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DOI: 10.1111/j.1475-679X.2005.00177.x Journal of Accounting Research

Vol. 43 No. 3 June 2005

Printed in U.S.A.

DOI: 10.1111/j.1475-679X.2005.00177.x Journal of Accounting Research Vol. 43 No. 3 June 2005 Printed in U.S.A. The

The Association between Corporate Boards, Audit Committees, and Management Earnings Forecasts: An Empirical Analysis

IRENE

KARAMANOU AND

NIKOS

VAFEAS

Received 23 July 2004; accepted 6 January 2005

ABSTRACT

We study how corporate boards and audit committees are associated with voluntary financial disclosure practices, proxied here by management earn- ings forecasts. We find that in firms with more effective board and audit com- mittee structures, managers are more likely to make or update an earnings forecast, and their forecast is less likely to be precise, it is more accurate, and it elicits a more favorable market response. Together, our empirical evidence is broadly consistent with the notion that effective corporate governance is associated with higher financial disclosure quality.

1. Introduction

Sound financial disclosure diminishes agency problems by bridging the information asymmetry gap that exists between management and share- holders. In contrast, poor financial disclosure often misleads shareholders and has adverse effects on their wealth, as suggested by the wave of recent fi- nancial reporting scandals. Given sharp differences in disclosure outcomes

University of Cyprus. We are indebted to Abbie Smith (the editor) and an anonymous referee for their insightful comments and suggestions. We thank Maria Christodoulou for research assistance, and First Call Corporation, a Thomson Financial company, for providing the analyst and management forecast data free of charge. The University of Cyprus provided funding for this research.

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Copyright C , University of Chicago on behalf of the Institute of Professional Accounting, 2005

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across firms, the reasons some firms opt to exercise sound disclosure prac- tices and others do not is not a priori clear. Therefore, identifying the fac- tors affecting management’s voluntary disclosure decisions is a fundamental research problem with implications for policy makers, the business commu- nity, and academics. In response to recent financial disclosure scandals, the U.S. Congress, the Securities and Exchange Commission (SEC), and the major stock ex- changes focused on corporate boards as primary vehicles for improving the quality of financial information provided by firms. In particular, standing board audit committees have come to the forefront of public attention be- cause they are the core decision-making body that is expected to monitor financial reporting practices. An initiative by the stock exchanges resulted in the Blue Ribbon Committee’s (1999) report, a code of best practice for the functioning of corporate audit committees. As a result, the New York Stock Exchange (NYSE) has recently approved new corporate governance rules (SR-NYSE-2002-33). In parallel, motivated by the Sarbanes-Oxley Act of 2002, the SEC adopted new standards relating to listed company audit committees (rule 33-8220). Drawing on these regulatory reforms, we suggest that corporate gover- nance structure, as expressed by corporate boards, audit committees, and ownership characteristics, is associated with financial disclosure decisions, and specifically we hypothesize that effective governance mechanisms are positively associated with the quality of financial disclosure practices. Prior work shows that heightened disclosure is beneficial to the market. Among other things, disclosure is shown to be positively related to firm liquidity and negatively related to the cost of capital. 1 Despite these benefits, managers have incentives to withhold information because lack of information hinders the ability of the capital and labor markets to monitor managers effectively. 2 The effect of corporate governance on this disclosure agency problem is not extensively examined in the literature even though the effect of corpo- rate governance is examined in several other issues. For example, Dechow, Hutton, and Sloan [1996] examine the effect of corporate governance on SEC enforcement actions, Klein [2002] examines the effect of corporate governance on earnings management, and Anderson and Bizjak [2003] ex- amine corporate governance in the context of executive compensation. Prior work examines the impact of various aspects of compensation and ownership on corporate disclosure practices. Nagar, Nanda, and Wysocki [2003] find that stock-based incentives mitigate the disclosure agency prob- lem. Healy, Hutton, and Palepu [1999] find that institutional investors are more attracted to firms with higher disclosure rankings. Bushee and Noe [2000] find that it is mostly transient institutions that positively react to increases in disclosure rankings. Finally, Bamber and Cheon [1998] study

1 See, for example, Diamond and Verrecchia [1991], Welker [1995], Botosan [1997], and Leuz and Verrecchia [2000]. 2 See, for example, Shleifer and Vishny [1989] and Edlin and Stiglitz [1995].

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the effects of block ownership on forecast precision, their proxy for finan- cial disclosure. We extend this line of research by illuminating corporate boards and their standing audit committees as another potentially important monitoring mechanism being associated with corporate financial disclosure practices. Like Bamber and Cheon [1998], we choose management forecasts as the testing stage for studying the relation between governance and financial disclosure. This choice is advantageous for two main reasons: Theoretically, unlike other more regulated forms of disclosure, management has consid- erable discretion in terms of whether to make a forecast, and in deciding its timing, form, and specificity. This discretion allows “good” managers to separate themselves more clearly from “bad” managers through their fore- cast choices. Empirically, given that forecasts contain several discrete and well-defined features pertaining to their timing, form, and specificity, the study of the link between disclosure choices and corporate governance prac- tices is more feasible. Furthermore, unlike financial statement disclosures, a management forecast is usually an isolated event that can be evaluated by the stock market with less noise. Even though extant research examines management earnings forecasts extensively, the relation between corporate governance and this voluntary disclosure mode is not thoroughly examined. To this end, our study addresses the following specific questions: How is the structure of a firm’s governance related to the likelihood that manage- ment makes an earnings forecast? How is governance structure related to the level of precision in a management forecast and to the accuracy of the forecast? Is the reaction to a management forecast announcement by the stock market and by equity analysts related to the announcing firm’s gov- ernance structure? How does the nature of the forecast (i.e., good news vs. bad news) affect the answers to these questions? In our tests we consider management forecasts made by 275 Fortune 500 firms between 1995 and 2000, and variables proxying for how boards, audit committees, and institutional shareholders monitor management. We initially find that firms with effective governance mechanisms are more likely to make a management forecast, especially when that involves bad news. This evidence suggests that better governance in public corporations is associated with less information asymmetry between management and shareholders, especially when shareholders are most likely to be at risk of suffering wealth losses. We also find that among forecasting firms, forecast precision decreases with better governance, but only when bad news is con- veyed. One possible explanation for this result is that well-governed firms are more mindful of their obligation not to mislead shareholders. The dan- ger of misleading shareholders is greater when a firm performs worse than expected, and issuing more vague forecasts reduces this danger. Also, the soundness of corporate governance is related to forecast accuracy and, more weakly, to forecast bias. Finally, we find evidence that the market reaction to management forecast announcements is related to board and audit committee characteristics, especially when the forecast releases good

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news. This evidence suggests that investors have greater confidence in good news forecasts that undergo the scrutiny of more effective boards and audit committees. Against the backdrop of recent efforts to regulate the structure and oper- ations of corporate boards and their standing audit committees, our results are likely to be of interest to policy makers because they are consistent with certain board and audit committee attributes being systematically associated with the quality of financial disclosure. Furthermore, these results are likely to be of interest to investors and equity analysts because they provide a basis for evaluating the quantity and quality of information contained in manage- ment forecasts. Third, these results extend academic research by furthering our understanding of the link between financial disclosure, boards, and au- dit committees, and, more broadly, by providing further evidence on the role of corporate governance mechanisms in alleviating conflicts of inter- est between management and shareholders. Last, our results are potentially useful to managers because they suggest that the credibility, and ultimately the value relevance, of their forecasts is assessed, in part, in the backdrop of the structure of their firm’s board of directors and audit committee. Our results broadly suggest a potential path for managers wishing to enhance the quality and credibility of their financial disclosures. The article proceeds as follows. Section 2 describes the corporate gov- ernance measures considered in this study, section 3 discusses our four research propositions linking corporate governance mechanisms to man- agement forecasts, section 4 describes the data and methods used, section 5 presents the results, and section 6 provides discussion and concluding remarks.

