2001 johnson kasznik nelson.pdf

|oiirnal of Accounting Research• Vol. 39 No. 2 September 2001

Printed in U.S.A.

The Impact of Securities LitigationReform on the Disclosure of

Forward-Looking InformationBy High Technology Firms

MARILYN F. JOHNSON, * RON KASZNIK.fAND KAREN K. NELSONf

Received 5January 1998; accepted 24 November 1999

ABSTRACT

This study evaluates corporate voluntary disclosure of forward-looking in-formation under the safe harbor provision of the Private Securities LitigationReform Act of 1995. Using a sample of 523 computer hardware, computersoftware, and pharmaceutical firms, we find a significant increase in both thefrequency of firms issuing earnings and sales forecasts and the mean numberof forecasts issued following the Act's passage. To provide more direct evidencethat our findings are attributable to the Act reducing firms' legal exposure,we develop a proxy for litigation risk and examine whether the increase in dis-closure is more pronounced for firms at greatest risk of a lawsuit. As expected,we find that the change in disclosure is increasing in firms' ex ante risk oflitigation. Finally, we report that the safe harbor had no adverse impact on thequality of forward-looking information. Forecast errors, whether directionalor non-directional, were not significantly affected by the Act's passage.

* Michigan State University; fStanford University. We appreciate the comments of Con-nie Bagley, Linda Bamber, Michael Bamber, Mary Barth, Bill Beaver, Ed Maydew, MaureenMcNichols, Mort Pincus, Catherine Schrand, Dotig Skinner, Sam Tiras, Ram Venkataraman,Richard Willis, seminar participants at the Australian Gradtiate School of Management, DtikeUniversity, the University of Georgia, the University of Iowa, the University of Oregon, PennState University, Stanford University, the University of Utah, and especially two anonymousreviewers. Kabir Misra, Derek Schrier, Michael Smith, and Kenton Yee provided valuable datacollection assistance. Marilynjohnson acknowledges thesupportofErnst&Young. Ron Kasznik

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Copyright©, University of Chicago on behalf of the Institute of Professional Accounting, 2001

298 M. F. JOHNSON, R. KASZNIK, AND K. K. NELSON

1. Introduction

The incidence of shareholder lawsuits in recent years, particularly forcompanies in high technology industries, has raised concerns regarding theeffects of frivolous litigation on the voluntary disclosure of forward-lookinginformation (e.g., AICPA [1994] andBreeden [1995]). Partly in response tothis concern. Congress made sweeping revisions to the federal securities lawsby enacting the Private Securities Litigation Reform Act of 1995 (the Act) onDecember 22, 1995. The intent of this legislation is to reduce abusive classaction securities litigation through a variety of measures, including statutoryprotection for financial projections and other forward-looking statements.This paper examines the Act's impact on the voluntary disclosure of earningsand sales forecasts by 523 firms in three high technology industries (com-puter hardware, computer software, and pharmaceuticals).

We address two primary research questions. First, we examine whetherthe Act increased firms' voluntary disclosure of forward-looking informa-tion. Controlling for other factors that may affect the disclosure decision,we find evidence of a significant increase in both the frequency of firmsissuing forecasts and the mean number of forecasts issued in the first yearfollowing the Act's passage. To provide more direct evidence that this in-crease in disclosure is attributable to reduced legal exposure for forward-looking statements, we examine the cross-sectional association betweenchanges in disclosure and estimated pre-Act risk of litigation. Consistentwith expectations, we find that the increase in post-Act disclosure is morepronounced for firms with a relatively high risk of litigation prior to theAct's passage. Additional evidence indicates that firms increased both shortand long horizon forecasts of good news, but only short horizon forecastsof bad news. Finally, we find that high litigation risk firms issue signifi-cantly more forecasts containing specific quantitative information as wellas more forecasts of general qualitative information following the Act'spassage.

Our second research question examines the impact of the safe harboron the quality of forward-looking information. Critics alleged that the safeharbor would encourage firms to issue false, reckless, or even fraudulentstatements about expected future performance. However, we find no evi-dence that forecasts issued after the Act's passage are more optimisticallybiased than those issued previously. Unexpectedly, there is some evidencethat forecasts are less noisy following enactment of the safe harbor, al-though additional analysis reveals that this result is attributable to changesin other factors that affect forecast accuracy. Taken together, otir evidencedoes not support allegations that the safe harbor provides a "license tolie."

and Karen Nelson acknowledge the support of the Financial Research Initiative at StanfordLIniversity Graduate School of Business.

THE IMPACT OF SECURITIES LITIGATION 299

This study is related to concurrent research that examines the market re-action to the Act's passage (Johnson, Kasznik, and Nelson [1999]) and the in-cidence of shareholder litigation under the new law (Grundfest and Perino[1997] and Levine and Pritchard [1998]). In contrast to these studies, whichassess the Act's impact by examining the behavior of parties external to thefirm, we investigate managers' response to the Act's safe harbor for forward-looking information. Documenting whether the Act was successful in en-couraging more forward-looking disclosure is important because increaseddisclosure may yield economic benefits such as greater investor interest(Lang and Lundholm [1996]) and a lower cost of capital (Botosan [1997]).

This study also makes several contributions to the literature on man-agement forecasting behavior. Recent research examining litigation-basedincentives to voluntarily disclose bad news (e.g.. Skinner [1994], Francis,Philbrick, and Schipper [1994b], and Skinner [1997]) provides conflictingevidence on the causal relation between forecasts of bad news and the in-cidence of shareholder litigation. Although not conclusive, our evidenceof a significant increase in bad news disclosures under the Act's new safeharbor does not support the argument that managers' primary motivationfor the preemptive disclosure of bad news is to protect against shareholderlitigation. Our study is also among the first to provide direct evidence onthe relation between the legal environment and the voluntary disclosure ofgood news. In addition, we extend the literature on cross-sectional variationin the attributes of managers' earnings forecasts (see King, Pownall, andWaymire [1990] for a review) by providing evidence on how a change in le-gal liability affects the type of news disclosed, and the horizon and specificityof the forecast announcements.

Finally, the evidence presented in this paper is relevant to securities reg-ulators and the accounting profession because of their ongoing interest inthe impact of litigation reform on voluntary disclosure. For example, theSEC reported that the "quality and quantity of forward-looking disclosurehas not significantly improved following enactment of the safe harbor forforward-looking statements" (SEC [1997], p.2). However, the SEC basedthis conclusion on anecdotal evidence, whereas our results are based ona detailed statistical analysis of earnings and sales projections made by thebusiness sector most likely to be impacted by the Act's safe harbor provision.In addition, private sector groups such as the AICPA's Jenkins Committeehave been hesitant to recommend that the financial reporting model beexpanded to include additional forward-looking information due to the po-tential legal liability associated with prospective disclosures (AICPA [1994]).Our evidence suggests that the expected legal costs of these disclosures de-creased following the Act's passage.

The paper proceeds as follows. Section 2 provides instittidonal back-ground on the Act and discusses its safe harbor provision. Section 3 outlinesour research questions. Section 4 describes the sample, and section 5 de-velops our empirical methodology. Sections 6 and 7 present the empiricalfindings. Section 8 summarizes and concludes.


2. The Private Securities Litigation Reform Act of 1995

2.1 BACKGROUND

The Act represents the culmination of a lengthy legislative effort to reformfederal securities laws. First introduced into Congress on January 4, 1995,the Act became law on December 22, 1995, when Congress overrode Pres-ident Clinton's veto.' In drafting the legislation, Congress sought to curbseveral perceived abuses in securities class action litigation. For example,proponents of reform alleged that federal securities laws promoted the rou-tine filing of "strike" suits based solely on a large decline in stock price; thetargeting of defendants with "deep pockets" regardless of their culpability;the coercion of settlements from defendants who were unwilling or unableto incur the high costs of protracted discovery and litigation; and the use of"professional plaintiffs" who are paid to file lawsuits against companies inwhich they have only a nominal interest (Conference Report [1995]). Addi-tionally, Congress was concerned that abusive litigation was severely limitingmanagers' communication of forward-looking information to the securitiesmarket (Conference Report [1995]).

The Act contains a diverse assortment of provisions designed to addressthese concerns. In addition to the safe harbor, which we discuss in detailbelow, the Act requires courts to appoint the lead plaintiff under the pre-sumption that the most capable representative of the potential class mem-bers is the person or group with the largest financial interest at stake inthe specific case; limits attorney's fees to a "reasonable percentage" of anydamage award; adopts pleading standards which make it more difficult tofile a lawsuit without specific allegations of the nature of the fraud perpe-trated; provides for a stay of discovery while a motion to dismiss is pending;establishes a system of proportionate, as opposed to joint and several, lia-bility for defendants who do not knowingly commit fraud; and gives vic-tims of abusive litigation the opportunity to recover their defense costsfrom the plaintiffs and/or the plaintiffs' attorneys. However, the Act isambiguous regarding whether reckless misconduct is sufficient for liabil-ity, leading some commentators to suggest that Congress purposefully leftthe resolution of this issue to the courts (e.g., Avery [1996] and Beckett[1997]).

Althovtgh it is too early to reach definitive conclusions regarding the Act'simpact on litigation activity, preliminary findings reported by Grundfestand Perino [1997] indicate that the number of federal lawsuits filed in 1996declined 50 percent from the average annual rate experienced during thepreceding five years, 1991-1995. Most of this decline appears to be due toplaintiffs shifting venue to state courts in an attempt to avoid the stringentprovisions of the new federal law. Moreover, Levine and Pritchard [1998]

' See Johnson, Kasznik, and Nelson [1999] for a detailed discussion ofthe Act's legislativehistory.

