Analyst Earning Forecasts and Advertising and R&D Budgets: Role of Agency Theoretic Monitoring and Bonding Costs

Abstract

Because security analysts, who serve as brokers between public firms and investors, arrive at their forecasts by incorporating guidance from managers, there is immense pressure on the managers to meet or beat analyst earnings forecasts; moreover, investors reward (penalize) firms for exceeding (missing) analyst forecasts. Reasoning that decisions taken in response to analyst forecasts involve discretionary budgets, the authors study four contingent conditions under which quarterly analyst forecasts drive unanticipated adjustments to advertising and R&D budgets, and the long-term consequences of these budgetary changes. The choice of contingent conditions is related to agency theory–driven concepts of monitoring and bonding costs. Results from a panel data set of 515 firms and a hierarchical Bayesian model that provides firm-level coefficients show that both artificially imposed incentives on managers (monitoring costs) and personal career management concerns (bonding costs) moderate the extent to which managers react to analyst forecasts. Specifically, (1) bonus versus equity proportion of CEO compensation enhances the likelihood of managers reacting to analyst forecasts with unanticipated decreases in advertising and R&D budgets; (2) output experience of CEOs decreases this likelihood; (3) throughput experience of CEOs increases this likelihood; and (4) increasing marketing and R&D intensity decreases this likelihood. The authors also find that the unanticipated adjustments in advertising and R&D budgets adversely affect long-term firm returns and risk.