The Understatement of Large Negative Earnings News in Managers' Annual Guidance

Abstract

This study examines whether managers understate large negative earnings news in annual forecasts that are generally issued early when limited earnings information of the fiscal year is publicly available. I find that management forecasts of annual earnings conveying relatively large negative earnings news are systematically optimistic, and it is more (less) pronounced for firms with greater litigation risk or financial distress (net insider sale). The results suggest that fear of immediate lawsuits or job loss instead of trading opportunism motivates managers to understate large negative earnings news to mitigate immediate significantly negative consequences. I also provide evidence consistent with the market not identifying the bias in managers’ annual earnings guidance. This study has important implications for market participants relying on annual management forecasts to form earnings expectations early in the fiscal year and for regulators attempting to balance the quality and quantity of management guidance.

Keywords: Management Forecasts; Annual Guidance; Understatement of Large Negative Earnings News; Optimistic Forecast Bias

JEL Classification: G02; M41