Stock Liquidity Risk and the Cross‐sectional Earnings‐Returns Relationship

We argue that a higher sensitivity to aggregate market‐wide liquidity shocks (i.e., a higher liquidity risk) implies a tendency for a stock's price to converge to fundamentals. We test this intuition within the framework of the earnings‐returns relationship. We find a positive liquidity risk effect on the relationship between return and expected change in earnings. This effect on the earnings‐returns relationship is distinct from the negative effect observed for stock illiquidity level. Notably, the liquidity risk effect is evident (absent) during periods of neutral/low (high) aggregate market liquidity. We also show that the liquidity risk effect is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book‐to‐market; and (c) are profit making.     

Investment Dynamics and Earnings‐Return Properties: A Structural Approach

We propose the standard neoclassical model of investment under uncertainty with short‐run adjustment frictions as a benchmark for earnings‐return patterns absent accounting influences. We show that our proposed benchmark generates a wide range of earnings‐return patterns documented in accounting research. Notably, our model generates a concave earnings‐return relation, similar to that of Basu [1997], and predicts that the earnings‐return concavity increases with the volatility of firms’ underlying shock processes and decreases with the level of firms’ investments. We find strong empirical support for these predictions. Overall, our evidence suggests that our proposed benchmark is useful for understanding the joint dynamics of variables of interest to accounting research (e.g., earnings, returns, investment, market‐to‐book) absent accounting influences, a necessary precondition for inferring the effects of accounting from these dynamics.     

Does Investor Sentiment Affect Earnings Management?

I hypothesize and find that earnings management via accruals is driven partially by the prevailing market‐wide investor sentiment. Managers inflate earnings in periods of higher sentiment, but report more conservatively during periods of low sentiment. Moreover, the likelihood of income‐increasing earnings management to avoid negative earnings surprises is also positively associated with investor sentiment. These results are robust to: (i) controls for time‐varying firm characteristics such as growth, investment opportunity sets, future profitability, leverage and size; (ii) macroeconomic variables such as future inflation, GDP growth, and growth in industrial production; (iii) multiple proxies for investor sentiment; and (iv) discretionary revenues as alternative measure of earnings management. Cross‐sectional analyses reveal that firms whose stock returns co‐move more with investor sentiment are more (less) likely to manage earnings upward via abnormal accruals in quarters of higher (lower) sentiment. The findings of managers’ strategic use of abnormal accruals show the need for increased attention from boards of directors, auditors and regulators to heightened managerial incentives to overstate earnings and to report optimistic earnings numbers during periods of high investor sentiment.     

Evaluating the information content of earnings forecasts

This study develops a framework to compare the ability of alternative earnings forecast approaches to capture the market expectation of future earnings. Given prior evidence of analysts’ systematic optimistic bias, we decompose earnings surprises into analysts’ earnings surprises and adjustments based on alternative forecasting models. An equal market response to these two components indicates that the associated earnings forecast is a sufficient estimate of the market expectation of future earnings. To apply our framework, we examine four recent regression-based earnings forecasting models, alongside a simple earnings-based random walk model and analysts’ forecasts. Using the earnings forecasts of the model that satisfies our sufficiency condition, we identify a set of stocks for which the market is unduly pessimistic about future earnings. The investment strategy of buying and holding these stocks generates statistically signi?cant abnormal returns. We offer an explanation as to why this and similar strategies might be successful.     

The Predictive Content of Aggregate Analyst Recommendations

Using more than 350,000 sell‐side analyst recommendations from January 1994 to August 2006, this paper examines the predictive content of aggregate analyst recommendations. We find that changes in aggregate analyst recommendations forecast future market excess returns after controlling for macroeconomic variables that have been shown to influence market returns. Similarly, changes in industry‐aggregated analyst recommendations predict future industry returns. Changes in aggregate analyst recommendations also predict one‐quarter‐ahead aggregate earnings growth. Overall, our results suggest that analyst recommendations contain market‐ and industry‐level information about future returns and earnings.     

