Does Accounting Conservatism Make Good News Forecasts More Credible and Bad News Forecasts Less Alarming?

Abstract

I investigate whether conservatism in financial statements helps investors to interpret the information revealed through voluntary disclosure, specifically earnings guidance. Research shows that investor reaction to guidance is affected by two issues. First, managers’ incentives to please the market cause positive guidance to lack credibility. This makes investors underreact initially to good news forecasts. Second, the same incentives cause negative guidance to raise investor uncertainty amid mounting concerns that the bad news disclosure is incomplete and more bad news will soon follow. This makes investors overreact initially to bad news forecasts. I argue that conservatism can increase the credibility of good news forecasts by subjecting good news to stronger verification requirements before being recognized in future reports. Consistent with this argument, I find that, when conservatism is higher, positive forecast news is associated with (a) a more positive initial response and (b) a less positive subsequent drift. I also argue that conservatism, by reassuring investors that the recognition of bad news in periodic reports has been complete and timely, can mitigate the surge in uncertainty that follows negative guidance and contain investor overreaction. Consistent with this argument, I also find that, when conservatism is higher, negative forecast news is associated with (a) a less negative initial response, (b) a less positive subsequent correction, and (c) a smaller increase in investor uncertainty.