Analyst Coverage and Earnings Management: Article in Press

ARTICLE IN PRESS
Journal of Financial Economics 88 (2008) 245–271

www.elsevier.com/locate/jfec
Analyst coverage and earnings management$

Fang (Frank) Yu
Barclays Global Investors, San Francisco, CA 94105, USA
Received 2 March 2006; received in revised form 2 January 2007; accepted 17 May 2007
Available online 4 March 2008
Abstract
What is the role of information intermediaries in corporate governance? This paper examines equity analysts’ influence
on managers’ earnings management decisions. Do analysts serve as external monitors to managers, or do they put
excessive pressure on managers? Using multiple measures of earnings management, I find that firms followed by more
analysts manage their earnings less. To address the potential endogeneity problem of analyst coverage, I use two
instrumental variables based on change in broker size and on firm’s inclusion in the Standard & Poor’s 500 index, and I
find that the results are robust. Finally, given the number of covering analysts, analysts from top brokers and more
experienced analysts have stronger effects against earnings management.
r 2008 Elsevier B.V. All rights reserved.
JEL classifications: G34; M41; G24
Keywords: Earnings management; Financial analyst; Corporate governance; Analyst coverage
1. Introduction
Existing research on equity analysts focuses on analysts’ role in investment and studies how analysts affect
investors’ decisions and stock price. However, only limited research has been done on analysts’ role in
corporate governance. How does the presence of analysts affect managers’ behavior? Do analysts serve as
external monitors to managers, or do they put excessive pressure on managers? This paper attempts to study
$
I would like to thank my advisors, Marianne Bertrand, Abbie Smith, Richard Thaler, and Luigi Zingales, for their guidance and
support. I also thank John Boyd, Henrik Cronqvist, Douglas Diamond, Eugene Fama, Raife Giovinazzo, Zhaoyang Gu, Steven Levitt,
Felix Meschke, Lan Shi, Bill Schwert (the editor), Tracy Wang, Peter Wysocki, Xiaoyun Yu, an anonymous referee, and the participants
of research seminars at the Arizona State University, Barclays Global Investors, Carnegie Mellon University, Federal Reserve Bank of
Boston, Georgia State University, Harvard Business School, Hong Kong Science and Technology University, Indiana University, Purdue
University, Western Finance Association, University of Chicago, University of California, Irvine, University of Notre Dame, University
of Minnesota, University of Oregon, and University of Toronto, for valuable comments and suggestions. I gratefully acknowledge the
contribution of Thomson Financial in providing analyst forecast data through I/B/E/S. This data is provided as part of a broad academic
program to encourage earnings expectations research. Research support from the Oscar Mayer Foundation is gratefully acknowledged.
All errors are my own.
Corresponding author.
E-mail address: frank.yu@barclaysglobal.com
0304-405X/$ - see front matter r 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jfineco.2007.05.008
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246 F. Yu / Journal of Financial Economics 88 (2008) 245–271
these questions in the context of financial reporting. Specifically, the paper examines whether analyst coverage
affects firms’ earnings management behavior.
Previous research has already shown that analysts have significant influence on investor behavior. Managers
perceive analysts as one of the most important groups affecting the share price of their corporations (Graham,
Harvey, and Rajgopal, 2005). But it is unclear what effect analyst coverage exerts on earnings management.
On the one hand, analysts can be deemed to be external monitors of managers (Jensen and Meckling, 1976;
Healy and Palepu, 2001). With training in finance and substantial industry background knowledge, analysts
track corporate financial statements on a regular basis. They usually interact directly with management and
raise questions on different aspects of earnings numbers through earnings release conferences. They have been
directly involved in the discovery of corporate fraud in companies such as Compaq Computer, CVS,
Electronic Data System, Gateway, Global Crossing, Motorola, PeopleSoft, and Qwest Communication
International (Dyck, Morse, and Zingales, 2006).1
On the other hand, analyst coverage is often held responsible for creating excessive pressure on managers to
manage earnings. In capital markets, increased coverage is usually accompanied by increased pressure on
managers to perform. Firms that miss analyst forecasts usually suffer significant declines in their stock price.
In practice, one of the primary earnings targets that managers try to achieve is to meet analysts’ forecast
consensus (e.g., Degeorge, Patel, and Zeckauser, 1999). Furthermore, analysts themselves are under pressure
from a variety of sources, which could distort their incentives and affect their role in governance. These
pressures include the need to pursue investment banking business, the need to maintain good relationships
with management for access to private information, and the need to avoid downgrades in stocks in which
major clients have significant holdings (for example, Dechow, Hutton, and Sloan, 2000; Lin and McNichols,
1998; Michaely and Womack, 1999). Among those pressures, the incentive for analysts to seek favor with
management could be potentially reduced after the Regulation Fair Disclosure Act of 2000, which prohibits
firms from making selective, nonpublic disclosures to favored investment professionals (for example, Bailey,
Lin, and Zhong, 2003; Bushee, Matsumoto, and Miller, 2004; Agrawal, Chadha, and Chen, 2006).
Using discretionary accruals as the main proxy for earnings management, I examine the relation between
analyst coverage and earnings management with a sample of publicly listed firms from 1988 to 2002.
Controlling for other firm characteristics, including institutional ownership, I find that firms with high analyst
coverage have a lower level of discretionary accruals than firms with low coverage. I also find that firms with
coverage have a lower level of discretionary accruals than firms with no coverage.
A major concern with these results is the potential endogeneity of analyst coverage. The existing literature
has shown that analysts tend to cover firms with a better information environment (e.g., Lang and Lundholm,
1996; Francis, Hanna, and Philbrick, 1998; Bhushan, 1989; Bushman, Piotroski, and Smith, 2005). In this
case, analysts could choose to cover firms with less earnings management, which could drive the effect found
here. To address this concern, I adopt two instrumental variables to capture exogenous variations in analyst
coverage: (1) change of brokerage house size and (2) firm’s inclusion in the Standard & Poor’s 500 index.
These instrumental variables affect analyst coverage but are less susceptible to the selection problem. The
estimates from instrumental variable regressions also suggest that firms with more analysts do less earnings
management.
For robustness, I use the discontinuity of earnings distribution around earnings targets as an alternative
measurement of earnings management. I test whether the presence of more covering analysts make firms less
likely to narrowly meet earnings targets or whether more analysts pressure managers to narrowly meet
earnings target more frequently. I find that the distribution of earnings of firms with lower coverage exhibits a
much stronger discontinuity around earnings targets than that of firms with high coverage, which also suggests
that firms with more analysts do less earnings management.
I further explore whether the characteristics of analysts affect earnings management. I find that, given the
number of covering analysts, better analysts who make more accurate earnings forecasts, such as those
affiliated with top brokerage houses and those with more experience, have stronger effects against earnings
management than other analysts. Analysts who are more effective in processing information also seem to be
more effective in monitoring.
1
Dyck, Morse, and Zingales (2006) provide a comprehensive summary of cases with details of analysts’ involvement in fraud discovery.
ARTICLE IN PRESS
F. Yu / Journal of Financial Economics 88 (2008) 245–271 247
This paper contributes to the literature by examining financial analysts’ influence on firms in the
information distribution process from corporations to investors. It helps to provide an understanding of how
information intermediaries affect the production of information. Financial analysts reduce the information
asymmetry between corporations and investors not only through their ability to summarize and distribute
information to investors but also through their presence to affect information quality. More generally, this
study sheds light on the potential role of information intermediaries in corporate governance. Information
intermediary agents, such as financial analysts, create an external layer of scrutiny for the financial reporting
process. Their role as external monitors can be potentially significant in areas such as earnings management,
when internal controls might not be effective.
The rest of the paper is organized as follows. Section 2 reviews the literature and develops the hypotheses.
Section 3 describes the sample selection and the measures of earnings management. Section 4 presents the
results of the effect of analyst coverage from ordinary least squares and two-stage least squares tests. Section 5
reports the effect of analyst characteristics on earnings management. Section 6 concludes.
2. Background and hypothesis development
This section provides the background about earnings management and analysts’ influence on managers’
decision.
2.1. Analysts’ influence on managers
Analysts often interact directly with management during earnings release conference calls, when analysts are
given the opportunity to question aspects of a firm’s financial reporting. Corporate executives, usually chief
financial officers, have to be able to provide answers to those questions. In the question and answer session,
analysts often ask a wide spectrum of questions regarding the company’s financial statement, such as
abnormal change in revenues and crucial financial ratios. Executives who make decisions have to face and
answer those questions.
In addition to conference calls, analysts have other channels to express their concerns about covered firms,
namely, through their research reports to their clients, through recommendations and forecasts to general
investors, and through their appearance in public media such newspapers and TV programs to an even
boarder audience. Analysts also play an active role in corporate fraud detection. Dyck, Morse, and Zingales
(2006) find that the most efficient external whistleblowers for corporate fraud are analysts, while the Securities
and Exchange Commission and auditors play only a minor role in the discovery of fraud. Analysts’
involvement contributes directly to the discovery of corporate fraud in a number of companies.
Because of analysts’ active participation in the information distribution process, managers’ financial
reporting decisions can be influenced by the intensity of analyst coverage. In the Graham, Harvey, and
Rajgopal (2005) survey of 401 financial executives, about 90% said analysts are either the most important
group in terms of setting company stock price or the second most important group next to institutional
investors.
Healy and Palepu (2001) suggest that information intermediaries such as analysts and rating
agencies engage in private information production that helps to detect managers’ misbehavior. Jensen and
Meckling (1976, p. 353) argue that ‘‘as security analysis activities reduce the agency costs associated with the
separation of ownership and control, they are indeed socially productive.’’ Although numerous studies
examine analysts’ role in security price formation, relatively little empirical research exists on the role
of analysts in corporate governance. Most evidence collected thus far on this topic is indirect. For example,
Chung and Jo (1996) find that the level of analyst coverage is positively related to Tobin’s q. Irvine
(2003) shows that firms’ liquidity increases after the initiation of analyst coverage. Chang, Dasgupta,
and Hilary (2006) document that analyst coverage affects firms’ patterns of security issuance and capital
structure. The study here takes a more direct approach and investigates the role of analysts in corporate
governance by examining the relation between a firm’s level of analyst coverage and its earnings management
behavior.
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2.2. Earnings management
Because of the impact of a series of major accounting scandals, earnings management has become a highly
visible topic in recent years. A growing number of studies examine the relation between traditional governance
devices and earnings management. A series of studies (Healy, 1985; Bergstresser and Philippon, 2006; Burns
and Kedia, 2006; Safdar, 2003) show that high-powered executive compensation structures create incentives
for managers to manage earnings more. Bolton, Scheinkman, and Xiong (2005) suggest that earnings
management is not primarily driven by the conflict between ownership and control but by the conflict between
current and future shareholders, because current shareholders could choose to incentivize management for
short-term stock performance, even with the understanding that this creates incentives for management to
manipulate earnings. In this case, the expectation is that internal governance devices designed to resolve
ownership and control problems would not restrain earnings management effectively. Yu (2005) confirms that,
in addition to high-powered compensation, concentrated ownership and smaller boards, traditionally
considered to be effective governance features, are associated with more earnings management.
Compared with traditional types of governance devices, analysts possess several distinctive characteristics
that could make them effective monitors against earnings management. First, unlike internal governance
devices designed to protect current shareholders interest, analysts are expected to provide information in the
interest of not only current shareholders but also prospective shareholders as well as other participants in the
market. Second, analysts usually have financial training in finance and accounting as well as background in
the industries they cover. They have the resources to go through tedious financial statements and complicated
footnotes. Third, analysts track firms on a regular basis, continuously scrutinizing management behavior and
financial reporting irregularities. This represents a level of oversight not usually afforded to other gatekeepers
such as board members, who usually meet once every quarter, and SEC staff, who are able to review only a
small fraction of financial reports (General Accounting Office, 2002a, b).2
Despite the edge they apparently hold, analysts have some disadvantages that could prevent them from
guarding against earnings management and likely even exacerbate the problem. First, analysts are often
accused of exerting excessive pressure on firms. Managers complain about pressure from the market, and one
of their most important goals is to meet analysts’ expectations about earnings. Second, analysts themselves
also receive pressure from a variety of sources that could affect their incentives and reduce their role in
guarding against earnings management. Analysts are pressured by their employers to secure more investment
banking business, are pressured by peer competition to maintain a good relationship with managers to gain
access to private information,3 and are pressured by major clients of their brokerage houses. They are less
likely to issue negative opinions when major clients have significant holdings in certain companies (Dechow
et al., 2000; Lin and McNichols, 1998; Michaely and Womack, 1999).
If analysts play the role of external monitor, a firm’s earnings management behavior could decrease as
the number of analysts following the firm increases (monitoring effect). On the other hand, if the existence
of analysts creates excessive pressure on managers, a firm’s earnings management behavior may increase as
the number of analysts following the firm increases (pressure effect). A third possibility is that there
is no relationship between analyst coverage and earnings management, if analysts’ role as monitor is
entirely compromised by numerous pressures they face from their employers, their clients, and management
of the firms they cover. Or perhaps the monitoring effect and pressure effect coexists and cancel each
other out.
3. Sample selection and measurement of earnings management
This section explains the selection of sample and the measurement of earnings management.
2
For example, the SEC completed financial reviews of only 16% of the annual reports filed in 2001.
3
With enactment of the Regulation Fair Disclosure Act in 2000, firms are prohibited from making selective, nonpublic disclosures to
favored investment professionals. Analysts’ pressure to maintain good relationships with management has been reduced.
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3.1. Sample selection
I obtained analyst information from the Institutional Brokers Estimate System (I/B/E/S) database and
accounting variables from Compustat. I deleted firm-year observations of foreign firms; firms with unclassified
industry code; firms that are missing values for sales, total assets, net income before extraordinary items,
and cash flow from operations; firms with a market value of less than $10 million; and firms from the financial
industry.
The sample starts in 1988, when the variable of cash flow from operations is available in Compustat. Cash
flow from operations is the key input to estimate accruals accurately. Another reason to start the sample in
1988 is a concern for the quality of I/B/E/S data for the early 1980s, when there was a much smaller number of
analysts compared with the 1990s. Among all firm-year observations in I/B/E/S, I extracted accounting
variables for 33,127 firm-year observations from 1988 to 2002.
The sample does not contain information for all financial analysts. One major missing component is
information for buy-side analysts, which is not included in the I/B/E/S database. Buy-side analysts’ forecasts
and reports are usually internal and distributed to a limited audience, such as the institutions for whom they
work directly. For this study, because of the data restrictions, I focus only on the coverage from sell-side
analysts.
To account for the effect of institutional investor, which is positively correlated with analyst coverage
(O’Brien and Bhushan, 1990) and could also affect earnings management, I control for institutional ownership
in all the tests. I extract institutional ownership information from CDA/Spectrum Institutional 13(f) filings.
These filings contain quarterly information on common-stock positions greater than ten thousand shares or
$200,000 for each institution with more than $100 million in securities under management. For each
institution, I use the average holdings of four quarters for its annual holdings. If I could not find any
information in the 13(f) filings, I assume that the institutional holdings of a firm are zero, which is the case for
about 3.7% of the sample (1,220 out of 33,127 observations). In the sample, the average institutional holdings
is 42% with a standard deviation of 23%.
I also adopt a measure for firms’ external financing activities, which could affect both earnings management
and analyst coverage. Following Bradshaw, Richardson, and Sloan (2006), I measure firms’ external financing
activities as the sum of net proceeds from equity financing and debt financing scaled by total assets. The
proceeds from equity financing are measured by net cash received from the sale of common and preferred
stock less cash dividend paid. The proceeds from debt financing are measured by net cash received from the
issuance (or reduction) of short- and long-term debt.
Panel A of Table 1 shows the summary statistics at the firm level. A median firm in the sample has 0.31
billion in market value, a market-to-book ratio of 2.1, a growth rate of assets of 9%, and about 42% of
institutional ownership. For a median firm, the absolute value of discretionary accruals is 4.9% of lagged
assets, which is of similar magnitude as that of other studies (e.g., Bowen, Shivaram, and Venkatachalam,
2005; Francis, LaFond, Olsson, and Schipper, 2005; Bergstresser and Philippon, 2006). A median firm is
covered by six analysts, one of whom is from a top brokerage house. An analyst is defined as an analyst from a
top brokerage house if he or she is affiliated with a broker ranked as an All-American research team by
Institutional Investors in a given year. I also calculate the experience of analysts. Experience with a firm is
defined as the number of years that an analyst has followed a given firm; experience as an analyst is defined as
the number of years that an analyst has been working as an analyst. On average, a firm is covered by analysts
with 3.05 years of experience with the firm and 6.55 years as analyst.
Panel B of Table 1 presents the summary statistics at the analyst level. The total number of analysts
increases over time from 2,243 in 1988 to 4,308 in 2002. Panel C of Table 1 presents the information about
sample selection. Among all the firm-year observations for which I am able to estimate discretionary accruals,
33,127 observations are in the I/B/E/S database, and I assume that the remaining 23,320 observations are not
covered by analysts. Approximately one-third of the observations in I/B/E/S do not have enough accounting
information in Compustat to estimate discretionary accruals. Table 2 provides correlation coefficients between
the level of discretionary accruals and firm characteristics. The number of covering analysts exhibits a negative
correlation with the level of discretionary accruals and total accruals while showing a positive correlation with
the level of nondiscretionary accruals.
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Table 1
Summary Statistics
This table presents the summary statistics for the sample. The sample consists of firms in Institutional Brokers’ Estimate System from
1988 to 2002 with accounting information from Compustat. Discretionary accruals are estimated by a cross-sectional version of the
modified Jones model, presented as percentage of lagged assets. Return on assets is calculated by net income divided by total assets.
Standard & Poor’s index dummy is equal to 1 if a firm is included in the S&P industry index and zero otherwise. Growth rate of assets is
calculated by the change of assets scaled by lagged assets. Cash flow volatility is estimated by the standard deviations of cash flows of a
firm in the entire sample period, scaled by lagged assets. Institutional ownership is measured by the percentage of common shares owned
by institutional investors. External financing activities are measured by the sum of net cash received from equity and debt issuance scaled
by total assets. An analyst is defined as an analyst from top brokers if he or she is affiliated with a broker ranked as an All-American
research team by Institutional Investors in a given year. Experience with firm is defined as the number of years that an analyst has followed
a given firm. Experience as analyst is defined as the number of years that an analyst has worked as an analyst.
Panel A Firm level
Variable Number of Mean Median Standard deviation