Accruals and the Conditional Equity Premium

Accruals correlate closely with the determinants of the conditional equity premium at both the firm and the aggregate levels. The common component of firm‐level accruals, which cannot be diversified away by aggregation, explains the positive relation between aggregate accruals and future stock market returns. The residual component, which accounts for most variation in firm‐level accruals, is responsible for the negative cross‐sectional relation between firm‐level accruals and future stock returns. Consistent with the risk‐based explanation, aggregate accruals, as a proxy for the conditional equity premium, forecast changes in aggregate economic activity. Moreover, we document a similar comovement of earnings with the conditional equity premium at both the firm and the aggregate levels, which helps explain the negative relation between changes in aggregate earnings and contemporaneous market returns.     

Cross‐Firm Real Earnings Management

Our analysis is rooted in the notion that stockholders can learn about the fundamental value of any firm from observing the earnings reports of its rivals. We argue that such intraindustry information transfers, which have been broadly documented in the empirical literature, may motivate managers to alter stockholders’ beliefs about the value of their firm not only by manipulating their own earnings report but also by influencing the earnings reports of rival firms. Managers obviously do not have access to the accounting system of peer firms, but they can nevertheless influence the earnings reports of rival firms by distorting real transactions that relate to the product market competition. We demonstrate such managerial behavior, which we refer to as cross‐firm real earnings management, and explore its potential consequences and interrelation with the practice of accounting‐based earnings management within an industry setting with imperfect (nonproprietary) accounting information.     

Does Greater Firm‐Specific Return Variation Mean More or Less Informed Stock Pricing?

Roll [1988] observes low R² statistics for common asset pricing models due to vigorous firm‐specific return variation not associated with public information. He concludes that this implies “either private information or else occasional frenzy unrelated to concrete information”[p. 56]. We show that firms and industries with lower market model R² statistics exhibit higher association between current returns and future earnings, indicating more information about future earnings in current stock returns. This supports Roll's first interpretation: higher firm‐specific return variation as a fraction of total variation signals more information‐laden stock prices and, therefore, more efficient stock markets.     

Earnings Quality Measures and Excess Returns

This paper examines how commonly used earnings quality measures fulfill a key objective of financial reporting, i.e., improving decision usefulness for investors. We propose a stock‐price‐based measure for assessing the quality of earnings quality measures. We predict that firms with higher earnings quality will be less mispriced than other firms. Mispricing is measured by the difference of the mean absolute excess returns of portfolios formed on high and low values of a measure. We examine persistence, predictability, two measures of smoothness, abnormal accruals, accruals quality, earnings response coefficient and value relevance. For a large sample of US non‐financial firms over the period 1988–2007, we show that all measures except for smoothness are negatively associated with absolute excess returns, suggesting that smoothness is generally a favorable attribute of earnings. Accruals measures generate the largest spread in absolute excess returns, followed by smoothness and market‐based measures. These results lend support to the widespread use of accruals measures as overall measures of earnings quality in the literature.     

The Value Relevance of Mandatory Non‐GAAP Earnings

This paper examines the value relevance of earnings components where there is a mandatory requirement to report generally accepted accounting principles (GAAP) earnings and non‐GAAP earnings, and where the items to be eliminated from GAAP earnings are defined in detail. The setting is different from non‐GAAP earnings disclosures presented in the United States and elsewhere, where managers have discretion over whether to report a non‐GAAP earnings number, and what to exclude from GAAP earnings. Our mandatory setting enables us to report value relevance results that are not confounded by managers' discretionary choices regarding non‐GAAP earnings exclusions. We use price‐level regressions, based on the Ohlson (1995) model, to test for incremental and relative value relevance. The results show that non‐GAAP earnings reported under a mandatory regime have higher value relevance than GAAP earnings. The disaggregation of these items is useful to investors in a setting where managerial motivations are minimized.     

