Why Do Large Firms' Prices Anticipate Earnings Earlier than Small Firms' Prices?*

This paper presents evidence that the positive association between firm size and price leads of earnings is not solely a function of private search incentives for firm‐specific information. Specifically, we find that small‐firm prices also lag large‐firm prices with respect to industry‐wide information. Our empirical analysis extends Collins, Kothari, and Rayburn 1987 and Freeman 1987, who document that security‐price leads of earnings are positively associated with market capitalization. In particular, we examine the association between firm size and the timing of security returns for two components of annual earnings changes: the average change for a firm's industry and the firm's idiosyncratic change. We find that large firms' prices have a longer lead than small firms' prices with respect to both components. Large firms' early lead on industry‐wide earnings suggests that returns of large firms predict returns of same‐industry small firms. To test this implication, we construct a portfolio of long (short) positions in small firms when the prior month's returns of large firms in their industry are above (below) average for large firms in other industries. This zero investment portfolio earns 4.5 percent over 12 months.     

Ownership Structure,Business Group Affiliation,Listing Status,and Earnings Management: Evidence from Korea*

Using a large sample of both publicly traded and privately held firms in South Korea (hereafter “Korea”), we investigate whether, and how, the deviation of controlling shareholders' control from ownership, business group affiliation, and listing status differentially affect the extent of earnings management. Our study yields three major findings. First, we find that as the control‐ownership disparity becomes larger, controlling shareholders tend to engage more in opportunistic earnings management to hide their behavior and avoid adverse consequences such as disciplinary action. The result of our full‐model regression reveals that an increase in the control‐ownership wedge by 1 percent leads to an increase in the magnitude of (unsigned) discretionary accruals by 1.3 percent of lagged total assets, ceteris paribus. Second, we find that for our full‐model regression, the magnitude of (unsigned) discretionary accruals is greater for group‐affiliated firms than for nonaffiliated firms by 0.8 percent of lagged total assets. This result suggests that business group affiliation provides controlling shareholders with more incentives and opportunities for earnings management. Finally, we find that for our full‐model regression, the magnitude of (unsigned) discretionary accruals is greater for publicly traded firms than for privately held firms by 1.2 percent of lagged total assets. This result supports the notion that stock markets create incentives for public firms to manage reported earnings to satisfy the expectations of various market participants that are often expressed in earnings numbers.     

Last‐Chance Earnings Management: Using the Tax Expense to Meet Analysts' Forecasts*

We assert that the tax expense is a powerful context in which to study earnings management, because it is one of the last accounts closed prior to earnings announcements. Although many pre‐tax accruals must be posted in the year‐end general ledger, managers estimate and negotiate tax expense with their auditors immediately prior to earnings announcements. We hypothesize that changes from third‐ to fourth‐quarter effective tax rates (ETRs) are negatively related to whether and how much a firm's earnings absent tax expense management miss analysts' consensus forecast, a proxy for target earnings. We measure earnings absent tax expense management as actual pre‐tax earnings adjusted for the annual ETR reported at the third quarter. We provide robust evidence that firms lower their projected ETRs when they miss the consensus forecast, which is consistent with firms decreasing their tax expense if non‐tax sources of earnings management are insufficient to achieve targets. We also find that firms that exceed earnings targets increase their ETR, but this effect is less significant. By studying the tax expense in total, rather than narrow components of deferred tax expense, our results provide general evidence that reported taxes are used to manage earnings.     

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

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.     

