: An Examination of Bid - Ask Spreads. Journal of Accounting Research 35

J. Cotter, I. Tuna, and P. D. Wysocki. 2006. Expectations Management and Beatable Targets: How Do Analysts React to Explicit Earnings Guidance? Contemporary Accounting Research 23

S. Das, C. Levine, and K. Sivaramakrishnan. 1998. Earnings Predictability and Bias in Analysts' Earnings Forecasts. The Accounting Review 73

R. Kasznik, and M. McNichols. 2002. Does Meeting Earnings Expectations Matter? Evidence from Analyst Forecast Revisions and Share Prices. Journal of Accounting Research 40

RJ Kueppers, NM Sandford, and T. Thomspon Jr. 2009. Earnings Guidance: The Current State of Play

R. Lambert, C. Leuz, and R. Verrecchiai. 2007. Accounting Information, Disclosure, and the Cost of Capital. Journal of Accounting Research 45

Info from a 'summary' source

Firms are usually more eager to disclose good information, while they tend to delay the announcement of bad information (Aboody & Kaznik, 2000). Thus, good information is essentially reflected in stock returns when it is announced, while bad information constitutes new information to investors (Hand, Holthausen, & Leftwich, 1992). Firms with informative disclosures tend to exhibit larger analyst following and less dispersion in analyst forecasts (Lang & Lundholm, 1993).

Are all management earnings forecasts created equal? Expectations management versus communication by Yongtae Kim and Myung Seok Park

By examining relations among MEFs, analysts' forecasts, and actual earnings, we classify MEFs into three incentive categories: (1) expectations management, (2) communication, and (3) other incentives. We find that a significant proportion (approximately 45%) of MEFs is issued to convey accurate earnings information to the market (that is, communication incentive).