Showing papers on "Post-earnings-announcement drift published in 2002"

Management's Incentives to Avoid Negative Earnings Surprises

Abstract: Recent reports in the business press allege that managers take actions to avoid negative earnings surprises. I hypothesize that certain firm characteristics are associated with greater incentives to avoid negative surprises. I find that firms with higher transient institutional ownership, greater reliance on implicit claims with their stakeholders, and higher value‐relevance of earnings are more likely to meet or exceed expectations at the earnings announcement. I also examine whether firms manage earnings upward or guide analysts' forecasts downward to avoid missing expectations at the earnings announcement. I examine the relation between firm characteristics and the probability (conditional on meeting analysts' expectations) of having (1) positive abnormal accruals, and (2) forecasts that are lower than expected (using a model of prior earnings changes). Overall, the results suggest that both mechanisms play a role in avoiding negative earnings surprises.

Bringing the Future Forward: The Effect of Disclosure on the Returns‐Earnings Relation

Abstract: This paper studies how firm disclosure activity affects the relation between current annual stock returns, contemporaneous annual earnings and future earnings. Our results show that firms with relatively more informative disclosures “bring the future forward” so that current returns reflect more future earnings news. We also find that changes in disclosure activity are positively related to changes in the importance of future earnings news for current returns. These results suggest that a firm’s disclosure activity reveals credible, relevant information not in current earnings, and that this information is incorporated into the current stock price.

Predicting Earnings Management: The Case of Earnings Restatements

Abstract: This paper examines the usefulness of accounting information in predicting earnings management. We investigate a comprehensive sample of firms from 1971-2000 that restated annual earnings. We find that firms restating earnings have high market expectations for future earnings growth and have higher levels of outstanding debt. We also find that a primary motivation for the earnings manipulation is the desire to attract external financing at a lower cost. Furthermore, our evidence suggests that restating firms have been attempting to maintain a string of consecutive positive earnings growth and consecutive positive quarterly earnings surprises. Together, our evidence is consistent with capital market pressures acting as a motivating factor for companies to adopt aggressive accounting policies. Finally, we document that information in accruals, specifically, operating and investing accruals, are key indicators of the earnings manipulation that lead to the restatement. Collectively, the evidence suggests that market participants can gain substantial value from a careful consideration of information in financial statements.

Expanded Disclosures and the Increased Usefulness of Earnings Announcements

Abstract: We investigate three explanations for prior studies' finding that the usefulness of earnings announcements, as measured by their absolute market responses, has increased over time. We confirm this increase for a sample of 426 relatively large, stable firms over 1980–1999. We find no evidence that this over‐time increase in the magnitude of the market reaction to our sample firms' earnings announcements is attributable to increases in the absolute amount of unexpected earnings conveyed in the announcements or to increases in the intensity of investors' average reaction to unexpected earnings. To test the third explanation—an over‐time expansion in the amount of concurrent (with bottom line earnings) information in earnings announcement press releases—we analyze and code the contents of 2,190 earnings announcement press releases made by 30 of our sample firms over 1980–1999. Concurrent disclosures increased significantly over this period and we find that these concurrent disclosures, especially the inclusio...

The World Price of Earnings Opacity

Abstract: We analyze the financial statements of 58,653 firm-years from 34 countries for the period 1985-1998 to construct a panel data set measuring three dimensions of earnings opacity for each country - earnings aggressiveness, loss avoidance, and earnings smoothing. We combine these three dimensions to obtain an overall earnings opacity time-series measure per country. We then explore whether earnings opacity affects two dimensions of an equity market in a country - the return the shareholders demand and how much they trade. While not all results are consistent for our three individual earnings opacity dimensions, our panel data tests document that, after controlling for other influences, an increase in overall earnings opacity in a country is linked to an increase in the cost of equity and a decrease in trading in the stock market of that country.

Arbitrage Risk and Post-Earnings-Announcement Drift

Abstract: This study examines whether the magnitude of post-earnings-announcement drift is related to the risk faced by arbitrageurs who may view the anomaly as a trading opportunity. Consistent with this hypothesis, the magnitude of the drift is strongly related to the arbitrage risk measure developed by Wurgler and Zhuravskaya (2002). The effect of arbitrage risk is statistically and economically significant under a wide range of specifications. The results suggest that post-earnings-announcement drift represents an underreaction to earnings information and that arbitrage risk impedes arbitrageurs from eliminating it.

