Earnings Signals Research Articles

Earnings benchmarks, earnings management and future stock performance of Chinese listed companies reporting under ASBE-IFRS

Purpose Prior literature has revealed three key earnings benchmarks: earnings level; earnings change; and analysts’ expectations. The purpose of this paper is twofold. First, the authors seek to establish which earnings benchmark induces the largest extent of earnings management. Second, the authors explore the implications of earnings management on firm future performance. Both of these purposes are investigated for Chinese listed companies during China’s IFRS/ISA reporting era. Design/methodology/approach The authors rely upon the unique regulations and incentives for Chinese listed companies in order to develop four testable hypotheses. Next, the authors employ both logistic and ordinary least squares regressions to test the hypotheses. Findings The results suggest that Chinese listed firms have the highest level of income increasing discretionary accruals around the earnings level benchmark, followed by the earnings change benchmark. The authors do not find any evidence of earnings management to beat analysts’ expectation. In addition, the authors find evidence that Chinese listed firms with relatively high level of earnings management and low earnings exhibit relatively weak future stock performance. Originality/value The findings are the first to document an earnings management benchmark hierarchy with respect to the extent of income increasing discretionary accruals, while simultaneously establishing a link between earnings management and firm future stock performance, for Chinese listed companies. The findings are valuable for regulators and investors by suggesting that management intervention in the reporting process during China’s IFRS/ISA reporting era may act to circumvent delisting regulations and cloud earnings signal for firms that beat certain earnings benchmarks.

Another Look at the Macroeconomic Information Content of Aggregate Earnings: Evidence from the Labor Market

We examine the macroeconomic information content of aggregate earnings from the labor market’s perspective. We use insights from the labor economics literature to characterize the information contained in aggregate GAAP earnings and its components that is relevant for predicting aggregate job creation and destruction. Our results suggest that not only does aggregate earnings news convey information about future labor market aggregates, but its information content is incremental to other macroeconomic variables at near-term horizons. Further, the source of this information stems primarily from two earnings components: aggregate core earnings and special items. Shocks to core earnings signal persistent changes in economy-wide profitability that predict aggregate job creation up to four quarters ahead, while shocks to special items predict job destruction up to one quarter. Taken together, our results suggest that aggregate earnings contain useful information about future labor market conditions, with the nature of such information varying across earnings components.

Ownership concentration, earnings management and stock market liquidity: evidence from Malaysia

PurposeThis paper aims to examine whether ownership concentration and earnings management affect the stock market liquidity of Malaysian firms.Design/methodology/approachThis study uses a sample of 2,020 yearly firm observations in Bursa Malaysia over the period 2009-2012. The ordinary least square regression is used to examine the relationships. The study undertakes a sensitivity test by regressing the main study variables by using different measurements. Another robustness test is then used, where a regression based on the change in variables and a one-year lag of the independent variables are used. Furthermore, to alleviate the concern of possible endogeneity, the simultaneity and reverse causality are checked using the lag of the dependent variable, fixed effect regression, two-stage least squares using the instrumental variables and the generalized method of moments using instrumental variables analysis.FindingsThe study finds that firms with a high level of ownership concentration have discrepancies in information between informed and uninformed traders, which impair the stock market liquidity. In addition, this study finds that firms with high earnings management experience greater liquidity. A possible explanation for this is that firms might manage earnings to convey private information to enhance the information content of the earnings. Overall, the evidence suggests that manipulating earnings signals information informatively, particularly in a country with a higher level of ownership concentration and a higher likelihood of expropriating minority shareholders.Originality/valueThis study enriches the limited empirical research devoted to the impact of earnings management and ownership concentration on stock market liquidity especially in the context of emerging economies. The findings of this study are robust to alternative liquidity measurements, to alternative estimation methods, and to endogeneity bias.

Differences in Prior Beliefs, Differential Interpretation, and the Consensus Effect of Quarterly Earnings Signals and Trading Volume

Models of financial economists including Karpoff, Varian, Holthausen and Verrecchia, and Dontoh and Ronen have demonstrated that there are three distinct fundamental determinants of trading volume reaction to new information releases: first, the extent of differences in investors’ prior beliefs; second, differences in their interpretations of the information; and third, the level of consensus that the information release induces among them. Although these effects are well understood theoretically, empirical studies that investigate trading volume reaction to the arrival of new information have tended to combine these three fundamental determinants, thereby masking their distinct incremental effects on trade. In this article, we examine all three potential sources of trade in response to information: heterogeneous prior beliefs, differential interpretation, and the consensus effect of the news. We find that all three of these effects have a distinct incremental impact on trading volume, thereby corroborating the theoretical models of financial economists.

