JulyAugust 2012 Supplement 105

Is Corporate Governance Related to the

Conservatism in Management Earnings Forecasts?
Hsu-Huei Huang, Min-Lee Chan, Chih-Hsiang Chang, and
Jing-Ling Wong
ABSTRACT: Managers are more likely to overestimate earnings if they are less likely to be
penalized when their forecasted earnings cannot be achieved. Since corporate governance is
expected to influence a firms monitoring mechanism, the authors argue that the corporate
governance mechanism will also affect the conservatism in management earnings forecasts.
This studys results indicate that earnings forecasts tend to be more conservative for those
firms with larger insider shareholdings, higher institutional shareholdings, or that have a
CEO serving as the board chairman. They tend to be less conservative for the firms that are
controlled by a family or are characterized by a pyramidal ownership structure.
KEY WORDS: board composition, conservatism, corporate governance, earnings forecasts,
ownership structure.

The management earnings forecast is of particular significance to investors who adopt a

value-investing strategy because the information regarding future earnings is helpful in a
stocks valuation. In particular, when the invested firms face great uncertainty or a rapidly
changing environment, such as firms in the information technology (IT) industry, it will
be more difficult for investors to estimate the firms future earnings. As a consequence,
the investors will tend to place more reliance on the management earnings forecast as
the basis of the stocks valuation.
However, it is inevitable that an earnings forecast error will arise, which can either be
due to overestimation or underestimation. Which kinds of errors are more likely to hurt the
investors, then? The authors consider that an overestimated forecast error will be relatively
unfavorable to investors because it will cause them to suffer from investment losses when
firms revise their prior earnings forecasts downward or subsequently release information
on actual earnings that are lower than the forecast. Therefore, investors might like to know
what kinds of firms will tend to make a conservative earnings forecast to reduce the possibility of losses to investors who believe overestimated earnings. Past research has not
addressed this issue so far, and thus this study is an attempt to investigate the topic from
the viewpoint of corporate governance. Some interesting results emerge.
The emerging markets have been becoming increasingly important among the global
stock markets and more and more attractive to investors. Taiwan is a prominent emerging market, and the firms in Taiwans IT industry are particularly attractive to investors.
However, it is not easy for investors to evaluate these firms since the fickle environment
of the IT industry makes their future earnings unpredictable. Under such circumstances,
Hsu-Huei Huang (hhhuang@nuk.edu.tw), corresponding author, is a professor of finance at the
National University of Kaohsiung. Min-Lee Chan (chanml@pu.edu.tw) is an associate professor
of finance at Providence University, Taiwan. Chih-Hsiang Chang (cch@nuk.edu.tw) is an associate
professor of finance at the National University of Kaohsiung. Jing-Ling Wong (M0973207@mail.
nuk.edu.tw) is a senior staff member at E.Sun Commercial Bank. The authors are grateful to the
editor of this journal and to two anonymous referees for useful comments.
Emerging Markets Finance & Trade / JulyAugust 2012, Vol. 48, Supplement 2, pp. 105121.
Copyright 2012 M.E. Sharpe, Inc. All rights reserved. Permissions: www.copyright.com
ISSN 1540-496X (print)/ISSN 1558-0938 (online)
DOI: 10.2753/REE1540-496X48S206

