Voluntary Management Earnings Forecasts and Value Relevance in Financial Reports

ABSTRACT

We propose a positive association between voluntary MEFs and the value relevance of earnings in audited financial reports based on the confirmation, signaling, and expectation management effects of voluntary MEFs. China is characterized by a weaker information environment, which provides a meaningful institutional setting for testing the usefulness of MEFs. We find that firms that provide voluntary MEFs have significantly higher value relevance of earnings and earnings components (i.e., operating cash flows and normal/abnormal accruals) in financial reports. We also find that the specificity of MEFs is associated with higher value relevance of earnings. In a placebo test, we do not find a similar relation between MEFs and the value relevance of balance-sheet items in most regressions, indicating that our findings are unlikely to be driven by other differences in fundamentals. Our findings are robust to different research designs and confirm the usefulness of voluntary MEFs in emerging markets.

KEYWORDS:

• Management earnings forecasts
• value relevance
• financial reports
• forecast characteristics
• Chinese listed firms

Notes

1. Although other types of voluntary disclosure, such as environmental/social responsibility, are also relevant to stakeholders, their association with the value relevance of financial reports might be limited because of the lack of comparability and verifiability.

2. Voluntary MEFs might also be provided by managers to mitigate expected litigation risks (Skinner 1994, 1997), which is discussed in the section “Background and hypothesis.”

3. https://www.cnbc.com/2017/06/21/msci-puts-china-mainland-stock-in-indices-but-theres-a-catch.html.

4. In December 2000, Chinese stock exchanges required firms to expedite information release by issuing warnings if managers anticipate a loss for the current year. In December 2001, the exchanges expanded the scope of mandatory forecasts to include anticipated large changes in earnings (i.e., earnings increases or decreases of at least 50% over the previous year). In 2004, mandatory forecasts were required in an additional circumstance: anticipated profit in the current year after a loss in the prior year. These thresholds for earnings changes and levels comprise earnings information that regulators deem especially material (Huang et al. 2018).

5. The confirmation, signaling, and expectation management effects may coexist and complement one another, together predicting a positive relation between voluntary MEFs and the value relevance of earnings. We admit that it is difficult to differentiate those effects of voluntary MEFs, as they have the same direction. Regardless of the effects, we predict that voluntary MEFs convey useful information to investors and then enhance the value relevance of earnings. As mentioned elsewhere, voluntary MEFs are unlikely to be explained by litigation risks as the overall litigation risks are not prominent in China. So, we exclude the explanation of litigation risk in prior studies on developed countries.

6. Although market prices may react differently to a profit and loss (Collins, Pincus, and Xie 1999; Zhang 2014), we do not control for it because our sample does not include firms reporting a loss, which are required to submit MEFs in China.

7. We use SGROW to capture the opportunity for growth and product market risk for a company, as in Yu (2013), which ensure larger sample size. Results are substantially the same if we strictly follow Lai and Krishnan (2009) and use earnings growth in three consecutive years.

8. In our sample, about 89% of the observations do not have multiple yearly voluntary MEFs. Our main results are robust if we drop the observations with multiple yearly voluntary MEFs.

9. As recommended by one of the reviewers, we also add a principal component analysis of four governance factors: LARGEST, INST, AUDSIZE, and SUSPECT. We generate a dummy called CGscore based on the mean of the PCA scores calculated by the weighted total of the first two principal components. Subsample regression results show that our findings are more dominant for firms with a lower CGscore and suggest that the significantly higher value relevance of earnings for firms providing voluntary MEFs are probably not attributable to better governance (untabulated and available upon requests).

10. The interaction corrected treatment effects model is adopted because the endogenous treatment variable MEF interacts with other variables in the second-stage regression. This model fits a treatment-effects model with a similar computational logit and produces corrected predictions on the dependent variable with interaction terms on the treatment variable. The command for this program in STATA 14 is “itreatreg.”

11. Results are robust when we use last year’s values of EARN, BE, and SGROW in the first-stage probit regression.

12. The performance of financial analysts in China is frequently questioned and criticized. In May 2016, for example, an article in Bloomberg was titled “China Stock Analysts Were among World’s Worst amid Surprise Rout.”

13. We also run an interaction corrected treatment effects regression based on the second return model as in Table 4. We find the results still support our hypothesis.

14. The total proportion of the exempted firms in our sample is less than 4%.

15. MEFs may even reduce ERCs to some degree because they “leak” earnings information prior to financial reports.

Additional information

Funding

This work was supported by the National Natural Science Foundation of China [71302146,71472148]; Outstanding Accounting Scholar Training Project of China Ministry of Finance [CK[2015]14].