Determinants of Managerial Earnings Guidance Prior to Regulation Fair Disclosure and Bias in Analysts' Earnings Forecasts*

Prior to Regulation Fair Disclosure (“Reg FD”), some management privately guided analyst earnings estimates, often through detailed reviews of analysts' earnings models. In this paper I use proprietary survey data from the National Investor Relations Institute to identify firms that reviewed analysts' earnings models prior to Reg FD and those that did not. Under the maintained assumption that firms conducting reviews guided analysts' earnings forecasts, I document firm characteristics associated with the decision to provide private earnings guidance. Then I document the characteristics of “guided” versus “unguided” analyst earnings forecasts. Findings demonstrate an association between several firm characteristics and guidance practices: managers are more likely to review analyst earnings models when the firm's stock is highly followed by analysts and largely held by institutions, when the firm's market‐to‐book ratio is high, and its earnings are important to valuation but hard to predict because its business is complex. A comparison of guided and unguided quarterly forecasts indicates that guided analyst estimates are more accurate, but also more frequently pessimistic. An examination of analysts' annual earnings forecasts over the fiscal year does not distinguish between guidance and no‐guidance firms; both experience a “walk‐down” in annual estimates. To distinguish between guidance and no‐guidance firms, one must examine quarterly earnings news: unguided analysts walk down their annual estimates when the majority of the quarterly earnings news is negative; guided analysts walk down their annual estimates even though the majority of the quarterly earnings news is positive.     

Is Real Earnings Smoothing Harmful? Evidence from Firm‐Specific Stock Price Crash Risk

This study examines whether and when real earnings smoothing influences firm‐specific stock price crash risk. Using a sample of U.S. public firms for the years 1993 through 2014, we find real earnings smoothing to be positively associated with firm‐specific stock price crash risk. This finding is consistent with the view that real earnings smoothing helps managers withhold bad news, keep poor‐performing projects, conceal resource diversion, and engage in ineffective risk management, which increases crash risk. Further, we find a stronger relation between crash risk and real earnings smoothing when firm uncertainty is higher, product market competition is lower, and balance sheet constraint is higher. Overall, our study suggests that real earnings smoothing destroys shareholder value in that it increases stock price crash risk.     

Investor Overreaction to Earnings Surprises and Post‐Earnings‐Announcement Reversals

Prior literature suggests that the market underreacts to the positive correlation in a typical firm's seasonal earnings changes, which leads to a post‐earnings‐announcement drift (PEAD) in prices. We examine the market reaction for a distinct set of firms whose seasonal earnings changes are uncorrelated and show that the market incorrectly assumes that the earnings changes of these firms are positively correlated. We also document that positive (negative) seasonal earnings changes in the current quarter are associated with negative (positive) abnormal returns in the next quarter. Thus, we observe a reversal of abnormal returns, consistent with a systematic overreaction to earnings, rather than the previously documented PEAD. Additional analysis indicates that financial analysts similarly overestimate the autocorrelation of these firms, although to a lesser extent. We also find that the magnitude of overestimation and the subsequent price reversal are inversely related to the richness of the information environment. Our results challenge the notion that investors recognize but consistently underestimate earnings correlation and provide a new perspective on the inability of prices to fully reflect the implications of current earnings for future earnings. That is, we show that investors predictably overestimate correlation when it is lacking, but underestimate it when it is present.     

Optimal Conservatism with Earnings Manipulation

This paper examines the role of conservatism when an agent can manipulate upcoming earnings before all uncertainty is resolved. An increase in conservatism, by reducing the likelihood of favorable earnings, requires steeper performance pay to maintain the same level of incentives, which in turn increases the equilibrium earnings manipulation. Trade‐offs between inducing effort and curbing manipulation predict an interior level of conservatism as optimal. The optimal level of conservatism is positively associated with enforcement, economic profitability and earnings quality, and negatively associated with agency frictions. In particular, we show that more economically profitable firms choose to be more conservative. We also establish that the association between performance pay and manipulation identifies whether conservatism is optimally chosen or exogenously imposed. In an application to debt contracting, we show that optimal conservatism is negatively associated with borrowers’ bargaining power.     

