Pertemuan 5 - EQUITY METHOD INVESTMENT AND SELL SIDE ANALYST INFORMATION ENVIRONTMENT PDF

THE ACCOUNTING REVIEW American Accounting Association
Vol. 88, No. 6 DOI: 10.2308/accr-50539

2013
pp. 2089–2115
Equity Method Investments and Sell-Side

Analysts’ Information Environment
Sam (Sunghan) Lee
Shailendra Pandit
University of Illinois at Chicago
Richard H. Willis
Vanderbilt University
ABSTRACT: We study the joint effects of intercompany investing and reporting of

equity method investments on the accuracy and dispersion of analysts’ annual earnings-
per-share (EPS) forecasts. We compare firm-year observations with and without equity
method investments. We posit two non-mutually exclusive explanations for how equity
method investments may affect analyst forecast properties. The Opacity Effect posits
that the condensed equity method disclosures increase information asymmetry,
increasing analysts’ forecast errors and forecast dispersion. The Diversification Effect
suggests that the diversification of the investor and its investee earnings streams
enhances earnings predictability, decreasing analysts’ forecast errors and forecast
dispersion. Our findings are consistent with both effects operating in the analyst
forecasting task. Additional analyses are consistent with the Opacity Effect dominating.
This occurrence results, on net, in less accurate and more dispersed forecasts for firm-
years with equity method investments.
Keywords: security analysts; equity method investments; forecast accuracy; forecast
dispersion; information environment.
JEL Classiﬁcations: G14; M41.
We thank two anonymous reviewers and John Harry Evans III (senior editor). We also appreciate comments from Nick
Bollen, Paul Chaney, Ram Ramakrishnan, Michael Smith, Alexandra Wu, and workshop participants at the 2011 AAA
Annual Meeting, Chungang University, Southern Illinois University, the University of Illinois at Chicago, Vanderbilt
University, and Yonsei University. We thank Patricia Rosenberg and Xiu Yang for excellent research assistance. We
appreciate the financial support of the Center for Education and Research in Financial Reporting Quality (CERFRQ) at
the College of Business Administration at the University of Illinois at Chicago and the Owen Graduate School of
Management at Vanderbilt University. Analyst forecast data are from I/B/E/S. Data for investor ownership interests in
investees are from the Mergers and Acquisition database of Thomson ONE.
Errors or omissions are our responsibility.
Editor’s note: Accepted by John Harry Evans III.
Submitted: November 2011
Accepted: June 2013
Published Online: June 2013
2089
2090 Lee, Pandit, and Willis
I. INTRODUCTION
W
e study the joint effects of intercompany investing and reporting of equity method
investments on the accuracy and dispersion of analysts’ annual earnings-per-share
(EPS) forecasts. Using the equity method of accounting, firms (‘‘investors’’) recognize
investments in firms in which they have significant influence (‘‘investees’’) by initially recording the
investment at cost as an asset on the balance sheet. The investment account is subsequently adjusted
(reduced) for the investor’s proportionate share of the investee’s net income or loss (cash dividend
payments). The investor recognizes its share of investee profit or loss as a line item on the income
statement. The single line item recognition on the investor’s balance sheet and income statement
under the equity method is different from consolidation, wherein the financial position and income
of the separate entities are combined on a line-item by line-item basis.
Prior research investigates whether firms use the equity method of accounting opportunistically
(Bauman 2003; Comiskey and Mulford 1986) or how alternative investment accounting methods
affect bond ratings (Bauman 2007). Our objective is to gauge the impact of the equity method of
accounting for investments on analysts’ forecast properties. Equity method accounting treatment
arises from a firm’s decision to undertake a significant noncontrolling stake in another entity.1 Our
primary test, therefore, assesses the joint effect of intercompany investing and reporting of equity
method investments on the accuracy and dispersion of analyst forecasts. In the small sample test,
we restrict the focus to firm-years with ownership stakes near 50 percent and using either the equity
method only or consolidation only. This test better isolates equity method reporting effects on
analysts’ forecast properties by holding constant the investment stake. Both tests provide consistent
results.
Ex ante, the effects of the equity method of accounting for investments on analysts’ earnings
forecasts are unclear. On one hand, equity method investments may lead to less accurate and more
dispersed analyst forecasts. The single line item recognition of the investor’s share of investee
earnings and net assets may increase information complexity about investor (total) earnings because
of the lack of disclosure about the components of the investor’s total earnings, namely investee(s)
earnings performance. This outcome, which we label the ‘‘Opacity Effect’’ of equity method
investments, yields less (more) accurate (dispersed) forecasts of investor earnings.
On the other hand, equity method investments may lead to more accurate and less dispersed
analyst forecasts. First, if the investor’s earnings excluding its share of investee earnings and the
earnings of its investee(s) are not perfectly correlated, then earnings volatility could be reduced,
yielding a more predictable earnings stream. Second, analysts may independently forecast investor
and investee earnings streams, and the forecast errors they make in predicting these separate
earnings streams may not be perfectly correlated. As a result, forecasting the individual earnings
streams and combining the forecasts may be more accurate than devising one forecast for the
combined earnings stream. These outcomes, which we label the ‘‘Diversification Effect’’ of equity
method investments, yield more (less) accurate (dispersed) forecasts of investor earnings.
Understanding the effects of equity method investments on analysts’ forecasts is important.
First, the equity method is widely used as reflected by an average of 34.7 percent of firm-year
observations in our sample using the equity method; the sample average of all firm-years in
Compustat is 20.1 percent. Equity method earnings also account for a significant portion of total
1
Typically, the equity method is used when the investor owns 20 percent to 50 percent of the investee common
stock (FASB ASC Topic 323, Investments—Equity Method and Joint Ventures). The presumption is that the
investor exerts significant influence, but does not govern investee operations. The consolidation (cost) method
generally is used when the investor owns more than 50 percent (less than 20 percent) of the investee. If an
investor governs investee operations, then the investor is required to use the consolidation method for investee
ownership stakes less than 50 percent.
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Equity Method Investments and Sell-Side Analysts’ Information Environment 2091
earnings before extraordinary items for firms with equity method investments. The average is 17.4
percent of earnings before extraordinary items in our sample and 29.8 percent on Compustat;
median percentages are 6.0 percent and 6.8 percent in our sample and on Compustat, respectively.
Second, as sophisticated users of financial statement information, analysts represent a primary
audience to whom financial statement disclosures are addressed (Schipper 1991). The description in
Appendix A indicates that, in 45 percent of the analyst reports that we examine for a randomly
chosen year in our sample, analysts explicitly discuss or provide separate earnings estimates for
equity method investments. A finding that equity method investments decrease analyst forecast
accuracy and/or increase forecast dispersion could suggest that the current disclosures required by
U.S. GAAP about equity method investees are inadequate.
Our primary test compares firm-year observations with and without equity method investments.
We find that analysts’ annual consensus earnings forecasts are less accurate and the forecasts
comprising the consensus are more dispersed for firm-year observations with equity method
investments. These findings are consistent with the Opacity Effect. This result also holds in the
within-firm analysis, using the firm as its control, in which we examine the subset of firms with
equity method investments in some, but not other years.
Because the Opacity and Diversification Effects are not mutually exclusive, we use two proxies
to identify firms for which we expect the Diversification Effect to be more pronounced. Our
findings from these tests suggest that the benefits of the Diversification Effect reduce, but do not
fully undo the Opacity Effect. Overall, we conclude that both effects operate in the analyst
forecasting environment, but that the Opacity Effect overwhelms any benefits in easing the
analysts’ forecasting task that may be attributable to the Diversification Effect.
The sample may be affected by self-selection because firm-years are not randomly assigned to
observations with or without equity method investments. Other attributes associated with firms with
equity method investments, such as business conditions or financial performance, could affect
analysts’ information environment. We assess whether self-selection influences our inferences by
using the Heckman (1979) two-step estimation procedure. In the first stage of the primary sample
Heckman estimation, the firm chooses whether to undertake a 20 to 50 percent investment
accounted for with the equity method. The second stage compares all firm-year observations with
and without equity method investments. The two-step test controlling for self-selection confirms
our conclusions from the primary tests.
The primary sample Heckman test remains potentially confounded, however, if there are
systematic differences in firms’ information environments conditional on firms’ ownership stake(s)
in the investee(s). As previously noted, the primary sample addresses the joint effect of
intercompany investing and reporting of equity method investments. In the small sample Heckman
estimation, we restrict the sample to firm-years with comparable investee ownership stakes. This
subsample contains all firm-years from the primary sample having ownership stakes in all investee
firms near 50 percent, and using the equity method only or consolidation only. Thus, we better
isolate equity method reporting effects by conditioning the sample on comparable ownership stakes.
We continue to find reduced (increased) forecast accuracy (dispersion) for firm-years with equity
method investments. The small sample test, although less generalizable, corroborates the primary
sample findings and, by controlling for the level of investment, sheds light on the financial
reporting effects of equity method accounting for intercompany investments.
Given our primary findings of differences in analysts’ forecast properties for firm-year
observations with and without equity method investments, we investigate the association between
analyst forecast properties and the magnitude of equity method earnings. This analysis provides
additional insight regarding our primary conclusion by investigating whether firm-years with a
greater proportion of total earnings attributable to equity method investments are associated with

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larger forecast errors and greater forecast dispersion. Our tests confirm this relation and are robust to
alternative methods of capturing the importance of investee earnings to total firm earnings.
This study makes the following contributions. First, we establish that the investing and
reporting issues of the equity method of accounting adversely affect analysts’ information
environment, leading to less accurate and more dispersed analyst forecasts. This result is of interest
to United States standard setters, as other countries, such as the United Kingdom and Canada,
require more disaggregated information disclosures regarding equity method investees than the U.S.
Second, relative to prior work, our setting is unique in that both the Opacity and Diversification
Effects coexist. The settings in prior work have generally been conducive to investigating either the
Opacity Effect or the Diversification Effect on analysts’ information environment, but not both. For
example, Botosan and Stanford (2005) study the impact of segment disclosure on analysts’
information environment. They examine a sample of 615 ‘‘change firms,’’ which had previously
reported no segment information, but initiated segment reporting under SFAS 131, Disclosures
about Segments of an Enterprise and Related Information. Thus, they focus on a variant of the
Opacity Effect, changing from less to more disaggregated information regarding firm earnings.
They find decreased annual EPS forecast accuracy for the subsample of change firms with annual
earnings forecasts available before and after the reporting of segment disclosures. This result is
sensitive to the set of firms examined. When they extend their analysis one year, they find no
evidence of a change in analysts’ EPS forecast accuracy.
Thomas (2002), on the other hand, examines the Diversification Effect. He studies whether the
disclosure of segment earnings information diversifies a firm’s combined earnings, potentially
reducing analysts’ information asymmetry and enhancing (reducing) forecast accuracy (dispersion).
He finds that more diversified firms have more accurate (less dispersed) analyst forecasts. His
finding, however, is sensitive to the empirical specification he uses. We attempt to distinguish
between the Opacity Effect and the Diversification Effect empirically. Our ability to explore the
potential interplay of these effects, however, relies on the strengths of our proxies.
We review related research and develop our hypotheses in Section II. Section III describes the
sample. We present the empirical work in Section IV. Section V concludes.
II. PRIOR RESEARCH AND HYPOTHESES DEVELOPMENT

