An Empirical Analysis of the Effects of Online Trading on Stock Price and Trading Volume Reactions to Earnings Announcements*

This study provides evidence regarding the effects of online trading on stock price and trading volume reactions to quarterly earnings announcements. We test for differences in stock price and volume reactions to quarterly earnings announcements between a period with a significant amount of online trading (1996‐99) and a period without online trading (1992‐95). We conjecture that online trading has increased the proportion of naive investors in the market. We predict that this will result in (1) a decrease in the average precision of investor information prior to earnings announcements leading to higher earnings response coefficients (ERCs), (2) an increase in differential interpretation of earnings leading to higher trading volume reactions that are unrelated to price change, and (3) a decrease in differential prior precision leading to a decrease in the association between trading volume and absolute price change. We find evidence consistent with all three predictions. Our findings are relevant for assessing the validity of concerns about online trading expressed by regulators and the validity of theoretical models of trade with asymmetrically informed investors.     

Earnings Management under Price Regulation*

Price controls¹ have a major impact on firms' earnings and cash flows. Because price control regulation is costly to firms, it is a type of regulatory intervention that can impact a firm's accounting decisions (Watts and Zimmerman, 1978). Thus, regulatory changes that give firms relief from price controls provide incentives for earnings management. This paper examines discretionary accruals made by New Zealand manufacturing firms in response to two sets of regulations issued in 1971 and 1972. These regulations allowed manufacturing firms to apply for price increases to gain relief from financial hardship caused by the 1970 Price Freeze Regulation. Using a modified accruals mode! that adjusts for price-level movements, the paper tests discretionary accruals of two samples of manufacturing firms and one control sample of nonmanufacturing firms. The results provide evidence of income decreasing discretionary accruals by manufacturing firms for the years during which they could apply for price increases. The control firms do not exhibit significant discretionary accruals in 1971 or 1972. Also, this paper provides evidence that failing to adjust for price-level movements in high inflationary periods could result in inferences of income decreasing discretionary accruals where none may exist.     

Going-Concern Status,Earnings Persistence,and Informativeness of Earnings*

Abstract. Valuation theory recognizes that the relation between earnings innovations and changes in security valuation is increasing in the persistence of the earnings innovations. Analyses in this article reveal that the present value of revisions in expected future benefits is a function of the length of revision horizon, suggesting that earnings persistence is determined, in part, by an entity's going-concern status. These analyses predict an inverse relation between earnings informativeness and an entity's probability of termination. Drawing on a sample of quarterly earnings and returns data from more than 1,500 distinct firms for the period 1981–1990, a statistically significant inverse relation is documented between an entity's probability of termination and the informativeness of earnings—the latter measured as the coefficient from a regression of returns on earnings. Further empirical analyses reveal that this result is a pervasive economic phenomenon not attributable to extreme conditions or other prevailing explanations of earnings informativeness. This inference is robust to variations in research design, including measurement of earnings informativeness and of termination probability and alternative specifications of the relation between returns and earnings. Consequently, the evidence in this article is consistent with a fundamental role for an entity's going-concern status in determining the usefulness of earnings. Résumé. La théorie de l'évaluation reconnaît le fait que la relation entre les nouvelles informations relatives au bénéfice net et les changements dans l'évaluation des titres s'intensifie lorsque persistent lesdites informations. Les analyses réalisées par les auteurs révèlent que la valeur actualisée des rajustements dans les gains futurs espérés dépend de l'horizon du rajustement, ce qui donne à penser que la persistance du bénéfice net est en partie fonction de la continuité de l'exploitation de l'entreprise. Selon ces analyses, le potentiel informatif du bénéfice net devrait être en relation inverse avec la probabilité de fermeture de l'entité. En s'appuyant sur un échantillon de données trimestrielles relatives au bénéfice net et au rendement recueillies auprès de plus de 1500 entreprises distinctes pour la période 1981–1990, les auteurs observent une relation inverse statistiquement significative entre la probabilité de fermeture d'une entité et le potentiel informatif du bénéfice—ce dernier étant mesuré sous forme de coefficient, au moyen d'une régression des rendements sur les bénéfices. D'autres analyses empiriques révèlent que cette conclusion est un phénomène économique répandu qui n'est pas attribuable à des conditions extrêmes ou à d'autres explications prédominantes du potentiel informatif du bénéfice net. Cette inference résiste aux variations dans le plan de recherche, y compris la mesure du potentiel informatif du bénéfice net et de la probabilité de fermeture, et les autres caractéristiques possibles de la relation entre le rendement et le bénéfice. Les résultats obtenus confirment donc que la continuité de l'exploitation joue un rôle fondamental dans la détermination de l'utilité du bénéfice net.     

