Association Between Accounting Conservatism and Analysts' Forecast Inefficiency

Abstract

We find that analysts' earnings forecasts do not fully impound the implications of accounting conservatism. Forecast optimism is negatively associated with the magnitude of beginning-of-year balance sheet reserves (BSR), which are associated with conservative accounting in prior years. However, this result vanishes once we allow for the negative association, documented in several prior studies, between BSR and Basu's asymmetric timeliness measure of conservatism [Journal of Accounting and Economics 24 (1997) 3]. After controlling for this association, we find that forecasters' under-reaction to bad versus good news is negatively associated with the magnitude of BSR. We obtain similar results after allowing for the positive association between asymmetric timeliness and Khan and Watts' C_Score [Journal of Accounting and Economics 48 (2009) 132]. Therefore, our results are consistent with a subtle form of inefficiency of forecasts with respect to accounting conservatism; that is, analysts do not fully appreciate that the earnings of companies with lower BSR. or higher C_Scores are likely to be both: (i) lower relative to forecast; and (ii) more asymmetrically timely than the earnings of companies exhibiting higher BSR or lower C_Scores.