We posit two, non-mutually exclusive, explanations regarding the effect of the equity method
of accounting for investments on analysts’ information environment.
Opacity Effect
The Opacity Effect is predicated on the financial reporting and disclosure of equity method
investments increasing information asymmetry between firms and analysts regarding the firms’
earnings prospects relative to firms that do not use the equity method, regardless of whether they
use the cost method or consolidate. This increased information asymmetry could be attributable to
the non-consolidation of results from equity investments, the reporting of net equity income absent
footnote disclosure of its major components, or the lack of segment data for equity method
investees; we are unable to distinguish among these explanations in an archival setting.
Nonetheless, this increased information asymmetry heightens the complexity of the forecasting
task. Prior research shows that increased task complexity induces subjects to use simpler decision
rules to complete tasks (Payne 1976; Payne et al. 1988). Simpler decision rules result in the
incomplete use of available information and undermine performance (Earley 1985).
Thus, we posit that the increased information asymmetry associated with firm-year
observations with equity method investments increases the complexity of the forecasting task
relative to firm-year observations that do not have equity method investments. This increased

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complexity may induce analysts to simplify the process by which they forecast earnings—reducing
performance and yielding larger forecast errors and more dispersed forecasts. Hence, analysts’
annual earnings forecasts would be less accurate and more dispersed for firm-year observations with
equity method investments.
Diversification Effect
An entity that has equity method investments represents a portfolio of earnings streams—the
earnings associated with the investor, excluding its share of investee earnings, and the earnings
associated with the investor’s equity method investee(s). The Diversification Effect can affect
analysts’ forecasts in at least two ways. First, if the two earning streams are not perfectly correlated,
then combined earnings of the investor (less investee) and investee earnings streams are likely to be
less volatile and potentially more predictable, easing the forecasting task, an outcome we call
‘‘operational diversification.’’ Our empirical results confirm that firm-years with equity method
investments have lower earnings volatility than firm-years without equity method investments.
Second, the existence of distinct earnings streams may affect analysts’ forecast errors of total
earnings if analysts separately predict investor and investee(s) earnings and combine those forecasts
to produce a forecast of total firm earnings, an outcome we call ‘‘informational diversification.’’2 If
the analyst separately attends to individual earnings streams and her forecast errors for each
earnings stream are imperfectly correlated, then a combined earnings forecast for a firm for which
an analyst has separately forecasted investor (less investee) and investee earnings streams will be
more accurate than one forecast developed for combined earnings (Thomas 2002).3 This outcome
holds for any level of the correlation of the earnings streams less than a perfect positive correlation.
Thus, analysts’ annual earnings forecasts would be more accurate and less dispersed for firm-year
observations with equity method investments.
III. SAMPLE
We gather all split-adjusted annual earnings-per-share forecasts for U.S. firms during 1985 to
2010 from the I/B/E/S Detail File. We use annual forecasts because the investor’s share of investee
income must be recognized as a separate line item in the investor’s annual income statement; there
is no such requirement for quarterly filings. We retain the last forecast issued by an analyst at most
90 calendar days before the annual earnings announcement date on I/B/E/S. Because we calculate
the consensus earnings forecast and forecast dispersion from analyst-level observations, we require
that at least three analysts issue an earnings forecast during this period. We calculate the consensus
EPS forecast as the equally weighted average of the firm-year forecasts. We measure the forecast
error, AB_ERR, as the absolute value of the difference between actual EPS and the consensus EPS
forecast, deflated by share price at the beginning of the fiscal year. We measure forecast dispersion,
DISP, as the standard deviation of the forecasts comprising the consensus forecast calculation, also
deflated by stock price at the beginning of the fiscal year. We multiply AB_ERR and DISP by 100 to
minimize rounding effects.
2
We define the categories ‘‘investor (less investee) earnings’’ and ‘‘investee earnings’’ to be mutually exclusive
and exhaustive. Combined earnings of the firm, which we call ‘‘investor earnings,’’ equal ‘‘investor (less
investee) earnings’’ plus ‘‘investee earnings.’’ AB_ERR and DISP, defined in Section IV, are calculated using
‘‘investor earnings.’’ When the context is clear, we refer to ‘‘investor (less investee) earnings’’ as ‘‘investor
earnings.’’
3
Thomas (2002) examines diversified and focused firms, defined based on the number of segments and the
Herfindahl index.

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This initial sample contains 38,697 firm-year observations. We require that Compustat data
contain nonmissing values for ‘‘equity in earnings—unconsolidated subsidiaries’’ (Compustat
mnemonic ESUB), reducing the sample by 9,059 observations. Requiring the necessary Compustat
data to calculate the control variables reduces the sample by 8,302 firm-year observations, yielding
the primary sample containing 21,336 firm-year observations.
Table 1, Panel A presents the annual percentage of firms in the primary sample and, as a basis
for comparison, all firm-year observations on Compustat with available data, with equity method
investments. The equity method is widely used in every year of the sample, with 34.7 percent of the
sample firm-years having equity method investments, compared with 20.1 percent of Compustat
firm-year observations. This difference is consistent with the sample firms being larger than the
typical Compustat firm, given the analyst following requirement. The mean (median) value of assets
is $5.2 ($1.0) billion for the sample compared with $1.7 billion ($86 million) for all firm-years on
Compustat (not tabulated). We also report the mean and median percentages of equity method
income as a percentage of total firm earnings before extraordinary items for both samples. The
mean (median) values of these percentage are 17.4 percent (6.0 percent) and 29.8 percent (6.8
percent) for the primary sample and Compustat, respectively.
Table 1, Panel B contains descriptive statistics on EQMETHOD, firm-year observations with
equity method investments, and Non-EQMETHOD, firm-year observations without equity method
investments, respectively. All the mean (median) comparisons between the EQMETHOD and
Non-EQMETHOD samples are statistically different at two-tailed p , 0.01. Variables are defined in
Section IV. We find univariate evidence consistent with the Opacity Effect. Average absolute
forecast errors (AB_ERR) and average forecast dispersion (DISP) are larger for the EQMETHOD
sample than for the Non-EQMETHOD sample (0.854 versus 0.679 for AB_ERR; 0.626 versus 0.472
for DISP). Relative to firm-year observations with equity method investments, firm-year
observations without equity method investments have, on average, lower analyst following
(FOLLOW, 6.981 versus 8.262 analysts following the firm), more volatile earnings (VOLATILE,
0.084 versus 0.058), higher return on assets (ROA, 6.0 percent versus 5.0 percent), more incidences
of negative earnings (LOSS, 17.5 percent of firm-years versus 15.6 percent), more institutional
ownership (INSTOWN, 57.8 percent versus 53.2 percent), and are smaller (ASSETS, $3,096.3
million versus $9,172.0 million). Our univariate comparison for VOLATILE is consistent with firms
with equity method investments having lower earnings volatility and perhaps more predictable
earnings.
To assess the economic significance of the univariate differences, Panel C shows that the mean
difference in AB_ERR (DISP) as a percent of the combined sample mean for AB_ERR (DISP) is
23.6 percent (29.3 percent). We interpret these differences as economically meaningful. Medians,
presented in Panel D, yield similar inferences.
Table 2 contains the Pearson correlation coefficients. Consistent with prior work (e.g., Heflin et
al. 2003), we find that absolute forecast error, AB_ERR, and forecast dispersion, DISP, are highly
positively correlated (Pearson correlation ¼ 0.639, two-tailed p , 0.01). Given this positive
correlation, we summarize the correlations between AB_ERR and the control variables because the
correlations between DISP and the control variables are quite similar in magnitude and statistical
significance.
AB_ERR and FOLLOW are negatively correlated (Pearson correlation ¼ 0.065, two-tailed p
, 0.01). Kim and Verrecchia (1994, 1997) model settings in which more information, as proxied
by analyst following, can increase or decrease information asymmetry; our univariate correlations
are consistent with the latter. As in Agrawal et al. (2006) and Heflin et al. (2003), we find a positive
correlation between AB_ERR and VOLATILE (Pearson correlation ¼ 0.048, two-tailed p , 0.01).
Forecast errors for loss firms, LOSS, tend to be larger as shown in Brown (2001) (Pearson
correlation ¼ 0.294, two-tailed p , 0.01). Forecast errors for better-performing firms tend to be

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TABLE 1
Primary Sample Descriptive Statistics
(n ¼ 21,336)
Panel A: Firms with Equity Investments and Equity Earnings as Percent of Total Earnings
Equity Earnings as Equity Earnings as
Percent of Firms Percent Total Earnings Percent Total Earnings
w/Equity Investments (Mean) (Median)
Primary Primary Primary
Year Sample Compustat Sample Compustat Sample Compustat
1985 47.1% 20.3% 17.9% 35.9% 7.8% 9.9%
1986 44.6% 19.8% 22.5% 37.6% 8.6% 9.3%
1987 43.9% 19.5% 22.1% 37.7% 8.6% 9.6%
1988 41.0% 18.7% 16.6% 35.6% 6.1% 9.1%
1989 31.6% 18.0% 18.5% 34.7% 8.2% 9.3%
1990 31.8% 17.4% 15.1% 35.2% 7.0% 9.6%
1991 31.6% 16.7% 18.0% 36.1% 7.8% 9.2%
1992 32.7% 16.5% 16.6% 34.0% 6.5% 8.3%
1993 33.1% 16.1% 18.6% 32.5% 6.0% 8.3%
1994 32.7% 16.7% 19.3% 30.8% 7.6% 7.5%
1995 30.6% 17.4% 20.5% 30.6% 7.1% 7.4%
1996 28.9% 18.3% 16.4% 28.9% 6.6% 7.2%
1997 31.0% 18.9% 18.0% 29.3% 7.2% 7.2%
1998 33.5% 19.1% 23.5% 30.5% 8.0% 7.6%
1999 32.8% 19.2% 17.7% 30.2% 7.0% 7.1%
2000 31.9% 20.2% 20.4% 30.4% 6.2% 7.1%
2001 33.1% 21.6% 21.1% 32.2% 6.6% 7.2%
2002 33.7% 22.4% 22.1% 29.2% 6.5% 6.5%
2003 36.0% 22.7% 17.5% 29.1% 6.3% 6.7%
2004 35.3% 23.0% 14.8% 24.5% 4.8% 5.0%
2005 34.5% 23.0% 12.9% 24.4% 4.1% 4.9%
2006 35.2% 23.5% 12.1% 22.5% 3.6% 4.4%
2007 34.7% 23.4% 13.7% 22.5% 3.6% 3.7%
2008 35.8% 24.5% 13.3% 22.5% 2.8% 3.6%
2009 38.2% 25.0% 16.1% 26.1% 3.6% 4.5%
2010 37.8% 26.3% 13.5% 23.0% 3.2% 4.2%
Total 34.7% 20.1% 17.4% 29.8% 6.0% 6.8%
Panel B: Primary Sample Descriptive Statistics (n ¼ 21,336)

