Explaining Earnings Forecasts with Accounting, Industry, and Economic Variables

Abstract

This paper looks at the importance of forecasted information as a key input to investors decision models. The research design uses accounting variables suggested by financial accounting theory, industry variables and economic variables. Analysis of the data indicated that only return on investment yield and capital intensity were associated with earnings. In an environment of rapidly changing economic conditions and attendant uncertainty, the scrutiny of forecast accuracy has is crucial. For a firm, the allocation of resources is based upon forecasts of financial information that may affect its survival. Earnings and dividends forecast, and the growth rates in these forecast are key informational inputs in investor decision models (Chang and Most, 1980). In addition, Securities and Exchange Commission, recognizing the importance of this subjective and non‐verifiable information, permits and encourages firms to include financial forecasts in their annual reports by granting them a “safe harbor”. The accounting profession responded to this demand for forecasted information by producing audit guidelines for these forecasts. Accounting‐based financial forecasts are used in a variety of ways. Banks and non bank financial institutions use forecasts to evaluate credit. Earnings forecasts are useful to financial analysts who attempt to isolate a firm's intrinsic characteristics such as residual income after removing the effect of economy and industry conditions through the use of index models. Auditors use accounting forecasts as a basis for expectations concerning reported items to determine the extent of detailed tests (Stringer, 1975; Kinney, 1978). Lev (1980, p.525) stated that the “… crucial stage of the analytical review process is the generation of expected, or reasonable, values of financial statement items.” Managers use internally generated earnings forecasts for resource allocation decisions concerning present operations as well as future operations and expansions/contractions.

Citation

Westcott, S. and Khumawala, S. (1990), "Explaining Earnings Forecasts with Accounting, Industry, and Economic Variables", Managerial Finance, Vol. 16 No. 3, pp. 3-10. https://doi.org/10.1108/eb013643