Once Bitten, Twice Shy - The Relation Between Outcomes of Earnings Guidance and Management Guidance Strategy by Mei Feng and Adam Koch

Electronic copy available at: http://ssrn.com/abstract=932839

Once Bitten, Twice Shy: The Relation Between Outcomes of EarningsGuidance and Management Guidance StrategyMei FengKatz School of Business, University of PittsburghE-mail:mfeng@katz.pitt.edu andAdam KochMcIntire School of Commerce, University of VirginiaE-mail:ask8m@virginia.edu March 2008Abstract:We examine how management quarterly guidance strategy is affected by various outcomes from previously issued guidance. We find that managers are less likely to provide quarterly earningsguidance for a given year when past management forecasts have been overly optimistic, when past forecasts have resulted in earnings disappointments, when past forecasts were unsuccessfulat influencing analysts’ expectations, and when past forecasts were followed by increased levelsof stock price volatility. In addition, even firms continuing to guide give less precise guidanceand guide for fewer quarters within a year when they have previously experienced adverseoutcomes from issuing guidance. Finally, we document that outcomes from previously issuedguidance also help explain the recent discontinuation of quarterly earnings guidance by manyhigh-profile U.S. firms.We appreciate the helpful comments of Yonca Ertimur, Harry Evans, Robert Freeman, Weili Ge,Guojin Gong, Vicky Hoffman, Craig Lefanowicz, Chan Li, Yinghua Li, Roger Martin, SarahMcVay, Nandu Nagarajan, Doug Skinner, and workshop participants at American University,Carnegie Mellon University, Fordham University, George Mason University, GeorgeWashington University, Southern Methodist University, the University at Buffalo, the Universityof New Hampshire, the University of Pittsburgh, the University of Texas at Dallas, and theUniversity of Virginia.

Electronic copy available at: http://ssrn.com/abstract=932839

1. Introduction

This study examines how management quarterly guidance strategy is affected byoutcomes from previously issued guidance. Forecasting earnings is fundamentally a multi- period process in which outcomes from one period influence managerial, investor, and analystdecisions about future forecasts. However, a recent review by Venkataraman, et al. (2008)emphasizes that most prior research ignores the extent to which forecast outcomes from one period influence forecast antecedents and characteristics in subsequent periods. Our study begins to fill this void by documenting the extent to which a wide-range of adverse outcomesaffect future guidance behavior. This is an important contribution because, as Venkataraman, etal. (2008) argue, exploring the multi-period nature of forecasting is necessary to extend our understanding of forecasting beyond immediate one-time decisions and reactions.Our empirical work examines the effects of an extensive array of adverse outcomes onfuture quarterly guidance strategy, including: 1) whether managers meet or beat their ownforecasts, 2) whether managers meet or beat market expectations after providing guidance, 3) theextent to which analysts fail to revise their own forecasts towards management guidance, and 4)sustained volatility increases following the release of guidance. The first two factors aremotivated by prior research suggesting that giving guidance, but subsequently falling short of management or analyst forecasts, can damage managerial reputation (e.g., Graham, et al, 2005;Feng, 2006) and expose the firm to legal liability (e.g., Kasznik, 1999; Soffer, et al., 2000). Our third factor is motivated by prior research suggesting that guidance is frequently intended tomove analyst forecasts towards earnings targets that can be met or beaten (e.g., Richardson, etal., 2004; Cotter, et al., 2006). Our fourth factor is motivated by prior research suggesting thatearnings guidance can create sustained increases in stock price volatility, either throughattracting transient institutional investors (e.g., Bushee and Noe, 2000) or through providingdifficult to interpret information (e.g., Piotroski, 2002).Determining the effect of past outcomes on future guidance strategy is of interest becausefirms can react to adverse outcomes in a number of ways. For example, a firm that experienced

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adverse outcomes could re-assess the costs and benefits associated with forecasting, concludethat forecasting is no longer in their interest, and choose not to forecast again. However firmsmay choose to continue providing guidance for at least two reasons. First, firms that abandonguidance forego a wide range of benefits the prior research has attributed to the provision of guidance.

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Second, firms may be reluctant to change their long-term disclosure policy based onone period of negative consequences, particularly if they perceive such consequences to betransient. Rather than abandoning forecasting, firms experiencing adverse outcomes couldcontinue to forecast, changing their strategy in other ways to avoid adverse outcomes. For example, firms could reduce intra-year forecast frequency or change the form of guidance (e.g., providing a range of possible values, rather than a point estimate), improving

ex post

guidance“accuracy” by reducing

ex ante

guidance precision. Given the benefits attributed to guidance, itremains on open empirical question as to whether and how adverse past outcomes influencemanagement forecast behavior.We empirically investigate how adverse outcomes affect multiple dimensions of futurequarterly forecasting strategy. First, we document the effect of adverse outcomes on the decisionto provide any quarterly guidance for the following year. We find that firms falling short of their own guidance, disappointing market participants at earnings announcements despite the provision of guidance, failing in attempts to influence analysts’ expectations, or experiencingsustained volatility increases following previous guidance are less likely to continue providingquarterly guidance. Unfavorable outcomes in one year significantly discourage firms fromissuing guidance in the next year. For firms that continue to provide guidance, we next examinethe effect of adverse outcomes on the intra-year frequency and precision of future guidance.Such firms tend to forecast for fewer quarters within the year and provide less precise guidance.

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Prior research attributes a number of benefits to providing earnings guidance including reducing litigation risk (e.g., Skinner, 1994; Skinner, 1997), building a reputation for transparent reporting (e.g., Graham, et al., 2005;Hutton and Stocken, 2006), and guiding analysts’ forecasts towards beatable earnings targets (e.g., Cotter, et al.,2006). Chen, et al. (2006) find that decisions to stop the provision of guidance are accompanied by an average-4.8% return for the three days around the announcement

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