Variable Sample Mean Std. Dev. Q1 Median Q3
AB_ERR EQMETHOD 0.854 1.936 0.079 0.230 0.678
Non-EQMETHOD 0.679 1.585 0.064 0.196 0.553
DISP EQMETHOD 0.626 1.137 0.099 0.244 0.586
Non-EQMETHOD 0.472 0.931 0.070 0.175 0.438
FOLLOW EQMETHOD 8.262 5.576 4.000 6.000 11.000
Non-EQMETHOD 6.981 4.922 4.000 5.000 8.000
VOLATILE EQMETHOD 0.058 0.084 0.018 0.033 0.063
(continued on next page)

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TABLE 1 (continued)
Non-EQMETHOD 0.084 0.118 0.020 0.042 0.098
ROA EQMETHOD 0.050 0.090 0.021 0.050 0.086
Non-EQMETHOD 0.060 0.126 0.023 0.066 0.119
LOSS EQMETHOD 0.156 0.363 0.000 0.000 0.000
Non-EQMETHOD 0.175 0.380 0.000 0.000 0.000
INSTOWN EQMETHOD 0.532 0.286 0.341 0.569 0.743
Non-EQMETHOD 0.578 0.272 0.381 0.590 0.782
ASSETS (millions $) EQMETHOD 9,172.0 15,916.1 971.0 3,016.8 9,377.8
Non-EQMETHOD 3,096.3 9,318.2 212.2 613.7 1,932.2
Panel C: Economic Significance: Mean AB_ERR and DISP (Price-Deflated)

Panel B Panel B Difference as
Mean for Mean for Mean for Percent of
Combined EQMETHOD Non-EQMETHOD Combined
Sample Sample Sample Difference Sample Mean
AB_ERR 0.740 0.854 0.679 0.175 23.6%
DISP 0.525 0.626 0.472 0.154 29.3%
Panel D: Economic Significance: Median AB_ERR and DISP (Price-Deflated)

Panel B Panel B
Median for Median for Median for Difference as
Combined EQMETHOD Non-EQMETHOD Percent of Combined
Sample Sample Sample Difference Sample Median
AB_ERR 0.207 0.230 0.196 0.034 16.4%
DISP 0.198 0.244 0.175 0.069 34.8%
Panel A presents the percentage of firms with non-zero equity method earnings in the sample (n ¼ 21,336) and on
Compustat by year. Also provided are the mean and median percentage of which equity method earnings account as a
percentage of total earnings before extraordinary items for the sample and all firm-years on Compustat with available
data. Before calculating the mean percentage for the year, the Compustat and sample percentages are winsorized by year
at the top and bottom 1 percent to reduce the influence of outliers.
Panel B presents descriptive statistics for the EQMETHOD (n ¼ 7,400) and Non-EQMETHOD (n ¼ 13,936) samples,
which we call the ‘‘Primary Sample.’’ The EQMETHOD (Non-EQMETHOD) sample contains all firm-years during 1985
to 2010 with available Compustat data for which equity method earnings in the current (year t) or prior (year t1) fiscal
year is non-missing and non-zero (Compustat mnemonic ESUB). All mean and median comparisons are statistically
different at two-tailed p , 0.01. Panel B statistical comparisons are conducted testing the equality of the means
(medians) using the t-test (Wilcoxon rank sum test).
Panel C (D) presents the economic significance of the mean (median) univariate differences for the primary variables of
interest, AB_ERR and DISP, deflated by share price as of the beginning of the fiscal year, as a percent of the combined
sample mean (median). Variable definitions follow (Compustat mnemonics in parentheses). AB_ERR ¼ absolute value of
the difference between the most recent analysts’ consensus annual earnings-per-share (EPS) forecast and the firm’s actual
EPS reported on I/B/E/S deflated by share price as of the beginning of the fiscal year. The consensus EPS forecast is
calculated: (1) requiring a minimum of three individual EPS forecasts from distinct analysts; and (2) using the most
recent EPS forecast from each analyst that is issued 90 calendar days or less before the annual earnings announcement
date; DISP ¼ standard deviation of the most recent analysts’ annual EPS forecasts comprising the consensus EPS
forecast, deflated by share price at the beginning of the fiscal year; FOLLOW ¼ number of analysts on I/B/E/S providing
at least one annual EPS forecast in a firm-year; VOLATILE ¼ standard deviation of income before extraordinary items
(IB) over the previous 12 years, deflated by total assets (AT) at the beginning of the fiscal year. VOLATILE is calculated
on a rolling basis. For example, for a firm-year observation in 1995, we use IB over the previous 12 years, 1983 to 1994,
to estimate VOLATILE, requiring a minimum of three years of nonmissing IB data. ROA ¼ return on assets of the prior
year, calculated as income before extraordinary items during the previous fiscal year deflated by total assets at the
beginning of the prior fiscal year; LOSS ¼ an indicator variable equal to 1 if the firm has negative income before

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TABLE 1 (continued)
extraordinary items for the year, 0 otherwise; INSTOWN ¼ number of common shares held by institutional investors at
the beginning of the fiscal year deflated by the number of common shares outstanding at the beginning of the fiscal year,
collected from the Thomson Reuters Mutual Fund Holdings database; and ASSETS ¼ total annual assets (AT) in millions
of U.S. dollars.
smaller; we document a negative correlation between return on assets, ROA, and AB_ERR (Pearson
correlation ¼ 0.172, two-tailed p , 0.01). We find a negative correlation between AB_ERR and
institutional ownership, INSTOWN (Pearson correlation ¼0.120, two-tailed p , 0.01), consistent
with Ljungqvist et al. (2007), and AB_ERR and firm size, measured by ASSETS (Pearson
correlation ¼ 0.037, two-tailed p , 0.01), consistent with Atiase (1985). Finally, consistent with
the Opacity Effect, forecast errors are larger for firms with equity method investments; the
correlation between AB_ERR and EQMETHOD is 0.049 (two-tailed p , 0.01).
In summary, as in prior research, we find that analyst forecast errors tend to be larger when
forecast dispersion is larger, for firms with more volatile earnings, and for loss firms. We find that
analyst forecast errors tend to be smaller for firms that are followed by more analysts, better
performing, have more institutional ownership, and are larger.
TABLE 2
Pearson Correlation Coefficients for the Primary Sample
(n ¼ 21,336)
AB_ EQ- FOL- VOL- INST-
ERR DISP METHOD LOW ATILE ROA LOSS OWN ASSETS
AB_ERR 1.000 0.639 0.049 0.065 0.048 0.172 0.294 0.120 0.037
, 0.01 , 0.01 , 0.01 , 0.01 , 0.01 , 0.01 , 0.01 , 0.01
DISP 1.000 0.072 0.021 0.085 0.220 0.316 0.136 0.007
, 0.01 , 0.01 , 0.01 , 0.01 , 0.01 , 0.01 0.34
EQMETHOD 1.000 0.126 0.114 0.038 0.024 0.079 0.390
, 0.01 , 0.01 , 0.01 , 0.01 , 0.01 , 0.01
FOLLOW 1.000 0.081 0.088 0.061 0.149 0.431
, 0.01 , 0.01 , 0.01 , 0.01 , 0.01
VOLATILE 1.000 0.216 0.247 0.023 0.272
, 0.01 , 0.01 , 0.01 , 0.01
ROA 1.000 0.417 0.020 0.005
, 0.01 0.01 0.44
LOSS 1.000 0.017 0.109
0.01 , 0.01
INSTOWN 1.000 0.128
, 0.01
ASSETS 1.000
This table provides the Pearson correlations and, beneath, two-tailed p-values, testing whether the population correlation
coefficient differs from zero. Variable definitions follow. EQMETHOD ¼ an indicator variable equal to 1 if the firm has a
non-zero and non-missing value of equity earnings (Compustat mnemonic ESUB) in the current fiscal (year t) or prior
fiscal (year t1) year or both, 0 otherwise; FOLLOW ¼ natural log of the number of analysts on I/B/E/S providing at least
one annual earnings-per-share forecast in a firm-year; and ASSETS ¼ natural log of total assets. The remaining variables
are defined in the notes to Table 1.

November 2013
IV. EMPIRICAL RESULTS

If the Opacity (Diversification) Effect dominates, then we expect analysts’ annual EPS forecasts
will be less accurate and more dispersed (more accurate and less dispersed) for firm-year observations
with equity method investments. Both the Opacity and Diversification Effects may operate in a firm’s
information environment. After presenting our primary findings in the first subsection below, we
attempt to disentangle Diversification from Opacity to address whether one or both explanations
describe the effect(s) of equity method investments on analysts’ forecast properties. We then model
the choice to invest 20 to 50 percent in another entity to assess whether selection may confound our
inferences. We also construct a subsample of observations with comparable investment stakes to
better isolate the influence of equity method reporting. We build on the findings in the first subsection
below by analyzing the effect of the magnitude of equity method earnings on analysts’ forecast
properties. In all estimated regressions, we transform the values of the continuous dependent and
independent variables to range from 0 to 100 to facilitate across coefficient estimate comparisons,
consistent with Clement and Tse (2003).4 We adjust standard errors for serial and cross-sectional
correlation following Petersen (2009), clustering standard errors at the firm and year level, and include
industry effects, defined using one-digit SIC codes, in all regression analyses.
Equity Method Investments and Analyst Forecast Properties

To compare forecast accuracy between firm-year observations with and without equity method
investments, we estimate the following regression at the firm-year level using ordinary least squares
(subscripts suppressed):5
AB ERR ¼ b0 þ b1 EQMETHOD þ b2 FOLLOW þ b3 VOLATILE þ b4 ROA þ b5 LOSS
þ b6 INSTOWN þ b7 ASSETS þ e: ð1Þ
The transformed independent and dependent variables are:
AB_ERR ¼ absolute value of the difference between the most recent analysts’ consensus annual
EPS forecast and the firm’s actual EPS reported by I/B/E/S, deflated by share price at the
beginning of the fiscal year (Compustat mnemonic PRCC_F). This quantity is multiplied
by 100;
EQMETHOD ¼ an indicator variable equal to 1 if the firm-year observation has equity method
investments (Compustat mnemonic ESUB . 0 and non-missing) in the current fiscal year
(year t) or prior fiscal year (year t1) or both, 0 otherwise;
FOLLOW ¼ natural logarithm of the number of analysts on I/B/E/S providing at least one
annual earnings-per-share forecast for the firm during the fiscal year;
VOLATILE ¼ standard deviation of income before extraordinary items (Compustat mnemonic
IB) over the past 12 years, deflated by total assets (Compustat mnemonic AT) at the
beginning of the fiscal year;6
4
Clement and Tse’s (2003) transformation scales variables to range between 0 and 1 by developing empirical
cumulative distribution functions. We use their algorithm and multiply the scaled variables by 100 to aid the
economic interpretation of the coefficient estimates and alleviate the contamination effect of outliers.
5
We control for forecast horizon (HORIZON) in our calculation of the consensus forecast. In untabulated results
we included HORIZON, the average of the number of days between the forecast release date and the annual
earnings announcement date for the individual forecasts comprising the consensus. All inferences are unaffected.
6
We use rolling historical IB to estimate VOLATILE, requiring a minimum of three years of nonmissing data. We
recalculate VOLATILE requiring a minimum of seven, rather than three, years of nonmissing data. To reduce the
length of the time series of annual observations required, we recalculate VOLATILE using four years of quarterly
data. The magnitudes and statistical significance of all coefficient estimates are quite similar to the results
tabulated.