A Qualitative Assessment of GE's Performance Prospects

In this article the author discusses the final elements of GE's reorganization plan to produce a stronger, streamlined industrial giant that has shed an increasingly burdensome finance arm. The simplest assessment is that the full benefits of the reorganization may take time to emerge as the after‐effects of divestitures linger and acquisitions take time to close and digest. New risks come with the reorganization; and the reorganization and the new business model is exposed to several layers of new regulations. The final result may not deliver as clear an industrial earnings signal as first expected. The plan may not be executed as cleanly as expected, making that signal noisy. © 2016 Wiley Periodicals, Inc.

Inconsistent Signals, Earnings Announcements and Market Uncertainty

We test the proposition in Johnstone (2016) that new information may lead to higher, rather than lower, uncertainty about firms’ future payoffs. Based on the Bayesian rule, we hypothesize earnings news that is inconsistent with investors’ prior belief will lead to higher market uncertainty. Using earnings signals in the past eight quarters to proxy for investors’ prior belief, we find supporting evidence that, relative to consistent earnings news, inconsistent news increases market uncertainty measured by implied volatility. Inconsistent earnings news has a larger effect on market uncertainty when prior beliefs are stronger, when the news is negative, and when firms have a better information environment. Overall, our evidence highlights the importance of prior belief and inconsistent signals in understanding the effect of earnings news on market uncertainty.

Analysts’ and Investors’ Reactions to Consistent Earnings Signals

AbstractWe investigate (1) whether the trajectory of the current‐quarter earnings expectation path (defined by the signs of the forecast revision and the earnings surprise) provides information about future firm performance, and (2) the extent to which analysts and investors react to that information. Our results indicate that analysts underreact more to earnings information revealed by consistent‐signal earnings expectation paths than to earnings information communicated by inconsistent‐signal expectation paths. We also find that the current earnings expectation path provides incremental explanatory power for future abnormal returns, even after controlling for the sign and magnitude of the earnings surprise. Overall, our evidence is consistent with underreaction stemming from analysts’ and investors’ bias in processing the information in consistent‐signal earnings expectation paths.

Do changes in gross margin percentage provide complementary information to revenue and earnings surprises?

Purpose – The purpose of this paper is to investigate the association between gross profit percentage, abnormal market returns, revenue surprises and earnings surprises. Gross margin is relied upon by various market participants, as its predictive power is incremental and distinct from revenue and earnings signals; however, gross margin has received little researcher attention. Design/methodology/approach – General regression specifications found in the prior literature are extended to assess the informational content of changes in gross margin percentage. In addition, various portfolios are created based around the nature of the signals (positive or negative), provided by each income statement metrics (revenue, gross margin and earnings). A sample of 5,582 quarterly observations of S & P 500 firms is compiled. The main regressions are exposed to three robustness tests that focus on industry sub-groupings, institutional ownership and fourth-quarter observations. Findings – The main findings reveal that gross margin percentage changes and earnings surprises are significantly related to abnormal market returns in the short window around the earnings announcement date and persist into a wider window measured as the quarter after the earnings announcement date. The relationship between gross margin percentage changes and abnormal returns is more pronounced when positive (negative) changes in gross margin percentage are accompanied by positive (negative) revenue and earnings surprises. Research limitations/implications – This study relies upon S & P 500 firms which are all relatively large firms. Therefore, the results may not be generalizable to smaller firms. In addition, the gross margin change is measured as the quarter-over-quarter percentage change because there is no analyst expectation for gross margin. Originality/value – This paper extends the prior literature by developing three testable hypotheses that investigate the linkages between abnormal market returns, gross margin and revenue and earnings surprises. This is the first known study to investigate the informational content of changes in gross margin percentage.

Post Earnings Announcement Drift, a Price Signal?

This paper investigates the robustness of post-earnings-announcement-drift (PEAD) on a price signal perspective, unlike the traditional literature that focuses on fundamental signal. The studied period is 2003-2015, for four main US indices. The results suggest that some economic agents are too slow to integrate the information, although they still have a major market impact. We find a strong empirical evidence of the preeminence of this bias for Momentum stocks rather than blue-chips or non-Momentum small-caps. Even by challenging the strategy, the conclusion remains strong with abnormal returns linked to such market inefficiency, with better returns for positive signals than negative ones. We choose Nasdaq Composite as the backbone of our development as it is the closest index to Uncia’s field of expertise. For indices known as Momentum, we find strong predictability of the systematic net exposure, the latter being a consequence of the long and short positions implied by the earnings signals.

