The association between the accuracy of long-run qualitative earnings forecasts by managers and discretionary accounting in the Netherlands

Many earnings forecasts studies are conducted for the Anglo-Saxon countries, but to date very few have focused on continental Europe. This paper examines whether there is a relationship between discretionary accounting and the accuracy of long-run forecasts of annual earnings voluntarily disclosed by managers in the directors' report, which is a mandatory chapter of the annual report in the Netherlands. Long-run forecasts mean forecasts made at least seven months before year-end. First, we discuss the rationale for management's incentive to improve the accuracy of earnings forecasts voluntarily disclosed (in the directors' report). We then provide some information with respect to the institutional background in the Netherlands. Afterwards we conduct empirical tests to determine whether qualitative earnings forecasts provide additional information on future performance over and above the information from auto-regressive models i.e. reported EPS on t-1 and EPS on t-1 after the correction for discretionary accounting and also whether there is support for the hypothesized relationship between discretionary accounting and qualitative management forecast accuracy. Our empirical results indicate that qualitative earnings forecasts provide a statistically significant better prediction of the actual earnings than reported EPS on t-l and EPS on t-l after the correction for discretionary accounting and that there is a relationship between high pre-discretionary forecast errors and the adoption of discretionary accounting. After adopting discretionary accounting, the forecast errors are reduced. Overall, the study shows that management has an incentive to engage in discretionary accounting to improve the accuracy of the disclosed qualitative earnings forecasts in their directors' reports. However, one should bear in mind that 'either discretionary accounting is used to improve the accuracy of earnings forecasts disclosed in the directors reports or managers' earnings forecasts are sometimes disclosed in anticipation of planned discretionary accounting actions (Jaggi and Sannella, 1995).