An examination of the effect of the safe harbor rule on the prediction error of management earnings forecasts : some empirical evidence

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1988

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Abstract

The subject of management earnings forecast disclosures has received considerable attention over the years. The majority of research in this area has focused on the usefulness of management earnings forecasts to investors by examining either the relative accuracy or the information content of such forecasts. Management earnings forecasts have been found to be useful to investors even though the precise investors' decision models remain a subject of debate. Since management has access to undisclosed information and provides such information to selected parties (e.g., financial analysts) who might thereby obtain an unfair advantage, it has been argued that more meaningful disclosures are required to assist investors in making informed investment decisions. To reduce this information asymmetry problem, the SEC and the AICPA encourage the disclosure of management earnings forecasts and have provided several guidelines. For example, in 1976, the SEC issued a release to present its position on the voluntary disclosure of forecasts. Many companies, however, still refrain from disclosing their earnings forecasts to the public. The principal reason is the fear of legal liability if forecasts later proved to be incorrect Therefore, in July 1979, the SEC adopted a "safe harbor" rule to encourage voluntary disclosure of management earnings forecasts. This rule is designed to protect firms from legal liability as long as forecasts are prepared with a reasonable basis or disclosed in good faith. The objective of this study is to investigate the effect of the safe harbor rule on the prediction error of management earnings forecasts. Also, the combined effect of the safe harbor rule and each of three relevant variables on management earnings forecasts is examined. The three relevant variables are: the degree of management ownership control, the frequency of forecast disclosures, and the timing of forecast disclosures. Each of these three variables has been found in the previous studies to be significantly related to management earnings forecast disclosures. Management earnings forecasts made over a period of eight years (1975-1982) were examined in this study. Individual effects of the four independent variables were first observed in the error metrics. Then, further statistical tests were conducted to assess the significance of the hypothesized relationship between these variables and prediction errors of management earnings forecasts with the individual effect and the combined effect. Both nonparametric (i.e., Wilcoxon) and parametric (i.e., ANOVA) statistics were applied to test the hypotheses in this study. They resulted in identical statistical inferences. The results of this study suggest the following: (1) After the adoption of the safe harbor rule, more firms disclosed their earnings forecasts, but higher prediction errors of management earnings forecasts were also found. However, management forecasts observed in this study are still more accurate than analyst forecasts on average. (2) The relationship between the degree of management ownership control and prediction errors of management earnings forecasts was significant only for the firms in high BTE (barrier-to-entry) industry. The effect of the safe harbor rule was significant regardless of the degree of management ownership control even though its effect appeared to be greater for management-controlled firms than others. (3) The frequency and the timing of forecast disclosures demonstrated a significant relationship with prediction errors of management earnings forecasts, respectively. After the adoption of the safe harbor rule, not only more earnings forecasts were disclosed, but also earlier disclosures were encouraged. Specifically, routine forecast disclosures showed smaller prediction errors than non-routine forecast disclosures. Similarly, late forecast disclosures showed smaller prediction errors than early forecast disclosures. The impact of the safe harbor rule on management earnings forecasts is an important issue for the SEC. The results of this study provide some evidence regarding the effectiveness of the safe harbor rule in motivating firms to disclose earnings forecasts. In addition, this study provides valuable insights into the relationship of the three relevant variables to prediction errors of management earnings forecasts. Thus, the issues examined are relevant to both earnings disclosure regulations and the accounting research of management earnings forecasts. These findings also provide an association between the relative accuracy of management earnings forecasts and the behaviors of firms.

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Keywords

Corporate profits--Forecasting

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