# Firm-specific corporate governance and analysts’ earnings forecast characteristics: Evidence from Asian stock markets

Minna Yu (Department of Accounting, Monmouth University, West Long Branch, New Jersey, USA)
Yanming Wang (School of Accounting, Shanghai University of Finance and Economics, Shanghai, China)

ISSN: 1834-7649

Publication date: 6 August 2018

## Abstract

### Purpose

The purpose of this paper is to examine the impact of corporate governance on the capital market participants’ abilities to forecast future performance, as measured by the properties of analysts’ earnings forecasts in Asian stock markets.

### Design/methodology/approach

This paper hypothesizes that higher corporate governance is associated with lower forecast errors, lower forecast dispersion and lower forecast revision volatility.

### Findings

These predictions are supported with a sample of companies across eleven Asian economies over 2004-2012. The results of this paper suggest that corporate governance plays a significant role in the predictability of firm’s future performance and, therefore, improves the financial environment in Asian stock markets. Furthermore, the impact of corporate governance on analysts’ forecast properties is more pronounced in countries with strong investor protection.

### Research/limitations/implications

The authors acknowledge the following limitations of this paper. First, the results of this paper may be subject to omitted-variable bias and endogeneity issue. The authors have used control variables in the regressions to reduce the omitted variable bias. The authors have run lead-lag regressions to address causality issue. Second, CLSA corporate governance scores are collected for largest companies in each jurisdiction. Therefore, the sample is biased towards the largest companies in those jurisdictions and may not be representative of the average firm in the Asia.

### Originality/value

The results of this paper speak to the benefit of having strong corporate governance in terms of reducing the information asymmetry between investors and corporate management.

## Keywords

#### Citation

Yu, M. and Wang, Y. (2018), "Firm-specific corporate governance and analysts’ earnings forecast characteristics", International Journal of Accounting & Information Management, Vol. 26 No. 3, pp. 335-361. https://doi.org/10.1108/IJAIM-03-2017-0040

### Publisher

:

Emerald Publishing Limited

## 1. Introduction

In this paper, we investigate whether effective corporate governance enhances the predictability of firms’ future performance, measured by financial analysts’ earnings forecast characteristics. As noted in La Porta et al. (2000), firm-specific corporate governance is a set of mechanisms through which outside investors protect themselves against expropriation by the management. Weak corporate governance has been considered a major contributor of Asian financial crisis during 1997-1998. In fact, the weak corporate governance systems explain the extent of stock market decline better than macroeconomic factors (Johnson et al., 2000). After the financial crisis, firms in the Asian capital markets have actively implemented good corporate governance structures and processes. Prior research documents that, during the post-crisis period, Asian firms with good corporate governance tend to have higher market value and lower cost of capital (Klapper and Love, 2004; Chen et al., 2009). Are these positive capital market consequences of good corporate governance because of the reduced information asymmetry between investors and management? Until now, we lack evidence on the impact of good corporate governance on such information asymmetry.

Byard et al. (2006) document the positive association between analysts’ earnings forecast accuracy and attributes of corporate governance in the USA. However, in a US setting and most regions in the globe, corporate governance systems remain unchanged for long periods of time, which has been referred to as “stickiness” (Brown et al., 2011). The stickiness of corporate governance measure has posed significant challenges for research. The post-financial-crisis period in Asia is a desirable setting for examining the impact of corporate governance. Studying the association between analysts’ forecast characteristics and corporate governance practices enhances our understanding as to whether corporate governance reduces information asymmetry between investors and management in the Asian setting.

We use analysts’ earnings forecasts as proxies[1] for investors expectation for future earnings because investor’ prediction about firm’s performance is not observable. We use three measures of analyst forecast characteristics in earnings forecasts that have been commonly studied in prior research (Lang and Lundholm, 1996; Ali et al., 2007): forecast accuracy, forecast dispersion and volatility in forecasts.

We obtain the corporate governance rating scores developed by Credit Lyonnais Securities Asia (CLSA) as a measure of the firm-level corporate governance quality. CLSA corporate governance scores have been widely used as a proxy for the quality of firms’ internal corporate governance mechanisms by prior studies (Klapper and Love, 2004; Shen and Chih, 2007; Chen et al., 2009; Yu, 2010). Extant research on the impact of corporate governance on analyst behavior has concentrated on a single corporate governance dimension, such as ownership structure (Lang et al., 2004; Ali et al., 2007). The composite score of corporate governance is superior to a single dimension because the composite score measures the overall strength of all corporate governance mechanisms (Brown et al., 2011) and using a parsimonious index is more effective than including all individual corporate governance characteristics (Brown and Caylor, 2006; Bebchuk et al., 2009).

