Disaggregating Management Forecasts to Reduce Investors’ Susceptibility to Earnings Fixation

Abstract

This study examines disaggregated management forecasts as a mechanism to reduce investors’ fixation on announced earnings. Our experimental results suggest that investors’ earnings fixation is reduced when they initially observe a disaggregated management forecast (earnings and its components) versus when they observe an aggregated forecast (earnings only). We also provide theory-consistent evidence that this reduction in earnings fixation is associated with investors interpreting the summary net income figure as one of several similarly important evaluation inputs rather than a substantially more important input (relative to its components). Finally, we provide evidence that suggests our results are not bounded by the level of emphasis on net income in the subsequent earnings announcement, and not fully explained by three plausible alternative explanations. Our study extends the voluntary disclosure literature by providing evidence that the form of management disclosures can influence investors’ interpretation of subsequently announced information, and contributes to practice by providing a potential alternative to stopping earnings guidance.

Level of business insights in the MD&A and nonprofessional investors' judgments

“…Similarly, when investors receive high-insight MD&A, they are more likely to rely on the details to understand a firm's earnings if the earnings results in a negative surprise than a positive surprise. The latter prediction is also consistent with the finding from Elliott et al (2011) and Merkley et al (2013) that disaggregation will have a more significant effect on investor judgment when the underlying earnings information is unfavourable than when it is favourable. As a result, high-insight MD&A, when it includes a plausible external attribution, is expected to lead investors to decrease their judgments of earnings persistence more significantly when it is for a negative earnings surprise than for a positive earnings surprise.…”

“…According to Elliott et al (2011) and Hirst et al (2007), disaggregated earnings information is defined as the bottom-line earnings numbers plus the details on how a firm achieves the key components of its earnings. In contrast, aggregated earnings information includes only the bottom-line earnings numbers.…”

Response of the EAA Financial Reporting Standards Committee to the IASB Discussion PaperA Review of the Conceptual Framework for Financial Reporting

“…To be clear, the difficulty here is not with the claim that some form of profit or loss subtotal is useful, nor indeed that users also benefit from other such aggregations and subtotals on the face of the financial statements, such as gross profit (Elliott et al, 2011;Bloomfield et al, forthcoming). In general, the notion is well established in the literature that different categories of information are used in different ways, not least because they have different value-relevance, and in general the literature supports the type of distinction that is currently made between 'earnings' and comprehensive income (Dhaliwal et al, 1999;O'Hanlon and Pope, 1999;Barton et al, 2010;Young, 2014).…”

Financial estimates against investors’ preferences: anchoring, denial and spillover effects

“…Nevertheless, existing research suggests that although many non-professional investors use filtered information provided by professional intermediaries, some use unfiltered information disclosed by company management, such as 10-Ks (Hodge and Pronk 2006, Elliott et al 2008, Pennington and Kelton 2016. Importantly, financial regulators consider such investors in regulating financial disclosures (Elliott et al 2011, Financial Reporting Council 2017.…”

“…Much previous financial accounting research has focused on the decision usefulness of the accounting information provided (see, for example, , Elliott et al 2011, Nelson and Rupar 2015, with implications for policy, the quality of financial information and the need for investor education programmes. In a similar vein, this study examines how investors use one of the most prominently disclosed sources of accounting information, namely sensitivity disclosures.…”