November 2013
ROA ¼ return on assets of the prior year, calculated as income before extraordinary items
during the previous fiscal year deflated by total assets at the beginning of the prior fiscal
year;
LOSS ¼ an indicator variable equal to 1 if the firm has negative income before extraordinary
items for the fiscal year, 0 otherwise;
INSTOWN ¼ number of common shares held by institutional investors at the beginning of the
fiscal year deflated by the number of common shares outstanding at the beginning of the
fiscal year (collected from the Thomson Reuters Mutual Fund Holdings database); and
ASSETS ¼ natural logarithm of total assets as of the beginning of the fiscal year.
To compare forecast dispersion between firm-year observations with and without equity
method investments, we estimate the following regression at the firm-year level using ordinary least
squares (subscripts suppressed):
DISP ¼ b0 þ b1 EQMETHOD þ b2 FOLLOW þ b3 VOLATILE þ b4 ROA þ b5 LOSS
þ b6 INSTOWN þ b7 ASSETS þ e; ð2Þ
where the transformed dependent variable, DISP, is the standard deviation of the most recent
analysts’ annual earnings forecasts deflated by stock price at the beginning of the fiscal year,
multiplied by 100.
In Equations (1) and (2), we expect a negative coefficient estimate between the dependent
variable (AB_ERR or DISP) and ROA, INSTOWN, and ASSETS; we expect positive coefficient
estimates for VOLATILE and LOSS. We make no predictions for FOLLOW (given Kim and
Verrecchia [1994, 1997]) or EQMETHOD. A positive (negative) coefficient estimate associated
with EQMETHOD would be consistent with the Opacity (Diversification) Effect after controlling
for other factors associated with forecast accuracy.7
The results in Table 3 show that the estimated intercepts in the regressions do not tie with the
Table 1, Panel C univariate means for AB_ERR and DISP because all regressions are estimated
using transformed variables.8 The Equation (1) and (2) estimations reveal, consistent with
expectations, positive coefficient estimates for VOLATILE ðb ^ ¼ 0:061 and 0.076, two-tailed p ,
3
0.01, with AB_ERR and DISP as the dependent variable, respectively) and LOSS ðb ^ ¼ 11:988; and
5
12.418, two-tailed p , 0.01). Also as expected, we find negative coefficient estimates for ROA
^ ¼ 0:209 and 0.248, two-tailed p , 0.01), INSTOWN ðb
ðb ^ ¼ 0:162 and 0.218, two-tailed
4 6
^
p , 0.01), and ASSETS ðb7 ¼ 0:085 and 0.093, two-tailed p , 0.01). FOLLOW is not
statistically significant in Equation (1); in Equation (2), FOLLOW is positive ðb ^ ¼ 0:164; two-
2
tailed p , 0.01), consistent with Kim and Verrecchia (1994, 1997), in which analyst following can
increase information asymmetry in the form of forecast dispersion in our setting. Turning to
7
To assess the robustness of our results, we reestimated Equations (1) and (2) after including the interaction of
EQMETHOD with other independent variables in Equations (1) and (2) in addition to the variables specified in
the text. EQMETHOD remained statistically positive at two-tailed p , 0.01 in the accuracy and dispersion
specifications. All of the interaction terms, except EQMETHOD 3 INSTOWN, were not reliably different from 0
at conventional statistical levels. We include EQMETHOD as an intercept effect in Equations (1) and (2) because
our research question compares the mean forecast accuracy and mean forecast dispersion for firm-year
observations with and without equity method investments.
8
We make directional predictions for many coefficient estimates, but conduct statistical tests with two-tailed p-
values to be conservative. We perform the following checks for Equations (1) and (2). We eliminate observations
for which the price deflator associated with the dependent variable is less than $1 or for which AB_ERR or DISP
exceeds 2. We repeat all empirical tests for the sample period 1985–2002, given the consolidation requirement
mandated by FASB ASC 810-10-25-38 for variable interest entities (VIEs) meeting the ‘‘primary beneficiary’’
definition. This consolidation requirement was effective for reporting periods ending after December 15, 2003;
before this time, VIEs were typically accounted for using the equity method. All inferences were unaffected.

November 2013
TABLE 3
The Association between Analysts’ Information Environment and Equity Method Investments
(Primary Sample Estimations)
AB ERR ¼ b0 þ b1 EQMETHOD þ b2 FOLLOW þ b3 VOLATILE þ b4 ROA þ b5 LOSS
þb6 INSTOWN þ b7 ASSETS þ e: ð1Þ
DISP ¼ b0 þ b1 EQMETHOD þ b2 FOLLOW þ b3 VOLATILE þ b4 ROA þ b5 LOSS

þb6 INSTOWN þ b7 ASSETS þ e: ð2Þ
Equation (1) Equation (2)

Variable Pred. Sign AB_ERR DISP
Intercept ? 65.363*** 58.048***
[8.63] [8.37]
EQMETHOD þ/ 3.620*** 4.995***
[4.45] [5.85]
FOLLOW þ/ 0.011 0.164***
[0.49] [6.16]
VOLATILE þ 0.061*** 0.076***
[2.61] [2.61]
ROA 0.209*** 0.248***
[14.23] [14.50]
LOSS þ 11.988*** 12.418***
[8.57] [9.03]
INSTOWN 0.162*** 0.218***
[7.79] [9.99]
ASSETS 0.085*** 0.093***
[3.40] [3.29]
Industry Effects Included Included
n 21,336 21,336
Adjusted R2 16.0% 23.2%
*** Significant at two-tailed p , 0.01.
This table reports ordinary least squares regression results for Equations (1) and (2) in the text. The dependent and
independent variables are transformed following Clement and Tse (2003) as described in the text. Coefficient estimates
are presented with t-statistics in brackets. Standard errors are adjusted for serial and cross-sectional correlation following
Petersen (2009); standard errors are clustered at the firm and year level. Industry effects are constructed based on one-
digit SIC codes. EQMETHOD, FOLLOW, and ASSETS (remaining variables) are defined in the notes to Table 2 (Table
1).
^ ¼ 3:620 and 4.995, two-tailed p

EQMETHOD, we find positive coefficients in both estimations ðb 1
, 0.01).9
9
As discussed in Section II, the Opacity Effect may increase the complexity of the forecasting task. In case task
complexity induces analysts to expend more effort on the forecasting task, we control for analyst effort,
EFFORT (Barth et al. 2001). After including EFFORT as an additional control variable in Equations (1) and (2),
EQMETHOD remains statistically positive (two-tailed p , 0.01). We also investigated whether our results are
robust to a firm’s portfolio ‘‘churn,’’ CHURN, the average change in the investment balance sheet account
(Compustat mnemonics IVAEQ þ IVAO) deflated by total assets (over the previous twelve years). CHURN is
marginally positive in Equation (1) (two-tailed p , 0.10), consistent with firms that rotate their investments more
frequently, undermining analysts’ forecast accuracy. CHURN is positive, but insignificant, in Equation (2).
EQMETHOD remains statistically positive (two-tailed p , 0.01) in Equations (1) and (2).

November 2013
As another test, we control for unobservable time-invariant firm characteristics associated with
equity method investments by comparing forecast accuracy and dispersion within the sample of
firms that have equity method investments in some, but not other, years. This test uses the firm as its
own control by comparing forecast accuracy and dispersion within firms. We reestimate Equations
(1) and (2) for the subsample of 11,525 firm-year observations, satisfying this requirement
(untabulated). EQMETHOD remains statistically positive at two-tailed p , 0.01 in the AB_ERR and
DISP estimations ðb ^ ¼ 3:188 and 4.075, respectively). These findings are consistent with forecast
1
errors and dispersion being larger for firms during the time periods in which the firm has equity
method investments. We conclude that analyst forecasts are less accurate and more dispersed for
firms with equity method investments, consistent with the Opacity Effect.
To interpret the economic significance of our Table 3 forecast accuracy results, we summarize
two analyses. First, the Equation (1) coefficient estimate of 3.620 indicates that the average forecast
error is 3.6 percent larger for firm-years with equity method investments, after controlling for
additional forecast error correlates. The variable transformation we employ facilitates across
coefficient comparisons, providing another means of assessing the economic significance of this
result. Consistent with Brown (2001), who documents that loss quarters are associated with
significantly larger quarterly forecast errors than quarters with positive earnings, we find that, of the
independent variables in Equations (1) and (2), LOSS has the largest effect on forecast accuracy
(11.988 percent). The estimated effect of EQMETHOD is approximately 30 percent (3.620 4
11.988), as large as the estimated effect of LOSS for AB_ERR.
Second, in untabulated analyses, we reestimated Equations (1) and (2) using the raw values of
the dependent and independent variables instead of transformed values. In these regressions, the
coefficient estimate for EQMETHOD is 0.197 (0.120) in the AB_ERR (DISP) regressions. The
mean value of AB_ERR (DISP) in the combined sample is 0.740 (0.525) as shown Table 1, Panel C.
Therefore, EQMETHOD accounts for 0.197 4 0.740 ¼ 26.6 percent (0.120 4 0.525 ¼ 22.9 percent)
of the mean value of AB_ERR (DISP) after considering the effects of the control variables. We
interpret this evidence as further indicating that the effect of EQMETHOD on analysts’ forecast
properties is economically meaningful.
Opacity versus Diversification

The Opacity Effect posits that analysts’ annual EPS forecasts will be less accurate (more
dispersed) as a result of the condensed equity method disclosures and the increased information
asymmetry about investee earnings. The Diversification Effect conjectures the opposite. Our
previous findings are consistent with the Opacity Effect operating more prominently in analysts’
information environment. We now investigate if the Opacity Effect might, in some cases, be
attenuated by the Diversification Effect. Intuitively, we wish to identify a setting where the benefits,
in terms of easing the forecasting task, of the Diversification Effect undo some of the unfavorable
influences of the Opacity Effect.
Specifically, we examine the benefits of earnings diversification achieved through ‘‘external’’
diversification using equity method investments in other entities. External diversification differs
from ‘‘internal’’ diversification achieved through business segments within the same entity that
operate in different industries or geographic locations.10 The Diversification Effect posits that
higher external diversification leads to smaller forecast errors and smaller forecast dispersion via the
mechanisms described in the ‘‘Diversification Effect’’ section above.
10
We make no assumptions about the relation between a firm’s internal and external diversification. We neither
know nor assume that internal and external diversification are complements, substitutes, or correlated.