2. Measures of Corporate Governance

Corporate boards are responsible for monitoring managerial perfor- mance in general, and financial disclosures in particular, a task that is dele- gated to audit committees. The prior literature suggests several board and audit committee attributes as determinants of monitoring performance. In this article we draw from this literature to consider a plethora of alternative measures of good governance and discuss each of these measures.

2.1 MEASURES OF GENERAL FIRM GOVERNANCE

Drawing from Fama and Jensen [1983], a large body of empirical evi- dence finds that outside directors who are independent of management’s influence help enhance shareholder value by protecting shareholder inter- ests against managerial opportunism (see Hermalin and Weisbach [2001] for a review of the literature). Focusing on financial reporting issues in particular, Dechow, Hutton, and Sloan [1995], Beasley [1996], and Klein [2002] find that outside directors are effective monitors of managerial ac- tions. Second, board size is also likely to be related to board performance because adding more people to the board enhances its knowledge base, yet

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larger boards are less flexible and more inefficient. Given that boards in most public firms are fairly large, the second effect seems to dominate the first (Yermack [1996]). Third, Vafeas [1999] suggests that board meeting frequency is a proxy for the time directors have to monitor management. He finds empirical evidence that boards meet more frequently after crises and that performance increases as a result. Carcello et al. [2002] find that boards meeting more frequently pay higher audit fees and conclude that board activity complements auditor oversight. Drawing from these studies, we expect that a board’s degree of independence, size, and meeting fre- quency are related to its monitoring performance. Ownership structure is also likely to be related to greater alignment of in- terests between management and shareholders. Jensen and Meckling [1976] theorize that managerial ownership helps alleviate manager-shareholder conflicts in public corporations. Early work by Morck, Shleifer, and Vishny [1988] and McConnell and Servaes [1990] supports this notion empirically. War field, Wild, and Wild [1995] find evidence that earnings are more in- formative when insiders have a greater ownership stake in the firm. 3 In addition to manager-owners, large institutional stockholders are likely to be well suited to monitor management because they usually have better information about the firm and can thus deter management from behav- ing opportunistically. Also, their equity investment in the firm is usually higher, providing them with a stronger incentive to monitor management, unlike small shareholders who are frequently free riders because of insuf- ficient information and incentives. We thus expect that higher ownership by insiders and institutions is likely to be related to better monitoring over management.

2.2 AUDIT COMMITTEE MEASURES

The Blue Ribbon Committee [1999] prescribes a series of characteristics an effective audit committee should possess. The Blue Ribbon Committee extends the notion of director independence that has been widely applied to boards to emphasize that audit committees should also be independent. The rationale is that independent directors serving on audit committees are more likely to be free from management’s influence in ensuring that objective financial information is conveyed to shareholders. Second, to mon- itor effectively the quality of financial information that is disclosed by the firm, committee members should have essential skills in understanding and interpreting that information correctly. The Blue Ribbon Committee sug- gests that audit committees should be composed of directors who are, or become within a reasonable time, financially literate, and that at least one committee member should have accounting or related financial manage- ment expertise. The importance of financial knowledge by audit committee

3 It is also possible that the relation between insider ownership and performance is not monotonic and that high inside ownership levels are associated with managerial entrenchment and exploitation of minority shareholders.

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members is highlighted by Bull and Sharp [1989] and empirically supported by Kalbers and Fogarty [1993] and DeZoort [1998]. Third, committee size is likely to have an ambiguous effect on the committee’s monitoring per- formance. Larger audit committees have a wider knowledge base on which to draw but are likely to suffer from process losses and diffusion of respon- sibility. In practice, audit committees are usually understaffed and usually comprise four to five members (see Klein [1998]), leading the Blue Ribbon Committee to suggest that audit committees should have at least three mem- bers. Fourth, committees that meet more frequently allow directors more time, on average, to carry out their monitoring duties and are more likely to exercise effective control over the quality of financial information that is conveyed to shareholders (see Menon and Williams [1994]). In sum, we expect that more independent, expert, larger, and active audit committees exhibit better monitoring performance over management.

3. Research Propositions

The following section reviews the relevant literature on management fore- casts and develops arguments linking management forecasts to corporate governance. Given that we examine a plethora of governance mechanisms, we present our expectations in this section in the form of four general re- search propositions.

3.1 THE LIKELIHOOD OF MAKING A MANAGEMENT EARNINGS FORECAST

In deciding whether to issue a forecast, management has to weigh the forecast benefits against the forecast costs. Prior research suggests several reasons that may render an earnings forecast beneficial to a firm. For ex- ample, Trueman [1986] argues that forecasts give investors a favorable as- sessment of the managers’ ability to anticipate economic events and thus translate into higher market values. Frankel, McNichols, and Wilson [1995] document evidence that is consistent with the notion that management earnings forecasts aid the firm in eliciting funds from the capital markets. Skinner [1994] suggests that managers are likely to make a forecast to con- vey bad news to investors. A bad news warning protects management against the potential danger of litigation and reduces reputation costs. Kasznik and Lev [1995] find that managers are more likely to make an earnings forecast preceding a significant negative, rather than a significant positive, earnings surprise. Finally, Coller and Yohn [1997] argue that management forecasts are more likely in the face of information asymmetry between management and investors, as captured by bid-ask spreads, whereas Clement, Frankel, and Miller [2003] find that forecasts that confirm the market’s beliefs about earnings are also received favorably, possibly because they reduce uncer- tainty about future earnings. Nevertheless, casual observation suggests that most firms do not issue forecasts, possibly because heightened disclosure entails costs as well. Costs stem from a greater risk of litigation and the disclosure of proprietary

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information to competitors. In line with the presence of disclosure costs, Francis, Philbrick, and Schipper [1994] find that the likelihood of issuing a forecast is inversely related to the risk of litigation, whereas Bamber and Cheon [1998] and Baginski, Hassell, and Kimbrough [2004] find that liti- gation risk is associated with lower forecast specificity. Finally, Bamber and Cheon document evidence that firms facing higher proprietary costs issue less specific forecasts that target a narrower immediate audience. We posit that effective corporate governance is an additional factor that may determine the likelihood that management will make a forecast. It is well documented that voluntary disclosures, among other mechanisms, help reduce agency conflicts by bridging the information asymmetry gap that exists between management and shareholders (e.g., Healy and Palepu [2001]). Management forecasts are one such disclosure tool, whose useful- ness is likely to be determined, to a large extent, by the incentives man- agers have to protect shareholders. Specific governance mechanisms such as boards and audit committees are bestowed the responsibility of providing managers with these incentives by monitoring the quality of financial disclo- sures conveyed by management. Nevertheless, there is wide variation in the structure and effectiveness of boards, committees, and ownership in pub- lic firms, suggesting that the quality of monitoring over managerial actions varies across firms. We therefore expect that more effective boards, more effective audit committees, and better ownership incentives are related to a higher likelihood of high-quality disclosure and thus to the likelihood of management earnings forecasts. Furthermore, firms with effective boards and audit committees may be more sensitive to litigation risk stemming from failure to disclose value- relevant information, especially if that information is unfavorable (Skinner [1994]). Therefore, such firms may be more likely to generate a fore- cast to reduce litigation risk. (It is also possible, however, that when di- rectors who are mindful of their obligation to shareholders abstain from making a forecast to reduce the risk, they somehow mislead sharehold- ers through that forecast.) On balance, we deem that effective governance would be associated with more disclosure and suggest that corporate gov- ernance mechanisms complement disclosure practices in reducing agency conflicts.