106 Emerging Markets Finance & Trade

the investors rely more on the management earnings forecasts as the basis for valuation.
Accordingly, this study explores the conservatism in management earnings forecasts for
firms in Taiwans IT industry.
Why would firms voluntarily issue an earnings forecast if they are not legally required
to do so? One of the key reasons why firms issue earnings forecasts is in order to reduce
the asymmetry in information between managers and investors (Ajinkya and Gift 1984;
Verrecchia 2001). In addition, revealing information to the public to reduce information
asymmetry can reduce a firms cost of capital by attracting increased demand from large
investors due to the increased liquidity of its securities (Diamond and Verrecchia 1991;
Leuz and Verrecchia 2000). Coller and Yohn (1997) also support the notion that there is a
relationship between information asymmetry and firm behavior. Specifically, firms issuing
management earnings forecasts are noted for having higher information asymmetry prior
to making such forecasts than firms that do not issue them. In addition, their findings
suggest that management forecasts are effective in reducing information asymmetry.
However, it is still necessary for the investors to note that there could be a significant
difference between a management earnings forecast and the actual earnings. For example,
Hassell and Jennings (1986) provide evidence that forecast errors range from 0 to 242
percent with a mean error rate of 15 percent. Prior studies also show that managers quarterly forecasts are more accurate than their annual forecasts (Chen 2004; Hribar and Yang
2011; Kasznik 1999). In addition, the past literature attempts to examine the determinants
of management forecast errors. Hribar and Yang (2011) report that managers who appear
to be overconfident issue optimistically biased forecasts. Lang and Lundholm (2000)
indicate that firms issuing earnings forecasts around equity offerings are optimistically
biased, suggesting the important role of incentives in understanding managers forecasting
behavior. Furthermore, Karamanou and Vafeas (2005) provide evidence that is broadly
consistent with the notion that effective corporate governance is associated with a higher
quality of financial disclosure. Specifically, firms with more effective boards would issue
earnings forecasts that are more accurate. Shen and Lin (2010) further suggest that it is
beneficial to firms to improve their governance.
As mentioned earlier, while the determinants of management forecast accuracy have
been extensively documented, no research has examined the factors influencing the
conservatism in earnings forecasts. Why, then, is it so important to focus on the issue of
conservatism in earnings forecasts? It would appear that this is because forecast errors
may be categorized into two types: positive errors and negative errors. Prior research
related to forecast accuracy fails to distinguish between a positive error, where the actual
earnings are higher than the forecasted earnings, and a negative error, where the actual
earnings are lower than the forecasted earnings, which might have a substantially different meaning to the investors. For example, a positive error of 20 percent and a negative
error of 20 percent will have completely different effects on investors. An investor who
employs a value-investing strategy decides to invest in a stock based on the management earnings forecast could suffer losses due to believing the overestimated earnings
forecast, which will cause an overvaluation of the firm. By contrast, the investor might
experience an even better return if the actual earnings released later are higher than the
forecasted earnings issued previously, since actual earnings that are higher than expected
will enhance firm value and might be likely to increase the stock price.
Which factors would cause managers earnings forecasts to be overestimated or underestimated? We believe that managers are likely to overestimate their future earnings
when they are expected to achieve a certain level of firm performance as requested by the

JulyAugust 2012 Supplement 107

board of directors. However, managers are also likely to underestimate their future earnings to avoid poor performance as a result of failing to achieve the forecasted earnings.
Based on the above two reasons, this paper argues that managers would be more likely
to overestimate earnings if they were less likely to be punished when unable to achieve
their forecasted earnings, and that since corporate governance is expected to influence
the efficacy of monitoring managers, corporate governance will also affect managers
conservatism in earnings forecasts.
To be specific, we believe that family-controlled firms or firms with a pyramidal
ownership structure, firms with lower insider shareholdings, and firms with lower institutional shareholdings are associated with a weaker monitoring mechanism, and their
managers are less likely to be penalized should they fail to achieve the forecasted earnings. Consequently, managers in these firms are more likely to overestimate their future
earnings. As to chief executive officer (CEO) dualitythat is, a CEO who concurrently
serves as the chairman of the boardwe believe that firms with CEO duality are less
likely to set a high performance standard for managers, and managers are more likely to
be conservative in their earnings forecasts. However, while the managers in these firms
are also less likely to be punished by the board of directors when they are unable to
achieve the forecasted financial performance, they will still face pressure from outside
monitors, such as institutional investors. Therefore, we believe that firms with a CEO
concurrently serving as the chairman of the board will tend to be more conservative in
their earnings forecasts.
Based on the results of quantile regression analysis, we find that governance mechanisms do affect a firms conservatism in its earnings forecasts. Such a result has valuable
implications for those investors employing a value-investing strategy, especially conservative investors such as insurance companies or pension funds. In other words, if investors
evaluate a stock based on the earnings information provided by the firms that issue more
conservative earnings forecasts, they will be less likely to experience an investment loss
arising from the firms actual earnings being lower than its forecasted earnings.
Ownership Structure, Board Composition, and Corporate Governance
Ownership structure is likely to be related to a greater alignment of interests between management and shareholders. Jensen and Meckling (1976) theorize that managers may act
according to their own self-interest when the firms control and ownership are separated,
which might lead to a decrease in corporate value. They also propose the convergence of
interest hypothesis, whereby interests between managers and outside shareholders will
converge when insider shareholdings are increased, and early work supports the notion
that a relatively high shareholding of insiders will have a significantly positive influence
on corporate performance and value. For example, Mueller and Spitz-Oener (2006) report
that corporate performance would be better for firms with higher managerial ownership,
and Hanson and Song (2003) indicate that the performance of firms with a high level of
managerial ownership is superior to that for firms with a low level of managerial ownership following a divestiture of assets. Furthermore, Chen et al. (2003) find that firm value
is higher when managers hold larger ownership shares.
In addition to insider shareholdings, a large body of research has focused on the role
of institutional investors as corporate monitors. Institutional investors are more likely
to monitor management effectively because they usually have better information about
the firm. Moreover, only large shareholders such as institutional investors, who stand

