Analyst Forecast Errors and Stock Price Behavior Near the Earnings Announcement Dates of LIFO Adopters

Abstract

Between June 1974 and May 1975 over 400 firms on the New York and American stock exchanges adopted the last-in, first-out (LIFO) inventory costing method. Responding to the first round of double-digit since WWII, these firms were able to assign their newer and thus higher inventory costs to units sold, thereby realizing substantial tax savings.1 However, Ricks [1982] found that stock returns near the earnings disclosure dates of 1974 LIFO adopters were negative and significantly lower than returns near the earnings disclosure dates of firms not using LIFO. Given that firms adopting LIFO in 1974 were voluntarily switching to an accounting method providing often significant tax savings, it is not obvious why investors would have reacted negatively. Nor is it likely that investors were unaware of many of the firms' LIFO adoption decisions; Stevenson [1987] found that at least two-thirds of the firms in Ricks' sample had disclosed their LIFO adoptions prior to their earnings disclo- sure dates. If investors were reacting to the effects of the LIFO adoptions, why did they react negatively given the increased cash flows and prior disclosures? If investors were not reacting to the effects of the LIFO adoptions, what caused the significant negative excess returns near the earnings disclosure dates of firms adopting LIFO in 1974? This study presents evidence suggesting that the negative excess re- turns observed by Ricks [1982] were associated with, and possibly due to, analysts' systematic overestimates of earnings of firms adopting LIFO in 1974. We are aware of no previous study documenting systematic errors in analysts' earnings forecasts conditional on a voluntary account- ing method change.' As a first step, we assess the generality of Ricks' finding by examining excess returns near the preliminary earnings disclosure dates (hereafter, prelim. dates) of all New York (NYSE) and American Stock Exchange (AMEX) firms adopting LIFO between 1973 and 1980. The results confirm negative excess returns around the prelim. dates of firms adopt- ing LIFO in 1974. There is little evidence of significant excess returns (negative or positive) near the prelim. dates of firms adopting LIFO in other years. To explain the negative returns of the 1974 adopters, we examine the association between excess returns and earnings forecast errors. We find that Standard & Poor's analysts systematically overestimated the earn- ings of these firms. Analyst forecast errors are found to be significantly correlated with both the excess returns around the prelim. dates and the earnings reductions due to the LIFO adoptions. Finally, we offer two possible explanations for the negative excess returns and the positive correlations between excess returns, analyst earnings forecast errors, and earnings effects of the 1974 LIFO adoptions. First, the availability of information regarding the likely earnings effects of the 1974 LIFO adoptions, combined with the relative novelty of this accounting change, may have led analysts and investors to underestimate the LIFO earnings effects and may have made it difficult for the market to discern immediately the cause of the resulting negative forecast errors. Evidence consistent with this limited information hypothesis is found in the predictions of Value Line analysts of LIFO earnings effects. The actual mean earnings-per-share effect of the LIFO adoptions ($.947) was 62% higher than the average Value Line estimate ($.584). However, tests for the stock price reversals which would be implied by the information explanation are inconclusive. A second possible explanation is that the magnitudes of LIFO earnings effects were caused by and/or provided implications regarding another factor which was important in valuing the firms, yet difficult for analysts and investors to predict. Inflation is suggested as the likely candidate. Since LIFO tax savings are a function of the rate at which inventory costs are increasing, firms experiencing higher rates of would have greater incentives to adopt LIFO.4 Thus, the self-selected sample of firms which adopted LIFO in 1974 may include firms most affected by that year's surge of inflation. Since the extent to which inventory costs have increased is reflected in the magnitudes of the earnings effects of LIFO adoptions, the negative analyst forecast errors and the positive correlation between these forecast errors and the earnings effects of LIFO adoptions could be explained by analyst underestimates of the rates of experienced by these firms. Evidence consistent with this inflation hypothesis is found in the fact that managers of firms adopting LIFO underestimated the impact of on their own firms. In addition, negative excess returns and earnings overestimates are observed for a sample of established LIFO users, consistent with analysts and investors being surprised by the impact of on these firms as well. However, aggregate tests based on cross-industry correlations between changes in wholesale prices and LIFO-related variables are generally inconclusive.