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Beating the Forecast
What Companies Do to Report Better Earnings
In the stock market, a company’s earnings report tends to have a quick impact on share price. That price can drop not only when a firm reports an unexpected, if small, loss, but also when it reports less of a profit than financial analysts had been predicting.
In the last decade a number of researchers have identified evidence that small negative earnings surprises (lower profits) and small losses are unexpectedly rare among publicly traded companies. In response, Michael Eames, Associate Professor of Accounting at the Leavey School of Business and his co-author David Burgstahler of the University of Washington have researched how analyst and management behaviors relate to those results.
“Ten years ago we had evidence that there weren’t as many small negative earnings surprises as expected, but we didn’t know the source of this anomaly,” Eames says.”
In their research, published in the Journal of Business Finance and Accounting, they look at how public companies manage to avoid small negative earnings surprises and achieve positive surprises relative to analysts’ earnings forecasts.
Looking at earnings surprises over a 14-year period, they considered three ways a company can beat the projections of financial analysts.
One is through business management, which involves a concentrated effort to improve results in a short period. This can take such forms as cutting expenses in a quarter or simply working harder in the short run.
Another approach is to use the ordinary latitude present in accounting rules to increase profitability through such strategies as lowering depreciations and reducing loss reserves and bad-debt allowances.
Finally, corporate managers can talk down analysts’ forecasts simply by releasing relatively pessimistic news in advance of the earnings report. This last approach is in line with generally accepted thinking that it’s better to get bad news, even if it’s fairly minor, out sooner rather than later.
Eames, who describes himself as a “capital markets empiricist,” has spent most of his professional career researching earnings forecast bias, which he says is essentially a behavioral issue within the markets. In further research, Eames and Burgstahler find that analysts’ forecasts typically anticipate that firms will manage earnings to avoid reporting small losses.
“However,” he says, “we also find that analysts often get it wrong, in the sense that they commonly anticipate earnings management to avoid small losses that do not occur and fail to anticipate this management when it does occur.”
BEATING EXPECTATIONS: Michael Eames has done extensive research in how publicly traded companies manage earnings to beat the predictions of financial analysts.