observations
Firm characteristics
Absolute level of discretionary accruals 33,127 9.30 4.91 13.23
Discretionary accruals 33,127 1.33 0.54 17.82
Market value (in billions) 33,127 2.44 0.31 11.69
Market-to-book ratio 33,127 3.95 2.08 45.44
ROA 33,127 0.00 0.04 0.26
S&P index dummy 33,127 0.16 0.00 0.37
Growth rate of assets 33,127 0.24 0.09 1.00
Cash flow volatility 32,900 0.20 0.09 1.24
Institutional ownership 33,127 41.81 41.68 23.54
External financing activities 33,105 0.04 0.00 0.17
Analyst coverage
Analysts 33,127 9.44 6.00 9.13
Analysts from top brokers 33,127 2.57 1.00 3.14
Experience with firm 33,043 3.05 2.67 1.73
Experience as analyst 33,043 6.55 6.33 2.64
Panel B Analyst level
Year Number of Analysts from Tenure with Tenure as Average coverage

analysts top research firm analyst
teams
1988 2,243 599 2.42 3.62 11.24

1989 2,579 683 2.38 3.70 11.94
1990 2,442 593 2.55 4.20 10.74
1991 2,172 517 2.96 4.91 9.92
1992 2,109 510 3.26 5.49 9.52
1993 2,385 556 3.17 5.52 9.75
1994 2,736 663 3.03 5.45 8.93
1995 2,944 678 3.01 5.58 8.68
1996 3,280 735 2.80 5.33 8.32
1997 3,757 843 2.72 5.18 8.15
1998 4,112 1062 2.72 5.26 8.45
1999 4,256 1138 2.78 5.41 9.01
2000 4,329 1174 2.73 5.44 9.40
2001 4,280 993 2.65 5.40 9.77
2002 4,308 1255 2.52 5.05 10.25
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Table 1 (continued)
Panel C Sample selection
Year Uncovered firms Covered firms Covered firms with no DA