November 2013
We cannot construct a direct measure of external diversification because we do not have

information about equity-method investees such as their number, size, or industry membership. We
do, however, have information about the investor firm’s internal diversification (that is, the
investor’s segment information). To use measures of internal diversification to capture the benefits
from external diversification, we assume that the benefits of diversification for analysts have
diminishing returns to scale. This assumption implies that if a firm already has many internal
segments, then the diversification benefit from the firm’s equity method investments is reduced.
Conversely, for a firm that is internally highly focused, an analyst would gain relatively more, in
terms of easing the forecasting task, if the firm were to have equity method investments. In
summary, the marginal benefits of external diversification to the analysts’ forecasting task are
inversely related to the degree of internal diversification. Less internally diversified (more focused)
firms would be associated with analysts reaping greater benefits from external diversification
through equity method investments.
Following Thomas (2002), we use two proxies to measure internal diversification. The first
proxy, NO_SEG, is the number of segments the investor firm reports; the second proxy, HERF, is
the sales revenue concentration ratio of the segments reported, calculated using the Herfindahl
index.11 We define NO_SEG and HERF such that a value of 1 indicates higher internal
diversification:
NO_SEG ¼ an indicator variable equal to 1 if the number of reported segments of the firm in
the current fiscal year is greater than the sample median, 0 otherwise; and
HERF ¼ an indicator variable equal to 1 if the Herfindahl index for the firm based on sales in
the current fiscal year is less than the sample median, 0 otherwise. We calculate the
Herfindahl index by summing the squared market shares of segment sales as a percent of
the total firm sales.
We estimate the following regressions at the firm-year level using ordinary least squares with
subscripts suppressed. Our proxy for internal diversification, NO_SEG or HERF, is substituted for
INT_DIV in Equations (3) and (4). All variables are transformed as described previously:
AB ERR ¼ b0 þ b1 EQMETHOD þ b2 INT DIV þ b3 EQMETHOD 3 INT DIV þ b4 FOLLOW

þ b5 VOLATILE þ b6 ROA þ b7 LOSS þ b8 INSTOWN þ b9 ASSETS þ e:
ð3Þ
DISP ¼ b0 þ b1 EQMETHOD þ b2 INT DIV þ b3 EQMETHOD 3 INT DIV þ b4 FOLLOW

ð4Þ
Given Thomas (2002), we expect that forecast errors and dispersion will decrease as internal
diversification increases, leading to a negative coefficient estimate on INT_DIV. We also expect that
as INT_DIV increases, the marginal benefits of external diversification through equity method
investments decrease, resulting in a more prominent role for the Opacity Effect. Thus, at higher
11
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, effective for fiscal
periods beginning after December 15, 1997, required companies to report segment information based on segment
definitions used for internal decision-making. This standard is now FASB ASC Topic 280, Segment Reporting.
To assess whether this potential change in a firm’s definition of its segments affects our results for NO_SEG, we
reestimated Equations (3) and (4) using the sample period 1998 to 2010. The magnitude and statistical
significance of all coefficient estimates are unchanged from the tabulated results.

November 2013
(lower) levels of internal diversification, the Opacity (Diversification) Effect is likely to assume a
more prominent role, leading to a positive coefficient estimate on EQMETHOD 3 INT_DIV.
Table 4, Panel A contains the estimation results. The coefficient estimates associated with
EQMETHOD, b ^ ; remain statistically positive. Consistent with the finding in Thomas (2002) that
1
analyst forecast errors are smaller for more internally diversified firms, the coefficient estimates
associated with INT_DIV, b ^ ; are statistically negative. As predicted, the coefficient estimates
2
associated with EQMETHOD 3 INT_DIV, b ^ ; are statistically positive. The magnitudes and
3
statistical significance of the remaining coefficient estimates are quite similar to Panels A and B of
Table 3.
In Table 4, Panel B, we explore the interactive relation between the Opacity and Diversification
Effects by holding constant the level of internal diversification measured by NO_SEG; the statistical
relations are stronger using HERF. NO_SEG assumes two values, LOW and HIGH. We find that
the Opacity Effect is stronger when NO_SEG is HIGH. The absolute forecast error, AB_ERR, and
forecast dispersion, DISP, are statistically larger for the EQMETHOD sample compared to the Non-
EQMETHOD sample (5.091 and 6.868 for AB_ERR and DISP). When NO_SEG is LOW, we
continue to find that AB_ERR and DISP are statistically larger for the EQMETHOD sample
compared to the Non-EQMETHOD sample (1.927 and 2.898 for AB_ERR and DISP). Turning to
the HIGH LOW comparison, the difference between AB_ERR (DISP) for the EQMETHOD
versus Non-EQMETHOD samples is greater when NO_SEG is HIGH versus when NO_SEG is
LOW (3.164 for AB_ERR; 3.970 for DISP; two-tailed p , 0.01 in both cases). This result confirms
that the Diversification Effect becomes stronger when NO_SEG is LOW. This finding is consistent
with Diversification Effect benefits, in terms of easing the forecasting task, offsetting somewhat the
Opacity Effect. Nonetheless, the Opacity Effect appears to dominate the Diversification Effect,
^ is still significantly positive, although marginally so in the
regardless of its beneficial effects, as b 1
case of AB_ERR (two-tailed p , 0.10 for AB_ERREQMETHOD AB_ERRNon-EQMETHOD; two-tailed p
, 0.05 for DISPEQMETHOD DISPNon-EQMETHOD).
We conclude the following. First, the Opacity Effect dominates the Diversification Effect in its
effects on analysts’ information environment. Second, the Opacity Effect is reduced, but not
overcome, in cases in which we expect that the Diversification Effect is more pronounced. The
latter finding is consistent with equity method investments affecting analysts’ information
environments differently depending on the level of internal, segment-based diversification.
Two-Step Estimation
The equity method is indicated under U.S. GAAP for ownership stakes between 20 and 50
percent. Firms for which the ownership percentage is less than 20 percent (greater than 50 percent)
use the cost (consolidation) approach. We acknowledge that underlying firm characteristics may
influence the investment decision. For example, it may also be that equity method firms’ business
conditions affect analysts’ forecast accuracy and dispersion. Although we attempt to control for a
firm’s business conditions in Equations (1) and (2), firm-year observations are not randomly
assigned to firms with and without equity method investments. Therefore, it remains possible that
attributes of the firm or managers’ information, unobservable to researchers, affect the choice to
undertake a 20 to 50 percent ownership stake accounted for using the equity method. To address
potential ‘‘selection on unobservables,’’ we estimate a two-stage model using the Inverse Mills ratio
(IMR), similar in spirit to Heckman (1979) (Tucker 2010; Wooldridge 2010).
Our objective is to provide further evidence that the increased analyst forecast errors and
dispersion we document are attributable to equity method investments, rather than to the nature of
the firm and its activities. In the first stage, we estimate the probit model in Equation (5) to capture
the likelihood that a firm undertakes a 20 to 50 percent investment stake for which it is required to

November 2013
TABLE 4
Opacity versus Diversification as an Explanation for the Association between Analysts’
Information Environment and Equity Method Investments
AB ERR ¼ b0 þ b1 EQMETHOD þ b2 INT DIV þ b3 EQMETHOD 3 INT DIV þ b4 FOLLOW
ð3Þ
DISP ¼ b0 þ b1 EQMETHOD þ b2 INT DIV þ b3 EQMETHOD 3 INT DIV þ b4 FOLLOW

ð4Þ
Panel A: OLS Regression Estimations

Dependent Variable ¼ AB_ERR Dependent Variable ¼ DISP
Pred. INT_DIV ¼ INT_DIV ¼ INT_DIV ¼ INT_DIV ¼
Variable Sign NO_SEG HERF NO_SEG HERF
Intercept ? 66.836*** 65.663*** 60.023*** 58.513***
[8.62] [8.90] [8.48] [8.85]
EQMETHOD þ/ 1.927* 2.638*** 2.898*** 3.509***
[1.90] [2.73] [2.95] [3.89]
INT_DIV 5.073*** 5.766*** 6.824*** 7.903***
[3.31] [3.64] [3.67] [–4.00]
EQMETHOD 3 INT_DIV þ 3.164*** 2.196** 3.970*** 3.266***
[3.05] [2.13] [3.27] [2.75]
FOLLOW þ/ 0.022 0.027 0.149*** 0.143***
[0.98] [1.23] [5.69] [5.61]
VOLATILE þ 0.069*** 0.075*** 0.087*** 0.095***
[3.26] [3.74] [3.29] [3.78]
ROA 0.209*** 0.207*** 0.248*** 0.246***
[14.29] [14.22] [14.59] [14.43]
LOSS þ 12.117*** 12.231*** 12.594*** 12.748***
[8.89] [9.09] [9.51] [9.83]
INSTOWN 0.148*** 0.143*** 0.200*** 0.193***
[7.67] [7.78] [9.80] [9.89]
ASSETS 0.060*** –0.055*** –0.058** 0.051**
[2.81] [2.71] [2.48] [2.34]
Industry Effects Included Included Included Included
n 21,336 21,336 21,336 21,336
Adjusted R2 16.4% 16.6% 24.1% 24.4%

November 2013
TABLE 4 (continued)
Panel B: Hypothesis Tests for Difference in AB_ERR and DISP (INT_DIV ¼ NO_SEG)
Level of Coeff. AB_ERREQMETHOD DISPEQMETHOD
NO_SEG Estimate AB_ERRNon-EQMETHOD DISPNon-EQMETHOD
HIGH LOW b3 3.164*** 3.970***
LOW b1 1.927* 2.898***
HIGH b1 þ b3 5.091*** 6.868***
*, **, *** Significant at two-tailed p , 0.10, p , 0.05, and p , 0.01, respectively.