108 Emerging Markets Finance & Trade

to benefit significantly from monitoring, have an incentive to monitor (Grossman and

Hart 1980). Cornett et al. (2007) and Liang et al. (2011) find evidence of a significant
relationship between a firms operating performance and both the percentage of institutional stock ownership and the number of institutional stockholders. Shleifer and Vishny
(1986) document that large shareholders may have a greater incentive to monitor managers than members of the board of directors, who may have little or no wealth invested
in the firm. Moreover, large institutional investors have the opportunity, resources, and
ability to monitor, discipline, and influence managers. In this way, agency problems can
be reduced. Sias et al. (2006) provide evidence that changes in ownership by institutional
investors has both temporary and permanent positive price effects. Most other related
studies generally support the monitoring capability of institutional investors (Agrawal
and Mandelker 1990; Brickley et al. 1988).
A pyramidal ownership structure is defined as being that of an entity whose ownership
structure displays a top-down chain of control (La Porta et al. 1999). In such a structure,
LaPorta et al. (1999) argue that the controlling shareholders typically have control over
firms considerably in excess of their cash flow rights, which would normally allow controlling shareholders to pursue their own interests at the expense of minority shareholders. This is because they often control large firms through pyramidal structures. These
controlling shareholders have the power to expropriate the minority shareholders, as well
as an interest in so doing. Claessens et al. (2002) and Smith et al. (2009) indicate that the
influence of the pyramidal structure on firm valuation is negative. Liu and Pang (2009)
report that agency problems arising from a pyramidal ownership structure are responsible for the misallocation of internal funds. The above studies argue that the pyramidal
ownership structure is associated with a relatively severe agency problem.
Corporate boards are responsible for monitoring managerial performance and financial
disclosures in general. Both Fama (1980) and Williamson (1983) document that the board
of directors has the responsibility to protect firm benefits and to supervise management,
thereby reducing the agency problem. However, family-controlled firms tend to have
lower levels of board independence compared to nonfamily firms (Setia-Atmaja et al.
2009). In family-controlled firms, the concern is that managers may act for the controlling
family but not for shareholders in general (Morck and Yeung 2003). La Porta et al. (1999)
document that family control of firms seems to be common and typically unchallenged by
other shareholders. In addition, family control may facilitate corruption because it gives
the controlling shareholders enormous autonomy in decision making. Boubakri et al.
(2010) report that family control is related to a higher cost of equity following the Asian
financial crisis. Lausten (2002) also finds that the relationship between CEO turnover
and firm performance is weakened when the manager acquires power through family ties,
that is, a CEO in a family-controlled firm is less likely to be dismissed because of poor
performance. The above results indicate that the agency problem is relatively severe in
a family-controlled company.
Whether or not the chairman of the board and the CEO should be the same person in
order to improve firm value is an issue that remains unresolved. Jensen (1993) proposes
that the function of the chairman is to run board meetings and oversee the process of
hiring, firing, evaluating, and compensating the CEO. Therefore, for the board to be
effective, it is important to separate the CEO and chairman positions. Dayton (1984)
also confirms that if one person holds both positions, then the chairman of the board
will easily control the board and the firms development, and thus the board will not be
able to fully exercise its monitoring function. Pi and Timme (1993) suggest that, after

