Quarterly Earnings Forecasting Decisions by Family Firms and the Market Reaction to Them
We study the disclosure incentives for family firms by examining the characteristics of their quarterly earnings forecasts and analysts’ and investors’ responses to them. Forecasts offered before the fiscal quarter-end (guidance) by S&P 500 family firms are generally more specific and timely than those offered by S&P 500 non-family firms, particularly when they convey bad news or confirm analysts’ current expectations. Further, family firm guidance elicits a stronger response from both analysts and investors. While many of these differences largely disappear when the forecasts are offered after the quarter-end but before the earnings announcement itself (preannouncements), family firm preannouncements still tend to be more specific when they contain bad news. These more specific preannouncements also generate a significantly stronger response from analysts. Overall, our results suggest that large, visible family firms use manager-generated earnings forecasts to create a more transparent information environment, and that these forecasts are likely to be most useful in reducing information asymmetry and agency costs when they are issued as guidance.
Key Words: Management earnings forecasts, family firms, preannouncements, earnings warnings.
Data Availability: Data are available from the sources listed in the text.
Family firms are generally defined as companies that are significantly influenced by founding family members or their descendants, through large shareholdings and/or operational control.
Anderson and Reeb (2003a, 2003b) report that family members hold approximately 18% of the equity of the family firms in the S&P 500, on average, and control 45% of the CEO positions. In addition, family members often hold seats on the board of directors or are part of upper-level management in these firms (“Family Inc.”, Business Week, November 10, 2003). The structure inherent in these family firms gives rise to different agency problems than those in firms with much greater separation of ownership and control. Specifically, the family firm structure significantly limits the agency problems that arise from the separation of ownership and control (often referred to as Type I agency problems) while exacerbating those that arise in the conflict between controlling and non-controlling shareholders (often referred to as Type II agency problems, see Ali et al. 2007, Chen et al. 2007, Wang 2006 and Anderson and Reeb 2003a). It is well known that the second type of agency problem can be partially mitigated by frequent and transparent disclosure. However, it is also possible that reputational concerns may arise from the long-term nature of family members’ investment in their firm, mitigating this problem and reducing the need for more frequent and transparent disclosure (Wang 2006).
The purpose of this paper is to add to our understanding of these competing incentives for differential disclosure by examining the characteristics of quarterly earnings forecasts issued by the management of family firms and the response of sell-side analysts and investors to them. Recent accounting research that examines mandatory financial disclosures by family firms suggests that reputational concerns alone may not be sufficient: Characteristics of family firms’ mandatory financial reports are consistent with their being used to mitigate the agency problem between controlling and non-controlling shareholders. More specifically, Ali et al. (2007) and Wang (2006) show that large family firms offer higher quality financial reports as evidenced by lower discretionary accruals, greater ability of earnings to predict cash flows and larger earnings response coefficients. In addition, Ali et al. (2007) find that family firms in the S&P 500 are more likely to voluntarily issue earnings forecasts during periods of earnings declines. However, they also find that family firms are less forthcoming in their disclosures about corporate governance. In a paper that was written concurrently with ours, Chen et al. (2007) study the frequency of voluntary disclosures (earnings and non-earnings forecasts and conference calls) from a larger sample of firms that includes the S&P 500, S&P MidCap 400 and S&P SmallCap 600 in the five years before the enactment of Regulation Fair Disclosure (Reg FD). They also find that family firms are more likely to issue bad-news earnings warnings but overall make fewer forward-looking disclosures than non-family firms, and conclude that their results are consistent with family owners having a longer investment horizon and better monitoring of management, characteristics that obviate the need for greater disclosure.
This paper contributes to the growing literature on the disclosures of family firms by studying one of the most informative and common types of voluntary financial disclosures—the company’s own forecasts of its quarterly earnings per share—and sell-side analysts’ and investors’ responses to them. More specifically, we examine the characteristics of these disclosures (forecast specificity, surprise and accuracy), and the impact they have on important market indicators—professional analysts’ earnings estimates and stock prices. Thus, our analysis is designed to provide additional evidence on the relation between ownership structure and the quality of the firm’s information environment and, in particular, complements the existing empirical evidence on the characteristics and informativenesss of mandatory financial disclosures made by family and non-family firms (Ali et al. 2007 and Wang 2006).
