The Interactive Role of Difficulty and Incentives in Explaining the Annual Earnings Forecast Walkdown*

Within-year patterns of analysts’ earnings forecasts have been attributed to analysts’ incentives to curry favor with managers by releasing optimistic forecasts at longer horizons, followed by a walkdown to levels at which actual earnings meet or beat the forecast at year end. We propose that forecasting difficulty interacts with such incentives and manifests in the observed walkdown. Although difficulty should affect forecast error but not necessarily optimism, the cognitive psychology literature on motivated reasoning supports a predicted interaction between incentives to be optimistic and the difficulty of the task. Applying that theory to the analyst forecast setting, greater forecast difficulty generates more degrees of freedom for analysts to support a biased outcome, even if the bias is not deliberate. We find cross-sectional variation in earnings forecast difficulty is associated with the slope of the walkdown. More importantly, we find that the interaction between analysts’ incentives to be optimistic and difficulty is the most significant factor in explaining the earnings forecast walkdown. In addition, we examine revenue forecasts as a benchmark of lower forecast difficulty and find no substantive evidence of a revenue forecast walkdown. The overall results suggest the well-known earnings forecast walkdown is not a simple manifestation of analysts’ strategic incentives, but is significantly influenced by the difficulty of forecasting earnings.