Are Securitizations in Substance Sales or Secured Borrowings? Capital‐Market Evidence*

Two standard‐setting approaches have emerged globally to guide the choice of accounting for securitizations: the control and components approach (SFAS No. 125 and SFAS No. 140) and the risks and rewards transfer approach (IAS No. 39). A lack of consensus about derecognition accounting is a major impediment to achieving convergence in global standards that must be resolved. Thus, both SFAS No. 140 and IAS No. 39 will be reexamined, and evidence pertinent to the debate is timely and important. In this study, we present evidence consistent with the view of credit‐rating analysts, who view many securitizations as, in substance, secured borrowings. Specifically, for a sample of originators applying sale accounting guidance in SFAS No. 125 / 140 during the period 1997‐2003, we show that off‐balance‐sheet debt related to securitizations has, on average, the same risk‐relevance for explaining market measures of risk (that is, CAPM beta) as on‐balance‐sheet debt. We also find that, in a returns and earnings association framework, the pricing multiple on securitization gains declines as the amount of off‐balance‐sheet debt increases, implying that investors take off‐balance‐sheet debt into account when assessing the valuation‐relevance of such gains. For those who advocate the control and components approach to securitization accounting, our results suggest that, at least for frequent securitizers, the put option arising from implicit recourse is a “missing piece” that is not currently accounted for when calculating securitization gains. Our results challenge the extant measurement standards in SFAS No. 140.     

Earnings Announcement Disclosures and Changes in Analysts' Information

This study examines how financial disclosures with earnings announcements affect sell‐side analysts' information about future earnings, focusing on disclosures of financial statements and management earnings forecasts. We find that disclosures of balance sheets and segment data are associated with an increase in the degree to which analysts' forecasts of upcoming quarterly earnings are based on private information. Further analyses show that balance sheet disclosures are associated with an increase in the precision of both analysts' common and private information, segment disclosures are associated with an increase in analysts' private information, and management earnings forecast disclosures are associated with an increase in analysts' common information. These results are consistent with analysts processing balance sheet and segment disclosures into new private information regarding near‐term earnings. Additional analysis of conference calls shows that balance sheet, segment, and management earnings forecast disclosures are all associated with more discussion related to these items in the questions‐and‐answers section of conference calls, consistent with analysts playing an information interpretation role with respect to these disclosures.     

Institutional Ownership and the Extent to which Stock Prices Reflect Future Earnings*

Articles in the financial press suggest that institutional investors are overly focused on current profitability, which suggests that as institutional ownership increases, stock prices reflect less current period information that is predictive of future period earnings. On the other hand, institutional investors are often characterized in academic research as sophisticated investors and sophisticated investors should be better able to use current‐period information to predict future earnings compared with other owners. According to this characterization, as institutional ownership increases, stock prices should reflect more current‐period information that is predictive of future period earnings. Consistent with this latter view, we find that the extent to which stock prices lead earnings is positively related to the percentage of institutional ownership. This result holds after controlling for various factors that affect the relation between price and earnings. It also holds when we control for endogenous portfolio choices of institutions (e.g., institutional investors may be attracted to firms in richer information environments where stock prices tend to lead earnings). Further, a regression of stock returns on order backlog, conditional on the percentage of institutional ownership, indicates that institutional owners place more weight on order backlog compared with other owners. This result is consistent with institutional owners using non‐earnings information to predict future earnings. It also explains, in part, why prices lead earnings to a greater extent when there is a higher concentration of institutional owners.     

The Incremental Informativeness of Stock Prices for Future Accounting Earnings*

This study extends previous research that documents a stock price reaction leading accounting earnings. The primary issue is that prior studies use a naive earnings expectation model (random walk) as the benchmark for the information content of lagged returns and do not adequately address the “incremental” information content of lagged returns. This study identifies and estimates firm-specific models of earnings to control directly for the autocorrelation in earnings. The explanatory power of lagged prices with respect to this earnings residual is investigated using both a multiple regression model of lagged returns and a multiple time-series vector autoregressive model. In-sample estimation of the models provides clear evidence that stock prices impound information about future earnings incremental to the information contained in historical earnings data. Holdout period analysis of the earnings forecasts from these lagged return models finds that both models outperform the naive seasonal random walk expectation, but neither model outperforms the more sophisticated Box-Jenkins forecasts. On an individual firm basis, earnings forecasts supplemented with the lagged return data tend to be less precise than the Box-Jenkins forecasts, but the price-based models demonstrate an ability to rank the earnings forecast errors from the time-series models. The analysis helps to characterize the limitations of lagged returns as a means of predicting future earnings innovations.     