November 3, 1998, President Glinton signed the Securities Litigation Uniform Stan-dards Act which effectively closes this loophole by requiring most securities class action lawsuitsto be heard in federal court.

THE IMPAGT OF SECURITIES LITIGATION 301

report that federal judges have dismissed 60 percent of shareholder fratidsuits filed during 1996-1997, compared to 40 percent during 1990-1992.They attribute the higher dismissal rate to the Act's heightened pleadingstandards and stay of discovery.

2.2 THE SAFE HARBOR PROVISION

One of the Act's most significant provisions is the safe harbor for thevoluntary disclosure of financial projections and other forward-looking in-formation. The concept of a safe harbor originated in 1979 when the SECadopted Rule 175 (promulgatedunder the Securities Act of 1933) and Rule3b-6 (promulgated under the Securities Exchange Act of 1934) to provide asafe harbor for certain forward-looking statements made with a "reasonablebasis" and in "good faith." Nevertheless, the SEC perceived that registrantswere reluctant to disclose prospective information because of concerns re-garding the safe harbor's effectiveness (SEC [1994]). The SEC was in theprocess of evaluating their safe harbor provisions when Congress placedlitigation reform on the legislative docket.

The Act amends prior securities laws to create a statutory safe harbor thatapplies to both written and oral forward-looking statements that meet twobroad criteria. First, the statements must be specifically identified by the dis-closing firm as forward-looking. The Act defines forward-looking statementsto include projections of revenues, income, or other financial items, man-agement's plans and objectives for future operations (including productsor services), and statements regarding future economic performance.'^ Sec-ond, the forward-looking statements must be accompanied by "meaningful"cautionary language identifying "important" factors that could cause actualresults to differ from those projected. Failure to include the particular fac-tor that ultimately causes the projection to be in error does not precludethe statement from being protected by the safe harbor so long as the factorsthat are identified are relevant to the projection, and could realistically haveaffected its outcome. Although the Conference Committee cautions that"boilerplate warnings" will not suffice as meaningful cautionary language,they are silent on how courts should determine whether a cautionary state-ment meets the above criteria except to specify that it should not includean examination of the state of mind of the defendant (Conference Report[1995]).''

In the absence of an appropriate disclaimer, the safe harbor providesa second avenue of protection. This defense focuses not on the forward-looking and cautionary statements themselves, but rather on the state ofmind of the party issuing the statement. Specifically, the defendant will be

" Certain forward-looking statements, most notably those included in financial statementsprepared in accordance with generally accepted accounting principles or made in connectionwith a tender offer or initial public offering, are specifically excluded from the safe harbor.

Read literally, this prong ofthe safe harbor wotild thtis protect forward-looking statemenLsthat were known to be false or misleading, provided they were accompanied by appropriatecautionary language (Avery [1996]). As a practical matter, it may be difficult for the defendantto win a dismissal on these grounds.


held liable only if the plaintiff can prove that the statements were made withactual knowledge that they were false or misleading.^ Under either prong ofthe safe harbor, plaintiffs must identify the specific statement or statementsthat are misleading when they file the lawsuit rather than undertaking a"fishing expedition" for supporting documentation during the discoveryprocess. Finally, the safe harbor provision does not impose a duty to updatepreviously issued forward-looking statements. It is unclear, however, whetherthis language eliminates an affirmative duty to update or correct underexisting law.

3. Research Questions

This section outlines our two primary research questions. The first re-search question examines whether the voluntary disclosure of forward-looking information increased following the Act's passage. In this regard,we consider both the overall level of disclosure provided by firms and thelevel of disclosure for various types of forecast announcements (e.g., goodversus bad news, long versus short horizon). The second research questionassesses whether the quality of forecasted information deteriorated after thesafe harbor was enacted. To assess disclosure quality, we examine the extentto which forecasts issued after the Act's passage are more biased and/ornoisier indicators of realized future performance.

3.1 IMPACT ON THE QUANTITY OF VOLUNTARY DISCLOSURE

Congress was motivated to adopt the safe harbor provision by testimonyand evidence suggesting that the pre-Act legal environment was not con-ducive to voluntary disclosure of forward-looking information (ConferenceReport [1995]). For example, survey evidence compiled prior to the Act'spassage indicated that 79 percent of managers were reluctant to discuss fu-ture prospects with investors because of a belief that such disclosures exposethem and their companies to shareholder litigation (ASE [1994]). Consis-tent with the perception that the pre-Act legal climate deterred forward-looking disclosure. Frost [1998] finds that the number of firms disclosingprospective information, and the frequency of forecast issuance, was lowerin the U.S. in 1993 than in three other countries where legal actions allegingfalse or misleading forecasts are infrequent. By improving the effectivenessof safe harbor protection. Congress believed that issuers would disclose moreforward-looking information.

We also investigate whether the frequency of various types of forecastannouncements changed after the Act's passage. For example, it is a com-monly held view that limiting investors' ability to sue when projections are

•'' If the forward-looking statement was made by a business entity rather than a natural per-son, the plaintiff would be required to prove that it was made by or with the approval of anexecutive officer of the entity with actual knowledge by that officer that the statement was falseor misleading.


not realized will make managers more likely to issue good news forecasts(e.g.. Skinner [1995]). Research using data prior to the mid-1970's gen-erally finds that the market reacts positively, on average, to the release ofearnings forecasts (Patell [1976], Penman [1980], and Waymire 1984]). Incontrast, studies using data from more recent periods document a meanreaction that is zero or negative (McNichoIs [1989], Pownall, Wasley, andWaymire [1993], and Skinner [1994]). One interpretation of this evidenceis that managers disclosed fewer good news forecasts as the legal costs of dis-closure increased. Because the Act's safe harbor provision was expected toreduce these costs, we expect an increase in good news disclosures followingthe Act's passage. Thus, one contribution of our study is to provide directevidence on the relation between the legal environment and the incidenceof good news disclosures.

Although prior research has directly examined the impact of securitieslitigation on managements' voluntary disclosure of bad news, these stud-ies provide conflicting evidence on the nature of litigation-based disclosureincentives. On the one hand. Skinner [1994] suggests that managers haveincentives to voluntarily disclose bad news that prepares investors for a disap-pointing earnings announcement. Consistent with this argument. Skinner[1994] and Kasznik and Lev [1995] report that managers are more likelyto preempt large, negative earnings surprises than other types of earningsnews. Because the Act reduced the marginal benefit of voluntarily disclosingbad news, this argument suggests that managers will issue fewer bad newsforecasts after the Act's passage.

Alternatively, other research suggests that the voluntary disclosure of badnews may be a contributing factor in securities litigation (Francis, Philbrick,and Schipper [1994b], and Skinner [1997]). From this perspective, man-agers will be more likely to issue bad news forecasts after the Act's pas-sage because the marginal cost of these announcements is reduced. Con-sequently, the Act's effect on the voluntary disclosure of bad news dependson the extent to which it reduces the marginal benefits of disclosure rel-ative to the marginal costs ceteris paribus, if the former (latter) effectdominates, bad news disclosures will decrease (increase) after the Act's pas-sage. Thus, our evidence may provide some resolution to the controversy inprior literature regarding managers' motivation to voluntarily disclose badnews.

The expected legal costs associated with failing to achieve managementforecasts may also influence the form in which forward-looking informationis communicated to the market, particularly when there is uncertainty aboutthe company's prospects. For example, Waymire [1985] finds that firmsissuing point or range forecasts have less volatile earnings, while Frost [1998]finds that forward-looking disclosures in the U.S. are less specific and shorterin horizon than disclosures in countries where securities litigation is lessprevalent. Taken together, this evidence suggests that managers may bereluctant to issue forecasts that have a high likelihood of being wrong expost. Because the safe harbor protects issuers from liability when projections

304 M. F.JOHNSON, R. KASZNIK, AND K. K. NELSON

are not realized, we expect the Act to increase disclosure of long horizonforecasts as well as forecasts providing a more specific estimate of anticipatedresults.

Our ability to identify the Act's effect on the level of voluntary disclosuremay be confounded by changes in other environmental factors affectingcorporate disclosure policies. For example, anecdotal evidence in the busi-ness press suggests that there has been a recent increase in the amountof guidance managers provide to the investment community because ofthe reputational costs associated with negative earnings surprises (e.g., Ip[1997] and Lowengard [1997]). Thus, an increase in the disclosure of badnews may be due, at least in part, to this alternative motivation for disclo-sure. In the sections that follow, we discuss the implications of this issue forour research design and present the results of empirical tests designed toisolate the change in disclosure attributable to litigation reform.

3.2 IMPACT ON THE QUALITY' OF VOLUNTARY DISCLOSURE

Our second research question examines the Act's impact on the qualityof forecasted information. King, Pownall, and Waymire [1980] suggest thatprospective disclosures are useful to investors to the extent that the infor-mation is credible, i.e., free of intentional bias or misrepresentation, andprecise, i.e., free of extraneous noise. Thus, we define forecast quality alongthese two dimensions. Critics of the Act were particularly concerned thatmanagers would perceive the safe harbor as a "license to lie," and as a con-sequence would be overly optimistic in their statements to investors (Carey[1996]). McNichoIs [1989] and Frankel, McNichoIs, and Wilson [1995] findno evidence that managers issued biased forecasts prior to the Act's passage,suggesting that legal liability acts as a deterrent to this type of behavior. Be-cause the Act does not remove managers' liability for fraudulent disclosures,they may be no more likely to issue biased forecasts than they were prior tothe Act's passage.