JulyAugust 2012 Supplement 109

controlling for firm size and certain other variables, costs are lower and the return on
assets is higher for firms in which these offices are held by different people. However,
Brickley et al. (1997) provide evidence that the costs of such independence exceed the
corresponding benefits for most firms.
Sample and Methodology
The main purpose of this study is to examine the effect of corporate governance mechanisms on the conservatism in management earnings forecasts. Our sample includes IT
industry firms listed on the Taiwan Stock Exchange (TSE) that issued annual earnings
forecasts during the period 2003 to 2008. Since early annual earnings forecasts are more
valuable to investors than forecasts issued later, the research sample includes only firms
that issue annual earnings forecasts before the end of June. The final sample includes
658 management earnings forecasts that meet the above criteria. Because there are two
missing values among the institutional shareholdings, there are only 656 observations
when the effect of institutional shareholdings on the management earnings forecasts is
examined. By the same token, the regression analyses contain 486 observations due to
the missing values for the control variables. All the information required for this study
is collected from the Taiwan Economic Journal.
Panel A in Table 1 shows that the annual number of sample firms declined significantly
after 2004, because the regulation on management earnings forecasts was changed from
mandatory to voluntary; this may have affected firms earnings forecast behavior. While
this regulatory change reduced the sample size, we still obtained enough observations to
investigate the influence of governance mechanisms on management earnings forecasts.
We were also able to further examine whether this change would have had any impact on
the conservatism in earnings forecasts. Moreover, Panel A also shows that 63.1 percent
of sample firms had annual earnings forecasts that were higher than their actual earnings,
indicating that most of the firms tended to overestimate their earnings when issuing their
earnings forecasts. Panel B reveals that there are 634 firms that issued mandatory earnings
forecasts and twenty-four firms that issued voluntary earnings forecasts, implying that the
legal requirement to issue the earnings forecast plays an important role in determining
the willingness of firms to issue earnings forecasts. Panel C illustrates that there are 185
annual earnings forecasts that are followed by downward revisions of those forecasts. This
implies that if investors believe the overestimated earnings forecast and buy the stock,
they may suffer a loss on their investment due to the firms subsequently releasing lower
actual earnings or a downward revision in the firms earnings forecast.
Panel D shows that, on average, the market value and trading value of the IT industry
accounted for 53.44 percent and 62.25 percent of the total market, respectively. These
figures indicate that the IT industry plays a prominent role in the Taiwan stock market.
We use ordinary least squares (OLS) and quantile regression to examine whether
governance mechanisms have any impact on the degree of conservatism in earnings
forecasts, as follows:
CONSi = + 1INSHi + 2 INTH i + 3 PYR i + 4 FAMCi + 5 CEODi

(1)
+ 6 MONTHi + 7 STDi + 8 MANDi + 9 SIZEi + i ,


where CONS represents the conservatism in earnings forecasts in terms of actual earnings minus forecasted earnings divided by total assets. The larger the value of CONS, the
more conservative the earnings forecast. The governance mechanisms include the owner-

299
335
17
4
2
1
658

Number of annual
earnings forecasts

Mandatory management earnings forecasts

Voluntary management earnings forecasts

Panel B

2003
2004
2005
2006
2007
2008
Total

Forecast year

Panel A

Table 1. Sample distribution

634
24

Number of annual
earnings forecasts

164
237
9
4
1
0
415

Number annual
earnings forecasts
higher than actual
earnings
0.548
0.707
0.529
1.000
0.500
0.000
0.631

Proportion of
annual earnings
forecasts higher
than actual
earnings

110 Emerging Markets Finance & Trade

2003
2004
2005
2006
2007
2008
Average

364,996
434,877
473,854
595,444
635,422
355,608

Total market value

of all firms listed
on TSE

Panel D (millions of dollars)

