Earnings forecast disclosure regulation and earnings management evidence from Taiwan IPO firms

1、 earnings forecast disclosure regulation and earnings management: evidence from taiwan ipo firms bikki jaggi*faculty of managementschool of businessrutgers university - new brunswickpiscataway, nj 08854email: tel: (732) 445-3539chen-lung chindepartment of accountingnational cheng

2、 chi universitytaipei, taiwanhsiou-wei william lindepartment and graduate institute of international businessnational taiwan universitytaipei, taiwainpicheng leedepartment of accountinglubin school of businesspace universitynew york, ny 10038 march 2005*correspondence authorwe received valuable comm

3、ents at the 2003 american accounting association and 2004 euorpean accounting association annual meetings. we also thank the participants at the research seminars at rutgers university, city university of hong kong, and pace university, for their insightful comments. picheng lee especially thanks pa

4、ce university for 2003 summer research grant.earnings forecast disclosure regulation and earnings management: evidence from taiwan ipo firms abstractthis study examines whether the taiwanese regulation requiring disclosure of earnings forecasts in the ipos resulted in disclosure of more optimistic o

5、r conservative earnings forecasts. additionally, it examines whether the firms reduced the forecast error by manipulating the reported earnings or revising earnings forecasts to meet the forecast error threshold. the study is based on 759 forecasts issued by the taiwanese ipo firms from 1994 to 2001

6、, i.e. 8-year period after the regulation was modified to increase the forecast error threshold to 20%.the findings show that the disclosure regulation on earnings forecasts resulted in more optimistic forecasts than conservative forecasts, especially for firms that expected better performance in th

7、e forecast year compared to the previous year. firms, especially those who had optimistic earnings forecasts, engaged more in manipulation of reported earnings than revision of forecasts to meet the forecast error threshold. these findings thus suggest that the disclosure regulation resulted in mani

8、pulation of reported earnings, which reduced the earnings quality. key words: earnings management, disclosure regulation, discretionary accruals, mandatory earnings forecasts, forecast error threshold. earnings forecast disclosure regulation and earnings management: evidence from taiwan ipo firms i.

9、introductionin 1991, the taiwan securities and futures exchange commission (tsfec) issued a regulation requiring the ipo firms to include annual earnings forecasts in the ipo prospectuses and also disclose forecasts for two years subsequent to the issuance of ipo the tsfec issued “guidelines for dis

10、closure of financial forecasts by public companies”, which required the companies desiring to list with the taiwan stock exchange (tse) to disclose financial forecasts pursuant to the listing. the preparation of financial forecasts shall be subject to the statements of financial accounting standards

11、 no. 16 ”preparation of financial forecasts” published by the accounting research and development foundation of republic of china in taiwan. the underlying objective of this regulation is to reduce asymmetry of information among insiders and investors at large by disseminating forecast information t

12、o all potential investors on a fair and equitable basis the tsfecs administrative rule (no. 82-taiwan-finance-securities-(vi)-02581 issued on october 30, 1993) mentions that disclosure of forward looking information will reduce information gap between informed and uninformed traders, and this will f

13、inally prevent the use of inside information for making arbitrary profits. . the provision for forecast revision is apparently included in the regulation to encourage firms to revise their forecasts rather than manipulate the reported earnings to meet the forecast error threshold set by the regulati

14、on. lower earnings manipulation is expected to result in better quality of reported earnings and thus improve the usefulness of earnings information of the ipo firms. this study empirically tests whether as a result of this disclosure regulation, more optimistic than conservative forecasts were issu

15、ed, and whether the expectation of better future operating performance was associated with disclosure of optimistic forecasts. additionally, it examines whether the forecast error, especially of optimistic forecasts, was reduced by manipulating the reporting earnings using positive discretionary acc

16、ruals or revising the earnings forecasts. it can be argued that the ipo firms are likely to issue more optimistic forecasts for sending positive signals to the market, and they will especially do so when they expect higher operating performance during the forecast period compared to the previous yea

17、r. if the forecast error of optimistic forecasts exceeds the forecast error threshold set by the regulation, managers will be motivated to manipulate the reported earnings upward than revising the forecasts downward. upward adjustment of reported earnings will be preferred over downward revision of

18、forecasts because downward revisions may be interpreted as a negative signal. in the case of conservative forecasts, managers may have an option either to revise the earnings forecasts upward, which will provide a positive signal to the market, or adjust the reported earnings downward and use the sa

19、ved earnings in the future periods. the study is based on 759 earnings forecasts that were disclosed by 253 taiwan industrial ipo firms from 1994 through 2001 the regulation was issued in 1991 and the forecast error threshold was originally set at 10% of forecasts. in 1994, the forecast error thresh

