Earnings Increases as a Type-Revealing Signal

Abstract

While increases in earnings are common, we identify a setting in which they signal a separating equilibrium. Firms that “defy gravity’ (DG) by reporting increases in earnings despite experiencing a decline in sales from continuing operations, signal their viability as a going- concern, and achieve separation from other firms with decreasing sales. We find that DG signals higher future earnings, cash flows, and one-year-ahead stock returns. More importantly, we find that the DG signal is more credible when more costly to produce: DG firms subsequently perform better when (1) they are ex ante in poorer financial health, (2) the magnitude of the earnings shortfall is larger (they have higher downward cost rigidity), (3) they pass up the opportunity of taking a ‘big bath’ in times of crisis (years where declines in earnings can be blamed on economy-wide shocks), and (4) when they have less flexibility to manage earnings upwards. Finally, because some degree of pooling remains within DG firms, we show that the DG signal is more credible when it is produced contemporaneously with abnormal CEO buying. To our knowledge, this study is the first to provide empirical evidence that earnings increases that are more costly to achieve are more credible signals of future performance.