Journal of Accounting and Economics 33 2002 173 204 The rewards to meeting or beating earnings expectations Eli Bartova Dan Givolyb Carla Haync a Stern School of Business New York University New York NY 10012 1118 USA Graduate School of Management University of California at Irvine Irvine CA 92697 3125 USA c The Anderson Graduate School of Management University of California at Los Angeles Los Angeles CA 90095 1481 USA b Received 2 March 2001 received in revised form 5 December 2001 Abstract This paper nds that rms that meet or beat current analysts earnings expectations MBE enjoy a higher return over the quarter than rms with similar quarterly earnings forecast errors that fail to meet these expectations Further such a premium to MBE although somewhat smaller exists in the cases where MBE is likely to have been achieved through earnings or expectations management The ndings also indicate that the premium to MBE is a leading indicator of future performance This premium and its predictive ability are only marginally affected by whether the MBE is genuine or the result of earnings or expectations management r 2002 Elsevier Science B V All rights reserved JEL classification G14 M41 Keywords Earnings expectation Analysts forecast Expectations management Earnings management Loss We gratefully acknowledge the helpful comments of Bill Baber Michael Brennan Jack Hughes Patricia Hughes Jim Ohlson Joshua Ronen Jerry Zimmerman Ross Watts the editor Leonard Soffer the referee and participants of the accounting workshops at the University of British Columbia Emory University Pennsylvania State University the University of Rochester Tel Aviv University the University of Washington at St Louis the 2001 Annual Conference on Financial Economics and Accounting held at the University of Michigan and the Annual Corporate Earnings Analysis Seminar sponsored by the Center for Investment Research The capable computer assistance provided by Ashok Natarajan is appreciated We thank Thomson First Call I B E S International Inc for providing the data on analysts earnings forecasts Corresponding author Tel 1 310 206 9225 fax 1 310 825 3165 E mail address chayn agsm ucla edu C Hayn 0165 4101 02 see front matter r 2002 Elsevier Science B V All rights reserved PII S 0 1 6 5 4 1 0 1 0 2 0 0 0 4 5 9 174 E Bartov et al Journal of Accounting and Economics 33 2002 173 204 1 Introduction Meeting or beating analysts forecasts of earnings is a notion well entrenched in today s corporate culture From corporate boards deliberations to nancial press reports and Internet chats emphasis is placed on whether a company meets its earnings forecasts The following comment typi es the view of the nancial press regarding the importance of meeting Wall Street s expectations In January for the 41st time in 42 quarters since it went public Microsoft reported earnings that meet or beat Wall Street estimatesy This is what chief executives and chief nancial of cers dream of quarter after blessed quarter of not disappointing Wall Street Sure they dream about other thingsyBut the simplest most visible most merciless measure of corporate success in the 1990s has become this one Did you make your earnings last quarter see Fox 1997 p 77 The importance assigned to meeting earnings expectations is not surprising given the valuation relevance of earnings information Recent anecdotal evidence however suggests that companies are not merely passive observers in the game of meeting or beating contemporaneous analysts expectations hereafter referred to as MBE Rather they are active players who try to win the game by altering reported earnings or managing analysts expectations see for example McGee 1997 Vickers 1999 The motivations often suggested for such a behavior are to maximize the share price to boost management s credibility for being able to meet the expectations of the company s constituents e g stockholders and creditors and to avoid litigation costs that could potentially be triggered by unfavorable earnings surprises In this paper we test whether after controlling for the earnings forecast error for the period there is a market premium to rms that MBE formed just prior to the release of quarterly earnings Note that nding a premium to rms that meet or beat market expectations after controlling for the earnings forecast error for the period is quite distinct from the well established nding in the literature of a positive relation between earnings and stock returns rst documented by Ball and Brown 1968 For a premium to MBE to exist the return over the period must be a function of not only unexpected earnings for the period measured relative to the expectations held at the beginning of the period but also the manner by which earnings expectations changed over the period or the expectation path This point is further discussed in Section 3 Exploring the MBE phenomenon further we examine the extent to which the data on earnings forecast revisions and earnings surprises are consistent with expectations management or earnings management Expectations management takes place whenever management purposefully dampens analysts earnings forecasts to produce a positive earnings surprise or avoid a negative earnings surprise upon the earnings release Earnings management generally involves using accrual accounting in order to produce earnings that surpass the forecasted earnings target In the cases where earnings or expectations are likely to have been managed we examine whether the premium to MBE still exists Finally various explanations for the potential payoffs from an MBE strategy are explored that are consistent with investor rationality E Bartov et al Journal of Accounting and Economics 33 2002 173 204 175 Based on a sample of nearly 130 000 quarterly earnings forecasts made between the years 1983 and 1997 and covering approximately 65 000 rm quarters we nd that in line with previous research instances in which companies meet or beat contemporaneous analysts estimates have increased considerably in recent years The trend is common to all quarterly reporting periods and is also present in the annual period It is observed for both large and small rms On average analysts forecasts made at the beginning of the period overestimate earnings see similar ndings by Bare eld and Comiskey 1975 Brown 1997 Richardson et al 1999 among others However as the end of the reporting period approaches analysts optimism i e their overestimation of earnings turns as