The Informedness Effect and Volume of Trade

Theoretical models of trade show that information-based trading is a consequence of four fundamental determinants: heterogeneous prior beliefs, differential interpretations, the consensus effect, and the informedness effect. Although the effects of these determinants on trading volume are clear theoretically, there is no prior empirical evidence on the relation between the informedness effect and the volume of trade, nor is there any empirical evidence on the incremental effect of each of the four determinants on the volume of trade. This study provides empirical evidence to fill this void. Consistent with theoretical predictions in Holthausen and Verrecchia, we find a significantly positive relation between the informedness effect and trading volume reactions to quarterly earnings announcements. We also find that the proxies for each of the four fundamental determinants of trading volume—prior belief heterogeneity, differential interpretation, the consensus effect, and the informedness effect of quarterly earnings signals—play a significant incremental role in explaining trading volume, thereby corroborating the theoretical results of financial economists. An important implication of our results is that empirical models of trade should consider controlling for each of these determinants.

Monthly Employment Reports and the Pricing of Firm-Level Earnings News

I use the monthly release of the Employment Situation by the Bureau of Labor Statistics to examine the impact of macroeconomic uncertainty on the pricing of firm-level earnings news. Uncertainty about employment conditions is high the day before the employment report is released and is resolved just after the release of the report. I find a muted initial response to earnings announcements made the day before the employment report. This effect is stronger when ex-ante uncertainty about the contents of the employment report is high. The muted initial response is followed by a stronger-than-usual earnings-return relation measured two days after the earnings announcement, or the day after the release of the employment report. These results are consistent with investors applying less weight to earnings signals when there is high uncertainty about macroeconomic conditions, and increasing the weight applied to these signals after the resolution of macroeconomic uncertainty. Additional results show that earnings announcements made on employment-report Fridays have a muted initial market response followed by greater-than-usual post-earnings-announcement drift, and that the proportion of bad news earnings announcements (negative unexpected earnings) is significantly higher on employment-report Fridays than on other days, including other Fridays.

The signalling effect of dividends in Pakistan: executive and analyst perspectives

PurposeThe purpose of this paper is to investigate the views of company executives and investors regarding the signalling impact of dividends in Pakistan. Quantitative research in the area has been scant, but recent large sample evidence suggests a number of noteworthy idiosyncrasies exist in terms of the market reaction and these require further analysis.Design/methodology/approachThe study involves interviews with 16 financial analysts and 23 company officials regarding the impact of dividends on share prices in Pakistan. Recent work in the nation suggests that the market reaction to dividends in Pakistan is characterised by pre‐announcement leakage and interaction with the attendant earnings signal – these issues were thus central to the discussions.FindingsThe results suggest that individual perceptions both support and contradict the earlier quantitative findings in specific ways. The interviewees, particularly the company executives, were sceptical about the scope for information leakage to occur in Pakistan. In contrast, the interaction between earnings and dividend numbers was acknowledged, with – as in the earlier quantitative studies – the former figure dominating.Originality/valueThis is the first detailed study of perspectives about the impact of dividends on share prices in Pakistan; for reasons outlined above, this represents a major gap in the literature regarding firm‐market communication. The work follows the publication of the first large‐sample study of share price movements in Pakistan; it thereby allows a pervasive conclusion to be drawn about the over‐riding importance of earnings figures in the nation's markets and in the attitudes of the firms listed on them. The study demonstrates the importance of mixed methods research in a developing market context.

Disclosures of Insider Purchases and the Valuation Implications of Past Earnings Signals

ABSTRACTThis study examines whether disclosures of insider equity purchases on Securities and Exchange Commission (SEC) Form 4 resolve uncertainty regarding the valuation implications of reported earnings. Defining information uncertainty as ambiguity about firm value arising from low earnings precision, I predict and find that insider purchase filings trigger more positive market reactions in firms with greater information uncertainty (lower quality accruals). After controlling for future earnings changes, I further find that market reactions to purchase filings are predictably associated with prior earnings changes. The strength of this effect is increasing in the magnitude of insider purchases, as well as the level of information uncertainty. Overall, these findings suggest that, in addition to signaling future earnings information, Form 4 purchase filings help investors learn about the valuation implications of past earnings signals.Data Availability: All data are available from public sources.

Who, if Anyone, Reacts to Accrual Information?

We show that the vast majority of investors ignore value-relevant accruals information when it is first released, but that investors who initiate trades of at least 5,000 shares tend to transact in the proper direction. These investors trade on accruals information only when the previously-announced earnings signal is non-negative. Unconditionally, those investors initiating the smallest trades appear to respond to accruals in the wrong direction, but further investigation suggests this behavior is explained by their attraction to attention-grabbing stocks. Finally, we find that those who trade on accruals information have insufficient market power to mitigate the accruals anomaly.

Who, if anyone, reacts to accrual information?

We show that the vast majority of investors ignore value-relevant accruals information when it is first released, but that investors who initiate trades of at least 5,000 shares tend to transact in the proper direction. These investors trade on accruals information only when the previously-announced earnings signal is non-negative. Unconditionally, those investors initiating the smallest trades appear to respond to accruals in the wrong direction, but further investigation suggests this behavior is explained by their attraction to attention-grabbing stocks. Finally, we find that those who trade on accruals information have insufficient market power to mitigate the accruals anomaly.