As noted above, we focus on a particular type of voluntary disclosure, management’s forecasts of quarterly earnings per share, and do so for two reasons. First, prior research indicates that these forecasts are highly value-relevant—and more value-relevant than management forecasts of annual earnings per share (Pownall et al. 1993, Baginski and Hassell 1997). As a result, we believe that the quarterly forecasts are particularly well-suited for examining the different incentives family and non-family firms face in their attempts to control Type I and II agency problems, respectively. For example, higher quality forecasting by family firms (in terms of their forecasts being more specific, timely and accurate) is consistent with such firms creating a more transparent information environment and reducing a potentially severe Type II agency problem. Second, we are able to use a non-stock-price measure of the news in these management forecasts in our empirical work, which allows us to more effectively analyze the market’s perception of the differential information content in the forecasts made by family and non-family firms. We also separate our sample of forecasts into guidance (i.e., forecasts made prior to the end of the quarter) and preannouncements (i.e., forecasts made after the quarter ends but before earnings are released). We do this because the forecast horizon associated with preannouncements is very short, sometimes a matter of two or three weeks, and because much of the uncertainty regarding the forthcoming earnings number is resolved by the fiscal quarter end for most, if not all, firms, regardless of whether or not they are controlled by a family. Thus, the Type II agency problem in family firms, if it dominates the Type I agency problem, is more likely to be mitigated through the provision of guidance than preannouncements. This leads us to hypothesize that the characteristics of guidance, but not preannouncements, are systematically related to family-firm status, and that analysts and investors will react differently to the guidance, but not to preannouncements, issued by family firms, holding all else constant.
We test our hypotheses on the quarterly earnings forecasts made between 1998 and 2006 by the family and non-family firms in the S&P 500 index, as identified by Business Week (November 10, 2003) and contained in the First Call Company Issued Guidance (CIG) database. There are two aspects of our sample that should be highlighted. First, our sample firms are among the largest, most stable and most visible in the U.S. As a result, our results may not generalize to smaller, less visible family firms such as those included in Chen et al.’s (2007) sample. Second, our sample period spans the implementation of Reg FD. Thus, we provide evidence that complements the pre-Reg-FD evidence in Chen et al. (2007) and the limited post-Reg-FD evidence in Ali et al. (2007).
The results of our empirical tests generally indicate that the guidance provided by family firms is of higher quality than that provided by non-family firms. In particular, after controlling for other influencing factors, we find that the family firms in our sample provide significantly more specific guidance (in terms of forecast form and narrowness of forecast range) than non-family firms, especially when conveying bad news or offering confirmatory guidance. We also find that family firms use guidance to make smaller average adjustments to the market’s estimate of the upcoming quarterly earnings than non-family firms, especially when conveying bad news. This is consistent with their being more timely in offering corrections to analysts’ estimates. More importantly, we find some evidence of a stronger and quicker response by analysts (as measured by the number of subsequent earnings estimate revisions and the speed with which they occur) to the guidance issued by family firms, and strong evidence of a significantly greater investor response (as measured by announcement-period abnormal stock returns) to the guidance issued by family firms. These findings, taken together, indicate that guidance is more informative and more useful to the market when it is issued by a family firm. They are also consistent with family firms using guidance to create a more transparent information environment, which therefore, complements the finding of higher quality financial reporting by family firms in Ali et al (2007) and Wang (2006).
Consistent with our expectations, we find little evidence of differences in the characteristics of preannouncements issued by family and non-family firms, although there is some (weak) evidence of family-firm preannouncements being more specific when they contain bad news. Also consistent with our expectations, we find no evidence of a differential stock price response to preannouncements made by family and non-family firms, although we do find that analysts response more strongly to family-firm preannouncements, especially when they contain bad news. These results, when considered with the guidance results discussed above, suggest that family firms produce higher quality earnings forecasts than non-family firms, particularly when they are offered as guidance or contain bad news, and that their guidance is more informative and useful to investors and analysts. Thus, our paper provides evidence of family firms using management-generated earnings forecasts to create a more transparent information environment.