Unintended Effects of Preannouncements on Investor Reactions to Earnings News*

This study uses an experiment to examine three alternative theoretical explanations for the unintended effects of preannouncements on investor reactions to earnings news. The theoretical explanations are cue consistency, recency effects, and diminishing marginal reactions. The experiment varies the amount of a management preannouncement at five different levels while holding constant consensus analyst expectations prior to the preannouncement and the subsequent earnings announcement. Participants provide preliminary forecasts of current‐ and next‐period earnings per share (EPS) prior to the preannouncement, after the preannouncement, and after the earnings announcement. The pattern of participants' final next‐year EPS forecasts and the results of follow‐up analyses appear most consistent with the predictions of diminishing marginal reactions and, to a somewhat lesser extent, cue consistency, suggesting that both mechanisms play a role in determining the effects of preannouncements. There is little evidence supporting recency effects. Finally, supplemental evidence indicates that participants are unaware that preannouncements influence their reactions to earnings news, suggesting that the effects are unintended. This study has implications for managers who make preannouncement disclosure decisions and for academics who wish to understand and interpret prior research on earnings preannouncements.     

The Relation Between Security Returns,Firm Earnings,and Industry Earnings*

Abstract. In this paper we examine the relation between a firm's stock return and the earnings of other firms in the same industry, controlling for the firm's own earnings. We present a model in which the sign of this relation depends on the relative uncertainty there is about the size of the total industry value versus the division of that value between firms. We document considerable cross-industry variation in the relation between a firm's return and other firms' earnings, and demonstrate empirically that the sign of the relation depends on information provided prior to the industry earnings announcement period. Résumé. Les auteurs examinent la relation entre le rendement de l'action d'une société et les bénéfices des entreprises appartenant au même secteur d'activité, en veillant à contrôler les bénéfices de la société en question. Dans le modèle qu'ils proposent, le sens (positif ou négatif) de cette relation dépend de l'incertitude relative qui caractérise l'importance de la valeur globale du secteur d'activité par rapport au partage de cette valeur entre les entreprises qui le constituent. Les auteurs ont recueilli quantité d'information confirmant l'existence d'une forte variation dans la relation entre le rendement des actions d'une entreprise et les bénéfices des autres entreprises d'un même secteur; ils démontrent aussi empiriquement que le sens de la relation dépend de l'information produite avant la période où les bénéfices du secteur sont communiqués.     

The Relation between Market Values,Earnings Forecasts,and Reported Earnings*

Recently, much of the research into the relation between market values and accounting numbers has used, or at least made reference to, the residual income model (RIM). Two basic types of empirical research have developed. The “historical” type explores the relation between market values and reported accounting numbers, often using the linear dynamics in Ohlson 1995 and Feltham and Ohlson 1995 and 1996. The “forecast” type explores the relation between market value and the present value of the book value of equity, a truncated sequence of residual income forecasts, and an estimate of the terminal value at the truncation date. The analysis in this paper integrates these two approaches. We expand the Feltham and Ohlson 1996 model by including one‐ and two‐period‐ahead residual income forecasts to infer “other” information regarding future revenues from past investments and future growth opportunities. This approach results in a model in which the difference between market value and book value of equity is a function of current residual income, one‐ and two‐period‐ahead residual income, current capital investment, and start‐of‐period operating assets. The existence of both persistence in revenues from current and prior investments and growth in future positive net present value investment opportunities leads us to hypothesize a negative coefficient on the one‐period‐ahead residual income forecast and a positive coefficient on the two‐period‐ahead residual income forecast. Our empirical results strongly support our hypotheses with respect to the forecast coefficients.     

