Management forecasts and earnings announcements: An examination of adverse selection costs and post earnings announcement drift

To further investigate the role of management earnings forecasts in the stock market, this dissertation examines three questions: (1) whether management forecasts reduce the firm's cost of equity capital by decreasing the level of information asymmetry around earnings announcements, (2) whether management forecasts decrease the magnitude of earnings surprise and (3) whether management forecasts decrease the magnitude of post earnings announcement drift.; The first question is addressed by comparing the adverse selection cost component of the bid-ask spread, which reflects information asymmetry, for firms that have released a management forecast with those that have not. If management forecasts provide information that helps investors interpret the earnings announcement, then transactions costs due to information asymmetry should be reduced around earnings announcement.; Based on the conjecture that management forecasts reduce uncertainty in the market, forecasting firms should have a lower magnitude of unexpected earnings than non-forecasting firms. The second question is addressed by comparing unexpected earnings of forecasting firms with unexpected earnings of non-forecasting firms.; Post earnings announcement drift is an anomaly that is not explained by the efficient market hypothesis. If management forecasts improve investors' ability to interpret the earnings report at the time of its announcement, they should also reduce the degree of the drift. Accordingly, the third question is addressed by comparing the magnitude of the post earnings announcement drift of firms that have released a management forecast with those that have not.; The results support the first and third hypotheses. The level of information asymmetry for firms releasing management forecasts is significantly lower than the level of information asymmetry for non-forecasting firms around the earnings announcement. Thus, management forecasts appear to reduce transaction costs around earnings announcements. Also, the degree of post earnings announcement drift of management forecasting firms is not significantly different from zero, while the degree of post earnings announcement drift of non-forecasting firms is significantly different from zero. Therefore, although management forecasts do not appear to reduce unexpected earnings, they do appear to help the market to function efficiently by reducing both transactions costs and the degree of post earnings announcement drift.