Our paper contributes to two bodies of research: the growing literature on disclosures by family firms, as noted before, and the established literature on management forecasts. While our paper is most closely related to Ali et al. (2007), Chen et al. (2007) and Wang (2006), who examine the mandatory financial disclosures of family firms and the frequency of their voluntary disclosures, we also complement Anderson et al.’s (2006) analysis of other dimensions of disclosure transparency. Anderson et al. (2006) find that family firms are significantly more opaque than non-family firms as measured by a summary statistic that captures the effects of trading volume, the bid-ask spread, analyst following and analyst forecast errors. Taken together, the evidence in Anderson et al. (2006) and our paper suggest that certain types of transparent disclosures appear to be better suited than others to mitigating the agency problem that arises between controlling and non-controlling owners.
The literature on management forecasts is more mature and, as a result, guides much of the structure for our analysis. Consequently, we follow prior work by Ajinkya and Gift (1984), Baginski and Hassell (1990, 1997), Bamber and Cheon (1998), Baginski et al. (2002, 2004), Ajinkya et al. (2005) and others, in designing our tests. In a recent paper, Hirst et al. (2007) provide a review of this literature and propose a framework for continued research in this area. They observe that choices concerning the characteristics of management earnings forecasts are not yet well understood and suggest that additional work addressing this issue is needed. Our contribution to the literature on management forecasts is to analyze the differential impact of Type I and Type II agency problems on the characteristics of management earnings forecasts provided by family and non-family firms, including the time of their release, as well as the market and analyst reactions to them. Thus, we add to the initial evidence on the underlying reasons for providing management forecasts in different forms and with different specificity—and on their impact of the stock prices of family and non-family firms. Finally, our results on confirmatory guidance support and extend the results in Clement et al. (2003).
The rest of the paper is organized as follows. In Section 2, we review of the relevant literature and develop hypotheses. In Section 3, we describe our sample and data, and in Section 4, we present the empirical tests. We offer concluding remarks in Section 5.
2. Literature Review and Hypothesis Development
Family firms are defined in the academic literature as firms in which founders or their descendants exercise control either because they are significant shareholders or because they are part of top management or the board of directors. Not only are family firms common in Europe and Asia (see, for example, LaPorta et al. 1999, Claessens et al, 2000, Gomez-Mejia et al. 2001 and Faccio and Lang 2002), they comprise approximately one-third of the S&P 500 in the U.S. (Anderson and Reeb 2003a). Further, family members’ ownership stakes are significant: Anderson and Reeb (2003a) report that in the S&P 500, family members hold, on average, 18% of the voting shares in their companies.
A large literature on family firms has recently developed in accounting and finance, much of it focused on the differences in agency problems that arise in family and non-family firms. Of particular interest to us are the agency problems arising from (1) the separation of ownership and control, and (2) the conflict between controlling and non-controlling shareholders. The papers that examine these conflicts generally argue that (1), referred to as the “Type I” agency problem in Ali et al. (2007), is less important for family firms because of the unusually close alignment of owners and management in those firms when compared to non-family firms (e.g., Ali et al. 2007, Chen et al. 2007, Wang (2006). They also argue that the tight linkage between some owners and control in family firms exacerbates (2), referred to as the “Type II” agency problem in Ali et al. (2007), in which family members transfer wealth to themselves to the detriment of other shareholders. As is well known, such agency problems can be partially mitigated by frequent and transparent disclosure, suggesting that family firms are more likely to offer a variety of mandatory and voluntary disclosures whose implications are clearer to market participants. In contrast, Wang (2006) suggests that family firms may not face a more severe Type II agency problem if the long-term nature of their investment is well understood by the market. In essence, he argues that long-term investors are less likely to exploit agency problems for short-term gain—thus, family firms may not need to resort to greater frequency or transparency of disclosures.