information
1988 1,408 1,576 623

1989 1,297 1,602 664
1990 1,108 1,591 731
1991 1,213 1,652 745
1992 1,397 1,754 806
1993 1,619 1,990 1,040
1994 1,725 2,239 1,103
1995 1,869 2,357 1,187
1996 1,930 2,612 1,495
1997 2,086 2,837 1,467
1998 1,868 2,810 1,483
1999 1,814 2,703 1,606
2000 1,559 2,605 1,562
2001 1,479 2,528 1,241
2002 1,386 2,271 1,154
Total 27,320 33,127 16,907
Percentage 35.32 42.83 21.85
Table 3 presents summary statistics based on the level of analyst coverage. The first two rows show that,
compared with firms without analyst coverage, firms with coverage have higher market valuation, better
performance, and lower level of discretionary accruals. A median firm with no coverage has 51 million in
market value, a 1% return on assets from the previous year, and a level of discretionary accrual of 7.12, while
a median firm with coverage has 311 million in market value, a 4% return on assets from the previous year,
and a level of discretionary accrual of 4.91.
The next four rows of Panel E show that, among firms with coverage, firms with a higher level of coverage
also have higher market valuation and a lower level of discretionary accruals than firms with a lower level of
coverage. A median firm with only one analyst has 54 million in market value and a level of discretionary
accrual of 6.19, while a median firm with more than ten covering analysts has 1.91 billion in market value and
a level of discretionary accrual of 3.94. The negative correlation between analyst coverage and level of
discretionary accruals is consistent with the hypothesis that analysts act as external monitors of managers and
reduce earnings management behavior. However, because many other factors also have an effect on
discretionary accruals, I need to use a multivariate framework to further explore this issue.
One concern could be whether a higher level of analyst coverage is associated not only with a lower level of
discretionary accruals but also with a lower level of nondiscretionary accruals. Table 3 shows that the level of
nondiscretionary accruals is 6.13 for an uncovered median firm and 5.11 for a covered median firm. The
difference is not as strong as the difference in the level of discretionary accruals (7.12 versus 4.91). Among
covered firms, no clear pattern emerges between the level of nondiscretionary accruals and the number of
analysts. The median of nondiscretionary accruals for firms with one covering analyst is 5.51, and 5.70 for
firms with more than ten covering analysts, while the respective difference for discretionary accruals is much
greater, 6.19 versus 3.94.
3.2. Estimation of earnings management
I adopt discretionary accruals as the main proxy for earnings management. Earnings have two major
components, cash flow and accounting adjustments called accruals. Because the determination of the signs and
sizes of accruals requires managers’ judgment and estimation, accruals are more vulnerable to manipulation.
But not all accruals are the result of earnings manipulation. Given industry and operational conditions, some
accrual adjustments are necessary and appropriate, and they need to be applied on a regular basis. Thus, total
252
Table 2
Correlation structure of key variables
This table presents the correlation matrix of key variables in the paper. The sample consists of firms in Institutional Brokers’ Estimate System from 1988 to 2002 with accounting
information from Compustat. Total accruals (TAs) equals net income minus cash flow from operations. Discretionary accruals (DAs) and nondiscretionary accruals (NDAs) are
estimated by a cross-sectional version of the modified Jones model, presented as percentage of lagged assets. Return on assets is calculated by net income divided by total assets.
Growth rate of assets is calculated by the change of assets scaled by lagged assets. Cash flow volatility is estimated by the standard deviations of cash flows of a firm in the entire sample
period, scaled by lagged assets. Institutional ownership is measured by the percentage of common shares owned by institutional investors. External financing activities are measured by
the sum of net cash received from equity and debt issuance scaled by total assets.
Number Market-to- Return Growth Market Cash

of analysts book ratio on assets rate of value flow
Variable Abs_DA DA Abs_NDA NDA Abs_TA TA assets volatility IO EFA
Absolute discretionary accruals (Abs_DA) 1.00

Discretionary accruals (DA) 0.26 1.00
Absolute level of nondiscretionary accruals (Abs_NDA) 0.61 0.51 1.00
Nondiscretionary accruals (NDA) 0.51 0.53 0.93 1.00
Absolute level of total accruals (Abs_TA) 0.62 0.30 0.22 0.17 1.00
Total accruals (TA) 0.14 0.67 0.19 0.24 0.51 1.00
Number of analysts 0.08 0.04 0.01 0.02 0.04 0.07 1.00
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Market-to-book ratio 0.05 0.01 0.05 0.05 0.04 0.03 0.01 1.00
Return on assets 0.28 0.33 0.08 0.08 0.44 0.45 0.08 0.04 1.00
Growth rate of assets 0.22 0.03 0.21 0.18 0.27 0.08 0.01 0.01 0.05 1.00
Cash flow volatility 0.07 0.03 0.03 0.01 0.09 0.04 0.02 0.01 0.00 0.10 1.00
Market value 0.01 0.01 0.04 0.04 0.02 0.02 0.41 0.01 0.06 0.02 0.01 1.00
F. Yu / Journal of Financial Economics 88 (2008) 245–271
Institutional ownership (IO) 0.09 0.00 0.02 0.00 0.11 0.00 0.38 0.01 0.16 0.01 0.03 0.09 1.00
External financing activities (EFA) 0.21 0.03 0.15 0.12 0.22 0.06 0.11 0.04 0.24 0.33 0.08 0.06 0.09 1.00
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Table 3
Firm characteristics by size of analyst coverage
Panel A presents the summary statistics for firm characteristics. The sample consists of firms in Institutional Brokers’ Estimate System
from 1988 to 2002 with accounting information from Compustat. Total accruals (TAs) equal net income minus cash flow from operations.
Discretionary accruals (DAs) and nondiscretionary accruals (NDAs) are estimated by a cross-sectional version of the modified Jones
model, presented as percentage of lagged assets.
Coverage: Market value Last year

number of (in millions) return on Number of
analysts Abs_DA DA Abs_NDA NDA Abs_TA TA assets observations
Median 7.12 0.31 6.13 5.43 8.04 5.69 51.41 0.01 27,320
0 Mean 15.12 0.32 12.38 9.91 14.93 9.50 679.24 0.27
Median 4.91 0.54 5.11 4.85 6.76 5.18 311.62 0.04 33,301
40 Mean 9.59 1.33 8.24 7.26 9.99 5.89 2429.27 0.04
Median 6.19 1.00 5.51 5.16 7.20 4.82 54.91 0.03 3,903
1 Mean 11.78 1.73 9.40 7.88 11.33 5.88 118.81 0.07
Median 5.67 0.88 4.95 4.63 7.04 4.62 121.18 0.04 11,163
2–5 Mean 10.59 2.01 8.14 6.97 10.47 5.01 256.07 0.12
Median 4.91 0.52 4.81 4.54 6.59 4.81 382.82 0.05 7,618
6–10 Mean 9.23 1.41 7.80 6.87 9.60 5.44 716.73 0.01
Median 3.94 0.14 5.70 5.55 6.58 6.26 1906.26 0.05 10,558
410 Mean 8.00 0.36 8.46 7.98 9.50 8.15 6797.88 0.02
accruals can be further decomposed into two parts, nondiscretionary accruals (NDAs) and discretionary
accruals (DAs). Discretionary accruals are used as the proxy for earnings management in a variety of studies
related to earnings management, such as initial public offerings (Teoh, Welch, and Wong, 1998a), seasoned
equity offerings (Rangan, 1998; Teoh, Welch, and Wong, 1998b; Shivakumar, 2000), management buyouts
(DeAngelo, 1986; Perry and Williams, 1994), mergers and acquisitions (Erickson and Wang, 1999), proxy
contests (DeAngelo, 1988), debt covenants (DeFond and Jiambalvo, 1994), and compensation plans (Healy,
1985; Holthausen, Larcker, and Sloan, 1995; Bergstresser and Philippon, 2006; Burns and Kedia, 2006).
I use a modified version of the Jones model (Jones, 1991; and Dechow, Sloan, and Sweeney, 1995), which
estimates discretionary accruals from cross-sectional regressions of total accruals on changes in sales and on
property, plant, and equipment (PPE) within industries. The details of the estimations are described in
Appendix. The magnitude of a firm’s discretionary accruals is indicated as a percentage of the lagged assets of
the firm. Positive DAs suggest income-increasing manipulations, while negative DAs indicate income-
decreasing manipulations. Managers have incentives to manage earnings not only upward, but also
downward. In good years, they could want to hide some earnings for future reporting use, while, in bad years,
they could take a bath (e.g., overstate bad assets or take a large restructuring charge) to make future earnings
targets easier to meet. Because I am interested in manipulations in both directions, I use the absolute value of
discretionary accruals, also used in several recent studies (e.g., Warfield, Wild, and Wild, 1995; Gu, 1999;
Klein, 2002; Bergstresser and Philippon, 2006). In addition, I split the sample according to the sign of
discretionary accruals for all the tests. Doing so allows me to check whether the patterns of effects on signed
discretionary accruals are consistent with each other.
Using DAs to measure earnings management does have drawbacks. First, for firms with merger and
acquisition activities, discontinued operations, or significant foreign currency accounts, the amount of the
accrual is often misestimated by using a balance sheet approach (Hribar and Collins, 2002). To calculate total
accruals more accurately, I use cash flow information taken directly from statements of cash flow. Second,
discretionary accruals are more likely to be overestimated for firms with extreme performance, strong growth,
or volatile cash flows (e.g., Dechow and Dichev, 2002). To reduce the model error problem, I control for firm
profitability, growth rate, and cash flow volatility, as well as other firm characteristics. I winsorize the value of
discretionary accruals at the tails of 0.5% and 99.5% to reduce the influence of outliers.
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For robustness, I use alternative measures for earnings management, namely, the discontinuity of earnings
distribution around earnings targets (Burgstahler and Dichev, 1997; Degeorge, Patel, and Zeckauser, 1999).
I examine whether firms with different coverage have different tendency to narrowly meet or beat earnings
target.
4. The effect of analyst coverage on earnings management
In the first part of this section, I use discretionary accruals as a proxy for earnings management and start the
analysis with OLS regressions. Then I use IV regressions with two instrument variables based on change in
broker size and on firm’s inclusion in the S&P 500 index. I also examine the effect of change of analyst
coverage on change of earnings management and compare covered firms with uncovered firms. In the second
part of this section, I use discontinuity of earnings distribution as a proxy for earnings management and
reexamine the effect.
4.1. Ordinary least squares regression
Analyst coverage is associated with many factors, such as firm size, past performance, growth, external
financing activities, and volatility of business (Bhushan, 1989; Dechow and Dichev, 2002; Kasznik, 1999).
Some of those factors could also affect firms’ earnings management. To control for those factors, I first run the
following regression:
Analyst Coverage ¼ firm size þ past performance þ growth þ external financing activities
þ cash flow volatilities þ year dummies, (1)
where analyst coverage is the number of analysts who made forecasts about firm’s earnings in any given year.
Firm size is measured by market value, past performance is measured by lagged return on assets, growth is
measured by growth rate of assets, external financing activities is measured by net cash proceeds from equity
and debt financing scaled by total assets, and cash flow volatilities is measured by standard deviations of cash
flow of a firm in the entire sample period, scaled by lagged assets.
I label the residuals from the above regression as ‘‘residual coverage’’ and use it as the main proxy for
analyst coverage.4 It can be considered as a component of analyst coverage that is uncorrelated with firm size,
past performance, growth, external financing activities, or volatility of business. Table 4 reports the results
from this regression. Analyst coverage is positively correlated with market value, past performance, and firm
growth and negatively correlated with external financing activities and cash flow volatility.
I then estimate the effect of analyst coverage on earnings management with the following OLS regression:

Discretionary Accrual it ¼ at þ gk þ b ResidualCoverageit þ lControlsit þ it , (2)
where t indexes years, i indexes firms, k indexes industries, at are year fixed effects, gk are industry fixed effects,
and eit is an error term. ResidualCoverageit is the residual from regression Eq. (1) for firm i in year t. Controlsit
is a vector of firm level controls that includes size, market-to-book ratio, profitability, growth rate of assets,
cash flow volatility, external financing activities, and institutional ownership. All the standard errors in
regressions are clustered at the firm level to adjust for heteroskedasticity.
Table 5 shows the results of the OLS regressions. Columns 1–3 show the results of the regressions that
control only year and industry fixed effect. Column 1 reports the regression using all the observations in
the sample. Column 2 reports the regression using observations with positive discretionary accruals, and
Column 3 reports the regression using observations with negative discretionary accruals. The coefficient on
residual coverage is significantly negative, indicating that a higher level of coverage is associated with a lower
level of earnings management.
Columns 4–6 of Table 5 show the results of the regressions with all the control variables except for
institutional ownership. The coefficients on residual coverage are still negatively significant and similar
compared with the results from Columns 1–3. Columns 7–9 show the results from the regressions with all the
4
The results from all the tests are qualitative similar if I use the raw number of analysts instead of residual coverage.
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Table 4
Regression that generates residual coverage
This table reports the results of the ordinary least squares regression that generates residual analyst coverage. The sample consists of
firms in Institutional Brokers’ Estimate System from 1988 to 2002 with accounting information from Compustat. Lagged return on asset is
calculated by net income divided by total assets from previous year. Growth rate of assets is calculated by the change of assets scaled by
lagged assets. Cash flow volatility is estimated by the standard deviations of cash flows of a firm in the entire sample period, scaled by
lagged assets. External financing activities are measured by the sum of net cash received from equity and debt issuance scaled by total
assets. Standard errors, reported in parentheses, are adjusted for firm-level clustering. Statistical significance at the 10, 5, and 1% level is
indicated by *, **, and ***, respectively.
Dependent variable: number

of covering analysts
Market value (in billions) 0.31

(0.04)***
Lagged return on assets 2.95
(0.51)***
Growth rate of assets 0.44
(0.09)***
External financing activities 2.91
(0.43)***
Cash flow volatility 0.19
(0.18)
Constant 9.76
(0.21)***
Year dummies yes
Number of observations 28,798
R-squared 0.20
control variables including institutional ownership. The magnitude of coefficients on analyst coverage is even
smaller and only of marginal significance. Institutional ownership exhibits a significant negative association
with earnings management, which is consistent with the view that institutional investors also serve as external
monitors (see, for example, Clay, 2000). In addition, because most buy-side analysts work for institutional
investors, the effect of buy-side analysts could also be captured by institutional ownership control.
I also run a regression with the level of nondiscretionary accruals as dependent variable, controlling for
other factors, and find that the coefficient of analyst coverage is not significant. This suggests that a higher
level of analyst coverage is not associated with a lower level of nondiscretionary accruals.
4.2. Expected coverage as instrument
One immediate concern for the OLS test is the endogeneity of analyst coverage, which could be affected by
firms’ earnings management behavior. Analysts could intentionally choose to cover firms with less earnings
management. Existing studies show that analysts tend to cover firms with a better information environment
(Bhushan, 1989; Bushman, Piotroski, and Smith, 2005). Firms are likely to have more covering analysts if they
have a higher rating of voluntary disclosure (Lang and Lundholm, 1996; Healy, Hutton, and Palepu, 1999),
more corporate presentations (Francis, Hanna, and Philbrick, 1998), and fewer business segments (Bhushan,
1989). The negative relation between analyst coverage and earnings management could be driven by the
selection of analysts.
To address the potential endogeneity problem, I use the 2SLS test adopting different instruments to capture the
variations in analyst coverage that are exogenous to firms’ earnings management behavior. In this subsection, I
first introduce an instrumental variable constructed to capture change of the size of brokerage houses.
The size of a brokerage house changes over time, usually depending on the change of its revenue or profit.
Moreover, it is unlikely to be affected by earnings management behaviors of certain firms that the brokerage
house covers. When a brokerage house reduces its size, it employs fewer analysts and tends to drop some of its
existing coverage to reduce total workload. For example, in 1990, Lehman Brothers reported a $966 million
256
Table 5
The effect of analyst coverage on earnings management: ordinary least squares regressions
This table reports the results of ordinary least squares regressions examining the effect of analyst coverage on earnings management. The sample consists of firms in Institutional
Brokers’ Estimate System from 1988 to 2002 with accounting information from Compustat. Residual coverage is the residuals from a regression of number of covering analysts on firm
size, past performance, growth, external financing activities, and cash flow volatilities. Discretionary accruals are estimated by a cross-sectional version of the modified Jones model.
Return on assets is calculated by net income divided by total assets. Growth rate of assets is calculated by the change of assets scaled by lagged assets. Cash flow volatility is estimated
by the standard deviations of cash flows of a firm in the entire sample period, scaled by lagged assets. External financing activities are measured by the sum of net cash received from
equity and debt issuance scaled by total assets. Size is the market value of a firm. Institutional ownership is measured by the percentage of common shares owned by institutional
investors. Standard errors, reported in parentheses, are adjusted for firm-level clustering. Statistical significance at the 10, 5, and 1% level is indicated by *, **, and ***, respectively.
Dependent variable: absolute value of discretionary accruals (Abs_DA)
Sample All firms Firms with Firms with All firms Firms with Firms with All firms Firms with Firms with
positive DA negative DA positive DA negative DA positive DA negative DA
Residual coverage 0.05 0.08 0.03 0.05 0.08 0.02 0.02 0.03 0.02
(0.01)*** (0.01)*** (0.01)*** (0.01)*** (0.01)*** (0.01)* (0.01)* (0.01)** (0.01)*
Market-to-book ratio 0.01 0.01 0.03 0.01 0.01 0.03
(0.00)*** (0.00)*** (0.00)*** (0.00)*** (0.00)*** (0.00)***
Return on assets 11.65 9.53 17.12 11.05 11.16 16.78
(0.97)*** (1.59)*** (1.63)*** (0.93)*** (1.61)*** (1.65)***
Growth rate of assets 2.90 2.59 2.65 2.94 2.62 2.68
(0.58)*** (0.67)*** (0.71)*** (0.59)*** (0.66)*** (0.72)***
Cash flow volatility 0.83 1.61 0.81 0.82 1.47 0.81
(0.20)*** (0.58)*** (0.17)*** (0.19)*** (0.55)*** (0.17)***
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External financing activities 2.65 9.37 0.91 2.40 9.32 0.71

(1.40)* (1.69)*** (1.74) (1.38)* (1.68)*** (1.71)
Size 0.01 0.02 0.00 0.00 0.01 0.00
(0.01) (0.01) (0.01) (0.01) (0.01) (0.01)
Institutional ownership 0.04 0.06 0.02
(0.01) (0.01) (0.01)

Constant 9.73 10.42 9.61 8.70 10.10 7.69 10.79 13.21 9.02
(0.28)*** (0.45)*** (0.35)*** (0.28)*** (0.45)*** (0.34)*** (0.39)*** (0.59)*** (0.60)***
Year fixed effect Yes Yes Yes Yes Yes Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes Yes Yes Yes Yes Yes
Number of observations 28,661 15,262 13,399 28,661 15,262 13,399 28,661 15,262 13,399
Adjusted R -squared 0.15 0.20 0.10 0.23 0.25 0.37 0.23 0.25 0.37
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net operation loss, and the number of its analysts and the number of the firms it covered dropped
substantially. I treat this change of coverage driven by the change of size of brokerage houses as an exogenous
variation.
To capture this variation, I construct a variable labeled ‘‘expected coverage.’’ I use the following equations
to calculate expected coverage:
ExpectedCoverageitj ¼ ðBrokersizejt =Brokersizej0 ÞnCoveragei0 and

Xn
ExpectedCoverageit ¼ ExpectedCoverageitj , (3)
j¼1
ExpectedCoverageitj is the expected coverage of firm i from broker j in year t. BrokerSizejt and BrokerSizej0 are
the number of analysts employed by broker j in year t and year 0, respectively. Coveragei0 is the size of the
coverage of firm i in year 0. ExpectedCoverageit is the expected coverage of firm i in year t.
I constrain the maximum number of analysts that a broker sends to cover a firm to one, because brokerage
houses rarely assign more than one analyst to cover a firm in practice.5 In essence, the expected coverage from
a certain broker can be interpreted as the probability of a broker continuing to cover a firm after its size
changes.
The example in Table 6 illustrates how I calculate expected coverage. Suppose a company is covered by
three brokerage firms, B1, B2, and B3, in year 0. The numbers of analysts employed by the brokerage firms are
as follows.
Using Eq. (3), I first calculate the expected coverage from each broker separately according to the change of
each broker’s size. In this case, in year t, the expected coverage of the company from B1, B2, and B3 is 1, 0.5,
and 1, respectively. Thus the total expected coverage of the company is equal to the sum of the expected
coverage from each broker, which is 2.5.
One might worry that a broker’s choice of which firm to stop covering might also be prone to the selection
problem. However, the selection issue that affects the realized coverage does not affect the expected coverage,
because the expected coverage measures the tendency to keep the coverage before a broker decides which firm
to keep.
The limitation of this method is that expected coverage can capture only the reduction of coverage but not
the initiation of coverage. To study the expected initiation of coverage, however, one has to consider the
change of size of all brokerage houses and all listed firms in the market. Thus expected initiation is reduced to
a form of year fixed effect and is thus not suitable as an instrument.
To calculate the expected coverage for any given firm, I need it to be covered by at least one brokerage
house in the benchmark year. To generate expected coverage for as many firm-year observations as possible, I
use 1995, the middle year of the sample period from 1988 to 2002, as the benchmark year. I lose 5,154
observations from the original sample because they were not covered in 1995. I also exclude all the
observations in 1995 from the regression tests. The selection of other years, such as 1988, as benchmark years
usually generates fewer firm-year observations for regressions but does not affect the results.
I estimate the following 2SLS regressions:
Residualoverageit ¼ ct þ ck þ f1 ExpectedCoverageit þ f2 Controlsit þ Zit