The second property of forecast quality that we examine is noise. Theabove discussion suggests that the threat of disclosure-related litigation maycause managers to refrain from issuing forecasts when it is difficult to predictfuture performance. If litigation concerns are lessened by the existence ofthe safe harbor, managers may be more inclined to release forecasts whenearnings are volatile or when they receive a relatively noisy signal of futureearnings. As a result, management forecasts may be less accurate after theAct's passage.

3.3 SUMMARY

Prior literature and conventional wisdom suggest that the enactment ofthe safe harbor will lead to an increase in the disclostire of forecasts thatcontain good news, span a long horizon, and offer a precise estimate offuture performance. However, we are unable to make explicit predictionsregarding the Act's affect on other types of forecasts (e.g., bad news forecasts.


and short horizon forecasts). There is also some debate regarding whetherthe quality of forecasted information will deteriorate after the Act's passage.

4. Sample Selection and Description

We focus our investigation on firms in the computer hardware (SIC codes3570-3577), computer software (SIC codes 7371-7379), and pharmaceuti-cal (SIC codes 2833-2836) industries because they are frequently the targetof securities litigation. For example, Jones and Weingram [1996] find thathigh technology firnis were twice as likely as other companies to be suedduring 1989-1992. Moreover, high technology industries were particularlyvocal about the detrimental effects of securities litigation on voluntary dis-closure, and actively supported litigation reform (Avery [1996]).

Our sample period consists of the two years immediately surroundingthe Act's passage. We refer to calendar year 1994 as the pre-Act period andcalendar year 1996 as the post-Act period.^ The initial sample consists of547 U.S. public companies identified in a related study on the market reac-tion to the Act's passage (Johnson, Kasznik, and Nelson [1999]) ? From thissample, we exclude 24 firms that merged or were acquired during 1996 topreclude the possibility that changes in disclosure are due to differences insample composition between the pre-Act and post-Act periods. Therefore,our primary sample consists of 523 firms, distributed fairly evenly betweenthe three industries (135 hardware, 181 software, and 207 pharmaceuti-cal).

We focus our analysis on forecasts of earnings and sales for two rea-sons. First, empirical evidence documents that 76 percent of complaintsalleging false forward-looking statements concern earnings or sales pro-jections (Grundfest and Perino [1997]). Second, the ex post accuracyof these forecasts can be assessed by comparing them to the earningsor sales realization reported in the firm's financial statements. Althoughmanagers release other forward-looking information that falls within thescope of the safe harbor (e.g., expected future capital expenditures, an-ticipated product releases, and management's strategic plans), outcomesassociated with such predictions are neither easily obtained nor objectivelydetermined.

We obtained earnings and sales forecasts by searching the LEXIS/NEXISNews Wires file using various keywords typically associated with such

^We exclude calendar year 1995 from our study because, as indicated above, the Act wasunder legislative consideration for all but a few days of that year. Moreover, anecdotal evidencesuggests that there was a sharp increase in lawsuits filed prior to the Act's passage by attorneysseeking to have their cases decided under the older, more plaintiff-friendly rules (Schmitt[1996]). If this litigation activity affected Brms' normal disclosure practices, including 1995 inthe pre-Act period may confound our results. We discuss the comparability of the sample firmsin the pre-Act and post-Act periods in section 6.

' Specifically, these firms have complete 1995 CRSP daily retums data available, and are alsolisted on Compustat.


announcements.^ We read all identified articles to verify that they contain aforecast made by the company or one of its officers. If a particular announce-ment contains a forecast of both earnings and sales for the same fiscal period,we only include the earnings forecast in our sample.^ Announcementscontaining forecasts of earnings or sales pertaining to different fiscal pe-riods are coded individually.

Table 1 provides descriptive information on the management forecastsissued by our sample firms. Panel A indicates that 44 percent of our sam-ple issued at least one forecast during the pre-Act period, compared to 50percent after the Act's passage. By comparison, Kile, Pownall, and Waymire[1998] report that the average annual rate of disclosure for a randomlyselected sample of firms was 46 percent during 1980-1989. Although differ-ences in sample composition prevent a direct comparison of the disclosurefrequencies in the two samples, it appears the level of disclosure has beenrelatively stable in the years preceding the Act's passage.

Panel B of table 1 categorizes the forecasts by type of news, forecast hori-zon, and forecast specificity. As in Skinner [1994], we classify forecasts asgood/bad/no news when the announcement indicates that earnings or saleswill be better/worse/same than previously expected by investors, or in theabsence of information about prior expectations, better/worse/same thanthe corresponding prior period's earnings or sales. When in doubt, we clas-sify the observation as no news.'" Half of all forecasts issued in the pre-Actperiod convey good news, compared to 30 percent that convey bad news.Although both types of forecasts are more frequent after the Act's adoption,the increase is larger for bad news forecasts. As a result, the relative propor-tion of good (bad) news forecasts decreases (increases) to 46 (37) percentin the post-Act period.

We consider a forecast to have a long (short) horizon if it is issued more(no more) than one quarter ahead ofthe relevant fiscal period." Panel Bof table 1 indicates that long and short horizon forecasts occur with approx-imately equal frequency in both sample periods. Similar to the partition on

*• Frankel, Johnson, and Skinner [1999] and Tasker [1998] stiggest that managers oftenprovide more forward-looking information dtiring conference calls than in the accompanyingpress release. However, we do not consider the extent to which firms increased voliintaiydisclosure in conference calls because transcripLs of these calls are not readily available.

'•• Earnings and sales forecasts issued at the same time and pertaining to the same fiscal periodare likely to contain similar information about the firm's prospecLs. Consequently, incltidingboth forecasts in our sample will overstate firms' disclosure activity.

'"The classification is based on the authors' assessment ofthe information conuiined ina particular annotincement btit is ustially fairly straightforward. In section 6.3 we discuss thesensitivity of our results to the type of expectations data (i.e., analysts' forecasts versus historicalrealizations) used to classify the news content of forecasts.

' ' Preliminary earnings or sales announcements made after the end of the fi.scal period,but before release of the financial statements, are included in the short horizon forecasts.Untabulated results yield similar inferences when these pre-annotincements are excluded fromthe analysis.

THE IMPACT OF SECURITIES LITICATION 307

TABLE 1Comparison of Management Forecasts in the pre-Act and post-Act Periods

pre-Act post-ActPanel A: Number of Forecasts per Firm0 293 (56%) 262 (50%)1 109(21%) 111(21%)2 52(10%) 57(11%)3 S3 (6%) 33 (6%)4 16 (3%) 28 (6%)

5 or more 20 (4%) 32 (6%)

Mean (median) number of forecasts by firmsissuing at least one forecast 2.1 (2.0) 2.5 (2.0)

Panel B: Categorization of ForecastsNews-'Good news 245 (50%) 296 (46%)Bad news 144 (30%) 238 (37%)Nonews 100(20%) 112(17%)Horizon''Long 248 (51%) 310 (48%)Short 241 (49%) 336 (52%)Specificity'Point 78 (16%) 92 (14%)Bounded range 84(17%) 81(13%)Open range 125(26%) 174(27%)Qualitative 202 (41%) 299 (46%)

This table presents descriptive data for 489 pre-Act and 646 post-Act forecasts of earnings or sales issuedby the 523 sample firnis. The pre-Act period is January 1,1994 to December 31, 1994; the post-Act period isJanuary 1, 1996 to December 31, 1996.

" Good/bad/no news forecasts indicate that earnings or sales will be better/worse/same than previouslyexpected by investors, or in the absence of information about prior expectations, better/worse/same thanthe corresponding prior period's earnings or sales. The classification is based on the authors' assessment ofthe information contjiined in a particular announcement

'' Long horizon forecasts relate to fiscal periods beyond the quarter in which the forecast was made; allothers are classified as short horizon forecasts, including preliminary earnings or sales announcements madeafter the end ofthe fiscal period but before release ofthe financial statements.

' Point forecjLsts indicate a single point estimate; bounded range forecasts indicate both a lower and upperbound; open range forecasts indicate either^ lower or upper bound; and qualitative forecasts conuiin specificconinieilLs about earnings or sales but no quantitative infonnation.

type of news, both long and short horizon forecasts increase in the post-Act period, although the increase is more pronounced for short horizonforecasts. Finally, qualitative forecasts are issued at nearly twice the rate ofopen-ended range forecasts, which in turn are nearly twice as common asbounded range and point forecasts. Although point estimates are more fre-quent in the post-Act period, qualitative forecasts demonstrate the largestincrease. Interestingly, point forecasts occur in our sample at a lower ratethan documented in prior research. Specifically, we report that 16 (14)percent of the pre-Act (post-Act) forecasts issued by our sample are pointestimates. In contrast, Pownall, Wasley, and Waymire [1993] indicate that 21percent of their sample forecasts are point estimates, while Skinner [1994]reports a frequency of 26 percent. Because our firms operate in industriesat relatively high risk of litigation, they may be less willing than other firmsto issue precise point estimates.