197,809
208,215
272,064
334,026
340,012
183,229

Market value of
firms in IT industry

Annual earnings forecasts with downward forecast revisions

Annual earnings forecasts without downward forecast revisions

Panel C

54.19
47.88
57.41
56.10
53.51
51.53
53.44

Percentage of
market value of IT
industry to TSE

185
473

Number of annual
earnings forecasts

602,809
757,521
579,937
742,342
1,033,235
811,457

Total trading value

of all firms listed
on TSE

344,789
387,020
415,513
520,660
698,566
452,889

Trading value of
firms in IT industry

57.20
51.09
71.65
70.14
67.61
55.81
62.25

Percentage of
trading value of IT
industry to TSE

JulyAugust 2012 Supplement 111

112 Emerging Markets Finance & Trade

ship structure and board composition. Variables related to ownership structure comprise
insider shareholdings (INSH) measured by the shareholdings of the boards of directors
and supervisors; institutional shareholdings (INTH); and the pyramidal ownership structure
(PYR), where the pyramidal ownership structure is a dummy variable, which is assigned a value
of 1 if the firm has a pyramidal ownership structure and 0 otherwise. We adopt the definition of
a pyramid structure found in LaPorta et al. (1999): a firms ownership structure is pyramidal
if the controlling shareholder exercises control through at least one publicly traded company.
Variables related to board composition include the family-controlled company (FAMC) and
CEO duality (CEOD). FAMC is a dummy variable; it is assigned a value of 1 if a firm is family
controlled and 0 otherwise. A family-controlled company is defined as any company in which
more than half the directors are family members. CEOD is also a dummy variable and is
assigned a value of 1 if the firm has a CEO concurrently serving as the chairman of the
board of directors and 0 otherwise.
Control variables include MONTH, STD, MAND and SIZE, where MONTH is the
month in which an annual earnings forecast was issued; STD is the standard deviation of
the daily stock return over a one-year period prior to the forecast year; MAND is a dummy
variable that is assigned a value of 1 if the management earnings forecast is mandatory
and 0 otherwise; and SIZE is firm size measured by the log of equity market value.
Table 2 shows the descriptive statistics for the governance mechanisms and control
variables. The variables regarding ownership structure show that the average ratio of
shareholdings of the board of directors and supervisors is only 26.6 percent, indicating
the existence of a significant deviation between ownership and control. In addition, the
average institutional shareholding is merely 35.2 percent, which is significantly lower than
that in the case of U.S. firms, in which more than half the shares are held by institutional
investors. Thus, monitoring by institutional investors would be weaker in Taiwan-listed
firms. Moreover, Table 2 also shows that 38.1 percent of sample firms are characterized
by a pyramidal ownership structure. The variables regarding board composition indicate
that 12.6 percent of firms are controlled by a family. Since we define the family-controlled
company as any firm in which more than half the directors are family members, the family members are fully able to control the boards decisions in these firms. These figures,
therefore, show that family control has a significant influence on Taiwans listed firms.
Finally, in one-third of the sample firms the CEO concurrently serves as the chairman
of the board.
Empirical Results
Panel C in Table 1 shows that 185 out of 658 firms revised their forecast downward after
issuing annual earnings forecasts. We therefore attempt to investigate whether these
revisions hurt the investors or not. We use the event study based on the market model
to examine the announcement effect of revising the forecast downward; the estimation
period is between 150 days and 31 days before the revision of the earnings forecast. The
results are shown in Table 3.
Table 3 depicts the seven event windows where the cumulative abnormal returns
(CARs) are all significantly negative. From the results of the window of ten days before
and after the revision of the earnings forecast, the CAR is 7.3 percent, indicating that
revising the forecast downward could lead to a substantial decline in the stock price. If
that is the case, then why would a firm revise its forecast downward? It basically comes
down to the overestimated earnings forecast issued previously. If the investors believe the

JulyAugust 2012 Supplement 113

Table 2. Descriptive statistics

Shareholdings of
directors and
supervisors
Institutional
shareholdings
Pyramidal ownership
structure
Family-controlled
company
CEO also serving as the
chairman of the board
The month in which
annual earnings
forecast was issued
Standard deviation of
daily stock return
Whether earnings
forecast is mandatory
Firm size

Max

Standard
deviation

0.650

81.330

13.394

0.220

97.570

21.378

Mean

Median

Min

26.648

23.410

35.226

32.325

0.381

0.486

0.126

0.332

0.336

0.473

3.540

1.183

2.967

2.972

0.852

4.713

0.699

0.964

0.188

14.946

14.673

11.970

20.454

1.436

overestimated forecast and buy the stock, they will incur substantial losses on their investment when the firm later revises its forecast downward. How, then, could the investors
avoid the losses? One feasible way is to buy shares in a firm that issues more conservative
earnings forecasts because the firm is less likely to revise its earnings forecast downward
after issuing it. Thus, it could protect the investors from the losses that would result from
revising the earnings forecast downward.
The rest of this section further examines the firm characteristics that are related to a
more conservative earnings forecast. A firm issuing a conservative earnings forecast might
be more trustworthy, since the investors would be less likely to incur losses when buying
a stock based on a conservative earnings forecast used to value the firm. Table4 examines
the influence of ownership structure on the possibility of issuing an overestimated earnings
forecast. As mentioned with respect to Table1, 63.1 percent of the sampled firms were
found to issue earnings forecasts that were higher than actual earnings, suggesting that
it is common among Taiwan-listed firms to issue overestimated earnings forecasts.
In Panel A of Table 4, the sample firms are divided into two groups based on the median shareholdings of the boards of directors and supervisors. The results show that the
proportion of firms issuing annual earnings forecasts that are higher than actual earnings
are 0.708 and 0.553 for the firms with low and high levels of shareholdings, respectively,
and the ttest further illustrates that both proportions are significantly higher than 0.5,
indicating that both groups of firms tend to issue overestimated earnings forecasts.
However, the results also show that a significantly lower proportion of firms with a high
level of board shareholdings will issue overestimated earnings forecasts, suggesting
that firms with sufficiently high insider shareholdings are more likely to issue relatively
conservative forecasts.
In addition, the sample firms are also divided into two groups based on the median
shareholdings of the institutions. Panel B in Table 4 demonstrates that the proportion

114 Emerging Markets Finance & Trade

Table 3. Cumulative abnormal returns (CARs) from announcing the forecast

downward revisions
Windows
(1, +1)
(1, +5)
(1, +10)
(5, +5)
(10, +10)
(20, +20)
(30, +30)

CAR

t (CAR)

4.048
5.037
4.698
6.499
7.275
6.616
7.597

8.905***
7.254***
5.167***
7.466***
6.049***
3.937***
3.706***

* Significant at the 10 percent level; ** significant at the 5 percent level; *** significant at the 1percent level.