Auditor Conservatism,Asymmetric Monitoring,and Earnings Management*

In this paper, we investigate whether, and how, audit effectiveness differentiation between Big 6 and non‐Big 6 auditors is influenced by a conflict or convergence of reporting incentives faced by corporate managers and external auditors. In so doing, we incorporate into our analysis the possibility that managers self‐select both external auditors and discretionary accruals, using the two stage “treatment effects” model. Our results show that only when managers have incentives to prefer income‐increasing accrual choices are Big 6 auditors more effective than non‐Big 6 auditors in deterring/monitoring opportunistic earnings management. Contrary to conventional wisdom, we find Big 6 auditors are less effective than non‐Big 6 auditors when both managers and auditors have incentives to prefer income‐decreasing accrual choices and thus no conflict of reporting incentives exists between the two parties. The above findings are robust to different proxies for opportunistic earnings management and different proxies for the direction of earnings management incentives.     

Cross-Quarter Differences in Stock Price Responses to Earnings Announcements: Fourth-Quarter and Seasonality Influences*

Abstract. This article examines the impact of one form of sales seasonality on the response of equity returns to earnings announcements in different quarters. We regress unexpected announcement period returns on unexpected earnings and compare the results for seasonal firms—those with sales consistently concentrated in the same quarter each year—to those of other firms. For seasonal firms, we find robust evidence of a greater regression intercept and some evidence of a greater earnings response coefficient in peak sales quarters than in nonpeak quarters. These results are consistent with a greater resolution of the uncertainty about seasonal firms' prospects in their peak sales quarters than in other quarters. Our evidence also shows that fourth-quarter earnings announcements have smaller stock price response coefficients than do interim announcements. Some prior has found smaller fourth-quarter earnings response coefficients for small but not large firms. We find some evidence that fourth-quarter earnings response coefficients are smaller than interim-quarter response coefficients for large firms as well as for small firms. This suggests that explanations for smaller fourth-quarter earnings response coefficients need to be applicable to both large and small firms. Résumé. Les auteurs examinent, pour différents trimestres, l'incidence d'une forme de caractère saisonnier des ventes sur la réaction du rendement des actions aux déclarations de bénéfices. Ils effectuent une analyse de régression des rendements imprévus des trimestres par rapport aux bénéfices imprévus et comparent les résultats obtenus dans le cas des entreprises dont les activités sont saisonnières—c'est-à-dire dont les ventes sont systématiquement concentrées dans le même trimestre chaque année—aux résultats obtenus dans le cas des autres entreprises. Dans le cas des entreprises dont les activités sont saisonnières, les résultats de l'analyse démontrent vigoureusement que l'intersection de la régression est supérieure et confirment avec moins de fermeté que le coefficient de réaction aux bénéfices déclarés est supérieur pour les trimestres où le volume des ventes culmine, par rapport aux autres trimestres. Ces résultats permettent de conclure à une plus grande résorption de l'incertitude relative aux perspectives des entreprises dont les activités ont un caractère saisonnier dans les trimestres où les ventes de ces entreprises culminent que dans les autres trimestres. Les résultats de l'analyse démontrent également que les déclarations de bénéfices au quatrième trimestre donnent lieu à des coefficients plus faibles de réaction du cours des actions que les déclarations des trimestres intermédiaires. Certains travaux antérieurs ont établi que les coefficients de réaction aux déclarations de bénéfices du quatrième trimestre étaient plus faibles pour les petites entreprises que pour les grandes. L'analyse des auteurs tend ici à démontrer que les coefficients de réaction aux déclarations de bénéfices du quatrième trimestre sont plus faibles que les coefficients de réaction des trimestres intermédiaires pour les grandes entreprises aussi bien que pour les petites entreprises. Ces constatations donnent à penser que les facteurs qui expliquent les coefficients de réaction plus faibles aux déclarations de bénéfices du quatrième trimestre devraient pouvoir s'appliquer tant aux grandes qu'aux petites entreprises.     

Earnings Announcements and Market Depth*

Abstract. This paper investigates how strategic trading around the time of earnings announcements affects market liquidity (e.g., bid-ask spreads). We model an investor with private information in advance of an earnings announcement (e.g., inside information). The investor trades before and after the earnings announcement in a market populated by liquidity-motivated traders who have some discretion over the timing of their trades. The main result of the analysis is that an earnings announcement that reduces an insider's private information may lead to a less liquid market in the postannouncement period.     

