Sources of earnings variability and their effect on earnings forecasts

Previous research shows that analysts’ forecasts of earnings do not fully incorporate information contained in reported earnings variability. This study investigates whether the inefficient forecast is because of a failure to incorporate observable information on two components of earnings variability: variability in operating performance and income smoothing. Our results show that analysts’ forecasts fully incorporate information contained in earnings variability for firms with high income smoothing and for firms with low operating variability. A smaller serial correlation of forecast errors is observed for firms with low operating variability, which suggests that analysts recognize the permanence in earnings for such firms.     

Does financial reporting above or below operating income matter to firms and investors? The case of investment income in China

We explore a unique regulatory change in China in 2007 that moves investment income in an income statement from below the line of operating income to above the line. We find that, post-regulatory change, firms report high investment income when core earnings (operating income excluding investment income) are low and vice versa. Investment income and core earnings exhibit a significantly negative correlation every year post regulation, in contrast to a significantly positive correlation beforehand. We also find that investors do not fully see through the change. Before the regulation, both core earnings and investment income are positively correlated with contemporaneous stock returns and uncorrelated with future stock returns, suggesting appropriate pricing of the information. However, afterward, the results on core earnings are similar to those in the pre-regulation period, but investment income is negatively correlated with future stock returns, implying that the stock market overreacts to the information in investment income in the contemporaneous year.     

Information content of credit ratings in pricing of future earnings

This paper examines whether credit ratings convey information about the firm’s future earnings to the capital markets. Using the future earnings response coefficient methodology, we find that the current stock returns of rated firms reflect more future earnings than do the stock returns of non-rated firms. We also find that the market reflect more future earnings in current returns for higher-rated firms. In addition, we present evidence that returns impound future earnings to a greater extent after a ratings initiation or upgrade. We empirically eliminate the possibility that our findings are driven by earnings smoothing, market liquidity or omitted default risk factors associated with ratings. Our results are robust to controlling for potential omitted variables, endogeneity bias, loss versus profit firms, and serial correlation of error terms. Overall, the evidence suggests that credit ratings help disseminate private information to reduce information uncertainty about the firm’s future profitability among market participants.     

Accounting-based downside risk and expected stock returns: Evidence from China

We document that earnings downside risk contains information on firms' future operating performance and is positively associated with expected stock returns in Chinese stock markets, and the return predictability of earning downside risk mainly comes from its accrual downside risk component. The pricing of earnings downside risk is especially evident among firms with more transparent information environment and stronger governance efficacy, such as large firms, non-high-tech firms, old firms, and firms with high analyst coverage. Lastly, we show that aggregated earnings downside risk and its components at the market level are all significantly and positively associated with subsequent stock market returns, which is consistent with the notion that the accounting-based downside risk measures contain information about future macroeconomic conditions.     

Confirming Management Earnings Forecasts, Earnings Uncertainty, and Stock Returns

In this study we examine the association among confirming management forecasts, stock prices, and analyst expectations. Confirming management forecasts are voluntary disclosures by management that corroborate existing market expectations about future earnings. This study provides evidence that these voluntary disclosures affect stock prices and the dispersion of analyst expectations. Specifically, we find that the market's reaction to confirming forecasts is significantly positive, indicating that benefits accrue to firms that disclose such forecasts. In addition, although we find no significant change in the mean consensus forecasts (a proxy for earnings expectations) around the confirming forecast date, evidence indicates a significant reduction in the mean and median consensus analyst dispersion (a proxy for earnings uncertainty). Finally, we document a positive association between the reduction of dispersion of analysts' forecasts and the magnitude of the stock market response. Overall, the evidence suggests that confirming forecasts reduce uncertainty about future earnings and that investors price this reduction of uncertainty.     

Analyst Report Readability and Stock Returns

This study investigates the market's response to analyst report readability. We posit that readable reports decrease uncertainty of earnings expectations and by extension increase stock prices. Our results show that the equity market reacts more positively to readable reports and that this positive reaction is attributable to a reduction in uncertainty of future performance. Moreover, we find that the effect of readability on stock prices is significantly positive only for firms with greater R&D spending, higher bid‐ask spreads, a greater proportion of uninformed investors, and more experienced analysts, which suggests that readability matters only when information asymmetry in the equity market is high.     