Investors and regulators increasingly view effective corporate governance as crucial to mitigating the agency problem as high levels of corporate governance reduce conflicts by better aligning managers’ interest with that of investors. In contrast, in firms that lack adequate monitoring systems, managers are more likely to obscure or manipulate disclosures and make inefficient operating, investing and financing decisions, which make future performance less predictable. Therefore, good corporate governance mechanisms facilitate analysts’ judgment of the quality of financial information and the future performance. Conversely, firms with missing or ineffective corporate governance mechanisms making forecasting task more complex. This leads to our prediction that analyst earnings’ forecasts should be more accurate for firms with good corporate governance mechanisms than for firms without good corporate governance mechanisms. Applying the above reasoning, we also predict that stronger corporate governance is associated with lower analyst forecast dispersion and less volatility in analysts’ forecast revisions.

We find that, controlling for other factors, analysts’ earnings forecast error, forecast dispersion and volatility in forecast revisions are lower for firms that have implemented better corporate governance systems. This finding is consistent with that, for firms with relatively strong corporate governance mechanisms, investors tend to have more accurate beliefs about future performance; there is less asymmetry in individual investors’ beliefs about forecasted firms’ performance; and investor expectations about earnings change more smoothly over the year.

In general, Asia’s emerging markets feature a relatively weak legal system where shareholder rights are not well protected and information asymmetry is relatively high (Claessens and Fan, 2002; Fan and Wong, 2002; Haw et al., 2011; Ariff et al., 2014). However, Asian jurisdictions have institutional differences in the country-level corporate governance. We further examine how cross-country corporate governance differences explain the strength of the associations between firm-level corporate governance and analyst behavior. We predict and find that our results are primarily driven by jurisdictions with stronger country-level corporate governance.

Our paper contributes to the literature in the following ways. First, our paper adds to the research stream of how firm characteristics affect the predictability of future earnings. It specifically joins the increasing stream of research on the effect of firm-level corporate governance on analyst behavior (Lang et al., 2003; Lang et al., 2004; Byard et al., 2006; Ali et al., 2007; Gul et al., 2013).

Second, we hypothesize and provide evidence on the effect of firm-level corporate governance quality on the analysts’ forecast properties. Hope (2003b) documents the positive association between country-level corporate governance and analyst forecast accuracy. Instead, we examine the association using firm-level corporate governance and find the association is significant. We further examine the interaction of country-level corporate governance and firm-level corporate governance on analysts’ earnings forecast properties. Our findings suggest that firm-level corporate governance affects information asymmetry in common law jurisdictions, which feature strong investor protection.

Our paper has practical implications for corporate managers as well as policy-makers and capital market regulators. Specifically, the evidence provided in this paper suggests that, by adopting better corporate governance mechanisms, firms in Asian stock markets can improve the accuracy of market expectations, reduce information asymmetries and limit market surprises, especially in jurisdictions with stronger investor protection. The findings shed light on the advantage of improving corporate governance on firms’ information environment and, therefore, are relevant to the cost-benefit analysis of improving internal corporate governance.

The paper proceeds as follows. Section 2 reviews relevant literature and develops testable hypotheses. Section 3 describes the research models to test the hypotheses. Section 4 introduces our proxy for corporate governance quality as well as provides the sample distribution and univariate statistics. Section 5 presents empirical results and Section 6 runs additional robustness checks. We conclude in Section 7.

## 2. Literature review and hypotheses development

We establish the association between the strength of corporate governance on the predictability of earnings based on the research findings of the association between corporate governance and the quality of information provided by the management. Effective corporate governance mechanisms reduce agency problems, which in turn will enhance information quality produced by analysts and reduce information risk faced by investors. Good corporate governance gives rise to high-quality management-investor communication because the interest of managers is better aligned with that of investors. As such, managers do not have incentives to hide information or abuse accounting discretion. Good corporate governance constrains real-activities earnings management (Malik, 2011) and accrual-based earnings manipulation (Klein, 2002; Davidson et al., 2005).

In Singapore, Eng and Mak (2003) find that lower managerial ownership and significant government ownership are associated with more non-mandatory strategic, non-financial and financial disclosures that is not mandatory. Chau and Gray (2010) as well as Ho and Wong (2001) find similar evidence in Hong Kong. Therefore, we conjecture that good governance mechanisms will lead to reduction in analysts’ earnings forecast error. Prior research has also well documented that higher-quality disclosures, more disclosures on accounting policies, more readable annual reports, as well as voluntary management forecasts will enhance the forecast accuracy (Waymire, 1986; Lang and Lundholm, 1996; Hope, 2003a; Frankel et al., 2006; Lehavy et al., 2011).