and

Discretionary Accrual it ¼ at þ gk þ b ResidualCoverageit þ lControlsit þ it , (4)
where t indexes years, i indexes firms, k indexes industries, at and ct are year fixed effects, gk and ck are
industry fixed effects, eit and Zit are error terms, and Controlsit is a vector of firm level controls for firm i in
year t.
5
Only 7.27% of broker-firm observations in the sample have more than one analyst to cover a firm. The Gilson, Healy, Noe, and Palepu
(2001) field interviews with bankers reveal that brokers usually assign one analyst to one stock and that the presence of multiple analysts
within the same brokerage house is driven almost exclusively by analyst turnover.
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Table 6
An example of calculating expected coverage based on the change of broker size
Aanalysts Analysts employed in year t Covergae from broker Expect

employed in year j in year 0 coverage
0 from broker
Broker j in year t
1 10 10 1 1
2 10 5 1 0.5
3 10 15 1 1
Expected coverage at year t ¼ 2.5
Table 7
Exogenous variations from the change of broker size: two-stage least-squares regressions
This table reports the results of two-stage least-squares (2SLS) regressions with expected coverage or expected change of coverage as
instrumental variables. The sample consists of firms in Institutional Brokers’ Estimate System from 1988 to 2002 (excluding 1995) with
accounting information from Compustat. Expected coverage is estimated by the method using the change of broker size discussed in
Subsection 4.2. Standard errors, reported in parentheses, are adjusted for firm-level clustering. Statistical significance at the 10, 5, and 1%
level is indicated by *, **, and ***, respectively.
Dependent variable
Number of analysts Absolute value of discretionary accruals
First stage Second stage

Sample All firms All firms Firms with positive DA Firms with negative DA
Expected coverage 1.04

(0.02)***
Residual coverage (instrumented) 0.05 0.04 0.05
(0.01)*** (0.02)** (0.02)***
Institutional ownership 0.06 0.03 0.05 0.01
(0.00)*** (0.01)*** (0.01)*** (0.01)*
Market-to-book ratio 0.01 0.01 0.00 0.01
(0.00)** (0.00) (0.01) (0.01)*
Return on assets 0.82 10.62 7.60 19.07
(0.55) (1.71)*** (1.90)*** (3.13)***
Growth rate of assets 0.12 4.12 3.80 3.90
(0.16) (0.44)*** (0.69)*** (0.53)***
Cash flow volatility 0.26 0.81 2.28 0.71
(0.25) (0.14)*** (0.71)*** (0.10)***
External financing activities 3.57 0.51 5.03 3.75
(0.44)*** (1.03) (1.36)*** (1.45)***
Size 0.00 0.00 0.00 0.00
(0.00)*** (0.00) (0.00) (0.00)
Constant 8.31 2.59 5.34 1.08
(0.22)*** (0.71)*** (1.43)*** (0.71)
Year fixed effect Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes
Number of observations 22,949 22,825 12,012 10,813
Adjusted R -squared 0.66 0.20 0.24 0.32
Table 7 shows the results of the 2SLS tests. The coefficients on residual coverage instrumented by expected
coverage are negatively significant and of greater magnitude than those in the OLS tests. The coefficient
suggests that an increase in the size of analyst coverage from the 25th to the 75th percentile indicates a drop in
the level of DAs equal to 14% (26%) of the sample mean (median).
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4.3. S&P index dummy as instrument
For robustness, I use another instrumental variable, inclusion in the S&P 500 index. A firm that is included
in the index tends to have more following analysts than a similar firm that is not included in the index. Because
the criteria for being added to the index are based on the industry conditions to which the firm belongs as well
as on how representative a firm is of its industry (S&P 500 Fact Sheet, 2004), the difference in coverage caused
by a stock’s inclusion in the S&P 500 index is less likely to be influenced by discretionary accrual component in
firm’s earnings. One potential problem for this instrument is that, when a firm is added to the index, many
other factors could change and potentially affect earnings management. One example is institutional
ownership, which tends to increase after a firm is added in the S&P 500 index. I control for institutional
ownership in all the regressions in this study-however, there could still be other factors that are difficult to
control for, such as media coverage. As an instrument, the S&P index dummy is not as clean as the expected
coverage method introduced in the Subsection 4.2 but it is simpler to use and able to capture both increase and
decrease of analyst coverage.
I estimate the following 2SLS regressions:
ResidualCoverageit ¼ ct þ ck þ f1 DummySP500it þ f2 Controlsit þ Zit
and

Discretionary Accrual it ¼ at þ gk þ b1 ResidualCoverageit þ lControlsit þ it , (5)
where t indexes years, i indexes firms, k indexes industries, at and ct are year fixed effects, gk and ck are industry
fixed effects, eit and Zit are error terms, and DummySP500it equals 1 if firm i is included in S&P 500 index in
year t. Controlsit is a vector of firm level controls for firm i in year t.
Table 8 reports the results of the 2SLS tests that use the S&P index dummy as the instrument. Consistent
with the OLS tests, the coefficient on analyst coverage is significantly negative. The estimates from the 2SLS
tests, larger than those of the OLS regression, are similar in magnitude to the coefficients from previous
specifications that use expected coverage as instrument.
4.4. The effect of change of analyst coverage
I also examine the effect of the change of analyst coverage on the change of the level of discretionary
accruals. Because analyst coverage usually does not undergo significant change every year, I estimate the
change over a longer time span, namely, every three years, which reduces the sample to 6,824 observations for
this test. The first column of Table 9 shows the results from the following OLS regression:

DDiscretionary Accrual it ¼ at þ gk þ bDResidualCoverageit þ lControlsit þ it , (6)
where t indexes years, i indexes firms, k indexes industries, at is year fixed effect, and gk is industry fixed effect.
The estimate indicates that the change of analyst coverage is negatively associated with the change of level of
DAs, controlling for other factors. One concern is that this effect is driven by negative discretionary accruals
from those firms that take large write-offs. To address this concern, I break down the sample by the sign of
discretionary accruals. The second and third columns show the results of OLS regressions with only positive
and negative discretionary accruals, respectively. The effect of the change of analyst coverage seems to be
fairly symmetric for positive and negative accruals, which indicates that the effect is likely not mainly driven
by large write-offs. I also tried dropping extreme values of negative accruals (about 5% of the sample) and
found that the test yields similar results.
To address the endogeneity problem, I use expected change of coverage as the instrument for the change of
analyst coverage. Expected change of coverage is the difference between the coverage in the benchmark year
and the expected coverage in year t. In the example in Subsection 4.2, in which the company’s coverage in year
0 is 3 and the expected coverage in year t is 2.5, the expected change of coverage is then 0.5. The fourth to sixth
columns of Table 9 show the results of the regressions with expected change of coverage as instrument. The
coefficients from 2SLS regressions are negatively significant and similar in magnitude to those from the OLS
regression. The seventh to ninth columns of Table 9 show the results of the 2SLS regression with the change of
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Table 8
Exogenous variations from Standard & Poor’s index inclusion: two-stage least-squares regressions
This table reports the results of two-stage least squares (2SLS) regressions with S&P index dummy as instrumental variable. The sample
consists of firms in Institutional Brokers’ Estimate System from 1988 to 2002 with accounting information from Compustat. S&P index
dummy is equal to one if a firm is included in S&P industry index and zero otherwise. Standard errors, reported in parentheses, are
adjusted for firm-level clustering. Statistical significance at the 10, 5, and 1% level is indicated by *, **, and ***, respectively.
Dependent variable
Number of analysts Absolute value of discretionary accruals
First stage Second stage

Sample All firms 1.04 All firms Firms with positive DA Firms with negative DA
S&P index dummy 11.30

(0.43)***
Residual coverage (instrumented) 0.07 0.04 0.08
(0.02)*** (0.02)* (0.02)**
Institutional ownership 0.10 0.03 0.05 0.01
(0.00)*** (0.00)*** (0.01)*** (0.01)
Market-to-book ratio 0.00 0.01 0.01 0.03
(0.00) (0.00)*** (0.00)*** (0.00)**
Return on assets 2.07 11.26 10.95 16.97
(0.42)*** (0.95)*** (1.61)*** (1.67)**
Growth rate of assets 0.02 2.90 2.59 2.66
(0.10) (0.58)*** (0.66)*** (0.72)**
Cash flow volatility 0.27 0.82 1.44 0.82
(0.14)** (0.18)*** (0.54)*** (0.17)**
External financing activities 2.87 2.61 9.52 0.85
(0.38)*** (1.39)* (1.67)*** (1.73)
Size 0.00 0.00 0.00 0.00
(0.00)*** (0.00) (0.00) (0.00)
Constant 6.96 8.71 10.94 2.86
(0.22)*** (0.38)*** (0.53)*** (0.62)**
Year fixed effect Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes
Number of observations 28,798 28,661 15,262 13,399
Adjusted R-squared 0.41 0.23 0.25 0.37
S&P index inclusion as instrument. The coefficients are also negatively significant. The estimates from the OLS
and two 2SLS regressions all suggest a negative relation between the change of analyst coverage and the
change of level of DAs.
4.5. Covered versus uncovered firms
The sample from the I/B/E/S database used in the above tests is made up of firms with at least one analyst.
But what about those firms not covered in the I/B/E/S data set? Do uncovered firms do more earnings
management than covered firms? To address this question, I expanded my sample to include uncovered firms
for which I could obtain discretionary accruals information from Compustat. Panel C of Table 1 compares the
number of covered firms and uncovered firms over time. The expanded sample has 23,320 uncovered and
33,127 covered observations.
With the expanded sample, I ran OLS tests with a dummy for analyst coverage as an explanatory variable.
Table 10 shows that uncovered firms have a much higher level of discretionary accruals than covered firms. On
average, controlling for other characteristics and year and industry fixed effect, the discretionary accrual level
of a firm with analyst coverage is lower than that of an uncovered firm by about 20% (37%) of the sample
mean (median).
Table 9
The effect of change of coverage on change of earnings management over every three-year span
This table reports the results of regressions examining the effect of change of analyst coverage on the change of earnings management over every three-year span. The sample consists
of firms in Institutional Brokers’ Estimate System from 1988 to 2002 with accounting information from Compustat. Discretionary accruals are estimated by a cross-sectional version of
the modified Jones model. Standard errors, reported in parentheses, are adjusted for firm-level clustering. Statistical significance at the 10, 5, and 1% level is indicated by *, **, and ***,
respectively.
Dependent variable: change of absolute value of discretionary accruals
Ordinary least squares regressions Expected change of coverage as IV (2SLS) Standard & Poor’s index inclusion as IV(2SLS)
Sample All firms Firms with Firms with All firms Firms with Firms with All firms Firms with Firms with
positive DA negative DA positive DA negative DA positive DA negative DA
(1) (2) (3) (4) (5) (6) (7) (8) (9)

