How credible are management forecasts? Not very (page 3 of 3)

Since bad news forecasts are every bit as likely to be strategically manipulated as good-news forecasts, it's crucial to view both of them skeptically. Look carefully for any incentives management may have in making their forecasts and assess what these incentives are, Stocken suggests. "If you look at much of the academic literature out there, you would think bad news is credible. But it's not good for investors to think that way."

For managers, the message is to try to overcome public skepticism by developing a reputation for forecasting truthfully. They can do this by helping investors evaluate the integrity of their forecast, reconciling the forecast to the earnings announcement that's been examined by the firm's auditors (assuming, of course, that the public believes earnings announcements can still be trusted). After all, a discrepancy doesn't always mean management was dishonest in the forecast. Macroeconomic circumstances can change a lot in 190 days, as can competitive positions. If management can point to specific circumstances that explain, say, a 10-cent discrepancy in earnings, investors will probably accept that explanation." "Investors might even be more inclined to [accept] subsequent forecasts if the manager has a history of reconciling forecasts," says Stocken.

Finally, for policymakers, the study indicates that it may be time to re-examine the 1995 extension of safe-harbor provisions. One of the study's most important conclusions is that managers are more tempted to manipulate forecasts if they are less likely to be exposed for it. With the 1995 legislation, they are less likely to be sued because a plaintiff is now required to prove that a forecast was made in bad faith, meaning made with actual knowledge that it was false or misleading. Simple reckless or incompetent forecasting is no longer enough to get a manager sued.

Bad faith is obviously an extremely tough case to prove, which is why critics of the legislation initially branded the law a "license to lie," Stocken notes. The law's proponents claimed that market forces - like impact on a manager's reputation - would induce truthful forecasts. But Stocken says that the results of this study indicate that market forces may not be enough. "You have to be very careful about generalizing from this very small study that the law should be revisited or changed, because there are many forces at play," he warns. "But you can certainly raise questions about this piece of legislation. It's at least cause for debate."



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