Can “Big Bath” and Earnings Smoothing Co-exist as Equilibrium Financial Reporting Strategies?

Abstract: We study a model of financial reporting where investors infer the precision of reported earnings. Reporting a larger earnings surprise reduces the inferred earnings precision, dampening the impact on firm value of reporting higher earnings, and providing a natural demand for smoother earnings. We show that for sufficiently “bad” news, the manager under-reports earnings by the maximum, preferring to take a “big bath” in the current period in order to report higher future earnings. If the news is “good,” the manager smoothes earnings, with the amount of smoothing depending on the level of cashflows observed. He either over-reports or partially under-reports for slightly good news, and gradually increases his under-reporting as the news gets better, until he is under-reporting the maximum amount for sufficiently good news. This result holds both when investors are “naive” and ignore management’s ability to manipulate earnings, or “sophisticated” and correctly infer management’s disclosure strategy.

Earnings Surprise “Materiality” as Measured by Stock Returns

Abstract: Ranked earnings surprise portfolios formed from First Call files for 1992–97 are used to assess the annual earnings surprise magnitude for an individual firm sufficient to expect a “significant market reaction.” We find that, for an individual firm, the maximum probability of a gain from trading on prior knowledge of any surprise magnitude is .622. The lack of probable trading gains is due to the S–shaped surprise/return relation and the large variance of returns for a given magnitude of surprise. In turn, we find that the S–shape is related empirically to the dispersion of analyst forecasts. Thus, factors underlying dispersion differences are related to the importance or “materiality” of earnings surprise as measured by stock returns and explain at least part of the S–shaped surprise/return relation.

The Effect of 10K Restatements on Firm Value, Information Asymmetries, and Investors' Reliance on Earnings

Abstract: Restating 10-Ks has become an increasingly common phenomenon in financial reporting. Restatements clearly signal that the firm's prior financial statements were not credible and were of relatively lower "quality". In this study, we examine the effect of restatements on investors' and dealers' perceptions of the firm. First, we examine the market returns and the bid-ask spread effects at the announcement of the accounting problem that leads to restatement. We find negative market returns for accounting problem announcements, and we find that the negative reaction is most pronounced for firms with revenue recognition issues. We also find an increase in spreads surrounding the announcement of revenue recognition problems. Second we examine returns and spreads from the announcement of the restatement to the filing of the restated financial statements. We find a significant negative market reaction and a larger negative reaction for firms with revenue recognition problems. We find no change in spreads from before the announcement of the accounting problem to after the restatement is filed. Finally, we examine the effect of the restatement on earnings response coefficients, and find that the market reacts less to earnings after a restatement than to earnings prior to a restatement. In general, these results indicate that investors and dealers react negatively to restatements and are more concerned with revenue recognition problems than with other financial reporting errors.