Research proposition 1:

The likelihood of a management earnings forecast is higher for firms with a more effective governance structure in place.

3.2 MANAGEMENT FORECAST PRECISION

After deciding whether to issue an earnings forecast, managers must de- cide on the amount of information they wish to provide to investors, via the specificity of the forecast. Management forecasts may be precise estimates of future earnings, define an expected range of estimated earnings, provide an open interval, or give an altogether qualitative estimate of future earnings.

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Other things being equal, providing more precise information is expected to be more valuable to investors. Baginski, Conrad, and Hassell [1993] find evidence that investors react more to point versus less precise forecasts, whereas Pownall, Wasley, and Waymire [1993] report mixed evidence on this issue. Hirst, Koonce, and Miller [1999] find experimental evidence to side with the notion that forecast precision interacts with forecast accuracy to provide more useful information to investors. Prior work also studies the reasons managers issue forecasts of different specificity. Baginski and Hassell [1997] find that managers produce more precise forecasts of annual earnings in firms with a greater analyst following, and thus more private information, and in smaller firms, for which there is less publicly available information. Bamber and Cheon [1998] find that managers are less likely to issue specific forecasts when exposure to legal liability is high and when proprietary information costs are high. They also find that poor earnings are also predicted in less precise terms. The preceding discussion suggests that managers being guided by effec- tive boards, effective audit committees, and active shareholders have greater pressures to provide better information, in terms of forecast precision, to investors. More precise information is relatively more revealing about man- agement’s expectations and allows investors to make more informed in- vestment decisions. Therefore, conditional on managers making a forecast, and other things being equal, it is possible that firms with more appropriate governance structures will be more likely to issue more precise forecasts. On the other hand, Bamber and Cheon [1998] use nonaffiliated block ownership as a proxy for legal exposure and find this variable to be inversely related to management forecast precision. In a related vein, Carcello et al. [2002] find that more effective board characteristics are positively associated with greater audit fees, their proxy for audit quality. McMullen [1996] finds that the presence of an audit committee is associated with more reliable fi- nancial reporting—in particular, less errors, fewer irregularities, and fewer illegal acts. One interpretation of these findings is that firms with more ef- fective corporate governance structures in place are more sensitive to legal liability issues. This, in turn, leads to an expected negative relation between forecast precision and the effectiveness of boards, audit committees, and ownership structures. Essentially, what we argue is that failing to disclose value-relevant information may expose managers to litigation risk. There- fore, managers may decide to guide the market’s expectations by issuing a forecast (Skinner [1994]) but, conditioned on that, may be cautious in the amount of specificity they provide through that forecast. In sum, there exist counterveiling theoretical arguments about the relation between forecast precision and governance structures. Therefore, we ultimately address this question empirically.

Research proposition 2:

The precision of a management earnings forecast is asso- ciated with the effectiveness of the issuing firm’s corporate governance structure.

BOARDS, AUDIT COMMITTEES, AND EARNINGS FORECASTS 3.3 THE ACCURACY OF MANAGEMENT FORECASTS

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Prior research suggests that the accuracy of management forecasts pro- vides a clear indication regarding management credibility. For example, Williams [1996] documents that managers establish a forecasting reputation based on the accuracy of prior earnings forecasts and that accuracy serves as an indicator about the believability of a current management forecast. Similarly, Tan, Libby, and Hunton [2002] argue that the accuracy of man- agement forecasts captures management competence. Rogers and Stocken [2002] document that the forecast error is not random and that it varies with management incentives and the market’s ability to detect the forecast bias. In addition to the magnitude of the absolute forecast error, the error sign is the topic of much prior research. Skinner [1994] suggests that managers have incentives to be conservatively biased in their forecasts because the risk of litigation is greater when managers are erroneously optimistic (i.e., litigation risk is asymmetric). In line with this notion, Bamber and Cheon [1998] find that management forecasts convey bad news relative to analysts’ expectations. Rogers and Stocken [2002] also argue that overly pessimistic forecasts may be intended to discourage firms from entering the industry, especially when that industry is more concentrated and thus more profitable. In contrast, it is also possible that managers behaving opportunistically have incentives to portray an overly optimistic picture of the firm’s earnings, consistent with the well-documented tendency of managers to disclose good news and delay or withhold bad news. Managers whose firms are in financial distress, in particular, may issue optimistic forecasts to convince temporarily investors that they are implementing a sound business plan to keep their job and to reduce the probability of bankruptcy or a hostile takeover (Rogers and Stocken [2002]). We probe further into the determinants of forecast accuracy and bias by positing that the quality of a firm’s governance mechanisms is associated with the magnitude and sign of the forecast error. We expect that the qual- ity of boards and audit committees will be inversely related to the extent of misinformation (the absolute value of the forecast error). Furthermore, we expect this effect to be asymmetric. To protect the firm from litigation, all else being equal, managers in firms with sound governance structures are expected to make more conservative forecasts. That is, we expect the hypoth- esized inverse relation between the effectiveness of governance mechanisms and the forecast error to be more pronounced among good news forecasts.

Research proposition 3a: The accuracy of a management earnings forecast is higher for firms with a more effective corporate gover- nance structure in place. Research proposition 3b: A management earnings forecast is more conservative for a firm with a more effective corporate governance structure in place.

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    • 3.4 THE MARKET REACTION TO MANAGEMENT FORECASTS

The information content of management forecasts is well documented by prior research (e.g., Pownall and Waymire [1989]). Other work focuses on explaining the reasons investors value these announcements differently across firms and in time. For example, Jennings [1987] suggests that forecast credibility and believability, measured by subsequent analyst forecast revi- sions, explain the market reaction to management forecasts. More recently, Williams [1996] documents that analyst response to a current forecast is partly determined by the usefulness of a prior forecast by management. Rogers and Stocken [2002] report that the market responds as if it under- stands the good news bias in forecasts. The market eventually identifies the bias in bad news forecasts as well. Finally, Hutton, Miller, and Skinner [2003] find that although bad news forecasts are always informative, good news forecasts are only informative when accompanied with verifiable forward- looking information. The credibility and believability of a forecast is likely to be related to the independence of the monitors that oversee this mode of voluntary disclo- sure. We therefore expect that an important determinant of how investors react to a management forecast will be the effectiveness of the firm’s cor- porate governance structure. This point is especially relevant given recent evidence by Kasznik [1999] that some managers will manipulate earnings to meet their forecasts. When a good news forecast is released, it will be more believable if screened by an effective governance team. When bad news is conveyed through the forecast, investors are likely to view the new information with greater suspicion when coming from a poorly monitored management team. Such a team may be conceived as less than fully truthful, potentially hiding the full extent of the negative information it possesses. Therefore, on balance, we expect that the market reaction to both positive and negative forecasts will be more favorable in the presence of an effective governance structure.

