| This study empirically examines the relations among financial distress, bias in forecasting, and the credibility of management earnings forecasts. While prior research suggests that institutional penalties (such as loss of reputation, employment penalties, and legal liability) are sufficient to deter overly optimistic forecasting, I argue that the effectiveness of such penalties declines as financial distress intensifies. As a result, the incentives to issue biased forecasts may be greater for firms in financial distress. My empirical work examines whether management earnings forecasts for financially distressed firms are biased relative to forecasts for non-distressed firms. In addition, I examine whether the credibility of management earnings forecasts varies with financial distress.; My results are generally consistent with the hypotheses that management earnings forecasts issued by distressed firms exhibit greater upward bias and are viewed as less credible than similar forecasts made by non-distressed firms. For earnings forecasts in excess of analysts' existing expectations (forecasts containing “good news”), I find that the upward bias in management earnings forecasts increases as financial distress intensifies. In addition, I find evidence that analyst forecast revisions surrounding the release of management forecasts in excess of current expectations become less positive as financial distress intensifies, consistent with the hypothesis that the credibility of such forecasts declines with financial distress. I also find evidence that analyst forecast revisions surrounding the release of management forecasts below analysts' existing expectations become more negative as financial distress intensifies, consistent with my prediction that such forecasts are actually more credible when made by firms in financial distress. These findings are robust to changes in the sample selection criteria and model specification. |
