Bias and Accuracy of Management Earnings Forecasts: An Evaluation of the Impact of Auditing*

Abstract

This paper assesses how the bias and accuracy of managers' earnings forecasts in prospectuses were affected by a 1989 regulation that required the forecasts to be audited by public accountants. Theory suggests that auditors" association with the forecasts would reduce positive (optitnistic) bias, by reducing moral hazard. Regulators expected that the audit requirement would also improve the accuracy of the forecasts. Both predictions were tested using management earnings forecasts disclosed in prospectuses of Canadian initial public offerings. The results show that audited forecasts contained significantly less po.sitive bias than reviewed forecasts, but there was only a marginally significant improvement in accuracy.

Management disclosure bias and audit services

“…For example, some forecasts might tend to be overstated by pre-float owners/managers who are exiting the business, in an attempt to maximise their final payout. The potential for behaviour of this type has been discussed in the literature concerning prospectus disclosures (for example, McConomy, 1998) and in the broader accounting and finance literature on agency theory (Jensen and Meckling, 1976). 5 Pertinent to these points is the possible systematic biases that might be observed within management forecasts often published in Australian IPO prospectuses, but also within the normalised historic financial trend data.…”

“…First, management disclosure bias is investigated in the context of earnings forecasts disclosed in Australian IPO prospectuses and so the study adds to the little knowledge accumulated in this IPO context to date. In a recent paper documenting his Canadian study of IPO management forecast bias, McConomy (1998) acknowledged a limitation to his work and scope for further research in that "different results might apply to other jurisdictions . .…”

“…For the latter, see Copeland and Marioni (1972), Elton and Gruber (1972), Lorek et al (1976), Ruland (1978), Hagerman and Ruland (1979), and Imhoff, Jr. and Pare (1982). 2 Mak (1989), Keasey and McGuinness (1991a and b), Hartnett (1993), Lee et al (1993a), Pedwell et al (1994), Chan et al (1996), Baginski and Hassell (1997), McConomy (1998), Hartnett and Römcke (2000). 3 Notably McConomy (1998). Second, hypotheses are formulated and the research method is explained.…”

“…2 Mak (1989), Keasey and McGuinness (1991a and b), Hartnett (1993), Lee et al (1993a), Pedwell et al (1994), Chan et al (1996), Baginski and Hassell (1997), McConomy (1998), Hartnett and Römcke (2000). 3 Notably McConomy (1998). Second, hypotheses are formulated and the research method is explained. Third, the study's results are presented and finally, conclusions are discussed.…”

Analysis of IPO Dividend Forecasts for Australian LPTs

“…Two thirds of the forecasts were optimistic and the mean earnings forecast was 21.4% higher than the actual earnings. Similarly, McConomy (1998), in Canada, investigated 192 prospectuses for IPO companies that sought to list on the Toronto Stock Exchange between 1983 and 1994 and also found optimistic bias in the forecasts, with the mean average earnings forecast being around 6% higher than the actual earnings. Firth and Smith (1992) investigated 89 New Zealand IPOs between 1983and 1986 and found similar results regarding the accuracy of the forecasts in the prospectuses in that only 19% of the companies in the sample set reported earnings within 20% of their forecast.…”