20、old was revised to 20%. in order to have uniform sample for the study, we focus on ipos issued after the forecast error threshold was revised, i.e. 1994. discretionary accruals are used as a proxy for earnings management, and an ex-post change in the return on assets (roa) is used as a proxy for exp

21、ectation of better future operating performance by ipo firms. ols regression and logit regression analyses are conducted to evaluate the association between optimistic forecasts and expectation of better operating performance in the forecast year. reduction in the forecast error as a result of forec

22、ast revisions and earnings management is evaluated by conducting t-tests and non-parametric wilcoxon tests. the results of this study show that the taiwanese ipo firms issued more optimistic forecasts than conservative forecasts after the disclosure regulation was issued. the ols and logit regressio

23、n results show a positive association between optimistic forecasts and positive change in roa in the forecast year compared to the pre-forecast year. this finding supports the expectation that the ipo firms issued more optimistic forecasts especially when the firms were expecting better operating pe

24、rformance during the forecast year. the results with regard to the reduction of forecast error show that the forecast error threshold is met mostly by adjusting the reported earnings with discretionary accruals than revising the forecasts. the results especially indicate a higher adjustment of repor

25、ted earnings with positive discretionary accruals for optimistic forecasts compared to conservative forecasts. these results support our expectation that the forecast error is reduced more by manipulating the reported earnings than revising the forecasts, which would mean lower quality of reported e

26、arnings. these findings thus suggest that the regulation has not achieved the objective of improving the usefulness of earnings information. the study makes the following important contributions to the accounting literature. first, the findings show that mandatory disclosure of earnings forecasts is

27、 likely to result in more optimistic forecasts by ipo firms. second, managers are likely to manipulate the reported earnings to meet the forecast error threshold, especially of optimistic forecasts, and this will reduce the quality of reported information. thus, a mandatory regulation for disclosure

28、 of earnings forecasts, especially in countries that are associated with low legal investor protection, i.e. developing countries in the south east asian region, is not likely to improve the usefulness of earnings information for investment decisions and reduce the asymmetry of information between i

29、nsiders and investors at large.the remainder of the paper is organized as follows. in the part ii, we briefly describe the tsfec regulation and provide literature review related to the study. the research design is discussed in part iii, which includes discussion on hypotheses, research methodology

30、used in the study, and sample selection procedures. the results are presented in part iv and conclusion is provided in part v.ii. tsfec regulation and literature review1. tsfec regulationdisclosure of earnings forecasts on a voluntary basis is not common in countries with developing economies our in

31、vestigation indicated that the taiwan ipo firms rarely issued earnings forecasts before the tsfec regulation. moreover, the development of earnings forecasts by security analysts is not a common phenomenon in taiwan. consequently, investors, who have no access to inside information, depend on source

32、s other than disclosures by managers for forward-looking information. thus, non-availability of reliable information on the firms future operating performance to all potential investors on an equitable basis results in significant information asymmetry between informed and uninformed investors. in o

33、rder to reduce information asymmetry for ipo firms, the tsfec issued a regulation in 1991 that made it mandatory for taiwan ipo firms to include earnings forecasts in their ipo prospectuses and also disclose earnings forecasts for two years after issuance of ipos. the tsfec regulation also stipulate

34、s penalty for firms that do not meet the forecast error threshold. the firms violating the forecast error threshold are not allowed to raise additional capital in the market without special permission. though the original threshold was set at 10% of forecast error, it was revised to 20% effective 19

35、94. according to the revised forecast error threshold, the actual reported earnings shall not deviate more than 20% from the predicted earnings in either direction. the firms are, however, allowed to revise their forecasts without any restriction on the number of revisions before actual earnings are

36、 reported the tsfec regulation has placed no limit on the number of revisions so long as the revisions are issued before the actual earnings are reported. the intended objective of allowing forecast revisions is probably to encourage managers to issue more realistic earnings forecasts. the tsfec may

37、, however, also ask the firms to revise the earnings forecasts if it considered that the forecasts were unrealistic examples of the directives to revise the forecasts are found in the following article, which is excerpted from china times press dated october 14, 1998: “after the two cases of unduly

38、biased management forecasts done by tung-ho steeland action electronics, tsfec has requested eight more firms to revise their financial forecasts. since there are many other firms coming out with downward forecast revisions, it is expected that more firms will show up on tsfecs sanctioning list.”. i

39、f violating firms intend to raise additional capital in the market, they are required to request for a review process tsfecs attitude plays an important part in the process of ipo application. as stated in article 12 of the criteria governing the offering and issuance of securities by securities iss

40、uers in taiwan, new shares of a listed company can be issued upon approval of tsfec. if a firm is required by the tsfec to correct the publicly disclosed financial forecast for two times in the year of application or during the two previous years or even the financial forecasts are modified more tha

