To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance

This post is from Baruch Lev of NYU Stern School of Business.

In “To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance”, which I co-wrote with Joel F. Houston and Jennifer W. Tucker, and which was recently accepted for publication in Contemporary Accounting Research, we investigate the importance of quarterly earnings guidance. Quarterly earnings guidance—managers’ public forecasts of forthcoming earnings—is widespread yet highly controversial. Arguments for ending the practice of guidance are made by purists, who claim that managers should tend to their business and leave securities valuation and the underlying forecasts of future performance to investors and analysts, and by pragmatists, lawyers in particular, who caution managers that guidance increases litigation exposure. Regulators and commentators are often concerned that a previously issued forecast will motivate managers to meet the guidance even if doing so would require costly changes in real activities, such as cutting capital expenditures or R&D, and sometimes induce them to manage earnings toward the forecast. On the pro-guidance side, managers often claim that the practice is necessary to keep analysts’ earnings forecasts—issued with or without corporate guidance—within a reasonable range to avoid large earnings surprises and the consequent high stock price volatility and investors’ heightened risk perceptions.

We empirically examine in this study a sample of 222 U.S. firms that ceased to provide quarterly earnings guidance during 2002 through the first quarter of 2005, after having routinely done so. Only a few of these “stoppers” publicly announced and rationalized their decision, whereas the majority just ceased to provide guidance. We first examine the determinants of the stopping decision with particular reference to the pro and con arguments made by challengers and supporters of the practice. Although managers often cite reducing short-termism as the motive for stopping guidance, an unstated reason could be poor performance and repeated consensus misses. We then examine the post-stoppage changes in the stoppers’ long-term investments, in their complementary disclosures, and in their information environment. Using a control sample of 676 guidance “maintainers,” along with the 222 stoppers, we find that poor performance is the main reason for guidance cessation. Our stoppers are characterized by (1) a decline in earnings before stopping, (2) a poor record of meeting or beating analyst consensus forecast, and (3) a deterioration of anticipated earnings. Additionally, we document that guidance cessation is associated with (1) a change in top management, likely ushering in new management philosophy, (2) a relatively low frequency of guidance by industry peers, and (3) past as well as anticipated difficulties in predicting earnings. In addition, we do not find that stoppers enhance investment in capital expenditure and research and development after guidance cessation. Contrary to the claim that firms would provide more alternative, forward-looking disclosures in lieu of the guidance, we find that such disclosures are curtailed. We also find a deterioration in the information environment of guidance stoppers in the form of increased analyst forecast errors and forecast dispersion and a decrease in analyst coverage. Taken together, our evidence indicates that guidance stoppers are primarily troubled firms and stopping guidance does not benefit either the stoppers or their investors.

The full paper is available for download here.

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