Equilibrium Earnings Management,Incentive Contracts,and Accounting Standards*

In this paper, we model earnings management as a consequence of the interaction among self‐interested economic agents ‐ namely, the managers, the shareholders, and the regulators. In our model, a manager controls a stochastic production technology and makes periodic accounting reports about his or her performance; an owner chooses a compensation contract to induce desirable managerial inputs and reporting choices by the manager; and a regulatory body selects and enforces accounting standards to achieve certain social objectives. We show that various economic trade‐offs give rise to endogenous earnings management. Specifically, the owner may reduce agency costs by designing a compensation contract that tolerates some earnings management because such a contract allocates the compensation risk more efficiently. The earnings‐management activity produces accounting reports that deviate from those prescribed by accounting standards. Given such reports, the valuation of the firm may be nonlinear and s‐shaped, thereby recognizing the manager's reporting incentives. We also explore policy implications, noting that (1) the regulator may find enforcing a zero‐tolerance policy ‐ no earnings management allowed ‐ economically undesirable; and (2) when selecting the optimal accounting standard, valuation concerns may conflict with stewardship concerns. We conclude that earnings management is better understood in a strategic context that involves various economic trade‐offs.     

Earnings,Book Values,and Dividends in Equity Valuation*

Abstract. The paper develops and analyzes a model of a firm's market value as it relates to contemporaneous and future earnings, book values, and dividends. Two owners' equity accounting constructs provide the underpinnings of the model: the clean surplus relation applies, and dividends reduce current book value but do not affect current earnings. The model satisfies many appealing properties, and it provides a useful benchmark when one conceptualizes how market value relates to accounting data and other information. Résumé. L'auteur élabore et analyse un modèle dans lequel il conceptualise la relation entre la valeur marchande d'une entreprise et ses bénéfices, ses valeurs comptables et ses dividendes actuels et futurs. Deux postulats de la comptabilisation des capitaux propres servent de charpente au modèle: a) la relation du résultat global s'applique et b) les dividendes réduisent la valeur comptable actuelle sans influer, cependant, sur les bénéfices actuels. Le modèle présente de nombreuses propriétés intéressantes et il peut, fort utilement, servir de repère dans la conceptualisation de la relation entre la valeur marchande et les données comptables et autres renseignements.     

Initial Public Offerings,Accounting Choices,and Earnings Management*

Abstract. This paper investigates whether entrepreneurs manipulate earnings in the periods prior to taking their firms public through the choice of accounting conventions. The preponderance of evidence, using powerful accrual tests that were able to detect earnings management in other contexts, indicates little, if any, manipulation. To the extent that there is earnings management, the results suggest that this phenomenon is more pronounced among small firms and among firms with large financial leverage and is to a lesser degree related to the quality of the underwriters and auditors employed when going public. Résumé. Les auteurs ont voulu savoir si les entrepreneurs manipulaient les bénéfices dans les exercices précédant un appel public à l'épargne par le truchement du choix des normes et conventions comptables. La prépondérance des preuves recueillies à l'aide des puissantes techniques existantes de sondage des produits et des charges visant à déceler les cas d'? accommodation » des bénéfices dans d'autres contextes, révèle une faible manipulation, sinon aucune. Dans la mesure où il y a accommodation des bénéfices, les résultats obtenus donnent à penser que le phénomène est davantage accentué chez les entreprises de petite taille ou dont le levier financier est élevé, et qu'il est relié de façon plus ténue à la qualité des preneurs fermes et des vérificateurs à qui l'entreprise a recours lorsqu'elle fait appel public à l'épargne.     

Audit Committees,Boards, and the Quality of Reported Earnings*

I use data on 252 U.S. firms between 1994 and 2000 to study the relationship between audit committees and boards of directors with financial reporting quality. I initially document several changes in committee and board profile during the sample period. Results from logistic regressions suggest that measures of audit committee and board structure are related to earnings quality in a manner that is generally consistent with the predictions of agency theory. This study contributes to extant knowledge by employing different earnings quality measures from prior studies, and by expanding the range of audit committee attributes deemed important in determining audit committee performance.