Panel A reports ordinary least squares regression results for Equations (3) and (4) in the text. The dependent and
independent variables are transformed following Clement and Tse (2003) as described in the text. Coefficient estimates
are presented with t-statistics in brackets. Standard errors are adjusted for serial and cross-sectional correlation following
Petersen (2009); standard errors are clustered at the firm and year level. Industry effects are constructed based on one-
digit SIC codes. Variable definitions follow. NO_SEG ¼ an indicator variable equal to 1 if the number of segments of the
firm is greater than the sample median, 0 otherwise; and HERF ¼ an indicator variable equal to 1 if the concentration
ratio from sales is less than the sample median, 0 otherwise. We measure the concentration ratio using the Herfindahl
index, which we calculate by summing the squared market shares of segment sales as a percent of total firm sales. We
define NO_SEG and HERF such that a value of 1 indicates more diversified earnings based on internal diversification
(INT_DIV). EQMETHOD, FOLLOW, and ASSETS (remaining variables) are defined in the notes to Table 2 (Table 1).
Panel B contains hypotheses tests for the EQMETHOD 3 NO_SEG interaction term. The coefficient estimate associated
with b3, which corresponds to the case of HIGH LOW, captures the extent to which the Opacity (Diversification)
Effect is more (less) prominent when NO_SEG is HIGH versus when NO_SEG is LOW. Results for INT_DIV ¼ HERF
are statistically stronger.
apply equity method accounting:

ProbðEQMETHOD ¼ 1Þ
¼ Gðb0 þ b1 VOLATILE þ b2 LEVERAGE þ b3 INVESTMENT þ b4 LOSS
þ b5 INSTOWN þ b6 ASSETS þ b7 ROA þ b8 MTBÞ:
ð5Þ
Variables not previously defined, transformed as described earlier, are:
G ¼ cumulative probit distribution function;
LEVERAGE ¼ leverage ratio defined as total long-term debt (Compustat mnemonic DLTT)
divided by total assets (Compustat mnemonic AT) at the beginning of the fiscal year;
INVESTMENT ¼ total investment (Compustat mnemonics IVAEQ þ IVAO) divided by total
assets at the beginning of the fiscal year; and
MTB ¼ market-to-book ratio defined as market value (Compustat mnenomics CSHO 3
PRCC_F) divided by book value (Compustat mnemonic CEQ) at the beginning of the
fiscal year.
To develop Equation (5), we rely on economic intuition, prior work studying the choice of the
equity method of accounting versus the cost method of accounting for investments, and the
univariate comparisons in Table 1, Panel B.
Based on the arguments in Section II that firms with more volatile earnings may undertake
equity method investments to reduce earnings volatility, we include VOLATILE and expect a
positive association with EQMETHOD. We include LEVERAGE because prior work (Bøhren and
Haug 2006) finds that more levered firms are more likely to use the equity method, perhaps because
the single line item recognition is less likely to result in debt covenant violations. We include
INVESTMENT because we expect that firms for which more assets are dedicated to the investment
account are more likely to use the equity method (Mazay et al. 1993). Thus, we expect positive
relations between LEVERAGE and EQMETHOD and between INVESTMENT and EQMETHOD.

November 2013
We include LOSS and expect, based on the univariate comparisons in Table 1, Panel B, a negative
relation with EQMETHOD. Similarly, we include INSTOWN (ASSETS) and expect a negative
(positive) relation with EQMETHOD. We include ROA and MTB without sign predictions.12
Table 5, Panels A and B contain the selection model estimation for the primary sample (n ¼
21,336) in the first two columns. Consistent with our predictions, we find a positive relation
between EQMETHOD and VOLATILE, LEVERAGE, INVESTMENT, and ASSETS, and a negative
relation between EQMETHOD and INSTOWN. Neither LOSS nor MTB is statistically significant;
ROA is statistically positive. The Pseudo-R2 measure of the probit model is 23.0 percent; thus, the
model performs reasonably well in classifying firm-year observations.
We use the estimates from Equation (5) to calculate the Inverse Mills ratio. We reestimate
Equations (1) and (2) in Table 3 after including IMR as an additional independent variable. Results,
presented in Table 5, Panel B, are similar to Table 3. EQMETHOD is statistically positive in the
AB_ERR ðb ^ ¼ 10:849; two-tailed p , 0.01) and DISP ðb ^ ¼ 11:928; two-tailed p , 0.01)
1 1
estimations. Results for the control variables are similar to Table 3. These findings are consistent
with forecast errors and dispersion being larger for firm-years with equity method investments after
addressing potential selection in the decision to have equity method investments. We interpret these
findings as consistent with the Opacity Effect.
The two-step model presented in the first two columns of Table 5, Panels A and B is estimated
on the primary sample. Thus, the model captures firms’ investment decision with respect to whether
and how much to invest in other companies and the reporting outcome of that decision. To better
isolate the equity method reporting effect, we wish to estimate the two-stage model on the
subsamples of firms that have adopted a similar investment strategy, but whose investments could
be accounted for under U.S. GAAP using the equity method or some other method.
Ideally, we wish to compare two sets of subsamples: (1) firm-years for which the ownership
percentage is close to 50 percent for firms that use the equity method versus firm-years for which
the ownership percentage is close to 50 percent that consolidate, which we call the ‘‘Ownership near
50 percent’’ subsample; and (2) firm-years for which the ownership percentage is close to 20
percent that use the equity method versus firm-years for which the ownership percentage is close to
20 percent that use the cost method, which we call the ‘‘Ownership near 20 percent’’ subsample.
Constructing these subsamples is challenging. First, firms often simultaneously own equity
method and cost method investments as well as consolidated subsidiaries, thus using two or more
accounting methods. We eliminate firm-year observations for which multiple accounting methods
are used, leaving firm-year observations using only the cost method or equity method or
consolidation.13 Second, firms with ownership stakes below 20 percent use the cost method and
disclose the dollar amount of the investment; a small number of firms disclose the ownership
percentage voluntarily. This concern is less important empirically because we have few firms for
which the ownership percentage in all investees is close to 20 percent. Only 50 firm-year
12
Bøhren and Haug (2006) study firms listed on the Oslo Stock Exchange, where firms may choose either the cost
or equity method for 20 percent to 50 percent equity holdings in other firms. Mazay et al. (1993) examine
Australian companies’ compliance with new regulations prohibiting the use of the equity method in favor of the
cost method and find that compliance is related to the materiality of investments in associates. Given institutional
differences between these studies and the U.S., it is unclear how applicable this research is to our setting. We use
these studies as a starting point because our model specification is somewhat exploratory.
13
We identify equity method firms if equity in investee earnings (Compustat mnemonic ESUB) or investment and
advances—equity (Compustat mnemonic IVAEQ) is non-zero. We identify cost method firms if investment and
advances—other (Compustat mnemonic IVAO) is non-zero. We identify consolidation method firms if minority
interest (Compustat mnemonics MII or MIB) is non-zero. We use minority interest assuming investors do not
own 100 percent of an investee. This assumption is not critical to our analysis because we focus on firms using
the consolidation method and with ownership in all investees near 50 percent.

November 2013
TABLE 5
The Association between Analysts’ Information Environment and Equity Method
Accounting: Controlling for the Choice to Have Equity Method Investments
Panel A: Two-Stage Estimations (Selection Model)
Primary Sample Ownership Near 50 Percent
Pred. Equation (5) Equation (5) Equation (5) Equation (5)
Variable Sign AB_ERR DISP AB_ERR DISP
VOLATILE þ 0.004*** 0.004*** 0.007** 0.007**
[10.91] [10.91] [2.18] [2.18]
LEVERAGE þ 0.008*** 0.008*** 0.018*** 0.018***
[20.62] [20.62] [5.11] [5.11]
INVESTMENT þ 0.027*** 0.027*** 0.072*** 0.072***
[46.26] [46.26] [10.26] [10.26]
LOSS 0.030 0.030 0.057 0.057
[1.00] [1.00] [0.22] [0.22]
INSTOWN 0.005*** 0.005*** 0.000 0.000
[13.30] [13.30] [0.09] [0.09]
ASSETS þ 0.016*** 0.016*** 0.000 0.000
[38.73] [38.73] [0.04] [0.04]
ROA ? 0.001*** 0.001*** 0.002 0.002
[2.92] [2.92] [0.52] [0.52]
MTB ? 0.001 0.001 0.003 0.003
[1.47] [1.47] [0.77] [0.77]
Pseudo-R2 23.0% 23.0% 37.4% 37.4%
Panel B: Two-Stage Estimations (Main Model)

Primary Sample Ownership Near 50 Percent
Pred. Equation (1) Equation (2) Equation (1) Equation (2)
Variable Sign AB_ERR DISP AB_ERR DISP
EQMETHOD þ 10.849*** 11.928*** 11.314** 13.082***
[8.98] [10.33] [2.52] [3.10]
FOLLOW þ/ 0.011 0.164*** 0.028 0.147***
[1.31] [20.95] [0.49] [2.81]
VOLATILE þ 0.053*** 0.068*** 0.096* 0.002
[7.06] [9.50] [1.85] [0.04]
ROA 0.207*** 0.246*** 0.260*** 0.293***
[29.13] [36.29] [5.26] [6.30]
LOSS þ 11.982*** 12.412*** 16.339*** 22.628***
[21.99] [23.85] [4.42] [6.51]
INSTOWN 0.146*** 0.204*** 0.190*** 0.129***
[20.55] [29.92] [4.07] [2.94]
ASSETS 0.135*** 0.140*** 0.042 0.024
[11.67] [12.73] [0.71] [0.42]
IMR ? 4.850*** 4.651*** 2.850 5.494*
[6.41] [6.43] [0.89] [1.83]
Industry Effects Included Included Included Included
n 21,336 21,336 426 426

November 2013
TABLE 5 (continued)
Panel C: Ownership Near 50 Percent Subsample Descriptive Statistics (n ¼ 426)

AB_ERR EQMETHOD 0.544 1.075 0.072 0.190 0.554
Non-EQMETHOD 0.402 1.172 0.039 0.116 0.339
p-value 0.25 0.07
DISP EQMETHOD 0.440 0.774 0.087 0.194 0.450
Non-EQMETHOD 0.342 0.855 0.039 0.104 0.269
p-value 0.27 0.01
FOLLOW EQMETHOD 7.705 5.363 4.000 6.000 10.000
Non-EQMETHOD 7.087 5.242 4.000 5.000 8.000
p-value 0.30 0.15
VOLATILE EQMETHOD 0.072 0.093 0.021 0.041 0.086
Non-EQMETHOD 0.095 0.141 0.021 0.038 0.113
p-value 0.06 0.65
ROA EQMETHOD 0.044 0.104 0.025 0.057 0.092
Non-EQMETHOD 0.058 0.097 0.021 0.068 0.105
p-value 0.24 0.65
LOSS EQMETHOD 0.155 0.363 0.000 0.000 0.000
Non-EQMETHOD 0.154 0.363 0.000 0.000 0.000
p-value 0.97 0.97
INSTOWN EQMETHOD 0.610 0.236 0.459 0.626 0.783
Non-EQMETHOD 0.651 0.268 0.523 0.658 0.810
p-value 0.47 0.18
ASSETS (millions $) EQMETHOD 5,335 11,525 586 1,791 4,514
Non-EQMETHOD 3,661 9,419 466 1,014 3,392
p-value 0.18 0.01
*, **, *** Significant at two-tailed p , 0.10, p , 0.05, and p , 0.01, respectively.
Panels A and B report two-stage estimation results using the Inverse Mills ratio (Greene 2003). We estimate Equation
(5) as a probit model, calculate the Inverse Mills ratio (IMR), and include IMR as an additional independent variable
in Equations (1) and (2). We tabulate the Pseudo-R2 measure (Greene 2003) associated with the estimation of
Equation (5). The dependent and independent variables are transformed following Clement and Tse (2003) as
described in the text. Coefficient estimates are presented with t-statistics in brackets. We estimate the consistent
asymptotic variance covariance matrix of the coefficient estimates using the delta method (see Greene 2003, 674).
Industry effects are constructed based on one-digit SIC codes. Variable definitions follow (Compustat mnemonics in
parentheses). LEVERAGE ¼ leverage ratio defined as total long-term debt (DLTT) divided by total assets (AT) at the
beginning of the fiscal year; INVESTMENT ¼ total investment (IVAEQ þ IVAO) divided by total assets at the
beginning of the fiscal year; and MTB ¼ market-to-book ratio defined as market value (CSHO 3 PRCC_F) divided by
book value (CEQ) at the beginning of the fiscal year. EQMETHOD, FOLLOW, and ASSETS (remaining variables) are
defined in the notes to Table 2 (Table 1).
Panel C presents descriptive statistics for the EQMETHOD (n ¼ 322) and Non-EQMETHOD (n ¼ 104) subsamples,
which we call the ‘‘Ownership near 50 percent’’ subsample, the selection criteria for which are described in the text.
See Table 1, Panel B for equivalent descriptive data for the primary sample. All mean and median comparisons are
conducted testing the equality of the means (medians) using the t-test (Wilcoxon rank sum test).
observations have ownership percentages in all investees in the range of 20 percent to 21 percent.
We eliminate the ‘‘Ownership near 20 percent’’ comparison because of the small sample.
For the remaining firm-year observations using only the equity method or only consolidation,
we require that the firm have ownership near 50 percent for all its investees in that year. We use two
approaches to collect investor ownership interests in their investees. We collect all investee
acquisition and divestiture information from the Thomson ONE Mergers and Acquisitions database.

