Exploring Managers' Accrual-Related Forecast Bias

Abstract

In this study, we examine the effect of accrual-based earnings management on the association between managers’ earnings forecast errors and accruals, which we label “managers’ accrual-related forecast bias.” We build on extensive research which finds that managers engage in accrual-based earnings management to meet or beat earnings benchmarks and report smooth earnings series. We hypothesize that managers bias their subsequent-year forecasts in the direction of accruals management to increase market confidence in the managed earnings numbers. Consistent with our expectations, we find a positive association between managers’ earnings forecast errors and discretionary accruals, but no association between managers’ earnings forecast errors and nondiscretionary accruals. Furthermore, the association between managers’ earnings forecast errors and discretionary accruals is stronger when managers have limited ability to continue managing subsequent-year accruals to support the bias in their forecasts. We also find a substantial decline in managers’ accrual-related forecast bias following the enactment of the Sarbanes-Oxley Act of 2002 (SOX), which restricted managers’ use of accrual-based earnings management. More importantly, we find that the effect of forecasting difficulty on managers’ accrual-related forecast bias occurs only in the pre-SOX period. Overall, our results suggest that, contrary to claims in prior research, managers’ accrual-related forecast bias is not simply a product of forecasting difficulty related to accruals. Rather, at least in some cases, it appears to be intentional.

Keywords: Management Earnings Forecasts, Managers' Accrual-Related Forecast Bias, Earnings Management, Disclosure Quality

JEL Classification: M4, M40, M41, M42