5. Research Design

5.1 QUANTITY OF DISCLOSURE

We measure the level of forward-looking information released to the mar-ket for all types of forecasts combined as well as for various partitions of thedata based on forecast type. Our primary measure of disclosure, DUMDISC,is an indicator variable equal to one (zero) if the firm issued one or more(no) forecasts during the year.'^ We compare firms' pre-Act and post-Actdisclosure behavior using the following model:

Prob(DUMDISq, ^ 1 ) = F(a-\-

, +(1)

where F(») is the logistic c.d.f., and:

DUMDISC = one if firm i issued one or more forecasts during year t, andzero otherwise,

PERIOD = one for the post-Act period, and zero for the pre-Actperiod,

ABSCHINC — the absolute value of the change in earnings from continu-ing operations, deflated by total assets at the beginningof the year,

DCHINC = one if the change in earnings from continuing operationsis positive, and zero otherwise,

LOGASSET — log of total assets at the beginning of the year,DISSUE = one if there was a public offering of debt or common stock

in year / or the following year, and zero otherwise, andt = 1994 (pre-Act), 1996 (post-Act).

A positive coefficient estimate on PERIOD indicates an increase in thefrequency of forecast issuance in the post-Act period, incremental to theeffect ofthe other disclosure-related variables. Ajinkya and Gift [1984] sug-gest that managers issue forecasts to avoid large earnings surprises. Thus,the magnitude of the earnings surprise, ABSCHING, is expected to be pos-itively associated with the level of disclosure. Moreover, the type of newsdisclosed should be consistent with the sign of the earnings surprise. Thus,we expect DGHING to be positively (negatively) associated with the level

' An alternative meastire of disclosure, which we refer to as SUMDISC, is the total ntimber offorecasts issued by each firm. If each forecast increases the amount of information conveyed toinvestors, but also the potential for litigation, this measure provides a meaningftil characteriza-tion ofthe benefits and costs of firms' disclosure practices. However, if firms reiterate the sameor similar information in multiple forecasts issued throughotit the year, this measure overstatesthe substance of disclosure activity. We focus on DUMDISC because it is the more conservativemeastire of disclosure. However, the restilts tabtilated below are similar with SUMDISC as thedependent variable.


of good (bad) news disclosures.''' We include LOGASSET in our empiricalspecification because Lev and Penman [1990] and Frankel, McNichoIs, andWilson [1995], among others, find that disclosure is increasing in firm size.Finally, to reduce information asymmetry, firms have an incentive to increasedisclosure prior to accessing the capital markets (Frankel, McNichoIs, andWilson [1995]). Offsetting this incentive are restrictions on pre- filing dis-closures and increased susceptibility to litigation before securities offerings,suggesting that firms will maintain or decrease the level of disclosure prior toissuing securities.''' Consequently, we do not offer a directional predictionfor DISSUE.

Although the estimation of equation (1) provides evidence on whetherthe level of disclosure increased between the pre-Act and post-Act periods, itdoes not indicate whether the difference is attributable to litigation reformor to some other phenomenon. One approach to addressing this issue is tocompare the behavior ofthe sample firms to that of a matched control groupthat is seemingly unaffected by the Act, i.e., firms that are at relatively lowrisk of litigation prior to the Act's passage. However, this research design isproblematic because it is difficult to adequately control for all other factorsthat may influence the disclosure decision.'"' Therefore, we adopt an alter-native approach that examines whether changes in voluntary disclosure varycross-sectionally with our sample firms' ex ante risk of litigation.'^ Evidencethat the increase in post-Act disclosure is more pronounced for firms witha relatively high risk of litigation is consistent with firms' increasing theirdisclosure in response to the Act's passage.

We estimate the probability of litigation using firm-specific measuresof market risk (Francis, Philbrick, and Schipper [1994a] and Jones andWeingram [1996]) and financial reporting risk (Dechow, Sloan, andSweeney [1996]). Appendix A provides detail on the empirical estimation,which is based on a reduced sample of 489 firms from our initial sample

"We tise earnings from continuing operations to calctilate ABSCHINC and DCHINC be-catise this is typically the variable being forecasted by management. Moreover, the dependentvariable in equation (1) is a summary measure of each firm's disclosure activity, and thus it is notpossible to tailor the meastirement of these two control variables to each forecast isstied by thefirms in our sample. Untabulated statistics indicate that earnings from contintiing operationsand net income are equivalent for over 90 percent of our firm-year obsei-vations.

''' Frankel, McNichoIs, and Wilson [1995] find that, on average, firms are no more likely toisstie forecasts before securities offerings than at other times. However, they also report thattitilities are significantly less likely to isstie forecasts prior to obtaining external financing, whichthey suggest is dtie to the expected costs of legal liability exceeding the informational benefitsof forecasting for these firms.

'•'' Theoretically, the experimental and control groups wotild be identical in all respects ex-cept for litigation risk, thtis eliminating the need to control for other determinants of voluntarydisclostire. However, by virttie of their self-selection into the high or low risk category, this istinlikely to be the case. See Ball [1980] and Wolfson [1980] for a thorough disctission ofthedesign issties associated with the use of a control sample.

""This research design is similar to the approach adopted by Berger [1993], who tises thecross-sectional \'ariation in the market response to the adoption ofthe 1981 research and de-velopment (R&D) tax credit to isolate the change in theqtiantityof R&D indticed by the credit.


of 547 that have the additional data required by this analysis. Untabulatedsummary statistics indicate that the estimated probabilities range from 0.04to 0.83, with a mean (median) of 0.27 (0.24). We interpret these estimatesas proxies for firms' pre-Act risk of litigation, and denote this variable asUriCRISK."

Because we use a firm-specific measure of litigation risk, we move fromthe pooled time-series, cross-sectional design in equation (1) to a changesspecification. In addition to providing an implicit control for firm-specific in-tertemporally constant correlated omitted variables, this approach mitigatespotential serial correlation in the regression residuals. Our primary measureof the change in disclosure between the pre- and post Act periods is UPDISC,an indicator variable equal to one if the firm issued more forecasts in 1996than in 1994, and zero otherwise.'^ Similarly, we control for non-litigationfactors that may affect changes in disclosure by first-differencing the inde-pendent variables in our levels analysis. The empirical model is as follows:

Proh( UPDISC i, = 1 ) = F(a + fit LITIG.RISKi, +

+ fi^DIFFASSET,,

(2)

where:

UPDISC = one if the firm issued more forecasts in the post-Actperiod than in the pre-Act period, and zero otherwise,

LITIC-RISK = firm-specific estimated probability of securitieslitigation,

ABS JDIFFINC — absolute value of the difference between earnings fromcontinuing operations scaled by lagged total assets inthe post-Act and pre-Act periods,

DUM JOIFFINC — one if earnings from continuing operadons scaled bylagged total assets in the post-Act period is greater thanin pre-Act period, and zero otherwise,

DII'FASSET — difference between the log of total assets in the post-Actand pre-Act periods, and

DIFFISSUE = difference between DISSUE in the post-Act and pre-Actperiods, where DISSUE is as defined above.

" In a related study Qohnson, Kasznik, and Nelson [ 1999]), we find that the market responseto the Act's passage is hicreasing in the estimated probability of litigation. This evidence pro-vides external validity for our meastire of litigation risk.

We also examine the sensitivity of otir results to two alternative measures of the change indisclosure. The first, CHCDISC, equals the number of forecasts issued in 1996 less the numberissued in 1994. As with SUMDISC, this measure may overstate the effective change in firms'disclostire activity. The second measure, INTDISC, indicates whether a firm initiated disclosurein the post-Act period. It is equal to one if the firm did not issue any forecasts in 1994, butisstied at least one in 1996, and zero otherwise. Untabulated results for both of these measuresare consistent with those reported for UPDISC.


If an increase in disclosure between 1994 and 1996 is attributable to theAct's safe harbor provision, the coefficient estimate on LITIG-RISK v/iW bepositive. Our predictions for the control variables remain unchanged fromthe levels analysis discussed above.

5.2 QUALITY OF DISCLOSURE

Consistent with prior literature (e.g., McNichoIs [1989] and Kasznik[1999]), we use the ex post forecast error to proxy for directional biasin management forecasts. Specifically, we measure management forecasterrors, MFERROR, as the split-adjusted difference between the earnings orsales realization and management's forecast, divided by lagged total assets.'^If managers tend to issue optimistically biased forecasts, the average forecasterror will be negative. We calculate forecast errors for all point and boundedrange forecasts, setting management's forecast equal to the mid-point oftheupper and lower estimates of the bounded range forecasts. If a firm issuedmore than one forecast pertaining to the same fiscal period, we exclude allbut the earliest forecast from our analysis. We compare forecast bias in thepre-Act and post-Act periods using the following empirical model:

MFERRORF = a-\- P^PERIODF + P2CHPERFF +

+ fiiDISSUEp + PSHORIZONF + rip (3)

where:

MFERROR — actual earnings or sales less management's forecast, scaledby lagged total assets,

PERIOD = one for forecasts issued during the post-Act period, andzero for forecasts issued in the pre-Act period,

GHPERE = the one-year change in the performance measure beingforecasted (i.e., earnings from continuing operations, netincome, or sales), measured over the fiscal period to whichthe forecast relates and deflated by lagged total assets,

LOGASSET = log of total assets at the beginning of the forecast year,DISSUE = one if there was a public offering of debt or common stock

during the year of or the year following the issuance of theforecast, and zero otherwise,

HORIZON = the number of days between the forecast announcementand the end of the fiscal period to which the forecastrelates, and

E = 1, . . . , N, where N is the number of forecasts.

