Management Earnings Guidance as a Commitment Device

Abstract

This paper examines whether issuing management earnings guidance motivates a firm to raise its performance. We hypothesize that managers understand failing to attain a forecast reflects poorly on them and would ex post motivate management and employee effort. Thus, managers choose to issue guidance ex ante to commit themselves to exert this effort. Consistent with this commitment, management then hone their firm’s production function to raise firm performance. In our analyses, we find evidence supporting this hypothesis: management issue guidance and raise performance at firms where commitment should be most beneficial for the firm, such as where (i) employee effort is impactful, (ii) performance is credibly measured, and (iii) capital markets strongly reward increased performance. Further, we find that firms alter their operating activities, rather than manage their accruals, to increase performance. The enhancement in firm performance from using managerial earnings guidance as a commitment device is accomplished by reductions in operating leverage and is strongest among firms issuing moderately aggressive forecasts. Excessively aggressive forecasts, on the other hand, yield no performance benefit. Inconsistent with concerns that forecasting causes myopia and incentivizes short-term real earnings management, performance increases persist for several years.