Research proposition 4: The market reaction to a management earnings forecast is more favorable for firms with a more effective governance structure in place.

4. Method and Data Sources

  • 4.1 METHOD

4.1.1. Corporate Governance and the Likelihood of Making a Forecast. Con- sistent with our discussion in section 2, in examining our four research propositions we capture corporate governance structures using the percent- age of outside directors, board size, board meetings, inside ownership, and institutional ownership. We capture audit committee structure and func- tioning with the percentage of committee outsiders, the percentage of com- mittee members with financial expertise, committee size, and committee meetings. All variables are defined in the appendix.

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In the forecast likelihood tests we control for the effects of the in- formation environment using analyst following (Lang and Lundholm [1996], Abarbanell, Lanen, and Verrecchia [1995]) and firm size (Brown, Richardson, and Schwager [1987], Collins, Kothari, and Rayburn [1987], Lang and Lundholm [1996]). We expect firms that are more generous in terms of the information they supply to the market to also be more in- clined to release earnings forecasts. We also control for the dispersion in analyst forecasts. In previous studies dispersion is used as a proxy for the information environment (Lang and Lundholm [1996]) and as a proxy for earnings uncertainty (Abarbanell, Lanen, and Verrecchia [1995], Barron and Stuerke [1998]). We thus expect that firms will be more likely to is- sue a forecast in periods with greater dispersion in analyst forecasts, that is, when there is greater uncertainty regarding their earnings. 4 Following Kasznik and Lev [1995], we also control for high-technology industry mem- bership. Finally, we control for the sign of the news that management has the discretion of conveying. If actual earnings for the period are less than the consensus analyst forecast, we deem the news as bad. For nonforecasting firms, we measure the nature of the news, analyst forecast dispersion, and analyst following on the forecasting sample’s mean management forecast date, measured relative to the end of the forecasted period.

4.1.2. Corporate Governance and Forecast Precision. Next, we code forecast precision as 1 if the forecast is a point estimate of earnings, and 0 other- wise. We use logistic regression to link forecast precision to the corporate governance and control variables outlined in the forecast likelihood tests. There are three notable differences, however. First, the dummy variable we construct for bad news is based on the difference between the management forecast (midpoint for a range forecast) and the consensus analyst forecast. 5 As in Bamber and Cheon [1998], we include a bad news dummy to capture greater exposure to legal liability. Second, we include a variable measuring the number of days from the forecast date to the end of the relevant period to control for the fact that forecasts that substantially precede the end of the fiscal period for which earnings are forecasted are less likely to be precise (e.g., see Baginski and Hassell [1997], Bamber and Cheon [1998]). We ex- pect that the earlier the forecast is made, the less is the precision because of greater uncertainty regarding actual earnings. Third, we include a forecast update dummy and expect first-time forecasts to be less precise than forecast updates.

4 We only keep the most recent forecast of each analyst made in the period to minimize the effects of stale forecasts. 5 The sign of news is captured in different ways in the existing literature. Baginski and Hassell [1997], for example, use the sign of the three-day cumulative abnormal return around the management forecast date, whereas Bamber and Cheon [1998] use the sign of the change in actual earnings.

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    • 4.1.3. Corporate Governance and the Absolute Value of the Management Forecast

Error. Next, we focus on the sample of firms issuing a point forecast. We measure forecast accuracy by the absolute value of the forecast error, thus greater accuracy is related to a smaller absolute forecast error. We define the absolute forecast error as the absolute difference between the actual earn- ings and the management forecast deflated by the forecast. In this model we control for the same variables as in the precision model. We estimate three ordinary least squares (OLS) regressions studying the link between the ab- solute forecast error and corporate governance for the full sample and for good news and bad news subsamples separately. In a fourth regression we address the link between forecast bias, defined as signed forecast error, and corporate governance for the full sample of point forecasts.

  • 4.1.4. Corporate Governance and the Market Reliance on Management Forecasts.

Finally, we examine the reliance of the market on released management fore- casts in relation to corporate governance characteristics. We regress cumu- lative market-adjusted returns over the three-day window (1,0,1) around the management forecast date on all governance and control variables de- scribed earlier. We base the bad news dummy on the difference between the value of the forecast and the consensus analyst forecast, following the results in Skinner [1994] who finds that the market reaction to a bad news forecast is in absolute terms greater than the reaction to a good news fore- cast. However, because this model captures the market reaction to the fore- cast, we also include a variable capturing the magnitude of the surprise, which is based on the difference between the management forecast and the consensus analyst forecast deflated by beginning-of-period price. To be consistent with the result in Kasznik and Lev [1995], we interact the sign of news variable with the difference variable to capture possible slope dif- ferences in the magnitude of the surprise due to the sign of the surprise. Finally, following Baginski, Conrad, and Hassell [1993], we include the pre- cision of the released forecast as another control variable in the model because it is possible that the market relies more on point forecasts. Last, as an alternative test of the information contained in the forecast, we study how equity analysts revise their own forecasts in response to a management forecast.

4.2 DATA SOURCES AND SAMPLE

We collected information on corporate governance from annual proxy statements except for the institutional ownership data, which we gathered from Compact Disclosure. Furthermore, we obtained information regarding management and analyst forecasts as well as actual earnings from First Call, return data from the Center for Research in Security Prices (CRSP) database, and financial information from Compustat. In selecting our sample, we initially considered firms that are listed in the 1995 Fortune 500 survey. These firms are usually widely held, exhibit- ing great separation between ownership and control. Voluntary disclosure

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is likely to play an important role in bridging the information asymmetry gap that exists between their management and shareholders. We excluded financial institutions and utilities from the sample because their regula- tory environment could confound the effect of governance practices on disclosure. We identified 325 of these firms in both the Edgar database, where we located proxy statements, and First Call, where we retrieved data on management forecasts. We then reduced the sample by firm-year ob- servations for which First Call does not provide sufficient analyst forecast data, Compustat does not provide sufficient financial data, and CRSP does not have returns available in the three days around the forecast announce- ment date. Last, we deleted foreign firms. This leaves a final sample of 275 firms that announced 1,621 forecasts in 1,274 firm-years between 1995 and 2000.

5. Discussion of Results

5.1 CORPORATE GOVERNANCE AND THE LIKELIHOOD OF MAKING A MANAGEMENT EARNINGS FORECAST

To assess the association between corporate governance mechanisms and management’s decision to issue an earnings forecast, we initially compare the governance characteristics of 517 firm-years that had at least one man- agement forecast with the respective characteristics of 757 firm-years that had no management forecasts. We assess statistical differences using both the parametric t -test and the nonparametric Wilcoxon z -test, and present the results in table 1. Consistent with our first research proposition, firms making forecasts have a greater fraction of institutional ownership, and their audit committees meet more frequently. In contrast, the forecast years are as- sociated with lower inside ownership levels. Management is also more likely to make an earnings forecast when analyst forecasts are less dispersed, and when the firm is followed by more analysts, belongs in a high-tech industry, and is larger. In table 2 we present Pearson (Spearman) pairwise correlations above (below) the diagonal among the governance variables and the forecast like- lihood dummy. Results between Pearson and Spearman correlations are generally similar. Board and audit committee efficacy variables and institu- tional ownership are generally positively related, suggesting that these mea- sures serve as complements in disciplining management. Nevertheless, the correlation coefficients are always below 0.40, suggesting that each measure captures a sufficiently distinct dimension of the monitoring process. Inside ownership is negatively related to board and audit committee measures, consistent with the notion that it is a substitute monitoring mechanism; that is, there is a greater need for effective boards and audit committees in firms with low managerial ownership levels. Last, there is weak evidence that management forecasts are correlated with relatively more active boards and audit committees and with lower inside ownership levels.

