Signaling via earnings downgrades: How reputational concerns shape analyst responses to corporate fraud?

Abstract

AbstractResearch Question/IssueThis study examines reactions of financial analysts to the disclosure of corporate fraud. We posit that analysts downgrade earnings forecasts of fraudulent firms after fraud disclosure to signal their quality and integrity. We explore how internal and external contingencies shape analysts' reputational concerns, influence their motivation to signal via earnings downgrades, and consequently affect their responses to corporate fraud.Research Findings/InsightsUsing longitudinal data on Chinese publicly traded firms between 2002 and 2013 and employing a difference‐in‐differences design, this study documents that financial analysts significantly lower their earnings estimates of fraudulent firms after fraud disclosure compared with the control group of non‐fraudulent firms. In addition, post‐disclosure earnings downgrades are larger for more experienced analysts, for analysts following firms with stronger analyst coverage, and after the revision of the professional ethics code for analysts.Theoretical/Academic ImplicationsThis study provides empirical support to signaling theory. We show that earnings downgrades of fraudulent firms may serve as a signal for financial analysts to indicate their quality and integrity. We document that analysts' motivation to signal via earnings downgrades is influenced by their reputational concerns, which are moderated by their career experience, peer pressure, professional norm, and social expectations.Practitioner/Policy ImplicationsThis study offers insights to policy makers on how a professional labor market and codes of ethics could serve as disciplinary mechanisms to strengthen the external governance role of financial analysts.