On the Determinants of Optimism in Financial Analyst Earnings Forecasts: The Effect of the Market's Ability to Adjust for the Bias

Abstract

This paper examines whether the documented bias in analyst earnings forecasts is intentional by examining whether it is related to the market's ability to adjust for this bias. For intentional bias to exist it is not enough for analysts to face incentives but rather, analysts should also be willing to respond to these incentives. As the market's ability to adjust for the bias increases, its market effects decrease while analyst reputation costs increase reducing analyst willingness to bias their forecasts. The paper utilizes a firm-specific design that allows for both the bias component of the forecast error and the market's ability to adjust for the bias to be computed at the firm level. Results suggest that even though forecast error is positive in the latter part of the period under review reflecting overall analyst pessimism, the bias embedded in the forecasts is optimistic throughout the period. More importantly, I find that analyst forecast bias is decreasing in the market's ability to adjust for it. This result provides further evidence that analysts knowingly bias their forecasts and provides support for the existence of reporting bias, in particular. Thus, the evidence provides justification for recent regulatory efforts to increase the objectivity of analyst research reports. © 2011 The Author. Abacus© 2011 Accounting Foundation, The University of Sydney.