of firms that issue annual earnings forecasts that are higher than actual earnings are
0.716 and 0.543 for the firms with low and high levels of institutional shareholdings,
respectively, and the difference in the proportion between these two groups reaches a
significant 17 percent. These results indicate that the firms with a sufficiently high level
of institutional shareholdings are less likely to issue overestimated earnings forecasts. In
PanelC of Table 4, the sample firms are divided into two groups according to whether
or not the firm has a pyramidal ownership structure. The results show that there is no
significant difference between these two groups in terms of the proportion of firms that
issue overestimated earnings forecasts.
Table 5 investigates the effect of board composition on the proportion of firms issuing
earnings forecasts that are higher than actual earnings. Panel A shows that the proportions
of firms issuing overestimated earnings forecasts among the family-controlled and nonfamily-controlled firms are 0.627 and 0.637, respectively, indicating that it is common
for these two groups of firms to issue overestimated forecasts, and the difference in terms
of the proportions is not significant between them. Panel B reveals that firms both with
and without a CEO serving as the chairman of the board tend to issue earnings forecasts
that are higher than actual earnings, and the difference in terms of the proportion of firms
issuing an overestimated forecast is also not significant.
The results in Tables 4 and 5 reveal that it is common for firms to issue overestimated
earnings forecasts. However, a relatively smaller proportion of those firms with higher
insider shareholdings or institutional shareholdings tend to issue earnings forecasts that
are higher than actual earnings, suggesting that the investors who buy these stocks are
less likely to suffer investment losses arising from believing the overestimated earnings
forecasts.
Table 6 presents the results of OLS regressions used to examine the influence of corporate governance on conservatism in management earnings forecasts. The independent
variables include governance mechanisms and four related control variables: the month
in which the earnings forecast is to be issued (MONTH), corporate operating risk (STD)
measured by the standard deviation of the daily stock return, whether or not a management earnings forecast is mandatory (MAND), and firm size (SIZE).
The dependent variable is the conservatism in the management earnings forecast.
According to the definition used here, firms with conservatism variables with relatively
large values have earnings forecasts that are more conservative. Table6 shows that INTH

JulyAugust 2012 Supplement 115

Table 4. Ownership structure and annual earnings forecasts

Panel A
Low shareholdings of the
board of
directors and
supervisors
High shareholdings of the
board of
directors and
supervisors
Difference
t-test
Panel B
Low shareholdings of the
institutions
High shareholdings of the
institutions
Difference
t-test
Panel C
Without pyramidal ownership
structure
With pyramidal
ownership
structure
Difference
t-test

Number of
annual earnings
forecasts

Number of
annual earnings
forecasts higher
than actual
earnings

Proportion of
annual earnings
forecasts higher
than actual
earnings

t-tests for the

proportion
equal to 0.5

329

233

0.708

7.553***

329

182

0.553

1.930*

0.155
4.174***
328

235

0.716

7.841***

328

178

0.543

1.546

0.174
4.685***
575

364

0.633

6.381***

83

51

0.614

2.086**

0.019
0.326

* Significant at the 10 percent level; ** significant at the 5 percent level; *** significant at the 1percent level.

positively influences the conservatism in Model 2, indicating that firms with relatively
high institutional shareholdings tend to issue more conservative earnings forecasts.
However, the influence of other corporate governance variables is not significant. As to
the control variables, we find that the firms with greater operating risk or larger size will
issue more conservative forecasts, and a mandatory earnings forecast will be relatively
not conservative.
The primary function of the above OLS analysis is merely to determine the conditional
mean of the conservatism in the earnings forecast given the governance mechanism variables. However, the quantile regression enables us to investigate the relationship between
the governance mechanisms and conservatism in earnings forecasts at any quantile of the

116 Emerging Markets Finance & Trade

Table 5. Board composition and annual earnings forecasts

Panel A
Non-familycontrolled
company
Family-controlled
company
Difference
t-test
Panel B
CEO not serving
as the chairman of the
board
CEO also serving
as the chairman of the
board
Difference
t-test

Number of
annual earnings
forecasts

Number of
annual earnings
forecasts higher
than actual
earnings

Proportion of
annual earnings
forecasts higher
than actual
earnings

407

255

0.627

5.106***

251

160

0.637

4.355***

t-tests for the

proportion
equal to 0.5

0.011
0.282
437

273

0.625

5.214***

221

142

0.643

4.238***

0.018
0.449

* Significant at the 10 percent level; ** significant at the 5 percent level; *** significant at the 1percent level.