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TABLE 1

Univariate Comparisons of 275 Fortune 500 Firms in 517 Management Forecast Years and 757 Nonforecast Years

All variables are defined in the appendix. The mean (median) value for each variable is pro- vided in the top (bottom) row. , , and indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed).

All

Periods

Forecast Nonforecast

Periods

Periods

Difference

Wilcoxon

t -test

z -test

Sample size Firm governance variables

Pct. of outside directors

Board size

1,274

78.16

80.00

11.60

517

78.25

80.00

11.59

Board meetings

Insider ownership (%)

Institutional ownership (%)

11

7.63

11

7.81

77

5.79

2.19

58.38

63.96

4.79

2.00

60.22

65.80

Audit committee variables

Pct. of committee outsiders

Pct. committee members with financial expertise Committee size

Committee meetings

Control variables

Bad news

Forecast dispersion

Analyst following

High-tech industry

Total assets

97.04

100.00

20.90

20.00

4.55

4.00

3.58

97.02

100.00

21.05

20.00

4.51

4

3.64

33

0.52

1.00

0.15

0.04

13.53

13

0.12

0.00

12,241

5,564

0.54

1.00

0.07

0.03

14.07

13

0.15

0.00

14,280

5,889

757

78.09

80.00

11.60

11

7.50

7

6.47

2.28

57.13

62.65

97.05

100.00

20.80

20.00

4.58

5

3.53

3

0.51

1.00

0.21

0.04

13.17

12

0.11

0.00

10,849

5,361

0.16

0.25

0.01

0.05

1.10

0.87

0.31

2.00

1.12

1.68

3.35 1.77

3.09

2.41

2.91

0.03

0.04

0.25

0.19

0.07

0.88

0.11

1.40

0.57

0.41

1.64

2.32

0.03

0.95

0.95

0.14

7.89 2.68

0.90

2.21

1.44

0.04

2.10

2.15

3,431

In table 3 we present results from the logistic regression model described previously that is estimated three times: on the full sample of 1274 firm-years for which all data are available, and on bad news and good news subsamples separately. When there is more than one forecast in a year we consider the first forecast of the year to compute our bad news dummy, forecast dispersion, and analyst following variables. The fourth model in table 3 focuses on all management forecasts made over the sample period and, given that a forecast is made, assesses the likelihood that the forecast is subsequently revised.

0.07

0.07

0.19

0.06

0.05

0.05

1.00

0.03

0.02

0.02

10

TABLE 2 Pearson (Spearman) Correlations Above (Below) the Diagonal among Variables Approximating Board and Audit Committee (AC) Structure, and the Likelihood of Management Earnings Forecasts for 1274 Firm-Year Observations All variables are defined in the appendix. , , and indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed).

0.15

0.11

0.34

0.29

0.21

0.05

1.00

0.01

0.01

0.01

9

0.08

0.13

0.15

0.10

0.11

0.08

0.04

1.00

0.01

0.01

8

0.14

0.30

0.13

0.07

1.00

0.03

0.03

0.01

0.01

0.01

7

0.25

0.14

0.06

0.07

0.04

0.04

1.00

0.03

0.01

0.01

6

0.25

0.09

0.18

0.20

0.17

0.25

0.12

0.09

0.04

1.00

5

0.19

0.09

0.39

0.12

0.20

0.15

0.21

0.06

0.06

1.00

4

0.15

0.08

0.19

0.14

0.16

0.20

0.15

0.09

1.00

0.01

3

0.18

0.24

0.28

0.09

0.14

0.16

0.05

1.00

0.03

0.01

2

0.06

0.07

0.06

0.05

0.04

1.00

0.02

0.01

0.01

0.01

1

1. Forecast dummy 2. Board outsiders 3. Board size 4. Board meetings 5. Insider ownership 6. Institutional ownership 7. AC outsiders 8. AC experts 9. AC size 10. AC meetings

BOARDS, AUDIT COMMITTEES, AND EARNINGS FORECASTS

467

  • 468 I. KARAMANOU AND N. VAFEAS

TABLE 3

Logit Regressions Examining the Impact of Corporate Governance and Control Variables on the Likelihood of Making or Updating a Management Earnings Forecast

In the three left-hand models, the dependent variable equals 1 if management issued at least one earnings forecast in the year, and 0 otherwise. In the right-hand model, the dependent variable equals 1 for management forecast updates, and 0 for first-time forecasts. All variables are defined in the appendix. For each variable, coefficient estimates (p -values) are reported in the top (bottom) row. , , and indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed).

All

Firm-Years

Bad News

Years

Good News

Years

Forecast

Updates

Intercept

Firm governance variables

Pct. of outside directors

Board size

Board meetings

Insider ownership (%)

Institutional ownership (%)

Audit committee variables

Pct. of committee outsiders

Pct. committee members with financial expertise Committee size

Committee meetings

Control variables

Bad news

Forecast dispersion

Analyst following

High-tech industry

Log(Total assets )

Annual forecast

Forecast years (forecast updates) Zero forecast years (first forecast) χ 2 for covariates

0.734

(0.47)

1.361

(0.04)

0.025

(0.37)

0.003

(0.91)

0.030

(<0.01)

0.007

(<0.01)

0.868

(0.23)

0.070

(0.81)

0.154

(<0.01)

0.048

(0.31)

0.300

(0.02)

2.205

(<0.01)

0.083

(<0.01)

0.513

(0.02)

0.063

(0.40)

2.036

(<0.01)

517

757

307.08

1.655

(0.22)

1.352

(0.17)

0.011

(0.78)

0.007

(0.85)

0.017

(0.13)

0.002

(0.59)

0.982

(0.32)

0.601

(0.16)

0.160

(0.04)

0.007

(0.91)

2.091

(<0.01)

0.099

(<0.01)

0.600

(0.07)

0.095

(0.37)

2.300

(<0.01)

281

391

203.07

2.923

(0.08)

1.653

(0.10)

0.032

(0.41)

0.01

(0.79)

0.041

(<0.01)

0.014

(<0.01)

0.755

(0.52)

0.408

(0.32)

0.133

(0.10)

0.070

(0.32)

2.400

(<0.01)

0.069

(<0.01)

0.354

(0.06)

0.224

(0.04)

1.792

(<0.01)

237

366

123.90

7.560

(<0.01)

3.247

(<0.01)

0.061

(0.01)

0.030

(0.18)

0.019

(<0.01)

0.012

(<0.01)

0.564

(0.44)

0.918

(<0.01)

0.035

(0.47)

0.035

(0.41)

0.054

(0.64)

0.609

(0.04)

0.018

(0.08)

0.630

(<0.01)

0.125

(0.05)

1.789

(<0.01)