Loss firms’ annual report narratives and share price anticipation of earnings

We extend prior research into the association between disclosure quality and share price anticipation of earnings by discriminating between firms that report profits and firms that report losses. As a measure of disclosure quality we count the number of forward-looking earnings statements in annual report narratives. To measure the extent to which current share price movements anticipate future earnings changes we regress current stock returns on current and future earnings changes. The coefficients on the future earnings change variables are our measure of share price anticipation of earnings.Our regression results show that the association between annual report narratives and share price anticipation of earnings is not the same for profit and loss firms. For loss firms we find that the ability of stock returns to anticipate next period's earnings change is significantly greater when the firm provides a large number of earnings predictions in annual report narratives. We make no such observation for profit firms. In addition, once we control for variations in the intrinsic lead–lag relation between returns and earnings across industries, the observed difference between profit and loss firms becomes statistically significant. Overall, our results are consistent with annual report narratives being a particularly important source of information for loss-making firms.     

Do stock splits signal future profitability?

This study examines whether stock split announcements contain information content about future profitability, measured in terms of future earnings change, future earnings, or future abnormal earnings. We find that the split announcement year has the highest earnings change and the earnings change declines substantially over the subsequent five years. Our empirical results show little evidence that stock splits are positively related to future profitability. In fact, stock splits are in general negatively related to future profitability in subsequent years after the announcement, except for dividend-paying firms with a split factor less than 0.5. This negative relation holds regardless of future profitability measure. Therefore, our empirical finding suggests that stock splits are not useful signals of a firm’s future earnings prospects. JEL Classification G30     

EXTRAORDINARY ITEMS AND INCOME SMOOTHING: A POSITIVE ACCOUNTING APPROACH

This is an empirical study of single-period income smoothing which uses an incentives-based model to explain classificatory choices. An index is constructed to measure the smoothing effect of these choices. Weighted least squares regression results indicate that classificatory choices consistent with smoothing are more likely to be observed in firms with high earnings variability, high dividend payout, substantial managerial holdings of share options and diffuse share ownership. The existence of material scope for smoothing strengthens these findings. The model as a whole is statistically significant and, although the proportion of variability in smoothing explained is modest, it compares very favourably with other accounting choice studies. The relationship between smoothing and alternative earnings management strategies, including big bath accounting, is explored.     

The Effect of Analyst Coverage on the Informativeness of Income Smoothing

This study examines whether analyst coverage affects the informativeness of income smoothing. I find that income smoothing enhances earnings informativeness more greatly for firms with high analyst coverage than for firms with low analyst coverage. The results suggest that income smoothing more efficiently communicates private information to investors when firms are followed by more analysts, consistent with the notion that analysts play an important information intermediary role in enhancing the informativeness of income smoothing.     

The effects of corporate name changes on firm information environment and earnings management

We study how corporate name changes affect a firm's information environment and its earnings management. We show that the stock market reacts negatively to name changes. This effect is specifically pronounced for firms that have lower visibility. We also find that firms that change their names tend to have a relatively worse information environment. Finally, we show that earnings management is positively related to firm name changes.     

Information Uncertainty,Earnings Management,and Long‐run Stock Performance Following Initial Public Offerings

We examine how information uncertainty surrounding IPO (initial public offering) firms influences earnings management and long‐run stock performance. For low‐information‐uncertainty issuers, at‐issue earnings’ management is positively related to subsequent unmanaged earnings and has no relationship to market reaction to earnings announcement and long‐run stock performance following the offering. For high‐information‐uncertainty issuers, however, at‐issue earnings’ management is unrelated to subsequent unmanaged earnings and negatively related to market reaction to earnings announcement and long‐run stock performance following the offer. The evidence suggests that, on average, managers in low‐information‐uncertainty firms tend to engage in earnings’ management for informative purposes, while managers in high‐information‐uncertainty firms engage in earnings’ management for opportunistic purposes.     

The incidence of earnings management on information asymmetry in an uncertain environment: Some Canadian evidence

In this study, we investigate the association between earnings management and information asymmetry considering environmental uncertainty. Results show that a complex and dynamic environment weakens the relationship between discretionary accruals and information asymmetry measured as share price volatility and bid-ask spread. More specifically, the positive relationship between earnings management and information asymmetry is weakened for diversified firms, those intensively investing in R&D, and those facing high sales volatility. This highlights the difficulty for investors to assess earnings management in an uncertain environment. Finally, in such a context, discretionary accruals are more likely to be detected by investors for firms cross-listed on a U.S. stock exchange, a more liquid and transparent stock market compared with the Canadian stock market.     