Analysts’ and Investors’ Reactions to Consistent Earnings Signals

We investigate (1) whether the trajectory of the current‐quarter earnings expectation path (defined by the signs of the forecast revision and the earnings surprise) provides information about future firm performance, and (2) the extent to which analysts and investors react to that information. Our results indicate that analysts underreact more to earnings information revealed by consistent‐signal earnings expectation paths than to earnings information communicated by inconsistent‐signal expectation paths. We also find that the current earnings expectation path provides incremental explanatory power for future abnormal returns, even after controlling for the sign and magnitude of the earnings surprise. Overall, our evidence is consistent with underreaction stemming from analysts’ and investors’ bias in processing the information in consistent‐signal earnings expectation paths.     

Aggregate Earnings and Corporate Bond Markets

I examine the previously unexplored relation between aggregate earnings changes and corporate bond market returns. I find that aggregate earnings changes have a negative relation to investment‐grade corporate bond market returns and a positive relation to high‐yield corporate bond market returns. The aggregate earnings‐returns relation is lower (i.e., less positive or more negative) for bonds with higher credit ratings and longer maturities. Further, I show that the aggregate earnings‐returns relation is driven by both the expected and the news component of aggregate earnings changes. The expected component is negatively related to expected returns, and the news component is positively related to cash flow news and changes in nominal interest rates, and negatively related to changes in default premia. My results contribute to the understanding of the role of earnings in corporate bond markets as well as the macroeconomic role of accounting information.     

Value versus growth: Australian evidence

The value‐growth effect is one of the most pervasive patterns in stock prices. In this study, the ability of four proxies for value‐growth, book‐to‐market, sales‐to‐price, earnings‐to‐price and cash‐flow‐to‐price to explain equity returns is analysed. The findings show that in aggregate, book‐to‐market best explains cross‐sectional variation in Australian equity returns, which in isolation suggests that it is the superior proxy for value‐growth. The analysis is taken further and the value‐growth effect is examined separately in positive and negative earnings firms. After segregating firms, it is found that in the negative earnings sample, book‐to‐market is the best value‐growth proxy and in the positive earnings sample, cash‐flow‐to‐price has the highest level of significance and is thus the superior value‐growth proxy. The economic significance of this result is telling, as the firms that report positive earnings are much larger than those that report negative earnings.     

Product market competition and earnings management: A firm‐level analysis

In this paper, we employ a firm‐level measure of product market competition constructed from the textual analysis of firms’ 10‐K filings to examine the relationship between managers’ perceived competition pressure and earnings management. We find that accounting irregularities and accrual‐based earnings management are positively related to product market competition. This finding is consistent with the notion that competition pressure increases managerial incentives to manage earnings, due to their career concerns. We also find that real earnings management is negatively related to product market competition. This finding suggests that real earnings management involves actions that decrease firms’ competitiveness and thus is costly for firms confronted with high competition pressure.     

A new perspective on post‐earnings‐announcement‐drift: Using a relative drift measure

Prior research finds that there is a delayed reaction to both analyst‐based earnings surprises and random‐walk‐based earnings surprises. Focusing on the market reaction from the post‐announcement window, prior studies show that analyst‐based drift is larger than random walk‐based drift. This finding is counter‐intuitive if we believe large, sophisticated investors tend to trade on analysts’ forecast earnings news and thus react faster and more completely than smaller and less sophisticated investors react to random walk earnings news. In this study, we construct a relative measure of post‐earnings‐announcement drift (PEAD) (i.e., drift as a proportion of total market reaction to earnings news) which we refer to as the ‘drift ratio’, and we provide evidence, consistent with our intuition, that analyst‐based drift ratio is smaller (not greater) than random‐walk‐based drift ratio. We find that this difference is more pronounced in more recent periods and for firms with more sophisticated investors. Our approach to measure the PEAD is more intuitive than that in traditional PEAD literature. Our results thus complement existing research findings by utilizing the drift ratio measure to generate new insights about the drift phenomenon.     