A negative coefficient estimate on PERIOD indicates that forecasts aremore optimistically biased after enactment ofthe safe harbor. Equation (3)

'® Scaling by share price at the beginning ofthe forecast announcement period yields similarresults (not tabulated).


also includes control variables for several additional determinants of fore-cast bias documented in prior literature. For example, Kasznik [1999] findsthat forecast errors are increasing in firm size {LOCASSET) and changesin firm performance (CHPERF). In addition, Frankel, McNichols, andWilson [1995] suggest that the threat of legal sanctions is sufficient to determanagers from issuing biased forecasts to artificially boost share prices inpre-offering periods. Because we do not know the extent to which these com-peting incentives exist for our sample firms, we do not predict the sign ofthe coefficient estimate on DISSUE. Finally, we include HORIZON to controlfor the effect of forecast horizon on the forecast error, although we do notoffer a directional prediction for this variable.

We use the absolute value of the forecast error, ABSERROR, to examinewhether the noise in management's forecasts increased following the Act'spassage, as follows:

ABSERROR F = a + ^iPERIOD,. + P^ABSCHPERFp + fis

+ P^DlSSUEp + P^HORIZONf + v,.- (4)

where ABSCHPERFis the absolute value of CHPERF, and all other variablesare as defined above. Our predictions for the independent variables are thesame as given above, except that the coefficient estimate on HORIZON isexpected to be positive because long-horizon forecasts are more likely to bewrong ex post than short-horizon forecasts.

6. Did the Safe Harbor Increase VoluntaryForward-Looking Disclosure ?

This section presents our findings with respect to the first research ques-tion that addresses the impact of litigation reform on the level of voluntarydisclosure. In section 6.1, we report descriptive statistics for the disclosurevariables and the controls for non-litigation determinants of disclosure.Section 6.2 presents the results of the logit estimations of equations(1) and (2). We discuss the results of several sensitivity checks in section 6.3.

6.1 DESCRIPTIVE STATISTICS

Table 2 reports the frequency of sample firms issuing forecasts in the pre-Act and post-Act periods (DUMDISQ, and the frequency of firms issuingan increased number of forecasts in the post-Act period (UPDISC). Withrespect to the first disclosure measure, the results indicate that 50 percentof the sample issued at least one forecast in the post-Act period, comparedto 44 percent before the safe harbor was enacted (significant at the 0.05level). This result is primarily attributable to an increase in the frequency offirms disclosing long horizon forecasts of good news (/>-value 0.02) and shorthorizon forecasts of bad news (/rvalue 0.00). In contrast, there is no evidenceof an increase for short (long) horizon forecasts of good (bad) news. Finally,the frequency of firms issuing at least one point or range forecast is not


TABLE 2Erequency of Firms Issuing Eorecasts in the pre-Act and post-Act Periods (N= 523)

All Forecasts

News/Horizon"Good/LongGood/ShortBad/LongBad/ShortSpecificity''PointBounded rangeOpen rangeQualitative

pre-Act

0.44

0.200.140.050.16

0.110.110.150.24

DUMDISC

post-Act

0.50

0.260.140.060.24

0.130.110.190.30

p-value

0.05

0.020.790.340.00

0.450.840.160.03

UPDISC

0.31

0.180.110.060.19

0.120.080.140.22

Variable definitions; DUMlVSCis an indicator \'ariable equal to one (zero) if the firm issued one or more(no) forecasts during the relevant period. UPDISC is an indicator variable equal to one if the finn issuedmore forecasts in the post-Act period than in the pre-Act period, and zero otherwise. The tabulated figuresare the mean values of the relevant variables. The prc-Act period is January 1, 1994 to December 31, 1994;the post-Act period isjanuar)' 1, 1996 to December 31, 1996. Reported /(-values for t-tests of differences inthe mean are based on two-tailed significance levels.

•' Good/bad news forecasts indicate that earnings or sales will be better/worse than previously expected byinvestors, or in the absence of information abotit prior expectations, better/worse than the correspondingprior period's earnings or sales. The cla.ssification is based on the authors' assessment of the informationcontained in a particular announcement. Long horizon forecasts relate to fiscal periods beyond the quarterin which the forecast was made; all others are classified as short horizon forecasts, including preliminaryearnings or sales announcements made after the end of the fiscal period but before release of the financialstatements.

'* Point forecasts indicate a single point estimate; bounded range forecasts indicate both a lower and upperbound; open range forecasts indicate either a lower or upper bound; and qualitative forecasts contain specificcomments about earnings or sales but no quantitative information.

significantly higher in the post-Act period, but the frequency of firms issuingat least one qualitative forecast is significantly higher {p-value 0.03).^"

The last column of table 2 indicates that 31 percent of the sample firmsissued more forecasts in the post-Act period than in the pre-Act period. Thisincrease is significantly greater than the 23 percent of firms that decreaseddisclosure (not tabulated). Moreover, untabulated findings indicate that62 percent of the firms increasing disclosure issued no forecasts in the pre-Act period. Taken together, these statistics suggest that the Act not onlyelicited additional disclosure from firms already providing forecast informa-tion, but also that it encouraged firms that had previously refrained fromissuing forecasts to adopt a more forthcoming disclosure policy. The infer-ences for the various types of forecast announcements in the remainder ofcolumn 2 are similar to those discussed above for DUMDISC, i.e., the most

^ We also examine whether firms increased the specificity of their forecasts by narrowing thedistance between upper and lower bound estimates, where at the limit these two estimates areeqtial and the firm issues a point forecast. To do this, we calculate the difference between theupper and lower bound, scaled by the midpoint of the forecasted range. Untabulated statisticsreveal that the mean and median values of this alternative meastire of forecast specificity arestatistically indistinguishable between the pre- and post-Act periods.


TABLE 3Comparison of Sample Eirms in the pre-Act and post-Act Periods (N= 523)

Performance:INCCHINCABSCHINCDCHINC

Six£:

ASSETSBVMVSALESNUMAN

Financing:LEVERAGEDISSUE

Mean

-0.16-0.03

0,190.54

674.42275.61

1,099.67618.20

4.90

0.360.15

Pre-Act

Median

0.010.010.091.00

40.9124.08

101.1132.90

2.00

0.330.00

Std. Dev.

0.560.390.350.50

4,145.791,341.374,552.893,420.43

7.63

0.220.35

Mean

-0.17-0.02

0.210..54

850.45368.65

2,211.30848.02

4.98

0.360.14

Post-Act

Median

-0.020.010.101.00

54.0934.46

136.5241.79

2.00

0.330.00

Std. Dev.

0.510.400.340.50

4,420.331,538.529,602.144,332.61

7.47

0.210.34

t-test

0.760.740.380.85

0.510.300.020.340.86

0.940.66

p-v:iltie

Wilcoxon

0.320.660.070.85

0.000.010.000.020.54

0.940.66

Variable definitions: INCis earnings from continuing operations, deflated by total assets at the beginningof the year; CHINC is the cbange in earnings from continuing operations, deflated by total assets at tbebeginning of tbe year; ABSCHlNCk tbe absolute value of tbe cbange in earnings from continuing operations,deflated by total assets at tbe beginning of tbe year; DCHINC is equal to one if the cbange in earnings fromconlinuing operations is positive, and zero otberwise; ASSIL'I'S \S total assets at tbe end of ibe fiscal year; BVis book value of equity at the end of tbe fiscal year; MV is market value of equity at tbe end of tbe fiscalyear; .SAIJi.S is total sales; NUMANis tbe number of analysts following tbe company as reported by I/B/E/S;UiVEKACE is tbe ratio of total liabilities to total assets; and DISSUE is an indicator variable equal to one ifthere was a public offering of debt or common stock witbin tbe following year, and zero otherwise. ASSETS.BV. MV.and SA/JiS are .stated in millions of dollars. Tbe pre-AcI period is January 1, 1994 lo December 31,1994; tbe post-Act period is January 1, 1996 to December 31,1996. Reported p-values are based on two-lailedsignificance levels.

pronounced increases in disclosure are for long (short) horizon forecastsof good (bad) news and for qualitative forecasts.

To assess the extent to which the firms in our sample are comparable in1994 and 1996, we examine a number of performance, size, and financingmeasures. These descriptive statistics are presented in table 3. We find nomaterial differences in firm performance and financing activity betweenthe two periods. However, there is some evidence of an increase in thesize of sample firms between the pre-Act and post-Act periods. Specifically,median total assets (ASSETS), book value ofequity (BV), market value ofequity (MV), and sales (SALES) are significantly higher in the post-Act pe-riod, although differences in the mean values of these variables are gen-erally insignificant. In the regression analyses that follow, we control forthe possibility that the increase in sample firms' forecasting activity docu-mented in table 2 is attributable to economic differences between the twoperiods.

6.2 REGRESSION RESULTS

Summary statistics from the estimation of equation (1) are presentedin table 4.^' A positive coefficient estimate on PERIOD indicates an

Becatise we do not have a directional prediction for all empirical tests, we conser\';uivelyreport the results of two-tailed tests of significance throtighotit the paper.