We conjecture that good corporate governance mechanisms facilitate analysts’ judgment of the quality of financial information and the future performance. Conversely, firms with missing or ineffective corporate governance mechanisms making forecasting task more complex. A number of papers report that nonfinancial indicators of investments in intangible assets are important predictors of revenues (Trueman et al., 2001), operating income (Behn and Riley, 1999) and firm value (Amir and Lev, 1996). Prior research has documented the difficulty of forecasting for high-technology firms as such firms have significant research and development projects (Barron et al., 2002). Good corporate governance will ensure that managers make effective decisions, which reduce the uncertainty and complexity of operations as well as investing and financing activities. Bhat et al. (2006) document the importance of corporate governance-related disclosures for analyst forecast accuracy, even after controlling for financial transparency. It appears analysts place some importance on governance characteristics, as this enables them to assess the credibility of the firm’s disclosures. Hope (2003b) finds stronger country-level enforcement gives managers higher incentives to follow accounting rules, which reduces analysts’ uncertainty about future earnings.

We argue that firms with better corporate governance are subject to less uncertainties and risks, which reduce the difficulty of forecasting and therefore reduce analysts’ forecast error. Lack of adequate governance mechanisms gives rise to increased uncertainty, which in turn complicates the forecasting task of analysts. Duru and Reeb (2002) argue that earnings forecast error depends on the difficulty or complexity of the forecasting task and show that analyst earnings forecasts are less accurate for multinational enterprises than domestic firms. Chen et al. (2010) find that analysts’ earnings forecasts are less accurate for firms with high-level political connections because analysts experience more difficulty in predicting earnings.

Research in the USA has documented the relation between certain aspects of corporate governance (such as internal control, ownership structure and board composition) and analyst forecast characteristics. Xu and Tang (2012) document more accurate analyst earnings’ forecasts with firms which report internal control material weaknesses. Ali et al. (2007) document that analysts are able to make more informative forecasts for family firms and also have lower level of forecast dispersion and lower volatility in forecast revisions. Gul et al. (2013) find that the presence of women on the board increases governance and therefore lead to higher analyst forecast accuracy and lower dispersion. Given that a variety of aspects of corporate governance affects analysts’ forecasting abilities, we predict that the overall corporate governance characteristics have an impact on the ability of financial analysts to forecast earnings accurately. Therefore, our first hypothesis is:

H1.

Analysts’ one-year-ahead earnings forecast accuracy is positively related to forecasted firms’ quality of corporate governance mechanisms.

As good corporate governance leads to less agency problem from the separation of ownership and management and enhances the communication between managers and investors though public disclosures, we expect lower forecast dispersion for firms with better corporate governance. Therefore, our second hypothesis is:

H2.

Analysts’ earnings forecast dispersion is negatively associated with forecasted firms’ quality of corporate governance mechanisms.

Following the same logic, corporate governance also has an impact on the smoothness of earnings prediction during the forecasting period. Analysts are more likely to update their expectations with firms facing governance problems. Conversely, investor expectations about earnings change more smoothly over the year for firms with relatively good corporate governance mechanisms. Prior research, such as Aboody et al. (2006) and Bartov et al. (2007), provide evidence managers manipulate inputs for fair values for their own interests. However, in some situations, managers may use their private information to credibly report fair values (Barth et al., 1998). Good corporate governance reduces information asymmetry through improved timeliness of the disclosures. For example, Song et al. (2010) document that for firms with strong corporate governance, the fair values have higher value relevance. The improved timeliness of disclosure, in turn, leads to smoother adjustments in analyst forecasts. Therefore, our third hypothesis is as follows:

H3.

The volatility of analysts’ earnings forecast revisions is negatively related to the quality of corporate governance.

We next examine whether the associations between analysts’ earnings forecast characteristics and corporate governance vary across institutional environments. Hope (2003b) documents the positive effect of stronger legal enforcement on analyst forecast accuracy. Furthermore, in jurisdictions with higher level of investor protection, analysts have more incentives to improve their forecasts (Barniv et al., 2005) and analyst forecasts outperform the historical earnings forecasting model (Barniv and Myring, 2006). Therefore, we expect that, in jurisdictions with higher level of investor protection (rather than in jurisdictions with lower level of investor protection), it is easier for analysts to assess firms’ future prospects based on the strength of firm-level corporate governance.

