Do Opinions On Financial Misstatement Firms Affect Analysts’ Reputation With Investors? Evidence From Reputational Spillovers
Boston College – Carroll School of Management
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February 28, 2016
We examine whether opinions on firms subsequently revealed to have misstated earnings affect analysts’ reputation with investors. We find that positive opinions by bullish analysts hurt their reputation, leading investors to react less to their research on non-misstatement firms after the misstatement revelation (i.e., negative spillovers). We also find that bearish analysts issuing more negative opinions gain reputation and experience positive spillovers. Finally, for analysts who dropped coverage of the misstatement firm before the misstatement revelation, we find no spillovers, which suggests that analysts experience limited reputational gains when they did not issue a public negative opinion.
Do Opinions On Financial Misstatement Firms Affect Analysts’ Reputation With Investors? Evidence From Reputational Spillovers – Introduction
Analysts are sophisticated information intermediaries who form opinions on a firm’s investment value by analyzing its fundamentals. Research suggests that for firms misstating earnings, some analysts question the financial reporting process or business model before the misstatement is revealed, and thus cease coverage or issue negative opinions (e.g., Dechow et al. 1996; Dyck et al. 2010; Miller 2006; Peng and Young 2013).1 An unaddressed issue is whether these actions affect the analysts’ reputations with investors. A bearish analyst may gain reputation, or, because he was not bullish, minimize reputational loss. Anecdotally, Healy and Palepu (2003, p.19) highlight that “[bullish] analysts have received considerable criticism for failing to provide an earlier warning of problems at Enron.” However, Brown et al. (2015) interviewed analysts who stated that they pay limited attention to potential misstatements, as they believe the reputational consequences are minimal. In this study, we examine whether an analyst’s opinions on misstatement firms affect his reputation. This will further our understanding of how analysts gain or lose reputation and whether reputational effects are important for them to consider when covering firms with potential misstatements.
We identify financial misstatement firms as those associated with Accounting and Auditing Enforcement Releases (AAERs) from the SEC.2 Our test focuses on whether misstatement revelations affect investors’ perceptions of the analyst, leading investors to change their reaction to the analyst’s research on non-misstatement firms (i.e., spillover effects). For these spillovers to occur, investors must judge that the analyst’s skills affect his analyses of both the misstatement and non-misstatement firms. This is the case when the two firms are in the same industry, as the analyst’s industry knowledge is critical in the assessment of the investment values of both firms (Hilary and Shen 2013). In addition to industry knowledge, skills such as gathering and synthesizing information from multiple sources also affect the analyst’s research on both firms. Hereafter, we use analyst ability to refer to an analyst’s proficiency in these skills.
When a misstatement is revealed, investors are likely to doubt bullish analysts’ ability. They will, for example, question the analysts’ knowledge of industry trends or whether they can effectively assess the reasonableness of company-provided information when formulating their investment opinions. These doubts lead investors to downplay the analysts’ research on non-misstatement firms, which results in negative spillovers. Conversely, investors are likely to deem the bearish analysts’ negative opinions as a positive reflection of their ability, which leads to positive spillovers. Regarding the analysts who dropped coverage of the misstatement firm before the misstatement revelation, prior studies suggest that they might have anticipated the misstatement (Dechow et al. 1996). As a result, investors might view them favorably, but the positive spillovers could be limited as the analysts did not issue a public negative opinion on the misstatement firm.
For each misstatement firm, we follow prior research (Dechow et al. 1996) and verify when the misstatement is revealed to the public. We identify analysts who followed the misstatement firm before the misstatement revelation and measure their bullishness relative to other analysts covering the same firm. We construct a summary measure that considers analyst bullishness across three key research outputs: (1) stock recommendations, (2) target prices, and (3) annual earnings forecasts. In an additional test for a hand-collected subsample, we also consider bullishness in the analyst’s qualitative comments on the misstatement firm.
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