Ali et al. (2007) and Wang (2006) empirically test these competing predictions by comparing aspects of the accounting disclosures made by family and non-family firms. Both find that earnings quality is higher for family firms, especially when a founder CEO is in place. Thus, both provide some evidence consistent with family firms mitigating their Type II agency problems—or responding to the demands of the users of financial statements—with higher quality disclosures. More specifically, Ali et al. (2007) document lower discretionary accruals and greater earnings persistence for S&P 500 family firms compared to S&P 500 non-family firms. In addition, they find that the association between earnings and stock returns is higher for the family firms. Similarly, Wang (2006) finds that S&P 500 founding family firms have lower abnormal accruals, greater earnings informativeness and less persistence in transitory loss components in earnings. He extends this analysis by considering the effect of the percentage of common stock owned by family members on the magnitude of the Type II agency problem. Interestingly, he finds that the relation is nonlinear: When founding family ownership is above (approximately) 60%, the quality of the earnings reported by non-family firms exceeds that of family firms. Ali et al. (2007) also provide some evidence inconsistent with family firms mitigating their more severe Type II agency problem through the use of disclosures: They observe that family firms are less forthcoming about their corporate governance practices and that when they employ a dual class share structure, earnings quality is lower relative to when they do not have such a structure.
Another method for testing whether family firms mitigate the potentially more severe Type II agency costs—or respond to financial statement users’ demand for high quality accounting information—through greater frequency and transparency of disclosures is to examine the issuance of management earnings forecasts by family and non-family firms. Complicating this is the litigation argument proposed by Skinner (1994) and Kasznik and Lev (1995) which suggests that the use of earnings warnings will vary positively with the litigation risk that the firm faces, and inversely with the severity of the firm’s Type I agency problem (Ali et al. 2007). However, since the Type II agency problem is expected to be more severe and the Type I agency problem less severe in family firms (Ali et al. 2007), family firms would be expected to provide management forecasts to mitigate both types of agency problems, holding litigation risk constant. The relative severity of the Type II agency problem further suggests that family firms’ earnings forecasts will be of higher quality (i.e., more specific, timely and accurate), and that market participants (e.g., sell-side analysts and investors) will respond more strongly to them.
Ali et al. (2007) provide initial evidence in favor of this hypothesis when they observe that family firms are more likely to provide earnings warnings (i.e., guidance that warns of a forthcoming earnings decline) than non-family firms. In a more recent paper, however, Chen et al. (2007) provide evidence that family firms make fewer voluntary disclosures than non-family firms. They collect ownership and founding family information from several sources to identify family firms in the S&P 1500 and find that family firms are (1) 8.1% less likely to provide management forecasts of all kinds (i.e., annual and quarterly earnings, revenues, cash flows, etc.), and (2) less likely to hold conference calls as well. They also find, however, that family firms are more likely than non-family firms to issue bad-news earnings warnings. Chen et al. (2007) conclude that these results, when considered collectively, indicate that family firms’ owners prefer less disclosure because of their long investment horizon and effective monitoring of managers, but that their concern with reducing litigation costs results in an increased likelihood of bad news earnings warnings.
In this paper, we hope to add to our understanding of the relative importance of the competing incentives studied in previous work by examining (1) the characteristics of management forecasts of quarterly earnings per share (both guidance, which is offered prior to the end of the quarter, and preannouncements, which are offered after quarter-end but before the actual earnings announcement) of family and non-family firms, and (2) the response of sell-side analysts and investors to those forecasts. In particular, we hope to add to our understanding of the disclosure choices of family firms by determining whether their own earnings forecasts are more specific, timely and accurate, consistent with family firms providing higher quality disclosures—and whether those forecasts are viewed as being of higher quality by market participants as measured by their response to the disclosure. We also separate our forecasts into guidance and preannouncements under the assumption that any family-firm effect will be more likely to be observed in guidance because of the longer horizon over which the forecasts can be made. More specifically, in the case of preannouncements, there is a very short forecast horizon (e.g., a few weeks beyond the end of the quarter) and so we do not expect large differences in timeliness of the preannouncements between family and non-family firms. Further, because much of the uncertainty about the earnings numbers is resolved by quarter-end, differences in the specificity of preannouncements between family and non-family firms, if any, are likely to be small. Finally, motives to provide preannouncements are likely to be dominated by the litigation argument proposed by Skinner (1994) and Kasznik and Lev (1995). If this is the case, differences in characteristics of voluntary earnings forecasts, and in market participants’ responses to them, are likely to be concentrated in guidance.
