The association between qualitative management earnings forecasts and discretionary accounting in the Netherlands

Abstract

This paper examines whether there is an association between discretionary accounting and the accuracy of long-run forecasts of annual earnings disclosed voluntarily by Dutch companies in the directors’ report. In particular, investigations were made of the consistency in the sign and direction of discretionary accounting techniques and qualitative earnings forecasts. Long-run forecasts are defined, for the purposes of this paper, as forecasts made at least seven months before the year-end. Although not mandatory, qualitative forecasts are released by well over 60% of the listed companies in the Netherlands. Empirical results indicate that there is consistency in the sign and direction of qualitative earnings forecasts and discretionary accounting. After adopting discretionary accounting, the forecast errors are reduced if the company can reach the management earnings forecast (target). In the event that reserves are insufficient to accomplish this goal, managers choose their next best option and take an earnings bath in order to maximize reserves available for future use. By partitioning the sample in various sub-sets it is shown that earnings management and forecast errors occur most in the extreme ranges of financial performance. Overall, the study shows that management engages in discretionary accounting to present results in line with the disclosed qualitative earnings forecasts in their directors’ reports. Whilst discretionary accounting may clearly improve the consistency of companies’ earnings forecasts released via the directors’ reports and the actual earnings, managers’ earnings forecasts are sometimes disclosed in anticipation of planned discretionary accounting actions.