November 2013
We assume that the investee ownership stake remains the same until an acquisition or divestiture
indicates a change in the investor’s ownership of a given investee. We cross-reference and
supplement this sample with hand-collected data from the Form 10-K on investee ownership
percentages for each firm’s investments for each year it appears in the sample.
Using this information, we identify two subsamples of firms, those for which: (1) only the
equity method is used and all investee ownership percentages are 49 percent to 50 percent; and (2)
only the consolidation method is used and all investee ownership percentages are 49 percent to 51
percent.14 These requirements yield the ‘‘Ownership near 50 percent’’ subsample of 426 firm-year
observations (322 [104] firm-years using the equity method [consolidation]). Given the small
sample, this analysis is supplementary, supporting the more generalizable primary sample
estimations. This test, however, allows examination of a subsample of firms where the equity
method reporting effect is better isolated by holding constant the investment decision. By
construction, in the ‘‘Ownership near 50 percent’’ subsample, the investor firms own a substantial
portion of their investees. This ownership, however, need not imply that the investment is a
substantial portion of the investor’s total assets. The mean (median) percentages of equity income
as a percentage of total firm earnings before extraordinary items in the ‘‘Ownership near 50 percent’’
subsample is 21.2 percent (7.0 percent), somewhat comparable to the descriptive statistics of 17.4
percent (6.0 percent) presented in Table 1, Panel A for the primary sample.
Table 5, Panel C, similar to Table 1, Panel B, presents EQMETHOD versus Non-EQMETHOD
comparisons for the ‘‘Ownership near 50 percent’’ subsample. The median values of AB_ERR and
DISP are statistically different, although the means are not. Furthermore, the mean and median
values of the control variables are not significantly different, suggesting that firm differences are
reduced in the subsample, potentially due to holding the ownership stake constant.
We reestimate Equation (5) on the ‘‘Ownership near 50 percent’’ subsample, recalculate the
Inverse Mills ratio, and reestimate Equations (1) and (2) after including IMR as an additional
independent variable.15 Results for EQMETHOD, presented in the final two columns of Table 5,
Panel B are unchanged relative to the primary sample estimation. EQMETHOD remains statistically
positive in the forecast error ðb^ ¼ 11:314; two-tailed p , 0.05) and forecast dispersion ðb ^ ¼
1 1
13:082; two-tailed p , 0.01) estimations. Estimation results for the control variables are similar to
the primary sample results, although fewer coefficient estimates are statistically significant, as
expected given the small sample. Despite the smaller sample, however, our primary findings for
EQMETHOD are unchanged. We continue to conclude, consistent with the Opacity Effect, that
forecast errors and dispersion are larger for firms using the equity method of accounting after
abstracting from the potential confounding effect of the firm’s investment strategy.
The Magnitude of Equity Method Earnings and Analysts’ Forecast Properties

Equations (1) and (2) do not incorporate the magnitude of equity method earnings. Ex ante, our
research question was predicated on investigating differences between groups of firm-year
observations with and without equity method investments. In the extreme, if there were no
differences between these groups, then an investigation of how the magnitude of equity method
earnings might be associated with analysts’ information environment would be less compelling. Ex
post, given the Table 3 findings, we probe whether the magnitude of the equity method investment,
14
This requirement is the most restrictive. Comparing firm-year observations for which only the equity method is
used and all investee ownership percentages are 45 percent to 50 percent with the subsample of firms for which
only consolidation is used and all investee ownership percentages are 45 percent to 55 percent does not change
the results.
15
Estimating Equations (5) and (1) and Equations (5) and (2) using full information maximum likelihood (FIML)
does not change our conclusions for the primary sample or the ‘‘Ownership near 50 percent’’ subsample.

November 2013
measured by the portion of equity earnings, is uniform in its effect on analysts’ information
environments. We create three indicator variables corresponding to the bottom, middle, and top
thirds of non-zero equity earnings (using quartile indicators does not change the results). Firm-year
observations with no equity method earnings are assigned to the intercept.
EQGROUP1 ¼ an indicator variable equal to 1 if the magnitude of equity method earnings is in
the bottom third of the distribution of all non-zero and non-missing firm-year equity
method earnings, 0 otherwise. The magnitude of equity method earnings is defined as the
absolute value of equity in earnings of unconsolidated subsidiaries per share (Compustat
mnemonic ESUB in year t divided by common shares used to calculate earnings per share
in fiscal year t [Compustat mnemonic CSHPRI]) scaled by share price at the beginning of
fiscal year t (Compustat mnemonic PRCC_F);
EQGROUP2 ¼ an indicator variable equal to 1 if the magnitude of equity method earnings
(calculated as above) is in the middle third of the distribution of all non-zero and non-
missing firm-year equity method earnings, 0 otherwise; and
EQGROUP3 ¼ an indicator variable equal to 1 if the magnitude of equity method earnings
(calculated as above) is in the top third of the distribution of all non-zero and non-missing
firm-year equity method earnings, 0 otherwise.
These indicator variables capture the magnitude of equity method earnings per share as a
percentage of share price. We use price as the deflator to maintain consistency with the deflator used
for AB_ERR and DISP. Hence, EQGROUP1 through EQGROUP3 do not measure the magnitude
of equity method earnings relative to investor earnings. We use indicator variables because they
preserve the EQMETHOD versus Non-EQMETHOD group distinction (with groups redefined to
capture the magnitude of equity method earnings in certain distributional categories). The mean
(median) values for EQGROUP1, EQGROUP2, and EQGROUP3 are 0.068 percent (0.059
percent), 0.385 percent (0.362 percent), and 2.309 percent (1.516 percent), respectively.
We modify Equations (1) and (2) and separately estimate them using ordinary least squares. All
variables are transformed as described earlier:
AB ERR ¼ b0 þ b1 EQGROUP1 þ b2 EQGROUP2 þ b3 EQGROUP3 þ b4 FOLLOW
þ b5 VOLATILE þ b6 ROA þ b7 LOSS þ b8 INSTOWN þ b9 ASSETS þ e: ð1aÞ
DISP ¼ b0 þ b1 EQGROUP1 þ b2 EQGROUP2 þ b3 EQGROUP3 þ b4 FOLLOW

Table 6, Panel A contains the estimations. We discuss the results for the EQGROUP coefficient
estimates, as the signs and statistical significance of the other variables presented in Table 6, Panel
A are unchanged from Table 3. b ^
^ is not statistically different from zero in Equation (1a) or (2a). b
1 1
estimates the difference between firm-year observations with no equity method earnings and equity
method earnings in the bottom third of the distribution. Hence, we detect no effects on analysts’
information environment for firm-year observations for which equity method earnings are relatively
smaller. We conclude that the Opacity Effect influences analysts’ forecast properties when equity
method earnings surpass some minimal threshold.
The coefficient estimates associated with EQGROUP2 and EQGROUP3 are statistically
^ ¼ 2:557; two-tailed p , 0.01; b
positive in the forecast error ðb ^ ¼ 8:522; two-tailed p , 0.01)
2 3
and forecast dispersion ðb ^ ¼ 4:147; two-tailed p , 0.01; b ^ ¼ 9:865; two-tailed p , 0.01)
2 3
estimations. We report the t-statistics testing H0: b1 ¼ b2 and H0: b2 ¼ b3 in Table 6, Panel B; both
null hypotheses are rejected at two-tailed p , 0.01. Thus, the magnitudes of the coefficient
estimates associated with EQGROUP1, EQGROUP2, and EQGROUP3 are monotonically

November 2013
TABLE 6
The Association between Analysts’ Information Environment and Tercile Groups of Equity
Method Earnings
AB ERR ¼ b0 þ b1 EQGROUP1 þ b2 EQGROUP2 þ b3 EQGROUP3 þ b4 FOLLOW
DISP ¼ b0 þ b1 EQGROUP1 þ b2 EQGROUP2 þ b3 EQGROUP3 þ b4 FOLLOW

Panel A: Ordinary Least Squares Regressions

Pred. Equation (1a) Equation (2a)
Variable Sign AB_ERR DISP
Intercept ? 65.417*** 58.094***
[8.95] [8.53]
EQGROUP1 ? 0.540 0.616
[0.71] [0.79]
EQGROUP2 þ 2.557*** 4.147***
[2.58] [4.55]
EQGROUP3 þ 8.522*** 9.865***
[7.54] [8.33]
FOLLOW þ/ 0.012 0.163***
[0.55] [6.26]
VOLATILE þ 0.063*** 0.078***
[2.72] [2.70]
ROA 0.203*** 0.242***
[14.07] [14.31]
LOSS þ 11.862*** 12.297***
[8.44] [8.92]
INSTOWN 0.159*** 0.216***
[7.71] [10.00]
ASSETS 0.085*** 0.092***
[3.46] [3.33]
Industry Effects Included Included
n 21,336 21,336
Adjusted R2 16.5% 23.7%
Panel B: Hypotheses Tests

Equation (1a) Equation (2a)
Null Hypothesis Difference Difference
H0: b2 b1 ¼ 0 3.097*** 3.531***
[3.55] [3.93]
H0: b3 b2 ¼ 0 5.965*** 5.718***
[5.43] [5.83]

November 2013
TABLE 6 (continued)
*** Significant at two-tailed p , 0.01.

