Summary
We examine whether UK firms engage in earnings management or forecast guidance to ensure that their reported earnings meet analyst earnings expectations. We explore two earnings management mechanisms: (a) positive abnormal working capital accruals; and (b) classification shifting of core expenses to non-recurring items. We find no evidence of a positive association between income-increasing, abnormal working capital accruals and the probability of meeting analyst forecasts. Instead we find evidence consistent with a subset of larger firms shifting small core expenses to other non-recurring items to just hit analyst expectations with core earnings. We also find that the probability of meeting analyst expectations increases with downward-guided forecasts. Overall our results suggest that UK firms are more likely to engage in earnings forecast guidance or, for a subset of larger firms, in classification shifting rather than in accruals management to avoid negative earnings surprises.
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Earnings Management or Forecast Guidance to Meet Analyst Expectations?
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1. IntroductionSurvey-based evidence in the US (Graham et al., 2005) and the UK (Choi et al., 2006) shows that meeting analyst expectations is a fundamental earnings target. Severe stock market reactions to negative earnings surprises and a market reward to positive earnings surprises give managers strong incentives to walk down analyst earnings forecasts in order to increase the probability of hitting the final forecast (earnings forecast guidance) or to use their discretion over reported earnings to meet expectations (earnings management). In this paper, we examine whether UK firms use earnings management or forecast guidance to meet analyst expectations. In addition to the practice of accruals management, we examine a recently explored earnings management mechanism: inflating core earnings through classification shifting of core expenses to income-increasing (negative), non-recurring items. As both managers and analysts exclude non-recurring items from core earnings, firms may engage in classification shifting of recurring losses or expenses to inflate core earnings and meet analyst expectations. Examining the practice of classification shifting by UK firms is of special interest, as over our study period FRS 3 Reporting Financial Performance, which was in force for UK firms from 1993 until the adoption of International Financial Reporting Standards in 2005, required firms to report net income per share, but allowed them to distinguish between core and transitory earnings by exercising discretion in classifying non-recurring items. In line with FRS 3's approach, IAS 1 Presentation of Financial Statements requires a clear distinction between core and exceptional income components, allowing firms to disclose material items of an exceptional nature separately in the income statement.Prior evidence does not explore fully the link between the UK regulatory framework for reporting financial performance and the mechanisms UK firms use to meet expectations. In their survey of investment professionals and financial managers, Choi et al. (2006) report a consensus view that the general quality of earnings improved post-FRS 3 and that, while earnings forecast guidance might be a widespread phenomenon, firms are now less likely to use discretionary accounting choices to meet analyst expectations. At the same time, the survey reveals concern over the potential manipulation of non-recurring items despite the increased transparency requirements of FRS 3. The evidence of Choi et al. (2005) that a substantial proportion of the 500 largest UK listed non-financial firms (over 70%) exploited the option to disclose alternative earnings per share (EPS) on core earnings supports this concern. Athanasakou et al. (2007) lend further support to this concern by documenting an overall increase in the practice of income smoothing using classifications of non-recurring items post-FRS 3. Even though Peasnell et al. (2000a) and Gore et al. (2007) provide preliminary evidence consistent with UK firms using non-recurring items pre-FRS 3 to hit earnings benchmarks, they do not find similar evidence for the post-FRS 3 period. Therefore, to date there is no direct evidence on whether UK firms use classifications of non-recurring items post-FRS 3 to hit analyst forecasts.In view of this discussion, we undertake an archive-based examination of the use of accruals management, classification shifting and earnings forecast guidance to meet analyst expectations in the post-FRS 3 period, 1994-2002. We constrain our sample period to 2002 due to data unavailability for key variables in our study post-2002. We use logistic analysis to examine the association of income-increasing, discretionary accruals and downward-guided forecasts with the probability of meeting analyst forecasts. As a proxy for discretionary accruals, we use abnormal working capital accruals (AWCAs) estimated using the modified Jones model including lagged return on assets (ROA) to control for operating performance (Kothari et al., 20...See the full content of this document
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