Costly short -selling and stock price adjustment to earnings announcements

Abstract: We study the effect of short sale constraints on the informational efficiency of stock prices using a direct measure of shot sale constraints. Specifically, we test the Diamond and Verrecchia (1987) hypothesis that short sale constraints reduce the speed at which prices adjust to private information. We show that stocks for which short selling is costly have larger price reactions to earnings announcements, especially to bad news. We confirm the Diamond and Verrechia (1987) prediction that the distribution of announcement day returns is more left skewed and returns have larger absolute values when short selling is constrained. We find that trading volume falls and prices become less informative when short selling is constrained. Furthermore, the fraction of long run price reaction realized on the day of the announcement is smaller when short selling is constrained. *I gratefully acknowledge the comments and suggestions of Richard Evans, Chris Géczy, Gary Gorton, Jeff Jaffe, Alan Lee, Ken Kavajecz, Don Keim, David Musto, Krishna Ramaswamy, Rob Stambaugh, Ro Verrecchia and seminar participants at Arizona State University, the Board of Governors of the Federal Reserve, Emory University, Georgia Tech, HEC Montreal, the University of North Carolina, the University of Pennsylvania, the University of Virginia, and Washington University in St. Louis. Tamala Grissett and Mehmet Orhan provided valuable assistance. All errors are my own. Address correspondence to Adam Reed, Kenan Flagler Business School, The University of North Carolina at Chapel Hill, Campus Box 3490, Chapel Hill, NC 27599 or e-mail: adam_reed@unc.edu. For many years, the effect of short sale constraints has motivated research with important and controversial implications for stock prices. Early papers, such as Miller (1977), argue that short sale constraints prevent pessimistic traders from short selling without restricting optimistic traders from buying, thereby imparting an upward bias to stock prices. In recent years, finance scholars have sought to measure the effects of Miller (1977) and similar models empirically. This article looks at short sale constraints from a different perspective. We characterize the informational efficiency of stock prices in the presence of short sale constraints. Using a timely and accurate measure of short sale constraints, we study the distribution of returns when information is revealed to the public. Diamond and Verrecchia (1987), DV hereafter, sets up a rational expectations model in which market participants take short sale constraints into consideration when formulating their demand and pricing decisions. In the model, short sale constraints lead to a decrease in trading as informed and uninformed traders are prevented from short selling. Since some relatively informative “sell or short” orders are removed from the market, prices take longer to adjust to private information. Price adjustment is particularly slow in the presence of negative private information because informed investors who do not own shares cannot trade on their information, further reducing the number of informative trades. Since securities subject to short sale constraints are slow to incorporate private information, they have relatively large price reactions when private information is publicized. Furthermore, since price adjustment to negative private See Asquith, Pathak, and Ritter (2005), Boehme, Danielsen and Sorescu (2006), Chen, Hong and Stein (2001), Danielsen and Sorescu (2001), Diether Malloy and Scherbina (2002), Jones and Lamont (2002), Nagel (2005), Sorescu (2000), among others, for a discussion of the empirical work. Lamont (2004) reviews the evidence. information is particularly slow, large price reactions are more likely in the presence of bad news, which increases the left skewness of the announcement day return distribution. Previous empirical work has used the introduction of exchange traded options as a proxy for the reduction in short selling costs (i.e. Jennings and Starks (1986), Skinner (1990)). In this paper, we use rebate rates determined in the equity lending market to test the DV hypothesis. To be sold short, stocks are often borrowed in the equity lending market. The borrowing cost fluctuates with market conditions, making some stocks, or specials, temporarily costly to short sell. Using the borrowing cost as an accurate and timely measure of short selling difficulty, we find evidence that supports the DV hypothesis. To measure the efficiency of private information in the presence of short sale constraints, quarterly earnings are taken to be private information until firms announce their earnings to the public. Consistent with the DV prediction that announcement day price reactions will be larger when short selling is constrained, results show that the absolute value of announcement day returns is significantly larger when stocks are on special (0.076 vs. 0.058). We also find that the distribution of announcement day returns is more left skewed when short selling is constrained (measured skewness is 0.228 vs. 4.222), which bears out the DV prediction that large announcement day returns are more likely in the presence of negative information. Furthermore, after controlling for stock characteristics, we find that stocks have larger price reactions and larger announcement day volatilities when short selling is costly. We also find empirical evidence consistent with the mechanism underlying DV. The DV hypothesis hinges on the fact that short sales are removed from the sample of “sell or short” trades when short selling is constrained. We show that volume decreases by an average of 28,442 shares per day when stocks are on special. Furthermore, following Hasbrouck (1993), we decompose returns into informative and transient components. We find that short sale constraints decrease the informativeness of trades by 30%. Furthermore, in a setting where we control for stock characteristics, we find that specialness significantly decreases market quality. In addition to stock price reactions to earnings announcements, we look at the relationship between costly short selling and the post earnings announcement drift anomaly. Papers such as Bernard and Thomas (1989) and Abarbanell and Bernard (1992), document that stocks with extreme earnings surprises tend to drift in the direction of their earnings surprise for periods of up to one year. If the costs of short selling reduce the informational efficiency of private information before the announcement, we might also expect efficiency to be reduced after the information becomes public. In particular, the full incorporation of negative earnings surprises will be delayed. Experiments presented in this paper support this hypothesis; stocks that are on special on the day negative earnings are announced have an abnormal return of -12.8% over the next three months, whereas stocks that are not on special have an abnormal return of 1.2% over the same period. To allow for the possibility of different amounts of post earnings announcement drift in the two samples, we present results comparing the percentage of eventual drift realized on the day of the earnings announcement with and without borrowing constraints. We find that stocks realize 32% less of their eventual post earnings announcement drift on the day of the announcement when short selling is costly. One of the concerns about the effect of costly short selling on stock prices is endogeneity. Since short selling can drive scarcity in the lending market, the short sale constraint measure used in this paper could be problematic private information is driving short selling which, in turn, drives the sort sale constraint. We address this concern in two ways. First, we isolate four corporate events that drive short selling but have nothing to do with private earnings information. These events, mergers, seasoned equity offerings, dividend reinvestment discount programs and initial public offerings, are associated with a sub sample of stock specials for which we can be reasonably certain that the cause of specialness is not related to quarterly earnings. Although the sub sample is small, the distribution of announcement day returns reflects the predictions of the DV hypothesis; the distribution of announcement day returns has a larger average absolute value and more left skewness when short selling is constrained. Second, as a direct test for correlation between private information and specialness, we run a regression of earnings announcement surprises on specialness. We find no relationship, which suggests that stock specials are not associated with private earnings information. The balance of this paper proceeds as follows. Section 1 describes and interprets the equity lending data. Section 2 describes the relationship between this work and existing literature, and Section 3 characterizes our findings. Section 4 concludes. 1. Data One of the largest U.S. securities lenders has generously provided a database describing their daily loan portfolio from November 1, 1998 through October 29, 1999. The database has prices and quantities for the lender’s U.S. equity loans in this period. The rebate rate is a timely measure of short sale constraints. As Table 1 shows, the median loan duration is 3 days, and the mode of the distribution is 1 day. There are 287,838 observations representing new loans, 1,579,763 observations representing changes to existing loans, and 1,617,773 observations representing loans that were extended but otherwise unchanged. Using averaging over multiple loans in a given stock each day, we have 684,007 unique loan rate observations. The database is more fully described in Geczy, Musto and Reed (2002). We construct a measure of specialness from the loan database. Equity loans are priced by the interest rate earned on a borrower’s cash collateral, or the rebate rate. Specialness is the difference between the general rebate rat

