Lisa Koonce

Management Earnings Forecasts: A Review and Framework

SYNOPSIS: In this paper, we provide a framework in which to view management earnings forecasts. Specifically, we categorize earnings forecasts as having three components—antecedents, characteristics, and consequences—that roughly correspond to the timeline associated with an earnings forecast. By evaluating management earnings forecast research within the context of this framework, we render three conclusions. First, forecast characteristics appear to be the least understood component of earnings forecasts—both in terms of theory and empirical research—even though it is the component over which managers have the most control. Second, much of the prior research focuses on how one forecast antecedent or characteristic influences forecast consequences and does not study potential interactions among the three components. Third, much of the prior research ignores the iterative nature of management earnings forecasts—that is, forecast consequences of the current period influence antecedents and chosen characteristics in subsequent periods. Implications for researchers, educators, managers, investors, and regulators are provided.

The persuasiveness of audit evidence: The case of accounting policy decisions

Abstract This study examines how auditors respond to precedents in accounting situations where authoritative guidance does not exist. Three experiments were conducted with practicing audit managers and partners from a Canadian Big Six accounting firm. The results show that auditors rely to a greater extent on precedents that are similar (versus not similar) to the problem situation. When the clients position on the accounting matter was known to the auditor and all available precedents pointed to the same treatment of the accounting issue in question, auditors did not heed the clients position. Rather, they used the available precedents to judge the appropriate accounting. In contrast, when the clients position was known and the available precedents were mixed in their implications for the appropriate accounting treatment, auditors tended to follow the clients position. These results are considered in light of issues of auditor independence and the accounting regulatory environment.

Judging the Risk of Financial Instruments: Problems and Potential Remedies

Although information that firms provide about financial instruments and derivatives should help investors judge risk, such information often is not effective for this purpose. We experimentally demonstrate that the labels firms use to describe financial instruments and derivatives cause investors to judge risk based on thoughts associated with the labels rather than the underlying economic exposures of those instruments. We also show that loss-only disclosures currently used to describe the market risks facing companies force investors to make assumptions or inferences to judge risk. These inferences are systematic and often incorrect. We test two possible disclosures that might remedy these problems. Our results show that labeling effects are not eliminated by additional disclosures explicating the underlying economic exposures, but that providing investors with upside and downside market-risk disclosures help them distinguish among firms using different risk management strategies. Implications for managers and regulators are provided.

Earnings Trend and Performance Relative to Benchmarks: How Consistency Influences Their Joint Use

Archival research shows that the market reacts to earnings trend as well as to earnings performance relative to analysts’ forecasts (i.e., benchmark performance). We conduct four experiments to investigate how and why investors react to these two measures when both are available over multiple time periods. Our results show that investors rely on an earnings measure only when it is consistent over time. When both measures are consistent over time, investors use them in an additive fashion, suggesting that they view them as providing different information about the firm. Further tests show that investors believe that earnings trend and benchmark performance each provides information about a firm’s future prospects and management’s credibility. Although judged future prospects fully explains the effect of earnings trend on investor judgments, neither judged future prospects nor management credibility completely explain the effect of benchmark performance. Our study has implications for firm managers and researchers.

The Effects of Norms on Investor Reactions to Derivative Use

Prior research indicates that a firms use of derivatives to manage business risks is viewed favorably by investors. However, these studies do not consider a potentially key factor in this setting—namely, the typical behavior (or norms) regarding derivatives by other firms in the industry or the firm itself. In this paper, we report the results of multiple experiments that test whether norms are influential in affecting investors’ evaluations of firms’ derivatives choices. Our results show that the generally favorable reactions to derivative use actually reverse and become unfavorable when firms’ derivative decisions are inconsistent with industry or firm norms. Somewhat surprisingly, though, we find that industry and firm norms are not viewed similarly by investors. These results expand our understanding of how investors respond to firms derivative use decisions and demonstrate the role of norms as factors that influence investors’ judgments in financial reporting settings. Our results have implications for firm managers making decisions about derivative use.

Behavioral Implications of the SEC Market Risk Disclosures

In this paper, we draw on judgment and decision making research to examine the behavioral implications of the SECs Financial Reporting Release No. 48 on derivative and market risk disclosures. While these disclosures have been examined from an empirical point of view, no research has investigated how these disclosures might affect the users. The purpose of our paper is to identify and analyze the behavioral implications of the new risk disclosures. We draw on research done in the judgment and decision making arena to analyze the likely behavioral consequences of these disclosures. Our paper identifies a number of areas for future research on the important topic of market risk.

A Model of Audit Judgment: Cognition in a Professional Context

Some twenty years ago the sociologist Talcott Parsons (1968) wrote of the importance of the professional in the structure of modern societies. More recently, Abbott wrote of the extensive influence of professionals in our lives: “They heal our bodies, measure our profits, save our souls” (1988, p. 1). Modern society continues to become more dependent on the judgments of professionals such as lawyers, physicians, and accountants. This increased dependence appears to be a natural consequence of both the general expansion of human knowledge and the efficiencies that arise from specialization. Professional judgments are characterized by the wealth of domain-specific knowledge that the professional brings to the judgment task and the existence of high stakes in many judgment settings. It is precisely this application of domain-specific knowledge in light of such high stakes that constitutes the essence of professional judgment.

Investors’ Reactions to Retractions and Corrections of Management Earnings Forecasts

Timely voluntary disclosure of information by companies sometimes results in erroneous disclosure that must be later retracted (i.e., withdrawn) and/or corrected (i.e., replaced with a corrected disclosure). Although such retractions and corrections appear to be relatively easy and costless ways to fix the erroneous disclosure, our results generally show that both actions have unexpected effects on investor judgment. The results of four experiments, which are consistent with affect theory from psychology, indicate when a company provides a retraction of a previous erroneous voluntary disclosure, investors’ judgments continue to reflect the implications of the initial erroneous information. That is, investors under-adjust. In contrast, when a company provides a correction (alone or with a prior retraction) with an opposite earnings implication, investors tend to over-adjust. Our results also show that if investors do not form a strong initial affective reaction to the initial erroneous forecast, they are less prone to over-adjustment when the correction is later received. Implications for regulators and standard setters are provided.

Investor Reactions to Derivative Use: Experimental Evidence

How do investors evaluate managers who choose to use or not use derivatives once the outcomes of those decisions become known? Competing theories make different predictions, and we test these in three experiments. Results show that even when outcomes are held constant, investors are more satisfied and assign a higher value to a company that uses derivatives than to one that does not use derivatives. This finding is consistent with decision justification theory. Additional tests reveal that this result occurs because investors believe that firm managers who use derivatives to address risk exposures exhibit a higher level of decision-making care. In contrast, we find that speculative use of derivatives is not assumed to result from careful thought, resulting in harsher judgments about management. Overall, our study adds to our understanding of how investors judge companies who use derivatives, given the outcomes that result from such use.

Firms with Inconsistently Signed Earning Surprises: Do Potential Investors Use a Counting Heuristic?

Although prior research reports that firms that consistently beat their earnings expectations are rewarded with a market valuation premium, most firms are inconsistent in the signs of their benchmark performance, sometimes missing and sometime beating. In this paper, we report the results of multiple experiments to test the idea that potential investors, evaluating firms that have inconsistent benchmark performance, use a counting heuristic to discriminate among them. Our results provide strong support for the hypothesis that these investors distinguish among firms by counting the number of beats and misses they experience over an observed time interval. The judgmental effect of this beat-frequency is incremental to the effect of the magnitude of the beats and misses of the benchmark. Our study has implications for researchers and firm managers.