Analysts' Earnings Forecasts: Implications for Managed Earnings Via Pension Expense

INTRODUCTION Analysts' earnings forecasts create capital market incentives for firms to manage bottom-line reported earnings. This study examines whether or not pension expense is strategically used by firms to manipulate reported earnings in the direction that will move them closer to their analysts' earnings forecasts than they would otherwise be without the earnings manipulation. The primary motivation for this study is the integrity of financial statement reporting because it is vitally important to capital markets. Various stakeholders, such as investors, creditors, directors, auditors, regulators, standard setters, and academicians rely heavily on the integrity of financial statement reporting in assessing firm value and in making a wide range of business decisions. Therefore, when the true economic condition of a firm is distorted by financial statement manipulation the ultimate outcome is poor decisions based on flawed information. Capital markets are weakened and public confidence in the accounting profession is impaired as a result of financial statement manipulation. For these reasons, this study is relevant to decision makers in today's business environment and makes an important contribution to accounting literature. This study extends earlier research by not limiting the sampling technique to only those firms with actual reported earnings in the vicinity extremely near their analysts' earnings forecasts. This allows for a broader array of firms to be included in this study and not just those firms expected to exhibit the strongest sensitivity to manage earnings. The research design raises public awareness and provides pertinent information about the predicted directional change in pension expense that is crucial in detecting and preventing future earnings management of this kind. This study provides basic information and practical analyses for stakeholders, particularly standard setters, to more carefully monitor the changes in pension expense to reduce future financial statement manipulation. A common obstacle associated with attempting to identify financial statement manipulation is that of determining what a firm's financial statements would report absent the manipulation. The Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions (SFAS No. 87), provides a unique measure of what pension expense should be from year to year based on its built-in corridor smoothing (1) technique. Firms are allowed to smooth pension expense to avoid the immediate recognition of wide swing market fluctuations that affect pension investments. The rationale behind the allowed smoothing of pension expense is a long-term perspective where market fluctuations are expected to average out smoothly over the long-term. This technique allows for the reasonable estimation of what a firm's pension expense would be absent manipulation. A basic characteristic of the research design is modeling the behavior of pension expense to identify its discretionary and nondiscretionary components. This study builds on an approach similar to the random walk approach whereby the prior year's pension expense is assumed to be the most relevant and reliable approximation for predicting the current year pension expense. Theoretically, pension expense is expected to be the same from year to year. Therefore by design, any change in pension expense from year to year is considered discretionary and is the primary focus of explanation in this study. In addition, the specific accruals research design is used because it is powerful in detecting earnings management because the explanatory factors for the discretionary portion of pension expense are tested directly. An earlier study by Powall et al. (1993) finds evidence that earnings forecasts are value relevant, and thus, establishes their importance in capital markets. Investors often use analysts' earnings forecasts in assessing firm value rather than using more costly and complex valuation tools. …