As in prior research, we recognize that because of competing forces, whether the guidance of family firms is of higher quality is an empirical question. Thus, our formal hypotheses regarding guidance are non-directional, as in Chen et al. (2007) and Wang (2006):
H1: The specificity, timeliness and content of earnings guidance is systematically related to whether the firm is classified as a family firm.
H2: Sell-side analysts’ and investors’ responses to earnings guidance is systematically related to whether the issuing firm is classified as a family firm.
3. Sample and Data.
Our sample is comprised of 4,130 management quarterly earnings guidance announcements issued between 1998 and 2006 by the family and non-family firms in the S&P 500 as identified by Business Week in its November 10, 2003, issue. Business Week defines a family firm as “…any company where founders or descendants continue to hold positions in top management, on the board, or among the company’s shareholders.” To identify family firms, Business Week relies on the methodology developed by Anderson and Reeb (2003a, 2003b) as well as their advice and the help of Spencer Stuart as they “…examined regulatory filings, company Web sites and corporate histories” to ensure significant family involvement in the company. (For details, see “Defining Family,” Business Week, November 10, 2003, p. 111.) Before proceeding, we want to highlight certain aspects of our sample. First, because the Business Week classification pertains to only S&P 500 firms, the firms in our sample are among the largest, most stable and most profitable companies in the U.S. As a result, our findings might not extend to mid- or small-cap companies. Second, our reliance on the Business Week classification means that we do not form a new sample of family and non-family firms each year. However, as Ali et al. (2007) note, family firm status is sticky, and thus misclassifications due to changing firm status will most likely bias against our finding significant results. Third, Business Week’s classification scheme is designed to identify firms that are controlled by a family without relying on a single proxy for control, such as ownership share. As a result, it captures features of family firms, beyond simply having large blockholders, that are likely to exacerbate Type II agency problems. Fourth, by using Business Week’s classification, which is based on the “standard” developed by Anderson and Reeb, our results are more easily compared to many prior results. Finally, while we recognize that Business Week might not accurately classify every firm, both types of classification errors (i.e., misclassifying firms without significant family control as family firms, and misclassifying firms with significant family control as non-family firms) limit our ability to detect differences in the forecasts of family and non-family firms and therefore bias against our finding significant results.
We form our sample by first gathering all forecasts of quarter-ahead earnings made between 1998 and 2006 by the S&P 500 as of June 2003 from the First Call Company Issued Guidance (CIG) database. We lose 1,994 of the original 7,694 observations because of unavailability of (1) necessary Compustat and CRSP data, (2) actual earnings per share and other analyst forecast data from First Call, and (3) observations with multiple actual earnings per share numbers. After deleting stale forecasts (those made before the prior quarter’s earnings announcement date), we retain all “guidance” observations (forecasts made at the same time as or after the prior earnings announcement and at or before the quarter end, N = 4,332). We trim the sample to mitigate the effect of outliers as follows. First, we eliminate the top and bottom one-half percent of the management forecast errors in each sample, the top and bottom one-half percent of the forecast surprises in each sample, the top and bottom one-half percent of the three-day cumulative abnormal returns in each sample and finally, the top and bottom one-half percent of return volatility ratios in each sample—and retain the union of the remaining observations. (These variables are defined in the Appendix and will be discussed in detail later.) We then eliminate 62 firm quarter observations whose stock price is less than $5 as of the beginning of the quarter. This results in a final sample of 4,130 guidance announcements. One-hundred-and-forty six of the 177 family firms identified by Business Week (82.5%) provide guidance during our sample period as compared to 240 of the 323 non-family firms in the S&P 500 (74.3%). 