710

916

392.31

BOARDS, AUDIT COMMITTEES, AND EARNINGS FORECASTS

469

Each of the four models in table 3 is jointly significant in explaining the likelihood of making a forecast at the 0.001 level or better, as signified by the χ 2 statistic for the covariates. Focusing first on the sample studying forecast likelihood, firms are more likely to make a forecast when their boards are more independent from management’s influence, when managerial own- ership is lower (Ruland, Tung, and George [1990]), and when institutions own a greater fraction of the firm’s stock. Finally, the results suggest that the likelihood of making a forecast is inversely related to committee size. Together, these results generally agree with the first proposition and the no- tion that better incentive alignment between management and shareholders is associated with the provision of more information from management to shareholders. Management is also more likely to issue a forecast when anticipating bad news and when analyst forecasts are less dispersed. Firms with greater analyst following are also more likely to issue a management forecast, whereas firms in high-tech industries are less likely to issue a forecast. In the bad news subsample, among the governance variables, only audit committee size is significant in explaining the likelihood of a forecast. In con- trast, in the good news subsample, board independence, insider ownership, and institutional holdings are all significant in explaining the likelihood of a forecast. Results on the control variables are generally consistent across the two models. Finally, to gain further insight into the relation between corporate gov- ernance and management forecasts, we study the likelihood of updating a forecast. The results suggest that forecast updates are more likely in firms with more independent and larger boards, firms with a greater fraction of experts in their audit committee, and firms in which insiders and institutions own a higher fraction of equity. The likelihood of management forecast up- dates is also higher for larger firms, firms with greater analyst following, and firms belonging in a high-tech industry, and it is lower for firms with greater analyst forecast dispersion. In sum, although some of the evidence from table 3 is different from the univariate comparisons presented in table 1, the overall findings generally suggest that better governance leads to more disclosure flowing from management to shareholders. 6

5.2 CORPORATE GOVERNANCE AND THE PRECISION OF MANAGEMENT EARNINGS FORECASTS

Focusing next on forecast precision, we partition the 1621 forecasts in our sample into 609 forecasts that make a point estimate of the firm’s future earnings and 1,012 forecasts that do not. (These include range forecasts that specify upper and lower bounds for future earnings, open-ended forecasts that specify either of the bounds but not both, and qualitative forecasts that do not provide any numeric guidance on future earnings.) In table 4 we

6 Reported results implement 1% outlier elimination based on the Pearson residual. Not eliminating outliers does not meaningfully change the interpretation of results.

  • 470 I. KARAMANOU AND N. VAFEAS

TABLE 4

Univariate Comparisons of 1,621 Management Forecasts Partitioned by Degree of Precision

All variables are defined in the appendix. Other forecasts comprise range, open-ended, and qualitative forecasts. The mean (median) value for each variable is provided in the top (bottom) row. , , and indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed).

 

All

Wilcoxon

Forecasts

Point

Other

Difference

t -test

z -test

Sample size

1,621

609

1,012

Dependent variable

Forecast-induced return

2.09

1.09

2.69

1.70

3.57

5.30

0.79

0.07

1.51

Firm governance variables

Pct. of outside directors

79.33

77.83

80.16

2.33

4.18

3.92

80.00

80.00

81.81

Board size

11.69

11.73

11.66

0.07

0.44

0.26

12

12

12

Board meetings

7.80

7.50

7.98

0.48

3.38

1.96

77

8

Insider ownership (%)

5.53

5.55

5.52

0.03

0.07

0.17

1.93

1.98

1.93

Institutional ownership (%)

60.34

60.25

60.41

0.16

0.14

0.60

65.71

65.90

65.54

Audit committee variables

Pct. of committee outsiders

97.15

96.84

97.00

0.16

0.34

0.70

100.00

1.00

1.00

Pct. committee members

22.76

20.90

23.90

3.00

2.55

1.92

with financial expertise

20.00

20.00

20.00

Committee size

4.65

4.52

4.73

0.21

2.87

2.84

54

5

Committee meetings

3.68

3.72

3.66

0.06

0.72

0.66

44

4

Control variables

Bad news

0.57

0.43

0.66

0.23

8.91

8.79

1.00

0.00

1.00

Forecast dispersion

0.06

0.04

0.07

0.03

3.92

5.55

0.02

0.02

0.03

Analyst following

15.10

15.21

15.03

0.18

0.49

1.02

14

14

14

High-tech industry

0.18

0.18

0.18

0.00

0.22

0.22

0.00

0.00

0.00

Days to end of financial

111.4

111.2

111.9

0.7

0.14

0.13

reporting period

78

79.5

77

Total assets (in $millions)

16,989

13,249

19,239

5,990

4.21

0.85

7,490

7,170

7,867

employ both the parametric t -test and the nonparametric Wilcoxon z -test to assess cross-sample univariate differences in each of the governance and control characteristics. We find that firms with a higher fraction of independent directors serving on their boards, with boards that meet more frequently, with larger audit committees, and with a higher fraction of financial experts tend to make less

BOARDS, AUDIT COMMITTEES, AND EARNINGS FORECASTS

471

precise forecasts. Thus, better corporate governance is associated with lower forecast precision. Moreover, the content of the message is a significant determinant of the level of specificity in the forecast; that is, bad news is conveyed in less precise terms. Last, more precise forecasts are more likely when analyst forecasts are less dispersed. To probe further into the variation in the level of precision in manage- ment earnings forecasts, we estimate logistic regression models of the deci- sion to issue a point forecast on corporate governance and control charac- teristics and present the results in table 5. We estimate three models: one on the full sample of 1,621 forecasts, and two on subsamples of bad news and good news forecasts. 7 Each of the models is statistically significant in explaining the likelihood of issuing a point forecast. Focusing first on the full model, firms with independent boards, greater insider ownership, and more expert and larger audit committees are less likely to issue a point forecast, suggesting that these firms actually provide less guidance to the market. Institutional ownership is positively related to forecast precision. Finally, we find that bad news is conveyed in less pre- cise terms, consistent with greater legal liability being associated with lower forecast precision (Bamber and Cheon [1998]). Next, we observe that the full-sample results are driven by the bad news forecasts. Well-governed firms issue less precise forecasts in the face of bad news. Specifically, among the subsample of bad news, point forecasts are less likely for firms with more independent directors and a greater fraction of inside ownership. The only significant variable in the good news sample is institutional ownership. In sum, we find that less precise forecasts are more likely among well-governed firms conveying negative news to investors. 8

5.3 CORPORATE GOVERNANCE AND THE ACCURACY AND BIAS OF MANAGEMENT EARNINGS FORECASTS

Table 6 presents results of OLS regressions addressing the link between forecast accuracy and bias to corporate governance characteristics. To obtain a precise measure of the forecast error, we focus on the 553 point forecasts in our sample for which data are available. (Alternatively, employ- ing both point and range forecasts in the tests produced qualitatively similar results.) Results from the full sample of point forecasts suggest that the abso- lute value of the forecast error (forecast accuracy) declines (increases) with increases in board independence, consistent with our third research propo- sition. Thus, boards with a greater fraction of outside directors make more accurate forecasts. Also, in firms with greater insider ownership managers

7 If the management forecast is less than the consensus analyst forecast, we deem the news as bad. 8 Reported results implement 1% outlier elimination based on the Pearson residual. Not eliminating outliers in the overall sample increases the significance of insider ownership to the 1% level but decreases the significance of committee size to the 10% level. Committee expertise is no longer significant.

  • 472 I. KARAMANOU AND N. VAFEAS

TABLE 5

Logistic Regressions Examining the Impact of Corporate Governance and Control Variables on the Precision of Management Earnings Forecasts

The dependent variable is set to 1 for point forecasts and 0 for range, open-ended, and qualita- tive forecasts. All variables are defined in the appendix. For each variable, coefficient estimates (p -values) are reported in the top (bottom) row. , , and indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed).