The Effect of Earnings Forecasts on Earnings Management

Abstract: We develop a theory of the association between earnings management and voluntary management forecasts in an agency setting. Earnings management is modeled as a “window dressing” action that can increase the firm’s reported accounting earnings but has no impact on the firm’s real cash flows. Earnings forecasts are modeled as the manager’s communication of the firm’s future cash flows. We show that it is easier to prevent the manager from managing earnings if he is asked to forecast earnings. We also show that earnings management is more likely to follow high earnings forecasts than low earnings forecasts. Finally, our analysis shows that shareholders may not find it optimal to prohibit earnings management. Earlier results rationalize earnings management by violating some assumption underlying the Revelation Principle. By contrast, in our model the principal can make full commitments and communication is unrestricted. Nonetheless, earnings management can be beneficial as it reduces the cost of eliciting truthful forecasts.

Market Response to Earnings Surprises Conditional on Reasons for an Auditor Change

Abstract: Our interest in this study is the relative informativeness of earnings announcements reported before and after Form 8-K disclosures of the reason for an auditor change. We appeal to several models that predict that the market's response to an earnings surprise is positively related to the perceived precision of the earnings report. We predict that the Form 8-K reason disclosures aid investors in updating their expectations of earnings precision by providing useful information about the financial reporting process that produces the earnings report. For 802 auditor changes from late 1991 through late 1997, the average price response per unit of earnings surprise is lower subsequent to an auditor change for companies that switched for disagreement-related or fee-related reasons and higher for those that switched for service-related reasons. This paper provides further evidence on the effects of differential earnings quality on differences in the returns-earnings relation across companies and over time as well as the efficacy of Form 8-K disclosures of reasons for auditor changes.