conservatism. Since institutional shareholdings is the only corporate governance variable

that is significant in the OLS results, the relationship between the governance mechanisms
and conservatism across different quantiles was further examined using quantile regression. Although most of the corporate governance variables are insignificant in the OLS
analysis, we believe that the governance mechanisms might significantly influence the
conservatism in the forecasts of firms for the high or low quantiles of conservatism.
Table 7 indicates that the governance mechanisms actually have different influences
on the conservatism in earnings forecasts across firms for different levels of conservatism in the forecasts. This result helps investors understand which firms tend to issue the
most conservative earnings forecasts. Table 7 reveals that the governance mechanisms
influence the conservatism in earnings forecasts most significantly for the firms at the
95th quantile, that is, among the top 5 percent of the conservative firms issuing forecasts.
The results show not only that all the corporate governance variables have statistically
significant impacts on the conservatism in earnings forecasts, but also that pseudo R2
reaches its highest level.
First, for the 95th quantile group, the regression coefficients tend to be significantly
positive for both INSH and INTH, meaning that the firms with higher insider shareholdings or institutional shareholdings are more likely to issue the most conservative
earnings forecasts. In addition, the significantly negative PYR indicates that the firms
with pyramidal ownership structures are less likely to issue conservative forecasts. As to
the board composition factors, we find that FAMC is significantly negative, suggesting

0.001
(0.255)
0.010
(1.889)*
0.034
(2.053)**
0.006
(2.435)***
0.024
486

0.177
(4.415)***
0.039
(1.532)

0.001
(0.291)
0.009
(1.773)*
0.032
(1.935)*
0.003
(0.897)
0.031
486

0.042
(2.225)**

0.136
(3.298)***

Model 2

0.002
(0.538)
0.008
(1.741)*
0.015
(1.073)
0.009
(4.394)***
0.033
486

0.009
(1.010)

0.172
(4.285)***

Model 3

0.001
(0.487)
0.007
(1.665)*
0.017
(1.193)
0.009
(4.400)***
0.035
486

0.008
(1.282)

0.164
(4.156)***

Model 4

0.002
(0.371)
0.001
(0.533)
0.007
(1.704)*
0.016
(1.092)
0.009
(4.280)***
0.032
486

0.168
(4.170)***

Model 5

0.153
(3.446)***
0.017
(0.599)
0.034
(1.615)
0.010
(1.132)
0.004
(0.613)
0.001
(0.065)
0.001
(0.211)
0.010
(1.850)*
0.033
(1.958)*
0.004
(1.300)
0.026
486

Model 6

Notes: The dependent variable in this table is the conservatism in management earnings forecasts. Independent variables include ownership structure and board
composition. Variables on ownership structure comprise insider shareholdings (INSH), institutional shareholdings (INTH), and the pyramidal ownership structure
(PYR). Variables on board composition include the family-controlled company (FAMC) and the CEO also serving as the chairman of the board (CEOD). Control
variables include MONTH, STD, MAND, and SIZE, where MONTH is the month in which the annual earnings forecast was issued; STD is the standard deviation of daily stock returns over a one-year period prior to the forecast year; MAND is a dummy variable assigned a value of 1 if the earnings forecast is mandatory; and SIZE is the log of equity market value. * Significant at the 10 percent level; ** significant at the 5 percent level; *** significant the 1percent level.

Adjusted R2
Observations

SIZE

MAND

STD

MONTH

CEOD

FAMC

PYR

INTH

INSH

Constant

Model 1

Table 6. Corporate governance and conservatism in management earnings forecasts

JulyAugust 2012 Supplement 117

118 Emerging Markets Finance & Trade

Table 7. Quantile regression analysis

Constant
INSH
INTH
PYR
FAMC
CEOD
MONTH
STD
MAND
SIZE
Pseudo R2
Observations

Model 1
5%

Model 2
25%

Model 3
50%

Model 4
75%

Model 5
95%

0.329
(3.040)***
0.069
(1.145)
0.060
(1.356)
0.004
(0.189)
0.029
(2.004)**
0.022
(1.428)
0.008
(1.171)
0.009
(0.808)
0.036
(1.014)
0.015
(2.439)**
0.095
486

0.195
(3.150)***
0.021
(0.611)
0.030
(1.194)
0.003
(0.246)
0.002
(0.260)
0.006
(0.630)
0.003
(0.710)
0.003
(0.435)
0.000
(0.011)
0.007
(2.010)**
0.033
486

0.128
(3.414)***
0.020
(0.960)
0.034
(2.221)**
8.981e-7
(1.238e-4)
0.007
(1.375)
0.007
(1.325)
0.005
(2.078)**
0.009
(2.348)***
0.003
(0.269)
0.004
(1.778)*
0.035
486