THE IMPACT OF SECURITIES LITIGATION

TABLE 4Ijigit Analysis of the Level of Disclosure in the pre-Act and post-Act Periods (N= 1,046)

Prob(DUMDISCit = l) = F(a

315

+ PiLOCASSETi, +

All Forecasts

News/Horizon^Good/Long

Good/Short

Bad/Long

Bad/Short

Specificity''Point

Bounded range

Open range

Qualitative

IN7ERCEPT

-1.18(0.00)

-2.26(0.00)

-2.58(0.07)

-3.70(0.00)

-2.01(0.00)

-3.07(0.00)

-3.35(0.07)

-2.19(0.00)

-1.67(0.00)

PERIOD

0.16(0.20)

0.29(0.06)

-0.12(0.52)0.15

(0.61)0.39

(0.01)

0.05(0.79)

-0.09(0.66)0.15

(0.36)0.26

(0.06)

ABSCHINC

0.25(0.19)

0.06(0.79)0.11

(0.69)0.43

(0.14)0.19

(0.38)

0.25(0.35)

-0.04(0.90)0.61

(0.01)-0.20(0.42)

DCHINC

-0.09(0.47)

0.05(0.76)0.16

(0.39)-1.29(0.00)

-0.93(0.00)

-0.21(0.28)

-0.36(0.10)

-0.70(0.00)

-0.02(0.87)

LOCASSET

0.25(0.00)

0.22(0.00)0.19

(0.00)0.27

(0.00)0.21

(0.00)

0.26(0.00)0.33

(0.00)0.18

(0.00)0.16

(0.00)

DISSUE

-0.40(0.03)

-0.84(0.00)

-0.90(0.01)0.15

(0.69)-0.69(0.01)

-0.13(0.66)

-0.49(0.15)

-0.46(0.09)

-0.74(0.00)

Modeix2

56.66(0.00)

51.26(0.00)28.49(0.00)28.86(0.00)63.29(0.00)

28.74(0.00)47.27(0.00)38.28(0.00)38.72(0.00)

Variable definitions: DUMDISC is an indicator variable equal to one (zero) if the firm issued one or more(no) forecasts during the year; PERIOD is an indicator variable equal to one (zero) for post-Act (pre-Act)period firm-year observations; ABSCHINC is the absolute value of the change in earnings from continuingoperations, deflated by total assets at the beginning of the year; DCHINC is equal to one if the change inearnings from continuing operations is positive and zero otherwise; LOGASSET is the log of total iissets atthe beginning of the year; and DISSUE is equal to one if there was a public offering of debt or commonstock within the following year and zero otherwise. The pre-Act period is January 1, 1994 to December 31,1994; the post-Act period is January 1, 1996 to December 31,1996. Reported /^valuesare based on two-tailedsignificance levels.

^Good/bad news forecasts indicate that earnings or sales will be better/worse than previously expected byinvestors, or in the absence of information about prit)r expectations, better/worse than the correspondingprior period's earnings or sales. The classification is based on the authors' assessment of the informationcontained in a particular announcement. Long horizon forecasts relate to fiscal periods beyond the quarterin which the forecast was made; all others are classified as short horizon forecasts, including preliminaryearnings or sales announcements made after the end of the fiscal period but before release of the financialstatements.

^Point forecasts indicate a single point estimate; bounded range forecasts indicate botk a lower and upperboimd; open range forecasts indicate either a lower or upper bound; and qualitative forecasts contain specificcomments about earnings or sales but no quantitative information.

increase in the frequency of sample firms issuing forecasts, incrementalto the effect of the control variables. The estimation results are generallyconsistent with the univariate analyses reported previously, except for the"All Forecasts" specification where the coefficient estimate on PERIOD ispositive, as predicted, but not significant (/7-value 0.20). However, there is asignificant increase in the frequency of firms issuing long horizon forecastsof good news (/7-value 0.06), suggesting that managers are more inclinedto volunteer favorable information about their companies* extended out-look under the protection of the Act's safe harbor. There is also a signifi-cant increase in the frequency of firms disclosing short horizon forecasts of


bad news (p-value 0.01), consistent with a reduction in the net legal costsassociated with this type of forecast announcement. Finally, the coefficientestimate on PERIOD is statistically indistinguishable from zero for pointand range forecasts, although it is significantly positive at the 0.06 level forqualitative forecasts. Thus, for the sample as a whole there does not appearto be any evidence that managers were motivated to provide more specificforecasts once the safe harbor took effect.

The results for the control variables are generally consistent with priorempirical evidence. For example, we find a significantly positive associationbetween forecast issuance and firm size (LOCASSET), regardless of the typeof news released, length of forecast horizon, and forecast specificity. Wealso find that the estimated coefficient on DISSUE is significantly negativein most estimations, indicating that sample firms are less likely to issue amanagement forecast when obtaining external financing. In contrast, theassociation between DUMDISC and the firm performance measures is rela-tively weak. For example, the coefficient estimate on ABSCHINCis generallypositive, as predicted, but is only statistically significant in one regression.The coefficient estimate on DCHINC indicates that firms with an increase(decrease) in annual earnings are more likely than other firms to issue fore-casts containing good (bad) news, although this relation is significant onlyfor the bad news firms.^^

To summarize, the regression results presented in table 4 document apost-Act increase in the frequency of sample firms issuing certain types ofprospective disclosures, specifically long horizon forecasts of good news andshort horizon forecasts of bad news, that is not explained by factors identifiedin prior research. Although this evidence is consistent with firms increasingdisclosure in response to the Act's passage, it is also possible that therewas a structural increase in the level of disclosure between 1994 and 1996for reasons unrelated to litigation reform. To discriminate between thesealternative explanations, we estimate equation (2) to investigate whetherthe change in disclosure is associated with firms'ex ante risk of litigation. Apositive association provides direct evidence of a link between an increasein firm disclosure and the Act's passage.

Results of this analysis are presented in table 5. The estimation is based ona reduced sample of 475 firms that meet the initial sample selection criteriaand have the data available to estimate pre-Act litigation risk. Consistentwith predictions, the coefficient estimate on LITIC-RISKis significantly pos-itive (/7-value 0.00) in the "All Forecasts" specification, indicating that firmswith relatively high litigation risk in the pre-Act period were more likelythan others to increase the number of forecasts issued during the first yearfollowing the Act's passage. Moreover, we find that increases in both longand short horizon forecasts of good news are positively associated with ex

'^'^ The tintabulated psetido R s for the estimations reported in table 4 are approximately 0.05,suggesting that much of the variation in disclosure remains unexplained. The low explanatorypower may also be attributable to noise in our summary measure of firms' disclosure policies.


0 ) 0O Oo d o

^ p p pl o o o o o d o o( M - ' C ^ ^ — G ^ ^ — ^—

o o o o o o o o o o o o o o o o ^ o o

p ; ^ ^o o o o o o o o o o o o o o o o

po o

p ^ po o o o o o o oI . . ^ I .—- I - ^ o o o o o o o oI ^ I ^^ I ""^ I '

Ol toOf pd d o o o o o o o o

— oI "

ox:en

O

o

ITDC33O

oa

IIo

3

itiliililimUt1 |

i i

5 U

a I

cs

lii


ante litigation risk at less than the 0.05 level. Short horizon forecasts of badnews also demonstrate a strong positive association with litigation risk (p-value 0.00). Finally, the coefficient estimate on LITIC-RISK is significantlypositive across all four categorizations of forecast specificity, suggesting thathigh litigation risk firms are inclined to provide more quantitative as well asqualitative forecasts in the post-Act period.^^

Regarding the control variables, the estimation results generally indicateno association between changes in disclosure and changes in firm size andcapital market activity between 1994 and 1996. Although the findings intable 4 and in prior empirical studies reveal a cross-sectional associationbetween these variables and firms' forecasting activity, their ability to ex-plain changesin disclosure policy is limited because these variables generallyexhibit litde variation over the two-year period. However, we find that thecoefficient estimate on ABS.DIFFINC is significantly positive, as predicted,for the "All Forecasts" specification (p-value 0.06). Moreover, firms with a de-cline in profitability between 1994 and 1996, as measured by DUM.DII'FINC,are significantly more likely to increase the number of bad news forecasts is-sued (/7-value 0.00 for both long and short horizon), which also significantlyimpacts the total increase in forecasts issued (p-value 0.02) . ''

6.3 SENSITIVITY CHECKS

Taken together, the evidence presented above indicates that there wasa significant increase in the level of voluntary disclosure during the post-Act period, and that this increase appears to be a direct response to thereduced legal exposure for forward-looking statements. We test the robust-ness of these results using the alternative measures of the level of disclosure(SUMDISC) and the change in disclosure (CHGDISCand IN^FDISC) definedabove. The results of these untabulated analyses are similar to those reportedin tables 4 and 5, respectively.

^' Becatise otir sattiple comprises only three different indtistiies, it is possible that the vol-untary disclostire policy of sample firms is cross-sectionally correlated, leading to a potentialunderstatement of the coefficient standard errors. However, because each firm is representedin our sample in only two years, our data do not permit explicit recognition of the potentialdependence tising feasible GLS or other empirical techniques (see Bernard [ 1987]). Neverthe-less, we do not expect cross-sectional correlation to be a seriotis isstie for the restilts reported intable 5 because the changes specification mitigates correlated omitted variables that could leadto dependence among observations. Consistent with this argument, we find no evidence thatthe regression residuals from an OLS version of equation (2) using CHCDISCas the dependentvariable exhibit any industry clustering.

'' Prior research suggests earnings variability may explain cross-sectional variation in fore-casting behavior (Waymire [1985]). Because our sample of high technology firms comprisesmany yoting firms for which a meaningftil time-series estimation ofearnings variability is notfeasible, we do not incorporate this variable in our primary tests. However, untabulated resultsindicate that the coefficient of variation in earnings (measured as the standard deviation ofannual earnings from contintiing operations divided by the absoltite valtie of the mean) forthe 357 firms with at least Bve years of available data is not incrementally significant in theestimation of equation (2).