The Effect of Earnings–Announcement Timing on Earnings Management

Abstract: This paper examines whether firms which delay earnings announcements engage in earnings management. The cross–sectional version of the modified Jones 1995 model is used to estimate ‘normal’ accruals. Prior research has documented that, on average, delayed earnings announcements are associated with negative earnings surprises. Our evidence suggests that the market anticipates unfavorable earnings news when it observes reporting delays. As a consequence, late reporters appear to make the most of a bad situation by employing income–decreasing accruals in big–bath–type earnings management and in contractual renegotiations. We find that the magnitude of income–reducing abnormal accruals is related to the reporting lag.

Can Stock Recommendations Predict Earnings Management and Analysts' Earnings Forecast Errors?

Abstract: We investigate whether the direction and magnitude of earnings management by a firm is affected by analysts' current perception of its equity investment potential (i.e., its perceived ability to generate positive abnormal returns). We argue that firms whose investment potential is perceived to be high (low) by analysts have strong (weak) incentives to meet earnings expectations. Accordingly, firms whose investment potential is perceived to be high are expected to manage earnings towards expectations (to ratify analysts beliefs), whereas firms whose investment potential is perceived to be low are expected to manage earnings away from expectations (to create the greatest possible amount of accounting slack for the future). Relying on analysts' Buy, Hold and Sell recommendations as proxies for firms' perceived investment potential and analysts' earnings forecasts to measure earnings expectations, we find evidence that strongly supports these hypotheses. Specifically, we find that after being rated a Sell, firms engage more frequently in extreme income-decreasing earnings management than other firms, indicating strong incentives to take earnings baths to create accounting slack. This earnings management behavior is associated with extreme bad news earnings surprises. In contrast, after being rated a Buy, firms engage in more frequent (but not more extreme) income-increasing earnings management than other firms. This behavior is associated with a high incidence of reported earnings that meet or slightly exceed the target of analysts' earnings forecasts. Our findings provide evidence of widespread earnings management in response to equity market incentives. They also suggest that some portion of apparent "optimism" in analysts' forecasts previously documented may be attributable to actions taken by managers subsequent to the issuance of forecasts rather than incentives to bias forecasts often ascribed to analysts.

Modeling Sustainable Earnings and P/E Ratios with Financial Statement Analysis

Abstract: This paper yields a summary score that informs about the sustainability (or persistence) of earnings and about the trailing P/E ratio. The score is delivered from a model that identifies unsustainable earnings from the financial statements by exploiting accounting relations that require that unsustainable earnings leave a trail in the accounts. The paper also builds a P/E model that recognizes that investors buy future earnings, so should pay less for current earnings if those earnings cannot be sustained in the future. In out-of-sample prediction tests, the analysis reliably identifies unsustainable earnings, and also explains cross-sectional differences in P/E ratios. The paper also finds that stock returns are predictable when traded P/E ratios differ from those indicated by our P/E model.

Earnings Management and the Market Performance of Acquiring Firms

Abstract: I examine the market's efficiency in processing manipulated accounting reports and provide an explanation for the post-merger underperformance anomaly. I find strong evidence suggesting that acquiring firms overstate their earnings in the quarter preceding a stock swap announcement. I also find evidence of a reversal of the stock price effects of the earnings management in the days leading to the merger announcement. However, the pre-merger reversal is only partial. There is evidence of a post-merger reversal of the stock price effects of the pre-merger earnings management. The results suggest that the extant evidence of post-merger underperformance by acquiring firms is partly attributable to the reversal of the price effects of earnings management. The study also suggests that the post-merger reversal is not fully anticipated by financial analysts in the month immediately following the merger announcement. However, consistent with suggestions in the financial press that managers guide analysts' forecasts to "beatable" levels, the effect of the earnings management reversal seems to be reflected in the consensus analysts' forecasts by the time of the subsequent quarterly earnings releases.

To Be or Not Be …‘Too Late’: The Case of the Belgian Semi‐annual Earnings Announcements

Abstract: In this study, we demonstrate that the average reporting lag of Belgian interim reports is large but has decreased slightly over the years 1991–1998. Contrary to US findings, we show that the disclosure of interim reports containing bad (good) news is not systematically delayed (speeded up). Interim reports are value relevant since good (bad) news, according to a naive earnings expectations model, induces positive (negative) abnormal returns. The ‘short term’ timeliness of the information disclosure, however, seems not to matter at all.