All

Firm-Years

Bad News

Forecasts

Good News

Forecasts

Intercept

Firm governance variables

Pct. of outside directors

Board size

Board meetings

Insider ownership (%)

Institutional ownership (%)

Audit committee variables

Pct. of committee outsiders

Pct. committee members with financial expertise Committee size

Committee meetings

Control variables

Bad news

Annual forecast

Forecast dispersion

Analyst following

High-tech industry

Days to end of financial reporting period Forecast update

Log(Total assets )

Point forecasts Range and qualitative forecasts χ 2 for covariates

1.457

(<0.01)

1.602

(<0.01)

0.017

(0.46)

0.034

(0.13)

0.014

(0.05)

0.007

(0.03)

0.047

(0.94)

0.420

(0.09)

0.124

(<0.01)

0.068

(0.11)

1.038

(<0.01)

0.135

(0.93)

0.923

(0.14)

0.010

(0.30)

0.095

(0.58)

0.001

(0.41)

0.139

(0.30)

0.001

(0.99)

584

1,007

135.34

3.729

(<0.01)

3.382

(<0.01)

0.026

(0.40)

0.024

(0.44)

0.059

(<0.01)

0.003

(0.47)

0.633

(0.47)

0.429

(0.23)

0.101

(0.13)

0.082

(0.22)

0.098

(0.67)

1.449

(0.13)

0.007

(0.58)

0.031

(0.89)

0.001

(0.79)

0.109

(0.57)

0.072

(0.39)

252

673

54.71

1.672

(0.27)

0.186

(0.83)

0.005

(0.90)

0.049

(0.14)

0.012

(0.27)

0.016

(<0.01)

0.467

(0.64)

0.366

(0.30)

0.108

(0.11)

0.025

(0.65)

0.093

(0.70)

0.856

(0.34)

0.027

(0.07)

0.344

(0.19)

0.001

(0.34)

0.140

(0.44)

0.124

(0.23)

332

335

27.88

BOARDS, AUDIT COMMITTEES, AND EARNINGS FORECASTS

T A BLE

6

473

Ordinary Least Squares Regressions Examining the Impact of Corporate Governance and Control Variables on the Accuracy and Bias of Management Earnings Forecasts

Forecast accuracy (bias) is the absolute value of the difference (signed difference) between actual earnings and the management forecast. All variables are defined in the appendix. Co- efficient estimates (p -values) are reported in the top (bottom) row. , , and indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed).

Absolute Forecast Error

All Forecasts

Bad News

Good News

Forecast Bias

All Forecasts

Intercept

Firm governance variables

Pct. of outside directors

Board size

Board meetings

Insider ownership (%)

Institutional ownership (%)

Audit committee variables

Pct. of committee outsiders

Pct. committee members with financial expertise Committee size

Committee meetings

Control variables

Bad news

Annual forecast

Forecast dispersion

Analyst following

High-tech industry

Days to end of financial reporting period Forecast update

Log(Total assets )

Sample size F -statistic Adjusted R 2 (in pct. points)

0.210

(0.24)

0.229

(0.03)

0.002

(0.71)

0.001

(0.77)

0.006

(<0.01)

0.001

(0.33)

0.201

(0.11)

0.076

(0.13)

0.012

(0.18)

0.001

(0.92)

0.164

(<0.01)

0.057

(0.08)

0.150

(0.19)

0.005

(<0.01)

0.103

(<0.01)

0.001

(<0.01)

0.028

(0.28)

0.014

(0.29)

553

9.90

21.65

0.447

(0.06)

0.015

(0.93)

0.003

(0.70)

0.001

(0.98)

0.007

(0.02)

0.001

(0.96)

0.337

(0.06)

0.017

(0.85)

0.022

(0.14)

0.018

(0.20)

0.058

(0.26)

1.270

(<0.01)

0.004

(0.28)

0.062

(0.29)

0.001

(0.44)

0.042

(0.29)

0.007

(0.71)

217

3.20

13.96

0.402

(0.18)

0.252

(0.32)

0.368

(0.02)

0.001

(0.86)

0.006

(0.33)

0.005

(<0.01)

0.001

(0.31)

0.001

(0.99)

0.017

(<0.01)

0.005

(0.90)

0.004

(0.06)

0.001

(0.28)

0.171

(0.37)

0.145

(0.03)

0.035

(<0.01)

0.004

(0.64)

0.001

(0.99)

0.042

(0.54)

0.016

(0.20)

0.014

(0.15)

–0.247

0.081

(<0.01)

0.093

(0.08)

0.232

(0.15)

0.006

(0.04)

0.172

(<0.01)

0.001

(0.03)

0.027

(0.49)

0.020

(0.31)

(0.04)

0.103

(0.51)

0.007

(<0.01)

0.081

(0.09)

0.001

(<0.01)

0.024

(0.61)

0.030

(0.09)

335

5.19

16.68

557

9.07

19.79

  • 474 I. KARAMANOU AND N. VAFEAS

make less accurate forecasts, possibly because of the entrenchment effect of ownership. This result is consistent with earlier findings presented in this article that higher inside ownership is associated with a lower likelihood of a management forecast and with lower forecast precision. The sample break- down reveals that independent boards are more accurate when making good news forecasts, whereas higher ownership is associated with a greater forecast error in both subsamples. For the good news subsample, absolute forecast error increases with committee size and, counterintuitively, with commit- tee expertise. Neither result appears in the full-sample tests. Results on the control variables suggest that management forecasts are more accurate when conveying bad news and when pertaining to annual earnings. Fore- casts are less accurate in firms with a high analyst following and in high-tech firms. Last, governance measures are not generally associated with any systematic bias in management forecasts, proxied by the signed forecast error, except for board size and inside ownership levels, both of which are associated with more optimistic forecasts. Management forecasts are more pessimistic when bad news is disclosed, when annual earnings are forecasted, and when issued by a larger firm, whereas forecasts are more optimistic for high-tech firms, for firms with greater analyst following, and for firms with a longer time from the forecast to the end of the reporting period. In sum, the results in table 6 pertaining to our third proposition suggest that effective boards and audit committees are related to forecast accuracy but not to forecast bias.

5.4 CHANGES IN CORPORATE GOVERNANCE AND MANAGEMENT EARNINGS FORECASTS

One issue that has to be addressed regarding our results is the possibil- ity that board and audit committee characteristics are endogenously deter- mined, depending on factors that are not controlled for in this study—for example, on each firm’s managerial labor, corporate control, and other factor and product markets; ownership structure; regulation intensity; and volatility in the operating environment (e.g., Demsetz and Lehn [1985]). The related concern is that unobserved omitted variables could be corre- lated with both governance structures and forecast attributes, leading to a spurious relation between the governance and forecast variables. To ad- dress empirically the endogeneity problem, prior work has modeled these relations in systems of equations (e.g., Agrawal and Knoeber [1996]) to rec- ognize the possibility that each of the corporate governance characteristics depends on another set of firm attributes. Alternatively, another set of studies addresses endogeneity by com- plementing tests associating various phenomena to levels of corporate governance with tests linking such phenomena to changes in corporate governance (e.g., see Klein [2002]). The intuition behind the focus on gov- ernance changes is that there is likely to be much lower temporal fluctuation

