Academic journal article Multinational Business Review

An Investigation of Asymmetric Earnings Forecasts of Japanese Financial Analysts

Academic journal article Multinational Business Review

An Investigation of Asymmetric Earnings Forecasts of Japanese Financial Analysts

Article excerpt

ABSTRACT: A number of U.S. studies have documented an optimistic bias in analysts' forecasts of earnings. This study investigates whether the optimistic bias and asymmetric behavior of forecast errors found in most U.S. studies exists in Japan. We find that for firms reporting profits, Japanese analysts' forecasts have much greater accuracy and exhibit a small pessimistic bias in comparison to firms reporting losses, where analysts' forecasts exhibit extremely poor accuracy and an extremely significant optimistic bias. The lack of ability to forecast losses is due to their transitory nature and not due to earnings management. Forecast accuracy and bias are not related to firm size, but are related to the magnitude of reported losses and profits.

INTRODUCTION

Forecasts of corporate profits influence the price of corporate stocks. When a firm announces that earnings will not be as large as the forecasted value, the firm's stock price immediately falls. In a similar way, when a firm earns higher profits than that forecasted, the company's stock price increases. Numerous studies in accounting and finance have found results suggesting that earnings forecasts made by U.S. analysts display an optimistic bias (i.e., forecasted earnings exceed actual earnings).1 A number of explanations have been offered regarding this phenomenon. Some studies focus on the behavior of analysts making the forecasts while others focus on the behavior of the managers of firms whose earnings are being forecasted.

With respect to the analysts, one argument is that those making forecasts may have incentives to overestimate earnings (Philbrick and Ricks, 1991; Dugar and Nathan, 1995), while another explanation is simply that the analysts are not able to make rational forecasts of earnings. With respect to the latter, Dowen (1996) and Hwang et al. (1996) find that analysts have difficulty predicting losses and large profits because of the highly transitory nature of these occurrences.2

A second line of reasoning focuses on the behavior of managers and explores whether the optimistic bias is the result of certain kinds of earnings management or, possibly, the result of firms having the ability to manage analysts' forecasts. With regard to earnings management, Brown (1998) argues that an optimistic bias (forecast > actual earnings) often exists when managers expect to report losses, because they may take efforts to exacerbate the loss (leading to a large optimistic forecast error) hoping to have a more prosperous following year.3 But when managers expect profits, a slight pessimistic bias (forecast < actual earnings) often exists because they attempt to exceed the analyst's forecasts by a small amount. An additional source of manipulation of the forecast error is a firm's management, through its communications with analysts, influencing the analysts' forecasts (forecast management). In a recent speech, Arthur Levitt, former chairman of the Securities and Exchange Commission (SEC) articulates these issues:

"This is the pattern earnings management creates: companies try to meet or beat Wall Street earnings projections in order to grow market capitalization and increase the value of stock options. Their ability to do so depends on achieving the earnings expectations of analysts. And analysts seek constant guidance from companies to frame those expectations." (Levitt, 1998).

A major objective of this study is to investigate whether the optimistic bias and asymmetric behavior of forecast errors found in most U.S. studies exists in Japan. There are a number of reasons that we focus on Japanese firms. First, while Japan has the second largest stock market in the world with over 343 trillion yen in market value of stocks on the Tokyo Stock Exchange-First Section as of February 2001, there has been little investigation of biases in analysts' forecasts of Japanese firms. Second, large amounts of U.S. and international funds have flowed into the Japanese stock market and, as such, international investor interest in Japanese stocks is high. …

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