Do Business Relationships Affect the Accuracy of Analyst Earnings Forecasts? Evidence from China

• Author: Shengnian Wang,Liang Han,Chunyan Wei
• DOI: http://doi.org/10.1111/ajfs.12164
• Date: 01 February 2017
• Published date: 01 February 2017

Do Business Relationships Affect the

Accuracy of Analyst Earnings Forecasts?

Evidence from China*

Shengnian Wang

School of Economics and Management, Shihezi University, China

Chunyan Wei

School of Accountancy, Shanghai University of Finance and Economics, China

Liang Han**

Henley Business School, University of Reading, UK

Received 21 July 2016; Accepted 28 November 2016

Abstract

Supporting the “conflicts of interest hypothesis,” we show that, in China, better-informed

analysts issue more optimistically biased forecasts and the reputation of financial analysts

mitigates the bias. We contribute to the literature by showing that such an adverse informa-

tion effect varies over types of investment banking relationships and a better developed local

legal environment reduces forecast bias. Our results call for a better developed market mecha-

nism to discipline analysts so as to issue independent and accurate earnings forecasts in

China.

Keywords Financial analyst; Investment banking relationship; Forecast bias; Reputation; Legal

environment

JEL Classification: G14, G24, M40, M41, M49

1. Introduction

The role played by institutional investors in shareholdings and activism has become

increasingly important. For example, the value of institutional shareholding

*This work was supported by the National Natural Science Foundation of China (71562029)

and the Key Research Center for Social Sciences of Committee of Education of Xinjiang,

China (XJEDU020116B01). We thank Professor Kwangwoo Park, the editor, an associate edi-

tor, and two anonymous reviewers for their valuable comments, which have significantly

improved the paper. All remaining errors are ours.

**Corresponding author: Liang Han, Henley Business School, University of Reading, Reading,

RG6 6UD, UK. Tel: +44 (0) 1483 689944, Fax: +44 (0) 118 9314404, email: liang.han@henley.

ac.uk.

Asia-Pacific Journal of Financial Studies (2017) 46, 155–177 doi:10.1111/ajfs.12164

©2017 Korean Securities Association 155

increased from US$16 trillion in 2005 to US$30 trillion in 2011 in the US and from

£2.7 trillion to £3.6 trillion in the UK over the same period. Meanwhile, stock mar-

kets in emerging economies have also developed very quickly over the last two dec-

ades, especially before the financial crisis. The total stock market capitalization in

China, for instance, accounted for 53% of GDP in 2007 with a value of US$3.9 tril-

lion and 162 million investors, and the institutional shareholding increased from

5% in 2002 to 49% in 2007. Hence, the increasing importance of institutional and

individual shareholding has created a strong demand for professional financial ana-

lysts who regularly forecast the earnings ability and corporate performance of target

firms (Lonkani and Firth, 2005). Moreover, China, as an emerging market, has an

enormous financial market which is not fully developed and, therefore, financial

analysts could have a strong impact on share prices, further strengthening institu-

tional investors’ incentives to exert pressure on analysts. The pressure from institu-

tional investors is also facilitated by the lack of public scrutiny (Firth et al., 2013 ;

Gu et al., 2013). Hence, the investment banking relationship effects on analysts’ bias

are likely to be more prominent in China.

It has been widely acknowledged that analysts’ earnings forecasts are useful for

decision making and long-term earnings forecasts explain more variations in fore-

casted price than short-term forecasts (Bandyopadhyay et al., 1995). Analysts’ earn-

ings expectations also have been found to have a strong impact on the behavior of

managers, and the average return associated with more accurate recommendations

is greater than that recommended by analysts with lower forecast accuracy, by

1.27% per month (Kross and Suk, 2012), suggesting that, in an imperfectly efficient

market, costly and accurate information collection would be rewarded by the mar-

ket (Loh and Mian, 2006). Because of the important role played by analysts’ fore-

casts, the effects of earnings forecasts and guidance, such as on marke t return

(Anilowski et al., 2007) and stock market sensitivity to analysts’ forecasts (Beyer,

2008) have also been investigated both empirically and theoretically.

It is expected that analysts’ forecasts should be as accurate as possible by fully

reflecting all relevant information available so as to provide unbiased guidance to

institutional and individual users. However, the accuracy could be adversely affected

by various factors, such as the investment banking relation and trading commission

motivations. Governing bodies have attempted to regulate analysts’ forecasts by, for

example, issuing financial penalties to misleading analysts and structurally reform-

ing companies that provide simultaneous investment banking services and forecasts.

In June 2003, the US Securities and Exchange Commission (SEC) alleged firms that

had associated analyst financial compensation with their investment banking rev-

enue promised favorable forecasts in order to create greater underwriting opportu -

nities. The “Global Settlement,” for example, issued a total of US$1.4 billion

financial penalties to 10 investment banks and required a complete separation of

investment banking business from research departments to ensure there is neither a

direct nor an indirect relation between analyst compensation and investment bank-

ing revenue. Analysts are therefore expected to be able to provide independent and

S. Wang et al.

156 ©2017 Korean Securities Association