0.045
(1.307)
0.035
(1.868)*
0.037
(2.656)***
0.005
(0.783)
0.009
(2.031)**
0.001
(0.207)
0.003
(1.445)
0.012
(3.514)***
0.003
(0.293)
0.001
(0.609)
0.044
486

0.144
(6.681)***
0.075
(6.261)***
0.026
(2.959)***
0.026
(6.302)***
0.011
(3.922)***
0.009
(2.883)***
0.010
(7.551)***
0.034
(15.668)***
0.071
(10.163)***
0.013
(10.560)***
0.141
486

Notes: The dependent variable in this table is the conservatism in management earnings forecasts.
Independent variables include ownership structure and board composition. Variables on ownership structure comprise insider shareholdings (INSH), institutional shareholdings (INTH), and the
pyramidal ownership structure (PYR). Variables on board composition include the family-controlled
company (FAMC) and the CEO also serving as the chairman of the board (CEOD). Control variables
include MONTH, STD, MAND, and SIZE, where MONTH is the month in which the annual earnings
forecast was issued; STD is the standard deviation of the daily stock return over a one-year period
prior to the forecast year; MAND is a dummy variable assigned a value of 1 if the earnings forecast is
mandatory; and SIZE is the log of equity market value. * Significant at the 10 percent level; **significant at the 5 percent level; *** significant the 1percent level.

that the earnings forecasts will tend to be less conservative when firms are controlled
by family members. The positive coefficient of CEOD is also significant, meaning that
the firms with a CEO concurrently serving as the chairman of the board are more likely
to issue the most conservative forecasts. In addition, the results of the control variables
show that, among the sample firms, those that are larger in size or have higher operating risk are more likely to issue the most conservative forecasts, and that the mandatory
forecasts tend to be less conservative.
To summarize the results in Table 7, if investors hope to avoid investment losses resulting from believing an overestimated earnings forecast, they could gather information
regarding the firms governance mechanisms before making a buying decision based on
an earnings forecast. Investors will then be less likely to suffer investment losses as a
result of believing the earnings forecasts of the most conservative firms. Since most of
the sample events involve mandatory management earnings forecasts and the voluntary
cases account for only 3.6 percent, we also use the sample that includes mandatory

JulyAugust 2012 Supplement 119

management earnings forecasts in order to reexamine the relationship between corporate

governance and conservatism in earnings forecasts. The results of these robustness tests
are similar to those in Tables 6 and 7. That is, the governance mechanisms mentioned
above do have a significant effect on conservatism in earnings forecasts.
Conclusions
The key principle of a value-investing strategy for investors is to buy only stocks with
a stock price lower than their true value. In the decision to buy stock, the valuation is
important, but it is difficult. Investors are usually able to evaluate a stock based on the
firms future cash flows. This valuation, however, might become more difficult for firms
facing changeable environments, such as firms in the IT industry. In these cases, investors will tend to rely more on the earnings forecast issued by the firm to help provide a
reasonable estimate of the value of the firm.
Although managers are more informed about the firms future operating performance
than outside investors, the earnings forecasts are inevitably accompanied by errors. While
the determinants of a forecasts accuracy have been extensively documented, the issue of
conservatism in earnings forecasts has not yet been investigated. As to why it is worth
examining the factors that influence the conservatism in earnings forecasts further, it
could be that forecast errors can be classified into positive errors and negative errors,
which lead to totally different results for the investors.
When investors, especially conservative ones, make a decision to buy stock, they may
be eager to know the corporate characteristics that are more likely to protect them from
investment losses. This paper argues that investors who buy stock with a more conservative
earnings forecast are less likely to experience investment losses arising from believing
an overestimated earnings forecast. Because firms issuing more conservative earnings
forecasts are less likely to have actual earnings that are lower than forecasted earnings,
an investment based on a conservative earnings forecast that is used to evaluate stock
would be safer.
This paper shows that managers are more likely to overestimate their future earnings
when they were less likely to be punished for failing to achieve forecasted earnings.
Since corporate governance is related to the firms monitoring mechanism, we argue that
corporate governance mechanisms influence the conservatism in management earnings
forecasts. The results presented here indicate that firms that have higher levels of insider
or institutional shareholdings, or that have a CEO who also serves as the chairman of the
board, tend to issue more conservative earnings forecasts, while firms that are controlled
by a family or that have a pyramidal ownership structure issue less conservative forecasts.
We therefore conclude that investors who hope to reduce the possibility of incurring
investment losses should consider the firms governance mechanisms before evaluating
a stock based on a management earnings forecast.
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