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

Abstract

In this article we present evidence that a firm's stock price sensitivity to earnings news, as measured by outstanding stock recommendation, affects its incentives to manage earnings and, in turn, affects analysts’ex postforecast errors. In particular, we find a tendency for firms rated a Sell (Buy) to engage more (less) frequently in extreme, income–decreasing earnings management, indicating that they have relatively stronger (weaker) incentives to create accounting reserves especially in the form of earnings baths than other firms. In contrast, firms rated a Buy (Sell) are more (less) likely to engage in earnings management that leaves reported earnings equal to or slightly higher than analysts’ forecasts. Our empirical results provide direct evidence of purported, but heretofore, weakly documented equity market incentives for firms to manage earnings. They are also consistent with a growing body of literature that finds analysts either cannot anticipate or are not motivated to anticipate completely in their forecasts firms’ efforts to manage earnings.