Panel A reports ordinary least squares regression results for Equations (1a) and (2a) estimated for the primary sample (n
¼ 21,336). The dependent and independent variables are transformed following Clement and Tse (2003) as described in
the text. Coefficient estimates are presented with t-statistics in brackets. Standard errors are adjusted for serial and cross-
sectional correlation following Petersen (2009); standard errors are clustered at the firm and year level. Industry effects
are constructed based on one-digit SIC codes. Variable definitions follow (Compustat mnemonics in parentheses).
EQGROUP1 ¼ an indicator variable equal to 1 if the magnitude of equity method earnings is in the bottom third of the
distribution of all non-zero and non-missing firm-year equity method earnings, 0 otherwise. The magnitude of equity
method earnings is defined as the absolute value of equity in earnings of unconsolidated subsidiaries (ESUB) in year t
divided by market value of equity [common shares outstanding at the beginning of fiscal year t (CSHO) multiplied by
share price at the beginning of fiscal year t (PRCC_F)]; EQGROUP2 ¼ an indicator variable equal to 1 if the magnitude
of equity method earnings is in the middle third of the distribution of all non-zero and non-missing firm-year equity
method earnings, 0 otherwise; and EQGROUP3 ¼ indicator variable equal to 1 if the magnitude of equity method
earnings is in the top third of the distribution of all non-zero and non-missing firm-year equity method earnings, 0
otherwise. FOLLOW and ASSETS (remaining variables) are defined in the notes to Table 2 (Table 1).
Panel B presents hypotheses tests examining the equality of the coefficient estimates for Equations (1a) and (2a).
increasing. This result indicates that as the magnitude of equity method investment earnings
increases, analysts’ information environment is more affected. We conclude that for groups of firms
with a larger portion of equity method earnings, the effects on analysts’ information environment,
as reflected in decreased forecast accuracy and increased forecast dispersion, are greater.16
V. CONCLUSION
We study the joint effects of intercompany investing and reporting of equity method
investments on the accuracy and dispersion of analysts’ annual earnings-per-share forecasts. We
compare firm-year observations with and without equity method investments. We posit two
non-mutually exclusive hypotheses regarding the effects of the equity method of accounting for
investments on analyst forecast properties. The Opacity Effect conjectures that the reduced
disclosures inherent in the equity method will be positively associated with analysts’ absolute
forecast errors and dispersion. The Diversification Effect argues that the diversification of the
investor and its investee earnings streams enhances earnings predictability, and equity method
investments will be negatively associated with analysts’ absolute forecast errors and dispersion. Our
results are consistent with both explanations applying, but the Opacity Effect dominating, yielding
less accurate and more dispersed annual earnings forecasts. We also find that as the magnitude of
equity method earnings increases, the Opacity Effect becomes more pronounced. Last, our
two-stage estimations suggest that our results are not an artifact of selection.
Our tests do not identify which aspect(s) of equity method reporting may affect the forecasting
task. We provide evidence, using the ‘‘Ownership near 50 percent’’ subsample, that the
non-consolidation of equity method investments may undermine analysts’ abilities to forecast
investor earnings. We cannot, however, eliminate alternative equity method reporting consider-
ations for the Opacity Effect. The recognition of net equity income without disclosure of its
components in the footnotes, incomplete segment data for equity method investees, and lack of
16
An alternative specification is to calculate the indicator variables as equity method earnings deflated by
combined earnings. The results are unchanged; the coefficient estimates for these three indicator variables are
statistically positive and monotonically increasing in Equations (1a) and (2a). We also consider a continuous
measure, EQMAG, calculated as equity method earnings per share deflated by share price per share. Replacing
the EQGROUP variables with EQMAG in Equations (1a) and (2a) does not change the results. The coefficient
estimates for EQMAG are statistically positive in Equations (1a) and (2a).

November 2013
information about the equity investments’ fair values may contribute to the Opacity Effect. These
questions might be addressed in future research.
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APPENDIX A
Survey of Analyst Reports
Business press articles suggest that analysts attend to information about equity method
investments when present, recognizing the usefulness of separately forecasting equity earnings in
developing their forecasts of a firm’s overall earnings. For example, regarding General Motor’s
anticipated initial public offering at $33 per share, Denning (2010) wrote, ‘‘CRT [Capital Group]
estimates GM’s share of 2011 net income from [unconsolidated subsidiaries accounted for using the
equity method of accounting] at $1.7 billion . . . or more than $10 a share.’’ We provide evidence on
the importance of equity method earnings relative to total firm earnings in Table 1, Panel A for the
sample and all firm-year observations on Compustat with available data.
To provide more systematic evidence that analysts separately attend to equity investee
earnings performance, we randomly chose fiscal year 1999 from our sample period. Fiscal year
1999 contains 151 firms that are in the sample and have December year-ends. For these firms, we
require that the annual earnings announcement date be available on I/B/E/S (reducing the sample
to 128 firms). For these 128 firms we define a report window beginning 60 calendar days and
ending one calendar day before the annual earnings announcement date. We focus on a time
period preceding, rather than following, the annual earnings announcement date because Chen et
al. (2010) conclude that analysts primarily engage in information discovery (identifying and
processing new information) before an earnings announcement. Chen et al. (2010) describe the
period after an earnings announcement as characterized by analysts engaging in information
interpretation—a recapitulation of news contained in the earnings release. Thus, the use of a pre-
earnings-announcement window should increase the likelihood that, if analysts are attending to
equity investee earnings information, then they are doing so of their own volition, rather than
responding to information that may have been contained in an earnings announcement about
those investees.
For each of these 128 firms, we search Thomson ONE (formerly Investext) for all analyst
research reports during the 60-calendar-day pre-earnings-announcement window specific to each
firm. When more than one report for a given firm is issued during this window, we randomly
choose one report. We identified an analyst report for 91 firms (71 percent) and read each report.
Our primary interest is whether a report contains an explicit forecast for equity investee earnings
(typically, an earnings-per-share forecast). For 32 of the 91 reports in our sample (35 percent), the
analyst provided an explicit forecast for equity investee earnings. An additional nine reports do not
contain an explicit EPS forecast for equity method investments, but contain either qualitative or
quantitative discussion of the firm’s equity method investments. Thus, for 41 (32 þ 9) of the 91
reports (45 percent), we find evidence that analysts specifically attend to equity method
investments, although they may not always provide (in their report) a separate forecast for equity
method EPS. Thus, we conclude: in almost half the cases we examine, analysts attend to equity
method investments and that attention merits explicit mention in their published research reports
and, frequently, a separate forecast for equity method investment earnings. Examples of
representative analyst disclosures regarding equity method investments in the reports we examined
follow.

November 2013
Broker
Company (Date of Report)
(AEA Date) [Recommendation] Excerpts of Report Content
Equity method earnings forecasts provided

Cox Communications Barrington Research ‘‘However, net earnings on an absolute and a
(February 9, 2000) (January 20, 2000) per share basis will follow no discernible
[Buy] pattern, due primarily to significant equity
losses in affiliated companies.’’ Report
provides forecasts for ‘‘Equity in
Affiliates’’ for fiscal years 2000, 2001, and
2002.
Honeywell International, Deutsche Banc Alex Provides actual results by quarter for fiscal
Inc. (January 20, 2000) Brown (January 4, year 1998 and first three quarters of 1999
2000) [Buy] for ‘‘Equity in Affiliated Cos.’’ Provides
fourth-quarter forecast for equity method
investments in 1999; provides quarterly
forecasts for equity method investments for
each quarter of fiscal year 2000; provides
annual forecast for equity method
investment earnings for fiscal year 2001.
No equity method earnings forecast; other equity method discussion provided
Harrah’s Entertainment Robertson Stephens ‘‘Harrah’s also holds an equity interest in the
(February 9, 2000) (January 19, 2000) Harrah’s Jazz project in New Orleans,
[Buy] which opened in October 1999.’’
Rohm and Haas (January Warburg Dillon Read ‘‘[Shipley microelectronics] has pro forma
25, 2000) (December 9, 1999) annual revenues of $390 million.
[Hold] Approximately 40 percent of this unit’s
sales come from Rohm and Haas’s 48
percent equity interest in Rodel and thus
are not consolidated.’’
The above representative reports were randomly chosen from the 41 reports identified in the
sampling methodology described on the previous page. The date in parentheses below the company
name is the annual earnings announcement date from I/B/E/S. The date in parentheses below the
broker name is the published date contained in the analyst’s report; beneath this date, in square
brackets, is the summary stock recommendation contained in the report. The ‘‘Excerpts of Report
Content’’ column contains a summary of the information contained in the analyst’s report that is
pertinent to investments accounted for using the equity method of accounting.

November 2013
Copyright of Accounting Review is the property of American Accounting Association and its
content may not be copied or emailed to multiple sites or posted to a listserv without the
copyright holder's express written permission. However, users may print, download, or email
articles for individual use.

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THE ACCOUNTING REVIEW American Accounting Association

Vol. 88, No. 6 DOI: 10.2308/accr-50539

Equity Method Investments and Sell-Side

ABSTRACT: We study the joint effects of intercompany investing and reporting of

The Accounting Review

The Accounting Review

II. PRIOR RESEARCH AND HYPOTHESES DEVELOPMENT

The Accounting Review

The Accounting Review

The Accounting Review

Panel B: Primary Sample Descriptive Statistics (n ¼ 21,336)

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Panel C: Economic Significance: Mean AB_ERR and DISP (Price-Deflated)

Panel D: Economic Significance: Median AB_ERR and DISP (Price-Deflated)

The Accounting Review

The Accounting Review

IV. EMPIRICAL RESULTS

Equity Method Investments and Analyst Forecast Properties

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The Accounting Review

DISP ¼ b0 þ b1 EQMETHOD þ b2 FOLLOW þ b3 VOLATILE þ b4 ROA þ b5 LOSS

Equation (1) Equation (2)

^ ¼ 3:620 and 4.995, two-tailed p

The Accounting Review

Opacity versus Diversification

The Accounting Review

We cannot construct a direct measure of external diversification because we do not have

AB ERR ¼ b0 þ b1 EQMETHOD þ b2 INT DIV þ b3 EQMETHOD 3 INT DIV þ b4 FOLLOW

DISP ¼ b0 þ b1 EQMETHOD þ b2 INT DIV þ b3 EQMETHOD 3 INT DIV þ b4 FOLLOW

The Accounting Review

The Accounting Review

DISP ¼ b0 þ b1 EQMETHOD þ b2 INT DIV þ b3 EQMETHOD 3 INT DIV þ b4 FOLLOW

Panel A: OLS Regression Estimations

(continued on next page)

The Accounting Review

*, **, *** Significant at two-tailed p , 0.10, p , 0.05, and p , 0.01, respectively.

apply equity method accounting:

The Accounting Review

The Accounting Review

Panel B: Two-Stage Estimations (Main Model)

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Panel C: Ownership Near 50 Percent Subsample Descriptive Statistics (n ¼ 426)

The Accounting Review

The Magnitude of Equity Method Earnings and Analysts’ Forecast Properties

The Accounting Review

DISP ¼ b0 þ b1 EQGROUP1 þ b2 EQGROUP2 þ b3 EQGROUP3 þ b4 FOLLOW

The Accounting Review

DISP ¼ b0 þ b1 EQGROUP1 þ b2 EQGROUP2 þ b3 EQGROUP3 þ b4 FOLLOW

Panel A: Ordinary Least Squares Regressions

Panel B: Hypotheses Tests

The Accounting Review

*** Significant at two-tailed p , 0.01.

The Accounting Review

The Accounting Review

The Accounting Review

Equity method earnings forecasts provided

The Accounting Review

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, , Significant at two-tailed p , 0.10, p , 0.05, and p , 0.01, respectively.