H4.

The associations between firm-specific corporate governance strength and analysts’ earnings forecast accuracy, forecast dispersion and revision volatility are more pronounced in jurisdictions with higher level of investor protection.

## Table IX.

Correlation matrix

FERRORit DISPERSIONit VOL_REVit CGit SIZEit SD_ROEit LOSSit EARNINGS_SURit LEGALc ANTIDIRECTOR_RIGHTSc R_ANTIDIRECTOR_RIGHTSc
FERRORit 0.378 (0.001) 0.382 (0.001) −0.031 (0.043) −0.022 (0.078) 0.290 (0.001) 0.169 (0.001) 0.035 (0.007) −0.060 (0.001) −0.045 (0.002) 0.013 (0.385)
DISPERSIONit 0.515 (0.001) 0.538 (0.001) −0.095 (0.001) −0.065 (0.001) 0.037 (0.005) 0.283 (0.001) 0.223 (0.001) −0.121 (0.001) −0.081 (0.001) 0.020 (0.181)
VOL_REVit 0.455 (0.001) 0.462 (0.001) −0.057 (0.001) −0.042 (0.001) 0.052 (0.001) 0.115 (0.001) 0.003 (0.831) −0.019 (0.152) −0.021 (0.136) 0.001 (0.946)
CGit −0.114 (0.001) −0.142 (0.001) −0.084 (0.001) −0.069 (0.001) −0.078 (0.001) −0.026 (0.086) 0.008 (0.620) 0.132 (0.001) 0.056 (0.001) −0.028 (0.102)
SIZEit −0.028 (0.277) −0.078 (0.001) 0.002 (0.861) −0.067 (0.001) 0.005 (0.687) −0.024 (0.056) −0.016 (0.227) −0.162 (0.001) −0.400 (0.001) 0.018 (0.198)
SD_ROEit 0.139 (0.001) 0.144 (0.001) 0.259 (0.001) −0.026 (0.090) 0.001 (0.918) 0.088 (0.001) 0.019 (0.151) −0.048 (0.001) −0.052 (0.001) 0.009 (0.546)
LOSSit 0.240 (0.001) 0.181 (0.001) 0.217 (0.001) −0.025 (0.076) −0.013 (0.297) 0.134 (0.001) 0.007 (0.611) −0.002 (0.902) −0.041 (0.004) −0.001 (0.546)
EARNINGS_SURit 0.357 (0.001) 0.334 (0.001) 0.349 (0.001) −0.061 (0.920) 0.033 (0.001) 0.243 (0.001) 0.232 (0.001) −0.022 (0.117) −0.012 (0.432) −0.012 (0.416)
LEGALc −0.084 (0.001) −0.180 (0.001) −0.143 (0.001) 0.106 (0.001) −0.102 (0.001) −0.109 (0.001) −0.002 (0.902) −0.149 (0.001) 0.827 (0.001) 0.063 (0.001)
ANTIDIRECTOR_RIGHTSc −0.074 (0.001) −0.096 (0.001) −0.170 (0.001) 0.025 (0.155) −0.348 (0.001) −0.115 (0.001) −0.045 (0.002) −0.159 (0.001) 0.794 (0.001) 0.441 (0.001)
R_ANTIDIRECTOR_RIGHTSc 0.001 (0.925) 0.025 (0.099) −0.120 (0.001) −0.051 (0.003) −0.126 (0.001) −0.018 (0.198) −0.046 (0.001) −0.096 (0.001) 0.236 (0.001) 0.577 (0.001)
Notes:

## Table XI.

Cross-country variation in the association between corporate governance and analysts’ earnings forecast characteristics (tests of H4) (number of observations = 2,865): anti-director right index: Original measure and revised measure

Jurisdiction Original measure (La Porta et al., 1998) Revised measure (Djankov et al., 2008)
China NA NA
Hong Kong 5 5
Indonesia 2 5
India 5 5
Japan 4 4.5
Korea 2 4.5
Malaysia 4 5
The Philippines 3 4
Singapore 4 5
Thailand 2 4
Taiwan 3 3
Note:

From Spamann (2010) Table I on page 475

## Table XII.

Cross-country variation in the association between corporate governance and analysts’ earnings forecast characteristics (tests of H4) (number of observations = 2,865): regression results