To check the impact of our procedure for classifying forecasts accordingto their news content, we identify whether the benchmark expectation inthe announcement is an analyst forecast (47 percent of our sample) orhistorical results (53 percent). Because our coding ofthe news content offorecasts in the latter category is relatively noisy, we re-estimate equation (2)excluding these observations from the analysis. Consistent with the resultsreported in table 5, our untabulated findings indicate that both long andshort horizon forecasts of good news and short horizon forecasts of badnews are positively associated with LITIG-RISK. Moreover, the significancelevel ofthe good/long result improves to 0.01.

We also examine intra-industry variation in firms' disclosure behavior. ^These findings (not tabulated) indicate that there is a significant post-Actincrease in disclosure for hardware and software firms, but not for pharma-ceutical firms. Moreover, the increase in disclosure is significantly associatedwith the ex ante risk of litigation for hardware and software firms, but notpharmaceutical firms. We explore two non-mutually exclusive explanationsfor these findings. First, we investigate whether there are systematic differ-ences in the value-relevance of earnings across the three industries becausefirms may be less likely to issue forecasts if the information is not useful to in-vestors. Untabulated results indicate that the firm-specific earnings/returnscorrelation is significantly lower for the sample of pharmaceutical firms. ''Moreover, pharmaceutical firms provide less disclosure than the other twoindustries in both the pre-Act and post-Act periods. Taken together, thisevidence suggests that pharmaceuticals may have less of an incentive to is-sue earnings projections, and thus may have altered their forward-lookingdisclosures to a lesser extent as a result ofthe Act's passage. Second, pharma-ceuticals may not have significantly increased disclosure because they wererelatively unaffected by the Act's passage. Consistent with this conjecture, wefind that the average estimated probability of litigation is 0.35 for hardwarefirms, 0.30 for software firms, and 0.18 for pharmaceutical firms (all threepairwise differences in industry means are significant at the 0.05 level orless).

Our final sensitivity analysis compares the level of disclosure in the pre-Act and post-Act periods on a quarterly basis because firms may have beeninitially hesitant to provide more forward-looking information than theyhad prior to enactment of the safe harbor. In addition, an initiative on theNovember 1996 California ballot known as Proposition 211 sought to elim-inate the safe harbor for forward-looking statements for any company that

'•^ Untabulated analyses indicate that the three sample industries are similar in terms ofthevarious firm size and performance measures tabulated above in table 3. In addition, approxi-mately 80 percent of sample firms in each ofthe three indtistries are traded Over-the-Counteror on the NASDAQ National Market System. However, pharmaceutical firms have significantlylower beta and leverage than hardware and software firms.

26 yi g earnings/returns correlation is the correlation betiveen annual market-adjtisted re-ttirns and the change in annual earnings from continuing operations, calculated over a maxi-mtim of ten years.


conducts business or has at least one shareholder in California. Althoughthis measure was defeated on November 5, 1996, several technology firmsindicated tbat they suspended disclosure of forward-looking informationin tbe fourth quarter of 1996 to avoid exposure to potential litigation ifProposition 211 passed (e.g., Reuters Financial Service [1996a] and UnitedPress International [1996]). Untabulated results indicate that disclosure byour sample of hardware and software firms increased significantly in the firstthree quarters following enactment of the safe harbor, but that it decreasedin the fourth quarter when Proposition 211 threatened to reverse the pro-tection provided by the federal law. Although we do not have the data todetermine if this decline was temporary, anecdotal evidence suggests that itwas (e.g., Reuters Financial Service [1996b]).

7. Did Forecast Quality Deteriorate After the SafeHarbor Was Enacted"?

This section presents our findings with respect to the second researchquestion which addresses the impact of the safe harbor on the quality offorward- looking information. In section 7.1, we investigate critics' primaryconcern that managers will abuse the safe harbor by issuing overly optimisticstatements intended to bolster stock prices. In Section 7.2, we examinewhether management forecasts are less precise in the post-Act period.

7.1 ANALYSIS OF BIAS IN MANAGEMENT FORECASTS

Panel A of table 6 reports the mean and median management forecasterror for our sample of 157 (164) point and bounded range forecasts is-sued in the pre- Act (post-Act) period.^^ Contrary to the allegations of theAct's critics, there is no evidence that forecasts issued after enactment of tbesafe harbor are more optimistically biased than those issued before. Specif-ically, the mean (median) forecast error in the pre-Act period is —0.019(-0.001), compared to a post-Act forecast error of-0.021 (-0.001). Bothof these differences are statistically indistinguishable from zero. In addition,the magnitude of these errors is comparable to that found in the prior litera-ture on management forecast accuracy (e.g., McNichols [1989] and Kasznik[1999]).

Summary statistics from the estimation of equation (3) are presented inpanel B of table 6. Although the coefficient estimate on PERIODis negative, itis statistically insignificant (p-\a\ue 0.739). Thus, there is no evidence to sup-port claims that managers issue more optimistic forecasts after enactmentof the safe harbor, perhaps because the Act did not eliminate liability fordeliberately false or misleading forward-looking statements. As expected, wefind that management forecast errors are significantly negatively associated

^' Because this analysis excludes all but the earliest forecast pertaining to a particular fiscalperiod, there are fewer point and bounded range observations than reported above in table 1.


TABLE 6Analysis of Bias in Management Forecasts

Panel A: Distributional Statistics

N

157164

MFERROR

Mean

-0.019-0.021(0.884)

Median

-0.001-0.001(0.973)

pre-Actpost-Actp-value

Panel B: Summary Regression Statistics

MEERRORF =a + PiPERIODi.'+ PiCHPERE^ + (i^LOCASSET,.--t- P4DISSUEF + P^HORIZON/.- + rir

Variable Coefficient Estimate p-value

INTERCEPT -0.048 0.002PERIOD -0.004 0.739CHPERE 0.112 0.005LOGASSET 0.007 0.013DISSUE 0.008 0.732HORIZON -0.001 0.013Af=321R^ = 0.03

Variable definitions: MFERROR equals actual earnings or sales less management'sforecast, scaled by lagged total assets (for bounded range forecasts, management's fore-cast is equal to the mid-point of the upper and lower bound estimates); PERIOD is anindicator x'ariable t qual to one for post-Act forecasts and zero otherwise; CHPERF isthe one-year change in the performance measure being forecasted (e.g., earnings fromcontinuing operations, net income, or sales), deflated by total asset.s at the beginningof the year; CHPERF is measured over the fiscal period to which the forecast relates;LOGASSET'is the log of total assets at the beginning of the year; DISSUE'is equal to one ifthere was a public offering of debt or common stock within the following year, and zerootherwise; and HORIZON is the length of the forecast horizon measured in days. Thepre-Act period is January 1, 1994 to December .SI, 1994; the post-Act period is January1, 1996 to December 31, 1996. Reported Rvalues are based on two-tailed significancelevels.

with forecast horizon (HORIZON), and are significantly positively associatedwith changes in firm performance (CHPERF) and firm size (LOCASSE'T). Incontrast, there is no association between management forecast errors andfirms' activity in the capital markets.

7.2 ANALYSIS OF NOISE IN MANAGEMENT FORECASTS

Although there is no indication that post-Act forecasts are systematicallymore biased than pre-Act forecasts, they may contain more noise. We mea-sure the noise in management forecasts using the absolute value of the expost management forecast errors (ABSERROR). Panel A of table 7 presentsdistributional statistics for ABSERROR Contrary to expectations, both themean and median absolute forecast errors are smaller in tbe post-Act pe-riod, with the differences significant at the 0.087 (0.098) level, respectively.

Panel B presents summary statistics from the estimation of equation (4).Although the coefficient estimate for PERIOD is negative, it is statistically


Panel A:

pre-Actpost-Actp-value

TABLE 7Analysis of Noise in Management Forecasts

Distributional Statistics

N

157164

ABSERROR

Mean

0.0540.037

(0.087)

Median

0.0120.002

(0.098)

Panel B: Summary Regression Statistics

ABSERRORr = a + fiiPERIODy-i- ^2 ABSCHPERF,.- -f /?., LOGASSETr+ P4 DISSUEr + ft HORIZONF + vy

Variable Coefficient Estimate p-value

INTERCEPTPERIODABSCHPERFLOGASSETDISSUEHORIZONN=321F? = 0.36

0.040-0.001

0.179-0.007

0.0050.001

0.0020.8890.0010.0010.7760.001

Variable definitions: ABSERROR e(\\a\s lhe absolute value ofthe difference betweenactual earnings or sales and management's forecast, scaled by lagged total assets (forbounded range forecasts, management's forecast is equal to the mid-point of the upperand lower bound estimates); PERIOD is an indicator variable equal to one for post-Actforecasts and zero otherwise; ABSCHPERE'is the absoltite value the one-period change inthe performance measure being forecasted (e.g., earnings from continuing operations,net income, or sales), deflated by total assets at the beginning of the year; ABSCHPEIWis measured over the accounting period to which the forecast relates; LOGASSET isthe log of total asseis at the beginning of the year; DISSUE is equal to one if therewas a public offering of debt or common stock within the following year, and zerootherwise; and HORIZON is the length of the forecast horizon measured in days. Thepre-Act period isjanuary 1, 1994 to December 31, 1994; the post-Act period isjanuaiy1, 1996 to December 31, 1996. Reported //-values are based on two-tailed significancelevels.

insignificant (/^value 0.889). This finding indicates that, controlling forother factors associated with forecast accuracy, management forecasts is-sued in the post-Act period are no more or less noisy than forecasts issuedprior to enactment of the Act. We also find that the estimated coefficienton HORIZON 1% significantly positive, consistent with long horizon forecastsbeing less accurate, on average, than short horizon forecasts. The estimatedcoefficient on LOGASSET is significantly negative, indicating that the noisein management forecasts is greater for smaller firms. Also as expected, theestimated coefficient on ABSGHPERFis significantly positive, suggesting thenoise in management forecasts is greater for firms with higher earningsvolatility.