BOARDS, AUDIT COMMITTEES, AND EARNINGS FORECASTS

475

in any omitted variable for a given firm than there is fluctuation of such a variable across firms at a given time. One drawback of this approach is that it is more data intensive, a thorny issue when working with hand-collected governance data. Also, governance structures remain relatively unchanged through time. Such stickiness reduces the statistical power of the tests on changes. These limitations notwithstanding, we exploit the six-year panel structure of our data set and repeat our analysis on the likelihood, preci- sion, and accuracy of management forecasts, focusing on changes in boards and audit committees rather than on the respective variable levels. Our results are presented in table 7. The forecast likelihood regression focuses on firms with at least one man- agement forecast in the prior year. The dependent variable equals 1 if the firm issues a management forecast in the current year as well, and 0 oth- erwise, thus separating forecasting firms from firms switching to the non- forecasting group. We find that 369 firm-years exhibit such a change in forecasting policy and use them in the tests. Given that a change in the binary forecast variable is examined, we use first differences in the control variables as well. Consistent with earlier results and our first proposition, we find that as boards become more independent, management is significantly more likely to continue making forecasts. Other governance effects are in- significant, whereas committee independence is weakly negative. Among the controls, we find that firms with lower analyst forecast dispersion and smaller firms are less likely to switch to a nonforecasting status. The results on the model estimating the relation between forecast preci- sion and governance changes are generally similar to the results from table 5 on governance levels. Specifically, as board independence and board activity rise, boards make less precise forecasts, a finding that is consistent with our earlier conclusion. As boards become more effective, they are less likely to risk providing precise forecasts to the market. Similarly, increases in insider ownership are also associated with less precise forecasts. Last, less precision is associated with bad news and greater uncertainty (dispersion) among analysts. Results linking forecast accuracy to governance changes are weak. Coun- terintuitively, increases in audit committee independence are associated with lower accuracy. Given the relative rarity of intertemporal changes in that variable (the vast majority of audit committees include all outsiders throughout the sample period), this finding is best seen as anecdotal. Bad news, greater analyst following, greater firm size, and greater time proximity to the end of the financial reporting period are all associated with greater forecast accuracy. Also, forecast updates are more accurate than first-time forecasts after controlling for the time to the end of the financial report- ing period. Compared with earlier results based on variable levels, results from variable changes are weakly aligned for likelihood tests, more strongly aligned for tests on forecast precision, and not aligned for tests on forecast accuracy.

  • 476 I. KARAMANOU AND N. VAFEAS

TABLE 7

Governance Changes and Management Forecast Likelihood, Precision, and Accuracy

The nonforecasting status regression focuses on firms switching from forecasting in the prior year to nonforecasting in the current year, and it considers the changes in, rather than levels of, the control variables. Nonforecasting status and forecast precision are explained using logistic regression; accuracy is explained using ordinary least squares regression. All variables are defined in the appendix. The p -values are in parentheses. , , and indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed).

Nonforecasting

Status

Forecast

Precision

Forecast

Accuracy

Intercept

Firm governance variables Pct. of outside directors

Board size

Board meetings

Insider ownership

Institutional ownership

Audit committee variables Pct. of committee outsiders

Pct. committee members with financial expertise Committee size

Committee meetings

Control variables

Bad news

Annual forecast

Forecast dispersion

Analyst following

High-tech industry

Log(Total assets )

Days to end of financial reporting period Forecast update

Sample size 2 log-likelihood (F -statistic) Pct. adjusted R 2 (pseudo-R 2 )

0.248

(0.12)

4.815

(0.03)

0.043

(0.65)

0.003

(0.96)

0.150

(0.14)

0.006

(0.47)

3.505

(0.06)

0.329

(0.65)

0.065

(0.72)

0.055

(0.61)

0.217

(0.24)

3.376

(<0.01)

0.007

(0.76)

0.001

(0.03)

369

452.42

(9.6%)

0.749

(0.11)

3.798

(<0.01)

0.072

(0.16)

0.072

(0.01)

0.070

(0.04)

0.001

(0.81)

1.073

(0.25)

0.064

(0.85)

0.035

(0.68)

0.018

(0.74)

0.96

(<0.01)

0.001

(0.98)

2.273

(<0.01)

0.007

(0.44)

0.141

(0.40)

0.073

(0.23)

0.001

(0.69)

0.20

(0.13)

1,516

121.4

(7.1%)

0.405

(<0.01)

0.060

(0.79)

0.015

(0.13)

0.001

(0.88)

0.005

(0.38)

0.001

(0.30)

0.313

(0.04)

0.046

(0.49)

0.005

(0.76)

0.001

(0.92)

0.180

(<0.01)

0.032

(0.37)

0.168

(0.24)

0.007

(<0.01)

0.051

(0.16)

0.023

(0.06)

0.001

(0.09)

0.068

(<0.01)

532

(7.88)

18.0%

BOARDS, AUDIT COMMITTEES, AND EARNINGS FORECASTS

477

5.5 CORPORATE GOVERNANCE AND THE MARKET REACTION TO MANAGEMENT EARNINGS FORECASTS

5.5.1. Price Reaction Tests. In the first three models in table 8 we address our fourth research proposition, studying the relation between corporate governance structures and forecast-induced abnormal returns. Again, we partition the sample of management forecast announcements into bad news and good news to study the relation between governance structures and announcement-related returns for the two samples separately. Each of the models in table 8 is jointly significant at the 5% level or better, as signified by the respective model F -statistics. Furthermore, a χ 2 test suggests that het- eroskedasticity is not a significant problem for our results (White [1980]). Focusing first on the full sample of announcements, the three-day an- nouncement return is positively related to the number of independent di- rectors serving on the board. Also, the forecast-induced return is negatively related to board size and audit committee size. In addition, the fraction of directors with financial expertise serving in the audit committee is posi- tively associated to the announcement return. These results are consistent with the predictions of our fourth proposition, supporting the notion that forecasts are assessed more favorably when screened by more effective gov- ernance mechanisms. The sample breakdown reveals that most of these results hold in both the bad and good news subsamples. Specifically, in the bad news sample board independence and financial expertise are both positively related to announcement returns, as expected, while committee size is negatively related to returns. Among the sample of good news an- nouncements, the market reacts more favorably when the announcement comes from a smaller but less active board, and a more independent audit committee that meets more frequently. In the full-sample model, the return is significantly lower for bad news announcements while the magnitude of the surprise matters more in the case of bad news. Last, the market reacts more positively to annual forecasts, to forecasts by larger firms, and to more precise forecasts, probably because of skepticism toward more vague forecasts. Also, precision is rewarded only for bad news, probably because greater information asymmetry reduces in- vestor trust in firms that issue vague forecasts. In the good news subsample the market is more positive toward annual forecasts and toward forecasts by firms with a lower analyst following. Finally, firm size is positively related to returns in both samples. 9 In sum, the results from table 8 suggest that fore- casts by firms with effective boards and audit committees are received more favorably by the market, consistent with our fourth research proposition.

5.5.2. Equity Analyst Reaction. To shed further light on the relation among boards, audit committees, and the informativeness of management

9 Outliers are eliminated based on the studentized residual using a cutoff of |3.0|. Results are not sensitive to the cutoff used.

  • 478 I. KARAMANOU AND N. VAFEAS

TABLE 8

Corporate Governance and the Market Reaction to Management Earnings Forecasts

All variables are defined in the appendix. The models are estimated using ordinary least squares. The p -values are in parentheses.