Caught in an Expectations Trap: Risks of Giving Securities Analysts What They Expect

Although recent research shows that there is mounting pressure on firms to achieve earnings expectations of securities analysts, firms are far from being passive conformers; many firms proactively manage such pressure, particularly with earnings management tools. Yet why does the pressure to meet analyst expectations persist despite firms’ efforts to reduce it? To address the question, we develop an intertemporal model of the mutually reinforcing relationships between analyst expectations and firms’ strategic response, combining the behavioral theory of the firm and the concept of expectations trap. We argue that firms’ efforts to meet analyst expectations strengthen their salience as a predominant performance benchmark and, in doing so, ironically put them under greater pressure from analysts in three sequentially related steps—escalating future earnings expectations, imposing more severe penalties for failure to meet heightened expectations, and generating compensatory action for missed expectations. Our analysis, using data on more than 700 of the largest listed U.S. firms between 1986 and 2015, supports our arguments. Our study expands the scope of the behavioral theory of the firm, by demonstrating the increasing importance of performance feedback based on analyst expectations. Our study also contributes to the research on earnings pressure, by illuminating why the pressure persists despite firms’ efforts to reduce or evade it, and finally to the literature on strategic management of external expectations, by elaborating its unintended, long-term consequences. Supplemental Material: The e-companion is available at https://doi.org/10.1287/orsc.2021.1569 .