Summarizing the evidence presented in this section, we find that the safeharhor had no adverse impact on the quality of forward-looking informa-tion released hy management. Specifically, the results indicate that forecasterrors, whether directional or non-directional, were not significantly


impacted by the Act's passage. ^ However, we find that several other fac-tors, most notably firm size, changes in firm performance, and the lengthof tbe forecast horizon, are significant determinants of the bias and noisein managements' forecasts in both the pre-Act and post-Act periods.

8. Summary and Concluding Remarks

This study evaluates the effect of the Private Securities Litigation ReformAct on corporate voluntary disclosure of forward-looking information. De-spite tbe general "stickiness" of firms' disclosure practices and tbe relativelyshort time period we examine, we find evidence of a significant post-Actincrease in both tbe frequency of firms issuing forecasts and the mean num-ber of forecasts issued. The increase in prospective disclosure is primarilyattributable to managers issuing more long horizon forecasts of good newsand short horizon forecasts of bad news. More important, we document thatthe change in disclosure is increasing in our estimate of firms' ex ante riskof litigation. This result holds not only for the total change in disclosure, butalso for both short and long horizon forecasts of good news, short horizonforecasts of bad news, and quantitative as well as qualitative forecasts. Thisanalysis provides critical evidence that the increased level of disclosure is inresponse to the Act's passage rather than to a structural cbange in firms'economic environment between 1994 and 1996.

We find no evidence that the increase in the quantity of forward-lookingdisclosures was accompanied by a significant decrease in the bias and accu-racy of forecast information, holding other factors constant. Thus, althoughthere was no improvement in forecast quality following enactment of thesafe harbor, there was also no deterioration as was feared by the Act's critics.Taken together, our results are important because they provide some of themost direct evidence to date of a link between the litigation environmentand firms' voluntary disclosure of forward-looking information.

APPENDIX A

Estimation of Litigation Risk

Prior research on the determinants of litigation risk suggests that mar-ket capitalization, equity beta, and share turnover are positively associatedwith the probability of being sued, and that prior cumulative returns andreturn skewness are negatively associated with the probability of being sued(Francis, Philbrick, and Schipper [1994a] andjones and Weingram [1996]).

^ We obtain similar inferences when we examine the various news/horizon forecast typesseparately (results not tabulated). In particular, we find no statistically significant differencesbetween the pre-Act and post-Act periods with respect to the qtiality of forecasts (as measuredby MITLRROR and ABSERROR) that contain good news and/or are isstied over long horizons.Additional untabulated sensitivity analysis indicates that the results in tables 6 and 7 are robustto deletion of the sales forecasts in our sample.

324 M. F . JOHNSON, R. KASZNIK, AND K. K. NELSON

For parsimony, we conduct a factor analysis of these five variables, whichyields the following two summary measures: Volatility (positively correlatedwith equity beta and share turnover) and Performance (positively correlatedwith prior cumulative returns and return skewness).

Because accounting irregularities are one of the most common typesof fraud alleged in class action securities litigation (Grundfest and Perino[1997]), we include the risk factors found by Dechow, Sloan, and Sweeney[1996] to be associated with aggressive financial reporting: CEO Power(a proxy for the CEO's influence over the Board of Directors), Monitoring

TABLE 8Descriptive Statistics of Litigation Risk Characteristics (N= 489)

Variable

Litigation

Market risk:

MVEBetaReturnSkewnessTurnover

Factors:

VolatilityPerformance

Reporting risk:

% Independent% OutsideAuditBig 6BlockCOBFounder

Factors:

CEO PowerMonitoring

FinancingLeverage

Mean

0.27

1.711.240.610.560.60

0.000.00

72.033.790.980.920.730.600.33

-0.000.01

0.240.38

Std. Dev.

0.44

7.170.940.701.130.25

1.001.00

15.179.260.150.270.440.490.47

0.991.00

0.430.27

Median

0.00

0.121.210.530.500.61

0.00-0.06

75.000.781.001.001.001.000.00

-0.130.07

0.000.33

Minimum

0.00

0.010.10

-LOO-5.36

0.04

-2.61-4.13

0.000.000.000.000.000.000.00

-1.70-1.50

0.000.03

Maximum

LOO

80.643.854.947.81LOO

2.304.54

100.0046.34

1.001.00LOOLOOLOO

8.951.67

LOO2.35

Variable definitions: Litigation is equal lo one if the Securities Class Action Alert indicated that the finn wa.sa defendant in a securities class action lawsuit in either 1994 or 1995, and zero othei"wise; MVE is marketrallle of common equity at the end of the 1994 calendar year (billions); Beta'xs the slope coefficient from aregression of daily retm'ns for the first eleven months of 1995 on the equal-weighted market index; /ifitumis tbe cumulative daily return for the first eleven months of 1995; Skewness is tbe skewness of raw leturns,measured using daily returns for the first eleven months of 1995; Turnovers equal lo 1 - (1 -Turn)'-''" , whereTurn is average daily trading volume divided by the number of sbares outstanding, and 2.S1 is the number oftrading days in tbe first eleven months of 1995; Volatility is a factor obtained from the five market variablesIhat is positively correlated witb Beta and Turnover, Performance is a factor obtained from tbe live marketvariables that is positively correlated witb lietum and Skamess; %Initependent is equal lo tbe percentage ofdirector wbo are not officers of tbe company; %Outside is equal to tbe percentage of oulstanding sharesbeld by outside directors; Audit is equal lo one if tbe firm has an audit committee, and zero otbeiwise; liig 6is equal to one if the firm has a Big 6 auditor, and zero otherwise; Block is equal to one if the firm has a 13Dfiler who is not an insider, and zero otherwise; COB is equal to one if the CEO is chairman of tbe board ofdirectoi-s, and zero otberwise; Founderh equal to one if tbe CEO is tbe company founder, and zero otherwise;CEO Pmver is a factor obtained from the seven corporate governance variables thai is positively correlatedwith COB and Founder: Monitoring is a factor obtained from tbe .seven corporate governance v-jriables that ispositively correlated with Audit, Big 6, and Block; Financingis equal to one if tbe firm issued debt or equity in1994 or 1995, and zero othenvise; and /..everageis the ratio of debt to equity al the end of 1994.


(a proxy for the effectiveness of the Board's oversight). Financing (a proxyfor capital markets activity), and Leverage (a proxy for the firm's closenessto debt covenant violation). As in Dechow, Sloan, and Sweeney [1996], weobtain CEO Power and Monitoring from a factor analysis of seven corporategovernance variables band-collected from company proxy statements: theproportion of insiders on tbe Board, the proportion of common shares heldby outside directors, the existence of an audit committee, the use of a Big6 auditor, the existence of an outside blockholder, the presence of a CEOwho is also Chairman of the Board, and the presence of a CEO who is alsoa founder of tbe company.

We estimate litigation risk using the following probit model:

Prob(Litigation-= 1) = C(OCQ-\-

-\- Ss CEO Poweri -{• P j

-\- fi^Financing- -\- fi^Leverage.)

where G(») is the standard normal c.d.f., and Litigation is equal to one if thefirm was a defendant in a class action securities lawsuit in either 1994 or1995, as reported by tbe Securities Class Action Alert, and zero othenvise. Theadditional data requirements for this analysis reduce our primary sample of523 firms to 489 firms, consisting of 128 hardware, 170 software, and 191pharmaceutical firms.

TABLE 9Probit Estimation of Litigation Risk (N= 489)

Prob(Litigation- = 1) = C(a(,-\- fi\Volatiltity^-

-)- P^Monitoring^ + fi^Finandng- -f fi^ Leverage j)

Variable

ConstantVolatilityPerformanceCEO PowerMonitoringFinancingLeverageModelX^

PredictedSign

?

+-+-

+

CoefficientEstimate

-0.850.40

-0.160.000.070.510.69

65.71

/^valtle

0.000.000.010.990.290.000.000.00

Variable definiiions: Litigation is equal to one if the Securities Class Action Alert indicated tliat thefirm was a defendant in a securities class action lawsuit in either 1994 or 1995, and zero otherwise;Volatility is a factor measuring stock price volatility that is positively correlated with equity betaand share turnover; Performance is a factor measuring stock price performance that is positivelycorrelated with prior cumulative returns and return skewness; CEO Poxoer is a factor measuringthe CEO's influence over the Board of Directors that is positively correlated with the presenceof a CEO who is also the Chairman of the Board of Directors or the founder of the company;Monitoringis a factor measuring the effectiveness of the Board of Director's oversight of managementthat is positively correlated with the existence of an audit committee, the use of a Big 6 auditor,and the existence of an outside blockholder; Einancing is equal to one if the firm issued debt orequity in 1994 or 1995, and zero otherwise; and Leverageis the ratio of debt to equity at the end of1994.


Table 8 presents descriptive statistics for the above variables. Summarystatistics from the estimation of the probit model are reported in table 9.Consistent with prior research, we find that litigation is increasing in stockprice volatility and decreasing in stock price performance. The results re-garding the four aggressive reporting risk proxies are mixed. Although CEOPowerand Monitoringa.re insignificant conditional on the other risk proxies.Financing a.nd Leverage are both significant at the 0.01 level in the predicteddirection.

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