Do Managers Use Meeting Analyst Forecasts to Signal Private Information? Evidence from Patent Citations

• Author: Katherine Gunny,Tracey Chunqi Zhang
• DOI: http://doi.org/10.1111/jbfa.12082
• Date: 01 September 2014
• Published date: 01 September 2014

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(7) & (8), 950–973, September/October 2014, 0306-686X

doi: 10.1111/jbfa.12082

Do Managers Use Meeting Analyst

Forecasts to Signal Private Information?

Evidence from Patent Citations

KATHE RIN E GUNNY AND TRACEY CHUNQI ZHANG∗

Abstract: This study examines whether firms manage earnings to meet analyst forecasts to

signal superior future performance. Prior research finds that firms use earnings management

to just meet analyst forecasts and that these firms have a positive association with future

performance (Bartov et al., 2002). There are two potential explanations for the positive

association – signaling and attaining benefits that allow for better future performance (i.e., the

real benefits explanation). Prior studies cannot provide evidence of signaling because they do

not control for the real benefits explanation. Our research design enables us to control for the

real benefits explanation because we can identify potential signaling firms within the sample of

firms that just meet analyst forecasts. We use a unique database from the National Bureau of

Economic Research to construct a proxy for the manager’s belief about future firm value due

to patents. We find that firms with more patent citations are more likely to just meet the analyst

forecast and manage earnings to achieve this goal. We also find firms that just meet analyst

forecasts with more patent citations have significantly better performance than firms with fewer

patent citations, which is consistent with signaling and not the real benefits explanation.

Keywords: signaling, analyst forecasts, earnings management, patents, research and develop-

ment

1. INTRODUCTION

We examine the signaling hypothesis as an explanation for the discontinuity around

zero analyst forecast errors. Several studies find that a disproportionate number of

firms meet or slightly beat analyst forecasts (Degeorge et al., 1999; Payne and Robb,

2000; Burgstahler and Eames, 2003) and that firms manage earnings to meet this

benchmark (Matsumoto, 2002; Graham et al., 2005; Ayers et al., 2006; Roychowdhury,

2006). Prior literature also consistently finds a market premium and superior future

∗The first author is from the Leeds School of Business, University of Colorado, Boulder, USA. The second

author is from the Singapore Management University,School of Accountancy, Singapore. The authors thank

Hall, Jaffe and Trajtenberg for sharing the NBER Patent data. The authors are grateful for the helpful

comments received from Lawrence Brown, Robert Freeman, John Jacob, Bjorn Jorgensen, Bin Ke, Per

Olsson, Meng Yang and the workshop participants at the 2009 American Accounting Association Annual

Meeting (held on April 8, 2009). (Paper received June 2014, revised version accepted July 2014)

Address for correspondence: Katherine Gunny, Leeds School of Business, University of Colorado, Boulder

CO 80309, USA.

e-mail: katherine.gunny@colorado.edu

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performance for firms meeting analyst forecasts of earnings (Bartov et al., 2002;

Kasznik and McNichols, 2002).

The positive association between just meeting earnings benchmarks and future

performance is consistent with two explanations – signaling, and attaining benefits

that allow for better performance in the future (i.e., the real benefits explanation).

The signaling explanation asserts that firms manage earnings to meet analyst forecasts

to signal superior future performance. If meeting the forecast (via earnings manage-

ment) is a credible signal about a firm’s favorable outlook, we would expect future

performance to be better for firms that meet the target than for those that miss.

The real benefits explanation, in contrast, suggests that the act of meeting an

earnings benchmark may provide benefits, such as enhancing the firm’s credibility

and reputation with stakeholders (Burgstahler and Dichev, 1997). These benefits

could lead to stronger relationships with such stakeholders as customers, suppliers

and creditors, which could enhance future performance.1

Our research objective is to investigate signaling after controlling for the confound-

ing effect of the real benefits explanation. We examine a sample of patent-intensive

firms that may have difficulty credibly communicating their future value. Management

can communicate the level of research and development (R&D) expenditure and the

number of patents created in a particular year but the underlying value of the patents

is difficult to credibly communicate. Graham et al. (2005) report that 74.1% of the

401 executives surveyed acknowledge they try to meet earnings benchmarks because

it helps to convey growth prospects to investors, and prior literature documents that

patent citations are indicators of future firm value (Deng et al., 1999; Hall et al., 2005).

Signaling by meeting the analyst forecast thus may be a way to communicate private

information about future firm performance.

Examining a sample of patent-intensive firms also allows us to identify potential

signaling firms within the dichotomy of just meeting analyst forecasts. To test for

signaling, we need a proxy for the manager’s unobservable information about future

firm value. Prior literature provides evidence that the number of citations received by

a patent is an indicator of its economic impact on future firm value (Trajtenberg,

1990; Deng et al., 1999; Lanjouw and Schankerman, 2004; Hall et al., 2005). We

use patent citations (i.e., citations received by a patent from future patents) to

proxy for managers’ beliefs about firm growth prospects. By using this measure, we

assume that ex-post citation counts capture managers’ ex-ante information about the

quality of their firms’ patents and thus future firm performance. Consistent with this

assumption, Ahuja et al. (2005) examine insider trading and find managers possess

foresight about the value of their firms’ patents. We can obtain information on patent

counts and citations from the NBER US Patent Citations Data File. Every patent

document contains information about the invention, the inventor, the assignee and

the technological antecedents of the invention (cited patents).

To test the signaling hypothesis, we use a sample of 5,491 firm-years (653 firms)

from 1983–98. First, we hypothesize that managers of firms with more valuable patents

will signal future firm value by meeting analyst forecasts and find evidence consistent

1 Another explanation for the discontinuity around zero analyst forecasts is managerial opportunism in

which executives engage in earnings management to just meet analyst forecasts in an effort to exploit

stakeholders, maximize personal gain, or mislead investors (Matsunaga and Park, 2001; Barua et al., 2006;

Christensen et al., 2008). However, managerial opportunism is inconsistent with a positive association

between just meeting forecasts and future performance.

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