Analysts Earnings Forecasts and the Roles of Earnings and Book Value in Equity Valuation

Abstract: This study examines the effect of the degree of association between current earnings and expected future earnings on the relative importance of earnings and book value for explaining equity price. Consensus analysts forecasts of one-year-ahead earnings are used to proxy for expected future earnings and are compared to reported current earnings to measure the degree of the association. We find that the value-relevance of current earnings negatively correlates with the extent to which consensus analysts forecasts deviate from current earnings. We also find that the explanatory power of book value for equity price positively correlates with this measure. These results remain robust after controlling for factors known to be affecting the value-relevance of earnings such as negative earnings and the earnings-to-book ratio. Our results also show that this analysts' forecast-based measure of 'earnings persistence' dominates historical earnings variance in explaining cross-sectional variations in the value-relevance of earnings and book value.

The Value of U.S. MNC Earnings Changes from Foreign and Domestic Operations

Abstract: This study examines whether the stock return associated with changes in domestic and foreign earnings varies depending upon the sign of the change. Evidence is presented that negative foreign (vs. domestic) earnings changes are associated with significantly larger stock returns. In contrast, positive foreign and domestic earnings changes are associated with statistically indistinguishable returns. The large association coefficient corresponding to negative foreign earnings changes is especially pronounced for firms with substantial free cash flow and for firms with high anticipated growth opportunities. No evidence is found that positive foreign earnings changes result in high returns due to foreign market growth opportunities.

Fourth Quarter Reversals in Earnings Changes and Earnings Management

Abstract: This paper investigates potential cases of earnings management by observing the pattern of quarterly earnings changes. We identify firms for which the sign of (seasonal) earnings changes observed in interim quarters reverses in the fourth quarter. We hypothesize that a firm performing poorly in interim quarters may attempt to increase earnings of the fourth quarter to achieve a desired annual earnings target, while a firm performing well in interim quarters may attempt to decrease earnings of the fourth quarter to build "reserves" for the future. Our results show that reversal of earnings changes in the fourth quarter is a common phenomenon and its occurrence is greater than would be expected by chance. Other indicators of earnings management, such as the size and direction of changes in fourth quarter accruals, reversals in subsequent earnings performance, and the use of special items in the income statement, suggest that firms with earnings reversals are more likely to have managed earnings than a control sample of nonreversal firms. Our results also indicate that the reversal firms may have debt-contracting and political costs-related incentives to manage earnings and a significant percentage of them may manage earnings to avoid reporting a decrease in annual earnings. Capital market participants and financial analysts both appear to attach lower credibility to earnings reported by the reversal samples. Our collective evidence leads us to suspect that fourth quarter reversals reflect earnings management behavior rather than some other phenomena, such as mean reversion of earnings or fourth quarter settling up.

How Naïve Is the Market’s Use of Firm-Specific Earnings Information?

Abstract: Recent studies suggest the apparent delay in the stock-price response to earnings announcements (i.e., post-earnings announcement drift) is caused by investors who underestimate the autocorrelation of seasonally-differenced earnings (persistence). I present results that suggest: (1) a firm’s future persistence is predictable on the basis of its past persistence; (2) the immediate stock-price response to earnings is positively related to historical persistence; (3) post-earnings-announcement drift is independent of historical persistence; and (4) consistent with (2) and (3), the difference between a firm’s current observed persistence and that implied in stock prices is independent of its historical persistence. These results extend prior research by demonstrating that investors are aware not only that seasonally-differenced earnings are autocorrelated, but that investors recognize firm-specific differences in the magnitude of the autocorrelation.

The Relationship between Accounting Numbers and Returns in the Baltic Stock Markets

Abstract: This paper analyses the relationship between accounting data and market price returns in the stock markets of Lithuania, Latvia and Estonia. Given the different informational environment and accounting practices from those of developed markets, and relatively thinly traded Baltic stocks, the paper aims to evaluate the relevance of accounting numbers for investors in their investment decisions. It investigates both the contemporaneous one-period return-earnings relation and leading period returns in regression model of the main and secondary list securities (totalling 99 companies) over a 5-year period (1995-2000). Leading period returns in regression model are used order to reduce downward bias in the earnings response coefficient when prices lead earnings, meaning that information reflected in the markets expectations and thus in prices is richer than that in the past series of earnings. Transitory earnings, the other common cause of low returns-earnings association, are analysed as well. I look at the effects of transitory earnings by accounting for the asymmetry in relation to losses and also for the nonlinearity of the returns-earnings regression.