Market Reaction to Multiple Contemporaneous Earnings Signals: Earnings Announcements and Future Earnings Guidance

We examine market reactions to contemporaneous announcements of current earnings and future earnings guidance for evidence on how investors trade off relevance and reliability. Current earnings are more reliable than future earnings guidance, but future earnings guidance may be more relevant for predicting future performance. We find that current earnings are more strongly associated with announcement-period returns than concurrently disclosed future earnings guidance, consistent with investors’ relative preference for reliability. We find similar return reactions to stand-alone earnings and to earnings released with guidance. In contrast, return reactions are lower for guidance announced simultaneously with current earnings than for stand-alone guidance.     

Earnings Announcements and Systematic Risk

Firms scheduled to report earnings earn an annualized abnormal return of 9.9%. We propose a risk‐based explanation for this phenomenon, whereby investors use announcements to revise their expectations for nonannouncing firms, but can only do so imperfectly. Consequently, the covariance between firm‐specific and market cash flow news spikes around announcements, making announcers especially risky. Consistent with our hypothesis, announcer returns forecast aggregate earnings. The announcement premium is persistent across stocks, and early (late) announcers earn higher (lower) returns. Nonannouncers' response to announcements is consistent with our model, both over time and across firms. Finally, exposure to announcement risk is priced.     

The Pricing of Relative Performance Based Incentives for Executive Compensation

Japanese firms report both parent-only and consolidated financial statements. Because of the unique business environment in Japan, there is a widely held view that parent-only data provides a better means for assessing the value of the entire firm. We find that both parent-only and subsidiary earnings are important in predicting future consolidated earnings. However, while stock prices accurately reflect the persistence of parent-only earnings, the Japanese stock market appears to underestimate the persistence of subsidiary earnings, causing a significant positive relation between changes in subsidiary earnings in year t and stock returns in year t +1. This relation between subsidiary earnings and future stock returns does not persist beyond year t 7plus;1. Taking a long (short) position in firms with large, positive (negative) changes in subsidiary earnings results in an average annual abnormal return of 7.06% with positive returns in 12 of the 13 years in the test period.     

Aggregate Market Reaction to Earnings Announcements

This analysis identifies a distinct immediate announcement period negative relation between earnings announcement surprises and aggregate market returns. Such a relation implies that market participants use earnings information in forming expectations about expected aggregate discount rates and, specifically, that good earnings news is associated with a positive shock to required returns. Consistent with this interpretation we find that Treasury bond rates and implied future inflation expectations respond directly to earnings news. We also find some evidence that the negative relation between earnings news and market return persists beyond the immediate announcement period, suggesting that market participants do not immediately fully impound these future market return implications of aggregate earnings news.     

Pushing the future back: The impact of policy uncertainty on the market pricing of future earnings

We examine whether policy uncertainty triggered by presidential elections pushes the future back by reducing the extent to which current prices reflect information about future earnings. We estimate future earnings response coefficients (FERCs) for the years 1975–2013, a period that covers ten presidential elections. We find that FERCs are significantly lower (by 11.8%) during presidential election years compared to other years. Additional analyses using pseudo election years, ex‐ante polls, contract prices from the Iowa Electronic Political Market, and cross‐sectional firm characteristics provide corroborating evidence that the lower FERCs during election years are related to policy uncertainty. We also investigate potential explanations for the lower FERCs during election years. We find that the lower FERCs relate to forecasting difficulty rather than to changes in the discount rate or in the amount of noise trading. Finally, we find that market prices move toward future earnings to a greater degree during presidential election years compared with other years once the policy uncertainty is resolved. A trading strategy based on this drift yields significant abnormal returns. Overall, we contribute to the literature by providing the first empirical evidence that shocks to policy uncertainty influence the pricing of earnings information.