Does Regulation Fair Disclosure affect analysts’ forecast performance? The case of restructuring firms

The main purpose of this paper is to investigate how the enactment of Regulation Fair Disclosure (Reg. FD) influences analysts’ forecast characteristics for restructuring firms. The Reg. FD requires all firms disseminate material information not only to some institutional investors and certain financial analysts, but to all market participants simultaneously. We expect that the regulatory effect of Reg. FD on financial analysts’ forecast performance would be pronounced because of uncertain earnings signals and information complexity produced by restructuring activities. Particularly, we examine how the enactment of Reg. FD affects the relationship between analysts’ earnings forecast attributes and the occurrence and magnitude of restructuring charges. Our general finding is that analysts’ forecast errors and forecast dispersion have declined in the post-FD period for restructuring firms. However, such an impact cannot be persistent with an increase in the relative magnitude of restructuring charges, the proxy for restructuring complexity. This study provides additional evidence that Reg. FD has limited private information, and attempts to provide all users with the same access to information within the context of firms reporting restructuring charges.

Market Reaction to an Earnings Shock: A Test of the Conservatism Effect

In this paper, I empirically test the conservatism effect of Barberis, Shleifer and Vishny (1998). Conditioning on a shock to quarterly earnings, firms ranking in the top (bottom) earnings shock quintile exhibit substantial price momentum over the next three-month periods following the initial earnings shock. In the subsequent quarter, firms reporting earnings performance that maintain their ranking positions in the highest (lowest) earnings quintile exhibit a marginal incremental price run above that of the initial earnings signal. However, firms that fail to keep (succeed at moving out of) their ranking positions in the highest (lowest) earnings quintile experience a strong price reversal. These findings are robust to the four-factor regression (the Fama-French three-factor model extended by the momentum factor) and various robustness tests. Evidence reported in this paper is not consistent with the view that investors underreact to a recent earnings change. Rather, the evidence points to a market that systematically overreacts to extreme earnings news.

Information Uncertainty and the Post-Earnings-Announcement Drift Anomaly: Insights from REITs

This is the first study to examine the post-earnings-announcement drift anomaly in a Real Estate Investment Trust (REIT) context. The efficient markets hypothesis suggests that unexpected earnings should be fully incorporated into asset prices soon after being publicly announced. We hypothesize that publicly announced earnings signals may be more certain for REITs due to the presence of a parallel (private) asset market, suggesting less drift for REIT stocks. However, we find a large REIT drift component that is both statistically and economically significant. Furthermore, while the initial earnings surprise response is more muted for REITs, we find that the magnitude of the drift is significantly larger for REITs than for ordinary common stocks (NonREITs). Thus, information does not appear to move between the private and public asset markets in such a way as to render REIT earnings signals more certain than NonREIT earnings signals.

It’s All Overreaction: Earning Momentum to Value/Growth

In this paper, I examine whether consistent quarterly earnings signals generate momentum and subsequent return reversals. Conditioning on growth consistency in quarterly earnings, I show that an unbroken earnings string creates a strong financial momentum that peaks at the end of the first three months following the ranking period and then reverses over the next nine-month period. By the end of the first twelve months, this momentum has been completely dissipated. The magnitude of this price continuation and subsequent reversal are more pronounced for consistent high (low) growth firms than inconsistent good (bad) performers. This evidence shows securities markets in which stock prices systematically overreact to consistent earnings signals. As well, my finding suggests that the earning momentum and the value/glamour effect are likely to be empirically linked. These results are robust to the Fama-French three-factor model and the momentum factor as well as to earnings surprise effects and various robustness tests. Evidence reported in this study is consistent with the spirit of the behavioral models.

The Value of Long-Term Accrual Management

In this paper, we examine both value-enhancing and value-detrimental effects of smooth earnings on forward-looking value proxies of future returns from one-month to five-year horizons. Some prior studies, on one hand, find that smoothed earnings signal superior performance, enhancing thereby firm value; some others, on the other hand, argue that smooth earnings achieved through managerial intervention are noisy. We capture the potentially harmful long-term managerial intervention aspects of earnings smoothing by multi-period accruals volatility that increases with smooth earnings. Consistent with previous literature, we treat the correlation (“correlation”) between cash flows and accrual as the value enhancing aspect of earnings smoothing. In multivariate regressions that control for a battery of risk factors, future returns are positively related to earnings smoothing of the correlation variable but negatively associated with accrual volatility. Moreover, economic significance tests performed in this paper show that the value detrimental effects of accrual volatility completely wipe out future returns increases associated with any increase in correlations. These results are particularly pronounced in discretionary accruals and in firms with high information asymmetry and underlying operating uncertainty. The evidence suggests that due to its large accrual volatility effect, excessive long-term accrual management, whether voluntary or involuntary, is valuedetrimental.