Change of residual coverage 0.10 0.10 0.11 0.09 0.10 0.09 0.50 0.59 0.39
(0.03)*** (0.04)** (0.04)** (0.04)** (0.05)* (0.06) (0.17)*** (0.32)* (0.20)*
Change of institutional ownership 0.01 0.02 0.00 0.01 0.02 0.01 0.01 0.01 0.02
(0.01) (0.02) (0.02) (0.01) (0.01) (0.02) (0.02) (0.02) (0.02)
Change of market-to-book ratio 0.01 0.02 0.00 0.01 0.02 0.00 0.01 0.02 0.00
(0.01) (0.00)*** (0.01) (0.01) (0.00)*** (0.01) (0.01) (0.00)*** (0.01)
Change of return on assets 11.35 3.78 14.17 11.24 2.88 13.97 11.77 4.51 14.44
(2.01)*** (3.11) (3.34)*** (2.03)*** (3.18)*** (3.37)*** (2.13)*** (3.20) (3.46)***
Three-year growth rate of assets 2.38 2.94 2.24 2.22 2.45 2.16 2.82 4.16 2.40
(0.71)*** (0.80)*** (0.91)** (0.73)*** (0.81)*** (0.96)** (0.79)*** (1.15)*** (0.96)**
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Cash flow volatility 1.29 1.08 2.65 1.05 1.25 2.43 2.01 1.02 3.37
(1.15) (1.70) (1.46)* (1.20) (1.88) (1.48) (1.23) (1.62) (1.53)**
Change of financing activities 5.74 6.13 5.49 6.26 6.57 6.25 6.22 6.58 5.77
(1.15)*** (1.59)*** (1.71)*** (1.17)*** (1.57)*** (1.80)*** (1.20)*** (1.64)*** (1.75)***
Change of size 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
(0.00)* (0.00) (0.00)* (0.00) (0.00) (0.00) (0.00)*** (0.00)* (0.00)*

Constant 0.10 -0.14 -0.52 1.18 0.59 4.18 4.12 -2.13 3.87
(0.25) (0.38) (0.40) (2.00) (2.34) (3.17) (1.81)** (3.84) (2.99)
Year fixed effect Yes Yes Yes Yes Yes Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes Yes Yes Yes Yes Yes
Number of observations 6,824 3,654 3,170 6,507 3,472 3,035 6,824 3,654 3,170
Adjusted R -squared 0.12 0.09 0.19 0.12 0.09 0.20 0.09 0.05 0.18
261
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Table 10
Uncovered versus covered firms
This table reports the results of regressions examining the difference of earnings management between uncovered firms and covered
firms. The sample consists of firms in Institutional Brokers’ Estimate System from 1988 to 2002 with accounting information from
Compustat. Dummy of coverage is equal to one if a firm has one or more analysts and zero otherwise. Standard errors, reported in
parentheses, are adjusted for firm-level clustering. Statistical significance at the 10, 5, and 1% level is indicated by *, **, and ***,
respectively.
Dependent variable: absolute value of discretionary accruals
Ordinary least squares regressions
Firms with positive Firms with negative

Sample All firms DA DA
Dummy of coverage 1.85 0.99 2.69

(0.18)*** (0.23)*** (0.25)***
Institutional ownership 0.09 0.09 0.08
(0.00)*** (0.01)*** (0.01)***
Market-to-book ratio 0.00 0.00 0.00
(0.00) (0.00)** (0.01)
Return on assets 0.61 0.01 1.27
(0.31)* (0.06) (0.57)**
Growth rate of assets 0.12 0.56 0.05
(0.17) (0.16)*** (0.12)
Cash flow volatility 0.86 0.86 0.65
(0.24)*** (0.50)* (0.23)***
External financing activities 15.52 12.58 17.26
(0.73)*** (0.94)*** (1.11)***
Size 0.00 0.00 0.00
(0.00) (0.00) (0.00)*
Constant 18.76 18.87 18.61
(0.35)*** (0.51)*** (0.51)***
Year fixed effect Yes Yes Yes
Industry fixed effect Yes Yes Yes
Number of observations 58,921 31,004 27,917
Adjusted R -squared 0.18 0.21 0.18
4.6. Discontinuity of distribution of earnings
An alternative measure of earnings management is to examine the discontinuity of earnings distributions

around earnings targets. Burgstahler and Dichev (1997) and Degeorge, Patel, and Zeckauser (1999) find that
there is a much higher percentage of firms that narrowly meet or beat earnings targets than firms that narrowly
miss earnings targets, which indicates the existence of earnings management. In this study, there are two
possible effects between analyst coverage and firms’ tendency to narrowly meet earnings target: (1) the
presence of more analysts reduces the room for earnings management and makes managers less likely to
narrowly meet targets (monitoring hypothesis); and (2) the presence of more analyst puts more pressure on
managers and makes them more likely to narrowly meet targets (pressure hypothesis). The test presented in
this subsection tries to examine which effect is dominant.
The distribution approach relies on fewer assumptions and can capture not only earnings management by
accounting manipulations but also earnings management by real operations. The limitation of this method is
that it does not provide firm-level variations. Therefore, I construct portfolios based on the levels of coverage
and compare the discontinuity of earnings distributions across these portfolios. I use the raw I/B/E/S data
unadjusted for stock splits to accurately calculate the actual forecast errors.6 I use analyst expectation as the
earnings target, because opportunistic managers try to avoid earnings disappointment. The sample is divided
6
See Diether, Malloy, and Scherbina (2002) for details on the potential rounding error problem for standard I/B/E/S data adjusted for
splits.
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Quartile 1 low coverage Quartile 2

0.2 Narrowly meet or beat target 0.2
0.15 Narrowly miss 0.15

target
Fraction
Fraction
0.1 0.1
0.05 0.05
0 0
-0.5 0 0.5 -0.5 0 0.5
Analyst forecast errors Analyst forecast errors
Quartile 3 Quartile 4 high coverage

0.2 0.2
0.15 0.15
Fraction
Fraction
0.1 0.1
0.05 0.05
0 0
-0.5 0 0.5 -0.5 0 0.5
Analyst forecast errors Analyst forecast errors
Low High
coverage coverage
1 2 3 4 All
Number of firms that narrowly missing analysts' forecasts 1,159 1,338 1,450 1,446 5,393
Number of firms narrowly beating or meeting analysts' forecasts 1,927 1,948 1,817 1,646 7,338
Number of firms meeting analysts' forecasts 408 116 56 8 588
Ratio of number of firms that narrowly meet or beat forecasts to
1.66 1.46 1.25 1.14 1.36
number of firms that narrowly miss forecasts
Average coverage 1.67 4.43 9.18 22.55
Absolute forecast errors 0.26 0.19 0.20 0.26
Expectation change -0.11 -0.14 -0.16 -0.24
Absolute expectation change 0.17 0.21 0.23 0.37
Fig. 1. Distribution approach. The sample is divided into four quartiles by the level of analyst coverage. The graph presents different
earnings distributions around analysts’ expectations of these portfolios. Analysts’ expectation is measured as the average forecasts of all
following analysts for any given firm in a given year. Absolute forecast errors are the average absolute forecast errors for all the stocks by
all the analysts in a portfolio. Expectation change is the difference between average last forecasts and average first forecasts from all the
analysts.
into quartiles by the level of analyst coverage. Each quartile contains approximately 8,400 observations. The
firms in the highest quartile are followed by 13 or more analysts, and the firms in the lowest quartile are
followed by no more than three analysts.
I compare the discontinuity around analyst expectation, measured by the mean of all analysts’ most
updated forecasts. Fig. 1 shows that the quartile with the lowest coverage exhibits much stronger discontinuity
around earnings expectation than the quartile with the highest coverage. I divide the earnings surprise range
from -$1.00 to $1.00 into 50 bins and count the number of firms that fall into different bins. The bin on the
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immediate right-hand side of earnings targets contains firms that either narrowly meet or beat earnings
targets. The bin on the immediate left hand side of earnings targets contains firms that narrowly fail to meet
earnings targets. Of all the observations, there are 36% more firms in the right-hand bin than in the left-hand
bin, which is consistent with the results of Burgstahler and Dichev (1997) and Degeorge, Patel, and Zeckauser
(1999) on the discontinuity of earnings distributions in general. For the quartile with the lowest coverage,
there are 67% more firms in the right-hand bin than in the left-hand bin, while for the quartile with the highest
coverage, there are only 13% more firms in the right-hand bin than in the left-hand bin. The P-value from a
Kolmogorov and Smirnov test of the equality of distributions between the two quartiles is smaller than 0.001.
The pattern suggests that high analyst coverage is associated with lower earnings management, consistent
with the regression tests reported in the previous subsections (4.1, 4.2, 4.3, 4.4, and 4.5) that use a discretionary
accruals measure. One concern is that the quality of consensus by only a few analysts is not as good as that by
a greater number of analysts and thus forecast precision could increase with more following analysts. To
examine whether forecast precision varies across portfolios with different coverage, I compare the average
absolute level of forecast errors of all the firms in each portfolio. There is no significant difference between the
portfolio with the highest coverage (0.264) and the one with the lowest coverage (0.262). The P-value is 0.47.
An alternative explanation for the difference in the discontinuity of earnings distributions is that it is the
outcome of manipulations of analyst expectation, not the outcome of direct manipulation of earnings.
Managers have incentive to walk down or up analyst forecasts to make earnings targets easier to meet
(Richardson, Teoh, Wysocki, 2004). Analysts frequently cooperate, because revisions based on managers’
guidance make their forecasts more accurate. This is another type of opportunistic behavior by managers, but
it is not earnings management per se. In fact, I find that the average magnitude of revisions of the quartile with
the highest coverage is about twice as high as that of the quartile with the lowest coverage, which suggests that
firms with higher coverage are more likely to engage in expectation management activities.
To address the potential confounding effect of expectation management, I adopt the following strategy. I
construct a dummy variable to capture firms’ propensity to narrowly meet or beat earnings targets. The
dummy variable is one if a firm’s reported earnings are equal to analyst expectations or exceed analyst
expectations by less than four cents, and zero otherwise. I run regressions with this dummy variable as the
dependent variable and use the magnitude of the change of analyst consensus to control for the effect of
expectation management. The basic structure of the regressions is
DummyofMeetingEarningsT arg etit ¼ at þ gk þ bResidualCoverageit

