When managers issue a forecast of their firm's earnings, they do not always take into account prior forecasting errors, according to research in the current issue of the Journal of Business Finance & Accounting.
Weihong Xu, assistant professor of accounting in the University at Buffalo School of Management, analyzed more than 11,000 firm-quarter observations. She found that managers often underestimate the implications of their past forecasting errors when forecasting earnings.
This underestimation of past errors can affect how the market responds to a new earnings forecast. Specifically, it can contribute to "post-earnings announcement drift;" that is, stock prices continue to drift in the direction of the initial price response to an earnings announcement.
"Managers underestimate the information in their prior forecast errors to a greater extent when they make earnings forecasts with a longer horizon," Xu says.
She notes that further study is needed to see if the underestimation is intentional on the part of management in order to provide biased forecasts.
- Weihong Xu. Evidence That Management Earnings Forecasts Do Not Fully Incorporate Information in Prior Forecast Errors. Journal of Business Finance & Accounting, 2009; 36 (7-8): 822 DOI: 10.1111/j.1468-5957.2009.02152.x
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