Before turning to the empirical analysis, we note for the reader that the management guidance we gather from the CIG database is not split-adjusted whereas the analysts’ estimates and reported earnings per share in the main First Call file are (further, they are rounded to the nearest penny). An I/B/E/S unadjusted data file is available but unfortunately, we would lose a significant number of observations if we were to use it. Consequently, to keep the sample size as large as possible and still allow for comparability, we split-adjust the management guidance from the CIG file using the split-adjustment procedures used for the analysts’ estimates and reported earnings per share in the First Call file.
4. Empirical Analysis.
4.1. Univariate Analysis.
We present descriptive statistics for the guidance announcements, firm-specific characteristics and variables relating to analysts and stock returns in Table 1. We also include the results of two-sample t-tests and Wilcoxon signed rank sum tests for each variable. As noted before, we provide a list of variables and their definitions in the Appendix.
We begin with forecast characteristic metrics designed to help us understand the differences, if any, in the specificity, timeliness, frequency and content of the earnings forecasts offered by the management of family and non-family firms. We present descriptive statistics first for the form of the forecast (an indicator of specificity) as measured by Forecast Form. As is well known, forecasts in the CIG database take one of several forms, which we code in the following manner: If the forecast is a specific earnings per share number (a point forecast), it is coded as 4; if it is a range of possible earnings per share numbers (a range forecast), it is coded as 3; if it consists of a one-sided directional forecast (either a maximum or minimum forthcoming earnings per share number), it is coded as 2; and if it contains no quantitative information (a qualitative forecast), it is coded as 1. Note that our coding scheme is designed so that a higher value of Forecast Form indicates a more specific forecast. To further examine forecast specificity, we focus next on Forecast Width for range forecasts, which measures the difference between the maximum and minimum earnings per share figures offered in the forecast. (A narrower width indicates a more specific forecast.) In later tests, we include point forecasts as forecasts with a width of zero. To examine forecast timeliness, we use Forecast Horizon which is the number of calendar days from the management forecast date until the end of the quarter. More days in the forecast horizon indicate more timely forecasts. Finally, we form Annual Frequency and Quarterly Frequency variables, which measure the number of annual and quarterly management forecasts for each of our sample firms in the CIG database from 1994 through 2006, scaled by the total number of possible forecasting years (for Annual Frequency) or quarters (for Quarterly Frequency) to date.
The descriptive statistics and statistical tests for Forecast Form provide initial evidence consistent with family firms issuing significantly more specific guidance than non-family firms. In particular, Forecast Form has slightly higher numerical values, on average, for family firms (p = .028, using the Wilcoxon test). To further explore the potential differences, we examine the frequency distributions of the forms that guidance takes, as presented in Figure 1. As is obvious from the figure, range forecasts are by far the most common form of guidance for both family and non-family firms, making up nearly two-thirds of all guidance in our sample. Further, both family and non-family firms offer approximately 89% of their guidance as point or range forecasts. However, family firms offer relatively more of the more specific point forecasts (28% versus 23% for non-family firms) and relatively fewer of the less specific range forecasts (61% versus 66% for non-family firms). Conversely, guidance in the form of qualitative statements or minimum/maximum earnings per share numbers is unusual in our sample, regardless of the type of firm examined. The small number of qualitative forecasts in our First Call sample is inconsistent with Hutton et al. (2003) and Miller (2002), who find a substantially larger number of such forecasts when hand-collecting their samples than are included in the First Call database. (Anilowski et al. 2006 also suggest that First Call is more likely to include quantitative forecasts than qualitative ones.) This suggests that our sample is most likely incomplete and most representative when only quantitative forecasts are considered. For these reasons and because many tests require that we restrict attention to point and range forecasts, we will generally focus our discussion on point and range forecasts only.
As just noted, range forecasts are the most common type of guidance in our sample. While it is clear from Figure 1 that non-family firms issue more range forecasts as guidance than family firms, Table 1 indicates that those issued by family firms are significantly narrower, as measured by Forecast Width (p = .000 for both the Wilcoxon and the two-sample t tests). This finding, when considered with the preliminary evidence of greater usage of point forecasts by family firms, suggests that guidance issued by family firms is generally more specific than that issued by non-family firms, consistent with H1.
The next two forecast c