41、n two times in any year, the tsfec may not allow a firm to raise equity or debt capital in the market.2. literature review though, to the best of our knowledge, there is no requirement for issuing earnings forecasts by ipo firms in any country, some countries, however, allow disclosure of earnings f

42、orecasts by the ipo firms on a voluntary basis. we briefly review the literature dealing with earnings forecasts issued by ipo firms (included in the ipo prospectuses) in the uk, new zealand, australia and canada on a voluntary basis to examine whether the forecasts are more optimistic or conservati

43、ve and how the forecast error is reduced we focus on these countries because the existing literature discusses the earnings forecasts included in the ipo prospectuses by firms in these countries. additionally, we discuss relevant studies on earnings management by us ipo firms and disclosure of earni

44、ngs forecasts on a voluntary basis by us firms. the literature review indicates that, on an overall basis, disclosure of earnings forecasts by ipo firms on a voluntary basis did not result in disclosure of more optimistic forecasts in the uk, new zealand, australia, and canada, probably because of w

45、ell developed financial markets in these countries. the findings of studies on the forecasts issued by the uk ipo firms indicate that these forecasts have generally been more conservative than optimistic, i.e. the reported earnings are generally higher than earnings forecasts (e.g. dev and webb, 197

46、2). thus, there has been no need to adjust the reported earnings upward to reduce the forecast errors. similarly, the forecasts included in the ipo prospectuses of new zealand firms are also reported to be more conservative (e.g. firth and smith, 1992). prior to 1991, the australian firms rarely dis

47、closed earnings forecasts in the ipo prospectuses, and if the forecasts were disclosed, they were found to be highly inaccurate (e.g. brown, et al., 2000). after the 1991 corporations law, there has been an increase in the frequency of forecasts included in the ipo prospectuses, and their accuracy a

48、lso improved (how and yeo, 2001). these studies, however, do not evaluate how the forecast error is reduced.though the ontario securities commission allowed the canadian firms to include earnings forecasts in their ipo prospectuses on a voluntary basis from 1982, the firms rarely included the earnin

49、gs forecasts in their ipo prospectuses. according to clark, et al. (1992), the canadian ipo firms disclose earnings forecasts only when they believe that the forecasts would improve market expectations. earnings forecasts are rarely included in the ipo prospectuses of the us firms. the findings of s

50、tudies evaluating the us ipo firms, however, indicate that the us firms generally engage in upward manipulation of reported earnings during the pre-ipo years to send positive signals to the market (e.g. friedlan, 1994; teoh, et al., 1998b; teoh, et al., 1998; ducharme, et al., 2001). as a result of

51、upward manipulation of reported earnings in the pre-ipo years, a portion of the earnings is shifted from the post-ipo period to the pre-ipo period. consequently, the ipo firms are found to be associated with underperformance during the post-ipo period (e.g. teoh, et al., 1998b). a number of us firms

52、, however, issue earnings forecasts on a voluntary basis outside the ipo period. in order to reduce the forecast error, the firms may adjust the reported upward either by using positive discretionary accruals (e.g. kasznik, 1999) or through the choice of accounting methods (e.g. jaggi and sannella,

53、1995). the main motivation for reducing the forecast error in the usa, unlike the requirement for meeting the forecast error threshold for taiwan ipo firms, is to avoid costs associated with potential legal actions by the shareholders if the reported earnings deviate from the forecasted earnings con

54、siderably (e.g. skinner, 1994; frankel, et al., 1995; teoh, et al., 1998b; baginski, et al., 2002). iii research designafter discussing hypotheses for the study, we explain how the forecast error is measured and how discretionary accruals, a proxy for earnings management, are calculated. then we exp

55、lain how the sample is selected for this study.1.hypotheses(a)disclosure regulation and earnings forecastsit has been argued in the literature that ipo firms, especially the us ipo firms do not include earnings forecasts in the ipo prospectuses. instead, they may send positive signals to the market

56、by manipulating the reported earnings during the pre-ipo years (e.g teoh, et al., 1998b; clarkson, et al., 1992). the findings of the existing studies based on the ipo firms in common law countries support this argument. the main reason for not including earnings forecasts in the ipo prospectuses of

57、 the firms from the common law industrialized countries may be strong protection rights for investors. if optimistic forecasts are issued, investors can take legal action against the firms to recover their losses. unlike regulatory bodies in common law countries, the taiwan regulatory body, i.e. tsf

58、ec, required the firms to include earnings forecasts in the ipo prospectuses. we would like to examine whether this regulation will motivate managers to issue optimistic or conservative earnings forecasts. it can be argued that managers will have strong motivation to issue optimistic forecasts when they are required to include forecasts in the ipo prospectuses. it has been reported in the literature that the taiwan legal system, and also the legal system of other economically countries in the asian pacific basin region, provides weak protection to investors