Firm strategy and market reaction to earnings

We examine whether a firm's strategy affects the information content of the firm's earnings announcement. A cost leadership strategy is characterized by low sales margins coupled with large sales volumes, economies of scale and major investments in plant and physical assets, whereas a differentiation strategy involves high sales margins achieved through product quality and branding realized by investments in intangibles such as R&D and advertising. These characteristics of the strategies result in differential impact on investor reactions to new information that is revealed about firms. Our results show that firms pursuing a cost leadership strategy have earnings announcements that are more commonly interpreted and result in a greater change in the average belief about stock price. On the other hand, earnings announcements of firms pursuing a differentiation strategy result in more heterogeneous interpretation accompanied by a smaller change in the average belief about stock price. This paper advances our understanding of the cross-sectional variation in the market's reaction to earnings announcements. In addition, the paper demonstrates a predictable instance of divergence in the price reaction and trading volume reaction to an earnings announcement.     

Stock Dividends,Stock Splits,and Signaling

This paper provides evidence that firms signal their private information about future earnings by their choice of split factor. Split factors are increasing in earnings forecast errors, after controlling for differences in pre-split price and firm size. Furthermore, price changes at stock dividend and split announcements are significantly correlated with split factors, holding other factors constant, and with earnings forecast errors. These correlations suggest that management's choice of split factor signals private information about future earnings and that investors revise their beliefs about firm value accordingly. The analysis also suggests, however, that announcement returns are significantly correlated with split factors after controlling for earnings forecast errors. This suggests that earnings forecast errors measure management's private information about future earnings with error, that split factors signal other valuation-relevant attributes, or that a signaling explanation is incomplete.     

The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly

We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective, and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by special items. We then show that special item-low accrual firms have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have poor past performance and declines in investor recognition (analyst coverage and institutional holdings). Special items continue to explain future returns after controlling for these factors.     

More than words: Can tone of consumer product reviews help predict firms’ fundamentals?

Although financial market participants are increasingly interested in the financial value of unstructured qualitative information regarding the prospects of a firm, empirical evidence remains sparse on the properties of qualitative content in consumer product reviews and their capital market implications. Using a broad sample of consumer reviews posted on Amazon.com, I examine whether the linguistic tone of aggregate consumer product reviews conveys information that is associated with firms’ sales, earnings, stock returns and risk. I find that aggregate review tone successfully predicts a firm's forthcoming quarterly sales. Moderating analyses show that this predictability is stronger for firms operating in a highly competitive environment. I further find that review tone predicts a firm's quarterly earnings surprises, abnormal stock returns and risk. A path analysis shows that the effect of review tone on stock prices is partially channeled through its effect on firms’ earnings. I finally find that negative review tone is more informative and useful than positive tone in predicting a firm's fundamentals. Importantly, these results hold after controlling for other review characteristics, including review rating, review volumeand review dispersion. Overall, my findings highlight the importance of considering the tone of consumer reviews when evaluating a firm's prospects and value.     

Non‐operating earnings and firm risk*

We find that non‐operating earnings reduce total earnings volatility, stock price volatility, idiosyncratic risk, and crash risk. The risk‐reducing effects of non‐operating earnings are higher than those of operating earnings for risk measures based on stock market data. Non‐operating earnings serve to mitigate risks among firms with operating losses, high financial leverage, high growth uncertainty, and low‐ability managers.     

Do investors overreact to earnings warnings?

This study shows that contrary to what many managers argue, there is no overreaction to earnings warnings. Our sample consists of 986 firms that had significantly lower fourth-quarter earnings than analysts' forecasts during the period of 1983 to 1998. About 9% of these firms released quantitative earnings information while 6.5% of the firms disclosed qualitative earnings information prior to the formal earnings report dates. We find that although these firms experience significant stock price declines during the warning period, their share prices are still higher than the economic values, calculated using Ohlson's residual income model. Further, long-run operating and stock performance of these firms are not more positive than the performance of firms that do not warn. We also find that investor reaction to both warning and non-warning firms is positively related to the firms' long-run stock and operating performance. These findings support the argument that investors do not overreact to the warnings but base their reaction on anticipated long-term performance of the firms.     

Financial reporting quality and idiosyncratic return volatility

Campbell et al. (2001) document that firms’ stock returns have become more volatile in the U.S. since 1960. We hypothesize and find that deteriorating earnings quality is associated with higher idiosyncratic return volatility over 1962–2001. These results are robust to controlling for (i) inter-temporal changes in the disclosure of value-relevant information, sophistication of investors and the possibility that earnings quality can be informative about future cash flows; (ii) stock return performance, cash flow operating performance, cash flow variability, growth, leverage and firm size; and (iii) new listings, high-technology firms, firm-years with losses, mergers and acquisitions and financial distress.