Accounting Theory

Much of the bias has been ascribed to conflicts of interest that arise when securities firms provide a mix of investment banking, brokerage, and investment advisory services. Financial analysts have faced conflicts in supporting these disparate functions. Analysts have allegedly issued overly optimistic earnings forecasts and inflated stock recommendations in order to support investment-banking deals, curry favor with management, and stimulate trading fees. Analysts intentionally issue optimistically biased earnings forecasts to curry favor with management. The forecaster is willing to tradeoff loss in forecast accuracy with gains in accuracy resulting from better access to management’s information.

Incentives relating to the brokerage function encourage optimistic earnings forecasts and “buy” over “sell” recommendations. Analysts publish both stock recommendations and earnings forecasts. Because recommendations are relatively static, most earnings forecasts are generated within the context of an outstanding stock recommendation. Analysts’ earnings forecasts are biased by their motive to support their stock recommendation. Analysts intentionally bias earnings forecasts to motivate investors to trade, which boosts commissions earned on trades. Analyst intentionally bias earnings forecasts to increase the likelihood their firm will be awarded lucrative investment banking business.

In addition, the analyst is biased when the issue of compensation of the analyst arises. Positive recommendations published could increase both financial interest as well as the firm’s reputation. An unfavorable report might alienate the firm’s client or a potential client. Compensation arrangements can put pressure on analysts to issue positive research reports and recommendations. Besides that, ownership interests in the company may arise when an analyst own significant positions in the companies an analyst covers. In order to maximize their own interest, the analyst will tend to...