Did Analyst Forecast Accuracy and Dispersion Improve after 2002 Following the Increase in Regulation?

This article examines the accuracy and dispersion of analyst earnings forecasts from October 1993 to September 2013. The authors found an improvement in these forecast properties in the short run following various regulations in the early 2000s. Over the extended period, however, forecast accuracy significantly declined and dispersion significantly increased. The results are robust to various sensitivity tests and indicate that these regulations did not collectively improve the information environment despite the reduction in analyst conflicts of interest. The problem seems to be largely due to the quality of financial reports. In the early 2000s, several high-profile accounting scandals and violations of securities laws triggered concerns about the reliability and accuracy of corporate disclosures and suggested that investors were being misled by biased analyst forecasts and recommendations. These concerns led to the passage of Regulation Fair Disclosure, the Sarbanes–Oxley Act (SOX), and the Global Analyst Research Settlement in the early 2000s. These regulations were intended to reduce analyst biases due to conflicts of interest and to restore investor confidence in the financial reports of public companies by improving the reliability of companies’ disclosures and governance quality. The improvements in the quality of information available to market participants (including analysts), in turn, were expected to reduce analyst forecast error and dispersion. Prior research has generally shown an improvement in the information environment and in analyst forecast accuracy and dispersion in the few years after the regulations (supporting association but not proving causation). Whether such improvements persisted in the long run is the question that this article addresses. Specifically, we examined the patterns in the properties of analyst forecasts made from October 1993 to September 2013 to determine whether analyst forecast accuracy and dispersion improved in the short term and long term after the regulations. Obviously, as with prior studies, we were not able to attribute any observed improvement to a specific regulation. Given that all the regulations were aimed at improving the accuracy and reliability of accounting information and reducing analyst conflicts of interest, however, the absence of any lasting improvement in analyst forecast properties suggests that, ultimately, these regulations were collectively ineffective in achieving their objectives. Our univariate and multivariate tests indicate that the level and reliability of companies’ disclosures improved slightly in the few years after the regulations (i.e., forecast error and dispersion trended downward during the short-term post-regulation period). Our tests show, however, that analyst forecast error and dispersion significantly increased over the long-term post-regulation period. Therefore, even if we assume that these regulations caused the improvement in the observed analyst forecast properties in the short run, they did not have a lasting effect. The results are robust to alternative measures of error and dispersion, specifications of pre- and post-regulation periods, and sample composition, and they imply that these regulations did not collectively improve the information environment despite the reduction in analyst conflicts of interest. The continued problem with the information environment, therefore, seems to be largely due to the quality of financial reports. Given that the improvement in forecast properties is not sustained, we conclude that there is no improvement in—and there may actually be a reduction in—the quality of information from financial analysts in the long run. The initial improvements in forecast properties after these regulations were implemented may have been in response to the increased scrutiny companies and analysts experienced immediately after the passage of the regulations. For example, the increased legal liability associated with SOX may have made managers less willing to disclose “softer” information. Therefore, a future research question is whether regulations in general lose their effectiveness in the long run, either because managers and others find ways to avoid violating the regulations while pursuing their agenda or because the fear of penalties subsides over time (reflecting the Hawthorne effect and availability bias). Our findings suggest that regulators need to weigh the cost of regulations against both their short- and long-term benefits and that investment practitioners must recognize that regulations may or may not have the intended consequences for the reliability and accuracy of information reported by companies and analyst forecasts, at least in the long run. Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.