Measure of ENVIRONMENTc LEGALc ANTIDIRECTOR_RIGHTSc R_ANTIDIRECTOR_RIGHTSc
Sign (4) (5) (6) (4) (5) (6) (4) (5) (6)
Intercept ? 0.016* (1.42) 0.023*** (11.20) 0.014*** (4.76) 0.034* (1.42) 0.020*** (4.50) −0.002 (−0.41) 0.007 (0.18) −0.001 (−0.01) 0.017* (1.63)
CGit −0.014* (1.38) 0.013* (−1.36) 0.010* (1.50) −0.031** (−2.20) 0.013*** (2.55) 0.015** (2.02) −0.025*** (−2.43) 0.016* (1.49) 0.030** (1.83)
CGit*ENVIRONMENTc −0.011*** (−2.82) −0.008*** (−3.17) −0.004** (−2.27) −0.006*** (−2.84) −0.006*** (−4.44) −0.005*** (−2.36) −0.003*** (−5.25) −0.005** (−2.26) −0.007** (−1.94)
ENVIRONMENTc ? −0.010 (−1.07) 0.001 (0.73) 0.006** (2.24) −0.007 (−1.06) 0.001 (0.27) 0.007*** (3.64) 0.002 (0.23) 0.006*** (4.12) −0.001 (−0.31)
SIZEit −0.001 (−0.13) −0.001*** (−6.95) −0.001*** (−4.95) −0.001 (−0.16) −0.001*** (−6.11) −0.001*** (−4.47) −0.001 (−0.14) −0.001*** (−6.14) −0.001*** (−4.46)
SD_ROEit + −0.001** (−2.30) −0.001** (−1.72) 0.001 (0.83) −0.001** (−2.22) −0.001** (−1.69) 0.001 (0.54) −0.001** (−2.23) −0.001* (−1.64) 0.001 (0.56)
LOSSit + 0.017*** (3.63) 0.016*** (17.03) 0.018*** (13.78) 0.017*** (3.04) 0.015*** (14.69) 0.020*** (12.75) 0.017*** (3.05) 0.015*** (14.58) 0.020*** (12.70)
EARNINGS_SURit + 0.469*** (41.78) 0.032*** (15.00) 0.059*** (18.80) 0.502*** (40.48) 0.030*** (12.79) 0.057*** (16.57) 0.502*** (40.46) 0.030*** (12.92) 0.058*** (16.66)
Country fixed effect Yes Yes Yes Yes Yes Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes Yes Yes Yes Yes Yes
Year fixed effect Yes Yes Yes Yes Yes Yes Yes Yes Yes
Adjusted R2 (%) 36.45 22.68 23.94 38.69 21.02 23.71 38.68 21.24 23.06%
Notes:

FERRORit= d0+ d1CGit+ d2CGit*ENVIRONMENTc+ d3ENVIRONMENTc+ d4SIZEit+d5SD_ROEit+d6LOSSit+ d7EARNINGS_SURit+εit (4); DISPERSIONit= e0+ e1CGit+ e2CGit*ENVIRONMENTc+ e3ENVIRONMENTc+ e4SIZEit+ e5SD_ROEit+e6LOSSit+ e7EARNINGS_SURit+εit (5); VOL_REVit= f0+ f1CGit+ f2CGit*ENVIRONMENTc+ f3ENVIRONMENTc+ f4SIZEit+ f5SD_ROEit+f5LOSSit+ f6EARNINGS_SURit+εit (6); White-adjusted t-statistics for ordinary least squares estimation are in parentheses;

***

significant at the 1% level;

**

significant at the 5% level;

*

## Notes

1.

Sell-side analysts’ forecasts have been used as a proxy for investor prediction of future earnings in accounting and finance research.

2.

La Porta et al. (1998) document that common law countries offer shareholders stronger legal protections against managerial entrenchment. As reported in Table 6 of Hung (2001), the Pearson (Spearman) correlation coefficient for legal system and anti-director rights index is 0.83 (0.79), both significant at 0.01 level.

3.

CLSA started to provide corporate governance ratings for a sample of emerging market economies in 2001 and 2002. The corporate governance ratings are unavailable in 2003 and starting from 2004, CLSA have only provided ratings for Asian-Pacific economies.

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## Acknowledgements

The authors thank Credit Lyonnais Securities Asia (CLSA) for providing corporate governance ratings data. They appreciate valuable inputs from our discussant, Luminita Enache and other conference participants at American Accounting Association’s 2014 Mid-Atlantic Region Meeting as well as conference participants at 2014 Accounting Conference at Temple University. Minna Yu acknowledges the summer research support from Business Council of Leon Hess Business School. In addition, this work was supported, in part, by a Creativity and Research Grant from Monmouth University.

## Corresponding author

Minna Yu can be contacted at: miyu@monmouth.edu