#2958 - Stream 1 Reading Does The Stock Market See A Zero Or Small Positive Earnings Surprise As A Red Flag - Financial Accounting, Analysis and Valuation

Prior studies show that firms manipulate earnings and/or analyst expectations to avoid missing analyst forecasts (e.g. Degeorge et al. 1990)

• Levitt (1998) called this the “numbers game”

Akerlof’s (1970) analysis of a market with information asymmetry suggests that investors are not naïve

• If potential buyers cannot distinguish good used cars from bad ones, Akerlof (1970) shows, the prices they will pay for all used cars are lower than what good used cars are worth

Analysis suggests that an increasing incidence of firms managing earnings and/or analyst expectations will induce investors to discount not only the shares of firms that are confirmed manipulators, but also those of firms that are mere “suspects”

Rising trend in the number of firms meeting or narrowly beating analyst earnings forecasts relative to the number of firms narrowly missing the forecasts in the period 1992-2006

• Suggests a rising prevalence of firms playing the numbers game

Earnings Response Coefficient (ERC)

Results suggest that investor’s scepticism toward zero or small positive earnings surprises is a fairly recent event

• Its development over time was induced by the rising tide of firms playing the numbers game

• Also suggests that investors see a zero or small positive earnings surprise as a red flag in and of itself in 2000s

There is also evidence that investors and analysts are sceptical about firms that narrowly avoid quarterly losses or quarterly earnings declines throughout the same period

Results suggest that investors and analysts associate certain firms with manipulation even in the absence of hard evidence

Brown and Caylor (2005) show that the number of firms reporting a small negative earnings surprise declined in the period 1985-2002, suggesting a rising prevalence of firms playing the numbers game

Calculated a manipulation index for each year in the period

Clear upward trend, suggesting a rising incidence of manipulation to avoid negative surprises

Investors are likely to have grown sceptical about how firms “make the numbers” especially those that report a zero or small positive earnings surprise

• We therefore expect investors to reward firms that report such an earnings surprise less generously now than before

• Sensing a dwindling reward to a zero or small positive earnings surprise, manipulating firms would either increase the extent of manipulation to engineer larger positive earnings surprises if the cost of doing so is not unjustifiably high

• Or quit the numbers game altogether

Therefore there will be a gradual decline over time in the number of firms reporting a zero or small positive earnings surprises

Evidence that the “correction” has already begun

Investors perceive moderate earnings surprises to be more sustainable

Beaver, Nichols, and Nelson (2007) argue, however, that the empirical finding may be explained by accounting conservatism and a difference in tax treatment between profits and losses

Skinner and Sloan (2002) show that abnormal returns to negative earnings surprises are more negative for growth stocks than for value stocks

• Suggests high growth firms are more likely to manage earnings and/or analyst expectations to avoid negative earnings surprises, and that investors should be more sceptical about zero and small positive earnings surprises reported by such firms

Results are consistent with Skinner and Sloan (2002)

Subsets of investors may view small positive or zero earnings surprises differently

Copeland and Galai (1983) and...