Cost Management and Strings of Increasing Earnings

Abstract

Barth et al. (1999) document that firms sustaining a string of increasing earnings have higher price-earnings ratios and Myers et al. (2007) find such firms receive higher abnormal stock market returns during the string periods compared to firms not exhibiting this earnings pattern. The primary objective of the current study is to improve our understanding of how firms can maintain a consecutive string of increasing earnings. Most firms that have a string on increasing earnings do so by increasing revenues (Ghosh et al., 2005). Firms that maintain a string of earnings during periods of decreasing revenues must effectively manage costs to decrease their expenses sufficiently to increase earnings during those periods. Prior literature does not provide insights into the characteristics of firms and their market environments that allow them to maintain a string of consecutive earnings over periods that include both increasing and decreasing revenues. This paper contributes to filling that gap in the literature using large data and shows that cost flexibility is an important factor associated with a firm that can maintain a string of increasing earnings and finds that demand uncertainty for a firm’s products is inversely related to a firm’s ability to maintain a string of increasing earnings. In addition, an examination of the asymmetric cost behavior of the firms that experience at least one sales decrease during a consecutive string of increasing earnings indicates that these firms are associated with anti-sticky cost behavior during the string periods and exhibit sticky costs when the string ends.