A Comparison of Analystsʹ and Investorsʹ Biases in Interpreting Accruals: A Valuation Approach

Elgers, Lo, and Pfeiffer (2003) argue that analystsʹ earnings forecasts are less biased than the marketʹs earnings expectation in interpreting accruals. Their argument implies that analystsʹ earnings forecasts could potentially mitigate the marketʹs mispricing of accruals by guiding investors to reduce their earnings prediction errors arising from the misinterpretation of accruals. Their results call for further investigation, however, owing to two questionable research design choices: (1) estimating the magnitude of the marketʹs bias using the traditional earnings response coefficient (ERC) model, which is vulnerable to the well-known omitted-variable problem; and (2) examining only the bias in short-term (i.e., one-year-ahead) earnings expectations, ignoring possible bias in earnings expectations for longer future periods. To alleviate these concerns, we take an alternative approach in which we compare the bias of the marketʹs equity value estimates (i.e., stock prices) against the bias of equity value estimates based on analystsʹ earnings forecasts in valuing accruals. By taking this alternative approach, we find that analystsʹ earnings forecasts are more biased than stock prices in interpreting accruals. Thus, contrary to Elgers, Lo, and Pfeiffer (2003), we conclude that analystsʹ earnings forecasts do not mitigate the marketʹs mispricing of accruals.