Auditor Quality and the Accuracy of Management Earnings Forecasts*

In this study, we appeal to insights and results from Davidson and Neu 1993 and McConomy 1998 to motivate empirical analyses designed to gain a better understanding of the relationship between auditor quality and forecast accuracy. We extend and refine Davidson and Neu's analysis of this relationship by introducing additional controls for business risk and by considering data from two distinct time periods: one in which the audit firm's responsibility respecting the earnings forecast was to provide review‐level assurance, and one in which its responsibility was to provide audit‐level assurance. Our sample data consist of Toronto Stock Exchange (TSE) initial public offerings (IPOs). The earnings forecast we consider is the one‐year‐ahead management earnings forecast included in the IPO offering prospectus. The results suggest that after the additional controls for business risk are introduced, the relationship between forecast accuracy and auditor quality for the review‐level assurance period is no longer significant. The results also indicate that the shift in regimes alters the fundamental nature of the relationship. Using data from the audit‐level assurance regime, we find a negative and significant relationship between forecast accuracy and auditor quality (i.e., we find Big 6 auditors to be associated with smaller absolute forecast errors than non‐Big 6 auditors), and further, that the difference in the relationship between the two regimes is statistically significant.     

Are Investors Misled by “Pro Forma” Earnings?*

This paper uses stock market data to investigate the popular claim that investors are misled by the “pro forma” earnings numbers conspicuously featured in the press releases of some U.S. firms. We first document the frequency and magnitude of pro forma earnings in press releases issued during June through August 2000, and describe the 433 firms that engaged in this financial disclosure strategy. Our test period predates public expressions of concern by trade associations and regulators that pro forma earnings may mislead investors and the subsequent issuance of guidelines and rules on the disclosure of pro forma earnings numbers. We use two complementary approaches to determine whether the share prices that investors assign to pro forma firms are systematically higher than the prices assigned to other firms. Our market‐multiples tests for differences in price levels find some evidence suggesting that pro forma firms may be priced higher than firms that do not use the disclosure strategy. This apparent overpricing is not, however, related to the pro forma earnings numbers themselves. Our narrow‐window stock returns tests reveal no evidence of a stock return premium for pro forma firms at the quarterly earnings announcement date. Collectively, the results cast doubt on the notion that investors are, on average, misled by pro forma earnings disclosures despite the widespread concern expressed in the financial press and by regulators.     

The Link between Earnings Conservatism and the Price‐to‐Book Ratio*

We hypothesize and find that (1) earnings conservatism, the tendency of firms to recognize bad news in earnings on a more timely basis than good news, is substantially greater in portfolios of firms with lower price‐to‐book ratios than in portfolios of firms with higher price‐to‐book ratios; and (2) the negative association between earnings conservatism and the price‐to‐book ratio stems primarily from the accrual component of earnings, not the operating cash flow component of earnings. Our results suggest that studies using earnings‐returns associations to investigate cross‐sectional or time‐series differences in earnings conservatism risk drawing erroneous inferences unless the research designs control for cross‐sectional or time‐series variation in price‐to‐book ratios.     

The Association between Changes in Interest Rates,Earnings, and Equity Values*

Numerous studies have documented that stock returns are negatively related to changes in interest rates, but there has been little corroborating research on the information in interest‐rate changes about the fundamentals that the stock market prices. The negative correlation is often attributed to changes in the discount rate, a denominator effect in a valuation model. However, there may also be a numerator effect on the expected payoffs that are discounted. This paper shows that changes in interest rates are positively related to subsequent earnings, but the change in earnings is typically not large enough to cover the change in the required return. Hence, the net (numerator and denominator) effect on equity value is negative, consistent with the results of the research on interest rates and stock returns.     