Earnings Persistence, Losses and the Estimation of Earnings Response Coefficients

Abstract: One of the major themes of capital markets accounting research concerns mapping the relation between accounting earnings and security returns. There is still not agreement on the functional form of this relation. The models analysed here are those where: the level of earnings alone, the change in earnings alone, or both, scaled by price, are used as explanatory variables for returns. This article demonstrates that if earnings are either completely permanent or entirely transitory, the earnings response coefficients (ERCs) estimated by levels and changes models should coincide. However, if earnings comprise a mixed process of permanent and transitory components, the ERC estimated by the levels will differ from that estimated by the changes model. Using losses to identify transitory components in earnings, empirical evidence consistent with these predictions is provided. A combined model using both the level of, and change in, earnings is justified as a weighted average of an earnings and a book value valuation model (e.g., Ohlson, 1989). An alternative rationalization concerns the mitigation of an errors-in-variables problem associated with the estimation of unexpected earnings (Ali and Zarowin, 1992). The results for the combined model are more consistent with the latter. In this context, some previous empirical studies perceive the levels variable as a useful addition to the changes variable when there are transitory components in earnings. However, the evidence reported here suggests that the level of earnings, scaled by price, appears to be the fundamental earnings explanatory variable for returns (Ohlson, 1991, p. 1). The changes variable can, when the errors-in-variables problem is not mitigated by other methods, be a useful addition to the levels variable.

The Relation between Aggregate Earnings and Security Returns over Long Intervals

Abstract: This paper provides a theoretical explanation and consistent empirical evidence for the increase in the contemporaneous correlation between returns and aggregate earnings as the return interval is lengthened. Consistent with intuition and with Easton, Harris, and Ohlson 1992, the analysis shows that aggregation over time renders the lag in accounting recognition relatively less important and thus improves the returns-earnings R2. Interestingly, the analysis also reveals that aggregating earnings over longer periods increases the positive covariance between aggregate earnings and the accounting lag, which may further increase the R2. This positive covariance can lead to an earnings coefficient greater than one over some range of aggregation, which is consistent with the findings of Easton et al. that over the 10-year interval the returns-earnings regression slope coefficient is greater than one (1.7). The empirical results highlight the fact that the slope coefficient, which is greater than one and increasing with the interval, accounts for much of the increment to the returns-earnings R2. In fact, constraining the slope coefficient to be one results in an R2 of 11 percent for the 10-year interval, which is considerably lower than the R2 of 47 percent when the regression is unconstrained. Hence, the positive covariance between current earnings and the accounting lag, rather than the diminishing effect of the accounting lag, appears to be the dominant explanation for the observed high R2 over long intervals.

The Dynamics of Earnings Forecast Management

Abstract: This paper investigates whether firms manage analyst forecasts to generate positive earnings surprises and the consequences of such forecast management. We first document that firms "talk down" forecasts. Forecasts of quarterly earnings issued later in the forecasting horizon grow increasingly pessimistic on average. More importantly, the exact timing of changes in earnings forecasts turn out to be a key determinant of whether a firm indeed succeeds at generating positive earnings surprises. In particular, (i) changes in consensus early in the forecast horizon have no effect on the probability that earnings will exceed the consensus, (ii) late forecasts that raise the consensus sharply reduce the probability of a positive earnings surprise, and (iii) late forecasts that lower the consensus sharply raise the probability of a positive earnings surprise. These last two findings are the opposite of what would be predicted if deviations of late forecasts from the consensus were due to new information arrival. We then find evidence that investors are systematically "misled" by late arriving forecasts. In particular, downward revisions in the consensus lead to large positive cumulative abnormal returns following the earnings announcement. Finally, while the finding that investors reward firms that successfully manage forecasts down might seem to provide a rationale for downward forecast management, this is not so. Specifically, controlling for the extant earnings-consensus forecast differential, the negative impact of downward forecast revisions on stock price dominates the stock price appreciation following the earnings announcement. This begs the question: Firms manage analyst forecasts (down), but why?