þ ZDAnalystConsensusit þ lControlsit þ it , (7)
where t indexes years, i indexes firms, k indexes industries, at are year fixed effects, and gk are industry fixed
effects. DAnalystConsensusit is measured by the difference between average last forecasts and average first
forecasts from all the analysts following a given firm. Controlsit is a vector of firm level controls for firm i in
year t. I multiply the dummy of meeting earnings target by one hundred to make the estimates easier to read.
For a more compatible comparison, in this regression I use a sample consisting of firms that either meet or
beat their earnings targets by zero to four cents or miss their earnings targets by one to eight cents.
Column 1 in Panel A of Table 11 shows the results of the OLS regression without controlling for
expectation management. Analyst coverage is negatively associated with the propensity of a firm to narrowly
meet its earnings target. Column 2 shows that, when I control for the change of analyst consensus, the size of
the coefficient on analyst coverage declines by about 10% but is still significant. The coefficient on expectation
management is positive and significant, consistent with the notion that more expectation management makes
firms more likely to meet their earnings targets.
To account for endogeneity problems, I also ran 2SLS tests with the instrumental variables used in the
Subsection 4.2 and 4.3. Column 3 presents the results from the 2SLS regression with the expected coverage as
instrument. Column 4 shows the results of 2SLS tests that use the dummy of S&P 500 index inclusion as an
instrument. The coefficient on analyst coverage is negative and significant.
One concern about the above result is that it could be simply driven by mechanical reasons. It could be more
difficult for firms with more analysts to set up a single number as the earnings target from a large group of
forecasts by many analysts. Those firms’ earnings distribution around earnings targets could be more
Table 11
Probability of meeting earnings target
This table reports the results of regressions using firms’ propensity of meeting earnings expectations as the measure of earnings management. The sample consists of firms in
Institutional Brokers’ Estimate System from 1988 to 2002 with accounting information from Compustat that either meat/beat their earnings targets by zero to four cents or miss their
earnings targets by one to eight cents. The dependent variable is the dummy to narrowly meet or beat earnings target, which is one hundred if a firm’s reported earnings are equal to
analyst expectation or exceed analyst expectation by less than $0.04 and zero otherwise. Columns 1, 2, and 5 are the results from ordinary least squares regressions, Column 3 is the
results from two-stage least squares regressions with expected coverage as instrument, and Column 4 is the result from two-stage least squares regressions with the dummy of Standard
& Poor’s index inclusion as instrument. Standard errors, reported in parentheses, are adjusted for firm-level clustering. Statistical significance at the 10, 5, and 1% level is indicated by *,
**, and ***, respectively.
OLS OLS (controlled for 2SLS (Expected change 2SLS(Standard Poor’s OLS
change of consensus) of coverage as IV) index inclusion as IV)
Dummy of narrowly Dummy of narrowly Dummy of narrowly Dummy of narrowly Dummy of narrowly
Dependent variable meeting or beating target meeting or beating target meeting or beating target meeting or beating target missing target
(1) (2) (3) (4) (5)

Residual coverage 0.45 0.41 0.19 0.26 0.25
(0.06)*** (0.06)*** (0.10)* (0.12)** (0.06)***
Change of analyst consensus 25.05 24.58 25.60 4.58
(2.08)*** (2.52)*** (2.09)*** (1.60)***
Institutional ownership 0.00 0.00 0.04 0.05 0.01
(0.00) (0.00) (0.03) (0.03)* (0.00)***
Market-to-book ratio 9.78 8.39 0.01 0.00 1.32
(3.83)** (3.46)** (0.04) (0.00) (1.91)
Return on assets 1.59 1.00 22.07 8.93 0.66
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(1.01) (0.97) (4.86)*** (3.55)** (0.86)

Growth rate of assets 1.32 1.31 1.49 0.99 0.54
(0.61)** (0.58)** (1.27) (0.98) (0.31)*
Cash flow volatility 0.05 0.07 1.26 1.30 0.04
(0.02)** (0.02)*** (0.49)** (0.58)** (0.02)**
External financing activities 3.81 3.73 3.49 4.04 6.68

(3.93) (3.80) (4.73) (3.83) (3.24)**
Size 0.00 0.00 0.00 0.00 0.00
(0.00)** (0.00)* (0.00)** (0.00)* (0.00)***
Constant 47.41 48.16 51.34 50.47 36.33
(1.91)*** (1.88)*** (19.79)*** (1.95)*** (1.76)***
Year fixed effect Yes Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes Yes
Number of observations 13,402 13,402 9,425 13,402 13,402
Adjusted R -squared 0.02 0.04 0.04 0.04 0.01
265
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dispersed, which is why firms with more analysts are less likely to narrowly beat or meet earnings targets.
There are two responses to this concern. First, in practice, consensus of earnings forecasts by analysts can be
easily found in many sources, such as major finance websites. Earnings targets for companies with many
following analysts are salient and unambiguous. Second, if earnings distribution around earnings targets were
more dispersed for firms with more analysts, the expectation is that those firms are also less likely to narrowly
miss earnings targets. But empirical evidence suggests that this is not the case. Column 5 of Table 11 shows
that firms with more analysts are more likely to narrowly miss the earnings target. The impact of analyst
coverage is asymmetric.
5. Characteristics of analysts and earnings management
Do different types of analysts have different effects on earnings management? I study whether analyst
characteristics, such as affiliation and experience, affect firms’ earnings management behavior, given the level
of coverage. Previous studies have shown that analysts affiliated with top brokerage houses and analysts with
more experience are better forecasters than other analysts (Stickel, 1992; Clement 1999; Jacob, Lys, and Neale,
1999; Mikhail, Walther, and Willis, 1997, 2003). The tests in this section examine whether analysts who are
better at processing information are also better monitors.
5.1. Affiliation
Analysts from more prestigious brokerage houses make more accurate forecasts and their revisions have a
bigger impact on the market (Stickel, 1992; Clement, 1999; Jacob, Lys, and Neale, 1999). Top brokerage
houses are able to hire better talent than non-top brokerage houses (Hong and Kubik, 2003). Analysts with
top brokerage houses have better resources to conduct their research, such as more extensive databases and
better research support staff. Their opinions also have more influence because of the higher credibility and
better distribution channels of top brokerage houses. These factors can also make them more effective
monitors. I test whether a firm’s earnings management behavior can decrease with the number of analysts
from top brokerage houses that follow the firm, given the level of analyst coverage.
I use the Institutional Investors All-American research team ranking as the proxy for the status of brokerage
houses. I collected top-ten research team information from 1988 to 2002. Approximately 24% of the analysts
are from the top-ten All-American research teams. In the sample, a median firm is followed by about one
analyst from a top brokerage house and five analysts from non-top brokerage houses.
5.2. Experience
Experienced analysts are better at incorporating past information and make more accurate forecasts
(Mikhail, Walther, and Willis, 1997, 2003; Clement, 1999); they are also more likely to deviate from consensus
and make bold forecasts (Hong, Kubik, and Solomon, 2000). The better forecast ability of experienced
analysts could be the result of either selection (because weaker analysts cannot survive as long as good
analysts, senior analysts could begin with higher ability) or learning (senior analysts’ skills improve over time
through experience, both in their general analytical skills, such as understanding financial statements and
analyzing data, and in their company-specific skills, such as communicating with management and being
familiar with the product of the company or the background of the industry). Because senior analysts tend to
have better ability and improved skills, they could also be more effective in deterring earnings management.
I test whether a firm’s earnings management behavior decreases with the average experience of analysts that
follow the firm, given the level of analyst coverage. I use two variables to measure analysts’ experience: general
experience, the number of years an analyst has worked as an analyst; and firm-specific experience, the number
of years an analyst has followed a given company. In implementation, general experience is measured by the
number of years since an analyst was first included in the I/B/E/S database (from 1982 to 2002), and firm-
specific experience is measured by the number of years that an analyst issued earnings forecast for a given firm.
An average firm in the sample is followed by analysts with 6.55 years of experience as analyst and 3.05 years of
experience with the firm.
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Table 12
The effect of analyst characteristics on earnings management
This table reports the results of regressions examining the effects of analyst characteristics on earnings management. The sample consists
of firms in Institutional Brokers’ Estimate System from 1988 to 2002 with accounting information from Compustat. An analyst is defined
as an analyst from top brokers if he or she is affiliated with a broker ranked as an All-American research team by Institutional Investors in a
given year. Experience with firm is defined as the average number of years that all analysts have followed a given firm. Experience as
analyst is defined as the average number of years that all analysts have worked as analyst. Standard errors, reported in parentheses, are
adjusted for firm-level clustering. Statistical significance at the 10, 5, and 1% level is indicated by *, **, and ***, respectively.
Dependent variable: absolute value of discretionary accruals
Experience as analyst Experience with firm

Firms with Firms with Firms with Firms with
positive negative positive negative
Sample All firms DA DA All firms DA DA
Analysts from top brokers 0.24 0.08 0.27 0.19 0.05 0.24
(0.05)*** (0.07) (0.05)*** (0.05)*** (0.07) (0.05)***
Experience as analyst 0.35 0.34 0.35
(0.11)*** (0.16)** (0.13)***
2
(Experience as analyst) 0.01 0.01 0.02
(0.01) (0.01) (0.01)**
Experience with firm 1.20 1.06 0.80
(0.14)*** (0.20)*** (0.16)***
(Experience with firm)2 0.08 0.07 0.05
(0.01)*** (0.02)*** (0.02)***
Number of analysts 0.07 0.00 0.10 0.08 0.01 0.10
(0.02)*** (0.02) (0.02)*** (0.02)*** (0.02) (0.02)***
Institutional ownership 0.03 0.05 0.02 0.03 0.05 0.02
(0.00)*** (0.01)*** (0.01)*** (0.00)*** (0.01)*** (0.01)***
Market-to-book ratio 0.01 0.01 0.03 0.01 0.01 0.03
(0.00)*** (0.00)*** (0.00)*** (0.00)*** (0.00)*** (0.00)***
Return on assets 10.81 11.33 16.83 10.88 10.83 16.82
(0.78)*** (1.46)*** (1.48)*** (0.79)*** (1.45)*** (1.48)***
Growth rate of assets 2.76 2.65 2.54 2.68 2.60 2.49
(0.40)*** (0.49)*** (0.47)*** (0.39)*** (0.48)*** (0.46)***
Cash flow volatility 0.38 1.22 0.34 0.36 1.09 0.33
(0.18)** (0.48)** (0.14)** (0.17)** (0.49)** (0.14)**
External financing activities 2.82 9.21 0.68 2.10 8.49 0.23
(1.08)*** (1.42)*** (1.34) (1.05)** (1.40)*** (1.32)
Size 0.00 0.00 0.00 0.01 0.00 0.00
(0.01) (0.01) (0.01) (0.01) (0.01) (0.01)
Constant 12.68 15.44 10.24 13.00 15.37 10.23
(0.52)*** (0.77)*** (0.72)*** (0.42)*** (0.63)*** (0.57)***
Year fixed effect Yes Yes Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes Yes Yes
Number of observations 32,299 17,330 14,969 32,299 17,330 14,969
Adjusted R-squared 0.24 0.25 0.38 0.24 0.26 0.38
5.3. Test results
I estimate the following regressions:

Discretionary Accrual it ¼ at þ gk þ b1 AnalystCoverageit
þ b2 AnalystCharacteristicsit þ lControlsit þ it , (8)
where t indexes years, i indexes firms, k indexes industries, at are year fixed effects, gk are industry fixed effects,
and AnalystCharacteristicsit represents the number of analysts from top brokerage houses and the average
experience of analysts for firm i in year t. Controlsit is a vector of firm level controls.
Table 12 shows that, given the size of coverage, firms with more analysts from top brokerage houses have a
lower level of discretional accruals, both for positive and negative DAs. The coefficients on analysts from top
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brokers imply that, given the size of coverage and other factors, an increase in the number of analysts
from top brokers from the 25th percentile (no analysts from top brokers) to the 75th percentile (three analysts
from top brokers) is associated with a drop in the level of DAs equal to 8% (15%) of the sample mean
(median).
Table 12 also shows that, given the size of coverage, firms with more experienced analysts have a lower level
of discretionary accruals. This is true for both general experience (Columns 1–3) and firm specific experience
(Columns 4–6). The positive coefficients on the squared term of experience variables capture the nonlinearity
of the tenure effect. The marginal benefit of the increase in experience decreases for more senior analysts. With
nonlinearity taken into consideration, the estimates of analyst tenure imply that, given the size of coverage, for
an average firm, an increase of one standard deviation in the average general experience level of analysts (2.64)
is associated with a drop in the level of DAs equal to 9% (17%) of the sample mean (median), while an
increase of one standard deviation in average firm-specific experience (1.73) is associated with a drop in the
level of DAs equal to 20% (37%) of the sample mean (median). Analysts’ firm-specific experience has a
stronger effect on earnings management than general experience, which is consistent with previous research
showing that analysts’ forecasting ability benefits more from firm-specific experience than from general
experience (Clement, 1999).
Table 12 suggests that analysts’ affiliation and experience play an important role in analysts’ effect on
earnings management. An experienced analyst from a top broker has a much stronger impact on the firm he or
she covers than an inexperienced analyst from a non-top broker. One caveat for these tests of analysts’
characteristics is the selection issue: Certain types of analysts could select to cover certain types of firms. This
selection issue is less of a concern at the industry level, since industry fixed effect is included in all the
regressions. But it still exists within industries. Analysts from top brokerage houses or analysts with more
experience could have a preference for certain firms and thus lead to the results in Table 12. But it is not clear
why analysts from top brokerage houses or experienced analysts would be more likely to cover firms with less
earnings management, given that there is more demand from investors for better talent devoted to more
complicated cases. In addition, the selection of different types of analysts has not been shown in the literature
and could be of interest in itself.
6. Conclusion
This paper explores the role of information intermediaries in corporate governance within the context of the
effect of analyst coverage on earnings management. Accounting for the endogeneity problem of analyst
coverage and using multiple measures for earnings management, I find that a higher level of analyst coverage
is related to less earnings management and that change of analyst coverage is negatively related to change of
earnings management. The potential endogeneity problem of analyst coverage is a significant challenge to this
study, because the quality of financial reporting can also affect analyst coverage and reverse the causal
inference.
To address the endogeneity problem, I adopt two instrumental variables based on change of broker size and
on firm’s inclusion in the S&P 500 index, and I find the results are robust. In addition, the effect of analyst
coverage is stronger for analysts who make better forecasts, including those from top brokerage houses and
those with more experience.
The existing literature suggests that a high level of analyst coverage creates a better information
environment for firms and leads to less asymmetric information (Bushman and Smith, 2001; Healy and
Palepu, 2001). This study contributes to the literature by highlighting a direct source of the reduction in
asymmetric information: More analysts lead to less earnings management. Analysts not only facilitate
information distribution but also affect the corporate production of information.
This study also sheds light on the question of how to deter opportunistic earnings management, when
traditional governance devices do not seem to work well or even sometimes backfire (Healy, 1995; Bergstresser
and Philippon, 2006; Bolton, Scheinkman, and Xiong, 2005). Analysts have distinctive features that are
different from traditional internal governance devices. Their jobs are designed to serve not only current
shareholders but also all potential shareholders and other stakeholders in the market. They have more
financial sophistication and resources for detecting earnings management than traditional gatekeepers.
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More generally, the results suggest that the role of information intermediaries in corporate governance is
potentially significant. The hypothesis that information intermediaries serve as external monitors has testable
implications for research in other areas of corporate governance, such as fraud detection, insider trading,
executive compensation, etc.
Appendix. Estimation of discretionary accruals
I use a modified version of the Jones model (Dechow, Sloan, and Sweeney, 1995), which estimates
discretionary accruals from regressions of total accruals on changes in sales and on property, plant, and
equipment within industries.
I obtained accounting information from the Compustat Annual Industrial, Research and Full Coverage
files. I delete firm-year observations of foreign firms; unclassified firms; firms missing values for sales, total
assets, net income before extraordinary items, and cash from operations; firms with a market value of less than
$10 million; and firms from the financial industry. Ultimately, I am able to estimate discretionary accruals for
57,903 firm-year observations over the period from 1988 to 2002.
To determine discretionary accruals, I first run the following cross-sectional OLS regression by the first
two-digit standard industrial classification (SIC) code to estimate coefficients a1,a2, and a3.
TAit 1 DREV it PPE it
¼ a1 þ a2 þ a3 þ it , (9)
Ait1 Ait1 Ait1 Ait1
where i indexes firms, t indexes time, TAit equals Net Income (Compustat item 172) minus Cash Flow from
Operations (item 308), DREVit is the changes in sales revenues (item 12), DARit is the change in receivables
(item 2), and PPE is gross property, plant, and equipment (item 7). All the variables used here are scaled by
total assets at the beginning of the period (item 6). I estimate the cross sectional models separately for each
combination of calendar year and two-digit SIC code with a minimum of 15 observations.
I then use the estimated a^ 1 ; a^ 2 ; and a^ 3 to calculate nondiscretionary accruals.

1 DREV it DARit PPE it
NDAit a^ 1 þ a^ 2 þ a^ 3 . (10)
Ait1 Ait1 Ait1 Ait1
Thus, I can derive discretionary accruals as
TAit
DAit it ¼ NDAit . (11)
Ait1
Because all the variables are scaled by total assets at the beginning of the period, the magnitude of a firm’s
discretionary accruals is indicated as a percentage of the assets of the firm.
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ARTICLE IN PRESS

Journal of Financial Economics 88 (2008) 245–271

Analyst coverage and earnings management$

JEL classifications: G34; M41; G24

Keywords: Earnings management; Financial analyst; Corporate governance; Analyst coverage

2. Background and hypothesis development

2.1. Analysts’ influence on managers

2.2. Earnings management

3. Sample selection and measurement of earnings management

3.1. Sample selection

Panel A Firm level

Variable Number of Mean Median Standard deviation

Panel B Analyst level

Year Number of Analysts from Tenure with Tenure as Average coverage

1988 2,243 599 2.42 3.62 11.24

Panel C Sample selection

Year Uncovered firms Covered firms Covered firms with no DA

1988 1,408 1,576 623

3.2. Estimation of earnings management

Number Market-to- Return Growth Market Cash

Absolute discretionary accruals (Abs_DA) 1.00

Coverage: Market value Last year

4. The effect of analyst coverage on earnings management

4.1. Ordinary least squares regression

Dependent variable: number

Market value (in billions) 0.31

4.2. Expected coverage as instrument

Dependent variable: absolute value of discretionary accruals (Abs_DA)

External ﬁnancing activities 2.65 9.37 0.91 2.40 9.32 0.71

(0.01) (0.01) (0.01)

ExpectedCoverageitj ¼ ðBrokersizejt =Brokersizej0 ÞnCoveragei0 and

Residualoverageit ¼ ct þ ck þ f1 ExpectedCoverageit þ f2 Controlsit þ Zit

Aanalysts Analysts employed in year t Covergae from broker Expect

Number of analysts Absolute value of discretionary accruals

First stage Second stage

Expected coverage 1.04

4.3. S&P index dummy as instrument

4.4. The effect of change of analyst coverage

Number of analysts Absolute value of discretionary accruals

First stage Second stage

S&P index dummy 11.30

4.5. Covered versus uncovered firms

Dependent variable: change of absolute value of discretionary accruals

(1) (2) (3) (4) (5) (6) (7) (8) (9)

(0.00)* (0.00) (0.00)* (0.00) (0.00) (0.00) (0.00)*** (0.00)* (0.00)*

Dependent variable: absolute value of discretionary accruals

Ordinary least squares regressions

Firms with positive Firms with negative

Dummy of coverage 1.85 0.99 2.69

4.6. Discontinuity of distribution of earnings

An alternative measure of earnings management is to examine the discontinuity of earnings distributions

Quartile 1 low coverage Quartile 2

0.15 Narrowly miss 0.15

Quartile 3 Quartile 4 high coverage

DummyofMeetingEarningsT arg etit ¼ at þ gk þ bResidualCoverageit

(1) (2) (3) (4) (5)

(1.01) (0.97) (4.86)*** (3.55)** (0.86)

External ﬁnancing activities 3.81 3.73 3.49 4.04 6.68

5. Characteristics of analysts and earnings management

Dependent variable: absolute value of discretionary accruals

Experience as analyst Experience with ﬁrm

5.3. Test results

I estimate the following regressions:

(1.01) (0.97) (4.86)* (3.55) (0.86)