The Effect of Limited Liability on the Informativeness of Earnings: Evidence from the Stock and Bond Markets*

Previous empirical research on the informativeness of earnings has focused on stockholders, and has not examined differences in earnings' informativeness for stockholders and bondholders. Because stockholders are residual claimants and bondholders are fixed claimants, the informativeness of earnings should differ for these two types of investors. When a firm's default risk is low, changes in its financial condition should be of limited relevance to bondholders, but should be relevant to stockholders. In contrast, as the likelihood of financial distress increases, stockholders' limited liability allows them to abandon the firm to the bondholders (Fischer and Verrecchia 1997). Accordingly, as a firm's default risk increases, changes in its financial condition should be increasingly important to bondholders and less important to shareholders. Because earnings provide information on firm value, the stock return-earnings association should decrease as the firm's financial strength declines, while the bond return-earnings association should increase. We use two measures of a firm's financial strength: the firm's bond rating and its reporting of a loss. Consistent with our hypotheses, we find that the association between stock returns and changes in annual earnings decreases as bond ratings decline, while the association between bond returns and changes in annual earnings increases. These results suggest that as the company's financial condition deteriorates, earnings become less relevant for stock valuation and more relevant for bond valuation. When we partition firms based on their loss status, we find a stronger association between stock returns and annual earnings changes for firms with positive earnings (profit firms) than for firms with losses, consistent with earlier studies. In contrast, we find that the association between bond returns and earnings changes is greater for loss firms than for profit firms. These results suggest that losses reduce the informativeness of earnings for stockholders but increase informativeness for bondholders, suggesting that investors view losses as indicating increased credit risk.     

Earnings Management to Avoid Losses and Earnings Decreases: Are Analysts Fooled?*

This paper explores whether analyst forecasts impound the earnings management to avoid losses and small earnings decreases documented in Burgstahler and Dichev 1997, whether analysts are able to identify which specific firms engage in such earnings management, and the implications for significant forecast error anomalies at zero earnings and zero forecast earnings. We use data from Zacks Investment Research 1999 and find that analysts anticipate earnings management to avoid small losses and small earnings decreases. Further, analysts are much more likely to forecast zero earnings than firms are to realize zero earnings, and analysts are unable to consistently identify the specific firms that engage in earnings management to avoid small losses. This latter inability contributes to significant forecast pessimism associated with zero reported earnings and significant forecast optimism associated with zero earnings forecasts.     

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.     

Earnings Non‐Synchronicity and Voluntary Disclosure

Earnings non‐synchronicity reflects the extent to which firm‐specific factors determine a firm's earnings. Prior research suggests that high earnings non‐synchronicity impedes corporate outsiders' ability to process information. This study examines the impact of earnings non‐synchronicity on managers' decisions to provide earnings forecasts. We propose that high earnings non‐synchronicity motivates managers to issue earnings forecasts to reduce information asymmetry between managers and investors and to preempt costly information acquisition by outsiders. Consistently, we find a positive relation between earnings non‐synchronicity and managers' propensity to issue earnings forecasts, particularly long‐horizon forecasts. This positive relation is weaker when earnings are easier to predict based on the firm's earnings history and is stronger when the firm has higher institutional ownership and greater analyst following. We also find that the market's reaction to management forecasts increases with earnings non‐synchronicity. Overall, the evidence suggests that managers voluntarily provide earnings forecasts to alleviate the adverse consequences of earnings non‐synchronicity. These findings provide a more complete picture about the impact of earnings non‐synchronicity on a firm's information environment, and highlight the effect of the nature of information asymmetry on voluntary disclosures.