Management Forecast Quality and Capital Investment Decisions

Abstract

ABSTRACT:Corporate investment decisions require managers to forecast expected future cash flows from potential investments. Although these forecasts are a critical component of successful investing, they are not directly observable by external stakeholders. In this study, we investigate whether the quality of managers' externally reported earnings forecasts can be used to infer the quality of their corporate investment decisions. Relying on the intuition that managers draw on similar skills when generating external earnings forecasts and internal payoff forecasts for their investment decisions, we predict that managers with higher quality external earnings forecasts make better investment decisions. Consistent with our prediction, we find that forecasting quality is positively associated with the quality of both acquisition and capital expenditure decisions. Our evidence suggests that externally observed forecasting quality can be used to infer the quality of capital budgeting decisions within firms.

Common auditors and cross-country M&A transactions

“…In complex deals or where the acquirer lacks prior M&A experience, investment bankers are usually appointed (Servaes and Zenner, 1996) to alleviate M&A uncertainty by providing acquirers with advise on target valuation, deal price and structure (Goodman et al, 2014). In a similar vein and more related to our study, Agrawal et al (2013) and Cai and Sevilir (2012) show that shared investment advisors and interlocked directors significantly influence M&A quality by reducing information asymmetry in the M&A transaction.…”

“…Asquith et al, 1983;Bradley et al, 1988;Cai and Sevilir, 2012;Agrawal et al, 2013;Goodman et al, 2014;Cai et al, 2016) we use acquisition announcement returns as our main measure of M&A quality and expect common auditors to be associated with higher acquisition announcement returns. Subsequently, we test whether other proxies used in prior literature to capture M&A quality, give us similar results.…”

The relation between disclosure quality and reporting quality: A discussion of Cassell, Myers, and Seidel (2015)

“…Managers may prefer to understate earnings when (1) the excess earnings would not translate into extra compensation for the current period or would not be sustainable in the future, (2) the management has just taken over the firm, (3) firms want to avoid political or union attention, or (4) firms want to avoid renegotiations with major suppliers and customers. Moreover, given the reversal property of accounting 4 An interesting study by Goodman, Neamtiu, Shroff, and White (2014) examines the relation between management forecast quality and investment efficiency based on the intuition that managers use the same forecasting skills in both tasks. accruals, it is infeasible for managers to use their discretion to report higher earnings year after year.…”

A Review of the IFRS-Adoption Literature

“…Several studies show that better reporting quality decreases information asymmetry between insiders and outsiders, which in turn attracts capital to positive net-present-value projects and increases investment opportunities by lowering investors' required returns (e.g., Biddle, Hillary, and Verdi 2009;Raman, Shivakumar, and Tamayo 2012;Goodman, Neamtiu, Shroff, and White 2014). Better financial reporting quality also enhances the effectiveness of corporate governance mechanisms and thus mitigates managerial excesses, including under-and overinvestments.…”